Innovation and Dynamic Efficiencies in Merger Review

Report

April 9, 2007

(PDF; 597 KB; 45 Pages)

---

Prepared By:
Andrew Tepperman and Margaret Sanderson
CRA International

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

Disclaimer
This report provides the views of the authors.  It does not necessarily reflect the views or opinions of other staff or consultants with CRA International.  As a result, CRA International makes no representation or warranty as to the accuracy or completeness of the material contained in this document and shall have, and accepts, no liability for any statements, opinions, information or matters (expressed or implied) arising out of, contained in or derived from this document or any omissions from this document, or any other written or oral communication transmitted or made available to any other party in relation to the subject matter of this document.

Executive Summary

This report addresses issues that arise when incorporating innovation issues into the merger review process.  Competition based on innovation, whereby firms attempt to gain market share through the introduction of new or improved products or services-dynamic competition-is at the heart of many modern industries.  Accordingly, an understanding of dynamic competition is relevant for merger review.  When incorporating innovation issues into merger review several considerations arise.  First, there is no settled economic model that relates the extent of market concentration to the extent of innovation and as a result, we do not know how concentration today affects firms’ levels of innovative activity, which differs from the clear link that exists between concentration and pricing.  Second, innovation is highly uncertain, making it much more difficult to measure and quantify than price and output.  Third, these measurement problems make it difficult to quantify a merger’s likely effect on the rate or outcome of innovation.  Finally, innovative activity is a form of up-front investment, and prices must be expected to exceed short-run marginal cost to justify the investment, on average.  As a result, static measures of economic efficiency that fail to account for the flow of surplus from the introduction of new products cannot tell the whole story when innovation is important to the merger review.  An appropriate treatment of efficiency must recognize these dynamic gains, without ignoring the importance of competitive rivalry among firms within markets at a point in time.

With these considerations in mind, in this report we propose a framework that allows for the effect of merger transactions on innovation to be incorporated into merger review, where the current approach found in the Merger Enforcement Guidelines is not sufficient to fully capture dynamic competition.  The current approach found in the Guidelines works well for addressing when mergers are likely to lead to a reduction in either actual or potential competition in an existing goods market.  The framework we propose is aimed at addressing future goods markets, while making use of information available today.  It should be of assistance to competition authorities faced with mergers that may raise competition issues in future goods markets, or that may involve future innovations which obviate any competition concerns in existing goods markets.

The framework proceeds by making the following inquiries:

1. Is innovation important in the industry in question?
2. Can affected future products and firms be identified?
3. Would the merging firms compete against each other in those future markets but for the merger?
4. Would the merger reduce the existing level of innovation?
5. Would the merger result in an increase in prices in the future market above what they would be without the merger?

In light of the special considerations associated with innovation, application of this framework is likely to be highly fact specific. A number of factors that can be taken into account under each of these five inquiries are discussed.

The merger review process also calls for gains resulting from improved innovative conditions to be considered as a potential offset to static efficiency losses resulting from price and output changes.  Such dynamic efficiency considerations may be difficult for parties to prove, but could be expected to arise from a number of plausible sources.  In particular, merging firms may be able to eliminate duplicative research and development programs, or may be able to realize economies of scale or scope in research and development.  Again, a dynamic efficiency analysis must be case-specific in nature and would require a careful consideration of factual material.