The Nature of Competition in the Digital Age

I finally got around to reading this interesting little paper by Justus Haucap and Ulrich Heimeshoff published by the Düsseldorf Institute for Competition Economics entitled, “Google, Facebook, Amazon, eBay: Is the Internet Driving Competition or Market Monopolization?” It offers a nice snapshot of the current state of play in several online sectors and surveys much of the relevant economic literature on the issue of antitrust and information technology markets. The authors also familiarize readers with the basic economic concepts that are hotly debated in the field of digital economics, including: network effects, switching costs, multi-homing, and economies of scale.

What I particularly like about their paper is that it struggles with the two competing narratives that dominate debates over digital age economics. Here’s how Haucap and Heimeshoff put it in the introduction:

On the one hand, it is rather obvious that many very successful Internet-based companies are nearly monopolists. Google, Youtube, Facebook, and Skype are typical examples for Internet firms who dominate their relevant markets and who leave only limited space for a relatively small competitive fringe. Furthermore, most of these providers do not generate content themselves, but “only” provide access to different content on the Internet. On the other hand, the crucial question from a competition policy perspective is not so much whether these firms have such a dominant position today, but rather why they have such a large market share and whether this is a temporary or non-temporary phenomenon. Do these Internet monopolies enjoy a dominant position because they are protected from competition though barriers to entry or do they just enjoy the profits of superior technology and innovation? Are we observing some sort of Schumpeterian competition where one temporary monopoly is followed by another, with innovation as the driving competitive force, or are we dealing with monopoly firms that mainly try to foreclose their markets through anticompetitive behavior?

Faithful readers know from my past rantings here on this blog, in Forbes columns, and in various working papers, that I am firmly in the latter (“Schumpeterian competition”) camp. For example, in a column on “‘Tech Titans’ and Schumpeter’s Vision,” I argued that:

Simply put, we now live in Joseph Schumpeter’s economy. The Austrian-born economist had the digital economy figured out seven decades ago. Cascading waves of continuous change, or what Schumpeter called the “perennial gales of creative destruction,” reverberate all around us in the tech economy. Innovative risk-takers are constantly shaking things up and displacing yesterday’s lumbering, lethargic giants. In markets built largely upon binary code, the pace and nature of change has become hyper-Schumpeterian: unrelenting and utterly unpredictable.

In another column (“The Rule Of Three: The Nature of Competition In The Digital Economy“), I explained the Schumpeterian paradigm in this fashion:

Austrian economist Joseph Schumpeter explained long ago that competition and technological innovation often spring from the quest for the prize of market power. “In capitalist reality as distinguished from its textbook picture, it is not [perfect] competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization,” he argued. This is competition that “strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other,” he argued, because the “ever-present threat” of dynamic, disruptive change “disciplines before it attacks.”

In an online symposium on “Competition in Online Search” hosted by the Antitrust & Competition Policy Blog, I documented the recent history of turbulent, Schumpeterian change in the digital economy. Some examples I offered by walking backward in time:

Just five years ago, MySpace dominated social networking and had The Guardian wondering, “Will MySpace Ever Lose Its Monopoly?” A short time later, MySpace lost its early lead and became a major liability for owner Rupert Murdoch. Murdoch paid $580 million for MySpace in 2005 only to sell it for $35 million in June 2011.
Just six to eight years ago, the mobile landscape was ruled by Palm, BlackBerry, Nokia, and Motorola. Palm is now all but dead and BlackBerry is trying to stay afloat while Nokia and Motorola had to cut deals with Microsoft and Google respectively in order to survive.
Just 10 years ago, AOL’s hegemony in online services was thought to be unassailable, especially after its merger with Time Warner. But the merger quickly went off the rails and AOL’s online “dominance” quickly evaporated. Losses grew to over $100 billion and the entire deal unraveled within just a few years as AOL’s old dial-up, walled-garden business model had been completely superseded by broadband and the new Web 2.0 world.
Just 12 years ago, Yahoo! and AltaVista were the go-to companies for online search. No one turns to them first today when they go looking for information online.
And just 15 years ago, Microsoft was on everyone’s mind. Today, the firm is struggling to remain part of cocktail party chatter when the topic of modern Tech Titans is discussed. For example, a recent Fast Company cover story on “The Great Tech War of 2012” only mentioned Microsoft in passing. The rise of search, social media, and cloud computing represented disruptive shifts that Microsoft wasn’t prepared for, although the company continues to innovate and remain relevant.

