[Economic Report of the President (2002)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 3

Realizing Gains from Competition

The organization of the firms that contribute to our Nation's
economic output is constantly in flux. Some changes in organization
are limited to a firm's internal operations, as when firms develop
innovative ways to produce an existing good or service, or introduce
incentives that encourage workers to be more efficient. Other
organizational changes involve changing a firm's size or scope. This
might include expanding production or offering new goods or services,
to gain a greater share of a market or to broaden the firm's geographic
reach. Finally, firms may alter their relationships with other firms
that supply them, buy from them, or compete with them. For instance,
they might merge to combine operations with a former rival, or
outsource some part of their operations to another firm.
Some of these changes may be quite visible to consumers. They may
change the names of companies with which consumers have become
familiar. They may even affect the types of products available in the
market. Other changes may be less visible.
At the same time, the overall composition of the economy is also
undergoing constant change. In particular, high-technology industries
such as biotechnology and information technology have become a much
more prominent part of the economy than they were even a decade ago.
Innovations are central to the success of the firms that make up these
industries.  These innovations have brought us remarkably more powerful
computers, more effective drug therapies, and much else.
One might naturally ask what the Federal Government's role in the
economy should be in light of these ongoing changes in the
organization of firms and the composition of the economy. The vast
majority of firms face healthy competition from other firms. A great
virtue of this competition is that it yields a number of benefits for
consumers without the need for government to intervene in the
day-to-day decisions of firms. First, competition keeps prices low.
Competition in its various forms discourages any one firm from raising
prices above what others would charge for similar goods or services.
Second, competition ensures that only those firms that can meet
consumer demands at the lowest possible cost will remain viable.
Finally, competition encourages innovation in products and services,
as well as in production and distribution methods, among other things.
Many of the organizational adjustments that firms undertake are
necessary responses to changing conditions, as competition motivates
them to constantly seek ways to lower their costs and improve their
products. But in some limited cases these changes in organization may
have the effect of reducing the vigor of competition. Recognizing this
possibility, since the end of the 19th century all three branches of
the Federal Government have contributed to the development of antitrust
policy, a particularly important component of competition policy.
Three laws passed by Congress form the statutory basis of antitrust
policy in the United States. Together, the Sherman Act of 1890, the
Clayton Act of 1914, and the Federal Trade Commission Act of 1914 set
forth broad principles forbidding behavior or changes in the
organization and relationships of firms that may harm competition. The
specific implications of these laws have evolved as Federal courts
have interpreted their broad principles in deciding cases brought
before them. Two Federal agencies, the Department of Justice and the
Federal Trade Commission (FTC), actively enforce these laws. Under the
Sherman and Clayton Acts, private individuals and firms may also bring
suit against firms they believe are engaged in anticompetitive
practices. As the courts consider each new case, they are given an
opportunity to further refine their interpretation of these antitrust
laws.
Competition policy seeks to prevent behavior and changes in the
organization and relationships of firms that may harm competition and
therefore consumers. But the fundamental challenge in developing
competition policy is to ensure that government measures intended to
accomplish this goal do not inadvertently prevent the other, more
beneficial behavior and changes that firms undertake. To do so would
handicap the ability of firms to lower their costs, improve their
products, and thereby benefit consumers and society generally.
This chapter examines the various motivations for changes in the
organization of firms, and the resulting implications for competition
policy. It begins by focusing on what motivates a firm to combine its
assets with those of other firms or to take a financial interest in
them. Taking as a starting point the progress that has been made in
policies relating to mergers, the chapter then discusses how economic
ideas and analysis have been and can continue to be incorporated in
the ongoing refinement of competition policy. Next, in view of the
increasingly global markets in which firms compete, the chapter
addresses how the international nature of competition and of some
firms' operations can affect both the motivations for changes in
their organization and the impact of other nations' competition
policies on our economy. Finally, the chapter addresses the
implications for competition policy of the increasingly prominent role
of innovation-intensive industries in the economy.
The longstanding core principles of U.S. competition policy remain
sound. But competition policy continues to evolve to recognize changes
in modern firm structures, market competition, dynamic forms of
competition, and advances in our knowledge of the effects of firm
behavior. This evolution is proceeding along several fronts. First,
because firms today are engaging not only in mergers, but also in
hybrid organizational forms such as partial acquisitions and joint
ventures, policy must be sensitive to the efficiency gains these forms
of organization create. Second, because firms' activities, and
therefore national competition policies, more frequently cross
international borders than in the past, inefficient competition
policies in any one nation may impose costs on firms and consumers
worldwide. The United States is pursuing harmonization of these
policies in a way that will spread best-practice and efficient
competition policy to all countries. Finally, industries characterized
by active innovation and dynamic competition are raising new issues
for competition policy, which must respond in ways that foster this
innovative activity and maximize the resulting benefits to society.
Motivations for Organizational Change
Firms may change their organization for any of a number of reasons.
One of the fundamental forces driving the behavior of firms is the
desire to maximize their profits. This leads firms to strive
constantly to minimize the costs and maximize the value of the goods
and services they produce.

Meanwhile developments in individual markets and in the broader
economy are constantly changing the costs associated with each of the
various ways that firms can choose to organize their operations. These
developments may also alter the business opportunities they face,
perhaps opening new markets or affecting the competition they
encounter. In the past two decades, some of the most significant of
these developments have been improvements in the power and reductions
in the costs of information technology; deregulation of certain
industries; and the globalization of markets. These or other
developments may make it profitable for firms to alter their
organization or operations.
The work of Nobel Prize-winning economist Ronald Coase provides a
framework for understanding how and why firms might restructure their
organizations in response to developments such as these. Coase views
a firm's operations, internal and external, as a set of transactions,
whether it be obtaining materials for production or arranging for the
promotion of the firm's products. To maximize its profits, the firm
will seek to minimize the cost of each of these transactions. These
costs are influenced in part by whether the transaction is performed
within the firm or with another party on the open market. The relative
costs of these two options will largely determine which one the firm
will choose. When developments in its markets or in the broader
economy change these relative costs, the firm will review these
options and may decide to change an internal transaction to an
external one, or vice versa. The result is a change in its
organizational structure. For instance, a firm may perceive an
opportunity to outsource some of its inventory management to another
firm that specializes in that task. But if this task needs to be
closely integrated with other operations in the firm, outsourcing may
become preferable only when communications costs fall below some
threshold. In this chapter we address the fact that firms today face
more than just two alternatives in choosing how to organize their
operations. We highlight some of the alternatives that constitute
particularly important developments in the organization of firms and
industries for the future.
The Role of Agency Costs in Organizational Change
Agency costs are an important component of costs that a firm can lower
by adjusting its organizational structure. They can arise whenever one
person or firm (the agent) contracts to perform certain tasks for
another (the principal). Differing incentives facing the two parties,
coupled with the inability of the principal to costlessly monitor the
agent's actions, cause the latter to perform the contracted tasks in
a way that does not best serve the principal's interest. Ultimately,
a firm's owners (in the case of a corporation, its shareholders) are
those most interested in maximizing its profits. Not only are they the
residual claimants on the firm's profits, but the value of their
shares is affected by expectations of those profits today and in the
future. Yet there are many others, both within and outside the firm,
whose actions affect the firm's profits but who do not benefit enough
from an increase in those profits to make maximizing them their only
objective.
For example, the decisions of a firm's chief executive officer (CEO)
can clearly have a significant effect on the firm's profits. Although
the CEO may be interested in maximizing those profits, he or she may
also have other, conflicting objectives: perhaps the CEO would like to
increase his or her perquisites by purchasing a company jet, even
though that would not be an efficient allocation of the firm's
resources. Because the CEO runs the firm's day-to-day operations, the
CEO is an agent of the firm's shareholders, and the cost associated
with the CEO's pursuit of interests aside from profit maximization is
an agency cost. This cost arises from the separation of ownership of
the firm from control of it.
Just as they may choose to outsource an operation in order to minimize
costs, so, too, may shareholders alter the organization of their firm
in order to reduce these agency costs. Certain internal institutional
arrangements can serve to better align owner and manager incentives.
For publicly traded corporations, a commonly used compensation package
for CEOs and other senior managers consists of ``pay for
performance'': executive pay is determined in part by bonuses based on
sales or profits, often coupled with the grant of stock options. When
managers own stock or stock options in the company they manage, their
interests become more aligned with the shareholders' interests. One
study found that, with the recent dramatic increases in such forms of
compensation, the average effect of a change in the value of a firm
on its CEO's wealth grew by almost a factor of 10 between 1980 and
1998. Clearly, pay for performance has become an increasingly prominent
feature of corporate life, suggesting that it may prove a valuable way
for shareholders to reduce agency costs.
In addition to the CEO, many other individuals and entities influence
a firm's profits, and so a comprehensive definition of agency costs
must include costs due to their actions as well. Therefore changes in
the organization of firms designed to reduce agency costs may extend
well beyond arrangements for compensating managers. For instance, if
the actions of a particular supplier can significantly affect a firm's
profits, the firm may seek to arrange its relationship with that
supplier in a way that aligns the supplier's interests more closely
with those of the firm's shareholders. Much as in the case of pay for
performance contracts, this may be achieved by having the supplier
hold stock in the firm.
Mergers
One of the most visible manifestations of changes in the organization
of firms is the growing number and value of mergers and acquisitions.
During the second half of the 1990s the United States witnessed a
remarkable surge in merger activity (Chart 3-1). Indeed, even with the
economic slowdown, merger activity in 2001 was well above average
levels during the past three decades.
In a significant share of mergers today, one or both parties are firms
with operations in more than one country, and many mergers even involve
firms with headquarters in different countries. These are often
referred to as cross-border mergers. In 2001, 29 percent of all
announced mergers and acquisitions in which a U.S.-headquartered firm
was a party also involved either a foreign buyer or a foreign seller.
This was a markedly higher percentage than was common during much of
the 1970s and 1980s (Chart 3-2).
Although general economic theory and empirical research provide a
broad framework within which to understand organizational changes
across firm boundaries, such as mergers, a substantial body of
research has developed that specifically examines the motivations for
mergers. The motivations behind each merger are, of course, unique.
But some mergers may share certain motivations, and motivations may
generally differ across the three broad types of mergers: horizontal,
vertical, and conglomerate. Horizontal mergers involve a joining of
firms that compete in the same market; vertical





mergers occur when a customer buys a supplier, or vice versa; and
conglomerate mergers join firms in different businesses. The
international nature of cross-border mergers adds another set of
potential motivations.
One motivation for mergers is efficiency gains. Two firms may
consummate a merger because they expect that the assets of the two
firms can be used more efficiently in combination than separately.
This might be achieved if merging allows them to lower their costs,
improve their products, or expand their operations more effectively
than they could as separate entities.

