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Do Acquisitions Help or Hurt Innovation?
I didn't choose the antitrust life. The antitrust life chose me.
Another week, another federal government lawsuit against “big tech” companies. This week it is the FTC suing Facebook over “monopolization”.
So once again, I’m discussing news. Sort of. I’m sorry.
I haven’t had time to fully digest the FTC’s argument, so I will be speaking more generally. Hopefully, this discussion is relevant beyond this specific suit. Instead, today we will think about the question: do acquisitions help or hurt innovation?
Let's start with the basics, so we are on the same page. What should we even be looking at?
For simplicity, start with 2 firms. Let’s give one firm a simple label, say FB. And the other firm gets a different label, say IG. FB is deciding whether to acquire IG; FB will only acquire IG if the expected value from the acquisition is worth what FB has to pay. IG will only accept getting acquired if it's expected profit rises.
By definition, profits can only rise if one of two things happens. Either the price needs to rise for FB and IG's goods or their costs need to fall. For policy or welfare discussions, both of these changes could be good for consumers and society or they could be bad.
I made this fancy chart to make sense of it 👇
The bad effects are emphasized in antitrust discussions. After the acquisition, FB could raise the price since there is no longer competition from IG, or FB could slack off and let their quality decline since they no longer are “losing” customers to IG.
Despite what the government tries to argue in every antitrust case, the merger can be good for consumers because of “synergies” (🤮 at the word). Prices may rise because the new products that the FB/IG jointly offer are simply better (maybe they integrate better), or production may be more efficient combined (they can remove redundancies).
In this static model, to make the case the case that an acquisition is socially bad, one needs to show that the effect of the increase in prices (which must mean a corresponding decrease in quantity) plus the decrease in quality dominates the improvements in products or the cost savings.
We need to be looking for proper measures of the price, quantity, and quality. Maybe the quality is lower because there are more ads. Maybe.
And the comparison is always to a proper counterfactual where the acquisition does not take place. Compared to what? I can’t simply take every change to FB since the acquisition I do not like about FB and blame it on the acquisition. That’s not social science.
The title says this is a post about innovation???
But worrying about the static monopoly problem is really arguing over scraps. I get it’s what antitrust often does (that’s a problem with antitrust), but the welfare losses from a static monopoly are just tiny, compared to any effects on innovation. Without innovation, we lose out on all the gains from trade, not just the marginal gains from trade.
So how do we start thinking about innovation and acquisitions? Noticed that above I assumed FB and IG fall from the sky onto earth and then they need whether to acquire each other or not. This idea of a fixed "exogenous" number of firms (and the so-called structure-conduct-performance paradigm) is rejected within industrial organization, which is the field that studies this issue, despite its popularity in popular discussions.
The number of firms that enter a market will change with policy. Circling back to innovation, the important part is that firms will decide whether to innovate, make new products, and enter the market, depending on the policy. Firms won’t simply innovate regardless of their incentives.
To keep things simple, let’s now assume IG has to decide whether to even start-up or not with their product. How does the ability to be acquired affect IG’s decision to enter?
The prospect of FB paying IG a lot of money is an incentive to enter the market in the first place. From my simple understanding of how these new ventures work, many are created with the hope of being acquired. Any policy that makes acquiring firms harder directly decreases the number of new products introduced.
As I’ve argued before, for more innovation, we want to allow IG to appropriate more money for themselves, which means allowing them to be acquired by FB in this scenario.
There are two ways that I can think of where acquisitions actually hurt innovation. First, FB could acquire IG to then “kill” it. That happens sometimes. Of course, preventing the acquisition does not increase innovation on net if IG responds by not starting up in the first place.
The second way the acquisition could hurt innovation is that the FB/IG combo could scare off more new competitors more than they would separately. I’m struggling to see how this works since we are assuming that now FB/IG is offering higher-priced products of worse quality. But you could get the theory to work that way.
There is one more complication I'd like to mention that's not just price theory. Much of my academic work is on "coordination problems". Acquisitions require coordinated actions by two firms. In particular, both firms need to pay a fixed cost without any guarantee from the other side.
For our discussion, let's focus on a simple case where the acquired firm has to pay to create the initial product and the acquiring firm has to pay to initiate the acquisition. Both of these have to occur before people actually get paid for the benefits of the acquisition.
A general result in this literature is that it is really easy for the synergistic 🤮 moves to unravel and lead to "coordination failures" where neither side invests because they are worried that the other side won’t or the deal won't go through. Even if FB is confident they will be allowed to acquire IG, IG may not be so confident. And if IG is not confident it can be acquired, it will never startup and FB will never be able to persuade IG that the acquisition will go through.
As I show in my dissertation, one way around these coordination failures is to allow for free and open markets for these types of complementary investments. Let these markets operate. Let people experiment. Let the next IG learn that the going rate for innovations in this market is $1 billion. Leave the acquisition market open so that people can better learn the value of their own innovations.
Taken together (the static, dynamic, and coordination/complementary aspects), I feel uneasy about the cursory way that people throw around the idea of breaking up companies or stopping acquisitions.
That’s my feeling. That’s not science.
Ultimately, as with most interesting questions, this is an empirical question. For policy, we need to trade off the expectations of socially helpful acquisitions vs. harmful acquisitions.
But any empirical analysis requires that we have a theory to help us understand what the evidence means. Economics and price theory provide us with the tools for thinking through the evidence. We can think deeper than the simple idea that big is bad.