Dynamic competition and anti-trust policy

Through its influence on the development of competition policy over the years, economic analysis has brought a dramatic improvement in the abilityof government agencies and the courts to accurately judge the strength ofcompetition in a market. This has enhanced their capacity to distinguishthose cases that properly raise concerns about anticompetitive effects fromthose that might have raised concerns in the past, but should no longer, inlight of a better understanding of competitive forces. These changes in antitrust policy are important in that they afford firms greater flexibility to lower costs and improve their products through adjustments to their operations and organization. But many of these improvements in policy have largely focused on better understanding markets in which firms compete with one another throughincremental changes in the prices, quality, and quantity of relatively similarproducts or services. In some increasingly prominent industries, such as theinformation technology and pharmaceuticals industries, another importantform of competition is taking place. It arises where there is a constant threatof innovations leading to a new or improved product being introduced thatis far superior to existing products in a market. This type of competition issometimes called competition for the market, or dynamic competition.
The increasingly important role of innovations in our economy can be seen in a number of indicators of innovative activity. After remaining nearlyunchanged during the 1970s, industry’s funding of research and develop-ment, measured as a share of GDP, grew two-thirds during the following twodecades, reaching 1.8 percent of GDP in 2000. The number of patentsgranted each year by the U.S. Patent and Trademark Office provides someindication of the rate at which patentable innovations are being developed.
Since the mid-1980s, the number of patents issued for inventions each yearhas grown dramatically (Chart 3-3). Although such a change could resultfrom a number of other factors, such as increased incentives to file for apatent based on adjustments to the legal environment, evidence suggests thata burst in innovation is a driving factor behind this rise. Whereas some of themost visible innovations contributing to dynamic competition are techno-logical in nature, such as improvements in the performance of computers,others may involve changes in management or business practices. The importance of substantial innovations to the economy, as well as the unique form of competition they bring about, was recognized in 1942 by theeconomist Joseph Schumpeter. He noted that a significant part of the long-term growth of many industries resulted from what he called the “perennialgale of creative destruction.” At the heart of this creative destruction is theintroduction of new products or services, technologies, or organizational forms that lead to dramatic changes in an industry’s structure or costs, or inthe quality of its products or services. In Schumpeter’s view, it was periods ofcreative destruction that brought “power production from the overshot waterwheel to the modern power plant… [and] transportation from the mailcoachto the airplane.” Indeed, as he stated, the kind of competition resulting fromfirms bringing forth these changes or innovations is one that “commands adecisive cost or quality advantage and which strikes not at the margins of theprofits… of the existing firms but at their foundations and their very lives.”Because of his early insights, dynamic competition involving the introduc-tion of markedly improved goods or services is often referred to asSchumpeterian competition. The significance of innovation—and hence of dynamic competition—will vary from market to market: it will be negligible in some and a pervasiveforce in others. Product improvements are commonly made in virtually allmarkets. But in markets experiencing the kinds of substantial innovation thatSchumpeter addressed, these innovations can be so dramatic or disruptive asto make the products that they improve upon significantly inferior incomparison. The benefits of these innovations to society can be found allaround us. Computer processors produced today are, by one measure, more than 250 times more powerful than those produced in 1980, and more thantwice as powerful as those produced in 1999. New drugs have vastlyimproved our ability to treat various illnesses. Other examples abound.
It has long been recognized that particular incentives are necessary to foster these market-transforming innovations. These innovations are often theresult of substantial research and development investments on the part ofcompanies or individuals. Since these investments must be made before it isclear that any profitable innovations will come of them, they are fundamen-tally risky. Encouraging innovation rests upon an interrelated set of internaland external rewards. The external rewards are those provided in the market-place to the successful innovating organization. The internal rewards arethose provided by the firm, joint venture, or other governance structure.
Both economic organization and public policy therefore play significantroles in encouraging innovation.
