LECTURE NOTES ON MANAGERIAL ECONOMICS BY-_DR.
NEHA MATHUR MA'AM
Profit: Types, Theories and Functions of Profit
The term profit has distinct meaning for different people, such as
businessmen, accountants, policymakers, workers and economists.
Profit simply means a positive gain generated from business
operations or investment after subtracting all expenses or costs.
In economic terms profit is defined as a reward received by an
entrepreneur by combining all the factors of production to serve the
need of individuals in the economy faced with uncertainties. In a
layman language, profit refers to an income that flow to investor. In
accountancy, profit implies excess of revenue over all paid-out
costs. Profit in economics is termed as a pure profit or economic
profit or just profit.
Profit differs from the return in three respects namely:
a. Profit is a residual income, while return is a total revenue
b. Profits may be negative, whereas returns, such as wages and
interest are always positive
c. Profits have greater fluctuations than returns
According to modern economists, profits are the rewards of purely
entrepreneurial functions. According to Thomas S.E., “pure profit is
a payment made exclusively for bearing risk. The essential function
of the entrepreneur is considered to be something which only he can
perform. This something cannot be the task of management, for
managers can be hired, nor can it be any other function which the
entrepreneur can delegate. Hence, it is contended that the
entrepreneur receives a profit as a reward for assuming final
responsibility, a responsibility that cannot be shifted on the
shoulders of anyone else.”
For understanding the profit as a business objective, you need to
learn two most important concepts, such as economic profit and
accounting profit.
Types of Profit:
Different people have described profit differently. Individuals have
associated profit with additional income revenue, and reward.
However, none of the description of profit is said to be right or
wrong; it only depends on the field which the word profit is
described.
On the basis of fields, profit can be classified into two
types, which are explained as follows:
i. Accounting Profit:
Refers to the total earnings of an organization. It is a return that is
calculated as a difference between revenue and costs, including both
manufacturing and overhead expenses. The costs are generally
explicit costs, which refer to cash payments made by the
organization to outsiders for its goods and services. In other words,
explicit costs can be defined as payments incurred by an
organization in return for labor, material, plant, advertisements,
and machinery.
The accounting profit is calculated as:
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials
The accounting profit is used for determining the taxable income of
an organization and assessing its financial stability. Let us take an
example of accounting profit. Suppose that the total revenue earned
by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs.
10, 000. The accounting profit equals = Rs. 2, 50,000 – Rs. 10,000
= Rs. 2, 40,000. It is to be noted that the accounting profit is also
called gross profit. When depreciation and government taxes are
deducted from the gross profit, we get the net profit.
ii. Economic Profit:
Takes into account both explicit costs and implicit costs or imputed
costs. Implicit that is foregone which an entrepreneur can gain from
the next best alternative use of resources. Thus, implicit costs are
also known as opportunity cost. The examples of implicit costs are
rents on own land, salary of proprietor, and interest on
entrepreneur’s own investment.
Let us understand the concept of economic profit. Suppose an
individual A is undertaking his own business manager in an
organization. In such a case, he sacrifices his salary as a manager
because of his business. This loss of salary will opportunity cost for
him from his own business.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs + implicit costs)
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit-(opportunity cost + unauthorized
payments, such as bribes)
Economic profit is not always positive; it can also be negative, which
is called economic loss. Economic profit indicates that resources of
a business are efficiently utilized, whereas economic loss indicates
that business resources can be better employed elsewhere.
The difference between the accounting profit and
economic profit is shown in Table-1:
Theories of Profit:
Profits of businesses depend on the successful management of risks
and uncertainties by entrepreneurs. These risks can be cost risks
due to change in wage rates, prices, or technology, and other market
risks. Different economists have presented different views on profit.
Some of the most popular theories of profit are shown in Figure-1:
The different theories of profit (as shown in Figure-1).
