Rent,wages,interest and profitPresentation Transcript
Rent, Wages, Interest and Profit
Goods or services, which contribute in producing something, are called the factors of production. The major factors of production as classified by economists are land, labor, capital and entrepreneurship.
The factors of production are rewarded for their contribution to the production of goods and services. The reward for land is rent, for labor it is wages, for capital it is interest and the reward for entrepreneurship is called profit.
Determination of factor prices is different from the determination of product pricing which is based on the demand and supply of products.
The reason is that unlike products, factors of production have a derived demand and also joint demand as they contribute in a combined way in the production of goods or services
Moreover, the supply of factors of production is also different from the supply of goods as the cost of production with regard to factors of production is difficult to estimate.
On the other hand, modem economists believe that factors of production can also be priced based on the forces of demand and supply in a manner similar to the determination of product prices.
While determining the demand for any factor of production, profit maximization acts as the principle and the market demand is determined by summing up the demand from all the firms.
The supply of factors of production in a market is determined by summing up the supply of factors of production from all the factor owners in the market.
THEORIES OF FACTOR PRICING
Factor pricing means the price paid for the services rendered by the factor of production but not the price of the factor itself.
As goods are produced through the combined efforts of the factors of production, the income earned through sale of products or remuneration for services is distributed among the four factors of production.
Theories of factor pricing suggest the ways to distribute the income among the factors of production.
The process of income distribution can be done in two ways. They are: personal distribution and functional distribution.
Personal Distribution : In this form of income distribution, the national income of a country is distributed among the owners of various factors of production such as rent for land rented, wages for labor, interest on the capital invested, and profit for entrepreneurship.
Thus, the pattern of individual income generation is studied under personal distribution.
Functional Distribution: Functional distribution of income distribution deals with the distribution of income among the four factors of production - land, labor, capital, and the entrepreneur.
It lays emphasis on the sources of income for factors of production such as rent for land, wages for labor, interest for capital, and profit for entrepreneur.
There are two theories for functional income distribution. They are the macro theory of distribution and micro theory of distribution (Theory of factor pricing).
Macro & Micro theory of distribution
Macro theory of distribution:
Macro theory of income distribution deals with the distribution of national income among the factors of production. This process of national income distribution can be termed as macro distribution.
The macro theory of distribution helps determine the relative shares of different factors of production and also deals with the effects of economic development on those relative shares.
Micro theory of distribution theory of factor pricing:
Micro theory of income distribution concentrates on individuals unlike macro theory which deals with aggregates of a nation. This theory of factor pricing determines the ways to distribute rewards for factors of production.
Basically two micro theories are considered for the determination of factor prices. They are: marginal productivity theory of factor pricing and modem theory of factor pricing
Marginal Productivity theory of Factor Pricing:
Many economists have contributed to the development of the marginal productivity theory determining the rewards for various factors of production.
David Ricardo initially used the theory to determine rent for land. The statement of marginal productivity theory as given by J.B. Clark is, "Under static conditions, every factor including the entrepreneur would get remuneration equal to its marginal product”.
Demand for factors of production is derived from the demand from firms for the same. Since factors of production are utilized in the production process, their demand is based on their productivity.
As the productivity of a factor increases, its price also increases. Marginal Physical Productivity (MPP) is the change in the total physical product or production, when one more unit of anyone factor of production is added while other factors are kept constant.
Marginal Value Product (MVP) is the monetary representation of the MPP i.e., MVP =MPP x Price.
Marginal Revenue Productivity (MRP) is the change in the total revenue for the producer when an additional unit of a factor of production is employed while the quantity of other factors is kept constant.
Average Revenue Productivity (ARP) is the average revenue per unit of a factor of production.
Marginal productivity theory is developed as an explanation to the following points:
Reward of each factor unit is equal to its marginal productivity.
Reward for each factor of production will be the same in every use.
