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1. ECONOMICS :)
CONCEPT OF INTEREST AND PROFIT
SUBMITTED TO: MRS RICHA TYAGI
SUBMITTED BY : KARAN
01320603819
BALLB- 3RD SEMESTER

2. WHAT IS INTEREST?
• The reward for capital is known as interest. The owner of the capital receives interest for lending
his/her capital to others
• Capital can be classified into two types – fixed capital and variable capital. In fact, when we say
capital, it includes both fixed and variable capital.
• However, interest is the income earned only on the variable capital. Interest is earned only on that
portion of capital which is given by the owner to the borrower.
• In other words, it is the price paid by the borrower to the lender who parted with his money.

3. • Why do people get paid for lending their money?
• Money in the form of cash provides the holder with benefit because it enables him to buy anything
that he desires.
• However, if an individual lends it to another person, then he will have to wait until he gets back his
money and only then he can utilize it.
• According to John Maynard Keynes, "Interest is a reward for parting with liquidity for a
specified period."

4. BASIC CONCEPTS
Gross interest : When the borrower pays an amount to the lender for borrowing the lender's money,
the amount so paid by the borrower is known as 'interest‘
Therefore, when people refer to interest, they generally refer to 'gross interest'. Gross interest is the
total amount paid by the borrower to the lender of the money.
Net interest : Net interest is the amount paid to 'capitalists' only for the use of 'capital'. It is the
reward paid to the capitalists exclusively for the use of capital.
Net interest is the compensation for lending capital to others under conditions where there is no risk
or inconvenience due to investment (investments made with no savings motive) and the lender is not
required to perform any work other than lending his money.
Therefore, net interest is a part of the gross interest. Gross interest consists of some charges along
with the net interest

5. • Gross Interest = Price of the Capital (Net Interest) + Reward for taking risk of money lending +
Reward for management of loan + Others (such as the reward for accepting the inconveniences
involved in money lending)
• Gross interest thus includes compensation for loan of capital, compensation to cover risk of loss
(either business risk or personal risk), compensation for inconvenience of investment,
compensation for work and apprehension related to monitoring investment.
• Saving and investment: According to the theory, savings and investment are not interdependent.
It is known that the income level changes along with the changes in investments.
• The changes in investment levels invariably have an impact on the savings of individuals.
Therefore, it is not correct to say that saving and investment are independent of each other

6. LIQUIDITY PREFERENCE THEORY OF INTEREST
• John Maynard Keynes (Keynes) propounded the 'liquidity preference theory of interest'. His theory
is based upon the belief that people prefer absolute liquidity (cash) to other forms of wealth in the
short run.
• Keynes criticized the classical theory of rate of interest on the grounds that they combined real and
monetary factors together.
• According to Keynes, the rate of interest is purely a monetary phenomenon. He said that
determination of interest, thus, is dependent upon the demand for and supply of money in the
economy. Keynes proposed that interest is equilibrium between the demand for and supply of
money.

7. • Keynes opined that a person who lends money gets the reward called 'interest' for parting with'
liquid money'.
• Keynes explains, “The rate of interest is the premium which is to be offered to induce the people to
hold wealth in some form or the other than hoarded money." According to him, interest is the
incentive that drives moneylenders to part with their money and lend it to people.
• What is liquidity preference? The liquidity feature of money empowers us with 'purchasing power',
hence, the preference for cash to other forms of money. People's fondness for cash or liquid money is
called as 'liquidity preference' .

8. • Why do people prefer liquidity? According to Keynes, people prefer liquidity to other forms of money
because they want to satisfy the three kinds of motives:
• Transaction motive
• Precautionary motive
• • Speculative motive

9. • Transaction motive: When people demand for liquid money to carry out their day-to-day
transactions, the demand for such liquidity is known as 'transaction motive‘.
• For example, people need money to travel from one place to another, to buy goods and services, etc.
• For this, they are required to stock some amount of cash with them. So, when people require cash
to complete their economic transactions, the motive behind the demand for such cash is known as
transaction motive.

