Page 574 - Krugmans Economics for AP Text Book_Neat

the accounting profit of a business is its total revenue minus its explicit cost and de-
The economic profit of a business is the
preciation. The accounting profit is the number that Babette has to report on her
business’s total revenue minus the
income tax forms and that she would be obliged to report to anyone thinking of in-
opportunity cost of its resources. It is usually
less than the accounting profit. vesting in her business.
Accounting profit is a very useful number, but suppose that Babette wants to decide
The implicit cost of capital is the
whether to keep her restaurant open or do something else. To make this decision, she
opportunity cost of the capital used by a
business—the income the owner could have will need to calculate her economic profit—the total revenue she receives minus her op-
realized from that capital if it had been used portunity cost, which includes implicit as well as explicit costs. In general, when econo-
in its next best alternative way. mists use the simple term profit, they are referring to economic profit. (We adopt this
simplification in this book.)
Why does Babette’s economic profit differ from her accounting profit? Because she
may have an implicit cost over and above the explicit cost her accountant has calcu-
lated. Businesses can face an implicit cost for two reasons. First, a business’s capital—its
equipment, buildings, tools, inventory, and financial assets—could have been put
to use in some other way. If the business owns its capital, it does not pay any
money for its use, but it pays an implicit cost because it does not use the capi-
tal in some other way. Second, the owner devotes time and energy to the
business that could have been used elsewhere—a particularly important fac-
tor in small businesses, whose owners tend to put in many long hours.
The New Yorker Collection. 2000 William Hamilton from cartoonbank.com. All Rights Reserved. equipment in her own restaurant, the best alternative Babette has is to sell
If Babette had rented her appliances and furnishings instead of owning
them, her rent would have been an explicit cost. But because Babette owns
her own equipment, she does not pay rent on them and her accountant
deducts an estimate of their depreciation in the profit statement. How-
ever, this does not account for the opportunity cost of the equipment—
what Babette forgoes by owning it. Suppose that instead of using the

the equipment for $50,000 and put the money into a bank account where it
would earn yearly interest of $3,000. This $3,000 is an implicit cost of run-
ning the business. The implicit cost of capital is the opportunity cost of the
“I’ve done the numbers, and I will marry you.”
capital used by a business; it reflects the income that could have been earned
if the capital had been used in its next best alternative way. It is just as much a true cost
as if Babette had rented her equipment instead of owning it.
Finally, Babette should take into account the opportunity cost of her own time.
Suppose that instead of running her own restaurant, she could earn $34,000 as a chef
in someone else’s restaurant. That $34,000 is also an implicit cost of her business.
Table 52.2, in the column titled Case 1, summarizes the accounting for Babette’s Cajun
Café, taking both explicit and implicit costs into account. It turns out, unfortunately, that

table 52.2

Profit at Babette’s Cajun Café
Case 1 Case 2
Revenue $100,000 $100,000
Explicit cost –60,000 –60,000
Depreciation –5,000 –5,000
Accounting profit 35,000 35,000
Implicit cost of business

Income Babette could have earned on capital used in the next best way –3,000 –3,000
Income Babette could have earned as a chef in someone else’s restaurant –34,000 –30,000
Economic profit –2,000 +2,000

532 section 10 Behind the Supply Curve: Profit, Production, and Costs