What Does Zero Economic Profits Really Mean?
A Common Principle of Microeconomics
Throughout my economics courses, we would frame the world through markets. In any market, you have supply and demand. If the market is perfectly competitive, the intersection will be where price and quantity are set.
We refer to this equilibrium outcome as ‘efficient’.
If you have taken an economics course, you might remember that for an ‘efficient’ market with perfect competition, long run economic profits are zero.
I remember when I first learned this, it didn’t really make sense. If you were confused by it, the common response would be that economic profits are different than accounting profits. Accounting profits are the profits we usually think of — by taking revenues and subtracting costs. Economic profits were different though, in that they were dealing with the opportunity costs as well the actual costs.
Yet, this still didn’t seem to clarify things. Even as I continued on with my degree in economics, I never seemed to fully grasp what was meant by this.
I hope this example can help clarify things.
Example: The Opportunity Costs of Starting a Coffeeshop
Suppose you decide to start your own coffeeshop.
To begin, you need investment money to cover costs. You will need to purchase a store front, espresso machines, tables, etc. Suppose that you decide to use $70,000 of your own savings (these costs are fictitious — I don’t know how much it would cost to start this).
Now here’s the thing: there is an opportunity cost to that investment. You could’ve used that $70,000 as a down payment to buy a house, for instance. Or you could’ve put that into the stock market. Either of these could have made a return on investment that you forego by instead using it to start your business.
Let’s say that the average return on investment of your other options (house, stock market, etc.) would be 8%.
Therefore, to cover the opportunity cost of your decision to start a coffeeshop, you aim to have a profit of at least 8%.
Now, suppose the coffeeshop starts up and running. You have plenty of customers coming in ready to order lattes and iced coffee. Perhaps you begin by yourself, but you soon realize that you will need employees to help.
Just like when investing in the business initially, you face an opportunity cost in hiring each employee. Maybe you hire them at the minimum wage, which we will say is $9 an hour.
You could use that money to make a return elsewhere. For instance, you could use that for local advertising and marketing purposes. If you could make more money in using it for other purposes, you would not hire workers. Yet, you realize that you need the employees in order to provide service to the increasing number of customers you have, and therefore the opportunity cost of not hiring an employee is higher than the other options.
Similarly, if you find two workers who are willing to accept minimum wage for their labor, this suggests that they will be making a higher return on their time investment in working for you than they could make elsewhere. For instance, suppose that another similar business was hiring at $9.50 an hour for their same skill level. In this case, they would face a higher opportunity cost by not working for your competitor, and instead switch to working there.
In other words, the wage rate covers the opportunity cost for both the worker and for the employer to hire them.
And just like for your employees, there is an opportunity cost for your time managing and operating the coffeeshop. You plan to at least make 8% to cover the opportunity cost of your investment. This though only covers the opportunity cost of that capital, but does not cover the effort and risk you take. Putting money in the stock market might not take that much effort, but starting a business does.
For example, the time you put in to managing the coffeeshop could be used to work for someone else and make money. You likely will be putting in far more hours in starting your own business, and expect to make a higher return as a result. You also face the risk that your business will fail, and so you expect to make a higher return for that as well.
Let’s say that, on average, for someone starting a coffeeshop, they expect to at least make an extra 7% return on investment for their effort and risk (above the 8% for their opportunity cost of placing their money elsewhere).
Revenues and Costs
So let’s say the coffeeshop continues running, and over time we evaluate the revenues and costs to assess profitability.
With the revenues generated, you first pay labor costs, and thereby cover the opportunity cost of labor. Then you might pay off any expenses related to the storefront or machinery/capital, covering the opportunity cost of capital. Lastly, you have accounting profits that remain after covering these costs.
In this case, in a perfectly competitive market, we would expect the profits (as a % ROI) to provide a 15% return on investment for you. Therefore, you cover the 8% return you could’ve generated by placing your money elsewhere. You also cover the additional 7% return you need in order to cover the opportunity cost associated with the risk and effort you put into the business.
In this case, you make money (accounting profits) but you do not earn excess profits greater than the opportunity costs you face. Economic profits are therefore zero.
Along with this, because each resource (capital/investment, labor, management, etc) is being used to maximize their opportunity cost, we would say that they have been allocated efficiently. In other words, resources are being used to their best ability.