In some cases these efficiencies can be realized through cost savings
arising from the increased size of the merged entity, often referred
to as economies of scale or scope. This may result from consolidating
and spreading certain fixed overhead costs across the combined
operations. For instance, economies of scale appeared to be a factor
motivating mergers and acquisitions in the food retailing industry
during the late 1990s. When two supermarket chains merge, distribution
centers made redundant by the merger can be eliminated, and the costs
of the remaining distribution centers can be spread over a larger
number of supermarkets.
In a horizontal merger, efficiencies might also come from combining
the best elements of each firm's operations. One motivation for
vertical mergers may be that certain transactions between a supplier
and a customer are particularly difficult to arrange between
independent firms and can be more efficiently arranged if both parties
are part of the same firm. Vertical mergers may also be an efficient
method of removing pricing distortions that arise when firms transact
with one another in the chain of production, each adding its margin
along the way. Elimination of these so-called double margins leads to
lower final product prices.
Reduction of agency costs, discussed above, can be another significant
source of efficiencies. If a corporation's executives are unwilling to
make or incapable of making decisions to increase shareholders'
profits, they may be replaced in a merger or acquisition. Or if the
firm has assets that a new set of managers could put to higher value
use, the firm may be acquired and new, better managers introduced. In
some cases, the existing management team may be underperforming
because the incentives it faces may be inadequate for it to act in the
shareholders' interest, or may even promote behavior that runs counter
to their interest. The acquisition or merger of such a firm provides a
valuable opportunity for new owners not only to replace management,
but also to change the firm's governance structure in order to fix
these inadequate or perverse incentives.
Although merger and acquisition activity may sometimes be a response
to agency problems, in some settings it may actually be a
manifestation of such problems. Some acquisitions may be motivated by
a manager's ambition to increase the size of the firm under his or
her control, even though the acquisition is likely to reduce the
shareholders' profits. But research also suggests that such poor
acquisitions can increase the likelihood that the acquirer itself will
become a target for acquisition.
Cross-border mergers can enjoy efficiencies similar to those described
above, but the international nature of these transactions introduces
another set of potential efficiency gains as well. Just as the opening
of world markets to international trade raises productivity, so, too,
might a cross-border merger create benefits that no purely domestic
reorganization could achieve. These might result, for example, from
overcoming barriers to trade that hinder a firm from exporting to
another country but not from acquiring production facilities and
producing the same goods there. Other efficiency gains from
cross-border mergers might come from gaining a better understanding
of customers in a foreign market, or from a company with good products
acquiring a company with good foreign distribution channels.
Alternatively, efficiencies may arise from differences in wages between
countries that make it more profitable for firms to locate their
labor-intensive operations in countries with abundant unskilled labor,
while locating other operations, such as research and management, in
countries where skilled labor is relatively plentiful.
Of course, some of these gains may not require mergers, but can be
realized simply by establishing new operations overseas. But in some
cases, merging with an established firm may be more efficient. Two
advantages that mergers can provide are quicker entry into new markets
and access to existing proprietary resources and capabilities, such as
established brands.  A further benefit that a merger or joint venture
may provide is the transfer of managerial or technological know-how
across national and firm boundaries. The transfer of innovative
manufacturing systems may be best achieved through some form of
integration. This is discussed in greater depth later in the chapter
in the context of the General Motors-Toyota joint venture.
As described above, firms constantly look for potential efficiencies
from possible mergers in order to enhance their profitability in a
competitive market. Mergers with these motivations have the potential
to provide consumers with less expensive and better products or
services. But some mergers may reduce competition. This can happen if
a merger of competitors allows the merged firm or a collection of
remaining firms to raise the prices of the goods or services they sell,
or lower the prices they pay for the goods or services they buy from
suppliers. In the case of a vertical merger, a firm may be able to
reduce the competition it faces by gaining control of either an
important supplier to its industry or a significant customer. As in
virtually all transactions that come under antitrust scrutiny, this
potential to reduce competition may be either a deliberate motivation
for, or an inadvertent consequence of, the merger.
Higher prices to consumers as a result of reduced competition are due
to what economists call monopoly power, that is, the power of a single
seller to affect the market price. Lower prices to input suppliers as
a result of reduced competition are due to what economists call
monopsony power, that is, the power of a single buyer to affect the
market price. Both effects are exercises of market power, and thus a
concern of competition policy. Government has a role in preventing
those mergers whose adverse effects on competition exceed any benefit
from accompanying efficiency gains. The evolving way in which the
Federal Government performs this role through its competition policy
will be described in more depth later in the chapter.
Other Organizational Forms: Joint Ventures and Partial Equity Stakes
The various possible sources of increased efficiency from mergers,
including those that reduce agency costs, can also motivate other
forms of organizational change that do not involve complete transfer
of both ownership and control. The distribution of ownership and
control across parties to an organizational structure affects the
parties' incentives and opportunities, their ensuing decisions, and
therefore the creation of social value.
Joint Ventures
A joint venture is a business entity created and jointly controlled by
two or more separate firms, each of which makes a substantial
contribution to the enterprise. Firms may seek to enter a joint venture
for any of a number of reasons. Joint ventures may allow firms to
combine their complementary skills or assets in a way that improves
their ability to accomplish a project. Such a venture may also allow
the participants to expand the scale of a project to a size necessary
to realize certain cost savings. By avoiding additional costs
associated with a full merger, a joint venture may best accomplish the
firms' objectives.
One specific type of joint venture, the research joint venture, has
its own particular advantages. A joint venture to undertake scientific,
technical, or other research may appropriately reward innovation and
spread development costs in a setting where the resulting new
knowledge, if created by a single firm, would spill over to benefit
others. Since in that case no single firm would reap all the benefits
of its research, a joint venture may be the most efficient avenue for
undertaking it.
But joint ventures might also raise concerns. For example, a production
joint venture between horizontal competitors might reduce their
ability or incentive to compete independently. Conceivably the
participants could contribute all their manufacturing assets to the
joint venture, and their financial stakes in the joint venture could
then lead to a reduction in output by the two firms comparable to that
in an anticompetitive merger. Even if the joint venture participants
retain independent production assets, the joint venture may create the
environment for the exchange of competitively sensitive information on
prices and costs. This might facilitate an attempt by the firms to
raise prices in an anticompetitive manner.
Partial Equity Stakes
A merger or complete acquisition occurs when the ownership of the
assets of two firms is combined, for example through one firm's
acquisition of 100 percent of the shares of the other, or when two
firms exchange all of their shares for those of a new, successor
corporation. In contrast, a partial acquisition occurs when one firm
takes a partial equity stake in another firm, which remains legally
independent.
Partial equity acquisitions, like merger transactions, must be reported
to the Department of Justice and the FTC under the 1976
Hart-Scott-Rodino Act if the transaction meets certain conditions. In
fiscal 2000, 23 percent of all transactions reported to the two
agencies resulted in the acquirer having less than a 50 percent share
of the target firm's equity. Although these may be supplemented by
later purchases, it suggests that partial purchases are not uncommon.
Partial acquisitions create a form of corporate governance that raises
some basic questions about the ``ownership'' and ``control'' of one
party over another. Partial equity investments by one firm in another
can grant the investing firm substantial influence over the other firm.
A majority shareholder can be presumed to exercise control, although
under some constraints imposed by the duty toward minority
shareholders. But research suggests that even ownership of far less
than a majority of a company's shares may allow the exercise of
control, if the remaining shares are widely dispersed.
PepsiCo, Inc.'s investment in the Pepsi Bottling Group, Inc., is an
example of a partial equity stake that involves some control. The Pepsi
Bottling Group is the world's largest manufacturer, seller, and
distributor of Pepsi-Cola beverages. It has the exclusive right to
manufacture, sell, and distribute these beverages in much of the United
States and Canada, as well as in Spain, Greece, and Russia. PepsiCo
holds the licenses for Pepsi-Cola beverages and is a minority
shareholder, although also the largest shareholder, in the Pepsi
Bottling Group. There is close coordination between the two businesses,
but each remains a legally independent entity whose interests are not
legally presumed to align with the other's.
At the other extreme, an individual who buys a few shares in a public
company may do so as an investment for retirement or for other
purposes. These small purchases best exemplify so-called passive
investments, in that the shareholder has no current plans to gain
influence over the firm's conduct or to access certain information
about its operations, and there is no good reason to expect such plans
to emerge in the future. Likewise, one firm may purchase a small equity
stake in another firm without such plans or any realistic potential
for such plans to emerge.
A partial acquisition can affect the firms' subsequent decisions
through three distinct channels: by altering incentives, altering
information, or altering control. Through these channels, an
acquisition could have anticompetitive or pro-competitive effects. The
potential anticompetitive effects are considered first, because without
those effects there is no concern for antitrust policy.
Even if a firm has only a passive investment in another firm, this
might, through altering incentives, affect the former's production and
pricing decisions. For example, if firm A owns a 5 percent stake in
firm B, it will make production and pricing decisions to maximize its
own profits plus 5 percent of firm B's profits. The acquirer of a
partial equity stake will consequently internalize some of the
spillover effects of its actions on the target's profits. This is true
whether or not the acquirer can exercise control over the target.
Such a passive investment could have an anticompetitive effect in an
imperfectly competitive market if the two firms are direct competitors.
If firm A raises its price, for example, the 5 percent stake in firm
B could reduce the effect of any loss of customers on firm A's profits
because some of the lost customers would begin purchasing from firm B.
Firm A would capture part of firm B's increased profits, reducing its
overall losses from raising prices. This diminishes firm A's incentives
to keep prices at a competitive level. Nonetheless, this concern should
not arise if other firms in the market are able to expand their output
and win most of the customers that firm A loses when it raises its
prices. Thus competition guards against the rise in prices.
The information effect arises from closer unilateral or bilateral
communication between the partial acquirer and the target about
business operations. For example, if the partial acquirer receives a
seat on the target's board of directors, that may become an avenue for
improved communication between the firms. This improved communication
could facilitate anticompetitive conduct, for example if two
competitors attempted to coordinate a rise in prices.
Finally, a partial acquirer may be able to influence the target's
business decisions through the control effect. This could have
anticompetitive consequences if the two firms are competitors. For
example, the acquirer might raise its price and exert its influence
so that the target responds by increasing its own price. But these
effects can also be prevented if other firms in the market expand
their output in response to higher prices.
Partial acquisitions may have socially desirable consequences,
operating through these same channels. In particular, partial equity
stakes may be undertaken as part of a larger business relationship,
such as a marketing or supply agreement. Such partial equity stakes
may align incentives, internalizing spillovers in ways that are
socially beneficial. These business relationships may also be cemented
by the information and control benefits facilitated by a partial
equity stake.
One study examined 402 partial ownership stakes established between
1980 and 1991 in which a nonfinancial corporation held a minimum of
5 percent of the outstanding shares of another firm. Thirty-seven
percent of the target firms had explicit business relationships with
the corporation holding their shares.
More recent, although preliminary, data suggest that about 5 percent
of Fortune 500 nonfinancial companies in 2001 had a corporate
blockholder of 5 percent or more of their shares in that year. (This
sample examines the Fortune 500 companies, excluding those in finance,
insurance, real estate, or retail trade. Companies in which there was
a majority shareholder were also excluded.) In this preliminary
research, corporate blockholders appear to be more prevalent in
certain industries than others. In the rapidly evolving
telecommunications sector, for example, about a third of major U.S.
corporations had at least one corporate blockholder in 2001.
An example of how partial equity stakes may align the incentives
between parties in a business relationship is  the 1997 co-production
agreement between Walt Disney Company and Pixar. At the time of their
co-production agreement, Disney acquired about a 5 percent stake in
Pixar. This example is described in Box 3-1.
The potential for a partial equity stake to encourage efficiency gains
in the long-term relationship between a supplier and a customer
highlights an advantage of this form of organization. In a long-term
supply relationship, both customer and supplier may make
relationship-specific investments, such as fabricating machine tools
to produce a part according to the buyer's specifications. If the
buyer's input needs change unexpectedly, it may want rapid delivery
of a modified input from its supplier. If the supplier has an equity
stake in the customer, and hence a claim to some of the customer's
profits, the supplier may have a stronger incentive to meet the
customer's request, even if it must incur overtime costs to adjust its
machine tools. If the partial equity stake allows one firm to exercise
some control over the other firm, the coordination between their
operations is likely to be further strengthened.
________________________________________________________________________

