Preserving innovation whilst preventing the abuse of market power

The UK Government is proposing to give to the Competition and Markets Authority a raft of new powers to regulate large digital firms with a “strategic position” by virtue of their “substantial and entrenched market power”. One of these proposals instructs these firms to “not […] make changes to non-designated activities that further entrench the firm’s position in its designated activity/ activities unless the change can be shown to benefit users”.

This proposal is a reaction to concerns that large digital firms could leverage their strong position in one market to exclude rivals in another market. However, as we have explored in a recent paper, it risks making the UK a less attractive place to launch and experiment with new and better products.

What is leveraging and when is it a concern?

Leveraging refers to a firm that is active in one area expanding to launch products or services in a new area. These practices are everywhere in the economy because there are often benefits in offering customers more than one service, such as lower costs or better convenience.

The Government has noted that leveraging can lead to competition concerns, such as the foreclosure of rivals, which, in turn, can lead to higher prices and lower quality. However, harmful outcomes of this nature don’t automatically arise when leveraging happens, but rather in specific circumstances where:

• a firm has significant power in at least one of the markets;
• there is a strong link between the two markets, which means that influence in one market counts on the other;
• the firm can use this linkage to unfairly disadvantage rivals; and
• the consumer must receive a worse service as a result, with no offsetting benefit from leveraging that would outweigh any competition impact.

Outside these specific circumstances there is a lot of leveraging activity that creates substantial benefits for UK consumers. In particular:

• Leveraging can enable greater innovation that benefits consumers. Leveraging can promote innovation, particularly when there is a strong complementarity between the adjacent and core market. If there are potential benefits to the firm’s core activity, there will be incentives to innovate in all sorts of adjacent markets, even if many do not pay off. Innovation of this nature often occurs most efficiently and organically when it occurs inside the tent, rather than through arms-length commercial relationships with third parties active in the related market. Large and diverse firms are often well placed to drive innovation of this nature, as they can hedge their bets across a range of ideas, rather than betting everything on a single idea that may fail.
• Leveraging can boost competition by enabling new entrants to challenge incumbents. Leveraging has the effect of strengthening competition in adjacent markets when it helps to develop new business models, and therefore encourage market entry. Technology provides an opportunity to change the way consumers access products and services. Sometimes firms may be incentivised to try new ways of serving customers inhouse because existing markets are not already set up to do so. This can disrupt and challenge established market power where customers face poor service and a lack of innovation and can have a substantial pro-competitive effect. For example, the innovations made by Apple and Google of adding high-quality cameras to phones – a move that transpired to be critically problematic for digital camera manufacturers – turned out to be beneficial to customers.

The baby and the bathwater

The UK Government’s proposal is motivated by the idea that regulation should seek to prevent “reverse leveraging” whereby presence in an adjacent market might reinforce barriers to entry in the ‘home’ market where a firm already has an entrenched dominant position. The problem with this proposal is that it casts the net of regulation over all forms of leveraging, including the many pro-competitive and pro-innovation activities described above. This is concerning for two reasons:

• First, this proposal could harm consumers by limiting or even eliminating innovation, product development or existing service improvement in the UK. Arguably any change in behaviour to exploit synergies could be construed as strengthening the position of the ‘core’ activities of the firm and could be considered to ‘entrench’ a large digital firm’s position. As such, this regulation could lead to product feature paralysis as large digital firms lose the ability to respond to changing customer needs. The regulation could also impede the development of new and unique products and services that are better for customers and provide a new source of competition – in a way that simply will not or cannot be replaced or replicated by others. This could be especially damaging to competition in dynamic markets the where speed of being able to introduce a new product or service, or react to one launched by a rival, can be critical.
• Second, the proposed ‘get out’ clause that permits innovation if firms can prove that it will be beneficial ignores the commercial reality of the innovation process. The very nature of innovation means that it is impossible to know what will and won’t work ex ante. Moreover, experimentation necessarily means embracing trial and error, and taking steps that may have unknown benefits. Because innovation is a process of discovery, it is a serious error to assume that synergies or customer responses are or can be always known in advance.

The proposals could have an especially damaging effect on organisations’ ability to foster a culture of day-to-day experimentation. The term innovation is often associated with ‘big bang’ disruptive changes like new products or services. But in reality innovation means many things, and the overwhelming majority of it happens continuously, incrementally and organically. Many firms aspire to create an ethos of experimentation whereby combination of curiosity and an exploration of the unknown through research and testing means that everyone is encouraged to experiment, learn from failure and put forward new ideas to make the customer offering more appealing. Practically, it would be very difficult to maintain a culture of devolved, continual innovation if each initiative required regulatory review and clearance before it could be tested on the market.

Conclusion

Large digital firms, those who will likely be subject to the new regulatory regime, are a critical source of innovation and competitive challenge when they expand into adjacent markets. Whilst some leveraging can be harmful, this will almost always relate to activities where a firm holds a position of strong market power. Expanding the scope of regulation beyond this to cover all of the activities of such a firm affects a wide range of pro-competitive and pro-innovation activity that is beneficial for consumers. The fact that a firm offers new and better products in a market where it faces strong competition should not be seen as a problem. Regulating to require permission for all this activity cannot be a proportionate approach. Legislation should instead prescribe a more targeted approach. As we propose in our paper, that can and should be done by focusing efforts on using established criteria to identify those cases where leveraging is of genuine concern.