What seems to be a big reward to innovation ultimately reduces the incentive to innovate, argues a new Stigler Center working paper by Krishna Kamepalli, Raghuram Rajan, and Luigi Zingales. Their analysis of Google and Facebook’s acquisitions shows that “It is dangerous to apply twentieth-century economic intuitions to twenty-first-century economic problems.”



Photo by Microsiervos via Flickr [CC BY 2.0]


Late last week, Google announced its intention to purchase Fitbit, the health tracker manufacturer, as a reaction to Apple Watch’s market dominance. The usual response to news of a tech acquisition is that startuppers’ hard work will eventually be rewarded.


When a tech giant buys out a smaller company, the startup’s founders and shareholders have their opportunity to become very, very rich. Somewhere in a garage, nerdy college students in their twenties will read that story on their smartphone and find the motivation needed to transform their brilliant idea into entrepreneurship. That is how innovation proceeds, right? Not anymore, according to a new Stigler Center working paper.


Krishna Kamepalli, Raghuram Rajan, and Luigi Zingales from the University of Chicago argue that “high-priced acquisitions of entrants by an incumbent do not necessarily stimulate more innovation and entry in an industry where customers face switching costs and enjoy network externalities.” A large acquisition by Google or Facebook does not offer new incentives to create more innovation; on the contrary, it creates a “kill zone” where new companies will be reluctant to enter.


That is counterintuitive: How is it that a big reward for innovation can reduce the incentive to innovate? Kamepalli, Rajan, and Zingales argue that digital markets are different from traditional markets.


Digital platforms like Google and Facebook are “multi-sided markets that offer digital services to customers, often for free in exchange for data.” One important difference from traditional companies is that, on the customer side, there is no price competition but there are important network externalities and switching costs. A Twitter-star has a huge audience for her tweets, but if she moves to Instagram she has to start from scratch.


This particular market structure gives a relevant role to early adopters, those “techies” who are the first to test superior technologies because they care more about the increased performance than they do about the inevitably limited community of users. Techies are crucial for tech companies because they drive the adoption of a new technology by ordinary non-techie consumers. Techies create the bulk of network externalities, and they signal to the potential mass market that the new product’s quality is higher. Without early-adopters, there are no late-comers.


Foto by Francis Chung via Flickr [CC BY 2.0]


Techies are like bees: in pursuing their own interest they generate a positive externality. Bees look for food and the same time they pollinate flowers: Because of this externality, any environmental condition that affects bees’ incentives to roam across flowers has a much bigger effect than its direct effect on bees’ welfare. The same is true here. Any environmental condition that reduces the techies’ incentives to search for better platforms and switch to them has a magnified effect on the system.


Since techies test new technologies when the network externalities are low, they face a high “cost” in terms of time and effort. If they expect that the market incumbent will merge with the startup offering superior technology, they will have less incentive to face the switching costs: They will wait for the moment when the digital platform they already use has incorporated the superior technology. But if techies do not adopt the superior technology first, its network effect will be lower, its chance to succeed smaller, and the acquisition will probably never happen.


However, if a startup commits itself to fierce independence, it reduces its potential externalities and makes its technology less attractive both for users and investors. Customers can suffer too: If markets remain segmented, some customers will not enjoy the superior technology.


“The social optimum will not be an outright prohibition or complete laissez-faire, but some middle-of-the-road policy, which will trade-off the ex-post welfare losses produced by merger restrictions against the ex-ante gains in investments in innovation,” Kamepalli, Rajan, and Zingales argue.


Antitrust authorities have an important role, too. Companies are reluctant to engage in acquisitions that are likely to be blocked by antitrust enforcers. The announcement of an acquisition in a certain space can signal to the market that antitrust authorities are more willing to allow acquisition in that segment.


To test the impact of acquisitions to innovation, Kamepalli, Rajan, and Zingales collect data on the number of deals and dollar amounts invested by venture capitalists in specific sectors after major acquisitions by Facebook and Google are announced. They focus on acquisitions of software companies from the beginning of 2006 to the end of 2018.


Acquisitions Considered: All software companies acquired by Facebook or Google for more than $500M between the beginning of 2006 and the end of 2018. Source: Pitchbook


They find that, in the three years following an acquisition by Google or Facebook, venture capital investments in startups in the same space drop by 46 percent, and the number of deals by 42 percent.


One possible explanation could be that many startups were created with the only objective of being acquired by Google of Facebook. Once the incumbent buys the startup, all its direct competitors lose any chance to succeed and they lose access to new investments. To challenge this explanation, the paper’s authors only look at startups in a space that is similar, but not too close, to that of the acquired company (so that they cannot be considered perfect substitutes).



Is the fall of investment a good reason to advocate for regulatory intervention to stop all the incumbents’ acquisitions? The answer is difficult because every policy option has tradeoffs. “A blunt non-contingent rule (e.g., no large acquisitions by main incumbent platforms will be allowed) will provide greater predictability of outcomes, stimulating greater innovation; but it can be very costly, because it prevents the industry from realizing ex-post efficiencies,” the authors argue. However, it is possible to reduce the negative consequences of acquisitions.


Reducing switching costs, for example, would reduce the incumbent market power and encourage competition for new entrants. Mandating common standards, as authorities did for electric plugs, would reduce the two main frictions in the model: the switching costs from the old technology to the new one and the network externalities of the dominant technology. Take social media: If the government mandates a common application programming interface (API), it will be easier for intermediaries to connect customers from different social media.


Intellectual property protection is also relevant: If the incumbent can easily copy the new entrant’s technology, acquisitions are not even necessary to prevent competition.


The “kill zone” has political implications too. Look at Europe: New entrants have had to compete with already-established American tech giants, and the result is that today there are no European competitors for Google, Facebook, or Amazon. China had a different approach and protected its market from foreign technology. The Communist Party has always been aware that innovation could either be an existential threat to the Communist authoritarian regime or it could become its best ally. Chinese entrants did not have to face competition from Google or Amazon, and those entrants are now big corporations like Alibaba and Tencent. The kill zone protected American Big Tech from potential domestic rivals, but it left room for the rise of giant competitors under a strategic rival foreign power’s control.


“The most important message, though, is a simple one,” Kamepalli, Ragan, and Zingales conclude: “It is dangerous to apply twentieth-century economic intuitions to twenty-first-century economic problems. Our paper suggests one reason why.”


The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.