By Wall Street Journal staff reporters Yochi J. Dreazen, Greg Ip and Nicholas Kulish
Reprinted from The Wall Street Journal, Page A1
(Copyright (c) 2002, Dow Jones & Company, Inc.)
Everywhere you look, powerful forces are driving American industries to consolidate into oligopolies -- and the obstacles are getting less formidable.
The rewards for getting bigger are growing, particularly in the world of technology, media and telecommunications, where fixed costs are especially large and the cost of serving each additional customer is small. Some snapshots:
Even as economic forces push these industries toward oligopoly, some of the forces that checked this trend in the 1990s are weakening. U.S. antitrust cops, regulators and judges seem less antagonistic toward bigness. Just last week, a federal appeals court opened the door to another round of media mergers by striking down rules that in effect barred cable companies from buying broadcast networks.
And investors are less eager to finance upstarts who challenge giants. In all, about $73 billion was raised for enterprises of all sorts through venture-capital financing and initial public offerings last year. That was robust by long-term historical standards, but it was less than half the $164 billion raised in the peak year of 2000.
The appetite for mergers is restrained by a sagging stock market and recession, but it probably will revive as the economy rebounds. "Even with the economic slowdown," President Bush's Council of Economic Advisers noted recently, "merger activity in 2001 was well above average levels during the past three decades."
An oligopoly, a market in which a few sellers offer similar products, isn't always avoidable or undesirable. It can produce efficiencies that allow firms to offer consumers better products at lower prices and lead to industry-wide standards that make life smooth for consumers.
But an oligopoly can allow big businesses to make big profits at the expense of consumers and economic progress. It can destroy the competition that is vital to preventing firms from pushing prices well above costs and to forcing companies to change or die. Rates for cable television, for instance, have soared 36%, almost triple the amount of overall inflation, since the industry was deregulated in 1996 and then consolidated in a few big firms. The Organization of Petroleum Exporting Countries is a classic oligopoly. Members manipulate their control over the supply of oil to force consumers to pay prices well above levels at which market forces would otherwise set them.
"A certain amount of consolidation does generate a certain amount of efficiency and is good for customers," says economist Carl Shapiro, who served in the Clinton Justice Department's antitrust division and now teaches at the University of California at Berkeley. "That's what economies of scale are about. Particularly in a lot of these industries that have heavy fixed costs, it's natural to have some consolidation."
"Twenty [competitors] to four is good," Mr. Shapiro says. "It's four to two that is much more dubious."
The rise of early-21st-century oligopolies echoes the late 19th century. "They are both periods where there was a retreat from government oversight of the economy, a tremendous amount of entrepreneurial activity, lots of new technology -- and it wasn't clear who would be the winners and losers," says Naomi Lamoreaux, an economic historian at the University of California at Los Angeles. "Firms try to put some bounds on the chaos, to control some markets."
Many industries also face staggering costs. A typical semiconductor-fabrication plant now costs between $2 billion and $3 billion, compared with $1 billion five years ago. A maker of basic memory chips must sell far more chips to justify an investment of that size, which is why makers of dynamic random access memory, or DRAM, chips are so eager to merge. If Micron Technology Inc. succeeds in buying the chip-making assets of South Korea's Hynix Semiconductor Inc., four firms will control 83% of the market, up from 46% in 1995. It cost pharmaceutical companies $800 million to develop and get approval for a new drug in the last decade, according to Joseph DiMasi of Tufts University's Center for the Study of Drug Development, six times what it cost in the 1970s after adjusting for inflation.
For a textbook case of the pros and cons of oligopoly, look no further than the industry that produces textbooks. Last year, Thomson Co., No. 2 in the $3.2 billion-a-year college-text business, bid for the college-book line of Harcourt General Inc., No. 4. Charles James, the Justice Department's assistant attorney general for antitrust, initially objected, warning that competition in certain courses "will be substantially lessened, resulting in students paying higher prices." But the government cleared the deal after Thomson agreed to sell certain titles, from psychology to intermediate Spanish, as well as a testing company.
Today, three big companies -- Britain's Pearson PLC, Canada's Thomson, and New York-based McGraw-Hill -- dominate the U.S. college-textbook business. The industry says consolidation helps shareholders and students. In a bigger company, says Peter Jovanovich, chief executive of Pearson Education, sales representatives are more specialized and know more about the books they're hawking.
And because publishers must complement their textbook offerings with Internet services, each textbook becomes a more expensive proposition. Publishers post online simulations of chemical bonding, practice tests and ready-to-serve Power Point presentations for professors.
