Broken Symmetry

FTC Sues Intel Under Section 5 of the FTC Act

The complaint, statements, and new release from the FTC are here.

If you're around in Silicon Valley this morning, you can try to crash the Association of Corporate Counsel event I helped put together. Joe Farrell from the FTC will be dialing in and Mark Lemley, Peter Menell, and Aaron Thacker will be talking about IP & Antitrust.

Rolfe Winkler Looks Like a Major New Blogging Talent

From his post "Markets need rules":

Anyone in business knows how much trust matters on both sides of any transaction. When trust disappears, transactions stop. The market breaks down and individuals are forced to rely on themselves. In a perfectly free market, where economic Darwinism means competition always trumps cooperation, trade quickly grinds to a halt.

No one wants this. As economist Russell Roberts has argued, “self-sufficiency is the road to poverty.”

Laws align incentives so that cooperation can be more profitable than competition. So that individuals in the free market don’t have to worry about the market eating them alive.

Winkler's take is slightly different than mine. What I would (and did) say is this:

What Adam Smith taught us is that cooperation is the source of endogenous growth within an economy. Voluntary exchanges and divisions of labor literally create wealth within society. When it's money rather than goods or services that are exchanged, residual income (i.e., profit) is an excellent proxy for cooperation and endogenous growth. In fact, it's the best the world has ever known.

Crucially, the argument is that cooperation creates wealth, and that laws (or social norms) promote wealth creation to the extent that they facilitate and encourage cooperation. This claim may be quite counterintuitive to competition regulatory authorities, in particular, because much of competition regulatory theory is premised on the notion that competition is the engine of growth, with a few recognizing exceptions for temporary and otherwise limited monopolies (for example, for intellectual property). Winkler falls into the same trap by treating cooperation and competition as dichotomous. Competitions are simply one way to get people to cooperate.

Consider the facts of the American Needle case, for example. An unfettered market for NFL souvenirs is one form of private cooperation. The NFL IP licensing group is another. Both are procompetitive and anti-competitive, but among different stakeholders. NFL IP Licensing group promotes competition among professional leagues (MLB, NHL, etc.). A free market among manufacturers and distributors promotes competition among NFL teams, and probably lower prices and lower average quality in souvenirs overall. The question, which I think the Seventh Circuit got right, is what kind of cooperation/competiton we want to promote. The institution of market competition merely pushes people to differentiate or operate with more efficiency. When the market is already operating at peak technological efficiency and peak diversity, competition will be degrading and wasteful.

More fundamentally, the divisons of labor and voluntary exchanges that create wealth are acts of cooperation. In some cases, competiton is necessary to close the gap between bids and asks. In others, there are enough levers on the transaction such that competition isn't necessary to get overlap. In cases where transactions are occurring despite lack of competition, government should be careful not to destroy social capital -- often hard won over generations. That was Ellickson's central insight.

Functionalism and Systems Theory and the Supreme Court's Upcoming Review of American Needle

(If you need background on the case, skip to the * * * * * below.)

For proponents of functionalism and systems theory, there is no more important case before the Supreme Court right now.

Robert Ellickson is perhaps most famous for showing how the Coase Theorem does not hold among ranchers in rural Shasta County in California. His explanation is that shared cultural values are more important than legal rules in many particular social contexts. What the Seventh Circuit has done in American Needle is prevent antitrust law from interfering with privately evolved social norms of cooperation. The theory that individuals can evolve into groups with common norms is part of the sociological theory of functionalism.

In an earlier post on Robert Ellickson's Order Without Law, I pointed out how Ellickson's reasons and evidence for dismissing functionalism as a useful and valid part of systems theory are no longer sound. First, Ellickson rejected functionalism because of a fight among evolutionary biologists that was going on contemporaneous with his publication of Order Without Law. Functionalism is enjoying a resurgence among some evolutionary biologists, notably including E.O. Wilson, whom Ellickson cites in Order Without Law as an opponent of group selection theory. Wilson and Holldobler recently published, The Superorganism, which lays out a functionalist theory of group selection for how cooperation evolved among insects.

Second, there are now better theoretical tools for getting quantitative about functionalism. In particular, associating a group with a network, and individuals with nodes therein, permits evolution of group behavior to be modeled using mathematical models for network growth and decay, or phase transitions. Such models help to eliminate much of the conceptual circularity to which Ellickson objects in this passage.

The upshot is that social norms can evolve to facilitate group cooperation. These norms, in turn, can play a huge role in promoting health and economic growth. The case of IP licensing by the NFL is an easy example of the economic benefits of cooperation. Competition among the teams for licensing revenue -- which I understand is the norm among MLB teams -- leads to less social benefit for consumers and less revenue for the league. In many contexts, cooperation creates wealth that competition would destroy.

This is not to say that there is no role for antitrust regulation. The point is that regulators should not rely on the prescription of methodological individualists (including, most notoriously, neoclassical economists) that competition is a uniform good. Neither perfect competition nor perfect cooperation is optimal for a society. We must find a balance in which enough competition is permitted to allow existing relationships to be broken so that new experiments with resources, capital, and people can be tried. But we should remember that these experiments have an opportunity cost of stability and efficiency, which is too expensive when there is no theory tested by the experiments.

The Seventh Circuit's ruling on the "single-entity" doctrine should be upheld by the Supreme Court. It is a sophisticated answer to the question of how functional groups should be defined. The Seventh Circuit refuses to accept the oversimple definition of a group as a particular group of people. Rather, the group is defined (as W. Edwards Deming suggests it must be) by its shared purpose. Each individual has many goals, but a group of individuals will have only as many as are shared by each individual within it. This counterintuitive fact accounts, to a considerable extent, for the success of neoclassical theory -- only a handful of goals are shared by large groups of people over long periods of time, with the rational pursuit of happiness being the most obvious.

Long time readers will appreciate why I feel this decision is so important for the future prospects of our country. But to give just one illustration, refer back to the description of the effects of individual versus group competition described in this earlier post on executive compensation:

Chickens have always lived in groups, and in the modern egg production industry they are crammed inhumanely into cages usually containing nine to twelve hens. [Biologist William Muir] wanted to increase egg production by selective breeding, and he tried to do it in two ways. The first method involved selecting the most productive hen from each of a number of cages to breed the next generation of hens. The second method involved selecting all the hens from the most productive cages to breed the next generation of hens. You might think that the difference between the two methods is slight and that the first method should work better. After all, it is individuals who lay eggs, so selecting the best individuals directly should be more efficient than selecting the best groups, which might include some individual duds. The results told a completely different story.

When Bill presented his results at a scientific conference that I attended several years ago, he showed a slide of hens selected by the first method after six generations.The audience gasped. Inside the cage were only three hens, not nine, because the other six hens had been murdered. The three survivors had plucked each other during their incessant attacks and were now nearly featherless... What happened? The most productive individuals had achieved their success by suppressing the productivity of their cagemates.

By contrast, the second method resulted in higher production, and a cage that looked almost happy. If group selection could have such a dramatic impact on egg production, what impact might they have on the characteristics of individuals and groups in other situations in which group selection criteria are at work?

What kind of world do we want to live in? There is more at stake in how the Supreme Court decides this case than seems to be apparent to most people.

* * * * *

Here's how the Seventh Circuit summarized the facts and record on appeal (see here for links):

For those who do not know, the NFL is an unincorporated association of (now) 32 separately owned and operated football teams that collectively produce an annual series (or “season”) of over 250 interrelated football games. Each season culminates in a championship game—a game better known as the Super Bowl. As such, the product that the teams produce jointly—NFL football—requires extensive coordination and integration between the teams. After all, NFL football is produced only when two teams play a football game. Thus, although each team is a separate corporate entity or partnership unto itself, no team can produce a game—the product of NFL football—by itself, much less a full season of games or the Super Bowl. Likewise, the teams’ individual success is necessarily linked to the success of the league as a whole; to put it another way, it makes little difference if a team wins the Super Bowl if no one cares about the Super Bowl.

