The Rise of Star Firms: Intangible Capital and Competition

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

Stock-market short-termism is that rare enemy that unites left and right...Neither is correct...as a compelling short book from Harvard Law School Professor Mark Roe shows...The trickier critique is that short-term thinking leads companies to invest less than they should in long-term projects and in research and development, and to prioritize dividends and buybacks instead. If widespread, the economy would suffer. Yet, the data don’t back up the idea of broad damage to the economy. True, U.S. corporate investment in factories, equipment and suchlike is much lower, as a share of gross domestic product, than at its peak shortly before the 1980 recession. But the same applies to companies in countries where shareholders have less influence, and U.S. companies actually cut investment less. The argument that R&D is lower is simply wrong. U.S. R&D spending reached a post-World War II high in 2020, as a share of GDP. Companies are spending twice as much as in 1980. If there’s an R&D problem, it lies in the public sector, where R&D has been slashed, not the private sector.

James Mackintosh, "Quarterly Capitalism Isn’t Ruining the World,"Wall Street Journal, April 6, 2022, https://www.wsj.com/articles/quarterly-capitalism-isnt-ruining-the-world-11649237479

Quarterly Capitalism Isn’t Ruining the World

Stock-market short-termism is that rare enemy that unites left and right, management and employees, and some of the world’s biggest fund managers and consultants. On the left, “quarterly capitalism” is shorthand for venal executives and greedy shareholders abusing workers and the environment in pursuit of unsustainable profits. On the right, critics fear short-term-oriented stockholders pressure management to make dumb decisions, depressing investment and the economy.

Neither is correct, as a compelling short book from Harvard Law School Professor Mark Roe shows. And that matters for public policy, lawmakers and the dominant narrative in how America’s corporations are run. There are plenty of problems, but they need different fixes.

Start with the left-wing criticism, since it is easiest to debunk. Short-term thinking is clearly not the cause of climate change, pollution or poor treatment of staff. Indeed, it is often the exact opposite: Oil companies have to plan decades ahead before building an expensive new refinery or drilling costly offshore wells. DuPont polluted the Ohio River in West Virginia despite internal warnings about it, not because of a desire for short-term profits but because it didn’t expect to be caught. It succeeded in hiding the problem for many years, a long-term outcome.

The same goes for corporate treatment of workers: Paying only the minimum wage isn’t a short-term strategy, but it was perfectly sustainable for decades for many low-skill jobs, at least until the recent economic boom. Whatever your views on how much labor unions might hurt shareholders, opposing them is definitely not a short-termist approach: Amazon successfully fought against unionization drives for almost a quarter of a century before the first vote for an Amazon union this month.

There are genuine problems, but they are due to companies being able to offload costs—pollution, global warming, societal difficulties—onto others, not short-termism. The incentives for such dumping need fixing, and taking aim at short-term thinking will, as Prof. Roe’s book title says, be “Missing the Target.”

The trickier critique is that short-term thinking leads companies to invest less than they should in long-term projects and in research and development, and to prioritize dividends and buybacks instead. If widespread, the economy would suffer.

Yet, the data don’t back up the idea of broad damage to the economy. True, U.S. corporate investment in factories, equipment and suchlike is much lower, as a share of gross domestic product, than at its peak shortly before the 1980 recession. But the same applies to companies in countries where shareholders have less influence, and U.S. companies actually cut investment less.

The argument that R&D is lower is simply wrong. U.S. R&D spending reached a post-World War II high in 2020, as a share of GDP. Companies are spending twice as much as in 1980. If there’s an R&D problem, it lies in the public sector, where R&D has been slashed, not the private sector.

Companies might turn out to have made a horrible mistake if the cost of borrowing soars and they can’t meet the interest payments, but it has been a long-term trend, not short-term pandering to shareholders. Companies overall haven’t been starved of cash they could have invested elsewhere, contrary to what politicians claim.

Yet, it’s true that executives themselves admit to the worst sort of short-termism. Prof. Roe revisits the most compelling evidence, a widely cited study by John Graham, Campbell Harvey and Shiva Rajgopal, which found almost 80% of executives willing to accept a longer-run cost to maintain short-term earnings. Dig into the study, and while still damning—quarterly numbers shouldn’t matter this much—it turns out only 2% would sacrifice a large amount of value to smooth earnings, and 23% a moderate sacrifice.

