PRODUCTION AND COST ANALYSIS

Introduction: Production Function

The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of
inputs. Mathematically production function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs. Hence output
becomes the dependent variable and inputs are the independent variables.
The above function does not state by how much the output of “Q” changes as a consequence
of change of variable inputs. In order to express the quantitative relationship between inputs
and output, Production function has been expressed in a precise mathematical equation i.e.
Y= a+b (x)
Which shows that there is a constant relationship between applications of input (the only
factor input „X‟ in this case) and the amount of output (y) produced.
Importance:
1. When inputs are specified in physical units, production function helps to estimate the level
of production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without
altering the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types‟ input-output relationships namely „law of variable proportions‟
and „law of returns to scale‟. Law of variable propositions explains the pattern of output in
the short-run as the units of variable inputs are increased to increase the output. On the other
hand, law of returns to scale explains the pattern of output in the long run as all the units of
inputs are increased.
6. The production function explains the maximum quantity of output, which can be produced,
from any chosen quantities of various inputs or the minimum quantities of various inputs that
are required to produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole.
Production function will change with an improvement in technology.
Assumptions:
Production function has the following assumptions.
1. The production function is related to a particular period of time.
2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Law of Returns of Scale:
In the long run all factors of production are available. No factor is fixed. Accordingly, the
scale of production can be changed by changing the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis”
“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long
run concept.” Leibhafsky
Statement of the Law
The law of returns to scale explains the behaviour of the total output in response to change in
the scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e.,
in responses to a simultaneous and proportional increase in all the inputs. More precisely, the
Law of returns to scale explains how a simultaneous and proportionate increase in all the inputs
affects the total output at its various levels. The law of returns to scale explains the proportional
change in output with respect to proportional change in inputs.
The concept of variable proportions is a short-run phenomenon as in these period fixed
factors cannot be changed and all factors cannot be changed. On the other hand, in the long-
term all factors can be changed as made variable. When we study the changes in output when
all factors or inputs are changed, we study returns to scale. The degree of change in output
varies with change in the amount of inputs. For example, an output may change by a large
proportion, same proportion, or small proportion with respect to change in input.
The assumptions of returns to scale are as follows:
 The firm is using only two factors of production that are capital and labour.
 Labour and capital are combined in one fixed proportion.
 Prices of factors do not change.
 State of technology is fixed

On the basis of these possibilities, law of returns to scale can be classified into three
categories:
I. Increasing returns to scale

ii. Constant returns to scale

iii. Diminishing returns to scale

Explanation:
In long run, output can be increased by increasing all factors in the same proportion.
Generally, Law of returns to scale refer to an increase in output due to increase in all factors
in the same proportion. Such an increase is called return to scale.

Suppose, initially production function is as follow:

P= f (L,K)
Now, if both the factors of production i.e., labour and capital are increased in same proportion
i.e., x, product function will be rewritten as.
P1= f (xL,xK)

1. If P1 increases in the same proportion as the increase in factors of production i.e., P1/P= x,
it will be constant returns to scale.
2. If P1 increases in the less than proportional increase in factors of production i.e., P1/P< x, it
will be diminishing returns to scale.
3. If P1 increases more than proportional increase in factors of production i.e., P1/P > x, it will
be increasing returns to scale. Returns to scale can be shown with the help of table.

Table: showing different stages of return to scale

Unit of Units of % Total % increase in Returns to

Labour capital increase output/product the total scale
in Labour product
& Capital
1 3 - 10 - Increasing
2 9 100 30 200 return to
3 9 50 60 100 scale
4 12 33 80 33 Constant
5 15 25 100 25
6 18 20 120 20
7 21 16.6 130 8.33 Diminishing
The above stated table explains the following three stages of returns to scale:
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all factors of
production are increased., output increases at a higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than double. If the proportional change in the output
of an organization is greater than the proportional change in inputs, the production is said to
reflect increasing returns to scale. For example, to produce a particular product, if the quantity
of inputs is doubled and the increase in output is more than double, it is said to be an increasing
return to scale. When there is an increase in the scale of production, the average cost per unit
produced is lower. This is because at this stage an organization enjoys high economies of scale.
Hence, it is said to be increasing returns to scale. This increase is due to many reasons like
division external economies of scale. Increasing returns to scale can be illustrated with the help
of a diagram 10.
In figure. 10, OX axis represents increase in labour and capital while OY axis shows increase
in output. When labour and capital increases from Q to Q1, output also increases from P to
P1 which is higher than the factors of production i.e., labour and capital.

