This guest post is by Corbin K. Barthold, Litigation Counsel at Washington Legal Foundation.
Complexity need not follow size. A star is huge but mostly homogenous. “It’s core is so hot,” explains Martin Rees, “that no chemicals can exist (complex molecules get torn apart); it is basically an amorphous gas of atomic nuclei and electrons.”
Nor does complexity always arise from remoteness of space or time. Celestial gyrations can be readily grasped. Thales of Miletus probably predicted a solar eclipse. Newton certainly could have done so. And we’re confident that in 4.5 billion years the Andromeda galaxy will collide with our own.
If the simple can be seen in the large and the distant, equally can the complex be found in the small and the immediate. A double pendulum is chaotic. Likewise the local weather, the fluctuations of a wildlife population, or the dispersion of the milk you pour into your coffee.
Our economy is not like a planetary orbit. It’s more like the weather or the milk. No one knows which companies will become dominant, which products will become popular, or which industries will become defunct. No one can see far ahead. Investing is inherently risky because the future of the economy, or even a single segment of it, is intractably uncertain. Do not hand your savings to any expert who says otherwise. Experts, in fact, often see the least of all.
But if a broker with a “sure thing” stock is a mountebank, what does that make an antitrust scholar with an “optimum structure” for a market?
Not a prophet.
There is so much that we don’t know. Consider, for example, the notion that market concentration is a good measure of market competitiveness. The idea seems intuitive enough, and in many corners it remains an article of faith.
But the markets where this assumption is most plausible—hospital care and air travel come to mind—are heavily shaped by that grand monopolist we call government. Only a large institution can cope with the regulatory burden placed on the healthcare industry. As Tyler Cowen writes, “We get the level of hospital concentration that we have in essence chosen through politics and the law.”
As for air travel: the government promotes concentration by barring foreign airlines from the domestic market. In any case, the state of air travel does not support a straightforward conclusion that concentration equals power. The price of flying has fallen almost continuously since passage of the Airline Deregulation Act in 1978. The major airlines are disciplined by fringe carriers such as JetBlue and Southwest.
It is by no means clear that, aside from cases of government-imposed concentration, a consolidated market is something to fear. Technology lowers costs, lower costs enable scale, and scale tends to promote efficiency. Scale can arise naturally, therefore, from the process of creating better and cheaper products.
Say you’re a nineteenth-century cow farmer, and the railroad reaches you. Your shipping costs go down, and you start to sell to a wider market. As your farm grows, you start to spread your capital expenses over more sales. Your prices drop. Then refrigerated rail cars come along, you start slaughtering your cows on site, and your shipping costs go down again. Your prices drop further. Farms that fail to keep pace with your cost-cutting go bust. The cycle continues until beef is cheap and yours is one of the few cow farms in the area. The market improves as it consolidates.
As the decades pass, this story repeats itself on successively larger stages. The relentless march of technology has enabled the best companies to compete for regional, then national, and now global market share. We should not be surprised to see ever fewer firms offering ever better products and services.
Bear in mind, moreover, that it’s rarely the same company driving each leap forward. As Geoffrey Manne and Alec Stapp recently noted in this space, markets are not linear. Just after you adopt the next big advance in the logistics of beef production, drone delivery will disrupt your delivery network, cultured meat will displace your product, or virtual-reality flavoring will destroy your industry. Or—most likely of all—you’ll be ambushed by something you can’t imagine.
Does market concentration inhibit innovation? It’s possible. “To this day,” write Joshua Wright and Judge Douglas Ginsburg, “the complex relationship between static product market competition and the incentive to innovate is not well understood.”
There’s that word again: complex. When will thumping company A in an antitrust lawsuit increase the net amount of innovation coming from companies A, B, C, and D? Antitrust officials have no clue. They’re as benighted as anyone. These are the people who will squash Blockbuster’s bid to purchase a rival video-rental shop less than two years before Netflix launches a streaming service.
And it’s not as if our most innovative companies are using market concentration as an excuse to relax. If its only concern were maintaining Google’s grip on the market for internet-search advertising, Alphabet would not have spent $16 billion on research and development last year. It spent that much because its long-term survival depends on building the next big market—the one that does not exist yet.
No expert can reliably make the predictions necessary to say when or how a market should look different. And if we empowered some experts to make such predictions anyway, no other experts would be any good at predicting what the empowered experts would predict. Experts trying to give us “well structured” markets will instead give us a costly, politicized, and stochastic antitrust enforcement process.
Here’s a modest proposal. Instead of using the antitrust laws to address the curse of bigness, let’s create the Office of the Double Pendulum. We can place the whole section in a single room at the Justice Department.
All we’ll need is some ping-pong balls, a double pendulum, and a monkey. On each ball will be the name of a major corporation. Once a quarter—or a month; reasonable minds can differ—a ball will be drawn, and the monkey prodded into throwing the pendulum. An even number of twirls saves the company on the ball. An odd number dooms it to being broken up.
This system will punish success just as haphazardly as anything our brightest neo-Brandeisian scholars can devise, while avoiding the ruinously expensive lobbying, rent-seeking, and litigation that arise when scholars succeed in replacing the rule of law with the rule of experts.
All hail the chaos monkey. Unutterably complex. Ineffably simple.
In 2014, Benedict Evans, a venture capitalist at Andreessen Horowitz, wrote “Why Amazon Has No Profits (And Why It Works),” a blog post in which he tried to explain Amazon’s business model. He began with a chart of Amazon’s revenue and net income that has now become (in)famous:
A question inevitably followed in antitrust circles: How can a company that makes so little profit on so much revenue be worth so much money? It must be predatory pricing!
Predatory pricing is a rather rare anticompetitive practice because the “predator” runs the risk of bankrupting itself in the process of trying to drive rivals out of business with below-cost pricing. Furthermore, even if a predator successfully clears the field of competition, in developed markets with deep capital markets, keeping out new entrants is extremely unlikely.
Nonetheless, in those rare cases where plaintiffs can demonstrate that a firm actually has a viable scheme to drive competitors from the market with prices that are “too low” and has the ability to recoup its losses once it has cleared the market of those competitors, plaintiffs (including the DOJ) can prevail in court.
