Profit is the reward for taking risk and responsibility but not the reward from management or co-ordination. It is an income to the entrepreneurs. Profit is the difference between total revenue and total cost. Revenue is the amount obtained from the sales of production. Profit is the amount that remains after payment has been made to land, labor, and capital in the form of rent wages, interest respectively.
Profit is the difference between total revenue and total cost. Revenue is the amount obtained from the sales of production.
Thus, profit = total revenue - rent - wages - interest.
Gross profit is the excess revenue over the explicit cost of production. It is the difference between total revenue obtained from sales of production and explicit cost. Mathematically,
Gross profit = Total revenue – Explicit cost
Net profit is the excess revenue over all types of cost of production. It is the difference between total revenue obtained from sales of the production and the sum of explicit cost and implicit cost. Mathematically,
Net profit= Total revenue – (explicit cost + implicit cost)
Gross profit includes cost of inputs owned by entrepreneur too whereas net profit doesn’t include. Hence, the gross profit is always higher than net profit. If not a single input used is owned by entrepreneur, the gross profit and net profit are equal. Thus, the implicit cost will be equal to 0.
Risk bearing theory of profit is the traditional theories of profit. It was propounded by an American Economist F.B. Hawley in 1907. According to this theory, profit is the reward for taking risk and responsibility but not the reward from management or co-ordination. Simply more risk more gain, no risk no gain. According to Hawley, risks are of four types:
If one party can not fulfill the contract for some reason in such case replacement contract will be will be drawn up which requires the other party to return what they have been given already.
It is the risk of being outdated while undergoing production process. For e.g., if the Nokia Company is planning to manufacture a new mobile phone, there is a risk that Samsung Company may launch similar phone in advance. In such situation, the efforts and arrangement of Nokia go wastage.
It is the risk of marketability i.e. all the quantity of produced goods may not be sold out in the market. The consumer may not demand high amount as expected by the producer.
It is the non-insurable risk that may arise due to unusual circumstances like political protest, natural disaster, distraction in supply of input and output goods etc which may cause producer to suffer heavy loss.
The theory has been criticized by many economists. Some of the main criticisms are:
According to this theory, profit is the reward for taking risk. But profit arises due to the better management ability of business.
This theory does not show the relation between profit and risk taking. But in reality, many other factors influences the profit.
According to Prof. Knight foreseeable risk are provided against through insurance. For example, the risk of fire can be conversed through fire insurance.
According to Carver, profit arises due to risk bearing but because of ability of the entrepreneur to avoid risk.
This theory is known as improved version of risk theory. It was introduced by F. H. Knight. This theory explains that the profit is the reward for bearing uncertainty rather than taking risk. According to Knight the uncertainty are as follows:
In a perfect competition market, there is no barrier to entry for the new firms. So, when an entrepreneur starts the business, he may not know what degree of competition he has to face the time being. Such risk can’t be insured and it is called competitive risk.
The existing firm may not be able to catch up with the changing technology in production process. This makes the possibility that products could be outdated in market.
The government may introduce some specific rules and regulation for a particular industry at any time. Similarly, it may also intervene in fixing prices of the product. This could cause an entrepreneur suffer.
During recession and depression, there is a decline in purchasing power of the consumer which ultimately affects the market demand. In the globalized economy, the demand market is highly influenced by the business cycle in foreign countries.
(Jha, Bhusal and Bista)(Karna, Khanal, and Chaulagain)
Jha, P.K., et al. Economics II. Kalimati, Kathmandu: Dreamland Publication, 2011.
Karna, Dr.Surendra Labh, Bhawani Prasad Khanal and Neelam Prasad Chaulagain. Economics. Kathmandu: Jupiter Publisher and Distributors Pvt. Ltd, 2070.