The general public and the business community typically define profit as the residual of sales revenue minus the explicit costs of doing business. It is the amount available to fund equity capital after payment for all other resources used by the firm. This definition of profit is accounting profit, or business profit.
The economist also defines profit as the excess of revenues over costs. However, inputs provided by owners, including entrepreneurial effort and capital, are resources that must be compensated. The economist includes a normal rate of return on equity capital plus an opportunity cost for the effort of the owner-entrepreneur as costs of doing business, just as the interest paid on debt and the wages are costs in calculating business profit. The risk-adjusted normal rate of return on capital is the minimum return necessary to attract and retain investment. Similarly, the opportunity cost of owner effort is determined by the value that could be received in alternative employment. In economic terms, profit is business profit minus the implicit (noncash) costs of capital and other owner-provided inputs used by the firm. This profit concept is frequently referred to as economic profit.
The concepts of business profit and economic profit can be used to explain the role of profits in a free enterprise economy. Anormal rate of return, or profit, is necessary to induce individuals to invest funds rather than spend them for current consumption. Normal profit is simply a cost for capital; it is no different from the cost of other resources, such as labor, materials, and energy. A similar price exists for the entrepreneurial effort of a firm’s ownermanager and for other resources that owners bring to the firm. These opportunity costs for owner-provided inputs offer a primary explanation for the existence of business profits, especially among small businesses.