MCom I Semester Managerial Economics Profit Study Material notes
Table of Contents
MCom I Semester Managerial Economics Profit Study Material notes Gross Profit and Net Profit Normal Profit and Abnormal Profit Monopoly Profit Windfall Profit Rent Theory of Profit Wage Theory of Profit Marginal Productivity Theory of Profit Uncertainty Bearing Theory of Profit Demand and Supply Theory of Profit or Modern Theory of Profit Theory of Innovation Meaning of Depreciation Methods of Depreciation Theory of Monopoly and Market Imperfections Effect or Choice of Depreciation Method on Profit :
MCom I Semester Business Environment Consumer Protection Study Material Notes
PROFIT
MEANING AND DEFINITION OF PROFIT
Profit is that part of national income which goes to entrepreneurs in the process of distribution. Profit is paid at the last after the payment of rent, wages and interest. It is the difference between total revenue and total cost of production. Thus, profit is residual in nature. It is the only share of national income that can be negative. The term profit has been defined as under
1 “Profit is the reward for the work of entrepreneur or it is a payment of risks, uncertainties and innovations.” –Prof. Schumpeter
2. “Profit is commonly said to be a payment for risk bearing.” – Prof. H. Speight Thus, it may be concluded that-(i) profit is a reward for accepting risks and uncertainties, (ii) profit can arise only under dyanamic conditions, (iii) profit can arise only in imperfect competition.
(1) GROSS PROFIT AND NET PROFIT
Gross profit Gross profit is the difference between total revenue and explicit costs. There are two types of cost in a firm-Explicit cost and implicit costs-i) Explicit costs are the costs that are paid to the factors of production hired from outside-rent, wages and interest, (ii) Implicit costs means the reward of self-owned resources of entrepreneur costs. Excess of total revenue over explicit costs is known as gross profit. Thus,
Gross Profit = Total revenue-Explicit costs
Net Profit
Net profit is also known as economic profit. It is a part of gross profit. Net profit is the reward of enterprise only. To calculate net profit, implicit costs are deducted from gross profit. Thus,
Net Profit = Gross Profit – Implicit costs
Or, Net Profit = Total revenue – (Explicit costs + Implicit costs)
Difference Between Gross Profit and Net Profit
(i) Only explicit costs are deducted from total revenue while calculating gross profit and both the explicit and implicit costs are deducted while calculating net profit.
(ii) Net profit is the reward of enterprise only while gross profit is the reward of some other factors also.
(iii) Net profit is always less than gross profit.
(IT) NORMAL PROFIT AND ABNORMAL PROFIT
Normal Profit. Normal profit is the minimum level of profit which is just sufficient to encourage an entrepreneur to stay in a particular industry. Normal profit should always be paid to an entrepreneur because it is the reward for bearing risks and uncertainties.
Normal profit is a part of the cost of production and, thus, it enters into price. Entrepreneur is also an essential and scarce resource of production. Therefore, it should be paid a minimum price and this minimum price is called normal profit.
Abnormal Profit. Abnormal profit is the excess profit. When the income of an entrepreneur is more than normal profit, it is called abnormal profit. Abnormal profit is not necessary to induce an entrepreneur to stay in a particular industry, therefore, it does not enter into price and is not a part of cost of production. Thus,
Abnormal profit = Net profit – Normal profit
Difference Between Normal Profit and Abnormal Profit
(i) Normal profit is the minimum level of profit that should be paid to an entrepreneur while abnormal profit is the result of abnormal conditions.
(ii) Normal profit must always be paid to an entrepreneur while abnormal profit is not necessary to be paid.
(iii) If normal profit is not available, the entrepreneur may leave the industry while it is not so in case of abnormal profit.
(iv) Normal profit is a part of cost of production while abnormal profit is not included in cost of production.
(III) MONOPOLY PROFIT
Monopoly profit is the profit earned by a firm due to monopolistic conditions. When a firm operates under the conditions of monopoly, it becomes possible for the firm to earn some additional profit. This additional profit is known as monopoly profit. Monopoly profit is also known as monopoly rent of a firm.
