Against Platform Monopoly: Demand Inefficiencies

by on July 20, 2006 · 2 comments

This week I’ve been discussing the merits of platform monopolies. We’ve established that there’s a plausible case for granting such a monopoly, but that because of network externalities, there are also good reason to be skeptical of such monopolies. There remains the question of how to balance these two factors.

So now I’d like to make the case that the benefits of platform rights are greatly overestimated by the advocates of such rights. My argument comes in two parts. First, the negotiations required by a platform monopoly produces substantial deadweight losses: both because negotatiting permissions costs money, and (more importantly) because there will be socially-beneficial technologies that will never be developed because the necessary rights cannot be negotiated. And second, those profits that can be expected to reach the property owner don’t necessarily cause firms to direct their resources in ways that are economically beneficial.

Today I’ll focus on the first objection, which might be called the “demand side” objection.

The fundamental problem here is that a new platform can create a wide variety of possible uses, and only some of them will be capable of being monetized. This can occur for a variety of reasons. The first is that many uses might simply be too small and too diverse, taken individually, for the platform owner to bother negotiating usage rights. The inability to play iTunes songs on niche digital audio devices is an example of this. No doubt Apple would be happy to permit high-end audio users to play iTunes songs on those devices, but the potential revenues simply aren’t large enough to justify the extra work it would take for Apple to grant permission.

A more serious problem is one identified by Brett Frischmann of Loyola University and Mark Lemley of Stanford in their excellent paper “Spillovers”:

The market system works rather well in responding to consumer preferences measured by consumers’ willingness to pay for goods and services. But the demand signaling function of the price mechanism does not necessarily work well when purchasers/licensees use a resource as an input to produce a different good for which they themselves cannot expect to capture the full social value. Purchasers’/licensees’ willingness to pay reflects their private demand–that is, the value that they expect to realize–and does not take into account value that others might realize as a result of their use.

Open source software is a good example of this phenomenon. Open source projects can generate immense surpluses, but their creators tend to be poorly positioned to capture that surplus. As a result, the price open source developers are willing to pay for access to a proprietary platform will be far lower than the price that users, collectively, would be willing to pay if given the opportunity.

But the problem isn’t limited to open source developers. The fundamental problem is that a firm can never capture the full value of a product to the product’s users, and as a result, the price he is willing to pay to the platform holder will always understate the total value of access. As a result, platform access will be under-provided, and economically efficient uses of the platform will never occur.

This problem becomes worse the more intermediaries there are between the platform holder and the ultimate end user. Each intermediary will captuer only part of the value the guy below him places on access to the platform. As a result, the more intermediaries, the more the price offered to the platform owner will under-state the social value of access to the platform.

The net result of a monopoly licensing regime is to inefficiently “flatten” the development structure and undermine the division of labor. Firms with a high degree of vertical integration are at an advantage on a proprietary platform, because they are better positioned to capture more of the surplus created by their products. Technologies built on open platforms, in contrest, tend to have a high degree of division of labor, as developers incorporate components developed by many others into their own products. As a result, technologies built on proprietary platforms tend to be more expensive and less flexible than technologies built on open platforms.

The bottom line is that the mere existence of the monopoly licensing regime prevents certain beneficial uses of the technology from being developed, and it distorts the structure of the computer industry in other ways as well.

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