Theories of profit in Managerial Economics

January 11, 2017
Theories of Profit

| Lasse Lien |

The word equilibrium should perhaps be used sparingly here in this Austrian stronghold. Nevertheless, I shall dare to use it once or twice below. One of the biggest buzzes at the recent Academy of Management meeting in Atlanta was Richard Makadok’s paper, “Four Theories of Profit and Their Interaction.” Makadok’s main point was that we have four main classes of theories/mechanisms explaining positive profits in equilibrium, and that while we know a great deal about each theory individually, we do not know much about their interaction. I certainly agree that studying the interaction between such theories is worthwhile, and there is a lot to like about Makadok’s paper (which I BTW only have an older version of, therfore no link). What I am less sure about is what these basic theories should be, and how independent the four theories suggested by Makadok really are.

His candidates are 1) Collusion (i.e. Porter/Bain/Mason) 2) Competence/Capabilities (i.e. Ricardo/Penrose/Wenerfelt) 3) Timing, which has two sub-versions 3a) the ability to deter imitation by committing early (i.e. Stackelberg, Spence, Dixit), and 3b) flexibility, the ability to commit late when major uncertainties have been resolved (i.e. real options and dynamic capabilities). 4) Governance costs (i.e. transaction costs economics, agency theory, property rights).

Consider for example the first one, collusion. Collusion will not create more than fleeting positive profits unless we posit the existence of entry barriers, so collusion is apparently not sufficient for positive profits in equilibrium. Furthermore, if we assume that entry barriers are prohibitive, we can have positive profits without any collusion. This would for example be the case in both a Cournot game and a Bertrand game with differentiated products. So apparently collusion is not necessary for positive profits either. Finally, it would seem that entry barriers — while they may sometimes be created by collusion — are more often a result of asymmetries between incumbents and entrants along the dimensions described by the other three theories. So one may argue that profits due to collusion is not independent of these other theories/mechanisms either. Note that this certainly does not mean that it is uninteresting to study the interaction between collusion and, say, competences, as Makadok does very well. It only means that one may have legitimate doubts about whether tacit collusion is worthy the canonical status as a full blown member of such a typology.

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