THEORIES OF PROFIT: A REVIEW AND AN EXTENSION

CLIFF BOWMAN
Cranfield School of Management

We consider how profit has been explained and justified. We then build
on property rights theory to develop an alternative explanation of profits
and conclude that profits can be considered as an implicit payment for
access to the assets required for an individuals labour to be market
efficient. The nature of the bargains struck between employees and the
firms representatives affect the flow of value captured by the firm in the
form of profit, rather than these flows being captured by employees in the
form of higher salaries, and these bargains are essentially determined by
perceptions of reciprocal dependence between the firms representatives
and the employees.

Theories of Profit: a Review and an Extension

The field of strategic management focuses primarily on firms, rather than other forms of
organizations e.g. charities, government departments. What distinguishes firms from other
organizations is that they are explicitly established to create profits. Indeed, some strategy
scholars view strategy as a search for profits. The two dominant paradigms that underpin
most strategy discourse have profits at their centre. Porters (1980; 1985) view explores how
firms might be able to occupy privileged market positions that would enable them to earn
monopoly profits; whereas the resource-based view addresses imperfections in factor markets
that enable resource-endowed firms to earn sustainable rents, which are the source of supernormal profits. The achievement of competitive advantage and the related stream of popular
management books and consulting prescriptions that focus on the identification of the causes
of business success, are all couched in profit terms (e.g. Peters and Waterman; Collins and
Porras; Treacy and Wiersema).
Given the centrality of profit in strategy discourse we might expect that the profit
construct would be solidly underpinned by unambiguous economic theory. However, delving
into the economic underpinnings of profit reveals profit as being a rather slippery construct.
There are multiple and competing explanations about what it is, and where it comes from.
There are also many explanations for why it exists, and why its recipients deserve to receive
it.
This paper reviews profit theories, and then develops and extends a particular approach to
profits. Hart and Moore (1990) argue that a key right provided by ownership is the ability to
exclude people from the use of assets. We have argued that this authority over assets
translates into authority over people. (Hart and Moore, 1990, pp. 1150). This idea has been
developed by Rajan and Zingales (1998) into a more general treatment of power relationships
within the firm, and by Holmstrm (1999, pp.75-76), who puts forward the conjecture that
the firm gains power over human capital though ownership and control of assets. Ownership
confers contracting rights that allow the firm to decide who should be offered the opportunity
to work with particular assets and on what terms. Here we build on these ideas and conclude
that profits can be considered as an implicit payment for access to the assets required for an
individuals labour to be market efficient. The nature of the bargains struck between
employees and the firms representatives affect the flow of value captured by the firm in the
form of profit, rather than these flows being captured by employees in the form of higher

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salaries, and these bargains are essentially determined by perceptions of reciprocal

dependence between the firms representatives and the employees. We begin with a brief
review of profit theories.
Theories of Profit
Profits are an unusual form of value that can appear as a residual, as the difference
between the flows of revenues and the flows of cost. In this residual form it can give the
appearance of being an incidental and quixotic by-product of the firms activity. Indeed,
some stakeholder and coalitional views of the firm would not see the need to privilege the
pursuit of profit above other goals e.g. the meeting of consumer wants, or the provision of
satisfying and rewarding work opportunities for employees, or social responsibility.
However, as we have argued strategy as a domain of interest to academics and practitioners
seems to focus on the pursuit of profit as the primary goal or purpose of the firm. A perusal of
the economics field reveals (at least) twelve different explanations of profits:
1) monopoly gains due to imperfect competition e.g. the industrial organization (IO)
explanations of superior performance developed by Porter (1980)
2) rents to factors in inelastic supply e.g. as deployed in the resource-based view of the
firm (Barney, 1991)
3) profits as surplus value or unpaid labour (Marx, 1954)
4) profits as returns for the individual who incurs risks which are uninsurable (von
Thnen, 1850)
5) profits as a reward for individuals who are willing to buy at a certain price and sell at
an uncertain price (Cantillon, 1755)
6) profits as the windfall difference between the expected and the realized returns of an
enterprise (Knight, 1921)
7) profits as a reward to a fourth factor of production entrepreneurship (the others being
land, labour and capital), for decision making, coordination and organizing production
(Marshall, 1890)
8) profit as a rent of ability, an intra-marginal surplus accruing to superior business talent
9) profits as a residual left over after all contractual costs have been met, including the
transfer costs of management, insurable risks, depreciation, and payments to
shareholders sufficient to maintain investment at current levels (Blaug, 1997, pp. 440)
10) profits as a return to equilibrium-disturbing innovation (Schumpeter, 1912)
11) profits as a reward for equilibrium-restoring innovation (Kirzner, 1973)
12) profits as payments to shareholders sufficient to maintain investment at current levels
(Blaug, 1997, pp. 440)
We could add to this list theories of interest e.g. Seniors abstinence theory, and BohmBawerks view of interest as a reward for using roundabout production methods (see Blaug,
1997, pps. 186 and 488).
Some economists, for example, Samuelson (1976, pp. 621) have argued that this range of
explanations is unproblematic as they each explain a portion of the profits that a particular
firm might earn. Three of them (3,6,9) view profit as some form of residual or surplus that
remains once all other factors of production have been paid, whereas most other
explanations see profit as a reward of some kind (4,5,7,8,10,11). Presumably this is an
implicit reward as customers or the market cannot knowingly isolate and reward anyone,
or any particular factor of production involved in the collective enterprise of value creation.
It is useful to explore where the idea of profit as a reward emerged from. In marginal
productivity theory, in equilibrium, each productive agent will be rewarded in accordance
with its marginal product as measured by the effect on the total product of the addition or
withdrawal of a unit of that agent, the quantity of the other agents being held constant

