Here is an elaborated discussion on profit, highlighting:- 1. Meaning and Definition of Profit 2. Theories of Sources of Economic Profits 3. Profit as a Contractual Income 4. Profit and Producer Surplus.
Meaning and Definition of Profit:
In the theory of income distribution all incomes are classified according to their sources. Wages are income from direct labour; interest is income from allowing others to use one’s money; rent is the excess of the value produced by a factor input over the payment required to induce to work; and profit is the excess of income over the cost of production.
Profit is just another category of factor income. It can be defined as the remuneration or reward to the fourth factor of production, i.e., organisation or entrepreneurial talent, but there is no complete agreement about the nature and origin of profits. It is because a great deal of confusion exists about the proper functions of an entrepreneur. There is hardly a more controversial subject in economics than the meaning of profits.
We may define profit as a reward for the successful conduct of a business. Many people venture out in new directions in order to make profit, but only a few of them succeed in their ventures and end up making profits. It is said that the competitive profit and loss system ensures the survival of the fittest.
Profit is the difference which arises when a firm’s TR is greater than its TC. This definition ‘economic profit’ differs from that used commonly by business people (accounting profit) in that accounting profit only takes into account explicit costs.
Economic profit can be viewed in terms of the following:
(a) The return accruing to enterprise owners (entrepreneurs) after bearing all explicit costs (payments such as wages to outside factor-input suppliers) and all implicit costs (payments for the use of factor inputs — capital, labour, etc. — supplied by the owners themselves);
(b) A residual return to the owner(s) of a firm (an individual entrepreneur or a group of shareholders) for providing capital and for risk-bearing;
(c) the ‘reward’ to entrepreneurs for organising productive activity, for innovating (developing new products and processes), etc. and for risk taking;
(d) The prime mover of a private-enterprise economy serving to allocate resources between competing end uses in line with consumer demands ; and
(e) In aggregate terms, a source of income and thus included as a part of national income.
Theories of Sources of Economic Profits:
Profits arise when there is a surplus of revenue over costs in a period of trading. Now, rather than concentrating on the ratio of profits to sale, we can ask a more meaningful question- How much of a society’s income goes to wages and how much is left over for profit? It is generally believed that the capitalist class usually takes away the major portion or the lion’s share of GNP as profits.
We will now see that the word ‘profit’ has different meanings. In economics, we usually relate the concept of profit to a number of diverse factors dynamic innovation, uncertainty- bearing, the problems of monopoly, incentives and exploitation. We shall now discuss, one by one, three different but interrelated views on the nature and determinants (sources) of profits.
First View: Profit as a Reward for Innovation:
The innovation theory of profit has been popularized by Joseph Schumpeter (1883-1950). In essence, Schumpeter sees profits as reward earned by those firms which innovate. Innovations are those new products or processes which increase national income more than they increase national cost. The difference is profit.
The main function of the entrepreneur is innovation. And, in a dynamic world, there is a fair chance for somebody (the entrepreneur) to develop and promote a new product or find a way to lower cost on an old one. Many try. But few succeed. Thus profits result from the successful application of innovations (which are commercialisation of inventions).
However, those firms which identify new market opportunities develop new products or introduce new cost-reducing methods or production processes gain an advantage over their competitors and earn profit. The process continues until the advantage is taken over by new firms attracted into the market and imitating the new products or processes. So profit is basically a transitory phenomenon. It lasts as long as companies stay one step ahead of their competitors. Profit-earning firms are those that at best are sensing future trends and adapting to change.
According to J. A. Schumpeter profit must be regarded as the return to innovators. Furthermore, continuous emergence of profit is a precondition for successful innovation because it acts as incentive to innovate. In that sense profit is the cause of innovation.
All factors of production involved in producing the innovation are paid their opportunity costs. But the entrepreneur who developed the new idea and converted the same into a marketable good or service receives this surplus of income over costs as his reward.
However, after a time imitators will appear, product prices will tend to fall to a perfectly competitive level and the innovational profits will be wiped out. But, in reality, further innovation will appear on the scene (or what Schumpeter called the ‘Perennial Gale of Creative Destruction’), before equilibrium is attained and the cycle starts once again. In perfectly competitive economy without trade-marks, patent laws, etc., innovational profit would be soon competed away because, in the language of Schumpeter, “Imitators are many while innovators are few.”
Therefore, profit can be protected if it is possible to:
1. Introduce patent laws to protect the advantageous position of the entrepreneur, and
2. Ensure repeated innovations so that profits continue emerging out of them for a long time.
Successful innovations are made by the firms first entering a competitive industry. These firms are able to make excess profits in the short run before others are able to enter the industry. Some of the innovative firms are given patent protection and thus they succeed to form a monopoly.
