What is the relationship between economic and accounting profit? Economic profit is equal to accounting profit. Economic profit is greater than accounting profit. Economic profit is less than accounting profit. Economic profit may be equal to or less than accounting profit. Economic profit may be equal to or greater than accounting profit.
The Correct Answer and Explanation is:
The correct answer is: Economic profit may be equal to or less than accounting profit.
Explanation:
The key difference between economic profit and accounting profit lies in how costs are measured. Both are concepts used to evaluate business performance, but they differ in their treatment of certain costs.
- Accounting Profit:
- Accounting profit is calculated as the difference between a firm’s total revenue and its explicit costs (also known as accounting costs), which include wages, rent, raw materials, and other out-of-pocket expenses.
- It is the profit that is reported on the financial statements and used for tax purposes.
- Formula: Accounting Profit=Total Revenue−Explicit Costs\text{Accounting Profit} = \text{Total Revenue} – \text{Explicit Costs}Accounting Profit=Total Revenue−Explicit Costs
- Economic Profit:
- Economic profit takes a broader view by considering both explicit costs (as in accounting profit) and implicit costs (also called opportunity costs). Implicit costs represent the opportunity cost of using resources in one way rather than in their next best alternative use. These could include forgone wages, potential interest, or profits from alternative ventures.
- Economic profit provides a more comprehensive measure of a firm’s performance, as it accounts for all costs associated with a business decision, not just the direct, monetary outlays.
- Formula: Economic Profit=Total Revenue−(Explicit Costs+Implicit Costs)\text{Economic Profit} = \text{Total Revenue} – \left(\text{Explicit Costs} + \text{Implicit Costs}\right)Economic Profit=Total Revenue−(Explicit Costs+Implicit Costs)
Relationship:
- Since economic profit includes implicit costs, it is usually less than or equal to accounting profit. This is because accounting profit only subtracts explicit costs, while economic profit subtracts both explicit and implicit costs.
- If a firm has no implicit costs, then economic profit will be equal to accounting profit. However, in most cases, businesses do have implicit costs, which reduce the economic profit compared to accounting profit.
Thus, economic profit may be equal to or less than accounting profit depending on the implicit costs involved.
