ICYMI: For Competitive Industries, It’s The Software, Silly
Harvard Business Review editor Walter Frick and Boston University economist James Bessen’s new piece breaks down the conversation around competition and firm size by going beyond antitrust. Critics who tie the growth of leading tech services to monopolistic behavior are missing a key aspect of what makes some firms more competitive than others: Software.
Software has increased efficiencies for successful firms and is the result of significant investments.
The use of software to be more productive has led to a rise in large firms as well as concentration across most industries: “Most industries in the U.S. have grown more concentrated in the past 20 years, meaning that the biggest firms in the industry are capturing a greater share of the market than they used to. But why? Research by one of us (James) links this trend to software. Even outside of the tech sector, the employment of more software developers is associated with a greater increase in industry concentration, and this relationship appears to be causal. Similarly, researchers at the OECD have found that markups — a measure of companies’ profits and market power — have increased more in digitally-intensive industries. And academic research has found that rising industry concentration correlates with the patent-intensity of an industry, suggesting ‘that the industries becoming more concentrated are those with faster technological progress.’ For example, productivity has grown dramatically in the retail sector since 1990; inflation-adjusted sales per employee have grown by roughly 50%. Economic analysis finds that most of this productivity growth is accounted for by a few companies such as Walmart who used information technology to become much more productive.”
Firms have invested in developing code – an R&D decision that paid off. “Since 1998, the share of firm spending on software that goes to pre-packaged software (the vendor model) has been declining. Over 70% of the firms’ software budgets goes to code developed in-house or under custom contracts. And the amount they spend on proprietary software is huge — $250 billion in 2016, nearly as much as they invested in physical capital net of depreciation.”
Many different types of firms have powered their growth through software and the resulting competitive advantage and economies of scale – not network effects alone.
Successful use of logistics software is a competitive advantage; just look at Walmart: “Walmart is the country’s largest employer and largest company by revenue and it reached that position through an operating model made possible by proprietary logistics software. But Carr believed that by his writing in 2003 ‘the opportunities for gaining IT-based advantages are already dwindling’ and that ‘Best practices are now quickly built into software or otherwise replicated.’ It didn’t turn out that way. Although rivals have tried to build their own comparable logistics software and vendors have tried to commoditize it, Walmart’s software acumen remains part of its competitive advantage — fueled now by a rich trove of data. While Walmart faces new challenges competing online, it has maintained its logistics advantage against many competitors such as Sears.”
Vox Media uses its proprietary CMS to build its own advantage and surpass incumbents: “Vox is a digital publishing company known, in part, for its proprietary content management system. Vox does license its software to some other companies (so far, mostly non-competitors), but it is itself a publisher. Its primary business model is to create content and sell ads. It pairs proprietary publishing software with quality editorial to create competitive advantage. Venture capitalist Chris Dixon has called this approach the ‘full-stack startup.’ ‘The old approach startups took was to sell or license their new technology to incumbents,’ says Dixon. ‘The new, ‘full stack’ approach is to build a complete, end-to-end product or service that bypasses incumbents and other competitors.’ Vox is one example of the full-stack model.”
Intangible assets, like management and deep expertise, are more likely the reason for success of firms than network effects. “But the fact that the link between software and industry concentration is pervasive outside of the tech industry — where companies are less likely to be harnessing billions of users — suggests network effects are only part of the story. Part of the explanation for rising industry concentration, then, seems to hinge on the fact that software is more valuable for firms in combination with other industry-specific capabilities. These are often referred to as ‘intangible assets,’ but it’s worth getting more specific than that. Research suggests that the benefits of information technology depend in part on management. Well-managed firms get more from their IT investments, and big firms tend to be better managed. There are other ‘intangible’ assets that differentiate leading firms, and which can be difficult or costly to replicate.”
Incumbent firms are vulnerable to the same innovations that can make startups successful.
Incumbents tend to struggle when disruptive technologies fundamentally change the architecture of products. “Incumbent companies aren’t necessarily bad at using new technologies, Henderson argued, based on her study of the photolithography industry. In fact, incumbents were great at using new technologies to improve individual components of their products. But when a new technology fundamentally changed the architecture of that product — the way everything fit together — the incumbent struggled. Her point was that a company’s way of doing things is often deeply interconnected with the architecture of the products or services it creates. When the architecture changes, all the knowledge that was embedded in the organization becomes less useful, and the company’s way of doing things goes from advantage to disadvantage.”
Startups can find advantages in these same architectural innovations: “As Dixon, the VC, clearly recognized, these architectural innovations can create openings for startups. ‘Before [Lyft and Uber] were started, there were multiple startups that tried to build software that would make the taxi and limo industry more efficient,’ Dixon has noted. If Uber had merely created software for dispatching taxis, incumbents would have been well positioned to adopt it, according to Henderson’s theory. One ‘component’ of the service would have been changed by technology (dispatching) but not the entire architecture of the service. But ridesharing startups like Uber and Lyft didn’t didn’t just make taxis more efficient; they fundamentally changed the way the different pieces of the system fit together.”
Policymakers should focus on antitrust only in extreme cases; this is not solely an antitrust issue.
Policymakers should consider banning non-competes, reforming patents, or encouraging the use of open source software. “Antitrust may be able to help in extreme cases, including in reining in the tech platforms and their ability to buy up competitors. But policymakers should also consider ways to help software and software capabilities diffuse throughout the economy. To some degree, economies of scale will simply increase the average size of firms, and that’s ok. But banning non-competes would help employees spread their knowledge by moving jobs. Reforming patents, which aren’t always necessary to protect software innovation and are abused by patent trolls to the detriment of nearly everyone, would help, too. Anything governments can do to encourage the use of open source software could help as well.”
Government investment in technology clusters could encourage startup formation. “Encouraging startups is another promising avenue, as these firms are able to organize around software capabilities to take on incumbents. Doing so through public policy isn’t always easy, but government funding can help when done well, and at the state and city level policymakers can encourage the formation of technology clusters. These policies would pair well with more aggressive merger review, to ensure that promising startups are not all swallowed up by the incumbents they’re challenging.”