The Great Reversal

by Thomas Philippon

  Imagine for now that all firms are the same size. Then HHI = 1 / N = d / n. This is the simplest relationship we can envision. It says that concentration is the ratio of the exit rate over the number of entrants. An industry can become concentrated because the entry rate falls, because the exit rate increases, or both.

  In the simple example above, all firms are identical and concentration only depends on the entry and exit rates. In reality, firms have different sizes and different growth rates, so concentration depends on whether young firms grow quickly and whether large firms exit. The strategy of young firms once they have grown and the type of exit (say, merger versus liquidation) also matter. Nonetheless, entry and exit are the natural forces to study first.

  Entry and Exit

  A wide range of measures of firms’ dynamics points toward a sustained decline in business dynamism in the US. Figure 5.1 shows the entry and exit rates of establishments and firms. An establishment is a store or a factory, and firms often own several establishments, so the head counts differ.

  Both entry and exit, the figure indicates, have declined. Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014) refer to this evolution as a decline in business dynamism. It has been particularly severe in recent years. The same authors show that declining dynamism, which appeared only in selected industries during the 1980s and 1990s, happened in all sectors during the 2000s—including the traditionally high-growth information technology sector (Decker et al., 2015).

  You might qualify the importance of these trends by arguing that the nature of the entrants matters. If the decline in the entry rate is due to a decline in new “mom and pop” stores, but there is no decline in the entry rate of ambitious startups, then it might not matter as much for the economy. For this reason, MIT researchers Jorge Guzman and Scott Stern argue in a 2016 paper that the decline in entry is not as bad as we might think. They point out that early-stage financing of new companies has remained strong. Their measure of entrepreneurial quality looks different from the declining entry rate in Figure 5.1. It shows a rise during the 1990s and a sharp decline after 2000, followed by some stability at a level that remains higher than before 1990.

  FIGURE 5.1  Entry and exit rates of establishments (left) and firms (right). Data source: US Census Bureau, Business Dynamics Statistics

  Another factor that may dampen our pessimism is the age of successful entrepreneurs. Among the top 0.1 percent of new firms (the fastest growing out of 1,000 firms), you see that the founder is, on average, forty-five years old (Azoulay et al., 2018). The popular image of the twenty-something tech entrepreneur is not accurate. This is true even in the high-technology sectors and entrepreneurial hubs. Why is this good news? It means that an aging population does not automatically imply fewer successful new firms.

  On the other hand, the number of initial public offerings (IPOs) has been low in recent years, as shown in Figure 5.2. There is still a lot of early-stage financing of new companies, but most of them get acquired instead of going public. This has important implications for competition and growth, since buying a startup can be a way for incumbents to preempt future competition. A large incumbent may want to acquire a target and shelve its products. Colleen Cunningham, from the London Business School, and Florian Ederer and Song Ma, from the Yale School of Management (2018), call this a “killer acquisition.” They focus on the premarket acquisition and development of new drugs and find significant anticompetitive effects. A drug project is less likely to be developed when it overlaps with the acquirer’s portfolio of existing products, and the pattern is more pronounced when competition is already weak. This has not been the traditional focus of antitrust. Most of the existing research focuses on horizontal mergers of firms with existing products that compete in the same market and largely ignores innovation and premarket products.

  To summarize, there has been a decline in both exit and entry, but the decline has been more pronounced for entry. These changes are particularly visible in the average age of establishments. Figure 5.3 shows the aging of US businesses. We define young firms as those less than five years old. In 1980, young firms accounted for half of the number of firms, 40 percent of the number of establishments, and 20 percent of employment. Today, the fractions are much smaller, and young firms employ only about 10 percent of the US workforce.

  FIGURE 5.2  Number of IPOs per year, 1980–2017 (Ritter, 2019)

  FIGURE 5.3  The shrinking share of young firms in the US economy

  Mergers and Acquisitions

  We saw from Figure 5.1 that exit in the traditional sense (closing an establishment) has actually decreased and therefore has not contributed to the increase in concentration. Mergers, on the other hand, have played a key role in the consolidation of US industries. Mergers are a particular type of exit. Establishments need not close, but the number of independent firms decreases and competition often declines. Figure 5.4 shows the number of merger deals each year from 1950 to 2016.

  The increase in mergers and acquisitions (M&As) has several causes and consequences. As the Economist reported in March 2016, “since 2008 American firms have engaged in one of the largest rounds of mergers in their country’s history, worth $10 trillion. Unlike earlier acquisitions aimed at building global empires, these mergers were largely aimed at consolidating in America, allowing the merged companies to increase their market shares and cut their costs.”a

  Another immediate consequence is that the number of listed firms has been shrinking (Figure 5.5). High-profile mergers typically involve public firms. The increase in the number of mergers implies a decline in the number of publicly listed companies. On a per capita basis, the US has lost half its firms in forty years. In 1976, the US had 4,943 listed companies (firms listed on US exchanges). By 2016, that number was down to 3,627. As René Stulz points out, “from 1976 to 2016, the US population increased from 219 to 324 million, so the US went from 23 listed firms per million inhabitants to 11.”b

  The decline in the number of listed firms starts in the late 1990s. Circa 1980, the US had about 5,000 listed firms. Listings peaked in 1997, at about 7,500 companies. Since then the number of listed firms has fallen by more than half, and the main contributor has been the large number of mergers. The decline is widespread: it happens in all industries. And, as Stultz points out, few other countries have experienced such a large decline.