Realizing that the success of the NFL as a whole was in their best interests, in the early 1960’s the individual teams sought to collectively promote the NFL Brand—that is, the intellectual property of the NFL and its member teams—to compete against other forms of entertainment. With this promotional effort in mind, in 1963 the NFL teams formed NFL Properties: a separate corporate entity charged with (1) developing, licensing, and marketing the intellectual property the teams owned, such as their logos, trademarks, and other indicia; and (2) “conduct[ing] and engag[ing] in advertising campaigns and promotional ventures on behalf of the NFL and [its] member [teams].” Among other things, the NFL teams authorized NFL Properties to grant licenses to vendors so the vendors could use the teams’ intellectual property to manufacture and sell various kinds of consumer products that bear the teams’ logos and trademarks—products such as team jerseys, shirts, flags, and, as pertinent here, headwear, like baseball caps and stocking hats.

For a while after its establishment, NFL Properties granted headwear licenses to a number of different vendors simultaneously; one of those vendors was American Needle, which held an NFL headwear license for over 20 years. But then in 2000, the NFL teams authorized NFL Properties to solicit bids from the vendors for an exclusive headwear license. Reebok won the bidding war, and in 2001 the NFL teams allowed NFL Properties to grant an exclusive license to Reebok for ten years. NFL Properties thus did not renew American Needle’s headwear license, or the licenses of the other headwear vendors.

American Needle responded to the loss of its headwear license by filing an antitrust action against the NFL, NFLProperties, the individual NFL teams, and Reebok. As relevant here, American Needle claimed that the exclusive headwear licensing agreement between NFL Properties and Reebok violated § 1 of the Sherman Antitrust Act, which outlaws any “contract, combination . . . or conspiracy, in restraint of trade.” 15 U.S.C. § 1. As American Needle saw it, because each of the individual teams separately owned their team logos and trademarks, their collective agreement to authorize NFL Properties to award the exclusive headwear license to Reebok was, in fact, a conspiracy to restrict other vendors’ ability to obtain licenses for the teams’ intellectual property. American Needle also contended that, by authorizing NFL Properties to award the license to Reebok, the NFL teams monopolized the NFL team licensing and product wholesale markets in violation of § 2 of the Sherman Antitrust Act. See id. § 2.

And here's how the Seventh Circuit ruled on the question of whether the NFL can be considered a "single entity":

American Needle first contends that the district court erred by granting the NFL defendants’ summary judgment on its § 1 claim. Specifically, American Needle argues that the district court incorrectly concluded that the NFL teams constitute a single entity under Copperweld when collectively licensing their intellectual property. American Needle’s argument leads us into murky waters. We have yet to render a definitive opinion as to whether the teams of a professional sports league can be considered a single entity in light of Copperweld. The characteristics that sports leagues generally exhibit make the determination difficult; in some contexts, a league seems more aptly described as a single entity immune from antitrust scrutiny, while in others a league appears to be a joint venture between independently owned teams that is subject to review under § 1. See Brown v. Pro-Football, Inc., 518 U.S. 231, 248-49 (1996) (“[T]he clubs that make up a professional sports league are not completely independent economic competitors . . . . In the present context, however, that circumstance makes the league more like a single bargaining employer . . . .”); Bulls II, 95 F.3d at 597-99 (“To say that the league is ‘more like a single bargaining employer’ than a multi-employer unit is not to say that it necessarily is one, for every purpose.”); see also Super Sulky, Inc. v. U.S. Trotting Ass’n, 174 F.3d 733,741 (6th Cir. 1999) (“[T]he notion of concerted action liability in the field of professional sports is at best confusing.”). For instance, from the perspective of fans, a professional sports league can be seen as “a single source” of entertainment that produces “one product,” even though the league’s member teams are distinguishable. Bulls II, 95 F.3d at 599. Yet at the same time, individuals seeking employment with any of the league’s teams would view the league as a collection of loosely affiliated companies that all have the independent authority to hire and fire employees. See Brown, 518 U.S. at 249 (noting that professional football players “often negotiate their pay individually with their employers,” NFL teams); Bulls II, 95 F.3d at 599 (“[F]rom the perspective of college basketball players who seek to sell their skills, the teams [in the National Basketball League (NBA)] are distinct . . . .”).

That being said, we have nevertheless embraced the possibility that a professional sports league could be considered a single entity under Copperweld. Bulls II, 95 F.3d at 598. But see Fraser v. Major League Soccer, L.L.C., 284 F.3d 47, 55-56 (1st Cir. 2002) (citing Sullivan v. Nat’l Football League, 34 F.3d 1091, 1099 (1st Cir. 1994), to note that Bulls II has not yet been adopted by United States Court of Appeals for the First Circuit). But because of the many and conflicting characteristics that professional sports leagues generally exhibit, we have expressed skepticism that Copperweld could provide the definitive single-entity determination for all sports leagues alike. See id. at 599-600. This skepticism, in turn, has led us to opine that the question of whether a professional sports league is a single entity should be addressed not only “one league at a time,” but also “one facet of a league at a time.” Id. at 600. Thus, in reviewing the district court’s decision, we will limit our review to (1) the actions of the NFL, its members teams, and NFL Properties; and (2) the actions of the NFL and its member teams as they pertain to the teams’ agreement to license their intellectual property collectively via NFL Properties.

With this compartmentalization of Copperweld in mind, we turn to American Needle’s challenge to the district court’s single-entity determination. According to American Needle, the district court applied the wrong legal standard when concluding that the NFL teams were a single entity. As American Needle sees it, the district court concluded “that the NFL [t]eams are a single entity because they ‘act’ as a single entity in licensing their intellectual property.” American Needle asserts that this approach undercuts the Supreme Court’s central teaching in Copperweld: that the Sherman Antitrust Act was designed to combat the deprivation of independent sources of economic power in the marketplace. See 467 U.S. at 469-71.

Therefore, American Needle continues, instead of asking whether the NFL teams merely “ ‘act’ ” as a single entity, the district court should have inquired into whether the NFL teams’ agreement to license their intellectual property collectively deprived the market of sources of economic power that control the intellectual property. That question, the company contends, can be answered by looking to whether the teams could compete against one another when licensing and marketing their intellectual property. If so, American Needle posits, then it is the individual teams who actually control their intellectual property, meaning that they cannot be considered a single entity for the purposes of licensing their intellectual property.

We agree with American Needle that the Supreme Court in Copperweld was concerned about the anti-competitive effects that collective action might introduce into the market. We further agree that when making a single-entity determination, courts must examine whether the conduct in question deprives the marketplace of the independent sources of economic control that competition assumes.

But we are not convinced that the NFL’s single-entity status in the present context turns entirely on whether the league’s member teams can compete with one another when licensing and marketing their intellectual property. American Needle’s proposed approach is one step removed from saying that the NFL teams can be a single entity only if the teams have “a complete unity of interest”—a legal proposition that we have rejected as “silly.” Bulls II, 95 F.3d at 598. As we have explained, “Copperweld does not hold that only conflict-free enterprises may be treated as single entities”; “[e]ven a single firm contains many competing interests.” Id. at 598 (discussing Robert G. Eccles, Transfer Pricing as a Problem of Agency, in Principals and Agents: The Structure of Business 151 (1985)). Thus, though the several NFL teams could have competing interests regarding the use of their intellectual property that could conceivably rise to the level of potential intra-league competition, those interests do not necessarily keep the teams from functioning as a single entity. Id. at 597-98. We therefore cannot fault the district court for not considering whether the NFL teams could compete against one another when licensing and marketing their intellectual property.

