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Competitive Edge: Structural presumption in U.S. merger control policy would strengthen modern antitrust enforcement

Posted on December 19, 2018December 19, 2018 by Maria Monroe

Antitrust and competition issues are receiving renewed interest, and for good reason. So far, the discussion has occurred at a high level of generality. To address important specific antitrust enforcement and competition issues, the Washington Center for Equitable Growth has launched this blog, which we call “Competitive Edge.” This series features leading experts in antitrust enforcement on a broad range of topics: potential areas for antitrust enforcement, concerns about existing doctrine, practical realities enforcers face, proposals for reform, and broader policies to promote competition. John Kwoka has authored this month’s contribution.

The octopus image, above, updates an iconic editorial cartoon first published in 1904 in the magazine Puck to portray the Standard Oil monopoly. Please note the harpoon. Our goal for Competitive Edge is to promote the development of sharp and effective tools to increase competition in the United States economy.

In remarkably short order, the discussion about competition in the U.S. economy seems to have arrived at the substantial consensus that a problem exists. True, there are some economists and policymakers who still want more evidence, and others for whom no amount of evidence is likely to suffice. But the reality that stares consumers in the face every day is diminishing choice in airlines, brewing, cable TV, dog food, eyeglasses, financial services, grocery stores, hospitals, and, yes, “the entire alphabet of U.S. industries.” This impression is corroborated by economywide data documenting the rising levels of market concentration, the reduced rates of entry of firms into the economy and the overall decline in the number of firms, and the above-normal rates of profit, especially for leading companies. And these forces, in turn, have been associated not only with higher prices and reduced choice of goods and services, but also with longer-term adverse effects on innovation and productivity, worker wages and income equality, and other social objectives.

The time has come to move on to the question of how to fix this problem of diminished competition. My own analysis, in “Reviving Merger Control: A Comprehensive Plan for Reforming Policy and Practice,” has identified several distinct weaknesses of merger control and proposes 10 changes in policy and practice that would help remedy it. Among these, one stands out as uniquely important because it would simultaneously make merger control more effective and more efficient. It would make it more effective by preventing a higher fraction of anticompetitive mergers and more efficient by relieving the antitrust agencies of some of their current burden of proof.

What is this seemingly magical policy potion? It is nothing more than restoring the 50-year-old legal doctrine known as the structural presumption. The structural presumption says simply that large mergers in highly concentrated markets are so likely to be anticompetitive that they can be presumed anticompetive unless proven otherwise. This proposition effectively shifts the burden to companies proposing to merge, so that they have to demonstrate why their merger is the rare exception to the general rule and will not harm competition. This contrasts with the current process, where the antitrust agency bears the full burden of predicting exactly how each merger—no matter how obviously problematic—will harm competition in order to act against it.

Reviving the old tool of structural presumption to strengthen modern merger control

The structural presumption doctrine was advanced by the U.S. Supreme Court in its 1963 decision in United States v. Philadelphia National Bank. In that ruling, the court noted that merger analysis is a difficult exercise in prediction and urged “simplify[ing] the test of illegality” in certain cases by “dispensing … with elaborate proof.” Specifically, the court stated that “a merger which produces a firm controlling an undue percentage share of the relevant market, and results in a significant increase in the concentration of firms … is so inherently likely to lessen competition substantially that it must be enjoined in the absence of evidence clearly showing that the merger is not likely to have such anticompetitive effect.” This doctrine reflected economic research at the time that showed a statistical relationship between high market concentration and prices or profit margins. It was intended to ease the process of merger control in those cases where competitive harm was fully predictable, without requiring the same detailed analysis as otherwise might be necessary.

A clearer statement of policy could hardly be imagined. What remained was to set out the applicable thresholds of share and concentration, and to identify the possible factors that might offset the presumption. These should, in principle, be found in the Horizontal Merger Guidelines issued jointly by the the Antitrust Division of the U.S. Department of Justice and the Federal Trade Commission. Reality differs. The share and concentration thresholds for mergers in those guidelines do not constitute a true presumption but rather, simply varying degrees of scrutiny. In addition, the relevant thresholds have twice been relaxed, exempting ever more mergers from the highest level of scrutiny—and, in any event, mergers exceeding the stated thresholds are often approved.

This last point—the deviation of practice from policy—is clear from Federal Trade Commission data on the number of merger investigations and the number of challenges made by that agency from 1996 through 2011. These data show that for mergers in markets with more than four remaining significant competitors—which, the FTC suggested, might be one with at least a 10 percent share—the FTC has challenged an ever-smaller fraction over time. The agency challenged more than one-third of mergers with five to eight such firms in the period 1996 to 2003, but only one-sixth in 2004 to 2007, and then literally none—zero—starting in 2008.

While the agency continued to challenge mergers in the very highest category of concentration, all mergers—every single one in this medium-to-high-concentration group—were nonetheless approved. This evidence leaves little doubt that weakened antitrust policy has contributed directly to rising concentration.

Of course, some commentators would argue that this narrowing of enforcement has been desirable because it has avoided making the mistake of challenging beneficial mergers. But as noted, economic research has long documented the effect of high market concentration on prices. In addition, there is now even more compelling evidence that mergers in these high-to-moderately-high concentration markets are, in fact, generally anticompetitive. This evidence comes from so-called merger retrospectives—careful economic studies of the actual price outcomes of specific mergers. I have matched the price outcomes of about 40 of these studied mergers to their market concentration. While this is only a small fraction of all such mergers, the evidence tells two strikingly different stories.

