Economic Profit and Barriers to Entry

This is a bit more complex than some of the topics I’ve talked about here, not because the concepts are difficult, but because it brings together several seemingly disparate ideas.

First there’s “Economic Profit.” As defined in my Introduction to Microeconomics course it’s profit where you include not only the expenditure, but also the “opportunity cost”.  Allow me to expand on that a bit.  Opportunity cost is counting as a cost whatever would be the most valuable use for a given resource.  If the resource is money, it’s the “opportunity” you lose by spending it on one thing rather than another.  This is a little complicated, so let me illustrate with an example if you invest $100 in an investment that has a 5% rate of return your opportunity cost is the present value of the $100 plus what it would gain in interest.  First let me briefly address the idea of present value.  Present value simply means that some resource today is more valuable than having that same resource in the future.  See my telling of Bastiat’s The Plane for an illustration of how that works.  For instance, if we presume an interest rate for calculating PV of 3% (including both inflation and the loss of the use of the money in the interim) and invested that $100 in something offering 5% (compounded annually) for 10 years, the future value at the end of the 10 years would be $162.89 and the Present Value would be $121.21 (inflation eats up about $40 of that future value).  This assumes that there is no risk in the investment and that you can rely on inflation to be stable.  Investment risk and uncertainty in inflation would tend to reduce the present value to reflect the chance of lesser returns or greater inflation cutting into the value of that money.

So, if that 5% investment is the best you could do with that money the “opportunity cost” of using that $100 is $121.21 rendered as present value.  Whatever you use that $100 for doesn’t just cost you $100 (although it’s convenient to think of it that way).  It costs you the $121 of present value you could have had if you’d invested it.

With that idea in mind, an economic profit is one where the return is greater than the opportunity cost of the invested resources.  Basically, it has to return more (after adjusting for risk and uncertainty) than anything else that could be done with those resources.

Generally speaking and left to themselves, investments won’t be economically profitable, at least not for long.  If, for instance, you had a business that sells widgets at higher price, with a lower cost to produce, than other people, competitors will see that and say “I’m gonna get me some of that!” and start producing those widgets too.  This will increase the supply and tend to drive the costs down you’re back in line with everything else of similar risk.  This doesn’t happen in an instant, of course, so a business can be economically profitable for a while before others grab on.

Don’t confuse economically profitable with “profit” as a business considers it.  Balance sheets don’t generally show opportunity cost.  A business can be making money, making a profit as its investors and the IRS sees it, but only if it’s making a higher profit than businesses of similar risk is it economically profitable.

As I said, left to themselves businesses and investments won’t generally be economically profitable for long.  But there is something that can make them so.  That’s “Barriers to entry.” What prevents a business from becoming economically profitable is competition, others being able to see those profits and coming in, increasing supply until the market brings the profitability down to everyone else.  If you can prevent others from doing that, then you can continue being economically profitable.

One barrier to entry is if your business requires a talent or skill that’s in short supply.   Sports franchises are an example of this.   You can’t just pick up 53 people off the street and throw them (in groups of 11) at an NFL team.  Sports franchises aren’t the only example.

The big one, however, is government regulation and licensing.  If you can get the people who are allowed to use actual force to stop others from competing with you, then you’ve got one massive barrier to entry.  It may be a relatively porous barrier (pay a modest fee, sign your name, and get your license).  It may be a solid one (only a handful, or even a single, government chosen business need apply).  Those barriers can include such things as requiring long and expensive training before being allowed to work in the field (Doctors, Lawyers, Barbers).  Anything the government puts in the way that makes it harder for someone to enter a field is a barrier to entry.  And all barriers to entry, all licensing and regulation by government, act to stifle competition, limiting supply and therefore keeping prices high.  Attempts to alleviate the price problem by further regulation merely aggravates the shortages.  (Barriers to entry reduce supply.  Price controls reduce supply.  Both is a double whammy.)

This is why you’ll often find the strongest supporters of government regulation and licensing among those already in the field.  They can get the government to restrict future competition that might cut into their business?  What’s not to love (if you’re in that field wanting to make money.) It may not even be deliberate.  They may honestly believe their rhetoric about safety and protecting the public and the consumers.  But the incentive is there and will have an effect.

This is not to say that the regulation and/or licensing is always a bad thing on balance.  But all too often people proposing regulation neglect to consider the economic effects of that regulation.  One cannot ignore those economic effects however justified one may believe the regulation is on other grounds.  And since one of the effects is reduction of supply of the regulated good, the question then becomes if you’re really trying to protect people, ensure “exceptional quality”, or whatever legitimate reason you have for the regulation, the question becomes, what are the people who aren’t able to obtain the good because of the reduced supply supposed to do?  Just do without?  Are they really better off than if, say, some lower quality were available under less strict regulations?  Is “nothing” really the better option for those people?

These are questions everyone needs to ask themselves whenever new barriers to entry are proposed.  The whole package, not just the heartfelt rhetoric.

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