Productivity Growth Since The Role Of Competition example essay topic

Page 1 This paper seeks to contribute thinking on how the intellectual foundations of antitrust might be updated, based on a large body of theoretical and empirical research on company strategy, competition, and economic development. The aim is to outline a new direction for antitrust that can be incorporated into government policy and legal practice and pursued in litigation and legislation, both in the United States and internationally. This new thinking sets forth productivity growth as the basic goal of antitrust policy, and employs tools like industry structure analysis and locational analysis to evaluate potential impacts on competition. While there appears to be broad consensus on how to deal with much anticompetitive behavior such as deceptive practices and cartel formation, the current fault line in antitrust is the treatment of mergers.

This paper therefore focuses on the evaluation of mergers, though the same framework can be applied to evaluating joint ventures, other combinations, and other competitive practices. Finally, it should be noted that this paper is concerned principally with the content of antitrust, not the many important issues involved in structuring antitrust agencies and designing processes of enforcement. Section II argues that the true benefits of healthy competition are not fully articulated in much antitrust analysis. By linking competition to a nation's standard of living through productivity growth, it becomes apparent that far more is at stake in protecting competition than short-term consumer welfare defined by price-cost margins. Empirical evidence is provided to highlight the importance of protecting the vitality of competition. Furthermore, it is argued that local competition within a nation is particularly crucial for competitiveness, even in the era of globalization.

Section proposes that productivity growth become the new standard for antitrust, and reassesses the hierarchy of antitrust goals accordingly. Since healthy competition will foster productivity growth, antitrust must be equipped with adequate tools and frameworks for evaluating the health of competition. Yet frameworks broader than current practices resting in relevant market definitions and ability to elevate price above cost are required. So called "five forces" analysis is offered as a broader tool for evaluating overall industry competition, while the diamond framework for locational competitiveness is offered for evaluating the health of local competition. In Section IV, we turn to the analysis of mergers, outlining a three-level merger evaluation process that incorporates the productivity growth standard and the tools for evaluating the health of competition mentioned above. Section V offers a short case study of a merger evaluation, using the new procedure.

Finally, Section VI addresses some recent issues more specific to U.S. antitrust policy. The essential role of competition and antitrust policy in competitiveness is evident in recent research on industry competition and economic development. My conviction from working both with companies and public policymakers in many countries is that open competition, stimulated by strict antitrust enforcement, is essential not only to national DRAFT VERSION: 07/22/02 Page 2 prosperity, but to the health of companies themselves. Yet antitrust seems to be drifting. Antitrust policy is being challenged by skeptics who are mounting attacks on the need for antitrust under the guise of globalization or the requirements of the "new economy". Also, the theoretical and empirical literature on competition has moved beyond seller concentration, price-cost margins, and other ideas central to current enforcement.

1 It is an important moment to reinvigorate antitrust. Not to say that antitrust enforcement has been lax, nor that skilled practitioners have not been able to apply the law with great sophistication. However, recent court rulings and public debate suggest that the foundations of antitrust theory and practice are wearing thin. The goals of antitrust and its link to society's goals are often not convincingly articulated. The benefits of competition that underpin antitrust have not been made clear, and the tools for measuring impacts on competition are frequently controversial. Too often the discussion between business and government in antitrust proceedings concerns arcane matters such as HHI that erodes the legitimacy of antitrust with the private sector.

By relying too heavily on narrowly conceived consumer welfare theory, antitrust analysis may be overlooking some of the most important benefits of competition for society. Antitrust is not living up to its full promise in deterring behavior that is not in society's interest. My aim here is not to offer a comprehensive treatise, settle all of the issues raised, nor do justice to the scholarly or practitioner literature. Instead, the intention is to stimulate further dialogue and analysis. 1 See Sections II and. DRAFT VERSION: 07/22/02 Page 3 II.

COMPETITION, COMPETITIVENESS, AND STANDARD OF LIVING: THE ROLE OF ANTITRUST II. 1. Competition, productivity growth, and standard of living The stated role of antitrust policy is to promote and protect competition in the name of consumer welfare. Yet the rationale is frequently unclear, misunderstood, or too narrow in scope. While protecting short-run consumer welfare measured by price-cost margins is undeniably important, the benefits of healthy competition are in fact broader and more essential to consumers and to society.

The fundamental benefit of competition is to drive productivity growth through innovation, where innovation is defined broadly to include not only products, but also processes and methods of management. Productivity growth is central because it is the single most important determinant of longterm consumer welfare and a nation's standard of living. The underpinnings of economic prosperity are becoming better understood as a result of continuing research. While sound macroeconomic policies and stable political and legal institutions represent important preconditions for prosperity and competitiveness, they are necessary but not sufficient conditions for a prosperous economy. Prosperity is actually generated at the microeconomic level - in the ability of firms to create valuable goods and services productively that will support high wages and high returns to capital.

2 The goal of economic development is to achieve long term, sustainable improvement in a nation's standard of living, which can be approximated by per capita national income (GDP per capita). 3 Per capita income is determined by the productivity of a nation's economy, where productivity is defined as the total value of the goods and services (products) produced per unit of the nation's human, capital and physical resources. A nation's overall productivity is composed of the productivity of its firms, both those involved in traded industries and those involved in purely local commerce. The crucial issue, then, is how to create the conditions for rapid and sustained productivity growth in a nation's firms.

