We Can Have Better Products At Lower Prices Without More Gov’t Regulation
How we can make the market system work for consumers and employees instead of against them.
By using the profit motive together with one change to the corporate tax structure, we can give companies a financial incentive to pay higher wages and deliver better products at lower prices.
By David Grace (www.DavidGraceAuthor.com)
AUTHOR’S NOTE: This column was materially revised on March 21, 2018 from the previous version originally published on March 15, 2018.
The Importance Of Efficient Systems
Every society functions through its systems: A justice system. A political system. An educational system. An economic system.
An industrial economy is a vast and complicated system which cannot effectively function without built-in, positive-feedback mechanisms that automatically respond to and correct for changing conditions.
The communist system was a failure because production, distribution and pricing were all dependent on active, fallible, central planning rather than rapid, automatic, systemic corrections.
The benefit of a market system is that the profit motive drives competition among sellers which competition can (but doesn’t always) result in sellers offering adequate quantities of better products at lower prices.
The more fierce the competition in a specific product category, the more likely the market will have price competition and will give us products of higher quality and at lower prices in that category.
The less intense the competition for any product, the less likely there will be price competition and that product will be of higher quality and at a lower price.
The Profit Motive Does Not Automatically Mean Better Quality Products At Lower Prices
While consumers love price competition, sellers hate it. Every seller wants as little price competition and as close to a monopoly market as it can get.
Above all else, sellers want higher profits. There are four basic ways that sellers can get higher profits:
>Lower Costs, which they achieve through
- Cheaper materials
- Cheaper labor or less labor
- Fewer features
- Lower specifications
- Poorer warranties
- Less customer support
>Higher Prices, which they achieve through
- Reduced competition
- Unique features
- Limitations on competitors products
>Additional Fees, which take the form of
- Service fees
- Optional extras fees
- Penalty fees
>Larger Sales Volume, which they get through
- More advertising
- Lower prices, discounts, and rebates
- A larger distribution network
- Higher quality
- More Features
Sellers’ Least Favored Way To Increase Profits Is Greater Sales
In order to increase sales volume, manufacturers have to increase advertising and marketing, widen distribution channels, raise quality, add features, hire more workers, buy more materials, install additional equipment and offer lower prices.
That’s exactly what consumers want from the market — higher quality, more features, higher levels of employment and lower prices.
But manufacturers hate all those things. Sellers don’t want to hire more people, pay more for materials, incur higher costs and receive lower prices.
All the things that consumers want the market to give them are things that sellers don’t want to do. Manufacturers always want to reduce the cost per unit and increase the profit per unit, not the other way around.
If an extremely competitive market doesn’t force a seller to sell more units in order to increase profits, sellers won’t choose the “more sales” route as their first option to obtain greater profits.
As much as possible sellers will first choose the “Higher prices/lower costs” option and/or the “Additional fees” option to increase profits because those options are a much easier, more cost-effective way to increase profits and they make sellers more money without costing them more money.
It’s not that sellers don’t want to increase sales. It’s just that making more money by increasing sales is fourth on their list of ways to increase profits after raising prices, lowering costs, and adding fees.
The desires of consumers and the desires of sellers are diametrically opposed.
Manufacturers Make More Money By Charging More Than By Selling More
The more market advantages the seller has — control of vital distribution channels, brand-name identification which commands a premium price, patented product components, etc. — the less price competition the seller faces.
The less price-competition a seller faces, the higher the price the seller can charge.
Unless and until a higher price reduces sales so much that net profits fall (when price becomes inelastic), selling fewer units at a higher price is more desirable than selling more units at a lower price.
To use an extreme example, if it costs a manufacturer $.50 to make a widget and he sells 1,000 of them for $1 each he makes a profit of $500.
If he sells only 100 widgets for $10 each his gross revenue is unchanged at $1,000 but he almost doubles his profit to $950 because he saves the production costs, distribution costs, warranty costs and support costs for the 900 widgets he no longer has to build and sell.
Manufacturers Make More Money By Spending Less Than By Selling More
If the seller wants to increase his profits by selling more units he has to spend more money.
On the other hand, if the manufacturer is selling millions of units it can make hundreds of thousands of dollars of additional profit by simply shaving a few pennies off the cost of each unit.
