Question

PLEASE HELP!

What is the difference between economic profit and accounting profit? What is a normal rate of return and how does normal, less than normal, greater than normal inform resource allocation?

Answer 1

Accounting profit is the difference between the total monetary revenues and the total monetary costs. This consists of just the explicit costs that a firm incurs, for eg. wages, rents, material costs etc.

Economic profit is the difference between the total monetary revenues and the total costs. Here the costs include both the explicit costs as well as the implicit costs. For example implicit costs include the opportunity cost associated with production. Since economic profits also include these costs, the economic profits are lower than accounting profits.

A normal rate of return is any rate of return that exceeds the costs, expenses and taxes needed to sustain the business or activity. The rate of return determines whether the investment is good enough or not. If the there is more than normal rate of return, then it means it is a very good investment and more resources should be allocated to it. If it gives a normal rate of return, it means that it is an investment with decent returns and thus the manager should focus on improving returns. But is the rate of return is below normal, then it means that is a very poor investment and thus the manager should pull out resources from the investment.