PROFIT and Its Theories
SARBJEET KAUR
Lecturer in Economics
GCCBA-42, Chandigarh
• Meaning of Profit
• Difference between Accounting and Economic
Profit
• Different Theories of Profits
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.
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.
• 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)
• 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".
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Theories of Profit/Role of Profit in the
Operation of a Free Economy:
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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.
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".
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.
Uncertainty Theory of Profit:
• According to Professor Knight:
• "Profit is the reward for uncertainlybearing 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
"Profits, according to him are the reward of
uncertainty-bearing j rather than risk-taking
which is insurable".
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".
• 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.
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".