Thursday, May 26, 2022

Accounting Profit vs Economic Profit

this video we're going to go through some definitions and an example and this is the typical textbook kind of example except we're gonna carry it a little further than most textbooks would suppose Farmer Brown quits his job working for farmer blue where he was making forty thousand dollars per year .

He takes a hundred thousand dollars out of the bank and he was making five percent interest on that money before he would through it and he buys ten acres of land suppose he grows strawberries and sells them for ninety thousand dollars he also pays $1,000 for seeds five thousand dollars for fertilizer in ten thousand .

Dollars for a worker to help him pick the strawberries and additionally former Brown desires a minimum of five thousand dollars in compensation for his efforts as an entrepreneur owning this business now that's over and above any other labor effort that he puts in just five thousand dollars for the fact that he's in there taking a risk working as his .

Own boss it's it's annoying it's harder than working for someone else he also bought a tractor for ten thousand dollars which the IRS says over the last year depreciated by two thousand dollars but the tractor is still worth nine thousand dollars on the resale market and the typical problem will now ask you to identify which of these costs are .

Implicit which are explicit and then they'll ask you to calculate the accounting profit and the economic profit so let's do that an explicit cost is anything where you can imagine that Farmer Brown actually has to take money out of his pocket and hand it to another person so an explicit costs just like an explicit film it's right there in your .

Face and you can see it you can see the money changing hands so explicit means you can see the money move from one place to another so an explicit cost let's look at these different costs here and identify which involve Farmer Brown taking money and handing it to someone else this forty thousand dollars that he was making before he quit his former .

Brown this year going to be taking the forty thousand dollars out of his pocket handing it to someone else answer no that's $40,000 he won't make now it won't be coming to him but it's not money that's coming out of his pocket and you can see the money moving from his pocket to someone else's bucket it's not an explicit cost the $40,000 that .

He's not making anymore you think about it as an opportunity cost that's an implicit cost so $40,000 that he's not making now that he used to is an implicit cost he takes a hundred thousand dollars out of the bank that's not really a cost because he's buying land with it I guess we'd have to assume he could sell the land and get that .

Money back and in the real world there might be some other costs involved with doing that but that hundred thousand dollars isn't really a cost but what is a cost is the 5% money that he's not going to be getting anymore now this sounds just like the 40,000 he's not going to be making at the job anymore and so the 5% this year that he .

Could have made on the hundred thousand dollars that's five thousand that's another implicit costs of five thousand dollars he grows strawberries and he sells them for ninety thousand so that's not a cost that's actually his revenue so we can put that over here as his revenue total revenue equals ninety thousand dollars so maybe these were .

Nine dollars per pounds for strawberries and he sold ten thousand pounds of strawberries that's his revenue that's not a cost at all he also pays a thousand dollars for seeds five thousand for fertilizer and ten thousand for labor so when he goes and buys these seeds is that an explicit cost during implicit cost well I assume that he .

Actually has to pay for them take money out of his pocket or a credit card or a check doesn't matter if it's cash as long as it's money that moves from him to someone else you can see the money moving and so that's an explicit cost when he buys the fertilizer same thing that's an explicit .

Cost and the $10,000 he pays his workers that ten thousand dollars is also an explicit cost because money in some form cash check credit card has to move from Farmer Brown to someone else so those are all explicit costs let's just lump them together there and call that $16,000 in explicit costs also Farmer Brown desires a .

Minimum of $5,000 in compensation for his efforts as an entrepreneur this is the amount of money that Farmer Brown wants to pay himself otherwise it's just not worth it to him to stay in business now is that an implicit cost or an explicit cost well that's an implicit cost because it's not money that's moving from Farmer Brown to someone else .

But it's just something in Farmer Brown's mind that he's thinking about that he has to have otherwise he's going to get out of this business in the long run so that thought thousand is what we call normal profit or the return to the entrepreneur the return to entrepreneurship the amount that he's gonna want otherwise he's gonna get out .