  That naturally raises some questions. Are there too many mergers in the US? When and why are they allowed?

  FIGURE 5.4  Number of merger and acquisition deals

  FIGURE 5.5  Decline in the number of publicly listed US firms

  Merger Reviews

  Mergers and acquisitions between large firms are typically reviewed by the Department of Justice (DoJ) and the Federal Trade Commission (FTC). The parties to the transaction must file forms and wait for thirty days before they can consummate their merger. Depending on the product and industry, either the FTC or the DoJ may review the filings.c If the transaction appears to pose a threat to competition, the agencies ask for additional information (“Second Request”) and extend the waiting period for twenty days.

  Merger reviews build on what we call the economics of industrial organization (often simply called IO). This branch of economics allows us to understand how many firms are active in an industry and how they set prices, to predict their behavior after a merger, and to ask questions such as “is competition always good?” or “can there be too much entry?”

  Industrial organization began as an intellectual discipline in France in the 1830s. Antoine Augustin Cournot was the first to formalize the behavior of a duopoly—two firms competing in the same market. The Sherman Act, motivated by the growth of large-scale businesses during the Industrial Revolution, incorporated IO into US public policy in 1890. Nearly a quarter-century later, the Clayton Act of 1914 was the first attempt to deal with anticompetitive mergers and acquisitions. It was motivated by large mergers that fell outside the purview of the Sh
erman Act.d The Clayton Act prohibited any company from buying the stock of another company when “the effect of such acquisition may be substantially to lessen competition.” Section 7 of the Clayton Act and the Hart-Scott-Rodino Antitrust Improvements Act of 1976 give authority to the government to review mergers and acquisitions before the merger is consummated. The legislation prohibits mergers and acquisitions that may substantially lessen competition or tend to create a monopoly.

  The economic understanding of antitrust has evolved significantly over time. Early lawmakers were interventionist. Their doctrine was supported by the structure-performance-conduct paradigm of Edward Chamberlin and Joan Robinson in the 1930s. It viewed the market as a structure influencing the conduct of businesses and the performance of the industry. This set of ideas and principles came to be known as the Harvard School of antitrust.

  The Chicago School brought a counterrevolution in the 1970s which tried to put economic efficiency at the center of antitrust policy. Robert Bork’s highly influential book, The Antitrust Paradox, marked a shift in policy in 1978. As IO economists John Kwoka and Lawrence White (2014) explain, “the skepticism and even some hostility toward big business that characterized the initial period of antitrust have been replaced by current policy that evaluates market structure and business practices differently.” For instance, an idea from the Chicago School is that high concentration does not necessarily imply market power as long as the threat of entry is real, that is, as long as the market is contestable.

  These evolutions are reflected in the various vintages of the Merger Guidelines, initially developed by the DoJ’s Antitrust Division in 1968. Major revisions to the guidelines took place in 1982 and 2010. The DoJ and the FTC publish the guidelines in order to make the review process fair and predictable. As we have explained in Chapter 2, the DoJ considers a market to be highly concentrated when its HHI is above 2,500. In that case, a further increase by more than 200 points is a potential violation of antitrust regulations.

  The review includes the following steps:

  define the relevant market (product and region) and the firms that compete in it;

  compute the Herfindahl-Hirschman Index (HHI, defined in Chapter 2);

  assess the ease of entry by new firms;

  assess the likely impact of the merger;

  consider the efficiencies resulting from the merger.e

  The consequences of the merger depend on its impact on the market power of the firms, which depends on the elasticity of demand, as explained in Chapter 1.

  Market Power versus Efficiency

  The regulation of mergers embodies a tradeoff between market power and efficiency, captured in points 4 and 5 in the list above. Even if the merger creates a threat to competition, the agencies have some discretion to determine if the efficiencies outweigh the competitive risks. Efficiencies include economies of scale, production spillovers, and sharing of overhead expenses.

  FIGURE 5.6  Merger with efficiency gain

  Any merger that increases market power is bound to result in losses with regard to consumer welfare. So why would we ever allow them? Mergers are almost always motivated by claims of improved efficiency. To understand the issue, let us go back to the example we used in Chapter 2.

  Figure 5.6 depicts the case of a merger with efficiency gains. Imagine that we start from a competitive equilibrium where the price equals the marginal cost, labeled “old marginal cost” in the figure (you might want to review Figure 2.1). In that initial situation, there are no profits and consumer surplus is measured by the large triangle above the price / marginal cost line. Suppose the regulator allows a merger and suppose for now that there are no efficiency gains. Market power increases, and the price goes up. Consumer surplus is reduced to the small gray triangle. Firms make profits, represented by the rectangle. The rise in profits is less than the loss in consumer surplus, and the black triangle in Figure 5.6 indicates a welfare loss for society at large.

