Rent theory of profits

Profits

Profits are the reward for organization or entrepreneurship. Risk-taking and uncertainty-bearing are the main functions of an entrepreneur. So we may consider profit as the reward for the above functions.

Gross Profit : Generally when we speak of profit, we refer to the difference between the total expenses of producing a good and the total revenue from it. But this is gross profit.

Gross Profit and Net Profit : Gross profit includes besides net profit other things such as the interest on capital, rent of land, wages of manangement and some extra income on account of the monopoly position of a firm. It also includes some chance gains (windfall profits). While considering net profit 'or' pure profit, we have to deduct all the above things from gross profit. Net profit is the reward for risk - taking and uncertainty - bearing which are the main functions of an entrepreneur. The monopolist is the sole seller of a commodity for which there are no substitutes. As he controls the supply, it is possible for him to make huge profits. And this is known as monopoly profit.

Normal profit and super normal profit (excess profit)

Pure profit (net profit) can be divided into normal profit and supernormal profit. Normal profit is the minimum necessary to guarantee that an entrepreneur will continue to bear uncertainty and run the firm. That part of pure profit which is in excess of normal profit is excess or surplus profit or supernormal profit. Though firms under perfect competition may make surplus profits in the short run, it will disappear in the long run. Only a monopoly can earn excess profits indefinitely.

The early economists made no distinction between interest and profits because they considered the capitalist and the entrepreneur as one and the same person. The entrepreneur need not necessarily be the owner of capital. It is leadership rather than ownership that is important in the case of an entrepreneur. Today, organization has become a distinct factor of production. Profits differ from other incomes in three ways. First, it is a residual income. Second, there may be wide fluctuations in profits and sometimes, they may be negative. That is, there may be losses. We cannot think of negative wages. Third, profits are uncertain.

Theories of Profit

Some of the important theories of profit are (1) the rent theory of profits (2) The marginal productivity theory of profits ; (3) The wages theory of profits ; (4) the dynamic theory of profits ; (5) the innovation theory of profits (6) the risk theory of profits, and (7) the uncertainty - bearing theory of profits.

Rent theory of profits

Prof walker is the author of the rent theory of profits. In his view, profits are the 'rent of ability' and they are similar to rent. Rent arises because of differences in fertility of land. Similarly profits arise because of differences in ability. That is why it is called the 'rent of ability'. The main criticism against this theory is that it explains only why there are differences in profits. It does not answer the fundamental question why there are profits as such.

        The Marginal productivity theory of profits : The theory is an application of the general theory of distribution. According to this theory, under perfect competition, profits will be equal to the value of the marginal product of organization. We can apply all the criticisms against marginal productivity theory to this theory also.

        The wages theory of Profits : According to Prof. Taussig, profits are not different from wages. Profits, are the wages of the entrepreneur for his special ability. Profits are the wages of management. The criticism against the theory is that we can speak of negative profits (losses) but we cannot speak of negative wages. Organization is a distinct factor of production. And it is different from labour.

        The Dynamic Theory of profits: Prof. Clark is the author of this theory. According to him, profits are the result of dynamic changes in society. Clark has defined profits as the excess of the prices of goods over their costs. Some of the important changes relate to the size of population, supply of capital, production techniques, industrial organization and human wants. Though the dynamic theory is one of the modern theories of profits, 'it overlooks the fundamental question of the difference between a change that is foreseen a reasonable time in advance and one that is unforeseen'.

Innovation theory of profits: According to Schumpeter, profits are the reward for innovations. An innovation is something more than an invention. An invention becomes an innovation only when it is applied to industrial processes. Innovation includes introduction of new goods, or new methods of production and opening new market. And innovations are introduced by the entrepreneur. Change and economic development take place because of his activities. So he gets profits for innovations. The criticism against the theory is that though innovation is an important factor in the emergence of profits, it cannot be the only factor. It ignores the risk-bearing function of the entrepreneur.

        The Risk - bearing theory of profits :- According to Prof. Hawley, profits are the reward for an entrepreneur for risk- taking. Risk - taking is an important function of an entrepreneur. Risk-taking and profit-making go together. The main criticism against this theory is that it does not make distinction between known risks and unknown risks. Known risks (eg. theft, fire) can be insured against. We may say that profits are the reward for taking unknown risks. For there is a lot of uncertainty about such risks.

        The uncertainity-bearing theory of profits : Professor Knight is the author of the uncertainty - bearing theory of profits. He is of the view that 'profit is the reward not for risk - bearing but uncertainty-bearing'. His main point is that there is risk because future is uncertain. And uncertainty - bearing is an essential function of an entrepreneur.

        The entrepreneur can insure known risks. But unknown risks (eg. competition risks, risks of government action) cannot be insured against. These risks are uncertain. The entrepreneur earns profits because uncertainties are borne by him. The criticism against the theory is that uncertainty - bearing alone is not the only function of an entrepreneur.