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Home Profit   Theories of Profit/Role of Profit in the Operation of a Free Economy

Theories of Profit/Role of Profit in the Operation of a Free Economy:

 

There are various theories of profit which have been advanced from time to time regarding the nature of profit in a competitive economy. Almost all of them differ basically from one another and are inadequate to explain the actual role of profit in the operation of free economy. The most important theories are:

 

(i) Hawley's Risk Bearing Theory of Profit.

 

(ii) Uncertainty Theory of Profit.

 

(iii) Rent Theory of Profit.

 

(iv) Marginal Productivity Theory of Profit.

 

(v) Dynamic Theory of Profit.

 

(vi) Monopoly Theory of Profit.

(1) Hawley's Risk Bearing Theory of Profit:

Definition and Explanation:

This risk bearing theory of profit is associated with the name of F.B. Hawley. According to him:

"Profit is the reward of risk taking in a business. During the conduct of any business activity, all other factors of production, i.e., land, labor and capital have their guaranteed incomes from the entrepreneur. They are least concerned whether the entrepreneur makes profit or undergoes tosses".

In a business activity, as we know, there are every chance at any moment in the variation of demand for the commodity produced, The demand may change due to changes in fashion, tastes, condition of trade, prices of substitutes, distribution of wealth, etc., or the project undertaken may prove to be a complete failure.

In all such cases, if the entrepreneur is not able to cover his total costs from the sale of the commodities, then it is he who ultimately bears the loss. So he must be compensated for undertaking such risks.

Thus, according to Hawley, profit is a payment or a reward for the assumption of risks by the entrepreneur. The 'greater the risk, the higher must be the profits. It is because if the return on risky enterprise is at the same level as that obtained from the safe investment, then not a single entrepreneur will invest his capital in a risky enterprise.

Criticism:

Hawley's risk theory of profit is criticized on the following grounds:

(i) According to Hawley, profit is a reward for bearing risks in a business. The modern economists believe that there is no doubt that profits contain some remuneration for risk-taking in a business but it is wrong to assume that profits are in their entirely due to the element of risk- The profits can I arise on account of better management, better supervision or they may I be due to the monopolistic position of the entrepreneur or they may be I due to sheer chance, etc., etc.

(ii) Another criticism levied by Carver is that profits arise not because risks I are borne but because the superior entrepreneurs are able to reduce the risks.

(iii) It is also pointed out that profits are never in proportion to the risk undertaken, it can. happen that in a more risky enterprise, the profits may be low and high in a less risky enterprise,

(iv) There are certain businesses where risks can be more or less accurately foreseen by statistical evidence, e.g. in insurance, the entrepreneurs who I run these businesses earn profits. This theory fails to explain as to how I the profits are earned in such business where the risks can be insured.

(2) Uncertainty Theory of Profit:

Definition and Explanation:

According to Professor Knight:

"Profit is the reward for uncertainly-bearing  and not of risk-taking in a business".

According to him there are two kinds of  risks which entrepreneur has to bear. Some risks are of such a nature that they can be anticipated to a fair degree of accuracy, e.g., the risk of death,  accident, etc., and so can be insured in return for premium. The entrepreneur  can include the payment made in the form of premium in the total cost of  production, So such risks which can be calculated and insured should not entitle the entrepreneur to a profit. On the other hand, there are some risks which are unpredictable and unforeseen and so they are non-insurable.

For  instance, if the demand for the product of at entrepreneur suddenly down due to changes in fashions, tastes, etc., then he may not be able to; cover his total costs of production. Such risks which are unforeseen and cannot be statistically measured are called by Knight, as uncertainty-bearing risks.

"Profits, according to him are the reward of uncertainty-bearing j rather than risk-taking which is insurable".

Criticism:

(i) The total profits which an entrepreneur receives cannot be attributed solely to the element of uncertainty in a business. He performs other functions also such as coordinating, bargaining, and innovation in the business. So he must be paid for these services also.

(ii) It is not simply due to uncertainty-bearing that the supply of entrepreneur is restricted. There are other factors also which influence the supply the entrepreneur. For instance, lack of knowledge, lack of capital, opportunity, etc., do restrict the supply of an entrepreneur in a business.

(3) Rent Theory of Profit:

Definition and Explanation:

The Rent Theory of Profit is associated with the name of American economist, Francis A Walker. According to him:

"Profits are of the same genius as rent".

The main points of Walker's Theory of Profit can be summed up as such:

(i) Profit is rental in character. Just as superior grades of land earn more rent than the inferior grades of land, similarly superior entrepreneurs due to their exceptional ability or opportunity earn more profits than the inferior entrepreneurs.

(ii) As in the case of land, there is a no-rent or marginal land, so in the business also is a no-profit or marginal entrepreneur. The marginal entrepreneur is one whose ultimate receipts from the sale of the commodities just cover his total costs.

(iii) Just as rent is measured from the non-rent land, in the same way profits of the superior businessmen are calculated from the marginal entrepreneur.

(iv) The rent does not enter into price of agricultural production of the manufactured goods.