It would have cost General Motors only about $.57/vehicle to have changed its faulty ignition switch to a new design that would not have had the safety problem. Why didn’t it make that change voluntarily years before the problem became publicly known?
GM manufactured about 29M cars with the defective design. 29,000,000 X $.57 = $16,530,000 in lost profits balanced against a problem which executives assumed either would never be discovered, would be discovered after they had left the company, or would cost the company less than sixteen and a half million dollars to make go away.
So, GM did nothing. Saving a few pennies per unit times millions of units adds up to millions of dollars in additional profit and executives are usually willing to roll the dice in the hope that they won’t get caught in the explosion if things actually do blow up years later.
Opposing Manufacturer And Consumer Goals
The consumer’s goals are exactly the opposite of the manufacturer’s.
While the manufacturer wants to more easily make a higher profit by selling lower-quality units at a higher price and charging additional fees, the consumer wants to purchase higher quality units at a lower price with no fees.
While the manufacturer benefits from lower labor costs, the rest of society is harmed by lower labor costs because poorly paid workers:
- Consume less which makes for a weaker economy
- Pay less in sales, income and property taxes
- Consume more government services
- More poorly educate their children which poorly-educated children eventually themselves become more poorly paid workers
The Market Economy Needs An Additional Self-Correcting Mechanism
The profit motive coupled with strong market competition is the first stage of our market-based, self-correcting economic system. The desire for profit motivates people to invest in and produce new and better products and services.
A market economy, however, will reduce prices and increase quality only for those products where market competition is so strong that sellers must pursue increased sales as the primary mechanism to earn increased profits.
For those products without highly competitive market conditions which would prevent the sellers from increasing profits by offering lower quality products at higher prices, the sellers will strive to earn more profits through higher prices, lower costs and additional fees in preference to earning higher profits by increasing sales volume.
The question then is:
Is there a built-in, automatic mechanism we can add to the market system that will give all sellers of ALL products an incentive to increase profits by selling more units and deter sellers of ALL products from choosing to increase profits primarily by lowering costs, raising prices and adding fees?
The Purpose Of A Market System Is To Produce Better, Cheaper Products, Not Make Entrepreneurs Rich
We have to start by understanding the goal of the capitalist, market economic system.
Many of the people who buy lottery tickets think that the purpose of a lottery is to make people rich, but we know that’s not true. Lotteries weren’t created as philanthropic ventures to distribute money to poor people.
The real purpose of a lottery is to make a profit for the lottery operators from selling tickets. Lotteries give away money only as a lure to get people to buy more tickets.
Similarly, the purpose of the capitalist, market system is not to make people rich any more than the purpose of a lottery is to make people rich.
The purpose of making wealth available to entrepreneurs under the capitalist market system is to motivate people to invest in, start and operate businesses. Like the prizes in a lottery, the money that can be made under a capitalist system is only a lure to get people to invest in, design, build and sell better products and services.
Capitalism no more cares if any particular entrepreneur actually gets rich (or how rich) than the lottery operator cares if any particular ticket buyer wins the jackpot.
The lottery only wants and needs to offer a big enough prize for a low enough price to maximize net profits.
From a systems point of view, a lottery prize that is larger than necessary to generate the maximum ticket revenue reduces net profits and is a waste. A ticket price smaller than necessary to generate maximum ticket revenue reduces net sales revenues and is a mistake.
Capitalism is the same. The system needs the profit from starting and running a successful business to be large enough to generate the maximum level of innovation and investment.
From a systems point of view, profit beyond that level is a waste in the same way that a lottery prize larger than what is needed to maximize ticket revenue is a waste.
Ever higher business profits are not the sacred goal of a capitalist, market system any more than ever bigger jackpots are the sacred goal of the lottery system.
The entrepreneur’s and investor’s potential rewards from their ventures need to be big enough to motivate entrepreneurs and investors to invest in, start, and operate businesses. Rewards above that level are systemically unnecessary. They are superfluous.
Business profits above the level needed to drive entrepreneurs’ and investors’ participation in the market system are superfluous to the effective operation of the market system in the same way that a jackpot greater than that needed to maximize ticket revenue is superfluous to the effective operation of the lottery system.
