A Note on Theories of Profit

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Meaning of Profit 

Generally, the businessman thinks that the excess of income over his expenditure is profit. Profit is, therefore, the net income of the firm. The organization combines different factors of production like land, capital, labor, raw materials, fuel, and energy, etc. 

So the firm should receive some rewards for organizing the production activities and distributing them to the market. Profit is thus the reward for good management of resources.

In the words of Prof. Hansen, “Profits are residual income left after all the payments have been made, the other factors-land, labor, and capital are rewarded with rent, wages, and interest respectively. Thus, what is left after the contractual payment is profit for the entrepreneur.”

Profit is thus the excess of income from the sale of output over the cost of production.

So, Profit= Total Revenue- Total Cost

Or, Profit= P*Q-(w.L+r.K) = P*Q- w.L- r.K

Where the revenue would be equal to the price of the goods multiplied by the output of the firm (P*Q). On the other hand, the cost of the firm includes labor costs (L.w), capital cost (K.r), rent cost if any. If we substitute the production function Q= f (L, K), then we would see that the profit of the firm is based on factor prices and factor inputs. Hence a profit-maximizing firm has to hire an optimal level of factor inputs in order to maximize the amount of profit. 

Major Theories of Profit

There are different theories of profit. A note on theories of profit includes major theories of profit and presented as below;

Innovation Theory of Profit

We have different theories relating to profit given by different economists. One of them is the innovation theory of profit by Joseph A. Schumpeter.

According to Schumpeter, the main function of an entrepreneur is to introduce innovation in the economy, and profits are a reward for his performance or performing this function.

Innovation is new ideas that an entrepreneur adopts to reduce the cost of production or to boost demand for his products in the market. The innovation could be cost-reducing innovation and demand increasing innovation. 

Cost reduction innovations include the introduction of new technology, better and cheaper techniques of production, change in an internal organization set up, use of the new source of raw materials, a new form of energy, etc.  

On the other side, demand increasing innovations are related to stimulation to the consumers to buy more products. It this new product introduction, the new design of the product, effective and supportive method of advertisement, the discovery of a new market, etc. are included.  

The success of these innovations brings an increase in the profit of the business organization. In this way, it is among Major Theories of Profit. 

However, this theory is criticized by critics on the ground that, profit may arise due to so many reasons besides innovation only and they said theory left the sources of profit like playing with risk and uncertainty, economic dynamics, etc. 

Innovation theory has talked about one of the most important determinants of profit but it has ignored other determinants like efficiency and coordination of management which plays a direct and major role in making a profit. 

The Dynamic Theory of Profit

J.B. Clerk introduced the dynamic theory of profit.  According to Clark; profit arises due to the dynamic changes in societies. Clark sees the major function of an entrepreneur and manager in a dynamic world is to take advantage of the generic changes to promote their businesses. 

Clark gave the case of two types of economy as a static economy and dynamic economy. According to him, a static economy is that in which there is no change in economic and demographic variables or they change at a known rate, and as a result, there is no profit or frictional amount of profit that has no value.

But in a dynamic economy, profits arise because of dynamic changes in society. A dynamic economy is a representation of the real-world and profit is the outcome of such dynamism in the society and nation.   

He found profit is an outcome of the dynamic world. And dynamism of the economy is associated with an increase in population, capital, improvement in production techniques, changes in the forms of business organizations, and multiplication of consumer wants. 

These factors make the economy a dynamic one and businesses have to take advantage of earning profit from such dynamism.  According to him, the emergence, disappearance, and re-emergence of a profit in a dynamic economy continue process; genetic changes are continuous and managers with foresight continue to take advantage of changes and make a profit. 

This theory has been also criticized by critics as; according to Knight all changes do not bring profit and profits only arise from unforeseen changes but not others. This theory has ignored the role of managers as well as risk and uncertainty factors to generate profit.

Risk Bearing Theory of Profit

This theory was introduced by an American economist F.B. Hawley 1907. According to F.B Hawley, profit is the reward of risk, and profit will be higher with a higher degree of risk and vice versa. 

He pointed risk-taking is one of the prominent functions of managers and is the major determinants of profit to the firm. Profit is always associated with exposure and nobody will take the risk if there is no possibility of return or profit. So profit is the price paid to the undertaking the risk. 

Businesses will not take any risk if they are not getting adequate compensation above-average loss. So businesses are always looking for excess return over the expected loss.

Risk-taking is very difficult and it may create difficulties and troubles in the life of the business. So they claim the reward for all the pains and hurdles above the expected loss. The entrepreneur has always a critical role in the business as he has to tackle all the risks in the business undertakings. In this way, it is among Major Theories of Profit.

This theory is also criticized by different economists. They said risk bearing theory has narrow content and coverage for profit. Risk bearing only is not the cause of profit and besides risk-taking; there are other sources of profit like innovation, uncertainty, organizational efficiency, also. Critics also argued that there are no types of direct relationship between risk and profit. Higher risk always may not bring higher profit to the business.

Uncertainty Bearing Theory of Profit

Prof Knight in 1921 developed the uncertainty-bearing theory of profit. This theory is also said an improvement over risk bearing theory of profit. According to theory profit is the remuneration for uncertainty-bearing and it is not related to risk-taking in business. 

As per the theory, there are two types of risks that an entrepreneur has to bear. Some risk is insured by anticipation like the risk of death, accident, fire, etc. such risk can be insured for return premium, and payment made can be regarded as the cost of production by the company. So the premium obtained from the insurance of such anticipated risk is not included in profit. 

Other types of risk are unforeseen and not subject to any anticipation like change in fashion taste and preferences of the market and resulting fall in demand, and the cost of such risk cannot be covered.

So Knight believed that risk which is unforeseen and cannot be insured generates profit and profit is the reward of uncertainty bearing rather than risk-taking which are insurable. He pointed phases of the business cycle, change in policies, and change in the state of competition, technological shock, etc. as uninsurable risks and they give rise to profit. In this way, it is among Major Theories of Profit.

This theory has also been criticized by critics. They said that there is no direct relationship between profit and uncertainty. One can get high profit with low uncertainty also. The theory has also ignored other sources of profit as well.

A theory does not talk about possible losses. Profit is not always sure from uncertainty and sometimes entrepreneurs may get lost but such is not talked about in theory. Due to this reason, this theory is a one-sided theory according to critics. 

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