Rent, Wages, Interest

and Profit

 Goods or services, which contribute in producing

something, are called the factors of production.
The major factors of production as classified by
economists are land, labor, capital and
entrepreneurship.
The factors of production are rewarded for their
contribution to the production of goods and
services. The reward for land is rent, for labor it is
wages, for capital it is interest and the reward for
entrepreneurship is called profit.
Determination of factor prices is different from
the determination of product pricing which is
based on the demand and supply of products.
The reason is that unlike products, factors of
production have a derived demand and also joint
demand as they contribute in a combined way in
the production of goods or services

Moreover, the supply of factors of production

is also different from the supply of goods as the
cost of production with regard to factors of
production is difficult to estimate.
On the other hand, modem economists believe
that factors of production can also be priced
based on the forces of demand and supply in a
manner similar to the determination of product
prices.
While determining the demand for any factor of
production, profit maximization acts as the
principle and the market demand is determined
by summing up the demand from all the firms.
The supply of factors of production in a market
is determined by summing up the supply of
factors of production from all the factor owners
in the market.

THEORIES OF FACTOR PRICING

Factor pricing means the price paid for the

services rendered by the factor of production
but not the price of the factor itself.
As goods are produced through the combined
efforts of the factors of production, the
income earned through sale of products or
remuneration for services is distributed
among the four factors of production.
Theories of factor pricing suggest the ways
to distribute the income among the factors of
production.
The process of income distribution can be
done in two ways. They are: personal
distribution and functional distribution.

 Personal Distribution: In this form of income

distribution, the national income of a country is
distributed among the owners of various factors of
production such as rent for land rented, wages for
labor, interest on the capital invested, and profit for
entrepreneurship.
Thus, the pattern of individual income generation is
studied under personal distribution.
Functional Distribution: Functional distribution of
income distribution deals with the distribution of
income among the four factors of production - land,
labor, capital, and the entrepreneur.
It lays emphasis on the sources of income for factors
of production such as rent for land, wages for labor,
interest for capital, and profit for entrepreneur.
There are two theories for functional income
distribution. They are the macro theory of
distribution and micro theory of distribution (Theory
of factor pricing).

Macro & Micro theory of

distribution
Macro theory of distribution:

Macro theory of income distribution deals with the

distribution of national income among the factors of
production. This process of national income distribution
can be termed as macro distribution.
The macro theory of distribution helps determine the
relative shares of different factors of production and also
deals with the effects of economic development on those
relative shares.
Micro theory of distribution theory of factor pricing:
Micro theory of income distribution concentrates on
individuals unlike macro theory which deals with
aggregates of a nation. This theory of factor pricing
determines the ways to distribute rewards for factors of
production.
Basically two micro theories are considered for the
determination of factor prices. They are: marginal
productivity theory of factor pricing and modem
theory of factor pricing

 Marginal Productivity theory of

Factor Pricing:
Many economists have contributed to the
development of the marginal productivity
theory determining the rewards for
various factors of production.
David Ricardo initially used the theory to
determine rent for land. The statement of
marginal productivity theory as given by
J.B. Clark is, "Under static conditions,
every factor including the entrepreneur
would get remuneration equal to its
marginal product.

 Demand for factors of production is derived from

the demand from firms for the same. Since factors
of production are utilized in the production process,
their demand is based on their productivity.
As the productivity of a factor increases, its price
also increases. Marginal Physical Productivity (MPP)
is the change in the total physical product or
production, when one more unit of anyone factor of
production is added while other factors are kept
constant.
Marginal Value Product (MVP) is the monetary
representation of the MPP i.e., MVP =MPP x Price.
Marginal Revenue Productivity (MRP) is the change
in the total revenue for the producer when an
additional unit of a factor of production is employed
while the quantity of other factors is kept constant.
Average Revenue Productivity (ARP) is the average
revenue per unit of a factor of production.

