Archives For Innovation Markets

John E. Lopatka is A. Robert Noll Distinguished Professor of Law at Penn State Law School

People need to eat. All else equal, the more food that can be produced from an acre of land, the better off they’ll be. Of course, people want to pay as little as possible for their food to boot. At heart, the antitrust analysis of the pending agribusiness mergers requires a simple assessment of their effects on food production and price. But making that assessment raises difficult questions about institutional competence.

Each of the three mergers – Dow/DuPont, ChemChina/Syngenta, and Bayer/Monsanto – involves agricultural products, such as different kinds of seeds, pesticides, and fertilizers. All of these products are inputs in the production of food – the better and cheaper are these products, the more food is produced. The array of products these firms produce invites potentially controversial market definition determinations, but these determinations are standard fare in antitrust law and economics, and conventional analysis handles them tolerably well. Each merger appears to pose overlaps in some product markets, though they seem to be relatively small parts of the firms’ businesses. Traditional merger analysis would examine these markets in properly defined geographic markets, some of which are likely international. The concern in these markets seems to be coordinated interaction, and the analysis of potential anticompetitive coordination would thus focus on concentration and entry barriers. Much could be said about the assumption that product markets perform less competitively as concentration increases, but that is an issue for others or at least another day.

More importantly for my purposes here, to the extent that any of these mergers creates concentration in a market that is competitively problematic and not likely to be cured by new entry, a fix is fairly easy. These are mergers in which asset divestiture is feasible, in which the parties seem willing to divest assets, and in which interested and qualified asset buyers are emerging. To be sure, firms may be willing to divest assets at substantial cost to appease regulators even when competitive problems are illusory, and the cost of a cure in search of an illness is a real social cost. But my concern lies elsewhere.

The parties in each of these mergers have touted innovation as a beneficial byproduct of the deal if not its raison d’être. Innovation effects have made their way into merger analysis, but not smoothly. Innovation can be a kind of efficiency, distinguished from most other efficiencies by its dynamic nature. The benefits of using a plant to its capacity are immediate: costs and prices decrease now. Any benefits of innovation will necessarily be experienced in the future, and the passage of time makes benefits both less certain and less valuable, as people prefer consumption now rather than later. The parties to these mergers in their public statements, to the extent they intend to address antitrust concerns, are implicitly asserting innovation as a defense, a kind of efficiency defense. They do not concede, of course, that their deals will be anticompetitive in any product market. But for antitrust purposes, an accelerated pace of innovation is irrelevant unless the merger appears to threaten competition.

Recognizing increased innovation as a merger defense raises all of the issues that any efficiencies defense raises, and then some. First, can efficiencies be identified?  For instance, patent portfolios can be combined, and the integration of patent rights can lower transaction costs relative to a contractual allocation of rights just as any integration can. In theory, avenues of productive research may not even be recognized until the firms’ intellectual property is combined. A merger may eliminate redundant research efforts, but identifying that which is truly duplicative is often not easy. In all, identifying efficiencies related to research and development is likely to be more difficult than identifying many other kinds of efficiencies. Second, are the efficiencies merger-specific?  The less clearly research and development efficiencies can be identified, the weaker is the claim that they cannot be achieved absent the merger. But in this respect, innovation efficiencies can be more important than most other kinds of efficiencies, because intellectual property sometimes cannot be duplicated as easily as physical property can. Third, can innovation efficiencies be quantified?  If innovation is expected to take the form of an entirely new product, such as a new pesticide, estimating its value is inherently speculative. Fourth, when will efficiencies save a merger that would otherwise be condemned?  An efficiencies defense implies a comparison between the expected harm a merger will cause and the expected benefits it will produce. Arguably those benefits have to be realized by consumers to count at all, but, in any event, a comparison between expected immediate losses of customers in an input market and expected future gains from innovation may be nearly impossible to make. The Merger Guidelines acknowledge that innovation efficiencies can be considered and note many of the concerns just listed. The takeaway is a healthy skepticism of an innovation defense. The defense should generally fail unless the model of anticompetitive harm in product (or service) markets is dubious or the efficiency claim is unusually specific and the likely benefits substantial.

Innovation can enter merger analysis in an even more troublesome way, however: as a club rather than a shield. The Merger Guidelines contemplate that a merger may have unilateral anticompetitive effects if it results in a “reduced incentive to continue with an existing product-development effort or reduced incentive to initiate development of new products.”  The stark case is one in which a merger poses no competitive problem in a product market but would allegedly reduce innovation competition. The best evidence that the elimination of innovation competition might be a reason to oppose one or more of the agribusiness mergers is the recent decision of the European Commission approving the Dow/DuPont merger, subject to various asset divestitures. The Commission, echoing the Guidelines, concluded that the merger would significantly reduce “innovation competition for pesticides” by “[r]emoving the parties’ incentives to continue to pursue ongoing parallel innovation efforts” and by “[r]emoving the parties’ incentives to develop and bring to market new pesticides.”  The agreed upon fix requires DuPont to divest most of its research and development organization.

