PROXIES - Before the relationship between competition and innovation can be discussed,
attention has to be paid to the way both concepts are measured. In economic and empirical
227 Case No COMP/M.6281 – Microsoft/Skype, 7 October 2011, par. 81-84. This was also considered by the Commission in its decision concerning the acquisition of Yahoo’s search business by Microsoft. See Case No COMP/M.5727 – Microsoft/Yahoo! Search Business, 18 February 2010, par. 119.
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research, proxies are used to quantify competition and innovation. The existence of a strong and reliable link between the proxy and the concept that is measured is vital.228
INDICATORS OF COMPETITION - Several proxies can be used to measure the level of
competition in a market. Indicators that are often relied upon include market shares, firm size, market concentration and the price-cost margin. Market concentration is measured by the so- called Herfindahl-Hirschman Index which is calculated by squaring the market share of each firm in the market and then summing the resulting numbers. The outcome of the calculation ranges from 0 to 1 (or from 0 to 10,000 if whole percentages are used), moving from a large number of equally sized firms to a monopolist. The Herfindahl-Hirschman Index increases both as the number of undertakings in the market drops and as the difference in size between those firms grows.229 Price-cost margin is also referred to as the Lerner Index and is typically used as an indicator of market power. The price-cost margin is the difference between price and marginal cost as a function of price ([P-MC]/P) and ranges from 0 to 1 with higher numbers implying greater market power. The larger the difference between price and
marginal cost, the greater the degree of market power. Under the Lerner Index, the price in a perfectly competitive market equals marginal cost resulting in no market power and a price- cost margin of 0.230 As opposed to the price cost margin, market shares and market
concentration rely more directly on a particular definition of the geographic and product market.231 The main problem with the application of the price-cost margin is that it may be hard to find information about the costs of firms in the market. In addition, the theoretical foundations of the price-cost margin as a competition measure are not robust in the sense that models can be identified where more intense competition leads to a higher instead of a lower price-cost margin.232 The Boone indicator aims to address this issue by establishing a
relationship between relative profit differences and efficiency. The idea underlying the Boone indicator is that competition enhances the performance of efficient firms and impairs the performance of inefficient firms which is reflected in their respective profits. In other words, more intense competition leads to a reallocation of output to more efficient firms which changes the relationships between the profitability of market players.233 The discussed proxies may give an indication of the level of competition in the market. Nevertheless, it has to be noted that markets in which only a couple of firms are active can be highly competitive whereas competition can be weak in markets with a lot of players.234
228 J.B.B
AKER, "Beyond Schumpeter vs. Arrow: How Antitrust Fosters Innovation", Antitrust Law Journal 2007, vol. 74, no. 3, (575), p. 583-584.
229
See Guidelines on the assessment of horizontal mergers under the Council Regulation on the control of concentrations between undertakings (EU Horizontal Merger Guidelines) [2004] OJ C31/5, par. 16 and 19-21 for the application of the Herfindahl-Hirschman Index in merger review.
230
A.P.LERNER, "The Concept of Monopoly and the Measurement of Monopoly Power", Review of Economic
Studies June 1934, vol. 1, no. 3, (157).
231 See P.A
GHION,N.BLOOM,R.BLUNDELL, et al., "Competition and Innovation: An Inverted-U Relationship", Quarterly Journal of Economics 2005, vol. 120, no. 2, (701), p. 704-705.
232 J.B
OONE, "A New Way to Measure Competition", The Economic Journal 2008, vol. 118, no. 531, (1245), p. 1245.
233 J.B
OONE, "A New Way to Measure Competition", The Economic Journal 2008, vol. 118, no. 531, (1245). 234 In addition, these proxies assume the existence of a market with homogenous products. In order to take product differentiation into account, Farrell & Shapiro developed a tool referred to as ‘upward pricing pressure’ (UPP) to assess concerns in merger cases about unilateral price effects in markets for differentiated products (J.
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INDICATORS OF INNOVATION - R&D investment and patent activity are most commonly used
as indicators of innovation. It is difficult to design a single indicator capturing all the different aspects that have an impact on innovation. Patent activity signals technological progress, but not all patents are brought to the market and lead to new products. Similarly, the amount of R&D investment may indicate the importance that market players attach to innovation, but it does not capture the effects or the success rate of the innovation activities in the economy.235 R&D expenditure is an input to innovation that does not directly lead to innovative output. In other words, higher investment in R&D does not automatically translate into more innovation output.236 Often, a combination of several proxies is used in economic studies to make the analysis more accurate. In their model that is discussed below, Aghion et al. measured innovation by looking at the average number of patents acquired by firms in the industry weighed by the number of times each patent has been cited by another patent.237 Nevertheless, the fact remains that such indicators rather point to inventive activity which may or may not translate into innovation.
