Rent Theory of Profit
Rent Theory of Profit
The Rent Theory of Profit, as it may be called, was propounded by the American economist, FA. Walker. He was the first to introduce a distinction between a capitalist and an employer. An entrepreneur need not be a capitalist. He is a person who may undertake a business without using any of his own capital.
The Theory. Walker regards profit as rent of ability. Just as there are different grades of land, there are different grades of entrepreneurs. The least efficient entrepreneur, who must remain in the field of production to meet the current demand, just recovers his cost of production. Above him are entrepreneurs of superior ability. Just as rent arises because of the differential advantage enjoyed by a superior land over the marginal land, profit also is the reward for differential ability of the entrepreneur over the marginal entrepreneur or the no-profit entrepreneur. Profits are thus like rent and, like rent they do not enter into price.
Wages of managements are not profit and the marginal employer only earns the wages of management and no more. With a slight unfavorable turn of prices or costs, he would prefer to work as an employee rather than as an employer. Wages of management thus must be paid to keep up the given supply of entrepreneurs. Such wages thus enter into price.
This theory has the same weaknesses as Ricardo's Theory of Rent. The employer who will leave the business with a slight unfavorable turn of events, not necessarily the least efficient. He may be higher up in the scale and may be attracted by more profitable alternative employments.
The theory, moreover, does not explain the real nature of profits; it merely provides a measure of profits.
It is wrong to say, again, that profits do not enter into price. They may not enter in the short period, but they must be covered by price in the long run. The entrepreneur performs the essential function of risk-bearing and unless the price of the commodity is high enough to compensate the employer for this, supply of employers will decrease until the price rises high enough to pay for the risk-bearing service.
Some employers may earn high profits and others may suffer heavy losses. When the average is taken over a long period, the so-called surplus tends to disappear.
Finally, the theory even fails to explain the size of the profit. The differential gain is due to scarcity of superior employers but why does this scarcity arise? In the case of land, scarcity is due to natural limitations. In the case of entrepreneurs there are no such limitations. The theory of profit must explain the cause of such scarcity.
Thus, there is no doubt a differential element in profits as in rent, superior entrepreneurs earning higher profits. But the analogy ends here. There may exist no-rent land, but there cannot exist no-profit entrepreneurs. Rent may not enter into price but normal profits do. This is due to the fact that the supply of land is there, rent or no rent. But the supply of entrepreneurs cannot be maintained unless profits are paid. Expected profits or prospective profits do enter into price, though the realized profits may not But even realized profits enter indirectly into price in the long run by influencing expectations of profits.