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Video transcript

let's say this past year I started a restaurant and I now want to think about what type of a profit I've been making it that restaurant we're going to think about it in two 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 and we also think about it in terms of economic profit which we'll we'll see is a little bit different and 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 are actually running it so first let's focus on the traditional way of calculating profit so let's say my firm my restaurant my firm is a restaurant in year one it brings in in revenue in revenue it brings in $500,000 so 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 though 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 expenses now when you're starting or when you're running a restaurant one of the obvious expenses is going to be the cost of food so food we're going to say cost us $100,000 $100,000 and you have the cost of labor I have the weight staff and I have the chefs and the Busboys and all those people in this past year I spent $100,000 then I have and I'm going to assume that I don't own the building that I rent the building so building rent so I'm assuming this is on the building let's say that that was $200,000 and then finally I really just rented everything I also rented the equipment all of the stoves the the fridges and all of that stuff so I've got none of this stuff that I own so the equipment rent equipment rent I spent another $50,000 so how much profit do I have here and those are all my expenses I didn't borrow any money and so I didn't have any interest expense or anything like that how much profit do I have before paying tax or essentially my pre-tax profit and the reason why we think of in those terms is because your your the amount you pay in tax usually derived from your pre-tax profit and that depends on where where this business is what country what state what type of business it is and the easy way to calculate pre-tax profit pre-tax profit and this is pre-tax and we're thinking in terms of accounting profit right over here is we take how much money comes through the door and then we have to subtract out all of the all of them payments we essentially have to make to other people and what we have left is our pre-tax profit and so 500,000 minus the C minus 450 gives us a pre-tax profit in that same bright yellow of $50,000 and I'm assuming that I'm the only owner of this business and so I can essentially take it all out for myself and 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 in the business maybe I start buying my equipment or I expand in some way who knows what I might do with that money and this is just traditional accounting profit this is how profit is calculated all this is a super simple example the future I'd like to do more nuanced examples in the accounting world but this you referred to is just a counting profit accounting profit when people in the in the real and the in the everyday we will talk about profit this is normally what they're talking about now when economists talk about profit they're talking about something slightly different and the best way to realize that is to just calculate economic profit for this exact same business or this firm as an economist would call it and a firm really is a general idea for an organization that is trying to maximize profit so once again it's year 1 actually let me just copy and paste it so it's year 1 that's our revenue so I'm going to copy and I'm going to paste it so this right over here so far so good looks pretty similar but now we're going to think about things in a slightly different way economists view cost in terms of opportunity costs and as we'll see some of the opportunity costs you can measure in terms of dollars but some are less explicit so I'm going to write here just so we can get in the economists frame of mind opportunity opportunity costs and within opportunity cost or they're going to be explicit opportunity cost is an implicit opportunity costs so first let's do the explicit explicit opportunity costs well actually all of these are explicit opportunity cost so let me just copy and paste that so I will copy copy and paste so all of these are explicit opportunity costs and 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 and the rent of the part I don't own it I'm actually paying I'm paying whoever does on it I'm these are these are direct outlays out of the business I'm explicitly making these payments and the reason why we can think of them as opportunity costs even though they're given in dollar terms is that if I'm spending a hundred thousand dollars on food that's a hundred thousand dollars that I couldn't spend on something else if I'm starting a hundred thousand labor that's a hundred thousand dollars that I couldn't spend on something else so I'm just measuring the opportunity cost in terms of dollars but dollars that I could have spent on other things but so far it looks pretty much identical I'm just viewing it with a slightly different lens but you're like well what's the big deal here well we're going to see a little bit of divergence when we start think about the implicit costs that really weren't taken into account here the implicit opportunity cost especially implicit implicit costs so if I'm running this business and let's say that in order to run it I actually had to focus on it full-time I couldn't have I couldn't have actually quit my job then this there's an implicit cost of an implicit opportunity cost of the job that I gave up or my wages foregone so let me write this down wages wages foregone and let's say and this will depend on who we're talking about but let's say I was a doctor and I was making a nice steady risk-free $150,000 a year so I was giving up 150 thousand dollars a year now we've calculated we've listed all the X percent and the implicit opportunity cost now we're ready to calculate our economic profit so let me draw a line over here so our economic economic profit is going to be our revenue that we're taking in - all of these expenses that gives us positive $50,000 but now we have to subtract the wages foregone so then I get to negative $100,000 now this is interesting this is kind of a big discrepancy here one in in accounting terms I'm profitable in economic terms I'm not profitable and the important thing to realize is economic profit when it's negative isn't saying or you could say that this we're have a hundred thousand economic loss or an economic profit of negative one hundred thousand this isn't saying that the business or the firm isn't spitting out money what it is saying is it probably doesn't make sense to run this business or at least run this business in this way if this was neutral if this was zero that means hey it's probably making money but you're kind of neutral whether you whether it makes sense to run it this way or not if it's positive that means it definitely does make sense to to run the firm in this way and then it is definitely doing better than all of the all of the alternatives so this right over here is saying look you're making fifty thousand dollars a year that's the fifty thousand dollars 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 hundred fifty thousand dollars instead of making fifty thousand doing this you could have been making a hundred thousand dollars more doing something else so you are essentially giving up you are giving up one hundred thousand dollars to do this restaurant so if you're a rational decision-maker and you really are about maximizing your profit this actually might not make so much sense for you