Mapping the problem in AmericaNov 15th 2018Print edition | Special report
HOW CAN you identify the hotspots in the economy where competition might be a problem? The Economist has tried to answer this question with a series of filters which we have applied to the top 500 firms in America. The process is designed to narrow down where trustbusters may want to look more closely. Existing competition doctrine is not helpful in this exercise, since it lacks any clear sense of what competition is. Instead the inspiration is Warren Buffett, an investor. He argues that some firms have “moats” that protect them from competition. Often these are deserved, being the result of investment, innovation or excellence. In some cases they are not.
The first question is whether a moat exists. We include firms in concentrated markets, or ones that are heavily regulated or reliant on patents, or whose customer is the state. The next point to decide is whether companies are highly innovative or not. Schumpeter would, correctly, argue that firms which innovate deserve a window of competitive advantage. The third filter is the size of firms’ rents, or the free cashflow generated above a hurdle rate, which could reflect either innovation or a lack of competition (we assume a 12% hurdle rate, exclude goodwill and treat R&D as an asset with a ten-year life).
Then we consider openness, or whether market shares and returns on capital shift around, and whether new entrants exist. Finally, in a nod to worries about Amazon and Netflix, we consider the capacity for firms with keen prices and low rents to engage in long-term “clawback” by eventually cranking up prices in the future. It is a bad idea to punish firms that are a source of disruption, but worth keeping an eye on what they may do in future.
We use a traffic light system. A red light means action is needed to open the market. An orange one means a watching brief. A green light means there is nothing to worry about. Apple gets a green light: it has a large market share and high profits but is innovative and faces two credible new entrants from China. Google and Facebook are similar, but there is no sign of new entrants. That gets a red light. Amazon has a large market share in e-commerce and is innovative, but has low free cashflow (after adjusting for leases), indicating consumers get a good deal. The fear that it has enough power to claw back huge rents in the future earns it an orange light: it should be watched.
The exercise suggests that 24% of the market value of the S&P 500 is in firms that get a red light and 14% in firms that get an orange. That points to the need for precise interventions to spur competition in these limited parts of the economy, not a sprawling campaign to bash big business.
Clarification (November 20th, 2018): This article was amended to make clear Amazon's large market share refers to its market share in e-commerce.