Favouring Dynamic Competition over Static Competition in Antitrust Law

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Favouring Dynamic Competition over Static Competition in Antitrust Law[1]

J GREGORY SIDAK AND DAVID TEECE

I. Introduction

In 1988, in anticipation of the centennial of the Sherman Act, David J Teece and his Berkeley colleagues held a conference that led to the 1992 volume Antitrust, Innovation, and Competitiveness, with contributions from many of the day’s leading scholars in antitrust law and economics.[2] The conference was designed to alert the law and economics community to a set of emerging issues on antitrust and innovation. In hindsight, we believe that the conference was a watershed event. A slow and reluctant awakening to antitrust and innovation issues is now well underway.

In the introduction to the proceedings of the conference, Thomas Jorde and David Teece, as editors, endeavoured to reframe antitrust questions. The issue, they asserted, was that scholars and practitioners needed to take a more dynamic approach to competition in the spirit of Joseph Schumpeter:

As Schumpeter (1942) suggested…, the kind of competition embedded in standard microeconomic analysis may not be the kind of competition that really matters if enhancing economic welfare is the goal of antitrust. Rather, it is dynamic competition propelled by the introduction of new products and new processes that really counts. If the antitrust laws were more concerned with promoting dynamic rather than static competition, which we believe they should, we expect that they would look somewhat different from the laws we have today.[3]

Jorde and Teece posed the provocative hypothesis that ‘antitrust laws may be at odds with technological progress and economic welfare’.[4] In three subsequent articles, Teece and his co-authors made efforts to advance the Schumpeterian agenda.[5]

The Horizontal Merger Guidelines (‘the Merger Guidelines’)[6] are the intellectual cornerstone of modern antitrust law, yet they contain little discussion of innovation or dynamic competition. Since the mid-1990s, however, the intellectual winds have slowly begun to change. A milestone in that progression was the publication of an article by Michael L Katz and Howard A Shelanski in 2005 entitled, ‘“Schumpeterian” Competition and Antitrust Policy in High-Tech Markets’.[7] Antitrust scholars now actively debate the merits of replacing static competition with dynamic competition in antitrust analysis.[8] Moreover, the Federal Trade Commission (FTC) and Department of Justice (DOJ) staff and FTC commissioners also now profess that innovation is important to competition. The agencies promulgated the Intellectual Property Guidelines in 1995 to allow firms more confidence in exercising their intellectual property rights (IPRs),[9] and the Joint Venture Guidelines[10] in 2000 to outline acceptable forms of cooperation among competitors.

Although the guidelines of the antitrust enforcement agencies do not constitute law merely by virtue of their promulgation by the agencies, the courts previously have accepted the revised principles that the agencies have advocated. By embracing the reasoning in the Merger Guidelines promulgated several decades ago by the Antitrust Division and the FTC, the federal courts have caused antitrust case law to ossify around a decidedly static view of antitrust. Put differently, in the years since 1980, the Division and the FTC have successfully persuaded the courts to adopt a more explicitly economic approach to merger analysis, yet one that has a static view of competition. The result is not a mere policy preference. It is law. To change that law to have a more dynamic view of competition will therefore require a sustained intellectual effort by the enforcement agencies (as well as by scholars and practitioners) that, once more, engages the courts to re-examine antitrust law as they did in the late 1970s during the ascendancy of the Chicago School, when antitrust law became infused with its current, static understanding of competition. It appears that, before the Obama Administration took office, the Antitrust Division was attempting to incorporate more dynamic analysis, but the result was inconsistent across different mergers and different doctrinal areas of antitrust law. A necessary but not sufficient condition for infusing antitrust analysis with a dynamic competition perspective is a public process by which the Division and the FTC revisit and restate the Merger Guidelines in a manner that explicitly clarifies and defends the role of dynamic competition. We therefore applaud the announcement of the antitrust agencies in September 2009 to solicit public comment on the possibility of updating the Merger Guidelines.[11] Assuming that the Division and the FTC decide to revise the existing Merger Guidelines, those revised guidelines (and useful complementary undertakings, such as generalised guidelines on market power and remedies) will then require leadership by the enforcement agencies to persuade the courts that antitrust doctrine should evolve accordingly. That neo-Schumpeterian process may take a decade or longer to accomplish, but it is a path that we believe the Roberts Court is willing to travel.

II. Economic Theory and the Structuralist Tradition

Economists have long debated the significance of market structure on various indicia of economic performance, including innovation. As recently as September 2009, for example, the FTC and the Antitrust Division asked whether the Merger Guidelines should ‘be updated to address more explicitly…the effects of mergers on innovation’.[12] This assertion of the direction of causation seems to presuppose the relationship between market structure and innovation. Does market structure—and, thus, a merger that contributes to a particular change in market structure from the status quo—determine the level and nature of innovation in a market? Why might we doubt, as a matter of economic theory, that market structure determines innovation? Does a firm’s market share provide a reliable proxy for the firm’s ability to capture the returns to innovation? Does causation run in the opposite direction, such that innovation determines market structure? Does a failure to evaluate market share and market power in this dynamic context help to explain why evidence of the efficacy of antitrust intervention (in terms of advancing consumer welfare) is both hard to document and a source of bitter dispute among antitrust economists?