If that’s the case, the market may have fixed the problem by itself. Companies that give up profitable projects face more nimble competitors eager to step in, or might themselves start the project later. That could explain the lack of economywide evidence of problems, if the value-adding projects do eventually go ahead.

I support some small fixes that can be done at low or no cost, such as stopping quarterly earnings guidance. But politicians should focus elsewhere, rather than try to address a problem that mostly doesn’t exist—especially since so many of the supposed solutions would give more power to executives, creating other problems.

The book is a must-read for anyone interested in markets and policy, and a great overview of the state of the evidence. But it doesn’t address a linked concern that has always bothered me, that markets are fickle in their commitment to the long term, with damaging consequences.

Investors sometimes think far too long term, bidding up dot-com stocks in the late 1990s, encouraging miners to spend billions on new holes in the ground in the early 2010s, or pushing lossmaking and sometimes zero-revenue speculative growth companies to ridiculous prices early last year. Other times they think too short term, as when fearful investors demanded companies hold on to fortress balance sheets after the 2008 financial crisis in case of a repeat, rather than invest for growth.

I’m not sure there’s a fix for this capriciousness, and it may just be one of the many imperfections of capitalism that we have to live with.

Might firms' use of data create market power? To explore this hypothesis, we craft a model in which economies of scale in data induce a data-rich firm to invest in producing at a lower marginal cost and larger scale. Just like managers are taught to do in MBA programs, the firm decision makers in our model make investment decisions, taking risk into account. It is this effective risk aversion that causes firms to invest more when they have more data. Data is a tool to reduce risk. With less risk from random demand, a larger investment becomes optimal. Thus high-data firms do invest more, grow larger and exert more impact on prices But this simple story delivered some unexpected additional effects. We found that when managers price risk, markups reflect both market power and a compensation for risk. If data reduces risk by making uncertain outcomes more predictable, then is also reduces the risk premium and the markup. At the same time, firms react to data about demand by shifting their production to high-demand goods. These are high-markup goods. So data changes the composition of production. This composition effect leads firms to shift production toward high markup goods, which raises markups. The tug-of-war between risk reduction and the composition effects induced by data plays out different for product, firm and industry markups. A model designed to explore the logic of data and large firms turned out to explain why econometricians got different answers about what was happening to markups over time when they measured at different levels of aggregation. Out model suggests an new interpretation of existing facts. Constant product markups and rising firm and industry markups are not competing facts. They are consistent with an economy where firms are getting better and better at forecasting future demand.

Jan Eeckhout and Laura Veldkamp, "Data and Market Power," National Bureau Of Economic Research, May 2022, https://www.nber.org/papers/w30022

Primary Results: How Data Affects Markups

“…Figures 1 and 2 illustrate how the risk reduction and investment forces compete. When firminvestments greatly decrease marginal cost (low cc), then the cost channel is dominant and more data primarily increases investment, lowers costs and raises markups (Figure 1). When the cost reduction investment is inefficient (high cc), then data still prompts more investment, but this has little effect on marginal cost. Instead, the dominant force is risk reduction. Similarly, if the price of risk is high, risk reduction is also the dominant force. A data-rich firm faces less cost from taking on more risk with a large production plan. By producing more, data-rich firms drive prices down and lower markups (Figure 2)…”

“…One way American firms have improved their moats in recent times is through creeping consolidation. The Economist has divided the economy into 900-odd sectors covered by America’s five-yearly economic census. Two-thirds of them became more concentrated between 1997 and 2012 (see charts 2 and 3). The weighted average share of the top four firms in each sector has risen from 26% to 32%....These data make it possible to distinguish between sectors of the economy that are fragmented, concentrated or oligopolistic, and to look at how revenues have fared in each case. Revenues in fragmented industries—those in which the biggest four firms together control less than a third of the market—dropped from 72% of the total in 1997 to 58% in 2012. Concentrated industries, in which the top four firms control between a third and two-thirds of the market, have seen their share of revenues rise from 24% to 33%. And just under a tenth of the activity takes place in industries in which the top four firms control two-thirds or more of sales. This oligopolistic corner of the economy includes niche concerns—dog food, batteries and coffins—but also telecoms, pharmacies and credit cards….”

