Thursday, July 30, 2009

Economic Profits vs. Accounting Profits

I don't mean to pick on James Kwak over at Baseline Scenario because I do generally enjoy the blog, but a piece of a post he wrote today reminded me of an elementary mistake many people make that is worth pointing out.

Criticizing a piece in today's Washington Post written by a Yale Law professor, Kwak says:

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost.

But Kwak fails to draw the distinction that he is talking about a different type of profit than the professor is talking about.

The professor is referring to accounting profits. This is what a company reports to the public in the form of net income at the end of a quarter or year (corporate earnings, as the professor calls them). Quite simply, it is the company's total revenues, or sales, minus its expenses, which include the cost of labor, supplies, shipping, buildings, etc. It's what accountants get paid to figure out.

Kwak confuses things, though, because he is referring to economic profits. This is what an economic professor is talking about when he teaches you Econ 101. This includes "costs" an accountant would not consider when reporting net income, mainly opportunity costs. An opportunity cost, as Wikipedia nicely sums up, is the "value of the next best alternative forgone as the result of making a decision."* Economic profits -- not accounting profits -- go to 0 in a perfect economy because companies will continue to enter a market until the benefits of entering market B (in other words, the opportunity cost to entering market A) outweigh the benefits of entering market A. The cost of having to choose to enter market A instead of entering market B, though, is not an expense as an accountant would think of things, so you can easily have an accounting profit in a perfectly competitive market where economic profits are, in fact, equal to zero.

This doesn't necessarily mean Kwak's main argument is wrong, but it is a mistake worth mentioning (which is why I pointed it out in the comments of the post, too). Hopefully this post will keep you from making the same mistake in the future.

* For instance, let's say you take a job with company A for $50,000 over a job with company B for $45,000. The opportunity cost of taking the job is $45,000.

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