6.1 Competition is both a spur to the knowledge driven economy and a force for productivity improvement in general. Companies are more mobile internationally. Product cycles and product lives have been shortened. Improved information technology has given consumers and firms wider access to information (reducing search costs), markets are less protected, and firms are able to overcome entry barriers more quickly because products and information are delivered faster. Meanwhile, developments in science and technology have increased the rate of technical advance.

6.2 The degree of competition of an economy depends on a whole range of factors determining how firms interact. Across the economy, competitive pressures depend on openness to foreign trade and investment, on the domestic regulatory environment, the extent to which markets are liberalised and the degree of protection against monopoly power.

6.3 Although there is no room for complacency, overall the UK is seen as one of the most open and competitive countries in the OECD.(67) Measuring competitive pressures in terms of openness to trade, the UK compares well. Larger countries tend to trade less as a proportion of output. The UK is relatively open even when size is taken into account(Chart 6.1). There is considerable evidence that industries open to foreign competition perform more strongly.(68)

6.4 Competitive pressures are also enhanced by inward and outward foreign investment. The UK is the main location in Europe for inward investment and the third largest recipient of inward investment in the world after US and China. There is some evidence that inward investment boosts productivity.(69) We are also the second largest outward investor (Chart 6.2).

Competition and the changing market place
6.5 Companies in the knowledge driven economy often have the potential to be highly mobile. Those commodity based industries which mass-produce relatively unsophisticated products will tend to be mobile locating where they can find the necessary basic skills, low labour costs and a favourable tax and regulatory system. Other companies need access to location-specific factors - knowledge or resources - and these companies tend to cluster. The location of these companies depends on the continued availability and relevance of the core skills and assets which make that a desirable location to do business in. Between countries at the same level of economic development and with similar innovative capacities, it is likely that firms' decision to locate will increasingly depend on factors such as the tax and regulatory system, macroeconomic stability, infrastructure, the education system, and non-economic factors such as crime levels, climate and culture.(70)

6.6 But the changes in competitive pressure also affect companies in their domestic market. Traditional organisational structures are being challenged. For example, some companies in the financial services industry are already finding that their presence in every high street is becoming a disadvantage when they can be undercut by a small organisation with the potential, through the internet, to be in millions of homes without the cost of maintaining an expensive branch network. In order to compete with the newcomers, they need to find ways to make their network generate value for them (e.g. by offering more personalised services, or selling other products). Similar developments are taking place in the retail, travel, recruitment and property industries.

6.7 Newer firms (mainly SMEs) can have a tremendous advantage in comparison to larger organisations. Not only do they have the speed of communication and learning but also they do not bear the heavy cost of maintaining physical assets. They can exploit the latest technology and build their systems around that technology. And often the traditional barriers to small firms competing with larger ones are being removed. For instance, ICT allows small firms to access international markets without the need for a global marketing network.

6.8 However, wider market access can increase the incentives for other types of entry barriers, like sunk costs in advertising expenditure, which small firms may have problems overcoming.(71) But advertising can also be pro-competitive, as it can help consumers differentiate new products from old ones. Indeed, advertising and brand names may be considered as information or knowledge products themselves. In response to the challenge of cheaper products from abroad and the opportunity afforded by rising incomes, firms in industries as diverse as clothing, cars and beverages, are increasing the knowledge component of their products through branding and advertising.

Competition and protection of innovation
6.9 Some of the developments associated with the knowledge driven economy imply changes - in the nature of markets, the internal organisation of firms and their relations with other firms - that pose questions for the competition authorities. These go beyond the greater information problems faced by regulators in a world where output is driven by knowledge, and the regulated body increasingly has more information than the regulator.

6.10 One of the issues raised is the prevalence of increasing returns to scale in the production of goods and services with a large knowledge component. Production in the knowledge driven economy is often costly to produce but cheap to reproduce. The first tape of a Hollywood film costs a great deal more to produce than the second. Likewise, a new drug may cost millions of pounds to develop but only a few pence per unit to produce. Software, music or television programmes can be sent down a phone line at minimal cost. And once a piece of programming or music is known, one person using or playing it does not prevent somebody else doing the same.

6.11 The ease of reproduction and distribution of these products can have great benefits to consumers. However, they would not be produced in perfectly competitive markets since such markets would push price close to marginal cost (the cost of creating an additional unit), which in these cases would be close to zero. If this happened it would leave no margin to recover the huge fixed costs or to obtain a return from innovating. Information goods are typically highly differentiated and the market structure they are traded in is one of monopolistic competition or temporary monopoly. Firms compete vigorously, but the efficient price will still be above marginal cost.

6.12 Global competition for many products has made their potential market much larger. The larger the market, the less margin is needed to cover fixed costs. In some cases, firms may be able to capture a large enough market before their product is imitated to cover their fixed costs. In other cases, some protection may be needed to encourage for example the development of new drugs or the production of new films. Governments therefore afford protection by granting intellectual property rights (IPRs) to firms to allow them to recoup their investments in knowledge-based products.

