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Unit-5 Principles of Profit POE | BBA First Year 2023nit-5 Principles of Profit POE | BBA First Year 2023

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Principles of Profit

Principle1. Rent Theory of Profit:

• This theory was first propounded by American economist Walker. This senior and J.S. Is based on the ideas of. Mill. According to Mill, “the additional profit which any manufacturer derives from better talents for business or better business arrangements is very much the same as rent.” Walker says that “the profit is the same as rent. His theory of profit states that profit is the rent of the superior entrepreneur on the margin of the less efficient entrepreneur.
• According to these economists, there was considerable equality between rent and profit. Rent was the return on the use of land while profit was the return on the entrepreneur’s ability. Just as lands differ from each other in fertility, entrepreneurs differ from each other in capability. The rent of superior land is determined by the difference in productivity of marginal and extremely marginal land; Similarly, the profits of marginal and extremely marginal entrepreneurs also.
• In short it is the inter-marginal land which earns surplus on the marginal land. Similarly, inter-marginal entrepreneurs also earn surplus as compared to marginal entrepreneurs. Just as there is marginal land, there is also a marginal entrepreneur. No revenue is received from marginal lands; Similarly, the marginal entrepreneur is also an unprofitable entrepreneur.

Marginal entrepreneur sells his produce

• There is no other benefit at the cost price. He ensures only the salary of the management, not the profits. Thus profit is not included in the cost of production. Like rent, profit is also not included in the price. Thus profit is surplus.

Criticism:

1. According to critics, there cannot be complete equality between rent and profit. The rent is generally positive and in rare cases it may even be zero. But rent can never be negative. When the entrepreneur incurs losses the profit may be negative.
2. The theory explains profit as differential surplus rather than profit for an entrepreneur.

• Profit is not always the result of business efficiency. Profit may be due to monopoly or may arise due to friendly entrepreneurs.

1. chance to his theory believes that just as there is no rent for land, there is no profit making entrepreneur. But in practical life there is no such entrepreneur because whether the entrepreneur has qualifications or not, he gets benefits in the form of rewards.
2. The system of joint stock enterprise has become more important in the modern economy. The way dividends are distributed among shareholders has nothing to do with the capacity of the shareholders. Both lazy and intelligent shareholders enjoy the same dividends. In fact, less capable people can secure higher dividends if they own more shares
3. This theory assumes that benefits are not included in the price. But this is unrealistic because profit is included in the price as a part of the production cost.

• Rent is a known and expected surplus. This is also a contractual payment. Benefit is unknown.
• Walker has analyzed only surplus profit. But profit can be of many other types also.

1. Walker failed to understand the true nature of the benefits. According to Walker, profit arises because of the entrepreneur’s ability to take risk. Critics say that profit is not the reward for taking risk but rather the reward for avoiding risk.

Principle2. Salary Principle of Profit:

• This theory was propounded by American economist Taussig. According to this theory, profit is also a type of salary which is given to the entrepreneur for the services provided by him. In the words of Taussig, “Profit is the salary of the entrepreneur which he receives because of his ability”.
• Just as a laborer gets wages for his services, similarly an entrepreneur gets profits for the role he plays in production for his hard work. The only difference is that while the worker provides physical services, the entrepreneur performs mental work. Thus an entrepreneur is no different from a doctor, lawyer, teacher etc. who do mental work. Thus profit is a form of wages.

Criticism:

1. The main drawback of this theory is that it does not differentiate between salary and benefits. Wages are fixed and definite, but profits are uncertain income.
2. Entrepreneurs have to take risks in production; But the laborer does not take any such risk.
3. The entire responsibility of organizing the business rests with the entrepreneur, but the laborer is not required to do so.
4. Profit varies with prices but wages do not vary.
5. If the laborer has done the required amount of labor then he gets his wages, but the entrepreneur does not get profit even after working hard.
6. Profit may include windfall whereas salary does not include any such element.

