Theories
A. Profit as rent of ability:
As rent of land is the result of the superior fertility and location possessed by a given plot of land over the marginal land, so profit is the reward enjoyed by an entrepreneur for his superior talents or ability over the above those possessed by the marginal entrepreneur.
This theory is associated with the name of Francis Walker, the American economist. The treatment of profit as a source of surplus revenue accruing to the superior or intramarginal entrepreneur is similar to Ricardo’s treatment of rent as a source of surplus-earning going to the pockets of the owner of the superior (intramarginal) land.
It is true that both profit and rent belong to the genius “surplus,” since mathematically both are differences between income and cost. However, they cannot be regarded as identical in all respects.
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1. Joint stock companies play an important role in the economy today. The manner in which dividends are distributed among the shareholders is in no way related to the later’s ability. Both dull and intelligent shareholders enjoy equal dividends.
2. While rent is a known surplus, profit is unknown and emerges as a result of our inability to forecast correctly future events. Profit is due to uncertainty regarding future.
3. Rent can never be negative, profit can be both negative and positive. Negative profits are commonly known as losses.
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(B) Innovation theory of profit:
Innovation is directly related to profit. Innovation brings changes resulting in upward or downward changes in profits.
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Innovation, therefore, means changes .for the better and it is possible only in a dynamic state of economy.
If we assume the state of economy as static, nothing is left to change and everything is certain. Everyone is sure that the economic activities of this year will be duplicated next year.
There would be no new products, no new markets, no new inventions, no new methods of production, and no new supplies of factors of production.
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The only risks that can happen in production would be the ‘Acts of God’. In a stationary society, neither demand nor supply changes.
In a static equilibrium, therefore, the price of the product will be exactly equal to average total unit cost of production including normal profit to the organizer in the current year neither profit nor loss exists in such a state. The no-profit no-loss situation would apply to all industries in a static economy.
Therefore, in the actual dynamic world everything is uncertain and nothing can be clearly anticipated.
All the factors which influence demand- supply change continuously resulting in profit or loss. Changes in the population income, fashions bring about changes in demand.
An increase in demand will lead to a rise in price of the product and if cost of production remains the same, profit will rise.
Economists speak of two types of changes which can affect an economy. (i) General changes which are common to all firms in industry and sometimes common to all industries in the country; there are changes over which the firm has no control and (ii) Special changes which are deliberately introduced by individual firms in order to earn a profit. G.B. Clark and Joseph Schumpeter have developed the dynamic surplus concept of profit.
Thus profit as the difference between price and cost of production is said to arise when conditions change, affecting demand or supply or both.
The merit of this concept of profit as a dynamic surplus is that it explains the emergence of profits in the real world.
Innovation leads to dynamic changes which in turn lead to economic progress and higher profits. Innovation refers broadly to any purposeful change in production methods, techniques, consumer tastes that increases national output than it increases costs.
The net increase in output is profit that comes from innovations. It includes new raw materials, new markets new products, new organizations and new promotion etc.
It also includes a new way of doing things or different combination of existing methods to accomplish new things.
Invention and innovation are different Invention means creation of something new whereas innovation means the application of invention into business.
Many inventions never became innovations. Thus innovator is a person who turns invention or a new idea into a commercial proposition.
If inventor brings a new and superior product to the market, the public will be attracted and willing to pay a higher price to the innovator for it.
For a short period, till new competitors join, he can reap the profits of innovation. The profit of innovation will soon die out thereafter. Meanwhile, other innovation will be hitting the market in a dynamic economy.
Innovation, thus, is a continuous process and therefore, profit of innovation always exists.
This theory ignores the risks and uncertainty in the business but it can be said safely that innovation is the other name of risk bearing.
(C) Profit as a reward for risk and uncertainty bearing:
Profit is attributed to risk taking by the entrepreneur. The greater the risks the higher must be expected gain in order to induce an entrepreneur to start a business.
It is interesting to observe that profit arises not because risks are borne by the entrepreneur but because the superior entrepreneurs are able to reduce them. Prof. F. Frank Knight divides risks into two types-insurable and non-insurable.
(i) Insurable risks:
Those risks that can be calculated statistically and then insured such as loss of property due to fire and flood, theft, burglary etc.
(ii) Non-insurable risks:
Risks of competition, technological risks, business cycle risks, risks due to government action etc. These non- insurable risks are called uncertainties.
Insurable risks do not affect the profit because they can be calculated and may be insured with the insurance company whereas non-insurable risks or uncertainties hit the profit.
The profit is, therefore, said to be the reward for undertaking and managing uncertainties.