Month: January 2022

Profits or expected profit stream from a productive activity or an investment play a crucial role in decision making by managers.

Therefore, it is necessary to first explain the difference between business profits and economic profits. Business profits are an accounting concept and represent the residual sales revenue to the owners of the firm after making payments to all other factors or resources the firm uses.

These payments to hired factors include the wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw materials used by the firm. The expenditures on these factors or resources hired or purchased by the firms are call explicit costs. Business profit refers to the sales revenue of the firm minus its explicit costs. Thus

Business profits = Total sales revenue – Explicit costs

It is the concept of business profits that is generally used by the business community and accountants.

In their calculation of economic profit, the economists deduct not only explicit costs but also implicit costs from the sales revenue of the firm. The implicit costs refer to the opportunity costs of the resources provided by the firm’s owners themselves including capital and entrepreneurial ability.

These self-owned factors must be paid if they are too employed by the firm in its own production process otherwise, they will be employed elsewhere on hired basis. Thus, economists take into account the normal rate of return on capital used by the owner of the firm in its own business and the transfer earnings of the owner-entrepreneur as costs of doing business.

The risk adjusted rate of return on capital is the minimum return that is necessary to attract or retain it in business and is equal to what the owner could earn from investing in other firms.

Similarly, the opportunity cost of the entrepreneurial effort made by the owner entrepreneur is the salary that he could earn in his next best activity (say, as the manager of another firm). Likewise, the opportunity costs of other self-owned factors or inputs such as land, buildings used by the owner-entrepreneur in his own business will be counted as implicit costs.

The economic profit represents the sales revenue of the firm in excess of both explicit and implicit costs.

Economic profits = Sales revenue – Explicit costs – implicit costs.

While explaining maximisation of short-run profits or present value of the stream of expected profits in the future, economists assume that it is economic profits that owner- entrepreneur or managers of corporations seek to maximise. The concept of economic profits brings into sharp focus the question why such profits which is over and above the normal rate of return on equity capital and reward for entrepreneurial ability in case of owner-entrepreneur, exists and what is its role in a free enterprise system.

In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive market. Then, how does an economic profit, positive or negative, come into existence.

Function of Profits

Profits play an important role in a free market economy. Profits perform two important primary roles in such an economy.

First, profits serve as a signal to change the rate of output or for the firms to enter or leave the industry.

Second, profits play a critical role in providing incentive to introduce innovations and increase productive efficiency and take risks.

Thus, high economic profits being earned in an industry serve as a signal that consumers want more of the commodity being produced by that industry. These profits indicate to the firm to expend output of the commodity and for the new firms to enter the industry to gain a share of economic profits that exist in the industry. As a result, more resources will be allocated to the output of that industry.

On the other hand, below normal profits in an industry serve as a signal that either less output of the industry is demanded by the consumers or inefficient production methods are being used by the firms. In response to the lower demand for the product the firms will reduce their output and also some firms will leave the industry.

As a result, some productive resources will be released from that industry and made available for the production of other goods. If the lower profits are due to the inefficient production and organisation, this will induce firm to improve efficiency by changing the production methods or make organisational changes to reduce costs.

Profit motive drives a free-market economy. Although it has been observed that sometimes managers and entrepreneurs in a free market system are swayed by greed and avarice, and break laws to make money or profits by exploiting the consumers or workers but in general profits perform useful function of sending signals for changing levels of output of various products and for reallocation of resources among them.

Secondly, above normal rate of profits in a free enterprise system is an essential reward for introducing innovations and taking risks. No entrepreneur will introduce new products or more efficient of production methods or undertake investment in risky projects unless there is prospect of making profits. Some firms continue to earn above-normal rate of profit year after year as they are continually introducing new products, new production methods and providing good customer services.

In the economy changes in demand for the product often occur due to cyclical and structural changes. Besides, new strategies of rival firms also affect the demand for the product of a firm. All these uncertain and unanticipated changes involve a good deal of risk. An important function of economic profits is to reward entrepreneurs for taking these risks involved in making investment and organising factors for the production of products.

However, in some cases firms are also able to make supernormal profits by virtue of their having monopoly power. Their monopoly power may be due to some legal patent and license obtained from the government, the economies of large scale production, exclusive control over essential raw materials which prevent the other firms from producing the same product or service.

These enable the monopoly firms to charges higher prices and thereby make large economic profits. Therefore, even in free-market economies steps are taken to prevent the emergence of monopolies through anti-trust laws or Competition Acts as recently enacted in India. Of course, monopolies are legally permitted if they are needed in public interest. For example, in several cities Government grants license to some firms to provide public utility services such electricity, gas, telephone etc.

In these cases of legal monopolies government regulates them and fix reasonable prices to be charged by them from the public but at the same time ensures fair return or normal profits to them on their investment.

It is generally held that the main motive of a firm is to make profits. The volume of profit made by it is regarded as a primary measure of its success. Economic theory advocates profit maximisation as the chief policy of a firm. Modem business enterprises do not accept this view and relegate the profit maximisation theory to the back ground. This does not mean that modem firms do not aim at profits. They do aim at maximum profits but aim at other goals as well. All these constitute the profit policy.