There a number of factors responsible for increasing returns to scale.

Some of the factors are as follows:

I. Technical and managerial indivisibility:
Implies that there are certain inputs, such as machines and human resource, used for the
production process are available in a fixed amount. These inputs cannot be divided to suit
different level of production. For example, an organization cannot use the half of the turbine
for small scale of production.

Similarly, the organization cannot use half of a manager to achieve small scale of production.
Due to this technical and managerial indivisibility, an organization needs to employ the
minimum quantity of machines and managers even in case the level of production is much
less than their capacity of producing output. Therefore, when there is increase in inputs, there
is exponential increase in the level of output.

ii. Specialization:
Implies that high degree of specialization of man and machinery helps in increasing the scale
of production. The use of specialized labour and machinery helps in increasing the
productivity of labour and capital per unit. This results in increasing returns to scale.
iii. Concept of Dimensions:
Refers to the relation of increasing returns to scale to the concept of dimensions. According
to the concept of dimensions, if the length and breadth of a room increases, then its area gets
more than doubled.

For example, length of a room increases from 15 to 30 and breadth increases from 10 to 20.
This implies that length and breadth of room get doubled. In such a case, the area of room
increases from 150 (15*10) to 600 (30*20), which is more than doubled.

2. Constant Returns to Scale:

Constant return to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will also be doubled.

In this case internal and external economies are exactly equal to internal and external
diseconomies. This situation arises when after reaching a certain level of production.
Economies of scale are balanced by diseconomies of scale. This is known are homogenous
production function. Cobb-Douglas linear homogenous production function is a good
example of this kind. This is known in diagram 11. In figure 11, we see that increase in
factors of production i.e., labour and capital are equal to the proportion of output increase.
Therefore, the result is constant returns to scale.

Figure-11 shows the constant returns to scale

3. Diminishing Returns to Scale:

Diminishing returns or increasing costs refers to that production situation, where if all the
factors of production are increased in a given proportion, output increases in a smaller
proportion. It means, if inputs are doubled, output will be less than doubled. If 20 per cent
increase in labour and capital is followed by 10 per cent increase in output, then it is an instance
of diminishing returns to scale.
 Figure-9 shows the diminishing returns to scale
In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and
capital are given while on OY axis, output. When factors of production increase from Q to
Q1 (more quantity) but as a result increase in output, i.e., P to P1 is less. We see that increase
in factors of production is more and increase in production is comparatively less, thus
diminishing returns to scale apply.
Reasons for diminishing return to scale:

1. Fixed Costs
Diminishing Returns can occur when a business needs to purchase new capital equipment
or other fixed cost. For example, a manufacturer may create a new factory, but it may
produce less than existing factories – therefore creating diminishing returns.
2. Lower levels of Productivity
At a certain point, hiring an additional worker can be counterproductive. For example, 2
staff in a coffee house may be enough. However, a third, fourth, or fifth employee may
create a chaotic environment that is inefficient. They may also start talking with each other
rather than working on tables.

3. Limited Demand
A firm may hire an additional worker to satisfy demand, but they may not cover the full
output that the employee is capable of. For example, an employee may be able to produce
10 units, but there is only demand for 5. Therefore, the employee only produces 5,
resulting in diminishing returns. We may see this in local stores which see a low footfall.