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(Blaug, 1997, pp. 407). Thus a firm will, for example, continue to hire workers as long as
each additional worker adds more to revenues than to costs. This is a theory of factor prices,
where the marginal product determines e.g. the wage rate for all employees, not just the
marginal one. However, J. B. Clark (2001) regarded the theory as more than a theory of
factor prices. In his view market forces produce a set of returns to productive agents which
are not only efficient, they are also fair. Equilibrium theorizing leads us to the conclusion that
whatever a factor receives is directly proportional to that factors contribution: we all get our
just deserts. Hence the need to explain profit as a reward for some contribution to the
productive process, so profit rewards risk taking (theories 4 and 5), or entrepreneurial ability
(7 and 8) or innovation (10 and 11).
Lippman and Rumelts (2003a) payments perspective takes a different tack. They have
expunged the notion of economic profit; there is no surplus to attribute or explain, as all
revenues go towards paying for the cost of the various resources that came together to
create the revenue stream. But the man in the streets understanding of profit as a surplus
appropriated by shareholders is not considered as profit per se (12 above). In the
neoclassical view shareholders dividend payments are a necessary cost of production in the
same way that wages, and material costs are necessary costs. Only payments to shareholders
above the minimum required to sustain their investments are considered as true profit. The
problem with this thinking is it assumes that the shareholders investment actually has an
alternative use. However, this investment does not comprise a sum of money or finance
capital, which, if it was the case, this could easily be transferred elsewhere. Instead this
investment does not exist in and is not manifested in a transferable form at all: it has been
converted or transformed from a fungible money form, into a much more fixed, contextspecific concrete configuration of productive resources. These may have no alternative use,
i.e. their opportunity cost is zero.
The majority of these explanations stress the destination of profit as a reward for some
contribution to the value creation process within the firm. These explanations are necessary
from a neoclassical equilibrium standpoint: if we all receive our just deserts then profit must
be a payment or a reward for some contribution to value creation. We now consider profit as
a reward or payment for a particular contribution, factor of production or service.
Payments for Entrepreneurial Acumen
As we have seen, some theories explain that profits are a return or reward for
entrepreneurial acumen. The entrepreneurial role can be conceived of as a particular form of
labour that decides what should be made, how these things should be made, where and how
they should be sold etc. In most firms of any size and longevity these activities and decisions
are in fact taken by hired employees, be they managers or staff specialists. These decisions
would be distributed to functional specialists e.g. marketers decide how to advertise,
production engineers decide how to produce, procurement specialists what to buy etc. Indeed,
Schumpeter (1912) recognized that entrepreneurial innovation was a role, and this role was
unlikely to be situated within one person, or even within a defined group. We could group
these entrepreneurial functions into a generic category of entrepreneurial know-how in
action. Although we might wish to isolate entrepreneurial know-how from other forms of
know-how, the likelihood is that this is performed by many different people across functions
and across levels of hierarchy. What is clear is that the entrepreneurial role is not performed
by those who own shares in the firm, as they typically play no active role in use value
creation.

