For years, economists have believed that competition tends to equalize profits across firms, as inefficient firms either learn from better ones or go out of business, and as new firms enter markets and so compete away high profits. Several things, however, suggest that we need to change our mental model, because this basic common sense intuition might be wrong.
A few things I’ve seen recently point to this. Jason Furman and Peter Orszag say (pdf) "there has been a trend of increased dispersion of returns to capital across firms" in the US. David Autor and colleagues show that there has been a rise (pdf) of “superstar firms” earning very high profits. And Andy Haldane, echoing Bloom and Van Reenen (pdf), has said (pdf):
An upper tail of companies and countries has maintained high and rising levels of productivity. These productivity leaders are pulling ever-further away from the lower tail. Or, put differently, rates of technological diffusion from leaders to laggards have slowed, and perhaps even stalled, recently.
All this is the exact opposite of what we’d expect to see if competition equalized profits. So what’s going on? I suspect that here, as everywhere, there are no mono-causal explanations. A few possibilities are:
- Low interest rates and creditors’ forbearance mean that inefficient companies aren’t being killed off to the same extent they were in the 80s and 90s.
- Credit market imperfections prevent efficient firms starting or expanding (though this should be less of a problem now than a few years ago).
- Bad managers just can’t see how to up their game or exploit profit opportunities.
- Tough intellectual property laws impede firms from learning.
- Contrary to what Hayek thought, prices are not sufficient information. High prices don’t necessarily encourage firms to enter a market because they don’t tell us how long the profit opportunity from such prices will last.
- Many profitable companies operate in niches which are big enough to offer nice profits, but too small or too specialized to attract entrants: each week, the IC describes dozens of such firms.
- New technologies enjoy increasing returns to scale. As Stian Westlake and Jonathan Haskell say: “Intangibles are often very scalable: once you’ve developed it, the Uber algorithm or the Starbucks brand can be scaled across any number of cities or coffee shops.” This creates a winner-take-all effect.
- Network effects generate an incumbency advantage. If I set up a more efficient supermarket than Tesco, I should win enough business to get by, and to force Tesco’s prices down. But if I set up a potential rival to Facebook, I face a tougher job. Because the value of a networking site depends upon others using it, Facebook has a more entrenched advantage.
If all of this is right, and these are long-lasting changes – which is a big if – then we need to ditch some old mental models and rediscover some others. We should abandon the idea that competition equalizes profits and restrains monopolies and perhaps return to some older Marxian ideas.
Marx thought capitalism tended to generate monopolies. Some of his followers, most famously Baran and Sweezy, thought this would generate a tendency towards stagnation, as those monopolies generated more profits than they could spend.
For a long time, these ideas were mistaken. However, at a time when we’re seeing superstar firms build (pdf) up massive cash piles amid talk of secular stagnation, perhaps we need to rethink their relevance and implications.
is a greater % of the economy made up of natural monopolies, or industries where strategic entry deterrence is easier? (both ideas out of if not econ 101 then 102). Or is this about implicit collusion without any underlying structural change?
Posted by: Luis Enrique | May 18, 2017 at 02:09 PM
I'm sure someone in the 1970s thought that IBM was a natural monopoly too, what with computers being so large and expensive and there only being a limited number of customers.............20 years ago Apple was broke. A 2 or 3 good inventions later its flying high. But ripe for a fall - whats it done since the Ipad? New versions of existing ideas yes, anything genuinely innovative to drive the business forward into new markets, no.
Nothing lasts forever in the consumer world, Apple (and all the other currently stellar performers) will be no different.
Posted by: Jim | May 18, 2017 at 02:47 PM
I think IP laws and network effects can explain a significant part of this phenomenon.
I am still optimistic. If we can just remember the lessons from the big oil and telecoms anti-trust battles, I see no reason why we couldn't break modern monopolies.
In many ways Apple is the strangest animal. There seems to be no obvious moat in its business plan. Mobile phone competition is massive. Previous encumbents got destroyed: nokia, blackberry, etc... Maybe Apple will end up in the scrap heap as well...
But it's true that there seems to be only one massive winner at the time. They don't last for long though. Instead of lots of companies with small profits, you get a sequence of a single successful companies with massive profits.
