Profit

Economic Profit and Decision Making

Economic profit of zero indicates a "normal" level of profit. Positive economic profit can be thought of as exceptionally good, and negative economic profit can be thought of as specifically bad.
An individual is creating his own business. He expects this business to have a total revenue of $100,000 per year and a total explicit cost of $60,000 per year. Is entering into this business a smart move? It's tempting to conclude that the answer is yes, because the yearly accounting profit is positive ($100,000$60,000=$40,000)(\$100,000\;-\;\$60,000\;=\;\$40,000) . The person's business would make $40,000 per year.

However, the individual already has a job that pays $50,000 per year. He would have to quit his current job to start a business. His $50,000 per-year job counts as an implicit cost of starting the business. If he currently makes $50,000 per year, he would lose money by quitting his current job and starting a business that earns him $40,000. This kind of information is important to consider when making business decisions.

An economic profit analysis can be helpful in the decision-making process. Positive versus negative profit is important information when evaluating a business opportunity. If economic profit is negative, an individual might do better pursuing a different opportunity. If economic profit is positive, an individual should adhere to the choice.

Of course, economic profit could also be exactly equal to zero. An economic profit of zero indicates that there is not much difference between the chosen opportunity and the next-best alternative. The potential for zero economic profit is very common. It is incorrect to think of an opportunity only being valuable if it makes a profit. An economic profit of zero can be thought of as an "acceptable" level of profit. For this reason, normal profit exists when a firm's total costs and total revenue are equal.

Considering the economic profit can help an individual or business decide if the risk involved in a decision is worthwhile. There are always risks in business—if a business can make good decisions about what risks to take, the economic profit of the business will grow. Many businesses take time to increase economic profit from zero, but even at an economic profit of zero, the business is not losing money.

Negative economic profit over a period of time shows that despite investments and attempts to grow the business, it is not profitable. Understanding whether economic profit is at zero, negative, or positive is important when making decisions about starting, continuing, or closing down a business activity.
A business that is breaking even is considered to be functioning. A business making a profit is successful. A business making a loss (negative profit) is considered to be failing.