Archives For Schumpeter

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

Judges sometimes claim that they do not pick winners when they decide antitrust cases. Nothing could be further from the truth.

Competitive conduct by its nature harms competitors, and so if antitrust were merely to prohibit harm to competitors, antitrust would then destroy what it is meant to promote.

What antitrust prohibits, therefore, is not harm to competitors but rather harm to competitors that fails to improve products. Only in this way is antitrust able to distinguish between the good firm that harms competitors by making superior products that consumers love and that competitors cannot match and the bad firm that harms competitors by degrading their products without offering consumers anything better than what came before.

That means, however, that antitrust must pick winners: antitrust must decide what is an improvement and what not. And a more popular search engine is a clear winner.

But one should not take its winningness for granted. For once upon a time there was another winner that the courts always picked, blocking antitrust case after antitrust case. Until one day the courts stopped picking it.

That was the economy of scale.

The Structure of the Google Case

Like all antitrust cases that challenge the exercise of power, the government’s case against Google alleges denial of an input to competitors in some market. Here the input is default search status in smartphones, the competitors are rival search providers, and the market is search advertising. The basic structure of the case is depicted in the figure below.

Although brought as a monopolization case under Section 2 of the Sherman Act, this is at heart an exclusive dealing case of the sort normally brought under Section 1 of the Sherman Act: the government’s core argument is that Google uses contracts with smartphone makers, pursuant to which the smartphone makers promise to make Google, and not competitors, the search default, to harm competing search advertising providers and by extension competition in the search advertising market.

The government must show anticompetitive conduct, monopoly power, and consumer harm in order to prevail.

Let us assume that there is monopoly power. The company has more than 70% of the search advertising market, which is in the zone normally required to prove that element of a monopolization claim.

The problem of anticompetitive conduct is only slightly more difficult.

Anticompetitive conduct is only ever one thing in antitrust: denial of an essential input to a competitor. There is no other way to harm rivals.

(To be sure, antitrust prohibits harm to competition, not competitors, but that means only that harm to competitors necessary but insufficient for liability. The consumer harm requirement decides whether the requisite harm to competitors is also harm to competition.)

It is not entirely clear just how important default search status really is to running a successful search engine, but let us assume that it is essential, as the government suggests.

Then the question whether Google’s contracts are anticompetitive turns on how much of the default search input Google’s contracts foreclose to rival search engines. If a lot, then the rivals are badly harmed. If a little, then there may be no harm at all.

The answer here is that there is a lot of foreclosure, at least if the government’s complaint is to be believed. Through its contracts with Apple and makers of Android phones, Google has foreclosed default search status to rivals on virtually every single smartphone.

That leaves consumer harm. And here is where things get iffy.

Usage as a Product Improvement: A Very Convenient Argument

The inquiry into consumer harm evokes measurements of the difference between demand curves and price lines, or extrapolations of compensating and equivalent variation using indifference curves painstakingly pieced together based on the assumptions of revealed preference.

But while the parties may pay experts plenty to spin such yarns, and judges may pretend to listen to them, in the end, for the judges, it always comes down to one question only: did exclusive dealing improve the product?

If it did, then the judge assumes that the contracts made consumers better off and the defendant wins. And if it did not, then off with their heads.

So, does foreclosing all this default search space to competitors make Google search advertising more valuable to advertisers?

Those who leap to Google’s defense say yes, for default search status increases the number of people who use Google’s search engine. And the more people use Google’s search engine, the more Google learns about how best to answer search queries and which advertisements will most interest which searchers. And that ensures that even more people will use Google’s search engine, and that Google will do an even better job of targeting ads on its search engine.

And that in turn makes Google’s search advertising even better: able to reach more people and to target ads more effectively to them.

None of that would happen if defaults were set to other engines and users spurned Google, and so foreclosing default search space to rivals undoubtedly improves Google’s product.

This is a nice argument. Indeed, it is almost too nice, for it seems to suggest that almost anything Google might do to steer users away from competitors and to itself deserves antitrust immunity. Suppose Google were to brandish arms to induce you to run your next search on Google. That would be a crime, but, on this account, not an antitrust crime. For getting you to use Google does make Google better.

The argument that locking up users improves the product is of potential use not just to Google but to any of the many tech companies that run on advertising—Facebook being a notable example—so it potentially immunizes an entire business model from antitrust scrutiny.