A. Static Efficiency and the Disputed Efficacy of Antitrust Intervention

We remain bereft of evidence that antitrust intervention has benefited the consumer. Robert W Crandall and Clifford M Winston of the Brookings Institution ‘find little empirical evidence that past interventions have provided much direct benefit to consumers’.[13] They cite, as one of the causes of this unfortunate state of affairs, the ‘substantial and growing challenges of formulating and implementing effective antitrust policies in a new economy characterized by dynamic competition, rapid technological change, and important intellectual property’.[14]

The lack of compelling evidence indicating that antitrust has benefited consumers is a matter of concern and motivates our inquiry here. Our working hypothesis is that using static analysis to address antitrust issues in a dynamic economy is unlikely to improve consumer welfare and that a more dynamic analytical framework increases the likelihood of helping rather than hurting consumers. The problem may be that (1) static analysis still permeates much of economic theory; (2) the community of antitrust practitioners seems unaware of a substantial literature, much of it now quite robust, on evolutionary theory and the economic, organisational, behavioural, and strategic management foundations of innovation; or (3) although this new literature has generated useful general descriptions of market and organisational behaviour, those descriptions have only recently caught the attention of antitrust scholars. Due to this recent awareness, (4) the enforcement agencies are not confident about discarding conventional wisdom, despite that fact that many within the agencies know that much of that conventional wisdom is deeply discredited. Consequently, (5) the agencies sometimes strike the pose, not very convincingly, that existing statements of enforcement policy are living documents—sufficiently supple and far-sighted that they already embody dynamic analysis. Some at the enforcement agencies may subscribe to a hagiographic reverence toward the Merger Guidelines; others may see this position as an expedient justification for the maximisation of agency discretion. Alternatively, (6) one hears that the antitrust analysis of dynamic industries (formerly called the ‘new economy’, before that label became cliché) is no different from the antitrust analysis of less dynamic, ‘smokestack’ industries undergoing slower rates of technological innovation.[15]

This chapter explains why static analysis appears to dominate, even though thoughtful policy makers are aware of dynamic competition. Unfortunately, policy makers are left wielding static analysis in part because of an incorrect perception that scholars have not yet filled the intellectual void. Indeed, until that perception changes, antitrust analysis is not likely to improve. Indeed, Judge Richard A Posner has observed that ‘antitrust doctrine has changed more or less in tandem with changes in economic theory, albeit with a lag’.[16] If scholars do not embrace the now-robust behavioural and evolutionary approaches, antitrust economists will miss an opportunity to analyse dynamic considerations properly. They also risk doing consumers more harm than good.

B. Market Structure as a Determinant of Innovation

Unfortunately, many economists are stuck in a well-travelled and largely irrelevant debate, now a half century old, as to what form of market structure favours innovation. They label this topic the ‘Schumpeterian’ debate. Regrettably, this nomenclature is all that many have absorbed from the rich work of Joseph Schumpeter, the Austrian School, and the extensive developments in behavioural and evolutionary economics. This so-called Schumpeterian debate casts Schumpeter excessively narrowly and is not of much interest anymore. That debate, however, can still bog down discussions about competition policy and innovation.

A more careful reading of Schumpeter reveals at least three Schumpeterian propositions relevant to antitrust policy. (The first two are discussed in this section, the third in the next.) The first proposition relates to the impact of market structure on innovation. On this topic, Schumpeter himself articulated conflicting and inconsistent perspectives. In The Theory of Economic Development, first published when Schumpeter was only 28-years-old, he spoke in 1911 of the virtues of competition fuelled by entrepreneurs and small enterprises.[17] By the time Schumpeter, at the age of 59, published Capitalism, Socialism, and Democracy in 1942, his revised (second) proposition was that large firms with monopoly power are necessary to support innovation.[18] That transformation no doubt partly reflected the dramatic change that had occurred with respect to the principal sources of innovation in the American economy. So, with respect to the impact of market structure on innovation, Schumpeter seems to have maintained two almost diametrically opposite positions. We call his first position Schumpeter I and the second position Schumpeter II. If the popular celebration of new products coming from Silicon Valley is any indicator of informed opinion, Schumpeter I is perhaps more appealing today than Schumpeter II. Indeed, we believe that the debate over whether to favour competition over monopoly (as the market structure most likely to advance innovation) was won long ago in favour of some form of rivalry or competition.

