Accounting profit vs economic profit | APⓇ Microeconomics | Khan Academy

Summary

The video script discusses Sally's hamburger business, detailing its accounting profit and economic profit. Sally sells 5,000 hamburgers monthly at $5 each, incurring costs for supplies, employees, and utilities. Her accounting profit is calculated as $9,500 per month. However, considering opportunity costs, including potential rental income and her alternative salary as an accountant, her economic profit becomes negative $1,500 per month. This suggests it's not rational for Sally to continue the business based on the given financial data.

Takeaways

• 🍔 Sally's business sells 5,000 hamburgers per month at $5 each, generating $25,000 in total revenue.
• 💼 Sally's cost of supplies (goods sold) is $10,000 per month for ingredients like bread, meat, and lettuce.
• 👨‍🍳 She pays her two employees, Mike and Raj, $2,500 each per month, totaling $5,000 for labor costs.
• 🏠 Utilities for the restaurant cost $500 per month.
• 💰 The accounting profit is calculated as total revenue minus explicit costs, resulting in $9,500 per month.
• 🏢 Sally could earn additional income by renting her building for $5,000 per month if she didn't run the business.
• 📈 Her opportunity cost includes the potential earnings from renting the building and her salary as an accountant, $6,000 per month.
• 🔢 The economic profit considers both explicit and implicit costs, leading to a negative $1,500 per month.
• 🤔 Economic profit is always lower than accounting profit because it includes opportunity costs.
• 🚫 Based on the information provided, it is not rational for Sally to continue running her burger business due to the negative economic profit.

Q & A

What is the monthly revenue of Sally's business?

The monthly revenue of Sally's business is $25,000, calculated by multiplying the number of hamburgers sold (5,000) by the price per hamburger ($5).

How much does Sally spend on supplies for the hamburgers?

Sally spends $10,000 per month on supplies for the hamburgers, which is calculated by multiplying the number of hamburgers (5,000) by the cost per hamburger ($2).

What are the total monthly wages Sally pays to her employees?

Sally pays a total of $5,000 per month to her employees. This includes $2,500 each to Mike and Raj.

What is the monthly cost of utilities for the restaurant?

The monthly cost of utilities for the restaurant is $500.

What is the accounting profit of Sally's business?

The accounting profit of Sally's business is $9,500 per month, which is calculated by subtracting the total costs (supplies, employee wages, and utilities) from the total revenue.

What is the opportunity cost of Sally running the business instead of renting out her building?

The opportunity cost of Sally running the business instead of renting out her building is $5,000 per month, which is the potential rental income she foregoes.

How much could Sally earn per month if she worked as an accountant instead of running the business?

If Sally worked as an accountant instead of running the business, she could earn $6,000 per month.

What is the total opportunity cost Sally incurs by running her burger business?

The total opportunity cost Sally incurs by running her burger business is $11,000 per month, which includes the potential rental income and her potential earnings as an accountant.

What is the economic profit of Sally's business when considering opportunity costs?

When considering opportunity costs, the economic profit of Sally's business is negative $1,500 per month, calculated by subtracting the opportunity costs from the accounting profit.

Based on the information provided, is it rational for Sally to continue running her burger business?

Based on the information provided, it is not rational for Sally to continue running her burger business because her economic profit is negative, indicating that the opportunity costs outweigh the accounting profit.

What additional information might change the rationality of Sally continuing her burger business?

Additional information such as personal satisfaction, flexibility, or other non-financial benefits Sally might gain from running her own business could change the rationality of continuing the burger business, as these would affect the calculation of her overall utility or satisfaction.

Outlines

00:00

💼 Understanding Accounting Profit

In this segment, the instructor explores the concept of accounting profit through the example of Sally's hamburger business. Sally sells 5,000 hamburgers monthly at $5 each, resulting in a total revenue of $25,000. Her costs include $10,000 for supplies, $5,000 for employee salaries, and $500 for utilities. The accounting profit is calculated by subtracting these explicit costs from the total revenue, yielding a profit of $9,500 per month. However, the instructor emphasizes that to determine the rationality of continuing the business, one must also consider implicit costs, particularly opportunity costs.

05:00

💹 Economic Profit and Opportunity Costs

The second paragraph delves into the calculation of economic profit, which includes both explicit and implicit costs. Sally's opportunity costs are identified as potential earnings from renting her building ($5,000 per month) and her alternative income as an accountant ($6,000 per month), totaling $11,000. By subtracting these opportunity costs from her accounting profit, the economic profit is found to be negative $1,500 per month. This indicates that, from a purely economic standpoint, it is not rational for Sally to continue running her business, as the opportunity costs outweigh the accounting profit. The instructor suggests that additional information about Sally's personal preferences or non-financial benefits could alter this conclusion.