The external risks and rewards facing firms in innovation-intensive industries are highlighted by a preliminary study of firms in the computersoftware industry between 1990 and 1998, which found that success, asmeasured by sales growth over this period, was by no means certain. But,compensating for this risk, some firms that did end up being successful wereextremely so. At least 10 percent of firms saw sales fall to zero, and at leasthalf experienced negative sales growth over the period. Only 25 percent offirms experienced real annualized sales growth of at least 7 percent during theperiod. But about 1 percent experienced real annualized growth of greaterthan 130 percent. This pattern of success highlights the risk involved ininvestments in these innovation-intensive industries. Therefore firms musthave reason to expect that, taking into account the likelihood of failure, theprofits from any successful innovations that do result from their efforts willbe enough to justify the initial investment. Not only is investing in efforts to develop innovations risky and often expensive, but the innovations that result often produce beneficial knowledgeor insights that others can copy at relatively low cost. Furthermore, in theabsence of laws to the contrary, knowledge embodied in an innovation canbe hard to keep others from using. For instance, the research and development costs incurred by a firm in determining the correct chemical composition and treatment regime for aparticular drug therapy may be substantial. But it may be difficult to keepmuch of this information out of the hands of competitors that have not borne any of these costs, yet could use that information to produce the newdrug themselves. As a result, competition between the innovator and imita-tors could keep the price of the drug at the cost of manufacturing it. In sucha competitive environment, a firm’s profits from its innovation would notsuffice to cover its original research and development costs or justify its deci-sion to risk undertaking expensive research efforts that may bear no fruit.
Foreseeing this potential outcome, the innovator would have little incentiveto embark on the research and development in the first place. Even if a firm did not face competition from other firms benefiting from the knowledge produced by its innovation, firms or individuals may useaspects of the innovation for other purposes. Given how difficult it can be tokeep them from doing this, in the absence of laws to prevent it, the innovatormay receive little compensation from those that benefit from its innovation.
As a result, the rewards that a firm enjoys from its innovation could fall farshort of the benefits that the innovation produces for society. Consequently,in many cases, firms or individuals might not embark on developing aninnovation because, although the social benefit from it may be large enoughto justify its development costs, the firm or individual could not expect toreap enough of that benefit to justify those costs. The consequences of this problem were recognized in the U.S.
Constitution, which empowered Congress to develop a body of intellectualproperty laws, including those establishing patents. A patent for an inventionconfers on an individual or firm (the patentholder) limited rights to excludeothers from making, selling, or using the invention without the patent-holder’s consent. Patents generally are granted for 20 years, and as the rightsthey provide imply, the patentholder can license to other individuals or firmsthe right to use its innovation. Patents give a firm the legal power to keepothers from using its innovation to create competing products withoutbearing the cost of the innovation. Licensing provides a means whereby theinnovator can receive compensation, in the form of licensing fees, fromothers that find a beneficial use for the innovation. Thus policy has longrecognized that, to encourage innovation, firms must expect that successfulinnovations will yield a market position that allows them to earn profitsadequate to compensate for the risk and cost of their efforts. Indeed, intellectual property protection often plays an important role in dynamically competitive markets. But it is not the only mechanism that mayallow a firm to gain an adequate return on risky investments in developinginnovations. Intellectual property laws cannot always provide inventorscomplete protection against competitors using the knowledge embodied intheir inventions without compensation. First, even if they are valuable, notall innovations can be protected by intellectual property law. Second, firmscan often “invent around” a patent to create a competing product that, although similar in value to consumers, is different enough in its compositionor features so as not to violate the patent. Although this entails some devel-opment costs, these may be substantially reduced by the knowledge gainedfrom studying the original innovator’s efforts. On the other hand, someinnovations may be difficult enough to imitate that, even without intellectualproperty protection, the innovator can enjoy a substantial cost or qualityadvantage over its competitors for some period. In either case, other charac-teristics of some dynamically competitive industries are important in makingit likely that a successful innovation will yield a firm the leading position in amarket, and profits that are essential to encourage such innovations.