4. Negative Impact on Working Environment

On occasion, employing more people can disrupt others. For example, squeezing more
workers into the same office may create an uncomfortable atmosphere. Similarly, bringing
in a new piece of machinery might create unintended consequences. For instance, it may
alter the room temperate, thereby affect the quality of other products.
5. Short Run
The law of Diminishing Marginal Returns can only occur in the short-run. This is because
all factors are variable in the long-run. For example, having an additional worker in the
cafe may create for a chaotic environment. However, the employees may learn to work
more efficiently together and therefore produce better returns in the long-term.

COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon
its ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general, the selling price is not within the control of a firm but many costs are
under its control. The firm should therefore aim at controlling and minimizing cost. Since
every business decision involves cost consideration, it is necessary to understand the meaning
of various concepts for clear business thinking and application of right kind of costs.

COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and
the relevance of each for different kinds of problems are to be studied. The various relevant
concepts of cost are:
1. Opportunity costs and outlay costs: Out lay cost also known as actual costs obsolete costs
are those expends which are actually incurred by the firm these are the payments made for
labour, material, plant, building, machinery traveling, transporting etc., These are all those
expense item appearing in the books of account, hence based on accounting cost concept. On
the other hand, opportunity cost implies the earnings foregone on the next best alternative, has
the present option is undertaken. This cost is often measured by assessing the alternative, which
has to be scarified if the particular line is followed. The opportunity cost concept is made use
for long-run decisions. This concept is very important in capital expenditure budgeting. This
concept is very important in capital expenditure budgeting. The concept is also useful for taking
short-run decisions opportunity cost is the cost concept to use when the supply of inputs is
strictly limited and when there is an alternative. If there is no alternative, Opportunity cost is
zero. The opportunity cost of any action is therefore measured by the value of the most
favourable alternative course, which had to be foregoing if that action is taken.

2. Explicit and implicit costs:

Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. These costs include payment of wages and salaries,
payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid
etc. Implicit costs are the costs of the factor units that are owned by the employer himself.
These costs are not actually incurred but would have been incurred in the absence of
employment of self – owned factors. The two normal implicit costs are depreciation, interest
on capital etc. A decision maker must consider implicit costs too to find out appropriate
profitability of alternatives.

3. Historical and Replacement costs: Historical cost is the original cost of an asset. Historical
cost valuation shows the cost of an asset as the original price paid for the asset acquired in the
past. Historical valuation is the basis for financial accounts. A replacement cost is the price that
would have to be paid currently to replace the same asset. During periods of substantial change
in the price level, historical valuation gives a poor 34 projection of the future cost intended for
managerial decision. A replacement cost is a relevant cost concept when financial statements
have to be adjusted for inflation.
4. Short – run and long – run costs: Short-run is a period during which the physical capacity
of the firm remains fixed. Any increase in output during this period is possible only by using
the existing physical capacity more extensively. So short run cost is that which varies with
output when the plant and capital equipment in constant. Long run costs are those, which vary
with output when all inputs are variable including plant and capital equipment. Long-run cost
analysis helps to take investment decisions.

5. Out-of pocket and books costs: Out-of pocket costs also known as explicit costs are those
costs that involve current cash payment. Book costs also called implicit costs do not require
current cash payments. Depreciation, unpaid interest, salary of the owner is examples of back
costs. But the book costs are taken into account in determining the level dividend payable
during a period. Both book costs and out-of-pocket costs are considered for all decisions. Book
cost is the cost of self-owned factors of production.

6. Fixed and variable costs: Fixed cost is that cost which remains constant for a certain level
to output. It is not affected by the changes in the volume of production. But fixed cost per unit
decrease, when the production is increased. Fixed cost includes salaries, Rent, Administrative
expenses depreciations etc. Variable is that which varies directly with the variation is output.
An increase in total output results in an increase in total variable costs and decrease in total
output results in a proportionate decline in the total variables costs. The variable cost per unit
will be constant. Ex: Raw materials, labour, direct expenses, etc.

