BOOK REVIEW Journal of Economic Literature, Vol. XLVII (March 2009)

by Zoltan J. Acs, George Mason University

The subtitle of this book perhaps better explains
what this book is about than the main title, which
is rather vague. This book develops a theory of
market leaders and applies it to the Microsoft
story focusing on the role of both European and
American competition policy. The novel development
of the book is the introduction of a framework
characterized by Stackelberg equilibrium
with endogenous entry. The framework leads to
the characterization of entry as either competition
in the market or competition for the market.
In exogenous entry, the firms exist exogenously as
well as the product. Firms compete in the market
on price and quantity. With endogenous entry,
influenced by the work on endogenous technical
change, competition is for the market, where
entry can replace the incumbent.
This distinction between competition in the
market and for the market is a novel way to
bring the insights of the new growth theory to
industrial organization (Paul M. Romer 1990).
The book outlines four models of competition
starting with simple toy models and then subsequently
developing them in more detail, rigor,
and sophistication. The first typology goes back
to the early analysis of Augustin Cournot, whose
equilibrium concept corresponds to the one that
today we associate with John Nash: each firm
independently chooses its strategy to maximize
profit given the strategy of each other firm. The
second typology extends these models to endogenous
entry. This Marshallian equilibrium can be
thought of as Nash equilibrium with free entry.
The third typology of competition was introduced
by Heinrich von Stackelberg where a firm
has leadership over others, that is, first mover
advantage. Under Stackelberg competition, a
leader can exploit its first mover advantage taking
into account the reaction of its rivals. The final
typology of competition completes the taxonomy
of the basic market interactions combining the
analysis of leadership and endogenous entry.
While this is not the first such attempt in the
twentieth century, the author argues the previous
attempts were not developed in a coherent
game theoretic framework. “The development of
such a framework is the focus of the book, whose
theoretical contribution is the characterization
of the Stackelberg equilibrium with endogenous
entry and of its application” (p. 3).
All of this is laid our very carefully in chapter
1, “Competition, Leadership and Entry.”
The subsequent three chapters develop the
concepts in more detail. Chapter 2, “Strategic
Commitments and Endogenous Entry” develops
the concept of endogenous entry, competition
and quantities, strategic investment, cost reduction
and signaling, and optimal financial structure.
Chapter 3, “Stackelberg Competition and
Endogenous Entry,” develops the ideas of first
mover advantage, asymmetries, and antitrust and
collusion. Chapter 4, “Dynamic Competition and
Endogenous Entry,” integrates the two concepts
of first mover advantage and endogenous entry to
examine competition for the market. This is the
first part of the book. While highly technical in
nature, prose and intuition are clearly laid out
and easy to follow. The main theoretical conclusion
of the model is that, under endogenous entry,
the Stackelberg framework generates a crucial
result where the leader always invests in R&D,
and more so, than any other firm. Therefore, the
Stackelberg assumption, with endogenous entry,
delivers a new rational for the persistence of
monopoly. The development of the Stackelberg
framework leads into what I believe are the
relevant applications of the book—a look at antitrust
policy.
The framework is applied first to antitrust policy,
“Antirust and Abuse of Dominance” in chapter 5
and to a discussion of the Microsoft Corporation
in chapter 6, “Microsoft Economics.” Chapter 6 is
very useful since a whole literature has developed
around the Microsoft Corporation over the past
two decades. The chapter discusses the software
market, the antitrust case in the United States
and the European Union, the issue of monopoly
and its impact on price and innovation, bundling
and intellectual property rights—patents, trade
secrets, licenses, and standards. The author
makes two important points. First, markets in the
“new economy” work radically differently from
markets in the “old economy.” The point is that
markets in the old economy were characterized
as competition in the market, while in the new
economy competition can be characterized as
competition for the market. While not explained,
my read is that this is supposed to be consistent
with the accelerated use of knowledge in an economy
of ideas and bits. This subtle point is useful
Journal of Economic Literature, Vol. XLVII (March 2009) 210
because, in fact, traditional oligopoly markets in
steel, autos, and tires were indeed characterized
as competition in the market, at least in theoretical
models. The second point is that the behavior
of firms that are leaders in the new economy like
Microsoft can be better understood through the
concept of Stackelberg competition with endogenous
entry.
We are now in a position to evaluate some of the
issue raised in the book. To gain some insight into
this, it is useful to figure out what are the assumptions
behind the theoretical apparatus. Two issues
emerge: monopoly power and innovation by leaders
and they are both related to antitrust policy.
If in fact monopoly is anticompetitive and leaders
who are monopolists do not innovate, then we
have a strong case for antitrust in the traditional
sense. On page 31, the author gives us what we
are looking for. In two long quotes, we first get
reference to Joseph A. Schumpeter (1942) that
innovation comes from large firms and, second,
in a quote on page 33, from the Economist magazine
about why market leaders have an incentive
to innovate more so than any other firm. That is
as long as entry is free. However, what about the
situation when there are barriers to entry? The
author believes that, in the new economy, firms
that have monopoly power and innovate should
not be pursued with antitrust cases as they were
in the old economy when competition was in the
market not for the market.
The evidence on innovation has a long history
in the industrial organization and technological
change literature. With endogenous entry, the
incumbent firm will invest in R&D to improve
quality and introduce new products. Using the
Romer (1990) model, the author suggests that
monopolist will continue to invest in R&D and to
innovate. Using a knowledge production function,
the probability of innovation is bounded by zero
and one. The evidence cited on page 156 shows
that the elasticity of R&D with respect to innovation
is closer to unity then it is to zero, suggesting
that innovation is not a problem for monopolist.
However, this depends on the level of aggregation.
Zoltan J. Acs and David B. Audretsch (1988)
found that the correlation for the macro economy
is closer to 0.9 while at the industry level it
is less than 0.5. In other words, while there is a
close relationship between innovation and R&D
expenditures at the aggregate level, at the industry
level, more often than not, innovations do not
come from the incumbent firm but from entrants.
Acs and Audretsch also found evidence that
monopoly led to less innovation and not more.
This story is therefore a story of the faithful suggesting
the influence here is one of Schumpeter
(1942) and the large firm where innovation and
invention are the prerogative of large firms. This
is consistent with models of endogenous technical
change that also assume that innovation and
invention can be modeled as identical activities.
We now have a microeconomic version of this
with one firm existing at both the macro and
the industry level. Stackelberg competition with
endogenous entry suggests that technological
change comes from incumbents and outsiders.
While it creates the possibility of entry, it does
not answer a very important question, “If monopoly
is so innovative why do new entrants continue
to do the bulk of the radical innovation?” I guess
because the elasticity of R&D with respect to
innovation is large in some industries and small
in others. While this book has given us an interesting
read, the jury is still out and will have to be
interpreted through the eyes of the reader.

References

Acs, Zoltan J., and David B. Audretsch. 1988. “Innovation
in Large and Small Firms: An Empirical Analysis.”
American Economic Review, 78(4): 678–90.
Romer, Paul M. 1990. “Endogenous Technological
Change.” Journal of Political Economy, 98(5 Part 2):
S71–102.
Schumpeter, Joseph A. 1942. Capitalism, Socialism
and Democracy. New York: Harper and Row.