Imperfect markets don't mean that regulation is the answer; competition often does a better job than bureaucracy at improving outcomes.
America used to be the homeland of market freedom and innovation. Foreigners still believe it is. But is it?
Thomas Philippon thinks it is not. His book, The Great Reversal, is refreshing in many ways. He considers innovation’s impact upon the population at large. If you look at gadgets, the US is clearly producing more and newer and better, but if you look at the effect of innovation on people’s salaries, the EU is doing better. Innovation should increase people’s real salaries, that is, the stuff they can buy for a buck. For this reason, innovation is not separate from competition. In order to gain larger market shares in a competitive environment, firms need to innovate. This is why—all else being equal—competition drives prices down. In the process, products change: their quality increases and consumers can experience product differentiation. This is the magic by which competition turns a company’s self-interest into the greater good of consumers at large.
Because competition contributes to the greater good in this way, Philippon argues that it needs to be preserved by adequate rules. But it faces two enemies: one comes from within the market economy itself—market power—while the other is an external enemy—discretionary government intervention. The two can join forces as firms lobby governments to gain further protection, with the aim of raising the rivals’ costs and ultimately increasing their margins without embarking on costly and risky innovative efforts.
Philippon provides evidence that more dynamic competition yielded sizeable benefits for the American public. He identifies two key changes in the last half-century that caused markets to open up in the US. One is the deregulation of the airline industry under President Carter; the other is the break-up of the Bell system in 1982. He picks these two episodes on purpose: one is an example of a conscious change in the rules of the game; the other a case of antitrust enforcement. Changes in the rules of the game and antitrust enforcement are also the ways in which the European Union affects competition in its member states.
Philippon’s main point is that the EU learned the lesson from these two successful stories better than the US did. He argues that “many European markets appear to be more competitive than their American counterparts” because Europe succeeded in taking advantage and somehow “constitutionalizing” the above-mentioned examples of enlightened interventionism. On the one hand, Philippon argues that the Directorate-General for Competition (the EU’s antitrust arm) is an independent body, freer from lobbyists’ pressure than its counterparts elsewhere. On the other hand, rules against state aid are the backbone of the European common market and helped in diluting the weight and influence of government-owned companies. State aid rules are a unique feature of the EU legal framework. With a few exceptions, they ban any discretionary intervention from member states that may result in a distortion of the commerce between or within the member states themselves. The relative rigidity in their enforcement in the past few decades has been a primary ingredient in the attempt to create a level playing field across European firms.
Significantly, national governments have grown increasingly hostile to EU state aid rules that prevented them from pursuing “industrial policies” or from breeding national champions. It is not a surprise—and perhaps it may warrant a new chapter in the next edition of The Great Reversal—that member states seized the opportunity of the coronavirus crisis to call for a de facto suspension of the state aid discipline. While the new, more permissive framework is deemed to be “temporary,” only time will tell how long “temporary” measures will last.
In this context, it is a bit paradoxical that German ordoliberalism is not mentioned. Philippon is very alert to the influence of vested interests over institutions, which he correctly fears. But he pays little if any attention to the ideas which shape institutions and institution-builders in the longer run. How did Europe take a right turn? For an author so suspicious of motives of both privately-owned companies and politicians, Philippon is parsimonious of details when it comes to how institutions move in the right way. He points to campaign financing, lobbying, and spurious relationships between politics and business as a cause for things going wrong. But he does not explore the reasons why things may go the other way. Thus, controversial antitrust cases in the EU don’t get much scrutiny. Philippon can do that because he looks at aggregates, but what about the nuts and bolts of antitrust cases? Can we judge the result independent of its components?
Philippon’s reasoning can be summarized: competition has declined in most sectors of the US economy; that happened because of policy choices, influenced by lobbying and campaign finance contributions; such lack of competition widens inequalities. In order to develop his arguments, he first clarifies that market structure (i.e. market shares, the number of firms competing within an industry, etc.) matters at least as much as market design (i.e. the rules of the game).
He thus revives an old debate in economics between what we may call the neoclassical, traditional view of competition, as deduced from the writings of Léon Walras, and a competing (pardon the pun) understanding of competition, developed at the University of Chicago in the 1960s and 1970s. Free-market economists and legal scholars from Chicago and elsewhere pointed out that market share provides relevant information to understand a market or an industry, but it does not incorporate all the relevant information and possibly not even most of it. In other words, size matters—but only up to a point. The fact that a firm is big does not necessarily signal that a market is no longer competitive.
The Business of Lobbying
Competition policy was a pillar of the European Economic Community since its beginning, but it has grown in scope ever since. A rift of sort between US antitrust policy—which became more and more concerned with the institutional framework—and European policy, which remained obsessed with market shares and the number of competitors, emerged.