Economist Staff, "Too much of a good thing,"The Economist, March 26, 2016, https://www.economist.com/briefing/2016/03/26/too-much-of-a-good-thing

Too much of a good thing

AMERICA’S airlines used to be famous for two things: terrible service and worse finances. Today flyers still endure hidden fees, late flights, bruised knees, clapped-out fittings and sub-par food. The profit bit of the picture, though, has changed a lot. Last year America’s airlines made $24 billion—more than Alphabet, the parent company of Google. Even as the price of fuel, one of airlines’ main expenses, collapsed alongside the oil price, little of that benefit was passed on to consumers through lower prices, with revenues remaining fairly flat. After a bout of consolidation in the past decade the industry is dominated by four firms with tight financial discipline and many shareholders in common. And the return on capital is similar to that seen in Silicon Valley.

What is true of the airline industry is increasingly true of America’s economy as a whole. Profits have risen in most rich countries over the past ten years but the increase has been biggest for American firms. Coupled with an increasing concentration of ownership, this means the fruits of economic growth are being hoarded. This is probably part of the reason that two-thirds of Americans, including a majority of Republicans, have come to believe that the economy “unfairly favours powerful interests”, according to polling by Pew, a research outfit. It means that when Hillary Clinton and Bernie Sanders, the Democratic contenders for president, say that the economy is “rigged”, they have a point.

Opportunities

An intense burst of consolidation will boost their profits more. Since 2008 American firms have engaged in one of the largest rounds of mergers in their country’s history, worth $10 trillion. Unlike earlier acquisitions aimed at building global empires, these mergers were largely aimed at consolidating in America, allowing the merged companies to increase their market shares and cut their costs. The companies in question usually make no pretence of planning to pass the savings they make this way on to their customers; take their estimates of the synergies involved at face value and profits in America will rise by a further 10% or so.

Profits are an essential part of capitalism. They give investors a return, encourage innovation and signal where resources should be invested. Their accumulation allows investment in bold new ventures. Countries where profits are too low—Japan, for instance—can slip into morbid torpor. Firms that ignore profits, such as China’s state-run enterprises, lurch around like aimless zombies, as likely to destroy value as to create it.

But high profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off than creating it afresh, such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall of demand. This has been a pressing problem in America. It is not that firms are underinvesting by historical standards. Relative to assets, sales and GDP, the level of investment is pretty normal. But domestic cash flows are so high that they still have pots of cash left over after investment: about $800 billion a year.

High profits can deepen inequality in various ways. The pool of income to be split among employees could be squeezed. Consumers might pay too much for goods. In a market the size of America’s prices should be lower than in other industrialised economies. By and large, they are not. Though American companies now make a fifth of their profits abroad, their naughty secret is that their return-on-equity is 40% higher at home.

Most explanations of America’s high profits draw on national-accounts data which show that the fall in the share of output going to workers over the past decade is equivalent to about 60% of the rise in domestic pre-tax profits. Scholars typically have three explanations for this: technology, which has allowed firms to replace workers with machines and software; globalisation, which has made it easier to shift production to lower cost countries; and a decline in trade-union membership.

None of these accounts, though, explain the most troubling aspect of America’s profit problem: its persistence. Business theory holds that firms can at best enjoy only temporary periods of “competitive advantage” during which they can rake in cash. After that new companies, inspired by these rich pickings, will pile in to compete away those fat margins, bringing prices down and increasing both employment and investment. It’s the mechanism behind Adam Smith’s invisible hand.

In America that hand seems oddly idle. An American firm that was very profitable in 2003 (one with post-tax returns on capital of 15-25%, excluding goodwill) had an 83% chance of still being very profitable in 2013; the same was true for firms with returns of over 25%, according to McKinsey, a consulting firm. In the previous decade the odds were about 50%. The obvious conclusion is that the American economy is too cosy for incumbents.

In 1998, Joel Klein, who ran the antitrust operation at the Department of Justice (DoJ), declared that “our economy is more competitive today than it has been in a long, long time.” He may well have been right. In the post-war boom American firms grew into mighty conglomerates; in the 1960s J.K. Galbraith, a left-leaning economist, predicted the rise of a symbiotic “industrial state” in which large companies worked closely with the government. But in the 1980s deregulation opened some industries, such as telecoms and railways, to competition. And a new doctrine of shareholder value led big firms, such as RJR Nabisco, to be broken-up and sprawling conglomerates to become focused. In the 1990s American firms faced a wave of competition from low-cost competitors abroad (and, reciprocally, focused their energy on expanding overseas).

