PROFIT and Its Theories

1. PROFIT and Its Theories SARBJEET KAUR Lecturer in Economics GCCBA-42, Chandigarh

2. Meaning of Profit • Difference between Accounting and Economic Profit • Different Theories of Profits

3. Profit Profit acts as an incentive mechanism for business investment. Higher profits provide incentives for business growth. Profit also acts as an automatic signal for the allocation and reallocation of scarce resources.

4. Gross profit is the surplus which accrues to a firm when it deducts its total costs in producing products from its total income received from the sale of goods. In producing goods, a firm incurs explicit costs and implicit costs. In the ordinary language, the term profit is used in the sense of gross profit. The main elements of gross profit of a firm are as under: • Elements and Example of Gross Profit: • (i) Explicit costs: A firm's explicit costs are the actual cash payments it makes to those who provide resources. For example, rent is paid on land hired, wages are paid to the employees, interest is paid on capita!. In addition to this, a firm also pays insurance premium, and taxes and sets aside depreciation charges. • (ii) Implicit costs:Implicit costs are the opportunity costs of using resources owned by the firm or provided by the firm's owners. To the firm, the implicit costs are the money payments that self employed resources could have earned in their best alternative uses.

5. Net profit is the profit which accrues to an entrepreneur for his functions as an entrepreneur. These functions include risk bearing ability, innovating spirit, bargaining ability etc. Net profit is the reward of an entrepreneur for (i) organizing a business and undertaking risk (ii) his bargaining ability with the customers (iii) adopting new techniques of production (iv) monopoly gains if any (v) windfall gains due to sudden rise in the prices of goods.   • Net Profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs)

6. When all these explicit costs are subtracted from the firm's total revenue, we get  accounting profit • Accounting Profit = Total Revenue - Explicit Costs • Economic profit is different from accounting profit. Accounting profit ignores the opportunity cost of the firm's own resources used in the production of goods. The economist include these costs named as implicit costs while determining the total cost of production. • "If a firm's total revenue exceeds all its economic costs both explicit and Implicit, the residual which goes to the entrepreneur is called an economic or pure profit".

7. Theories of Profit/Role of Profit in the Operation of a Free Economy: • The most important theories are: • (i) Hawley's Risk Bearing Theory of Profit. • (ii) Uncertainty Theory of Profit. • (iii) Rent Theory of Profit. • (iv) Marginal Productivity Theory of Profit. • (v) Dynamic Theory of Profit. • (vi) Monopoly Theory of Profit.

8. Hawley's Risk Bearing Theory of Profit: • This risk bearing theory of profit is associated with the name of F.B. Hawley. • "Profit is the reward of risk taking in a business. During the conduct of any business activity, all other factors of production, i.e., land, labor and capital have their guaranteed incomes from the entrepreneur. They are least concerned whether the entrepreneur makes profit or undergoes tosses".

9. profit is a payment or a reward for the assumption of risks by the entrepreneur. The 'greater the risk, the higher must be the profits. It is because if the return on risky enterprise is at the same level as that obtained from the safe investment, then not a single entrepreneur will invest his capital in a risky enterprise.

10. Uncertainty Theory of Profit: • According to Professor Knight: • "Profit is the reward for uncertainly-bearing  and not of risk-taking in a business". According to him there are two kinds of  risks which entrepreneur has to bear. Some risks are of such a nature that they can be anticipated to a fair degree of accuracy

11. "Profits, according to him are the reward of uncertainty-bearing j rather than risk-taking which is insurable".

12. Rent Theory of Profit: • The Rent Theory of Profit is associated with the name of American economist, Francis A Walker. According to him: • "Profits are of the same genius as rent".

13. The main points of Walker's Theory of Profit can be summed up as such: • (i) Profit is rental in character. Just as superior grades of land earn more rent than the inferior grades of land, similarly superior entrepreneurs due to their exceptional ability or opportunity earn more profits than the inferior entrepreneurs. • (ii) As in the case of land, there is a no-rent or marginal land, so in the business also is a no-profit or marginal entrepreneur. The marginal entrepreneur is one whose ultimate receipts from the sale of the commodities just cover his total costs. • (iii) Just as rent is measured from the non-rent land, in the same way profits of the superior businessmen are calculated from the marginal entrepreneur. • (iv) The rent does not enter into price of agricultural production of the manufactured goods.

14. Dynamic Theory of Profit: • "Profit arises only in a dynamic economy. An economy is said to be dynamic when there is a change in the population growth or a change in the method of production or a change in the consumers wants, etc., A society which is without these changes is called a static society. In a static society only monopoly profits continue to exist. All other economic profits are gradually eliminated by competition".