Wednesday, November 23, 2016

The Impact of Corporate Concentration in America

The potential $85.4 billion AT&T - Time Warner merger will create a media/communications colossus that, if history repeats itself, will provide no benefit to American consumers.   A brief issued by the Council of Economic Advisors in April 2016 looks at the benefits of competition to the U.S. economy and, in particular, to consumers and workers and how this key component of a "free marketplace" is in decline.

It's pretty much a given that increased competition in a marketplace results in significant economic benefits as firms are forced to do three things:

1.) keep price increases at palatable levels 

2.) deliver higher quality products

3.) deliver innovative products

By doing these three things, firms generate economic growth and a higher living standard because the marketplace forces firms to compete for workers, raising the price of labor.

Where there is little competition (or a monopoly), firms can use their market power to raise prices and lower quality or, even worse, block entry to the marketplace by potential competitors.  In addition, where monopolies exist, firms are less likely to pursue cost reductions.  If we want to see some relatively modern examples, we can look at he former Soviet Union and its satellite states where a few state-owned companies dominated the marketplace, bringing us such quality products as the Lada, Yugo and Skoda brands of vehicles.  Microsoft is a recent American example of what happens when a technology company uses its power to control the PC operating system marketplace; by flexing its corporate muscle, it prevented the development and adoption of non-Microsoft browsers and the wide adoption of alternate operating systems by hardware manufacturers.

Sadly, history has shown that the presence of a significant number of competitors in a given marketplace sometimes does little to ensure competition.  In the case of the world's largest manufacturers of liquid crystal displays (LCDs), the ubiquitous product found in computer monitors, televisions and laptop computers, companies conspired to price fix inputs that directly affected the prices of LCDs.   According to the Department of Justice, during the four years that the conspiring corporations met to coordinate product pricing, the average margin per panel was $53 higher than it would have been otherwise.  While this may seem insignificant, it added up to more than $2 billion that was transferred from the wallets of American consumers to the "pockets" of the corporations involved.

With that background on the importance of competition, let's look at the current state of competition in the United States.  Let's start by looking at a table which shows the change in market concentration by economic sector between 1997 and 2012 for key industries and its impact on revenue:

The majority of key industries have seen the share of revenue earned by the 50 largest firms in the industry rise between 1997 and 2012, in some cases, by a significant amount.  For example, the national loan market share of the top ten banks rose from 30 percent in 1980 to 50 percent in 2010 and the deposit market share of the top ten banks rose from 20 percent to almost 50 percent over the same period.  Using the Herfindahl-Hirschman Index (HHI) which is defined as:

"A measure of market concentration that is created by summing up the squared shares of firms in a market. Higher values of the HHI indicate higher market concentration; it can be close to zero when a market is comprised of a large number of firms of small size and reaches a maximum of 10,000 when a market is controlled by a single firm."

...we can see how two industries have seen very significant concentration.  Between the early 1990s and 2006, the HHI for hospital markets increased by 50 percent to 3200 (the equivalent of just three equal-sized competitors in a market) and the HHI for wireless providers in a market rose from under 2500 in 2004 to over 3000 ten years later.  This shows us how dangerous concentration can become to consumers.

Here is a graph that shows one reason why there is decreasing competition in the U.S. marketplace, a drop in firm entry rates to the point where firm entry rates now equal firm exit rates:

Obviously, the dynamics of the American business marketplace have become rather subdued as the years have passed.  The reasons for declining firm entry rates are not clear however, they could be related to an increase of government legislation, marketplace advantages that exist for incumbent firms but not for new companies (i.e. economies of scale that allow larger firms to produce for less) and government lobbying by existing companies that protects them from competition.

There is one key additional factor that may be contributing to reduced competition; mergers and acquisitions.  As I noted in the opening of this posting, the upcoming AT&T - Time Warner merger will create a media/communications giant that will, no doubt, impact consumers and employees.   In 2015 alone, global mergers surpassed $5 trillion in value with $2.5 trillion of that in the United States, the largest transaction year on record.  Globally, deals larger than $10 billion in size account for 37 percent of global takeover values, up from  an average of 21 percent for the last five years.  Here is a graphic which shows the proportion of mergers with a value of greater than $1 billion between 2000 and 2014 (blue line):

The proportion of billion dollar plus mergers has more than doubled over the past decade and a half.  As well, the red line shows the percentage of these mergers that were subjected to investigations by antitrust authorities; this too has risen from around 25 percent in 2000 to nearly 50 percent in 2014.

The increase in corporate concentration has had one good impact; as shown on this graphic, the return on invested capital for the largest publicly-traded, non financial American firms (i.e. the 90th percentile) is now more than five times the median compared to just two times the median in the 1990s:

Obviously, one has to wonder what impact this increase in concentration has had on the American economy since the end of the Great Recession.  Even though corporate profits hit record levels, there is no doubt that economic growth is stagnant, wages are stagnant and productivity is stagnant.  

The authors of the report close with these statements which illuminates the problem facing the U.S. economy:

"Recent indicators suggest that many industries may be becoming more concentrated, that new firm entry is declining, and that some firms are generating returns that are greatly in excess of historical standards. In addition, the dollar volume of merger and acquisition activity is at record levels....Free markets have the potential to provide great improvements in living standards, channeling resources to productive uses and providing consumers with quality and choices. Sometimes, though, abuses of market power by firms can undermine many of these potential benefits. As this issue brief demonstrates, competition between firms can generate many benefits to consumers, workers, and small businesses. Yet, as this brief also discusses, some indicators suggest there is more market concentration, higher profits for a few firms, and declining entry, all of which could result from less competition." (my bold)

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