7. Post and Future costs: Post costs also called historical costs are the actual cost incurred and
recorded in the book of account these costs are useful only for valuation and not for decision
making. Future costs are costs that are expected to be incurred in the futures. They are not
actual costs. They are the costs forecasted or estimated with rational methods. Future cost
estimate is useful for decision making because decision is meant for future.

8. Traceable and common costs: Traceable costs otherwise called direct cost, is one, which
can be identified with a products process or product. Raw material, labour involved in
production is examples of traceable cost. Common costs are the ones that common are
attributed to a particular process or product. They are incurred collectively for different
processes or different types of products. It cannot be directly identified with any particular
process or type of product.

9. Avoidable and unavoidable costs: Avoidable costs are the costs, which can be reduced if
the business activities of a concern are curtailed. For example, if some workers can be
retrenched with a drop in a product – line, or volume or production the wages of the retrenched
workers are escapable costs. The unavoidable costs are otherwise called sunk costs. There will
not be any reduction in this cost even if reduction in business activity is made. For example,
cost of the ideal machine capacity is unavoidable cost.

10. Controllable and uncontrollable costs: Controllable costs are ones, which can be
regulated by the executive who is in charge of it. The concept of controllability of cost varies
with levels of management. Direct expenses like material, labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various
processes or products in some proportion. This cost varies with the variation in the basis of
allocation and is independent of the actions of the executive of that department. These
apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs: Incremental cost also known as different cost is the
additional cost due to a change in the level or nature of business activity. The change may be
caused by adding a new product, adding new machinery, replacing a machine by a better one
etc. Sunk costs are those which are not altered by any change – They are the costs incurred in
the past. This cost is the result of past decision, and cannot be changed by future decisions.
Investments in fixed assets are examples of sunk costs.

12. Total, average and marginal costs: Total cost is the total cash payment made for the input
needed for production. It may be explicit or implicit. It is the sum total of the fixed and variable
costs. Average cost is the cost per unit of output. If is obtained by dividing the total cost (TC)
by the total quantity produced (Q) TC Average cost = ------ Q Marginal cost is the additional
cost incurred to produce and additional unit of output or it is the cost of the marginal unit
produced.

13. Accounting and Economics costs: Accounting costs are the costs recorded for the purpose
of preparing the balance sheet and profit and ton statements to meet the legal, financial and tax
purpose of the company. The accounting concept is a historical concept and records what has
happened in the post. Economics concept considers future costs and future revenues, which
help future planning, and choice, while the accountant describes what has happened, the
economics aims at projecting what will happen.

Overview of short and long run cost curves

In economics, a cost curve is a graph of the costs of production as a function of total quantity
produced. In a free market economy, productively efficient firms optimize their production
process by minimizing cost consistent with each possible level of production, and the result is
a cost curve. Profit-maximizing firms use cost curves to decide output quantities. There are
various types of cost curves, all related to each other, including total and average cost curves;
marginal ("for each additional unit") cost curves, which are equal to the differential of the
total cost curves; and variable cost curves. Some are applicable to the short run, others to
the long run.

Short-run total cost (SRTC) and long-run total cost (LRTC) curves

The total cost curve, if non-linear, can represent increasing and diminishing marginal returns.
The short-run total cost (SRTC) and long-run total cost (LRTC) curves are increasing in
the quantity of output produced because producing more output requires more labour usage in
both the short and long runs, and because in the long run producing more output involves using
more of the physical capital input; and using more of either input involves incurring more input
costs.
With only one variable input (labour usage) in the short run, each possible quantity of output
requires a specific quantity of usage of labour, and the short–run total cost as a function of the
output level is this unique quantity of labour times the unit cost of labour. But in the long run,
with the quantities of both labour and physical capital able to be chosen, the total cost of
producing a particular output level is the result of an optimization problem: The sum of
expenditures on labour (the wage rate times the chosen level of labour usage) and expenditures
on capital (the unit cost of capital times the chosen level of physical capital usage) is minimized
with respect to labour usage and capital usage, subject to the production function equality
relating output to both input usages; then the (minimal) level of total cost is the total cost of
producing the given quantity of output .