Since the seminal contributions of Schumpeter (1943), Solow (1956) and Abramovitz (1956), it is widely understood that the only means of achieving sustained productivity growth in an economy is through innovation. 4 Innovation provides products and services 2 M.E. Porter, "The Microeconomic Foundations of Economic Development", in The Global Competitiveness Report 1998, 38 (Geneva: World Economic Forum, 1998). See also M.E. Porter, "Attitudes, Values, Beliefs, and the Microeconomics of Prosperity", in Culture Matters: How Values Shape Human Progress (L.E. Harrison & S.P. Huntington eds., 2000). 3 While income is the best available measure, other things contribute to national standard of living besides wages and returns to capital, such as the quality of health care, the absence of extreme income inequality, and environmental quality.

4 J. Schumpeter, Capitalism, Socialism, and Democracy (2d ed. 1943); R. Solow, "Technical Change and the Aggregate Production Function", 39 Review of Economics and Statistics 312 (1957); R. Solow, "A Contribution to the Theory of Economic Growth", 70 Quarterly Journal of Economics 65 (1956); (continue) DRAFT VERSION: 07/22/02 Page 4 of ever-increasing consumer value, as well as ways of producing products more efficiently, both of which contribute directly to productivity. Innovation, in this broad sense, is driven by competition. While technological innovation is the result of a variety of factors, there is no doubt that healthy competition is an essential part. One need only review the dismal innovation record of countries lacking strong competition to be convinced of this fact. Vigorous competition in a supportive business environment is the only path to sustained productivity growth, and therefore to long term economic vitality.

Productivity growth, then, is the missing, unstated link between competition and national standard of living. This provides the soundest explanation for why antitrust must protect competition: it is the key to a nation's economic prosperity. Productivity growth thinking also makes it clear that the focus of antitrust thinking should be on the long-term trajectory of product value and price, not just current consumer welfare measured by short-run prices. The following sections outline how the central role of productivity in development and societal welfare can be applied to antitrust and competition policy.

II. 2. Importance of Industry Competition: empirical evidence Recent empirical findings verify the importance of competition to raising and maintaining standard of living. This evidence squares well with my own experience.

Competition really matters, in the new economy and the old economy, and in all types of countries. One body of empirical evidence comes from The Global Competitiveness Report 2000, an annual study of competitiveness in 58 countries including all the OECD countries as well as many developing countries. 5 Data from the report are drawn from a survey of more than 4,000 corporate and other leaders, including a representative sample from each country. The survey is qualitative, but represents a large body of expert opinion on important dimensions of economic policy, for which there are no quantitative measures.

Figure 1 reproduces some of the statistical findings from the Report. For all three years in which this analysis has been conducted, the effectiveness of antitrust policy 6 proves to be one of the variables with the strongest positive association with the variation in GDP per capita across countries. This holds even in the subsample of developing (continued) M. Abramowitz, "Resource and Output Trends in the United States since 1870", 46 American Economic Review 5 (1956). 5 M.E. Porter, "The Current Competitiveness Index: Measuring the Economic Foundations of Prosperity", in The Global Competitiveness Report 2000 (Geneva: World Economic Forum, 2000).

6 In id. at 312, the effectiveness of antitrust policy was measured in a survey by responses to question 10.14, "The anti-monopoly policy effectively promotes competition", using a scale from 1-7, "strongly disagree" to "strongly agree". DRAFT VERSION: 07/22/02 Page 5 economies, an indication that antitrust is also important for poor countries, rather than just a luxury needed only in wealthy ones. The report also includes a survey question about the intensity of local competition. While the question is imperfect because of possible ambiguities in its interpretation by respondents, it also has a highly significant positive association with GDP per capita. Figure 1 Competition and Prosperity: Findings from The Global Competitiveness Report Regression Dependent Variable: 1994 - 99 GDP per capita growth Significance Adj R 2 Measure of National Business at 95% level Environment Intensity of local competition at 95% level. 255 Effectiveness of Antitrust policy at 95% level.

117 Regression Dependent Variable: 1994 - 99 GDP per capita growth Significance Adj R 2 Measure of National Business at 95% level Environment Intensity of local competition at 95% level. 117 Regression Dependent Variable: 1999 GDP per capita Significance Adj R 2 Measure of National Business at 95% level Environment Effectiveness of antitrust policy at 95% level. 700 Intensity of local competition at 95% level. 320 Regression Dependent Variable: 1999 GDP per capita Significance Adj R 2 Measure of National Business at 95% level Environment Effectiveness of antitrust policy at 95% level. 320 .".. countries where the intensity of competition is rising showed by far the greatest improvement in GDP per capita". Source: M.E. Porter, "The Current Competitiveness Index: Measuring the Microeconomic Foundations of Prosperity", in The Global Competitiveness Report 2000 (Geneva: World Economic Forum, 2000).

Turning to analysis of the rate of growth in GDP per capita, the effectiveness of antitrust policy and the intensity of competition are again highly significant variables and contribute substantially to explained variance. Note that the proportion of variance in GDP per capita growth rate that can be explained is inherently less than for the level of GDP, because growth in GDP is more sensitive to a wide variety of shocks and shortterm macroeconomic influences. We find that the competition / antitrust policy measures are as or more associated with prosperity as transportation infrastructure, telecom infrastructure, IT readiness, and the like. In a first difference analysis, countries where the intensity of competition is rising showed registered the greatest improvement in GDP per capita.

