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

5. Dynamic Efficiency Considerations

Parties may claim that a merger that gives rise to the exercise of market power, and consequently reduces allocative inefficiency, may be beneficial overall due to a positive impact on dynamic efficiency.  In this section we discuss generally how such issues may be incorporated into the framework proposed in the prior section.  We provide examples of the types of dynamic efficiencies that might be reasonable for parties to articulate and for the Bureau to seriously consider.

5.1. Impact and Quantification

Suppose a merger is expected to result in a significant increase in market power in an existing market.  The MEGs recognize that parties may attempt to prove offsetting efficiencies arising from a variety of possible sources, including dynamic efficiencies.⁷¹  The types of efficiencies that may be considered in the conventional case, and the process by which cost savings are found to be true savings in resources, are well understood.  In this respect, we note that the Competition Bureau considers fixed cost savings, as part of any efficiency claim: “Both variable and fixed cost savings are relevant to the analysis because both generate producer surplus (even though it is recognized that generally only variable (i.e. marginal) cost savings lead to price reductions).”⁷²  The list of cost savings that are either variable or fixed and that the Bureau will consider include the traditional product, plant-level and multi-plant level savings related to economies of scale, economies of scope, and economies of density and specialization, as well as savings in respect of distribution, advertising and raising capital.   This differs from U.S. practice, although the Tentative Recommendations of the US Antitrust Modernization Commission include a recommendation by some Commissioners that increased weight should be placed on fixed-cost efficiencies, particularly for dynamic, innovation-drive industries where marginal costs are low relative to prices.⁷³

Demonstrating causation and magnitude where dynamic efficiencies are relevant will normally be much less clear-cut than for these traditional fixed and variable cost savings.  This is largely due to the uncertainty and measurement problems associated with innovation, as described above. 
In general, it may be very difficult for parties to show that a merger will appreciably increase innovation, given that innovation is subject to a high degree of uncertainty to begin with.  For example, pre-merger the parties may expect to introduce new products within a certain time frame, say two years, although given uncertainty it could take longer or shorter; they may claim that by merging, they will be able to reduce the expected time for the next innovation to be commercialized to one year.  Proving that this is likely may be difficult for the party bearing the burden of proof, in this case the merging firms.⁷⁴  In addition, the parties would have to demonstrate that the proposed dynamic efficiencies are merger-specific, and not available through an alternative organizational form such as a strategic alliance devoted to R&D.

Even after addressing such causation issues, merging firms will still face the problem of estimating the incremental surplus created by the additional innovative effort, most or all of which may be tied to future products.  The attributes associated with those products may not be known with certainty at present, which will complicate the quantification of the surplus created.  We would expect that merging firms will normally have difficulty meeting the requisite level of proof required for causation and quantification.  However, given the ease with which claims of dynamic efficiencies can be made, and the fact that the merging firms will have much more information than the Bureau regarding their innovation prospects, the Bureau is right to approach such claims rigorously and with some skepticism. 
Clear results exist only for certain limiting cases that, while unlikely in practice, provide the bounds within which cases will generally fall.  Suppose that there are only two firms with the knowledge and expertise necessary to develop a new line of products, which will be the only line of products sold by the firms, and that for technical reasons R&D will only succeed if the firms combine their efforts by merging.  Post-innovation, the merged firm is expected to price higher than the prices that would be obtained if there was no merger and the two firms were competing.  Here, static allocative inefficiency and dynamic efficiencies arise from the same source: the introduction of the innovative products.  Consumers would receive no surplus without the merger, as arguably the product would not be introduced.  In such a case, dynamic efficiencies outweigh static inefficiencies.  At the other extreme, suppose the same merger would have little or no impact on the pace or likelihood of innovation.  Then static inefficiencies would be found to outweigh dynamic efficiencies because the negative price impact would remain post-merger without any positive improvement in consumer surplus from the introduction of new goods. 

The problem, of course, is that the direct link between changes in allocative inefficiency and dynamic efficiency that is present in these hypothetical illustrative examples will normally not exist.  If, for instance, the parties also sell an existing line of products in competition with each other, the allocative losses associated with the pricing of these products would have to be compared to the gains from the introduction of the future products.  Alternatively, suppose innovation was possible but uncertain pre-merger, but the merger would render it a certainty.  Then the surplus created under a no-merger scenario, which would arise with some probability less than one, would have to be compared to the smaller amount of surplus created by merging, which would exist with certainty. 
In general, we are unable to escape the need to make at least rough comparisons of the sizes of static and dynamic efficiencies.  While this may seem unpalatable, at least two arguments suggest that if the merging firms can successfully demonstrate plausible and likely dynamic efficiencies, these should be weighted heavily against suspected inefficiencies arising from price effects. 