(i) Industry Leadership:

Industry leadership may involve either the achievement of the maxi­mum sales volume or the manufacture of the maximum product lines. For the attainment of leadership in the industry, there has to be a satisfactory level of profit consistent with capital invested, labour force employed and volume of output produced.

(ii) Restricting the Entry:

If a firm follows a policy of restricting its profit, no competitors are likely to enter the market. Reasonable profits which guarantee its survival and growth are essential. According to Joel Dean, “Competitors can invade the market as soon as they discover its profitability and find ways to shift the patents and make necessary changes in design, technique, and production plant and market penetration.”

(iii) Political Impact:

High profits are considered to be suicidal for a firm. If the government comes to know that the firms are earning huge returns, it may resort to high taxation or to nationalisa­tion. High profits are often considered as an index of monopoly power and to prevent the govern­ment may introduce price control and profit regulation policies.

(iv) Consumer Goodwill:

Consumer is the foundation of any business. For maintaining con­sumer goodwill, firms have to restrict the profit. By maintaining low profit, the firms may seek the goodwill of the consumers. Consumer goodwill is valued so much these days that firms often make organised efforts through advertisements.

(v) Wage Consideration:

Higher profits may be taken as evidence of the ability to pay higher wages. If the labour associations come to know that the firms are declaring higher dividends to the shareholders, naturally they demand higher wages, bonus, etc. Under these circumstances in the inter­est of harmonious relations with employees, firms keep the profit margin at a reasonable level.

(vi) Liquidity Preference:

Many concerns give greater importance to capital soundness of a firm and hence prefer liquidity to profit maximisation. Liquidity preference means the preference to hold cash to meet the day to day transactions. The first item that attracts one’s attention in the balance sheet is the ratio of current assets to current liabilities. In order to give capital soundness, the business concerns keep less profit and maintain high cash.

(vii) Avoid Risk:

Avoiding risk is another objective of the modem business for which the firms have to restrict the profit. Risk element is high under profit maximisation. Managerial decision involving the setting up of a new venture has to face a number of uncertainties. Very often experienced manage­ments avoid the possibility of such risks. When there is oligopolistic uncertainty, firms may focus attention at minimising losses. The guiding principle of business economics is not maximisation of profit but the avoidance of loss.

1. Alternative Profit Policies:

Economists have suggested different profit policies which business firms may adopt as an alter­native to profit maximisation.

These alternative profit policies are listed below:

Prof. K. Rothschild observes, “Profit maximisation has until now served as the wonderful mar­ket key that opened all doors leading to an understanding of the behaviour of the entrepreneur. It was always realised that family pride, moral and ethical considerations, poor intelligences and similar factors may modify the results built on the maximum profit assumption, but it was right by assuming that these disturbing phenomena are sufficiently exceptional to justify their exclusion from the main body of price theory. But there is another motive which cannot be so lightly dismissed and which is probably a similar order of magnitude as the desire for maximum profits, namely the desire for secure profits”. He has suggested that the primary motive of an enterprise is long run survival.

According to him, the assump­tion of profit maximisation is no doubt valid to the situation of perfect competition or monopolistic competition. Under monopolistic condition, the aim of the firm is to secure monopoly profits. In the case of oligopoly, he says that the assumption of profit maximisation is not sufficient.

W.J. Baumol puts forth the maximisation of sales as the ultimate aim of the firm. He says while maximising sales the producer will not regard costs incurred as output and profits to be made. If the sales of the company increase, it means that the producer is not only covering costs but also making a usual rate of return on investment. Baumol’s theory of sales maximisation as a rational behaviour of the producer is considered as an alternative to the theory of profit maximisation.

Benjamin Higgins, Mekin Reder and Tibor Scitovsky have developed another alternative to the theory of profit maximisation, that of utility maximisation, if the producer is supposed to maximise his satisfaction. In this approach, they have introduced leisure as a variable. Leisure is an essential ingredi­ent of an individual welfare. If more work is put in by the producer, the less leisure he will be able to enjoy. It is said that the producer would get maximum satisfaction where his net profit is optimum.

Donaldson and Lorsch are of the opinion that career managers prefer policies that favour long term stability and growth of their firms which are possible only when they get maximum current profits. For the survival, self sufficiency and success, the top managers strive hard and augment corporate wealth. The more the wealth, the greater the assurance of the means of survival.

1. Aims of Profit Policy:

The firm seeks to achieve many objectives and profit making is the main objective but it is not the only objective. Profit making is no doubt necessary. In addition to adequate profit, the firm often pursues multiple and even contradictory objectives. If a firm makes sufficient profits, it can give good dividends and attractive salaries, etc. The firm can fix a target rate for profits as its investment. There is a problem in determining the target rate of profits.

They are:

(i) Competitive rate of profit

(ii) Historical profit rate

(iii) Rate of profit sufficient enough to protect the equity, and

(iv) Plough back of profit rate.

Competitive rate of profit is the rate earned by other companies in the same industry or of selected companies in other industries working under similar conditions. It may be slightly different from the rate of profit of other companies.

Historical rate of profit is the rate of profit determined as the basis of past earnings in the normal times. The rates should be sufficient enough to attract equity capital, have provided adequate dividend to shareholders and have not encouraged much competition.

