Merger analysis works best in markets with unchanging, undifferentiated products, and costs that are affected more by scale than by changes in production methods. This is mainly because merger analysis is forward looking and the more tomorrow will look like today, the more reliable our prognosis. However (fortunately!) few markets that I have dealt with fall into this category. Katz’ and Shelanski’s excellent paper on mergers and innovation deals with the twofold effects that “innovation” has on merger analysis:

1. Innovation disrupts market definition and competitive effects prognosis; and
2. Innovation may be threatened directly by the merger.

The first effect they refer to as “innovation impact,” the second as “innovation incentives.”

Innovation impact

As long as the technology that forms the backdrop of today’s products and thus market boundaries doesn’t change much, there is a robust positive correlation between the number of rivals, the intensity of competition, and consumer welfare gains. More rivals, more intense competition, lower prices. That’s the tried and true structure-conduct-performance or concentration-competition-welfare paradigm. But what if technology changes or is about to change? Disruptive innovation:

• Severs the continuity between pre- and post-merger market definition;
• Makes pre-merger market shares both less reliable and less significant, which, in practice, suggests that new customer sales or license revenues are often more telling than share of installed base;
• Makes it much harder to identify competitors and entrants;
• Renders the SSNIP test pretty much useless, because where innovation rules, “price” (of what?) is often not a useful reflection of value.

Innovation incentives

Here, the concern is that the merger itself might change the nature, pace, and direction of innovation itself. Consider the acquisition of a small electric car maker by a traditional gasoline car manufacturer. The small company has every incentive to disrupt the market and steal share. The large company has to balance incremental profits from electric cars against potential losses from selling fewer gasoline-powered cars and, more importantly, undermining the market itself. Cannibalization can therefore be a significant disincentive to radical innovation. Redeploying the small company assets to make better car batteries and starters might thus be the more “civilized” approach to innovation. (Here are slides from my antitrust/ip course, discussing the replacement effect.)

Katz and Shelanski discuss the two traditional approaches to “innovation incentives,” that courts and agencies have taken in the past.

1. Extension of the static rivals-competition-welfare model to innovation cases, assuming that more rivals lead to more intense competition for innovation, resulting in increased consumer welfare.
2. Schumpeterian competition, with a three phase model of monopoly, creative destruction through disruptive innovation, and a subsequent race to monopoly, repeated over and over.

The authors find that there is only a weak correlation between increased concentration and less R&D, except in cases of mergers to monopoly, and a somewhat weakened connection between R&D and welfare, considering that some R&D races are wasteful. For example, spending an incremental $1 billion to beat a competitor in a paten race by one day. The incremental day is hardly worth $1 billion to society.

Efficiencies

In “innovation cases,” companies often make claims as to increased post-merger innovation. Katz and Shelanski identify the following:

1. Combination of complementary IP and R&D assets
2. Better R&D funding through risk-spreading; and
3. Higher margins, which will allow greater R&D funding.

Personally, I have never heard anyone make argument (3), for obvious reasons. As to the other claims, Katz and Shelanski find (2) unpersuasive because of cannibalization and because there is no evidence that a larger firm invests in qualitatively better R&D. In contrast (1) is plausible, provided that the parties can show that cooperative R&D is more promising than parallel, competitive R&D. In my view, (2) is not per se unpersuasive. It all depends on whether and to what extent the acquired potential for innovation competes with the buyer’s present capabilities and its valuation of its present market position going forward. A large buyer looking to displace the status quo may well be a more powerful disruptive force than a small firm, for example, because customers are more likely to adopt a radically new technology if it is backed by a blue chip corporation.

There’s more in this great paper. Download it while it’s hot!

Technorati Tags: innovation, antitrust, mergers

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