Economic Growth and Creative Destruction Theory
The ultimate goal of a company is to stand out from this competition centered on innovation and win higher productivity and short-term monopolies or oligopolies power. This is the “economic growth theory” and “creative destruction theory” proposed by Joseph Schumpeter: In order to gain temporary market dominance, companies will continue to innovate and eliminate existing inferior technologies.
Innovation also provides opportunities for competitors to adopt new technologies and even outperform them, constantly crowding out leaders in the process. It is this competitive atmosphere of chasing each other that promotes the continuous progress of science and technology. Although Tesla (ticker: TSLA) is in the absolute leading position in the electric vehicle market, it is already surrounded by competitors. Competitors want to use more advanced and cheaper technology to wrestle with Tesla to see who is the real one. industry leader.
Buffett’s Moat Theory
Companies whom Buffett admires will build a moat around the castle to limit the entry of competitors, continuously consolidate their own power, and achieve a permanent monopoly. That is to say, if investors keep expanding the castle and at the same time use the profits to acquire more castles with moats, then Schumpeter’s theory of economic growth will no longer work.
Although the power of a monopoly can incentivize innovation and growth, this power is temporary and quickly disappears once competitors adopt the same or even more advanced technology. In addition, according to common sense, monopoly power does not lead to excess profits, because in order to achieve technological leaps and ultimately benefit from this temporary market dominance, companies must invest money.
On the other hand, companies also need to invest ahead of time based on expected profits, given that each competitor in the market is trying to outdo the other. As seasoned investors such as Warren Buffett say, the reason why profitable companies continue to innovate is often not to introduce new products and technologies or to reduce production costs, but to ensure that potential competitors cannot enter your own field and share a share with yourself. (Note: this is a typical kind of moat───entry barrier)
Perfect competition does not happen in the real world
A perfectly competitive market would not have any market power, and the profits of the business would not exceed the return on capital, but just adequately compensate investors for the risks and other costs.
Economists have long known that certain conditions must be met for competition (everyone has access to perfect information, markets free of externalities, economies of scale, economic frictions) that was described by Adam Smith to the “invisible hand” works at its full potential to help markets create the greatest benefit for the greatest number of people.
The difference between Hayek and Orwell is whether real markets satisfy the prerequisites necessary for perfect competition. Hayek argued that these preconditions were largely met, while Orwell argued that they were not, and that “liberal capitalism inevitably leads to the phenomenon of monopoly.”
At the end of the 19th century and the beginning of the 20th century, the healthy competition pictured by Hayek did not appear in the market. A few companies successfully broke through the siege of competitors and became monopolies in the industry.
The failure of Schumpeterian theory
What has happened in the past few decades is actually similar to what happened a century ago (that is, the period from 1890 to 1914): with the rapid progress of science and technology, Schumpeter’s theory has completely failed; With the help of means, those entrepreneurs firmly held market dominance in their own hands, and monopoly power almost became a permanent existence. After intense technological competition, those winning companies have successfully used technological advantages to keep their opponents out of the market while improving production efficiency.
Examples of monopoly or oligopoly abound
Cases of market power can be said to be ubiquitous, and almost every industry has a few companies that can dominate the entire industry. For example,
- Three companies produce 89% of cardiac pacemakers on the market, and Medtronic (ticker: MDT) is the largest one, accounting for more than half of the market share;
- 69% of infant milk powder in the United States is produced by Abbott ( ticker: ABT) and Mead Johnson (ticker: RBGLY);
- Dry cat food in the US market comes from Nestle (ticker: NSRGY); The mayonnaise produced by Unilever (ticker: UL) and Kraft (ticker: KHC) occupies 87% of the US market share.
- 70% of the social network is monopolized by Meta (ticker: META), Twitter and LinkedIn (ticker: MSFT) combined together, they only account for 15%;
- American Airlines (ticker: AAL), Delta Air Lines (ticker: DAL), United Airlines (ticker: UAL), Southwest Airlines (ticker: LUV) occupies 76% of the US domestic aviation market;
- Home Depot (ticker: HD) and Lowe’s (ticker: LOW) have 81% share of the US home hardware tools market;
- If you have a funeral for yourself, then you can almost only choose Batesville (unlisted) and Matthews (ticker: MATW) when choosing a coffin, because the coffins produced by these two companies account for 82% of the market share.
Note: This article is an excerpt from Chapter 1 “The Art of Managing Moats” of “The Profit Paradox” by Jan Eckhout
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