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\begin{comment}
Please include the following acknowledgements in any reproductions of this material.
Source document: Kevin A. Bryan and Heidi L. Williams, 2021. 
Figure #: © .  All rights reserved. [Citation with link to source]
Table #: © .  All rights reserved. [Citation with link to source]
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\title[]{Innovation: Market Failures and Public Policies} 
\subtitle{Lecture 5: Competition policy \vspace{3cm}}
\institute[]{\justifying The material covered in these slides is drawn from: Bryan, Kevin and Heidi Williams (2021) "Innovation: Market Failures and Public Policies," Chapter 13 in the \emph{Handbook of Industrial Organization Volume 4}, edited by Kate Ho, Ali Hortacsu, and Alessandro Lizzeri.}
\date{} 

\graphicspath{{graphics/}}

\begin{document}

\frame{\titlepage}

\begin{frame}{Introduction}

The rate and direction of innovation both determine and are endogenous to market structure

\vspace{6mm}

\begin{itemize}
    \item Competition policy is thus an important lever for incentivizing innovation
    \item Aghion and Tirole (1994): the relationship between innovation and market structure is the second-most studied question in industrial organization (after the link between profits and market structure)
    \item As the heavy study and continued contentiousness might suggest, the relationship is both theoretically complex and empirically challenging to measure
\end{itemize}

\end{frame}

\begin{frame}{Schumpeter against perfect competition}

Schumpeter (1942): dynamic competition, whereby large corporations bring new products to
market through costly effort, is ``the most powerful engine for progress''
\begin{itemize}
    \item Perfect competition is ``inferior'' since all profits which might fund research are competed away
    \item Recovering fixed costs of innovation requires sufficient scale or profitability per unit
    \item This argues against Marshallian welfare analysis, which champions ``perfect competition'', in the context of regulating innovative industries
    \begin{itemize}
        \item If price falls to marginal cost, there are no rents to pay for innovation, and hence no incentive to innovate
    \end{itemize}
\end{itemize}

\vspace{3mm}

However, the relationship between innovation and market structure is not so simple

\end{frame}

\begin{frame}{Arrow in favor of perfect competition}
    
Arrow (1962) considers the inventor of a cost-reducing invention who can make a take-it-or-leave-it offer to producing firms

\vspace{3mm}
In perfect competition:
\begin{itemize}
    \item For a small cost reduction of $\Delta$, the inventor will charge all firms precisely $\Delta$ per unit produced, earning $\Delta$ times the pre-invention competitive quantity sold
\end{itemize}

In monopoly:
\begin{itemize}
    \item To reduce costs, the monopolist is willing to pay no more than $\Delta$ times the \textit{monopoly} quantity sold
\end{itemize}

\vspace{3mm}

Since monopolists care about pre-innovation profits, and competitive market innovators care about the overall value of that new innovation, the ``replacement effect'' means monopolists will innovate less

\end{frame}

\begin{frame}{The ``inverted-U'' model}

Aghion et al. (2005) creates an ``inverted-U'' model that adds dynamics, finding another theoretical link between structure and innovation

\vspace{3mm}

\begin{itemize}
    \item When firms have a similar technology, small inventions are not very profitable
    \begin{itemize}
        \item Inventing firms' products are not so superior that a high price can be charged
        \item Firms never gain a large enough technological lead to discourage rivals' innovation
    \end{itemize}
    \item When one firm has a large technological lead, still little incentive to innovate
    \begin{itemize}
        \item Firm's existing product is likely profitable already, and rivals won't attempt to catch up
    \end{itemize}
    \item The intermediate range finds a balance of high Schumpeterian profits and low pre-innovation rents, maximizing innovation.
\end{itemize}
    
\end{frame}

\begin{frame}{Summarizing contrasting theories}

\begin{itemize}
    \item Schumpeter: Monopolized industries maximize innovation with high post-innovation rents
    \vspace{3mm}
    \item Arrow: Competitive industries maximize innovation because the total quantity of products to be improved is higher
    \vspace{3mm}
    \item Aghion et al.: Intermediate settings maximize innovation by expanding the dynamic gap between pre- and post-innovation profits
\end{itemize}

\vspace{3mm}

Which theory is correct? Even empirical evidence provides contradicting results
    
\end{frame}

\begin{frame}{Evidence on competition and innovation: Kang (2020)}

\vspace{1mm}

Kang (2020) finds that patenting activity increased by 57.7\% following a change in market structure related to the formation of a cartel

\begin{center}
    \includegraphics[scale=0.22]{figure10a_kang_1.pdf}
    \end{center}
\scriptsize \textcolor{red!75!green!50!blue!25!gray}{Note: The plotted estimates are event-time coefficient estimates of the inverse hyperbolic sine transformation of citation-weighted patents by firms before and after a cartel is formed.}

\end{frame}

\begin{frame}{Evidence on competition and innovation: Aghion et al. (2005)}

Aghion et al. (2005) finds an inverted-U pattern in a measure of competition against the number of citation-weighted patents per firm

\begin{center}
    \includegraphics[scale=0.4]{figure10b_bloom_fig1.pdf}
    \end{center}
\scriptsize \textcolor{red!75!green!50!blue!25!gray}{Note: The Lerner index is used to measure competition. Each point represents an industry-year. Only data points that lie between the tenth and ninetieth deciles of the citation-weighted patents distribution are included in this figure. The exponential quadratic curve that is overlaid was created by a Poisson regression of citation-weighted patents on competition and competition squared, including year and industry fixed-effects.}

\end{frame}

\begin{frame}{Barriers to entry}

Is market power in innovative industries a sign of quasirents recovering past R\&D spending, or of inefficient barriers to entry permitting supernormal profits for technological leaders?

