The Common Pool of Transitional Profits

0:00Let me, first of all, before I get right into the paper, a few words of introduction. Many of you might have been here this morning. I talked about my book, Producing Prosperity, and suggested that there is a research program that's suggested by that. And the paper that I'm presenting today is a kind of an outgrowth of thinking a little bit further about the ideas that are in the book. And let me make a couple of other comments. I know a lot of the people who are listening are economists, but just to get familiar with a couple of ideas, the paper is titled, The Common Pool of Transitional Profits, and economists will be familiar with the idea of a common pool, but just let me throw out the idea to you really quickly for people who might not be.

0:51There are common pool resources, and a good example of that might be fish in the sea, There are scarce and valuable resources but nobody has ownership over them and as a result there is an incentive for overuse that everybody wants to get out there and get their fish before other people and so common pool resources tend to be overused. That's what common pool refers to in the title of the paper. And I'll also mention that in the general equilibrium framework that's so popular in economics today, the economy is always in equilibrium in that general equilibrium framework and there aren't any transitional profits in general equilibrium. I don't mention that specifically in the paper because I think for economists who read the paper, they'll see that idea, but I'll just mention it by way of starting.

1:42Changes in market conditions or innovative activities of firms can result in firms earning above normal profits for a period of time. Those profits provide an incentive for other firms to enter that market, or for existing firms to expand their activities, the profitable market to try to capture some of that economic profit. The resulting entry into that profitable market competes those above normal profits away. Those temporary above normal profits Profits that are competed away by entry are transitional profits.

2:39They are a common pool because like fish in the ocean or grass in a common grazing ground, the existence of those transitional profits entices firms to enter that industry to share in those profits. And the result of that entry is that the profits are used up as they are competed away. The entry into a market that has transitional profits causes them to disappear, just as overgrazing a common grazing ground causes grass to disappear, or overfishing a common fishing area causes fish to disappear. So they will be no longer available to any of the firms trying to exploit them. The conventional wisdom on common pool resources is that because there are no clear property property rights to the resource, the resource is inefficiently over-exploited as people rush to claim a share before others.

3:33Transitional profits fit at least part of this characterization because there are no clear property rights over transitional profits, causing firms to rush to claim a share before the transitional profits are competed away and available to nobody. Is this inefficient? There are two views on this question. To frame the issue, consider which of the following two statements is true. First, economic profits are evidence that resources are being allocated inefficiently. Or second, economic profits are necessary for the efficient allocation of economic resources. The first statement follows from the neoclassical framework in which the optimal allocation of Resources is produced by a competitive equilibrium in which all firms are earning normal profits.

4:27In that framework, profit is a sign that either markets are not in equilibrium or firms are exercising monopoly power, either of which results in an inefficiency. The second statement follows from a dynamic framework in which the efficient allocation of Resources generates continual economic progress, and profit gives entrepreneurs the incentive to introduce innovations into the market. In the first view, profits create inefficiency, and entrepreneurs act to eliminate the inefficiency and move the economy toward a Pareto-optimal competitive equilibrium. In the second view, profits are the result of innovative activity and an indicator that resources are being allocated more efficiently than before.

5:17So that's the introductory section of my paper. And then I go on to talk about the relationship between profits and welfare. And let me give you an example to think through this. Back in the 1960s, IBM had an overwhelmingly huge share of the computer market, so much so that the Justice Department brought a lawsuit against IBM under antitrust laws for monopolizing the industry because of their huge market share and also their huge profit. IBM was a very profitable company.

6:04or those profits that IBM was making, a sign of efficiency or a sign of inefficiency? They assign of welfare loss or welfare gain? Well, in the static model that appears in your typical economics textbook, those profits are a sign of inefficiency because they result from monopoly power that the firm has. We're just looking at things in a static framework and those monopoly profits are inefficient because firms restrict their output in order to raise their prices, creating that inefficiency.

6:51But if we think about this in a dynamic framework, those profits don't look so bad. And I picked the case of IBM because it's an interesting case and it's an example of how economic theory can lead government policy astray, perhaps. We can take either side on this, but let me take the other side. That when IBM, actually the big innovation, IBM introduced their 360 mainframe computer in the 1960s and it was the first multitasking operating system for a computer. It used to be before the IBM 360, you'd run programs sequentially and you'd write code to be run on the computer and after one program ran then you could run another and then you could run another and the IBM 360 operating system you wrote the programs to run on the operating system not the computer and then the operating system would allocate computer time which we just take for granted now you know our computers run lots of programs but back at the time there was even a question about whether this was possible to do and it was a hugely expensive undertaking for IBM but the result is they came out with a

7:56And so, as a result, people were willing to pay more to get an IBM computer than to buy from the other competing computer manufacturers. So, if we look at it that way, prior to the introduction of the IBM 360, we have certain economic conditions. Then the IBM 360 computer comes along, IBM gets all these profits, those profits show the willingness of buyers to pay more to get the better product that IBM had brought to market. Those profits are an indicator of the welfare gain that IBM is bringing to the market by bringing a product that's worth more to consumers than the products that were available before.

8:50So there are two ways to look at that profit. The traditional neoclassical way of looking at it, there's a monopoly loss, it's a welfare loss, but if you think about it from the standpoint of economic progress, those profits are an indicator of the gain that consumers receive by being able to purchase a product that has characteristics that other products don't give. It's the extra value, those profits are an indicator of the extra value that IBM brought to them. I'm deliberately not saying they're a measure of the profit and a measure of the welfare gain. I'll talk about that a little bit later. So, flipping ahead in the paper here.

