Is Fixation of Profit Margin Prudent?

– This article was originally published by Ayushma Maharjan in the Himalayan Times on the August 25, 2019.

Have you ever marveled at the fact that portable telephones – once large and bulky luxury items, that only few affluent elites could afford – is today small, compact devices which is treated as a staple by everyone and can be afforded even by teenagers and people living in remote areas? The history and evolution of mobile phone is important to understand as it gives us an insight on how entrepreneurship and profiteering not only benefit entrepreneurs but also uplift the larger segment of society. Imagine if there were strict regulations that restricted mobile phone manufacturers to make abnormal profits. Would there still be enough incentive for them to invest further in research and innovation of the product? Would the industry still be flooded with a large number of new entrants, which provided hundreds of new jobs? Would society still benefit from the competitive forces of the market? The simplest answer to these questions is ‘No’.

Despite such miraculous achievements in the past, people in general still perceive profit making as immoral. The notion of few entrepreneurs earning abnormal profit and maximizing their wealth is viewed as a crime against consumers and against people who do not have the ability to pay for the products. Proponents of such idea are under the illusion that fair prices for all members in a society can only be achieved if the prices are low. Thus, popular legislations designed to prevent prices from rising, such as imposing price ceiling and fixing profit margins, have gained momentum.

In accordance with the same, Nepal has also adopted policies which restricts entrepreneurs engaged in trading business to take profit exceeding 20%. The legislation is surely drafted with good intention, however its impact on the economy is likely to pose huge repercussions. It is important to comprehend that such restrictive measures work only in the short run. In the long run, this not only will impede economic growth, but also will work against the benefit of the very consumers that it aims to protect.

Firstly, profit margin fixation largely affects the entrepreneurial sphere of an economy. When an individual is denied access to his/her expected level of return from the investment, the sector becomes less lucrative. The existing entrepreneurs will have fewer incentives to innovate and grow. Thus, they start pulling out resources like talent, capital and investment from the industry and seek for opportunities elsewhere to gain better returns. Correspondingly, new entry and investment in the industry will reduce significantly. As a consequence, only large companies with massive economies of scale remain in the market. In the long run, the reduction of trade in the economy, not only distorts competition, but also limits innovation.

Secondly, willing suppliers will not be able to sell the products to the willing buyers at an agreed price. Given that such strict policies distort a well-functioning market, where the demand is high and the supply limited, both buyers and sellers will be reluctant to engage in black markets. It is important to comprehend that when buyers are deprived of accessing goods through formal channels, it does not reduce the consumption of such goods. Instead they consume the goods and services from black markets and are often willing to pay higher price for the same. Consequently, the suppliers will benefit more from creating artificial shortages. The gap between demand and supply of the product acts as an incentive for the people to engage in behaviors that promote black markets, artificial shortages and rationing. On one hand, black markets are already a serious threat to economic growth as they are illegal markets where economic activities are not recorded, and its taxes not paid. On the other hand, in order to sustain, businessmen will choose to engage in other fraudulent practices like tax evasion and under invoicing of products that further harm the economy.

Thirdly, it has an adverse effect on consumer welfare. Reduction in number of operating firms, competition and innovation leads to fewer consumer choices. Additionally, when consumers are forced through lack of choice to use the informal market, they are denied their rights to safety, information, redress and a healthy environment.

The longer-term impact of profit margin fixation elucidates that, such restrictions squander more wealth and do not allow the economy to realize the potential gains from trade. Its wider impact on the consumers and entrepreneurs suggest that controlling price level is more unfair to the society.