Profit as Payment to Capital

So is profit a payment for the capital required in order to set up a market efficient
production process? Let us assume someone put up finance capital to establish the firm, these
would then become the equity owners. This finance capital that existed in a monetary form in
T1, is then transformed into a collection of productive inputs in T2 e.g. it has been used as
working capital to hire employees, procure raw materials, and it has been invested in fixed
capital e.g. machinery. These inputs are then the manifestation of the finance capital, but they
are not finance capital. Finance (money) does not contribute to the value creation process;
only productive inputs are involved. Profit, whether it is regarded as a payment, surplus,
reward or residual is part of the total revenue stream flowing into the firm. So in this respect
our starting point is identical to Lippman and Rumelts (2003a) payments perspective. This
revenue flow is a payment from customers for the products and services that the firm has
produced and managed to sell. These payments are for the benefits that these products confer
on the customer.
In this respect Lippman and Rumelt (2003a) have adopted a quite radical position in their
payments perspective. There is no mention of finance capital, or equity investments in their
payments schema. They include only those productive inputs that are directly involved in the
creation of products, and hence revenue flows. So when customers pay for products, they are
paying for the outputs these inputs interacted to produce. They cannot be paying for the
finance that was provided to buy these use values, because it is not present in the value
creation process. And if we separated a proportion of revenues to pay for the costs of
finance, what is the separate and distinct contribution to production provided by finance,
given that this finance has been converted into productive inputs? And if we did include a
cost, payment or charge for finance, would we not then be paying twice for effectively the
same productive resources?
The products and services bought by customers are created by productive use values e.g.
equipment, consumed materials etc, and labour. These use values have similarly been paid for
e.g. the provider of machinery has been paid, as has the supplier of electricity etc. These
payments may have occurred in prior time periods, as in the case of durable equipment like
trucks and machinery. Similarly, the firm that made inputs consumed in the process of
production received payment for their goods, probably in the current period. These
expenditures are in line with Lippman and Rumelts (2003a) payments to commodity inputs
and commodity resources.
We shall assume at this stage in the argument that the suppliers of labour received their
wages as full payment for their labour-time spent under the direction of the firms managers,
and that they received the prevailing market wage rate for their time. Similarly, those
directing the firm, the managers and supervisors, also receive their appropriate market rates
of pay. Where scarce resources are deployed, according to Lippman and Rumelt (2003a),
they too will receive their due payment, reflecting their scarcity and their peculiar
contribution to revenue creation. Lippman and Rumelt (2003a, pp. 908) state that: [w]e
believe that the spirit of the resource-based view is to impute payments to resources. But
where the firm owns the resources, then the firm receives the resource payments, not the
resource. And presumably, the shareholders, who own the firm, get their profits from these
payments. Where the resource is supplied or provided by a third party, an employee with
special talents, for example, then the resource supplier possibly gets all of the payments. But
they may well not receive the full payment for their contribution. If they do not, then this
needs some explanation. So there is a distinction between the payment to the resource, and
the owner of the resource receiving some or all of this payment.
All those who supplied use value inputs into the production process have received their
payments. The flow of revenues is the customers collective payment for the products or

