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Who’s afraid of big bad firms?

Asli Demirgüç-Kunt's picture

Superstar firms have been in the minds of world’s leading bankers and economists lately. Policymakers are concerned that America’s leading firms such as the FAANG stocks — Facebook, Apple, Amazon, Netflix and Google — are having adverse results on the rest of us and making economic policy less predictable. Why is this? Many of the companies have improved the lives of people across the world with highly desirable and useful products. These superstar firms have also done very well for many of their stakeholders and investors. The numbers are staggering. These five tech companies together account for roughly half of the gains achieved by the Standard & Poor’s 500 stock index in 2018. And in recent weeks, Apple became the world's first trillion-dollar corporation, with Amazon not far behind. While the superstar firms have made life easier for many consumers, it's hard for economists not to wonder whether the effects of their stratospheric success are entirely benign.

The standard concerns come in two flavors. First, we worry that by realizing very high returns on investment, these superstar firms are pulling away from the rest of the economy. The concern is that the gap could signal the evolution of a two-tiered economy, with most people working for second-tier firms that offer little in the way of employment growth prospects. Indeed, the rise of these firms has been linked to a decline in the labor share of national income. Second, economists also fear that mega-firms such as these tech titans are realizing their high profits in a very old-fashioned way — by restricting competition, which enables them to charge high prices without investing much.

Several studies published in recent years suggest that these concerns are warranted. A Council of Economic Advisors report from 2016 features a scary graph that shows returns on investment of the top 10 percent of public firms pulling away from the rest. Likewise, recent work by Jan De Loecker and Jan Eeckhout shows that the pricing power of the average firm in the United States — defined as how much the companies sell their products for compared to the cost of making them – is rising over time.

However, our research reveals that there may be an important omission in these analyses. The previous research relies on firms’ financial statements data, prepared according to the usual accounting conventions, which do not explicitly measure intangible capital — defined as a firm’s brands, R&D discoveries, intellectual property and organizational capital. This omission is non-trivial since our knowledge-driven economy has become increasingly dependent on intangible capital.

Once we apply this correction, the news is mostly good. When examining both return on investment and pricing power, we find no evidence that the superstar firms are worlds apart from the rest of the economy. So, the inequality among firms is, in fact, not growing. We also don’t find that the superstar firms are cutting output more than other firms in the economy at a given level of markups.

In recent decades, consumers have benefited precisely because Amazon and similar firms have kept their prices down as they prioritized growth over profits. However, it is not clear that workers, especially those in routine manual and low cognitive jobs, have benefitted as their industries have been disrupted by many of the innovators. But, it is likely that the superstars are disrupting the market for labor not because they are superstars, but because technology is changing. The decrease in the value of routine manual and low cognitive jobs in the U.S. market for labor that would have taken place whether the disruption is being spearheaded by one superstar firm or by a host of smaller firms. Whether there was one car company or many, the horse’s dominance was doomed. 

So, are the concerns about the market domination of these mega firms overstated? Not quite. Something else may be going on that could pose problems down the line. That’s because this handful of superstar firms may be playing a longer term strategic game. To quote Amazon’s Jeff Bezos in his 1997 letter to shareholders: “We believe that a fundamental measure of our success will be the shareholder value we create over the long term. We have invested and will continue to invest aggressively … to establish an enduring franchise.”

But now some superfirms have metamorphosed into behemoths, and there is a danger that they might use their spare cash to preempt future competition. Historically, companies have flexed their monopolistic power by driving competitors out of business. But a potentially more nefarious and difficult-to-spot strategy is to buy firms using nascent technologies that have the potential to emerge as competitors and consign them to Davy Jones’ Locker.

Recent research studies this same practice in the pharmaceutical industry. A recent paper by Cunningham, Ederer and Ma finds evidence that roughly 7 percent of all pharma mergers and acquisitions over the past two decades were “killer acquisitions” — strategic deals by big pharma companies to eliminate competition from smaller companies.

Current antitrust laws, with their focus on short-run consumer welfare, are not equipped to recognize the long-run growth strategy of the leading firms. Regulators must be on the lookout for new types of monopolistic behavior. We need policies that leave markets open enough so that “creative destruction” of market power is allowed to work. However, devising and implementing new regulations may be challenging and perhaps costly for the economy because policymakers will have to rely on judgments about the future potential of technologies that only insiders are skilled enough to attempt. But perhaps technology, with all its unpredictability, will be our friend. After all, the superfirms of yore that we were all afraid of would take over their industries, firms like GM, IBM, GE, Microsoft, Walmart and others, don’t seem such a big threat now. Perhaps we just need to slow down and take a long run view.

For further reading:

Ayyagari, Meghana, Asli Demirguc-Kunt and Vojislav Maksimovic, “Who are America’s Star Firms?” World Bank Policy Research Working Paper WPS8534.