Principle3. Profit-at-Risk Principle:

• This theory is associated with American economist Hawley. According to him, the reward for taking risk in business is profit. Taking risks is considered the most important function of an entrepreneur. Every production undertaken in anticipation of demand involves risk.
• According to Drucker, there are four types of risks. They are substitutability, obsolescence, reasonable risk and uncertainty.
• The first two are calculated and therefore insured. But the other two are unknown and unpredictable risks. Profit is paid to the entrepreneur for bearing such risk. If any entrepreneur receives only normal returns then he will not be willing to take risk.
• Therefore the reward for taking a risk must be greater than the actual value of the risk. If the entrepreneur does not get rewards he will not be ready to take risks. Thus, the greater the risk, the greater will be the possibility of profit.
• According to Hawley the entrepreneur can avoid certain risks by making a fixed payment to the insurance company. But he cannot get rid of all the risks through insurance. If he does so then he is not an entrepreneur and will only earn management salary and not profits.

Criticism:

1. Risk taking is not the only function of entrepreneurship that leads to the emergence of profits. Profits also occur due to the organizational and coordination abilities of the entrepreneur. It is also an award for innovation.
2. According to Carver, profit is paid to an entrepreneur not for taking risk but for reducing and avoiding risk.
3. This theory assumes that profits are proportional to the risk taken by the entrepreneurs. But this is not true in practical life because even those entrepreneurs who do not take any risk are given profit.
4. Knight says that not every risk pays off. It is the unexpected and uninsured risks that lead to profits. According to Knight there are two types of risks, predictable risks and unexpected risks. The risk of fire in a factory is a predictable risk and can be covered through insurance. Premiums paid for fire insurance can be included in production. The cost to the entrepreneur is to anticipate and insure such risk. Insurable risk is not really a risk and profit cannot be generated due to insurable risk.
5. There is little empirical evidence to prove that entrepreneurs earn more in riskier ventures. In a sense, all enterprises are risky because there is an element of uncertainty present in them and the aim of every entrepreneur is to earn huge profits.

Principle4. Dynamic Principle of Profit:

• J.B. Clark propounded the dynamic theory of profit in the year 1900. For them, profit is the difference between the price of an item and the cost of production. Profit is the result of progressive change in an organized society.
• Progressive change is possible only in a dynamic state. According to Clark, the entire economic society is divided into organized and unorganized society. Organized society is divided into stable and dynamic state. Profit arises only in the dynamic state.
• In the steady state, five general changes such as size of population, technical knowledge, amount of capital, production methods of firms and size of industry and desires of the people do not occur; Everything is stable and there is no change. The element of time is non-existent and there is no uncertainty. The same economic characteristics are repeated from year to year.
• Therefore the entrepreneur does not face any risk. The price of the item will be equal to the cost of production. Hence there is no benefit at all. The entrepreneur will receive salary for his labor and interest on his capital. If the price of the good is higher than the cost of production, competition will lower the price again to the level of the cost of production so that profits are eliminated.
• The presence of perfect competition makes the price equal to the cost of production thus eliminating excess normal profit. Thus Knight believes, “Since costs and selling prices are always equal, there can be no profit beyond wages for the routine work of supervision”.
• It is well known that society has always been dynamic. Many changes are taking place in the dynamic society.
• According to Clark, five major changes keep happening continuously in any society. they are:

(1) Change in the size of population,

(2) Changes in the supply of capital,

(3) Changes in production techniques,

(4) Change in the form of industrial organization, and

(5) Change in human needs.

• These dynamic changes affect the demand and supply of goods which leads to the emergence of profits. Sometimes individual companies can bring about dynamic change. For example, a firm can improve its production technology, reduce its costs and thereby increase its profits. Specific dynamic change is an invention. This enables the entrepreneur to produce more and reduce costs, thereby generating profits.

