jmherbenerIt’s more than just a construct for businesses to report to the government. It’s an aspect of economic calculation itself.
Let’s take a stylistic example. Joe and Mary Smith own the Main Street Diner, a mom and pop restaurant, in Grove City, Pennsylvania. For 2014, their net income was $80,000. During the year, Joe worked for 1,000 hours as a cook and Mary worked 1,250 hours as a waitress. They pay their cooks $12 an hour and their waitress $8 an hour. Considering the sources of their net income (i.e., what productive contribution did they make to the operation of their restaurant), $22,000 of their net income of $80,000 came from the value of their labor. They earned implicit or imputed wages since they could have earned $22,000 if they were hired elsewhere as a cook and waitress. Mary and Joe also invested $1 million of their own saving into the restaurant. The annual rate of interest on similar loans is 5 percent. Thus, $50,000 of their net income of $80,000 is implicit or imputed interest since they could have lent their $1 million to someone else and earned $50,000. Assuming that they make no other productive contribution, the residual $8,000 of their net income of $80,000 is profit for their entrepreneurship.
In making production decisions, it’s valuable for Joe and Mary to be able to calculate the sources of their income. If an economist wanted to compile everyone’s income, he would use these economic categories of sources of income: Wages for labor; Rent for land; Interest for capital; and Profit for entrepreneurship. Accurately compiling everyone’s income by source would require the economist to take account of implicit or imputed income earned in the four sources of income.