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Nicolas Petit is Professor of Law at the University of Liege (Belgium) and Research Professor at the University of South Australia (UniSA)

This symposium offers a good opportunity to look again into the complex relation between concentration and innovation in antitrust policy. Whilst the details of the EC decision in Dow/Dupont remain unknown, the press release suggests that the issue of “incentives to innovate” was central to the review. Contrary to what had leaked in the antitrust press, the decision has apparently backed off from the introduction of a new “model”, and instead followed a more cautious approach. After a quick reminder of the conventional “appropriability v cannibalizationframework that drives merger analysis in innovation markets (1), I make two sets of hopefully innovative remarks on appropriability and IP rights (2) and on cannibalization in the ag-biotech sector (3).

Appropriability versus cannibalization

Antitrust economics 101 teach that mergers affect innovation incentives in two polar ways. A merger may increase innovation incentives. This occurs when the increment in power over price or output achieved through merger enhances the appropriability of the social returns to R&D. The appropriability effect of mergers is often tied to Joseph Schumpeter, who observed that the use of “protecting devices” for past investments like patent protection or trade secrecy constituted a “normal elemen[t] of rational management”. The appropriability effect can in principle be observed at firm – specific incentives – and industry – general incentives – levels, because actual or potential competitors can also use the M&A market to appropriate the payoffs of R&D investments.

But a merger may decrease innovation incentives. This happens when the increased industry position achieved through merger discourages the introduction of new products, processes or services. This is because an invention will cannibalize the merged entity profits in proportions larger as would be the case in a more competitive market structure. This idea is often tied to Kenneth Arrow who famously observed that a “preinvention monopoly power acts as a strong disincentive to further innovation”.

Schumpeter’s appropriability hypothesis and Arrow’s cannibalization theory continue to drive much of the discussion on concentration and innovation in antitrust economics. True, many efforts have been made to overcome, reconcile or bypass both views of the world. Recent studies by Carl Shapiro or Jon Baker are worth mentioning. But Schumpeter and Arrow remain sticky references in any discussion of the issue. Perhaps more than anything, the persistence of their ideas denotes that both touched a bottom point when they made their seminal contribution, laying down two systems of belief on the workings of innovation-driven markets.

Now beyond the theory, the appropriability v cannibalization gravitational models provide from the outset an appealing framework for the examination of mergers in R&D driven industries in general. From an operational perspective, the antitrust agency will attempt to understand if the transaction increases appropriability – which leans in favour of clearance – or cannibalization – which leans in favour of remediation. At the same time, however, the downside of the appropriability v cannibalization framework (and of any framework more generally) may be to oversimplify our understanding of complex phenomena. This, in turn, prompts two important observations on each branch of the framework.

Appropriability and IP rights

Any antitrust agency committed to promoting competition and innovation should consider mergers in light of the degree of appropriability afforded by existing protecting devices (essentially contracts and entitlements). This is where Intellectual Property (“IP”) rights become relevant to the discussion. In an industry with strong IP rights, the merging parties (and its rivals) may be able to appropriate the social returns to R&D without further corporate concentration. Put differently, the stronger the IP rights, the lower the incremental contribution of a merger transaction to innovation, and the higher the case for remediation.

This latter proposition, however, rests on a heavy assumption: that IP rights confer perfect appropriability. The point is, however, far from obvious. Most of us know that – and our antitrust agencies’ misgivings with other sectors confirm it – IP rights are probabilistic in nature. There is (i) no certainty that R&D investments will lead to commercially successful applications; (ii) no guarantee that IP rights will resist to invalidity proceedings in court; (iii) little safety to competition by other product applications which do not practice the IP but provide substitute functionality; and (iv) no inevitability that the environmental, toxicological and regulatory authorization rights that (often) accompany IP rights will not be cancelled when legal requirements change. Arrow himself called for caution, noting that “Patent laws would have to be unimaginably complex and subtle to permit [such] appropriation on a large scale”. A thorough inquiry into the specific industry-strength of IP rights that goes beyond patent data and statistics thus constitutes a necessary step in merger review.

But it is not a sufficient one. The proposition that strong IP rights provide appropriability is essentially valid if the observed pre-merger market situation is one where several IP owners compete on differentiated products and as a result wield a degree of market power. In contrast, the proposition is essentially invalid if the observed pre-merger market situation leans more towards the competitive equilibrium and IP owners compete at prices closer to costs. In both variants, the agency should thus look carefully at the level and evolution of prices and costs, including R&D ones, in the pre-merger industry. Moreover, in the second variant, the agency ought to consider as a favourable appropriability factor any increase of the merging entity’s power over price, but also any improvement of its power over cost. By this, I have in mind efficiency benefits, which can arise as the result of economies of scale (in manufacturing but also in R&D), but also when the transaction combines complementary technological and marketing assets. In Dow/Dupont, no efficiency argument has apparently been made by the parties, so it is difficult to understand if and how such issues have played a role in the Commission’s assessment.

