Profit:
The reward for entrepreneur is known as profits. An entrepreneur is principle and active agent of production. An entrepreneur can be distinguished from other owners of factors of production on a number of criteria.
- An entrepreneur cannot be hired or purchased by other factors, so his income is non contractual, whereas, the entrepreneur enters in to contract with other factors. They are hired or purchased, thus there return is contractual.
- An entrepreneur may not earn reward for his efforts, whereas other factors always earn reward for their efforts.
- Entrepreneur performs functions which are all together different, such as he bears risk and uncertainty, introduces innovation etc. Other factors have defined functions such as labour performs manual work etc.
- An entrepreneur may get negative reward in case of losses, whereas, other factors always get positive reward.
Concept of profit:
1. Gross Profit is the excess of total revenue over the total explicit costs.
Gross Revenue = Total Revenue – Total Explicit cost
2. Net Profit: The residual available to the entrepreneur after accounting for all explicit and implicit costs involved in the production
Net Profit = Total Revenue – Total explicit cost- Total implicit cost (including depreciation) or Gross profit – Total implicit cost
3. Normal profit is the minimum profit which an entrepreneur must earn in order to induce him to keep the firm in operation. It is thus included in the cost of production just like any other expense.
4. Super normal profit is in excess of the minimum necessary to induce the entrepreneur to keep the firm within the industry he is currently operating in. They are the profit over and above the normal profit and thus not included in the cost of production. It is the level where the entrepreneur is earning more than the total opportunity costs. Super normal profit may arise because of the following reasons.
- Monopoly profits
- Windfall gains
- Difference in ability of entrepreneur
Risk and uncertainty theory of profit:
- This theory was propounded by American economist Frank H Knight in his book Risk, uncertainty and profit in 1921.According to him profit is the reward for uncertainty bearing. Knight asserted that there is a significant difference between risk and uncertainty. Although all uncertainties can be regarded as risk, all risks are not uncertain.
Knight divided the risk into two categories, insurable and non-insurable
1. Insurable Risk:
- There are some risks which can be for seen by the entrepreneur. These risks can be insured against to avoid any loss in the case of the risk materializing. Included in insurable risks are risks such as fire, flood, earthquake, theft etc.
- The entrepreneur pays insurance premium to guard against such risks. The actual risk is borne by the insurance companies and not the entrepreneur. So the entrepreneur dose not earns any profit on such risks. The premium paid for insuring against such risks is added to the cost of production and finally enters the price of the product.
2. Non-Insurable Risks:
- Apart from the risks which can be foreseen, there are also some other risks which are unforeseen and unpredictable. These risks constitute the second category of non-insurable risks because these cannot be insured against.
- No insurance company would be prepared to bear such risks. The entrepreneur has to bear these risks himself.
- Knight calls these non-insurable risks as uncertainty. Profit is the reward that accrues to the entrepreneur for uncertainty bearing. Some of the non-insurable risks or uncertainties are:
Competitive risks: These arise as a result of entry of new firms in the market.
Change in Government Policies: The govt. takes a number of policy decisions from time to time which create uncertainties for the firm. e.g, it may devalue the currency, introduce price ceilings, intervene in the affairs the firm, change its trade policy etc.
Technological Uncertainties: New techniques of production may render the older technology and machinery obsolete. This creates uncertainty for firms using the old techniques of production.
Business Cycle Risks: Uncertainties arise as a result of the trade cycles of boom, recession, depression and recovery.
- All the above risks are unforeseen and no insurer would be ready to indemnify for any loss arising out of such risks. Each entrepreneur has to bear these uncertainties and profit is the reward for successfully countering them.
- An entrepreneur always faces a degree of uncertainty. Higher the degree of uncertainty he is ready to bear, higher the chances of earning greater profits. There is always the possibility of diversion between expectations and results because of the uncertainty arising as a result of difference between the time a decision is taken and its eventual implementation. If the decisions are as per expectations, then the entrepreneur will earn positive profits. On the other hand, the actual result do not meet the expectations, the entrepreneur may suffer losses.
Criticisms of the Theory:
- Uncertainty bearing is not the only function of an entrepreneur. An entrepreneur performs many other functions like organizing the factors, introducing innovations, planning etc.
- In reality, there is nothing to suggest that an entrepreneur who bears uncertainty would earn profits as well.
- The modern world is characterized by joint stock companies. Ownership is completely divorced from management in such organizations. Those who bear the risks do not manage and those who take decisions do not bear the actual risk. The distribution of profits between the owners has not been explained.
- There is greater uncertainty during recession and depression than during the boom period. According to the theory, an entrepreneur should earn greater profits during recession and depression than boom. But the reality is usually the opposite.
- The theory gives uncertainty bearing the status of a separate factor of production. However, this is unrealistic.
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