services supplied, and the payments perspective allocates this total amount to the
participating resources. There is, then, no surplus or profit that needs to be explained or
accounted for. But clearly most firms make profits, so we are missing a piece of the jigsaw,
which is an explanation of the link between resource payments and shareholders capturing
profits.
Scarce Resources
We need to un-pack the nature of scarce resources. Proponents of the resource based
view (RBV) generally argue that human or 'cultural' resources are the sources of above
normal returns, not purchasable and tradable physical assets (Barney, 1986, 1991; Castanias
and Helfat, 1991; Dierickx and Cool, 1989). This is because physical inputs like computers
or machinery can usually be purchased by competing firms, thus any advantage from buying
a better piece of equipment is usually rapidly eroded as competing firms are free to acquire
the same equipment. So these commodity resources are priced and are imitable.
Moreover, it can be argued that the purchase of expensive equipment should not be a
barrier to a firm becoming market efficient if finance capital is available. All the firm needs
to do is to borrow the money from a bank, or have an individual invest equity capital in the
firm. But the price of such capital injections is paid out of the surplus the firm produces.
The bank may advance a loan, and if it cannot be secured against assets of enduring value e.g.
land and buildings, then it is likely that the interest rates would be relatively high. The equity
investor takes a bigger risk with his unsecured cash injections, and thus requires first claim on
the surpluses (net of any interest).
However, valuable human resources such as specially skilled or talented employees, or
resources that take the form of embedded tacit routines, tend to be difficult to replicate and
can therefore enable the firm possessing or controlling the deployment of these resources to
sustain higher levels of profit.
In most firms both the performance of valuable behaviours within the routines, social
networks, and cultures of the organization (Nelson and Winter, 1982), and the direction and
deployment of these resources with other inputs, are activities undertaken by hired
employees, be they executives, middle managers or shop-floor workers. This implies that
RBV rents derive primarily from the actions of various types of labour working on and with
other commodity inputs and procured resources (Lado and Wilson, 1994; Pfeffer, 1995).
Thus, within resource-based theorizing the "resources" that produce rents are more likely to
be human resources, rather than non-human separable resources (Bowman and Swart,
2007). The RBV also recognizes that resources can be built or bought (Makadoks (2001)
resource picking), and these resource creation and acquisition processes are, again, likely to
be performed by managerial and other types of labour.
From the payments perspective, these scarce resources should receive their due rewards,
commensurate with their contribution to revenue creation. We could assume for the sake of
argument that all the firms scarce resources were either artfully procured, or internally
created by different forms of hired labour. Employees past and present created and acquired
these scarce resources and some currently are these scarce resources. However, many of
these resources are non-human so cannot sensibly be rewarded, and they interact in
complex configurations of scarce resources and commodity inputs to create value. As
Alchian and Demsetz explain, in complex value creation processes it is impossible to isolate
the particular contribution made by a single resource (Alchian and Demsetz, 1972). So who
gets the scarce resource payments, and why? The answer is that the firms owners receive a
proportion of these payments in the form of profit, even though they are absent from the
value creation process. This again needs some explanation.

One explanation would be that although these resources were created by labour in the past
and in the present, the resources are owned by someone else, namely the shareholders in the
firm. But even this is not strictly correct. Shareholders own property rights to the legal entity
that is the firm, and as a consequence they can benefit from surpluses generated by the firm.
It is difficult to see how shareholders could own a collective routine performed by
employees, but they clearly can own any cash surpluses the firm throws off. Thus even
though a resource may be special collective know-how performed by a skilled team, where
we might think that these skilled employees owned their collective skills, the team do not
capture the payments to this scarce and valuable resource.
Commodity Inputs that Create, or are Scarce Resources
The trick here is that although special labour in action would be categorized as a scarce
resource, the supplier of this resource is remunerated as if they supplied what Lippman and
Rumelt (2003a) refer to as a commodity input. If their labour time is sold on a per hour,
week or monthly basis, at wage rates that reflect prevailing labour market conditions for
different generic skill sets, their special resource contribution will not be reflected in their
wages. But once a resource takes on a form separated from those who created it e.g. a
valuable routine has been captured in a codified form, or a patent is developed, these
resources are then separated from the individuals who originally performed or created them,
and in this form the scarce resource can possibly be priced, and traded.
The reification of resources, as in resources receive payments, disguises a critical
feature of the firm. This problem of reification is not merely a semantic problem. What is
being presented by Lippman and Rumelt (2003b) as a theory of resource payments is
abstracted from, and potentially obfuscates the underpinning relationships between people,
who come together and make deals as employees, owners, buyers, sellers etc. For instance, in
their bargaining perspective paper Lippman and Rumelt (2003b, pp. 1070), cite a rich silver
mine as an example of a scarce resource: [i]f it is more productive than other silver mines, it
will receive a larger payment for its services. And later they add our bargaining parties are
not firms or products, but rather the individual resources that lie behind them (2003b, pp.
1070), and we identify the active agent in our approach as the resource rather than the firm
(2003b, pp. 1075). But a brand name, or patent or a silver mine cannot be paid or rewarded,
neither can these things bargain, or be active agents, only people can.
To pursue this line of argument let us look at the contributions different productive use
values make to use value creation:
1. The bought in material (a commodity input in Lippman and Rumelts terminology) is
fixed in its contribution to new use value creation. The component has value, e.g. steel
screws have use value, but this use value contribution is unvarying, and it was created
outside the firm (Bowman and Ambrosini 2000).
2. The machine, a computer for example, (a commodity resource) contributes its
computing power to the overall production task. But note that this contribution is also
fixed. The computer or any machine or truck etc is what it is. Its contribution is fixed,
and it cannot, of its own volition, change, increase or alter its contribution. Note also
that this machine, or building or even logo could be unique to the firm i.e. it could
qualify as a scarce resource (Barney, 1991), but nevertheless its use value contribution
is still fixed.
3. This leaves the human resources. These are the sole source of added use value in the
process. Their contribution is not only variable in its intensity (some staff might work
harder than others) but labour will necessarily be variable in the quality of its
performance. Moreover, only human resources can introduce change, innovation,
creativity etc into the value creation process.