10. • Precautionary motive: Since people are uncertain about their future, they prefer to save money with
a view to safeguard their future.
• People attempt to meet contingencies and unforeseen circumstances that may happen in the future
by saving. Hence, the demand for liquidity to safeguard their future is known as the 'precautionary
motive'.
• Ex.1. Income levels of people impacts precautionary demand for liquidity to a great extent. 2. Some
people are optimistic about their future, while others are pessimistic. Optimistic people anticipate
lesser risk in the future when compared to pessimistic people. 3. A farsighted person can visualize
the future in advance and makes a better analysis of the future

11. • Speculative motive : This is the most important motive behind the demand for liquidity. The motive
for stocking cash here is to take advantage of the changes in the price levels of securities and bonds.
• If people anticipate that the prices of securities will go up in the future, hen they prefer to purchase
securities now. In such a situation, the liquidity preference of people will be low because they like to
spend cash and purchase securities (with a view to gain profit in the future).
• On the other hand, if they anticipate that the prices of securities would go down in the future, then
they prefer to hold cash.

12. • This is because, they would like to wait and purchase securities in the future when the
prices of the securities fall. In such a situation, the liquidity preference of people will be
high. Hence, it can be said that the liquidity preference of people is affected by the
speculative motives .

13. PROFIT

14. WHAT IS PROFIT?
• Just like rent is the reward for land, wages for labor and interest for capital, profit is the reward for
entrepreneurship
• While the rewards for other factors of production are paid by the entrepreneur, profit is the reward
received by entrepreneur himself.
• Simply put, profit is the income of an entrepreneur for utilizing his entrepreneurial abilities and
running a business. Profit is nothing but the surplus amount left with the entrepreneur after paying
all the factors of production.

15. • If the income earned by him is in excess of the costs incurred on the factors of production, then the
income can be called as profit.
• Therefore, profit can also be defined as the difference between the total value of output (total
revenues received by the businessman) and the total value of inputs (total costs incurred by the
businessman) of a business.
• Profit =Value of Outputs - Value of Inputs

16. BASIC CONCEPTS
• Profit consists of two major components – gross profit and net profit .
• Gross profit : Generally, people consider profit as the residual income left with the entrepreneur
after making all the payments to other factors of production.
However, it should be noted that this is gross profit. The gross profit is arrived at after excluding all
the explicit costs from the revenues received by the business.
It does not exclude implicit costs such as rent forgone by entrepreneur for utilizing his own land for
business purposes, interest forgone on his own capital, etc.
Gross Profit =Total Revenues - Total Explicit Costs
Gross profit thus includes those costs which go unrecorded in the books of accounts, but which are
nevertheless important to determine the profit made by the business.

17. • Net profit: The net profit can be arrived at by subtracting the implicit costs from gross profits.
• This is also sometimes referred to as 'pure profit'. Net profit is the surplus leftover after deducting
explicit and implicit costs from the sales receipts of a business.
• Net Profit =Gross Profit - Implicit Costs
• Thus, it can be observed that net profit is a portion of the gross profit. When a business gets zero
net profit, it means that the profit attained is just enough to meet the explicit costs of the business.
• In other words, the entrepreneur's revenues could not payoff his efforts (or implicit costs) such as
utilizing his own resources, undertaking risk and uncertainty of business, etc

18. • Normal profit : It is the minimum return that an entrepreneur receives for performing
entrepreneurial functions such as bearing risk and uncertainty, managing other factors of
production, etc.
• Abnormal or super profit: The income remaining with the entrepreneur after subtracting all costs
(both implicit and explicit) from the revenues received from the business. It is an excess over the
normal profit.

