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The Contestable Platform Paradox

Dirk Auer — 29 October 2021

Why do digital industries routinely lead to one company having a very large share of the market (at least if one defines markets narrowly)? To anyone familiar with competition policy discussions, the answer might seem obvious: network effects, scale-related economies, and other barriers to entry lead to winner-take-all dynamics in platform industries. Accordingly, it is that believed the first platform to successfully unlock a given online market enjoys a determining first-mover advantage.

This narrative has become ubiquitous in policymaking circles. Thinking of this sort notably underpins high-profile reports on competition in digital markets (here, here, and here), as well ensuing attempts to regulate digital platforms, such as the draft American Innovation and Choice Online Act and the EU’s Digital Markets Act.

But are network effects and the like the only ways to explain why these markets look like this? While there is no definitive answer, scholars routinely overlook an alternative explanation that tends to undercut the narrative that tech markets have become non-contestable.

The alternative model is simple: faced with zero prices and the almost complete absence of switching costs, users have every reason to join their preferred platform. If user preferences are relatively uniform and one platform has a meaningful quality advantage, then there is every reason to expect that most consumers will all join the same one—even though the market remains highly contestable. On the other side of the equation, because platforms face very few capacity constraints, there are few limits to a given platform’s growth. As will be explained throughout this piece, this intuition is as old as economics itself.

The Bertrand Paradox

In 1883, French mathematician Joseph Bertrand published a powerful critique of two of the most high-profile economic thinkers of his time: the late Antoine Augustin Cournot and Léon Walras (it would be another seven years before Alfred Marshall published his famous principles of economics).

Bertrand criticized several of Cournot and Walras’ widely accepted findings. This included Cournot’s conclusion that duopoly competition would lead to prices above marginal cost—or, in other words, that duopolies were imperfectly competitive.

By reformulating the problem slightly, Bertand arrived at the opposite conclusion. He argued that each firm’s incentive to undercut its rival would ultimately lead to marginal cost pricing, and one seller potentially capturing the entire market:

There is a decisive objection [to Cournot’s model]: According to his hypothesis, no [supracompetitive] equilibrium is possible. There is no limit to price decreases; whatever the joint price being charged by firms, a competitor could always undercut this price and, with few exceptions, attract all consumers. If the competitor is allowed to get away with this [i.e. the rival does not react], it will double its profits.

This result is mainly driven by the assumption that, unlike in Cournot’s model, firms can immediately respond to their rival’s chosen price/quantity. In other words, Bertrand implicitly framed the competitive process as price competition, rather than quantity competition (under price competition, firms do not face any capacity constraints and they cannot commit to producing given quantities of a good):

If Cournot’s calculations mask this result, it is because of a remarkable oversight. Referring to them as D and D’, Cournot deals with the quantities sold by each of the two competitors and treats them as independent variables. He assumes that if one were to change by the will of one of the two sellers, the other one could remain fixed. The opposite is evidently true.

This later came to be known as the “Bertrand paradox”—the notion that duopoly-market configurations can produce the same outcome as perfect competition (i.e., P=MC).

But while Bertrand’s critique was ostensibly directed at Cournot’s model of duopoly competition, his underlying point was much broader. Above all, Bertrand seemed preoccupied with the notion that expressing economic problems mathematically merely gives them a veneer of accuracy. In that sense, he was one of the first economists (at least to my knowledge) to argue that the choice of assumptions has a tremendous influence on the predictions of economic models, potentially rendering them unreliable:

On other occasions, Cournot introduces assumptions that shield his reasoning from criticism—scholars can always present problems in a way that suits their reasoning.

All of this is not to say that Bertrand’s predictions regarding duopoly competition necessarily hold in real-world settings; evidence from experimental settings is mixed. Instead, the point is epistemological. Bertrand’s reasoning was groundbreaking because he ventured that market structures are not the sole determinants of consumer outcomes. More broadly, he argued that assumptions regarding the competitive process hold significant sway over the results that a given model may produce (and, as a result, over normative judgements concerning the desirability of given market configurations).

The Theory of Contestable Markets

Bertrand is certainly not the only economist to have suggested market structures alone do not determine competitive outcomes. In the early 1980s, William Baumol (and various co-authors) went one step further. Baumol argued that, under certain conditions, even monopoly market structures could deliver perfectly competitive outcomes. This thesis thus rejected the Structure-Conduct-Performance (“SCP”) Paradigm that dominated policy discussions of the time.

Baumol’s main point was that industry structure is not the main driver of market “contestability,” which is the key determinant of consumer outcomes. In his words:

In the limit, when entry and exit are completely free, efficient incumbent monopolists and oligopolists may in fact be able to prevent entry. But they can do so only by behaving virtuously, that is, by offering to consumers the benefits which competition would otherwise bring. For every deviation from good behavior instantly makes them vulnerable to hit-and-run entry.

For instance, it is widely accepted that “perfect competition” leads to low prices because firms are price-takers; if one does not sell at marginal cost, it will be undercut by rivals. Observers often assume this is due to the number of independent firms on the market. Baumol suggests this is wrong. Instead, the result is driven by the sanction that firms face for deviating from competitive pricing.

In other words, numerous competitors are a sufficient, but not necessary condition for competitive pricing. Monopolies can produce the same outcome when there is a present threat of entry and an incumbent’s deviation from competitive pricing would be sanctioned. This is notably the case when there are extremely low barriers to entry.

Take this hypothetical example from the world of cryptocurrencies. It is largely irrelevant to a user whether there are few or many crypto exchanges on which to trade coins, nonfungible tokens (NFTs), etc. What does matter is that there is at least one exchange that meets one’s needs in terms of both price and quality of service. This could happen because there are many competing exchanges, or because a failure to meet my needs by the few (or even one) exchange that does exist would attract the entry of others to which I could readily switch—thus keeping the behavior of the existing exchanges in check.

This has far-reaching implications for antitrust policy, as Baumol was quick to point out:

This immediately offers what may be a new insight on antitrust policy. It tells us that a history of absence of entry in an industry and a high concentration index may be signs of virtue, not of vice. This will be true when entry costs in our sense are negligible.

Given what precedes, Baumol surmised that industry structure must be driven by endogenous factors—such as firms’ cost structures—rather than the intensity of competition that they face. For instance, scale economies might make monopoly (or another structure) the most efficient configuration in some industries. But so long as rivals can sanction incumbents for failing to compete, the market remains contestable. Accordingly, at least in some industries, both the most efficient and the most contestable market configuration may entail some level of concentration.

To put this last point in even more concrete terms, online platform markets may have features that make scale (and large market shares) efficient. If so, there is every reason to believe that competition could lead to more, not less, concentration.

How Contestable Are Digital Markets?

The insights of Bertrand and Baumol have important ramifications for contemporary antitrust debates surrounding digital platforms. Indeed, it is critical to ascertain whether the (relatively) concentrated market structures we see in these industries are a sign of superior efficiency (and are consistent with potentially intense competition), or whether they are merely caused by barriers to entry.

The barrier-to-entry explanation has been repeated ad nauseam in recent scholarly reports, competition decisions, and pronouncements by legislators. There is thus little need to restate that thesis here. On the other hand, the contestability argument is almost systematically ignored.

Several factors suggest that online platform markets are far more contestable than critics routinely make them out to be.

First and foremost, consumer switching costs are extremely low for most online platforms. To cite but a few examples: Changing your default search engine requires at most a couple of clicks; joining a new social network can be done by downloading an app and importing your contacts to the app; and buying from an alternative online retailer is almost entirely frictionless, thanks to intermediaries such as PayPal.

These zero or near-zero switching costs are compounded by consumers’ ability to “multi-home.” In simple terms, joining TikTok does not require users to close their Facebook account. And the same applies to other online services. As a result, there is almost no opportunity cost to join a new platform. This further reduces the already tiny cost of switching.

Decades of app development have greatly improved the quality of applications’ graphical user interfaces (GUIs), to such an extent that costs to learn how to use a new app are mostly insignificant. Nowhere is this more apparent than for social media and sharing-economy apps (it may be less true for productivity suites that enable more complex operations). For instance, remembering a couple of intuitive swipe motions is almost all that is required to use TikTok. Likewise, ridesharing and food-delivery apps merely require users to be familiar with the general features of other map-based applications. It is almost unheard of for users to complain about usability—something that would have seemed impossible in the early 21st century, when complicated interfaces still plagued most software.

A second important argument in favor of contestability is that, by and large, online platforms face only limited capacity constraints. In other words, platforms can expand output rapidly (though not necessarily costlessly).

Perhaps the clearest example of this is the sudden rise of the Zoom service in early 2020. As a result of the COVID pandemic, Zoom went from around 10 million daily active users in early 2020 to more than 300 million by late April 2020. Despite being a relatively data-intensive service, Zoom did not struggle to meet this new demand from a more than 30-fold increase in its user base. The service never had to turn down users, reduce call quality, or significantly increase its price. In short, capacity largely followed demand for its service. Online industries thus seem closer to the Bertrand model of competition, where the best platform can almost immediately serve any consumers that demand its services.

Conclusion

Of course, none of this should be construed to declare that online markets are perfectly contestable. The central point is, instead, that critics are too quick to assume they are not. Take the following examples.

Scholars routinely cite the putatively strong concentration of digital markets to argue that big tech firms do not face strong competition, but this is a non sequitur. As Bertrand and Baumol (and others) show, what matters is not whether digital markets are concentrated, but whether they are contestable. If a superior rival could rapidly gain user traction, this alone will discipline the behavior of incumbents.

Markets where incumbents do not face significant entry from competitors are just as consistent with vigorous competition as they are with barriers to entry. Rivals could decline to enter either because incumbents have aggressively improved their product offerings or because they are shielded by barriers to entry (as critics suppose). The former is consistent with competition, the latter with monopoly slack.

Similarly, it would be wrong to presume, as many do, that concentration in online markets is necessarily driven by network effects and other scale-related economies. As ICLE scholars have argued elsewhere (here, here and here), these forces are not nearly as decisive as critics assume (and it is debatable that they constitute barriers to entry).

Finally, and perhaps most importantly, this piece has argued that many factors could explain the relatively concentrated market structures that we see in digital industries. The absence of switching costs and capacity constraints are but two such examples. These explanations, overlooked by many observers, suggest digital markets are more contestable than is commonly perceived.

In short, critics’ failure to meaningfully grapple with these issues serves to shape the prevailing zeitgeist in tech-policy debates. Cournot and Bertrand’s intuitions about oligopoly competition may be more than a century old, but they continue to be tested empirically. It is about time those same standards were applied to tech-policy debates.

5 Thoughts on the Senate’s Proposed Platform Self-Preferencing Ban

Sam Bowman & Geoffrey Manne — 14 October 2021

A bipartisan group of senators unveiled legislation today that would dramatically curtail the ability of online platforms to “self-preference” their own services—for example, when Apple pre-installs its own Weather or Podcasts apps on the iPhone, giving it an advantage that independent apps don’t have. The measure accompanies a House bill that included similar provisions, with some changes.

1. The Senate bill closely resembles the House version, and the small improvements will probably not amount to much in practice.

The major substantive changes we have seen between the House bill and the Senate version are:

Violations in Section 2(a) have been modified to refer only to conduct that “unfairly” preferences, limits, or discriminates between the platform’s products and others, and that “materially harm[s] competition on the covered platform,” rather than banning all preferencing, limits, or discrimination.
The evidentiary burden required throughout the bill has been changed from “clear and convincing” to a “preponderance of evidence” (in other words, greater than 50%).
An affirmative defense has been added to permit a platform to escape liability if it can establish that challenged conduct that “was narrowly tailored, was nonpretextual, and was necessary to… maintain or enhance the core functionality of the covered platform.”
The minimum market capitalization for “covered platforms” has been lowered from $600 billion to $550 billion.
The Senate bill would assess fines of 15% of revenues from the period during which the conduct occurred, in contrast with the House bill, which set fines equal to the greater of either 15% of prior-year revenues or 30% of revenues from the period during which the conduct occurred.
Unlike the House bill, the Senate bill does not create a private right of action. Only the U.S. Justice Department (DOJ), Federal Trade Commission (FTC), and state attorneys-generals could bring enforcement actions on the basis of the bill.

Item one here certainly mitigates the most extreme risks of the House bill, which was drafted, bizarrely, to ban all “preferencing” or “discrimination” by platforms. If that were made law, it could literally have broken much of the Internet. The softened language reduces that risk somewhat.

However, Section 2(b), which lists types of conduct that would presumptively establish a violation under Section 2(a), is largely unchanged. As outlined here, this would amount to a broad ban on a wide swath of beneficial conduct. And “unfair” and “material” are notoriously slippery concepts. As a practical matter, their inclusion here may not significantly alter the course of enforcement under the Senate legislation from what would ensue under the House version.

Item three, which allows challenged conduct to be defended if it is “necessary to… maintain or enhance the core functionality of the covered platform,” may also protect some conduct. But because the bill requires companies to prove that challenged conduct is not only beneficial, but necessary to realize those benefits, it effectively implements a “guilty until proven innocent” standard that is likely to prove impossible to meet. The threat of permanent injunctions and enormous fines will mean that, in many cases, companies simply won’t be able to justify the expense of endeavoring to improve even the “core functionality” of their platforms in any way that could trigger the bill’s liability provisions. Thus, again, as a practical matter, the difference between the Senate and House bills may be only superficial.

The effect of this will likely be to diminish product innovation in these areas, because companies could not know in advance whether the benefits of doing so would be worth the legal risk. We have previously highlighted existing conduct that may be lost if a bill like this passes, such as pre-installation of apps or embedding maps and other “rich” results in boxes on search engine results pages. But the biggest loss may be things we don’t even know about yet, that just never happen because the reward from experimentation is not worth the risk of being found to be “discriminating” against a competitor.

We dove into the House bill in Breaking Down the American Choice and Innovation Online Act and Breaking Down House Democrats’ Forthcoming Competition Bills.

2. The prohibition on “unfair self-preferencing” is vague and expansive and will make Google, Amazon, Facebook, and Apple’s products worse. Consumers don’t want digital platforms to be dumb pipes, or to act like a telephone network or sewer system. The Internet is filled with a superabundance of information and options, as well as a host of malicious actors. Good digital platforms act as middlemen, sorting information in useful ways and taking on some of the risk that exists when, inevitably, we end up doing business with untrustworthy actors.

When users have the choice, they tend to prefer platforms that do quite a bit of “discrimination”—that is, favoring some sellers over others, or offering their own related products or services through the platform. Most people prefer Amazon to eBay because eBay is chaotic and riskier to use.

Competitors that decry self-preferencing by the largest platforms—integrating two different products with each other, like putting a maps box showing only the search engine’s own maps on a search engine results page—argue that the conduct is enabled only by a platform’s market dominance and does not benefit consumers.

Yet these companies often do exactly the same thing in their own products, regardless of whether they have market power. Yelp includes a map on its search results page, not just restaurant listings. DuckDuckGo does the same. If these companies offer these features, it is presumably because they think their users want such results. It seems perfectly plausible that Google does the same because it thinks its users—literally the same users, in most cases—also want them.

Fundamentally, and as we discuss in Against the Vertical Disrcimination Presumption, there is simply no sound basis to enact such a bill (even in a slightly improved version):

The notion that self-preferencing by platforms is harmful to innovation is entirely speculative. Moreover, it is flatly contrary to a range of studies showing that the opposite is likely true. In reality, platform competition is more complicated than simple theories of vertical discrimination would have it, and there is certainly no basis for a presumption of harm.

We discussed self-preferencing further in Platform Self-Preferencing Can Be Good for Consumers and Even Competitors, and showed that platform “discrimination” is often what consumers want from digital platforms in On the Origin of Platforms: An Evolutionary Perspective.

3. The bill massively empowers an FTC that seems intent to use antitrust to achieve political goals. The House bill would enable competitors to pepper covered platforms with frivolous lawsuits. The bill’s sponsors presumably hope that removing the private right of action will help to avoid that. But the bill still leaves intact a much more serious risk to the rule of law: the bill’s provisions are so broad that federal antitrust regulators will have enormous discretion over which cases they take.

This means that whoever is running the FTC and DOJ will be able to threaten covered platforms with a broad array of lawsuits, potentially to influence or control their conduct in other, unrelated areas. While some supporters of the bill regard this as a positive, most antitrust watchers would greet this power with much greater skepticism. Fundamentally, both bills grant antitrust enforcers wildly broad powers to pursue goals unrelated to competition. FTC Chair Lina Khan has, for example, argued that “the dispersion of political and economic control” ought to be antitrust’s goal. Commissioner Rebecca Kelly-Slaughter has argued that antitrust should be “antiracist”.

Whatever the desirability of these goals, the broad discretionary authority the bills confer on the antitrust agencies means that individual commissioners may have significantly greater scope to pursue the goals that they believe to be right, rather than Congress.

See discussions of this point at What Lina Khan’s Appointment Means for the House Antitrust Bills, Republicans Should Tread Carefully as They Consider ‘Solutions’ to Big Tech, The Illiberal Vision of Neo-Brandeisian Antitrust, and Alden Abbott’s discussion of FTC Antitrust Enforcement and the Rule of Law.

4. The bill adopts European principles of competition regulation. These are, to put it mildly, not obviously conducive to the sort of innovation and business growth that Americans may expect. Europe has no tech giants of its own, a condition that shows little sign of changing. Apple, alone, is worth as much as the top 30 companies in Germany’s DAX index, and the top 40 in France’s CAC index. Landmark European competition cases have seen Google fined for embedding Shopping results in the Search page—not because it hurt consumers, but because it hurt competing price –comparison websites.

A fundamental difference between American and European competition regimes is that the U.S. system is far more friendly to businesses that obtain dominant market positions because they have offered better products more cheaply. Under the American system, successful businesses are normally given broad scope to charge high prices and refuse to deal with competitors. This helps to increase the rewards and incentive to innovate and invest in order to obtain that strong market position. The European model is far more burdensome.

The Senate bill adopts a European approach to refusals to deal—the same approach that led the European Commission to fine Microsoft for including Windows Media Player with Windows—and applies it across Big Tech broadly. Adopting this kind of approach may end up undermining elements of U.S. law that support innovation and growth.

For more, see How US and EU Competition Law Differ.

