The following points highlight the eight theories of profit in economics.
The theories are: 1. The Rent Theory of Profit 2. The Wage Theory of Profit 3. The Marginal Productivity Theory of Profit 4. The Dynamic Theory of Profit 5. F.W. Hawley’s the Risk Theory of Profit 6. Knight’s Theory or the Uncertainty-Bearing Theory 7. Modern Theory or Perfect Competition or Demand and Supply Theory of Profit 8. Prof. Schumpeter’s Innovation Theory of Profit or “Profit is the Reward for Successful Innovation”.
Theory of Profit # 1. The Rent Theory of Profit:
This theory was developed by an American Economist Francis L. Walker. Walker has said that Profit is the rent of ability.
He has made a comparative study between different grades of land and entrepreneur’s different abilities. Entrepreneurs of superior ability earn Profits just as superior land earns rent.
According to Walker:
“Just as there is the marginal or no rent land, similarly there exists a marginal or no Profit entrepreneur who earns only wages of management. The marginal or no-profit entrepreneur is the least efficient one earning Profit not beyond an amount just sufficient to keep him or to carry on in his present industry. The industry managed and run by the marginal entrepreneur is similar to marginal land. Just as the land which is at margin is no rent, land, similarly, the marginal entrepreneur earns no profit.”
But there are other industries under the control of entrepreneurs possessing super abilities which yield Profits. The entrepreneur with superior ability earns Profit as the reward over the ability of the marginal or no-profit entrepreneur. Thus it can be said that the essential nature of Profit does not differ from that of rent because we are aware that rent is a differential surplus accruing to the superior land over the marginal or no rent land, similarly profit is a differential surplus which accrues to the superior ability entrepreneur over the marginal or no-profit entrepreneur.
The important criticisms of this theory are as follows:
a. This theory is unrealistic:
Walker’s view of Profit as a surplus like rent is unrealistic and it cannot be accepted as true approach of Profit.
b. It is not a true surplus as Marshall has said:
In this connection Marshall has said that land can earn positive or zero rent. But in the case of firm’s entrepreneurs may have negative profits or losses.
c. Profits only in a dynamic state:
Rent can emerge in both static and dynamic conditions whereas profits we can find only in a dynamic state.
d. Profit is not gift of ability:
Profit does not arise always due to the superior ability of the entrepreneur. It may arise due to monopoly, innovation, risk, uncertainty etc.
e. This theory overlooks the important function of the entrepreneur as a risk-bearer:
From the profits of entrepreneur we must deduct the losses sustained by some others, who have been driven to bankruptcy. When this is done, there may be no surplus element in Profit and the analogy to rent vanishes. Moreover, it fails to explain the Profit of the ordinary shareholder of a joint-stock company.
f. This theory fails to explain the main causes of the size of Profits:
The differential gain arises because of the scarcity of superior units, either of land or of entrepreneurs. But the real thing is the explanation of the causes of the scarcity of the superior units. In the case of the rent of land, the point is not of great importance because the limitation is due to nature. Here the rent theory can throw no light on the fundamental questions.
g. Profits do not enter into price this cannot be said here:
The reward for risk-bearing must enter into long-period cost of production. In the short-period, Profits may not enter into price. But in the long-run, supply of entrepreneurs not being fixed by nature, normal Profits must form a part of cost of production.
Theory of Profit # 2. The Wage Theory of Profit:
This theory was popularized and put forward by Prof. Taussig and Davenport the two most prominent economists. According to them—”Profits are best regarded as simply a form of wages. They accrue to the entrepreneur on account of his special ability.” They have argued that there is very close similarity between a labourer and entrepreneur. Just as labourers receive wages for his services, similarly entrepreneurs receive profit for his service.
The entrepreneur performs mental labour like—teachers, doctors, lawyers etc. But the only difference between entrepreneur and other mental workers is that the entrepreneur receives profit for his special ability and hard work. This is a surplus amount which the entrepreneurs receive after meeting all expenses of production where as the wage forms a part of the cost of production.
