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To restate the obvious, businesses naturally want to maximize the amount of money they make; that’s the fundamental incentive that drives them to do what they do. Without that potential to earn profits, there would be no financial reason for anyone to want to invest in a new business in the first place (as opposed to, say, just leaving their money in a savings account). In light of this supreme drive for profit, then, it’s no surprise that people so often accuse businesses of trying to exploit their customers by skimping on product quality while jacking up prices to extortionate levels – because after all, in a vacuum, that’s certainly what most companies would prefer to do. The thing is, though, most companies don’t exist in such a vacuum – they exist in a free market – and that means they have to compete for customers with other firms. This force of competition is what pushes back against the profit motive, and makes it so that, as much as self-interested companies might wish to cut corners and jack up prices, they largely have no choice but to keep quality high and prices low if they want to continue making any profit at all – because if they don’t, they’ll lose all their customers to their competitors who do. Wheelan describes the basic process:

In competitive markets, prices are driven relentlessly toward the cost of production. If it costs 10 cents to make a can of soda and I sell it for $1, someone is going to come along and sell it for 50 cents. Soon enough, someone else will be peddling it for a quarter, then 15 cents. Eventually, some ruthlessly efficient corporation will be peddling soda for 11 cents a can. From the consumer’s standpoint, this is the beauty of capitalism – [even if] from the producer’s standpoint, it is “commodity hell.”

He adds that this is especially true for basic commodities like wheat, soybeans, oil, etc. – which are all highly homogenous and fungible (meaning that one individual unit of them is basically identical to and interchangeable with every other unit):

Consider the sorry lot of the American farmer. A soybean is a soybean; as a result, an Iowa farmer cannot charge even one penny above the market price for his crop. Once transportation costs are taken into account, every soybean in the world sells for the same price, which, in most years, is not a whole lot more than it cost to produce.

Of course, the other side of this coin is that the further away a product gets from being perfectly homogenous and fungible in this way, the less likely it is that the price of the product will always be driven down to just above the cost of production. In the most extreme case, if a product is completely unique and can’t be replicated by competitors at all – i.e. if the producer of the product has an absolute monopoly over its production – then that producer won’t have any need whatsoever to maintain a competitive price; they’ll be able to charge up to the maximum amount that customers are willing to pay, and will be able to rake in major profits as a result. Naturally, not many firms are able to corner the market quite so fully – luckily for consumers, most products in a free market lie more toward the competitive end of the spectrum – but it is a spectrum, and the closer a firm is able to get toward a monopoly, the more potential it has to deliver outsized profits to its owners. Sowell illustrates this point:

Just as we can understand the function of prices better after we have seen what happens when prices are not allowed to function freely, so we can understand the role of competition in the economy better after we contrast what happens in competitive markets with what happens in markets that are not competitive.

Take something as simple as apple juice. How do consumers know that the price they are being charged for apple juice is not far above the cost of producing it and distributing it, including a return on investment sufficient to keep those investments being made? After all, most people do not grow apples, much less process them into juice and then bottle the juice, transport and store it, so they have no idea how much any or all of this costs. Competition in the marketplace makes it unnecessary to know. Those few people who do know such things, and who are in the business of making investments, have every incentive to invest wherever there are higher rates of return and to reduce their investments where the rates of return are lower or negative. If the price of apple juice is higher than necessary to compensate for the costs incurred in producing it, then higher rates of profit will be made—and will attract ever more investment into this industry until the competition of additional producers drives prices down to a level that just compensates the costs with the same average rate of return on similar investments available elsewhere in the economy.

Only then will the in-flow of investments from other sectors of the economy stop, with the incentives for these in-flows now being gone. If, however, there were a monopoly in producing apple juice, the situation would be very different. Chances are that monopoly prices would remain at levels higher than necessary to compensate for the costs and efforts that go into producing apple juice, including paying a rate of return on capital sufficient to attract the capital required. The monopolist would earn a rate of return higher than necessary to attract the capital required. But with no competing company to produce competing output to drive down prices, the monopolist could continue to make profits above and beyond what is necessary to attract investment.