5. The proposals are based on a misunderstanding of the state of competition in the American economy, and of antitrust enforcement. It is widely believed that the U.S. economy has seen diminished competition. This is mistaken, particularly with respect to digital markets. Apparent rises in market concentration and profit margins disappear when we look more closely: local-level concentration is falling even as national-level concentration is rising, driven by more efficient chains setting up more stores in areas that were previously served by only one or two firms.

And markup rises largely disappear after accounting for fixed costs like R&D and marketing.

Where profits are rising, in areas like manufacturing, it appears to be mainly driven by increased productivity, not higher prices. Real prices have not risen in line with markups. Where profitability has increased, it has been mainly driven by falling costs.

Nor have the number of antitrust cases brought by federal antitrust agencies fallen. The likelihood of a merger being challenged more than doubled between 1979 and 2017. And there is little reason to believe that the deterrent effect of antitrust has weakened. Many critics of Big Tech have decided that there must be a problem and have worked backwards from that conclusion, selecting whatever evidence supports it and ignoring the evidence that does not. The consequence of such motivated reasoning is bills like this.

See Geoff’s April 2020 written testimony to the House Judiciary Investigation Into Competition in Digital Markets here.

Why There Needs to Be More, not Less, Consolidation in Video Streaming

Dirk Auer — 12 October 2021

*Still from* **Squid Game***, Netflix and Siren Pictures Inc., 2021*

Recent commentary on the proposed merger between WarnerMedia and Discovery, as well as Amazon’s acquisition of MGM, often has included the suggestion that the online content-creation and video-streaming markets are excessively consolidated, or that they will become so absent regulatory intervention. For example, in a recent letter to the U.S. Justice Department (DOJ), the American Antitrust Institute and Public Knowledge opine that:

Slow and inadequate oversight risks the streaming market going the same route as cable—where consumers have little power, few options, and where consolidation and concentration reign supreme. A number of threats to competition are clear, as discussed in this section, including: (1) market power issues surrounding content and (2) the role of platforms in “gatekeeping” to limit competition.

But the AAI/PK assessment overlooks key facts about the video-streaming industry, some of which suggest that, if anything, these markets currently suffer from too much fragmentation.

The problem is well-known: any individual video-streaming service will offer only a fraction of the content that viewers want, but budget constraints limit the number of services that a household can afford to subscribe to. It may be counterintuitive, but consolidation in the market for video-streaming can solve both problems at once.

One subscription is not enough

Surveys find that U.S. households currently maintain, on average, four video-streaming subscriptions. This explains why even critics concede that a plethora of streaming services compete for consumer eyeballs. For instance, the AAI and PK point out that:

Today, every major media company realizes the value of streaming and a bevy of services have sprung up to offer different catalogues of content.
These companies have challenged the market leader, Netflix and include: Prime Video (2006), Hulu (2007), Paramount+ (2014), ESPN+ (2018), Disney+ (2019), Apple TV+ (2019), HBO Max (2020), Peacock (2020), and Discovery+ (2021).

With content scattered across several platforms, multiple subscriptions are the only way for households to access all (or most) of the programs they desire. Indeed, other than price, library sizes and the availability of exclusive content are reportedly the main drivers of consumer purchase decisions.

Of course, there is nothing inherently wrong with the current equilibrium in which consumers multi-home across multiple platforms. One potential explanation is demand for high-quality exclusive content, which requires tremendous investment to develop and promote. Production costs for TV series routinely run in the tens of millions of dollars per episode (see here and here). Economic theory predicts these relationship-specific investments made by both producers and distributors will cause producers to opt for exclusive distribution or vertical integration. The most sought-after content is thus exclusive to each platform. In other words, exclusivity is likely the price that users must pay to ensure that high-quality entertainment continues to be produced.

But while this paradigm has many strengths, the ensuing fragmentation can be detrimental to consumers, as this may lead to double marginalization or mundane issues like subscription fatigue. Consolidation can be a solution to both.

Substitutes, complements, or unrelated?

As Hal Varian explains in his seminal book, the relationship between two goods can range among three extremes: perfect substitutes (i.e., two goods are perfectly interchangeable); perfect complements (i.e., there is no value to owning one good without the other); or goods that exist in independent markets (i.e., the price of one good does not affect demand for the other).

These distinctions are critical when it comes to market concentration. All else equal—which is obviously not the case in reality—increased concentration leads to lower prices for complements, and higher prices for substitutes. Finally, if demand for two goods is unrelated, then bringing them under common ownership should not affect their price.

To at least some extent, streaming services should be seen as complements rather than substitutes—or, at least, as services with unrelated demand. If they were perfect substitutes, consumers would be indifferent between two Netflix subscriptions or one Netflix plan and one Amazon Prime plan. That is obviously not the case. Nor are they perfect complements, which would mean that Netflix is worthless without Amazon Prime, Disney+, and other services.

However, there is reason to believe there exists some complementarity between streaming services, or at least that demand for them is independent. Most consumers subscribe to multiple services, and almost no one subscribes to the same service twice:

This assertion is also supported by the ubiquitous bundling of subscriptions in the cable distribution industry, which also has recently been seen in video-streaming markets. For example, in the United States, Disney+ can be purchased in a bundle with Hulu and ESPN+.

The key question is: is each service more valuable, less valuable, or as valuable in isolation than they are when bundled? If households place some additional value on having a complete video offering (one that includes child entertainment, sports, more mature content, etc.), and if they value the convenience of accessing more of their content via a single app, then we can infer these services are to some extent complementary.

Finally, it is worth noting that any complementarity between these services would be largely endogenous. If the industry suddenly switched to a paradigm of non-exclusive content—as is broadly the case for audio streaming—the above analysis would be altered (though, as explained above, such a move would likely be detrimental to users). Streaming services would become substitutes if they offered identical catalogues.

In short, the extent to which streaming services are complements ultimately boils down to an empirical question that may fluctuate with industry practices. As things stand, there is reason to believe that these services feature some complementarities, or at least that demand for them is independent. In turn, this suggests that further consolidation within the industry would not lead to price increases and may even reduce them.

Consolidation can enable price discrimination

It is well-established that bundling entertainment goods can enable firms to better engage in price discrimination, often increasing output and reducing deadweight loss in the process.

Take George Stigler’s famous explanation for the practice of “block booking,” in which movie studios sold multiple films to independent movie theatres as a unit. Stigler assumes the underlying goods are neither substitutes nor complements:

Stigler, George J. (1963) “United States v. Loew’s Inc.: A Note on Block-Booking,” *Supreme Court Review*: Vol. 1963 : No. 1 , Article 2.

The upshot is that, when consumer tastes for content are idiosyncratic—as is almost certainly the case for movies and television series, movies—it can counterintuitively make sense to sell differing content as a bundle. In doing so, the distributor avoids pricing consumers out of the content upon which they place a lower value. Moreover, this solution is more efficient than price discriminating on an unbundled basis, as doing so would require far more information on the seller’s part and would be vulnerable to arbitrage.

In short, bundling enables each consumer to access a much wider variety of content. This, in turn, provides a powerful rationale for mergers in the video-streaming space—particularly where they can bring together varied content libraries. Put differently, it cuts in favor of more, not less, concentration in video-streaming markets (at least, up to a certain point).

Finally, a wide array of scale-related economies further support the case for concentration in video-streaming markets. These include potential economies of scale, network effects, and reduced transaction costs.

The simplest of these ideas is that the cost of video streaming may decrease at the margin (i.e., serving each marginal viewer might be cheaper than the previous one). In other words, mergers of video-streaming services mayenable platforms to operate at a more efficient scale. There has notably been some discussion of whether Netflix benefits from scale economies of this sort. But this is, of course, ultimately an empirical question. As I have written with Geoffrey Manne, we should not assume that this is the case for all digital platforms, or that these increasing returns are present at all ranges of output.

Likewise, the fact that content can earn greater revenues by reaching a wider audience (or a greater number of small niches) may increase a producer’s incentive to create high-quality content. For example, Netflix’s recent hit series Squid Game reportedly cost $16.8 million to produce a total of nine episodes. This is significant for a Korean-language thriller. These expenditures were likely only possible because of Netflix’s vast network of viewers. Video-streaming mergers can jump-start these effects by bringing previously fragmented audiences onto a single platform.

Finally, operating at a larger scale may enable firms and consumers to economize on various transaction and search costs. For instance, consumers don’t need to manage several subscriptions, and searching for content is easier within a single ecosystem.

Conclusion

In short, critics could hardly be more wrong in assuming that consolidation in the video-streaming industry will necessarily harm consumers. To the contrary, these mergers should be presumptively welcomed because, to a first approximation, they are likely to engender lower prices and reduce deadweight loss.

Critics routinely draw parallels between video streaming and the consolidation that previously moved through the cable industry. They suggest these events as evidence that consolidation was (and still is) inefficient and exploitative of consumers. As AAI and PK frame it:

Moreover, given the broader competition challenges that reside in those markets, and the lessons learned from a failure to ensure competition in the traditional MVPD markets, enforcers should be particularly vigilant.

But while it might not have been ideal for all consumers, the comparatively laissez-faire approach to competition in the cable industry arguably facilitated the United States’ emergence as a global leader for TV programming. We are now witnessing what appears to be a similar trend in the online video-streaming market.

This is mostly a good thing. While a single streaming service might not be the optimal industry configuration from a welfare standpoint, it would be equally misguided to assume that fragmentation necessarily benefits consumers. In fact, as argued throughout this piece, there are important reasons to believe that the status quo—with at least 10 significant players—is too fragmented and that consumers would benefit from additional consolidation.

Antitrust Dystopia and Antitrust Nostalgia

Geoffrey Manne & Dirk Auer — 9 September 2021

The dystopian novel is a powerful literary genre. It has given us such masterpieces as Nineteen Eighty-Four, Brave New World, and Fahrenheit 451. Though these novels often shed light on the risks of contemporary society and the zeitgeist of the era in which they were written, they also almost always systematically overshoot the mark (intentionally or not) and severely underestimate the radical improvements that stem from the technologies (or other causes) that they fear.

But dystopias are not just a literary phenomenon; they are also a powerful force in policy circles. This is epitomized by influential publications such as The Club of Rome’s 1972 report The Limits of Growth, whose dire predictions of Malthusian catastrophe have largely failed to materialize.

In an article recently published in the George Mason Law Review, we argue that contemporary antitrust scholarship and commentary is similarly afflicted by dystopian thinking. In that respect, today’s antitrust pessimists have set their sights predominantly on the digital economy—”Big Tech” and “Big Data”—in the process of alleging a vast array of potential harms.

Scholars have notably argued that the data created and employed by the digital economy produces network effects that inevitably lead to tipping and to more concentrated markets (e.g., here and here). In other words, firms will allegedly accumulate insurmountable data advantages and thus thwart competitors for extended periods of time.

Some have gone so far as to argue that this threatens the very fabric of western democracy. For instance, parallels between the novel Nineteen Eighty-Four and the power of large digital platforms were plain to see when Epic Games launched an antitrust suit against Apple and its App Store in August 2020. The gaming company released a short video clip parodying Apple’s famous “1984” ad (which, upon its release, was itself widely seen as a critique of the tech incumbents of the time). Similarly, a piece in the New Statesman—titled “Slouching Towards Dystopia: The Rise of Surveillance Capitalism and the Death of Privacy”—concluded that:

Our lives and behaviour have been turned into profit for the Big Tech giants—and we meekly click ‘Accept.’ How did we sleepwalk into a world without privacy?

In our article, we argue that these fears are symptomatic of two different but complementary phenomena, which we refer to as “Antitrust Dystopia” and “Antitrust Nostalgia.”

Antitrust Dystopia is the pessimistic tendency among competition scholars and enforcers to assert that novel business conduct will cause technological advances to have unprecedented, anticompetitive consequences. This is almost always grounded in the belief that “this time is different”—that, despite the benign or positive consequences of previous, similar technological advances, this time those advances will have dire, adverse consequences absent enforcement to stave off abuse.

Antitrust Nostalgia is the biased assumption—often built into antitrust doctrine itself—that change is bad. Antitrust Nostalgia holds that, because a business practice has seemingly benefited competition before, changing it will harm competition going forward. Thus, antitrust enforcement is often skeptical of, and triggered by, various deviations from status quo conduct and relationships (i.e., “nonstandard” business arrangements) when change is, to a first approximation, the hallmark of competition itself.

Our article argues that these two worldviews are premised on particularly questionable assumptions about the way competition unfolds, in this case, in data-intensive markets.

The Case of Big Data Competition

The notion that digital markets are inherently more problematic than their brick-and-mortar counterparts—if there even is a meaningful distinction—is advanced routinely by policymakers, journalists, and other observers. The fear is that, left to their own devices, today’s dominant digital platforms will become all-powerful, protected by an impregnable “data barrier to entry.” Against this alarmist backdrop, nostalgic antitrust scholars have argued for aggressive antitrust intervention against the nonstandard business models and contractual arrangements that characterize these markets.

But as our paper demonstrates, a proper assessment of the attributes of data-intensive digital markets does not support either the dire claims or the proposed interventions.

Data is information

One of the most salient features of the data created and consumed by online firms is that, jargon aside, it is just information. As with other types of information, it thus tends to have at least some traits usually associated with public goods (i.e., goods that are non-rivalrous in consumption and not readily excludable). As the National Bureau of Economic Research’s Catherine Tucker argues, data “has near-zero marginal cost of production and distribution even over long distances,” making it very difficult to exclude others from accessing it. Meanwhile, multiple economic agents can simultaneously use the same data, making it non-rivalrous in consumption.

As we explain in our paper, these features make the nature of modern data almost irreconcilable with the alleged hoarding and dominance that critics routinely associate with the tech industry.

2. Data is not scarce; expertise is

Another important feature of data is that it is ubiquitous. The predominant challenge for firms is not so much in obtaining data but, rather, in drawing useful insights from it. This has two important implications for antitrust policy.

First, although data does not have the self-reinforcing characteristics of network effects, there is a sense that acquiring a certain amount of data and expertise is necessary to compete in data-heavy industries. It is (or should be) equally apparent, however, that this “learning by doing” advantage rapidly reaches a point of diminishing returns.

This is supported by significant empirical evidence. As our survey of the empirical literature shows, data generally entails diminishing marginal returns:

Second, it is firms’ capabilities, rather than the data they own, that lead to success in the marketplace. Critics who argue that firms such as Amazon, Google, and Facebook are successful because of their superior access to data might, in fact, have the causality in reverse. Arguably, it is because these firms have come up with successful industry-defining paradigms that they have amassed so much data, and not the other way around.

This dynamic can be seen at play in the early days of the search-engine market. In 2013, The Atlantic ran a piece titled “What the Web Looked Like Before Google.” By comparing the websites of Google and its rivals in 1998 (when Google Search was launched), the article shows how the current champion of search marked a radical departure from the status quo.

Even if it stumbled upon it by chance, Google immediately identified a winning formula for the search-engine market. It ditched the complicated classification schemes favored by its rivals and opted, instead, for a clean page with a single search box. This ensured that users could access the information they desired in the shortest possible amount of time—thanks, in part, to Google’s PageRank algorithm.

It is hardly surprising that Google’s rivals struggled to keep up with this shift in the search-engine industry. The theory of dynamic capabilities tells us that firms that have achieved success by indexing the web will struggle when the market rapidly moves toward a new paradigm (in this case, Google’s single search box and ten blue links). During the time it took these rivals to identify their weaknesses and repurpose their assets, Google kept on making successful decisions: notably, the introduction of Gmail, its acquisitions of YouTube and Android, and the introduction of Google Maps, among others.

Seen from this evolutionary perspective, Google thrived because its capabilities were perfect for the market at that time, while rivals were ill-adapted.

3. Data as a byproduct of, and path to, platform monetization

Policymakers should also bear in mind that platforms often must go to great lengths in order to create data about their users—data that these same users often do not know about themselves. Under this framing, data is a byproduct of firms’ activity, rather than an input necessary for rivals to launch a business.

This is especially clear when one looks at the formative years of numerous online platforms. Most of the time, these businesses were started by entrepreneurs who did not own much data but, instead, had a brilliant idea for a service that consumers would value. Even if data ultimately played a role in the monetization of these platforms, it does not appear that it was necessary for their creation.

Data often becomes significant only at a relatively late stage in these businesses’ development. A quick glance at the digital economy is particularly revealing in this regard. Google and Facebook, in particular, both launched their platforms under the assumption that building a successful product would eventually lead to significant revenues.

It took five years from its launch for Facebook to start making a profit. Even at that point, when the platform had 300 million users, it still was not entirely clear whether it would generate most of its income from app sales or online advertisements. It was another three years before Facebook started to cement its position as one of the world’s leading providers of online ads. During this eight-year timespan, Facebook prioritized user growth over the monetization of its platform. The company appears to have concluded (correctly, it turns out) that once its platform attracted enough users, it would surely find a way to make itself highly profitable.

This might explain how Facebook managed to build a highly successful platform despite a large data disadvantage when compared to rivals like MySpace. And Facebook is no outlier. The list of companies that prevailed despite starting with little to no data (and initially lacking a data-dependent monetization strategy) is lengthy. Other examples include TikTok, Airbnb, Amazon, Twitter, PayPal, Snapchat, and Uber.

Those who complain about the unassailable competitive advantages enjoyed by companies with troves of data have it exactly backward. Companies need to innovate to attract consumer data or else consumers will switch to competitors, including both new entrants and established incumbents. As a result, the desire to make use of more and better data drives competitive innovation, with manifestly impressive results. The continued explosion of new products, services, and apps is evidence that data is not a bottleneck to competition, but a spur to drive it.

We’ve Been Here Before: The Microsoft Antitrust Saga

Dystopian and nostalgic discussions concerning the power of successful technology firms are nothing new. Throughout recent history, there have been repeated calls for antitrust authorities to reign in these large companies. These calls for regulation have often led to increased antitrust scrutiny of some form. The Microsoft antitrust cases—which ran from the 1990s to the early 2010s on both sides of the Atlantic—offer a good illustration of the misguided “Antitrust Dystopia.”

In the mid-1990s, Microsoft was one of the most successful and vilified companies in America. After it obtained a commanding position in the desktop operating system market, the company sought to establish a foothold in the burgeoning markets that were developing around the Windows platform (many of which were driven by the emergence of the Internet). These included the Internet browser and media-player markets.

The business tactics employed by Microsoft to execute this transition quickly drew the ire of the press and rival firms, ultimately landing Microsoft in hot water with antitrust authorities on both sides of the Atlantic.

