16 October 2006

The Iron Law of Oligopoly In Action

Markets naturally tend to form oligopolies (i.e. markets dominanted by a small number of firms), a tendency called the Iron Law of Oligopoly (aka Oligarchy).

The more common manifestation of this tendency is for a market with too many competitors to consolidate and shake out. For example, in the early days of the automobile industry, we saw dozens of independent automakers consolidate into the Big 3 which was stable for decades until in the 1960s and 1970s foreign automakers entered the U.S. market and upset the apple cart. The current rash of discussions about automobile company mergers can be seen as a natural consequence of the iron law of oligopoly in an era where the market for automobiles is now global, instead of national.

But, it works the other way too. When a market gets too consolidated, there is a natural tendency for competition to emerge. We see this most recently in the public accounting market. For years there were eight big accounting firms. Their numbers have now dwindled to the "Big Four" through a series of mishaps (Arthur Anderson was brought down by Enron), and mergers. But, now, a fifth big accounting firm is emerging as twenty-two regional accounting firms merge to form Baker Tilly USA, which strictly speaking is a "network" rather than a firm, but is positioning itself to serve as competition to the Big Four, and three more networks are on the way, returning us to a "Big Eight" era.

Three other networks of accounting firms are preparing to introduce their alternatives. Moores Rowland North America, the Leading Edge Alliance and Moore Stephens North America . . . . Those groups, with Baker Tilly, represent about two-thirds of the nation's top 100 accounting firms . . . Baker Tilly's total workforce of about 8,000 is far smaller than the staffs of the largest firms. Ernst & Young, for example, has 26,000 U.S. employees, and PriceWaterhouseCoopers has about 30,000. They each have around 140 affiliate offices around the world; Baker Tilly has 93.

Little Middle Ground

The latest round of network formation in the accounting industry may also reflect the bipolar distribution of firm size in the United States. Few medium sized businesses means little incentive to establish medium sized accounting firms.

U.S. law provides for a largely unregulated small business sector where business formation is subject to minimal securities regulation, businesses rarely have audited books, debt is primarily in the form of lending from commercial banks, there is no tax premium (as entities are operated as S corporations or LLCs or as C corporations that pay almost all profits as bonuses to ownrs), and is primarily composed of firms with ten or fewer families of owners, most of whom usually work in the business or are relatives of someone who does, occassionally with one or two "silent partners" who provide capital but don't manage the firm on a day to day basis.

U.S. law also provides for a highly regulated big business sector in which firms with hundreds or thousands of owners operate under the watchful eye of the SEC, stock markets, the financial press, bond rating agencies, institutional investors and large public accounting firms. Most pay a tax premium for doing so, in the form of the C corporation tax on profits.

There is a middle ground, but it is thinly populated. Going public carries with it largely indivisible compliance costs and tax costs, which are uncomfortably high for medium sized firms. Securities law exemptions permit medium sized groups of wealthy or high income sophisticated investors to invest in private companies, arrangements usually set up by venture capital firms with an eye towards making the medium sized business stage temporary. Alternately, businesses on the cusp of becoming medium sized that could have secured several dozen investors to finance the step, instead often seek to sell out to a larger company that will finance their expansion. Borders Books and Chipotle, for example, ultimately went this route to secure the financing needed to expand, and then, were ultimately spun off from the businesses (K-Mart and McDonalds respectively) that incumbated them.

The Narrow Range Of Participants In Which In Person Democracy Works

State corporation laws are actually largely tailored to medium sized businesses with dozens of shareholders, in which key decisions are actually made at an in person shareholder's meeting at which the vast majority of significant shareholders are present. But, very few corporations follow this model in practice. Generally, small corporations largely make decisions informally, while in public corporations, federal securities regulation is the dominant consideration in corporate managment regulation and businesses avoid the democratic process of shareholder control suggested by state corporation laws by offering shareholders a Soviet style ballot.

Real democratic management of organizations at in person meetings is largely restricted to medium sized non-profit organizations, like churches, political parties and unions, and in New England towns, where the practice is growing less popular with time, particularly in urbanized areas. Small groups tend to operate largely by consensus and fall apart if they don't, unless required by law to exist, while groups of a thousand or more are usually impractical to run on a face to face basis, except for rare, highly scripted and often mostly symbolic group meetings.

Even the United States House of Representatives and the United Kingdom's House of Commons, two of the largest public assemblies operating on a face to face basis, operate only by dint of strong committee and party structures, and rigid control of the organization's agenda by a small group (the Rules Committee in the House of Repesentatives and leadership in the House of Commons). In both bodies, floor debate plays only a small part in the decision making process, with noses usually counted before votes are taken on the floor and persuasion largely taking place in back offices.

The development of direct democracy in Greece (and in Iceland, another place with a long democratic history) probably owes a great deal to the accident that its number of citizens was neither too small, nor too large, to maintain a functioning face to face democratic forum.

1 comment:

Andrew Oh-Willeke said...

The original work by Michaels called it the "iron law of oligarchy" rather than "oligopoly" which is the modern term for what he meant.