 Marginal productivity theory is developed

as an explanation to the following points:
Reward of each factor unit is equal to its
marginal productivity.
Reward for each factor of production will
be the same in every use.
In
the
long-run,
under
perfect
competition, each factors of production
will get its remuneration that will be
equal
to
its
Marginal
Revenue
Productivity (MRP) which also equals its
Average Revenue Productivity (ARP)

Modern theory of Factor Pricing

As the marginal productivity theory of factor pricing was based

on impractical assumptions, and concentrated only on demand
side ignoring the supply side, the modern theory of factor
pricing was developed to explain the determination of factor
prices. In fact, the modem theory considered both the demand
side and supply side to determine prices for factors of
production.
Demand side Demand for factors of production is derived
demand or indirect demand unlike the demand for goods which
is direct. The demand for a factor of production is based on the
contribution of the factor with regard to the production of a
good, which can be termed as the productivity of the factor.
The demand for a factor of production also depends on the
demand for the goods produced using the factor.
By aggregating the individual demands or marginal revenue
productivity (MRP) curves of all firms in the market, the market
demand curve for a factor of production can be obtained.

 This marginal revenue productivity curve for

a factor of production is subject to changes in
demand and to the changes in the quantity
demanded.
Changes in demand for a factor of production
may be due to the following reasons:
Change in demand for the final product
produced using the factors of production.
Change in productivity in terms of quality or
quantity being produced.
Change in the prices of substitute or
complementary
factors
used
in
the
production process. For example, demand for
labor and machines are interrelated and firms
may utilize more or less of one of them, if the
relative price of either of the factors of
production increases against the other.

MEANING
OF
RENT
Rent can be termed as the reward for land which is one

of the four factors of production. For economists, the

term 'land' indicates natural resources like ground water,
forests, rivers, oil fields, mineral deposits, etc., apart
from the physical soil.
Since land is a natural product and cannot be
reproduced, the supply of land is permanently fixed and
in general perfectly inelastic. Usually the term rent
refers to the payment made to the owner of the factor to
use the same for a specific period of time.
Here, the term land includes any material asset which
has a fixed supply. For instance, payment made to use a
house, vehicle, or machine is termed as rent.
However, economists term it as 'contract rent' as it
includes return on capital invested in material assets.
'Economic rent' is the term used by economists to refer
to the payment made for usage of land.

 In fact there are variant views aired by economists with

regard to the concept of rent. Some of them are rent as a
differential surplus, scarcity rent, and quasi-rent.
Rent as a Differential Surplus: David Ricardo (Ricardo), a
British economist, defined rent as, "the price paid for the use
of original and indestructible powers of the soil." Ricardo
explained rent as differential surplus which indicates that
rent is the surplus of revenue over costs which arises due to
differences in the level of fertility or usability of land.
Higher rent can be earned by the landowners, if the quality
of land is better.
Scarcity Rent :
According to modem theory of factor pricing, the scarcity of
land acted as the basis for the concept of rent. According to
the theory, rent would arise even if all lands are of equal
quality.
The modem theory further suggested that rent does not
determine price but is determined by price i.e., when the
prices are high, high rent is charged and not vice-versa.

 Quasi-rent :
According to Alfred Marshall (Marshall), an English
economist, rent is the income obtained due to
ownership of land and other natural resources.
Marshall opined that land is a natural resource
and its supply is perfectly inelastic considering
the society as a whole. However, for an individual
person, firm, or industry, the supply of land
depends on the prevailing rent thus it is elastic in
nature.
In his view, as the supply of land is fixed, rent can
be earned even in the long-run. Apart from land,
other factors which have limited supply can also
earn rent but only for a short- period of time.

THEORIES OF RENT
Various economists have proposed different theories
for the origin of rent. Prominent among the theories of
rent are the Ricardian theory and the modern theory
of rent.
Ricardian Theory: David Ricardo, (Ricardo) a British
economist, proposed the 'Ricardian theory of rent'.
The definition of rent as, "Rent is that portion of the
produce of the earth which is paid to the landlord for
the use of the original and indestructible powers of the
soil."
It can be deduced from this definition that rent arises
due to the following two reasons:
1. Differences in the productivity of various pieces of
land.
2. Situational differences.

 Postulates of the Ricardian theory: Some of the

basic assumptions of Ricardian theory in relation to
land, and its demand and supply, are:
The supply of land is fixed and the existing quantity of
land gifted by nature cannot be increased or
decreased.
Another assumption is that original powers such as
fertility of land are gifted by God and are not due to
human efforts of any type.
Ricardo's theory of rent was based on assumption that
land is a non-perishable factor of production. The
powers/qualities of land cannot be destroyed and the
fertility of land never diminishes.
Another basic assumption is that utilization of land for
cultivation is done based on the order of fertility of
land. Most fertile land is cultivated first before using
the next grade land.

