WEBVTT NOTE The Common Pool of Transitional Profits 1 00:00:00.000 --> 00:00:06.700 Let me, first of all, before I get right into the paper, a few words of introduction. 2 00:00:06.700 --> 00:00:08.700 Many of you might have been here this morning. 3 00:00:08.700 --> 00:00:17.400 I talked about my book, Producing Prosperity, and suggested that there is a research program that's suggested by that. 4 00:00:17.400 --> 00:00:26.700 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. 5 00:00:26.700 --> 00:00:28.900 And let me make a couple of other comments. 6 00:00:28.900 --> 00:00:39.520 I know a lot of the people who are listening are economists, but just to get familiar with 7 00:00:39.520 --> 00:00:44.680 a couple of ideas, the paper is titled, The Common Pool of Transitional Profits, and economists 8 00:00:44.680 --> 00:00:48.820 will be familiar with the idea of a common pool, but just let me throw out the idea to 9 00:00:48.820 --> 00:00:51.840 you really quickly for people who might not be. 10 00:00:51.840 --> 00:00:56.320 There are common pool resources, and a good example of that might be fish in the sea, 11 00:00:56.320 --> 00:01:10.320 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. 12 00:01:10.320 --> 00:01:15.320 That's what common pool refers to in the title of the paper. 13 00:01:15.320 --> 00:01:32.320 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. 14 00:01:32.320 --> 00:01:42.320 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. 15 00:01:42.320 --> 00:02:07.320 Changes in market conditions or innovative activities of firms can result in firms earning 16 00:02:07.320 --> 00:02:12.980 above normal profits for a period of time. Those profits provide an incentive for other 17 00:02:12.980 --> 00:02:18.720 firms to enter that market, or for existing firms to expand their activities, the profitable 18 00:02:18.720 --> 00:02:26.840 market to try to capture some of that economic profit. The resulting entry into that profitable 19 00:02:26.840 --> 00:02:33.840 market competes those above normal profits away. Those temporary above normal profits 20 00:02:33.840 --> 00:02:39.680 Profits that are competed away by entry are transitional profits. 21 00:02:39.680 --> 00:02:44.880 They are a common pool because like fish in the ocean or grass in a common grazing ground, 22 00:02:44.880 --> 00:02:50.840 the existence of those transitional profits entices firms to enter that industry to share 23 00:02:50.840 --> 00:02:52.560 in those profits. 24 00:02:52.560 --> 00:02:58.560 And the result of that entry is that the profits are used up as they are competed away. 25 00:02:58.560 --> 00:03:04.360 The entry into a market that has transitional profits causes them to disappear, just as 26 00:03:04.360 --> 00:03:09.640 overgrazing a common grazing ground causes grass to disappear, or overfishing a common 27 00:03:09.640 --> 00:03:12.880 fishing area causes fish to disappear. 28 00:03:12.880 --> 00:03:19.900 So they will be no longer available to any of the firms trying to exploit them. 29 00:03:19.900 --> 00:03:24.600 The conventional wisdom on common pool resources is that because there are no clear property 30 00:03:24.600 --> 00:03:29.600 property rights to the resource, the resource is inefficiently over-exploited as people 31 00:03:29.600 --> 00:03:33.560 rush to claim a share before others. 32 00:03:33.560 --> 00:03:37.560 Transitional profits fit at least part of this characterization because there are no 33 00:03:37.560 --> 00:03:43.600 clear property rights over transitional profits, causing firms to rush to claim a share before 34 00:03:43.600 --> 00:03:48.060 the transitional profits are competed away and available to nobody. 35 00:03:48.060 --> 00:03:50.340 Is this inefficient? 36 00:03:50.340 --> 00:03:53.860 There are two views on this question. 37 00:03:53.860 --> 00:03:59.860 To frame the issue, consider which of the following two statements is true. 38 00:03:59.860 --> 00:04:07.360 First, economic profits are evidence that resources are being allocated inefficiently. 39 00:04:07.360 --> 00:04:15.520 Or second, economic profits are necessary for the efficient allocation of economic resources. 40 00:04:15.520 --> 00:04:20.480 The first statement follows from the neoclassical framework in which the optimal allocation 41 00:04:20.480 --> 00:04:27.400 of Resources is produced by a competitive equilibrium in which all firms are earning normal profits. 42 00:04:27.400 --> 00:04:33.800 In that framework, profit is a sign that either markets are not in equilibrium or firms are 43 00:04:33.800 --> 00:04:39.620 exercising monopoly power, either of which results in an inefficiency. 