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

4. Evaluating Innovation Concerns in Merger Review

4.1. Motivation

We now turn to how best to account for innovation concerns in merger review.  We begin by identifying the types of mergers in which innovation and dynamic efficiencies could play a significant role when reviewing the competitive effects of the transaction.  A useful classification scheme for mergers is provided by Richard Gilbert and Willard Tom, which they apply to U.S. mergers evaluated by the Federal Trade Commission (“FTC”) and the Antitrust Division of the Department of Justice (“DOJ”).⁴⁵  Gilbert and Tom group challenged mergers, including those involving innovation, into four categories:

• Mergers in which actual competition in an existing goods market would be reduced;
• Mergers in which potential competition in an existing goods market would be reduced;
• Mergers in which actual competition in an “innovation market” would be reduced; and,
• Mergers in which actual competition in a future goods market would be reduced. 

The first two types of mergers are adequately addressed using conventional tools, provided attention is paid to dynamic efficiency issues (which we discuss in the next section).  The third category is a special type of analysis that has been proposed by the FTC and DOJ for use in some cases.⁴⁶  The concept of the “innovation market” does not exist in Canadian jurisprudence, and we do not advocate it.  Instead, we believe the competitive effects related to innovation can most practically be addressed under the fourth merger category.⁴⁷  In speaking about a “future goods market” here, we do not intend to restrict ourselves to markets consisting of new goods that do not currently exist.  We have in mind a more general definition, in which a future goods market is simply a market as it exists at some future date; as a result, it may include existing goods as well as products that will come into existence at a later date.

It is useful to additionally motivate the discussion by considering two examples of mergers in which innovation effects are important, and for which a conventional merger analysis may not lead to the correct answer.  Any practical framework should be able to deal correctly with examples such as the following:

• Example 1: Two firms, A and B, currently sell products that are commonly understood to be complements from a demand perspective (i.e., an increase in the price of one of the goods decreases demand for the other).  However, B is currently engaged in innovation such that in the future, there is a strong likelihood that B’s product will be valued by consumers as a replacement for A’s (instead of used in connection with A’s), and there is likely to be little other competition for A’s product.  Firm A proposes to acquire firm B.
  
  
• Example 2:  Firms C and D currently compete with each other in the sale of some product.  No other firms currently sell similar products.  However, some set of firms E, F, and G are engaged in R&D that is likely to lead to future products that will be competitive with those offered by C and D.  Firms C and D propose to merge.

In Example 1, it is clear that if innovation concerns are not taken into account a merger might be permitted that would decrease economic efficiency if further entry in competition with a merged A/B is unlikely, despite the fact that at the time of the merger, the parties are not producing close substitutes for each other (and consequently their products are not considered to be part of the same relevant antitrust market at the time of the merger).  For instance, if Microsoft had proposed to acquire Netscape in the mid-1990s, and accepting the U.S. government’s theory of anticompetitive harm (i.e., that Netscape’s browser would eventually represent a strong threat to Microsoft’s dominance in the market for operating systems), a strong case for blocking the merger should be made.⁴⁸  Example 2 illustrates that accounting for innovation concerns can also have the effect of demonstrating that some mergers thought to be undesirable may actually not lead to a lessening of competition—the state of current competition, as represented (for example) by market shares, need not indicate the “true” long run level of competition after accounting for the likelihood of innovative entry.

4.2. A Framework

Given the discussion in the previous section,⁴⁹ we suggest that potential competitive effects of innovation are best dealt with using an approach that proceeds by asking five questions. 

1. Does innovation matter in the industry?
   
   This is a critical threshold issue, since if innovation is not a key attribute of competitive rivalry between firms, it is unlikely that innovation concerns are truly at the heart of any negative competitive effects feared from the proposed transaction.  On the other hand, if the merging firms operate in a highly innovative industry then an exclusive focus on existing goods markets may overlook competitive issues relating to future goods markets.
   
2. Is it possible to identify the type (or identity) of firms that may participate in the future goods markets?
   
   The claim that a merger is likely to result in a lessening of competition in a future goods market (as in Example 1) can only be compelling if it is possible to identify the firms that may plausibly compete in that future goods market and the innovative products that these firms would likely be selling, and if the relevance of the innovation to competitive success in that market is transparent.  Similarly, it is only reasonable to allow a merger that currently seems problematic on the grounds that innovative new products will be competitive in the future (as in Example 2) if the firms that may develop and sell those products—as well as the nature of the potentially competing products themselves—can be readily discerned.
   
