The theories of profit provide a framework for business owners and entrepreneurs to evaluate the potential of their venture. These theories center around a few key ideas, such as market share, cost control, and risk assessment. The knowledge gained through these theories can help entrepreneurs determine if their venture is worth the investment and the potential risk involved.
For example, by assessing the market share of a potential product or service, entrepreneurs can make informed decisions about whether to invest in the venture. The cost control measures that can be taken to increase profit potential should also be considered. Finally, entrepreneurs must evaluate the risk associated with each venture to determine which ones are worth pursuing.
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What are the Theories of Profit?
The Theories of Profit are a set of principles that businesses can use to maximize their profits. These theories consider factors such as market conditions, cost structure, and overall sales strategies. They help businesses understand how to best price their products or services to maximize profits.
The Theories of Profit also guide margin management and how to adjust pricing based on market conditions. By understanding these theories, businesses can make more informed decisions about their pricing strategy.
They are the foundation for effective sales and marketing tactics that can help businesses increase their profits in the long run. Ultimately, The Theories of Profit help businesses make smarter decisions about pricing and operations to ensure maximum profitability in the future.
Only normal profits are necessary for economic development and to ensure that a business remains viable. The theories of normal profit provide insight into how firms can determine their profit accurately, and allow an understanding of the various sources from which pure profit can derive.
The theories also suggest ways in which residual income may be generated through innovating unique processes and strategies, as well as by striving to achieve managerial excellence. The Theories of Profit are an essential tool for understanding the complexities of how profits and pricing can be determined in any market.
Types of Profit Theories
1. Rent Theory of Profit
The American Economist Walker initially suggested this concept, which was inspired by the theories of Senior and J.S Mill. As noted by Mill, any producer who acquires extra gains through their exceptional talents for business or superior management is likely to receive similar returns to rent.
Walker argued that profit and rent were of the same species. His notion of gain posited that success was earned by a better entrepreneur over their competitor’s marginal proficiency. These economists observed considerable agreement between return on investment for land and earnings from entrepreneurship, with the former being recompensed for the use of the property while the latter rewarded business acumen.
The soil fertility of land can vary, just as the acumen of entrepreneurs differs from person to person. The rent for superior lands is essentially determined by the difference in productivity between marginal and super-marginal areas; similarly, profits are observed by comparing those that inhabit these two divisions. In other words, it’s intra-marginal lands that outdo their counterparts’ returns.
Comparable to marginal land, marginal entrepreneurs generate no surplus. Thus, they are classified as no-profit entrepreneurs. However, intra-marginal business owners can often receive a profit above that of the average individual entrepreneur in their industry.
The entrepreneur who limply sells their goods at the same price for which they were bought, tiringly earns nothing more than a manager’s wages and not any profit. Consequently, this surplus is absent from production costs; similarly to rent, it isn’t included in the selling price either. Profit then becomes a bonus on top of what has already been earned.
2. Wage Theory of Profit
American economist Taussig suggested the concept that profits are a type of wage paid to entrepreneurs for their services.
To put it simply, as the entrepreneur articulated profit is a reward to be gained by demonstrating an aptitude. His innovative way of thinking changed how we perceive entrepreneurs and their duties in current businesses.
Similarly to how a laborer gets paid for their hard work, entrepreneur is rewarded with a profit in exchange for the vital role they play in production.
While a laborer puts in physical effort, an entrepreneur invests mental energy into their work. As such, they are no different from professions like doctors and lawyers that rely on the utilization of mind work. Profit then is seen as a form of compensation for this labor.
3. F.W. Hawley’s the Risk Theory of Profit
American economist Hawley proposed that profit is the result of taking risks in business. Particularly, an entrepreneur’s most crucial function is to make daring decisions. All production done in the hope of future demand carries with it a certain degree of danger.
As Drucker, has stated, there are four distinct types of risk: replacement, obsolescence, general risks, and uncertainties. Each of these kinds must be actively managed to ensure the successful outcome of any venture or goal.
Calculated risks are covered by insurance, but unknown and unforeseen ones come at the entrepreneur’s expense. Despite this fact, entrepreneurs still take on these uncertain dangers to earn a profit beyond the normal returns they would receive otherwise. Without the potential for increased rewards, no one would be willing to become an entrepreneur and bear such risk.