44 00:04:39.620 --> 00:04:44.300 The second statement follows from a dynamic framework in which the efficient allocation 45 00:04:44.300 --> 00:04:50.260 of Resources generates continual economic progress, and profit gives entrepreneurs the 46 00:04:50.260 --> 00:04:54.660 incentive to introduce innovations into the market. 47 00:04:54.660 --> 00:05:01.620 In the first view, profits create inefficiency, and entrepreneurs act to eliminate the inefficiency 48 00:05:01.620 --> 00:05:06.020 and move the economy toward a Pareto-optimal competitive equilibrium. 49 00:05:06.020 --> 00:05:11.540 In the second view, profits are the result of innovative activity and an indicator that 50 00:05:11.540 --> 00:05:17.220 resources are being allocated more efficiently than before. 51 00:05:17.220 --> 00:05:22.900 So that's the introductory section of my paper. 52 00:05:22.900 --> 00:05:26.820 And then I go on to talk about the relationship 53 00:05:26.820 --> 00:05:30.980 between profits and welfare. 54 00:05:30.980 --> 00:05:37.700 And let me give you an example to think through this. 55 00:05:37.700 --> 00:05:43.260 Back in the 1960s, IBM had an overwhelmingly huge share 56 00:05:43.260 --> 00:05:48.580 of the computer market, so much so that the Justice Department 57 00:05:48.580 --> 00:05:52.260 brought a lawsuit against IBM under antitrust laws 58 00:05:52.260 --> 00:05:54.660 for monopolizing the industry because 59 00:05:54.660 --> 00:05:59.900 of their huge market share and also their huge profit. 60 00:05:59.900 --> 00:06:04.220 IBM was a very profitable company. 61 00:06:04.220 --> 00:06:13.740 or those profits that IBM was making, a sign of efficiency or a sign of inefficiency? 62 00:06:13.740 --> 00:06:18.140 They assign of welfare loss or welfare gain? 63 00:06:18.140 --> 00:06:25.620 Well, in the static model that appears in your typical economics textbook, 64 00:06:25.620 --> 00:06:32.820 those profits are a sign of inefficiency because they result from monopoly power 65 00:06:32.820 --> 00:06:34.700 that the firm has. 66 00:06:34.700 --> 00:06:38.380 We're just looking at things in a static framework 67 00:06:38.380 --> 00:06:41.740 and those monopoly profits are inefficient 68 00:06:41.740 --> 00:06:45.060 because firms restrict their output 69 00:06:45.060 --> 00:06:50.060 in order to raise their prices, creating that inefficiency. 70 00:06:51.220 --> 00:06:54.660 But if we think about this in a dynamic framework, 71 00:06:54.660 --> 00:06:56.540 those profits don't look so bad. 72 00:06:56.540 --> 00:06:59.980 And I picked the case of IBM because it's an interesting case 73 00:06:59.980 --> 00:07:05.980 and it's an example of how economic theory can lead government policy astray, perhaps. 74 00:07:05.980 --> 00:07:10.980 We can take either side on this, but let me take the other side. 75 00:07:10.980 --> 00:07:18.980 That when IBM, actually the big innovation, IBM introduced their 360 mainframe computer in the 1960s 76 00:07:18.980 --> 00:07:22.980 and it was the first multitasking operating system for a computer. 77 00:07:22.980 --> 00:07:26.980 It used to be before the IBM 360, you'd run programs sequentially 78 00:07:26.980 --> 00:07:56.980 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 79 00:07:56.980 --> 00:08:11.980 And so, as a result, people were willing to pay more to get an IBM computer than to buy from the other competing computer manufacturers. 80 00:08:11.980 --> 00:08:21.980 So, if we look at it that way, prior to the introduction of the IBM 360, we have certain economic conditions. 81 00:08:21.980 --> 00:08:35.980 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. 82 00:08:35.980 --> 00:08:50.980 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. 83 00:08:50.980 --> 00:09:20.980 So 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. 84 00:09:20.980 --> 00:09:24.980 I'm deliberately not saying they're a measure of the profit and a measure of the welfare gain. 85 00:09:24.980 --> 00:09:28.980 I'll talk about that a little bit later. 86 00:09:28.980 --> 00:09:35.980 So, flipping ahead in the paper here. 87 00:09:35.980 --> 00:09:41.980 So, I skipped a couple of sections here in the paper and I have another section here 88 00:09:41.980 --> 00:09:46.980 explaining again in more detail that profits are a common pool. 89 00:09:46.980 --> 00:09:52.580 And again, let me use another example, a more recent example, but sort of from the same 90 00:09:52.580 --> 00:10:04.840 industry, that when Apple introduced the iPhone in 2007, it was a revolutionary new product 91 00:10:04.840 --> 00:10:05.840 in a sense. 