International Think-Tank on Innovation and Competition
Market Leaders, Innovation, and R&D Spillovers in a Dynamic Set-up
by Kresimir Zigic
November 6th, 2005
How good are dominant firms for conducting innovation? Whether and when these innovations lead to persistence of monopoly? What are the antitrust consequences in such situation where the competition takes place along other dimensions than pricing? These kinds of questions are not exactly new among economists, but they seem to be actual again judging by provocatively entitled text ''Slackers or Pace-Setters: monopolies may have more incentives to innovate than economists have thought'' in the celebrated rubric ''Economics Focus'' of the last year issue of “The Economist” (May 2004). Apparently, there is a controversial role of market power and monopolies in creating innovations and the key to the answer lies in the underlying incentives to undertake innovations. The recent empirical evidence seems to support these Schumpeterian allegations from ''The Economist'' in the sense that there is a positive relationship between market power and intensity of innovation. Moreover, this evidence is, in fact, consistent with pre-emptive, strategic R&D investment by the leaders. As a consequence of such strategic behavior, there may be only one firm that survives in the market in the long run, but then this firm would display far more competitive behavior than a standard monopolist. It would respectively generate higher flow of R&D, charge lower price and produce more.
There are many real-world examples of dominant firms that invest more in innovation and R&D than their rivals and that persists over long period of time. Here we could, for instance, mention AT&T as an example of such pattern. Founded in 1885, the company is one of the largest telephone companies and cable television operators in the world. After becoming a first long distance telephone network in the US, AT&T made huge investments in research and development. Its Bell Labs invented fiber optic technology, the transistor and many other najor technological advances. Many Nobel prizes for physics were between its scientists. As a result, the company obtained near monopoly power on long distance phone services. Heavy investments in R&D together with aggressive behavior on the market allowed AT&T to obtain crucial inventions and to spread its near monopoly power on other markets. The company was also buying patents for significant innovations. Only after a suit against AT&T in 1982 followed by the breakup of the company into several local independent units called ''Baby Bells'' in 1984 the US telephone industry became competitive and other companies entered the market. While loosing part of its market power on the long distance telephone services, the company has continued its aggressive investments in R&D. For example, in 2004 AT&T introduced a facility allowing businesses to securely run their private networks without any interruptions on AT&T's leading global Internet Protocol network. This innovation assures the company to remain a leader in IP networking. Even AT&T characterizes itself as ''backed by the research and development capabilities of AT&T labs, the company is a global leader in local, long distance, Internet and transaction-based voice and data services''.
The nature of the above relation between innovativeness, leadership and market power has tremendous implications for the antitrust policy and it was at the heart of some recent economic research in the filed More specifically, it is important to study the situation in which the market leader undertakes pre-emptive R&D investment that eventually leads to exit of the follower firm or/and prevents or limits the entry of the new firms and contrast this situation with the one in which the leader (within the same setup) ''accommodates'' the follower, that is, it co-exists with follower in a duopoly market structure. This comparison will enable to study both positive aspects of the two main strategies - accommodation and strategic predation - (like, for instance, which strategy yields higher R&D intensity or R&D stock) and normative aspect (social welfare implications) of the two resulting market structures - duopoly versus (constrained) monopoly.
Since strategic innovations are inherently dynamic phenomenon, suitable method aimed at capturing both accommodating and the pre-emptive or predatory behavior of the dominant firm should be explicitly dynamic. Furthermore, the relationship between the leader and the follower is often accompanied with R&D spillovers stemming from leader to follower (the importance of R&D spillovers, imitations and its economic implications is well and broadly documented in both theoretical and empirical literature). However, most of the theoretical models are static in nature and they focus on the accommodation strategies. That is, strategic predation is simply ignored or precluded by assumptions (so that it is never optimal). In such situations unilateral R&D spillovers create disincentives to invest in R&D and consequently hamper innovations. However, in the case when strategic predation is optimal, the economic implication of R&D spillovers is exactly opposite. They enhance the incentive to invest in R&D.
Contrary to the static set-up where (constrained) monopoly is usually a marginal market structure (and is therefore often excluded from the analysis by assumption), in the dynamic setup, this market structure becomes more prevalent as the speed of adoption of the new technology increases and the efficiency of R&D process is high. Put together, these two facts yield a testable prediction in that the most propulsive innovative firms, that commercialize their investment in innovation quickly and efficiently (like, say AT&T, Microsoft, etc.), are the ones likely to use the strategic predation through investing large sums of money into innovative activity that in turn, help them to attain monopoly or near monopoly position. As for the social welfare considerations, strategic predation as dominant market strategy is socially preferable as well since it leads to both higher consumer surplus, and to higher social welfare generated despite the fact that only one firm (the leader) remains in the market in the long run. This all bears important competition policy implications. Thus, the size of market share per se might not be sufficient condition for a legal offence and second the monopoly pricing and consumer protection, that is a usual concern of the competition and antitrust policy, is not an issue in the above setup. The challenge for the design of antitrust policy against predation is related to the ability of the antitrust authority to distinguish between the price that is low for other predatory purposes from a price that might be set very low as part of an efficiency enhancing process that in turn results in enhanced competition leading in the end to the exit of the competitors. For instance, in the presence of network effects or learning effects it would be legitimate and consistent with vigorous competition that firms set very low prices when they are introducing new products, when they are targeting new customer segments or rivals, installed bases, or when they are in the first phase of the learning curve. Thus, the competition authority with limited knowledge of industry- and firm-specific data faces a complex problem when attempting to identify those circumstances under which loss-inducing predatory prices cause harm to competition. For that reason the antitrust authorities have to be fully aware of the risks of misclassification when approaching a predation case (see more about it in An Economic Analysis to Article 82 by J. Gual, M. Hellwig, A. Perrot, M. Polo, P. Rey, K. Schmidt and R. Stenbacka).