Many industries that may experience dynamic competition are characterized by substantial economies of scale. In such industries, creating a new productentails high fixed costs, such as the costs of research and development and ofsetting up production and distribution facilities. But once these costs havebeen incurred, the incremental cost of making each unit of the product issmall, indeed sometimes close to zero, and it is often easy to expand produc-tion to high levels. In markets with these characteristics, an innovator may beable to introduce its new product and keep production levels high enough togain substantial market share before others can offer products of competingquality. As a result, economies of scale may allow the innovator to keep itsaverage costs well below that of new entrants offering similar products thathave smaller initial market shares. In some cases this advantage may beenough to keep other firms from providing significant competition unlessthey can offer a product that is notably superior. Network effects are another mechanism that can help an innovator maintain a market-leading position in many dynamically competitive indus-tries. A product or service is subject to network effects if its value to aconsumer increases the more it is used by others. For instance, over the pastdecade, the number of people using e-mail has grown dramatically, making ita much more valuable means of communication for any individual usertoday than it was a decade ago. Network effects can also influence the valueof some computer software. The more people who use a particular softwareapplication, or at least software compatible with it, the more valuable thatsoftware is to any individual who wants to share or exchange files with otherswho use that software. One study of prices of spreadsheet software between1986 and 1991 found that consumers were willing to pay a significantpremium for software that was compatible with Lotus 1-2-3, which was thedominant spreadsheet program during this period. As more people use a particular good, its value to consumers can also increase because this wider use encourages the production of complementarygoods. For instance, as more offices use a particular type of photocopier,businesses offering repair services and spare parts for that copier may becomemore common, making the copier even more attractive to offices. As a result of these network effects, the value that consumers attach to a product that is already widely used may be substantially greater than thevalue they place on a relatively similar product that is used by fewer people.
For instance, a manufacturer may introduce a new copier that offers perfor-mance largely similar to that of the market leader. But if the new copier isbuilt in such a way that users cannot draw from the same service and spareparts network, it may be less valuable than the incumbent product. Thus, ifa firm can quickly gain market share after introducing a new innovation,network effects can play an important role in helping the firm maintain thatmarket leadership in the face of competition from new entrants offeringsimilar products. This, in turn, increases its ability to reap the profits that arenecessary for it to earn an adequate return on its risky investment. Many have expressed concern that network effects can give such substantial advantages to incumbent products that new firms with potentially superiorproducts are unable to compete. In theory, this could happen, but it does nothappen necessarily. If a new product is clearly superior to the leadingproduct, whether network effects are large enough to keep the new productfrom successfully competing will depend on the value of those effectscompared with the net advantages it offers after taking into account the costof switching to it. But, of course, measuring either of these—the value of thenetwork effects or that of the new product’s superior features—is difficult. Although there have been cases where a new product took over a market- leading position from one that presumably enjoyed network effects,conclusive evidence that network effects have prevented the widespreadadoption of a markedly superior product has not yet been found. Forexample, one common case put forward to argue that network effects canhinder the entry of superior products is that of the QWERTY keyboard, thefamiliar, century-old keyboard arrangement that virtually all typewriters usedand that most computer terminals use today. In the 1980s a study suggestedthat a keyboard arrangement called the Dvorak keyboard, introduced in the1930s by August Dvorak, was superior to QWERTY but had failed to gainmarket share because of the network effects that the already-establishedQWERTY enjoyed. Yet a more recent study raises significant doubts aboutclaims that the Dvorak keyboard was superior. For instance, the mostdramatic claims of its superiority are traceable to research by Dvorak himself,who stood to gain financially from the patented keyboard’s success.
Examination of his research revealed that experiments comparing keyboards often failed to account for differences in the ability and experience of participating typists. The best-documented experiments, as well as recentergonomic studies, suggest little or no advantage for the Dvorak keyboard.
This highlights that generalizations cannot be made about the significance ofnetwork effects in deterring the entry of superior products into a market.
Their impact must be judged on a case-by-case basis.
