Implications of Dynamic Competition in Regimes of Rapid Technological Change

1. General

Static and dynamic competition have elements in common. Cur- rent law embraces both,6 although in my view when it relies on economic theory to inform it, the law gets a larger injection of static analysis than dynamic analysis. But dynamic analysis has always been embraced to some degree by the law.

Traditional static analysis focuses on detecting market power in product markets. Dynamic analysis views competition through a broader lens and focuses less on outcomes and more on process. It favors maintaining rivalry but it also protects property. The working assumption is that intellectual property rights are desirable institutional/legal arrangements providing necessary appropriabil- ity mechanisms to promote and reward innovation.

The framework also recognizes that the benefits of dynamic competition do not arrive immediately; some short-run static inef- ficiencies may have to be tolerated to support innovation. Wooden policies blind to innovation and fixated on short-run efficiencies are likely to hurt innovation, and thereby hurt competition.

If policy is to favor dynamic over static competition, a role for vigorous antitrust enforcement still remains, but it proceeds less self-confidently. Uncertainty and complexity are hallmarks of dynamic market environments. In particular, the tools of static analysis should be used sparingly, if at all. Simple rules based on static analysis may well stand in the way of competition. In particular, concentration analysis should be deemphasized, as Ordover indicates (perhaps for different reasons). To prohibit merg- ers merely to manage concentration is unlikely to help consumers. More generally, the presumption that more competitors are always better is overturned—once the goal is not just lowering price but also protecting innovation.

Barriers to entry may need to be examined over a longer time period and must be examined at the firm level.7 The role of sup- porting structures and government funding for research also affect entry conditions. They may purely reflect capabilities that incum- bents have developed that newcomers shouldn’t expect to possess. Capabilities are likely to reflect the search for unique advantages. Their possession drives competition.

In stark contrast to the basic assumption of the structure– conduct–performance (S-C-P) paradigm, in dynamic contexts con- duct in this framework is not a function of market structure. Market conduct is driven more by internal organizational fac- tors: standard operating procedures, investment routines, and improvement routines. Performance depends on the (relative) organizational capabilities and behavioral traits of the enterprise. Enhanced industrial performance also stems from the improve- ment in individual technologies, and the expansion in the use of more productive technologies.

As discussed above, some typical evolutionary patterns to indus- try dynamics can be observed—perhaps one can call it an industry life cycle. In the early stages of the evolution of an industry, firms tend to be small, and entry relatively easy, because of the diversity of technologies being employed. However, as the dominant design emerges, costs of entry rise as an established scale for competition activity becomes apparent.

Learning becomes cumulative, and established firms are some- what advantaged over the new entrants. After an industry shake- out, established firms settle into a more stable industry structure. This may sooner or later be overturned by a new technology that has the promise of being superior. Under normal circumstances, with entry and exit, the life of firms tends to be short (Geroski and Schwalbach, 1991; Geroski, 1995).

New technologies can be competency enhancing or competency destroying. The essence of the dynamic competition approach is that technological change itself shapes industry structure. Also path dependencies and dynamic increasing returns are likely to be present in many circumstances.

Put differently, the rate and direction of innovation at the level of the firm does not depend on market structure but on the com- petences of the firm, the internal and external knowledge the firm can draw on, the IP regime, and its complementary assets. Entry conditions are a function of appropriability and cumulativeness. Learning and innovation will also shape the boundaries of the firm.

Market concentration is likely to be an outcome of market selec- tion, which in turn depends on the uneven exploitation of learning opportunities; that is, concentration has little to do with market power.

Moreover, if the degrees of selection are interpreted as a proxy for how well markets work—in the sense that they quickly reward winners and weed out losers—then more efficient markets tend to yield, in evolutionary environments, more concentrated market structures, rather than more “perfect” ones in the standard sense.8

The possibility of innovation rests on the permanent existence of unexploited technological opportunities. A growing body of evi- dence from the microeconomics of innovation (Rosenberg, 1976, 1982; Freeman, 1982; Dosi, 1988) supports the notion that unex- ploited opportunities permanently exist and that what firms actu- ally explore is a small subset of what’s available. Accordingly, firms aren’t constrained by nature, but by their own capabilities—there are therefore almost always opportunities to be sensed and seized.

