Innovation and competition
in digital markets

Briefing Note

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BRIEFING NOTE

Competition and innovation in digital markets

Source:

Deller, D., Doan, T., Mariuzzo, F., Ennis, S., Fletcher, A., and Ormosi, P. (2021) “Competition and Innovation in Digital Markets”, BEIS Research Paper Number: 2021/040, April. https://ueaeprints.uea.ac.uk/id/eprint/80051/1/Published_Version.pdf

Executive Summary:

This paper is a research report commissioned by the UK government to examine the link between competition and innovation in digital markets. It explores how a future regulatory framework could address the innovation challenges identified in this sector. The report abelled various aspects, including the different forms of innovation, the influence of large technology companies (GAFAM), the role of new entrants, the impact of acquisitions, and the potential effectiveness of competition policy tools in stimulating innovation. Ultimately, it aims to provide informed recommendations for shaping regulation that promotes both competition and innovative dynamism in the digital economy.

Key words:

Digital innovation

Increased competition

New entrants

Technological acquisitions

Market regulations

Competition and Innovation in Digital Markets

1. Introduction and Definitions of Innovation:

The report highlights the importance of distinguishing between different types of innovation: incremental vs. disruptive, sustainable vs. disruptive, process vs. product, and the emergence of the concept of “soft innovation” (linked to sensory perception, aesthetics, or intellectual appeal rather than functional performance).

He cautions against a simplistic assessment of innovation based solely on R&D expenditures and patents, due to limitations such as defensive patents and the fact that many digital innovations (e.g., software code) are not patented and are protected by copyright as trade secrets.

Quote: “When it comes to digital markets, policymakers should be cautious about drawing conclusions solely from headline figures of R&D expenditures and patents.” (Recommendation 1)

2. Innovation in Digital Markets:

GAFAM (Google, Apple, Facebook, Amazon, Microsoft) companies have been behind major innovations, but the question is whether their current dominance is hindering future innovation, particularly disruptive innovation.

Market “contestability” is presented as a key factor in innovation. The threat of entry by new players encourages established firms to innovate to maintain their position, while the possibility of making profits motivates entrants.

Quote: “Hence, it is the threat of competition rather than the presence of competition that drives innovation.” (Section 2.1.2)

The report draws on Shapiro’s framework (contestability, appropriability, synergies) to analyze the forces influencing innovation.

3. Impact of Increased Competition on the Innovation of Dominant Digital Companies:

Assessing the effect of increased competition is complex because it is a counterfactual scenario. High R&D spending and new product launches by dominant players do not prove that they are innovating less than they would in a more competitive environment.

Although R&D expenditures increase with firm size, the number of innovations increases less proportionally, suggesting that distributed R&D could generate more innovations. However, larger firms may have financial incentives to pursue more marginal innovations due to their larger sales volume.

International comparisons (e.g., search engines in China and Russia) and the observation of “moligopoly” (competition between GAFAMs in adjacent markets rather than within their main markets) are examined to assess the impact of competition on innovation.

Quote: “(Petit, 2019) defines a new form of competition, abelled “moligopoly”, with which he captures the idea that large companies compete with one another across markets, including nearby markets, but not within the core markets they dominate.” (Section 3.2.4)

4. Role of New Entrants in Innovation:

New entrants are often the source of disruptive innovations. The threat of entry puts pressure on established firms to innovate.

It is important to distinguish between “new companies” and “new entrants” (an established company can enter a new market). Digital conglomerates (such as GAFAM) are often entrants into new markets.

The “incumbency advantage” (where a higher quality/cheaper entrant fails to gain significant market share due to network effects) means that entrants must offer significant intrinsic advantages to succeed.

5. Impact of Tech Giant Acquisitions on Innovation:

Acquisitions by GAFAM can have mixed effects on innovation:

Killer acquisitions: The elimination of innovation projects from the target that overlap with those of the acquirer. While possible, their frequency in the digital sector is debated.

Reverse killer acquisitions: Acquisition of potentially competing companies at an early stage.

Synergies: Technology transfer, complementarities and efficiencies resulting from the acquisition, stimulating innovation.

Stimulating innovative entry: The prospect of being acquired can encourage startup creation and venture capital investment.

Innovation direction: Startups targeting acquisition can focus on incremental innovations that complement the activities of dominant players rather than disruptive innovations.

“Kill zones” for startups: The acquisition activity of giants can discourage the creation and financing of startups in the markets where they operate or could operate.

Studies of “kill zones” using venture capital funding and startup entry as indicators show mixed results, with some suggesting a slowdown in activity in sectors close to GAFAM acquisitions.

