Description automatically generated “…Why have US aggregate profit rates increased while financial market rates decreased since 1980? We propose a mismatch hypothesis: Profit rates in the national accounts track the return on capital for all firms, while financial market rates track the cost of capital for public firms only. We show public-firm profit rates halved since 1980, matching trends in financial markets and suggesting low market power. Mechanically, this residual private capital return series shows private capital returns had to have increased substantially to account for this secular break between aggregate and public firm profitability. The degree of this shift is significant: Private firms’ profit rates are on average 10% higher than public firms’ in the post-2000 period. Nonfinancial domestic private-firm profit rates doubled, suggesting high market power or risk. Size and sector differences cannot explain the divergence, though intangible-intensity might. Our results indicate substantial biases in extrapolating public-firm trends to the aggregate economy….”

The Evidence

Public-Firm Profits Have Fallen

“…Figure 8 shows the return on book capital with separate corrections for R&D and goodwill. This figure shows our adjustments make little difference to the series. Indeed, our results show book capital profit rates are decreasing and other results in this paper are robust are a variety of different treatments of R&D and goodwill. We show the book profit rates Rb for both the IMA data and the Compustat sample in Figure 9. The two series follow each other fairly closely until the mid 1990s, when the publicly listed firm book profit rate drops markedly below the IMA book profit rate. Since then, public firm profits have fallen relative to profits in the national accounts. Figure 9 illustrates the importance of using a representative sample of firms to measure the cost of capital. Since the profit rates of public firms are different from those of private firms, it is not appropriate to apply measures of the cost of capital from public firms to the aggregate economy, which includes private firms….”

“…One alternative to analyzing the return on book in public-firm and aggregate data is to impute the replacement value of capital in Compustat using information from the IMAs. The IMAs provide the replacement and book values of the aggregate capital stock. By assuming the ratio of replacement-to-book values is the same in Compustat, we can infer the return on capital R of publicly listed firms. This approach highlight the quantitative differences in the two profit rates and their secular divergence in recent decades The left panel of Figure 10 shows the ratio of the replacement value of capital to the book value for inventories; property, plant, and equipment (PPE); and intellectual property products (IPP). Since the replacement value is typically above the book value, most of these series are above one most of the time. We can use these three series to transform our book capital profit rates back into our profit rates from above with replacement capital values, assuming Compustat firms have the same replacement-to-book ratios as in the IMA data. The right panel of Figure 10 shows this replacement-to-book ratio from the IMA data, leading to the same conclusion as before: public company profit rates have fallen….”

Increase in Private-Firm Profit Rates

“…If there is no mismeasurement of foreign and domestic activity, this residual return constitutes the return on capital for private firms in the US. We label this the private return on capital, with the important caveat that this measure has issues of measurement of foreign vs domestic activity. Figure 14 shows these results. Mechanically, this residual private capital return series shows private capital returns had to have increased substantially to account for this secular break between aggregate and public firm profitability. The degree of this shift is significant: Private firms’ profit rates are on average 10% higher than public firms’ in the post-2000 period….”

Potential Causes of Divergence

“…The first hypothesis we consider is that Compustat overrepresents large firms, so perhaps the secular shift is just driven by changes in the profit rates of large firms relative to those of smaller firms. The second hypothesis we consider is that public and private firms generally operate in different sectors Our third hypothesis posits that the disparity in profit rates between public and private firms can be attributed to the relative concentration of intangible assets capital as intangible instead of physical. To investigate this theory, we will examine whether the difference in profit rates between firms that are heavily invested in intangible assets and those that have a lower concentration of such assets explains the gap in return on the capital between public and private companies….”