Schumpeter was among the first to declare that perfect competition was incompatible with innovation. He noted that ‘[t]he introduction of new methods of production and new commodities is hardly conceivable with perfect—and perfectly prompt—competition from the start. And this means that the bulk of what we call economic progress is incompatible with it.’[19] However, the later Schumpeterian notion that small entrepreneurial firms lack financial resources also seems at odds with his earlier views and seems archaic in today’s circumstances where the funding of enterprises through venture capital plays such a large role in innovation. The new issues (stock) market has itself funded early stage biotech and internet companies with minimal revenues and negative earnings.

The fact that perfect competition is inconsistent with innovation does not necessarily mean that monopoly is a requirement. Schumpeter himself recognised, as we do, the importance of pluralism and rivalry in the economic system. However, one need not define rivalry as occurring inside some tightly circumscribed ‘antitrust market’ containing only existing competitors, with their capabilities proxied by existing market shares. Moreover, numerous variables complicate any simple relationship between the generation of monopolistic rents and the allocation of resources to develop new products and processes. We examine some of those variables below. The line of causation that is most commonly discussed in the industrial organisation literature runs only from competition to innovation. Reflecting this, the FTC said on the opening page of its report on innovation in 2003, ‘competition can stimulate innovation.’[20] ‘Competition amongst firms’, the agency reasoned, ‘can spur the invention of new or better products or more efficient processes’.[21] Although these statements are undoubtedly correct, they do not recognise that innovation may affect competition and market structure. Nor do they suggest what type of market structure is desirable. These statements suggest only that competition can drive innovation.

Despite 50 years of research, economists do not appear to have found much evidence that market concentration has a statistically significant impact on innovation. This relationship probably is not a useful framing of the problem, because market concentration alone is neither theoretically nor empirically a major determinant of innovation. In short, framing competition issues in terms of monopoly versus competition appears to have been unhelpful. At a minimum, doing so has been inconclusive. Rivalry matters, but market concentration does not necessarily determine rivalry. The empirical evidence is still murky. In a review of the literature published in 1989, Wesley M Cohen and Richard C Levin found that a strong linkage does not exist between market concentration and innovation.[22] The endogeneity of market structure is perhaps one reason that we have yet to find a robust statistical relationship between concentration and innovation. In addition, no significant relationship exists between market concentration and profitability. Paul L Joskow argued, in 1975, that ‘we have spent too much time calculating too many kinds of concentration ratios and running too many regressions of these against profit figures of questionable validity’.[23]

Some industrial organisation theories suggest that innovation is bound to decline with increasing competition, because the monopoly rents for new entrants will decline with increasing competition.[24] In contrast, Kenneth J Arrow has hypothesised a positive relationship between competition and innovation.[25] However, Arrow sets aside the appropriability problem (that is, how to capture value from innovation) and posits a perfect property right in the information underlying a specific production technique. One can perhaps interpret Arrow’s posited property right as a clearly specified and costlessly enforceable patent of infinite duration. His principal focus is on how the (pre-invention) structure of the output market affects the gain from invention. Competition prevails because output is greater under competition than monopoly. Hence, a given amount of reduction in unit costs is more valuable if the market is initially competitive. Protected by a perfect patent, the inventor simply licenses the invention at a price slightly below the cost saving that the invention makes possible. Put differently, competition will prevail and advance innovation when the business environment is characterised by what Teece elsewhere has called a ‘strong appropriability regime’.[26] Absent strong appropriability, the presumption that perfect competition is superior to alternative arrangements cannot be built on Arrow’s analysis. In fact, it is important to note that despite how Arrow’s article is usually interpreted (to claim that competition spurs innovation), his general position in his writings is, much like Schumpeter, that competitive markets provide inadequate incentives for firms to innovate.

As Sidney G Winter observes, Arrow’s analysis also sidesteps business model choices.[27] The producer and the inventor are the same. Of course, one must also recognise that business model innovation is important to economic welfare, just as technological innovation is. However, neither the theoretical nor the empirical literature in economics seems to address whether market structure is important to business model innovation.

Historical and comparative evidence suggests that competition and rivalry are important for innovation; but few believe that the world of perfect competition (in which firms compete in highly fragmented markets using identical non-proprietary technologies) is an organisational arrangement that any advanced economy would aspire to create. Nevertheless, many policy debates proceed on the assumption that highly fragmented markets assist innovation. Although rivalry and competition are important to innovation, belief in the virtues of perfectly competitive systems reflects casual empiricism and prejudice rather than careful theorising and empirical study. One can say the same for belief in the virtues of monopoly.

To summarise, the basic framework employed in discussions about innovation, technology policy, and competition policy is often remarkably naïve, highly incomplete, and burdened by a myopic focus on market structure as the key determinant of innovation. Indeed, it is common to find a debate about innovation policy amongst economists, collapsing into a rather narrow discussion of the relative virtues of competition and monopoly, as if they were the main determinants of innovation. Clearly, much more is at work. In subsequent sections, we identify various dimensions of internal firm structure and management that influence the rate and direction of innovation.