Short-run variable and fixed cost curves (SRVC and SRFC or VC and FC)

One can decompose total costs as the sum of fixed costs and variable costs. Here output is
measured along the horizontal axis. In the Cost-Volume-Profit Analysis model, total costs are
linear in volume.
Since short-run fixed cost (FC/SRFC) does not vary with the level of output, its curve is
horizontal as shown here. Short-run variable costs (VC/SRVC) increase with the level of
output, since the more output is produced, the more of the variable input(s) needs to be used
and paid for.

Short-run average variable cost curve (AVC or SRAVC)[edit]

A U-shaped short-run Average Cost (AC) curve. AVC is the Average Variable Cost, AFC the
Average Fixed Cost, and MC the marginal cost curve crossing the minimum of both the
Average Variable Cost curve and the Average Cost curve.
Average variable cost (AVC/SRAVC) (which is a short-run concept) is the variable cost
(typically labour cost) per unit of output: SRAVC = wL / Q where w is the wage rate, L is the
quantity of labour used, and Q is the quantity of output produced. The SRAVC curve plots the
short-run average variable cost against the level of output and is typically drawn as U-shaped.
However, whilst this is convenient for economic theory, it has been argued that it bears little
relationship to the real world. Some estimates show that, at least for manufacturing, the
proportion of firms reporting a U-shaped cost curve is in the range of 5 to 11 percent. [1][2]

Short-run average fixed cost curve (SRAFC)

Since fixed cost by definition does not vary with output, short-run average fixed cost
(SRAFC) (that is, short-run fixed cost per unit of output) is lower when output is higher, giving
rise to the downward-sloped curve shown.

Short-run and long-run average total cost curves (SRATC or SRAC and LRATC or
LRAC)
The average total cost curve is constructed to capture the relation between cost per unit of
output and the level of output. A perfectly competitive and productively efficient firm
organizes its factors of production in such a way that the usage of the factors of production is
as low as possible consistent with the given level of output to be produced. In the short run,
when at least one factor of production is fixed, this occurs at the output level where it has
enjoyed all possible average cost gains from increasing production. This is at the minimum
point in the above diagram.
Short-run total cost is given by
STC= PK+ K+PL+L,
where PK is the unit price of using physical capital per unit time, P L is the unit price of labour
per unit time (the wage rate), K is the quantity of physical capital used, and L is the quantity of
labour used. From this we obtain short-run average cost, denoted either SATC or SRAC, as
STC / Q:
Short-run average cost (SRATC/SRAC) equals average fixed costs plus average variable
costs. Average fixed cost continuously falls as production increases in the short run, because
K is fixed in the short run. The shape of the average variable cost curve is directly determined
by increasing and then diminishing marginal returns to the variable input (conventionally
labour).
The long-run average cost (LRATC/LRAC) curve looks similar to the short-run curve, but
it allows the usage of physical capital to vary.
Short-run marginal cost curve (SRMC)

Typical marginal cost curve

A short-run marginal cost (SRMC) curve graphically represents the relation
between marginal (i.e., incremental) cost incurred by a firm in the short-run production of a
good or service and the quantity of output produced. This curve is constructed to capture the
relation between marginal cost and the level of output, holding other variables, like technology
and resource prices, constant. The marginal cost curve is usually U-shaped. Marginal cost is
relatively high at small quantities of output; then as production increases, marginal cost
declines, reaches a minimum value, then rises. The marginal cost is shown in relation to
marginal revenue (MR), the incremental amount of sales revenue that an additional unit of the
product or service will bring to the firm. This shape of the marginal cost curve is directly
attributable to increasing, then decreasing marginal returns (and the law of diminishing
marginal returns). Marginal cost equals w/MPL. For most production processes the marginal
product of labour initially rises, reaches a maximum value and then continuously falls as
production increases. Thus marginal cost initially falls, reaches a minimum value and then
increases. The marginal cost curve intersects both the average variable cost curve and (short-
run) average total cost curve at their minimum points. When the marginal cost curve is above
an average cost curve the average curve is rising. When the marginal costs curve is below an
average curve the average curve is falling. This relation holds regardless of whether the
marginal curve is rising or falling.  

