The Next Revolution of the New Economy: Cloud Computing
New Empirical Evidence on the Positive Role of Market Leaders and IPRs Protection in R&D Investment
Stackelberg Competition: Entry Conditions and Market Leadership
The Dominance of Google in Online Advertising
The Economics of Proprietary vs. Open Source Software
Tectonic Shifts in Online Advertising
A Manifesto for the Endogenous Market Structures Theory
Should the EU Allow the Google-DoubleClick Merger?
Trade, Growth, and the Business Cycles: The EMS Approach
The Economic Implications of the CFI Ruling
Monopoly and Economic Efficiency
Competition Policy and Market Leaders
The Political Economy of the Microsoft Cases
Open source, Wikipedia and the Drivers of Innovation
Multi-sided Platforms in the Third Industrial Revolution
Tying, Media Player and Shoelaces
Export Subsidies and IPRs Protection
The Industrial Organization of the Software Market
An Economic Perspective on Market Dominance
Antitrust, Innovation and the Microsoft Case
Reforming EU Antitrust and Aftermarkets
Reforming EU Antitrust and Refusals to Supply
Reforming EU Antitrust I: Pricing Abuses
Reforming EU Antitrust II: Non-Pricing Abuses
A New Approach toward Exclusionary Abuses in Antitrust Policy
Beyond the Post-Chicago Approach to Antitrust: the New Theory of Market Leaders
Trade secrets and Interoperability
Market Leaders, Innovation, and R&D Spillovers in a Dynamic Set-up
On the European Approach to Competition Policy
The Role of IPRs in Promoting Innovations
Patents on Computer-Implemented Inventions in the EU
TOPICS OF THE MONTHS
December 2008: Cloud Computing and its Macroeconomic Impact
The development of cloud computing will shape the structure of the New Economy and probably not only that. This term refers to an Internet-based technology through which information is stored in servers and provided as a service (Software as a Service, or SaaS) and on-demand to clients (from the "clouds" indeed). Its impact will be spectacular on both consumers and firms. On one side, consumers will be able to access all of their documents and data from any device (the personal laptop, the mobile phone, an Internet Point..), as they already do for email services. On the other side, firms will be able to rent computing power (both hardware and software) and storage from a service provider and to pay on demand, as they already do for other inputs as energy and electricity.
In preparation to this new scenario, many hardware and software companies are investing to create new platforms able to attract customers. A “cloud platform” provides services for creating applications in competition or in alternative to “on-premises platforms”, that are the traditional ones based on an operating system as a foundation, a group of infrastructure services and a set of packaged and custom applications. The crucial difference is that, while on-premises platforms are designed to support consumer-scale or enterprise-scale applications, cloud platforms can potentially support multiple users at Internet scale.
Many companies are building huge data centres loaded with hundreds of thousands servers to be made available for customer needs. Locations are chosen strategically to minimize energy and cooling costs (cold regions are favourite). But also international legal issues associated with the global movement of informations may be crucial in the future.
The first mover in the field has been Amazon, that provides access to half a million developers by way of Amazon Web Services. Any small company can start a web-based service on its computer system, add extra virtual machines when needed and shut them down when there is no demand: for this reason the utility is called Elastic Cloud Computing. Animoto, a service that lets users turn photos into music videos, provides an interesting example. When it was launched on Facebook, it was forced by exponentially increasing demand to bring the number of machines on Amazon Web Services from 50 to 3500 within three days, something that would have never been possible without relying on a cloud platform.
Google is also investing huge funds in data centres - one of its futuristic plans includes centres located on ships to exploit the energy derived from the motion of the water! Already now, Google Apps provides word processing and spreadsheet applications online that can be accessed from any web browser, while the software and data are stored on the servers. The same Google search engine or its mapping service can offer cloud application services. For instance, when Google Maps was launched, programmers easily found out how to use its maps with other informations to provide new services, for instance the location of houses from the rental and sales listings of Craiglist.
Social networks have moved in the same direction turning into social platforms for consumer based applications, with Facebook in the front road. Oracle has introduced a cloud based version of its database program. Also Yahoo! is developing server farms. Hardware producers as Dell, HP and IBM are investing as well. Microsoft has started later but with huge investments in the creation of new data centres. In the fall of 2008, has introduced a cloud platform called Windows Azure, currently available only in a Community Technology Preview version. The Azure platform is able to provide a number of new technologies: a Windows-based environment in the cloud to store data in Microsoft data centres and to run applications; an infrastructure for both on-premises and cloud applications through .NET Services; a cloud based database through SQL Data Services (which can be used from different users and different locations); and an application tool to access Live Services which allows to synchronize and constantly update data across systems joined into a “mesh” (for instance all the personal devices as the PC, the office’s computer, the mobile phone and so on). Windows Azure provides a browser-accessible portal for customers with a Windows Live ID: these can create a hosting account to run applications or a storage account to store data in the cloud, and they can be charged through subscriptions, per-use fees or other methods. While many applications and services can perform well either on-premises or in the cloud, Microsoft envisions a wider range of combinations, enabling developers and customers to manage applications and data in the cloud, or on-premises, or via some combination of the two that provides the best outcome in terms of functionality and other concerns such as security or privacy (this approach is defined as Software plus Services).
The battle for the clouds is going to reshape the IT market structure as PC distribution did in the 80s. But according to the Economist (2008, Where the cloud meets the ground, Report, October 25th , 387) “cloud computing is unlikely to bring about quite such a dramatic shift. In essence, what it does is take the idea of distributed computing a step farther. Still, it will add a couple of layers to the IT stack. One is made up of the cloud providers, such as Amazon and Google. The other is software that helps firms to turn their IT infrastructure into their own cloud, known as a ‘virtual operating system for data centres’ … Will this prospective platform war produce a dominant company in the mould of IBM or Microsoft that is able to extract more than its fair share of the profits? Probably not, because it will be relatively easy to switch between vendors... Nor is it likely that one firm will manage to build a global cloud monopoly. Although there are important economies of scale in building a network of data centres, the computing needs of companies and consumers vary too widely for one size to fit all.” Most important, the need of creating network effects in the development of a cloud platform will keep low the margins for a while and will maximize the speed of diffusion of cloud computing between firms at the global level. For this reason it is crucial to understand the economic impact of the introduction of this general purpose technology. What is sure, is that the diffusion of cloud computing will create a solid and pervasive impact on the global economy. Some of the potential benefits of cloud computing include:
- Generalized reduction of the fixed costs of entry and production, in terms of shifting fixed capital expenditure in IT, which represents half of total in modern industries (Carr, 2003), to operative costs depending on the size of demand. This contributes to reduce barriers to entry especially for small businesses (as infrastructure is owned by the provider and does not need to be purchased for one-time or infrequent intensive computing tasks) and generate quick scalability and growth. The consequences on the endogenous structure of the markets with largest cost savings will be wide, with entry of new small and medium firms, a reduction of the mark ups and an increase in market sizes.
- Creation of multidimensional network effects due to the new possibilities of product creation in the cloud, that is between companies exploiting in different ways the potentialities of cloud computing through the same platform or different ones. This is related to another new possibility, the rapid adoption of changes: it is not uncommon, that applications in the cloud are modified on a daily base (to accommodate new requirements, or enable new economic venues), which is impossible with on-premise solutions.
- The possibility of sharing of resources (and costs) among a large pool of users, allowing for centralization of infrastructures in areas with lower costs, peak-load capacity increases and utilization and efficiency improvements for systems that are often only 10-20% utilised. These features will lead to additional savings in energy and to greater environmental sustainability.
A recent study of the International Data Corporation (see ) examines the role of IT cloud services across five major IT product segments representing almost two-thirds of total enterprise IT spending (excluding PCs): business applications (SaaS), infrastructure software, application development & deployment software, servers and storage. Of the $ 383 billion firms spend in 2008 for these IT services only $ 16.2 billion (4%) can be classified as cloud services. In 2012 the total figure is expected at $ 494 billion and the cloud part at $ 42 billion, which will correspond to 9% of customer spending, but also to a large part of the growth in IT spending. The majority of cloud spending is and will remain allocated to business applications, with a relative increase of investment in data storage.
Even if the relative size of IT cloud services may remain limited in the next few years, it is destined to increase and to have a relevant macroeconomic impact, especially in terms of creation of new small and medium size enterprises and of employment. In times of global crisis, this could be an important contribution to promote the recovery and to foster growth. Cloud platforms and new data centres are creating a new level of infrastructure that global developers can exploit, especially small and medium size firms that are so common in Europe. This will open new investment and business opportunities currently blocked by the need of massive up-front investments. The new platforms will enable different business models, including pay-as-you-go subscriptions for computing, storage, and/or IT management functions, which will allow small firms to scale up or down to meet the needs of their demand. As the Economist (2008) claims, “The internet disrupted the music business; Google disrupted the media; cloud-based companies could become disrupters in other inefficient industries.” The macroeconomic impact of the diffusion of this new general purpose technology may be quite large, as it happened for the introduction of the Internet in the 90s.
November 2008: Stackelberg Competition with Endogenous Entry and an Application
The theory of endogenous market structures and its implications for antitrust issues have been formalized in the article "Stackelberg Competition with Endogenous Entry" by F. Etro (The Economic Journal, October 2008) and in related works (see for instance Maci and Zigic, 2008, "Competition Policy and market Leaders"). A summary is reported below.
A crucial implication of the EMS approach to antitrust is that leading firms can play completely different roles in markets where there is a strong threat of entry of new competitors and those where the potential for rivals is weak. This finding has significant implications for how the activities of such firms are monitored and regulated by the competition authorities.
For example, Google and Microsoft are leaders respectively in the online advertising market and in the software market. But while Google currently faces competition from a fixed number of rivals in online advertising (virtually only Yahoo! and Microsoft), the software market is characterised by open access to a fringe of effective and potential entrants (including the open source community). This difference is crucial. On one side, a leader like Google is able to exploit the absence of entry threats by putting high mark-ups on its advertising services (at least double those of their main competitors), generating high prices in the industry, which ultimately hurts consumers worldwide. On the other side, a leader like Microsoft is forced by entry pressures to maintain low mark-ups (the price of Vista is estimated at 5-20% of the theoretical monopolistic price), which ultimately induces large welfare gains for the consumers worldwide.
Both Google and Microsoft retain large market shares but in markets with different entry conditions. For this reason, competition authorities should be more concerned about the moves of the former, as they did for the agreement with Yahoo! (to deliver relevant Google ads alongside Yahoo!'s own search results), which would have reduced competition and increased prices for publishers and advertisers. Even after the withdrawal of that deal under the pressure of the US Department of Justice, Google remains dominant and unconstrained by endogenous entry threats.
This research belongs to the recent efforts to characterise “endogenous market structures”, that is, structures of markets where firms interact strategically and entry is ‘endogenous’ or free. The main focus of the study is about competition in the market when a leading firm plays as a first mover – a Stackelberg leader, after the name of the famous German economist. The main result is that the leader is always more aggressive than its followers as long as there is a substantial entry pressure. The lower prices of the leader are associated with its larger market share: in such a case, high concentration and limited entry are a consequence of strong competitive forces and not of market power.
The essay "Stackelberg competition with endogenous entry" derives the conditions under which free entry of firms induces the leader to dominate most of a market through low pricing: this happens when firms produce highly substitutable goods and the average costs of production are decreasing (a typical feature of the software market). Finally, it shows that, as long as entry is endogenous, the aggressive strategy of the leader brings better outcomes for consumers. Such a result is in contrast to what happens when the leader faces an exogenous number of rivals (as in online advertising).
This leads to the policy implications of the article: in investigations concerning abuse of dominance, mergers or similar agreements, a preliminary examination of the entry conditions is crucial to verify whether large market shares of the leaders can be a symptom of dominance or just of competitive pressure on the leaders. Only when entry is not feasible in the medium run, the antitrust investigation should move forward.
October 2008: The Positive Role of Market Leaders and IPRs Protection in R&D Investment
In a recent paper on "The Effect of Entry on R&D Investment of Leaders: Theory and Empirical Evidence" Dirk Czarnitzki, Federico Etro and Kornelius Kraft have provided new empirical evidence on the determinants of R&D investment and on the role of market leaders and of the protection of intellectual property rights. There is a long debate on the role of market leaders in investing in R&D. Following Arrow (1962), a popular view regards competitive pressure as being supportive for innovative activity and claims that incumbents tend to be less innovative than the outsiders. This article reconsiders this view both from a theoretical and an empirical perspective. Following the endogenous market structures approach, a theoretical model provides hypotheses on the incentives to invest in R&D for incumbent leaders and outsiders. It establishes the crucial role of entry pressure on the behavior of leaders and followers. In markets with endogenous entry each firm tends to invest less, but when the incumbents have a leadership position in the competition for the market, they tend to invest more than the average firm. Hence, the endogenous market structures approach obtains the exact opposite of the commonly held view associated with Arrow.
These predictions are tested through a statistical (Tobit) model for R&D intensity (RDINT). The empirical investigation is based on a unique dataset on the German manufacturing sector, the Mannheim Innovation Panel from 2005, which includes a wide number of firm level data and answers to a survey conducted by the Centre for European Economic Research (ZEW) with a special focus on innovation. Besides we summarize the number of firms per industry, the percentage of leaders (defined below) and the average R&D intensity. The Information and Communication Technology sector and the Instruments/Optics industry exibit the higher rate of investment in R&D. A novel aspect of this empirical approach is given by the fact that the same firms provide a subjective view on the key determinants of R&D intensity, the entry pressure and the leadership. Rather than determining arbitrarily the size and composition of a market, assigning a degree of entry intensity in a discretionary way, and assigning a status of leadership on the basis of predetermined variables, using the questionnaire of the Mannheim Innovation Panel allows the firms to identify the size of their main market, the existence of an endogenous threat of entry in the market and the identity of the leader in the market. The key variables identify the existence of endogenous entry pressure (ENTRY) and the status of market leaders (LEADER). Control variables include employment (EMP), capital intensity (KAPINT), a measure of the firms’ patent stock (PSTOCK), the Herfindahl index of concentration (HHI) and sector dummies.
The independence of the entry variable from the dependent variable, R&D intensity, is supported through an instrumental variable analysis and a number of exogeneity tests - instruments for entry are a default index, the minimum efficient scale (MES) and dummy variables on the importance of substitutability between products and advertising. Descriptive statistics tell us that the average firm invests almost 2.3 % of its sales in R&D, employs 300 workers with a capital endowment of 78 thousand Marks each, and 8% of the firms are leaders in their main market.
The main regressions for R&D intensity adopt different technical assumptions on the statistical properties of the relations under investigation. In a first work they propose the homoscedastic Tobit model and find that R&D investement decreases as the threat of entry increases. The leaders' investment does not differ from that of the outsiders. When we add the interaction term of leadership and entry threat, however, interesting differences occur. While the leader dummy is still insignificant, we now find that leaders who are faced by potential entry invest more than the outsiders. The results remain robust when we control for prior R&D using the patent stock. The patent stock is highly significant and positive, confirming that firms receiving stronger protection of IPRs through patents tend to invest more - alternatively, firms that (successfully) conducted R&D in the past will also invest more in the current period.
With respect to the other covariates, we find a positive and concave relation with employment, while capital intensity is positively significant in all models, and the Herfindahl index is always insignificant. Furthermore there are differences in R&D investment across industries. The industry dummies are always jointly different from zero in the regressions, and our results emphasize a high correlation of R&D spending with firms of the Information & Communication Technology.
The assumption of homoscedasticity is rejected for all models, therefore we move to the heteroscedastic Tobit model. The industry and firm size dummies are always jointly significant. The main results are robust to the model modification. Leaders, in general, are still not differently investing in R&D than the outsiders, and R&D investment is negatively affected by the entry variable. Leaders that suffer from entry threat also invest more than outsiders in the heteroscedastic version. There are no dramatic changes in the estimates of the other covariates. The patent stock is still highly positively significant, confirming the positive relation between IPRs protection and investment in R&D. The estimated employment effect remains stable, however, the positive relationship between R&D and capital investment becomes statistically insignificant, once we correct for heteroscedasticity. To sum up, our findings on entry are in line with the hypothesis that investment decreases with the strength of endogenous entry threats. Furthermore, incumbent leaders do not differ in their investment from other firms (LEADER is insignificant), unless they are threatened by endogenous entry. Then the negative investment effect is offset (see the positive sign of the interaction term LEADER×ENTRY). Thus, incumbents invest more than the outsiders under endogenous entry threat.
In line with the theoretical prediction of the endogenous market structures approach, the competitive pressure of the potential entry of other firms induces the market leaders to invest in R&D more than any other firm. This implies that we may have to change our way of looking at persistent market dominance: this may be the result of strong competitive pressure rather than of market power. Finally, the size of the firms and their patent stocks, proxy for the protection of IPRs, are positively related to R&D intensity. Therefore, markets with large incumbent leaders pressured by endogenous entry (not in the production process but in the innovative process) and whose IPRs are well protected may be more innovative than other markets.
September 2008: Innovation, Global Growth and Leadership
Understanding the determinants of global growth and the reasons for which differentials in growth rates are so large is fundamental to foster economic progress around the world. While growth in developing countries is largely associated with the process of industrialization through established technologies and with the accumulation of physical and human capital in the neoclassical sense, growth in the Western developed countries is largely driven by the continuous process of expansion of the technological frontier.
Technology driven growth is mainly due to the innovations of firms investing in R&D to create new or better products and replace the existing ones. The profits, associated with the innovations and temporarily protected through intellectual property rights, provide the incentives to invest in R&D for all the firms of the high-tech sectors, and the structure of this form of competition for the market is a crucial element of the engine of growth. The EMSs approach has widely examined this structure, endogenizing strategic interactions in the investment choices and the entry process, and it has been also focused on the peculiar role of market leaders.
Entry of firms in the competition for the market is primarily driven by the size of the expected profits from an innovation, and therefore it is directly related to the strength of the protection of intellectual property rights. This protection, as the legal enforcement of contracts and the protection of the same physical property rights, is one of the founding elements of the free market economies, and possibly the most important, since growth (rather than static wealth) relies on it. Of course, entry changes the nature of the strategic interactions between the investors, increasing aggregate investment and reducing the expected profitability (per firm) at rates that depend on the substitutability or complementarity between the investments of the firms. The entry process is exhausted when the expected return on R&D investment is the same as the return on alternative investments, and this equilibrium determines the aggregate rate of technological progress.
The endogeneity of entry plays a crucial role in the decision of technological leaders to invest in R&D to perpetuate their status: leaders tend to invest less than their rivals and to reduce the aggregate investment when they face an exogenous number of competitors, but they tend to invest more and to increase the aggregate investment when they face an endogenous number of investors trying to replace the leading technology. This hypothesis has been tested by Czarnitzki, Etro and Kraft (2008) on a unique dataset about the German manufacturing sector, the Mannheim Innovation Panel, which includes a wide number of firm level data and answers to a survey conducted by the Centre for European Economic Research (ZEW) with a special focus on innovation. A novel aspect of this research is given by the fact that the same firms provide a subjective view on our key determinants of R&D intensity, the entry pressure and the leadership. Rather than determining arbitrarily the size and composition of a market, assigning a degree of entry intensity in a discretionary way, and assigning a status of leadership on the basis of predetermined variables, the questionaire of the Mannheim Innovation Panel allows us to ask the same firms to identify the size of their main market, the existence of an endogenous threat of entry in the market and the identity of the leader in the market. Using standard control variables as employment, capital intensity, stock of intellectual property rights and sector dummies, the econometric investigation confirms the main predictions of the EMSs approach: even if entry pressure reduces the average investment per firm, the incumbent leaders invest more than other firms when they are pressured by a strong threat of entry.
In the presence of sequential innovations, the consequence of the impact of the entry pressure on the investment of the leaders is that the likelihood of persistence of leadership is high exactly when there is endogenous entry in the competition for the market. Therefore, growth is mainly driven by the investments of the market leaders to perpetuate their positions. We can summarize this result with the following principle:
Growth is driven by the process of business creation and enhanced by a leadership of patentholders in the competition for the market, which leads to endogenous persistence of their technological leadership and to a growth process driven by market leaders.
There is a second way in which leaders play a crucial role in the innovation process, and this emerges in a spectacular way in the global competition. In a open economy context, the country with the largest market (or the largest integrated market) tends to develop a dynamic comparative advantage in the innovation sector and, in the long run, it leads alone the technological frontier with its firms playing leading roles. The same country (or integrated market) tends to export intermediate goods, to import final goods and to attract foreign capital to finance its superior investments in R&D. See Growth Leaders (2008, Journal of Macroeconomics) for a recent theoretical assessment of this view.
Such an scenario may describe the growth experience of the last decades, characterized by large R&D investments and high rate of technological progress in the US, by high US imports of final goods which allowed other countries to grow as well, exporting final goods to the US and importing US technology, and, finally, by impressive capital flows toward the US financing its large current account deficits, and turning US into the largest debtor country in the world. It should be noticed that after the recent enlargment process, the European Union became the largest integrated market in the world with a nominal GDP of 16,830,100 millions $ in 2007 (31 % of world GDP), followed by the United States with 13,843,825 millions $, Japan with 4,383,762 millions $ and China with 3,250,827 millions $ (IMF data). The GDP figures adjusted for purchasing power parity read as 14,712,369 $ mm for the European Union, 13,843,825 $ mm for the United States, 6,991,0361 $ mm for China and 4,289,809 $ mm for Japan. However, given the differences in the growth rates, our guestimate is that China will catch up with the US during the third decade of this century.
August 2008: Endogenous Market Structures and the Macroeconomy: Gains from globalization
Globalization, defined as the increase in trade in goods and factors of production and associated with the reduction of natural and artificial trade barriers, is one of the main phenomena of the last decades. Understanding the impact of increasing openness is one of the major aims of macroeconomic theory. It is often claimed that globalization leads to lower prices for the consumers but also to business destruction at the local level. However, the new trade theory has emphasized that opening up to trade leads mainly to other forms of gains and other forms of impact on business: it keeps monopolistic prices at the same level and it does not affect the number of active firms, while it increases the total number of goods available for consumption at the local level. This generates what are usually called the gains from variety due to openness.
The EMSs approach emphasizes a related but more complex mechanism. When a country opens up to trade, say with a bordering country, the domestic firms start competing with the foreign ones for both the domestic and the foreign market (which are an integrated market in the absence of trade frictions). This strengthening of competition leads always to a reduction of the mark ups and therefore of the prices of all the goods. Profitability and entry are affected in three ways: first, each firm serves two markets rather than one, which enhances profitability; second, each firm is sharing each market with a larger number of firms, which reduces profitability; third, stronger competition reduces the mark ups and the profitability. The net effect determines the impact on the number of firms active in each market. In the absence of asymmetries between the firms, the first two effects balance each other and the overall impact of opening up to trade is a reduction of the total number of firms, which implies business destruction at the local level.
The extent of this mechanism crucially depends on the type of traded goods. At one extreme we have perfectly differentiated goods with competition in prices: for these goods, all the gains from opening up to trade derive from an increase in the number of consumed varieties and not from price changes, while business destruction is absent. This is the typical situation that Paul Krugman had in mind when talking about the gains from intra-industry trade: globalization makes different brands of cars available for all consumers, which enlarges the options.
At the other extreme we have homogenous goods with competition in quantities: for these goods, all the gains from trade derive from lower prices, but business destruction is heavy (of course, in intermediate situations the gains from trade derive from both lower prices and more varieties, and business destruction is partial). This is what probably happened in most markets during the phase of intense globalization of the last years, and it is not surprising that many supporters of this process have constantly emphasized the price-reducing impact of openness while associating the business destruction effect with a pure reallocation of labor across firms. Summing up, we have the following principle:
Globalization brings gains from trade by strengthening competition and reducing mark ups and prices, and by increasing the number of available goods, but induces business destruction at the local level.
Notice that in the absence of labor market imperfections, business destruction is inconsequential for the agents: they switch jobs reallocating their work between a smaller number of firms that have a larger share of the global market. Nevertheless, job destruction due to globalization can have dramatic effects in the presence of labor market rigidities, both in terms of unemployment and income inequalities. Our distinction between different cases above can help us to understand better the consequences of globalization. One could think of sectors producing highly differentiated goods with competition in prices as sectors where innovation and design are the fruit of skilled labor: in these sectors business destruction due to globalization is limited. Meanwhile, sectors with homogenous goods and competition in quantities can be seen as sectors characterized by standard production processes employing low-skilled workers: for these sectors, we have seen that business destruction due to globalization is radical. Therefore, in the presence of labor market imperfections, the consequences of globalization can be worse for low skilled workers and can potentially lead to their unemployment and to income disparities between them and the skilled workers. For this reason, the gains from trade due to globalization and associated with lower prices are often criticized for their negative consequences on jobs and inequality.
July 2008: Endogenous Market Structures and the Macroeconomy: Steady state EMSs
Even if the mark ups and the number of firms, as all the aggregate variables as output, consumption, investment, labor force and profits are changing over the business cycle, in the long run their pattern must be determined by the structural parameters of the economy. Understanding the role of these factors is crucial to understand the huge economic differences between developed and developing countries. In general, the wealth of nations and also the growth of nations depend on total factor productivity, which summarizes the productivity of all the inputs and can be growing over time, and on the propensity to save and to work, which determine the size of investment and employment in the economy. There is not a unique path toward economic progress. Some countries have based their prosperity achieving high levels of productivity, others simply by saving a lot and giving up to current consumption for the well being of the future generations, and other countries just by working more. Some countries have done all these things in different phases of their growth process, some others have temporarily financed growth with foreign investments or producing to export abroad. But the countries that have grown successfully had all satisfied a fundamental precondition: they had been able to build the institutions, the infrastructures and the well functioning markets that are necessary for the above factors to create wealth and progress.
Taking as given the long run impact of these fundamental factors on the production possibilities, we claim that there is a second order impact that these and a few other technological and behavioral factors have on the market structures and consequently on the long run performance of the economies. The EMSs approach has been able to characterize the steady state mark up and the number of firms depending on few structural parameters and the form of competition. We point out five main determinants of the long run market structures and of the other aggregate variables. The first determinant is productivity (in our framework simply labor productivity): higher productivity leads to more business creation, which increases the steady state number of firms and enhances competition while reducing the mark ups.
The second determinant of the steady state EMSs is the size of the barriers to entry: when these are high, the profitability of entry is low and the long run equilibrium is characterized by high concentration and high mark ups. Of course, markets characterized by high sunk costs of entry due to technological conditions naturally lead to equilibria with few active firms, and this does not represent a problem in itself. Howevere, to the extent that the entry barriers are artificial, in the sense that they are due to product market regulations, reforms leading to deregulation reduce concentration and mark ups in the long run, with a positive impact on the performance of the economy as a whole.
The third structural factor determining the nature of the EMSs in the long run is a behavioral factor, the way people discount future. This degree of patience is what determines the propensity to save of the households, which in turn affects the equilibrium in the credit market. When agents are more patient, their large supply of savings reduces the interest rate, which means that the discounted sum of future profits is higher: this attracts more entry, strengthens competition and ultimately reduces the mark ups. Therefore more patient agents lead to a higher number of firms in the steady state.
The fourth element is the rate of business destruction due to exogenous reasons: when the risk of bankruptcy is high, the expected value of business creation is lower and business creation is limited. Therefore, in case of a high rate of default there are only few firms in the long run (but with a high rate of turnover), and they apply a high mark up to their goods.
The last determinant of the long run equilibrium emphasized in our framework is the degree of substitutability between goods. Higher homogeneity of the goods induces stronger competition between the firms and leads to lower mark ups, which in turn attracts a limited number of firms in the markets. On the contrary, when goods are highly differentiated, competition is relaxed and mark ups are higher, but this attractes more firms. Of course, markets with different levels of subsitutability between the goods produced by their firms cohexist in the real world, and we should think of these relations as general tendencies characterizing different markets. Summarizing the results obtained until now with a focus on the impact on the mark ups, we have the following principle:
In the long run, the steady state EMSs are characterized by mark ups increasing in the cost of entry and in the rate of business destruction and decreasing in labor productivity, in the discount factor and in the degree of substitutability between goods.
Notice that the steady state structure of the markets determines not only what is produced and at which price it is sold, but also how much of it is consumed, which is what matters for our understanding of the behavior of the economy and for its reaction to structural changes. The impact of the main structural parameters on long run consumption (under competition in prices in the markets) is the following: higher productivity, more substitutability between the goods and more patience ultimately lead to larger consumption bundles, while higher costs of entry and higher rates of business destruction lead to smaller consumption bundles in the long run.
June 2008: Endogenous Market Structures and the Macroeconomy: Short run EMSs and the competition effect
The fundamental novelty of the EMSs approach to macroeconomics relies on its analysis of the determinants of the structure of markets that populate modern economies. Perfect competition, which is the standard way to model competition in the neoclassical theory, requires that firms can be created at no cost and act as price-takers, in the sense that they do not perceive themselves as affecting market prices with their choices, and that in equilibrium they sell goods at the marginal cost of production, obtaining always zero profits. In such a framework, the market structure is indeterminate, in the sense that we have nothing to say about how many firms should be in the market and how much each one should produce in equilibrium. Contrary to the neoclassical approach, the EMSs approach departs from the perfectly competitive paradigma, and introduces more realistic forms of competition between firms choosing their prices or their production levels and interacting in a strategic way. Moreover, this approach takes in consideration that firms decide rationally whether to enter or not in a market according to the profitability conditions: in particular the technological conditions are generalized to include positive fixed costs of entry, so that only a few firms enter in each market and only if they foresee enough gross profits to cover the fixed costs. The combination of these ingredients leads to markets where the strategies of the firms and their number can be endogenously characterized in the short and long run as functions of the structural parameters of the economy.
Our approach can also depart from the neoclassical assumption that investment builds capital used as a factor of production together with labor. That was a good assumption to describe production in the industrialization phase, characterized by the dominance of the secondary sector (manufacturing) and by the social conflict between capital and labor, but not such a good one to describe production in the modern age, dominated by the tertiary sector (services) and by the New Economy, where creativity, know-how and innovations are the main inputs needed to bring new products to the market. This is even more evident when we think of growth, a process driven mostly by capital accumulation during the industrialization phase, but largely driven by business creation and innovations in the New Economy.
On the basis of these considerations, the EMSs approach takes a different route from the neoclassical one in assuming that investment simply creates new firms or new products which complement or replace the old ones. The mechanism of business creation works through a simple channel: the expectation of future profits induces entrepreneurs to invest in the creation of new products. However, this mechanism has already in nuce a counterbalancing effect. Entry of new firms increases the number of competitors, and these become more aggressive. They may actually compete in a number of different ways, for instance by choosing their prices (in Bertrand competition) or the quantity of production (in Cournot competition) or in more complex ways in the presence of leaders, asymmetries, heterogeneity between firms and so on. In all these cases, entry strengthens competition, which reduces the mark ups and the profits that other firms can expect from entering in the same market. Ultimately, in equilibrium, each firm must choose the profit maximizing strategy given those of the other firms, and the number of firms must be such that there are no other firms with incentives to enter.
The characterization of the aggregate equilibrium with EMSs emphasizes a new mechanism of propagation of the shocks in the short run that can be relevant to explain the business cycle. Consider a positive and temporary shock to the economy, say a sudden reduction in the price of oil (which reduces the price of the input energy and boosts productivity) or an increase in public spending (which increases aggregate demand). The positive impact on consumption leads to an increase in profits for the active firms, which attracts subsequent entry of new ones. Entry is only gradual and temporary, but it strengthens competition between all the firms, which leads to a gradual and temporary reduction in the mark ups and therefore in the prices. The temporary reduction in the prices, induces agents to substitute future consumption with current consumption (i.e. to temporarily increase consumption). This, in turn, has a feedback effect on profits, entry, competition and prices, which magnifies the impact of the shock. Of course, this mechanism could not take place in situations where mark ups were zero (as in the perfectly competitive framework) or in situations where mark ups were positive but constant and entry was independent from the profitability conditions (as in most of the New Keynesian literature based on monopolistic behavior). We can summarize this novel mechanism with the following principle:
In the short run, the EMSs link demand & supply conditions with endogenous entry and mark ups, and a positive shock to the economy attracts entry, strengthens competition and reduces mark ups and prices, which boosts consumption and propagates the shock.
An important consequence of this principle, is that the economy is characterized by procyclical entry of firms and countercylical mark ups, two patterns that are well documented in the data and that remain largely unexplained in the neoclassical theory or in its extensions to monopolistic behavior (which neglect entry and generate constant mark ups, so as to obtain a genuinely exogenous market structure). The simulation of the simplest possible model calibrated on the US economy shows that the EMSs approach allows us to mimic the variability of the main aggregate variables as output, consumption, investment, labor supply and profits at least as well as a more complex neoclassical model in the Real Business Cycle tradition, and potentially to do even better.
If the mechanism of propagation of the shocks suggested here represents an important component of the business cycle, it may allow us to reinterpret the reaction of economies to past and current shocks. At the time of writing, the world economy is witnessing one of the largest negative supply shocks of the last decades, with the price of oil steadily above 100 $ a barrel. A similar increase in the cost of energy has been the source of the global recessions during the first and second oil crises (1973 and 1979), and appears to be a major component of the third one (2008). Besides the recessionary impact of the temporary reduction in total factor productivity on aggregate supply and demand, largely emphasized by the Real Business Cycle approach, here we want to focus on the impact on profits, entry and competition of such a negative shock.
