Economists define different types of profits and costs in order to discuss how businesses operate and how well they operate. When determining the economic profit of a given business, an economist must consider not only explicit costs but also implicit costs -- including the normal profit required to maintain business as usual.
In economics, an "opportunity cost" of a business decision is anything that the decision prevents you from doing. For example, imagine you are able to either buy a giant, wall-to-wall television or take your family on a three-week vacation to Hawaii. You can buy the TV, but it will cost you the opportunity to go on vacation. If you take the vacation instead, the opportunity cost of taking a vacation is that you will be unable to buy a giant TV. Businesses are faced with similar choices when deciding how to use their finite resources.
Implicit vs. Explicit Costs
Opportunity costs may be either explicit or implicit costs. Explicit costs involve money that is spent on one resource and so it cannot be spent on another. For instance, you can't take your family on vacation because you don't have the money; you spent it all on a big-screen television. Implicit costs, however, are opportunity costs that do not involve spending money. For example, you can't drive your car to the airport for a vacation, because you are using it to drive to the store and buy a television. The implicit cost of a farmer's decision to grow potatoes is that he can't use the fields to grow anything else.
Normal profit describes the unpaid value of a business owner's time, or the minimum amount of profit that could sustain the business owner in his present model of production. For instance, a farmer works for over 40 hours a week, laboring in the fields and managing farm operations. Because he owns the business, he does not pay himself a salary; instead, he takes the money he could be earning and reinvests it into the business. Because he could be using his time and energy to earn a salary at a different job, this normal profit represents an opportunity cost of owning his farm. Because it does not involve the actual spending of money, normal profit is classified as an implicit cost of doing business.
Calculating Economic Profit
It is important for a business owner to track implicit costs such as normal profit, so that she can truly ascertain whether or not her business is profitable. For example, a business owner must subtract both explicit and implicit costs from total revenue to calculate the economic profit made by the business. If a business made $11,000 after subtracting only explicit costs from total revenue, it still might not be profitable if it is likely that the owner could have made $45,000 working at her mother's firm. In that case, the true economic profit would be $11,000 minus the normal profit value of $45,000 -- an actual economic loss of $34,000.