All these findings are consistent: competition and a vigorous antitrust policy are strongly associated with national prosperity. This research provides some positive evidence of the importance of strong antitrust for prosperity. There is also ample negative evidence to be cited. For example, Japan is a country with a history of weak antitrust enforcement, legal cartels, and extensive government-sponsored collaborative research projects among companies. During the height of the Japanese economic miracle, the case of Japan was a principal argument advanced in the United States for weakening antitrust law - for example, in allowing potentially anticompetitive collaborative activity. 7 7 M.E. Porter, H. Takeuchi & M. Sakakibara, Can Japan Compete?

(2000). DRAFT VERSION: 07/22/02 Page 6 Yet one of the major findings of a recent book is the steep price that Japan has paid for a lax antitrust policy. 8 Our research revealed that weak antitrust enforcement did not explain Japanese competitiveness, but was in fact an explanation for why certain industries in Japan were uncompetitive. Industries where competition was limited by Japanese government policy were uncompetitive. We also collected data on all the legal cartels in post-World War II Japan, and found that the industries in which cartels occurred were, with few exceptions, uncompetitive. We also collected data on all government-sponsored cooperative research projects, which involved several if not most industry competitors.

We found that those industries in which cooperative research projects occurred were no more likely than the average industry to be competitive, and many cooperative research projects actually worked against industry competitiveness. There have been many collaborative projects in the West involving multiple industry competitors growing out of the efforts to emulate the Japanese case, such as the electric vehicle project. With few if any exceptions, these have proven disappointing. The notion that Japan was competitive because of weak antitrust is resoundingly rejected.

Figure 2 highlights some additional data drawn from our study of Japan. We explored the relationship between the intensity of domestic competition and world export share in a broad sample of Japanese industries. All of the industries considered were global in scope. Industries able to command a high world export share were decreed to be highly productive. Instead of relying on market structure measures such as seller concentration to proxy the intensity of competition, we used the extent of fluctuations in domestic market share among leading firms over an 18-year period. The fluctuation in market share among leading competitors - controlling for outside shocks - provides a direct and far more compelling indication of the intensity of competition.

9 We found that domestic market share variability was by far the most powerful influence on Japanese world export share, dominating conventional measures of comparative advantage such as skilled labor intensity and capital intensity. The intensity of competition at home, then, was the strongest influence on Japanese competitiveness abroad. These statistical findings are consistent with hundreds of industry case studies that have been conducted on the determinants of competitiveness at the country level, as well as research on national and regional economic development. 10 Interestingly, we found that seller concentration had no significant relationship with Japanese world export share.

11 Nor was it significantly correlated with the extent of 8 Id. See also M. Sakakibara & M.E. Porter, "Competing at Home to Win Abroad: Evidence from Japanese Industry", 83 Review of Economics and Statistics 310 (2001). 9 See generally R. Caves & M. Porter, "Market Structure, Oligopoly, and Stability of Market Shares", 26 Journal of Industrial Economics 289 (1978). For a detailed application to Japan, including definitions, sources of data, cause and effect issues, see Sakakibara & Porter, supra note 8.10 See, e. g., "Clusters and Competition: New agendas for Companies, Governments, and Institutions" in M.E. Porter, On Competition (1998), which contains an extensive bibliography. 11 Sakakibara & Porter, supra note 8. DRAFT VERSION: 07/22/02 Page 7 domestic market share fluctuations.

These results are consistent with other research which raises doubts about the use of seller concentration as a proxy for the vitality of competition. 12 Figure 2 Competition and International Competitiveness: Evidence from Japanese Industry Competitiveness Competitiveness Local Competition Local Competition o Measured by World Export Share o Measured by Fluctuations in Domestic Market Share Sakakibara / Porter: "We find a positive and highly significant relationship between the extent of market share fluctuations [a measure of local rivalry] and trade performance Contrary to some popular views, our results suggest that Japanese competitiveness is associated with home market competition, not collusion, cartels, or government intervention that stabilize it". Source: M. Sakakibara & M.E. Porter, "Competing at Home to Win Abroad: Evidence from Japanese Industry", 83 Review of Economics and Statistics 310,318,319 (May 2001). II.

3. Importance of Local Competition 13: Externalities, cluster theory, and the link between clusters and innovation The Japanese research and other evidence suggest that, contrary to popular belief, local competition matters in global industries. Even where firms compete across borders, the configuration of locally based competitors and the vitality of competition in the local market are crucial to productivity and competitiveness. Local competition creates numerous positive externalities for industries and industry clusters, thus explaining its significant impact on firm competitiveness. Many industries can be considered global in competitive scope, which is often taken to imply that a firm's location is of no importance to the health of competition. Yet the actual distribution of firms belies this view.

We observe a strong tendency for successful 12 See, e. g., K. Ewing, "The Soft Underbelly of Antitrust", Antitrust Report, Sept. 1999 at 2; B. Harris & D. Smith, "The Merger Guidelines vs. Economics: A Survey of Economic Studies", Antitrust Report, Sept. 1999 at 23; C. Weller, "An Evolution of the Merger-JV Guidelines: The Productivity Paradigm As A Positive Antitrust Policy for Competitiveness and Prosperity", American Bar Association, Perspectives of the Task Force on Fundamental Theory (forthcoming, 2001). 13 It should be noted that the term local can apply to geographic areas ranging from a small county to a group of neighboring countries. The relevant economic area depends on geographic distance and the scope of local externalities. DRAFT VERSION: 07/22/02 Page 8 firms in a particular industry to cluster in particular countries, often along with firms in related industries.

