Top 6 Theories of Profit (With Criticisms)

The following points highlight the top six theories of profit. The theories are: 1. Rent Theory of Profit 2. Wage Fund Theory of Profit 3. Dynamic Theory of Profit 4. Marginal Productivity Theory of Profit 5. Risk and Uncertainty Theory of Profit 6. Innovation Theory of Profit.

Theory # 1. Rent Theory of Profit:

Rent theory of profit, as developed by Francis L. Walker, says that pure or net profit is the rent of ability. Just as land is heterogeneous in quality, entrepreneurs are also of different qualities. Rent arises due to the differences in productivity of lands. Rent arises in the case of superior or intra-superior land. Rent does not arise in the case of marginal land.

According to Walker, this is also true of entrepreneurs. Some entrepreneurs, say superior ones, earn profit, while inferior or marginal entrepreneurs do not earn any profit. Thus, profit is attributed to the differences in ability. Like rent, profit is a differential surplus which accrues to the superior or intra- superior entrepreneurs—profit is, thus the ‘rent of ability’.

Criticisms:

i. Profit may arise due to differences in ability. But profit may arise due to monopoly, innovation, risk, etc. Walker ignores all these elements.

ii. Walker’s logic is not convincing when he says that the marginal entrepre­neurs are non-profit earners and, therefore, profit does not enter into price. In economics, normal profit is included in the cost of production and, therefore, enters into price.

iii. The concept of no-profit entrepreneurs as envisaged by Walker is rather an unrealistic one. Profit is the best guide for an entrepreneur to stay in business. If marginal entrepreneurs do not get profit, what will be their incentive to stay in business? They should and would shut-down their businesses. This does not happen in the real world.

iv. In modern business, there has been a separation of ownership from manage­ment. Owners or the shareholders earn dividends—whether they are superior or not. So, profit is not the result of rent of ability even if the sleeping shareholders get profit in the form of dividends.

v. Finally, profit is the result of managerial function. An organizer is supposed to manage and coordinate various functions. But, at the same time, the organizer undertakes risk. Profit arises because the organizer undertakes risk. This important function has been ignored by Walker.

In view of all these criticisms, there is not a single believer of this theory.

Theory # 2.Wage Fund Theory of Profit:

Davenport and Taussig’s names are associated with the wages fund theory. According to Taussig, profits are regarded as simply a form of wage. They accrue to the entrepreneur on account of his special ability.

Therefore, profit is not a chance income; it arises due to the special skill possessed by the entrepreneur. As skill is the characteristic of labour, profits of the entrepreneurs should be regarded as wages. Since an entrepreneur is a special class of factor of production, he must receive profit.

Criticisms:

i. This theory finds an equivalence between wages and profit. But we know that wages are earned income — the result of toil and work; while profit is the result of a variety of things, including a ‘chance’.

ii. Workers get wages so long as they work. But profit is an uncertain income. It may be zero, or even negative.

iii. Shareholders, without performing any economic function, earn profit. This theory cannot explain this pheno­menon.

iv. Profit may arise due to (a) imper­fection, (b) innovation, (c) risk-taking, etc. Walker did not appreciate these elements.

In view of these criticisms, one can label this theory as a highly unsatisfactory theory.

Theory # 3. Dynamic Theory of Profit:

J. B. Clark propounded that profit arises in a dynamic society. In other words, profit does not arise in a static economy. A stationary economy is characterized by unchanged size of population, supply of capital, the methods of production, the organization of business etc. Thus, a static economy is a changeless economy.

According to Clark, five generic changes go on, every one of which reacts on the structure of society. In a dynamic state, population increases, capital increases, methods of production change or improve forms of business organization change, quantity and quality of human wants change.

We know that profit is a dynamic surplus beyond full cost of production. It is defined as the difference between selling price and, hence, total revenue and total cost. In a changeless economy, there does not occur any difference between revenue and cost; price tends to equal cost. Consequently, profit becomes, simply, zero. Profit is, thus, the result of five dynamic changes.

Criticisms:

i. There is no guarantee that a dynamic society always earns profit. We live in a changing world where variety of changes takes place. Under the circums­tances, one finds a number of losing firms. So, profits are not to be attrib­uted to changes alone.

ii. Clark emphasizes too much on changes and neglects managerial functions of an entrepreneur. An efficient manager may earn profit if he performs his func­tions efficiently. So profit is the result of entrepreneurial functions.

iii. No economy is a static one. An efficient innovative entrepreneur always brings about a change. Obviously, profit will arise. It is to be remembered that all changes may not give rise to profit. Only those changes which are unpredictable may give rise to profit.

iv. Profit may arise due to risk-taking. Clark did not find any relation between risk-taking and profit. What J.B. Clark says about five generic changes characterizing the dynamic economy are indeed “the divergence of actual conditions from those which have been expected.”

Theory # 4. Marginal Productivity Theory of Profit:

Marginal productivity theory of distribution can be applied to any input, including entrepreneur. In other words, it is the marginal productivity that determines the reward of an entrepreneur. Profit is determined in accordance with the marginal revenue product of an entrepreneur. Greater the marginal revenue product, greater will be the profit.

