The Paradox of Profits: Part 3

We cannot do without the profit system. But can we tinker with it effectively? That is the question I try to answer in this essay.

I have three main points to make.

  1. The profit system is partially self-correcting.
  2. Attempts to impose corrections are not as successful as one might hope.
  3. Rather than attempt to identify and correct market failures, it would be better to advocate policies that enhance the self-correcting mechanisms of the profit system. In particular, government interventions should be focused on enabling competition to overcome entrenched economic power.

Partially self-correcting

When the market leads to outcomes that we do not like, we should not under-estimate the power of the profit system to make things better. There are two reasons that the profit system tends to self-correct.

First, when a business does not serve customers well, this creates an opportunity for other firms to profit by fixing the problem. In the 1970s, American cars were terrible. You were lucky if a car lasted five years. Companies like Toyota saw an opportunity to profit. That in turn put pressure on American car companies to improve quality.

If a product is manufactured in a manner that wastes resources, a competing firm that uses cheaper materials or less labor can profit by making the product at lower cost.

If a vendor gives consumers bad experiences, a vendor with a better reputation will attract customers. In fact, this process works better (although far from perfectly) thanks to the Web, because there are sites like Amazon and Yelp that show how consumers rate products and services.

Second, when one business earns very high profits, this creates an incentive for other firms to try to come into that market to take away those profits. The entry or potential entry of new firms serves as a check on the amount of profit any incumbent firm can extract. Other entrepreneurs are prepared to try to jump in and offer something better at a lower price.

Government as a Correction Mechanism

Although the profit system has these self-correcting mechanisms, they never work perfectly. There are always ways that market outcomes could be improved.

But the fact that the profit system works imperfectly does not mean that government action works well as a correction mechanism. Government is not an omniscient deity. It is a human institution, operated by the same sort of imperfect humans that make decisions as consumers, workers, and bosses.

If government takes over the provision of a service, such as K-12 education or health care for veterans, that does not ensure perfect outcomes. On the contrary, by taking away the self-correcting mechanisms of the profit system, a government-run system can easily slide into mediocrity, complacency, and wastefulness.

When government regulates financial services or pharmaceuticals, that does not eradicate risk in those industries. It introduces errors made by government regulators. These may not be the same errors that would be made by the private sector, but sometimes the regulators’ miscalculations may be worse. For example, prior to 2008, banking regulators encouraged banks to hold complex mortgage securities, because they thought that mortgage security portfolios helped to enhance the safety of the financial system.

I find it sobering to read in the conclusion of a speech given in June of 2006 by Ben Bernanke of the Federal Reserve Board.

“ Indeed, banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Less than two years later, Mr. Bernanke was frantically trying to cope with the worst financial crisis since the 1930s.

Competition or Entrenchment

The self-correction mechanisms of the profit system are valuable. Government actors often have no better information or incentive to fix problems than do entrepreneurs.

I think that the best approach is for government to work with the profit system rather than against it. That means trying to make sure that competition can operate.

The opposite of competition is entrenchment. Entrenchment means that powerful incumbents are able to artificially stifle competition. This is the rationale for anti-trust laws, although such laws have rarely been used in a constructive way.

An example of an intervention in the profit system that I believe worked well is the 1982 breakup of AT&T. This helped unleash competition in the telecommunication sector.

Entrenched by government

Often, what stands in the way of competition is government itself. Big Pharma is entrenched by the system of regulation and patents, Big Agriculture is entrenched by subsidies and tariffs. Consolidation in health care is fueled by government regulation, which creates compliance costs that are too heavy for small medical practices to bear.

In many cases, the best way to unleash competition is to get government out of the way. For example, in the 1970s, trucking and air fares were heavily regulated. When these industries were deregulated, prices fell and service increased.

Auctioning spectrum was another policy that promoted competition, helping to enable the growth of wireless telephony. Nevertheless, the FCC continues to reserve too much spectrum for low-value uses, with many government agencies hoarding frequencies that they use inefficiently or not at all.

Many of the large firms whose profits might be undeserved are closely entangled with government. For example, big banks enjoy government guarantees and “too big to fail” status.

Cable television was established with an “exclusive local franchise” model overseen by local governments. Local phone companies eventually entered the market, but in my opinion competition is still not satisfactory in this sector. Perhaps government could do more to encourage competition from other technologies, including wireless.

Big Tech: The Four

What about the highly profitable tech firms, what Scott Galloway calls The Four, namely Amazon, Apple, Facebook, and Google? I think that each ought to be considered separately.

My perspective on these firms is affected by my age and by my experience watching the commercial Internet emerge in the 1990s.

Amazon was born in the 1990s, when investors were willing to throw money at firms like Pets.com that were out to capture market share without worrying about profit. Most of the e-retailers of that era subsequently crashed, but Amazon is still around, and still not earning much. If we think that most corporate shareholders tend to put pressure on businesses to focus on the short term and ignore the future, then Amazon’s shareholders are the exception. It is Amazon’s future profits that are the gleam in shareholders’ eyes. Meanwhile, Amazon certainly is not enjoying high profit margins in its retail business.

Next, consider Apple. Back in the twentieth century, Apple enjoyed periods of profitability alternating with periods of horrendous losses and at least one near-death experience. Over the past decade, it has been much more successful at earning sustained profits. Still, could Apple afford a mis-step that allowed its competitors to pull ahead in terms of innovation and user experience? I doubt that Apple’s brand loyalty would last very long if other firms were to offer clearly superior products. It seems evident that the pressure of competition continues to operate in the markets in which Apple enjoys its status.

Twentieth century history also affects my outlook on Facebook. In the 1990s, America Online was all the rage. I tried it, and for a while I enjoyed it, but once the Web took off I started using it less and less, until I dropped it altogether. For a while, AOL kept on expanding, becoming a media powerhouse. Years after I canceled my account, AOL was mighty enough to merge with Time-Warner on favorable terms. But eventually AOL faded into history.

With Facebook, I personally have reached the “using it less and less” phase. That does not mean that other people have come around to my attitude, and in fact the numbers show usage increasing. But wait and see.

Google is the one firm that concerns me. Suppose that someone else came up with a better way of auctioning advertisements, for example. Could this new ad-auctioning system break into the market, or would Google be able to quash it? If the latter is the case, then the government should look for ways to make the market more competitive.

Conclusion

I hope that these essays help readers think about the profit system. It is easy to criticize specific outcomes. However, the alternative is not some system that works for “the people” to provide perfect justice. The alternative is some form of intervention undertaken by a specific group of persons, presumably government officials, who themselves operate with gaps in knowledge and constraints on competence. Government intervention, when it does take place, ought to aim less at trying to directly fix problems and more toward fostering competition in order to take advantage of the profit system’s self-correction mechanisms.

My recommendation for government intervention in markets is that the government should try to work with the self-correcting mechanisms of the profit system, rather than try to over-ride them. That is, government intervention ought to focus on improving competition and allowing profit-seekers to correct problems.

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