26, April 2023
The Paradox of Corporate Profitability in Canada.
“Paradox” is defined as a seemingly absurd or self-contradictory statement or proposition that when investigated or explained may prove to be well founded or true.
Try the following thought experiment. Consider a mid sized country with poor and declining R&D spending and low ranking for innovation. How profitable would its companies be? Probably not very profitable, you might think.
Now consider Canada, a mid sized country with poor and declining R&D spending and a low ranking for innovation. But its corporate profits are sky high. Look at the graphic below. It shows after tax corporate profits in Canada as a percentage of GDP. This is not a flash in the pan or just one outstanding year. Profits as a percent of GDP have been rising steadily for thirty years. They are close to twice the profitability of US companies as a percentage of GDP.
What’s going on?
There are probably a number of factors involved, among them: corporate concentration, corporate size, and free trade.
It is well known that Canada has many very concentrated markets. Examples include airlines, telecoms, banks, and retail pharmacies. Canada’s food system is also among the most concentrated in the world1. It is also well known that concentrated markets confer market power that allows participants to raise prices higher then they could in more competitive markets. There has been much debate about the reasons for this concentration, much of it focusing on the Competition Act and its enforcement (or lack thereof).
Corporate concentration has been increasing. A paper by Bawania and Larkin from York University4 found that corporate concentration had increased in Canada since the late 1990’s, as it had in the US. They attributed the reasons for this to be (1). weak antitrust legislation and practices (2) increasing barriers to entry. They also noted that large firms had become more dominant; firms in industries with the largest increases in product market concentration started to generate higher profit margins and the volume of M&A deals, and horizontal deals in particular, has increased.
Company’s have been getting bigger, partly driven by significant merger and acquisition activity. It is also very likely that information technology has also helped companies get larger as it makes managing supply chains, logistics, communications, e-commerce and much else easier. “The larger companies can charge higher prices because consumers don’t have as many options,” explains Karim Bardeesy, executive director of Toronto Metropolitan University’s Leadership Lab. “And consolidated industries are less responsive to consumer feedback.”2
Larger companies are also more profitable. See the graph below.
The Free Trade Agreement of 1988 followed by NAFTA in 1994 represented a major change for Canadian business. It significantly increased cross border trade ad investment. A study from Ryerson University showed that by 2012 profitability of Canadian firms had been increased by NAFTA3, which they said was consistent with economic theory. That trend has continued since.
What about R&D and Innovation?
One of the main objectives of a company CEO is to generate profits for his or her shareholders. Canadian CEOs seem to be doing this very well, so the mindset seems to be “why spend on R&D and innovation if we’re doing so well? “
Does this matter?
Canada ranks #14 in the Global Competitiveness Report put out by the World Economic Forum. The OECD projects growth in real per capita GDP for Canada of below 1% a year up to 2060. It is the worst performing of 38 advanced countries for 2020-2030 and also for 2030-2060.
These are not encouraging numbers. Per capita GDP is the basis for our standard of living and provides resources to pay for service such as health care and services for an aging population. It is to be hoped that the new Canada Innovation Corporation will be able to play a role to change this mindset and increase R&D, innovation and eventually economic growth and per capita GDP in Canada.