The Fundamental Unit of Competition Is Not the Firm

The fundamental unit of competition is the individual. In American economic lore, the best way to promote innovation is to minimize barriers to entry into markets and increase the rewards to market entry, to ensure that innovators can bring cutting-edge products to market, challenging old and creaky incumbents. In this story, the unit doing the entering is the firm–often visualized as a scrappy startup–and the market consists of one or more incumbent firms serving a particular consumer need with legacy technology.

But why can’t the startup be an individual person–an innovator–and the market be the interior of some great big bureaucratic firm, plus that firm’s own customers? You have an idea for a new product, you take it to your boss, your boss approves it, and the firm starts selling it to customers. There’s competition here, because you compete with other employees of the firm. If your innovation does well, you get promoted.

We all understand that competition of this kind–within-firm competition–works, because we’ve all experienced it, at least to some extent, at that vast bureaucratic organization known as school. You compete against your classmates for grades. And that drives ambitious students to work around the clock to succeed (at least, it was that way at my high school). Why can’t firms produce great innovators internally, in the same way?

One might object that the unit of competition must be the firm because only firms have the resources to implement an individual’s innovative ideas. An individual employee of a great multinational won’t have the resources he needs to develop an idea into a marketable product. By contrast, the argument goes, a startup can assemble the resources it needs to implement its vision simply by tapping funding, labor, and other markets.

But that doesn’t make sense at all. An employee at a big firm can call upon all of the resources of the firm, and the firm itself can seek additional financing, in transforming a bright idea into a marketable product. Indeed, you would expect that a large firm would be able to deploy resources in favor of an employee’s bright idea more efficiently than would a market, because the firm can realize economies of scale in providing resources to support the employee. The startup might need to hire its own accountant, lawyer, and so on, whereas the employee of the big firm could use the firm’s existing accounting and legal staffs for support, potentially filling excess capacity in those departments.

In other words, the big firm is itself a platform upon which competition can thrive, so long as the firm is organized in a way that promotes competition between employees in innovative thinking. While business schools do spend a lot of time studying how to promote innovation within firms, and the tech giants have wrestled with the problem of internal innovation quite a bit, neither antitrust legal scholarship, nor the industrial organization field in economics that serves as antitrust’s social scientific foundation, devotes any time–to my knowledge–to the problem of how to promote competition within firms.

One does find, in Arrow’s famous work on innovation, the following hint of appreciation of the possibilities:

There is really no need for the firm to be the fundamental unit of organization in invention; there is plenty of reason to suppose that individual talents count for a good deal more than the firm as an organization. If provision is made for the rental of necessary equipment, a much wider variety of research contracts with individuals as well as firms and with varying modes of payment, including incentives, could be arranged.

Kenneth Arrow, Economic Welfare and the Allocation of Resources for Invention, in The Rate and Direction of Inventive Activity: Economic and Social Factors 609, 624 (R. Nelson ed., 1962).

The failure to consider competition within firms reflects, in my view, a cultural blindspot borne of our American aversion to bureaucratic solutions, regardless whether they work. It is reasonable to suppose that sometimes, the best way to promote competition, and reap its benefits in terms of greater innovation, will come not by making it easier for startups to enter a market, but by insisting that the large firms that dominate the market organize themselves internally in ways that promote innovation. In such cases, rather than impose remedies aimed at promoting external competition, antitrust enforcers should impose remedies that promote internal competition.

One hint that failure to consider internal competition is essentially cultural comes in a study cited in F.M. Scherer’s great, dated, industrial organization textbook. The study shows that in the middle of the 20th century, innovation rates were comparable across countries that pursued different approaches to industrial organization. In British markets that were dominated by large bureaucratic firms, innovation tended to happen internally, within those large firms, whereas in less concentrated American markets, innovation tended to come from startups. Our preconceptions regarding where innovation is possible may be all that limits where our innovation actually comes from.

I’ve been perplexed by our arbitrary insistence that the firm is the basic unit of innovative competition for a long time. What got me thinking about this today is the story of the Australian rocket scientist who invented the black box used on airplanes. While working for a government aeronautical research laboratory, he was able to convince his boss to let him work on the project, albeit in secret because it did not directly contribute to the lab’s mission.

The story of the black box is not directly on point–it involves a government agency and an innovation that was not the product of competition between individuals within the agency–but it does show how an enterprising innovator can marshal resources within a bureaucracy to achieve the kind of from-scratch innovation that we typically associate with startups.