The Profit Paradox: Applied Case of the Static Thinking Fallacy
The latest book I read was ‘The profit paradox’, an academic work that explains in clear terms some of the contemporary issues of our economies. I do, however, have some misgivings about this books that I find to be in line with my earlier view on static thinking.
Eeckhout argues that many of the problems we face today stem from the rise of market power: “moats” being build around companies that stifle competition and result in lower and stagnating wages, higher prices and so on. While a lot of these outcomes do reflect the consequences of market power, too many of the arguments feel hand-picked and insufficiently questioned.
Static View of Innovation
A representative example of what I’m alluding to is the invocation of Moore’s law (chapter 8) to suggest that technological progress leads to a cheaper cost of producing goods, and in competitive markets, also prices. Moore’s law is the famous example where the number of transistors fitting on an integrated circuit doubles about every two years, signifying the extreme progress being made in computing.
In the book this law functions as if technological innovation is exogenous and guaranteed. In short: progress is taken as a given. It is something that just exists and has a life of its own in the 21st century and requires no particular incentive structure or strategic investment. There seems to be this underlying assumption that no one has their hands on the wheel, and still this incredible innovation is brought to us.
And this could perhaps be the case under the logic of Adam Smith’s invisible hand, where self interest (incentive) lies at the basis of progress. And here is where the book’s static thinking becomes problematic. By proposing regulatory solutions that ignore the different incentive structures of government institutions and firms, it risks undermining the very invisible hand logic it implicitly relies on. With Moore’s law, it is implied that if there wasn’t market power, this law would lead to reduced costs and lower prices, but the whole reason this law exists is due the market power creating excess resources that are spent on R&D and other intangibles.
If firms operated in textbook perfect competitive equilibrium (price=marginal costs) then there would be no excess resources to spend on risky or long term investments. Schumpeter already touched upon this, saying “Monopoly profits are the price society pays for innovation” and while I don’t think it to be this clear cut, The Profit Paradox provides little nuance on the dynamic relationship between market power and innovation, and even less on how differing incentives shape these outcomes.
Static thinking in market interpretation
Eeckhout refers throughout the book to the example where Apple would sell a lot more iPhones, and hence make a lot more money, if they were to sell them at $400 instead of the current $1,200. And while this is correct according to the laws of supply and demand, pricing is a lot more nuanced than this reasoning suggests. If Apple would sell iPhones for 400 dollars, they’d lose the majority of their brand value, being that of sleek and premium design. As a result they would sell less iPhones and lose the excess resources that their market power provides to employ in AI research and improvements for future iPhones. There’s definitely a critique to be made about the fact that this isn’t done and that the new iPhone is practically a copy of the prior one, but suggesting market power leads to irrational price setting is far too simplistic.
There’s actually a name for the type of goods where higher price leads to higher demand, namely the Veblen effect. And in my personal view it’s not a completely unfair idea that heavy investment into brand value (intangibles) through excess resources (stemming from market power) lies at the basis of this phenomenon. This isn’t necessarily a disservice to customers, however, as I’d regard status items something a lot of people naturally crave. Just as the punk kids in school wore Iron Maiden shirts or the goths wore spikes and black clothing, there’s a subgroup of the population that demands overpriced goods.
A connection could even be made to the paradox of choice, which states that having an abundance of options often leads to less optimal decision making and less satisfaction with the eventual choice one makes.
In a saturated market with numerous options for smartphones, all having very similar features and no single competitor creating market power through differentiation or cost leadership, the customer will likely not choose the phone most adapted to their needs. Instead, through market power and brand value, this downside of choice abundance is reduced as there’s clear definition of simplicity and quality, as differentiated from competitors. As such it isn’t even just the superficial reason of using this overpriced good as a ticket to perceived social status, the high price serves as a filter that allows consumers to identify quality and reduce decision fatigue. Companies know this and clearly price this into their products.
Where the book succeeds
In other respects I do find a lot of value in this book. It shows how increased market power throughout industries leads to distorted prices and wages. It shows statistically how this has evolved over the past decades and provides good references and explanations on complex topics. Throughout all sectors, we see markups (price minus cost of goods) of the top firms increasing, while remaining the same or lower for the majority of firms. This is felt everywhere, from tire makers to bakeries, with results rippling through society. A lot of people are worse off as a byproduct, for instance when looking at the United States and their Opioid epidemic that is plausibly a direct result from misleading communication and lobbying from Purdue Pharma (Sackler family). This crisis is then further reinforced by the high prices these firms with little competition face leading to cheap illicit versions making the rounds, such as Fentanyl for OxyContin.
Nevertheless, I would say it’s crucial to distinguish between types of market power behavior. Some are extractive (exploitative) such as the telecom pricing example Eeckhout outlines well. On the other hand there’s productive behavior as well, such as Tesla having brand value and intangible assets allowing them to make the strategic yet risky decision to make their algorithms open source. This has the result of the industry as a whole accelerating its innovation and not only bring new resources to work on contemporary problems, but reduce the possible business risk of being so far into the first mover advantage that consumers’ alienation makes it a first mover disadvantage. Similarly, open-source contribution in AI by Google and Meta have had system wide effects while adding the additional competitive advantage of cheap brand value enhancements. These cases show how market power can fund forms of innovation and coordination that pure competitions fails to generate.