Cannibalization, technological change, and drastic innovation

Arrow’s cannibalization theory – namely that a pre-invention monopoly acts as a strong disincentive to further innovation – fails to capture that successful inventions create new technology frontiers, and with them entirely novel needs that even a monopolist has an incentive to serve. This can be understood with an example taken from the ag-biotech field. It is undisputed that progress in crop protection science has led to an expanding range of resistant insects, weeds, and pathogens. This, in turn, is one (if not the main) key drivers of ag-tech research. In a 2017 paper published in Pest Management Science, Sparks and Lorsbach observe that:

resistance to agrochemicals is an ongoing driver for the development of new chemical control options, along with an increased emphasis on resistance management and how these new tools can fit into resistance management programs. Because resistance is such a key driver for the development of new agrochemicals, a highly prized attribute for a new agrochemical is a new MoA [method of action] that is ideally a new molecular target either in an existing target site (e.g., an unexploited binding site in the voltage-gated sodium channel), or new/under-utilized target site such as calcium channels.

This, and other factors, leads them to conclude that:

even with fewer companies overall involved in agrochemical discovery, innovation continues, as demonstrated by the continued introduction of new classes of agrochemicals with new MoAs.

Sparks, Hahn, and Garizi make a similar point. They stress in particular that the discovery of natural products (NPs) which are the “output of nature’s chemical laboratory” is today a main driver of crop protection research. According to them:

NPs provide very significant value in identifying new MoAs, with 60% of all agrochemical MoAs being, or could have been, defined by a NP. This information again points to the importance of NPs in agrochemical discovery, since new MoAs remain a top priority for new agrochemicals.

More generally, the point is not that Arrow’s cannibalization theory is wrong. Arrow’s work convincingly explains monopolists’ low incentives to invest in substitute invention. Instead, the point is that Arrow’s cannibalization theory is narrower than often assumed in the antitrust policy literature. Admittedly, Arrow’s cannibalization theory is relevant in industries primarily driven by a process of cumulative innovation. But it is much less helpful to understand the incentives of a monopolist in industries subject to technological change. As a result of this, the first question that should guide an antitrust agency investigation is empirical in nature: is the industry under consideration one driven by cumulative innovation, or one where technology disruption, shocks, and serendipity incentivize drastic innovation?

Note that exogenous factors beyond technological frontiers also promote drastic innovation. This point ought not to be overlooked. A sizeable amount of the specialist scientific literature stresses the powerful innovation incentives created by changing dietary habits, new diseases (e.g. the Zika virus), global population growth, and environmental challenges like climate change and weather extremes. In 2015, Jeschke noted:

In spite of the significant consolidation of the agrochemical companies, modern agricultural chemistry is vital and will have the opportunity to shape the future of agriculture by continuing to deliver further innovative integrated solutions. 

Words of wisdom caution for antitrust agencies tasked with the complex mission of reviewing mergers in the ag-biotech industry?

Since Brussels has ordered Ireland to recover 13€ billion from Apple, much ink has been spilled on the European Commission’s (EC) alleged misuse of power and breach of the “rule of law.” In the Irish Times, Professor Liza Lovdahl-Gormsen wrote that the EC has been “bending” competition law to pursue a corporate taxation agenda in disguise. Former European Commissioner Neelie Kroes went so far as to suggest that the EC was attempting to rewrite international tax rules.

Conspiracy stories sell well, all the more so when the EC administration is on display. Yet, the claim that the Apple case is not a genuine competition case is a trick often used to deride enforcement — one that papers over an old lesson of mainstream economics: that monopolists are particularly good at “acquiring” public interest legislation. Nobel Prize winner George Stigler once wrote that “the most obvious contribution that a group may seek of the government is a direct subsidy of money.”  

While this basic economic teaching is not the narrative behind the EC decision against Ireland, there are clear signs that Apple is a textbook monopolist, and that rent-seeking theory could thus assist the EC in the forthcoming appeal. Let us look closer. Year after year, Apple sits atop the rankings as the most successful company of the 21st century. It has been the world’s largest company by market capitalization for some time. It is also the most profitable company in the history of the modern economy. Its flagship product, the iPhone, is the most expensive mass-market smartphone ever sold. On each device, Apple’s earns a 69% gross margin. Last year, industry analysts were taken aback when Apple outsold Samsung.