However, as we show in our article, though there were numerous calls for authorities to adopt a precautionary principle-type approach to dealing with Microsoft—and antitrust enforcers were more than receptive to these calls—critics’ worst fears never came to be.

This positive outcome is unlikely to be the result of the antitrust cases that were brought against Microsoft. In other words, the markets in which Microsoft operated seem to have self-corrected (or were misapprehended as competitively constrained) and, today, are generally seen as being unproblematic.

This is not to say that antitrust interventions against Microsoft were necessarily misguided. Instead, our critical point is that commentators and antitrust decisionmakers routinely overlooked or misinterpreted the existing and nonstandard market dynamics that ultimately prevented the worst anticompetitive outcomes from materializing. This is supported by several key factors.

First, the remedies that were imposed against Microsoft by antitrust authorities on both sides of the Atlantic were ultimately quite weak. It is thus unlikely that these remedies, by themselves, prevented Microsoft from dominating its competitors in adjacent markets.

Note that, if this assertion is wrong, and antitrust enforcement did indeed prevent Microsoft from dominating online markets, then there is arguably no need to reform the antitrust laws on either side of the Atlantic, nor even to adopt a particularly aggressive enforcement position. The remedies that were imposed on Microsoft were relatively localized. Accordingly, if antitrust enforcement did indeed prevent Microsoft from dominating other online markets, then it is antitrust enforcement’s deterrent effect that is to thank, and not the remedies actually imposed.

Second, Microsoft lost its bottleneck position. One of the biggest changes that took place in the digital space was the emergence of alternative platforms through which consumers could access the Internet. Indeed, as recently as January 2009, roughly 94% of all Internet traffic came from Windows-based computers. Just over a decade later, this number has fallen to about 31%. Android, iOS, and OS X have shares of roughly 41%, 16%, and 7%, respectively. Consumers can thus access the web via numerous platforms. The emergence of these alternatives reduced the extent to which Microsoft could use its bottleneck position to force its services on consumers in online markets.

Third, it is possible that Microsoft’s own behavior ultimately sowed the seeds of its relative demise. In particular, the alleged barriers to entry (rooted in nostalgic market definitions and skeptical analysis of “ununderstandable” conduct) that were essential to establishing the antitrust case against the company may have been pathways to entry as much as barriers.

Consider this error in the Microsoft court’s analysis of entry barriers: the court pointed out that new entrants faced a barrier that Microsoft didn’t face, in that Microsoft didn’t have to contend with a powerful incumbent impeding its entry by tying up application developers.

But while this may be true, Microsoft did face the absence of any developers at all, and had to essentially create (or encourage the creation of) businesses that didn’t previously exist. Microsoft thus created a huge positive externality for new entrants: existing knowledge and organizations devoted to software development, industry knowledge, reputation, awareness, and incentives for schools to offer courses. It could well be that new entrants, in fact, faced lower barriers with respect to app developers than did Microsoft when it entered.

In short, new entrants may face even more welcoming environments because of incumbents. This enabled Microsoft’s rivals to thrive.

Conclusion

Dystopian antitrust prophecies are generally doomed to fail, just like those belonging to the literary world. The reason is simple. While it is easy to identify what makes dominant firms successful in the present (i.e., what enables them to hold off competitors in the short term), it is almost impossible to conceive of the myriad ways in which the market could adapt. Indeed, it is today’s supra-competitive profits that spur the efforts of competitors.

Surmising that the economy will come to be dominated by a small number of successful firms is thus the same as believing that all market participants can be outsmarted by a few successful ones. This might occur in some cases or for some period of time, but as our article argues, it is bound to happen far less often than pessimists fear.

In short, dystopian scholars have not successfully made the case for precautionary antitrust. Indeed, the economic features of data make it highly unlikely that today’s tech giants could anticompetitively maintain their advantage for an indefinite amount of time, much less leverage this advantage in adjacent markets.

With this in mind, there is one dystopian novel that offers a fitting metaphor to end this Article. The Man in the High Castle tells the story of an alternate present, where Axis forces triumphed over the Allies during the second World War. This turns the dystopia genre on its head: rather than argue that the world is inevitably sliding towards a dark future, The Man in the High Castle posits that the present could be far worse than it is.

In other words, we should not take any of the luxuries we currently enjoy for granted. In the world of antitrust, critics routinely overlook that the emergence of today’s tech industry might have occurred thanks to, and not in spite of, existing antitrust doctrine. Changes to existing antitrust law should thus be dictated by a rigorous assessment of the various costs and benefits they would entail, rather than a litany of hypothetical concerns. The most recent wave of calls for antitrust reform have so far failed to clear this low bar.

Technology Mergers and the Market for Corporate Control

Sam Bowman, Dirk Auer & Geoffrey Manne — 10 August 2021

[This post adapts elements of “Technology Mergers and the Market for Corporate Control,” forthcoming in the Missouri Law Review.]

In recent years, a growing chorus of voices has argued that existing merger rules fail to apprehend competitively significant mergers, either because they fall below existing merger-filing thresholds or because they affect innovation in ways that are purportedly ignored.

These fears are particularly acute in the pharmaceutical and tech industries, where several high-profile academic articles and reports claim to have identified important gaps in current merger-enforcement rules, particularly with respect to acquisitions involving nascent and potential competitors (here, here, and here, among many others).

Such fears have led activists, lawmakers, and enforcers to call for tougher rules, including the introduction of more stringent merger-filing thresholds and other substantive changes, such as the inversion of the burden of proof when authorities review mergers and acquisitions involving digital platforms.

However, as we discuss in a recent working paper—forthcoming in the Missouri Law Review and available on SSRN—these proposals tend to overlook the important tradeoffs that would ensue from attempts to decrease the number of false positives under existing merger rules and thresholds.

The paper draws from two key strands of economic literature that are routinely overlooked (or summarily dismissed) by critics of the status quo.

For a start, antitrust enforcement is not costless. In the case of merger enforcement, not only is it expensive for agencies to detect anticompetitive deals but, more importantly, overbearing rules may deter beneficial merger activity that creates value for consumers.

Second, critics tend to overlook the possibility that incumbents’ superior managerial or other capabilities (i.e., what made them successful in the first place) makes them the ideal acquisition partners for entrepreneurs and startup investors looking to sell.

The result is a body of economic literature that focuses almost entirely on hypothetical social costs, while ignoring the redeeming benefits of corporate acquisitions, as well as the social cost of enforcement.

Kill Zones

One of the most significant allegations leveled against large tech firms is that their very presence in a market may hinder investments, entry, and innovation, creating what some have called a “kill zone.” The strongest expression in the economic literature of this idea of a kill zone stems from a working paper by Sai Krishna Kamepalli, Raghuram Rajan, and Luigi Zingales.

The paper makes two important claims, one theoretical and one empirical. From a theoretical standpoint, the authors argue that the prospect of an acquisition by a dominant platform deters consumers from joining rival platforms, and that this, in turn, hampers the growth of these rivals. The authors then test a similar hypothesis empirically. They find that acquisitions by a dominant platform—such as Google or Facebook—decrease investment levels and venture capital deals in markets that are “similar” to that of the target firm.

But both findings are problematic. For a start, Zingales and his co-authors’ theoretical model is premised on questionable assumptions about the way in which competition develops in the digital space. The first is that early adopters of new platforms—called “techies” in the authors’ parlance—face high switching costs because of their desire to learn these platforms in detail. As an initial matter, it would appear facially contradictory that “techies” both are the group with the highest switching costs and that they switch the most. The authors further assume that “techies” would incur lower adoption costs if they remained on the incumbent platform and waited for the rival platform to be acquired.

Unfortunately, while these key behavioral assumptions drive the results of the theoretical model, the paper presents no evidence to support their presence in real-world settings. In that sense, the authors commit the same error as previous theoretical work concerning externalities, which have tended to overestimate their frequency.

Second, the empirical analysis put forward in the paper is unreliable for policymaking purposes. The authors notably find that:

[N]ormalized VC investments in start-ups in the same space as the company acquired by Google and Facebook drop by over 40% and the number of deals falls by over 20% in the three years following an acquisition.

However, the results of this study are derived from the analysis of only nine transactions. The study also fails to clearly show that firms in the treatment and controls are qualitatively similar. In a nutshell, the study compares industry acquisitions exceeding $500 million to Facebook and Google’s acquisitions that exceed that amount. This does not tell us whether the mergers in both groups involved target companies with similar valuations or similar levels of maturity. This does not necessarily invalidate the results, but it does suggest that policymakers should be circumspect in interpreting those results.

Finally, the paper fails to demonstrate evidence that existing antitrust regimes fail to achieve an optimal error-cost balance. The central problem is that the paper has indeterminate welfare implications. For instance, as the authors note, the declines in investment in spaces adjacent to the incumbent platforms occurred during a time of rapidly rising venture capital investment, both in terms of the number of deals and dollars invested. It is entirely plausible that venture capital merely shifted to other sectors.

Put differently, on its own terms, the evidence merely suggests that acquisitions by Google and Facebook affected the direction of innovation, not its overall rate. And there is little to suggest that this shift was suboptimal, from a welfare standpoint.

In short, as the authors themselves conclude: “[i]t would be premature to draw any policy conclusion on antitrust enforcement based solely on our model and our limited evidence.”

Mergers and Potential Competition

Scholars have also posited more direct effects from acquisitions of startups or nascent companies by incumbent technology market firms.

Some scholars argue that incumbents might acquire rivals that do not yet compete with them directly, in order to reduce the competitive pressure they will face in the future. In his paper “Potential Competition and Antitrust Analysis: Monopoly Profits Exceed Duopoly Profits,” Steven Salop argues:

Acquisitions of potential or nascent competitors by a dominant firm raise inherent anticompetitive concerns. By eliminating the procompetitive impact of the entry, an acquisition can allow the dominant firm to continue to exercise monopoly power and earn monopoly profits. The dominant firm also can neutralize the potential innovation competition that the entrant would provide.

However, these antitrust theories of harm suffer from several important flaws. They rest upon several restrictive assumptions that are not certain to occur in real-world settings. Most are premised on the notion that, in a given market, monopoly profits generally exceed joint duopoly profits. This allegedly makes it profitable, and mutually advantageous, for an incumbent to protect its monopoly position by preemptively acquiring potential rivals.

Accordingly, under these theories, anticompetitive mergers are only possible when the acquired rival could effectively challenge the incumbent. But these are, of course, only potential challengers; there is no guarantee that any one of them could or would mount a viable competitive threat.

Less obviously, it must be the case that the rival can hope to share only duopoly profits, as opposed to completely overthrowing the incumbent or surpassing them with a significantly larger share of the market. Where competition is “for the market” itself, monopoly maintenance would fail to explain a rival’s decision to sell. Because there would be no asymmetry between the expected profits of the incumbent and the rival, monopoly maintenance alone would not give rise to mutually advantageous deals.

Second, potential competition does not always increase consumer welfare. Indeed, while the presence of potential competitors might increase price competition, it can also have supply-side effects that cut in the opposite direction.

For example, as Nobel laureate Joseph Stiglitz observed, a monopolist threatened by potential competition may invest in socially wasteful R&D efforts or entry-deterrence mechanisms, and it may operate at below-optimal scale in anticipation of future competitive entry.

There are also pragmatic objections. Analyzing a merger’s effect on potential competition would compel antitrust authorities and courts to make increasingly speculative assessments concerning the counterfactual setting of proposed acquisitions.

In simple terms, it is far easier to determine whether a merger between McDonald’s and Burger King would lead to increased hamburger prices in the short run than it is to determine whether a gaming platform like Steam or the Epic Games Store might someday compete with video-streaming or music-subscription platforms like Netflix or Spotify. It is not that the above models are necessarily wrong, but rather that applying them to practical cases would require antitrust enforcers to estimate mostly unknowable factors.

Finally, the real test for regulators is not just whether they can identify possibly anticompetitive mergers, but whether they can do so in a cost-effective manner. Whether it is desirable to implement a given legal test is not simply a function of its accuracy, the cost to administer it, and the respective costs of false positives and false negatives. It also critically depends on how prevalent the conduct is that adjudicators would be seeking to foreclose.

Consider two hypothetical settings. Imagine there are 10,000 tech mergers in a given year, of which either 1,000 or 2,500 are anticompetitive (the remainder are procompetitive or competitively neutral). Suppose that authorities can either attempt to identify anticompetitive mergers with 75% accuracy, or perform no test at all—i.e., letting all mergers go through unchallenged.

If there are 1,000 anticompetitive mergers, applying the test would result in 7,500 correct decisions and 2,500 incorrect ones (2,250 false positives and 250 false negatives). Doing nothing would lead to 9,000 correct decisions and 1,000 false negatives. If the number of anticompetitive deals were 2,500, applying the test would lead to the same number of incorrect decisions as not applying it (1,875 false positives and 625 false negatives, versus 2,500 false negatives). The advantage would tilt toward applying the test if anticompetitive mergers were even more widespread.

This hypothetical example holds a simple lesson for policymakers: the rarer the conduct that they are attempting to identify, the more accurate their identification method must be, and the more costly false negatives must be relative to false positives.

As discussed below, current empirical evidence does not suggest that anticompetitive mergers of this sort are particularly widespread, nor does it offer accurate heuristics to detect the ones that are. Finally, there is little sense that the cost of false negatives significantly outweighs that of false positives. In short, there is currently little evidence to suggest that tougher enforcement would benefit consumers.

Killer Acquisitions

Killer acquisitions are, effectively, a subset of the “potential competitor” mergers discussed in the previous section. As defined by Colleen Cunningham, Florian Ederer, and Song Ma, they are those deals where “an incumbent firm may acquire an innovative target and terminate the development of the target’s innovations to preempt future competition.”

Cunningham, Ederer, and Ma’s highly influential paper on killer acquisitions has been responsible for much of the recent renewed interest in the effect that mergers exert on innovation. The authors studied thousands of pharmaceutical mergers and concluded that between 5.3% and 7.4% of them were killer acquisitions. As they write:

[W]e empirically compare development probabilities of overlapping acquisitions, which are, in our theory, motivated by a mix of killer and development intentions, and non-overlapping acquisitions, which are motivated only by development intentions. We find an increase in acquisition probability and a decrease in post-acquisition development for overlapping acquisitions and interpret that as evidence for killer acquisitions. […]
[W]e find that projects acquired by an incumbent with an overlapping drug are 23.4% less likely to have continued development activity compared to drugs acquired by non-overlapping incumbents.

From a policy standpoint, the question is what weight antitrust authorities, courts, and legislators should give to these findings. Stated differently, does the paper provide sufficient evidence to warrant reform of existing merger-filing thresholds and review standards? There are several factors counseling that policymakers should proceed with caution.

To start, the study’s industry-specific methodology means that it may not be a useful guide to understand acquisitions in other industries, like the tech sector, for example.

Second, even if one assumes that the findings of Cunningham, et al., are correct and apply with equal force in the tech sector (as some official reports have), it remains unclear whether the 5.3–7.4% of mergers they describe warrant a departure from the status quo.

Antitrust enforcers operate under uncertainty. The critical policy question is thus whether this subset of anticompetitive deals can be identified ex-ante. If not, is there a heuristic that would enable enforcers to identify more of these anticompetitive deals without producing excessive false positives?

The authors focus on the effect that overlapping R&D pipelines have on project discontinuations. In the case of non-overlapping mergers, acquired projects continue 17.5% of the time, while this number is 13.4% when there are overlapping pipelines. The authors argue that this gap is evidence of killer acquisitions. But it misses the bigger picture: under the authors’ own numbers and definition of a “killer acquisition,” a vast majority of overlapping acquisitions are perfectly benign; prohibiting them would thus have important social costs.

Third, there are several problems with describing this kind of behavior as harmful. Indeed, Cunningham, et al., acknowledge that this kind of behavior could increase innovation by boosting the returns to innovation.

And even if one ignores incentives to innovate, product discontinuations can improve consumer welfare. This question ultimately boils down to identifying the counterfactual to a merger. As John Yun writes:

For instance, an acquisition that results in a discontinued product is not per se evidence of either consumer harm or benefit. The answer involves comparing the counterfactual world without the acquisition with the world with the acquisition. The comparison includes potential efficiencies that were gained from the acquisition, including integration of intellectual property, the reduction of transaction costs, economies of scope, and better allocation of skilled labor.

One of the reasons R&D project discontinuation may be beneficial is simply cost savings. R&D is expensive. Pharmaceutical firms spend up to 27.8% of their annual revenue on R&D. Developing a new drug has an estimated median cost of $985.3 million. Cost-cutting—notably as it concerns R&D—is thus a critical part of pharmaceutical (as well as tech) companies’ businesses. As a report by McKinsey concludes:

The recent boom in M&A in the pharma industry is partly the result of attempts to address short-term productivity challenges. An acquiring or merging company typically designs organization-wide integration programs to capture synergies, especially in costs. Such programs usually take up to three years to complete and deliver results.

Another report finds that:

Maximizing the efficiency of production labor and equipment is one important way top-quartile drugmakers break out of the pack. Their rates of operational-equipment effectiveness are more than twice those of bottom-quartile companies (Exhibit 1), and when we looked closely we found that processes account for two-thirds of the difference.

In short, pharmaceutical companies do not just compete along innovation-related parameters, though these are obviously important, but also on more traditional grounds such as cost-rationalization. Accordingly, as the above reports suggest, pharmaceutical mergers are often about applying an incumbent’s superior managerial efficiency to the acquired firm’s assets through operation of the market for corporate control.

This cost-cutting (and superior project selection) ultimately enables companies to offer lower prices, thereby benefiting consumers and increasing their incentives to invest in R&D in the first place by making successfully developed drugs more profitable.

In that sense, Henry Manne’s seminal work relating to mergers and the market for corporate control sheds at least as much light on pharmaceutical (and tech) mergers as the killer acquisitions literature. And yet, it is hardly ever mentioned in modern economic literature on this topic.

While Colleen Cunningham and her co-authors do not entirely ignore these considerations, as we discuss in our paper, their arguments for dismissing them are far from watertight.

A natural extension of the killer acquisitions work is to question whether mergers of this sort also take place in the tech industry. Interest in this question is notably driven by the central role that digital markets currently occupy in competition-policy discussion, but also by the significant number of startup acquisitions that take place in the tech industry. However, existing studies provide scant evidence that killer acquisitions are a common occurrence in these markets.

