Profit Theory – Risk

Profit Theory – Risk

The risk theory of profit is associated with the name of F.B. Holley, who considers risk taking to be the main function of the entrepreneur. Profit is the residual income that the entrepreneur receives when he takes a risk. The entrepreneur puts his business at risk and in return receives a reward in the form of profit because the internal quantity of payment is profit. Profit is the excess of payment over the real value of risk. If only normal returns are received, no entrepreneur will be willing to take risks. Therefore, the reward for taking risk should be more than the real value of risk.

Holley says that by paying a certain fixed amount to the insurance company, the entrepreneur can avoid many risks. But through insurance he cannot get rid of all types of risks because if he can do so, he will no longer be an entrepreneur and will only receive the wages of management and he will not get the benefits. But when the entrepreneur transfers his risk to the insurance company, he puts his function of taking risk on the insurance company and it receives the profit.  The reward for an insurance company is not the premium it receives but the difference between that premium and the ultimate loss it incurs. So the reward for taking risks, especially “carefully chosen” risks, is profit.

But since not everyone can take risks, risk acts as a barrier to entrepreneurial fulfillment. Those who stay in business can receive additional payments above the actuarial value of the risk and hence make a profit.

Its criticisms

Like other theories, the risk theory of profit has also been criticized for the following reasons:

1. The meaning of risk is unclear: Hawley did not clarify the meaning of risk. According to Knight, there are two types of risks: one is insurable and the other is such that cannot be insured. Specific risks are insurable. Such risks cannot generate profits because by paying premium, the entrepreneur covers such risks. Knight does not agree with Hawley on the fact that by insuring risks, the entrepreneur shifts his responsibility to the insurance company and instead the insurance company receives profit. The insurer does not gain, only the entrepreneur gains. The risks that cannot be insured are the uncertain ones that generate profits. Thus, according to Professor Knight, profits are the reward for bearing uncertainty.

2. Profit is the reward of entrepreneurial ability: Taking risk is not the only work of an entrepreneur that results in profits. Profits also emerge due to the entrepreneurs’ ability to organize and coordinate. This work reduces the costs of the industry.  Partly, this is also the reward for innovation.

3. Profit is the reward for risk aversion: According to Carver, those entrepreneurs can earn profit who avoid risk. Thus, profit is not earned because of risk-taking but because capable entrepreneurs avoid risk. The more risk an entrepreneur avoids, the more profit he earns.

4. Amount of profit is not related to the size of risk: The amount of profit is not related to the size of risk taken in any way. If it were, every entrepreneur would expose himself to great risks to earn more profit.

5. Incomplete theory: There is no empirical evidence to prove that entrepreneurs earn more profit in risky ventures. In a way, all ventures have risk because there is an element of uncertainty in them and the aim of every entrepreneur is to earn more profit. Thus, Hawley’s risk theory is also an incomplete theory of profit.