Chapter - One

Managerial Economics – An Introduction

Contents:

1.1 Course Structure Introduction

1.1.1 Course Description
1.1.2 Course Objectives
1.2 Notable Definitions
1.3 Objectives of Business Economics
1.4 Nature of Managerial Economics
1.5 Scope of Managerial Economics
1.6 Theory of the Firm

1.6.1 Risk-Bearing Theory of Profit

1.6.2 Uncertainty-Bearing Theory of Profit
1.6.3 Rent Theory of Profit
1.6.4 Innovation Theory of Profit
1.6.5 Dynamic Theory of Profit
1.6.6 Monopoly Power Theory of Profit
1.6.7 Labour Exploitation Theory of Profit
1.6.8 Marginal Productivity Theory of Profit
1.7 Role of Business in Society
1.8 Basic Economic Relations (Assignment)

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1.1 Course Structure Introduction:

1.1.1 Course Description: Managerial economics, meaning the application of economic

methods to the managerial decision-making process, is a fundamental part of any business
or management course. This course seeks to teach students the economic techniques and
tools needed for managerial decision making.

Topics covered include: The role of managers in identifying and implementing profitable
decision; demand, supply and market equilibrium; statistical analysis, marginal analysis
and optimal decisions; elasticity and demand; the theory of production; the theory of cost;
managerial decisions for firms in competitive markets for firms with market power;
strategic decision making in oligopolistic markets; advanced techniques for profit
maximization; managerial solutions to the problems of adverse selection, moral hazard;
how to structure incentives to get the employees and its various divisions to work in the
firms best interests.
1.1.2 Course Objectives:
 Apply economic analysis and techniques to problems facing managers.
 Combine microeconomics and various quantitative methods in a problem-solving and
decision-making context.
 Use economic analysis in identifying and evaluating decision alternatives, understanding
the competitive environment of firms, and examining the factors that influence firm
performance.
 Identify profitable decisions using benefit-cost analysis and being able to implement them
within an organization—the main trust of this course.
1.2 Notable Definitions:

1. Economics:

Economics the study of *scarcity, the study of how people use resources and respond to
incentives, or the study of decision-making. It often involves topics like wealth and finance.

*Scarcity: Shortage/Lack/Insufficiency

Economics is a social science that focuses on the production, distribution, and consumption
of goods and services, and analyzes the choices that individuals, businesses, governments,
and nations make to allocate resources.

Economics is to determine the most logical and effective use of resources to meet private
and social goals. Production and employment, investment and savings, health, money and

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the banking system, government policies on taxation and spending, international trade,
industrial organization and regulation, urbanization, environmental issues and legal
matters (enforcement of property rights), are just a sampling of the concerns at the heart of
the science of economics.

2. Microeconomics (Economics is Personal):

Microeconomics studies the implications of individual human action, and is key to a
person's financial health.
Some examples of common day-to-day economics questions include:
Should I pay cash, borrow or sign a lease to get that new car? Should I take out a home loan
or invest in the stock market?
Economists understand how to make these decisions in their own lives, and can advise
others on a personal or professional level.
So, the microeconomics is the study of an individual consumer or a firm is called
microeconomics. Microeconomics deals with behavior and problems of single individual
and of micro-organization.

3. Macroeconomics (Economics is Universal):

Macroeconomics studies how the economy behaves as a whole, including: inflation, price
levels, rate of growth, national income, gross domestic product and changes in employment
rates.

The study of ‘aggregate’ or total level of economic activities in a country is called

macroeconomics. It studies the flow of economics resources or factors of production (such
as land, labor, capital, organization and technology) from the resource owner to the
business firms and then from the business firms to the households.

It discusses aggregate consumption, aggregate investment, price level, and payment and so
on.

The study of individual decisions is called microeconomics. The study of the economy as a
whole is called macroeconomics.

4. Economic Analysis: Economic analysis refers to evaluating the costs and benefits to
check the viability of a project, investment opportunity. In other words, it involves
identifying, evaluating, and comparing costs and benefits.

As pointed out by Joel Dean "The purpose of managerial economics is to show how
economic analysis can be used in formulating business policies".

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5. Economic Theories: An economic theory is a set of concepts and principles that define
how various economies work. An economist may use theories for a variety of goals,
depending on their specific function. Some theories, for example, seek to explain why
certain economic events, such as inflation or supply and demand, occur.

6. Inflation: Inflation is typically a broad measure, such as the overall increase in prices or
the increase in the cost of living in a country. Inflation is a rise in prices, which can be
translated as the decline of purchasing power over time. The rise in prices, which is often
expressed as a percentage, means that a unit of currency effectively buys less than it did in
prior periods. Inflation can be contrasted with deflation, which occurs when prices decline
and purchasing power increases.

7. Deflation: Deflation is a decrease in the general price level of goods and services and
purchasing power increases. Deflation occurs when the inflation rate falls below 0%.
Inflation reduces the value of currency over time, but sudden deflation increases it.

