Theory of Profit by Knight

The Knight’s Theory of Profit was proposed by Frank. H. Knight, who believed profit as a reward for uncertainty-bearing, not to risk bearing. Simply, profit is the residual return to the entrepreneur for bearing the uncertainty in business.

Knight had made a clear distinction between the risk and uncertainty. The risk can be classified as a calculable and non-calculable risk. The calculable risks are those whose probability of occurrence can be anticipated through a statistical data. Such as risks due to the fire, theft, or accident are calculable and hence can be insured in exchange for a premium. Such amount of premium can be added to the total cost of production.

While the non-calculable risks are those whose probability of occurrence cannot be determined. Such as the strategies of a competitor cannot be accurately assessed as well as the cost of eliminating the completion cannot be precisely calculated. Thus, the risk element of such events is not insurable. This incalculable area of risk is the uncertainty.

Due to the uncertainty of events, the decision-making becomes a crucial function of an entrepreneur or manager. If the decisions prove to be correct by the subsequent events, an entrepreneur makes a profit and vice-versa. Thus, the Knight’s theory of profit is based on the premise that profit arises out of the decisions made under the conditions of uncertainty.

Knight believes that profit might arise out of the decisions made concerning the state of the market, such as decisions with respect to increasing the degree of monopoly in the market, decisions regarding holding stocks that might result in the windfall gains, decisions taken to introduce new product and technique, etc.

The major criticism of the knight’s theory of profit is, the total profit of an entrepreneur cannot be completely attributed to uncertainty alone. There are several functions that also contribute to the total profit such as innovation, bargaining, coordination of business activities, etc.

There are certain risks that are measurable and the probability of such risk can be statistically estimated and hence such risks can be insured. Example of insurable risks include theft of commodities, fire in the enterprise, accidental death etc. On the other hand, there are certain risks which cannot be calculated.

The probability of their occurrence cannot be statistically ascertained. Such risks include risks associated to changes in prices, demand and supply. These risks are non-insurable. Prof. Knight opined that the profit is the reward for bearing the non-insurable risks and uncertainties.

Uncertainty-bearing is one of the most vital functions in a dynamic economy. The entrepreneur bears the uncertainty involved in the enterprise. The expectation of profit is the supply price of the entrepreneurial uncertainty bearing exercise. In a state of economy (competitive) where there is no risk, every entrepreneur will have a minimum supply price.

If the reward allocated to the entrepreneur is below it, the entrepreneurs will abstain from providing their entrepreneurial services. The existence of uncertainty tends to raise the minimum supply price. The entrepreneurs expect a level of profit for bearing the uncertainty.

The salient points of Knight’s theory include:

1. According to the theory, the entrepreneur earns pure profits for bearing the uncertainty.
2. The probability of uncertainty or non-insurable risks cannot be statistically estimated.
3. Entrepreneurs undertake risks of varying degrees according to their ability ad inclination. The theory suggests that the more risky the nature of enterprise, the higher level of profit earned by the entrepreneurs.
4. Profit is the reward of the entrepreneur for bearing uncertainties and risks. Hence, it should be a part of the normal cost.
5. The reward of the entrepreneur is uncertain. Entrepreneur guarantees interest to lender of capital, wages to workers and rent to the landlord.
6. The level of uncertainty in business can be reduced by applying the technique of consolidation. The total level of uncertainty can be reduced by pooling individual instances.

Criticisms:

F.H. Knight’s theory is one of the most sophisticated theories to explain supply of entrepreneurship based on profit. But, the theory suffers from certain drawbacks as pointed by the critics.

1. The role of an entrepreneur has not been elaborately provided by the theory. The entrepreneur’s activity has been restricted to uncertainty bearing. Modern business activities are different. Often, there is a dichotomy between ownership and management. These factors have not been taken into consideration.
2. The uncertainty-bearing theory discussed the concept of profit in a vague way. The exact estimation of profit for the entrepreneur has not been provided in the theory.
3. Profit as a residual income of the entrepreneur has been criticized.
4. Critics feel that uncertainty-bearing should not be treated like other factors of production like land, labour and capital. It is a psychological concept and should be treated in a different manner.