From all that we have said above, it can be concluded that profits are the reward of differential business ability.

Criticism:

The modern economist have discarded the Walker's rent theory of profit on the following grounds:

(i) It simply provides a measure of profit. It does not throw light on the nature of profit which is of more importance.

(ii) Marshall is of the opinion that there is much difference between the rent of land and the entrepreneur's profit. The rent of land can either be positive or zero, but in case of business, the total receipts from the sale of the product can fall short of total costs. So the entrepreneur may suffer losses and thus his profit may be in the negative. In the opinion of Marshall, the price of the commodity in the market is determined not by the cost of production of marginal firm but by the representative firm. Representative firm is that "which has a fairly long lease of life and has a fair degree of success, which is managed with normal ability and which has access to the normal economies of production".

(iii) It is also pointed out that profit may not form a part of the cost of production of a commodity in the short period but in the long period if the business is to be continued, it must enter in the price of the product.

(iv) Profits do not arise simply because of the superior or exceptional ability of the entrepreneur, but they can also result due to chance gains or monopolistic position of the entrepreneur or they may be of the nature of the windfall income.

(4) Marginal Productivity Theory of Profit:

Definition and Explanation:

According to this theory:

"The earning of entrepreneur like the reward of other factors of production can be explained by the marginal productivity analysis".

In the words of Champmon:

"The profit tend to be equal to the marginal social worth of the employers in exactly the same sense in which the labor gets his marginal net product from the employers. The marginal net product of an entrepreneur is the amount which the community is able to produce with his help over and above what it could produce without his help".

Thus, we conclude that under conditions of perfect competition, the reward of the entrepreneur tends to be equal to the .marginal social worth of the employer. If the marginal productivity of the employer is high, the profit will also be high and the marginal net productivity is low, then profit will also be low.

Criticism:

One very important criticism levied on this theory is that the unit of factor, i.e., the enterprise is very large, if for finding out the marginal net productivity of the entrepreneur, we withdraw it from the business, then it will disorganize the entire productive organization. It, thus, becomes very difficult to ascertain the marginal net productivity of the labor.

(5) Dynamic Theory of Profit:

Definition and Explanation:

In the world of reality, according to J.B. Clark:

"Profit arises only in a dynamic economy. An economy is said to be dynamic when there is a change in the population growth or a change in the method of production or a change in the consumers wants, etc., A society which is without these changes is called a static society. In a static society only monopoly profits continue to exist. All other economic profits are gradually eliminated by competition".

In a dynamic society, an entrepreneur is always confronted with continuous unpredictable changes in demand for his product. The variation in demand may take place due to change in fashions, tastes, standard of living, distribution of income, population, new inventions, international repercussion and technological advances, etc. A prudent entrepreneur will always keep an eye on the future demand for his products. If he succeeds in increasing his sale by lowering the cost of production or by adoption of an innovation, then he can secure profits. Thus, we find, that profits are a reward, of progress, Schumpeter calls it the reward of innovation.

In a dynamic economy, if an entrepreneur produces a new thing and creates demand for his products, then he is likely to obtain big profits. But the profits of the entrepreneur cannot continue to exist for long period. The other entrepreneurs also adopt the innovation and produce similar products. As total output increases, the profits, gradually come down. Thus, we find that perpetual profits are the result of perpetual new successful innovations.

Criticism:

Prof, Knight has criticized the Clarkian Theory of profit on the ground that it is wrong to attribute all profits to dynamic changes. According to him, there are certain changes which are of a recurring and calculable nature. They can be anticipated and the output can be adjusted according to that. The profits do not arise on those regular changes but on those which are unforeseen or unpredictable. He thus observes that:

"It is not dynamic changes nor any changes as such which cause profits but he divergence of actual conditions from those which have been expected and on the basis of which business arrangements have been made".

(6) Monopoly Theory of Profit:

Definition and Explanation:

There is no doubt that profits arise from dynamic changes, innovations and from making a correct estimate of future economic conditions. Another view point of profit is that monopolistic and monopolistic competition in the market also give rise to profits. The firms under monopoly or monopolistic competition have greater control over the price of the product. They are the price makers rather than the price takers. As such they raise prices by restricting the level of output and thus keep profit at higher level. Monopoly power, thus, is the basic sources of business profits.

Criticism:

This Kalocki's theory of monopoly profits has also been criticized. It is 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.

Conclusion:

After discussing various theories of determination of profits, we come to this conclusion that all these theories are defective in one way or the other. The basic defect with these theories is that they particularize certain aspects of the function of an entrepreneur to the neglect of others. While the fact is that his functions are many aid varied. The profit can arise due to monopolistic position of the entrepreneur or adoption of innovation or sheer chance or some of the factors stated above.

Thus, we conclude that there is not a single theory of profit which gives as correct and comprehensive explanation of the nature and determination of the profits. Such a theory is yet to be propounded.

Relevant Articles:

Definition of Profit
Difference Between Accounting Profit and Economic Profit
Theories of Profit
Should Profit Be Controlled
 

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Rent
Wages
Interest
Profits
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance
History of Money

 

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