Sunday, August 13, 2006

The Profit Margin Puzzle

Take another look at this picture. Something screwy is going on. Labor costs have risen at an average rate of 1.5% over the past 15 years, but prices have risen at an average rate of more than 2%. That means labor is really cheap today compared to what it was 15 years ago. Why isn’t somebody hiring that cheap labor and undercutting competitors by charging lower prices (bringing down the rate of price growth, or bringing up the rate of labor cost growth by bidding more for labor)? I consider several explanations, but none seems quite satisfactory.

1. Rising raw material prices. If the cost of non-labor inputs is going up, then firms could be forced to raise prices even when labor is cheap. When you look at oil prices today, this seems like a good explanation, but take a look at this chart, which Barry Ritholtz found in a St. Louis Fed publication. Profits have risen dramatically as a share of national income, while compensation has fallen. If raw materials costs were the problem, we would expect them to be cutting into profits. Clearly they’re not, at least not in aggregate.

2. Increasing cost of capital. When economists talk about the “zero profit condition,” they are careful to distinguish economic profits from accounting profits. Accounting profits have clearly risen, but perhaps these profits just represent a higher required return on capital, not an increase in economic profit. This explanation fits well with the observation of a very low savings rate, which makes capital scarce. However, it is not consistent with the observation of a low interest rate. Obviously capital is still cheap for high-quality borrowers like the US government. Why would it be so expensive for businesses?

3. Increasing price of risk. The capital that gets compensated by profits is necessarily high-risk capital. Possibly, even though generic capital is cheap, the risk premium for equity capital has risen: investors have gotten more timid. If we compare today to 2000, this is almost certainly part of the story. But if we compare today to 1990, this argument is less compelling. Overall, price-earnings ratios have risen over the past 15-20 years, and dividend yields have fallen, which suggests people are more, not less, willing to invest in risky assets.

4. Rising rents. Some of what is counted as profits may actually be rents, and those rents may be rising. For example, an oil company that owns mineral rights continues to account for depletion based on original cost, even though the economic value of those rights has risen, so the implied rental cost shows up as profit. You could also argue that firms like Microsoft that own valuable intellectual property are earning large rents on that property, and those rents show up as profits. This explanation is more promising than some of the others. It’s certainly consistent with the observed unevenness of profits across sectors.

5. Reduced competition. Maybe the zero profit condition doesn’t apply any more. It’s hard to think of examples, though.

6. Product and labor market disequilibrium. Over the course of the business cycle, labor costs tend to rise during booms and fall during recessions, whereas prices rise more evenly throughout the cycle and perhaps accelerate before the boom phase is reached. If the Fed’s anti-inflation policies have made recessions more common than booms (“taking away the punch bowl before workers get to drink”), this could explain a shift of income away from labor. If this explanation is right, it bodes badly for profits in the future, because disequilibria tend to get corrected in the long run, no matter what the Fed does.

7. Capital market disequilibrium. Economic liberalization has resulted in a large increase in the effective global labor supply. According to classical economic theory, this should result in a (possibly temporary) increase in the cost of capital, as scarce capital is allocated toward the newly available labor. As noted earlier, observed low interest rates are not consistent with this story, but perhaps allocating capital is more complicated in the short run. Suppose, for example, that firms have a limit on the number of investment projects they can undertake at a given time. Even if capital is cheap, they won’t be able to take full advantage, but those projects they do undertake will be located where the plentiful labor is – i.e., not in the US. Thus the required return for US investments could be quite high (hence high US profits and high prices relative to wages) even if the raw cost of capital is low.

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19 Comments:

Blogger spencerengland said...

I have problems with your approach to raw material costs. If one firm is paying higher raw material prices it implies that another firm -- the raw material producer -- is receiving a higher price and higher profits. Do higher raw material cost really raise profits or just shift what sectors receive the higher profits. Higher oil prices mean oil producers are more profitable and oil consumers are less profitable, but does it significantly impact total profits?

But one way this may be working through the system is that oil companies are not reinvesting their
profits to nearly the extent that firms in other industries would reinvest their earnings. Is this some sort of a breakdown of Says' law that is impacting the overall economy?

Mon Aug 14, 11:45:00 AM EDT  
Anonymous Bruce Wilder said...

"Reduced competition. Maybe the zero profit condition doesn’t apply any more. It’s hard to think of examples, though."

Clearly, you live on air, and have never entered an American supermarket.

Concentration in supermarkets has risen dramatically, which, in turn, has driven up the size of consumer product conglomerates.

Mon Aug 14, 12:02:00 PM EDT  
Blogger knzn said...

Spencer, You’re quite right. Since I’m using the GDP deflator, it’s only the price of domestic value added that is at issue. Explanation 1 is really only an inaccurate way of stating explanation 4, and the fact that explanation 1, taken literally, fails to explain profit share, should not be a surprise. One thing I will say, though: if everything were perfectly accounted for and marked to market, the increase in raw materials costs should in large part take the form of capital gains to owners of natural resources, which, conceptually speaking, are not profits in the usual sense. (They shouldn’t be part of value added at all, because nobody is adding any value by bidding up the prices of existing assets.)

As for Say’s law, I never believed it in the first place.

Mon Aug 14, 12:05:00 PM EDT  
Anonymous Bruce Wilder said...

