I'll tell you a little story first,
and then we'll quantify it.
Suppose I told you that,
you know you've got a nice job,
let's say you're making a nice living,
$70,000, working your way up the chain at your business.
And you decide, you know what?
I'm tired of this rat race.
I'm going to buy a stainless steel hot dog cart and put it on the corner of the street.
So, pick any street, Manhattan, San Francisco, Chicago,
London wherever you're going to drop down one of these hot dog carts.
Start making hot dogs. Sell them on the street.
That's a good business. Now, at the end of the year,
you have to do your taxes.
You hire an accountant, and the accountant comes and looks at everything.
You've got a really good accountant.
The accountant takes kept track of all your costs,
all your revenues and he's got even the fines you had to pay the policeman,
because you parked in the wrong spot one day and,
all the other things that happen in your business.
And he says at the end,
walks up and shakes your hand and says "I got to tell you,
you're really a great guy.
You made $60,000 this year.
Your net profit was $60,000!"
And you say, "Well, thanks a lot."
And in fact, the accountant being a good accountant reminds you that
you have to report that on Schedule C of the IRS,
that is the tax form because the taxpayer wants to know how much income did you make,
your net profit as well.
The accountant has provided you with all the revenue information to put on Schedule C,
and all the cost information to put on Schedule C for the tax authority.
But something's beginning to nag you in the back of your head.
And that's something that was beginning to nag you is that you gave up
a job making 70,000 to take a job making 60,000.
Now, you may say "Well you know what,
I'm my own boss, that's what I wanted all along."
Well let's put that aside for a moment.
To an economist, remember what we did from the very beginning,
we're thinking about resource allocation issues.
We're thinking about who determines where funds are put in.
We had that little Torn old sheet about computer chip prices back in 1990.
And we know what happened in that industry,
is that people put lots of money into the industry,
they started moving into industry and they made lots of returns.
Well in this case,
you're putting money into a hot-dog industry but the market is telling you
"That's pretty good but looks like you'd be better off in other areas".
Somebody's willing to pay you 70,000 for your talent,
rather than a 60,000 for putting it on the side.
So, to an economist,
we take all of the costs that the accountant can bring up,
we call those explicit costs and we have to add in the opportunity costs.
What could you have done in your next best line of business?
It's incredibly important that we think about that.
And so, I'm going to put out some terminology here.
I'm going to say that,
accounting profit is equal to total revenue minus total explicit costs.
Economic profit, but you might notice I didn't put
any subscript there because this is an Econ class so,
we don't have to subscript that.
We said if we've got a pi there that means econ.
Alright. We'll put the eco on there
if we're talking about something other than economics.
But right now, economic profit is equal to total revenue minus total explicit costs.
Everything your accountant told you when he or
she added up all those costs and, those opportunity costs.
What could you have been doing in your next best line of business?
So, economic profit for us is just total revenue minus total cost.
But for us, this total cost includes opportunity costs.
Economists will tell you that the good manager is the person who when the accountant
walks into the CEO's office and drops down the books and says "Boss,
even in this terrible climate we're having in the economy these days,
this quarter we made three million dollars profit.
You did a great job". Accountant turns around and walks out.
Good managers will ask the very first question,
"I know I made positive profits,
and I know that's going to be reported in the paper but the question is,
what could I have done elsewhere?
What if I just liquidated my assets and got out of making
Twinkies and started making automobiles.
What if I started figuring out new batteries?"
All these sorts of other possibilities.
My assets are tied up into this production and I made some positive profit.
But I have to keep asking myself the question,
was it really positive economic profit?
If there's something out there that could've made more profit than this,
I'm going to have to report this positive profit to the government,
and I'm going to pay taxes on it.
But damn! I wish I had that over there.
So, moving forward,
our job is to figure out a way that allows us to understand what this graph looks like.