Criticism:

1. It is wrong to say that there is no profit in steady state because profit is paid to every entrepreneur regardless of the state of the economy.
2. This theory does not fully appreciate the nature of entrepreneurial work. If there is no profit in the steady state, it means there are no entrepreneurs. 
3. Mere changes in an economy will not bring benefits if those changes are predictable.
4. This theory assumes the existence of perfect competition and steady state. But this is far from reality.
5. This theory states that profits arise due to dynamic changes. But Knight says it’s only unexpected changes that lead to benefits.
6. This theory combines profits to simulate progressive changes in the economy. 
7. According to Taussig, “Dynamic theory has created an unnecessary and artificial distinction between “profit” and salary management.”

Principle5. Schumpeter’s Innovation Theory:

• This theory was propounded by Schumpeter. This theory is more or less similar to Clark’s theory. Instead of the five changes mentioned by Clark, Schumpeter explains the changes caused by innovations in the production process. According to this theory, profit is the byproduct of innovations. He uses the term innovation in a broader sense than the changes mentioned by Clark.
• Innovation refers to all those changes in the production process aimed at reducing the cost of a product so as to create a difference between the current price of the product and its new cost. Innovation can take any shape such as the introduction of a new technology or a new plant, a change in the internal structure or organizational structure of the company or a change in the quality of raw materials, a new form of energy, improved salesmanship, etc.
• Schumpeter distinguishes between invention and innovation. Profit is a byproduct of this strategic role, innovation is not possible by all entrepreneurs. Only extraordinary entrepreneurs can innovate. They are able to exploit new resources, technical knowledge and reduce the cost of production. Thus the main objective of bringing innovation is the desire to make profit. So profit is the reason for innovation.
• The benefits are of temporary nature. The innovative leader makes abnormal profits in a short period of time. Soon other entrepreneurs, “herding into groups”, compete for profit in the same manner. The pioneer will make another innovation. In a dynamic world innovation in one area can inspire other innovations in related areas.
• The emergence of the motor car industry could in turn encourage new investment in the manufacturing of highways, rubber, tires and petroleum products. Thus benefits are the cause and effect of innovation. The interest in profit leads the entrepreneur towards innovation and innovation leads to profit. Thus profits have a tendency to appear, disappear and reappear.
• Profits come from innovation and disappear from imitation. In Schumpeter’s opinion, innovative advantage is never permanent. Therefore it is separate from other income, such as rent, wages and interest. These are regular and permanent income generated in all circumstances. Profit on the other hand is a temporary surplus resulting from innovation.
• Schumpeter also clarified his views on the tasks of the entrepreneur. The entrepreneur organizes the business and connects various factors of production. But this is not his real work and he will not get any benefit from it. The real job of an entrepreneur is to bring innovation in business. It is innovation that brings them profit.

Criticisms:

1. This theory focuses only on innovation, which is only one of the many functions of the entrepreneur and not the only factor.
2. This theory does not consider profit as a reward for taking risk. According to Schumpeter, it is not the entrepreneur but the capitalist who takes the risk.
3. This theory has ignored the importance of uncertainty which is one of the factors determining profit.
4. This theory attributes profits only to innovation, ignoring other functions of the entrepreneur.
5. Monopoly profits are permanent in nature whereas Schumpeter says that innovation profits are temporary.
6. This theory has presented a very narrow view of the work of the entrepreneur. He not only introduces innovation but is also equally responsible for the proper organization of the business. However, profits are not just due to innovation. This also happens due to the organizational work done by the entrepreneur. 
7. It is an incomplete theory because it fails to explain all the factors affecting profit.

Principle6. Uncertainty Principle of Profit:

• This theory was propounded by an American economist Prof. Frank H. Knight did it. This theory begins on the foundation of Hawley’s risk bearing theory. Knight agrees with Hawley that profit is the reward for taking risks. There are two types of risks – predictable risks and unexpected risks.
• Knight views profit as a reward for tolerating non-insurable risks and uncertainties. He distinguishes between insurable and non-insurable risks. The risks of fire, theft, flood and accidental death are insurable. These risks are borne by the insurance company.
•  According to Knight these predicted risks are not actual economic risks eligible for any remuneration of profit. In other words insurable risk does not give rise to profit.
• According to Knight the profit is due to non-insurable risk or unexpected risk.

