Initially business regulation focused on anti-trust policies and barriers to entry. However, rent-seeking behaviour is not exclusive of natural or government sponsored monopolies and oligopolies. Rent-seeking is generally defined as the pursuit of payments beyond those necessary to have the service or factor supplied. Although most of these situations involve licensing, e.g. as in the case of doctors, taxis, drugs etc., or natural monopolies (as in the case of land), there are situations where market dominance may create the same type of rent-seeking behaviour.
I shall illustrate this with two examples related to new technologies and distribution, that is, – rent seekers vs. innovators and distributors vs producers.
With free entry, innovators will enjoy only a temporary monopoly until new imitators come in and drive profits to zero, thus eliminating any rents. However, in sectors subject to winner-takes-all economics that is no longer the case, because innovators can only compete until one of them dominates the market. That is, inventors become like lottery players, playing in the hope of winning a jackpot. Those who get it either retire or become a kind of private equity fund (doing little or no new research) but buying up any new innovators that threaten their dominance.
This eat-or-be-eaten is not always negative. Indeed, many so-called serial entrepreneurs thrive on finding new business opportunities and not on running them for long periods and therefore welcome the possibility of cashing-in and having a higher turnover in their investments. The problems exist when the acquirers use bundling and financial power to stop prematurely the natural selection of the winners.
Consider for example the social network Facebook’s acquisitions of Instagram and WhatsApp, for 20 billion USD, in order to secure dominance in global photo-sharing and mobile messaging. Can we be sure that those services had already achieved their position of winner-takes-all through competition or did they reach it prematurely by being acquired by a dominant player in the same space?
It is important to note that most of those payments were in Facebook shares, which may be seen as counterfeit currency if they are excessively overvalued because of the expected longevity of its oligopolistic position. So who is rent-seeking, the innovators or their acquirers? Probably both, because the innovators capitalize on the anticipation of a wider monopoly position while the acquirer achieves a higher valuation on the assumption that it will be able to maintain its dominant position and capture the rents achievable through such position longer than normal.
However, it is not uncommon that the acquirer ends up writing-off many of such acquisitions and ends up being the “sucker” while the tech entrepreneurs cashes in hefty gains. So, as long as this processes increases rather than limits entrepreneurship, the potential for market perfecting policies on the part of regulators is very limited.
This is possible because inventors also hold a monopolist position. This is quite different from the position of distributors and suppliers. To the extent that retailers manage to concentrate their retail outlets in a few locations their stores achieve a local oligopolistic situation which allows them to pursue rent-seeking. These oligopolies are often reinforced by local planning and licensing regulations.
For instance, during sudden recessions consumer demand contracts and retailers try to stop falling sales through discounts and lower prices. However, these reductions are transferred to their suppliers so that they manage to protect their profit margins throughout the recession. They are able to do so because suppliers no longer have direct access to end-user clients . Therefore, most of the adjustment takes place at the producers level. However, in contrast to the tech sector, here a write-off in the producers’ investment generates a reduction in entrepreneurship but the distributors will not incur write-off losses.
A similar process occurs in sectors (e.g. petrol stations) where the producers are in an oligopolistic position while the retail distributors are many and receive a fixed payment. Obviously, in this case, the producers are the only able to pursue rent-seeking.
That is, there are cases where producers impose a fixed price to retailers e.g. soft drinks, ice cream, petrol and domestic gaz. And the opposite, cases where distributors impose a price to producers, e.g. research, supermarkets, etc. Such practices are certainly anti-competition and may justify some form of regulation. However, in those sectors where both producers and distributors have oligopolistic power (e.g. IT and healthcare) it is not clear whether regulation can add much value.
In conclusion, striking the right balance between market perfecting regulation and intrusive messing up it is not always easy. For instance, in the financial sector excessive regulation often results in the protection of the incumbents which have the resources needed to cope with heavy regulation. Nevertheless, in most domains, whenever the right level of regulation cannot be ascertained, one should err on the low side.