Long-run marginal cost curve (LRMC)

The long-run marginal cost (LRMC) curve shows for each unit of output the added total cost
incurred in the long run, that is, the conceptual period when all factors of production are
variable. Stated otherwise, LRMC is the minimum increase in total cost associated with an
increase of one unit of output when all inputs are variable.
The long-run marginal cost curve is shaped by returns to scale, a long-run concept, rather than
the law of diminishing marginal returns, which is a short-run concept. The long-run marginal
cost curve tends to be flatter than its short-run counterpart due to increased input flexibility.
The long-run marginal cost curve intersects the long-run average cost curve at the minimum
point of the latter.   When long-run marginal cost is below long-run average cost, long-run
average cost is falling (as additional units of output are considered). When long-run marginal
cost is above long run average cost, average cost is rising. Long-run marginal cost equals short
run marginal-cost at the least-long-run-average-cost level of production. LRMC is the slope of
the LR total-cost function.
Graphing cost curves together with revenue curves

Cost curves in perfect competition compared to marginal revenue

Cost curves can be combined to provide information about firms. In this diagram for example,
firms are assumed to be in a perfectly competitive market. In a perfectly competitive market
the price that firms are faced with in the long run would be the price at which the marginal cost
curve cuts the average cost curve, since any price above or below that would result in entry to
or exit from the industry, driving the market-determined price to the level that gives
zero economic profit.
Profit: Types, Theories and Functions of Profit
The term profit has distinct meaning for different people, such as businessmen, accountants,
policymakers, workers and economists. Profit simply means a positive gain generated from
business operations or investment after subtracting all expenses or costs. In economic terms
profit is defined as a reward received by an entrepreneur by combining all the factors of
production to serve the need of individuals in the economy faced with uncertainties. In a layman
language, profit refers to an income that flow to investor. In accountancy, profit implies excess
of revenue over all paid-out costs. Profit in economics is termed as a pure profit or economic
profit or just profit.
Profit differs from the return in three respects namely:
a. Profit is a residual income, while return is a total revenue
b. Profits may be negative, whereas returns, such as wages and interest are always positive
c. Profits have greater fluctuations than returns
According to modern economists, profits are the rewards of purely entrepreneurial functions.
According to Thomas S.E., “pure profit is a payment made exclusively for bearing risk. The
essential function of the entrepreneur is considered to be something which only he can perform.
This something cannot be the task of management, for managers can be hired, nor can it be any
other function which the entrepreneur can delegate. Hence, it is contended that the entrepreneur
receives a profit as a reward for assuming final responsibility, a responsibility that cannot be
shifted on the shoulders of anyone else.” For understanding the profit as a business objective,
you need to learn two most important concepts, such as economic profit and accounting profit.
Types of Profit:
Different people have described profit differently. Individuals have associated profit with
additional income revenue, and reward. However, none of the description of profit is said to be
right or wrong; it only depends on the field which the word profit is described.
On the basis of fields, profit can be classified into two types, which are explained as
follows:
I. Accounting Profit: Refers to the total earnings of an organization. It is a return that is
calculated as a difference between revenue and costs, including both manufacturing and
overhead expenses. The costs are generally explicit costs, which refer to cash payments made
by the organization to outsiders for its goods and services. In other words, explicit costs can be
defined as payments incurred by an organization in return for labor, material, plant,
advertisements, and machinery.
The accounting profit is calculated as:
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials
The accounting profit is used for determining the taxable income of an organization and
assessing its financial stability. Let us take an example of accounting profit. Suppose that the
total revenue earned by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10,
000. The accounting profit equals = Rs. 2, 50,000 – Rs. 10,000 = Rs. 2, 40,000. It is to be noted
that the accounting profit is also called gross profit. When depreciation and government taxes
are deducted from the gross profit, we get the net profit.
ii. Economic Profit: Takes into account both explicit costs and implicit costs or imputed costs.
Implicit that is foregone which an entrepreneur can gain from the next best alternative use of
resources. Thus, implicit costs are also known as opportunity cost. The examples of implicit
costs are rents on own land, salary of proprietor, and interest on entrepreneur’s own investment.
Let us understand the concept of economic profit. Suppose an individual A is undertaking his
own business manager in an organization. In such a case, he sacrifices his salary as a manager
because of his business. This loss of salary will opportunity cost for him from his own business.
The economic profit is calculated as:
Economic profit = Total revenue- (Explicit costs + implicit costs)
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit- (opportunity cost + unauthorized payments, such as bribes)
Economic profit is not always positive; it can also be negative, which is called economic loss.
Economic profit indicates that resources of a business are efficiently utilized, whereas
economic loss indicates that business resources can be better employed elsewhere.