(IV) WINDFALL PROFIT
There are some circumstances in which a firm may earn extra profit. Such extra profit is known as windfall profit. Windfall profit arises because of unexpected circumstances. These circumstances may be accute shortage of a factor of production, war, unforeseen changes in the demand of a commodity and riots etc. These circumstances lead to a sudden rise in the prices of commodities and bring excess profit. Windfall profit cannot be attributed to any special talent of an entrepreneur. Such profit arises due to unexpected circumstances only. Q. 3. Explain rent theory of profit.
RENT THEORY OF PROFIT
This theory was propounded by American economist Prof. Walker. This theory is based upon Ricardian theory of rent. According to this theory, profit is the rent of ability. Prof. Walker believed that entrepreneurs differ in ability and efficiency just as various plots of land differ in fertility. Owing to such difference, entrepreneurs could be graded into marginal and intra-marginal. Marginal entrepreneurs are the entrepreneurs who earn only normal profit. More efficient and capable entrepreneurs will be in a position to earn differential surplus.
Thus, profit is a differential surplus earned by more efficient and able entrepreneurs over marginal entrereneurs. It implies that profit does not enter into the price. Rather, profit is determined by the price.
Criticisms
1 According to this theory, some entrepreneurs do not earn any profit. In practical life, it does not hold true.
2. According to this theory, profit does not enter into price but in real life, profit is a part of total cost and as such, it enters into the price.
3. According to this theory, profit can never be negative but the fact is that in certain circumstances, it can be negative also.
4. This theory ignores that profit is the reward of accepting risks and uncertainties. Q. 4. Explain wage theory of profit.
Profit Study Material notes
WAGE THEORY OF PROFIT
This theory was propounded by American economist Prof. Taussig. According to this theory, profits are a special type of wages earned by entrepreneurs. Prof. Taussig believed an entrepreneur is to put in a special type of labour which requires mental ability an entrepreneur is the result of such Criticisms boor which requires mental ability and efficiency. Income of preneur is the result of such mental ability and efficiency.
Criticism
1 This theory ignores that profit is a reward of accepting risks and
2. This theory puts enterprise on the same footing as labour.
3. Under the conditions of market imperfections, profit increases while wage rate decrease, therefore, wage and profit should be treated separately. O
MARGINAL PRODUCTIVITY THEORY OF PROFIT
Credit of this theory goes to Prof. Chapman, Stigler, Stonier and Hague. According to this theory, reward of entrepreneur tends to be equal to his marginal productivity. Higher the marginal productivity of entrepreneur, more will be his profit. Criticisms
1 Marginal productivity of entrepreneur cannot be calculated as such because there is a single entrepreneur in a firm.
2. This theory is incomplete because it ignores the supply of entrepreneurs.
3. This theory does not consider profit that arises by chance theory of profit.
UNCERTAINTY BEARING THEORY OF PROFIT
This theory was propounded by Prof. Knight. According to this theory, profit is the reward of accepting uninsurable risks and uncertainties. Prof. Knight distinguished between risk and uncertainty. According to him business risks can be of two types-(i) Insurable risks, and (ii) Uninsurable risks. Insurable Risks
Some are the risks that can be forecasted and therefore, insured. Example-Fire, accident, theft, dacoit etc. Therefore, entrepreneur should not get any reward for these risks because these risks are accepted by insurance company and not by the entrepreneur. So profit cannot be the reward of such risks. Uninsurable Risks
Some are the risks that cannot be forecasted and therefore, cannot be insured. Example-Changes in the methods of production, development of new varieties and substitutes of product, changes in demand, emergence of new competitors in market and possibility of technical developments etc.
Profit is the reward of accepting uninsurable risks only because these risk are accepted by entrepreneurs. Criticisms
1 Profit is the reward of business abilities of entrepreneur. It is not the reward of accepting uncertainty only.
2. Uncertainty should not be treated as a different factor of production because an entrepreneur has to perform many other duties also.