“…To understand exactly how representative public firms are of the aggregate economy, we plot the number of employees, as a fraction of aggregate employment, of various types of firms. We use both BDS and Compustat employment data to make the comparison. The left panel of Figure 16 shows the employment share of primarily goods-producing (instead of primarily service-providing) Compustat and BDS firms. The BDS series shows goods production has declined in aggregate in terms of employment shares. The Compustat series shows this decline has been less pronounced for public firms. The right panel of this figure shows the fraction of employment of mega-firms in the economy overall (see the BDS series) and the fraction of public mega-firm employment from Compustat. Note that a fairly stable 30% of aggregate employment is at mega-firms, while 80% or more of total public-firm employment is at mega-firms. Unsurprisingly, Compustat is not representative in terms of sector or firm size…”

“…Figure 17 combines the weights from 16 and shows neither the firm size nor sectoral composition hypotheses alone can explain the public and private firm mismatch. The left panel shows the rewighted Compustat book returns for both the goods and services sectors. The service sector has lower returns than the goods sector, so the over-representation of goods-producing firms in Compustat means the public and private firm mismatch is all the more puzzling. The right panel shows the reweighted book returns for Compustat mega-firms and other Compustat firms, revealing that mega-firm trend returns are higher than small-firm returns. Since public firms are disproportionately mega-firms, this also fails to explain the mismatch. Note the figure only shows public firm returns by sector and size because private firm returns are not freely available. Neverthless, reweighting suggests that neither size nor sectoral composition alone can explain the divergence in profit rates of public and private firms–otherwise we would expect to see the same divergence in trends between those groups within public firms….”

“…To determine if the trend of the public-private mismatch is influenced by firms that are heavily invested in intangible assets, we compared the return on capital of firms with R&D to book capital ratios above the median to those with lower ratios. The results, depicted in Figure 18, reveal there is no significant difference in returns on capital between the two groups of firms. This suggests the discrepancy in the concentration of intangible assets between public and private firms is not a driving factor behind the public-private return on capital mismatch….”

The Brass Tacks

“…In the US, aggregate profit rates have increased while financial market rates have decreased since 1980. We call their gap the “puzzle rate” and its rise the “profit puzzle.” The profit puzzle has led to suggestions that rising markups, risk, or intangible capital are contributing factors. In this paper, we propose an alternative hypothesis: Profit rates in the national accounts track the return on capital for all firms, while financial market rates track the cost of capital for public firms only. The capital profiles of public and private firms differ and vary over time, which can lead to financial market rates misrepresenting the cost of capital faced by a representative firm. Supporting this view, there is a large literature in asset pricing documenting higher returns for private firms compared to public firms. We call thisexplanation the “mismatch hypothesis.” To test our hypothesis, we analyze data on public-firm profit rates and find they have halved since 1980, matching trends in financial markets. Our results are robust to assumptions about the capitalization of R&D and goodwill, as well as the measurement of capital stocks at book or replacement value. When adjusted for differences in depreciation and tax rates, we find a tight link between the return on and cost of public-firm capital. The puzzle rate for public firms is small and well within statistical discrepancy. Hence, we view the mismatch hypothesis as a promising solution to the profit puzzle. Subsetting to nonfinancial domestic firms so we can compare Compustat and the IMAs, we estimate public firms represent 60% of the capital stock. Inferring from the residual, we find private-firm profit rates moved in lockstep until 1980, when they diverge. Private-firm profit rates are now over twice as high as public-firm profit rates. We show this secular shift is not driven by differences in the representation of size or sector of public-firms, though intangible-intensity offers a promising direction for future research….” Carter Davis, Alexandre Sollaci and James Traina, “Profit Puzzles,” Kelley School of Business Research Paper, February 1, 2023, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4015573

Share of Business Output, “..Figure 6 shows the percentage of sectors with low, medium, and high C4 in business output in 2002 and 2017.43 Sectors with a low concentration ratio, below 50 percent, had a much higher share in business output than medium (50-80 percent) and high (over 80 percent). Furthermore, low concentration industries became a larger share of the economy. While the low concentration sectors constituted 62 percent of the economy in 2002, by 2017, their share had grown to more than 80 percent. Inverse patterns occurred in medium and high levels of concentration. The share of economic output from highly concentrated industries fell from 10.6 percent in 2002 to 4.7 percent in 2017. In short, the U.S. economy is not becoming monopolistic, filled with giant rapacious firms gobbling up market share….”

