As discussed earlier, there is a third (usually overlooked) but very important proposition embedded in Schumpeter: dynamic competition should be favored over its poorer cousin, static compe- tition. I will describe both static and dynamic competition in turn. In doing so, I recognize that these styles of competition sometimes do not have bright lines separating them. Certainly, Schumpeter didn’t provide crisp delineation.
In this chapter I try to give some substance to Schumpeter’s intuition. Unfortunately, static competition is frequently favored unwittingly by antitrust economists. Dynamic competition is a style of competition which relies on innovation to bring forth new prod- ucts and processes and concomitant price reductions. It improves both productivity and consumer welfare. Promoting it may well mean recognizing that competitive conduct may involve holding short-run price competition in abeyance.2
Dynamic competition is not embraced as widely as it needs to be in part because the overwhelming focus in economic research is (implicitly) inside the paradigm of static competition. Indeed, a major contribution can come from simply revealing to judges, juries, the enforcement agencies, and legislators that most eco- nomic analysis is static, when it should be dynamic, and as a con- sequence innovation may well get harmed by superficial answers derived from implicitly held static notions about desirable forms of competition. This bias stems merely from the analytical tools used, as most every economist recognizes the importance of inno- vation, then usually proceeds to apply analytical approaches that ignore it. Recognizing this state of affairs should deflate the hubris with which many antitrust scholars approach issues. To the extent they wield analytical tools of static competitive analysis, antitrust analysts are quite likely to make prescriptions which harm both innovation and competition, and sap productivity.
In order to come up with prescriptions that do more good than harm, it is necessary to inquire about the determinants of innova- tion, and the impact of antitrust activity on innovation. Dynamic competition is advanced by rapid technological change. And this is where the problem starts. The analytical framework most com- monly used by economists stubbornly adheres to the view that market structure and little else determines the rate of technological change. This framework is grossly inadequate.
For instance, in merger analysis, as in many other forms of antitrust analysis, one is required to define a market and look at market shares. If a merger augments concentration above an accepted threshold, it may be blocked. Merger analysis usually proceeds this way, even though there are a growing number of economists who are beginning to think otherwise, particularly in differentiated product contexts.3
More often than not, however, avid antitrust economists (per- haps inadvertently), adopt the mantle of static competition. Because of its familiarity, they (unwittingly and inappropriately) use the apparatus of static microeconomics to analyze contexts where innovation is important. Innovation is at best an after- thought in static microtheory. The presence of innovation com- plicates the analysis, destroys equilibrium, and debases the value and utilities of the tool bags that most economists carry. This is unsettling, and tends to be resisted by the profession. Thus, dynamic analysis is shunned either because it isn’t known, or if known it is feared that recognizing it will be too hostile to well-accepted and well-practiced analytical frameworks. Compe- tition policy advocates should not accept this state of affairs any longer.
To preview what is to follow, this chapter recognizes that dynamic competition is associated with the change in external cir- cumstances and/or the generation of new products, new processes, and new business models. As Schumpeter said, competition fueled by the introduction of new products and processes is the more powerful form of competition: “competition from the new com- modity, the new technology, the new source of supply, the new type of organization—competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the output of existing firms, but at their foundations and their very lives” (Schumpeter, 1942: 8).
In today’s vernacular, dynamic competition is heavyweight com- petition; static competition is the “lite” version. Advocates of strong competition policy must surely favor the former. Static competi- tion is anemic compared to dynamic competition. More on this below.
1. Static Competition
Static competition reflects an intellectual framework, generally not a state of the world. Absent innovation, (static) competition mani- fests itself in the form of existing products offered at low prices. No new products are introduced, and rapid price reductions driven by innovation simply don’t exist. There’s no hurly-burly competition. Without innovation, all firms have the same technology and the same business models. Markets are in a comfortable equilibrium. Nobody makes any money of course, but nor do they innovate. Price gets squeezed down to marginal cost.
Agents are nevertheless rational and well informed. Prices are drawn down to the floor of long-run marginal cost; but that floor becomes their resting place. Firms just make their cost of capital and cover long-run marginal costs, and consumers are bereft of new products and true bargains. They never get overcharged, but there’s nothing to charge them up.
While the framework has a simple theoretical simplicity and ele- gance, the industrial dynamics behind it are uninteresting. Absent innovation, there is unlikely to be much or any new entry— if incumbents can satisfy demand, new entrants aren’t needed. Absent scale economies, no firm is likely to become dominant, and the ecology of firms is unchanging.
The static economics paradigm is what infuses, at least, the undergraduate economics textbooks. It is not a recognizable state of the world, except perhaps in a few local markets somehow insulated from competition. Unfortunately, it is what tends to spill over into antitrust economics as a normative paradigm. However, it is not and has never been a good abstraction of the economy. Nor has it ever been a state to which we should aspire.
2. Dynamic Competition
Dynamic competition is driven by innovation, but not exclusively. The term dynamic is a shorthand for a variety of rigorously com- petitive activities such as significant product differentiation and rapid response to change, whether from innovation or simply new market opportunities ensuing from changes in “taste” or other forces of disequilibrium. Dynamic competition is in fact more intuitive and much closer to today’s everyday language view of competition than is the (textbook) notion of static competition.