8. Gross Domestic Product (GDP): A country’s Gross Domestic Product, or GDP, is the
total monetary or market value of all the goods and services produced within that country’s
borders during a specified period of time. GDP is usually calculated annually, but it can be
calculated per quarter as well.

9. Product Mix: The marketing mix has been defined as the "set of marketing tools that the
firm uses to pursue its marketing objectives in the target market". The basic four product
mix (marketing mix) are: product, price, place, and promotion.

The seven-product mix are: product, price, place, promotion, packaging, positioning and
people. As products, markets, customers and needs change rapidly, one must continually
revisit these seven Ps to make sure the product of the firm is on track and achieving the
maximum results possible in today's marketplace.

Other seven product mix are: product, price, place, promotion, People, process, physical
evidence.

10. Input Mix: Input-mix efficiency is defined as the potential improvement in productivity
with change in input mix. Any change in input-mix will result in change in productivity.

Minimizing total costs helps to maximize profits. If different alternative factor input
combinations can be used to produce the optimal level of production output, the profit-
maximizing firm should select the combination of inputs that have the lowest cost.

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Firms employ different combinations of factor inputs (land, labor, capital and enterprise)
and the profit maximizing firm must be able to determine the most cost-effective
combination of inputs to employ for any given level of output.

11. Black Market: A black market, underground economy, or shadow economy is a

*clandestine market or series of transactions that has some aspect of illegality or is
characterized by **noncompliance with an institutional set of rules. A black market is an
economic activity that takes place outside government-sanctioned channels. Illegal market
transactions usually occur “under the table” to let participants avoid government price
controls or taxes.

Examples: Illegal drugs, prostitution. More serious and lesser-known black markets
operating worldwide include those in human organs, babies, weapons, and slave labor
(human trafficking).

*Clandestine: Underground/secret
**Noncompliance: Nonfulfillment/Refusal/Denial/Defiance

12. Labour Market: The labor market, also known as the job market, refers to the supply
of and demand for labor, in which employees provide the supply and employers provide
the demand.

13. Capital Markets: Capital markets are where savings and investments are channeled
between suppliers and those in need. Suppliers are people or institutions with capital to
lend or invest and typically include banks and investors. Those who seek capital in this
market are businesses, governments, and individuals. The most common capital markets
are the stock market and the bond market. They seek to improve transactional efficiencies
by bringing suppliers together with those seeking capital and providing a place where they
can exchange securities.

14. Equity Capital: Equity capital is funds paid into a business by investors in exchange for
common or preferred stock. This represents the core funding of a business, to which debt
funding may be added.

15. Equity Financing: Equity financing is the process of raising capital through the sale of
shares. Companies raise money because they might have a short-term need to pay bills or
need funds for a long-term project that promotes growth. By selling shares, a business
effectively sells ownership in its company in return for cash. Equity financing can be raised
from angel investors, venture capital firms, or corporate investors.

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16. Econometrics: Econometrics uses economic theory, mathematics, and statistical
inference to quantify economic phenomena. It turns theoretical economic models into
useful tools for economic policymaking.

It subjects real-world data to statistical trials and then compares the results against the
theory being tested.

Example: An economist may hypothesize that as a person increases their income, their
spending will also increase.

17. Market Share: Market share represents the percentage of an industry, or a market's
total sales, that is earned by a particular company over a specified time period. Market
share is calculated by taking the company's sales over the period and dividing it by the total
sales of the industry over the same period.

When the market share of a company increases or decreases, it gives analysts information
on how competitive that company’s goods or services are at that particular time.

18. Business Cycle: The business cycle is the natural rise and fall of economic growth that
occurs over time. The cycle is a useful tool for analyzing the economy and can help you
make better financial decisions. The four phases of the business cycle are: launch, growth,
maturity, and decline.

19. Adam Smith: Adam Smith is considered to be the Father of Economics. He is known
primarily for a single work—An Inquiry into the Nature and Causes of the Wealth of
Nations (1776).

Figure – 1.1: Adam Smith

The central point in Smith's definition is wealth creation. Implicitly, Smith identified wealth
with welfare. He assumed that the wealthier a nation becomes the happier are its citizens.
Thus, it is important to find out how a nation can be wealthy.

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20. Joel Dean: Joel Dean (1906–1979) was an American economist. Joel Dean was the
father of managerial economy. In his writing he reflected on the economic decisions of
business managers. Managerial Economics (also called Business Economics) a subject first
introduced by Joel Dean in 1951, is essentially concerned with the economic decisions of
business managers.

Figure – 1.2 2: Joel Dean

He represented his work on the basis of problem solving, organizing, analyzing, and
evaluating alternatives. Therefore, Joel Dean is the father of managerial economics
concerned on the methods and evaluations of economics.

39. Managerial Economics:

Managerial economics is the use of economic analysis to make business decisions involving
the best use (allocation) of an organization’s scarce resources.

Managerial economy represents the application and methods of economics through

managerial decision making.