\vspace{3mm}

Further complexity: these barriers to entry may be the result of past innovations
\begin{itemize}
    \item Sutton (1998) argues that firms endogenously choose to incur fixed costs which change the scale at which competitors can enter
    \item Since these ``endogenous sunk costs'' are often themselves innovation, a firm with market power affects the market structure-innovation relationship when it pursues activities to prevent future competition
\end{itemize}

\vspace{3mm}

Can we investigate these theories empirically by studying existing industries or proposed mergers?
    
\end{frame}

\begin{frame}{Empirical challenges}

Three challenges make empirical research on competition policy particularly complex:

\begin{enumerate}
    \item Measuring innovation itself is challenging
    \begin{itemize}
        \item Use patents, direct measures of R\&D, or an alternative?
        \item Weight by firm size (when firm size is itself endogenous to market structure)?
    \end{itemize}
    \item The appropriate measure for competition is not clear
    \begin{itemize}
        \item Use Herfindahl indices, a Lerner index, or some measure of business dynamism?
        \item Compare technologically similar firms, or downstream competitors?
    \end{itemize}
    \item Given the first-order impact of innovation on market structure, how can we isolate causal impact?
\end{enumerate}
    
\end{frame}

\begin{frame}{Early empirical literature}
    
Early studies generally found no relationship between market structure and R\&D

\begin{itemize}
    \item Gilbert (2006) reviews the early literature on market structure and innovation
    \begin{itemize}
        \item Studies take Schumpeter's hypothesis as an argument that bigger firms do more R\&D, when it would be more precise to highlight the role of concentrated markets
        \item Gilbert finds that raw cross-sectional analysis is limited by variance of technological opportunity across industries
    \end{itemize}
    \item Geroski (1990) supports Gilbert's argument, noting that including industry fixed effects overturns an uncontrolled result that concentrated British industries are more innovative
    \item Sutton (1998) argues that the homogeneity of a new product's potential submarkets endogenously affects the number of firms who will find it worth doing R\&D
\end{itemize}
    
\end{frame}

\begin{frame}{Recent work on competition and innovation}
    
Recent studies with more sophisticated empirical methodologies don't find a clear relationship between market structure and innovation
\vspace{3mm}

\begin{itemize}
    \item Kang (2020) observes that US cartels file more patents while price-fixing is in effect than after their breakup dates
    \item Similarly, Autor et al. (2020) uses the shock of Chinese export-growth to find that firms facing more competition do less R\&D and produce fewer patents
    \item However, Lampe and Moser (2016) finds that collusion on the R\&D side from shared patent pools decreases overall R\&D intensity
\end{itemize}
\vspace{3mm}

These results aren't necessarily in conflict: price collusion or insulation from foreign competition raises industry returns, while input collusion lowers an individual firm’s return to R\&D
    
\end{frame}

\begin{frame}{Other types of competition incentives}

Competition could push X-inefficient firms to pursue frontier technology {\scriptsize \textcolor{red!75!green!50!blue!25!gray}{[Leibenstein 1966]}}
\begin{itemize}
    \item Competitive industries cause inefficient firms to fail {\scriptsize \textcolor{red!75!green!50!blue!25!gray}{[Syverson 2004]}}, and drive firms to adopt better management practices {\scriptsize \textcolor{red!75!green!50!blue!25!gray}{[Bloom and Van Reenen 2007]}}
\end{itemize}
    
\vspace{3mm}

Moderate levels of competition could also encourage higher-variance invention

\begin{itemize}
    \item Gross (2020) uses variation in the level of competition in logo design contests to show that high probability of winning the logo contest causes firms to design very conventional logos
    \item Likewise, winner-take-all contests like many R\&D races can only be won by high variance research {\scriptsize \textcolor{red!75!green!50!blue!25!gray}{[e.g. Cabral 2003]}}
\end{itemize}
    
\end{frame}

\begin{frame}{Finding useful applications}
    
Though the link between competition and innovation is empirically ambiguous, theory and structural models are useful for examining specific policies

\vspace{3mm}

Example:
\begin{itemize}
    \item Segal and Whinston (2007) looks at the effects of allowing incumbents to sign exclusive contracts with buyers
    \begin{itemize}
        \item Being an incumbent becomes more valuable, encouraging R\&D
        \item However, entrants have less incentive to do the R\&D necessary to enter the market
    \end{itemize}
    \item Theoretical answer: aggregate innovation rises when exclusive buyer contracts are limited by limiting the fraction of customers who are forced by contract into old technology even though better alternatives have been invented
\end{itemize}

