Theories of Profit in Economics

In economics, profit is called pure profit, which may be defined as a residual left after all contractual costs have been met, including the transfer costs of management insurable risks, depreciation and payment to shareholders, sufficient to maintain investment at its current level.

theories of profit in economics

Theories of Profit in Managerial Economics

There are various theories of profit in economics, given by several economists, which are as follows:

1. Walker’s Theory of Profit as Rent of Ability

This theory is pounded by F.A. Walker. According to Walker, “Profit is the rent of exceptional abilities that an entrepreneur may possess over others”. Rent is the difference between the yields of the least and the most efficient entrepreneurs. In formulating this theory, Walker assumed a state of perfect completion in which all firms are presumed to possess equal managerial ability each firm receives only the wages which in Walker view forms no part of pure profit. He considered wages of management as ordinary wages thus, under perfectly competitive conditions, there would be no pure profit and all firms would earn only wages, which is known as normal profit.

2. Clark’s Dynamic Theory

This theory is propounded by J.B. Clark According to him, “Profits arise in a dynamic economy and not in static economy.”

A static economy and the firms under it, has the following features:

  • Absolute freedom of competition.
  • Population and capital are stationary.
  • Production process remains unchanged over time.
  • Homogeneous goods.
  • Factors of production enjoy freedom of mobility but do not move because their marginal product in very industry is the same.
  • There is no uncertainly and risk. If there is any risk, it is insurable
  • All firms make only normal profit.

A dynamic economy is characterized by the following features:

  • Increase in population.
  • Increase in capital.
  • Improvement in production techniques.
  • Changes in the forms of business organization.

The major function of entrepreneurs or managers in a dynamic economy is to take the advantage of all of the above features and promote their business by expanding their sales and reducing their costs of production.

According to J.B. Clark, “Profit is an elusive sum, which entrepreneurs grasp but cannot hold. It slips through their fingers and bestows itself on all members of the society”.  This result in rise in demand for factors pf production and therefore rises in factor prices and subsequent rise in the cost of production. On the other hand, because of rise in cost of production and the subsequent fall in selling price of the commodities, the profit disappears. Disappearing of profit does not mean that profit arise in dynamic economy once only, but it means that the managers take the advantage of the changes taking place in the economy and thereby making profits.

3. Hawley’s Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawley in 1893. Risk in business may arise due to obsolescence of a product, sudden fall in prices, non-availability of certain materials, introduction of a better substitute by a competitor and risks due to fire, war, etc. Hawley’s considered risk taking as an inevitable element of production and those who take risk are more likely to earn larger profits. According to Hawley, Profit is simply the price paid by society assuming business risks. In his opinion in excess of predetermined risk. They also look for a return in excess of the wags for bearing risk is that the assumption of risk is irrelevant and gives to trouble and anxiety. According to Hawley, Profit consists of two part, which are as follows:

  • One Part represents compensation for actual or average loss supplementing the various classes of risk.
  • The other part represents a penalty to suffer the consequences of being exposed to risk in the entrepreneurial activities.

Hawley believed that profits arise from factor ownership as long as ownership involves risk. According to Hawley, an entrepreneur has to assume risk to earn more and more profit. In case of absence of risks, an entrepreneur would cease to be an entrepreneur and would not receive any profit. In this theory, profits arise out of uninsured risks. The amount of reward cannot be determined, until the uncertainly ends with the sale of entrepreneur products profit in his opinion is a residue and therefore Hawley theory is also called as Residual theory.

4. Knight’s Theory of Profit

This theory of profit is propounded by frank H. Knight who treated profit as a residual return because of uncertainly, and not because of risk bearing. Knight made a distinction between risk and uncertainly by dividing risk into two categories, calculable and non-calculable risks. They are explained as below:

  • Calculable risks are those, the prodigality of occurrence of which van be calculated on the basis of available data. For example risk, due to fire theft accidents etc. are calculable and such risks are insurable.
  • Incalculable risks are those the probability of occurrence of which cannot be calculated. For Instance there may be a certain elements of cost, which may not be accurately calculable and the strategies of the competitors may not be precisely assessable. These risk are called includable risks. The risk element of such incalculable costs is also insurable.

It is in the area of uncertainly which makes decision-making a crucial function for an entrepreneur. If his decisions prove to be right, the entrepreneur makes profit, Thus according to knight profit arises from the decisions taken and implemented under the conditions of uncertainly. The profits may arises as a result of decision related to the state of market such as decision, which increase the degree of monopoly, decisions regarding holding of stocks that give rise to windfall  gains and the decisions taken to introduce  new techniques or innovations.

5. Schumpeter’s Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter, factors like emergence of interest and profits, recurrence of trade cycles only supplement the distinct process of economic development. To explain the phenomenon of economic development and profit, Schumpeter starts from the state of a stationary equilibrium, which is characterized by the equilibrium in all the spheres. Under these conditions stationary equilibrium, the total receipts from the business are exactly equal to the cost. This means that there will be no profit. The profit can be earned only by introducing innovations in manufacturing technique and the methods of supplying the goods innovations may include the following activities.

  • Introduction of a new commodity or new quality goods.
  • Introduction of a new method of production.
  • Introduction of a new market.
  • Finding the new sources of raw material.
  • Organizing the industry in an innovative manner with the new techniques.

The factor prices tend to increase while the supply of factors remains the same. As a result, cost of production increase. On the other hand with other firms adopting innovations, supply of goods and services increases resulting in a fall in their prices. Thus, on one hand, cost per unit of output goes up and on the other revenue per unit decrease. Finally, a stage comes when there is no difference between costs and receipts. As a result there are no profits at all. Here, economy has reached a state of equilibrium, but there is the possibility of existence of profits. Such profits are in the nature of quasi-rent arising due to some special characteristics of productive services. Furthermore, where profits arise due to factors such as patents, trusts, etc. they will be in the nature of monopoly revenue rather than entrepreneurial profits.