19 May 2015

Big business is ballooning in the US


Giant corporations are one aspect of modern capitalism that has come in for a lot of criticism in recent years. Detached from nation states, they are seen to be indifferent to concepts like job security and fair taxation. Detached from competition and accountability, they neglect customer service and allow executive pay to break the stratosphere.

Big business is, of course, not in itself a bad thing. Hal Varian, Chief Economist at Google, calculates that search engines (and Google has a 67% core market share) generate up to $150bn of consumer surplus each year, or $500 per user. Not bad for a free service. The benefits of scale mean that the world’s largest company, Walmart, has probably done as much to ease the cost of living as even the best designed government welfare policies. Apple makes profit margins of almost 40% on quarterly revenues of over $50bn, with a dominant but relatively small market share (20%) in smartphones.

Every new start-up dreams of establishing a monopoly in whatever they bring to the market. However, an economy which is characterised by excessive consolidation is one which loses out from the innovative benefits of dynamic competition and falls prey to rent seeking, corporate lobbying and over-management.

It is with some concern therefore that we should view developments in the Fortune 500 list of largest US companies. Andy Flowers at FiveThirtyEight has crunched the numbers, and it looks like America’s biggest businesses are getting much bigger.

“The overall revenues of Fortune 500 companies have risen from 58 percent of nominal GDP in 1994 to 73 percent in 2013. While that ratio of big business revenue to GDP has ticked down over the last two years, the upward trend over two decades is clear.

“As big business gets bigger, the biggest businesses are growing even faster. The Fortune 100, or the 100 companies with the highest revenue, have seen their proportion of nominal GDP rise from about 33 percent in 1994 to 46 percent in 2013. As a share of all Fortune 500 revenues, revenues for these top 100 companies were up to 63 percent in 2013 from 57 percent in 1994.”

This is not how it’s supposed to be. The biggest 100 companies shouldn’t be pulling away from the rest; they should be being displaced by rough and ready challengers offering better ways of doing things.

That they are not suggests we should be taking a closer look at merger activity. Last month, the $45.2bn merger between the two largest US cable operators, Comcast and TWC, was called off. But this owed more to the fact that these were two of the most wildly disliked companies in America, with dreadful records on customer service, and Comcast’s embroilment in last year’s net-neutrality debate, than a concerted effort of trust busting. There is no guarantee that the proposed $48.5bn deal between AT&T and DirecTV will face the same fate.

Recently, Richard Walker wrote a comprehensive piece for CapX on why most mergers fail to add value, and are motivated by shareholders chasing growth, the big egos of executives, and misplaced faith in management consultants and investment bankers offering “synergies” and efficiencies.

“The biggest misunderstanding is about the whole concept of buying a modern business. Companies used to be made up mainly of things like factories and machines. Now that has changed – the most valuable businesses are really collections of talents and intellectual property and brand equity, the so-called ‘intangibles’. It is estimated that the average proportion of intangibles in the valuation of a business has risen from 17% in 1975 to over 80% today.

“The problem here is that intangibles are rather volatile elements. The record shows that talented people detest the culture clash that follows a merger, and tend to leave (taking clients or customers with them), while the accompanying turmoil tears the brand to shreds. The very process of executing a merger more often than not destroys the value of that merger.”

It is not the first time that the United States, a country that by dint of institutions imported by generations of enterprising settlers coupled with generous material endowments, has fallen prey to the influence of trusts. The response in 1890 to wide-spread consolidation of industrial interests, particularly Standard Oil, was the Sherman Antitrust Act, which sought to strike a proper balance between success and abuse of market power – the kind that leads to higher prices, shoddy customer service and anaemic innovation.

One of the authors of the legislation, Massachusetts Senator George Hoar, made this clear:

“… [a person] who merely by superior skill and intelligence…got the whole business because nobody could do it as well as he could was not a monopolist..(but was if) it involved something like the use of means which made it impossible for other persons to engage in fair competition.”

Oliver Williamson, who shared the Nobel Prize in 2009 with Elinor Ostrom for his work on the economics of the firm, also understood the nuance of big business. Large companies exist because they are more efficient, but that does not mean they serve to benefit the market as a whole, as Louis Uchitelle explains in the New York Times:

“If a coal-burning electric power plant is near the only coal mine in the region, then integrating the two is sensible. On the other hand, if several coal mines are nearby, then integrating with just one of them could undermine the advantages of allowing the coal companies to compete for the utility’s business.”

Whether big business status is achieved through market success or acquired by merger activity, we have to be vigilant about the direction of the industrial landscape. At the top, no business should be too big to fail; at the bottom, good ideas should have a fair crack at disrupting the status quo. In advanced Western economies, growth-hacking is not an option. If we are to become more prosperous, we not only need to embrace the spirit of innovation but provide the market environment that allows it to thrive.

Zac Tate is Deputy Editor of CapX