International Think-Tank on Innovation and Competition
Beyond the Post-Chicago Approach to Antitrust: the New Theory of Market Leaders
January 2nd , 2006
Recent developments in the economic research on market structures suggest the need of a new approach to competition policy especially for the dynamic sectors of the New Economy moving beyond the socalled post-Chicago approach, which has been dominant in the last twenty years. In particular, the new theory of market leadership, founded on the classic analysis of pioneers such as Stackelberg (1934), Schumpeter (1942) and the Nobel prize Modigliani (1958), and formalized in modern terms in recent theoretical works (for instance Etro, 2006), tries to integrate the Chicago approach, which emphasizes the importance of competition in constraining market leaders and the post-Chicago approach, which emphasizes the strategic interaction between market leaders and competitors. While the former approach has ignored strategic interactions, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor. In our view, only a comprehensive understanding of the strategic interaction between market leaders and their competitors, taking into account the endogenous incentives of all these to enter in the market, can provide a sound approach to antitrust issues, and this is what the new theory of market leaders attempts to do.
In the 80s and 90s, the post-Chicago research on industrial organization studied market structures within a solid economic (game-theoretic) framework and introduced welfare considerations so as to derive normative implications from its research: such a welfare based approach to competition policy represents one of the main contribution of this approach. However, in most cases, this literature limited its analysis to the behaviour of an incumbent monopolist facing a single competitor. To cite the most famous works with strong relevance for antitrust issues, this was the case of the Dixit (1980) model of entry deterrence, of the model by Milgrom and Roberts (1982) on predatory pricing, of the work by Fudenberg and Tirole (1984) of strategic investments, of the Bonanno and Vickers (1988) model of vertical restraints, of the Whinston (1990) model of bundling for entry deterrence purposes, and of many other works, often based on analysis of duopolies. In this set up where the possibility of entry by third firms is not taken into account, it is easier for the incumbent to adopt strategies which hurt the rival and protect a dominant position. These anti-competitive strategies would be less effective or even counterproductive in case other firms could enter the market and interact strategically (so not even under perfect competition as in the older Chicago school) with both the incumbent and its immediate rival.
It is not surprising that the results of the post-Chicago approach are systematically biased toward an anti-competitive strategic role of incumbents: according to this view, incumbents tend to engage in predatory pricing, threaten and undertake overinvestments in complementary markets, impose exclusive dealing contracts or bundle their goods with the main purpose of deterring entry of the competitor, otherwise they engage in accommodating pricing, underinvest in quality and product differentiation and they stifle innovation. In such a simple world, what antitrust authorities should do is fighting against incumbents: punish their aggressive pricing strategies as predatory, and their accommodating pricing strategies as well (but in this case as monopolistic behaviours), punish investments in complementary markets (“embrace and extend” strategies) as attempts to monopolize them, forbid bundling strategies, and so on. The bottom line is that antitrust authorities should sanction virtually any behaviour of the incumbents which does not conform to that of their competitors.
It is true that the majority of the post-Chicago economists admit the possibility that most strategies adopted by the dominant firms can also have efficiency rationales and consequently suggest the need of a rule of reason to judge every single market case by case (see Motta, 2004 and Rey et al., 2005), but starting from such a bias against incumbents, it is often hard to find efficiency effects which compensate for the hypothetical anti-competitive strategic effects (and even harder, when these effects exist, to prove them). The consequences are on one side that competition policy is often ineffective, and on the other that market leaders tend to avoid potentially pro-competitive strategies because they may be covered by biased antitrust rules.