Rate of profit sufficient enough to protect the equity is the rate sufficient enough to attract equity capital and the rate of return on investment should protect the interest of present shareholders. Plough back of profit late is that late of profit Which should be such that there is a surplus after paying the dividends to finance further growth of the industry. Cyert and March have focused on five aims which represent main operative organisational goals.

They are:

(i) Production goal

(ii) Inventory goal

(iii) Sales goal

(iv) Marketing share goal and

(v) Profit goal

Production Goal:

The firms want to maintain the production of the product at a stable level to ensure stable employment and growth. The basic requirement is that the production does not fluctuate.

Inventory Goal:

To ensure a complete and convenient stock of inventory throughout the pro­duction, a minimum level of inventory has to be maintained so that the firm can prevent fluctuations in prices.

Sales Goal:

It is considered as very important from the point of view of stability and survival of the firm. Increasing sales mean progress of the firm. Sales strengthen the organisation. The more are the sales, the more is the profit.

Market Share Goal:

Company sales do not reveal how well the company is performing. If the company’s market share goes up, the company is gaining as a competitor, if it goes down the company is losing relative to competitors.

Profit Goal:

Profits are a function of the chosen price, advertising and sales promotion budgets. Normal profit is essential not only to pay dividends but also to ensure additional resources for reinvest­ment.

The term profit has distinct meaning for different people, such as businessmen, accountants, policymakers, workers and economists. Profit simply means a positive gain generated from business operations or investment after subtracting all expenses or costs.

In economic terms profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the need of individuals in the economy faced with uncertainties. In a layman language, profit refers to an income that flow to investor. In accountancy, profit implies excess of revenue over all paid-out costs. Profit in economics is termed as a pure profit or economic profit or just profit.

Profit differs from the return in three respects namely:

1. Profit is a residual income, while return is total revenue.
2. Profits may be negative, whereas returns, such as wages and interest are always positive.
3. Profits have greater fluctuations than returns.

 

1. Risk-Bearing Theory of Profit:

The main proponent of this theory is Prof. Hawley. According to Hawley, one of the major functions of an entrepreneur is to bear risk that is associated first with the setting up of the business and then with the management of the business.

The risks in a business are of two types:

(i) Risk involved in the selection of the field of business; and

(ii) Risk associated with the management of the business.

After investing capital in a particular busi­ness, the entrepreneur has to wait for a long time before he can know if his selection of the field of business has been appropriate this long wait is a form of risk-bearing.

Again, while managing the business, the entrepreneur has to bear all the risks arising out of unexpected changes in the demand and supply for the product.

There may be sudden changes in the demand for a good owing to changes in the tastes, habits and incomes of the buyers, changes in the availability and prices of the substitute products, etc.

Also, there may be unexpected changes in the supply of the good owing to changes in the availability of the factors of produc­tion and changes in production techniques, etc.

Therefore, that the entrepreneur has to bear the risks associated with the unexpected changes in demand and supply of the product and also the risks associated with the consequent changes in the price of the product, total revenue and profit of the firm. The greater the ability of the entrepreneur to bear all these risks, the higher would be his level of profit. This is the main contention of the risk-bearing theory.

Critical Evaluation of the Theory:

The arguments that may be advanced in favour of the theory are:

(i) The theory attracts our attention to the fact that one of the main functions of the entrepre­neurs is to bear the risks.

(ii) The theory focuses also on the fact that a very few persons come forward to play the role of entrepreneurs because here they would have to bear the risks. That is why the supply of entrepreneurial services is very limited.

Arguments Against the Theory:

Let us now come to the arguments against the theory. These are:

(i) Risk-bearing is not the only function of an entrepreneur who has to perform many vital functions. For example, the entrepreneur has to innovate at regular intervals new products, new markets and improved methods of production and business.

He may augment his revenue and reduce his expenditures through such innovations and, consequently, his profit level would go up. Therefore, profit may also be considered as a reward for effecting innovations. Again, the entrepreneurs, all of them, have not the same ability to face risks and to perform other activi­ties.

Therefore, owing to differences in such ability, some entrepreneurs may earn rent of abil­ity. Similarly, if the entrepreneur is able to establish a monopolistic dominance in the market, then also his income, i.e., profit, would include the added income acquired through monopoly power. Therefore, profit cannot be explained only as a reward for risk-bearing.

(ii) The entrepreneur has surely to bear risks and his profit, at least some part of it, may be considered to be a reward for risk-bearing. However, risk is a subjective concept. We cannot measure risk in an objective, cardinal manner. That is why it is not possible to establish a functional relationship between risk and profit.

(iii) The exponents of the risk-bearing theory of profit did not distinguish between insurable risk and non-insurable risk. But if we are to obtain a good estimate of the amount of risk- bearing, it is essential to remember this distinction. For, the entrepreneurs actually do not bear the burden of insurable risks, it is borne by the insurance companies.

Therefore, they cannot be considered as risks. According to Prof. Knight, the entrepreneurs bear the burden of non-insurable risks and he has called these non-insurable risks by the name of uncertainty. The entrepreneur should obtain profit as a reward for bearing this uncertainty.

2. Uncertainty-Bearing Theory of Profit:

Prof. F. H. Knight (1885-1973) has developed the uncertainty-bearing theory of profit. He says that we may distinguish between insurable risks and non-insurable risks. This distinction is important. For, the entrepreneurs actually do not bear the burden of insurable risks it is borne by the insurance companies. Therefore, they cannot be considered as risks for the entrepreneurs.