And with that said, American Needle’s assertion that the NFL teams have deprived the market of independent sources of economic power unravels. Certainly the NFL teams can function only as one source of economic power when collectively producing NFL football. Asserting that a single football team could produce a football game is less of a legal argument then it is a Zen riddle: Who wins when a football team plays itself? See Nat’l Collegiate Athletic Ass’n v. Bd. of Regents, 468 U.S. 85, 101 (1984)(“‘[Some] activities can only be carried out jointly. Perhaps the leading example is league sports. When a league of professional lacrosse teams is formed, it would be pointless to declare their cooperation illegal on the ground that there are no other professional lacrosse teams.’ ” (quoting Robert Bork, The Antitrust Paradox 278 (1978))); Bulls II, 95 F.3d at 599 (“[T]he NBA has no existence independent of sports. It makes professional basketball; only it can make ‘NBA Basketball’ games . . . .”). It thus follows that only one source of economic power controls the promotion of NFL football; it makes little sense to assert that each individual team has the authority, if not the responsibility, to promote the jointly produced NFL football. Indeed, the NFL defendants introduced uncontradicted evidence that the NFL teams share a vital economic interest in collectively promoting NFL football. After all, the league competes with other forms of entertainment for an audience of finite (if extremely large) size, and the loss of audience members to alternative forms of entertainment necessarily impacts the individual teams’ success. See Bulls II, 95 F.3d at 597; see also Brown, 518 U.S. at 248 (“[T]he [teams] that make up a professional sports league are not completely independent economic competitors, as they depend upon a degree of cooperation for economic survival.”); Nat’l Football League v. N. Am. Soccer League, 459 U.S. 1074, 1077 (1982) (Rehnquist, J., dissenting) (“The NFL . . . competes with other sports and other forms of entertainment in the entertainment market. Although individual NFL teams compete with one another on the playing field, they rarely compete in the market place.”).

But most importantly, the record amply establishes that since 1963, the NFL teams have acted as one source of economic power—under the auspices of NFL Properties—to license their intellectual property collectively and to promote NFL football. Tellingly, American Needle does not dispute that the NFL teams collectively license their intellectual property to promote NFL football; in fact, when opposing the NFL defendants’ motion for summary judgment, American Needle relied on NFL Properties’s Articles of Incorporation, which state that the teams formed NFL Properties “[t]o conduct and engage in advertising campaigns and promotional ventures on behalf of the [NFL] and the member [teams].” And our review of the record reveals no evidence that requires us to question the purpose of the teams’ licensing agreement.

Simply put, nothing in § 1 prohibits the NFL teams from cooperating so the league can compete against other entertainment providers. Indeed, antitrust law encourages cooperation inside a business organization—such as, in this case, a professional sports league—to foster competition between that organization and its competitors. See Bulls II, 95 F.3d at 599. Viewed in this light, the NFL teams are best described as a single source of economic power when promoting NFL football through licensing the teams’ intellectual property, and we thus cannot say that the district court was wrong to so conclude.

Moving on, the failure of American Needle’s § 1 claim necessarily dooms its § 2 monopolization claim. As a single entity for the purpose of licensing, the NFL teams are free under § 2 to license their intellectual property on an exclusive basis, see Cook Inc. v. Boston Scientific Corp., 333 F.3d 737, 740 (7th Cir. 2003), even if the teams opt to reduce the number of companies to whom they grant licenses, see Bulls II, 95 F.3d at 598 (“To say that participants in an organization may cooperate is to say that they may control what they make and how they sell it: the producers of Star Trek may decide to release two episodes a week and grant exclusive licenses to show them, even though this reduces the number of times episodes appear on TV in a given market . . . .”); Gregory J. Werden, Antitrust Analysis.

of Joint Ventures: An Overview, 66 Antitrust L.J. 701, 730-31 (1998) (“An antitrust claim based solely on a single firm’s denial of a license to a trademark would readily be dismissed . . . .”). As such, American Needle has no colorable claim that the NFL teams and NFL Properties created a monopoly by awarding Reebok the exclusive headwear licensing contract. See Cook Inc., 333 F.3d at 740 (discussing competitive effects of exclusive-licensing agreements); Bulls II, 95 F.3d at 598. The district court was therefore correct to grant summary judgment to the NFL defendants on American Needle’s § 2 monopolization claim.

Are markets flawed? Or is it competition?

Soros has this to say about the role of markets:

But markets are suitable only for individual choices, not for social decisions. They allow individual participants to engage in free exchange; but they are not designed to exercise social choices such as deciding the rules that should govern society, including how the market mechanism should function. That is the purview of politics. Extending the idea of a free-standing market, self-governing and self-correcting, to the political sphere is highly deceptive because it removes ethical considerations from politics which cannot properly function without them.

Soros didn't go far enough with reflexivity. But here he goes too far. It is not markets that are responsible for the emphasis we place on individual choice. It is the value placed on competition that devolves markets into individual free-for-alls. Competition, as currently understood by market actors and government regulators, has the underpinnings of the methodological individualism on which all of modern economics rests. Alternative methodologies and understandings of competition would not produce the same market dynamics, as comparison of various industries makes obvious (to borrow examples from Charlie Munger, consider cereal manufacturers on the one hand and airlines on the other).

Individuals spontaneously order into firms. What benefit is there to such integration if markets put less constraints on the same individuals? The function of markets is to synchronize buyers and sellers who cannot otherwise integrate their needs within a firm. Soros has it exactly backwards. It's not that markets are suitable only for individual choices; it's that individual choices are suitable only for markets.

In this context, Soros would do well to consider some of the New Institutional Economics and Organizational Theory literature, which provides theory on how and when institutional culture develops. I don't disagree with his point that institutional rules are needed. Just his point that government institutions are necessary or sufficient to meet those needs.

Mandelbrot and the Glassy State of the Economy

From Fractals and Scaling in Finance, page 367:

Everyone agrees that the distribution of firm sizes is far from Gaussian, hence the proper metaphor is not a "soft," but a "hard" object. This leaves open the question of whether it is a real solid or a glass. Physics describes glasses as being extremely viscous liquids that mimic solids and happen to be particularly difficult to study. In the same way, the lognormal distribution averages mildly in the very long run, but in the short run it mimics the wild randomness of the scaling in a very treacherous fashion. One can call it a sheep in wolf's clothing.

Why is Mandelbrot skeptical of lognnormal distributions of firm size? Because market concentration appears to be a scale invariant quantity -- i.e., the amount of concentration appears not to vary as much with the number of firms in the market as one would expect from distributions with finite variance.

Truth on the Market Merger Guidelines Symposium

Check it out. The symposium offers a preview of the arguments and evidence to be presented at FTC/DOJ hearings on the guidelines scheduled through the winter.

The big shift that could occur as a result of these hearings is a move away from market definition to more direct measurement of the effect of mergers on consumers. The legal formalists of antitrust law tend to go into fits at the suggestion, but is there an area of law more appropriate for legal realism than antitrust? Even legal formalists have to admit that there are rule of law virtues in issuing opinions on decisions that cite the actual grounds on which the decision turned, rather than a reframing of those grounds in terms of market definition rules that turn judges into home plate umpires.

What about the third hand?

Why not do an academic study on data provided by the FTC/DOJ?

Antitrust lawyers know the goal in a merger case is to preserve -- or restore -- competition, but the competitive concerns must be balanced against the economic realities, Wales says. But officials at the DOJ have argued the agency lacks the research capabilities of the FTC, which would be necessary to do a thorough assessment of the efficacy of various types of divestitures. And at a recent American Bar Association event, Bureau of Economics Director Joe Farrell said a divestiture study would strain scant resources at the agency. Instead, Farrell suggested, a divestiture study might best be done by academics with an interest in antitrust regulation, ignoring that such a data-intensive project would be ineffective without access to sensitive corporate information of the type the FTC easily collects.

What makes a market concentrated?

Does this qualify?

These days, bulge-bracket banks -- notably Goldman, Sachs & Co. and Morgan Stanley -- pretty much have a lock on underwriting new issues. (Goldman Sachs, for example, was co-lead manager on five of the seven IPOs that late-September week, and only Vitacost.com turned to bookrunners who weren't bulge-bracket banks.)