Fostering Innovation Through Organizational Structure Although the prospect of gaining a market-leading position can encourage firms to innovate, firms can reap the benefits of innovation through othermeans as well. As was mentioned above, the benefits of innovation are oftenshared by many. Licensing agreements offer one means by which a firm cancapture some of these spillovers. But such arrangements are an imperfect way of ensuring that innovators benefit from the spillover effects of their innovations while also encouraging additional beneficial uses of the innova-tion by others. As noted earlier, addressing this spillover problem is onemotivation for a research joint venture among firms that expect to mutuallygain from an innovation. Moreover, firms that develop new innovationssubject to network effects will benefit from the production of complemen-tary products that enhance those network effects. Partial equity stakes may provide a useful mechanism to foster the development of these complementary products. Even when conducted within a single firm, successful research requires appropriate effort from multiple parties. This includes not only the work ofresearch scientists and engineers, but also efforts by managers to craft anorganizational structure that attracts and rewards such personnel appropri-ately. Thus, successful innovating firms must address various agency costs inproduct discovery and development, to align the interests of these variousparticipants with the interests of the firm. For example, one study indicates that research programs in pharmaceutical companies that encourage publication by their scientists experience higherrates of drug discovery. Whereas stock options are often the focus of discus-sions about means of resolving agency costs, this example makes clear thatincentives must be carefully tailored to the desired objective. In this case,keeping a firm’s researchers closely connected to leading-edge developmentsin fundamental science may provide a critical advantage in developingcommercially valuable drugs. Thus, just as firms can use stock options as anincentive for managers to pursue shareholders’ interests, so, too, they cancreate incentives for researchers to be connected to developments at theleading edge of their science, by making a researcher’s standing in the greater scientific community a significant factor in promotion decisions. A furtherstudy suggests that these firms provide a balanced system of incentives: thosefirms that use a scientist’s publication record as a positive factor in promotionare also more aggressive in rewarding research teams that produce importantpatents. This reward structure helps direct scientists’ efforts to engage in bothbasic and applied research, culminating in successful drug discoveries. Decisionmaking at all levels of a firm can play an important role in determining its success in introducing substantial new innovations. A studyof the computer hard disk drive industry found that established firms oftenhad the technological know-how to develop what would turn out to be thenext disruptive technology in their market, such as the 3.5-inch disk drive. Infact, they were sometimes among the first to develop them. But new entrantswere always the leaders in commercializing the disruptive technologies examined in this study. In this industry, the failure of incumbents to lead in commercializing disruptive innovations was often traced to decisionmaking that focused onthe needs of their established market, failing to promote new technologieswhose initial applications fell outside that market. Yet it would be these tech-nologies that would eventually develop to become the leader in theestablished market. Thus the organizational structure and incentives faced bymanagers of established firms played a more important role than technolog-ical know-how in their failure to lead the commercialization of disruptiveinnovations. Of course, innovation benefits society whether it arises fromestablished or from entrant firms, but in either case, successful innovationrequires good organization. Dynamic Competition as Repeated Innovations All the factors we have examined—the market-transforming nature of some innovations, the presence of intellectual property protection, the poten-tial for economies of scale, and the presence of network effects—provideexplanations for why a firm can gain a market-leading position and earn highprofits after introducing an innovation. But what makes a market subject todynamic competition is the fact that the very same factors can allow anotherfirm, with an even greater innovation, to take much or all of the market awayfrom the leading firm. Indeed, as Joseph Schumpeter commented, thecompetition provided by new innovations “acts not only when in being butalso when it is merely an ever-present threat. It disciplines before it attacks.
The businessman feels himself to be in a competitive situation even if he isalone in his field.” One example of a market where dynamic competition prevails today is that for personal digital assistants (PDAs). Apple Computer, Inc., madesubstantial investments to develop the Newton, the first handheld PDA, which it introduced in 1993. This product did not succeed, but by 1996 at leastsix firms had operating systems for handheld PDAs either in development oralready available to consumers. The Palm Operating System soon emerged asthe preferred PDA, with a 73 percent market share in 1998. Although theinnovations embodied in its products have made Palm a leader in thismarket, it is losing market share to new PDAs.
This example demonstrates a number of the elements often found in markets undergoing rapid innovation. First, firms that make substantialupfront investments in product development do not always experience thesuccess necessary to gain an adequate return on those investments. Second,significant innovations can make a product the clear leader in a market at aparticular point in time. Finally, even these innovative market leaders facechallenges from later innovations by other firms that have the potential tomake the leader’s product obsolete. Therefore a potential innovator mustbelieve that, if it gains a market-leading position through innovation, theresulting profits will be adequate to justify the development costs, given notonly the possibility of failure but also the likelihood that future innovationswill make any market leadership short-lived. Box 3-3 describes anothermarket in which dynamic competition has been particularly intense.