Concentration and Profitability, "... There is essentially no relationship between industry profitability and the concentration ratio in 2017 (a correlation coefficient of 0.04)..."

The technology frontier isn’t concentrate, “…Anti-corporate populists have taken particular aim at technology sectors, claiming that “Big Tech,” particularly the Internet industry, is concentrated. However, the number of advanced technology industries with high levels of concentration is modest (see figure 5). Using the Brookings Institution list of 4-digit NAICS code of advanced technology industries, ITIF constructed a list of advanced technology industries at the 6-digit NAICS code level.34 Of 135 industries, only 8 have C4 ratios above 80 and 10 times more have C4 ratios below 50. Moreover, there were more unconcentrated tech sectors in 2017 than in 2002. The argument that tech sectors are becoming concentrated does not hold…”

Concentration and Prices, "...Surely concentration must enable firms to charge higher prices. In fact, of the 36 industries with a C4 ratio of over 70 percent in 2017, and for which there was data available on price changes from the BLS producer price index (PPI), 22 (61 percent) saw price increases from 2002 to 2017 that were lower than the economy-wideppI. In fact, the correlation between the C4 ratio and the change inppI was actually negative (-0.31), meaning the more concentrated the industry, the lower the price increase..."

The evidence, “…In 2017, 643 industries (76 percent) were unconcentrated with less than a 50 percent C4 ratio (see figure 1). A total of 173 (20 percent) were moderately concentrated with a C4 ratio between 50 percent and 80 percent. And just 35 industries (4 percent) were highly concentrated with a C4 ratio of 80 percent or more. Even at 80 percent, this means the top four firms had only 20 percent of the market share if they split it into equal shares….”

Change btw 2002-2017, “…On average, concentration increased only 1 percentage point between 2002 and 2017 after taking the simple average across all industries of the differences between C4 from both years (34.3 percent in C4 from 2002 and 35.3 percent in C4 from 2017). Given that industries with C4 ratios below 50 percent are considered unconcentrated, this is a very low number. The concentration of the eight largest firms (C8) increased even less, from 44.1 to 44.7 percent. Even considering the eight largest firms, the concentration ratio remained lower than 50 percent. Overall, 467 sectors (55 percent) increased in concentration, while 384 (45 percent) decreased (see figure 2). Again, this is hardly evidence of widespread growth of monopoly. Moreover, among the sectors that saw an increase, only 152 (18 percent of the total) increased by more than 10 percentage points..

Industry by concentration rate, “…Some industries clearly got less concentrated, while others got more. Table 1 shows the 20 industries with the greatest increases in C4 ratio. Only 30 percent had C4 ratios above 80 percent in 2017. And even for some of them, there was little risk of firms exerting much market power. For example, industries such as other performing arts companies, luggage and leather goods stores, geothermal power generation, and paint and wallpaper stores all face significant competition from firms in other industries such as movie theaters, department stores, and natural gas power generation. For some other industries, the U.S. trade balance deteriorated, meaning that imports took a larger share and provided more competition.30 This includes newsprint and electrical lighting manufacturing, in which the United States is the largest importer (importing 20 percent of the total international trade for both industries).31 For other industries, such as taxi service and travel agencies, the Internet enabled significant economies of scale and cost reductions, such as with the rise of Uber and Lift for taxis and Travelocity and Expedia for travel….”