A generalized reduction in aggregate demand exerts a first order negative impact on the profitability of all the firms. In particular, sectors that are largely dependent on the consumption of energy face a sudden increase in the costs of production, and a further reduction in profitability. If the shock is long enough, all this increases business mortality, reduces the incentives to create new firms and products, and ultimately leads to a net exit of firms, especially in the sectors where demand and costs are more influenced by the oil shock. The second order impact of this process of business destruction is a reduction in the degree of competition in these sectors. As a consequence, firms tend to increase their mark ups and prices, while the real wages tend to decrease, at least in the short run. Of course, the price increase feeds the recessionary impact of the shock leading to lower consumption by the households, lower total profits, less business creation and innovation, and so on. While it is clear that there is a structural component in the recent increase of the price of oil, the size and the duration of the temporary component will determine the entity of the recession the Western world is entering in.
Of course, the mechanism at work is the opposite in the presence of a positive shock, as could be the introduction of a general purpose technology. When the impact of PCs and the Internet on the global productivity became evident during the 90s, the profit expectations drastically improved in many sectors, and not just in sectors of the New Economy. In particular, service sectors, which represent the large majority of business in the developed world, benefited from the cost-reducing impact of new software and hardware, and a heavy process of business creation and innovation took place in these sectors. The consequence was one of the longest period of sustained growth in the US and in all those countries where the market forces (of business creation) were working well. The expectations on profitability and growth (mirrored by the stock market) have been positive for such a long period during the years of the Clinton Administration that US consumption started driving foreign growth as well, and US investment attracted capital from the rest of the world. As we know today, this process of consumption boom went too far, leading to an imbalance in the foreign accounts and to speculative bubbles in the financial and real estate sector (the same process could only stop with the drastic depreciation of the Dollar and the current recession).
May 2008: Search and Display Advertising
The temporary withdrawal of offer by Microsoft to buy Yahoo! could be missed occasion to strengthen competition in the market for search and online advertising, where Google is the dominant company and may even engage in further agreements with the distant follower Yahoo! The competitive and innovative pressure that Microsoft and Yahoo! could have exerted together would have been beneficial for the degree of competition in this fast developing market where further entry is difficult today and the size of the market share in "search" is essential to compete on the advertising side. In the absence of the acquisition, or even more in the case of further agreements between Google and Yahoo!, the dominant company will keep acting in a monopolistic fashion toward the advertisers (its prices "per click" are already substantially higher than those of its competitors), with negative consequences on efficiency and ultimately on the consumers.
Further understanding of the market for search and display advertising is crucial to realize the importance of the current events. Online advertising is one of the fastest growing global markets. Even with a looming global economic downturn, companies spend over US$ 600 billion worldwide on brand recognition annually. Today only around 12% of that total is spent on online advertising, but the figure is set to grow, and grow fast: half a million new Internet users a day, increased connectivity of mobile devices and even TV to the worldwide Web, websites’ increasing reliance on advertising to generate revenue, and the promise of reaching target groups with ever-greater precision, are just a few of the reasons for the migration of advertising dollars to the new medium.
The high stakes are prompting a scramble for Internet real estate, with dominant search engine Google taking steps to reinforce its position, and smaller rivals Yahoo!, Microsoft, AOL and News Corp (owner of MySpace) looking for combinations that would allow them to close the gap with the market leader. Microsoft’s offer to buy Yahoo! prompted Yahoo! CEO Jerry Yang to explore a slew of alternatives, in an anything-but-Microsoft reaction that has shareholders complaining that he was letting emotion get in the way of providing them value. The frantic search for a white knight has included a flirtation with the idea of contracting out search advert placement to Google, though this has got the US Department of Justice asking some awkward questions of the parties, and legal experts on both sides of the Atlantic doubt that anything that smacked of a non-compete agreement between the numbers one and two would pass antitrust scrutiny in either Brussels or Washington. In a letter sent by Microsoft CEO Steve Ballmer to Jerry Yang on Saturday 3rd May, Microsoft officially withdrew its proposal to acquire the company and decided to avoid a hostile takeover. One of the reasons was that any defensive partnership between Yahoo! and Google would have undermined Yahoo!’ strategy and long-term viability by encouraging advertisers to use Google and allowing Google to increase its prices and consolidate its dominance. As of now, it seems that Microsoft will try to catch up with Google through other minor acquisitions and further investments, but neither Microsoft or Yahoo! alone are likely to gain market shares against the dominance of Google.
Google is the top search engine in the world, with a market share of 90%-plus in a number of EU countries, and exceeding 50% in the US (as against 17% for Yahoo!, 7% for Microsoft’s Live, 6% for AOL and 3% for Ask.com at the start of 2008). Beyond search queries, Google dominates the lucrative business of placing text ads next to search engine results, an area where Yahoo! and Microsoft working independently have been unable to catch up. Google AdWords accounts for about 70% of search advertising revenue worldwide. Moreover, Google has been able to exploit its leadership applying higher prices and mark ups to advertisers: the "pay per click" system is characterized by substantially higher prices per click on Google compared to the prices per click on the search website of Microsoft or Yahoo! (in economic theory, this is exactly what we would expect from a Stackelberg leader in a market with price competition and exogenous entry).
Google's recent acquisition DoubleClick leads the industry in contextual advertising (the placing of banner ads on third-party websites), accounting for more than 75% of the direct channel, that is, the valuable advert inventory that large web publishers directly negotiate with advertisers. A similar alignment prevails in the market for so-called “remnant” advertising inventory, sold through intermediaries who buy from publishers and sell to advertisers. This can be seen as a separate market from the direct channel, and, again, Google plays a dominant role, with Yahoo! and Microsoft straggling behind. Google’s vertically integrated intermediation platform between online publishers and advertisers, AdSense, absorbs more than 80 % of the revenue in the indirect channel, targeting advertising to relevant websites and paying web publishers a percentage of its revenues. Advertisers buy inventories from the AdSense platform through bids on the keywords that match the content of the web-pages. DoubleClick has been offering an alternative ad serving/management product, DART, for both publishers and advertisers, with a market share of around 75 %. Its recent acquisition by Google leaves the latter with at least 80 % of the worldwide market for online advertising. It would be odd if this did not lead to price increases: before the merger, competitive forces kept online advertising rates under control (DoubleClick could not increase prices because many consumers would have quickly switched to AdSense, and Google was similarly disciplined by the prospect of customers switching to DoubleClick’s products DoubleClick’s products); following the merger, these competitive constraints no longer apply.
For consumers and advertisers, the consequences of the current consolidations are uncertain. A merger between Yahoo! and Microsoft would have created synergies in R&D without impacting the prices of either company’s main products, which are complements rather than substitutes. It would have allowed the two to join forces and develop search engine capabilities and online services that could constitute a genuine, competitive alternative to Google, whose dominance in pay-per-click Internet advertising is now combined with DoubleClick’s dominance in advert serving services. Giving content creators and advertisers a realistic alternative to Google would have ultimately led to reduced costs and greater consumer choice.
By contrast, a Google/Yahoo! tie-up, or even limited outsourcing of advert placement by Yahoo! to Google, such as that announced by Yahoo! a few weeks ago in the US, would radically reduce competition, while generating no significant “efficiencies” to benefit advertisers and consumers. Any combination of the two would likely violate EU antitrust rules, with an outsourcing deal that sidelines Yahoo! as a competitor allocating approximate 90% of search advertising to Google, virtually ending prospects for competition (see the column "" by F. Etro for the Scottish newspaper The Scotsman, April 30). Even more importantly from an antitrust point of view, locking Yahoo!’s search query share and online traffic into Google’s ad platform would ensure that no one could reach the scale necessary to mount a credible competitive alternative.
After the temporary withdrawal of Microsoft (see the interesting article "" by J. Rayport for Business Week, May 10, 2008, on its possible reasons) new developments are expected. Online advertising is one of the most important markets in the future of the global economy. Its structure will be the endogenous result of the current events.
April 2008: The Economics of Online Advertising
We are at a crucial point of the development of the market for online advertising, and, after the recent merger between Google and DoubleClick, the possible acquisition of Yahoo! by Microsoft could entirely reshape the structure of this market. It is calculated that worldwide spending on advertising is currently above 600 billions $, of which at least 40 billions are spent in the online field (less than 10 %). Since 1994, when HotWire sold the first banner for advertising, and 1995, when Infoseek introduced search-based advertising, online ads have been constantly growing in all of their different forms (search advertising associated with search engines, display advertising, classified listings on web sites and email advertising).
The market is clearly destined to increase its share in the general advertising market, at least for the following reasons: 1) the Internet is rapidly growing and the large majority of websites generate revenues from advertising (with the notable exception of transaction websites as eBay); 2) other devices as mobiles and TV will be always more often connected to the Internet; 3) software innovation allows more efficient mechanisms to reach targeted consumers, today on the basis of the characteristics of search (keyword bidding system) and of the same websites (contextual advertising), in the near future on the basis of the characteristics of the Internet users as well.
A merger between Microsoft and Yahoo! would produce substantial synergies between two companies active in complementary markets and, most of all, could create a strong competitor against Google, whose dominance in pay-per-click Internet advertising has been now combined with DoubleClick's dominance in ad serving services. It is now interesting to evaluate the consequences for the future of online advertising of these two crucial mergers (one completed, one possible in the near future). We need to keep in mind the conditions under which a merger involving a market leader hurt consumers. A necessary condition for this is that the merger relaxes competition between the two merging entities and leads them to increase prices. Two further requirements are needed: first, the merger does not create efficiency gains; second, it does not attract endogenous entry of new firms. Of course, the extent to which a merger leads to price increases depends on multiple factors. First, high substitutability between the products of the merging firms brings higher incentives to increase post-merger prices (after all, firms producing unrelated goods would have no reason to increase their prices). Second, when price-cost margins are high, it is more profitable to increase prices. Third, when the firms operate in a multi-sided market (as a software platform which charges both publishers and advertisers), a price change can optimize network effects between sides leading to higher profitability. A merger between Microsoft and Yahoo! would mainly create synergies in R&D efforts without consequences on the prices of the main products of Microsoft (its operating system and Office) and Yahoo! (Internet services), which are complements and not substitutes. Antitrust authorities would hardly contest such a merger. Moreover, it would allow Microsoft and Yahoo! to join their forces and develop search engine capabilities and online advertising services able to represent an alternative to Google, so as to strengthen competition in the Internet. For these reasons, also the stock market appears to appreciate the offer of Microsoft.
Let us look at Google now. As well known, Google is the leading search engine in the world, with 53 % search traffic in US at the beginning of 2008, against 17% of Yahoo!, 7 % of Microsoft’s Live, 6 % of AOL and 3% of Ask, but with even higher market shares in other parts of the world (with the exception of Japan, where Yahoo! is the leader, and China, where Baidu is the leader). By the way, Yahoo! has been the leader in the US until 2002: before 2000 it was followed by Altavista, in 2001 by Microsoft and in 2002 by Google, which subsequently obtained the lead. Notice that competition for the market is crucial since access to any search engine is free and simple, and most users simply employ the search engine that is regarded as the most valuable. Of course, network effects are crucial here and, in the absence of substantial product differentiation, they lead to a single dominant player: today, Google enjoys such a position. Beyond this, Google dominates the lucrative business of placing text ads next to search engine result. Google AdWords (launched in 2000) accounts for about 70 % of search advertising revenue worldwide. DoubleClick leads the industry in directly placing banner ads on third-party publishers, accounting for more than 75 % of the direct (or reserved) channel, that is the valuable ad inventory that large web publishers directly negotiate with the advertisers (through their direct sale forces). Of course, a lot of the advertising space available on large websites and all of the space available on medium size and small websites cannot be sold in direct negotiations. Therefore, most of online advertising is typically sold through indirect intermediaries that buy the so-called “remnant” ad inventory from publishers and sell it to advertisers. This can be seen as a separate market from the market for the direct channel.
Google plays a major role in the market for intermediation services for remnant ad inventory. Google provides vertically integrated intermediation platform between online web publishers and advertisers: Google's AdSense reaches more than 80 % of the ad revenue in the indirect channel with integrated ad networks. The Google platform targets advertising to the relevant websites (so-called “contextual advertising”) and pays the web publishers with a percentage of its revenues. Meanwhile advertisers buy inventories from the platform through Vickrey auctions on the keywords that match the content of the webpages and lead Internet users to click on their advertisement: charges are typically for each click on the ad (CPC, cost per click), and the highest bid for each keyword association wins (with the price given by the second highest bid). As a competitor of Google before the merger, DoubleClick has been offering an ad serving and ad management product, DART, for publishers (DFP) and advertisers (DFA). Such a publisher tool manages the inventory of a website, receives the ads from ad networks and delivers them in the relevant inventory (according to the behavioral history of Internet users), usually at a fixed cost per thousand impressions (so-called CPM) which is a small percentage of the price that the web publisher charges on the advertisers. The market share of ad revenue served by DoubleClick’s DFP in the indirect channel with non-integrated ad networks is around 75 %. Since almost 60% of online advertising taking place through the indirect channel adopts integrated intermediation, Google controls about half of the market and DoubleClick about a third of it. After the merger they are going to control at least 80 % of the worldwide market for online advertising.
The two intermediation services that were separately offered by Google and DoubleClick before the merger were highly substitutable and, as a matter of fact, many web publishers used both for different inventories in their websites and in different moments. Needless to say, for these publishers the two services were interchangeable: they could easily recode some space on the website served by one channel to be served by the other channel. Adoption of the publisher tool provided by DoubleClick, or switching to a different one involve high sunk costs in terms of substantial investments in software, in training the staff, coding all of the publisher’s web pages, creating novel datasets, transferring ad campaigns to the system and so on, with all the associated business risk. For the same reason, multi-homing (with multiple non-integrated ad networks) is highly inefficient in this case. Notice that the high switching costs, together with the difficulty of building alternative high quality intermediation services in the short run represent a substantial barrier to entry of new firms in the short and medium run, which is the relevant time frame in such a rapidly evolving market. Finally, notice that this merger could create efficiencies in R&D spending in the future, but it is not going to create efficiencies through reduction of the marginal costs of production for the simple reason that these marginal costs (as typical of the software market) are already close to zero. Consequently, any increase in mark ups after the merger is going to lead to an increase in prices.
The bottom line of this story is quite simple. Before the merger, competitive forces kept online advertising prices under control: DoubleClick could not increase prices because many consumers would have quickly switched toward AdSense, and Google could not increase prices because many customers would have switched immediately to DoubleClick’s products. After the merger, these competitive constraints are about to disappear: Google will easily increase the price of DFP services being sure that most of the lost customers would simply switch to AdSense (the direct channel would be unavailable and more expensive, and other publisher tools would be penalized by the high switching costs). Given the high margins and the network effects that Google could enjoy by increasing its market share, the profitability of the price increase would be further enhanced. Moreover, Google could exploit the merger in its favor and against the competitors in other ways. For instance, DoubleClick uses a sophisticated algorithm to match ads to Web pages, and reports to advertisers, to inform them whether their ads were seen by the customers they tried to reach; now Google could shift the algorithm, favoring Google's own AdSense rather than other competitors. Finally, higher prices of DoubleClick may jeopardize the competitiveness of other products competing with the Google’s integrated channel, and the dominance of Google after the merger would be strengthened once again.
At this point, the outcome of the attempt of Microsoft to buy Yahoo! is crucial for the destiny of the market for online advertising: the merger could create the conditions to compete effectively with the dominant force of Google in online advertising. In such a case customers could only gain, as always when competition gets more aggressive.
March 2008: The Economics of Proprietary vs. Open Source Software
It is hard to overemphasize the importance for the New Economy of the scenarios emerging after the virtual conclusion of the Microsoft antitrust case with the recent events. First, with the European Commission admitting that, at least since last October, the American company has complied with the requirements on interoperability (the last huge fine was related to the lack of compliance until October 2007). Second, with the announcement made by Steve Ballmer for which Microsoft is going to take further substantial steps to promote further interoperability in the software industry, even with the open source community, with which there has been a strong contrast until now. This will happen at the global level, going beyond the requirements of the EU antitrust authorities, whose reaction, nevertheless, has been quite cold. Not surprising, if we recall that the Competition Commissioner has explicitly cited as one of her objectives a radical reduction of the alleged monopolist’s market share (a view reiterated in many public interviews).
Such an objective may reflect a dangerous misunderstanding of this dynamic market. As a wide academic literature on the endogenous market structures has shown, a large market share in a high-tech sector can be the consequence of low prices charged by a leader in a market with network effects and endogenous entry, and not of unconstrained market power; therefore, antitrust enforcement to promote consumer welfare should not be driven by the aim of reducing a firm’s market share, but should instead preserve competitive entry in the market. Moreover, we should remember that a forced disclosure of intellectual property rights and trade secrets may be welcomed by competitors, but it may also act as a threat for the innovative efforts of other European companies that base their success on costly innovations - think of the biotech sector or the pharmaceutical one. Therefore, not only should Microsoft’s move not be dismissed, but it should be welcomed as a major change in the software sector that will help ensure endogenous entry by facilitating the development of products that work well with Microsoft’s own, and that will contribute to reduce the contrast between the open source world and the proprietary software world.
The lasts events in the software market lead us to an analysis of the economics of proprietary software versus open source software (OSS). Here, we will evaluate the relation between the two, and the role of the open source community in the R&D activity within the software market. While IPRs are fundamental drivers of innovations in all sectors, software development has recently been characterized by a certain amount of innovations obtained in a decentralized, voluntary and uncompensated way by programmers within the so-called open source movement. Let us first define the subject of our discussion: OSS is a software which is made available for direct use and modification (through direct access to the source code) under limited protection. For instance, the General Public License (GPL) grants unlimited right to use, modify and distribute software as long as its redistribution makes available the modified source code and does not impose further restrictions on the rights granted by the GPL. Besides software that is freely distributed, there is an increasing number of companies, like Red Hat and Novell, that profit from collateral services supplied jointly with free software. In a sense, the difference between proprietary software and open source software appears much less relevant: the former earns from licenses to end-users, the latter mainly licenses software free of charge and earns from selling support description needed by end-users to install and run the software.
These factors imply some limitations of the benefits of OSS compared to proprietary software:
- the effective total cost of ownership of OSS is not necessarily lower than the total cost of ownership of proprietary software, since the expected discounted value of the costs of consulting, maintenance, personnel training and of the updates represent the main part of the mentioned total cost;
- the short run cost of OSS can be lower, but the long run cost is typically higher compared to proprietary software, therefore institutions with short term constraints or objectives, or with a myopic management may adopt the former even when the latter is the best option in the long run (think of local government procurement under budget balance or political constraints).
While many private corporations support OSS because they supply products that are complementary to open source software, it remains surprising that such a large innovative process can take place, at least in part, through directly unrewarded efforts. Lerner and Tirole have provided a few explanations for the incentives of these individual programmers: career concern, ego gratification and signalling activity are quite powerful and effective in this field. Unfortunately, the same nature of these incentives shows the possible limitations of the innovative activity in the open source community:
- R&D in OSS is limited by the usual free riding problems emerging in the private provision of public goods (suboptimal incentives to invest in the creation of a public good as free knowledge);
- voluntary engagement in the development of OSS requires a complementary activity in the for-profit sector to motivate the career concern and the signalling activity;
- decentralized and voluntary R&D in OSS may be biased by research efforts that are different from general consumer needs and by adverse selection of the contributors;
- voluntary contribution to OSS may be effective to solve a number of small and short term problems, but less effective to solve multi-sided challenges and approach long term projects: for instance, it is often claimed that OSS is more effective than proprietary software in debugging activity (since many programmers find and solve many defects within a software and make the solutions freely available), but may have big problems confronting issues as synchronization of upgrades and efficient levels of backward compatibility.
These factors imply that OSS cannot replace the role of proprietary software in the software industry, but can only preserve a limited and complementary role. Beyond this, a complete evaluation of the role of OSS in research & development within the software sector must consider the crucial issue of the proper incentives to invest. Most academic researchers agree that the protection of intellectual property rights is the best way to promote innovative investments, and that the value of IPRs, and in particular of the patents, must trade off these benefits with the distortionary effects associated with pricing. A field in which patents are particularly valuable and induce high investments in R&D is exactly the software sector. Nevertheless, we cannot rule out the possibility that R&D in the OSS community can exert a positive effect on the incentives to invest of the major innovators in the field, the leaders in proprietary software: the competitive pressure from OSS has led technological leaders to continue investing in R&D, and major advances such as the iPhone or Microsoft Surface keep arriving from the commercial software world.
However, restrictive open source software creates a fundamental asymmetry. On one side, open source software companies (allied with big business, such as IBM) can use proprietary software within their products and freely distribute them while covering license expenditures through customer support services. On the other side, commercial companies cannot pursue their business model when including open source within their software, because they would infringe the "copyleft" if they apply a price to the license. This asymmetry can create substantial problems for the conventional business model, and may inhibit or bias consumer-driven innovation.
Finally, the notion, sometimes suggested by OSS advocates, that European competitiveness vis a vis fast growing countries as China or India will be enhanced by the promotion of the open source software model is preposterous. GPL is built on the proposition that anything you do and distribute can be freely appropriated by anyone within or outside Europe, in fact handing over the result of your investment to others on a silver platter. Moreover, notice that the same rapid development of the software sector in India has been entirely based on proprietary software and not on open source software: the most spectacular example in the world of growth driven by research & development in the software sector has nothing to do with OSS.
A last crucial point concerns the claimed advantages of OSS in terms of interoperability. It is sometimes claimed that there may be a trade-off between IPRs and trade secret protection and "interoperability" between products. Interoperability is important in the PC industry and it has strongly increased in the last decades. Problems arise, however, when interoperability is confused with "interchangeability" or with a right to clone the innovations of the competitors, a right often presented as natural sign of openness in the open source community. Fortunately, giving up the precious role of IPRs in promoting innovations is not needed at all to solve interoperability challenges. The market can do it much better: valuable ideas can be selectively commercialized on a voluntary basis through licenses, for instance under RAND (reasonable and non discriminatory) terms, a type of licensing typically used during standardization processes to promote the rapid adoption of standards and new technologies and to encourage entry. The RAND terms include a definition of reasonable royalties, and can include further restrictions as field-of-use clauses (that allow licensees to utilize a patented technology in a use that is directly related to the implementation of the standard), reciprocity clauses, or limits to sublicensing. Notice that extreme open source licenses can create frictions with RAND terms associated with other licenses, so as to jeopardize useful innovative activity - this is the case of the GNU General Public License, which is incompatible with technologies licensed with any positive royalty, field-of-use limitations or other standard restrictions.
February 2008: The Battle for the Internet
The possible acquisition of Yahoo! by Microsoft, announced on February 1st, 2008, and the merger between Google and DoubleClick, announced in April 2007 and currently under the scrutiny of the European Commission, will be a turning point in the fight to dominate the Internet. The first merger would produce substantial synergies between two companies active in complementary markets and, most of all, could create a strong competitor against Google for search engines and related on line advertising. The second merger would combine Google's dominance in pay-per-click Internet advertising with DoubleClick's dominance in ad serving services. Consumer groups have aggressively pushed regulators to reject the Google merger on the grounds that it would spawn a privacy nightmare, but after the strategic offer of Microsoft for Yahoo!, it can be useful to examine the issue from a purely economic point of view.
When does a merger involving a market leader hurt consumers? A pre-condition for this is that the merger relaxes competition between two firms and leads them to increase prices. Two further requirements are needed: first, the merger doesn’t create efficiency gains; second, it doesn’t attract entry of new firms. Of course, the extent to which a merger leads to price increases depends on multiple factors. First, high substitutability between the products of the merging firms brings higher incentives to increase post-merger prices (after all, firms producing unrelated goods would have no reason to increase their prices). Second, when price-cost margins are high, it is more profitable to increase prices. Third, when the firms operate in a multi-sided market (as a software platform which charges both publishers and advertisers), a price change can optimize network effects between sides leading to higher profitability.
A merger between Microsoft and Yahoo! would mainly create synergies in R&D efforts without consequences on the prices of the main products of Microsoft (its operating system and Office) and Yahoo! (Internet services), which are complements and not substitutes. Antitrust authorities would hardly contrast such a merger. Moreover, it would allow Microsoft and Yahoo! to join their forces and develop search engine capabilities and online advertising services able to represent an alternative to Google, so as to strengthen competition in the Internet. What about the merger between Google and DoubleClick? As well known, Google dominates the lucrative business of placing text ads next to search engine results. DoubleClick leads the business of placing banner ads on publishers, dominating the direct advertising channel, that is the valuable ad inventory that large web publishers directly negotiate with the advertisers. But this is not the end of the story, because most of the advertising space available on websites cannot be sold directly: most of it is sold through intermediaries that buy the so-called “remnant” ad inventory from web publishers and sell it to advertisers. In this huge “indirect” market Google and DoubleClick have been strongly competing, with Microsoft and Yahoo! playing a marginal role until today.
Google provides a vertically integrated intermediation platform between online publishers and advertisers: its AdSense reaches more than 80 % of the revenue in the indirect channel with integrated ad networks, again with Microsoft and Yahoo! trying to catch up. This platform targets advertising to the relevant websites and pays web publishers a percentage of its revenues. Meanwhile, advertisers buy inventories from the platform through bids on the keywords that match the content of the webpages. DoubleClick offers a substitute product, DART for both publishers (DFP) and advertisers (DFA). The publisher tool, in particular, manages the inventory of a website, receives the ads from ad networks and delivers them in the relevant inventory for a percentage of the advertising price. The market share of DFP is around 75 %. Since almost 60% of online advertising taking place through the indirect channel adopts integrated intermediation, Google controls about half of this global market and DoubleClick about a third of it. After the merger, they will control at least 80 % of the worldwide market for online advertising, with Microsoft and Yahoo! left behind.
The two services offered by Google and DoubleClick are highly substitutable (many web publishers use both for different inventories in the same website) and alternatives are hardly available. Switching to a different publisher tool involves high sunk costs in terms of investment in software, training of the staff, coding all of the publisher’s web pages, transferring ad campaigns to the system…These high costs, together with the difficulty for other companies, even Microsoft and Yahoo! until now, to build alternatives have represented a substantial limit to entry of competitors. Consequently, after the merger (which would not affect the marginal cost of production, already close to zero), Google will be able to increase the price of DFP services, and be sure that most of the lost customers will switch to AdSense. The profitability of this strategy would be enhanced further because of the high margins and of the network effects that Google could enjoy by increasing its market share (more publishers, more advertisers, more searches and so on). Moreover, higher prices of DoubleClick may jeopardize competition and innovation of other firms competing with Google’s integrated channel, and the dominance of Google after the merger would be strengthened once again. But all of this doesn’t take the Microsoft move into account.
The reply of Microsoft to the Google expansion is crucial: a merger with Yahoo! could create the conditions to compete effectively with the dominant force of Google in online advertising. As always in these cases, aggressive competition will reward consumers with better products and lower prices.
January 2008: Trade, Growth, Business Cycle and Entry
At the held on December 12, 2007, Prof. Etro, President of Intertic presented the basic insights of the Theory of Endogenous Market Structures and its applications. A technical version of the Lecture focusing on the macroeconomic applications of this approach can be found in Endogenous Market Structures and Macroeconomic Theory (2007, Tijdschrift voor Economie en Management, Vol. 52, 4, pp. 517-40). This work introduces the most recent theories of growth, international trade and business cycles taking into account market structures which depart from the perfectly competitive paradigm and endogenize strategic interactions and entry. In this sense, it goes beyond both the neoclassical theory and the more recent applications of the theory of monopolistic competition to macroeconomics. Our approach, that we define as the EMS ("endogenous market structure") approach, introduces standard theories of imperfect competition, as Cournot, Bertrand and Stackelberg competition in a macroeconomic framework where entry in the markets is free but constrained by costs of entry. The work builds on the microfoundations developed in recent industrial organization research, and applies it to revisit the theory of endogenous growth, the theory of international trade and the theory of real business cycles and to derive a number of policy results.
The foundation of the modern economic theory is based on neoclassical models developed within the constant returns to scale / perfect competition framework. In this framework, entry of firms is endogenous in the sense that all firms expect zero profits at each point in time, but the market structure is indeterminate: whether one or infinite firms produce each good is irrelevant as long as there are constant returns to scale, and strategic interactions do not play any role. This happens in the standard theory of real business cycles and in the neoclassical theory of trade (which are both based on perfect competition in the goods markets), and even in the standard theory of Schumpeterian growth (based on constant returns to scale and no arbitrage condition determining the aggregate investment in R&D). In the last three decades, economists have emphasized the importance of increasing returns to scale and market power, and these factors have been introduced and widely used in the modern theories of international trade (starting with Krugman, 1980), of the business cycle (starting with Blanchard and Kiyotaki, 1987), and of endogenous growth (starting with Romer, 1990). Nevertheless, most of the literature has adopted the monopolistic competition framework of Dixit and Stiglitz (1977) in which strategic interactions do not play any role given the high number of players, and the number of firms has been often kept exogenous (typically in the theory of business cycles). Therefore, the macroeconomic literature has systematically neglected either the strategic interactions between firms or the endogeneity of entry. We believe that the lack of consideration for the rationality of the entry decisions and of the interaction between these and the strategic decisions of the firms are a crucial limit of the modern economic literature, especially because the rest of it is largely relying on the rationality of all the agents and of their expectations.
Recent microeconomic investigations on market structures where entry is endogenous have provided a number of applications for the theory of industrial organization, especially for the understanding of investments in R&D and in advertising, of the determinants of the financial structure, and of the behavior of market leaders (with particular reference to predatory strategies, price discrimination, bundling and vertical restraints), of the effects of mergers and of the effectiveness of price fixing agreements (which of course have crucial consequences for antitrust policy). The endogenous entry approach, however, can be relevant also for the analysis of macroeconomic issues.
The main role the EMS approach for macroeconomic analysis is to clarify a new channel through which competition in markets affects the aggregate economy. We may describe it in a simple way taking in consideration the theory of business cycles. Most of the modern theory of the business cycle, starting with Kydland and Prescott (1982), is based on the constant returns to scale/ perfect competition/ flexible price framework of the so-called Real Business Cycle literature. Since a wide macroeconomic evidence suggests the relevance of departures from the perfectly competitive model, economists have introduced increasing returns to scale and monopolistic competition and have widely used them in the modern general equilibrium new Keynesian literature (together with price rigidities for monetary analysis). Nevertheless, strategic interactions have been neglected because they are absent in the standard monopolistic competition model, and because competition in quantities has never been taken in consideration in a literature that was mainly interested in introducing price rigidities to study the real effects of monetary shocks (and therefore always focused on price choices), while entry has been almost always considered exogenous because the crucial consequences of price rigidities (due to small menu costs or imperfect price adjustments) depended on the existence of market power and positive profits of the firms. As a consequence, macroeconomics has been virtually silent on the fluctuations of the number of firms, on the degree of competition in the markets, on the endogenous mark ups, and on the interaction between these fluctuations and those of the aggregate variables as output, consumption, and employment. To see how the endogenity of the market structures can play a crucial role in propagating the business cycle beyond what happens in standard neoclassical models, we will consider the impact of a standard productivity shock. Suppose that the marginal cost of production exhibits a temporary reduction in all the sectors (for instance because of a temporary reduction in the oil price). In a perfectly competitive sector, all prices equate the marginal costs of production and the shock is instantaneously transferred to the prices: since the price reduction follows the reduction in the marginal cost and is temporary, consumption has a temporary boom which in turn pushes the economy. Now consider sectors characterized by few firms competing in quantities and entering endogenously in the markets. Since firms price at a mark up on the marginal cost, the shock has an initial positive impact on the individual profits, which attracts entry of new firms. Entry strengthens competition which reduces the equilibrium mark ups. This in turn implies that the prices are reduced by more than the reduction in the marginal cost, and the boom in consumer demand is therefore magnified by the competition effect (compared to a perfectly competitive economy). Of course over time the strengthening of competition reduces the individual profits and brings back entry to the initial level. This set up allows to study a number of policy issues including the effects of fiscal and monetary policy. For more on this see Endogenous Market Structures and the Business Cycle.
The same mechanism works in an international context as well. Here, the EMSs approach emphasizes a new form of gains from trade, beyond the traditional one identified by Krugman and associated with the increase in varieties enjoyed by consumers after a country opens up to trade. When strategic interactions are relevant because the number of producers in each sector is limited, opening up to trade enlarges the set of competitors and strengthens competition, which reduces mark ups and prices in turn. This competition effect limits entry, therefore the gains from trade due to more varieties decrease and the gains from trade due to lower prices increase. Moreover, one can study the impact of shocks in an open economy context as well. For instance, a supply shock in one country may induce further entry of its firms in the local sectors for non tradable goods or in the global sectors for tradable goods, reducing the respective mark ups and magnifying the impact of the shock in the domestic market or in the global market as well. Finally, the EMS approach allows to address in a new way a number of aspects of trade policy. One of the most important results is the proof of the general optimality of export subsidies for firms competing in global markets with endogenous entry (against the traditional ambiguous results). For more on this see Endogenous Market Structures and Strategic Trade Policy.
