Profit Maximising Theory and Firms

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In the classical view, profits are said to arise either as rewards for risk-taking or due to the imperfections in the economy or as a reward for innovations (Dean 1977, pp. 5 – 9). These factors are briefly explained below:Rewards for risk-taking: Instead of keeping his capital in a risk-free investment like government bonds (which offer high security but minimum returns by way of interest or appreciation), an entrepreneur uses capital, both owned and borrowed, to set up a venture and offers a product or service to the market. He thus takes risks and is prepared to accept as his share of the (monetary) value of the enterprise activities, after all, costsImperfections in the economy: According to this view, profits arise due to ‘…the imperfections in the adjustment of the economy to change’ (Dean 1977, p.8). Changes occur due to competitive market conditions – supplies or suppliers increase. prices rise or fall. newer products or technologies pose challenges to the existing ones, etc. There is a time lag between the occurrence of a change and the return of the market to competitive position or equilibrium, and it is during this time of absorbing the change that profits accrue.The reward for innovation: In this third view on profits, it is stated that profits are what the entrepreneur is entitled to, for putting his business ideas into practice by organizing the activities for realizing the innovation. His innovation upsets the market equilibrium and continues to give him profits until the equilibrium is restored or till such time as he is able to create barriers preventing others to follow him through intellectual and other property rights, such as patents, trademarks, and secret formulas.Michael Porter views the activities of a firm as a ‘value chain’. To the seller, the net balance left in the value chain after providing for all costs of the activities is his margin.