Walker’s Theory:
An American economist, Prof F. A. Walker propounded the theory
of profit, known as rent theory of profit. According to him “as rent is
the difference between least and most fertile land similarly, profit is
the difference between earnings of the least and most efficient
entrepreneurs.” He advocated that profit is the rent of exceptional
abilities that an entrepreneur possesses over others.
According to Walker; profit is the difference between the earnings
of the least and most efficient entrepreneurs. An entrepreneur with
the least efficiency generally strives to cover only the cost of
production. On the other hand, an efficient entrepreneur is
rewarded with profit for his differential ability.
Thus, profit is also said to be the reward for differential ability of the
entrepreneur. While formulating this theory, Walker assumed the
condition of perfect competition in which all organizations are
supposed to have equal managerial ability. In this case, there is no
pure profit and all the organizations earn only managerial wages
known as normal profit.
The rent theory was mainly criticized for its inability to explain the
real nature of profits.
Apart from this, the theory failed on the following aspects:
a. Provides only a measure of profit. The theory does not focus on
the nature of profit, which is of utmost importance.
b. Assumes that profits arise because of the superior or exceptional
ability of the entrepreneur, which is not always true. Profit can also
be the result of the monopolistic position of the entrepreneur.
Clark’s Dynamic Theory:
Clark’s dynamic theory was introduced by an American economist,
J.B. Clark. According to him, profit does not arise in a static
economy, but arise in a dynamic economy. A static economy is
characterized as the one where the size of population, the amount of
capital, nature of human wants, the methods of production remain
the same and there is no risk and uncertainty. Therefore, according
to Clark, only normal profits are earned in the static economy.
However, an economy is always dynamic in nature that changes
from time to time.
A dynamic economy is characterized by increase in population,
increase in capital, multiplication of consumer wants, advancement
in production techniques, and changes in the form of business
organizations. The dynamic world offers opportunities to
entrepreneurs to make pure profits.
According to Clark, the role of entrepreneurs in a dynamic
environment is to take advantage of changes that help in promoting
businesses, expanding sales, and reducing costs. The entrepreneurs,
who successfully take advantage of changing conditions in a
dynamic economy, make pure profit.
There are internal and external factors that make the world
dynamic. The internal changes are changes that take place within
the organization, such as layoff and hiring of employees, product
changes, and changes in infrastructure. The external changes are of
two kinds, namely, regular changes and irregular changes.
Regular changes involve fluctuations in trades that affect profits On
the other hand; irregular changes include contingencies, such fire,
earthquake, floods, and war. Thus, according to Clark, profits are a
result of changes and no profit is generated in case of static
economy.
However Prof Knight criticized the dynamic theory on the basis that
only those changes that cannot be foreseen yield profits. He further
says, “It cannot, then, be change, which is the cause of profit, since
if the law of change is known, as in fact is largely the case, no profits
can arise. Change may cause a situation out of which profit will be
made, if it brings about ignorance of the future.”
Hawley’s Risk Theory:
The risk theory of profit was given by F. B. Hawley in 1893.
According to 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, capital have guaranteed
incomes from the entrepreneur. They are least concerned whether
the entrepreneur makes the profit or undergoes losses.”
Hawley refers profit as a reward for taking risk. According to him,
the greater the risk, the higher is the expected profit. The risks arise
in the business due to various reasons, such as non-availability of
crucial raw materials, introduction of better substitutes by
competitors, obsolescence of a technology, fall in the market prices,
and natural and manmade disasters. Risks in businesses are
inevitable and cannot be predicted. According to Hawley, an
entrepreneur is rewarded for undertaking risks.
There is a criticism against this theory that profits arise not because
risks are borne, but because the superior entrepreneurs are able to
reduce them. The profits arise only because of better management
and supervision by entrepreneurs. Another criticism is that profits
are never in the proportion to the risk undertaken. Profits may be
more in enterprises with low risks and less in enterprises with high
risks.