Keywords

💡Rational Agents

Rational agents are decision-makers who systematically and purposefully choose the best action available to them to achieve their objectives. In the video, Sally, who runs a business, is considered a rational agent as she makes decisions to maximize her profits. The concept is central to understanding economic behavior and decision-making processes.

💡Accounting Profit

Accounting profit is the difference between the revenue a business generates and its explicit costs, such as the cost of goods sold, salaries, and utilities. In the video, Sally's accounting profit is calculated by subtracting the explicit costs (cost of supplies, employee salaries, and utilities) from the total revenue. This profit is $9,500 per month, indicating the financial gain of the business before considering opportunity costs.

💡Explicit Costs

Explicit costs are the out-of-pocket expenses that a business incurs, such as the cost of supplies, employee wages, and utilities. In the video, Sally's explicit costs include $10,000 for supplies, $5,000 for employee salaries, and $500 for utilities. These are the direct monetary expenses that are easily identifiable and quantifiable.

💡Opportunity Cost

Opportunity cost refers to the potential benefit an individual, investor, or business misses out on when choosing one alternative over another. It's the value of the next best alternative that is foregone. In the video, Sally's opportunity costs include the potential rent of $5,000 per month for her building and $6,000 per month she could earn as an accountant. These implicit costs are not directly paid but represent the loss of potential income.

💡Economic Profit

Economic profit is the true profit of a business after accounting for all costs, including both explicit and implicit costs. It's the surplus that remains after all opportunity costs have been deducted. In the video, Sally's economic profit is negative (-$1,500) after considering her opportunity costs, indicating that her business is not economically viable as it doesn't cover the value of the next best alternative.

💡Revenue

Revenue is the total income generated by the sales of goods or services. In the video, Sally's business revenue is calculated by multiplying the quantity of hamburgers sold (5,000) by the price per hamburger ($5), resulting in $25,000 per month. Revenue is a key component in determining the profitability of a business.

💡Cost of Goods Sold (COGS)

Cost of goods sold (COGS) refers to the direct costs attributable to the production of the goods sold by a company. In the video, Sally's COGS is the cost of supplies needed to make the hamburgers, which is $10,000 per month. This cost is a significant factor in calculating the gross profit and is part of the explicit costs.

💡Utility Costs

Utility costs are the expenses related to the use of utilities such as electricity, water, and gas. In the video, Sally's utility costs are $500 per month. These are necessary expenses for the operation of her business and are considered explicit costs.

💡Self-Employment

Self-employment refers to working for oneself rather than for an employer. In the video, Sally is self-employed, running her own business. This status implies that she has control over her work but also bears all the risks and responsibilities associated with business ownership.

💡Rational Decision-Making

Rational decision-making is a process where individuals make choices by comparing the costs and benefits of different options available to them. In the video, the discussion revolves around whether it is rational for Sally to continue running her business based on the accounting and economic profits. Rational decision-making is crucial for understanding economic behavior and business sustainability.

Highlights

Sally's business sells 5,000 hamburgers per month at $5 each, generating a total revenue of $25,000.

Cost of supplies for making hamburgers is $10,000 per month, calculated as 5,000 hamburgers times $2 per hamburger.

Employee costs amount to $5,000 per month, with two employees, Mike and Raj, each earning $2,500.

Utilities cost $500 per month for the business operations.

Accounting profit is calculated as total revenue minus explicit costs, resulting in $9,500 per month.

Sally could potentially rent out her building for $5,000 per month if she didn't run the business.

As an accountant, Sally could earn $6,000 per month, which is an opportunity cost if she works full-time at the restaurant.

Opportunity costs total $11,000 per month, including potential rental income and lost earnings from accounting work.

Economic profit is determined by subtracting explicit and implicit costs from total benefits, resulting in a negative $1,500.

Economic profit is always lower than or equal to accounting profit, as it includes opportunity costs.

It is not rational for Sally to continue running her burger business based on the current economic profit calculation.

Additional information about Sally's personal preferences or benefits from running the business could change the rationality of her decision.

The decision to continue the business should consider both explicit costs and implicit opportunity costs.

Sally's accounting profit does not reflect the full economic cost of her decision to run the business.

The rationality of Sally's decision is based on comparing the economic profit, which includes opportunity costs, to zero.

A negative economic profit suggests that the next best alternative could be more profitable for Sally.

The video emphasizes the importance of considering both explicit and implicit costs in business decision-making.

Transcripts

- [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.