3. Are the merging firms likely to compete against each other in an identifiable future market, but for the merger?
   
   Assuming we are able to determine with some degree of confidence the future products and firms that will be of interest, this step involves determining if the existing or future products of the merging firms will compete in that future market.  At this stage, the question allows for an appropriate consideration of uncertainty.  Firms may be engaged in R&D which would result in competing products if both firms are successful, but if success by both occurs with only a low probability, then there is little reason to fear a merger among the two firms will substantially lessen competition in the future market, and the case for intervention is weak.
   
4. Would the merger result in a decrease in the resources devoted to one or more R&D programs, or the diversity of R&D programs such that the rate of innovation is likely to change following the merger?
   
   Provided (3) is answered in the affirmative, we ask whether evidence exists that the parties would change the manner in which they are pursuing innovation if the merger is permitted to proceed.  An affirmative answer at this stage would support a conclusion that the merger is likely to affect competition in future markets by reducing the level of innovation today.  This consideration is absent from merger analysis under the MEGs, but it is potentially important in scenarios involving innovation.  For instance, it may be the case that a merger will not be found to have any substantial effect on the prices of existing or future products, but may negatively impact on the speed at which the merging parties introduce new products.  If this effect is substantial enough, it might be desirable to challenge the merger despite the absence of price effects in either the existing or future market.  Step (4) therefore provides the opportunity to do so.
   
5. Would the merger result in the merged firm being able to raise prices in the identified future market, relative to prices but for the merger?
   
   This is analogous to the traditional question asked under merger analysis, and discussed in the MEGs.  Under the facts assumed in Example 1, we would expect the merger to allow the parties to raise the price of the future product, since the parties would otherwise be in competition but for the merger.  In Example 2, we would expect competition from innovators entering in the future to be able to constrain pricing by the merging parties.  Relative to the conventional case, another additional nuance is that there may be no pre-merger price to use as the base price; this complication arises in Example 1, for instance. 

   In setting out this framework, we do not advocate an exclusive focus on innovation at the expense of conventional price concerns.  A merger may lead to higher prices in a future market than would otherwise exist if the question posed in (3) is answered in the affirmative.  Nonetheless, a substantial price effect is not an inevitable consequence of a merger between likely competitors in a future market, just as it is not for a merger between actual competitors in an existing market.  Non-merging parties selling other products—including, as in Example 2, products that do not yet exist—may discipline the merged firm’s pricing.  To take another example, merging firms may be conducting R&D toward the introduction of new drug products that, if successful, would be sold in competition with a number of therapeutic alternatives offered by other firms, so while the merger may eliminate competition between the merging firms, this is not expected to have a substantial effect on prices in the future market given the competition expected from additional rivals.

4.3. Practical Issues in Applying the Framework

In this subsection, we focus on practical issues that are involved in using this framework to evaluate specific mergers.  Each of the five questions used to frame the analysis is discussed below.

4.3.1. Is innovation important in the industry?

This threshold question is usually relatively easy to address.  Research into the industry should be able to establish certain basic facts, including whether firms attempt to gain competitive advantage through innovation in any form, and whether consumers derive benefits from the introduction of innovative products.  Analyst reports covering the merging firms or the sector in which they operate may provide valuable information on the importance of innovation.  Studies of the industry in general or of specific markets within that industry may also exist.  These are often useful in understanding whether innovative product attributes drive consumer demand.  Any evidence that consumers tend to switch purchases among different producers based on product attributes—especially those attributes that have recently been introduced—is indicative of active innovation.

Qualitative information of this type should be supplemented by more quantitative inquiries.  One approach is to look at innovative inputs that are known to be correlated with innovative output.  R&D spending by industry participants is relevant, since industries in which participants make substantial and ongoing R&D commitments (normally measured as a share of sales) tend to be more innovative.⁵⁰  Another metric of innovative input that has been used with some success is scientific research activity, as indicated by publications in scientific journals.  Lim has shown that both pharmaceutical and semiconductor innovation (as represented by firm patenting) are strongly correlated with the number of publications by firm personnel in applied scientific journals.⁵¹

Another approach would be to look for evidence of innovation in market outcomes.  An observation of frequent changes in market share is one such indicator.  Fluctuations in market share from quarter to quarter or from year to year tend to indicate the presence of dynamic competition, as firms are constantly forced to reevaluate the effectiveness and attractiveness of their product offerings in light of their competitors’ performance in the marketplace.  The cellular handset industry provides an example of dynamic competition and changing market shares.  Leaders such as Nokia are unable to rest on past market successes, finding that if they do so other innovative cellular handset producers such as Motorola or Samsung will rapidly introduce products with attractive characteristics and gain market share.⁵²  Note that market share turnover is not a necessary condition to identify the importance of innovation to the sector, as is witnessed by Intel for example.

