ASSIGNMENT

SUBJECT- MANAGERIAL ECONOMIC

TOPIC- PROFIT

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 PROFIT
Profit is a factor income attributed to the entrepreneur. Main function of an entrepreneur is
to bear uncertainty or take risk. Income is that an entrepreneur gets in return for these
functions is called Profit

Definitions:

Broadly, there are two sets of opinions defining this term:

1. Profit as Surplus Income: The profit is a positive residue that an

entrepreneur gets when he deducts he from his total revenue of the business total
cost.EG, if TC of the firm is 10,000 for a year& TR is 12,000 for the same, than the
difference between two (TC-TR),i.e.,2000 is PROFIT. But if cost exceeds revenue, in
a given period, then the firm will give negative residue called LOSS. EG, cost of
firm is 10,000 but its revenue is 8000, then it will incur loss of 2,000.
PROFIT= TC-TR

2. Profit as a Reward for Entrepreneurial Services: In the words of

Prof.Henry Graycon, “Profit may be considered a reward for making innovations, a
reward for accepting risk and uncertainties and market imperfection”.

Concepts of Profit
Main concepts of profit are as follow:

 GROSS PROFIT: The term profit refers to business profit or gross profit.
The difference between TR of the firm and its explicit cost is called Gross Profit
Gross profit = Total Revenue-Explicit Cost

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 Suppose, TR of firm is $20,000. It pays $5,000, $4,000and $3,000 by way of wages,
interest, and rent. Its total explicit cost are $5,000+$4,000+$3,000=$12,000. Thus
Gross Profit of the firm is $20,000-$12,000=$8,000. Gross Profit includes many
constituents. These are known as constituents of Gross Profit

Constituents of Gross Profit

 ECONOMIC OR NET PROFIT: It is also called as pure profit .It is
Interestcalculated
on Wages
by ondeducting
own Rent on own cost,Depreciation
implicit depreciation Insurance Economic or
charges and insurance
own capital capital land Charges Charges Pure profit
charges etc., from gross profit.
OR
Economic Profit=Gross Profit – Implicit Cost Net profit= Total revenue –Total cost

Implicit Cost=Rent on own land + Interest on own capital+ wages of labour.

This includes income from six elements. These are known as Constituents of
Economic Profit.
Constituents of Economic or Net Profit

Reward for Reward for Reward for Ability Monopoly Windfall Gains Rewards for
Risk Taking Bearing Gains Innovations
Uncertainty

 Difference Between Gross Profit and Net profit:

The main difference between gross profit and net profit are as follows:

 Gross profit is a wider term and includes net profit in it.

 Gross profit includes implicit cost, whereas Net profit does not includes
any such cost.
 Real loss is estimated from Total Revenue and Total Cost relevant in the
context of Net Profit and not from Gross Profit.
 Net Profit is not earned under perfect competition rather a part of Gross
Profit is earned.

Net Profit is not earned under certain conditions in the long run, but only a part
of gross profit is obtained.

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 Does Profit Enter into Price?

Payments made for the services of the entrepreneur are called Profit or one can
say that Profit is also a factor price. The question arises whether profit is a part
of cost of production & so enter the price or not? Before answering this, it is imp
to study the nature of profit. Profit is a residual payment. Payments made to
the other factors are pre-determined and is contractual income. Wages to be
paid per day settled well before the laborer is put on work. But profit is not so
determined. That is why Walker and other economist’s holds that profit is not a
part of cost of production and so does not enter into price. Relation between
profit and cost should be under taken in the context of two different concepts.

 Cost and Normal Profit: The minimum amount necessary to retain

an entrepreneur in a given business called Normal Profit. It is equivalent to
the Opportunity cost of the entrepreneur and factors owned by him, like risk
and insurance charges, etc. Thus, while calculating TC, normal cost is
included in it. Being part of cost, normal profit influences the price of
product. In short, normal profit enters into price.
 Cost and Super Normal Profit: Super normal profit arises due to
monopoly position, windfall gains, ability of the entrepreneur to reduce
uncertainties of business, etc. Thus, it does not enter into price. It is a
surplus over and above the cost of production

In short, Normal profit is included in price but super normal profit

is not included in price.