First, as we discuss in the next subsection, there are many sources of dynamic efficiencies for innovating firms but there is just one source of allocative inefficiency.  Innovating firms may not even be aware of all the ways in which their actions may enhance the flow of consumer gains over time.  For example, there may be important spillover effects.  Parties do not take spillovers to other industry participants or society into account when making investment decisions—hence the bias toward too little innovation relative to the socially optimal level that we described earlier.⁷⁵  Yet such spillovers are a source of real gains to society, and may be orders of magnitude more important than the losses incurred by select consumers as a result of increased prices. 

Second, when dynamic efficiencies can be successfully demonstrated, any possible price effects, if they exist, may tend to be transitory, given the dynamically competitive nature of any industry where demonstration of important dynamic efficiencies is possible.  In such cases, higher initial prices are likely to bring forward a new round of innovation intended to replace the merged entity, assuming it attains market leadership status following the merger.  This effect would be absent, or mitigated, if the merger allowed the parties to gain control of scarce resources that would be necessary for others to innovate, or if barriers to entry by other potential innovators were otherwise high.

5.2. Sources of Dynamic Efficiencies

Given the variety of different types of innovation and forms of dynamic competition across firms and industries, merging parties may be expected to make a wide range of arguments in support of dynamic efficiencies.  Provided parties are able to demonstrate the necessity of the merger to realize these efficiencies, and quantify their magnitude against any inefficiencies associated with the merger, they should be free to make such arguments.  We provide in this subsection a brief discussion of sources of dynamic efficiencies that can be given economic support.

5.2.1. Elimination of duplicative R&D

The most obvious efficiency that may arise from a combination of R&D programs is elimination of redundant R&D.  Firms seeking to introduce a new product may need to complete certain stages of basic or applied research in order to make product development possible.  As a result, when multiple firms are seeking to innovate in the same area, the same research stages may be performed multiple times.  Efficiency would be improved if some of this duplication were eliminated, provided there is little or no effect on the pace of innovation. 

The difficulty here is judging “whether a company’s decision to shut down one of two research tracks, to focus its resources on just one track, would likely be procompetitive or anticompetitive.”⁷⁶  If there is a strong positive relationship between the number of competitors engaged in R&D and the likely pace of innovation, a case can be made that R&D programs are not likely to be duplicative; the existence of multiple programs results in consumers enjoying the benefits of new products at a faster rate.  This is clearly a factual question.  In addition, the Bureau must be sensitive to the possibility that often R&D programs are not substitutes for each other but rather complements: “reductions of so-called ‘duplicative’ R&D may actually represent the elimination of diverse research paths that could lead to different results[,] and … even if research paths were identical, different R&D researchers in different companies might draw different inferences from them, and hence achieve different results from the same discovery.”⁷⁷  Given the uncertainties associated with R&D, we urge caution in accepting claims that R&D programs are duplicative.⁷⁸  At the same time, it is not procedurally efficient for the Bureau to conduct large-scale investigations of the nature of merging parties’ R&D operations.  Our view is that if this argument has merit, it should be evident in the parties’ contemporaneous documents (e.g., strategic planning memoranda or presentations), and/or the assessments of independent market observers.

5.2.2. Economies of scale or scope in R&D

Another possibility is that a merger may allow the resulting firm to take advantage of economies of scale or scope in R&D activities.  Economies of scale in R&D arise when an R&D program of some size, say S, is more productive (in terms of the generation of innovative output) than two separate programs of equal size ½S.  Economies of scope in R&D exist when a firm engaged in a range of different R&D activities is more productive at each activity than a firm performing some smaller number of activities.  It has long been speculated that “larger” firms, measured according to some metric, are more successful innovators than “smaller” firms.  Indeed, this is one way of articulating the classic Schumpeterian hypothesis that posits a relationship between monopoly situations and innovation.  As Tirole summarizes:

[Schumpeter] suggests that large firms are better qualified or more eager to undertake R&D than smaller firms because increasing returns are prevalent in R&D; because R&D activity involves a high level of risk that is difficult to eliminate with insurance (for reasons of moral hazard), and large firms are more diversified and therefore more willing to take risks; because innovation, once generated, is implemented more rapidly in a large firm because there is an appropriate production structure; and because a monopolist does not have competitors ready to imitate his innovation or to circumvent an existing patent on this innovation.⁷⁹ 

