UNCERTAINTY THEORY OF PROFIT

UNCERTAINTY THEORY OF PROFIT

            According to professor Knight, profit is the reward for uncertainly-bearing and not of risk-taking in a business. According to him there are two kinds of risk which entrepreneur has to bear. Some risks are of such a nature that they can be anticipated to a fair degree of accuracy, e.g. the risk of death, accident, etc. and so can be insured in return for premium. The entrepreneur can include the payment made in the form of premium in the total cost of production. So such risks which can be calculated and insured should not entitle the entrepneur to a profit. On the other hand, there are some risks which are unpredictable and unforeseen and so they are non-insurable. For instance, if the demand for the product of at entrepneur suddenly comes down due to changes in fashions, tastes, etc. then he may not be able to cannot be statistically measured are called by Knight, as uncertainly-bearing risks. Profits, according to him are the reward of uncertainty-bearing rather than risk-taking which is insurable.

CRITICISM:

1.      The total profit which an entrepreneur receives cannot be attributed solely to the element of uncertainty in a business. He performs other functions also such as coordinating, bargaining, and innovation in the business. So he must be paid for these services also.

2.      It is not simply due to uncertainty-bearing that the supply of entrepreneur is restricted. There are other factors also which influence the supply of the entrepreneur for instance, etc. do restrict the supply of an entrepreneur in a business.

MARGINAL PRODUCTIVITY THEORY OF PROFIT

              According to this theory, the earning of entrepreneur like the reward of other factors of other factors of production can be explained by the marginal productivity analysis. In words of Champ man. “the profit tend to be equal to the marginal social worth of the employers in exactly the same sense in which the labour gets his marginal net product from the employers. The marginal net product of an entrepneur is the amount which the community is able to produce with his help over and above what it could produce without his help.

        Thus, we conclude that under conditions of perfect competition, the reward of the entrepreneur tends to be equal to the marginal social worth of the employer. If the marginal productivity of the employer is high, the profit will also be high and if the marginal net productivity is low, then profit will also be low.

CRITICISM:

     One very important criticism levied on this theory is that the unit of factor, I.e. the enterprise is very large. If for finding out the marginal net productivity of the entrepreneur, we withdraw it from the business, then it will disorganize the entire productive organization. It thus, becomes very difficult to ascertain the marginal net productivity of labour

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RENT THEORY OF PROFIT

RENT THEORY OF PROFIT

       The rent theory of profit is associated with the name of American economist, Francis A. Walker. According to him, profit are of the same genius as rent. The main points of Walker’s theory of profit can be summed up as such.

1.      Profit is rental in character. Just as superior grades of land earn more rent than the inferior grades of land, similarly superior entrepreneur due to their exceptional ability or opportunity earn more profit than the inferior entrepreneurs.

2.      As in the case of land, there is a no-rent or marginal land, so in the business also is a no-profit or marginal entrepreneur is one whose ultimate receipts from the sale of the commodities just cover his total costs.

3.      Just as rent is measured from the non-rent land, in the same way profit of the superior businessmen are calculated from the marginal entrepreneur.

4.      The rent does not enter into price of agricultural production of the manufactured goods.

          From all that we have said above, it can be concluded that profit are the reward of differential business ability.

CRITICISM:

     The modern Economist have discarded the Walker’s rent theory of profit on the following grounds:

Firstly, it simply provides a measure of profit. It does not throw light on the nature of profit which is more importance.

Secondly, Marshal is of the opinion that there is much difference between the rent of land and the entrepreneur’s profit. The rent of land can either be positive or zero, but in case of business, the total receipts from the sale of the product can fall short of total costs. So the entrepreneur may suffer losses and thus his profit may be in the negative. In the opinion of Marshall, the price of the commodity in the market is determined not by the cost of production of marginal firm but by the representative firm. Representative firm is the “which has a fairly long lease of life and has a firm degree of success, which is managed with normal ability and which has access to the normal economies of production”.

5.  It is also pointed out that profit may not from a part of the cost of production of a commodity in the short period but in the long period if the business is to be continued, it must enter in the price of the product.

Finally, profits do not arise simply because of the superior or exceptional ability of the entrepreneur, but they can also result due to chance gains or monopolistic position of the entrepreneur or they may be of the nature of the windfall income.

