Rent, Wages, Interest and Profit

• Goods or services, which contribute in producing

something, are called the factors of production. The major
factors of production as classified by economists are land,
labor, capital and entrepreneurship.
• The factors of production are rewarded for their
contribution to the production of goods and services. The
reward for land is rent, for labor it is wages, for capital it is
interest and the reward for entrepreneurship is called
profit.
• Determination of factor prices is different from the
determination of product pricing which is based on the
demand and supply of products.
• The reason is that unlike products, factors of production
have a derived demand and also joint demand as they
contribute in a combined way in the production of goods
or services
• Moreover, the supply of factors of production is also
different from the supply of goods as the cost of
production with regard to factors of production is
difficult to estimate.
• On the other hand, modem economists believe that
factors of production can also be priced based on the
forces of demand and supply in a manner similar to
the determination of product prices.
• While determining the demand for any factor of
production, profit maximization acts as the principle
and the market demand is determined by summing
up the demand from all the firms.
• The supply of factors of production in a market is
determined by summing up the supply of factors of
production from all the factor owners in the market.
 THEORIES OF FACTOR PRICING
• Factor pricing means the price paid for the services
rendered by the factor of production but not the
price of the factor itself.
• As goods are produced through the combined efforts
of the factors of production, the income earned
through sale of products or remuneration for
services is distributed among the four factors of
production.
• Theories of factor pricing suggest the ways to
distribute the income among the factors of
production.
• The process of income distribution can be done in
two ways. They are: personal distribution and
functional distribution.
• Personal Distribution: In this form of income distribution,
the national income of a country is distributed among the
owners of various factors of production such as rent for
land rented, wages for labor, interest on the capital
invested, and profit for entrepreneurship.
• Thus, the pattern of individual income generation is studied
under personal distribution.
• Functional Distribution: Functional distribution of income
distribution deals with the distribution of income among
the four factors of production - land, labor, capital, and the
entrepreneur.
• It lays emphasis on the sources of income for factors of
production such as rent for land, wages for labor, interest
for capital, and profit for entrepreneur.
• There are two theories for functional income distribution.
They are the macro theory of distribution and micro theory
of distribution (Theory of factor pricing).
 Macro & Micro theory of distribution
• Macro theory of distribution:
• Macro theory of income distribution deals with the distribution
of national income among the factors of production. This
process of national income distribution can be termed as macro
distribution.
• The macro theory of distribution helps determine the relative
shares of different factors of production and also deals with the
effects of economic development on those relative shares.
• Micro theory of distribution theory of factor pricing:
• Micro theory of income distribution concentrates on individuals
unlike macro theory which deals with aggregates of a nation.
This theory of factor pricing determines the ways to distribute
rewards for factors of production.
• Basically two micro theories are considered for the
determination of factor prices. They are: marginal
productivity theory of factor pricing and modem theory of
factor pricing
• Marginal Productivity theory of Factor Pricing:
• Many economists have contributed to the
development of the marginal productivity theory
determining the rewards for various factors of
production.
• David Ricardo initially used the theory to
determine rent for land. The statement of
marginal productivity theory as given by J.B. Clark
is, "Under static conditions, every factor including
the entrepreneur would get remuneration equal
to its marginal product”.
• Demand for factors of production is derived from the
demand from firms for the same. Since factors of
production are utilized in the production process, their
demand is based on their productivity.
• As the productivity of a factor increases, its price also
increases. Marginal Physical Productivity (MPP) is the
change in the total physical product or production, when
one more unit of anyone factor of production is added
while other factors are kept constant.
• Marginal Value Product (MVP) is the monetary
representation of the MPP i.e., MVP =MPP x Price.
• Marginal Revenue Productivity (MRP) is the change in the
total revenue for the producer when an additional unit of
a factor of production is employed while the quantity of
other factors is kept constant.
• Average Revenue Productivity (ARP) is the average
revenue per unit of a factor of production.
• Marginal productivity theory is developed as an
explanation to the following points:
• Reward of each factor unit is equal to its
marginal productivity.
• Reward for each factor of production will be the
same in every use.
