Accounting profit vs economic profit

- [Instructor] Let's continue thinking about how rational agents make decisions. So here we're told that Sally runs a business that only sells hamburgers in a building she owns. Every month, they sell 5,000 hamburgers at $5 per hamburger. She spends $2 per hamburger on supplies, bread, meat, lettuce, et cetera. She also pays Mike and Raj each $2,500 per month to work at the restaurant. Finally, utilities cost $500 per month. Sally works full-time at the restaurant and keeps the accounting profits for herself. What is the accounting profit of the business? So pause this video and see if you can figure that out. All right now let's think about this together. We're gonna think about it in terms of some of the types of costs we've thought about in the past. So when we think about benefits, and here we could think about it to a firm, although it's fully owned by Sally, the benefit to a firm of doing business is its revenue. So the total revenue that she collects, and everything we're gonna be doing is going to be per month, so her total revenue is going to be her price times quantity so it's going to be 5,000 hamburgers at $5 per hamburger. So that is going to be $25,000. Once again, all of this is going to be per month. So once again, we can view this as the total benefit that the firm, that her business, is getting. And now let's think about the costs. So first we could think about the cost of her supplies. It's oftentimes referred to costs of goods sold, but I'll just write supplies here. So costs, costs colon, so let's put supplies, supplies. That would be 5,000 hamburgers times $2 per hamburger, so that's a $10,000 cost, $10,000. Then she has the cost of her employees. So employees, I'll just write it, I'll abbreviate it like that. What's that going to be? Well she has two folks at $2,500 per month each. So that's going to be $5,000, two times $2,500, $5,000. And then last but not least, she has her utilities. So utilities, let's do util for short. That's going to be $500 per month. And so from this we can calculate the accounting profit. So we get the accounting profit, accounting profit, is going to be 25,000 minus 15,500. That's going to be $9,500 per month. And she gets to keep all of this, and so this seems like a pretty good amount of money to be earning. She's earning six figures a year. But the question is, is it rational for her to do this? Well some of you might be correctly thinking, well in order to determine whether it's rational for her to continue running this business, we have to know what the implicit costs are. Here we've only just looked at the explicit costs, and the most important of the implicit costs is the opportunity cost. And to factor that, we have to know, well maybe what she could've rented her building out, if she wasn't running this burger business, and maybe what she could do with her time if she wasn't working at the business full-time. So we need a little bit more information and let's see if we can get that. So now we are told that Sally could rent out her building for $5,000 per month. She can also make $6,000 per month as an accountant. Based on this, what is the economic profit of her business? So pause this video and see if you can figure this out. Well one way to think about it is, we can start with our accounting profit and then subtract out all the implicit costs, especially these opportunity costs right over here. So her opportunity cost, opportunity costs, are going to be per month, well if she doesn't run this business, she could rent out her building for $5,000 per month and then if she wasn't doing this full-time, she could make $6,000 per month as an accountant, $6,000 right over there. And so her opportunity costs are a total of $11,000. And so now her economic profit would be her total benefit minus her explicit costs minus her implicit costs. Her economic profit, economic profit, is going to be, well we could start at the 9,500 and subtract the 11,000, it is negative $1,500. It's important to realize, because economic profit always factors in the explicit costs and then other potential implicit costs, economic profit will never be higher than accounting profit. And assuming there are some implicit costs, it'll always be lower than accounting profit. So now based on all of what we've explored, is it rational for Sally to continue running her burger business? Well based on the information we've been given, it doesn't seem rational for her to continue running her burger business. She makes $9,500 in accounting profit from the business, but she's incurring $11,000 of opportunity cost to do so. And that's what makes her economic profit negative. This is not rational. Now if we had more information, maybe she hates being an accountant. Maybe there's a benefit for her working at the burger business. She has more flexibility with her time, she likes being self-employed, she doesn't have to listen to her manager tell her want to do. If that were the case, then it would change the calculations some because there would be an extra benefit from her running her burger joint. But we don't know, and based on the information we have, it doesn't seem rational for her to continue.