In our view, the fallacy of this line of thought derives from a simple fact: it is based on a partial view which does not take into account that, at least in most cases, entry by competitors is not an exogenous fact, but an endogenous decision. This holds not only for the market where the leader is primarily active, but also for the secondary markets where its strategies are supposed to have consequences. Taking this into account, the new theory of market leaders provides a more complete analysis of the market structures with dominant firms and of the behaviour of these dominant firms, which is what we need to properly approach competition policy. Within the new theory of market leaders, the following main results emerge:
1) market leaders are always aggressive (pro-competitive: set lower prices and hence have higher market shares) in markets where entry is free or constrained by (even large) entry costs, while they tend to be accommodating (anti-competitive: increase prices) in presence of real barriers to entry, that is when firms which would find profitable to enter, cannot enter (the first point is by Etro, 2006, the second goes back to Fudenberg and Tirole, 1984): as a consequence, very large market shares for dominant firms are more likely to be a symptom of a competitive environment rather than of market power;
2) competitive markets characterized by high fixed costs and constant variable costs or, more generally, by decreasing average costs, generate absolute or close to absolute dominance: under these conditions (satisfied for instance in the software market, where variable costs are close to zero and fixed costs of product development are huge), even an apparently monopolistic market share has no relation with effective market power, while it is likely to be the symptom of a competitive environment (a first discussion of such a result is by Modigliani, 1958; see also the contestable marke approach by Baumol, Panzar and WIllig, 1982; for a modern proof see Etro, 2005);
3) aggressive introductory pricing, bundling strategies (without entry deterrence purposes) and over-investments in complementary markets are always parts of a natural competitive behaviour of leaders in markets where entry is endogenous, while accommodating pricing, absence of bundling (or bundling to deter entry) and under-investment in complementary markets characterize the behaviour of dominant firms with market power (the first point is by Etro, 2006, the second appears in different contributions of the post-Chicago approach);
4) dominant firms invest more in R&D when threatened by a competitive pressure, while they only tend to stifle innovation in absence of such a pressure: hence, a leadership in high-tech sectors tends to be persistent if and only if there is effective dynamic competition, which leads to a faster rate of technological progress in the interest of consumers (the first result is due to Etro, 2004 while the second goes back to Arrow, 1962; see Blundell et al. (1999) and the recent book by Aghion and Griffith (2005) for supporting empirical evidence).
Market leadership and market dominance
The new theory of market leaders provides insights on what is a dominant position in a market and what should be an abuse of that. First of all, we should differentiate betwen market leaders and dominant firms: market leaders have some strategic advantage over their competitors, but they become dominant and potentially abusive only when they can use it to prevent effective competition and harm consumers. The all point is to understand when market leaders can prevent effective competition and when they cannot, and the new theory of market leaders provides clear answers on this.
First of all, the behaviour of market leaders tends to be pro-competitive whenever entry of competitors in their market is constrained just by entry costs, as large as they can be. Second, there should be no presumption that a certain market share amounts necessarily to dominance. As a matter of fact, the new theory of market leaders shows that, paradoxically, the correlation between market share and effective market power can be negative. To see this, consider a market where a leader and its rivals compete in prices. According to the post-Chicago approach, the leader could try to deter entry with a predatory strategy, or just be accommodating, sharing the market with the competitors. However, when entry in the market is endogenous and constrained just by technological conditions, the leader has to adopt a strategy of aggressive pricing, and by undercutting its competitors, it acquires a larger share of the market. In this case, the market share of the leader is higher when product differentiation is weaker, when fixed costs of production are higher and when variable costs are not too increasing with the production level. Actually, Modigliani (1958) and, in modern terms, Etro (2005) have derived the conditions under which free entry induces the leader to be so aggressive to conquer the all market. But this implies that the same possibility of entry until profitable opportunities for the entrants are exhausted is associated with the largest market share for the leader!
As an example, consider the software market. The basic technological conditions in this market are quite uncontroversial. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment, which corresponds to what we called a high fixed cost of production, and a constant marginal cost, in the sense that the cost of each additional unit of software is always the same, and, as well known, it is close to zero. The entry conditions in this market are more debated, however there are good reasons to believe that entry in the software market may entail large costs, but is substantially open. First of all, there are and there have been many firms active in this sector, and even more potential entrants – think of the giants in adjacent sectors of the New Economy (hardware, telecommunications and Internet in particular). Second, it is hard to think of a market which is more “global” than the software market: demand comes from all the world, transport costs are very small for the all world, knowledge andlabour force to project software are easily accessible worldwide and competition is global.
Nevertheless, it has been claimed that in the market for PC (or client) operating systems the high number of applications developed by many different firms for the leading operating system, Windows by Microsoft, represents a substantial barrier to entry. This is a typical example of confusion between costs of entry and barriers to entry. It is true that Microsoft competitors need to offer (and some do offer indeed) a number of standard and technologically mature applications upon entry to match the high quality of the Microsoft package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market, hence this is not a barrier to entry, but just a cost that a competitor has to undertake. There are at least two further elements in support of this. First, notice that the alleged “applications barrier to entry” is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really exhaust the needs of most active computer users. Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems “ported to” their own). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market or through innovations (to which I will return later on), there is no doubt that the opportunity to invest in innovations for future better software is widely open not only to large companies in the New Economy, but even to smaller ones.
Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the exact conditions under which we should expect a leader to serve the all market with very aggressive (low) prices. Hence (considering also that demand for software is also characterized by such strong network effects which reward products with larger market shares), there should be nothing surprising in the highmarket share of Microsoft. The presence of a few relatively large competitors and some smaller specialized competitors, in line with the same theory, is related to a certain degree of product differentiation. We can see the same fact from a different perspective: in absence of real barriers to entry, the leader in the software market finds convenient to keep prices low enough to expand its market share to almost all the market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative softwares at even lower prices to build their own network effects.
The extremely low price of the main software of Microsoft, Windows, represents an inverse proof of our arguments above. It is easy to realize that the behaviour of Microsoft in this sense has nothing to do with the behaviour of a real monopolist. To verify this, imagine for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by E-1, where E is the elasticity of demand for PCs (it means that a 1% increase in the price of PCs reduces demand by E %). Now, the above relation tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if E=2, 500 Euros if E=3, 333 Euros if E=4 and so on. It would take really unreasonable values of demand elasticity (above 10) to even get close to the real average price of Windows, which is around 50-100 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would increase a lot, hardware producers would be forced to reduce somewhat their prices. Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows: and to emphasize how low is the actual price of Windows compared to that.
What does all this tell us? Simply that Microsoft is not a monopolist and its prices are constrained well below the monopolistic price to compete aggressively with the other firms active in the operating system market and with the potential entrants in it. However, we can say more than just that Microsoft is not a monopoly. What the post-Chicago approach suggested about leaders in markets with barriers to entry and price competition was that they should be accommodating and exploit their market power setting higher prices than the competitors or engage in predatory pricing and, after having conquered the all market, increase prices. But in the last ten-fifteen years of global leadership, Microsoft has done neither one or the other of these things: since 1990 the (retail and street) price of Windows has been constantly declining (in nominal terms and even if the quality was widely increasing) and the same can be said for its Applications (Word and Excel in particular), something quite in contrast with what a monopolist should do while achieving and consolidating a monopolistic position. In reality, Microsoft has been constantly aggressive as any firm under the threat of competitive pressure would be. The new theory of market leaders has shown that a leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the larger (worldwide in the case of Microsoft) scale of production. The price should be below that of its immediate competitors or just low enough to avoid that they could exploit profitable opportunities.
In conclusion, the market share of some market leaders can be very high because their behaviour is forced to be extremely aggressive by strong competitive pressure. Nevertheless, this entry threat may remain mostly potential and not create massive entry in the market. In such a case, firms with high market shares have nothing to do with monopolists protected by barriers to entry: they are leaders but not dominant firms.
An application to bundling
As a particular example of the applicability of the new theory of market leaders in contrast with the traditional approach, let us consider bundling as a strategy subject to antitrust screening. To start with the strongest possible bias against the bundling firm, imagine that this is a monopolist in a primary market with the possibility to enter in a secondary market, and that there are no clear technological efficiencies derived by bundling the goods in the two markets.
The Chicago school has studied such a situation when the secondary market is perfectly competitive, that is firms price at marginal cost and earn no extra profits: in such a case, the monopolist has no incentives to bundle because this could only reduce demand in the primary market. More in general, if the goods are somewhat complementary, it has no reason to reduce competition in the secondary market because again this could only reduce profits in the primary one.
The post-Chicago approach (starting with Whinston, 1990) has studied the same situation when the secondary market is not perfectly competitive, while there is actually one single firm active strategically (and the possibility that other firms could enter is not taken in consideration). The main result is that bundling increases price competition in the secondary market and the only reason why the monopolist would like to adopt a bundling strategy is to induce exit of the rival in the secondary market. As a consequence, the post-Chicago approach associates a bundling strategy by dominant firms in a primary market with a strategy finalized to entry deterrence and hence with an abusive conduct hurting competitors and consumers. Both the US vs Microsoft case (which considered the bundling of Windows with Internet Explorer) and the EU vs Microsoft case (which considers the bundling of Windows with Media Player) have been largely inspired by the post-Chicago approach to bundling issues.
The new theory of market leaders has studied again the same situation but with a secondary market where firms decide “endogenously” whether to enter or not. In this case, bundling increases again price competition, but has nothing to do with entry deterrence, it is just an aggressive strategy (but not a predatory one) which has pro-competitive effects: it reduces the combined price level and increases welfare. Technically, the market leader can exploit a larger scale of production for the bundle to offer it at a very competitive price: bundling the two products works as a commitment device to be aggressive, that is to produce more for the secondary market and hence to be able to adopt a lower price. As a consequence, the leader can exploit larger scale economies, reduce the average price level for the consumers and hence increase welfare (see Etro, 2006).
