No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 164 So what can Tom do to increase his profits? By our definition, he has to either lower costs or increase revenues, or some combination of both. If he can increase revenues while not increasing costs (or at least costs must rise at a rate lower than revenues increase), profits will rise. Alternatively, if he can reduce costs while maintaining revenues (or reducing costs by a larger amount than revenues fall), his profit will rise. So most entrepreneurs will try to do both: increase revenues and decrease costs. ACCOUNTING PROFIT VS. ECONOMIC PROFIT Our discussion on profit is what should be called accounting profit . Keeping proper accounting is necessary to understand how well a business is doing, and it certainly helps you avoid going to jail for failure to pay taxes! However, accounting profit usually overstates the true economic profit , which must include the full opportunity cost of each asset used in the production process. From our understanding of opportunity cost, we can see a negative economic profit (loss) while accounting profits might show a gain. Consider our example with Tom above. His accounting profit was $135, but can you think of things we left out that should be considered in calculating the true economic profit? Hint: think about the opportunity cost for Tom. Tom is the entrepreneur in this case. We didn’t identify how much time and mental energy he put into the effort. Let’s say that Tom put in three hours putting this all together. We need to consider the opportunity cost of his time. If Tom is a brain surgeon making $1,000 per hour, and is doing this as a side business to make a little extra money, we can see he has suffered an economic loss! He could have continued three more hours of brain surgery and made $3,000 instead of the lemonade stand at $135—he lost $2,865! But Uncle Sam will insist he made a (an accounting) profit which he must pay taxes on. Similarly, what if Tom’s little sister was a piano prodigy and could earn $500 per hour playing piano? By employing her to sell lemonade, he lost the opportunity to hire her out to play piano with significantly higher returns. Opportunity cost considerations must be applied to every input to the production process in order to properly capture economic profit (or loss). This is important since the opportunity cost of productive inputs shows us where the market values the application of scarce capital. If the market values a resource input more highly in one area than another, an entrepreneur reduces social welfare by misapplying the scarce resource. He or she may make an accounting profit, but will suffer an economic loss. Accounting profit should be the beginning of an entrepreneur’s calculation, but certainly not the end; he or she must fully assess the opportunity cost of a given venture. Nonetheless, we will focus our discussion in this chapter on accounting profits since, as we’ve said, this is the beginning of an entrepreneur’s calculation. And to capture accounting profits, we need to now flesh out accounting costs. Accounting profits: the difference between total revenues and total costs (accounting costs). Economic profits: the difference between total revenues and total costs, to include opportunity costs of the use of the owner’s equity and talent (not included in accounting costs).