6.13 The perennial problem facing the IPR and competition authorities, intensified by the knowledge driven economy, is for how long and over how wide a product range protection by IPRs or market devices should be granted or tolerated. The need for drug manufacturers to be allowed to patent their products and for film-makers, authors and musicians to enjoy copyright protection has long been recognised. IPRs in effect give these producers an element of temporary monopoly to permit them to earn profits to cover their costs. And as new products and processes have emerged, new forms of IPRs have been developed to protect them.(72)

6.14 The challenge for the authorities is to set the right balance between encouraging innovation through patent protection, and allowing consumers free access to new goods and services at the lowest possible prices. The choice for the authorities is particularly difficult when network effects are present (see box). With the development of the knowledge driven economy, it becomes more important to get this balance right.

6.15 The protection IPRs afford allow innovators to trade information in competitive markets through licensing use of these IPRs. This market power also allows producers to recover fixed costs through more creative pricing and marketing arrangements. Price discrimination for information goods and services is common: different groups of consumers pay different prices, and quality discrimination is commonplace. Publishers first issue a book in hardback and only later in paperback. Films are released first in cinemas, then on video and television. In each of these examples, the sellers use delay to "segment" the market by willingness to pay. Other techniques to segment the market or tailor the product to new groups of consumers can be used as well.(74) Vertical restraints such as selective distribution of a film may also be used as part of a marketing campaign or to establish a brand image.

6.16 But some innovators may not be able to take advantage of IPRs. Some inventions do not meet the criteria for being granted an IPR. For example, a new type of corkscrew was too obvious a new step to those 'versed in the art' for it to be granted a patent (although lesser forms of IPR were available and used). Others may not be able to take advantage because IPRs relevant to their innovation are not yet available. For example, software for business methods is arguably patentable in the US but not yet in Europe. Yet others may not be able to take advantage of IPRs which have been granted to them because their products are too easily pirated. For example, artists' recorded performances may now be easily downloaded on to the Internet, making it difficult to recoup legitimate fees.

6.17 Alternatively, some companies may not be willing to apply for IPRs because the cost of being granted an IPR is that the innovation must be disclosed. Where a firm's competitive advantage resides in the ingenuity of a product that can be easily codified and imitated, such disclosure may give too much of an advantage to the next round of innovators. So these innovators may prefer to keep "trade secrets", an example being the Coca Cola recipe. Tacit knowledge is more difficult to copy, but also more difficult to patent.

6.18 In some of these cases, remedies may become available by the authorities extending the range of available IPRs, such as for business method software in the UK; or by increasing the penalties for piracy or by third parties, such as Internet providers accepting or having placed upon them obligations which would reduce the risk of piracy. But in general new regulations will lag behind market developments.

6.19 Meanwhile, innovators may seek some other form of protection which will complement or bypass outdated rules. They may seek to protect their intellectual property through investment in complementary assets, for example in tacit knowledge which cannot easily be imitated, in company architectures, links with major customers and databases of potential customers, in advertising, brand names or reputations.(75) All these steps increase the hurdles facing firms who would otherwise easily copy or reproduce their new products more cheaply. The complementary investment may itself have IPR protection; this is often the case for brand names.

6.20 Nevertheless, all forms of effective protection for innovation, whether through IPRs or market reactions, give innovators at least temporary market power. This may be beneficial where the resulting high market shares or profits are the reward for innovation, or even where long lasting high market shares or profits are the reward for continual innovation which keeps the leader ahead of the pack. On the other hand too much protection may unduly restrict the spread of knowledge, inhibiting further innovation, restricting choice and increasing prices to consumers.

6.21 The competition authorities need to be extremely vigilant to guard against lasting anti-competitive practices. The Government has already taken steps in this direction by introducing tough new laws to stamp these practices out. But the authorities also need to be forward-looking, alert to changes in technology and markets, and well focused on the key issues, without creating a bureaucratic burden for innocent commercial parties. In practice, it is difficult to generalise and a case by case approach to these issues may be required, leaving some discretion for the competition authorities.

6.22 However, discretion may allow uncertainty to creep into the market, raising the cost of capital and hence prices to final consumers. This uncertainty could be reduced if the authorities announced what their general policy towards innovation was. Such a general policy could be described for example as: optimistic,i.e. tolerant of high market shares or profits as rewards to innovation where they were not protected by long-lasting barriers to entry; pessimistic,i.e. wary that innovation might create more entry barriers than it withered or believing that innovation stemmed best from firms with small market shares; or even just pragmatic,i.e. wary of any generalisation. It may however be difficult to reduce uncertainty by such policy statements since in practice cases may vary considerably from each other.