This theory has been criticised for equating the functions of an entrepreneur with that of the workers on the following grounds:
a. Element of risk and uncertainty:
The entrepreneur’s work is full of risk and uncertainty and profit is given to face this risk. But the workers receive wages simply for his labour. Risk and uncertainty part do not incorporate anywhere in his activities. For labourer risk is of losing the job which is an extreme step.
b. Profit is flexible, it may vary:
Profits may rise or fall. It depends upon the business conditions and situations. But wage may remain stable and cannot fluctuate more in the short- period.
c. This theory is silent over the payment to shareholders:
The shareholders of any organisation or company do not perform any function but they receive the share of profits in the form of dividend for undertaking risk of money invested. This theory fails to explain this contention as to why they are paid.
d. Entrepreneurs windfall or chance profits:
The entrepreneur may receive windfall or chance profits but a worker cannot have opportunity to get wages of chance or windfalls.
Theory of Profit # 3. The Marginal Productivity Theory of Profit:
This theory was propounded by Prof. Marshall. According to him, “Profit is equal to the marginal productivity of the entrepreneur. He has said that the amount which the community is liable to produce with the help of entrepreneur over and above what it could produce with his help.”
Recently Stigler and Stonier and Hague have said that “Profit is the reward of an entrepreneur which is determined by its marginal revenue productivity, the higher are the profits and lower the marginal revenue productivity, the lower are the profits of an entrepreneur.”
Important criticisms given by various economists are as follows:
a. This theory is based on unrealistic assumptions:
These unrealistic assumptions are homogeneity of entrepreneurs in an industry. As entrepreneurs’ efficiency differ, therefore it is not possible that there will be one marginal revenue productivity curve for all entrepreneurs. So Profit cannot be same.
b. This theory fails to determine profit accurately:
Because efficiency of entrepreneurs differs, systems and methods of doing work differ, therefore. Profit cannot be calculated accurately.
c. The concept of marginal revenue productivity of entrepreneurship is a meaningless concept:
Because unlike other factors, there can be only one entrepreneur in a firm.
d. It is one sided theory:
This theory takes into account only the demand for entrepreneurs and do not take into account the supply or availability of entrepreneurs.
e. This is a static theory:
Where all entrepreneurs earn only normal profits, they have not considered that the world is dynamic also where some entrepreneurs can earn more than normal profits.
f. This theory has not taken into account the windfall or chance or gain or even monopoly profits.
Theory of Profit # 4. The Dynamic Theory of Profit:
Prof. J. B Clark propounded this theory in the year 1900. According to him—”Profit is the difference between the price and the cost of the production of the commodity”. But Profit is the result of dynamic change. Further, Prof. Clark was of this opinion that in a stationary state having static economic conditions of demand and supply, there can be no real or pure profit as a surplus. In a stationary economy, the quantum of capital invested, methods of production, managerial organisation, technology, demand pattern etc. remain constant.
Under competitive conditions, price tends to equal average costs; hence, the surplus is zero. So, no pure profit but there may be some frictional profits emerging due to frictions in the system. But, this cannot be regarded as real Profits.
Profit is the result exclusively of six dynamic changes i.e.:
(1) Changes or increase in population,
(2) Changes in tastes and preferences,
(3) Multiplication of wants,
(4) Capital formation,
(5) Technological advancement and
(6) Changes in the form of business organisation.
On account of these changes the economy tends to be dynamic. Demand and supply conditions are altered. Some entrepreneurs may get advantageous business positions against others and may reap surplus over costs, as a real profit. In short, those who takes advantage of changing situation can earn real profits according to their efficiency.
Inefficient and careless producers who fail to move with dynamic changes may not get any real profit and may even incur losses. Thus, Clark’s dynamic theory of Profit has an element of truth as it emphasis the dynamic aspect of Profit.
Clark’s dynamic theory of Profit has been severely criticised by Prof. Knight and others on the following grounds:
a. All changes are not foreseen:
Clark’s theory fails to make any difference between a change that is foreseen and one that is unforeseen in advance. If the six generic changes as assumed by Prof. Clark are to be foreknown in advance then the effects of changes will not hold at all. In reality, all changes are not foreseen. Some are foreseen and some are not. So, to have a clear understanding of the problem, it is essential to separate its effects from those of change as such.
b. This theory gives artificial dichotomy:
In this connection Taussig has said that Clark’s theory gives an artificial dichotomy of ‘Profit’ and ‘Wages of management’.
c. All changes do not lead to Profit:
Clark’s theory suggests that all dynamic changes lead to Profit. But critics are of this opinion that only unpredictable changes would give rise to profits. Predictable changes will not cause surplus to emerge on account of precise adjustments.
d. Here, the concept of frictional Profit is vague:
Clark’s theory indicates that in a stationary state, there is only a frictional profit. But the concept of frictional profit is vague. But it is the normal profit which is earned in a stationary state.
e. Element of risk involved in business:
Clark’s theory of Profit do not stress the element of risk involved in business due to dynamic changes. The best course is to combine elements of risk dynamic changes to understand the true nature of profit in a modern economy.
