J. W. Mason – In Praise of Profiteering

Of the usefulness of the concept, that is

J. W. Mason is Associate Professor of Economics at John Jay College, City University of New York and a Fellow at the Roosevelt Institute

Cross-posted from Josh’s blog Money and Things


In most of my writing on inflation, I’ve emphasized supply disruptions rather than market power. But as I’ll explain in this post, I think the market power or profiteering frame is a valuable one, beyond its application to the inflation of the past few years.

Thanks in large part to Lindsay Owens and her team at the Groundwork Collaborative, the idea that corporate profiteering has contributed to inflation is getting a surprising amount of traction. Naturally it’s also attracted some hostile pushback. This piece by Catherine Rampell in the Washington Post last year is a example. For critics like Rampell, the profiteering claim isn’t just wrong, but “conspiracy theory”, vacuous and incoherent:

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The theory goes something like this: The reason prices are up so much is that companies have gotten “greedy” and are conspiring to “pad their profits,” “profiteer” and “price-gouge.” No one has managed to define “profiteering” and “price-gouging” more specifically than “raising prices more than I’d like.” …

The problem with this narrative is that it’s just a pejorative tautology. Yes, prices are going up because companies are raising prices. Okay. This is the economic equivalent of saying “It’s raining because water is falling from the sky.”

The interesting thing about the profiteering story, to me, is precisely that it’s not a tautology. As a matter of logic, one might just as easily say “prices are going up because consumers are paying more.” It is not an axiomatic truth that businesses are who decide on prices. It is not a feature of textbook economics (where firms are price takers) nor is it an empirically true of all markets. As for profiteering, there is a straightforward definition — price increases that don’t reflect any change in the costs of production. Both economically and in the common-sense morality that terms like “price gouging” appeal to, there’s a distinction between price increases that reflect higher costs and ones that do not. And there’s nothing novel or strange about policies to limit the latter.

These two points are related. If prices were set straightforwardly as a markup over marginal costs, it would not make sense to say that “companies are raising prices.” And there would not be any question of price-gouging. The starting point, then, is, that’s not necessarily how prices are set. And once we agree that prices are a decision variable for firms, rather than an automatic market outcome, it’s not obvious why there shouldn’t be a public interest in how that decision gets made.

Think about water. It’s a commonplace that big increases in the price of bottled water in a disaster zone should not be allowed. The marginal cost of selling a bottle of water already on the shelf is no higher than in normal times. Nor are high prices for bottled water serving a function as signals — the premise is precisely that the quantity available is temporarily fixed. And everyone agrees that in these settings, willingness to pay is not a good measure of need.

What about water in normal times? In most of the United States, piped water is provided by local government. But in some places, it is provided by private water companies. And in those cases, invariably, its price is tightly regulated by a public utility commission, with price increases limited to cases where an increase in costs has been established. According to this recent GAO report, states with private water utilities all “rely on the same standard formula … to set private for-profit water rates. The formula relies on the actual costs of the utility …. including capital invested in its facilities, operations and maintenance costs, taxes, and other adjustments.”

The principle in these types of regulations — which, again, are ubiquitous and uncontroversial — is that in the real world prices may or may not track costs of production. Price increases that reflect higher costs are legitimate, and should be permitted; ones that do not are not, and should not.

Rent control is very controversial, both among economists and the general public. But I have never heard “water rate control” brought up as an example of an illegitimate government interference in the market, or seen a study of how much more water would be provided if utilities could charge what the market would bear. (Maybe some enterprising young economist will take that on.)

The same goes for many other public utilities — electricity, gas, and so on. Here in New York, a utility that wants to raise its electricity rates has to submit a filing to the Public Service Commission documenting the its operating and capital costs; if the proposed increase doesn’t reflect the company’s costs, it is not allowed. Obviously this isn’t so simple in practice, and the system certainly has its critics. But the point is, no one thinks that electricity — an industry that combines very high fixed costs, concentration and very inelastic demand, and which is an essential input to all kinds of other activity — is something where prices can be left to the market.

So the the question is not: Should prices be regulated or controlled? Nor is it whether some price increases are unreasonable. The answers to those questions are obviously, uncontroversially Yes. The question is whether the price regulation of utilities, and the economic analysis behind it, should be extended to other areas, or to prices in general.

