Economics 12 Notes for Economics Notes

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Uncertainty theory of profit

Uncertainty theory of profit
This theory is propounded by Knight. According to this theory, profit is reward for bearing uncertainty. Uncertainty is due to unforeseeable or non insurable risk. According to knight, there are two types of risk. They are foreseeable and unforeseeable. The possible loses due to foreseeable risk is avoidable with insurance. Therefore, the risks are insurable risk but possible loss due to unforeseeable risk is not avoidable with insurance. Therefore, the risks are non foreseeable risk. There are mainly four types of non insurable risk. They are

Risk due to competitors:
Any business firm has the risk due to increase in number of competitors, change in their marketing strategies, improvement in their quality and management, decrease in their cost of production per unit etc. This risk is not avoidable with insurance.
Risk due to change in policy of government:
The government may change its policy related to investment, export, import, taxes, and so on. Due to it, any firm may suffer loss. This risk is not avoidable with insurance.
Risk due to trade cycle:
During recession and depression, most of the business firms suffer loss. This risk is not avoidable with insurance.
Risk due to technological change:
Technology advances with flight of time. If any firm fails to adjust the change in technology, the firm suffers loss. This risk is also not avoidable with insurance.

Not direct relation between profit and uncertainty:
Profit is not directly related to uncertainty. If the business involves high risk, there is more probability of failure and loss rather than profit.
Profit is reward for avoidance of uncertainty:
Profits earned only if uncertainty is successfully avoided using skills, education, knowledge, experiences and so on. It is not earned mere taking uncertainty.
Uncertainty is not factor of production:
According to this theory, uncertainty seems to be the factor of production but factor of production is organization not uncertainty.
Reward for all things performed by organization:
Organization earns profit not only taking uncertainty but for all things it performs. They are innovation, effective combination of inputs, use of skills knowledge etc and bargaining power.

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