Archives For Coase

Zoom, one of Silicon Valley’s lesser-known unicorns, has just gone public. At the time of writing, its shares are trading at about $65.70, placing the company’s value at $16.84 billion. There are good reasons for this success. According to its Form S-1, Zoom’s revenue rose from about $60 million in 2017 to a projected $330 million in 2019, and the company has already surpassed break-even . This growth was notably fueled by a thriving community of users who collectively spend approximately 5 billion minutes per month in Zoom meetings.

To get to where it is today, Zoom had to compete against long-established firms with vast client bases and far deeper pockets. These include the likes of Microsoft, Cisco, and Google. Further complicating matters, the video communications market exhibits some prima facie traits that are typically associated with the existence of network effects. For instance, the value of Skype to one user depends – at least to some extent – on the number of other people that might be willing to use the network. In these settings, it is often said that positive feedback loops may cause the market to tip in favor of a single firm that is then left with an unassailable market position. Although Zoom still faces significant competitive challenges, it has nonetheless established a strong position in a market previously dominated by powerful incumbents who could theoretically count on network effects to stymie its growth.

Further complicating matters, Zoom chose to compete head-on with these incumbents. It did not create a new market or a highly differentiated product. Zoom’s Form S-1 is quite revealing. The company cites the quality of its product as its most important competitive strength. Similarly, when listing the main benefits of its platform, Zoom emphasizes that its software is “easy to use”, “easy to deploy and manage”, “reliable”, etc. In its own words, Zoom has thus gained a foothold by offering an existing service that works better than that of its competitors.

And yet, this is precisely the type of story that a literal reading of the network effects literature would suggest is impossible, or at least highly unlikely. For instance, the foundational papers on network effects often cite the example of the DVORAK keyboard (David, 1985; and Farrell & Saloner, 1985). These early scholars argued that, despite it being the superior standard, the DVORAK layout failed to gain traction because of the network effects protecting the QWERTY standard. In other words, consumers failed to adopt the superior DVORAK layout because they were unable to coordinate on their preferred option. It must be noted, however, that the conventional telling of this story was forcefully criticized by Liebowitz & Margolis in their classic 1995 article, The Fable of the Keys.

Despite Liebowitz & Margolis’ critique, the dominance of the underlying network effects story persists in many respects. And in that respect, the emergence of Zoom is something of a cautionary tale. As influential as it may be, the network effects literature has tended to overlook a number of factors that may mitigate, or even eliminate, the likelihood of problematic outcomes. Zoom is yet another illustration that policymakers should be careful when they make normative inferences from positive economics.

A Coasian perspective

It is now widely accepted that multi-homing and the absence of switching costs can significantly curtail the potentially undesirable outcomes that are sometimes associated with network effects. But other possibilities are often overlooked. For instance, almost none of the foundational network effects papers pay any notice to the application of the Coase theorem (though it has been well-recognized in the two-sided markets literature).

Take a purported market failure that is commonly associated with network effects: an installed base of users prevents the market from switching towards a new standard, even if it is superior (this is broadly referred to as “excess inertia,” while the opposite scenario is referred to as “excess momentum”). DVORAK’s failure is often cited as an example.

Astute readers will quickly recognize that this externality problem is not fundamentally different from those discussed in Ronald Coase’s masterpiece, “The Problem of Social Cost,” or Steven Cheung’s “The Fable of the Bees” (to which Liebowitz & Margolis paid homage in their article’s title). In the case at hand, there are at least two sets of externalities at play. First, early adopters of the new technology impose a negative externality on the old network’s installed base (by reducing its network effects), and a positive externality on other early adopters (by growing the new network). Conversely, installed base users impose a negative externality on early adopters and a positive externality on other remaining users.

Describing these situations (with a haughty confidence reminiscent of Paul Samuelson and Arthur Cecil Pigou), Joseph Farrell and Garth Saloner conclude that:

In general, he or she [i.e. the user exerting these externalities] does not appropriately take this into account.

Similarly, Michael Katz and Carl Shapiro assert that:

In terms of the Coase theorem, it is very difficult to design a contract where, say, the (potential) future users of HDTV agree to subsidize today’s buyers of television sets to stop buying NTSC sets and start buying HDTV sets, thereby stimulating the supply of HDTV programming.

