Innovation and Dynamic Efficiencies in Merger Review

Prepared By:
Andrew Tepperman and Margaret Sanderson
CRA International

Date: April 9, 2007
CRA Project No. D09208-00

2. Innovation and Dynamic Competition

2.1. Key Concepts

We begin by defining several of the terms we use extensively throughout this report.  Innovation can be thought of as the creation and development of new or improved products or processes.  A product innovation is a new or improved product (or service); a process innovation is a means by which existing production technology is made more efficient, with the consequence that costs of producing the product are decreased.  Quality improvements in existing products or the development of new features for existing products are captured in our notion of product innovation.  New or improved processes need not relate solely to production, but may also include cost-saving means of distribution or marketing. 

Innovation is inherently dynamic, which distinguishes it from more static price and output decisions.⁸  This is so because it is generally necessary to incur costs at some point in time (or over some extended interval of time) in order to enable an innovation to be realized later.  In this sense innovative activity—research and development (“R&D”)—is a form of sunk and risky investment, in which a cost (in dollars or hours of effort) precedes a potentially uncertain outcome. 
Both product and process innovations contribute to economic efficiency.  To see this, consider only the outcome of innovation, ignoring the costs of research and development, which are assumed to have taken place in the past.  Product innovations contribute to economic efficiency by increasing consumer surplus—the total amount by which consumers’ willingness to pay exceeds the price of the product for those consumers purchasing the product.  For existing products, an innovation leading to a product improvement increases the value that consumers place on using the product, assuming price is held constant.  For example, the introduction of the minivan generated large gains for consumers who valued its attributes as compared to existing cars.⁹  In the case of innovations that result in entirely new products, such as the introduction of the cellular telephone, consumer surplus increases from a level of zero pre-innovation to some positive and potentially substantial amount post-innovation.¹⁰  The potential gains to consumers from the introduction of new goods are typically far larger than those available from optimizing the pricing of existing goods.¹¹

Process innovations also promote economic efficiency by allowing existing products to be produced at lower costs.  This may not immediately translate into lower prices (and thus increased consumer surplus).  The innovating firm may instead hold a competitive advantage over its rivals for which it earns additional profits compared to the pre-innovation period.  As a result producer surplus is increased and efficiency improved even in the short term.  Then, as rival firms seek to imitate the innovation or develop their own cost-saving techniques, the cost-reducing technology is diffused across firms in the market leading to lower prices than would have existed without the process improvement over time.¹²  Consumer surplus may then be increased.

When considering competition through innovation, it is important not to confuse the improvement in earnings by the innovating firm with monopoly profits.  Instead, the firm is earning a return on its investments, which economists refer to as a quasi-rent.¹³  The existence of quasi-rents is not analogous to market power, yet the two are often confused, particularly if analysts look to firm profits at a single point in time as a means of measuring the extent of market power. 

Having established that innovations, once realized, lead to gains for consumers and producers, and that the act of innovation is not itself typically costless, it is clear that society overall is faced with a tradeoff.  A greater expenditure devoted to R&D can be expected, on average, to result in a greater number of innovations being realized.  Some positive level of expenditure on R&D would then seem to be desirable from a social perspective.  At the same time, there will eventually be diminishing returns to R&D expenditure.  The optimal level of innovative effort is that which economists call the dynamically efficient level.  Dynamic efficiency implies that the flow of surplus realized through the introduction of new products or processes over time, net of the cost of researching and developing these new products and processes, is at a maximum.

2.2. Dynamic Competition

Competition based on the successive introduction of new or better products over time is called dynamic competition.  Dynamic competition based on investment in R&D may be thought of as a form of “competition for the market”¹⁴ in contrast to price competition which is “competition in the market.”  This characterization is overly simplistic, however.  There are certainly many situations in which both forms of competition operate—firms may compete for customers’ business by reducing price and improving quality for existing goods, and by pursuing innovation in an effort to introduce new goods to market.¹⁵  Nonetheless, this way of dichotomizing competitive rivalry serves to emphasize an important contrast.  Static views of competition take the existing set of products and market participants as given, describing the outcome of competitive behaviour among those market participants using strategic instruments such as pricing or advertising that can be applied and varied in the “short term.”  Dynamic competition involves the creation of new products and potentially also new markets, along with the replacement or obsolescence of older products.  It also implicitly or explicitly involves entry and exit by firms—there is no guarantee that today’s successful firms will be able to offer the product attributes demanded by tomorrow’s consumers. 

