The Uncertainty-Bearing Theory of Profit

The uncertainty-bearing theory of profit was propounded by American economist Professor Frank Hyneman Knight in his 1921 book, "Risk, Uncertainty, and Profit."

Professor Knight systematically explained this theory. He elaborated on the concept of uncertainty and also differentiated between risk and uncertainty. 

According to him, risk refers to a situation in which the outcome of statistical probability can be determined. 

This outcome can be nullified through insurance by paying an appropriate insurance premium. In contrast, uncertainty refers to an event whose probability cannot be determined. This type of uncertainty cannot be insured.

According to Professor Knight, "profit is the reward for bearing uncertainty. This uncertainty cannot be insured."

In other words, profit arises as a result of the entrepreneur's work of bearing uncertainty, not risk. Entrepreneurs earn profit as a reward for bearing uncertainty even in a long-term equilibrium state.

Professor Knight distinguished between insurable risk and uninsurable uncertainty, which are presented below.

(a) Insurable Risk: 

Risks that can be measured or predicted and insured by paying an insurance premium are called known risks or insurable risks. Major losses that an entrepreneur may suffer from factory fires, theft, and accidents are insurable risks. These risks can be eliminated by paying an insurance premium. The amount of the insurance premium is a part of the production cost. Therefore, insurable risks do not provide any kind of reward or profit to the entrepreneur.

(b) Uninsurable Uncertainty: 

There are some risks in business or production that cannot be predicted and are unknown. Therefore, such risks are uninsurable. Competition, decline in demand, changes in government policy, etc., are uninsurable risks. Professor Knight called these risks uncertainties. Dynamic changes in the market create such uncertainties. Entrepreneurs bear these uncertainties and receive a special payment or reward in return, which is called profit.

Risks that cannot be predicted and insured are called uninsurable risks or uncertainties. These uncertainties include market conditions, competition, innovation, economic policy, and uncertainties related to the business cycle. Entrepreneurs receive profit for bearing these uncertainties.

Criticisms of the Uncertainty-Bearing Theory of Profit

The uncertainty-bearing theory of profit is not free from criticism. Some of the main criticisms of this theory are as follows:

1. Profit arises not only from bearing uncertainty but also from other factors such as innovation, coordination, contracts, etc. This aspect is not covered by the uncertainty-bearing theory of profit.

2. According to the uncertainty-bearing theory of profit, profit is the reward received by the entrepreneur for bearing uncertainty. However, critics argue that in some cases, entrepreneurs do not receive any profit even after bearing uncertainty.

3. Professor Knight considered uncertainty as a factor of production. However, critics consider uncertainty as a psychological concept and a part of real costs. Therefore, it is impossible to consider uncertainty as a separate factor in production.

4. The uncertainty-bearing theory of profit does not provide any basis for profit distribution among the owners of joint-stock companies.

5. In monopoly businesses, uncertainty is low, but profit is high. This aspect is not covered by the uncertainty-bearing theory of profit.