Theories of Profit

Introduction

The word ‘profit’ has different meaning to different people like businessmen, accountants, tax
collectors, workers and economists. In a general sense, ‘profit’ is regarded as income accruing to
the equity holders, in the same sense as wages accrue to the labourer; rent accrues to the owners
of rentable assets; and interest accrues to the money lenders. To a layman, profit means all
income that flows to the investors. To an accountant, profit means the excess of revenue over all
paid-out costs, including both manufacturing and overhead expenses. It is more or less the same
as ‘net profit’. Economist’s concept of profit is of ‘pure profit’, or ‘economic profit’ or ‘just
profit’, which is a return over and above the opportunity cost, i.e., the income that a businessman
might expect from the second best alternative use of his resources.

Profit is a monetary reward for the businessman for bearing risk and uncertainty. Profit is
necessary to induce the business to take risk rather than play safe. It is also essential to motivate
the businessman to successfully take the business forward. The greater the risk, the higher must
be the expected gain in order to induce an entrepreneur.

Theories of Profit

Economists have varying opinions on the sources of profit. It is in fact this issue that has been a
source of an unsettled controversy and has led to the emergence of various theories of profit. The
main theories of profit are as follows:

Walker’s theory of Profit: Profit as Rent of Ability

One of the most widely known theories of profit was propounded by F.A.Walker.
According to him, profit is the rent of “exceptional abilities that an entrepreneur may possess”
over others. Just as rent is the difference between the yields of the least and the most fertile
lands, profit is the difference between the earnings of the least and the most efficient
entrepreneurs .in the formulating his profit theory Walkers assumed a state of perfect
competition in which all firms are presumed to process equal managerial ability .each firm would
receive only the wages of management which in walker’s view, forms no part of pure profit .he
regarded wages of management as ordinary wages .thus under perfectly competitive conditions
there would be no pure profit and all firms would earn only managerial wages which is popularly
known as ‘normal profit’.

Clark’s dynamic theory:

According to J.B. Clark dynamic theory, profit arises in a dynamic economy, not in a static one.

A dynamic theory is characterized by the following generic changes:

1. Increase in population

2. Increase in capital

3. Improvement in production technique

4. Changes in the form of business organisation

5. Multiplication of consumer wants

The major functions of entrepreneurs or managers in a dynamic world are to take advantages
of generic changes and promote their business, expand their sales and reduce their cost. The
entrepreneurs who take successfully the advantage of changing conditions in a dynamic economy
make pure profit.

In Clarke’s own words, ‘Profit is an elusive sum which entrepreneurs grasp but cannot hold.
It slips through their fingers and bestows itself on all members of the society’.

This, however, should not mean that profits arise in a dynamic economy only once and
disappear forever. In fact, in a dynamic economy, generic changes are continuous and managers
with foresight continue to take advantage of the change and make profit.

Hawley’s Risk Theory of Profit

The risk theory of profit was proposed by F. B. Hawley in 1893. Risk in business may
arise for such reasons as obsolescence of a product, sudden fall in prices, non-availability of
certain crucial raw materials, introduction of a better substitute by a competitor, and risks due to
fire, war, etc. Hawley regarded risk-taking as an inevitable accompaniment of dynamic
production and those who take risks have a sound claim to an additional reward called ‘profit’.
According to him, profit is the price paid by society for taking business risks. Businessmen
would not assume risk without expecting adequate compensation in excess of actuarial value, i.e.
the premium on calculable risk. The reason why Hawley maintained profit as reward over and
above the actuarial risk is that the assumption of risk is irksome; it causes trouble, anxiety and
disutilities of various kinds. Thus, assuming risk gives the entrepreneur a claim to a reward in
excess of the actuarial value of the risk. Profit consists of two parts: one part represents
compensation for actuarial or average loss incidental to the various classes of risks necessarily
assumed by the entrepreneur; and the remaining part represents an inducement to suffer the
consequences of being exposed to risk in their entrepreneurial adventures

Hawley believed profits arise from factor ownership only as long as ownership involves
risk. An entrepreneur has to assume risk to qualify for profit. If an entrepreneur avoids risk by
insuring against it, he would cease to be an entrepreneur and would not receive any profit. It is
the uninsured risks out of which profits arise, and until the uncertainty ends with the sale of
products, the amount of reward cannot be determined. Profit, in his opinion, is a residue.
Hawley’s theory is thus a residual theory of profit.