 Ricardo assumed that the law of diminishing

returns or increasing costs operates in
agriculture.
It is also assumed that different lands have
different fertility levels.
Land is assumed to be free gift of nature.
Therefore, it does not have cost of production.
Assumption of perfect competition is also made.
Ricardo assumed the existence of margin land
which is a 'no rent land'. It could be understood
as the grade of land after which no land is used.
Ricardo's theory also supposes that lands are
located at different locations i.e. some of them
are near to the market than others.

 Explanation:
Ricardo believed that rent is a surplus arising because of
differences in fertility and locations of land. Ricardo
explained the origin of rent based on the assumption that
'marginal land' exists.
Marginal land can be defined as that area of land that
barely covers its costs with the market value of its produce.
To put it differently, marginal land represents the grade of
land below the level of which no land is used. The land with
better productivity than marginal land is termed as 'intramarginal land'. Ricardo opined that rent is the differential
surplus between the earnings of marginal land and intramarginal lands. Rent arises in both the two types of farming
techniques-extensive cultivation and intensive cultivation.
Extensive cultivation: In the farming technique of
'extensive cultivation', production of farm is increased by
bringing more and more land under cultivation.
Ricardo used the assumptions listed earlier to explain the
origin of rent in the extensive cultivation technique.

 Intensive cultivation: Under intensive cultivation

technique of farming, the production of the land is
increased by employing increased number of labor and
capital units.
Ricardo assumed the function of the law of 'diminishing
returns' in agriculture. It implies that when more and more
units of labor and capital are employed after a certain
stage, there is going to be diminishing rate of increase in
the production of the farm.
This indicates that rent arises even when all the plots of
land are equally fertile and all the plots of land are
comparable even with regard to nearness to the market.
Ricardo believed that as the law of diminishing returns is
applicable to agriculture, the marginal product of labor and
capital will be diminishing.

Marginal product refers to the increase in the total

production when one more unit of labor and capital are
employed while other factor units are kept constant.

Modern Theory of Rent

The modem theory of rent is an integrated set of
ideas of different economists such as Marshall,
Joan Robinson, and Boulding.
The modem theory improves on Ricardo's theory
of rent and extends the concept of rent which
was linked to land alone to other factors of
production which have inelastic supply in the
short run.
Ricardo believed that the supply of land is
permanently fixed i.e., perfectly inelastic, and
further the various lands have different fertility
levels.
The surplus produced by more fertile lands over
the marginal land is considered to be the rent.

 Modern economists are of opinion that the

supply of labor, capital, and entrepreneurs are
also limited when compared to their demand
and cannot be altered in the short run.
As different lands differ in their fertility levels,
other factors of production differ in the level of
efficiency and productivity.
Therefore, an improvement was made over the
Ricardian theory to introduce the idea that apart
from land, other factors of production, labor,
capital, and entrepreneur can also earn rent.
Other improvements are that since the supply of
land is fixed and is scarce, it earns scarcity rent,
and further due to difference in fertility levels of
various plots of land, they earn differential rents .

 Ricardo's theory of rent provided an explanation that

the surplus which is produced by the more fertile
lands above the cost of cultivation can be considered
to be the rent.
But the theory does not explain how to
determine the rent. Modern economists advocated
that rent can be determined by the forces of supply
and demand similar to the determination of prices
for products and other factors of production.
The modem theory of rent suggests that rent is
determined by the level of increase in demand for
land over its supply. As the supply of land is fixed,
higher demand for land will increase the rent of land.
Hence, modern theory of rent is also termed as
the scarcity theory of rent.

 Modern Analysis ; Modern economists differed with

the view of Ricardo. They believed that rent affects the
price of produce of land in the following situations:
When land is under control of few landlords who
compel fanners to pay rent on even the marginal land.
If people are more dependent on land in countries
like India, then the land owners increase the rents and
the actual rent becomes higher than economic rent.
The productivity of land differs when land is used for
production of different varieties of crops. Then the rent
affects price as there may be surplus when a particular
variety is produced while no surplus for other varieties
of crops.
The scarcity of fertile/prime land leads to rent having
an affect on price.