Commodity inputs and resources make a fixed and probably known and understood
contribution to the creation of new use values for sale. Human resources are solely
responsible for any valuable variations, and for any added use value that is created. To use a
simple example, in a business school we will find commodity inputs like lecture theatres,
projectors, computers etc. These are useful and valuable only if we have students to teach and
faculty to teach them. So these commodity inputs only add value when someone works with
them. The use value that these inputs contribute does not change, and this value was created
elsewhere, within another firm e.g. the manufacturer of projectors.
The problem with explanations like the payments perspective is that they equate the
sums received by suppliers, employees, managers etc as directly reflecting the value
contributed or created by these stakeholders.
Asset Access Payments
Hart and Moore (1990) and Rajan and Zingales (1998) argue that in many fields of
production in order for the labour of an individual to be market efficient this individual needs
to be able to interact with scarce and/or expensive separable assets. To gain access to the
necessary separable assets, which could be equipment, a brand name, a firms reputation,
collective routines etc the employee in effect pays an implicit hire charge to the firm for this
access, a lease cost or rental payment, if you will. These aggregated asset access payments
are the basis of profit.
How much profit is reaped from these transactions is a function of the perceived
dependence of the parties on the plethora of transactions involved in hiring staff, buying
equipment and selling products or services. These implicit access payments are estimated in
advance when employees are hired. As explained earlier, firms typically only take on staff if,
by hiring them, there is a belief that the firm can add more to revenues than to costs.
There are links between this argument and marginal productivity theory, which argues that
the wage rate is set at the marginal point where the contribution of one additional unit of
labour adds as much to costs as to revenues. But if the wage rate is set at this marginal point
all other units of labour must be contributing more to revenues than to costs. These intramarginal contributions are equivalent to our asset access payments.
The hiring deals done in Time 1 reflect local employment market conditions in T1 and
expectations of product market conditions in T2Tn. These implicit asset access payments
must cover all the costs of financing the firm, be they interest costs on debt, or dividends, as
well as pure profit. Thus whether a firm has been built up through the retention of profits,
whether it is owned by one person, or thousands, or whether or not it carries substantial fixed
interest debt, does not affect the asset access payments, although these financial
circumstances may affect the decisions to hire more or less staff.
In some markets where, due to the lack of technological innovations, it is possible for a
sole trader to still earn a living, individuals may opt to trade as independents. Consulting
would be a good example here. However, the individual consultant may choose to sell her
labour to a large consulting firm and may well be better off financially for so doing. The firm
allows her access to a stream of sales leads, a database, a reputation and brand name etc. So
when she interacts with these separable assets she can be far more productive in terms of
value creation than she would as a sole trader. She may well earn far more from selling her
labour to the consulting firm than she would earn as a sole trader. But she pays for this access
in the difference between the revenues attributable to her labour, and her salary. In this case
the implicit asset access payment can be identified as a proportion of the difference between
her daily pay rate and her charge-out rate.
Clearly, the crucial determinant of the level of profits would be the nature of the deals or
bargains struck between the firm and its employees, which we now turn to.