Theories of Profit

The theories are:

1. The Rent Theory of Profit 2. The Wage Theory of Profit 3. The Marginal
Productivity Theory of Profit 4. The Dynamic Theory of Profit 5. F.W. Hawley’s
the Risk Theory of Profit 6. Knight’s Theory or the Uncertainty-Bearing Theory 7.
Modern Theory or Perfect Competition or Demand and Supply Theory of Profit
8. Prof. Schumpeter’s Innovation Theory of Profit or “Profit is the Reward for
Successful Innovation”.

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1. The Rent Theory of Profit:

This theory was developed by an American Economist Francis L. Walker. Walker

has said that Profit is the rent of ability.

He has made a comparative study between different grades of land and

entrepreneur’s different abilities. Entrepreneurs of superior ability earn Profits
just as superior land earns rent

According to Walker:
“Just as there is the marginal or no rent land, similarly there exists a marginal or
no Profit entrepreneur who earns only wages of management. The marginal or
no-profit entrepreneur is the least efficient one earning Profit not beyond an
amount just sufficient to keep him or to carry on in his present industry. The
industry managed and run by the marginal entrepreneur is similar to marginal
land. Just as the land which is at margin is no rent, land, similarly, the marginal
entrepreneur earns no profit.”

But there are other industries under the control of entrepreneurs possessing
super abilities which yield Profits. The entrepreneur with superior ability earns
Profit as the reward over the ability of the marginal or no-profit entrepreneur.
Thus it can be said that the essential nature of Profit does not differ from that of
rent because we are aware that rent is a differential surplus accruing to the
superior land over the marginal or no rent land, similarly profit is a differential
surplus which accrues to the superior ability entrepreneur over the marginal or
no-profit entrepreneur.

Its Criticisms:

The important criticisms of this theory are as follows:

a. 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.

b. It is not a true surplus as Marshall has said:

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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.

c. 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.

d. 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.

e. 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. Moreover, it fails
to explain the Profit of the ordinary shareholder of a joint-stock company.

f. This theory fails to explain the main causes of the size of

Profits:

The differential gain arises because of the scarcity of superior units, either of
land or of entrepreneurs. But the real thing is the explanation of the causes of
the scarcity of the superior units. In the case of the rent of land, the point is not
of great importance because the limitation is due to nature. Here the rent
theory can throw no light on the fundamental questions.

g. Profits do not enter into price this cannot be said here:

The reward for risk-bearing must enter into long-period cost of production. In
the short-period, Profits may not enter into price. But in the long-run, supply of
entrepreneurs not being fixed by nature, normal Profits must form a part of cost
of production.

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2. The Wage Theory of Profit:

This theory was popularized and put forward by Prof. Taussig and Davenport
the two most prominent economists. According to them—”Profits are best
regarded as simply a form of wages. They accrue to the entrepreneur on account
of his special ability.” They have argued that there is very close similarity
between a labourer and entrepreneur. Just as labourers receive wages for his
services, similarly entrepreneurs receive profit for his service.

The entrepreneur performs mental labour like—teachers, doctors, lawyers etc.

But the only difference between entrepreneur and other mental workers is that
the entrepreneur receives profit for his special ability and hard work. This is a
surplus amount which the entrepreneurs receive after meeting all expenses of
production where as the wage forms a part of the cost of production.

Its Criticisms:

This theory has been criticised for equating the functions of

an entrepreneur with that of the workers on the following
grounds:

a. Element of risk and uncertainty:

The entrepreneur’s work is full of risk and uncertainty and profit is given to face
this risk. But the workers receive wages simply for his labour. Risk and
uncertainty part do not incorporate anywhere in his activities. For labourer risk
is of losing the job which is an extreme step.

b. Profit is flexible, it may vary:

Profits may rise or fall. It depends upon the business conditions and situations.
But wage may remain stable and cannot fluctuate more in the short- period.

c. This theory is silent over the payment to shareholders:

The shareholders of any organisation or company do not perform any function

but they receive the share of profits in the form of dividend for undertaking risk

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of money invested. This theory fails to explain this contention as to why they
are paid.

d. Entrepreneurs windfall or chance profits:

The entrepreneur may receive windfall or chance profits but a worker cannot
have opportunity to get wages of chance or windfalls.

