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Friday, July 20, 2012

Privatizing Profits and Socializing Losses

This phrase has become all-to-familiar post-financial crisis with bankers receiving government bailouts and allowed to continue their abhorrent bonus structures and other practices unchecked.

But, if you think about it, this problem is pervasive in our modern economy, even absent government intervention.

Textbook economics assumes perfect competition.  Students are often told, "well, nothing is ever truly perfectly competitive, but capitalism tends towards that."  It's often stated as a truism, even though evidence suggests that our real-life capitalism whether due to some combination of economics of scale, cronyism, information and power asymmetries, etc actually tends toward oligopoly.  Oligopolies have some significant degree of price manipulating power and can actually take losses for years and still not be forced to exit a market.  In oligopolistic economies, price is usually not the factor that businesses in an industry compete on.   Rather, they usually compete over product differentiation and advertising in general.   (A nice example here)

The point is, if an industry or even just an individual firm in that industry is hit by a significant loss (negative profit, say due to a financial crisis, or whatever), oligopolistic firms need not cut their prices in the face of low demand - they can simply cheapen their product, or tack on hidden fees, etc (all the while marketing the fact that their products are new and improved and inexpensive).   The result is that the losses that should at least partially be born by the industry, are actually largely passed on to the masses (the consumers) who are duped (via asymmetric information).  IE, losses are socialized. In the opposite case, due to their market power inherent in their structure, during 'good times', oligopolies can reap huge private profits.

A more obvious way in which losses are socialized is that poor decisions (and by poor, I mean fraudulent in most cases) by the institutional management in a firm creates costs, but those costs are often passed on not via punishments to the bad decision maker but to the employees in the form of pink slips.  Employment in financial and insurance services has fallen 7% from its peak in 2006 - about 400,000 employees.

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