Digital Platform Competition, Merger Control, and the Incentive to Innovate: Don't Kill the Goose That Lays the Golden Egg

• Jurisdiction: United States,Federal
• Author: By John Ceccio and Christopher Mufarrige
• Publication year: 2020
• Citation: Vol. 30 No. 2

DIGITAL PLATFORM COMPETITION, MERGER CONTROL, AND THE INCENTIVE TO INNOVATE: DON'T KILL THE GOOSE THAT LAYS THE GOLDEN EGG

By John Ceccio and Christopher Mufarrige¹

The purpose of the antitrust laws is to promote competition and innovation for the benefit of consumers.² Recently, there has been a growing chorus of critics who subscribe to the idea that acquisitions by large digital platforms are detrimental to this purpose. The common belief among these critics is that current antitrust law is ill-equipped to address transactions in digital markets. Much of this sentiment focuses on transactions where large digital platform firms acquire technology-focused start-ups. These interventionists argue that past transactions of start-ups have harmed competition and innovation because, by purchasing nascent competitive threats, platform incumbents eliminated much needed competitive constraints. Taken together, they argue that this course of conduct impedes incentives to innovate and ultimately harms consumers.

In response to these perceived problems, critics assert that antitrust merger enforcement should be less forgiving when scrutinizing large firm acquisitions and that potential legislative action is needed. Importantly, these types of changes to the antitrust laws would make it harder for venture capital-backed companies to be acquired. This raises two important questions: (1) do the current proposals promote competition, innovation, and consumer welfare; and if not, (2) are extant antitrust principles capable of effectively addressing large technology firm's purchasing alleged nascent competitive threats?

The short answers are no and yes. First, critics fail to fully appreciate the unintended negative consequences their proposals will have on the innovation ecosystem as a whole. Put simply, if the critics' proposals were enacted, the incentives for innovation and growth would be severely curtailed and the capacity for future innovation and growth would be in doubt. Second, the fundamental principles of extant antitrust merger enforcement are sound, and the current legal and analytical frameworks are sufficient to combat potentially anticompetitive acquisitions of smaller, adjacently related start-ups. While there is certainly room for more empirical research to better understand digital markets,³ any change in the law must first aim to do no harm or, in other words, not kill the goose that lays the golden egg. The sections that follow describe: (1) the recent literature surrounding the debate; (2) the various regulatory proposals; (3) why those proposals are flawed; and (4) why existing merger enforcement principles are up to the task.

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I. MERGER ACTIVITY AND BUSINESS DYNAMISM

The calls for increased scrutiny of small tech transactions stem from the growing commentary around large firms acquiring nascent competitive threats and the perceived fall in business dynamism. The various theories of harm related to nascent competition allege that, absent acquisition, the small start-up could have grown to provide an important competitive constraint on the large superstar digital platform, or that the large superstar firm would have innovated organically to develop its own competing product or service. In either case, the theories contend that competition and innovation in the particular market and adjacently related markets would have been better off without the transaction.

Besides the alleged softening of competition in the merging parties' markets, critics also argue that such acquisitions reduce business dynamism and innovation.⁴ Specifically, these critics argue that platform incumbents have maintained their dominant positions, in part, because start-ups are funded with a latent intention to ultimately sell to a large firm.⁵ They further argue that, because of the incentive to sell to and integrate with a large firm, innovative start-ups tend to compete to develop platform complements as opposed to competing for the platform itself.⁶ Critics claim that this has a deleterious effect on business dynamism and innovation incentives, thereby harming consumers.⁷ Some proposals have even called for legislation to alter venture capital investment incentives as a means to promote direct competition against digital platform incumbents.⁸,⁹ The following sections outline the commentary around each of these topics.

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A. The Theories And Concepts Underlying Nascent Competitor Transactions

The commentary and proposals to upend current merger enforcement principles come partly from the belief that the antitrust laws are ill-equipped to address large digital platforms acquiring small, but growing technology-focused firms. While discussion on the topic is plentiful, definitions and theories of harm often get incorrectly intertwined and misconstrued.

