Definition: The Knight’s Theory of Profit was proposed by Frank. H. Knight, who believed profit as a reward for uncertainty-bearing, not to risk bearing. Simply, profit is the residual return to the entrepreneur for bearing the uncertainty in business.
Knight had made a clear distinction between the risk and uncertainty. The risk can be classified as a calculable and non-calculable risk. The calculable risks are those whose probability of occurrence can be anticipated through a statistical data. Such as risks due to the fire, theft, or accident are calculable and hence can be insured in exchange for a premium. Such amount of premium can be added to the total cost of production.
While the non-calculable risks are those whose probability of occurrence cannot be determined. Such as the strategies of a competitor cannot be accurately assessed as well as the cost of eliminating the completion cannot be precisely calculated. Thus, the risk element of such events is not insurable. This incalculable area of risk is the uncertainty.
Due to the uncertainty of events, the decision-making becomes a crucial function of an entrepreneur or manager. If the decisions prove to be correct by the subsequent events, an entrepreneur makes a profit and vice-versa. Thus, the Knight’s theory of profit is based on the premise that profit arises out of the decisions made under the conditions of uncertainty.
Knight believes that profit might arise out of the decisions made concerning the state of the market, such as decisions with respect to increasing the degree of monopoly in the market, decisions regarding holding stocks that might result in the windfall gains, decisions taken to introduce new product and technique, etc.
The major criticism of the knight’s theory of profit is, the total profit of an entrepreneur cannot be completely attributed to uncertainty alone. There are several functions that also contribute to the total profit such as innovation, bargaining, coordination of business activities, etc.