Some Economics of Dominant Superstar Firms

A range of evidence suggests that in recent decades, the leading firms in a given industry have attained a more dominant position than in the past.

I’ve noted some of this accumulating evidence over time.

For example, back in 2015 the OECD published a report on “The Future of Productivity,” arguing that the productivity slowdown problems of many countries were occurring not because high-productivity firms were slowing down in their productivity growth, but because the firms with median and lower productivity weren’t keeping up. That year, Jae Song, David J. Price, Fatih Guvenen, and Nicholas Bloom wrote about how the pattern of diverging productivity across firms also led to diverging wages across firms. They argued that within a given firm, wage inequality has not changed much. But some high-productivity, high-profit firms were notably higher wages than other firms in the same industry, which was a major driver of growing market inequality in labor income. Nicholas Bloom summarized this evidence in a cover story in March 2017 for the Harvard Business Review.

The McKinsey Global Institute took up the mantle in 2018 with a report summarizing past evidence and offering new evidence in Superstars: The Dynamics of Firms, Sectors, and Cities Leading the Global Economy (October 2018). It looks at about 6000 of the world’s largest public and private firms: “Over the past 20 years, the gap has widened between superstar firms and median firms, and also between the bottom 10 percent and median firms. … The growth of economic profit at the top end of the distribution is thus mirrored at the bottom end by growing and increasingly persistent economic losses …”  In 2019, the US Census Bureau and the Bureau of Labor Statistics created an experimental database called Dispersion Statistics on Productivity, which let researchers look at how productivity was distributed across firms in a given industry: for example, firms in a certain industry at the 75th percentile of productivity are about 2.4 times as productive as those at the 25th percentile, on average. Again, there was some evidence that this gap is widening, and that best-practice methods of improving productivity are not spreading as well as they used to.

In short, an array of evidence suggests that the edge of dominant firms over their competitors has increased in a variety of industries. Jan Eeckhout reviews this evidence, and also looks at causes and effects, in his essay on “Dominant firms in the digital age” (UBS Center Public Paper #12, November 2022).

Eeckhout argues that the edge of dominant firms can be achieved in several ways in the digital era. The better-known approach, I think, is in the idea of network effects. For example, many buyers go to Amazon because many sellers are also at Amazon, and vice versa. Once such a network exists, it can be hard for a new firm to gain a foothold.

The more subtle approach is for firms to make investments that fall under the accounting category of “`Selling, General and Administrative expenses’ (SG&A). Those include expenditures on Research and Development (R&D), advertising, manager salaries, etc. and are often interpreted as fixed costs or intangibles. The observed rise in SG&A is a source of economies of scale as the fixed cost of production leads to declining average costs even with moderately decreasing returns in the variable inputs.” To put the point another way, some firms make substantial investments in technologies, brand names, and managers who can build on these capabilities. Eeckhout argues:

The rise of dominant firms that we have seen during the advent of the digital age is built on cost-reducing and efficiency-enhancing innovations that create increasing returns to scale. This implies a winner-takes-all market with a dominant firm achieving a long-lasting monopoly position. And while monopoly is often associated with higher prices, most of these firms achieve this position by doing the opposite, that is lowering prices. They can do this because their innovations and investments lead to an even larger reduction in costs. And that is why digital technology is so attractive for customers: technological innovation is the hero. But because costs decline more than prices due to scale economies, technological change is also the villain.

(For those interested in digging deeper here, the Summer 2022 issue of the Journal of Economic Perspectives includes a three-paper symposium on the rising importance of intangible capital in the US economy, including everything from innovations to brand names. The Summer 2019 issue includes a three-paper symposium on the issue of the extent to which price markups over cost have been changing over time, and the implications for labor markets and the macroeconomy. As has been true for more than decade now, all JEP articles back to the first issue are freely available. Full disclosure: I work as Managing Editor of the JEP, and thus am predisposed to think the articles are of wider interest!).