This is not surprising. Unlike in the pharmaceutical industry—where drugs need to go through a lengthy and visible regulatory pipeline before they can be sold—incumbents in digital industries will likely struggle to identify their closest rivals and prevent firms from rapidly pivoting to seize new commercial opportunities. As a result, the basic conditions for killer acquisitions to take place (i.e., firms knowing they are in a position to share monopoly profits) are less likely to be present; it also would be harder to design research methods to detect these mergers.

The empirical literature on killer acquisitions in the tech sector is still in its infancy. But, as things stand, no study directly examines whether killer acquisitions actually take place in digital industries (i.e., whether post-merger project discontinuations are more common in overlapping than non-overlapping tech mergers). This is notably the case for studies by Axel Gautier & Joe Lamesch, and Elena Argentesi and her co-authors. Instead, these studies merely show that product discontinuations are common after an acquisition by a big tech company.

To summarize, while studies of this sort might suggest that the clearance of certain mergers might not have been optimal, it is hardly a sufficient basis on which to argue that enforcement should be tightened.

The reason for this is simple. The fact that some anticompetitive mergers may have escaped scrutiny and/or condemnation is never a sufficient basis to tighten rules. For that, it is also necessary to factor in the administrative costs of increased enforcement, as well as potential false convictions to which it might give rise. As things stand, economic research on killer acquisitions in the tech sector does not warrant tougher antitrust enforcement, though it does show the need for further empirical research on the topic.

Conclusion

Many proposed merger-enforcement reforms risk throwing the baby out with the bathwater. Mergers are largely beneficial to society (here, here and here); anticompetitive ones are rare; and there is little way, at the margin, to tell good from bad. To put it mildly, there is a precious baby that needs to be preserved and relatively little bathwater to throw out.

Take the fulcrum of policy debates that is the pharmaceutical industry. It is not hard to point to pharmaceutical mergers (or long-term agreements) that have revolutionized patient outcomes. Most recently, Pfizer and BioNTech’s efforts to successfully market an mRNA vaccine against COVID-19 offers a case in point.

The deal struck by both firms could naïvely be construed as bearing hallmarks of a killer acquisition or an anticompetitive agreement (long-term agreements can easily fall into either of these categories). Pfizer was a powerful incumbent in the vaccine industry; BioNTech threatened to disrupt the industry with new technology; and the deal likely caused Pfizer to forgo some independent R&D efforts. And yet, it also led to the first approved COVID-19 vaccine and groundbreaking advances in vaccine technology.

Of course, the counterfactual is unclear, and the market might be more competitive absent the deal, just as there might be only one approved mRNA vaccine today instead of two—we simply do not know. More importantly, this counterfactual was even less knowable at the time of the deal. And much the same could be said about countless other pharmaceutical mergers.

The key policy question is how authorities should handle this uncertainty. Critics of the status quo argue that current rules and thresholds leave certain anticompetitive deals unchallenged. But these calls for tougher enforcement fail to satisfy the requirements of the error-cost framework. Critics have so far failed to show that, on balance, mergers harm social welfare—even overlapping ones or mergers between potential competitors—just as they are yet to suggest alternative institutional arrangements that would improve social welfare.

In other words, they mistakenly analyze purported false negatives of merger-enforcement regimes in isolation. In doing so, they ignore how measures that aim to reduce such judicial errors may lead to other errors, as well as higher enforcement costs. In short, they paint a world where policy decisions involve facile tradeoffs, and this undermines their policy recommendations.

Given these significant limitations, this body of academic research should be met with an appropriate degree of caution. For all the criticism it has faced, the current merger-review system is mostly a resounding success. It is administrable, predictable, and timely. Yet it also eliminates a vast majority of judicial errors: even its critics concede that false negatives make up only a tiny fraction of decisions. Policymakers must decide whether the benefits from catching the very few arguably anticompetitive mergers that currently escape prosecution outweigh the significant costs that are required to achieve this goal. There is currently little evidence to suggest that this is, indeed, the case.

How US and EU Competition Law Differ

Sam Bowman, Dirk Auer & Geoffrey Manne — 9 August 2021

[This post adapts elements of “Should ASEAN Antitrust Laws Emulate European Competition Policy?”, published in the Singapore Economic Review (2021). Open access working paper here.]

U.S. and European competition laws diverge in numerous ways that have important real-world effects. Understanding these differences is vital, particularly as lawmakers in the United States, and the rest of the world, consider adopting a more “European” approach to competition.

In broad terms, the European approach is more centralized and political. The European Commission’s Directorate General for Competition (DG Comp) has significant de facto discretion over how the law is enforced. This contrasts with the common law approach of the United States, in which courts elaborate upon open-ended statutes through an iterative process of case law. In other words, the European system was built from the top down, while U.S. antitrust relies on a bottom-up approach, derived from arguments made by litigants (including the government antitrust agencies) and defendants (usually businesses).

This procedural divergence has significant ramifications for substantive law. European competition law includes more provisions akin to de facto regulation. This is notably the case for the “abuse of dominance” standard, in which a “dominant” business can be prosecuted for “abusing” its position by charging high prices or refusing to deal with competitors. By contrast, the U.S. system places more emphasis on actual consumer outcomes, rather than the nature or “fairness” of an underlying practice.

The American system thus affords firms more leeway to exclude their rivals, so long as this entails superior benefits for consumers. This may make the U.S. system more hospitable to innovation, since there is no built-in regulation of conduct for innovators who acquire a successful market position fairly and through normal competition.

In this post, we discuss some key differences between the two systems—including in areas like predatory pricing and refusals to deal—as well as the discretionary power the European Commission enjoys under the European model.

Exploitative Abuses

U.S. antitrust is, by and large, unconcerned with companies charging what some might consider “excessive” prices. The late Associate Justice Antonin Scalia, writing for the Supreme Court majority in the 2003 case Verizon v. Trinko, observed that:

The mere possession of monopoly power, and the concomitant charging of monopoly prices, is not only not unlawful; it is an important element of the free-market system. The opportunity to charge monopoly prices—at least for a short period—is what attracts “business acumen” in the first place; it induces risk taking that produces innovation and economic growth.

This contrasts with European competition-law cases, where firms may be found to have infringed competition law because they charged excessive prices. As the European Court of Justice (ECJ) held in 1978’s United Brands case: “In this case charging a price which is excessive because it has no reasonable relation to the economic value of the product supplied would be such an abuse.”

While United Brands was the EU’s foundational case for excessive pricing, and the European Commission reiterated that these allegedly exploitative abuses were possible when it published its guidance paper on abuse of dominance cases in 2009, the commission had for some time demonstrated apparent disinterest in bringing such cases. In recent years, however, both the European Commission and some national authorities have shown renewed interest in excessive-pricing cases, most notably in the pharmaceutical sector.

European competition law also penalizes so-called “margin squeeze” abuses, in which a dominant upstream supplier charges a price to distributors that is too high for them to compete effectively with that same dominant firm downstream:

[I]t is for the referring court to examine, in essence, whether the pricing practice introduced by TeliaSonera is unfair in so far as it squeezes the margins of its competitors on the retail market for broadband connection services to end users. (Konkurrensverket v TeliaSonera Sverige, 2011)

As Scalia observed in Trinko, forcing firms to charge prices that are below a market’s natural equilibrium affects firms’ incentives to enter markets, notably with innovative products and more efficient means of production. But the problem is not just one of market entry and innovation. Also relevant is the degree to which competition authorities are competent to determine the “right” prices or margins.

As Friedrich Hayek demonstrated in his influential 1945 essay The Use of Knowledge in Society, economic agents use information gleaned from prices to guide their business decisions. It is this distributed activity of thousands or millions of economic actors that enables markets to put resources to their most valuable uses, thereby leading to more efficient societies. By comparison, the efforts of central regulators to set prices and margins is necessarily inferior; there is simply no reasonable way for competition regulators to make such judgments in a consistent and reliable manner.

Given the substantial risk that investigations into purportedly excessive prices will deter market entry, such investigations should be circumscribed. But the court’s precedents, with their myopic focus on ex post prices, do not impose such constraints on the commission. The temptation to “correct” high prices—especially in the politically contentious pharmaceutical industry—may thus induce economically unjustified and ultimately deleterious intervention.

Predatory Pricing

A second important area of divergence concerns predatory-pricing cases. U.S. antitrust law subjects allegations of predatory pricing to two strict conditions:

Monopolists must charge prices that are below some measure of their incremental costs; and
There must be a realistic prospect that they will able to recoup these initial losses.

In laying out its approach to predatory pricing, the U.S. Supreme Court has identified the risk of false positives and the clear cost of such errors to consumers. It thus has particularly stressed the importance of the recoupment requirement. As the court found in 1993’s Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., without recoupment, “predatory pricing produces lower aggregate prices in the market, and consumer welfare is enhanced.”

Accordingly, U.S. authorities must prove that there are constraints that prevent rival firms from entering the market after the predation scheme, or that the scheme itself would effectively foreclose rivals from entering the market in the first place. Otherwise, the predator would be undercut by competitors as soon as it attempts to recoup its losses by charging supra-competitive prices.

Without the strong likelihood that a monopolist will be able to recoup lost revenue from underpricing, the overwhelming weight of economic evidence (to say nothing of simple logic) is that predatory pricing is not a rational business strategy. Thus, apparent cases of predatory pricing are most likely not, in fact, predatory; deterring or punishing them would actually harm consumers.

By contrast, the EU employs a more expansive legal standard to define predatory pricing, and almost certainly risks injuring consumers as a result. Authorities must prove only that a company has charged a price below its average variable cost, in which case its behavior is presumed to be predatory. Even when a firm charges prices that are between its average variable and average total cost, it can be found guilty of predatory pricing if authorities show that its behavior was part of a plan to eliminate a competitor. Most significantly, in neither case is it necessary for authorities to show that the scheme would allow the monopolist to recoup its losses.

[I]t does not follow from the case‑law of the Court that proof of the possibility of recoupment of losses suffered by the application, by an undertaking in a dominant position, of prices lower than a certain level of costs constitutes a necessary precondition to establishing that such a pricing policy is abusive. (France Télécom v Commission, 2009).

This aspect of the legal standard has no basis in economic theory or evidence—not even in the “strategic” economic theory that arguably challenges the dominant Chicago School understanding of predatory pricing. Indeed, strategic predatory pricing still requires some form of recoupment, and the refutation of any convincing business justification offered in response. For example, in a 2017 piece for the Antitrust Law Journal, Steven Salop lays out the “raising rivals’ costs” analysis of predation and notes that recoupment still occurs, just at the same time as predation:

[T]he anticompetitive conditional pricing practice does not involve discrete predatory and recoupment periods, as in the case of classical predatory pricing. Instead, the recoupment occurs simultaneously with the conduct. This is because the monopolist is able to maintain its current monopoly power through the exclusionary conduct.

The case of predatory pricing illustrates a crucial distinction between European and American competition law. The recoupment requirement embodied in American antitrust law serves to differentiate aggressive pricing behavior that improves consumer welfare—because it leads to overall price decreases—from predatory pricing that reduces welfare with higher prices. It is, in other words, entirely focused on the welfare of consumers.

The European approach, by contrast, reflects structuralist considerations far removed from a concern for consumer welfare. Its underlying fear is that dominant companies could use aggressive pricing to engender more concentrated markets. It is simply presumed that these more concentrated markets are invariably detrimental to consumers. Both the Tetra Pak and France Télécom cases offer clear illustrations of the ECJ’s reasoning on this point:

[I]t would not be appropriate, in the circumstances of the present case, to require in addition proof that Tetra Pak had a realistic chance of recouping its losses. It must be possible to penalize predatory pricing whenever there is a risk that competitors will be eliminated… The aim pursued, which is to maintain undistorted competition, rules out waiting until such a strategy leads to the actual elimination of competitors. (Tetra Pak v Commission, 1996).

Similarly:

[T]he lack of any possibility of recoupment of losses is not sufficient to prevent the undertaking concerned reinforcing its dominant position, in particular, following the withdrawal from the market of one or a number of its competitors, so that the degree of competition existing on the market, already weakened precisely because of the presence of the undertaking concerned, is further reduced and customers suffer loss as a result of the limitation of the choices available to them. (France Télécom v Commission, 2009).

In short, the European approach leaves less room to analyze the concrete effects of a given pricing scheme, leaving it more prone to false positives than the U.S. standard explicated in the Brooke Group decision. Worse still, the European approach ignores not only the benefits that consumers may derive from lower prices, but also the chilling effect that broad predatory pricing standards may exert on firms that would otherwise seek to use aggressive pricing schemes to attract consumers.

Refusals to Deal

U.S. and EU antitrust law also differ greatly when it comes to refusals to deal. While the United States has limited the ability of either enforcement authorities or rivals to bring such cases, EU competition law sets a far lower threshold for liability.

As Justice Scalia wrote in Trinko:

Aspen Skiing is at or near the outer boundary of §2 liability. The Court there found significance in the defendant’s decision to cease participation in a cooperative venture. The unilateral termination of a voluntary (and thus presumably profitable) course of dealing suggested a willingness to forsake short-term profits to achieve an anticompetitive end. (Verizon v Trinko, 2003.)

This highlights two key features of American antitrust law with regard to refusals to deal. To start, U.S. antitrust law generally does not apply the “essential facilities” doctrine.Accordingly, in the absence of exceptional facts, upstream monopolists are rarely required to supply their product to downstream rivals, even if that supply is “essential” for effective competition in the downstream market. Moreover, as Justice Scalia observed in Trinko, the Aspen Skiing case appears to concern only those limited instances where a firm’s refusal to deal stems from the termination of a preexisting and profitable business relationship.

While even this is not likely the economically appropriate limitation on liability, its impetus—ensuring that liability is found only in situations where procompetitive explanations for the challenged conduct are unlikely—is completely appropriate for a regime concerned with minimizing the cost to consumers of erroneous enforcement decisions.

As in most areas of antitrust policy, EU competition law is much more interventionist. Refusals to deal are a central theme of EU enforcement efforts, and there is a relatively low threshold for liability.

In theory, for a refusal to deal to infringe EU competition law, it must meet a set of fairly stringent conditions: the input must be indispensable, the refusal must eliminate all competition in the downstream market, and there must not be objective reasons that justify the refusal. Moreover, if the refusal to deal involves intellectual property, it must also prevent the appearance of a new good.

In practice, however, all of these conditions have been relaxed significantly by EU courts and the commission’s decisional practice. This is best evidenced by the lower court’s Microsoft ruling where, as John Vickers notes:

[T]he Court found easily in favor of the Commission on the IMS Health criteria, which it interpreted surprisingly elastically, and without relying on the special factors emphasized by the Commission. For example, to meet the “new product” condition it was unnecessary to identify a particular new product… thwarted by the refusal to supply but sufficient merely to show limitation of technical development in terms of less incentive for competitors to innovate.

EU competition law thus shows far less concern for its potential chilling effect on firms’ investments than does U.S. antitrust law.

Vertical Restraints

There are vast differences between U.S. and EU competition law relating to vertical restraints—that is, contractual restraints between firms that operate at different levels of the production process.

On the one hand, since the Supreme Court’s Leegin ruling in 2006, even price-related vertical restraints (such as resale price maintenance (RPM), under which a manufacturer can stipulate the prices at which retailers must sell its products) are assessed under the rule of reason in the United States. Some commentators have gone so far as to say that, in practice, U.S. case law on RPM almost amounts to per se legality.

Conversely, EU competition law treats RPM as severely as it treats cartels. Both RPM and cartels are considered to be restrictions of competition “by object”—the EU’s equivalent of a per se prohibition. This severe treatment also applies to non-price vertical restraints that tend to partition the European internal market.

Furthermore, in the Consten and Grundig ruling, the ECJ rejected the consequentialist, and economically grounded, principle that inter-brand competition is the appropriate framework to assess vertical restraints:

Although competition between producers is generally more noticeable than that between distributors of products of the same make, it does not thereby follow that an agreement tending to restrict the latter kind of competition should escape the prohibition of Article 85(1) merely because it might increase the former. (Consten SARL & Grundig-Verkaufs-GMBH v. Commission of the European Economic Community, 1966).

This treatment of vertical restrictions flies in the face of longstanding mainstream economic analysis of the subject. As Patrick Rey and Jean Tirole conclude:

Another major contribution of the earlier literature on vertical restraints is to have shown that per se illegality of such restraints has no economic foundations.

Unlike the EU, the U.S. Supreme Court in Leegin took account of the weight of the economic literature, and changed its approach to RPM to ensure that the law no longer simply precluded its arguable consumer benefits, writing: “Though each side of the debate can find sources to support its position, it suffices to say here that economics literature is replete with procompetitive justifications for a manufacturer’s use of resale price maintenance.” Further, the court found that the prior approach to resale price maintenance restraints “hinders competition and consumer welfare because manufacturers are forced to engage in second-best alternatives and because consumers are required to shoulder the increased expense of the inferior practices.”

The EU’s continued per se treatment of RPM, by contrast, strongly reflects its “precautionary principle” approach to antitrust. European regulators and courts readily condemn conduct that could conceivably injure consumers, even where such injury is, according to the best economic understanding, exceedingly unlikely. The U.S. approach, which rests on likelihood rather than mere possibility, is far less likely to condemn beneficial conduct erroneously.

Political Discretion in European Competition Law

EU competition law lacks a coherent analytical framework like that found in U.S. law’s reliance on the consumer welfare standard. The EU process is driven by a number of laterally equivalent—and sometimes mutually exclusive—goals, including industrial policy and the perceived need to counteract foreign state ownership and subsidies. Such a wide array of conflicting aims produces lack of clarity for firms seeking to conduct business. Moreover, the discretion that attends this fluid arrangement of goals yields an even larger problem.

The Microsoft case illustrates this problem well. In Microsoft, the commission could have chosen to base its decision on various potential objectives. It notably chose to base its findings on the fact that Microsoft’s behavior reduced “consumer choice.”

The commission, in fact, discounted arguments that economic efficiency may lead to consumer welfare gains, because it determined “consumer choice” among media players was more important:

Another argument relating to reduced transaction costs consists in saying that the economies made by a tied sale of two products saves resources otherwise spent for maintaining a separate distribution system for the second product. These economies would then be passed on to customers who could save costs related to a second purchasing act, including selection and installation of the product. Irrespective of the accuracy of the assumption that distributive efficiency gains are necessarily passed on to consumers, such savings cannot possibly outweigh the distortion of competition in this case. This is because distribution costs in software licensing are insignificant; a copy of a software programme can be duplicated and distributed at no substantial effort. In contrast, the importance of consumer choice and innovation regarding applications such as media players is high. (Commission Decision No. COMP. 37792 (Microsoft)).