INNOVATION PERFORMANCE OF THE EU- The European Commission measures the innovation performance of the different Member States of the European Union in order to assess the strength and weaknesses of each country’s research and innovation system.238
The method that the Commission uses in its yearly Innovation Union Scoreboard shows the complexity of measuring innovation. The measurement framework, referred to as the Summary Innovation Index, consists of three types of main indicators which are each composed of several so-called innovation dimensions which in their turn include a total of twenty-five different factors. For the main indicators a distinction is made between ‘enablers’ that constitute the basic building blocks for innovation to take place (including human resources, open, excellent and attractive research systems as well as finance and support), ‘firm activities’ which capture the
innovation efforts at the level of the firm (including firm investments, linkages and
entrepreneurship as well as intellectual assets) and ‘outputs’ which cover the effects of the
FARRELL AND C.SHAPIRO, "Antitrust Evaluation of Horizontal Mergers: An Economic Alternative to Market Definition", The B.E. Journal of Theoretical Economics: Policies and Perspectives 2010, vol. 10, no. 1, (1)). Under their leadership, UPP was incorporated into the 2010 Horizontal Merger Guidelines (United States Department of Justice and Federal Trade Commission, ‘Horizontal Merger Guidelines’, 19 August 2010, par. 6.1).
235
R.J.GILBERT, "Competition and Innovation" in W.D.COLLINS (ed.), Issues in Competition Law and Policy, Volume I, Chapter 24, American Bar Association Antitrust Section, 2008, (577), p. 17, available at
http://eml.berkeley.edu/~gilbert/wp/competition_and_innovation.pdf. 236
R.GILBERT, "Looking for Mr. Schumpeter. Where Are We in the Competition-Innovation Debate?" in A.B. JAFFE,J.LERNER AND S.STERN (eds.), Innovation Policy and the Economy, The MIT Press, 2006, (159), p. 191. 237 P.A
GHION,N.BLOOM,R.BLUNDELL, et al., "Competition and Innovation: An Inverted-U Relationship", Quarterly Journal of Economics 2005, vol. 120, no. 2, (701), p. 703-704.
238 Such activities can be traced back to the work of Freeman and Lundvall relating to what later has been referred to as ‘National Innovation Systems’. See C.FREEMAN, Technology and Economic Performance:
Lessons from Japan, London, Pinter, 1987; B.-Å.LUNDVALL (ed.), National Innovation Systems: Towards a
Theory of Innovation and Interactive Learning, London, Pinter, 1992; and C.FREEMAN, "The 'National System of Innovation' in historical perspective", Cambridge Journal of Economics 1995, 19, 5-24 1995, vol. 19, no. 1, (5).
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innovation activities of firms on the economy as a whole (including innovators and economic effects such as employment).239
INNOVATION OUTPUT - In September 2013, the Commission introduced a new indicator that
focuses solely on innovation output and that complements the Innovation Union Scoreboard and the Summary Innovation Index. This new indicator consists of four components that are chosen for their policy relevance. The first component is technological innovation as
measured by patents. Patents are a crucial form of output of R&D investment and therefore show the ability of an economy to transfer knowledge into technology. Secondly, regard is had to the employment in knowledge-intensive activities as a percentage of total employment. This component captures the structural orientation of a country towards knowledge-intensive activities. The third component is the competitiveness of knowledge-intensive goods and services and is measured by aggregating ‘in equal weights the contribution of the trade
balance of high-tech and medium-tech products to the total trade balance, and knowledge- intensive services as a share of the total services exports’. This factor reflects the ability of
the economy to export innovative products and to participate in global trade. The last component is formed by the employment in fast-growing firms of innovative sectors.
According to studies, growth depends to a large extent upon fast-growing firms that generate a disproportionally share of jobs and contribute to increased innovation investments during economic recessions.240 The new indicator thus combines several proxies that relate to the output of innovation activities.
RELIABILITY OF THE INDICATORS - Although there seems to be a relatively well-developed method for calculating the total rate of innovation in a country, it continues to be very hard to find reliable proxies for measuring the level of innovation in a particular industry or market. According to Gilbert, a complete analysis of the factors that influence innovation activity requires ‘estimates of the expected values of discoveries and data on the R&D activities of all
potential innovators’. Since innovations often originate from unexpected sources such as
firms in unrelated industries and even from individual inventions, it is very hard to detect all the potential sources of innovation.241 With regard to indicators for competition, Gilbert argues that ‘competition depends on the levels and industry distribution of firm costs,
qualities, and brand recognition, on barriers to entry, on characteristics of demand, and on whatever animal spirits might motivate managers’.242 Proxies such as market shares, market concentration and price-cost margin may therefore not be able to capture all the different factors that influence the level of competition in a market. While economic scholarship is still in search for appropriate indicators that unambiguously quantify the rate of competition and
239 See E
UROPEAN COMMISSION, ‘Innovation Union Scoreboard 2015’, p. 7-8, available at
http://ec.europa.eu/growth/industry/innovation/facts-figures/scoreboards/files/ius-2015_en.pdf.
240
Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions. Measuring innovation output in Europe: towards a new indicator, COM(2013) 624 final, 13 September 2013, p. 3-4.
241 R.G
ILBERT, "Looking for Mr. Schumpeter. Where Are We in the Competition-Innovation Debate?" in A.B. JAFFE,J.LERNER AND S.STERN (eds.), Innovation Policy and the Economy, The MIT Press, 2006, (159), p. 191. 242 R.G
ILBERT, "Looking for Mr. Schumpeter. Where Are We in the Competition-Innovation Debate?" in A.B. JAFFE,J.LERNER AND S.STERN (eds.), Innovation Policy and the Economy, The MIT Press, 2006, (159), p. 192.
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innovation in an industry, a combination of several proxies for the measurement of each phenomenon seems to be the best approach for now.
3.3 Economic theory and empirical evidence on the relationship between competition