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ECONOMIC PROFIT
In order to survive firms should create value which, in private business, is synonymous with
profit; however, the economic concept of profit is different from the accounting concept of
profit. The former takes into account opportunity costs and sunk costs. In this unit we
therefore present these concepts, showing inter alia that firms may have different objectives
and that profit maximization is just one of them.
The value of the best foregone alternative1: the opportunity cost.
Economics as a discipline is about how people make choices under conditions of scarcity.
Scarcity compels individuals to take into account trade-offs between different alternatives.
When we consider the capital or the time available to a person, we should consider the
alternative uses which that person could make with those resources.
Even if a resource, my work or my capital does not cost me anything, I should take into
account the opportunities that I miss through using that resource to pursue a specific project
instead of other projects.
The working hours of an entrepreneur could be sold to a different firm where he or she
could go to work as an employee and earn a monthly wage.
Entrepreneur’s
opportunity cost2
=
Best possible net salary as an employee. 3
The capital of the entrepreneur could be invested with minimal risk in some safe bond and
it could give a safe return. Otherwise this capital could be invested in a different project with
the same risk as in this project, but with a higher return.
1
This is the definition by Besanko et al., (2007:587). Varian (2006:201) and Baumol and Blinder (1997:51)
give definitions, which are similar to this, even if ,in the case of Baumol and Blinder (1997:226) their definition
must be interpreted as that of Pindyck and Rubinfeld, “ Opportunity cost is the cost associated with
opportunities that are forgone by not putting the firm’s resources to their best alternative use” Pindyck and
Rubinfeld, (2015:244), which is similar to that of Bernheim and Whinston, (2008:66) and to that of Collins,
(2000:1092). According to Baumol and Blinder (1997: 226) “Economic profit equals net earnings, in the
accountant’s sense, minus the opportunity costs of capital and of any other inputs supplied by the firm’s
owners”. Since the accounting profit is a balance, only if they add an other balance, the difference between the
value of the best alternative use of the factor and it actual compensation, they can obtain the economic profit.
Both approaches are acceptable, here we follow the first.
2
By focusing on opportunity costs we are then considering the value of the next best alternative that must be
forgone in order to undertake an activity.
3
For consistency with what follows, here we consider the post tax salary.
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If the firm uses capital which belongs to the entrepreneur, to partners or to shareholders, that
capital may not appear as a cost in the income statement of the firm, because the firm uses
this production factor at zero cost. It will receive some remuneration in the eventual presence
of profits. In some cases the entrepreneur, his family or some shareholders lend money to the
firm at a rate below the market rate. In both cases the opportunity cost of capital must be
considered.
Opportunity
Cost of Capital
=
Potential remuneration in
the next best alternative
project4
Sunk costs vs recoverable costs.
Sometimes companies spend money on something such as a piece of equipment, a building,
or the acquisition of knowledge through training or a patent. Afterwards the same piece of
equipment, the same building, the same knowledge commands a much lower price on the
market. This lower value does not reflect the annual loss of value accruing to the capital of a
firm or country because of wear, obsolescence and accidents. We call that loss of value
“depreciation” and it has nothing to do with sunk costs. Here the problem is that there is an
asset which is designed to cater for specific activities and cannot easily be diverted to an
alternative use. The second-hand market for such assets is limited. Examples can for example
be found in certain training, advertising or R&D expenditures.
The company could only sell that asset at a loss. A large part of the initial cost cannot be
recovered; that part would remain even if the company stopped producing. For this reason we
can say that the part of a cost that cannot be recovered has little to do with the firm’s future
projects. It will be there both with and without them. Economists have introduced the concept
of “sunk cost” to describe this type of cost. A sunk cost is an “expenditure that has been made
and cannot be recovered. A sunk cost is usually visible, but after it has been incurred it
should always be ignored, when making future economic decisions. Because a sunk cost
cannot be recovered, it should not influence the firms’ decisions.” 5
Is a sunk cost the same as fixed cost? It is not: a fixed cost could sometimes be recovered in
the long run, for example if or when the firm completely abandons its industry. A sunk cost
cannot ever be recovered, whether in the short run or in the long run. All sunk costs are fixed
costs, but not all fixed costs are sunk costs.
