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 labor 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 labor, 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.

5. Profit as Reward for Risk-bearing or Risk-avoiding

According to Prof. F.B.Hawley, profit is a reward for risk-bearing in the process of production. If the returns were just to cover the cost, there would be no inducement for an entrepreneur to carry out production. All business enterprises are more or less speculative and hence involve risks. Unless and until an individual entrepreneur is prepared to take risks, he will not earn profits.

Two criticisms may be leveled against Hawley’s theory of profits:

  1. Although profits do contain some remuneration for risk-taking, yet the high profits reaped by the entrepreneurs cannot in their entirety be attributed to the element of risk. Profits are not, at any rate, in proportion to the risk undertaken.
  2. Prof. Carver points out that profits arise not because risks are taken but because the risks are avoided. Profit is a reward for risk-avoidance and not for risk-bearing.

6. Profit as the Reward for Uncertainty-Bearing

According to Prof. Frank H. Knight, profit is not a reward for risk-bearing but for uncertainty-bearing. Risks are classified into two categories: (a) those risks that can be insured and (b) those risks which are non-insurable.

The insurable risks, e.g. risks of death, accident, fire etc. are statistically computable with probability theories and insurance companies are prepared to cover these risks in return for premiums. The payments of these premiums are included in the cost of production. The entrepreneur gets no profits because of these risks. Hence risk-bearing becomes the function not of the entrepreneurs but of the insurance-companies.

The non-insurable risks refer to the genuine risks of market-ability of the product due to shifts in conditions of demand and supply. These changes are unpredictable and indeterminable. Some non-insurable risks are as follows:

  • Competitive Risks: i.e. new firms may enter and the demand for their product may decline.
  • Technical Risks: i.e. new types of machinery may be introduced and this will influence the conditions of demand and supply.
  • Risk of Government Intervention: e.g. the Government may fix maximum prices or minimum wages.
  • Business Cycle Risks: e.g. the economy may experience periods of upswings and downswings. During the period of up-swings, super-normal profits will be enjoyed because the prices of the commodities go on rising. But during a depression, the producer may face a crisis, and suffer losses.
  • Risks of Natural Calamities: e.g. failure of monsoons leading to crop failures, floods etc., interruption and dislocation of economy due to the emergence of war etc. Since these risks cannot be measured with any degree of accuracy, no insurance has to shoulder these risks all by himself. For shouldering these risks, he enjoys a reward in the form of profits. Thus, profit becomes the reward for uncertainty-bearing.

However, it may be pointed out that uncertainty-bearing is not the only cause of profits. There are also other factors involved, e.g. the initiating and the co-ordination ability of the entrepreneur.

7. Profit as Reward for Innovation

According to Joseph Schumpeter, an Austrian born economist who taught at Harvard, “the only source of profit is economic innovation.” An entrepreneur has been assigned an important role, that of an innovator. He is the man with vision, originality and daring. He need not be a scientist who invents new processes, but he is the one who successfully introduces them. An innovation may consist of:

  1. The introduction of new product;
  2. The introduction of new method of production;
  3. Opening of new market;
  4. Development or acquisition of a new source of raw materials;
  5. Substantial change in business organization.

To quote Samuelson, “Usually these profits accruing from innovations are temporary and are finally competed out of existence by rivals and imitators. But as one source of innovational profits is disappearing, another is being born. So altogether, these innovational profits will continue to exist.”

8. Profits as Monopoly Return

Under conditions of perfect competition, there are innumerable firms. As a result of competition, the price of the product will be pushed down to the minimum so as to just cover the cost of production. Only normal profits may be enjoyed. But competition is never “perfectly perfect” and we live in a world of little monopolies. Under imperfect competition, the monopolists may enjoy profits due to the following possibilities:

  1. The monopolist may restrict output by resorting to the creation of artificial scarcity or as Samuelson calls it “contrived-scarcity”, and thus, charge higher prices.
  2. The monopolist may sell large quantities at a price slightly higher than the average cost and thus reap huge profits.
  3. The monopolist may pay a price to the factors which are lower than their productivity and thus by exploiting them earn profits.
  4. The monopolist may take advantage of government interference, e.g. when government restricts imports by imposing import duties to restrict foreign competition, the monopolist may raise the price of his product in the domestic market in the absence of foreign competitors and thus enjoy profits.

From the above analysis, we conclude that sources of profits are innumerable and all of them taken jointly account for the cause and the determination of profits. “Profits,” according to Samuelson, “are the report card of the past, the incentive gold star for the future and also the grub stake for new ventures”.

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