The Economist recently estimated the global pool of supernormal profits (profits in excess of an assumed 12 percent hurdle rate) at $660 billion. This is essentially a transatlantic phenomena; an astounding 98 percent of these excess profits accrue to a handful of American and European firms. In the United States, a third is cornered by firms with legal and regulatory moats such as healthcare, military contracting, and other non-tradables. But two-thirds go to firms in industries with no such artificial barriers to entry (tech and other tradables) and that are more or less fully exposed to competitors from across the world. Why aren’t these rents bid away by the entry of hungrier rivals?
A major part of the answer is network externalities that turn the logic of market competition over its head. To wit, if everyone is on Facebook you have to be on Facebook too if you want to connect with others. This applies to everyone on Facebook. Another social network trying to break through Facebook’s moat, even one unambiguously superior to the surveillance platform, faces the insurmountable hurdle of getting everyone to coordinate their move. The result is a natural monopoly.
Yet, that can’t be the whole story. Most firms that exhibit persistent rents do not operate in an industry with decisive network externalities or regulatory moats. Amazon is an attractive platform for people trying to buy and sell stuff. And this part of Amazon’s business indeed exhibits network externalities. But that business is not a cash cow for Amazon; third-party sales account for only 17 percent of Amazon’s top line. Instead, Amazon makes most of its money by selling stuff directly to customers. Jeff Bezos is now the richest man in the world with an estimated net worth in excess of a hundred billion dollars.
The secret of Amazon’s success is that it is the world leader in supply chain management. Three billion products are shipped worldwide by Amazon every month. The Balance calls the firm’s operations the most efficient in the world:
The combination of sophisticated information technology, an extensive network of warehouses, multi-tier inventory management and excellent transportation makes Amazon’s supply chain the most efficient among all the major companies in the world.
Not only is Amazon the front-runner, it has been innovating faster than the laggards. From the same source:
The rate of Amazon’s innovations in supply chain management has been mesmerizing. The rate of change has been incredible, making it difficult for lower volume competitors to keep up.
Amazon is an example of superstar firms that corner markets not so much due to structural moats but largely due to their technological leadership. An even more clear-cut case is that of Apple. The firm’s virtual monopoly in high-end personal computing is not due to any moat. It is rather due to the fact that hungry global rivals have failed to produce superior personal computing machines.This may be true more generally.
Even firms selling to the state that could be described as enjoying a moat may also derive much of their rents from technical leadership; eg, aircraft manufacturers. Unlike Facebook, Google does not enjoy significant network externalities. Despite Facebook’s impregnable moat, the mass surveillance business is a near-duopoly. Why hasn’t Facebook crushed Google in digital ad-spend? The simple answer is that Google’s position in the surveillance market is built on its dominating position in Search.
Firms at the cutting-edge of know-how are containers of situated communities of skilled practice. Google’s leadership in machine learning/AI came organically out of the nature of Search. Financial pressure after the dot com bust explains why Google wanted to pioneer surveillance capitalism. It does not explain why it was able to do so. I wager that Google was in a position to innovate because Search served as a generative research agenda for the situated community at Google. Faced with the mighty ocean of surveillance data, they had to invent probes to interrogate it. That’s how Google came to invent Big Data. The firm’s mission ‘to organize the world’s information’ came directly out of Search. As did Google’s partnership with the intelligence community and Obama.
Market competition can be expected to reward the leaders handsomely. But the surplus accumulates automatically as long as the superiority lasts. This is not inconsistent with the interest of the consumer qua consumer as long as efficiency gains are passed on in the form of a bigger consumer surplus. But as subjects of surveillance capitalism, that is quite a different matter.
The main problem with superstar firms is not that they slow innovation or harm consumers — they don’t. It is that they drive wage inequality. Furman and Orszag have shown that inter-firm earnings dispersion rather than within-firm dispersion has driven income inequality. Moreover, for all the talk of global firms, the situated communities of skilled practice for which these firms serve as containers are located firmly in what a recent McKinsey report calls the fifty global superstar cities. That concentration of talent and income is what is driving regional polarization in the United States. The analysts find ‘a higher churn rate among superstar firms compared with cities, indicating higher levels of persistence among superstar cities.’