As Eeckhout points out, potential consequences of this rise in dominant superstar firms include greater inequality of wages created by these lasting differences across firms; a slowdown in new business startups as entrepreneurs face a more challenging environment; a shift in the flow of national income going to capital, rather than labor; and in general, a greater ability of more-dominant firms, less concerned competition, to charge higher prices.

What is an appropriate policy solution? One approach is higher taxes on the profits of dominant firms, but without staking out a position here on the extent to which this is desirable, it’s worth noting that the higher taxes would not alter the dominance of these firms, and many of the negative consequences would persist.

An alternative approach would be to recognize the phenomenon, but to take more of a hands-off attitude. After all, if the dominant firms are achieving success by making productivity-enhancing investments that reduce costs, this is broadly speaking a desirable goal, rather than something to be penalized. Besides, today’s dominant firms are not invulnerable, as anyone tracking the current performance of Meta (Facebook) or Twitter will attest. Not that long ago, companies like America Online and MySpace seemed to have dominant positions.

Besides, to what extent are consumers being “harmed” by, say, free access to email, word-processing, and spreadsheets offered by Google? Preston McAfee put it this way in an interview a few years ago:

First, let’s be clear about what Facebook and Google monopolize: digital advertising. The accurate phrase is ”exercise market power,” rather than monopolize, but life is short. Both companies give away their consumer product; the product they sell is advertising. While digital advertising is probably a market for antitrust purposes, it is not in the top 10 social issues we face and possibly not in the top thousand. Indeed, insofar as advertising is bad for consumers, monopolization, by increasing the price of advertising, does a social good. 

Amazon is in several businesses. In retail, Walmart’s revenue is still twice Amazon’s. In cloud services, Amazon invented the market and faces stiff competition from Microsoft and Google and some competition from others. In streaming video, they face competition from Netflix, Hulu, and the verticals like Disney and CBS. Moreover, there is a lot of great content being created; I conclude that Netflix’s and Amazon’s entry into content creation has been fantastic for the consumer. …

A more active approach would be to look for targeted opportunities to ensure greater competition. For example, McAfee suggests that consumers may well being harmed in a meaningful way by the Android-Apple duopoly in the market for smartphones, as well as in the very limited competition to provide home internet services.

Eeckhout emphasizes the general issue of “interoperability”–that is, the ability of consumers to shift between companies. He writes:

Interoperability has many applications. It is the regulation that ensures that a hardware producer cannot change the charger plug from product to product thus forcing users to buy an expensive new one each time, or whenever they need to replace an existing plug. And the concept of interoperability was at the heart of the development of the internet where the founding fathers of the world wide web ensured that the accessibility of different services was built in. They ensured that an email message for example could be sent from one provider (say Gmail) to another (say your company email servers). Similarly with the access to web pages that are hosted by different providers. This generates a lot of entry and competition from internet service providers. But this concept of interoperability does not come without regulation. For example, interoperability is not engrained in messaging services. It is impossible to send a message from WhatsApp to Snapchat since messaging services are closed. None of the services has an incentive to open their messaging platform to the messages of their competitors. As a result, compared to the number of service providers for email and the world wide web, the number of messaging services is very small.

If people should make a choice to transfer their personal information, or offer access to that information, from one setting to another, competition can be expanded. This goal isn’t a simple one. But if people could move their preferences and past shopping lists, even their financial and banking records and their health data, from one provider to another, competition in a number of areas could become easier. Another suggestion is that antitrust regulators should be skeptical when a dominant firm seeks to buy up smaller firms that have the potential to grow into future large-scale competitors.

The most active approach would go beyond specific situations of anticompetitive behavior and seek to use antitrust regulation in more aggressive ways, perhaps even with the goal of breaking up dominant firms. I don’t see a strong case for this kind of action. When the underlying issue is strong network effects, such effects are not going to go away. When the underlying issue is firms making major productivity-enhancing investments, that’s a good thing, not a bad one. Perhaps rather than figure out how to slow down the productivity leaders, we should be thinking more about what kinds of market structures and institutions might help to diffuse what they are already doing across the rest of the economy. Finding ways to level up the laggards is often harder than levelling down the leaders, but also ultimately more productive.