A framework for thinking about market power and rents

I’ve been thinking a lot about market power, rents, “superstar” firms, etc. — here’s my reading list — and one important thing to keep in mind is that firms can make excess profits for different reasons. And these different sources of rents can be more or less harmful.

But how should we think about the many different sources of rents? In my view, combining one theoretical distinction with an empirical one leads to a helpful framework.

In terms of theory, rents can be earned because of an industry’s structure, or because of differences in firm capabilities. That’s an imperfect distinction, of course. Michael Porter would note that successful firms tailor their strategies (and therefore their capabilities) to their industry, and their position in it. Nonetheless, this distinction is a helpful starting point.

Industry structure-based rents are a focus of Industrial Organization, a subfield of economics, and include barriers to entry, economies of scale, and the like. The study of firm capabilities happens more often within the strategy and management literatures (and in particular the strategy paradigm known as the resource-based view). The idea is that some firms are better managed than others, or have unique or hard to copy assets or capabilities, and these can allow them to earn excess profits.

Then there’s a simple empirical observation about the rise of rents and market power over the past 20 years: a big part of it has to do with digital technology. Of course, not all of it does, so it’s worth distinguishing between the role of digital tech and other sources of rents.

And so that leads to four buckets for categorizing potential sources of market power:

market power sources

Analog capabilities and assets includes good management, a strong brand, etc.

Digital capabilities and assets includes data, and expertise at building software or using analytics, for example.

Analog industry structure includes regulation, non-technology-related economies of scale, etc.

Digital industry structure includes economies of scale from IT, both on the demand and supply sides.

Some things don’t fit so neatly. IP is an asset, but it can be related to digital or not, and the importance of IP depends arguably on industry. Lobbying is a capability, but it’s more important in particularly regulated industries.

This isn’t the only way to think about this, and I’m certainly not implying that all four boxes are equally important! Nonetheless, I think this is a helpful way to bucket the various sources of market power. If some companies are temporarily making excess profits because they’re better adopters of technology — digital+firm — that’s not necessarily a problem. On the other hand, if companies are writing regulations in their favor — analog+industry — that’s more worrisome. If it’s mostly about digital scale economies — digital+industry — that may be somewhere in between.

One last point: research suggests that analog intangibles, like management, are complements to digital tech. Companies with good management are better at IT and vice versa. So the two quadrants on the right side reinforce each other in interesting ways.

Even if this framework doesn’t appeal to you, it’s important to consider the why behind market power. Different sources may be more or less problematic, and may need to be addressed in fundamentally different ways.

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