First, it shows that of these mergers with four or fewer remaining firms, prices did, in fact, rise in all cases. This provides support for the FTC’s strong—but not quite perfect—enforcement record against mergers in the highest concentration range. But the data also show that all mergers with five remaining competitors proved to be anticompetitive. The same is true for 80 percent of those with six remaining competitors and even for 50 percent of those with seven remaining competitors. Mergers, in short, prove to be anticompetitive in a significantly wider array of cases than the narrower set most recently targeted by the FTC.

The key and crucial discrepancy between enforcement and effects arises for mergers in high-to-moderately-high concentration markets, where there remain five, six, or even seven significant competitors. Here, enforcement has ceased despite clear evidence of competitive harm. To be sure, the failure of enforcement in this range is due to several factors, not all of which are within the control of the agency. The annual budgets of the two antitrust agencies are demonstrably inadequate for their mission. The judiciary is demanding ever greater proof of predicted anticompetitive outcomes. Ideological forces outside the agency have fostered an anti-antitrust view. Regardless of all the causes, however, antitrust policy has narrowed its mission and left a range of demonstrably anticompetitive mergers free to proceed.

A solution hiding in plain sight

Fortunately, a key initiative that would help to solve this problem is hiding in plain sight, suggested by the same data just used to identify the failure of merger enforcement. It is nothing more than the approach urged by the U.S. Supreme Court more than a half-century ago. After all, if all or nearly all mergers with fewer than some number of remaining significant competitors are known to be anticompetitive, that bright line standard—the structural presumption—could be used to prohibit them, absent some compelling reason, precisely as the Supreme Court urged. The evidence just reviewed makes clear that this would not result in excessive enforcement but rather would correct recent underenforcement.

Since the structural presumption originated with the court, it breaks no new legal ground. Nonetheless, new legislation to codify the presumption would strengthen the hands of the Antitrust Division of the Justice Department and the FTC in their use of the doctrine. In addition, more economic research into the best measures and thresholds of concentration would be important. And there are some practical hurdles to overcome. Specific “antitrust markets” would need to be defined. Characteristics of a “significant competitor” might need to be further specified. Potentially offsetting factors would need to be identified—and sharply circumscribed. And the courts would have to learn, or relearn, this doctrine.

A further advantage of structural presumption is that it would restore vitality to merger analysis concerning coordination among firms. Agencies have struggled with such cases due to the difficulty of proving that a particular merger crosses some line of predictable anticompetitive effects. But the very essence of the structural presumption is that beyond some small number of firms, coordination is, in fact, fully predictable, and therefore antitrust action is fully justified. This presumption would provide the crucial necessary tool for the agencies to bring and prevail in such cases.

So, based on the best current evidence, it would seem that an appropriately designed structural approach that shifts the burden for mergers with as many as five or six remaining competitors would be both effective and efficient. Such a policy would be effective since it would appear to make few errors, and whatever errors it might make would likely be offset by correcting the errors of inadequate current policy. It would be efficient since it would spare the antitrust agencies the burden they currently face of developing detailed, case-specific analyses of the mechanism for coordination and the dollar value of harms, buttressed by evidence from documents, data, and economic models. While all those might be necessary and feasible in some cases, recent antitrust cases show how the complexity of this process can result in bad court decisions. Moreover, avoidance of this burden would free up the agencies’ resources and allow them to bring more cases where enforcement has languished.

Merger analysis in recent times has benefitted from cutting-edge advances in economic models and methods, such things as unilateral effects and upward pricing pressure, diversion ratios and critical loss assessment, and others. But for the next—and necessary—step toward strengthening merger control, antitrust should look backward, back to the method provided by the U.S. Supreme Court for proceeding against mergers where case-specific evidence is difficult to assemble but the anticompetitive effects are nonetheless clear. Modern merger control can significantly improve enforcement by reviving the use of the structural presumption.

—John Kwoka is the Neal F. Finnegan Distinguished Professor of Economics at Northeastern University.

Who profits from patents within firms and among firms? Hint: Not women and not most employees

Posted on December 18, 2018December 17, 2018 by Maria Monroe

Traditional labor market models are premised on the theory that firms are wage-takers, meaning they pay workers the “going rate” determined by the market forces of supply and demand for labor. Yet a growing body of research presents evidence that firms themselves actually set wages and contribute to wage inequality among workers with identical skills. An array of new studies examining the relationship between between changes in a firms’ productivity and the wages earned by incumbent workers find that factors such as changes in product-market demand or labor market institutions can result in fluctuations in wages. These economic conditions can easily influence wages without indicating that firms are practicing any price-taking behavior.

Now comes a new working paper by four economists—Heidi Williams at the Massachusetts Institute of Technology, Neviana Petkova at the U.S. Department of the Treasury, Patrick Kline at the University of California, Berkeley, and Owen Zidar at Princeton University—that examines the connection between lucrative patent approvals and worker compensation. “Who Profit from Patents?” uses administrative panel data collected by the U.S. Patent and Trademark Office and business tax filings and worker earnings data to present a series of metrics that quantify firm performance as a result of having a patent approved or denied, while controlling for factors such as labor productivity.

The four Equitable Growth grantees find that the approval of a high-valued patent within the top quintile of value led firms with these patents to expand employment by approximately 22 percent, whereas lower-valued patents had no significant influence over a firms’ survival or expansion. The approval of these high-value patents correlates with an average $37,000 increase in revenue per worker. The co-authors also find that the pretax earnings of executive-level firm owners increased by $9,000, whereas earnings for employees rose by $3,600.

