Antitrust & Innovation in the New Economy: The Problem with the Static Equilibrium Mindset

In this new Money Morning article, “The Antitrust Curse: What Apple Can Learn From Microsoft, IBM,”  David Zeiler wonders whether the antitrust lawsuit filed against Apple and several book publishers by the U.S. Department of Justice last week could open the door to a broader case against Apple or, at a minimum, simply become a major distraction to the firm and it’s ability to innovate going forward. He uses IBM and Microsoft as case studies in this regard and notes that, “the problem with being in the DOJ’s gunsight is that it distracts management, makes the company hesitant to innovate, and blemishes the company’s public image.  While antitrust woes may not have been entirely responsible for Microsoft and IBM ceding their dominant positions in tech, they were clearly a major factor,” he says. “And worse for Apple, the e-book case could be just the beginning.”

Quite right. I raised the same concern in my recent Forbes column,”Regulatory, Antitrust and Disruptive Risks Threaten Apple’s Empire,” which Zeiler was kind enough to quote in his essay. In that piece, I argued:

Even if Apple beats back [the eBooks] investigation, broader questions are being raised about the company’s power that could invite a much broader investigation. The danger for Apple is that antitrust becomes an omnipresent threat that must be factored into all ongoing business decisions. Antitrust is a particular danger to Apple because the firm is highly vertically integrated and that integration is the source of many of their innovations.  As earlier tech titans like IBM and Microsoft learned, when antitrust hangs like the Sword of Damocles, every decision about how to evolve and innovate becomes a calculated gamble.

Regarding the earlier impact that antitrust Sword of Damocles had on Microsoft, Zeiler unearthed this terrific 2005 quote from Mark Kroese, a general manager of information services at the Microsoft Network, who described the impact of the MS antitrust case on innovation at the firm as follows: “Working at Microsoft today vs. five years ago is different,” Kroese said. “If anyone thinks the antitrust case hasn’t slowed us down, you’re wrong. If I want to meet with a products manager for Windows, there needs to be three lawyers in the room. We have to be so careful, we err on the side of caution. We are on such a fine line of conduct.” Regarding how antitrust chilled IBM, Zeiler cites veteran tech journalist Steve Wildstrom of Tech.pinions who noted,  “Twelve years of litigation were an enormous distraction in a time of rapid technological and business change. IBM management became cautious and over-lawyered, constantly looking over its shoulder-a condition that persisted for years after the case ended. The antitrust case was almost certainly a major cause of the serious decline of IBM in the late 1980s and early 90s,” Wildstrom said.

Of course, it is impossible to scientifically determine to what degree antitrust harassment contributed to either IBM or Microsoft’s inability to innovate and adapt to the rapidly changing market conditions. And let’s be clear: both IBM and MS have found ways to rebound and innovate in other ways. But one wonders what was lost in the process as the threat of antitrust constantly loomed and potentially chilled innovative efforts that could have kept both firms on the cutting-edge.

It’s not just Apple that faces similar threats today. Google is obviously another company increasingly mentioned as an antitrust target. Commenting of the dangers of a potential case against Google, Bernstein Research senior analyst Carlos Kirjner argues that “even if regulatory proceedings come to naught, the process has the potential, in the most extreme circumstances, to consume so much of the company’s energy that it can lead to important strategic missteps: many believe that Microsoft missed the boat on the Internet, and IBM on the importance of the personal computer, in large part because their management teams were focused on defending against the DoJ’s antitrust efforts.”

The better approach to disciplining tech firms and markets is to rely less on intervention and more on Schumpeter’s “perennial gales of creative destruction,” which are blowing harder than ever in our modern high-tech economy. In markets built largely upon binary code and governed by Moore’s Law, the pace and nature of change has become hyper-Schumpeterian: unrelenting and utterly unpredictable. Innovative risk-takers are constantly shaking things up and displacing yesterday’s lumbering, lethargic giants. Just ask some of the players that have been largely left in the dust, including AOL, AltaVista, MySpace, Palm, and others. Of course, there’s my favorite recent case study: Research In Motion’s BlackBerry smartphone.  As I noted in my recent column, “Bye Bye BlackBerry. How Long Will Apple Last?” BlackBerry was virtually synonymous with “smartphones” and was considered one of the tech titans that seemed destined to dominate for many years to come. But now the BlackBerry’s days appear numbered and its parent company Research In Motion Ltd. is struggling for its very survival.

Too many tech industry pundits today ignore these dynamic realities and instead rely a myopic analytical approach to the information economy that is fundamentally static in character. Many static equilibrium scholars in both the legal and economic profession tend to adopt a snapshot view of markets and innovation. Such critics often express an overly nostalgic view of the technological past while adopting an excessively gloomy view of the present and the chances for future progress.

But, a la Schumpeter, modern tech markets are highly dynamic. There is no static end-state, “perfect competition,” or “market equilibrium” in today’s information technology marketplace. Change and innovation are chaotic, non-linear, and paradigm-shattering. Schumpeter said it best long ago when he noted how, “in capitalist reality as distinguished from its textbook picture, it is not [perfect] competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization… competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other,” he argued, because the “ever-present threat” of dynamic, disruptive change “disciplines before it attacks.”

By contrast, the static equilibrium mindset is myopically fixated on short-term market share and price competition while ignoring “competition for innovation,” which is what matters most in the more dynamic Schumpeterian model. “Schumpeterian competition is primarily about active, risk-taking decision makers who seek to change their parameters,” note economists Jerry Ellig and Daniel Lin. “It is about continually destroying the old economic structure from within and replacing it with a new one.” Thus, while static or “perfect competition” models assume away innovation and are preoccupied with equilibrium, dynamic models revolve around disequilibrium and assume that the only constant is change. What is most important to economic progress, therefore, is the ongoing process of constant experimentation and spontaneous discovery that allows new business models and organizational structures to emerge in response to market signals.

The other danger of the static equilibrium mindset is that the same new innovators and innovations that obtain success and scale quite rapidly as a result of this process are sometimes thought to possess problematic market power. Accusations of “monopoly” quickly follow. As Nobel Laureate Ronald Coase noted, “if an economist finds something—a business practice of one sort or another—that he does not understand, he looks for a monopoly explanation. And as in this field we are very ignorant, the number of understandable practices tends to be very large, and the reliance on a monopoly explanation, frequent,” he argued.  Of course, non-economists are just as likely—perhaps more likely—to make that same error. This is why a short-term fixation on market share and market power is so problematic.

Moreover, as Schumpeter also taught us, it is essential that uneven entrepreneurial gains be tolerated so that innovation can occur and be continuously incentivized. Economies need innovators to take risks because progress is born from it. Penalizing the risk-takers by trying to “level the playing field” through rash regulation or antitrust interventions will simply sap the entrepreneurial spirit from the marketplace, limit technological innovation, and diminish the possibility of progress and prosperity over the long-haul.

If you’d like a better understanding of this dynamic conception of competition and an explanation of why the static equilibrium mindset — especially in the antitrust field — is so horribly misguided, then I strongly recommend you begin your investigation with the following readings:

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