Canada: Canada's Efficiency Defence: Why Ignoring Section 96 Does More Harm Than Good For Economic Efficiency And Innovation

Canada has a defence that allows efficiency enhancing mergers and collaborations between competitors. In another paper published in this edition of the Canadian Competition Law Review, Chiasson and Johnson argue that the efficiencies defence should be repealed because it reduces innovation and causes inefficiencies. In our view, Chiasson and Johnson take an overly simplistic view of the relationship between market concentration and innovation that misses a fundamental point: mergers between competitors often increase efficiency and innovation. We also argue that efficiencies are not given enough weight and anticompetitive effects are overemphasized under the Competition Bureau's approach to merger review, which creates a bias against efficiency enhancing mergers. Removing this bias would help the Competition Act function as Parliament intended. In the words of the Supreme Court of Canada: "the efficiencies defence is Parliamentary recognition that, in some cases, consolidation is more beneficial than competition."

Au Canada, il existe une défense fondée sur les gains en efficience qui permet les fusions et les alliances entre concurrents importants dans certaines circonstances. Dans leur article qui paraît dans cette édition de la Revue canadienne du droit de la concurrence, Chiasson et Johnson font valoir que ce recours devrait être éliminé au motif qu'il étouffe l'innovation et induit des inefficiences. À notre avis, les auteurs offrent une vision trop simpliste du rapport entre concentration du marché et innovation, omettant ainsi une réalité fondamentale  : les fusions entre concurrents sont, de fait, souvent porteuses d'innovation et de gains d'efficience. En outre, nous estimons que la méthode d'examen des fusions du Bureau de la concurrence accorde trop de poids aux effets anticoncurrentiels des fusions, et pas assez aux efficiences qu'elles induisent, ce qui crée un préjugé défavorable envers celles qui améliorent l'efficience. L'élimination de ce préjugé contribuerait à rendre le fonctionnement de la Loi sur la concurrence plus conforme à l'intention du législateur, que la Cour suprême du Canada résumait en ces mots  : «  le légi slateur reconnaît par la défense fondée sur les gains en efficience que, dans certains cas, le regroupement est plus avantageux que la concurrence.  »

The Competition Act is often considered one of the most economically sophisticated competition laws in the world, largely due to the recognition of efficiencies in Canadian merger review under section 96.² However, for over 20 years, a variety of inconsistent and contradictory statements from the Competition Bureau have made the role of efficiencies in merger review "disturbingly uncertain."³

Although the Supreme Court of Canada's decision in Tervita clarified the paramountcy of efficiencies in Canadian merger review,⁴ recent speeches⁵ and a draft Efficiencies Guide⁶ from the Competition Bureau have heightened the uncertainty⁷ associated with the application of the efficiencies defence.⁸ A recent paper by Matthew Chiasson and Paul Johnson from the Competition Bureau advocating for the repeal of section 96⁹—and building on recent comments along the same lines from the previous Commissioner of Competition¹⁰—could increase the uncertainty surrounding the efficiencies defence.

Chiasson and Johnson's core argument is that "competition spurs innovation and efficiency of enormous magnitude," and as a result, the efficiencies defence authorizes "anticompetitive mergers in the name of economic efficiency even though such mergers are more likely to reduce efficiency overall."¹¹

The fundamental premise of Chiasson and Johnson's paper, however, contradicts conclusions reached by the Competition Bureau, the U.S. Federal Trade Commission, and many commentators. Innovation takes place in a variety of market structures. Research shows that more competitive environments often have much lower levels of innovation. As the Competition Bureau concluded recently after hosting an innovation and antitrust workshop for over 100 participants, "There is no definitive answer as to whether increased scale and consolidation affect innovation negatively or positively."¹² Likewise, a presentation on innovation at the Canadian Bar Association's Economist Roundtable with the Competition Bureau in 2017 stated, "Does more competition lead to more innovation? Not necessarily."¹³ Christine Wilson, a Commissioner at the U.S. Federal Trade Commission, recently suggested that the U.S. adopt a total surplus standard to emulate Canada's efficiencies defence, which would "better capture dynamic efficiencies" and promote the spread of "innovations and cost-saving measures."¹⁴ In fact, Commissioner Wilson went so far as to say:

We should consider the experience of other jurisdictions that apply the total welfare standard. It has been noted that the welfare standard employed in Canada lies somewhere between a consumer welfare and a total welfare standard. The 1986 Competition Act of Canada expressly provides for an efficiencies defense for mergers that may increase prices for consumers. Their experience could be instructive.¹⁵