Posted by: acarraro | May 18, 2017 at 02:49 PM
In my business, bots for computer games, the market has become global and once you are established, its very very hard for a competitor to break in. From day 1 they have to scale up and support users all over the world or else get a terrible reputation. For example, this means Chinese language support from day 1. The effect is that once you are established, even a superior product can't even dent your revenues. Its nice for us but pretty bleak when you think this pattern is being repeated across all industries.
Posted by: Patrick Kirk | May 18, 2017 at 03:02 PM
@Jim,
IBM was never a monopoly (there were other mainframe suppliers), but it was sufficiently dominant that it could reinvent itself as a software and business business services provider once the "big tin" market was eroded by minis and desktops. The key to this transformation was its established global footprint, i.e. the infrastructure of offices, commercial partnerships and political contacts. In other words, the network effects that benefit incumbents were at work long before social media.
While competition was employed rhetorically to open up countries to globalisation, the result was the creation of a new class of multinationals who tended to shift from a vertically integrated model (controlling manufacture, distribution and sales) to a horizontally integrated model (focusing on "core competencies" such as R&D, brand and finance) with most of their operations sub-contracted. Apple is a good example of a business that went from vertical (e.g. insisting that eveything it made should be incompatible with other devices) to horizontal (essentially positioning itself as a luxury goods brand).
National competitors, who are often still vertically integrated for political reasons (keep the jobs here etc), are at a scale disadvantage while the cost of entry to new global competitors is now much greater. In other words, globalisation was justified by appeals to competition but it has produced a less competitive environment in many industries. It's possible that Apple will be knocked off its perch one day, but its also possible that it will simply buy-out any emerging threat. That has been the standard MO of most Silicon Valley giants for years (and one reason for the cash piles).
Posted by: Dave Timoney | May 18, 2017 at 04:11 PM
how is an unspoken agreement to collude observationally different from other possibilities?
Posted by: Luis Enrique | May 18, 2017 at 05:24 PM
Companies see little value in undercutting themselves or others, but much in extracting what they can to invest in the next big thing.
Posted by: Lord | May 18, 2017 at 05:27 PM
And when they don't see an immediate opportunity, they store it up as a future option and wait.
Posted by: Lord | May 18, 2017 at 05:32 PM
Patrick - if that's the case, and your company's market isn't contestable (another big if), it's a straightforward case!
Network effects and a need for 'instant excellence' in a global economy just need strong, enforced antitrust laws
Posted by: Jamie | May 18, 2017 at 06:25 PM
Would the possibility that many profits are of rentier type or simply from financial arbitrage/gambling (needing vast start-up capital and financial market know-how) not be a factor? Same for service industries where large chains own huge proportions of outlets and control locations on the high street. How profitable are firms with conventional business models of classical economic theory?
Posted by: scmatlock | May 18, 2017 at 07:37 PM
Jamie - you are correct. We are both confirming the thesis Chris offers. Competition has little impact on profits if you are market leader in an sector where, in your words, "instant excellence" is a requirement.
Posted by: Patrick Kirk | May 18, 2017 at 09:51 PM
Any increase in prices should be seen by the authorities as an indication of insufficient or ineffective competition which should, as the ultimate sanction, resulting in the confiscatory nationalisation or severe regulation of the firm in question.
If you lock the price side down, and ensure the population has alternative jobs to go to, then the firm can only increase income from cost reduction.
There's nothing wrong with profits or a monopoly if the firm in question is providing something of value. There is a problem with price gouging and rentier activity.
Posted by: Neil Wilson | May 19, 2017 at 06:14 AM
Good to see a shout out to Monthly Review, as well as Baran and Sweezy. Odd the author didn't mention "Stagnation and the Financial Explosion" (1987), which address's the author's incorrect (imnsho) assertion that Monopoly Capital thesis ideas "were mistaken."
Posted by: Duende | May 19, 2017 at 11:59 AM
Haldanes says
"An upper tail of companies and countries has maintained high and rising levels of productivity. "
But are they actually investing more in additional capital? Or are they essentially harvesting a kind of speculative return from infotech cost saves, patent and copyright subsidy, and labor arbitrage?
Posted by: john | May 19, 2017 at 12:34 PM