It may be true that tying the products in question was unnecessary. But merely dismissing this decision because distribution costs are near-zero is hardly an analytically satisfactory response. There are many more costs involved in creating and distributing complementary software than those associated with hosting and downloading. The commission also simply asserts that consumer choice among some arbitrary number of competing products is necessarily a benefit. This, too, is not necessarily true, and the decision’s implication that any marginal increase in choice is more valuable than any gains from product design or innovation is analytically incoherent.

The Court of First Instance was only too happy to give the commission a pass in its breezy analysis; it saw no objection to these findings. With little substantive reasoning to support its findings, the court fully endorsed the commission’s assessment:

As the Commission correctly observes (see paragraph 1130 above), by such an argument Microsoft is in fact claiming that the integration of Windows Media Player in Windows and the marketing of Windows in that form alone lead to the de facto standardisation of the Windows Media Player platform, which has beneficial effects on the market. Although, generally, standardisation may effectively present certain advantages, it cannot be allowed to be imposed unilaterally by an undertaking in a dominant position by means of tying.
The Court further notes that it cannot be ruled out that third parties will not want the de facto standardisation advocated by Microsoft but will prefer it if different platforms continue to compete, on the ground that that will stimulate innovation between the various platforms. (Microsoft Corp. v Commission, 2007)

Pointing to these conflicting effects of Microsoft’s bundling decision, without weighing either, is a weak basis to uphold the commission’s decision that consumer choice outweighs the benefits of standardization. Moreover, actions undertaken by other firms to enhance consumer choice at the expense of standardization are, on these terms, potentially just as problematic. The dividing line becomes solely which theory the commission prefers to pursue.

What such a practice does is vest the commission with immense discretionary power. Any given case sets up a “heads, I win; tails, you lose” situation in which defendants are easily outflanked by a commission that can change the rules of its analysis as it sees fit. Defendants can play only the cards that they are dealt. Accordingly, Microsoft could not successfully challenge a conclusion that its behavior harmed consumers’ choice by arguing that it improved consumer welfare, on net.

By selecting, in this instance, “consumer choice” as the standard to be judged, the commission was able to evade the constraints that might have been imposed by a more robust welfare standard. Thus, the commission can essentially pick and choose the objectives that best serve its interests in each case. This vastly enlarges the scope of potential antitrust liability, while also substantially decreasing the ability of firms to predict when their behavior may be viewed as problematic. It leads to what, in U.S. courts, would be regarded as an untenable risk of false positives that chill innovative behavior and create nearly unwinnable battles for targeted firms.

In Antitrust & Competition, Broadband, Cartels, Constitutional Law, Economic Theory, European Union, Exclusionary Conduct, Exclusive Dealing, Health Care, Intellectual Property, International, International Trade, Pharmaceuticals, Platforms, Price Discrimination, Resale Price Maintenance, Supreme Court, Telecommunications, Truth on the Market, Tying, Vertical Restraints abuse of dominance, antitrust, Antonin Scalia, cartels, competition, cost-benefit analysis, DGComp, essential facilities, European Commission, European Court of Justice, European Union, excessive pricing, Friedrich Hayek, Hayek, industrial policy, Leegin, microsoft, open access, pharmaceutical industry, political economy, predatory pricing, raising rivals’ costs, refusals to deal, RPM, SSRN, Trinko, tying, Unfairness, vertical restraints

Antitrust Statutorification

Nicolas Petit — 15 July 2021

[TOTM: The following is part of a symposium by TOTM guests and authors marking the release of Nicolas Petit’s “Big Tech and the Digital Economy: The Moligopoly Scenario.” The entire series of posts is available here.

This post is authored by Nicolas Petit himself, the Joint Chair in Competition Law at the Department of Law at European University Institute in Fiesole, Italy, and at EUI’s Robert Schuman Centre for Advanced Studies. He is also invited professor at the College of Europe in Bruges.]

A lot of water has gone under the bridge since my book was published last year. To close this symposium, I thought I would discuss the new phase of antirust statutorification taking place before our eyes. In the United States, Congress is working on five antitrust bills that propose to subject platforms to stringent obligations, including a ban on mergers and acquisitions, required data portability and interoperability, and line-of-business restrictions. In the European Union (EU), lawmakers are examining the proposed Digital Markets Act (“DMA”) that sets out a complicated regulatory system for digital “gatekeepers,” with per se behavioral limitations of their freedom over contractual terms, technological design, monetization, and ecosystem leadership.

Proponents of legislative reform on both sides of the Atlantic appear to share the common view that ongoing antitrust adjudication efforts are both instrumental and irrelevant. They are instrumental because government (or plaintiff) losses build the evidence needed to support the view that antitrust doctrine is exceedingly conservative, and that legal reform is needed. Two weeks ago, antitrust reform activists ran to Twitter to point out that the U.S. District Court dismissal of the Federal Trade Commission’s (FTC) complaint against Facebook was one more piece of evidence supporting the view that the antitrust pendulum needed to swing. They are instrumental because, again, government (or plaintiffs) wins will support scaling antitrust enforcement in the marginal case by adoption of governmental regulation. In the EU, antitrust cases follow each other almost like night the day, lending credence to the view that regulation will bring much needed coordination and economies of scale.

But both instrumentalities are, at the end of the line, irrelevant, because they lead to the same conclusion: legislative reform is long overdue. With this in mind, the logic of lawmakers is that they need not await the courts, and they can advance with haste and confidence toward the promulgation of new antitrust statutes.

The antitrust reform process that is unfolding is a cause for questioning. The issue is not legal reform in itself. There is no suggestion here that statutory reform is necessarily inferior, and no correlative reification of the judge-made-law method. Legislative intervention can occur for good reason, like when it breaks judicial inertia caused by ideological logjam.

The issue is rather one of precipitation. There is a lot of learning in the cases. The point, simply put, is that a supplementary court-legislative dialogue would yield additional information—or what Guido Calabresi has called “starting points” for regulation—that premature legislative intervention is sweeping under the rug. This issue is important because specification errors (see Doug Melamed’s symposium piece on this) in statutory legislation are not uncommon. Feedback from court cases create a factual record that will often be missing when lawmakers act too precipitously.

Moreover, a court-legislative iteration is useful when the issues in discussion are cross-cutting. The digital economy brings an abundance of them. As tech analysist Ben Evans has observed, data-sharing obligations raise tradeoffs between contestability and privacy. Chapter VI of my book shows that breakups of social networks or search engines might promote rivalry and, at the same time, increase the leverage of advertisers to extract more user data and conduct more targeted advertising. In such cases, Calabresi said, judges who know the legal topography are well-placed to elicit the preferences of society. He added that they are better placed than government agencies’ officials or delegated experts, who often attend to the immediate problem without the big picture in mind (all the more when officials are denied opportunities to engage with civil society and the press, as per the policy announced by the new FTC leadership).

Of course, there are three objections to this. The first consists of arguing that statutes are needed now because courts are too slow to deal with problems. The argument is not dissimilar to Frank Easterbrook’s concerns about irreversible harms to the economy, though with a tweak. Where Easterbook’s concern was one of ossification of Type I errors due to stare decisis, the concern here is one of entrenchment of durable monopoly power in the digital sector due to Type II errors. The concern, however, fails the test of evidence. The available data in both the United States and Europe shows unprecedented vitality in the digital sector. Venture capital funding cruises at historical heights, fueling new firm entry, business creation, and economic dynamism in the U.S. and EU digital sectors, topping all other industries. Unless we require higher levels of entry from digital markets than from other industries—or discount the social value of entry in the digital sector—this should give us reason to push pause on lawmaking efforts.

The second objection is that following an incremental process of updating the law through the courts creates intolerable uncertainty. But this objection, too, is unconvincing, at best. One may ask which of an abrupt legislative change of the law after decades of legal stability or of an experimental process of judicial renovation brings more uncertainty.

Besides, ad hoc statutes, such as the ones in discussion, are likely to pose quickly and dramatically the problem of their own legal obsolescence. Detailed and technical statutes specify rights, requirements, and procedures that often do not stand the test of time. For example, the DMA likely captures Windows as a core platform service subject to gatekeeping. But is the market power of Microsoft over Windows still relevant today, and isn’t it constrained in effect by existing antitrust rules? In antitrust, vagueness in critical statutory terms allows room for change.[1] The best way to give meaning to buzzwords like “smart” or “future-proof” regulation consists of building in first principles, not in creating discretionary opportunities for permanent adaptation of the law. In reality, it is hard to see how the methods of future-proof regulation currently discussed in the EU creates less uncertainty than a court process.

The third objection is that we do not need more information, because we now benefit from economic knowledge showing that existing antitrust laws are too permissive of anticompetitive business conduct. But is the economic literature actually supportive of stricter rules against defendants than the rule-of-reason framework that applies in many unilateral conduct cases and in merger law? The answer is surely no. The theoretical economic literature has travelled a lot in the past 50 years. Of particular interest are works on network externalities, switching costs, and multi-sided markets. But the progress achieved in the economic understanding of markets is more descriptive than normative.

Take the celebrated multi-sided market theory. The main contribution of the theory is its advice to decision-makers to take the periscope out, so as to consider all possible welfare tradeoffs, not to be more or less defendant friendly. Payment cards provide a good example. Economic research suggests that any antitrust or regulatory intervention on prices affect tradeoffs between, and payoffs to, cardholders and merchants, cardholders and cash users, cardholders and banks, and banks and card systems. Equally numerous tradeoffs arise in many sectors of the digital economy, like ridesharing, targeted advertisement, or social networks. Multi-sided market theory renders these tradeoffs visible. But it does not come with a clear recipe for how to solve them. For that, one needs to follow first principles. A system of measurement that is flexible and welfare-based helps, as Kelly Fayne observed in her critical symposium piece on the book.

Another example might be worth considering. The theory of increasing returns suggests that markets subject to network effects tend to converge around the selection of a single technology standard, and it is not a given that the selected technology is the best one. One policy implication is that social planners might be justified in keeping a second option on the table. As I discuss in Chapter V of my book, the theory may support an M&A ban against platforms in tipped markets, on the conjecture that the assets of fringe firms might be efficiently repositioned to offer product differentiation to consumers. But the theory of increasing returns does not say under what conditions we can know that the selected technology is suboptimal. Moreover, if the selected technology is the optimal one, or if the suboptimal technology quickly obsolesces, are policy efforts at all needed?

Last, as Bo Heiden’s thought provoking symposium piece argues, it is not a given that antitrust enforcement of rivalry in markets is the best way to maintain an alternative technology alive, let alone to supply the innovation needed to deliver economic prosperity. Government procurement, science and technology policy, and intellectual-property policy might be equally effective (note that the fathers of the theory, like Brian Arthur or Paul David, have been very silent on antitrust reform).

There are, of course, exceptions to the limited normative content of modern economic theory. In some areas, economic theory is more predictive of consumer harms, like in relation to algorithmic collusion, interlocking directorates, or “killer” acquisitions. But the applications are discrete and industry-specific. All are insufficient to declare that the antitrust apparatus is dated and that it requires a full overhaul. When modern economic research turns normative, it is often way more subtle in its implications than some wild policy claims derived from it. For example, the emerging studies that claim to identify broad patterns of rising market power in the economy in no way lead to an implication that there are no pro-competitive mergers.

Similarly, the empirical picture of digital markets is incomplete. The past few years have seen a proliferation of qualitative research reports on industry structure in the digital sectors. Most suggest that industry concentration has risen, particularly in the digital sector. As with any research exercise, these reports’ findings deserve to be subject to critical examination before they can be deemed supportive of a claim of “sufficient experience.” Moreover, there is no reason to subject these reports to a lower standard of accountability on grounds that they have often been drafted by experts upon demand from antitrust agencies. After all, we academics are ethically obliged to be at least equally exacting with policy-based research as we are with science-based research.

Now, with healthy skepticism at the back of one’s mind, one can see immediately that the findings of expert reports to date have tended to downplay behavioral observations that counterbalance findings of monopoly power—such as intense business anxiety, technological innovation, and demand-expansion investments in digital markets. This was, I believe, the main takeaway from Chapter IV of my book. And less than six months ago, The Economist ran its leading story on the new marketplace reality of “Tech’s Big Dust-Up.”

More importantly, the findings of the various expert reports never seriously contemplate the possibility of competition by differentiation in business models among the platforms. Take privacy, for example. As Peter Klein reasonably writes in his symposium article, we should not be quick to assume market failure. After all, we might have more choice than meets the eye, with Google free but ad-based, and Apple pricy but less-targeted. More generally, Richard Langlois makes a very convincing point that diversification is at the heart of competition between the large digital gatekeepers. We might just be too short-termist—here, digital communications technology might help create a false sense of urgency—to wait for the end state of the Big Tech moligopoly.

Similarly, the expert reports did not really question the real possibility of competition for the purchase of regulation. As in the classic George Stigler paper, where the railroad industry fought motor-trucking competition with state regulation, the businesses that stand to lose most from the digital transformation might be rationally jockeying to convince lawmakers that not all business models are equal, and to steer regulation toward specific business models. Again, though we do not know how to consider this issue, there are signs that a coalition of large news corporations and the publishing oligopoly are behind many antitrust initiatives against digital firms.

Now, as is now clear from these few lines, my cautionary note against antitrust statutorification might be more relevant to the U.S. market. In the EU, sunk investments have been made, expectations have been created, and regulation has now become inevitable. The United States, however, has a chance to get this right. Court cases are the way to go. And unlike what the popular coverage suggests, the recent District Court dismissal of the FTC case far from ruled out the applicability of U.S. antitrust laws to Facebook’s alleged killer acquisitions. On the contrary, the ruling actually contains an invitation to rework a rushed complaint. Perhaps, as Shane Greenstein observed in his retrospective analysis of the U.S. Microsoft case, we would all benefit if we studied more carefully the learning that lies in the cases, rather than haste to produce instant antitrust analysis on Twitter that fits within 280 characters.

[1] But some threshold conditions like agreement or dominance might also become dated.

The Virtues and Pitfalls of Economic Models

Dirk Auer — 22 June 2021

Interrogations concerning the role that economic theory should play in policy decisions are nothing new. Milton Friedman famously drew a distinction between “positive” and “normative” economics, notably arguing that theoretical models were valuable, despite their unrealistic assumptions. Kenneth Arrow and Gerard Debreu’s highly theoretical work on General Equilibrium Theory is widely acknowledged as one of the most important achievements of modern economics.

But for all their intellectual value and academic merit, the use of models to inform policy decisions is not uncontroversial. There is indeed a long and unfortunate history of influential economic models turning out to be poor depictions (and predictors) of real-world outcomes.

This raises a key question: should policymakers use economic models to inform their decisions and, if so, how? This post uses the economics of externalities to illustrate both the virtues and pitfalls of economic modeling. Throughout economic history, externalities have routinely been cited to support claims of market failure and calls for government intervention. However, as explained below, these fears have frequently failed to withstand empirical scrutiny.

Today, similar models are touted to support government intervention in digital industries. Externalities are notably said to prevent consumers from switching between platforms, allegedly leading to unassailable barriers to entry and deficient venture-capital investment. Unfortunately, as explained below, the models that underpin these fears are highly abstracted and far removed from underlying market realities.

Ultimately, this post argues that, while models provide a powerful way of thinking about the world, naïvely transposing them to real-world settings is misguided. This is not to say that models are useless—quite the contrary. Indeed, “falsified” models can shed powerful light on economic behavior that would otherwise prove hard to understand.

Bees

Fears surrounding economic externalities are as old as modern economics. For example, in the 1950s, economists routinely cited bee pollination as a source of externalities and, ultimately, market failure.

The basic argument was straightforward: Bees and orchards provide each other with positive externalities. Bees cross-pollinate flowers and orchards contain vast amounts of nectar upon which bees feed, thus improving honey yields. Accordingly, several famous economists argued that there was a market failure; bees fly where they please and farmers cannot prevent bees from feeding on their blossoming flowers—allegedly causing underinvestment in both. This led James Meade to conclude:

[T]he apple-farmer provides to the beekeeper some of his factors free of charge. The apple-farmer is paid less than the value of his marginal social net product, and the beekeeper receives more than the value of his marginal social net product.

A finding echoed by Francis Bator:

If, then, apple producers are unable to protect their equity in apple-nectar and markets do not impute to apple blossoms their correct shadow value, profit-maximizing decisions will fail correctly to allocate resources at the margin. There will be failure “by enforcement.” This is what I would call an ownership externality. It is essentially Meade’s “unpaid factor” case.

It took more than 20 years and painstaking research by Steven Cheung to conclusively debunk these assertions. So how did economic agents overcome this “insurmountable” market failure?

The answer, it turns out, was extremely simple. While bees do fly where they please, the relative placement of beehives and orchards has a tremendous impact on both fruit and honey yields. This is partly because bees have a very limited mean foraging range (roughly 2-3km). This left economic agents with ample scope to prevent free-riding.

Using these natural sources of excludability, they built a web of complex agreements that internalize the symbiotic virtues of beehives and fruit orchards. To cite Steven Cheung’s research:

Pollination contracts usually include stipulations regarding the number and strength of the colonies, the rental fee per hive, the time of delivery and removal of hives, the protection of bees from pesticide sprays, and the strategic placing of hives. Apiary lease contracts differ from pollination contracts in two essential aspects. One is, predictably, that the amount of apiary rent seldom depends on the number of colonies, since the farmer is interested only in obtaining the rent per apiary offered by the highest bidder. Second, the amount of apiary rent is not necessarily fixed. Paid mostly in honey, it may vary according to either the current honey yield or the honey yield of the preceding year.

But what of neighboring orchards? Wouldn’t these entail a more complex externality (i.e., could one orchard free-ride on agreements concluded between other orchards and neighboring apiaries)? Apparently not:

Acknowledging the complication, beekeepers and farmers are quick to point out that a social rule, or custom of the orchards, takes the place of explicit contracting: during the pollination period the owner of an orchard either keeps bees himself or hires as many hives per area as are employed in neighboring orchards of the same type. One failing to comply would be rated as a “bad neighbor,” it is said, and could expect a number of inconveniences imposed on him by other orchard owners. This customary matching of hive densities involves the exchange of gifts of the same kind, which apparently entails lower transaction costs than would be incurred under explicit contracting, where farmers would have to negotiate and make money payments to one another for the bee spillover.

In short, not only did the bee/orchard externality model fail, but it failed to account for extremely obvious counter-evidence. Even a rapid flip through the Yellow Pages (or, today, a search on Google) would have revealed a vibrant market for bee pollination. In short, the bee externalities, at least as presented in economic textbooks, were merely an economic “fable.” Unfortunately, they would not be the last.

The Lighthouse

Lighthouses provide another cautionary tale. Indeed, Henry Sidgwick, A.C. Pigou, John Stuart Mill, and Paul Samuelson all cited the externalities involved in the provision of lighthouse services as a source of market failure.

Here, too, the problem was allegedly straightforward. A lighthouse cannot prevent ships from free-riding on its services when they sail by it (i.e., it is mostly impossible to determine whether a ship has paid fees and to turn off the lighthouse if that is not the case). Hence there can be no efficient market for light dues (lighthouses were seen as a “public good”). As Paul Samuelson famously put it:

Take our earlier case of a lighthouse to warn against rocks. Its beam helps everyone in sight. A businessman could not build it for a profit, since he cannot claim a price from each user. This certainly is the kind of activity that governments would naturally undertake.

He added that:

[E]ven if the operators were able—say, by radar reconnaissance—to claim a toll from every nearby user, that fact would not necessarily make it socially optimal for this service to be provided like a private good at a market-determined individual price. Why not? Because it costs society zero extra cost to let one extra ship use the service; hence any ships discouraged from those waters by the requirement to pay a positive price will represent a social economic loss—even if the price charged to all is no more than enough to pay the long-run expenses of the lighthouse.

More than a century after it was first mentioned in economics textbooks, Ronald Coase finally laid the lighthouse myth to rest—rebutting Samuelson’s second claim in the process.

What piece of evidence had eluded economists for all those years? As Coase observed, contemporary economists had somehow overlooked the fact that large parts of the British lighthouse system were privately operated, and had been for centuries:

[T]he right to operate a lighthouse and to levy tolls was granted to individuals by Acts of Parliament. The tolls were collected at the ports by agents (who might act for several lighthouses), who might be private individuals but were commonly customs officials. The toll varied with the lighthouse and ships paid a toll, varying with the size of the vessel, for each lighthouse passed. It was normally a rate per ton (say 1/4d or 1/2d) for each voyage. Later, books were published setting out the lighthouses passed on different voyages and the charges that would be made.

In other words, lighthouses used a simple physical feature to create “excludability” and prevent free-riding. The main reason ships require lighthouses is to avoid hitting rocks when they make their way to a port. By tying port fees and light dues, lighthouse owners—aided by mild government-enforced property rights—could easily earn a return on their investments, thus disproving the lighthouse free-riding myth.

Ultimately, this meant that a large share of the British lighthouse system was privately operated throughout the 19th century, and this share would presumably have been more pronounced if government-run “Trinity House” lighthouses had not crowded out private investment:

The position in 1820 was that there were 24 lighthouses operated by Trinity House and 22 by private individuals or organizations. But many of the Trinity House lighthouses had not been built originally by them but had been acquired by purchase or as the result of the expiration of a lease.

Of course, this system was not perfect. Some ships (notably foreign ones that did not dock in the United Kingdom) might free-ride on this arrangement. It also entailed some level of market power. The ability to charge light dues meant that prices were higher than the “socially optimal” baseline of zero (the marginal cost of providing light is close to zero). Though it is worth noting that tying port fees and light dues might also have decreased double marginalization, to the benefit of sailors.

Samuelson was particularly weary of this market power that went hand in hand with the private provision of public goods, including lighthouses:

Being able to limit a public good’s consumption does not make it a true-blue private good. For what, after all, are the true marginal costs of having one extra family tune in on the program? They are literally zero. Why then prevent any family which would receive positive pleasure from tuning in on the program from doing so?

However, as Coase explained, light fees represented only a tiny fraction of a ship’s costs. In practice, they were thus unlikely to affect market output meaningfully:

[W]hat is the gain which Samuelson sees as coming from this change in the way in which the lighthouse service is financed? It is that some ships which are now discouraged from making a voyage to Britain because of the light dues would in future do so. As it happens, the form of the toll and the exemptions mean that for most ships the number of voyages will not be affected by the fact that light dues are paid. There may be some ships somewhere which are laid up or broken up because of the light dues, but the number cannot be great, if indeed there are any ships in this category.

Samuelson’s critique also falls prey to the Nirvana Fallacy pointed out by Harold Demsetz: markets might not be perfect, but neither is government intervention. Market power and imperfect appropriability are the two (paradoxical) pitfalls of the first; “white elephants,” underinvestment, and lack of competition (and the information it generates) tend to stem from the latter.

Which of these solutions is superior, in each case, is an empirical question that early economists had simply failed to consider—assuming instead that market failure was systematic in markets that present prima facie externalities. In other words, models were taken as gospel without any circumspection about their relevance to real-world settings.

The Tragedy of the Commons

Externalities were also said to undermine the efficient use of “common pool resources,” such grazing lands, common irrigation systems, and fisheries—resources where one agent’s use diminishes that of others, and where exclusion is either difficult or impossible.

The most famous formulation of this problem is Garret Hardin’s highly influential (over 47,000 cites) “tragedy of the commons.” Hardin cited the example of multiple herdsmen occupying the same grazing ground:

The rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another … But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit—in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons.

In more technical terms, each economic agent purportedly exerts an unpriced negative externality on the others, thus leading to the premature depletion of common pool resources. Hardin extended this reasoning to other problems, such as pollution and allegations of global overpopulation.

Although Hardin hardly documented any real-world occurrences of this so-called tragedy, his policy prescriptions were unequivocal:

The most important aspect of necessity that we must now recognize, is the necessity of abandoning the commons in breeding. No technical solution can rescue us from the misery of overpopulation. Freedom to breed will bring ruin to all.

As with many other theoretical externalities, empirical scrutiny revealed that these fears were greatly overblown. In her Nobel-winning work, Elinor Ostrom showed that economic agents often found ways to mitigate these potential externalities markedly. For example, mountain villages often implement rules and norms that limit the use of grazing grounds and wooded areas. Likewise, landowners across the world often set up “irrigation communities” that prevent agents from overusing water.

Along similar lines, Julian Morris and I conjecture that informal arrangements and reputational effects might mitigate opportunistic behavior in the standard essential patent industry.

These bottom-up solutions are certainly not perfect. Many common institutions fail—for example, Elinor Ostrom documents several problematic fisheries, groundwater basins and forests, although it is worth noting that government intervention was sometimes behind these failures. To cite but one example:

Several scholars have documented what occurred when the Government of Nepal passed the “Private Forest Nationalization Act” […]. Whereas the law was officially proclaimed to “protect, manage and conserve the forest for the benefit of the entire country”, it actually disrupted previously established communal control over the local forests. Messerschmidt (1986, p.458) reports what happened immediately after the law came into effect:
Nepalese villagers began freeriding — systematically overexploiting their forest resources on a large scale.

In any case, the question is not so much whether private institutions fail, but whether they do so more often than government intervention. be it regulation or property rights. In short, the “tragedy of the commons” is ultimately an empirical question: what works better in each case, government intervention, propertization, or emergent rules and norms?

More broadly, the key lesson is that it is wrong to blindly apply models while ignoring real-world outcomes. As Elinor Ostrom herself put it:

The intellectual trap in relying entirely on models to provide the foundation for policy analysis is that scholars then presume that they are omniscient observers able to comprehend the essentials of how complex, dynamic systems work by creating stylized descriptions of some aspects of those systems.

Dvorak Keyboards

In 1985, Paul David published an influential paper arguing that market failures undermined competition between the QWERTY and Dvorak keyboard layouts. This version of history then became a dominant narrative in the field of network economics, including works by Joseph Farrell & Garth Saloner, and Jean Tirole.

The basic claim was that QWERTY users’ reluctance to switch toward the putatively superior Dvorak layout exerted a negative externality on the rest of the ecosystem (and a positive externality on other QWERTY users), thus preventing the adoption of a more efficient standard. As Paul David put it:

Although the initial lead acquired by QWERTY through its association with the Remington was quantitatively very slender, when magnified by expectations it may well have been quite sufficient to guarantee that the industry eventually would lock in to a de facto QWERTY standard. […]
Competition in the absence of perfect futures markets drove the industry prematurely into standardization on the wrong system — where decentralized decision making subsequently has sufficed to hold it.

Unfortunately, many of the above papers paid little to no attention to actual market conditions in the typewriter and keyboard layout industries. Years later, Stan Liebowitz and Stephen Margolis undertook a detailed analysis of the keyboard layout market. They almost entirely rejected any notion that QWERTY prevailed despite it being the inferior standard:

Yet there are many aspects of the QWERTY-versus-Dvorak fable that do not survive scrutiny. First, the claim that Dvorak is a better keyboard is supported only by evidence that is both scant and suspect. Second, studies in the ergonomics literature find no significant advantage for Dvorak that can be deemed scientifically reliable. Third, the competition among producers of typewriters, out of which the standard emerged, was far more vigorous than is commonly reported. Fourth, there were far more typing contests than just the single Cincinnati contest. These contests provided ample opportunity to demonstrate the superiority of alternative keyboard arrangements. That QWERTY survived significant challenges early in the history of typewriting demonstrates that it is at least among the reasonably fit, even if not the fittest that can be imagined.

In short, there was little to no evidence supporting the view that QWERTY inefficiently prevailed because of network effects. The falsification of this narrative also weakens broader claims that network effects systematically lead to either excess momentum or excess inertia in standardization. Indeed, it is tempting to characterize all network industries with heavily skewed market shares as resulting from market failure. Yet the QWERTY/Dvorak story suggests that such a conclusion would be premature.

Killzones, Zoom, and TikTok

If you are still reading at this point, you might think that contemporary scholars would know better than to base calls for policy intervention on theoretical externalities. Alas, nothing could be further from the truth.

For instance, a recent paper by Sai Kamepalli, Raghuram Rajan and Luigi Zingales conjectures that the interplay between mergers and network externalities discourages the adoption of superior independent platforms:

If techies expect two platforms to merge, they will be reluctant to pay the switching costs and adopt the new platform early on, unless the new platform significantly outperforms the incumbent one. After all, they know that if the entering platform’s technology is a net improvement over the existing technology, it will be adopted by the incumbent after merger, with new features melded with old features so that the techies’ adjustment costs are minimized. Thus, the prospect of a merger will dissuade many techies from trying the new technology.

Although this key behavioral assumption drives the results of the theoretical model, the paper presents no evidence to support the contention that it occurs in real-world settings. Admittedly, the paper does present evidence of reduced venture capital investments after mergers involving large tech firms. But even on their own terms, this data simply does not support the authors’ behavioral assumption.

And this is no isolated example. Over the past couple of years, several scholars have called for more muscular antitrust intervention in networked industries. A common theme is that network externalities, switching costs, and data-related increasing returns to scale lead to inefficient consumer lock-in, thus raising barriers to entry for potential rivals (here, here, here).

But there are also countless counterexamples, where firms have easily overcome potential barriers to entry and network externalities, ultimately disrupting incumbents.

Zoom is one of the most salient instances. As I have written previously:

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.

Along similar lines, Geoffrey Manne and Alec Stapp have put forward a multitude of other examples. These include: The demise of Yahoo; the disruption of early instant-messaging applications and websites; MySpace’s rapid decline; etc. In all these cases, outcomes do not match the predictions of theoretical models.

More recently, TikTok’s rapid rise offers perhaps the greatest example of a potentially superior social-networking platform taking significant market share away from incumbents. According to the Financial Times, TikTok’s video-sharing capabilities and its powerful algorithm are the most likely explanations for its success.

While these developments certainly do not disprove network effects theory, they eviscerate the common belief in antitrust circles that superior rivals are unable to overthrow incumbents in digital markets. Of course, this will not always be the case. As in the previous examples, the question is ultimately one of comparing institutions—i.e., do markets lead to more or fewer error costs than government intervention? Yet this question is systematically omitted from most policy discussions.

In Conclusion

My argument is not that models are without value. To the contrary, framing problems in economic terms—and simplifying them in ways that make them cognizable—enables scholars and policymakers to better understand where market failures might arise, and how these problems can be anticipated and solved by private actors. In other words, models alone cannot tell us that markets will fail, but they can direct inquiries and help us to understand why firms behave the way they do, and why markets (including digital ones) are organized in a given way.

In that respect, both the theoretical and empirical research cited throughout this post offer valuable insights for today’s policymakers.

For a start, as Ronald Coase famously argued in what is perhaps his most famous work, externalities (and market failure more generally) are a function of transaction costs. When these are low (relative to the value of a good), market failures are unlikely. This is perhaps clearest in the “Fable of the Bees” example. Given bees’ short foraging range, there were ultimately few real-world obstacles to writing contracts that internalized the mutual benefits of bees and orchards.

Perhaps more importantly, economic research sheds light on behavior that might otherwise be seen as anticompetitive. The rules and norms that bind farming/beekeeping communities, as well as users of common pool resources, could easily be analyzed as a cartel by naïve antitrust authorities. Yet externality theory suggests they play a key role in preventing market failure.

Along similar lines, mergers and acquisitions (as well as vertical integration, more generally) can reduce opportunism and other externalities that might otherwise undermine collaboration between firms (here, here and here). And much of the same is true for certain types of unilateral behavior. Tying video games to consoles (and pricing the console below cost) can help entrants overcome network externalities that might otherwise shield incumbents. Likewise, Google tying its proprietary apps to the open source Android operating system arguably enabled it to earn a return on its investments, thus overcoming the externality problem that plagues open source software.

All of this raises a tantalizing prospect that deserves far more attention than it is currently given in policy circles: authorities around the world are seeking to regulate the tech space. Draft legislation has notably been tabled in the United States, European Union and the United Kingdom. These draft bills would all make it harder for large tech firms to implement various economic hierarchies, including mergers and certain contractual arrangements.

This is highly paradoxical. If digital markets are indeed plagued by network externalities and high transaction costs, as critics allege, then preventing firms from adopting complex hierarchies—which have traditionally been seen as a way to solve externalities—is just as likely to exacerbate problems. In other words, like the economists of old cited above, today’s policymakers appear to be focusing too heavily on simple models that predict market failure, and far too little on the mechanisms that firms have put in place to thrive within this complex environment.

The bigger picture is that far more circumspection is required when using theoretical models in real-world policy settings. Indeed, as Harold Demsetz famously put it, the purpose of normative economics is not so much to identify market failures, but to help policymakers determine which of several alternative institutions will deliver the best outcomes for consumers:

This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient. Users of the comparative institution approach attempt to assess which alternative real institutional arrangement seems best able to cope with the economic problem […].

The Supreme Court Misses the Big Consumer Welfare Picture in NCAA v. Alston

Alden Abbott — 21 June 2021

In its June 21 opinion in NCAA v. Alston, a unanimous U.S. Supreme Court affirmed the 9th U.S. Circuit Court of Appeals and thereby upheld a district court injunction finding unlawful certain National Collegiate Athletic Association (NCAA) rules limiting the education-related benefits schools may make available to student athletes. The decision will come as no surprise to antitrust lawyers who heard the oral argument; the NCAA was portrayed as a monopsony cartel whose rules undermined competition by restricting compensation paid to athletes.

Alas, however, Alston demonstrates that seemingly “good facts” (including an apparently Scrooge-like defendant) can make very bad law. While superficially appearing to be a relatively straightforward application of Sherman Act rule of reason principles, the decision fails to come to grips with the relationship of the restraints before it to the successful provision of the NCAA’s joint venture product – amateur intercollegiate sports. What’s worse, Associate Justice Brett Kavanaugh’s concurring opinion further muddies the court’s murky jurisprudential waters by signaling his view that the NCAA’s remaining compensation rules are anticompetitive and could be struck down in an appropriate case (“it is not clear how the NCAA can defend its remaining compensation rules”). Prospective plaintiffs may be expected to take the hint.

The Court’s Flawed Analysis

I previously commented on this then-pending case a few months ago:

In sum, the claim that antitrust may properly be applied to combat the alleged “exploitation” of college athletes by NCAA compensation regulations does not stand up to scrutiny. The NCAA’s rules that define the scope of amateurism may be imperfect, but there is no reason to think that empowering federal judges to second guess and reformulate NCAA athletic compensation rules would yield a more socially beneficial (let alone optimal) outcome. (Believing that the federal judiciary can optimally reengineer core NCAA amateurism rules is a prime example of the Nirvana fallacy at work.) Furthermore, a Supreme Court decision affirming the 9th Circuit could do broad mischief by undermining case law that has accorded joint venturers substantial latitude to design the core features of their collective enterprise without judicial second-guessing.

Unfortunately, my concerns about a Supreme Court affirmance of the 9^th Circuit were realized. Associate Justice Neil Gorsuch’s opinion for the court in Alston manifests a blinkered approach to the NCAA “monopsony” joint venture. To be sure, it cites and briefly discusses key Supreme Court joint venture holdings, including 2006’s Texaco v. Dagher. Nonetheless, it gives short shrift to the efficiency-based considerations that counsel presumptive deference to joint venture design rules that are key to the nature of a joint venture’s product.

As a legal matter, the court felt obliged to defer to key district court findings not contested by the NCAA—including that the NCAA enjoys “monopsony power” in the student athlete labor market, and that the NCAA’s restrictions in fact decrease student athlete compensation “below the competitive level.”

However, even conceding these points, the court could have, but did not, take note of and assess the role of the restrictions under review in helping engender the enormous consumer benefits the NCAA confers upon consumers of its collegiate sports product. There is good reason to view those restrictions as an effort by the NCAA to address a negative externality that could diminish the attractiveness of the NCAA’s product for ultimate consumers, a result that would in turn reduce inter-brand competition.

As the amicus brief by antitrust economists (“Antitrust Economists Brief”) pointed out:

[T]he NCAA’s consistent and growing popularity reflects a product—”amateur sports” played by students and identified with the academic tradition—that continues to generate enormous consumer interest. Moreover, it appears without dispute that the NCAA, while in control of the design of its own athletic products, has preserved their integrity as amateur sports, notwithstanding the commercial success of some of them, particularly Division I basketball and Football Subdivision football. . . . Over many years, the NCAA has continually adjusted its eligibility and participation rules to prevent colleges from pursuing their own interests—which certainly can involve “pay to play”—in ways that would conflict with the procompetitive aims of the collaboration. In this sense, the NCAA’s amateurism rules are a classic example of addressing negative externalities and free riding that often are inherent or arise in the collaboration context.