Finally, entry driven by profitable opportunities is what drives investments in R&D and therefore technological progress, and is at the basis of the theory of Schumpeterian growth. Applying the EMS approach to competition for the market in the presence of sequential innovations, allows to open the black box of the engine of growth and study a number of new issues. For instance, our approach allows to identify how many firms and which one invest in R&D, determine the incentives of the technological leaders to invest, derive the general optimality of R&D subsidies and characterize the optimal international organization of R&D policy. For more on this see Growth Leaders.
December 2007: A Manifesto for the Endogenous Market Structures Theory
The foundation of the modern economic theory is based on neoclassical models developed within the constant returns to scale / perfect competition framework. In this framework, entry of firms is endogenous in the sense that all firms expect zero profits at each point in time, but the market structure is indeterminate: whether one or infinite firms produce each good is irrelevant as long as there are constant returns to scale, and strategic interactions do not play any role. This happens in the standard theory of real business cycles and in the neoclassical theory of trade (which are both based on perfect competition in the goods markets), and even in the standard theory of Schumpeterian growth (based on constant returns to scale and no arbitrage condition determining the aggregate investment in R&D).
In the last three decades, economists have emphasized the importance of increasing returns to scale and market power, and these factors have been introduced and widely used in the modern theories of international trade (Krugman, 1980), of the business cycle (Blanchard and Kiyotaki, 1987), and of endogenous growth (Romer, 1990). Nevertheless, most of the literature has adopted the monopolistic competition framework of Dixit and Stiglitz (1977) in which strategic interactions do not play any role given the high number of players, and the number of firms has been often kept exogenous (typically in the theory of business cycles). Therefore, the macroeconomic literature has systematically neglected either the strategic interactions between firms or the endogeneity of entry. We believe that the lack of consideration for the rationality of the entry decisions and of the interaction between these and the strategic decisions of the firms are a crucial limit of the modern economic literature, especially because the rest of it is largely (and sometimes excessively) relying on the rationality of all the agents and of their expectations.
Recent microeconomic investigations on market structures where entry is endogenous have provided a number of applications for the theory of industrial organization, especially for the understanding of investments in R&D and in advertising, of the determinants of the financial structure, and of the behaviour of market leaders (with particular reference to predatory strategies, price discrimination, bundling and vertical restraints), of the effects of mergers and of the effectiveness of price fixing agreements (which of course have crucial consequences for antitrust policy). Many of these applications have been and are widely described and discussed by Intertic. The endogenous entry approach, however, may be relevant also for the analysis of macroeconomic issues.
The main role of a theory of endogenous market structures in macroeconomic analysis is to clarify a new channel through which competition in markets affects the aggregate economy. We may describe it in a simple way taking in consideration the theory of business cycles. Most of the modern theory of the business cycle, starting with Kydland and Prescott (1982), is based on the constant returns to scale/ perfect competition/ flexible price framework of the RBC literature. Since a wide macroeconomic evidence, at least starting with the work of Hall (1986, 1990), suggests the relevance of departures from the perfectly competitive model, economists have introduced increasing returns to scale and monopolistic competition and have widely used them in the modern general equilibrium newkeynesian literature (together with price rigidities for monetary analysis). Nevertheless, most of this literature has neglected both the strategic interactions between firms and the endogeneity of entry. Strategic interactions have been neglected because they are absent in the standard monopolistic competition model, and because competition in quantities has never ben taken in consideration in a literature that was mainly interested in introducing price rigidities to study the real effects of monetary shocks (and therefore always focused on price choices). Entry has been almost always considered exogenous because the crucial consequences of price rigidities (due to small menu costs or imperfect price adjustments) depended on the existence of market power and positive profits of the firms. As a consequence, macroeconomics has been virtually silent on the fluctuations of the number of firms, on the degree of competition in the markets, on the endogenous mark ups, and on the interaction between these fluctuations and those of the aggregate variables as output, consumption, and employment. We believe that the lack of consideration for the rationality of the entry decisions, and of the strategic decisions is a crucial limit of the modern literature on the business cycles.
To see how the endogenity of the market structures can play a crucial role in propagating the business cycle beyond what happens in standard neoclassical models, we will consider the impact of a standard productivity shock. Suppose that the marginal cost of production exhibits a temporary reduction in all the sectors (for intance because of a temporary reduction in the oil price). In a perfectly competitive sector, all prices equate the marginal costs of production and the shock is instantaneously transferred to the prices: since the price reduction follows the reduction in the marginal cost and is temporary, consumption has a temporary boom which in turn pushes the economy. Now consider sectors characterized by few firms competing in quantities and entering endogenously in the markets. Since firms price at a mark up on the marginal cost, the shock has an initial positive impact on the individual profits, which attracts entry of new firms. Entry strengthens competition which reduces the equilibrium mark ups. This in turn implies that the prices are reduced by more than the reduction in the marginal cost, and the boom in consumer demand is therefore magnified by the competition effect (compared to a perfectly competitive economy). Of course over time the strengthening of competition reduces the individual profits and brings back entry to the initial level. This mechanism has been developed in by Andrea Colciago and Federico Etro (November 2007).
The same mechanism works in an international context as well. For instance, a similar shock in one country may induce further entry of its firms in the local sectors for non tradable goods or in the global sectors for tradable goods, reducing the respective mark ups and magnifying the impact of the shock in the domestic market or in the global market as well. Finally, entry driven by profitable opportunities is what drives investments in R&D and therefore technological progress, and is at the basis of the theory of Schumpeterian growth. Further work is needed in particular at the borders between the three cited fields where the theory of endogenous market structures can provide a contribution: growth, business cycles and trade. The theory of Schumpeterian growth with endogenous market structures in the competition for the market could be used to investigate the impact of shocks on growth performance. The theory of business cycles with endogenous market structures could be extended to open economies, but also to monetary frameworks. Finally, the theory of trade with endogenous market structures could be used to study global endogenous growth.
October-November 2007: The Economic Implications of the CFI Ruling
On September 17, 2007 the Court of First Instance concluded the Appeal of the Microsoft vs EU Commission case and essentially upheld the 2004 Commission decision, finding that Microsoft abused its dominant position both for bundling the operating system Windows with Windows Media Player (WMP) and for the refusal to supply interoperability information in the work group server operating system market. The fine of EUR 497 million was also confirmed, while the Court annulled parts of the 2004 decision relating to the appointment of a monitoring trustee, which have no legal basis in the Community Law.
Here, I will comment on this ruling and its consequences from an economic point of view. This implies that I will pay particular attention to the implications for consumer welfare. While there is a wide economic consensus on giving priority to the interests of the consumers and the same Commissioner Kroes has repeatedly emphasized this aspect, the Microsoft case is a clear example of an antitrust case in which the interest of consumers has played a marginal role. First, the case started and developed without a single consumer or any consumers’ association complaining about Microsoft conduct, just through the complaints of rivals of Microsoft in different markets - in a similar way to what happened in the US vs. Microsoft case. Second, economic analysis of the interests of the consumers has played virtually no role in the discussion of the case emerging from the official documents - somewhat differently from what happened in the US case. Third, the outcome of the case was to punish Microsoft for distributing for free a product and to force Microsoft to disclose its patents and trade secrets. Even if I was a skilled politician, I would find it hard to explain to an average citizen and PC user why this decision could be in ones own interest. Of course, the magic formula for which Microsoft has been punished for abusing its quasi-monopolistic position could be used, but unfortunately what is behind the Microsoft case is quite different, and requires a more detailed analysis. My discussion will concentrate on the CFI ruling, focusing first on the bundling part of the case, which is the weakest and the most surprising after what happened in the recent years, and then on the interoperability part.
The reasoning of the Commission, substantially adopted by the CFI ruling is based on the following points:
1) media players would be separate products from OSs, therefore OSs and media players would characterize two distinct markets: a primary market for OSs and a secondary one for media players;
2) Microsoft is the leader of the primary market with an extremely large market share, therefore Microsoft is a dominant firm; Microsoft has engaged in pure (not mixed) bundling, therefore consumers would have no choice to obtain their optimal bundle;
3) the bundling strategy of the dominant firm may foreclose competition in the secondary market, therefore it would represent an abuse of a dominant position. In particular, potential foreclosure would occur through an indirect network mechanism:
3.1) content providers would choose to encode in a single media format and software developers would develop their technologies to be used on a single media format to save in costs;
3.2) the ubiquity of WMP obtained through bundling would lead content providers and software producers to limit their applications to WMP to reach the maximum percentage of consumers;
3.3) all consumers would use exclusively WMP since this would allow most of the content to be available.
Each one of these points is problematic.
Contrary to the claim in point 1), the fact that virtually all PCs (including those with other OSs than Windows) are sold with media player functionalities shows that there is not consumer demand for OSs without media player software, therefore there is not a distinct market for OSs without media players. Focusing on the existence of consumer demand for media players and emphasizing the existence of a separate market for media players (with the notable feature that its equilibrium price is zero), the Commission has ignored the recent evolution of the software market establishing a distinction that does not exist anymore. Whether or not consumer demand exists for the tied product is the wrong question to determine whether there are two distinct markets; the correct question is whether there is any significant consumer demand for the tying product without the tied product. Unless the analysis focuses on this question, there is a danger that the mere existence of consumer demand for the tied product may prevent the emergence of efficient tying arrangements and end up protecting suppliers of tied products at the expense of consumers and innovation. To exemplify our doubts, notice that, while there is clearly consumer demand for shoelaces, this should not mean that shoes and shoelaces are distinct products for the purposes of tying analysis. This issue can only be addressed by asking whether there is consumer demand for shoes without shoelaces.
Moreover, in the case of technical integration of two products that were previously distinct, the distinct products test itself may not be helpful for understanding market dynamics because, by definition, this test is backward-looking. A better approach in these cases would be simply to ask whether the company integrating the previously distinct products can make a plausible showing of efficiency gains in the interest of consumers: since technical tying is normally efficient, market leaders would be able to continue producing innovative products benefiting consumers without running systematic risk of incurring in the prohibitions on tying. None of this has been taken in consideration in the Microsoft case. Finally, since tying usually enhances price competition, it should never be abusive when it is standard commercial practice, which is also indirect evidence that such tying generates efficiencies, or that there is no demand for the unbundled product.
Ignoring altogether the efficiency rationale of bundling in an innovative and rapidly evolving sector, the Commission has clearly rejected the traditional approach to bundling associated with the so-called Chicago School (see for instance of Richard Posner, from the University of Chicago). On the contrary, the points 2) and 3) show that the Commission has entirely adopted one of the thesis of the so-called post-Chicago approach to antitrust (see in particular the theory of bundling of Michael Whinston, from Northwestern University): this theory suggests that bundling is used by a dominant firm to foreclose competition by a rival in the tied product market. The defense of Microsoft has been largely based on stressing the technological nature of the integration of Windows and WMP and the speculative nature of the indirect network theory. In reality, the reasoning of the Commission has other major problems that have emerged only indirectly in the case, and that brings us straight to the interests of consumers, which should be always the priority.
The economic rationale of the Commission is based on the idea that a monopolist in a primary market would bundle the primary good with a secondary good to strengthen price competition and to induce the exit of a rival which is exclusively active in the secondary market; the ultimate purpose of the monopolist would be to extend its monopoly power to both the primary and the secondary market. This idea is well known between economists and it is associated with the post-Chicago approach to antitrust, and in particular with the famous work of Whinston (1990): bundling for predatory purposes is indeed a realistic possibility and in theory it may induce harm to consumers. Nevertheless, it is also well known between economists that this theory does not work when (Etro, 2007):
1) the secondary market is characterized by rapid and endogenous entry and evolving technological conditions;
2) product differentiation which allows multiple secondary goods to be consumed with the primary good.
Under these conditions, bundling has the usual role of strengthening price competition, but the constant competitive pressure (both effective and potential) in the secondary market does not allow the bundling firm to increase the prices, and the level of product differentiation allows the rivals to maintain large market shares. As a consequence, the only reason for which bundling occurs is a normal form of healthy competition, which induces a reduction in the price level for both the bundle and the secondary goods, does not deter entry, and increases consumer welfare.
In other words, while the Commission would be correct in endorsing the post-Chicago theory to bundling cases in which a monopolist in a primary market faces a single competitor in a secondary market and induces the exit of the latter through bundling, the Commission is erroneously applying the same theory when the secondary market satisfies conditions a) and b) above. I will now point out the reasons for which these conditions are indeed satisfied in the Microsoft case.
First of all, the last decade has witnessed a rapidly evolving composition of the market for media players, with constant introduction of new and better products by multiple firms. Currently the most used media player is not even WMP, but Flash by Adobe, which is the media player commonly used to watch videos on YouTube. Competition is quite strong, to the point that the price of all the most used media players corresponds to the marginal cost, which in this market is zero, and the buying costs for consumers are also close to zero since these products can be freely downloaded in a few seconds online.
Second, the supply of media players is characterized by a substantial product differentiation, with some media players that are developed for audio content, some that are better for video contents, others for music content, and still others that are ideal for storing music files, and so on. Not by chance, most consumers have multiple media players and use different media players for different purposes and for different contents. Also for these reasons, content providers and software developers provide content and applications that interoperate with all the most used media players: this is what allows the maximum percentage of customers to be reached.
Consequently the bundling strategy of Microsoft could be simply seen as an aggressive and competitive strategy of a market leader active in a secondary market where entry is indeed endogenous. Moreover, in these markets the standard strategy is to provide free software to enhance network effects and earn from externalities associated with the use of the software (a typical strategy in multisided markets). For instance, in the case of digital media platforms, Microsoft looks for network effects on licenses of its OS, Real earns from content subscriptions, Apple from sales of digital audio and video devices (the iPod and, in perspective, the iPhone) and Adobe from Flash server sales. This implies different levels of platform integration and interoperability with different platforms. As Evans et al. (2006) noticed: "At one extreme is Apple. Its iPod/iTunes platform is integrated into the hardware and content-provider sides of the media platform, and its doesn't interoperate with any other platform. At the other extreme is Microsoft, whose media platform is integrated into neither hardware nor content and which interoperates with all other media platforms that allow it to do so. In the middle are vendors like RealNetworks, which limit interoperability - but not completely - and integrate - but only partially - into the content provider side." Even if these companies adopt very different business models, competition is quite intense because multi-homing is common practice: end users typically use multiple media players, and also PC manufacturers typically install multiple competing media players at their will (while this is not the case for digital music devices and mobile phones).
I will now move to the interoperability part of the case, which requires a wide premise on the role of intellectual property rights in the New Economy. In Etro (2007) I discussed the role of market leaders in innovative markets and the importance of the protection of IPRs in stimulating investment in R&D and technological progress. Both aspects are quite relevant in the understanding of the dynamics of the software market and the Microsoft case. The software market is a major example of an industry where competition is mainly for the market, and in such a case large market shares by single firms are a typical outcome. The counterpart of this, of course, is that these industries can exhibit catastrophic entry where innovators can replace current leaders quite quickly. In such an environment, it is exactly when competition is open that leaders have incentives to invest deeply to retain their leadership. On the contrary, when competition for the market is limited, technological leaders are able to have a quiet life, invest less in R&D and accept the risk that someone will come up with a better product. When competition for the market is open, this same risk is too high and incumbents prefer to accept the challenge and try to innovate first: paradoxically, competition leads to a more persistent leadership.
Moreover, when entry is endogenous, innovation by leaders creates a virtuous circle that also has important implications for the way we can evaluate such a market. The endogenous persistence of the technological leadership has a value that creates incentives for all firms to invest even more, which in turn strengthens the same incentives of the leader to invest and retain its leadership, and so on. In other words, persistence of leadership is a source of strong competition for the market (through investments in R&D to replace the current leader), and, given that leaders have higher incentives to invest as long as the race to innovate is open, we can also conclude that strong competition for the market is a source of persistence of leadership. This circular argument may appear paradoxical, but is the fruit of a radical distinction between static and dynamic competition: once more, there is no consistent correlation between market shares and market power in dynamic markets.
The endogenous multiplicative effect of the value of leadership that we have just summarized implies that in dynamic markets the rents of a leader may be spectacularly larger than those of its competitors, and the market value of a leadership may be extremely large even if the market is perfectly competitive in a dynamic sense. In our view, this is something not too far from what we can see in the software market and in the leadership of Microsoft, but also in many other high-tech sectors.
The source of the value of innovation, the starting point of the chain of value that we just described, must be a fundamental rent associated with innovations and protected through IPRs. Hence, all forms of IPRs are the ultimate source of leadership, innovation and technological progress. As we already noticed, the role of patent legislation is exactly to trade off the benefits of patents in terms of incentives to innovate with the costs related to temporary monopolistic pricing. In our opinion, there is no reason why antitrust authorities should interfere with this legislation when patent protection appears inconsistent with other goals. And even if these goals are legitimate and relevant, introducing a discretionary evaluation of IPRs would create uncertainty and jeopardize the investment, which, after all, goes against the ultimate objective of the same antitrust authorities. Nevertheless, in the Microsoft case the EU Commission has taken this dangerous direction, asking Microsoft to disclose a wide amount of technologies.
At the beginning of 2007 (Statement of Objections of March 1st), the Commission has asked to make them available royalty free unless they have an innovative nature (meaning that they involve an inventive and novel step compared to the prior art). Finally, it has started questioning the same innovative nature (and with it the license pricing) of most technologies that Microsoft was forced to disclose, technologies which are also covered by many patents approved by US and EU patent offices. This creates an even stronger contradiction between patent law and antitrust policy in the EU, and also a substantial divergence between the US approach to IPRs and the EU approach, with the former much more careful in protecting IPRs and promoting R&D. Unfotunately, the CFI ruling of September 17, 2007, has substantially approved the Commission approach.
In high-tech sectors, patents and trade secrets often cover fundamental inventions, and protecting those inventions amounts to promoting innovations that today are the main engine of growth. In some fields, however, there maybe, at least apparently, a trade-off between trade secret protection and "interoperability" between products - broadly speaking, this is the ability of heterogeneous information technology systems, components and services to exchange and use information and data, especially in networks. Interoperability is important in the PC industry and, as we have seen above, the level of interoperability has strongly increased in the last decades. Problems arise, however, when interoperability is confused with "interchangeability" or with a right to clone the innovations of the competitors.
For instance, take in consideration the leading on line search engine in the world, Google. We may look at Google's patented innovations, starting with the 2001 patent on the invention of the PageRank, but we would need to know its trade secrets to fully discover the mechanism of its precious algorithms. Forcing disclosure of such trade secrets may help software companies and websites to interoperate with Google even better than they already do, as it would allow other search engines to improve their performances compared to that of the leading search engine. But after that, surely, few companies would invest huge resources and take substantial risks to create a better search engine or other brilliant ideas like Google when they can just free ride on others' ideas and/or they can't be sure of their return. The same argument would apply for the trade secrets of Microsoft or Apple on the source codes of their OSs and to many other trade secrets of innovative leading companies. Any forced disclosure of similar trade secrets represents an expropriation of legitimate investments and establishes inappropriate legal standards with perverse effects on the incentives to innovate.
Fortunately, giving up the precious role of IPRs in promoting innovations is not the only way to solve interoperability challenges. The market can do it much better: valuable ideas can be selectively commercialized on a voluntary basis through licenses, for instance under RAND (reasonable and non discriminatory) terms, a type of licensing typically used during standardization processes to promote the rapid adoption of standards and new technologies and to encourage entry. The RAND terms include a definition of reasonable royalties, and can include further restrictions as field-of-use clauses (that allow licensees to utilize a patented technology in a use that is directly related to the implementation of the standard), reciprocity clauses, or limits to sublicensing. The Nobel prize winner Ronald Coase (1960) has clarified that whenever there is social value to generate, the market will properly allocate all the property rights. This is also true for the intellectual property rights: market mechanism can allocate them efficiently, insure the accessibility of the information that fuels interoperability and acknowledge legitimate ownership rights of the innovators, so as to enhance R&D investments.
In conclusion, also in this field, markets can properly balance the short run and long run interests of consumers better than policymakers: promote innovation, enable an efficient degree of interoperability and select the best standards. It would have been better to leave the ruling of intellectual property protection and of its limits to the legislative level rather than creating an important precedent for which antitrust authorities could force firms to reveal their IPRs, as recently happened in the Microsoft case.
September 2007: Microsoft and EU Competition Policy
In March 2004, the European Commission (EC) announced its ruling against Microsoft and imposed an unprecedented fine of 497 million EUR. The EC 1) mandated the licensing of certain software source code for server applications, and 2) ordered the company to sell a version of Windows in Europe without Microsoft’s Windows Media Player. In July 2006, the EC fined Microsoft 280.5 million EUR for failing to fully comply with the 2004 ruling. Microsoft appealed to this decision to the European Court of First Instance (CFI).
With the verdict of the CFI approaching, it seems an appropriate time to remind the public of the famous Microsoft versus EU case by briefly exploring the potential economic consequences of the verdict. So what does economic science in general, and industrial economics in particular, tell us about the possible results of EU decisions on these matters?
Firstly, let us look at the nature and characteristics of the dynamic markets of the New Economy, such as the market for software and particularly for operating system software. The supply side of these markets are characterized by high overall costs of production with constant (and close to zero) costs to produce additional units of the product. There is substantially open access by competitors able to create new software and the relevant market is the whole world. Protection of intellectual property rights (IPR) is essential due to intense innovation activity and resulting patents, copyrights and trade secrets. As for the demand side, the market for operating systems is characterized by strong network effects; as more people use a particular operating system, its value increases for both consumers and software developers. Thus it follows that the issue here is primarily focused on competition for-the-market rather than in-the-market. In such circumstances, the relevant economic theory predicts that the market will be rather concentrated, usually dominated by the market leader who would produce for the whole or largest part of the market, adopt aggressive pricing structures and direct a significant amount of money into innovation. Hence, it should not be surprising that, say, in the market for operating systems there is a very strong player, Microsoft, with a large market share. Since the entry into this market is free, the leader has to keep prices low to control for the entry of competitors and to keep upgrading the quality and functionality of its products. Thus in such an environment, there is a clear social value of market (and technology) leadership – low prices and enhanced investment in innovation and product quality! (To be sure, market leaders may also abuse their market position. For instance, in US Microsoft used certain licensing practice with PC original equipment manufacturers and contracts with internet service providers that were anticompetitive violating US competition regulations.)
So let us now look at the first EC verdict and its likely consequences. The EC requested compulsory licensing of the Microsoft software code to its direct competitors. The first and most obvious consequence of this will be a general disincentive to invest in innovation and a dangerous signal to other innovative firms in the EU that the EC has ultimate right to decide when to force a company to reveal the fruits of its long and hard research and development (R&D) efforts and related heavy investments. Given that investment in R&D and innovations is a key vehicle of the economic progress, and that this fact was explicitly acknowledged in the famous Lisbon strategy, such an EC verdict looks even more puzzling and contradictory.
Moreover, by requiring compulsory licensing, the EC not only shakes the foundations of sound IPR but revokes one of the basic property rights – freedom to contract. Such a decision also ignores international treaty obligations designed explicitly to prevent this type of broad-based compulsory licensing of intellectual property rights (see Article 13 of the WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights).
Secondly, and at a more subtle level, revealing the source code through compulsory licensing to competitors would remove or weaken the market leader and that would in turn enable more firms to stay in the market or/and enable the existing firms to raise the price and enjoy quieter lives. Thus it will lead to the change in what industrial economists refer to as toughness of price competition making it softer. Moreover, as innovation intensity in an industry is positively linked with the toughness of price competition, the industry level of R&D spending and innovations will almost certainly decline. The effect will be the exact opposite of alleged EU intentions to enhance industry innovation. The consumers will be the biggest losers in the end.
As for the second verdict, much like in the first one, the EC decision ignores the very nature of the competition on the dynamic software markets relying on the standard tying argument that considers tying illegal practice per se. The verdict requests Microsoft to offer a version of Windows in Europe without the media playback functionality that was designed as part of the operating system, even though this will harm consumers giving them a less capable product and hamper the interaction between Windows and applications that are built to run on it. Thus, like in the case of the EC’s first decision, requiring Microsoft to develop and market a version of Windows without an integrated media player, steps on Microsoft’s IPR to control its own trademark, effectively creating a compulsory licensing regime with all the consequences described above - In fact, Microsoft did prepare and commercialize a version of Windows without an integrated media player in Europe. However, demand for this reduced version of Windows (without the integrated media player) has been virtually zero in Europe!.
The victims in a standard tying case are the consumers who are forced to pay for what they do not want, and the excluded competitors who cannot do business with the tied consumers. None of this is present here. Firstly, there are many other high-quality media players around (Quick Time, Real Player, Winamp, VLC, BSPlayer, etc.) and some of their producers do the same kind of tying. In short, there is no foreclosure of competition going on here. Secondly, there are substantial benefits that the software developers, consumers and others in the PC industry derive from integration of media playback functionality in Windows since this integration has made PCs more attractive and easier for consumers to use and it has made Windows a better platform for software developers and web-based content providers. Therefore this is not a classical case of tying but it rather promotes the idea that product integration increases consumer welfare by adding functionality; this is often the result of market competition, not the lack of competition.
Given that nowadays more and more innovations occur via feature integration, policymakers must not presume that product integration amounts to tying that is per se illegal. Rather, policymakers should embrace an approach that considers the pro-consumer and pro-competitive effects of product integration.
As for the economic consequences of this second EC verdict, such an approach by the EC could easily undermine commercial practices in a wide variety of industries and generate uncertainty whether any market leader can be confident when integrating a new component or features in the future.
The lessons from the above discussion for EU competition policy are clear. It should promote and not upset the natural process of competition in the dynamic markets. Indeed Antitrust law sometimes does more harm than good, prompting one commentator to say that “in their static way, [competition policy] ban activities for which officials and scholars have not yet discovered the rationale; markets are more dynamic than that“. The 2005 revised Lisbon Strategy aims to make Europe a more attractive place to invest and work; promote knowledge and innovation; and create more and better jobs. However, the EC needs not only to generate more innovation in its productive sector but also be more innovative in its regulatory legislation. One of the key regulatory prerequisites in this respect is sound competition policy. Much like US antitrust legislation, it should focus on consumers’ welfare, protections of consumers and the very competition rather than on protection of competitors and their market shares. It also must ensure that there are proper incentives for creating intellectual property that enables the monetization of intellectual property through competition rules that allow businesses to combine and distribute innovations in new ways.
August 2007: Understanding Market Leadership
The new book Competition, Innovation, and Antitrust by Federico Etro, President of Intertic is finally available. In many occasions our website has described and commented the theory of market leaders and the endogenous entry approach to antitrust. A lot of empirical research to test that theory is needed, and here we provide a short guide to the empirical analysis of these issues.
The primary empirical implications of the theory of market leaders concern the discrimination between alternative strategies adopted by market leaders facing an exogenous or an endogenous number of competitors. Therefore any empirical investigation of its results should be based on a non-trivial analysis of the entry conditions. Most of the empirical work on the reaction of incumbents to entry takes entry as given; the problem of endogeneity of entry is briefly discussed in Thomas (1999), who examines the reactions of incumbents in the US ready-to-eat cereal industry. He finds that incumbents are accommodating between themselves, but they adopt aggressive pricing to face new entrants. This result may be due to the typical behavior of market leaders facing endogenous entry: while price competition would lead leaders to be accommodating when facing an exogenous number of firms, an aggressive pricing strategy is forced by endogenous entry.
Some markets are clearly characterized by exogenous constraints on the number of firms: for instance, when there are legal barriers to entry, when only a restricted number of firms have licenses, patents or other essential inputs needed to produce a certain good or service, or when a certain activity is confined to a predetermined number of subjects with special permission, we are in front of a market where the number of competitors is exogenous. Some other markets are clearly characterized by entry open to domestic and international firms that changes over time, reacts rapidly to variations in demand and supply conditions, and reduces to zero the supra-normal profits of the marginal entrants: when this is the case, we are in front of a market where the number of competitors can be regarded as endogenous. In other markets the situation is not so clear, therefore we need to add a few remarks to clarify how one could approach the concept of entry in an empirical investigation aimed at testing the theory of market leaders.
First, there are markets in which processes of liberalization or deregulation have radically changed the entry conditions, from a situation with a fixed number of competitors to one with endogenous entry: these shocks may represent interesting natural experiments for a test of our theory. Spiller and Favaro (1984) have studied the behavior of market leaders in the process of deregulation of the commercial banking sector (with data on the Uruguay experience in the late 70s). Their "results are consistent with a von Stackelberg type of industry where the degree of oligopolistic interaction among the leading firms is reduced as a consequence of the relaxation of the legal entry barriers." In recent times, it would be interesting to verify the impact of online banking, which has dramatically increased entry (also of international banks) and competition in the banking sector of many countries: in such a case, the theory of market leaders would imply the emergence of leaders offering better conditions on savings accounts (think of the Orange Savings Account by ING Direct).
Other exogenous shocks leading to entry of new firms may create interesting natural experiments.
Goolsbee and Syverson (2006) have examined how incumbents respond to the threat of entry of competitors. They use a case study from the American passenger airline industry, namely the evolution of Southwest Airlines' route network between 1993 and 2004, to identify routes where the probability of future entry rises suddenly for major US carriers as American, Continental, Delta, Northwest, TWA, United and US Airways. Notice that this is a market characterized by a limited degree of product differentiation (mostly driven by frequent flyer miles programs), by U-shaped cost functions, and by competition in prices between airlines active on each route. When Southwest begins operating in airports on both sides of a route but not the route itself, the probability that it will start flying that route in the near future increases. Examining the pricing of the incumbents on threatened routes in the period surrounding these events, and controlling for a number of airport-specific operating costs, it emerges that incumbents cut fares significantly when they have faced an exogenous number of competitors in the past, but expect endogenous entry in the future. More exactly, 3 to 4 quarters before Southwest starts its operations on a new route, the fares of the market leader on that route have fallen about 7 %, and by 1 to 2 quarters prior, they have fallen 10 %, while when Southwest actually starts operating, prices are almost 12 % lower, and after entry the total drop in fares is about 26%. However, price cuts (in the run up to Southwest starting operations) are absent in low-concentration routes, that is in the routes where, most likely, entry was already free.
Furthermore, the empirical analysis of Goolsbee and Syverson (2006) reveals a switch toward the aggressive behavior of market leaders facing endogenous entry and without exclusionary purposes. They test whether there are differences between the reactions of incumbents when pre-emptive deterrence is possible (Southwest's entry is likely after starting operations on both sides of a route, but could be avoided through price cuts) and when it is not (Southwest's entry in the route is announced simultaneously with its start of operations in the airport). The pricing strategies of the incumbent are quite similar in the two samples, and the conclusion is that "even on routes where deterrence is impossible, the incumbents engage in the same pre-emptive price cutting behavior. Thus the behavior cannot be motivated as seeking to deter entry." Following the traditional theory of price leadership which generates an accommodating behavior of the leaders, Goolsbee and Syverson (2006) are forced to conclude that "the firms are instead accommodating entry", which can be quite misleading since these leaders are radically reducing their prices rather than increasing them. The paradox disappears once we realize that we are in front of price leaders facing endogenous entry, and that our theory tells us that these leaders should be aggressive and also reduce their prices when they are not trying to deter entry.
A related situation emerges in markets with IPRs: when a patent or a copyright expire, endogenous entry suddenly takes place, and the effect on the behavior of the incumbents could be used to test our results. A similar experiment, which could be re-interpreted in the terms of our theory, is in Ellison and Ellison (2007). They examine the behavior of market leaders in the pharmaceutical industry in the periods around the expiration of patent protection for their patented drugs. Advertising by incumbents declines before entry occurs. Drug prices always decline when entry occurs, and also before the expiration of the patent, but only if the probability of entry is high. Again, these preliminary results are consistent with an aggressive strategy by the leaders, which is induced by endogenous entry. Bergman and Rudholm (2003) examine the Swedish pharmaceutical market where the commitment to a low price is enforced by a particular regulation (for which, if a price is reduced, it is impossible to increase it again). They show that the prices of the incumbent leaders fall at the time of the patent expiration (even before actual entry occurs) by 5-8% for products with small sales volumes.
Another interesting situation that could be used for empirical purposes emerges in markets that, after a period of protection from international competition, are opened to entry of foreign firms: this represents another experiment in which endogenous entry suddenly takes place.
In all of these examples, one can compare the behavior of market leaders relative to the behavior of the followers before and after endogenous entry takes place. Ideally, any empirical methodology should control for the differences between the leader and all of the other firms (our basic testable predictions refer to the behavior of leaders facing competition from equally efficient firms). Thomas (1999) has studied the behavior of incumbents in the ready-to-eat cereal industry, which is characterized by competition in prices, product differentiation and large advertising. The main result is that "incumbent firms accommodate one another on price but respond aggressively using advertising. Entrants on the other hand are more likely to be met with an aggressive price response." The difference in the behavior of market leaders may indicate a switch in strategy from a situation with an exogenous number of competitors (the incumbents) and a situation where entry (of new firms) is endogenous.
Second, there are intermediate situations in which entry can be regarded as exogenous in the short run, but endogenous only in the medium-long run simply because entry takes time. This time can be different in different sectors: rather than being a limit to the testability of the theory of market leaders, this variability in the degree of reactivity of entry to profit opportunities could be exploited as a useful control variable, especially if one has good instruments available to identify the entry conditions.