Enforcement claims that a merger will restrict innovation competition should be met with every bit the skepticism due defense claims that innovation efficiencies save a merger. There is nothing inconsistent in this symmetry. The benefits of innovation, though potentially immense – large enough to dwarf the immediate allocative harm from a lessening of competition in product markets – is speculative. In discounted utility terms, the expected harm will usually exceed the expected benefits, given our limited ability to predict the future. But the potential gains from innovation are immense, and unless we are confident that a merger will reduce innovation, antitrust law should not intervene. We rarely are, at least we rarely should be.

As Geoffrey Manne points out, we still do not know a great deal about the optimal market structure for innovation. Evidence suggests that moderate concentration is most conducive to innovation, but it is not overwhelming, and more importantly no one is suggesting a merger policy that single-mindedly pursues a particular market structure. An examination of incentives to continue existing product development projects or to initiate projects to develop new products is superficially appealing, but its practical utility is elusive. Any firm has an incentive to develop products that increase demand. The Merger Guidelines suggest that a merger will reduce incentives to innovate if the introduction of a new product by one merging firm will capture substantial revenues from the other. The E.C. likely had this effect in mind in concluding that the merged entity would have “lower incentives . . . to innovate than Dow and DuPont separately.”  The Commission also observed that the merged firm would have “a lower ability to innovate” than the two firms separately, but just how a combination of research assets could reduce capability is utterly obscure.

In any event, whether a merger reduces incentives depends not only on the welfare of the merging parties but also on the development activities of actual and would-be competitors. A merged firm cannot afford to have its revenue captured by a new product introduced by a competitor. Of course, innovation by competitors will not spur a firm to develop new products if those competitors do not have the resources needed to innovate. One can imagine circumstances in which resources necessary to innovate in a product market are highly specialized; more realistically, the lack of specialized resources will decrease the pace of innovation. But the concept of specialized resources cannot mean resources a firm has developed that are conducive to innovate and that could be, but have not yet been, developed by other firms. It cannot simply mean a head start, unless it is very long indeed. If the first two firms in an industry build a plant, the fact that a new entrant would have to build a plant is not a sufficient reason to prevent the first two from merging. In any event, what resources are essential to innovation in an area can be difficult to determine.

Assuming essential resources can be identified, how many firms need to have them to create a competitive environment? The Guidelines place the number at “very small” plus one. Elsewhere, the federal antitrust agencies suggest that four firms other than the merged firm are sufficient to maintain innovation competition. We have models, whatever their limitations, that predict price effects in oligopolies. The Guidelines are based on them. But determining the number of firms necessary for competitive innovation is another matter. Maybe two is enough. We know for sure that innovation competition is non-existent if only one firm has the capacity to innovate, but not much else. We know that duplicative research efforts can be wasteful. If two firms would each spend $1 million to arrive at the same place, a merged firm might be able to invest $2 million and go twice as far or reach the first place at half the total cost. This is only to say that a merger can increase innovation efficiency, a possibility that is not likely to justify an otherwise anticompetitive merger but should usually protect from condemnation a merger that is not otherwise anticompetitive.

In the Dow/DuPont merger, the Commission found “specific evidence that the merged entity would have cut back on the amount they spent on developing innovative products.”  Executives of the two firms stated that they expected to reduce research and development spending by around $300 million. But a reduction in spending does not tell us whether innovation will suffer. The issue is innovation efficiency. If the two firms spent, say, $1 billion each on research, $300 million of which was duplicative of the other firm’s research, the merged firm could invest $1.7 billion without reducing productive effort. The Commission complained that the merger would reduce from five to four the number of firms that are “globally active throughout the entire R&D process.”  As noted above, maybe four firms competing are enough. We don’t know. But the Commission also discounts firms with “more limited R&D capabilities,” and the importance to successful innovation of multi-level integration in this industry is not clear.

When a merger is challenged because of an adverse effect on innovation competition, a fix can be difficult. Forced licensing might work, but that assumes that the relevant resource necessary to carry on research and development is intellectual property. More may be required. If tangible assets related to research and development are required, a divestiture might cripple the merged firm. The Commission remedy was to require the merged firm to divest “DuPont’s global R&D organization” that is related to the product operations that must be divested. The firm is permitted to retain “a few limited [R&D] assets that support the part of DuPont’s pesticide business” that is not being divested. In this case, such a divestiture may or may not hobble the merged firm, depending on whether the divested assets would have contributed to the research and development efforts that it will continue to pursue. That the merged firm was willing to accept the research and development divestiture to secure Commission approval does not mean that the divestiture will do no harm to the firm’s continuing research and development activities. Moreover, some product markets at issue in this merger are geographically limited, whereas the likely benefits of innovation are largely international. The implication is that increased concentration in product markets can be avoided by divesting assets to other large agribusinesses that do not operate in the relevant geographic market. But if the Commission insists on preserving five integrated firms active in global research and development activities, DuPont’s research and development activities cannot be divested to one of the other major players, which the Commission identifies as BASF, Bayer, and Syngenta, or firms with which any of them are attempting to merge, namely Monsanto and ChemChina. These are the five firms, of course, that are particularly likely to be interested buyers.

