The ABC of counterfactuals

Breakfast is one of my favourite times of day. I’ve been out for a run with the dog so feel very virtuous, and of course have the Financial Times to enjoy. This morning, one article had me spluttering over my coffee, however. Premium headphone-maker Sennheiser is leading a campaign against fake electronic goods. This is understandable; as a spokesman pointed out, if people buy cheap rip-offs thinking they’re the real thing, it will damage the company’s reputation. But what provoked me was the statement that the fakes had cost the company $2m in lost sales.

No they haven’t. That sum is based on a comparison with the false counterfactual that everyone who bought fake headphones would have bought the real thing if the cheap copy had been unavailable. The true counterfactual is that almost nobody who bought the fake item would have otherwise bough the real one, which apparently costs around $300. If anybody suffered lost sales, it was makers of cheap headphones, who should be joining Sennheiser’s campaign. Similarly, almost nobody who buys a $20 ‘Louis Vuitton’ handbag at the local market would otherwise have spent $2000 on the real McCoy. I suspect that relatively few people who buy fakes consumer goods actually think they’re getting the real item, although some no doubt are fooled. The price contains the information about authenticity and most people understand that.

The erroneous counterfactual about market size is often introduced into discussions of online piracy too. Although some people who download free music from filesharing sites would otherwise have bought it, many would not. Demand is negatively correlated with price in most markets.

This is not to condone piracy at all. In the case of electronic items it can be seriously dangerous, and I think it’s a big problem. I just wish people would learn to think about counterfactuals. It isn’t taught properly in economics courses, although essential in competition analysis – and also in good econometrics, including estimating the effect of introducing a low-priced copy of a consumer good into a market. The best discussion I’ve come across is in Mostly Harmless Econometrics by Joshua Angrist and Jorn-Steffen Pischke.

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The unknown robber barons

In today’s Financial Times, Edward Luce points out that the US – creator of the internet – has dropped from top in the late 1990s to 16th now in the OECD league for average internet speeds, and has some of the highest prices too. He notes that South Koreans speak of trips to the US as ‘internet holidays’, so unfavourably does the experience compare with online access back home. Given the rise of Samsung – which spends more than twice as much proportionately on R&D as Apple (5.7% vs 2.2% of revenues respectively) – it can only be a matter of time before online leadership migrates decisively to Asia.

The article is clear about the problem – the Comcast monopoly, and the donations the company makes to Barack Obama, along with its enormous lobbying effort. Comcast’s senior VP David Cohen is apparently one of the US President’s biggest fundraisers. Comcast spent more than $14m on lobbying in 2011, making it the ninth biggest spender in the US.

This only confirms the argument of Susan Crawford’s book Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age, which directly compares Comcast to the giant trusts of the late 19th century, broken finally by the struggle to implement the 1890 Sherman Anti-Trust Act. I have to say the book isn’t the most exciting read in the world – not as enthralling as Tim Wu’s The Master Switch – but nevertheless it does a superb job of depicting Comcast’s strategy. It emerges as a superbly well-run business in strategic terms – although not, it seems, for customer service.

The company has been particularly astute about its engagement with Congress and regulators, and in judging the technological trajectory of the industry. However, the book also explains why and how the FCC made the decisions that now look mistaken, and is therefore a rare instance of insight into the complexities and compromises of the official and political world. This is much more useful than playing the blame game. So though there may be more US-centric detail than the general reader wants, this is an essential book for anyone interested in communications markets and digital convergence. I have to admit I’d heard of Comcast, but not at all of its controlling and founding family, the Roberts pere et fils, the unknown “robber barons” of the new gilded age.

Apparently Susan Crawford is a candidate for the post of next head of the FCC, but the book attacking the Comcast monopoly is seen to have damaged her chances. On the other hand, President Obama doesn’t need re-electing, so maybe he will be brave and nominate a candidate with the interests of American consumers at heart – I was staggered to read in Crawford’s book that the average user pays $143 a month for their high-speed internet and cable bundles.

For here is another example of the way big business has bought political power, and therefore the freedom to make still more money and buy still more power, in America. That subversion of social welfare in the interests of the rich affects the rest of the west too, not to mention cementing the future economic and geo-political strength of Asia.

A modest proposal (involving digital market dynamics)

One of the best books about the effect of digital technology on business dates from 1999. It’s Information Rules: A Strategic Guide to the Network Economy by Carl Shapiro and Hal Varian (now chief economist at Google). Until recently, I’ve thought it didn’t need updating, for although the examples are obviously dated, the principles are not.

However, a couple of excellent recent books on the telecommunications and media sector have made me start to wish for an update of Information Rules. They are Timothy Wu’s The Master Switch: The Rise and Fall of Information Empires and Susan Crawford’s new book, Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age. Telecoms is obviously a network industry, with the characteristic kind of increasing returns to scale you get with networks.

Both these newer books are excellent on the sector. What I’d like is an update – beyond the one chapter in the 1999 edition of Shapiro and Varian – on business strategy and market dynamics (including two-sided aspects) in network markets. For digital connectivity is making the network aspect more prominent in other sectors. Finance is obviously one, but there are more sectors where digital technologies are enabling new forms of intermediation as well as disintermediating old forms, where there are information asymmetries or experience goods, and where access to new platforms is becoming vital. Consider publishing, or indeed even retailing – say a new fashion designer facing a declining physical high street.