Showing posts with label Oligopolies. Show all posts
Showing posts with label Oligopolies. Show all posts
Wednesday, 16 December 2015
Wednesday, 8 October 2014
The Profit Motive and Capitalism
The pursuit of self-interest is the second pillar of capitalism and it is expressed by the profits attained. Without profits companies would not know whether an item or service is worth producing and could not measure their success. As remarked by Adam Smith (1776), “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.
Profits, or net income available to common shareholders to use the accountant’s terminology, are the difference between revenues and expenditures. The outlays include the compensation to suppliers, the taxes paid to governments and interest charged by creditors. This residual amount belongs to shareholders and may be distributed as dividends or kept in the firm as retained earnings.
Contrary to what some finance theories imply, profits may not be considered as a cost to be minimized but rather as a gain to be maximized. Yet, many still see profits as immoral or as something to be curbed rather than maximized because they encourage selfishness and greed.
The immorality of profits is preached by Marxists and some religious leaders. The later invoke arguments similar to those used in the Middle Ages to condemn charging interest on loans. The first appeal to Marx’s mistaken labor theory of value postulating that all goods, considered economically, are only the product of labor and cost nothing except labor. Both doctrines have been refuted by theory and history.
Nonetheless, the need for profit maximizing capitalists or firms is repeatedly debated and needs to be clarified. The debate involves three main topics – whether humans are really optimizers or satisfiers, if it is indispensable for optimal competitive markets and the likelihood of degenerating into a socially unacceptable concentration of wealth.
In relation to the first, recent research on human behavior shows that humans are often driven by motives that cannot be considered as self-interest. However, the proponents of self-interest maximization claim that such deviations are minor and that maximization is still a good proxy for human behavior. The risk of wealth concentration is real, but it is naturally bounded through diseconomies of scale and may be socially constrained through inheritance and income taxes. So, we focus on its indispensability for an optimal allocation of resources through competitive markets.
The idea that the profit motive is dispensable or at least is not foremost in modern capitalism stems from the widespread view that in a world where ownership is very removed from control companies have many stakeholders and that shareholders are merely one of them.
However, in competitive markets, the interests of other stakeholders are better served by shareholders pursuing profit maximization motives. One does not need to endorse Ayn Rand’s (1964) reclassification of selfishness and greed as virtues rather than evils. We can rely on Aristotle’s concept of mean or on Keynes (1936) statement that “it is better that a man should tyrannize over his bank balance than over his fellow-citizens” in the pursuit of his money-making passion subject to rules and limitations aimed at creating a levelled playing field.
Indeed, the profit motive is indispensable in both competitive and oligopolistic markets but the prevalence of one type of market over the other is not indifferent.
Let us illustrate first why the shareholders profit motive is indispensable, despite the current trend in finance theory to focus on firm value rather than shareholder value. Under such theory the manager’s role is to maximize the present value of future cash-flows discounted by the weighted average cost of capital. Assuming the possibility of risk-free arbitrage between debt and stock securities issued by a company or that stocks always sell at book value then the structure of capital would be irrelevant to determine the value of a firm. Thus the managers objective should be the maximization of operating profits (EBIT) rather than the shareholders profit (net income). Moreover, managers could ignore the owners’ desired debt/equity ratio because they can achieve whatever level they wished by leveraging their equity portfolio.
However profit maximization cannot be pursued regardless of who has claims on operating profits, that is, debt holders, tax authorities, shareholders and managers (retained earnings). In what concerns debt holders and taxation the company has a duty to minimize their share by procuring the cheapest source of financing and reducing its tax bill. Retained earnings could be a maximization objective. However, if we accept the proposition that the capital structure does not affect the value of the firm, then even managers trying to maximize the size of their company should be indifferent about whether its growth was financed with internal or external funding and may not feel compelled to maximize retained earnings. Therefore, only shareholders have a genuine and unequivocal interest in profit maximization, regardless of the degree of separation between ownership and control.
