What is profit , types of profit, theories of profit

in this report, it discuss about major role of profit , its types and various theories of profit to understand the principles of accounting. and how it helps to understand the various techniques to understand it

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WHAT IS PROFIT?
The term “profit” implies different meaning to different people. Such as, profit is
regarded as income to the equity holder, wages to the labor, rent to the owner,
interest to the money lender, etc. Typically the profits are the earnings that flow to
the investors.
Profit is a financial benefit that is realized when the amount of revenue gained
from a business activity exceeds the expenses, costs, and taxes needed to sustain
the activity.
Profit simply means a positive gain generated from business operations or
investment after subtracting all expenses or costs.
In economic terms profit is defines 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:
• Profit is a residual income, while return is total revenue.
• Profits may be negative, where as returns, such as wages and interest are
always positive.
• 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 hires, 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 that cannot be shifted on the
shoulders of anyone else.”

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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 right or wrong: it only depends on the field which
the word profit is described.
There are two concepts of profit:
❖ Accounting profit.
❖ Economic profit.
On the basis of fields, profit can be classified into types, which are explained as
follows:
1. 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
While calculating the profits, only the explicit costs or book costs, i.e. the cost
recorded in books of account is considered.

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The accounting profit is used for determining the taxable income of an
organization and assessing its financial stability. Let us take an example:
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
– 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.
2. Economic Profit:
The economic profit differs from the accounting profit in the sense; it takes into
account the implicit or imputed cost while calculating the profit of a firm. The
implicit cost is called an “opportunity cost”. The opportunity cost is the income
forgone that could be made from the use of the second best alternative. Such as, is
if entrepreneur uses his capital in his own business, he foregoes the dividend which
would have been earned by purchasing the shares of another company. The
examples of implicit cost are rents on own land, salary of proprietor, and interest
on entrepreneurs own investment.
The economic profit is also called as a pure profit. The pure profit makes the
provisions for depreciation, insurable risks, and necessary minimum payments to
the share holder so that they do not withdraw from the capital .Thus, pure profit is
the residual lest after all the contractual costs Viz. Transfer cost of management,
depreciation, insurable risks, payments to shareholders, have been met.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs+ implicit costs)
Pure profit = Accounting profit – (opportunity cost+ unauthorized payments, e.g.
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 business resources can be
better employed elsewhere.

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The difference between the accounting profit and economic profit is shown:
Table-1: Difference between Accounting profit and economic profit
ACCOUNTING PROFIT ECONOMIC PROFIT
Refers to the profit that is determined as
per as Generally accepting accounting
principles.
Refers to the profit that is determined by
economic principles.
Includes explicit costs only. Includes explicit and implicit costs.
Helps in assessing taxes and financial
performances of a business.
Helps in determining the entry, stay, or
exit of an organization.

Thus the major difference between these two types of profit does not take the
implicit or the opportunity cost into consideration while the economic profit does.

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THEORIES OF PROFIT
1) The Dynamic Theory:
Prof. J.B. Clark propounded the dynamic theory of profit in the year 1900. To him
profit is the difference between the price and the cost of production of the
commodity. Profit is the result of progressive change in an organized society. The
progressive change is possible only in a dynamic state. According to Clark the
whole economic society is divided into organized and unorganized society. The
organized society is further divided into static and dynamic state. But profit is the
result of dynamic change. In a dynamic state, “five generic changes are going on,
everyone of which reacts on the structure of society.” they are:
1. Population is increasing.
2. Capital is increasing.
3. Methods of production are improving.
4. The forms of industrial establishment are changing, the less efficient shops,
etc. Are passing from the field, and the most efficient are surviving.
5. The wants of consumers are multiplying.
In a static state, the competition tends to eliminate these five kinds of changes so
that each factor receives what it produces.
Thus profit is the result exclusively of these above mentioned five dynamic
changes. According to the Clark, “ two general results must follow: first, values,
wages and Interest will defer from the static standards ; secondly, the static
standards themselves will always be changing.” The typical change is an invention.
An invention enables the entrepreneur to produce more and reduce costs. A
divergence between the selling price and the costs of production leads to the
emergence of profit. But such profit is temporary, because competition leads to the
adoption of this invention by the other entrepreneurs in the industry. Production
increases and prices fall. On the other hand, competition for the services of factors
tends to raise their wage and interest rate.
Thus, according to Clark, the profit is an elusive amount which can be grasped, but
cannot be held by an entrepreneur as it slips through the fingers and bestows itself
to all the society members. Clark’s dynamic theory of profit should not be
misinterpreted as, the profits in the dynamic economy remain for a short period of
time and then disappears forever. But, however, generic changes take place