C. Why is a Nexus between Market Structure and Innovation Unlikely to Exist?

Why might no nexus exist between market structure and innovation? Consider, first, single-product firms. The notion that the funding of innovation requires the cash flows generated by the exercise of monopoly power assumes both that (1) capital markets are inefficient, and (2) the difference between competitive and monopolistic levels of internal cash flows are sufficient to justify research and development (R&D) programmes that would otherwise lie fallow. However, if capital markets are operating according to what Eugene Fama has called strong-form efficiency,[28] then actual cash flows need not be the source of funding. Firms with high-yield projects will be able to signal their profit opportunities to the capital market, and the requisite financial resources should be drawn forth on competitive terms. Thus, if there is strong-form efficiency and zero transaction costs (its corollary), cash should get matched to projects whether or not the cash is internally generated. Even if one were not to assume strong-form market efficiency, cash can be generated by mechanisms other than the sale of current products. Any source of cash flow can be used to invest in R&D in established enterprises, if management decides to do so. Put differently, cash is fungible inside the corporation.

Of course, the world is not properly characterised by zero transaction costs and strong-form capital market efficiency; but the absence of those stylised conditions does not imply that the availability of internal cash flows from monopoly (as compared to competitive) product market positions is what makes the difference between a firm being able to fund and not being able to fund development projects for new products or processes. Significant innovative efforts almost always involve expenditures in a particular year that may be many multiples of available cash flows. So the availability of marginally higher cash flows occasioned by monopoly power is unlikely to change the sources of funds very much, except in unusual circumstances. Furthermore, even in the absence of adequate internal cash flow, firms may access the capital markets to obtain the requisite financing.

It is also the case that product development goals can be accomplished by a myriad of collaborative organisational arrangements, including research joint ventures, co-production, and co-marketing agreements. With such arrangements, there is the possibility that the innovator’s capital requirements for a new project could be drastically reduced.[29] This possibility suggests that inter firm arrangements can harness economies of scale and scope.[30]

Any link between market power and innovation in specific markets is further unshackled if the multidivisional multiproduct firm (rather than the single-product firm) is admitted onto the economic landscape. The multiproduct structure allows the allocation of cash generated everywhere to be directed to high-yield purposes anywhere inside the firm. If a multidivisional multiproduct firm actually operates this way, then the link between market power in a particular market and the funding of innovation in that market collapses.

Put differently, if a multiproduct firm sells products in markets A to Z, then the cash generated by virtue of any market power in market A can fund innovation relevant to market A; but that cash can equally well fund innovative activity for products in market Z. The fungibility of cash inside the multiproduct firm thus unlocks any causal relationship between market structure and innovation. Clearly, Schumpeter’s hypothesis is not robust in the presence of multiproduct firms.

Another stream of research implicitly attacks the foundations of the Schumpeterian hypothesis. Since the late 1980s, Michael C Jensen has initiated a provocative body of scholarship in corporate finance that argues that, for firms to operate efficiently, free cash flow ought to be distributed to shareholders rather than be invested internally in discretionary projects.[31] Jensen’s basic insight is that the discipline of debt is needed to cause capital to be channelled to high-yield uses in the economy, as well as in the firm. The implicit assumption is that the principal-agent problem is so great that managers will fritter away shareholders’ money on unprofitable new projects and products. Accordingly, leveraging the corporation with debt will benefit shareholders—not only because of the tax deductibility of interest, but also because of avoidance of the principal-agent problem that Jensen believes exists if managers are left with cash to reinvest.

There are severe problems with Jensen’s thesis, not least of which is that debt holders are generally loss averse and not opportunity-driven. Although it may indeed be the case that free cash flows do sometimes get misallocated by managers, to restrict management access to free cash flow by burdening the enterprise with high debt levels will suffocate R&D, force the firm into equity markets to finance innovation, or both. This effect is not always desirable because the new issues markets, both public and private, are relatively expensive sources of new capital and may not be ‘open’ when needed to develop products to hit particular market ‘windows’. However, as a positive rather than normative matter, to the extent that Jensen’s thesis is correct and boards do encourage firms to load up with debt, then Schumpeterian mechanisms will be blunted by financial structure.

To summarise, innovation is risky and costly, and it clearly requires access to capital. On this point we agree with Schumpeter. The necessary capital can come from cash flows or from equity (private or public) or from debt financing. However, at least with respect to early-stage activity, debt financing is unlikely to be viable, unless the firm has other assets to pledge.[32] Nevertheless, certain downstream investments needed to commercialise innovation can be debt financed if they are redeployable. Alternatively, the firm can enter into alliances that reduce the need for new investment in complementary assets.

In short, many factors besides firm size and the presence or absence of market power affect an innovator’s capacity to access capital.[33] The firm’s financial structure and its multiproduct scope break any simple ex ante nexus between market structure and innovation. Hence, at least in today’s world of reasonably well developed venture capital and financial markets, we see no a priori reason to expect that circumstances will validate the Schumpeterian hypothesis.