2. Market Definition

Market definition issues typically play a central role in antitrust analysis, especially as it relates to Sherman Section II and Clayton Act issues. Defining the boundaries of one or more markets is the first step under the Merger Guidelines.

Economists recognize that market definition is merely an ana- lytical tool. As Janusz Ordover put it “Arguments for and against a merger that turn upon distinctions between broad and narrow markets definitions are, to an economic purist, an inadequate substitute for, and a diversion from, sound direct assessment of a merger’s effect”.

While Ordover is undoubtedly correct, in practice the courts and agencies seem to require market definition.

An evolutionary/dynamic competition perspective would appear to support Ordover’s position, as market share/concentration is unlikely to have much power in explaining conduct decisions, including those surrounding pricing. There is no general theorem establishing that higher concentration leads to higher prices or less output. There may be some theoretical support in static models to show that equilibrium output falls and equilibrium prices rise as the number of firms declines.

There is a modicum of empirical work in some markets like tele- com and airlines to support the S-C-P paradigm. But the evidence supporting it is weak, and when innovation is significant, theoret- ical connections and empirical correlations become even weaker.

Fortunately, the Merger Guidelines are clear that, at least in the merger context, market share is only a starting point—market definition is merely a tool. But it may not be even a good starting point or a good tool when the industry is characterized by rapid technological change. As discussed earlier, high market share may simply indicate that selection/competition processes are working well.

Also, as Katz and Shelanski note, in practice the hypothetical monopolist test is hard to apply in the context of innovation. Hartman et al. (1993) note that when innovation is present, prod- ucts are likely differentiated in quality, and price isn’t the main or only competitive weapon. Furthermore, we note that innovation can make it difficult to define relevant product markets because business executives and government officials alike may not yet know what the future products will be.

The hypothetical monopolist test to establish relevant markets may be better suited for quasi-commodity products than for high- tech companies. With innovation, value disparities are likely to exist amongst substitute products. In the context of the earlier discussion, before the emergence of the dominant design, compe- tition takes place on features, not price. Hence, the hypothetical monopolist test might not be applicable before the emergence of a dominant design. In the case of autos, an application of the test circa 1910 might have put steam cars, electric cars, internal combustion engine cars in separate markets, despite the fact that competition amongst these technologies was already fierce, and over the next few years led to the obliteration of producers who were not able to transition to the design and production of internal combustion engine autos.

More importantly, if one is to adopt a future-looking posture, then neither the agencies nor the courts are likely to know which products are likely to be good substitutes in the future. Since innovation produces new products and lowers the cost of existing products, it is necessary to include in the market such future prod- ucts; but this is quite difficult to do in many instances.

3. Market Share and Actual versus Potential Competitors

In traditional analysis, a market is first defined, and then actual competitors within it are identified and allocated a market share. In conventional analysis, actual but not potential competitors are included in the market. Potential competitors are recognized only when certain conditions of probability and immediacy of entry are met.

In dynamic contexts, potential competitors can be of very consid- erable importance. As discussed, what today may be thought of as a potential competitor can obliterate incumbents tomorrow in acts of Schumpeterian creative destruction. To exclude such competitors from the boundaries of the market would clearly be a mistake.

As discussed earlier, what is required is an assessment of capabil- ities. These are difficult to quantify; but a very large literature on capabilities now exists in the field of strategic management. This provides many clues with respect to how to assess the capabilities of both actual and potential competitors.

Furthermore, snapshots on market shares, whether present or forward looking, won’t tell you much if markets are in turmoil, as they frequently are in dynamic contexts. Moreover, high market share by no means suggests market power. Not only are today’s market shares a poor indicator of the future, but as already noted, a high market share may indicate not just superior performance, but strong selection (competition) at work in the industry.9

Accordingly, in both merger analysis and in Section II cases, when dynamic competition is at work, one must look beyond market share data. Serious consideration of potential competitors is required. After all, studies show that new entrants almost always drive innovation in established industries.