Box 3-1.  A Co-Production Agreement and a Partial Equity Stake: Pixar
and Disney
Pixar was formed in 1986. Its first fully computer-animated feature
film, ``Toy Story,'' was released in 1995, also the year of the
company's initial public offering of shares. ``Toy Story'' was
distributed by the Walt Disney Company, under a contract in which
Disney also bore all the budgeted production costs. In return, it
received a standard distribution fee from Pixar and the vast majority
of the film's revenue, including about 95 percent of box office
receipts during the year after its release.
In 1997 Disney and Pixar entered into a co-production agreement to
produce and distribute five new computer-animated feature films.
Under the agreement, Pixar would produce the films, on an exclusive
basis, for distribution by Disney. Disney and Pixar would split
production costs and all related receipts in excess of the amount
necessary to cover Disney's distribution costs and an associated
distribution fee. The films would also be co-branded.

This agreement was cemented by Disney's acquisition of a partial
equity stake in Pixar. Disney initially acquired 1 million of Pixar's
shares and received warrants to purchase up to an additional 1.5
million shares. At the time, exercising all these warrants would have
given Disney about a 5 percent stake in Pixar.

The Pixar-Disney co-production arrangement brought ``A Bug's Life''
to the big screen in 1998, and ``Monsters, Inc.'' in 2001. The alliance
benefits both companies and exploits a logical division of labor
between the firms. As Pixar's 2000 10-K filing states, ``This agreement
allows [Pixar] to focus on the production and creative development of
the films while utilizing Disney's marketing expertise and substantial
distribution infrastructure to market and distribute our co-branded
feature films and related products.''
An interesting wrinkle is that Disney is not only a partner with Pixar
but also a competitor. Pixar notes in its 2000 10-K filing that, under
the agreement, Disney directly shares in the profits from their
co-branded films, and therefore Pixar believes ``that Disney desires
such films to be successful.'' But the filing also points out that,
``Nonetheless, during its long history, Disney has been a very
successful producer and distributor of its own animated feature films.''
Thus, although the profit-sharing terms of the agreement give Disney
powerful incentives to use its marketing and distribution acumen to
further the success of the co-branded films, the partial equity stake
plays a complementary role. Through this investment, Disney shares
directly in Pixar's success, and so has additional reasons to foster
the collaboration.
_____________________________________________________________________________


