I was discussing economics with a friend of mine recently, and they brought up a point for which I had no answer. Here it is: given a free market, companies tend to have some average percentage profit if they survive at all. The total profit they make, then, is dependent upon the volume of business done in an industry. This provides the incentive for them to attempt to increase the volume of business in the entire industry. Health insurance companies, for example, would have incentive to increase the amount of procedures done (necessary or not) because it would increase the total amount of business done in the industry, and therefore their total profit, independent of their profit margin.
This, says my friend, is an example of the free market giving a result that is not in the interests of the consumer.
I’m going to first address your example and then address the more general concept because I don’t think that your example pertains to the general concept.
The idea behind insurance is that many people face a small risk of a catastrophe. For example, fire insurance protects against the risk of having your home destroyed by fire. Most of the insured do not expect to have a fire in any given year but statistics indicate that some percentage of them will. There is no way to know who among the insured will have their homes destroyed by fire. It therefore makes sense for many people to pay into an insurance pool so that those few who do have a fire can rebuild their homes.
Modern so-called health insurance is a different animal. It pays for routine doctor visits and planned pregnancies. Consequently, what we call health insurance is actually semi-socialized medicine. We should make this clear whenever someone advocates socialized medicine. All of the problems with semi-socialized medicine would only be compounded with socialized medicine.
As to your core question, I do not accept that companies tend to have some average percentage profit. Take a look at the income statements from any group of companies and you are sure to find wide variations in profit margins. Although in the very long term there might be a tendency for profit margins to move toward some average percentage, the short and medium terms are important to consider as well.
That said, the volume of business of any one company is certainly linked to the volume of business of their industry and it is in the best interest of any one company to increase this volume. This is why trade organizations spend money to promote the products and services of their members (got milk?). This is generally not a problem because the consumers make the final decision. In the case of health insurance, there is no incentive for consumers to limit the amount of consumption because the cost is about the same whether they use extensive health services or none at all.
Your question has both macro and micro components. The industry depends on the economy, and the company depends on the industry. some industries are more sensible to downturns in the economy than others and vice versa.
Companies survive as long as they can cover their variable costs in the short run, even when having a negative income.
Firms also compete to gain more market share in bad economic times and in good economic times. Although (in a free market) the battle is fierce during recessions.
So it pretty much depends on what is going on in the economy, the industry and the company’s ability to expand (big dog or small dog).
That’s a strange example your friend gave. A health insurance company pays out of its own pocket for medical procedures so I’m not sure how that would help them make more money. I guess he could argue that in the long run, people would be more worried about incurring expenses so they’d seek out insurance, but then you have a real free rider problem among insurance companies. That is, the insurance companies that are playing nice don’t have that added expense, so they’ll be more profitable than the abusive companies. On the other hand, you could actually say that the health care providers have an incentive to do this because they’re the ones getting paid. But that’s a very risky strategy when you consider that if you’re found out, your business and career might not ever recover.
More generally, businesses don’t have a “typical” profitability, but this tends to be more true for mature industries. But the companies that separate themselves from the pack in those cases are the ones that are most efficient and innovative.
Thanks everyone for responding. I tried to make the point that insurance companies cannot force people to have/want procedures. I’m not certain that the point was conceded, but another example was offered. Here it is: Consider a small town with a number of poor residents who pay for their water usage. An entrepeneur wants to build a golf course in this town, greatly increasing the demand for water. The much greater demand for water is fine for the water company, because they’re happy to charge more for their services, but this sucks for the poor residents of the town, who are forced to pay more for their already expensive (relative to their income) water. This, I was told, is a case wherein the interests of the majority of the consumers are not served by the free market, and the ability to vote against the installation of the golf course would be preferred. I tried to make the point that the increased demand (and therefore price) would simply motivate the consumers to use less water and the producers to bring more water into town. This was responded to with the idea that the water supply is relatively inelastic, and the poor people would have to pay too much for too long.
This argument implies that the total utility for the inhabitants of getting water at a lower price is higher than the utility the owners of the golf course get for gaining access to water.
The problem is that there can be no such interpersonal comparison of utility. If you accept that wrong position, you can come up with any argument at all. For example, I could say that since the golf course owners are willing to pay a higher price than the inhabitants, they value it more, and allowing them to do this would increase total welfare.
I assume he would say that that’s too much because if they cannot afford the water, then they would not survive. Can you clarify your question about elasticity?
I find myself in the uncomfortable situation of defending my opponent’s position so that I can defeat it! Anyway, I think he would say that it’s true that the total welfare is subjective, and this is why we use the democratic system to sort out what is best. “It’s not a perfect solution, but it’s the best we’ve got,” or somesuch.
And for what possible reason is that so? Why exactly would the water firm bring this about? What about its existing contracts and obligations? Why would consumers not shift their spending patterns?
I want to know when exactly the supply of something becomes “inelastic”.
I think the argument would be that they don’t care how little water the poor people can afford, if the rich golf course patrons are willing to pay the price for the more expensive water.
I don’t know, actually. It’s some kind of relative term, right? Like the cost for increasing the supply is an order of magnitude greater than that of other goods in the same class? (whatever “same class” means) I’ll grant you that I can’t answer this question definitively, but I’m confident he has some stock Keynesian answer ready for this. What might it be - any idea?
My point is, why would the firm shut out an entire section of the market? If it failed to please its consumers, some other firm would quickly take control of that portion of the market (regardless of the alleged “elasticity” of increasing supply in that way.) The firm would try and balance things, in all likelihood, to both enjoy the golf course and common folk as its consumers. Moreover, as I said, consumers usually have contracts with firms they subscribe to for things. If so it’d be acting in violation of it.
It’s how sensitive changes in supply are to price changes. There’s no real objective way of establishing this (other than the absolutes, i.e. completely elastic or inelastic.) It’s a historical datum of how prices tend to move, and nothing more.
Okay, I see what you mean, and I think that practically, this is the way it would go. If I were to play devil’s advocate, though, I would say: “What if the golf course required a certain minimum amount of water to operate? Suppose that this minimum added to the minimum amount of water required for the survival of the poor inhabitants of this town is greater than the total supply of water available through the supplying company. Also suppose that the golf course owners are willing and able to pay much more for the water than the poor inhabitants, and that the water supply company will be unable to increase the water supply beyond the sum of these minimums for a year. Finally, assume for the sake of argument that the poor people’s water contracts expire next month. Then would the free market not provide an incentive to abandon the poor to their dehydrated plight?”
It’s a lot of suppositions and hyperbole, I know, I’m just trying to fill in the holes.
And again I’d object, why would the firm not just seek to balance it and thus retain both markets and profit in the long-run? Don’t let your opponent try corner you with silly little hypotheticals like that. The more ridiculous they make the hypo, the less important it becomes, and this one’s already been stretched quite a lot.
Well, I’ll grant that it seems ridiculous to you and I, but I think they take such situations very seriously. I’d like to be able to point out economic principles that defuse their fears. Any suggestions?
I pointed to it in my previous response. Why would the firm simply shut out a potential source of profit when it can act more conservatively and gain more? Why wouldn’t another firm simply fill the niche? If it suspected there is profit to be had it would attain the water as fast as possible.