In modern economies, production is carried out by large enterprises with substantial market power. They are not price takers. For most goods and services, price is a decision variable for producers, involving tradeoffs on a number of margins. (For a discussion of these issues in. Post Keynesian theoretical framework, the go-to source is the late Fred Lee.).

In the models taught in introductory microeconomics, producers are price takers; they choose a quantity of output which they will sell at the going price. The critical assumption in these models is rising marginal costs — each additional unit of output costs more to produce than the last one. This means that in a competitive market, firms will carry out production just to the point where marginal cost equals the market price. This model is in principle consistent with the existence of fixed costs: Free entry and exit ensures that revenue at the market price just covers fixed costs, plus the normal profit (whatever that is).

The usual situation in a modern economy, however, is flat or declining marginal costs. Non-increasing marginal costs, nonzero fixed costs, and competitive pricing cannot coexist: In the absence of increasing marginal costs, a price equal to marginal cost leaves nothing to cover fixed costs. Modern industries, which invariably involve substantial fixed costs and flat or declining marginal costs at normal levels of output, require some degree of monopoly power in order to survive. This is the economic logic behind patents and copyrights — developing a new idea is costly, but disseminating it is cheap. So if we are relying on private businesses for this, they must be granted some degree of monopoly. (Obviously, intellectual property is not the only possible solution to this problem — the point is just that the problem is real.)

The question is, once we agree that some degree of market power is necessary in order for industries without declining returns to cover their fixed costs, how do we know how much market power is enough? Too much market power, and firms can make super-normal profits by holding prices above the level required to cover their costs, reducing access to whatever social useful thing they supply. Too little market power, and competing firms will be inefficiently small, drive each other to bankruptcy, or simply decline to enter, depriving society of the useful thing entirely. Returning to the IP example: To the extent that copyrights and patents serve an economic function, it is possible for them to be either too long or too short.

The problem gets worse when we think about what fixed costs mean concretely. On the one hand, the decision to pay for a particular long-lived means of production is irreversible and taken in historical time; producers don’t know in advance whether their margins over costs of production will be enough to recoup the outlay. But on the other hand, the form these costs take is financial: A company has, typically, borrowed to pay for its plant, equipment and intellectual property; the concrete ongoing costs it faces are debt service payments.  These may change after the fact, by, for example, being discharged in bankruptcy — which does not in general prevent the firm from continuing to operate. So there may be a very wide space between a price high enough to induce new firms to enter and a price low enough to induce existing firms to exit.

In addition, concerns over market share, public opinion, financing constraints,  strategic interaction with competitors and other considerations mean that the price chosen within this space will not necessarily be the one that maximizes short-term profits (to the extent that this can even be known.) A lower price might allow a firm to gain market share, but risk retaliation from competitors. A higher price might allow for increased payments to shareholders, but risk a backlash from regulators or bad press. Narrowly economic factors may set some broad limits to pricing, but within them there is a broad range for strategic choices by sellers.

These issues were central to economic debates around the turn of the last century, particularly in the context of railroads. In the second half of the 19th century, railroads were the overwhelmingly dominant industrial businesses. And they clearly did not fit the models of competitive producers pricing according to marginal cost that the economics profession was then developing.

Railroads provided an essential function, for which there were no good alternatives. A single line on a given route had an effective monopoly, while two lines in parallel were almost perfect substitutes. The largest part of costs were fixed. But on the other hand, a firm that failed to meet its fixed costs would see its debt discharged in bankruptcy and then continue operating under new ownership. The result was cycles of price gouging and ruinous competition, in which farmers and small businesses could (much of the time) reasonably complain that they were being crushed by rapacious railroad owners, and railroads could (some of the time) reasonably complain they were being driven to the wall by cutthroat competition.

In his classic history of business organization The Visible Hand, Alfred Chandler describes exactly this dynamic:

Railroad competition presented an entirely new business phenomenon. Never before had a very small number of very large enterprises competed for the same business. And never before had competitors been saddled with such high fixed costs. In the 1880s fixed costs…averaged two-thirds of total cost. The relentless pressure of such costs quickly convinced railroad managers that uncontrolled competition of through traffic would be “ruinous”. As long as a road had cars available to carry freight, the temptation to attract traffic by reducing rates was always there. … To both the railroad managers and investors, the logic of such competition would be bankruptcy for all.

As Michael Perelman explains in his excellent book Railroading Economics (from which the following quotes are drawn), the problem of the railroads was the problem for the first generation of American professional economists. Even as economists were developing models in which prices set in competitive markets would guarantee both a rational allocation of society’s resources and a normatively fair distribution of incomes, it was clear that in the era’s dominant industry, market prices did not work at all.

