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In 2015 I wrote about whether tech company profits were too high. I explained that the since about 90 percent of all tech startups either lose money or at best break even, the high profits of the few are needed to keep investors funding the sector.
However, critics of America’s tech giants (see here and here) continue to cite high corporate profits as one reason for breaking up Big Tech. And their views are gaining traction with some politicians and pundits.
So I’ll try again and explain the role of profits in providing dynamism in tech, hoping (perhaps foolishly) that logic and evidence matter in this debate.
Facebook’s share prices are seen inside the NASDAQ Marketsite in New York on May 18, 2012 – via REUTERS
Background: What are monopoly profits?
People use the term “monopoly profit” to describe tech profits. In economics, the term “monopoly” means that for a specific product, there are no close substitutes and there is only one supplier. Unfortunately, “monopoly” is being used in the current discourse to describe a firm with a large market share. For simplicity, and since “monopoly” in “monopoly profit” is an adjective rather than a noun, I’ll use “monopoly” in the popular sense for purposes of this blog.
Turning to “monopoly profit,” in economics we think of it as a risk-adjusted return that a firm receives that is greater than what is needed to keep investors providing capital. As I explain in the third section of this blog, that is almost appropriate. Unfortunately, economists illustrate this idea with simplified graphs and stories that give the illusion of a static world.
In reality, economics is all about the flow of resources. So an economist would not (or at least should not) look at a firm’s profits in, for example, 2018 and conjecture whether they are too high or low. The economic question is whether the capital provided in 2018 can be expected over its lifetime to provide a return that is adequate (or more than adequate) to cover investors’ next-best use of the money.
Must a successful firm receive profits that look monopolistic?
Yes. The profits aren’t really monopolistic. They just look that way because non-economists (and some economists) take a static view of a dynamic world.
Non-economists look at profits as expressed in accounting income statements, which show differences between revenue, operating and financing costs, and depreciation for a particular period of time. So when people look at Facebook’s income statements, for example, they see impressive operating profits and conclude that these represent monopoly profits because, well, who wouldn’t be willing to invest money that gives that high of a return?
But that view is wrong because it is static. Economics is about flow. Consider Uber’s income statements for the past few years, which show losses. If it is true that Facebook is receiving monopoly profits, then it must also be true that Uber has power over investors and is using that power to steal their money.
Of course Uber doesn’t have that kind of power. Uber’s investors are taking the dynamic view and enduring negative operating profits for some period of time in anticipation of receiving positive operating profits in the future that more than compensate for the losses.
So for investors to be willing to fund a start-up like Uber, they must believe that the company will perform more like Facebook in the future. So focusing just on the profitable phase gives a false impression.
Must there be superstar firms that significantly outperform everyone else, even over time?
Yes. Understanding this requires a broader view.
When investors decide whether to put money into tech, they consider whether a tech investment portfolio will provide a risk-adjusted return that is at least as good as the next-best alternative. So there is a profit floor for the sector.
But investors know that they cannot perfectly pick winners and losers. Some firms will lose their investors’ money and deny them the profits they could have received in another sector. So for tech to attract investors, there must be firms whose profits at least compensate for the other firms’ losses. Figure 1 illustrates this.
Figure 1. Expected profits and losses from pool of firms that investors are willing to fund, but that cannot identify ex ante which will be profitable over its lifetime beginning at the current time period. (Adapted from Mark A. Jamison, “Applying Antitrust in Digital Markets,” forthcoming.)
In Figure 1, the vertical axis is dollars of expected profits or losses over time from the investors’ perspective and the horizontal axis is the performance percentile of firms. The bottom 90 percent of firms are those that attract investors, but ultimately lose money. Their aggregate losses are the area of the red triangle. The top 10 percent are those that make money and the black triangle represents their profits.
(To keep Figure 1 simple, I assume that individual firm profits change linearly moving from left to right on the horizontal axis, until reaching the marginal firm — at the 90th percentile, per my 2015 blog — and then proceeding on a different linear trajectory for the remaining 10 percent of firms.)
What does Figure 1 show? For the sector to attract capital, the expected profits for a biggest winner must be 9 times the expected losses of a biggest loser. Winners not only must make up for their start-up costs, they must make up for the start-ups that ultimately fail.
What are the implications for antitrust?
The implications for antitrust can be significant. Antitrust policies that reflect “anti-bigness” will drive capital from the sector, making it harder for startups to get funding. This hurts competition and consumers. Anti-merger policies also decrease the number of startups because the policies decrease profit prospects for both the lower end of the industry and the higher end.
Also, current practices for estimating the effect of antitrust actions on consumers overestimate the benefits of regulatory action when the actions decrease investment incentives for the sector. Current practices need an estimate of the consumer impact of fewer startups and products.
Advocates for greater antitrust action are right that digitization of markets changes a lot in antitrust. But they have the direction wrong: We need fewer traditional antitrust actions, not more.
Advocates of antitrust action against Big Tech ignore the fact that large profits are required to entice investors to take risks. “Anti-bigness” policy will drive capital away, hurting competition and consumers.
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