CONCEPT
OF
WAGES
Labor is one of the four factors of production. In economics,
the term labor refers to both physical and mental work.
Wage is the remuneration paid for labor. Payment of wages
can be done in different modes such as time wages, piece
wages, task wages, cash wages, kind wages and service
wages.
Time wages are the wages which are paid on the basis on
number of hours worked.
Piece wages are the wages which are paid depending on the
quantity of output produced.
Task wages are the wages which consider accomplishment of a
task for payment of wages.
Cash wages are the wages which are paid in money form.
Kind wages are the wages which are paid in the form of
commodities.
Service wages are the wages which are paid through a return
service for the service rendered.

DISTINCTION BETWEEN REAL WAGES AND

NOMINAL WAGES
Apart from the different types of wages we have discussed till now, wages
can also be classified on the economic basis into nominal wages and real
wages. The value of wages earned by a worker is different in terms of
nominal wages and real wages.
Real Wages: Organizations provide various facilities to workers apart
from paying salaries. The additional facilities such as transportation
facilities, medical facilities, accommodation, and other allowances paid in
addition to the salary constitute the real wages of workers.
Real wages or real earnings refer to the purchasing power of the worker's
remuneration i.e., the amount of necessaries, comforts and luxuries which
the worker can command in return for his services."
If the money earned by a worker is Rs. 10,000 per month, his/her nominal
wage is Rs. 10,000 but the real wage refers to the purchasing power of the
money earned i.e., how much the worker can purchase with Rs. 10,000.
Real wages serve as indicators with regard to the prosperity level of
workers. If the purchasing power of money is high, real wages are
considered to be high.
Smith, a renowned economist, stated that the laborer is rich or poor, is
well or ill-rewarded in proportion to the real, not the nominal, wages of his
labor.

 Nominal Wages: According to Prof. Thomas, "nominal

wages or nominal earnings refer to the amount of the
wages as measured in terms of money.
Nominal wages are also known as money wages and refers
to the payment to a worker for the service rendered in
terms of money. For instance, if an amount of Rs.I0,000 is
credited to a worker's bank account as a salary for a month
that amount is referred as the nominal wage of the worker.
Production of goods is not complete without the combined
efforts of all factors of production. Hence, successful
management of business is dependent on the successful
management of all the factors of production.
The reward for land is rent, whereas the reward for labor is
called wages. In this chapter, we will discuss about the
remaining two factors of production namely, capital and
organization or the entrepreneur.
The reward for capital is known as interest and the reward
for entrepreneurship is known as profit.

 Therefore, an entrepreneur is concerned with the interest rates

because interest rates will have an impact on his business.
For instance, an increase in interest rates would cause the
entrepreneur to lower his capital requirements, and this in turn
would have an impact on the production process.
An entrepreneur uses his entrepreneurial abilities and
manages all the factors of production. In this way, he
successfully accomplishes the task of producing goods.
He further makes efforts to sell these finished goods in the
market. The reward he gets for all these efforts is known as
profit.
Profits motivate entrepreneurs to improve their efforts and
thereby improve the production process.
Thus, profits have an impact on business practices. Therefore,
an understanding of interest and profit are crucial for the
successful management of business.
Hence, the rewards for capital and entrepreneurship are of
great importance to an 'entrepreneur'

INTEREST

What is Interest?
The reward for capital is known as interest. The owner of the
capital receives interest for lending his/her capital to others.
Capital can be classified into two types fixed capital and variable
capital. In fact, when we say capital, it includes both fixed and
variable capital.
However, interest is the income earned only on the variable
capital. Interest is earned only on that portion of capital which is
given by the owner to the borrower.
In other words, it is the price paid by the borrower to the lender
who parted with his money.
Why do people get paid for lending their money? Money in the
form of cash provides the holder with benefit because it enables
him to buy anything that he desires.
However, if an individual lends it to another person, then he will
have to wait until he gets back his money and only then he can
utilize it.
According to John Maynard Keynes, "Interest is a reward for
parting with liquidity for a specified period."

