PROFIT MANAGEMENT
Based on:
Dominic Salvatore, Managerial Economics (Adopted by
Ravikesh Srivastava), OUP, 2009
M. L. Ahuja, Principles of Microeconomics, S. Chand
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Profit theories
Schumpeter
Risk & Uncertainty
Breakeven
Measurement of Profit
Profit Maximization
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• General Notion of Profit (Business profit):
• Revenue of the firm– Explicit Costs- useful for
accounting and tax purposes
• Explicit (Accounting) Costs: Actual out-of-pocket
expenditure on inputs
• Economic Profit: Revenue of the firm– Explicit
and implicit Costs- useful in reaching correct
investment decisions
• Implicit Costs: What the same inputs would have
earned in the next best alternative use outside
the firm
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• Sum p16-17
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Theories of Profit
• Lack of agreement
• Profits as Residual Income left after payment
of contractual rewards to other factors of
production
• contractual rewards are always positive, but
non contractual rewards may be positive or
negative.
• Risk bearing theories:
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Profits As Dynamic Surplus
1. J. B. Clarke’s Dynamic Theory of Profits
In competitive long run equilibrium, P= AC
(including normal profits) and therefore, there
is no pure profit.
But profits will emerge if P > AC due to
changes(disequilibrium) either in demand or
supply
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Clarke’s Dynamic Theory
5 changes that occur in a dynamic economy and
give rise to profits:
Changes in
- Quantity & quality of human wants
- Methods of production
- Amount of capital
- Forms of organization
- Growth of population
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Clarke’s Dynamic Theory
• In addition, 2 more changes:
• Innovation and External change
• According to Knight, it is not change which leads
to profits, but dynamic changes give rise to
profits ONLY if changes and their consequences
are unpredictable- because of uncertainty of
Future.
• “In an economy where nothing changes, there
can be no profits; there is no uncertainty about
the future, so there is no risk and no profit”Stonier & Hague
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2. Schumpeter’s Innovations Theory of
Profits
Main function of entrepreneur is to introduce
innovations in the economy and profits are a
reward for this function.
2 types:
A. Innovations that reduce cost of production (
those which change the production function)
Include new machinery, new processes and
techniques of production, new source of raw
material, new ways of organising business
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Schumpeter’s Innovations Theory
B. Innovations that increase the demand for the
product ( those which change the demand or
utility function- to sell more or at a better
price)
Include:
New product, new variety, new design of
product, new method of advertising, discovery
of new market
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Schumpeter’s Innovations Theory
• Profits accrue not to those who conceived the
innovation or financed it or to the one who
introduced it
• Profits from a particular innovation are
temporary- (He is in a monopoly position for
sometime- transitional unless he can
construct a permanent monopoly)
• With patents, he can continue to make profits
for a long time
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Schumpeter’s Innovations Theory
In a competitive economy without patents,
existing competitors will soon adopt any
successful innovation and profits disappear.
In a progressive, competitive economy
entrepreneurs continue to introduce new
innovation and earn profits.
“The successful innovator can continuously seek new
equilibrium profits since the horizon of conceivable
innovations is unlimited”- Stigler
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3. Knight: Risk, Uncertainty &Profits
Uncertainty is a permanent feature of the
economic system
“So long as entrepreneurs start production with
imperfect knowledge of the market, anticipated
marginal product of hired factors deviate from
their actual product, so long a surplus would
persist”
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Knight: Risk, Uncertainty & Profits
Causes of Uncertainty
Changes in fashions & taste
Changes in incomes
Changes in Government policies (Taxation, wage and
labor laws, export policies)
Movement of prices as a result of inflation and
deflation
Changes in production technology
Competition from new firms
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Knight: Risk, Uncertainty & Profits
Insurable & Non insurable Risks
• Insurable: fire, theft, accident etc- may cause
huge losses but by paying premium, can insurePremium becomes part of cost of production
• Non Insurable Risks: Relate to the outcome of
price-output/product design/advertisement
expenditure decisions made by the entrepreneur
-Can’t be insured- Involve uncertainty and give
rise to economic profits, positive or negative
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Knight: Risk, Uncertainty & Profits
• The theory explains why supernormal
(economic) profits arise in fields like
petroleum exploration (have higher risks)
• Expected returns on stocks is higher than the
interest on bonds because of higher risks.
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4. Managerial Efficiency Theory
• Some firms are more efficient than others in
terms of productive operations/ higher
managerial skills- Hence need to be
compensated with supernormal profits.
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5. Monopoly Theory Of Profit
5. Due to Monopoly
Through
Patents
Licenses
Economies of scale
Exclusive control over raw materials which
prevent competitors from entering
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6. Frictional Theory
• In the long run, in a perfectly competitive
equilibrium , firms tend to earn only a normal
return or zero profit.
• At any time firms are not likely to be in such
long run equilibrium and earn profit or loss
• Why?
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• Which theory is most acceptable?
• Salvatore & Srivastava, p19, Case 1-3 on
Apple
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Role & Functions of Profit
IN A FREE MARKET, PROFITS HAVE TWO
FUNCTIONS.
1. SIGNAL: That consumers want more , to
change the rate of output and firms to enter
and exist
2. REWARD: Incentive: to innovate, increase
efficiency an take risks
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• EFFICIENT ALLOCATION of resources
• Soviet economic system collapsed because of
lack of profit motive
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Debate
Milton Freidman: “ Business has only one social
responsibility- to make profits (so long as it
stays within the legal and moral rules of the
game established by the society)
… to make as much money as possible for their
share holders
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How would the following affect Profits
of your firm?
1. Firm is required by government to shift to Green
technology
2. RBI reduces its Repo rate
3. A new rival firm enters the industry
4. Rate of inflation rises steeply
5. Import duty on the product you manufacture is
greatly slashed
6. A Trade Union is started newly in your industry
where none existed before
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