Corporate Profits
Generally Accepted Accounting Procedures (GAAP) define the rules for business accounting, including defining the constituents of profits and costs. GAAP is approximately 7,600 pages long.
For now, let’s just think about profits and costs in a very simplistic way.
In the most simplistic way, profits are what’s left over after paying all tax-deductible business expenses — labor, materials, new equipment, research and development, etc.
The amount left over after paying all the bills can either be distributed to shareholders as dividends, paid to shareholders to repurchase their stock, paid to executives as additional compensation, or put in the bank.
Every business wants to make as much money for shareholders and executives as possible. More profit also increases the stock price which earns executives millions on their stock options.
The desire for higher profits that can be distributed to shareholders, increase the compensation to executives, or added to net assets thus increasing stock prices, drives corporations to raise prices, increase fees, use cheaper materials, pay lower wages, and, lastly, increase unit sales.
We Need The Lure Of Profits To Fuel Entrepreneurship and Investment
If the opportunity to earn net profits is too limited:
- Entrepreneurs will not have the incentive to work hard to create new companies,
- Existing companies will not have the incentive to create new products or improve old ones
- Investors will not have the incentive to risk their money.
We want entrepreneurs and investors to do all those things. Profits are the food that nourishes capitalism’s goose that lays the golden eggs. We want the system’s profit potential to be high enough for entrepreneurs to build new companies and for investors to fund them.
We don’t want to starve the goose that lays the golden eggs. But we also don’t want to overfeed the goose.
We want to give the goose just enough food to keep it laying golden eggs and nothing more, because the pursuit of more, more, more drives anti-consumer behavior.
What’s A Big Enough Payout To Keep Entrepreneurs & Investors Building New Businesses?
Because the insatiable desire for ever higher stock prices, dividends, stock re-purchases, and executive bonuses drives excessive prices, high fees, low wages, poor service and environmental pollution, we don’t want profits to be larger than are necessary to keep the system working well.
Feed the goose, yes. Overfeed the goose, no.
Assume that a company’s gross revenues are $1 billion and its costs are $800 million leaving it with profits of $200 million. That company’s ratio of profits to costs is $200 Million in profits/$800 Million in costs or a profits-to-costs ratio of 25%.
Based on published numbers, Apple’s recent profits as a percentage of costs have been in the range of 18% to 23%. Microsoft’s from about 13% to 25%. On the low end, in 2015 IBM’s profit as a percentage of costs was only about 5.5%.
A profit-to-cost ratio of 25% or less was enough to motivate IBM, Microsoft, Apple and other companies to greatly innovate, aggressively invest, strongly compete and actively introduce new products, so that should be a good enough level to keep the capitalist, market system ticking along.
That’s enough to keep our goose healthy and well fed.
If we look at Mylan, famous for its EpiPen monopoly-price increases of approximately 600% over a ten year period, we find that its recent profit-to-cost ratio was $450M/$550M or about 82%!
Isn’t it amazing what monopoly pricing can do for you.
That’s a grossly overfed goose.
A ratio of profits to costs of about 25% seems to be more than enough to keep the capitalist engine working hard.
Let’s call this 25% Profit-To-Cost ratio the Sufficient Profit Ratio and profits equal to 25% of costs Maximum Distributable Profits.
Let’s call profits in excess of the Maximum Distributable Profits, Non-Distributable Profits.
Encouraging More Price Competition, Discouraging Higher Prices
We want a mechanism that, without active government intervention, will automatically give businesses an incentive to increase competition, improve product quality, lower prices, increase wages, and discontinue additional fees and which will also deter businesses from lowering product quality, increasing prices and adding additional fees.
Is there a tool we can add to the market system that will do this?
Yes. That tool is a rule that limits shareholder distributions and executive compensation to no more than Maximum Distributable Profits.
Capping Distributable Profits
Suppose you’re a generic drug manufacturer. Your sales were $1 billion and your costs were $800 million so your profit ratio was $200 M/$800 M or 25% meaning that the maximum you can spend on executive compensation, shareholder dividends and stock repurchases is $200 million.
You and the other two manufacturers of some vital drug, let’s say digitalis, would all like to increase your prices in lock step by 200%.