For example, we know from experience that factory premises are exposed to the risk of fire. We also know why there may be fire in a factory premise, and so, we may adopt necessary measures for prevention of fire.

In spite of all this, there remains the risk of fire, and, once the insurance companies agree to bear this risk, it no longer remains a risk. In other words, according to Knight, insurable risks should not be considered as risks and there is no question of the entrepreneurs bearing this risk.

However, the entrepreneurs bear the burden of non-insurable risks for there is no insurance company to bear these risks on their behalf. Prof. Knight has called these risks the uncertainties.

He tells us that the entrepreneur should get profit as a reward for bearing the uncertainties of the business world. The more prudently an entrepreneur bears the uncertainties, the more should be the amount of profit to reward him with.

Critical Evaluation of the Theory:

The following arguments are advanced in favour of the uncertainty-bearing theory of profit:

(i) The theory attracts our attention to the fact that not all types of risk are to be borne by the entrepreneur. He actually bears the non-insurable risks. The insurable risks are taken care of by the insurance agencies.

(ii) The theory tells us that, like all other productive services, uncertainty-bearing is also a productive service. The entrepreneur supplies this productive service and profit is the price of this service.

(iii) Since, in general, people are averse to uncertainty-bearing, the supply of entrepreneurs in the real world is very small. This impression is also obtained from the theory.

Arguments Against the Theory:

The following arguments are advanced against the theory:

(i) Uncertainty-bearing is not the only function of an entrepreneur. The innovation of new products, new markets or new production and business techniques are also among the main tasks of an entrepreneur.

Therefore, along with the function of uncertainty-bearing, that of innovation may also be the source of profit. Again, the rent of ability and monopolistic dominance may also be the sources of profit. Similarly, a firm may earn profit owing to its goodwill in the market. Therefore, we cannot say that profit arises only as a reward for uncertainty-bearing.

(ii) Uncertainty is something subjective: It has no objective, cardinal measure. In the case of organisation and management of a particular business, different entrepreneurs may have different perceptions of the degree of uncertainty involved. Therefore, it is almost impossible to build up a functional relation between uncertainty and profit.

3. Rent Theory of Profit:

An American economist, Francis A. Walker (1840-97), is the exponent of the rent theory of profit. Walker says that an entrepreneur acquires profit because of his ability to perform. Walker argues like this. In a certain production process, if an entrepreneur uses land, labour and capital owned by his own self, then the residual part of his revenue, after payment is made to all these factors of production, is profit.

Now, at any particular price of the product, some entrepreneurs may have this profit equal to zero. They are called the marginal entrepreneurs. Any such mar­ginal entrepreneur can have nothing in excess of the wage, interest and rent earned by his own labour, capital and land.

Therefore, if an entrepreneur’s ability to perform is more than that of a marginal entrepreneur, then his cost of production would be smaller, and he would be able to earn a positive profit. In fact, the greater the efficiency of a particular entrepreneur than that of a marginal entrepreneur, the more would be the amount of profit earned by him.

There is some similarity between profit and rent. For, in the Ricardian theory of rent also, we have seen that rent is zero on marginal land and the less the cost of production and more the productivity on a plot of land, the more would be the rent enjoyed by its owners. Because of this similarity between profit and rent, Walker’s theory is called the rent theory of profit.

Critical Evaluation of the Theory:

Like the other theories of profit, Walker’s theory cannot satisfactorily explain as to why the firm and its entrepreneur should get profit. However, the theory attracts our attention to the similarity between profit and rent. But we should remember that rent is not the only element of profit.

Walker has argued that profit of the marginal entrepreneur is zero and the profits earned by an intra-marginal entrepreneur are all rent.

This contention of Walker may be correct if:

(i) An entrepreneur may supply his services only in his present business and he has no alternative employment to go to; and

(ii) The supply of entrepreneurial services or the number of entrepre­neurs is completely fixed.

However, in the real world, we always see that the entrepreneurs can supply their services to many alternative areas and from the point of view of a particular business, supply of entrepre­neurial services is not completely fixed—the supply can increase if the reward increases. There­fore, in any particular business, the minimum supply price of entrepreneurial services is not zero.

Loosely speaking, the minimum supply price of an entrepreneur in his present business would be equal to the maximum amount of reward that he may avail of in an alternative field of engagement, other things (i.e., risk or harassment factors) remaining the same. The minimum supply price of the entrepreneur’s services in his present engagement is called his normal profit.

If an entrepreneur is able to earn profits in excess of his normal profit, then this excess is a surplus and this surplus is called pure or economic profit. The amount of pure profit an entre­preneur may earn would depend upon the efficiency of his performance.

The more his effi­ciency, the more he would be able to earn as pure profit. Therefore, pure profit which is the excess over normal profit, is of the nature of the rent of ability. However, we have to remember here that the profit of a firm also includes what is known as windfall or chance income.

There­fore, the pure profit is a surplus which includes the rental surplus as also the surplus due to the windfall or chance factors. Therefore, pure profit is a mixed surplus.

4. Innovation Theory of Profit:

The innovation theory of profit was developed by Prof. Joseph A. Schumpeter (1883-1950). According to Schumpeter, the main function of an entrepreneur is to innovate. Here we have to remember first the distinction which Schumpeter had made between invention and innovation.