It turns out that has happened before.

Economies of Scale as a Product Improvement: Once a Convenient Argument

Once upon a time, antitrust exempted another kind of business for which products improve the more people used them. The business was industrial production, and it differs from online advertising only in the irrelevant characteristic that the improvement that comes with expanding use is not in the quality of the product but in the cost per unit of producing it.

The hallmark of the industrial enterprise is high fixed costs and low marginal costs. The textile mill differs from pre-industrial piecework weaving in that once a $10 million investment in machinery has been made, the mill can churn out yard after yard of cloth for pennies. The pieceworker, by contrast, makes a relatively small up-front investment—the cost of raising up the hovel in which she labors and making her few tools—but spends the same large amount of time to produce each new yard of cloth.

Large fixed costs and low marginal costs lie at the heart of the bounty of the modern age: the more you produce, the lower the unit cost, and so the lower the price at which you can sell your product. This is a recipe for plenty.

But it also means that, so long as consumer demand in a given market is lower than the capacity of any particular plant, driving buyers to a particular seller and away from competitors always improves the product, in the sense that it enables the firm to increase volume and reduce unit cost, and therefore to sell the product at a lower price.

If the promise of the modern age is goods at low prices, then the implication is that antitrust should never punish firms for driving rivals from the market and taking over their customers. Indeed, efficiency requires that only one firm should ever produce in any given market, at least in any market for which a single plant is capable of serving all customers.

For antitrust in the late 19th and early 20th centuries, beguiled by this advantage to size, exclusive dealing, refusals to deal, even the knife in a competitor’s back: whether these ran afoul of other areas of law or not, it was all for the better because it allowed industrial enterprises to achieve economies of scale.

It is no accident that, a few notable triumphs aside, antitrust did not come into its own until the mid-1930s, 40 years after its inception, on the heels of an intellectual revolution that explained, for the first time, why it might actually be better for consumers to have more than one seller in a market.

The Monopolistic Competition Revolution

The revolution came in the form of the theory of monopolistic competition and its cousin, the theory of creative destruction, developed between the 1920s and 1940s by Edward Chamberlin, Joan Robinson and Joseph Schumpeter.

These theories suggested that consumers might care as much about product quality as they do about product cost, and indeed would be willing to abandon a low-cost product for a higher-quality, albeit more expensive, one.

From this perspective, the world of economies of scale and monopoly production was the drab world of Soviet state-owned enterprises churning out one type of shoe, one brand of cleaning detergent, and so on.

The world of capitalism and technological advance, by contrast, was one in which numerous firms produced batches of differentiated products in amounts sometimes too small fully to realize all scale economies, but for which consumers were nevertheless willing to pay because the products better fit their preferences.

What is more, the striving of monopolistically competitive firms to lure away each other’s customers with products that better fit their tastes led to disruptive innovation— “creative destruction” was Schumpeter’s famous term for it—that brought about not just different flavors of the same basic concept but entirely new concepts. The competition to create a better flip phone, for example, would lead inevitably to a whole new paradigm, the smartphone.

This reasoning combined with work in the 1940s and 1950s on economic growth that quantified for the first time the key role played by technological change in the vigor of capitalist economies—the famous Solow residual—to suggest that product improvements, and not the cost reductions that come from capital accumulation and their associated economies of scale, create the lion’s share of consumer welfare. Innovation, not scale, was king.

Antitrust responded by, for the first time in its history, deciding between kinds of product improvements, rather than just in favor of improvements, casting economies of scale out of the category of improvements subject to antitrust immunity, while keeping quality improvements immune.

Casting economies of scale out of the protected product improvement category gave antitrust something to do for the first time. It meant that big firms had to plead more than just the cost advantages of being big in order to obtain license to push their rivals around. And government could now start reliably to win cases, rather than just the odd cause célèbre.

It is this intellectual watershed, and not Thurman Arnold’s tenacity, that was responsible for antitrust’s emergence as a force after World War Two.

Usage-Based Improvements Are Not Like Economies of Scale

The improvements in advertising that come from user growth fall squarely on the quality side of the ledger—the value they create is not due to the ability to average production costs over more ad buyers—and so they count as the kind of product improvements that antitrust continues to immunize today.

