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?

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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.

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.