Business Profits, Economic Profits, and Rents

The IRS defines profits as total revenue minus total allowable costs. In general only costs that have an objective basis are allowed (though a few other items like allowable depreciation of assets can also be counted in the costs). Thus, you have to be able to document that you actually paid someone or some firm a specific amount. These “profits” are, for the most part, really a return to the stockholders of the firm on their investment in the firm. In fact, paying stockholders as much as they could have earned elsewhere on the dollar value of their investment in the firm is really a part of the firm’s costs and should be included as part of the costs.
Economists argue that profits should be defined as total revenue minus total costs when every single input (every hour of labor, every nail, every computer, every building, every machine, every truck, every plane, etc.) is paid its opportunity costs—as much as that input could have earned in its next best alternative even if the firm owns the trucks, buildings, machines, and planes and therefore does not have any objective measure of the cost (any receipt or record of the transaction’s cost). Therefore, if any thing is left over after subtracting total costs from total revenues, it is not the reward to, or due to, any specific factor of production—it is economic profit, simply a residual. Why would economic profit arise? Unexpectedly the firm finds that the demand for what it produces has increased allowing it to sell more and, likely, charge a higher price leading to a positive residual. This will entice other firms into the market, increasing the market supply—or from the point of view of the firm, reducing its demand—leading to falling prices and an elimination of the profits. Or...

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