Not only does their "brand" dominate, but they've done a good job of convincing pre-IPO companies of their worth. "The common joke is that no CEO gets fired for hiring Goldman Sachs," says Cowen's Biele.

Domination means that these larger banks can pretty much dictate IPO terms. With very few exceptions, they demand IPOs of $100 million or more "to make it worth their while," one venture capitalist says.

That translates into a minimum valuation of $400 million to $500 million, which excludes a whole universe of high-growth, middle-market concerns.

But the FTC and DOJ by themselves cannot solve this problem. They need to work with SEC to clear the hurdles to smaller companies making offerings. Without an IPO option, these companies have to negotiate with potential acquirers with zero leverage.

What's Wrong with HHI? Or: What Kind of Competition is Bad for Consumers?

The DOJ/FTC have announced upcoming workshops to review the Merger Guidelines, which are now (depending on whether you count the 1997 revision) either about to start or about to end their teenage years -- i.e., in an awkward stage.

Recently the paper by Shapiro and Farrell on upward price pressure came to my attention:

We propose a simple, new test for making an initial determination of whether a proposed merger between rivals is likely to reduce competition and thus lead to higher prices. Under current antitrust policy, the government can establish a presumption that a proposed horizontal merger will harm competition by defining the relevant market and showing that the merger will lead to a substantial increase in concentration in that market. However, this approach can perform poorly in markets for differentiated products, where market boundaries are unclear and the proximity of the products sold by the merging firms is a key determinant of the merger's effect on competition. Our test looks for upward pricing pressure (UPP) resulting from the merger. We develop a simple diagnostic for UPP based on the price/cost margins of the products sold by the merging firms and the magnitude of direct substitution between the two firm's products. We argue that our approach is well grounded in economics, workable in practice, and superior to existing methods in a substantial class of mergers.

In general, I am enthusiastic about this paper and what it signifies about how this administration will approach these complex problems. In short, UPP avoids the rather artificial analysis of market share using HHI by substituting a direct measure of relative cross-elasticity (or, more precisely, the diversion rato) adjusted by profit margins. In other words, within the UPP framework, the higher the profit margins and the lower the cross-elasticity, the more likely the merger will be bad for consumers. Both economists and lawyers should appreciate how this is a vast improvement over the entirely static calculation of HHI for the market pre- and post-merger.

But for me the problems with HHI suggest a different angle of attack. More specifically, if we agree that one of the core problems with HHI is that it provides too static a picture of competition, then one can justly ask whether UPP really solves the core problem rather than substituting a different (albeit better) measure of the prospective effect of the merger.

What is HHI? For the uninitiated, HHI is an index calculated by adding in quadrature the market share (usually in percentage units) of various companies pre- and post-merger. One of the consequences of adding in quadrature, of course, is that the square of the post-merger market share will always be less than the sum of the two pre-merger companies' market shares squared. Why is that?

I do not know what H and H or others have to say. At first, I was putting off this post until I could find out. Today I realized that that could be a long while. So I will offer my own thoughts.

In probability theory, we add the error of normal variables in quadrature. In other words, if a calculation depends on two measurements, each of which has a certain tolerance for error (e.g., 10 meters plus or minus 2 meters and 4 meters plus or minus 1 meter), then the result of the calculation will be the sum of the measurements, but the error will be the sum of the squares of the errors (i.e., here, 2^2 + 1^2 = 5), not merely the sum of the errors (i.e., 2 + 1 = 3).

The reason errors are added in quadrature is because an error in one direction can cancel an error in the other. That is, if the two measurements are made along the same dimension of units, a statistical fluctuation in the positive direction for one can cancel a statistical fluctuation in the negative direction for the other.

This all carries over very naturally to our analysis of HHI. At bottom, what HHI invites us to imagine is that our market share percentages are actually the variance (or, if the distribution is gaussian, the "standard deviation") of some distribution of possible market share. Hence, to determine market share after combining two distributions associated with two companies, we add in quadrature.

Notice that if we think about market share in these terms, then there is an implicit role for time in the picture. Namely, the distributions are produced by "measurements" in the form of dealflow that result in a distribution with particular variance over some period of time. If the distributions are not stationary (and why would they be?), then that variance should fluctuate. But only when two distributions are combined in the sense that they stop competing for the same dealflow will their variance change discontinuously. That fits nicely with the HHI picture.

But what does it leave out? How about how the variance is changing over time? Wouldn't you like to know whether the distributions are getting fatter are narrower over time?

On my view, the key parameter for defining competition is change in distribution width per unit time. In practice, this would produce a dimensionless number, the internal rate of return, or IRR. If, even adjusting for mergers, a company has posted an IRR over a certain percentage, then there is a reasonable chance that their growth has been built through the use of unsustainable modes of operating, such as fraud.

UPP is an improvement, but doesn't really get to the core problem, which is dynamic.

UPDATE: Investigation of Herfindahl's early papers shows an infatuation with the chi-squared distribution. There are serious fundamental problems with relying upon a chi-squared distribution to fit market concentration, perhaps the most important of which is that market shares cannot and should not be assumed to be independent. Another is that any actual distribution of market shares will probably not be stationary, either over same-width intervals or at different length intervals. We should have cast this kind of theory to the flames a long time ago.

The entropy concentration index is an interesting slice at the problem of characterizing concentration, and brings out the fact that it is the correlation of market shares rather than their statistical independence per se that makes HHI unrealistic. But the entropy index fails for the same reason -- i.e., that market share measurements are not uncorrelated, as they must be for entropy to be an extensive quantity (i.e., for S of 1 and 2 combined to equal S1 + S2). In this regard, a generalization to nonextensive entropy metrics might be considered useful. But there are conceptually and practically simpler ways to get at the degree of correlation in market share, such as cross-correlations in the time-series of cash-flows of different firms.

What should the FTC and SEC do first to help consumers?

The answer is redesign financial statements. Don't leave it to the FASB, which is like letting the foxes guard the henhouse.

The occasion for this reflection came today as Christine Varney announced a series of workshops aimed at improving the Merger Guidelines. Lots of interesting hints in this speech. I was particularly interested in this topic:

[W]e are interested in your views on the use of more direct evidence that is not strictly based on inferences drawn from increases in market concentration. There are several categories of such evidence worth exploring: (1) evidence of the actual, post-merger competitive effects of consummated mergers, (2) evidence of "natural experiments" obtained by looking across different geographic markets, time periods, customer categories, or similar product markets; (3) evidence of the firms' post-merger plans; (4) evidence of customer views of post-merger competition; (5) historical evidence of actual head-to-head competition between the merging firms; and (6) historical evidence of actual or attempted coordination in the industry. Although the Agencies routinely rely heavily on these kinds of evidence to assess competitive effects, the Guidelines address their relevance only in passing and only secondarily, after the relevant market is defined and concentration in that market is measured. Courts also regularly rely on this type of evidence in assessing competitive effects.28 We are interested in views on whether we should adjust the Guidelines to address explicitly what kinds of direct evidence are pertinent and how they should be weighed.

Is it too much to ask that the FTC and the SEC coordinate on this? Recall that Goldman Sachs CEO Lloyd Blankfein recently suggested reforming the accounting rules to require all exposure to flow through to financial statements. Not only might these kinds of reforms benefit the SEC in enforcing its rules, it would give the FTC a better source of data -- at least for public companies -- on which to base econometric analyses of substitutability, for example. Needless to say, investors and ultimately consumers would benefit from having better information too.

Long time readers of Broken Symmetry may recall earlier posts (here, here, and here, for example) on how financial statement report only snapshots in time and time-averages of sales and costs of sales. These were all that was needed when buying and selling patterns changed only annually, or at fastest quarterly. To handle more rapid changes, you have to increase the sampling rate. What we need is a time-series of balance sheet accounts, or income/cash-flow statements on shorter intervals.

Having better designed financial statements would benefit consumers far more overall than even perfectly clear merger guidelines or perfectly efficient SEC enforcement.