That is, shareholders are indispensable for profit maximization irrespective of whether they prefer capital gains or distributions (dividends and stock repurchases).
This is an important conclusion because, theoretically, a corporation could be established by any of the so-called stakeholders - employees, managers, clients, governments, creditors, entrepreneurs and shareholders – interested only in maximizing their own return (e.g. salaries or executive compensation) and minimizing that of the other stakeholders. Even if we consider the so-called serial entrepreneurs, who are successful at finding and developing new business opportunities and are driven more by the entrepreneurship thrill than capital gains or control, they still need the profit motive of passive shareholders to compel management to pursue profit maximization and secure the success of their ventures.
Finally, let us discuss if the profit motive is efficient and indispensable in all human activities and organizations, and in particular for big businesses operating in oligopolistic markets. In the case of public goods and services it is normal that the objective is not the maximization of the financial return for those who provided the funding (taxpayers), but rather the minimization of the cost for the consumers of such services. Likewise, in the case of philanthropic and other non-profit organizations, the objective is not to maximize the donors satisfaction but to maximize the beneficiaries benefit. Although in these organizations we may find many instances where the interests of the ultimate beneficiaries have been hijacked by the interests of the insiders (e.g. politicians, directors, officers or employees) they still cannot be driven by the profit motive.
Fortunately, most human needs are better fulfilled by for-profit organizations. Yet, except under special circumstances, the pursuit of profit maximization does not guarantees Pareto efficiency in the case of markets dominated by oligopolistic firms capable of securing monopolistic rents. So, while profit maximization is an essential foundation of capitalism it needs to be complemented by competitive markets.
In a world where most people is to a greater or lesser extent a passive capitalist increasingly removed from the control of his investments and there is a growing oligopolization in many industries we need to understand how capitalism depends on the preservation of free and competitive markets.
Profits, or net income available to common shareholders to use the accountant’s terminology, are the difference between revenues and expenditures. The outlays include the compensation to suppliers, the taxes paid to governments and interest charged by creditors. This residual amount belongs to shareholders and may be distributed as dividends or kept in the firm as retained earnings.
Contrary to what some finance theories imply, profits may not be considered as a cost to be minimized but rather as a gain to be maximized. Yet, many still see profits as immoral or as something to be curbed rather than maximized because they encourage selfishness and greed.
The immorality of profits is preached by Marxists and some religious leaders. The later invoke arguments similar to those used in the Middle Ages to condemn charging interest on loans. The first appeal to Marx’s mistaken labor theory of value postulating that all goods, considered economically, are only the product of labor and cost nothing except labor. Both doctrines have been refuted by theory and history.
Nonetheless, the need for profit maximizing capitalists or firms is repeatedly debated and needs to be clarified. The debate involves three main topics – whether humans are really optimizers or satisfiers, if it is indispensable for optimal competitive markets and the likelihood of degenerating into a socially unacceptable concentration of wealth.
In relation to the first, recent research on human behavior shows that humans are often driven by motives that cannot be considered as self-interest. However, the proponents of self-interest maximization claim that such deviations are minor and that maximization is still a good proxy for human behavior. The risk of wealth concentration is real, but it is naturally bounded through diseconomies of scale and may be socially constrained through inheritance and income taxes. So, we focus on its indispensability for an optimal allocation of resources through competitive markets.
The idea that the profit motive is dispensable or at least is not foremost in modern capitalism stems from the widespread view that in a world where ownership is very removed from control companies have many stakeholders and that shareholders are merely one of them.
However, in competitive markets, the interests of other stakeholders are better served by shareholders pursuing profit maximization motives. One does not need to endorse Ayn Rand’s (1964) reclassification of selfishness and greed as virtues rather than evils. We can rely on Aristotle’s concept of mean or on Keynes (1936) statement that “it is better that a man should tyrannize over his bank balance than over his fellow-citizens” in the pursuit of his money-making passion subject to rules and limitations aimed at creating a levelled playing field.