Of this business so that 5,000 that's an implicit cost another cost here he bought a tractor for ten thousand just like the land that's not that whole thing's not a cost just how much it's depreciating but there's two different ways to view depreciation one way to view depreciation is what the IRS says accounting depreciation and they say .

That's $2,000 now is that $2,000 an implicit or an explicit cost is the money going from him to someone else answer no he already bought the tractor for ten thousand that was an explicit transfer of money but not really a cost because it's an asset now but the 2,000 depreciation I guess most people would say that's an implicit cost let's put .

That in here 2,000 but there are two ways to measure depreciation accountants do it according to a rule book GAAP generally accepted accounting principles in the United States but economists look at depreciation a different way we want to know not how much does a book say depreciation is depreciation is really supposed to reflect .

How much the value of the asset has gone down and economists would say well you bought the tractor for ten thousand how much could you sell it for now nine thousand okay the real depreciation is a thousand and so we have two different versions of this implicit cost and again they're implicit because as the value of the tractor goes down the person is not .

Visibly seen handing money over to someone so that's why it's an implicit cost but there are two different ways we could view that cost according to a rule book two thousand the accountants version or a thousand for the Economist version of depreciation now that we've gone through all these numbers what you would normally be asked to do is .

Calculate what would an accountant say the profit would be and what would an economists say the profit would be well what an accountant is going to do is take the total revenue of ninety thousand and then start subtracting off explicit costs accountants don't count implicit costs for the most part except for depreciation an accountant measures .

The money as it flows away from a business as costs for the most part so they're gonna take the 90,000 and then they're gonna subtract off the 16,000 and explicit costs and then subtract off the $2,000 in accountants depreciation and the accountants version of the profit would be 90 thousand minus eighteen thousand is seventy two .

Thousand dollars an economist on the other hand is going to say wait a minute you forgot some costs and you got the depreciation wrong so you could think about us starting with that seventy two thousand dollar figure and the first thing we would do is add back a thousand dollars in that depreciation to correct for that and get seventy three thousand .

Right then after we say we fixed that problem with depreciation we would say there are some other costs of a Farmer Brown getting into this business one cost is that he's losing $40,000 that he could have made somewhere else so we subtract off the 40,000 and then we say he's also losing $5,000 that he could have earned .

An interest if he was not if he didn't have his money in this business and then also Farmer Brown told us that just to make it worth it to him to be involved in this business the extra stress of being an entrepreneur the extra worry he wants to make it a minimum another $5,000 to return to him being an entrepreneur so we're going to .

Subtract off these things so the economists version of profit would be $23,000 $23,000 is what we would call his economic profit now is that a good thing or a bad thing well it would be a good thing because we have accounted for all the costs that Farmer Brown had for getting in this business and what this 23,000 means as he did better than he .

Could doing the other thing he could have done this 20,000 23,000 dollars in economic profit means that Farmer Brown by becoming an entrepreneur is making 23,000 more dollars than he could make if he were still doing what he was doing before so this 23,000 dollars is a good thing and it just says that you're doing .

23,000 dollars more than better than you could do in some other comparative option that you have and to just compare it's a little more difficult than that because remember we added in this thousand dollars difference in depreciation but but really when you get down to it Farmer Brown had 73 thousand dollars that he made by farming .

Strawberries for himself but when we compare that to what would he have made in the other option well he would have made forty thousand dollars in salary he would have made $5,000 in interest in the bank and this other $5,000 remember is the compensation he demands for the pain and trouble think about it it's gray hair .

Worry stress of being an entrepreneur so he would have had $50,000 that he earned anyway doing the other thing and 5,000 of that is an intangible unless stress but that's fine we compared the 50,000 he would have made to the 73,000 that he did make and that tells us that he did $23,000 better and that's all an economic profit means .

If it's positive it means that you did better than you could in that other option after all the other costs are taken into account if it's negative it means that you did worse than you could have in that other option and if it's zero that's not a bad thing it's not a good thing it just means that compared to the other option you're doing exactly .

