Over the past 20 years, three-quarters of U.S. industrial sectors have become more concentrated, with a small number of large firms earning an outsized share of total revenue. This increased concentration seems to have boosted the ability of these so-called “superstar firms” to maintain higher profit margins and equity returns, but this may also be responsible for less pleasant trends shaping the U.S. economy.
- Impact of large firms can benefit industries but may dampen overall economy
- Larger firms carry greater influence on direction of labor market
- Balancing out the power of large firms could help the smaller firms
There are a number of potential causes for this rising concentration. First, a number of growing industries are characterized by positive network externalities, where the value of the service depends partly on the number of users. For example, social networks, search engines, and software platforms all benefit from increased users. Such markets tend to favor a small number of large firms who are able to build up a dominant position with a large user base, making entry by potential competitors look less attractive.
Second, it may be that only a small number of firms are able to reap the full benefits of increasing globalization. Access to talented workers across the world and a much larger pool of potential consumers are extremely valuable to firms. In practice, however, only a relatively small number of U.S. firms export or recruit globally, so these benefits are only captured by a small proportion of firms.
Third, regulatory and competition policy may not have favored large incumbents over smaller competitors and potential entrants. For example, there is evidence that industries where regulation has increased the most also had the largest increases in industry concentration. This may be because large firms are better at lobbying regulatory agencies to pursue policies in their favor.
Or as regulation has grown in complexity, the fixed costs of regulatory compliance have grown (for example, more legal and risk related staff may be required), which may favor larger companies who are better placed to swallow these costs.
Whatever the precise cause of increased industrial concentration – and it will vary from sector to sector – the phenomenon has important implications for investors, consumers and workers.
Impacts of size on costs
In a competitive market, firms struggle sustainably to charge prices above their own marginal costs of production. However, as firms grow in size, the balance of bargaining power tends to shift away from consumers. Firms are able to raise their prices above their marginal production costs without having a big negative impact on demand as consumers have fewer alternative options, and firms are empowered to set higher prices. A recent paper by De Loecker and Eeckhout showed that firms are increasingly able to charge prices above marginal costs. They found that the average public U.S. firm charged 18% above marginal cost in 1980, 30% in 1990, and 67% in 2014.
This growing capacity to increase prices over costs means firms are able to enjoy much higher profit margins, and seems to partly explain the secular rise in margins over the last 20 years. This in turn has led to higher equity returns for the superstar firms, and suggests such returns may be sustainable to the extent the firm’s superstar position is deeply entrenched.
It also suggests that one popular explanation for low inflation over the last few years – that increased competition and price transparency, perhaps due to online retailers, has reduced the ability of firms to put up prices – is misguided. If anything, the rise in pricing power over time has pushed inflation higher than it otherwise would have been.
One major caveat to this analysis is that measuring mark-ups is extremely difficult. This is because it is not clear which reported accounting costs match up with the economic concept of “marginal cost.” De Loecker and Eeckhout used Cost of Goods Sold as their measure of marginal cost, but recent research by Traina has suggested that Selling, General and Administrative Expenses should also be included in the calculation of marginal costs. Using this wider measure of costs significantly reduces the size of reported mark-ups, suggesting that the increase in market power may be smaller than the headline cost figures imply.
Big firms influence labor
Large firms not only have enhanced bargaining power vis-à-vis consumers, but also seem to have greater wage bargaining powers with workers. As industries become more concentrated, there is a more limited pool of potential employers for workers to move between. This means firms may be able to pay them less than they would be paid in a more competitive market. For example, a recent study by Azar et al find that increasing concentration at a local level (from the 25th percentile to the 75th percentile on the concentration distribution) is associated with a 17% decline in wages.
Along with globalization and automation, this concentration effect probably goes a long way to explaining the striking fall in the share of national income that goes to labor. After remaining relatively constant for 75 years, labor incomes have fallen by 6 percentage points since 1999, from around to 64% of income to 58%. For example, Autor et al estimate that the increasing concentration accounted for a third of the fall in the service sector labor share since 1982, while Barkai provides even more striking results, arguing that roughly 100% of the decline in labor share is due to rising industry concentration.
So while increased concentration tends to put upward pressure on prices, it also tends to put downward pressure on wage growth. The overall impact of changes to market structure on inflation is consequently complicated, but it may continue to pose a downside risk to wage growth. In particular, real (i.e. inflation-adjusted) wage growth may be even weaker if inflation is pushed higher and nominal wage growth is held back.
Investors should therefore pay close attention to the underlying industrial organization of an economy, as it is intrinsically linked to broader macroeconomic and market developments. This is especially true as regulators begin to consider whether certain concentrated sectors – such as utilities and parts of the technology industry - raise pressing public policy questions.