Profit theories look at the core concepts that guide how companies create, preserve, and maximize profits. These theories explore the relationships between pricing, market demand, and production and offer insights into various methods of maximizing profits.
Businesses may be able to boost profitability by making well-informed decisions about innovation, cost structures, competitiveness, and marginal value. Profit theories provide the groundwork for understanding corporate growth and guiding financial strategies in monopolistic and competitive markets.
Acquiring knowledge of these concepts helps companies to keep or grow their profit margins while adapting to changing market conditions.
Profit theories study the various factors and procedures that companies employ to turn a profit in the realm of business finance. Regarding topics like risk-taking, creativity, entrepreneurial skill, labor exploitation, and risk-taking, each theory has a different approach.
These ideas aid in the understanding of the incentives for and limitations on profit maximization by businesses and economists.
From Walker’s idea of entrepreneurial genius as profit to Schumpeter’s emphasis on innovation, these concepts—which highlight the intricate relationships between rivalry, market pressures, and production processes—elucidate the dynamic nature of profit in a range of economic systems.
Key Profit Theories Behind Business Success
Let us unlock a few of the key profit theories behind business success today in this topic below, and learn business finance principles that can guide profitability strategies.
Profit Rent Theory
Francis L. Walker, an American economist, proposed this idea, which is based on the concept of Profit after taxes. Prof. Walker likened his thesis to Ricardian theory.
Profit, according to him, is the rent of skill. Rent is computed by comparing the abilities of marginal and super marginal land, and profit is derived by comparing the abilities of marginal and super marginal entrepreneurs. Profit provides funding for competence, while rent covers the cost of land use.
Entrepreneurs differ in ability as much as pieces of land differ in fertility. In the theory, an able entrepreneur is defined as a super marginal entrepreneur, and his ability is compared to that of a marginal entrepreneur, who sells his product at cost and gets no profit.
Walker contends that profit is different from price because it is the leasing of knowledge and other resources.
Criticism
- Profit is not necessarily the result of skill; other factors (macro variables) are also responsible for profit.
- Rent is normally positive and, in certain situations, zero, whereas profit can be positive, zero, or even negative.
- There is no such thing as a marginal entrepreneur in the real world.
- Profit arises in a dynamic economy, where changes occur on a constant basis, rather than in a static economy.
- This is a short-term theory in which profit enters into price, which is not feasible in a long-term theory.
Profit Wage Theory
This theory was presented by American economist Taussig and is strongly backed by Davenport. Profit, according to this notion, is analogous to a pay paid to an entrepreneur for services done in the business. This hypothesis shows how labor and entrepreneur are similar.
In the same way that labor receives salaries for services rendered in the business, an entrepreneur receives profit in the business for providing services in the business. As a result, this idea emphasizes that profit is a form of salary for the entrepreneur.
But this argument misses the fact that an employee never takes a risk in order to make money; an entrepreneur, on the other hand, does this on a regular basis. Moreover, this line of thinking fails to acknowledge the fact that wages are always positive because they are paid regardless of the circumstances, but profits are never positive.
Criticism
- Although wages are usually positive, profit is not always positive. Dimensions might be positive, zero, or even negative.
- Labor and entrepreneur are not synonymous. Labor often performs physical tasks, whereas entrepreneurs engage in mental activity.
- This theory does not account for the profit gained by the shareholder who is not providing any service.
- Labor does not take any risks, however an entrepreneur does, hence there is no similarity between labor and entrepreneur.
Profit Risk Theory
In 1907, American economist Hawley proposed this notion. Profit, according to this view, is the payoff for taking risks. If an entrepreneur in business takes a risk, he is likely to profit; if he is unwilling to take a risk, he is unlikely to profit. Thus, this theory is founded on the fundamental idea that the higher the risk, the higher the profit, and the lesser the risk, the lower the profit.
Criticism
- Risk and profit have no direct link.
- Profit does not accrue as a result of risk taking, but rather as a result of risk avoidance.
- Profit does not result from all sorts of risk.
- It does not calculate profit volume.
Profit Uncertainty Bearing Theory
F. H. Knight, an American economist, proposed this idea in 1927. Profit, according to this view, is the payoff for bearing uncertainty. This idea is also known as Knight’s idea of Profit, because he establishes that profit does not result from all sorts of risk. As a result, he classified risk into two categories: expected risk and unforeseen risk.
Foreseen risks are those that can be forecast and covered by insurance. It covers risks such as fire, threat, and so on, whereas unanticipated risks are those that cannot be forecast and cannot be covered by insurance. This includes government policy, business cycles, competitive risk, technical risk, and so on.
Profit can be made from any form of risk, according to Prof Knight. It’s the outcome of an avoidable risk. Because this risk cannot be predicted and no insurable firm is prepared to cover it, it is referred to as non-insurable risk or uncertainty bearing risk.
Criticism
- Uncertainty bearing is not a production component.
- Profit is not the only prize for bearing uncertainty.
- This theory does not calculate profit volume.
- This theory only explains profit in a sudden and causal manner.
