There is a growing debate amongst economists about whether competition regulators can oversee digital disruption across the economy without themselves being disrupted. This is more than a debate about whether competition regulators need more powers to Big Tech – although many competition regulators say that’s the quick answer. It’s about whether competition law itself needs to be rebased to better capture the fundamentally different characteristics of the digital economy compared to the old industrial economy.

In a recent paper, two leading US economists, Nicolas Pettit and David Teece, summarise the debate as follows:

“On the one hand, there is a tendency to treat Big Tech firms as different because innovation in general (both technological and business model), and technical inputs in particular (big data, intelligent algorithms, and skilled engineers), clearly impact market structure and economic performance. On the other hand, industrial age explanations like monopoly power, anticompetitive leveraging, and predatory mergers are often used to supply theories for the durability and diversification of Big Tech firms.”

Pettit/Teece say that applying the traditional monopoly theory to Big Tech just doesn’t add up. Monopoly theory says big firms prefer the ‘quiet life’ that insulation from competition makes possible, but that does not seem to apply to Big Tech:

“There are many indicators suggesting that dynamism, not a base of monopoly power, is what is at work. The digital economy shows unprecedented productivity growth, rapid innovation, and new firm entry…..This state of affairs could not reasonably exist if Big Tech firms were dominant players that suppressed competition by using scale, supposedly like the large iron, oil, and steel trusts of the industrial age.”

That leads competition regulators into speculation about whether markets could be even more innovative without the power of Big Tech – which the UK’s CMA acknowledged in its recent report on mobile ec0-system is a tricky exercise.

Pettit/Teece propose a fresh approach they call ‘a dynamic capabilities framework’. Its complicated, but it’s an important debate so stick with us as we try to explain their thinking.

Which theory of efficiency should be the cornerstone of the analysis of tech markets?

The baseline of Pettit/Teece’s argument is that current competition law is largely built on static efficiency model, whereas analysis of technology markets should be based around dynamic efficiency:

• Static competition describes a situation in which firms compete for existing rents. In static competition, firms supply close to perfect substitute products. Rivalry results in short-term price decreases, cost-cutting, including wage reductions.
• Dynamic competition describes a situation in which firms compete for future rents. In dynamic competition, firms use innovation to introduce new products, processes, and services. It is a type of competition animated not by firms that compete head-on with similar products but by heterogeneous competitors, complementors, suppliers, and customers, using innovation to bring forth new products and processes. Such competition improves long-term factor productivity, raises consumer welfare, and supports higher wages.

The static model of competition reliably addressed competition issues in industries that neatly align with the static model of competition, for example, ‘predictable’ industries driven by cost efficiency rather than innovation. However, the nature of commerce is irreversibly changing: data-based innovation is becoming an integral feature of business operations across many sectors of the economy. As a result, many industries are emerging as less ‘predictable’, calling the applicability of the static model of competition – and the laws drawing on its principles – into question.

Pettit/Teece also acknowledge that most competition regulators would not disagree with the importance of dynamic efficiency to competition, but they consider it is given insufficient weight, if much at all. Partly this is because dynamic efficiency is hard to measure. Innovation often does not show up immediately in directly observable economic statistics, such as prices, markups, or cost data. Also, there can be a trade-off between long-run innovation benefits from dynamic competition and possible short-term reductions in price competition. Applying the competition law version of ‘a bird in the hand is worth two in the bush’, there is a tendency to discount future rewards more than present ones.

But fault can, in Pettit/Teece’s view, also be laid at the door of Chicago School which, while will bringing great clarity to economic thinking, also drove a rigid focus on ‘here and now’ efficiency, treating R&D as “just a cost with uncertain benefits.”

In the search for a better understanding of how innovation works in technology markets, Pettit/Teece say that competition regulators should look to models found in the field of management. These alternative models hold that changes are necessary for an incumbent to survive when it faces competence-destroying innovation. They suggest that change is not easy, because larger firms develop inertia, which is “the organizational equivalent of high cholesterol”. Incumbents are vulnerable because new entrants are not saddled with conventional managerial wisdom, established value networks, or existing technological performance trajectories to follow.