The schematic map of the U.S. clusters in figure 3 shows that geographic clustering can occur even in sub-national regions within countries. This ubiquitous phenomenon reveals powerful insights into the role of location in healthy competition. Figure 3 Selected Regional Clusters of Competitive U.S. Industries Omaha Telemarketing Hotel Reservations Credit Card Processing Wisconsin / Iowa / Illinois Agricultural Equipment Detroit Auto Equipment and Parts Rochester Imaging Equipment Western Massachusetts Polymers Boston Mutual Funds Biotechnology Software and Networking Venture Capital Hartford Insurance Providence Jewelry Marine Equipment New York City Financial Services Advertising Publishing Multimedia Pennsylvania / New Jersey Pharmaceuticals North Carolina Household Furniture Synthetic Fibers Hosiery Dalton, Georgia Carpets South Florida Health Technology Computers Nashville / Louisville Hospital Management Baton Rouge / New Orleans Specialty Foods Southeast Texas / Louisiana Chemicals Dallas Real Estate Development Wichita Light Aircraft Farm Equipment Los Angeles Area Defense Aerospace Entertainment Silicon Valley Microelectronics Biotechnology Venture Capital Cleveland / Louisville Paints & Coatings Pittsburgh Advanced Materials Energy West Michigan Office and Institutional Furniture Michigan Clocks Carlsbad Golf Equipment Minneapolis Cardio-vascular Equipment and Services Warsaw, Indiana Orthopedic Devices Colorado Computer Integrated Systems / Programming Engineering Services Mining / Oil and Gas Exploration Phoenix Helicopters Semiconductors Electronic Testing Labs Optics Las Vegas Amusement / Casinos Small Airlines Oregon Electrical Measuring Equipment Woodworking Equipment Logging / Lumber Supplies Seattle Aircraft Equipment and Design Boat and Ship Building Metal Fabrication Boise Sawmills Farm Machinery Firms cluster in particular locations not because of traditional comparative advantages stemming from natural resources or pools of cheap labor. Rather, they obtain competitive advantages by locating in areas benefiting from the strong presence of other firms in the industry, firms in related industries, and the presence of specialized inputs, information, and institutions.

The explanation for geographic clustering is that local competition provides an exceptional stimulus to productivity growth that is extremely valuable to firms. The two major contributions of local competition are: 1. Incentive and Informational Benefits: The immediate presence of a rival stimulates greater comparison, improvement, and upgrading versus competing with a firm in a foreign country. Companies that compete at home are better prepared to compete with foreign rivals abroad. 2. Positive Externalities: Geographic proximity of rivals generates otherwise unattainable positive externalities, such as a specialized labor pools, knowledge spillovers, specialized supplier formation, etc. discussed below.

DRAFT VERSION: 07/22/02 Page 9 The Positive Externalities of Local Rivalry. Competition creates positive externalities for the local business environment that boost productivity for the entire industry, and often for related and supporting industries in the same location as well. A group of competing local rivals tends to spawn a base of local suppliers and providers of specialized support services. This boosts productivity by reducing transactions costs, facilitating the exchange of information, increasing flexibility, and speeding innovation.

Local rivalry also works to increase the local availability of specialized skills, infrastructure, scientific and technical resources, and other assets and institutions that boost productivity and raise the rate of productivity growth. As these externalities deepen, they can foster new entry and spinoffs, coming full circle to reinforce local rivalry. Such externalities are what give rise to what I term clusters, or geographic concentrations of interconnected companies and institutions in a particular field. California wine provides a good example of a cluster (see figure 4). There are hundreds of wineries in California, but also thousands of independent growers of grapes.

All the inputs, production equipment, and services required to grow grapes and produce wine are available locally. Local universities and other institutions provide ample skilled labor and technological information. As a result, the productivity of California as a wine producing region in terms of yield per acre appears to be the highest in the world, and firms command high prices per bottle for their premium-quality products. The rate of productivity growth has been rapid, as California wine companies upgraded from jug wine to super premium segments. Figure 4 The California Wine Cluster Educational, Research, & Trade Organizations (e.g. Wine Institute, UC Davis, Culinary Institutes) Educational, Research, & Trade Organizations (e.g. Wine Institute, UC Davis, Culinary Institutes) Growers / Vineyards Growers / Vineyards Wineries / Processing Facilities Wineries / Processing Facilities Grapestock Grapestock Fertilizer, Pesticides, Herbicides Fertilizer, Pesticides, Herbicides Grape Harvesting Equipment Grape Harvesting Equipment Irrigation Technology Irrigation Technology Winemaking Equipment Winemaking Equipment Barrels Barrels Labels Labels Bottles Bottles Caps and Corks Caps and Corks Public Relations and Advertising Public Relations and Advertising Specialized Publications (e. g., Wine Spectator, Trade Journal) Specialized Publications (e. g., Wine Spectator, Trade Journal) Food Cluster Food Cluster Tourism Cluster Tourism Cluster California Agricultural Cluster California Agricultural Cluster State Government Agencies (e. g., Select Committee on Wine Production and Economy) DRAFT VERSION: 07/22/02 Page 10 Source: M.E. Porter, On Competition (1998), at ch. 7.

Other well-known examples of U.S. clusters include the Silicon Valley IT cluster, the Houston oil and gas cluster, and the Boston area biopharmaceuticals and mutual fund clusters. The Global Competitiveness Report includes measures of the quality and quantity of local suppliers and, in the 2000 report the extent of clusters in a national economy. All three variables have a strong positive association with GDP per capita. Taking into account the essential benefits of local competition leads to the conclusion that antitrust analysis should weigh not just the generalized benefits of rivalry for productivity growth but also the systemic benefits of local rivalry. When local rivalry is muted, a nation pays a double price. Not only will companies face less pressure to be productive, but the business environment for all local companies in the industry, their suppliers, and firms in related industries will become less productive.

