There are two reasons for expecting that the market structure in tech sectors will differ from the model of perfect competition with plentiful companies competing on price, quality and increasingly innovation.

First is the economics of information. Once some research has been completed, the costs of replication are very low. So we get what I have sometimes called ‘super-economies of scale’. In The Flat White Economy I refer to one of the versions of Windows that cost $550 million to develop. It sold 10 million licences in the first two years of operation at around $60-90 a piece, yielding a decent profit of around $100 million. Had the sales been only half what was expected, the profit would have turned into a $150 million loss. Scale is absolutely critical in this sector.

Second is network effects. The value of the product increases with the number of other users. Metcalfe’s Law is that the value of a network is proportional to the square of the numbers of connections. Obviously there can be saturation when this ceases to apply.

Both these factors encourage market concentration. Tech markets themselves are hard to define and measure and so there is little reliable research available on the extent of concentration in the sector. But studies do point to rising concentration in the industry as a whole: ’Information Technology and Industry Concentration’ by James Bessen of Boston University School of Law suggests that differences in IT expenditure are driving productivity differentials in a wide range of industries leading to increased market share by top 4 firms of 4-15 percentage points. David Autor et al[1] point to the rise of the ‘superstar firms’ boosting market concentration in the US while similar conclusions, demonstrated by data showing a rising Herfindahl-Hirschman Index, have also been reached for Europe.[2]

Meanwhile, casual observation suggests dominant positions for Intel, Microsoft, Apple, Google, Amazon and Uber and to a lesser extent for Huawei, Ali Baba, Ten Cent and Samsung.

Does this matter? Traditionally it has been argued that tech does its own regulation, with new products and business models disrupting the old. Yet the market valuations suggest the markets do not expect this to happen. Within just five years, the NASDAQ Tech Index has risen from 2,124 at the beginning of January 2016 to 7,427 at the equivalent point this year. The price-to-earnings ratio (P/E) is 25, the highest since 1999, just before the tech bust of 2000. For these valuations to be justified, the respective companies will have to hold on to their dominant positions for many years.

Meanwhile, there are increasing concerns about monopsonistic purchasing by the biggest players. For example, when Uber started to operate in the UK they charged their drivers 15-17%, now this is 20-25%. Furthermore, we observe uneasiness about competition reducing consumer choice, the complex role that platforms such as Twitter, YouTube and Facebook play in propagating misinformation as well as censoring free speech and a whole host of anti-competitive practices. However, the normal charge that dominant companies underinvest in innovation seems so far not to be the case. The top tech companies invest up to 15% of revenues in R&D.

Paradoxically, for companies that are so hard nosed in their capitalism, the tech companies are closely aligned with the political left, especially in the US. Alphabet (Google parent company), Microsoft, Amazon, Facebook and Apple were Joe Biden’s top five corporate financial supporters through their PACs and employees. It seems unlikely that there will be direct action taken against these companies in the very short term. But in the longer term, a new Teddy Roosevelt may arise to bust the tech trusts. And long term they will either face competition from tech developments or from government sponsored anti-trust activity.

So we would caution against assuming that tech valuations at their current level can be justified.

[1] Autor, D, D Dorn, L Katz, F Patterson and J Van Reenen (2020), “The fall of the labor share and the rise of superstar firms”, The Quarterly Journal of Economics 135(2): 645-709.

[2] Bighelli, T, F di Mauro, M Melitz and M Mertens (2020), “European Market Concentration and Productivity”, paper presented at the ECB/CompNet Online Event

For more information, please contact:

Douglas McWilliams dmcwilliams@cebr.com phone: 07710 083652​