- Profit is the financial benefit realized from the business activity when the revenues generated exceeds the costs and expenses incurred in the operation of such activities. Simply, the total cost deducted from total revenue yields profit.
- The profits of the organization depend on the successful management of business operations, i.e. how well an entrepreneur manages the risks and uncertainties of the firm.
- Although the profits are directly linked to the entrepreneur and his functions, several economists have given their varied views on origin, nature and role of profit. Till date, there is no complete consensus among the economists with respect to the true nature and origin of profit. Due to this, several theories of profit came into existence.
- The main reason behind the formation of so many profit theories is the confusion among the economists arising due to lack of agreement between them regarding the true and proper function of the entrepreneur. Some believed that the function of an entrepreneur is to coordinate and organize the factors of production; others have described the role of the entrepreneur as a risk bearer, while some considered profits as a non-functional income.
Theories of Profit
- Walker’s Theory of Profit: Profit as Rent of Ability
- Clark’s Dynamic Theory of Profit
- Hawley’s Risk Theory of Profit
- Knight’s Theory of Profit
- Schumpeter’s Innovation Theory of Profit
- Monopoly Theory of profit: Monopoly Power as Source of Profit
WALKER’S THEORY OF PROFIT AS RENT OF ABILITY
- Walker’s Theory of Profit, also called as a Rent Theory of profit was propounded by F.A. Walker, who believed that profit is regarded as a rent of differential ability that an entrepreneur may possess over the others.
- Walker’s theory of profit works on the same principle as that of land rent, which is the difference between the yields of least and most effective fertile lands. Likewise, the profit is the rent of the least and most efficient entrepreneurs. Generally, the least efficient worker tries hard to cover only the cost of production while the efficient worker earns extra for his differential abilities. Thus, the rent theory of profit posits that the profit of an entrepreneur depends on a degree to which his abilities are exceptionally different or unique over the others
- The walker’s theory of profit is based on the assumption that a state of perfect competition prevails, wherein all the firms are presumed to attain the same managerial ability. Each firm would draw wages for management ability, which in the Walker’s view do not form a part of the pure profit. The wages of management are regarded as ordinary wages. Thus, under the perfect completion scenario, there will be no pure profit and each firm will earn the management wages, known as normal profit.
- The walker’s theory of profit is mainly criticized due to its inability to explain the nature of profit. It provides only the measure of profits and not its real nature, which is of utmost importance. The assumption that profits arise due to the differential ability of an entrepreneur does not always stand true. The rise in the profits could also be due to the entrepreneur’s monopoly in the market.
- This theory is unrealistic: Walker’s view of Profit as a surplus like rent is unrealistic and it cannot be accepted as true approach of Profit.
- It is not a true surplus as Marshall has said: In this connection Marshall has said that land can earn positive or zero rent. But in the case of firm’s entrepreneurs may have negative profits or losses.
- Profits only in a dynamic state: Rent can emerge in both static and dynamic conditions whereas profits we can find only in a dynamic state.
- Profit is not gift of ability: Profit does not arise always due to the superior ability of the entrepreneur. It may arise due to monopoly, innovation, risk, uncertainty etc.
- This theory overlooks the important function of the entrepreneur as a risk-bearer: From the profits of entrepreneur we must deduct the losses sustained by some others, who have been driven to bankruptcy. When this is done, there may be no surplus element in Profit and the analogy to rent vanishes.
CLARK’S DYNAMIC THEORY of profit
- J. B. Clark advocated his theory of profit in 1900. J. B. Clark is of the opinion that profits arise in a dynamic economy, not in a static economy.
- Astatic economy is defined as the one in which there is absolute freedom of competition; population and capital are stationary; production process remains unchanged overtime; goods continue to remain homogeneous; there is freedom of factor mobility; there is no uncertainty and no risk; and if risk exists, it is insurable.
- In a static economy therefore, firms make only the ‘normal profit’ or the wages of management.
- A dynamic economy on the other hand, is characterized by the generic changes. In the dynamic world the factors undergo a process of change.
The generic changes include
- The size of population increases;
- Amount of capital increases;
- Enhancement in production method;
- The forms of business organizations changes; and,
- Increase of consumers’ wants.
- The major functions of entrepreneurs or managers in a dynamic environment are in taking advantage of the generic changes and promoting their businesses, expanding sales, and reducing costs. The entrepreneurs who successfully take advantage of changing conditions in a dynamic economy make pure profit.
- From Clark’s point of view, pure profit is momentary. In the long-run with the passage of time competition forces other firms to imitate changes made by the leading firms, leading to a rise in demand for factors of production. Consequently, production costs rise, thus reducing profits, especially when revenue remains unchanged.
- The gist of Clark’s theory is that profit is a reward for inventing products and techniques of production and for managing the functions of entrepreneurs under dynamic conditions. Profit is recognition of dynamic entrepreneurship.
