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

1. Introduction

We have been retained by the Competition Bureau (“Bureau”) to consider how the Bureau might assess innovation and dynamic efficiency when undertaking merger reviews.  While the nature and extent of change and innovation in a relevant market is an identified factor in the Competition Act to be considered in order to determine if a merger is likely to substantially prevent or lessen competition,¹ to our knowledge it has not been addressed in a broad Bureau policy report.  In particular, a practical framework to address issues of innovation and dynamic efficiency in merger review has not been previously advanced.  We hope this report will fill that gap. 

Having said this, we do not wish to imply that innovation is a foreign concept in current merger review.  The 2004 Merger Enforcement Guidelines (“MEGs”) discuss change and innovation in the context of determining when mergers may have anti-competitive consequences and when discussing the types of efficiencies that the Bureau will consider under section 96.  The MEGs indicate the Bureau will consider the competitive impact of technological developments in products and processes arising from many areas of the merging parties’ operations.²  Change and innovation may reduce barriers to entry, for example, thereby making it difficult for the merging firms to sustain a material price increase post-merger.³  Alternatively, a merger may facilitate the exercise of market power if it eliminates an innovative firm from the market that posed a serious threat to incumbent firms.  In such circumstances the merger may substantially lessen or prevent competition by delaying the introduction of new products or processes.⁴

Gains in dynamic efficiency arising from the introduction of new or improved products and processes are also recognized by the Bureau as important considerations in merger review.⁵  Such gains are described in the MEGs as “crucial to both the general evolution of competition and the international competitiveness of Canadian industries.”⁶  They are also regarded as inherently difficult to measure or substantiate.  Improved dynamic efficiency as a public policy goal is sufficiently important in the context of merger review that it warranted a chapter of discussion in the Report of the Advisory Panel on Efficiencies.⁷  Nonetheless the Advisory Panel Report did not provide (nor was it asked to provide) practical advice on how to consider dynamic efficiencies in merger review. 

In this report, we explore these and related issues.  We accept as a general proposition that Canadian competition law is flexible enough to allow for a rigorous analysis of innovation and its potential competitive consequences in merger review.  Indeed, competition in a market with differentiated products will often take the form of product innovation as well as price and cost reduction.  In such markets, a successful product innovation by one firm will stimulate imitation of the innovation by others, and may spur competitors to conduct innovation aimed at leapfrogging one another’s technological advancements.  As a result, innovative rivalry can be viewed as one form of competition that the Competition Act seeks to protect by preventing mergers that substantially lessen or prevent competition along this dimension.  Similarly, the long-term gains that accrue to consumers (and firms) as a result of innovative behaviour can be encompassed within the efficiencies provisions of Section 96 of the Act. 

Rivalry in the form of innovation can be distinguished from our usual focus in merger review on pricing in the following ways: 

1. Innovation involves future products or services making it intrinsically uncertain;
   
   
2. Innovation is a form of investment, requiring (at least) a normal rate of return on average, which is typically obtained through above-cost pricing in the short term, leading to a potential tension between short-term and long-term efficiency concepts;
   
   
3. There is no agreed-upon economic theory of innovation-based competition, and as a result a detailed analysis of the facts surrounding each potential transaction is critical; and,
   
   
4. Measurement issues make it difficult to say what constitutes “more” or “less” innovation in relation to a pre-merger benchmark.

In light of these special characteristics associated with innovation, we do not presume that the merger review process described in the MEGs can necessarily be applied without modification to cases where innovation concerns are paramount.  While the framework embodied in the MEGs can be successfully applied to most mergers, it may not provide the correct conclusion in situations where the merger involves two firms that do not currently compete, but that would be significant rivals in respect of a future goods market (which may include existing goods), or if the merger raises substantial competition concerns but future innovation is likely to reduce these concerns.  Thus, we depart from the MEGs on certain specific issues, as we will describe in more detail below.

Prior to setting out the framework for analyzing innovation in merger review, it is useful to define key terms.  We do this in the next section (Section 2), following which we elaborate on some of the inherent properties of innovation-based competition in Section 3.  In Section 4, we outline a pragmatic analytical framework that we believe allows for due consideration to be given to innovation and dynamic efficiencies in considering a merger’s potential competitive effects, while not ignoring the traditional merger concerns related to price and output.  This is followed in Section 5 with a discussion of how merger review should address efficiency claims in respect of innovation.  Concluding remarks are found in Section 6.

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¹ Section 93(g) of the Competition Act, R.S. 1985, c. C-34.

² Paragraph 5.7 of the MEGs notes that change and innovation may be in respect of distribution, service, sales, marketing, packaging, buyer tastes, purchase patterns, firm structure, regulatory environments and the economy as a whole.

³ MEGs, ¶ 5.8.

⁴ MEGs, ¶ 5.9.

⁵ MEGs, ¶ 8.15.

⁶ MEGs, ¶ 8.15.

⁷ Chapter 4 of the Report of the Advisory Panel on Efficiencies, August 2005.