But the textbook industry also shows two big economic risks that consolidation poses for consumers.
The first is rising prices. The best-selling introductory economics textbooks go for more than $100 now. The Labor Department's measure of textbook prices that publishers charge bookstores and distributors has climbed 65% over the past 10 years while overall producer prices rose just 11.2%.
The other risk is that the textbook oligopoly, with its profits dependent on hard-backed textbooks and its Web sites primarily intended to help sell books rather than replace them, will stifle innovation. "The odds that somebody will come up with a successful innovation go up with the number of people who are trying new things," says Paul Romer , a Stanford business-school professor. His new company -- Aplia Inc. of San Carlos, Calif. -- offers online teaching tools that aren't tied to any particular textbook. And the fewer the players, the lower the likelihood that a ground-breaking innovation will be perfected and rolled out quickly.
DSL, or digital subscriber line, the high-speech Internet pathway that relies on normal telephone lines, was developed by a Bell engineer in 1989. It languished for almost a decade because the Bells didn't want to cannibalize another, more lucrative high-speed Internet service for businesses. The Bells began deploying DSL broadly only after upstarts like Covad Communications Co., a Bell rival founded in 1996, quickly proved there was a consumer market for it.
With money flowing in from eager investors, upstarts rolled out new technologies and business models that the Bells had been unwilling or unable to devise. Some newcomers used high-capacity fiber-optic cables instead of old copper phone lines. Others allowed Internet service providers to install equipment at telephone switching centers. But when the capital markets all but stopped funding the Bell rivals two years ago, many innovators disappeared.
The pressure to consolidate is evident in the young online recruitment industry. For a while, it looked as if HeadHunter.Net Inc. would be a rare dot-com startup: profitable and independent. Last summer, it showed its first quarter of positive cash flow. A month later, it agreed to be bought by CareerBuilder Inc., itself the product of a merger.
The Web sites face huge marketing costs to attract a critical mass of job seekers and employers, says Craig Stamm, who was chief financial officer of HeadHunter.Net and now has the same post with the merged firm. With enough customers, the added cost of a new one is nearly nil. With too few, he says, "You slow down sales and marketing. Customers go away. There's even less revenue to invest. It's a downward spiral."
In online recruitment, market leader Monster.com was spending heavily on marketing, backed by its deep-pocketed parent, TMP Worldwide Inc. Worried about keeping up, HeadHunter.Net decided to merge with CareerBuilder, which is backed by two newspaper chains. The Federal Trade Commission scrutinized the deal and approved it without comment last November. TMP Worldwide's agreement to buy another competitor, HotJobs Inc., was scuttled, in part because of repeated requests for information from the FTC. In the end, Yahoo Inc. bought HotJobs.
All this transformed a market that at the height of the Internet bubble had more than 10 competitors, most routinely offering 50% discounts to lure job postings. Today the market is dominated by three firms, which are more committed to holding the line on prices. (Dow Jones & Co., publisher of this newspaper, operates a recruitment Web site for executives and professionals.)
In other industries the growing strength and size of customers is prompting suppliers to get bigger, too. In eastern Massachusetts, three big organizations came to control 75% of the insurance market, which gave them substantial bargaining power with local hospitals. If a hospital wouldn't offer one health maintenance organization deep discounts, the HMO could easily divert patients to other hospitals that would.
Then the hospitals started to join forces through mergers. The most significant was the December 1993 merger of two of the most prestigious, Massachusetts General Hospital and Brigham & Women's -- a combination that created Partners HealthCare System Inc. "In order to increase your leverage in a competitive environment, you need to increase your size," says Richard Averbuch, a spokesman for the Massachusetts Hospital Association. In 1993, metropolitan Boston had 34 separate hospital networks. Today it has 12 -- and life for patients is already changing.
In the fall of 2000, nearly 200,000 of the 900,000 members of one big HMO, Tufts Health Plan, got letters announcing that they would no longer be able to use hospitals or physicians affiliated with Partners. The reason: Tufts wouldn't accept the fee increases Partners wanted. The uproar was enormous. Without Partners, says James Roosevelt Jr., Tufts general counsel, so many HMO members and their employers "would drop us that we wouldn't have a health network anymore." Even people who never used Partners' doctors wanted the option of going to the top teaching hospitals in town in case of a serious illness. "They would switch their health plan even though that wasn't where they normally went for their medical care." Tufts went back to Partners, and agreed to a fee increase of 30% over three years.