Summarizing, while approaching a bundling case we need to verify the entry conditions of the secondary market. If there is a dominant firm in this market as well (the case studied by the post-Chicago approach), the main problem is not the bundling strategy, but the lack of competition in the secondary market, and it should be addressed within this market: punishing the bundling strategy would just strengthen the monopolistic rents of the dominant firm in the secondary markets. However, when the secondary market is not monopolized, but open to limited entry (even if it is not perfectly competitive, in the sense that firms do not price at marginal cost), then bundling is a pro-competitive strategy and punishing it would hurt consumers. Finally, notice that we achieved these conclusions ignoring the possibility that the bundling firm could create technological efficiencies by bundling its products, excluding that this firm could have a somewhat limited market power in the primary market and even ignoring the benefits from bundling in case of complementarities between the products: taking these factors in consideration could only strengthen the results against the punishment of a bundling strategy.
Dynamic competition and innovation
The new theory of market leaders provides insights on a more dynamic view of competition, the one which characterizes most high-tech sectors and most fields of the New Economy. In these fields, competition is not so much “in the market”, in the sense of focusing on prices and marketing of the products, but it is competition “for the market”, in the sense of focusing on innovation to create new and better products. This kind of competition is fundamental in driving technological progress and growth, hence antitrust authorities should pay double attention to it and be extremely careful in intervening. Unfortunately, also in this case the traditional view is in striking contrast with the new theory of market leaders.
As a recent Economic Focus of the Economist (2004) has written, “Joseph Schumpeter, an Austrian economist, pointed out many years ago that established firms play a big role in innovation. In modern times, it appears that many product innovations, in industries from razor blades to software, are made by companies that have a dominant share of the market. Most mainstream economists, however, have had difficulty explaining why this might be so. Kenneth Arrow, a Nobel prize-winner, once posed the issue as a paradox. Economic theory says that a monopolist should have far less incentive to invest in creating innovations than a firm in a competitive environment: experience suggests otherwise. How can this be so?”. Indeed, wide empirical evidence shows that dominant firms invest a lot in R&D and obtain relatively more innovations than smaller firms (see Blundell et al., 1999). The recent theories of market leadership (see Etro, 2004; Aghion and Griffith, 2005; Wiethaus, 2005; Zigic et al., 2005) have clarified the mechanics of these results. In a sense, patents drive competition through innovation in these markets and induce technological progress led by market leaders.
For instance, Etro (2004) proposes a solution to the above cited Arrow’s paradox showing that dominant firms have more incentives to invest in innovation than the followers when the market for innovation, or what sometimes is called the patent race, is characterized by free entry (as long as the dominant firms have a leadership, which in economic jargon means just that they can commit to an investment choice before the other firms). The crucial thing here, is that dominant firms often remain dominant thanks to their investments, but this should not be seen as evidence of inefficiency or of monopolistic power, but rather as a proof of the opposite: the competitive environment spurs investment by leaders and consequently induces a chance that their dominance persists. Think of the software market again. Even if believing that Microsoft has some relevant market power in the market, it is far more reasonable to agree on the fact that the market for innovation in this sector is quite open. The immediate proof is that in the last ten-fifteen years the number of new companies with brilliant and new ideas in the field of software, and huge financing easily found in the capital markets, has been impressive. Well, the only way for Microsoft to keep up with this competition for the market (beyond the competition in the market) has been investing in innovation. This is really the main form of competition in the software market, as in many other high-tech sectors, and a lot of the growth of the western world in the last years is strictly related with this kind of competition.
Clearly, this has strong implications for industrial policy. What the above theory suggests, however, is that market leaders in high-tech sectors investing a lot in innovation may create an efficient situation. Quoting again the Economist (2004) “antitrust authorities should be especially careful when trying to stamp out monopoly power in markets that are marked by technical innovation. It could still be that firms like Microsoft are capable of using their girth to squish their rivals; the point is that continued monopoly is not cast-iron evidence of bad behaviour…when one company dominates a market, people should be careful in assuming that it is guilty of sloth. It may be fighting for its life.”
In conclusion, the new theory of market leaders suggests the necessity of a new approach to antitrust issues, and in particular to abuse of dominance, which departs, at least to some extent, from the post-Chicago approach. The bottom line is that market leaders can act in a pro-competitive and welfare enhancing way when they face a real entry threat, while only in the absence of such a threat their strategies become anti-competitive.