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frequently, and the manager or entrepreneur through his foresight must capitalize
on it and continue to make a profit in excess of the normal profit.
Criticism:
Clark’s dynamic theory of profit has been severely criticized mainly by Prof.
Knight on the following counts.
● It is wrong to say that there is no profit in static state because every
entrepreneur is paid profit irrespective of the state of an economy.
● This theory does not fully appreciate the nature of the entrepreneurial
function. If there are no profits in a static state, it means there is no
entrepreneur. But without an entrepreneur it is not possible to imagine how
different factors of production would be employed.
● Mere change in an economy would not give rise to profits if those changes
are predictable. It is only the unpredictable, provision can be made for such
changes and the expenditure can be included in the cost of production.
● This theory assumes the existence of perfect competition and static state. But
they are far from reality.
● This theory states that profit arises because of dynamic changes. But Knight
says that it is only unforeseen changes that give rise to profit.
● This theory associates profit for imitating progressive changes in the
economy. But in reality profit is paid to entrepreneur for other important
functions like risk taking and uncertainty bearing.

2) 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.
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;

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● 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.

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 goods and
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
disappears. Thus, the profit in excess of the normal profit disappears. This
innovation process continues and also the profits continue to appear or disappear.

Criticism:
1. Shareholders Earn profit: according to Schumpeter, risk taking is the
function of the capitalist and not the entrepreneur. But in his later book
“capitalism, socialism and democracy”, he points out that the rapid
economic development of the 19
th
century in capitalist economies was partly
due to many innovations made by entrepreneurs who happened to be risk
takers. It is the shareholders of modern corporations who undertake risks and
thus earn profit.
2. Profit the reward for uncertainty: profit is not regarded as the reward of
uncertainty which is not a correct view because every innovation is
associated with uncertainty. If the innovation takes place without the
element of uncertainty, the reward for innovation is not profit but simply
wages of management.

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3. Incomplete explanation: innovation is not the only function of the
entrepreneur for which he earns profit. Profit accrues to the entrepreneur
because of his organizational ability, when he is able to reduce business
costs. Thus Schumpeter’s theory is an incomplete explanation of the
emergence of profit.

3) The Risk theory:
This theory is associated with American economist Hawley. According to him
profit is the reward for risk-taking in business. Risk-taking is supposed to be the
most important function of an entrepreneur. Every production that is undertaken in
anticipation of demand involves risk.
For bearing such risk, profit is paid to entrepreneur. No entrepreneur will be
willing to undertake risks if he gets only the normal return. Therefore the reward
for risk-taking must be higher than the actual value of the risk. If the entrepreneur
does not receive the reward, he will not be prepared to undertake the risk. Thus
higher the risk greater is the possibility of profit.
But all persons are incapable of undertaking risks, so risks act as a deterrent to the
supply of entrepreneurs. Those who remain in the business are able to earn an
excess of payment above the actuarial value of the risk and thus Earns profit.
Criticism:
● Meaning of risk unclear: Hawley does not clarify the meaning of the risk.
According to knight, risks are of two types, insurable and non-insurable.
Risks proper refer to insurable risks. Such risk taking cannot give rise to
profit because the entrepreneur’s covers risk by the payment of premium.
● Profit due to entrepreneurial ability: risk taking is not the only
entrepreneurial function which leads to the emergence of profit. Profit is also
due to the organizational and coordinating ability of the entrepreneurs.
● Profit the reward do avoiding risks: according to Carver, those
entrepreneurs who are able to avoid risks earn profit. Hence, profit arises not
because risks are undertaken but because they are avoided by able
entrepreneurs.

