Question

In a free enterprise system, economic profits play an important role in guiding the decisions made by the thousands of competing independent resource owners.

a. Explain the concept of economic profit. Illustrate using an example.

b. Why do different resource owners obtain different profits, even when operating in the same industry?

Answer 1

An economic profit is different from a accounting profit. Accounting profit is the difference between revenue earned and actual cost incurred. Economic profit also takes into account the opportunity cost. For example, if we take a factory whose actual cost is 1000 and revenue 1200, accounting profit is 200. But suppose that 1000 is invested in an alternative business which gives a return of 100. Then this profit is foregone by investing in the factory. So economic profit is 1200-1100= 100.

Different resource owners have different profits due to the difference in opportunity cost. If someone's resources have a higher opportunity cost, it's profit will be lower evne in the same industry.