• In the long-run, under perfect competition, each
factors of production will get its remuneration
that will be equal to its Marginal Revenue
Productivity (MRP) which also equals its Average
Revenue Productivity (ARP)
 Modern theory of Factor Pricing
• As the marginal productivity theory of factor pricing was based on
impractical assumptions, and concentrated only on demand side
ignoring the supply side, the modern theory of factor pricing was
developed to explain the determination of factor prices. In fact, the
modem theory considered both the demand side and supply side to
determine prices for factors of production.
• Demand side Demand for factors of production is derived demand or
indirect demand unlike the demand for goods which is direct. The
demand for a factor of production is based on the contribution of the
factor with regard to the production of a good, which can be termed
as the productivity of the factor.
• The demand for a factor of production also depends on the demand
for the goods produced using the factor.
• By aggregating the individual demands or marginal revenue
productivity (MRP) curves of all firms in the market, the market
demand curve for a factor of production can be obtained.
• This marginal revenue productivity curve for a factor
of production is subject to changes in demand and
to the changes in the quantity demanded.
• Changes in demand for a factor of production may
be due to the following reasons:
Change in demand for the final product produced
using the factors of production.
Change in productivity in terms of quality or
quantity being produced.
Change in the prices of substitute or complementary
factors used in the production process. For example,
demand for labor and machines are interrelated and
firms may utilize more or less of one of them, if the
relative price of either of the factors of production
increases against the other.
•
MEANING OF RENT
Rent can be termed as the reward for land which is one of the
four factors of production. For economists, the term 'land'
indicates natural resources like ground water, forests, rivers, oil
fields, mineral deposits, etc., apart from the physical soil.
• Since land is a natural product and cannot be reproduced, the
supply of land is permanently fixed and in general perfectly
inelastic. Usually the term rent refers to the payment made to the
owner of the factor to use the same for a specific period of time.
• Here, the term land includes any material asset which has a fixed
supply. For instance, payment made to use a house, vehicle, or
machine is termed as rent.
• However, economists term it as 'contract rent' as it includes
return on capital invested in material assets. 'Economic rent' is the
term used by economists to refer to the payment made for usage
of land.
• In fact there are variant views aired by economists with regard to the
concept of rent. Some of them are rent as a differential surplus,
scarcity rent, and quasi-rent.
• Rent as a Differential Surplus: David Ricardo (Ricardo), a British
economist, defined rent as, "the price paid for the use of original and
indestructible powers of the soil." Ricardo explained rent as differential
surplus which indicates that rent is the surplus of revenue over costs
which arises due to differences in the level of fertility or usability of
land.
• Higher rent can be earned by the landowners, if the quality of land is
better. •
• Scarcity Rent :
• According to modem theory of factor pricing, the scarcity of land acted
as the basis for the concept of rent. According to the theory, rent
would arise even if all lands are of equal quality.
• The modem theory further suggested that rent does not determine
price but is determined by price i.e., when the prices are high, high
rent is charged and not vice-versa.
• Quasi-rent :
• According to Alfred Marshall (Marshall), an English
economist, rent is the income obtained due to
ownership of land and other natural resources.
• Marshall opined that land is a natural resource and
its supply is perfectly inelastic considering the society
as a whole. However, for an individual person, firm,
or industry, the supply of land depends on the
prevailing rent thus it is elastic in nature.
• In his view, as the supply of land is fixed, rent can be
earned even in the long-run. Apart from land, other
factors which have limited supply can also earn rent
but only for a short- period of time.
 THEORIES OF RENT
• Various economists have proposed different theories for
the origin of rent. Prominent among the theories of rent
are the Ricardian theory and the modern theory of rent.
• Ricardian Theory: David Ricardo, (Ricardo) a British
economist, proposed the 'Ricardian theory of rent'. The
definition of rent as, "Rent is that portion of the produce
of the earth which is paid to the landlord for the use of
the original and indestructible powers of the soil."
• It can be deduced from this definition that rent arises due
to the following two reasons:
• 1. Differences in the productivity of various pieces of land.
• 2. Situational differences.
• Postulates of the Ricardian theory: Some of the basic
assumptions of Ricardian theory in relation to land, and its
demand and supply, are:
• The supply of land is fixed and the existing quantity of land
gifted by nature cannot be increased or decreased.
• Another assumption is that original powers such as fertility of
land are gifted by God and are not due to human efforts of any
type.
