Corporate Inequality Is the Defining Fact of Business Today

Perhaps the most overlooked aspect of economic inequality has been the role that firms play in it.

The best-performing companies seem to be pulling away from the rest, according to a growing body of research, and that fact explains a large part of the growth in inequality between individuals. The result, at least in developed nations, is a highly unequal corporate landscape, where some firms are incredibly productive and the amount of money a person makes is tied to the company they work for, not just the job that they do.

There are several competing explanations for why this is happening, and there’s plenty we still don’t know. Nonetheless, it is not a stretch to say that if you want to understand competition today, you have to think about inequality. And if you care about addressing inequality, you have to consider why companies rise and fall.

Profits Are High, but Not for Everyone

It’s true that corporate profits are at or near all-time highs in the U.S., a fact that hasn’t escaped scrutiny on the campaign trail. But that’s a bit like saying the defining feature of American economic life is high incomes. By ignoring the distribution, that statistic masks a more important trend: As the McKinsey Global Institute has documented, variance in corporate earnings has increased substantially as well. “Not only are profits rising,” write the authors of the McKinsey report, “but in some industries, the leading firms are winning bigger than ever before.”

Researchers at the OECD documented something similar, looking at firms’ productivity in 23 of the organization’s member countries. Since 2000 productivity growth at the most productive “frontier” firms has sharply outpaced the average.

And this growing productivity gap shows up within industries, not just between them. “This is not happening just in retail, or in IT-producing sectors,” said Chiara Criscuolo, an OECD economist and coauthor of the report. “It’s happening a bit across the board.”

“Some firms clearly ‘get it’ and others don’t,” Criscuolo wrote on HBR.org earlier this year, “and the divide between the two groups is growing over time.”

Evidence of this trend toward greater corporate inequality has been trickling in for a while now. In 2008 Andrew McAfee and Erik Brynjolfsson wrote about their researchon U.S. public companies from the 1960s up to 2005 in HBR: “Since the mid-1990s, a new competitive dynamic has emerged — greater gaps between the leaders and laggards in an industry, more concentrated and winner-take-all markets, and more churn among rivals in a sector.”

Similarly, in 2007 Giulia Faggio and John Van Reenen of the London School of Economics and Kjell G. Salvanes of the Norwegian School of Economics and Business Administration reported that the productivity gap between firms had risen in the UK between 1984 and 2001, and that this phenomenon was linked to income inequality.

Two things happened in the intervening years. First, debate has proliferated over the causes of this corporate inequality. Second, researchers have documented at length why it matters and why everyone, not just CEOs, should care.

Where You Work Increasingly Predicts Your Pay

Most people are used to thinking about inequality as the pay gap between a CEO and an administrative assistant, or a software developer and a manufacturing worker. That gap definitely matters, but it actually hasn’t changed all that much.

Over the past few years several academic studies have documented that the majority of the increase in income inequality in the U.S. and elsewhere is driven by differences in how well different firms pay. In other words, the increase in inequality is about the gap in wages between companies, not within them.

That pay gap seems to be linked to rising inequality in corporate performance. But there are two explanations of why it is happening.

It could be that different companies are paying more generously or less generously for the exact same sort of work. For an extreme example, take Chobani. In April the yogurt company’s CEO decided to reward full-time employees by giving them stock, based on tenure and other factors, amounting to an average of $150,000 each. If you’re, say, an HR manager who happened to take a job at Chobani early on, your compensation suddenly looks considerably better than many of your peers.

It could also be that more-productive, higher-paying companies are hiring better workers. Engineers at Google might be getting paid more than engineers elsewhere because they’re better engineers. If these highly sought-after workers are increasingly clustered at top companies, that could explain the rising pay gap between firms.

It’s safe to say that a significant part of the growing gap in how well different firms pay can be attributed to the latter “talent sorting” effect — but exactly how much continues to be debated.

Using data from Portugal, David Card of Berkeley and his coauthors estimate that differences between employees explains 40% of the between-firm wage gap. Card finds evidence of worker sorting in Germany as well. Work by Nicholas Bloom of Stanford finds an even larger role: His analysis suggests that this worker sorting effect can explain the bulk of the increase of inequality in the U.S., with the exception of the rise of the 1%.

“Back in the 1980s, college graduates and low-skilled people would be in every firm,” said Bloom. Today, much like our neighborhoods, companies seem to be more segregated by education and skill.

This segregation isn’t only about hard skills like coding, argues Bloom, pointing to a paper by Christina Håkanson of the Swedish National Bank and her colleagues. Workers are sorting by soft skills, too, as the top-performing firms vacuum up the most-desirable workers. As Bloom puts it, “Nice, fun, polite people are sorting into some firms, and assholes are sorting into others.”

The human capital measures in these studies have their limits — basically, they infer a worker’s value from how much that worker gets paid above or below what’s typical at the company they work for. This approach has many advantages, but the studies that employ it can’t say for sure that what they’re measuring is skill. At a minimum, the workers who typically get paid more seem to be working together more than in the past. The experts I spoke to believe skill is a big part of that story.