Breaking down changes to earnings between workers within a firm after a patent is granted shows that the gap between inventors at the firm and noninventors increased by an average of 18 percent after the initial granting of valuable patents. When accounting for the earnings of officers—or employees with executive-level authority—and nonofficers, the authors find that the earnings of officers increased by $3,700, whereas nonofficers saw no significant changes in response to a patent. Overall, there was no effect of the initial patent on the earnings of the bottom three quartiles of employees, whereas workers in the top quartile saw average earnings grow by roughly $8,000.

One of the takeaways from this analysis is that firms do share their “rents”—economic parlance for profits in excess of the cost of production—with workers, which indicates that workers’ earnings are attached to the outcomes of their firms, rather than being set by the labor market. Thus, firms that are awarded higher-valued patents lead to the rise of superstar firms with higher wage distributions than other firms, which, in turn, increases earnings inequality among workers with similar skills. The distribution of these economic rents also indicates that this so-called within-firm inequality grows as firms are awarded higher-valued patents and as executives earn a larger proportion of these rents, compared to the lower-skilled workers in the same firm.

A surprising result of the granting of patents was that the earnings gap widened between male and female employees following approval of the patents. The four authors find that high-value patents resulted in an approximately 10 percent increase in male earnings, whereas female earnings were unresponsive to the granting of the patents. For firms that employed both men and women, the earnings gap increased by 30 percent as a result. The takeaway from this study is that the distribution of economic rents from patents leads to increased gender wage inequality within firms, as well as between similarly skilled workers in different firms, and also that women see very minimal positive changes in their earnings as a result of the allowance of patents even when controlling for officer status and inventor status.

The authors conjecture that one reason for firms to distribute the economic rents earned from patents with their workers is because it is economically efficient to share the rent with workers rather than bear the cost of training new workers—even if the distribution is unequal. This could be because firms understand that incumbent workers are more valuable than new hires, and so incumbent workers—especially those who are highly skilled—get the largest proportion of the economic rents distributed. As such, workers who were employed at a firm during the year of the patent application saw a 61 cent increase in earnings for every dollar increase in surplus. These differences in the replacement costs of differently skilled workers further contributes to income inequality both within and across firms.

Weekend Reading “The Robots are Taking Over” Edition

Posted on December 14, 2018 by Maria Monroe

This is a weekly post we publish on Fridays with links to articles that touch on economic inequality and growth. The first section is a round-up of what Equitable Growth published this week and the second is the work we’re highlighting from elsewhere. We won’t be the first to share these articles, but we hope by taking a look back at the whole week, we can put them in context.

Equitable Growth round-up

Equitable Growth Grantee Brian Callaci recently released research that compiles the history of franchising laws and finds that franchise contracts contribute to the decline in bargaining power of both franchisees and workers. Through vertical restraints, franchisors are able to set the working conditions and business models of their franchisee’s establishments, thus creating a fissured workplace where workers are unable to climb a career ladder or seek protections within the workplace. Callaci summarized his two working papers here.

Equitable Growth’s Executive Director Heather Boushey sat down with Harvard University economist and former U.S. Treasury and Federal Reserve Board official Karen Dynan to talk about the role of consumption patterns in economic inequality. They discussed Milton Friedman’s Permanent Income Hypothesis and how it provides a basepoint for models surrounding consumption behavior. Dynan, an Equitable Growth Steering Committee member, highlighted research and data that shows that low-income households have a higher propensity to consume, therefore a low propensity to save, which leaves them vulnerable in economic crises.

Brad DeLong compiles his most recent worthy reads on equitable growth both from Equitable Growth and outside press and academics.

The U.S. Bureau of Labor Statistics earlier this week released the newest data from the Job Openings and Labor Turnover Survey covering the month of October. Kate Bahn and Austin Clemens put together four graphs utilizing JOLTS data.

The U.S. House of Representatives Committee on Education and the Workforce proposed a hearing to debate the consequences of a $15 minimum wage on workers and small businesses. Kate Bahn consolidated research surrounding the $15 minimum wage discussion that indicates an increase in the federal minimum wage will boost workers’ well-being while avoiding detrimental effects on small businesses.

Links from around the web

Dylan Matthews shines light on a not-so-well-known anti-poverty bill called the American Family Act of 2017 that is similar to Europe’s child-allowance policy, which provides all but the wealthiest households approximately $3,000 annually per child. The proposed U.S. policy would expand upon the child tax credit to support low-income families’ access to high-quality child care and development. Matthews argues that research shows that child-allowance policies work abroad, thus the United States should look into adopting a similar program. [vox]

A recently-filed antitrust lawsuit in the United States against generic drug manufacturers over two drugs escalated into a major case of alleged price-fixing between 16 manufacturers and regarding 300 drugs. These manufacturing companies partook in anti-competitive agreements to drive up the prices of generic drugs, swap sensitive information about markets and prices, and discuss “fair-share” divisions of sales from over-priced drugs. U.S. antitrust investigators say that this “cartel’s” actions have targeted consumers with or without insurance, because insurance plans often have high deductibles or limitations on prescription drug benefits. [wapo]

In looking at the investment patterns of the world’s wealthiest 0.001 percent, The Economist reports that the wealthiest 0.001 percent manage their assets through the creation of “family offices”—personal investment firms that seek out global markets in the hunt for investment treasures. As billionaire-run family offices continue to grow, there are concerns that family offices can weaken the stability of financial markets, increase inequality by making the very-rich even richer, and give these billionaires the power and accessibility to exclusive information to control the markets. [economist]

Research by Massachusetts Institute of Technology economists Daron Acemoglu and Pascual Restrepo indicate a greater ratio of robots/automation to populations in the Midwest and parts of the South than in any other region of America. They find that one more unit of automation in a commuting zone reduces employment by six workers. These lost jobs are concentrated in blue-collar industries such as manufacturing. Their colleague at MIT, David Autor, explains that automation “reduces labor’s share of value-added in the industries in which it originates” while devaluing skills, disrupting the political environment, and displacing workers. [nyt]

A new report by Vox’s Dylan Scott details the argument that a Medicare-for-all system can complicate the healthcare coverage of 160 million Americans who currently receive insurance through their employers. Scott explains how 83 percent of respondents said that they consider their employer-sponsored insurance excellent or good, mainly because it covers a wide range of individuals and healthcare needs. Scott also examines evidence that shows single-payer health insurance programs prove to be more equitable and accessible to low-income individuals who don’t have access to employment with adequate health insurance. [vox]

Friday Figure

Figure is from Equitable Growth’s, JOLTS Day Graphs: October 2018 Report Edition

Brad DeLong: Worthy reads on equitable growth, December 6–13, 2018

Posted on December 13, 2018June 7, 2019 by Maria Monroe

Worthy reads from Equitable Growth:

Apply for an Equitable Growth grant. “We are now accepting applications in response to our 2019 Request for Proposals. Letters of inquiry for academic grants are due by 11:59 p.m. EST on Thursday, January 31, 2019. Proposals for doctoral/postdoctoral grants and applications to the Dissertation Scholars Program are due by 11:59 p.m. EDT on Sunday, March 10, 2019…”
If you missed Anne Case and Angus Deaton on “deaths of despair” when it came out at the start of this year, you need to go back and read it. Iris Marechal examined their paper in her column, “The Opioid Crisis: A Consequence of U.S. Economic Decline?,” in which she wrote: “The opioid epidemic continues to devastate families and communities across the United States, causing serious health and socioeconomic crises. The high prescription rate for opioids and the subsequent misuse of this medication by millions of Americans accelerated addiction and has led to a four-fold increase in the rate of overdoses since 1999 … Anne Case and Angus Deaton at Princeton University attribute the sharp increase in drug overdoses between 1999 and 2015 to ‘deaths of despair’ rather than to the increased ease of obtaining opioids: That is, their research suggests that higher drug suicides are attributable to social and economic factors such as a prolonged economic decline in many parts of the United States. They show that white Americans are more affected by the opioid epidemic, yet less affected by economic downturns than other racial and ethnic groups in the country.”
Raksha Kopparam makes a very nice catch and sends us to the Center for Financial Services Innovation’s “U.S. Financial Health Pulse: 2018 Baseline Survey.” Read her “New Financial Health Survey Shows That Traditional Metrics of Economic Growth Don’t Apply to Most U.S. Households’ Incomes and Savings,” in which she writes: “Single aggregate data points do not capture how economic growth is experienced by different people in very different ways … underscoring the importance of knowing who specifically benefits from a strong economy is a new survey by the Center for Financial Services Innovation.”

Worthy reads not from Equitable Growth:

All the people who say that it is really not that important to get inflation up leave me flummoxed. I try to determine what they think will happen when the next recession comes. I fail. For some insight, read Joseph E. Gagnon and Takeshi Tashiro, “Abenomics Is Working, Don’t Stop Now,” in which they write: “Japan is on track for its longest postwar economic expansion, with female labor force participation and corporate profits at record highs and unemployment at a 25-year low … [is] the goal of raising inflation to 2 percent … really necessary[?]”
To what extent is geographic divergence the result of rent-seeking land-use planning run amok? Simon Wren-Lewis examines this question in his “Helping the Left Behind: Its (Economic) Geography, Stupid, in which he writes: “Martin Sandbu points us to a report from the Brookings Institution [that says] ‘for much of the 20th century, market forces had reduced job, wage, investment, and business formation disparities between more- and less-developed regions. By closing the divides between regions, the economy ensured a welcome convergence among the nation’s communities.’ But from the 1980s onwards, they argue that digital technologies increased the reward to talent-laden clusters of skills and firms.”
It is becoming increasingly clear that the best road forward for the American worker on trade is to join the Trans-Pacific Partnership and keep NAFTA. Read Gary Clyde Hufbauer and Jeffrey J. Schott, “Under the Hood, the USMCA Is a Downgrade for North America,” in which they write: “Trump … called the North American Free Trade Agreement (NAFTA) the worst trade deal ever made. Trade negotiators have branded its intended replacement … a ‘modernized’ improvement. The upgrades draw heavily from the Trump-abandoned Trans-Pacific Partnership … The deal also includes costly new regulations and requirements that discourage investment, especially in the auto sector … higher prices for cars at a time when auto sales are flagging. Ford and GM are already laying off workers … The USMCA limits trade more than promoting it.”
I think Rich Clarida’s argument in “Data Dependence and U.S. Monetary Policy” is wrong. I think the lower level of the neutral rate of interest and the fact that the Fed has not pursued its 2 percent per year inflation target symmetrically have consequences. Those are that medium-term risks are overwhelmingly asymmetric on the downside. What does Clarida think he is going to do to stem the next recession when it comes? Here’s what he says: “As the economy has moved to a neighborhood consistent with the Fed’s dual-mandate objectives, risks have become more symmetric and less skewed to the downside than when the current rate cycle began 3 years ago. Raising rates too quickly could unnecessarily shorten the economic expansion, while moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks. Although the real federal funds rate today is just below the range of longer-run estimates presented in the September SEP, it is much closer to the vicinity of r-star than it was when the FOMC started to remove accommodation in December 2015. How close is a matter of judgment, and there is a range of views on the FOMC.”
This ought to be the conventional wisdom about the importance of the American union movement, from Noah Smith’s “Unions Did Great Things for the American Working Class,” in which he writes: “Politically and economically, unions are sort of an odd duck. They aren’t part of the apparatus of the state, yet they depend crucially on state protections in order to wield their power. They’re stakeholders in corporations, but often have adversarial relationships with management. Historically, unions are a big reason that the working class won many of the protections and rights it now enjoys.”

New research shows the franchise business model harms workers and franchisees, with the problem rooted in current antitrust law

Posted on December 13, 2018April 25, 2019 by David Evans

After negative publicity, investigations by several state attorneys general and pressure from Sens. Cory Booker (D-NJ) and Elizabeth Warren (D-MA), several franchise chains recently announced an end to so-called no-poaching agreements. These agreements—which are part of the uniform franchise contracts that companies such as McDonald’s Corp. offered on a take-it-or-leave-it basis to the franchisees who operate their stores—prevent workers within a chain from moving from one outlet to another. Research from economists Alan Krueger and Orley Ashenfelter at Princeton University suggests that such agreements are mechanisms to enhance the monopsony power of franchise employers over workers by restricting workers’ ability to find alternative employment, reducing worker bargaining power and wages.

Eliminating these agreements removes a particularly egregious mechanism to restrain wages in franchise contracts, but my two new working papers suggest that franchisors’ influence over labor costs and working conditions at franchised establishments goes far beyond no-poaching agreements. This column examines my research findings: That franchise contracts still enable franchisors to increase their bargaining power over franchisees and workers; that, in some instances, so-called vertical restraints further harm franchisees and their workers; and that the legal creation of franchising beginning in the 1960s was, in large part, the story of the loosening of antitrust restrictions on franchisors, often to the detriment of franchisees and their workers.

How franchisors increase their bargaining power over franchisees and workers

Through a simple economic model and descriptive analysis of common contractual provisions in franchise agreements, my paper, “Franchising as Power-Biased Organizational Change,” shows that franchisors are, in a sense, co-employers who intimately shape employee working conditions—despite not being the payroll employer of those workers. I argue that franchise contracts function in part to reduce the bargaining position of both franchisees and workers, allowing franchisors to extract more labor effort from a low-wage workforce, reducing unit labor costs, and raising profits for the franchisors.

Franchising is a business form in which a firm owning a valuable brand outsources the delivery of goods or services to a separate firm or individual in exchange for the remittance of a royalty, usually calculated as a percentage of gross sales. In 2012, the most recent year for which data are available, franchising firms accounted for 7.9 million jobs in the United States, compared to 13.4 million jobs in manufacturing. Franchisors accounted for more than 450,000 business establishments, or 10.45 percent of all establishments. Sales of franchised chains were about $1.3 trillion in 2007, or 9.2 percent of total U.S. Gross Domestic Product.

Franchising is the dominant mode of industrial organization in the fast-food industry, with 73 percent of the 3.58 million fast food workers in the United States employed in franchised chains. Franchising is also common in the hotel, auto repair, and janitorial industries.

At first glance, franchising appears to be an efficiency-enhancing business model because it aligns franchisee incentives with franchisors. The franchisee of a typical fast food chain—let’s call him Joe Independent, operating a Fresh Fries franchise—is incentivized to work hard because Joe Independent keeps the profits, minus the royalties paid to Fresh Fries. Since Joe Independent shares in the profits, he also gets the benefit of his own hard work alongside the work of his employees. Franchising appears at this stage to be both fair and efficient.

But a close look at franchise contracts reveals that franchisors go beyond merely aligning incentives. They also make investments in bargaining power to reduce the bargaining fallback position of franchisees who, similar to Joe Independent, raise their effort levels beyond what aligning incentives through profit sharing achieves on its own.

Here’s how it works: Think of Joe Independent’s effort as a function of the value he gets out of being a franchisee, relative to his fallback position should the franchisor terminate or fail to renew his contract. This means that Joe will work harder the more money he can make as a franchisee, but less hard the stronger his fallback position is.

Indeed, the fallback position of franchisees is a function of the value of their assets outside the franchise relationship, their expected income outside that same relationship, and their probability of finding alternative employment or other income-generating activity outside the franchise relationship. By reducing what franchisees such as Joe Independent can earn outside the franchise relationship relative to within it, franchisors can induce franchisees like Joe to work even harder than they would have agreed to—based on the value of the franchise alone prior to entering the contract.

An analysis of franchise contracts reveals the prevalence of such power-reducing contract terms. From a public records request to the state of Wisconsin, which requires franchisors to file copies of their contracts, I collected franchise contracts from all 530 franchisors operating in Wisconsin with more than 85 outlets nationwide. An analysis of these contracts revealed a number of contract terms that tilt power toward franchisors. These include the following:

Most franchisors impose noncompete agreements on franchisees, which prevent them from using the human and physical capital they have accumulated in the franchised business in alternative employment once the contract ends. The average duration of noncompete agreements in my sample is 19 months.
Ninety-three percent of contracts require franchisees to sign a personal guarantee, giving the franchisor recourse to their personal assets in the event of bankruptcy or litigation.
Fifty-eight percent of franchise contracts in the sample impose mandatory arbitration on franchisees, which forces them to give up their right to class action litigation and jury trials.
Ninety-one percent contain a forum clause, which forces franchisees to travel to the home jurisdiction of the franchisor in any litigation, dramatically raising the cost of challenging the franchisor in court.
Eighty-five percent give the franchisor a right of first refusal to any sale of the franchisee’s business, lowering the potential resale value of the franchise assets.

In short, a franchisor can induce very high levels of franchisee effort by leveraging such one-sided contract terms to reduce the franchisee’s bargaining position. In this sense, franchisors extract not just high effort from franchisees, but also more effort than the franchisees bargained for. Rather than enhance efficiency by achieving more output per unit input, franchise contracts coerce extra output from the franchisee input.

Channeling franchisee effort through vertical restraints

Franchise contracts do more than extract extra effort from franchisees. The contracts also channel that extra effort in certain directions favored by the franchisor. Importantly for the efficiency implications of franchise contracts, franchisees typically do not directly produce output. Rather, they manage the workers who do. These workers are paid in wages, not profit shares, and do not share in the proceeds of any additional effort they put into their jobs.

Contract terms known as vertical restraints—controls on franchisee decision-making such as on prices, suppliers, and customers—remove franchisee discretion over their “independent” businesses and focus their efforts on just a handful of areas. I collected data on six common vertical restraints:

Fifty-five percent of franchise contracts contain the no-poaching agreements referenced above. (My sample of contracts is from 2016. As mentioned above, some of the chains have since ceased including these terms in new contracts offered to franchisees.)
Forty-five percent of franchise contracts give franchisors the right to fix the maximum or minimum prices the franchisees may charge.
Ninety-one percent prohibit franchisees from offering for sale any products not approved by the franchisor.
Sixty-four percent (ninety-two percent in the fast food industry) give franchisors the right to set mandatory hours of operation.
Eighty-two percent restrict the site where the franchisee can choose to locate.

Franchise contracts also place restrictions on the suppliers franchisees may choose. On average, 47 percent of ongoing franchisee purchases must be made from suppliers restricted by the franchisor. The average percentage in fast food is 78 percent.

As Krueger and Ashenfelter have shown, no-poaching agreements represent direct efforts by franchisors to disempower workers by reducing their fallback position, despite franchisors not directly employing those workers. But other vertical restraints also play a role in disempowering workers.

For one thing, vertical restraints create what David Weil, dean of the Heller School for Social Policy and Management at Brandeis University, has called “fissured workplaces,” where “lead” firms such as franchisors replace direct employment of workers with outside contractors such as temp agencies and franchisees. Workplace fissuring reduces wages by putting workers outside the boundaries of the lead firm, blocking them from access to career ladders, firm-specific wage premia, and workplace protections such as union rights. Without the ability to control franchisees through vertical restraints, franchisors such as McDonald’s and Yum! Brands Inc. (the franchisor of the Taco Bell fast food chain) would be forced to take direct ownership of their retail outlets to maintain the uniform chain-store appearance that is essential to their brand, eliminating fissuring.

In the franchising context, vertical restraints also constrain worker wages in more direct ways by focusing the attention and effort of franchisees on the control of labor costs. The more variables that are taken out of the franchisee’s decision set, the more they must focus on labor cost as the variable they can control. Many franchisees operate under contracts where their prices and most of their nonlabor input costs are determined by the franchisor. The wage bill and extraction of worker effort become one of the few variables under their control to maximize their profits.

Thus, franchise contracts loaded with vertical restraints squeeze effort from franchisees at the task of squeezing effort from production workers. While franchise contracts increase franchisor profits in efficiency-enhancing ways through aligning franchisee incentives with franchisors by achieving more output per unit input, these contracts also increase profits in nonefficient ways by squeezing additional (uncompensated) effort from the labor input.

Franchising in this context functions as a type of organizational surveillance and as a vehicle for labor discipline by franchisors, in which franchise contracts induce franchisees to surveil production workers and extract high levels of effort from them, reducing the investments in monitoring and/or wage premia that franchisors would otherwise have to make to attract and motivate production workers. Yet because franchisors are not the legal employers of production workers, franchisors escape legal responsibility for their terms and conditions of employment.

The legal creation of franchising

In a second paper, “Control Without Responsibility: The Legal Creation of Franchising 1960–1980,” I trace the creation of franchising as a business model from 1960 to 1980. I show that franchising was far from a natural evolution of business organization, growing over time due to efficiency reasons alone. In fact, the growth of franchising required a struggle through lobbying and litigation to achieve the policy changes necessary to allow it to take root.

The history of the creation of franchising is all about these contractual controls on independent franchisees such as on prices, suppliers, and customer restrictions. These controls were and remain the mechanisms franchisors rely on to create the uniform chain-store appearance of their far-flung operations in the absence of formal vertical integration.

Vertical restraints were frowned upon by antitrust authorities during the early years of franchising in the 1950s and 1960s, who interpreted their antitrust role more broadly as including the protection of small businesses such as franchisees from domination by large corporations such as franchisors. Limitations on the freedom of franchisees to choose their own customers or set their own prices through vertical restraints were therefore frowned upon in the early years of franchising.

Not so today. Under current antitrust interpretations, antitrust authorities focus narrowly on low consumer prices as their objective. This shift in focus came about in part because franchisors litigated and lobbied to overturn antitrust restrictions on vertical restraints, prevailing in legalizing nonprice vertical restraints in the 1977 court case Continental T.V., Inc. v. GTE Sylvania, Inc., and eventually in legalizing even price vertical restraints in the State Oil Co. v. Khan court case in 1997.

Whatever the efficiency implications of franchising, the increasing legalization of vertical restraints also had the benefit for franchising firms of allowing them to fissure workplaces and pull in the legal boundaries of the firm, leaving workers and other stakeholders outside. And at the same time that franchisors pursued franchising as a kind of vertical integration by other means, they also lobbied to preserve the legal benefits of franchisees being separate firms under a variety of laws such as access to Small Business Administration loans and exclusion of workers at franchised establishments from access to collective bargaining and other rights against the franchisors who really control their working conditions.

Franchising is thus very much a legal and policy creation. Among its consequences are workplace fissuring and enhancing the ability of powerful corporations to control working conditions and reduce labor costs without the legal responsibilities that have traditionally accompanied such control. As a creation of law and policy, however, changes in law and policy also hold the key to mitigating its negative effects. The end of no-poaching agreements is an important step in remedying the ill-effects of the franchising model on small businesses and workers, but it is only a first step.

—Brian Callaci is a graduate student of economics at the University of Massachusetts Amherst and a 2017 Equitable Growth grantee.

In conversation with Karen Dynan

Posted on December 12, 2018December 20, 2018 by David Evans

What to consider during the planned congressional hearing on a $15 minimum wage

Posted on December 11, 2018December 13, 2018 by Emilie Openchowski

The U.S. House of Representatives Committee on Education and the Workforce is planning a hearing on the $15 minimum wage, focusing on the “consequences for workers and small businesses.” The hearing is being held in anticipation of early legislation in the next Congress on the $15 minimum wage. The current chair of the committee, Rep. Virginia Foxx (R-NC), and other members of the current majority in Congress are opposed to substantially increasing the minimum wage.

This hearing is an attempt to focus the policymaking narrative about minimum wage increases solely on business outcomes. Yet there is sparse evidence that increases in the minimum wage will reduce employment across businesses. Recent empirical research from Equitable Growth’s network of academics and grantees demonstrates that state and local increases in the minimum wage have increased worker well-being without the predicted deleterious effects to the economy. Specifically:

A new report by the Center on Wage and Employment Dynamics at the University of California, Berkeley’s Institute for Research on Labor and Employment examines the effect of increases to the minimum wage on food service workers who would likely be impacted at the city-level in Chicago; Washington, D.C.; Oakland, California; San Francisco; Seattle; and San Jose, California. Equitable Growth grantees and economists Sylvia Allegretto, Anna Godoey, Carl Nadler, and Michael Reich of UC Berkeley find that cities that increased the minimum wage above $10 per hour had stronger private-sector job growth than the average comparison county.
Analysis from the Economic Policy Institute led by economist Ben Zipperer examines the research of a team of economists at University of Washington on Seattle’s $15 an hour minimum wage, and concludes that their findings on negative or ambiguous effects of the increased wage on employment levels are premised on faulty methodology. Zipperer’s analysis verifies the research by Allegretto, Godoey, Nadler, and Reich.
Minimum wage increases also reduce income inequality. An Equitable Growth working paper by grantees and U.S. Census Bureau economists Kevin Rinz and John Voorheis links data from the Current Population Survey to earnings records from the Social Security Administration to examine accurate earnings for workers across the income distribution over a 5-year time period. They find that state-level increases to the minimum wage had the strongest effects for those at the lower end of the income distribution, with gains accumulating over time up to 5 years.
Equitable Growth Research Advisory Board Member and grantee Arindrajit Dube of the University of Massachusetts Amherst also finds evidence of increased earnings at the bottom of the income distribution in an Equitable Growth working paper. Furthermore, Dube finds that a higher minimum wage reduced eligibility for public assistance but also that it reduced some of the gains of the increased wage among workers likely to be affected by changes to the minimum wage—with the overall impact remaining positive for workers.
Further work by Zipperer looks at how the declining real value of the federal minimum wage has effected black and Hispanic workers, finding that it has increased poverty rates for these families.
In an Equitable Growth working paper, Research Advisory Board Member David Howell of the New School, along with Kea Fiedler of the New School and Stephanie Luce of the City University of New York, argue that the test of zero job loss for the success of a minimum wage increase is too narrow. While direct impacts on business are one consideration, the overall goal of a minimum wage increase should be a “minimum living wage.”

Indeed, the congressional hearing detracts from the purpose of increasing the minimum wage in the first place: improving the well-being of low-wage workers and ensuring our economic growth is shared along the income distribution. As was discussed in the recent column, “Refocusing the minimum wage debate on the well-being of U.S. workers,” the “no job loss standard” for increases to the minimum wage is misdirected. Disemployment is an aspect of raising the minimum wage for which there is ambiguous or no evidence, while the body of evidence demonstrates that increasing minimum wages in a tight labor market can ensure economic growth is broadly shared with workers at the bottom of the earnings distribution. The result: increased earnings and consumption, reduced job turnover and increased job tenure, and higher family income.

JOLTS Day Graphs: October 2018 Report Edition

Posted on December 10, 2018December 10, 2018 by Austin Clemens

Every month the U.S. Bureau of Labor Statistics releases data on hiring, firing, and other labor market flows from the Job Openings and Labor Turnover Survey, better known as JOLTS. Today, the BLS released the latest data for October 2018. This report doesn’t get as much attention as the monthly Employment Situation Report, but it contains useful information about the state of the U.S. labor market. Below are a few key graphs using data from the report.

