The latest SBE evening meeting brought together two of the UK’s leading regulators to discuss how incentives to innovate shape competition and regulation policy. Dr Mike Walker, Chief Economist at the Competition and Markets Authority highlighted the difference between static efficiency, dynamic efficiency, and why regulators often choose the wrong one at the cost of a country’s long term growth prospects.  Geoffrey Myers, Director of Competition Economics at Ofcom, showed how balancing competition and investment incentives shaped successive auctions for the UK’s mobile spectrum.

Dr Walker began with two key propositions.  The first is that dynamic efficiency is much more important to growth than static efficiency.  In the long term growth calculus, whether companies shave off a few extra percentage points of margin on product X is eclipsed by whether the market supports the development of products Y and Z. 

The second proposition is that for all its importance, dynamic efficiency tends to be underestimated in competition policy, perhaps because comparative static approaches are easier to measure.  We can relatively easily model the impact of a merger on incremental changes in price using standard oligopoly models.  But dynamic efficiency is much harder to estimate - we don’t have good models of how a merger may affect innovation.  In broadest terms, we know that monopoly isn’t good for innovation - the Arrow-Schumpeter debate was resolved by Shapiro (2011) in Arrow’s favour - but we don’t know how to quantify the differences.

Does it follow that competition authorities should be more hands off in the face of what they don’t know? Walker argued that this is a mistake, because the desire of firms to maximise and entrench situations which earn them rents.  Even an apparently benign case, where static inefficiency clearly has a dynamic benefit (such as IP protection for incumbents) can slide into a dynamically inefficient position such as market domination. 

Microsoft has found itself in the courts for turning innovation into dominant positions (such as the free bundling of the Internet Explorer browser with Windows) - which both saw off the challenger Netscape and sent a warning to any other would-be disruptor.  Similarly, ‘pay for delay’ cases, where pharma companies held patents of disputed legal value and negotiate payments with generic producers to prevent entry, were a classic example of anti-competitive behaviour.

The incentives facing firms to protect and maximise rents create a gravitational pull towards this type of market-dominating behaviour.  It therefore seems likely that authorities will be drawn into many industries however minimally they interpret their role.

That said, there are limits.  Regulation which proves detrimental to innovation is itself a source of dynamic inefficiency.  This outcome is never intended at the outset but appropriate regulation can become outdated.  In the market for taxi services, for instance, one could argue that consumer protection is performed more efficiently by technology now, meaning that the current regulatory framework is harming competition without an offsetting benefit to consumers.

How can authorities become smarter in their interventions?  First, better models of market structure and innovation are needed to develop conviction in assessing dynamic effects.  Second, more case studies of innovation would help to inform the debate from the empirical side - with the caveat that they are much better systematised than is common in business school studies.  Third, more ex-post evaluation of decisions by authorities would build our understanding of the dynamic impacts. Historically, institutions have avoided such introspection, but it is vital to avoid repeat mistakes.

Geoffrey Myers, Director of Competition Economics, Ofcom provided context from regulatory decisions in one of the most dynamic and innovative industries - mobile telephony.  With mobile data usage expanding by around 50%pa, suppliers need radio spectrum, more efficient technology, and more sites for masts and other infrastructure in order to keep pace.

The move to each generation of mobile signal naturally generates static efficiency gains in terms of greater productivity with each generation - people can fulfil existing needs more cheaply and in greater volume.  But there is also huge potential for dynamic gains in terms of new services.  Realising those gains is a function of maximising take up, and ensuring consumers enjoy the benefits.

The move to 2G in 1991 came with only 2 mobile players established in the market - Vodafone and Cellnet. The opportunity was taken to move to a 4 player market: 80% of new 1800mhz spectrum went to new players One2One and Orange.  Entrants were unusually successful compared to other countries, with take-up going from 1.5m users in 1993 to 27m in 1999.

The 3G auction in 2000 created a licence for a 5th player, with significant competition from 9 players, until 3 launched on 03/03/2003.  The gains to HM Treasury attracted column inches but were less important than the disruption brought by Three - lower prices, video calling, unlimited data, and so on. Three is now the largest operator by data volume from only 11% of UK mobile subscribers.

4G was auctioned in 2013.  That some of the spectrum usable for 4G was already in the hands of EE was a consideration; in the end it was decided that EE’s head start would be in consumer interests to allow faster take up - but in practice, take up only really stepped up once EE’s head start had lapsed.  Ofcom also took steps to ensure that spectrum was reserved for a smaller player (Three or a new entrant), ensuring at least a 4-player market.

In this spirit the European Commission blocked the merger of Three and O2 in 2016, though this decision has been appealed. It was unclear what the dynamic effects of the merger would have been, so the more clear-cut static case was decisive at the time.

Myers ended with a brief summary of the emerging 5G technology, which can offer enhanced mobile broadband, massive machine communications (also know as the Internet of Things), and ultra-reliable low latency (ie minimal lag time) communications for critical services such as driverless automotive and remote surgery.  It seems likely that when the time comes for the next spectrum auction, the stakes will be higher than ever in terms of long-term growth effects.  Whether theory and evidence can catch up in time to deliver the right decisions remains to be seen.

Audio of meeting:

Interview with speakers: