If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
CBA‑2 (EU)
CBA‑2.C (LO)
CBA‑2.C.1 (EK)
CBA‑2.C.2 (EK)

Video transcript

Background voice: Let's say this past year I started a restaurant and I want to think about what type of a profit I've been making at that restaurant. We're going to think about it in 2 different ways. We're going to think about it in terms of an accounting profit, which is really the type of profit that most of us associate with a business or a firm. We're also going to think about it in terms of economic profit, which we'll see is a little bit different. Instead of telling us whether a business is producing income, it tells us whether it makes sense to even run the business in the way that we're actually running it. First, let's focus on the traditional way of calculating profit. Let's say my firm, my restaurant, (my firm in a restaurant) in year 1 it brings in, in revenue, it brings in $500,000. Revenue literally is the amount of money the customers pay me to eat at the restaurant. They are paying for their dinners. This is literally the money that's coming in the door. Sometimes people call it the top line, because it's literally the top line of our income statement. I just wrote it. It's the top line. Now we have to think about our expenses. Expenses. Now, when you're running a restaurant one of the obvious expenses is going to be the cost of food. Food, we're going to say cost us $100,000. $100,000. Then, you have the cost of labor. I have the wait staff. I have the chefs and the bus boy. On all of those people, in this past year, I spent $100,000. Then, I have, and I am going to assume that I don't own the building, that I rent the building. So, building rent. I'm assuming this is on the building, let's say that that was $200,000. Then finally, I really just rented everything. I also rented the equipment, all of the stoves, the fridges, all of that stuff. None of this is stuff that I own, so the equipment rent. Equipment rent, I spent another $50,000. How much profit do I have here? Those are all of my expenses. I didn't borrow any money, so I didn't have any interest expense or anything like that. How much profit do I have before paying tax, or essentially my pretax profit? The reason why we think of it in those terms is because the amount you pay in tax is usually derived from your pretax profit. That depends on where this business is, what country, what state, what type of business it is. The easy way to calculate pretax profit, pretax profit. This is pretax and we're thinking in terms of accounting profit right over here. We take how much money comes through the door and then we just have to subtract out all of the payments we essentially have to make to other people. What we have left is out pretax profit. 500,000 minus 450,000 gives us a pretax profit (I'll do it in that same bright yellow) of $50,000. I'm assuming that I'm the only owner of this business, so I can essentially take it all out for myself. Maybe help pay my own personal rent or whatever else, or I could take some of this or all of this and reinvest it back into the business. Maybe I start buying my equipment or I expand in some way. Who knows what I might do with that money. This is just traditional accounting profit. This is how profit is calculated. Although, this is a super simple example. In the future I would like to do more nuanced examples in the accounting world. This, you would refer to as just accounting profit. Accounting profit. When people in the everyday world talk about profit, this is normally what they're talking about. Now, when economist talk about profit, they're talking about something slightly different. The best way to realize that is to just calculate economic profit for this exact same business, or this firm, as a economist would call it. A firm really is a general idea for an organization that is trying to maximize profit. Once again, it's year 1. Actually let me just copy and paste it. It's year 1, that's our revenue. I'm going to copy and I'm going to paste it. This right over here. So far, so good. Looks pretty similar. Now, we're going to think about things in a slightly different way. Economist view cost in terms of opportunity cost. As we'll see, some of the opportunity cost you can measure in terms of dollars. Some are less explicit. I'm going to write here, just so we can get in the economist frame of mind, opportunity cost. Within opportunity cost there are going to be explicit opportunity cost and implicit opportunity cost. First, let's do the explicit. Explicit opportunity cost. Actually, all of these are explicit opportunity cost. Let me just copy and paste that. I will copy and paste. All of these are explicit opportunity cost. The reason why they are explicit is I'm actually making up ... I'm paying money for all of these things. Even the equipment and the rent of the apartment, I don't own it. I'm actually paying whoever does own it. These are direct outlays out of the business. I'm explicitly making these payments. The reason why we can think of them as opportunity cost, even though they're given in dollar terms, is that if I was spending $100,000 on food, that's $100,000 that I couldn't spend on something else. If I'm spending $100,000 on labor, that's $100,000 that I couldn't spend on something else. I'm just measuring the opportunity cost in terms of dollars, but dollars that I could have spent on other things. So far, it looks pretty much identical. I'm just viewing it with a slightly different lens. You're like, "Well, what's the big deal here?" We're going to see a little bit of divergence when we start thinking about the implicit cost that really weren't taken into account here, the implicit opportunity cost especially. Implicit cost. If I am running this business and let's say, in order to run it I actually had to focus on it full time. I couldn't have actually quit my job. Then, there's an implicit cost of … An implicit opportunity cost of the job that I gave up, or my wages foregone. Let me write this down, wages foregone. Let's say, and this will depend on who we're talking about. Let's say I was a doctor and I was making a nice steady, risk free $150,000 a year. I was giving up $150,000 a year. Now, we've listed all of the explicit and the implicit opportunity cost. Now we're ready to calculate our economic profit. Let me draw a line over here. Our economic profit is going to be our revenue that we're taking in, minus all of these expenses. That gives us a positive $50,000. Now, we have to subtract the wages foregone. Then, I get to negative $150,000. This is interesting. This is kind of a big discrepancy here. In accounting terms, I'm profitable. In economic terms, I'm not profitable. The important thing to realize is economic profit, when it's negative, isn't saying, or you say that you have $100,000 economic loss, or an economic profit of negative $100,000. This isn't saying that the business or the firm isn't spinning out money. What it is saying, is it probably doesn't make sense to run this business or at least to run this business in this way. If this was 0, that means, hey, it's probably making money, but you're kind of neutral whether it makes sense to run it this way or not. If it's positive, that means it definitely does make sense to run the firm in this way and that it is definitely doing better than all of the alternatives. This right over here is saying, look, you're making $50,000 a year, that's the 50,000 that you have to spend, if you're the owner, or reinvest in the firm. This is saying, essentially, look, you could have been making more money than that $150,000. Instead of making $50,000 doing this, you could have been making $100,000 more doing something else. You are essentially giving up, you are giving up $100,000 to do this restaurant. If you are a rational decision maker and you're really are about maximizing your profit, this actually might not make so much sense for you.
AP® is a registered trademark of the College Board, which has not reviewed this resource.