Profits under Competition

My last post probably generated more confusion than clarity. Let me try to clarify some conceptual points that might help bring my thinking into focus. In that post, I was trying to work through the inequality/rents connection. I argued that the standard way I've seen it presented doesn't make sense to me. I tried to argue that increasing rents is neither necessary, nor sufficient for increasing inequality. In the more speculative parts of the post, I suggested why I think this confusion exists.

Let me try to make a related point that I might clarify what I have in mind. I'll try to be less speculative and simply present basic economic theory.

Let me tell the story I've heard:

Economics rents, sometimes associated with monopoly rents, are often presented in opposition to the perfectly competitive market. They are two "extreme" forms of markets. It's said that in the perfectly competitive markets profits are driven to zero. However, with a monopolist in the figure below, quantity supplied is "restricted" to Qm. This drives up the price of the good the monopolist sells to Pm, which allows him to make a producer surplus, profit, or a monopoly "rent," whatever one wants to call it.

Monopolists are bad, because they generate a deadweight loss shown in the figure. In addition, because monopolists make profit, this creates an incentive for firms to try to make themselves a monopolist. If for example, a firm can get the government to prevent other firms from producing a produce, then a firm will lobby for such protections. This lobbying is called "rent-seeking," which I talked about in the last post. Rent-seeking is wasteful.  That's another reason that monopoly rents are bad.

Therefore, the contrast presented is between perfectly competitive markets with zero profits, which is sometimes endowed with a positive connotation, and monopoly markets with profits, which is sometimes endowed with a negative connotation. Rent-seeking is thrown in for good measure.

That's not the actual theory though.

The sleight of hand came when defining the perfectly competitive market. A perfectly competitive market does not require zero profits. Let me say that again. A perfectly competitive market does not require zero profits. My students make this slip often, which is my fault as an instructor.

Perfect competition doesn't require zero profits in the Econ 101 version or the fancy math versions we learn in graduate school. We can make assumptions that lead to zero profit in the long run, but zero profits is neither part of the definition of a competitive market, nor a direct implication.

Take the standard example below with an upward sloping supply curve and downward sloping demand curve.

This market can be perfectly competitive. There are no externalities and everyone takes prices as given.

But there are still profits. Only good number Q* has zero profit. Inframarginal goods before that make a profit, or economic rent.

As is hopefully clear from this, profits or rents cannot be used to distinguish the monopoly case from the perfectly competitive. In both, firms make profits. Nor can we use "income" as a proxy for rents, because of what I said in the last post.

The connection between income, rents, inequality, competition is just not tight enough to make inferences between two of them. Remember that when someone tries to use "rents" to make you react like Pavlov's dog. "Rents" are not enough for positive predictions, let alone for normative policy implications.

Institutional Details

We need to have a more subtle theory to make these connections. This is where we need to look at the property rights structure and broader institutions that a market is a part of. Such institutional details are the way to distinguish monopoly from competitive markets, "good" profits from "bad" profits.

This means looking at the rules of the game, not looking at the outcomes of the game, say by looking through the balance sheet. In the article mentioned in my previous post, Dean Baker hints at the institutional details, but mainly focuses on outcomes, such as revenue.

If one examines a market, say in pharmaceuticals, and wants to judge whether "rents" are increasing or decreasing, we need to look at the rules of the game. Are patents extended? Is it harder to get drugs approved? That's the evidence of increased rents from monopoly privilege, not the increased revenue or accounting profit.

Distinguishing these two aspects is vital for talking about clearly about monopoly rents and inequality. Once we've established an increase in rents associated with monopoly privilege, then we can possibly see a connection to inequality.

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