Managerial economics is a branch of economics involving the application of economic

methods in the managerial decision-making process.

“Managerial Economics is concerned with business efficiency” - Christopher Savage and

John R. Small.

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Managerial Economics is the “the integration of economic theory with business practice for
the purpose of facilitating decision making and forward planning by management.” - Milton
H. Spencer and Lonis Siegelman.

Following is the briefing of Managerial economics:

Managerial economics is applied in microeconomics, macroeconomics.

Managerial economics deals with “How decisions should be made by managers to
achieve the firm’s goals – in particular, how to maximize profit”.
Managerial economics applies economic theory and methods to business and
administrative decision making.
It prescribes rules for improving managerial decisions.
It also helps managers recognize how economic forces affect organizations.
It links economic concepts with quantitative methods to develop vital tools for
managerial decision making.
And it also describes the economic consequences of managerial behavior.
Managerial economics identifies ways to efficiently achieve goals (pricing and
production decisions).
Managerial economics is the application of logic and tools of economic analysis that
are used in the process of decision making.
Adam Smith is widely considered as the first modern economist. Smith defined
economics as “an inquiry into the nature and causes of the wealth of nations”.

1.3 Objectives of Business Economics:

1. Managerial economics provides such tools necessary for business decisions. Managerial
economics answers the five fundamental problems of decision making. These problems
are:

a. What should be the product mix?

b. Which is the least cost production technique and input mix?
c. What should be the level of output and price of the product?
d. How to take investment decisions?
e. How much should be the selling cost?

2. To apply economic concepts: and principles to solve business problems.

3. To employ the most modern instruments and tools to solve business problems.
4. To allocate the scarce resources in the optimal manner.
5. To make overall development of a firm.

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6. To achieve other objectives of a firm like attaining industry leadership, expansion of the
market share.
7. To minimise risk and uncertainty.
8. To help in demand and sales forecasting.
9. To help in formulating business policies.
10. To help in profit maximisation.

1.4 Nature of Managerial Economics:

1. Microeconomics: Managerial economics is concerned with finding the solutions for

different managerial problems of a particular firm. It aids the management in forecasting
and evaluating the trends of the market. Knowledge of macroeconomic issues such as:
business cycles, taxation policies, industrial policy of the government, price and
distribution policies, wage policies and antimonopoly policies and so on…

2. Macroeconomics: The macroeconomics conditions of the economy are also seen as

limiting factors for the firm to operate. In other words, the managerial economist has to be
aware of the limits set by the macroeconomics conditions such as government industrial
policy, inflation and so on.

3. Normative Economics: It is concerned with varied corrective measures that a

management undertakes under various circumstances. It deals with goal determination,
goal development and achievement of these goals. Future planning, policy-making,
decision-making and optimal utilization of available resources, come under this banner.

4. Interdisciplinary: The contents, tools and techniques of managerial economics are

drawn from different subjects such as economics, management, mathematics, statistics,
accountancy, psychology, organizational behavior, sociology and etc.

5. Decision-making: Decision-making is the action or process of thinking through possible

options and selecting one. Decision making involves identification of problems
development of various alternative solutions, selection of best alternative and finally
implementation of the decision.

Poor decision-making is unlikely to drive the entire firm out of existence, but it can lead to
many adverse outcomes such as:

 Reduced productivity if there are too few workers or insufficient supplies.

 Increased expenses if there are too many workers or too many supplies.
 Frustration among employees increased turnover.

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6. Evaluate Alternatives: Managerial economics provides an opportunity to evaluate each
alternative in terms of its costs and revenue. The managerial economist can decide which
is the better alternative to maximize the profits for the firm.

7. Uses Theory of Firm: Managerial economics employs economic concepts and principles,
which are known as the theory of Firm or ‘Economics of the Firm’. Theory of firm states
that the primary aim of the firm is to maximize wealth.

8. Econometrics: Managerial economics is used in the study of Econometrics where it is

used as a statistical tool for assessing economic theories by empirically measuring
relationship between economic variables. Accordingly, it is used as factual data for solution
of economic problems. Managerial Economics is of great help in price analysis, production
analysis, capital budgeting, risk analysis and determination of demand.
9. Managerial Economics is a Science: Science is a systematic body of knowledge. It is
based on the methodical observation. Managerial economics is also a science of making
decisions with regard to scarce resources with alternative applications. It is a body of
knowledge that determines or observes the internal and external environment for decision
making.
In science any conclusion is arrived at after continuous experimentation. In Managerial
economics also policies are made after persistent testing and trailing. Managerial
economist takes decisions by utilizing his valuable past experience and observations.
Science principles are universally applicable. Similarly, policies of Managerial economics
are also universally applicable.

There are following characteristics of any science subject, such as:

i. It is based on systematic study of knowledge or facts;

ii. It develops correlation-ship between cause and effect;

iii. All the laws are universally accepted

iv. All the laws are tested and based on experiments;

v. It can make future predictions;

vi. It has a scale of measurement.