Clark’s dynamic theory of Profit has been severely criticized by Prof. Knight and others on the following grounds
- All changes are not foreseen:
- This theory gives artificial dichotomy:
- All changes do not lead to Profit
- Here, the concept of frictional Profit is vague
- Element of risk involved in business
HAWLEY’S RISK THEORY OF PROFIT
- Hawley’s Risk Theory of Profit was propounded by F.B. Hawley, who believed that those who have the risk taking ability in the dynamic production have a sound claim on the reward, called as profit. Simply, profit is the price that society pays to assume the business risk.
- The risk in business may arise due to several factors, Viz. Obsolescence of a product, non-availability of crucial materials, sudden fall in the prices, and introduction of a better substitute by the competitor, risk due to war, fire or any other natural calamity.
- Hawley’s risk theory of profit is based on the notion that the businessman would expect adequate compensation in excess of the actuarial value, i.e., premium on calculable risk, for assuming the risk. Every entrepreneur strives to gain in excess of wages of the management for bearing the business risk.
- The major reason behind the Hawley’s opinion that profit should be maintained over and above the actuarial risk is that the assumption of risk is annoying; it leads to trouble, anxiety, and disutilities among the businessman of several kinds. Thus, assuming risk grants entrepreneur a claim to a reward above the actuarial business risk.
- According to Hawley, the profit consists of two parts: One representing the compensation for the actuarial loss suffered due to several classes of risks assumed by the entrepreneur; Second part represents the inducement to bear the consequences due to the exposure to risk in the entrepreneurial adventures.
- Hawley’s risk theory of profit is based on the assumption that profits arise from the factor ownership, as long as the ownership involves risk. Hawley believed that an entrepreneur must assume risks to qualify for the additional rewards (profit). On the contrary, if he avoids the risk by insuring against it, then he would cease to be an entrepreneur and would not be entitled to profits. Thus, it can be concluded that it is the uninsured risk from which the profit arises and until the product is sold an entrepreneur’s amount of reward cannot be determined. Hence, in Hawley’s opinion, the profit is a residue and therefore his theory is also called a Residual Theory of Profit.
- Risk-taking is not the only entrepreneurial function which leads to emergence of profits. Profits are also due to the organizational and coordinating ability of the entrepreneur. It is also reward for innovation.
- According to Carver profit is paid to an entrepreneur not for beaming the risk but for minimizing and avoiding risk.
- This theory assumes that profit is proportional to risk undertaken by entrepreneurs. But this is not true in practical life because even entrepreneurs who do not take any risk are paid profit.
- Knight says that it is not every risk that gives profit. It is unforeseen and non-insured risks that account for profit. According to Knight Risks are of two types viz., foreseeable risk and unforeseeable risk. The risk of fire in a factory is a foreseeable risk and can be covered through insurance. The premium paid for the fire insurance can be included in the cost of production. The entrepreneur can foresee such a risk and insures it. An insurable risk in reality is no risk and profit cannot arise due to insurable risk.
- There is little empirical evidence to prove that entrepreneurs earn more in risky enterprises. In a way all enterprises are risky, for an element of uncertainty is present in them and every entrepreneur aims at making large profits.
KNIGHT’S THEORY OF PROFIT
- This theory of profit is propounded by frank H. Knight who treated profit as a residual return because of uncertainly, and not because of risk bearing. Knight made a distinction between risk and uncertainly by dividing risk into two categories, calculable and non-calculable risks. They are explained as below:
- Calculable risks are those, the prodigality of occurrence of which van be calculated on the basis of available data. For example risk, due to fire theft accidents etc. are calculable and such risks are insurable.
- Incalculable risks are those the probability of occurrence of which cannot be calculated. For Instance there may be a certain elements of cost, which may not be accurately calculable and the strategies of the competitors may not be precisely assessable. These risks are called incalculable risks. The risk element of such incalculable costs is also insurable.
- It is in the area of uncertainly which makes decision-making a crucial function for an entrepreneur. If his decisions prove to be right, the entrepreneur makes profit, Thus according to knight profit arises from the decisions taken and implemented under the conditions of uncertainly. The profits may arises as a result of decision related to the state of market such as decision, which increase the degree of monopoly, decisions regarding holding of stocks that give rise to windfall gains and the decisions taken to introduce new techniques or innovations.
- According to this theory, profit is the reward for uncertainty bearing. But critics point out that sometimes an entrepreneur earns no profit in spite of uncertainty bearing.
- Uncertainty bearing is one of the determinants of profit and it is not the only determinant. Profit is also a reward for many other activities performed by entrepreneur like initiating, coordinating and bargaining, etc.
- It is not possible to measure uncertainty in quantitative terms as depicted in this theory.