• Ricardo's theory of rent was based on assumption that land is
a non-perishable factor of production. The powers/qualities of
land cannot be destroyed and the fertility of land never
diminishes.
• Another basic assumption is that utilization of land for
cultivation is done based on the order of fertility of land. Most
fertile land is cultivated first before using the next grade land.
• Ricardo assumed that the law of diminishing returns or
increasing costs operates in agriculture.
• It is also assumed that different lands have different
fertility levels.
• Land is assumed to be free gift of nature. Therefore, it
does not have cost of production.
• Assumption of perfect competition is also made.
• Ricardo assumed the existence of margin land which is a
'no rent land'. It could be understood as the grade of
land after which no land is used.
• Ricardo's theory also supposes that lands are located at
different locations i.e. some of them are near to the
market than others.
• Explanation:
• Ricardo believed that rent is a surplus arising because of differences in
fertility and locations of land. Ricardo explained the origin of rent
based on the assumption that 'marginal land' exists.
• Marginal land can be defined as that area of land that barely covers
its costs with the market value of its produce.
• To put it differently, marginal land represents the grade of land below
the level of which no land is used. The land with better productivity
than marginal land is termed as 'intra-marginal land'. Ricardo opined
that rent is the differential surplus between the earnings of marginal
land and intra-marginal lands. Rent arises in both the two types of
farming techniques-extensive cultivation and intensive cultivation.
• Extensive cultivation: In the farming technique of 'extensive
cultivation', production of farm is increased by bringing more and
more land under cultivation.
• Ricardo used the assumptions listed earlier to explain the origin of
rent in the extensive cultivation technique.
• Intensive cultivation: Under intensive cultivation technique of
farming, the production of the land is increased by employing
increased number of labor and capital units.
• Ricardo assumed the function of the law of 'diminishing returns' in
agriculture. It implies that when more and more units of labor and
capital are employed after a certain stage, there is going to be
diminishing rate of increase in the production of the farm.
• This indicates that rent arises even when all the plots of land are
equally fertile and all the plots of land are comparable even with
regard to nearness to the market.
• Ricardo believed that as the law of diminishing returns is
applicable to agriculture, the marginal product of labor and capital
will be diminishing.
• Marginal product refers to the increase in the total production
when one more unit of labor and capital are employed while
other factor units are kept constant.
 Modern Theory of Rent
• The modem theory of rent is an integrated set of ideas of
different economists such as Marshall, Joan Robinson,
and Boulding.
• The modem theory improves on Ricardo's theory of rent
and extends the concept of rent which was linked to land
alone to other factors of production which have inelastic
supply in the short run.
• Ricardo believed that the supply of land is permanently
fixed i.e., perfectly inelastic, and further the various lands
have different fertility levels.
• The surplus produced by more fertile lands over the
marginal land is considered to be the rent.
• Modern economists are of opinion that the supply of
labor, capital, and entrepreneurs are also limited when
compared to their demand and cannot be altered in the
short run.
• As different lands differ in their fertility levels, other
factors of production differ in the level of efficiency and
productivity.
• Therefore, an improvement was made over the Ricardian
theory to introduce the idea that apart from land, other
factors of production, labor, capital, and entrepreneur can
also earn rent.
• Other improvements are that since the supply of land is
fixed and is scarce, it earns scarcity rent, and further due
to difference in fertility levels of various plots of land, they
earn differential rents.
• Ricardo's theory of rent provided an explanation that the
surplus which is produced by the more fertile lands above
the cost of cultivation can be considered to be the rent.
• But the theory does not explain how to determine the
rent. Modern economists advocated that rent can be
determined by the forces of supply and demand similar to
the determination of prices for products and other factors
of production.
• The modem theory of rent suggests that rent is
determined by the level of increase in demand for
• land over its supply. As the supply of land is fixed, higher
demand for land will increase the rent of land.
• Hence, modern theory of rent is also termed as the
scarcity theory of rent.
• Modern Analysis ; Modern economists differed with the
view of Ricardo. They believed that rent affects the price of
produce of land in the following situations:
• When land is under control of few landlords who compel
fanners to pay rent on even the marginal land.
• If people are more dependent on land in countries like
India, then the land owners increase the rents and the
actual rent becomes higher than economic rent.