Invention is the discovery of a law of nature by a scientist. On the other hand, if an entrepre­neur manufactures a new product or introduces a new production technique by using the newly discovered law of nature, and thereby makes the commercial use of the invention possible, then this is called innovation.

For example, the scientists have discovered or invented the laws of science that are behind the manufacture of the goods like electric lights or fans, radio sets, television sets, refrigerators and such other goods. But the entrepreneurs have innovated these goods. Innovation is the commercial use of the laws of science that have been discovered by the scientists.

Schumpeter has said that if the entrepreneur can innovate new techniques of production and sale, if he can innovate a new product or a new model of an old product and if he can find new markets for selling the product, then Only, he will be able to play the role of a pioneer in the business world and increase the amount of profit. We may call this increase in profit the innovation-induced profit.

Criticisms of the Theory:

Schumpeter’s innovation theory of profit has explained nicely how an entrepreneur may increase the amount of profit by means of innovations. But this theory cannot fully explain why profit arises or why the entrepreneurs should earn profit.

For example, we know that an entre­preneur should obtain profit as a reward for bearing risk or uncertainty, for his ability to estab­lish monopolistic dominance, and for many other reasons. But Schumpeter did not consider these factors that might work behind the emergence of profit.

5. Dynamic Theory of Profit:

According to J. M. Clark (1884-1963), an American economist, profit can emerge only in a dynamic society. That is why his theory is called the dynamic theory of profit. We have to remember here the distinction between a dynamic society and a static society.

The society which is constantly changing and where the socio-economic factors like population and labour force, saving and investment, volume of capital, tastes and choices of the people, the standard of education, health and culture, etc. are always changing, is called a dynamic society.

On the other hand, the society where these changes do not occur, is called a static society. According to Clark, changes do not occur in a static society. That is why here there is no risk or uncertainty. In such a society, everything goes on according to routine and everyone has a prior information of what will happen and when.

So here the entrepreneur bears no uncertainty while organising a production process, and he should not get profit as a reward. Therefore, Clark concludes that profit does not arise in a static society. The entrepreneur obtains a price for his product in this society, which would just cover only his cost (including normal profit).

The dynamic society, on the other hand, goes through changes. There the tastes, habits and fashion, the availability of factors of production and the methods and techniques of production are all changing. That is why, in such a society, the entrepreneur has to bear uncertainty. The more successful he is in managing the uncertainties, the higher would be the profit level acquired by him.

It is clear in the above analysis that in a dynamic society, the entrepreneur has to be innovative, for innovations lead to changes and changes inspire innovations. On the other hand, in a static society, innovations do not occur, for such a society does not experience changes. That is why the dynamic theory of profit is considered to be a more general form of Schumpeter’s innovation theory.

Critical Estimates:

The dynamic theory attracts our attention to the fact that dynamism is urgently necessary for the social and economic progress of a society. If the society is dynamic, the entrepreneurs would earn profit and, if they can earn profit, the supply of entrepreneurship increases and, consequently, production in the society increases.

But the dynamic theory of profit also is not a complete theory. Because, this theory also does not explain all the causes of the emergence of profit. For example, this theory does not mention that profit may also arise because of the monopoly power of the firm.

6. Monopoly Power Theory of Profit:

Many economists think that if there is perfect competition in the markets, there cannot be any profit, because absence of competition creates opportunities in the markets to acquire profit. As we know, under perfect competition, the buyers and sellers are assumed to possess full knowledge about the conditions prevailing in the markets.

That is why if the firms in an industry happen to earn more than normal profit in the short run, then in the long run, number of firms and the supply of the product would be increasing and the price of the product would be decreasing till all the existing firms would earn just the amount of normal profit. A firm under perfect competition is one of a large number of firms.

That is why it can sell more or less any amount of its product at the market-determined price. The entrepreneur, here, is not required to take an individual initiative to increase the demand for his product and his sales. Therefore, here the entrepreneur performs his routine activities and for this he gets no more than the normal profit.

On the other hand, if the entrepreneur possesses monopoly power in the market, then he would have to exert individual initiative in giving leadership in the market. Now, in order to maintain his monopoly power and to increase this power, he would have to exercise necessary efforts.

The entrepreneur here has to bear risk and uncertainty, and he would have to expand the dominance of his firm in the market through innovations. If the entrepreneur can perform his job successfully, then he can increase the demand for his product and get a higher price. Consequently, the amount of pure profit earned by him may increase.

Criticisms:

We may argue in favour of this theory that it has rightly emphasised the role of monopoly power in the emergence of profit. But this also cannot be a complete theory of profit.

For we know that even a monopolistic firm can earn less than normal profit or negative pure profit, i.e., we may have p < AC at his MR = MC point. Therefore, the existence of monopoly elements in the market may be a necessary condition for the emergence of profit but it is not a sufficient condition.

7. Labour Exploitation Theory of Profit:

According to the great philosopher and classical economist, Karl Marx (1818-1883), labour is the only factor of production which can produce surplus value. The capitalists acquire profit by expropriating this surplus value. Marx has said that labour is the only productive factor.