But given the pervasiveness of this mode of product improvement in the tech economy—the fact that virtually any tech firm that sells advertising can claim to be improving a product by driving users to itself and away from competitors—it is worth asking whether we have not reached a new stage in economic development in which this form of product improvement ought, like economies of scale, to be denied protection.

Shouldn’t the courts demand more and better innovation of big tech firms than just the same old big-data-driven improvements they serve up year after year?

Galling as it may be to those who, like myself, would like to see more vigorous antitrust enforcement in general, the answer would seem to be “no.” For what induced the courts to abandon antitrust immunity for economies of scale in the mid-20th century was not the mere fact that immunizing economies of scale paralyzed antitrust. Smashing big firms is not, after all, an end in itself.

Instead, monopolistic competition, creative destruction and the Solow residual induced the change, because they suggested both that other kinds of product improvement are more important than economies of scale and, crucially, that protecting economies of scale impedes development of those other kinds of improvements.

A big firm that excludes competitors in order to reach scale economies not only excludes competitors who might have produced an identical or near-identical product, but also excludes competitors who might have produced a better-quality product, one that consumers would have preferred to purchase even at a higher price.

To cast usage-based improvements out of the product improvement fold, a case must be made that excluding competitors in order to pursue such improvements will block a different kind of product improvement that contributes even more to consumer welfare.

If we could say, for example, that suppressing search competitors suppresses more-innovative search engines that ad buyers would prefer, even if those innovative search engines were to lack the advantages that come from having a large user base, then a case might be made that user growth should no longer count as a product improvement immune from antitrust scrutiny.

And even then, the case against usage-based improvements would need to be general enough to justify an epochal change in policy, rather than be limited to a particular technology in a particular lawsuit. For the courts hate to balance in individual cases, statements to the contrary in their published opinions notwithstanding.

But there is nothing in the Google complaint, much less the literature, to suggest that usage-based improvements are problematic in this way. Indeed, much of the value created by the information revolution seems to inhere precisely in its ability to centralize usage.

Americans Keep Voting to Centralize the Internet

In the early days of the internet, theorists mistook its decentralized architecture for a feature, rather than a bug. But internet users have since shown, time and again, that they believe the opposite.

For example, the basic protocols governing email were engineered to allow every American to run his own personal email server.

But Americans hated the freedom that created—not least the spam—and opted instead to get their email from a single server: the one run by Google as Gmail.

The basic protocols governing web traffic were also designed to allow every American to run whatever other communications services he wished—chat, video chat, RSS, webpages—on his own private server in distributed fashion.

But Americans hated the freedom that created—not least having to build and rebuild friend networks across platforms–—and they voted instead overwhelmingly to get their social media from a single server: Facebook.

Indeed, the basic protocols governing internet traffic were designed to allow every business to store and share its own data from its own computers, in whatever form.

But American businesses hated that freedom—not least the cost of having to buy and service their own data storage machines—and instead 40% of the internet is now stored and served from Amazon Web Services.

Similarly, advertisers have the option of placing advertisements on the myriad independently-run websites that make up the internet—known in the business as the “open web”—by placing orders through competitive ad exchanges. But advertisers have instead voted mostly to place ads on the handful of highly centralized platforms known as “walled gardens,” including Facebook, Google’s YouTube and, of course, Google Search.

The communications revolution, they say, is all about “bringing people together.” It turns out that’s true.

And that Google should win on consumer harm.

Remember the Telephone

Indeed, the same mid-20th century antitrust that thought so little of economies of scale as a defense immunized usage-based improvements when it encountered them in that most important of internet precursors: the telephone.

The telephone, like most internet services, gets better as usage increases. The more people are on a particular telephone network, the more valuable the network becomes to subscribers.

Just as with today’s internet services, the advantage of a large user base drove centralization of telephone services a century ago into the hands of a single firm: AT&T. Aside from a few business executives who liked the look of a desk full of handsets, consumers wanted one phone line that they could use to call everyone.

Although the government came close to breaking AT&T up in the early 20th century, the government eventually backed off, because a phone system in which you must subscribe to the right carrier to reach a friend just doesn’t make sense.