4.3.2. Can firms and products in future goods markets be identified?

This question is posed to determine whether there is likely to be an identifiable future market for which the transaction raises competitive concerns.  To identify any such market, we must be able to describe the firms that could plausibly be participants in the future market along with the product(s) that could potentially be at issue.  As we have discussed above, these products could include those that already exist and are expected to remain available, as well as new products that will result from innovation.  Analyst reports will again be of use here—stock analysts are particularly attuned to factors that may influence the future development of markets in which the companies they cover operate.  In telecommunications, for example, analyst reports offer various opinions on the likely take-up of voice-over-Internet Protocol telephony, and what this will mean for incumbent telephone providers. 

The parties’ internal documents will also offer insight, particularly in sectors where innovation is central.  In any “racing” situation, for example, we would expect some discussion in the firms’ internal documents comparing its research advances to those of important rival firms, thereby allowing the Bureau to identify the most relevant rivals to the merging firms.  Thus, for instance, IBM will comment on Sun’s and HP’s latest Unix advances when discussing funding for new mainframe models.  Documents that discuss research setbacks or that make requests for further funding may contrast the firm’s innovation success with important rivals. 
In addition to reviewing available descriptive material on the industry, certain economic and technological considerations must be taken into account.  Consider first how information on the form of innovation could be useful in identifying possibly competing firms.  Innovation in some industries may arrive unpredictably from outside sources, or from firms or individuals that are only peripherally involved in the industry at present.  By looking at firms that currently operate in the industry in such cases, we would be unable to determine the firms that might be active in particular markets in the future, and the sources of innovation for those firms.  An example of this type of industry might be computer software.  Many software innovations arrive in the form of computer code written by programmers who may not be affiliated with established firms.  Software firms can spring up almost overnight to take advantage of perceived market opportunities, facilitated by the fact that entry into software markets requires programmer effort and time, and relatively little capital investment.⁵³  Moreover, programmers are ingenious at devising methods to achieve the same functional goals by means that are different from those currently practiced.⁵⁴  Predicting which software firms might be competing in some future market years hence would then be extremely difficult, if not impossible.  In cases such as this we would recommend against challenging a merger based on innovation concerns.

At the other extreme, innovations in some industries may arrive in a relatively systematic fashion as a result of R&D efforts conducted within established firms.  Drugs or medical devices are examples of industries in which many innovations result from diligent, systematic internal efforts.  Only a select handful of firms may have the necessary physical and human capital assets to pursue particular innovations and commercialize the resulting products.  Industry participants and informed observers will normally be well aware of the identities of these firms.  Pharmaceutical and medical device products must also pass through a lengthy governmental review and approval process before they can be sold on the market.  A wealth of regulatory documentation, together with patents filed by innovating firms, is publicly accessible.  These facts ensure that it is relatively straightforward to identify well in advance firms that may ultimately compete in a future market.  It is probably for these reasons that the majority of merger challenges brought by the U.S. agencies based on innovation issues have involved pharmaceutical or medical device firms. 

Equally important is isolating the contribution of the innovation to the value and functioning of the resulting product.  For the reasons discussed previously, it will normally only be possible to do this in a rough and qualitative way.  For illustrative purposes we offer two extreme cases for discussion. 

At one extreme, the typical innovation in an industry might resemble the incremental improvement to logical processing noted previously in the microchip example.  Even if it is somehow known that a set of firms are pursuing similar innovations, it is difficult to predict how a merger between two firms pursuing this research would likely have a negative impact on future product markets, given the great disparity between the scale on which innovation takes place and the ultimate scale of the product.  A great deal would have to be known or assumed about the technical relationship between the innovation and the additional complementary components necessary to build up from the innovation level to the product level—for example, would innovation failure imply that no product would be forthcoming?  Or would the product simply be different somehow?  If innovation succeeds, would different firms develop different products using alternative sets of complementary components?  Generally, the more oriented the innovative activity is toward “basic research” (or the further the product is from commercialization) the more difficult it is to evaluate reliably the potential competitive effects resulting from a merger.  In such circumstances, a merger between two firms, even when both are pursuing similar research, is not likely to result in an identifiable lessening of innovation or increase in prices in future goods markets.
At the other extreme, some products are effectively made up of a single innovation.  Pharmaceutical products are a good example.  Successful R&D in the pharmaceutical industry results in an “active pharmaceutical ingredient”—essentially a chemical compound with attractive clinical attributes—that can be incorporated into various dosage forms for sale to consumers.  Here, it may be relatively easy to predict the extent of competition in a future market, given the observed relationship between R&D along a particular technological trajectory and competition in existing (and past) product markets.  Two firms engaged in clinical trials for drug products that aim to treat the same condition in these circumstances will very likely be product market competitors should their development programs succeed.