Already in the 1870s, Charles Francis Adams could observe:

The traditions of political economy,…notwithstanding, there are functions of modern life, the number of which is also continually increasing, which necessarily partake in their essence of the character of monopolies…. Now it is found that, whenever this characteristic exists, the effect of competition is not to regulate cost or equalize production, but under a greater or less degree of friction to bring about combination and a closer monopoly. This law is invariable. It knows no exceptions.

Arthur Hadley, an early president of the American Economic Association, made a similar argument. Where railroads competed, prices fell to a level that was too low to recover fixed costs, eventually sending one or both lines into bankruptcy. In the absence of competition, railroads could charge monopoly prices, which might be much higher than fixed costs. Equating prices to marginal costs made sense in an economy of small farmers or artisans. But in industries where most costs took the form of large, irreversible investments in fixed capital, there was no automatic process that would bring prices in line with costs. In Perelman’s summary:

In order to attract new capital into the business, rates must be high enough to pay not merely operating expenses, but fixed charges on both old and new capital. But, when capital is once invested, it can afford to make rates hardly above the level of operating expenses rather than lose a given piece of business. This “fighting rate” may be only one-half or one-third of a rate which would pay fixed charges. Based on his knowledge of the railroads, [Hadley] concluded that “survival of the fittest is only possible when the unfittest can be physically removed—a thing which is impossible in the case of an unfit trunk line.”

Perelman continues:

The root of the problem, for Hadley, was that to build a new line, owners had to expect rates high enough to cover not only the costs of operating it but the costs of constructing it, the financing charges, and a premium for risk; while to continue running an existing line, rates only had to cover operating costs. And these costs were essentially invariant to the volume of traffic on the line.

Or as John Bates Clark  put it in 1901: “There is often a considerable range within which trusts can control prices without calling potential competition into positive activity.”

These were some of the leading figures in the economics profession around the turn of the century, so it’s striking how unambiguously they rejected the  Marshallian orthodoxy of equilibrium prices. When the American Economics Association met for the first time, its proposed statement of principles included the line: “While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals.” Politically, they were not socialists or radicals. They rejected laissez-faire, but they did not reject private ownership. That left the question, how should prices be regulated?

For a conservative like Hadley, the answer was social norms:

This power [of the trusts] is so great that it can only be controlled by public opinion—not by statute…. There are means enough. Don’t let him come to your house. Disqualify him socially. You may say that it is not an operative remedy. This is a mistake. Whenever it is understood that certain practices are so clearly against public need and public necessity that the man who perpetrates them is not allowed to associate on even terms with his fellow men, you have in your hands an all-powerful remedy.

Unfortunately, in practice, the withholding of dinner party invitations is not always an operative remedy.

In principle, there are many other ways to solve the problem. Intellectually, one can assume it away by simply insisting on declining returns to scale; or one can allow constant returns but have firms rent the services of undifferentiated capital, so there are no fixed costs. If the problem is not assumed away — a more practical option for theorists than for policymakers — it could in principle be solved by somehow ensuring that producers enjoy just the right degree of monopoly. This is what patents and copyrights are presumably supposed to do. Another possible answer is to say that where competition is not possible, that is an activity that should be carried out by the public. That was, of course, where urban rail systems ended up. For someone like Oskar Lange, it was a decisive argument for socializing production more broadly. “Only a socialist economy,” he argued, “can satisfy the claims made by many economists with regard to the achievements of free competition.”

Alternatively, one might accept cartels or monopolies (perhaps under the tutelage of dominant banks) in the hopes that social pressure or norms will limit prices, or on the grounds that a useful service provided at monopoly prices is still better than it not being provided at all. This was, broadly, the view of figures like Hadley, Ely and Clark, and arguably a big part of how things worked out.

But the main resolution to the problem, at least in the case of railroads, came from the increasing public pressure to regulate prices. The Interstate Commerce Commission was established to regulate railroad rates in 1887; its authority was initially limited, and it faced challenges from hostile Gilded-Age courts. But it was strengthened over the ensuing decades. The guiding principle was that rates should be high enough to cover a railroad’s full costs and a reasonable return, but no higher. This required railroads, among other things, to adopt more systematic and consistent accounting for capital costs.