Third, one has to take into consideration entry in the competition in the market but also entry in the competition for the market: the former is visible and active in the same market, while the latter is often not visible because firms may be effectively competing for a market and investing in R&D, but they will not enter in the market until they actually develop a successful product.
Fourth, one has to distinguish between effective entry and potential entry: while the former is visible and the latter is not, the existence of potential entry is the essential element of a market in which entry is endogenous compared to a market in which the number of competitors is exogenous.
Another important preliminary issue concerns the form of competition in the market. It is well known that the difference between competition in prices and in quantities is more a theoretical abstraction than a clear-cut element of differentiation between sectors. However, there are some markets in which price choices are an essential component of competition, and others where production decisions determine, to a large extent, the equilibrium price: markets for highly differentiated goods typically belong to the first group, while markets for homogenous goods belong more often to the second group. These broad differences should be kept in mind when comparing results from different markets. This is particularly important because entry conditions can fundamentally change the behavior of market leaders under competition in prices. Furthermore, when firms compete in multiple strategies, it is important to understand which preliminary investments or commitments can substantially affect competition: the different behavior of market leaders in undertaking strategic investments compared to other firms is a crucial element of the theory of market leaders. Röller and Sickles (2000) have performed the first empirical study of a two-stage competition with preliminary investment in cost reducing capacity. They considered the European airline industry in the period 1976-1990, before the recent liberalization efforts. On the basis of a panel of the largest carriers (Air France, Alitalia, British Airways, Iberia, KLM, Lufthansa, SABENA and SAS) and a large dataset on cost, network and demand data, they have shown that airline companies behaved as puppy dogs: underinvesting in capacity to keep high prices. It would be interesting to compare that situation with the current situation in which EU liberalization is promoting the entry and competition: according to the theory of market leaders, we would expect leading carriers to turn into top dogs and overinvest in capacity to reduce their relative marginal costs.
Finally, our predictions refer to the behavior of market leaders versus the behavior of their followers, and the definition of leaders and followers requires some additional specifications. In this case, market shares can be useful because it is normal to associate first mover advantages to the leading firm in terms of market share. One may consider more than one firm as a leader according to the sector under consideration: theoretical analysis has shown that multiple leaders would tend to replicate the behavior of a single leader. Of course, there can be differences between firms that are beyond the strategic advantages: for instance costs differences, differences in product quality or locational differences. Since the basic results of the theory of market leaders refer to symmetric firms from a technological point of view, these exogenous differences should be used as control variables in the analysis.
Given these short but crucial methodological premises, in what follows we will list some of the empirical predictions of the theory of market leaders that distinguish between markets with an exogenous number of firms and markets with endogenous entry.
Endogenous entry turns market leaders into more aggressive players compared to a situation in which all firms (leaders and followers) do not face entry threats. In particular, our analysis allows one to discriminate a radical change of strategy under competition in prices: when the number of firms is exogenous, market leaders should choose higher prices than the followers, when entry is endogenous they should choose lower prices. This strong implication does not necessarily hold when firms compete in quantities, but in all cases we would expect that the price of the leaders decreases compared to the price of the followers when endogenous entry occurs. Therefore, our first testable implication is a weak one and can be expressed as follows:
P.1a : The gap between the price of the leaders and the average price of the followers decreases with entry.
When this prediction is satisfied in the data, one can look at the stronger result, which is supposed to hold for markets with competition in prices, and test the following implication:
P.1b: Market leaders facing exogenous entry choose higher prices than the followers; market leaders facing endogenous entry choose lower prices than the followers.
Of course, the stronger hypothesis P.1b implies the weaker hypothesis P.1a, while the opposite is not true. Eventually, one could test further predictions of the basic model of Stackelberg competition with endogenous entry. For instance, in the presence of homogenous goods, increasing marginal costs, and competition in quantities we would expect that the equilibrium price corresponds to the marginal cost of the leader but it is higher than its average cost, while the same price is above the marginal cost of the marginal entrant but just enough to match its average cost. This is consistent with positive profits for the leader and endogenous entry. When one introduces product differentiation, also the equilibrium price for the leader is above its marginal cost according to a mark up which increases in the degree of product differentiation, but the equilibrium price of the followers is still equal to their average cost. These predictions could be tested against other hypotheses using the tools of the new empirical industrial organization (see Berry et al. (2004) on the US automobile market, and Kadiyali (1996) with particular reference to entry deterrence and accommodation in the US consumer market for photographic film in the period 1970-1990, when Kodak was the leader and Fuji the follower) and are summarized as follows:
P.2: In a sector with homogenous goods and increasing marginal costs, the equilibrium price of a market leader facing endogenous entry is equal to its marginal cost and above its average cost, and the equilibrium price for the marginal entrant is above its marginal cost and equal to its average cost; an increase in product differentiation increases the equilibrium price above the marginal cost of the leader.
Let us move to the case of strategic investments by market leaders. With competition in the market entry conditions affect the way leaders undertake preliminary investments. In particular, using the classic taxonomy of business strategies, leaders facing endogenous entry always act as top dogs or with a lean and hungry look, and never as puppy dogs or fat cats: ultimately, they are always aggressive compared to the entrants in the competition in the market, which is in line with the previous results. Between the many commitments one can analyze, some can be particularly interesting for empirical investigations. For instance, we analyzed cost reducing and demand enhancing investments. From the first category one can obtain neat predictions (leaders invest more in cost reducing activities when facing endogenous entry), and later we will revisit them again when dealing with more general forms of investments in R&D. From the second category one obtains results that depend crucially on the kind of demand enhancing investments under consideration.
Consider product quality. Here, our focus will be on the implications of the theory of market leaders in the presence of a double choice on both the quality and the price of the products. Summarizing the strategies with the quality-price ratio, a strong prediction deriving from our characterization would be the following:
P.3: Market leaders facing an exogenous number of firms choose a lower quality-price ratio than the followers; market leaders facing endogenous entry choose a higher quality-price ratio than the followers.
Given the complex strategic interactions emerging in a situation where firms choose multiple variables, it could be reasonable to limit the analysis to a weaker implication like the following: the quality-price ratio of the leaders increases with entry compared to the quality-price ratio of the followers. Another form of demand enhancing investment is the expenditure on nonprice advertising aimed at increasing demand. If we focus on markets with product differentiation and competition in prices, the theory implies the following strong testable prediction:
P.4: Market leaders spend more than the followers in nonprice advertising (as a percentage of turnover) when the number of firms is exogenous, and less when entry is endogenous.
Finally, after pointing out empirical implications for the policies concerning price, product and promotion, we emphasize an implication for the last strategic investment that characterizes the marketing mix of a firm (the fourth P), place which stands for distribution. From our analysis on the choice of wholesale prices to retailers in the presence of downstream distribution channels, we have the following prediction:
P.5: Market leaders set higher wholesale prices for their retailers than their competitors when the number of firms is exogenous, while they set lower prices when entry is endogenous.
Concerning financial issues, we need to take care of a more subtle differentiation on the source of uncertainty in the market, which can be used as an additional control variable (an interesting related analysis on the effect of debt on prices is in Chevalier (1995), but that treatment does not take into account the source of uncertainty and the endogeneity of entry). Then, we have the following prediction based on the hypothesis of competition in prices:
P.6: The financial structure of market leaders is biased toward debt financing compared to the financial structure of the followers when the number of firms is exogenous, while it is biased toward equity financing when entry is endogenous, as long as uncertainty is mainly on the demand side (while uncertainty on costs pushes the predictions in the opposite direction).
Notice that under competition in quantities the model always implies a bias toward debt financing for the leader, therefore, once again, we can distinguish a weaker hypothesis from the strong one stated above: the debt-equity ratio of the market leaders should increase with entry.
Investments in cost reductions aimed at reducing the price of a good give rise to neat predictions under competition in prices: in particular, market leaders should spend less than the other firms in R&D investments in cost reductions when the number of firms is exogenous, and they should spend more when entry is endogenous. One should always keep in mind that this hypothesis holds under competition in prices, while under competition in quantities the leader would generally spend more than the followers in cost reductions under both entry conditions. However, we can generalize our result under general forms of competition for the market. The theory of market leaders provides radical predictions concerning the incentives to invest in R&D by the firms already present in a market with the leading products. We can express the main implications in different ways. We start from the weakest possible prediction, which is already in contrast with the traditional result of the theory of innovation (see Malerba and Orsenigo (1999), Blundell et al. (1999), Czarnitzki and Kraft (2007a) and Hughes (2007) on evidence on the high investment in R&D by market leaders):
P.7: Incumbent market leaders facing endogenous entry in the competition for the market invest in R&D.
Of course the theory of market leaders suggests more than this. First of all, leaders invest more than the followers when entry is endogenous. This is true in all models of competition for the market, independently from the kind of strategic interaction between firms. Therefore, we state this as an intermediate hypothesis:
P.8: The investment rate in R&D of market leaders is higher than the average investment rate in R&D of the followers when entry in the competition for the market is endogenous.
We also have a radically strong hypothesis that derives from a model in which the investments of the firms are strategic complements:
P.9: Market leaders invest less in R&D (as a percentage of turnover) than the followers when the competition for the market is between an exogenous number of firms, they invest more when entry is endogenous.
Finally, the theory of sequential innovation by leaders suggests a way to discriminate between different degrees of persistence of leadership in innovative sectors. When entry of firms in the competition for the market is endogenous we should expect that technological leaders invest a lot and their persistence is more likely. Of course, when there is no competition for the market we should expect that the monopolistic leadership is also persistent. However, when the degree of competition for the market is intermediate (entry is not free but more than one firm invests), we should expect that the incumbent does not invest much in R&D and that its leadership is more likely to be replaced. This suggests our last prediction:
P.10: The degree of persistence of leadership should follow and inverted U relation with the degree of entry in the competition for the market.
These testable implications could be brought to the data in future research. Many other issues could be studied through the market leaders approach and, accordingly, other empirical implications could be derived and eventually tested.
June-July 2007: The Political Economy of the Microsoft Antitrust Cases
Microsoft's leading position in the software market has induced large opposition in the industry and the emergence of multiple antitrust cases with importance at the global level. From the history of these cases and from the positions of major players and observers (in particular many important economists who have followed these cases) we can learn a lot about the current European case, which is about to arrive at a conclusion with the result of the Appeal expected for this summer.
Microsoft has been under investigations in the US by the Federal Trade Commission and the Department of Justice since 1990, primarily for its contracts with computer manufacturers and for bundling secondary products with its OSs. Already in the mid 90s we could see important economists in action in these early cases. In 1995 the Nobel prize Kenneth Arrow intervened saying that "Microsoft appears to have achieved its dominant position in its market as a consequence of good fortune and possibly superior products and business acumen" and that Microsoft's licensing practices toward original equipment manufacturers "made only a minor contribution to the growth of Microsoft's installed base. Even this minor contribution overstates the impact of Microsoft's licensing practices on its installed base barrier to the entry and growth of competing operating systems" (Declaration of Kenneth Arrow, U.S.. v. Microsoft Corp., Civil Action No. 94-1564 (SS), January 17, p. 11-12). However, it was only in the late 90s, under the Democratic Clinton Administration, that the most important US case began, followed after a few years by the EU case.
In the main Microsoft vs. US case, started in 1998, the software company was accused of protecting its monopoly in the OS market from the joint threat of the Internet browser Netscape Navigator and the Java programming language, which could have developed a potential substitute for OSs allowing software applications to run on hardware independently from the desktop OS. Basically, the hypothetical threat for Microsoft was the development of an alternative to the software platform based on the OS, a sort of middleware platform or a web-based platform leading to the "commoditization" of the OS (as ten years before the software platform led to the commoditization of hardware), and hence to the loss of leadership of Microsoft. Microsoft reacted by improving its Internet Explorer (IE) browser, engaging in contractual agreements with computer manufacturers and Internet service providers to promote preferential treatment for IE (notably AOL, whose "You've got mail" sound track was attracting more than 20 millions Americans at the time), and finally tying Windows with IE.
As Benjamin Klein (2001) pointed out in an academic survey on the Journal of Economic Perspectives (Symposium on the Microsoft case), "Microsoft spent hundreds of millions of dollars developing an improved version of its browser software and then marketed it aggressively, most importantly by integrating it into Windows, pricing it at zero and paying online service providers and personal computer manufacturers for distribution. All of this was aimed at increasing use of Microsoft's Internet Explorer browser technology, both by end users and software developers, to blunt Netscape's threat to the dominance by Windows of the market for personal computer operating systems." Microsoft's investments in browser technology, which largely improved IE until it became a superior product compared to Netscape Navigator (see the empirical analysis in Stan Liebowitz and Stephen Margolis, 1999), and Microsoft's pricing of IE at zero (as always since then) appear to us as examples of aggressive strategic investment and aggressive pricing by a market leader facing competition, and not as anti-competitive strategies. According to Klein, "a crucial condition for anticompetitive behavior in such cases is that the competitive process is not open. In particular, we should be concerned only if a dominant firm abuses its market power in a way that places rivals at a significant competitive disadvantage without any reasonable business justification. Only under these circumstances can more efficient rivals be driven out of the market and consumers not receive the full benefits of competition for dominance. The only Microsoft conduct ... that may fit this criteria for anticompetitive behavior are the actions Microsoft took in obtaining browser distribution through personal computer manufacturers".
After a failed attempt by Judge Richad Posner (one of the fathers of the Chicago school) to mediate in settlement negotiations, Judge Thomas Penfield Jackson decided to impose heavy behavioral and structural remedies on Microsoft, including the break up in an operating system and an application company (the so-called "Baby Bills", as Baby Bells were the companies derived from the 1984 break up of AT&T). At the time, this draconian remedy was criticized by many economists as Richard Schmalensee, consultant for Microsoft in the case, but also other economists with different perspectives on the case, for excessively penalizing the company without a clear relation between the punishment and the alleged crime, and for inducing perverse consequences for consumers. For instance, on the pages of The New York Times, Paul Krugman pointed out the risk of creating two monopolists engaging in double marginalization: "The now `naked' operating-system company would abandon its traditional pricing restraints and use its still formidable monopoly power to charge much more. And at the same time applications software that now comes free would also start to carry heftly price tags." Nevertheless, the government proposal of splitting Microsoft into two companies, which was adopted by the Judge without substantive changes, had been supported by declarations of important economists, including Paul Romer and Carl Shapiro. For instance, Shapiro declared that, while "network monopolies can be very strong, they are most vulnerable to attack by firms with a strong position in the provision of a widely-used complementary product", hence "the proposed reorganization of Microsoft into separate applications and operating systems businesses will lower entry barriers, encourage competition and promote innovation" (Declaration of Carl Shapiro, U.S. v. Microsoft Corp., Civil Action N0. 98-1232 (TPJ), p. 7 and p 29).
After the appeal phase and the return of the Republican Administration with George W. Bush, the DOJ changed attitude looking for a settlement. The November 2002 ruling of the District of Court decided on behavioral remedies aimed at preventing Microsoft from adopting exclusionary strategies against firms challenging its market power in the market for OSs. Moreover, the Court adopted forward looking remedies that required limited disclosure of APIs, communication protocols, and related technical information in order to facilitate interoperability, and created a system of monitoring of Microsoft's compliance which has been working quite well in the last years. Since other derivative private actions have also been dismissed or settled, it seems that this long-standing conflict has arrived to its end in the US.
The Microsoft vs. EU case was subsequently developed on somewhat similar issues. In particular, Microsoft has been accused of abuse of dominance in the market for OSs through technological leveraging and in particular in two ways: first, by bundling Windows with Media Player, a software for downloading audio/video content, and, second, by refusing to supply competitors with the interface information needed to achieve interoperability between work group server OSs and Windows [a work group server OS is a software providing services to share files and printers and other administration services to a group of users connected in a network, typically in office environments]. Contrary to the US case, the bundling part of the EU case is a traditional case of bundling, since the competitors in the secondary market, notably RealNetworks, do not represent a threat for Windows, the primary product of Microsoft.
In the famous antitrust decision of March 24, 2004, Competition Commissioner Mario Monti imposed on Microsoft the largest fine in the history of antitrust (€ 497 million), required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers on one side, and competitor products on the other side. After this decision, Microsoft paid the fine, developed and released a version of Windows without Media Player, and entered into extensive discussions with the Commission about the implementation of the remedies concerning interoperability. In the original decision this required to prepare a complete and accurate interface documentation describing portions of Microsoft server operating system software and to license innovations created by Microsoft under "reasonable and non discriminatory" (so-called RAND) terms to competitors. These imply that the royalties should be set at levels that enable use by other developers in a commercially practicable way with reference to standard valuation techniques, to an assessment of whether the protocols are innovative, and with reference to market rates for comparable technologies.
Over time, the new Competition Commissioner Neelie Kroes has continued to extend the scope of the information required, from information that would enable interoperability with Windows PCs and servers for the purpose of creating new products for which there is unmet consumer demand, to information that would allow a competitor to produce clones or "drop-in replacements" of the Windows server OS. Even more controversially, the Commission's Competition Directorate-General has sought to loosen the terms under which Microsoft would be able to licence its information, so as to allow products implementing its technical specifications to be released under so-called Open Source licences (DG Competition was prepared to make an exception for technologies that involved an inventive step and were considered novel by comparison with the prior art, thus meeting the criteria for patentability). Such release, by revealing to the world Microsoft's own implementations of its technical specifications, would irreparably undermine the trade secret protection to which these technologies, some of which are not patented, are subject. In a further shift, the Commission made clear in Spring of 2007 that it expected Microsoft to forego royalty payments on any technologies that were not covered by patents. With the compliance process made more difficult on both sides by the technical complexity of the material and key policy differences (e.g. over the intellectual property issues), DG Competition challenged Microsoft to comply with the interoperability remedy by 15 December 2005, on pain of massive penalty payments for non-compliance. In early 2006, Microsoft provided further information needed for interoperability purposes, and even made available to its competitors selective access to the source code of Windows. Nevertheless, in July 2006 the Commission levied fines of € 1.5 million a day from the December hearing onwards (for a total of other € 280.5 million), and threatened to double the fine if the company did not comply. The case is still unresolved: Microsoft's Appeal of the Commission's 2004 landmark decision was heard by the European Court of First Instance in April 2006. By the way, also in this case important economists played a crucial role: for instance with Joseph Stiglitz, on the European Commission side and David Evans on the Microsoft side. A decision is expected by mid 2007, and the hope is that it will put an end to a situation that in the last years has largely jeopardized R&D investment in the European markets of the New Economy.
A common element in both the US and EU cases has been the substantial involvement of competitors of Microsoft on the side of the antitrust authorities. In a neat article about the US vs. Microsoft case on Business Week, Robert Barro (1998) noticed that: "a sad sidelight in the Microsoft case is the cooperation of its competitors, Netscape, Sun and Oracle Corp., with the government. One might have expected these robust innovators to rise above the category of whiner corporations [...] The real problem is that whining can sometimes be profitable, because the political process makes it so. The remedy requires a shift in public policies to provide less reward for whining. The bottom line is that the best policy for the government in the computer industry is to stay out of it." Nevertheless, IBM, Sun, Oracle, Novell, Sun Microsystems and the wide open source movement have been quite active against Microsoft in the EU case, and most likely, they will continue to be after the end of this case.
April-May 2007: Open Source, Wikipedia and the Limits of the Boldrin-Levine Analysis
While intellectual property rights are fundamental drivers of innovations in all sectors, software development has recently been characterized by a large amount of innovations obtained in a decentralized, voluntary and uncompensated way by programmers within the so-called open source movement.
Technically, open source software is made available for direct use and modification (through direct access to the source code) under limited protection. For instance, the GPL (General Public License, first used in 1981 by Richard Stallman, the leader of the Free Software Movement) grants unlimited right to use, modify and distribute software as long as its redistribution makes available the modified source code and does not impose further restrictions on the rights granted by the GPL. These enforcement mechanisms make cooperative innovation quite effective and immune from free riding, but can create problems when an innovation includes both open source software and licensed proprietary software.
Major results of the open source movement are Linux, an Operating System based on Unix (an old Operating System first created at Bell Labs) and developed in 1991 by Linus Torvalds, Apache, a world wide web (HTTP) server, and Mozilla Firefox, a web browser. Besides software that is freely distributed, there is an increasing number of companies, like Red Hat and Novell, that profit from collateral services supplied jointly with free software. In theory, any rival could resell Red Hat software at a lower price because it is under GPL (and some firms actually do it), but Red Hat managed to sidestep this problem protecting its products with trademark law. In this sense, the difference between proprietary software and open source software appears much less relevant: the former earns from licenses to end-users, the latter mainly licenses software free of charge and earns from selling support description needed by end-users to install and run the software.
While many private corporations support open source software because they supply products that are complementary to open source software (IBM first of all, but also HP, Intel, Sun, Oracle,...), it remains surprising that such a large innovative process can take place, at least in part, through directly unrewarded efforts. Some economists, as Lerner and Tirole, have provided a few explanations for the incentives of these individual programmers: career concern, ego gratification and signalling activity are quite powerful and effective in this field. Unfortunately, the same nature of these incentives shows the possible limits of the innovative activity in the open source community: it is limited by the usual free riding problems emerging in the private provision of public goods (it is interesting that an information good as software is substantially a public good: it can be provided to new agents at no substantial cost and without reducing the utility of the other agents), it requires a complementary activity in the for-profit sector (to motivate the career concern and the signalling activity), it may be biased by research efforts that are different from general consumer needs and by adverse selection of the contributors, and it may be effective to solve a number of small and short term problems, but less effective to solve multi-sided challenges and approach long term projects. Notice that it is often claimed that open source software is more effective than proprietary software in debugging activity (since many programmers find and solve many defects within a software and make the solutions freely available), but may have big problems confronting issues as synchronization of upgrades and efficient levels of backward compatibility.
While the development of this new form of innovative activity is a symptom of high competitive pressure in the sector, it does not provide any evidence against the fundamental role of the protection of IPRs in driving core innovations. Actually, we believe that the current coexistence of open source software and proprietary software exerts a positive impact on innovation on both sides. To see why, think of a different sort of open source activity: is a famous and successful on line encyclopedia where anybody can post a new voice or edit an old one. While it contains a lot of useful and constantly updated information (especially in certain fields, as those related to the on line community), it often includes unmotivated and misleading references or mistakes that are the normal consequences of overlapping additions by heterogeneous contributors whose preparation is not properly controlled and whose effort is not rewarded. Traditional encyclopedias based on rewarded contributions by selected experts are not constantly updated as Wikipedia, but they provide a standard of quality and a balanced unifying structure that Wikipedia lacks. The trade-off for the end users is clear, and coexistence appears natural.
In a recent interesting book by Michele Boldrin and David Levine (see the version in ) have adopted open source software as a main example of innovation created without IPRs, and have collected a large amount of anecdotic evidence suggesting that innovations can perfectly take place in absence of what they call "intellectual monopoly". Their idea behind this possibility is that the first mover advantage in the market of an innovator preserves a certain amount of profits even when entry of imitators is free, and this Stackelberg advantage can be sufficient to promote innovation. We already know from the theory of market leaders that leaders with a first mover advantage can obtain positive profits even in markets where entry is free by adopting aggressive strategies, and the standard Schumpeterian theory of growth is perfectly compatible with incentives deriving from the profits of a market leader facing free entry, rather than deriving from a monopolistic position. Therefore, the idea of Boldrin and Levine can have reasonable implications. However, the problematic point for the relevance of their provocative idea is another one: how much innovation can be promoted by the simple first mover advantage?
Without a deeper analysis of the industrial organization of the competition for the market it is quite hard to answer this question, and the general equilibrium analysis of Boldrin and Levine concluding that that the first mover advantage induces the first best amount of innovation neglects to a large extent the industrial organization of the market for innovations. Unfortunately, whether the incentives to invest are efficient or not is more an empirical question than a theoretical one, and we still don't see a consistent piece of evidence showing that current patent systems provide excessive incentives in a systematic way, or that we should totally eliminate IPRs, as Boldrin and Levine actually suggest.
As a matter of fact, the opposite may be true. Recently, Denicolò has analyzed a general model of the organization of innovations and has obtained a simple rule for the optimal level of patent protection: his empirical estimates suggest that current patent systems do not over-compensates innovators, while they may actually induce too limited incentives to invest in R&D.
This leads us back to the rational for the protection of intellectual property rights on software. We believe that the rationale for these patents is strong: while their main social gain is to promote innovation in the most dynamic sectors, the social cost is smaller than for other patents since in these sectors competition mainly works through frequent price-reducing and quality-improving innovations, therefore price distortions are less relevant and do not last long anyway. Neglecting these traditional economic insights, opponents of the patent system as Boldrin and Levine, have tried to claim that patents stifle innovation, but there is not clear empirical evidence behind these claims. In US, the extension of patent protection to CIIs started in 1980 (the first patent of this kind was granted by the US Patent and Trademark Office in 1981), and it was associated with a clear increase in R&D investment during the eighties. The R&D/sales ratio for US firms innovating on computer, telecommunications and electronic components (the relevant field here) increased from 5.5% to above 8% in 1989.
In a careful empirical study Mann (2005) has shown that patents bestow significant benefits, especially for start up companies, in terms of traditional appropriability, information signalling and cross-licensing revenue, while Merges (2006) looking at patent data in the US software market found that "new firms entry remains robust, despite the presence of patents (and, in some cases, perhaps because of them). Successful incumbent firms have adjusted to the advent of patents by learning to put a reasonable amount of effort into the acquisition of patents and the building of patent portfolios. Patent data on incumbent firms shows that several well-accepted measures of `patent effort' correlate closely with indicators of market success such as revenue and employee growth." In conclusion, we have no reason to doubt that standard incentive mechanisms to promote innovations based on the protection of intellectual property rights are effective in the software field as they are in many other fields.
February-March 2007: Multi-sided Platforms in the Third Industrial Revolution
In a recent important book, Evans, Hagiu and Schmalensee (2006, Invisible Engines, MIT Press) have emphasized the crucial role that software platforms are playing in shaping our economies, the functioning and the development of many sectors, and ultimately our way of living. These "invisible engines", as they call them, power not only the PC industry but also other industries as those associated with mobile phones and other handheld devices, video games, digital music, and (with strong externalities for the rest of the economy) on-line auctions, online searches and web-based advertising. Their convincing claim is that, as the steam engine was at the basis of the first industrial revolution (1760-1830) and electric power at the basis of the second industrial revolution (1850-1930), microprocessors and software platforms are at the basis of the third industrial revolution (since 1980), which started with the introduction of commercial PCs and had a second phase starting in 1995 with the Internet.
A software platform is a software program that makes services available to other software programs through Application Programming Interfaces (APIs). Examples are the operating systems running on PCs as Windows, Mac OS or Linux, those employed by videogame consoles as the Sony one for PlayStation or Windows 2000 for the Xbox, Palm OS for personal digital assistants (PDAs), RIM for the BlackBerry, iPod OS for the Apple iPod, the Symbian operating system for cellular phones - Symbian is a joint venture founded by Nokia, Ericsson and Motorola, which left it in 2003; it is currently owned by Ericsson (15.6%), Nokia (47.9%), Panasonic (10.5%), Samsung (4.5%), Siemens AG (8.4%), and Sony Ericsson (13.1%).
To understand the peculiarities of software platforms in general it is convenient to focus briefly on the main functions of PC operating systems. The main one is to serve as a platform on which applications (such as spreadsheets or word processors) can be created by software developers. Operating systems supply different types of functionality, referred to as system services, that software developers can call upon in creating their applications. These system services are made available through APIs. When an application calls a particular API, the operating system supplies the system service associated with that API by causing the microprocessor to execute a specified set of instructions. Software developers need well-defined platforms that remain stable over time. They need to know whether the system services on which their applications rely will be present on any given PC. If they did not, then software developers would have to write the software code to provide equivalent functionality in their own applications, generating redundancy, inefficiency and a lack of interoperability. Moreover, modern OSs provide a user interface, the means by which a user interacts with his computer. User interfaces for computers have evolved dramatically over the last decades, from punch card readers, to teletype terminals, to character-based user interfaces, to graphical user interfaces, first introduced by Apple with Macintosh. Finally, operating systems enable users to find and use information contained in various storage devices: local ones, such as a floppy diskette, a CD-ROM drive or the hard drive built into a PC, or remote ones, such as local area networks that connect computers in a particular office, wide area networks that connect computers in geographically separated offices, and the Internet.
Over time, the OS of Microsoft became the most popular because Microsoft continually added new functionality to the OS and licensed it to a wide range of computer manufacturers with extremely aggressive pricing strategies. Microsoft recognised early on that an OS that served as a common platform for developing applications and could run on a wide range of PCs would provide substantial benefits to consumers. Among other advantages, development costs would fall and a broader array of products would become available because products could be developed for the common platform rather than for a large number of different platforms. By providing a single OS that ran on multiple brands of PCs, Microsoft enabled software developers to create applications, confident that users could run those applications on PCs from many different computer manufacturers. In addition, applications developed for a single platform are more easily interoperable because they rely on the same functionality supplied by the underlying OS. The winning strategy of Microsoft was the creation of these network effects between hardware producers, software developers and consumers: computer manufacturers benefit because their PCs can run the many applications written for Windows and because users are familiar with the Windows user interface; software developers benefit because their applications can rely on system services exposed by Windows via published APIs and because they can write applications with assurance that they will run on a broad range of PCs; consumers benefit because they can choose from among thousands of PC models and applications that will all work well with one another and because such broad compatibility fosters intense competition among computer manufacturers and software developers to deliver improved products at attractive prices.
Software platforms deal with multiple sides. Microsoft deals with at least three: consumers, software developers and PC manufacturers. Apple produces hardware internally, hence it deals with the remaining two sides: consumers and software developers. Sometimes relationships are even more complex, as in the platform ecosystem for smart mobile phones where, beyond OSs, software developers and handset makers, there are network operators (Vodafone, NTT DoCoMo, T-Mobile, Tim,..) to play a coordinating role and even competition between layers is strong.
In the presence of multiple sides with network effects between them, the choice of which ones should be charged more to use the platform is not simple. and others have been the first to notice that software platforms, as other similar multi-sided platforms, give rise to market structures that are quite different from traditional ones. For simplicity, here we will refer to two-sided platforms, which connect two sides in such a way that for each side the valuation of the interactions with the other side depends on the number of agents on the others side. These network externalities, and in particular the non neutral impact of the pricing structure on both sides (and hence on these externalities) distinguishes a two-sided market from a traditional one-sided market with different consumers (and possibly price-discrimination between them).
An analogous situation to software platforms emerges in many completely different contexts. A classic example is given by newspapers. They are sold to readers, but they also sell advertising space to advertisers: the reader is not only a "customer" of the newspaper, the reader is also a supplier of "eyeballs" that the newspaper sells to advertisers. Here, network effects emerge because advertisers (the sellers for the platform) value their advertising more in a newspaper when the number of its readers (the buyers of the platform) is higher (the effect in the other direction may exist but is typically less important). This has crucial consequences on the pricing structure since a low price for the readers increases the number of sold copies and hence the value of advertising. Such a phenomenon is even stronger when the newspaper is competing with other newspapers, and a low price reduces the readers of competing newspapers and the value of advertising on these competing newspapers.
Other two-sided platforms include other media networks as television channels, real estate agencies, traditional auction houses, shopping malls, night clubs and dating clubs, payment card systems, telephone networks and many industries of the New Economy as those related with video game consoles, smart phones, digital music, PDAs, i-Mode (this was created by the main Japanese mobile network operator, DoCoMo, to connect mobile phones with Internet content providers and application developers. Both the US and the EU lag behind in the development of a similar platform), search engine-based portals (like Google), on line messaging (like Yahoo!), on line chatting (like Skype), on line social networks (MySpace or asmallworld), on line academic articles (JSTORE or SSRN), on line shopping (Amazon) and on line auctions (eBay). In many of these markets, multi-homing on at least one of the two sides is common: people often buy more than one journal or watch more TV channels (as companies advertise on multiple medias), hold multiple credit cards (as merchants accept multiple cards) and software developers prepare applications for multiple OSs (while individuals typically use only one).
In each one of these examples, network externalities are crucial to the success of a software platform, and the pricing structure toward buyers and sellers is crucial to the creation of these network effects. In particular, a platform typically ends up charging one of the two sides less than the other, taking into account demand elasticities and which side values the other side more: the aim is to get on board as many agents as possible from one side, so as to increase the value of the platform for the other side and earn more revenue from it. For instance, when the price is the strategic variable, it is optimal to charge the side whose demand is more elastic relatively more because this allows one to maximize the total volume of interactions – but this is the exact opposite of what happens normally, when it is optimal to charge less consumers with a less elastic demand! Prices will be constrained downward when there are competing platforms (especially in case of multi-homing), but the general principles on a balanced price structure between the two sides remain unchanged. In extreme cases, one side may even receive its goods or its services for free or even be subsidized so as to maximize earnings from the other side.