And yet it is far from clear that consumers and firms can never come up with solutions that mitigate these problems. As Daniel Spulber has suggested, referral programs offer a case in point. These programs usually allow early adopters to receive rewards in exchange for bringing new users to a network. One salient feature of these programs is that they do not simply charge a lower price to early adopters; instead, in order to obtain a referral fee, there must be some agreement between the early adopter and the user who is referred to the platform. This leaves ample room for the reallocation of rewards. Users might, for instance, choose to split the referral fee. Alternatively, the early adopter might invest time to familiarize the switching user with the new platform, hoping to earn money when the user jumps ship. Both of these arrangements may reduce switching costs and mitigate externalities.

Danial Spulber also argues that users may coordinate spontaneously. For instance, social groups often decide upon the medium they will use to communicate. Families might choose to stay on the same mobile phone network. And larger groups (such as an incoming class of students) may agree upon a social network to share necessary information, etc. In these contexts, there is at least some room to pressure peers into adopting a new platform.

Finally, firms and other forms of governance may also play a significant role. For instance, employees are routinely required to use a series of networked goods. Common examples include office suites, email clients, social media platforms (such as Slack), or video communications applications (Zoom, Skype, Google Hangouts, etc.). In doing so, firms presumably act as islands of top-down decision-making and impose those products that maximize the collective preferences of employers and employees. Similarly, a single firm choosing to join a network (notably by adopting a standard) may generate enough momentum for a network to gain critical mass. Apple’s decisions to adopt USB-C connectors on its laptops and to ditch headphone jacks on its iPhones both spring to mind. Likewise, it has been suggested that distributed ledger technology and initial coin offerings may facilitate the creation of new networks. The intuition is that so-called “utility tokens” may incentivize early adopters to join a platform, despite initially weak network effects, because they expect these tokens to increase in value as the network expands.

A combination of these arrangements might explain how Zoom managed to grow so rapidly, despite the presence of powerful incumbents. In its own words:

Our rapid adoption is driven by a virtuous cycle of positive user experiences. Individuals typically begin using our platform when a colleague or associate invites them to a Zoom meeting. When attendees experience our platform and realize the benefits, they often become paying customers to unlock additional functionality.

All of this is not to say that network effects will always be internalized through private arrangements, but rather that it is equally wrong to assume that transaction costs systematically prevent efficient coordination among users.

Misguided regulatory responses

Over the past couple of months, several antitrust authorities around the globe have released reports concerning competition in digital markets (UK, EU, Australia), or held hearings on this topic (US). A recurring theme throughout their published reports is that network effects almost inevitably weaken competition in digital markets.

For instance, the report commissioned by the European Commission mentions that:

Because of very strong network externalities (especially in multi-sided platforms), incumbency advantage is important and strict scrutiny is appropriate. We believe that any practice aimed at protecting the investment of a dominant platform should be minimal and well targeted.

The Australian Competition & Consumer Commission concludes that:

There are considerable barriers to entry and expansion for search platforms and social media platforms that reinforce and entrench Google and Facebook’s market power. These include barriers arising from same-side and cross-side network effects, branding, consumer inertia and switching costs, economies of scale and sunk costs.

Finally, a panel of experts in the United Kingdom found that:

Today, network effects and returns to scale of data appear to be even more entrenched and the market seems to have stabilised quickly compared to the much larger degree of churn in the early days of the World Wide Web.

To address these issues, these reports suggest far-reaching policy changes. These include shifting the burden of proof in competition cases from authorities to defendants, establishing specialized units to oversee digital markets, and imposing special obligations upon digital platforms.

The story of Zoom’s emergence and the important insights that can be derived from the Coase theorem both suggest that these fears may be somewhat overblown.

Rivals do indeed find ways to overthrow entrenched incumbents with some regularity, even when these incumbents are shielded by network effects. Of course, critics may retort that this is not enough, that competition may sometimes arrive too late (excess inertia, i.e., “ a socially excessive reluctance to switch to a superior new standard”) or too fast (excess momentum, i.e., “the inefficient adoption of a new technology”), and that the problem is not just one of network effects, but also one of economies of scale, information asymmetry, etc. But this comes dangerously close to the Nirvana fallacy. To begin, it assumes that regulators are able to reliably navigate markets toward these optimal outcomes — which is questionable, at best. Moreover, the regulatory cost of imposing perfect competition in every digital market (even if it were possible) may well outweigh the benefits that this achieves. Mandating far-reaching policy changes in order to address sporadic and heterogeneous problems is thus unlikely to be the best solution.

