IGA AFR PHOTOGRAPH BY GLENN HUNT 03042012.GENERIC-Fortitude Valley IGA store.Economists joke that, whereas they are taught that any barriers to new firms entering a market are bad, allowing profits to be too high, MBA students are taught that “barriers to entry” are good, and shown ways to raise them.
Economists have no quarrel with businesses making profits. The shareholder-owners who provide the financial capital needed to sustain those firms are entitled to a return on their investment, one that reflects not only the (opportunity) cost of their capital, but also the riskiness of the particular business they’re in.
Economists call such a return on equity “normal profit”. But sometimes the various barriers to new firms entering a market limit competition, allowing the incumbents to make profits in excess of those needed to induce them to stay in the industry.
These are called “super-normal” profits (super as in “above”). Now get this: the other name for super-normal profits is “rents” – economic rents, to be precise.
We’re used to thinking of rent-seekers as businesses or industries that ask governments for special treatment. But it’s common for rents to be sought in situations that have nothing to do with government favours.
One of the most informative pieces of economic research undertaken last year was conducted by Jim Minifie, of the Grattan Institute, who made detailed estimates of the economic rents being earned in particular industries – something no government agency would be game to do.
He focused on the two-thirds of the economy made up by the “non-tradable private sector”, excluding export and import-competing industries and the public sector.
He found that the annual return on equity in the most competitive part of this sector averaged 10 per cent. That compares with returns exceeding 30 per cent in internet publishing, which includes online classified advertising of homes, jobs and cars.
Then came internet service providers on 25 per cent and wired telecom on a fraction less. Supermarkets were on about 23 per cent, sports betting on 22 per cent, liquor retailing on 19 per cent, and wireless telecom and (get this) private health insurance on about 18 per cent.
Delivery services and fuel retailing are on 15 per cent, with banking not far behind on 14 per cent, level pegging with electricity distribution and airport operations.
But the rate of an industry’s super-normal profit or economic rent isn’t the same as its absolute amount. Most industries with very high rates of profit are quite small.
Measured in dollar terms, the most rents are in banking, followed by supermarkets, electricity distribution (just the local poles and wires), wired and wireless telecom.
Minifie estimates that rents account for 20 per cent of the non-tradable private sector’s total annual after-tax profits of $200 billion. This is equivalent to more than 2 per cent of gross domestic product.
Another way to judge the significance of super-normal profits is to express them as “mark-ups” – as proportions of total sales.
The average mark-up across the whole non-traded private sector is 2 per cent. So, if rents were eliminated, but costs didn’t change, average prices would fall by 2 per cent.
Within that average, however, the mark-up in internet publishing is 26 per cent. Then come airport operations on 20 per cent, wired telecom on 19 per cent and electricity distribution on 12 per cent.
Further down the league table, electricity transmission – the high-voltage power lines, not the local poles and wires – has an estimated mark-up of 7 per cent.
But get this: the banks’ mark-up is just 4 per cent and the supermarkets’ is a bit over 3 per cent.
How come, when super-profits account for more than half the supermarkets’ total profit? Because supermarkets are a high-volume, low-margin business (as are banks).
Minifie notes that Coles and Woolworths are so big they achieve huge economies of scale. And, as dairy farmers well know, they achieve further cost savings by using their market power to force down the prices they pay their suppliers.
Trick is, they pass much of these cost savings on to their customers, but keep enough of them to remain highly profitable.
Coles and Woolies have substantially higher profit margins than their smaller rival IGA, even though their average prices are lower than IGA’s prices. So the big two’s costs must be a lot lower than IGA’s.
The list of industries with the highest super-profits reminds us how badly governments have stuffed-up the national electricity market, how much better they could be doing in controlling the prices of monopoly businesses such as Telstra, airports and port terminals, and in charging for liquor and gambling licences, not forgetting the indulgent treatment of private health funds.
Ross Gittins is the Herald’s economics editor.