  Let us finally bring in the efficiency gains. Imagine that the merger lowers the cost of production from the old cost to a new, lower cost. This is the interesting part of the analysis. These extra profits represent efficiency gains and, unlike the previous ones, they do not come from a reduction in consumer surplus. To properly assess total welfare we need to compare the black triangle of consumer losses to the gray rectangle of extra profits. What can we say?

  Not surprisingly, the conclusion of our analysis depends on two effects: the markup effect versus the efficiency effect. Suppose we start from an industry with marginal cost c and price p, and thus a markup m = p − c. In the figure we assumed initially that m = 0, but the industry might not be perfectly competitive in the first place. If we allow the merger, two things happen: the markup increases from m to m′, and the marginal cost decreases from c to c′. The new price is therefore p′ = c′ + m′. There are two cases to consider:

  The win / win case: the new price is lower than the old price (p′ < p). This happens when the increase in the markup is smaller than the efficiency gain: m′ − m < c − c′. In that case, consumers are better off, and firms’ shareholders are better off. This is clearly a good merger.

  The ambiguous case: the new price is higher than the old price despite the efficiency gain (p′ > p). This happens when the increase in the markup is larger than the efficiency gain: m′ − m > c − c′. In that case consumers are worse off, but shareholders are better off. The regulator needs to estimate and compare the relative impacts on consumers’ surplus and new profits.

  The win / win case is rare in practice. In the ambiguous case, a critical issue is what economists call the contestability of the market. If the merger creates efficiencies, this is good for the economy. If entrants can challenge the incumbent in the future, then prices will not increase much, and might even decrease if entrants can realize the same efficiency gains as the merging firms at some point in the future. In other words, the threat of entry might bring us toward a win / win, if not immediately, at least eventually. This highlights the critical role of entry, or more formally, what we call the contestability of markets.

  Merger Reviews in Recent Years

  There is a lively discussion regarding the role of antitrust enforcement and regulations in the evolution of US markets. On balance, however, one can make the case that merger reviews have become rather lax in the US. Bruce A. Blonigen and Justin R. Pierce (2016) find that, between 1998 and 2006, mergers between rival manufacturing firms led to higher profits without lower costs. Orley Ashenfelter and Daniel Hosken (2010) study five mergers that were close to the investigation threshold (but were not challenged) and find that four led to higher prices. John Kwoka (2015) shows that the FTC gradually reduced enforcement between 1996 and 2008. In recent years, merger enforcement actions by the FTC dropped to essentially zero in moderate-concentration industries, that is, those in which at least five competitors remain after the merger. In effect, the agency seems to have decided that five competitors are enough to ensure adequate competition in most markets.

  Based on this evidence, Kwoka criticizes the weakening on merger reviews in the US over the past twenty years. This led to a sharp debate among antitrust experts.f Competition can take many forms, making IO a complicated field in economics. Moreover, as the economy develops, the variety of goods and services expands. A bit more than a century ago, Standard Oil produced a commoditized product, and the antitrust case was relatively simple. In most modern cases of antitrust, however, the product is not commoditized, and market power depends on a host of forces beyond the simple restriction of supply. In the telecom industry, for instance, competition takes place not only with prices but also with the bundling of services (phone, internet, TV) and the quality of the components.

  This complexity, together with the lobbying efforts of the industry, makes it difficult for experts to agree, and I expect the debate to continue over individual cases. What is undeniable, however, is that mergers have been allowed to proceed at an unpre
cedented pace, which has significantly contributed to a rise in concentration in the US.

  Trade Talks and Merger Reviews

  Trade and competition interact in many fascinating ways. In the second half of the book we will study in detail the political economy of lobbying and campaign finance, but let’s enjoy a quick preview of how foreign competition is often used to justify dubious domestic mergers. It also gives me a chance to talk about one of my favorite podcasts.

  In their deliciously wonky podcast, Trade Talks, Soumaya Keynes and Chad P. Bown discuss economics and trade policy. In January 2018, President Trump imposed tariffs on washing machines and solar panels. The story of washing machines is fascinating, by the way, so after reading this section, I encourage you to put down this book for twenty minutes and listen to Trade Talks #20.

  Back in the mid-2000s, two manufacturing companies—Whirlpool and Maytag—dominated the US production of washing machines with a combined market share of 60 percent. When they decided to merge, the DoJ was understandably worried. The DoJ eventually approved the deal because it thought that foreign competitors (Korean manufacturers LG and Samsung in particular) would keep market power in check. As the New York Times reported on March 30, 2006, “Thomas O. Barnett, the assistant attorney general for antitrust, said yesterday that foreign competitors—although they are primarily supplying more expensive machines now—can still put meaningful pressure on appliance prices. ‘It’s not a question of whether they will enter the U.S.,’ Mr. Barnett said. ‘In this case, they’re quite credible given that they’re already here.’ ”

  A team of economists studied the evolution of prices in appliance markets affected by the merger (Ashenfelter, Hosken, and Weinberg, 2011). They found significant price increases for dishwashers and clothes dryers, but not for washing machines. In that last market, the competition from abroad seemed to keep prices low.