Goseeko blog

Explain Theory of Profit?

by Puja

Theory of profit is the reward to an entrepreneur for the functions he renders in productive activity. Out of the income earned by the farm, land owner is paid rent, labourer is paid wage and capitalist is paid interest. Whatever is left over goes to the entrepreneur as profit. Hence, profit is also called a residual income

Theory of profit

Risk Bearing Theory of Profit

According to Professor Hawley, profits are the rewards for risk taking, which is an important function of an entrepreneur. However, the risks due to theft, accidental damages, price changes (which may again be due to change in fashion, tastes, preferences, etc), labour strike and so on may cause losses. Hence, the entrepreneur has to reduce these risks wherever it is possible. The risk taking is an unpleasant work, though an essential job, for which the entrepreneur has to be suitably rewarded. The remuneration for known risks is not profit.

Uncertainty-Bearing Theory of Profit

This theory was propounded by F.H. Knight. He divide risks into (i) foreseeable risk-a risk that can be foreseen by the entrepreneur and (ii) unforeseeable risk-a risk, which cannot be foreseen by the entrepreneur. Knight calls this unforeseeable risk as uncertainty. According to Knight, profit does not arise on account of foreseeable risk, since such risks can be insured. Hence, risk taking is not the function of the entrepreneur, but of the insurance companies. Profit, according to Professor knight, is due to non-insurable risk (or, unforeseeable risk). A loss due to fire accident in a factory is an insurable risk. A few cases of non-insurable risks are: (i) Loss due to labour strike, (ii) loss due to heavy competition from rival companies, (iii) Loss due to changes in tastes and preferences of the consumer which in turn would result in low demand for the product.

Rent Theory of Profit

The entire earning of the entrepreneur is not pure profit. Suppose an entrepreneur uses his own capital, land and devotes his own labour in the production process. The pure profit is then obtain by deducting the payments of all factors employed by him from his total earnings. According to Walker, this pure profits not only depends on the ability of the entrepreneur but also the ability of the marginal entrepreneur. Marginal entrepreneur is that entrepreneur who can only manage the cost of production. Thus marginal entrepreneur operates at the break-even point where price equals average cost.

The theory of rent and the rent theory of profit are quite similar to each other. In the rent theory of land there is no rent on marginal land. Similarly in case of profit, marginal entrepreneur enjoys zero profit or normal profit. The rent of a land arises if the fertility of that land is relatively higher than the marginal land. By adopting the same approach we can say that the profit of a firm depends on the efficiency and ability of the entrepreneur relative to marginal entrepreneur. It can also be argued that rent is surplus and does not determine price, while price determines the rent. Similarly, profit is also a surplus value and it doesn’t determine price , while change in price will cause the change in profit.

Dynamic Theory of Profit

The dynamic theory of profit developed by J. B. Clark suggests that profit is generate in a society which is dynamic in nature. The dynamic nature of a society means that the population, size of capital, level of output, taste and preferences of people of that society are changing. All these changes cause the gap between price and unit cost. Profit arises when price exceeds unit cost. In a static society there are no changes in above variables and as a consequence the difference between price and unit cost does not arise. Thus profit is not generate in static society. There are risks or uncertainties associated with dynamic society and as a result of this it is difficult to forecast the future positions of price and output level. Thus entrepreneur claims profit as a reward of undertaking these risks or uncertainties in the dynamic society.

Innovation Theory of Profit

The innovation theory of profit is developed by Schumpeter. The creation of new products or new process of production is called invention, while innovation is the commercial utilization of invention. Thus the innovator derives profit by utilizing commercially the newly invented products. An entrepreneur is said to be an innovator when he brings a new product for commercial purpose and can earn super normal profit. However, this super normal profit can be obtained only in the short run.

Interested in learning about similar topics? Here few hand picked blogs for you –

You may also like