With this in mind, it is apparent why many of the recent mergers challenged by the U.S. agencies on the basis of innovation issues have involved firms in the pharmaceutical industry.⁵⁵  It is not because these were the only innovation-intensive industries in which firms proposed to merge.  Rather, we believe it is because problems of identifying the likely firms and products in future goods markets, which tend to be highly speculative in many other industries, can more frequently be resolved in the pharmaceutical industry.⁵⁶  As a result the potential competitive repercussions from mergers involving firms that are likely to compete in these future markets can be more readily predicted.

4.3.3. Would the merging firms compete against each other in an identifiable future market, but for the merger?

Suppose we are able to adequately resolve the previous set of issues, and can identify a class of innovation-embodying products (perhaps together with existing products) that would be considered close substitutes in a future market.  Additionally, assume we can determine the firms that are engaged in innovation with the goal of selling products in the future goods market, and also those that are expected to be able to sell such products through the use of alternative technologies.⁵⁷  One might be tempted to conclude (erroneously) that since these firms would compete in the same market following the conclusion of the innovation stage, a merger involving firms that account for a substantial part of this market (as later defined) will be found to be anticompetitive.  However, it does not follow from these assumptions that there is an appreciable likelihood that the merging firms will actually compete against each other in the resulting market, viewed from today’s perspective.  Several specific areas of concern—the uncertainty associated with innovation, the potential for patent holdings to interfere with the ability to bring a product to market, and the need for complementary assets for commercialization—may substantially decrease the likelihood that innovating firms meet in the future product market following the innovation stage.  We advocate a great degree of sensitivity to these issues to prevent challenges based on an unrealistic view of the post-innovation market.⁵⁸

Consider first an example addressing the issue of uncertainty.  Suppose it is known from an analysis of similar projects that the R&D undertaken by two particular firms is highly risky, such that each firm will succeed with an estimated 25% probability.  (In other words, three out of four similar R&D projects have failed to lead to a viable product.)   Then in the absence of a merger, these firms would only compete against each other with a 6% probability.⁵⁹  This would suggest that the competitive effect of concern, whether it is in the form of reduced innovation or increased pricing, would have to be quite large to warrant intervention in the presence of any offsetting efficiencies. 

One might wonder whether it is reasonable to expect data on the probability of R&D success to be readily available.  In fact, where R&D involves a closely monitored regulatory procedure, as in pharmaceuticals and medical devices, data are available.  A recent study of R&D success factors in drug development used data collected on over 1,900 drug compounds developed in the U.S. between 1988 and 2000.  The authors calculated various measures of R&D “success” based on whether or not the Food and Drug Administration (“FDA”) approved the compound for treatment of particular symptoms at various stages of clinical trials.⁶⁰  Success rates conditional on a treatment starting Phase 1 clinical trials (initial human testing for safety) vary across therapeutic area, ranging from 30% for respiratory drugs to 78% for hormone preparations.  Drugs targeted toward a larger market seem to have a lower probability of success.  Thus, at least in the pharmaceutical area, good data are available on R&D success rates.

A second factor may pose a barrier to direct competition between innovators even if both firms’ innovations successfully proceed to the commercialization stage: the existence of intellectual property rights.  Firms in many industries vigorously patent their discoveries.  To the extent that a firm’s patent rights for a particular discovery are valid, in that the discovery is novel, useful, and non-obvious,⁶¹ the rights conferred allow the patentee to exclude others from practising the invention.  Products sold by firms that do not have a licence to the patent and that embody technologies that fall within the patent’s claims are said to infringe.  The patentee has a right to sue the infringer to prevent infringement.  Of course, the patentee may choose to license to the infringing firm in return for a royalty, but it need not do so.  In some cases, where the technologies contained in products are complex and involve multiple discrete intellectual property rights, patentees may find themselves in a mutually infringing situation, where neither firm can sell its product without access to the patent rights held by the other.  Patents in this situation are said to be “blocking.”  Blocking patent positions are commonly resolved through licensing negotiations, whereby each firm grants the other the right to produce and sell (referred to as a “cross-licence”), possibly with the exchange of a fee or royalty.  Mutual infringement of this type is especially common in high-tech industries such as semiconductors, where any given product may draw on literally thousands of disparate inventions, each potentially covered by some firm’s patent rights.