D. Why Market Share is a Poor Proxy for Appropriability

As we discussed above, Schumpeter also developed the thesis that large firms were necessary for innovation. In his view, large firms not only routinised the innovation process, but also developed market power, which generated the high profits necessary for innovators to appropriate sufficient returns to justify the risks associated with investing in R&D.

In the preceding sections we explained why no a priori basis exists to expect there to be a nexus between R&D investment and market share—at least with respect to the large multiproduct firm and firms that have access to venture capital and other sources of cash flow not internally generated. In this section, we elaborate why Schumpeter’s appropriability theory, in which high market share is necessary to enable the innovator to appropriate (capture) value from innovation, is misguided. We examine the key elements of appropriability and show that market share and market power are not the key to appropriability and stimulating R&D. In fact, high market share may have the opposite effect. The fear of cannibalising one’s own market share (which might be called ‘anti-cannibalism’) might actually dampen or thwart innovation if the new product or innovation displaces sales and profits at a higher rate for the incumbent than for competitors and new entrants.

As already noted, the Schumpeterian thesis is implicitly an appropriability thesis, at least in part. Schumpeter argued that a firm needs market power to enable it to capture sufficient profit to justify the costs and risks of investment in innovative activity. We agree that investors need an adequate return for their investment in risky R&D. However, capturing high market share in a product market and pricing above some hypothetical competitive level is not the only business model available for profiting from innovation.

Elsewhere, Teece has suggested that the two most important factors conditioning appropriability (of the returns from innovation) are not high market share but the efficacy of legal mechanisms of protection (that is, intellectual property) and the nature of the new knowledge that has been created.[34] The ownership of complementary assets also helps govern returns from innovation. Market power is likely to be a second-order factor relative to these considerations. It is as much a result as a cause of innovative activity.

Winter observes that Teece’s profiting-from-innovation thesis represents a logical progression from the Schumpeterian thesis.[35] We now outline the elements of this post-Schumpeterian approach.

Consider intellectual property, particularly patents. Patents can be used to exclude competitors and generate profits, even if the firm has low market share. Patents work through technology markets; dominance in a technology market may or may not lead to exclusion from a product market. This distinction provides yet another reason why the Schumpeterian thesis connecting market concentration and market power to innovation is flawed.

Moreover, it is well known that patents do not work in practice as they do in theory. Rarely, if ever, do patents confer perfect appropriability, although they do afford considerable protection in some instances, such as with new chemical products and rather simple mechanical inventions.[36] It is often the case that rivals can ‘invent around’ many patents at modest costs.[37] In fact, one experienced patent law practitioner we know claims that he can ‘invent on demand’ by writing a patent application for a client that can invent around any existing patent. Even if our friend is mildly boasting, his comment underscores that patents are often ineffective at protecting innovation. Often patents provide little protection because the legal and financial requirements for upholding their validity or for proving their infringement are high, and they are narrow because prior art is substantial in fields where there is rich innovation.

One must also recognise that the degree of legal protection that a firm enjoys is not necessarily an exogenous attribute. The inventor’s own intellectual property strategy itself enters the equation. So does the fundamental nature (or lack thereof) of the invention. The inventor of core technology not only can seek to patent the invention, but can also seek complementary patents on new features or manufacturing processes (or both) and possibly on designs. The way that a patent counsel writes the claims in the patent application also matters. Of course, the more fundamental the invention, the higher the probability that a broad patent will be granted and granted in multiple jurisdictions around the world.

Exclusionary rights are not fully secured by the mere issuance of a patent, of course. Although a patent is presumed to be valid in many jurisdictions, validity is never firmly established until a patent has been upheld in court. A patent is merely a passport to another journey down the road to enforcement and possible licensing fees. The best patents are broad in scope, have already been upheld in court, and cover a technology essential to the manufacture and sale of products in high demand.

In some industries, particularly where the innovation is embedded in processes, trade secrets are a viable alternative to patents. Trade secret protection is possible, however, only if a firm can put its product before the public and still keep the underlying technology secret. Usually, only chemical formulas and industrial-commercial processes can be protected as trade secrets after the products embodying them are released to the public. And, of course, the filing of a patent application constitutes public disclosure of the trade secret and consequently forfeits protection under state trade secret law regardless of whether a valid patent subsequently issues under federal law.

The degree to which knowledge about an innovation is tacit or easily codified also affects the ease of imitation, and hence appropriability. Tacit knowledge is, by definition, difficult to articulate. Consequently, it is hard to transfer to others unless those who possess the know-how can demonstrate it to others. It is also hard to protect tacit knowledge using intellectual property law. Codified knowledge is easier to transmit and receive, and it is more exposed to industrial espionage. On the other hand, codified knowledge is often easier to protect using the instruments of intellectual property law.

