The Theory of Profits

8/6/2019 The Theory of Profits

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THE THEORY

OF

PROFITS



INTRODUCTION

� Profits are said to be the rewards for enterprise, the fourth

factor of production.

� Different economist give different views about profit. Eg:

Joan Robinson, Chamberlin & M. Kalecki have associated

profits with imperfect competition and monopoly.� Profits has been connected by F.H.Knight with uncertainty,

by Schumperter with innovations, by Hawley with risk

bearing, and by others with the degree of monopoly power.

� B.S.Keristead, therefore, expresses the view that profits

originate from monopoly, successful innovations and acorrect estimate of uncertain future.



PROFITS AS A RESIDUAL INCOME

� Profits are residual income left after the payment of

the contractual rewards to other factors of

production.

� The entrepreneur while engaging other factors of

production, pays wages to the workers, rent on theland employed, interest on the loans taken at the

rates already fixed by contracts.

� The entrepreneur makes payment for these factors

much in advance of the realization of the values of

output. What is left after paying the contractualreward is the profits of entrepreneur.

� Profits are non-contractual income which may be

positive or negative.



PROFITS AS A DYNAMICS SURPLUS:CLARKS

DYNAMIC THEORY OF PROFITS

� Profits result when selling prices of the goodsexceed their cost of production.

� In a competitive run equilibrium, price equalsaverage cost of production and therefore noprofits are made. If no changes either in theconditions of demand or in the conditions of supply occur, competitive equilibrium will persistand therefore no pure profits will be earned bythe entrepreneur.

� Changes in the demand or supply, which result inprice exceeding cost of production will lead tolosses.

� Therefore, profits arise due to disequilibriumcaused by the changes in demand & supplyconditions.



Types of changes:

� Changes in quantity & quality of human wants.

� Changes in methods or techniques of production.

� Changes in the amount of capital

� Changes in the forms of business organization.

� The growth of population

All the changes which take place and as a result of

which profits arise in a dynamic economy may be

classified into:

INNOVATIONS

EXTERNALCHANGES



SCHUMPETERS INNOVATIONS THEORY OF

PROFITS

� Main function of entrepreneur is to introduceinnovations in the economy and profits are reward forhis performing this function.

� Innovations are any new measure or policy adopted byan entrepreneur to reduce his cost of production or to

increase the demand for his product.� Innovation can be divided into two categories:

Those which reduce cost of production-includesintroduction of new machinery, new & cheapertechniques of production, utilization of new source of raw material etc.

Those which increase the demand for the product-introduction of a new product, new variety or design of the product, new & superior methods of advertisementetc.



� Profits emerge due to successful innovations either cost

falls below the prevailing price of the product or the

entrepreneur is able to sell more and at a better price thanbefore.

� Profits caused by a particular innovation are temporary

and tend to be competed away as others imitate and also

adopt that.

� In a competitive and progressive economy theentrepreneurs always continue to introduce new

innovations and thus profits continue emerging out of

them.

� Profits can therefore, be said as both the cause and effect

of innovations.



RISK, UNCERTAINTY AND PROFITS:

KNIGHTS THEORY OF PROFITS

� Profit is the reward for uncertainty and risk. According to Knight,

dynamic changes give rise to profits only if changes & their

consequences are of unpredictable character. Only those changes

whose occurrence cannot be known before hand give rise to profits.

� It is the ignorance about the future and uncertainty of it gives rise toprofits.

WHAT CAUSES UNCERTAINTY?

There are two types of changes that cause uncertainty:

Innovation which are introduced by the entrepreneurs themselves.

External changes- changes in tastes & fashion of the people,changes in government policies and laws, wages & labour policies,

movements of prices as a result of inflation & depression, changes in

the income of the people & changes in production technology etc.



INSURABLE & NON INSURABLE RISK

� All risks do not cause uncertainty & give rise to profits. It is only non-

insurable risks that involve uncertainty and the entrepreneur earns profits

for bearing those non insurable risks.

� Risks like fire, theft, accident etc can be insured against on the payment of

a fixed premium. Insurance premium is included in the cost of production.Thus no uncertainty arises due to insurable risks as far as individual

entrepreneurs are concerned & therefore they cannot give rise to profits.

� Risks which cannot be insured & have to be borne by the entrepreneur are

called non insurable risks. These relate to the outcomes of the price

output decisions taken by the entrepreneur.� Risks as a result of his decision regarding mode of advertisement etc

requires him to guess about demand and cost conditions & there is risk of

suffering losses as a result of these decisions.



MONOPOLY AND PROFITS: MONOPOLY

THEORY OF PROFITS

� Monopolistic position gives rise to profits both in static & dynamic

conditions.

� Monopolist commands a control over the price of a product and therefore

manages to make profits by virtue of his monopoly power. He raises his

price by restricting his level of output and thereby makes profit.� With restricted entry of firms under monopolistic competition, demand

curve does not fall in the long run to the tangency position with the

average cost curve so that the entrepreneurs working under monopolistic

competition also continue to enjoy positive profits by virtue of their

monopoly power.� According to Lerner, if p stands for price and m for marginal cost, the

difference p-m measures the deviation from perfect competition. The

difference (p-m)/p is Learners measure of degree of monopoly.



� The greater the degree of monopoly, the greater the size of profits earned

by the entrepreneur or a firm.

� The degree of monopoly power of a firm ie its power to set price abovethe marginal cost of production depends upon the elasticity of demand

curve facing the entrepreneur.

� Monopoly power of a firm also depends upon its market share or the total

output of the industry. The greater its share in the industrial output or

market for the product, the greater the extent of monopoly powerwielded by the producer.

� With the monopoly power gained by the extent of distinctiveness of his

product and his share In the total output of the market, the greater will be

his freedom and independence in setting the price above the average cost

of production and thereby earns supernormal profits for himself.

� In case of unfavorable demand cost conditions ie when the demands for

the product is inadequate and cost of production is high, producers

working under pure monopoly, monopolistic competition and oligopoly

enjoy varying degrees of monopoly power can make losses.



� Through the devices of advertisement, product variation and other sales

promotion activities the big firms with greater monopoly power see to it

that the demand curve for their product remains above cost of production

yielding them a good deal of profits.

� Monopoly power of a firm manifests itself in its ability to rise prices of the

products. But if a firm sets a higher price and thereby earns excessive

profits, it will attract other firms into the industry and will reduce the

monopoly power of the existing firms and eliminates excessive profits.� Thus, monopoly power depends on the restrictions on the entry of new

firms.

� Control over supply of essential raw materials, legal restrictions in certain

cases, existence of goodwill enjoyed by the existing firms, reputation of

the brand name, economies of large scale production and difficulty of organizing production on a large scale are some of the important factors

that put restrictions on the entry of firms.



CRITICAL EVALUATION OF MONOPOLY

THEORY OF PROFITS

� Kaleckis assertion that monopoly is the only source or determinant of

profits is not right.

� Further there is no contradiction between uncertainty and monopoly

theories of profits.

� Kaleckis concept of the degree of monopoly (p-m) and profits resting on ithas been criticized.

� For instance, measure of the degree of monopoly is zero under perfect

competition, since price is equal to marginal cost. 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.� The criticism is only against degree of monopoly and not on monopoly .



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The Theory of Profits