The European Commission’s Google Android decision takes a mistaken, ahistorical view of the smartphone market

Julian Morris —  23 July 2018

What to make of Wednesday’s decision by the European Commission alleging that Google has engaged in anticompetitive behavior? In this post, I contrast the European Commission’s (EC) approach to competition policy with US antitrust, briefly explore the history of smartphones and then discuss the ruling.

Asked about the EC’s decision the day it was announced, FTC Chairman Joseph Simons noted that, while the market is concentrated, Apple and Google “compete pretty heavily against each other” with their mobile operating systems, in stark contrast to the way the EC defined the market. Simons also stressed that for the FTC what matters is not the structure of the market per se but whether or not there is harm to the consumer. This again contrasts with the European Commission’s approach, which does not require harm to consumers. As Simons put it:

Once they [the European Commission] find that a company is dominant… that imposes upon the company kind of like a fairness obligation irrespective of what the effect is on the consumer. Our regulatory… our antitrust regime requires that there be a harm to consumer welfare — so the consumer has to be injured — so the two tests are a little bit different.

Indeed, and as the history below shows, the popularity of Apple’s iOS and Google’s Android operating systems arose because they were superior products — not because of anticompetitive conduct on the part of either Apple or Google. On the face of it, the conduct of both Apple and Google has led to consumer benefits, not harms. So, from the perspective of U.S. antitrust authorities, there is no reason to take action.

Moreover, there is a danger that by taking action as the EU has done, competition and innovation will be undermined — which would be a perverse outcome indeed. These concerns were reflected in a statement by Senator Mike Lee (R-UT):

Today’s decision by the European Commission to fine Google over $5 billion and require significant changes to its business model to satisfy EC bureaucrats has the potential to undermine competition and innovation in the United States,” Sen. Lee said. “Moreover, the decision further demonstrates the different approaches to competition policy between U.S. and EC antitrust enforcers. As discussed at the hearing held last December before the Senate’s Subcommittee on Antitrust, Competition Policy & Consumer Rights, U.S. antitrust agencies analyze business practices based on the consumer welfare standard. This analytical framework seeks to protect consumers rather than competitors. A competitive marketplace requires strong antitrust enforcement. However, appropriate competition policy should serve the interests of consumers and not be used as a vehicle by competitors to punish their successful rivals.

Ironically, the fundamental basis for the Commission’s decision is an analytical framework developed by economists at Harvard in the 1950s, which presumes that the structure of a market determines the conduct of the participants, which in turn presumptively affects outcomes for consumers. This “structure-conduct-performance” paradigm has been challenged both theoretically and empirically (and by “challenged,” I mean “demolished”).

Maintaining, as EC Commissioner Vestager has, that “What would serve competition is to have more players,” is to adopt a presumption regarding competition rooted in the structure of the market, without sufficient attention to the facts on the ground. As French economist Jean Tirole noted in his Nobel Prize lecture:

Economists accordingly have advocated a case-by-case or “rule of reason” approach to antitrust, away from rigid “per se” rules (which mechanically either allow or prohibit certain behaviors, ranging from price-fixing agreements to resale price maintenance). The economists’ pragmatic message however comes with a double social responsibility. First, economists must offer a rigorous analysis of how markets work, taking into account both the specificities of particular industries and what regulators do and do not know….

Second, economists must participate in the policy debate…. But of course, the responsibility here goes both ways. Policymakers and the media must also be willing to listen to economists.

In good Tirolean fashion, we begin with an analysis of how the market for smartphones developed. What quickly emerges is that the structure of the market is a function of intense competition, not its absence. And, by extension, mandating a different structure will likely impede competition, or, at the very least, will not likely contribute to it.

A brief history of smartphone competition

In 2006, Nokia’s N70 became the first smartphone to sell more than a million units. It was a beautiful device, with a simple touch screen interface and real push buttons for numbers. The following year, Apple released its first iPhone. It sold 7 million units — about the same as Nokia’s N95 and slightly less than LG’s Shine. Not bad, but paltry compared to the sales of Nokia’s 1200 series phones, which had combined sales of over 250 million that year — about twice the total of all smartphone sales in 2007.

By 2017, smartphones had come to dominate the market, with total sales of over 1.5 billion. At the same time, the structure of the market has changed dramatically. In the first quarter of 2018, Apple’s iPhone X and iPhone 8 were the two best-selling smartphones in the world. In total, Apple shipped just over 52 million phones, accounting for 14.5% of the global market. Samsung, which has a wider range of devices, sold even more: 78 million phones, or 21.7% of the market. At third and fourth place were Huawei (11%) and Xiaomi (7.5%). Nokia and LG didn’t even make it into the top 10, with market shares of only 3% and 1% respectively.

Several factors have driven this highly dynamic market. Dramatic improvements in cellular data networks have played a role. But arguably of greater importance has been the development of software that offers consumers an intuitive and rewarding experience.

Apple’s iOS and Google’s Android operating systems have proven to be enormously popular among both users and app developers. This has generated synergies — or what economists call network externalities — as more apps have been developed, so more people are attracted to the ecosystem and vice versa, leading to a virtuous circle that benefits both users and app developers.

By contrast, Nokia’s early smartphones, including the N70 and N95, ran Symbian, the operating system developed for Psion’s handheld devices, which had a clunkier user interface and was more difficult to code — so it was less attractive to both users and developers. In addition, Symbian lacked an effective means of solving the problem of fragmentation of the operating system across different devices, which made it difficult for developers to create apps that ran across the ecosystem — something both Apple (through its closed system) and Google (through agreements with carriers) were able to address. Meanwhile, Java’s MIDP used in LG’s Shine, and its successor J2ME imposed restrictions on developers (such as prohibiting access to files, hardware, and network connections) that seem to have made it less attractive than Android.

The relative superiority of their operating systems enabled Apple and the manufacturers of Android-based phones to steal a march on the early leaders in the smartphone revolution.

The fact that Google allows smartphone manufacturers to install Android for free, distributes Google Play and other apps in a free bundle, and pays such manufacturers for preferential treatment for Google Search, has also kept the cost of Android-based smartphones down. As a result, Android phones are the cheapest on the market, providing a powerful experience for as little as $50. It is reasonable to conclude from this that innovation, driven by fierce competition, has led to devices, operating systems, and apps that provide enormous benefits to consumers.

The Commission decision would harm device manufacturers, app developers and consumers

The EC’s decision seems to disregard the history of smartphone innovation and competition and their ongoing consequences. As Dirk Auer explains, the Open Handset Alliance (OHA) was created specifically to offer an effective alternative to Apple’s iPhone — and it worked. Indeed, it worked so spectacularly that Android is installed on about 80% of all new phones. This success was the result of several factors that the Commission now seeks to undermine:

First, in order to maintain order within the Android universe, and thereby ensure that apps developed for Android would function on the vast majority of Android devices, Google and the OHA sought to limit the extent to which Android “forks” could be created. (Apple didn’t face this problem because its source code is proprietary, so cannot be modified by third-party developers.) One way Google does this is by imposing restrictions on the licensing of its proprietary apps, such as the Google Play store (a repository of apps, similar to Apple’s App Store).

Device manufacturers that don’t conform to these restrictions may still build devices with their forked version of Android — but without those Google apps. Indeed, Amazon chooses to develop a non-conforming version of Android and built its own app repository for its Fire devices (though it is still possible to add the Google Play Store). That strategy seems to be working for Amazon in the tablet market; in 2017 it rose past Samsung to become the second biggest manufacturer of tablets worldwide, after Apple.

Second, in order to be able to offer Android for free to smartphone manufacturers, Google sought to develop unique revenue streams (because, although the software is offered for free, it turns out that software developers generally don’t work for free). The main way Google did this was by requiring manufacturers that choose to install Google Play also to install its browser (Chrome) and search tools, which generate revenue from advertising. At the same time, Google kept its platform open by permitting preloads of rivals’ apps and creating a marketplace where rivals can also reach scale. Mozilla’s Firefox browser, for example, has been downloaded over 100 million times on Android.

The importance of these factors to the success of Android is acknowledged by the EC. But instead of treating them as legitimate business practices that enabled the development of high-quality, low-cost smartphones and a universe of apps that benefits billions of people, the Commission simply asserts that they are harmful, anticompetitive practices.

For example, the Commission asserts that

In order to be able to pre-install on their devices Google’s proprietary apps, including the Play Store and Google Search, manufacturers had to commit not to develop or sell even a single device running on an Android fork. The Commission found that this conduct was abusive as of 2011, which is the date Google became dominant in the market for app stores for the Android mobile operating system.

This is simply absurd, to say nothing of ahistorical. As noted, the restrictions on Android forks plays an important role in maintaining the coherency of the Android ecosystem. If device manufacturers were able to freely install Google apps (and other apps via the Play Store) on devices running problematic Android forks that were unable to run the apps properly, consumers — and app developers — would be frustrated, Google’s brand would suffer, and the value of the ecosystem would be diminished. Extending this restriction to all devices produced by a specific manufacturer, regardless of whether they come with Google apps preinstalled, reinforces the importance of the prohibition to maintaining the coherency of the ecosystem.

It is ridiculous to say that something (efforts to rein in Android forking) that made perfect sense until 2011 and that was central to the eventual success of Android suddenly becomes “abusive” precisely because of that success — particularly when the pre-2011 efforts were often viewed as insufficient and unsuccessful (a January 2012 Guardian Technology Blog post, “How Google has lost control of Android,” sums it up nicely).

Meanwhile, if Google is unable to tie pre-installation of its search and browser apps to the installation of its app store, then it will have less financial incentive to continue to maintain the Android ecosystem. Or, more likely, it will have to find other ways to generate revenue from the sale of devices in the EU — such as charging device manufacturers for Android or Google Play. The result is that consumers will be harmed, either because the ecosystem will be degraded, or because smartphones will become more expensive.

The troubling absence of Apple from the Commission’s decision

In addition, the EC’s decision is troublesome in other ways. First, for its definition of the market. The ruling asserts that “Through its control over Android, Google is dominant in the worldwide market (excluding China) for licensable smart mobile operating systems, with a market share of more than 95%.” But “licensable smart mobile operating systems” is a very narrow definition, as it necessarily precludes operating systems that are not licensable — such as Apple’s iOS and RIM’s Blackberry OS. Since Apple has nearly 25% of the market share of smartphones in Europe, the European Commission has — through its definition of the market — presumed away the primary source of effective competition. As Pinar Akman has noted:

How can Apple compete with Google in the market as defined by the Commission when Apple allows only itself to use its operating system only on devices that Apple itself manufactures?

The EU then invents a series of claims regarding the lack of competition with Apple:

  • end user purchasing decisions are influenced by a variety of factors (such as hardware features or device brand), which are independent from the mobile operating system;

It is not obvious that this is evidence of a lack of competition. A better explanation is that the EU’s narrow definition of the market is defective. In fact, one could easily draw the opposite conclusion of that drawn by the Commission: the fact that purchasing decisions are driven by various factors suggests that there is substantial competition, with phone manufacturers seeking to design phones that offer a range of features, on a number of dimensions, to best capture diverse consumer preferences. They are able to do this in large part precisely because consumers are able to rely upon a generally similar operating system and continued access to the apps that they have downloaded. As Tim Cook likes to remind his investors, Apple is quite successful at targeting “Android switchers” to switch to iOS.

 

  • Apple devices are typically priced higher than Android devices and may therefore not be accessible to a large part of the Android device user base;

 

And yet, in the first quarter of 2018, Apple phones accounted for five of the top ten selling smartphones worldwide. Meanwhile, several competing phones, including the fifth and sixth best-sellers, Samsung’s Galaxy S9 and S9+, sell for similar prices to the most expensive iPhones. And a refurbished iPhone 6 can be had for less than $150.

 

  • Android device users face switching costs when switching to Apple devices, such as losing their apps, data and contacts, and having to learn how to use a new operating system;

 

This is, of course, true for any system switch. And yet the growing market share of Apple phones suggests that some users are willing to part with those sunk costs. Moreover, the increasing predominance of cloud-based and cross-platform apps, as well as Apple’s own “Move to iOS” Android app (which facilitates the transfer of users’ data from Android to iOS), means that the costs of switching border on trivial. As mentioned above, Tim Cook certainly believes in “Android switchers.”

 

  • even if end users were to switch from Android to Apple devices, this would have limited impact on Google’s core business. That’s because Google Search is set as the default search engine on Apple devices and Apple users are therefore likely to continue using Google Search for their queries.

 

This is perhaps the most bizarre objection of them all. The fact that Apple chooses to install Google search as the default demonstrates that consumers prefer that system over others. Indeed, this highlights a fundamental problem with the Commission’s own rationale, As Akman notes:

It is interesting that the case appears to concern a dominant undertaking leveraging its dominance from a market in which it is dominant (Google Play Store) into another market in which it is also dominant (internet search). As far as this author is aware, most (if not all?) cases of tying in the EU to date concerned tying where the dominant undertaking leveraged its dominance in one market to distort or eliminate competition in an otherwise competitive market.

Conclusion

As the foregoing demonstrates, the EC’s decision is based on a fundamental misunderstanding of the nature and evolution of the market for smartphones and associated applications. The statement by Commissioner Vestager quoted above — that “What would serve competition is to have more players” — belies this misunderstanding and highlights the erroneous assumptions underpinning the Commission’s analysis, which is wedded to a theory of market competition that was long ago thrown out by economists.

And, thankfully, it appears that the FTC Chairman is aware of at least some of the flaws in the EC’s conclusions.

Google will undoubtedly appeal the Commission’s decision. For the sakes of the millions of European consumers who rely on Android-based phones and the millions of software developers who provide Android apps, let’s hope that they succeed.

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