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THE ROLE OF PROFIT IN THE OPERATION OF A FREE ECONOMY

THE ROLE OF PROFIT IN THE OPERATION OF A FREE ECONOMY

             There are various theories which have been advanced from time to time regarding the nature of profit in a competitive economy. Almost all of them differ basically from one another and are inadequate to explain the actual role of profit in the operation free economy. The most important theories are:

        I.            Hawley’s Risk-bearing theory of profit.

      II.            Professor Knight’s uncertainty theory of profit.

    III.            Walker’s rent theory of profit.

    IV.            Clark’s dynamic theory of profit

HAWLEY’S RISK BEARING THEORY OF PROFIT

           This risk bearing theory of profit is associated with the name of F.B Hawley. According to him, profit is the reward of risk taking in business. During the conduct of any business activity, all other factors of production, i.e. land, labour, capital have their guaranteed income from the  entrepreneur. They are least concerned whether the entrepreneur makes profit or undergoes losses in a business activity. As we know, there are every chance at any moment in the variation of demand for the commodity produced, The demand may change due to changes in fashion, tastes, condition of trade, prices of substitutes, distribution of wealth, etc., or the project undertaken may prove to be a complete failure. In all such cases, if the entrepreneur is not able to cover his total costs from the sale of the commodities, then it is he who ultimately bears the loss. So he must be compensated for undertaking such risks.

              Thus, according to Hawley, profit is a payment or a reward for the assumption of risks by the entrepreneur. The greater the risk, the higher must be the profits. It is because if the return on risky enterprise is at the same level as that obtained from the safe investment, then not a single entrepreneur will invest his capital in a risky enterprise.

CRITICISM:

      Hawley’s risk theory of profit is criticized on the following grounds:

1.      According to Hawley’s, profit is a reward for bearing risks in a business the modern economists believe that there is no doubt that profit contain some remuneration for risk-taking in a business but it is wrong to assume that profits are in their entirely due to the element of risk. The profits can arise on account of better management, better supervision or they may be due to the monopolistic position of the entrepreneur or they may be due to sheer chance etc.

2.      Another criticism levied by carver is that profits arise not because risks are borne but because the superior entrepreneurs are able to reduce the risks.

3.      It is also pointed out that profit are never in proportion to the risk undertaken. It can happen that in a more risky enterprise, the profits may be low and high in a less risky enterprise.

4.      There are certain businesses where risks can be more or less accurately foreseen by statistical evidence, e.g. in insurance, the entrepreneurs who run these businesses earn profit. Thus theory fails to explain as to how the profits are earned in such business where the risk can be insured.

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THE ACCOUNTING AND ECONOMIST DEFINITION OF PROFIT

THE ACCOUNTING AND ECONOMIST DEFINITION OF PROFIT

(A) ACCOUNTING DEFINITION OF PROFIT:

               There is no satisfactory definition of the term profit. Generally profit of a firm is defined as the access of revenue over its current costs. The word cost carries. Different meaning with economists and accountants, in accounting, the term profit equals total revenue – explicit costs. This is the profit used by accountants to determine a firm’s taxable income. Explicit costs are the actual cash payments for resources purchased in resource markets. These are the rent the rent paid on land and plant and equipment, wages to labour, interest on capital, cost of raw material, transport charges etc. when all these explicit costs are substracted from the firm’s total revenue, we get gross profit or accounting profit. Accounting profit = total revenue – explicit costs.

      Accounting profit is explained by taking a simple example, let us suppose, the total revenue of a firm from the sale of goods inn 2006 is Rs. 90,000. Its costs on the purchase of raw material, payment of wages and other utilities i.e. explicit costs are 35,000. The firms accounting profit will be Rs. 55,000.

Total sales revenue……………Rs.90,000.

Cost of raw material……… = Rs. 15,000.

Wages to labour and other utilities = Rs. 20,000

Accounting profit = Rs. 90,000 – 15,000 + 20,000 = 55,000

(total revenue – explicit cost)

           When deprecation charges of capital equipment used by the firm and the amount of money paid to the government as taxes is deducted from gross profit accounting profit, we get net profit of accountants.

(B) ECONOMIC PROFIT:

           Economic profit is different from accounting profit. Accounting profit ignores the opportunity cost of the firm’s own resources used in the production of goods. The economist include cost of production. Thus economic profit equals total revenue less all costs both explicit and implicit.

   A firm’s implicit costs are the opportunity costs of using its self-owned, self-employed resources, implicit cost include use of firm’s own building, use of its own capital, and the business owner time given for the production of goods. While determining the total costs, the money payment which these self-employed resources could have earned in their best alternative uses should be worked out and added in cost. The implicit costs are in a way opportunity costs. Economic profit takes into account the opportunity costs of all resources used in production. Implicit costs also include normal profit earned by a firm. Normal profit is the minimum amount required to keep on entrepreneur engaged in the present line of production.

ECONOMIC PROFIT = TOTAL REVENUE LESS ALL COSTS BOTH EXPLICIT AND IMPLICIT.

Example: Suppose a person uses, his own resources, land, capital, his own time in the production of goods. The opportunity costs of these resources in included below in finding out economic profit of the firm.

Accounting profit                                   = Rs. 55,000

Entrepreneur’s own foregone salary     =Rs. 40, 000

Foregone interest on capital                  = Rs.   1,000

Foregone rent                                          =Rs.    2,000

Economic profit                                        =Rs.  12,000

                           OR

 Summing up (a) Accounting profit is the firm’s total revenue less its explicit costs (b) Economic profit to the economist, is the total revenue of a firm less explicit and implicit cost. Implicit cost includes normal profit to attract and retain an entrepreneur engaged in the present line of production Economic profit: if a firm’s total revenue exceeds all its economic costs both explicit and implicit, the residual which goes to the entrepreneur is called an economic or pure profit.

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PROFIT

PROFIT

MEANING OF PROFIT:

      Profit is a basic concept in market economy. Profit acts an incentive mechanism for business investment. Higher profits provide incentives for business growth. Profit also acts as an automatic signal for the allocation and reallocation of scarce resources. Profit which is the hub of all economic activities has no precise definition of its own, in fact it is the most controversial topic of economic theory. To get an accurate idea of profit it is necessary to first distinguish gross profit from net profit.

Gross profit and net profit:

(1) Gross profit is the surplus which accrues to a firm when it deducts its total costs in producing products from its total income received from the sale of goods. In producing goods, a firm incurs explicit is used in the sense of gross profit. The main elements of gross profit of a firm are as under.

        I.            Explicit costs: A firm’s explicit costs are the actual cash payments it makes to those who provide resources. For example, rent is paid on land hired, wages are paid to the employees, interest is paid on capital. In addition to this, a firm also pays insurance premium, and taxes and sets aside depreciation charges.

      II.            Implicit costs: Implicit costs are the opportunity costs of using resources owned by the firm or provided by the firm’s owners. To the firm, the implicit costs are the money payments that self-employed resources could have earned in their best alternative uses. for example, you are working as a manager in a shoe factory and getting Rs. 30000 salary per month, while calculating cost. Implicit costs include (a) rent on entrepreneur own land (b) interest on his own capital (c) wage of the entrepreneur which he could earn in alternative occupation.

NET PROFIT: Net profit is the profit which accrues to an entrepreneur for his functions as an entrepreneur. These function include risk bearing ability, innovating spirit, bargaining ability etc. Net profit is the reward of an entrepreneur for (i) organizing a business and undertaking risk (ii) his bargaining ability with the customers (iii) adopting new techniques of production (iv) monopoly gains if any (v) windfall gains due to sudden rise in the prices of goods.

In short:

Gross Profit     =      Total revenue – Total explicit costs

Net Profit         =     Total revenue    - Total explicit costs + Total implicit costs.

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SHIFT IN SUPPLY CURVE

SHIFT IN SUPPLY CURVE:

            When there is a change in quantity supplied of a good resulting from a change in any of its determinants, other than the price of a good. It causes the supply curve shift rightward or leftward. The supply curve can shift due to advance in technology, change in production cost, climatic changes etc.

REAL WAGE:

               The amount of goods and services which a worker actually receives for his labour is called his real wage depends upon the price level, opportunities of extra earning, status in the society, pension benefits etc.

Nominal wage:

            Nominal wage is the total amount of money income earned, by person for this work during a certain period.