According to all these economists, ‘economics” has also several characteristics similar to
other science subjects.

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10. Managerial Economics is Art: ‘Knowledge is science, action is art.’ According to Pigou,
Marshall etc., economics is also considered as an art. In other way, art is the practical
application of knowledge for achieving particular goals. Science gives us principles of any
discipline however; art turns all these principles into reality. Therefore, considering the
activities in economics, it can be claimed as an art also, because it gives guidance to the
solutions of all the economic problems. Managerial economist should have an art to put in
practice his theoretical knowledge regarding elements of economic environment.

1.5 Scope of Managerial or Business Economics: From the following fields, we can
examine the scope of business economics.

1. Demand Analysis and Forecasting: A business firm is an economic unit which

transforms productive resources into saleable goods. Since all output is meant to be sold,
accurate estimates of demand help a firm in minimizing its costs of production and storage.
A firm must decide its total output before preparing its production schedule and deciding
on the resources to be employed. Demand forecasts serves as a guide for maintaining its
market share in competition with its rivals, thereby securing its profit. A firm can survive
only if it is able to the demand for its product at the right time, within the right quantity.

2. Cost and Production Analysis: A firm's profitability depends much on its costs of
production. Cost estimates of a range of output, identify the factors causing variations in
costs and choose the cost-minimising output level. Also Considered the degree of
uncertainty in production. Sound pricing policies depend much on cost control.

3. Pricing Decisions, Policies and Practices: A firm's income and profit depend mainly on
the price decision. The pricing policies decisions are to be taken after careful analysis of the
nature of the market in which the firm operates. The important topics covered in this field
of study are: Market Structure Analysis, Pricing Practices and Price Forecasting.
Competition’s analysis includes the anticipation of the response of competitions the firm’s
pricing, advertising and marketing strategies are important place.

4. Resource Allocation: Resource allocation is the process in which a company decides

where to allocate scarce resources for the production of goods or services. A resource can
be considered a production factor that’s used to produce goods or services. Resources can
be many things, including labour, machinery, technology, natural, real estate, financial
resources, etc. Managerial Economics is the traditional economic theory that is concerned
with the problem of optimum allocation of scarce resources.

5. Profit Management: Each and all business firms are tended for earning profit, it is profit
which provides the chief measure of success of a firm in the long period. Economists tells
us that profits are the reward for uncertainty bearing and risk taking. A successful business

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manager is one who can form more or less correct estimates of costs and revenues at
different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him. It is therefore, profit-planning and profit
measurement constitute the most challenging area of business economics.

6. Capital Management: Capital is the foundation of business. Investments are made in the
plant and machinery and buildings which are very high. Availability of capital from various
sources like capital market, equity capital, institutional finance etc. may help to undertake
large-scale operations. Knowledge of capital theory can help very much in taking
investment decisions. This involves, capital budgeting, feasibility studies, analysis of cost of
capital etc.

7. Inventory Management: A firm should always keep an ideal quantity of stock. If the
stock is too much, the capital is unnecessarily locked up in inventories. At the same time if
the level of inventory is low, production will be interrupted due to non-availability of
materials. Hence, a firm always prefers to have an optimum quantity of stock. Therefore,
managerial economics will use some methods such as ABC analysis, inventory models with
a view to minimising the inventory cost. Follow the principle of Just in time (JIT).

8. Business Cycles: Business cycles affect business decisions. They refer to regular
fluctuations in economic activities in the country. The different phases of business cycle are
depression, recovery, prosperity, boom and recession.

9. Environmental Issues: A study of economic environment is the type of economic

system in the country. The following are the economic environment of the country.

a. The general trends in production, employment, income, prices, saving and investment.
b. Trends in the working of financial institutions like banks, financial corporations,
insurance companies
c. Magnitude and trends in foreign trade;
d. Trends in labour and capital markets;
e. Government’s economic policies viz. industrial policy monetary policy, price policy etc.

Environmental issues also refer to social and political atmosphere within which the firm
operates.

a. The social environment refers to social structure as well as social organization like trade
unions, consumer’s co-operative etc. The firm owes a responsibility to the society.

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b. The political environment refers to the nature of state activity, chiefly states’ attitude
towards private business, political stability etc.

1.6 Theory of the Firm

According to the theory of the firm, every business organization is driven by the motive of
maximizing profits. This theory influences decisions for allocating resources, methods of
production, adjustments in prices, and manufacturing in huge quantum.

A limitation of the traditional theory of the firm is that it equates utility maximisation with
profit maximization. But in reality, besides profit maximization, companies emphasize on
maximising sales, maximising market share, social responsibilities (e.g. looking after the
environment) and co-operatives which seek to improve the welfare of all society.

Following are the main theories of profit in managerial economics.