4
For consistency with what follows, here we consider the post tax compensation.
Pindyck and Rubinfeld (2015:245-246); see also (Besanko et al., 2007:18), Varian (2006:363), and Bernheim
and Whinston (2008:81 and 251) and; for a different interpretation see Baumol and Blinder (1997:159).
5
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Short Run vs Long Run
We often say that firms use labour and capital. “Any firm obviously uses far more
than two inputs in its production process. The level of some of these inputs may
be changed on rather short notice. Firms may ask workers to work overtime, hire
part time replacement from an employment agency, or rent equipment (such as
power tools or automobiles) from some other firm. Other types of inputs may take
somewhat longer to be adjusted; for example, to hire new, full-time workers is a
relatively time consuming (and costly) process, and ordering new machines
designed to unique specifications may involve a considerable time lag. At the
most lengthy extreme, entirely new factories can be built, new managers may be
recruited and trained, and new raw material suppliers can be developed.”
(Nicholson, 1994:241).
Short run and long run denote the length of time over which a firm may make a
decision. This distinction is quite useful when studying market responses to
changed conditions.
“For example if only the short run is considered, the firm may treat some of its
inputs as fixed, because it may be technically impossible to change those inputs on
short notice. If a time interval of only one week is involved, the size of a firm’s
factory would have to be treated as absolutely fixed. Similarly, an entrepreneur
who is committed to a particular business in the short run would find it impossible
(or extremely costly) to change jobs – in the short run, the entrepreneur’s input to
the production process is essentially fixed. Over the long run, however, neither of
those inputs needs to be considered fixed, since a firm’s plant size can be altered
and the entrepreneur can indeed quit the business.” (Nicholson, 1994:238).
In the short run at least one production input, for example a piece of equipment, is
used in a fixed quantity which cannot be changed. In the long run the quantities of
all input factors can be changed. For example the locomotive or engine of a train
of a railway company is a fixed cost for the company, whether it travels and pulls
a train or not; its cost does not change and must be paid. However, one day the
railway company may decide to sell that engine and recover its value. The engine
in the short term is a fixed cost, but in the long run it is a recoverable cost. If the
same railway company trains its staff to do very specific operations which nobody
else in the industry undertakes, the company will probably not ever be able to
recover the money spent on that training. There is no way that the company can
recover its money, regardless of whether or not the staff which received that
training work for the company and produce something. That cost is sunk.
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“Suppose that you have decided to lease an office for a year. The monthly rent that you have
committed to pay is a fixed cost, since you are obligated to pay it regardless of the amount of
output you produce. Now suppose that you decide to refurbish the office by painting it and
buying furniture. The cost for paint is a fixed cost, but it is also a sunk cost since it is a
payment that is made and cannot be recovered. The cost of buying the furniture, on the other
hand, is not entirely sunk, since you can resell the furniture when you are done with it. It’s
only the difference between the cost of the new and used furniture that is sunk.” 6
Incumbents are those companies which have operated in a certain industry for some time with
some success. They have already spent money on something, for example a plant, the
acquisition of a certain technology or of certain skills. Sometimes they cannot recover that
money for one reason or another. If they spent 100 to acquire certain capabilities and now
their market value - that is, the price they can get in the market today - is 10, then most of
their cost, 90, is now non-recoverable or “sunk”. We say that those companies have “sunk
costs”7. This is true whenever the market value, the price, which could be obtained on the
market, is lower than the book value, that is the value written in accounting books. Sunk costs
are the effects of past choices and one can do nothing to eliminate them.
Sometimes understanding the behaviour of a company may be difficult if we do not realize
that its costs are different from those of its competitors. Outsiders may consider challenging
this company by entering its market. They still have to face certain costs. For the challenger,
entering the industry implies bearing the full cost, while not entering means saving the money
and using it otherwise. For the incumbent firm, this alternative does not exist because it
cannot recover the money which it spent on unrecoverable expenses (sunk costs); so any
decision on whether or not to stay in the industry should be made taking into account the fact
that sunk costs will not be recovered, even if the firm’s operations are terminated. Sunk costs
will have to be paid in any event. In this option (remaining in the industry) as much as any
alternative option (leaving this industry) it has to be paid. For this reason sunk costs, once
incurred, should not be considered a cost that the incumbent faces as a consequence of its
continuous commitment not to abandon the industry. We cannot say the same for an outside
challenger; the outsider may save money if it simply decides not to enter the industry. In this
case incumbents and challengers may face substantially different costs even if they use the
same technology. In this sense sunk costs may constitute barriers to the entry of new firms
(challengers) into the industry. Therefore one should not be surprised if incumbents and
challengers behave in different ways.