Basic Concepts

Gross interest: When the borrower pays an amount to

the lender for borrowing the lender's money, the amount
so paid by the borrower is known as 'interest'.
Therefore, when people refer to interest, they generally
refer to 'gross interest'. Gross interest is the total amount
paid by the borrower to the lender of the money.
Net interest: Net interest is the amount paid to
'capitalists' only for the use of 'capital'. It is the reward
paid to the capitalists exclusively for the use of capital.
Net interest is the compensation for lending capital to
others under conditions where there is no risk or
inconvenience due to investment (investments made with
no savings motive) and the lender is not required to
perform any work other than lending his money.
Therefore, net interest is a part of the gross interest.
Gross interest consists of some charges along with the
net interest.

 Gross Interest = Price of the Capital (Net Interest)

+ Reward for taking risk of money lending +
Reward for management of loan + Others (such as
the reward for accepting the inconveniences
involved in money lending).
Gross interest thus includes compensation for loan of
capital, compensation to cover risk of loss (either
business risk or personal risk), compensation for
inconvenience of investment, compensation for work
and apprehension related to monitoring investment.
Saving and investment: According to the theory,
savings and investment are not interdependent. It is
known that the income level changes along with the
changes in investments.
The changes in investment levels invariably have an
impact on the savings of individuals. Therefore, it is not
correct to say that saving and investment are
independent of each other.

Liquidity Preference Theory of

Interest
John Maynard Keynes (Keynes) propounded the

'liquidity preference theory of interest'. His

theory is based upon the belief that people prefer
absolute liquidity (cash) to other forms of wealth in
the short run.
Keynes criticized the classical theory of rate of
interest on the grounds that they combined real
and monetary factors together.
According to Keynes, the rate of interest is purely a
monetary phenomenon. He said that determination
of interest, thus, is dependent upon the demand for
and supply of money in the economy. Keynes
proposed that interest is equilibrium between the
demand for and supply of money.

 Keynes opined that a person who lends money

gets the reward called 'interest' for parting with'
liquid money'.
Keynes explains, The rate of interest is the
premium which is to be offered to induce the
people to hold wealth in some form or the other
than hoarded money." According to him,
interest
is
the
incentive
that
drives
moneylenders to part with their money and lend
it to people.
What is liquidity preference? The liquidity
feature of money empowers us with 'purchasing
power', hence, the preference for cash to other
forms of money. People's fondness for cash or
liquid money is called as 'liquidity preference' .

 Why do people prefer liquidity? According to

Keynes, people prefer liquidity to other forms of money
because they want to satisfy the three kinds of motives:
Transaction motive
Precautionary motive
Speculative motive
Transaction motive: When people demand for liquid
money to carry out their day-to-day transactions, the
demand for such liquidity is known as 'transaction
motive'.
For example, people need money to travel from one
place to another, to buy goods and services, etc. For
this, they are required to stock some amount of cash
with them. So, when people require cash to complete
their economic transactions, the motive behind the
demand for such cash is known as transaction
motive.

 Precautionary motive: Since people are

uncertain about their future, they prefer to save
money with a view to safeguard their future.
People attempt to meet contingencies and
unforeseen circumstances that may happen in
the future by saving. Hence, the demand for
liquidity to safeguard their future is known as the
'precautionary motive'.
Ex.1.
Income levels
of people impacts
precautionary demand for liquidity to a great
extent. 2. Some people are optimistic about their
future, while others are pessimistic. Optimistic
people anticipate lesser risk in the future when
compared to pessimistic people. 3. A farsighted
person can visualize the future in advance and
makes a better analysis of the future.

 Speculative motive: This is the most important motive

behind the demand for liquidity. The motive for stocking
cash here is to take advantage of the changes in the price
levels of securities and bonds.
If people anticipate that the prices of securities will go up
in the future, hen they prefer to purchase securities now. In
such a situation, the liquidity preference of people will be
low because they like to spend cash and purchase
securities (with a view to gain profit in the future).
On the other hand, if they anticipate that the prices of
securities would go down in the future, then they prefer to
hold cash.
This is because, they would like to wait and purchase
securities in the future when the prices of the securities
fall. In such a situation, the liquidity preference of people
will be high.
Hence, it can be said that the liquidity preference of people
is affected by the speculative motives.

