PROFIT

What is profit?

Profit refers to a reward enjoyed by an entrepreneur for his

entrepreneurship or for his contribution to the process of
production.

P =TR (Total receipts – TC (Total cost).

This is called gross profit i.e. residual income left after
deducting the money payments made to all hired factors.

Some economists define profit as a compensation received by

an entrepreneur for his managerial functions or for organizing
production.

According to some economists it is a reward for bearing risk

and uncertainty by an entrepreneur and for introducing
innovations by him.

Characteristics of profit:
Profit differs from other factor rewards like rent, wages and
interest.
1. Profit is derived from various sources like
organizational ability, monopoly position, innovations
such as new products, new techniques, risk and
uncertainty bearing, windfall gains. Profit is affected
by new modes of advertisement and sales.
2. Profit is a fluctuating income. It goes on fluctuating
widely from time to time; high during prosperous
periods and low during recession. Other factor incomes
are elastic over a period of time.
3. Profit is not a fixed or contractual income. Other
factor incomes are predetermined.

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 4. Profit is uncertain-changes with conditions of
demand and supply.
5. Profit is a residual surplus or income. It is what is
left after deducting rent, wages, interest and all other
expenses.
6. Profit is received after the completion of production
and sales. Payment to other factors is made. Total
sales- Total cost of production
7. Profit can be positive, zero or negative. Rent, wages
and interest are always positive.
8. Profit is not determined in an entrepreneurial
market. Rent, wages and interest are determined in the
respective market.
9. Non-insurable risks are responsible for a profit
which is not the case for determination of rent, wages
and interest.

Distinction between gross profit and net profit:

Gross profit refers to the total revenue minus the total explicit
cost. Gross profit includes implicit cost.
Gross profit includes the following items:
1. Implicit returns, implicit rent, implicit wages and
implicit interest pertaining to land, labour, and capital
respectively owned and supplied by the entrepreneur
himself.
2. Normal profit is included in implicit cost. It is a
minimum return for his organizational functions.
3. Imputed costs such as depreciation of capital assets
and maintenance charges are imputed which are
included in the implicit cost.

Gross profit also includes the reward to an entrepreneur for

his functions like uncertainty bearing, innovations, etc. It also

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includes profits due to monopoly position, windfall gains on
account of a sudden increase in demand for a commodity, etc

Net profit is also called real or economic or pure profit earned

by an entrepreneur.

Net profit = Gross profit minus implicit costs including normal

profit, depreciation and maintenance charges.

Thus, net profit is a reward to an entrepreneur due to the

following causes:
1. Risk and uncertainty-bearing by him
2. Introduction of innovations by him
3. Profits due to a monopoly position enjoyed by him
4. Profits due to exploitation of workers and
consumers
5. Windfall gains or abnormal profits due to
unexpected increase in demand
6. Product differentiation introduced by him

Normal profits and super-normal profits:

1. Normal profit is a reward paid to the entrepreneur

for organizing business. Super-normal or excess profit
is the reward paid to the entrepreneur for bearing risk.
2. Normal profits can be guaranteed in advance.
Super-normal profits cannot be anticipated /forecasted
in advance.
3. Normal profits are sufficient to induce the
entrepreneur to remain in the market. New firms/
entrepreneurs will enter the industry or market if
there are super- normal profits.

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Role of profit in business:

1. It is the barometer of the performance of the firm.

Decisions such as what to produce , how much to
produce , how to produce, where to produce are taken
by the producer based upon profit-motive
2. Profit is a premium that covers the cost of staying in
the business
3. Profit ensures expansion of business. Profits are
ploughed back in the business.
4. Profit strengthens the balance-sheet. Reserves are
created out of profit.
In order to maximize their profits, the producers will select
those methods of production which will help them to produce
their products at the lowest average cost of production.

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 THEORIES OF PROFIT

There are various theories of profit

1. Risk-bearing theory of profit:

According to F.B Howley, the profit is a reward to

entrepreneurs for assuming risks associated with any business
or enterprise. This is because any business or enterprise would
involve some risks. The greater the risk, the higher is the size
of profit and vice-versa.