In the long-run, under perfect competition, each factors of production will get its remuneration that will be equal to its Marginal Revenue Productivity (MRP) which also equals its Average Revenue Productivity (ARP)
Modern theory of Factor Pricing
As the marginal productivity theory of factor pricing was based on impractical assumptions, and concentrated only on demand side ignoring the supply side, the modern theory of factor pricing was developed to explain the determination of factor prices. In fact, the modem theory considered both the demand side and supply side to determine prices for factors of production.
Demand side Demand for factors of production is derived demand or indirect demand unlike the demand for goods which is direct. The demand for a factor of production is based on the contribution of the factor with regard to the production of a good, which can be termed as the productivity of the factor.
The demand for a factor of production also depends on the demand for the goods produced using the factor.
By aggregating the individual demands or marginal revenue productivity (MRP) curves of all firms in the market, the market demand curve for a factor of production can be obtained.
This marginal revenue productivity curve for a factor of production is subject to changes in demand and to the changes in the quantity demanded.
Changes in demand for a factor of production may be due to the following reasons:
Change in demand for the final product produced using the factors of production.
Change in productivity in terms of quality or quantity being produced.
Change in the prices of substitute or complementary factors used in the production process. For example, demand for labor and machines are interrelated and firms may utilize more or less of one of them, if the relative price of either of the factors of production increases against the other.
MEANING OF RENT
Rent can be termed as the reward for land which is one of the four factors of production. For economists, the term 'land' indicates natural resources like ground water, forests, rivers, oil fields, mineral deposits, etc., apart from the physical soil.
Since land is a natural product and cannot be reproduced, the supply of land is permanently fixed and in general perfectly inelastic. Usually the term rent refers to the payment made to the owner of the factor to use the same for a specific period of time.
Here, the term land includes any material asset which has a fixed supply. For instance, payment made to use a house, vehicle, or machine is termed as rent.
However, economists term it as 'contract rent' as it includes return on capital invested in material assets. 'Economic rent' is the term used by economists to refer to the payment made for usage of land.
In fact there are variant views aired by economists with regard to the concept of rent. Some of them are rent as a differential surplus, scarcity rent, and quasi-rent.
Rent as a Differential Surplus: David Ricardo (Ricardo), a British economist, defined rent as, "the price paid for the use of original and indestructible powers of the soil." Ricardo explained rent as differential surplus which indicates that rent is the surplus of revenue over costs which arises due to differences in the level of fertility or usability of land.
Higher rent can be earned by the landowners, if the quality of land is better. •
Scarcity Rent :
According to modem theory of factor pricing, the scarcity of land acted as the basis for the concept of rent. According to the theory, rent would arise even if all lands are of equal quality.
The modem theory further suggested that rent does not determine price but is determined by price i.e., when the prices are high, high rent is charged and not vice-versa.
According to Alfred Marshall (Marshall), an English economist, rent is the income obtained due to ownership of land and other natural resources.
Marshall opined that land is a natural resource and its supply is perfectly inelastic considering the society as a whole. However, for an individual person, firm, or industry, the supply of land depends on the prevailing rent thus it is elastic in nature.
In his view, as the supply of land is fixed, rent can be earned even in the long-run. Apart from land, other factors which have limited supply can also earn rent but only for a short- period of time.
THEORIES OF RENT
Various economists have proposed different theories for the origin of rent. Prominent among the theories of rent are the Ricardian theory and the modern theory of rent.
Ricardian Theory: David Ricardo, (Ricardo) a British economist, proposed the 'Ricardian theory of rent'. The definition of rent as, "Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil."
It can be deduced from this definition that rent arises due to the following two reasons:
1. Differences in the productivity of various pieces of land.
2. Situational differences .
Postulates of the Ricardian theory: Some of the basic assumptions of Ricardian theory in relation to land, and its demand and supply, are:
• The supply of land is fixed and the existing quantity of land gifted by nature cannot be increased or decreased.
Another assumption is that original powers such as fertility of land are gifted by God and are not due to human efforts of any type.
Ricardo's theory of rent was based on assumption that land is a non-perishable factor of production. The powers/qualities of land cannot be destroyed and the fertility of land never diminishes.
