FOOL'S EYE VIEW
Excessive Profit Is Complete Nonsense

By David Kuo (TMFDragon)
March 14, 2002

Carburton Street, London -- There is profit and then there is negative profit, which is another way of saying a loss. But there is no such concept as long-term "excessive profit" as the Competition Commission seems to think is the case with banking services for small businesses.

There are market inefficiencies that might help some businesses make abnormally high profits in the short-term. But the important point about profit, in the context of a business operation, is that it is a residual after all production costs are deducted. These costs could include wages and salaries, interest payments, rental costs and other expenses that allow the business to function properly. And profit is what remains from the businesses' revenues after all those inputs have been accounted for.

What is important about profit is its unpredictability. It is nigh on impossible to determine precisely today what a company's profit will be in the future. We can take a stab at what we think a company will make next year or perhaps the year after that but those future profits are both uncertain and variable. However we can know with certainty (except perhaps in the case of Enron) what a company has made in profit in previous years. These are well documented in the company's annual accounts. But we cannot know what the company will make in profit tomorrow because perfect knowledge is an illusionary concept.

That is why "excessive profit" is a complete nonsense and any attempt to eradicate excessive profit through taxing those earnings is almost as farcical. But before we venture too far down this road, let's take a look at what excessive profit might mean. Excessive profit can be interpreted as the profit that is made over and above normal profit that is included in establishing average cost. In March last year the Competition Commission presented their findings on their investigation into small business banking to the Treasury. The regulator found that the big four banks in the UK, through their complex monopoly, were making excessive profit from providing banking services to small businesses. They concluded that £5b of the banks' combined profits of £10b were excessive.

But what makes the Competition Commission so sure that the banks will continue to make "excessive profits" in the future. Have they in fact found the route to the Holy Grail of profit forecasting that has eluded business analysts for years? It should be remembered that in any free market persistent excessive profit would attract more competition. This in turn increases supply causing prices to fall and the resultant restoration of normal profit. The only hindrance to re-establishing normal profits is barrier to entry into a market.

Absolute barriers to entry can only emanate from one source, namely through government legislation that prevents the free market to operate efficiently. Businesses, no matter how powerful, are unable by themselves to erect barriers to entry that prevent competition. Only government can lift a business above the laws of the free market.

The Treasury responded to the Competition Commission's report today. They have put forward recommendations to address the issue of the complex monopoly that the big four banks are said to operate. A complex monopoly arises when at least one quarter of services are supplied by a group of two or more who either voluntarily or not, and whether by agreement or not, conduct their respective affairs to prevent, restrict or distort competition with the supply of those services.

Thankfully the Treasury has chosen not to tax the banks on those "excessive profits". That would have been a serious deterrent to competition by distorting the free market for business banking. Instead they have opted for a menu of measures that would have been adopted by the banks over time anyway. These include payment of interest on current accounts, portable credit history and an unbundling of banking services.

We should remember that in a free market a dominant market player is only dominant because it is able to deliver a service better than any potential entrant could have. What is required within the banking industry is less regulation not more if competition is to be encouraged.