PRESENTATION ON PROFIT (BUSINESS ECONOMICS)

CONTENTS OF THE PRESENTATION  What is Profit  Gross Profit  Net Profit  Difference between Gross Profit & Net Profit  Dynamic Theory of Profit  Innovation Theory of Profit  Risk Theory of Profit  Can Profit be Zero or do Profit tend to Equality  Uncertainty Bearing Theory of Profit  Theory of Monopoly Profit  Nature of Profit

Profit is factor income attributed to the entrepreneur. Main function of entrepreneur is to bear uncertainty or take risk. Income that entrepreneur gets in return for these functions is called profits. Definitions:  Profit as a surplus income: Economists are of the opinion that profit is a positive residue that an entrepreneur gets when he deducts from his total revenue of the business total cost. For e.g: if the total cost of the firm manufacturing furniture is Rs for a year and its total revenue is for the same period then the diff. between the two i.e will be the profit.  Profit as a reward for entrepreneurial services: many economists define profit according to its cause of emergency. In the Words Of Henry Graycon,” profit may be considered a reward for making innovations, reward for accepting risks and uncertainties and market imperfections.

CONCEPTS OF PROFIT

GROSS PROFIT In common parlance the term profit refers to business profit or gross profit. The diff. between total revenue of the firm and its total explicit cost is called gross profit or business profit. Gross profit= total revenue-explicit cost. Supposing the total revenue of the firm is p.a.. it pays rs5000, rs4000, and rs 3000 by way of wages, interest and rent respectively. Thus its total explicit cost are rs = Thus firm’s gross prfit is Rs =8000. By deducting depreciation and insurance charges from it, the firm arrives at net business profit.

CONSTITUENTS OF GROSS BUSINESS PROFIT  Interest on entrepreneur’s own capital  Wages of entrepreneur’s own labour  Rent on entrepreneur’s own land  Depreciation charges  Insurance charges  Economic or pure profit

ECONOMIC OR PURE PROFIT By profit in economics meant net profit. It is called economic or pure profit. It is calculated by deducting implicit cost, depreciation charges, insurance charges etc from the gross profit. Economic profit= gross profit-implicit cost, Or Economic profit=total revenue-total cost.

ELEMENTS OF ECONOMIC OR NET PROFIT  Reward for risk taking  Reward for uncertainty  Reward for ability  Monopoly gains  Windfall gains  Reward for innovations

DIFFERENCE BETWEEN GROSS PROFIT AND NET PROFIT  Gross profit is a wider term and includes net profit in it.  Gross profit includes implicit cost whereas net profit doesn’t include such cost.  Real loss is estimated from total revenue and total cost. Relevant in the context of net profit and not from gross profit  Net profit is not earned under perfect competition rather a part of gross profit is earned  Net profit is not earned under certain conditions in the long run but only a part of gross profit is obtained.

THEORIES OF PROFIT

DYNAMIC THEORY OF PROFIT This theory has been put forth by Prof. J.B. Clark. According to him profit is a dynamic surplus that arrive only under dynamic conditions. There is no profit under static condition. In the words of Clark, profit arises because of the difference btw. The selling price of the product and its cost of production. Under static condition there is no change in factors like demand, supply, size of population etc. there is no risk or uncertainty to be faced by entrepreneur. Each factor of production gets reward equal to marginal productivity. Thus the entire national product is distributed among the factors. Entrepreneur gets only wages of management or normal profit. Under this condition price=average cost. Hence there is no profit in terms of surplus earning.

CRITICISM Criticizing this theory Prof. Knight said that all kind of changes didn’t give rise to profit. Changes can be of two kinds:  Anticipated changes which can be foreseen. These changes can be insured against and thus loss likely to be caused by then can be avoided. Such changes don’t cause any disequilibrium btw. Demand and supply and so no profit arises on account of foreseen changes.  Uncertain changes are those which cannot be predicted. These uncertain changes are responsible for profit. Knight therefore, is of the opinion that in place of dynamic theory of profit, uncertainty-bearing theory of profit is more useful.