Another basic assumption is that utilization of land for cultivation is done based on the order of fertility of land. Most fertile land is cultivated first before using the next grade land.
Ricardo assumed that the law of diminishing returns or increasing costs operates in agriculture.
It is also assumed that different lands have different fertility levels.
Land is assumed to be free gift of nature. Therefore, it does not have cost of production.
Assumption of perfect competition is also made.
Ricardo assumed the existence of margin land which is a 'no rent land'. It could be understood as the grade of land after which no land is used.
Ricardo's theory also supposes that lands are located at different locations i.e. some of them are near to the market than others.
Ricardo believed that rent is a surplus arising because of differences in fertility and locations of land. Ricardo explained the origin of rent based on the assumption that 'marginal land' exists.
Marginal land can be defined as that area of land that barely covers its costs with the market value of its produce.
To put it differently, marginal land represents the grade of land below the level of which no land is used. The land with better productivity than marginal land is termed as 'intra-marginal land'. Ricardo opined that rent is the differential surplus between the earnings of marginal land and intra-marginal lands. Rent arises in both the two types of farming techniques-extensive cultivation and intensive cultivation.
Extensive cultivation: In the farming technique of 'extensive cultivation', production of farm is increased by bringing more and more land under cultivation.
Ricardo used the assumptions listed earlier to explain the origin of rent in the extensive cultivation technique.
Intensive cultivation: Under intensive cultivation technique of farming, the production of the land is increased by employing increased number of labor and capital units.
Ricardo assumed the function of the law of 'diminishing returns' in agriculture. It implies that when more and more units of labor and capital are employed after a certain stage, there is going to be diminishing rate of increase in the production of the farm.
This indicates that rent arises even when all the plots of land are equally fertile and all the plots of land are comparable even with regard to nearness to the market.
Ricardo believed that as the law of diminishing returns is applicable to agriculture, the marginal product of labor and capital will be diminishing.
Marginal product refers to the increase in the total production when one more unit of labor and capital are employed while other factor units are kept constant .
Modern Theory of Rent
The modem theory of rent is an integrated set of ideas of different economists such as Marshall, Joan Robinson, and Boulding.
The modem theory improves on Ricardo's theory of rent and extends the concept of rent which was linked to land alone to other factors of production which have inelastic supply in the short run.
Ricardo believed that the supply of land is permanently fixed i.e., perfectly inelastic, and further the various lands have different fertility levels.
The surplus produced by more fertile lands over the marginal land is considered to be the rent.
Modern economists are of opinion that the supply of labor, capital, and entrepreneurs are also limited when compared to their demand and cannot be altered in the short run.
As different lands differ in their fertility levels, other factors of production differ in the level of efficiency and productivity.
Therefore, an improvement was made over the Ricardian theory to introduce the idea that apart from land, other factors of production, labor, capital, and entrepreneur can also earn rent.
Other improvements are that since the supply of land is fixed and is scarce, it earns scarcity rent, and further due to difference in fertility levels of various plots of land, they earn differential rents .
Ricardo's theory of rent provided an explanation that the surplus which is produced by the more fertile lands above the cost of cultivation can be considered to be the rent.
But the theory does not explain how to determine the rent . Modern economists advocated that rent can be determined by the forces of supply and demand similar to the determination of prices for products and other factors of production.
The modem theory of rent suggests that rent is determined by the level of increase in demand for
land over its supply. As the supply of land is fixed, higher demand for land will increase the rent of land.
Hence, modern theory of rent is also termed as the scarcity theory of rent .
Modern Analysis ; Modern economists differed with the view of Ricardo. They believed that rent affects the price of produce of land in the following situations:
• When land is under control of few landlords who compel fanners to pay rent on even the marginal land.
• If people are more dependent on land in countries like India, then the land owners increase the rents and the actual rent becomes higher than economic rent.
• The productivity of land differs when land is used for production of different varieties of crops. Then the rent affects price as there may be surplus when a particular variety is produced while no surplus for other varieties of crops.