From this evidence, I have argued that Schumpeter’s “gales of creative destruction” have rarely blown harder through any sector of our economy. Even when some “tech titans” rise to the top of the mountain and win the race for the prize of market power, their reign tends to be brief and is immediately challenged by others looking to knock them off their perch. This is also why it is so essential that policymakers not disrupt this Schumpeterian process with preemptive antitrust strikes or misguided regulatory interventions. The quest for the prize is what drives the most important forms of market competition and innovation. As Justice Scalia argued in a notable 2004 Supreme Court antitrust-related decision (Trinko): “the opportunity to charge monopoly prices—at least for a short period—is what attracts ‘business acumen’ in the first place; it induces risk taking that produces innovation and economic growth.”

Schumpeterian thinking remains as controversial today as it did during his lifetime, but I think it perfectly explains the cycles of competition and innovation we at see at work in the modern digital economy. So, what conclusion do Haucap and Heimeshoff come to in their paper?

It is not possible to generalize with respect to the degree of competition in online markets. While some markets tend to lean towards high concentration ratios, the strong market position of Google and Facebook do not necessarily need to be longlasting. . . In the case of Facebook, multi-homing is not too costly so that there is scope for further competition. The entry of Google+ in 2011 is an interesting development for competition, but the further development remains to be seen. In contrast, eBay has managed to hold on to its dominant position in the market for private online auctions which is difficult to contest, as sellers’ reputations are not transferable across platforms. . . . .

If direct and indirect network effects play an important role in a particular online market, it is not clear ex ante whether a monopoly or a dominant market position is actually good or bad from an efficiency perspective. While some authors . . . . argue for a stronger market regulation of eBay, there are also good and valid counter-arguments, based on innovation incentives. In fact, many online markets have been characterized by a large degree of Schumpeterian competition where one dominant player follows the other. A notable exception has only been eBay which has managed to hold on to its dominant position for more than a decade now. Still, a more interventionist approach beyond the application of general competition law rules appears not to be warranted so far.

The authors’ focus on eBay is interesting. As I noted on Twitter the other day, I would agree that eBay is a bit of anomaly when it comes to digital age competition. eBay is really only digital platform that’s been able to maintain lasting dominance in its field (online auctions). Over the past 12 years, it has not been significantly disrupted like other digital providers and platforms. But two caveats are in order here.

First, eBay actually does face credible competition at the margin for particular goods. For example, I am a car fanatic. I have moved 6 cars on eBay over the past decade. But I have also used Cars.com and AutoTrader.com to work deals or at least research cars I would later buy or sell on eBay. Likewise, I’m obsessed with consumer electronics, especially home theater gear. I can find plenty of great deals on eBay, but I also shop at dozens of other sites (some high-end retailers like Crutchfield; others are trading sites just for home theater stuff). And the same is true for many other types of products. There’s an endless assortment of places online to find apparel and media content, for example. And heck, Amazon is a pretty big dog that eBay must contend with in several sub-markets. And there are plenty of other competitors that keep eBay’s market power in check despite its continued dominance of the “online auction” marketplace, however you choose to define it.

Second, even if you think eBay has serious dominance in its market, what of it? Haucap and Heimeshoff note that a few scholars have called for greater regulation of eBay, but there has never been a serious push by academics or policymakers to drop the antitrust hammer on eBay’s head. And the reason is simple: It is impossible to make a case that eBay is harming consumer welfare. In fact, eBay’s “market power” helps consumers by greatly diminishing search and transaction costs. How many of us want to go sign up for a dozen different sites when we hope to auction off our old comic book or baseball card collection? Not me. I know that eBay will guarantee me the best chance to maximize the profit margin on my old junk by bringing together the largest universe of potential buyers all in one spot. If eBay ever tried to gouge users with outrageous listing fees or restrictive trading rules, I think we’d see other firms look to break into the market fairly quickly. The tough question is whether there would be any way to port over our reputational history / rankings to other sites. Probably not, but I still don’t think that ends the threat of potential entry or innovation, especially at the margin for really popular goods.

Taken together, these two points make it clear that the online auction marketplace is what economists would call a “contestable market.” The looming threat of entry at the margin keeps eBay on its toes and their “market power” in check.

Anyway, I encourage you to read the Haucap and Heimeshoff paper. It’s quite interesting and I think they are right to conclude that “a more interventionist approach beyond the application of general competition law rules appears not to be warranted so far.” Finally, if you really enjoy this topic and want to read some of the best literature in the field, you might want to check out my list of “The 12 Best Papers on Antitrust & the Digital Economy” that I put together last Fall.

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Additional Reading: