A copy of the full analysis can be downloaded by clicking on the link at the bottom of this blog entry.

In order to encourage big bets, Jeopardy is winner-take-all … Only the person in first place keeps their total at the end of the game. There’s a very powerful incentive to be aggressive... The most important thing isn’t the absolute number of dollars you have on the board. It’s how strongly you’re beating the other players.

– Julio Rodriguez, “Poker Player Crushing Jeopardy With Unorthodox Strategy”

Winner-Take-All markets – where small groups of companies or individuals receive an over-sized share of earnings – seem to characterize an increasing portion of markets in today’s economy.

There are actually two, distinct, simultaneously-occurring phenomena that have been enabling fewer individuals to extract larger portions of wealth from global markets. The first phenomenon is a shift in leverage that is enabling fewer individuals to extract more wealth from certain types of markets; that is, it’s an intra-market shift. The second phenomenon is an increase in the size of markets due to the erosion of barriers that had previously prevented regional markets from consolidating globally; that is, the second shift is an inter-market shift.

What are the factors driving these two sets of phenomena? Are the resulting WTA markets good or bad for society? If/when they’re bad, how can we mitigate against the effects? These are the issues that this analysis addresses. In Part 1 of the analysis, I describe the forces contributing to the creation of Winner-Take-All markets. In Part 2 of the analysis, I provide some examples of WTA markets, together with ways of mitigating negative effects in WTA markets. In Part 3 of the analysis, I discuss some strategic issues associated with WTA markets.

Sherwin Rosen was the first person to describe Winner-Take-All (WTA) markets. In his 1981 paper, “The Economics of Superstars,” Rosen focused mostly on entertainment markets (music, movies, athletics, etc.) and their characterization.

Robert H. Frank and Philip J. Cook revisited the topic in their 1995 book, The Winner-Take-All Society: Why the Few at the Top Get So Much More Than the Rest of Us. Since then, Frank has published numerous articles on the subject, mostly rehashing the findings in his 1995 book. Subsequently, in 2011, Frank came out with a new book, The Darwin Economy: Liberty, Competition and the Common Good, in which he extends his winner-take-all phenomenon to characterize the evolution of species in nature.

In this part of the analysis (Part 1), I provide an overview of Frank and Cook’s characterizations of WTA markets.

Distinguishing Characteristics of WTA Markets

According to Frank and Cook, there are two distinguishing features of WTA markets.

First, it is relative performance, not absolute performance, that determines rewards. And second, rewards are concentrated among a few individuals with the greatest relative performance.

Reward by relative performance is the single most important distinguishing characteristic of winner-take-all markets. In the markets that economists normally study, by contrast, reward depends only on absolute performance. For instance, a production worker’s pay – to the extent that it depends on performance at all – depends on the number of units he assembles each week, not on how his productivity compares with that of his coworkers.

A second feature of winner-take-all markets is that rewards tend to be concentrated in the hands of a few top performers, with small differences in talent or effort often giving rise to enormous differences in incomes. Both features – reward by relative performance and high concentration of rewards – show up in Sherwin Rosen’s description of the market for classical musicians:

The market for classical musicians has never been larger than it is now, yet the number of full-time soloists on any given instrument is on the order of only a few hundred (and much smaller for instruments other than voice, violin, and piano). Performers of the first rank comprise a limited handful of these small totals and have very large incomes. There are also known to be substantial differences between [their incomes and the incomes of] those in the second rank, even though most consumers would have difficulty detecting more than a minor differences in a “blind” hearing.

Forces Contributing to Value Extraction Effects

As I mentioned in the introduction, there are two distinct transitions that have been occurring that have increased the incidence of Winner-Take-All markets in the global economy. The first transition involves a shift in leverage, where fewer market participants have been able to extract a larger portion of the value created in the market. This value extraction effect is illustrated in Figure 1.

Figure 1

Which factors transform a market from one in which total revenues are reasonably distributed across players, to one in which a few players are able to extract an over-sized share of revenues? In other words, which factors cause WTA markets associated with value extraction effects to form?

Frank and Cook provide several supply- and demand-side forces that contribute to the formation of WTA markets. I provide a very brief description of the most common forces.

Production Cloning

On the supply side, the ultimate source of a mass winner-take-all market is that the services of the best performers can be reproduced, or "cloned," at low additional cost…

More generally, whenever there are economies of scale in production or distribution, there is a natural tendency for one product, supplier, or service to dominate the market.

Network Economies

On the demand side of many markets, a product becomes more valuable as greater numbers of consumers use it…

Network economies are especially relevant in the choice between alternative modes of communication.

Positive-Feedback Effects

Lock-in is a supply-side phenomenon that occurs at the early stages of supply of a new product or service. Early advantages of one technology over another attract more resources to the advantaged technology, which give it further advantages, leading to yet more advantages, and so on.

Other positive feedback effects, known as success breeds success, refer to the self-reinforcing process in which individuals who succeed are given better opportunities than their less successful peers. Having access to better opportunities, in turn, increases the possibility of even greater subsequent success.

Cognitive Limits

Some winner-take-all markets arise because of cognitive limitations on the part of buyers. In many product markets, we are either unable to, or we simply choose not to, keep track of a host of similar competing products.

If we’re going to track only a small number of items in a category, the obvious choice is to track the best or otherwise most popular items.

Purely Positional Concerns

By its very nature, the demand for top rank can be satisfied by only a limited number of products in any given category. And this, together with the fact that people are often willing to pay substantial premiums for top-ranked products, often gives rise to intense winner-take-all competitions between the aspiring suppliers of those products.

Shifts in US Public Policy

In “Winner-Take-All Politics: Public Policy, Political Organization, and the Precipitous Rise of Top Incomes in the United States,” Jacob S. Hacker and Paul Pierson mention several additional factors that have contributed to the recent rises in rewards earned by top performers.

… [M]ajor organizational shifts in the 1970s tilted the balance of political power ...sharply in favor of those at the very top of the economic ladder, paving the way for America’s winner-take-all inequality. … [W]e bring these analytic elements together to show that winner-take-all inequality is substantially rooted in fundamental shifts in four core areas of U.S. public policy—related to financial markets, corporate governance, industrial relations, and taxation—that have been powerfully driven by this political-organizational transformation.

Taxes

Hacker and Pierson argue that changes in tax policies have favored the wealthy and enabled them to retain a larger portion of their earnings.

Studies of specific battles over the estate tax and the alternative minimum tax have suggested that policy makers repeatedly chose courses of action that strongly advantaged the very wealthy at the expense of the much larger group of the merely well-to-do. In all these accounts, the influence of organized interests—particularly lobbyists representing business and the wealthy, conservative antitax groups such as Americans for Tax Reform, and free-market think tanks like the Cato Institute—loom much larger than the sway of voters or pull of general public sentiment.

Industrial Relations

Hacker and Pierson also claim that the waning strength of labor unions have given management relatively more leverage to retain company profits for themselves, rather than having to pay them out in earnings to workers.

In short, the severe decline of organized labor in the United States was in part a political outcome, driven by new antiunion enactments as well the failure to update policy to reflect the increasing relative strength of employers in a more global, service-oriented economy. There were policy alternatives that would have reduced the decline, and that had advocates within the United States. The opponents of such reforms, possessing formidable and growing organizational resources, mobilized effectively to stop them. They then used their organizational resources to exploit the resulting drift and launch a vigorous assault on American labor, with effects felt not just in the economic sphere but also in American politics.

Corporate Governance and Executive Compensation

Hacker and Pierson further argue that shifts in corporate governance have enabled top executives to extract company resources for themselves, rather than directing them to company shareholders.

The rise in executive pay seems related to a broader shift in structures of corporate governance, ostensibly toward maximization of “shareholder value” but arguably toward what Peter Gourevitch and James Shinn call “managerism,” in which opportunities for well-positioned elites to extract resources increase. The hypothesis to consider is that the capacity of managers to engage in such extraction has increased. The issue, as the financier John Bogle has recently put it, is whether the United States moved toward an “ownership society” in which managers serve owners or an “agency society” in which managers serve themselves.

Financial Deregulation

Hacker and Pierson finally claim that deregulation of the financial sector has enabled financialization of the system, which enables sector workers to extract large amounts of financial rewards for themselves.

The rise of finance is virtually synonymous with the rise of winner-take-all, since in no major sector of the economy are gains so highly (and increasingly) concentrated at the top. In part, this is just a chapter of the broader rise of executive pay. But the other part is the runaway rewards that have flowed into the pockets of the rich out of America’s widening range of exotic new financial institutions—from boutique hedge funds to massive financial conglomerates crossing once-inviolable regulatory boundaries. These rewards have involved the development of complex new financial products that, for most Americans, offered limited benefits—and sometimes real economic risks—but which held out the prospect of big returns from every financial transaction and spectacular incomes for those within the industry.

Forces Contributing to Market Consolidation Effects

The second transition that has increased the incidence of Winner-Take-All markets in the global economy involves a shift in market size, where regional markets have been consolidating into global markets. Regional market leaders have become global market leaders, thereby being able to extract more value than before. This market consolidation effect is illustrated in Figure 2.

Figure 2

What causes markets in which total revenues are moderately sized to grow into much larger markets? In other words, which factors lead to market consolidation effects?

Frank and Cook provide a list of barriers that used to exist that ended up limiting the size of markets. However, “rapid erosion of the barriers that once prevented the top performers from serving broader markets” have led to much larger market sizes, by consolidating what used to be multiple smaller, regional winners into fewer, larger, global winners. These barriers are described briefly below.

Transportation Costs

The costs of transporting good and services to global markets have decreased dramatically over the past several decades.

Computing and Telecommunications Costs

Perhaps the most profound changes in the underlying forces that give rise to winner-take-all effects have stemmed from technological developments in two areas—telecommunications and electronic computing.

Lower communications costs enable buyers and sellers to find each other more easily across larger geographic regions.

The Growing Role of English

Not even the most advanced electronic technologies can facilitate communication if people do not share a common language. The very existence of cheap means of communication appears to have accelerated the emergence of English as the de facto international language, and, with it, the further expansion and intensification of winner-take-all markets.

Erosion of Inter-Industry Boundaries

Under these [informal] norms it was once almost universal practice to promote business executives from within, which frequently enabled companies to retain top executives for less than one-tenth of today's salaries.

…But since then [the 1980s] interfirm and interindustry boundaries have become increasingly permeable, and business executives are today little different from the free agents of professional sports. Firms that fail to pay outstanding executives their due now stand to lose them to aggressive rivals.

The Rise of Independent Contracting

Decreases in communication costs have contributed towards a shift in which “traditional employment contracts [are being] increasingly replaced by independent-contractor relationships.” Whereas the pay of company workers tends to be determined as much by bureaucratic factors as by merit, the pay to independent contractors is much more closely tied to “the economic value of what he or she produces.”

The move to independent-contractor status eliminates this subsidy, and enables the most productive individuals to come much closer to capturing their full market value.

The Amplifying Effect of Benchmarking

As highly productive individuals (executives) started retaining more of their value through higher salaries, those higher salaries have served as benchmarks for other highly productive individuals in other companies to justify demanding their own higher salaries. This type of benchmarking has had as a self-reinforcing and amplifying impact on raising the salaries of all highly productive individuals across companies and across industries.

Go to Part 2