Incorporating Economic Insights into Competition Policy
Economists have long studied the implications of changes in the
structure and conduct of firms, creating a body of knowledge that
encompasses the insights described above. Developments in this body of
knowledge provide an important basis for improving the effectiveness
of competition policy.
The evolution of U.S. policy relating to horizontal mergers -- those
between companies that compete for customers in the same market --
provides one example of how economic thought has substantially enhanced
competition policy in the past two decades. As explained above, a
merger between such companies can bring about benefits through
reductions in the cost and improvements in the quality of the merging
firms' products. But some such mergers have the potential to harm
competition. In determining whether to challenge a particular merger,
the Department of Justice or the FTC must assess whether the merger
threatens to harm competition, and whether the potential benefits of
increased efficiencies outweigh any adverse effect the merger could
have on competition. To do so, the agencies have developed an
analytical framework that allows them to move from a set of observable
characteristics of the merging firms and the markets in which they
compete to an assessment of the likely competitive effect of the
transaction, balanced against any efficiency benefits.
The analytical framework used is important in that it influences the
types of characteristics considered in evaluating mergers and related
acquisitions, whether the enforcement agencies challenge them, and how
they are ultimately viewed by the courts. This framework provides a
focus for arguments about the merits of or problems associated with
a merger. Finally, an analytical framework that is consistently
adhered to increases firms' ability to assess whether a merger they
are considering will be challenged, before they embark on the costly
process of initiating it.
It is in contributing to the improvement of this analytical framework
that developments in economic thought have significantly affected
merger policy. This effect is visible in the evolution of the
Horizontal Merger Guidelines, a description of this framework that
was first established by the Department of Justice in 1968 and
periodically revised since then by both the Justice Department and the
FTC. Although the need for flexibility in enforcing antitrust law
causes these guidelines to be somewhat general in nature, the trend
toward an increasing incorporation of a rigorous economic framework is
nonetheless still apparent in the periodic revisions to the guidelines.
Because the ability to gain the favorable ruling of a judge in an
antitrust case affects these agencies' ability to successfully
challenge mergers, changes in the guidelines also to some extent
reflect accompanying changes in the judicial interpretation of
antitrust law.
Of the various revisions made during the past two decades, the 1982
guidelines and the revisions made to them in 1984 together marked the
most dramatic departure from prior guidelines in their incorporation
of contemporary economic thought. One significant advance in these
revisions was a shift away from a singular focus on market
concentration in assessing the effect of a merger. Market concentration
is a measure of the extent to which the supply of products and services
in a particular market is concentrated among few providers. The earlier
focus was consistent with economic thinking, developed in the middle
decades of the twentieth century, according to which increases in the
concentration of markets harmed competition. As a result, in the
1960s, mergers that raised concentration by increasing a firm's
market share to even as little as 5 percent were at risk of being
challenged.
The 1982 and 1984 revisions reflected an evolving economic perspective
on the effect of concentration on competition in a market. This
perspective had been increasingly gaining judicial recognition by the
mid-1970s. Theoretical and empirical work had begun to call into
question the idea that there is a simple link between a market's
concentration and the intensity of competition in that market. By 1982,
judicial decisions and enforcement policies had already begun to
incorporate the conclusion from economic research that, although high
concentration could contribute to reduced competition, by itself it was
not sufficient to bring about that outcome. Thus the 1982 and 1984
revisions codified the increasingly accepted view that examining market
concentration provides only a useful first step in considering whether
a merger raises competitive concerns, and that other factors needed to
be present to validate this concern. In line with this view, the
revisions described quantitative levels of market concentration and
changes therein that would likely cause the Justice Department and the
FTC to go on to examine the full set of factors and possibly challenge
a merger. The 1984 guidelines also clearly established a level of
market concentration below which, ``except in extraordinary
circumstances,'' mergers would not be challenged. This ``safe harbor''
level of market concentration is important in that it reduces the
uncertainty that firms considering a merger may have about how the
government will respond. Such a clear safe harbor was absent in the
1968 guidelines.
One of the additional factors that the 1980s revisions incorporated
as an important consideration in evaluating the intensity of
competition in a market was the ease with which new firms could enter
that market. Although existing firms in a market are the most visible
source of competition for each other, they are not the only source.
In considering whether it would be profitable to raise prices above
existing levels, a firm or group of firms must not only consider
the response of firms already in the market. They must also consider
the possibility that higher prices will encourage other firms to enter
the market, adding to competition. Thus, in some cases, even if there
are few firms in a market today, the threat of new firms entering
tomorrow can provide a strong incentive for incumbent firms to keep
prices competitive. In an improvement on the earlier merger
guidelines, the 1980s guidelines recognized that a merger could only
harm competition if there were reasons to believe that other firms
would not or could not enter the market to the extent necessary to
keep the merging firms from maintaining prices above premerger levels.
Another substantial advance in the 1984 guidelines, and improved upon
since then, was a greater recognition of potential efficiency gains
from mergers. Today it is widely accepted among economists that
mergers should be evaluated in terms of a tradeoff between any
potential adverse impact on competition and their potential
enhancement of competition by improving the merging firms' operations.
The 1968 guidelines had focused attention almost exclusively on
whether a merger could harm competition, with little consideration
given to the potential benefits, because these were considered hard
to evaluate and often realizable by other means. In contrast, the 1984
guidelines recognized that mergers that might otherwise be challenged
may nonetheless be ``reasonably necessary to achieve significant net
efficiencies.'' The guidelines set forth a number of types of
efficiency improvements that could be considered in assessing the
impact of a merger, such as economies of scale. Moreover, the tradeoff
often presented by mergers was explicitly recognized in the 1984
guidelines, which state that ``a greater level of expected net
efficiencies [is needed] the more significant are the competitive
risks identified.'' Improvements in the consideration of these
efficiencies, and in other elements of the analytical framework
applied to evaluating mergers, continued in later revisions.
Competition Policy, Corporate Governance, and the Mergers of the
1980s and 1990s
In the years leading up to 1982, some elements of the new thinking
that would later appear in the revisions to the Horizontal Merger
Guidelines had already begun to be incorporated in the Justice
Department's and the FTC's enforcement practices, and in the
interpretation of antitrust laws by the courts. Nonetheless, the
revisions were important in codifying this dramatic adjustment in
antitrust policy, which allowed firms greater flexibility during the
substantial restructuring of the economy that occurred in the 1980s.
In contrast, during the 1960s and much of the 1970s, in line with the
1968 guidelines, Federal policy and judicial decisions relating to
horizontal and vertical mergers had been quite restrictive.
During the 1980s the total value of merger activity picked up
considerably. In 1988 the total dollar value of mergers and
acquisitions was, in real terms, more than four times greater than it
had been a decade earlier. Two types of reorganization were prevalent
during this period, both of which might have faced greater opposition
under the 1968 guidelines. The first involved the merging of two large
firms in the same industry, and the second involved the breakup of a
conglomerate, in which individual business lines were often sold to
firms competing in the same market as the business line they were
acquiring. Although such mergers and acquisitions might still be
opposed under the revised guidelines if they presented significant
concerns about the effects on competition, the improved economic
understanding of competition in markets that was reflected in the
revisions caused antitrust enforcement policy to be less restrictive
toward such mergers. The trend whereby mergers increasingly involved
two firms in the same industry continued in the 1990s.
In the 1980s and 1990s, mergers were clustered in particular
industries, although the industries in which they were clustered
varied over time. This suggests that mergers may have provided an
important means for companies to respond to industry-wide shocks such
as deregulation, technological innovations, or supply shocks. Between
1988 and 1997, on average, nearly half of annual merger deal volume
was in industries adjusting to changing conditions brought about by
deregulation. One study of Massachusetts hospitals shows the effect of
technological innovation on merger activity. The study found that new
drug therapies and improvements in medical procedures were partly
responsible for a significant decline in the number of inpatient days
from the early 1980s to the mid-1990s. This reduction in the need for
hospital beds contributed to a significant consolidation among
hospitals during this period, much of which was facilitated by mergers.
Evidence of stock market reactions to merger announcements during the
1980s and 1990s suggests that, on the whole, they created value for
the shareholders of the combined firms. Moreover, studies have found
that, in the aggregate, the operating performance of merging firms has
improved following the merger. But these aggregate results present
evidence of only modest gains, the source of which is unclear.
Yet this is to be expected, because mergers have numerous motivations,
and, as with all business decisions in a competitive market, not all
will yield the success that is hoped for. As a result, more narrow
studies of particular industries, particular types of mergers, and
even specific mergers can yield a richer understanding of the sources
and extent of gains. For instance, detailed examinations of bank
mergers during the 1990s found cases of postmerger performance
improvements that likely came from a variety of sources, including
opportunities afforded by the merger to expand service offerings and
the efforts of a vigorous management team acquiring a laggard bank.
Perhaps indicative of larger trends, however, along with uncovering
successes, these examinations also revealed some bank mergers with
disappointing results.
The important point for competition policy is that, although the
overall efficiency consequences of the mergers of the 1980s and 1990s
may be debated, there is little evidence that they harmed competition.
Thus it appears that thoughtful and adaptive antitrust policy has
afforded businesses greater flexibility to respond to changing
economic conditions while preventing such responses from
significantly harming competition.
The agencies' improved understanding of the sources of possible
competitive harm also helped firms structure or restructure their
proposed transactions so as to achieve the efficiencies they sought
without raising competitive concerns. For example, a 1998 transaction
sought to combine two of the Nation's largest grain distribution and
trading businesses. The combination had the potential to lower
operating and capital costs but might also have depressed the prices
farmers received in certain locations for their grain. The parties
agreed to divest certain facilities at certain locations, settling
the Department of Justice's challenge to the transaction and allowing
the acquisition to proceed. Cases such as this one can be seen as a
manifestation of an increasingly thoughtful and adaptive competition
policy.
The Role of Corporate Governance Changes
For many of the mergers and takeovers of the 1980s that appeared to
create social value, changes in corporate governance and ensuing
reductions in agency costs often played an important role. In some
cases, takeovers led to the breakup of large conglomerates, forcing
apart business units that were presumably more valuable on their own
or in other companies' hands. Many incumbent managers resisted these
restructurings until forced to accept them through the market for
corporate control, as takeovers or the threat thereof often led to
changes in the organization of firms.
Although many types of mergers and acquisitions may have led to
changes in corporate governance, some of the most dramatic changes
therein came about as a result of leveraged buyouts (LBOs). Moreover,
evidence suggests that LBOs during the 1980s led to significant
improvements in the productivity of firms. In an LBO or a management
buyout, corporations become closely held companies as their public
stock is bought by a group of investors using borrowed money.
Consequently, ownership becomes much more concentrated and more
tightly connected to control. This new ownership and capital structure
creates significantly greater incentives for managers to increase
profits as much as possible. One study showed that CEOs of firms
involved in LBOs during the 1980s saw their ownership stake rise by
more than a factor of four, thereby making them more interested in
increasing the firm's profits. Moreover, the need to service debt
issued to finance the buyout provided a disciplining force on
management.
Taken together, it was likely that these incentives influenced
decisions by some firms to sell off assets that had higher value
outside the firm than inside it. Many LBOs did not raise antitrust
issues because the initial transaction simply involved changing the
ownership of an existing firm, rather than a combination with a
competitor. However, some selloffs of business units that followed
certain LBOs were to firms in the unit's industry. Therefore, where
these selloffs could improve the performance of the firms without
affecting competition, the increased flexibility afforded by
adjustments to antitrust policy may have been important.
Once the firm's operations were restructured and a new governance
structure was put in place, many LBO firms were successfully taken
public again. Although LBO activity dwindled in the 1990s, the
expansion of pay for performance suggests that mechanisms to align
managerial with shareholder interests remain an important, enduring
element of corporate governance.
The restructurings of the 1980s provide an example of the importance
of adapting competition policy in response to improvements in the
understanding of the conditions within industries that may harm or
benefit consumers. The ongoing incorporation of these insights into
the analytical framework used to guide competition policy has
strengthened the effectiveness of antitrust enforcement, while
reducing the likelihood that antitrust enforcement will hinder
reorganizations whose economic benefits to society would outweigh
any potential harm from reduced competition.
Policy Lessons for Promoting Organizational Efficiencies
As noted earlier, organizational change in today's economy takes place
not only through mergers but also through other organizational forms
such as joint ventures and partial acquisitions. The challenge for
antitrust scholarship and public policy is to provide an integrated
framework for all these organizational innovations that properly
accounts for both competitive and efficiency effects. These types of
transactions evoke intertwined issues in corporate governance and
competition policy, and so an integrated framework supports sound
policymaking. For example, how a given partial equity acquisition is
likely to affect the acquirer's relationship with the target depends
on more than just the size of the partial equity interest acquired
and the nature of any accompanying shareholder agreement, which may,
for example, confer the right to appoint representatives to the firm's
board of directors. It also depends on the acquirer's current and
likely future plans, and those of other blockholders and the firm's
incumbent managers. Even ascertaining that the acquirer will gain
control need not imply that the transaction would be anticompetitive;
as in merger policy, that depends upon the market environment and on
the efficiencies that the transaction would create.
Policy Lessons from Joint Ventures
Joint ventures can lower the costs of producing goods and services
and widen consumer choice. But partners in a joint venture may also
be actual or potential competitors in the product market. In 1983,
for example, General Motors (GM) Corp. and Toyota Motor Corp. agreed
to establish a joint venture to produce a subcompact car at a former
GM plant in Fremont, California. This venture was later formalized as
New United Motor Manufacturing, Inc. (NUMMI). Both partners expected
to benefit from the undertaking: GM by adding to its capabilities in
producing smaller cars, Toyota from the opportunity to test its
production methods in an American environment. It was an unprecedented
initiative and generated an extensive, 15-month FTC investigation, which
resulted in its approval.
A new organizational innovation, by definition, will not have an
established track record for an antitrust agency to review. But such an
organization may create genuine, important efficiencies even if those
efficiencies are difficult to document at the time of the transaction.
For example, a key issue before the FTC was whether the joint venture
would enable Toyota to learn how its ``lean'' production and assembly
system would function in an American factory, and enable GM to learn
details of the Toyota system that could be applied to raise
productivity at its other plants.
If Toyota's manufacturing success was completely embodied in a
superior piece of equipment, then merely licensing that equipment to
U.S. automakers might have been sufficient to transfer that success
to American soil. That type of efficiency gain also would have been
relatively easy to document contemporaneously. Yet, as subsequent
scholarship has confirmed, Toyota's lean production system is an
interrelated set of practices, affecting factory and job design,
labor-management relations, relationships with suppliers, and
management of inventories. As the FTC majority opinion concluded,
``in depth, daily accumulation of knowledge regarding seemingly minor
details is a more important source for increased efficiency than a
broad but shallow understanding of Japanese methods. Such in depth
knowledge appears to be achieved only through the kind of close
relationship the [joint] venture will allow.''
Experience shows that the joint venture did lead to productivity
improvements. One study indicated that, within a few years, each
automobile produced at the NUMMI plant required 19 assembly hours of
labor, versus 31 hours at one of GM's mass production plants in the
United States, and 16 hours at one of Toyota's plants in Japan. The
productivity of the NUMMI plant was close to that of Toyota's Japanese
plant even though NUMMI workers were relatively early in the learning
process about lean production, suggesting that this system could indeed
be transplanted successfully. Several other welcome developments
followed in the wake of the joint venture's early success. Toyota
expanded its own production and assembly plant operations in the United
States. GM and other U.S. automakers adopted elements of lean
production, improving their productivity. And NUMMI expanded. By 1997
the joint venture had produced its 3-millionth vehicle, and in 2001
the Fremont facility was producing three vehicle models.
The broader policy lesson is that joint ventures and other
organizational hybrids may create efficiencies in ways that are
difficult to prove at the time of the transaction. In evaluating
transactions that might also raise anticompetitive concerns, antitrust
authorities face the uncertain prospect of improved efficiency as a
factor in evaluating the joint venture's likely effect. A new,
potentially efficiency-enhancing organization can benefit society in
two ways. Society gains direct benefits from the organization. Society
also receives the demonstration of the types of efficiencies that
such an organization could create. This provides evidence to other
firms, and to the antitrust enforcement agencies, about the private
and social gains of such organizations. If the new organization proves
efficient, other firms may adopt that form. If it does not prove
efficient, market forces will motivate the firms to abandon it. In
either case, the antitrust agencies will have a broader track record
to rely upon when evaluating similar transactions that might raise
competitive questions.
The guidelines describing how U.S. enforcement agencies assess mergers
or collaborations such as joint ventures indicate that efficiencies
arising from them will be considered if they are verifiable and cannot
be practically achieved through other means, making them transaction
specific. ``Verifiable'' here means that the parties must substantiate
efficiency claims so that the agencies can verify, by reasonable means,
their likelihood and magnitude. In these guidelines, certain
efficiency claims are viewed as less likely to meet these criteria
than are others. For instance, the agencies view improvements
attributed to management as less likely to meet the criteria
necessary for consideration. But efficiency gains from mergers or
joint ventures may be closely tied with managerial improvements, such
as combining Toyota management with unionized American workers in
NUMMI. Managerial and organizational improvements may indeed be
difficult to verify, but given their potential social value, expending
the resources necessary to investigate those claims thoroughly is
justified. This policy lesson applies to mergers as well as joint
ventures.
Legislation indeed exists to encourage efficient joint ventures. In
1984 the National Cooperative Research Act (NCRA) became law, to be
followed 9 years later by the National Cooperative Research and
Production Act. These two acts encourage research and production joint
ventures by codifying antitrust treatment of such ventures. They
lowered the maximum penalty that could be assessed in a successful
private antitrust lawsuit against any venture that notified the
Justice Department at the time of its formation. For all joint
ventures, the act also ensured that, in any antitrust challenge, the
courts would consider efficiencies arising from the joint venture. This
clarified that defendants could exonerate themselves by establishing
the benefits of their joint ventures. Since the passage of the NCRA
more than 900 research or production ventures have registered with the
Justice Department.
Successful research joint ventures may foster innovation and thus bring
benefits to society. This and other ways in which economic organization
and competition policy promote innovation are elaborated in the section
on dynamic competition later in this chapter.
Shaping Policies to Address Partial Equity Stakes
As we have seen, firms make partial equity investments under a variety
of conditions, to achieve a variety of ends. The overall effect can be
to promote efficiency or reduce competition, depending on the nature
of the acquisition and the conditions under which it is made. Partial
acquisitions most dramatically confer control, or influence, over the
target company when a majority of its outstanding equity is acquired.
Acquirers obtain substantial influence in some instances with much
smaller stakes, however. Partial acquisitions also give the acquirer
a stake in the target firm's future profits. This gives the acquirer
an incentive to take those profits into account when making its own
business decisions. Finally, a partial acquisition can make it easier
for the acquirer to obtain access to the management of the target
firm. All these elements can have substantial effects on the
relationship between the target and the acquiring firm. Because strong
product market competition can depend on the independence of firm
actions, all of these aspects of partial acquisitions can raise serious
antitrust enforcement concerns. The challenge in shaping policies to
address partial equity ownership by corporations lies in
distinguishing cases that pose serious threats to product market
competition from those that promote efficient cooperation between
suppliers. Although some of these issues are fairly new, the challenge
is similar to that posed by the analysis of mergers and, of course,
joint ventures.
With the emergence of partial acquisitions among major U.S.
corporations, the Justice Department and the FTC have created an
enforcement record that publicly illustrates some of the concerns
these acquisitions can raise.  For example, Primestar was formed in
1990 as a joint venture involving five of the Nation's largest cable
television providers and a satellite provider. In 1997 Primestar
announced its intention to acquire satellite assets from two other
companies. These assets could be used for direct broadcast satellite
(DBS) service, which transmits video programming directly from
satellites to subscribers' homes and competes for customers with cable
television. The cable companies involved in the original joint venture
would have maintained a substantial ownership and control stake in the
entity resulting from the proposed acquisition. Since the assets in
question were the last available that other independent providers of
DBS could use or expand into, Primestar's ownership structure raised
concerns at the Justice Department during its review of the
acquisition. Concerned that the cable companies would exert their
influence in Primestar to limit how the acquired assets would be
used in competing with cable, the Justice Department challenged the
acquisition, which was subsequently abandoned. The determination that
this acquisition would have caused competitive harm hinged upon an
assessment of how the new entity's governance structure would affect
its behavior (Box 3-2).
As the Primestar case illustrates, the government's evaluation of how
partial acquisitions are likely to affect competition requires the
examination of conditions under which the parties to the transaction
compete, as would be the case in the evaluation of a full merger. Only
to the extent that competition between cable and DBS benefits
consumers, or society generally, would the Primestar acquisition have
been likely to have a serious adverse effect on competition. The
partial nature of the cable companies' stake in Primestar thus raised
questions in addition to, rather than apart from, those that arise in
the traditional evaluation of mergers. Also, as in the evaluation of
mergers and joint ventures, the Justice Department and the FTC
typically consider the evidence on whether each partial acquisition
may promote efficiency.
Some of the tools that economists use to analyze efficiency gains
derived from vertical relationships generally may prove useful in the
analysis of partial acquisitions between suppliers of complementary
products. For example, the influence or control that the acquirer may
exercise over the target raises the acquirer's incentive to make
certain relationship-specific investments. Relationship-specific
investments are those that, once made, are much more valuable inside
a particular business relationship than outside it, such as
fabrication equipment that is specialized to a particular customer's
design. The acquirer's control rights make it less likely that the
target will later ``hold up'' the acquirer, and deprive it of its
appropriate return on its investment. These control rights are
important because it is costly to go to court to try to enforce a
written agreement. If one party effectively controls the other party,
disputes over the business arrangement may be resolved at lower cost
internally. Although the costs of dispute resolution may be

__________________________________________________________________________

Box 3-2. The Primestar Acquisition
A basic assumption in assessing the competitive implications of a
merger is that the merged firms will act in such a way as to maximize
the new entity's profits. A firm's owners, however,  may also have
other objectives. Usually these other objectives are not significant
enough to alter the basic assumption. But when a firm's owners clearly
have other interests, such as financial stakes in other ventures,
these could influence their decisions regarding the firm's actions.
In such cases, those assessing a merger must consider how strong
those influences might be on an owner and that owner's ability to
affect firm decisions in ways that may harm competition.
Primestar was formed in 1990 as a joint venture involving five of the
largest cable television providers and a satellite provider. Given
that the five cable providers would control almost 98 percent of the
voting shares in Primestar after the proposed acquisition, there were
concerns about how this would affect its use of the acquired assets.
If Primestar used these new assets to compete vigorously with cable
for subscribers in order to maximize its profits, under certain
assumptions the effect of lost customers on the profits of some
owners' cable businesses might outweigh their share of the gains
from Primestar improving its subscriber base. As a result, one might
reduce its competition with cable.
On the other hand, Primestar's managers and board of directors would
have had legal obligations to serve the interests of minority
shareholders that would benefit financially from Primestar competing
vigorously with cable television, and the board included independent
outside directors. Moreover, it appeared that not all the cable
providers would have had an incentive to prevent such competition.
Thus the composition of Primestar's ownership and governance structure
suggested that there might be opposing forces that would seek different
outcomes of decisions affecting competition in the consumer market that
DBS serves.
The Justice Department analyzed the totality of incentive and
governance effects in this case and concluded, on balance, that
the transaction would harm competition and consumers. It filed suit
to block the acquisition, leading to its abandonment. This case
demonstrates that an assessment of a merger or acquisition's
competitive implications can require an understanding of how the
governance structure of a company allows those with a share in its
control, or a financial stake in its operations, to influence
decisions affecting the firm's actions.
__________________________________________________________________________

lowered through a partial or complete equity interest of one party in
the other, there are other costs to this integration, such as `
`influence costs'' as agents seek to lobby decisionmakers within the
organization.  But market forces will lead firms to choose the
arrangement that minimizes their total costs.
Another example derives from the lesson from scholarship that, if one
firm acquires another outright, the acquirer's specific investment
incentives are strengthened, but the target's specific investment
incentives are weakened. In the context of a corporate acquisition,
this means that stakeholders in the target company care much less how
that company's assets are deployed after selling their stakes.
Therefore, if a project can best succeed through such investment by
both parties, an optimal ownership arrangement may be one in which
one party holds a partial equity stake in, rather than completely
owning, the other. This raises the investment incentives of the
partial owner while not unduly undermining those of the target.
An important challenge in the development of competition policy toward
these new corporate governance practices will be to make effective use
of these tools in light of the evidence that has emerged on the
antitrust concerns that those practices can raise, and the beneficial
effects that can result from them. Some progress will arise through
the identification of factors that enforcement authorities will
increasingly consider in evaluating partial acquisitions, and that
parties will increasingly consider when deciding whether to propose
them. Other progress will emerge from a clearer understanding of how
these practices affect product markets and economic efficiency more
generally. With a clearer sense of the general consequences of these
transactions, and of the specific factors that can lead those
consequences to vary from case to case, we can expect further advances
in the development of tools to evaluate these new governance practices.
Policy Toward Vertical Relations
Some tools for the analysis of these governance practices may derive
from a well-developed economics literature on vertical relations
between independent firms, a subject in which important issues in firm
organization and competition policy arise. Firm activities and market
transactions often involve a vertical production and distribution
chain, such as a relationship between a manufacturer (called in this
situation the upstream firm) and a distributor (the downstream firm).
Antitrust law and its enforcement have a long history of influence
over these organizational decisions, such as whether a firm owns the
retail outlets for its goods or services. For example, the owner of a
business format and brand name for a fast-food restaurant concept may
also own individual restaurants, or it may enter into a franchise
agreement. A franchise agreement is one between two legally independent
firms, the franchisor (the owner of the business format) and the
franchisee (in this example the owner of the individual restaurant).
The agreement might specify that the franchisee may operate a
restaurant at the given location according to the specified format, in
exchange for a franchising fee and a royalty rate on the restaurant's
sales.
This organizational choice is, in part, a response to various agency
costs. In particular, since a franchisee owns the individual
restaurant, he or she has incentives to exert certain types of effort
to build up the value of that store. Under company ownership, the
manager of the restaurant is an employee and, even if paid a bonus wage
based on sales, does not have as strong an incentive as a storeowner
to invest effort to raise the value of that store. But franchising may
exacerbate other agency costs. For example, the owner-operator of the
only restaurant on a busy interstate highway may expect to have many
one-time customers, and therefore might charge prices that are too
high -- a decision that may be profitable for that owner but tarnishes
the brand name and lowers its nationwide value. In a company-owned
restaurant, the manager has less incentive or ability to act in this
manner. The fact that both franchise stores and company-owned stores
successfully coexist in our economy reflects differences in agency
costs in various industries and settings.
These organizational choices can also be influenced by competition
policy, which affects the costs of various possible terms of an
agreement between independent upstream and downstream firms, such as a
franchise agreement. For example, the upstream firm might wish to
specify a maximum retail or ``resale'' price, which would prevent an
individual store from taking advantage of its local market position
and potentially harming the reputation of the brand name. As the
Supreme Court acknowledged in its 1997 State Oil v. Khan decision,
there are pro-competitive rationales for such vertical restraints,
which is why such a pricing provision is now evaluated for its
competitive consequences on a case-by-case basis. Before the Supreme
Court's decision, however, an attempt to set a maximum resale price
in an agreement between legally independent upstream and downstream
firms would have been illegal per se. As a result, owners of a
business format who were concerned about the possibility of
franchisees pricing too high may have instead chosen to own those
restaurants or stores outright. That choice would have addressed the
pricing issue but increased other agency costs related to effort by
restaurant managers. This example shows one way in which competition
policy with regard to vertical restraints nowadays takes into account
the social benefits that may be created by having transactions
organized between two separate firms rather than through common
ownership or vertical integration.
Cross-Border Organizational Changes
Competition policy continues to respond to other changes in the
organization of economic activity. The GM-Toyota joint venture, for
example, presaged something that has become much more prominent since
the venture's establishment: changes in firm organization, including
mergers, that occur across national boundaries. This section describes
some of the challenges that the international nature of these changes
presents for antitrust policy, and how the United States is responding.
Multijurisdictional Review
Merger proposals involving or creating multinational enterprises can
result in reviews by the antitrust authorities of many nations, often
referred to as multijurisdictional review. The United States has
managed the issues posed by multijurisdictional review through both
bilateral cooperative relationships and multilateral arrangements.
This has produced an impressive degree of analytical convergence among
the U.S. and other antitrust agencies, resulting in a long line of
compatible decisions in transnational mergers. However, some
differences remain, and these can have significant consequences. A
striking recent example came with the proposed acquisition by General
Electric Company (GE) of Honeywell International Inc. Both GE and
Honeywell are U.S.-headquartered corporations, but because these
multinational enterprises also have significant European sales, the
deal was subject to review by antitrust authorities of the European
Union.
GE and Honeywell agreed on their merger in October 2000. Although each
operates in a number of product lines, a key focus of the case was the
complementary goods they produce for the commercial aviation industry.
GE is one of three independent global manufacturers of large
commercial aircraft engines, and Honeywell makes a number of systems
essential for aircraft operation, ranging from landing gear to
communications and navigation systems.
After agreeing to some changes to their transaction, including the
divestiture of Honeywell's helicopter engine division, the parties
received conditional clearance from the Justice Department in May 2001
to proceed with their merger. But the merger could not be consummated
until it received clearance from the European Commission and other
authorities. The Commission sought additional changes and conditions
that were unacceptable to the parties. In July 2001 the Commission
rejected the deal, and so the proposed merger did not take place.
The Assistant Attorney General for Antitrust issued this statement
after that decision:

Having conducted an extensive investigation of the GE/Honeywell
acquisition, the Antitrust Division reached a firm conclusion that
the merger, as modified by the remedies we insisted upon, would have
been procompetitive and beneficial to consumers. Our conclusion was
based on findings, confirmed by customers worldwide, that the
combined firm could offer better products and services at more
attractive prices than either firm could offer individually. That,
in our view, is the essence of competition.
The EU, however, apparently concluded that a more diversified, and
thus more competitive, GE could somehow disadvantage other market
participants. Consequently, we appear to have reached different
results from similar assessments of competitive conditions in the
affected markets.
Clear and longstanding U.S. antitrust policy holds that the
antitrust laws protect competition, not competitors. Today's EU
decision reflects a significant point of divergence.
For years, U.S. and EU competition authorities have enjoyed close
and cooperative relations. In fact, there were extensive
consultations in this matter throughout the entire process. This
matter points to the continuing need for consultation to move
toward greater policy convergence.