This demonstrates in particular the danger in arguments about the creation of "national champions" in an industry in the home country in order to gain the scale to compete internationally. Unless a firm is forced to compete at home, it will usually quickly lose its competitiveness abroad. Local competition matters for productivity and productivity growth, even in industries whose geographic scope is global. 14 Note that no mention has been made of the ownership of the locally based firms.

This is because ownership has much less importance for externalities than the nature of the activities undertaken in a given location. All firms in a given location must be considered part of the cluster, not merely the domestic ones. Special weight for competition derives from locally based entities that have significant development, production, and other activities located in a nation. These offer far greater potential for externalities than does competition from imports.

Trade is not a full substitute for local competition. 14 See, e. g., The Global Competitiveness Report 1998 (various authors) (Geneva: World Economic Forum, 1998); The Global Competitiveness Report 1999 (various authors) (Geneva: World Economic Forum, 1999); The Global Competitiveness Report 2000 (various authors) (Geneva: World Economic Forum, 2000). DRAFT VERSION: 07/22/02 Page 11 - THE GOALS AND TOOLS OF ANTITRUST POLICY. 1. New Standard for Antitrust: Productivity Growth Since the role of competition is to increase a nation's standard of living and long-term consumer welfare via rising productivity growth, the new standard for antitrust should be productivity growth, rather than price / cost margins or profitability. All combinations or practices scrutinized in antitrust should be subjected to the following question: how will they affect productivity growth?

If a merger, joint venture, or other arrangement will significantly enhance productivity growth, it is probably good for society and for consumers (as well as the firms involved). Transactions with dubious benefits for productivity growth, or those that offer only a one-time productivity benefit, are likely to be net negatives for society if they pose any risk to the overall health of competition. This is because competition is a primary determinant of future long-term productivity growth. How would the productivity growth standard affect antitrust?

The current explicit and implicit goals of U.S. antitrust policy fall roughly into the following hierarchy (see figure 5). Drawing on Welfare theory, the primary focus in U.S. antitrust for the last twenty years has been on limiting price / cost margins or firm profitability (allocative inefficiency) as the most important outcome for consumers. Market power is seen as giving firms the ability to elevate prices and sustain high margins. Hence, limiting market power is the major focus of attention. Figure 5 Goals of Antitrust Policy Traditional View Alternative View Profitability / Price-Cost Margins (allocative efficiency) Cost reduction (static efficiency) Cost (static efficiency) Innovation (dynamic efficiency) Innovation (dynamic efficiency) Value improvement (static productivity) Profitability / Price-cost margin standard Productivity growth standard Profitability / Price-Cost Margins (allocative efficiency) Second in importance in antitrust evaluations has been cost or technical efficiency. The efficiency justification can be used to offset a finding of market power to elevate DRAFT VERSION: 07/22/02 Page 12 margins.

At the bottom of the current hierarchy is innovative ness, or the rate of dynamic improvement. The effect of mergers or competitive practices on the overall rate of innovation is usually only paid lip service. If these three goals are tested against the productivity growth standard, it becomes clear that the traditional hierarchy of goals should be reversed. Because of its direct effect on productivity growth, the most important goal for society is a healthy process of dynamic improvement, which requires innovations in products, processes, or ways of managing. If the rate of dynamic improvement is healthy, over time this dominates static technical and allocative efficiency concerns. For example, a faster rate of innovation in new approaches overwhelms static economies of scale in existing approaches, particularly in an age where knowledge-based competition is the rule.

A productivity growth standard suggests that technical (static) efficiency should be the second most important goal, but that it must be assessed with more subtlety. While antitrust analysis tends to focus on cost justifications, equal attention should be paid to product or service value. Roughly speaking, productivity is price times quantity divided by the quantity of labor or capital involved. It can be divided into two distinct components: the prices that products command in the marketplace (which reflect value) and the efficiency with which a unit of product can be produced.

Thus, productivity is enhanced not just by efficiency improvements, but also by improvements in product quality, features, and services. Product variety is also an essential component of value, giving customers more choices to better meet their particular needs. High-value products provide the consumer with superior performance and features, and therefore justify higher prices. With a focus on price / cost margins, however, high prices are often seen as inherently undesirable for consumers.

Higher prices should be a danger sign in antitrust analysis only if they are not justified by rising customer value. Limiting short-term price / cost margins or profitability is a dubious goal for antitrust. Firm profitability is a good thing if it reflects truly superior products or significant advantages in process technology or operating efficiency. It is a bad thing if it occurs in the absence of a healthy rate of dynamic improvement. In a typical industry, average price-cost margins and profitability will vary significantly among competitors, reflecting varying levels of fundamental competitiveness.

Short-term consumer welfare measured by price, then, is a dubious goal on two levels. First, it fails to measure true consumer welfare by ignoring product value. Second, we care much more about the long-term trajectory of value, prices, and costs than we do about consumer welfare in the short run or immediately after a merger. Moreover, a productivity growth standard is entirely consistent with the language of the main antitrust laws.

