Earlier today I described the concept of network effects and analogized it to gains from trade. I suggested that public policy should encourage open systems in order to maximize the gains to interoperability.
But there’s an obvious objection to this line of argument, which is hinted at in the IEEE article I referenced yesterday:
Surely it would require a singularly obtuse management, to say nothing of stunningly inefficient financial markets, to fail to seize this obvious opportunity to double total network value by simply combining the two.
In other words, if there are gains to interoperability, it’s in the interests of the firms themselves to make their platforms interoperable in order to increase their value. Firms, therefore, have the necessary incentive to maximize the value of their platforms with or without a platform monopoly.
The problem with this response is that it ignores the question of who captures the gains to interoperability. In a closed platform controlled by a single firm, most of the surplus flows to the platform owner, who is able to raise prices to capture the increased value. Apple is currently reaping the financial rewards from sitting atop a closed platform as it grows to dominate its market. On the other hand, in an open platform, competition pushes down prices. As a result, most of the surplus flows to the consumer. Given that price-fixing agreements are difficult to enforce (not to mention illegal), companies may rationally opt to keep their platforms separate.
The free trade analogy applies perfectly here: from an economic perspective, the companies choosing not to interoperate are behaving like protectionist firms. Free trade simultaneously increases total wealth and reduces the profits of the formerly-protected industry. Likewise, interoperability increases societal wealth but it reduces the profits of the firm that previously had exclusive control over its platform.
Of course, this analysis ignores the possibility of inter-platform competition. If switching between platforms is inexpensive, then inter-platform competition will drive down prices the same way intra-platform competition does. Unfortunately, a lot of technological platforms have high switching costs. Moreover, switching costs tend to grow over time, as users make more and more platform-specific investments. Once one has spent $500 on iTunes music, one is unlikely to purchase a music player that will not play iTunes songs, no matter how superior it might otherwise be to the Apple-branded alternatives. So once a market has matured, so that most users have made large platform-specific investments, the owners of the respective platforms are likely to enjoy considerable market power.
Of course, my argument here doesn’t fully answer the argument I laid out on Sunday, because any discussion of how to divide the profits from a platform is academic if the platform is never created in the first place. It’s possible that the only way we’ll get certain types of platforms is if we give the firm that creates them a monopoly on platform access. I’ll explore that question next.