Coupled with the finding that CEOs earned so little of the value they created for shareholders, Friedman’s arguments opened the way for boards to pay management enormous amounts of stock-based compensation. The rationale was that this would align management incentives with shareholders. In practice, this raised a number of concerns. There is no clear guidance on how much is enough. Usually, in a competitive market, a worker is paid on the basis of the value he adds. However, if a new CEO enhances the company’s share price by $10 billion more than would normally be expected, does she deserve to be paid the entire $10 billion? How much growth is because of the unique assets and workers the firm possesses, which the CEO only pointed in the right direction as opportunities came along? With no real guidance, corporate boards could engage in a compensation race, which they often did by asking their compensation committees to make sure their CEO was paid more than the industry average. As many did this, the industry average escalated.
High CEO pay sent a strong signal to employees, and to society more generally, that money was the central measure of worth. To the extent that money could only be made by doing the right thing by society, Friedman’s dictum was beneficial. There were many other ways of making money, though. Most immediately, if corporate management could “manage” their boards and their compensation committees, payouts could be enormous, and totally unrelated to long-term performance. Some indeed were.43
More problematic was that Friedman’s dictum also encouraged misbehavior. Friedman was careful to add the caveat “so long as it [the corporation] stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Yet, if management is given very high-powered incentives to make profits, and CEOs of highly profitable companies are accorded high social status, not everyone will make profits by respecting the rules of the game. Management of powerful corporations can break not only the rules, but it can also change them. The important question is whether the enhanced incentives for good behavior outweigh misbehavior. Unfortunately, misbehavior has not been negligible, especially after the easy steps to increase productivity and competitiveness in underperforming firms were taken in the 1980s and 1990s.
Pay for performance has encouraged deception, especially in the financial sector, where it is very hard to identify true performance in the short run. Management can always goose up performance for a while by taking on hidden risk, and unless compensation contracts are structured well, performance pay can fuel excessive risk-taking. Furthermore, when a dictum like shareholder value maximization takes hold of a firm, more nuanced understandings get lost, not just at the top but also as the dictum is pushed down to the operational level. The medieval proscription of the sin of avarice was, in part, to protect the poor rural peasant from exploitation by the traveling merchant, in a world where information was hard to come by. Even though many transactions today are governed by caveat emptor (let the buyer beware), society still does not take kindly to systematic exploitation of the vulnerable—the enormous fines levied on banks for misselling mortgages in the run-up to the Global Financial Crisis is a case in point. It is all very well to say that the principle of shareholder value maximization does not condone misselling—it truly does not—yet misselling can maximize profits in the short run. Implicit in rewarding employees for the profits they make is the belief that this will be done legally, and not in a way that will hurt the corporation in the long run. Yet, in the mind of the employee, the size of the year-end bonus can dwarf all these other considerations.
Pay for performance may also have motivated firms to seek the easy route to profits; shutting down the competition. In a sense, this is no different from Adam Smith’s frequently articulated concerns about anticompetitive instincts of corporations, but there is a greater urgency about this threat today. As new technology and global markets give firms enormous economies of scale, large firms can get even bigger and more productive as a matter of course. This gives them huge resources to influence the political process, something my colleague and frequent coauthor, Luigi Zingales, writes about in his perceptive book A Capitalism for the People. Writing in the early 1900s, Ida Tarbell was appalled that despite their efficiency, Rockefeller’s managers felt the need to stifle the competition. We should similarly be concerned that despite their productivity and advantages stemming from size and access, some of the largest corporations still try to alter the system to shield themselves from competition or taxes.
Perhaps of greatest concern, if enough corporations follow Friedman and focused solely on profits, they undermine the private sector’s ability to be a political force for social good. Friedman was right that a fair amount of corporate social responsibility substitutes for actions the state should take, and panders to the specific charitable interests of a firm’s top managers. This is not beneficial for the firm. Yet the firm exists in the community; if there is a local earthquake and the state is underprepared, the firm cannot keep its earthmoving equipment off the roads, regardless of whether it will ever get paid. More substantially, Friedman enjoined corporations to take the rules of the game as given, which meant they ought not to protest if a government turned authoritarian or despoiled the environment. Presumably, he believed nothing so drastic would happen in the United States. Yet, when an enormous source of independent power, the private sector, is passive, or worse, rendered suspect in the eyes of the community because its every action has to be in pursuit of corporate profits, there are fewer checks on the arbitrary power of the state. Clearly, corporations are not meant to be political organizations, and should not attempt to be so. Nevertheless, they ought to stand up and be counted when the fundamental tenets of society are at risk, for in the long run, this will affect everyone’s ability to make profits. An overly narrow focus on firm profit maximization will ensure that when needed, many will be missing in action.
The renewed emphasis on individualism, on profits, and on rolling back the state, as exemplified by Friedman’s dictum, certainly raised efficiency initially. The roll back has been selective, though, typically favoring powerful large private players at the expense of weaker smaller ones. This could affect economic dynamism in the longer run, further exacerbating inequality of opportunity and outcomes.