If the expected result from the innovation is mutual blocking or simply one-way infringement, the existence of valid patent rights may pose a barrier to direct and unfettered competition between innovating merging firms.  Where this is likely to be the case, it would be inaccurate to compare the post-merger outcome to a but-for environment that entailing direct competition between the two firms.⁶²  In a world without the merger, competition would simply not arise unless the firms chose to license.  Even if a licence were agreed upon, its terms might call for running royalties that would affect the prices charged in the future product market.  For example, holders of blocking patent rights may seek to resolve their dispute by licensing each other with a running royalty that results in each choosing to sell at the price that maximizes their joint profit, just as though they were part of the same firm.  Such a licence would be permissible under the Bureau’s Intellectual Property Enforcement Guidelines, since it is consistent with a “mere exercise” of valid intellectual property rights.  Alternatively, the parties may resolve their dispute by licensing in a lump-sum form that does not impact on market prices.  Where patent threats are roughly symmetric, blocking positions are often cleared up by royalty-free cross-licensing.  These possibilities highlight the difficulty in speculating ex ante upon the eventual outcome in markets characterized by broad patent rights.  That being said, in industries where licensing is common there may be past examples upon which the Bureau may rely to determine the most likely outcome should the merger not proceed.

A final issue to be considered is whether the innovating firms possess the assets necessary to commercialize the products resulting from the innovation stage.  The farther away from commercialization is the state of technology under development, the greater the need for inventor cooperation to bring the innovation to the commercialization stage.⁶³  Some innovating firms may be vertically integrated into the production and distribution stages and may therefore have access to all the necessary assets, including perhaps specialized production equipment and highly trained marketing and sales forces.  Others may be innovation “specialists” that do not have access to these assets.  Such firms are faced with the choice of licensing their successful innovations to others, or attempting to develop the complementary assets needed for commercialization themselves.  Licensing is often the preferred alternative.⁶⁴ 

There are likely to be differences in the ex ante competitive considerations depending on whether innovating firms are “integrated” or “specialized.”  Our analysis thus far implicitly assumes that innovating firms are integrated; but what if one or both innovators are specialized and have no intention of producing and selling the resulting product?  Although the innovating firms, if specialized, may not participate directly in the resulting product market, they would participate indirectly in the absence of the merger by offering licences to firms with the requisite complementary assets.  Should the complementary assets be scarce, however, there may be a limited number of attractive licensees, and these licensees would have bargaining power over licence terms.  In the extreme case, if there is only a single viable licensee, the licensee would capture the gains from competition among the licensing firms, and may or may not pass these on to final consumers, depending on the structure of the future product market.  More generally, the extent to which competition among licensors translates into gains for consumers in the future product market would depend on the structure of the “market” for licensees, and these licensees’ competitive strengths in the product market.  While such considerations complicate the analysis, an evaluation of the distribution of complementary assets is essential if the merging firms are not integrated.

4.3.4. Would the merger result in decreased R&D resources being allocated to innovation?

If the innovating firms are expected to compete against each other in a future product market, one competitive concern is that the merger would result in a decrease in the combined firm’s level of innovation.  For example, where the separate firms are pursuing different R&D paths that, if successful, would result in two differentiated products being sold, the combined company might choose to cancel the least promising program.  Consumers would be deprived of the expected benefits of price competition offered by the forgone product, as well as any special benefits offered to particular consumers by the cancelled product’s specific attributes.  As an alternative example, both R&D programs might be maintained, but the merged firm, perceiving less urgency than two separate firms, might decide to scale back each program.  Innovation might be expected to take longer to yield results in this case, so gains to consumers would arrive at a more distant date than would be the case but for the merger. 

Whether a merger would impact on the resources devoted to innovation is fundamentally a context-specific issue.  This follows from the earlier discussion of the general inadequacy of theoretical or empirical results concerning the effect of concentration on innovation, and the lack of a clear predictive model relating concentration to innovation activity.  A fact-specific analysis might take into account the following factors:

• Information available from parties on resources devoted to R&D, and planned expenditures going forward.  Basic planning documents maintained by the parties in the ordinary course of business would help to characterize the level and type of R&D that would likely exist in the absence of the merger.
  
  
• Information that might have been revealed since R&D began on the size of the eventual market or the expected costs of completing the R&D phase.  There is nothing wrong with planning to reduce or eliminate R&D if that R&D is no longer deemed to be warranted in light of market circumstances.  Should this information come to light at around the time the merger is announced, it might be erroneously linked to the merger.  We must be careful to distinguish actions caused or made possible by the merger from those that the parties would have engaged in regardless, as is done now with any merger investigation.  Studies performed or collected by the parties on the possible market prospects for the expected products, as well as internal studies updating estimates of the likely R&D resources necessary to get there, would be helpful for this analysis.
  