The use of contractual restrictions (vertical restraints) to counteract free riding and other negative externalities generated in manufacturer-distributor interactions are well-recognized by antitrust courts. Although the restraints at issue in NCAA (and many other joint venture situations) are horizontal in nature, not vertical, they may be just as important as other nonstandard contracts in aligning the incentives of member institutions to best satisfy ultimate consumers. Satisfying consumers, in turn, enhances inter-brand competition between the NCAA’s product and other rival forms of entertainment, including professional sports offerings.

Alan Meese made a similar point in a recent paper (discussing a possible analytical framework for the court’s then-imminent Alston analysis):

[U]nchecked bidding for the services of student athletes could result in a market failure and suboptimal product quality, proof that the restraint reduces student athlete compensation below what an unbridled market would produce should not itself establish a prima facie case. Such evidence would instead be equally consistent with a conclusion that the restraint eliminates this market failure and restores compensation to optimal levels.

The court’s failure to address the externality justification was compounded by its handling of the rule of reason. First, in rejecting a truncated rule of reason with an initial presumption that the NCAA’s restraints involving student compensation are procompetitive, the court accepted that the NCAA’s monopsony power showed that its restraints “can (and in fact do) harm competition.” This assertion ignored the efficiency justification discussed above. As the Antitrust Economists’ Brief emphasized:

[A]cting more like regulators, the lower courts treated the NCAA’s basic product design as inherently anticompetitive [so did the Supreme Court], pushing forward with a full rule of reason that sent the parties into a morass of inquiries that were not (and were never intended to be) structured to scrutinize basic product design decisions and their hypothetical alternatives. Because that inquiry was unrestrained and untethered to any input or output restraint, the application of the rule of reason in this case necessarily devolved into a quasi-regulatory inquiry, which antitrust law eschews.

Having decided that a “full” rule of reason analysis is appropriate, the Supreme Court, in effect, imposed a “least restrictive means” test on the restrictions under review, while purporting not to do so. (“We agree with the NCAA’s premise that antitrust law does not require businesses to use anything like the least restrictive means of achieving legitimate business purposes.”) The court concluded that “it was only after finding the NCAA’s restraints ‘patently and inexplicably stricter than is necessary’ to achieve the procompetitive benefits the league had demonstrated that the district court proceeded to declare a violation of the Sherman Act.” Effectively, however, this statement deferred to the lower court’s second-guessing of the means employed by the NCAA to preserve consumer demand, which the lower court did without any empirical basis.

The Supreme Court also approved the district court’s rejection of the NCAA’s view of what amateurism requires. It stressed the district court’s findings that “the NCAA’s rules and restrictions on compensation have shifted markedly over time” (seemingly a reasonable reaction to changes in market conditions) and that the NCAA developed the restrictions at issue without any reference to “considerations of consumer demand” (a de facto regulatory mandate directed at the NCAA). The Supreme Court inexplicably dubbed these lower court actions “a straightforward application of the rule of reason.” These actions seem more like blind deference to rather arbitrary judicial second-guessing of the expert party with the greatest interest in satisfying consumer demand.

The Supreme Court ended its misbegotten commentary on “less restrictive alternatives” by first claiming that it agreed that “antitrust courts must give wide berth to business judgments before finding liability.” The court asserted that the district court honored this and other principles of judicial humility because it enjoined restraints on education-related benefits “only after finding that relaxing these restrictions would not blur the distinction between college and professional sports and thus impair demand – and only finding that this course represented a significantly (not marginally) less restrictive means of achieving the same procompetitive benefits as the NCAA’s current rules.” This lower court finding once again was not based on an empirical analysis of procompetitive benefits under different sets of rules. It was little more than the personal opinion of a judge, who lacked the NCAA’s knowledge of relevant markets and expertise. That the Supreme Court accepted it as an exercise in restrained judicial analysis is well nigh inexplicable.

The Antitrust Economists’ Brief, unlike the Supreme Court, enunciated the correct approach to judicial rewriting of core NCAA joint venture rules:

The institutions that are members of the NCAA want to offer a particular type of athletic product—an amateur athletic product that they believe is consonant with their primary academic missions. By doing so, as th[e] [Supreme] Court has [previously] recognized [in its 1984 NCAA v. Board of Regents decision], they create a differentiated offering that widens consumer choice and enhances opportunities for student-athletes. NCAA, 468 U.S. at 102. These same institutions have drawn lines that they believe balance their desire to foster intercollegiate athletic competition with their overarching academic missions. Both the district court and the Ninth Circuit have now said that they may not do so, unless they draw those lines differently. Yet neither the district court nor the Ninth Circuit determined that the lines drawn reduce the output of intercollegiate athletics or ascertained whether their judicially-created lines would expand that output. That is not the function of antitrust courts, but of legislatures.

Other Harms the Court Failed to Consider

Finally, the court failed to consider other harms that stem from a presumptive suspicion of NCAA restrictions on athletic compensation in general. The elimination of compensation rules should favor large well-funded athletic programs over others, potentially undermining “competitive balance” among schools. (Think of an NCAA March Madness tournament where “Cinderella stories” are eliminated, as virtually all the talented players have been snapped up by big name schools.) It could also, through the reallocation of income to “big name big sports” athletes who command a bidding premium, potentially reduce funding support for “minor college sports” that provide opportunities to a wide variety of student-athletes. This would disadvantage those athletes, undermine the future of “minor” sports, and quite possibly contribute to consumer disillusionment and unhappiness (think of the millions of parents of “minor sports” athletes).

What’s more, the existing rules allow many promising but non-superstar athletes to develop their skills over time, enhancing their ability to eventually compete at the professional level. (This may even be the case for some superstars, who may obtain greater long-term financial rewards by refining their talents and showcasing their skills for a year or two in college.) In addition, the current rules climate allows many student athletes who do not turn professional to develop personal connections that serve them well in their professional and personal lives, including connections derived from the “brand” of their university. (Think of wealthy and well-connected alumni who are ardent fans of their colleges’ athletic programs.) In a world without NCAA amateurism rules, the value of these experiences and connections could wither, to the detriment of athletes and consumers alike. (Consistent with my conclusion, economists Richard McKenzie and Dwight Lee have argued against the proposition that “college athletes are materially ‘underpaid’ and are ‘exploited’”.)

This “parade of horribles” might appear unlikely in the short term. Nevertheless, in the course of time, the inability of the NCAA to control the attributes of its product, due to a changed legal climate, make it all too real. This is especially the case in light of Justice Kavanaugh’s strong warning that other NCAA compensation restrictions are likely indefensible. (As he bluntly put it, venerable college sports “traditions alone cannot justify the NCAA’s decision to build a massive money-raising enterprise on the backs of student athletes who are not fairly compensated. . . . The NCAA is not above the law.”)

Conclusion

The Supreme Court’s misguided Alston decision fails to weigh the powerful efficiency justifications for the NCAA’s amateurism rules. This holding virtually invites other lower courts to ignore efficiencies and to second guess decisions that go to the heart of the NCAA’s joint venture product offering. The end result is likely to reduce consumer welfare and, quite possibly, the welfare of many student athletes as well. One would hope that Congress, if it chooses to address NCAA rules, will keep these dangers well in mind. A statutory change not directed solely at the NCAA, creating a rebuttable presumption of legality for restraints that go to the heart of a lawful joint venture, may merit serious consideration.

Breaking Down House Democrats’ Forthcoming Competition Bills

Sam Bowman — 10 June 2021

Democratic leadership of the House Judiciary Committee have leaked the approach they plan to take to revise U.S. antitrust law and enforcement, with a particular focus on digital platforms.

Broadly speaking, the bills would: raise fees for larger mergers and increase appropriations to the FTC and DOJ; require data portability and interoperability; declare that large platforms can’t own businesses that compete with other businesses that use the platform; effectively ban large platforms from making any acquisitions; and generally declare that large platforms cannot preference their own products or services.

All of these are ideas that have been discussed before. They are very much in line with the EU’s approach to competition, which places more regulation-like burdens on big businesses, and which is introducing a Digital Markets Act that mirrors the Democrats’ proposals. Some Republicans are reportedly supportive of the proposals, which is surprising since they mean giving broad, discretionary powers to antitrust authorities that are controlled by Democrats who take an expansive view of antitrust enforcement as a way to achieve their other social and political goals. The proposals may also be unpopular with consumers if, for example, they would mean that popular features like integrating Maps into relevant Google Search results becomes prohibited.

The multi-bill approach here suggests that the committee is trying to throw as much at the wall as possible to see what sticks. It may reflect a lack of confidence among the proposers in their ability to get their proposals through wholesale, especially given that Amy Klobuchar’s CALERA bill in the Senate creates an alternative that, while still highly interventionist, does not create ex ante regulation of the Internet the same way these proposals do.

In general, the bills are misguided for three main reasons.

One, they seek to make digital platforms into narrow conduits for other firms to operate on, ignoring the value created by platforms curating their own services by, for example, creating quality controls on entry (as Apple does on its App Store) or by integrating their services with related products (like, say, Google adding events from Gmail to users’ Google Calendars).

Two, they ignore the procompetitive effects of digital platforms extending into each other’s markets and competing with each other there, in ways that often lead to far more intense competition—and better outcomes for consumers—than if the only firms that could compete with the incumbent platform were small startups.

Three, they ignore the importance of incentives for innovation. Platforms invest in new and better products when they can make money from doing so, and limiting their ability to do that means weakened incentives to innovate. Startups and their founders and investors are driven, in part, by the prospect of being acquired, often by the platforms themselves. Making those acquisitions more difficult, or even impossible, means removing one of the key ways startup founders can exit their firms, and hence one of the key rewards and incentives for starting an innovative new business.

For more, our “Joint Submission of Antitrust Economists, Legal Scholars, and Practitioners” set out why many of the House Democrats’ assumptions about the state of the economy and antitrust enforcement were mistaken. And my post, “Buck’s “Third Way”: A Different Road to the Same Destination”, argued that House Republicans like Ken Buck were misguided in believing they could support some of the proposals and avoid the massive regulatory oversight that they said they rejected.

Platform Anti-Monopoly Act

The flagship bill, introduced by Antitrust Subcommittee Chairman David Cicilline (D-R.I.), establishes a definition of “covered platform” used by several of the other bills. The measures would apply to platforms with at least 500,000 U.S.-based users, a market capitalization of more than $600 billion, and that is deemed a “critical trading partner” with the ability to restrict or impede the access that a “dependent business” has to its users or customers.

Cicilline’s bill would bar these covered platforms from being able to promote their own products and services over the products and services of competitors who use the platform. It also defines a number of other practices that would be regarded as discriminatory, including:

Restricting or impeding “dependent businesses” from being able to access the platform or its software on the same terms as the platform’s own lines of business;
Conditioning access or status on purchasing other products or services from the platform;
Using user data to support the platform’s own products in ways not extended to competitors;
Restricting the platform’s commercial users from using or accessing data generated on the platform from their own customers;
Restricting platform users from uninstalling software pre-installed on the platform;
Restricting platform users from providing links to facilitate business off of the platform;
Preferencing the platform’s own products or services in search results or rankings;
Interfering with how a dependent business prices its products;
Impeding a dependent business’ users from connecting to services or products that compete with those offered by the platform; and
Retaliating against users who raise concerns with law enforcement about potential violations of the act.

On a basic level, these would prohibit lots of behavior that is benign and that can improve the quality of digital services for users. Apple pre-installing a Weather app on the iPhone would, for example, run afoul of these rules, and the rules as proposed could prohibit iPhones from coming with pre-installed apps at all. Instead, users would have to manually download each app themselves, if indeed Apple was allowed to include the App Store itself pre-installed on the iPhone, given that this competes with other would-be app stores.

Apart from the obvious reduction in the quality of services and convenience for users that this would involve, this kind of conduct (known as “self-preferencing”) is usually procompetitive. For example, self-preferencing allows platforms to compete with one another by using their strength in one market to enter a different one; Google’s Shopping results in the Search page increase the competition that Amazon faces, because it presents consumers with a convenient alternative when they’re shopping online for products. Similarly, Amazon’s purchase of the video-game streaming service Twitch, and the self-preferencing it does to encourage Amazon customers to use Twitch and support content creators on that platform, strengthens the competition that rivals like YouTube face.

It also helps innovation, because it gives firms a reason to invest in services that would otherwise be unprofitable for them. Google invests in Android, and gives much of it away for free, because it can bundle Google Search into the OS, and make money from that. If Google could not self-preference Google Search on Android, the open source business model simply wouldn’t work—it wouldn’t be able to make money from Android, and would have to charge for it in other ways that may be less profitable and hence give it less reason to invest in the operating system.

This behavior can also increase innovation by the competitors of these companies, both by prompting them to improve their products (as, for example, Google Android did with Microsoft’s mobile operating system offerings) and by growing the size of the customer base for products of this kind. For example, video games published by console manufacturers (like Nintendo’s Zelda and Mario games) are often blockbusters that grow the overall size of the user base for the consoles, increasing demand for third-party titles as well.

For more, check out “Against the Vertical Discrimination Presumption” by Geoffrey Manne and Dirk Auer’s piece “On the Origin of Platforms: An Evolutionary Perspective”.

Ending Platform Monopolies Act

Sponsored by Rep. Pramila Jayapal (D-Wash.), this bill would make it illegal for covered platforms to control lines of business that pose “irreconcilable conflicts of interest,” enforced through civil litigation powers granted to the Federal Trade Commission (FTC) and the U.S. Justice Department (DOJ).

Specifically, the bill targets lines of business that create “a substantial incentive” for the platform to advantage its own products or services over those of competitors that use the platform, or to exclude or disadvantage competing businesses from using the platform. The FTC and DOJ could potentially order that platforms divest lines of business that violate the act.

This targets similar conduct as the previous bill, but involves the forced separation of different lines of business. It also appears to go even further, seemingly implying that companies like Google could not even develop services like Google Maps or Chrome because their existence would create such “substantial incentives” to self-preference them over the products of their competitors.

Apart from the straightforward loss of innovation and product developments this would involve, requiring every tech company to be narrowly focused on a single line of business would substantially entrench Big Tech incumbents, because it would make it impossible for them to extend into adjacent markets to compete with one another. For example, Apple could not develop a search engine to compete with Google under these rules, and Amazon would be forced to sell its video-streaming services that compete with Netflix and Youtube.

For more, check out Geoffrey Manne’s written testimony to the House Antitrust Subcommittee and “Platform Self-Preferencing Can Be Good for Consumers and Even Competitors” by Geoffrey and me.

Platform Competition and Opportunity Act

Introduced by Rep. Hakeem Jeffries (D-N.Y.), this bill would bar covered platforms from making essentially any acquisitions at all. To be excluded from the ban on acquisitions, the platform would have to present “clear and convincing evidence” that the acquired business does not compete with the platform for any product or service, does not pose a potential competitive threat to the platform, and would not in any way enhance or help maintain the acquiring platform’s market position.

The two main ways that founders and investors can make a return on a successful startup are to float the company at IPO or to be acquired by another business. The latter of these, acquisitions, is extremely important. Between 2008 and 2019, 90 percent of U.S. start-up exits happened through acquisition. In a recent survey, half of current startup executives said they aimed to be acquired. One study found that countries that made it easier for firms to be taken over saw a 40-50 percent increase in VC activity, and that U.S. states that made acquisitions harder saw a 27 percent decrease in VC investment deals.

So this proposal would probably reduce investment in U.S. startups, since it makes it more difficult for them to be acquired. It would therefore reduce innovation as a result. It would also reduce inter-platform competition by banning deals that allow firms to move into new markets, like the acquisition of Beats that helped Apple to build a Spotify competitor, or the deals that helped Google, Microsoft, and Amazon build cloud-computing services that all compete with each other. It could also reduce competition faced by old industries, by preventing tech companies from buying firms that enable it to move into new markets—like Amazon’s acquisitions of health-care companies that it has used to build a health-care offering. Even Walmart’s acquisition of Jet.com, which it has used to build an Amazon competitor, could have been banned under this law if Walmart had had a higher market cap at the time.

For more, check out Dirk Auer’s piece “Facebook and the Pros and Cons of Ex Post Merger Reviews” and my piece “Cracking down on mergers would leave us all worse off”.

ACCESS Act

The Augmenting Compatibility and Competition by Enabling Service Switching (ACCESS) Act, sponsored by Rep. Mary Gay Scanlon (D-Pa.), would establish data portability and interoperability requirements for platforms.

Under terms of the legislation, covered platforms would be required to allow third parties to transfer data to their users or, with the user’s consent, to a competing business. It also would require platforms to facilitate compatible and interoperable communications with competing businesses. The law directs the FTC to establish technical committees to promulgate the standards for portability and interoperability.

Data portability and interoperability involve trade-offs in terms of security and usability, and overseeing them can be extremely costly and difficult. In security terms, interoperability requirements prevent companies from using closed systems to protect users from hostile third parties. Mandatory openness means increasing—sometimes, substantially so—the risk of data breaches and leaks. In practice, that could mean users’ private messages or photos being leaked more frequently, or activity on a social media page that a user considers to be “their” private data, but that “belongs” to another user under the terms of use, can be exported and publicized as such.

It can also make digital services more buggy and unreliable, by requiring that they are built in a more “open” way that may be more prone to unanticipated software mismatches. A good example is that of Windows vs iOS; Windows is far more interoperable with third-party software than iOS is, but tends to be less stable as a result, and users often prefer the closed, stable system.

Interoperability requirements also entail ongoing regulatory oversight, to make sure data is being provided to third parties reliably. It’s difficult to build an app around another company’s data without assurance that the data will be available when users want it. For a requirement as broad as this bill’s, that could mean setting up quite a large new de facto regulator.

In the UK, Open Banking (an interoperability requirement imposed on British retail banks) has suffered from significant service outages, and targets a level of uptime that many developers complain is too low for them to build products around. Nor has Open Banking yet led to any obvious competition benefits.

For more, check out Gus Hurwitz’s piece “Portable Social Media Aren’t Like Portable Phone Numbers” and my piece “Why Data Interoperability Is Harder Than It Looks: The Open Banking Experience”.