Labour is given a rate of wage which is much smaller than the net value produced by it with the help of machines, raw materials, etc. The surplus value is defined as the difference between the net value produced by labour and what it actually gets as wage.

This surplus value is the profit of the entrepreneur who represents the capitalists. There would be an increase in the productivity of labour when this profit is converted into capital and invested again, for now the labour would be able to use more of capital goods or machines.

As the productivity of labour increases, the surplus value created by labour also increases for the rate of wage of the workers generally does not increase, or, increases at a much smaller rate. Thus exploitation of labour goes on increasing at an increasing rate and, along with it, the stock of capital also increases.

Criticisms:

In the labour exploitation theory of profit, the role of labour in the creation of surplus value and the subject of labour exploitation have been rightly emphasised. However, many economists think that, like labour, the other factors of production, like land and capital, are also productive.

Besides, Marx has said that it is the capitalists that acquire profit, i.e., he thinks that capitalists are identical with entrepreneurs, although, in modern economic system, entrepreneurs and capitalists may be separate persons.

Lastly, Marx does not consider the fact that sometimes the entrepreneurs may have to bear risks and uncertainties. Therefore, Marx’s theory, too, cannot be considered to be a complete theory of profit.

8. Marginal Productivity Theory of Profit:

We already know how the marginal productivity (MP) theory of factor pricing may be applied to the determination of the rates of wage and interest. We shall now see how far the theory is relevant in determining the rate of profit. The MP theory says that the price of a factor would be equal to the value of its marginal product (VMP).

Therefore, according to the MP theory, the rate of profit would be equal to the VMP of entrepreneurship or entrepreneurial services. According to definition, the MP of entrepreneurship is the increment in total output obtained as a result of use of the marginal unit of entrepreneurial services.

It may be noted here that if we talk of one marginal unit of entrepreneur in place of one marginal unit of entrepreneurial services, then there would be confusion since a business firm may have one, or, at best, a few entrepreneurs, and entrepreneur is not a continuous variable.

Therefore, while examining the relevance of the MP theory in the area of profit, we should talk not of entrepreneurs, but of entrepreneurial services, the quantity used of which may be measured, say, in units of time as quantity used of labour is expressed in hours.

Then we would be able to say: if the VMP of entrepreneurial services is greater than the rate of profit determined in the market, then the entrepreneur would go on increasing the amount of entrepreneurial services used till the VMP of these services diminishes owing to the law of diminishing returns, to become equal to the rate of profit.

Economies of scope are “efficiencies formed by variety, not volume” (the latter concept is “economies of scale”). In economics, “economies” is synonymous with cost savings and “Scope” is synonymous with broadening production/services through diversified products. Economies of scope is an economic theory stating that average total cost of production decrease as a result of increasing the number of different goods produced. For example, a gas station that sells gasoline can sell soda, milk, baked goods, etc. through their customer service representatives and thus gasoline companies achieve economies of scope.

Whereas economies of scale for a firm involve reductions in the average cost (cost per unit) arising from increasing the scale of production for a single product type, economies of scope involve lowering average cost by producing more types of products.

Economies of scope make product diversification, as part of the Ansoff Matrix, efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example, as the number of products promoted is increased, more people can be reached per unit of money spent. At some point, however, additional advertising expenditure on new products may become less effective (an example of diseconomies of scope). Related examples include distribution of different types of products, product bundling, product lining, and family branding.

Economies of scope exist whenever the total cost of producing two different products or services (X and Y) is lower when a single firm instead of two separate firms produces by themselves.

DSC = TC(q1) + TC(q2) – TC(q1, q2) / TC(q1, q2)

Where:

• TC(q1) is the cost of producing quantity q1 of good a separately
• TC(q2) is the cost of producing quantity q2 of good b separately
• TC(q1+q2) is the cost of producing quantities q1 and q2 together
• Economies of Scope (S) is the percentage cost saving when the goods are produced together. Therefore, S would be greater than 0 when economies of scope exist.

If DSC > 0, there is economies of scope. It is recommended that two firms can corporate and produce together.

If DSC = 0, there is no economies of scale and economies of scope.

If DSC < 0, there is diseconomies of scope. It is not recommended to work together for the two firms. Diseconomies of scope means that it is more efficient for two firms to work separately since the merged cost per unit is higher than the sum of stand-alone costs.

Joint costs

The essential reason for economies of scope is some substantial joint cost across the production of multiple products. The cost of a cable network underlies economies of scope across the provision of broadband service and cable TV. The cost of operating a plane is a joint cost between carrying passengers and carrying freight, and underlies economies of scope across passenger and freight services.

Natural monopolies

While in the single-output case, economies of scale are a sufficient condition for the verification of a natural monopoly, in the multi-output case, they are not sufficient. Economies of scope are, however, a necessary condition. As a matter of simplification, it is generally accepted that markets may have monopoly features if both economies of scale and economies of scope apply, as well as sunk costs or other barriers to entry.

