BATCH 21 - GROUP 1

Milind R. Chandane - KHR2010SMBA21P009

Sunita Kadam - KHR2010SMBA21P014

Samrat Mazumder - KHR2010SMBA21P028

Kaushal Patel - KHR2010SMBA21P042

Divya Suresh - KHR2009SMBA18P042

Vaibhav Gupta - KHR2010SMBA21P049

THEORIES OF PROFIT

INTRODUCTION Profit is the reward of the entrepreneur,

rather of the entrepreneurial functions. Profits differ from the returns on other factors

of production such as land - rent, labour – wages, capital – interests.

Ordinary language - profit is all about excess of income over costs of production. It includes – earnings of self used factors – entrepreneur’s own land, capital and his own labour work called respectively.

But in economics, profit is regarded as a reward for the entrepreneurial functions of final decision making and ultimate uncertainty – bearing.

As a difference between total revenue and total cost – as a reward for risk taking or uncertainty- bearing as a reward for innovation and so on.

TYPES OF PROFIT

1. Gross Profit and Net Profit: Gross Profit is the surplus profit which

accrues to a firm when it subtracts its total expenditure from its total revenue.

Gross Profit = Total Revenue – Total Cost. Which includes – net profit, remuneration for

the factors of production such as rent, interest, wages etc and depreciation and maintenance charges.

Net Profit or Pure Profit is the residual left with the entrepreneur after deducting the remuneration for the factors of production contributed by entrepreneur, depreciation and maintenance charges and extra personal profits from gross profits.

Net Profit is a reward for co-ordination, reward for innovation, reward for risk taking and reward for uncertainty bearing.

2. Business Profit and Economic Profit: Business Profit/Accounting Profit –

excess of revenue receipts over the cost of production of goods and services.

Business Profit = Total Revenue – Explicit Cost.

Economic Profit includes both explicit and implicit cost of production.

Economic Profit = Total Revenue – Explicit and Implicit Cost

3. Normal Profit and Super Normal Profit: Normal Profit is the profit which accrues to

an entrepreneur in the long period, where price of the product = average cost (MC = MR and AR = AC).

It is included in the cost of production. Super Normal Profit is a kind of surplus

which accrues to the super marginal entrepreneurs, where price of product is higher than average cost (Price > AC).

It is not included in cost of production.

THEORIES OF PROFIT Risk Theory of Profit

Uncertainty - Bearing Theory of Profit

Schumpeter’s Innovation Theory of Profit

Marginal Productivity Theory

Keynesian Theory of Profit

RISK THEORY OF PROFIT Risk Theory of Profit was advocated by an

American Economist – Prof. Hawley.

Profit arise because the entrepreneur undertakes the risk of the business.

If the entrepreneur is not rewarded he will not be prepared to undertake risks.

Higher the risk greater is the possibility of profit.

TWO TYPES OF RISK

1. Insurable Risks: These are predictable/measurable and which

are insurable for – fire, theft, flood, accident etc (which are the risks in business).

2. Non Insurable Risks: These are unforeseeable risks or cannot be

measured/identified. For instance, competitive risks, technical risks, risk of government risk arising out of business cycle.

UNCERTAINTY-BEARING THEORY OF PROFIT

Uncertainty-Bearing Theory was advocated and developed by Knights. It is also called as Modern Theory of Profits.

According to Knight, pure profits are linked with uncertainty and risk bearing.

There is a direct relationship between profit and uncertainty bearing. Greater the uncertainty bearing, higher the level of profits.

It is considered as a separate factor of production.

SCHUMPETER’S THEORY OF INNOVATION

The theory propounded by Schumpeter explains the changes caused by innovation in the productive process.

According to this theory, profit is the reward of innovations.

Innovations refers to all those changes in the production process with an objective of reducing the cost of production.

Innovation always reduces cost of production.

CHOOSING A HISTORICAL ROOT: INNOVATION THEORY

CHOOSING A CURRENT ENG SYS METHOD: STRATEGY DEVELOPMENT

OVERVIEW

CONNECTIONS BETWEEN INNOVATION THEORY AND STRATEGY DEVELOPMENT

WHICH MODERN DISCIPLINES ARE IMPACTED BY SCHUMPETER’S WORK?

FORMS OF INNOVATION Introduction of a new technique or a new plant.

Changes in the internal structure or organization’s setup.

Changes in the quality of the raw material.

New sources of energy.

Better method of salesmanship.

TECHNOLOGICAL INNOVATION

Innovations revolutionize production in ways Innovations revolutionize production in ways even innovators can’t foresee…even innovators can’t foresee…

1954 1954 expertexpert vision of 2004 “home computer” vision of 2004 “home computer”

MARGINAL PRODUCTIVITY THEORY

It was developed by Prof. Chapman – Profits are equal to marginal worth of the entrepreneur and are determined by marginal productivity of the entrepreneur.

When the marginal productivity is high, profits will also be high and vice-versa.

But it is difficult to measure the marginal productivity of the entrepreneur.

In case of other factors such as land, labour and capital, marginal productivity can be measurable either increasing or decreasing the units of factors.

THREE(OR FOUR) MARGINALS

The focus of marginal productivity theory is on marginal product. There are, however, three related "Marginals" that need to be noted:

Marginal Product: This is the change in total product resulting from an incremental change in the quantity of the variable factor input used.