  
• Indications that the first firm to innovate would garner a disproportionate share of the rewards.  Recall that the patent race model assumes that only the first innovating firm will earn returns from innovation.  This gives the model its “racing” property.  The winner-take-all assumption is unlikely to hold generally, but it is worth investigating whether the market in question has any characteristics that would allow some of the insights of the patent race model to apply.  For example, if the first innovating firm is able to lock consumers in to a proprietary standard, so that later innovators would have great difficulty surmounting this first-mover advantage, there would be a strong incentive for participants to bring innovations to market as soon as possible.
  
  
• Information on the degree of overlap between participating firms’ R&D programs.  A transaction that has the effect of reducing duplicative R&D, while leaving the rate of innovation effectively unchanged, should not be subject to challenge on innovation grounds.  The obvious difficulty is in determining whether R&D is truly duplicative or whether firms are instead pursuing different paths toward a similar goal.⁶⁵  In this latter case, elimination of an R&D program would be undesirable.  Technical expertise will normally be necessary to make this assessment.

The recent FTC Genzyme decision is an interesting example of the use of case-specific information in practice.  It also highlights the conflict between those that would adhere to a more formalistic view of innovative rivalry and those, such as then-Chairman Muris, who advocate a more fact-intensive inquiry.  The FTC’s initial challenge was brought on an “innovation markets” theory: since Genzyme and Novazyme were the only two firms conducting R&D toward a particular product, the transaction amounted to a merger to monopoly in the innovation market consisting of firms performing such R&D.  Ultimately the Commission voted not to challenge the transaction.  Chairman Muris summarized the factors that contributed toward his decision to vote with the majority against a challenge.⁶⁶  He commented that “[a]ssessing the effects of a merger on the pace of innovation is especially fact-dependent,” and pointed toward the “lack of any clear theoretical or empirical link between increased concentration and reduced innovation.”⁶⁷  Muris also argued that the merging firms would not have been “racing” to market in the absence of the merger, since there was some evidence that Genzyme’s product was viewed as a short-term treatment while Novazyme’s was more in the nature of an “improved, second-generation therapy.”⁶⁸  The majority appears to have concluded that the facts supported an inference that the firms’ R&D programs were separate and independent, rather than competing and thus interrelated.  A dissenting statement was offered by Commissioner Thompson who argued that Genzyme would face reduced pressure to innovate with Novazyme removed as a rival, essentially under a formal patent race theory: “[Competition from Novazyme] was important because it created a race between Genzyme and Novazyme to develop Pompe ERTs [enzyme replacement therapies], thus increasing the pace of innovation.”⁶⁹  As under the patent race model, Commissioner Thompson viewed the removal of an innovator as likely to lead to a decrease in the overall incentive to innovate.⁷⁰

4.3.5. Would the merger lead to increased prices?

In the final step of the analysis, the traditional merger competitive effects assessment is undertaken, but with the complication that we are dealing with a future post-merger environment compared to a future market without a merger.  As a result, there is likely to be no pre-merger price or output level for the future product to use as a comparison.  This is obviously true when the innovative product is in some sense pioneering and would face no close competition from existing products.  Less obviously, it is true even if the innovation leads to an improvement in an existing class of products.  If firms are pursuing product improvements, quality-adjusted prices would be expected to change pre- and post-innovation.  This effect is distinct from the purely nominal change in price that would result from a firm having increased market power in a given product market.  The critical question is then whether we can identify the undesirable price impact in an environment of changing quality-adjusted prices, where the latter are often unobservable. 

Data and measurement problems will normally prevent us from being able to answer this question directly—we will rarely have the information necessary to predict post-innovation prices with and without the merger.  Accordingly, we propose a practical indirect solution.  One way of proceeding is by abandoning the (somewhat artificial) distinction between the merger’s effects on innovation and its effects on pricing, and treating these as a single inquiry.  The value of this approach can be seen by examining a simplified framework in which there are four possible cases of interest, depending on whether the merger materially reduces the level of innovation, and whether the combined company has a high share of the post-innovation market. 

• No impact on innovation, large share. Here, the traditional conclusion would apply; prices (both quality-adjusted and nominal) might be higher than without the merger, depending on other characteristics of the post-merger market.
  
  
• No impact on innovation, small share.  Here there should be no cause for concern. 
  
