Stephen L. Carter on Profits

As Ezra Klein says, it was very strange of the editors of the Washington Post’s opinion pages to decide that running an op-ed that just drifts from a generalized defense of the existence of capitalism to some specific points about health care reform. But any day you read a Washington Post op-ed that doesn’t contain a deliberate effort to mislead the audience is a pretty good day.

Unfortunately, even his generalized analysis of profit is wrong:

High profits are excellent news. When corporate earnings reach record levels, we should be celebrating. The only way a firm can make money is to sell people what they want at a price they are willing to pay. If a firm makes lots of money, lots of people are getting what they want.

This is not correct. Carter is stumbling over an ambiguity in the ordinary language phrase “make money.” What’s true is that the only way a firm can generate sales is to sell people what they want at a price they are willing to pay. So if a firm has an enormous sales volume, then lots of people are getting what they want. But profit is the difference between revenue and costs. Very high profits indicate a lack of competition.

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Sometimes that’s because public policy is distorting the market. When you make it illegal to issue new liquor licenses in Adams-Morgan, you generate monopoly profits for existing license-holders. Sometimes it’s just because barriers to entry are high. Starting a company capable of building civilian jumbo jets would be extremely difficult, so Boeing and Airbus don’t face much competition. Sometimes it’s a matter of deliberate public policy — we grant temporary monopolies to pharmaceutical companies, thus allowing them to generate giant profits, in hopes of encouraging capital to be invested in the pharmaceutical R&D; sector. Sometimes it’s because of network effects — the fact that most people use Windows is a good reason to use Windows, which makes it hard for Microsoft to lose market share. And sometimes it’s just transient — the first gas station in town might earn huge profits, but that encourages people to open new gas stations and drives the revenues down to close to the marginal cost, shaving the profits.

Profit’s not the worst thing in the world, but it’s hardly the best. When you’re looking at big profits, you really do need to ask where they come from and whether or not this is something you want. In the pharma case, people endlessly debate whether or not there isn’t a better model. The incentive effect is good, but the mechanism for producing it seems wasteful. The liquor licenses thing is definitely wasteful — instead of grandfathering certain business in and letting them generate monopoly profits you ought to auction the licenses and let the public capture the regulatory surplus. In the case of airplanes, it doesn’t seem worth doing anything. My guess is that one day China will decide it wants to waste its citizens’ money on launching a third civilian airplane maker, and people who live outside the US/EU/China “axis of perverse determination to build airplanes” will benefit from the increased competition.

One should also note that for all of Carter’s love of profits, he’s a professor at Yale. The higher education sector is everywhere dominated by governments and non-profit foundations and you rarely see professors complaining about this.