Definition: The Innovation Theory of Profit was proposed by Joseph. A. Schumpeter, who believed that an entrepreneur can earn economic profits by introducing successful innovations.
In other words, innovation theory of profit posits that the main function of an entrepreneur is to introduce innovations and the profit in the form of reward is given for his performance. According to Schumpeter, innovation refers to any new policy that an entrepreneur undertakes to reduce the overall cost of production or increase the demand for his products.
Thus, innovation can be classified into two categories; The first category includes all those activities which reduce the overall cost of production such as the introduction of a new method or technique of production, the introduction of new machinery, innovative methods of organizing the industry, etc.
The second category of innovation includes all such activities which increase the demand for a product. Such as the introduction of a new commodity or new quality goods, the emergence or opening of a new market, finding new sources of raw material, a new variety or a design of the product, etc.
The innovation theory of profit posits that the entrepreneur gains profit if his innovation is successful either in reducing the overall cost of production or increasing the demand for his product. Often, the profits earned are for a shorter duration as the competitors imitate the innovation, thereby ceasing the innovation to be new or novice. Earlier, the entrepreneur was enjoying a monopoly position in the market as innovation was confined to himself and was earning larger profits. But after some time, with the others imitating the innovation, the profits started disappearing.
An entrepreneur can earn larger profits for a longer duration if the law allows him to patent his innovation. Such as a design of a product is patented to discourage others to imitate it. Over the time, the supply of factors remaining the same, the factor prices tend to rise as a result of which the cost of production also increases. On the other hand, with the firms adopting innovations the supply of good sand services increases and their prices fall. Thus, on one hand the output per unit cost increases while on the other hand the per unit revenue decreases.
There is a point of time when the difference between the costs and receipts gets disappear. Thus, the profit in excess of the normal profit disappears. This innovation process continues and also the profits continue to appear or disappear.