The European Union's objection to the merger centered around advantages
that the combination would yield for the merged firm over its
competitors in the markets for aircraft engines, avionics, and other
aircraft systems. The Commission found that, among other factors, GE's
vertical integration into aircraft leasing through its GECAS
subsidiary, along with GE's deep financial resources, would lead
inexorably to the merged firm's dominance in markets for certain
aircraft systems. In addition, the Commission found that the merger
would give the combined GE-Honeywell the ability and the incentive
to offer complementary products on more attractive terms than could
competitors with narrower product lines. This last category of
objections has been termed ``range'' or ``portfolio'' effects.
The Commission found that these mechanisms would have the effect of
driving the premerger competitors of both GE and Honeywell out of
effective participation in their respective markets, presumably
leading to higher prices in the long run as the merged firm became
unconstrained by competitive pressures. U.S. antitrust authorities,
in contrast, found that most of the alleged harms under the
Commission's theory flowed from what are normally considered benefits
of a merger -- efficiencies that lead to lower prices. They found
little evidence that competitors would be unable to respond to any
lower prices generated by the merger and thus be driven from the
market. Finding more efficient combinations of productive resources
that lead to lower costs and lower prices is, as the Assistant
Attorney General said, the essence of competition. Blocking mergers
that generate such efficiencies risks serious economic harm to
consumers and to markets generally.
Elements of International Policy Convergence
Halting efficient multinational mergers destroys value precisely
because an integrated, multinational firm can create specific
efficiencies. As noted earlier, these may include exploiting economies
of scale and scope, and combining central managerial guidance and
appropriate pay for performance with the local knowledge of managers
in various overseas markets. The European Commission might have been
more likely to clear the GE-Honeywell merger if GE had agreed to
divest its aircraft leasing subsidiary GECAS. But such a divestiture
might have sacrificed efficiencies.
As the GE-Honeywell example indicates, there are some important
differences in competition policy between the United States and other
nations. But cases that produce such conflicting results have been
rare and are likely to remain the exception. Moreover, steps toward
appropriate convergence have already taken place, and this
Administration is committed to seeking further convergence to promote
the spread of sound antitrust policy. The United States should not
seek convergence for its own sake, of course, but rather in order to
establish certain core principles of sound competition policy across
all jurisdictions.
Core Principles of Competition Policy
Competition policy should operate according to explicit guidelines,
based on clear economic principles. Economic analysis should be
central, because competition policy shapes fundamental economic
decisions, such as production, pricing, and the organization of firms.
These guidelines should reduce uncertainty by providing an indication
to firms as to what kinds of conduct and transactions may bring
scrutiny from competition authorities.
Competition policy should be concerned with protecting competition,
not competitors, as a means of promoting efficient resource allocation
and consumer welfare. There might be rare exceptions, such as certain
monopolization cases, in which consumer harm is hard to measure, and
then harm to competitors may be examined as an indicator of consumer
harm. Indeed, harm to competitors does not play a central role in U.S.
merger policy, although it does motivate private antitrust litigation.
Since such competitor complaints are often at variance with consumer
interests, antitrust enforcement agencies and courts should view them
skeptically. In the European Union the more significant and involved
role of competitors in the merger review process has created a
perception by some that the Commission's analysis is driven more by
effects on competitors than is the case in the United States.
As the International Competition Policy Advisory Committee noted in
its final report to the Attorney General in 2000, ``Nations should
recognize that the interests of the competitors to the merging parties
are not necessarily aligned with consumer interests.'' Indeed, a
merger may be opposed by competitors precisely because it would create
a more efficient firm, one that will aggressively serve customers
better than the existing industry configuration. Blocking such
acquisitions deprives the world of an avenue to increased productivity.
The United States and the European Union have already achieved
considerable cooperation and substantive convergence. U.S. and EU
antitrust authorities have come to similar conclusions about a large
number of transatlantic mergers. More work is required, however. The
United States has undertaken several steps in bilateral and
multilateral forums to facilitate convergence of competition policy
to serve efficiency ends.
Bilateral Enforcement Agreements
The United States has entered into bilateral cooperation agreements
with several important trading partners -- Australia, Brazil, Canada,
Germany, Israel, Japan, Mexico, and the European Communities -- to
facilitate antitrust enforcement. These agreements are implemented by
the Justice Department and the FTC, working in cooperation with their
counterpart agencies in the other countries.
These agreements typically provide for, among other things, sharing of
nonconfidential information, coordination of parallel investigations,
and positive comity. Under positive comity one country can request
that another investigate possibly anticompetitive practices in its
jurisdiction that adversely affect important interests of the country
making the request. Such a request does not require the country
receiving the request to act, nor does it preclude the country making
the request from undertaking its own enforcement. The United States
has also entered into one agreement, with Australia, under the
International Antitrust Enforcement Assistance Act, which among other
things allows the enforcement agencies to share confidential information.
The United States and the European Union have also created a working
group to identify and pursue areas of possible further convergence in
merger enforcement. Having completed a successful project on remedies
in merger cases, the working group has established new task forces to
examine conglomerate merger issues and other important substantive and
procedural topics.
The International Competition Network
In October 2001 the Department of Justice and the FTC joined with top
foreign antitrust officials to launch the International Competition
Network (ICN). The ICN will provide a venue for senior antitrust
officials from around the world to work on reaching consensus on
appropriate procedural and substantive convergence in competition
policy enforcement. The ICN will initially focus on
multijurisdictional merger review (procedures, substantive analysis,
and investigative techniques) and the advocacy role of antitrust
authorities in favoring pro-competitive government policies. To
facilitate the diffusion of best practices, the ICN will develop
nonbinding recommendations for consideration by individual enforcement
agencies. The ICN's interim steering group consists of representatives
from a cross section of developing and developed countries, including
the United States. It will hold its first conference in the early fall
of 2002.

The World Trade Organization
The World Trade Organization (WTO) is an international institution in
which the United States negotiates agreements with 143 other members
to reduce barriers to trade. At the fourth WTO Ministerial Conference
in Doha, Qatar, in 2001, members adopted a ministerial declaration.
That declaration included a statement that the Working Group on the
Interaction between Trade and Competition Policy will focus on the
clarification of core principles, modalities for voluntary
cooperation, and support for progressive reinforcement of competition
institutions in developing countries. The role of the WTO and other
international institutions in promoting economic well-being is
detailed in Chapter 7.
Benefits of Appropriate Convergence
In some cases, the lack of antitrust harmonization may yield benefits.
For example, in an unsettled policy area, in the absence of
harmonization, nations might experiment with different competition
policies. The world could then learn from these experiences what
constitutes best practice in antitrust enforcement in the area in
question. The bilateral and multilateral forums into which the United
States has entered address this concern by sharing information to
promote best practices. This consultation will enable the results of
successful policy experiments to be disseminated. Moreover, the
United States remains committed to appropriate convergence, in which
efficient competition policies are spread worldwide, rather than
seeking harmonization for its own sake and potentially promoting less
than sound policies.
Dynamic Competition and Antitrust Policy
Through its influence on the development of competition policy over
the years, economic analysis has brought a dramatic improvement in
the ability of government agencies and the courts to accurately judge
the strength of competition in a market. This has enhanced their
capacity to distinguish those cases that properly raise concerns about
anticompetitive effects from those that might have raised concerns in
the past, but should no longer, in light of a better understanding of
competitive forces. These changes in antitrust policy are important
in that they afford firms greater flexibility to lower costs and
improve their products through adjustments to their operations and
organization.
But many of these improvements in policy have largely focused on
better understanding markets in which firms compete with one another
through incremental changes in the prices, quality, and quantity of
relatively similar products or services. In some increasingly
prominent industries, such as the information technology and
pharmaceuticals industries, another important form of competition is
taking place. It arises where there is a constant threat of innovations
leading to a new or improved product being introduced that is far
superior to existing products in a market. This type of competition is
sometimes called competition for the market, or dynamic competition.

The increasingly important role of innovations in our economy can be
seen in a number of indicators of innovative activity. After remaining
nearly unchanged during the 1970s, industry's funding of research and
development, measured as a share of GDP, grew two-thirds during the
ollowing two decades, reaching 1.8 percent of GDP in 2000. The number
f patents granted each year by the U.S. Patent and Trademark Office
provides some indication of the rate at which patentable innovations
are being developed. Since the mid-1980s, the number of patents
issued for inventions each year has grown dramatically (Chart 3-3).
Although such a change could result from a number of other factors,
such as increased incentives to file for a patent based on adjustments
to the legal environment, evidence suggests that a burst in innovation
is a driving factor behind this rise. Whereas some of the most visible
innovations contributing to dynamic competition are technological in
nature, such as improvements in the performance of computers, others
may involve changes in management or business practices.
The importance of substantial innovations to the economy, as well as
the unique form of competition they bring about, was recognized in
1942 by the economist Joseph Schumpeter. He noted that a significant
part of the long-term growth of many industries resulted from what he
called the ``perennial gale of creative destruction.'' At the heart
of this creative destruction is the introduction of new products or
services, technologies, or organizational forms that lead to dramatic
changes in an industry's structure or costs, or in the quality of its
products or services. In Schumpeter's view, it was periods of creative
destruction that brought ``power production from the overshot water
wheel to the modern power plant... [and] transportation from the
mailcoach to the airplane.'' Indeed, as he stated, the kind of
competition resulting from firms bringing forth these changes or
innovations is one that ``commands a decisive cost or quality
advantage and which strikes not at the margins of the profits... of
the existing firms but at their foundations and their very lives.''
Because of his early insights, dynamic competition involving the
introduction of markedly improved goods or services is often referred
to as Schumpeterian competition.
The significance of innovation -- and hence of dynamic competition --
will vary from market to market: it will be negligible in some and a
pervasive force in others. Product improvements are commonly made in
virtually all markets. But in markets experiencing the kinds of
substantial innovation that Schumpeter addressed, these innovations
can be so dramatic or disruptive as to make the products that they
improve upon significantly inferior in comparison. The benefits of
these innovations to society can be found all around us. Computer
processors produced today are, by one measure, more