• The productivity of land differs when land is used for
production of different varieties of crops. Then the rent
affects price as there may be surplus when a particular
variety is produced while no surplus for other varieties of
crops.
• The scarcity of fertile/prime land leads to rent having an
affect on price.
 CONCEPT OF WAGES
• Labor is one of the four factors of production. In economics, the term
labor refers to both physical and mental work.
• Wage is the remuneration paid for labor. Payment of wages can be
done in different modes such as time wages, piece wages, task
wages, cash wages, kind wages and service wages.
• Time wages are the wages which are paid on the basis on number of
hours worked.
• Piece wages are the wages which are paid depending on the quantity
of output produced.
• Task wages are the wages which consider accomplishment of a task
for payment of wages.
• Cash wages are the wages which are paid in money form.
• Kind wages are the wages which are paid in the form of commodities.
• Service wages are the wages which are paid through a return service
for the service rendered.
 DISTINCTION BETWEEN REAL WAGES AND
NOMINAL WAGES
• Apart from the different types of wages we have discussed till now, wages can
also be classified on the economic basis into nominal wages and real wages. The
value of wages earned by a worker is different in terms of nominal wages and real
wages.
• Real Wages: Organizations provide various facilities to workers apart from paying
salaries. The additional facilities such as transportation facilities, medical facilities,
accommodation, and other allowances paid in addition to the salary constitute
the real wages of workers.
• “Real wages or real earnings refer to the purchasing power of the worker's
remuneration i.e., the amount of necessaries, comforts and luxuries which the
worker can command in return for his services."
• If the money earned by a worker is Rs. 10,000 per month, his/her nominal wage
is Rs. 10,000 but the real wage refers to the purchasing power of the money
earned i.e., how much the worker can purchase with Rs. 10,000.
• Real wages serve as indicators with regard to the prosperity level of workers. If
the purchasing power of money is high, real wages are considered to be high.
• Smith, a renowned economist, stated that the laborer is rich or poor, is well or ill-
rewarded in proportion to the real, not the nominal, wages of his labor.
• Nominal Wages: According to Prof. Thomas, "nominal wages or
nominal earnings refer to the amount of the wages as measured in
terms of money.“
• Nominal wages are also known as money wages and refers to the
payment to a worker for the service rendered in terms of money. For
instance, if an amount of Rs.I0,000 is credited to a worker's bank
account as a salary for a month that amount is referred as the nominal
wage of the worker.
• Production of goods is not complete without the combined efforts of
all factors of production. Hence, successful management of business is
dependent on the successful management of all the factors of
production.
• The reward for land is rent, whereas the reward for labor is called
wages. In this chapter, we will discuss about the remaining two factors
of production namely, capital and organization or the entrepreneur.
• The reward for capital is known as interest and the reward for
entrepreneurship is known as profit.
• Therefore, an entrepreneur is concerned with the interest rates
because interest rates will have an impact on his business.
• For instance, an increase in interest rates would cause the
entrepreneur to lower his capital requirements, and this in turn would
have an impact on the production process.
• An entrepreneur uses his entrepreneurial abilities and manages all the
factors of production. In this way, he successfully accomplishes the
task of producing goods.
• He further makes efforts to sell these finished goods in the market.
The reward he gets for all these efforts is known as profit.
• Profits motivate entrepreneurs to improve their efforts and thereby
improve the production process.
• Thus, profits have an impact on business practices. Therefore, an
understanding of interest and profit are crucial for the successful
management of business.
• Hence, the rewards for capital and entrepreneurship are of great
importance to an 'entrepreneur'
 INTEREST
• What is Interest?
• The reward for capital is known as interest. The owner of the capital receives
interest for lending his/her capital to others.
• Capital can be classified into two types – fixed capital and variable capital. In
fact, when we say capital, it includes both fixed and variable capital.
• However, interest is the income earned only on the variable capital. Interest is
earned only on that portion of capital which is given by the owner to the
borrower.
• In other words, it is the price paid by the borrower to the lender who parted
with his money.
• Why do people get paid for lending their money? Money in the form of cash
provides the holder with benefit because it enables him to buy anything that he
desires.
• However, if an individual lends it to another person, then he will have to wait
until he gets back his money and only then he can utilize it.
• According to John Maynard Keynes, "Interest is a reward for parting with
liquidity for a specified period."
