I have blogged on several occasions about certain disturbing features of modern free-market capitalism - widening inequality, business concentration, massive executive compensation, prioritisation of stock market returns, start-up valuation bubbles, efficiency maximisation at the cost of resilience, market bubbles and so on. The underlying dynamic behind each is the same.
This post will point to four examples that highlight market failures arising from the inherent dynamics of free-market capitalism.
The first example is about the labour market. In a recent paper, Renjie Bao, Jan De Loecker, and Jan Eeckhout identify the contribution of market power to the salaries of managers. They use a model of executive compensation where firms have market power and the market for managers is competitive,
We identify two distinct channels that contribute to manager pay in the model: market power and firm size. Both increase the profitability of the firm, which makes managers more valuable as it increases their marginal product. Using data on executive compensation from Compustat, we quantitatively analyze how market power affects Manager Pay and how it changes over time. We attribute on average 45.8% of Manager Pay to market power, from 38.0% in 1994 to 48.8% in 2019. Over this period, market power accounts for 57.8% of growth. We also find there is a lot of heterogeneity within the distribution of managers. For the top managers, 80.3% of their pay in 2019 is due to market power... The best managers are lured by large, high markup firms where they create high profits for the shareholders, but disproportionately little additional value to the economy. The rise in the top 1 percent income is not only of concern on the grounds of equity, it is also of concern for efficiency...
Because of the complementarity between manager ability and firm productivity, the most productive firms can widen the gap even more by hiring a highly skilled manager. This increases their markups even further. The lower productive firms have low markups and hence have little to gain from hiring a superstar manager. Because there is competition for managers, all top firms in their own market who benefit from having a top manager will bid up the top wages. They are paid for increasing the gap between their direct competitors.
They conclude with an important general observation,
Finally, the central mechanism that links market power to compensation is not restricted to man- agers. A superstar coder who improves an algorithm that is be used by a dominant tech firm for example, will command a superstar salary as her code will help her firm outperform competitors. And in the sports leagues, there is strategic interaction that derives from the zero-sum nature of sports com- petitions. The team that attracts the top players is more likely to win games, and this will make them bid up the compensation for the top players.
This finding builds on the large body of research on superstar effects that end up privileging incumbents in the market for executives.
Eeckhout and Loecker have an earlier paper where they show how market power translates to price mark-ups in industries characterised by high levels of concentration among the top few producers.
The second example is about the self-fulfilling nature growth of wealth itself. Consider this,
In his book “Capital in the Twenty-First Century,” the French economist Thomas Piketty notes that the new economic order has made it difficult for the superrich not to get richer: “Past a certain threshold,” he writes, “all large fortunes, whether inherited or entrepreneurial in origin, grow at extremely high rates, regardless of whether the owner of the fortune works or not.” He uses the examples of Bill Gates and Liliane Bettencourt, the heiress to the L’Oréal fortune. Bettencourt “never worked a day in her life,” Piketty writes, but her fortune and Gates’s each grew by an annual rate of about 13 percent from 1990 to 2010. “Once a fortune is established, the capital grows according to a dynamic of its own,” Piketty notes, adding that bigger fortunes tend to grow faster — no matter how extravagant, their owners’ living expenses are still such a small proportion of the returns that even more is left over for reinvestment.
People forget that there are at least two increasing returns to scale forces driving the rich towards getting richer. One, one's wealth or income is an important determinant in that person's risk appetite. So a very rich person has a very high risk appetite, and alongside a much higher risk opportunities. And the immensely rich have the opportunities to take several such risks, at least some of which will invariably strike gold. Second, there is the base effect - a doubling of 10 or 100 or 1000 is altogether different from a doubling of a million or billion in terms of their wealth effects. The result of these two forces (and enabling rules that tax the main income sources of the richest, capital gains, at a lower rate than that of the regular salaried earners) are that the rich by merely being rich find it difficult to not become richer, and that too at a pace much faster than those who are not similarly endowed.
This dynamic works within markets too and manifest in the form of a resource misallocation problem. Left to the dynamics of the market, certain narrow or elite market segments which are lucrative for the producers end up cornering a disproportionate share of attention, investment, and innovation. The trickle down of market development takes an eternity to reach the mass market. The attraction of demand does not automatically translate to supply especially when a segment in that market offers much larger margins and is itself large enough to absorb the available supply of capital and entrepreneurs. The result is that outside of this small sliver, market development remains largely still-born.
The third example is about failures within markets. Consider the issue of affordable housing. I've blogged here, here, and here, highlighting it as among the most intractable of public policy challenges across the world.
Sample this about the declining share of affordable housing loans in India.
In absolute terms too, affordable housing loans have hit a hard rock
In April 2015, the priority sector home loans and the non-priority sector home loans both stood at Rs 3.2 trillion. After that, the non-priority home loans kept growing, whereas the priority home loans took a beating... In February 2020, the priority home loans peaked at Rs 5.2 trillion. Two years later, they stood at Rs 4.9 trillion. This primarily means that banks haven’t given out a single rupee of fresh priority home loans on a net basis during the last two years. So, banks aren’t financing many homes worth less than Rs 45 lakh in cities and less than Rs 30 lakh in other areas... In the last five years, lending to the non-priority sector has grown at 17.3% per year, which means it has more than doubled. In March 2017, the total loans had stood at Rs 4.9 trillion. By February 2022, they had jumped to Rs 10.9 trillion. During the same period, the priority home loans have increased from Rs 3.6 trillion to Rs 4.9 trillion.
The depressed supply of affordable housing in large markets like India is a good example of failures within markets. This applies just as much to markets offering services like affordable education and healthcare. In both, entrepreneurial efforts and capital gravitate to the top of the market, and even when they look beyond, they are confined to the mid-market segments. I recently blogged about medical education.