So, according to this view, profits are not wages of management. Instead, profit is taken to be the temporary excess return to the innovating entrepreneur.
Second View: Profit as Return for Risk-Taking and Uncertainty-Bearing:
If the future could be foreseen with accuracy and perfect certainty, there would be no scope for innovation. Everything would already be known. The implication is that innovators’ profits are closely tied up with risk and uncertainty. Innovations require individuals in an economy to take risks and commit capital to make their ideas work out in practice. In making judgement about whether to pursue a possible innovation, innovators or entrepreneurs must form expectations about the future.
However, as they are dealing with new ideas, products or processes, there is no certainty that new business ventures, which require the commitment of their time and capital, will give good returns. The entrepreneur normally cannot buy insurance to cover most of the risks he (she) faces. Thus entrepreneurs must be willing to bear the risks themselves. Accordingly, we can think of economic profits as a reward to entrepreneurs for assuming these risks.
According to risk-bearing theory, profit is the reward earned by businesses for undertaking risks involved in business operations. So it is necessary to induce people to take risk. Most people prefer to avoid risks and uncertainties. But, in general, business people are unable to do so. Firms must take actions now with a view to satisfying consumer needs in a risky or uncertain tomorrow. Consequently, a higher reward is required as the risk and/or uncertainty in the situation increases. Without this reward firms would avoid such situations and so needs and wants of tomorrow would remain unsatisfied.
The source of the uninsurable risks faced by entrepreneurs arises from the unpredictable shifts in demand and supply conditions facing the firms they set up. Since the projects they set up are new, they have no reputation in the market. Hence, it is difficult, at this stage, to raise finance for such projects. Lenders (including the general public) may be reluctant to provide funds for fear of default.
Moreover, technological developments are unpredictable and may make their business ventures obsolete overnight. In a dynamic economy with new innovations constantly occurring — sometimes replacing older ones whose associated profits are eaten away by competition — there is a regular flow of economic profits to reward new successful innovators.
According to Frank Knight, all true profit is linked with uncertainty. And innovators’ profits, represent an important category of uncertainty-induced profit. In the context, Knight distinguished between calculable/insurable and uninsurable risk.
Some future events lime fire or accident can be very easily insured against. In case of any loss the entrepreneur will get compensation from the insurance company. So no question of profit arise in such cases. This means that profit arises due to the undertaking of uninsurable risks. We may now classify the various types of risks as in Table 29.1.
Knight argued that entrepreneurs who start a firm not only have to be rewarded for their labour input and investment but also for the risk they are taking. As G.S. Maddala and E. Miller have put it, “There is always a chance that the business might fail and that the entrepreneur might lose all the investment and effort. Profit is a reward for this risk. It is the existence of this reward that prompts many individuals to innovate and produce new products or produce old products by using improved production methods. It is the driving force behind all development. Thus these rewards serve a socially useful and productive purpose”.
We can now summarise the notion of profit as the reward for risk-bearing thus:
1. If most people do not like to take risk, feeling that the marginal utility of rupees they gain is less than that of the rupees they lose, they will prefer small steady incomes to fluctuating incomes.
2. Hence those who engage in activities that involve uncertainty will receive a positive premium to compensate for aversion to risk.
3. Therefore, the yield on capital invested in risky ventures will involve, in addition to pure interest corresponding to safe investments, an extra risk-premium in the form of positive profit.
These statements accord with the economists’ traditional view of profit as the last component of competitive price which is the sum-total of wage, interest, rent and profit risk- premium.
Third View: Profit as Monopoly Return:
Apart from the fact the economic profits serve as rewards to entrepreneurs, the presence of monopoly power generates economic profits. So there is two-way causation. A firm under perfect market condition becomes equal to marginal cost of its product. But, in the long run due to completely free entry, profit is competed away and the firm earns only normal profit, that is, wage of routine management which is included in the cost of production.
In a perfectly competitive economy in a state of equilibrium, profits do not exist because each entrepreneur has equal opportunities and equal capacities to exploit them. In contrast, due to its ability to restrict output and deter entry a monopolist may keep its price above the competitive level, generating economic profits. So profits are the result of market frictions and imperfections.
They exist because of disequilibrium and imperfect competition. They tend to persist because the economy can rarely adjust immediately to changes in cost and demand conditions. In short, in a competitive industry, the excess profits disappear completely in the long run with the entry of new firms. This is not, however, the case with monopoly. Since entry is restricted, the excess profits may not disappear even in the long run.
This is the monopoly theory of profit. It may be argued, however, that it is the prospect of earning monopoly profits, at least temporarily, that induces firms to venture into undertaking risks in starting a new business enterprise.
Modem business devices may make it possible to prolong the temporary gains of a quasi-monopolistic firm accruing from successful innovations. Moreover learners to entry product differentiation, etc. may result in the existence of pure profit, both short run and in the long run under imperfect competition.
