Profit is a residual income. It is the income over and above the cost of production. Profits emerge as a reward for the function of an entrepreneur. An enterprise worthy of getting. Profit because he takes important decisions regarding the production risks in the business and introduces innovation in production. Thus for his entrepreneurial activities, he receives profit. What he gets as reward for his effort is called gross profit.
Net profit is a part of gross profit. When the to explicit and implicit cost are subtracted from the total revenue we get net profit. Net profit is a part of gross profit. By deducting wages of management, rent on owner’s own land, and interest on his own capital we get net profit.
Thus net profit which is otherwise called pure profit includes payment for risk and uncertainty, reward for bargaining ability, reward for innovations, monopoly gains and chance gains etc. Net profit may be either normal or abnormal. It may also arise due to monopolistic advantage.
Constituents of Net Profit:
The constituents of net profit are (i) Normal profit (ii) Abnormal profit (iii) Monopoly profit (iv) Chance profit.
(i) Normal Profit: –
Normal profits are the minimum income which the entrepreneur must get in order to stay in business or industry. If the entrepreneur does not get this basic minimum he will not start production. This profit is a definite amount which is included in the cost of production.
This profit being, a fixed amount gets distributed over the large volume of output. Normal profit is thus an incentive to produce output. This profit arises due to the function of the entrepreneur. At this profit no existing firms leave the industry nor do any new firms enter the business. Business men neither expand nor contracts business at this normal profit. Normal profit accrues to a firm in the long period. This long run profit is more or less stable and almost remains constant.
(ii) Abnormal or Supernormal Profit: –
The profit earned over and above the normal profit is called abnormal or supernormal profit. In the long run the most inefficient firm earns normal profit. There are other firms who are more efficient. They earn profit more than the marginal firm.
The excess of revenue over and above the revenue of marginal firm is known as abnormal profit. Abnormal profit being surplus revenue is not a part of the cost of production. Abnormal profit arises because of uncertainty and risk bearing it also arises on account of introduction of innovation in the production.
Hawley says that it is the risks that the entrepreneur undertakes gives rise to profit. F.H. night also opines that uncertainty bearing of an entrepreneur in the business also leads to profit. According to Schumpeter it is the introduction of innovation in the line of production which gives rise to abnormal profit may arises due to certain risks in the business. Risks are of two types. Some risks are predictable and some are non-predictable.
The risks which are predictable can be known before hand and hence can be insured. Thus these risks are insurable. Thus the profit earned by taking these insurable risks in the business is called normal profit. But abnormal profit arises due to non-insurable risks which cannot be predicted before hand. Abnormal profit may be positive or negative but normal profit is always positive.
Abnormal profit may arise due to business uncertainty. Uncertainty about the future conditions of demand and supply is the cause of profit. An entrepreneur reaps persistent profit out of introducing innovation i.e. new technique of production in the business; He reaps such windfall profit so long as other competitors follow the innovation. Profit disappears only when the innovation in question is adopted by other competing firms.
(iii) Monopoly Profit: –
Monopoly profit emerges because of the nature of market. This profit has no concern with the entrepreneurial effort. This monopoly probity it is a part of the net profit. This profit arises under monopoly business. Under monopoly there is a single seller producing and selling a single commodity having no close substitute. Entry in to this business is strictly prohibited.
Thus a monopolist never faces rivals or competitors. Thus it is one man’s business. The monopolist because of his monopolistic advantage charges higher prices without opposition. Thus he reaps high profit. He buys factors at cheaper price and sells at higher price. By doing this he increases the profit. This profit is not reaped for any special function but for the very nature of market.
(iv) Chance Profit: –
Abnormal profit sometimes emerges on account of chance factors. These chance factors are purely temporary. Therefore these factors are called short-run factors. Because of certain favorable conditions due to the occurrence of natural calamity the entrepreneur gets abnormal profit.
Due to the occurrence of natural calamity like flood, drought and cyclone, crops fail and product suffers. Supply of agricultural produce declines demand for agricultural product rises. Supply will be less than demand. Price will rise and profit increases. This increase in profit is due to chance. Chance factors are purely natural and therefore independent of human wish.