MADE BY PALLAK MBA IB

PROFITS: DEFINITION
Profit, a basic concept in market economy

acts as 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. To get an accurate idea of profit, it is necessary to first distinguish gross profit from net profit.

GROSS PROFIT AND NET PROFIT

GROSS PROFIT 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 costs and implicit costs FORMULA Gross Profit = Total Revenue - Total Explicit Costs

i) Explicit costs: A firm's explicit costs are the actual cash payments it makes to those who provide resources. 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.

NET PROFIT Net profit is the profit which accrues to an entrepreneur for his functions as an entrepreneur. 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. FORMULA Net Profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs)

DIFFERENCE BETWEEN ACCOUNTING PROFIT AND ECONOMIC PROFIT

a) Accounting profit is the firm's total revenue less its

explicit costs FORMULA: Accounting Profit = Total Revenue Explicit Costs (b) Economic profit to the economist is the total revenue of a firm less explicit and Implicit cost. FORMULA:Economic profit=Total revenue-(Explicit costs+implicit costs)

Theories of profit
There are various theories of profit which have been advanced from time to time regarding nature of profit in a competitive economy The most important theories are: (i) Hawley's Risk Bearing Theory of Profit. (ii) Uncertainty Theory of Profit. (iii) Rent Theory of Profit. (iv) Marginal Productivity Theory of Profit. (v) Dynamic Theory of Profit. (vi) Monopoly Theory of Profit

(1) Hawley's Risk Bearing Theory of Profit:

EXPLANATION
According to F.B.Hawley,"Profit is the reward of risk

taking in a business. During the conduct of any business activity, all other factors of production, i.e., land, labor and capital have their guaranteed incomes from the entrepreneur. They are least concerned whether the entrepreneur makes profit or undergoes tosses". The 'greater the risk, the higher must be the profits.

(1) Hawley's Risk Bearing Theory of Profit:

CRITICISM it is wrong to assume that profits are in their entirely due to

the element of risk- The profits can I arise on account of better management, better supervision or they may I be due to the monopolistic position of the entrepreneur profits arise not because risks I are borne but because the superior entrepreneurs are able to reduce the risks. profits 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 This theory fails to explain as to how I the profits are earned in such business where the risks can be insured.

(ii) Uncertainty Theory of Profit.

EXPLANATION 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 risks 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 entrepreneur to a profit. On the other hand, there are some risks which are unpredictable and unforeseen and so they are non-insurable.

(ii) Uncertainty Theory of Profit

CRITICISM
(i) An entrepreneur performs other functions also such

as coordinating, bargaining, and innovation in the business. So he must be paid for these services also. (ii) It is not simply due to uncertainty-bearing that the supply of entrepreneur is restricted. There are other factors also which influence the supply the entrepreneur like lack of knowledge, lack of capital, opportunity, etc.

(iii) Rent Theory of Profit.

EXPLANATION According to Pro Francis A Walker, "Profits are of the same genius as rent". (i) Profit is rental in character. Just as superior grades of land earn more rent than the inferior grades of land, similarly superior entrepreneurs due to their exceptional ability or opportunity earn more profits than the inferior entrepreneurs. (ii) As in the case of land, there is a no-rent or marginal land, so in the business also is a noprofit or marginal entrepreneur. The marginal entrepreneur is one whose ultimate receipts from the sale of the commodities just cover his total costs.
(iii) Just as rent is measured from the non-rent land, in the same way profits of the superior businessmen are calculated from the marginal entrepreneur. (iv) The rent does not enter into price of agricultural production of the manufactured goods. It can be concluded that profits are the reward of differential business ability.

(iii) Rent Theory of Profit.

CRITICISM (i) It simply provides a measure of profit. It does not throw light on the nature of profit which is of more importance. (ii)The rent of land can either be positive or zero, but in case of business, entrepreneur may suffer losses and thus his profit be in the negative. (iii) It is also pointed out that profit may not form 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. (iv) 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.

(iv) Marginal Productivity Theory of Profit.

EXPLANATION In the words of Champmon:
"The profit tend to be equal to the marginal social worth of

the employers in exactly the same sense in which the labor gets his marginal net product from the employers. The marginal net product of an entrepreneur is the 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 of the employer is high, the profit will also be high and the marginal net productivity is low, then profit will also be low

(iv) Marginal Productivity Theory of Profit.

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 the labor.

(v) Dynamic Theory of Profit.

EXPLANATION
"Profit arises only in a dynamic economy. An economy

is said to be dynamic when there is a change in the population growth or a change in the method of production or a change in the consumers wants, etc., A society which is without these changes is called a static society. In a static society only monopoly profits continue to exist. All other economic profits are gradually eliminated by competition".

(v) Dynamic Theory of Profit.

CRITICISM
Prof, Knight has criticized the Clarkian Theory of

profit on the ground that it is wrong to attribute all profits to dynamic changes. According to him, there are certain changes which are of a recurring and calculable nature. They can be anticipated and the output can be adjusted according to that. The profits do not arise on those regular changes but on those which are unforeseen or unpredictable.

(vi) Monopoly Theory of Profit

EXPLANATION There is no doubt that profits arise from dynamic changes,

innovations and from making a correct estimate of future economic conditions. Another view point of profit is that monopolistic and monopolistic competition in the market also give rise to profits. The firms under monopoly or monopolistic competition have greater control over the price of the product. They are the price makers rather than the price takers. As such they raise prices by restricting the level of output and thus keep profit at higher level. Monopoly power, thus, is the basic sources of business profits.

(vi) Monopoly Theory of Profit

CRITICISM
This Kalocki's theory of monopoly profits has also

been criticized. It is said that monopoly is no doubt an important cause and source of monopoly profits but it does not replace other theories. Monopoly power only supplements other theories.

Should profits be controlled?

The profits which an entrepreneur earns by unlawful

means should altogether be checked. The abnormal profits which an entrepreneur gains due to his monopolistic position or by sheer chances should be controlled and the normal profits which serve as an incentive payment to the entrepreneur must remain in the business so that the productive activities of the economic organization may progress.