1. Risk-Bearing Theory of Profit

2. Uncertainty-bearing Theory of Profit

3. Rent Theory of Profit

4. Innovation Theory of Profit

5. Dynamic Theory of Profit

6. Monopoly Power Theory of Profit

7. Labour Exploitation Theory of Profit

1.6.1 Risk-Bearing Theory of Profit: According to Hawley, one of the major functions of
an entrepreneur is to bear risk that is associated first with the setting up of the business
and then with the management of the business.
The risks in a business are of two types:

i. Risk involved in the selection of the field of business.

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ii. Risk associated with the management of the business.

After investing capital in a particular business, the entrepreneur has to wait for a long time
before he can know if his selection of the field of business has been appropriate—this long
wait is a form of risk-bearing. Again, while managing the business, the entrepreneur has to
bear all the risks arising out of unexpected changes in the demand and supply for the
product.

Therefore, that the entrepreneur has to bear the risks associated with the unexpected
changes in demand and supply of the product and also the risks associated with the
consequent changes in the price of the product, total revenue and profit of the firm. The
greater the ability of the entrepreneur to bear all these risks, the higher would be his level
of profit. This is the main contention of the risk-bearing theory.

Arguments Against the Theory:

1. Innovative Ideas: Risk-bearing is not the only function of an entrepreneur who has to
perform many vital functions. For example, the entrepreneur has to innovate at regular
intervals new products, new markets and improved methods of production and business.
Therefore, profit also be considered as a reward for effecting innovations.

2. Monopolistic Dominance: If the entrepreneur is able to establish a monopolistic

dominance in the market, then also his income, i.e., profit, would include the added income
acquired through monopoly power. Therefore, profit cannot be explained only as a reward
for risk-bearing.

3. Risk-bearing: The entrepreneur has surely to bear risks and his profit, at least some
part of it, may be considered to be a reward for risk-bearing. The exponents of the risk-
bearing did not distinguish between insurable risk and non-insurable risk. For, the
entrepreneurs actually do not bear the burden of insurable risks—it is borne by the
insurance companies. Entrepreneurs bear the burden of non-insurable risks and he has
called these non-insurable risks by the name of uncertainty. The entrepreneur should
obtain profit as a reward for bearing this uncertainty.

1.6.2 Uncertainty-Bearing Theory of Profit: The uncertainty-bearing theory of profit was

propounded by the American Economist Prof. F. H. Knight in his book “Risk, Uncertainty,
and Profit”, published in 1921 A. D. Prof. Knight has focused and explained the uncertainty
and distinguished it from risk. According to this theory there is a direct relationship
between profit and uncertainty bearing. Greater the uncertainty bearing the higher the

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level of profit. According to Knight, profit is the reward of bearing uncertainties which are
not insurable but the risk can be insured.

For example, we know from experience that factory premises are exposed to the risk of fire.
We also know why there may be fire in a factory premise, and so, we may adopt necessary
measures for prevention of fire. In spite of all this, there remains the risk of fire, and, once
the insurance companies agree to bear this risk, it no longer remains a risk. In other words,
according to Knight, insurable risks should not be considered as risks and there is no
question of the entrepreneurs bearing this risk.

However, the entrepreneurs bear the burden of non-insurable risks for there is no
insurance company to bear these risks on their behalf. Prof. Knight has called these risks
the uncertainties.

Professor Knight has distinguished between insurable risk and uninsurable uncertainties
as follows: -

1. Insurable Risk: The risks which are predictable and can be insured against on payment
of an insurance premium are known as risks. E.g.:- Risks of a factory caught fire, theft or
accident, etc. The insurable risk will not give any reward to an entrepreneur.

Table – 1.1: Insurable and Non-insurable Risks

2. Un-insurable Un-certainties: The risks which are unpredictable or uninsurable are

known as uncertainties. E.g. :- Reduction in demand, change in government policies,
increase in competition, etc. An entrepreneur bears these uncertainties and gets a reward
in return which is called profit.

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The risks which cannot be predicted are explained as follows:

a. Uncertainty Market Condition: The change in demand and supply conditions in the
market lead the entrepreneur to uncertainty.

b. Competitive Uncertainty: When new firms enter the market, it increases competition
among themselves and the profit of existing firm will become uncertain.

c. Innovation: Due to the introduction of new technology, machines and capital goods need
to be replaced before they become obsolete. Thus, the uncertainties of entrepreneur
increase due to innovations.

d. Economic Policies: Economic policies can be classified into microeconomic policy and
macroeconomic policy. Because of the change in these policies, the entrepreneurs may get
windfall gains or suffer losses.

e. Business Cycle: The business cycle also called the trade cycle is a common feature of a
capitalist economy. It refers to the fluctuation in the economic activity which changes
aggregate demand and aggregate supply. Consequently, business uncertainties of the
entrepreneur grow.

Criticisms of the uncertainty-bearing theory of profit:

1. No profit/Low profit despite uncertainty-bearing: Critics pointed out that sometimes

an entrepreneur earns no profit even after taking uncertainties.

2. Incomplete Theory: Profit is not the reward for bearing uncertainties. According to
critics, other causes like co-ordinating, bargaining, etc. also give profits. So, it is an
incomplete theory of profit.