Since then the pendulum seems to have swung back. Huge companies, long the focus of American worries about competition, have not actually got any bigger. In 2014 the top 500 listed firms made about 45% of the global profits of all American firms, as they did in the late 1990s. Instead they, and other companies, have become more focused. The strategy can be seen as an amalgam of the philosophies of two deeply influential business figures. Jack Welch, the boss of General Electric for two decades at the end of the 20th century, advised companies to get out of markets which they did not dominate. Warren Buffett, the 21st century’s best-known investor, extols firms that have a “moat” around them—a barrier that offers stability and pricing power.

These data make it possible to distinguish between sectors of the economy that are fragmented, concentrated or oligopolistic, and to look at how revenues have fared in each case. Revenues in fragmented industries—those in which the biggest four firms together control less than a third of the market—dropped from 72% of the total in 1997 to 58% in 2012. Concentrated industries, in which the top four firms control between a third and two-thirds of the market, have seen their share of revenues rise from 24% to 33%. And just under a tenth of the activity takes place in industries in which the top four firms control two-thirds or more of sales. This oligopolistic corner of the economy includes niche concerns—dog food, batteries and coffins—but also telecoms, pharmacies and credit cards.

Concentration does not of itself indicate collusion. Other factors at play might include regulations that keep competitors out. Business spending on lobbying doubled over the period as incumbents sought to shape regulations in ways that suited them. The rising importance of intangible assets, particularly patents, has meant that an ability to manage industry regulators and the challenges of litigation is more valuable than ever.

The ability of big firms to influence and navigate an ever-expanding rule book may explain why the rate of small-company creation in America is close to its lowest mark since the 1970s (although an index of startups run by the Kauffman Foundation has shown flickers of life recently). Small firms normally lack both the working capital needed to deal with red tape and long court cases, and the lobbying power that would bend rules to their purposes. A lack of lobbying clout and legal savvy may also help explain foreign firms’ loss of momentum. In the 1990s adventurers from abroad piled into America, with the share of output from foreign-owned subsidiaries rising steadily. But foreign firms seem to have lost their mojo. Since 2003 their contribution has been flat at about 6% of private business output.

Another factor that may have made profits stickier is the growing clout of giant institutional shareholders such as BlackRock, State Street and Capital Group. Together they own 10-20% of most American companies, including ones that compete with each other. Claims that they rig things seem far-fetched, particularly since many of these funds are index trackers; their decisions as to what to buy and sell are made for them. But they may well set the tone, for example by demanding that chief executives remain disciplined about pricing and restraining investment in new capacity. The overall effect could mute competition.

Quantifying the effect of the corporate America’s defences is tricky. Profits are not the whole picture. In some industries—banking is a case in point—rent-seeking will result in high pay to an employee elite instead. But one can get a crude sense of what is going on by dividing the profits all firms generate into the “bog-standard” and the “exceptional”. Over the past 50 years return on capital has averaged about 10% (excluding goodwill) and that is what investors tend to demand, so let that represent bog-standard profits. The excess on top of that—which may reflect brilliant innovations, wise historic investments in intangible assets such as brands, or, perhaps, a lack of competition—is the exceptional bit. For S&P 500 firms these exceptional profits are currently running at about $300 billion a year, equivalent to a third of taxed operating profits, or 1.7% of GDP.

I love you, you pay my rent

About a quarter of America’s abnormal profits are spread across a wide range of sectors. Returns on capital, concentration and prices have risen in many pockets of the economy. The cable television industry has become more tightly controlled, and many Americans rely on a monopoly provider; prices have risen at twice the rate of inflation over the past five years. Consolidation in one of Mr Buffett’s favourite industries, railroads, has seen freight prices rise by 40% in real terms and returns on capital almost double since 2004. The proposed merger of Dow Chemical and DuPont, announced last December, illustrates the trend to concentration. After combining, the companies plan to split into three specialist companies each of which will have a higher share of its market than either original company had before the deal. They say the plan will yield $3 billion in cost savings. Since 2008 American mergers have sought to remove recurring annual costs of about $150 billion from industrial ledgers. Few firms that are not regulated utilities have public plans to pass these gains on to consumers.