At the risk of grave oversimplifications, one can divide appropriability regimes into ‘weak’ regimes (innovations are difficult to protect because they can be easily codified and legal protection of intellectual property is ineffective) and ‘strong’ regimes (the profits from invention/innovation can be protected because knowledge about the invention/innovation is tacit or they are well protected legally, or both). Despite recent efforts to strengthen the protection of intellectual property, strong appropriability is the exception rather than the rule. This state of affairs has been so for centuries, and it will never be substantially different in democratic societies, where individuals and ideas move with little governmental interference, and where intellectual property protection is inherently limited.

Implicitly, then, appropriability need not depend on market share or market power in product markets. In this article, we do not endeavour to analyse technology markets, but we do note that the ‘Schumpeterian thesis’, as it has come to be known, references product markets, not technology markets. Because overlaps between technology markets and product technology markets are loose, it is easy to see that the Schumpeterian thesis is flawed on this account alone. Clearly, appropriability for a particular innovation depends on more microanalytic factors than Schumpeter and the subsequent mainstream industrial economics literature have recognised.

Besides the appropriability regime itself, there is yet another class of factors that determines the returns to the innovator. Those factors are complementary assets. Ownership of complementary assets affects returns to innovation even though they are outside the appropriability regime that we define here.[38]

Notably, Schumpeter overlooked complements and complementary assets. He stressed how ‘gales of creative destruction’ could overturn the existing order.[39] The new would drive out the old. Substitution was the primary consequence of Schumpeterian innovation. Schumpeter’s single-minded emphasis on substitution is too narrow, as it ignores complements. Innovation can enhance the value of complements. There are several reasons for this result.

First, as stressed by Teece,[40] innovation is rarely sold (licensed) in disembodied form. To be useful, and to generate a revenue stream, inventions must become embedded in products. To produce and sell products, one usually needs to employ complements. At the most general level, the importance of complementary technologies and complementary assets has been recognised by historians for a long time.[41] The complementarity of factor inputs has been part of the theory of production since the writings of Adam Smith, Augustin Cournot, and David Ricardo. However, it is only relatively recently, after the topic has been embedded in a contracting framework,[42] that the nature and role of complementary assets in the theory of innovation has become better understood.

Once a contracting framework is adopted, it is a small step to recognise that (1) the asset value of complements may rise if the overall demand for complements is enhanced by innovation and (2) if in fact the innovation and the complement are co-specialised to each other, and if the co-specialised asset is not under the control of the innovator, then rents (profits) can be extracted from the innovator by the owner of the co-specialised asset.[43] Complementors are especially important in a multi-sided market, which we will discuss later in the context of antitrust intervention.

E. Innovation as a Determinant of Market Structure

Despite evident theoretical flaws in the Schumpeterian market structure-innovation hypothesis, the received wisdom and dominant logic in industrial organisation studies remain that market structure is the main determinant of innovation. A less familiar logic—but in our view, a far more convincing and empirically supportable logic—runs the other way: innovation shapes market structure. At a general level, the argument was first articulated by Almarin Phillips in his study of the evolution of the civilian aircraft industry.[44]

Phillips’ field research led him to conclude that developments in jet engine technology available in the United Kingdom and Germany immediately after World War II were largely exogenous to the development activity in US industry. Boeing and Douglas and other companies in the United States successfully used these technologies to develop the civilian jet aircraft. Domestic market structure did not drive these decisions and developments. Market outcomes in the United States were then very much affected by how and when Boeing, McDonnell, Douglas, Lockheed, and others decided to tap into a largely external reservoir of technological know-how available in the United States, United Kingdom, and Germany.

Boeing did so quickly and successfully. It leveraged its success with the KC-130 jet tanker that it built for the US Air Force into a civilian version, the Boeing 707. Boeing captured the lead in market share globally with this airplane. It maintained its lead until the emergence and growth of Airbus. Philips’ historical analysis led him to conclude that

an important influence on market structures and on research and development programs and innovative behavior of firms stems from the presence or absence of related technological and scientific changes which occur for reasons generally exogenous to market phenomena and the goals of the particular firm.[45]

Studies find that various types of externally shaped and externally funded technological regimes exist.[46] For example, university-funded and government-funded research in science and technology has created vibrant technological environments that fuel venture-funded new businesses. Biotech is a case where US government funds distributed through the National Institutes of Health have helped to create technological opportunities that are then seized upon and developed further by new venture-funded startups.[47] Although most of these companies fail, enough survive to influence the structure of the pharmaceutical industry.

The concept of technological opportunity, although poorly developed in economics, has been used as a surrogate for issues associated with an industry’s external reservoir of know-how and ferment in the underlying technological base. However, technological opportunity is a remarkably passive concept that needs further explication. Nelson and Winter claim that knowledge and opportunity are determined by the underlying ‘technological regime’, and that regimes differ from industry to industry.[48] How and why some firms tap into technological opportunities remains enigmatic. Economic theory—or any other theory, for that matter—poorly explains the microanalytics of these decisions.