Instead, Congress and state legislatures stepped in to take the edge off monopoly by regulating phone pricing. And when antitrust finally did break AT&T up in 1982, it did so in a distinctly regulatory fashion, requiring that AT&T’s parts connect each other’s phone calls, something that Congress reinforced in the Telecommunications Act of 1996.

The message was clear: the sort of usage-based improvements one finds in communications are real product improvements. And antitrust can only intervene if it has a way to preserve them.

The equivalent of interconnection in search, that the benefits of usage, in the form of data and attention, be shared among competing search providers, might be feasible. But it is hard to imagine the court in the Google case ordering interconnection without the benefit of decades of regulatory experience with the defendant’s operations that the district court in 1982 could draw upon in the AT&T case.

The solution for the tech giants today is the same as the solution for AT&T a century ago: to regulate rather than to antitrust.

Microsoft Not to the Contrary, Because Users Were in Common

Parallels to the government’s 1990s-era antitrust case against Microsoft are not to the contrary.

As Sam Weinstein has pointed out to me, Microsoft, like Google, was at heart an exclusive dealing case: Microsoft contracted with computer manufacturers to prevent Netscape Navigator, an early web browser, from serving as the default web browser on Windows PCs.

That prevented Netscape, the argument went, from growing to compete with Windows in the operating system market, much the way the Google’s Chrome browser has become a substitute for Windows on low-end notebook computers today.

The D.C. Circuit agreed that default status was an essential input for Netscape as it sought eventually to compete with Windows in the operating system market.

The court also accepted the argument that the exclusive dealing did not improve Microsoft’s operating system product.

This at first seems to contradict the notion that usage improves products, for, like search advertising, operating systems get better as their user bases increase. The more people use an operating system, the more application developers are willing to write for the system, and the better the system therefore becomes.

It seems to follow that keeping competitors off competing operating systems and on Windows made Windows better. If the court nevertheless held Microsoft liable, it must be because the court refused to extend antitrust immunity to usage-based improvements.

The trouble with this line of argument is that it ignores the peculiar thing about the Microsoft case: that while the government alleged that Netscape was a potential competitor of Windows, Netscape was also an application that ran on Windows.

That means that, unlike Google and rival search engines, Windows and Netscape shared users.

So, Microsoft’s exclusive dealing did not increase its user base and therefore could not have improved Windows, at least not by making Windows more appealing for applications developers. Driving Netscape from Windows did not enable developers to reach even one more user. Conversely, allowing Netscape to be the default browser on Windows would not have reduced the number of Windows users, because Netscape ran on Windows.

By contrast, a user who runs a search in Bing does not run the same search simultaneously in Google, and so Bing users are not Google users. Google’s exclusive dealing therefore increases its user base and improves Google’s product, whereas Microsoft’s exclusive dealing served only to reduce Netscape’s user base and degrade Netscape’s product.

Indeed, if letting Netscape be the default browser on Windows was a threat to Windows, it was not because it prevented Microsoft from improving its product, but because Netscape might eventually have become an operating system, and indeed a better operating system, than Windows, and consumers and developers, who could be on both at the same time if they wished, might have nevertheless chosen eventually to go with Netscape alone.

Though it does not help the government in the Google case, Microsoft still does offer a beacon of hope for those concerned about size, for Microsoft’s subsequent history reminds us that yesterday’s behemoth is often today’s also ran.

And the favorable settlement terms Microsoft ultimately used to escape real consequences for its conduct 20 years ago imply that, at least in high-tech markets, we don’t always need antitrust for that to be true.

Source: Benedict Evans

[N]ew combinations are, as a rule, embodied, as it were, in new firms which generally do not arise out of the old ones but start producing beside them; … in general it is not the owner of stagecoaches who builds railways. – Joseph Schumpeter, January 1934

Elizabeth Warren wants to break up the tech giants — Facebook, Google, Amazon, and Apple — claiming they have too much power and represent a danger to our democracy. As part of our response to her proposal, we shared a couple of headlines from 2007 claiming that MySpace had an unassailable monopoly in the social media market.

Tommaso Valletti, the chief economist of the Directorate-General for Competition (DG COMP) of the European Commission, said, in what we assume was a reference to our posts, “they go on and on with that single example to claim that [Facebook] and [Google] are not a problem 15 years later … That’s not what I would call an empirical regularity.”

