Standing on the shoulders of dwarfs

Updated: Sep 28

On January 14th, the Portuguese Competition Authority invited Luís Cabral for a seminar on innovation incentives in asymmetric industries, highlighting implications for current competition policy. During the seminar Luís Cabral presented results from his recent paper “Standing on the Shoulders of Dwarfs: Dominant Firms and Innovation Incentives”.

Luís Cabral completed his undergraduate degree in economics at Católica and concluded his master’s degree in economics at Universidade Nova de Lisboa. He then received a Ph.D. in economics from Stanford University. Currently, Cabral is the Paganelli-Bull Professor of Economics and International Business at New York University’s Stern School of Business. He is widely regarded for his contributions to industrial organisation.

During the first part of the seminar, Cabral summarised the most important results from the literature regarding the economics of innovation. The three most important effects were the replacement effect, stating that a monopolist has fewer incentives to innovate than a firm in a competitive market; the joint-profit effect (also called efficiency effect), showing that a monopolist has more to lose from not innovating than a challenger can gain from innovation; and the innovator-size effect, the higher the level of output of a firm, the more the firm values a decrease in costs or an increase in the quality of the product.

Cabral outlined some particularities of digital and high-tech industries. They are characterized by platform-based markets and generally market asymmetry. In most cases, digital industries include a dominant firm, the industry leader (the giant) and some smaller firms (the dwarfs). However, often industry leaders are not technology leaders, which calls for an analysis of the relationship between innovation and market asymmetry and the impact of competition policy on both.

The title “standing on the shoulders of dwarfs” allows for two different interpretations: imitation and acquisition.

Imitation is common in the digital industry. As Microsoft has rarely been the innovator it serves well as an example. Microsoft Excel was an imitation of Lotus 123, and Lotus 123 was an imitation of VisiCalc. Microsoft PowerPoint was an imitation of Harvard Graphics and prior to the commercialisation of Microsoft Word there had already been several other word processors. More recent examples are Google Play Music All Access, which looks very much like Spotify or Pandora, but has been developed later.

Google and Android, Google and Waze or Facebook and Instagram are just a few of the recent acquisitions in the digital sector. They have in common that the innovators (the dwarfs) often have very little commercial capabilities. The dwarf’s sole interest lies in selling the innovation to a dominant firm. Thus, the incentives to innovate are given by the price of technology and not by the will to compete with Google, Facebook or other giants. This business model, adopted by many start-ups worldwide, is called “innovation for buyout”.

Whether a giant imitates or acquires a dwarf depends on merger and patent policies and on antitrust regulation in general. If a dwarf is unwilling to sell its technology, the giant will simply try to imitate it. An example of this is the case of Google and Idealab, where Idealab rejected to sell its technology to Google. Google successfully imitated Idealab’s model of pay-per-click advertisement and settled intellectual property right issues later in court.

Cabral has found that, in the absence of technology transfers, an increase in the degree of firm dominance will decrease innovation. The most important result for authorities and regulators might be that when firm asymmetry is sufficiently large and efficient technology transfers are possible, there will be an increase in innovation (this is related to the above “innovation for buyout” effect). Vice versa, this means that if firm asymmetry is rather small and technology transfers are possible, this will lead to a decrease in innovation.

But what kind of innovation are we talking about? There are two possible types of innovation: incremental and radical innovation. Incremental innovations are improvements to an already existing product or production process. Through incremental innovations, a firm can improve its position in the market but will not necessarily become the next dominant firm. Radical innovations however, are the invention of something completely new. They offer the possibility to become a dominant firm because radical innovations are not competition in the market, but competition for the market as a whole. Cabral found that the ability to efficiently transfer technology will lead to an increase in incremental innovations at the cost of a decrease in radical innovations.

Most of today’s antitrust cases in digital industries apply to dominant firms and most often solely discuss issues related to market power and consumer protection. However, Cabral’s findings have shown that an analysis of the impact on innovation is at least as important and should be included in antitrust practice.

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