• The scarcity of fertile/prime land leads to rent having an affect on price.
CONCEPT OF WAGES
Labor is one of the four factors of production. In economics, the term labor refers to both physical and mental work.
Wage is the remuneration paid for labor. Payment of wages can be done in different modes such as time wages, piece wages, task wages, cash wages, kind wages and service wages.
Time wages are the wages which are paid on the basis on number of hours worked.
Piece wages are the wages which are paid depending on the quantity of output produced.
Task wages are the wages which consider accomplishment of a task for payment of wages.
Cash wages are the wages which are paid in money form.
Kind wages are the wages which are paid in the form of commodities.
Service wages are the wages which are paid through a return service for the service rendered.
DISTINCTION BETWEEN REAL WAGES AND NOMINAL WAGES
Apart from the different types of wages we have discussed till now, wages can also be classified on the economic basis into nominal wages and real wages. The value of wages earned by a worker is different in terms of nominal wages and real wages.
Real Wages : Organizations provide various facilities to workers apart from paying salaries. The additional facilities such as transportation facilities, medical facilities, accommodation, and other allowances paid in addition to the salary constitute the real wages of workers.
“ Real wages or real earnings refer to the purchasing power of the worker's remuneration i.e., the amount of necessaries, comforts and luxuries which the worker can command in return for his services."
If the money earned by a worker is Rs. 10,000 per month, his/her nominal wage is Rs. 10,000 but the real wage refers to the purchasing power of the money earned i.e., how much the worker can purchase with Rs. 10,000.
Real wages serve as indicators with regard to the prosperity level of workers. If the purchasing power of money is high, real wages are considered to be high.
Smith, a renowned economist, stated that the laborer is rich or poor, is well or ill-rewarded in proportion to the real, not the nominal, wages of his labor.
Nominal Wages: According to Prof. Thomas, "nominal wages or nominal earnings refer to the amount of the wages as measured in terms of money.“
Nominal wages are also known as money wages and refers to the payment to a worker for the service rendered in terms of money. For instance, if an amount of Rs.I0,000 is credited to a worker's bank account as a salary for a month that amount is referred as the nominal wage of the worker.
Production of goods is not complete without the combined efforts of all factors of production. Hence, successful management of business is dependent on the successful management of all the factors of production.
The reward for land is rent, whereas the reward for labor is called wages. In this chapter, we will discuss about the remaining two factors of production namely, capital and organization or the entrepreneur.
The reward for capital is known as interest and the reward for entrepreneurship is known as profit.
Therefore, an entrepreneur is concerned with the interest rates because interest rates will have an impact on his business.
For instance, an increase in interest rates would cause the entrepreneur to lower his capital requirements, and this in turn would have an impact on the production process.
An entrepreneur uses his entrepreneurial abilities and manages all the factors of production. In this way, he successfully accomplishes the task of producing goods.
He further makes efforts to sell these finished goods in the market. The reward he gets for all these efforts is known as profit.
Profits motivate entrepreneurs to improve their efforts and thereby improve the production process.
Thus, profits have an impact on business practices. Therefore, an understanding of interest and profit are crucial for the successful management of business.
Hence, the rewards for capital and entrepreneurship are of great importance to an 'entrepreneur'
What is Interest?
The reward for capital is known as interest. The owner of the capital receives interest for lending his/her capital to others.
Capital can be classified into two types – fixed capital and variable capital. In fact, when we say capital, it includes both fixed and variable capital.
However, interest is the income earned only on the variable capital. Interest is earned only on that portion of capital which is given by the owner to the borrower.
In other words, it is the price paid by the borrower to the lender who parted with his money.
Why do people get paid for lending their money? Money in the form of cash provides the holder with benefit because it enables him to buy anything that he desires.
However, if an individual lends it to another person, then he will have to wait until he gets back his money and only then he can utilize it.
According to John Maynard Keynes, "Interest is a reward for parting with liquidity for a specified period."