We appreciate the invitation to show that prematurely dubbing companies “unassailable monopolies” is indeed an empirical regularity.

It’s Tough to Make Predictions, Especially About the Future of Competition in Tech

No one is immune to this phenomenon. Antitrust regulators often take a static view of competition, failing to anticipate dynamic technological forces that will upend market structure and competition.

Scientists and academics make a different kind of error. They are driven by the need to satisfy their curiosity rather than shareholders. Upon inventing a new technology or discovering a new scientific truth, academics often fail to see the commercial implications of their findings.

Maybe the titans of industry don’t make these kinds of mistakes because they have skin in the game? The profit and loss statement is certainly a merciless master. But it does not give CEOs the power of premonition. Corporate executives hailed as visionaries in one era often become blinded by their success, failing to see impending threats to their company’s core value propositions.

Furthermore, it’s often hard as outside observers to tell after the fact whether business leaders just didn’t see a tidal wave of disruption coming or, worse, they did see it coming and were unable to steer their bureaucratic, slow-moving ships to safety. Either way, the outcome is the same.

Here’s the pattern we observe over and over: extreme success in one context makes it difficult to predict how and when the next paradigm shift will occur in the market. Incumbents become less innovative as they get lulled into stagnation by high profit margins in established lines of business. (This is essentially the thesis of Clay Christensen’s The Innovator’s Dilemma).

Even if the anti-tech populists are powerless to make predictions, history does offer us some guidance about the future. We have seen time and again that apparently unassailable monopolists are quite effectively assailed by technological forces beyond their control.

PCs

Source: Horace Dediu

Jan 1977: Commodore PET released

Jun 1977: Apple II released

Aug 1977: TRS-80 released

Feb 1978: “I.B.M. Says F.T.C. Has Ended Its Typewriter Monopoly Study” (NYT)

Mobile

Source: Comscore

Mar 2000: Palm Pilot IPO’s at $53 billion

Sep 2006: “Everyone’s always asking me when Apple will come out with a cellphone. My answer is, ‘Probably never.’” – David Pogue (NYT)

Apr 2007: “There’s no chance that the iPhone is going to get any significant market share.” Ballmer (USA TODAY)

Jun 2007: iPhone released

Nov 2007: “Nokia: One Billion Customers—Can Anyone Catch the Cell Phone King?” (Forbes)

Sep 2013: “Microsoft CEO Ballmer Bids Emotional Farewell to Wall Street” (Reuters)

If there’s one thing I regret, there was a period in the early 2000s when we were so focused on what we had to do around Windows that we weren’t able to redeploy talent to the new device form factor called the phone.

Search

Source: Distilled

Mar 1998: “How Yahoo! Won the Search Wars” (Fortune)

Once upon a time, Yahoo! was an Internet search site with mediocre technology. Now it has a market cap of $2.8 billion. Some people say it’s the next America Online.

Sep 1998: Google founded

Instant Messaging

Sep 2000: “AOL Quietly Linking AIM, ICQ” (ZDNet)

AOL’s dominance of instant messaging technology, the kind of real-time e-mail that also lets users know when others are online, has emerged as a major concern of regulators scrutinizing the company’s planned merger with Time Warner Inc. (twx). Competitors to Instant Messenger, such as Microsoft Corp. (msft) and Yahoo! Inc. (yhoo), have been pressing the Federal Communications Commission to force AOL to make its services compatible with competitors’.

Dec 2000: “AOL’s Instant Messaging Monopoly?” (Wired)

Dec 2015: Report for the European Parliament

There have been isolated examples, as in the case of obligations of the merged AOL / Time Warner to make AOL Instant Messenger interoperable with competing messaging services. These obligations on AOL are widely viewed as having been a dismal failure.

Oct 2017: AOL shuts down AIM

Jan 2019: “Zuckerberg Plans to Integrate WhatsApp, Instagram and Facebook Messenger” (NYT)

Retail

Source: Seeking Alpha

May 1997: Amazon IPO

Mar 1998: American Booksellers Association files antitrust suit against Borders, B&N

Feb 2005: Amazon Prime launches

Jul 2006: “Breaking the Chain: The Antitrust Case Against Wal-Mart” (Harper’s)

Feb 2011: “Borders Files for Bankruptcy” (NYT)

Social

Feb 2004: Facebook founded

Jan 2007: “MySpace Is a Natural Monopoly” (TechNewsWorld)

Seventy percent of Yahoo 360 users, for example, also use other social networking sites — MySpace in particular. Ditto for Facebook, Windows Live Spaces and Friendster … This presents an obvious, long-term business challenge to the competitors. If they cannot build up a large base of unique users, they will always be on MySpace’s periphery.

