Let’s return to Ashley Hildreth and assume that she faces the choice of either completing a two-year full-time graduate program in teaching or spending those two years working in her original field of advertising. We’ll also assume that in order to be certified as a teacher, she must complete the entire two years of the graduate program. Which choice should she make?

To get started, let’s consider what Ashley gains by getting the teaching degree—what we might call her revenue from the teaching degree. Once she has completed her teaching degree two years from now, she will receive earnings from her degree valued today at $600,000 over the rest of her lifetime. In contrast, if she doesn’t get the degree and stays in advertising, two years from now her future lifetime earnings will be valued today at $500,000. The cost of the tuition for her teaching degree program is $40,000, which she pays for with a student loan that costs her $4,000 in interest.

At this point, what she should do might seem obvious: if she chooses the teaching degree, she gets a lifetime increase in the value of her earnings of $600,000 − $500,000 = $100,000, and she pays $40,000 in tuition plus $4,000 in interest. Doesn’t that mean she makes a profit of $100,000 −$40,000 − $4,000 = $56,000 by getting her teaching degree? This $56,000 is Ashley’s accounting profit from obtaining her teaching degree: her revenue minus her explicit cost. In this example her explicit cost of getting the degree is $44,000, the amount of her tuition plus student loan interest.

Although accounting profit is a useful measure, it would be misleading for Ashley to use it alone in making her decision. To make the right decision, the one that leads to the best possible economic outcome for her, she needs to calculate her economic profit—the revenue she receives from the teaching degree minus her opportunity cost of staying in school (which is equal to her explicit cost plus her implicit cost). In general, the economic profit of a given project will be less than the accounting profit because there are almost always implicit costs in addition to explicit costs.

When economists use the term profit, they are referring to economic profit, not accounting profit. This will be our convention in the rest of the book: when we use the term profit, we mean economic profit.

How does Ashley’s economic profit from staying in school differ from her accounting profit? We’ve already encountered one source of the difference: her two years of forgone job earnings. This is an implicit cost of going to school full time for two years. We assume that the value today of Ashley’s forgone earnings for the two years is $57,000.

Once we factor in Ashley’s implicit costs and calculate her economic profit, we see that she is better off not getting a teaching degree. You can see this in Table 9-2: her economic profit from getting the teaching degree is −$1,000. In other words, she incurs an economic loss of $1,000 if she gets the degree. Clearly, she is better off sticking to advertising and going to work now.

Let’s consider a slightly different scenario to make sure that the concepts of opportunity costs and economic profit are well understood. Let’s suppose that Ashley does not have to take out $40,000 in student loans to pay her tuition. Instead, she can pay for it with an inheritance from her grandmother. As a result, she doesn’t have to pay $4,000 in interest. In this case, her accounting profit is $60,000 rather than $56,000. Would the right decision now be for her to get the teaching degree? Wouldn’t the economic profit of the degree now be $60,000 −$57,000 = $3,000?

The answer is no, because in this scenario Ashley is using her own capital to finance her education, and the use of that capital has an opportunity cost even when she owns it.

Capital is the total value of the assets of an individual or a firm. An individual’s capital usually consists of cash in the bank, stocks, bonds, and the ownership value of real estate such as a house. In the case of a business, capital also includes its equipment, its tools, and its inventory of unsold goods and used parts. (Economists like to distinguish between financial assets, such as cash, stocks, and bonds, and physical assets, such as buildings, equipment, tools, and inventory.)

The point is that even if Ashley owns the $40,000, using it to pay tuition incurs an opportunity cost—what she forgoes in the next best use of that $40,000. If she hadn’t used the money to pay her tuition, her next best use of the money would have been to deposit it in a bank to earn interest.

To keep things simple, let’s assume that she earns $4,000 on that $40,000 once it is deposited in a bank. Now, rather than pay $4,000 in explicit costs in the form of student loan interest, Ashley pays $4,000 in implicit costs from the forgone interest she could have earned.

This $4,000 in forgone interest earnings is what economists call the implicit cost of capital—the income the owner of the capital could have earned if the capital had been employed in its next best alternative use. The net effect is that it makes no difference whether Ashley finances her tuition with a student loan or by using her own funds. This comparison reinforces how carefully you must keep track of opportunity costs when making a decision.