Theories of Profit in Economics

In Economics profit is called Pure Profit, which may be defined as a residual left after all
contractual costs have been met, including the transfer costs of management insurable
risks, depreciation and payment to shareholders, sufficient to maintain investment at its
current level
Theories of Profit
There are various theories of profit, given by several economists, which are as follows:
1. Walkers Theory of Profit as Rent of Ability
This theory is pounded by F.A. Walker. According to Walker, Profit is the rent of
exceptional abilities that an entrepreneur may possess over others. Rent is the difference
between the yields of the least and the most efficient entrepreneurs. In formulating this
theory, Walker assumed a state of perfect completion in which all firms are presumed to
possess equal managerial ability each firm receives only the wages which in Walker view
forms no part of pure profit. He considered wages of management as ordinary wages thus,
under perfectly competitive conditions, there would be no pure profit and all firms would
earn only wages, which is known as normal profit.
2. Clarks Dynamic Theory
This theory is propounded by J.B. Clark According to him, Profits arise in a dynamic
economy and not in static economy.
A static economy and the firms under it, has the following features:

Absolute freedom of competition.

Population and capital are stationary.

Production process remains unchanged over time.

Homogeneous goods.

Factors of production enjoy freedom of mobility but do not move because their marginal
product in very industry is the same.

There is no uncertainly and risk. If there is any risk, it is insurable

All firms make only normal profit.

A dynamic economy is characterized by the following features:

Increase in population.

Increase in capital.

Improvement in production techniques.

Changes in the forms of business organization.

The major function of entrepreneurs or managers in a dynamic economy is to take the
advantage of all of the above features and promote their business by expanding their sales
and reducing their costs of production.
According to J.B. Clark, Profit is an elusive sum, which entrepreneurs grasp but cannot
hold. It slips through their fingers and bestows itself on all members of the society. This
result in rise in demand for factors pf production and therefore rises in factor prices and
subsequent rise in the cost of production. On the other hand, because of rise in cost of
production and the subsequent fall in selling price of the commodities, the profit disappears.
Disappearing of profit does not mean that profit arise in dynamic economy once only, but it
means that the managers take the advantage of the changes taking place in the economy
and thereby making profits.
3. Hawleys Risk Theory of Profit
The risk theory pf profit is propounded by F.B. Hawley in 1893. Risk in business may arise
due to obsolescence of a product, sudden fall in prices, non-availability of certain materials,
introduction of a better substitute by a competitor and risks due to fire, war, etc. Hawleys
considered risk taking as an inevitable element of production and those who take risk are
more likely to earn larger profits. According to Hawley, Profit is simply the price paid by
society assuming business risks. In his opinion in excess of predetermined risk. They also
look for a return in excess of the wags for bearing risk is that the assumption of risk is
irrelevant and gives to trouble and anxiety. According to Hawley, Profit consists of two part,
which are as follows:

One Part represents compensation for actual or average loss supplementing the various
classes of risk.

The other part represents a penalty to suffer the consequences of being exposed to risk in
the entrepreneurial activities.
Hawley believed that profits arise from factor ownership as long as ownership involves risk.
According to Hawley, an entrepreneur has to assume risk to earn more and more profit. In
case of absence of risks, an entrepreneur would cease to be an entrepreneur and would not
receive any profit. In this theory, profits arise out of uninsured risks. The amount of reward
cannot be determined, until the uncertainly ends with the sale of entrepreneur products

profit in his opinion is a residue and therefore Hawley theory is also called as Residual
theory.
4. Knights Theory of Profit
This theory of profit is propounded by frank H. Knight who treated profit as a residual return
because of uncertainly, and not because of risk bearing. Knight made a distinction between
risk and uncertainly by dividing risk into two categories, calculable and non-calculable risks.
They are explained as below:

Calculable risks are those, the prodigality of occurrence of which van be calculated on the
basis of available data. For example risk, due to fire theft accidents etc. are calculable and
such risks are insurable.

Incalculable risks are those the probability of occurrence of which cannot be calculated. For
Instance there may be a certain elements of cost, which may not be accurately calculable
and the strategies of the competitors may not be precisely assessable. These risk are called
includable risks. The risk element of such incalculable costs is also insurable.
It is in the area of uncertainly which makes decision-making a crucial function for an
entrepreneur. If his decisions prove to be right, the entrepreneur makes profit, Thus
according to knight profit arises from the decisions taken and implemented under the
conditions of uncertainly. The profits may arises as a result of decision related to the state of
market such as decision, which increase the degree of monopoly, decisions regarding
holding of stocks that give rise to windfall gains and the decisions taken to introduce new
techniques or innovations.
5. Schumpeters Innovation Theory of Profit
Joseph A. Schumpeter developed the innovation theory of Profit. According to Schumpeter,
factors like emergence of interest and profits, recurrence of trade cycles only supplement
the distinct process of economic development. To explain the phenomenon of economic
development and profit, Schumpeter starts from the state of a stationary equilibrium, which
is characterized by the equilibrium in all the spheres. Under these conditions stationary
equilibrium, the total receipts from the business are exactly equal to the cost. This means
that there will be no profit. The profit can be earned only by introducing innovations in
manufacturing technique and the methods of supplying the goods innovations may include
the following activities.