Marginal Physical Product: This is another term for marginal product which serves to emphasize that production is measured in physical units rather than monetary units.

Marginal Revenue: This is the change in total revenue resulting from an incremental change in the quantity of the output produced.

Marginal Revenue Product: This is the change in total revenue resulting from an incremental change in the quantity of the variable factor input used.

Marginal Revenue Product = Marginal Product x

Marginal Revenue

KEYNESIAN THEORY OF PROFIT

Relates money supply variability and uncertainty to inflation and deflation.

Variability of prices is a major cause of business cycles.

Wages and other costs of production adjust more slowly than prices.

Therefore price variability affects profits and therefore investment.

Investment cycles cause business cycles.

THE GENERAL THEORY If the consumer is an economic optimizer, he/she

must be unable to buy the goods they planned to buy because of some kind of constraint—risk, convention, social institutions, cash, or ...?

According to the classical model, the consumer has insatiable wants.

The consumer sells his/her labor in exchange for enough income to buy the goods.

The money value of the incomes received must be equal to the value of the output produced.

So how can unsold goods pile up in warehouses, causing firms to lay off workers?

The GENERAL THEORY (2) Say’s Law cannot hold. (“Supply creates its

own demand.”)

If spending constraints are in effect, then there will be a difference between (unlimited) demand and “effective demand”.

Actual (effective) demand will usually be “deficient” to purchase total output.

THE GENERAL THEORY (3) Microeconomics and macroeconomics do not

operate on the same basis. One cannot assume that what is true for the economic agent at the level of the individual consumer or firm is true in aggregate. This amounts to the fallacy of composition.

In microeconomics, relative price effects dominate. This is not true in macroeconomics. In macroeconomics, income effects dominate, making income more important in determining aggregate economic behavior.

THE GENERAL THEORY (4) Therefore, consumption depends primarily

upon income, not interest rates. C C(r), but rather C = C(Y).

“People don’t change their standard of living simply because the interest rate changes a few points.”

THE GENERAL THEORY (5) Saving occurs as the result of a habit,

convention, or social norm. People on average set aside a certain percentage of their income. Saving is not a function of interest rates.

S S(r), but rather S = S(Y).

Investment is related to interest rates, but also to business people’s expectations for the future.

That is, I = I(r,E).

THE GENERAL THEORY (6) If S = S(Y) and I = I(r,E), then there is no coordinating

variable to bring supply and demand together in the loanable funds (capital) market.

There is no reason to assume that supply equals demand in this market.

There is no reason to believe that there will be adequate funds available to provide adequate investment demand.

Since AD = C + I + G + NX, if investment demand is deficient, then AD < AS, and inventories may pile up, with unemployment a natural outcome.

Without the coordinating variable, this will be the normal outcome, with AD = AS only happening accidentally.

THE GENERAL THEORY (7) Investment is a large and long-term

commitment, and is based on weakly supported expectations about the future. This makes investment very different from consumption. Investment decisions will be erratic and emotional, and the risks associated with investment are very high. As a result, business decision makers will tend to under-invest, further worsening the problem of deficient investment.

THE GENERAL THEORY (8) It may be a natural outcome of the

organization and institutions of modern economies that prices and wages may not be fully flexible. This would result in markets (like the labor and goods markets) being unable to clear, leading to unemployment and aggregate supply exceeding demand.

THE GENERAL THEORY (9) Money plays a key role in the economy. The use

of money leads to uncertainty, and makes “piercing the veil” impossible. A money economy is fundamentally different from a barter economy. The classical dichotomy cannot hold.

Interest rates are established in the money market.

People may rationally hoard money, holding money for purposes other then making transactions.

Equilibrium is not AD=AS. It is a state that persists.

CONSUMPTION

01000

2000300040005000

60007000

0 2000 4000 6000 8000 10000

Real GDP

Con

sum

pti

on

CONSUMPTION FUNCTION c = mpc = C/Yd = marginal

propensity to consume

C0

Yd

C

C

Yd

C = C0 + mpc x YdOr

C = C0 + cYd

ORIGINAL AGGREGATE EXPENDITURE MODEL

Total ExpenditureC+I+G

d

Plannedexpenditureexceeds real GDP

Real GDP (trillions of 1992 dollars per year)

4.0

6.0

8.0

10.0

0 2 4 6 8 10

a

b c

e

f

Real GDP exceedsplanned expenditure

45o line

Equilibriumexpenditure

IG

C0

Aggregate planned

expenditure(trillions of

1992 dollars/year)

ALGEBRA OF THE MODEL

Y = C + I + GBut C = C0 + c(Y-T), So Y = C0 + c(Y-T) + I +

GY = C0 + cY – cT + I + GY – cY = C0 + I + G – cTY(1-c) = C0 + I + G – Ct

But this means that

cTGICc

Y

01

1*

Gc

Y

1

1

Ic

Y

1

1

Cc

Y

1

1

Tc

cY

1

But

POLICIES OF PROFIT The main motive of the businessman is to

make profits. Every firm tries to maximize profits.

The amount of profit that a firm makes shows its success and efficiency.

The profit that a firm makes should not be at the point of exploitation of the people.

It should be done through maximizing sales and achieving the lowest cost of production.

Businessman should provide goods and services of good quality at reasonable prices.

THANK YOU