Gross interest : When the borrower pays an amount to the lender for borrowing the lender's money, the amount so paid by the borrower is known as 'interest'.
Therefore, when people refer to interest, they generally refer to 'gross interest'. Gross interest is the total amount paid by the borrower to the lender of the money.
Net interest : Net interest is the amount paid to 'capitalists' only for the use of 'capital'. It is the reward paid to the capitalists exclusively for the use of capital.
Net interest is the compensation for lending capital to others under conditions where there is no risk or inconvenience due to investment (investments made with no savings motive) and the lender is not required to perform any work other than lending his money.
Therefore, net interest is a part of the gross interest. Gross interest consists of some charges along with the net interest.
Gross Interest = Price of the Capital (Net Interest) + Reward for taking risk of money lending + Reward for management of loan + Others (such as the reward for accepting the inconveniences involved in money lending).
Gross interest thus includes compensation for loan of capital, compensation to cover risk of loss (either business risk or personal risk), compensation for inconvenience of investment, compensation for work and apprehension related to monitoring investment.
Saving and investment: According to the theory, savings and investment are not interdependent. It is known that the income level changes along with the changes in investments.
The changes in investment levels invariably have an impact on the savings of individuals. Therefore, it is not correct to say that saving and investment are independent of each other.
Liquidity Preference Theory of Interest
John Maynard Keynes (Keynes) propounded the 'liquidity preference theory of interest'. His theory is based upon the belief that people prefer absolute liquidity (cash) to other forms of wealth in the short run.
Keynes criticized the classical theory of rate of interest on the grounds that they combined real and monetary factors together.
According to Keynes, the rate of interest is purely a monetary phenomenon. He said that determination of interest, thus, is dependent upon the demand for and supply of money in the economy. Keynes proposed that interest is equilibrium between the demand for and supply of money.
Keynes opined that a person who lends money gets the reward called 'interest' for parting with' liquid money'.
Keynes explains, “The rate of interest is the premium which is to be offered to induce the people to hold wealth in some form or the other than hoarded money." According to him, interest is the incentive that drives moneylenders to part with their money and lend it to people.
What is liquidity preference? The liquidity feature of money empowers us with 'purchasing power', hence, the preference for cash to other forms of money. People's fondness for cash or liquid money is called as 'liquidity preference' .
Why do people prefer liquidity? According to Keynes, people prefer liquidity to other forms of money because they want to satisfy the three kinds of motives:
• Transaction motive
• Precautionary motive
• Speculative motive
Transaction motive: When people demand for liquid money to carry out their day-to-day transactions, the demand for such liquidity is known as 'transaction motive'.
For example, people need money to travel from one place to another, to buy goods and services, etc. For this, they are required to stock some amount of cash with them. So, when people require cash to complete their economic transactions, the motive behind the demand for such cash is known as transaction motive.
Precautionary motive: Since people are uncertain about their future, they prefer to save money with a view to safeguard their future.
People attempt to meet contingencies and unforeseen circumstances that may happen in the future by saving. Hence, the demand for liquidity to safeguard their future is known as the 'precautionary motive'.
Ex.1. Income levels of people impacts precautionary demand for liquidity to a great extent. 2. Some people are optimistic about their future, while others are pessimistic. Optimistic people anticipate lesser risk in the future when compared to pessimistic people. 3. A farsighted person can visualize the future in advance and makes a better analysis of the future.
Speculative motive : This is the most important motive behind the demand for liquidity. The motive for stocking cash here is to take advantage of the changes in the price levels of securities and bonds.
If people anticipate that the prices of securities will go up in the future, hen they prefer to purchase securities now. In such a situation, the liquidity preference of people will be low because they like to spend cash and purchase securities (with a view to gain profit in the future).
On the other hand, if they anticipate that the prices of securities would go down in the future, then they prefer to hold cash.
This is because, they would like to wait and purchase securities in the future when the prices of the securities fall. In such a situation, the liquidity preference of people will be high.
Hence, it can be said that the liquidity preference of people is affected by the speculative motives .
