Does Common Ownership Explain Higher Oligopolistic Profits?

Edward B. Rock is the Martin Lipton Professor of Law at New York University School of Law and Daniel L. Rubinfeld is Professor of Law at New York University School of Law. This post is based their recent paper. Related research from the Program on Corporate Governance includes Horizontal Shareholding (discussed on the Forum here) and New Evidence, Proofs, and Legal Theories on Horizontal Shareholding (discussed on the Forum here) both by Einer Elhauge; Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here).

There is compelling evidence that both concentration and profitability in oligopolistic industries have increased over the past two decades. Over roughly the same time period, the concentration of shareholding in the hands of the largest institutional investors has dramatically increased, with an increase in the degree to which investors (such as Vanguard, State Street and BlackRock) own large equity stakes in competing portfolio companies. A number of authors—focusing initially on airlines and commercial banking—have argued that the growth in this “common ownership” has caused the increase in oligopoly profits. They have followed this with a variety of policy responses.

We start with the core puzzle. The “Structure-Conduct-Performance paradigm”—which asserts a connection between concentration and profits—has long been a staple of antitrust policy. Yet, compelling empirical support for this connection has historically been sparse, for reasons well discussed in the Industrial Organization literature. Interestingly, according to the empirical evidence, something changed around 2000. Since then, the evidence for a link between concentration and profitability has become quite strong. As a result, an adequate theory must explain two things. First, why is there a correlation between concentration and profitability? Second, why has there been a strong(er) correlation post 2000 than pre-2000?

The “common ownership” literature asserts that the increase in common ownership by the largest institutional investors since 2000 is what caused oligopolies to become more profitable. We review the evidence for this claim and find it lacking.

But if the change is not the growth in common ownership, what could it be? Two candidates come to mind: technology (especially in markets with strong network effects); and the old bogeyman, regulation. Might some combination of these explain the observed changes? Might the increase in concentration, the increase in profitability and the increase in common ownership all be a consequence of the impact of technology and/or regulation?

Autor, et al. (2020) suggests that “superstar firms”—firms whose productivity and rate of innovation allows them to outgrow their competitors—account for the increased market shares of the leading firms in some industries. On this account, the higher productivity of the superstars allows them to cut costs and reduce price (while in many cases increasing their price/cost markups and their profitability). The ability to undercut competitors allows the firm to grow market share as well.

What “special sauce” could make a firm into a superstar and allow it to remain one? Bessen (2019) makes a plausible argument that the “special sauce” is the sustained increase in productivity that derives from proprietary advances in information technology. Whether due to network effects, technological advances, or more generally effective competitive mechanisms, the more technologically productive firms plausibly have a substantial competitive advantage over firms that are less productive.

Delving more deeply into the sources of IT productivity, Bessen credits the differential productivity of firms to management’s ability to utilize its software development abilities to take advantage of economies of scale as well as network effects. He notes that the development of IT systems has varied substantially across firms. The key is whether firms (a) have the ability to develop cutting edge systems, and (b) have the management or software-development skills to put new technologies into the marketplace.

Airlines and commercial banking—the industries at the center of the “common ownership” literature—seem to exemplify precisely the kinds of capabilities that Bessen suggests are key. This raises the intriguing possibility that the observed increase in profitability in airlines and banking is an instance of the “superstar” effect. This explanation does not depend on any obscure channels of influence through which large common owners supposedly convince firms to maximize the value of their large shareholders’ portfolios in preference to individual firm value, and would explain why profits have risen in these oligopolies but not in some others.

The complete paper is available for download here.

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