Granted, high prices and large profits do not a monopolist make. So let us consider other metrics: among tech’s frightful five, Apple is the slacker when it comes to investing in innovation: It spent about 3.5% of its revenue on research and development in 2016. By way of comparison, Alphabet (Google) spent 16%, Microsoft spent 14%, and Facebook spent a whopping 27%. Apple didn’t even feature in the EU ranking of the top 50 highest R&D-intensive companies, trailing behind a host of less-glitzy manufacturers of telecoms infrastructure equipment like Nokia and Ericsson and even “mundane” suppliers of cars, chemicals, and agricultural products. At such low levels of R&D investment, it is even questionable that Apple can be called a “high tech” company (the minimum to be part of that league is 5-7.5%). 

Apple also features as the world champ payer of dividends and purchaser of its own shares in financial analysts’ recommendations. Instead of retaining earnings to devote to internal R&D projects as a patient capitalist, Apple returns comparatively more profits to shareholders than any of its peers. It also sits atop a mountain of unproductive capital.

Beyond financial numbers, Apple’s body language also denotes behavioural signs of monopoly power. In his best seller, “Zero to One,” Peter Thiel writes that “monopolists lie to protect themselves.” Apple is a grandmaster at this game. In a bid to reduce the prices it pays for certain inputs, Apple has routinely claimed to be an antitrust victim in proceedings in the US, the EU, and Asia, accusing upstream component suppliers and innovators such as Qualcomm and Nokia, but also rivals such as Samsung, of unlawful monopolization. To assist it, Apple enlisted the help of a former European Commission official who spent over ten years spearheading the EU’s assaults on Intel, Microsoft, Google and other high-tech firms. To the trained observer, this should come as no surprise. For monopolists, the ends justify the means – including efforts to instrumentalise the regulatory process. 

With such facts in mind, it is now much less obvious that the EC Apple tax case is not plain vanilla competition policy, and much more clear that Apple behaved as a textbook rent-seeking monopolist when it secured 13€ billion from the Irish Government. 

That monopolists expend vast resources in rent-seeking, unproductive activities aimed at capturing rents from governments is a fundamental teaching of modern economic theory.  Like theft, corruption or bribery, those resources – and those invested by governments to counter rent-seeking strategies – are pure waste; they generate no socially valuable production. The EC would be well advised to keep this narrative in mind when defending its case against allegations of unlawful tax harmonization before the EU courts. As I often tell my students, forget the legalese; go for the big picture.

Thanks to Truth on the Market for the opportunity to guest blog, and to ICLE for inviting me to join as a Senior Scholar! I’m honoured to be involved with both of these august organizations.

In Brussels, the talk of the town is that the European Commission (“Commission”) is casting a new eye on the old antitrust conjecture that prophesizes a negative relationship between industry concentration and innovation. This issue arises in the context of the review of several mega-mergers in the pharmaceutical and AgTech (i.e., seed genomics, biochemicals, “precision farming,” etc.) industries.

The antitrust press reports that the Commission has shown signs of interest for the introduction of a new theory of harm: the Significant Impediment to Industry Innovation (“SIII”) theory, which would entitle the remediation of mergers on the sole ground that a transaction significantly impedes innovation incentives at the industry level. In a recent ICLE White Paper, I discuss the desirability and feasibility of the introduction of this doctrine for the assessment of mergers in R&D-driven industries.

The introduction of SIII analysis in EU merger policy would no doubt be a sea change, as compared to past decisional practice. In previous cases, the Commission has paid heed to the effects of a merger on incentives to innovate, but the assessment has been limited to the effect on the innovation incentives of the merging parties in relation to specific current or future products. The application of the SIII theory, however, would entail an assessment of a possible reduction of innovation in (i) a given industry as a whole; and (ii) not in relation to specific product applications.

The SIII theory would also be distinct from the innovation markets” framework occasionally applied in past US merger policy and now marginalized. This framework considers the effect of a merger on separate upstream “innovation markets,i.e., on the R&D process itself, not directly linked to a downstream current or future product market. Like SIII, innovation markets analysis is interesting in that the identification of separate upstream innovation markets implicitly recognises that the players active in those markets are not necessarily the same as those that compete with the merging parties in downstream product markets.

SIII is way more intrusive, however, because R&D incentives are considered in the abstract, without further obligation on the agency to identify structured R&D channels, pipeline products, and research trajectories.

With this, any case for an expansion of the Commission’s power to intervene against mergers in certain R&D-driven industries should rely on sound theoretical and empirical infrastructure. Yet, despite efforts by the most celebrated Nobel-prize economists of the past decades, the economics that underpin the relation between industry concentration and innovation incentives remains an unfathomable mystery. As Geoffrey Manne and Joshua Wright have summarized in detail, the existing literature is indeterminate, at best. As they note, quoting Rich Gilbert,

[a] careful examination of the empirical record concludes that the existing body of theoretical and empirical literature on the relationship between competition and innovation “fails to provide general support for the Schumpeterian hypothesis that monopoly promotes either investment in research and development or the output of innovation” and that “the theoretical and empirical evidence also does not support a strong conclusion that competition is uniformly a stimulus to innovation.”