 Basic Concepts
• Gross interest: When the borrower pays an amount to the lender
for borrowing the lender's money, the amount so paid by the
borrower is known as 'interest'.
• Therefore, when people refer to interest, they generally refer to
'gross interest'. Gross interest is the total amount paid by the
borrower to the lender of the money.
• Net interest: Net interest is the amount paid to 'capitalists' only for
the use of 'capital'. It is the reward paid to the capitalists exclusively
for the use of capital.
• Net interest is the compensation for lending capital to others under
conditions where there is no risk or inconvenience due to
investment (investments made with no savings motive) and the
lender is not required to perform any work other than lending his
money.
• Therefore, net interest is a part of the gross interest. Gross interest
consists of some charges along with the net interest.
• Gross Interest = Price of the Capital (Net Interest) + Reward
for taking risk of money lending + Reward for management of
loan + Others (such as the reward for accepting the
inconveniences involved in money lending).
• Gross interest thus includes compensation for loan of capital,
compensation to cover risk of loss (either business risk or
personal risk), compensation for inconvenience of investment,
compensation for work and apprehension related to
monitoring investment.
• Saving and investment: According to the theory, savings and
investment are not interdependent. It is known that the
income level changes along with the changes in investments.
• The changes in investment levels invariably have an impact on
the savings of individuals. Therefore, it is not correct to say
that saving and investment are independent of each other.
 Liquidity Preference Theory of Interest
• John Maynard Keynes (Keynes) propounded the 'liquidity
preference theory of interest'. His theory is based upon
the belief that people prefer absolute liquidity (cash) to
other forms of wealth in the short run.
• Keynes criticized the classical theory of rate of interest on
the grounds that they combined real and monetary factors
together.
• According to Keynes, the rate of interest is purely a
monetary phenomenon. He said that determination of
interest, thus, is dependent upon the demand for and
supply of money in the economy. Keynes proposed that
interest is equilibrium between the demand for and supply
of money.
• Keynes opined that a person who lends money gets the
reward called 'interest' for parting with' liquid money'.
• Keynes explains, “The rate of interest is the premium
which is to be offered to induce the people to hold
wealth in some form or the other than hoarded money."
According to him, interest is the incentive that drives
moneylenders to part with their money and lend it to
people.
• What is liquidity preference? The liquidity feature of
money empowers us with 'purchasing power', hence,
the preference for cash to other forms of money.
People's fondness for cash or liquid money is called as
'liquidity preference'.
• Why do people prefer liquidity? According to Keynes, people
prefer liquidity to other forms of money because they want
to satisfy the three kinds of motives:
• Transaction motive
• Precautionary motive
• Speculative motive
• Transaction motive: When people demand for liquid money
to carry out their day-to-day transactions, the demand for
such liquidity is known as 'transaction motive'.
• For example, people need money to travel from one place to
another, to buy goods and services, etc. For this, they are
required to stock some amount of cash with them. So, when
people require cash to complete their economic transactions,
the motive behind the demand for such cash is known as
transaction motive.
• Precautionary motive: Since people are uncertain about
their future, they prefer to save money with a view to
safeguard their future.
• People attempt to meet contingencies and unforeseen
circumstances that may happen in the future by saving.
Hence, the demand for liquidity to safeguard their future
is known as the 'precautionary motive'.
• Ex.1. Income levels of people impacts precautionary
demand for liquidity to a great extent. 2. Some people
are optimistic about their future, while others are
pessimistic. Optimistic people anticipate lesser risk in the
future when compared to pessimistic people. 3. A
farsighted person can visualize the future in advance and
makes a better analysis of the future.
• Speculative motive: This is the most important motive behind the
demand for liquidity. The motive for stocking cash here is to take
advantage of the changes in the price levels of securities and
bonds.
• If people anticipate that the prices of securities will go up in the
future, hen they prefer to purchase securities now. In such a
situation, the liquidity preference of people will be low because
they like to spend cash and purchase securities (with a view to
gain profit in the future).
• On the other hand, if they anticipate that the prices of securities
would go down in the future, then they prefer to hold cash.
• This is because, they would like to wait and purchase securities in
the future when the prices of the securities fall. In such a
situation, the liquidity preference of people will be high.