3. Not applicable in case of a joint stock company: The shareholders of joint stock
companies who are entitled to a profit, do not perform any functions of an entrepreneur.

4. Unable to explain monopoly profit: This theory does not suit well to expose the
phenomenon of monopoly profit, where there is very less uncertainty involved in a
monopoly business.

Favour of the uncertainty-bearing theory of profit:

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i. The theory attracts our attention to the fact that not all types of risk are to be borne by
the entrepreneur. He actually bears the non-insurable risks. The insurable risks are taken
care of by the insurance agencies.

ii. The theory tells us that, like all other productive services, uncertainty-bearing is also a
productive service. The entrepreneur supplies this productive service and profit is the
price of this service.

Arguments Against the Theory:

i. Uncertainty-bearing is not the only function of an entrepreneur.

ii. The innovation of new products, new markets or new production and business
techniques are also among the main tasks of an entrepreneur.
iii. The rent of ability and monopolistic dominance may also be the sources of profit.
iv. Similarly, a firm may earn profit owing to its goodwill in the market.

1.6.3 Rent Theory of Profit: An American economist, Francis A. Walker (1840-97), is the
exponent of the rent theory of profit. Walker says that an entrepreneur acquires profit
because of his ability to perform. He states that profit is the rent of ability. In a certain
production process, if an entrepreneur uses land, labour and capital owned by his own self,
then the *residual part of his revenue, after payment is made to all these factors of
production, is profit.
*Residual: Remaining after the greater part or quantity has gone.

As per Rent Theory of Profit, rent was the reward for the use of land, while profit was the
reward for the ability of the entrepreneur. Just as lands differ in fertility, entrepreneurs
differ in business ability. Due to the differences in the fertility of land, rent arises. Similarly
due to the differences in the ability of entrepreneurs, profits arise. As superior lands earn
more rent, superior entrepreneurs earn more profit.

If an entrepreneur is able to earn profits in excess of his normal profit, then this excess is a
surplus and this surplus is called pure or economic profit. The amount of pure profit an
entrepreneur may earn would depend upon the efficiency of his performance. The more his
efficiency, the more he would be able to earn as pure profit.

1.6.4 Innovation Theory of Profit: The innovation theory of profit was developed by Prof.
Joseph A. Schumpeter (1883-1950). According to Schumpeter, the main function of an
entrepreneur is to innovate. Schumpeter believed that an entrepreneur can earn economic

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profits by introducing successful innovations. Here we have to remember first the
distinction which Schumpeter had made between invention and innovation.

Difference Between Invention and Innovation:

Figure -1.2: Difference between Invention and Innovation

Figure -1.3: Example of Invention to Innovation – Gramophone to Flash Drive

Invention is the discovery of a law of nature by a scientist. On the other hand, if an

entrepreneur manufactures a new product or introduces a new production technique
thereby makes the commercial use of the invention possible, then this is called innovation.

Innovation can be classified into two categories; The first category includes all those
activities which reduce the overall cost of production such as the introduction of a new
method or technique of production, the introduction of new machinery, innovative
methods of organizing the industry, etc.

The second category of innovation includes all such activities which increase the demand
for a product. Such as the introduction of a new commodity or new quality goods, the
emergence or opening of a new market, finding new sources of raw material, a new variety
or a design of the product, etc.

For example, the scientists have discovered or invented the laws of science that are behind
the manufacture of the goods like electric lights or fans, radio sets, television sets,

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refrigerators and such other goods. But the entrepreneurs have innovated these goods.
Innovation is the commercial use of the laws of science that have been discovered by the
scientists.

Schumpeter has said that if the entrepreneur can innovate new techniques of production
and sale, if he can innovate a new product or a new model of an old product and if he can
find new markets for selling the product, then only, he will be able to play the role of a
pioneer in the business world and increase the amount of profit. We may call this increase
in profit the innovation-induced profit.

Criticisms of the Theory: The following points highlight the major criticisms of
Schumpeter’s theory of economic development.

1. Role of innovator over emphasized: The innovational activities have become a matter
of routine these days and there is no need of special agent like innovator for carrying on
such activities. Thus, Schumpeter has over glorified the place of innovator in his model.

2. Role of savings ignored: This theory ignores the important sources of real savings such
as deficit financing, budgetary savings, public borrowings and other fiscal measured.

3. Innovators are the limelight: This theory explains that rational behaviour of
innovators and intellectual class is responsible for the success of capitalism. The
Schumpeter’s Hero i.e. innovator or entrepreneur is a forward looking man in the economic
matters and he is an adaptable individual who can overcome all sorts of difficulties and
obstacles. But in social and political field, he may be quite weak.

4. Innovations is not the main cause of economic development: Schumpeter regards

innovations as the main cause of economic development. However, this view is far from
reality because economic development of a country does not depend on innovations only
but also on many economic and social factors.