Key factoids, “… Just 35 of 851 industries (4 percent) were highly concentrated, with the top-4 firms (the C4 concentration ratio) holding more than 80 percent of the market….In 2017,80 percent of U.S. business output was from industries with low levels of concentration, with that share increasing from 62 percent in 2002…..Fifty-five percent of industries increased concentration between 2002 and 2017; 45 percent decreased…..The average C4 ratio increased by just 1 percentage point between 2002 and 2017, from 34.3 percent to 35.3 percent, while the average C8 ratio increased even less, from 44.1 percent to 44.7 percent…..There was a slight negative correlation between the C4 level in 2002 and the percentage point change in C4 between 2002 and 2017….Among the industries with increases in concentration, only one-third increased by greater than 10 percentage points…..Of the 20 industries showing the greatest increase in the C4 ratio from 2002 to 2017, only 30 percent had C4 ratios above 80 percent in 2017…..Of the 115 industries with a C4 ratio of 60 percent or more in 2002, the majority got less concentrated, with the average C4 declining 4 percentage points…..For every advanced technology industry with a C4 ratio over 80 percent, there were 10 with a C4 ratio below 50 percent….Producer prices rose less from 2002 to 2017 in industries with higher levels of concentration than overall prices…”

Robert Atkinson and Filipe Lage de Sousa use Census data to argue that there hasn’t been an increase in concentration, asBen noted they aren’t using HHI series that the vast majority of people looking at this space do. Their bottom line, “…And the facts (data from the Economic Census) do not support assertions of monopolization. More than 80 percent of business output is in sectors with low concentration ratios, including many advanced technology industries. Moreover, from 2002 to 2017, concentration mostly stayed low and increased very little. In addition, more-concentrated industries did not on average show greater increases in prices or boosted profits than others…”

New NEBR paper, suspect will be hearing for about it from the left as it's arguing that the decline of the labor share, decline of capex, as well as the decline in low-skilled wages all are given a tailwind by the increase in markups and market power

given that within industry they found the highest markups went to firms that already had the highest markups seems like it could be the rise of superstar firms as opposed to market power.

"...Using micro data on the accounts of publicly traded firms in the US starting in 1950, we find that markups have been relatively constant between 1950 and 1980 at around 20% above marginal cost. From 1980 onwards, there has been marked change in this pattern with markups steadily rising from 18% to nearly 67% in 2014, a three and a half fold increase. We have documented the properties of this rise, which is mainly due to a change within industry, and which can be attributed mostly to the increase of markup of the firms with the highest markups already.Markups tend to be larger in smaller firms, but this seems to be due mainly to a composition effects across industries as this disappears when we decompose the markup at the fine industry level. We use this increase to investigate the implications this has for secular macroeconomic trends in the last decades: 1. decrease in labor share; 2. decrease in capital share; 3. decrease in low skill wages; 4. decrease in labor force participation; 5. decrease in labor flows; 6. decrease in migration rates; 7. slowdown in output and GDP. There are of course other secular trends that happen to coincide with the increase in market power: 1. decrease in startup rate of new firms due to higher barriers erected by incumbents 2. decrease in the long term interest rate due to the fall in demand for capital (due to quantity reduction of firms with market power) and an increase in the supply of capital (due to higher profits); 3. the increase in wage inequality46 from to the decrease in low skill wages as documented above together with an increase in skilled wages due to profit sharing by managers; 4. the great moderation, or the idea that output fluctuations have decreased since 1980, has lost appeal since the great recession, but which is still very much observed in the data, especially in the last decade, with of course, the notable exception of 2008. As we have shown, with incomplete pass-through the same individual firm level productivity shocks lead to lower output adjustments. There is evidence however that the transmission of aggregate shocks is also incomplete. As a result, higher market power would translate in smaller aggregate fluctuations GDP in response to aggregate shocks as well. While we believe that each of these four secular trends are as important as, if not more important than, the ones we have analyzed, we leave them as a priority for future research. There are two profound policy consequences that result from the rise in market power.The first relates to inflation. Relative to a scenario without a rise market power and with the same evolution of technology, prices would have gone up by 1% per year (42% over 35 years, from 1.18 to 1.67). This implies that inflation has been higher than it would have been without the rise in market power.This is surprising given the low inflation rates in the last decades - and particularly low ones since the great recession. Of course, monetary policy is not the appropriate policy tool to remedy that source of inflation. That would be the prerogative of anti-trust policy. The second consequence pertains to the value of the stock market. Stocks prices reflect the discounted flow of dividends and thus profits. The stock market under market power is therefore overvalued relative to a competitive economy. If investors believe that the current profit level that is four times higher than in 1980 is permanent, then we would expect that the stock market capitalization would be four time higher than under perfect competition. That would put the Dow Jones at 5,500 instead of its nearly 22,000 level today. Of course, that is a naïve calculation since market capitalization also reflects the extensive margin, the total value of goods sold, and that decreases with market power. How big the effect of market power is on the stock market value depends on the elasticity of demand. Note also that the stock market can go up if output deceases, for example when productivity growth is zero and market power and hence profits increase. In the presence of market power, the stock market is therefore not a good gauge of an economy’s output. While we have focused on the consequences of the rise in market power, in this paper we have remained silent on the causes. Especially when it comes to finding remedies, it is essential to understand the causes. We limit ourselves to listing a number of candidate explanations: the rise of merger & acquisition activity (Figure B.9 in the Appendix), deregulation, the higher share of network goods, the increase in wholesale transaction (Ganapati (2016)), private equity, improved product differentiation, increased vertical and financial integration of competitors. A common factor in each of these is technology. Rapid technological change allows firms to better create and preserve situations of market power. Markups are reaching heights multiple times higher than ever seen, at least since the second world war when our data start. It is open to speculation whether this trend will continue, but for now there are no signs that markups will decrease substantially any time soon..."