What is Profit? Just like rent is the reward for land, wages for labor and interest for capital, profit is the reward for entrepreneurship.
While the rewards for other factors of production are paid by the entrepreneur, profit is the reward received by entrepreneur himself.
Simply put, profit is the income of an entrepreneur for utilizing his entrepreneurial abilities and running a business.
Profit is nothing but the surplus amount left with the entrepreneur after paying all the factors of production.
If the income earned by him is in excess of the costs incurred on the factors of production, then the income can be called as profit.
Therefore, profit can also be defined as the difference between the total value of output (total revenues received by the businessman) and the total value of inputs (total costs incurred by the businessman) of a business.
Profit =Value of Outputs - Value of Inputs
Profit is also viewed as a reward earned by the entrepreneur for performing the entrepreneurial
function in a business. There are other economists who believe that profit is the reward for making innovations in business.
Profit consists of two major components - gross profit and net profit .
Gross profit : Generally, people consider profit as the residual income left with the entrepreneur after making all the payments to other factors of production.
However, it should be noted that this is gross profit. The gross profit is arrived at after excluding all the explicit costs from the revenues received by the business.
It does not exclude implicit costs such as rent forgone by entrepreneur for utilizing his own land for business purposes, interest forgone on his own capital, etc.
Gross Profit =Total Revenues - Total Explicit Costs
Gross profit thus includes those costs which go unrecorded in the books of accounts, but which are nevertheless important to determine the profit made by the business.
Net profit: The net profit can be arrived at by subtracting the implicit costs from gross profits.
This is also sometimes referred to as 'pure profit'. Net profit is the surplus leftover after deducting explicit and implicit costs from the sales receipts of a business.
Net Profit =Gross Profit - Implicit Costs
Thus, it can be observed that net profit is a portion of the gross profit. When a business gets zero net profit, it means that the profit attained is just enough to meet the explicit costs of the business.
In other words, the entrepreneur's revenues could not payoff his efforts (or implicit costs) such as utilizing his own resources, undertaking risk and uncertainty of business, etc.
Normal profit : It is the minimum return that an entrepreneur receives for performing entrepreneurial functions such as bearing risk and uncertainty, managing other factors of production, etc.
Abnormal or super profit: The income remaining with the entrepreneur after subtracting all costs (both implicit and explicit) from the revenues received from the business. It is an excess over the normal profit.
THEORIES OF PROFIT
Though there are several theories of profit that attempt to explain the emergence and growth of profit, none of the theories give a comprehensive picture on profit.
Traditional Theories : F.A. Walker one of the prominent non-classical economists, propounded the 'rent theory of profit ', which was similar to David Ricardo's (Ricardo) 'theory of rent '. Later, Taussig and Davonport developed the 'wage theory of profit ' and proposed that like a laborer works physically and earns his wage, an entrepreneur works mentally and earns his wage called profit..
Walker's rent theory of profit : The 'rent theory of profit' was developed by Francis. A. Walker (Walker). Be advocated that different lands earned different rents depending upon the fertility of land.
In the same way, businessmen earned 'rent of ability' called profit. He opined that some entrepreneurs earned higher profits because of their greater ability to run business when compared to other entrepreneurs.
According to him, the rent earned by more fertile or intra-marginal lands was the difference between the total production of intra-marginal and marginal lands.
He further explained that there existed both intra-marginal entrepreneurs and marginal entrepreneurs and that the former are abler than the latter. Hence, the intra-marginal entrepreneurs earned rent of ability called profit.
He opined that rent and profit are no different from each other and just as there is a no-rent or marginal land, there is also a no-rent entrepreneur or marginal entrepreneur.
Limitations of 'rent theory of profit':
Critics said that comparing profits with rent is impracticable. Rent can never be zero and is always positive. However, the same is not the case with profits, as profits can be negative or zero.
One of the main opponents of Walker's 'rent theory of profit', J.B. Clark, opined that profits occur only under dynamic conditions. However, rent can be earned under both static and dynamic conditions.