Implications of Dynamic Competition forCompetition Policy Competition policy also has a role to play in markets characterized by dynamic competition. Markets experiencing rapid or substantial innovationcan still be subject to conditions or behavior by firms that hinder competi-tion. For instance, price fixing among firms will harm competition even inindustries undergoing dramatic innovation. Other behavior may have moreambiguous implications for competition, dynamic or otherwise. Thereforethe antitrust agencies will continue to scrutinize behavior by firms in thesemarkets. Since the lawfulness of certain actions by a firm depends, in part, onthe degree of competition in the firm’s market, the ability to properly assessall types of competition is essential. Consequently, the analytical frameworkused to assess competition must encompass its potentially dynamic dimen-sion. This involves recognizing the shortcomings of traditional methods forassessing competition when applied to markets undergoing rapid innovation,and developing new methods for determining how significant dynamiccompetition is in a particular market. Highlighting the importance of developing and applying such methods is the fact that markets characterized by significant dynamic competition maynot appear competitive through the lens of some common tools of tradi-tional competition policy. Thus continuing adjustments in competition Box 3-3. Dynamic Competition in the Market for Prescription
Anti-Ulcer Drugs
The dramatic nature of innovations in the drug industry can give a firm that introduces a new drug significant market share. But subsequent, equally dramatic innovations by competitors can makethis market leadership short-lived. Such leapfrog leadership is onecharacteristic of markets subject to dynamic competition. As an example, in 1977 SmithKline introduced the first anti-ulcer prescription drug, Tagamet. Just 6 years later, however, Glaxo plc intro-duced a competing drug called Zantac. Compared with Tagamet,Zantac had fewer adverse interactions with other drugs and needed tobe taken only twice rather than four times a day. Within a year, on arevenue basis, Zantac had gained more than a quarter of the market forprescription anti-ulcer drugs, and by 1989 that share had risen to morethan half while Tagamet’s had fallen to about a quarter (Chart 3-4). In 1989 Merck & Co., Inc., introduced a drug developed by Astra AB called Prilosec, the first of a new class of anti-ulcer drugs called protonpump inhibitors. The new drug had to be taken only once a day. Also,studies have shown that it heals a greater percentage of patients thanZantac does in a 4-week period. By 1998 Prilosec accounted for abouthalf of total sales revenue for prescription anti-ulcer drugs, whileZantac’s share of sales revenue had fallen to about 5 percent. (In thewake of mergers and other developments, the names of the firms thatsell all three drugs have changed.) This example demonstrates the rapid rate of innovation in the drug industry and how it can quickly render obsolete even highly innovativedrugs that companies have spent hundreds of millions of dollars devel-oping. In such a competitive environment, patents play an essentialrole in encouraging firms to spend the huge resources needed todevelop ideas and products that competitors could easily copy in theabsence of legal protection. This example also shows that, even with a patent, a firm can see its market share taken away by another firm that develops an even betterdrug for the same illness or condition. In this example, Prilosec wasintroduced into the market well before Zantac’s patent expired. Giventhe substantial upfront investments in drug research and development,companies will be motivated to develop drugs only if successful drugscan achieve high profits and capture a leading market share in the rela-tively short time before new innovations emerge. In the drug industry,substantial market share can easily be lost in just a few years.
policy are needed to avoid incorrect conclusions. Likewise, continuingadjustments are needed to correctly identify markets in which high profitsand market leadership cannot be explained by the ongoing nature or pace ofinnovation, suggesting that the market may indeed not be competitive. As noted in the discussion of merger policy above, a market’s degree of concentration is typically used as a screening mechanism to evaluate compe-tition in that market. Although finding that a market is highly concentrateddoes not by itself suffice to conclude that competition is limited, finding thatit is not highly concentrated usually does suffice to allay any such concern.