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● Incomplete theory: there is little empirical evidence to prove that
entrepreneurs earn more in risky enterprises. In a way, all enterprises are
risky for an element of uncertainty is present in them. And every
entrepreneur aims at making large profit. Thus Hawley’s risk theory is also
an incomplete theory of profit.
4) The Uncertainty Bearing:
Frank's H. Knight treated profit as residual return to uncertainty bearing, not to risk
bearing. Obviously, knight made a distinction between risk and uncertainty. He
decided risk into calculable and non-calculable risk. Calculable risk is those whose
probability of occurrence can be statistically estimated on the basis of available
data. For ex. Risk due to fire, theft, accident, etc. Are calculable and such risk are
insurable. There remains, however, an area of risk in which probability of risk
occurrence cannot be calculated. For instance, there may be a certain element of
cost which may not be accurately calculable and the strategies of the competitor
may not be precisely assessable.
It is in the area of uncertainty that decision making become a crucial function of
entrepreneur. If his decision are proved right by the subsequent function of
interpreter makes profit and vice versa. Profit arises from the decision taking ang
implemented under the condition of uncertainty.
Criticisms:
● This theory concentrates only on innovation, which is only one of the many
functions of the entrepreneur and not the only factor.
● This theory does not consider profit as the reward for risk-taking. According
to Schumpeter it is the capitalist not the entrepreneur who undertakes risk.
● This theory has ignored the importance of uncertainty bearing which is one
of the factors that determines profit.
● This theory attributes profit only to innovation ignoring other functions of
entrepreneur.Uncertainty bearing cannot be looked upon as a separate factor
of production like land, labour or capital. It is a psychological concept which
forms part of the real cost of production.

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5) Marginal Productivity:
In the words of J.B. Clark, “Under static conditions, every factor including
entrepreneur would get a remuneration equal to marginal product.” As per Mark
Blaug, “The marginal productivity theory contends that in equilibrium each
productive agent will be rewarded in accordance with its marginal productivity.”

When an organization increases one unit of a factor of production (while keeping
the other factors constant), the marginal productivity increases to a certain level of
production. After reaching a certain level, the marginal productivity starts
declining. This is because when an organization keeps on increasing the amount of
a particular factor of production, the marginal cost also increases.

After reaching a certain point, the marginal cost exceeds marginal revenue, thus
the marginal productivity declines. On the other hand, if the marginal revenue is
greater than marginal cost, the organization opts for employing an additional unit
of factor of production.
The different types of marginal productivity are explained as follows:

i. Marginal Physical Productivity:
Refers to an increase in output occurred due to the increase in one unit of factor of
production. According to M.J. Ulmer, “Marginal physical productivity may be
defined as the addition to total production resulting from employment of one unit
of a factor of production, all other things being constant.”
Let us understand the concept of marginal physical productivity with the help of an
example. Suppose one labor is able to produce four quintals of wheat. If one more
labor is hired, then the yield of wheat would reach to eight quintals. In such a case,
the marginal physical productivity for the additional labor is four quintals of wheat
(8-4=4).

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ii. Marginal Revenue Productivity:
Refers to the concept of marginal productivity with respect to change in total
revenue. As per M.J. Ulmer, “Marginal revenue productivity may be defined as the
addition to total revenue resulting from employment of one unit of a factor of
production, all other things being constant.”

Let us understand the concept of marginal revenue productivity with the help of an
example. Suppose one labor is able to produce wheat, which is worth of Rs. 50. If
one more labor is hired, then the revenue generated from wheat would be Rs. 60.
In such a case, the marginal revenue productivity for the second labor is Rs. 10
(60-50-10).
Criticism:
● This theory is not a satisfactory theory of profit because it is very difficult to
calculate the marginal productivity of entrepreneurship.
● Like land, labour, or capital the marginal revenue productivity of
entrepreneurship is a meaningless concept in the case of a firm because
unlike other factors, there can be only one entrepreneur in a firm.
● This theory is based on the homogeneity of entrepreneur, in an industry.
Entrepreneurs differ in efficiency. It is therefore, not possible to have one
marginal revenue productivity curve for all entrepreneurs. This theory thus
fails to determine profit accurately.
● This theory fails to explain why entrepreneurs sometimes earn windfall or
chance gains and even monopoly profits.
● It is one-sided theory which takes into account only the demand for
entrepreneurs and neglects supply of entrepreneurs.
● It is a static theory according to which all entrepreneurs earn only normal
profits in the long- run. In the real world entrepreneurs earn more than
normal profit due to its dynamic nature.