"The bargaining power in the system has, in fact, shifted back to the providers, indisputably," says John E. McDonough, a health-policy professor at Brandeis University and a former Democratic state legislator. Last month, hospitals say, the Massachusetts attorney general opened an investigation into allegations of anticompetitive activities by the hospitals in connection with physician referral practices. The attorney general's office will neither confirm nor deny the existence of an investigation.
Earlier waves of concentration provoked a government reaction. And since Enron Corp.'s implosion, public hostility to big business has grown. The Bush administration's top antitrust officials insist they intend to be as aggressive as their Clinton predecessors.
Those expecting easier treatment from the Bush FTC appointees will be "disappointed," FTC Chairman Timothy Muris told an American Bar Association forum last summer. Mr. James, the Justice antitrust chief, said much the same at the event.
Indeed, not every merger sails through the Bush administration. But there's no doubt about the change in tone.
The new Economic Report of the President declares that there is "little evidence" the mergers of the 1980s and 1990s "harmed competition." At the FCC, Chairman Michael Powell says he is largely unconcerned about preventing concentration in any one industry as long as cable, old-style telephone, wireless and satellite are all competing to serve consumers.
Such comments are sparking predictions that the Powell FCC will approve Comcast Corp.'s proposed acquisition of AT&T Corp.'s cable arm, which would leave three companies in control of 65% of the cable business. There's also speculation that the FCC might allow a Bell company to buy a long-distance giant like Worldcom Inc. or Sprint Corp., a combination that would have been unthinkable even two years ago. Last week's appeals-court decision struck down FCC rules barring cable-TV operators from owning broadcast stations in the same market and forces the FCC to reconsider old rules preventing broadcast networks from owning local affiliates that reach more than 35% of the nation.
In the Microsoft case, the most celebrated antitrust action in decades, the Bush administration is widely regarded to be softer than its Clinton predecessors. After a seven-judge federal appeals court upheld the finding that Microsoft Corp. used its monopoly power to protect its Windows product, Mr. James agreed to a settlement that has been criticized as too soft and riddled with loopholes to restore competition.
"To say that it sets a tone for how this administration will be perceived is an understatement," says Robert Lande, a critic of Microsoft and an antitrust specialist at University of Baltimore law school. Even Einer Elhauge, a Harvard law professor and supporter of the Bush administration's antitrust approach, has criticized the settlement, now being reviewed by a federal judge. "The proposed settlement leaves Microsoft free to harm competition at the cost of technological progress in precisely the way it was found to have done so in the past." Mr. Elhauge says.
For much of the 1990s, ebullient stock and bond markets offered a vigorous countervailing force to the oligopolistic tendencies of American business by financing scores of aggressive upstarts. Indeed, Congress was counting on capital flowing into new ventures when it deregulated the telecommunications industry in 1996. Lawmakers envisioned a world in which nimble upstarts, known as "competitive local exchange carriers," would challenge the behemoths controlling local phone markets.
Investors poured tens of billions of dollars into CLECs, wagering that these rivals to the Bell companies would eventually take as much as 50% of the $112 billion market. XO Communications Inc. raised more than $258 million in a 1997 IPO, and saw its shares rise 34% above their offering price on the first day of trading. ICG Communications Inc. of Denver raised more than $2.5 billion from investors like Hicks Muse and Liberty Media Corp., AT&T's media-investment arm, and then had a hugely successful IPO.
In just two years, 1998 and 1999, more than $50 billion in high-yield telecom bonds were issued, according to Thomson Financial Securities Data. Private equity investors like Hicks, Muse, Tate & Furst, Kohlberg Kravis Roberts & Co. and Bain & Co. invested $10.3 billion in stakes in telecommunications companies.
By 2000, however, investors had begun to sour on the upstarts, which showed few signs of turning profits anytime soon. Companies that survived are still trying to adjust to the change. "It's really unprecedented. We've gone from full spigot to a situation where every capital source has shut down at the same time," says Randall Curran, chief executive of ICG Communications, which filed for bankruptcy protection in November of 2000. XO now trades at five cents a share.
Consumer groups and many of the upstarts blame the Bells for the CLECs' woes. They accuse the giants of trying to thwart competition by charging unfairly high prices for access to their phone lines, which they're required to share with competitors, or intentionally providing poor service to the upstarts' customers. The Bells say the companies expanded too fast and failed to develop a sustainable business model.
At the end of 2000, there were 330 CLECs challenging the Bells. A year later, there were 150 left.