A focus on potential competition will help ensure that market analysis is forward thinking. Market share is likely to be irrelevant in regimes of rapid change; competition  for the market is likely to be as significant as competition within it (Teece and Coleman, 1998; Pleatsikas and Teece, 2001b).

Katz and Shelanski likewise note that market share may be altogether irrelevant in some cases because there may be markets in which innovation is so characteristic and sustained that firms compete not just  for  market  share,  but  for  markets  as  a  whole. A firm’s monopoly today may say little about the firm’s prospects one, two, and five years down the  road  (Katz  and  Shelanski, 2007).

One should note that there have already been efforts to come up with new analytic approaches to market definition in recognition of the fact that defining the market at the level of the product is difficult when successful future products cannot be predicted with any degree of certainty. I refer to Gilbert and Sunshine’s proposal for innovation markets (Gilbert and Sunshine, 1995). They put potential competition to one side, and focused instead on what they call “innovation markets”, by which they seem to mean R&D markets. Although this concept was used in US v. GM, the concept seems to have been forgotten.

Despite its shortcomings, the innovation market approach did shift the attention away from product markets to activity upstream. This required antitrust authorities to determine what skills and assets are needed to innovate, and determine who possesses those skills. This can be a fundamentally different inquiry from exam- ining demand side substitution, which is now quite familiar to economists and many courts. The innovation market approach might have been pushed to its logical conclusion—the analysis of capabilities, which we now discuss.

4. Analyzing Capabilities to Assess Competitor Positions and Economic Power

As was noted by Edith Penrose ([1959] 1995), an enterprise should be defined not by its current products, but by its (upstream) “resources”, or what some prefer to call capabilities.

Penrose defined the internal resources of the firm as “the productive services available to a firm from its own resources”, particularly those from management experience. “A firm is more than an administrative unit; it is a collection of productive resources” (pp. 149–50). She saw that “many of the productive services created through an increase in knowledge that occurs as a result of experience gained in the operation of the firm as time passes will remain unused if the firm fails to expand” (p. 54). Penrose saw the capabilities of management—not exhaustion of technologically based economies of scale—as determining whether a firm could expand to take advantage of opportunities. In reality of course, the resources/capabilities of the firm are defined by other assets too—like innovation capabilities—but it is important to note that Penrose laid out a model which implicitly eschewed market shares as a measure of how a firm is “positioned” to compete.

Subsequent research has established that firms exhibit more sta- bility in their capabilities than in their products. In this sense, capa- bilities are easier to analyze than products. Capabilities are a proxy for those interrelated and interdependent aspects of the enter- prise that govern its competitive significance. They are arguably a better proxy for competitive position than (downstream) market share.

Strategy refers to the broad set of commitments made by the firm that define and rationalize its objectives and how it intends to pursue them. Some of this may be explicit, and some implicit in its culture and values. Strategy is often more a matter of faith and determination, not one of calculation. Structure refers to how a firm is organized and governed and how decisions are made and implemented. Strategy and structure shape capabilities; but what an organization can do well is likely to be partly a function of what it has done in the past. However, its R&D activities and success at acquiring external technologies can mold its going-forward capa- bilities. Strategy helps determine what capabilities one should own and protect.

The world is too complicated for a firm to have “an optimal strategy”, and while its capabilities are always in a state of flux, existing capabilities are a good guide to what a company can do in the future. The capabilities approach would be quite a break from standard analysis. It would calibrate a firm versus competitive standing not by reference to products but by reference to more enduring traits.

In a dynamic context a firm will have a changing kaleido- scope of products—yet its underlying capabilities are likely to be more stable. For instance, rather than analyzing Honda’s mar- ket share in outboard motors, lawnmowers, and small electric generators, perhaps a more meaningful approach for antitrust analysis would be to look at a capability “market”. Here the relevant capability might be around small four-stroke internal combustion engines. A capabilities approach may lead to “mar- kets” being defined more narrowly or broadly than product markets.

