Recent merger decisions have revived the debate on the role of innovation in merger control. The theory of harm put forward by competition authorities in these recent merger cases posits that a merger between rival innovators may lessen competition not only because of a reduction in (static) competition on current products, but also because of a lessening of (dynamic) competition on future products. According to this theory of harm, the loss of future competition may, at least in part, stem from a reduction in innovation.

This article, available here, reviews the debate on the relationship between horizontal mergers and innovation up to this point (i.e. 2017). I think it provides a good overview of the various arguments invoked to subject mergers affecting innovation to more stringent scrutiny during a first stage of the debate.

Section II offers a succinct historical account of economic thinking on the relationship between competition and innovation.

Innovation theories of harm in merger control are premised on a view of competition as a process of rivalry between firms which generates a number of benefits to society and consumers – including dynamic efficiencies (i.e. innovation and new products). The proposition that rivalry between firms fosters dynamic efficiency has a long pedigree in the history of economic thought. This view of competition as a process of rivalry takes innovation as one of the competitive parameters (just like price or quality) that firms can use to gain sales at the expense of their rivals, and to protect their existing sales from their rivals, in order to increase their profits. Competition increases both the rewards from innovating and the threat from not innovating – thus increasing the overall incentive to innovate.

The notion of competition as a process of rivalry contrasts with a more static view of (perfect) competition as an end-state where allocative efficiency is promoted (i.e. prices are close to cost). This static notion of competition as an end-state has arguably received greater attention from modern formal economics than the more dynamic view of competition as process of rivalry, and is silent on whether and how competition contributes to productive and dynamic efficiency. By contrast, competition policy has broadly embraced the ‘process-view’ of competition as a driver of dynamic efficiency – as is made clear by merger control guidelines, jurisprudence and administrative practice.

Section III reviews insights from the current economic literature on the impact of horizontal mergers on innovation.

The economic literature suggests that horizontal mergers are likely to affect innovation incentives predominantly through three channels: innovation competition, product market competition and appropriability. Each channel corresponds to a distinct externality which may be at work between the merging parties.

Innovation competition gives rise to a negative externality between competing firms. By investing in innovation, a firm reduces the expected profits that its rivals can expect to make in the product market. After a merger between rival innovators, the common owner of the two firms will take into account the fact that innovation by one of the two firms will reduce the expected profits of the other firm (and vice versa). This effect is internalised with the merger, increasing the opportunity cost of innovation for each of the merging parties. The higher opportunity cost of innovating unambiguously depresses the innovation incentive of the merging firms. This effect is similar to that which occurs as regards price, and is closely related to the concept of competition as a dynamic process of rivalry. The academic literature has identified the innovation externality in different settings, some of which go beyond horizontal mergers.

As regards product competition, it has an ambiguous impact on incentives to innovate. The economic literature has analysed the nature of the product market competition channel in a variety of settings. Parallels have been drawn with the work of Aghion and Howitt as evidence that the relationship between competition and innovation is ambiguous. It is however not possible to draw implications for merger control from this strand of the literature. The Aghion-Howitt framework studies the impact of changes in competition only in the product market, whilst keeping the structure of competition at the innovation stage unchanged. This approach therefore does not incorporate the innovation competition channel, which is one of the key effects of a merger between rival innovators.

In effect, a merger simultaneously affects innovation competition and product market competition. In order to characterise the overall impact of a merger on innovation incentives through its effect on market power alone (i.e. absent other potential countervailing effects) it is necessary to simultaneously consider both the innovation competition channel and the product market competition channel. A number of recent papers shed light on the combined impact of the two channels in the specific contexts of a horizontal merger and/or of coordination between competing firms. These papers suggest that horizontal mergers are likely to reduce the innovation incentives of merging firms through their impact on market power. From a consumer welfare perspective, the harm to consumers due to a merger is not just the result of lower innovation, but also of higher prices. The interplay of the two channels affects the nature of this loss of competition. It determines in particular whether the loss of future competition manifest itself only or primarily through higher future prices (i.e. a lower pass-on to consumers of the future benefits of innovation), or through a combination of lower innovation effort and less intense future product market competition. The existing economic literature suggests that the second scenario is the more likely one.

The third channel through which a merger of rivals may affect innovation incentives relates to appropriability, i.e. the ability by an innovator to capture the social value of its invention by limiting imitation by competing firms (e.g. by preventing knowledge spillovers). Greater appropriability enhances the incentives to innovate, by allowing the innovator to obtain a higher reward from its invention. A merger can affect the degree of appropriability by eliminating the risk of imitation between the two merging parties. The scope for mergers or R&D cooperation agreements to increase innovation incentives in the presence of knowledge spillovers is widely noted in the economic literature. More generally, the policy literature has frequently emphasised the fact that the degree of appropriability prevailing in the absence of a merger is an important determinant of the effects of a merger on innovation. Merger control can recognise the possible countervailing effect of greater appropriability on innovation incentives, as long as the increase of appropriability can be causally attributed to the merger (that is, it cannot be achieved by alternative and less anticompetitive arrangements).

