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America isn’t creating as many new companies as it used to. That, even though in many ways it’s easier than ever to start your own firm, thanks to cheap digital technologies. But it’s just not happening, as I have written frequently. Here is JPMorgan economist Michael Feroli in a morning note on the phenomenon and what might explain it:
Job gains at opening establishments amounted to only 1.06% of total employment, the lowest on record going back to the early ’90s. As we discussed in a note a few months ago (The consequences of economic calcification), the decline in start-up activity has been a disconcerting feature of this expansion. Given the maturity of the expansion, the proposition that this weakness owes to demand factors is looking less credible. This is especially the case since most measures of business profit margins look elevated, which should stimulate new business formation. In fact, traditional views of the margin cycle see start-up activity, as well as capital spending, as forces that ensure the mean-reverting nature of profit margins: both tend to rise when margins expand, slowly eroding the profits of incumbents.
The absence of these responses may help explain the surprising strength of corporate profits. What is not explained is why start-up activity hasn’t responded as would be expected. One hypothesis is that those elevated margins owe to natural monopoly profits, perhaps due to an increased prevalence of network effects. In this case, the incumbent profits are incontestable, and start-up activity shouldn’t be expected to increase.
Network effects are positive feedback loops. The more people who use a technology — eBay, Skype, Facebook, Bloomberg terminals, LinkedIn — the more valuable it becomes and the more unassailable its market position. As one venture capital firms puts it: “Network Effects are special because they 1) provide logarithmic growth and value creation potential, 2) erect barriers to entry to thwart would-be competitors, and 3) can create “Winner Take All” market opportunities. Network Effects are like a flywheel–the faster you spin it the more momentum you generate and enjoy.” It that the explanation, and is it the only explanation? Well, it might be one factor, though I think there are others.But it is an explanation that I had not previously considered. This analysis does have much in common, though, with the “creative monopolies” that Peter Thiel discusses in his new book:
In a static world, a monopolist is just a rent collector. If you corner the market for something, you can jack up the price; others will have no choice but to buy from you. … Creative monopolists give customers more choices by adding entirely new categories of abundance to the world. Creative monopolies aren’t just good for the rest of society; they’re powerful engines for making it better. …The dynamism of new monopolies itself explains why old monopolies don’t strangle innovation. With Apple’s iOS at the forefront, the rise of mobile computing has dramatically reduced Microsoft’s decades-long operating system dominance.
Before that, IBM’s hardware monopoly of the 1960s and ’70s was overtaken by Microsoft’s software monopoly. AT&T had a monopoly on telephone service for most of the 20th century, but now anyone can get a cheap cellphone plan from any number of providers. If the tendency of monopoly businesses was to hold back progress, they would be dangerous, and we’d be right to oppose them. But the history of progress is a history of better monopoly businesses replacing incumbents. Monopolies drive progress because the promise of years or even decades of monopoly profits provides a powerful incentive to innovate. Then monopolies can keep innovating because profits enable them to make the long-term plans and finance the ambitious research projects that firms locked in competition can’t dream of.
If network effects are making it tougher for startups to compete with incumbents, then all the more reason to look at how government policy is impeding entrepreneurial efforts.