3., Uncertainty cannot be measured. Therefore, profit also cannot be determined according to this theory.
4. According to this theory, wherever there is uncertainty, there should be profit but in real life, it does not hold true.
5. This theory does not consider monopoly profit and windfall profit.
DEMAND AND SUPPLY THEORY OF PROFIT OR MODERN THEORY OF PROFIT
According to modern economists, profit is determined by the demand and supply of entrepreneurs. Profit is determined in the same manner as price of a commodity.
Demand of Entrepreneurs
Demand of entrepreneurs depends upon his marginal productivity. Higher the marginal productivity of entrepreneur, more will be his demand. Demand of entrepreneurs is affected by following factors : (i) Economic development, (ii) Social conditions, (iii) Possibilities of investment. There is inverse relationship between profit expectation and demand of their marginal productivity and profit expectation. Higher the marginal entrepreneurs. Higher the profit expectation, less will be the demand. Demand curve of entrepreneurs slopes downwards to the right as under
In this diagram, number of entrepreneurs is shown on OX-axis and profit expectation on OY-axis. DD is demand curve which slopes downwards to the right. It implies that demand of entrepreneurs will go on decreasing on an increase in profit expectation.
Supply of Entrepreneurs
Supply of entrepreneurs depends and vice-versa upon many factor such as-(i) Size of population, (ii) Rate of increase in population, (ii) Availability of capital, (iv) Industrial development of the Supply curve country, (v) Social conditions prevailing in the country, (vi) Degree of risk in business, etc. Higher the rate of profit more will be the supply of entrepreneur. Since, there is direct relationship between rate of profit, and the supply of Entrepreneurs entrepreneur. Supply curve of Fig. Supply of Entrepreneur. entrepreneur will slope downwards to the left as is evident from the following diagram
In this diagram, number of entrepreneur is shown on OX-axis and profit expectation on OY-axis. SS is supply curve which moves upwards to right. It implies that supply of entrepreneurs goes on increasing on an increase in profit expectation. Determination of Profit
Profit is determined at the point at which demand curve of entrepreneur intersects supply curve. It can be presented diagrammatically as follows Supply curve In this diagram, number of entrepreneur is shown on OX-axis and profit expectation on OY-axis. DD is demand curve, SS is supply curve and E is equilibrium point. Demand and supply curves intersect each other at ‘E At this point, number of Profit Determination. entrepreneurs will be ON and profit expectation will be OP.
THEORY OF INNOVATION
This theory was propounded by Prof. Schumpeter. According to this theory, profit arises due to regular innovations of a business enterprise. The term ‘Innovation’ in this respect means and includes all the activities which are performed by an entrepreneur to reduce the cost of production, to improve the quality of production, to present the product in a new form, to improve the product, to make the product more useful and to improve the selling and distribution efforts of the enterprise by using new and improved techniques. An entrepreneur tries to attract more and more customers to his product through innovation so that he can increase the demand of his product in market and he may earn maximum profit through maximum sales. To maintain profit position of an enterprise, it is necessary that the process of innovation should contine for ever because as soon as an entrepreneur introduces some innovation, his competitors copy it and importance of innovation comes to an end.
Though this theory of profit determination emphasizes upon innovation which is an important factor for the success of an enterprise but it does not consider risks and uncertainties borne by an entrepreneur. From this point of view, this theory cannot be regarded as satisfactory.
THEORY OF MONOPOLY AND MARKET IMPERFECTIONS
According to this theory, an entrepreneur can get profit only under the situation of monopoly and market imperfections. An entrepreneur can earn profit by controlling the supply of his product, by getting the advantage of ignorance of consumers and by fixing relatively high price for his product. Under perfect competition, no such factor helps the entrepreneur in earning profit.