In Part I of this paper, we focus on Chiasson and Johnson's arguments about competition and innovation,¹⁶ explaining that they adopt an overly simplistic view of the relationship between economic concentration and innovation that misses half of the story. Mergers can promote innovation and productivity improvements through dynamic efficiencies, increased economies of scale, and greater incentives to develop new products and services. The empirical evidence shows a complex relationship between concentration and innovation, suggesting that more competitive environments may be less innovative in many circumstances. Competition in a narrowly defined antitrust market may also have no relationship to innovation across an industry as a whole. The complex relationship between competition and innovation has been widely recognized by the Competition Bureau, the U.S. Federal Trade Commission, and others.

In Part II, we focus on Chiasson and Johnson's arguments about X-efficiency in the context of the efficiencies trade-off, explaining that there is no evidence of a systematic bias in favour of efficiencies—if anything, the bias in practice is often against mergers likely to bring about net gains in efficiency to the Canadian economy:

• Chiasson and Johnson state that the Competition Bureau will be challenged to adduce evidence of X-inefficiency, which could be a future harm from a merger. However, a theoretical concern of unknown magnitude does not justify an approach that would ignore proven benefits from a merger through increased efficiencies. Moreover, the Competition Bureau has tools to collect evidence relating to potential X-inefficiencies under the SIR process for merger review, if in fact they are likely to arise.
• Mergers also generate dynamic efficiencies, improvements in product quality, and other benefits for consumers and the Canadian economy as a whole that are challenging for the merging parties to quantify ex ante and are often ignored. One cannot assume that potential X-inefficiencies will be greater than dynamic efficiencies, improvements in product quality, and/or other qualitative benefits from a merger, since the magnitude of each factor is often unknown in advance.
• In practice, the bias, if there is one, is against efficiencies in merger reviews. The Competition Bureau's methodology significantly overestimates the size of potential anticompetitive effects in many cases, which we refer to as the "X-deadweight loss reduction."
• There is no evidence that any merger cleared on the efficiencies defence has reduced innovation and productivity in Canada. Based on our experience, mergers relying on the efficiencies defence are often likely to significantly increase innovation and productivity in Canada. In Part III, we explain why the efficiencies defence remains an underutilized mechanism for promoting innovation and productivity in Canada. 

I. The Other Half of the Story

a. Why More Competition Does Not Necessarily Promote  Innovation and Productivity

Concentrated markets often have greater levels of innovation, not less, and mergers can be a powerful mechanism for promoting greater innovation and productivity. However, by largely ignoring the complexities of the relationship between concentration and innovation, Chiasson and Johnson's paper is missing an important part of the story. As discussed in greater detail below, the empirical evidence on innovation and market structure shows a complex relationship where greater competition can both increase and decrease the level of innovation in an industry depending on a range of factors. Opportunities and incentives for greater innovation may increase as competition decreases for a variety of reasons:

Dynamic efficiencies from mergers and acquisitions. Mergers and acquisitions can be an especially effective mechanism for fostering innovation and spreading better business practices throughout the rest of the economy. There are often broader economic forces bringing together merging parties, such as the growth of a highly productive competitor or removal of a stagnant competitor. In this way, mergers may generate dynamic efficiencies from greater innovation and productivity while also resulting in greater market concentration. As Roberts and Salop (1995) explain:

Mergers can increase the financial returns from investment in innovative activities by increasing the speed and magnitude of cost savings. First, a merger may combine complementary assets in a way that increases efficient resource use. Second, a merger may allow the merged entity to spread unit cost savings over a larger output base. Third, a merger may reduce the risk associated with the investment. Fourth, a merger may allow the combined firm to implement efficiency improvements more rapidly than the two firms could independently.¹⁷

Similarly, Jullien and Lefouili (2018) explain that mergers can reduce wasteful duplications in R&D efforts by better coordinating research projects, substantially increase investment (and the resulting likelihood of success) for key research projects, and increase incentives to develop innovations with spillover effects between the operations of the merging parties.¹⁸ However, Chiasson and Johnson's argument does not take into account the fact that mergers can generate dynamic efficiencies that increase innovation following a merger.

