The Dark Side of Acquisitions
They are usually told as stories with happy endings: brilliant startups being acquired by tech giants, entrepreneurs rewarded, innovations finding the resources to fulfil their potential. Facebook buying Instagram and WhatsApp, Google incorporating YouTube and Waze, Microsoft taking over LinkedIn. Seemingly harmless transactions, very often too small to attract the attention of antitrust authorities.
Yet beneath the surface of this reassuring narrative lies a less visible risk that could have significant consequences for the future of innovation. It is the risk that the accumulation of acquisitions will permanently strengthen the market power of the largest players, making it increasingly difficult for true competitors to emerge over time.
This issue is addressed in an article published in The RAND Journal of Economics by Michele Polo (Department of Economics, Bocconi University; GREEN and IGIER) and Vincenzo Denicolò (University of Bologna and CEPR), “Acquisitions, Innovation and the Entrenchment of Monopoly”. The central idea is as simple as it is striking: acquisitions can stimulate innovation in the short term, but stifle it in the long term.
The “invention-for-buyout” paradox
The paper’s starting point is a practice well known to innovation economists: the invention-for-buyout effect. Many startups are not created with the goal of becoming large independent companies, but rather in the hope of being acquired. The prospect of a profitable outcome increases the incentives to invest in research and development, especially in sectors—such as digital or software—where bringing innovation to market requires assets that small businesses do not possess. According to the authors, in fact, “in the short run, they enhance the incentive to innovate due to the invention-for-buyout effect.” This is the classic argument of those who advocate a permissive antitrust policy: prohibiting acquisitions would mean reducing the expected rewards for innovators. But this is only half the story.
When a monopoly reinforces itself
The most original result of the paper emerges when the time horizon is extended. Denicolò and Polo set up a dynamic model in which innovation is a continuous process, consisting of repeated challenges between new entrants and a dominant incumbent. If it were unable to absorb innovations by acquiring start-ups, the dominant firm would eventually be replaced by new firms, a form of Schumpeterian competition. Through repeated acquisitions, the incumbent remains at the technological frontier and progressively strengthens its position.
Each acquisition, the authors explain, can strengthen the dominant company’s competitive advantage through consumer loyalty, dynamic economies of scale, and privileged access to data. This generates what the authors call the entrenchment of monopoly, the “crystallization” of monopoly.
The mechanism is described precisely: “The entrenchment-of-monopoly effect occurs when an acquisition increases the incumbent’s competitive advantage over potential challengers.” The result is that future innovators, faced with an increasingly strong opponent, scale back their R&D investments.
Furthermore, even when startups continue to be acquired, their negotiating position worsens: “The incumbent’s entrenchment worsens their outside options and therefore reduces the acquisition price they can negotiate with the incumbent.” In other words, the more the monopoly consolidates, the less it pays to innovate.
Short term v long term: the antitrust blind spot
The crux of the article lies here: if we look only at the immediate effect of a single acquisition, as antitrust authorities unfortunately often do, the verdict is almost always a clearance. But this approach is short-sighted.
“Acquisitions should not be evaluated in isolation. Adopting such a myopic approach in our model would invariably lead to a lenient policy but is generally sub-optimal,” write the authors. A policy truly oriented toward consumer welfare must be forward-looking, i.e., capable of considering cumulative effects over time. The model therefore shows that, when the monopoly consolidation effect is sufficiently strong, prohibiting acquisitions can increase innovation in the long run, even if it slows it down in the short run. This is a counterintuitive but very important result: future competition may be worth more than a few additional innovations today.
What really matters
Polo and Denicolò’s paper fits directly into the most recent debate on the evolution of antitrust policies, particularly in the United States and Europe. The new US Merger Guidelines, as well as the European Digital Markets Act, show a growing focus on serial acquisitions and their dynamic effects. In this context, the size of the acquired startup is often irrelevant. What really matters is the strength of the acquiring firm. In innovative markets, the risk is not so much the elimination of a current competitor as the sterilization of future ones.
