Note on Profit

  • Note
  • Things to remember

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.

source:www.netpicks.com
source:www.netpicks.com

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.

Concept of Gross Profit and Net Profit

Gross profit

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

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.

Causes of profit

  • Effective combination of other inputs:
    The organization brings verities of inputs like land, capital etc. together and combines for production. Organization should obtain profit as its remuneration.
  • Innovation:
    Organization brings innovation in quality and quantity of products, management, and technology. For this also the organization has to earn a profit.
  • Bargaining power:
    Every organization has bargaining power due to more or less control in the market, resources, and special skills and so on. For this too organization should earn profit.
  • Risk involved in business:
    There is always risk involved in business and there may be different types of risk. For taking risk too, the organization should earn profit as compensation.
  • Uncertainty:
    Some economists consider that organization should earn a profit for bearing uncertainty due to unforeseeable or uninsurable risk.

Risk Bearing Theory of Profit

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:

  1. Replacement risk:

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.

  1. Obsolescence risk:

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.

  1. Risk proper:

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.

  1. Uncertainty:

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.

Criticisms of Risk Bearing Theory of Profit

The theory has been criticized by many economists. Some of the main criticisms are:

  1. Cause of profit

According to this theory, profit is the reward for taking risk. But profit arises due to the better management ability of business.

  1. Relation between profit and risk taking

This theory does not show the relation between profit and risk taking. But in reality, many other factors influences the profit.

  1. Foreseeable risk can be insurance

According to Prof. Knight foreseeable risk are provided against through insurance. For example, the risk of fire can be conversed through fire insurance.

  1. Profit to avoid risk

According to Carver, profit arises due to risk bearing but because of ability of the entrepreneur to avoid risk.

Uncertainty Bearing Theory of Profit

source:slideplayer.com
source:slideplayer.com

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:

  1. Competitive risk:

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.

  1. Technical 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.

  1. Government intervention:

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.

  1. Business cycle:

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.

Criticisms of Uncertainty Bearing Theory of Profit

  • Profit relates not only to uncertainty.
  • Uncertainty is not a separate factor of production.
  • It ignores the distribution of profit.
  • It does not study monopoly profit.

(Jha, Bhusal and Bista)(Karna, Khanal, and Chaulagain)

Bibliography

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.

  1. Profit is the reward for taking risk and responsibility but not the reward from management or co-ordination. 
  2. Gross profit is the excess revenue over the explicit cost of production. 
  3. Net profit is the excess revenue over all types of cost of production.
  4. Risk bearing theory of profit is the traditional theories of profit. It was propounded by an American Economist F.B. Hawley in 1907.
  5. Uncertainty-bearing theory  is known as improved version of risk theory. It was introduced by F. H. Knight. 
  • Causes of profit
  1. Effective combination of other inputs
  2. Innovation
  3. Bargaining power
  4. Risk involved in business
  5. Uncertainty

 

 

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