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6) Shackle’s Theory:
Prof. G.L.S. Shackle has extended Knight’s theory of profit by introducing
expectations under conditions of uncertainty. According to Shackle, expectations
are of two types: general and particular. General expectations relate to variables
general to the economy as a whole.

They are associated with future macro-variables such as the general price level,
GNP. Balance of payments, etc. On the other hand, particular expectations relate to
variables particular to a firm or industry. They are associated with such micro-
variables as the future reaction of a particular marketing strategy adopted by a
firm, the future pricing policy of a competitive firm, etc.

The decisions of the business community are generally based on general
expectations. If it regards them favorable, investments are made. But there is
‘subjective certainty’ in the case of general expectations. Their time horizon is
about 12 months.

As the general expectations have subjective certainty and their time horizon is also
of reasonable duration, the business community is able to anticipate price and
income increases correctly for the economy as a whole, and by adopting
appropriate inventory policies, it earns windfall profit.

But in the case of particular expectations, there is “subjective uncertainty” and the
time horizon is also quite long ranging between 100 to 150 months. Under
particular expectations, a firm or an industry may earn either innovative profit or
monopoly profit depending upon its policies and competitors. Under perfect
competition, the number of buyers and sellers of a similar product is very large.

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A firm which innovates in introducing new techniques of production or new
products or new techniques of management earns innovator’s profit. On the other
hand, when there is monopolistic competition and the product is differentiated, it is
the marketing policy that leads to profit. As there is subjective uncertainty and the
time horizon is quite long, it is

the taking of correct decisions by a firm about marketing, advertising, etc. of its
products in relation to the products of its competitors that lead to monopoly profit.
Thus profit whether monopoly or innovative arises under subjective uncertainty
depending upon correct decision-making by a firm.

Who takes such decisions in a firm and what is the basis? According to Shackle,
decision-making under uncertainty is done by the entrepreneur of a firm. The
routine types of decisions which often require “weighing the evidence” are made
by the respective heads of departments in the firm.

So far as the basis of decision-making is concerned, Shackle adopts a
psychological approach. According to him, the entrepreneur formulates hypotheses
about the future consequences of his decision. He imagines a neutral point to the
right of which he places those hypotheses that are pleasing and to the left of it,
those that are displeasing.

All pleasing or displeasing consequences that are close to the neutral point appear
“very plausible” and have a low degree of “potential surprise”. But more pleasing
and more displeasing hypotheses that are moving away from the neutral point on
both directions have a growing degree of potential surprise.

To take one hypothesis, it is a combination of its plausibility and its relative
pleasantness and unpleasantness. When the entrepreneur moves towards the right

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of the neutral point, the hypothesis grows in pleasantness faster than it grows in
implausibility. But after a point, the increasing pleasantness offsets the increasing
implausibility of the hypothesis. Ultimately, there is “peak” hypothesis on the
pleasant side.

On the other hand, when the entrepreneur moves towards the left of the neutral
point, the hypothesis grows in pleasantness faster than it grows in plausibility. But
after a certain point, the increasing unpleasantness offsets the increasing
plausibility of the hypothesis.

Ultimately, there will also be a peak hypothesis on the unpleasant side. Shackle
calls the pleasant side peak the “focus gain” and unpleasant side peak the “focus
loss”. If the focus gain exceeds the focus loss, the entrepreneur will make a
positive decision.

He will make investments and earn profit. On the contrary, if the focus loss
exceeds the focus gain, the entrepreneur will make a negative decision and refrain
from making investments because his particular expectations are likely to be
unfavorable. Thus in Shackle’s theory, the entrepreneurial decision-making is
neither irrational nor whimsical. Rather, it is based on his intuitive perception.

Criticism:

Prof. Shackle has formulated a psychological theory of profit which is highly
abstract. But it contains within it the elements of Knight’s uncertainty theory of
profit, Schumpeter’s innovations theory of profit and monopoly theory of profit.