Available theoretical research also fails to establish a directional relationship between mergers and innovation incentives. True, soundbites from antitrust conferences suggest that the Commission’s Chief Economist Team has developed a deterministic model that could be brought to bear on novel merger policy initiatives. Yet, given the height of the intellectual Everest under discussion, we remain dubious (yet curious).

And, as noted, the available empirical data appear inconclusive. Consider a relatively concentrated industry like the seed and agrochemical sector. Between 2009 and 2016, all big six agrochemical firms increased their total R&D expenditure and their R&D intensity either increased or remained stable. Note that this has taken place in spite of (i) a significant increase in concentration among the largest firms in the industry; (ii) dramatic drop in global agricultural commodity prices (which has adversely affected several agrochemical businesses); and (iii) the presence of strong appropriability devices, namely patent rights.

This brief industry example (that I discuss more thoroughly in the paper) calls our attention to a more general policy point: prior to poking and prodding with novel theories of harm, one would expect an impartial antitrust examiner to undertake empirical groundwork, and screen initial intuitions of adverse effects of mergers on innovation through the lenses of observable industry characteristics.

At a more operational level, SIII also illustrates the difficulties of using indirect proxies of innovation incentives such as R&D figures and patent statistics as a preliminary screening tool for the assessment of the effects of the merger. In my paper, I show how R&D intensity can increase or decrease for a variety of reasons that do not necessarily correlate with an increase or decrease in the intensity of innovation. Similarly, I discuss why patent counts and patent citations are very crude indicators of innovation incentives. Over-reliance on patent counts and citations can paint a misleading picture of the parties’ strength as innovators in terms of market impact: not all patents are translated into products that are commercialised or are equal in terms of commercial value.

As a result (and unlike the SIII or innovation markets approaches), the use of these proxies as a measure of innovative strength should be limited to instances where the patent clearly has an actual or potential commercial application in those markets that are being assessed. Such an approach would ensure that patents with little or no impact on innovation competition in a market are excluded from consideration. Moreover, and on pain of stating the obvious, patents are temporal rights. Incentives to innovate may be stronger as a protected technological application approaches patent expiry. Patent counts and citations, however, do not discount the maturity of patents and, in particular, do not say much about whether the patent is far from or close to its expiry date.

In order to overcome the limitations of crude quantitative proxies, it is in my view imperative to complement an empirical analysis with industry-specific qualitative research. Central to the assessment of the qualitative dimension of innovation competition is an understanding of the key drivers of innovation in the investigated industry. In the agrochemical industry, industry structure and market competition may only be one amongst many other factors that promote innovation. Economic models built upon Arrow’s replacement effect theory – namely that a pre-invention monopoly acts as a strong disincentive to further innovation – fail to capture that successful agrochemical products create new technology frontiers.

Thus, for example, progress in crop protection products – and, in particular, in pest- and insect-resistant crops – had fuelled research investments in pollinator protection technology. Moreover, the impact of wider industry and regulatory developments on incentives to innovate and market structure should not be ignored (for example, falling crop commodity prices or regulatory restrictions on the use of certain products). Last, antitrust agencies are well placed to understand that beyond R&D and patent statistics, there is also a degree of qualitative competition in the innovation strategies that are pursued by agrochemical players.

My paper closes with a word of caution. No compelling case has been advanced to support a departure from established merger control practice with the introduction of SIII in pharmaceutical and agrochemical mergers. The current EU merger control framework, which enables the Commission to conduct a prospective analysis of the parties’ R&D incentives in current or future product markets, seems to provide an appropriate safeguard against anticompetitive transactions.

In his 1974 Nobel Prize Lecture, Hayek criticized the “scientific error” of much economic research, which assumes that intangible, correlational laws govern observable and measurable phenomena. Hayek warned that economics is like biology: both fields focus on “structures of essential complexity” which are recalcitrant to stylized modeling. Interestingly, competition was one of the examples expressly mentioned by Hayek in his lecture:

[T]he social sciences, like much of biology but unlike most fields of the physical sciences, have to deal with structures of essential complexity, i.e. with structures whose characteristic properties can be exhibited only by models made up of relatively large numbers of variables. Competition, for instance, is a process which will produce certain results only if it proceeds among a fairly large number of acting persons.

What remains from this lecture is a vibrant call for humility in policy making, at a time where some constituencies within antitrust agencies show signs of interest in revisiting the relationship between concentration and innovation. And if Hayek’s convoluted writing style is not the most accessible of all, the title captures it all: “The Pretense of Knowledge.