Advantages

Economies of scope have the following advantages for businesses:

• Extreme flexibility in product design and product mix
• Rapid responses to changes in market demand, product design and mix, output rates, and equipment scheduling
• Greater control, accuracy, and repeatability of processes
• Reduced costs from less waste and lower training and changeover costs
• More predictability (e.g., maintenance costs)
• Faster throughput thanks to better machine use, less in-process inventory, or fewer stoppages for missing or broken parts. (Higher speeds are now made possible and economically feasible by the sensory and control capabilities of the “Smart” machines and the information management abilities of computer-aided manufacturing (CAM) software.)
• Distributed processing capability made possible and economical by the encoding of process information in easily replicable software
• Less risk: A company that sells many product lines, sells in many countries, or both will benefit from reduced risk (e.g., if a product line falls out of fashion or if one country has an economic slowdown, the company will likely be able to continue trading).

Strategies Economies of Scope

1. Related Diversification

If a company is able to use its operational expertise, resources, and capabilities across its organization, then it can take advantage of related diversification. For example, hiring designers and marketers who can use their skills across different product lines allows for the production of a wide range of products.

2. Flexible Manufacturing

Flexible manufacturing exists if multiple products can be produced using the same manufacturing systems and inputs for example, using the same preparation and storage facilities when making hamburgers and fries, as opposed to using two separate facilities.

3. Mergers

Mergers often enable a company to share research and development expenses to reduce costs and diversify its product portfolio or knowledge. For example, two pharmaceutical companies might merge to combine their research and development expenses to create new products.

4. Linking the Supply Chain

Integrating vertical supply chain assists in reducing costs and wastage. For example, operating multiple businesses under the same entity or having combined management rather than running as separate entities.

5. Acquisition of Companies with Similar Products

Mergers with horizontal acquisition or strategic acquisitions will help achieve the economies of scope as the company will benefit from synergies due to utilization of similar raw materials, production and assembly lines.

6. Diversification

Companies producing different products using similar inputs and production processes will improve productivity.

A cost function is a formula used to predict the cost that will be experienced at a certain activity level. This formula tends to be effective only within a range of activity levels, beyond which it no longer yields accurate results. Beyond the outer thresholds of these activity levels, the cost function must be adjusted to account for such factors as changes in volume discounts and the incurrence of step costs.

Cost functions are typically incorporated into company budgets, so that modelled changes in sales and unit volumes will automatically trigger changes in budgeted expenses in the budget model.

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms optimize their production process by minimizing cost consistent with each possible level of production, and the result is a cost curve. Profit-maximizing firms use cost curves to decide output quantities. There are various types of cost curves, all related to each other, including total and average cost curves; marginal (“for each additional unit”) cost curves, which are equal to the differential of the total cost curves; and variable cost curves. Some are applicable to the short run, others to the long run.

Notation

There are standard acronyms for each cost concept, expressed in terms of the following descriptors:

SR = Short-run (when the amount of physical capital cannot be adjusted)

LR = Long-run (when all input amounts can be adjusted)

A = Average (per unit of output)

M = Marginal (for an additional unit of output)

F = Fixed (unadjustable)

V = Variable (adjustable)

T = Total (fixed plus variable)

C = Cost

These can be combined in various ways to express different cost concepts (with SR and LR often omitted when the context is clear): one from the first group (SR or LR); none or one from the second group (A, M, or none (meaning “level”); none or one from the third group (F, V, or T); and the fourth item (C).

From the various combinations we have the following short-run cost curves:

• Short-run average fixed cost (SRAFC)
• Short-run average total cost (SRAC or SRATC)
• Short-run average variable cost (AVC or SRAVC)

• Short-run marginal cost (SRMC)
• Short-run fixed cost (FC or SRFC)
• Short-run total cost (SRTC)
• Short-run variable cost (VC or SRVC)

and the following long-run cost curves:

• Long-run average total cost (LRAC or LRATC)
• Long-run marginal cost (LRMC)
• Long-run total cost (LRTC)

SRTC and LRTC

The short-run total cost (SRTC) and long-run total cost (LRTC) curves are increasing in the quantity of output produced because producing more output requires more labor usage in both the short and long runs, and because in the long run producing more output involves using more of the physical capital input; and using more of either input involves incurring more input costs.

With only one variable input (labour usage) in the short run, each possible quantity of output requires a specific quantity of usage of labour, and the short–run total cost as a function of the output level is this unique quantity of labor times the unit cost of labor. But in the long run, with the quantities of both labour and physical capital able to be chosen, the total cost of producing a particular output level is the result of an optimization problem: The sum of expenditures on labor (the wage rate times the chosen level of labor usage) and expenditures on capital (the unit cost of capital times the chosen level of physical capital usage) is minimized with respect to labor usage and capital usage, subject to the production function equality relating output to both input usages; then the (minimal) level of total cost is the total cost of producing the given quantity of output.

Short-run variable and fixed cost curves (SRVC and SRFC or VC and FC)

Since short-run fixed cost (FC/SRFC) does not vary with the level of output, its curve is horizontal as shown here. Short-run variable costs (VC/SRVC) increase with the level of output, since the more output is produced, the more of the variable input(s) needs to be used and paid for.

Short-run average variable cost curve (AVC or SRAVC)

Average variable cost (AVC/SRAVC) (which is a short-run concept) is the variable cost (typically labor cost) per unit of output: SRAVC = wL / Q where w is the wage rate, L is the quantity of labor used, and Q is the quantity of output produced. The SRAVC curve plots the short-run average variable cost against the level of output and is typically drawn as U-shaped. However, whilst this is convenient for economic theory, it has been argued that it bears little relationship to the real world. Some estimates show that, at least for manufacturing, the proportion of firms reporting a U-shaped cost curve is in the range of 5 to 11 percent.

