Profit Theory of Bearing Uncertainty
Profit Theory of Bearing Uncertainty
Professor Frank H. Knight considers profit as the reward for bearing those risks and uncertainties which cannot be insured. He distinguishes between insurable and uninsurable risks. Some risks can be measured to the extent that their occurrence can be calculated statistically. Risks like fire, theft of goods and death due to accident are insurable. Such risks are borne by insurance companies. There are some specific risks which cannot be calculated. Due to uncertainty, the probability of their occurrence cannot be calculated statistically. Such risks are related to changes in prices, demand, supply etc. No insurance company can calculate the expected loss arising from such risks and hence those risks are uninsurable. According to Professor Knight, profit is the reward for bearing such uninsurable risks and uncertainties. This difference arises from the uncertainty in actual and expected earnings.
Profit is the residue which remains after deducting the contractual income of other factor services. In a competitive economy, if entrepreneurs compete carefully and do not raise the prices of factor services to the value of their marginal output, they will have positive profits. If, on the other hand, they are optimistic about large expectations, profits will be negative, because factor services are paid more than their previously estimated marginal outputs. Positive or negative profits reflect the entrepreneur’s decision to cope with a situation of uncertainty.
But, uncertainty is found in the whole society and profit, positive or negative, is in some way accrued to all resource-services. In other words, we can say that profit has a part in all types of income. But the division of social income into profit and contractual income depends on the supply of entrepreneurial ability. When the supply of entrepreneurial ability is less, the amount of profit increases. The supply of entrepreneurial ability operates under diminishing returns and diminishing returns reduce the amount of profit. The practice of diminishing returns on entrepreneurship is nothing but the amount of uncertainty present in business.
Taking up uncertainty is a very important task in a dynamic situation. The entrepreneur either hands over this task to others or takes it upon himself. The expectation of profit is in a way the supply price of taking up entrepreneurial uncertainty. In a competitive economy, where there is no risk, the supply price of every entrepreneur is minimum. If his reward falls below this, the supply of entrepreneurial services will stop. But the existence of uncertainty increases the minimum supply price, which is actually the risk premium that the entrepreneur expects to receive. This is the profit. But changes caused by innovation and external forces, such as climatic and other unpredictable changes, constantly upset these expectations, so that in the long run each entrepreneur earns only normal profits. Only unpredictable changes generate profits. Changes in population and capital, being predictable, do not generate imperfect competition or profits. Thus profits arise from the uninsurable risks and uncertainties created by dynamic change.
Criticisms of these
Knight’s theory of profit is more comprehensive than other theories because it combines the theories of risk, economic change and business ability. But it has its own shortcomings too.
1. Concept of superiority is not clear: There is no clear concept of entrepreneurship in it. Bearing uncertainty is considered to be the only function of the entrepreneur. But in modern business companies, ownership is separated from control. The task of decision making is done by salaried managers who control and organize the entire company, while ownership remains in the hands of the shareholders who ultimately have to bear the uncertainties of business. Knight does not keep the two separate and hence his theory becomes unrealistic.
2. No solution to the distribution of profits among the controllers of corporations: As a natural consequence of this, this theory is unable to solve the problem of division or distribution of profits between the controlling and owner classes of corporations and thus leaves the problem of determination of profit unsolved.
3. No empirical evidence to measure uncertainty bearing: Even Professor Knight himself could not find any empirical evidence to measure uncertainty bearing to find out the amount of profit earned by a firm. Thus, the theory of bearing uncertainty explains the emergence of profits. It explains the emergence of profits in a vague manner.
4. Changes in population and capital are unpredictable: Knight’s statement that changes in population and capital are predictable is true only when we consider the entire economy. But his study of profit is in relation to a firm for which changes in population and capital are unpredictable and according to Knight, profits can be positive or negative as a result of those changes.
5. Profit is not residual income: Knight’s view that profit is residual income which is received by the entrepreneur on the basis of his own decision has also been criticized. Professor J.F. According to Weston, “It is not necessary that decision makers be compensated as recipients of residual income. Decision making is an economic service. The rules explaining the compensation for this service are similar to the rules explaining the compensation for other services. Hence, profit is not a residual income.
6. Uncertainty bearing is not a separate factor of production: Uncertainty bearing cannot be considered a separate factor of production like land, labour or capital. This is a psychological attitude which forms a part of the real cost of production but entrepreneurial ability is a different matter, the supply of a factor service also depends on its opportunity cost rather than its real cost.
7. Monopoly does not study profits: This theory does not shed any light on monopoly profits. Monopolistic firms earn much higher profits than competitive firms and those profits are not due to the existence of uncertainty.
Despite these shortcomings, Knight’s theory of uncertainty bearing is considered to be the only satisfactory explanation of the nature of profits.