The above theoretical implications are surprisingly confirmed by what happens in the above mentioned two-sided markets, whose companies typically settle on pricing structures that are heavily skewed toward one side of the market, or in other words adopt what is sometimes called a "divide and conquer" strategy. Newspapers, television networks and even websites typically earn more from advertisers than from consumers, real estate agencies earn more from sellers (or from landlords) than from buyers (or renters), auction houses from sellers rather than from the buyers, shopping malls from stores rather than from the shoppers, night clubs from men rather than from women, payment card companies from merchants rather than from cardholders, phone operators (often) from call makers rather than from receivers, video game platforms from royalties on game developers rather than from buyers of consoles (that are often sold below cost), while most of the other software platforms, including PC operating systems, earn more from end users rather than from software developers. This happens in different ways however: Microsoft licensees Windows, Palm and Symbian license their OSs to manufacturers of PCs, PDAs and cellular phones, while RealNetworks licenses access to digital content and Apple sells PCs and iPods, but none of these companies charges content owners (Apple and RealNetworks actually pay them) or software developers (which are typically subsidized).
Notice that, in spite of the network effects, most of these two-sided markets are also characterized by a certain degree of fragmentation between platform providers (real estate agencies, dating clubs, traditional auction houses), often associated with a certain degree of differentiation (newspapers, TV channels and other medias, shopping malls). Only when technological innovation is particularly important and fixed costs of investment in R&D are high (while marginal costs of production are particularly low), the number of competing platforms is endogenously reduced, as in the above mentioned markets of the New Economy (but tipping on a single leader rarely happens, especially when product differentiation and multi-homing have a role, as for video games). Nevertheless, even in these cases, competition for the market can be quite effective and induce periods of persistent leadership with occasional replacement of the leader: pathbreaking innovations (or "killer applications") is what competitive firms really look for.
For instance, in the console video game industry, sequential innovations brought to leadership a number of companies as Atari (that reached 80% share of the market in 1980), Nintendo (90% of the market in 1987), Sega (leader in the early 90s), Nintendo again (in the mid 90s) and Sony with the PlayStation in different improved versions (during the last decade): recently Microsoft Xbox started gaining market shares, and Nintendo is still active, but the leadership of Sony (58% market share in 2004) does not appear under threat yet, especially after the recent successful launch of PlayStation 3. Similarly, after a number of unsuccessful attempts by many companies, Palm's PDA gained success and leadership in the market for OSs for organizers thanks to a simple handwriting recognition system (65% market share in 2000) until Microsoft competing platform and other handheld devices, including Blackberry and (in perspective) Apple's iPhone, gained success.
January 2007: Tying, Media Player and Shoelaces
Economists today generally acknowledge that tying multiple products in a single one can produce positive efficiencies and consumer benefits, and that a rule of reason should be adopted in evaluating its effects on markets and the possibility that tying could create anticompetitive effects. The positive effects of tying are particularly pronounced in the case of technical tying (when companies innovate by linking formerly separate technologies or products, efficiencies often emerge through improved performance and quality), but they also emerge because tying is often used as an aggressive strategy which leads to lower prices. Nevertheless, the current EU approach to abuse of dominance and also its recent proposals of revision perpetuate a bias against tying per se.
The EU approach to tying places too much emphasis on consumer demand for the tied product. Such demand does not shed light on whether there exist distinct products for the purposes of tying analysis. In other words, while there is clearly consumer demand for shoelaces, this should not mean that shoes and shoelaces are distinct products for the purposes of tying analysis. This issue can only be addressed by asking whether there is consumer demand for shoes without shoelaces. In sum, whether or not consumer demands exists for the tied product is the wrong question; the correct question is whether there is any significant consumer demand for the tying product without the tied product. Unless the analysis focuses on this question, there is a danger that the mere existence of consumer demand for the tied product may prevent the emergence of efficient tying arrangements and end up protecting suppliers of tied products at the expense of consumers and innovation.
Moreover, in the case of technical integration of two products that were previously distinct, the distinct products test itself may not be helpful for understanding market dynamics because, by definition, this test is backward-looking. A better approach in these cases would be simply to ask whether the company integrating the previously distinct products can make a plausible showing of efficiency gains: since technical tying is normally efficient, market leaders would be able to continue producing innovative products benefiting consumers without running afoul of the prohibitions on tying. Finally, since tying usually enhances price competition, it should never be abusive when it is standard commercial practice (which is also indirect evidence that such tying generates efficiencies, or that there is no demand for the unbundled product).
We are also concerned that the current EU approach fails to acknowledge that bundling can be used to create value for consumers in markets that experience network effects or in multi-sided markets. For instance, in the first case, bundling is a valuable strategy to gain broader distribution of the products or service that is subject to network effects. And the broader the distribution, the greater the value produced for all consumers. This is particularly true when the product or service in question has a low (or no) marginal costs, because the supplier can costlessly include the product or service in bundles with other products.
Finally, the standard of proof the antitrust authority is required to meet to establish harmful foreclosure effects is too low, particularly in light of the fact that the analysis of foreclosure effects can be speculative in nature. In the case of bundling, actual market foreclosure effects are not required: it is enough that such effects are "likely" to occur. In other words, the mere risk of foreclosure can result in a finding against a dominant company. A standard of proof that requires convincing evidence would rather help ensure that companies will not be deterred from bringing new products to market as a result of concerns about remote, potential foreclosure effects.
There are contrasting views on bundling. The Chicago school has advanced efficiency rationales in its favour with positive, or at worst ambiguous, consequences on welfare, including production or distribution cost savings, reduction in transaction costs for customers, protection of intellectual property, product improvements, quality assurance and legitimate price responses. Moreover, according to the so-called "single monopoly profit theorem", as long as the secondary market is competitive, a monopolist in a separate market cannot increase its profits in the former by tying the two products. Actually, in the presence of complementarities, it can only gain from having competition and high sales in the secondary market to enhance demand in its monopolistic market. A similar theory has been advanced at a theoretical level by Davis and Murphy (2000, American Economic Review) and by Economides (2001) to explain the tying strategies of Microsoft. With particular reference to the US case, notes that Microsoft could not have been interested in the browser market when this was perfectly competitive, but only when this market became dominated by Netscape for two main reasons. "First, Netscape had a dominant position in the browser market, thereby taking away from Microsoft's operating system profits to the extent that Windows was used together with the Navigator. Second, as the markets for Internet applications and electronic commerce exploded, the potential loss to Microsoft from not having a top browser increased significantly... Clearly, Microsoft had a pro-competitive incentive to freely distribute IE since that would stimulate demand for the Windows platform." The very same point could be made for the free distribution of Media Player with Windows, the subject of the tying part of the EU case.
The post-Chicago approach has shown that, when the bundling firm has some market power, commitment to bundling can only be used for exclusionary purposes since it enhances competition in the secondary market and increases the profits of the leader only if it excludes rivals from this secondary market (Whinston, 1990, AER). Nevertheless, even the same proponent of this theory has expressed doubts on its applicability to Microsoft: evaluating the tying of Windows and IE, Michael Whinston (2001, JEP) notes that "Microsoft seems to have introduced relatively little incompatibility with other browsers. Since marginal cost is essentially zero, bundling could exclude Netscape only if consumers, or computer manufacturers for them, faced other constraints on adding Navigator to their system", which did not appear to be the case.
The theory of market leaders emphasizes that when entry in the secondary market is endogenous, an incumbent may only gain in this market by adopting an aggressive pricing strategy and in our framework, bundling the primary good and the secondary good is exactly a way to commit to aggressive pricing. Hence, bundling is the standard competitive strategy of the incumbent as long as the reduction in the profits in the primary market is compensated by the gains in the secondary market. Of course, if there is some complementarity between the products, or there are unexploited network effects, the expansion of demand following the bundling strategy with aggressive pricing can make more likely that bundling is optimal. But what matters for our purposes is that bundling is not an extreme strategy adopted by an incumbent firm to deter entry, but a standard aggressive strategy that, by reducing the final prices, may indeed reduce entry by followers but would not exclude entry overall. Hence, in a world of price competition, it appears hard to conclude that bundling could be used as a predatory strategy when it does not lead to the exit of all the competitors, but just to a permanent reduction of the price level.
To sum up, when approaching a bundling case we suggest to verify the entry conditions of the secondary market. If there is a dominant firm in this market as well, the main problem is not the bundling strategy, but the lack of competition in the secondary market, and it should be addressed within that same market: punishing the bundling strategy would just guarantee the monopolistic (or duopolistic) rents of the dominant firm in the secondary market. However, things are different when the secondary market is not monopolized but open to endogenous entry (even if it is not perfectly competitive, in the sense that firms do not price at marginal cost). In such a case bundling is a pro-competitive strategy and punishing it would hurt consumers. In the case of Microsoft, we have the impression that in both bundling cases, that of Windows with Internet Explorer and that of Windows with Media Player, the tied market was characterized and (most of all) still is characterized by endogenous entry: just think of new successfull browsers as Mozilla or Firefox and media player softwares as RealPlayer, Quick or the more recent Macromedia Flash. Consequently the bundling strategy of Microsoft could be simply seen as an aggressive and competitive strategy of a market leader active in a secondary market where entry is indeed free.
Beyond this theoretical point, it should be added that in dynamic markets as the software market, the same concept of a good is changing over time, since both demand and supply change. If demand by PC users for media player functionalities was limited just a few years ago, now it appears that these functionalities are an essential component of a OS. Because of this, an increasing number of software applications and on line services are associated with media player functionalities, so that demand is even strenghtened by network effects. Finally, as a consequence of this, better OSs must take into account the necessities of these functionalities and bundling has a natural technological rationale. In other words, while a few years ago a OS and a media player could be regarded as separate goods whose union could be associated with a bundling strategy, nowadays a OS must incorporate media player functionalities (as it must incorporate a browser) so that we cannot even talk of a traditional form of bundling (this is common for software: for instance, word processors and spell checkers were in separate markets many years ago, not today; handwriting and voice recognition are separate today, but we can expect that they will be integrated in word processors at some point soon). In this perspective, the attempts of antitrust authorities to stop or delay the evolution of OS through additional features, as browsers and media players, appear quite dangerous: while it is difficult to verify in which moment it would be optimal to bundle secondary products in an evolving primary product, it is not clear why antitrust authorities should have a better guess than market driven firms.
Notice that since the 2004 Commission's decision, Microsoft had to prepare and commercialize a version of Windows without Media Player in Europe. Just after that important students of bundling issues have notice that "all we need to know is that if the remedy does have any impact, that's a sure sign that Microsoft abused its position and hence we should be happy to have the remedy in place. Just as King Solomon's proposal to divide the baby only caused pain to the true mother, the Commission's remedy will only cause pain to a monopolist who abused its position." (). Demand for the version of Windows without Media Player has been virtually zero in all Europe, a likely sign that Microsoft bundling strategy was at least not hurting consumers.
December 2006: Supporting Export Promotion and R&D Subsidies
We are against many forms of passive protectionism, since they are often associated with excessive tariffs and quotas that ultimately reduce the gains from trade. Nevertheless, under certain conditions, we are advocates of active forms of promotion of domestic firms in the international competition, as export promotion, export subsidies, R&D subsidies and protection of intellectual property rights for exporting firms. Here we provide some arguments for some forms of strategic export promotion and we discuss their relation with the traditional economic ideas.
What are the strategic advantages that export promoting policies create for domestic firms? What is the optimal trade policy with respect to exporting firms? How much should we invest to promote international demand of domestic products? Should we always subsidize R&D and protect IPRs for international firms? Do competitive devaluations give a real advantage to national firms in the foreign markets? There is a lot of debate about these questions between policymakers. This is not surprising since also at a theoretical level there are not clear or unambiguous answers.
Common wisdom on the benefits of export subsidization largely departs from the implications of trade theory. While export promotion is often seen as welfare enhancing at least in the short run and often supported by governments, theory is hardly in favour of its direct or indirect forms. In the standard neoclassical theory with perfect competition, the scope of trade policy is to improve the terms of trade, that is the price of exports relative to the price of imports, and, as long as a country is large enough to affect the terms of trade, it is optimal to tax exports (since this is equivalent to set a tariff on imports). In case of imperfect competition, a second aim of strategic trade policy is to shift profits toward the domestic firms, something which was pointed out at the beginning of the eighties in a number of seminal contributions by James Brander, Paul Krugman and Barbara Spencer. Hence, a large body of literature has studied international markets with a fixed number of firms. Here, the optimal unilateral policy is an export tax under price competition, or whenever strategic complementarity holds. Under quantity competition, an export subsidy can be optimal, but only under certain conditions. The same ambiguity of these crucial results has been a limit for their application at the policy level.
Nevertheless, different forms of direct or indirect export subsidies are widespread even if the WTO is against their direct implementation (except for agriculture). Governments strongly support exporting firms, they often hide forms of export promotion behind nationalistic pride, and consider the conquer of larger market shares abroad as a positive achievement in itself. The European Union coordinates trade between its members and the rest of the world in a similar spirit, and subsidizes exports of agricultural products and the aircraft industry. France is use to support its "national champions" with public funding. Italy has a long tradition of public support of the Made in Italy, which is quite important for the promotion of fashion, design and food industries. Japan, Korea and other East-Asian countries have implemented export promoting policies for decades. Heavily protected South-American countries have tried to subsidize manufactured products in which they could develop a comparative advantage (and not only those). Even US has implemented strong forms of export subsidization through tax exemptions for a fraction of export profits, foreign tax credit and export credit subsidies.
The traditional result associated with Brander and Spencer, who were the first to strongly support the use of export subsidies as optimal strategic trade policy, is strengthened and generalized when firms compete in international markets where entry is free. Notice that free entry is a realistic assumption since a foreign country without a domestic firm in the market can only gain from allowing free entry of international firms. Under free entry, export subsidization is always the best unilateral policy both under quantity and price competition, or, more generally, under strategic substitutability and strategic complementarity. The intuition is simple. While firms are playing some kind of competition in the foreign market, a government can give a strategic advantage to its domestic firm with an appropriate trade policy. When entry is free, an incentive to be accommodating is always counterproductive, because it just promotes entry by other foreign firms and shifts profits away from the domestic firm. It is instead optimal to provide an incentive to be aggressive, that is to expand production or (equivalently) lower the price, since this behaviour limits entry increasing the market share of the domestic firm. As usual, this is only possible by subsidizing its exports. Ultimately, the intuition of Brander and Spencer was right under more general conditions than we were use to think.
The same argument can be applied to other forms of indirect export promotion, as policies which boost demand or decrease transport costs for the exporting firms: as long as these policies increase the marginal profitability of the domestic firm, there is a strategic incentive to use them unilaterally. An important example emerges when competition is for the market rather than in the market, that is it take place through international patent races or contests to conquer new markets with innovations. In this case the optimal strategic export policy always requires R&D subsidies and the protection of intellectual property rights important for domestic firms that are active in the international arena. This form of active protectionism can be quite relevant and ultimately positive for the global economy (but, unfortunately, some countries tend to give more importance to passive forms of protectionism as fighting against the intellectual property rights of foreign firms).
Last but not least, governments undertake competitive devaluations with the specific aim to support exporting firms. In spite of this, economic theory is again ambiguous on the merits of these policies. The traditional Mundell-Fleming model emphasizes the beggar-thy-neighbor effects of unilateral devaluations. However, the recent new open-economy macroeconomics shows that these devaluations can be beggar-thy-self policies (this happens because in presence of imperfectly competitive markets and sticky prices, they lower the purchasing power of domestic agents'income and this negative terms of trade externality can more than offset the positive expansionary effect due to the reduction of real wages under nominal rigidities). Moreover, economists tend to underlie the perverse consequences that competitive devaluations have in terms of inflationary bias and creation of self-fulfilling financial crisis and bank runs, which have a recessionary impact on the real economy. Finally, notice that also competitive devaluations induce perverse retaliatory reactions and can induce contagion of financial crisis. The IMF broadly accepts this negative view on competitive devaluations and tends to oppose them unless a fixed exchange rate clearly appears unsustainable.
Again, in front of this theoretical ambiguity it is difficult to make sense of the common wisdom according to which unilateral devaluations provide a positive strategic advantage on the international markets. Surprising result, however, emerge if we evaluate the strategic incentives to exchange rate devaluations in a scenario where the incidence of exchange rate variations on prices is endogenous. Strategic effects of devaluations emerge only when firms produce at home, not if they directly produce in the foreign market. While under barriers to entry competitive devaluations may be a bad idea to provide a strategic advantage to domestic exporters, especially under price competition, under free entry there is always a strategic incentive to depreciate the currency to promote exports. Nevertheless, we believe that in this case the costs associated with retaliation are by far superior to the benefits of devaluations and international coordination to avoid competitive devaluations (for instance through monetary unions) is optimal from a global perspective.
Anyway and in conclusion, the rationale behind all these forms of exports promotion is always the same as long as the adoption of these policies helps the domestic firm to be aggressive in the foreign market, which is always the case when entry is free in this market. Ultimately, the scope of export policy is just to conquer market shares abroad and shift profits from firms of other countries toward domestic firms. If we interpret globalization as the opening up of new markets to international competition we can restate the main result as follows: in a globalized word, there are strong strategic incentives to conquer market shares abroad by promoting exports and adopting forms of active protectionism.
November 2006: The Industrial Organization of the Software Market
The software market, one of the markets of the so-called New Economy, developed in the very last decades through progress in the Information & Communication Technology. In the 1960s, the computer industry was dominated by IBM, which manufactured expensive mainframe computers that were used by large enterprise customers; at the time, very few consumers had access to computers. Apart from IBM, mainframes were offered by firms such as Bull, Burroughs, Data General, Fujitsu, ICL, Nixdorf and Sperry-Rand. There was little or no interoperability among mainframes from different vendors. For the most part, an enterprise customer was required to choose an all IBM solution or an all Nixdorf solution. In the 1970s, Digital Equipment achieved considerable success with a line of less expensive minicomputers that were well-suited to engineering and scientific tasks. Again, however, there was little or no interoperability between these minicomputers and mainframes offered by IBM and others. The structure of the industry at that time was still largely vertical. By 1980, a number of companies had started offering less expensive microcomputers which were not interoperable with one another: early PCs by Tandy, Apple, Commodore and Atari ran their own operating systems, meaning that applications written for one brand of PC would not run on any other brand: the industry was fragmented. In mid-1980, IBM announced plans to introduce an IBM personal computer. The first one was offered with a choice of three operating systems: CP/M-86 from Digital Research, UCSD-P System and MS-DOS from Microsoft, a company founded by Bill Gates, a young software architect who dropped his studies at Harvard to develop what was going to become a symbol of market leadership.
To understand the peculiarities of the software market in general it is convenient to focus briefly on the main functions of PC operating systems (OSs). The main one is to serve as a platform on which applications (such as spreadsheets or word processors) can be created by software developers. OSs supply different types of functionality, referred to as system services, that software developers can call upon in creating their applications. These systems services are made available through Application Programming Interfaces (APIs). When an application calls a particular API, the OS supplies the system service associated with that API by causing the microprocessor to execute a specified set of instructions. Software developers need well-defined platforms that remain stable over time. They need to know whether the system services on which their applications rely will be present on any given PC. If they did not, then software developers would have to write the software code to provide equivalent functionality in their own applications, generating redundancy, inefficiency and a lack of interoperability.
Moreover, modern OSs provide a user interface, the means by which a user interacts with his computer. User interfaces for computers have evolved dramatically over the last decades, from punch card readers, to teletype terminals, to character-based user interfaces, to Graphical User Interfaces, first introduced by Apple with Macintosh. Finally, operating systems enable users to find and use information contained in various storage devices: local ones, such as a floppy diskette, a CD-ROM drive or the hard drive built into a PC, or remote, such as local area networks that connect computers in a particular office, wide area networks that connect computers in geographically separated offices, and the Internet.
Over time, the OSs of Microsoft became the most popular because Microsoft continually added new functionality to the operating system and licensed it to a wide range of computer manufacturers with extremely aggressive pricing strategies. Microsoft recognised early on that an OS that served as a common platform for developing applications and could run on a wide range of PCs would provide substantial benefits to consumers. Among other advantages, development costs would fall and a broader array of products would become available because products could be developed for the common platform rather than for a large number of different platforms. By providing a single operating system that ran on multiple brands of PCs, Microsoft enabled software developers to create applications, confident that users could run those applications on PCs from many different computer manufacturers. In addition, applications developed for a single platform were more easily interoperable because they were relying on the same functionality supplied by the underlying OS. In other words, network effects were created.
In 1981, Microsoft released its first operating system, MS-DOS, which had a character-based user interface that required users to type specific instructions to perform tasks. In 1985, Microsoft introduced a new product called Windows that included a GUI, enabling users to perform tasks by clicking on icons on the screen using a pointing device called a mouse. Windows 3.0, shipped in 1990, was the first commercially successful version of Windows. In 1995, Microsoft released Windows 95, which integrated the functionality of Windows 3.1 and MS-DOS in a single operating system. In 2000, Microsoft shipped Windows 2000 Professional, a new generation of PC operating system built on a more stable and reliable software code base than earlier versions of Windows. Windows XP and the forthcoming Vista represent furthers evolution of the operating system, with a range of added functionality for both business and home users. Even if official and unanimous data are unavailable, consistent evidence suggests that the market share of Windows on sales of OSs for PCs rapidly increased toward 80% in the first half of the 90s to gradually arrive at 92% in 1996, 94% in 1997, 95% in 1998 and remained basically at this level since then: meanwhile the average consumer price of Windows (calculated as average revenue per licence in OEM channel based on Microsoft sales) was constant (in nominal terms) around 44-45$.
Beyond OSs, Microsoft produces very successful applications. Some essential applications have been freely bundled with the operating system: for instance a basic word processing software, WordPad, a browser to access Internet and media player functionalities have been gradually added for free to subsequent versions of Windows when they became standard components of a modern OS. Other more sophisticated applications are supplied separately. Most notably this is the case of the Office Suite consisting of the advanced word processor Word, the spreasheet Excel, the software for presentations PowerPoint and more. The main two applications, Word and Excel, have been successfully competing against alternative products like WordPerfect, WordStar, AmiPro and others on one side and Lotus, Quattro and others on the other side. Liebowitz and Margolis (1999) have shown convincing evidence for which a better quality/price ratio together with network effects were at the basis of this success (it is important to notice that Microsoft achieved leadership in the Macintosh market, hence without exploiting the presence of its own OS, considerably earlier than in the PC market). In the market for word processing applications, Microsoft's market share was hardly above 10% at the end of the 80s, to gradually increase at 28% in 1990, 40% in 1991, 45% in 1992, 50% in 1993, 65% in 1994, 79% in 1995, 89 in 1996, 94% in 1997 and to arrive at 95% in 1998, meanwhile the average consumer price of Word (calculated as average revenue per license) decreased from 235$ in 1988 to 39$ in 2001. In the market for spreadsheet applications, Microsoft followed a similar progress, with a market share of 18% in 1990, 34% in 1991, 43% in 1992, 46% in 1993, 68% in 1994, 76% in 1995, 84% in 1996, 91% in 1997 and 94% in 1998, with minor progress in the following years, while the average consumer price of Excel was decreasing from 249$ in 1988 to 42$ in 2001.
The leading position of Microsoft induced large opposition in the industry and the emergence of multiple antitrust cases with importance at a global level. In the main Microsoft vs US case, the software company was accused of monopolizing the PC operating systems market for Intel-compatible computers, tying its Windows operating system with the Internet Explorer browser with predatory purposes and to engage in anti-competitive contractual agreeements with computer manufacturers and Internet service providers. After an initial decision which imposed heavy behavioural and structural remedies on Microsoft, including the break up in a operating system and an application company (the socalled "Baby Bills"), the November 2002 ruling of the District of Court decided only to impose behavioural remedies aimed at preventing Microsoft from adopting exclusionary strategies against firms challenging its market power in the market for operating systems.
The Microsoft vs EU case was developed on very similar issues, in particular on the bundling of Windows with mediaplayer functionality and on the level of interoperability with softwares by other companies; at the time of writing, the case is still unresolved. In the March 2004 decision, the European Commission imposed the largest fine in the history of antitrust, required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers and competitor products. Microsoft's Appeal of the decision was heart by the European Court of First Instance in April 2006 and a decision is expected by the end of the year.
A common element in both cases has been the substantial involvement of competitors of Microsoft on the side of the antitrust authorities, something that usually can create suspicion on the fact that a firm is really behaving as a monopolist rather than as an aggressive competitor. In a neat article on Business Week, Robert Barro (1998, ) noticed that "[a] sad sidelight in the Microsoft case is the cooperation of its competitors, Netscape, Sun and Oracle Corp., with the government. One might have expected these robust innovators to rise above the category of whiner corporations... The real problem is that whining can sometimes be profitable, because the political process makes it so. The remedy requires a shift in public policies to provide less reward for whining. The bottom line is that the best policy for the government in the computer industry is to stay out of it." Nevertheless in the European case Sun, Oracle, Novell, IBM and the Free Software Movement are active sides against Microsoft.
The technological conditions in the software market are well known. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment and a constant marginal cost which, as well known, is close to zero. The entry conditions in this market are more debated, but there are good reasons to believe that even though entry into the software market may entail large costs, it is substantially open, i.e. endogenous. First of all, there are already many firms producing OSs (as IBM, Red Hat, Oracle, Sun, Apple, HP, Compaq, Data General,...), and even more potential entrants -- think of the giants in adjacent sectors of the New Economy (hardware and telecommunications in particular). Second, it is hard to think of a market which is more "global" than the software market: demand comes from all over the world, transport costs are virtually zero, the knowledge required to build software is easily accessible worldwide and competition is global. Nevertheless, it has been claimed that in the market for PC (or client) operating systems, the high number of applications developed by many different firms for Windows represents a substantial barrier to entry. Unfortunately, such a claim usually leads to misleading conclusions. It is true that competitors need to offer (and some do offer already) a number of standard and technologically mature applications upon entry to match the high quality of the Windows package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market. There are at least two reasons for this. First, notice that the alleged "applications barrier to entry" is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really satisfy the needs of most active computer users (McKenzie, 2001). Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems "ported to" theirs). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market (as opposed to competition in the market), there is no doubt that the opportunity to invest in innovations for future, better software is widely open not only to large companies in the New Economy, but even to smaller ones.
Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the ideal conditions under which we should expect a leader to produce for the whole market with very aggressive (low) prices. Hence, it should not be surprising that, at least in the market for operating systems, a single firm, Microsoft, has such a large market share. We can see the same fact from a different perspective: since entry into the software market is endogenous, the leader has to keep prices low enough to expand its market share to almost the whole market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative software at even lower prices to build their own network effects. Not by chance low prices in presence of network effects are very common and often extreme: most email services such as Yahoo or search engines as Google are free because this is the best strategy available for their leading suppliers under the constraint of effective competition. All these market leaders gain from collateral services, and, for sure, their leadership has nothing to do with dominance.
The extremely low price of Windows represents a double proof of our arguments above. Assume for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by ε-1, where ε is the elasticity of demand for PCs (including both hardware and software): it means that a 1% increase in the price of PCs reduces demand by ε%. Now, the above relationship tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if ε=2, 500 Euros if ε=3, 333 Euros if ε=4 and so on. It would take really unreasonable values of demand elasticity to even get close to the real price of Windows, which is around 50 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would double tomorrow, hardware producers would be forced to reduce somewhat their prices (eventually switching to lower cost techniques and/or lower quality products). Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows, that is, even beyond the real price of Windows.
What does all this tell us? Simply that Microsoft is not an unconstrained price-setter, while its prices are limited well below the monopolistic price to compete aggressively with the other firms active in the operating system market and with the potential entrants in it. Important economists have supported this position. concludes in a similar fashion: "Microsoft priced low because of the threat of competition. This means that Microsoft believed that it could not price higher it if were to maintain its market position." McKenzie (2001) supports this view: "some firms with high market shares might act more like competitors than other firms in markets where they have much smaller market shares. The reason is that the threat posed by potential competitors in a highly concentrated market can be more constraining than the competitive threat of actual competitors in less-concentrated markets".
What the post-Chicago approach suggested about leaders in markets with price competition was that they should be accommodating and exploit their market power, setting higher prices than competitors, or otherwise engage in predatory pricing and, after having conquered the whole market, increase prices. But in the last 10-15 years of global leadership, Microsoft has done neither of these things. It has been constantly aggressive, as any firm under the threat of competitive pressure would be. The theory of market leaders has shown that a market leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the large (worldwide in the case of Microsoft) scale of production. Its (quality adjusted) price should be slightly below that of its immediate competitors or just low enough to avoid that they can exploit profitable opportunities increasing their prices. Where other theories cannot, the theory of market leaders can make perfect sense of Microsoft's large market share, large profits and relatively low prices in a global and open market.
October-September 2006: Antitrust Economics and Dominant Market Position
The economics of competition policy is a fascinating field where the link between economic theory and policy implications is extremely direct and crucial. This holds in particular for issues concerning abuses of dominant market position, which are widely debated in both the economic literature and the practice of antitrust policy both in the United Stated and Europe.
In the US the main federal antitrust statute is the Sherman Act of 1890, which was developed in reaction to the widespread growth of large scale business trusts. Section 1 prohibits restraints of trade in general, while Section 2 deals with monopolization stating that “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony”. The current interpretation of US antitrust law associates abusive conduct with predatory or anticompetitive actions having the specific intent to acquire, preserve or enhance monopoly power distinguished from acquisition through a superior product, business acumen or historical accident (hence a dominant market position per se is not illegal). It is generally accepted that an action is anticompetitive when it harms consumers.
In Europe competition policy has a more recent history which is mostly associated with the creation of the EU and its coordination of policies for the promotion of free competition in the internal market. The main provisions of European Competition Law concerning abuse of dominance are contained in the Article 82 of the Treaty of the European Communities which states that “Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common market in so far as it may affect trade between Member States. Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.” The application of EU competition law on abuse of dominance involves the finding of a dominant market position and of an abusive behaviour of the dominant firm, usually associated with excessive pricing or with exclusionary practices as predatory pricing, rebates, tying or bundling, exclusive dealing or refusal to supply. However, the analysis of both dominance and abusive behaviours entail complex economic considerations and is the subject of an on going revision.
Historically, two main approaches to the economics of competition policy have been dominant in the last decades. The Chicago approach of the 60’s and 70’s has emphasized the importance of competition in constraining market leaders, while post-Chicago approach of the 80’s and 90’s has emphasized the strategic interaction between market leaders and competitors. The recent theory of market leadership, on which we will focus here, tries to integrate these approaches. While the former one has ignored strategic interactions and the asymmetric role of market leaders, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor: the theory of market leaders tries to fill these gaps. The results, however, are conflicting: under price competition, while the post-Chicago approach associates any aggressive pricing with predatory purpose, the new theory of market leaders shows that aggressive pricing can have a pro-competitive and welfare enhancing role without exclusionary purposes.
The general theory of market leaders clarifies the role of market leaders by studying their incentives to undertake preliminary investments and other market strategies to gain advantage over their competitors. For instance, consider investment in R&D: the post-Chicago approach taught us that when competition in quantities takes place between two firms, one of them would usually gain by over-investing in R&D to reduce costs, which allows it to be aggressive in the market (expanding production and inducing its rivals to produce less), but under competition in prices, the same firm would prefer to under-invest in R&D to reduce costs so as to be accommodating (increasing its price so as to induce its rivals to raise prices). The theory of market leadership, however, shows that things change when entry is endogenous, that is when firms endogenously decide to enter or not in the market according to their opportunities. In this case, the pressure of entry induces a firm to undertake always investments to be aggressive in the market; that is, to expand production under competition in quantities and decrease prices under competition in prices. For instance, a leader will always find it optimal to over-invest in R&D to reduce costs and be able to sell more at a price below the price of its competitors. This outcome emerges in many other contexts and under any form of competition as long as entry for competitors is endogenous. When this condition applies, the competitors’ fear induces a market leader to be aggressive: its best strategy requires reducing costs, improving product quality, engaging in a lot of advertising, producing complementary products, bundle complementary goods and so on. This allows the leader to lower its price, gain market share and gain from a reduction in the average costs of production, but it also disciplines competitors and keeps prices at a low level, with unambiguous benefits for consumers.
It is also easy to derive simpler and even more radical results in a more basic context where the leader does not undertake a preliminary strategic investment but directly decides its own strategy before the other firms. In general, a leader in a market where fixed or sunk costs constrain entry will produce more and will set lower prices than its competitors. Actually, in a market of homogeneous products where production requires a fixed sunk cost and a constant marginal cost of production and firms choose their production levels (a simple structure typical of energy and telecommunication industries and some high-tech sectors), the competitive equilibrium implies that only the leader produces in the market. Paradoxically, such apparently monopolistic markets completely dominated by a single firm are perfectly competitive and extremely efficient since they save in costs of entry, making the productive process much cheaper, and consequently keep prices at a low level. Hence, a proper competition policy in this situation should not obstruct the market leader and should limit its intervention to promote entry.