Bottom line: Inequality among individuals is deeply intertwined with the fates of companies, whether through hiring, generosity, or some mix of both. So long as top-performing companies continue to surge ahead, we can expect income inequality to get worse.

There’s Too Much Competition

So why did corporate performance become more unequal in the first place?

Experts have more or less narrowed it down to two theories: Firms have been exposed to increasingly intense winner-take-all competition, or leading firms have cemented their market power and are earning fat profits without much threat of competition.

The competition story revolves around digital technology. The McKinsey Global Institute surveyed the firm’s clients about their digital investments and adoption, concluding that the most digital companies are leaving the rest behind.

As McKinsey’s researchers write in their report:

The most digitized sectors in the U.S. economy — especially software-intensive sectors such as media, professional services, and finance — tend to be highly profitable as well. Over the past 20 years, their average profit margins have grown two to three times as much as those in less digitized sectors. Even within these sectors, the margin spreads between the top-performing companies and the lowest performers are two to four times as large as in non-digitized sectors. In other words, the most digital sectors are developing a winner-take-all dynamic.

Faggio and his colleagues saw evidence for this in their UK data as well. They found that IT investment could “essentially account for all of the increase in productivity [inequality].”

McAfee and Brynjolfsson report something similar in their 2008 HBR article. To explain it, they use the example of CVS rolling out a change to its prescription fulfillment process using software:

Before the advent of enterprise IT, a successful innovation by a manager at one store could lead to dominance in that manager’s local market. But because no firm had a monopoly on good managers, other firms might win the competitive battle in other local markets, reflecting the relative talent at these other locations. Sharing and replication of innovations (via analog technologies like corporate memos, procedures manuals, and training sessions) would be relatively slow and imperfect, and overall market share would change little from year to year.

With the advent of enterprise IT, however, not just CVS, but its competitors have the option to deploy technology to improve their processes. Some may not exercise this option because they don’t believe in the power of IT. Others will try and fail. Some will succeed, and effective innovations will spread rapidly. The firm with the best processes will win in most or all markets.

Globalized competition may also be playing a role. Exporters tend to pay better than other firms, when all else is equal. And sure enough, there is research connecting trade to both the productivity and wage gaps between firms. “The chance of winning the extra prize of exporting induces firms to bet on bigger innovation projects with more-spread-out outcomes,” explains Alessandra Bonfiglioli of Universitat Pompeu Fabra and her colleagues in recent research.

Bloom thinks outsourcing is a cause as well. “Companies are restructuring from an industry focus to an occupational focus,” he told me. “Think of General Electric.” The company outsources catering and some of its IT, yet its headcount hasn’t been shrinking. Instead, Bloom says, GE has specialized in engineering and coding.

Essentially, Bloom believes companies have been “reassembling” over the past couple of decades based around their core competencies, which is why workers have been increasingly segregated by skill.

There’s Too Little Competition

Unless of course that’s not it at all. Last year Jason Furman, chair of the president’s Council of Economic Advisers, and Peter Orszag of Citi and Brookings published a discussion paper that painted the inequality between firms in darker terms.

Their focus is on economic “rents,” wasteful profits above and beyond what firms should make in a competitive market. If a single firm dominates an industry, for example, it’s able to charge extra for its products. Economists refer to those extra profits as rents, and Furman and Orszag worry that those rents are becoming more common. They suggest that industry consolidation could be a cause.

“To the extent industries look more like oligopolies than perfectly competitive markets, they will generate economic rents,” Furman and Orszag write. An “uptick in merger and acquisition activity” could be creating such a dynamic. They also cite the possible role of lobbying and regulations like occupational licensing that might limit competition, thereby increasing profits for certain firms or industries.

Another piece of evidence for the “lack of competition” theory is the decline of startups in the U.S. as well as in most developed countries. Recent work has found that although the number of high-potential startups in the U.S. has accelerated, these firms are still somehow less likely to grow or reach a significant “exit.”

Finally, Dean Baker of the Center for Economic and Policy Research has suggested that patents and copyright law are skewing corporate returns, a possibility Criscuolo mentioned to me as well.

“One problem with American capitalism has been overlooked: a corrosive lack of competition,” wrote The Economist in March, summing up these concerns. “America is meant to be a temple of free enterprise. It isn’t.”

Mr. Schumpeter Goes to Washington

Of course, competition and concentration can sometimes go hand in hand.

“One might think winner-take-all goes with one winner staying there, but it doesn’t have to be that way,” said Brynjolfsson. “You win, and when you win, you win big. But someone else is waiting in the wings.”

That’s the Schumpeterian model of competition, where firms compete for brief stints as monopolists, and when they’re on top, they’re more productive and profitable than their competitors. Brynjolfsson believes that digital technology makes this model of competition more common, for the reasons outlined in the CVS example.

But there’s a pessimistic synthesis between the competition and concentration stories. Perhaps the gap between firms starts out as the inevitable result of competition. Firms concentrate on what they’re good at, adopt new technology, and deliver products and services more efficiently. Having reached those heights, they then cement their status through lobbying or M&A. “Once those firms get there, it may be that they can actually draw up the drawbridge,” said Van Reenen. Maybe competition creates corporate inequality. But maybe it’s lack of competition that preserves it.

Harvard Business Review