92 00:10:05.840 --> 00:10:08.860 I mean, there were already cell phones and so forth. 93 00:10:08.860 --> 00:10:13.600 But if you recall, it's not that many years back, so we can probably remember when Apple 94 00:10:13.600 --> 00:10:19.260 I'll introduce the iPhone, that the experts in the market said, well, it's kind of an 95 00:10:19.260 --> 00:10:26.620 interesting device, but, you know, for real users of phones, they want to have a physical 96 00:10:26.620 --> 00:10:31.280 keypad, you know, so the touch screen on the Apple, I mean, that's kind of an interesting 97 00:10:31.280 --> 00:10:37.500 gimmick, but not really what people want in a phone, but of course, we now know after 98 00:10:37.500 --> 00:10:42.200 a few years experience, that turns out not to be true, and I don't know, you know, recently 99 00:10:42.200 --> 00:10:48.480 in the news you notice that Blackberry that used to so dominate that market and they had 100 00:10:48.480 --> 00:10:55.040 the phones with the keypads, Blackberry just came out with their touchscreen phone to compete. 101 00:10:55.040 --> 00:10:59.800 But so what happened, Apple comes out with this product and it's a great example of entrepreneurship 102 00:10:59.800 --> 00:11:05.160 I mean because here's a new product that comes into market and the entrepreneur can always 103 00:11:05.160 --> 00:11:08.640 speculate you know I think this is going to be a really good product but you can never 104 00:11:08.640 --> 00:11:09.640 never know. 105 00:11:09.640 --> 00:11:13.960 Because entrepreneurship means you're doing something that hasn't been done before, right? 106 00:11:13.960 --> 00:11:17.700 So you can never know, you can have all the good guesses in the world, but there's never 107 00:11:17.700 --> 00:11:22.520 any actual evidence because the entrepreneur is bringing forward something to market that 108 00:11:22.520 --> 00:11:24.840 nobody's seen before, nobody's done before. 109 00:11:24.840 --> 00:11:30.320 Okay, so the iPhone comes out and of course we know it was hugely, hugely profitable and 110 00:11:30.320 --> 00:11:37.720 now some years afterwards we see that transitional, that common pool of transitional profits being 111 00:12:07.720 --> 00:12:23.720 In 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. 112 00:12:23.720 --> 00:12:37.720 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. 113 00:12:37.720 --> 00:12:49.720 So, okay, so the common pool of transitional profits is dissipated. Where do these profits go? They turn into consumer surplus. 114 00:12:49.720 --> 00:13:12.720 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, 115 00:13:12.720 --> 00:13:42.720 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 116 00:13:42.720 --> 00:13:52.720 When profits are dissipated, they turn from profits to the producers into consumer surplus benefits for consumers. 117 00:13:52.720 --> 00:14:01.720 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. 118 00:14:01.720 --> 00:14:05.720 And why are we that well off? Why do we have all these benefits? 119 00:14:05.720 --> 00:14:17.720 It's because for decades, maybe centuries in the past, these transitional profits that entrepreneurs earned temporarily have been dissipated into consumer surplus. 120 00:14:17.720 --> 00:14:23.720 We're the beneficiaries of those things and we get that welfare gain. 121 00:14:23.720 --> 00:14:31.720 So, is there some optimal rate of depletion of these transitional profits? 122 00:14:31.720 --> 00:14:36.460 Transitional Profits, and let's think about a couple of extremes here. 123 00:14:36.460 --> 00:14:41.960 At one extreme, these profits could be immediately dissipated, immediately competed away. 124 00:14:41.960 --> 00:14:46.880 So as soon as they appear on the market, competitors rush into entry and they're immediately dissipated 125 00:14:46.880 --> 00:14:47.880 and competed away. 126 00:14:47.880 --> 00:14:52.840 And really, that's the general equilibrium framework where markets are always in general 127 00:14:52.840 --> 00:14:53.840 equilibrium. 128 00:14:53.840 --> 00:15:01.200 Now, that can't be optimal because those transitional profits, that's what gives the entrepreneurs 129 00:15:01.200 --> 00:15:12.200 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. 130 00:15:12.200 --> 00:15:19.200 You have to have those transitional profits in order for the economic progress to occur. 131 00:15:19.200 --> 00:15:24.200 So we take that extreme, and no, I don't think that's optimal. 