Firm Dynamics, Market Power and Productivity Puzzles

Lead Research Organisation: University of Kent
Department Name: Sch of Economics

Abstract

PROBLEM
Nobel laureate Paul Krugman famously remarked `Productivity isn't everything, but in the long run it is almost everything'. By which he means productivity dictates mankind's ability to produce more output from a given amount of inputs: at a primitive level more crops from a given amount of land or at an advanced level more medicine from a given number of pharmacists. Ultimately, sustained productivity improvement increases society's health and living standards and offers future generations a better life.

After the 2007 financial crisis, UK labour productivity fell 4% in two years, only returning in 2015. Hypothetically, a surgeon performing 100 operations in 2007 only performed 96 in 2009 and returned to 100 in 2015. Worse still, productivity was 16% below the level it would have been if pre-crisis trend had continued -- it should have been 116 operations in 2015! The causes of this are still largely unknown: a 'productivity puzzle'.

EXPLANATION
Our research investigates a new explanation. We hypothesise that existing large corporations used recession to strengthen their market dominance as competitors closed. Then they exploited this dominance, which economists call 'market power', to charge higher prices which weakened productivity. Media and policy commentators have hinted at this channel, but rigorous data analysis is absent. Using big data on the population of UK firms provided by the UK Data Service, we will statistically analyse UK market power, causes of it, and solutions to it. This will inform evidence-based policy of the UK's central bank, treasury and competition regulator.

In a well-functioning economy, a firm that charges prices in gross excess of costs is driven out of business by competitors who jump into the market, charge a lower price, and steal business. This process forces down the difference between price and cost, which economists call the 'price markup' on a good. Contrary to this, our theory is that the Great Recession has weakened competition allowing remaining firms to increase markups. Increased markups are bad for productivity. A firm can cut its units of production but still cover input costs because each unit is priced higher. Therefore output falls for a given amount of inputs -- the definition of productivity decrease!

If our hypothesis is correct, it has far wider-reaching implications for society than weakening productivity. Increased markups hurt consumers since goods are more expensive. Increased markups hurt workers because less work is available. Increased markups benefit owners who receive more revenue. The result is increased inequality.

SOLUTION
Traditionally policymakers analyse competition in each industry of the economy independently. In the future they must recognize the overall impact that market power can have on an economy. This is crucial in the UK at a time when it moves away from the EU, which successfully challenged abuses of market power, and at a time when disruptive technologies are creating new industries with dominant firms and few competitors. Effectively managing competition should form a pillar of the government's 'New Industrial Strategy', which could harm productivity if it slows the churn of businesses, and protects the market power of existing businesses. Competition authorities need power and resources to identify and tackle market power, which allows firms to hoard profits, invest less, raise inequality and depress productivity. Our research will analyse solutions to improve competition, weaken market power and decrease markups.

Our aim is to strengthen productivity throughout the UK economy in order to improve the health and well-being of society, and ensure the gains of economic growth are evenly distributed.

Planned Impact

Growth in firm market power and consequently lower productivity affects many participants in the economy.

1. Society -- abuses of market power lead to higher prices, worse working conditions, lower wages for workers and higher prices with less choice for consumers. It weakens productivity which has the effect of lowering living standards. Growing market power gives corporations higher price setting ability. Under this scenario they cut production and increase prices. This reduces demand for labor, and accrues more rent to owners. The result is lower wages for workers and higher incomes for firm bosses. This causes increased inequality.

2. Consumers -- any consumers of goods produced by firms because growth in monopoly power allows firms to dictate prices which harms consumers.

3. Workers -- any wage earner employed by a firm, or unemployed people seeking work. Greater market power drives a wedge between workers' wage and their productivity (marginal product of labor). Zero hours contracts. AI displacing routine labor jobs (deeper concern about how to deal with disruptive technologies)

4. Policymakers -- The research provides new insight on how to understand productivity puzzles, but more importantly provides solutions to overcome them. Many policymaking organization, both domestic and international, are challenged with understanding low productivity growth and finding solutions to the problem. Notably Competition and Markets Authority (CMA); HM Treasury (HMT); Business, Energy & Industrial Strategy (BEIS); Organisation for Economic Co-operation and Development (OECD) and central banks: Bank of England (BoE); European Central Bank (ECB); Deutsche Bundesbank.

5. Charities and Nonprofit Organizations -- The Third Sector plays a vital role in helping small businesses and start-ups compete and lobby against larger incumbent firms who may seek to exert uncompetitive behaviour. Examples are NESTA (National Endowment for Science, Technology and the Arts); the British Chambers of Commerce (BCC); the Federation of Small Business Owners (FSB); the Confederation of British Industry (CBI) (its mission is to promote the conditions in which businesses of all sizes and sectors in the UK can compete and prosper for the benefit of all). These users will benefit from scientific evidence of growing market power if it exists, as it affects the people they represent and the causes they are dedicated to such as promoting innovation; helping small businesses; and improving the public's view of business in the UK.

6. Students in Further and Higher Education -- In elementary terms, our research addresses 'market failure' which is one of six units that is core to all A-level exam boards. The concepts of price markups, market power, market concentration and imperfect competition are all part of the A-level syllabus, and are taught to first year undergraduate students. Fortunately our research has a simple story underlying the advanced statistical and mathematical analysis. It provides an excellent contemporary case study to engage young economists who have some awareness of the UK's productivity puzzle and would be interested to relate it to the oftentimes abstract theory from class. All of what we propose can be explained in terms that challenge but reinforce the concepts covered by novice economics students. It will therefore benefit student economists at all stages of learning.

7. Thinktanks and Research Groups -- Outside of academia and direct policymaking roles, there are many economics research organizations with interest in the productivity puzzle that have considerable impact on influencing public discourse and policy debate. Examples are National Institute of Economic and Social Research (NIESR), Institute of Fiscal Studies (IFS), Policy Exchange. These users will benefit from a new perspective on a puzzle they have been grappling with for several years. We will ensure our research is communicated directly to these user

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