Comments: Innovation and monopoly power

What did the Fabled economist say about Microsoft.

Microsoft, doesn't really deal in patents, it just sells the most popular operating system in the world, and of course all the best software on it. When someone comes up with a good idea, this idea is then incorporated into the operating system in the next release, therfore eliminating the need for an independent product. Case in point Netscape.

The good part about Microdsoft stuff is that one can build a new product on it and it won't cost you too much money in the form of licensing to do so.

its a bit like taking a ride on the back of a shark. its fun while it lasts, but watch out for the teeth.

JMS

Posted by James Saunders at June 8, 2004 03:55 PM

The comment on my research is apparently correct but substantially misleading. First of all, my main result that market leaders have strong incentives to invest in R&D clearly matches evidence in many sectors beyond the market for software: from the pharmaceutical sector, to the automobile and any high tech sector all the way to razor blades, as a pointed out in a recent article on The Economist (22nd-28th May in the Economic Focus). Second, even scientific studies show a positive correlation between market share and innovative activity and support my conclusion. Third, it doesn't take a lot to agree with the fact that Microsoft provides constant improvements in its operating system; whether this innovations are entirely created within the Microsoft or by independent companies or single inventors who sell them out to the leading firm in the sector is not relevant for the consumers. What matters from their point of view is that the final product is constantly improved or it becomes cheaper. A market leader like Microsoft induces high (direct or indirect) investment in R&D and huge scale economies in production and marketing, allowing both things to happen.
I take this opportunity to clarify some points on my research on market leaders. Traditionally, market leadership has been associated with collusion and lack of competition. Economists think of market leaders as firms with greater market power than other firms or able to protect monopolistic positions by threatening price wars against aggressive competitors. This negative view inspires the fight of anti-trust authorities against dominant firms, but it is conceptually misleading. The source of collusion is lack of competition and not market leadership. Market leaders have a different behaviour if they face real competition and in this case they actually create gains for consumers.
In general, a leader in a competitive market will produce more and in a more efficient way and will set lower prices than its competitors (and will also invest more in R&D). To see why this happens, imagine a market of homogeneous products where firms choose their production level and the market price just equates demand and supply. This simple structure characterizes many mature sectors where product differentiation is minimal, like many commodity markets, the detail distribution and even the distribution of standard services as flights, telecomunications, energy,... In absence of a leader, a number of competitive firms could share production and sell at a price equal to the average cost. However, if there is a leading firm, this firm can expand its own production up to a level which makes unprofitable for other firms to operate. The leader keeps low prices and produces high quantities to avoid entry (higher prices would allow entry by competitors and shift some profits toward them). Paradoxically, such an apparently monopolistic market completely dominated by a single firm is perfectly competitive and it is the only possible equilibrium in such a market! And it is also extremely efficient since it saves in fixed costs of entry making the productive process much cheaper, and consequently it keeps prices at a low level. Under a leadership, the society gains from greater cost efficiency and lower prices.
Now, to extend the analysis to other contests, imagine that products are not homogeneous but they differ in quality. This happens when consumer needs or tastes are quite differentiated, like in the automobile market or many other sectors where the design and the inner quality of products plays an important role. Under these circumstances firms often compete in prices by choosing different mark-ups for different products. When quality differs, it is important to have a number of firms producing different varieties of goods. A competitive market typically satisfies such a requisite, but it tends to induce excessive proliferation of products. The presence of market leaders is again beneficial. They will not overtake the entire market as before, but they will expand production and consequently reduce their price below the prices of their competitors, some of which will be driven out of the market. Consumers will then face a lower variety of alternative products but pay less for some of them. Again market leadership creates a net gain for the society.
What are the implications of this analysis? The presence of leaders in markets should not be seen as a negative factor. Even when one single firm dominates a market, it may be that this is perfectly competitive! But then, anti-trust authorities should approach policy intervetion with a new vision. They have been fighting both entry barriers and dominant firms with partial success either against one or the other: the results on market prices are sometimes positive but small and other times even ambiguous. This approach, however, is extremely misleading. A main example of its fallacy is in the use of indexes of market concentration as measures of market power. When there are few firms and they have very unequal market shares, a sector becomes suspect of collusive behaviour, the leading firm being the main culprit. In reality, we have seen that the opposite can be true and even a sector with one single firm operating may be perfectly competitive and extremely cost efficient.
It is clear that such a view is too radical to be promptly accepted at a policy level, but anti-trust authorities should at least shift their priorities and move ahead the promotion of free entry. Unfortunately, as of now, the priority appears to be fighting market leaders: this keeps delivering poor results in sectors with high barriers to entry and even negative results in sectors where there are not effective barriers to entry!

Posted by Federico Etro at June 9, 2004 05:14 PM

>>>>>>>In reality, we have seen that the opposite can be true and even a sector with one single firm operating may be perfectly competitive and extremely cost efficient>>>>>>>>>>The points about market leadership are well taken. However, a single operating firm is by all definition a monopoly and monopoly by all definition is the absence of competition. There is no need to overstate the argument for the economic benefits of market leadership by stating that a single firm operating in industry may be perfectly competitive or to demonstrate a well received economic perspective that in the absence rent-seeking behavior, a monopolist can produce at the lowest cost possible and charge the lowest price possible. The monopolist declining long run average total cost curve derives from several factors: Economies of scale, economies of scope, learning effects, experience curve, and higher marginal propensity to innovate, etc. Further, the effects and economies of market leadership may be circular and cumulative. And as long as the effects and economies of market leadership are monopoly-enhancing rather than monopoly-reducing they will continue to run afoul of anti-trust laws everywhere and in the United States in particular.

Posted by Prof. James Gaius Ibe, Ph.D., CAE. at December 26, 2008 05:49 AM