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However, it is essentially a decision theory which is based on the psychology of
the entrepreneur. As pointed out by Prof. Kier stead, “Professor Shackle himself
uses the device of introspection effectively, but introspection can allow him to
discover how he makes a decision; it cannot tell with any certainty how an
entrepreneur or a Board of Directors makes a decision.”

7) Rent Theory of Profit:
This theory was first propounded by the American Economist Walker. It is based
on the ideas of Senior and J.S. Mill. According to Mill, “the extra gains which any
producer obtains through superior talents for business or superior business
arrangements are very much of a kind similar to rent. Walker says that “Profits are
of the same genus as rent”. His theory of profits states that profit is the rent of
superior entrepreneur over marginal of less efficient entrepreneur.

According to these economists, there was a good deal of similarity between rent
and profit. Rent was the reward for the use of land while a profit was the reward
for the ability of the entrepreneur. Just as land differs from one another in fertility,
entrepreneurs differ from one another in ability. Rent of superior land is
determined by the difference in productivity of the marginal and super marginal
land; similarly the profits of the marginal and super marginal entrepreneurs.In
short it is the intra-marginal lands that earn a surplus over marginal lands. So also
intra marginal entrepreneurs earn a surplus over marginal entrepreneur. Just as
there is the marginal land, there is the marginal entrepreneur. The marginal land
yields no rent; so also marginal entrepreneur is a no profit entrepreneur.

The marginal entrepreneur sells his produce at cost price and gets no profit. He
secures only the wages of management not profit. Thus profit does not enter into
cost of production. Like rent, profit also does not enter into price. Profit is thus a
surplus.

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Criticism:
● This theory is unrealistic: Walker’s view of Profit as a surplus like rent is
unrealistic and it cannot be accepted as true approach of Profit
● It is not a true surplus as Marshall has said: In this connection Marshall
has said that land can earn positive or zero rent. But in the case of firm’s
entrepreneurs may have negative profits or losses.
● Profits only in a dynamic state: Rent can emerge in both static and
dynamic conditions whereas profits we can find only in a dynamic state.
● Profit is not gift of ability: Profit does not arise always due to the superior
ability of the entrepreneur. It may arise due to monopoly, innovation, risk,
uncertainty etc.
● This theory overlooks the important function of the entrepreneur as a
risk-bearer: From the profits of entrepreneur we must deduct the losses
sustained by some others, who have been driven to bankruptcy. When this is
done, there may be no surplus element in Profit and the analogy to rent
vanishes. Moreover, it fails to explain the Profit of the ordinary shareholder
of a joint-stock company.
● This theory fails to explain the main causes of the size of Profits:The
differential gain arises because of the scarcity of superior units, either of
land or of entrepreneurs. But the real thing is the explanation of the causes of
the scarcity of the superior units. In the case of the rent of land, the point is
not of great importance because the limitation is due to nature. Here the rent
theory can throw no light on the fundamental questions.
● Profits do not enter into price this cannot be said here: The reward for
risk-bearing must enter into long-period cost of production. In the short-
period, Profits may not enter into price. But in the long-run, supply of
entrepreneurs not being fixed by nature, normal Profits must form a part of
cost of production.

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8) Wage Theory of Profit:

This theory was propounded by Taussig, the American economist. According to
this theory, profit is also a type of wage which is given to the entrepreneur for the
services rendered by him. In the words of Taussig, “profit is the wage of the
entrepreneur which accrues to him on account of his ability”.
Just as a labourer receives wages for his services, the entrepreneur works hard gets
profit for the part played by him in the production. The only difference is that
while labourer renders physical services, entrepreneur puts in mental work. Thus
an entrepreneur is not different from a doctor, lawyer, teacher, etc., who do mental
work. Profit is thus a form of wage.