Theory of Profit # 5. F.W. Hawley’s the Risk Theory of Profit:
This theory of Profit is associated with F. B. Hawley who has considered the risk-taking as the important function of an entrepreneur. The entrepreneur exposes his business to risk, and in turn he receives a reward in the form of Profit because the task of risk-taking is irksome.
It is definite that no entrepreneur will like to undertake risks if he gets only the normal return. Therefore, the reward for risk-taking must be higher than the actual value of the risk. Further, it has been said that the actual value of the risk.
Further, it has been said that more risky the business, the higher is the expected Profit rate. As Professor D. M. Holland has said that “riskier the industry or firm, the higher is its Profit rate.” But he was warned that this tentative view must be tested in depth.
Like other theories, the risk theory of profit has also been criticised on the following grounds:
a. There cannot be functional relationship between Risk and Profit:
Those persons who dare to take high risks in certain businesses may not necessarily earn high profits.
b. Profit is not based on entrepreneur’s ability:
In this connection Prof. Carve has said that “Profit is not based on entrepreneur’s ability to undertake the risks of the business, but rather as his capability of risk avoidance.”
c. It is an incomplete theory:
From business point of view, all enterprises are risky and an element of uncertainty is present there. But every entrepreneur aims at making large profits which is also uncertain. Therefore, Hawley’s Risk Theory can also be called as an incomplete theory of Profit.
d. Amount of Profit not related to size of risk involved:
The amount of Profit is not in any way related to the size of the risk undertaken. If it were so related then every entrepreneur would involve himself into huge risks in order to earn larger profits.
e. Concentrates mostly on risk and not on anything else:
This theory mostly disregards many other factors attributable to Profit and just concentrate on risks and risks alone.
Theory of Profit # 6. Knight’s Theory or the Uncertainty-Bearing Theory:
Prof. Knight’s theory of uncertainty bearing theory of Profit is an improvement and refinement theory of Profit over Hawley’s risk-bearing theory of Profit. Here, Profit according to Knight, is the reward of bearing non-insurable risks and uncertainties. It is a deviation arising from uncertainty.
Uncertainty prevails in the entire society and profits, positive or negative, in a way accrues to all factor services. In other words, there is profits element in all types of income. But the division of social income between Profit and contractual income depends on the supply of entrepreneurial ability.
Uncertainty bearing is the most important function in a dynamic state. It is the entrepreneur who either delegates this function among different personnel or assumes it himself. The expectation of Profit is, in a way, the supply price of entrepreneurial uncertainty-bearing. In a competitive economy where there is no risk, every entrepreneur will have a minimum supply price.
In short Knight’s theory implies that:
(i) Profit is reward for uncertainty-bearing.
(ii) The un-measurable risks are termed as uncertainty. These un-measurable risks are true hazards of business.
(iii) Pure Profit is, however, a temporal and unfixed reward. It is turned with uncertainty. Once the unforeseen circumstances become known, necessary adjustment would be possible. Then pure Profit disappears.
Knight’s theory of Profit has been criticised on the following grounds:
a. This theory does not give clear notion of entrepreneurship therefore it has been called unrealistic:
In this theory there is no indication as to who are the real owners because owners are shareholders and policy decision-makers are salaried people.
b. Difficulty in the distribution of profit:
This theory does not solve the problem of allocation or distribution of profit among the controlling and ownership group, therefore, this theory keeps the problem of the determination of Profit unsolved.
c. This theory fails to expose the phenomenon of monopoly profit:
The theory does not suit well to expose the phenomenon of monopoly profit. When there is least uncertainty involved in a monopoly business.
d. Profit is not a residual income:
Knight has mentioned in his theory that Profit is a residual income but J. F. Weston has said that “the exercise of judgment of Profit may be sold on a fixed-price basis or on a variable price-basis.” This is how the expert manager sell their services to earn Profit.
e. This theory has not said anything on monopoly profit:
This theory does not throw any light on the monopoly profit. As we have studied that monopoly firms earn much larger profits than competitive firms and they are not due to the presence of uncertainty.
f. Above all, the uncertainty element cannot be qualified to improve profits.