How hard would it be for economists from the FTC to sit down with economists from the SEC and hammer out a set of economic data that should be required from public companies but that isn't in the financial statements now? To make it palatable politically, they could offer to get rid of Sarbanes-Oxley hassles in exchange for more information. Have a time-delay of the release of real-time balance sheet info to deal with the trade secret issues.

What do referees or umpires do?

Consider the analogy drawn by Hayek to illustrate the "pretence of knowledge" in the social sciences:

Consider some ball game played by a few people of approximately equal skill. If we knew a few particular facts in addition to our general knowledge of the ability of the individual players, such as their state of attention, their perceptions and the state of their hearts, lungs, muscles etc. at each moment of the game, we could probably predict the outcome. Indeed, if we were familiar both with the game and the teams we should probably have a fairly shrewd idea on what the outcome will depend. But we shall of course not be able to ascertain those facts and in consequence the result of the game will be outside the range of the scientifically predictable, however well we may know what effects particular events would have on the result of the game. This does not mean that we can make no predictions at all about the course of such a game. If we know the rules of the different games we shall, in watching one, very soon know which game is being played and what kinds of actions we can expect and what kind not. But our capacity to predict will be confined to such general characteristics of the events to be expected and not include the capacity of predicting particular individual events.

Yet we generally agree on the need for referees and umpires, however much we complain about their judgment after "a bad call." What makes for a good umpire or referee?

Having played water polo for a coach, Bruce Watson, who was widely regarded as one of the best refs at the international level in his time, I remember a few principles. One was that a good ref tends to call the game towards a tie. Why? Because it's not as much fun to watch a team get slaughtered. And it's not a good test of the skills of either team.

Bruce was rumored to have made a personal fortune in the market before "retiring" to coach water polo full-time.

I'm indebted to Mario Rizzo for the pointer to Hayek here and in the last post. Hayek is often a tough read -- probably something to do with his native language being Austrian -- but with wonderful gems that bear revisiting.

Highlights from the 2009 IP Business Congress

Monday and Tuesday of this week I attended the second annual IP Business Congress, which this year was venued at the Four Seasons Hotel in Chicago. There were almost 400 attendees at the event, which was a good turnout given the economic climate. Attendees represented stakeholders in nearly every part of the IP Market, both primary and secondary. As expected, the panels organized by IAM magazine were excellent and informative, especially the question and answer sessions afterward. This is an event that I expect to put on my calendar annually.

Highlights for me as an attendee to this event included (1) the first panel on Monday on the state of IP rights in China, India, Japan, Europe, and the United States; (2) the panel on patent pools on Monday afternoon; (3) the panel on open innovation on Monday afternoon; and (4) the Gala dinner on Monday night. Tuesday's panels were also excellent, but of less interest to me because of my more direct involvement with many of the issues addressed on Tuesday.

State of IP Rights Internationally

Harvey (expert on China) kicked things off by noting how IP rights had been a strong influence on the development of rule of law more generally in China: IP was the first private property right to be recognized by the Chinese government after the cultural revolution. Harvey also explained that in number of lawsuits, there is more IP litigation in China than in any other nation. The picture he painted was of a thriving IP system in China that was operating decoupled from the rest of the IP world. The coupling of China's IP system into the rest of the world's will produce winners and losers of epic proportion, and now is the time for us to think strategically about how to prepare our clients and customers for this inevitable merge of the Chinese system into the rest of the world.

McGinley (EPO Officer) followed Harvey with sobering statistics on the patent application bubble that is growing inside the US, EPO, and Japanese patent offices: 2 million applications althogether are now pending inside these offices. Given how the rate of examination has not kept up with the rate of growth in filing, McGinley suggested that the system was beginning to resemble a pyramid scheme! This was a brave position for a government official to take, but everybody in the system should appreciate what McGinley is trying to do. Where might we have been had more financial regulatory authorities here in the U.S. pointed out the pyramid-scheme-like growth of the subprime mortgage market? McGinley was short on answers as to how to solve the problem, but he did suggest that Chinese officials were probably at the top in terms of training practices and the reduction of systematic errors in examination. This seemed unsurprising to this listener given the on-the-ground experience of many Chinese with more complex manufacturing workflows!

The presenter from Japan had little of interest to say, and presented some confusing interpretations of statistics on patenting in Japan. For example, he pointed out that the largest number of patents issued in Japan were to computer companies rather than pharma companies. Pharma companies need only one well-drafted and prosecuted patent to protect their products. This is not very surprising, and is true everywhere in the world.

Basheer from India gave in many ways the most interesting presentation. His was mostly a diplomatic presentation of facts about the IP market in India, where the political agenda is driven by the success of generic drug manufacturers. As a few BS readers may know, Basheer is also one of the authors of the consistently excellent (but very detailed!) Spicy IP blog. From listening to Basheer, one could piece together a picture of India in a critical state, in which more or less IP protection could result from a sharp push in either direction. Too difficult to call for the time being. On my view, it seems that Indian biotech and pharma researchers have a regulatory arbitrage over their U.S. counterparts, who have many years of redtape to cut through before carrying out even relatively safe clinical trials! Note that beating heart transplants are now being carried out in Indian hospitals. There are many high-risk, high-reward medical treatments now avaiable in India that may never be available in the United States. Another trend to watch carefully.

The first question/comment for this panel was also notable. It came from Sherry Knowles of GSK, who noted that Chinese generic manufacturers were getting drugs to market before US manufacturers by simply scraping clinical data off the clinicaltrials.gov website on which U.S. manufacturers, such as GSK, have to post their data by law! There's one for the USTR to call to Chinese government attention.

Patent Pooling

The Monday afternoon panel on patent pools included Sisvel founder Dini, Hinman from Verizon, and Michel from the FTC. Dini gave a great pitch for hiring independent administrators (such as Sisvel) for allocating profits among patent pool participants, and for getting such admins involved at as early a stage as possible. Michel gave a presentation of the recent history of FTC regulation of patent pools, including a summary of the federal court holdings relating to Rambus's participation in JEDEC. Hinman talked about the perils of patent pool participation, and noted that even opt-out could be anti-competitive. Referring to one patent pool in particular, he pointed out that all but two industry participants had entered. I saw Michel scribbling notes!

The upshot is that if your company is involved with patent pools, you need to hire experienced outside counsel with knowledge at the interface of IP and Antitrust law to help ensure your business strategy reduces the risk of antitrust liability. Your author knows and works with a few such experts, and is happy to make an intro. Note that most corporate lawyers or IP lawyers will not be aware of the perils of competition law because the Bush and Clinton administrations were relatively lax on this front. All indications are that the Obama administration will be more active in enforcing competition law.

Open Innovation

By now the term "open innovation" has become relatively well-known within the business community. Some IP owners may believe that open innovation represents a form of socialism -- an alternative to a system of property rights. Attendance to this panel would have been the antidote to such misunderstandings of this theory. Panelists Weedman from P&G, Simonton from Exelixis, and Bergelt from the Open Innovation Network (and formerly of Paradox) talked about the dynamic growth that the feedback loops established by open innovation networks facilitate for the companies that take open innovation seriously.

Because the theory of open innovation is a paradigm shift from traditional neoclassical economic theories, only a handful of businesses (including P&G and Exelixis) have been fortunate enough to find leaders willing to foster the organizational commitments necessary to make open innovation work. This business model is the future of every large public corporation in the world. Watching these businesses continue to outgrow their competitors, others will eventually follow.

Gala Dinner

One of the best parts of the event was meeting the attendees. Over drinks before the Gala dinner, I had the chance to catch up with Niels Reimers, who later that evening was inducted into the IP Hall of Fame for his path-breaking work in technology transfer. In this rare moment of opportunity, I had the chance to ask Niels about how he worked at Stanford. By Niels's description, he was practicing the same technique followed by the best founders and managers in Silicon Valley both then and now -- "management by walking around." Dave Packard and Bill Hewlett, Bill Perry at ESL, and Nils at Stanford were all doing management by walking around. Niels's personal accounts of his work connecting Stanford music department (!) professor John Chowning with Hamamatsu corporation engineers were a highlight among highlights for this event.