I'm not sure what narrative you might produce, but you might consider the effects of rapid advancement in computing and communication technologies on the shape of capital investment.

1.) for some major industries, capital requirements are decreasing and existing capital made obsolete: telephone companies, sitting on a mountain of copper and municipal franchises, desperately trying to become fiber optic/DSL companies (something which requires less than 1/3rd the capital stock of plain old telephone service, circa 1980).

2.) consumers, who are drawn in by a proliferation of services: how many monthly service fees can a suburban household pay? Sticking with the phone example, we went thru multiplying household phones, fax machines, then cell phones, cable services, etc. Do we climb down? After decades of new area codes, the number of phone numbers in use declines now at a rate of 150,000 per month.

3.) As a general matter, advances in computing technologies makes control cheap. One implication, which has been an established trend for decades, is that an increasing proportion of all costs of production are sunk costs and/or fixed/overhead costs. Management accounting schemes, which allocated overhead costs in manufacturing in proportion to direct labor costs had to be abandoned a decade ago, because direct labor costs were so diminished in most manufactured products. An $800 washing machine might have less than an hour of direct labor; a $20,000 auto might represent less than 30 hours of labor, including less than 15 hours of assembly!

Rents don't have to be rising, if quasi-rents are proliferating and dominating.

Mon Aug 14, 12:21:00 PM EDT  
Blogger true dough said...

What about rival acquisition and vertical integration.
A firm could overtake its competition and then proceed to cultivate its own raw material, handle its own factory production, and finalize its own product. This seems to be happening. Also, by charging high prices, the firm could subsidize its costs of labour.

Wed Aug 16, 07:34:00 AM EDT  
Anonymous happyjuggler0 said...

I'm not clear on why you drew your chart with 1991 as a starting point. This was the immediate aftermath of a recession, while we are currently five years into an economic expansion. Perhaps 1996 would be a better starting point.

I'm in favor of point 7 myself. The Soviet Union finally collapsed in 1991, while this path was becoming clear for some years. In essence a whole destructive form of economic system was ended as a theoretical plausible idea (except for a few diehards, mostly in universities). This moved the whole economic right/left center of the world towards the right.

Thus "the rest of the world" became a safer place to invest in theory, with practice coming down to an individual country basis. It became more and more clear over time that China was becoming more market based, Latin America mostly gave up socialism's ghost (at least until fairly recently) and *tried* to move rightward, whole swathes of Central Europe became more economically libertarian than "Old Europe", or at least Old Europe's Big Four.

Thus starting right about the time you chose to start your chart, the world's labor pool suddenly became massively larger relative to "Western" capital. Supply/demand, price of capital relative to labor increases, or to put it the other way, the price decreases for labor relative to capital.

This process is ongoing, with China still not entirely capitalist, and huge amounts of India's economy still legally cut off from new competition and market efficiency, and with both countries requiring large amounts of capital going forward for infrastructure. If Africa ever manages to dump its kleptocracies then another chunk of radically underutilized labor hits the market too.

As this infrastructure gets laid down (telephony, electricity, roads, airports, seaports) and market institutions arise and deepen, these countries will attract yet more Western capital continuing the supply/demand trend for capital/labor.

This tends to raise the return on multinational's capital. With R&D also being outsourced to a certain degree to cheap Indian brains and elsewhere, this helps explain another puzzle.

Quite frankly I'm a bit surprised the effect hasn't been larger. Over time this will eventually arbitrage itself out, but it may well take awhile.

For a US policy maker who wishes to change the price of labor organically (as opposed to foolhardy coercion such as employer prohibitions or price floors on labor), they need to change the supply/demand balance, namely increase the supply of capital employed in the US by foreign multinationals, increase the supply of capital for "the little guy" who opens or wants to expand his small business. The US corporate tax rate is among the very highest in the world and acts as a deterrent to foreigners investing in the US, as well as changes the "should I be a safe employee or a risk taking employer instead" equation.

Abolishing captial gains and dividend taxes would seem a logical help too, especially towards entreprenurialism. Encouraging labor via tax changes, (and perhaps some bully pulpit preaching?) to become more and more of an owner of employer's capital, instead of an owner of real estate for example, would also help out labor indirectly.

Since high skill capital is going to get utilized in the US or abroad, I also (selfishly) suggest radically increasing its supply in the US by increasing high skill immigration rather than having this valuable labor utilized overseas. Each "brainy nerd" that a high tech company employs in the US or abroad can't do everything by himself (unfortunately rarely herself). As such companies require all kinds of support personal as well for these "brainy nerds", such as other high skilled workers who have a bit less skill, not to mention myriad other office workers, as well as those employed to design and build their work infrastructure, as well as the companies (and their employees) they purchase goods from (usually domestically sourced) with their US salaries instead of their salaries back home where they otherwise wouldn't have emigrated from.

Wed Aug 16, 05:55:00 PM EDT  
Blogger knzn said...

On the original chart, I chose 1991 because 15 years was the best multiple of 5 to represent the beginning of a low-inflation regime. (The 80s were still more of a moderate-inflation regime.) But if you go back to 1987 or 1988, the divergence gets even larger. Taking out cyclical patterns, the two series grow at roughly the same rate from the late 40s to the early 80s and then start to diverge.

Wed Aug 16, 10:06:00 PM EDT  
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