Criticism:
i. F.H. Knight criticizes this theory on the ground that
Howley did not distinguish between risk and uncertainty.
Risks can be insured. Hence, profits are due to bearing
such risks called uncertainty.
ii. There are other sources of profit such as monopoly,
innovations, etc.
iii. Profits can arise due to better organizational capacities of
some entrepreneurs in comparison to an average
entrepreneur.
iv. Profits arise because entrepreneurs are in a position to
minimize or avoid risk.

2. Knight’s Risk and uncertainty-bearing theory of profit:

Net-profit as the reward for uncertainty-bearing:

According to Knight, pure profits arise due to uncertainty

borne by an entrepreneur. So pure profit is a reward for
bearing of uncertainty by an entrepreneur, in a dynamic
society where uncertain changes occur.

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According to Knight, there are two types of risks (1) insurable
risks (2) non insurable risks (risks which cannot be foreseen).

i. Insurable risks:The common risks arising out of fire,

floods, accidents, earthquakes, theft etc. are called
insurable risks. Such risks can be foreseen or predicted and
insured with an insurance company only. The insurance
premium paid by him is included in the cost of production.
According to Knight, pure profit does not arise on account
of insurable risk.
ii. Non-insurable risk: Such risks are called uncertainty.
They cannot be predicted or foreseen. Such risks cannot be
insured by an insurance company. Such uncertainty is
borne by an entrepreneur only for he produces a product
in anticipation of demand for it in future.
Pure profits are due to uncertainty bearing.

Some non-insurable risks might arise due to the following

factors:
i. Competitive or competition risk-Some new product
produced by an existing firm or a new firm might be
introduced in the market. In such a case, competition will
increase. This would cause a decrease in demand for the
product of the entrepreneur and may cut his existing
market share. A fall in price may result in decrease in
profit or losses.
ii. Technical risks-A rival producer may introduce cost
saving devices by using new machines or better techniques
of production. This would reduce his average cost of
production. Hence the rival producer will be in a position
to sell his product at a lower price. Changing technology is
not that easy.
iii. Trade cycle risk-There may be a fall in consumer’s
income due to recession or depression. There will be a
decrease in demand.

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 iv. Govt. risks-Risks can also arise because of unpredictable
changes in the government policies regarding taxation,
banking, imports, exports, agriculture, industry, etc. The
imports of similar products might be liberalized or higher
tax rates might be imposed on the domestically produced
products. As a result, the preferences of the consumer may
change. Hence the demand for the product might reduce.
v. Risks due to changes in demand- Changes in demand for
a product may result in a decrease in its demand for this.
As a result, its price will fall causing a loss to the
entrepreneur.
vi. Risks due to natural calamities-There might be
earthquakes, floods, draughts, etc. affecting the supplies of
agriculture commodities. An entrepreneur has to shoulder
such risks himself.
vii. Risks due to labour unrest-There might be sudden
strikes. Such situations may cause losses to the
entrepreneur.
viii. Risk of war-A war may disrupt and dislocate an
economy. Such changes cannot be predicted.
ix. Risks due to structural changes- There are structural
changes in a dynamic society such as changes in the tastes
of consumers.
If his anticipations regarding the future demand for his
product prove correct, he would be rewarded by means of
excess or net profit bearing such uncertainties.
Criticism:
i. The theory considers only one cause viz. uncertainty
bearing as the source of profit. However, there are many
other causes of profits such as monopoly, monopolistic
competition, windfall gains, innovations, industrialization
etc.
ii. It is also criticized on the ground that the uncertainty
bearing cannot be regarded as a separate factor of
production. This is because an entrepreneur may earn

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 profit because of his greater ability to foresee the future
events even in uncertain situations. Hence profit becomes a
reward for his ability.
iii. It is also pointed out that an entrepreneur may not be
able to make any profit inspite of his bearing uncertainty.