The same you're doing just as well now as you would in the other option now let me go through one other part of this story and this is a particular example that blew my mind when I first heard it years ago so right now former Brown is making twenty three thousand dollars in economic profit suppose that absolutely .

Nothing changes but we're ten years in the future nothing changes except this land the Farmer Brown bought for one hundred thousand dollars remember II took the hundred thousand dollars out of the bank and he bought ten acres of land with it suppose absolutely nothing has changed except now a real estate agent comes and .

Says hey farmer brim you got ten acres of land here you know this the city around you is growing and that land how much did you pay for it I paid a hundred thousand dollars he says you know I bet that you could sell that land now for 1 million dollars and Farmer Brown says really fill it for a million well you know this economist guy who just .

Came by he said that I should keep farming because he said I'm making twenty three thousand dollars in economic profit and that means I'm making more doing what I'm doing then if I was doing something else so I need to keep farming so sorry real estate agent you should go away well that's not true this is a .

Game-changer right now remember how that hundred thousand dollars in land came into the equation it came in right here this five thousand dollars in lost interest that Farmer Brown could have made but now that has changed if we've got a really look at what could he do now instead of being a farmer well if he sells the land for a million and puts it .

In the bank at 5% how much money would he make an interest well if we multiply that times 5% point oh five now he could make $50,000 in interest and so if we put this 50,000 in here instead of $5,000 what is his economic profit going to be now well we take the 5,000 out of the equation we start with 73 thousand after .

Correcting for that depreciation 73 minus 40,000 is 33,000 then we subtract off the $5,000 he needs to be compensated for being an entrepreneur and then we subtract off $50,000 that he could be making in the bank if he sold his land and got fifty thousand a year in interest and now we're going to calculate that his economic profit is .

Equal to negative twenty two thousand dollars what does that mean well that tells him that look at this money you could be making if you did the other thing you could go back to working for former blue and you can earn $40,000 there you could go and put that money in the bank if you sell your farm and earn $50,000 a year on interest on the money .

In the bank and you could you know we subtracted off that 5,000 that that you wouldn't have to earn to compensate you for the stress of being an entrepreneur what's the best choice well this negative 22,000 tells Farmer Brown that now if he got out of farming and did the other thing he could be making ninety thousand dollars in income .

Plus avoiding five thousand dollars of gray hair worry stress and you compare that 90 thousand dollars plus the five thousand for not having to worry to the seventy three thousand that you're actually making now and you could be $22,000 a year better off if you got out of farming and so I told you the first time I heard this I was floored I didn't .

Really understand and maybe you still don't quite get it how is it that I could be so much worse off when the value of my land goes up well it's not that you're worse off the fact that that your land is more valuable now that is a good thing it is a good thing but economic profit microeconomics is all about helping people make the right .

Decisions and the economic profit the only thing is used for is to tell us if it's positive I'm doing better that I could do doing something else if it's zero I'm doing the same I could do in another opportunity and if it's negative it tells you you should do the other thing the other thing is now better and the reason it's better is the value of .

Your land is so much higher now as soon as that money you could make from the land investing it in some other way gets to be better you know so much higher that you're making more by selling the land and by keeping the land that's the point where the economic profit will become negative and it'll tell you to do that other thing this is .

Precisely what we see in a lot of areas as a city grows and expands and gets nearer and nearer to farmland the value of that farmland gets higher and higher to where it just makes more sense at some point to sell the land to a developer take the money invest it and get a job somewhere else there are some other intangible things maybe you really .

Like farming maybe you don't want to let this farm land be turned into just another housing development and if that's true for you as a farmer then you would want to build in those factors into your costs how much you value things should be put into this and it should affect your decision in the next lecture we're gonna go back and look at .

Calculating things and tables but the thing you need to take from this discussion you really need to understand what economic profit means because every time we calculate profit from now on in an economics class we're going to be talking about economic profit and so if you're making zero profit remember that's not bad .

It means you're making a profit that you're making the same amount of money you would be making doing something else

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