Needless to say, this kind of monopolization isn’t ideal for consumers. But for the business owners who are able to establish such an arrangement, it’s a golden ticket; as Alexander notes, Peter Thiel himself (one of the richest people on Earth) has identified monopoly power as the primary reason why ultra-wealthy business owners like him are able to accrue such wealth in the first place:

[Thiel’s] basic economic argument goes like this: In a normal industry (eg restaurant ownership) competition should drive profit margins close to zero. Want to open an Indian restaurant in Mountain View? There will be another on the same street, and two more just down the way. If you automate every process that can be automated, mercilessly pursue efficiency, and work yourself and your employees to the bone – then you can just barely compete on price. You can earn enough money to live, and to not immediately give up in disgust and go into another line of business (after all, if you didn’t earn that much, your competitors would already have given up in disgust and gone into another line of business, and your task would be easier). But the average Indian restaurant is in an economic state of nature, and its life will be nasty, brutish, and short.

This was the promise of the classical economists: capitalism will optimize for consumer convenience, while keeping businesses themselves lean and hungry. And it was Marx’s warning: businesses will compete so viciously that nobody will get any money, and eventually even the capitalists themselves will long for something better. Neither the promise nor the warning has been borne out: business owners are often comfortable and sometimes rich. Why? Because they’ve escaped competition and become at least a little monopoly-like. Thiel says this is what entrepreneurs should be aiming for.

In short, if a firm is enjoying unusually high profit margins, it will typically be because they’ve managed to carve out some degree of monopoly power (whether it be through proprietary technology, economies of scale, or some other such means) – so they no longer have to worry about anyone competing with them. From the perspective of everyone except the monopolists, of course, this profiteering can seem pretty exploitative, which is why you’ll so often see people responding to it with outraged denunciations of corporate greed. But the thing is, the problem in these situations isn’t just that there’s a self-interested company trying to maximize its profits in a particular product market; it’s that there aren’t more self-interested companies trying to maximize their profits in that market. It’s like that analogy of the drowning person and the lone rescue ship all over again: We might think it’s objectionable for the person in the ship to ask for so much from the drowning person in exchange for rescuing them, but the only reason they’re able to do so in the first place is that there aren’t any other rescuers out there making better offers. And the same is true for monopolistic businesses and their customers: If there were more competition in their product markets, companies would no longer be able to profit so much at consumer expense; they’d have to maintain a competitive price, or else go out of business. What this means, then, is that when we’re looking for a solution to the problem of monopoly profits, we shouldn’t assume that the most productive course of action will be to simply yell at big corporations to be less greedy; rather, it’s more likely that the most effective solution will be to break the monopolies by turning them into competitive markets (or at worst, allow them to continue their market dominance but tax their surplus profits and return them to the public if they exceed the competitive rate by too much). The companies themselves might not be too happy about it, but as Harford points out, there’s a difference between being pro-business and pro-market, and the two are often directly at odds:

Economists believe there’s an important difference between being in favor of markets and being in favor of business, especially particular businesses. A politician who is in favor of markets believes in the importance of competition and wants to prevent businesses from getting too much scarcity power. A politician who’s too influenced by corporate lobbyists will do exactly the reverse.

Now, mind you, there’s always an exception to every rule – so at this point, I should note that monopoly profits aren’t always something that should be prevented at all costs. As Wheelan points out, there are certain situations in which it might make sense to allow companies to receive some monopoly profits as an incentive to produce goods that would otherwise never get produced:

The ingredients in Viagra cost pennies a pill, but because Pfizer has a patent on Viagra that gives it a monopoly on the right to sell the product for twenty years, the company sells each pill for as much as $7. This huge markup, which is also common with new HIV/AIDS drugs and other lifesaving products, is often described as some kind of social injustice perpetrated by rapacious companies—the “big drug companies” that are periodically demonized during presidential campaigns. What would happen if other companies were allowed to sell Viagra, or if Pfizer were forced to sell the drug more cheaply? The price would fall to the point where it was much closer to the cost of production. Indeed, when a drug comes off patent—the point at which generic substitutes become legal—the price usually falls by 80 or 90 percent.

