Friday, June 21, 2013

Have Profits Become Disconnected From Investment?

Paul Krugman believes that the structure of the economy is changing.  We can still learn from the past, but this time it may really be different.  The big change in the economy is that profits are rising in the absence of increased production.  The profits come monopoly rents.  The link between profits and investment in new capacity has been broken.  Apple is a good example of this change.  It has an enormous sum of retained earnings which keeps growing without making additional investments.  Its profits come from the intellectual property, which it has created, and from the brand image that it has created.  It employs a relatively small number of smart people in the US to develop the intellectual property and to market its products.  Most of its production has been offshored, and its manufacturing value added is small relative to its non-production value added.  This contrasts remarkably from the time when GM employed around 1% on non-farm workers in the US.  GM's value added from producing cars was high relative to the rest of its value added. 

The financial services sector provides another example.  It earns around 30% of US profits but it employs a relatively small number of people.  That is why compensation per capita in the finance sector is much higher than it is in other sectors.  The high profits come from proprietary investments and from monopoly power.  It is a very highly concentrated industry.

Krugman does not mention other industries but the same pattern holds.  For example, your cable company and your cell phone company can add a new customer to its network almost zero cost.  Once the network has been put in place, and the fixed costs are amortized, no production is required to increase profits.  Moreover, they can increase profits by adding new services for existing customers.  At some point network capacity will need to be increased but the same pattern will follow after the cost of new capacity has been amortized.  This is also a very concentrated industry that enjoys monopoly profits.

These structural changes in the economy explain some of the problems that industrial nations are facing.  Rising inequality is partially explained by the rising share of income that comes from profits and the falling share of income that goes to wages.  As wages fall, so does aggregate demand, and the need for more employees.

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