1. Nascent Competition Vs. Potential Competition

As an initial matter, the concepts of "nascent competitor" and "potential competitor" are not the same. This is important because US antitrust law has developed standards to analyze "potential competitor" transactions, which would make challenges to even anticompetitive mergers exceedingly difficult if applied to "nascent competitor" transactions.¹⁰ Thus, given the high level of concern over digital platform dominance, current potential competition doctrine seems too strict and is nonetheless inapplicable given the difference in the two concepts.¹¹

The term "potential competitor" is typically defined as a firm that is predicted to have an undifferentiated or slightly differentiated product that will compete in the acquiring party's market at some point in the future, but does not do so currently.¹² In contrast, the concept of "nascent competitor" stems from the holding and reasoning in the seminal Microsoft case.¹³ There, the court describes the concept as a differentiated product or technology that exists as a competitive threat to the incumbent but has not yet fully matured into a significant competitor.¹⁴ In other words, a nascent competitor may be characterized as a product or service that satisfies a consumer's underlying need for the incumbent's current product in a new and innovative way.¹⁵

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While the definition of a nascent competitor is still somewhat in flux, it is well settled that the term conveys that the company has created an innovative product. Consequently, it is helpful to understand the different approaches firms take to innovation. But rather than looking at innovation from the perspective of existing markets and developing technologies—it is more useful to follow battle-tested antitrust analysis and view competition from the eyes of consumers. Specifically, when thinking about the nascent competitor concept, it helps to frame the analysis around the solution or service the innovator is attempting to provide in response to current—or anticipated future—consumer needs and preferences.¹⁶ Innovation framed this way falls into three buckets:

• (innovation that offers a breakthrough solution to existing consumer demands;
• (innovation that redefines an existing solution to consumer demands and preferences; and,
• (innovation that anticipates or creates future consumer demand and seizes a brand-new opportunity.¹⁷

A category one innovator is the prototypical nascent competitor. Think of the music industry. CDs were a breakthrough solution (over cassette tapes) satisfying consumer demand regarding storing and replaying sound recordings. Thus, at its very early stages, CD companies were nascent competitive threats to the cassette industry.

A category two innovator may, but does not always, constitute a nascent competitor.¹⁸ The determination rests on the amount of demand the innovative new product or service could divert from the existing industry, as well as the competitive constraint the newly defined product will have on the incumbent industry.¹⁹ Innovation strategies that redefine an existing industry problem and solve the redefined problem lead to both disruptive and nondisruptive creation. By slightly redefining the problem, a category two innovator can shift industry boundaries in creative ways. Take the Nintendo Wii, for example. The console redefined the problem the video game industry had long focused on from how to deliver the best graphics, to how to deliver an easy-to use video-game system that combined the movement of physical sports with family-friendly games everyone could play together at home.²⁰ The Wii's family-focused environment was easy to navigate and its operation was governed by motion, not button-pushing. The Wii pulled a slice of demand from the existing video game industry, "creating an element of disruption, but it also expanded the industry in a nondisruptive manner by attracting a mass of people—from young children to senior citizens—who had never played video games."²¹

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On the other end of the spectrum is a category three innovator. This type of innovator is not properly characterized as a nascent competitor. A category three innovator creates new markets beyond industry boundaries, rather than eating at the margins or the core of existing industries. At its inception, Sesame Street was a category three innovator. It created a brand-new opportunity that unlocked a new market of preschool edutainment without replacing preschools or libraries.²²

2. Killer Acquisitions

The Killer acquisitions theory is a variation on the more general nascent competitor theory of harm. The term "killer acquisition" comes from the title of a 2019 paper by Yale economists Colleen Cunningham, Florian Ederer, and Song Ma.²³ Cunningham et al. describe a killer acquisition as a case in which the acquiring firm's strategy is "to discontinue the development of the targets' innovation projects and preempt future competition."²⁴ The paper concludes that the acquiring party exited the competing project in approximately 5% to 7% of the transactions examined. Thus, according to the authors, "[i]ncumbents acquire...