Introduction of a new commodity or new quality goods.

Introduction of a new method of production.

Introduction of a new market.

Finding the new sources of raw material.

Organizing the industry in an innovative manner with the new techniques.

The factor prices tend to increase while the supply of factors remains the same. As a result,
cost of production increase. On the other hand with other firms adopting innovations, supply
of goods and services increases resulting in a fall in their prices. Thus, on one hand, cost
per unit of output goes up and on the other revenue per unit decrease. Finally, a stage
comes when there is no difference between costs and receipts. As a result there are no
profits at all. Here, economy has reached a state of equilibrium, but there is the possibility of
existence of profits. Such profits are in the nature of quasi-rent arising due to some special
characteristics of productive services. Furthermore, where profits arise due to factors such
as patents, trusts, etc. they will be in the nature of monopoly revenue rather than
entrepreneurial profits

Discuss the various theories of profit which have been offered from time to time
Rent theory of profit :This theory is offered by Prof. Walker. He says, that profit is determined just like the rent of
land. The main points of this theory are given below :
1. Profit is like run :He says that as superior grade of land earned more rent then the inferior grade of land,
similarly superior entrepreneur earn more than the inferior.
2. Marginal entrepreneur :Just as the rent is measured from no rent land in the same way profits of the superior
businessman are calculated from the marginal entrepreneur.
3. Profit is not included in cost :Profit is not included in the cost of production, it is something extra just like the theory of
Ricardo.
CRITICISM
1. difference in land and entrepreneur :Marshall says that there is much difference between the rent of land and entrepreneur's
profit.
2. Objection on superior ability :Profit can not arise only due to the superior ability but there are so many other factors which

are responsible for profit.

3. Nature of profit ignored :This theory does not throw light on the nature of profit which is more important.
4. Profit is the part of cost :It is also stated that profit is not included in cost , it is not correct.
5. Case of loss :In case of land, there is no chance of loss but in case of entrepreneur loss can also be
suffered.
Risk-bearing theory of profit :F.B Hawlay. says that profit is the reward of risk taking in business. In a business activity we
know that there is a chance of loss very moment. The greater the risk, the higher must be
the profit. If there would be equal rate of profit in all the business, then nobody would invest
the capital in a risky enterprise.
CRITICISM
1. Demand and supply side ignored :This theory is ignored the demand and supply aspect.
2. Better management :The profit can arise on account of better management instead of risk taking only.
3. Monopoly and by chance profit ignored :This theory does not throw light on the monopoly gains and by chance gains.
4. Superiority of entrepreneur :Superior entrepreneurs are able to reduce the risks, so it is not correct to say that profit
raises due to risk.
Uncertainty theory of profit :This theory is offered by Prof. Knight. He says that profit is the reward for uncertainty
bearing and not of risk taking in business. He divides the risks in to two kinds.
1. Insurable risks. 2. Non insurable.
Those risks which can not be insured, such as the change in demand due to fashion, these
are called uncertainty bearing. According to him profit is the reward of uncertainty bearing
rather than risk taking, which are insurable.

CRITICISM
1. Other services ignored :The total profit can not be reward of uncertainty in a business because the entrepreneur
also performs other functions like bargaining and co-coordinating the business.
2. Demand and supply ignored :This theory ignored the demand and supply side.
3. Monopoly and by chance profit ignored :This theory does not throw light on the monopoly gains and by chance gains.
4. Restricted supply :Profit is not simply reward of uncertainty bearing but it is paid due to restricted supply of the
entrepreneur.
Dynamic theory of profit :This theory is offered by Prof. Clark. He says that profit is reward of entrepreneurs ability
that he uses his creative forces and bringing many changes the makes the business
dynamic. Every entrepreneur wants that the cost of his production should be minimum and
profit should be maximum.
Prof. Schumpeter says that entrepreneur earns profit by using innovations. So profit is the
reward of innovations.
CRITICISM
Prof. Knight criticisms that all profits are not due to the dynamic changes.
This theory also fails to explain that how profit is determined in the market.
Marginal productivity theory :According to "Chapman" The profit tends to equal to the marginal social worth of the
employer as the labourer gets his marginal net product from the employer." The marginal
net product is an amount which the community is able to produce with his help over and
above what it could produce without his help. If the marginal productivity is higher then the
profit will high. If the marginal product is low then profit will also be low.