Market Power or Just Scale Economies?

While increased economies of scale may offer a partial explanation for higher margins and declining dynamism in the US economy, growing market power provides a better explanation, argues Jonathan Baker. 

 

 


Editors’ note: In the last few weeks, the Federal Trade Commission has been holding a series of public hearings to discuss whether competition enforcement policies should be updated to better reflect changes in the US economy, namely market concentration and the proliferation of new technologies. The FTC hearings, which will be held throughout the fall and winter, cover topics as varied as privacy and big data, the consumer welfare standard in antitrust and labor market monopsonies. In order to provide ProMarket readers with a better understanding of the debates, we have asked a number of selected participants to share their thoughts on the topics at hand.

 

You can read all previous installments here


 

Market power has been growing in the US for decades.  I surveyed the evidence, much of it available only recently, in a policy brief and updated the references in my FTC hearings testimony. Jason Furman gave a complementary presentation at the same FTC session.

 

In this post, which is based on my FTC testimony, I explain why growing market power provides a better explanation for higher price-cost margins and rising concentration in many industries, declining economic dynamism, and other contemporary US trends, than the most plausible benign alternative: increased scale economies and temporary returns to the first firms to adopt new information technologies (IT) in competitive markets.

 

The benign alternative has an initial plausibility because the efficient size of firms has likely grown over time in many industries. That is the natural consequence of the high fixed costs of investments in information technology, the growing importance of network effects, and an increased scope of geographic markets. Under such circumstances, firms could grow larger, concentration could rise, and price-cost margins could increase even if markets are competitive. In addition, the first firms to invest in new information technologies may earn substantial rents. The rents should be temporary if those investments don’t confer market power and rivals follow suit with investments of their own.

 

Yet six of the nine reasons I gave for thinking market power is substantial and widening in the US in my testimony cannot be reconciled with the benign alternative. I set forth evidence showing that anticompetitive coordination, mergers, and exclusion are underdeterred, that market power is durable, that increased equity ownership of rivals by financial investors softens competition, and that governmental restraints on competition have grown. As I explained in my testimony, none of the reasons is individually decisive: there are ways to question or push back against each. But their weaknesses are different, so, taken collectively, they paint a compelling picture of substantial and widening market power over the late 20th century and early 21st century.

 

The benign story offers a more colorable alternative explanation for the three remaining reasons: the growth of dominant platforms, rising concentration and margins in many industries, and the lessening of dynamism in the economy. But this evidence is also consistent with growing market power.

 

First, the growth of dominant platforms probably owes a lot to scale economies and first mover advantages. But that observation is not decisive, as those platforms may also have the ability to exercise market power by excluding rivals. 

 

Second, scale economies and rents to early adopters of new technologies probably contributed to rising concentration and rising markups in various industries, but there is often independent evidence that firms in these concentrated markets exercise market power. That observation is not surprising: the same fixed expenditures that make scale economies and rents to first movers possible can deter entry and soften competition.

 

Some of the evidence for the loss of economic dynamism in the US could be consistent with the benign alternative of growing scale economies and returns to early adoption of new technologies in competitive markets, as well as consistent with increasing market power. Examples may include the rising profit share of GDP and the growing gap in accounting profitability between the most and least profitable firms.

 

But other aspects of declining dynamism cannot easily be reconciled with the benign alternative. The benign interpretation assumes that profits rise because markets are increasingly dynamic, with higher rates of entry, investment, and business failure. In competitive markets, growing scale economies yield higher profits because entrants have a greater risk of failure when fewer firms can succeed. Early adopters of new technologies would earn profits but they would be temporary, competed away by new or expanding rivals making their own investments.

 

Accordingly, the benign interpretation is inconsistent with the evidence showing the reverse: a slowing rate of new entry, a declining rate of expansion when firms and plants grow more productive, and a secular slowdown in business investment. In addition, the financial markets appear to view corporate profit streams as generally less risky than in the past. Yet if markets were increasingly dynamic, as the benign interpretation supposes, those streams would be viewed as riskier.

 

The bottom line is that growing market power is a better explanation for declining dynamism, rising concentration and markups in many industries, and the other reasons for concern, taken as a whole, than the alternative of increasing scale economies and early-adopter rents in competitive markets. The benign alternative may be a partial explanation for some trends, but increasing market power is a key part of the story.

 

I discuss the reasons for concern about growing market power in more detail, and what to do about them, in my forthcoming book.

 

Jonathan B. Baker, a former chief economist at the FTC and the FCC, is Research Professor of Law, American University Washington College of Law.  He is the author of The Antitrust Paradigm: Restoring a Competitive Economy, forthcoming from Harvard University Press.

 

 

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