What would Galbraith think about Google?

I’ve been grazing along the shelf of my old Penguin economics texts and stumbled on this quote from J.K.Galbraith’s (1952) American Capitalism: The Concept of Countervailing Power (in M.A.Utton’s Industrial Concentration): “The modern industry of a few large firms is an excellent instrument for  inducing technical change. It is admirably equipped for financing technical development and for putting it into use. The competition of the competitive world, by contras, almost completely precludes technical development.”


Galbraith is talking complete nonsense, of course. As this little textbook points out in the next paragraph: “The supposed antithesis between price competition and innovation is false: they are different forms of the same competitive process. Innovation is competition.” Many is the oligopolistic industry that has failed to innovate. As Will Baumol pointed out in his book The Free Market Innovation Machine, big firms tend to do incremental innovation, while radical innovation tends to come from small entrants.

This is the heart of the competition debate about Google etc. Will some new entrant come along an torpedo it in the search market, or has it through its scale effectively foreclosed new entry? Critics of the EU competition authorities’ assault on Google (including this week Barack Obama – but listen here to Martha Lane-Fox demolish him) point to its continuing record of innovation; but from another perspective, that looks like it leveraging its scale advantages into new markets, something dominant firms always try to do. I’m with Tim Wu, whose fabulous book The Master Switch argues that the opportunity for new entrants to cause upheaval in technology and communication markets has always been created by a regulatory intervention.


To be fair to Galbraith, this being one of his books I’ve not read, this summary suggests he was not relaxed about oligopoly power; however, he suggests the ‘countervailing power’ of organised labour is the way to control it. I’m all for workers having adequate bargaining power in the labour market but fail to see how that fixes a lack of competition in product markets. Google’s workers are very well treated. I wonder what Galbraith would make of these modern business titans?


Fast and slow thoughts about extended warranties

Dozing through the early business news this morning, I heard that extended warranties are back in the frame for offering consumers a bad deal (I’ll add the link when the programme is up on the iPlayer). It brought back memories. More than ten years ago (in 2002-3), I was a member of a Competition Commission inquiry into the UK extended warranties market.

For the great majority of consumers, these service or insurance contracts on domestic electrical goods are never a good deal. Appliances are well covered against malfunction by manufacturers’ warranties and UK consumer law, and often against accidental damage by normal domestic insurance policies too; and are anyway not all that prone to breaking down these days. The expected cost of repair bills or replacement is sufficiently low that most people are better off self-insuring (i.e. using their savings). A small number of cash-constrained (i.e. poor) people will benefit from paying for an extended warranty when they have the money upfront, but that’s about it.

At the time on the Competition Commission, we debated whether or not we should ban the sale of the warranties in-store. It was a close call – we decided instead to insist that stores display the warranty price alongside the price of the item so customers had a bit of time to think about it rather than (as was then the norm) being pressed to buy one when paying at the till.

With hindsight, I think we should have banned their sale in stores. Knowing what we now do about behavioural insights – especially how bad people are at assessing probabilities and expected values – would have tipped the decision, I think. The OFT looked at the market again in 2011, and the ombudsman is still saying the market isn’t working well for consumers. Oxera has a nice report about behavioural insights for these products. The right behavioural remedy it alludes to in the conclusion is probably to stop people having to decide under any pressure at all whether or not to buy one – they should do so at home, at leisure, and stores could always send them home with a form or email them a link. Maybe a copy of Kahneman’s Thinking, Fast and Slow as well?

A Nobel Prize for real world economics

The news that this year’s Nobel memorial prize in economics has gone to Jean Tirole is absolutely excellent, a really well-deserved award. I’m not going to compete with the swift and thorough summary already put out by Tyler Cowen. But I do want to add one comment just in case there are people out there thinking, why on earth has the prize gone to an economist who does theoretical, highly mathematical work – isn’t that yet another sign of how remote from the real world the whole discipline of economics has become? No economist who knows Tirole’s work will think so, and I’m sure there will be general delight about his selection, but maybe there are others who might make this mistake.

This is of course a common complaint about economics. It’s only partly true, and therefore partly false. There are for sure some economists who rely too much on basically very simple mathematics to gussy up economic analysis that doesn’t really need any equations. However, often economic thinking about the messy, complicated real world gets to a point at which the inter-relationships between variables are so knotty that mathematics is better able than words to keep track of them. The results are sometimes surprising.

Jean Tirole’s mathematics is of this kind. For example, in the work I know on two-sided markets (those where a platform stands between buyers and sellers), competition and market power look very different than they do in conventional markets like those for clothes or haircuts – so the conclusions competition authorities should draw from pricing on one side of the market might be very different from the usual ones. As the Scientific Background paper says:

“Tirole’s models have sharpened policy analysis. Focusing on the fundamental
features that generate a divergence between private and public interests, Tirole has
managed to characterize the optimal regulation of specific industries. Often, his rigorous
thinking has overturned previous conventional wisdom. For example, he successfully challenged the once prevalent view that monopoly power in one market cannot be profitably leveraged into another market by vertical integration. As a result, competition authorities have become more alert to the potential dangers posed by vertical integration and restraints. More generally, Tirole has shown how the justifications for public intervention frequently boil down to problems of information asymmetries and credible commitments. These general lessons — together with a catalogue of specific applications — form a robust foundation for policy analysis.”

