A casualty.

Photographer: Paul J. Richards/AFP/Getty Images

Tech Fuels the Winner-Take-All Economy

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Several new pieces of research have investigated the cause of declining dynamism among U.S. businesses. The drop in the number of startups is a real concern, since new high-growth businesses are believed to be an important driver of economic expansion.

One new paper, by Massachusetts Institute of Technology economists Jorge Guzman and Scott Stern, argues that new companies are having trouble scaling up. The researchers used historical data to identify companies that are likely to grow a lot in the future -- such as where the company is registered (Delaware is best). Five out of the eight characteristics they use involve the company’s name -- in the past, for example, new companies with shorter names have tended to grow more later on. Guzman and Stern find that many more companies with these telltale indicators of growth potential have been started in the last few years, but that these companies have been succeeding much less frequently than in the past.

Guzman and Stern’s method has an obvious shortcoming -- it can’t actually be that easy to identify companies with high growth potential. If everyone knew that businesses with short names were likely to experience huge growth, every startup that pitched itself to venture capitalists would just pick a short name. Eventually, low-quality companies embracing the short-name trend would drive down the success percentage for short-named companies. This kind of fad might be responsible for some part of the effect that Stern and Guzman find.

But probably not all of it. Other measures, like patenting and incorporation, are far less easy to game. The decreasing success of ambitious companies should be worrying, especially because influential figures in industry have been warning us about it for quite some time. Andrew Grove, former chief executive officer of Intel, has written that U.S. companies struggle to achieve large scale, especially in manufacturing. He largely blames the short-termism of the financial system and the lack of a domestic manufacturing ecosystem.

Another cause that some have suggested is rent-seeking. This is the economics term for when existing companies use regulation to block new competitors. Obviously, if new companies can’t steal business from old ones, there is less room for growth. Large corporations are more dominant today than in the past. One problem for this thesis is that some research indicates that increasing regulation hasn’t had much of an impact on dynamism. So if rent-seeking is the problem, it’s still an open question as to how, exactly, big companies are using the government to block their competitors.

I would like to suggest a third -- and more worrying -- possibility. The changing nature of technology may have altered the structure of competition in the U.S. economy, encouraging more monopolies.

Venture capitalists have been noticing the troubling rise of winner-take- all situations in the startup world. For example, here is legendary venture capitalist Marc Andreessen in 2013:

In normal markets you can have Pepsi and Coke. In technology markets in the long run you tend to only have one…The big companies, though, in technology tend to have 90 percent market share. So we think that generally these are winner-take-all markets. Generally, number one is going to get like 90 percent of the profits. Number two is going to get like 10 percent of the profits, and numbers three through 10 are going to get nothing.

 

Why are today’s growth industries more likely to be winner-take-all? The Internet. Companies such as Facebook or Snapchat have strong network effects -- the more users they have, the more it pays to become a user. It just doesn’t make sense to have three or four Facebooks out there. Strong network effects create natural monopolies -- industries where competition tends to vanish on its own.

Natural monopolies existed in old-line industries, of course. Utilities are a prime example. Where they did exist, they were usually heavily regulated. The reason is that monopolies are bad for the economy -- they keep prices too high and choke off demand. That is also why the government has antitrust laws -- to prevent collusion between companies and ensure that competition keeps the economy efficient.

Natural monopolies are a unique threat to competition, because they don’t rely on collusion, and can’t easily be broken up. Imagine if the government ordered Facebook to split into two social networks. People would eventually abandon one and move to the other, to be connected to more of their friends, and the monopoly would return.

If the Internet breeds natural monopolies that crowd out competition, it could spell trouble for the U.S. economy. That will lead to most new ambitious companies failing -- exactly what Guzman and Stern have seen happening in the past decade and a half. The result won’t just be a less dynamic economy, it will also be a less efficient one, as monopolies jack up prices above their efficient levels.

This is a troubling possibility because the remedy isn’t clear. Facebook and other tech companies probably can't be regulated like utilities, and even if they were, the benefit would be ambiguous. Natural monopoly is an economic threat that the U.S. simply hasn’t had to cope with very much in the past, and policy makers don’t have good countermeasures available.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net