LONDON (Reuters Breakingviews) - Equity investors concerned only about the short term can rejoice. Corporate profitability remains on an upward trend in developed economies. Everyone else should be worried by the cause: winner-takes-most dynamics.
That phrase is used by a research team from the International Monetary Fund that set out to measure corporate pricing power. It focussed on “markups”, a complex calculation which tries to measure the “ratio of price to marginal cost”. The group, led by Federico Díez and Romain Duval, looked at detailed financial statements from 2000 to 2015 for 900,000 firms in 27 countries, two-thirds of them in developed economies.
What they found is dismal, if unsurprising. The most profitable firms and sectors 15 years ago are even more so now, all over the developed world. More precisely, over the course of the study, markups in wealthier economies increased by 6 percent overall, but by 30 percent in the firms which already had the highest 10 percent of markups.
The authors conclude that in most cases, the driving force was “the ability of a small fraction of high-markup firms to strengthen their market power”. The trend is discouraging for starry-eyed believers in the power of competitive markets. Even if profit-trimming competition is the natural state of affairs, price-based rivalry seems to be on the wane. That’s especially true, the study found, in industries that use digital technologies most intensively.
That reflects a natural trend. In sophisticated and highly specialised industries, the market leaders benefit from network effects and economies of scale which squeeze smaller rivals. With few constraints on pricing, market winners are also profit winners. This trend to higher profitability and market dominance can cause problems. The IMF study points out several.
To start with, it seems that when companies become dominant, they slow down their pace of technical improvement. The IMF researchers reckon that if markups were to increase between 2015 and 2030 as they did in the preceding 15 years, the leading firms will invest less and create 4 percent fewer patents than if markups stayed at 2015 levels.
Then there’s the effect on mergers. One of the truisms of academic research is that takeovers that increase market share rarely pay off for acquiring companies’ shareholders. Seen in the context of a corporate culture of high markups, that may not be true.
On the contrary, increased size now often brings higher markups. However, more rapid increases in market share also accelerate the arrival of the technological tipping point, when companies have more to lose from disrupting their own technology than they can gain from adding new customers.
Harder to measure is the effect on management smugness, which does not lend itself to a highly quantitative study. However, it’s fair to assume that the profitability trend encourages the already arrogant people at the top of big companies to add to their self-regard, because they easily – and falsely – believe that high profits are a sign of their own merit.
Multimillion-dollar pay packages fit perfectly with that mindset, and success, huge wealth and attitude encourage the people at the top to live lives in almost total exclusion from the 99.9 percent. Rather, they are surrounded by sycophants and servants, travel in private planes and are housed in great luxury. It’s not exactly their fault: economic and technological forces are increasingly relegating the concept of level playing fields to introductory economics text books.
It is probably true that society would be healthier with lower profitability and more accountable bosses. However, the traditional remedy for monopolies, breaking them up, is often not suitable. Take, for example, Alphabet-owned search engine Google. It dominates the market for finding information online, but it’s hard to see how it could be broken up without reducing convenience and functionality for users.
Direct regulation is a better way to reduce markups. Bureaucratic controls and decisions already determine the paths of research, industry standards and many operating rules. Profitability could fairly easily be added to the list.
The idea is hardly new. Pre-modern guilds sometimes established “just prices”. In modern times, the prices of everything from electricity to taxis have been set by administrative fiat in many countries. However, the approach has gone out fashion. For four decades, governments, particularly in the United States, have preferred to trust the profit-controlling magic of markets.
As the IMF study shows, this magic has increasingly gone awry. Fortunately, there’s a blunter instrument. First, decide how much is enough. Then, use laws and regulation to make sure that companies, and bosses, do not earn more than they need and deserve. Almost no governments are currently brave enough to make that leap. The next generation just might take a few baby steps.
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