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PROFIT MANAGEMENT

Based on:Dominic Salvatore, Managerial Economics (Adopted by

Ravikesh Srivastava), OUP, 2009M. L. Ahuja, Principles of Microeconomics, S. Chand

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• Profit theories• Schumpeter• Risk & Uncertainty• Breakeven• Measurement of Profit• Profit Maximization

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• General Notion of Profit (Business profit):• Revenue of the firm– Explicit Costs- useful for

accounting and tax purposes• Explicit (Accounting) Costs: Actual out-of-pocket

expenditure on inputs• Economic Profit: Revenue of the firm– Explicit and

implicit Costs- useful in reaching correct investment decisions

• Implicit Costs: What the same inputs would have earned in the next best alternative use outside the firm

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• Sum p16-17

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Theories of Profit

• Lack of agreement• Profits as Residual Income left after payment

of contractual rewards to other factors of production

• contractual rewards are always positive, but non contractual rewards may be positive or negative.

• Risk bearing theories:

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Profits As Dynamic Surplus

1. J. B. Clarke’s Dynamic Theory of ProfitsIn competitive long run equilibrium, P= AC

(including normal profits) and therefore, there is no pure profit.

But profits will emerge if P > AC due to changes(disequilibrium) either in demand or supply

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Clarke’s Dynamic Theory

5 changes that occur in a dynamic economy and give rise to profits:

Changes in- Quantity & quality of human wants- Methods of production- Amount of capital- Forms of organization- Growth of population

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Clarke’s Dynamic Theory

• In addition, 2 more changes:• Innovation and External change• According to Knight, it is not change which leads to

profits, but dynamic changes give rise to profits ONLY if changes and their consequences are unpredictable- because of uncertainty of Future.

• “In an economy where nothing changes, there can be no profits; there is no uncertainty about the future, so there is no risk and no profit”- Stonier & Hague

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2. Schumpeter’s Innovations Theory of Profits

Main function of entrepreneur is to introduce innovations in the economy and profits are a reward for this function.

2 types:A. Innovations that reduce cost of production

( those which change the production function)Include new machinery, new processes and

techniques of production, new source of raw material, new ways of organising business

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Schumpeter’s Innovations Theory

B. Innovations that increase the demand for the product ( those which change the demand or utility function- to sell more or at a better price)

Include:New product, new variety, new design of

product, new method of advertising, discovery of new market

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Schumpeter’s Innovations Theory

• Profits accrue not to those who conceived the innovation or financed it or to the one who introduced it

• Profits from a particular innovation are temporary- (He is in a monopoly position for sometime- transitional unless he can construct a permanent monopoly)

• With patents, he can continue to make profits for a long time

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Schumpeter’s Innovations Theory

In a competitive economy without patents, existing competitors will soon adopt any successful innovation and profits disappear.

In a progressive, competitive economy entrepreneurs continue to introduce new innovation and earn profits.

“The successful innovator can continuously seek new equilibrium profits since the horizon of conceivable innovations is unlimited”- Stigler

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3. Knight: Risk, Uncertainty &Profits

Uncertainty is a permanent feature of the economic system“So long as entrepreneurs start production with

imperfect knowledge of the market, anticipated marginal product of hired factors deviate from their actual product, so long a surplus would persist”

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Knight: Risk, Uncertainty & Profits

Causes of Uncertainty Changes in fashions & tasteChanges in incomesChanges in Government policies (Taxation, wage and

labor laws, export policies)Movement of prices as a result of inflation and

deflationChanges in production technologyCompetition from new firms

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Knight: Risk, Uncertainty & Profits

Insurable & Non insurable Risks• Insurable: fire, theft, accident etc- may cause

huge losses but by paying premium, can insure- Premium becomes part of cost of production

• Non Insurable Risks: Relate to the outcome of price-output/product design/advertisement expenditure decisions made by the entrepreneur -Can’t be insured- Involve uncertainty and give rise to economic profits, positive or negative

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Knight: Risk, Uncertainty & Profits

• The theory explains why supernormal (economic) profits arise in fields like petroleum exploration (have higher risks)

• Expected returns on stocks is higher than the interest on bonds because of higher risks.

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4. Managerial Efficiency Theory

• Some firms are more efficient than others in terms of productive operations/ higher managerial skills- Hence need to be compensated with supernormal profits.

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5. Monopoly Theory Of Profit

5. Due to MonopolyThroughPatentsLicensesEconomies of scaleExclusive control over raw materials which

prevent competitors from entering-

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6. Frictional Theory

• In the long run, in a perfectly competitive equilibrium , firms tend to earn only a normal return or zero profit.

• At any time firms are not likely to be in such long run equilibrium and earn profit or loss

• Why?

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• Which theory is most acceptable?

• Salvatore & Srivastava, p19, Case 1-3 on Apple

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Role & Functions of Profit

IN A FREE MARKET, PROFITS HAVE TWO FUNCTIONS.

1. SIGNAL: That consumers want more , to change the rate of output and firms to enter and exist

2. REWARD: Incentive: to innovate, increase efficiency an take risks

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• EFFICIENT ALLOCATION of resources• Soviet economic system collapsed because of

lack of profit motive

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Debate

Milton Freidman: “ Business has only one social responsibility- to make profits (so long as it stays within the legal and moral rules of the game established by the society)

… to make as much money as possible for their share holders

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How would the following affect Profits of your firm?

1. Firm is required by government to shift to Green technology

2. RBI reduces its Repo rate3. A new rival firm enters the industry4. Rate of inflation rises steeply5. Import duty on the product you manufacture is

greatly slashed6. A Trade Union is started newly in your industry

where none existed before

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