- October 7, 2017
- Posted by: Staff
- Category: Entrepreneurship
Across industries and across countries, a small number of “superstar” firms are pulling away from the competition. They’re more productive, as the chart below illustrates. They’re also more profitable, more innovative, and they pay better. But why are these companies doing so well? Are they out-competing their rivals, or are they using their size and influence to avoid competition altogether?
One answer to that first question shows up in study after study: superstar firms are succeeding in large part due to information technology.
In a new paper, James Bessen of Boston University provides evidence of that linkage, and of its importance. He finds that the rise in industry concentration – the share of revenue captured by the top firms in a sector – is largely explained by the adoption of IT. His measure of IT better explains the rise in industry concentration than do measures of M&A or entrepreneurship.
Bessen compared measures of industry concentration from the U.S. Census to the share of workers in an industry in IT-related roles. (He excluded tech industries from the analysis since his aim was to study how IT adoption was helping firms, rather than industries that produce IT-related products.) Industries with a higher share of IT workers saw more concentration between 2002 and 2007, even after controlling for M&A activity and several other variables. In separate analyses, he links IT adoption to higher output per worker and higher profit margins. (He also finds some evidence linking lobbying to higher profit margins, but it appears to be less significant than IT adoption.)
Bessen’s findings are consistent with a lot of other data. Erik Brynjolfsson and Andrew McAfee reported a link between IT adoption and industry concentration in HBR in 2008; since then, multiple analyses have linked increased use of digital technology to higher profitability at both the industry and company level. Researchers at the OECD have documented the rise of superstar firms and their relationship to wage inequality, and found that use of IT is one of the primary drivers. Other academic research has found the same.
But why is IT leading to winner-take-all competition? Bessen’s paper can’t answer that, however he raises two possibilities. It could be because “software development typically requires large upfront fixed costs,” meaning that firms that are already pretty large are the ones who can afford to invest in it. If it’s expensive to adopt and get good at IT, it’s more economical for big companies like Wal-Mart that can spread those costs out over lots and lots of products sold.
Or maybe the firms succeeding with IT know something their competitors don’t. Perhaps, as OECD economist Chiara Criscuolo wrote in 2015, “Some firms clearly ‘get it’ and others don’t.”
In their new book Capitalism Without Capital, Jonathan Haskel of Imperial College London and Stian Westlake of Nesta argue that these are two sides of the same coin. They document that physical investment (machines, factories, equipment) has declined relative to intangible investment (software, data, employee training, management). And they argue that the economic properties of intangibles lend themselves to the emergence of superstar firms. First, they argue, intangibles often involve considerable upfront investment, then are cheaper to scale. Second, intangibles complement each other. For instance, research has shown that IT is more effective when paired with good management. Getting the most out of, say, analytics software also requires well-designed processes and effective managers — the two are more valuable together than either would be on its own.
Their argument implies that superstars aren’t succeeding because of IT per se, but because they effectively combine it with other intangibles, like good management, well-known brands, or intellectual property. And, as with IT, each of those can require considerable upfront investment, meaning bigger players are better positioned to take advantage.
This hypothesis is bolstered by another recent paper. In it, John Van Reenen, Christina Patterson, and their coauthors find that industries with superstars aren’t distinguished by more investment in computers, but by more innovation as measured by patents. It’s not IT that creates superstars, but the combination of IT with other intangibles like R&D. Bessen also finds evidence linking intangible investment to higher profit margins. And it’s possible that his measure of IT employees isn’t a proxy for IT investment, but for the intangibles required to make IT profitable.
For an example of scalable intangibles in action, we can turn to McDonald’s. As Stanford’s Nicholas Bloom explains, McDonald’s created a system for running a restaurant, which required upfront effort but then could be scaled across stores. “Once a firm ‘invents’ good management it will then grow rapidly and dominate the market,” Bloom argues.
But like a meal at McDonald’s, this explanation comes with a grain of salt, at least for now. For one thing, as Raffaella Sadun of Harvard Business School told me, it’s not clear whether good management totally fits the McDonald’s model of upfront investment that quickly scales — good management also requires ongoing investment. Moreover, as Sadun, Bloom, and Van Reenen have documented, cost isn’t the only reason some firms fail to adopt good management practices. Many managers simply don’t realize that their firms are poorly run; something similar could be happening with IT. In other words, maybe firms with terrible IT don’t realize how far behind they really are.
And, finally, although IT is consistently linked to superstar firms, it’s a mistake to write off lobbying, M&A, antitrust, and a decline of entrepreneurship as possible explanations for industry concentration. The nature of competition is changing, in complicated and often contradictory ways. Technology is clearly part of it, as is the trend toward intangible investment. But just as McDonald’s didn’t get where it is solely through one scalable good idea, there’s unlikely to be any single, comprehensive explanation for why a handful of firms are increasingly outpacing all the rest.
Walter Frick is a senior editor at Harvard Business Review.