The importance of new entrants to innovation is consistent with the importance of ‘exogenous factors’—factors outside the market or even the industry. It is well established that new entrants have been responsible for a substantial share of revolutionary new products and processes. They include the jet engine (Whittle in England, Henkel and Junkers in Germany), catalytic cracking in petroleum refining (Houdry), the electric typewriter (IBM), electronic computing (IBM), electrostatic copying (Haloid), PTFE vascular grafts (WL Gore), the microwave oven (Raytheon), and diet cola (RC Cola). These anecdotes and other evidence further erode any connection between market structure and innovation, which further suggests that (1) incumbency and market share or market power is by no means a prerequisite for innovation and (2) no particular firm size is conducive to technological progress.

In summary, with exogenous factors including technological opportunity playing such a large role, one can readily understand and agree with John Sutton’s characterisation that ‘there appears to be no consensus as to the form of relationship, if any, between R&D intensity and concentration’.[49] As already noted, Wesley Cohen’s and Richard Levin’s authoritative study in the Handbook of Industrial Organization likewise concluded that the evidence on the market structure-innovation nexus was mixed.[50] Once one includes control variables, the partial correlation between R&D intensity and concentration is extremely weak.

Sutton speculates that a ‘bounds issue’[51] may exist—that is, the relationship between market structure and innovation might well exist in some narrowly circumscribed set of bounds. However, even if Sutton’s conjecture is true, it suggests that market concentration may not be particularly helpful in understanding innovation and its determinants. Furthermore, game-theoretic models are unlikely to provide much insight and, to the contrary, may in fact prove empirically empty.[52]

F. Summary and Recapitulation

For almost three-quarters of a century, economists have devoted much effort (we would say too much effort) to exploring relationships between market structure and innovation. One hypothesis, often attributed to Schumpeter,[53] is that profits accumulated through the exercise of monopoly power (assumed to be correlated with large firms) are a key source of funds to support risky and costly innovative activity. As discussed, these predictions as a matter of economic theory are not well grounded in the nature of the (modern) firm.[54]

Nor is there good theory to suggest, alternatively, that perfect competition is the ideal regime. As discussed later, many other factors are at work, particularly factors that are internal to firms. So on a priori grounds one would not expect any relationships between market structure and innovation to be strong. Indeed, the evidence indicates at best a weak effect. Also, as already discussed, causation is more likely to run in the opposite direction, from innovation to market structure.[55]

More formal theoretical modeling on market structure has likewise provided little insight. The industrial organisation textbook by Frederick M Scherer and David Ross has noted that ‘through astute choice of assumptions, virtually any market structure can be shown to have superior innovative qualities’ and ‘to avoid biased inferences, it is necessary to take into account variables other than market structure that affect the pace of innovation’.[56] Interestingly, the main independent variable to which many scholars, including Scherer and Ross, gravitate is technological opportunity—‘the rate at which more or less exogenous and cumulative advances in science and technology generate profitable new innovative possibilities’[57] Scherer and Ross further note that ‘the structure-to-innovation linkage probably operated over a much shorter time span than the innovation-to-structure linkage’.[58] This second linkage is expected to be stronger in industries with rich technological opportunities. The idea is that concentration is more conducive to innovation in slow-moving fields. That is, technological opportunity, often manifested by radical breakthroughs, favours newcomers, not incumbents. These refinements seem plausible. However, perhaps the biggest reason why three-quarters of a century of scholarly work has failed is that the various economic theories of innovation pay very little attention to factors inside the firm. We commence an effort to remedy that situation in subsequent sections. Accordingly, we find ourselves not in agreement with Schumpeter, that monopoly power is necessary for innovation. So long as rivalry is maintained, it may help; but other factors are likely to be more important. However, as we explain in the next section, there is a third Schumpeterian hypothesis with which we agree.

III. Static Competition and Dynamic Competition

As we discussed above, a third proposition is embedded in Schumpeter. Usually overlooked, but very important, and one with which we agree, it is that dynamic competition should be favoured over its weaker cousin, static competition. Schumpeter observed that

[t]his kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff.[59]

We will describe both static competition and dynamic competition in turn. In doing so, we recognise that sometimes these styles of competition do not have bright lines separating them. Certainly, Schumpeter did not provide any crisp delineation.

We attempt to give some substance to Schumpeter’s intuition. Unfortunately, antitrust economists often unwittingly favour static competition. They are often unaware that there are many ways to conceptualise competition. Dynamic competition is a style of competition that relies on innovation to produce new products and processes and concomitant price reductions of substantial magnitude. Such competition improves productivity, the availability of new goods and services, and, more generally, consumer welfare. Promoting dynamic competition may well mean recognising that competitive conduct may involve holding short-run price competition in abeyance. For example, the argument against generic ‘me-too’ drugs may be of this kind; generics may lower prices for existing drugs, but they may slow the development of new drugs, yielding a classic trade-off between static efficiency and dynamic efficiency.

