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The monopoly economy

US companies have enjoyed increased monopoly power in recent years. This might support profits in the short term but not perhaps the longer term
October 17, 2018

One of the better justifications for the big rise in the S&P 500 in recent years is that US companies have enjoyed an increase in their monopoly power. This could mean that their profits are less likely to be eaten away by competition, which justifies higher valuations.

This poses the question: why has monopoly power increased?

At an aggregate level, it has: the share of profits in GDP has risen this century while labour’s share has fallen. But why?

One influential paper last year by Jan De Loecker and Jan Eeckhout estimated that companies’ mark-ups over variable costs have generally increased since the early 1980s. Chicago University’s James Traina, however, questions this. De Loecker and Eeckhout measure variable costs by the cost of goods sold (COGS) – labour and materials. But, Mr Traina says, if we add selling, general and administrative costs (SGA) to these, mark-ups haven’t changed much at all.

To see the difference, compare an old-fashioned manufacturer such as Coronation Street’s Underworld to Apple. At Underworld, variable costs are mostly wages and materials, so COGS are a good measure of them. At Apple, however, these are only a tiny fraction of what it costs to produce a smartphone. Instead, the main costs are research and marketing. Measured by COGS, mark-ups are enormous. Measured by SGA, which include those marketing expenses, they are less so.

What we’ve seen since the 1980s in the US is a decline of old-fashioned manufacturing and rise of companies such as Apple which have lots of intangible assets such as good ideas and powerful brands. The ratio of SGA to COGS has therefore risen, and so too therefore has the ratio of prices to COGS. 

In saying this, Mr Traina agrees with recent research by MIT’s David Autor and colleagues. The rise in the aggregate profit share, they say, is due not to a rise in general monopoly power by all companies but to the fact that globalisation and technical change have increased the importance of “superstar” companies. Because these have high margins and low labour shares, so aggregate margins have risen and wage shares fallen.

All this is consistent with two recent findings. One, by Arizona State University’s Hendrik Bessembinder, is that all of the rise in the S&P 500 since 1926 is due to only 4 per cent of all the companies that have ever been listed. The stock market’s long-term rise has been driven by superstar companies, not so much by the average one. The other comes from Tilda Nguyen at the University of Hawaii. She shows that companies with lots of intangible assets have had higher average returns than others. This could be because investors have underestimated the extent to which intangibles give a company a degree of monopoly power and therefore sustainable profits that won’t be so easily competed away.

This could be good news for investors. If mark-ups have risen across the economy merely because of cheap labour, they could easily be squeezed if fuller employment leads to rising wages. If, however, the rise is due to superstar companies, it might be more sustainable. To see why, compare Apple and Underworld. If Underworld’s profits rise, they could be competed away by competitors because underwear factories are easily replicated. Apple, however, has more monopoly power. Yes, many companies produce good smartphones. But they lack Apple’s brand power. They cannot replicate Apple.

In this context, there’s a big difference between COGS and SGA. COGS mostly comprises things that are fungible and replicable such as unskilled labour and materials. SGA, however, has an idiosyncratic component. Superstar companies don’t just spend more on R&D and marketing. They spend better. Boston University’s James Bessen has shown, for example, that companies’ operating margins are closely linked to their abilities to use new technology successfully or not.

To the extent that all this is the case, the rise of monopoly power is not due merely to inadequate competition policy. It’s because of a change in the very nature of the market economy. The increasing importance of intangible assets such as research and brand power mean that successful companies cannot be so easily copied, which means they enjoy more sustained market power. Hence high valuations in anticipation of future profits.

For stock-pickers, this presents a challenge. You must look very carefully at what Warren Buffett calls economic moats. Are the sources of a company's monopoly power sustainable or not? Even if they are, might investors be paying too much for them? Can we spot underpriced companies now which might have such moats in future? The fact that very few fund managers beat the S&P 500 over reasonable periods suggests that these questions are mostly unanswerable.

It doesn’t, however, follow that we should simply buy US tracker funds. Superstar companies are not invulnerable. History warns us that changes in tastes and technologies can bring down even giant companies: Kodak and AOL had monopoly power once. In the long run, these forces of creative destruction are largely unforeseeable; as Paul Ormerod and Bridget Rosewell have shown, companies have very little foresight about their own fate, so we shouldn’t expect investors to have any better idea.

Also, one fact remains – that the share of wages in US national income has fallen for years, which has led to talk that the economy is no longer working for ordinary Americans. We have yet to see the full political consequences of this. They might not be pleasant for investors.