Mara Faccio is the Tom and Patty Hefner Chair in Finance and Professor of Management, and John J. McConnell is the Burton D. Morgan Distinguished Chair of Private Enterprise in Finance, Emeritus, at the Daniels School of Business, Purdue University. This post is based on their article forthcoming in the Journal of Finance.
A fundamental premise of economic theory, dating back to Joseph Schumpeter, is that, over a sufficiently long period of time, old firms are displaced by new ones. As one saying that Schumpeter cites goes: “three generations from overalls to overalls.” In this process, known as the Schumpeterian process of “creative destruction,” new innovation is incessantly created by new firms that replace old innovators, including the most successful ones. This process is widely recognized as a driving force behind long-term economic growth. While extensive research has elucidated the importance of innovation and firm entry in fostering growth, less scrutiny has been devoted to the corresponding replacement of incumbents. Do large, established firms truly get replaced over time, or do they maintain their dominance despite the theoretical benefits of replacement?
In a recent manuscript titled “Impediments to the Schumpeterian process in the replacement of large firms”, forthcoming in the Journal of Finance, we investigate why, across many countries and over extensive periods of time, including a century-long horizon, the largest firms often retain their dominant positions, thereby defying the expected turnover that Schumpeter envisioned. Earlier empirical investigations link the lack of replacement to lower economic growth. Such evidence gives rise to an important question: if the replacement of incumbents is so beneficial, why is it so infrequent?
Our study investigates several explanations. Schumpeter himself suggests that large incumbent firms remain large by continuously reinventing themselves, leveraging their financial strength to innovate. Alternative views are articulated in the work of early 20th-century thinkers Louis Brandeis and Lincoln Steffens. Brandeis condemns “money trusts” formed through interlocking directorates (specifically, the networks of intertwined board memberships with financial institutions) that stifle competition and enable incumbents to suppress rivals. Steffens highlights the systematic capture of political institutions by big business, which manipulates regulation to serve private interests rather than the public good. These views suggest that political entrenchment, rather than superior market performance, underpins the persistence of dominant firms.
Our findings strongly support this latter explanation: political connections, defined as instances in which one of a large firm’s top officers, directors, or blockholders is a member of parliament or is a government minister, materially enhance large firms’ ability to maintain their dominant status. Firms embedded within political networks exhibit significantly higher probabilities of remaining among their countries’ largest firms even over extended periods of time. Crucially, our analyses refute the notion that politically connected firms are able to maintain their dominant market position simply because they outperform their competitors. Various performance metrics reveal that politically connected firms, if anything, underperform their peers instead. Especially, large politically connected firms remain among the very largest firms because of greater protective political influence. This is especially the case in countries characterized by regulatory barriers consisting of tariffs, quotas, and restrictions on cross-border capital flows, which insulate large domestic incumbents from competition. In more open economies, where such barriers are not present, political connections lose their protective power, and the forces of competitive displacement lead to the demise of old large firms.
Summarizing, while innovation remains a crucial engine of growth, our research cautions that entrenched political power combined with protectionist policies can impede the natural Schumpeterian process of replacement of large firms, dampening economic growth. READ MORE
