Do Higher Concentration and Markups Reflect a Rise in Market Power or Higher Productivity?

Meghana Ayyagari
Vojislav Maksimovic
April 17, 2023


The Rise of Star Firms
Meghana Ayyagari et al.
November 17, 2022

There is a large academic and public policy debate on whether the observed macro trends on concentration and markups—in the US and worldwide—reflect a rise in market power or an increase in firm productivity. In the literature, the rise of star firms—those with significantly higher returns and markups—has been largely linked to an increase in the concentration of product markets over time and firms’ ability to exploit market power. However, we have little systematic evidence on the characteristics of star firms and whether they exploit their market power in traditional ways by cutting output and investment compared to other firms. Importantly, we also know little about whether the rise of star firms is associated with another dominant trend in the economy—the introduction of new technologies and a fundamental structural change towards a more intangible- intensive economy. While other papers have alluded to productivity differences between firms and sectors, in our recent research we try to understand the extent to which the high returns on capital of star firms are due to unmeasured differences in intangible invested capital, and how, once these are corrected, star firms differ in their output and investment strategies from other firms. If you want a one sentence summary of our results: Correcting for mismeasurement, our evidence points not to exploitation of market power but to the superior ability of star firms.

We first identify star firms as firms in the top 10 percent of pre-tax return on invested capital (ROIC) using a dataset of publicly listed firms from the Compustat database. Next, we outline a model of heterogeneous firms facing monopolistic competition to generate predictions on how star status (or more generally, ROIC) is related to firm markups and intangible capital. In doing so, we account for one of the key concerns with the measurement of intangible capital, that conventional return metrics do not capitalize research and development, brand capital, or other forms of organizational capital with far-reaching consequences for earnings and estimates of pricing power. Our model and empirical analysis yield four main findings.    

Measurement of intangible capital is key to understanding the profits and market power of star firms

When we use financial statement data as conventionally presented, star firms, especially in industries with high levels of intangible capital, are pulling away over time from other firms in the economy in terms of their return on capital. However, conventional financial statements do not capitalize R&D expenditures or organizational capital. Once we adjust firms’ returns to capital to address these shortcomings, there is little evidence that the most profitable 10 percent of firms are pulling away from the rest of the economy, and the differences in firm returns in industries with high levels of intangible capital and other industries shrink dramatically. Furthermore, once we adjust markups based on operating expenses for investment in intangible capital, we only find a modest increase in markups, especially in industries with high levels of intangible capital.

Star firms may have higher markups than other firms, but these happen early in their life cycle, are persistent, and predict subsequent star status

Consistent with the model predictions, we find that markups are positively related to high profits and greater probability of being a star. However, firms’ markups in the early years of the firm are persistent and predict subsequent star status in both high and low intangible intensity industries. Young firms are small and unlikely to have accumulated much market power by actions considered unreasonable and predatory by antitrust authorities. If early markups predict future star status, it is more likely that future star firms were founded to exploit products that are priced high because they are more highly valued by customers, have discovered new markets, or have unique managerial talent that is contributing to their high initial pricing power and their future star status.

Star firms do not generate high profits by following a strategy of low output and low investment

In contrast, we show that at every level of intangible capital intensity, star firms have higher output and investment (Capex, R&D, and SG&A) per unit of invested capital than non-star firms, consistent with our predictions. Hence, there is no evidence that star firms produce less than similar non-star firms. Consistent with this, we also find that star firms have more economically important patents than non-stars. Our findings suggest that star firms have higher innovation output than non-stars. Relatedly, we also find that higher total factor productivity is positively associated with star status.

Star firms are not differentially affected compared to other firms by exogenous shocks to their market power

If star status is acquired by restricting competition, then star firms would be more severely affected by competitive shocks than other firms. We measure increased competition in US manufacturing by the penetration of Chinese imports into the US, instrumented by Chinese imports into eight other developed economies. While the exogenous shock to competition (increase in Chinese imports to the US) affects return on invested capital, output, and markups of all firms negatively, we find no evidence that star firms are differentially affected by import competition compared to other firms in the economy, suggesting that monopoly power is not the key driver of star status.

Overall, we see little evidence that star firms are using their market power to reduce output to achieve super normal returns more than other comparable firms. The evidence is consistent with star firms being more productive than other firms and maximizing value by increasing output, investment, and R&D but at the margin following different long-term strategies, trading off some additional profits for a stronger long-term franchise through higher revenues.

However, there may be reason for concern regarding a smaller subset of elite publicly listed firms. The usual suspects for membership in such an elite group are Apple, Facebook, Google, Amazon, and Microsoft. When we examine these firms individually, the ROIC and markups of most of them do not seem extraordinary initially and then explode, but again only for a couple of firms that have built up a large enough market. Even for these firms, the critical policy concern may not only be the regulation of their use of market power today, but also the need to maintain contestable markets that allow the creation of independent technologies in the future.




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