Question

What are the theories of Profit in Economics? Name them. 

What is meant by Dynamic Theory, Risk-bearing Theory, Uncertainty Bearing Theory and Schumpeter's Innovation Theory? Illustrate these theoris one by one.

Answer 1

PROFIT THEORIES -

 

There are various theories of profit in the economics. But some important theories of profit are as follows: 

1.  Dynamic Theory of Profit

2.  Risk-bearing Theory by Hawley

3.  Uncertainty Bearing Theory by Knight

4.  Schumpeter's Innovation Theory

Let us discuss all these theories one by one -

 

1.  Dynamic Theory of Profit -

This theory was given by J.M. Clark. According to him, profit arises due to dynamic state of the economy. In a static state where future demand, cost and price is known before hand, no profit would arise. In such a situation every production would be adjusted with its demand and the price of a product would eventually be equal to its cost and, therefore, no profits would arise. The entrepreneur would only get the wages of supervision (his normal profit).

In this way, the dynamic nature of economy is the first condition for profits to take place. According to Clark, dynamics in economy arises due to the following factors.

(a) Change in population

(b) Change in the income of consumers

(c) Change in technique of production

(d) Increase in capital formation and

(e) Change in business organization

If the above changes do not take place, the economy would be a static economy and profits would disappear.

 

2.  Risk-bearing Theory by Hawley -

Prof. F.B. Hawley, had emphasized that risk-bearing is the primary function of an entrepreneur, and profit is the reward for risk-bearing. Every business involves risk and if there is nobody to bear that risk, the production activity can not take place. It is only the entrepreneur who is ready to bear this risk, because other factors want their contractual payments and are not concerned with risk of business. The entrepreneur will be ready to bear the risk only if he expects some reward in return. If there is no expectation of reward, then the entrepreneur would not have any motivation to bear the risk and all business would come to a standstill. Hawley considered profit as a cost of staying in the business and if risk is greater, the expectation of profit should also be higher. If profit can not cover the cost, then staying in business is not possible.

 

3.  Uncertainty Bearing Theory by Knight -

The famous economist Frank Knight, in his book 'Risk, Uncertainty and Profit published in 1940, had analysed several profit theories and gave his own thoughts in conclusion, which came to be called the ‘Uncertainty Bearing Theory'.

In his analysis of Hawley's´Risk bearing Theory', F. Knight was of the view that risk is of several types and an entrepreneur does not bear all types of risks. He divided risks in two categories.

(i) Insurable Risks

(ii) Uninsurable Risks

Insurable risks are those risks, which we can get insured e.g. risk of theft, accident, fire, marine risks etc. Once we pay insurance premium, this risk is eliminated, This is so because now it is the responsibility of the insurance company to make good any loss that may happen in future. According to Knight, once an entrepreneur gets insurance for these risks he need not bother about them as these risks have been converted into costs (premium).

Apart from these risks, there are several other risks, which Knight called uncertainties, e.g. change in market demand, introduction of a new product by a rival firm, change in technology or technological obsolescence, change in consumer tastes, change in government policies or national and international conditions etc. All these will be called business uncertainties and no insurance company is ready to insure these uncertainties.

According to Knight, insurable risks are those risks which are statistically determinable, but uninsurable risks, called uncertainties, are those which can not be estimated. Since no insurance company is ready to insure them, it is only the entrepreneur who has to bear it and profit is the reward for bearing these uncertainties.

Knight's approach received wide acclaim, especially his classification of insurable and uninsurable risks and that is why it is a widely accepted theory.

 

4.  Schumpeter's Innovation Theory -

Amongst profit theories, Joseph Schumpeter's innovation theory has a unique place because it is different from earlier approaches. Schumpeter, considered innovation to be the primary function of an entrepreneur and attributed profits to this function.

What is Innovation?

Innovation is a process of change whereby the gap between revenue and cost can be widened. Innovation is different from invention. While invention is a scientific/ technological activity, innovation is a commercial activity. It is basically oriented towards satisfying the needs of the consumers. Mere technical change or improvement in a product will not be called innovation unless it is done to meet the needs of the consumers. While invention needs technologies and scientific knowledge, innovation needs only a high degree of commonsense and deep sense of observation.

According to Schumpeter, innovations can be of two types.

(a) Those which stimulate the demand and

(b) Those which reduce the costs.

First category innovations are those which either bring new consumers or increase the demands of existing customers. This can be brought about by change of name, shape, colour, designing, packaging or means of advertising. By these methods demand is stimulated.

Second category of innovations are those changes through which costs can be brought down. This may be done through finding a new source of raw material, new technique of production, identifying and removing wastages or making use of by-products.

Whatever be the type of innovation that has been made, it will increase the profits of the entrepreneur. Schumpeter, further added that innovation should be a continuous activity or an on going process. The reason is that whenever an innovation is done, after sometimes, other competitors tend to adopt it and start making similar (if not identical) products. As a result, the uniqueness or speciality of the original innovator is lost and his profits start declining. Under these circumstances, Schumpeter added, that an entrepreneur who wants continuous profits, should undertake innovations on a continuous basis.

 

 

This theory was given by J.M. Clark. According to him, profit arises due to dynamic state of the economy.