Theories of Profit

Theory of Profit

Profit

Profit may be defined as a reward for the services of entrepreneurs in production the term profit when used in ordinary language generally refers to gross profit.

In the general sense profit is referred to the difference between the selling price and the cost of a product but in the modern production system, it has a great significance.

Scholars have the following definitions-

1. “Profit is the earning of management.” -Marshall

2.”Profit is the award of those risks that are not insured.-H.M. Crum

Modern (Innovation) Theory of Profit

Prof. Schumpeter propounded the innovation theory of profit Schumpeter has given the term innovation very wide meaning. Discovery of a new material or a new technique of production resulting in the lowering of the cost of production or improving the quantity of the product is an innovation.

Any new measure or new policy initiated by the entrepreneur comes under innovation as Schumpeter uses the term innovation may be two types:

1. Those, which change the production, function and reduce the cost of production
2. Those which stimulate the demand for the product. According to him, innovation include-

• Introducing a new good or new quality of goods.
• Introducing a new method of production.
• Uses of new sources of raw materials.
• New methods of persuading customers to buy more of a product.
• Finding a new market to sell.

When an entrepreneur introduces an innovation, it generates surplus over cost of innovation called profit provided the price of the innovated commodity does not fall below its cost and the average, cost of production with new methods.

Uncertainty Bearing Theory of Profit

The American economist, Prof. Knight first propounded this theory. According to Prof. Knight profit is the reward for uncertainty bearing. Profit accrues to the entrepreneur, because he bears uncertainty in business. Prof. Knight divided risks under two heads:

• Foreseeable Risk and
• Unforeseeable Risk.

He calls unforeseeable risk as uncertainty bearing and it is because of this uncertainty bearing that profit accrues to the entrepreneur Profit. According to him, does not arise on account of foreseeable risk because such a risk can be covered through insurance. Insurable risk, thus, does not give rise to profit. Profit according to Prof. Knight is due to non-insurable or unforeseeable risks. Some of the non-insurable risks which are as in modern business are as follows:-

1. Competitive Risks –

   Some new firms might enter into the industry and the existing firm may have to face serious competition from them. This will inevitably lower down the profit of the firm in question.

2. Technical Risks –

   Some new techniques of production might come into vogue or some new types of machinery might be invented. The existing firm may not be in a position of adopt or incorporate these changes into its organizational setup and may thus suffer losses in competition with other firms

3. Risks of Governmental intervention –

   The government might, in course of time, intervene in the affairs of the industry by fixing the maximum, price of the product. This might ultimately reduce the profit of the firm.

4. Business Cycle Risks:

   The advent of business recession or even depression might result in reduced consumer purchasing power and consequently less demand for the product of the firm.

Since these risks cannot be foreseen and statistically measured, no insurance company will be prepared provide cover against them. Hence, these are non-insurable risks or uncertainty bearing. According to Prof. Knight there is a direct relationship between profit and level of profit. Thus, according to this theory, profit is not due to risk taking out due to uncertainty bearing.

Criticism:

The theory has been criticised on the following basis-

1. Economic Friction:

   Uncertainty is not the only factor that limits the supply of entrepreneurs. Lack of funds, lack of knowledge, lack of opportunities and the presence of economic frictions are some of the factors that restrict the supply of entrepreneurs.

2. Reward of other Service:

   Uncertainty bearing is not the only function of the entrepreneur. The Profit that he gets is also the reward for other services that he renders e.g. initiating, co-coordinating etc.

3. Real Cost –

   uncertainty bearing cannot be elevated to the status of a factor of production. it is an element of real costs, which means exertion, abstinence, sacrifice etc., as distinguished from money cost. Cost is not generally measures in terms of real cost. We know that capital is a factor of production but not abstinence that capital.

4. Imaginary:

   Knight’s theory does not seem to have much relevance to the real world. Businessmen continue to estimate profits ex-ante in defiance of this theory. This theory has been criticised as heavily insulated from empirical testing and empirical relevance.

Rent Theory of Profit

Walker and other American economists developed the rent theory of profits. This theory is based on the concept of pure profits. The actual earnings of an entrepreneur come partly from ownership of capital, land and other factors of production and partly from his ability. Only the latter i.e. ability is called pure profit: On this basis, we can say that:

Pure Profit= Gross Income of the Entrepreneur

= (interest on this own capital + rent of his own land and buildings + wages of his work).

= The net income of entrepreneurial ability :

As seen from the above, the pure profit of an entrepreneur is dependent upon the difference between his ability and the ability of the marginal producer in the market. The marginal producer is a person who earns only his expenses of production, of course including the costs of factors supplied by him.

The market price is equal to the cost of production of such an entrepreneur and he earns no profit. An entrepreneur of superior ability is able to produce goods at a cost much less than the market price. Only those entrepreneurs earn profits that are of superior ability as compared to those of the marginal producers. Such an entrepreneur may be called the intra-marginal producer. The amount of profits which an entrepreneur earns depends on the extent of his superiority over the marginal producer.

Thus, we see that the above view of profits makes it analogous rent of land. In this theory, it has been assumed that there are a variety of grades of business workmen and ability in the same way as there are a variety of grades of land. The rent of a plot of land also depends on the extent of its superiority over the marginal land in the same way the pure profit of an entrepreneur depends on how much superior he is as compared to the marginal entrepreneur or producer.

Criticism:

The Rent theory of profits has been criticised on the following grounds:

• It does not explain how the amount of true profits is determined.
• This theory overlooks the elements of risks and uncertainty.
• An entrepreneur usually undertakes some amount of risks and faces uncertainty. In case he would not keep the productions or business going. Therefore the normal rates of profits cannot be zero.
• Profit is not an unearned surplus like rent. A positive rate of profit is necessary to enable the entrepreneur to continue production or business.

Distinction between Profits and Rent

The following distinction between profit and rent may be noted;

• Profit is a reward for the risk undertaken, while rent is an income derived from the gifts of nature.
• Profit is the rent of ability, while rent is the reward which the landlord gets in lieu of nature.
• Profit is not static, but it is dynamic in character Rent is often static and there is no possibility of an immediate change therein.
• The rate of profits is not definite, while the rate of rent is definite.
• In order to gain profit it is necessary to undertake risks while in the case of rent it is no possibility for the landlords to undertake risks.
• There is uncertainty in profit, while there is certainty in rent.
• It is often that profits are influenced by price, while price does not influence rent.
• A number of persons benefit from the profits, but in the case of rent it is only the landlord who profit.
• Profits are a specialised type of wages, while rent has no concern with labour.
• Profit, to a certain extent, depends on chance, whereas rent has nothing to do with chance. The landlord gets his rent under every circumstance.

Important links

• Price-Discrimination- Degree & Essential Conditions
• Price determination under Oligopoly
• Kinked Demand Curve
• Monopolistic competition- Price & Output Determination
• Wages- Meaning, Causes, Marginal theory etc.

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