Later, when Niels cited the Teece Model of innovation in his acceptance speech, I nearly fell out of my chair. The same model was cited by FTC Commissioner Tom Rosch in his speech about new theories in competition law on June 1, 2009. Note that Teece was also cited in the explanation of systems theory provided in your author's letter comment to the FTC on the Evolving IP Marketplace.

Final Thoughts

Another highlight made possible by my attendance to the event, but not directly related thereto, was an invitation to a breakfast with Congressman Bill Foster on Tuesday morning. I am already a fan. Foster is an entrepreneur and physicist who decided (after 22 years of building superconducting magnets to detect subatomic particles) to roll up his sleeves and try to help fix government. I'm pretty sure there's nobody else in Congress who would know what the title of this blog refers to. The discussion of the patent system and innovation at this breakfast was the best I've heard ever anywhere, but it also revealed to me the underlying problem facing patent reform: nobody has a complete view of the whole system. Almost everybody (at least) focuses on the broken incentives and procedures facing them in their subsystem, without stepping back to see how all of the subsystems coalesce into an competitive and innovative ecosystem. Nonetheless, the kinds of questions asked and answers given at this breakfast suggest that already the level of discourse has progressed far beyond the pat answers that were served up last year when patent reform was before Congress. There is more widespread awareness at least of how the public has been manipulated to some extent by the more technologically sophisticated and media-connected subset of stakeholders in the system. Perhaps we will have sensible patent reform after all. Here's to that hope.

The Structured Rule of Reason Approach to Antitrust Regulation

From a speech given by Commissioner Rosch on June 1, 2009:

In sum, while I do not believe that antitrust law has yet to settle on the right economic theory (or group of theories as the case may be) to accurately account for the complexities of rational and irrational seller and buyer conduct, I think in the last few years, developments in economic thinking have brought us much closer to that objective. And just as in the 1960s, quantum physics was reborn stronger than ever, I am hopeful that as these ideas are incorporated into the mainstream thinking among members of the judiciary and the antitrust bar, we will soon see new life breathed into the antitrust laws through a doctrinal framework that can best identify and prevent anticompetitive conduct.

Commissioner Rosch falls squarely within the American tradition of pragmatism, which takes an opportunistic rather than a loyal attitude toward methodological commitment.

A careful reading of this speech suggests that industry incumbents may need to be more careful in their pre- and post-acquisition strategy. Separately, I am happy to report that patent law and policy fits very well within the framework of experimentation theory as articulated by Farrell and Teece. See an earlier post on this topic here.

Letter Comment to the FTC on the Evolving IP Marketplace

Here are a few excerpts:

According to systems theory, innovation emerges from iterated cycles in which data, theory, and the people who collect data and form theory constitute feedback loops, which evolve over time. Each cycle manifests as the gathering and exchange of information among a network of experts who act as gatekeepers to a set of symbolic rules and procedures. Following the terminology of Mihaly Csikszentmihalyi, I call the network of experts a “field,” and the set of symbolic rules and procedures a “domain.” To give examples, topology, physical chemistry, and constitutional law are domains. Each of these domains is associated, respectively, with the fields of mathematicians who specialize in topology; academic and practicing physical chemists; and academics, practicing lawyers, and judges who work on constitutional law.

From the point of view of an economist, the most important difference between systems theory and neoclassical theory may be that systems theory permits for economic actors (the field) to have preference functions (the domain) that evolve over time. As a result, although neoclassical theory is still a useful model of economic activity when changes in preferences are small within the window of time in which economic activity is observed, more generally no stable equilibrium may be reached because preferences may change during the period of observation. In addition, because systems theory need not assume that economic actors know how their preferences have or will change over time, an assumption that actors will try to match their allocation of resources to their preferences can be called “rational” only in a weak sense. Under systems theory, whether an economic actor will engage in an activity of consumption, production, or exchange is a function of: (1) their history of preferences; (2) their history of consumption, production, and exchanges with others; and (3) the frequency of their exchanges with others. Whereas within neoclassical theory institutions are designed to promote allocative efficiency, within systems theory institutions are designed to promote the discovery of information about preferences, and thereby the synchronization and frequency-matching of consumption and production activities through exchange and cooperation.

For example, the systems theory makes explicit the spatial and temporal dynamics underlying the knowledge problem described by F.A. Hayek in “The Use of Knowledge in Society.” With the systems theory in mind, we can identify the function of markets with their facilitation of the exchange of information and coordination of economic activity independent of central planning. This is in stark contrast with neoclassical theory, which often identifies the function of markets with the maximization of aggregate utility based on an assumption of stable preferences — a function that cannot be carried out by a central planner beyond a small scale. The systems theory therefore identifies markets as a mechanism for rewarding information exchange and cooperation, thereby facilitating economic growth.

Download Letter Comment to FTC on the Evolving IP Marketplace (Final)

Berkeley FTC Hearing on the Evolving IP Marketplace

I'll be there tomorrow. Click on email me to the left if you'll be there and are interested in meeting up.

What Kind of Competition Promotes Innovation?

Charlie Munger offers his view here:

Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.

If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure -- a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields like cereals, for example almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.

Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.

Here's my question: When an industry ends up in price competition alone, shouldn't we expect competition regulatory authorities to do something just as much as we would expect the same competition regulatory authorities to do something if the industry ended up with too little competition? Why don't we have both protrust and antitrust law?

We do. This is exactly the problem that intellectual property law is setup to solve. Granting temporary monopolies forces competitors to differentiate rather than competing on price alone. A properly tuned system of intellectual property rights transforms competition into an engine for discovery of new information about the market. Crescat scientia; vita excolatur.

F. Scott Kieff on New Institutional Economics in Patent and Antitrust

Truth on the Market has been posting guest comments on a new treatise on IP & Antitrust from Prof. Michael Carrier this week. As usual, Prof. Kieff brings order to the confusion of proposals for reform of IP and antitrust law:

Indeed, while much is made about the uncertainty of patents – it’s all the rage today – one of the central problems with many of the legal changes that Michael proposes is that these changes inject into the patent system a much greater uncertainty, and an uncertainty of a much more pernicious type. Business can deal well with factual uncertainty – in fact many forms of business thrive on it (think options, futures, insurance, etc) – but the one type of uncertainty that is particularly bad for business overall is the uncertainty caused by having the underlying legal rules of the game enforced as a function of fashion and politics. But this is what you get when the enforcement mechanism (the details of the particular framework of the legal institutional design) are matters of flexible discretion.

For an earlier post on law as a game see here. Regardless of whether you agree with Prof. Kieff's conclusions about what that theory implies, I find no way to disagree with his suggestion that New Institutional Economics provides the best theory for analyzing the effect of changes in the rules of the IP and antitrust game.

Cooperation in the Steel Industry: the Gary Dinners Revisited

From the Legal History Blog, a link to a new article by William Page on an important historical episode in antitrust law:

Between 1907 and 1911, executives of American steel manufacturers gathered in a series of social events and meetings that became known as the Gary dinners. Their founder, Judge Elbert H. Gary, chairman of the board of the United States Steel Corporation, believed the dinners were a lawful way to stabilize steel prices by fostering information-sharing and an ethos of cooperation among manufacturers. The government agreed that the dinners stabilized prices, but took a different view of their legality. It brought suit in 1911, pointing to the dinners as one of the reasons why the court should dissolve U.S. Steel as an illegal monopoly. In 1915, a trial court composed of four members of the Third Circuit held that the dinners amounted to price fixing, but that U.S. Steel's resort to them only proved that it could not control steel prices on its own and therefore could not have monopolized the industry. In 1920, the Supreme Court affirmed.

