Time to Rediscover Competition

Economic outcomes are most efficient in the presence of competition. Competition minimises distortions, creates a sense of fairness, and makes policy choice rational. When competition recedes, and the concentration of market power grows, belief in fairness ebbs, political tensions rise, and rational policy choice becomes more difficult. Economic outcomes are rarely good in this kind of environment, and there is increasing evidence that this environment prevails today.

The stylized facts of rising market power are hard to deny[1]. They range from the rise in occupational licensing, a trend increase in the revenue share of the top firms in a given industry, reductions in firm entry and exit rates, rising anti-trust prosecutions, and observable increases in the in the Herfindahl-Hirshman index of industrial concentration just to name a few[2].

Milton Friedman argued for a classical liberal economic mantle to promote economic efficiency, and a belief in competition was crucial to his arguments which were influential to say the least. But Friedman was wary of business corporations, and characterised them as no friends of free enterprise, identifying them as a chief source of danger. 

Regardless of one’s political economy beliefs, rising market power and concentration is delivering economic inefficiency and welfare losses, and is an issue that policy makers should face. This includes monetary policy makers as there is emerging evidence that concentration in market power has added to inflation and is making it more difficult for monetary policy to stabilize the economy in the face of shocks.

Competition is good, it clarifies, it cuts through

Public policy should encourage competition wherever and whenever it can, and if concentration of market power emerges, then it needs to be confronted with competition which is the antidote to the distortions of market power.

We know this because competition delivers lower prices and higher output than other forms of industrial organization, for example monopoly, oligopoly, and monopolistic competition. Competition also delivers greater product variety and better product quality. It promotes greater rates of innovation, higher productivity growth, employment opportunity, and higher overall living standards and popular satisfaction.

There is growing evidence that firms are both monopolists and monopsonists in product and service markets, this is most evident in labour markets[3]. While unemployment rates are relatively low in most advanced countries, median real incomes have stagnated as the labour share of GDP has declined.

Consumers, who are also employees, are doubly squeezed by monopoly and oligopoly; they receive lower earnings and fewer employment opportunities to move up the wage scale. They also face higher consumption prices than they would if competition were to prevail. 

Despite the increasingly obvious signs of market power, finding the right measure of market power is crucial to extract the right policy prescription as antidote to the concentration disease. 

Concentration is good but mark-ups are best

Looking across the economic landscape, it is hard to deny that concentration and abuse of market power has been an emergent and increasingly dominant trend in the past thirty years, becoming more pronounced in the past ten. But market share alone is not a sufficient measure of market power.

Brand loyalty, for example, may allow a firm to charge a high price yet the supplier may not have a particularly large market share. Firms may also use sophisticated tools to exploit single price discrimination to distort pricing in their favour.[4]

A large market share may also reflect the fact that a company has achieved large economies of scale, or efficiencies, that deliver new and innovative products at a lower cost than would otherwise prevail. Achieving scale economy with just a few firms would deliver lower prices and more output than a pooling of smaller firms would be able to achieve. Just because a few firms dominate, is not evidence alone that these firms are pushing the economy to an inefficient point.

In recent years, so-called “super firms” have emerged with “network” effects that have positive spill-overs, this is most recently demonstrated with social media. One provider emerges with the leading product and becomes the dominant provider, against which it becomes difficult to compete[5]. 

Initially social media was seen as providing a positive externality to accompany a new business venture, bringing people together in an efficient and low-cost way. Here was a totally new product, with positive marginal social benefits, all at low cost. But, after a time, the marginal social benefit was perceived to swing negative. The power of the network effect to concentrate revenue and aggregate excess profits led to unwelcome disruption to existing industries. Moreover, new innovators and competitors are now quickly absorbed and vanquished by the now dominant players. 

While these are all clear behavioral markers of concentration and the exercise of excess market power, they are not really useful for analytical examination. 

Mark-ups and excess rents

Mark-ups – or an excess of price over a competitively determined level -- are a better measure of market power. Mark-ups are better because the persistence of excess profits in the absence of new market entrants precisely identifies excess market power. Mark-up are a better time series to deploy in analysis of the impact of increasing market power on interest rates and asset prices.

In competition, price is equal to marginal cost, or the cost of producing an additional unit of output. In a competitive equilibrium, when price is taken above marginal cost, excess profits exist, and a new entrant will come to the market to access the excess profit. If prices are persistently above marginal cost, then it is clear that mark-ups exist and there are barriers to entry, so a degree of market power is conferred on the producer. 

There has been a trend increase in mark-ups across the G7 since 1980. The Bank of England calculates that the net implied impact on annual CPI has been about 1.3%.[6]   Both the BoE and the IMF[7] show that mark-ups have been trending up. The capital share of GDP has risen and the labour share of GDP has fallen.  This maps onto the sense of growing inequity felt by many citizens of advanced countries who are now demanding some action.

The drift up in mark-ups can be seen in many different economic sectors, but they are most pronounced in the upper end of the firm distribution. That is, a small number of very powerful firms are responsible for the lion’s share of the increase. According to the IMF, the top decile of firms globally is responsible for almost all of the increase in mark-ups, and nearly all of that mark-up occurs in advanced countries. 

One could argue that an economy can settle into any equilibrium it wants to, just not the competitive equilibrium that maximizes the distributional welfare. The micro economics of monopoly versus competition is quite clear: prices are higher and output is lower. The net loss from a drift to monopoly has the same impact as a distortionary tax on consumption. Instead of the tax being collected by the exchequer, it is collected as profits, and the economy settles into a new and lower equilibrium with potentially large welfare losses.