To extend the analysis to other contexts, imagine that goods are not homogeneous but they differ in quality. This happens when consumer needs or tastes are quite differentiated, as is the case in many sectors where the design and the inner quality of products play an important role. Under these circumstances, firms often compete in prices by choosing different mark-ups for different products. When quality differs, it is important to have a number of firms producing different varieties of goods. A competitive market typically satisfies this requirement, but it tends to induce excessive proliferation of products. The presence of market leaders is again beneficial: they will not conquer the entire market as before, but they will expand production and consequently reduce their prices below the prices of their competitors, some of which will be driven out of the market. Consumers will then face a lower variety of alternative products but pay less for some of them. Again market leadership with endogenous entry creates a net gain for society. An analogous situation appears when we relax the other assumption adopted in the basic example, that of constant marginal costs. When the average cost function has a standard U-shape due to increasing marginal costs (at least beyond a certain production level), the leader again produces more than each competitor. In such a case, the price of the market leader is also equal to its marginal cost: hence, the theory of market leaders confirms that, in this situation, the theoretical price above which there cannot be predatory purposes corresponds to the marginal cost, which, according to the traditional Areeda-Turner test, is best approximated by the average variable cost. The adoption of other standard price levels above which predation should not be an issue in general is here inconsistent with these results.
This discussion implies two main conclusions. First, a leading market position associated with aggressive strategic investments can be the consequence of a competitive market environment and not the result of market power. Second, whenever firms engage in price competition, the post-Chicago approach associates aggressive pricing or other aggressive strategies (including bundling) with a predatory purpose, while the theory of market leaders provides arguments for which an aggressive strategy is generally pro-competitive and without exclusionary purposes. Moreover, the new theory of market leaders provides insights into what constitutes a dominant position in a market and what an abuse of that position should consist of. First of all, it would be better to differentiate market leaders from dominant firms: market leaders have some strategic competitive advantage over their competitors, but only when they can use it to prevent effective competition and harm consumers should they be considered to be dominant and their behaviour potentially abusive. Second, there should be no presumption that a certain market share amounts necessarily to dominance. As a matter of fact, the theory of market leaders shows that, paradoxically, the correlation between market share and effective market power can be negative. Consider a market where a leader and its rivals compete on price. According to the post-Chicago approach, the leader could try to deter entry with a predatory strategy, or just be accommodating, sharing the market with competitors, in which case its market share may be even smaller than that of its competitors. However, when entry into the market is endogenous and constrained just by technological conditions, the leader has to adopt a strategy of aggressive pricing, and, by undercutting its competitors, it acquires a larger share of the market. In this case, the market share of the leader is increasing when product differentiation is weaker, when fixed costs of production are higher and when variable costs do not increase too much as production level goes up. In conclusion, considering a large market share per se a finding of dominance is potentially highly misleading.
Competition in high-tech markets is dynamic in the Schumpeterian sense that it takes place as competition for the market in a so called winner-takes-all-race, and such an element requires an even deeper rethinking of industrial policy than suggested in the analysis of the previous sections, which was mostly focused on a static concept of competition in the market. Even if most economists are used to thinking about market leaders as firms with weaker incentives to invest in R&D, recent theoretical and empirical research has also noticed that market leaders play a crucial role in the innovation sector for competitive markets. The fact that market leaders often remain at the top of the technological frontier in their respective industries may not be the sign of a monopolistic position in the traditional sense, but the fruit of their investments and of the competitive threat deriving from other firms and potential entrants.
The recent theories of market leadership have clarified the mechanics of these results. Leaders have more incentives to invest in innovation than the outsiders when the market for innovation, or what sometimes is called the patent race, is characterized by endogenous entry (as long as there is a leadership, which in economic jargon means just that there is the possibility to commit to an investment choice before the other firms). The crucial thing here, is that market leaders often remain on top thanks to their investments, but this should not be seen as evidence of inefficiency or of dominance, but rather as a proof of the opposite: the competitive environment spurs investment by leaders and consequently induces a chance that their leadership persists.
Clearly, this has strong implications for competition policy. What the above theory suggests in this case, is that market leaders in high-tech sectors investing a lot in innovation may create an efficient situation. Antitrust authorities should be especially careful when trying to stamp out monopoly power in markets that are marked by technical innovation. Moreover, they should careful not to erode the IPRs of the market leaders because exactly these property rights and the expectations on the protection of future property rights are what provides the strong incentives to invest in R&D: both for the leaders and patentholders and for their followers trying to catch up. This is a possible way to approach the well-known tension between antitrust policy and IPRs policy.
In December 2005 the European Commission published a Discussion Paper on exclusionary abuses under Article 82 which is the subject of an open debate and gives an important indication as to how the Commission may approach exclusionary abuses in the future. The Discussion Paper states that the purpose of Article 82 is “the protection of competition on the market as a means of enhancing consumer welfare and of ensuring an efficient allocation of resources”. This implies that antitrust should protect competition and not competitors and be based on an economic approach aiming at the maximization of consumer welfare and allocative efficiency rather than based on a legalistic approach. In the current proposal there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines.
According to the European Competition Law abuse of a dominant market position is subject to antitrust screening. Hence, the preliminary phase of any antitrust case applying Article 82 must define the relevant market and verify the existence of a dominant market position. The Discussion Paper briefly refers to the definition of a proper market, which can be more complex in Article 82 cases because the market price could be above its competitive level. This creates problems with the usual methods of market definition. For instance the SSNIP-test, which defines the relevant separate market as the smallest market where a Small but Significant Non-transitory Increase in (competitive) Prices (say of 5-10%) increases the profits of a hypothetical monopolist, is biased when the market is characterized by higher than competitive prices (which is more likely in cases of abuse of dominance): such a bias usually leads to a too-wide market definition, which in turn may lead to a finding of no dominance, the so-called “cellophane fallacy” (from the classic du Pont case). However, it should be noticed that the cellophane fallacy only applies in presence of a single monopolist in the market and when entry is impossible, while the SSNIP-test at the prevailing prices remains a valid test whenever the market leader is constrained by effective competition and/or potential entry.
Following a traditional definition, the Discussion Paper associates dominance with “a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of the consumers”. Such a definition requires “a leading position on that market” compared to the rivals and the lack of “effective competitive constraints” in the process in which “the undertaking and the other players act and inter-act on the market”. Given the positive stress put on an economic-based approach to competition policy, it is important to notice that this definition of dominance is clearly associated with two situations: the pure monopoly and the market leadership. According to the theory of market leaders, it should be emphasized that a market leader can really act independently of its rivals (so as to satisfy the above condition for dominance) only when the number of competitors is exogenously set and further entry is impossible, while a market leadership constrained by effective competition and potential entry cannot be associated with dominance: in this case leaders tend to be aggressive (pro-competitive) in their pricing and investment strategies, conquering larger market shares in a way that has nothing to do with dominance as defined above, and which is also beneficial to consumers.
The general stress on market shares in the evaluation of dominance appears in clear contrast with the conclusions of the theory of market leadership: leaders have larger market shares exactly when they are constrained by effective and potential competition since in this case they adopt more aggressive (pricing and investment) strategies which expand their market shares. In other words there is not necessarily a positive correlation between the presence of larger market shares and a dominant position and, especially in highly dynamic markets, there is not unambiguous theoretical support for a statement saying that market share “is only a proxy for market power”. The structural indicators which traditionally serve as proxies for ‘dominance’ can be accurate at most in some traditional markets, but not in others, as indeed in high-tech and New Economy industries, as computer hardware and software, online businesses, mobile telephony and biotechnology. [A clear contradiction emerges in the application of a new positive rule, the efficiency defense, which would allow otherwise abusive strategies if they create a net efficiency gain. The effectiveness of this rule in safeguarding consumer welfare is weakened when it is stated that some firms are virtually excluded from the possibility of an efficiency defence. In particular, a strange concept of market position “approaching that of a monopoly” is introduced and associated with market shares above 75%, something without any justification in economic theory: a firm is a monopoly or is not (in which case, its behaviour is constrained by competitors), but it cannot be an “almost monopoly” or a “near monopoly”].
Finally, and maybe even more importantly, the part on dominance clearly refers to competition in the market, while it is hardly useful to evaluate cases where competition for the market takes place. In these cases, typical of the New Economy, competition is dynamic and innovators conquer large parts of a market, so that any static analysis of market shares cannot say anything about dominance. In other words, a market can be currently dominated by a single firm, but if many other firms which are not even active in this market are investing in R&D to enter into it, as it happens in many high-tech sectors, this market is substantially competitive in a dynamic sense. Nevertheless, any leader in such a competitive winner-takes-all market would be always characterized as dominant by the static and market-share-based approach.
Moreover, as we saw earlier, the theory of market leaders tells us that in these dynamic sectors market leaders, as long as they are constrained by effective competition in the market for innovations, invest more than their competitors and hence are more likely to remain leaders. In this sense, statements saying that “high market shares, which have been held for some time, indicate a dominant position” can be true in some sectors, but not in some high-tech sectors with competition for the market. In conclusion, the general impression is that there is an excessive stress on the importance of market shares to evaluate dominance, and that this can be highly misleading especially for dynamic markets.
In conclusion, recent developments in the economics of competition policy and dominant market positions have emphasized the need of a more careful approach to antitrust and to the role of market leaders especially in dynamic and innovative markets. In this sense, parallel developments in the policy debate still need a more solid economic foundation.
August 2006: Market Dominance - An Economic Perspective on Art. 82 EU - Part II (see July 2006 for Part I)
In December 2005 the European Commission published a Discussion Paper on exclusionary abuses under Article 82 which is the subject of an open debate and gives an important indication as to how the Commission may approach exclusionary abuses in the future. The Discussion Paper states that the purpose of Article 82 is “the protection of competition on the market as a means of enhancing consumer welfare and of ensuring an efficient allocation of resources” (# 4). This implies that antitrust should protect competition and not competitors and be based on an economic approach aiming at the maximization of consumer welfare and allocative efficiency rather than based on a legalistic approach. In the current proposal there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines.
According to the European Competition Law, dominance in a market or its creation cannot be punished, while only its abuse by dominant firms is subject to antitrust screening. Hence, the preliminary phase of any antitrust case applying Article 82 must define the relevant market and verify the existence of a dominant position. The Discussion Paper briefly refers to the definition of a proper market, which can be more complex in Article 82 cases because the market price could be above its competitive level (#11-19). This creates problems with the usual methods of market definition. For instance the SSNIP-test, which defines the relevant separate market as the smallest market where a Small but Significant Non-transitory Increase in (competitive) Prices (say of 5-10%) increases the profits of a hypothetical monopolist, is biased when the market is characterized by higher than competitive prices (which is more likely in cases of abuse of dominance): such a bias usually leads to a too-wide market definition, which in turn may lead to a finding of no dominance, the so-called “cellophane fallacy” (from the du Pont case). However, it should be noticed that the cellophane fallacy only applies in presence of a single monopolist in the market and when entry is impossible, while the SSNIP-test at the prevailing prices remains a valid test whenever the market leader is constrained by effective competition and/or potential entry.
Following a traditional definition, the Discussion Paper associates dominance with “a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of the consumers” (# 20). Such a definition requires “a leading position on that market” compared to the rivals (# 22) and the lack of “effective competitive constraints” (# 23) in the process in which “the undertaking and the other players act and inter-act on the market”( # 23). Given the positive stress put on an economic-based approach to competition policy, it is important to notice that this definition of dominance is clearly associated with two situations: the pure monopoly, as an extreme case of dominance, and the market leadership where the dominant firm faces some competitors, which is the subject of the theory of market leaders previously studied. It should be emphasized that, according to this theory, a market leader can really act independently of its rivals (so as to satisfy the above condition for dominance) only when the number of competitors is exogenously set and further entry is impossible, while a market leadership constrained by effective competition and potential entry cannot be associated with dominance: in this case, modern economic theory tells us that leaders tend to be aggressive (pro-competitive) in their pricing and investment strategies, conquering larger market shares in a way that has nothing to do with dominance as defined above, and which is also beneficial to consumers.
As a consequence of the approach of the Discussion Paper, a certain ambiguity emerges in the statement at # 27 saying that “the fact that an undertaking is compelled by the pressure of its competitors’ price reductions to lower its own prices is in general incompatible with […] the existence of substantial market power” and hence with dominance. In particular this should be always true and not just “in general”, since in this case the market leader is constrained by effective competition and cannot act independently from it, as the definition of dominance would require and should be extended to any other form of aggressive competition, that is not only competition in prices, but also competition in quantities or in alternative forms of strategic investments. Hence, the fact that an undertaking is compelled by the pressure of its competitors’ aggressive strategies to adopt aggressive (pricing and investment) strategies should be always incompatible with dominance.
The stress on market shares in the evaluation of dominance (# 29- 33) appears in clear contrast with the conclusions of the theory of market leadership: market leaders have larger market shares exactly when they are constrained by effective and potential competition since in this case they adopt more aggressive (pricing and investment) strategies which expand their market shares. In other words there is not necessarily a positive correlation between the presence of larger market shares and a dominant position and, especially in highly dynamic markets, there is not unambiguous theoretical support for a statement saying that “[m]arket share is only a proxy for market power” (# 32). The structural indicators which traditionally serve as proxies for ‘dominance’ can be accurate at most in some traditional markets, but not in others, as indeed in high-tech and New Economy industries (as computer hardware and software, online businesses, mobile telephony and biotechnology).
Finally, and maybe even more importantly, the part on dominance clearly refers to competition in the market, while it is hardly useful to evaluate cases where competition for the market takes place. In these cases, typical of the New Economy, competition is dynamic and innovators conquer large parts of a market, so that any static analysis of market shares cannot say anything about dominance. In other words, a market can be currently dominated by a single firm, but if many other firms which are not even active in this market are investing in R&D to enter into it, as it happens in many high-tech sectors, this market is substantially competitive in a dynamic sense. Nevertheless, any leader in such a competitive winner-takes-all market would be always characterized as dominant by the static and market-share-based approach of the Discussion Paper.
Moreover, as we saw earlier, the theory of market leaders tells us that in these dynamic sectors market leaders, as long as they are constrained by effective competition in the market for innovations, invest more than their competitors and hence are more likely to remain leaders. In this sense, statements saying that “high market shares, which have been held for some time, indicate a dominant position” can be true in some sectors, but not in high-tech sectors with competition for the market. In conclusion, the general impression is that there is an excessive stress on the importance of market shares to evaluate dominance, and that this can be highly misleading especially for dynamic markets.
Finally, the part of the Discussion Paper on barriers to expansion and entry (# 34-40) concerns a concept which is far from unambiguous in economic theory. The definition of these barriers as “factors that make entry impossible or unprofitable while permitting established undertakings to charge prices above the competitive level” (# 38) applies well to legal barriers but not to other factors which are sometimes seen as barriers. For instance, high fixed costs of production and R&D or investments needed to develop network externalities or learning by doing advantages, do not make entry impossible: the correct definition in these cases would be that these factors endogenously limit entry or endogenously determine how many and which firms profitably enter. The difference is not just in the definition but also in the economic consequence, since modern economic theory has shown that when entry is impossible market leaders may behave in an anti-competitive way, but when entry is constrained by technological or demand conditions they (always) behave in a pro-competitive way even if the cited factors limit entry and the market leaders obtain high market shares.
July 2006: Market Dominance - An Economic Perspective on Art. 82 EU - Part I (see August 2006 for Part II)
In line with the recent evolution of US antitrust, the European Commission is trying to implement an important reform for the EU approach to abuse of dominance with foreclosure of competitors, moving from a formal approach to antitrust to a more modern welfare-based approach focused on the protection of consumers and of competition (not of the competitors). While this attempt is positive, there are some concern that these efforts will not be fully carried through into the recent proposal of the Commission, the DG Competition Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses. For instance, still in line with outdated economic views, dominance is associated too closely with large market shares and the efficiency defence - the chance for the dominant firm to prove that its aggressive strategy enhances consumer welfare or improves the allocation of resources - is virtually excluded in case of large enough market shares. This article will approach the debate on this reform focusing on the particular issue of market dominance. The analysis will be largely based on an economic point of view, hence, it will start with a description of the basic insights of economic theory on this issue.
Recent developments in the economic research on market structure suggest the need of a new approach to competition policy. The new theory of market leadership, inspired by the classic analysis of pioneers such as Stackelberg, Schumpeter and Modigliani, tries to integrate the Chicago approach of the 60’s and 70’s, which has emphasized the importance of competition in constraining market leaders and the post-Chicago approach of the 80’s and 90’s, which has emphasized the strategic interaction between market leaders and competitors. While the former approach has ignored strategic interactions and the asymmetric role of market leaders, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor: the theory of market leaders tries to fill these gaps. The results, however, are conflicting: under price competition, while the post-Chicago approach associates any aggressive pricing with predatory purpose, the new theory of market leaders shows that aggressive pricing can have a pro-competitive and welfare enhancing role without exclusionary purposes.
The general theory of market leaders clarifies the role of market leaders by studying their incentives to undertake preliminary investments and other market strategies to gain advantage over their competitors. Traditionally, the post-Chicago approach taught us that when competition in quantities takes place between two firms, one of them would usually gain by over-investing to reduce costs, which allows it to be aggressive in the market (expanding production and inducing its rivals to produce less), but under competition in prices, the same firm would prefer to under-invest in cost reductions so as to be accommodating (increasing its price so as to induce its rivals to raise price). The theory of market leadership, however, shows that things change when entry is endogenous, that is when firms endogenously decide to enter or not in the market according to their opportunities to make profits. In this case, the pressure of entry induces a firm to undertake always investments to be aggressive in the market; that is, to expand production under competition in quantities and decrease prices under competition in prices. For instance, a leader will always find it optimal to over-invest in cost reductions to be able to produce more and to reduce its price below the price of its competitors. This outcome emerges in many other contexts: in any market where entry is endogenous, the leader always over-invests to gain a strategic advantage and conquer a larger market share. However, this results in a reduction in prices with a net gain for consumers!
Such a phenomena happens under any form of competition (including in prices and in production levels) as long as entry for competitors is endogenous. As long as this condition applies, the competitiors’ fear induces the leader to be aggressive: its best strategy requires reducing costs, improving product quality, engaging in a lot of advertising, producing complementary products and so on. This allows the leader to lower its price, gain market share and gain from a reduction in the average costs of production, but it also disciplines competitors and keeps prices at a low level, with unambiguous benefits for society.
It is also easy to derive simpler and even more radical results in a more basic context where the leader does not undertake a preliminary strategic investment but directly decides its own strategy before the other firms. In general, a leader in a market where fixed or sunk costs constrain entry will produce more and will set lower prices than its competitors. Actually, in a market of homogeneous products where production requires a fixed sunk cost and a constant marginal cost of production and firms choose their production levels (a simple structure typical of energy and telecommunication industries and some high-tech sectors), the competitive equilibrium implies that only the leaders produces in the market. Paradoxically, such apparently monopolistic markets completely dominated by a single firm are perfectly competitive and extremely efficient since they save in costs of entry, making the productive process much cheaper, and consequently keep prices at a low level. With this kind of market leadership, society gains from greater cost efficiency and lower prices. Hence, a proper competition policy in this situation should not obstruct the market leader and should limit its intervention to promote entry.
Now, to extend the analysis to other contexts, imagine that goods are not homogeneous but they differ in quality. This happens when consumer needs or tastes are quite differentiated, as is the case in many sectors where the design and the inner quality of products play an important role. Under these circumstances, firms often compete in prices by choosing different mark-ups for different products. When quality differs, it is important to have a number of firms producing different varieties of goods. A competitive market typically satisfies this requirement, but it tends to induce excessive proliferation of products. The presence of market leaders is again beneficial: they will not conquer the entire market as before, but they will expand production and consequently reduce their prices below the prices of their competitors, some of which will be driven out of the market. Consumers will then face a lower variety of alternative products but pay less for some of them. Again market leadership with endogenous entry creates a net gain for society. An analogous situation appears when we relax the other assumption adopted in the basic example, that of constant marginal costs. When the average cost function has a standard U-shape due to increasing marginal costs (at least beyond a certain production level), the leader again produces more than each competitor. In such a case, the price of the market leader is also equal to its marginal cost: hence, the theory of market leaders confirms that, in this situation, the theoretical price above which there cannot be predatory purposes corresponds to the marginal cost, which, according to the traditional Areeda-Turner test, is best approximated with the average variable cost. The adoption of other standard price levels above which predation should not be an issue in general is here inconsistent with our results.
This discussion implies two main conclusions. First, a leading market position associated with aggressive strategic investments can be the consequence of a competitive market environment and not the result of market power. Second, whenever firms engage in price competition, the post-Chicago approach associates aggressive pricing or other aggressive strategies (including bundling) with a predatory purpose, while the theory of market leaders provides arguments for which an aggressive strategy is generally pro-competitive and without exclusionary purposes. This creates doubts about the traditional approach to predatory pricing and other exclusionary conducts that characterises EU competition policy.
Moreover, the new theory of market leaders provides insights into what constitutes a dominant position in a market and what an abuse of that position should consist of. First of all, it would be better to differentiate market leaders from dominant firms: market leaders have some strategic competitive advantage over their competitors, but only when they can use it to prevent effective competition and harm consumers should they be considered to be dominant and their behavoiur potentially abusive. The point is to understand when market leaders can prevent effective competition and when they cannot.
As previously noticed, the behaviour of market leaders tends to be pro-competitive whenever entry of competitors in their markets is constrained by entry barriers or fixed costs of entry. Second, there should be no presumption that a certain market share amounts necessarily to dominance. As a matter of fact, the theory of market leaders shows that, paradoxically, the correlation between market share and effective market power can be negative. Consider a market where a leader and its rivals compete on price. According to the post-Chicago approach, the leader could try to deter entry with a predatory strategy, or just be accommodating, sharing the market with competitors, in which case its market share may be even smaller than that of its competitors. However, when entry into the market is endogenous and constrained just by technological conditions, the leader has to adopt a strategy of aggressive pricing, and, by undercutting its competitors, it acquires a larger share of the market. In this case, the market share of the leader is increasing when product differentiation is weaker, when fixed costs of production are higher and when variable costs do not increase too much as production level goes up. Actually, as we have seen before, the theory of market leaders describes the conditions under which endogenous entry induces the leader to be so aggressive as to conquer the whole market. But this implies that the same possibility of entry and hence lack of effective market power is associated with the largest market share for the leader. In conclusion, considering a large market share per se a finding of dominance is potentially highly misleading.
Competition in the high-tech markets is dynamic in the Schumpeterian sense that it takes place as competition for the market in a so called winner-takes-all-race, and such an element requires an even deeper rethinking of industrial policy than suggested in the analysis of the previous sections, which was mostly focused on a static concept of competition in the market.
Even if most economists are used to thinking about market leaders as firms with weaker incentives to invest in R&D, recent theoretical and empirical research has also noticed that market leaders play a crucial role in the innovation sector for competitive markets. As an Economic Focus of the Economist (May 20th, 2004) has recently written, “Joseph Schumpeter, an Austrian economist, pointed out many years ago that established firms play a big role in innovation. In modern times, it appears that many product innovations, in industries from razor blades to software, are made by companies that have a dominant share of the market. Most mainstream economists, however, have had difficulty explaining why this might be so. Kenneth Arrow, a Nobel prize-winner, once posed the issue as a paradox. Economic theory says that a monopolist should have far less incentive to invest in creating innovations than a firm in a competitive environment: experience suggests otherwise. How can this be so?”
Indeed, wide empirical evidence shows that dominant firms invest a lot in R&D and obtain relatively more innovations. An important economist in the field, Segerstrom talks about Intel Economics referring to a main example of a technological leader, in the chips market, which in 2000 invested 11.5% of its total sales in R&D. High investments can also be found in many other major firms of high tech sectors. In the same year, the R&D/Sales ratio was 15% for Pfizer and 5.8% for Merck, two leaders in the pharmaceutical sector, 16.4% for Microsoft, the leading firm in operating systems, and 5.8% for IBM, and 5.4% for Hewlett Packard, two leaders in computer technologies and services, 11.8% for Motorola and 8.5% for Nokia, leaders in wireless, broadband and automotive communications technologies, 10% for Johnson & Johnson, the world's most comprehensive manufacturer of health care products and services, 6.6% for 3M and 6.3% for Du Pont, which are active in many fields with a leading role, 5.6% for Xerox (mostly focused on the legendary Palo Alto Research Center) and for Kodak, leaders in the markets for printers and photographs. The fact that these companies remain at the top of the technological frontier in their respective industries may not be the sign of a monopolistic position in the traditional sense, but the fruit of their investments and of the competitive threat deriving from other firms and potential entrants.
The recent theories of market leadership have clarified the mechanics of these results. Dominant firms have more incentives to invest in innovation than the outsiders when the market for innovation, or what sometimes is called the patent race, is characterized by endogenous entry (as long as the dominant firms have a leadership, which in economic jargon means just that they can commit to an investment choice before the other firms). The crucial thing here, is that market leaders often remain on top thanks to their investments, but this should not be seen as evidence of inefficiency or of dominance, but rather as a proof of the opposite: the competitive environment spurs investment by leaders and consequently induces a chance that their leadership persists.
Clearly, this has strong implications for competition policy. What the above theory suggests in this case, is that market leaders in high-tech sectors investing a lot in innovation may create an efficient situation: antitrust authorities should be especially careful when trying to stamp out monopoly power in markets that are marked by technical innovation.
June 2006: The EU approach to Aftermarkets
The Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses of the European Commission presents a short part on abusive behaviour in aftermarkets, that is markets for “secondary” products, such as spare parts, consumables or servicing, which are bought after the purchase of the primary product, e.g., toner cartridges for printers, replacement parts for household appliances, maintenance for computer equipment, or even software applications for operating systems.
When an after-market is “brand-specific” (i.e. where secondary products for one brand of primary product cannot be used with another brand of primary product), the supplier may have a very large share of that after-market, but this does not necessarily imply that the supplier enjoys market power, as the relationship between the primary market and the aftermarket may be such as to effectively restrain the supplier’s conduct on the aftermarket (e.g., a supplier’s charging high after-market prices may adversely affect its sales on the primary product market). The examination of after-markets accordingly focuses on how the relationship between the primary market and the after-market impacts on whether the supplier holds a dominant position on the aftermarket and the factors that will be taken into account by the Commission in this assessment.
The Discussion Paper also draws a distinction between those customers that may purchase the primary product in the future and those customers that have already purchased the primary product. Competition on the primary market may protect future customers from potentially harmful conduct by the supplier on the aftermarket, but may not protect existing owners of the primary products from harm if the supplier changes his commercial policy on the after-market (e.g., by raising prices). The key to assessing whether competition on the primary market will protect future customers is the extent to which future customers make “life cycle” pricing decisions, by taking after-market prices into account in their decision to purchase products on the primary market. However, competition on the primary market may not restrain a supplier’s conduct on the after-market, particularly with regard to existing customers of the primary product who are effectively “tied in” to purchasing the after-market product. The supplier may change its commercial policy on the after-market (e.g., through raising prices) to take advantage of the installed base of existing customers effectively “tied in” to purchasing the after-market product (so-called “installed base opportunism”).
We suggest that the Commission examine the competitive links between products and systems at the stage of market definition. The Commission would thus recognise, in line with economic analysis, that main products and their spare parts or consumables should, in appropriate cases, be considered as systems which, together with other systems against which they are in competition, constitute a single relevant product market.
As the Discussion Paper notes, it is common for the supplier of such equipment to have “a very strong position” in the sale of “secondary” products and services used with its own brand of equipment (paragraph 253). Indeed, undertakings with smaller positions in the primary equipment market may have even larger shares of their brand’s aftermarket because third-party suppliers and other primary market firms typically focus on the most successful equipment brands since those brands provide the largest aftermarket revenue opportunity. As a result, there is a risk that undertakings with quite modest positions in the primary market would be viewed as dominant in the aftermarket if the assessment were to be focused only on an aftermarket consisting of products and services for their individual brand of equipment.
We believe that the Discussion Paper is correct in emphasizing that the “secondary markets” should not be viewed in isolation since “the actual degree of market power of the supplier [in the aftermarket] … may be constrained by competition in the primary market.” (paragraph 246). As the Discussion Paper explains, “competition in the primary market may make price increases in the aftermarket unprofitable due to its impact on sales in the primary market, unless prices in the primary market are lowered to offset the higher aftermarket prices.” (paragraph 246). This fundamental insight regarding the key relationship between the primary market and any related aftermarkets means that a separate examination of a single brand aftermarket under Article 82 is rarely, if ever, appropriate.
The Discussion Paper appears to accept this conclusion for “customers who may buy the primary product in the future” since competition in the primary market will protect such customers (paragraphs 254-259). However, the Discussion Paper draws a distinction between “future customers” and “prior purchasers” on the basis that “competition in the primary market does not protect customers who have already bought the primary product.” (paragraph 254). We believe that the distinction in the Discussion Paper between “future customers” and “prior purchasers” is misguided. Since every “prior purchaser” was, by definition, a “future customer” before it acquired the primary product, competition in the primary product market also protects this subset of customers. In addition, as noted in the Discussion Paper, the “prior purchasers” are also protected by the supplier’s interest in its reputation with respect to its aftermarket pricing and practices because its reputation will affect its future sales of the primary product as well as its future sales of other equipment that requires aftermarket products and services (paragraph 262).
We believe that the complex, multi-step analysis of aftermarkets set forth in the Discussion Paper is both unnecessary and counterproductive. The Discussion Paper appears to acknowledge that harm to customers through actions by a supplier of aftermarket products and services is a limited concern. The only example provided is one in which a supplier adopts a “policy change” with respect to aftermarket products or services (paragraphs 261-262).
However, such a change is likely to take place only in very unusual circumstances – where both a) the entire primary market is declining or the particular supplier has decided to exit or is losing market share and b) the relevant supplier is not engaged in other equipment markets and thus would not be deterred by the impact of the “policy change” on its reputation (paragraph 262). Even in those very limited situations, there would be no harm to customers if the customers utilized the primary market competition to protect themselves by contract when they purchased the equipment (paragraph 263). We submit that it is preferable to address this limited concern regarding “installed based opportunism” through private contracts rather than by attempting to apply Article 82 to single-brand aftermarkets and treating a “policy change” as a potential abuse of dominance. Otherwise, there is a risk that suppliers will be deterred from adopting more open and flexible aftermarket policies in the first place if future changes in those policies will subject them to a risk of costly investigations, fines, and private damages actions for violation of Article 82.
There is a risk that the Discussion Paper’s focus (for example, paragraph 247) on customers who have already purchased the primary product will lead to an over-restrictive analysis on the basis of alleged "lock-in". First, the supplier would need to be able to discriminate against the so-called "locked-in" customers so as not to prejudice sales in the primary market. Secondly, the practical possibility of switching to a different "system" would need to be analysed and not just by reference to up-front purchase costs. This latter point is relevant, for example, in markets where the customer already owns and uses different (competing) systems, for example machinery used with consumable products, and can switch between them whenever the price of the consumables for one system is increased without the need to make a further capital investment (which may be significant in comparison with the increase in the price of the consumables) (see paragraph 249).
Moreover, the supplier risks losing sales in the primary market going forward if, having acquired a sufficiently large "installed base" to make discrimination worthwhile, it then increases prices in the secondary market to customers who genuinely are locked-in, for example because switching costs are too high. The supplier may, however, then suffer reputation damage which reduces future demand in the primary market. This point appears to be missing from the discussion in paragraph 254 -- see also paragraph 261 which postulates a change in policy by the supplier -- albeit that it is raised in paragraph 262 in the more limited circumstances of a supplier with declining sales and poor market prospects or of a supplier who has to exit the market. The same reputation point can be made in relation to the possibility of the supplier lowering quality once the customer is locked-in (see paragraph 254), as can the point that the supplier would need the ability to discriminate. In other words, it is appropriate to consider all of the factors which may exercise a constraining influence on the future conduct of the supplier.
May 2006: The EU Approach to Refusals to Supply
Vertical foreclosure can be anticompetitive. According to the Discussion Paper, examples include halting supplies to punish buyers for dealing with competitors and refusing to supply buyers that do not agree to exclusive dealing or tying arrangements and mainly refusals to supply, that is “situations where a dominant company denies a buyer access to an input in order to exclude that buyer from participating in an economic activity” (# 209). The Discussion Paper distinguishes three situations: where an existing supply relationship is terminated, where there is a refusal to commence supplying an input, including situations where this input is covered by IPRs, and where the input is information necessary for interoperability.
The Discussion Paper states that four conditions have to be fulfilled in order to find the termination of such a supply relationship to be abusive: (i) the behaviour must be properly characterised as a termination of the supply arrangement; (ii) the refusing undertaking must be dominant; (iii) the refusal must be likely to have a negative effect on competition; and (iv) the refusal must not be justified objectively or by efficiencies. There is no reference to the need to show that the input is “indispensable”. This implies that the termination of an existing supply relationship is more likely to be abusive than a refusal to supply a new customer. Assuming dominance and a termination of a supply arrangement are proven, the Commission would simply have to demonstrate that the termination is likely to have a “negative effect on competition” in order to establish a prima facie case that the conduct is abusive. The dominant supplier could, thereafter, only escape a finding of abuse by showing that the refusal is justified objectively or by efficiencies.