Theory of Profit # 3. The Marginal Productivity Theory of

Profit:

This theory was propounded by Prof. Marshall. According to him, “Profit is equal
to the marginal productivity of the entrepreneur. He has said that the amount
which the community is liable to produce with the help of entrepreneur over and
above what it could produce with his help.”

Recently Stigler and Stonier and Hague have said that “Profit is the reward of an
entrepreneur which is determined by its marginal revenue productivity, the
higher are the profits and lower the marginal revenue productivity, the lower
are the profits of an entrepreneur.”

Its Criticisms:

Important criticisms given by various economists are as

follows:

a. This theory is based on unrealistic assumptions:

These unrealistic assumptions are homogeneity of entrepreneurs in an industry.

As entrepreneurs’ efficiency differ, therefore it is not possible that there will be
one marginal revenue productivity curve for all entrepreneurs. So Profit cannot
be same.

b. This theory fails to determine profit accurately:

Because efficiency of entrepreneurs differs, systems and methods of doing work

differ, therefore. Profit cannot be calculated accurately.

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c. The concept of marginal revenue productivity of
entrepreneurship is a meaningless concept:

Because unlike other factors, there can be only one entrepreneur in a firm.

d. It is one sided theory:

This theory takes into account only the demand for entrepreneurs and do not
take into account the supply or availability of entrepreneurs.

e. This is a static theory:

Where all entrepreneurs earn only normal profits, they have not considered
that the world is dynamic also where some entrepreneurs can earn more than
normal profits.

f. This theory has not taken into account the windfall or chance or gain or even
monopoly profits.

Theory of Profit # 4. The Dynamic Theory of Profit:

Prof. J. B Clark propounded this theory in the year 1900. According to him—
”Profit is the difference between the price and the cost of the production of the
commodity”. But Profit is the result of dynamic change. Further, Prof. Clark was
of this opinion that in a stationary state having static economic conditions of
demand and supply, there can be no real or pure profit as a surplus. In a
stationary economy, the quantum of capital invested, methods of production,
managerial organisation, technology, demand pattern etc. remain constant.

Under competitive conditions, price tends to equal average costs; hence, the
surplus is zero. So, no pure profit but there may be some frictional profits
emerging due to frictions in the system. But, this cannot be regarded as real
Profits.

Profit is the result exclusively of six dynamic changes i.e.:

(1) Changes or increase in population,

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(2) Changes in tastes and preferences,

(3) Multiplication of wants,

(4) Capital formation,

(5) Technological advancement and

(6) Changes in the form of business organisation.

On account of these changes the economy tends to be dynamic. Demand and

supply conditions are altered. Some entrepreneurs may get advantageous
business positions against others and may reap surplus over costs, as a real
profit. In short, those who takes advantage of changing situation can earn real
profits according to their efficiency.

Inefficient and careless producers who fail to move with dynamic changes may
not get any real profit and may even incur losses. Thus, Clark’s dynamic theory
of Profit has an element of truth as it emphasis the dynamic aspect of Profit.

Its Criticisms:

Clark’s dynamic theory of Profit has been severely criticised

by Prof. Knight and others on the following grounds:

a. All changes are not foreseen:

Clark’s theory fails to make any difference between a change that is foreseen
and one that is unforeseen in advance. If the six generic changes as assumed by
Prof. Clark are to be foreknown in advance then the effects of changes will not
hold at all. In reality, all changes are not foreseen. Some are foreseen and some
are not. So, to have a clear understanding of the problem, it is essential to
separate its effects from those of change as such.

b. This theory gives artificial dichotomy:

In this connection Taussig has said that Clark’s theory gives an artificial
dichotomy of ‘Profit’ and ‘Wages of management’.

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c. All changes do not lead to Profit:

Clark’s theory suggests that all dynamic changes lead to Profit. But critics are of
this opinion that only unpredictable changes would give rise to profits.
Predictable changes will not cause surplus to emerge on account of precise
adjustments.

d. Here, the concept of frictional Profit is vague:

Clark’s theory indicates that in a stationary state, there is only a frictional profit.
But the concept of frictional profit is vague. But it is the normal profit which is
earned in a stationary state.

e. Element of risk involved in business:

Clark’s theory of Profit do not stress the element of risk involved in business due
to dynamic changes. The best course is to combine elements of risk dynamic
changes to understand the true nature of profit in a modern economy.