Theories of Profit:
Profits of businesses depend on the successful management of risks and uncertainties by
entrepreneurs. These risks can be cost risks due to change in wage rates, prices, or technology,
and other market risks. Different economists have presented different views on profit. Some of
the most popular theories of profit-
Walker’s Theory: An American economist, Prof F. A. Walker propounded the theory of
profit, known as rent theory of profit. According to him “as rent is the difference between least
and most fertile land similarly, profit is the difference between earnings of the least and most
efficient entrepreneurs.” He advocated that profit is the rent of exceptional abilities that an
entrepreneur possesses over others.
According to Walker; profit is the difference between the earnings of the least and most
efficient entrepreneurs. An entrepreneur with the least efficiency generally strives to cover only
the cost of production. On the other hand, an efficient entrepreneur is rewarded with profit for
his differential ability.
Thus, profit is also said to be the reward for differential ability of the entrepreneur. While
formulating this theory, Walker assumed the condition of perfect competition in which all
organizations are supposed to have equal managerial ability. In this case, there is no pure profit
and all the organizations earn only managerial wages known as normal profit. The rent theory
was mainly criticized for its inability to explain the real nature of profits.
Apart from this, the theory failed on the following aspects:
a. Provides only a measure of profit. The theory does not focus on the nature of profit, which
is of utmost importance.
b. Assumes that profits arise because of the superior or exceptional ability of the entrepreneur,
which is not always true. Profit can also be the result of the monopolistic position of the
entrepreneur.
Clark’s Dynamic Theory: Clark’s dynamic theory was introduced by an American economist,
J.B. Clark. According to him, profit does not arise in a static economy, but arise in a dynamic
economy. A static economy is characterized as the one where the size of population, the amount
of capital, nature of human wants, the methods of production remain the same and there is no
risk and uncertainty. Therefore, according to Clark, only normal profits are earned in the static
economy. However, an economy is always dynamic in nature that changes from time to time.
A dynamic economy is characterized by increase in population, increase in capital,
multiplication of consumer wants, advancement in production techniques, and changes in the
form of business organizations. The dynamic world offers opportunities to entrepreneurs to
make pure profits.
According to Clark, the role of entrepreneurs in a dynamic environment is to take advantage
of changes that help in promoting businesses, expanding sales, and reducing costs. The
entrepreneurs, who successfully take advantage of changing conditions in a dynamic economy,
make pure profit.
There are internal and external factors that make the world dynamic. The internal changes are
changes that take place within the organization, such as layoff and hiring of employees, product
changes, and changes in infrastructure. The external changes are of two kinds, namely, regular
changes and irregular changes.
Regular changes involve fluctuations in trades that affect profits On the other hand; irregular
changes include contingencies, such fire, earthquake, floods, and war. Thus, according to
Clark, profits are a result of changes and no profit is generated in case of static economy.
However, Prof Knight criticized the dynamic theory on the basis that only those changes that
cannot be foreseen yield profits. He further says, “It cannot, then, be change, which is the cause
of profit, since if the law of change is known, as in fact is largely the case, no profits can arise.
Change may cause a situation out of which profit will be made, if it brings about ignorance of
the future.”
Hawley’s Risk Theory: The risk theory of profit was given by F. B. Hawley in 1893.
According to Hawley, “profit is the reward of risk taking in a business. During the conduct of
any business activity, all other factors of production i.e. land, labour, capital have guaranteed
incomes from the entrepreneur. They are least concerned whether the entrepreneur makes the
profit or undergoes losses.”
Hawley refers profit as a reward for taking risk. According to him, the greater the risk, the
higher is the expected profit. The risks arise in the business due to various reasons, such as
non-availability of crucial raw materials, introduction of better substitutes by competitors,
obsolescence of a technology, fall in the market prices, and natural and manmade disasters.
Risks in businesses are inevitable and cannot be predicted. According to Hawley, an
entrepreneur is rewarded for undertaking risks.
There is a criticism against this theory that profits arise not because risks are borne, but because
the superior entrepreneurs are able to reduce them. The profits arise only because of better
management and supervision by entrepreneurs. Another criticism is that profits are never in the
proportion to the risk undertaken. Profits may be more in enterprises with low risks and less in
enterprises with high risks.
Knight’s Theory: Prof Knight propounded the theory known as uncertainty-bearing theory of
profits. According to the theory, profit is a reward for the uncertainty bearing and not the risk
taking. Knight divided the risks into calculable and non-calculable risks. Calculable risks are
those risks whose probability of occurrence can be easily estimated with the help of the given
data, such as risks due to fire and theft.
The calculable risks can be insured. On the other hand, non-calculable risks are those risks that
cannot be accurately calculated and insured such as shifts in demand of a product. These non-
calculable risks are uncertain, while calculable risks are certain and can be anticipated.
According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk taking is not
a function of an entrepreneur, but of insurance organizations. Therefore, an entrepreneur gets
profit as a reward for bearing uncertainties and not for risks that are borne by insurance
organizations.

