PROFIT MANAGEMENT Based on Dominic Salvatore Managerial Economics

PROFIT MANAGEMENT Based on: Dominic Salvatore, Managerial Economics (Adopted by Ravikesh Srivastava), OUP, 2009 M. L. Ahuja, Principles of Microeconomics, S. Chand 1

• • • Profit theories Schumpeter Risk & Uncertainty Breakeven Measurement of Profit Maximization 2

• General Notion of Profit (Business profit): • Revenue of the firm– Explicit Costs- useful for accounting and tax purposes • Explicit (Accounting) Costs: Actual out-of-pocket expenditure on inputs • Economic Profit: Revenue of the firm– Explicit and implicit Costs- useful in reaching correct investment decisions • Implicit Costs: What the same inputs would have earned in the next best alternative use outside the firm 3

• Sum p 16 -17 4

Theories of Profit • Lack of agreement • Profits as Residual Income left after payment of contractual rewards to other factors of production • contractual rewards are always positive, but non contractual rewards may be positive or negative. • Risk bearing theories: 5

Profits As Dynamic Surplus 1. J. B. Clarke’s Dynamic Theory of Profits In competitive long run equilibrium, P= AC (including normal profits) and therefore, there is no pure profit. But profits will emerge if P > AC due to changes(disequilibrium) either in demand or supply 6

Clarke’s Dynamic Theory 5 changes that occur in a dynamic economy and give rise to profits: Changes in - Quantity & quality of human wants - Methods of production - Amount of capital - Forms of organization - Growth of population 7

Clarke’s Dynamic Theory • In addition, 2 more changes: • Innovation and External change • According to Knight, it is not change which leads to profits, but dynamic changes give rise to profits ONLY if changes and their consequences are unpredictable- because of uncertainty of Future. • “In an economy where nothing changes, there can be no profits; there is no uncertainty about the future, so there is no risk and no profit”Stonier & Hague 8

2. Schumpeter’s Innovations Theory of Profits Main function of entrepreneur is to introduce innovations in the economy and profits are a reward for this function. 2 types: A. Innovations that reduce cost of production ( those which change the production function) Include new machinery, new processes and techniques of production, new source of raw material, new ways of organising business 9

Schumpeter’s Innovations Theory B. Innovations that increase the demand for the product ( those which change the demand or utility function- to sell more or at a better price) Include: New product, new variety, new design of product, new method of advertising, discovery of new market 10

Schumpeter’s Innovations Theory • Profits accrue not to those who conceived the innovation or financed it or to the one who introduced it • Profits from a particular innovation are temporary- (He is in a monopoly position for sometime- transitional unless he can construct a permanent monopoly) • With patents, he can continue to make profits for a long time 11

Schumpeter’s Innovations Theory In a competitive economy without patents, existing competitors will soon adopt any successful innovation and profits disappear. In a progressive, competitive economy entrepreneurs continue to introduce new innovation and earn profits. “The successful innovator can continuously seek new equilibrium profits since the horizon of conceivable innovations is unlimited”- Stigler 12

3. Knight: Risk, Uncertainty &Profits Uncertainty is a permanent feature of the economic system “So long as entrepreneurs start production with imperfect knowledge of the market, anticipated marginal product of hired factors deviate from their actual product, so long a surplus would persist” 13

Knight: Risk, Uncertainty & Profits Causes of Uncertainty Changes in fashions & taste Changes in incomes Changes in Government policies (Taxation, wage and labor laws, export policies) Movement of prices as a result of inflation and deflation Changes in production technology Competition from new firms 14

Knight: Risk, Uncertainty & Profits Insurable & Non insurable Risks • Insurable: fire, theft, accident etc- may cause huge losses but by paying premium, can insure. Premium becomes part of cost of production • Non Insurable Risks: Relate to the outcome of price-output/product design/advertisement expenditure decisions made by the entrepreneur -Can’t be insured- Involve uncertainty and give rise to economic profits, positive or negative 15

Knight: Risk, Uncertainty & Profits • The theory explains why supernormal (economic) profits arise in fields like petroleum exploration (have higher risks) • Expected returns on stocks is higher than the interest on bonds because of higher risks. 16

4. Managerial Efficiency Theory • Some firms are more efficient than others in terms of productive operations/ higher managerial skills- Hence need to be compensated with supernormal profits. 17

5. Monopoly Theory Of Profit 5. Due to Monopoly Through Patents Licenses Economies of scale Exclusive control over raw materials which prevent competitors from entering 18

6. Frictional Theory • In the long run, in a perfectly competitive equilibrium , firms tend to earn only a normal return or zero profit. • At any time firms are not likely to be in such long run equilibrium and earn profit or loss • Why? 19

• Which theory is most acceptable? • Salvatore & Srivastava, p 19, Case 1 -3 on Apple 20

Role & Functions of Profit IN A FREE MARKET, PROFITS HAVE TWO FUNCTIONS. 1. SIGNAL: That consumers want more , to change the rate of output and firms to enter and exist 2. REWARD: Incentive: to innovate, increase efficiency an take risks 21

• EFFICIENT ALLOCATION of resources • Soviet economic system collapsed because of lack of profit motive 22

Debate Milton Freidman: “ Business has only one social responsibility- to make profits (so long as it stays within the legal and moral rules of the game established by the society) … to make as much money as possible for their share holders 23

How would the following affect Profits of your firm? 1. Firm is required by government to shift to Green technology 2. RBI reduces its Repo rate 3. A new rival firm enters the industry 4. Rate of inflation rises steeply 5. Import duty on the product you manufacture is greatly slashed 6. A Trade Union is started newly in your industry where none existed before 24

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