The Business World: Can we learn to love excessive profits?

THE BUSINESS implications of the conquest of inflation will dominate strategic thinking in the early years of the next millennium.

Probably the most important consequence of low inflation is that relative price movements become very apparent - and those who put up prices are quickly accused of profiteering. And so, as macro-economic counter-inflation policy moves out of the political limelight, we see micro-economic policy moving to centre stage.

In the 1970s and 1980s the standard medicine for too much inflation was to print less money. Now, the fashionable cure is increased competition.

It is a cure that goes well with the New Labour policy agenda. New Labour wants to be business-friendly. Business is all about making a profit. Yet profit was anathema to Old Labour. So a new synthesis is emerging, which says that a normal return on capital is respectable, indeed necessary, but that excessive profits are obscene.

High profits are a sign of too high prices, and the cure for both is more competition. An example of this has been the furore over the supermarkets.

The big food retailers have given us efficient modern shopping machines that are always crowded with people who profess to dislike them. The press ran several "rip-off Britain" stories last summer when the strong pound pushed UK shop prices above their Continental counterparts.

But who is to blame for high prices? Before macro-economic policy was taken out of the political arena, the press might have focused on the exchange rate. Instead, it ran a profit story. So it was not long before the Government launched an Office of Fair Trading (OFT) enquiry, which concluded that the food retailers warranted investigation by the Competition Commission.

When the OFT investigates an industry it is because a small number of suppliers have a stranglehold on the market. The aim is to define a market, show that a few players have a very large share, and nail them for abusing a dominant position.

But it is difficult to make this kind of charge stick in the case of food retailing: supermarkets were invented to lure the once-a-week car- bound shopper, who is willing to drive some distance to save a few pounds on the weekly shop. The market is clearly pretty competitive.

But some stores do make a lot of money. So the OFT looked directly at profits, aiming to show that the supermarkets were making an excessive return on capital.

What does excessive mean? The issue is complex - indeed the regulation of the privatised utilities has spawned a whole new literature on the subject.

Successful innovation in any sphere usually generates big profits. Innovators such as Microsoft and the Internet entrepreneurs are modern variations on an old theme: early settlers take a big risk, but can reap the biggest rewards.

But for every success story there are many failures. The returns of the successful are not the norm.

In some spheres, the importance of innovation and the importance of rewarding the successful, are explicitly recognised. For instance, drug companies can earn huge returns on their capital, if they find a way to produce a drug for a few pence and then sell it for several pounds. Patent laws will protect the company from imitators.

These laws provide a proper reward for the huge sums spent by innovators on research and development. If they were repealed the nation's drugs bill would plummet - but there would be no new drugs. So we allow the pharmaceutical industry to be the most profitable industry in the world.

Pharmaceutical companies typically plough a large proportion of their profits back into research. The rates of return earned by the pharmaceutical industry - which are way in excess of the normal return on equity capital - provide the incentive (and in some cases the funds) for further innovation.

The pharmaceutical example illustrates the point that profits that appear at first glance excessive may nevertheless be socially acceptable. Such profits may provide both a reward for running risk and an incentive to innovation. They may also supply the funding for further innovation.

We may be able to live with "excessive" profits for drugs companies, but what about property speculators? Although it may be harder to swallow, the same arguments apply.

A successful development - the shopping mall at Brent Cross or the huge Broadgate complex in the City, for example - can command very high rents, which suggests that someone is earning a very high return on capital. But nobody (yet) is suggesting that the developers be investigated by the OFT, and rightly so.

The financiers took a very large risk, and the results of their enterprise are shops and offices for which people willingly pay high rents. If those rewards for success were disallowed, there would be no further innovation.

Food retailers need similar incentives. Although they have been pretty innovative over the past decade or two, and transformed the food shopping experience, the grocery retail revolution is far from over. Food distribution has caught up with the invention of the motor car. It has not yet come to terms with the Internet, which will one day transform shopping from home. The retailers still need the incentive to innovate.

Does this mean that we should stop worrying about the profitability of supermarkets? Not quite, because there is one important feature of the food retailing industry that certainly is stifling competition: planning restrictions.

Successive governments have decreed that the success of out-of-town retailing is threatening town centres, and have imposed all kinds of restrictions on developments.

So if there is a problem about the profitability of these stores, it is largely of the Government's making. All of which makes it rather difficult to predict where an investigation of the profitability of supermarkets will lead.

Bill Robinson is a director of the consultancy London Economics

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