Economies of scale. Economies of scale are an important driver of innovation and productivity, but increased competition can make it more difficult for firms to achieve economies of scale in their operations.¹⁹ Economies of scale give firms the financial resources to make the significant investments in R&D required for innovation, as well as the opportunity and incentive to apply such technological improvements across their operations. Denicolò and Polo (2018) explain how mergers in particular can enhance incentives for innovation and productivity by increasing the size and scale of a firm. ²⁰ As a firm's aggregate output increases by combining two firms, so does the value of innovation and process improvements over the merged firm's output, increasing incentives to innovate.²¹ Consistent with this, Statistics Canada data shows a strong and positive relationship between firm size and innovation, with the smallest manufacturing firms (having less than 20 employees) reporting innovation at roughly half the rate of the largest firms (having more than 2000 employees).²² Statistics Canada data also shows that large enterprises are significantly more likely than small enterprises to use advanced technologies and introduce organizational innovations.²³

The extraordinary innovation carried out at Bell Labs in the middle of the 20th century provides a remarkable example of how economies of scale in the absence of competition can facilitate technological progress. Among its many achievements, Bell Labs created the transistor (which is the building block of all digital products today), the silicon solar cell, the first patent for a laser, the first communications satellites, the theory and development of digital communications, the first cellular telephone systems, the chargecoupled device that forms the basis for digital photography, the first fiber optic cable systems, and the Unix and C computer programming languages.²⁴ Researchers at Bell Labs published ground-breaking papers in the fields of physics, chemistry, astronomy, and mathematics, and nine Nobel Prizes were awarded for work completed at Bell Labs.²⁵ It is therefore hardly an exaggeration to describe the research undertaken at Bell Labs as an "effort that rivals the Apollo program and the Manhattan Project in size, scope and expense."²⁶ However, in discussing the many scientific and technological achievements at Bell Labs, what is sometimes overlooked is that Bell Labs was the research and development division at AT&T, a monopolist until its breakup by U.S. antitrust regulators in 1982. As a result, Bell Labs had a "large and dependable income ensured by its monopoly status" to devote to research and greater time and flexibility in the absence of short-term competitive pressure to pursue long-term research goals.²⁷

In addition, a careful reading of a number of the studies discussed by Chiasson and Johnson suggests that the key driver of the increased innovation and productivity being analyzed was actually the achievement of economies of scale. For example, the study by Foster, Haltiwanger, and Krizan (2006) concludes:

[T]he dominant role of net entry is associated with the entry of more productive establishments that are part of large, national firms displacing the much less productive exiting establishments that are single-unit establishments. Our results suggest that the enormous restructuring of the retail trade sector towards large, national chains has been at the core of the productivity gains in the retail trade sector.²⁸

Chiasson and Johnson also refer to the entry of Uber as an example of competition improving quality, but it was actually Uber's economies of scale and network effects that gave it an important advantage over traditional taxi drivers and allowed it to provide such beneficial services for consumers.²⁹

Greater incentives for innovation. As discussed above, mergers can enhance incentives for innovation by increasing the value of innovation as the size and scale of a firm's aggregate output increases.³⁰ Mergers will also increase incentives to develop innovations with spillover effects between the operations of the merging parties.³¹ As Schumpeter first observed, greater competition reduces post-innovation profits, which reduces the incentive to innovate relative to an industry with fewer competitors,³² and which, as Shapiro notes, must be considered in conjunction with Arrow's observation that competition may also motivate a firm to disrupt the status quo.³³ Firms will receive a greater benefit from innovation when they have a greater share of the market. Moreover, a firm developing an innovative product will be able to sell it at a higher price when there are fewer competitors, which increases the returns to investment in research and development and increases a firm's incentive to innovate.³⁴ In fact, this is a key reason why we grant "monopolies" in the form of patents to innovators who create new inventions, as there would be less incentive to innovate if the benefits of such inventions were cannibalized by competitors.³⁵ The same principle also applies to new productive techniques, operational practices, or organizational structures that may generate critical gains in productivity and innovation but not necessarily qualify for patent protection.