19. THEORIES OF PROFIT
• Though there are several theories of profit that attempt to explain the emergence and growth of
profit, none of the theories give a comprehensive picture on profit.
• Traditional Theories : F.A. Walker one of the prominent non-classical economists, propounded the
'rent theory of profit ', which was similar to David Ricardo's (Ricardo) 'theory of rent '.
Later, Taussig and Davonport developed the 'wage theory of profit ' and proposed that like a laborer
works physically and earns his wage, an entrepreneur works mentally and earns his wage called
profit.
Walker's rent theory of profit : The 'rent theory of profit' was developed by Francis. A. Walker
(Walker). Be advocated that different lands earned different rents depending upon the fertility of
land.

20. • According to him, the rent earned by more fertile or intra-marginal lands was the difference
between the total production of intra-marginal and marginal lands.
• He further explained that there existed both intra-marginal entrepreneurs and marginal
entrepreneurs and that the former are abler than the latter. Hence, the intra-marginal
entrepreneurs earned rent of ability called profit.
• He opined that rent and profit are no different from each other and just as there is a no-rent or
marginal land, there is also a no-rent entrepreneur or marginal entrepreneur

21. • Limitations of 'rent theory of profit':
• Critics said that comparing profits with rent is impracticable. Rent can never be zero and is
always positive. However, the same is not the case with profits, as profits can be negative or zero.
• One of the main opponents of Walker's 'rent theory of profit', J.B. Clark, opined that profits occur
only under dynamic conditions. However, rent can be earned under both static and dynamic
conditions.

22. • The theory assumes the existence of marginal entrepreneur i.e. entrepreneurs who do
not earn any profit. This is an absurd concept because any businessman who does not
earn profits would pull back from business. Further, critics said that just as there
cannot be a 'no-rent land', there also cannot be a 'no-profit entrepreneur

23. MODERN THEORIES
• The modem theories of profit include Clark's dynamic theory , Schumpeter's innovation theory ,
Hawley's risk theory , Knight's uncertainty-bearing theory among others.
• Dynamic theory of profit: According to him, profit is the difference between the cost of producing
goods and the prices of these goods. In a stationary state, there is always equilibrium between
demand and supply of goods.
• Hence, there is no difference between the prices of goods and their costs, and therefore net profits
do not accrue to the entrepreneur. Under dynamic conditions, however, there is disequilibrium
between demand and supply conditions of economy. In such a state, there are often changes in the
determinants of demand and supply.

24. • Innovation theory of profit : Joseph Schumpeter propounded the 'innovation theory of profit '. He
proposed that profit is the reward for the innovative abilities of entrepreneurs.
• According to him, an entrepreneur who introduces innovation in businesses process reaps benefits
in the form of profits, if the innovation proves successful in the market.
• Schumpeter defined innovation as any new process or policy adopted by the businessman with a
view to obtain reduction in cost of production, or to improve the demand for the product in the
marketplace

25. • Uncertainty-bearing theory : According to Frank H. Knight (Knight), the most important function
of an entrepreneur is to bear uncertainties in business in the form of risks that cannot be insured
against.
• Risk can be defined as the measurable probability of the occurrence of profit or loss situation.
• With a view to differentiate between risk and uncertainty, Knight divided risks into:
• Insurable risks :- According to Knight, insurable risks are those risks which the entrepreneur can
avoid through insurance. These risks can be in the form of loss of assets due to fire, accident, theft,
etc. An entrepreneur gets cover for these losses by paying a premium to the insurance companies
and reclaiming the same in the event of mishap. Therefore, he does not have to bear uncertainties
for insurable risks.

26. • Non-insurable risks :- These risks can be in the form of changes in people's habits, price level
fluctuations, etc.
• Non-insurable risks are unpredictable and unavoidable and hence are uncertainties. Knight
proposed that profits or losses are the rewards an entrepreneur receives for bearing these
uncertainties.
• Uncertainty arises for non-insurable risks. Non-insurable or unpredictable risks are those risks
which are unforeseen and for which no information is available to estimate or forecast. Also, non-
insurable risks cannot be covered under insurance coverage.