Indeed, there’s a sense in which the logic of Langean socialism describes much of the evolution of private markets over the 20th century. The spread of cost-based price regulation forced firms to systematically measure and account for marginal  costs in a way they might not have done otherwise. Mark Wilson, in his fascinating Destructive Creation, describes how the use of cost-plus contracts during World War II rationalized accounting in a broad range of industries. Systems of railroad-like rate regulation were applied to a number of more or less utility-like businesses both before and after the war, imposing from above the rational relationship between costs and prices that the market could not. Many of these regulations have been rolled back since the 1970s, but as noted earlier, many others remain in place.

Late 19th-century debates over railroad regulation might not be the most obvious place to look for guidance to today’s inflation debates. But as Axel Leijonhufvud points out in a beautiful essay on “The Uses of the Past,” economics is not progressive in the way that physical sciences are — we can’t assume that the useful contributions of the past are all incorporated into today’s thought. Economists’ thinking often changes for reasons of politics or fashion, while the questions posed by reality are changing as well as well, often in quite different ways. Older ideas may be more relevant to new problems than the current state of the art. History of economic thought becomes useful, Leijonhufvud writes,

when the road that took you to the ‘frontier of the field’ ends in a swamp or blind alley. A lot of them do. … Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time.

The road I want to take from those earlier debates is that in a setting of high fixed costs and pervasive market power, how businesses set prices is a legitimate question, both as an object of inquiry and target for policy. One of the central insights of the railroad economists is that in modern capital-intensive industries, there is a wide range over which prices are, in an economic sense, indeterminate. Depending on competitive conditions and the strategic choices of firms, prices can be persistently too high or too low relative to costs. This indeterminacy means that pricing decisions are, at least potentially, a political question.

It’s worth emphasizing here that in empirical studies of how firms actually set prices — which admittedly are rather rare in the economics literature — an important factor in these decisions often seems to be norms around price-setting. In a classic paper on sticky prices, Alan Blinder surveyed business decision-makers on why they don’t change prices more frequently. The most common answer was, “it would antagonize customers.” In a recent ECB survey, one of the top two answers to the same question from businesses selling to the public was, similarly, that “customers expect prices to remain roughly the same.” (The other one was fear that competitors would not follow suit.)

This kind of survey data supports the idea, relied on by the Groundwork team, that businesses with substantial market power might be reluctant to use it in normal times. Those inhibitions would be lifted in an environment like that of the pandemic recovery, where individual price hikes are less likely to be seen as norm violations, or to be noticed at all. (And are more likely to be matched by competitors.)

Even more: It suggests that the moralizing language that critics like Rampell object to can, itself, be a form of inflation control. If fear of antagonizing customers is normally an important restraint on price increases then maybe we need to stoke up that antagonism! The language of “greedflation,” which I admit I didn’t originally care for, can be seen as an updated version of Arthur Hadley’s proposal to “disqualify socially” any business owner who raised prices too much. It is also, of course, useful in the fight for more direct price regulation, which is unlikely to get far on the basis of dispassionate analysis alone.

And this, I think, is a big source of the hostility toward Groundwork and toward others making the greedflation argument, like Isabella Weber. (There is obviously also a fair bit of misogyny and elite-economist tribalism in the mix.) They are taking something that has been understood as a neutral, objective market outcome and reframing it as a moral and political question. This is, in Keynes’ terms, a question about the line between the Agenda and the Non-Agenda of political debates; and these are often more acrimonious than disputes where the legitimacy of the question itself is accepted by everyone, however much they may disagree on the answer.

By the same token, I think this line-shifting is a central contribution of the profiteering work. The 2022-23 inflation seems on its way to coming to an end on its own as supply disruptions gradually revolve themselves, just as (albeit more slowly than) Team Transitory always predicted. But even if the aggregate price level is behaving itself, rising prices can remain burdensome and economically costly in all kinds of areas (as can ruinous competition and underinvestment in others). Prices will remain an important political question, even if inflation is not.

My neighbor Stephanie Luce, who spent many years working in the Living Wage movement, often points out that the direct impact of those measures was in general quite small. But that does not mean that all the hard work and organizing that went into them was wasted. A more important contribution, she argues, is that they establish a moral vision and language around wages. Beyond their direct effects, living wage campaigns help shift discussions of wage-setting from economic criteria to questions of fairness and justice. In the same way, establishing price setting as a legitimate part of the political agenda is a step forward that will have lasting value even after the current bout of inflation is long over.

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