Thus measures of concentration provide a useful screen, because manymarkets may not be concentrated enough to warrant further investigation. However, given the significant role of innovation in markets characterized by dynamic competition, it is common to see one leading firm that, throughinnovation, has for the time being created a superior product. Although sucha market would be highly concentrated, there may in fact be substantialdynamic competition in the market, with new innovations emerging tothreaten the leading firm’s position. Consequently, because many marketsundergoing rapid innovation will have a high measured concentration, suchmeasurements may not be as useful a screening device if dynamic competi-tion is the primary form of competition in that industry. In light of this shortcoming, the development of effective screening mechanisms to evaluatedynamic competition may be a useful supplement to concentrationmeasures. Such screening mechanisms could allow businesses in innovativeindustries to better predict the responses of antitrust agencies to their actions,just as the safe harbor provisions relating to concentration measures did inthe 1980s. In assessing competition in a market, antitrust agencies and the courts also examine whether the threat of entry by a firm into that market would beboth likely to occur and sufficient to counteract any ability of existing firmsto exercise significant market power. However, for it to be adequate toassuage concerns, entry in response to such behavior must generally be ableto take place within a period of 2 years, essentially ensuring that the incum-bent firm or firms’ ability to profitably raise prices is only that durable. As thelength of patents indicates, firms may need substantially more than 2 yearsfor profits to provide an adequate return on their research and developmentinvestments. Moreover, in a typical assessment of the impact of a merger oncompetition, the threat of entry can be viewed as adequate to counteractanticompetitive price increases if it would prevent the merging firms fromkeeping prices significantly above premerger levels. But as Schumpeterpointed out, even if they may take longer than a few years to emerge, inno-vations in dynamically competitive markets may not only reduceincumbents’ profits that are above competitive levels, but indeed threaten thevery viability of incumbent companies. Such competition surely threatensthe durability of a firm’s market power.
Some common tools of antitrust policy may thus be less complete and informative in dynamically competitive markets than in other situations. Butjust as the antitrust agencies improved on simple concentration measures inassessing competition during the late 1970s and early 1980s, so, too, theexisting toolkit can be further augmented to deal with dynamic competition.
The central role of innovation in these markets suggests the kind of information that is useful in assessing this type of competition. In general, antitrust enforcement must continue the effort to understand the patterns, nature, and pace of innovation in a given market. In establishedindustries, the antitrust agencies and the courts can examine firm andindustry history to assess the significance of innovative activities. These activ-ities would include research and development expenditures andcomplementary investments in production or distribution that would havemuch less value if the product they support lost its market to a competitor’sinnovation. The risky investments associated with developing innovations gowell beyond research and development to include all investments that futureinnovations could render obsolete.
An industry’s history can also provide indications of the fragility of market leadership to substantial innovations in that industry. For instance, thehistory of innovations in the market for prescription anti-ulcer drugs,reviewed in Box 3-3, suggests that the threat of future innovations willremain an important competitive force. Where such threats are important,one might conclude that the industry is dynamically competitive. Brand-new industries, of course, lack such a history. Nonetheless, antitrust officials should still endeavor to assess the importance of innovative activityin these markets, and thus the potential significance of dynamic competition.
For both new and old markets, the potential for competition from develop-ments in other rapidly innovating fields should also be considered—even ifthe technologies of the respective fields are fundamentally different—as longas the application of those technologies is converging. For instance, vasculargrafts are used today to repair and replace diseased or damaged blood vessels.
But any assessment of competition in that market must take into account thepotential for substantial innovations in other invasive procedures or in drugtherapies that could either reduce the incidence of diseased or damagedblood vessels or provide alternative treatments. In both new and establishedindustries, we must encourage dynamic competition and the benefits ofinnovation it secures, by updating competition policy appropriately. Such updating has already taken place with respect to the scope of intellectual property protection and the effect it might have on other firms’abilities to innovate. Although intellectual property protection is importantto encourage firms to innovate, it can also be used in ways that hinder thedevelopment of future, and potentially competing, innovations by otherfirms. The FTC and the Justice Department have addressed this possibility inguidelines that recognize the interaction between intellectual property lawand antitrust law. These guidelines encourage the development of new tech-nologies and the improvement of existing ones, while seeking to preserve thedesired incentives underlying the creation of intellectual property.
Antitrust policy has contributed greatly to the economy by fostering competition and allowing the efficient adaptation of markets to new oppor-tunities. This chapter has showcased some recent changes in the organizationof economic activity and market competition and outlined the adjustmentsthat competition policy is making in response. First, corporate governance and structure continue to evolve, as the rapid pace of merger activity proceeds and hybrid organizational forms such as joint ventures and partial equity stakes continue to be established.

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