If the dominant supplier has not previously supplied the input to a potential buyer, an additional criterion is added to the four criteria mentioned above: the input must be “indispensable” to carry on normal economic activity in the downstream market. A facility will be an “indispensable” input, or a socalled “essential facility”, only when the duplication of the existing facility is impossible or extremely difficult, either because it is physically or legally impossible to duplicate, or because a second facility is not economically viable. Nevertheless, the Discussion Paper correctly points out that “to maintain incentives to invest and innovate, the dominant firm must not be unduly restricted in the exploitation of valuable results of the investment. For these reasons the dominant firm should normally be free to seek compensation for successful projects that is sufficient to maintain investment incentives, taking the risk of failed projects into account. To achieve such compensation, it may be necessary for the dominant firm to exclude others from access to the input for a certain period of time. The risks facing the parties and the sunk investment that must be committed may thus mean that a dominant firm should be allowed to exclude others for a certain period of time in order to ensure an adequate return on such investment, even when this entails eliminating effective competition during this period” (# 235).
The Section of the Discussion Paper on Refusal to Supply seems to start from the existing case-law, but still raises many controversial policy issues that need further consideration by the European Commission:
- Necessary or sufficient conditions: It is not clear whether the conditions for finding an abuse are necessary or simply sufficient. The Discussion Paper qualifies that “normally” those conditions must be fulfilled; therefore, it seems to leave open the possibility that on a case-by-case basis the Commission could identify other criteria beyond those listed above. This significantly undermines legal certainty and potentially leads to open-ended cases of intervention.
- Different thresholds: The Discussion Paper does not explain the basis for the view that, in general, continuing a supply relationship should be presumed to be pro-competitive. We consider that this should be the result of a case-by-case assessment of the economic circumstances of each case and not the subject of a legal presumption. We submit that the threshold for intervention should be the same as for cases of de novo refusals to supply and, therefore, the requirement that the input is indispensable should also be added for termination of existing supply relationships.
- Indispensable input: The definition of the indispensable input does not address the necessary economic analysis that should be carried out to decide whether duplication of the input is impossible, difficult or expensive for any competitor or for “as efficient” competitors. The Commission should clarify that the focus of the analysis should be on whether a second, substitute product can be created by “as efficient” competitors, rather than whether any competitors will in fact make the investment to create it. This approach would be consistent with the Commission’s objective of protecting competition on the merits.
- Foreclosure effect: The standard for intervention by the Commission is not fully developed. In particular, the Discussion Paper does not give sufficient guidance on the degree of the likely anticompetitive foreclosure effects in the market. It states that the market distorting foreclosure effect should not be understood to mean the complete elimination of all competition, but it does not specify to what extent competition in the downstream market should be affected for an abuse to be found. Furthermore, there is no mention of the economic analysis that should be carried out of the effects of the abuse, in particular to assess the degree of efficiency of excluded competitors. The Commission should clarify that the foreclosure effect should be substantial and at least amount to the creation of dominance in the downstream market (in terms of price increases or output reduction) resulting from the exclusion of “as efficient” competitors.
- Finally, the thresholds to argue efficiencies and objective justifications seem to be too high to be realistically successful in practice. Furthermore, the Discussion Paper fails to acknowledge that an input may become indispensable simply as a result of a company’s superior business performance. A duty to deal/supply should not be imposed simply because consumers prefer the dominant undertaking products.
Compulsory licensing of intellectual property rights is a very sensitive and controversial area under Article 82 and, therefore, deserves particular attention. It is important to preserve companies’ incentives to engage in research and development and other ventures aimed at generating innovative products and services. We welcome a number of pronouncements in the Discussion Paper that appreciate the benefits of the IPR regime and IPR protection. The Discussion Paper clearly states the priority of IPRs protection saying that “[i]mposing on the holder of the rights the obligation to grant to third parties a licence for the supply of products incorporating the IPR, even in return for a reasonable royalty, would lead to the holder being deprived of the substance of the exclusive right”. Hence, another more restrictive criterion is added in the case of a refusal to license IPRs: the undertaking which requests the licence should intend to produce new goods or services not offered by the owner of the IPRs and for which there is a potential consumer demand. This additional criterion is in line with established case-law, but the Commission introduces an exception to this criterion. It states that a refusal to license IPR-protected technology which is indispensable for follow-on innovation may be abusive even if the license is not sought to directly incorporate the technology in clearly identifiable new goods and services since “[T]he refusal of licensing an IPR protected technology should not impair consumers’ ability to benefit from innovation brought about by the dominant undertaking’s competitors” (# 240). However, this exception is not motivated by economic analysis and inconsistent with its mainstream theories: there are not serious economic arguments supporting the view that weakening IPRs would strengthen innovation in the long run: while this may happen in the short run, the current approach of the Discussion Paper on this matter may have strong negative consequences for EU innovation in the long run.
In setting out the exceptional circumstances where refusal to licence an IPR may constitute an abuse, the Discussion Paper starts from the principles and approach well established in the case-law of the Court of Justice (notably and most recently, IMS Health). However, it then fails to give guidance on some key issues still left open by IMS Health and, in some instances, expands the scope of potential compulsory licensing to cover cases beyond the requirements of exceptional circumstances set out in IMS Health, thus potentially having a chilling effect on incentives to invest and innovate.
The Discussion Paper sets out that the refusal by a dominant company to license access to an IPR could be considered abusive when the five conditions for de novo refusal to start supplying an input are satisfied, and “the refusal to grant a licence prevents the development of the market for which the licence is an indispensable input, to the detriment of consumers”. The threshold for intervention in cases of refusals to license IPRs is therefore higher than in other cases of refusals to supply. In summary, the conditions under the Discussion Paper are as follows: the behaviour can be properly characterised as a refusal (again, including cases of constructive refusals such as delaying tactics in supplying, imposing unfair trading conditions, or charging excessive prices for the input); the company refusing to license must be dominant in the market where input is provided; the input must be indispensable (i.e., it must not be possible to turn to any workable alternative technology or to “invent around” the IPR – the Discussion Paper mentions as examples cases where the technology has become the standard or where interoperability is necessary); the refusal is likely to have a negative effect on competition; there is no objective justification; and the additional condition is that the refusal prevents the development of new goods or services and for which there is a potential consumer demand.
The Discussion Paper does not give guidance on some open issues. The first concern dominance in an upstream market: The dominance requirement as set out in # 227 of the Discussion Paper broadens the scope of potential reach of compulsory licenses for IPRs that have no commercial or independent use (i.e. that are not marketed separately), but are only used as an input in other commercial products or services. Under IMS Health, there must be two identifiable markets as a necessary condition for IPR compulsory licensing. The Discussion Paper states that it is sufficient to identify a “captive”, “potential” or even a “hypothetical” upstream market, and that “such is the case where there is actual demand for the input on the part of the undertakings seeking to carry out the activity for which the input is indispensable” . This broad construction can lead to a greater number of compulsory licensing of IPRs (provided the other conditions are met) by covering IPRs that are only used as an input without the need to identify a distinct product or service that would be sold or licensed separately. Furthermore, there is no reference or explanation in the Discussion Paper of the qualification given by the Court of Justice in IMS Health that the potential market must at least correspond to an identifiable “stage of production”. Finally, there is no economic assessment of the conditions under which holding an IPR could amount to market power, which should be the correct framework of analysis without any presumption that holding an IPR may automatically give rise to market power. Without further qualification, such a potentially broad application of Article 82 could have a negative impact on incentives to invest in developing IPRs and investing in new production processes and research.
Another open issue is about the “New product” requirement. There is no explanation of the requirement that the refusal to license must prevent the appearance of new goods or services. The Discussion Paper says that the company requesting the licence should not limit itself to the duplication of goods/services already offered. However, it does not provide any guidance on the criteria to identify or define a “new” product. The Commission should clearly specify that it must be a new kind of product (rather than just an incremental or minor improvement of an existing product) that must expand the market rather than steal sales. In this respect, it would helpful to clarify, consistently with IMS Health, that the new product should satisfy consumer demand that is not satisfied by existing products.
Despite having some deference for IPRs in a number of welcome pronouncements as explained above, the Discussion Paper does not fully carry them through and goes significantly beyond the exceptional circumstances for compulsory licensing set out in IMS Health. We are concerned about the following sections that may carry the risk of reducing the incentives to invest and innovate in the long term. For follow-on innovations, the additional condition that the refusal prevents the development of new goods or services is not necessary. In # 240 of the Discussion Paper states that “a refusal to licence an IPR protected technology which is indispensable as a basis for follow-on innovation by competitors may be abusive even if the licence is not sought to directly incorporate the technology in clearly identifiable new goods and services. The refusal of licensing an IPR protected technology should not impair consumers’ ability to benefit from innovation brought about by the dominant undertaking’s competitors.” This goes much further than the exceptional circumstances set out in IMS Health and the statements of principle in the Discussion Paper. This would be a worrying departure from the established principles of the European case-law, because it effectively means the introduction of open compulsory licensing to competitors for a myriad of IPRs. Furthermore, the Discussion Paper does not define what could amount to “follow-on innovation” and does not explain why intervention is required in this area to bring benefits to consumers. Finally, inefficient competitors may effectively have the possibility to free-ride on the investments and risks taken by a dominant undertaking. For all these reasons, companies may be deterred from investing and innovating in the first place, with a potential much bigger negative impact on consumers in the medium-long term.
Finally, the Discussion Paper states that leveraging market power from one market to another by refusing to supply interoperability information may be abusive. “Although there is no general obligation even for dominant companies to ensure interoperability, leveraging market power from one market to another by refusing interoperability information may be an abuse of a dominant position” (#241). The Commission will, even if such information is considered a trade secret, not apply the same high threshold as regards IPRs. However, there is no guidance on the lower standards that the Commission will apply and on the definition of “information needed for interoperability” and this statement appears to open doors to a systematic possibility that innovative firms are forced not only to reveal IPRs but even trade secret. The same uncertainty induced by this ambiguous wording is likely to jeopardize the incentives to invest in R&D with dangerous consequences for (future) consumer welfare, exactly the opposite of what the Discussion Paper was aiming to.
April 2006: A Crucial Month for the Future of European Innovation
In the coming month, two crucial processes are likely to reshape the future of innovation and competition in Europe: the debate on the reform of EU competition enforcement in the area of abuse of dominance, and developments in the EU Microsoft case.
In line with the recent evolution of US antitrust policy, Dutch Commissioner Neelie Kroes is trying to implement an important reform, moving from a formal approach to antitrust toward a more modern welfare-based approach focused on the protection of consumers and of competition (rather than of competitors): the idea is that a particular behavior should not be condemned for being abusive per se, but only when it creates net losses for consumers. While the apparent shift in direction is positive, I have some concern that it is not being fully carried through at the level of specific proposals, beginning with the Commission’s recent Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses.
For instance, in this Discussion Paper, still in line with old economic views, dominance in a market is associated too closely with a large market share and the efficiency defence - the chance for the dominant firm to prove that its aggressive strategy is not abusive if it enhances consumer welfare or improves the allocation of resources - is virtually excluded in case of market shares over a given threshold. Such an approach to the finding of dominance can be extremely dangerous with respect to the fast-moving markets of high-tech and New Economy industries (computer hardware and software, online businesses, mobile telephony and biotechnology). These industries are often characterised by massive R&D investments, strong reliance on IPRs and other intangible assets, first-mover advantages, high fixed sunk costs and low marginal costs. Competition in these markets is dynamic in the sense that it is often competition for the market in winner-takes-all races. Leading firms in these markets may enjoy high market shares yet be subject to massive competitive pressure to constantly create better products at lower prices, due to the threat from innovative competitors and potential entrants. Companies that hold a significant share of the market at any given point in time may see this share decrease rapidly and significantly following the development and supply of a new and more attractive product by an actual or potential competitor (the launch of the iPod by Apple and its impact on the distribution of so-called “MP3 players” is a good example of such rapid and drastic market developments). Hence, a static definition of dominance based on market share that fails to take account of the entry and technology conditions may be highly misleading.
Parallel to this debate, Microsoft’s appeal of the Commission’s March 2004 antitrust decision will be heart by the European Court of First Instance at the end of April. In this landmark decision, the Commission imposed the largest fine in the history of antitrust, required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers and competitor products. The last point has turned out to be the most problematic: the picture that is emerging from Bruxelles is of a Commission that has continued to extend the scope of the information required, while deliberately declining to spell out exactly what would constitute compliance with the remedy.
The recent Microsoft's offer of access to Windows source code, including for technologies that are covered by patents and trade secrets, seems to have done nothing to dispel the threat of daily fines of up to € 2 million, fines that would put the company in a difficult position (to stay the least) going into the Court proceedings. One should always keep in mind that in EU antitrust there is not the substantial parity between defense and prosecution before a judge that is taken for granted in the US (something to keep in mind in a reform process). Nevertheless, the Commission is aware that its case is much weaker than two years ago. Microsoft offered Windows without Media Player and nobody bought it, which strongly suggests that the “bundling” strategy was at least not damaging consumers. Microsoft was forced to licence more than a hundred technologies and in Europe not one of its competitors has taken out a license, a sign that the existing level of interoperability was not as low as it was depicted.
The crucial issue for the future of innovation in Europe is whether the Commission will insist on forcing the disclosure of intellectual property rights that are the fruit of years of work and huge investments, something which may seriously jeopardize future investments in R&D not only in the software market, but in all the high-tech sectors. Unfortunately, the Commission’s current proposal on exclusionary abuses deals with refusals to supply intellectual property rights to ensure interoperability in an ambiguous way: in particular, it states that defending patents and trade secrets is fundamental to promote investments, but opens the door to uncertain conditions under which forced disclosure can be required, in a way that seems to go beyond the carefully balanced case law. This could have chilling effects on incentives to invest and innovate and could ultimately end up protecting inefficient competitors that may free ride on the risks and investments of successful companies, in apparent contradiction to the Commission’s important and positive objective of protecting competition on the merits.
Where the Commission comes down in the next weeks on Article 82 reform and the Microsoft case will provide some important guidance about the future of innovation, competition and consumers’ interests in the European Union.
March 2006: Reforming Article 82 of EU Competition Policy
The main provisions of European Competition Law (what in US terminology would be Antitrust Law) concerning abuse of dominance are contained in the Article 82 of the Treaty of the European Communities. This article (as Article 81 on horizontal and vertical agreements) is part of the law of each member state and is enforced by the European Commission (in particular the Directorate General for Competition) and by all the National Competition Authorities. In December 2005 the European Commission published a (hence on, the Discussion Paper) which is the subject of an open debate and gives an important indication as to how the Commission may approach exclusionary abuses in the future. The Discussion Paper states that the purpose of Article 82 is “the protection of competition on the market as a means of enhancing consumer welfare and of ensuring an efficient allocation of resources” (# 4). This implies that antitrust should protect competition and not competitors and be based on an economic approach aiming at the maximization of consumer welfare and allocative efficiency rather than based on a legalistic approach.
In the current proposal of the guidelines for EU antitrust there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines. In what follows, we will review the EU approach to competition law regarding abuse of dominance commenting on the recent proposal and relating the EU competition policy with the principles of the theory of market leaders. We will also provide our own suggestions on how to improve the application of the EU competition policy.
According to the European Competition Law, dominance in a market or its creation cannot be punished, while only its abuse by dominant firms is subject to antitrust screening. Hence, the preliminary phase of any antitrust case applying Article 82 must define the relevant market and verify the existence of a dominant position. The Discussion Paper briefly refers to the definition of a proper market, which can be more complex in Article 82 cases because the market price could be above its competitive level (#11-19). This creates problems with the usual methods of market definition. For instance the SSNIP-test, which defines the relevant separate market as the smallest market where a Small but Significant Non-transitory Increase in (competitive) Prices (say of 5-10%) increases the profits of a hypothetical monopolist, is biased when the market is characterized by higher than competitive prices (which is more likely in cases of abuse of dominance): such a bias usually leads to a too-wide market definition, which in turn may lead to a finding of no dominance, the so-caled “cellophane fallacy” (from the du Pont case). It should be noticed that the cellophane fallacy only applies in presence of a single monopolist in the market and when entry is impossible, while the SSNIP-test at the prevailing prices remains a valid test whenever the market leader is constrained by effective competition and/or potential entry.
Following a traditional definition, the Discussion Paper associates dominance with “a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of the consumers” (# 20). Such a definition requires “a leading position on that market” compared to the rivals (# 22) and the lack of “effective competitive constraints” (# 23) in the process in which “the undertaking and the other players act and inter-act on the market”( # 23).
Given the positive stress put on an economic-based approach to competition policy, it is important to notice that this definition of dominance is clearly associated with two situations: the pure monopoly, as an extreme case of dominance, and the market leadership where the dominant firm faces some competitors, which is the subject of the theory of market leaders previously studied. It should be emphasized that, according to this theory, a market leader can really act independently of its rivals (so as to satisfy the above condition for dominance) only when the number of competitors is exogenously set and further entry is impossible, while a market leadership constrained by effective competition and potential entry cannot be associated with dominance: in this case, modern economic theory tells us that leaders tend to be aggressive (pro-competitive) in their pricing and investment strategies, conquering larger market shares in a way that has nothing to do with dominance as defined above, and which is also beneficial to consumers.
As a consequence of the approach of the Discussion Paper, it would be better to eliminate a certain ambiguity in the statement at # 27 saying that “the fact that an undertaking is compelled by the pressure of its competitors’ price reductions to lower its own prices is in general incompatible with […] the existence of substantial market power” and hence with dominance. In particular this should be always true and not just “in general”, since in this case the market leader is constrained by effective competition and cannot act independently from it, as the definition of dominance would require and should be extended to any other form of aggressive competition, that is not only competition in prices, but also competition in quantities or in alternative forms of strategic investments. Hence, the fact that an undertaking is compelled by the pressure of its competitors’ aggressive strategies to adopt aggressive (pricing and investment) strategies should be always incompatible with dominance.
The stress on market shares in the evaluation of dominance (# 29- 33) appears in clear contrast with the conclusions of the modern theory of market leadership: market leaders have larger market shares exactly when they are constrained by effective and potential competition since in this case they adopt more aggressive (pricing and investment) strategies which expand their market shares. In other words there is not necessarily a positive correlation between the presence of larger market shares and a dominant position and, especially in highly dynamic markets, there is not unambiguous theoretical support for a statement saying that “[m]arket share is only a proxy for market power” (# 32).
As Rey et al. (2005) have correctly pointed out, “the case law tradition of having separate assessments of dominance and of abusiveness of behavior simplifies procedures, but this simplification involves a loss of precision in the implementation of the legal norm. The structural indicators which traditionally serve as proxies for ‘dominance’ provide an appropriate measure of power in some markets, but not in others”, as indeed in high-tech and New Economy industries (as computer hardware and software, online businesses, mobile telephony and biotechnology).
Finally, the part on dominance clearly refers to competition in the market, while it is hardly useful to evaluate cases where competition for the market takes place. In these cases, typical of the New Economy, competition is dynamic and innovators conquer large parts of a market, so that any static analysis of market shares cannot say anything about dominance. In other words, a market can be currently dominated by a single firm, but if many other firms which are not even active in this market are investing in R&D to enter into it, as it happens in many high-tech sectors, this market is substantially competitive in a dynamic sense. Nevertheless, any leader in such a competitive winner-takes-all market would be always characterized as dominant by the static and market-share-based approach of the Discussion Paper.
Moreover, modern economic theory tells us that in these dynamic sectors market leaders, as long as they are constrained by effective competition in the market for innovations, invest more than their competitors and hence are more likely to remain leaders. In this sense, statements saying that “high market shares, which have been held for some time, indicate a dominant position” can be true in some sectors, but not in high-tech sectors with competition for the market. In conclusion, the general impression is that there is an excessive stress on the importance of market shares to evaluate dominance, and that this can be highly misleading especially for dynamic markets.
The part of the Discussion Paper on barriers to expansion and entry (# 34-40) concerns a concept which is far from unambiguous in economic theory. The definition of these barriers as “factors that make entry impossible or unprofitable while permitting established undertakings to charge prices above the competitive level” (# 38) applies well to legal barriers but not to other factors which are sometimes seen as barriers. For instance, high fixed costs of production and R&D or investments needed to develop network externalities or learning by doing advantages, do not make entry impossible: the correct definition in these cases would be that these factors endogenously limit entry or endogenously determine how many and which firms profitably enter. The difference is not just in the definition but also in the economic consequence, since modern economic theory has shown that when entry is impossible market leaders may behave in an anti-competitive way, but when entry is constrained by technological or demand conditions they (always) behave in a pro-competitive way even if the cited factors limit entry and the market leaders obtain high market shares.
Despite the Discussion Paper claims that “the purpose of Article 82 is not to protect competitors from dominant firms’ genuine competition based on factors such as higher quality, novel products, opportune innovation or otherwise better performance, but to ensure that these competitors are also able to expand in or enter the market and compete therein on the merits, without facing conditions which are distorted or impaired by the dominant firm.” (# 54), these principles are not fully carried through into certain aspects of the analytic framework. In particular, it would be better to stress more that the interests of consumers are always paramount of those of competitors, to move even further away from form-based rules and presumptions towards a more economics- and fact-based approach, and to expand the avenues through which account may be taken of the efficiency-enhancing effects of challenged conduct. The analysis of whether a firm has engaged in abusive conduct under Article 82 should ultimately turn on the conduct’s actual effects on efficiency and consumer welfare. Thus, if the pro-consumer benefits of a dominant undertaking’s conduct are significant, it should be immune from liability even if it disadvantages certain competitors: inventing better products or more efficient methods of distribution, reducing prices or offering better terms of trade, and more quickly adapting to changes in the market can disadvantage rivals and maybe even cause them to exit the market, but these forms of conduct often also enhance efficiency and consumer welfare.
In spelling out the concept of foreclosure, the Discussion Paper states that “it is sufficient that the rivals are disadvantaged and consequently led to compete less aggressively” (# 58). This proposition gives cause for concern. First, this statement is not consistent with the theory of market leaders which has made clear that an aggressive behaviour of the market leader inducing a less aggressive competition of its competitors is not sufficient to create any harm to consumers (actually the net effect is typically the opposite happens). The inconsistency of this statement is even more clear when it is claimed that “[r]ivals may be disadvantaged where the dominant company is able to … reduce demand for the rivals’ products” (# 58) which is really what any aggressive or pro-competitive strategy would do. Putting together the two sentences, we are told that it would be sufficient to establish foreclosure that the strategy of the dominant firm reduces demand for the rivals’ product: but this amounts to banish any pro-competitive strategy by market leaders. Moreover, the above statement could arguably support the conclusion that a dominant company in a market characterized by network effects could be guilty of abuse if it is able to attract new customers on the basis of a new, superior technology. This view is contrary to the basic principle that dominant companies should be permitted (and indeed encouraged) to compete aggressively on the merits. Allowing a finding of abuse merely where competitors are “disadvantaged” would penalise dominant firms for engaging in a wide range of conduct that is ultimately pro-competitive. In our view, this aspect of the analytic framework should be revised to clarify that conduct by a dominant firm would be deemed to be an abuse only if its net effect is to harm consumer welfare.
The Discussion Paper states that the Commission may at times prohibit the use of price discounts where doing so will “protect competitors that are not (yet) as efficient as the dominant company” (# 67). In our view, there is no economic justification for barring dominant firms from decreasing prices simply in order to protect less efficient rivals (particularly since such a prohibition will mean that these rivals will face even less competitive pressure to become more efficient). This condition also places dominant firms in the untenable position of having to guess what level of rival inefficiency will be used to judge whether the dominant firm’s own efficiency-enhancing conduct is lawful. The Discussion Paper also states, in its discussion of the meeting competition defense, that a dominant firm has an obligation to weigh “the interests of its competitors to enter or expand” into the market when deciding upon alternative courses of action, and that dominant firms can only benefit from this defence if they prove there was no less anticompetitive alternative (# 82-83). In the real world, the best businesses are focused on advancing the interests of their customers, not their competitors (which, of course, is one sign of a competitive market). Thus, most dominant firms will be ill-equipped to evaluate which of various possible options will least disadvantage their competitors. We would therefore recommend that this requirement that dominant firms weigh the interests of competitors be dropped from the analysis.
EU Competition Law has been criticised for focusing more on the form of unilateral conduct than on its actual effects in the marketplace. There is broad consensus among economists that (unilateral) price- and non-price conduct of dominant firms may produce both pro- and anticompetitive effects. The ambiguous nature of conduct of dominant firms militates in favour of a full appreciation of the (positive and negative) effects on consumers. It is therefore vital that the framework for analysis under Article 82 provides for a rigorous, economics-based examination of the market context in which unilateral conduct occurs. For instance, the Commission should clarify that, despite the references to the “form and nature” of conduct in the general discussion of exclusionary abuses (# 58-59), whether market foreclosure will be found to exist will ultimately turn on the actual effects of the conduct in the marketplace. Also, while we commend the Commission for placing less reliance on per se rules and irrebutable presumptions of market foreclosure and abuse, the Discussion Paper retains elements of this approach. For example, in several places, certain forms of conduct or market shares will make it “highly unlikely” that some legal determination will result (# 30, 90, 91). We would urge the Commission to lessen its reliance even on these quasi-per se rules and to adopt a more thoroughgoing, economics- and effects-based analysis that focuses on increasing consumer welfare and is based on sound economic theory of the behaviour of market leaders and on solid empirical analysis.
Rey et al. (2005) correctly emphasized the need of solid theoretical and empirical foundations in the antitrust procedure: “a natural process would consist of asking the competition authority to first identify a consistent story of competitive harm, identifying the economic theory or theories on which the story is based, as well as the facts which support the theory as opposed to competing theories. Next, the firm should have the opportunity to present its defense, presumably to provide a counter-story indicating that the practice in question is not anticompetitive, but is in fact a legitimate, perhaps even pro-competitive business practice.”
Conduct that generates efficiencies should not, in our view, be deemed abusive unless it is demonstrated that the impact of this conduct on competition will result in consumer harm outweighing these efficiencies. While the Discussion Paper acknowledges that promoting efficiency is one of the primary objectives of Article 82, the framework for analysis itself actually provides relatively limited scope for taking efficiencies into account. This manifests itself in a variety of ways.
First, the Discussion Paper indicates that, consistent with existing practice, it will fall on dominant firms to prove the extent to which their conduct was justified on grounds of efficiency (# 77, 79). Bringing efficiencies into the analysis only as an affirmative defense will send the wrong signal to the business community: it means that investigations will often have moved quite far along before efficiency considerations fully come into play. Placing the burden of proof on competition authorities, by contrast, makes more sense as they are likely to be in a better position to obtain relevant evidence from the dominant firm as well as other market participants (such as consumer organizations) on whether challenged conduct promotes efficiency—and have the expertise and resources to undertake such an inquiry. Accordingly, we believe it is for the authority investigating an alleged infringement of Article 82 to support any finding of abuse by evidence that the conduct at issue is not justified by efficiencies, in particular in those instances where the dominant company proposes a prima facie efficiency justification.
Second, according to the Discussion Paper, to assert a successful efficiency defense under the proposed analytic framework, dominant firms will be required to show that their conduct was “indispensable” in order to achieve the resulting efficiencies and that “competition in respect of a substantial portion of the products concerned [was] not eliminated” (# 84). To meet the first of these conditions, the defendant must “demonstrate that there are no other economically practicable and less anticompetitive alternatives to achieve the claimed efficiencies” (# 86). This condition means that liability could be imposed even on conduct whose efficiency and consumer benefits far outweigh its adverse effect on competitors simply because there exists an alternative that would have disadvantaged rivals less. In our view, this rule has no economic justification: at most, it will merely provide an excuse for rivals to second-guess the business decisions of their dominant competitors. The latter condition implies that efficiency claims by dominant firms, particularly those with high market shares, will systematically be given short shrift because of the difficulty of satisfying this condition: in essence, dominant firms effectively will be required to place the interests of competitors and the competitive process over the interests of efficiency and consumer welfare.
Finally, the Discussion Paper also seems to suggest that, where a dominant firm holds a market share above 75 %, the protection of competitors will be given priority over efficiency. In our view, efficiencies should be assessed in the same manner in all cases, regardless of the defendant’s market share. Under the Treaty, and consistent with the goals of Article 82 as articulated by Commissioner Kroes, firms that generate pro-competitive efficiencies that benefit consumers should not be penalised regardless of the level of market share or potential impact on less efficient competitors. Moreover, the Discussion Paper introduces a concept of market position “approaching that of a monopoly” (# 92), for market shares above 75%, which has not any foundation in economic analysis. And the same economic analysis does not justify any separate treatment for firms with high market shares. Moreover, as emphasized by the theory of market leadership, market leaders tend to have higher market shares exactly when they face an effective competitive pressure which induces them to adopt aggressive (pricing and investment) strategies and hence to expand their market shares in a pro-competitive way: under these conditions, exceptionally high market shares (but not monopolistic ones) can be due to relevant scale economies or to the existence of learning by doing or network effects, but they do not justify exclusion from efficiency defence.
February 2006: Economic Approaches to Bundling
In many occasions this website has discussed the new theory of market leaders and its implications for competition policy. One of the issues were the new theory applies and provides new insights is bundling, that is the combination of two separate products in a single one sold alone. Notice that tying refers to selling one product (the tying product) conditional on the purchase of another one (the tied product), but there will not be any substantial difference between the two for our purposes. Virtually any product is a bundle since it combines multiple basic products which could be or are sold separately: a car bundles many separate components, a dinner at a restaurant bundles food and drinks of different brands, Coke bundles many ingredients (covered by trade secret), a computer bundles hardware, a operating system and basic softwares of general interest, Sunday issues of many newspapers bundle the basic journal with a magazine or special offers.
The Chicago school has advanced efficiency rationales in favour of bundling with positive, or at worst ambiguous, consequences on welfare, including production or distribution cost savings, reduction in transaction costs for the customers, protection of intellectual property, product improvements, quality assurance and legitimate price responses. Moreover, according to the so called “single monopoly profit theorem”, as long as the secondary market is competitive, a monopolist in a separate market cannot increase its profits in the former by tying the two products. Actually, in presence of complementarities, it can only gain from having competition and high sales in the secondary market to enhance demand in its monopolistic market. This point is made just stronger in presence of network effects, as made clear by in his recent discussion of the software market.
The post Chicago approach has shown that, when the bundling firm has some market power, bundles can have a predatory purpose, that is they can deter entry in the tied product market to expand monopolistic power and reduce consumer welfare at least in the long run (Whinston, 1990). Summarizing the past economic research in the field, Tirole (2005) has pointed out that the impact of tying on competition in the tied market ranges from a negligible impact on the rivals’ ability to compete to entry deterrence, depending on a number of factors like “the marginal cost of manufacturing the tied product; the rivals’ ability to differentiate horizontally or vertically their offering from the tied product (that is, to offer some features that are not available in the tied product); and, if the market is multi-sided, the ability to differentiate, in the side where there is no tie, through technological features, in-house supply, or exclusive contracts with third-party vendors, and the ease with which users on the tying side can multi-home.” According to Tirole (2005), and we agree on this, tying should be submitted to a rule-of-reason standard, since it can have both efficiency and anti-competitive purposes.
The theory of market leaders emphasizes that bundling by the incumbent 1) is just an aggressive (pro-competitive) strategy of the incumbent for a competitive tied product market, 2) may not have a specific entry deterrence purpose, and 3) may increase welfare even without taking efficiency reasons into account.
To derive these results, let us adopt the strongest bias against the bundling firm, imagining that this is a monopolist in a primary market with the possibility to enter in a secondary market, and that there are no clear technological efficiencies to obtain by bundling goods in the two markets. The Chicago school has studied such a situation when the secondary market is perfectly competitive, that is firms price at marginal cost and earn no extra profits: in such a case, the monopolist has no incentives to bundle because this could only reduce demand in the primary market. The post-Chicago approach has studied the same situation when the secondary market is not perfectly competitive and there is actually one single firm active strategically and no possibility for other firms to enter: then the only reason why the monopolist would like to adopt a bundling strategy is to induce exit of the rival in the secondary market (Whinston, 1990).
Finally, the new theory of market leaders has studied again the same situation but with a secondary market where firms decide “endogenously” whether to enter or not. In this case, the purpose of bundling has nothing to do with entry deterrence, it is just an aggressive strategy (but not a predatory one) which has pro-competitive effects: it reduces the combined price level and increases welfare. Technically, the market leader can exploit a larger scale of production for the bundle to offer it at a competitive price: bundling the two products works as a commitment device to be aggressive, that is to produce more for the secondary market and hence to be able to adopt a lower price. As a consequence, the leader can exploit larger scale economies, reduce the average price level for the consumers and hence increase welfare (see Etro, 2006, for a detailed proof).
Summarizing, while approaching a bundling case we need to verify the entry conditions of the secondary market. If there is a dominant firm in this market as well, the main problem is not the bundling strategy, but the lack of competition in the secondary market, and it should be addressed within this market: punishing the bundling strategy would just guarantee the monopolistic rents of the dominant firm in the secondary markets. However, things are different when the secondary market is not monopolized but open to endogenous entry (even if it is not perfectly competitive, in the sense that firms do not price at marginal cost). In such a case bundling is a pro-competitive strategy and punishing it would hurt consumers. Finally, notice that we achieved these conclusions ignoring the possibility that the bundling firm could create technological efficiencies by bundling its products, excluding that this firm could have a somewhat limited market power in the primary market and even ignoring the benefits from bundling in case of complementarities between the products: taking these factors in consideration could only strengthen the results against the punishment of a bundling strategy.
