In this article we will discuss about the innovation theory of profit.
Although profits arise due to frictions (i.e., time lags in market adjustments) and monopoly positions, the innovation theory, advanced by Schumpeter, goes one step ahead to suggest that profit is the reward for innovation.
Profit is a necessary reward for inducing individuals to undertake the risks associated with developing new products, new production techniques, or new marketing strategies. These individuals earn higher than normal profits. But, such profits are of a transitory nature. Such profits will gradually disappear unless strong barriers’ can be created.
Innovation refers to a number of things such as the development or discovery of new markets or new products, improved consumer acceptance because of successful product differentiation programmes, or successful market segmentation. The growth and development of USA Federal Express is an obvious example of innovation through market segmentation.
The success of Federal Express in providing overnight delivery to a segment of the communications market is an innovation that spawned an entire industry and thousands of new jobs by providing a needed service.
Thus, the key ingredient to the innovation theory of profit is the dynamic and ever-changing nature of demand that supports and rewards successful innovators. Innovation — trying something new — is vitally necessary for economic growth. Successful innovation provides a great stimulus to new investment, and may well lead to the growth of large scale industries.
Various types of risks are associated with the running of a business. Some risks such as the risk of loss due to flood, fire or burglary, or injuries to employees, are insurable. It is so because the laws of probability can be applied to such events and insurance companies can calculate the degree of risk involved and fix premium on the basis of such calculation.
But, no one can calculate the numerical probability that a firm, or a group of firms, will make profits or losses in future. In a dynamic world characterised by constant changes in tastes and preference of buyers and technological progress or frequent changes in government policy the success or failure of a particular enterprise in the past is no good guides as to the likely success or failure of a similar enterprise in the future. Thus, profits are to be treated as the reward for taking non-insurable risks.
J. A. Schumpeter has, of course, emphasised the role of profit as a necessary incentive for innovation. Innovation refers to the introduction of a new product or a new method of producing an old product, or opening up a new market. No doubt, all enterprises in a capitalist economy involve a high degree of risk, but innovations of the type mentioned above carry a much higher degree of risk. Innovators are encouraged by the prospects of large profits. Such profits often accrue to the pioneer—one who is the first in the field.