Why is supernormal profit bad?

Supernormal profit can be considered detrimental primarily because it often signifies a lack of competition in a market, leading to reduced consumer welfare, stifled innovation, and inefficient allocation of resources.

What is Supernormal Profit?

Supernormal profit, also known as abnormal profit or economic profit, refers to the profit a firm makes over and above the normal profit. Normal profit is the minimum profit necessary to keep a firm in business, covering all explicit and implicit costs, including the opportunity cost of capital. Therefore, when a firm earns supernormal profit, it is making significantly more than it needs to survive, thrive, and attract investors. This excess profit typically arises when a firm possesses substantial market power, allowing it to charge prices higher than what would prevail in a perfectly competitive market.

Why Supernormal Profit Can Be Detrimental

While profit is a fundamental driver of innovation and economic growth, supernormal profit, especially when sustained over long periods, can indicate market failures that harm the broader economy and consumers.

1. Reduced Consumer Welfare

One of the most direct negative impacts of supernormal profit is on consumers. Firms earning exceptionally high profits often do so by charging higher prices than they would in a more competitive environment.

• Higher Prices: Consumers pay more for goods and services than necessary, reducing their disposable income and overall purchasing power. This can diminish consumer surplus, which is the difference between what consumers are willing to pay and what they actually pay.
• Limited Choice and Quality: Without competitive pressure, firms may have less incentive to innovate, improve product quality, or offer a diverse range of choices. This can lead to stagnation in the market and a poorer experience for consumers.
• Exploitation: In industries where supernormal profits are persistent, consumers might feel exploited, especially in essential services or goods where they have few alternatives.

2. Stifled Competition and Innovation

Supernormal profits are often a symptom of insufficient competition, which can actively prevent new businesses from entering the market.

• Barriers to Entry: High profits can be maintained by significant barriers to entry, such as high start-up costs, proprietary technology, strong brand loyalty, or legal protections (like patents or licenses). These barriers make it difficult for new firms to challenge the incumbents, preserving their dominant position.
• Reduced Innovation: Firms with guaranteed supernormal profits may become complacent, seeing less need to invest in research and development or improve their processes. This can slow down technological advancement and hinder overall economic progress.
• Predatory Practices: Dominant firms may use their excessive profits to engage in anti-competitive practices, such as predatory pricing (lowering prices temporarily to drive out rivals) or acquiring smaller, innovative competitors, further solidifying their market power.

3. Market Inefficiency

Economists often categorize the negative effects of supernormal profits under market inefficiency.

• Allocative Inefficiency: This occurs when resources are not distributed to produce the goods and services that society most desires. Firms earning supernormal profits typically set prices above their marginal cost (P > MC), meaning that some consumers who value the product more than its cost of production are unable to purchase it. This results in a deadweight loss to society, as potential gains from trade are unrealized.
• Productive Inefficiency: Firms facing little competition may not be compelled to operate at the lowest possible cost. They might tolerate slack, unnecessary expenses, or outdated production methods, leading to higher average costs than necessary. This reduces overall economic efficiency.

4. Potential for Income Inequality

The accumulation of supernormal profits by a few firms or individuals can contribute to wealth concentration and exacerbate income inequality. The benefits of these profits accrue disproportionately to shareholders, executives, and owners, rather than being distributed more widely through lower prices for consumers or higher wages for workers.

Addressing Supernormal Profits

Governments and regulatory bodies employ various strategies to mitigate the negative impacts of persistent supernormal profits, aiming to foster competitive markets and protect consumer interests.

• Antitrust Laws and Competition Policy:
  • Merger Control: Preventing mergers and acquisitions that would create excessively dominant firms.
  • Abuse of Dominant Position: Prohibiting anti-competitive practices like predatory pricing or exclusive dealing.
  • Breaking Up Monopolies: In extreme cases, breaking up large firms to increase competition.
• Regulation of Natural Monopolies: For industries where a single provider is most efficient (e.g., utilities), regulation can impose price caps or service standards to prevent exploitation.
• Promoting Market Entry: Reducing administrative burdens for new businesses, providing access to essential infrastructure, or encouraging innovation through subsidies or grants.
• Intellectual Property Reform: Balancing the protection offered by patents and copyrights (which allow for temporary supernormal profits to incentivize innovation) with the need to ensure fair access and competition over the long term.

Key Takeaways

In conclusion, while profits are a sign of business success, supernormal profits, especially when sustained due to lack of competition, can lead to significant economic disadvantages for consumers and society as a whole. They often signal market power that is detrimental to efficiency, fairness, and dynamic innovation.