When Are Large Profit Margins Sustainable?

Driverless cars is exactly the play. Once driverless cars arrive, [Uber’s] margins will jump from 20% to something like 50-80% overnight.

That is a commenter known as mchusma on Hacker News, from this thread.

I’ve heard such comments throughout my life on various topics, usually from not-terribly-sophisticated people.  So I’d like to here explore why such comments aren’t all that sophisticated, and when perhaps they are none-the-less valid.

So the short rejoinder to all such statements that Company X is going to make gigantic profits is this:

If they’re going to make 50% profit margins, why won’t someone else undercut them?

That is, a 50% net profit would be incredible.  You can have a very healthy company on a 10-20% net profit.  So why doesn’t another organization do just that?  Why doesn’t someone come along and say, “I’ll take a 40% net profit, undercut you with your customers, and I’ll take home the money instead of you — not quite as much as you’d have had, but still something.”  And then the response is, “Well, I’ll cut my profits down to 30%,” and then the competitor cuts their profits down to 20%, and so forth until both companies are ordinarily, rather than extraordinarily, profitable.

This argument is the core of the reason why classical economists tend to regard a functioning market as being a good thing for the general public.  The reasoning is that if everyone is free to do their economic activity more or less any way they want to, then any outsized profits rapidly turn into price-cuts instead, benefiting society as a whole rather than a small group of rich people.

And, if you’re going to take the 10,000 foot summary of the world, that classical economics view is correct.  By and large, most companies do not make enormous profits compared to their revenue.

But some do!

And we can perhaps understand a bit more about the world by examining circumstances under which it is possible to make an outsized profit margin.

The first such situation is corruption:  monopolies or cartels.

The reason that monopolies are considered bad is that they can disrupt this basic dynamic.  Say that Wheatey-Crisps is a gigantic company that controls 100% of the cracker market.  They charge outrageous prices, and enjoy an 80% net profit.  I am going to start Rebel-Crisps, a company that aims for a much more reasonable price-point and undercut Wheatey-Crisps to take over the bread market.  But Wheatey-Crisps recognizes the threat and tells all the farmers not to sell me any wheat — if the farmers do sell me wheat, then Wheatey-Crisps will crush those farmers by not buying from them.  Since I can’t buy the farmers’ output on my own (because I’m currently small), the farmers do what Wheatey-Crisps says.  Wheatey-Crisps is a monopolist.

A cartel is when a bunch of ostensibly independent companies basically agree not to compete with each other and instead behave like a single monopolist.

These situations aren’t very interesting.  They fail in a couple of ways:  first, they’re illegal.  If the government catches you doing this, it’ll just break up your company.  Second, monopoly power isn’t THAT strong.  A monopolist might be able to stop a by-the-bootstraps tiny competitor, but they probably can’t stop, say, a giant from a neighboring industry that’s extremely large from moving horizontally into the monopolist’s industry.

The second such situation is that nobody is able to compete with the company making large profits, for legal reasons.

In the modern world, this for the most part means that the company making the large profits has one or more highly valuable patents.  Patents are legal monopolies.  They’re even better than being an actual monopolist, because you don’t have to pressure your suppliers or bribe your customers to defend your monopoly: you can just sue your competitors.

Patents are only available for a limited length of time after an invention, but that length of time is 20 years.

The third and most interesting situation is that nobody is able to compete with the company making large profits, for execution reasons.

Some companies just seem to be able to pull off the magical.  They produce products or services for $X that their best competitors can’t match for $2X.  Why?  Probably unique technological knowhow or a really superior organization.  Something they can do that nobody else can.

This advantage probably degrades over time.  It seems like not even the best companies can maintain unique talent or perfect execution for decades at a time.

The fourth reason is that the opportunity for outsized profits is too short-term for anyone to bother undercutting you.  When a hurricane is threatening a town, you may be able to sell bottled water for $20 a bottle — other people might want to undercut you, but by the time they get into the bottled water business, the hurricane will already have passed.

So now let’s look at the most profitable company in the modern world:  Apple.

Apple isn’t a monopolist, and they aren’t dealing with a time-limited situation.  They’re a combination of situations 2 and 3.  They have valuable patents which have prevented some of their technologies from being copied, and also they’re just able to execute better than their rivals.  Remember how long it took before other smartphones were even playing in the same league as Apple?

And now we can evaluate whether Uber is going to be able to enjoy a 50-80% profit margin in a future of driverless cars:

  1. Will they be a monopolist?  Well, maybe.  But if so the government will likely step in, and besides they aren’t going to be so big a monopoly that they could fend off Amazon or Google or Apple or GE — probably they won’t have the kind of monopoly that could protect a gigantic profit margin.
  2. Will they have patents on key technologies?  It doesn’t seem like they will.  Nothing that Uber does is not done by bunches of their competitors already.
  3. Will they just be able to execute better than their competitors?  Again, it seems unlikely.  The core customer experience that we’re imagining is a driverless car driving you around.  Uber isn’t going to MAKE the driverless cars.  Why couldn’t a competitor just buy the same cars and send them to pick up other passengers?
  4. Is this a time-limited situation?  Presumably not.

So we can tell mchusma that, no, probably Uber won’t have super-high margins even if driverless cars become a reality.

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