INNOVATION THEORY This theory of profit was propounded by Prof. Schumpeter. According to this theory, the function of entrepreneur is to introduce innovations or new inventions. Reward that an entrepreneur gets fro innovating is called profit. What are innovations? All those inventions and changes due to which cost of production can be reduced or average revenue can be increased or the diff. btw. Revenue and cost can be enlarged are called innovations. According to this theory profit due to innovation is temporary. Other entrepreneurs imitate the innovation. Competition among the entrepreneur grows and thus economic profit disappears. The lure of profit encourages entrepreneur to go in for more innovations. Thus innovations give rise to profits and lure of profits stimulates entrepreneur to innovate.

 Schumpeter has given no importance to the element of uncertainty in the determination of profit. As a matter of fact, there is an element of uncertainty in all innovations. If there is no uncertainty then profit will be similar to wage.  Schumpeter, like Clark, has also not given any importance to risk taking function of the entrepreneur. According to Schumpeter, “the entrepreneur is never risk-taker. The one who gives loan comes to grief if the under- taking fails.” Thus, according to him, risk taking is the function of the capitalist and not of the entrepreneur as such.  According to this theory, profit is the result of innovation. Schumpeter, in his theory, has ignored other factors which are also responsible for the emergence of profit.

RISK THEORY OF PROFIT Eminent American economist F.B. Hawley in his book, “Enterprise and Productive-Process”, has put forward Risk theory of Profit. This theory regards risk-taking as the main function of the entrepreneur. An entrepreneur coordinates other factors of production like capital, labour, land etc. and initiates production. These factors are paid there contractual payment in accordance with the pre- determined terms. The goods produced by the factors take time in their disposal. During the time-lag between the production of the goods and their sale, there can be so many changes. Consequently, the total sale proceeds may fall short of total cost of production. Thus, the entrepreneur may run the risk of loss. An entrepreneur will undertake the risk only if he gets a reward in return. The reward is called profit.

CRITICISM  Reward for reducing risk: According to Carver, “Profit arise not because risks are borne by the entrepreneurs, but because the superior entrepreneurs are able to reduce them.” Thus, profit arise not because risks are undertaken, but because they are avoided by able and competent entrepreneurs.  Not a reward for all types of risk: According to Prof. Knight, profit is not the reward for all types of risks only those risks which cannot be foreseen and so are non-insurable can give rise to profit.  Narrow theory: According to critics, risk theory of profit is narrow theory. For them, profit is not the reward for taking risk alone. Profit are also due to the organizational and coordinating ability of the entrepreneurs, his monopoly position and due to innovations made by him. This theory takes into consideration only one factor and ignores all other factors.  No Proportional Relation btw. Profit and Risk: According to critics there is no proportional relationship btw. Profit and risk. It is not necessary that high risks may be accompanied with large profits. Had it been so, then all entrepreneurs, with a view to earning large profits would have undertaken big risks and nothing else.

According to Prof Frank H. Knight, main function of the entrepreneur is to bear all uncertainties relating to production. Profit is reward for bearing uninsurable future uncertainty. Besides bearing uncertainties, an entrepreneur can also perform other functions in his industry or business, such as, the function as labourer, a capitalist, a manager etc. and he may get reward for all these functions but all these reward do not form part of the profit of an entrepreneur. All these rewards represent wages, interest etc. and so are included in cost of production. They cannot be called profit. Profit is concerned exclusively with uncertainty bearing. In other words, profit is not the reward for managing and coordinating the business, it is the reward exclusively for uncertainty bearing. It is better to distinguish between uncertainty and risk.

CRITICISM  Ignores other Determinants of Profit  Unrealistic assumption  Vague theory  Not applicable in case of joint stock companies  Uncertainty is not a separate factor of production

THEORY OF MONOPOLY PROFITS OR POSITION OF ADVANTAGE According to Samuelson, in respect of profits, if most of the people are not skeptical, they are definitely critical. Those who criticize profit, for them profit doesn’t assume the form of wage or reward that equalizes risk in competitive market. The image that they conceive of a profiteer is of a person who is adept in manipulating accounts and who persist in exploiting rest of the community in one way or the other. Presumably, critics interpret profit as income earned by virtue of being monopolist. Because of his advantageous position, the profit that a monopolist earns is called monopoly profit. By regulating the supply and price of his commodity, a monopolist can earn more than normal profit. A monopolist has the capability of prohibiting the entry of a new firm, consequently by restricting the supply of his product he can continue to earn supernormal profit even in the long-run. In this respect, position of a monopoly firm is more advantageous than that of a competitive firm.