Knight’s theory of profit:

Frank H. Knight treated profit as a residual return to uncertainty bearing, not to risk
bearing. Obviously, Knight made a distinction between risk and uncertainty. He divided risk into
calculable and non-calculable risks.

Calculable risks are those whose probability of occurrence can be statistically estimated
on the basis of available data. For example, risk due to fire, theft, accidents etc. are calculable
and such risks are insurable. Non-calculable risks are those whose probability of risks
occurrences cannot be calculated. For instance, there may be a certain element of cost which may
not be accurately calculable and the strategies of the competitors may not be precisely
assessable. The risk element of such incalculable events are not insurable. The area of
incalculable risk is the area of uncertainty.

It is in the area of uncertainty that decision-making becomes a crucial function of an

entrepreneur. If his decisions are proved right by the subsequent events, the entrepreneur makes
profits and vice versa. Thus, according to Knight, profit arises from the decisions taken and
implemented under the conditions of uncertainty. In his view, the profits may rise as a result of
decisions concerning the state of market, e.g., decisions which result in increasing the degree of
monopoly, decisions with respect to holding stocks that give rise to windfall gains, and decision
taken to introduce new techniques or innovations.

Profit theory of Innovation by Joseph Schumpeter:

Innovation is a very important factor responsible for profits. It has been held by Joseph
Schumpeter that the main function of the entrepreneur is to introduce innovation in the economy
and profits are reward for performing this function.

Innovation is any measure or policy adopted by an entrepreneur to reduce his cost of

production or to increase the demand for his product. Thus innovation can be of two categories.

Innovation which reduce the cost of production- This includes the introduction of a new
machinery, new and cheaper technique or process of production, exploitation of a new source of
raw material, a new and better method of organizing the firm.

Innovations which increases the demand of the product- This includes introduction of a
new product, a new variety or design of the product, a new and superior method of
advertisement, discovery of new markets etc.,

If an innovation is successful that is if it achieves the aim of either reducing the cost of
production or enhancing the demand of the product it will give rise to profit.

Profits caused by particular innovation are only temporary. When an entrepreneur

introduces new innovation he is first in a monopoly position and earns more profits. After
sometimes others also adopt it in order to get a share profits will disappear. Therefore in a
competitive and progressive economy the entrepreneur should continue to introduce new
innovations so that profits will continue to emerge out of them.

Monopoly profits:

Most profits theories have been propounded in the background of perfect competition.
But perfect competition, as conceived in theoretical models, is neither non-existent nor is rare
phenomenon. An extreme contrast of perfect competition is the existence of monopoly in the
market.

Monopoly may arise due to such factors as:

1. Economies of scale

2. Sole ownership of certain crucial raw materials

3. Legal sanction and protection

4. Mergers and takeovers

5. Creation of entry barriers

6. High capital requirement

A monopolist may earn pure profits which are called as ‘monopoly profits’. Monopoly
powers include:

1. Powers to control supply and price

2. Powers to prevent the entry of competitors by price cutting

3. Monopoly powers in certain input market

These powers help a monopoly firm to make pure profit. In such cases, monopoly is the
source of pure profit.

Conclusion:

Profit is necessary to induce businessman to take risks rather than to play safe. Greater
the risk, higher must be the expected gain.

No one of the above theories is necessarily used in all the situations and describes
economic profits obtained for different reasons. These theories are in some sense
complementary. Since uncertainty, innovation, monopolies are factors which affect every
businessman as regards its profit – earning capacity.
 Uncertainty bearing profits and innovational profits has a justification because they
constitute a reward for performing important productive functions. Monopoly profits, however,
are generally frowned upon and are often a target of attack. Often government has to take
measures to regulate monopoly profits by putting legal restrictions such as profit ceilings.