Concentration is contagious. As firms become more powerful those elsewhere on associated chains of customers and suppliers bulk up in response. Google now dominates internet searches for flights and hotels. This has led Expedia, the leading internet travel-agent, to beef up by buying two of its main rivals over the past two years. The spectre of very big online travel sites dominating the purchase of hotel rooms has led the hotel firms to consolidate, too, with Marriott agreeing to buy Starwood this month. (A Chinese firm, Anbang, may make a counter-bid).

Roughly another quarter of abnormal profits comes from the health-care industry, where a cohort of pharmaceutical and medical-equipment firms make aggregate returns on capital of 20-50%. The industry is riddled with special interests and is governed by patent rules that allow firms temporary monopolies on innovative new drugs and inventions. Much of health-care purchasing in America is ultimately controlled by insurance firms. Four of the largest, Anthem, Cigna, Aetna and Humana, are planning to merge into two larger firms.

The rest of the abnormal profits are to be found in the technology sector, where firms such as Google and Facebook enjoy market shares of 40% or more. By Silicon Valley’s account such penetration reflects the popularity and inventiveness of the products on offer, some of which are free to consumers. Today’s dominant firms could be tomorrow’s Nokia or Blackberry: Apple now trades on just 11 times earnings, suggesting investors expect it to decline. Firms such as Uber and Airbnb are a rare source of disruption in the economy, competing fiercely with incumbents.

But many of these arguments can be spun the other way. Alphabet, Facebook and Amazon are not being valued by investors as if they are high risk, but as if their market shares are sustainable and their network effects and accumulation of data will eventually allow them to reap monopoly-style profits. (Alphabet is now among the biggest lobbyists of any firm, spending $17m last year.) A fall from grace in the tech world is not as bad as you might imagine. Microsoft’s operating profits today are twice what they were in 2000, when Mr Klein was prosecuting it in an antitrust trial. And the “sharing economy” startups that are being so highly rated by some investors mostly seek to dominate their markets. The large mountains of cash they are burning today can only be justified if they eventually mature to enjoy very high market shares and margins.

In the past, periods of high and stable profits have ended. Just three years after Mr Galbraith made his 1967 prediction of a cosy, collaborative business world, it was already toast: profits had collapsed by a third relative to GDP as recession struck. Today’s profits, too, may be more vulnerable than they look. If wages finally pick up it could crimp margins. The earnings-per-share of listed firms have fallen slightly in the past few quarters, though a strong dollar and declining oil revenues explain much of that. Some observers of the stockmarket argue that it is already signalling more decline. The gap between the real yield on equities and that on government bonds suggests that either firms are riskier than ever, bond yields are freakishly low, or that profits face a cyclical downturn.

Even so, it is hard to identify a mechanism by which profits might fall to more normal levels. Investors and managers continue to place extraordinarily high profit multiples on businesses with “moats”. The cable television industry is supposedly under pressure from the likes of Netflix and Amazon Prime. Yet in 2015 Charter Communications, a cable company, bought Time Warner Cable for $79 billion, or 26 times its free cash flow, which implies that it believes it will be in a position to raise prices. When Heinz (part-controlled by Mr Buffett) bought Kraft Foods in 2015, it paid 31 times the free cash flow and promptly slashed spending to boost margins, suggesting it felt the threat from rival makers of cheese slices was rather small.

Antitrust, but verify

Perhaps antitrust regulators will act, forcing profits down. The relevant responsibilities are mostly divided between the DoJ and the Federal Trade Commission (FTC), although some industries, such as railways and telecoms, also have their own regulators. The DOJ and FTC are busy trying to police the mergers-and-acquisition boom. Rather than contest every deal they select cases that set new precedents and argue them in court: of the 15,000 deals between 2005-14, about 3% have been subject to close scrutiny.

Together the two bodies have roamed far and wide. The DoJ has blocked domestic deals, such as the takeover by AT&T of T-Mobile USA in 2011, and cross-border combinations that would have caused concentration in global industries, such as the merger of two chipmakers, Applied Materials and Tokyo Electron, in 2015. The FTC spends a big chunk of its time looking at health care. It has blocked hospital mergers and fought “pay-for-delay” deals in which pharmaceutical firms try to stop generic competitors from launching rival products when patents expire. The DoJ is casting a beady eye over the airlines.