Anecdotal examples of dynamic competition are not hard to come by.  Consider an example from the pharmaceutical area.  SmithKline’s breakthrough anti-ulcer medication Tagamet was largely free from direct competitors in the late 1970s.  Newer products with desirable attributes soon arrived on the market, beginning with Glaxo’s Zantac in the early 1980s, and Tagamet’s share dropped off as several competing firms offering different chemical entities to treat the same set of symptoms emerged.¹⁶  In the microprocessor industry, Intel continues to undertake a tremendous amount of innovative effort in order to stay ahead of its rivals, introducing generation after generation of chip since its first products were launched in the 1970s.  Only recently have other microprocessor firms such as Advanced Micro Devices been able to make inroads into Intel’s share of the chip market by offering high-quality and innovative products with characteristics desired by consumers.¹⁷

As manufacturers bring new technical features forward, they can create demand for their particular product from both new and established customers.  Consider for example the increased demand generated over time for computing processing power.  Throughout the 1990s, IBM made a series of investments in its mainframes that significantly enhanced mainframe functionality.  A fundamental innovation during this time was the introduction of technology to alleviate the need for large water-cooling systems that prior processor technology required, thereby allowing mainframes to be much smaller in physical size and dramatically lowering their cost.  Competing mainframe manufacturers Amdahl and Hitachi had difficulty replicating the significant technology advances of IBM and ceased producing mainframes.  Yet IBM’s mainframes still faced competition from an alternative technology known as Unix.  Sun Microsystems and Hewlett-Packard in particular advanced Unix technology to the point that by 2001 Unix-based server systems had mainframe-like power and comparable performance characteristics.  Technology has since advanced further still, allowing firms to link a number of Intel-based servers together to have the computing processing power and performance features of Unix supercomputers.  With each new development, IBM invests more in its mainframe technology to improve upon it, while Sun and Hewlett-Packard invest further in Unix technology.  Intel and Microsoft, meanwhile, invest in their technologies.  New technologies appear, disrupting old technologies and providing the motivation for incumbent firms to continue investing and developing new products. 

2.3. Basic Principles

From this high-level overview of the relevant concepts, we present two principles to inform the remaining discussion. 

2.3.1. Tension may exist between static and dynamic efficiency

To sustain innovative efforts, and thus support dynamic efficiency, firms do not expect to price at short-run marginal cost at every point in time and as a result some degree of allocative inefficiency may be inevitable.  Motivating firms to make costly investments in R&D requires some prospect of “profit,” which as noted above is in the form of quasi-rents.  In the absence of this positive return per unit of output sold, a firm would never be able to recoup its up-front investment in R&D, and would therefore have no incentive to undertake this investment.  In other words, innovating firms anticipate a period of “incumbency” during which they are able to sell a product at a price exceeding not only the short-run marginal cost of production, but potentially also the price of existing products (if any) that do not incorporate the innovation.  Consumers are willing to pay the higher price because they value the additional attributes embodied in the new or improved product sufficiently to pay a premium for it over other firms’ products. 