Empirical studies focusing on innovation at the industry level have produced mixed results on whether there are increasing returns to R&D activity by virtue of economies of scale and scope.  More recent studies have focused on data related to individual R&D programs, which is the level of disaggregation necessary to evaluate the issue.  The key references are Henderson and Cockburn’s studies of pharmaceutical firm R&D.  In a 1996 paper, these authors presented evidence from the R&D programs of ten large pharmaceutical firms observed over an average of 20 years per firm.⁸⁰  They test whether research output, as measured by the output of “important” patents (those filed in several different countries) is responsive to the firm’s total R&D effort across all programs, and whether research productivity increases with the number of programs within a firm.  They find evidence supporting each of these hypotheses, with a mean research elasticity of about 0.3 in each case.  In other words, a 10% increase in total research spending results in about a 3% increase in research output for a given project, and a 10% increase in the number of large R&D projects also leads to a 3% increase in output.  In a later paper, Henderson and Cockburn ask whether scale and scope confer similar advantages at the development (as opposed to the discovery) stage.⁸¹  They test whether scale or scope affect the likelihood of receiving FDA approval for a new drug product and find a significant impact for scope, but not scale.  From this research, they conclude: “The performance advantage of large firms appears to lie in economies of scope rather than economies of scale: all else equal, a development program initiated within a more diverse development effort is significantly more likely to result in an [approved drug] than one initiated within a more narrowly focused effort.”⁸² 

As a result, some good evidence exists that mergers enhancing the scope of R&D efforts may have salutary and measurable effects on innovation, at least in the pharmaceutical area.  This is a developing research area in economics, and few results are available for other industries.  One exception is a recent paper by Helfat studying R&D on coal conversion technologies in the petroleum industry.⁸³  She finds a positive association between R&D and a measure of R&D capital stock, implying that firms find additional impetus toward innovation from their direct experience with past R&D efforts.

5.2.3. Improved intellectual property enforcement

Many firms seek to protect the returns from their innovations using intellectual property rights.  Indeed, a key principle underlying the intellectual property system is that in the absence of additional incentives for innovation provided by the formalized right to exclude, firms will under-invest in R&D.  As we have argued above, generating a new idea in the industrial context typically requires incurring sunk, up-front R&D expenditures.  Once these costs have been incurred, the incremental cost of employing the innovation, or creating copies of it, is generally quite low.  Moreover, since any number of people can use the innovation at the same time, the inventor or author is unlikely to be able to recoup his or her sunk investments if others can exploit the innovation by incurring only the incremental cost after the fact.  Intellectual property rights exist to give innovators the incentives to incur the up-front costs of innovation. They do so by giving the inventor or author the temporary right to prevent others from “free riding” on his/her efforts.  

Recent research has shown, however, that in some cases, firms are unable to access the intellectual property system in the manner it was intended, and as a result these firms may not be able to protect the returns on their R&D expenditures to an efficient degree.  Lanjouw and Schankerman have studied the determinants of patent suits and settlements across a range of technology areas over 1978-1999, focusing on the ability of small firms to protect their innovations.⁸⁴  They find that the probability of filing a suit on any particular patent owned by a firm is negatively related to the number of patents that firm holds in its portfolio, and that this effect is stronger for smaller firms (as measured by employment).  In other words, small firms are less likely to be able to settle disputes on advantageous terms and more likely to find themselves embroiled in costly, risky patent litigation, unless they have unusually strong patent portfolios.  Lanjouw and Schankerman conclude that as a result, “the enforcement process undermines the R&D incentives of small firms.”⁸⁵ 

Intellectual property issues may also negatively affect smaller firms in specific high-tech sectors.  Josh Lerner, studying patenting behaviour in the biotechnology industry, has found that firms—especially those that are relatively inexperienced or financially weak—tend to avoid research areas in which others have patented intensively, even if these might be fruitful avenues for research.⁸⁶  With reference to the semiconductor and communications industries, the widespread practice of cross-licensing of entire patent portfolios for relatively long (typically five-year) periods has developed to resolve patent issues.  Through this means firms are able to settle potential infringement battles before they occur and avoid costly overlapping licence payments.⁸⁷  Those firms that are especially reliant on technologies that are covered by a diverse and fragmented set of ownership rights find it less costly to negotiate all the necessary licences ex ante than to develop strong patent portfolios of their own to use as a reciprocal threat if necessary.⁸⁸  Smaller firms without strong portfolios may find it necessary to enter into complex and resource-consuming negotiations in order to obtain access to the necessary intellectual property if they wish to compete in such technology areas.

In sum, intellectual property rights may justify a set of dynamic efficiency considerations, provided firms are able to document these appropriately.  Mergers to consolidate resources may allow firms to better protect their intellectual property rights, thus enhancing returns to their R&D efforts; and, depending on the industry in which the firms operate, mergers may also help firms to clear a path through the thorny intellectual property positions of other firms, freeing up resources for other value-enhancing activities.