Widely observed trends like the stagnation and decline of many cities and the rise and rise of a few very large metropolitan cities is a national-level macro trend that's similarly driven, at least partially, by the dynamic of modern capitalism.
Finally, another area of market failure is the pervasive distortions engendered by efficiency maximisation to maximise profits, another issue on which I have blogged extensively. Left to itself, unfettered market competition drives businesses into an inexorable spiral of cost-cutting on everything that contributes to the production cost - inputs, logistics, shop-floor practices, suppliers, labour, capital cost, inventories, treasury management etc. The driver of cost-cutting is to eliminate any cost other than that required for effective daily operations - just-in-time management. Since efficiency maximisation seeks to eliminate any extra cost except that required for buffers, insurances, and redundancies, it ends up eroding the system's resilience and capacity to absorb disruptions and shocks.
Worse still, the cost-cutting mantra also extends to seeking opportunities to legally externalise costs while appropriating all benefits. An efficient firm seizes the opportunity to benefit from any legal and regulatory arbitrage. In fact, one could formulate a new firm theory of regulatory arbitrage - a firm's legal form and practices are shaped by the laws and trends which imposes the least cost. So, if employee salary can be palmed off to social security and the tax payer OR if some of the costs can be outsourced away to a distant and less visible location, then it's efficient management to do so.
In the old economy, this was mostly about easily identifiable environmental pollution. Mobilising public indignation and controlling it was easy. Unfortunately, in the new tech-economy, it's diffused and shrouded in arcane legalese, all of which are essentially about shirking obligations in limiting social damage or shrinking market competition. Sample the debates surrounding publisher Vs content carrier (Facebook), employee Vs independent contractor (Uber), seller Vs platform (Amazon), private carrier Vs common carrier (App store) etc. In each of these, the old-economy firm doing substantially the same activity plays by a cost internalising rules of the game whereas the corresponding new economy firm is allowed to externalise those same costs. Worse still, the narrative has been spun such that the latter is lauded by opinion makers and rewarded by the markets for these same practices.
Morgan Housel had a recent blog post
We are pushed toward maximizing efficiency in a way that leaves no room for error, despite room for error being the most important factor of long-term success. The world is competitive. If you don’t exploit an opportunity your competition will. So opportunity is usually exploited to its fullest extent as soon as possible. That’s great – it pushes the world forward. But it has a nasty side effect: When all opportunity is exploited there is no room for error, and when there’s no room for error any system exposed to volatility and accident will eventually break.
These are only four illustrations. There are several markets in which this dynamic is today egregious - individual goods and services market segments, labour market for executives, stock markets, start-up funding, upmarket goods and services etc. They manifest in the form of business practices, salaries and compensation, capital gains, valuations, inequalities and so on.
Markets are not normative. They are agnostic to morals and values. In fact, for all practical purposes one could argue that they are completely transactional. They work through the instrument of price signals and the idea of marginal utility to maximise the material gains of agents. Accordingly, people and businesses prioritise the maximisation of their income or profit or wealth. These actions of individual agents over time engender a collective dynamic which most often (perhaps invariably) ends up serving the interests of those are already ahead (advantaged) while also penalising those who are already behind (or disadvantaged). Those who begin with an advantage increase their advantage whereas those who start with a disadvantage become more disadvantaged. The dynamic of capitalism ends up creating a Mathew Effect (Mathew 25:29)
For to every one who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away.
In simple terms, the rich get richer and the poor poorer!
In Econ 101speak, this can be described a case of increasing returns to scale. The more advantaged become even more advantaged and entrenched in their markets. The very nature of the market dynamics invariably creates conditions that become entry barriers by themselves and thereby stifle competition and distort incentives.
The most damaging consequence of these trends is that it seriously erodes the social contract. Once a group or interest becomes entrenched, it ends up capturing the political system itself. In even the most robust democracies, all the arms of the government get directly or indirectly captured. They then effectively control the rule-making process itself. They get to set the rules of the game. See this and this.
The rules of the game of modern capitalism and political systems favour the larger firms disproportionately. The taxation regime (corporate tax, capital gains/buybacks, tax deductibility on interest expenses etc), ease of financing (lower cost of capital for the largest firms), the public bailout backstop (too big to fail), public policy dominance of stock markets health over that of real markets, and so on are examples. Most disturbingly, the setting of these rules themselves are captured by the same elite companies. And therein lies the risk to the sustainability of modern capitalism.
Update 1 (29.04.2022)
FT long read on the acute scarcity of rental housing in the western cities. This about Berlin and housing affordability concerns posed by financialisation,
“Berlin is the new New York: everybody wants to live there,” she says. “And the city never had a co-ordinated land policy in response. Public procurement rules push local government land sales to the highest bidders, often those building the most expensive homes, ignoring the lower bids from not-for-profit associations providing affordable rental housing.” The growing popularity of rental housing to investors is not confined to Berlin. New money flowing into Europe’s rental sector from institutions such as pension funds and insurance companies worldwide increased from $75bn in 2019 to $124bn in 2021; in the US it increased from $193bn to $350bn, according to Real Capital Analytics, a real estate data company. Leilani Farha, a housing campaigner who was UN special rapporteur on the right to adequate housing until 2020, is worried about the social impact of the “financialisation” of housing in this way. She says investment funds are ill suited to owning homes: the need to generate returns for investors must either jack up rents or cut their maintenance costs; either way tenants lose out. In many cases, investors target affordable housing schemes in the US and Europe where people are especially sensitive to price rises. “When you’re a pension fund you’re just looking for a good return,” she says. “Favourable conditions for investors and real estate professionals will not work for tenants.”