PROFIT
What is Profit? Just like rent is the reward for land, wages for
labor and interest for capital, profit is the reward for
entrepreneurship.
While the rewards for other factors of production are paid by the
entrepreneur, profit is the reward received by entrepreneur
himself.
Simply put, profit is the income of an entrepreneur for
utilizing his entrepreneurial abilities and running a
business.
Profit is nothing but the surplus amount left with the entrepreneur
after paying all the factors of production.
If the income earned by him is in excess of the costs incurred on
the factors of production, then the income can be called as profit.
Therefore, profit can also be defined as the difference between
the total value of output (total revenues received by the
businessman) and the total value of inputs (total costs incurred
by the businessman) of a business.
Profit =Value of Outputs - Value of Inputs

 Profit is also viewed as a reward earned by the entrepreneur for

performing the entrepreneurial
function in a business. There are other economists who believe
that profit is the reward for making innovations in business.
Basic concepts
Profit consists of two major components - gross profit and net
profit.
Gross profit : Generally, people consider profit as the residual
income left with the entrepreneur after making all the payments
to other factors of production.
However, it should be noted that this is gross profit. The gross
profit is arrived at after excluding all the explicit costs from the
revenues received by the business.
It does not exclude implicit costs such as rent forgone by
entrepreneur for utilizing his own land for business purposes,
interest forgone on his own capital, etc.
Gross Profit =Total Revenues - Total Explicit Costs
Gross profit thus includes those costs which go unrecorded in the
books of accounts, but which are nevertheless important to
determine the profit made by the business.

 Net profit: The net profit can be arrived at by

subtracting the implicit costs from gross profits.
This is also sometimes referred to as 'pure profit'.
Net profit is the surplus leftover after deducting
explicit and implicit costs from the sales receipts of
a business.
Net Profit =Gross Profit - Implicit Costs
Thus, it can be observed that net profit is a portion
of the gross profit. When a business gets zero net
profit, it means that the profit attained is just
enough to meet the explicit costs of the business.
In other words, the entrepreneur's revenues could
not payoff his efforts (or implicit costs) such as
utilizing his own resources, undertaking risk and
uncertainty of business, etc.

 Normal profit : It is the minimum

return that an entrepreneur receives for
performing entrepreneurial functions
such as bearing risk and uncertainty,
managing other factors of production,
etc.
Abnormal or super profit: The
income
remaining
with
the
entrepreneur after subtracting all costs
(both implicit and explicit) from the
revenues received from the business. It
is an excess over the normal profit.

THEORIES OF PROFIT

Though there are several theories of profit

that attempt to explain the emergence and
growth of profit, none of the theories give a
comprehensive picture on profit.
Traditional Theories: F.A. Walker one of the
prominent
non-classical
economists,
propounded the 'rent theory of profit',
which was similar to David Ricardo's (Ricardo)
'theory of rent'. Later, Taussig and
Davonport developed the 'wage theory of
profit' and proposed that like a laborer works
physically
and
earns
his
wage,
an
entrepreneur works mentally and earns his
wage called profit..

 Walker's rent theory of profit : The 'rent theory of

profit' was developed by Francis. A. Walker (Walker). Be
advocated that different lands earned different rents
depending upon the fertility of land.
In the same way, businessmen earned 'rent of ability'
called profit. He opined that some entrepreneurs earned
higher profits because of their greater ability to run
business when compared to other entrepreneurs.
According to him, the rent earned by more fertile or intramarginal lands was the difference between the total
production of intra-marginal and marginal lands.
He further explained that there existed both intra-marginal
entrepreneurs and marginal entrepreneurs and that the
former are abler than the latter. Hence, the intra-marginal
entrepreneurs earned rent of ability called profit.
He opined that rent and profit are no different from each
other and just as there is a no-rent or marginal land, there
is also a no-rent entrepreneur or marginal entrepreneur.

 Limitations of 'rent theory of profit':

Critics said that comparing profits with rent is
impracticable. Rent can never be zero and is always
positive. However, the same is not the case with
profits, as profits can be negative or zero.
One of the main opponents of Walker's 'rent theory
of profit', J.B. Clark, opined that profits occur only
under dynamic conditions. However, rent can be
earned under both static and dynamic conditions.
The theory assumes the existence of marginal
entrepreneur i.e. entrepreneurs who do not earn
any profit. This is an absurd concept because any
businessman who does not earn profits would pull
back from business. Further, critics said that just as
there cannot be a 'no-rent land', there also cannot
be a 'no-profit entrepreneur'.