Spending money on non-recoverable costs sometimes constitutes a message that a firm
transmits to the world: it shows its commitment to a certain field. This is the case with a
tenant who spends money on refurbishing his or her rented property: he or she shows her
intention to rent it for a certain period, not just in the short term. Spending on sunk costs is
like destroying the bridge you have just crossed. If you enter an industry with major sunk
costs, you declare that you intend to stay there. The money you spend on recoverable costs
6
7
(Varian, 2006: 362).
Baumol and Willig, 1981
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can still be recovered. Choice is still available. Incumbents usually have greater sunk cost
than new entrants, because they have spent money on specific plants, equipment, knowledge
or training. In many cases these specific assets can only be resold to third parties at a price
much lower than the price recorded in the company books. In some cases the asset cannot be
sold at all. Companies know that if they dispose of these assets they should acknowledge the
loss incurred by selling something at a price below the cost of acquiring it, even after duly
taking depreciation into account. Incumbents have to pay eventual debts on these assets
anyway, whether or not they remain in the industry. Therefore if we say that these assets are a
consequence of their present choice of remaining in the industry, we are committing an error.
Now assume that we have to decide whether this company should continue in or leave this
industry. We calculate the company’s future revenues and costs if it remains in the industry.
Should we include in this calculation those costs that the company pays now, but it would
also pay if it left the industry? The answer is no, for if we did, we would not be evaluating the
value of the economic choice expressed by “the company will remain in this industry” and
we would be making the decision in the wrong way. Sunk costs strengthen the position of a
company in its industry, but can also limit its wish to do new things. Established companies
in an industry are often resistant to disruptive innovation which threatens their existing
capabilities and cannibalizes their existing products. Imagine a company which has invested
huge sums in being a leader in fossil energy. Will it be willing to see renewable energies
triumph? The answer is probably not; if renewable energies become cheap most of the
company’s assets (mines, oil wells, knowhow, pipelines, etc.) will lose much of their value.
The company owners know that the introduction of certain innovations may reduce or
completely destroy the market value of their assets. They also know that the market value of
their assets may become much lower than the value recorded in their balance sheet for those
same assets. In such a case they would record losses. The value of those assets would then be
“sunk” or non-recoverable; the sum originally spent would become a “sunk” or
“unrecoverable” cost. Sunk costs not only explain companies’ choices but are also a key
consideration when appraising the sustainability of a business.
Examples:
 A company builds a plant which is very specific to a certain production process and
which could just be bought by competitors at a low price in order to shut it down.
 A person has acquired skills in a specific field which cannot be used in other fields.
 A company has developed a brand which cannot easily be sold to others.
 A company has spent money on R&D to acquire knowledge that is difficult to sell on
the market.
 What was the advantage of developing railways for those established in the horseand-carriage business?
 Can you guess why Kodak was unable to become leader in digital photography?
In the development of a firm’s or country’s business plan, sunk costs should not be treated as
part of overall costs. The decision-maker will bear their burden anyway, with or without the
planned business.
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When we discuss whether we can save a plant in which 100 employees work, the fact that the
book value of the plant is $50m is irrelevant; this is true even if the plant has a market value
much lower than $50m and cannot be sold anyway. In the business plan we could only
include the present market value of the plant, provided that we would in fact be ready to sell
it.
The sunk cost fallacy
“Once you have bought something, the amount you paid is “sunk” or no longer recoverable.
So future behaviour should not be influenced by sunk costs. But, alas, real people tend to
care about how much they paid for something. Researchers have found that the price at
which owners listed8 condominiums in Boston was highly correlated with the buying price9.
As pointed out earlier, owners of stock are very reluctant to realize losses, even when it
would be advantageous for tax reasons.