Put succinctly, competition policy rooted in static economic analysis sees the policy goal as minimising the Harberger (deadweight loss) triangles from monopoly. A new competition policy, recognising the special power of dynamic competition, would advance the availability of new products and the co-creation of new markets that allows latent demand (and hence new amounts of consumer surplus associated with new demand curves) to be realised by consumers. It would also recognise cost savings flowing from innovation as an indicator of likely future consumer welfare gains. Put differently, the focus of a revised competition policy and merger-guideline framework would still very much be on the consumer, but it would be future-oriented and would recognise that certain business practices might lead to market creation (or at least co-creation) that would yield new demand curves with large gains in consumer surplus (because demand for new products could be satisfied). The minimisation of Harberger deadweight loss triangles would be a secondary focus. Where minimising Harberger triangles today stands in the way of creating new and significant future demand curves, a new competition policy would likely favour the future and recognise the welfare benefits associated with creating or co-creating new markets.

Economists do not embrace the concept of dynamic competition as widely or as wisely as they should, partly because the overwhelming focus in economic research is implicitly inside the marginalist paradigm of static competition. Indeed, a major contribution can come from simply revealing to judges, juries, the enforcement agencies, and legislators that most economic analysis is static—when it should be dynamic—and that, consequently, superficial answers derived from implicitly held static notions about desirable forms of competition may well harm innovation and, in the long run, consumers. This bias stems merely from the analytical tools that economists use for their convenience. Although most economists recognise the importance of innovation, they usually proceed to apply analytical approaches that ignore it or are ill-suited to studying it. Recognising that this state of affairs exists should deflate the hubris with which many antitrust scholars approach alleged restraints of trade. To the extent that they wield analytical tools of static competitive analysis, antitrust analysts are likely to make prescriptions that harm both innovation and competition and thus sap productivity. Needless to say, such prescriptions are likely to harm consumer welfare as well.

To develop policy prescriptions that do more good than harm, economists and antitrust scholars and practitioners need to inquire into the determinants of innovation and the impact of antitrust activity (including merger policy) on innovation. Rapid technological change advances dynamic competition. The problem is that the analytical framework that economists most commonly embrace adheres stubbornly to the view that market structure—and little else—determines the rate of technological change. As already discussed, that framework is grossly inadequate and cannot be supported.

For instance, in merger analysis, as in many forms of antitrust analysis under the rule of reason, one is required to define a market and examine market shares. If a merger would raise concentration above an accepted threshold, the Government may block it. Merger analysis usually proceeds this way, even though a growing number of economists are beginning to think otherwise, particularly in the context of differentiated products. In such cases, that emerging consensus seems to be that the particular firms that one is examining are what matters.

More often than not, however, avid antitrust economists allow the concept of static competition to guide their analysis. Because of its familiarity and simplicity, they inappropriately use the apparatus of static microeconomics to analyse contexts where innovation is important. Innovation is at best an afterthought in static microeconomic theory. The presence of innovation complicates economic analysis. It destroys equilibrium, thereby debasing the value and usefulness of the familiar toolkit that most economists carry. It leads to indivisibilities, rendering marginal analysis of limited value. It generates spillovers and raises ‘appropriability’ and ‘public good’ issues. For these and other reasons, the profession tends to resist abandoning the old tools of neoclassical economics. Economists shun dynamic analysis either because they do not understand that framework or because they fear that recognising it will be excessively hostile to well-accepted and well-practiced analytical frameworks. We contend that advocates of competition policy should not accept this state of affairs any longer. We therefore applaud the FTC and the Antitrust Division for asking whether the Merger Guidelines ‘[s]hould…be revised to explain more fully than in the current [version] how market shares and market concentration are measured and interpreted in dynamic markets, including markets experiencing significant technological change’.[60]

Dynamic competition is powered by the creation and commercialisation of new products, new processes, and new business models. As Schumpeter said, competition fuelled by the introduction of new products and processes is the more powerful form of competition:

competition from the new commodity, the new technology, the new source of supply, the new type of organization—competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the output of existing firms, but at their foundations and their very lives.[61]

Advocates of strong competition policy must surely favour dynamic competition, for static competition is anemic in comparison. However, by unwittingly using static microeconomic theory, advocates of strong competition policy end up settling for less competition and lower consumer welfare than they would get if they developed policies to favour the dynamic genre. In what follows, we elaborate in more detail upon some of the differences between these modes of competition.

A. Static Competition

Static competition reflects an intellectual framework, less so a state of the world. Static competition manifests itself in the form of multiple providers of existing products offered at low prices, offering an unchanging menu of unimproved products at very good prices. When firms introduce no new products, rapid price reductions driven by innovation do not occur. The constant churn of customers will be commonplace, and profits will be thin. However, fierce competition associated with the introduction of new products, or new features, or new pricing approaches does not exist. Without innovation, all firms have the same technology and the same business models. Markets are in a comfortable but bland equilibrium.