A Profit Paradox or Simply Good Business Practice?

In this blog post, I provide an alternative perspective from the point of view of business strategy to the profit paradox.

The Profit Paradox

The Profit Paradox by Jan Eeckhout (ISBN: 978-0691214474), published by Princeton University Press, tells a story about firms exploiting market power enabled by technological innovation. Market power enables firms to set selling prices higher than they would be in competitive markets. Furthermore, the resulting increase in firm profits are kept within the firm rather than passed on to employees.

A key statistic is that the ratio of profit share vis-a-vis labor share of revenue has increased. In the early 1980s, firm profit share was 2% of revenue and labor wage share was 20%. Today, firm profit is 10% of revenue while labor wage share remains stagnant at 20%. So, the ratio of firm share to wage share increased from 5% to 50%.

The Profit Paradox points out that technological innovation is both good and bad for everyone. It is good because in competitive markets it lowers the cost of goods and services, therefore, lower the price of those goods and services to consumers. It is bad, because firms use the technological innovation to construct moats and increase barriers to entry to make the market less competitive. Due to the less competitive markets, the cost-savings from technological innovation actually end up maintaining the high prices for the consumers.

It reminds me of this incredible Counterpoint statistic I saw a while ago, which stated that, within the global smartphone market, Apple captured 85% of the operating profits with only 48% of the revenue share and a measly 18% of the shipment share.

A Business Strategist’s Perspective

As a consumer, my instant reaction to the significant increase of firm profits vis-à-vis stagnant wages is anger. Firm profits could be passed on to the consumer as lower prices or to employees as higher wages. I feel that’s very much the popular sentiment that drives the fight against “corporate greed.” However, as a business strategist, I can’t align that sentiment with what I see day-to-day.

Another perspective may be considered if we look at the post-1980 explosion in the field of corporate and business strategy theory (i.e., Porter’s Five Forces) and the subsequent rapid increase of professionals (MBAs) applying those theories in the real world.

Source: National Center for Education Statistics (NCES)

These professional managers are first and foremost tasked with looking after the firm’s health, not the broader economy. The increased productivity comes partly from professional managers focusing more intensely on best practices (i.e., Toyota TPS) which enable higher efficiency with a given capital investment. Suppose productivity increases are firm-specific, meaning the inter-firm optimized interaction between people and assets. In that case, it seems fair to attribute the resulting increases in profit to the firm and not employee wages. Hence, we get an increase of the profit share vis-à-vis the wage share.

toyota tps

Furthermore, business strategists have learned that competition is bad for business precisely because consumers will pick the lowest price if all other things are equal. So, there’s a solid incentive to devise business strategies that avoid competition (i.e., Blue Ocean vs Red Ocean). Operating within a “blue ocean” with no direct competitors offering near-identical products or services enables companies to set pricing as they see fit. That results in higher prices and higher profits.

Lastly, perhaps we should not say “higher” prices and profits but “healthier” prices and profits, at least from the firm’s perspective. Healthy operating profits are essential to firms because they enable healthy reinvestment in the firm. This reinvestment comes in various forms, including hiring more people, increasing inventory levels for faster customer delivery, expanding operations, or diversifying into new markets. Too low profits prohibit these “healthy” business activities. Too high profits entice other firms to compete and steal some market or, even worse, have innovation disruptors come for your entire market. In other words: maintaining a healthy profit share is simply good business practice, even if that means less goes to wages and consumers pay higher prices.

This reasoning would ultimately imply that healthy businesses are bad for the economy. I find that hard to wrap my head around.

May 10, 2023 Update

Following my blog post, I reached out to the author for additional feedback on my line of thinking. The author was kind enough to provide an insightful clarification on the topic which adds more food for thought.

The crux of the argument laid out in the Profit Paradox is that the while business efficiency improvements (like Toyota TPS) are help improve the efficiency of the company, they don’t necessarily improve the efficiency of the market as a whole. Less efficient markets – where certain players exert excess market power – are not good for the consumer as they end up paying higher prices and see their wages stagnate.

Healthy markets provide a platform for many firms to make healthy profits, but avoids few firms making excess profits.

As a final note, I also appreciate the author’s perspective on mergers and acquisitions. Not only because of the arguments related to increasing market power as laid out in the book but also because M&A is notorious for being the #1 firm value destroyer, as NYU professor Mr. Damodaran has argued many times over.

Whether it’s increasing market power or destroying firm value, M&A tends to benefit no one other than those collecting fees and commissions on executing the transaction. Therefore it’s probably in most people’s best interest to put the onus on the acquirer to prove a transaction will create value prior to regulator approval.