Criticisms:

i. This theory is based on unrealistic assumptions of perfect competition, homogeneity of entrepreneurs, etc. If these assumptions are removed, marginal productivity theory of profit will breakdown. For instance, entrepreneurs differ in quality. For each entrepreneur there must be a separate marginal revenue product. Profit thus determined involves inaccuracies.

ii. This theory fails to explain why windfall profit or monopoly profit arise.

iii. This theory is a one-sided theory as it neglects the supply side of an entre­preneur.

Thus, marginal revenue product cannot determine the price of an entrepreneur. No entrepreneur can—consciously or uncon­sciously—measure the marginal revenue product. In view of all these reasons, no one believes in this theory.

Theory # 5. Risk and Uncertainty Theory of Profit:

Hawley’s Risk Theory:

According to F. B. Hawley, the main function of an entrepreneur is to bear risk. Profit is the reward for undertaking risk. An entrepreneur produces goods in anticipation. If his anticipation goes right then his currently produced goods could be sold in future.

Otherwise, if his anticipation turns out to be false, he will have to suffer losses. This, in fact, is the risk in business. People go into business with the hope of getting profit. But the future is uncertain. In this uncertain world, nothing works out in accordance with the plans and the targets the businesses make. Business decisions are made and actions are taken.

Such actions may be right and so profits arise; if such actions prove to be mistakes, losses arise. Thus, profit is the consequence of uncertainty. Obviously, the entrepreneur must be rewarded in the form of profit. Otherwise, he won’t undertake any business. Risks vary from business to business. Greater the risks involved in any business undertaking, greater will be the profit.

However, this theory has been criticized on the following grounds. Firstly, some people think that the whole amount of profit is not due to risk. Occasionally, the organizer reaps windfall gain not connected with risk. Secondly, risky businesses may not always ensure greater profit.

It is the plastic surgeon who gets larger profit despite a minimum risk compared to an abdominal surgeon who is susceptible to larger risk. Ironically, it is the latter who gets smaller remuneration. Thirdly, an entrepreneur always tries to minimize his risk. In fact, minimization of risk involves greater profit. Fourthly, all risks do not generate profit.

Non-insured risk arises due to uncertainty. Profit is the reward of uncertainty. Knight suggested this. Frank Knight also suggested that producers may experience negative profit. It is to be borne in mind that the ‘market economy is a profit—and—loss economy’—such profit and loss can arise only in an uncertain world.

Knight‘s Uncertainty Theory:

F. H. Knight extended and modified Hawley’s risk theory and finally provided the uncertainty theory of profit. According to him, there are two types of risk. Risks which can be known beforehand are known as foreseeable risk or certain risk, such as the possibility of catching fire in a go-down. This sort of risk can be avoided by buying an insurance policy.

Insurance companies are willing to bear this type of risk against premium. These risks do not cause the emergence of profit. On the other hand, there are certain risks which cannot be known earlier and, therefore, non- insurable. These risks are called unforesee­able risk or uncertain risks, e.g., change in fashion, innovation of new product, etc.

Businessmen can never insure these risks since insurance companies do not come forward to undertake these risks even if a fantastic amount of premium is paid. In other words, as the statistical incidence of the occurrences of these incidents cannot be calculated these risks are called non- insurable risks.

These risks are the result of the actions of men not foreseen even in the aggregate. These non-insurable risks arise due to uncertainty. In other words, it is the uncertainty that causes the emergence of profit. Profit is the reward for bearing uncertainty.

Criticisms:

In the first place, an entrepreneur’s only function is not to bear uncertainty, though this theory claims so. Profit may arise due to organizational ability, innovation, etc. Knight did no’, consider these. Secondly, it is absolutely difficult to make a monetary measure of uncertainty. Naturally, amount of profit must remain indeterminate.

Thirdly, profit may also arise due to imperfections of the market. This theory is silent in this respect. Finally, uncertainty is not only borne by the organizers alone; almost all factors of production face some sort of uncertainty.

Theory # 6. Innovation Theory of Profit:

J. Schumpeter is of the opinion that the main function of an entrepreneur is innovation. Profit is the result of innovation. A free enterprise capitalistic economy is characterized by perfect competition. In the long run perfectly competitive situation, economic profits tend to become zero. There cannot be pure profits.

But Schumpeter argues that, even in the long run, sources of competition never dry up. In addition to routine job, entrepreneurs always innovate.

An innovation may consist of the introduction of a new product, a new market, the discovery of a new source of raw materials, the introduction of a new method of production, and the carrying out of the non- organizational function of any industry, like the creation of monopoly position, etc.

As a result of these innovations, some entrepre­neurs enjoy pure profit because of reduced cost of production. These innovations cannot remain secret. Once these are known to others, they will follow these innovations in “swarm-like clusters”.

But, in the long run, other entrepreneurs imitate the innovations of earlier entrepreneurs or innovators— thereby reducing profit. Ultimately, profits tend to zero. But again, a newer innovation will appear and, consequently, pure profit.

Criticisms:

i. Schumpeter emphasizes on innovating functions of an entrepreneur. But there are other functions of an entrepreneur for which profit may arise. Schumpeter ignores these factors. He provides only an incomplete explanation.

ii. Profit is due to risk-taking and uncer­tainty as has been emphasized by Hawley and Knight. Schumpeter does not regard risk-taking as the function of an entrepreneur.