Peter Howitt also points out that intensified competition is particularly likely to reduce innovation by technologically laggard firms, since such competition will reduce the anticipated profits from catching-up on innovation. The established technology leaders in the same industry, on the other hand, will continue to earn profits regardless of competition levels because rivals cannot match their cost structure and product offering, and therefore competition does not have a significant impact on the leaders' incentives to innovate. As a result, industry-wide innovation will fall as competition increases.³⁶

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Footnotes

1 Brian A. Facey is a partner and David Dueck is an associate in the Competition, Antitrust & Foreign Investment group at Blake, Cassels & Graydon LLP. The authors thank Renée Duplantis, Margaret Sanderson, Navin Joneja, Micah Wood, Joshua Krane, and anonymous reviewers for their comments, but the authors retain sole responsibility for any errors and the views expressed herein. The opinions expressed herein are those of the authors and do not necessarily reflect the views of Blake, Cassels & Graydon LLP or its clients. Brian Facey and David Dueck represented Superior Plus Corp. in connection with the Competition Bureau's review of its acquisition of Canwest Propane, and Brian Facey, along with Neil Finkelstein, represented Superior Propane Inc in proceedings relating to its acquisition of ICG Propane Inc.

2 Michael Trebilcock & Ralph A. Winter, "The State of Efficiencies in Canadian Merger Policy," (Winter 1999–2000) Canadian Competition Record 106 at 106.

3 Ibid.

4 Tervita Corp v Canada (Commissioner of Competition), 2015 SCC 3, at paras. 110–111 and 85 [Tervita].

5 See e.g., John Pecman, "Populism, Public Interest and Competition," (Speech delivered at the C.D. Howe Institute, April 27, 2018), online: https://www.canada.ca/en/competition-bureau/news/2018/05/john-pecman-commissionerof-competition---populism-public-interest-and-competition.html, and John Pecman, "Strengthening competition: Innovation, collaboration and transparency," (Paper delivered at the Canadian Bar Association's Competition Law Fall Conference, October 6, 2016), online: http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/04148.html.

6 Competition Bureau, A Practical Guide to Efficiencies Analysis in Merger Reviews (March 20, 2018), online: http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/04350.html [Draft Efficiencies Guide].

7 See Brian Facey & Joshua Krane, "Promoting Innovation and Efficiency by Streamlining Competition Reviews" C.D. Howe Institute E-Brief (March 2, 2017) at 6–7, online: https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/e-brief_254_0.pdf.

8 For detailed critiques of the draft Efficiencies Guide, see Blake, Cassels & Graydon LLP, "Blakes Comments on the Bureau's Draft Guide on Efficiencies," Responses to the Consultation on a Practical Guide to Efficiencies in Merger Reviews (May 2018), online: https://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/04379.html and the Canadian Bar Association, "Re: Practical Guide to Efficiencies in Merger Reviews," Responses to the Consultation on a Practical Guide to Efficiencies in Merger Reviews (May 3, 2018), online: https://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/04379.html.

9 Matthew Chiasson & Paul A. Johnson, "Canada's (In)efficiency Defence: Why Section 96 May Do More Harm Than Good for Economic Efficiency and Innovation" (2019) 32:1 Canadian Competition Law Rev 1.  Matthew Chiasson is a Senior Officer and Paul A. Johnson is the T.D. MacDonald Chair in Industrial Economics at the Competition Bureau.

10 John Pecman, "Unleash Canada's Competition Watchdog: Improving the effectiveness and ensuring the independence of Canada's Competition Bureau" (2018) 31:1 Canadian Competition Law Rev 1, and Pecman, "Populism, Public Interest and Competition," supra note 5.

11 Chiasson & Johnson, supra note 9 at 2–3.

12  Competition Bureau, "Highlights: Competition Bureau's innovation and antitrust workshop" (November 5, 2015), online: http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03864.html ["Highlights"] [emphasis added].

13  Paul A. Johnson, "Competition, innovation, and quality" (Presentation delivered at the Economists Roundtable with the Competition Bureau, May 8, 2017), at 10 [unpublished] [emphasis added].

14  Christine S. Wilson, "Welfare Standards Underlying Antitrust Enforcement: What You Measure is What You Get" (Luncheon Keynote Address delivered at the George Mason Law Review 22nd Annual Antitrust Symposium, Arlington, VA, February 15, 2019), online: https://www.ftc.gov/system/files/documents/public_statements/1455663/welfare_standard_speech_-_cmr-wilson.pdf.

15  Ibid. [emphasis added].

16  Note that much of Chiasson and Johnson's paper focuses on the introduction of better business practices, discussing the impact of competition on both innovation and X-efficiency. Technically, innovation and X-efficiency are distinct but closely related factors: innovation refers to the introduction of new products, services, and processes, while X-efficiency refers to the relationship between the theoretical maximum productive efficiency achievable by a firm and its actual productive efficiency.  The development and introduction of better business practices represents both an improvement in innovation and in X-efficiency. In analyzing many of the arguments in Chiasson and Johnson's paper, we also discuss both innovation and X-efficiency, at times focusing primarily on one factor and at times discussing both. For instance, Part I of this paper focuses more heavily on Chiasson and Johnson's arguments about innovation, while Part II focuses more directly on their arguments about X-efficiency in the context of the efficiencies trade-off in section 96.

