Profitability as a Policy Problem



I thought that I had come up with a radical idea (for me, anyway) but discovered subsequently that I had merely rediscovered fire.  Actually, I found that my little idea's intellectual genesis lay in an obscure political philosophy called ordoliberalism. So while I can't claim discovery of a new idea, I can at least apply an old and dusty philosophy to a live and troubling problem.  

The idea is simple and the problem is huge: It is that an increasing proportion of corporate profits could be a result of market power.

Big deal, you might say. And perhaps you'd be right. But in fact market power is better thought of as a company-consumer relationship continuum anchored, arguably, at one end by overweening service and at the other by indifferent extortion. 

As companies increase market power, their responsiveness falls. Worse, you (we!) are paying too much. 

Think about your latest mobile phone bill…if you're from outside of Canada, you are rightly appalled by the amount of money we pay in this country for a service that has, for all intents and purposes, become commodified. (Don't even get me started on roaming data fees…)

Or banking. Again, apply the same logic – if you are paying too much for too little, and can't find a provider who gives you what you need at your preferred willingness-to-pay level, it's likely a good sign of market power picking your pocket.

The technical measure used to determine the level of market power is something called the Herfindahl Hirschman Index. Mathematically, it's the summed squares of each company's market share, expressed in percentage terms. 

A fully monopolized market (one provider, with tremendous market power) would have a HHI score of 10,000.  A fully competitive market (many providers, each with very little market power and likely very low profits) could have a score theoretically close to zero.

In practice, an industry with an HHI of 1,800 or above is thought to be highly concentrated. (Mergers that raise the HHI by more than 100 points are usually given considerable scrutiny.)

The traditional weapon that governments have used to fight concentration has been antitrust legislation.  It's long, legal, and requires proof in a court of law. Appeals are possible. Resolution takes years. Customers suffer in the meantime.

My remedy is simple: treat profitability as a sign that something is wrong with a market's structure. 

But instead of using antitrust legislation, governments should avoid courts entirely, and take an active role to enable more competition. The express aim of such activity should be reducing aggregate profits within a high-profit industry.

This effort should include measures that encourage the formation of domestically-domiciled new entrants, and in lowering barriers that prevent foreign companies from considering entry. Other measures might be needed, depending on the chracteristics of a particular industry. Regardless, the goal should remain the same – to create more competitors.

The rationale: today, technologies, education, and access to information are more evenly distributed across countries. (No, it's not a perfectly flat world…)

Second, information moves essentially at zero cost.

Third, due to these two factors, fewer companies have genuine core competencies (rent-generating capabilities – they have to be valuable, rare, hard to imitate and lack a substitute) that justify above-normal profits.

So where else could profits come from?

To be fair, I haven't factored in two other potential sources of excess profitability – valuable brands and network effects. But not all industries have customers who are brand-sensitive. Nor do network effects exist everywhere either.

If companies can only earn profits by coercion, governments can and should act as counterweights in favour of customers. The quid pro quo for companies? Lower taxes on those profits earned honourably.  

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