Dynamic competition is of course embedded in the Austrian eco- nomics framework of Carl Menger and his fellows (e.g. Kirzner). The Austrian treatment is quite different from neoclassical eco- nomics. The focus of the latter is on a static equilibrium in which there is a minimum number of known exogenous variables. Aus- trian economics does not purport to compute any equilibrium, because the essence of competition is taken to be the dynamic pattern by which it comes about, not the equilibrium itself. The truth is, Hayek argued, that “competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis” (Hayek, 1948: 94). The wishes and desires of consumers cannot be regarded as given infor- mation to producers but ought to be regarded as problems to be solved by the process of competition.
With dynamic competition, new entrants and incumbents alike engage in new product and process development and other adjust- ments to change. Frequent new product introductions followed by rapid price declines are commonplace. New innovations stem from investment in R&D, and/or the improvement and combination of older technologies. There are continuous introductions of product innovations, and from time to time dominant designs emerge. With innovation, there are explosions in the number of new entrants; but once dominant designs emerge, implosions are likely and mar- kets become more concentrated. As with dynamic competition, innovation and competition are tightly linked.
The model of dynamic competition recognizes that competition is a process, and that entrepreneurs and entrepreneurial man- agers are essential to it. Stagnation is defeated by perennial gales of competition. Maintaining innovation depends upon the exist- ence of entrepreneurs and institutional structures that support innovation.
Technological innovation comes in waves, based on different technologies. These waves cause what Schumpeter called “creative destruction” (Schumpeter, 1942: 83). A large fraction of new (rad- ical) technologies are introduced by enterprises new to an industry; however, incumbents do sometimes pioneer, and if not are often able to imitate or improve on the new entrant’s products. The ben- efits of creative destruction may not come immediately; changes take time. Innovation drives competition, and competition is in turn driven by innovation.
This paradigm of industrial change has been refined by Abernathy and Utterback (1978) and given some theoretical motivation by Burton Klein (1977). There is now considerable evidence supporting it over a wide range of technologies (Klepper and Graddy, 1990; Utterback and Suarez, 1993; Malerba and Orsenigo, 1996). It implicitly recognizes inflexion points in tech- nological and market evolution. The advent of new technologi- cal ensembles or paradigms is usually marked by a wave of new competitors entering an industry to sustain success. Incumbents must master discontinuities as well as incremental change and improvement.
There are many other complementary “models” of innovation. At their core, most can be related to an evolutionary theory of economic change and a behavioral theory of the firm. As Sydney Winter once said, the methodological imperative of evolution- ary theories is “dynamics first”; the methodological imperative of behavioral theory is that internal firm structure (not market struc- ture) and internal processes such as learning, diffusion, sensing, seizing, reconfiguring impact firm behavior.
Evolutionary theory in economics is sometimes understood to be economic Darwinism; but the logical structure of an evolutionary theory is much broader than its biological versions. Evolutionary theory draws attention to what went before. As a general principle, novelty comes about by changing and combining existing artifacts and structure. “Descent with modification” crystallizes this key point.4 Selection leaves behind variants that are unfit according to the selection criterion at work.
Selection processes include not only birth and deaths of individ- ual firms (Hannan and Freeman, 1989), but also the ability to adapt to the changing environment by changing strategies and structures.
Scholars disagree on the amount of adaptation that is possible. Some evolutionary economists see firms as strongly constrained; strategic management scholars claim much greater capacity for change effectuated by managers. All recognize that the advance of change in the context of changing markets and technologies will lead to diminished prospects for the enterprise.
Another common thread to behavioral/evolutionary mecha- nisms is that they are probabilistic rather than determinative (Aldrich, 1999: 33–50). Rigorous evolutionary theories will make probabilistic statements like “there is a Z probability that individual Y will not replicate (die when the entity has a limited life span) under the selection environment X” (Murmann, 2003: 15).
Because business enterprises are guided by routines that interact in highly complex ways, managers more often than not find it difficult to figure out what makes the enterprise successful. This ambiguity around causation becomes a problem when the envir- onment changes, as causal ambiguity makes it difficult to figure out what the enterprise should do differently. When Japanese auto manufacturers started to take a large share away from the US manufacturers in the 1980s, a string of explanations were put up by the US auto industry to explain the phenomenon, including a view that the cost of capital was lower in Japan, that unfair trade barriers in Japan prevented exports from the USA, to concerns that the US firms were falling behind in the use of robotics, etc. It took nearly two decades for the US auto industry to figure out for itself that labor–management issues, and management itself, were key causal factors associated with decline.
Once causation was more accurately diagnosed, management and organizational changes were made that began to make a dif- ference. Often it is necessary to create a breakout structure to unshackle the new from the old.
There are a number of assumptions and propositions that char- acterize dynamic competition. Many of them are rooted in an evolutionary theory of economic change. As Schumpeter said, “in dealing with capitalism, you are dealing with an evolutionary process”. Features of evolutionary theory are outlined in the next section.
Source: Teece David J. (2009), Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press; 1st edition.