Functions of Profit
Profit is the primary objective of all business organizations. The expectation of earning higher
profits of business organizations induces them to invest money in new ventures. This results in
large employment opportunities in the economy which further raises the level of income.
Consequently, there is a rise in the demand for goods and services in the economy. In this way,
profit generated by business organizations play a significant role in the economy.
According to Peter Ducker, there are three main purposes of profit, which are explained
as follows:
I. Tool for measuring performance: Refers to the fact that profit generated by an organization
helps in estimating the effectiveness of its business efforts. If the profits earned by an
organization are high, it indicates the efficient management of its business. However, profit is
not the most efficient measure of estimating the business efficiency of an organization, but is
useful to measure the general efficiency of the organization.
ii. Source of covering costs: Helps organizations to cover various costs, such as replacement
costs, technical costs, and costs related to other risks and uncertainties. An organization needs
to earn sufficient profit to cover its various costs and survive in the business.
iii. Aid to ensure future capital: Assures the availability of capital in future for various
purposes, such as innovation and expansion. For example, if the retained profits of an
organization are high, it may invest in various projects. This would help in the business
expansion and success of the organization.
Apart from aforementioned functions, following are the positive results of high profits: I.
Investment in research and development: Leads to better technology and dynamic
efficiency. An organization invests in research and development activities for its further
expansion, if it earns high profit. The organization would lose its competitiveness, if it does
not invest in research and development activities.
ii. Reward for shareholders: Includes dividends for shareholders. If an organization earns
high profits, it would provide high dividends to shareholders. As a result, the organization
would attract more investors, which are crucial for the growth of the organization.
iii. Aid for economies: Implies that profits are helpful for economies. If organizations generate
high profits, they would be able to cope with adverse economic situations, such as recession
and inflation. This results in stability of economies even in adverse situations.
iv. Tool to stimulate government finances: Implies that if the profits generated by
organizations are high, they are liable for paying high taxes. This helps government to earn
high revenue and spend for social welfare.