132 00:15:24.200 --> 00:15:27.200 Let's take the other extreme. Let's say they never dissipate. 133 00:15:27.200 --> 00:15:31.520 so a firm introduces a new product the iPhone comes out and Apple keeps those 134 00:15:31.520 --> 00:15:36.800 profits forever for you know one reason or other competitors don't enter or 135 00:15:36.800 --> 00:15:40.560 whatever that's a traditional monopoly model well we know that's not optimal 136 00:15:40.560 --> 00:15:44.760 either I mean what happens is over time those benefits dissipate and increase 137 00:15:44.760 --> 00:15:51.360 everybody's well-being so so you know is there some optimal rate of depletion of 138 00:15:51.360 --> 00:15:55.360 those transitional profits I think the answer to that is yes and it's not 139 00:15:55.360 --> 00:16:04.360 Not instantaneously, like in the general equilibrium framework, and it's not that they last forever, but there's some optimal rate of depletion. 140 00:16:04.360 --> 00:16:18.360 Okay, so if that's the case, can we figure that out? What's the optimal rate of depletion? 141 00:16:18.360 --> 00:16:24.280 Well, first of all, we need to recognize that these transitional profits, what encourages 142 00:16:24.280 --> 00:16:32.660 the innovation, what causes the welfare gain to occur, is the anticipation of future profit. 143 00:16:32.660 --> 00:16:38.360 So it's really, it's the anticipated future profits that create the welfare gain. 144 00:16:38.360 --> 00:16:41.680 Once the profits are realized, the welfare gain is already in the past. 145 00:16:41.680 --> 00:16:44.280 It's like getting a trophy at the end of the race, right? 146 00:16:44.280 --> 00:16:48.840 I mean, the work comes first, you know, you win the race, then you get the trophy, okay? 147 00:16:48.840 --> 00:16:54.280 So the firm is anticipating, hey, there are profits from this, and so it's those anticipated profits 148 00:16:54.280 --> 00:16:58.040 that create the welfare gain, right? And once the profits come in, 149 00:16:58.040 --> 00:17:05.800 the welfare gain has already been realized. So when you look at it that way, and when you realize 150 00:17:05.800 --> 00:17:09.560 that really there's no certainty, I mean, you can't be sure that something's even going to be 151 00:17:09.560 --> 00:17:14.160 Profitable. I mean we focus on successful entrepreneurs like Steve Jobs and Henry 152 00:17:14.160 --> 00:17:17.840 Ford and and so forth but you know for all of them there are a lot of other 153 00:17:17.840 --> 00:17:24.200 entrepreneurs who try something that doesn't work out so well. So I would 154 00:17:24.200 --> 00:17:32.080 suggest that it you know we can't calculate an optimal rate of depletion. 155 00:17:32.080 --> 00:17:35.600 Now and I'm running a little short on time but I have a couple other points 156 00:17:35.600 --> 00:17:37.600 I hate that sign. 157 00:17:37.600 --> 00:17:45.600 So let me talk about government policy towards transitional profits. 158 00:17:45.600 --> 00:17:48.600 Because it's interesting when you look, how does government treat these things? 159 00:17:48.600 --> 00:17:50.600 What kind of public policies do we have about them? 160 00:17:50.600 --> 00:17:52.600 Actually, we kind of go on two sides. 161 00:17:52.600 --> 00:17:56.600 On the one hand, we have a bunch of policies that say, 162 00:17:56.600 --> 00:17:59.600 these transitional profits are too big or they last too long, 163 00:17:59.600 --> 00:18:00.600 we need to get rid of them. 164 00:18:00.600 --> 00:18:01.600 And I trust law. 165 00:18:01.600 --> 00:18:09.600 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. 166 00:18:09.600 --> 00:18:23.600 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. 167 00:18:23.600 --> 00:18:29.320 When you look at public policy toward transitional profits, public policy tends to go both ways. 168 00:18:29.320 --> 00:18:36.000 We have some public policies that solidify those transitional profits, like patent copyright 169 00:18:36.000 --> 00:18:37.000 law. 170 00:18:37.000 --> 00:18:41.920 We have others like antitrust law that try to get rid of those transitional profits. 171 00:18:41.920 --> 00:18:47.460 But the key thing to see is that it's those transitional profits that create the incentive 172 00:18:47.460 --> 00:18:53.080 for entrepreneurship, that create innovation, that's what leads to economic progress. 173 00:18:53.080 --> 00:18:57.000 So I think Peter is about ready to pull me off the stage here, so anyways, thank you 174 00:18:57.000 --> 00:18:58.000 very much for your attention.