Yet the system suffers two limitations. One is constitutional. The two bodies’ job is to police infringements of a well-established and mature body of law through the courts. This leaves them admirably free of overt political interference and lobbying but it also limits their scope. Lots of important subjects are beyond their purview. They cannot consider whether the length and security of patents is excessive in an age when intellectual property is so important. They may not dwell deeply on whether the business model of large technology platforms such as Google has a long-term dependence on the monopoly rents that could come from its vast and irreproducible stash of data. They can only touch upon whether outlandishly large institutional shareholders with positions in almost all firms can implicitly guide them not to compete head on; or on why small firms seem to be struggling. Their purpose is to police illegal conduct, not reimagine the world. They lack scope.

The second limitation is intellectual. America’s antitrust apparatus has gone through periods of leniency (1915-35) and stridency (1936-72). By the 1980s the Chicago school of free-market thought was ascendant. Its insistence that the efficiency benefits of big mergers should not be dismissed had a big influence on the courts. Antitrust guidelines which held that any deal involving a firm with a market share of 35% or more should be considered suspect on principle have been set aside in favour of a more granular approach, with regulators looking ever more closely at the specific effects of a deal. To work out if a deal lowers consumers’ level of choice or lets firms hike prices they will study micro-markets in specific regions.

Who does not prefer the rifle to the blunderbuss, the scalpel to the axe? Such sophistication allows regulators to demand clever remedies, such as the disposal of subsidiaries. But with their heads deep in data and court rulings that set fine precedents, the scientists of antitrust are able to sidestep some troubling questions. If markets are truly competitive, why do so many companies now claim they can retain the cost synergies that big deals create, not pass them on to consumers? Why do investors believe them? Why have returns on capital risen almost everywhere?

These legal and intellectual limitations of the antitrust apparatus raise the question of competition to the political sphere—currently, alas, a realm well supplied with blunderbusses and axes wielded haphazardly and at the wrong targets. Americans’ mistrust of their economic system and the companies that make so much money in it has so far been channelled into calls for protectionism and government intervention. Free trade should be limited. Health-care firms should be more regulated. Foreign firms—particularly Chinese ones—should be discriminated against. Wages should be forced up. Taxes on companies should be raised.

Memories of the future

Nowhere has the alternative approach been articulated. It would aim to unleash a burst of competition to shake up the comfortable incumbents of America Inc. It would involve a serious effort to remove the red tape and occupational-licensing schemes that strangle small businesses and deter new entrants. It would examine a loosening of the rules that give too much protection to some intellectual-property rights. It would involve more active, albeit cruder, antitrust actions. It would start a more serious conversation about whether it makes sense to have most of the country’s data in the hands of a few very large firms. It would revisit the entire issue of corporate lobbying, which has become a key mechanism by which incumbent firms protect themselves.

Large firms no longer employ all that many people in America: the domestic employee base of the S&P 500 is only around a tenth of total American employment. New firms would invest more, employ more staff, and force incumbents to invest more in order to compete. If this sounds pie in the sky, consider the shale revolution over the past decade. Although the industry is now suffering from low oil prices, it is a rare example of entrepreneurial spirit taking on a stodgy industry to the benefit of all. A new commitment to competition could be the source of optimism that America is desperately searching for. After all, it is only a healthy dollop of greed and a belief in a better future that prompts people to start from scratch and try to cross the moat that has been dug around corporate America.

Nancy Rose, "Concerns About Concentration," Aspen Institute, 2019, https://www.economicstrategygroup.org/wp-content/uploads/2019/12/Maintaining-the-Strength-of-American-Capialism-Concerns-About-Concentration.pdf

Her takeaway from the current evidence, “….government has likely retreated too far from the role it assumed almost 130 years ago with the passage of the Sherman Antitrust Act to ensure open, fair, and competitive markets. Rebalancing competition law to invigorate enforcement will require a combination of agency action and legislative intervention. But some competition problems may not be actionable through antitrust enforcement. In these cases, recognizing that both markets and regulation are imperfect is essential to determining whether intervention is likely to improve outcomes, and to designing effective policy in those cases…”

Her four primary takeaways from the current concentration literature:

1) “…Studies of broad industry categories at the national levelsuggest increased concentration of revenue among the largest firms over the past 20 to 40 years….”
2) “…Rising national concentration is not mirrored by increased concentration at the more local level, which recent work suggests has declined on average. A plausible explanation for this divergence is growth in the national revenue share of the largest firms in most industry categories accompanied by expansion of those firms into geographies..”
3)“…Aggregate estimates of average markups or profit rates appear to have increasedover time….”

