Let's begin by getting in the mindset of a business or investor.
The point of owning a business or being an investor is to make a profit, which, for a business, is simply revenues or sales minus costs.
Profit = Revenues - Costs
Now, firms have to make strategic decisions all the time, such as what to produce, which technology to use, whether to hire more labor, etc.
Whatever their decision, they are sacrificing something else.
EXAMPLEFor example, suppose a firm has to make a decision about producing Product A or Product B. If they decide to focus their attention on Product A, they are sacrificing the ability to produce Product B, as well as sacrificing the potential returns that Product B could have given them.
Investors also make decisions. When investing, they are looking at which company will yield a better return.
They need to evaluate whether a potential investment is safe versus risky.
Therefore, whatever their decision, investors are also sacrificing the return that could have been made on the other option.
Opportunity costs are the sacrifices made by choosing one value or opportunity over another.
This concept is important in economics because opportunity costs help us decide whether we made a good decision or not.
Accounting profit is rather straightforward: total revenue minus total cost.
Total revenue--abbreviated TR--is the price of the product times the quantity sold.
Total cost is the cost per unit times the quantity. Note that the cost per unit here represents explicit, out-of-pocket costs only.
In economics, we take this a step further, stating that economic profit is our total revenue minus all of our costs, which would also include opportunity costs.
In the economic profit formula, total costs doesn't simply include things like paying your employees or purchasing your raw materials. It also includes what you are sacrificing or giving up.
EXAMPLEFor example, if you did take your money out of a safe investment and put it into a more risky investment, you are giving up the return that the initial invested amount could be earning. Or, if you quit your job to start a business, an economist would say that you need to measure the salary that you are giving up in order to start the new business.
These things are not included in a straightforward accounting profit, but they are very much considered in economic profit, because they represent opportunity costs.
Source: Adapted from Sophia instructor Kate Eskra.