Different Approaches to Profit in Managerial Economics

Profit is the reward which goes to organization as a factor of production for its participation in the process of production.

Profits differ from other factor rewards in the following ways:

  1. Profit is a residual income left after the payment of contractual rewards to other factors of production. The entrepreneur while hiring other factors of production enters into contract with them. He pays wages to workers, rent for land and interest for borrowed capital and the residue or whatever is left is his profit. Thus profits become non-contractual in character.
  2. The various factors of production are rewarded even before the sale of the product and irrespective of its sales whereas profits accrue only after the product is sold.
  3. The rewards of other factors have been fixed. They do not fluctuate whereas profits go on fluctuating so much so that the entrepreneur bears the risk of even incurring losses which we call negative profits. Thus the nature of profits differs from the nature of rewards accruing through other factors of production.

Different Approaches to Profit in Managerial Economics

1. Profits as an “Accounting Surplus”

In the sense of “Accounting Surplus”, profit is the surplus of total revenue over total cost. However, costs have been classified into two categories, viz. Explicit Costs and Implicit Costs. Explicit costs are costs shown in the books of accounts as payments made in the form of rent, wages, interest and for the purchase of raw materials. The excess of Total Revenue over Total Explicit Costs gives us Gross Profits; and from these Gross profits if we deduct taxes and depreciation, then we get Net Profits in a purely accounting sense, i.e. in Accounting or Statistical sense:

Gross Profit = Total Revenue – Explicit Costs.

Whereas Net Profit  = Total Revenue – (Explicit Costs +Depreciation +Tax) or

Net Profit  = Gross Profits – (Depreciation amount + Tax).

But, as Samuelson points out, “Such statistical profits are a hodgepodge of different elements. Obviously part at least of the reported profits is merely the return to the owners of the firm for the factors supplied by them. Thus, part may be the return to the personal work provided by the owners of the firm, part may be the rent return on self-owned natural resources part may be the equivalent of interest on the owners’ own capital.” Thus, the entrepreneur may provide his own labor, land, and capital and has the right to enjoy some returns on them. But these returns which he should get for his own labor, land and capital are not shown in the books of accounts. These are the implicit costs.

In economics, Net Profit would be arrived at not by taking into consideration only the explicit costs but also the implicit costs. Thus, to quote Samuelson, “Much of what is ordinarily called profit is really nothing but interest, rent and wages under a different name. Implicit interest, implicit rent, and implicit wages are the names economists give to this part of profit, i.e. to the earnings of self-used factors.”

2. Profits as a Cost

Profit does constitute an item of cost from the economist’s point of view. It is a cost, because it is necessary to call forth a supply of enterprise, which is as necessary to the production of wealth as any other factor. An entrepreneur is induced to undertake production because of the profits that he expects to receive; in the ordinary course, an individual may rent out his labour to any other producer in return for wages or salaries; rent out his land to enjoy rent; and lend capital to enjoy interest – all this with the minimum element of risk, but when he employs his own labour, capital and land in the process of production, he expects a reward which must compensate at least the opportunities forgone. However, to simplify matters, that part of profit which the entrepreneur expects to receive if he has to be just induced to continue his implicit costs, and any profit above normal, is termed Supernatural Profit.

3. Profit as Rent of Ability

According to Walker, and American economist, “Profit is the rent of ability”. Just as rent arises due to differences in fertility of land, profit accrues due to differences in ability of an entrepreneur. No doubt, the Rent Theory of Profits is subject to certain criticisms:

  1. Rent can never be negative, profits can be negative.
  2. Profit is not always the reward for ability but it may arise on account of other factors, e.g. monopoly element or windfalls.
  3. There may prevail a no-rent land, according to Ricardo, but it is difficult to come across no-profit entrepreneur.
  4. This theory cannot explain why the shareholders enjoy dividends even without showing any ability.

Hence this theory fails to offer any comprehensive explanation of profit.

4. Profit as a Dynamic Surplus

According to J.B. Clark, profits arise due to dynamic changes in society. Profits cannot arise in a static economy. In a static society, the elements of time and expectations are non-existent. The economic activities of the past will be repeated in the present and in the future. There is no risk of any kind for an entrepreneur in a static society. The price of goods will be equal to the cost of production. The conditions of demand and supply are given under static economy, production is made to order and not in anticipation of demand. The entrepreneur will get not profits but only wages for his labor. It is only under a dynamic situation that profits are likely to arise. According to Clark, five main changes are constantly taking place in a dynamic society:

  1. Changes in the size of population.
  2. Changes in the size of capital.
  3. Changes in the production techniques.
  4. Changes in the form of industrial organization.
  5. Changes in human wants.

These changes take place almost with a kaleidoscopic rapidity, affecting the conditions of demand and supply and hence account for profits.