AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/3/3-4)
Unit 3 · Topic 3.4
3.4 Types of Profit
Accounting profit subtracts only explicit costs from revenue. Economic profit subtracts implicit costs too, so it measures whether a business beats the owner's next-best option. Firms make entry and exit decisions based on economic profit, and zero economic profit is normal profit, which is still a good outcome.
Key terms
- explicit cost
- implicit cost
- accounting profit
- economic profit
- normal profit
Explicit and implicit costs, again
You met these in topic 1.5. Explicit costs are payments the firm actually makes: wages to employees, rent, materials, utilities. Implicit costs are the opportunity costs of resources the owner provides without being paid for them: the salary the owner could earn working elsewhere, the interest the owner's savings could earn, the rent the owner could charge for a building they already own, or a fair reward for the risk the owner takes on.
Two kinds of profit
Economic profit is always less than or equal to accounting profit, because it subtracts more. A business can show a healthy accounting profit and still have negative economic profit if the owner would do better elsewhere.
In this course, 'profit' means economic profit unless a question says otherwise, and every cost curve (ATC, AVC, MC) includes implicit costs.
| Measure | Formula | Who uses it |
|---|---|---|
| Accounting profit | Total revenue − explicit costs | Accountants and tax forms |
| Economic profit | Total revenue − explicit costs − implicit costs | Economists, and the AP exam |
Normal profit
When economic profit is exactly zero, the firm is earning a normal profit. That means total revenue covers every cost, including the owner's opportunity costs. The owner is doing exactly as well as in their next-best option, so there's no reason to leave. Zero economic profit doesn't mean the business is failing; the accounting profit is positive and equals the implicit costs.
Normal profit is a key idea for long-run equilibrium. In perfect competition (topic 3.7) and monopolistic competition (topic 4.4), entry and exit push economic profit to zero in the long run.
Profit on the cost graph
Because the cost curves include implicit costs, normal profit is built into ATC. When price equals ATC at the firm's output, total revenue exactly covers explicit and implicit costs, so economic profit is zero and the owner is earning a normal profit. When price is above ATC, the rectangle between them is economic profit: money beyond what the owner needs to stay. When price is below ATC, the rectangle is an economic loss, even if the firm's accountant still reports a positive accounting profit.
So whenever a graph or question says 'profit', read it as economic profit, measured against ATC.
Why economic profit drives decisions
Positive economic profit means resources earn more in this industry than anywhere else, which attracts new firms. Negative economic profit (an economic loss) means the owner could do better elsewhere, so in the long run some firms leave. Accounting profit alone can't tell you this, because it ignores what the owner gives up.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Accounting vs. economic profit
Ana runs a bakery. Last year, revenue was $200,000. She paid $120,000 for ingredients, rent and employees' wages. To run the bakery, she left a job paying $60,000 a year, and she invested $50,000 of her savings that could have earned 4% interest. Find her accounting profit and economic profit.
Show the solutionHide the solution
- Step 1: Accounting profit = revenue − explicit costs = $200,000 − $120,000 = $80,000.
- Step 2: Implicit costs: forgone salary $60,000 plus forgone interest 4% × $50,000 = $2,000. Total implicit costs = $62,000.
- Step 3: Economic profit = $80,000 − $62,000 = $18,000.
- Step 4: Positive economic profit means the bakery beats Ana's next-best option.
Answer: Accounting profit $80,000; economic profit $18,000.
- Example 2
Zero economic profit (classic trap)
A firm in long-run equilibrium earns zero economic profit. Its owner's implicit costs are $45,000. A classmate says the owner is 'making no money and should close.' What is the owner's accounting profit, and is the classmate right?
Show the solutionHide the solution
- Step 1: Economic profit = accounting profit − implicit costs. With economic profit = 0, accounting profit = implicit costs = $45,000.
- Step 2: The owner is earning exactly what she'd earn in her next-best option. That's a normal profit.
- Step 3: Closing wouldn't make her better off, so the classmate is wrong.
Answer: Accounting profit is $45,000. The owner is earning a normal profit and has no reason to close.
Common mistakes
- Leaving implicit costs out of economic profit, especially the owner's forgone salary or interest.
- Treating zero economic profit as a loss. It's a normal profit: every opportunity cost is covered.
- Thinking economic profit can be larger than accounting profit. It subtracts more, so it's always equal or smaller.
On the exam
- Expect short calculations that list revenue, explicit costs and implicit costs; label which is which before you subtract.
- Free-response questions about long-run equilibrium often ask whether the firm earns positive, negative or zero economic profit; answer 'zero (normal profit)' when entry and exit are free.
Connected topics
Videos
Check yourself
4 questions on 3.4 Types of Profit. Pick an answer to see if you got it, and why.
Marcus owns a small bike repair shop. Last year the shop took in $200,000 in revenue.
He paid $120,000 for rent, parts and an assistant's wages.
To run the shop, Marcus gave up a job that would have paid him $60,000. He also put $100,000 of his savings into the shop; that money could have earned $10,000 in interest elsewhere.
Hypothetical scenario
What was the shop's accounting profit?
What was the shop's economic profit?
Which of the following is the best interpretation of the shop's economic profit?
A firm is earning a normal profit. Which of the following must be true?
0 of 4 answered