The report notes that the distribution of economic profit obeys a power curve with the top 10 percent of firms capturing 80 percent of the profits accruing to all firms (with revenues above a billion) and the top 1 percent capture 36 percent. Not too long ago it was not quite so polarized:
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. Today’s superstar firms have 1.6 times more economic profit on average than superstar firms 20 years ago. … 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, suggesting that in addition to firm specific dynamics, a broader macroeconomic dynamic may be at work.
Superstar firms are concentrated in superstar sectors. They find that the shift in global profits to superstar sectors amounted to $3 trillion dollars in 2017 alone across the G20.
We find that 70 percent of gains in gross value added and gross operating surplus have accrued to establishments in just a handful of sectors over the past 20 years. This is in contrast to previous decades, in which gains were spread over a wider range of sectors. … [These sectors] include financial services, professional services, real estate, and two smaller (in gross value-added and gross operating-surplus terms) but rapidly gaining sectors: pharmaceuticals and medical products, and internet, media, and software.
While these sectors not only have ‘fewer fixed capital and labor inputs, more intangible inputs, and higher levels of digital adoption’, they are ‘two to three times more skill-intensive’ and have ‘relatively higher R&D intensity and lower capital and labor intensity’. But ‘the higher returns in superstar sectors accrue more to corporate surplus rather than labor’ and ‘their gains are more geographically concentrated compared with sectors in relative decline. For instance, gains to internet, media, and software activities are captured by just 10 percent of US counties, which account for 90 percent of GDP in that sector.’
City size is known to obey the power law. But could increasing concentration in superstar firms and superstar sectors be driving a concentration of talent and money in superstar cities?
The 50 cities account for 8 percent of global population, 21 percent of world GDP, 37 percent of urban high-income households, and 45 percent of headquarters of firms with more than $1 billion in annual revenue. The average GDP per capita in these cities is 45 percent higher than that of peers in the same region and income group, and the gap has grown over the past decade.
The analysts go on to speculate that the three — superstar firms, sectors, and cities — may be linked and mutually reinforcing:
We find linkages between firms, sectors, and cities that may be reinforcing superstar status and that raise the question of whether a “superstar ecosystem” exists. For example, superstar sectors generate surplus mostly to corporations rather than to labor, driving a geographically concentrated wealth effect in superstar cities with a disproportionate share of asset management activity and high-income-household investors. Labor gains from superstar sectors are also concentrated in narrow geographic footprints within countries, often in superstar cities and accrue mostly to high-skill workers.
So superstar firms, even if their market positions are well-earned and consistent with consumer and geoeconomic interests, are responsible for increasing vertical and regional polarization of wealth and income. Seeking a more equitable distribution of money may demand a more vigorous antitrust regime. But the strategy of breaking them up or otherwise pulling them down is inconsistent with the geopolitical imperative to foster innovation. Helping laggards catch up with firms at the technological frontier may sound like sound industrial policy. But championing the laggards may not be a sound geopolitical strategy against rivals championing their leaders. Put bluntly, superstar firms are the winners of the global economy; you want as many as possible in your jurisdiction and you want them to innovate faster than anyone else. That’s the reality facing mayors, governors, and presidents. Whence the red carpets and the special offers.
A more promising solution to the challenge of wage polarization and geoeconomic strategy is highly-skilled immigration. US immigration policy should serve the national interest. The current regime of spinning the wheel blindly between all applicants is absurd. It has resulted in the capture of the annual pool by tech firms who only care about head count. They can thus afford to make 1000 applications if they want 100 software engineers. This is not true of any firm wanting to hire a particularly skilled individual. It would be better to ration the mandated number of H1Bs by compensation — that would automatically tend to reduce high incomes. A more focused strategy would be to calibrate migration by targeting superstar sectors. Where incomes are offensively high, eg tech and finance, firms should be allowed to secure talent from the uttermost ends of the earth. It would thus serve as a market mechanism to temper wage premia. And if the goal is seriously compete with China in the long run, the United States may have to consider substantially expanding skilled immigration well beyond superstar sectors.
We need to think more seriously about the consequences of our policy designs. The solution I propose is attractive in that it exploits the market mechanism to secure an important social democratic goal. Whether it can work should be explored in finer detail. But I believe it deserves serious consideration.