5. Little relevance for underdeveloped countries: In the context of underdevelopment,

the Schumpeter theory is found to be inadequate. In underdeveloped counties, the class of
innovators is very small because of the small extent of the market, and the low expectation
of profits. Schumpeter has talked of a private innovator as the prime mover of economic
growth, but in most of the poor countries, the government is the biggest innovator.

1.6.5 Dynamic Theory of Profit: According to J. M. Clark (1884-1963), an American

economist, profit can emerge only in a dynamic society. That is why his theory is called the

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dynamic theory of profit. We have to remember here the distinction between a dynamic
society and a static society.

The society which is constantly changing and where the socio-economic factors like
population and labour force, saving and investment, volume of capital, tastes and choices of
the people, the standard of education, health and culture, etc. are always changing, is called
a dynamic society.

According to J. B. Clark, five main changes are constantly taking place in dynamic society.
They are:
1. Changes in the number of humans wants
2. Changes in the methods of production
3. Changes in the capital formation in the economy
4. Changes in the method of organization of the business
5. Changes in the size of population and incomes of the people

On the other hand, the society where these changes do not occur, is called a static society.
That is why here there is no risk or uncertainty. In such a society, everything goes on
according to routine and everyone has a prior information of what will happen and when.

So here the entrepreneur bears no uncertainty while organising a production process, and
he should not get profit as a reward. Therefore, Clark concludes that very little profit arises
in a static society. In a static society, innovations do not occur, for such a society does not
experience changes.

The dynamic society, on the other hand, goes through changes. There the tastes, habits and
fashion, the availability of factors of production and the methods and techniques of
production are all changing. That is why, in such a society, the entrepreneur has to bear
uncertainty. The more successful he is in managing the uncertainties, the higher would be
the profit level acquired by him. It is clear in the above analysis that in a dynamic society,
the entrepreneur has to be innovative, for innovations lead to changes and changes inspire
innovations. That is why the dynamic theory of profit is considered to be a more general
form of Schumpeter’s innovation theory.

The dynamic theory attracts our attention to the fact that dynamism is urgently necessary
for the social and economic progress of a society. If the society is dynamic, the
entrepreneurs would earn profit and, if they can earn profit, the supply of
entrepreneurship increases and, consequently, production in the society increases.

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Criticism of Dynamic Theory of Profits:

This theory of profit has been criticized on the following grounds

1. Types of risks: According to Knight all types of dynamic changes do not yield profit.
According to him two types of changes takes place in society. a) Foreseeable changes. b)
Unforeseeable changes. According to him only unforeseeable changes brings profits.

2. Determination of profit: The theory does not explain how the rate of profits can be
determined.

3. Losses: According to Clark, whenever there is a change in the economy, it brings profit.
But in reality, it is not correct. Sometimes they may cause losses also.

4. Profit in the reward: This theory states that profits arise due to dynamic changes. It
does not recognize that profits are the reward for entrepreneurs.

1.6.6 *Monopoly Power Theory of Profit:  Many economists think that if there is perfect
competition in the markets, there cannot be any profit, because absence of competition
creates opportunities in the markets to acquire profit. As we know, under perfect
competition, the buyers and sellers are assumed to possess full knowledge about the
conditions prevailing in the markets.

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 Figure-1.4: Monopoly Market

That is why it can sell more or less any amount of its product at the market-determined
price. The entrepreneur, here, is not required to take an individual initiative to increase the
demand for his product and his sales. Therefore, here the entrepreneur performs his
routine activities and for this he gets no more than the normal profit.

*Monopoly Theory of Profit posit that the firms enjoying the monopoly power restricts the
output and charge higher prices for its products and services, than under perfect
completion.

Companies that provide electricity, gas, and water to the public are the examples of this
kind where the entire market, and regulations provided by the government make it hard
for new players to join the market.

If the entrepreneur possesses monopoly power in the market, then he would have to exert
individual initiative in giving leadership in the market. In order to maintain his monopoly
power and to increase this power, he would have to exercise necessary efforts. The
entrepreneur here has to bear risk and uncertainty, and he would have to expand the
dominance of his firm in the market through innovations.

According to the monopoly theory of profit, an entrepreneur can earn monopoly profit and
can maintain it for a longer time period by using his **monopoly powers.

These powers are:

i. Power to control the supply and price of products.

ii. Power to prevent the entry of a new competitor into the market by price cutting.

*Monopoly: A single firm in an industry with no close substitutes.

**Monopoly powers/ Market Power: Ability of a firm to set the price of a good. Also called
monopoly power.

Criticisms: It cannot be denied that monopoly is, a very important source of profit. But this
cannot be a complete theory of profit. Innovations by the bold entrepreneurs and
uncertainty also contribute to profits.

Dynamic changes in any theory of profits, the influence of these factors cannot be ignored.
In fact, market imperfections in monopolistic competition increase uncertainty, which also
makes the entry of new firms into industry difficult.

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1.6.7 Labour *Exploitation Theory of Profit:  According to the great philosopher and
classical economist, Karl Marx (1818-1883), labour is the only factor of production which
can produce surplus value. The capitalists acquire profit by **expropriating this surplus
value.