The theory assumes the existence of marginal entrepreneur i.e. entrepreneurs who do not earn any profit. This is an absurd concept because any businessman who does not earn profits would pull back from business. Further, critics said that just as there cannot be a 'no-rent land', there also cannot be a 'no-profit entrepreneur'.
Several economists pointed out profits earned are also a result of risk-bearing, innovation, etc. and not just because some entrepreneurs are 'abler' than others.
Some economists criticized that while rent is a fixed (or expected) income, profit on the other hand was unknown. An entrepreneur cannot anticipate whether he will get profits or losses in future and its magnitude.
As land is a free gift of nature, its supply is limited. However, the supply of entrepreneurs is not limited and is perfectly elastic.
Modern Theories: The modem theories of profit include Clark's dynamic theory , Schumpeter's innovation theory , Hawley's risk theory , Knight's uncertainty-bearing theory among others.
Dynamic theory of profit: According to him, profit is the difference between the cost of producing goods and the prices of these goods. In a stationary state, there is always equilibrium between demand and supply of goods.
Hence, there is no difference between the prices of goods and their costs, and therefore net profits do not accrue to the entrepreneur. Under dynamic conditions, however, there is disequilibrium between demand and supply conditions of economy. In such a state, there are often changes in the determinants of demand and supply.
Clark said that in reality, however, there exists a dynamic economy. He said that there are bound to be unforeseen changes in demand and supply. According to Clark, the dynamics in demand and supply conditions could be a result of:
• Changes in the quality and quantity of human wants
• Changes in governmental rules and regulations regarding trade
• Changes in technology that effect the production process
• Rise in population
• Adjustments with regard to amount of capital stock with the economy
In a dynamic economy, surplus occurs because of the frictions or obstructions to mobility of resources and even the existence of monopoly element.
According to the theory, surpluses would be eliminated by the forces of competition in the long run.
Innovation theory of profit : Joseph Schumpeter propounded the 'innovation theory of profit '. He proposed that profit is the reward for the innovative abilities of entrepreneurs.
According to him, an entrepreneur who introduces innovation in businesses process reaps benefits in the form of profits, if the innovation proves successful in the market.
Schumpeter defined innovation as any new process or policy adopted by the businessman with a view to obtain reduction in cost of production, or to improve the demand for the product in the marketplace.
According to this theory, the difference between price and costs keep on increasing, if there are continuous innovations in the marketplace. This is also how profits originate.
But, such profits are not stable in nature and are only temporary. An entrepreneur can earn these profits only in the short term. This is because his competitors too adopt the same innovation, thus reducing the entrepreneur's profit.
So, once again the entrepreneur has to differentiate his products from that of competitors through innovations. This again increases the difference between the costs and prices, thus enabling the entrepreneur to earn profits again, until his innovations are imitated by others and profits fall again .
Uncertainty-bearing theory : According to Frank H. Knight (Knight), the most important function of an entrepreneur is to bear uncertainties in business in the form of risks that cannot be insured against. Risk can be defined as the measurable probability of the occurrence of profit or loss situation.
With a view to differentiate between risk and uncertainty, Knight divided risks into:
• Insurable risks
• Non-insurable risks
According to Knight, insurable risks are those risks which the entrepreneur can avoid through insurance. These risks can be in the form of loss of assets due to fire, accident, theft, etc.
An entrepreneur gets cover for these losses by paying a premium to the insurance companies and reclaiming the same in the event of mishap. Therefore, he does not have to bear uncertainties for insurable risks.
These risks can be in the form of changes in people's habits, price level fluctuations, etc. Non-insurable risks are unpredictable and unavoidable and hence are uncertainties.
Knight proposed that profits or losses are the rewards an entrepreneur receives for bearing these uncertainties.
Uncertainty arises for non-insurable risks. Non-insurable or unpredictable risks are those risks which are unforeseen and for which no information is available to estimate or forecast. Also, non-insurable risks cannot be covered under insurance coverage.