Short-run average fixed cost curve (SRAFC)

Since fixed cost by definition does not vary with output, short-run average fixed cost (SRAFC) (that is, short-run fixed cost per unit of output) is lower when output is higher, giving rise to the downward-sloped curve shown.

Short-run and long-run average total cost curves (SRATC or SRAC and LRATC or LRAC)

The average total cost curve is constructed to capture the relation between cost per unit of output and the level of output, ceteris paribus. A perfectly competitive and productively efficient firm organizes its factors of production in such a way that the usage of the factors of production is as low as possible consistent with the given level of output to be produced. In the short run, when at least one factor of production is fixed, this occurs at the output level where it has enjoyed all possible average cost gains from increasing production. This is at the minimum point in the above diagram.

STC = Pk*K + PL*L

Short-run marginal cost curve (SRMC)

A short-run marginal cost (SRMC) curve graphically represents the relation between marginal (i.e., incremental) cost incurred by a firm in the short-run production of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost curve is usually U-shaped. Marginal cost is relatively high at small quantities of output; then as production increases, marginal cost declines, reaches a minimum value, then rises. The marginal cost is shown in relation to marginal revenue (MR), the incremental amount of sales revenue that an additional unit of the product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns). Marginal cost equals w/MPL. For most production processes the marginal product of labour initially rises, reaches a maximum value and then continuously falls as production increases. Thus, marginal cost initially falls, reaches a minimum value and then increases. The marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. When the marginal cost curve is above an average cost curve the average curve is rising. When the marginal costs curve is below an average curve the average curve is falling. This relation holds regardless of whether the marginal curve is rising or falling.

Long-run marginal cost curve (LRMC)

The long-run marginal cost (LRMC) curve shows for each unit of output the added total cost incurred in the long run, that is, the conceptual period when all factors of production are variable. Stated otherwise, LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable.

The long-run marginal cost curve is shaped by returns to scale, a long-run concept, rather than the law of diminishing marginal returns, which is a short-run concept. The long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased input flexibility. The long-run marginal cost curve intersects the long-run average cost curve at the minimum point of the latter. When long-run marginal cost is below long-run average cost, long-run average cost is falling (as additional units of output are considered).  When long-run marginal cost is above long run average cost, average cost is rising. Long-run marginal cost equals short run marginal-cost at the least-long-run-average-cost level of production. LRMC is the slope of the LR total-cost function.

The demand function is a mathematical representation that shows the relationship between the quantity of a good or service demanded and the factors influencing it, such as its price, consumer income, tastes, and the prices of related goods.

It is typically expressed as Qd = f(P, I, Pr, T, etc.),

where

Qd is the quantity demanded,

P is the price of the good,

I represents income,

Pr is the price of related goods (substitutes or complements),

T stands for consumer preferences.

The demand function helps in analyzing how changes in these factors impact the demand for a product.

Market Demand Schedule
Quantity demanded (Units)	Price per Unit (Rupees) Rs.
2,000	6
3,000	5
4,000	4
5,000	3
5,500	2
6,000	1

Quite often it is more convenient to work with the graph of a demand schedule, called a demand curve, rather than with the schedule itself. Figure shows the demand curve which is a graphical representation of the demand schedule presented in Table. Each price-quantity combination (Rs. 6, 2,000), (Rs. 5, 3,000), and so on is plotted. The locus of such points (each one showing a partic­ular combination of p and q) DD’ is the demand curve.

The demand curve indicates the quantity of the good consumers are willing and able to buy at a fixed point of time at alternative prices, i.e., at every price from Rs. 6 to Rs. 1. Since price and quan­tity demanded are inversely related, the curve slopes downward.

Indeed, all market demand curves (which are arrived at by adding up demand curves of individual consumers) are downward sloping because of the law of demand. Individuals purchase less when price rises. Furthermore, as price increases, some individuals do not purchase anything at all, again causing the quantity demanded at each price to fall.

Alternatively, we can express demand as a function

Qx = ƒ(Px)

In this function, the other variables (income, and so on) are held constant. The quantity demanded of a commodity is a function of the price of the good, holding constant the other (proximate) determinants of demand.

Discounting principle is a continuation of time perspective & we can say it is a corollary of time perspective.

The old proverb “A bird in hand is better than two in the bush” is a representative of this discounting principle. The worth of a rupee receivable tomorrow is less than that of a rupee receivable today. Since the future is unknown & incalculable, also there is a lot of risk & uncertainty about the future. If the return is same for now & future, then definitely present return will be given importance. So, the future must be discounted both for the elements of waiting & risk of the future. Even if one is certain that he will get some income in the future, it is essential to make a discount in the income because he has to wait for the future, which involves sacrifice. Moreover, inflation may reduce the purchasing power. For making a decision regarding investment which will yield a return over a period of time, it is important to find its net present worth. To know the returns over a period of years to decide over an alternative investment, it is necessary to use discounting principle.

This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surround­ing the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.

The formula is:

PV = 100/(1+i)

Where,

PV = Present Value

i = Rate of Interest.

The principle involved in the above discussion is called the discounting principle and is stated as follows: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”

The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.