Hence, to foster entrepreneurial risk-taking and profit opportunities, the reward must exceed the value of any risks taken. Without this monetary incentive, entrepreneurs will be less likely to take on these ventures. As such, greater risks equate to larger potential rewards in business endeavors.
Hawley informs us that as an entrepreneur, you can avoid certain risks by paying a fixed premium to the insurance company. However, it is impossible to mitigate all risks through this method; if attempted, you would become an ordinary manager and not generate any profit.
4. The Dynamic Theory of Profit
In 1900, Prof. J.B. Clark set forth his progressive Dynamic Theory of Profit – which states that profit is the consequence of economic advancement in a structured society and is determined by subtracting the price from cost when producing goods or services.
Clark’s notion is that economic society can be divided into organized and unorganized groups, with the former, further categorized as static or dynamic. It is only through a state of dynamism that progress may occur and profit becomes available.
In a static setting, no alteration occurs in factors such as the size of the population, technological expertise, capital quantity, production approaches of firms, and industry scale – all are stagnant. Additionally, time is abstracted from this context as there is a total absence of doubt; economic aspects remain unchanged throughout successive years.
The entrepreneur, therefore, can be assured that no risks are posed. The price of the goods will equal their cost of production; thus meaning there is no room for profit. Labor and capital used by said entrepreneur would warrant wages or interest respectively – as recompenses for services rendered. Such an arrangement ensures that if any competition arises to increase the commodity’s price above its cost of production level, such a shift shall quickly be reversed to eliminate potential profits from being made.
Perfect competition inherently renders the price equal to the cost of production, erasing any potential for excess profit. As Knight puts it, the prices of goods and services are always consistent, leaving no room for wage hikes above supervisory responsibilities. Our society is constantly fluctuating in a state of flux; dynamic changes are occurring all around us daily.
5. Schumpeter’s Innovation Theory
Schumpeter proposed a theory that is quite similar to Clark’s, only Schumpeter’s theory delved deeper into the five changes mentioned by Clark and discussed how changes caused by innovations in production processes lead to profit. Here, “innovation” was referred to more holistically than the changes previously articulated by Clark. Consequently, this theory provides insight into how innovators are rewarded with profit for their original ideas.
Innovation is a term used to describe modifications in the production process that aim to reduce the cost of goods. This can take many forms, such as introducing a new technique or plant, altering internal structures and organizational setup, changing raw material quality, or incorporating alternative energy sources. With innovative techniques and strategic salesmanship, companies can create gaps between their current prices and newly reduced costs.
According to Schumpeter, there is a clear delineation between invention and innovation. Innovation strives towards reducing production costs as an agent of cost-cutting; thus offering economic profit in return for this role. It’s important to note that not all entrepreneurs possess the capability of creating innovations.
Innovative entrepreneurs can draw on diverse resources such as technical expertise and cost-reduction strategies to succeed. Profit-seeking is the primary impetus for introducing innovation, making it clear that profit is the driving force of progress. Consequently, only those entrepreneurs who possess remarkable skills are equipped with this ability.
According to Prof. Schumpeter, entrepreneurs are responsible for more than merely organizing and combining the various factors of production; their true purpose is to bring in novel innovations that will result in substantial profits. By introducing new ideas and ways of doing things into an organization, they can provide a competitive advantage over other businesses and give them an edge when it comes to earning income.
6. Uncertainty Bearing Theory of Profit
American economist Prof. Frank H. Knight propounded uncertainty-bearing theory built on Hawley’s risk-bearing foundation that states profit is an incentive for taking risks. There are two kinds of risks: foreseeable and unforeseeable, with the latter being referred to as ‘uncertainty beaming’ by Knight himself.
Knight believed that financial compensation should be given to individuals who accept non-insurable risks and unforeseen cases. He distinguished between two types of risk: those which can be calculated with statistical methods, such as fire or theft; and those which cannot. Examples like flooding and injury from an accident are all insurable means for insurance companies to cover the costs associated with them.
The cost of insurance premiums is embedded in the total price of production. As Knight, suggested, these anticipated risks do not qualify as genuine economic risks that are worthy of any reward or profit. Put simply, the insurable risk does not bring forth financial gain. Knight states that profit is derived from non-insurable risks and unpredictable risk factors.
7. Marginal Productivity Theory of Profit
Professor Chapman’s theory of distribution applies to the factor, entrepreneur. To be specific, he claims that profits equate to the marginal worth of entrepreneurs and are determined by their respective marginal productivity.
