Victor D. Norman
One of the oldest controversies in competition analysis concerns the relationship between market structure and innovation. As usually posed, the question is whether monopoly is more conducive to innovation than competition. No-one has been able to give a clear-cut answer, probably because there is none. In a sense, however, the question is more interesting than the answer - not so much in its own right as in what it reveals about the traditional way of thinking about market structure. Most economists, and virtually all designers of competition policy, take market structure as their starting point - as something which is somehow, almost exogenously, given (although it may be affected by competition policy), and which produces results in terms of costs, prices, innovations, etc. Elementary microeconomics tells us that this is wrong. Market structure is inherently endogenous; determined by the behaviour of existing firms and by entry of new ones, simultaneously with costs, prices, product ranges, and investments in R&D and marketing. Exogenous variables (if any) are things like the fundamental characteristics of the products and the production processes, entry conditions, the initial preferences of the consumers, variables determined in other markets, and government policy. To ask if there will be more innovation with monopoly than with competition is no more meaningful than to ask whether price-cost margins will be higher if costs are high than if they are low.
This is true not only for the relationship between market structure and innovation - it is true more generally for the relationship between market structure, competition, and economic efficiency. We can, of course, easily construct cases in which a high degree of market concentration goes along with lack of competition and inefficient resource use. We can, however, equally well construct examples in which concentration is the result of aggressive competition, and where the result is efficiency. It is also possible to construct cases where concentration reflects monopoly, but where monopoly power is exploited in a way which is consistent with efficiency.
The question that should be asked is not, therefore, what the ‘ideal’ market structure might be, but what set of circumstances are conducive to static and dynamic efficiency and what implications that has for the design of competition policy and for the way in which the competition authorities should handle particular cases. Once the question is formulated in this way, it is immediately apparent that market structure by itself is of little interest. Circumstances will affect efficiency to the extent that they affect the behaviour of firms; and the behaviour of firms reflects profit opportunities and other incentives that firms face. It is through the effects on firm incentives, therefore, that exogenous variables affect efficiency. It follows that the focus of competition analysis should be on incentives and variables that affect those.