 Several economists pointed out profits

earned are also a result of risk-bearing,
innovation, etc. and not just because some
entrepreneurs are 'abler' than others.
Some economists criticized that while rent is
a fixed (or expected) income, profit on the
other hand was unknown. An entrepreneur
cannot anticipate whether he will get profits
or losses in future and its magnitude.
As land is a free gift of nature, its supply is
limited.
However,
the
supply
of
entrepreneurs is not limited and is perfectly
elastic.

 Modern Theories: The modem theories of profit

include Clark's dynamic theory, Schumpeter's
innovation theory, Hawley's risk theory, Knight's
uncertainty-bearing theory among others.
Dynamic theory of profit: According to him, profit
is the difference between the cost of producing
goods and the prices of these goods. In a stationary
state, there is always equilibrium between demand
and supply of goods.
Hence, there is no difference between the prices of
goods and their costs, and therefore net profits do
not accrue to the entrepreneur. Under dynamic
conditions, however, there is disequilibrium between
demand and supply conditions of economy. In such a
state, there are often changes in the determinants of
demand and supply.

 Clark said that in reality, however, there exists a dynamic

economy. He said that there are bound to be unforeseen
changes in demand and supply. According to Clark, the
dynamics in demand and supply conditions could be a
result of:
Changes in the quality and quantity of human wants
Changes in governmental rules and regulations
regarding trade
Changes in technology that effect the production process
Rise in population
Adjustments with regard to amount of capital stock with
the economy
In a dynamic economy, surplus occurs because of the
frictions or obstructions to mobility of resources and even
the existence of monopoly element.
According to the theory, surpluses would be eliminated by
the forces of competition in the long run.

 Innovation theory of profit : Joseph

Schumpeter propounded the 'innovation
theory of profit'. He proposed that profit is
the reward for the innovative abilities of
entrepreneurs.
According to him, an entrepreneur who
introduces innovation in businesses process
reaps benefits in the form of profits, if the
innovation proves successful in the market.
Schumpeter defined innovation as any new
process or policy adopted by the businessman
with a view to obtain reduction in cost of
production, or to improve the demand for the
product in the marketplace.

 According to this theory, the difference between

price and costs keep on increasing, if there are
continuous innovations in the marketplace. This is
also how profits originate.
But, such profits are not stable in nature and are
only temporary. An entrepreneur can earn these
profits only in the short term. This is because his
competitors too adopt the same innovation, thus
reducing the entrepreneur's profit.
So, once again the entrepreneur has to
differentiate his products from that of competitors
through innovations. This again increases the
difference between the costs and prices, thus
enabling the entrepreneur to earn profits again,
until his innovations are imitated by others and
profits fall again.

 Uncertainty-bearing theory: According to Frank H. Knight

(Knight), the most important function of an entrepreneur is to
bear uncertainties in business in the form of risks that cannot
be insured against. Risk can be defined as the measurable
probability of the occurrence of profit or loss situation.
With a view to differentiate between risk and uncertainty,
Knight divided risks into:
Insurable risks
Non-insurable risks
Insurable risks
According to Knight, insurable risks are those risks which the
entrepreneur can avoid through insurance. These risks can be
in the form of loss of assets due to fire, accident, theft, etc.
An entrepreneur gets cover for these losses by paying a
premium to the insurance companies and reclaiming the
same in the event of mishap. Therefore, he does not have to
bear uncertainties for insurable risks.

 Non-insurable risks
These risks can be in the form of changes in
people's habits, price level fluctuations, etc.
Non-insurable risks are unpredictable and
unavoidable and hence are uncertainties.
Knight proposed that profits or losses are the
rewards an entrepreneur receives for bearing
these uncertainties.
Uncertainty arises for non-insurable risks.
Non-insurable or unpredictable risks are
those risks which are unforeseen and for
which no information is available to estimate
or forecast. Also, non-insurable risks cannot
be covered under insurance coverage.