Top 5 Profit Theories | Maximization of Profit | Business Objectives

Profit maximization is usually assumed to be the goal/objective of the firm. 

But what is profit? 

What are the sources of profit? 

Economists have propounded different theories of sources of profit. 

Among them Top 5 Theories of profit are explained below.

Schumpeter's Innovation Theory of Profit

schumpeter's innovation theory of profit

Joseph A. Schumpeter has developed the innovation theory of profit. 

Schumpeter had presented a theory where profits occur on innovations in the manufacturing sector or even in the technique of supplying the goods. 

These innovations are expensive and must be rewarded to flow continuously. Hence, innovating firms are sometimes awarded patent rights for a specific period. During this time, no other firm is permitted to copy the product and/or technology. Profits are thus considered a reward for innovation partly.

Innovations may include:

1. Introduction of a new commodity or quality of goods.
2. Introduction of a new method of production.
3. Opening of a new market.
4. Finding new sources of raw material.
5. Innovatively organizing the industry with the new techniques.

For example, innovation theory of profit may occur when a new product or a new quality of the product is launched, or a new technique of production is introduced. However, over time, these profits may get wiped out. Over time, the supply of factors remains the same. Factor prices tend to increase. As a result, the cost of production increases. On the other side, with other firms adopting innovations, the supply of goods and services increases resulting in a fall in their prices.

On the one hand, the cost per unit of output increases, and, on the other, revenue per unit goes down. Ultimately a stage comes when there is no difference between costs and receipts. Therefore, profits disappear. In the process, the economy reaches a higher level of stationary equilibrium.

In order to explain the phenomenon of economic development (and, the profit), Schumpeter firstly explains the stationary equilibrium. Under the state of stationary equilibrium, the total receipts from the business are equal to the total costs, and there is no profit. Firms can make profits only by introducing innovations in production techniques and methods of supplying the goods. 

His theory of profit is rooted in his theory of economic development.

According to him, factors like appearance of interest and profits, repetitions of trade cycles and such others are only related to a distinct process of economic development. The certain principles that could explain the process of economic development would also explain these economic variables. 

It is quite likely that profit exits despite the process of profits being wiped out. Such profits are in the nature of quasi rent arising due to some special characteristics of productive services. Moreover, when profits arise due to factors such as patents, trusts, cartels, etc., it would be in the nature of monopoly revenue instead of entrepreneurial profits.

Hawley's Risk Theory of Profit 

hawley's risk theory of profit

F.B. Hawley developed the risk theory of profit in 1893. He had presented a theory where profit is a return on bearing the risk. One who takes a risk earns a reward in the form of a profit; he would not be willing to take a risk when he does not get a return. According to him, profit arises from the decisions made and implemented under the conditions of uncertainty; alternatively, profit is simply the price paid by society for assuming business risks.

Risk-bearing firms invest large sums in the production system, expecting to produce goods and make profits. However, the production may run into difficulties, be delayed, and there may not be an adequate market when production is ready. In consequence, rewards for entrepreneurship are highly uncertain. The firms take these risks and must be adequately rewarded. Hawley regarded risk-taking as an essential dimension of business, and those who take risks get profit as a reward.

Risk in business may arise for the following reasons:

1. Obsolescence of a product, 
2. Sudden fall in the price of product, 
3. Non-availability of inputs, 
4. Better substitute introduced by competitor, 
5. Risks due to fire, war, etc. 

In his opinion, business people would not assume risk without expecting adequate compensation in excess of actuarial value, that is, the premium on calculable risk. Business people always look for a return in excess of the wages of management for bearing risk. 

Hawley proposed that profit is over and above the actuarial risk because the assumption of risk is troublesome; it gives rise to trouble, anxiety, and disabilities of various kinds. Therefore, assuming risk provides the entrepreneur with a claim reward in excess of the actuarial value of risk. 

Hawley believed that profits arise as long as it involves risk. In his view, an entrepreneur has to assume risk to qualify for profit. If an entrepreneur would not receive any profit, it is the uninsured risks out of which profits arise. The uncertainty ends with the sale of products. The amount of reward cannot be estimated until the products are sold. According to him, profit is a residue. Hence Hawley's theory is a residual theory of profit.

Knight's Theory of Profit

knight's theory of profit

According to Frank H. Knight, profit is a return on bearing the uncertainty. He treated profit as a residual return to uncertainty bearing, not to risk-bearing. 

Frank H. Knight made a distinction between risk and uncertainty:

1. Calculable or Insurable risks- Calculable risks are those whose probability of occurrence can be statistically estimated on the basis of available data. Calculable risks can be insured, for example, risks due to accidents and fire.
2. Non- Calculable or Uninsurable risks- Incalculable risks cannot be insured and hence falls in the area of uncertainty, for example, uncertainties regarding the competitor’s reaction. 

Because of the condition of uncertainty that decision making becomes an important function of an entrepreneur. If the decisions of entrepreneur are proved right by further events, then he makes a profit otherwise not.

In his opinion, the profits may arise as a result of decisions related to the state of the market. For example, decisions that increase the degree of monopoly, decisions with respect to holding stocks that give rise to windfall gains decision taken to introduce new techniques and innovation.

Read Also: Goals and Objectives of Business

Clark's Dynamic Theory of Profit

clark's dynamic theory of profit

J. B. Clark had presented the dynamic theory where profits occur only in a dynamic economy, not in a static one. However, this profit will disappear in the long-run. But in a dynamic economy where the change is a continuous process, profits keep occurring. In a static economy, there would be no profits.

What is a static economy?

The characteristics of a static economy are:

1. Absolute freedom of competition.
2. Population and capital are stationary.
3. Production process remains unchanged over time; goods continue to remain homogenous.
4. Due to the same marginal product in every industry, factors of production do not move.
5. There is no uncertainty, therefore, no risk. If there's any risk, it is insurable/calculable.
6. All firms make only the 'normal profit,' that is, the wages of management.

What is a dynamic economy?

A dynamic economy has the following characteristics:

1. Changes like an increase in the population
2. Change in the wants of the consumer,
3. Growth of capital and technology,
4. Improvement in production technique,
5. Changes in the forms of business organizations.

The entrepreneurs who make take advantage of changing conditions in a dynamic economy successfully make pure profit.

Pure profits exist only in short run. In the long run, other firms imitate the changes made by the leading firms. This leads to rise in demand for factors of production and there rise in both factor prices and cost of production. On the other side, rise in output in the market causes a decline in product prices. Hence ultimately, pure profit disappears. 

It should not mean that profits arise in a dynamic economy only once and disappear for ever. In a dynamic economy, the above-mentioned changes are continuous, and efficient managers always take advantage of the change and hence are able to make a profit. Making a profit is a continuous process; it emerges, disappears, and re-emerges.

Walker's Theory of Profit

walker's theory of profit

According to F.A.Walker, profit is the rent of "exceptional abilities that an entrepreneur may possess" over others In his view, an entrepreneur, who possesses the extraordinary abilities, earns rent on these abilities when he uses the abilities in business. This rent is the profit earned by him. 

Like rent, which is the difference between the returns on the less and the more fertile land, profit is the difference between the less and the more competent entrepreneurs' earnings.

In his profit theory, Walker assumed there existed only the perfect competition in which all firms possess equal managerial skills. Each firm would receive only the wages of management, that according to him are, ordinary wages. Thus, under perfect competition, there would be no pure profit. All firms would earn only ordinary wages, which is 'normal profit.'

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