Google as a Monopoly

From the NYT via Venture Hacks:

“You almost feel sorry for Google,” said Danny Sullivan, editor in chief of Search Engine Land. “They’re doing a good job and people are turning to them. But when they pass 70 percent share, people are going to be uncomfortable about Google becoming a monopoly.”

Let's hope that they get uncomfortable enough to build a better mechanism for connecting people to needed information. Let's not go after Google just because they've got the best search engine within some margin of switching costs. There are things I really hate about Google's culture, but Google was legitimately the first to solve the problem of connecting people to websites in a scalable way. They deserve their reward for that work.

Awhile back, Mark Cuban proposed that competitors essentially bribe customers away from using Google. As a culture, we must recognize that treating customers as a commodity and competing on price alone is going to have nasty consequences. Look at the airline industry if you need an illustration.

A competition in which competitors differentiate and repackage goods and services into more appealing bundles creates wealth, both for customers and investors. A competition in which competitors offer the same goods and service and compete on price alone destroys wealth, both for customers and investors.

That being said, a while back I had a friend who noticed the traffic to his site drop precipitously after switching from AdSense to another ad network. That traffic was from Google searches. That didn't look cricket to me.

Second FTC Hearing on the Evolving IP Marketplace

The FTC web page with agenda, panelists, presentations and transcript of the December hearing is here.

The second hearing was held last week. Aron Levko presented preliminary data from the 2009 PwC survey of patent litigation. Bryan Lord from AmberWave gave a presentation with an interesting model (from Karl Ulrich at Wharton) of how technology and markets need to develop concurrently for economic growth to obtain.

The next hearing is scheduled for March 18 and 19 and is free and open to the public. See earlier post about the first hearing here.

Favoring Dynamic Over Static Competition: Implications for Antitrust Analysis and Policy by David Teece

An evolutionary approach underscores the importance of maintaining variety in the economic system. Competition policy authorities as well as other agencies must be concerned with protecting economic diversity and meaningful variety in organizational forms. The focus need not be a particular market - - - it should be broader as what’s outside the market tends to be amongst the best candidates for Schumpeterian entry and radical innovation.

...

More generally, the presumption that more competitors is always better is overturned - - - once the goal is not just lowering price but also protecting innovation. Barriers to entry may need to be examined over a longer time period and must be examined at the firm level.

The role of supporting structures and government funding for research also affect entry conditions. They may purely reflect capabilities that incumbents have developed that newcomers shouldn’t expect to possess. Capabilities are likely to reflect the search for unique advantages. Their possession drives competition.

...

Subsequent research has established that firms exhibit more stability in their capabilities than in their products. In this sense, capabilities are easier to analyze than products. Capabilities are a proxy for those interrelated and interdependent aspects of the enterprise that govern its competitive significance. They are arguably a better proxy for competitive position than (downstream) market share.

Here's the paper. And here's the website for the Law & Economics of Innovation Conference at George Mason University, where the paper was presented last year.

Keynote from FTC Commissioner J. Thomas Rosch: a Dynamic Analysis of Innovation Markets

In a pleasant turn of events, the most provocative remarks from day one of the IP & Antitrust Conference were provided by neither a practitioner nor an academic, but by FTC Commissioner Tom Rosch. A PDF of Commissioner Rosch's remarks is available from the FTC here.

Commissioner Rosch took as his topic the question of whether and to what extent restraints affecting pure innovation markets should be challenged by regulators. In considering the question, he undertook a review of academic literature, the history of regulation of such markets, the practical problems encountered throughout that history, and the prominent legal issues raised in that history.

His review of the academic literature recounted Schumpeter's arguments in favor of concentration in innovation markets and Arrow's arguments in favor of more competition in such markets. His purpose was not to deal with the nuances of these authors' work, but rather to point out that views are divided within the academy as to what level of concentration or competition is best to foster innovation. His remarks called to my attention the extraordinary remarks of Justice Scalia in the 2004 Trinko decision:

The mere possession of monopoly power, and the concomitant charging of monopoly prices, is not only not unlawful; it is an important element of the free-market system. The opportunity to charge monopoly prices–at least for a short period–is what attracts “business acumen” in the first place; it induces risk taking that produces innovation and economic growth.

Commissioner Rosch insisted that this was dicta in the Trinko decision. Nonetheless it is a clear statement of what would be called a Schumpeterean view of competition in innovation markets.

Next came a summary of the last few decades of the history of regulation of innovation markets. Commissioner Rosch is an eyewitness to much of this history. He was working at the FTC, for example, when Xerox was investigated in 1974 on the theory that its patent portfolio and joint venture with another company were anticompetitive. His conclusion, however, was that through this history, there was not a single instance in which the agency had made a successful challenge to allegedly anticompetitive conduct in an innovation market.

Commissioner Rosch left off his survey of the regulation of innovation markets with the provocative observation that innovation is "necessarily dynamic and evolving" and that static market definitions (such as the definitions required under Philadelphia Bank or the 2 year rule under the guidelines for review of horizontal restraints) make no sense in such markets.

Regular readers of Broken Symmetry will appreciate how these words struck a chord with me. Only a few weeks ago we enjoyed hearing from guest blogger Michael A. Gollin about the importance of a dynamic equilibrium approach to understanding IP. Without competition regulatory authorities onboard with any industry plan to plant a new redwood forest, it is only too likely that industry agreements to conserve or preserve certain resources will be challenged as anticompetitive conduct ("You logging companies can't agree to stop other companies from cutting down those trees!").

The challenge has now been laid down by Commissioner Rosch. It is up to this generation of academics, practitioners, and regulators to rethink how we regulate markets to accommodate growth that occurs on a week-to-week basis rather than a year-to-year or decade-to-decade basis. What new standards can be applied to harmonize the goals of antitrust and IP law? How can academics make a dynamic theory of innovation easy enough for everybody involved -- business people, politicians, and the public -- to agree and buy in to a new model?

At the meeting, Commissioner Rosch specifically implicated the market definition rule as an unnecessary distraction to determining whether anticompetitive conduct has occurred in an innovation market. How can such markets be well-defined when they are so rapidly changing? He pointed to an interchange between Judges Douglas Ginsburg and Diane Wood on this question, although I didn't quite catch whether this was on the record for them. (They sit on different courts, but both teach at the University of Chicago.)

Here are a few of my own thoughts on these matters: besides market definition, even market share is not a meaningful figure if such markets are considered at only a single moment in time. Moving from a static to a dynamic picture of IP and Antitrust will require us to take multiple snapshots in time. Unfortunately, what we have going against us in setting up a new model are the facts that dominant mental models of economic equilibrium are time-independent and the accounting theory behind our financial statements is based on a static model of firm value in liquidation.

In the future, time-dependent measures, such as cash-flow per unit time, will provide a more reliable way to measure the effect of a given activity within an innovation market. The effect of given activities might even be deconvoluted out of a time-series of cash flows -- i.e., by looking at how growth curves of accounts inside various firms changed (or didn't change) as the result of a questionable activity, we might be able to tell whether that activity had an anticompetitive effect.

So for example, it might make more sense to gather statistics on the average internal rate of return for successful and unsuccessful startups in a given market. Perhaps only startups over a certain minimum IRR and annual revenue should be subject to antitrust scrutiny. Growth below that threshold (which probably is technology dependent; consumer internet IRRs are right now much higher than semiconductor IRRs) is not subject to review because it is unlikely to have been due to collusion.

Moreover, competition regulatory authorities should take into account how macroeconomic factors (such as the economic inaccessibility of IPOs for companies with under several hundred million dollars in revenue) can influence competition. In fact, if the FTC really wanted to promote competition, then the first thing it should do is sit down with the SEC and identify exactly who each agency seeks to protect, and what rules are designed to do that. As Hume would have said, whatever remains should be cast to the flames. Technological change has happened fast enough so that incremental changes to the regulatory regimes within these agencies will probably not get the job done.

