What Equity Markets Say About the State of Competition in the US Economy

A look at stock market valuations shows that barriers to entry are protecting the economic rents being earned by many corporations. There are likely multiple causes for the US economy’s competition problem, but improving the effectiveness of antitrust enforcement could address some of the changes in the competitive landscape.




Equity market investors are convinced that the US has a competition problem. They are signaling that many non-financial corporations are protected by barriers to entry, because they are valuing these corporations at levels that are only consistent with an ability to earn rates of profit that measurably exceed competitive levels.


This signal can be detected by looking at the ratio of the equity market value of corporations to the replacement cost of the physical and intangible capital stock that they employ. This ratio— called “Tobin’s Q”—should be equal to 1 under competitive market conditions. When it is larger than 1, the equity market value of a firm exceeds the replacement cost of its capital, which we wouldn’t expect to see in a competitive market. Values of Q greater than 1 indicate that a firm is earning returns above the competitive level—in other words, in addition to competitive profits, they are earning what are called “economic rents.”


Careful measures of firm-level Q values for non-financial corporations show that Q values have been trending upward since the late 1970s and are now significantly greater than 1. Average and 90th percentile values of Q ratios for nearly all non-financial corporations, for the period 1975-2015, are presented graphically in Figure 1. (See Jarsulic (2019) for an explanation the Q metric, and the data used to produce the figures discussed in this note.)



While not all firms are publicly traded, and those that are listed on equity markets are generally larger than private firms, the sample is still quite large and suggests that entry is not acting to compete away the economic rents being earned by many corporations.


There is also evidence that firms have an increased ability to maintain rates of profit once they attain them. Figure 2 displays the share of firms in our sample with a Q greater than 1 in one year that maintained a Q greater than 1 in the next year. This number rises from around 10 percent of firms in 1980 to around 30 percent of firms in 2015, suggesting increased inertia around rent extraction. In other words, it has become more likely that a firm that earns a measurable rent will be able to do so in the subsequent year. This suggests that, over time, barriers to entry, which prevent new competitors from reducing the market power of rent-earning firms, have become stronger.



The conviction that there are strong barriers to entry does not appear to be an artifact of irrational exuberance by equity market participants. If that were the case, we would expect a generalized increase in Q ratios across firms. What we observe, however, is something different: While the mean value of Q has trended upward, Q values for many firms reflect competitive returns.


Figure 3 shows the distribution of Q values for individual firms in our sample averaged across 1981–1985 and 2011–2015. Both mean and median values have shifted right, and the right-hand tail of the distribution is more heavily populated. But a large fraction of firms continues have Q values at or below 1.



There are likely multiple causes for the rise in this signal of barriers to competition. Some may be related to changes in the economic environment in which firms operate. The rise of superstar firmspossessing technical superiority and increasing returns to scaleis a potential source of what we observe. The increased use and availability of intellectual property protection is another. And so is the existence of network externalities and lock-in in digital platforms.


But failures in antitrust policy and enforcement have also played a role. Beginning in the 1980s, intentional policy decisions have hindered antitrust enforcement. Regulators largely abandoned challenging mergers where market concentration was below the upper threshold of what is considered to be competitive. A recent empirical study by economist John Kwoka presents convincing evidence that merger enforcement decisions allowing increased concentration have often led to price increases.  Similarly, enforcers became increasingly reluctant to bring unilateral conduct cases, leading to an environment in which dominant firms could aggressively pursue anticompetitive conduct—such as foreclosure—without legal repercussions.


Moreover, antitrust agencies may have systematically missed the importance of acquisitions by incumbent firms already protected by entry barriers. There is, for example, evidence that pharmaceutical companies have used so-called “killer acquisitions” to discontinue innovations at target companies in order to pre-empt competition and preserve revenue from existing investments. This same motive, along with a desire to provide complements to goods and services that already produce network externalities, appears to generate some acquisitions in the software and IT services industries. The acquisitions of Waze, YouTube, and DeepMind by Google and Instagram and WhatsApp by Facebook all appeared to be at a large premium to existing revenue and to strengthen the dominance of the acquiring firms. These and other acquisitions have not been subject to antitrust challenges.


Improving the effectiveness of antitrust enforcement may not address all of the observed changes in the competitive landscape, but it could nonetheless be important. Pervasive market power shifts the distribution of income, interferes with the efficient allocation of capital, and can deter innovation or its deployment. The firm-level metrics we have discussed can be helpful in identifying where changes to enforcement strategy would be important.


Marc Jarsulic is a senior fellow and chief economist at the Center for American Progress. He has worked on economic policy matters as deputy staff director and chief economist at the Joint Economic Committee, as chief economist at the Senate Banking Committee, and as chief economist at Better Markets. He has practiced antitrust and securities law at the Federal Trade Commission, the Securities and Exchange Commission, and in private practice. Before coming to Washington, he was a professor of economics at the University of Notre Dame.


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