An implication is that textbook “perfect competition” may be inconsistent with dynamic efficiency, a point recognized by Joseph Schumpeter decades ago, and developed in subsequent macroeconomic and microeconomic literature.¹⁸  Once we realize that the basic assumptions necessary for perfect competition to hold—including, inter alia, homogeneous products, infinitesimally small firms, perfect information, and small fixed costs per firm—cannot possibly apply in the vast majority of real world markets, it is clear that competition is often “imperfect,” and prices are expected to exceed short-run marginal cost.  As a result, a price above marginal cost does not suggest market power exists, in and of itself.¹⁹ 

The existence of above-marginal cost pricing in any particular market may be explained by a wide range of factors.  One common explanation is that products may be differentiated from the perspective of consumers (for example, breakfast cereal), which tends to reduce the intensity of price competition.  Alternatively, production may require firms to incur substantial and ongoing fixed costs in order to set up or to stay in business (as is the case with infrastructure industries such as transportation or telecommunications service provision).  From a purely static perspective, products with similar (but not identical) attributes may coexist, exerting competitive pressure on the innovator’s pricing decision.  From a dynamic perspective, any discussion of whether returns are competitive or supra-competitive must confront the problem of how to define market power in the context of a dynamically competitive market; we defer discussion of that issue to a later section.

Incumbency status enabling above-marginal cost pricing must be expected to persist for long enough to make the investment worthwhile.  It is a firm’s expectation that quasi-rents will exist that drives the investment decision.  Should a different state of the world materialize in the future such that ex post returns on the product are insufficient to justify the investment, this will not alter the product’s current existence.  Instead, it would be expected to factor into the firm’s next investment decision, or those of similar firms.  Legal instruments such as patents may serve to protect a firm’s investment to a certain extent.²⁰ 

In many instances, the process of dynamic competition prevents any one firm from enjoying a position of leadership for very long, unless that firm continues to innovate.  “Follower” firms will perceive the benefits of incumbency status and will compete by engaging in R&D, or by imitating.  This process normally imposes limits on the length of time any given incumbent can expect to remain ahead of its rivals before its existing product is replaced in a new round of innovation.  Recently, economists studying the determinants of economic growth have sought to understand and fully model these forces.²¹ 

2.3.2. More R&D is good, but more innovation is better

The private incentives to innovate that firms face may not give rise to the optimal level of innovation from a social perspective.  As discussed above, the socially optimal level of innovation is that which maximizes dynamic efficiency, or the flow of surplus net of R&D expenditure.  The incentives faced by private firms, on the other hand, are determined by a number of different factors, which can give rise to either too much or too little innovation.²²  Two effects in particular tend to promote underinvestment in innovation because: (i) innovating firms fail to capture the benefits that their innovations provide to future researchers by moving the technological frontier ahead they invest less than the socially optimal level;²³ and (ii) firms cannot typically receive all of the increase in consumer surplus that is created by a successful new product.²⁴  Working in the opposite direction toward overinvestment in R&D is the “business stealing effect.”  This effect is driven by firms failing to take into account the fact that while each firm benefits when it replaces another as incumbent, no such gain accrues to society; so firms may have an excessive incentive (relative to that which is socially optimal) to seek to replace other firms.

On balance, the evidence suggests that firms face insufficient incentives to innovate relative to socially optimal levels.  Numerous studies have attempted to empirically measure the spillover benefits generated by firms’ R&D efforts in order to test this theory.²⁵  These spillovers seem to be large, and as a result the social rate of return from R&D exceeds the private rate of return.  The implication is that underinvestment in R&D is real and significant.²⁶ 

This is not to suggest that a discussion of innovation should begin and end with R&D.  The considerable attention R&D expenditure receives in practice is warranted to a certain extent because worthwhile innovations do not typically spring fully-formed from inventors’ minds, and thus R&D is a necessary condition for innovation.  In addition, R&D is easy to measure, so it is used extensively in empirical studies; for example, public firms report R&D spending in their financial statements, and most empirical studies of innovation rely on publicly available data.  Yet too close a focus on R&D risks obscuring the important fact that it is not R&D per se that is of interest—it is innovative output.  Consumers do not derive benefits from an additional dollar of R&D spending unless that dollar results in an increased likelihood of either a new product being developed or an existing product being made available for a lower price.  As a result, the ultimate focus of any investigation into the impact on innovation of a particular transaction must be on the output of the innovative process.  Transactions that would reduce total R&D expenditures but leave the level of innovation constant (perhaps because of the existence of duplicative R&D efforts across firms) should not be subject to challenge.

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