His research has built the fundamental methods for the applied study of actual markets characterised by information asymmetries, moral hazard, lock-in, the exercise of power – features that are all too prevalent in the real world of business. It has huge practical relevance to regulators, including in the financial sector, and competition authorities. As Tyler points out, Tirole has also written on intrinsic motivation versus financial incentives.

The example of his work emphasises a broader point, which is that appropriate mathematics is essential in economics. And as Tony Yates recently pointed out, the maths needed as economics – thank goodness – gets ever closer to the real world is likely to get harder and harder. Say, if the subject takes more seriously non-linear dynamic systems, or strategic interactions between firms with different degrees of market power in a network market. Having said that, I always like F.Y.Edgeworth’s advice to regard mathematics as a kind of intellectual scaffolding, essential for the construction process, but preferably to be removed at the end.

Innovation, competition and public good

The Idea Factory: Bell Labs and the Great Age of American Innovation by Jon Gertner is a fabulously interesting and readable book. It’s a terrific business history about the research and development arm of AT&T during its golden, monopoly era. Scientists and engineers at Bell Labs created some of the defining technologies of modern times, including the transistor, the semiconductor, the laser, fibre optics, Claude Shannon’s information theory, submarine cables, satellites (Telstar), early work on mobile communications, and more.(Francis Spufford’s lovely book Backroom Boys has a chapter on the UK’s contribution to mobile communications at the same time.)

“Finding an aspect of modern life that doesn’t incorporate some strand of Bell Labs’ DNA would be difficult,” as Gertner rightly puts it.

The book is also a thoughtful exploration of how this institution was able to be so consistently innovative for such a long time. The key is the implicit deal between AT&T and the US authorities to permit the company its monopoly of local and, for many years, long-distance calls as long as the fruits of the research were shared with competitors. Thus key technologies such as the transistor were quickly licensed at low cost. It was an excellent system for delivering the public good of innovative ideas. The parent company was a dull but profitable utility. It paid good and steady dividends to shareholders, and to Bell Labs. “The paradox of course was that a parent company so dull, so cautious, so predictable was also in custody of a lab so innovative,” Gertner writes.

An interesting question is therefore how Bell Labs came to be so innovative in the first place. Apart from the steady flow of generous funding from the parent company, its rules seemed to have played a vital role. People were strongly discouraged from closing their doors. Anybody could ask anybody else – no matter how eminent – to help on a problem. The different disciplines were located in close proximity. All work had to be written down in specified notebooks and countersigned, so ideas were attributed, but nobody could claim individual patents. Everyone had to work on their own side-projects, an idea copied by Google. Its director saw the lab as a living organism, with physical proximity essential for the fruitful cross-fertilisation of ideas.

In those pre-competitive times, the value of patents was well understood, and Bell Labs was careful to patent its discoveries, but there was no inhibition in exchanging ideas with the broader scientific community. For example, in the early days of semi-conductor research, visitors from Fairchild Semiconductor in Palo Alto and Texas Instruments in Dallas were frequent visitors to the Bell Lab home in New Jersey. It’s hard to recall a time when commercial entities were so open with each other about their R&D.

Eventually of course the monopoly power for social returns deal broke down – and apart from Bell Labs, the other social aspect of it was AT&T’s use of long distance profits to subsidise local calls. By the time the break up of AT&T into the Baby Bells occurred in 1984, there had been several assaults on the monopoly by various US regulators. (Tim Wu’s The Master Switch gives an account of the communication monopoly from a far more sceptical perspective than The Idea Factory.) The Federal judge who finally oversaw the agreement to break up AT&T was not concerned about the vertical integration of AT&T with its research subsidiary or Western Electric, the equipment subsidiary, seeing economic benefit to consumers in the supply chain links, but rather with the horizontal integration. Hence the deal to break off the regional Baby Bells. Competition from MCI on long distance calls was already occurring. But some people anyway saw the end of the monopoly as an inevitable result of the earlier licensing of key technologies. AT&T and Bell Labs had given birth to their own future competitors.

The inevitable question is what kind of innovation system could again deliver such fundamental technological advances? All of the communications technologies have involved vast, vast sums of money and multi-year, multi-person efforts. Mariana Mazzucato has argued that government involvement in innovation is always essential, due to the scale of funding and effort, and the risk involved, giving examples mainly from the computer industry in her book The Entrepreneurial State. Governments of course fund university research, as do some foundations, but direct public funding of research and – importantly – development in the commercial sector is rare – often done through the defense budget in the US, previously through nationalised entities in other countries.

Elsewhere, and in the post-privatisation era, it is pretty rare. And today’s information sector monopolists and quasi-monopolists do not seem to have the same sense of public obligation as their Bell Labs predecessors; the profit motive did not drive the creation of transistors and semi-conductors, although it was vital in getting them into new products in the market once they had been invented. Dominant companies in digital businesses with low marginal costs and strong network effects have tremendous market power which it’s hard for competition authorities to address because there are large consumer benefits and because there’s always the hope of disruptive entry by a new and better soon-to-be-dominant company. Perhaps the right public policy approach is to learn a lesson from the history of Bell Labs and look at what public or social benefits these dominant players offer until that disruption happens?

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.