Criticism:

● Element of risk and uncertainty: The entrepreneur’s work is full of risk
and uncertainty and profit is given to face this risk. But the workers receive
wages simply for his labour. Risk and uncertainty part do not incorporate
anywhere in his activities. For labourer risk is of losing the job which is an
extreme step.
● Profit is flexible, it may vary: Profits may rise or fall. It depends upon the
business conditions and situations. But wage may remain stable and cannot
fluctuate more in the short- period.
● This theory is silent over the payment to shareholders: The shareholders
of any organisation or company do not perform any function but they
receive the share of profits in the form of dividend for undertaking risk of
money invested. This theory fails to explain this contention as to why they
are paid.
● Entrepreneurs windfall or chance profits: The entrepreneur may receive
windfall or chance profits but a worker cannot have opportunity to get wages
of chance or windfalls.

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PROFIT MAXIMIZATION:
The ability for company to achieve a maximum profit with low operating
expenses.

Profit Maximizations Theory:
In the neo-classical theory of the firm, the main objective of a business firm is
profit maximization. The firm maximizes its profits when it satisfies the two rules.
MC = MR and the MC curve cuts the MR curve from below Maximum profits
refer to pure profits which are a surplus above the average cost of production.
The profit maximization condition of the firm can be expressed as:

Maximize p (Q)
Where p (Q) = R (Q) – C (Q)
where p (Q) is profit, R(Q) is revenue, С (Q) are costs, and Q are the units of
output sold The two marginal rules and the profit maximization condition stated
above are applicable both to a perfectly competitive firm and to a monopoly firm.
Assumptions:

The profit maximization theory is based on the following assumptions
✔ The entrepreneur is the sole owner of the firm.
✔ The firm has complete knowledge about the amount of output which
can be sold at each price.
✔ The firm’s own demand and costs are known with certainty.
✔ New firms can enter the industry only in the long run. Entry of firms
in the short run is not possible.
✔ The firm maximizes its profits over some time-horizon.
✔ Profits are maximized both in the short run and the long run.

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Profit Maximizations under Perfect Competition:
under conditions of perfect competition, the MR curve of a firm coincides with its
AR curve. The MR curve is horizontal to the X-axis because the price is set by the
market and the firm sells its output at that price.
The firm is, thus, in equilibrium when MC = MR = AR (Price). The equilibrium of
the profit maximisation firm under perfect competition is shown in Figure 1.
Where the MC curve cuts the MR curve first at point A.
It satisfies the condition of MC = MR, but it is not a point of maximum profits
because after point A, the MC curve is below the MR curve. It does not pay the
firm to produce the minimum output when it can earn larger profits by producing
beyond OM.


It will, however, stop further production when
it reaches the OM1 level of output where the
firm satisfies both conditions of equilibrium. If
it has any plans to produce more than OM1 it
will be incurring losses, for the marginal cost
exceeds the marginal revenue after the
equilibrium point B. Thus the firm maximises
its profits at M1B price and at the output level
OM1.

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Profit Maximizations under Monopoly:

There being one seller of the product under
monopoly, the monopoly firm is the industry
itself. In any situation, the ultimate aim of the
monopoly firm is to maximise its profits. The
conditions for equilibrium of the monopoly firm
are (1) MC = MR< AR (Price), and (2) the MC
curve cuts the MR curve from below.
the profit maximising level of output is OQ and
the profit maximisation price is OP (=QA). If
more than OQ output is produced, MC will be
higher than MR, and the level of profit will fall.
If cost and demand conditions remain the same,
the firm has no incentive to change its price and
output. The firm is said to be in equilibrium.
Criticism:

The profit maximisation theory has been severely criticised by economists on the
following grounds:

Profits uncertain:The principle of profit maximisation assumes that firms are
certain about the levels of their maximum profits. It is, therefore, not possible for
firms to maximise their profits under conditions of uncertainty.
No perfect knowledge: The profit maximisation hypothesis is based on the
assumption that all firms have perfect knowledge not only about their own costs
and revenues but also of other firms.
Firms do not bother about MC and MR:
It is asserted that the real world firms do not bother about the calculation of
marginal revenue and marginal cost. Most of them are not even aware of the two
terms.
Principle of average-cost maximises profits: Hall and Hitch found that firms do
not apply the rule of equality of MC and MR to maximise short run profits. Rather,
they aim at the maximisation of profits in the long run. Thus the main aim of the
profit maximising firm is to set a price on the average cost principle and sell its
output at that price.