So why do we allow Pfizer to fleece Viagra users? Because if Viagra did not get patent protection, then Pfizer never would have made the large investments that were necessary to invent the drug in the first place. The real cost of breakthrough drugs is the research and development—scouring the world’s rain forests for exotic tree barks with medicinal properties—not making the pills once the formula is discovered. The same is true with drugs for any other illness, no matter how serious or even life-threatening. The average cost of bringing a new drug to market is somewhere in the area of $600 million. And for every successful drug, there are many expensive research forays that end in failure. Is there a way to provide affordable drugs to low-income Americans—or poor individuals elsewhere in the world—without destroying the incentive to invent those drugs? Yes; the government could buy out the patent when a new drug is invented. The government would pay a firm up front a sum equal to what the firm would have earned over the course of its twenty-year patent. After that, the government would own the property right and could charge whatever price for the drugs it deemed appropriate. It’s an expensive solution that comes with some problems of its own. For example, which drug patents would the government buy? Is arthritis serious enough to justify using public funds to make a new drug more affordable? How about asthma? Still, this kind of plan is at least consistent with the economic reality: Individuals and firms will make investments only when they are guaranteed to reap what they sow, literally or figuratively.

In these kinds of situations, then, strategically allowing for some level of monopoly profit (or an equivalent financial prize paid by the government for specific breakthroughs) can be a good thing for everybody, and the issue of making sure poorer customers can still afford the products in question can be resolved despite the monopolization. Having said that, though, it bears repeating that these situations are generally the exception to the rule; for the most part, monopolies are not what we should want to see in a free market. An ideal competitive market (barring circumstances like those described above) is not one in which business owners get filthy rich at the expense of their customers – it’s one in which the businesses’ competition with each other keeps their profits at the minimum possible level. And what level is that, exactly? It’s simple – in Harford’s words:

Profits in a competitive industry are high enough only to pay workers and persuade entrepreneurs that their money isn’t better off in a savings account—no higher.

Again, it’s clear that in our real-world economy, things don’t always perfectly conform to this ideal model. There are plenty of companies out there that enjoy sufficient monopoly power to pull in huge profits and make their owners extremely rich. But even so, despite these glaring counterexamples, we can consider it a positive thing that most areas of the market economy are actually pretty competitive, and that most companies’ profits are accordingly relatively low. Granted, those profits might still be huge in terms of absolute dollar amounts – after all, a billion-dollar company will still generate massive amounts of money purely as a result of how large a scale it’s operating on – but in percentage terms, the profit margin for an average business is only in the single digits (even despite the larger profit margins of the monopolies pulling up that average). As Alexander writes:

The average American thinks the average company makes a 36% profit – it actually makes about 8%. The AEI speculates that a lot of “raise the minimum wage, the companies can just take the losses out of the buckets of cash the greedy owners are hoarding for themselves” type of arguments come from this misunderstanding.

(The linked AEI post also mentions, for what it’s worth, that a lot of the most vilified companies have even lower profit margins still; big oil’s profit margin, for instance, is only about 6% after taxes, and Walmart’s is just 2%.)

Making sure that these profits stay relatively low – that customers aren’t being made to give up nearly their entire consumer surplus to producers – is an important task; and it’s also such a massive one that it would be hopeless for a government to try to tackle it alone. Luckily for us, though, our government doesn’t have to shoulder the burden of enforcing price controls on every single product across the entire economy, because the mechanism of market competition does the bulk of that work for us. True, government might have a corrective role to play here and there (like enforcing anti-monopoly laws) – but as far as setting prices for the vast majority of consumer goods, that’s a job that, thankfully, has a way of doing itself. And we consumers are all much better off for it.

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