The term "negative economic profit" may sound like a euphemism for a "loss," but it's more complicated than the traditional concepts of profit and loss. For economists, profit involves more than revenues and costs — it also considers alternative ways in which individuals and businesses may have deployed their available resources.
In accounting, profit is the difference between revenues and costs and is the figure traditionally reported in corporate balance sheets and financial reports. This differs from economic profit, which is the difference between accounting profit and the cost of ownership, or equity capital. When the cost of equity capital exceeds the accounting profit, firms have what's known as a "negative economic profit." This means that a firm can have a positive accounting profit and a negative economic profit simultaneously.
Understanding negative economic profit requires consideration of implicit costs and revenues, as well as the explicit revenues and costs considered by accountants. Explicit revenues and costs include the money received from the sale of goods and the cost of producing those goods, such as labor and equipment. Implicit revenues and costs involve the value of capital goods, such as facilities used by firms to produce goods. For economists, revenue includes the money received by a firm for selling its products and services, plus any increase in the value of assets the company owns, such as its factory and equipment. Harvard economist Gregory Mankiw defines implicit costs as those that don't require a firm to spend money.
A key implicit cost is what economists call an opportunity cost, or the cost of what an individual or business must give up to get something else. For economists, using a resource for one purpose means that resource can't be allocated to another use. Mankiw cites the example of a woman buying a business instead of leaving the money in an interest-bearing account. The opportunity cost of buying the business is the interest she could have earned on her money. If the foregone interest is greater than the accounting profit generated by this business, she has a negative economic profit.
Because accountants don't consider implicit costs, accounting profits are usually bigger than economic profits, according to Mankiw. Economic profit, however, provides a means for coordinating economic activity. Positive economic profits attract more investors, while negative ones drive away investors, who then search for more productive firms and sectors in which to invest their money.
- "Principles of Economics" (3rd ed.); N. Gregory Mankiw; 2004
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