Asset Access Payments and Perceived Dependence

In addressing the issue of the size of asset access payments relative to the wage or salary
received, we extend the resource dependence arguments used by Hill and Jones (1992) and
we develop Hart and Moores (1990) argument that an agents bargaining position will
depend on which assets he or she controls. Hart and Moore explain that a key right provided
by ownership is the ability to exclude people from the use of assets (1990, pp. 1150). Where
an individual perceives they have little choice but to work with these assets if they are to earn
a living, they would see themselves as having little bargaining power or leverage in setting
the terms of their employment.
In general we would argue that the terms of trade in a deal or contract between any
stakeholder and the firm is a function of perceived dependence. The employee perceives
themselves to be more or less dependent on making this particular deal at this particular time.
Perceptions of dependence will be influenced by, inter alia, the extent to which the employee
perceives they can make alternative deals that are similarly attractive. Where they perceive
they have many viable alternatives, then they perceive low dependence and vice versa.
Similarly, the firms agent who is deciding who to hire bargains from their perceptions of the
firms dependence on recruiting and retaining this particular individual.
Although thus far we have referred to the firm as making deals, selling products etc we
now need to qualify this shorthand terminology. Firms dont make deals, people do. They
may act as agents on behalf of the firm, but they operate on the basis of their individual
cognitions and perceptions. There are search costs involved in transactions, and individuals
will likely limit their search activity in all but the most critical transactions to them
personally.
The profit or net cash flow the firm generates will be a function of the terms of trade of the
contracts struck, over time, with suppliers (including employees) and customers. The
individual acts on behalf of the firm in making these deals; and this effectively means the
individual negotiator (agent) is acting for the equity owners of the firm (principal).
The prices paid for inputs (in factor markets) are not directly connected to prices the firm
realizes in product markets. Not only are the markets that the firm trades in disconnected in
terms of the use values being traded, they are also usually disconnected in time. The market
conditions in factor markets in T1 reflect different buyers and different competing sellers to
those conditions prevailing in product markets in T2. Therefore it makes little sense to
aggregate historic costs into a determination of current prices. The firm as a value-creation
system should be valued according to its future potential to generate profits. If the firm is not
judged to be able to generate future profits then the break up value of the firm would be the
sum of the prices each separable asset could command at that time. So logically firms would
be dissolved where the break up value exceeded its value as an integrated and functioning
system.
Where firms are profitable this suggests that the collection of assets and know-how in
action has synergistic interactions. However, because use values are created through
interactions, it is impossible to allocate or attribute portions of captured revenues to the
parties in the interaction. This is akin to trying to determine which blade of a pair of scissors
does the cutting. The captured revenue is distributed through processes that reflect
dependence relationships and bargaining power. There is no objective way of apportioning
captured value, and the sums received by suppliers of labour and other inputs do not
correspond to their respective contributions to revenue creation.
Then the problem of profit creation reduces to: how to make advantageous deals with
input suppliers in T1, how to deploy these inputs, human and otherwise, to create valuable
products and services in T2 which will enable the firm to make advantageous deals with

customers in T3 (the issue of timing in making deals is dealt with in Rajan and Zingales,
1998). Making deals with input suppliers requires the decision maker to capture as much use
value for as little exchange value passed on to the supplier: to maximize bangs for buck.
Strategies that can assist here are about increasing the perceived dependence of the supplier
on the firm and the resultant reductions in the perceived bargaining power of suppliers.
Making advantageous deals with customers means capturing the maximum amount of
exchange value for a given quantity of use values: maximizing bucks for bang. There are
clearly sequential interaction effects that connect deals with customers and deals with
suppliers. For example, advantageous deals with suppliers could lead to lower relative costs;
these could allow the firm to price more aggressively and therefore increase sales volumes;
which in turn could give the firm more leverage over suppliers.
As we have suggested, we would expect the terms of trade in a deal to be a function of
perceived dependence (Hill and Jones, 1992). Each stakeholder, supplier or customer,
perceives themselves to be more or less dependent on making this particular deal at this
particular time. In figure 1 we have juxtaposed a stakeholders (or contractors) perceptions
against those of an agent acting on behalf of the firm. Perceptions of dependence will be
influenced by, inter alia, the extent to which the stakeholder perceives they can make
alternative deals that are similarly attractive (Coff, 1999). Where stakeholders perceive they
have many viable alternatives, then they perceive low dependence and vice versa. The matrix
also builds on the arguments set out in Williamsons (1979) paper on transactions costs.
The matrix applies to any contracts the firms agents enter into, with customers or
commodity suppliers, etc but in our explanation of each cell of the matrix we focus on the
implications for the contracts with the suppliers of labour.
FIGURE 1
Power Relationships Between Contractors and the Firm
Perceived dependence of Firms
agent on this transaction
Low

