Sustained High Profits: Should You Be Worried?

Stephen Carter, one of my best professors at law school and also an accomplished novelist, has an op-ed in today’s Washington Post arguing that high corporate profits are a good thing, and as a consequence we need to have a strong and profitable for-profit health insurance sector. Here’s the essence of his argument:

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.

I agree that the pursuit of high profits is a good thing. That is what makes a free-market capitalist system work, and it’s what made me start a company eight years ago. But basic microeconomics says that high profits themselves are generally not a good thing.

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost. (Steve Goldman, one of my economics professors, once said that if you wake an economist up in the middle of the night and ask him or her, “what is price?,” he should answer, “marginal cost.”)

The real world is different, of course. Companies have to earn profits sufficient to cover their cost of capital. And if you invent a successful new product, you will earn excess profits for some period of time; but over time your competitors will catch up and those excess profits will go away (see the IBM personal computer, for example).

So if you see a company that has very high profits over a sustained period, there are two possibilities: either it is benefiting from a non-competitive market (e.g., it is a monopoly), or it is simply exceptional at innovating and staying ahead of the competition for years on end. If you see a whole industry that has sustained high profits, however, the latter explanation cannot hold, and you should immediately suspect a lack of competition.

In short, the thing that we should celebrate is not high profits, but competition. The pursuit of high profits is what motivates competition; but if a whole industry achieves high profits, then what you are seeing is not competition, but its opposite.

Now what’s going on in health care? Look at page six of this report. In most states, the combined market share of the top two health insurers is well over sixty percent. That is not a competitive market, but a market controlled by one or two companies.

In addition, there are good reasons why a free market is not how you want to allocate health care anyway. For one thing, as I have argued, a free market for health care is a market in which sick people die, because no one will sell a sick person an insurance policy that costs less than his or her expected costs under the policy.

Second, as Paul Krugman explains, health care is a good that does not conform to the basic assumptions that you need for free markets to produce optimal solutions. I won’t try to summarize, since he already summarizes elegantly. But before you dismiss Krugman as a liberal pundit, note that his main source is a paper by Kenneth Arrow – as in the Arrow-Debreu Theory, the centerpiece of general equilibrium theory and of mainstream microeconomics in general in the last fifty years.

Now, it is perhaps possible that private health insurers could be part of a well-functioning health care system – if, for example, they were not allowed to engage in medical underwriting (which is what makes sick people unable to buy insurance at any price they can afford). But that’s not the system we have now. Instead, we have local oligopolies, and if they earn high profits, that’s a product of market power and lobbying clout, not “lots of people . . . getting what they want.” (Do you know anyone who actually buys insurance – either someone in the individual market or someone who buys insurance for an employer – who is happy about what he or she is getting these days?)

Obviously companies should make profits; the need to make profits is what separates good companies from bad ones. And people should be able to get rich making excess profits that result from innovation; you can make a lot of money in the period between the innovation and the competition catching up with you. But if you see sustained high profits by an entire industry of corporate behemoths, you should be very, very worried.

About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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