Key Economic Concepts: Profit Theories, Investment Drivers, and Keynesian Employment

Posted on Jun 22, 2025 in Economy

Understanding Theories of Profit

Profit is the reward earned by an entrepreneur for organizing and managing the factors of production. Economists have proposed various theories to explain the origin and nature of profit. Each theory highlights a different aspect of entrepreneurship. The six major theories of profit are explained below:

1. Rent Theory of Profit – F.A. Walker

  • This theory compares profit to rent.
  • Just like landowners receive rent for using more fertile land, entrepreneurs earn profit due to their superior ability.
  • Entrepreneurs with better skills, foresight, and judgment earn more profit.
  • Less efficient entrepreneurs may earn no profit or even incur losses.

Criticism:

  • It ignores the risk and uncertainty faced by entrepreneurs.
  • It assumes profit is only due to natural ability, which is not always true.

2. Wage Theory of Profit – Taussig

  • This theory posits that profit is like wages paid to the entrepreneur for their mental and managerial labor.
  • Just as workers receive wages for physical work, entrepreneurs earn profit for their mental work and efforts.

Criticism:

  • Profit is uncertain and not fixed, unlike wages.
  • Entrepreneurs may suffer losses, while workers still get paid.

3. Dynamic Theory of Profit – J.B. Clark

  • Clark stated that profit arises in a dynamic economy, where there are constant changes like:
    • Population growth
    • Technological improvements
    • Changes in consumer tastes
  • These changes create opportunities, and the entrepreneur earns profit by adapting to them.

Criticism:

  • It does not explain losses in a dynamic economy.
  • It ignores the personal role of the entrepreneur.

4. Risk-Bearing Theory of Profit – F.B. Hawley

  • This theory suggests profit is a reward for taking risks in business.
  • Entrepreneurs invest capital and face the possibility of loss, so profit is the payment for bearing risk.

Criticism:

  • Not all risks result in profit — sometimes entrepreneurs get nothing.
  • Some risks (like natural disasters) are uninsurable and unpredictable.

Factors Influencing Investment Decisions

Investment is a key component of economic growth. It refers to the spending on capital goods that increase future productive capacity. However, investment decisions depend on many economic and non-economic factors.

In simple terms: Investment increases when businesses or governments expect higher returns and feel confident about the future. There are both internal and external factors that influence how much is invested in an economy.

1. Rate of Interest

  • Investment is inversely related to interest rates.
  • If interest rates are high, borrowing becomes expensive, so firms invest less.
  • Low interest rates make borrowing cheaper and investment more attractive.

2. Marginal Efficiency of Capital (MEC)

  • MEC is the expected rate of return on an additional unit of capital.
  • Higher MEC encourages more investment.
  • If businesses expect higher profits, they are likely to invest more.

3. Level of Income and Demand

  • If people’s income is rising, demand for goods increases, which encourages firms to expand production and invest.
  • In times of low demand, businesses avoid investing in new projects.

4. Business Expectations

  • Investment depends on future expectations about the economy.
  • If businesses expect economic growth and political stability, they invest more.
  • Negative expectations (like recession or war) reduce investment.

The Keynesian Theory of Employment

The Keynesian Theory of Employment was developed by John Maynard Keynes, a British economist, during the Great Depression of the 1930s. At that time, economies around the world were facing massive unemployment and low demand, and classical economic theories had failed to offer solutions. Keynes challenged the classical view and provided a new explanation of employment.

In simple terms: Keynes stated that employment depends on the level of effective demand in the economy, not just wages or price levels.

Main Assumptions of the Theory:

  1. The economy can remain in underemployment equilibrium for a long time.
  2. Wages are sticky downward (they don’t fall easily).
  3. Supply adjusts to demand, not the other way around.
  4. There is no automatic mechanism to reach full employment.

Key Concepts of Keynesian Theory:

  1. Effective Demand:

    • This is the total demand for goods and services in an economy.
    • It consists of Consumption Demand (C) and Investment Demand (I).
    • Employment depends directly on the level of effective demand.
    • More demand → More production → More employment

  2. Aggregate Demand (AD):

    • Total amount of goods and services people are willing to buy at various income levels.
    • Includes consumer spending + investment spending.

  3. Aggregate Supply (AS):

    • Total amount of goods and services firms are willing to produce at different income levels.
    • Employment is determined at the point where AD = AS.

  4. Underemployment Equilibrium:

    • Keynes argued that the economy can be in equilibrium even with unemployment.
    • Full employment is not automatic; government action is required.

  5. Role of Government:

    • Keynes strongly supported government intervention in the economy.
    • Through public spending, subsidies, and monetary policies, the government can increase demand and reduce unemployment.