The fact that ordinary people are subject to the sunk cost fallacy is interesting, but perhaps it
is even more interesting that professionals are less susceptible to this problem. For example,
the authors of the condominium example mentioned above found that individuals who bought
condos for investment purposes were less likely to be influenced by sunk costs than
individuals who lived in the condos. (...) It appears that one reason to hire professional
advisers is to draw on their dispassionate analysis of decisions”. 10
Accounting Profit
The accountants’ objective is an accurate measurement of costs and benefits that accrue
profits or losses to the firm, with the aim of reporting them to shareholders, creditors and tax
authorities. They can take a static picture of the firm at a given moment in terms of assets and
liabilities (balance sheet) or they can show what the firm has achieved over a certain period in
terms of what it earned and what costs it had to pay (income statement or P&L). They pay
attention to written and unwritten contracts, which generate rights and duties. They always
have a legal basis. They pay attention to historical facts: “we bought this at a certain price on
March 15th 2009”. Costs and revenues are explicit: they derive from an invoice, a debt or a
payment.
In accounting terms the cost of capital is the sum of interest + depreciation. The wage bill
represents the cost of labour. The wage bill sometimes includes a salary for the entrepreneur
who works in the company; sometimes it does not. Profits are the basis for corporate taxes,
dividends or retained earnings.
8
Listed here means “advertised for sale”.
David Genovese and Christofer Mayer, 2001, “Los aversion and seller behavior: evidence from the housing
market,” Quarterly Journal of Economics, 116, 4:1233-1260.
10
Varian,2006:556.
9
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Table 1 Calculating the Accounting Profit
+
=
=
=
=
Revenues (price X quantity)
cost of raw materials, partly finished goods, utilities and labour costs
depreciation
OPERATING PROFIT
interest or financial costs
PRE-TAX ACCOUNTING PROFIT
tax
AFTER TAX ACCOUNTING PROFIT
dividends
RETAINED EARNINGS
The accounting profit is used to report to shareholders, pay taxes and obtain credit from
banks.
The Economic Profit: Comparing two Scenarios.
Basically the economic profit of a project derives from the comparison of a scenario which
includes that project with the best alternative scenario that excludes it. In the first scenario
you have the project (the firm) as it is. In the second scenario you consider the situation of the
entrepreneur and shareholder if he or she did not carry out this project (or did not invest in
this company) but chose the best from the available alternative projects carrying
approximately the same level of risk as this one. In that case eventual sunk costs would also
be paid since they do not depend on the project under consideration.
Table 2 Two alternative scenarios
Scenario with this project
Scenario without this project
The entrepreneur works for this project The entrepreneur works for some alternative
project or company and receives a salary.
or this company.
The entrepreneur invests his/her money His/her capital is invested in an investment
with no greater risk and generates a return.
in this project or in this company.
Sunk Costs, for example old debts on Sunk Costs, for example old debts on nonnon-recoverable expenses, must be paid recoverable expenses, must be paid (there is
no way to avoiding them).
(there is no way of avoiding them).
The sunk costs are thus a common feature of both scenarios.
For the entrepreneur this project makes sense (and an economic profit) if the entrepreneur is
better off in a scenario with this project than in a scenario without it.
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Table 3 Calculating the earnings of the owner in the alternative scenario (without this project)11
-
best possible alternative after-tax labour income of the owner (opportunity cost of
the labour of the owner)
best possible alternative after-tax return on the invested capital (opportunity cost of
capital)
Costs to pay anyway, even when not following this project (sunk costs)
=
Net earnings of the owner in the alternative scenario
+
+
If the after-tax accounting profit of a firm (or a project) is greater than the net earnings of the
owner in an alternative scenario, the firm (or project) makes an economic profit.
Economic
Profit
=
After-Tax
Accounting Profit
-
Net earnings of the owner
in the alternative scenario
In some cases we encounter firms which operate with zero economic profit. This sounds odd
only if we ignore the meaning of economic profit. In reality these firms remunerate the
work and capital of the owner as much as in their best alternative uses.
An example is given overleaf.