  
• Reduced innovation, small share.  If only the merging firms’ level of innovation is expected to change, while other non-merging participants are expected to be equally active in the post-innovation market regardless of the merger, the reduction in innovation by the merging parties is likely to have little effect on consumer welfare.  Product characteristics and quality-adjusted prices are expected to be virtually unchanged with the merger compared to a world without the merger, and therefore a challenge is unnecessary. 
  
  
• Reduced innovation, large share.  The firm’s large share in the future market suggests that for a given set of products, it would be able to sustain a nominal price increase relative to the price level that would exist in the absence of the merger, holding all else (including the level of innovation) constant.  Combined with the negative impact on innovation, we would conclude that quality-adjusted prices are likely to be higher compared to a world without the merger.

This set of results indicates a compelling case may be made for a merger challenge if (and only if) the merger would result in the combined company having a large share of the future market.  This result is intuitive, and it also has the attractive property that it “nests,” as a special case, mergers that do not have innovation effects.  We caution that these results are obtained from a highly simplified example; in any practical application, there are more possibilities than just “high” or “low” shares and “negative” or “neutral” impacts on innovation.  As a specific example, it is conceivable that a merger may result in an increased level of innovation, an efficiency effect that would tend to offset a large combined company presence in the future product market.  It is to such cases that we turn in the next section.

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⁴⁵ Richard J. Gilbert and Willard K. Tom, “Is Innovation King at the Antitrust Agencies?  The Intellectual Property Guidelines Five Years After,” Antitrust Law Journal, Vol. 69, 2001, p. 49.

⁴⁶ See U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the Licensing of Intellectual Property, April 6, 1995, § 3.2.3.

⁴⁷ Process innovations are encompassed in our framework as well as product innovations.  Where process innovations are concerned, the future product market might be identical to an existing market, with the competitive concern that the merger would result in less cost-reducing innovation than would otherwise have occurred.  This notwithstanding, the various problems we have discussed will tend to be most acute (and interesting) in the case of product innovations, and accordingly we focus our discussion there.

⁴⁸ We are grateful to Tim Brennan for suggesting this example and this way of motivating the ensuing discussion.

⁴⁹ In Section 3, we detailed the reasons why it is not feasible to define product and geographic markets based on the prevailing “price” of the future innovation and analyze post-merger competitive effects using indicia such as market shares related to innovation “output.”

⁵⁰ See e.g., Bronwyn H. Hall, “The Private and Social Returns to Research and Development,” Chapter 6 in B. Smith and C. Barfield (eds.), Technology, R&D, and the Economy, Brookings Institute, 1996.

⁵¹ Kwanghui Lim, “The Relationship between Research and Innovation in the Semiconductor and Pharmaceutical Industries (1981-1997),” Research Policy, Vol. 33, 2004.

⁵² Tony Hallett, “Nokia Upbeat in Face of Declining Market Share,” Silicon.com, June 14, 2004.  A detailed case study of dynamic competition in the cellular infrastructure and handset industries is provided in Zi-Lin He, Kwanghui Lim, and Poh-Kam Wong, “The Dynamics of Entry in the Mobile Telecommunications Industry,” working paper, February 2006.

⁵³ See e.g., Federal Trade Commission, To Promote Innovation: The Proper Balance of Competition and Patent Law and Policy, October 2003, Chapter 3, p. 45.

⁵⁴ Although software firms attempt to protect their innovations using instruments such as patents, some observers have questioned how well software patents perform in terms of excluding others from practicing a software “idea”—it may be possible to reproduce a particular software functionality without infringing a patent simply because in software, there tend to be “many solutions to any particular problem” (Ronald J. Mann, “Do Patents Facilitate Financing in the Software Industry?” Texas Law Review, Vol. 83, 2005, p. 979).

⁵⁵ Gilbert and Tom (2001) review 8 U.S. merger investigations prior to 2001 in which innovation concerns were critical.  Five of these were mergers of pharmaceutical companies.

⁵⁶ Carl Shapiro’s remarks in a recent symposium are apposite: “Part of your comment asks: ‘Even if all the people pursuing this line of research were to merge would they have any power to slow down innovation or raise prices, given that they have to compete against other products?’  That’s a fair question.  But it may be hard to tell, if the future competition is years away and involves products whose attributes are not yet fully defined.  It is not a coincidence these issues have come up in the FDA context where we tend to know who the players are years in advance.  In many other sectors of the economy there is greater uncertainty about who is currently doing relevant R&D, the likely timing of those projects, or who is going to enter surprisingly from some other market.”  (Antitrustsource.com, “The Role of Innovation in Competitive Analysis,” The Chair’s Showcase Program, ABA Section of Antitrust Law Spring Meeting, March 31, 2005, available at http://www.abanet.org/antitrust/source/07-05/Jul05-FullSource7=28f.pdf.)