Pettit/Teece say that there management theories take the opposite view of incumbency to the standard monopoly model used in competition law:

“commonplace models in the field of (technology) management appear to turn the standard model of static competition on its head. While established competition policy analysis tends to treat incumbency as a benefit, the (technology) management literature more often considers incumbency as a liability.”

As evidence, they point to the “fragility of market leadership” in technology markets: e.g. look what happened to IBM of “Big Blue” fame.

Entrepreneurship in Big Tech

To be fair, competition law has always recognised the role of marginal disruptive players: the mavericks.

What is different in the Pettit/Teece discussion is that they say the positive force of entrepreneurship which delivers future benefits to consumers can be found, at least in some cases, in the management teams of large firms. They argue that “the search for a functional relationship between market structure and innovation that has traditionally motivated competition policy research has suffocated a broader enquiry”: in other words, while it is commonly said in standard competition law analysis that “big is not (necessarily) bad”, the implicit assumption is that in a concentrated market structure large firms cannot be the innovators (unless they have an anti-competitive purpose in mind).

Instead, Pettit/Teece argue that “[w]hat is needed is a theory of the innovating firm that accepts that conduct and performance is impacted by heterogeneity, and in particular by firm-level differences in strategies, business models, organizational processes, ecosystem structures, and, of course, management.” When comparing firms in a market, the analysis tends to stop “at the boundaries of the firm” (i.e. what are the relative market shares or ‘sizes’ of the firms in the market), whereas Pettit/Teece argue that the analysis needs to look ‘inside the firms’ at the differences (i.e. heterogeneity) between market participants in their dynamic capabilities.

The next step in their reasoning is that in highly innovative industries, success requires a firm to be good at ‘orchestrating’ a range of assets, personnel and data in a climate of uncertainty: e.g. as new technologies emerge or as new uses for existing data are found. They say that this capability usually has to be built, not bought and that therefore integration is the rule and market-based transactions are the exception:

“Building and assembling cospecialized assets and data inside the firm (rather than accessing them through a skein of contracts) is not done primarily to guard against opportunism and recontracting hazards. Instead, effective coordination of assets, resources, and data is important but difficult to achieve through the price system. Existing property institutions do not enable efficient opportunities for trade and economic exchange because information knowledge is a “fugitive resource” subject to low appropriability and intellectual property (“IP”) protection…Taken together, these two factors suggest that special value accrues to achieving good asset alignment inside the firm in the digital economy.”

They give the example of the mess Boeing got into with its hi-tech Dreamliner project relying on a global array of suppliers.

Monopoly rents vs rents for future investment

The profitability of Big Tech is often identified as evidence of dominance (‘monopoly rents’). Pettit/Teece have a detailed analysis of good rents vs bad rents, but come to the following conclusions:

• innovation and dynamic capabilities are not viable in the absence of the financial returns necessary to draw forth continued investment in the ecosystem;
• big is not bad, and dominance-based intervention thresholds are inappropriate. Competition between platforms tends to reduce winner take all outcomes. Most small firms cannot afford the R&D and professional management that is needed to develop commanding dynamic capabilities;
• criteria are needed to distinguish between “undesirable” profits (monopoly) and “desirable” rents, such as temporary rents from an innovation. Monopoly rents arise might arise because of (unnecessary) exclusionary conduct lacking efficiency or appropriability justifications. High-performing firms that invest despite deep uncertainty are unlikely to be the beneficiaries of naked monopoly rents. Firms with strong dynamic capabilities also generate wider benefits, paying better wages, building skills, creating hotbeds of innovation and building better capabilities in a virtuous cycle for the firm and more widely.

What does this mean for competition law?