Indeed, the profit motive is indispensable in both competitive and oligopolistic markets but the prevalence of one type of market over the other is not indifferent.
Let us illustrate first why the shareholders profit motive is indispensable, despite the current trend in finance theory to focus on firm value rather than shareholder value. Under such theory the manager’s role is to maximize the present value of future cash-flows discounted by the weighted average cost of capital. Assuming the possibility of risk-free arbitrage between debt and stock securities issued by a company or that stocks always sell at book value then the structure of capital would be irrelevant to determine the value of a firm. Thus the managers objective should be the maximization of operating profits (EBIT) rather than the shareholders profit (net income). Moreover, managers could ignore the owners’ desired debt/equity ratio because they can achieve whatever level they wished by leveraging their equity portfolio.
However profit maximization cannot be pursued regardless of who has claims on operating profits, that is, debt holders, tax authorities, shareholders and managers (retained earnings). In what concerns debt holders and taxation the company has a duty to minimize their share by procuring the cheapest source of financing and reducing its tax bill. Retained earnings could be a maximization objective. However, if we accept the proposition that the capital structure does not affect the value of the firm, then even managers trying to maximize the size of their company should be indifferent about whether its growth was financed with internal or external funding and may not feel compelled to maximize retained earnings. Therefore, only shareholders have a genuine and unequivocal interest in profit maximization, regardless of the degree of separation between ownership and control.
That is, shareholders are indispensable for profit maximization irrespective of whether they prefer capital gains or distributions (dividends and stock repurchases).
This is an important conclusion because, theoretically, a corporation could be established by any of the so-called stakeholders - employees, managers, clients, governments, creditors, entrepreneurs and shareholders – interested only in maximizing their own return (e.g. salaries or executive compensation) and minimizing that of the other stakeholders. Even if we consider the so-called serial entrepreneurs, who are successful at finding and developing new business opportunities and are driven more by the entrepreneurship thrill than capital gains or control, they still need the profit motive of passive shareholders to compel management to pursue profit maximization and secure the success of their ventures.
Finally, let us discuss if the profit motive is efficient and indispensable in all human activities and organizations, and in particular for big businesses operating in oligopolistic markets. In the case of public goods and services it is normal that the objective is not the maximization of the financial return for those who provided the funding (taxpayers), but rather the minimization of the cost for the consumers of such services. Likewise, in the case of philanthropic and other non-profit organizations, the objective is not to maximize the donors satisfaction but to maximize the beneficiaries benefit. Although in these organizations we may find many instances where the interests of the ultimate beneficiaries have been hijacked by the interests of the insiders (e.g. politicians, directors, officers or employees) they still cannot be driven by the profit motive.
Fortunately, most human needs are better fulfilled by for-profit organizations. Yet, except under special circumstances, the pursuit of profit maximization does not guarantees Pareto efficiency in the case of markets dominated by oligopolistic firms capable of securing monopolistic rents. So, while profit maximization is an essential foundation of capitalism it needs to be complemented by competitive markets.
In a world where most people is to a greater or lesser extent a passive capitalist increasingly removed from the control of his investments and there is a growing oligopolization in many industries we need to understand how capitalism depends on the preservation of free and competitive markets.
Friday, 1 July 2011
Grow or Fail!?
The FT published recently some comments by James Murdoch claiming that News Corporation – the world’s largest media conglomerate – is not big enough. The reason, he argues, is that “When you actually look at the competitive set in an all-media market place, where you have monolithic brands, from Google and Apple etc, to the big [telecoms incumbents] Telefónica, Deutsche Telekom, Verizon – all the characters on a playing field or a terrain that has essentially collapsed – there are much, much bigger beasts than a News Corporation, or a Time Warner”.