As a result, when an individual’s contribution is exceptionally high then so too are their potential rewards – demonstrating that entrepreneurial success hinges upon substantial effort!
The marginal revenue productivity curve of an entrepreneur is the equivalent of their demand curve, and as more businesses join the industry, this MRP declines.
This leads to a downward-sloping MRP curve for entrepreneurs. In perfect competition conditions, we can assume that the supply curve for entrepreneurs is perfectly elastic.
8. Frictional Theory of Profits
This theory suggests that a typical rate of profit should be paid to the owners of capital as an incentive for them not to squander their earnings or stockpile them, but instead invest and save.
In a static economic environment in which no unanticipated changes to demand or cost conditions happen, firms would eventually reach a long-term equilibrium and receive only their normal rate of profit on investment and entrepreneurial talent.
Such circumstances would render businesses unable to gain economic benefits. The Frictional Theory of Profit elucidates that disturbances or shocks are inevitable in an economy and can be caused by unexpected alterations in consumer demand or cost conditions, leading to the disruption of equilibrium.
It is these times of imbalance that give rise to either positive or negative economic profits for some companies. Companies in a highly competitive industry may experience profits due to disequilibrium, even if all entrepreneurs are identical. This kind of unbalance can be seen across the entire sector and create sustainable profit margins for firms that capitalize on it.
When the costs of production are lower than expected, or if they can charge higher prices than anticipated, entrepreneurs will make a bigger return on their resources compared to other products.
If costs are unexpectedly high or prices lower than anticipated, entrepreneurs will make a negative profit. Meanwhile, positive profits can remain for an extended period if firms in other industries start entering the sector and negative profits may persist as long as specialized equipment generates more money when used within that industry than outside of it–for example, turning it into scrap metal.
9. Monopoly Theory of Profits
Monopoly firms can generate above-normal profits due to their monopoly power, which allows them to reduce output and increase prices. This results in higher returns for the monopolistic company compared to if there were perfect competition.
Joan Robinson, E.H. Chamberlin, and M. Kalecki all agreed that certain companies possess the power to earn excessive profits due to their monopolistic status in a market where entry barriers are high–allowing them to maintain these advantages over long periods even when competition should eventually arise naturally.
Monopoly power can emerge for a variety of reasons- due to an individual or company having sole control over essential resources necessary for production, from economies of scale, legal sanctioning and patents, as well as governmental restrictions on imports.
10. Prof. Schumpeter’s Innovations Theory of Profits
According to the theory of profits, economic prosperity is produced by revolutionary ideas and inventions developed by entrepreneurs. Joseph Schumpeter asserted that a business leader’s primary purpose was to conceive novel concepts in an economy, and as a reward for this valuable contribution they receive profits.
In the words of Schumpeter, innovation is any new initiative or policy adopted by a businessperson to decrease the cost of production and/or increase demand for their product. In other words, it’s an essence that helps entrepreneurs get ahead in today’s competitive world.
Consequently, innovations can be divided into two categories. The first type of innovation reduces the cost of production and may include introducing new machinery, a cheaper technique or process for production, exploiting a new source for raw materials, as well as creating better organizational methods within the firm.
There are two sorts of innovations: those that lower production costs, and those that increase the demand for a product. This could be something like launching a new item, introducing an innovative design or variant of it, finding better advertising strategies to draw customers in -– pretty much anything that helps create more attention around your product. If these endeavors result in success –- if they bring down expenses or boost sales — then this would mean higher profits.
11. Managerial Efficiency Theory of Profits
Finally, this theory acknowledges that some companies are more skilled than others in terms of managing their production processes and providing customers with the right product or service.
Companies with average efficiency levels are rewarded with an average rate of return. But companies that demonstrate superior managerial skills and production capacity deserve to be compensated for their excellence, thus earning above-normal profits (i.e., economic profits).
This theory is also known as the compensatory theory of profit margins.
The theories of profit discussed above can help marginal entrepreneur determine their profits accurately. Entrepreneur needs to consider the demand and wages as well as the normal return on their investments when calculating potential profits.
The only wages considered part of the calculation are those directly related to production costs. Therefore, entrepreneurs need to have a clear understanding of their costs and the amount of profit they can expect to make, to maximize their potential profits. By understanding the basic theories of profit, entrepreneurs can ensure that their business is successful.
What do you think about the importance of understanding the theories of profit for entrepreneurs? Share your thoughts with us in the comments below!
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