Theory of Profit # 5. F.W. Hawley’s the Risk Theory of Profit:

This theory of Profit is associated with F. B. Hawley who has considered the risk-
taking as the important function of an entrepreneur. The entrepreneur exposes
his business to risk, and in turn he receives a reward in the form of Profit
because the task of risk-taking is irksome.

It is definite that no entrepreneur will like to undertake risks if he gets only the
normal return. Therefore, the reward for risk-taking must be higher than the
actual value of the risk. Further, it has been said that the actual value of the risk.

Further, it has been said that more risky the business, the higher is the expected
Profit rate. As Professor D. M. Holland has said that “riskier the industry or firm,
the higher is its Profit rate.” But he was warned that this tentative view must be
tested in depth.

Its Criticisms:

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Like other theories, the risk theory of profit has also been
criticised on the following grounds:

a. There cannot be functional relationship between Risk and

Profit:

Those persons who dare to take high risks in certain businesses may not
necessarily earn high profits.

b. Profit is not based on entrepreneur’s ability:

In this connection Prof. Carve has said that “Profit is not based on
entrepreneur’s ability to undertake the risks of the business, but rather as his
capability of risk avoidance.”

c. It is an incomplete theory:

From business point of view, all enterprises are risky and an element of
uncertainty is present there. But every entrepreneur aims at making large
profits which is also uncertain. Therefore, Hawley’s Risk Theory can also be
called as an incomplete theory of Profit.

d. Amount of Profit not related to size of risk involved:

The amount of Profit is not in any way related to the size of the risk undertaken.
If it were so related then every entrepreneur would involve himself into huge
risks in order to earn larger profits.

e. Concentrates mostly on risk and not on anything else:

This theory mostly disregards many other factors attributable to Profit and just
concentrate on risks and risks alone.

Theory of Profit # 6. Knight’s Theory or the Uncertainty-

Bearing Theory:

Prof. Knight’s theory of uncertainty bearing theory of Profit is an improvement

and refinement theory of Profit over Hawley’s risk-bearing theory of Profit.

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Here, Profit according to Knight, is the reward of bearing non-insurable risks and
uncertainties. It is a deviation arising from uncertainty.

Uncertainty prevails in the entire society and profits, positive or negative, in a

way accrues to all factor services. In other words, there is profits element in all
types of income. But the division of social income between Profit and
contractual income depends on the supply of entrepreneurial ability.

Uncertainty bearing is the most important function in a dynamic state. It is the

entrepreneur who either delegates this function among different personnel or
assumes it himself. The expectation of Profit is, in a way, the supply price of
entrepreneurial uncertainty-bearing. In a competitive economy where there is
no risk, every entrepreneur will have a minimum supply price.

In short Knight’s theory implies that:

(i) Profit is reward for uncertainty-bearing.

(ii) The un-measurable risks are termed as uncertainty. These un-measurable

risks are true hazards of business.

(iii) Pure Profit is, however, a temporal and unfixed reward. It is turned with
uncertainty. Once the unforeseen circumstances become known, necessary
adjustment would be possible. Then pure Profit disappears.

Its Criticisms:

Knight’s theory of Profit has been criticised on the following

grounds:

a. This theory does not give clear notion of entrepreneurship

therefore it has been called unrealistic:

In this theory there is no indication as to who are the real owners because
owners are shareholders and policy decision-makers are salaried people.

b. Difficulty in the distribution of profit:

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This theory does not solve the problem of allocation or distribution of profit
among the controlling and ownership group, therefore, this theory keeps the
problem of the determination of Profit unsolved.

c. This theory fails to expose the phenomenon of monopoly

profit:

The theory does not suit well to expose the phenomenon of monopoly profit.
When there is least uncertainty involved in a monopoly business.

d. Profit is not a residual income:

Knight has mentioned in his theory that Profit is a residual income but J. F.
Weston has said that “the exercise of judgment of Profit may be sold on a fixed-
price basis or on a variable price-basis.” This is how the expert manager sell
their services to earn Profit.

e. This theory has not said anything on monopoly profit:

This theory does not throw any light on the monopoly profit. As we have
studied that monopoly firms earn much larger profits than competitive firms
and they are not due to the presence of uncertainty.

f. Above all, the uncertainty element cannot be qualified to

improve profits.