5.2.4. Increased financial resources for R&D

Tirole’s synopsis of the Schumpeterian hypothesis, excerpted above, alludes to a possible beneficial effect of increased internal financial resources on innovation.  The argument is that it may be excessively costly for firms to obtain external financing (from equity or bond markets) for R&D activities and, as a result, firms with larger internal financial resources are better positioned to engage in R&D.  If this is true, then a merger that combines one firm’s ideas with another’s cash would tend to lead to more innovation than if the creative firm attempted to exploit its ideas on its own.

Hall summarizes the empirical work that has been done in this area to date.⁸⁹  She observes that R&D is quite sensitive to a firm’s internal cash flow, and that as a result, “any problems associated with financing investments in new technology will be most apparent for new entrants and startup firms.”⁹⁰  The availability of venture capital funding does not appear to offer a complete solution to these problems, despite the fact that venture capital financiers are able to much more closely monitor the use of funds than are ordinary stock market investors.  Lerner, Shane, and Tsai study a related issue in biotechnology, which is a very R&D-intensive sector.  Innovative biotechnology firms often turn to alliances with larger, better-funded partners to overcome financial constraints.⁹¹  They observe that during periods of unfavourable equity market activity, innovative biotechnology firms in need of financing are more likely to enter into alliance agreements which in the longer term are less successful, as measured by subsequent progression through clinical trial and approval phases.  This would suggest that hybrid organizational forms such as alliances are an imperfect solution to the funding problem, and that in some cases allowing firms to merge may be the best approach.

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⁷¹ “The Bureau also examines claims that the merger has or is likely to result in gains in dynamic efficiency, including those attained through the optimal introduction of new products, the development of more efficient productive processes, and the improvement of product quality and service.”  See MEGs, ¶ 8.15.

⁷² MEGs, fn. 98, page 33.

⁷³ Antitrust Modernization Commission, Tentative Recommendations, issued January 11, 2007, at 8(b).

⁷⁴ We do not advocate changing the burden of proof.  When considering claims of dynamic efficiency, the burden is appropriately with the merging firms, as they will possess greater information to substantiate such claims than the Bureau.

⁷⁵ See also Gary L. Roberts and Steven C. Salop, Efficiencies in Dynamic Merger Analysis: A Summary,” World Competition, Vol. 19, 1996, who argue that cost-reducing efficiencies should be viewed as taking place within a larger dynamic framework where the benefits of cost reduction achieved by a merged entity eventually spill over to other market participants.

⁷⁶ Federal Trade Commission, Anticipating the 21st Century: Competition Policy in the New High-Tech, Global Marketplace , Vol. 1, 1996, Chapter 7, p. 17.

⁷⁷ FTC, 1996, Chapter 7, pp. 17-18.

⁷⁸ In addition, it may often be the case that duplicative R&D can be eliminated by forming an R&D strategic alliance, so even where this source of efficiency gain is potentially present, it may not be merger-specific.

⁷⁹ Tirole, 1988, p. 390.

⁸⁰ Rebecca Henderson and Iain Cockburn, “Scale, Scope, and Spillovers: the Determinants of Research Productivity in Drug Discovery,” RAND Journal of Economics, Vol. 27, 1996.

⁸¹ Rebecca Henderson and Iain Cockburn, “Scale and Scope in Drug Development: Unpacking the Advantages of Size in Pharmaceutical Research,” Journal of Health Economics, Vol. 20, 2001.

⁸² Henderson and Cockburn, 2001, p. 1053.

⁸³ Constance E. Helfat, “Know-How and Asset Complementarity and Dynamic Capability Accumulation: The Case of R&D,” Strategic Management Journal, Vol. 18, 1997.

⁸⁴ Jean O. Lanjouw and Mark Schankerman, “Protecting Intellectual Property Rights: Are Small Firms Handicapped?” Journal of Law and Economics, Vol. XLVII, 2004.

⁸⁵ Lanjouw and Schankerman, 2004, p. 48. 

⁸⁶ Josh Lerner, “Patenting in the Shadow of Competitors,” Journal of Law and Economics, Vol. XXXVIII, 1995.

⁸⁷ See e.g., Bronwyn Hall and Rosemarie Ham Ziedonis, “The Patent Paradox Revisited: An Empirical Study of Patenting in the U.S. Semiconductor Industry, 1979-1995,” RAND Journal of Economics, Vol. 32, 2001.

⁸⁸ Rosemarie Ham Ziedonis, “Don’t Fence Me In: Fragmented Markets for Technology and the Patent Acquisition Strategies of Firms,” Management Science, Vol. 50, 2004.

⁸⁹ Bronwyn Hall, “The Financing of Innovation,” mimeo, December 2005.

⁹⁰ Hall, 2005, p. 20.

⁹¹ Josh Lerner, Hilary Shane, and Alexander Tsai, “Do Equity Financing Cycles Matter?  Evidence from Biotechnology Alliances,” Journal of Financial Economics, Vol. 67, 2003.