An increasingly inefficient steady state

There are monetary policy issues for management of the rise in markups, but there is little research on the topic. There are both structural and cyclical challenges for central banks as market power increases.

If an increase in market power is negative for a number of inputs into trend GDP growth, then there are implications for the level of equilibrium interest rats, or r-star (r*). With the equilibrium rate low and interest rates near the zero-lower bound (ZLB) central banks have less room to manoeuvre to smooth prices and output after a shock. 

The trend of rising markups is a shock in and of itself, and some modelling of the impact of rising mark-ups suggests that there is more output and inflation volatility if the central bank responds to smooth demand and inflation. This is clearly a less efficient outcome, and one consistent with the micro-economics of concentration and power.

The ability to drive through a price increase, and a simultaneous suppression of wages, amounts to a negative supply shock. How should monetary policy respond to a potential negative productivity shock? A negative productivity shock would reduce the economy’s productive potential growth relative to a competitive state.

Signal Extraction and Policy Action Given Positive and Negative Supply Shocks

If the central bank wanted to respond to this development by smoothing, then it would face a signal extraction problem: namely, should it respond to falling growth and attempt to return demand to the prior prevailing path, or should it attempt to constrain the inflation that results from the rise in markups?

Of course, the increase in markups has been a slow-moving, trend, event that does not present central bankers with an obvious, large, discrete shock necessitating a time-critical response. Cyclical shocks tend to overshadow underlying structural shocks. 

As far as the central bank is concerned, the reduction in productivity maps to the underlying equilibrium interest rate, and thus is important for anchoring, or benchmarking, interest rate action. In this case, r* is lower than it would otherwise have been.

The decline in productivity has been accompanied by a decline in investment, and this has been demonstrated by the IMF in its most recent World Economic Outlook. Fund economists show, consistent with the Bank of England and others, that the rise in markups has been concentrated in firms in the top of the distribution, in the top decile of their global data set, and this is correlated with a profound reduction in investment and lower interest rates. A clear sign of rent seeking behaviour[8]. 

This suggests that as the trend in productivity has declined, so has the equilibrium interest rate consistent with the micro economics of monopoly, where there is a net loss in economic output and a loss in so-called consumer surplus[9]. For the econogeeks out there, this is known as the “Harberger triangle”.  The loss in consumer surplus summed across the economy could be substantial.

The policy challenge is increasingly political

Economic outcomes have been much weaker than expected in the past ten years, and measures of trend GDP growth are lower than they were prior to the 2008-2009 financial crisis. Monetary policy has been warning about its inability to manage the next big cyclical downturn, and more recently the debate has shifted to a more active use of fiscal policy to lift underlying trend rates of growth and restore equilibrium interest rates to a higher level.

The public policy discussion is now turning to acknowledge that the rise of industrial concentration and market power is having a negative distributional effect, and is delivering an inefficient economic outcome. This adds a new and challenging dimension to macro management. 

Dealing with concentration and market power will inevitably require political engagement and a regulatory response, which is antithetical to the neo-liberal agenda prevailing since the late 1970s.

But, the wedge between rising capital and labour shares of GDP, along with diminishing employment opportunities, will keep the pressure on politicians to eventually deal with the pressures exerted by a new gilded age. 

The use of fiscal policy to help monetary policy manage output is unlikely to be enough to deliver higher equilibrium output and higher equilibrium interest rates. Renewed interest in, and the pursuit of, competition policy will also likely be needed to return economic activity to something more acceptable. 

Given the immense political heat such a shift to regulatory intervention will generate, absent a major and negative economic shock a competitive crack-down is unlikely to be unveiled any time soon. If mark-ups continue to rise, interest rates are likely to stay low for a considerable period of time.  

Capitalism is an efficient means of production and distribution, but it does not lead to an equitable distribution of output. Capitalism’s inequities are accepted as necessary to create the incentives to take risk and drive economic efficiency for all, even if some benefit more than others along the way. However, if the rewards to risk become the rewards to excess market power, then radical political solutions and disruption are likely to come.  

We beware fear and frustration, but they eventually generate political pressure for reform forcing yesterday’s rules and norms to give way to new rules and norms fit for today. New policies will inform how macro management is to proceed. 

As political demand for action intensifies, and only sovereign governments can respond, it should be no surprise that global economic space is reverting to sovereign space, and the gains to trade are receding. This too is a negative productivity shock that suggests flat to higher interest rates rather than the lower rates the market has now priced-in. 

Investors should continue to review their investment beliefs, distinguish between risk and uncertainty, and renew their understanding of the limits of demand management we assume are fit for today’s purpose, yet are likely to fall short.   

[1] Council of Economic Advisers Issue Brief, April 2016. 

[2] The Herfindahl-Hirshman index is an accepted index of firm concentration in a given sector. However, there are limitations in its applicability. 

[3] A monopolist is the single provider of a good or service to the market and a monopsonist is the only buyer of a good or service in the market. This outcome can prevail without strict monopoly with just a few providers serving a market, but the outcome can be much the same: higher prices and lower wages.

[4] Airline are particularly skilled at this technique.

[5] Artour et al 2017.

[6] See Haldane et al 2018. 

[7] IMF WEO April 2019, Chapter 2: The Rise of Corporate Power and its Macroeconomic Effects

[8] See figure 2.9 in Chapter 2, WEO April 2019

[9] Consumer surplus is the difference between what consumers would pay and what they actually pay in a competitive equilibrium. As the market moves away from equilibrium consumer surplus is transferred to the monopolist as prices rise and output falls leaving consumers relatively worse off than producers.