9:35So, I skipped a couple of sections here in the paper and I have another section here explaining again in more detail that profits are a common pool. And again, let me use another example, a more recent example, but sort of from the same industry, that when Apple introduced the iPhone in 2007, it was a revolutionary new product in a sense. I mean, there were already cell phones and so forth. But if you recall, it's not that many years back, so we can probably remember when Apple I'll introduce the iPhone, that the experts in the market said, well, it's kind of an interesting device, but, you know, for real users of phones, they want to have a physical keypad, you know, so the touch screen on the Apple, I mean, that's kind of an interesting gimmick, but not really what people want in a phone, but of course, we now know after a few years experience, that turns out not to be true, and I don't know, you know, recently

10:42in the news you notice that Blackberry that used to so dominate that market and they had the phones with the keypads, Blackberry just came out with their touchscreen phone to compete. But so what happened, Apple comes out with this product and it's a great example of entrepreneurship I mean because here's a new product that comes into market and the entrepreneur can always speculate you know I think this is going to be a really good product but you can never never know. Because entrepreneurship means you're doing something that hasn't been done before, right? So you can never know, you can have all the good guesses in the world, but there's never any actual evidence because the entrepreneur is bringing forward something to market that nobody's seen before, nobody's done before. Okay, so the iPhone comes out and of course we know it was hugely, hugely profitable and now some years afterwards we see that transitional, that common pool of transitional profits being

12:07In other words, those profits are competed away, just like, you know, when more fishermen come to the common fishing ground, the fish are depleted, the common pool of transitional profits is dissipated. So, let's see, I'm skipping ahead some other sections in here, and I do have a section here on concepts of equilibrium and progress that I'll skip over, partly I talked about some of that material this morning. So, okay, so the common pool of transitional profits is dissipated. Where do these profits go? They turn into consumer surplus. Firms introduce new products, the profit goes to the firm, entry occurs, prices are competed down and the benefit that initially goes to the sellers, to the producers, increasingly over time as the common pool of transitional profits is dissipated, increasingly the benefit that transitional profit is is transferred from profit into consumer surplus a benefit that goes to consumers I mean again if you go back to the the iPhone example as profits are competed away does that mean that the product isn't producing the same benefits that it was before actually it's producing more benefits because now there are more producers more sellers prices are being competed down so over time as those transitional profits

13:42When profits are dissipated, they turn from profits to the producers into consumer surplus benefits for consumers. And so you look at how well off we all are today with our iPhones and our flat-screen TVs and our air-conditioned automobiles and so forth and so on. And why are we that well off? Why do we have all these benefits? It's because for decades, maybe centuries in the past, these transitional profits that entrepreneurs earned temporarily have been dissipated into consumer surplus. We're the beneficiaries of those things and we get that welfare gain. So, is there some optimal rate of depletion of these transitional profits?

14:31Transitional Profits, and let's think about a couple of extremes here. At one extreme, these profits could be immediately dissipated, immediately competed away. So as soon as they appear on the market, competitors rush into entry and they're immediately dissipated and competed away. And really, that's the general equilibrium framework where markets are always in general equilibrium. Now, that can't be optimal because those transitional profits, that's what gives the entrepreneurs It's risky to introduce a new product, and if there's no return to doing it, no incentive to do it, economic progress will stop. You have to have those transitional profits in order for the economic progress to occur.

15:19So we take that extreme, and no, I don't think that's optimal. Let's take the other extreme. Let's say they never dissipate. so a firm introduces a new product the iPhone comes out and Apple keeps those profits forever for you know one reason or other competitors don't enter or whatever that's a traditional monopoly model well we know that's not optimal either I mean what happens is over time those benefits dissipate and increase everybody's well-being so so you know is there some optimal rate of depletion of those transitional profits I think the answer to that is yes and it's not Not instantaneously, like in the general equilibrium framework, and it's not that they last forever, but there's some optimal rate of depletion.

16:04Okay, so if that's the case, can we figure that out? What's the optimal rate of depletion? Well, first of all, we need to recognize that these transitional profits, what encourages the innovation, what causes the welfare gain to occur, is the anticipation of future profit. So it's really, it's the anticipated future profits that create the welfare gain. Once the profits are realized, the welfare gain is already in the past. It's like getting a trophy at the end of the race, right? I mean, the work comes first, you know, you win the race, then you get the trophy, okay? So the firm is anticipating, hey, there are profits from this, and so it's those anticipated profits that create the welfare gain, right? And once the profits come in, the welfare gain has already been realized. So when you look at it that way, and when you realize that really there's no certainty, I mean, you can't be sure that something's even going to be Profitable. I mean we focus on successful entrepreneurs like Steve Jobs and Henry

17:14Ford and and so forth but you know for all of them there are a lot of other entrepreneurs who try something that doesn't work out so well. So I would suggest that it you know we can't calculate an optimal rate of depletion. Now and I'm running a little short on time but I have a couple other points I hate that sign. So let me talk about government policy towards transitional profits. Because it's interesting when you look, how does government treat these things? What kind of public policies do we have about them? Actually, we kind of go on two sides. On the one hand, we have a bunch of policies that say, these transitional profits are too big or they last too long, we need to get rid of them.

18:00And I trust law. and Trust Law, right, so it would break up the monopolies and whatever like IBM, right, the Justice Department sues them and says, no, it's too much profit. On the other hand, we have a bunch of other policies that says the pool of transitional profits doesn't last long enough, so we have patent law and copyright law and things that cause these transitional profits to persist. When you look at public policy toward transitional profits, public policy tends to go both ways. We have some public policies that solidify those transitional profits, like patent copyright law. We have others like antitrust law that try to get rid of those transitional profits. But the key thing to see is that it's those transitional profits that create the incentive for entrepreneurship, that create innovation, that's what leads to economic progress.

18:53So I think Peter is about ready to pull me off the stage here, so anyways, thank you very much for your attention.