LOW ENTRY AND GROWING CONCENTRATION
According to the United States census, the pace of new business creation in the United States has fallen steadily since the late 1970s.44 In contrast, the pace of exits—companies either being taken over or going out of business—has remained fairly constant, with peaks in recessions. Why is new company formation falling, when ostensibly a more liberalized and competitive environment should encourage more such activity? A clue may be available in a study by economists Xiaohui Gao, Jay Ritter, and Zhongyan Zhu, where they note the alarming decline in initial public offerings (whereby young companies go public) in the United States—from an average of 310 per year between 1980 and 2000 to only 108 per year from 2001 to 2016.45 They argue that it is harder for small companies to make money—the uptrend in small public companies reporting losses started in the 1980s and continues. Perhaps as a result, and increasingly, small start-ups are selling out to large companies rather than staying independent and going public. In the last decade, Google bought over 120 companies, Monsanto over 30, and Oracle over 80.46 It is easier to be part of a large public firm today than be small and independent. If the path to becoming big and profitable is harder, it would explain the decline in entry.
The average US public firm today is three times larger, even after correcting for inflation, than it was two decades ago.47As a number of studies have shown, US industries are becoming more dominated by a few large firms today—they are becoming more concentrated, in econ-speak.48 For example, between 1982 and 2012, retail trade saw the share of the top four firms double from 15 percent to 30 percent. In the critical sector of information technology, media, and communications, the Economist magazine found the top four firms now accounted f
or nearly 50 percent of the revenue.49
Concentration has been made easier by a more lax antitrust environment, as argued by my colleague Sam Peltzman.50 Right until the early 1980s, antitrust authorities were quite active in preventing mergers that increased industry concentration substantially. The legal scholar Robert Bork (yes, he of the failed Supreme Court nomination) argued in his book The Antitrust Paradox in 1978 that it is possible that rising concentration in an industry may reflect gains in market share for more efficient players rather than growing monopolization.51 He urged antitrust regulators to focus on whether the consumer was better off rather than whether industry was dominated by a few firms. In a sense, Bork pushed for a focus on outcomes such as whether the customer got a better price rather than whether the industry structure and processes would allow it to be monopolized. This reflected an abiding faith that potential innovation and entry would keep monopoly practices under check. In 1982, the US Department of Justice bought this argument, and set out guidelines that would, in principle, allow merged parties to have very large and unchallenged market shares. As Peltzman writes, “the war against mergers was over, and Bork won.” Certainly, antitrust action has fallen off in the United States in recent years. From 1970 to 1999, regulators brought sixteen cases against mergers on average every year; in the period 2000–2014, this had fallen below three.52
In recent years, a strong positive correlation has emerged between the concentration of industry and the profitability of firms in it.53 As Bork argued, growing profitability in a concentrated industry need not be a sign only of monopolistic practices, it could be a sign of the greater efficiency of large incumbents that allows them to gain market share. Greater size itself could reduce costs if there are scale economies in the industry. Also, the size of the customer base could increase demand if there are network effects—where the product increases in value as more people use it. Compounding all these effects, large firms do seem to attract better management.54
It is hard for researchers to tell monopoly power from efficiency since an increase in a company’s revenues for a given amount of input costs could be because the company has raised prices unduly or because it produces more, higher-quality output at the same costs. The former is a sign of monopoly, the latter a sign of productivity. At this point, it is fair to say that a mix of higher productivity and monopoly power is responsible for the higher profitability of industries that are dominated by large firms, with the importance of each explanation varying by industry.55 Health care in the United States has more monopoly and less productivity, while consumer products are the reverse.
Regardless, as industry sales concentrate in a small number of firms—dubbed “superstar firms”—a substantial portion of the rise in inequality of worker incomes that we discussed earlier seems to be largely because highly paid workers work at firms that pay their average worker better: Productive, well-paid workers seem to congregate in profitable firms.56 Growing inequality in profitability between firms is translating into inequality between the incomes of the employees of those firms. The relatively stagnant median wage problem actually seems to be a stagnant median firm problem. While some of this is because of economies of scale and network effects, indubitably some of this is also because large firms have altered the rules of the competitive game.
SCARING COMPETITION AWAY AND ALTERING THE RULES OF THE GAME
Economists since Joseph Schumpeter have argued that just because competition is weak today does not mean it will be weak in the future. In an economy where technological progress is rapid, competition does not just come from existing firms, it also comes from the possible firms of the future, who use entirely new technologies to upend incumbents. After all, Google’s search engine took away the market from Yahoo!, while Facebook destroyed GeoCities (acquired, then closed, by Yahoo!) and Myspace (acquired, then eventually sold for a pittance, by News Corp).