*Exploitation: the action or fact of treating someone unfairly in order to benefit from their
work (Misuse, Mistreatment, Manipulation)
**Expropriating: Taking/Stealing/Seizing

Labour is given a rate of wage which is much smaller than the net value produced by it with
the help of machines, raw materials, etc. The surplus value is defined as the difference
between the net value produced by labour and what it actually gets as wage. There would
be an increase in the productivity of labour when this profit is converted into capital and
invested again, for now the labour would be able to use more of capital goods or machines.

As the productivity of labor increases, the surplus value created by labour also increases
for the rate of wage of the workers generally does not increase, or, increases at a much
smaller rate. Thus, exploitation of labour goes on increasing at an increasing rate and, along
with it, the stock of capital also increases.

Criticisms: In the labor exploitation theory of profit, the role of labour in the creation of
surplus value and the subject of labour exploitation have been rightly emphasised.
However, many economists think that, like labour, the other factors of production, like land
and capital, are also productive.

Besides, Marx has said that it is the capitalists that acquire profit, i.e., he thinks that
capitalists are identical with entrepreneurs. Lastly, Marx does not consider the fact that
sometimes the entrepreneurs may have to bear risks and uncertainties. Therefore, Marx’s
theory, too, cannot be considered to be a complete theory of profit.

1.7 Role of Business in Society: Businesses always played a key role in the economic and
social development of the communities in which they operate. Role of business in society
“creates commitment to the society by behave ethically and contribute to economic
development while improving the quality of life of the workforce and their families as well
as of the local community and society at large”.
Some of the followings are the role of business in society:
1. Promotes Capital Formation
2. Creates Large-Scale Employment Opportunities

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3. Promotes Balanced Regional Development
4. Reduces Concentration of Economic Power
5. Wealth Creation and Distribution
6. Improvement in the Standard of Living
7. Promotes Country's Export Trade
8. Creating Social Value
9. Interacting with the Community
10. Protecting Environmental Pollution
1. Promotes Capital Formation: Entrepreneurs invest capital resources for setting up
their enterprises. Such type of entrepreneurial activities leads to value addition and
creation of wealth, which is very essential for the industrial and economic development of
the country.
2. Creates Large-Scale Employment Opportunities: With the setting up of more and
more units by entrepreneurs, both on small and large-scale numerous job opportunities are
created for others. In this way, entrepreneurs play an effective role in reducing the problem
of unemployment in the country which in turn clears the path towards economic
development of the nation.
3. Promotes Balanced Regional Development: Entrepreneurs help to remove regional
disparities through setting up of industries in less developed and backward areas. The
growth of industries and business in these areas lead to a large number of public benefits
like road transport, health, education, entertainment, etc. Setting up of more industries lead
to more development of backward regions and thereby promotes balanced regional
development.
4. Reduces Concentration of Economic Power: Industrial development normally leads to
concentration of economic power in the hands of a few individuals which results in the
growth of monopolies. In order to redress this problem a large number of entrepreneurs
need to be developed, which will help reduce the concentration of economic power
amongst the population.
5. Wealth Creation and Distribution: It stimulates equitable redistribution of wealth and
income in the interest of the country to more people and geographic areas, thus giving
benefit to larger sections of the society. Entrepreneurial activities also generate more
activities and give a multiplier effect in the economy.
6. Improvement in the Standard of Living: Entrepreneurs play a key role in increasing
the standard of living of the people by adopting latest innovations in the production of wide
variety of goods and services in large scale that too at a lower cost. This enables the people

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to avail better quality goods at lower prices which results in the improvement of their
standard of living.
7. Promotes Country's Export Trade: Entrepreneurs help in promoting a country's
export-trade, which is an important ingredient of economic development. They produce
goods and services in large scale for the purpose of earning huge amount of foreign
exchange from export in order to combat the import dues requirement. Hence import
substitution and export promotion ensure economic independence and development.
8. Creating Social Value: The level of social contribution is affected by the conditions the
organization creates as an employer. The level of social contribution is influenced by the
approach taken toward labor standards, payment levels and terms, geographic sourcing.
Business provides social value through paying taxes. As a producer, business creates social
value through providing goods and services to meet human needs.
9. Interacting with the Community: Businesses interact within their community in
different ways and for different reasons and their interaction with it is an important part of
social integration and conduct. Business in society deals by improving working conditions
and in the development of wider social infrastructure, such as housing, education and
health care.
10. Protecting Environmental Pollution: The business community clearly understands
that increasing production, producing large volumes of products due to the irrational use of
natural resources, predatory methods of their extraction and processing, and subsequent
pollution with waste from its production, are the notable issues go against environmental
protection. State bodies of environmental control and supervision, environmental
protection agencies, public organizations, eco-activists, volunteers, and many other entities
have become involved in solving environmental problems.
1.8 Basic Economic Relations Assignment
*******

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