A new focus on the network capital of movers and shakers

Can we utilise the power of connections and still facilitate competition?

One of the most long-standing questions in economics is who earns what in a market economy.

In almost any industry, production involves financial capital (money), physical capital (plant and equipment), intangible assets (brand names or ‘know how’), and human capital (ideas and the skills of workers).

Understanding the relative returns of these different ‘factors of production’ is crucial to determining whether firms are operating efficiently and to understanding where productive investment opportunities exist.

The standard or ‘neoclassical’ model says that in competitive markets, each factor of production earns its so-called ‘marginal product’ – how much it contributes to an incremental bit of output or profit.

But according to UNSW Business School professor of economics Richard Holden, the standard model is missing one important component – the role of network position. 

Outsize rewards

In a series of recent papers with co-author Robert Akerlof, an associate professor at Warwick University, Holden has explored how centrally connected people and firms in networks add economic value and earn returns.

“Most projects, in most walks of life, require the participation of multiple parties,” Holden says, “and the people who can bring those parties together – we call them ‘movers and shakers’ in our Quarterly Journal of Economics paper – create economic value and can also earn large rents.”

For Akerlof and Holden these movers and shakers are “socially useful, to be sure, but can derive ‘outsize’ rewards. And it is easy to misattribute a mover and shaker’s success to her skill. In fact, a mover and shaker may succeed in spite of – rather than because of – her skill.”

This has implications for the present debate about rising inequality, sparked by the now famous work, Capital in the 21st Century, by French economist Thomas Piketty. 

According to Holden, “this debate has focused to a large degree on returns to capital versus labour, but relatively little on what might be called ‘returns to social position’. 

“But this is a crucial part of the puzzle. We know the pros and cons of taxing financial capital, but it’s not even clear how to do that with network capital, and what both the benefits, or the unintended consequences, might be.”

'Having a large market share in a platform market is not a guarantee of future success'

RICHARD HOLDEN

Winning big

In recent work with co-author and former University of Chicago colleague Luis Rayo, Holden and Akerlof focus on markets with network externalities, such as platform markets that include large firms such as Amazon, Facebook, Google, and Uber. This work offers a new way of thinking about competition in these markets and how much market power large firms have.

“The traditional way of thinking about market dominance is to focus on market share,” Holden says, “but having a large market share in a platform market is not a guarantee of future success. In these markets, winners win big, but their position is fragile. 

“Just look at Netscape, which once dominated the browser market, but quickly lost out to Microsoft. This is why firms are constantly innovating – Google tweaks their search algorithm all the time, Uber offers new products and features, Facebook runs randomised controlled trials on their platform to optimise the user interface.”

This means, according to the authors, that breaking up Facebook, Amazon or Google would be a bad idea—it would rob consumers of the ability to connect with lots of other buyers, sellers, and users. 

“These big players may not have a lot of pricing power, but they can be bad for innovation in some circumstances,” Holden says. “They can and do buy up smaller rivals. 

“I would be looking at acquisitions such as Facebook’s purchase of Instagram or WhatsApp more closely, rather than breaking Facebook into three bits as Senator Elizabeth Warren seems to want to do.”

This work has not only received attention from top journals such as the QJE, but also from players in digital markets. Holden was invited to speak, along with six Nobel laureates in economics, in June at a conference organised by the Luohan Academy and Alibaba Group founder Jack Ma, in Hangzhou.

“The key issue is around how firms in the digital era can continue to drive innovation, and how we can facilitate competition without damaging the power of networks and connections. That’s the central challenge for policy-makers,” Holden says.