Knight’s Theory:
Prof Knight propounded the theory known as uncertainty-bearing
theory of profits. According to the theory, profit is a reward for the
uncertainty bearing and not the risk taking. Knight divided the risks
into calculable and non-calculable risks. Calculable risks are those
risks whose probability of occurrence can be easily estimated with
the help of the given data, such as risks due to fire and theft.
The calculable risks can be insured. On the other hand, non-
calculable risks are those risks that cannot be accurately calculated
and insured such as shifts in demand of a product. These non-
calculable risks are uncertain, while calculable risks are certain and
can be anticipated.
According to Knight, “risks are foreseen in nature and can be
insured”. Thus, risk taking is not a function of an entrepreneur, but
of insurance organizations. Therefore, an entrepreneur gets profit
as a reward for bearing uncertainties and not for risks that are
borne by insurance organizations.
The theory of uncertainty bearing is criticized on the
following grounds:
a. Assumes that profit is the result of uncertainty bearing ability of
an entrepreneur, which does not always hold true. The profit can
also be the reward for other aspects, such as strong co-ordination
and market share.
b. Fails to show any relevance with the real world.
Schumpeter’s Innovation Theory:
Joseph Schumpeter propounded a theory called innovation
according to which profits are the reward for innovation He
advocated that innovation is the introduction of a new product, new
technology, new method of production, and new sources of raw
materials. This helps in lowering the cost of production or
improving the quality of production. Innovation also includes new
policy or measure by an entrepreneur for an organization.
In general, innovation can take place in two ways, which
are as follows:
a. Reducing the cost of production and earning high profit. The cost
of production can be reduced by introducing new machines and
improving production techniques.
b. Stimulating the demand by enhancing the existing improvement
or finding new markets.
According to innovation theory, profit is the cause and effect of
innovations. In other words, it acts as a necessary incentive for
making innovation.
Schumpeter’s innovation theory is criticized on two
aspects, which are as follows:
a. Ignores uncertainty as a source of profit
b. Denies the role of risk in profit
Functions of Profit:
Profit is the primary objective of all business organizations. The
expectation of earning higher profits of business organizations
induces them to invest money in new ventures. This results in large
employment opportunities in the economy which further raises the
level of income. Consequently, there is a rise in the demand for
goods and services in the economy. In this way, profit generated by
business organizations play a significant role in the economy.
According to Peter Ducker, there are three main purposes
of profit, which are explained as follows:
i. Tool for measuring performance:
Refers to the fact that profit generated by an organization helps in
estimating the effectiveness of its business efforts. If the profits
earned by an organization are high, it indicates the efficient
management of its business. However, profit is not the most
efficient measure of estimating the business efficiency of an
organization, but is useful to measure the general efficiency of the
organization.
ii. Source of covering costs:
Helps organizations to cover various costs, such as replacement
costs, technical costs, and costs related to other risks and
uncertainties. An organization needs to earn sufficient profit to
cover its various costs and survive in the business.
iii. Aid to ensure future capital:
Assures the availability of capital in future for various purposes,
such as innovation and expansion. For example, if the retained
profits of an organization are high, it may invest in various projects.
This would help in the business expansion and success of the
organization.
Apart from aforementioned functions, following are the
positive results of high profits:
i. Investment in research and development:
Leads to better technology and dynamic efficiency. An organization
invests in research and development activities for its further
expansion, if it earns high profit. The organization would lose its
competitiveness, if it does not invest in research and development
activities.
ii. Reward for shareholders:
Includes dividends for shareholders. If an organization earns high
profits, it would provide high dividends to shareholders. As a result,
the organization would attract more investors, which are crucial for
the growth of the organization.
iii. Aid for economies:
Implies that profits are helpful for economies. If organizations
generate high profits, they would be able to cope with adverse
economic situations, such as recession and inflation. This results in
stability of economies even in adverse situations.
iv. Tool to stimulate government finances:
Implies that if the profits generated by organizations are high, they
are liable for paying high taxes. This helps government to earn high
revenue and spend for social welfare.