3. Dynamic theory of profit:

According to Prof. I.B.Clerk, pure or net profit is a surplus

over cost of production. This surplus arises due to a difference
between the price of a product and its average cost of
production. The dynamic changes in an economy are
responsible for the emergence of pure profit.
According to him, pure profits do not arise in a static or a
stationary society. This is because, in such a society, the
conditions of demand and supply are static in nature. In such a
society, the price of a product tends to be equal to its average
cost providing only normal profits. However, in a static society,
there may be some frictional profits arising out of some
frictions in the economy. Such frictional profit is not pure
profit.
The pure profits arise only in a dynamic society or economy
where there are five types of dynamic changes:
i. Changes in the size of population
ii. Changes in the supply of capital
iii. changes in the technique or methods of production
iv. Changes in the form of industrial organization
v. Changes in human wants.
Because of the above changes, the economy tends to become
dynamic. Hence, the conditions of demand and supply change.
When, for instance, the demand for the products of a firm
increases or its cost of production falls, pure profits would be
enjoyed by that firm only. This indicates that more efficient

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firms enjoy pure profits. The less efficient firms which do not
move with dynamic changes may not get pure profits.
When the demand for a product increases, its price would rise
and it would take some time for its supply to adjust itself to the
demand for it. During that period, pure profits would arise.
Also, the price remaining constant, an entrepreneur may
introduce a cost-reducing method for production. Hence, the
average cost of production would fall. So, he will enjoy pure
profits.
So, entrepreneurs introduce cost reducing devices to enjoy
pure profits by means of a difference between the price and
average cost. But the profits would be temporary. This is
because, in the long run, their competitors would also adopt
the same method of production.
The competition among producers would also result in a fall in
the prices of their products. So, ultimately the product price
would become equal to the average cost and all pure profits
would disappear, unless, meanwhile, some producers introduce
some other changes which would give rise to pure profits
again.
Criticism:
i. According to Knight, all dynamic changes are not
responsible for pure profits. If the future changes can be
fully predicted well in advance, the supply of a product can
be adjusted to the demand for it. Hence, the price and the
average cost would be equal. So, there will be no pure
profits. Pure profits are associated with only those changes
which are uncertain so that they cannot be fully predicted
or foreseen.
ii. This theory ignores the importance of non-insurable risks
in the business arising out of dynamic changes. It also
ignores the importance of monopoly and other factors
determining pure profits.

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 iii. According to Clerk, there may be frictional profits in a
stationary economy. But the meaning of frictional profit is
not precisely given by him.

MONOLPOY AND PROFITS

Monopoly is another source of profits. Monopolistic position

gives rise to profits both in static and dynamic conditions.
Monopolist commands a control over price of a product. He
can raise price by restricting output. Monopoly power is
exercised not only by a pure monopolist who produces the
product which has no close substitutes. Price determined is
often higher than the marginal the cost of production .Owing
to the strong barriers for the entry of new firms, the firms
working under pure monopoly and oligopoly continue to make
super natural profits even in the long run. Product
differentiation gives a firm a certain degree of monopoly power
in setting his own price and no new firms can produce exactly
the same product as that of any existing firm under
monopolistic competition.
A.S.Lerner has provided a quantitative measure of the degree
of monopoly present in any market situation. Lerner’s
quantitative measure of the degree of monopoly is based on the
fact that whenever monopoly power is present, price set by the
producer will deviate from marginal cost.
According to Lerner:
If p stands for price and m for marginal cost, the difference;
p-m measures the extent of monopoly power. The difference;
p-m expressed as a fraction of price p, i.e. p-m/p is Lerner’s
measure of the degree of monopoly.

The second factor on which monopoly power of a firm depends

is its share in the market or in the total output of the industry.
Greater the market share, the greater the extent of monopoly
power yielded by a producer.

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It is often pointed out that monopoly power possessed by a
producer is no guarantee of positive profits if the demand for
his product is inadequate and cost of production is high.

Critical evaluation:
It is incorrect to state that monopoly is the only source or
determinant of profits. Dynamic changes, innovations by
entrepreneurs, uncertainty are important causes of profit.
The measure of degree of monopoly (p-m)/p is zero under
perfect competition, since price (p) = the marginal cost (m)
under it. It implies that under perfect competition with zero
degree of monopoly, the share of profits will be zero and the
share of labour will be 100% which is unrealistic and
ridiculous.

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