Could Tech Giants Be Making Our Economy Less Innovative?

With a business model built on fewer employees, their dominance saps dynamism.

The proliferation of new technology applications and a buoyant stock market dominated by names that didn’t exist a decade or two ago give the impression of an exceedingly dynamic business environment in the U.S. But that doesn’t square with the actual statistics on business dynamism (the ongoing cycle of new businesses being created and growing while established businesses are shrinking and failing). Those readings have been on the decline since the mid-1980s, and the lack of activity has grown more pronounced since the mid-2000s.

Meanwhile, a seemingly separate trend in the economy is that younger firms are hiring fewer employees than older firms running similar businesses. Instead the newer entrants are investing in technology. And it’s paying off for them as their market values are rising at a faster pace than the market values of older firms did at the same point in their development. Additionally, these new firms contribute an aggregate market valuation comparable to that of the older firms at the same point in their development. This stable valuation persists despite the lower employment the newer firms generate.

A working paper by London Business School’s Simcha Barkai and UCLA Anderson’s Stavros Panageas suggests that these two trends, in fact, have a lot to do with one another. Their findings may provide more data for the growing debate around regulating big tech. In the researchers’ model, the arrival of young firms with new technologies and stickier demand for their products than older firms experienced account for a host of factors related to the decline in business dynamism.

These tech-savvy younger firms find it easier to defend their profits without making large adjustments to either their capital or workforce. In comparison, companies in prior eras wanting to protect their profits required decades to erect moats around their businesses — using low costs and high market shares to discourage new competition. The Googles and Apples and Facebooks and Amazons of today achieve that status with remarkable speed.

Using Compustat and PitchBook data from 1985-2014, cohorts of firms founded within the same five-year period were created. The cohorts come from the years 1985-1989, 1990-1994, 1995-1999, 2000-2004, 2005-2009, and 2010-2014 as can be seen in the graph below. The researchers gathered data on the firms’ exit values — their market value at IPO or their acquisition price when acquired by another firm. This data, which was adjusted for stock market gains over time, illustrates that the younger cohorts are rising more rapidly in value over each previous cohort at the same point in time — with one exception, the 1995-1999 cohort that came of age during the internet bubble.

Barkai and Panageas model the long-term impact to the economy as these new firms arise. Their model suggests that wages decline, employment falls and fewer new jobs are created. A key result of the model is that it indicates rising profits for the new firms.  As for output, the paper suggests that the impact on long-term economic output depends on whether or not it’s just a few industries where young firms are able to dominate that is driving the decline in business dynamism or if this business shift occurs across all industries. Only the latter case is likely to translate into a large decline in economic output over time.

The University of Cambridge’s Maarten De Ridder reaches some similar and symbiotic findings in a 2019 paper that explores the impact of the rise of technology — and other intangibles like patents — on production and competition. De Ridder’s paper describes a scenario in which the successful newer companies’ investment in technology and employment of fewer workers drives competitors out of business.

While the newer firms may end up with higher fixed costs than their competitors due to sizable technology investments, they have lower variable costs due to their need for fewer employees. Lower variable costs lead to lower costs than their competitors for each new product or service they produce. This is a competitive advantage that the newer firms can use to lower their prices and put pressure on their existing competitors and potentially drive them out of business. The low prices then discourage new competitors from entering the market and this reduces future innovation.

Barkai and Panageas’ research comes as the U.S. Department of Justice in October filed an antitrust lawsuit against Google over the way it protects its huge market share in the search and advertising businesses. Their paper suggests we will see more firms like Amazon, Facebook and Google dominating industries in the future. And their model suggests that as more dominant young firms such as Amazon, Facebook and Google continue to develop, business dynamism will continue to decline.