When Markets and Politics Collide, Innovation May Lose Out
In regulated markets, the threat of new competitors can lead dominant firms to pull back.
Does competition spur innovation? Not necessarily. | iStock/dickcraft
Public policies that affect business, like antitrust oversight, have long been guided by the precept that competitive markets spur innovation, cater more to consumers, and generally make society better off. The going assumption is the more competition the better.
That principle can be derived from the supply and demand graphs taught in Econ 101 or any of the fancier microeconomic models used in research. But all of those models have one thing in common: They focus on market dynamics and treat governments’ actions as given.
“Basically, markets and politics are treated as separate realms, with no real interaction,” says Steven Callander, a professor of political economy at the Stanford Graduate School of Business.
That’s a useful simplification for many purposes, he says. But it ignores the fact that when a firm grows to dominate its market — as most hope to do eventually — it also gains political influence, which it will reliably wield in its own interests.
Ignoring that reality has only grown more problematic, Callander notes, because studies show that market power, as measured by things like profit margin, has increased in recent decades — especially in the U.S., where industries like e-commerce and wireless carriers have been captured by a single big player.
To study the interaction between economics and politics, Callander, along with fellow Stanford GSB professors Dana Foarta and Takuo Sugaya, built a new model that depicts an industry in which regulatory actions and firm behavior depend on each other and are jointly determined.
The results are striking. For one thing, they find that there is a clear feedback loop in which a company can co-opt its regulator and influence policy in a way that further entrenches its market position. “Market power begets political power begets market power,” as Foarta puts it.
And modeling the regulator as a partially self-interested agent, instead of being purely altruistic, means it will want to protect the market leader from competition — for in that way, to put it indelicately, the company will have more wealth that the regulator can share.
That much might be expected, and Sugaya says we’ve seen plenty of cases in the real world where public policy serves to buttress the power of dominant firms. He cites the regulation of AT&T in 1913, which effectively created a government-sponsored monopoly for 70 years. (In 1984, the telecom giant was broken up into several smaller, regional companies, and new competitors emerged.)
Yet what’s truly startling here is that competition does not necessarily lead to better outcomes. “In a world where you have both public and private sectors,” Callander says, “the threat of market entry and competition may actually stifle investment and innovation.”
Managing the Competition
The reason for that, the authors say, is that when you bring the government into it, there are two ways for a company to gain an edge over its rivals: It can spend on R&D (or acquire innovative startups) or it can lobby for preferential policies.
In economic terms, the two forms of spending are substitutes. The more you have of one, the less you need of the other. In fact, Foarta says, the typical path is that a startup introduces a disruptive innovation, separates itself from the pack, then seeks protection from the government and throttles back.
On the other side, the regulator is inclined to offer that protection, since it increases the monopoly profits or “rents” available to extract. “In this way, the interests of the leading firm and the regulator align,” Callander says. But they don’t align perfectly, and that’s an issue.
Over time, as the firm’s market power changes, so does the balance of power in its relationship with the regulator. If it gets too strong technologically, it has less need for protection, and the regulator loses leverage. Picture a tech giant thumbing its nose at policymakers.
“To remain relevant,” Callander says, “the regulator will at some point reduce its protection and facilitate competition to reel the company back in.” That creates an inflection point. And knowing that, the dominant firm will stop innovating before it crosses that line.
Under this “managed competition,” the authors show, the equilibrium is even worse than what you’d get with an unregulated monopoly, with less efficiency and less innovation. “It’s the worst of all worlds,” Foarta says.
Rethinking Antitrust Policy
Given the concentration of market power in the U.S. today, the model suggests we’re paying a steep price for it in economic stagnation. “There’s a lot of productive investment that might have happened that just didn’t in the end,” Callander says.
There’s no way to quantify the losses, since we don’t know what unrealized innovations would have been possible. “You can’t measure a counterfactual, but it’s safe to assume there’s a lot more inefficiency out there than meets the eye,” he says.
You can get a sense of this, Sugaya notes, by looking at developing countries where local businesses are protected from international competition. “That’s a really good example of this symbiotic relationship between governments and markets, and they’re well behind the global productivity frontier.”
As for why market power has increased in so many U.S. industries, Callander ties it to a shift in antitrust policy 30 to 40 years ago. “Antitrust has been dominated by a ‘consumer welfare’ standard,” he says. “You look at a merger and ask if it’s bad for consumers at a point in time.”
“That’s much too narrow. What we’re saying is, you need to look at it broadly and dynamically. Not just will prices go up or down, but how will it affect investment? And if it gives one firm an edge today, will that translate into political protection that deters future competition? If so, the effects of this merger are going to be a lot worse than you’d otherwise think.”
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