• Hence, it can be said that the liquidity preference of people is
affected by the speculative motives.
 PROFIT
• What is Profit? Just like rent is the reward for land, wages for labor
and interest for capital, profit is the reward for entrepreneurship.
• While the rewards for other factors of production are paid by the
entrepreneur, profit is the reward received by entrepreneur himself.
• Simply put, profit is the income of an entrepreneur for utilizing his
entrepreneurial abilities and running a business.
• Profit is nothing but the surplus amount left with the entrepreneur
after paying all the factors of production.
• If the income earned by him is in excess of the costs incurred on the
factors of production, then the income can be called as profit.
• Therefore, profit can also be defined as the difference between the
total value of output (total revenues received by the businessman)
and the total value of inputs (total costs incurred by the
businessman) of a business.
• Profit =Value of Outputs - Value of Inputs
• Profit is also viewed as a reward earned by the entrepreneur for performing
the entrepreneurial
• function in a business. There are other economists who believe that profit is
the reward for making innovations in business.
• Basic concepts
• Profit consists of two major components - gross profit and net profit.
• Gross profit : Generally, people consider profit as the residual income left with
the entrepreneur after making all the payments to other factors of production.
• However, it should be noted that this is gross profit. The gross profit is arrived
at after excluding all the explicit costs from the revenues received by the
business.
• It does not exclude implicit costs such as rent forgone by entrepreneur for
utilizing his own land for business purposes, interest forgone on his own
capital, etc.
Gross Profit =Total Revenues - Total Explicit Costs
• Gross profit thus includes those costs which go unrecorded in the books of
accounts, but which are nevertheless important to determine the profit made
by the business.
• Net profit: The net profit can be arrived at by subtracting
the implicit costs from gross profits.
• This is also sometimes referred to as 'pure profit'. Net
profit is the surplus leftover after deducting explicit and
implicit costs from the sales receipts of a business.
Net Profit =Gross Profit - Implicit Costs
• Thus, it can be observed that net profit is a portion of the
gross profit. When a business gets zero net profit, it
means that the profit attained is just enough to meet the
explicit costs of the business.
• In other words, the entrepreneur's revenues could not
payoff his efforts (or implicit costs) such as utilizing his
own resources, undertaking risk and uncertainty of
business, etc.
• Normal profit : It is the minimum return that an
entrepreneur receives for performing
entrepreneurial functions such as bearing risk
and uncertainty, managing other factors of
production, etc.
• Abnormal or super profit: The income remaining
with the entrepreneur after subtracting all costs
(both implicit and explicit) from the revenues
received from the business. It is an excess over
the normal profit.
 THEORIES OF PROFIT
• Though there are several theories of profit that
attempt to explain the emergence and growth of
profit, none of the theories give a comprehensive
picture on profit.
• Traditional Theories: F.A. Walker one of the
prominent non-classical economists, propounded
the 'rent theory of profit', which was similar to
David Ricardo's (Ricardo) 'theory of rent'. Later,
Taussig and Davonport developed the 'wage theory
of profit' and proposed that like a laborer works
physically and earns his wage, an entrepreneur
works mentally and earns his wage called profit..
• Walker's rent theory of profit : The 'rent theory of profit' was
developed by Francis. A. Walker (Walker). Be advocated that different
lands earned different rents depending upon the fertility of land.
• In the same way, businessmen earned 'rent of ability' called profit. He
opined that some entrepreneurs earned higher profits because of their
greater ability to run business when compared to other entrepreneurs.
• According to him, the rent earned by more fertile or intra-marginal
lands was the difference between the total production of intra-
marginal and marginal lands.
• He further explained that there existed both intra-marginal
entrepreneurs and marginal entrepreneurs and that the former are
abler than the latter. Hence, the intra-marginal entrepreneurs earned
rent of ability called profit.
• He opined that rent and profit are no different from each other and
just as there is a no-rent or marginal land, there is also a no-rent
entrepreneur or marginal entrepreneur.
• Limitations of 'rent theory of profit':
• Critics said that comparing profits with rent is impracticable.
Rent can never be zero and is always positive. However, the
same is not the case with profits, as profits can be negative
or zero.
• One of the main opponents of Walker's 'rent theory of
profit', J.B. Clark, opined that profits occur only under
dynamic conditions. However, rent can be earned under
both static and dynamic conditions.