RANKS OF ELASTICITY OF DEMAND TO BE NAMED:

           There are five degrees or ranks of elasticity

(i) Elasticity to unity. (Ed = 1)

(ii) Perfectly inelastic demand (Ed = O)

(iii) Perfectly elastic demand (Ed = 00)

(iv) Elasticity greater than unity (Ed >1)

(v) Elasticity less than unity (Ed<1)

OPPORTUNITY COST:

         The opportunity cost of capital is the available rate of return or the amount of income which could have been earned by investing in the next best alternative. For example, a person has Rs. One lakh in cash which he has kept in the locker, suppose the rate of return on the invested capital in the bank is 10% annually. If the money is kept in the locker, it earns no interest. In case it is invested, it yields 10% interest a year. So the opportunity cost of holding Rs. One lakh in locker is 10% interest which is foregone yearly.

QUASI RENT:

              Economic rent which can only be earned by man-made factors in the short run due to inelastic supply is called Quasi rent.

REGRESSIVE TAX:

           In case the rate of tax is lowered as the taxable income of an individual or firm increases the tax is called regressive. The burden of regressive tax falls more on the poor than on the rich people. Indirect taxes tend to be regressive.

PROGRASSIVE TAX:

             When the rate of increases as the taxable income of a person or firm increase, it is called progressive tax, in other words, the higher the income of a person, the higher the proportion of income paid in tax.

PROPORTIONAL TAX:

         When the rate of tax remains same on all the taxable slabs of income, it is called proportional tax. If the proportional rate of tax is 10%, a person with a taxable income of rs. 20,000/= will pay 2,000/= as the tax and another person with taxable income and maximum employment in the country.

GIFFEN PARADOX:

             The Giffen paradox is named after the name of British economist Robert. According to him there are certain cases of inferior goods to which the law of demand does not apply. These goods are named as Giffen goods. According to Giffen, “when the price of an inferior good decreases its demand decreases and when its price increases, its demand also increases. (the demand for inferior quality of rice increases with the rise in its price in low income groups)

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SCALE OF PRODUCTION

GLOSSARY

SCALE OF PRODUCTION:

                 Scale of production is set by the size of pant, the number of plants installed and the technique of production adopted by the producer. The scale of production is classified as under: (a) Small Scale Production.

(b) Large Scale Production.

(C ) Optimum Scale of Production

(a) Small Scale Production: If a firm produces goods with small sized plants, the scale of production is said to be small. Small scale of production is associated with low capital output and capital labor rations. In the small scale of production, the economies of scale do not occur to the firm.

(b) Large Scale Production: If a firm uses more capital and larger quantities of other factors, it is said to be operating on large scale. Large scale production enjoys both internal economies of scale.

(C ) Optimum Scale of Production: The optimum scale of production refers to that size of production which is accompanies by maximum net economies of scale. It is a scale at which the cost of production per unit is the lowest.

ALLOCATIVE EFFICIENCY:

          It is condition when the resources are used to produce the goods and services which are most preferred by consumers.

ARC ELASTICITY OF DEMAND:

        When price elasticity of demand is calculated between any two finite points on a demand curve, it is named ARC ELASTICITY.

ELASTICITY OF DEMAND:

       Price elasticity of demand is the degree of responsiveness of demand for a good due to the change in its price. It is computed by the percentage change in its price.

SUPPLY:

             Supply in the schedule of the quantities of a good which its producers are prepared to sell at various prices during a specified time period.

SUPPLY FUNCTION:

               Supply function is based on the law of supply. If states the relationship between the quantity supplied of a good ( as a dependent variable ) and its determinants ( as independent variables ) Q_s * =f(P_x).

SUNK COST:

              Sunk cost is that cost which has been incurred in the past and is not recoverable now. For example, the cost of advertising for the sale of product is a sunk cost.

SHUT DOWN COMPETITIVE FIRM:

             The price which is equal to the minimum average variable cost of the competitive firm and below which it will produce no output is called shut down price shut down=when price < AVC.

RENT:

            According to Ricardo, rent is that portion of the produce of earth which is paid to the landlord for the use of original and indestructible powers of the soil. In brief, it is the payment which the land owners receive for the use of their land.

REGRESSIVE TAX:

           In case the rate of tax is lowered as the taxable income of an individual or firm increases the tax is called regressive. The burden of regressive tax falls more on the poor than on the rich people. Indirect taxes tend to be regressive.

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