Static view of regulation
Where I think the author misses the boat completely is in providing purely static regulatory propositions. While treating innovation as a given, Eeckhout proposes solutions: stronger antitrust enforcement; reversing the burden of proof in M&A (firms must pre-prove synergies ex-ante); anonymized open access to data instead of algorithms; and mandated interoperability, where firms are allowed to use other’s infrastructure against a fee set by the regulator, thus allowing newcomers lower barriers to entry.
In a nutshell, what these measures entail is that government gets a lot more control over business. This risks slowing the very engines of progress it aims to protect. By requiring companies to prove synergy, companies have no incentive to merge given the lost time and resources in trying to convince the bureaucracy of merit that that bureaucracy by its very nature cannot fully grasp in advance.
It’s not just presumptuous to treat innovation as a constant, it’s also dangerous to empower institutions with very different incentive structures to manage sectors that drive most GDP. From the development of my own personal view on business, I’ve come to regard it as a competitive battlefield where each party tries to make products no one else thought of or making them in a way no one else could (Michael Porter). It’s a place where people still waged war but with their minds, where survival wasn’t to be interpreted in the literal but is in the intellectual sense. By considering competition statically, the drive to win the competition and outsell rivals is taken completely out of the equation. If, as a result of competition being captured statically, there is nothing to be won and competitors know that participation is the only token of merit, the incentive system devolves into something else entirely.
At its heart that system becomes a Sisyphean tale, where people must find meaning in the participation itself and cannot consider either the reward of succeeding nor the future that might be built upon accumulated success. The incentive of this system won’t promote creating better (more novel) or more cost effective products, but in its place put incentives that make the journey of Sisyphus must comfortable and lucrative in a static sense. This in turn denounces meritocracy in terms of goal orientation, but put in its place a meritocracy of the social dimension, leading to nepotism in the worst case.
I’m sure we all agree government and regulators have the primary goal of protecting the customer and ensuring maximal welfare. Here as well one should consider the static and dynamic natures. Protecting consumers statically equates to considering them either ‘better off’ or ‘worse off’. On the other hand, people are very complex and there are multiple dimensions to each of our lives, so quite easily one can sense that having us be better off in one area might leads to being worse off in another area, not because of ill-will, but it’s inconceivable that anyone can analyze and map all the consequences from proposed measures in such detail such as to preserve individual welfare in full. While it’s the primary goal of government to protect and ensure maximal welfare, the incentive structure of a regulator is contrary to classic economical view on how welfare is preserved. So it will be the natural inclination of regulators to slow down business so as to capture it statically and then optimize that snapshot.
Dynamic alternative
Such is the system Adam Smith describes with his invisible hand. People who are driven by self interest will create welfare for others without this being their explicit goal. When starting a company, the rational purpose should be to become a monopoly, set prices the way you wish, dominate the market and have excess profits you could invest as you see fit. This is the perfect form of success. Whether this is best for society in the long run? Likely not, as the cost of this situation is highest for the consumer, who pays more than they otherwise would. That is the static way of looking at it.
What Adam Smith describes, however, is at its heart a case of dynamic thinking. A good example is that of Standard Oil of New Jersey, the conglomerate John D. Rockefeller founded by practices that are commonly referred to as the Cleveland massacre. He would make deals with the railroads to have his oil shipped at low prices, making it possible for him to sell way more and have more income, and then go to competition and explain to them that he can do it so much cheaper, basically undercutting them, and offer to take them over. Once takeover is finalized, economies of scale grew even larger, and a cycle continued until Standard Oil owned the market. Such practices are now illegal, and probably for the better. However, if we look at it from a theoretical point, what if these practices weren’t illegal?
This is what leads me to a possible dynamic case: The transformation of the oil industry because of Rockefeller’s monopolization went from very rudimentary to much safer practices while also enabling a very high innovation rate (enabling less waste and better applications). What if you’d allow period’s of such competition, and once a final monopoly is established, a single intervention is made to repeat that precious process of competition that leads to innovation? Kind of like the trust busting attempts by Theodore Roosevelt but implemented differently so that actual competition ensues, taking into consideration incentives as a first priority. This is then a case based breakup, where all the incentives are considered and the course of action leading to genuine increased competition is strategically stipulated.
This must all occur in complete secrecy, however, for the moment information is leaked of a target breakup, the incentives for everyone adjust. Sure, here again we can reason about the assumption of staticness, where once one such case has presented itself, all companies in such situations would adjust their composition so that they don’t fall within target range. Here secrecy is the important guide for the recipe to work. No clear idea must be shaped by anyone about how the selection and practice of this authority works, such that it retains a dynamic nature and large companies that have won their competition must remain on their toes such that fear drives them towards genuine value creation instead of extortion practices.
By doing it in such a way, trust busting on a case-related basis, without normative rules prescribing what companies would or wouldn’t be targeted, the market can remain unshackled yet isn’t so restricted as to have gotten a changed incentive structure.
Reflection
This book provides great food for thought. My main point is that it treats innovation as a background constant, like gravity. I’m not arguing that market power is always good or that regulation is always bad. My point is that innovation often depends on the space and resources that market power provides. When a firm has a moat, it can afford to take risks, think long-term, and fund projects that don’t pay off right away. When regulation shifts control to institutions with very different incentives than firms, the conditions that make innovation possible dissipate. Therefore, if you don’t account for how incentives drive behavior you risk protecting the present at the cost of the future.