Lecture-31

Profits and Risk and uncertainty theory of profit

Learning objective: Concepts of profit and Frank H Knight theory of
profit
The reward for entrepreneur is known as profits. An entrepreneur is principle and
active agent of production. An entrepreneur can be distinguished from other
owners of factors of production on a number of criteria.
1) An entrepreneur cannot be hired or purchased by other factors, so his income is
non contractual, whereas, the entrepreneur enters in to contract with other factors.
They are hired or purchased, thus there return is contractual.
2) An entrepreneur may not earn reward for his efforts, whereas other factors always
earn reward for their efforts.
3) Entrepreneur performs functions which are all together different, such as he bears
risk and uncertainty, introduces innovation etc. Other factors have defined
functions such as labour performs manual work etc.
4) An entrepreneur may get negative reward in case of losses, whereas, other factors
always get positive reward.
Concept of profit:
Gross Profit is the excess of total revenue over the total explicit costs.
Gross Revenue = Total Revenue Total Explicit cost
Net Profit: The residual available to the entrepreneur after accounting for all explicit and
implicit costs involved in the production
Net Profit = Total Revenue Total explicit cost- Total implicit cost (including
depreciation) or
Gross profit Total implicit cost
Normal profit is the minimum profit which an entrepreneur must earn in order to induce
him to keep the firm in operation. It is thus included in the cost of production just like
any other expense.
Super normal profit is in excess of the minimum necessary to induce the entrepreneur to
keep the firm within the industry he is currently operating in. They are the profit over and
above the normal profit and thus not included in the cost of production. It is the level
where the entrepreneur is earning more than the total opportunity costs. Super normal
profit may arise because of the following reasons.
Monopoly profits
Windfall gains
Difference in ability of entrepreneur

Risk and uncertainty theory of profit:

This theory was propounded by American economist Frank H Knight in his book Risk,
uncertainty and profit in 1921.According to him profit is the reward for uncertainty
bearing. Knight asserted that there is a significant difference between risk and
uncertainty. Although all uncertainties can be regarded as risk, all risks are not uncertain.

Knight divided the risk into two categories, insurable and non-insurable
1 Insurable Risk:
There are some risks which can be for seen by the entrepreneur. These risks can be
insured against to avoid any loss in the case of the risk materializing. Included in
insurable risks are risks such as fire, flood, earthquake, theft etc.
The entrepreneur pays insurance premium to guard against such risks. The actual risk is
borne by the insurance companies and not the entrepreneur. So the entrepreneur dose not
earns any profit on such risks. The premium paid for insuring against such risks is added
to the cost of production and finally enters the price of the product.
2 Non-Insurable Risks:
Apart from the risks which can be foreseen, there are also some other risks which are
unforeseen and unpredictable. These risks constitute the second category of non-insurable
risks because these cannot be insured against.
No insurance company would be prepared to bear such risks. The entrepreneur has to
bear these risks himself.
Knight calls these non-insurable risks as uncertainty. Profit is the reward that accrues to
the entrepreneur for uncertainty bearing. Some of the non-insurable risks or uncertainties
are:
Competitive risks: These arise as a result of entry of new firms in the market.
Change in Government Policies: The govt. takes a number of policy decisions from
time to time which create uncertainties for the firm. e.g, it may devalue the currency,
introduce price ceilings, intervene in the affairs the firm, change its trade policy etc.
Technological Uncertainties: New techniques of production may render the older
technology and machinery obsolete. This creates uncertainty for firms using the old
techniques of production.
Business Cycle Risks: Uncertainties arise as a result of the trade cycles of boom,
recession, depression and recovery.
All the above risks are unforeseen and no insurer would be ready to indemnify for any
loss arising out of such risks. Each entrepreneur has to bear these uncertainties and profit
is the reward for successfully countering them.
An entrepreneur always faces a degree of uncertainty. Higher the degree of uncertainty he
is ready to bear, higher the chances of earning greater profits. There is always the
possibility of diversion between expectations and results because of the uncertainty
arising as a result of difference between the time a decision is taken and its eventual
implementation. If the decisions are as per expectations, then the entrepreneur will earn
positive profits. On the other hand, the actual result do not meet the expectations, the
entrepreneur may suffer losses.
Criticisms of the Theory:
1 Uncertainty bearing is not the only function of an entrepreneur. An entrepreneur
performs many other functions like organizing the factors, introducing innovations,
planning etc.

2 In reality, there is nothing to suggest that an entrepreneur who bears uncertainty would
earn profits as well.
3 The modern world is characterized by joint stock companies. Ownership is completely
divorced from management in such organizations. Those who bear the risks do not
manage and those who take decisions do not bear the actual risk. The distribution of
profits between the owners has not been explained.
4 There is greater uncertainty during recession and depression than during the boom
period. According to the theory, an entrepreneur should earn greater profits during
recession and depression than boom. But the reality is usually the opposite.
5 The theory gives uncertainty bearing the status of a separate factor of production.
However, this is unrealistic.
Questions
1 ___________ is the reward of entrepreneurial function
a) Rent
b) Wages
c) Interest
d) Profit
2Uncertainity bearing theory of profit was proposed by
a) FA Walker
b) JB Clark
c) FB Hawley
d) Frank Knight
3 Net profits is otherwise called as
a) True profit
b) Economic profit
c) Pure profit
d) All of the above
4 ________ is the amount which accrues to the entrepreneur for assuming the risk
inseparable from business
a) Rent
b) Wages
c) Profit
d) Interest
5Profit is reward for uncertainty bearing rather than than risk taking was explained by
a) Dynamic theory of profit
b) The innovation theory
c) The risk bearing
d) The uncertainty theory
Answers
1 d)
2 d)
3 d)
4 c)
5 d)