Kill Zone

Sai Krishna Kamepalli is a Research Professional; Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance; and Luigi Zingales is the Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance, all at the University of Chicago Booth School of Business. This post is based on their recent paper.

There is a growing worry that digital platforms (multi-sided markets that offer digital services to customers, often for free, in exchange for data) might be gaining market power, distorting competition, and slowing innovation. A specific concern is that such platforms might acquire any potential competitors, dissuading others from entering, and thus preventing innovation from serving as the competitive threat that is traditionally believed to keep monopoly incumbents on their toes. In a sense, such platforms create a “Kill Zone” around their areas of activity. Yet, this decline in the raw numbers could be driven by other concurrent factors. Most importantly, the idea that acquisitions discourage new investments is at odds with a standard economic argument; if incumbents pay handsomely to acquire new entrants, why should entry be curtailed? Why would the prospect of an acquisition not be an extra incentive for entrepreneurs to enter the space, in the hope of being acquired at hefty multiples?

In this paper we argue that this standard economic argument relies critically on the value at which firms are acquired being adequate compensation for innovation. This may not hold in the context of acquisitions by digital platforms, because the economics of digital platforms differ significantly from the neoclassical economics of firms taught in standard textbooks.  To show this, we build a simple model of platform competition that contains the key novel ingredients present in this space: First, they are two-sided in that one side faces advertisers while the other side provides customers a service, which is often priced at zero. As a result, there isn’t any price competition on the customer side. Second, there are important network externalities on the customer side of the market. Third, some customers face switching costs.

We show that a crucial role in the success of an innovation is played by early adopters amongst customers, whom we shall term “techies”. Techies choose their favored platform mainly for its technical characteristics, and have the incentive to uncover the underlying quality of each rival entrant. The mass of early techie adopters, in turn, drives the adoption by ordinary non-techie customers for two reasons. First, the mass of techie adopters offers a signal about the fundamental quality improvement brought about by the new platform. Second, this mass creates a network externality for ordinary customers, who have to choose whether to adopt the new platform.

Consider the decision of techies. They care primarily about the fundamental technical quality of the platform. However, they also engage deeply in any technology, so they have high switching costs (of learning every minor aspect of any platform they adopt). If techies expect two platforms to merge, they will be reluctant to pay the switching costs and adopt the new platform early on, unless the new platform significantly outperforms the incumbent one. After all, they know that if the entering platform’s technology is a net improvement over the existing technology, it will be adopted by the merged entity. Thus, the prospect of a merger will dissuade many techies from trying the new technology. By staying with the incumbent, however, they reduce the stand-alone value of the entering platform.

The stand-alone market value of the entering platform is driven both by its perceived quality and the total number of customers who adopt it (because of network externalities). Yet, this number depends crucially on the number of techies who adopt it, which in turn depends on the expectation this platform would indeed stand alone. Since the stand-alone value represents the entrant’s reservation value in any merger negotiation with the incumbent, the prospect of a future acquisition can sufficiently reduce adoption by techies, and thus the entrant’s payoff, so as to discourage more entry.

If it is so important for an entrant to signal that she will not sell out to the incumbent, why doesn’t she commit to it? An entrant entrepreneur will try her best to portray fierce independence, committing to uphold the “purity” of her new technology. In fact, the often-claimed presence of super egotistic CEOs/founders, driven more by a vision than by money, can be interpreted as an attempt to commit credibly to never sell the platform. Nevertheless, in a world of rational agents, it is hard to see how the entrepreneur can credibly commit not to sell when selling maximizes her profits (given that a monopolist’s profits are greater than the sum of the profits of two duopolists). This is where antitrust enforcement can help. If a large incumbent is prevented by regulation from acquiring new platforms operating in a similar space, then entrant entrepreneurs are credibly committed not to sell. This commitment will increase the valuation of new entrants, stimulating investments in technological improvements and entry.

From a welfare point of view, these restrictions on mergers will have costs: if the market remains segmented, network externalities will be lower than otherwise achievable, and some customers will not enjoy a superior technology. If the market eventually converges to the superior technology, too many customers would have to pay the switching costs. Thus, 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.

Let us turn to evidence. Since companies are reluctant to engage in acquisitions that will be blocked by antitrust, the announcement of an acquisition signals that antitrust authorities are likely to allow acquisitions in a certain space. Under this assumption, a counter-intuitive implication of our model is that acquisitions of new entrants at generous multiples by incumbent digital platforms can lead to a decrease in new entry and a decrease in the amounts invested in similar businesses at similar stages of development.

We collect data on the number of deals and dollar amounts invested by the venture capitalist in specific sectors, after major acquisitions by Facebook and Google are announced. We find that, relative to the mean in the entire software sector, VC investments in start-ups in the same space as the company acquired by Google and Facebook drop by 40% and the number of deals by 43% in the three years following an acquisition. Similarly, the financing of new startups in the same space decreased by 51% relative to the financing of all new start-ups in the software industry.

We consider alternative explanations of these results, including the possibility that most (if not all) the start-ups similar to the ones acquired by Google or Facebook were created with the only objective of being acquired by Google or Facebook. Thus, when a tech giant chooses another target, the potential alternatives lose their likely buyer and thus financing. To address this concern, we only look at startups that are in a similar space, but not too close to the space of the acquired ones (so that they cannot be considered perfect substitutes). Our results are if anything stronger. We also consider the possibility of the acquired start-up being a complement rather than a substitute to the incumbent platform.

Finally, our paper suggests an alternative remedy to prohibiting mergers: require interoperability. With interoperability, the new entrant obtains the incumbent’s network externalities. Consequently, competition primarily focuses on the intrinsic quality differences, increasing the return to innovation. If there is a policy conclusion to be drawn from our model, it is this: interoperability across platforms helps resolve many of the distortions in digital platforms because it reduces the incumbency advantage from network externalities and switching costs.

The complete paper is available for download here.

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