1. The quit rate remained high at 2.3%, above levels in the previous expansion, demonstrating continued worker confidence in the labor market.

2. The vacancy yield is at historic lows, below the levels of the full employment economy in the year 2000.

3. The unemployment-per-job openings ratio continues its downward trend, with fewer unemployed workers actively seeking a job than the number job openings.

4. The Beveridge Curve is little changed for October, representing a tight labor market.

Weekend reading: “The economy should work for all Americans” edition

Posted on December 7, 2018 by David Evans

Equitable Growth round-up

This week, Equitable Growth added a new working paper from Equitable Growth grantee and University of Leuven economist Mariana Zerpa to our working paper series. Using a new dataset including a variety of universal and targeted early childhood education programs at the state level, Zerpa analyzes the durability over time of the academic and behavioral improvements caused by these programs. As I summarized in a blog post, Zerpa finds substantial reductions in grade repetition and in the occurrence of developmental and behavioral problems that persist for at least 8 years after children participate in early childhood programs.

Raksha Kopparam summarized some of the key data points in the “U.S. Financial Health Pulse: 2018 Baseline Survey” from the Center for Financial Services Innovation. In addition to pointing out that large numbers of U.S. households are financially “coping” or “vulnerable,” Kopparam documents persistent disparities across racial and ethnic lines. These findings provide further support for the need for disaggregated economic data to get a better sense of the economic well-being of the economy as a whole.

Senior Policy Advisor Liz Hipple highlighted a recent paper from the Federal Reserve Board on the economic circumstances of millennial Americans. Notably, the paper finds that earnings were 27 percent higher for Generation Xers and baby boomers compared to millennials of the same age. The authors argue, however, that the challenges facing millennials likely reflect the exacerbating labor and credit market conditions in the aftermath of the Great Recession. Hipple concludes by citing Equitable Growth grantee and University of California, Berkeley economist Jesse Rothstein’s work on the centrality of labor markets to intergenerational mobility.

Yesterday, Brad Delong shared his thoughts on recent research and writing in economics with a focus on macroeconomic analysis. In addition to highlighting the significant potential role of peer effects and externalities in Zerpa’s working paper, Brad quotes from our Executive Director and Chief Economist Heather Boushey’s column for The Hill on the disastrous employment and growth effects of the failed tax-cut experiment in Kansas.

Links from around the web

Equitable Growth steering committee member and Princeton University economist Alan Blinder discusses how the United States has become the most unequal rich country in the world despite once being a land of opportunity characterized by social mobility and the American dream. Blinder cites research by former Equitable Growth steering committee member and Harvard University economist Raj Chetty, which documents how rising economic inequality has been accompanied by declining social mobility. Blinder concludes by arguing that strengthened unions, pensions, entitlements, and estate taxes must be core features of any plan to return the United States to the levels of mobility and opportunity experienced by many workers in the 1950s. [wsj]

In addition to deregulation, lower taxes for the wealthy, and declining unions, New York Times columnist David Leonhardt points out that changes in corporate structure have been an important cause of rising inequality and persistent wage stagnation for most Americans. Indeed, since the 1970s, corporations began focusing less on serving the public as a whole and more on delivering value exclusively for their shareholders. The route to restoring the American dream and creating a fairer economy must therefore include increasing the power of workers, consumers, and communities in corporate decision making. [nyt]

Benjamin Wallace-Wells at The New Yorker discusses the implications for the racial wealth gap of the recent “baby bond” proposal from U.S. Senator Cory Booker. The proposed policy would entail creating trust accounts worth $1,000 for every child born in the United States to grow over time and provide them with a solid financial foundation to transition to adulthood and progress in their careers. Discussing work by Equitable Growth grantees and economists William Darity, Jr., and Darrick Hamilton, Wallace-Wells notes that one key effect of such a policy would be to reduce the massive average wealth disparity between black and white families—$17,000 vs. $170,000 per household. [new yorker]

Pat Ferrier at the Coloradoan takes a deep dive into the market for childcare in Fort Collins, Colorado. Ferrier argues that both low availability and high costs are substantial burdens for middle class families—and even larger obstacles for poor families working to join the middle class. Through statistics and anecdotes, Ferrier illustrates how childcare provision is characterized by a market failure in which those who need it most are the least financially able to pay for it. This structural flaw in the childcare market underlies the indispensable role of public policy in securing childcare access for all children in the United States. [coloradoan]

Friday figure

Figure is from Equitable Growth’s, “Are today’s inequalities limiting tomorrow’s opportunities?”

Equitable Growth’s Jobs Day Graphs: November 2018 Report Edition

Posted on December 7, 2018December 7, 2018 by Austin Clemens

Earlier this morning, the U.S. Bureau of Labor Statistics released new data on the U.S. labor market during the month of November. Below are five graphs compiled by Equitable Growth staff highlighting important trends in the data.

1. The employment rate of prime-age workers continues its upward trend and still has room to grow before reaching pre-Recession levels

2. The U-6 measure of under-employment is below pre-Recession levels, but could potentially still expand further to reach the full employment level of 2000.

3. Wage growth continues across the wage distribution, but can still improve further to remain on track with expected levels of growth in a tight labor market.

4. Employment in construction and manufacturing continues upward, but these historically volatile sectors should be watched closely in the coming year for the impacts of trade negotiations.

5. An increasing share of newly employed workers are coming from out of the labor force, demonstrating that these workers were not lost but rather waiting for a tight enough market.