Against Platform Monopolies: Introduction

by on July 16, 2006 · 14 comments

Lately, there’s been quite a bit of discussion on TLF and elsewhere about the merits of giving companies legal rights to control access to the technological devices they control. The central thesis of my DMCA paper was that the DMCA was an ineffective piracy deterrent, but that it did create unnecessary platform monopolies. I wrote that paper assuming that it would be obvious that platform monopolies are a bad thing.

That assumption proved false. A number of smart people have since made the argument that this feature of the DMCA isn’t so much a bug as a feature–that it’s a good thing to give Apple control over the iPod-iTunes platform, to give Microsoft control over the XBox platform, etc. One of the smartest of my former colleagues at Cato made such an argument to me when I was in DC, and in recent months Randy Picker has had a series of posts laying out the case for such platform monopolies (or platform property rights, depending on your perspective).

Back in October, Picker made the analogy between the iPod/iTunes synergy and the classic “razors and blades” marketing strategy where Gillette underprices its razors and makes the money up by charging premium prices for razor blades. A few weeks ago, Picker expanded on that argument in a response to Ed Felten’s post on the effort to install unauthorized third-party hardware on the XBox. I also weighed in on that discussion.

I think this is the most intellectually serious defense of the DMCA I’ve seen. If giving companies exclusive rights to the platforms they create is good economics, then the fact that the DMCA creates such platform monopolies ought not to concern us. I’ve been meaning for some time to write an article or paper analyzing this argument in detail, but it’s becoming clear to me that I’m not going to have time to do so in the near future. So instead, I’m going to take a page out of Ed Felten’s playbook and offer my (possibly disjointed) thoughts on the subject in a series of blog posts, which I may or may not turn into something more formal in the future.

I should warn you at the outset that this discussion is likely to be a bit fragmentary and meandering, as I’m still working out some of the details of my argument. I’m going to spend a couple of posts laying some conceptual and historical groundwork–discussing the important concept of network effects and describing some of the history of innovation and platform creation in the computer industry. With those preliminaries out of the way, I’ll hopefully get to the meat of the argument later this week or early next week.

Below the fold, I kick things off by summarizing the argument for platform property rights and dispensing with an oft-heard but faulty argument against them.

The basic problem is that technological platforms, like most high-tech products, have large fixed capital costs that must somehow be recouped in the price of the final product. Microsoft invested hundreds of millions of dollars designing the hardware and software for the XBox, setting up manufacturing facilities, organizing a distribution system, and orchestrating a marketing campaign. If companies that made such expenditures were consistently unable to recoup them, the products wouldn’t get produced, and people wouldn’t have the option of purchasing them.

One way that companies maximize revenues from a technological platform is through price discrimination. One strategy is to sell several versions of the product, and price them so that the most expensive products have the highest margins, so that those buying the better models are covering a much larger fraction of the fixed costs of the platform. Another important price discrimination strategy is what Picker calls the “razors and blades” model. The strategy is to sell everybody the same “razor,” priced at near marginal cost, but to price “blades” at a premium. That effectively price-discriminates based on how much each user uses the platform. A customer who buys a lot of “blades” pay a hefty premium and produce a lot of profit for the company. In contrast, a customer who buys only one “blade” provides very little profit. A modern example of this model is the inkjet printer market. Inkjet printers tend to be very cheap, but they are designed to work with ink cartridges made by the printer manufacturer. A customer who buys a printer and never buys an ink cartridge makes very little profit for the company. On the other hand, a customer that buys a new ink cartridge every month is very lucrative.

Price discrimination clearly benefits the company, but it can also be beneficial to society as a whole, because it allows the company to price its low-end products at very close to marginal cost, thereby putting them within the reach of more customers. If the razors and blades model becomes impossible (if, say, generic printer cartridge manufacturers enter the market and drive down the cost of cartridges), the printer maker might be forced to react by raising the price of printers. As a result, some of the most price-sensitive consumers would get priced out of the market. The company is harmed, but so are the customers who can no longer afford a printer.

So here we have an argument for giving HP the right to exclude generic cartridge makers from making cartridges compatible with its printers. Such a rule could have two beneficial effects: first, it could increase the total profitability of designing printers, thereby stimulating the development of additional printer. And secondly, it could enable HP to lower the price of its printers, thereby bringing them within reach of more customers (this assumes that the light users are also the most price-sensitive, a not unreasonable assumption).

I think the most common response to this argument is to point out that the company in question has already recouped its investment, and that therefore further increasing the profitability of the platform is simply a “windfall profit” to the company. But this proves too much, because it ignores the role of risk in entrepreneurial activities. Viewed ex post, Apple is certainly raking in the profits from the iPod-iTunes platform, but it wasn’t so obvious that the products would be a success when the iPod was launched in 2001 and iTunes was launched in 2003. The prospect of increased is likely to induce companies to invest more in creating more and better products in hopes of cashing in on the larger rewards.

The same phenomenon can be seen in most intellectual property industries. The vast majority of books, albums, movies, and drugs lose money, but the few that succeed produce enormous profits that allow the companies to produce more. The larger the profits of successful products, the more money companies will invest in creating new products, and the more risks they can afford to take on quirky or unconventional products. Policies that reduce the profitability of blockbusters is likely to reduce the number and quality of new products, and that might be bad for consumers. (Although not always–I’ll have more to say about this later)

In fact, this isn’t an issue that’s specific to technology or to intellectual property issues. The calls for windfall profits taxes and anti-gouging laws against oil companies are wrong for precisely the same reasons. Viewed ex post it might appear unfair that oil companies are currently raking in enormous profits. But if those profits are confiscated, it reduces the incentive of oil companies to have spare capacity on hand to deal with demand spikes. In the long run, windfall profit taxes and anti-gouging laws reduce the resiliency of the oil distribution system by encouraging companies not to plan for sudden oil shortages.

So I think this critique–which might be called the populist case against platform monopolies–fails. In the next few days I hope to lay out a better one.

Update: Prof. Picker kindly reminded me that a more comprehensive treatment of his argument is available from SSRN.

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