Merger Filing Fee Modernization Act

A bill that mirrors language in the Endless Frontier Act recently passed by the U.S. Senate, would significantly raise filing fees for the largest mergers. Rather than the current cap of $280,000 for mergers valued at more than $500 million, the bill—sponsored by Rep. Joe Neguse (D-Colo.)–the new schedule would assess fees of $2.25 million for mergers valued at more than $5 billion; $800,000 for those valued at between $2 billion and $5 billion; and $400,000 for those between $1 billion and $2 billion.

Smaller mergers would actually see their filing fees cut: from $280,000 to $250,000 for those between $500 million and $1 billion; from $125,000 to $100,000 for those between $161.5 million and $500 million; and from $45,000 to $30,000 for those less than $161.5 million.

In addition, the bill would appropriate $418 million to the FTC and $252 million to the DOJ’s Antitrust Division for Fiscal Year 2022. Most people in the antitrust world are generally supportive of more funding for the FTC and DOJ, although whether this is actually good or not depends both on how it’s spent at those places.

It’s hard to object if it goes towards deepening the agencies’ capacities and knowledge, by hiring and retaining higher quality staff with salaries that are more competitive with those offered by the private sector, and on greater efforts to study the effects of the antitrust laws and past cases on the economy. If it goes toward broadening the activities of the agencies, by doing more and enabling them to pursue a more aggressive enforcement agenda, and supporting whatever of the above proposals make it into law, then it could be very harmful.

For more, check out my post “Buck’s “Third Way”: A Different Road to the Same Destination” and Thom Lambert’s post “Bad Blood at the FTC”.

In Administrative Law, Amazon, Antitrust & Competition, Antitrust Division, Apple, Banking, Data Privacy & Security, European Union, Exclusive Dealing, Facebook, Federal Trade Commission, Financial Regulation, Google, International, Justice Department, Law & Economics, Merger Guidelines, Mergers & Acquisitions, Monopolization, Platforms, Regulation, Truth on the Market, Tying, United Kingdom, Vertical Restraints Advertising, anticompetitive foreclosure, anticompetitive market distortions, anticompetitive petitioning, antitrust, antitrust and platforms, antitrust penalties, antitrust populism, CALERA, competition, Congress, consumer protection, contracts, cost-benefit analysis, data security, Digital Markets Act, DOJ Antitrust Division, entrepreneurship, European Union, ftc, international competition, internet, law enforcement, Monopoly, platforms, privacy, self-preferncing, SSRN, startups

Against the Jones Act

Colin Grabow & Thomas Grennes — 7 June 2021

Economist Josh Hendrickson asserts that the Jones Act is properly understood as a Coasean bargain. In this view, the law serves as a subsidy to the U.S. maritime industry through its restriction of waterborne domestic commerce to vessels that are constructed in U.S. shipyards, U.S.-flagged, and U.S.-crewed. Such protectionism, it is argued, provides the government with ready access to these assets, rather than taking precious time to build them up during times of conflict.

We are skeptical of this characterization.

Although there is an implicit bargain behind the Jones Act, its relationship to the work of Ronald Coase is unclear. Coase is best known for his theorem on the use of bargains and exchanges to reduce negative externalities. But the negative externality is that the Jones Act attempts to address is not apparent. While it may be more efficient or effective than the government building up its own shipbuilding, vessels, and crew in times of war, that’s rather different than addressing an externality. The Jones Act may reflect an implied exchange between the domestic maritime industry and government, but there does not appear to be anything particularly Coasean about it.

Rather, close scrutiny reveals this arrangement between government and industry to be a textbook example of policy failure and rent-seeking run amok. The Jones Act is not a bargain, but a rip-off, with costs and benefits completely out of balance.

The Jones Act and National Defense

For all of the talk of the Jones Act’s critical role in national security, its contributions underwhelm. Ships offer a case in point. In times of conflict, the U.S. military’s primary sources of transport are not Jones Act vessels but government-owned ships in the Military Sealift Command and Ready Reserve Force fleets. These are further supplemented by the 60 non-Jones Act U.S.-flag commercial ships enrolled in the Maritime Security Program, a subsidy arrangement by which ships are provided $5 million per year in exchange for the government’s right to use them in time of need.

In contrast, Jones Act ships are used only sparingly. That’s understandable, as removing these vessels from domestic trade would leave a void in the country’s transportation needs not easily filled.

The law’s contributions to domestic shipbuilding are similarly meager. if not outright counterproductive. A mere two to three large, oceangoing commercial ships are delivered by U.S. shipyards per year. That’s not per shipyard, but all U.S. shipyards combined.

Given the vastly uncompetitive state of domestic shipbuilding—a predictable consequence of handing the industry a captive domestic market via the Jones Act’s U.S.-built requirement—there is a little appetite for what these shipyards produce. As Hendrickson himself points out, the domestic build provision serves to “discourage shipbuilders from innovating and otherwise pursuing cost-saving production methods since American shipbuilders do not face international competition.” We could not agree more.

What keeps U.S. shipyards active and available to meet the military’s needs is not work for the Jones Act commercial fleet but rather government orders. A 2015 Maritime Administration report found that such business accounts for 70 percent of revenue for the shipbuilding and repair industry. A 2019 American Enterprise Institute study concluded that, among U.S. shipbuilders that construct both commercial and military ships, Jones Act vessels accounted for less than 5 percent of all shipbuilding orders.

If the Jones Act makes any contributions of note at all, it is mariners. Of those needed to crew surge sealift ships during times of war, the Jones Act fleet is estimated to account for 29 percent. But here the Jones Act also acts as a double-edged sword. By increasing the cost of ships to four to five times the world price, the law’s U.S.-built requirement results in a smaller fleet with fewer mariners employed than would otherwise be the case. That’s particularly noteworthy given government calculations that there is a deficit of roughly 1,800 mariners to crew its fleet in the event of a sustained sealift operation.

Beyond its ruinous impact on the competitiveness of domestic shipbuilding, the Jones Act has had other deleterious consequences for national security. The increased cost of waterborne transport, or its outright impossibility in the case of liquefied natural gas and propane, results in reduced self-reliance for critical energy supplies. This is a sufficiently significant issue that members of the National Security Council unsuccessfully sought a long-term Jones Act waiver in 2019. The law also means fewer redundancies and less flexibility in the country’s transportation system when responding to crises, both natural and manmade. Waivers of the Jones Act can be issued, but this highly politicized process eats up precious days when time is of the essence. All of these factors merit consideration in the overall national security calculus.

To review, the Jones Act’s opaque and implicit subsidy—doled out via protectionism—results in anemic and uncompetitive shipbuilding, few ships available in time of war, and fewer mariners than would otherwise be the case without its U.S.-built requirement. And it has other consequences for national security that are not only underwhelming but plainly negative. Little wonder that Hendrickson concedes it is unclear whether U.S. maritime policy—of which the Jones Act plays a foundational role—achieves its national security goals.

The toll exacted in exchange for the Jones Act’s limited benefits, meanwhile, is considerable. According to a 2019 OECD study, the law’s repeal would increase domestic value added by $19-$64 billion. Incredibly, that estimate may actually understate matters. Not included in this estimate are related costs such as environmental degradation, increased congestion and highway maintenance, and retaliation from U.S. trade partners during free-trade agreement negotiations due to U.S. unwillingness to liberalize the Jones Act.

Against such critiques, Hendrickson posits that substantial cost savings are illusory due to immigration and other U.S. laws. But how big a barrier such laws would pose is unclear. It’s worth considering, for example, that cruise ships with foreign crews are able to visit multiple U.S. ports so long as a foreign port is also included on the voyage. The granting of Jones Act waivers, meanwhile, has enabled foreign ships to transport cargo between U.S. ports in the past despite U.S. immigration laws.

Would Chinese-flagged and crewed barges be able to engage in purely domestic trade on the Mississippi River absent the Jones Act? Almost certainly not. But it seems perfectly plausible that foreign ships already sailing between U.S. ports as part of international voyages—a frequent occurrence—could engage in cabotage movements without hiring U.S. crews. Take, for example, APL’s Eagle Express X route that stops in Los Angeles, Honolulu, and Dutch Harbor as well as Asian ports. Without the Jones Act, it’s reasonable to believe that ships operating on this route could transport goods from Los Angeles to Honolulu before continuing on to foreign destinations.

But if the Jones Act fails to meet U.S. national security benefits while imposing substantial costs, how to explain its continued survival? Hendrickson avers that the law’s longevity reflects its utility. We believe, however, that the answer lies in the application of public choice theory. Simply put, the law’s costs are both opaque and dispersed across the vast expanse of the U.S. economy while its benefits are highly concentrated. The law’s de facto subsidy is also vastly oversupplied, given that the vast majority of vessels under its protection are smaller craft such as tugboats and barges with trivial value to the country’s sealift capability. This has spawned a lobby aggressively dedicated to the Jones Act’s preservation. Washington, D.C. is home to numerous industry groups and labor organizations that regard the law’s maintenance as critical, but not a single one that views its repeal as a top priority.

It’s instructive in this regard that all four senators from Alaska and Hawaii are strong Jones Act supporters despite their states being disproportionately burdened by the law. This seeming oddity is explained by these states also being disproportionately home to maritime interest groups that support the law. In contrast, Jones Act critics Sen. Mike Lee and the late Sen. John McCain both hailed from land-locked states home to few maritime interest groups.

Disagreements, but also Common Ground

For all of our differences with Hendrickson, however, there is substantial common ground. We are in shared agreement that the Jones Act is suboptimal policy, that its ability to achieve its goals is unclear, and that its U.S.-built requirement is particularly ripe for removal. Where our differences lie is mostly in the scale of gains to be realized from the law’s reform or repeal. As such, there is no reason to maintain the failed status quo. The Jones Act should be repealed and replaced with targeted, transparent, and explicit subsidies to meet the country’s sealift needs. Both the country’s economy and national security would be rewarded—richly so, in our opinion—from such policy change.

European Commission Objection to App Store Rules Lack Empirical Support

Paula Pernas Castrillo — 27 May 2021

The European Commission recently issued a formal Statement of Objections (SO) in which it charges Apple with antitrust breach. In a nutshell, the commission argues that Apple prevents app developers—in this case, Spotify—from using alternative in-app purchase systems (IAPs) other than Apple’s own, or steering them towards other, cheaper payment methods on another site. This, the commission says, results in higher prices for consumers in the audio streaming and ebook/audiobook markets.

More broadly, the commission claims that Apple’s App Store rules may distort competition in markets where Apple competes with rival developers (such as how Apple Music competes with Spotify). This explains why the anticompetitive concerns raised by Spotify regarding the Apple App Store rules have now expanded to Apple’s e-books, audiobooks and mobile payments platforms.

However, underlying market realities cast doubt on the commission’s assessment. Indeed, competition from Google Play and other distribution mediums makes it difficult to state unequivocally that the relevant market should be limited to Apple products. Likewise, the conduct under investigation arguably solves several problems relating to platform dynamics, and consumers’ privacy and security.

Should the relevant market be narrowed to iOS?

An important first question is whether there is a distinct, antitrust-relevant market for “music streaming apps distributed through the Apple App Store,” as the EC posits.

This market definition is surprising, given that it is considerably narrower than the one suggested by even the most enforcement-minded scholars. For instance, Damien Geradin and Dimitrias Katsifis—lawyers for app developers opposed to Apple—define the market as “that of app distribution on iOS devices, a two-sided transaction market on which Apple has a de facto monopoly.” Similarly, a report by the Dutch competition authority declared that the relevant market was limited to the iOS App Store, due to the lack of interoperability with other systems.

The commission’s decisional practice has been anything but constant in this space. In the Apple/Shazam and Apple/Beats cases, it did not place competing mobile operating systems and app stores in separate relevant markets. Conversely, in the Google Android decision, the commission found that the Android OS and Apple’s iOS, including Google Play and Apple’s App Store, did not compete in the same relevant market. The Spotify SO seems to advocate for this definition, narrowing it even further to music streaming services.

However, this narrow definition raises several questions. Market definition is ultimately about identifying the competitive constraints that the firm under investigation faces. As Gregory Werden puts it: “the relevant market in an antitrust case […] identifies the competitive process alleged to be harmed.”

In that regard, there is clearly some competition between Apple’s App Store, Google Play and other app stores (whether this is sufficient to place them in the same relevant market is an empirical question).

This view is supported by the vast number of online posts comparing Android and Apple and advising consumers on their purchasing options. Moreover, the growth of high-end Android devices that compete more directly with the iPhone has reinforced competition between the two firms. Likewise, Apple has moved down the value chain; the iPhone SE, priced at $399, competes with other medium-range Android devices.

App developers have also suggested they view Apple and Android as alternatives. They take into account technical differences to decide between the two, meaning that these two platforms compete with each other for developers.

All of this suggests that the App Store may be part of a wider market for the distribution of apps and services, where Google Play and other app stores are included—though this is ultimately an empirical question (i.e., it depends on the degree of competition between both platforms)

If the market were defined this way, Apple would not even be close to holding a dominant position—a prerequisite for European competition intervention. Indeed, Apple only sold 27.43% of smartphones in March 2021. Similarly, only 30.41% of smartphones in use run iOS, as of March 2021. This is well below the lowest market share in a European abuse of dominance—39.7% in the British Airways decision.

The sense that Apple and Android compete for users and developers is reinforced by recent price movements. Apple dropped its App Store commission fees from 30% to 15% in November 2020 and Google followed suit in March 2021. This conduct is consistent with at least some degree of competition between the platforms. It is worth noting that other firms, notably Microsoft, have so far declined to follow suit (except for gaming apps).

Barring further evidence, neither Apple’s market share nor its behavior appear consistent with the commission’s narrow market definition.

Are Apple’s IAP system rules and anti-steering provisions abusive?

The commission’s case rests on the idea that Apple leverages its IAP system to raise the costs of rival app developers:

“Apple’s rules distort competition in the market for music streaming services by raising the costs of competing music streaming app developers. This in turn leads to higher prices for consumers for their in-app music subscriptions on iOS devices. In addition, Apple becomes the intermediary for all IAP transactions and takes over the billing relationship, as well as related communications for competitors.”

However, expropriating rents from these developers is not nearly as attractive as it might seem. The report of the Dutch competition notes that “attracting and maintaining third-party developers that increase the value of the ecosystem” is essential for Apple. Indeed, users join a specific platform because it provides them with a wide number of applications they can use on their devices. And the opposite applies to developers. Hence, the loss of users on either or both sides reduces the value provided by the Apple App Store. Following this logic, it would make no sense for Apple to systematically expropriate developers. This might partly explain why Apple’s fees are only 30%-15%, since in principle they could be much higher.

It is also worth noting that Apple’s curated App Store and IAP have several redeeming virtues. Apple offers “a highly curated App Store where every app is reviewed by experts and an editorial team helps users discover new apps every day.”While this has arguably turned the App Store into a relatively closed platform, it provides users with the assurance that the apps they find there will meet a standard of security and trustworthiness.

As noted by the Dutch competition authority, “one of the reasons why the App Store is highly valued is because of the strict review process. Complaints about malware spread via an app downloaded in the App Store are rare.” Apple provides users with a special degree of privacy and security. Indeed, Apple stopped more than $1.5 billion in potentially fraudulent transactions in 2020, proving that the security protocols are not only necessary, but also effective. In this sense, the App Store Review Guidelines are considered the first line of defense against fraud and privacy breaches.

It is also worth noting that Apple only charges a nominal fee for iOS developer kits and no fees for in-app advertising. The IAP is thus essential for Apple to monetize the platform and to cover the costs associated with running the platform (note that Apple does make money on device sales, but that revenue is likely constrained by competition between itself and Android). When someone downloads Spotify from the App Store, Apple does not get paid, but Spotify does get a new client. Thus, while independent developers bear the costs of the app fees, Apple bears the costs and risks of running the platform itself.

For instance, Apple’s App Store Team is divided into smaller teams: the Editorial Design team, the Business Operations team, and the Engineering R&D team. These teams each have employees, budgets, and resources for which Apple needs to pay. If the revenues stopped, one can assume that Apple would have less incentive to sustain all these teams that preserve the App Store’s quality, security, and privacy parameters.

Indeed, the IAP system itself provides value to the Apple App Store. Instead of charging all of the apps it provides, it takes a share of the income from some of them. As a result, large developers that own in-app sales contribute to the maintenance of the platform, while smaller ones are still offered to consumers without having to contribute economically. This boosts Apple’s App Store diversity and supply of digital goods and services.

If Apple was forced to adopt another system, it could start charging higher prices for access to its interface and tools, leading to potential discrimination against the smaller developers. Or, Apple could increase the prices of handset devices, thus incurring higher costs for consumers who do not purchase digital goods. Therefore, there are no apparent alternatives to the current IAP that satisfy the App Store’s goals in the same way.

As the Apple Review Guidelines emphasize, “for everything else there is always the open Internet.” Netflix and Spotify have ditched the subscription options from their app, and they are still among the top downloaded apps in iOS. The IAP system is therefore not compulsory to be successful in Apple’s ecosystem, and developers are free to drop Apple Review Guidelines.

Conclusion

The commission’s case against Apple is based on shaky foundations. Not only is the market definition extremely narrow—ignoring competition from Android, among others—but the behavior challenged by the commission has a clear efficiency-enhancing rationale. Of course, both of these critiques ultimately boil down to empirical questions that the commission will have overcome before it reaches a final decision. In the meantime, the jury is out.

Archives For SSRN

The Bertrand Paradox

The Theory of Contestable Markets

How Contestable Are Digital Markets?

Conclusion

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One subscription is not enough

Substitutes, complements, or unrelated?

Consolidation can enable price discrimination

Scale-related economies

Conclusion

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The Case of Big Data Competition

We’ve Been Here Before: The Microsoft Antitrust Saga

Conclusion

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Kill Zones

Mergers and Potential Competition

Killer Acquisitions

Conclusion

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Exploitative Abuses

Predatory Pricing

Refusals to Deal

Vertical Restraints

Political Discretion in European Competition Law

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Bees

The Lighthouse

The Tragedy of the Commons

Dvorak Keyboards

Killzones, Zoom, and TikTok

In Conclusion

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The Court’s Flawed Analysis

Other Harms the Court Failed to Consider

Conclusion

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Platform Anti-Monopoly Act

Ending Platform Monopolies Act

Platform Competition and Opportunity Act

ACCESS Act

Merger Filing Fee Modernization Act

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The Jones Act and National Defense

Disagreements, but also Common Ground

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Should the relevant market be narrowed to iOS?

Are Apple’s IAP system rules and anti-steering provisions abusive?

Conclusion

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