Philippon argues that the Americans were so much more interested in the framework (i.e., freedom to entry) that they ended up becoming totally uninterested in the outcomes of competition. This created a window of opportunity for lobbyists who found it easier to capture regulators and persuade them to introduce increasingly costly regulation that ultimately resulted in lower levels of market entry, less competition, and higher margins for the incumbents. That is the case, for example, of entry regulation in the banking sector (which is supposed to protect customers but also makes it harder to challenge the incumbents) or the applications of the “too big to fail” principle in industries as diverse as finance, healthcare, and pharma.
Philippon is well aware that a high number of small firms is not always the best option. For example, the rise of Walmart led to a consolidation in the American retail industry, but it also brought about greater efficiencies that were, by and large, passed over to consumers. Yet, in the past few years, concentration rose in the US without a discernible benefit for the consumers. The EU instead provides a successful case-history where concentration did not increase as much, consumers were better off, and—all else being equal—innovation was not given up. Up to this point, Philippon is very persuasive. His case becomes less strong as he ventures into other fields: explaining why Europe overcame America as the land of the free (at least as far as competition is concerned), and exploring the digital environment as a new frontier for monopolization.
Lobbying can indeed “explain some of the differences that we observe across time, regions, and industries,” when it comes to degrees of competition. But is it really fair to compare the US federal government and the EU Commission? While they are superficially equivalent, the powers they possess and their sources of legitimacy are quite different. Just to give an example, the EU Commission has no power in fiscal policy and it relies on a relatively small budget of about one percent of the GDP, equal to about two percent of the combined budget of the member states; on the other side, the US federal budget is more than twice as large as the combined states’ budget. To some extent, there is a similar discrepancy when it comes to regulatory powers, too, although the EU institutions have more authority there than they do over fiscal policy. The expected payoff from capture, therefore, may provide an explanation for the larger amounts of money that are spent to lobby the US Federal government as compared to the EU Commission.
Whatever the causes, Philippon provides strong evidence that regulatory capture played at least a role in some industries, where US policy-makers introduced regulation whose effect, if not intention, was to make market entry more costly. This is the case with banking and, to some extent, healthcare. He also argues that large online platforms, like the so-called GAFAMs (Google, Amazon, Facebook, Apple, Microsoft) switched sides in the struggle for competition versus regulation: when they emerged, they were true disruptors, bringing about greater efficiencies, lower costs, and increased productivity. However, as their success made them big enough, they stopped challenging the incumbents and became the incumbents. Their lobbying priorities changed accordingly, shifting from calling for more freedom of enterprise to seizing monopoly powers.
While any specific allegation against these companies may or may not be grounded in the evidence and, what matters most, may or may not harm consumers, we find a broad case against the GAFAMs very weak. The broad case relies on a very convenient definition of the relevant market, aimed at considering each of these companies as a monopolist in its own market. That may be reasonable under a few circumstances, but these firms exist and prosper because they created their own markets in the first place, and in doing so they compete with each other (and with further companies) because the larger one market is, the smaller the other ones may become: they all compete to grab a resource that is becoming increasingly scarce—the user’s time and attention.
From this perspective, they may still be described as monopolists, but their monopolies overlap significantly and each limits the others’ market power. That means that, while each may engage in anti-competitive behavior, they still contribute to enhance social welfare and they need not be regulated as strongly as Philippon advocates. At most, one may make a case for a more stringent regulation to protect personal data and the user’s privacy, although that does not necessarily mean that an optimal regulation should be as strict as Europe’s GDPR. In fact, the GDPR itself raises the cost of entry, with the paradoxical result that a regulation that Philippon himself praises may, a few years from now, turn into an obstacle to competition.
The Great Reversal is a thought-provoking, ingenious book. However, it may soon look like a relic from the past. As we already pointed out, the EU discipline on state aid is currently suspended for the sake of allowing rapid relief to businesses. Member states’ governments are flirting with the idea of nationalization: in Germany, the idea of nationalization has been promoted in the context of securing “safer” provision of healthcare products in countries such as Italy on a much wider scale. The EU Commission itself released a communication regarding the guidelines under which national governments are allowed to buy stakes in firms. In fact, Italy’s first anti-pandemic response included the nationalization of its long-faltering Alitalia airline.
While the US government is engaging extensively in economic interventionism too, it seems to be less determined in its resolve to increase its own scope. The American commitment to competition was tested in the aftermath of the 2007-2008 crisis. The US government bailed banks out, but was quick to exit the financial sector. By 2013, the US government had sold all of its holdings in AIG, for example. Because it had to bail out states, not banks, in the great crisis, the EU has had no similar test so far. Covid-19 provides one.