Top 5 Theories of Profit – Explained!

The following theories are briefly discussed below:

1. Frictional Theory of Profits:

According to this theory there exists a normal rate of profit which is a return on capital that must be paid to the owners of capital as a reward for saving and investment of their funds rather than to consume all their income or hoard them.

In a static economy where no unanticipated changes in demand or cost conditions occur, in long-run equilibrium the firms would be earning only normal rate of profit on their capital and entrepreneurial talent.

Under these conditions economic profits would not accrue to the firms. Frictional theory of profit explains that shocks or disturbances occasionally occur in an economy as a result of unanticepated changes in product demand or cost conditions which cause disequilibruim conditions. It is these disequilibrium conditions that brings into existence positive or negative economic profits for some firms.

Thus, according to frictional theory, economic profits exist for some time because of frictional factors which prevent an instanteous adjustment of the system to the new conditions. For example, at the time of sharp size in petroleum prices in the 1990 as a result of US-Iraq war many petroleum-refining firms enjoyed handsome economic profits. Similarly, as a result of slowdown in world trade in the years 1999-2001 many Indian firms doing export business suffered losses due to the decrease in the demand for their products in the USA and other countries.

When economic profits are made in the short run, more firms will enter the industry in the long run until all economic profits are driven down to zero (that is, firms will be making only normal return or profits on their capital investment).

On the other hand, when firms are making losses (i.e. negative profits), some firms will leave the industry. This will cause price of the product to rise so that losses are eliminated and the remaining firms make only normal profits.

Prof. G.J. Stigler, a winner of Nobel Prize in economics sums up the frictional theory of profits in the following words: “Firms in a competitive industry may receive profits……………… because of a state of disequilibrium…. these profits can arise even if all entrepreneurs are identical for disequilibrium can characterize a whole industry. If prices are higher, or costs lower than were anticipated, entrepreneurs will receive a return in excess of the alternative product of their resources.

If prices were lower or costs higher than were anticipated, entrepreneurs will receive less than the alternative product of their resources i.e., negative profits. Positive profits may persist for a long time if firms outside the industry are show to enter the industry and negative profits can persist as long as specialised equipment yields more when used in the industry than used elsewhere, say as scrap.”

2. Monopoly Theory of Profits:

Another explanation of above-normal profits attributes them to the monopoly power enjoyed by firms. Firms with monopoly power restrict output and charge higher prices than under perfect competition. This causes above-normal profits to be earned by the monopolistic firms.

Joan Robinson, E.H. Chamberlin, M. Kalecki associated super-normal profits with monopoly power enjoyed by some firms. Because of strong barriers to the entry of new firms, monopoly firms can continue to earn economic profits even in the long run. Monopoly power may arise due to sole control over some essential raw material required for the production of a commodity, from economies of scale, from legal sanction or from ownership patents, from Government restrictions on the import of a commodity.

3. Innovations Theory of Profits:

This theory of profits explains that economic profits arise because of successful innovations introduced by the entrepreneurs. It has been held by Joseph Schumpeter that the main function of the entrepreneur is to introduce innovations in the economy and profits are reward for his performing this function.

Now, what is innovation? Innovation, as used by Schumpeter, has a very wide connotation. Any new measure or policy adopted by an entrepreneur to reduce his cost of production or to increase the demand for his product is an innovation.

Thus innovations can be divided into two categories. First types of innovations are those which reduce cost of production. In this first type of innovations are included the introduction of a new machinery, new and cheaper technique or process of production, exploitation of a new source of raw materials, a new and better method of orgainising the firm, etc.

Second types of innovations are those which increase the demand for the product. In this category are included the introduction of a new product, a new variety or design of the product, a new and superior method of advertisement, discovery of new markets etc. If an innovation proves successful, that is, if it achieves its aim of either reducing the cost of production or increasing the demand for a product, it will give rise to profits.

Profits emerge because due to successful innovations either cost falls below the prevailing price of the product or the entrepreneur is able to sell more and at a better price than before.

It is here worth mentioning that profits caused by a particular innovation tend to be competed away as others imitate and also adopt it. An innovation ceases to be new or novel, when others also come to know of it and adopt it. When an entrepreneur introduces a new innovation, he is first in a monopoly position because the new innovation is confined to him only, He therefore makes large profits. When after some time others also adopt it in order to get a share, profits will disappear.

If the law allows and the entrepreneur is able to get his new innovation e.g., new product patented, then he will continue to earn profits for a longer period. For example, Xerox Corporation made large economic profits because it successfully developed and marketed a superior copying technology.