Petit/Teece recognise that a structural overhaul of the existing competition law framework is probably unwarranted as the existing static competition framework reliably addresses antitrust in predictable industries. However, bringing a dynamic understanding to regulation in the tech sector will:

1. acknowledge the pivotal role of innovation in producing cross-sector, sustainable competition in pursuit of optimal consumer welfare
2. shift the regulatory focus away from market power to anticompetitive conduct, recognising that the latter is not, by default, a corollary of the former
3. encourage holistic regulation where innovation is balanced with protecting competition from anticompetitive practices

Petit/Teece illustrate how this would look in three circumstances: market definition, merger analysis and self-preferencing.

(a) Market definition

In traditional competition law, market definition for the purpose of market power analysis is evaluated with reference to the Small but Significant Non-transitory Increase in Price (SSNIP) test. The SSNIP test turns on the demand or supply-side substitution following a marginal increase in price.

While such quantitative analysis can be performed neatly and conveniently, Petit/Teece argue that this approach fails to recognise how ecosystems within the digital world ‘endeavour to attract and support complements and their pricing reflects complex interdependencies not factored into the design of the SSNIP test’. An approach more forgiving of dynamic capabilities and innovation rectifies concerns that the current test is biased in favour of monopoly power when applied to digital markets.

(b) Merger analysis

Petit/Teece’s dynamic capabilities framework suggests that some acquisitions are less problematic than others.

Competition policy should be less permissive about diversification in areas where a firm has low capabilities:

“ it should be self-evident that it will be harder for a firm stuck with just ordinary capabilities to catch up with rivals with strong dynamic capabilities….In these cases, anticompetitive purpose or effects will be easier to infer, for firms without dynamic capabilities should know that they have little chance to catch up, and so might be more tempted to revert to anti-competitive conduct.”

Conversely, diversification that builds upon or extends existing capabilities is about the only form of diversification that a capabilities-based competition policy should view as meritorious.

Pettit/Teece think a more nuanced view needs to be taken of so-called ‘killer acquisitions’ where Big Tech buys a start-up. Successful dynamic capabilities absorption will be more important for firms who have already developed a “path of learning”, than for firms who have closed it. Absorption of dynamic capabilities is also easier when the acquired firm is young. By contrast, older firms possess deep ingrained routines that are hardwired into the organization and difficult to transfer by acquisition or agreement – which suggests that something else, less desirable, is going on.

(c) Self-preferencing

Prominent examples of alleged self-preferencing in the digital economy include Apple consistently favouring its apps by displaying them more prominently than similar apps in App Store search results.

The prevailing competition framework evaluates self-preferencing by considering whether a firm has capacity to leverage its power to exclude rivals in another market. Essentially, self-preferencing under this model is another example of ‘quiet life’ by a monopolist: grabbing the low hanging profit opportunities, instead of investing in R&D to develop new products.

While not denying the risks of self-preferencing, Pettit/Teece comment that “self-preferencing has a strong developmental dimension” and that “a dynamic capabilities-trained eye will instantly notice how self-preferencing fits within the panoply of sensing, seizing, and/or transforming activities”. Self-preferencing can be a means for firms to ‘weed out bad designs and settle on a dominant one’ to compete.

Conclusion

Pettit/Teece conclude by saying that “[a] new competition economics paradigm is needed…[a]t a time where fiercely competitive diversified firms represent a feature not a bug of the digital economy”.

Their essential point is that economic and legal experts must develop tools and models that operationalize the idea that innovation drives competition as much as competition drives innovation. So far, the recognition that advancing dynamic competition and supporting innovation benefits consumers has been perfunctory in competition economics.

But they also say their focus on dynamic competition is less a disruption of competition law than a natural extension: “a trained competition eye will recognize the common thread between dynamic capabilities and policies against cartels that combat organizational structures limiting the uncertainty of competition or stabilizing strategic positions.”

 

Read more: Innovating Big Tech Firms and Competition Policy: Favoring Dynamic Over Static Competition