Unit 2 Theories of Entrepreneurship

Schumpeter’s Innovation Theory of Profit

Definition: The Innovation Theory of Profit was proposed by Joseph. A.
Schumpeter, who believed that an entrepreneur can earn economic profits by
introducing successful innovations.

The innovation theory of a trade cycle is propounded by J.A. Schumpeter. He

regards innovations as the originating cause of trade cycles. The term
“innovation” should not be confused with inventions. Inventions, in ordinary
parlance, are discoveries of scientific novelties. Innovation is the application of
such inventions to actual production (i.e., exploiting them).

Schumpeter classifies innovation into five categories as follows:

(i) Introduction of new type of goods.

(ii) Introduction of new methods of production.

(iii) Opening of new markets.

(iv) Discovering of new sources of raw materials.

(v) Change in the organisation of an industry, like the creation of a monopoly,

trust, or cartel or breaking up of a monopoly, cartel, etc.

In other words, innovation theory of profit posits that the main function of an
entrepreneur is to introduce innovations and the profit in the form of reward is
given for his performance. According to Schumpeter, innovation refers to any
new policy that an entrepreneur undertakes to reduce the overall cost of
production or increase the demand for his products.

Thus, 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.

The innovation theory of profit posits that the entrepreneur gains profit if his
innovation is successful either in reducing the overall cost of production or
increasing the demand for his product. Often, the profits earned are for a shorter
duration as the competitors imitate the innovation, thereby ceasing the
innovation to be new or novice. Earlier, the entrepreneur was enjoying a
monopoly position in the market as innovation was confined to himself and was
earning larger profits. But after some time, with the others imitating the
innovation, the profits started disappearing.

An entrepreneur can earn larger profits for a longer duration if the law allows
him to patent his innovation. Such as a design of a product is patented to
discourage others to imitate it. Over the time, the supply of factors remaining the
same, the factor prices tend to rise as a result of which the cost of production also
increases. On the other hand, with the firms adopting innovations the supply of
good sand services increases and their prices fall. Thus, on one hand the output
per unit cost increases while on the other hand the per unit revenue decreases.

There is a point of time when the difference between the costs and receipts gets
disappear. Thus, the profit in excess of the normal profit disappears. This
innovation process continues and also the profits continue to appear or
disappear.

McClelland’s Need for achievement theory

McClelland’s Needs Theory posits that the person’s level of effectiveness and
motivation is greatly influenced by the three basic needs.

Need for Power,

Need for Affiliation and
Need for Achievement
Power is the ability to induce or influence the behavior of others. The people with
high power needs seek high-level positions in the organization, so as to exercise
influence and control over others. Generally, they are outspoken, forceful,
demanding, practical/realistic-not sentimental, and like to get involved in the
conversations.
The people with high power needs seek high-level positions in the organization,
so as to exercise influence and control over others. Generally, they are outspoken,
forceful, demanding, practical/realistic-not sentimental, and like to get involved in
the conversations.
Need for Affiliation –
People with high need for affiliation derives pleasure from being loved by all and
tend to avoid the pain of being rejected. Since, the human beings are social
animals, they like to interact and be with others where they feel, people accept
them. Thus, people with these needs like to maintain the pleasant social
relationships, enjoy the sense of intimacy and like to help and console others at
the time of trouble.
Need for Achievement –McClelland found that some people have an intense
desire to achieve.
Some prefer working on tasks of moderate difficulty, prefer work in which the
results are based on their effort rather than on anything else, and prefer to
receive feedback on their work. Achievement based individuals tend to avoid both
high-risk and low-risk situations. Low-risk situations are seen as too easy to be
valid and the high-risk situations are seen as based more on the luck of the
situation rather than the achievements that individual made. This personality type
is motivated by accomplishment in the workplace and an employment hierarchy
with promotional positions.

Knight’s Theory of Profit

Definition: The Knight’s Theory of Profit was proposed by Frank. H. Knight, who
believed profit as a reward for uncertainty-bearing, not to risk bearing. Simply,
profit is the residual return to the entrepreneur for bearing the uncertainty in
business.

According to Prof. Knight the main function of the entrepreneur is Uncertainty

bearing and not risk taking. He divides risks into two classes.

1 ) Foreseeable risks and, 2) Unforeseeable risks.