In-spite of the weaknesses as mentioned above, this theory of Knight is regarded as the only satisfactory explanation of the nature of profit.
Theory of Profit # 7. Modern Theory or Perfect Competition or Demand and Supply Theory of Profit:
This modern theory of Profit defines the entrepreneur as a business enterprise itself and ‘Profits’ as his net income. In this theory profits have been regarded as the reward of an entrepreneur and are governed by the demand for and supply of entrepreneur.
Demand for Entrepreneurs:
The demand for entrepreneurs mostly depends upon the level of industrial development, the elements of uncertainty in the industry, the scale of production and the marginal revenue productivity of entrepreneurship. If the level of industrial progress is high, the scale of production is large and efficiency and productivity increase, the profits will be high. The marginal revenue productivity of entrepreneurship is the most important factor in influencing the demand for entrepreneurs.
Supply of Entrepreneurs:
Similarly, the supply of entrepreneurs depends upon various factors like the availability of capital, the existence of managerial and technical personal, the number of entrepreneurs and the condition of society etc. The larger the availability of capital, the larger is the supply of entrepreneur’s capital may be available in sufficient amount, but an entrepreneur has to depend largely on the managers and other technical personal for organising and running the business successfully.
If trained managerial and other personal are available in the market, the supply of entrepreneurs is bound to increase. Further, the economists are also of this opinion that the size of population is another factor that influences entrepreneurship. The larger the size of population, the higher will be the demand for various products which will attract more people to entrepreneurship and the supply of entrepreneurs will increase.
While criticising this theory Knight has said that Profit has been regarded as the reward for bearing non-insurable risks and uncertainties, then under perfect competition there can be no profit in the long-run. It is a static state where population, capital, technology, tastes, business organisation and income do not change.
If they change they can be predicted. Thus, there is no risk and uncertainty. The marginal revenue productivity curve of entrepreneurship would be zero. Therefore, Profit will also be zero. In a static state, profits exist because Profits are not competed away due to the presence of imperfect competition. So what entrepreneurs earn are monopoly profits rather than pure profits. It should be remembered that Manager-entrepreneurs earn wages of management and capitalist—entrepreneurs earn interest.
Theory of Profit # 8. Prof. Schumpeter’s Innovation Theory of Profit or “Profit is the Reward for Successful Innovation”:
Schumpeter deemed Profit as the reward to enterprise and innovation. In his opinion, the entrepreneur initiates innovation in the business and when he succeeds, he earns Profit as his reward. Now, the question is what is innovation? “Innovation means commercial application of new scientific inventions and discoveries.”
An innovator is, therefore a businessman with vision, foresight, originality and is bold enough to bear high risks involved in undertaking new activities on a new basis. The innovator is not a scientist, but he successfully introduces new inventions on a commercial basis.
In giving opinion over this Samuelson has written as an example—”The scientific theory of radio wave was the brain-work of Maxwell. It was experienced upon by Hertz and its commercially profitable use was carried out by Marconi and Sarnoff, who are the innovators in radio manufacturing.”
Innovation is of two types:
(i) Product innovations, and
(ii) Market innovations.
Product innovations affect the cost and quality of the product while market innovations include discovery and exploitation of new market, introducing new variety of products and product improvement, modes of advertising and sales propaganda etc. It has been said that any form of innovation leads to a Profit. It is called as innovational profit. This Profit is uncertain and unpredictable. It is temporary in nature.
Schumpeter’s innovation theory has been criticised on the following grounds:
a. Schumpeter has never considered Profit as the reward for risk-taking:
He is of this opinion that risk-taking is the function of the capitalist and not of the entrepreneur. It is the shareholders who undertake risks and thus earn profits.
b. There is no place of uncertainty in Schumpeter’s innovation theory:
Profit is not the reward of uncertainty it is simply the wages of management.
c. This theory is incomplete:
Profit accrues to the entrepreneur for his organisational ability and nothing else. Therefore, this theory has been called as an incomplete explanation of the emergence of profits.