Innovation is important. No one disagrees. But the role of competition in stimulating innovation is not well understood. Except in unusual cases, antitrust institutions are ill-equipped either to recognize innovation efficiencies that save a merger threatening competition in product markets or to condemn mergers that threaten only innovation competition. Indeed, despite maintaining their prerogative to challenge mergers solely on the ground of a reduction in innovation competition, the federal agencies have in fact complained about an adverse effect on innovation in cases that also raise competitive issues in product markets. Innovation is at the heart of the pending agribusiness mergers. How regulators and courts analyze innovation in these cases will say something about whether they perceive their limitations.

Joanna Shepherd is Professor of Law at Emory University School of Law.

Today, three of the largest proposed mergers — Bayer/Monsanto, Dow/Dupont, and ChemChina/Syngenta — face scrutiny in both the U.S. and Europe over concerns that the mergers will slow innovation in crop biotechnology and crop protection.   The incorporation of innovation effects in the antitrust analysis of these agricultural/biotech mergers is quickly becoming more mainstream in both the U.S. and E.U. The concerns are premised on the idea that, by merging existing competitors into one firm, consolidation will reduce incentives to develop new products in the future.  Since 2015, the Department of Justice has opposed proposed mergers between Applied Materials/Tokyo Electron, Comcast/Time Warner Cable, and Halliburton/Baker Hughes at least partly based on innovation concerns. Similarly, the European Commission has raised innovation concerns in its analyses of several mergers since 2015, including Biomet/Zimmer Holdings, GlaxoSmithKline/Novartis, and BASE/ Liberty Global.

Although most of these contested deals are not based exclusively on innovation markets, fear of harms to innovation often result in the required divestiture of innovation-related assets.  For example, both the FTC and European Commission allowed the 2014 merger between Medtronic/Covidien only on the condition that Covidien divest its drug-coated balloon catheter business to protect innovation in that market. And just this week, Dupont agreed to divest a large part of its existing pesticide business, including its global R&D organization, to secure approval for the Dow/Dupont merger in the EU.

Certainly the incorporation of innovation effects in antitrust analysis could be relevant in specific mergers or acquisitions if the consolidating firms are the primary innovators in the area, the firms innovate internally, and there are limited sources of external innovation. However, in many industries, this model simply doesn’t apply.  Take, for example, the pharmaceutical industry; as I explain in a recent Article, concerns about consolidation’s impact on drug innovation are largely based on an outdated understanding of the innovation ecosystem in the pharmaceutical industry.

Today, most drug innovation originates not in traditional pharmaceutical companies, but in biotech companies and smaller firms, where a culture of nimble decision-making and risk-taking facilitates discovery and innovation.  In fact, about two-thirds of New Molecular Entities approved by the FDA originate in biotech and small pharmaceutical companies, and these companies account for almost 70 percent of the current global pipeline of drugs under development.

To complete the development process and commercialize their drugs, biotech companies regularly collaborate with large pharmaceutical companies that push drugs through the grueling late-stage clinical trials and regulatory hurdles of the FDA, organize their manufacturing and distribution capabilities to bring the drugs to market, and mobilize their vast sales force to quickly achieve peak sales.  In this current ecosystem, biotech and pharmaceutical firms are each able to specialize in what they do best, bringing expertise and efficiencies to the innovation process.

This specialization has dramatically changed the share of internally-developed versus externally-developed drugs in the pharmaceutical industry. Whereas in the 1970s and early 1980s, almost all drug discovery and early stage development took place inside traditional pharmaceutical companies, today, the companies increasingly shift resources away from internal R&D expenditures and projects and towards external sources of innovation.  Externally-sourced drugs now account for an incredible 74 percent of new drugs registered with the FDA for sale in the U.S.  Internal R&D is no longer the primary source of drug innovation in large pharmaceutical companies.

As a result, antitrust analyses that focus on pharmaceutical mergers’ impacts on internal R&D and innovation largely miss the point.  In the current innovation ecosystem, where little drug innovation originates internally, a merger’s impact on internal R&D expenditures or development projects is oftentimes immaterial to aggregate drug innovation. In many consolidated firms, increases in efficiency and streamlining of operations free up money and resources to source external innovation. To improve their future revenue streams and market share, consolidated firms can be expected to use at least some of the extra resources to acquire external innovation. This increase in demand for externally-sourced innovation increases the prices paid for external assets, which, in turn, incentivizes more early-stage innovation in small firms and biotech companies.   Aggregate innovation increases in the process!

Thus, proper antitrust analyses must take into account the innovation ecosystem in the merging firms’ industries.  In industries in which most innovation originates externally, as in the pharmaceutical industry, analyses should be less concerned with mergers’ impacts on internal innovation, and more focused on whether consolidation will increase demand for externally-sourced innovation and, ultimately, increase aggregate drug innovation.

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.