Conclusion. Profit is the reward for enterprise. Enterprise is an essential factor of production. Profit is paid to the entrepreneur. Profit is the reward of bearing risks and uncertainties by an entrepreneur. It is the reward of taking pains by an entrepreneur to run his business enterprise. Several Economists have propounded several theories of profit determination. According to the theory of entrepreneurial compensation profit is the reward for the labour of an entrepreneur put in by him in his enterprise. According to the theory of monopoly and market imperfections, profit can arise only under the situations of monopoly and imperfect competition.
Profit Study Material notes
MEANING OF DEPRECIATION
Every business and industrial enterprise uses some fixed assets. Useful life of these fixed assets is limited. Therefore, it becomes necessary to provide for depreciation on fixed assets of a business and industrial enterprise. Depreciation means a fall in the value of fixed assets. Such fall in the value of fixed assets may be caused either by their continuous use or by obsolesence or by a change in their market price or by an accident etc. Book value of fixed assets decreases because of depreciation. It affects profit also because depreciation is a charge against profit to the enterprise.
METHODS OF DEPRECIATION
Fixed Instalment Method Or Straight Line Method. This method of preciation is based upon the assumption that the cost of an fixed asset should capportioned on its useful life equally. Under this method, the scrap value of xed asset is substracted from its real cost and the balance amount is divided oy its estimated useful life. This method is suitable for the fixed assets in respect of which, there is no possibility of obsolesence. Under this method, annual depreciation is calculated as follows–
Original Cost – Scrap Value Annual Depreciation =
* Estimated Service Life in Years
It is important to note in this regard that if some installation charges are paid to install the machine, these charges should be added to the cost of machine. Similarly, if an old machine is purchased and some amount is paid on its repairs and renewal, it should also be added to the cost of machine.
2. Diminishing Balance Method. Under this method of depreciation, the amount of depreciation goes on reducing. Under this method, depreciation is charged on the balance amount of fixed asset every year. This, amount of depreciation is high in begining and it goes on reducing in later years. Under this method, a certain rate is determined to provide depreciation and this rate remains the same for all the years. This rate is calculated with the help of following formula
Above formula can be solved easily with the help of logarathims and anti-logarathims.
This method is suitable for the fixed assets which require heavy amount of repairs and maintenance every year such as machines and vehicles etc.
3.Sum of the Years’ Digit Method. This method is also like diminishing balance method. Under this method, the amount of depreciation goes on redceing year after year. Amount of depreciation is calculated as follows
(1) Effective Life of Fixed Asset is determined.
(ii) Estimated Life of Fixed Asset is written in inverse order. For example, if the life of an asset is estimated to be five years, it will be written as-5, 4, 3, 2, 1. This figures will be used as numerator to calculate depreciation for a year.
(iii) Estimated Life of Fixed Assest, written in inverse order is added. In above example, this total will be ’15’. This figure is used as denominator to calculate the amount of depreciation.
(iv) Scrap Value of Fixed Asset is substracted from its original cost. The balance amount is multiplied by depreciation ratio and the amount so calculated is the amount of annual depreciation on Fixed Asset.
EFFECT OF CHOICE OF DEPRECIATION METHOD ON PROFIT
Problem: A Company wants to purchase a fixed asset costing Rs. 10,000 estimated life of asset is five years and the scrap value is estimated at Rs. 1,000. Calculate the amount of annual depreciation and cumulative depreciation under all the three methods of depreciation.
Study of above table makes it clear that the amount of annual depreciation is significantly different under all the three methods of depreciation. Since depreciation is a charge on profit of an enterprise, this amount affects the amount of profit also significanlty. Under fixed instalment method, the amount of depreciation remains constant in all the years. Therefore, it bears equal effect upon profits in all the years. Under diminishing balance method and sum of the year’s digits method, amount of depreciation is continuously decreasing. As a result, profit will go on increasing year after year. Out of these two methods also, the amount of depreciation in first year is more under diminishing balance method and in all the remaining four years, it is more under sum of the year’s digits method.
