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Studying for a test? Prepare with these 5 lessons on Production decisions and economic profit.
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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 at that restaurant we really think about it in two different ways really 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're paying for their dinners this is literally though the food the money that's coming in the door sometimes people call the top line because literally the top line of our income statement I just wrote it is the top line now have to think about our expenses expenses expenses now when you're starting it 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 wait staff and have the chefs in the busboy and all those people in this past year I spent $100,000 then I have and I would 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 as a that was $200,000 and then finally I really disrupted everything I also rented the equipment all of the stowe's the fridges and all of that stuff so I'm 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 your those are all my expenses I didn't borrow any money as I didn't have any interest expense or anything like that how much profit do I have before paying tax or sent you my pre-tax profit those terms because you're you're the amount you pay in taxes 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 in with again terms of accounting profit right over years we take how much money comes to the door and then we have to subtract out all of the all of them payment we essentially have to make two other people and what we have left is our pre-tax profit and so 500,000 minuses see mine is 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 I may be helping my own personal rent or whatever else or I could take some of this or all of this and reinvested back into business maybe I start buying my equipment to expand in some way who knows what I might do that money and this is just traditional accounting profit this is how profit is cocky at all this is a super simple example the future I'd like to do more nuanced examples in the accounting world but this you'd offered to assist accounting profit accounting profit when people in the in the real in the in the everyday world about profit this isn't really what they're talking about now one economist talk about product they're talking about something slightly different than 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 really is a general idea for an organization that is trying to maximize profit so once again it's year was actually just copy and paste it so it's year one that's our revenue so I'm gonna copy and I'm going to paste it this right over here so so far so good looks pretty similar but now we're going to think about things in a slightly different way economist you cost in terms of opportunity costs and it will see some of the opportunity cost you can measure in terms of dollars but some are less explicit so i'm gona right here so we can get in the economist frame of mind opportunity opportunity costs and within opportunity cost there what they're going to be explicitly opportunity costs and implicit opportunity cost so first let's do the explicit explicit opportunity cost well actually all of these are explicit opportunity cost let me just copy and paste that so I will copy copy and paste so all of these are explicitly opportunity costs and the reason why they are explicitly as I'm actually making up and paying money for all of these things even though equipment and the and the rented apartment I don't own it I'm actually paying and paying whoever does on a time these are these are direct outlays out of the business I'm explicitly making these payments and the reason why we can't think of them as opportunity cost even though they're given in dollar terms is that if I'm spending $100,000 on food that's $100,000 that I couldn't spend on something else from 700,000 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 but so far it looks pretty much identical I'm just doing it with a slightly different lens would you like what what's the big deal here we're going to see a little bit of divergence we're starting but the implicit costs that really weren't taken into account you the implicit opportunity costs especially implicit implicit costs so fine running this business and let's say that in order to to run it I actually had to focus on it full time I couldn't have I couldn't have actually quit my job than this there is an implicit cost of an important opportunity cost of the job that I gave up for my wages foregone you write this down wages wages for gone and let's say and this will depend on who were talking about 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 one hundred and fifty thousand dollars a year now we've got it we've listed all the experts and the implicit opportunity cost now we're ready to calculate our economic profit draw a line over here so our economic economic profit is going to be our revenue they were taking in minus all of these expenses that gives us two positive $50,000 but now have to sub subtract the wages far for gone so then I get to negative $100,000 now this is interesting that with this is kind of a big discrepancy here one in an accounting terms I'm profitable and economic terms I'm not profitable and the important thing to realize is economic profit with its negative isn't saying or you could say that this write-up hundred-thousand economic loss on economic profit of negative hundred-thousand this is it saying that the business of 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 run this business in this way if this was new to this 10 that means he's probably making money but you 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 that it is definitely doing better than all of the all of the alternatives so this right over here saying look you're making $50,000 a year that's the $50,000 that you have to spend if you're the owner reinvest in the firm this is saying essentially look you could have been making more money than $150,000 is that making fifty thousand doing this you could have been making $100,000 more doing something else so you are essentially giving up your giving up $100,000 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