High

Perceived
dependence of
contractor on this
transaction

High

Coercive

Calculative

Asymmetric

Symmetric power

Power with the firm

Mutual dependence
2

Low

Commoditised

Compliant

Symmetric power

Asymmetric Power

Mutual independence

Power with the contractor

1

10

In Cell 1 Commoditized Deals the stakeholder perceives low dependence, as does the
firms agent. Both parties perceive that they could walk away from this deal with only a
negligible loss. This would be a standardized transaction (Williamson, 1979, pp. 241) with
no specific idiosyncratic investments in the transaction by either party. They are likely to
bargain from a position of more or less equal perceived power, but no great energy is likely to
be expended in this bargaining process. The perceived power relationship, based on mutual
perceptions of their independence with regard to this deal, then would be symmetrical. But
because of the mutual perception of their being many alternatives for both parties, the terms
of trade are likely to reflect the prices ruling in a competitive market for the use values
supplied. So Cell 1 deals would approximate to Lippman and Rumelts (2003a) commodity
inputs. An example might be a student looking for casual evening work serving in a bar. The
wage paid will reflect market conditions for unskilled labour.
In Cell 2 Coercive Deals the stakeholder perceives himself to be highly dependent on
doing this deal at this time. But because the firms agent perceives there to be many
alternative potential stakeholders to transact with, there is an asymmetric power relationship.
Here the power lies with the firms agent and we would assume, if the costs involved were
perceived by the agent to be significant for the firm and if the agent was concerned about
costs i.e. salience was high, then the agent would look to bargain hard and establish terms of
trade advantageous to the firm. So in these circumstances the employee is likely to accept a
low wage rate. Where firms are able to site in locales where there are few alternative ways of
earning a living, coercive deals will likely produce relatively significant levels of profit.
Moreover, where the employee has developed know-how that is only perceived to be
valuable in the context of this firm, there is a potential hold up problem, especially if the
firm is able to choose between many such individuals (Williamson, 1979).
In Cell 3 Compliant Deals we also have the case of an asymmetric power relationship, but
this time the power lies with the contractor not the firms agent. The agent perceives the
supplier to be offering something special to the firm, something that could not be easily
acquired elsewhere. However, the stakeholder perceives that they can easily (rightly or
wrongly) take their use values to another firm, who would be happy to deal with them. The
stakeholder could then negotiate from this position of perceived strength and establish
advantageous terms of trade. Note however, that for any deal to be done the agent must
nevertheless perceive there to be value in the deal (from either the agents personal interests,
or for the interests of the firm). The agent must still perceive there to be some consumer
surplus in the deal, even at a high price to the firm. In the Cell 3 case, the firm may find
itself conceding a large proportion of added value to the contractor, to the point where there
may even be a loss on the deal, given that the deal struck in T1, and value is created in
T2Tn. In this case the firms agent has miscalculated the future market conditions and the
firm makes a net loss by hiring this individual.
Cell 3 deals would apply where an individual employee was aware of their special value to
the firm, and where they also perceived that they had other equally attractive job offers i.e.
their special skills were not firm specific. The danger to the firm in Cell 3 negotiations is
overpaying in T1 for value that does not materialize in T2. Poor recruitment decisions in
sport, entertainment etc would be Cell 3 problems.
In Cell 4 Calculative Deals both parties perceive themselves to be dependent on doing this
particular deal. Neither party perceives that they have viable alternatives at this time to the
current opportunity. But both parties also understand the dependence of the other party to this
deal. Williamson (1979) refers to a situation of bilateral monopoly, which is akin to a Cell 4
bargaining situation, and Holmstrm and Roberts (1998) cite possible Cell 4 examples where,
due to mutual dependence on the deal hold-up problems are minimized.

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This should lead to an informed negotiation, factoring in these perceptions of mutual

