5  Dynamic efficiency and the modern economy

Dynamic efficiency is so important to the performance of an economy and characteristics of innovation and production has so changed in the last 50 years that we return to consider it. Modern developed economies markets are characterised by growth in the share of services, rapid evolution of technological change and product quality, lower transactions costs, relatively high fixed to variable costs of new products, and the debated importance of actual and virtual network effects.[45] These have direct implications for competition law.[46] We note that the effect of electronic communication and declining transport more generally of the modern economy on the implications for distance for trade are complex.[47] It follows that their implications for competition law across economies will not be straightforward either.

McLeod (2003) suggests that a distinguishing outcome of markets that have sourced the modern “digital” economy, at least from the perspective of competition law, is the profitability of their leading firms (Microsoft and Intel for example). These reflect the competition for the field and the winner take-all proclivity of products with network effects. As a range of literature points out,[48] it is the prospect of profits in an environment of rivalrous competition to differentiate their products and services, and innovate that drives dynamic efficiency: price competition may play a limited role.

Although profits may be prominent and, in modern-economy, industries characterised by network effects and/or economies of scale, there may be limited space for viable competing products, this does not imply that the profits are inhibiting or even not necessary for continued economically beneficial evolution. The incentives for innovation implied by profits and the possibility of the winner take-all means that potential profits—indicated by an ability to retain actual profits—are necessary for dynamic change. Measuring any inessential (monopoly) profits is extremely fraught in the modern economy, particularly in those sectors of rapid technological advance.

5.1  Industry structure and innovation

A great deal of literature has recently been produced on the characteristics of market structure in industries.[49] There is a growing consensus in the economics literature that the ideal market structure for industries lies somewhere between perfect competition and complete monopoly. At both these extremes there are limited incentives, and at the small-firm end limited resources, for firms to innovate and it is somewhere at an intermediate level that such incentives are maximised.

Baumol (2002) endorses the long-established Schumpetarian argument that the market structure that maximises the rate of innovation is oligopoly. However, the empirical evidence is much more equivocal.[50] We note that empirical studies of the relationship between market structure and determining features have had a long history of grappling with unstable empirical results and that these arise from the fact that on the basis of theory there is no stable relationship between market structure and performance as it depends critically upon the nature of the industries. We consider it reasonable to presume that innovation does arise from firms of all sizes and that there is no reason for discriminating among firm sizes through the efficiencies calculation of competition law. Of course typically oligopolies will be the focus of competition law. While relative to other markets a predominance of oligopoly might be expected in a small economy, in fact this need not be the case if products and industries of smaller firms are relatively more profitable in these economies.

5.2  Cooperation and competition

Competing firms may benefit from cooperation in a variety of circumstances. These circumstances include risk sharing, particularly when large risky irreversible investments are contemplated, access to networks that have natural monopoly characteristics (eg, transaction networks and product standards (in relation to virtual networks)), and externalities such as the costs and outcomes of research. Particularly providing that these firms are otherwise competing, the literature[51] argues that firms operating in dynamically competitive markets will often choose to cooperate for these purposes in the instances in which it is in society’s interests as well as their own. A good example is provided by joint venture arrangements. In these arrangements parties that otherwise may compete cooperate in particular projects that have certain of the defining characteristics that predispose cooperation. These parties may or may not be competing head to head in (other) markets, but even if they are not they will be competing in seeking and developing other projects that further their private interests. Thus generally joint venture arrangements produce quite different outcomes from mergers that lead to single-firm ownership. Efficient outcomes from joint ventures reflect the tension between co-operation and competition. Cooperation is essential for certain activities and the presence of competition will generally limit the extent and focus of it to the bounds of the project.[52]

The literature[53] suggests that a key to unlocking the benefits of innovation in new economy industries lies in setting conditions where both competition and cooperation are unrestricted and permitted to co-exist and reinforce each other. As with competition, the primary role for government in promoting efficiency enhancing cooperation lies in removing barriers to such cooperation. In the absence of barriers, cooperation will emerge wherever and whenever firms view it as a useful adjunct to their competitive activities.

The literature (see Baumol 2002 and CRA 2002a, for example) suggests that the efficient development of new economy industries requires the removal of barriers to entry rather than focus on the level of a market’s concentration. The argument is based on the position that new economy industries rely particularly on the process of dynamic competition. Evans and Schmalensee (2001) explain it this way:

In particular, the analysis of market power in new economy industries must consider the vulnerability of leading firms to entry powered by drastic innovation, not just to the entry of firms producing equivalent products with known processes. Analysis of this sort of fragility may require difficult judgements about the likelihood of disruptive innovations in the future, but simply to assume such innovations cannot occur is to ignore history and to impart substantial and obvious bias to market power analysis in important sectors.[54]

Dynamic efficiency and the characteristics of digital-goods markets imply the substitution of detailed rule-of-reason analysis for traditional rule of thumb competition analyses. In order to economise on the resource use that this implies they suggest that:

The only apparent approach to mitigation of these problems is to develop presumptions and structured rules of reason that reflect new economy realities and that are designed to lighten the courts’ analytical burden. When the world is changing rapidly, an approximate analysis of today’s conditions is much more likely to be useful than an exact analysis of conditions a decade ago.[55]

It is a consensus in the literature that in new economy markets, the application of competition law should be less concerned with levels of concentration per se. However, the natural advantages—eg, first-mover advantage—of monopoly in new economy industries, in the view of some, may facilitate the adoption of exclusionary devices that prolong and enhance the market power to the detriment of even dynamic efficiency.[56]

It is part of this consensus (eg, CRA 2002a, Shapiro 2002) that the focus of competition authorities should shift from the structure of a new technology industry to the conduct of individual firms in the market. The CRA study concluded that competition laws in new economy markets should concentrate on conduct and its alleged effect on competition. Because of the cost of implementing such a case-specific approach the study suggested that action should only be taken in new economy markets when there were substantial potential benefits from intervention.