than 250 times more powerful than those produced in 1980, and more
than twice as powerful as those produced in 1999. New drugs have
vastly improved our ability to treat various illnesses. Other examples
abound.
It has long been recognized that particular incentives are necessary
to foster these market-transforming innovations. These innovations
are often the result of substantial research and development
investments on the part of companies or individuals. Since these
investments must be made before it is clear that any profitable
innovations will come of them, they are fundamentally risky.
Encouraging innovation rests upon an interrelated set of internal
and external rewards. The external rewards are those provided in the
marketplace to the successful innovating organization. The internal
rewards are those provided by the firm, joint venture, or other
governance structure. Both economic organization and public policy
therefore play significant roles in encouraging innovation.
Sources of Incentives for Innovation
The external risks and rewards facing firms in innovation-intensive
industries are highlighted by a preliminary study of firms in the
computer software industry between 1990 and 1998, which found that
success, as measured by sales growth over this period, was by no means
certain. But, compensating for this risk, some firms that did end up
being successful were extremely so. At least 10 percent of firms saw
sales fall to zero, and at least half experienced negative sales
growth over the period. Only 25 percent of firms experienced real
annualized sales growth of at least 7 percent during the period. But
about 1 percent experienced real annualized growth of greater than
130 percent. This pattern of success highlights the risk involved in
investments in these innovation-intensive industries. Therefore firms
must have reason to expect that, taking into account the likelihood of
failure, the profits from any successful innovations that do result
from their efforts will be enough to justify the initial investment.
Intellectual Property Protection
Not only is investing in efforts to develop innovations risky and
often expensive, but the innovations that result often produce
beneficial knowledge or insights that others can copy at relatively
low cost. Furthermore, in the absence of laws to the contrary,
knowledge embodied in an innovation can be hard to keep others from
using.
For instance, the research and development costs incurred by a firm in
determining the correct chemical composition and treatment regime for a
particular drug therapy may be substantial. But it may be difficult
to keep much of this information out of the hands of competitors that
have not borne any of these costs, yet could use that information to
produce the new drug themselves. As a result, competition between the
innovator and imitators could keep the price of the drug at the cost of
manufacturing it. In such a competitive environment, a firm's profits
from its innovation would not suffice to cover its original research
and development costs or justify its decision to risk undertaking
expensive research efforts that may bear no fruit. Foreseeing this
potential outcome, the innovator would have little incentive to embark
on the research and development in the first place.
Even if a firm did not face competition from other firms benefiting
from the knowledge produced by its innovation, firms or individuals
may use aspects of the innovation for other purposes. Given how
difficult it can be to keep them from doing this, in the absence of
laws to prevent it, the innovator may receive little compensation
from those that benefit from its innovation. As a result, the rewards
that a firm enjoys from its innovation could fall far short of the
benefits that the innovation produces for society. Consequently, in
many cases, firms or individuals might not embark on developing an
innovation because, although the social benefit from it may be large
enough to justify its development costs, the firm or individual could
not expect to reap enough of that benefit to justify those costs.
The consequences of this problem were recognized in the U.S.
Constitution, which empowered Congress to develop a body of
intellectual property laws, including those establishing patents. A
patent for an invention confers on an individual or firm (the
patentholder) limited rights to exclude others from making, selling,
or using the invention without the patent-holder's consent. Patents
generally are granted for 20 years, and as the rights they provide
imply, the patentholder can license to other individuals or firms
the right to use its innovation. Patents give a firm the legal power
to keep others from using its innovation to create competing products
without bearing the cost of the innovation. Licensing provides a means
whereby the innovator can receive compensation, in the form of
licensing fees, from others that find a beneficial use for the
innovation. Thus policy has long recognized that, to encourage
innovation, firms must expect that successful innovations will yield
a market position that allows them to earn profits adequate to
compensate for the risk and cost of their efforts.
Indeed, intellectual property protection often plays an important
role in dynamically competitive markets. But it is not the only
mechanism that may allow a firm to gain an adequate return on risky
investments in developing innovations. Intellectual property laws
cannot always provide inventors complete protection against
competitors using the knowledge embodied in their inventions without
compensation. First, even if they are valuable, not all innovations
can be protected by intellectual property law. Second, firms can often
``invent around'' a patent to create a competing product that, although
similar in value to consumers, is different enough in its composition
or features so as not to violate the patent. Although this entails some
development costs, these may be substantially reduced by the knowledge
gained from studying the original innovator's efforts. On the other
hand, some innovations may be difficult enough to imitate that, even
without intellectual property protection, the innovator can enjoy a
substantial cost or quality advantage over its competitors for some
period. In either case, other characteristics of some dynamically
competitive industries are important in making it likely that a
successful innovation will yield a firm the leading position in a
market, and profits that are essential to encourage such innovations.
Economies of Scale
Many industries that may experience dynamic competition are
characterized by substantial economies of scale. In such industries,
creating a new product entails high fixed costs, such as the costs of
research and development and of setting up production and distribution
facilities. But once these costs have been incurred, the incremental
cost of making each unit of the product is small, indeed sometimes
close to zero, and it is often easy to expand production to high
levels. In markets with these characteristics, an innovator may be
able to introduce its new product and keep production levels high
enough to gain substantial market share before others can offer
products of competing quality. As a result, economies of scale may
allow the innovator to keep its average costs well below that of new
entrants offering similar products that have smaller initial market
shares. In some cases this advantage may be enough to keep other firms
is notably superior.
Network Effects
Network effects are another mechanism that can help an innovator
maintain a market-leading position in many dynamically competitive
industries. A product or service is subject to network effects if
its value to a consumer increases the more it is used by others. For
instance, over the past decade, the number of people using e-mail has
grown dramatically, making it a much more valuable means of
communication for any individual user today than it was a decade ago.
Network effects can also influence the value of some computer software.
The more people who use a particular software application, or at least
software compatible with it, the more valuable that software is to any
individual who wants to share or exchange files with others who use that
software. One study of prices of spreadsheet software between 1986 and
1991 found that consumers were willing to pay a significant premium for
software that was compatible with Lotus 1-2-3, which was the dominant
spreadsheet program during this period.
As more people use a particular good, its value to consumers can also
increase because this wider use encourages the production of
complementary goods. For instance, as more offices use a particular
type of photocopier, businesses offering repair services and spare
parts for that copier may become more common, making the copier even
more attractive to offices.
As a result of these network effects, the value that consumers attach
to a product that is already widely used may be substantially greater
than the value they place on a relatively similar product that is used
by fewer people. For instance, a manufacturer may introduce a new
copier that offers performance largely similar to that of the market
leader. But if the new copier is built in such a way that users cannot
draw from the same service and spare parts network, it may be less
valuable than the incumbent product. Thus, if a firm can quickly gain
market share after introducing a new innovation, network effects can
play an important role in helping the firm maintain that market
leadership in the face of competition from new entrants offering
similar products. This, in turn, increases its ability to reap the
profits that are necessary for it to earn an adequate return on its
risky investment.
Many have expressed concern that network effects can give such
substantial advantages to incumbent products that new firms with
potentially superior products are unable to compete. In theory, this
could happen, but it does not happen necessarily. If a new product is
clearly superior to the leading product, whether network effects are
large enough to keep the new product from successfully competing will
depend on the value of those effects compared with the net advantages
it offers after taking into account the cost of switching to it. But,
of course, measuring either of these -- the value of the network
effects or that of the new product's superior features -- is difficult.
Although there have been cases where a new product took over a
market-leading position from one that presumably enjoyed network
effects, conclusive evidence that network effects have prevented the
widespread adoption of a markedly superior product has not yet been
found. For example, one common case put forward to argue that network
effects can hinder the entry of superior products is that of the QWERTY
keyboard, the familiar, century-old keyboard arrangement that
virtually all typewriters used and that most computer terminals use
today. In the 1980s a study suggested that a keyboard arrangement
called the Dvorak keyboard, introduced in the 1930s by August Dvorak,
was superior to QWERTY but had failed to gain market share because of
the network effects that the already-established QWERTY enjoyed. Yet
a more recent study raises significant doubts about claims that the
Dvorak keyboard was superior. For instance, the most dramatic claims
of its superiority are traceable to research by Dvorak himself, who
stood to gain financially from the patented keyboard's success.
Examination of his research revealed that experiments comparing
keyboards often failed to account for differences in the ability and
experience of participating typists. The best-documented experiments,
as well as recent ergonomic studies, suggest little or no advantage
for the Dvorak keyboard. This highlights that generalizations cannot
be made about the significance of network effects in deterring the
entry of superior products into a market. Their impact must be judged
on a case-by-case basis.
Fostering Innovation Through Organizational Structure
Although the prospect of gaining a market-leading position can
encourage firms to innovate, firms can reap the benefits of innovation
through other means as well. As was mentioned above, the benefits of
innovation are often shared by many. Licensing agreements offer one
means by which a firm can capture some of these spillovers. But such
arrangements are an imperfect way of ensuring that innovators benefit
from the spillover effects of their innovations while also encouraging
additional beneficial uses of the innovation by others. As noted
earlier, addressing this spillover problem is one motivation for a
research joint venture among firms that expect to mutually gain from an
innovation. Moreover, firms that develop new innovations subject to
network effects will benefit from the production of complementary
products that enhance those network effects. Partial equity stakes may
provide a useful mechanism to foster the development of these
complementary products.
Even when conducted within a single firm, successful research requires
appropriate effort from multiple parties. This includes not only the
work of research scientists and engineers, but also efforts by managers
appropriately. Thus, successful innovating firms must address various
agency costs in product discovery and development, to align the
interests of these various participants with the interests of the firm.
For example, one study indicates that research programs in
pharmaceutical companies that encourage publication by their
scientists experience higher rates of drug discovery.  Whereas stock
options are often the focus of discussions about means of resolving
agency costs, this example makes clear that incentives must be
carefully tailored to the desired objective. In this case, keeping a
firm's researchers closely connected to leading-edge developments in
fundamental science may provide a critical advantage in developing
commercially valuable drugs. Thus, just as firms can use stock options
as an incentive for managers to pursue shareholders' interests, so,
too, they can create incentives for researchers to be connected to
developments at the leading edge of their science, by making a
researcher's standing in the greater scientific community a significant
factor in promotion decisions. A further study suggests that these
firms provide a balanced system of incentives: those firms that use a
scientist's publication record as a positive factor in promotion are
also more aggressive in rewarding research teams that produce important
patents. This reward structure helps direct scientists' efforts to
engage in both basic and applied research, culminating in successful
drug discoveries.
Decisionmaking at all levels of a firm can play an important role in
determining its success in introducing substantial new innovations. A
study of the computer hard disk drive industry found that established
firms often had the technological know-how to develop what would turn
out to be the next disruptive technology in their market, such as the
3.5-inch disk drive. In fact, they were sometimes among the first to
develop them. But new entrants were always the leaders in
commercializing the disruptive technologies examined in this study.
In this industry, the failure of incumbents to lead in commercializing
disruptive innovations was often traced to decisionmaking that focused
on the needs of their established market, failing to promote new
technologies whose initial applications fell outside that market.
Yet it would be these technologies that would eventually develop to
become the leader in the established market. Thus the organizational
structure and incentives faced by managers of established firms played
a more important role than technological know-how in their failure to
lead the commercialization of disruptive innovations. Of course,
innovation benefits society whether it arises from established or from
entrant firms, but in either case, successful innovation requires good
organization.