A merger may also give rise to pro-competitive effects on innovation that are not fully captured under the appropriability channel. For example, a merger may increase the productivity of R&D by bringing together complementary R&D assets and/or by enabling cost synergies. Complementarities in R&D activities may specifically arise in the context of non-horizontal mergers. These potential pro-competitive effects are based on traditional efficiency arguments, which are not necessarily specific to innovation.

Section IV concludes.

Economic principles suggest that a merger between rival innovators may harm consumers through its negative impact on future competition (i.e. competition on future, improved, products), as result of both lower innovation effort by the merging parties and higher future  prices. An innovation theory of harm in merger control is consistent with the ‘original’ concept of competition as a dynamic process of rivalry, and it is also in line with the approach currently adopted by competition authorities in their policy guidelines.

Harm to future competition is more likely to be significant if a merger brings together two out of a limited number of effective innovators in the same R&D trajectory. An innovation-based theory of harm is also more likely to be applicable if the merger does not give rise to countervailing pre-competitive effects – for example, if the merger does not increase appropriability, or does not lead to cost efficiencies in R&D. Consumer harm is also more likely if the market is characterised by high and durable barriers to entry and expansion in R&D, implying that the loss of dynamic competition due to the merger is unlikely to be mitigated by the response of competing firms (including new entrants).

Contrary to the interpretation that is sometimes put forward in debates on competition policy, economic theory does not suggest that the relationship between horizontal mergers and innovation is generally ambiguous, with no clear guidance for competition policy. On the contrary, the literature highlights general principles that can be used both to determine when an innovation theory of harm is likely to be relevant, and to guide the identification and assessment of the relevant factual evidence. These principles suggest that several elements of the framework that is traditionally associated with the analysis of unilateral effects on prices can be transposed to the assessment of the effects of a merger on innovation and future competition. In particular, concepts that are central to the assessment of static unilateral effects (e.g. market concentration; the degree of closeness between the merging parties; the existence of barriers to entry; and the presence of countervailing efficiencies) are also relevant to the evaluation of an innovation theory of harm.

To capture the full competitive impact of a merger, however, the competition assessment may need to look beyond the current overlaps between the merging parties, i.e. those in relation to existing products or clearly foreseeable future products (e.g. pipeline products in an advanced stage of development). The merger review may also need to consider the likelihood and nature of future competition between the merging parties, on the basis of their R&D activities and innovation capabilities and those of actual or potential rivals. Depending on the  circumstances of the case, the assessment of the possible loss of dynamic competition due to a merger can be more complex and will by its nature be often less precise than the evaluation of the impact on static price competition. This calls for a careful case-by-case analysis and a degree of caution in reaching conclusions on the significance of the loss of innovation competition that may result from a merger.

Comment:

This paper provides a very useful and comprehensive overview of recent studies – mainly of European origin – concerning the impact of horizontal mergers on innovation. It has a clear pro-enforcement slant, with which I take no issue. However, it would have been useful to identify specific authors and arguments defending that the effect of horizontal mergers on innovation is ambiguous, instead of just raising them as a foe to be explained away by the sheer number of studies in favour of the author’s position – even though, as we shall see, a number of such ‘foes’ took little time in coming out as a reaction to the arguments made in this paper.

I am also not sure what the distinction between static and process-oriented views of competition, which occupies a fair amount of space, plays here. The author clearly favours the latter, but at no point explains why it should be favoured or what difference this would make for his arguments. I suspect this reflects discussions concerning the Dow/DuPont merger, where the static analysis did not identify clear anticompetitive effects but the transaction was found to create problems from a dynamic standpoint.

Lastly, I also find that the author’s argument concerning the anticompetitive effect of horizontal mergers on innovation would have benefitted from being linked more clearly to concerns about market power. For example, a reader could come away from the article thinking that all horizontal mergers are inherently anticompetitive absent efficiencies, and hence require intervention. Does that mean that a merger between two companies in a market with ten players is problematic and should be prohibited? If so, in what circumstances? I do not believe the author is making such a sweeping argument, but it would have been good to have fleshed out the relevance of market power for the analysis a bit more. At the same time, I suspect there are limits to what an economist at the European Commission can say. I understand, and even sympathise.

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