2018 ccfin reinvestingmarketpower 883x432 1

Reinvesting market power for the betterment of shareholders

10 December 2018

The article at a glance

On the supply side, highly competitive industries are generally characterised as having many firms and low barriers to entry. The first condition …

hand sketching a flow chart on a blackboard
Scott B. Guernsey
Dr Scott B. Guernsey

On the supply side, highly competitive industries are generally characterised as having many firms and low barriers to entry. The first condition implies that existing firms cannot dictate or influence prices, and the second that new firms can enter markets at any time and at relatively low cost when incentivised to do so. Taken together then, in equilibrium, this setting suggests that existing firms only earn enough revenue to remain competitive and cover their total costs of production.

Yet, in reality, most industries in the United States have become increasingly less competitive. For example, in the article “Are US industries becoming more concentrated?“, forthcoming in Review of Finance, Gustavo Grullon (Rice University), Yelena Larkin (York University), and Roni Michaely (University of Geneva), find that more than 75 per cent of US industries experienced an increase in concentration over the past two decades.[1] As such, these industries are now composed of fewer firms, are less at risk of entry by newcomers, and earn “economic rents” or revenues in excess of that which would be economically sufficient in a competitive environment. Given these new developments, it is important for shareholders to understand how a reduction in competition might affect their holdings.

 In the article “Product market competition and long-term firm value: evidence from reverse engineering laws“, CERF Research Associate Dr Scott B. Guernsey examines the value and investment policy implications of decreased product market competition for equity holders in the US manufacturing industry.

To empirically analyse the relationship between competition and firm outcomes, Dr Guernsey centres his study on the adoption of anti-plug-mould (APM) laws, which were adopted by 12 US states from 1978 to 1987, and their subsequent reversal by a US Supreme Court ruling in 1989. APM laws directly influenced the intensity of competition in product markets by protecting firms headquartered in the law adopting states from competitors copying their products using a specific type of reverse engineering (RE) [2] – the “direct moulding process”.

The direct moulding process enabled competitors to circumvent the R&D and manufacturing costs incurred by the originating firm by using an already finished product to create a mould which would then be used to produce duplicate items. For example, a boat manufacturer using this RE process would buy an existing boat on the open market, spray it with a mould-forming substance (e.g. fibreglass), remove the original boat from the hardened substance, which would then become the mould used to produce replica boats. However, under the protection of APM laws, firms were given legal recourse to stop competitors in anyUS state from using the direct moulding process to compete with their products.

Using the staggered adoptions of APM laws by different states in different years, Dr Guernsey finds that firms located in states with RE protection experienced increases in their value, when compared to firms operating in the same industry but located in states without the laws. Moreover, when the APM laws were later overturned by a US Supreme Court ruling, which found the state laws in conflict with federal patent law, he finds all of the previous value gains subside.

Next, Dr Guernsey explores a possible economic explanation for the increase in value experienced by firms in less competitive industries. He finds evidence for the “innovation incentives” hypothesis which poses that any of the economic rents the APM protected firms earn from increased market power are being allocated to investments in new and existing production technologies. For instance, relative to industry rivals, firms located in APM-enacting states increase their investments in R&D and organisational capital.

Overall, Dr Guernsey shows a reduction in competition is value enhancing for a subset of shareholders in the manufacturing industry as it leads their firms to reinvest the spoils of market power back into the company.


Grullon, G., Larkin, Y. and Michaely, R. (2018) “Are US industries becoming more concentrated?” Review of Finance (forthcoming)

Gutiérrez, G. and Philippon, T. (2017) “Declining competition and investment in the US.” Unpublished Working Paper, National Bureau of Economic Research.

Kahle, K.M. and Stulz, R.M. (2017) “Is the US public corporation in trouble?” Journal of Economic Perspectives 31: 67–88

[1] Gutiérrez and Philippon (2017) and Kahle and Stulz (2017) also document evidence confirming the recent trend in rising US industry concentration.

[2] The standard legal definition of reverse engineering in the US is described as “starting with the known product and working backward to divine the process which aided in its development or manufacture.”