⁵⁷ The previous subsection described how information on the form of innovation might help identify the former group of firms.  We have less to say about the latter, believing that identification of non-innovating firms that are expected to be equipped to compete for one reason or other will tend to be highly dependent on the situation at hand.  See Christopher Pleatsikas and David Teece, “The Analysis of Market Definition and Market Power in the Context of Rapid Innovation,” International Journal of Industrial Organization, Vol. 19, 2001, for a discussion of difficulties in identifying competing firms and technologies.

⁵⁸ We do not attempt to address the even more difficult problem of how to identify non-innovating firms that may possibly participate in the future market at some point. 

⁵⁹ The probability that both firms are successful equals 0.25 x 0.25 or approximately 6%. 

⁶⁰ Patricial M. Danzon, Sean Nicholson, and Nuno Sousa Pereira, “Productivity in Pharmaceutical-Biotechnology R&D: The Role of Experience and Alliances,” Journal of Health Economics, Vol. 24, 2005.

⁶¹ See Canadian Intellectual Property Office, “A Guide to Patents: Patent Protection,” available at http://strategis.ic.gc.ca/sc_mrksv/cipo/patents/pat_gd_protect-e.html: “There are three basic criteria for patentability.  First, the invention must be new (first in the world).  Second, it must be useful (functional and operative).  Finally, it must show inventive ingenuity and not be obvious to someone skilled in that area.”

⁶² Complicating the analysis is the fact that even if the scope of coverage of some given patent or set of patents were known with certainty (which it generally is not, due in part to the inherent vagueness of verbal descriptions of technological phenomena), patents are not guaranteed to be valid.  Some evidence suggests that nearly half of litigated U.S. patents are found to be invalid.  On these issues, see Mark A. Lemley and Carl Shapiro, “Probabilistic Patents,” Journal of Economic Perspectives, Vol. 19, 2005.  Uncertainty of this magnitude should clearly also be incorporated into any consideration of the intellectual property holdings of merging parties.

⁶³ The need for inventor cooperation with the licensee stems from two phenomena.  First, there is typically asymmetric information, in that the inventor has greater information than the licensee about the technology and, therefore, the value of the licence.  As a result, the licensee will be reluctant to undertake specific investments in the technology without some assurance of its profitability.  Second, there is a moral hazard problem, in that the probability of commercial success is positively related to inventor effort.  Thus, the licence contract between the inventor and licensee must link a portion of the inventor’s license income to the inventor’s effort expended in additional development.  See Richard Jensen and Marie Thursby, “Proofs and Prototypes for Sale: The Licensing of University Inventions,” American Economic Review, Vol. 91, 2001.

⁶⁴ See e.g., Joshua S. Gans and Scott Stern, “The Product Market and the Market for ‘Ideas’: Commercialization Strategies for Technology Entrepreneurs,” Research Policy, Vol. 32, 2003.  These authors argue that licensing is likely to be an attractive strategy to an entrant primarily when formal intellectual property rights are strong and incumbents control valuable complementary assets.

⁶⁵ In 1998 the U.S. DOJ challenged the proposed merger between Northrop Grumman and Lockheed Martin on the basis that it was important to preserve a diversity of R&D paths (Gilbert and Tom 2001, p. 59).

⁶⁶ “Statement of Chairman Timothy J. Muris in the matter of Genzyme Corporation/Novazyme Pharmaceuticals, Inc.,” available at http://www.ftc.gov/os/2004/01/murisgenzymestmt.pdf (“Muris Genzyme Statement”).

⁶⁷ Muris Genzyme Statement, p. 3.

⁶⁸ Muris Genzyme Statement, pp. 11-12.

⁶⁹ “Dissenting Statement of Commissioner Mozelle W. Thompson: Genzyme Corporation’s Acquisition of Novazyme Pharmaceuticals Inc., File No. 021-0026,” available at http://www.ftc.gov/os/2004/01/thompsongenzymestmt.pdf, p. 4.

⁷⁰ It is interesting to note that as Balto and Sher point out, even the dissenting Commissioners seem to have ignored the impact of the merger on post-innovation pricing: “Even assuming that Genzyme had every incentive in the world to quickly get the best product to market to reach as wide a group of customers as possible, what would stop Genzyme from reaping monopoly profits in the goods market?” (David A. Balto and Scott A. Sher, “Refining the Innovation Focus: The FTC’s Genzyme Decision,” Antitrust, Spring 2004, p. 31.)