Benefits of a Productivity Growth Standard. Why is the productivity growth standard different and important for antitrust? First, it is a positive standard that relates directly to DRAFT VERSION: 07/22/02 Page 13 competitiveness, a nation's standard of living, and long-term consumer value, while price / cost margins and technical efficiency are theoretically suspect. Productivity growth is also more understandable and palatable to managers. Imagine how much more constructive it would be for corporations and their attorneys to debate whether a merger will boost productivity growth rather than continuing to debate the size of HHI. Second, a productivity growth standard would shift antitrust away from a narrow focus on static, short-term consumer welfare to a dynamic and more all-encompassing view of competition and its benefits to consumers, firms, and society as whole.

Defining the goal of antitrust in terms of price / cost margins and profitability creates a zero-sum game between firms and consumers. If consumers are to benefit from lower prices, firms must earn lower profits. In contrast, a productivity growth standard raises no inevitable trade-off. If productivity is growing, consumers can enjoy better products and / or lower prices, companies can earn attractive returns on capital, and workers can enjoy rising wages.

A productivity growth standard, then, unites the perspectives of consumers, workers, and companies. It embodies a positive sum rather than a zero-sum view of competition. An approach to competition based on productivity growth will lead to outcomes that benefit consumers far more than a shortsighted concern with static profitability. Finally, productivity growth addresses the reality of high-technology industries and the so-called new economy by highlighting the fundamental importance of innovation. While there are few true conceptual differences between the "new" and "old" economies, the apparent mismatch between the static focus of antitrust and the rapid change in technology-intensive industries has undermined antitrust's legitimacy.

Since innovation is the basic driver of productivity growth, promoting and protecting it should be central.. 2. Analysis of competition How would the productivity standard be applied in practice? The best way to attain maximal productivity growth in an industry is to ensure that industry competition is healthy, since competition determines long-term productivity growth. It is possible to measure past productivity growth in various ways, and we advocate that this become part of antitrust analysis. However, predicting future productivity growth is more difficult.

Hence, there is a need for tools to assess the likely future health of competition, since this will be the single most important factor in whether future gains in productivity will reach their potential.. 2.1. Measuring the health of industry competition: Five Forces Analysis To measure the health of competition in practice, we agree with those who believe that seller concentration, the number of firms in a market, and profitability are not very good indicators. 15 They capture only part of a complex phenomenon and divert analyses 15 See, e. g., Ewing, supra note 12; Harris & Smith, supra note 12; Weller, supra note 12. DRAFT VERSION: 07/22/02 Page 14 of competition to much less productive debates over where to draw relevant market boundaries.

Instead, a broader approach is necessary. One such approach with acceptance in business practice is the "five forces" analysis of the intensity of competition. The Five Forces Model. 16 The five forces model is a dynamic approach to analyzing industry structure, based on five competitive forces acting in an industry or sub-industry: threat of entry, threat of substitution, bargaining power of buyers, bargaining power of suppliers, and rivalry among current competitors. 17 This approach, with roots in industrial economics but moving beyond its narrower interpretations, posits that competition in an industry is broader than price, and includes product features, services, and processes.

Competition is also seen as driven by many influences. The five forces framework seeks to encompass all the important dimensions of competition (see figure 6). It embodies the notion that competition is much broader than just rivalry, where seller concentration (HHI) analysis is focused. Any of the five forces can be significant in determining the health of competition, depending on the particular industry. For example, the power of customers to push down price or pressure improvements in service can be just as important to productivity growth as the number and size distribution of competitors in the market.

18 Five forces theory also argues that for any one of the competitive forces, the causes of competitive intensity are multidimensional. In assessing the intensity of rivalry, for example, seller concentration does have a role, although our interpretation would focus more on the balance of competitors (the more balanced, the more rivalry). But the intensity of rivalry also depends on a series of other dimensions, including, for example, the industry cost structure. Where variable costs are low, strong pressures are created to cut price in order to contribute to fixed cost. With such a cost structure, even a concentrated industry can exhibit strong rivalry. Switching costs are another important influence on rivalry.

Where it is easy for customers to shift from one supplier to another, the effect of concentration is mitigated. The five forces methodology involves analysis on an industry-by-industry basis, and does not rest on the determination of the relevant market. Every industry is different, 16 There is an extensive literature on five forces analysis that is beyond the scope of this article to summarize here. The early references are M.E. Porter, Inter brand Choice, Strategy, and Bilateral Market Power (1976); M.E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (1980). 17 Brandenburger and Nalebuff have appropriately stressed the role of complementary products in competition, and some have suggested complementary products as a sixth force (A. Brandenburger & B. Nalebuff, Co-o petition, (1996) ). However, complementary products do not directly influence the health of competition, but affect it indirectly through the influence of complements on the five forces.

The presence of a complementary product is neither good nor bad for competition per se. It depends on how the complement influences, for example, barriers to entry or the power of the customer. 18 There is substantial empirical support for the importance of this broader set of industry attributes for competition. DRAFT VERSION: 07/22/02 Page 15 both in terms of the relative influence of the forces and the array of drivers of each force.

This approach, which squares with actual industry competition, has been well accepted in corporate practice and in management consulting firms to assess the nature of industry competition. Figure 6 Assessing the Health of Competition: Five Forces Framework Threat of Substitute Products or Services Threat of New Entrants Rivalry Among Existing Competitors Bargaining Power of Suppliers Bargaining Power of Buyers Source: M.E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors 187 (1980). Many of the elements of the five forces approach have been known to or used in economics for a long time. Also, many of the considerations raised in the five forces model appear somewhere in current merger analysis.

Five forces analysis is different in how, when and why the model is applied. Current antitrust analysis first determines the relevant geographic and product market, then uses its tools to analyze competitive effects. Current analysis starts with seller concentration as the principal metric. Other considerations are brought in, both only later and secondarily.