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De Loecker, Jan, Jan Eeckhout, and Gabriel Unger. November 22, 2018. “The Rise of Market Power and the Macroeconomic Implications.” NBER.http://www.janeeckhout.com/wp-content/uploads/RMP.pdf

Meghana Ayyagari, Asli Demirguc-Kunt, and Vojislav Maksimovic, “The Rise of Star Firms: Intangible Capital and Competition,” Social Science Research Network, June 8, 2020, https://papers.ssrn.com/sol3/papers.cfm

Note their return on invested capital is pre-tax

Figure 3 shows adjusting for intangibles lowers ROIC as the increase in invested capital is > uptick in earnings.

Paper goes on to adjust the markups:“…. Furthermore, once we adjust markups based on operating expenses for investment in intangible capital, we only find a modest increase in market power especially in high skilled industries. Star firms tend to be larger, younger, and have higher markups. While they may have more pricing power than other firms, at each level of markup star firms tend to produce more than other firms. We also find no evidence that star firms are differentially affected by import competition compared to other firms in the economy. Overall, we see little evidence that these star firms are using their market power to reduce output and raise prices to achieve super normal returns more than other firms.However, there may be reason for concern regarding a smaller subset of elite publicly-listed firms. The usual suspects for membership in such an elite group are Apple, Facebook, Google, Amazon, and Microsoft. When we examine these firms individually, the ROIC and markups of most of these elite firms do not seem extraordinary initially and then explode but again only for a couple of firms that have built up a large enough market. Even for these firms, the critical policy concern may not only be the regulation of their use of market power today, but also the need to maintain contestable markets that allow the creation of independent technologies in the future….”

“…Figure 1 shows that there is a large rise in capital returns over the past three decades where the ratio of the 90th percentile ROIC firm to the median ROIC firm has increased by over 69%. We also see that the divergence of the top decile of firms from the rest of the economy really takes off in the 1990s…conventional financial statements do not capitalize R&D expenditures or organizational capital. Once we adjust firms’ returns to capital to address these shortcomings, there is little evidence that the most profitable 10% of firms are pulling away from the rest of the economy, and the differences in firm returns in highly skilled and other industries shrink dramatically…”

More pushback at market power hypothesis. Paper finds that the divergence btw “star” firms and the rest of the economy is largely explained by mismeasurement of intangible capital. The leading firms produce and invest more per dollar of invested capital: