Paternalism and the iPod, Part Trois

The WSJ Law Blog reports (via this AP Report) that the French law allowing regulators to force Apple to make its iPod compatible with rival offerings went into effect Thursday. “Me too” regulatory movements are already underway in Britain, Norway, Sweden, Poland and Denmark. This, as Microsoft plans to introduce “Zune,” its entry into the media player market. First, it was Apple’s shiny packaging and exploitation of consumer irrationality that explained Apple’s success in the media player market. Now, the French law adopts a different theory: it’s iTunes.

It goes something like this: Apple is a dominant firm and is exercising market power by excluding would be rivals from using its software (iTunes) to increase its market dominance. Throw in a couple of buzzwords like “network effects,” “first-mover advantage,” “path dependence,” and “lock-in,” and we’ve got ourselves a 21st century style antitrust case. By the way, I don’t mean to suggest that these economic phenomena are not “real.” I just mean that we should not let theory get in the way of facts here. And the fact is that the iPod has generated huge benefits for consumers and there is no threat of competitive harm in sight.

But since we’re here, lets talk about the theory of competitive harm here. Professor Bainbridge, for instance, is skeptical that Zune will prove to be an “iPod Killer” because Apple is reaping the competitive benefits of “path dependence” in the presence of network effects that have created substantial barriers to entry:

Apple has managed to create a proprietary system in which music downloaded from iTunes can be played only on iPods (hence, France’s recent attempt to legislate opening the iPod format). If you’ve been an iTunes user for some years, as I have, you’ve got a huge investment in downloaded music. The costs of buying all that music over again so as to use it on a Microsoft Zune strike me as prohibitive . . ..

Toss in herd behavior, whether you call it a fad or brand cachet, and Apple looks to have pretty serious lock-in effect. It’s hard to think of any other Microsoft competitor that had such a built-in protection against competition. Netscape didn’t. WordPerfect didn’t. In both cases, there were few barriers to switching. Perhaps Sony’s Playstation is the only comparable example, and in that case while the xBox has dented Playstation, it surely hasn’t been a Playstation “killer.” So it’s very hard for me to believe Zune will prove an iPod killer.

To be fair, the good Professor does not suggest anywhere in his post that Apple’s bundling is an antitrust problem (just that Zune will not “kill” the iPod). I certainly don’t know whether Zune will be uproot Apple’s iPod success. Maybe they will offer a unique service with new features, maybe they will pay consumers to replicate their iTunes libraries, maybe they will fall flat on their face. Maybe Apple’s new attempts to increase distribution by integrating iPod functionality in automobiles will attract new consumers and keep current iPod users. I don’t pretend to have the answer. The answer is best left to the marketplace. My point is simply to illustrate the underlying economic concepts underlying the call for mandatory unbundling. Enough of that. Some thoughts on bundling, the French law, the underlying anticompetitive theory, and comparisons to Microsoft below the fold.

There is more to the economics of bundling than game theory and behavioral economics (see, e.g. my colleage Bruce Kobayashi’s excellent literature review of the economics literature or Evans & Salinger on cost-based bundles). There are plenty of pro-competitive reasons for firms to bundle products, not the least of which is that consumers prefer to get the products together. I, for one, prefer my shoelaces integrated with my tennis shoes. What I find puzzling is that the regulatory-speak has focused so much on these buzzwords and speculative theoretical effects and so little on consumer welfare. Let’s keep in mind that Apple’s success, and the benefits that have accrued to consumers because of it, derives precisely from their business model of integrating iPod and iTunes.

But let’s take the anticompetitive theory seriously for a moment. One might believe that despite all these competitive benefits, Apple is patiently waiting until the lock-in effects are so great that it can finally appropriate its barriers to entry in the form of raising prices. For example, in the comments to Dave Hoffman’s post on the strategy of Apple using faulty products and short warranties to increase its dominance and extract monopoly rents, Frank Pasquale gives a nice example of the conventional anticompetitive theory here (though not as creative as the monopolization via snazzy packaging gambit):

But far from leading us to celebrate the iPod, such developments should spark skepticism and concern about Apple’s business practices. As James Boyle’s brilliant FT article “The Apple of Forbidden Knowledge” suggests, Apple’s tactics here are just Microsoft-style monopolizing writ small. It’s using DRM to lock people into iTunes, using iTunes to lock people into its players, and who knows when they might suddenly decide to leverage that dominance into an effort to force all iPod users to buy Macs? “Just buy a Mac desktop” was suggested to me more than once by the guys at the ironically named “Genius Bar” at my local Apple store. Interoperability should be a paramount goal for the digital economy. To the extent Apple uses its dominant position to thwart it, it deserves scrutiny under the relevant competition laws.

There are a few important things to get straight here, at least about the relevant competition laws in the United States. The first is that the presence of network effects is not a sufficient condition for antitrust liability. Neither is lock-in. Nor is DRM. The US antitrust laws do not generally require a monopolist to assist its rivals. Nor do they prohibit a firm merely because it is a monopolist. US antitrust laws condemn the abuse of such power, not its existence per se, under the Sherman Act. And for good reason. A policy that penalized a firm for earning a dominant market share by producing a superior mousetrap would be anti-thetical to the purposes of competition law. We can expect firms with large shares to emerge in markets with demand side economies. It is important that we do not restrain competition in these markets by forcing the firm best able to satisfy consumer preferences to roll over.

Which brings me to my second point: I disagree with Frank’s assessment that Apple’s iPod is just “Microsoft style monopolzing writ small.” I admit, there is one important antitrust similarity between the two cases: the lack of concrete evidence of competitive harm. The theory of harm, in both cases, is speculative. The most important difference, from an antitrust perspective, is that while the D.C. Circuit condemned that portion of Microsoft’s behavior for which it could not find any sort of pro-competitive justification (even in the absence of evidence of anticompetitive effects), the benefits deriving from Apple’s bundling are not only common sensical, but also tried and true antitrust justifications. I am not saying that Microsoft was a good decision for consumers, or even decided correctly. I don’t think either of those things. But that is another post. The point is merely that the absence of an intuitively obvious pro-competitive justification for Microsoft’s conduct was a key factor in the D.C. Circuit’s opinion. It is not, however, take much of an imagination to identify the pro-competitive virtues of integrating iPod functionality with a vehicle, or bundling iTunes with the iPod. The antitrust laws do not and should not require a firm with dominant market share to refrain from competition on the merits. Offering consumers what they want, in short, is competition on the merits.

But what about Frank’s concern that one day Apple might leverage and exploit its monopoly power? Does my approach suggest that we turn a blind eye to the prospect of this future harm? No. There are two important points to be made here. The first is that future anticompetitive harm occurs, unsurprisingly, in the future. In the presence of substantial consumer welfare gains in the present, meaning that there are substantial costs to condemning the conduct today, as well as high error rates in terms of predicting future harm (read Hanno Kaiser’s excellent post on the comparative willingness to predict competitive effects in the US and EU here), antitrust policy ought to err towards the bird in the hand. Second, well … what about the possibility that Apple may exploit its power in the future (and by exploit, I mean do something more than push Apple products in the Apple store)? As I wrote before:

Even a monopolist is allowed to allow its salespeople to suggest that you buy their products. In the meantime, Apple is offering substantial benefits to consumers by improving its product and developing complements. If we are truly concerned about the risk of future anticompetitive harm, wouldn’t it be wise to allow consumers to receive those benefits until the risk materializes? We are not talking about the costly “unscrambling� of a merger that turns out to be anticompetitive.

The point is that should Apple exploit consumers at some point in the future, the supra-competitive profits would attract innovative entry from rivals. As a policy matter, it does little good to obstruct vigorous competition for the field of this variety that, by all accounts, is making consumers better off. Speaking of rivals and potential upstarts poised to discipline the market with competitive entry, Microsoft, is as my colleague and office neighbor Tom Hazlett writes, “let us put this calmly, a well-equipped upstart.” The French antitrust rule takes exactly the wrong stance here, forbidding Apple to engage in consumer welfare enhancing conduct while allowing would be competitors to do so. The reward for a competitor like Apple who has earned its market share by delivering a bundle that consumers demand should not be forcing it to play the rest of the game with one hand behind its back. Instead, regulators should allow obviously vigorous competition “for the field” to continue and smile as consumers benefit.

Hazlett puts the French law in its context quite nicely:

The French law aims to disrupt a process that was enhancing the wealth of nations. From the rubble of file sharing, with its Pirates of the Caribbean business model and its “junkyard� user experience, emerged a spiffy iTunes marketplace where songs and their listeners embrace, 99 cents a hug. The format brought artists together with users, ending their conflict and forming a virtuous circle of co-operation. A rival field of dreams is now being built by the Microsofts, Sonys, Dells, Amazons and T-Mobiles, stomachs growling and each eager to devour a little Apple. Antitrust regulators should stand back and let Apple feast or be eaten.

Indeed. But on the bright side, at least Microsoft and Google aren’t the only one who need antitrust lawyers now.