4)“…There is vigorous debate over the implications of these patterns in aggregateconcentration and markups for the state of competition….”

Industries should be defined narrowly"...economy-wide concentration studies typically use the North American Industrial Classification system (NAICS) or Standard Industrial Classification (SIC) codes to define industries, with levels of aggregation that range from very broad one or two digit sectors ("Manufacturing") to more narrow four - (SIC) or six-digit (NAICS) industry-specific codes ("Breakfast Cereal Manufacturing."Aggregations less specific than the four digit SIC industry code are almost surely too expansive to provide insight into anything beyond the question of whether large firms in broad sectors are getting larger. As an example, the NAICS three digit "Food Manufacturing" industry comprises manufacturers of breakfast cereal, chocolate and confectionary, dog and cat food, and animal slaughterhouses, among many, many others. It is difficult to think of what one could learn from changes in firm revenue shares, let alone concentration, across this mix of activities. The specificity of four digit SIC or six digit NAICS codes generally produces more interpretable industry definitions, though even those are rarely well-defined markets from a competitive standpoint…”
Measures of revenue shares should be built up from establishment data, not from assignment of top-line, firm level sales, "...Some studies in this literature rely on firm level databases, such as Compustat that report a primary industry code for a firm, typically at a four-digit SIC level. The assignment of all of a firm's revenue to one code in most cases systemically biases measures of industry concentration upward. It is much more accurate to measure industry revenues in the United States using the establishment level data produced by the Economic Census..."

Concentration measures should be based on the universe of firms, not only large or publicly traded firms, "...Economic activity in many small and privately held firms may be missing in databases such as Orbis or Compustat, which rely on publicly reported financial data, such as 10-Ks, that privately held firms may not disclose.If the total commerce in these firms is significant, individually or in the aggregate, statistics excluding their activities may be misleading and will distort changes when the companies sampled change overtime. This is especially problematic for studies of European concentration based on Orbis data, which expanded coverage of small and midsize European companies over time.
Concentration measures should reflect the size distribution of firms, "...Industrial organization economists and antitrust practitioners prefer the Hirschman Herfindahl Index, or HHI, which is the sum of squared market shares of all firms. Higher HHI's reflect more concentrated revenue, with an upper limit of 1 (or 10,000, if shares are measured as 0-100%) for monopoly. This provides more information about revenue distribution than concentration ratios, which are the revenue share accounted for by the largest N firms (commonly four or eight, denoted as CR4 or CR8). For example, a CR8 or 80% could reflect one firm with a 75% share, or eight firms with 10% shares, with very different implications for market structure. The HHI would distinguish between these situations….”

Concentration measures should reflect the appropriate geographic scope of a given product market, "This is aspirational and is virtually never satisfied in aggregate studies of concentration. Almost all studies apply a single geographic aggregation, typically national, to all industries. This is too narrow for markets with globally traded goods, such as aircraft, cement, or petroleum, and much too broad for markets with locally delivered goods and services, such as scheduled airline service between cities, concrete, or retail gasoline. Furthermore, to the extent that imports or exports are important in a given market, measures built up from sales only by U.S. entities could have severe mismeasurement. This is also problematic for firm-level data sources like Compustat, for which U.S. sales may be a fraction of firms' recorded global revenue..."

MIT's Nancy Rose on what best practices for measuring concentration should be:

Nancy Rose argues that many of the most commonly used aggregated measures of concentration across industries should not be used to study concentration dynamics given methodological challenge and we should look at industry level studies, which that this point while showing an increase in concentration it's still well under what is commonly though of as anti-competitive

But as Ben pointed out to me there is no published series such as Barkai’s. It requires a little work to back out what the economic profits actually are.”