- In modern business corporations ownership is separate from control. Decision-making is done by the salaried managers who control and organise the corporation. Ownership rests with the shareholders who ultimately bear uncertainties of business. Knight does not separate ownership and control and this theory becomes unrealistic.
- Uncertainty bearing cannot be looked upon as a separate factor of production like land, labor or capital. It is a psychological concept which forms part of the real cost of production.
- Monopoly firms earn much larger profits than competitive firms and they are not due to the presence of uncertainty. This theory throws no light on monopoly profit.
Knight’s theory of profit is more elaborate than other theories, because it combines the conception of risk, of economic change and of the role of business ability.
SCHUMPETER’S INNOVATION THEORY OF PROFIT
- Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter, factors like emergence of interest and profits, recurrence of trade cycles only supplement the distinct process of economic development.
- To explain the phenomenon of economic development and profit, Schumpeter starts from the state of a stationary equilibrium, which is characterized by the equilibrium in all the spheres. Under these conditions stationary equilibrium, the total receipts from the business are exactly equal to the cost. This means that there will be no profit. The profit can be earned only by introducing innovations in manufacturing technique and the methods of supplying the goods innovations may include the following activities.
- Introduction of a new commodity or new quality goods.
- Introduction of a new method of production.
- Introduction of a new market.
- Finding the new sources of raw material.
- Organizing the industry in an innovative manner with the new techniques.
- The factor prices tend to increase while the supply of factors remains the same. As a result, cost of production increase. On the other hand with other firms adopting innovations, supply of goods and services increases resulting in a fall in their prices.
- Thus, on one hand, cost per unit of output goes up and on the other revenue per unit decrease. Finally, a stage comes when there is no difference between costs and receipts.
- As a result there are no profits at all. Here, economy has reached a state of equilibrium, but there is the possibility of existence of profits. Such profits are in the nature of quasi-rent arising due to some special characteristics of productive services. Furthermore, where profits arise due to factors such as patents, trusts, etc. they will be in the nature of monopoly revenue rather than entrepreneurial profits.
Schumpeter’s innovation theory has been criticised on the following grounds:
- Schumpeter has never considered Profit as the reward for risk taking: He is of this opinion that risk-taking is the function of the capitalist and not of the entrepreneur. It is the shareholders who undertake risks and thus earn profits.
- There is no place of uncertainty in Schumpeter’s innovation theory: Profit is not the reward of uncertainty it is simply the wages of management.
- This theory is incomplete: Profit accrues to the entrepreneur for his organisational ability and nothing else. Therefore, this theory has been called as an incomplete explanation of the emergence of profits.
- Another source of a pure profit (over and above the normal profit) is said to be a Monopoly, characterized by a single seller without any close substitute. Monopoly Theory of Profit posits that the firms enjoying the monopoly power restricts the output and charge higher prices for its products and services, than under perfect completion.
- So far, all the theories of profit have been propounded on the premise of perfect competition. But theoretically, the perfect market condition is perceived as non-existent or very rare phenomena. Thus, an extreme to the perfect competition is the monopoly market structure wherein the firms under monopoly can decide on the level of output and can charge a higher price for its products.
Monopoly in the market may arise due to the following factors
- Economies of scale, i.e. the cost decreases with the increase in production.
- Mergers and takeovers
- Ownership of unique materials
- Legal sanction or protection
According to the monopoly theory of profit, an entrepreneur can earn a pure profit, also called as a monopoly profit and can maintain it for a longer time period by using his monopoly powers. These powers are:
- Power to control the supply and price of products.
- Power to prevent the entry of a new competitor into the market by price cutting.
- In certain situations, a monopoly power to control or regulate certain input markets.
- Thus, a firm under monopoly can use any of these powers to earn a pure profit. Thus, monopoly serves as an important source to make a pure profit. It is important to note that, monopoly too is a rare phenomenon.
- The Monopolies exists, especially in the government sectors such as production and supply of water, electricity, energy, etc. or come under the existence by the government sanction and are under the control and regulation of the government.
Explanation of Figure 1
- In this figure 1, monopoly firm decide production at MC = MR
- Then average cost (AC) curve and the demand curve (AR) that the monopolist faces.
- The equilibrium quantity is 5.Then monopolist decides what price to charge?
- For a quantity of 5, the corresponding price on the demand curve is $800.
- The large box, with quantity on the horizontal axis and demand (which shows the price) on the vertical axis, shows total revenue for the firm.
- The lighter-shaded box, which is quantity on the horizontal axis and average cost of production on the vertical axis, shows the firm’s total costs.
- The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows monopoly profits. – Since the price charged is above average cost, the firm is earning positive profits.
- Kalecki’s comments on theory of monopoly profits; He said that monopoly is no doubt an important cause and source of monopoly profits, but it does not replace other theories.
- Monopoly power only supplements other theories.