Xerox continued to make large profits until other firms entered the field to compete away these super-normal profits earned by it. Likewise, Bill Gates introduced Windows operating system and MS-office types of computer software and has become billionaire by making huge profit on his innovations.

4. Risk and Uncertainty Bearing Theory of Profit:

This theory explains that profits are a necessary reward of the entrepreneur for bearing risk and uncertainty in a changing economy. So this is functional theory of profits. Profits arise as a result of uncertainty of future.

Entrepreneurs have to undertake the work of production under conditions of uncertainty. In advance they have to make estimates of the future conditions regarding demand for the product and other factors which affect price and costs. In view of their estimates and anticipations, they make contract with the suppliers of factors of production in advance at fixed rates of remuneration.

They realize the value of output produced by the hired factors after it has been produced and sold in the market. But a good deal of time is spent in the process of producing and selling the product. But between the times of contracts and sale of output many changes may take place which may upset anticipations for good or for worse and thereby give rise to profits, positive and negative.

Now if the conditions prevailing at the time of the sale of output could be known or predicted when the entrepreneurs enter into contractual relationships with the factors of production about their rates of remuneration, there would have been no uncertainty and, therefore, no profits. Thus uncertainty, that is, ignorance about the future conditions of demand and supply, is the cause of profits.

It should be noted that positive profits accrue to those entrepreneurs who make correct estimate of the future or whose anticipations prove to be correct. Those whose anticipations prove to be incorrect will have to suffer losses.

Causes of Uncertainty:

Apart from the innovations which are introduced by the entrepreneurs themselves, changes which cause uncertainty are:

(1) Changes in tastes and fashions of the people,

(2) Changes in Government policies and laws especially taxation, wage and labour policies and laws, liberalisation of imports, etc.

(3) Movements of prices as a result of inflation and depression,

(4) Changes in income of the people,

(5) Changes in production technology,

(6) Competition from the new firms that might enter the industry. All these changes cause uncertainty and bring profits, positive or negative, into existence.

F.H. Knight who propounded the uncertainty theory of profits draws distinction between insurable and non-insurable risk. Risks of factory catching fire, occurrence of any theft or accident which may cause huge losses to the entrepreneur are the kinds of risk which can be ensured against on payment of an insurance premium which forms a part of the cost of production.

But there are risks that cannot be insured. These non-insurable risks relate to the outcome of price-output decisions made by the entrepreneur. Due to uncertainty his decisions may prove to be right or wrong.

What output he should produce, what price, higher or lower, he should fix for his output. In view of uncertainty about future conditions he cannot be sure whether, given his price and output decisions, he will make profits or losses.

Similarly, he has to bear risk as a result of his decision regarding mode of advertisement and expenditure made on it, regarding variation in product design. For taking all these decisions he has to guess about demand and cost conditions and there is always a risk of incurring losses as a result of his business decisions.

No insurance company can insure the entrepreneur against business losses which result from his particular price, output, product design, and advertisement expenditure which fall upon him due to adverse changes that may take place in the economy. Thus, it is non-insurable risks that involves uncertainty and gives rise to economic profits, positive or negative.

Risk and uncertainty theory explains why super-normal profits (that is economic profits) are required by the firms who operate in such fields as petroleum exploration which involves relatively higher risks. Likewise, expected return on stocks has to be higher than the interest on bonds because of greater uncertainty and riskiness of investment in stocks of the companies.

5. Managerial Efficiency Theory of Profits:

Lastly, this theory recognizes that some firms are more efficient than others in terms of management of productive operations and successfully meeting the needs of consumers. Firms with average level of efficiency earns average rate of return. Firms with higher managerial skills and production efficiency are required to be compensated by above-normal profits (i.e. economic profits). Therefore, this theory is also called compensatory theory of profits.

Conclusion:

All the theories of profits explained above have some element of truth. No single theory can adequately explain the existence of profits in all cases. Thus, economic profits can arise as a result of disequilibrium caused by dynamic changes in the economy and frictions in the instantaneous adjustment to the new conditions. They can arise due to the existence of monopoly in the product and factor markets, due to the introduction of innovations by the entrepreneurs, due to higher risk and correctly estimating the uncertain future and due to higher managerial efficiency and skills. B.S. Keirstead rightly writes, “Profits may come to exist as a result of monopoly or monopsony as a reward for innovation, as a reward for the correct estimate of uncertain factors either particular to the industry or general to the whole economy”.