1. Foreseeable Risks : These risks can be foreseen and estimated in advance.

Example, fire accidents, marine accidents, theft etc. All these risks can be ensured
with an insurance company. If there is any loss that insurance company pays the
total value of the lost property. Thus, this kind of risks will be born by insurance
companies and got by the entrepreneur. The entrepreneur gets no profits on
account of these risks.
2. Unforeseeable Risks: These risks cannot be foreseen and predicted accurately.
According to Knight these unforeseen risks are known as uncertainties, as they
cannot be known and foreseen. Following are some of the unforeseeable risks.
1) Changes in prices due to technological changes,

2) Decrease in the demand due to changes in tastes and fashions, population,

incomes etc.
3) Competition from new firms or new products,

4) Government may interfere into the affairs of the industry and fix lower prices,

5) Cyclical economic depressions resulting in lack of demand, falling prices etc.

Since these risks cannot be foreseen and estimated accurately no insurance

company will be prepared to cover against them. Hence, these are called
uncertainties. According to Prof. Knight there is a direct relationship between profit
and uncertainty bearing. Greater the uncertainty bearing, the higher will be the
level of profits and vice versa. Uncertainty hearing has become so important in
business. So, uncertainty bearing is regarded as a separate factor of production.
The entrepreneur himself has to bear these uncertainties. But all persons are not
capable of undertaking uncertainties. So, uncertainties restrict the supply of
entrepreneurs. According to Prof. Knight profit is the reward for bearing these
uncertainties.

Due to the uncertainty of events, the decision-making becomes a crucial function

of an entrepreneur or manager. If the decisions prove to be correct by the
subsequent events, an entrepreneur makes a profit and vice-versa. Thus, the
Knight’s theory of profit is based on the premise that profit arises out of the
decisions made under the conditions of uncertainty.

Knight believes that profit might arise out of the decisions made concerning the
state of the market, such as decisions with respect to increasing the degree of
monopoly in the market, decisions regarding holding stocks that might result in
the windfall gains, decisions taken to introduce new product and technique, etc.
 x efficiency theory of Lieberstein

Economic theory assumes that the management of firms act to maximize

economic profits—which is accomplished by adjusting the inputs used or the
output produced. In perfect competition, the free entry and exit of firms tends
toward firms producing at the point where price equals long run average costs
and long run average costs are minimized. Thus firms earn zero economic profits
and consumers pay a price equal to the marginal cost of producing the good. This
result defines economic efficiency or, more precisely, allocative economic
efficiency.

X-Efficiency refers to the behavior, performance and efficiency that traders and
firms maintain in imperfect competition. In a perfect market competition,
elements of monopoly do not exist in the market and the prices of commodities
are not controlled by individuals. Under perfect competition, firms and individuals
are able to exhibit efficiency to the full potential which in turn cause them to
make profits. In imperfect competition, the market structure tilts towards
monopolistic competition and exhibit some features of competitive markets. The
x-efficiency theory evaluates how inefficiency of individuals and firms is linked to
imperfect competition.
X-Efficiency theory states that a greater amount of product market competition
will pressure firm members to produce with more effort so that the firm is
producing closer to their frontiers

Leibenstein identifies two main roles for entrepreneurs. The first role is the ‘input
completion’ involves making available inputs which improve efficiency of existing
production methods or facilitates the introduction of new ones. It is normally
effected by intermediation in factor markets, in particular the markets for venture
capital and management skills. The role of entrepreneur is to improve the flow of
information in these markets.

The second role ‘gap filling’ is closely related to arbitrage.

EE Hagen’s theory of social change

EE Hagen introduced the theory of social change as an endeavor to explain how
individuals change their social status in order to gain societal respect. The core
notion that drives this sociological theory is that when individuals feel that they
are no longer respected by the society, they tend to implement innovative ways
by means of which their social status can get positively transformed. The aim is to
regain their lost status.

This desire to change the prevailing social status can be indicated as the acquired
tendency of an individual to become an entrepreneur. This happens in three
situations:

➢ When the individual loses their existing social status to someone who has
suddenly regained superiority and enhanced social respect.
➢ If there is any form of defamation of the values and position of the
individual by someone superior to him.
➢ If the individual is unable to accept the newly acquired social status due to
the transformation of the existing society into a new social order
➢ Thus, this theory emphatically shows that withdrawal from existing social
status acts as a driver which influences entrepreneurial qualities in an
individual. Eventually, this transforms an individual from an ordinary person
to an entrepreneur