Quote: “(Kamepalli, Rajan, & Zingales, 2020)…find that venture capital funding and the number of funding deals for start-ups similar to acquired companies dropped by 46% and 50%, respectively, in the three years after an acquisition occurred.” (Section 5.2.6)

6. The Role of Competition Policy in Increasing Innovation:

Competition policy decision-making is difficult due to the scarcity of conclusive econometric evidence.

The DMU could play a crucial role in generating further evidence by establishing a research agenda and using its investigative powers to access data from digital platforms.

Quote: “Given the limited econometric evidence found, the DMU could establish a pipeline of research to generate evidence on questions where it is currently lacking.” (Section 6.1.3)

The report discusses the pros and cons of a unilateral approach by the UK to international cooperation on digital regulation.

7. Business Behaviors and Market Characteristics to be Targeted by Competition Policy:

Contestableness is a central element of the debate. Increasing contestableness could have mixed effects on incentives to innovate.

“Route to market” (access of new entrants to consumers) is crucial. Dominant firms can use their power to restrict these routes.

European competition policy decisions reflect concerns about abuse of dominant positions related to innovation, particularly the foreclosure of potential rivals. Cases such as Microsoft (interoperability and bundling) and Google (Android, Shopping) illustrate these issues.

Quote: “First, innovation itself can be a tool for foreclosure.” (Section 7.1.3)

8. The Role of New Regulatory Tools:

The report examines how new regulatory tools could increase innovation, including mergers and acquisitions, stable and open interoperability standards, and access to data to increase contestability.

Access to data is considered a key factor in contestability, but questions remain about whether incumbent data constitutes an “essential facility” and about the frictions (e.g., privacy rules) that hinder data sharing. Data portability is presented as an alternative.

9. Potential Side Effects of Competition Policy on Innovation:

Overly restrictive merger controls could block future innovation synergies.

Regulation of data and algorithms could reduce innovation if it limits the amount or types of data available.

The imposition of mandatory interoperability/interconnection standards could have unintended consequences.

The structural separation of integrated companies could jeopardize existing innovation synergies and the pooling of large data sets.

Quote: “structural separation could put at risk the existing innovation synergies of integrated firms. Some innovations might also be hampered if large pools of data are separated.” (Section 9.1.4)

10. General Conclusions:

In summary, the report highlights the complex relationship between competition and innovation in digital markets, emphasizing the need for a nuanced and evidence-based approach to competition policy and regulation. It emphasizes the importance of contestability, careful scrutiny of acquisitions, and the need to develop a better understanding of the specific innovation dynamics of digital markets through additional research and international cooperation.

Digital markets have characteristics (network effects, economies of scale and scope) that tend toward dominance by a few firms. Competition “for the market” is often more realistic than competition “within the market.”

Maintaining and increasing contestability is crucial to drive competition and innovation.

Acquisitions have complex impacts on innovation and require case-by-case assessment.

Regulatory interventions aimed at increasing contestability (e.g., interoperability, data access) must be carefully assessed for their benefits and drawbacks.

Key Recommendations:

The report makes a series of recommendations for policymakers, including:

Be cautious about drawing conclusions solely from aggregate R&D and patent figures (Recommendation 1).

Focus pro-competitive regulation on firms with an established market position where contestability is limited (Recommendation 2).

Provide mechanisms for regular review of pro-competitive regulations (Recommendation 3).

Conduct research to understand the evolution of innovation in digital market segments where competition has varied (Recommendation 5).

Evaluate acquisitions of dominant platforms on a case-by-case basis (Recommendation 7).

The DMU should engage stakeholders on areas of competition-related research that have been hampered by lack of access to data from digital platforms (Recommendation 12).

Consider a framework for independent researchers to access relevant data from digital platforms (Recommendation 13).

The DMU should be able to request data from companies globally (Recommendation 14).

Conduct an investigation into the pros and cons of making attracting innovative businesses to the UK an explicit objective of digital markets regulation (Recommendation 15).

Conduct a detailed assessment of the best approach for the UK: unilateral initiatives or global cooperation (Recommendation 16).

If international cooperation is desirable, the UK should seek to build consensus with governments with similar interests (Recommendation 17).

Undertake retrospective studies to understand the impact on innovation of competition authorities' decisions regarding abuses of dominant position (Recommendation 18).

Carefully assess the likely positive and negative effects of pro-competitive regulatory measures for dominant platforms (Recommendation 19).

The CMA and DMU should work with the ICO to ensure a mutual understanding of the implications for competition and innovation of the application of data protection law (Recommendation 20).

Regularly undertake ex-post studies on the impact of DMU regulatory interventions, including their effects on innovation (Recommendation 21).

Where pro-competitive regulatory interventions are implemented, provide for the collection of data necessary for effective ex-post evaluation (Recommendation 22).

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Paper Summary Initial Draft By NotebookLM