Because people must have your product and most purchasers are covered by some kind of medical insurance your sales volume would remain about the same and your costs would be the same at $800 million. Your gross revenues would double from $1 billion to $2 billion and your profits would increase to $2 B — $800 M = $1.2 B.
Your Maximum Distributable Profits would be 25% X $800 M in costs = $200 M.
Your Non-Distributable Profits would be $1.2B total profits — $200 M Distributable Profits = $1 B in Non-Distributable Profits. Since you couldn’t give this money to shareholders or executives what could you do with it?
If you could just put it in the bank that would increase the stock price and the shareholders would be able to indirectly get this money by selling their shares at this higher price, thus materially nullifying the cap on distributable profits, in other words, an end-run on the cap.
In order to discourage companies from doubling their prices and just parking the extra profits in a bank account as an alternate way to get extra money to stockholders, any non-distributable profits that were retained and not spent on legitimate corporate expenses would be subject to a retained-earnings tax of at least 50%.
If a company found itself with a huge profit, it would either have to put it the bank and pay a 50% tax or spend that extra money on valid corporate expenses such as higher wages, higher quality products, discounts and rebates to customers, more R&D, new factories, and other sorts of valid corporate purposes.
So, knowing that the increased profits from doubling the price of your product couldn’t be given to either the shareholders or the executives and would be subject to a 50% tax if just put in the bank, the board would very likely abandon the idea of doubling the price of digitalis, which is exactly what we as consumers want to have happen.
This Is Exactly What Supporters Of The Free Market Promise Us The Market Will Do
Lower prices and better products are exactly what we want to encourage companies to do. That’s exactly the kind of conduct that believers in the competitive, free market promise us that the market will deliver.
What valid complaint do believers in a competitive free-market economy have against a rule that will motivate businesses to actually behave the way they promise that they will?
Increasing Shareholder Dividends
Under these rules, how can a company give more money to its shareholders and executives? By making higher profits from increased sales instead of from higher prices.
If the ONLY way the company can increase the amount of money it can give to its executives and shareholders is to increase sales instead of increasing its prices, that’s exactly what we as consumers want it do and that’s exactly what the supporters of the free market promise us the market will deliver, namely that the desire for more profits will spur competitive behavior which in turn will give us lower prices and higher quality.
In our example, if you double the number of units sold, your sales would be $2 billion, your costs would be $1.6 billion. 25% X $1.6 Billion = $400 million in distributable profits instead of $200 million.
If you cap distributable profits as a percentage of costs
- You cannot double distributable profits if you double your price,
- But, you can double distributable profits if you double your sales.
To increase sales your company would have to increase distribution and marketing, improve the product, lower the price, and offer discounts — all things consumers and believers in the free-market system want to see happen, all actions that are consistent with the goals of the market system, and all achieved without active government intervention.
The Effect Of Limiting Distributable Profits
Once a company has maxed out on Distributable Profits it will have no incentive to:
- cut wages
- increase prices
- reduce quality
- add fees.
because it won’t be able to give the extra money those activities generate to the executives or shareholders. It will just have to turn around and spend those extra funds on legitimate corporate purposes.
Instead the company will only be able to give more money to shareholders and executives by increasing unit sales while keeping its profit-to-cost ratio at no greater than 25%.
This Reduces Gov’t Bureaucracy & Regulation
Instead of needing to employ armies of government investigators, bureaucrats and inspectors to discover, prove and then prosecute tens of thousands of anti-trust violations, unsafe working conditions infractions, toxics failures, hidden fees, fraudulent conduct and the like, by limiting Distributable Profits the market itself will work to curb these unwanted activities by taking away the profit motive for those activities.
If we make unwanted activities unprofitable we also make them irrelevant.
If companies decrease profits by paying employees more and cutting prices and they increase profits by paying employees less and increasing prices, then as often as possible they will cut wages and increase prices.
On the other hand, if cheapening its products and raising its prices gains a company nothing, companies will have no motive to do it.
Instead, if in order to increase their profits businesses will be required to spend their energy increasing their sales, they will be forced to offer better and cheaper products with the added benefit of fewer government regulations, less government interference, and an overall smaller government.
A cap on Distributable Profits would make the profit motive work for consumers instead of against them, thus giving us better products, lower prices and less need for government regulation.
— David Grace (www.DavidGraceAuthor.com)
