The Profit Mystery

The Economic Policy Institute recently posted an interesting brief on the incredible surge in corporate profits that has accompanied the economic recovery over the past two years. (Thanks, Greg, for alerting me to this.)

The data, from the BEA’s national income accounts, provides another representation of something that we’ve already seen in other ways (Brad DeLong has a couple of good posts on the subject) – the fact that the lion’s share of the increase in income in the US over the past few years has been in the form of profits, and relatively little has been in the form of higher labor income.

This is extremely unusual. Typically, labor income comprises close to two-thirds of total national income, while profits typically are only around 10% of national income. So why has this recovery been so different, with over 50% of the increase in income going to profits and just 15% going to labor? Put another way, why have the owners of corporations been able to increase their share of income at the expense of workers?

Part of the answer is surely connected to the jobless (or job-loss) nature of this recovery. Since productivity has been increasing, firms have been able to increase output (and thus sales) without increasing their labor inputs. But this just begs a new question: why haven’t workers been able to capture some of the gains from this increase in productivity? Typically we would expect worker to be paid their marginal product – as they become more productive, they should be able to demand (and firms should be able to afford) higher wages.

But this is obviously not happening right now. Why not? Here’s my nomination for the reason: insufficient competition.

Given the sky-high profits of American firms (due to the fact that firms have been able to increase their workers’ output without paying them more) we would typically expect to see lots of new firms entering the market, in addition to fierce competition among already existing firms, thus driving profits down. Specifically, greater competition should do two things: drive down the price of the goods being sold, and drive up the wages of the workers who know how to make those goods, as firms compete for them. Both forces would reduce profits, and increase labor’s share of income.

Hence my conclusion that too many industries in the US suffer from a lack of adequate competition, and that it has apparently become increasingly difficult for new firms to enter established industries. I’m not quite sure why competition has declined in recent years – though I think that less vigilant anti-trust oversight in the past few years, along with intense merger activity, is a likely culprit – but if my logic is right then I think that declining competition may be enough to explain the profit mystery.