See Shapiro (2012) and Baker (2007) on where most models agree as to appropriate competition policy
    
\end{frame}

\begin{frame}{Separating differential costs and incentives}

A series of recent papers have estimated dynamic structural models of R\&D, where differential costs and incentives to innovate are identified from forward-looking behavior

\begin{itemize}
    \item Goettler and Gordon (2017) models competition between AMD and Intel dynamically, suggesting Intel would've innovated more in a monopoly instead of a duopoly
    \item In contrast, Igami (2017) finds the gap in innovation between incumbent and entrant hard drive makers is due to Arrovian replacement effects dulling incentives of market leaders
    \begin{itemize}
        \item Igami and Uetake (2020) models competition in the same industry, finding that dynamic incentives to preempt competition causes innovation incentives to increase moving from 1 to 3+ competitors
    \end{itemize}
    \item Yang (2020) finds that a hypothetical merger between Qualcomm and a smartphone manufacturer helps coordinate R\&D efforts and reduce double marginalization, outweighing the harm of foreclosing entry or increasing costs for other smartphone makers
\end{itemize}
    
\end{frame}

\begin{frame}{Cunningham et al. (2021) on acquisitions}
    
How do acquisitions by technological leaders impact innovative industries?

\vspace{6mm}

Cunningham et al. (2021) argues that `` killer acquisitions'' may occur - leaders acquire inventors of competing products just to mothball them
\begin{itemize}
    \item The authors use data on pharmaceutical acquisitions, measuring substitutability by the overlap in method of action and target of acquired therapy compared to acquirer's existing portfolio
    \item Competing drugs are almost 30\% less likely to be developed than non-competing drugs which are acquired
    \item They estimate 6\% of all pharma acquisitions are made to limit competition
\end{itemize}
    
\end{frame}

\begin{frame}{More on acquisitions}

\begin{itemize}
    \item Bryan and Hovenkamp (2020) models fringe firms who can sell to industry leaders or laggards, or license to both
    \begin{itemize}
        \item Mandatory licensing rules can prevent the narrow diffusion of new technology that is most useful to incumbents  
    \end{itemize}
    
    \vspace{3mm}
    \item Kamepalli et al. (2020): consumers won't adopt products if they worry large incumbents will acquire and kill the product
    \begin{itemize}
        \item VC investment in areas related to firms acquired by Google and Facebook fall substantially after acquisition
    \end{itemize}
    
    \vspace{3mm}
    \item Cabral (2018): start-up acquisition policy affects direction of research
    \begin{itemize}
        \item Cabral finds that mergers increase the relative return to startups of incremental Arrovian invention relative to incumbent-replacing radical Schumpeterian invention
    \end{itemize}
\end{itemize}
    
\end{frame}

\begin{frame}{Technology competition vs. product market competition}

Distinguishing between \textit{technology} competition and \textit{product market} competition has important policy implications

\vspace{3mm}

\begin{itemize}
    \item Bloom et al. (2013): firms may to R\&D in similar areas even though they produce products sold in very different markets
    \item How licensing and acquisition policy affects innovation in these settings is not well studied
    \item Two exceptions:
    \begin{itemize}
        \item Marshall and Parra (2019) considers how competition affects innovation when firms are competing both to invent and in the product market
        \item Watzinger et al. (2020) shows that government-mandated compulsory licensing at Bell Labs in the 1950s led to a substantial increase in forward citations to affected Bell patents
    \end{itemize}
\end{itemize}
    
\end{frame}

\begin{frame}{Role of firm architecture}
    
\begin{itemize}
    \item Firm structure is sticky, making it challenging for incumbents to adopt technology which doesn't match their existing capabilities {\scriptsize \textcolor{red!75!green!50!blue!25!gray}{[Henderson 1993; Helper and Henderson 2010]}}
    \item The stickiness affects the nature of competition for inventions which strong incumbents find difficult to adopt
    \item Bresnahan et al. (2010): Incumbents cannot simply set up subdivisions that replicate entrants because of ``diseconomies of scale'' 
\end{itemize}

\vspace{3mm}

Better understanding of differences in the ability to incorporate innovations into incumbent firms is greatly needed
    
\end{frame}

\begin{frame}{Summing up}

\begin{itemize}
    \item Empirical challenges in key areas - measuring innovation, measuring competition, causal inferences - persist
    \item There are few universal truths, both theoretically and empirically, due to variation in industry characteristics and trade-offs
    \item When the gap between pre- and post-innovation returns for potential innovators is small, generally less innovation results
    \begin{itemize}
        \item e.g. when technology-dominant firms sell at monopoly markups, or when strong post-entry competition restricts inventor profits
    \end{itemize}
    
\end{itemize}

Convincing empirical evidence of specific changes in competition policy with first-order welfare benefits remains an important open problem for future research 

\end{frame}

\end{document}