KINDS OF RISKS According to Hawley, an entrepreneur have to bear four kinds of risks:  Replacement risk  Risk proper  Uncertainty  Obsolescence. Replacement refers to depreciation. It can be calculated and so is included in the cost of production. It therefore does not give rise to any profit. So far as obsolescence is concerned, no accurate estimate of it is possible. It can not be said with any amount of certainty as to whether the machines will be rendered obsolete with the introduction of new technology, or not. Nevertheless, its expenses are included in the cost. Risk proper arises due to time-lag between the production of the goods and their sale. During this time-lag there can be so many unforeseen changes. Consequently, the entrepreneur may have to bear the loss. An entrepreneur would be willing to undertake these risks only if he gets a reward for the same. This reward is called profit.

TYPES OF BUSINESS RISK  Certain risks: These are the risks which can be insured against. These refer to theft, accident, fire etc. Every entrepreneur can foresee them and can get rid of them by means of insurance. As such these are called insurable risks. Payment of insurance premium with regard to these risks forms part of cost of production. Hence the questions of profit does not arise.  Uncertain risks: According to Knight, an entrepreneur has to bear several types of uncertain risks. E.g., changes in demand, new inventions, change in government policy, competition etc. These risks cannot be foreseen or insured against. These risks alone give rise to profit.

CAN PROFIT BE ZERO OR DO PROFITS TEND TO EQUALITY There is disagreement among the economists on the question : Can profit be zero or do profits tend to equality? Profit in this context refers to super-normal profit. 1. Profit can be zero: According to Ricardo, Clark, Schumpeter etc. profit can be zero. They hold that under the condition of perfect competition, each firm gets only normal profit in the long-run. Super normal profit are enjoyed by the firms in the short run only. In the long-run, new firms enter into the industry. Total production of the product increases, price of the product falls and thus super normal profit disappears. All the firms, therefore, will get just normal profit. Clark is of the opinion that if static condition prevails in the market, then price(AR) will be equal to average cost and the firm will get only normal profit. Accordingly in the long run, under perfect competition, because of static condition and lack of innovation, profits can be zero.

2. Profits cannot be zero: In real life, we experience either imperfect competition or monopoly. Profits cannot be zero under these market conditions. One witnesses all sorts of changes taking place all-over the world, innovations are also introduced continuously, as such, profit cannot tend to be zero. Knight is of the opinion that, even if, conditions of perfect competition are obtained in an economy, yet there will be super normal profits due to the element of uncertainty and these super normal profits will be divergent having no tendency to equality. In short, in real life, because of dynamic changes and uncertainties profit will continue to arise and persist.

Regarding the nature of profit, it is usually said that it is uncertain. In this context, Prof F.H. Knight says, “Perhaps no term or concept in economic discussion is used with a more bewildering variety of well established meaning than profit.” Some fifty years back, Prof Taussig said, “Profit is a mixed and vexed income.” In fact, there is no unanimity among the economists, as yet, regarding the true nature of profit. Classical economists made no distinction between an entrepreneur and capitalist. According to them, profit is earned by those entrepreneurs who conduct a business and invest capital therein. Marshall has given a broad view of profit. According to Marshall, “Profit is that minimum payment which must be paid to the entrepreneurs to keep a given amount of capital invested in the business.” In the long-run, entrepreneur must get normal profit. However, this view of Marshall is not complete. It doesn’t prove why abnormal profit arise in the long run ?

Prof Walker is of the view that Profit is of the nature of rent. Like rent, it is also a surplus accruing to the entrepreneur for his ability. But this argument is also not valid. Shareholders of joint stock company get profit without showing their ability. Besides, there are many differences between rent and profit. Prof Taussig is of the opinion that profit is of the nature of wage which is paid to the entrepreneur for his work. However this argument is also not logical. There are differences between profit and wage. For example, profit can be zero but not the wage. The only conclusion drawn from the above analysis is, that profit is uncertain. No solid principle can be put forth to explain its emergence.

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