• The theory assumes the existence of marginal entrepreneur
i.e. entrepreneurs who do not earn any profit. This is an
absurd concept because any businessman who does not
earn profits would pull back from business. Further, critics
said that just as there cannot be a 'no-rent land', there also
cannot be a 'no-profit entrepreneur'.
• Several economists pointed out profits earned are
also a result of risk-bearing, innovation, etc. and
not just because some entrepreneurs are 'abler'
than others.
• Some economists criticized that while rent is a
fixed (or expected) income, profit on the other
hand was unknown. An entrepreneur cannot
anticipate whether he will get profits or losses in
future and its magnitude.
• As land is a free gift of nature, its supply is limited.
However, the supply of entrepreneurs is not
limited and is perfectly elastic.
• Modern Theories: The modem theories of profit include
Clark's dynamic theory, Schumpeter's innovation theory,
Hawley's risk theory, Knight's uncertainty-bearing theory
among others.
• Dynamic theory of profit: According to him, profit is the
difference between the cost of producing goods and the
prices of these goods. In a stationary state, there is always
equilibrium between demand and supply of goods.
• Hence, there is no difference between the prices of goods
and their costs, and therefore net profits do not accrue to
the entrepreneur. Under dynamic conditions, however,
there is disequilibrium between demand and supply
conditions of economy. In such a state, there are often
changes in the determinants of demand and supply.
• Clark said that in reality, however, there exists a dynamic
economy. He said that there are bound to be unforeseen changes
in demand and supply. According to Clark, the dynamics in
demand and supply conditions could be a result of:
• Changes in the quality and quantity of human wants
• Changes in governmental rules and regulations regarding trade
•Changes in technology that effect the production process
• Rise in population
• Adjustments with regard to amount of capital stock with the
economy
• In a dynamic economy, surplus occurs because of the frictions or
obstructions to mobility of resources and even the existence of
monopoly element.
• According to the theory, surpluses would be eliminated by the
forces of competition in the long run.
• Innovation theory of profit : Joseph Schumpeter
propounded the 'innovation theory of profit'. He
proposed that profit is the reward for the innovative
abilities of entrepreneurs.
• According to him, an entrepreneur who introduces
innovation in businesses process reaps benefits in the
form of profits, if the innovation proves successful in the
market.
• Schumpeter defined innovation as any new process or
policy adopted by the businessman with a view to obtain
reduction in cost of production, or to improve the
demand for the product in the marketplace.
• According to this theory, the difference between price and
costs keep on increasing, if there are continuous
innovations in the marketplace. This is also how profits
originate.
• But, such profits are not stable in nature and are only
temporary. An entrepreneur can earn these profits only in
the short term. This is because his competitors too adopt
the same innovation, thus reducing the entrepreneur's
profit.
• So, once again the entrepreneur has to differentiate his
products from that of competitors through innovations.
This again increases the difference between the costs and
prices, thus enabling the entrepreneur to earn profits
again, until his innovations are imitated by others and
profits fall again.
• Uncertainty-bearing theory: According to Frank H. Knight (Knight),
the most important function of an entrepreneur is to bear
uncertainties in business in the form of risks that cannot be insured
against. Risk can be defined as the measurable probability of the
occurrence of profit or loss situation.
• With a view to differentiate between risk and uncertainty, Knight
divided risks into:
• Insurable risks
• Non-insurable risks
• Insurable risks
• According to Knight, insurable risks are those risks which the
entrepreneur can avoid through insurance. These risks can be in the
form of loss of assets due to fire, accident, theft, etc.
• An entrepreneur gets cover for these losses by paying a premium to
the insurance companies and reclaiming the same in the event of
mishap. Therefore, he does not have to bear uncertainties for
insurable risks.
• Non-insurable risks
• These risks can be in the form of changes in people's
habits, price level fluctuations, etc. Non-insurable
risks are unpredictable and unavoidable and hence
are uncertainties.
• Knight proposed that profits or losses are the
rewards an entrepreneur receives for bearing these
uncertainties.
• Uncertainty arises for non-insurable risks. Non-
insurable or unpredictable risks are those risks which
are unforeseen and for which no information is
available to estimate or forecast. Also, non-insurable
risks cannot be covered under insurance coverage.