Hi again k9queen!
First, let's define a couple terms:
"The difference between a business's revenue and it's accounting
expenses. This is the profit that's listed on a company's balance
sheet, appears periodically in the financial sector of the newspaper,
and is reported to the Internal Revenue Service for tax purposes. It
frequently has little relationship to a company's economic profit
because of the difference between accounting expense and the
opportunity cost of production. Some accounting expense is not an
opportunity cost and some opportunity cost is does not show up as an
"The difference between business revenue and total opportunity cost.
This is the revenue received by a business over and above the minimum
needed to produce a good. In this sense, economic profit is a sign of
inefficiency. If a business receives an economic profit, then society
(the buyers) are spending more on a good than society (the resource
owners) are giving up to produce the good."
Now lets take another look at your question:
Bill runs his own business and last year he had a positive accounting
profit of $45,000 but a negative economic profit of $35,000. Bill
argues that the accouting profit represents money in the bank while
the economic profit is in some sense less real. Convince him that he
should pay attention to the economic profit because it does represent
how much better or worse off he could be; it is as real as any
Based on the information above, we know that:
Accounting profit = Revenues - Accounting Expenses = $45000
Economic profit = Revenues - total opportunity cost = $(35000)
Implicitly, this tells us that total opportunity cost here is $35000
more than whatever revenue is being made by the business. From our
definition, we know that "society (the buyers) are spending LESS on a
good than society (the resource owners) are giving up to produce the
good". This means that there is a certain inefficiency in that either
he is not running a business that even comes close to minimizing his
total opportunity cost.
Consider this example - say there is a man who is an extraordinarily
good musician, but he ignores this talent and decides to become an
accountant. Now the total opportunity cost of being an accountant is
the difference between his income as an accountant and as a musician
(assume he could sign a multi-million dollar contract with a record
company tomorrow if he wants). Now this man is running a severely
negative economic profit because he is not providing society with the
result of what he does best.
In much the same way, Bill is undervaluing himself - assuming his
accounting expenses were to remain the same, Bill could actually
increase his *accounting profit* by $35000 if he chose to do what he
was able to do best (in the economical sense). Therefore it is a
significant mistake to ignore economic profit as it measures how much
you can improve your situation!
Hope this answers your question - let me know if you have any
questions about the information above :)