Sample Problem: Economic Profits

Kirsten is earning $40,000 per year as a stylist in Sally’s Salon. She has worked hard to save $60,000 and is currently earning 5% annual interest on her savings account. She decides to quit her job at Sally’s Salon and uses her savings to open her own hair salon. In the first year of ownership, her salon earns revenues of $200,000 and has explicit costs of $157,000. What is Kirsten’s profit (or loss) in the first year?

Economic profit is the total revenues minus total opportunity costs of all inputs used, or the total of all implicit and explicit costs.

For this example we know the following for the first year:

Revenue = $200,000

Explicit costs = $157,000

The implicit costs include Kirsten’s foregone salary from giving up her previous job of $40,000 for the year and lost interest from invested savings ($60,000 saved * 5% annual interest so the interest forgone for the year is $3,000)

Economic profit = Revenues – explicit costs – implicit costs

Economic profit = $200,000 – 157,000 – 40,000 – 3,000 = $0

Kirsten’s economic profit is $0. Note that earning an economic profit of $0 means:

1. The owner made an accounting profit. This is because an accounting profit is greater than the economic profit because the same explicit costs are subtracted from revenue, but accounting cost does not also subtract the implicit costs.

2. The owner could not have made a greater profit in some other line of work. If they could the implicit cost of the forgone salary in another line of work would cause the economic profit to be negative.

3. The owner did not lose money; the economic profit would have to be negative in order for the owner to lose money.

4. An economic profit of $0 is the normal rate of profit for firms in this industry.