The Problem with Profits

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.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.

6 Responses to "The Problem with Profits"

  1. Little Saver   July 31, 2009 at 11:29 am

    “If a firm makes lots of money, lots of people are getting what they want.”I must firmly disagree on this thesis.My version: If a firm makes lots of money, lots of people are getting what the company wants them to get.This goes from tobacco, drugs, hamburgers, SUV’s, (too) expensive medical treatment… to irresponsible mortgages and corrupted politicians.

  2. Mark C   July 31, 2009 at 11:52 am

    The thesis is absolutely true. You can’t make an analogy between health care and hamburgers. The correct analogy is health care and education. A person’s economic circumstances may force them to do with hamburgers or SUVs, and society is not therefore forced to buy those products for him. If he doesn’t have health care (or an education), he will show up in emergency rooms (or prison) and society WILL pay for that. Why can’t conservatives grasp this?

  3. Little Saver   July 31, 2009 at 10:09 pm

    “Wants” are to a great degree the result of manipulation by firms. People may want healthy food but may end up eating what firms want them to eat, profit margins as an important factor.

  4. Guest   August 1, 2009 at 9:13 am

    You and your buddy Krugmann give up way too easy on free markets. The problems is that THE CURRENT SYSTEM IS NOT A FREE MARKET PRODUCT. Otherwise, you would have competition and low costs so let’s fix what’s broken rather than seek discredited, inefficient, socialist solutions. How come anybody can become an economist but the number of doctors is kept limited? Let the hospitals outsource and offshore at will just like the rest of the economy and the costs will come down quickly. The government should REGULATE RATHER THAN JUST FORBID outsourcing. Like in a game of whatever, the government should be an impartial referee, not take sides or else the game would suck.”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”?? You do not buy flood insurance when your house is already under water but BEFORE.

  5. Guest   August 1, 2009 at 9:34 am

    Ask yourself: what does the government do well as single payer?You have to look at large agencies that don’t just regulate but execute and that don’t get deeper and deeper in the red.Let’s compare with education: the larger the single payer is, the more screwed-up the education is – just look at California and all large cities.

  6. Guest   August 1, 2009 at 6:35 pm

    “…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.”Very few people outside the insurance business (I am in insider) understand how any and al insurance works. The basic principle is: a pool of individual people, individual companies or individual governments contains a few who are going to need more money than they can – or want to – provide from savings at some time for some reason. More individuals (it has to be more) are not going to need such money. You sell insurance against that need to everyone in the pool, charging the genuine needers higher premiums and the others lower premiums. In a true unregulated and unhindered market, the genuine needers will not pay in enough for their own costs (both because if they had to they wouldn’t buy your insurance in the first place, and because – as Kwak points out – somebody else would insure them at less than cost if you didn’t.Thus, always, it is those who don’t actually need the insurance who are paying both the costs of the needers and the operating costs and profits of the insurance company. For retail insurance companies, the claims department is the most important section, its job being to deny payouts to needers when the time comes. The game is to convince the non-needers that they need to give their money away (all insurance marketing is about raising anxiety), unless you can get the gov’t to make buying your insurance product madantory (like auto insurance). No private insurance company ever offers a good driver, safe homeowner, or healthy person a chance to break even on his/her money; if they did, they the insurance company would go out of business.For these reasons, all private health insurance is a losing proposition for healthy individuals, unless they are lucky enough to have their boss give money away for their coverage, or some gov’t somewhere gives the taxpayer’s money away for their coverage. From a societal macroeconmic point of view, there is no benefit whatsover in having insurance for anything, other than transferring cash from someone (consumers, employers, or gov’t) into the hands of the insurance industry (which owns more assets worldwide than any other industry). It gets especially ugly when insurance companies don’t have any reserves set aside to pay claims (think AIG’s CDS business) – after, all that would lower profits – which is how most insurance companies would be operating in an unregulated world.”Health” is the absolute stupidest thing for a society to make a “right” and to use the mechanism of insurance for distributing access to. “Health” is an inherently unbounded concept which can be consumed in unlimited quantities at any price, and which can (and is close to being) defined as “everything humanly possible that medicine – a goose laying golden eggs for its practitioners – can do.”If you understand how insurance works, then you understand that “a free market” in health insurance would simply drain our GDP from everything else into health care at an even faster rate than is happening now, and gov’t health insurance would do exactly the same thing unless it’s emphasis was on limiting coverage, not expanding it.