dependence. Power would then be symmetric. Cell 4 situations might occur where an
employee has developed firm-specific skills. The skills cannot be readily transferred to
another firm, but the firm is also highly dependent on the contributions from this individual.
These Cell 4 negotiations may well apply where the stakeholder is supplying a resource in
resource-based thinking (Barney 1991). The terms of this deal are likely to lead to a sharing
of the spoils where the terms of the deal are attractive to both parties.
So our matrix helps us explain the circumstances that underpin deals made when
individual employees contract with the firm. For a firm to enjoy healthy profits, the net effect
of these deals with employees must be such as to ensure that the payments to the scarce and
other kinds of resources that these employees create or enact do not get fully passed on to the
employees. The reason for this likely outcome is that most employees are likely to see
themselves to be in Cells 1 and 2, perceiving that they have a weak bargaining position. For
an unskilled person access to any assets is better than no job at all. Those with specialized
skills may need access to specific assets in order to be productive. This may render them
either more compliant in negotiation (Cell 2) if they feel they have few alternatives, or more
robust (Cell 3) if they feel the firm needs them more than they need the firm (Hart and
Moore, 1990).
One corollary of this thinking would be that it might be in the firms interests to persuade
as many employees as possible that they are in fact in Cell 1 or 2, even where their
contributions to resource creation and value creation are extremely high. Further, where poor
deals have been made from the firms point of view, where there are no possibilities to renegotiate deals done in T1, employees may capture more value than they contribute, and zero
profits or indeed losses may result. Finally, we have assumed all employees and all nonhuman resources play a productive role in the firm. This may well not the case in a specific
firm, where resources are poorly deployed, and staff are adding far more to costs than to
revenues.
The matrix is generic and can be readily adapted to deals between the firm and customers.
In Cell 1 the customer perceives that they have many potential suppliers for their needs, and
at the same time the firms agent (the salesperson) also perceives that the firm has many
alternative customers. Deals will be done in a way that approximates to the workings of an
anonymous competitive market. In Cell 2 the product is perceived to be highly valuable to
the customer, and the agent knows that there are many other customers after the product, so
the price charged will be high, leading to low consumer surplus. In Cell 3 the firm is
desperate for this clients business, and client knows it too, and the client will hence be able
to bargain hard for a low price deal, resulting in high consumer surplus. In Cell 4 both parties
need the deal to go ahead so value will likely be shared out in a mutually acceptable way
between the customer and the firm. In dealing with customers the firms power would stem
from the relative perceived use value of the product at the point in time that the customer is
looking to purchase. Thus strategies that enhanced relative perceived use value should enable
the firm to sell more, and to sell at more favorable terms of trade. But the challenge for the
strategist is in anticipating what customers might value in future periods, anticipating what
competing product offers are likely to be, and then determining a productive process that not
only delivers high perceived use value, but one that does this at relatively low costs.
Perceived dependence and bargaining power can increase or decrease through unmanaged
exogenous events or through deliberate actions by managers. This framework can, then, be
developed to incorporate many aspects of the strategy landscape. The advantages of freeing
our thinking from the operations of an anonymous market allows us to recognize explicitly
that a) only people make deals, b) deals are made at specific points in time, c) deals are made

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only on the basis of what parties can perceive and interpret at a point in time, d) deals struck
reflect perceptions of dependence, and e) equilibriums never exist.
Summary and Conclusion
We have surveyed the current state of profit theory, which reveals that most explanations
of profit consider it as a reward of some kind. The just deserts approach to explaining the
distribution of value captured by the firm from its markets assumes that whatever a factor
receives is an exact reflection of that factors contribution to value creation. Hence, profits
must be a reward for some contribution to value creation. We considered two particular lines
of argument: profit as a reward to entrepreneurship, and profit as a payment or reward for
finance capital. We made the point that entrepreneurship in most firms is an activity
performed by hired employees, and it certainly not performed by owners who are absent from
the use value creation processes. We then consider finance capital and argued that finance
capital per se is absent from the use value creation process as it no longer exists in money
form; it has been transformed into productive use values. So the finance is manifested in
concrete productive use values, which may have no alternative use. If the productive use
values are rewarded for their contribution to value creation, and in addition those supplying
finance capital get additional rewards then the market is in effect paying twice for the same
inputs.
Non-human inputs make a fixed contribution to the use value creation process. These use
values were created elsewhere and in the past. The only source of additional value is the
labour that works with these inputs. However, firm production is characterized by complex
interactions between people and things, and as with a pair of scissors, it is impossible to
identify the contribution of any particular input to a collective, interactive process. What we
can say, though, is that any additional value can only derive from living labour working with
these other inert inputs. The payments or rewards perspective finesses this problem by
asserting that factor payments reflect factor contributions.
In the final section of the paper we explain that factor payments, and wages in particular
are determined by power relationships and bargaining processes. These deals reflect beliefs
about the contribution of, say, a particular individual employee, and from the employees
perspective, their likelihood of getting as better deal elsewhere etc. The larger and more
complex the firms use value creation system the more difficult it will be to make decent a
priori estimates of the value contribution of an employee. What we can say with confidence
is that whatever wages are received cannot be an accurate measure of the employees
contribution.
We introduced the idea of asset access payments as the source of surplus and profit.
Additional value derives from living labour interacting with other inert inputs and assets. Due
to the bargains struck between the firm and its employees (including managers) which are a
function of the employees perceived dependence, they most likely will capture only a
proportion of the additional value created. The difference is profit, and it can be viewed as a
price the employee pays for access to market-efficient productive assets.
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