Five forces analysis, on the other hand, avoids the first step by going straight to analyzing competitive effects in any and all submarkets deemed relevant by customers and competitors. It views seller concentration as only one and not the most important determinant of rivalry. It brings in all five forces as equally important. Finally, it does not rely heavily on price and quantity as the principal indicators of welfare.

By assessing competition beyond existing rivals, the need is reduced for debates on where to draw industry boundaries, or the relevant market in antitrust terms. Any definition of a market is essentially a choice of where to draw the line between established competitors and substitute products, between existing firms and potential entrants, and between existing firms and suppliers and buyers. If these influences on competition are all recognized, and their relative impact assessed, as they are in five forces analysis, then where the lines are actually drawn becomes more or less irrelevant to strategy formulation and, I suggest, the antitrust analysis of competition. Latent sources of competition will not be overlooked, nor will key dimensions of competition. The need to determine the relevant market is eliminated. DRAFT VERSION: 07/22/02 Page 16 While there is a systematic approach to market definition defined in the Merger Guidelines, it begins with the questionable premise that a single market definition is a meaningful concept.

Moreover, the approach to market definition relies heavily on price effects which are an incomplete measure of social benefit, not to mention a largely shortterm and static one. Productivity Growth and Forms of Competition. The multidimensional nature of rivalry is important for understanding the link between rivalry and productivity. Some forms of rivalry are more productivity-enhancing than others, and thus are more valued socially. For example, one can array types of rivalry along a spectrum including the following (see also figure 7): 1. Competition based on imitation / price discounting 2.

Competition based on strategic positioning. The first type of competition is on operational effectiveness, or the extent to which companies approach best practices in areas such as production processes, technologies, marketing methods, and management techniques. The second, and more fundamental to success in an advanced economy, is competition to create different value propositions for customers, a function of the degree to which companies have distinctive strategies. Figure 7 Rivalry and Productivity Growth Imitation and Price Discounting Strategic Rivalry o Homogeneous products / services at low prices o Multiple, different value propositions - e. g., features, services, processes, price levels o Different approaches to design, operations, marketing, etc. "Zero sum competition"Positive sum competition" o Incremental cost improvements o Potential for fundamental process improvements o Lots of customer choice o Expanded market o Little true customer choice o Imitate best practices Assessing the two according to the productivity growth standard gives very different results.

Imitation-based competition leads to similar products among rivals and strong pressures for price discounting. Strategic competition occurs when rivals pursue different DRAFT VERSION: 07/22/02 Page 17 value propositions: some firms offer low prices producing stripped down products, others have higher prices but provide better service, while still others concentrate on various segments of the market, tailoring their products and value chains accordingly. If price / cost margins are used as the metric of social benefit, then imitation and price discounting seem ideal. Customers get the benefit of low prices, and the ability to play one company against others.

From a productivity growth standpoint, however, this form of competition may lead to slower dynamic improvement. Competition on strategic positioning can foster increased variety and greater choices for customers in terms of the product that best meets their needs, not to mention more innovation in products and processes. In strategic competition, markets often expand as new needs are met and new customers are drawn into the market. It is important to note that internationally competitive, advanced nations have more innovation- and differentiation-based competition, while less competitive nations tend to compete on imitation and price.

19 This analysis leads to the controversial conclusion that holding down profitability is the wrong issue for society. Profitability has a contingent relationship with productivity growth. The American software industry is far more profitable than the software industries in other countries, but it is also far more productive and internationally competitive. High profits are fine, provided competition is healthy and there are strong pressures for dynamic improvement. The productivity growth standard, then, casts new light on how we assess competition. It reveals the importance of understanding the kind of competition a nation should really be looking for.. 2.2.

Measuring the health of local competition: The Diamond framework As has been argued, it is not sufficient to consider only industry competition generally. We must also have a means of gauging the health of local competition. Here, one such approach to assessing the potential productivity of a local business environment is embodied in the so-called diamond framework. 20 The productivity of a national business environment can be modeled using four interacting components that can be depicted as a diamond (see figure 8). These are: 1. Context for firm strategy and rivalry 2.

Factor (input) conditions 3. Demand conditions 19 For supporting statistical findings, see Porter, supra note 5. Results are similar in previous years' reports. See the full The Global Competitiveness Reports for 1998, 1999 & 2000; and Porter, Takeuchi & Sakakibara, supra note 7.20 M.E. Porter, The Competitive Advantage of Nations (1990).

For the empirical application of Diamond theory to 59 countries, see The Global Competitiveness Report 2000, at 40-58,101-221, including data definitions and sources at 223-333. For 1998 and 1999, see The Global Competitiveness Report for those years. For an extensive empirical application of Diamond theory to Japan, see Porter, Takeuchi & Sakakibara, supra note 7. DRAFT VERSION: 07/22/02 Page 18 4.

Related and supporting industries Like the five forces, this framework aims to capture the many influences on the productivity of the local business environment in an industry or overall. Rivalry among locally based competitors is not only important to productivity growth directly but also creates positive externalities for the local business environment. A group of competing local rivals helps customers become more knowledgeable and competitive, encourages more specialized suppliers to develop, and enhances the local supply of high-quality, specialized inputs. This gives rise to a series of new questions that must be addressed in analyzing the impact on competition of a merger or other competitive practice, which will be discussed below. Figure 8 The Externalities of Rivalry: Locational Determinants of Productivity and Productivity Growth Related and Supporting Industries Related and Supporting Industries o Open and vigorous competition among locally based rivals o Rivalry among locally-based competitors is not only important directly but also creates positive externalities for the local business environment Context for Firm Strategy and Rivalry Context for Firm Strategy and Rivalry Factor (Input) Conditions Factor (Input) Conditions o Sophisticated and demanding local customer (s) whose needs anticipate those elsewhere o Unusual local demand in specialized segments that can be served globally o Presence of capable, locally based suppliers and firms in related fields Demand Conditions Demand Conditions o A local context that encourages investment and sustained upgrading o Availability of high quality and specialized inputs Source: M.E. Porter, The Competitive Advantage of Nations 133 (1990). DRAFT VERSION: 07/22/02 Page 19 IV.

EVALUATING MERGERS AND JOINT VENTURES IV. 1. Why mergers should be of particular concern for antitrust Where productivity growth is the central goal of antitrust, it becomes clear that mergers should be treated with special caution compared to other corporate growth strategies. This is true for five reasons: First, mergers raise almost inevitable issues for the health of competition by removing independent competitors from the market. The question is not whether there is a risk to competition, but how much. This risk stems from the potential lessening of competitive pressure among firms in the industry, the potential reduction in product choice and variety, and the reduction in the number of different approaches being pursued to product / process development and hence the likelihood of innovation.

Second, a merger requires no "skill, foresight, and industry", 21 only financial resources. It demands no new strategy, and yields no automatic productivity improvements. By contrast, introducing a new product, changing a distribution model, or building a new plant are far more likely to boost productivity. Society, then, should be biased in favor of independent company actions over mergers. Third, the empirical evidence is striking that mergers have a low success rate. A wide range of studies finds that most mergers do not meet expectations, and most of the profits are captured by the seller, not the buyer.

Fourth, the strategy literature suggests that smaller, focused acquisitions are more likely to improve productivity than mergers among leaders. When a large company buys a small company and integrates it into its strategy, major productivity gains are possible. Mergers among large companies appear to rarely yield such benefits, though they may produce reduction in joint overhead and eliminate major competitors from a market. Fifth, there are strong financial market pressures favoring mergers over other growth strategies. These arise at least in part from agency problems afflicting both investment managers compensated based on near term stock price appreciation, and company executives given incentives with stock options. Finally, accounting rules make merger a vehicle for distorted performance measurement, creating artificial pressures for companies to merge.

We cannot assume that a merger will be efficient and profitable just because companies propose it. Companies make mistakes. Every merger needs to be weighed against the productivity growth standard. Indeed, a positive antitrust policy based on 21 U.S. vs. Aluminum Co. of America, 148 F. 2d 416,430 (2d Cir.

1945) (Hand, J. ). DRAFT VERSION: 07/22/02 Page 20 productivity growth might actually enhance both the performance of companies and consumer welfare, which would be even better for society. IV. 2. Towards a New Merger Evaluation Process In dealing with a proposed merger, the primary concern for antitrust should be how the merger, if allowed, would affect productivity growth. We must consider both likely future productivity growth in the industry, as well as the near term productivity impact on the merged firms.

The effect of the merger on the health of competition will be central to its likely productivity impact, net of any direct positive productivity growth impacts that can be convincingly demonstrated. Three Levels of Analysis. In analyzing a merger or joint venture then, the three basic levels of analysis needed are: 1. Merger significance and baseline productivity growth analysis. 2. The effect of the transaction on the health of competition using the five forces and the diamond framework in all significant markets and submarkets that are relevant based on industry and customer practice.

3. A risk / reward analysis of the merger, where its effect on the health of competition is weighed against proposed direct benefits using the productivity growth standard. IV. 2.1. Significance and Baseline Productivity Growth Analysis This analysis can be broken up into three principal tasks: (1) identifying the set of relevant markets and submarkets and the relevant geographic area; (2) determining whether or not the firm meets a predetermined combined market share cutoff in the relevant markets and submarkets; and if so, (3) establishing the baseline productivity performance of the industry and the firms party to the transaction.

Step 1. Rather than going through the lengthy and controversial exercise of trying to define the market affected by a merger, this new merger evaluation process is applied to all relevant markets and submarkets. There are usually a number of economically relevant market definitions, and each of these is considered. In determining plausible markets or submarkets, three practical criteria can be helpful: 1. How the industry itself defines submarkets 2.

How consumers segment the market 3. Whether there is a competitor focused on the submarket (i. e., a focused company dedicated only to serving the submarket, which suggests that it is a viable array of products, varieties, and customers with distinct needs) DRAFT VERSION: 07/22/02 Page 21 Once all plausible markets and submarkets have been identified, the geographic area over which local externalities apply is determined. Note that the relevant geographic area is not based on the geography of sales, but on the externalities in production. The starting assumption is that the geographic unit is the national economy.

In some industries, the relevant geographic area can be smaller than a nation. Clusters occur within a region or metropolitan area. In some cases, externalities can cross national borders of immediate neighboring countries. Step 2. To invest the resources required to investigate a particular merger or joint venture, some significance threshold is inevitable. We advocate a relatively low minimum market share threshold of, say, 25 percent combined share in any submarket (discussed below).

Such a threshold will conserve resources and screen out transactions where the probability of material impact on competition is small. There is no contradiction between this cut-off level and our rejection of seller concentration as a measure of market power. We use concentration solely as a significance indicator. A merger involving a small portion of any submarket is unlikely to raise important a.