11
See Cabral and Backus (2001)
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An example
A small software house in 2008 had a revenue of €1,000,000. Expenses for employees were €500,000. It
paid €300,000 in other invoices (non-durable goods). It also paid €50,000 for the participation fee in a
research consortium. Two years ago the company committed itself to participating in this consortium and
paying €50,000 every year for three years. The owner who invested €2,000,000 in this business often
receives job offers from Google, Microsoft and Facebook. The last-mentioned offered her a net salary of
€100,000 per year. Risk-free bonds offer a 1,5% tax-free interest. Now the owner needs to understand
whether carrying out this business this year was or was not a way of creating value.
First we calculate the accounting profit of this firm.
Revenues
Expense for employees
Invoices not for durable goods
Consortium fee
Pre- tax profit
Taxes (33%)
After-tax accounting profit
+1,000,000
-500,000
-300,000
-50,000
+150,000
-50,000
= 100,000
Now we calculate the net earnings of the owner in the in the alternative scenario.
+
best possible alternative after-tax labour
income of the owner (opportunity cost of
the labour of the owner)
+100,000
Salary the owner could earn outside as an employee.
+
best possible alternative after-tax return on
the invested capital (opportunity cost of
capital)
-
Costs to pay anyway, even not following
this project (sunk costs)
+ 30,000
1,5% of 2,000,000
Earning of capital invested in risk free bonds
- 50,000
Consortium fee
=
Net earnings of the owner in the
alternative scenario
+80,000
Therefore
Economic
Profit
20,000
=
After Tax
Accounting Profit
100,000
-
Net earnings of the owner in the
alternative scenario
80,000
The accounting profit is 100,000, but the owner’s labour and capital can generate earnings. This year the
economic profit of the owner - the benefit deriving from carrying out this activity rather than being in the
best alternative scenario is 20,000.
The owner is financially better-off in this scenario than in the alternative scenario.
I
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Different Objectives of the Firms
Is economic profit the only possible goal that a firm may have? A firm can actually choose
from many alternative goals, viz.:
1. Revenue Maximization can be part of a strategy of maximizing long-term profits; you
secure a market share, and eliminate competitors so as to behave as a monopolist in the
future; as a monopolist you will be able to exploit consumers. In other cases this strategy
is simply a way of satisfying the managers’ desire for power. In this perspective you can
explain much merger and acquisition activity.
2. Maximization of the utility of the owner and of his/her family is very frequent in familybased systems, as for example in Italy. The final objective is not firm growth but family
welfare. Possible expressions of this strategy are the renunciation of using the managerial
market (preference for many family members as managers and directors) or limited
growth so as not to share control with strangers or become accountable to third parties.
3. Employment Maximization and Welfare Maximization sometimes characterise public
administrations and charities. You can pursue them if some external source supplies
resources (subsidies) for survival. Otherwise they must be complemented with some goal
of minimal profitability in order to guarantee the survival of the organization.
4. Long-term profit maximization is the objective more linked with the firm’s growth.
5. Short-term profit maximization is used as a proxy for ‘4’ and it is particularly used by
firms which are under strict scrutiny by financial markets. Sometimes it leads to some
distortions, e.g. firms avoid certain investments because they could negatively affect
short-term profits, even if they would be beneficial for their long-term sustainability.
Watch:
https://www.khanacademy.org/economics-finance-domain/microeconomics/firm-economicprofit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit
N.B. This video calls “Explicit Opportunity Costs” those costs which are included in both the
economic and the accounting analysis. It calls “Implicit Opportunity Costs” those which we
call “Opportunity Costs”.
Question for course participants:

If the accounting profit of a company is a positive number, does it mean that this
company is creating value?

Did you ever think that if you were in a partially or totally different business you
could actually earn more than you earn now?

Would you be surprised in discovering that many businesses operate for long periods
without generating substantial economic profits?
Analysis of the video
The video presents some concepts presented in this unit. The fact that accounting profit is
positive does not mean that the business creates value. If opportunity costs are added, a profit
may become a loss. Many businesses may operate for long periods without generating
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economic profit; they basically survive and remunerate intermediate consumption, capital and
labour, but do not add any further value. This is the frequent case with many small
businesses.
A company can have economic losses while it is posting accounting profits. An example:
in 2002 McDonald's posted accounting profits of $893,000,000, but if investors put their
money into an investment with similar or lower risk project, they earned $124 million
dollars more.
Economic profit of some companies (Besanko et al. , 2007)