January 2006: A New Approach toward Exclusionary Abuses in Antitrust Policy
A new of the Treaty to exclusionary abuses is likely to inspire a wide debate on the proper aims and methods of antitrust policy in Europe. In the current proposal of the guidelines for EU antitrust there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines. The section on the efficiency defences for the dominant firms appears to be going in the right direction since it allows otherwise abusive strategies if they create a net efficiency gain which benefits consumers: through an objective necessity defence “where the dominant company is able to show that the otherwise abusive conduct is actually necessary conduct on the basis of objective factors external to the parties involved and in particular external to the dominant company” or a meeting competition defence “where the dominant company is able to show that the otherwise abusive conduct is actually a loss minimising reaction to competition from others” (# 78). Nevertheless the effectiveness of these rules in safeguarding consumer welfare is weakened in # 90-92, where without any economic justification, some firms are virtually excluded from the possibility of an efficiency defence. In particular, a strange concept of market position "approaching that of a monopoly" is introduced and associated with market shares above 75%, something without any justification in economic theory: a firm has a monopolistic position or it has not, but it cannot be an "almost monopoly" or a "near monopoly"! Needless to say, the definition of dominance in the cited guidelines is still strictly related with the concept of market share, in line with outdated views.
Beyond the many weak points of these guidelines, the general need for a new approach to competition policy and in particular to exclusionary abuses is strong. Recent developments in the economic research on market structures argue in favour of a move beyond the socalled post-Chicago approach, which has been dominant in the last twenty years. In particular, the new theory of market leadership tries to integrate the Chicago approach, which emphasizes the importance of competition in constraining market leaders and the post-Chicago approach, which emphasizes the strategic interaction between market leaders and competitors. While the former approach has ignored strategic interactions, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor. Only a comprehensive understanding of the strategic interaction between market leaders and their competitors, taking into account the endogenous incentives of all these to enter in the market, can provide a sound approach to antitrust issues, and this is what the new theory of market leaders is aiming at.
In the 80s and 90s, the post-Chicago research on industrial organization studied market structures within a solid economic (game-theoretic) framework and introduced welfare considerations so as to derive normative implications from its research: such a welfare based approach to competition policy represents one of the main contribution of this approach. However, in most cases, this literature limited its analysis to the behaviour of an incumbent monopolist facing a single competitor. To cite the most famous works with strong relevance for antitrust issues, this was the case of the Dixit (1980) model of entry deterrence, of the model by Milgrom and Roberts (1982) on predatory pricing, of the work by Fudenberg and Tirole (1984) of strategic investments, of the Bonanno and Vickers (1988) model of vertical restraints, of the Whinston (1990) model of bundling for entry deterrence purposes, and of many other works, often based on analysis of duopolies. In this set up where the possibility of entry by third firms is not taken into account, it is easier for the incumbent to adopt strategies which hurt the rival and protect a dominant position. These anti-competitive strategies would be less effective or even counterproductive in case other firms could enter the market and interact strategically (so not even under perfect competition as in the older Chicago school) with both the incumbent and its immediate rival.
It is not surprising that the results of the post-Chicago approach are systematically biased toward an anti-competitive strategic role of incumbents: according to this view, incumbents tend to engage in predatory pricing, threaten and undertake overinvestments in complementary markets, impose exclusive dealing contracts or bundle their goods with the main purpose of deterring entry of the competitor, otherwise they engage in accommodating pricing, underinvest in quality and product differentiation and they stifle innovation. In such a simple world, what antitrust authorities should do is fighting against incumbents: punish their aggressive pricing strategies as predatory, and their accommodating pricing strategies as well (but in this case as monopolistic behaviours), punish investments in complementary markets (“embrace and extend” strategies) as attempts to monopolize them, forbid bundling strategies, and so on. The bottom line is that antitrust authorities should sanction virtually any behaviour of the incumbents which does not conform to that of their competitors. It is true that the majority of the post-Chicago economists admit the possibility that most strategies adopted by the dominant firms can also have efficiency rationales and consequently suggest the need of a rule of reason to judge every single market case by case, but starting from such a bias against incumbents, it is often hard to find efficiency effects which compensate for the hypothetical anti-competitive strategic effects (and even harder, when these effects exist, to prove them). The consequences are on one side that competition policy is often ineffective, and on the other that market leaders tend to avoid potentially pro-competitive strategies because they may be covered by biased antitrust rules. Unfortunately, the cited guidelines proposed from the European Commission, following the post-Chicago tradition, do not fully solve these problems.
The fallacy of the post-Chicago approach derives from a simple fact: it is based on a partial theory which does not take into account that, at least in most cases, entry by competitors is not an exogenous fact, but an endogenous decision. This holds not only for the market where the leader is primarily active, but also for the secondary markets where its strategies are supposed to have consequences. Virtually, all the research by the post-Chicago school examines the behaviour of incumbents when it is assumed that one competitor (or a fixed exogenous number of competitors) could enter their markets, but completely disregards the possible choice of other firms to enter these markets: in other words, this school does not endogenize entry of competitors. This leads to misleading results. Whether entry is more or less costly, entry is an endogenous decision by the potential competitors (except for cases of natural monopoly or legal barriers to entry, which should not be a subject of antitrust analysis), especially in globalized markets where entry can originate everywhere in the world, as for most markets in the New Economy. There are two different kinds of constraints on entry: barriers to entry are traditionally defined as sunk costs of entry for the competitors which are above the corresponding costs of the incumbent (or have been already paid by the incumbent), while simple fixed costs of entry are equally faced by the incumbent and the followers to produce in the market. While there is a fundamental difference between the two concepts, their role in constraining entry, and hence in endogenizing it, is basically the same. Only a comprehensive understanding of the behaviour of incumbents when entry is endogenous and when it is not can provide the required tools to judge real world markets. Unfortunately, the endogeneity of entry makes a lot of difference and overturns most of the results of the post-Chicago school, which would imply a revision of the traditional approach to antitrust policy.
Within the new theory of market leaders, the following main results emerge: 1) market leaders are always aggressive (pro-competitive: set lower prices and hence have higher market shares) when entry is free or endogenously constrained by barriers to entry or pure fixed costs of entry (Etro, 2006): as a consequence, very large market shares for dominant firms are more likely to be a symptom of a competitive environment rather than market power; 2) competitive markets characterized by high fixed costs and constant variable costs or, more generally, by decreasing average costs, generate absolute or close to absolute dominance: under these conditions even an apparently monopolistic market share has not any relation with effective market power, while it is likely to be the symptom of a competitive environment (a first discussion of such a result is by Modigliani, 1958; for a modern proof see Etro, 2005); 3) aggressive introductory pricing, bundling strategies (without entry deterrence purposes!) and over-investments in complementary markets are always parts of a natural competitive behaviour of leaders in competitive markets; 4) dominant firms invest more in R&D when threatened by a competitive pressure, while they tend to stifle innovation in absence of such a pressure: hence, a leadership in high-tech sectors tends to be persistent if and only if there is effective dynamic competition, which leads to a faster rate of technological progress in the interest of consumers (Etro, 2004; see Blundell et al. (1999) and the recent book by Aghion and Griffith (2005) for supporting empirical evidence).
Notice that these results show the total inconsistency of definitions of market positions "approaching that of a monopoly" when the market share is above a certain threshold (a 75% threshold is suggested by the cited guidelines of the European Commission to exclude the possibility of efficiency defence): high market shares for the leaders are perfectly compatible with strong competition in and for the market.
As an example, consider the software market. The technological conditions in this market are well known and quite uncontroversial. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment, which corresponds to what we called a high fixed cost of production, and a constant marginal cost, in the sense that the cost of each additional unit of software is always the same, and, as well known, this is close to zero. The entry conditions in this market are more debated, but there are good reasons to believe that entry in the software market may entail large costs, but is substantially open. First of all, there are already many firms active in this sector, and even more potential entrants – think of the giants in adjacent sectors of the New Economy (hardware and telecommunications in particular). Second, it is hard to think of a market which is more “global” than the software market: demand comes from all the world, transport costs are virtually close to zero for the all world, knowledge to build software is easily accessible worldwide and competition is global. Nevertheless, it has been claimed that in the market for PC (or client) operating systems the high number of applications developed by many different firms for Windows represent a substantial barrier to entry. Unfortunately, such a claim usually leads to misleading conclusions. It is true that Microsoft competitors need to offer (and some do offer already) a number of standard and technologically mature applications upon entry to match the high quality of the Windows package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market. There are at least two reasons for this. First, notice that the alleged “applications barrier to entry” is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really exhaust the needs of most active computer users in the world. Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems “ported to” their one). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market (as opposed to competition in the market) or through innovations, there is no doubt that the opportunity to invest in innovations for future better software is widely open not only to large companies in the New Economy, but even to smaller ones.
Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the ideal conditions under which we should expect a leader to produce for the all market with very aggressive (low) prices. Hence, it should not be surprising that, at least in the market for operating systems, a single firm has such a large market share. We can see the same fact from a different perspective: since entry in the software market is an endogenous factor depending on the behaviour of the leader, this finds convenient to keep prices low enough to expand its market share to almost all the market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative softwares at even lower prices to build their own network effects.
The extremely low price of the main software of Microsoft, Windows, represents an inverse proof of our arguments above. It is easy to realize that the behaviour of Microsoft in this sense has nothing to do with the behaviour of a real monopolist. To verify this, imagine for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by E-1, where E is the elasticity of demand for PCs (it means that a 1% increase in the price of PCs reduces demand by E %). Now, the above relation tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if E=2, 500 Euros if E=3, 333 Euros if E=4 and so on. It would take really unreasonable values of demand elasticity (above 10) to even get close to the real average price of Windows, which is around 50-100 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would increase a lot, hardware producers would be forced to reduce somewhat their prices. Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows: and to emphasize how low is the actual price of Windows compared to that.
What does all this tell us? Simply that the software market is not monopolistic and its prices are constrained well below the monopolistic level because the leader has to compete aggressively with the other firms active in the market and with the potential entrants. However, we can say more than that. What the post-Chicago approach suggested about leaders in markets with price competition was that they should be accommodating and exploit their market power setting higher prices than the competitors or engage in predatory pricing and, after having conquered the all market, increase prices. But in the last ten-fifteen years of global leadership, Microsoft has done neither one or the other of these things: since 1990 the (retail and street) price of Windows has been constantly declining (in nominal terms and even if the quality was widely increasing) and the same can be said for its Applications (Word and Excel in particular), something quite in contrast with what a monopolist should do while achieving and consolidating a monopolistic position. In reality, Microsoft has been constantly aggressive as any firm under the threat of competitive pressure would be. The new theory of market leaders has shown that a leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the larger (worldwide in the case of Microsoft) scale of production. The price should be below that of its immediate competitors or just low enough to avoid that they could exploit profitable opportunities. Similar considerations apply in many other markets of the New Economy.
In conclusion, the market share of some market leaders can be very high because their behaviour is forced to be extremely aggressive by strong competitive pressure. Nevertheless, this entry threat may remain mostly potential and not create massive entry in the market. In such a case, firms with high market shares have nothing to do with monopolists protected by barriers to entry: they are leaders but not dominant firms.
December 2005: IPRs, trade secrets and interoperability: from Coca-cola to the New Economy
New ideas are often protected with patents, but these are not the only form of protection for innovations. Not all inventive and innovative activities fall under the scope of patentability and it is not always in the interest of a firm to patent every single innovation: some of them are just kept secret. Trade secrets exist in any business, they are also the result of years of investments and experience, and often represent a deserved comparative advantage in the market. In most high tech sectors, firms adopt a combination of patents and trade secrets to protect products which are the result of multiple innovations. Defending (intellectual or material) property rights is one of the fundamental conditions for a proper functioning of the market economy: defending trade secrets has not a minor role in this context. But there is more than that. Let us start from one of the most famous trade secrets.
A key of the success of Coca-Cola has been, for more than a century, the formula of its famous soft drink. More precisely, in 1886, in Atlanta, the pharmacist Dr. Pemberton’s prepared the popular syrup added of carbonated water for the first time in his backyard. At first he distributed the new product by carrying Coca-Cola in a jug down the street to Jacobs Pharmacy. The bookkeeper of the pharmacy, Frank M. Robinson, suggested the name and penned Coca-Cola in the unique flowing script that now is well known worldwide. As the company expanded, the new owner Candler could not prepare the syrup all himself, so the ingredients were all simply labelled 1 to 9 and the managers at the branch factories were only told the proportions required and the mixing procedure. Today, the secrete of Coke lies in a safe deposit vault at the Trust Company of Georgia (USA) and, it is said, only the company directors can authorise the opening of the vault. Although numerous outlets around the world have a franchise to bottle or can and to distribute the beverage, none knows the precise ingredients. They are simply supplied with syrups and other ingredients from the Coca-Cola company and mix them with carbonated water.
This trade secret represents a competitive advantage for Coca-Cola, but many companies around the world invest to prepare new and original soft drinks competing with Coke. While there is at least one well known global competitor, Pespi, which has created a similar successful drink (as well known, behind the vanilla, coca and kola tastes, Coke is more orange-biased, and Pepsi is more lemon-flavoured and sweeter), the market for soft drinks is quite competitive and there is substantially free entry at the local level. Many competitors have tried to discover Coke’s trade secret. William Poundstone did some painstaking research when he published in his 1993 book “Big Secrets”. He suggests that the basics ingredients of Coke are: 1) sugar, 2) caramel, 3) caffeine, 4) phosphoric, 5) coca leaf extract (with its cocaine content removed) and a small amount of cola nut extract, 6) citric acid and sodium citrate, 7) lemon, orange, lime, cassia (a type of cinnamon), nutmeg oils, and probably others, 8) glycerine, 9) vanilla. Although the proportions of some of these ingredients all mixed with carbonated water can be discovered by chemical analysis; the most important and most elusive is the mixture of essential oils is merchandise 7). The flavour of the mixture is not simply the sum totals of the oils, because other flavours are created by the interaction of the oils. Anyone trying to reproduce the mixture would need to know the exact ingredients which are difficult to analyse with certainty and their precise proportions. It is rumoured that not less than two and no more then three picked people ever know it at the same time, and they never travel together.
Now imagine that Coca-cola was required to disclose its secret formula. Anybody could reproduce the very same drink, “clone” it under a different name if you like, but it is hard to believe that this would create large gains for consumers. Close substitutes to Coke already exist and there are small margins to substantially reduce prices. However, the incentives for any other firm to invest and create new products could be drastically reduced if trade secrets would not be protected (again, not all innovations are patentable and, in general, trade secrets can be advantageous over patents for certain innovations).
Things get more complicated in high-tech sectors. In these sectors trade secrets often cover fundamental innovations and protecting them amounts to promote new fundamental innovations, which are the main engine of growth. In some fields, however, there maybe, at least apparently, a trade-off between trade secret protection and “interoperability” between products, which is, broadly speaking, the ability to exchange and use information and data, especially in networks (like telecommunications, on line business, software). For instance, take in consideration the leading on line search engine in the world, Google. We may look at its patented innovations, but after that, we would need to know its trade secrets to fully discover the mechanism of its precious algorithms. This would help many software companies and websites to interoperate with Google even better than they already do, as it would allow other search engines to improve their performances compared to that of the leading search engine. But after that, we can bet, few companies would invest huge resources and take substantial risks to create a leading search engine or other brilliant ideas like Google when they can just free ride on other’s ideas.
Fortunately, giving up to the precious role of trade secrets, or other IPRs, in promoting innovations is not the only way to solve interoperability challenges. The market can do it much better! Valuable ideas can be selectively commercialized on a voluntary basis through licenses. The Nobel prize R. Coase (1960, The Problem of Social Cost, Journal of Law and Economics) has clarified that whenever there is social value to generate, the market will properly allocate even the IPRs, insuring the accessibility of the information that fuels interoperability and acknowledging legitimate ownership rights of the innovators, and hence enhancing R&D investments. This result is just strengthened in the markets of the New Economy, where interoperability enhances network effects and hence it is in the interest of the largest firms to promote it adequately to strengthen demand for their products. In particular, as the new theory of market leaders as shown, market leaders have a further incentive to promote high levels of interoperability through licenses of their IPRs so as to increase the size of their networks and markets, while any exogenous weakening of IPRs can only reduce the incentives to invest in R&D by both the leaders and their competitors.
And dynamic market forces can do even more. As long as IPRs are well protected and firms can invest with the safe confidence that successful innovations will be rewarded, market forces can select the best standard when multiple standards are available and interoperability is only partial. In a famous book, S. Liebowitz and S. Margolis (1999, “Winners, Losers, and Microsoft: Competition and Antitrust in High Technology”) have shown that this was the case in many episodes. For instance, in the adoption of the QWERTY keybord, the one which is probably in front of you while reading Intertic (look at the first five letters on the top left of your keyboard): for years it has been claimed that the usual allocation of letters of this keyboard was an inefficient standard, while these researchers found out that all the evidence suggests that the Qwerty keyboard, somehow selected by the market, is not worse than any other alternative.
It can be very dangerous to weaken the protection of trade secrets and IPRs in high tech sectors, even under the purpose of promoting interoperability. Markets can properly balance the short run and long run interests of the consumers: promote innovation, enable an efficient degree of interoperability and select the best standards.
November 2005: Persistence of Leadership as an Antitrust Issue?
How good are dominant firms for conducting innovation? Whether and when these innovations lead to persistence of leadership? What are the policy implications in such situation where the competition takes place along other dimensions than pricing? These kinds of questions are not exactly new among economists, but they seem to be actual again judging by a provocatively entitled text '''' in the celebrated rubric ''Economics Focus'' of “The Economist” (May 2004). Apparently, there is a controversial role of market leaders in creating innovations and the key to the answer lies in the underlying incentives to undertake innovations. The recent empirical evidence seems to support these Schumpeterian allegations from ''The Economist'' in the sense that there is a positive relationship between market power and intensity of innovation. Moreover, this evidence is, in fact, consistent with pre-emptive, strategic R&D investment by the leaders. As a consequence of such strategic behavior, there may be only one firm that survives in the market for a while, but then this firm would display far more competitive behavior than a standard monopolist. It would respectively generate higher flow of R&D, charge lower price and produce more.
There are many real-world examples of dominant firms that invest more in innovation and R&D than their rivals and that persists over long period of time. We may mention AT&T, Intel and many other leaders of the New Economy and of many advanced sectors including the pharmaceutical one. While many commentators are used to associate persistent leaderships with monopolistic positions, recent research has suggested that in many cases, it may work the other way around: leadership persists because markets are highly competitive and leaders are forced by the competitive pressure to invest a lot, innovate and hence maintain their techonological and market leadership.
The nature of the above relation between innovativeness, leadership and market power has tremendous implications for the antitrust policy. It is important to study the situation in which the market leader undertakes aggressive pre-emptive R&D investment that eventually leads to a limitation of entry by followers and contrast this situation with the one in which the leader (within the same setup) ''accommodates'' the followers, that is, it co-exists with followers in a oligopolistic market structure. This comparison will enable to study both positive aspects of the two main strategies – accommodating and aggressive (like, for instance, which strategy yields higher R&D intensity or R&D stock) and normative aspect (social welfare implications) of the two resulting market structures.
Since strategic innovations are inherently dynamic phenomenon, suitable methods aimed at capturing both accommodating and aggressive behavior of the dominant firm should be explicitly dynamic. Furthermore, the relationship between the leader and the follower is often accompanied with R&D spillovers stemming from leader to follower (the importance of R&D spillovers, imitations and its economic implications is well and broadly documented in both theoretical and empirical literature). However, most of the research by economists is static in nature and it focuses on the accommodation strategies: in such situations unilateral R&D spillovers create disincentives to invest in R&D and consequently hamper innovations. However, in the case when aggressive strategies are optimal, the economic implication of R&D spillovers is exactly opposite: they enhance the incentive to invest in R&D.
Contrary to the static set-up where (constrained) monopoly is usually a marginal market structure, in the dynamic setup, this market structure becomes more prevalent as the speed of adoption of the new technology increases and the efficiency of R&D process is high. Put together, these two facts yield a testable prediction in that the most propulsive innovative firms, that commercialize their investment in innovation quickly and efficiently, are the ones likely to use aggressive strategies through investing large sums of money into innovative activity that in turn, help them to attain or keep technological and market leadership. As for the social welfare considerations, aggressive investment strategies are socially preferable as well since they lead to both higher consumer surplus, and to higher social welfare generated despite the fact that only one firm (the leader) remains in the market in the long run.
This all bears important competition policy implications. First, the size of market share per se might not be sufficient condition for a legal offence and, second, abuses of dominant positions may not even be an issue in dynamic markets where competition takes place through investments in R&D rather than through static pricing and competitors constraint the behaviour of market leaders. The challenge for the design of antitrust policy against predation is related to the ability of the antitrust authority to distinguish between the price that is low for other predatory purposes from a price that might be set very low as part of an efficiency enhancing process that in turn results in enhanced competition leading in the end to the exit of the competitors but not to price increases. For instance, in the presence of network effects or learning effects it would be legitimate and consistent with vigorous competition that firms set very low prices when they are introducing new products, when they are targeting new customer segments or rivals, installed bases, or when they are in the first phase of the learning curve. Thus, the competition authority with limited knowledge of industry- and firm-specific data faces a complex problem when attempting to identify those circumstances under which loss-inducing predatory prices cause harm to competition. For that reason the antitrust authorities have to be fully aware of the risks of misclassification when approaching a predation case.
October 2005: Toward a New Approach to Competition Policy
Recently many economists have pointed out the necessity of a closer focus on consumer welfare in the implementation of competition policy. While antitrust legislation was written with this objective in mind, its concrete application has been often biased against market leaders and in defense of their competitors rather than toward the defense of free competition and of the interests of consumers. The two objectives do not necessarily overlap. The development of the New Economy, characterized by very dynamic and innovative markets, has increased the pressure for a new approach. In July 2005 a Report by a group of important economists of the Economic Advisory Group for Competition Policy of the European Union has argued in favor of an effect-based approach to competition policy, which associates abuses of dominant positions with anti-competitive strategies that harm consumers (“” by J. Gual, M. Hellwig, A. Perrot, M. Polo, P. Rey, K. Schmidt and R. Stenbacka). The proposal is an interesting starting point to build a new approach to antitrust and deserves close attention.
A new approach to competition policy should be based on rigorous economic analysis, from both a theoretical and an empirical point of view. The Report emphasizes this element in the antitrust procedure: “a natural process would consist of asking the competition authority to first identify a consistent story of competitive harm, identifying the economic theory or theories on which the story is based, as well as the facts which support the theory as opposed to competing theories. Next, the firm should have the opportunity to present its defense, presumably to provide a counter-story indicating that the practice in question is not anticompetitive, but is in fact a legitimate, perhaps even pro-competitive business practice.” Now, any theory of the market structure able to provide guidance in detecting abuses of dominant positions should: 1) take into account the role and the strategies of dominant firms; 2) describe the equilibrium outcomes in function of the access of competitors to the market and of the demand and supply conditions; and 3) provide welfare comparisons under alternative set ups. In other words, we need a theory of market leadership simple but general enough to be applicable to analyze markets under many possible situations: different demand conditions or production technologies characterized by different cost functions, possibly by network externalities or learning by doing, different modes of competition as “in prices” or “in quantities”, different strategic investments as in advertising, product differentiation or R&D, bundling strategies, multimarket and dynamic strategies, and so on.
Recent theories of the market leadership have provided a simple unified framework which matches these requirements (technically we speak of generalized theories of Stackelberg competition). They are not the only available theories for this purpose, but they are simple and able to found a comprehensive guidance to understand whether any specific behavior of a dominant firm is harmful to the consumers or not. Rather than discussing all possible situations, it is useful to provide the general insights of these recent theories and go over a few explanatory cases. The general principle proved in this new research is that dominant firms may behave in an anti-competitive (accommodating) way in markets with barriers to entry, while they always behave in a pro-competitive (aggressive) way whenever entry in the market is endogenous. More precisely, when there are not exogenous barriers to the entry of competitors, dominant firms produce more, invest more to reduce costs or improve product quality, engage in more informative advertising, innovate more and so on: this allows them to increase their market shares, reduce prices and gain from a reduction in the average costs of production, but it also disciplines the competitors and keeps market prices at a low level, with unambiguous benefits for the consumers.
Some factors make leaders even more aggressive and tend to increase their market share (eventually until other firms exit): these are scale economies, network effects and learning by doing in dynamic contexts, product homogeneity and rapid technological development, all factors typical of the markets in the New Economy. The consequence is that markets with high concentration due to the presence of a dominant firm are perfectly consistent with efficiency. This has drastic consequences for the competition policy: while the old approach to abuses of dominant positions needs to verify dominance through structural indicators and the existence of a certain abusive behavior, a new economic approach would just need to verify the existence of harm to consumers. As the Report correctly points out, “the case law tradition of having separate assessments of dominance and of abusiveness of behavior simplifies procedures, but this simplification involves a loss of precision in the implementation of the legal norm. The structural indicators which traditionally serve as proxies for ‘dominance’ provide an appropriate measure of power in some markets, but not in others”, as indeed in the New Economy.
Moreover, in line with the new theories of market leadership, the same Report clarifies that “in an effects-based, non-dirigiste approach the analysis of competitive harms naturally focuses on keeping the competitive process open and avoiding the exclusion of actual or potential rivals from the market”: again the main role of competition (antitrust) policy should be to guarantee (verify) that entry is - at least potentially - free in every market. Another implication of this recent research is that aggressive pricing by the leaders can have a predatory role under barriers to entry, but not under free entry (even if it leads to exit of some competitors). The same holds for other strategies which typically have exclusionary motivations under barriers to entry, like dumping (in presence of learning by doing and network effects) or bundling and tying strategies. As long as entry of firms is endogenous and remains potentially free, the adoption of these strategies by a dominant firm ends up beneficial to consumers.
Finally, notice that what matters is not only welfare of current consumers but also that of future ones. The Report provides a simple example on “the problem of monopoly pricing. One response to the problem might be for the competition authority to intervene, citing excessive pricing by a monopolist as an infraction of the abuse-of-dominance prohibition in Article 82 of the Treaty. Another response might be to leave the matter alone, hoping that the profits that the monopolist earns will spur innovation or imitation and entry into the market, so that, eventually, the problem will be solved by competition.” What the theory of market leaders suggests on this matter is that the dynamic gains in efficiency can be quite high, once again if entry in the market for innovation is free. The leadership of dominant firms may persist because of their high incentives to invest in R&D under the threat of entry; nevertheless, this should not be seen as a signal of abusive conduct, but, oddly enough, as the result of competitive pressure.
In conclusion, a new effect-based approach to antitrust founded on solid economic theory would represent a major step forward in the implementation of competition policy in the interest of consumers, and we now have the theoretical and empirical tools to adopt it.
September 2005: Patents and Innovation
Since the work of the Austrian economist Joseph Schumpeter, economic research has repeatedly emphasized the positive relation linking patents to investments in innovation and these investments to technological progress and growth. In high-tech sectors (think of hardware, software, pharmaceuticals, biotechnologies,…) firms compete mainly by innovating. This is possible as long as there are well defined IPRs, and especially patents, defending their innovations and investments, which is ultimately what leads technological progress in our economies.
Moreover, even if most economists are used to thinking about market leaders as firms with weaker incentives to invest in R&D, recent theoretical and empirical research has also noticed that market leaders play a crucial role in the innovation sector for competitive markets. Market leaders invest a lot in R&D: for instance, in 2000 Microsoft spent more than 16 % of its turnover, but even apart from this special case, Intel spent 11,5 %, Motorola 11,8 %, Nokia 8,5 %, IBM, Hewlett Packard and Xerox between 5 and 6 %, and so on. The fact that these companies remain at the top of the technological frontier in their respective industries is not the sign of a monopolistic position in the traditional sense, but the fruit of their investments and of the competitive threat deriving from other firms and potential entrants. Theoretical research in the New Industrial Organization (the industrial economics and policy for the New Economy) has recently clarified the mechanics of these results. In a sense, patents drive competition through innovation in these markets and induce technological progress led by market leaders.
To understand the role of IPRs in promoting innovation we rely on a old argument by William Nordhaus. In general, the arguments goes, patents create a temporary monopolistic power for the innovators, which creates price distortions and hence a social cost, but they also create the incentives for many firms to invest and try to gain market leadership, and this investment leads to social benefits through technological progress and growth. Clearly social benefits and costs can be different for different inventions and in general for different fields of technology. For simplicity and to avoid discriminations between fields of technology, patents have typically a uniform length. Nevertheless, from a strictly economic point of view one may question such a uniformity and evaluate the advantages for different levels of protection in different sectors (at least this could avoid the inefficient choice of radically excluding certain innovations from patentability rather than allowing a more limited protection). More importantly, an evaluation of the social benefits and costs of patents for different fields is essential in judging the net benefit of a patents system.
Let us consider an example concerning the pharmaceutical sector, where the role of patents on new drugs is, to say the least, at the basis of competition in the market and of scientific progress in the world. These kinds of patents have been often criticized for jeopardizing health defense around the world and especially in developing countries, where western drugs are very important but very expensive: in other words the social cost of patents on drugs can be high. Nevertheless, one should not forget that those same patents induced many firms to invest and some of them to invent new drugs which are now available, something which would have hardly happened otherwise: in other words the social benefit of patents on drugs is very high. Fortunately there are ways to reduce the problems related with the pricing of drugs and their adoption depends mostly on the public sector. For instance, governments could buy drugs and distribute them at lower prices through the medical system, or just pay part of the prices. They may even directly buy the same patents from the innovators and produce the drugs (or outsorce their production) and sell them at lower prices. Finally, western governments could redirect their international aids toward similar initiatives in favour of developing countries. These solutions, widely discussed in the economic literature, may preserve the proper incentives to invest and discover new drugs while spreading their effects globally. Ultimately, this suggests that patents in the pharmaceutical sectors are a crucial determinant of innovations and should be enforced while finding alternative solutions to guarantee health defense for poor classes and poor countries.
Consider now another example which is essentially related with the New Economy and the main kind of research which is underlying it: that concerning computer based innovations. This is quite interesting since in the last years the European Union tried to complete a process of harmonization of the patent system for computer-implemented inventions with the aim to provide proper incentives to invest and innovate in the New Economy, something which was realized in the United States since the 80s. After a long procedure, the Common Position adopted by the European Council in March 2005 proposed the patentability of computer implemented innovations when they provide a technical contribution to a field of technology. While this positive proposal simply reaffirmed the requirements already adopted in Europe for the last two decades and it excluded from patentability any pure software, business methods and consulting practices (which are patentable in US), part of the European Parliament proposed a number of amendments aimed at radically changing the current situation which excludes most of the innovations in the Information and Communication Technology from patentability. As a consequence of such a confusing situation, the European Parliament ended up rejecting the all Directive in July 2005. While this avoided the introduction of those dangerous restrictions on patentability, there is still a need for a deeper harmonization of the European patent systems (not just for computer based ones, but for all fields since each one of the Member States still has its own patent system!) and the debate is likely to continue in the near future.
Notice that the rationale for patents on computer based innovations is quite strong. While the main social gain from all patents on computer based innovations is to promote innovation in the most dynamic sectors, the social cost, traditionally associated with market power of patentholders, is smaller than for other patents since in these sectors competition mainly works through frequent price-reducing and quality-improving innovations. Neglecting these traditional economic insights, opponents of the patent system have often claimed that patents stifle innovation. Unfortunately, even the evidence on the US experience provided by few works against these patents does not convincingly support such a view. The extension of patent protection to software related inventions started in 1980 (the first patent of this kind was granted by the US Patent and Trademark Office in 1981) and it was associated with a clear increase in R&D investment during the eighties. The R&D/sales ratio for US firms innovating on computer, telecommunications and electronic components (the relevant field here) increased from 5.5% to above 8% in 1989. Moreover, the works against patentability did not compare investment in computer based innovations with investment in other technologies and did not take into account other (macroeconomic or sector-specific) factors, hence there is no any rigorous econometric evidence against patents which could be drawn from the American experience. Nevertheless a misleading interpretation of this research has created a lot of confusion in the debate.
These examples and the economic research underlying them allow us to draw a number of conclusions and suggestions for the future debate on rules for high-tech patents, with particular reference to the European debate:
1) protecting IPRs is necessary to properly promote innovations, but an optimal patent system should trade-off social benefits and costs, eventually enforcing more IPRs in those fields, as the New Economy, where the net benefits of patents are higher or those fields, like the pharmaceutical sector, where social benefits are higher and there are proper policies which can reduce the social costs;
2) restrictions to the patentability of innovations in high-tech sectors for one country or a group of countries could severely jeopardize investment in innovation and technological progress in the leading high-tech sectors with negative consequences on growth and competition in the global economy and would shift investments toward other countries where IPR are better protected;
3) limitations to the enforcement of the current patent system would open doors to foreign low cost productions which, without patent protection, would be free to imitate even high-tech production, with negative consequences on employment and on innovative firms;
4) improvements of the effectiveness of the current patent systems should rather promote access to patents especially for SMEs, traditionally less able to exploit this opportunity (in this sense, it would helpful to establish institutional ways to provide financial, technical and administrative support to SMEs dealing with patents);
5) enhancement of the spillovers created by the patent system on the diffusion of knowledge could be obtained through further requirements on a disclosure of the patented inventions which should be sufficiently clear and complete to be carried out by a person skilled in the art.