Some of the non-insurable risks arising in modern business are as follows:

 (a) Competitive Risk:

• Some new companies enter the market unexpectedly. Existing firms may have to face serious competition from them. This will inevitably reduce the profits of companies.

(b) Technical Risk:

• This risk arises from the possibility of machinery becoming obsolete due to the discovery of new processes. The existing firm may not be in a position to adopt these changes in its organization, and hence may suffer losses.

(c) Risk of Government Intervention:

• Over time, the government interferes in industry matters such as price controls, tax policy, import and export restrictions, etc., which may reduce the profits of the firm.

(d) Cyclical Risk:

• This risk arises from business cycles. Due to business downturn or recession, the purchasing power of the consumer decreases, as a result the demand for the company’s product also falls.

(e) Demand Risk:

• It arises from changes or variations in demand in the market.
•  According to this theory there is a direct relationship between profit and uncertainty.
• The greater the uncertainty, the higher the level of profit. Like other factors it also has a supply price and entrepreneurs accept uncertainty in the hope of earning a certain level of profit. Thus, profit is a byproduct of accepting uncertainty.
• In modern days, production has to happen before consumption. Manufacturers face competition from rival producers and the future is uncertain and unknown. These are uncertainties. Some entrepreneurs are able to see this more clearly than others and are therefore able to make profits.
  

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Criticism:

1. According to this theory, profit is the reward for bearing uncertainty. But critics say that sometimes an entrepreneur does not make any profit despite uncertainty.
2. The impact of uncertainty is one of the determinants of profit and is not the only determinant.
3. It is not possible to measure uncertainty in quantitative terms as shown in this theory.
4. In modern business corporations ownership is distinct from control. Ownership remains with the shareholders who ultimately bear the uncertainties of the business. Knight does not separate ownership and control and this principle becomes unrealistic.
5. It is a psychological concept which forms part of the real cost of production.
6. Monopoly companies earn much higher profits than competitive companies and this is not because of the presence of uncertainty. This theory does not throw any light on monopoly profit.

• Knight’s theory of profit is more detailed than other theories, as it combines the concept of risk, economic change, and the role of business efficiency.

Principle7. Principle of Marginal Productivity Benefit:

• The general principle of distribution also applies to the factor, the entrepreneur.When marginal productivity is high, profits will also be high.
• Just as the marginal revenue productivity of any factor represents the demand curve of any factor, similarly the marginal revenue productivity curve of an entrepreneur is the demand curve of an entrepreneur. As more and more companies enter the industry, the marginal revenue productivity (MRP) of entrepreneurship decreases. The slope of the MRP curve will be negative. Under perfect competition the supply curve of the entrepreneur will be perfectly elastic.

Criticism:

1. This theory is not a satisfactory theory of profit because it is very difficult to calculate the marginal productivity of entrepreneurship.
2. Marginal revenue productivity of entrepreneurship like land, labor or capital is a meaningless concept in the case of a firm because unlike other factors, a firm can have only one entrepreneur
3. This theory is based on uniformity of entrepreneur in an industry. Entrepreneurs vary in efficiency. Therefore, it is not possible to have a marginal revenue productivity curve for all entrepreneurs. Thus this theory fails to accurately determine profit.
4. This theory fails to explain why entrepreneurs sometimes earn unexpected or windfall profits and even monopoly profits.
5. It is a one-sided theory which only takes into account the demand of entrepreneurs and ignores the supply of entrepreneurs.
6. This is a stable principle according to which all entrepreneurs earn normal profits in the long run. Entrepreneurs in the real world make higher profits than usual due to their dynamic nature.

•  The functional theory of profit considers profit as the return of a factor of production. Secondly, the rent theory of profit considers profit as residual income or price in excess of costs. Institutional theory emphasizes the unearned nature of profits in the form of monopoly profits.

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