In other words, whoa if true.
Khan’s Predatory Pricing Accusation
In 2017, Lina Khan, then a law student at Yale, published “Amazon’s Antitrust Paradox” in a note for the Yale Law Journal and used Evans’ chart as supporting evidence that Amazon was guilty of predatory pricing. In the abstract she says, “Although Amazon has clocked staggering growth, it generates meager profits, choosing to price below-cost and expand widely instead.”
But if Amazon is selling below-cost, where does the money come from to finance those losses?
In her article, Khan hinted at two potential explanations: (1) Amazon is using profits from the cloud computing division (AWS) to cross-subsidize losses in the retail division or (2) Amazon is using money from investors to subsidize short-term losses:
Recently, Amazon has started reporting consistent profits, largely due to the success of Amazon Web Services, its cloud computing business. Its North America retail business runs on much thinner margins, and its international retail business still runs at a loss. But for the vast majority of its twenty years in business, losses—not profits—were the norm. Through 2013, Amazon had generated a positive net income in just over half of its financial reporting quarters. Even in quarters in which it did enter the black, its margins were razor-thin, despite astounding growth.
Just as striking as Amazon’s lack of interest in generating profit has been investors’ willingness to back the company. With the exception of a few quarters in 2014, Amazon’s shareholders have poured money in despite the company’s penchant for losses.
Revising predatory pricing doctrine to reflect the economics of platform markets, where firms can sink money for years given unlimited investor backing, would require abandoning the recoupment requirement in cases of below-cost pricing by dominant platforms.
Below-Cost Pricing Not Subsidized by Investors
But neither explanation withstands scrutiny. First, the money is not from investors. Amazon has not raised equity financing since 2003. Nor is it debt financing: The company’s net debt position has been near-zero or negative for its entire history (excluding the Whole Foods acquisition):
As Priya Anand observed in a recent piece for The Information, since Amazon started breaking out AWS in its financials, operating income for the North America retail business has been significantly positive:
But [Khan] underplays its retail profits in the U.S., where the antitrust debate is focused. As the above chart shows, its North America operation has been profitable for years, and its operating income has been on the rise in recent quarters. While its North America retail operation has thinner margins than AWS, it still generated $2.84 billion in operating income last year, which isn’t exactly a rounding error compared to its $4.33 billion in AWS operating income.
Below-Cost Pricing in Retail Also Known as “Loss Leader” Pricing
Okay, so maybe Amazon isn’t using below-cost pricing in aggregate in its retail division. But it still could be using profits from some retail products to cross-subsidize below-cost pricing for other retail products (e.g., diapers), with the intention of driving competitors out of business to capture monopoly profits. This is essentially what Khan claims happened in the Diapers.com (Quidsi) case. But in the retail industry, diapers are explicitly cited as a loss leader that help retailers to develop a customer relationship with mothers in the hopes of selling them a higher volume of products over time. This is exactly what the founders of Diapers.com told Inc Magazine in a 2012 interview (emphasis added):
We saw brick-and-mortar stores, the Wal-Marts and Targets of the world, using these products to build relationships with mom and the end consumer, bringing them into the store and selling them everything else. So we thought that was an interesting model and maybe we could replicate that online. And so we started with selling the loss leader product to basically build a relationship with mom. And once they had the passion for the brand and they were shopping with us on a weekly or a monthly basis that they’d start to fall in love with that brand. We were losing money on every box of diapers that we sold. We weren’t able to buy direct from the manufacturers.
An anticompetitive scheme could be built into such bundling, but in many if not the overwhelming majority of these cases, consumers are the beneficiaries of lower prices and expanded output produced by these arrangements. It’s hard to definitively say whether any given firm that discounts its products is actually pricing below average variable cost (“AVC”) without far more granular accounting ledgers than are typically maintained. This is part of the reason why these cases can be so hard to prove.
A successful predatory pricing strategy also requires blocking market entry when the predator eventually raises prices. But the Diapers.com case is an explicit example of repeated entry that would defeat recoupment. In an article for the American Enterprise Institute, Jeffrey Eisenach shares the rest of the story following Amazon’s acquisition of Diapers.com:
Amazon’s conduct did not result in a diaper-retailing monopoly. Far from it. According to Khan, Amazon had about 43 percent of online sales in 2016 — compared with Walmart at 23 percent and Target with 18 percent — and since many people still buy diapers at the grocery store, real shares are far lower.
In the end, Quidsi proved to be a bad investment for Amazon: After spending $545 million to buy the firm and operating it as a stand-alone business for more than six years, it announced in April 2017 it was shutting down all of Quidsi’s operations, Diapers.com included. In the meantime, Quidsi’s founders poured the proceeds of the Amazon sale into a new online retailer — Jet.com — which was purchased by Walmart in 2016 for $3.3 billion. Jet.com cofounder Marc Lore now runs Walmart’s e-commerce operations and has said publicly that his goal is to surpass Amazon as the top online retailer.
Sussman argues that the company has been inflating its free cash flow numbers by excluding “capital leases.” According to Sussman, “If all of those expenses as detailed in its statements are accounted for, Amazon experienced a negative cash outflow of $1.461 billion in 2017.” Even though it’s not dispositive of predatory pricing on its own, Sussman believes that a negative free cash flow implies the company has been selling below-cost to gain market share.
2. Amazon Recoups Losses By Lowering AVC, Not By Raising Prices
Instead of raising prices to recoup losses from pricing below-cost, Sussman argues that Amazon flies under the antitrust radar by keeping consumer prices low and progressively decreasing AVC, ostensibly through using its monopsony power to offload costs on suppliers and partners (although this point is not fully explored in his piece).
But Sussman’s argument contains errors in both legal reasoning as well as its underlying empirical assumptions.
While there are many different ways to calculate the “cost” of a product or service, generally speaking, “below-cost pricing” means the price is less than marginal cost or AVC. Typically, courts tend to rely on AVC when dealing with predatory pricing cases. And as Herbert Hovenkamp has noted, proving that a price falls below the AVC is exceedingly difficult, particularly when dealing with firms in dynamic markets that sell a number of differentiated but complementary goods or services. Amazon, the focus of Sussman’s article, is a useful example here.
When products are complements, or can otherwise be bundled, firms may also be able to offer discounts that are unprofitable when selling single items. In business this is known as the “razor and blades model” (i.e., sell the razor handle below-cost one time and recoup losses on future sales of blades — although it’s not clear if this ever actually happens). Printer manufacturers are also an oft-cited example here, where printers are often sold below AVC in the expectation that the profits will be realized on the ongoing sale of ink. Amazon’s Kindle functions similarly: Amazon sells the Kindle around its AVC, ostensibly on the belief that it will realize a profit on selling e-books in the Kindle store.
Yet, even ignoring this common and broadly inoffensive practice, Sussman’s argument is odd. In essence, he claims that Amazon is concealing some of its costs in the form of capital leases in an effort to conceal its below-AVC pricing while it works to simultaneously lower its real AVC below the prices it charges consumers. At the end of this process, once its real AVC is actually sufficiently below consumers prices, it will (so the argument goes) be in the position of a monopolist reaping monopoly profits.
The problem with this argument should be immediately apparent. For the moment, let’s ignore the classic recoupment problem where new entrants will be drawn into the market to win some of those monopoly prices based on the new AVC that is possible. The real problem with his logic is that Sussman basically suggests that if Amazon sharply lowers AVC — that is it makes production massively more efficient — and then does not drop prices, they are a “predator.” But by pricing below its AVC in the first place, consumers in essence were given a loan by Amazon — they were able to enjoy what Sussman believes are radically low prices while Amazon works to actually make those prices possible through creating production efficiencies. It seems rather strange to punish a firm for loaning consumers a large measure of wealth. Its doubly odd when you then re-factor the recoupment problem back in: as soon as other firms figure out that a lower AVC is possible, they will enter the market and bid away any monopoly profits from Amazon.
Sussman’s Technical Analysis Is Flawed
While there are issues with Sussman’s general theory of harm, there are also some specific problems with his technical analysis of Amazon’s financial statements.
Capital Leases Are a Fixed Cost
First, capital leases should be not be included in cost calculations for a predatory pricing case because they are fixed — not variable — costs. Again, “below-cost” claims in predatory pricing cases generally use AVC (and sometimes marginal cost) as relevant cost measures.
Capital Leases Are Mostly for Server Farms
Second, the usual story is that Amazon uses its wildly-profitable Amazon Web Services (AWS) division to subsidize predatory pricing in its retail division. But Amazon’s “capital leases” — Sussman’s hidden costs in the free cash flow calculations — are mostly for AWS capital expenditures (i.e., server farms).
According to the most recent annual report: “Property and equipment acquired under capital leases was $5.7 billion, $9.6 billion, and $10.6 billion in 2016, 2017, and 2018, with the increase reflecting investments in support of continued business growth primarily due to investments in technology infrastructure for AWS, which investments we expect to continue over time.”
In other words, any adjustments to the free cash flow numbers for capital leases would make Amazon Web Services appear less profitable, and would not have a large effect on the accounting for Amazon’s retail operation (the only division thus far accused of predatory pricing).
Look at Operating Cash Flow Instead of Free Cash Flow
Again, while cash flow measures cannot prove or disprove the existence of predatory pricing, a positive cash flow measure should make us more skeptical of such accusations. In the retail sector, operating cash flow is the appropriate metric to consider. As shown above, Amazon has had positive (and increasing) operating cash flow since 2002.
Your Theory of Harm Is Also Known as “Investment”
Third, in general, Sussman’s novel predatory pricing theory is indistinguishable from pro-competitive behavior in an industry with high fixed costs. From the abstract (emphasis added):
[N]egative cash flow firm[s] … can achieve greater market share through predatory pricing strategies that involve long-term below average variable cost prices … By charging prices in the present reflecting future lower costs based on prospective technological and scale efficiencies, these firms are able to rationalize their predatory pricing practices to investors and shareholders.
“’Charging prices in the present reflecting future lower costs based on prospective technological and scale efficiencies” is literally what it means to invest in capex and R&D.
Sussman’s paper presents a clever attempt to work around the doctrinal limitations on predatory pricing. But, if courts seriously adopt an approach like this, they will be putting in place a legal apparatus that quite explicitly focuses on discouraging investment. This is one of the last things we should want antitrust law to be doing.
(The following is adapted from a recent ICLE Issue Brief on the flawed essential facilities arguments undergirding the EU competition investigations into Amazon’s marketplace that I wrote with Geoffrey Manne. The full brief is available here. )
Amazon has largely avoided the crosshairs of antitrust enforcers to date. The reasons seem obvious: in the US it handles a mere 5% of all retail sales (with lower shares worldwide), and it consistently provides access to a wide array of affordable goods. Yet, even with Amazon’s obvious lack of dominance in the general retail market, the EU and some of its member states are opening investigations.
Commissioner Margarethe Vestager’s probe into Amazon, which came to light in September, centers on whether Amazon is illegally using its dominant position vis-á-vis third party merchants on its platforms in order to obtain data that it then uses either to promote its own direct sales, or else to develop competing products under its private label brands. More recently, Austria and Germany have launched separate investigations of Amazon rooted in many of the same concerns as those of the European Commission. The German investigation also focuses on whether the contractual relationships that third party sellers enter into with Amazon are unfair because these sellers are “dependent” on the platform.
One of the fundamental, erroneous assumptions upon which these cases are built is the alleged “essentiality” of the underlying platform or input. In truth, these sorts of cases are more often based on stories of firms that chose to build their businesses in a way that relies on a specific platform. In other words, their own decisions — from which they substantially benefited, of course — made their investments highly “asset specific” and thus vulnerable to otherwise avoidable risks. When a platform on which these businesses rely makes a disruptive move, the third parties cry foul, even though the platform was not — nor should have been — under any obligation to preserve the status quo on behalf of third parties.
Essential or not, that is the question
All three investigations are effectively premised on a version of an “essential facilities” theory — the claim that Amazon is essential to these companies’ ability to do business.
There are good reasons that the US has tightly circumscribed the scope of permissible claims invoking the essential facilities doctrine. Such “duty to deal” claims are “at or near the outer boundary” of US antitrust law. And there are good reasons why the EU and its member states should be similarly skeptical.
Characterizing one firm as essential to the operation of other firms is tricky because “[c]ompelling [innovative] firms to share the source of their advantage… may lessen the incentive for the monopolist, the rival, or both to invest in those economically beneficial facilities.” Further, the classification requires “courts to act as central planners, identifying the proper price, quantity, and other terms of dealing—a role for which they are ill-suited.”
The key difficulty is that alleged “essentiality” actually falls on a spectrum. On one end is something like a true monopoly utility that is actually essential to all firms that use its service as a necessary input; on the other is a firm that offers highly convenient services that make it much easier for firms to operate. This latter definition of “essentiality” describes firms like Google and Amazon, but it is not accurate to characterize such highly efficient and effective firms as truly “essential.” Instead, companies that choose to take advantage of the benefits such platforms offer, and to tailor their business models around them, suffer from an asset specificity problem.
A content provider that makes itself dependent upon another company for distribution (or vice versa, of course) takes a significant risk. Although it may benefit from greater access to users, it places itself at the mercy of the other — or at least faces great difficulty (and great cost) adapting to unanticipated, crucial changes in distribution over which it has no control.
Third-party sellers that rely upon Amazon without a contingency plan are engaging in a calculated risk that, as business owners, they would typically be expected to manage. The investigations by European authorities are based on the notion that antitrust law might require Amazon to remove that risk by prohibiting it from undertaking certain conduct that might raise costs for its third-party sellers.
Implications and extensions
In the full issue brief, we consider the tensions in EU law between seeking to promote innovation and protect the competitive process, on the one hand, and the propensity of EU enforcers to rely on essential facilities-style arguments on the other. One of the fundamental errors that leads EU enforcers in this direction is that they confuse the distribution channel of the Internet with an antitrust-relevant market definition.
A claim based on some flavor of Amazon-as-essential-facility should be untenable given today’s market realities because Amazon is, in fact, just one mode of distribution among many. Commerce on the Internet is still just commerce. The only thing preventing a merchant from operating a viable business using any of a number of different mechanisms is the transaction costs it would incur adjusting to a different mode of doing business. Casting Amazon’s marketplace as an essential facility insulates third-party firms from the consequences of their own decisions — from business model selection to marketing and distribution choices. Commerce is nothing new and offline distribution channels and retail outlets — which compete perfectly capably with online — are well developed. Granting retailers access to Amazon’s platform on artificially favorable terms is no more justifiable than granting them access to a supermarket end cap, or a particular unit at a shopping mall. There is, in other words, no business or economic justification for granting retailers in the time-tested and massive retail market an entitlement to use a particular mode of marketing and distribution just because they find it more convenient.
[N]ew combinations are, as a rule, embodied, as it were, in new firms which generally do not arise out of the old ones but start producing beside them; … in general it is not the owner of stagecoaches who builds railways. – Joseph Schumpeter, January 1934
Elizabeth Warren wants to break up the tech giants — Facebook, Google, Amazon, and Apple — claiming they have too much power and represent a danger to our democracy. As part of our response to her proposal, we shared a couple of headlines from 2007 claiming that MySpace had an unassailable monopoly in the social media market.
Tommaso Valletti, the chief economist of the Directorate-General for Competition (DG COMP) of the European Commission, said, in what we assume was a reference to our posts, “they go on and on with that single example to claim that [Facebook] and [Google] are not a problem 15 years later … That’s not what I would call an empirical regularity.”
We appreciate the invitation to show that prematurely dubbing companies “unassailable monopolies” is indeed an empirical regularity.
It’s Tough to Make Predictions, Especially About the Future of Competition in Tech
No one is immune to this phenomenon. Antitrust regulators often take a static view of competition, failing to anticipate dynamic technological forces that will upend market structure and competition.
Scientists and academics make a different kind of error. They are driven by the need to satisfy their curiosity rather than shareholders. Upon inventing a new technology or discovering a new scientific truth, academics often fail to see the commercial implications of their findings.
Maybe the titans of industry don’t make these kinds of mistakes because they have skin in the game? The profit and loss statement is certainly a merciless master. But it does not give CEOs the power of premonition. Corporate executives hailed as visionaries in one era often become blinded by their success, failing to see impending threats to their company’s core value propositions.
Furthermore, it’s often hard as outside observers to tell after the fact whether business leaders just didn’t see a tidal wave of disruption coming or, worse, they did see it coming and were unable to steer their bureaucratic, slow-moving ships to safety. Either way, the outcome is the same.
Here’s the pattern we observe over and over: extreme success in one context makes it difficult to predict how and when the next paradigm shift will occur in the market. Incumbents become less innovative as they get lulled into stagnation by high profit margins in established lines of business. (This is essentially the thesis of Clay Christensen’s The Innovator’s Dilemma).
Even if the anti-tech populists are powerless to make predictions, history does offer us some guidance about the future. We have seen time and again that apparently unassailable monopolists are quite effectively assailed by technological forces beyond their control.
Nov 2007: “Nokia: One Billion Customers—Can Anyone Catch the Cell Phone King?” (Forbes)
Sep 2013: “Microsoft CEO Ballmer Bids Emotional Farewell to Wall Street” (Reuters)
If there’s one thing I regret, there was a period in the early 2000s when we were so focused on what we had to do around Windows that we weren’t able to redeploy talent to the new device form factor called the phone.
Mar 1998: “How Yahoo! Won the Search Wars” (Fortune)
Once upon a time, Yahoo! was an Internet search site with mediocre technology. Now it has a market cap of $2.8 billion. Some people say it’s the next America Online.
AOL’s dominance of instant messaging technology, the kind of real-time e-mail that also lets users know when others are online, has emerged as a major concern of regulators scrutinizing the company’s planned merger with Time Warner Inc. (twx). Competitors to Instant Messenger, such as Microsoft Corp. (msft) and Yahoo! Inc. (yhoo), have been pressing the Federal Communications Commission to force AOL to make its services compatible with competitors’.
Dec 2000: “AOL’s Instant Messaging Monopoly?” (Wired)
There have been isolated examples, as in the case of obligations of the merged AOL / Time Warner to make AOL Instant Messenger interoperable with competing messaging services. These obligations on AOL are widely viewed as having been a dismal failure.
Seventy percent of Yahoo 360 users, for example, also use other social networking sites — MySpace in particular. Ditto for Facebook, Windows Live Spaces and Friendster … This presents an obvious, long-term business challenge to the competitors. If they cannot build up a large base of unique users, they will always be on MySpace’s periphery.
Feb 2007: “Will Myspace Ever Lose Its Monopoly?” (Guardian)
Jun 2011: “Myspace Sold for $35m in Spectacular Fall from $12bn Heyday” (Guardian)
Dec 2003: “The subscription model of buying music is bankrupt. I think you could make available the Second Coming in a subscription model, and it might not be successful.” – Steve Jobs (Rolling Stone)
Predicting the future of competition in the tech industry is such a fraught endeavor that even articles about how hard it is to make predictions include incorrect predictions. The authors just cannot help themselves. A March 2012 BBC article “The Future of Technology… Who Knows?” derided the naysayers who predicted doom for Apple’s retail store strategy. Its kicker?
And that is why when you read that the Blackberry is doomed, or that Microsoft will never make an impression on mobile phones, or that Apple will soon dominate the connected TV market, you need to take it all with a pinch of salt.
But Blackberry was doomed and Microsoft never made an impression on mobile phones. (Half credit for Apple TV, which currently has a 15% market share).
Nobel Prize-winning economist Paul Krugman wrote a piece for Red Herring magazine (seriously) in June 1998 with the title “Why most economists’ predictions are wrong.” Headline-be-damned, near the end of the article he made the following prediction:
The growth of the Internet will slow drastically, as the flaw in “Metcalfe’s law”—which states that the number of potential connections in a network is proportional to the square of the number of participants—becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.
Robert Metcalfe himself predicted in a 1995 column that the Internet would “go spectacularly supernova and in 1996 catastrophically collapse.” After pledging to “eat his words” if the prediction did not come true, “in front of an audience, he put that particular column into a blender, poured in some water, and proceeded to eat the resulting frappe with a spoon.”
A Change Is Gonna Come
Benedict Evans, a venture capitalist at Andreessen Horowitz, has the best summary of why competition in tech is especially difficult to predict:
IBM, Microsoft and Nokia were not beaten by companies doing what they did, but better. They were beaten by companies that moved the playing field and made their core competitive assets irrelevant. The same will apply to Facebook (and Google, Amazon and Apple).
Elsewhere, Evans tried to reassure his audience that we will not be stuck with the current crop of tech giants forever:
With each cycle in tech, companies find ways to build a moat and make a monopoly. Then people look at the moat and think it’s invulnerable. They’re generally right. IBM still dominates mainframes and Microsoft still dominates PC operating systems and productivity software. But… It’s not that someone works out how to cross the moat. It’s that the castle becomes irrelevant. IBM didn’t lose mainframes and Microsoft didn’t lose PC operating systems. Instead, those stopped being ways to dominate tech. PCs made IBM just another big tech company. Mobile and the web made Microsoft just another big tech company. This will happen to Google or Amazon as well. Unless you think tech progress is over and there’ll be no more cycles … It is deeply counter-intuitive to say ‘something we cannot predict is certain to happen’. But this is nonetheless what’s happened to overturn pretty much every tech monopoly so far.
If this time is different — or if there are more false negatives than false positives in the monopoly prediction game — then the advocates for breaking up Big Tech should try to make that argument instead of falling back on “big is bad” rhetoric. As for us, we’ll bet that we have not yet reached the end of history — tech progress is far from over.
First, [my administration would restore competition to the tech sector] by passing legislation that requires large tech platforms to be designated as “Platform Utilities” and broken apart from any participant on that platform.
* * *
For smaller companies…, their platform utilities would be required to meet the same standard of fair, reasonable, and nondiscriminatory dealing with users, but would not be required to structurally separate….
* * * Second, my administration would appoint regulators committed to reversing illegal and anti-competitive tech mergers…. I will appoint regulators who are committed to… unwind[ing] anti-competitive mergers, including:
Let’s consider for a moment what this brave new world will look like — not the nirvana imagined by regulators and legislators who believe that decimating a company’s business model will deter only the “bad” aspects of the model while preserving the “good,” as if by magic, but the inevitable reality of antitrust populism.
Utilities? Are you kidding? For an overview of what the future of tech would look like under Warren’s “Platform Utility” policy, take a look at your water, electricity, and sewage service. Have you noticed any improvement (or reduction in cost) in those services over the past 10 or 15 years? How about the roads? Amtrak? Platform businesses operating under a similar regulatory regime would also similarly stagnate. Enforcing platform “neutrality” necessarily requires meddling in the most minute of business decisions, inevitably creating unintended and costly consequences along the way.
Network companies, like all businesses, differentiate themselves by offering unique bundles of services to customers. By definition, this means vertically integrating with some product markets and not others. Why are digital assistants like Siri bundled into mobile operating systems? Why aren’t the vast majority of third-party apps also bundled into the OS? If you want utilities regulators instead of Google or Apple engineers and designers making these decisions on the margin, then Warren’s “Platform Utility” policy is the way to go.
Grocery Stores. To take one specific case cited by Warren, how much innovation was there in the grocery store industry before Amazon bought Whole Foods? Since the acquisition, large grocery retailers, like Walmart and Kroger, have increased their investment in online services to better compete with the e-commerce champion. Many industry analysts expect grocery stores to use computer vision technology and artificial intelligence to improve the efficiency of check-out in the near future.
Smartphones. Imagine how forced neutrality would play out in the context of iPhones. If Apple can’t sell its own apps, it also can’t pre-install its own apps. A brand new iPhone with no apps — and even more importantly, no App Store — would be, well, just a phone, out of the box. How would users even access a site or app store from which to download independent apps? Would Apple be allowed to pre-install someone else’s apps? That’s discriminatory, too. Maybe it will be forced to offer a menu of all available apps in all categories (like the famously useless browser ballot screen demanded by the European Commission in its Microsoft antitrust case)? It’s hard to see how that benefits consumers — or even app developers.
Internet Search. Or take search. Calls for “search neutrality” have been bandied about for years. But most proponents of search neutrality fail to recognize that all Google’s search results entail bias in favor of its own offerings. As Geoff Manne and Josh Wright noted in 2011 at the height of the search neutrality debate:
[S]earch engines offer up results in the form not only of typical text results, but also maps, travel information, product pages, books, social media and more. To the extent that alleged bias turns on a search engine favoring its own maps, for example, over another firm’s, the allegation fails to appreciate that text results and maps are variants of the same thing, and efforts to restrain a search engine from offering its own maps is no different than preventing it from offering its own search results.
Nevermind that Google with forced non-discrimination likely means Google offering only the antiquated “ten blue links” search results page it started with in 1998 instead of the far more useful “rich” results it offers today; logically it would also mean Google somehow offering the set of links produced by any and all other search engines’ algorithms, in lieu of its own. If you think Google will continue to invest in and maintain the wealth of services it offers today on the strength of the profits derived from those search results, well, Elizabeth Warren is probably already your favorite politician.
And regulatory oversight of algorithmic content won’t just result in an impoverished digital experience; it will inevitably lead to an authoritarian one, as well:
Any agency granted a mandate to undertake such algorithmic oversight, and override or reconfigure the product of online services, thereby controls the content consumers may access…. This sort of control is deeply problematic… [because it saddles users] with a pervasive set of speech controls promulgated by the government. The history of such state censorship is one which has demonstrated strong harms to both social welfare and rule of law, and should not be emulated.
Digital Assistants. Consider also the veritable cage match among the tech giants to offer “digital assistants” and “smart home” devices with ever-more features at ever-lower prices. Today the allegedly non-existent competition among these companies is played out most visibly in this multi-featured market, comprising advanced devices tightly integrated with artificial intelligence, voice recognition, advanced algorithms, and a host of services. Under Warren’s nondiscrimination principle this market disappears. Each device can offer only a connectivity platform (if such a service is even permitted to be bundled with a physical device…) — and nothing more.
But such a world entails not only the end of an entire, promising avenue of consumer-benefiting innovation, it also entails the end of a promising avenue of consumer-benefiting competition. It beggars belief that anyone thinks consumers would benefit by forcing technology companies into their own silos, ensuring that the most powerful sources of competition for each other are confined to their own fiefdoms by order of law.
Breaking business models
Beyond the product-feature dimension, Sen. Warren’s proposal would be devastating for innovative business models. Why is Amazon Prime Video bundled with free shipping? Because the marginal cost of distribution for video is close to zero and bundling it with Amazon Prime increases the value proposition for customers. Why is almost every Google service free to users? Because Google’s business model is supported by ads, not monthly subscription fees. Each of the tech giants has carefully constructed an ecosystem in which every component reinforces the others. Sen. Warren’s plan would not only break up the companies, it would prohibit their business models — the ones that both created and continue to sustain these products. Such an outcome would manifestly harm consumers.
Both of Warren’s policy “solutions” are misguided and will lead to higher prices and less innovation. Her cause for alarm is built on a multitude of mistaken assumptions, but let’s address just a few (Warren in bold):
“Nearly half of all e-commerce goes through Amazon.” Yes, but it has only 5% of total retail in the United States. As my colleague Kristian Stout says, “the Internet is not a market; it’s a distribution channel.”
“Amazon has used its immense market power to force smaller competitors like Diapers.com to sell at a discounted rate.” The real story, as the founders of Diapers.com freely admitted, is that they sold diapers as what they hoped would be a loss leader, intending to build out sales of other products once they had a base of loyal customers:
And so we started with selling the loss leader product to basically build a relationship with mom. And once they had the passion for the brand and they were shopping with us on a weekly or a monthly basis that they’d start to fall in love with that brand. We were losing money on every box of diapers that we sold. We weren’t able to buy direct from the manufacturers.
Like all entrepreneurs, Diapers.com’s founders took a calculated risk that didn’t pay off as hoped. Amazon subsequently acquired the company (after it had declined a similar buyout offer from Walmart). (Antitrust laws protect consumers, not inefficient competitors). And no, this was not a case of predatory pricing. After many years of trying to make the business profitable as a subsidiary, Amazon shut it down in 2017.
“In the 1990s, Microsoft — the tech giant of its time — was trying to parlay its dominance in computer operating systems into dominance in the new area of web browsing. The federal government sued Microsoft for violating anti-monopoly laws and eventually reached a settlement. The government’s antitrust case against Microsoft helped clear a path for Internet companies like Google and Facebook to emerge.” The government’s settlement with Microsoft is not the reason Google and Facebook were able to emerge. Neither company entered the browser market at launch. Instead, they leapfrogged the browser entirely and created new platforms for the web (only later did Google create Chrome).
Furthermore, if the Microsoft case is responsible for “clearing a path” for Google is it not also responsible for clearing a path for Google’s alleged depredations? If the answer is that antitrust enforcement should be consistently more aggressive in order to rein in Google, too, when it gets out of line, then how can we be sure that that same more-aggressive enforcement standard wouldn’t have curtailed the extent of the Microsoft ecosystem in which it was profitable for Google to become Google? Warren implicitly assumes that only the enforcement decision in Microsoft was relevant to Google’s rise. But Microsoft doesn’t exist in a vacuum. If Microsoft cleared a path for Google, so did every decision not to intervene, which, all combined, created the legal, business, and economic environment in which Google operates.
Warren characterizes Big Tech as a weight on the American economy. In fact, nothing could be further from the truth. These superstar companies are the drivers of productivity growth, all ranking at or near the top for most spending on research and development. And while data may not be the new oil, extracting value from it may require similar levels of capital expenditure. Last year, Big Tech spent as much or more on capex as the world’s largest oil companies:
The exact causes of the decline in business dynamism are still uncertain, but recent research points to a much more mundane explanation: demographics. Labor force growth has been declining, which has led to an increase in average firm age, nudging fewer workers to start their own businesses.
Furthermore, it’s not at all clear whether this is actually a decline in business dynamism, or merely a change in business model. We would expect to see the same pattern, for example, if would-be startup founders were designing their software for acquisition and further development within larger, better-funded enterprises.
Will Rinehart recently looked at the literature to determine whether there is indeed a “kill zone” for startups around Big Tech incumbents. One paper finds that “an increase in fixed costs explains most of the decline in the aggregate entrepreneurship rate.” Another shows an inverse correlation across 50 countries between GDP and entrepreneurship rates. Robert Lucas predicted these trends back in 1978, pointing out that productivity increases would lead to wage increases, pushing marginal entrepreneurs out of startups and into big companies.
It’s notable that many in the venture capital community would rather not have Sen. Warren’s “help”:
just to sustain constant growth in GDP per person, the U.S. must double the amount of research effort searching for new ideas every 13 years to offset the increased difﬁculty of ﬁnding new ideas.
If this assessment is correct, it may well be that coming up with productive and profitable innovations is simply becoming more expensive, and thus, at the margin, each dollar of venture capital can fund less of it. Ironically, this also implies that larger firms, which can better afford the additional resources required to sustain exponential growth, are a crucial part of the solution, not the problem.
Warren believes that Big Tech is the cause of our social ills. But Americans have more trust in Amazon, Facebook, and Google than in the political institutions that would break them up. It would be wise for her to reflect on why that might be the case. By punishing our most valuable companies for past successes, Warren would chill competition and decrease returns to innovation.
Finally, in what can only be described as tragic irony, the most prominent political figure who shares Warren’s feelings on Big Tech is President Trump. Confirming the horseshoe theory of politics, far-left populism and far-right populism seem less distinguishable by the day. As our colleague Gus Hurwitz put it, with this proposal Warren is explicitly endorsing the unitary executive theory and implicitly endorsing Trump’s authority to direct his DOJ to “investigate specific cases and reach specific outcomes.” Which cases will he want to have investigated and what outcomes will he be seeking? More good questions that Senator Warren should be asking. The notion that competition, consumer welfare, and growth are likely to increase in such an environment is farcical.
The difficulty presented by the merger was, in some ways, its lack of difficulty: Even critics, while hearkening back to the Brandeisian fear of large firms, had little by way of legal objection to offer against the merger. Despite the acknowledged lack of an obvious legal basis for challenging the merger, most critics nevertheless expressed a somewhat inchoate and generalized concern that the merger would hasten the death of brick-and-mortar retail and imperil competition in the grocery industry. Critics further pointed to particular, related issues largely outside the scope of modern antitrust law — issues relating to the presumed effects of the merger on “localism” (i.e., small, local competitors), retail workers, startups with ancillary businesses (e.g., delivery services), data collection and use, and the like.
Steven Horwitz opened the symposium with an insightful and highly recommended post detailing the development of the grocery industry from its inception. Tracing through that history, Horwitz was optimistic that
Viewed from the long history of the evolution of the grocery store, the Amazon-Whole Foods merger made sense as the start of the next stage of that historical process. The combination of increased wealth that is driving the demand for upscale grocery stores, and the corresponding increase in the value of people’s time that is driving the demand for one-stop shopping and various forms of pick-up and delivery, makes clear the potential benefits of this merger.
Others in the symposium similarly acknowledged the potential transformation of the industry brought on by the merger, but challenged the critics’ despairing characterization of that transformation (Auer, Manne & Stout, Rinehart, Fruits, Atkinson).
At the most basic level, it was noted that, in the immediate aftermath of the merger, Whole Foods dropped prices across a number of categories as it sought to shore up its competitive position (Auer). Further, under relevant antitrust metrics — e.g., market share, ease of competitive entry, potential for exclusionary conduct — the merger was completely unobjectionable under existing doctrine (Fruits).
To critics’ claims that Amazon in general, and the merger in particular, was decimating the retail industry, several posts discussed the updated evidence suggesting that retail is not actually on the decline (although some individual retailers are certainly struggling to compete) (Auer, Manne & Stout). Moreover, and following from Horwitz’s account of the evolution of the grocery industry, it appears that the actual trajectory of the industry is not an either/or between online and offline, but instead a movement toward integrating both models into a single retail experience (Manne & Stout). Further, the post-merger flurry of business model innovation, venture capital investment, and new startup activity demonstrates that, confronted with entrepreneurial competitors like Walmart, Kroger, Aldi, and Instacart, Amazon’s impressive position online has not translated into an automatic domination of the traditional grocery industry (Manne & Stout).
Symposium participants more circumspect about the merger suggested that Amazon’s behavior may be laying the groundwork for an eventual monopsony case (Sagers). Further, it was suggested, a future Section 2 case, difficult under prevailing antitrust orthodoxy, could be brought with a creative approach to market definition in light of Amazon’s conduct with its marketplace participants, its aggressive ebook contracting practices, and its development and roll-out of its own private label brands (Sagers).
Skeptics also picked up on early critics’ concerns about the aggregation of large amounts of consumer data, and worried that the merger could be part of a pattern representing a real, long-term threat to consumers that antitrust does not take seriously enough (Bona & Levitsky). Sounding a further alarm, Hal Singer noted that Amazon’s interest in pushing into new markets with data generated by, for example, devices like its Echo line could bolster its ability to exclude competitors.
More fundamentally, these contributors echoed the merger critics’ concerns that antitrust does not adequately take account of other values such as “promoting local, community-based, organic food production or ‘small firms’ in general.” (Bona & Levitsky; Singer).
Rob Atkinson, however, pointed out that these values are idiosyncratic and not likely shared by the vast majority of the population — and that antitrust law shouldn’t have anything to do with them:
In short, most of the opposition to Amazon/Whole Foods merger had little or nothing to do with economics and consumer welfare. It had everything to do with a competing vision for the kind of society we want to live in. The neo-Brandesian opponents, who Lind and I term “progressive localists”, seek an alternative economy predominantly made up of small firms, supported by big government and protected from global competition.
And Dirk Auer noted that early critics’ prophecies of foreclosure of competition through “data leveraging” and below-cost pricing hadn’t remotely come to pass, thus far.
Meanwhile, other contributors noted the paucity of evidence supporting many of these assertions, and pointed out the manifest value the merger seemed to be creating by pressuring competitors to adapt and better respond to consumers’ preferences (Horwitz, Rinehart, Auer, Fruits,Manne & Stout) — in the process shoring up, rather than killing, even smaller retailers that are willing and able to evolve with changing technology and shifting consumer preferences. “For all the talk of retail dying, the stores that are actually dying are the ones that fail to cater to their customers, not the ones that happen to be offline” (Manne & Stout).
At the same time, not all merger skeptics were moved by the Neo-Brandeisian assertions. Chris Sagers, for example, finds much of the populist antitrust objection more public relations than substance. He suggested perhaps not taking these ideas and their promoters so seriously, and instead focusing on antitrust advocates with “real ideas” (like Sagers himself, of course).
Coming from a different angle, Will Rinehart also suggested not taking the criticisms too seriously, pointing to the evolving and complicated effects of the merger as Exhibit A for the need for regulatory humility:
Finally, this deal reiterates the need for regulatory humility. Almost immediately after the Amazon-Whole Foods merger was closed, prices at the store dropped and competitors struck a flurry of deals. Investments continue and many in the grocery retail space are bracing for a wave of enhancement to take hold. Even some of the most fierce critics of deal will have to admit there is a lot of uncertainty. It is unclear what business model will make the most sense in the long run, how these technologies will ultimately become embedded into production processes, and how consumers will benefit. Combined, these features underscore the difficulty, but the necessity, in implementing dynamic insights into antitrust institutions.
Offering generous praise for this symposium (thanks, Will!) and echoing the points made by other participants regarding the dynamic and unknowable course of competition (Auer, Horwitz, Manne & Stout, Fruits), Rinehart concludes:
Retrospectives like this symposium offer a chance to understand what the discussion missed at the time and what is needed to better understand innovation and competition in markets. While it might be too soon to close the book on this case, the impact can already be felt in the positions others are taking in response. In the end, the deal probably won’t be remembered for extending Amazon’s dominance into another market because that is a phantom concern. Rather, it will probably be best remembered as the spark that drove traditional retail outlets to modernize their logistics and fulfillment efforts.
For a complete rundown of the arguments both for and against, the full archive of symposium posts from our outstanding and diverse group of scholars, practitioners, and other experts is available at this link, and individual posts can be easily accessed by clicking on the authors’ names below.
What actually happened in the year following the merger is nearly the opposite: Competition among grocery stores has been more fierce than ever. “Offline” retailers are expanding — and innovating — to meet Amazon’s challenge, and many of them are booming. Disruption is never neat and tidy, but, in addition to saving Whole Foods from potential oblivion, the merger seems to have lit a fire under the rest of the industry.
This result should not be surprising to anyone who understands the nature of the competitive process. But it does highlight an important lesson: competition often comes from unexpected quarters and evolves in unpredictable ways, emerging precisely out of the kinds of adversity opponents of the merger bemoaned.
So why this deal, in this symposium, and why now? The best substantive reason I could think of is admittedly one that I personally find important. As I said, I think we should take it much more seriously as a general matter, especially in highly dynamic contexts like Silicon Valley. There has been a history of arguably pre-emptive, market-occupying vertical and conglomerate acquisitions, by big firms of smaller ones that are technologically or otherwise disruptive. The idea is that the big firms sit back and wait as some new market develops in some adjacent sector. When that new market ripens to the point of real promise, the big firm buys some significant incumbent player. The aim is not. just to facilitate its own benevolent, wholesome entry, but to set up hopefully prohibitive challenges to other de novo entrants. Love it or leave it, that theory plausibly characterizes lots and lots of acquisitions in recent decades that secured easy antitrust approval, precisely because they weren’t obviously, presently horizontal. Many people think that is true of some of Amazon’s many acquisitions, like its notoriously aggressive, near-hostile takeover of Diapers.com.
Amazon offers Prime discounts to Whole Food customers and offers free delivery for Prime members. Those are certainly consumer benefits. But with those comes a cost, which may or may not be significant. By bundling its products with collective discounts, Amazon makes it more attractive for shoppers to shift their buying practices from local stores to the internet giant. Will this eventually mean that local stores will become more inefficient, based on lower volume, and will eventually close? Do most Americans care about the potential loss of local supermarkets and specialty grocers? No one, including antitrust enforcers, seems to have asked them.
The gist of these arguments is simple. The Amazon / Whole Foods merger would lead to the exclusion of competitors, with Amazon leveraging its swaths of data and pricing below costs. All of this begs a simple question: have these prophecies come to pass?
The problem with antitrust populism is not just that it leads to unfounded predictions regarding the negative effects of a given business practice. It also ignores the significant gains which consumers may reap from these practices. The Amazon / Whole foods offers a case in point.
Even with these caveats, it’s still worth looking at the recent trends. Whole Foods’s sales since 2015 have been flat, with only low single-digit growth, according to data from Second Measure. This suggests Whole Foods is not yet getting a lift from the relationship. However, the percentage of Whole Foods’ new customers who are Prime Members increased post-merger, from 34 percent in June 2017 to 41 percent in June 2018. This suggests that Amazon’s platform is delivering customers to Whole Foods.
The negativity that surrounded the deal at its announcement made Whole Foods seem like an innocent player, but it is important to recall that they were hemorrhaging and were looking to exit. Throughout the 2010s, the company lost its market leading edge as others began to offer the same kinds of services and products. Still, the company was able to sell near the top of its value to Amazon because it was able to court so many suitors. Given all of these features, Whole Foods could have been using the exit as a mechanism to appropriate another firm’s rent.