The tools for assessing capabilities may not be well developed yet, but they are developed enough to allow tentative application. Clearly, product market analysis can be unhelpful and misleading in dynamic contexts. Using the right concepts imperfectly is better than a precise application of the wrong ones.

The question arises as to whether simply doing a better job at analyzing potential competition would help. Clearly it might. In the  end,  however, one  would be forced to  look  at the  capabili- ties of potential competitors—so there is probably no escape from developing the analytics of a capabilities approach.

The innovation market approach introduced by Gilbert and Sun- shine (1995) implicitly recognizes that focusing on product market analysis is inadequate. But it too narrowly focuses on R&D as the arena for measuring innovation competition. Even if it is defined quite broadly, R&D is usually just one element of the resources and problem solving that goes into innovation. The resources that must be committed—and the skills that must be employed—to succeed at innovation are usually much greater than that needed for just R&D. Furthermore, R&D concentration has little to do with innovation outcomes, except possibly in industries characterized by cumulative technological change—and even here, the linkage can be expected to be weak. The widespread adoption of ele- ments of an open innovation10 model—whereby elements of the innovation process are outsourced—makes this point even more compelling.

5. Merger Analysis

Despite the misgivings of an increasing number of economic schol- ars, in practice merger policy in the USA, the European Union, and most other jurisdictions where there is competition law focuses on how the merging party’s combinations will affect concentration in one or more product markets. In effect, an increase in con- centration is taken as a proxy for a decrease in competition that if of sufficient size will lead to an increase in the prices faced by consumers.

Focus on dynamic competition is likely to be especially rele- vant in high-technology industries. The evolutionary/behavioral economics approaches outlined here are not ones that lead to the abandonment of antitrust, or even necessarily to its restric- tion. But they do lead to a more careful approach that recognizes uncertainty and complexity and relentlessly asks: does this practice support/discourage innovation? Will this merger assist or burden dynamic competition?

The evolutionary/behavioral economics framework which we advance suggests a number of modifications in the way that some analysts may view a particular merger:

  1. Market structure is not a meaningful concern, at least not until a domi- nant design has emerged, and the evolutionary paradigm is established and likely to remain for quite some time.
  2. If the analysis is to be deflected away from products in the market, the natural place to look is at These transcend products.
  3. Only if the merger entities are the only ones with the necessary capabilities to innovate in a broad area should concerns arise. Katz and Shelanski suggest that if new product development efforts are under way to create or improve products and processes, and these products are not yet in the market, then harm arises from a merger because it may cripple future product market competition in a mar- ket that does not exist. A capabilities approach would soften such concerns—the question should be framed not in terms of whether product market competition will be impaired—as that is too much of an immediate concern—but whether capabilities will be brought under unitary control, thereby possibly thwarting future variety in new product development.

6. Intellectual Property Issues

Favoring dynamic (over static) competition does double duty. It also softens the patent–antitrust debate. Static analysis looks upon patents with considerable awkwardness—and fuels tension between the patent system and antitrust.

The DOJ-FTC intellectual property guidelines have endeavored to reconcile the tension between intellectual property and antitrust by declaring intellectual property just another form of property, and by noting that patents only imply market or monopoly power if they enable control of a relevant market, which is rarely the case. Still, justifying the exclusivity provided by the patent system is not easy for many competition policy advocates. In practice, neo- classical economists are often hostile to patents, believing that the appropriability problem is naturally solved by other mechanisms, which is often not the case.

Embracing dynamic competition causes tension between intel- lectual property and antitrust paradox to soften. The patent system provides some amount of exclusion; and some amount of exclusion is required to foster innovation, particularly in more competitive market environments.

Of course, once antitrust doctrine sees the promotion of innova- tion as its major goal, innovation and competition snap into greater harmony. But the harmony isn’t perfect, as questions remain with respect to the degree of intellectual property protection needed to foster innovation and competition. The cumulative/sequential nature of innovation means that intellectual property protection needs to be calibrated in a careful manner. There will almost always be more users of intellectual property than generators of it; so the danger particularly is that the users will try to crimp the scope of intellectual property rights provided to the generators.

Source: Teece David J. (2009), Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press; 1st edition.

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