Theories of Profit

Profit is the income of the entrepreneur -- the person who organises land, labour, and capital, takes decisions, and bears the consequences of those decisions.

Gross profit and net profit. The total surplus an entrepreneur draws from a business -- gross profit -- is not a pure reward for entrepreneurship alone. It usually contains implicit payments the entrepreneur is effectively making to themselves in other capacities: wages of management (for their own labour of running the business), interest on whatever capital of their own is tied up in the business, and rent on any premises they own and use. Stripping these implicit payments out of gross profit leaves net (or pure) profit -- the true, distinct reward for entrepreneurship and risk-taking:

Dynamic surplus theory (J.B. Clark). Clark argued that in an imagined static economy -- one with no change at all in population, capital stock, technique, tastes, or business organisation -- competition would, over time, wipe out pure profit entirely, since every factor, entrepreneurship included, would end up paid exactly its marginal contribution, with nothing left over. Pure profit, in his view, can only appear in a dynamic, changing economy: growth of population and capital, improvements in technique, shifting consumer tastes, and new ways of organising business keep opening temporary gaps between cost and revenue, and profit is the surplus captured by the entrepreneur who exploits such a gap before rivals close it.

Risk-bearing theory (F.B. Hawley). Hawley held that profit is simply the price of bearing business risk. Every venture carries the risk that a product will not sell, that costs will rise unexpectedly, or that demand will collapse, and someone has to accept these risks in exchange for the chance of a return; the entrepreneur is that person, and profit is the compensation for shouldering the risk of production. A more hazardous line of business should, on this view, offer a higher average expected profit.

Uncertainty-bearing theory (Frank Knight). Knight refined Hawley's argument by drawing a sharp line between two things often loosely called "risk." A risk, in his technical sense, is a situation whose odds can be worked out statistically and can therefore be insured against -- once insured, it no longer justifies any special reward, because the insurance premium itself already covers it. A true uncertainty, on the other hand, is a one-off, unique situation whose probability simply cannot be calculated in advance -- whether a genuinely new product will succeed with consumers, for instance. Because such uncertainty cannot be pooled away through insurance, Knight argued that profit is specifically the reward for bearing this non-insurable uncertainty, and that this, rather than risk-bearing in general, is what most precisely marks out the entrepreneur's own function. …