$3000 per month that would be missed by the accountant who measures
only the explicit cost of her wage at $1000 per month.
Opportunity Cost of Financial Capital
What is the opportunity cost of the financial capital that owners have
invested in a firm? This question applies equally to small, owner-operated
businesses and to large corporations. The answer is best broken into two
parts. First, ask what could be earned by lending this amount to someone
else in a riskless loan. The owners could have purchased a government
bond, which has no significant risk of default. Suppose the return on this
is 3 percent per year. This amount is the risk-free rate of return on capital.
It is clearly an opportunity cost, since the firm could close down
operations, lend out its money, and earn a 3 percent return. Next, ask
what the firm could earn in addition to this amount by lending its money
to another firm where risk of default was equal to the firm’s own risk of
loss. Suppose this is an additional 4 percent. This is the risk premium, and
it is clearly also a cost. If the firm does not expect to earn this much in its
own operations, it could close down and lend its money out to some
equally risky firm and earn 7 percent (3 percent risk-free return plus 4
percent risk premium).
Economists include both implicit and explicit costs in their measurement of profits, whereas
accountants include only explicit costs. Economic profits are therefore less than accounting
profits.Table 7-1 compares economic and accounting profits for a hypothetical
owner-operated firm that produces gourmet soups. In that example, both
3