Feb 2007: “Will Myspace Ever Lose Its Monopoly?” (Guardian)

Jun 2011: “Myspace Sold for $35m in Spectacular Fall from $12bn Heyday” (Guardian)

Music

Source: RIAA

Dec 2003: “The subscription model of buying music is bankrupt. I think you could make available the Second Coming in a subscription model, and it might not be successful.” – Steve Jobs (Rolling Stone)

Apr 2006: Spotify founded

Jul 2009: “Apple’s iPhone and iPod Monopolies Must Go” (PC World)

Jun 2015: Apple Music announced

Video

Source: OnlineMBAPrograms

Apr 2003: Netflix reaches one million subscribers for its DVD-by-mail service

Mar 2005: FTC blocks Blockbuster/Hollywood Video merger

Sep 2006: Amazon launches Prime Video

Jan 2007: Netflix streaming launches

Oct 2007: Hulu launches

May 2010: Hollywood Video’s parent company files for bankruptcy

Sep 2010: Blockbuster files for bankruptcy

The Only Winning Move Is Not to Play

Predicting the future of competition in the tech industry is such a fraught endeavor that even articles about how hard it is to make predictions include incorrect predictions. The authors just cannot help themselves. A March 2012 BBC article “The Future of Technology… Who Knows?” derided the naysayers who predicted doom for Apple’s retail store strategy. Its kicker?

And that is why when you read that the Blackberry is doomed, or that Microsoft will never make an impression on mobile phones, or that Apple will soon dominate the connected TV market, you need to take it all with a pinch of salt.

But Blackberry was doomed and Microsoft never made an impression on mobile phones. (Half credit for Apple TV, which currently has a 15% market share).

Nobel Prize-winning economist Paul Krugman wrote a piece for Red Herring magazine (seriously) in June 1998 with the title “Why most economists’ predictions are wrong.” Headline-be-damned, near the end of the article he made the following prediction:

The growth of the Internet will slow drastically, as the flaw in “Metcalfe’s law”—which states that the number of potential connections in a network is proportional to the square of the number of participants—becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.

Robert Metcalfe himself predicted in a 1995 column that the Internet would “go spectacularly supernova and in 1996 catastrophically collapse.” After pledging to “eat his words” if the prediction did not come true, “in front of an audience, he put that particular column into a blender, poured in some water, and proceeded to eat the resulting frappe with a spoon.”

A Change Is Gonna Come

Benedict Evans, a venture capitalist at Andreessen Horowitz, has the best summary of why competition in tech is especially difficult to predict:

IBM, Microsoft and Nokia were not beaten by companies doing what they did, but better. They were beaten by companies that moved the playing field and made their core competitive assets irrelevant. The same will apply to Facebook (and Google, Amazon and Apple).

Elsewhere, Evans tried to reassure his audience that we will not be stuck with the current crop of tech giants forever:

With each cycle in tech, companies find ways to build a moat and make a monopoly. Then people look at the moat and think it’s invulnerable. They’re generally right. IBM still dominates mainframes and Microsoft still dominates PC operating systems and productivity software. But… It’s not that someone works out how to cross the moat. It’s that the castle becomes irrelevant. IBM didn’t lose mainframes and Microsoft didn’t lose PC operating systems. Instead, those stopped being ways to dominate tech. PCs made IBM just another big tech company. Mobile and the web made Microsoft just another big tech company. This will happen to Google or Amazon as well. Unless you think tech progress is over and there’ll be no more cycles … It is deeply counter-intuitive to say ‘something we cannot predict is certain to happen’. But this is nonetheless what’s happened to overturn pretty much every tech monopoly so far.

If this time is different — or if there are more false negatives than false positives in the monopoly prediction game — then the advocates for breaking up Big Tech should try to make that argument instead of falling back on “big is bad” rhetoric. As for us, we’ll bet that we have not yet reached the end of history — tech progress is far from over.

 

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?