In-spite of the weaknesses as mentioned above, this theory of Knight is

regarded as the only satisfactory explanation of the nature of profit.

Theory of Profit # 7. Modern Theory or Perfect Competition

or Demand and Supply Theory of Profit:

This modern theory of Profit defines the entrepreneur as a business enterprise

itself and ‘Profits’ as his net income. In this theory profits have been regarded as
the reward of an entrepreneur and are governed by the demand for and supply
of entrepreneur.

Demand for Entrepreneurs:

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The demand for entrepreneurs mostly depends upon the level of industrial
development, the elements of uncertainty in the industry, the scale of
production and the marginal revenue productivity of entrepreneurship. If the
level of industrial progress is high, the scale of production is large and efficiency
and productivity increase, the profits will be high. The marginal revenue
productivity of entrepreneurship is the most important factor in influencing the
demand for entrepreneurs.

Supply of Entrepreneurs:

Similarly, the supply of entrepreneurs depends upon various factors like the
availability of capital, the existence of managerial and technical personal, the
number of entrepreneurs and the condition of society etc. The larger the
availability of capital, the larger is the supply of entrepreneur’s capital may be
available in sufficient amount, but an entrepreneur has to depend largely on the
managers and other technical personal for organising and running the business
successfully.

If trained managerial and other personal are available in the market, the supply
of entrepreneurs is bound to increase. Further, the economists are also of this
opinion that the size of population is another factor that influences
entrepreneurship. The larger the size of population, the higher will be the
demand for various products which will attract more people to
entrepreneurship and the supply of entrepreneurs will increase.

Its Criticisms:

While criticising this theory Knight has said that Profit has been regarded as the
reward for bearing non-insurable risks and uncertainties, then under perfect
competition there can be no profit in the long-run. It is a static state where
population, capital, technology, tastes, business organisation and income do not
change.

If they change they can be predicted. Thus, there is no risk and uncertainty. The
marginal revenue productivity curve of entrepreneurship would be zero.
Therefore, Profit will also be zero. In a static state, profits exist because Profits
are not competed away due to the presence of imperfect competition. So what
entrepreneurs earn are monopoly profits rather than pure profits. It should be

pg. 15
remembered that Manager-entrepreneurs earn wages of management and
capitalist—entrepreneurs earn interest.

Theory of Profit # 8. Prof. Schumpeter’s Innovation Theory of

Profit or “Profit is the Reward for Successful Innovation”:

Schumpeter deemed Profit as the reward to enterprise and innovation. In his

opinion, the entrepreneur initiates innovation in the business and when he
succeeds, he earns Profit as his reward. Now, the question is what is
innovation? “Innovation means commercial application of new scientific
inventions and discoveries.”

An innovator is, therefore a businessman with vision, foresight, originality and is

bold enough to bear high risks involved in undertaking new activities on a new
basis. The innovator is not a scientist, but he successfully introduces new
inventions on a commercial basis.

In giving opinion over this Samuelson has written as an example—”The scientific

theory of radio wave was the brain-work of Maxwell. It was experienced upon by
Hertz and its commercially profitable use was carried out by Marconi and Sarnoff,
who are the innovators in radio manufacturing.”

Innovation is of two types:

(i) Product innovations, and

(ii) Market innovations.

Product innovations affect the cost and quality of the product while market
innovations include discovery and exploitation of new market, introducing new
variety of products and product improvement, modes of advertising and sales
propaganda etc. It has been said that any form of innovation leads to a Profit. It
is called as innovation profit. This Profit is uncertain and unpredictable. It is
temporary in nature.

Its Criticisms:

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Schumpeter’s innovation theory has been criticised on the
following grounds:

a. 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.

b. 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.

c. 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

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