Instead, the optimal policy notably depends on whether, in a given case, users and firms can coordinate their decisions without intervention in order to avoid problematic outcomes. A case-by-case approach thus seems by far the best solution.

And competition authorities need look no further than their own decisional practice. The European Commission’s decision in the Facebook/Whatsapp merger offers a good example (this was before Margrethe Vestager’s appointment at DG Competition). In its decision, the Commission concluded that the fast-moving nature of the social network industry, widespread multi-homing, and the fact that neither Facebook nor Whatsapp controlled any essential infrastructure, prevented network effects from acting as a barrier to entry. Regardless of its ultimate position, this seems like a vastly superior approach to competition issues in digital markets. The Commission adopted a similar reasoning in the Microsoft/Skype merger. Unfortunately, the Commission seems to have departed from this measured attitude in more recent decisions. In the Google Search case, for example, the Commission assumes that the mere existence of network effects necessarily increases barriers to entry:

The existence of positive feedback effects on both sides of the two-sided platform formed by general search services and online search advertising creates an additional barrier to entry.

A better way forward

Although the positive economics of network effects are generally correct and most definitely useful, some of the normative implications that have been derived from them are deeply flawed. Too often, policymakers and commentators conclude that these potential externalities inevitably lead to stagnant markets where competition is unable to flourish. But this does not have to be the case. The emergence of Zoom shows that superior products may prosper despite the presence of strong incumbents and network effects.

Basing antitrust policies on sweeping presumptions about digital competition – such as the idea that network effects are rampant or the suggestion that online platforms necessarily imply “extreme returns to scale” – is thus likely to do more harm than good. Instead, Antitrust authorities should take a leaf out of Ronald Coase’s book, and avoid blackboard economics in favor of a more granular approach.

Not surprisingly, we’ve discussed Coase quite a bit here at Truth on the Market. Follow this link to see our collected thoughts on Coase over the years.

Probably my favorite, and certainly most frequently quoted, of Coase’s many wise words is this:

One important result of this preoccupation with the monopoly problem is that if an economist finds something—a business practice of one sort or other—that he does not understand, he looks for a monopoly explanation. And as in this field we are very ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on a monopoly explanation, frequent.

Of course this, a more generalized statement of the above from The Problem of Social Cost, is the essence of his work:

All solutions have costs, and there is no reason to suppose that governmental regulation is called for simply because the problem is not well handled by the market or the firm. Satisfactory views on policy can only come from a patient study of how, in practice, the market, firms and governments handle the problem of harmful effects…. It is my belief that economists, and policy-makers generally, have tended to over-estimate the advantages which come from governmental regulation. But this belief, even if justified, does not do more than suggest that government regulation should be curtailed. It does not tell us where the boundary line should be drawn. This, it seems to me, has to come from a detailed investigation of the actual results of handling the problem in different ways.

 

Ronald Coase on regulation

Geoffrey Manne —  2 September 2013

As Gus said, there will be much more to say, and much more said by others, on Coase’s passing. For now, I offer this excerpt from a 1997 Reason interview he gave with Tom Hazlett:

Hazlett: You said you’re not a libertarian. What do you consider your politics to be?

Coase: I really don’t know. I don’t reject any policy without considering what its results are. If someone says there’s going to be regulation, I don’t say that regulation will be bad. Let’s see. What we discover is that most regulation does produce, or has produced in recent times, a worse result. But I wouldn’t like to say that all regulation would have this effect because one can think of circumstances in which it doesn’t.

Hazlett: Can you give us an example of what you consider to be a good regulation and then an example of what you consider to be a not-so-good regulation?

Coase: This is a very interesting question because one can’t give an answer to it. When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies–perhaps all the studies–suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been. I was not willing to accept the view that all regulation was bound to produce these results. Therefore, what was my explanation for the results we had? I argued that the most probable explanation was that the government now operates on such a massive scale that it had reached the stage of what economists call negative marginal returns. Anything additional it does, it messes up. But that doesn’t mean that if we reduce the size of government considerably, we wouldn’t find then that there were some activities it did well. Until we reduce the size of government, we won’t know what they are.

Hazlett: What’s an example of bad regulation?

Coase: I can’t remember one that’s good. Regulation of transport, regulation of agriculture– agriculture is a, zoning is z. You know, you go from a to z, they are all bad. There were so many studies, and the result was quite universal: The effects were bad.