Patent Pooling Panel

Mallun Yen of Cisco kicked off the conference with her moderation of a panel on the aforementioned topic, which included two academics and two practitioners: David Djavaherian from Tessera, Joseph Farrell and Richard Gilbert from Berkeley, and Henry Su from Howery.

The topic for this panel squarely raised what is in this writer's view the most important issue in patent and competition law today: when many people contribute to the development of a new technology -- especially a platform technology, or other technology that must be standardized to maximize it's benefit to consumers --, how should the profits be split up?

Before we had a patent system, there was a de facto (albeit not optimal) answer: the biggest firm (or group of firms, or "trust" of firms in the late 19th Century) wins. Nobody liked that might makes right rule.

So when smaller companies and individuals figured out at the turn of the 20th Century (think Edison) that patents could give them a foothold in the game with larger entities, they got a lot of them.

Naturally, the large companies weren't going to stand for that -- two can play at that game -- and soon thereafter began accumulating their own large portfolios. Aside from partially solving the problem of threats from new entrants (blocking patents), this widespread accumulation had an unanticipated added bonus for the incumbents: patent pools are a handy way to punish (and hence enforce) cartel agreements among horizontal competitors.

But antitrust authorities and courts alike got wise to this game and started breaking up patent pools in the mid-20th Century, and
that is where the lawmaking was left off until very recently.

What happened? Well recently an explosion of platform technologies (ahem the Internet and it's many subtechnologies) have made the value (and hence potential profit) of cooperating to develop standards clearer than ever. There are more standards setting organizations (SSOs), playing more important roles, than ever. We only notice this now as consumers when SSOs fail (see Blu-ray vs. HD).

But patents, at least until two or three years ago, have not gotten weaker. Hence, many newer companies (without any institutional knowledge of the antitrust perils of patent pools) have been patenting the heck out of industry standards. And who can blame them for trying, right? What a business model: no overhead for commercialing technology; just R&D costs plus legal expenses to tap into future profits.

Naturally, the companies that do make and sell things have gotten much more interested in patent pooling again. Nobody likes to work hard for years making a commercial hit, and then get hit with a tab for the supposedly shared standard technology.

But the core problem here is that the best way (maybe the only way) that these problems can be solved without litigation is early in time when the SSO does its work. But at that time there is no data about demand for a particular technology, much less for a bunch of alternative technologies, to settle debates. Everybody's idea is worth a million dollars.

Did the panel get to the meat of this? Some. But there could have been a more detailed discussion. We are still talking about whether patents are good or bad for competition. We need to deal with one problem at a time to understand the system and make improvements. In this context, we should assume that some R&D wouldn't get done without patents, so we just have to deal with the fragmentation of patent rights if we want to have new technology to standardize.

Any answer to this problem is going to have to be narrowly tailored to the details of a particular technology and market. Thus, on my view, the ultimate answer to this problem will not hinge on what but who. That is, not what terms (royalty percent, exclusivity, etc.), but who gets to set them.

The who should be the inventors working at an SSO at the point in time when the standards are set. Licensing of patents should be a clear prerequisite (clear as in enforceable by contract, see Federal Circuit in 2003 Rambus decision) to partcipation in an SSO, and part of the work done by the SSO should include an ex ante agreement as to how profits should be splitup. Are CEOs going to go along with that? Yes IF we get their buy-in at THAT momentum time. Of course they're going to lawyer up and fight if they had no idea that that was part of the deal.

How's that for a workable solution?

IP and Antitrust Conference at Berkeley

I'll be in attendance Thursday and Friday, and would be happy to meetup with readers there.

IP as Solution to Market Failure: a Few Responses to Mr. Gollin

What an inspiration to hear that Senator Bayh is still so active in his 80s!  His first-hand knowledge of and experience with the last major round of patent reform is even more important now, and it's great to hear that he's still keeping a hand in the game.

Your first post raises many very interesting points, and I want to try and draw you out a little more on some of them.

First, you are rather too charitable in attributing to me the observation of a need for what you call a shared model of innovation.  But I very much like the vision you have of IP striking a balance between self-interest in exclusivity and self-interest in access.  Indeed such tensions have always existed between innovators and the beneficiaries of their work, and I think we both agree with Lincoln that the IP system has over time proved to be an ingenious way of striking that balance.

I think it's intriguing to consider, however, how much the identities of the parties to these types of negotiations have changed over the past few decades.  You give "two individuals, two companies, or two nations" as examples of the parties to such a negotiation, examples that tend to suggest (and perhaps this was not your intent) relative equality of position -- i.e., relatively symmetrical costs and benefits on each side.  In this sense, important symmetries have been broken within IP law over the past few decades.  These broken symmetries (I can't help using the metaphor, which fits so well here) are largely an unanticpated consequence of many improvements that have been made to the IP system (and I'll stick to patents here, although I see similar trends in copyright):

• Costs of prosecution have generally been stable or decreasing, putting patent rights within grasp of individuals and foreign entities
• Costs of litigation have skyrocketed as the number of litigations and litigation defendants has increased much faster than the supply of lawyers qualified to handle the work
• Bayh-Dole, at the same time that it opened up new sources of private funding for universities, has also raised the transactions costs of clearing IP ownership

As a result, the patent system is no longer adequately described as a competition among large corporations, which occasionally erupts into patent wars, and is settled by cross-licensing treaty.  Rather, an incredibly rich ecosystem is emerging in which individual inventors, R&D labs (public like Rambus, private like Intellectual Ventures, or private like universities), private equity funds (RPX, for example), public investment funds (like Acacia), and the public and private corporations that want access to IP owned by the preceding entities and are net payers under the patent system.  The richness of the system itself is ultimately what merits a more sophisticated theory, such as that presented in your book.

With that lead in, I wonder if you couldn't say a little about your concept of "IP as a motor for the innovation cycle" and how that vision of IP is more useful in the rich ecosystem that has developed?  If the problem is no longer one of simply reallocating rights among large corporations, and smaller entities can't effectively negotiate with large corporations without strong IP rights, then aren't we effectively threatening innovation by limiting damages and rights to injunctions?

I will leave that one big question for you, but I wanted also to address briefly your other comments on the three reform proposals I raised:

The idea of making patent disclosures more user friendly to people other than patent attorneys (and leveraging new technology to do so) is one that occurred to me after seeing that an inventor has started a company called Planet Eureka, the business of which is to provide a website for inventors to post descriptions of their inventions in an attempt to attract licensees.  Planet Eureka runs a workshop, which coaches the inventors on how to pitch their work using multimedia, and then has a catalog of the various inventions up on their website for potential licensees.  I hate to say it, because Planet Eureka does excellent work, but the PTO should ultimately put this kind of website out of business!  The patent system isn't working quite right if inventors are willing to go that route rather than dislcose to the public through the PTO in exchange for exclusive rights.  Ideally, the PTO would collaborate with Planet Eureka to make its services available to all inventors and potential buyers.

Second, Jon Dudas deserves kudos for overseeing the complete overhaul of the PAIR and EFS system.  In this regard, the progress made at the PTO during his tenure substantial and excellent.  In fact, the PAIR system makes determining patent ownership (except, perhaps, for some pesky corporate and bankruptcy law issues) cheap and fast.  In that sense, an ownership clearinghouse of the kind that IDEA appears to have in mind already a reality.  I'm probably missing some nuances of the proposal.

But what I had in mind was the proposal by Mark Lemley and Nathan Myhrvolds that all buyers and sellers of patents should be required to disclose the terms of all licenses and assignments of patents to the government, much as public corporations are required to report their financial statements to the SEC.  Most people flinch at this idea when they hear it because that information absolutely must be kept confidential in the world we live in now.  The question is whether we might all be better off if nobody was allowed to keep it private.  A long time ago I wrote about how such a rule is like the NHL's decision to require players to wear helmets long ago.

I'll get back to antitrust if I see the opportunity later, but suffice it to say that the FTC handling of the Rambus and Schering-Plough cases makes it obvious that some of the folks there don't really understand how IP can promote competition.