Profit Dynamic Theory
J.B. Clark, an American economist, proposed this idea. Profit, he claims, always arises in a dynamic economy rather than a static economy. The primary reason for profit in a dynamic economy is the economy’s constant changing.
There is no change in the economy in the case of a static economy. The previous year’s actions will be repeated in the current year, resulting in a price equal to its cost and no profit.
According to Clark, there are five changes that are constantly occurring in the dynamic economy and are accountable for profit. They are as follows:
- Constant population change
- Constant changes in manufacturing techniques
- Continual changes in capital supply
- Continual changes in organizational structure
- Continual changes in human desires as a result of changes in consumer taste, preference, and habit
According to Clark, only those entrepreneurs that make these adjustments in order to satisfy consumer wants will survive, develop, and prosper. Those entrepreneurs who refuse to accept these changes will perish and make no profit.
Criticism
- Not every change is profitable.
- In the actual world, there is no such thing as a static economy.
- This approach places less emphasis on uncertainty and risk taking.
- It does not calculate profit volume.
Profit Innovation Theory
J.A.Schumpeter, an American economist, proposed this hypothesis. This hypothesis is quite close to the Dynamic Profit hypothesis. Instead of adopting the five changes that are constantly occurring in the economy, this view focuses on innovation.
According to Schumpeter, innovation is the application of cutting-edge industrial processes that typically result in reduced production costs and increased profitability.
If a company wishes to enhance its profit, it can do so in two ways:
- It can either raise the price of the goods or decrease it.
- Make an effort to lower production costs.
The industry’s increased competition has rendered the first method ineffective. If the firm raises the price of the product, the other competitor will not raise the price, causing demand to plummet and further reducing the profit margin.
Regarding augmenting the earnings, the second strategy fared much better. This profit will accrue to the firm indefinitely, until the firm rejects this innovation. As a result, it is correct to state that the profit generated through invention has now lapsed.
Thus, according to this idea, profit accrues to the corporation solely as a result of innovations and not for any other reason.
Criticism
- This hypothesis disregards the entrepreneur’s risk factor.
- Profit does not accrue just as a result of innovations.
- This approach fails to account for profit volume.
- This hypothesis only applies to a limited period of time.
Profit Marginal Productivity Theory
According to this theory, the reward for each and every factor of production can be determined by the marginal productivity of that factor of production. According to the theory, one of the production factors is entrepreneurial skill.
This idea holds that the value of entrepreneurial abilities, i.e. profit, is determined by his marginal productivity. As the marginal productivity curve for a factor of production is the demand curve for that factor, the marginal productivity curve for an entrepreneur is the demand curve for that entrepreneur.
Entrepreneurial aptitude is in short supply, and it is determined by how much they earn in an industry or his income, i.e. transfer income and opportunity cost. It cannot be readily and quickly increased or decreased. A skilled entrepreneur has a higher demand and generates a higher profit, and vice versa. Because supply is limited, entrepreneurs profit greatly from higher marginal productivity.
Under perfect competition, an entrepreneur’s profits tend to equal his marginal output. However, when we examine this idea, we discover that perfect competition does not exist in the real world. It is impossible to achieve perfect competitiveness.
Criticism
- This idea is incorrect because it implies all entrepreneurs of the same sort have identical skill.
- This theory is biased. It focuses on the demand side while ignoring the supply side.
- This theory is founded on the premise of ideal competition, which is not often the case in practice. An ideal competition does not exist.
- This theory excludes windfall profit.
- It is difficult to establish entrepreneur marginalproductivity since in case but in case of a there is just one entrepreneur
Socialist Profit Theory
Karl Marx, an American economist, proposed this hypothesis. According to this notion, the value of a product is defined by the labor engaged in the manufacturing process.
Under a capitalist system, the majority of total output is captured by capitalists, with only a small fraction of output distributed to labor. Marx referred to the majority of what capitalists take away as “surplus value.”
Thus, according to this idea, the fundamental reason for profit is capitalist exploitation of labor, also known as “legalized robbery,” because the majority of produce is grabbed by capitalists themselves.
As a result, the economy will be divided into two parts: haves and have nots. The first category benefits at the expense of the second. However, the second category will suffer from exploitation and will resort to strikes and lockouts. They will expect better salary and other luxuries. As a result, profit will tend to diminish in the long run.
Criticism
- This theory asserts that labor is the single component responsible for profit accumulation, which is incorrect. There are various other elements that influence production speed, including labor.
- Profit is not the result of labor exploitation; rather, it is the result of the entrepreneur’s ability.
- This theory disregards taking risks and dealing with uncertainty.
- This theory does not consider the issue of windfall profit.
- This theory does not provide any means of calculating profit volume.
Conclusion
Profit theories cover a wide range of topics, such as how businesses make money, innovation, labor exploitation, taking risks, and entrepreneurial skill. All theories highlight important components, such as the significance of uncertainty or dynamic market fluctuations, but they are criticized for being unduly basic or for missing important elements, such as competition and risk.
Economists and companies can gain a better understanding of how market conditions, innovation, and entrepreneurial strategies impact profits by grasping these concepts. This comprehension could offer valuable perspectives on attaining sustained profitability amidst tumultuous economic conditions.