Dynamic Competition as Repeated Innovations
All the factors we have examined -- the market-transforming nature of
some innovations, the presence of intellectual property protection, the
potential for economies of scale, and the presence of network effects
-- provide explanations for why a firm can gain a market-leading
position and earn high profits after introducing an innovation. But
what makes a market subject to dynamic competition is the fact that
the very same factors can allow another firm, with an even greater
innovation, to take much or all of the market away from the leading
firm. Indeed, as Joseph Schumpeter commented, the competition provided
by new innovations ``acts not only when in being but also when it is
merely an ever-present threat. It disciplines before it attacks. The
businessman feels himself to be in a competitive situation even if he
is alone in his field.''
One example of a market where dynamic competition prevails today is
that for personal digital assistants (PDAs). Apple Computer, Inc., made
substantial investments to develop the Newton, the first handheld PDA,
which it introduced in 1993. This product did not succeed, but by 1996
at least six firms had operating systems for handheld PDAs either in
development or already available to consumers. The Palm Operating
System soon emerged as the preferred PDA, with a 73 percent market
share in 1998. Although the innovations embodied in its products have
made Palm a leader in this market, it is losing market share to new
PDAs.
This example demonstrates a number of the elements often found in
markets undergoing rapid innovation. First, firms that make substantial
upfront investments in product development do not always experience the
success necessary to gain an adequate return on those investments.
Second, significant innovations can make a product the clear leader in
a market at a particular point in time. Finally, even these innovative
market leaders face challenges from later innovations by other firms
that have the potential to make the leader's product obsolete.
Therefore a potential innovator must believe that, if it gains a
market-leading position through innovation, the resulting profits
will be adequate to justify the development costs, given not only the
possibility of failure but also the likelihood that future innovations
will make any market leadership short-lived. Box 3-3 describes another
market in which dynamic competition has been particularly intense.
Implications of Dynamic Competition for Competition Policy
Competition policy also has a role to play in markets characterized
by dynamic competition. Markets experiencing rapid or substantial
innovation can still be subject to conditions or behavior by firms
that hinder competition. For instance, price fixing among firms will
harm competition even in industries undergoing dramatic innovation.
Other behavior may have more ambiguous implications for competition,
dynamic or otherwise. Therefore the antitrust agencies will continue
to scrutinize behavior by firms in these markets. Since the lawfulness
of certain actions by a firm depends, in part, on the degree of
competition in the firm's market, the ability to properly assess all
types of competition is essential. Consequently, the analytical
framework used to assess competition must encompass its potentially
dynamic dimension. This involves recognizing the shortcomings of
traditional methods for assessing competition when applied to markets
undergoing rapid innovation, and developing new methods for determining
how significant dynamic competition is in a particular market.
Highlighting the importance of developing and applying such methods
is the fact that markets characterized by significant dynamic
competition may not appear competitive through the lens of some common
tools of traditional competition policy. Thus continuing adjustments
in competition
________________________________________________________________________

Box 3-3. Dynamic Competition in the Market for Prescription Anti-Ulcer Drugs

The dramatic nature of innovations in the drug industry can give a
firm that introduces a new drug significant market share. But
subsequent, equally dramatic innovations by competitors can make this
market leadership short-lived. Such leapfrog leadership is one
characteristic of markets subject to dynamic competition.
As an example, in 1977 SmithKline introduced the first anti-ulcer
prescription drug, Tagamet. Just 6 years later, however, Glaxo plc
introduced a competing drug called Zantac. Compared with Tagamet,
Zantac had fewer adverse interactions with other drugs and needed to
be taken only twice rather than four times a day. Within a year, on a
revenue basis, Zantac had gained more than a quarter of the market for
prescription anti-ulcer drugs, and by 1989 that share had risen to
more than half while Tagamet's had fallen to about a quarter (Chart 3-4).
In 1989 Merck & Co., Inc., introduced a drug developed by Astra AB
called Prilosec, the first of a new class of anti-ulcer drugs called
proton pump inhibitors. The new drug had to be taken only once a day.
Also, studies have shown that it heals a greater percentage of
patients than Zantac does in a 4-week period. By 1998 Prilosec
accounted for about half of total sales revenue for prescription
anti-ulcer drugs, while Zantac's share of sales revenue had fallen to
about 5 percent. (In the wake of mergers and other developments, the
names of the firms that sell all three drugs have changed.)
This example demonstrates the rapid rate of innovation in the drug
industry and how it can quickly render obsolete even highly
innovative drugs that companies have spent hundreds of millions of
dollars developing. In such a competitive environment, patents play
an essential role in encouraging firms to spend the huge resources
needed to develop ideas and products that competitors could easily
copy in the absence of legal protection.
This example also shows that, even with a patent, a firm can see
its market share taken away by another firm that develops an even
better drug for the same illness or condition. In this example,
Prilosec was introduced into the market well before Zantac's patent
expired. Given the substantial upfront investments in drug research
and development, companies will be motivated to develop drugs only if
successful drugs can achieve high profits and capture a leading market
share in the relatively short time before new innovations emerge. In
the drug industry, substantial market share can easily be lost in
just a few years.
________________________________________________________________________




policy are needed to avoid incorrect conclusions. Likewise, continuing
adjustments are needed to correctly identify markets in which high
profits and market leadership cannot be explained by the ongoing nature
or pace of innovation, suggesting that the market may indeed not be
competitive.
As noted in the discussion of merger policy above, a market's degree
of concentration is typically used as a screening mechanism to evaluate
competition in that market. Although finding that a market is highly
concentrated does not by itself suffice to conclude that competition is
limited, finding that it is not highly concentrated usually does
suffice to allay any such concern. Thus measures of concentration
provide a useful screen, because many markets may not be concentrated
enough to warrant further investigation.
However, given the significant role of innovation in markets
characterized by dynamic competition, it is common to see one leading
firm that, through innovation, has for the time being created a
superior product. Although such a market would be highly concentrated,
there may in fact be substantial dynamic competition in the market,
with new innovations emerging to threaten the leading firm's position.
Consequently, because many markets undergoing rapid innovation will
have a high measured concentration, such measurements may not be as
useful a screening device if dynamic competition is the primary form
of competition in that industry. In light of this shortcoming, the
development of effective screening mechanisms to evaluate dynamic
competition may be a useful supplement to concentration measures. Such
screening mechanisms could allow businesses in innovative industries
to better predict the responses of antitrust agencies to their actions,
just as the safe harbor provisions relating to concentration measures
did in the 1980s.
In assessing competition in a market, antitrust agencies and the courts
also examine whether the threat of entry by a firm into that market
would be both likely to occur and sufficient to counteract any ability
of existing firms to exercise significant market power. However, for
it to be adequate to assuage concerns, entry in response to such
behavior must generally be able to take place within a period of 2
years, essentially ensuring that the incumbent firm or firms' ability
to profitably raise prices is only that durable. As the length of
patents indicates, firms may need substantially more than 2 years for
profits to provide an adequate return on their research and development
investments. Moreover, in a typical assessment of the impact of a
merger on competition, the threat of entry can be viewed as adequate to
counteract anticompetitive price increases if it would prevent the
merging firms from keeping prices significantly above premerger levels.
But as Schumpeter pointed out, even if they may take longer than a few
years to emerge, innovations in dynamically competitive markets may
not only reduce incumbents' profits that are above competitive levels,
but indeed threaten the very viability of incumbent companies. Such
competition surely threatens the durability of a firm's market power.
Some common tools of antitrust policy may thus be less complete and
informative in dynamically competitive markets than in other
situations. But just as the antitrust agencies improved on simple
concentration measures in assessing competition during the late 1970s
and early 1980s, so, too, the existing toolkit can be further
augmented to deal with dynamic competition. The central role of
innovation in these markets suggests the kind of information that is
useful in assessing this type of competition.
In general, antitrust enforcement must continue the effort to
understand the patterns, nature, and pace of innovation in a given
market. In established industries, the antitrust agencies and the
courts can examine firm and industry history to assess the significance
of innovative activities. These activities would include research and
development expenditures and complementary investments in production or
distribution that would have much less value if the product they
support lost its market to a competitor's innovation. The risky
investments associated with developing innovations go well beyond
research and development to include all investments that future
innovations could render obsolete.
An industry's history can also provide indications of the fragility of
market leadership to substantial innovations in that industry. For
instance, the history of innovations in the market for prescription
anti-ulcer drugs, reviewed in Box 3-3, suggests that the threat of
future innovations will remain an important competitive force. Where
such threats are important, one might conclude that the industry is
dynamically competitive.
Brand-new industries, of course, lack such a history. Nonetheless,
antitrust officials should still endeavor to assess the importance of
innovative activity in these markets, and thus the potential
significance of dynamic competition. For both new and old markets, the
potential for competition from developments in other rapidly innovating
fields should also be considered -- even if the technologies of the
respective fields are fundamentally different -- as long as the
application of those technologies is converging. For instance, vascular
grafts are used today to repair and replace diseased or damaged blood
vessels. But any assessment of competition in that market must take
into account the potential for substantial innovations in other
invasive procedures or in drug therapies that could either reduce the
incidence of diseased or damaged blood vessels or provide alternative
treatments. In both new and established industries, we must encourage
dynamic competition and the benefits of innovation it secures, by
updating competition policy appropriately.
Such updating has already taken place with respect to the scope of
intellectual property protection and the effect it might have on other
firms' abilities to innovate. Although intellectual property
protection is important to encourage firms to innovate, it can also be
used in ways that hinder the development of future, and potentially
competing, innovations by other firms. The FTC and the Justice
Department have addressed this possibility in guidelines that
recognize the interaction between intellectual property law and
antitrust law. These guidelines encourage the development of new
technologies and the improvement of existing ones, while seeking to
preserve the desired incentives underlying the creation of intellectual
property.
Conclusion
Antitrust policy has contributed greatly to the economy by fostering
competition and allowing the efficient adaptation of markets to new
opportunities. This chapter has showcased some recent changes in the
organization of economic activity and market competition and outlined
the adjustments that competition policy is making in response.
First, corporate governance and structure continue to evolve, as the
rapid pace of merger activity proceeds and hybrid organizational forms
such as joint ventures and partial equity stakes continue to be
established. Competition policy should be sensitive to the
efficiencies that new structures have brought and can continue to
bring to society. Since a large source of these efficiencies may be
rooted in managerial and organizational improvements, it is worthwhile
for the enforcement agencies to investigate such factors thoroughly.
Second, the growth of multinational enterprises and cross-border
mergers will continue to make more goods and services available to
consumers at lower cost. But possible anticompetitive concerns arising
out of such mergers can now result in reviews by antitrust authorities
from many nations. The application of inefficient competition policies
worldwide could harm U.S. interests. The United States is working to
narrow divergences in countries' competition law and policy through
cooperation with other national antitrust authorities, under a number
of bilateral cooperation agreements. Through the creation of the
International Competition Network, the United States has joined with
other nations to facilitate procedural and substantive convergence.
Finally, competition policy in the United States and abroad must
address the greater prominence of markets characterized by dynamic
competition. Competition policy should take into account that
characteristics, such as high profits and substantial market share,
that might warrant concern about competition in some markets may
mask vigorous dynamic competition among firms in innovation-intensive
markets.