However, once a firm comes to dominate an area after an initial flurry of competition, for example because consumers find it hard to switch away from it because it has their data, the market may come to believe in its continuing dominance. This could make the monopoly self-fulfilling, as Luigi Zingales and I argue.57 In part, this is because the stock market will bid the firm’s share price to stratospheric levels in view of its expected monopoly profits. The firm’s high-priced shares will then give it the currency to buy up any threatening competitors, way before they get to a size where an acquisition might raise antitrust concerns. Indeed, in the pharmaceutical industry, firms even undertake “killer” acquisitions whereby they acquire targets only to shut down promising drug projects that would compete with their existing drugs.58 If the competitor is stubborn enough not to sell out, the dominant firm could threaten a prolonged price war or blatantly mimic the competitor’s product, secure in the knowledge that it has the resources to afford a lengthy court battle over intellectual property. Independent innovators will consequently have a lower incentive to innovate, knowing that their access to the customer is blocked by the dominant firm, and knowing they will eventually have their product replicated or be forced to sell out to it at a discounted price. Indeed, venture capitalists refuse to fund start-ups whose projects lie within a “kill-zone” that can be replicated or acquired by dominant platforms. This reinforces the platforms’ dominance.
Dominant firms could also alter the rules of the game. For instance, the Dodd–Frank Wall Street Reform and Consumer Protection Act on financial regulation after the financial crisis certainly helped reduce risk in large banks, but it was also shaped by an army of their lobbyists to favor their interests. Compliance costs increased and disproportionately hurt small banks that had less business to spread it over. Similarly, large online platforms have protected themselves with both the Computer Fraud and Abuse Act and the Digital Millennium Copyright Act, which make it a crime punishable by prison for any outside firm to plug into their platforms. This holds back interoperability, which would allow others to benefit from the platform’s network effects and let them compete on a more level playing field.
As worrisome as the effects on the incentives to innovate is the effect on the diffusion of knowledge. Patents and copyright laws protect the right for an innovator or artist to benefit from their innovation for a while. If granted overly long or expansive protection, though, the innovator can stand in the way of new innovation or creativity. This is why patents should be granted carefully, and should terminate after a reasonable period, as should copyrights. Moreover, the free granting of patents, especially for fairly obvious ideas, creates a minefield for anyone who follows. Often, innovators unknowingly follow similar paths. It is impossible for anyone to check everything they do against the enormous stock of existing patents. This means any successful innovator is a target for an incumbent who holds significant patents and can employ good lawyers.
Large firms also seem to have the ability to extend protections afforded by the government. For example, every time Disney’s copyright on Mickey Mouse is scheduled to expire, a new act extends copyright protection.59 Perhaps the United States would benefit if companies could not “evergreen” their copyrights or their patents with minor improvements so easily. As Brink Lindsey and Steven Teles argue, the United States established a Court of Appeals for the Federal Circuit in 1982, which lowered the earlier standard for granting a patent.60 It also extended protection to software, business processes, and even the human genome. Since then, the number of patents issued has exploded. After moving up and down around a steady level in the two decades before 1983, patents have grown over fivefold since then, from 61,982 in 1983 to 175,919 in 1993 to 325,979 in 2015, even while productivity—the desired consequence of true innovation—has slowed.61
Yet another source of protection is non-compete agreements preventing employees from quitting a firm to work at a competitor’s, in part to prevent them for transferring secrets to rivals. A number of states enforce these agreements (California, one of the most i
nnovative states, does not), and over a quarter of American workers are bound by such agreements, even in innocuous industries like fast food.62 As my colleague, Jessica Jeffers, shows, the enforcement of such clauses favors incumbent firms at the expense of entrants, reducing worker quits in incumbents and enhancing investment, while reducing new entry into the industry.63 Such agreements constrain worker freedom even as they reduce the diffusion of ideas.
There is some indication that diffusion of knowledge is slowing. In a study of industries in twenty-three countries, an OECD study finds a growing gap between the large profitable patenting firms at the frontier of productivity and the rest within the industry.64 A study in the United States finds that in industries where technology diffusion fell by more (as reflected in the slowdown of patent citations), industry dominance by a few firms rose by more.65 Slower diffusion of knowledge from innovative productive firms to the rest would partly explain why productivity has not picked up in advanced countries even in the midst of seemingly frenetic innovation.
The broader point is that the liberalization that started in the 1980s in the United States has been uneven. While initially it incentivized corporations to become more efficient, it also opened the way for them to create new sources of protection through market dominance and excessive protection of intellectual property. The former may have been achieved by a pushback on antitrust regulation, the latter by an increase in patent and copyright regulation as well as non-compete clauses restricting employee mobility. The common theme has been to favor large incumbent corporations. The profitability of large corporations has been further enhanced by their ability to both influence the tax code, as well as to adopt multinational tax-avoidance strategies. All this may have created an uneven playing field, and when coupled with emerging advantages of size like scale economies and network effects in a globalized economy, could explain slowing small-firm entry.
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