So here’s a modest proposal: please will somebody write about these new market dynamics (and the competition and distributional implications) where we need two-sided market models, increasing returns and non-linearities, and the experience good/public good characteristics taken into account?!

Where *do* banks get their money?

Yesterday I attended an interesting session trying to identify specific reforms to the banking system – competition policy, regulatory change, consumer-facing advice and so on – run by the Finance Innovation Lab. The event ran under the Chatham House Rule so I can’t be specific about who said what. There were some very thoughtful comments, however.

- there are large (private) economies of scale in finance but large (social) diseconomies of scale. How should competition and other policy interventions change to reflect the latter?

- financial services lies at the bottom of the Edelman trust barometer, tech companies at the top. Why this contrast, when finance is also an IT-intensive information business – what does it tell us about finance?

Edelman – trust in industries

- is low trust an opportunity to bring about change?

- the big incumbent UK banks simply can’t lend to SMEs as they’re too big. If Lloyds wants to grow its £1 trillion balance sheet by a modest 5% a year, it will be looking to lend to hedge funds, not people or small businesses.

- the cost of financial intermediation has not fallen despite the growth in the finance sector; Thomas Philippon’s paper ‘Has the US finance industry become less efficient?’ was cited.

I can talk about my own contribution, which was my usual riff about competition: UK (retail) banking is not a ‘market’ as there is no entry and no exit, only failed or unprofitable new entrants; the incumbent UK banks’ back-book of inert deposits combines with other barriers to make entry impossible, and they might need to be broken up, not just into retail and investment banks, but into smaller units altogether; banking is the only dinosaur industry not yet made extinct by digital disruption, but it’s ripe for this – if only regulators will make it possible for new technology-based entrants with entirely different business models. I’m not wildly optimistic about this. The regulators know this in principle but they don’t have the understanding or staff or contact with new start-ups to enable it.

Another speaker was Professor Richard Werner of Southampton University, whose contribution I can describe because he’s published it in Where Does Money Come From? A Guide to the UK Monetary and Banking Sytem. He  talked persuasively of the need for regional or local institutions with detailed knowledge of local businesses. He also quite rightly pointed out that almost nobody understands money, not least because all the textbooks he has ever looked at get it wrong (I agree!). I didn’t buy his argument for centralised, state-owned money creation. But I’ll read his essay in the book to give the argument a chance.

What will make banks care about their customers?

Yesterday I gave evidence to the Parliamentary Commission on Banking Standards, on competition (lack of) in retail banking – alongside two distinguished former competition regulators, John Fingleton and Clare Spottiswoode. The transcript will be published later. My message was that banks are mistaken when they say they are competing vigorously with each other – just look at the cut-throat rates on offer in the ‘best buy’ comparison tables. My experience on the Competition Commission for eight years taught me that big firms always regard their competition as intense but they can’t distinguish their intense oligopolistic rivalry from a competitive market. That intense – often loss-leading – rivalry over a narrow range of goods for a small group of customers is cross-subsidised by high margins on other extensive areas of business. (Indeed, you can tell what the banks think of the small group of mobile customers they are competing over from the fact that the industry term for them is “rate tarts”.)

Most bank customers are inert. Switching banks is a huge hassle. If it goes wrong, the consequences are an even bigger hassle, causing enormous potential disruption to bill payments and so on. The only alternatives available will be just as poor in terms of service quality or rates offered. The lack of switching and the cross-subsidies between different groups of customers are clear signs that competition in retail (and SME) banking in the UK is inadequate.

Understandably, there has been a lot of focus since the crisis on tougher regulation. But regulation alone will not improve things for customers. If you rely on regulation to improve service standards, banks will focus on their regulators. It will take competition to get them to focus on their customers. Indeed, more and more regulation will make it harder to get new competitors into the market, and the regulators are not sufficiently focused on using competition as a tool to achieve their aim of improving consumer outcomes – after all, regulators regulate. Competition works indirectly but it is a powerful force for serving consumers, and in particular for innovating and anticipating customer needs.

There is a good example in the Competition Commission’s decision to break up the BAA airport monopoly. The counter-argument was that there are economies of scale, and it’s a complex business, with break-up disruptive and uncertain. But who would have predicted that after the divestment, Gatwick Airport proved able to clear the unexpected snow off its runways quickly and efficiently in December 2010, while Heathrow, still in the hands of the old monopolist, was paralyzed for days?

I’ve not quite finished Anat Admati’s and Martin Hellwig’s The Bankers’ New Clothes. It’s absolutely excellent at skewering the bogus claims the banking lobby makes about the consequences of increasing equity requirements and limiting bonuses. It addresses regulatory issues.

What it doesn’t do is consider the competition question. Indeed, in all I’ve read about the banks in recent years, competition issues have been overlooked. There is a misperception that “too much” competition contributed to the crisis, I think, but that’s to make the same mistake of confusing a competitive market with oligopolistic feuding in some areas. The empirical evidence is mixed but leans firmly towards indicating that more competitive banking systems are more stable – the banks tend to be smaller so the “too big to fail” problem is less acute, and smaller banks are simpler so regulators (and their boards) can monitor them more easily.

The Parliamentary Commission on Banking Standards was, though, clearly well aware of the importance of increasing competition and new entry. More power to their elbow.