So, he means that because the whole media sector (from production to distribution) is going through a technological revolution we are in for a “winner-takes-all competition”. I do not think so!
Interestingly enough the founders of News Corp, Google and Apple still control their companies and are not considered as part of the managerial capitalism sector, which thrives on rent-seeking behavior secured through oligopoly and regulatory protection. So, he is probably just voicing the usual kids whine about “that boys’ toy is bigger than mine” so dear to CEOs of managerial controlled firms.
There is however a case to consider whether the new technologies are promoting a mitigated from of winner-takes-all, the so called long-tail business model. In this model (with a long history in music and book publishing) the top sellers take about 80/90% of the total revenue while the remaining millions of producers have to fight for the residual 10/20% of revenues.
Whether this will be exacerbated or attenuated will depend not only on technology but also on the profit maximization choices of the leading companies. Should those “running the pipes” and the viewing devices – the telecoms and IT companies (e.g. Verizon and Apple) – be allowed to build oligopolistic positions based on competition for subscribers by offering “”all-you-can-eat” contents and devices for free, and then some producers and content aggregators (e.g. News Corp) would become almost entirely dependent on an oligopolistic advertising aggregator (e.g. Google). Under this scenario, it is not unreasonable to expect that content aggregators would also need to build oligopolistic positions.
Thus the fundamental question is whether atomized content producers and end-consumers would be well served by a supply chain (from aggregators to device manufacturers) that would be mostly oligopolistic. I do not think that they would benefit from such an end-game. Here is where economists and regulators should focus their attention. Our first impression is that some size limits should be considered before we get into “too big to fail” situations, regardless of whether they are managerial or entrepreneurial run firms.
These limits should be designed in a way similar to those that we advocate for the managerial sector in general. Not based on some old fashioned ideas like the percentages of ownership and national content.
Only a leading sector of market capitalism can protect the entire capitalist system as one of the main pillars of happiness for humankind.
So, he means that because the whole media sector (from production to distribution) is going through a technological revolution we are in for a “winner-takes-all competition”. I do not think so!
Interestingly enough the founders of News Corp, Google and Apple still control their companies and are not considered as part of the managerial capitalism sector, which thrives on rent-seeking behavior secured through oligopoly and regulatory protection. So, he is probably just voicing the usual kids whine about “that boys’ toy is bigger than mine” so dear to CEOs of managerial controlled firms.
There is however a case to consider whether the new technologies are promoting a mitigated from of winner-takes-all, the so called long-tail business model. In this model (with a long history in music and book publishing) the top sellers take about 80/90% of the total revenue while the remaining millions of producers have to fight for the residual 10/20% of revenues.
Whether this will be exacerbated or attenuated will depend not only on technology but also on the profit maximization choices of the leading companies. Should those “running the pipes” and the viewing devices – the telecoms and IT companies (e.g. Verizon and Apple) – be allowed to build oligopolistic positions based on competition for subscribers by offering “”all-you-can-eat” contents and devices for free, and then some producers and content aggregators (e.g. News Corp) would become almost entirely dependent on an oligopolistic advertising aggregator (e.g. Google). Under this scenario, it is not unreasonable to expect that content aggregators would also need to build oligopolistic positions.
Thus the fundamental question is whether atomized content producers and end-consumers would be well served by a supply chain (from aggregators to device manufacturers) that would be mostly oligopolistic. I do not think that they would benefit from such an end-game. Here is where economists and regulators should focus their attention. Our first impression is that some size limits should be considered before we get into “too big to fail” situations, regardless of whether they are managerial or entrepreneurial run firms.
These limits should be designed in a way similar to those that we advocate for the managerial sector in general. Not based on some old fashioned ideas like the percentages of ownership and national content.
Only a leading sector of market capitalism can protect the entire capitalist system as one of the main pillars of happiness for humankind.
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