Ben and I are thinking about this and Ben drew a meaningful distinction btw economic profits and accounting profits. So the series you liked to on FRED can be hard to interpret because companies try to limit their own tax burdens. To the extent that they’re measuring economic profits, it seems like they’re only measuring the profits that firms were unable to shift into something else. One way of approaching it is how Barkai attempted to define profits in his Declining Labor and Capital Shares (which was cited in chapter) this is pre-tax"....I draw a distinction between capital costs and pure profits and show that this distinction is critical for understanding the decline in the labor share. Capital costs are the annual costs of using all capital inputs in production. In a world in which firms lease all of their capital inputs, constructing capital costs would be simple: we would sum all annual leasing expenses. Pure profits are what a firm earns in excess of all production costs (material inputs, labor costs, and capital costs).Firms that use a lot of expensive equipment have high capital costs. Firms that charge consumers high prices relative to the cost of production have high pure profits. An increase in the capital share, equal to the ratio of capital costs to gross value added, at the expense of the labor share is indicative of a substitution from labor to capital inputs into production. By contrast, an increase in the pure profit share, equal to the ratio of pure profits to gross value added, is indicative of an increase in market power and a decline in competition...Consistent with earlier research,I find that pure profits were very small in the early 1980s. However, pure profits have increased dramatically since the early 1980s. In the main specification, the pure profit share (equal to the ratio of pure profits to gross value added) increases by 13.5 percentage points. To offer a sense of the magnitude, the value of this increase in pure profits amounts to over $1.2 trillion in 2014, or $14.6 thousand for each of the approximately 81 million employees of the non-financial corporate sector….”

“…To give the ftc its due, delineating digital markets is devilishly tricky. Like Facebook, most social-media firms do not charge users, so the typical approach of looking at an industry’s consumer-derived sales is no use. Facebook does have paying customers, firms that buy ads on its platforms, but the extent of that market, too, is hazy. If all American online advertising counts, its share is 25%, according to an estimate by The Economist (see chart). Looking just at social-media advertising it does rise to 60% in America (though globally Facebook’s share is declining).But what qualifies as social media is amorphous, as features and rivals pop up and fizzle….”

Economist Staff, “Is Facebook a monopolist?”The Economist, July 3, 2021, https://www.economist.com/business/2021/07/03/is-facebook-a-monopolist

Is Facebook a monopolist?

At last, it’s happening. Or so big tech’s critics thought. President Joe Biden has named one of their own, Lina Khan, to head the Federal Trade Commission (ftc). A Congressional committee has approved six bills to rein in Alphabet, Amazon, Apple and Facebook. Then, on June 28th, a federal judge provided a heavy dose of realism by summarily dismissing two antitrust cases against Facebook.

The unexpected ruling, which sent Facebook’s market value past $1trn, was a reminder that, in America, the swelling “techlash” may yield meagre results (see chart 1). Judge James Boasberg—appointed by Mr Biden’s former boss, Barack Obama—threw out one of the cases, brought by 46 states, on a technicality. The complaint, which accused Facebook of acquiring nascent rivals, such as Instagram in 2012 and WhatsApp in 2014, to cement its social-networking dominance, was deemed too tardy. More profoundly, the judge found the second case, lodged by the ftc, “legally insufficient”. “It is almost as if the agency expects the Court to simply nod to the conventional wisdom that Facebook is a monopolist,” he wrote.

That indeed seems to be what the ftc expected. It asserted that Facebook has a “dominant share of the market (in excess of 60%)” without explaining what that market is. And it defined “personal social networking” to exclude things like professional networks (LinkedIn) or video-sharing sites (YouTube).

To give the ftc its due, delineating digital markets is devilishly tricky. Like Facebook, most social-media firms do not charge users, so the typical approach of looking at an industry’s consumer-derived sales is no use. Facebook does have paying customers, firms that buy ads on its platforms, but the extent of that market, too, is hazy. If all American online advertising counts, its share is 25%, according to an estimate by The Economist (see chart 2). Looking just at social-media advertising it does rise to 60% in America (though globally Facebook’s share is declining). But what qualifies as social media is amorphous, as features and rivals pop up and fizzle.

The judge conceded that Facebook has market power (“no one who hears the title of the 2010 film ‘The Social Network’ wonders which company it is about”) and he has given the ftc 30 days to show this more precisely. However, he also threw out one of the agency’s core claims. The ftc accused Facebook of stifling competition by blocking rivals from its platform. According to Supreme Court precedents, the judge pointed out, such conduct is legal: monopolists have no “duty to deal”.

That may make sense in the analogue world. Critics like Ms Khan argue that in the digital one, where dominant platforms look a lot like pipe-owning utilities, it amounts to a licence to kill competition. If more cases against big tech stumble—as may happen to those involving Apple and Google—that would lend weight to demands to reform antitrust laws. Even this may not be enough to get any of the six bills, or anything like them, passed by the gridlocked Senate. Despite a bipartisan consensus in Washington that big tech is too powerful, Democrats and Republicans are unlikely to agree on the details of what to do about it.