17  Gary L. Roberts & Steven C. Salop, "Efficiencies in Dynamic Merger Analysis: A Summary," (1995) 19:4 World Competition 5 at 8 [emphasis added], also noting that over time (i.e., in a dynamic framework) the implications of the total welfare and price-down standard converge.

18 Bruno Jullien & Yassine Lefouili, "Horizontal Mergers and Innovation" (2018) Toulouse School of Economics Working Paper No 18–892 at 11–26.

19  See e.g., Jeffrey R. Church & Roger Ware, Industrial Organization: A Strategic Approach (Toronto: McGraw-Hill, 2000) at 249–254.

20 Vincenzo Denicolò & Michele Polo, "The Innovation Theory of Harm: An Appraisal" (2018) IEFE Working Paper No 103 at 13.

21  Ibid.

22  See Statistics Canada, "Innovation Analysis Bulletin: Vol 5, No 3" (October 2003) at 5, online: https://www150.statcan.gc.ca/n1/pub/88-003-x/88-003x2003003-eng.pdf, which measures innovation as reported by firms across a variety of industries, finding the effect is pervasive across most industries.

23 Statistics Canada, Table 27-10-0054-01: Innovation and business strategy, types of organizational innovation introduced, online: https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=2710005401, which measures the reported introduction of new business practices, new methods of organizing work responsibilities and decision making, and new methods of organizing relationships with other firms and institutions; and Statistics Canada, Table 27-10-0122-01: Innovation and business strategy, advanced technology use by industry and enterprise size, online: https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=2710012201, which measures the reported use of advanced technologies like computerized design and engineering, advanced communication technologies, advanced automated material handling technologies, etc.

24 Jon Gertner, "True Innovation," The New York Times (February 25, 2012), online: https://www.nytimes.com/2012/02/26/opinion/sunday/innovation-andthe-bell-labs-miracle.html [Gertner]. See also Jon Gertner, The Idea Factory: Bell Labs and the Great Age of American Innovation (Penguin Books Ltd, 2013).

25 Ibid. The Nobel Prizes were often awarded many years later for the work carried out at Bell Labs during this period.

26 Ibid.

27 Ibid.

28 Lucia Foster, John Haltiwanger & Cornell J. Krizan, "Market selection, reallocation, and restructuring in the US retail trade sector in the 1990s" (2006) 88:4 Rev Economics & Statistics 748 at 749 [emphasis added].

29 Judd Cramer and Alan B. Krueger, "Disruptive Change in the Taxi Business: The Case of Uber" (2016) 106:5 American Economic Rev 177.

30 Denicolò & Polo, supra note 20 at 13.

31 Jullien & Lefouili, supra note 18 at 11–26

32 Joseph A. Schumpeter, Capitalism, Socialism & Democracy, 5th ed (George Allen & Unwin Ltd, 1976).

33 Carl Shapiro, "Competition and Innovation: Did Arrow Hit the Bull's Eye?" in Scott Stern & Josh Lerner, eds, The Rate and Direction of Inventive Activity Revisited (Chicago: University of Chicago Press, 2012). Shapiro argues one should take into account the principles of Contestability, Appropriability, and Synergies in assessing innovation from mergers. The Contestability principle fits well with both the Schumpeter effect and the Arrow effect, while the Appropriability principle fits well with the Schumpeter effect.  The Synergies principle recognizes the fact that combining assets can enhance a firm's ability to innovate, and as a result, the potential for synergies to enhance innovation is especially critical to keep in mind when discussing the role of the efficiencies defence.

34 See e.g., Jullien & Lefouili, supra note 18.

35 See e.g., Competition Bureau, Intellectual Property Enforcement Guidelines (March 31, 2016), online: http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/04031.html ("This claim on the rewards flowing from IP enhances the incentive for investment and future innovation in IP, just as it does for other forms of private property.)

36 Peter Howitt, "Mushrooms and Yeast: The Implications of Technological Progress for Canada's Economic Growth," C.D. Howe Institute, Commentary No. 433 (September 2015), at 5–6, online: https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/Commentary_433.pdf.

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