Many people regard profit as a necessary evil because it is the earning of monopoly or the result of artificial scarcity. But this view is not accepted by others. A P Lerner has developed a measure conveniently called ‘the degree of monopoly power which is defined as the excess or price over marginal cost, divided by the original price.
In symbol, where M stands for monopoly profit, and other symbols have their usual meanings:
M = (P – MC)/P = (P – MR)/P = [P – P (1 – 1/EP)]/P = 1/EP
Thus the more inelastic the demand for a commodity is, the greater will be the scope of exploitation by the monopolist and the larger will thus be the volume of monopoly profit. True, profits accrue to companies as a result of the monopoly power which they possess in their markets. This allows them to raise price by restricting output.
Monopoly profits do not serve any social purpose. Instead coercive (extortive) profits involve some social costs. The existence of monopoly profits results in a number of socially unproductive activities, called rent-seeking activities or directly unproductive profit-seeking activities. No doubt profit occurs due to artificial scarcities – a surplus return which could easily be taxed away without affecting incentives. So there is a case of excess profit tax.
Profit is the difference between total revenue and total cost. Profit is calculated by subtracting from total sales revenue all expenses (wages, salaries, materials, interest, excise duties, and other contractual payments). Profit is a mixed income in the sense that it is a combination of different elements, including the implicit returns on owner’s capital, reward for risk bearing and success.
Profit is of two types — normal and net (excess). Much of corporate profit is normal profit. Such profit is primarily the return to the owners of the firm for the capital and labour provided by the owners, that is, factors of production supplied by them.
For example, some profits are the return on the personal work done by the owners of the firm — such as the doctor or the lawyer who works in his own chamber and does all the work himself, rather than keeping a compounder or an assistant. Part is the rent of land owned by the firm.
In large corporations most profits are the opportunity cost of invested capital. These returns are called implicit returns (or costs) which are the opportunity cost of factors owned by firms. These returns are contractual in nature. Thus profit includes a contractual element. In fact, a portion of profit is really rentals, rent and wages under a different name. ‘Implicit rentals’, ‘implicit rent’, and ‘implicit wages’ are the earnings on factors owned by the firm itself.
In this context we may draw a distinction between business profit and economic profit. Business profits are sales revenue less costs. Such profits include an implicit return on the capital owned by firms. Economic profits are the earnings after all costs — both money and implicit (opportunity) costs — are subtracted. In large corporations, therefore, economic profits would equal business profits less an implicit return on the capital owned by the firm along with any other costs (such as unpaid management time) not fully compensated at market prices.
Entrepreneurs devote their time to bring potential investors together, hiring workers or executives and financing the operation of the firm. There is, thus, involvement of both labour and capital of the entrepreneurs. The amount of money attributable to the entrepreneur’s efforts is called normal profit.
This includes wages for labour (the amount the entrepreneur would have earned in the competitive industry) and interest for investment for expenditure (the return on investment that would have been earned elsewhere). Since these are really ‘opportunity costs’, these should be treated as contractual elements of profit.
Preference shares also entitle the holder to a fixed rate of dividend. This is a form of contractual return on risk capital. Cumulative preference shares carry forward the right to preferential dividends, if unpaid, from one year to the next.
Profit and Producer Surplus:
Profit is defined as the firm’s sales revenue minus its cost of production:
Economic profit = total revenue – all costs of production.
Costs are of two types: outlay (explicit) costs and opportunity (implicit) costs. Outlay cost refers to any payment made to an outsider such as wages and salaries and outlays on raw materials. For the firm’s owners, opportunity cost is the total value of everything sacrificed to produce output. For example, if an owner contributes his own time or money to the firm, there will be foregone wages or foregone investment income. Both are implicit costs for the firm.
Another concept of profit is normal profit (which is also known as zero economic profit). When a firm is making zero economic profit it is still earning enough to cover all of the owner’s costs — including compensation for any foregone investment income or foregone salary.
Producer surplus on a unit of a good is the difference between what the seller actually gets and the smallest amount that the seller would accept in exchange for the good:
Producer surplus = total revenue – total variable cost – non-sunk cost.
That is, producer surplus for an individual firm is equal to the difference between its total revenue and total non-sunk costs.
In the short run, when some of the firm’s fixed costs might be sunk, a firm’s producer surplus and its economic profit are not equal. They differ by the extent of the firm’s sunk fixed costs.
Producer surplus = economic profit + sunk fixed costs
In the long run, when all of the firm’s costs are non-sunk (i.e., avoidable), producer surplus and economic profit are identical:
Producer surplus = economic profit.
In both cases the differences in producer surplus at one market price and that at another market price is equal to the difference in the firm’s economic profits at these two prices (since fixed sunk costs remain the same whether price is high or low).