On Sunday I offered one reason that platform monopolies might not stimulate as much innovation as the ideal case would suggest.
Here’s another reason: R&D spending often has diminishing returns. The surplus generated by a successful new platform (DOS/Windows, x86, iTunes/iPod, etc) provides an enormous windfall to the company that creates it–a windfall that may be totally out of proportion to the amount of money the company spent developing the platform. The first version of Microsoft’s DOS operating system, was called QDOS (for quick and dirty OS) and was licensed from another company for a small sum. It’s not at all obvious that there’s any connection between the amount of R&D Microsoft did on early versions of DOS and the large subsequent profits they made.
If we had changed public policy in the 1970s to halve or double the long-run rewards to creating a PC operating system, it’s not obvious it would have changed the outcome for Microsoft one bit. For many technological categories, the winning platform tends to be made by the firm that is in the right place at the right time. Above a certain point, increased R&D spending is likely to show diminishing returns. It only costs so much to develop a microchip, an iPod, or an operating system. If the return on doing so is 10 or 100 times the cost, we don’t want firms to spend money beyond the point of diminishing returns.
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On May 8, 1998, Paramount Pictures released a summer blockbuster in which a comet was discovered on a collision course with Earth. A team of astronauts is dispatched to destroy the comet with nuclear weapons before it hits Earth. After some setbacks, the astronauts do save the planet from total destruction, but they lose their lives in the effort.
On July 1, 1998, Touchstone Pictures released a summer blockbuster in which an asteroid was discovered on a collision course with Earth. A team of oil drillers is dispatched to destroy the asteroid with a nuclear weapon before it hits Earth. After some setbacks, the drillers do save the planet from destruction, but one of them loses his life in the effort.
The first film, Deep Impact cost $75 million to make and brought in $349 million worldwide. The second, Armageddon cost $140 million to make and brought in $553 million.
One of the assumptions behind the pro-platform rights argument I laid out last week was that increasing the rewards for platform creation lead firms to engage in socially-beneficial R&D spending. The hope is that increasing the returns to platform-creation will stimulate new R&D spending, which will in turn lead to innovations that expand the size of the economic pie. And, we hope, the pie should grow enough to offset the social costs of platform rights that I’ve laid out in previous posts.
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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.
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On Monday I laid out the case for platform monopolies: that they provide firms with incentives to create new products by allowing them to recoup their fixed costs. Yesterday I had two posts arguing that closed platforms can harm consumers by preventing gains to interoperability.
The question is, Is a platform monopoly an effective way to promote the creation of new devices? And is this benefit sufficient to outweigh the opportunity costs of reduced interoperability?
In considering these questions, it’s vital to distinguish between creating a device and creating a platform. Obviously, we want to create incentives for firms to produce more and better devices. But we don’t necessarily want firms to create new platforms. In fact, we only want firms to create new platforms to the extent necessary to enhance the functionality of new devices. If an existing platform will do the job as well, we should prefer the firm to use it, both because that saves the costs of developing the new platform, and because it permits gains to interoperability with compatible devices.
To illustrate this point, I want to offer a brief history of one of the world’s most successful platforms, the x86 computer chip architecture. I’ve discussed Intel’s x86 chip architecture (which powers almost all modern PCs) before as an example of beneficial reverse engineering. What I didn’t talk about explicitly was the role of network effects on the fortunes of the x86 architecture.
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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.
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Yesterday I presented an argument that’s sometimes heard for granting companies that create technological platforms monopoly rights in those platforms. Today I’m going to start to explore what’s wrong with that argument. Today, I’ll discuss network effects, the idea that as new users are added to a network, its value grows faster than the number of users.
My claim is that the more people who use a technological platform, the more valuable that platform will be per user. One classic statement of this idea is Metcalfe’s law, which is summarized well in this article:
Metcalfe was ideally situated to watch and analyze the growth of networks and their profitability. In the 1970s, first in his Harvard Ph.D. thesis and then at the legendary Xerox Palo Alto Research Center, Metcalfe developed the Ethernet protocol, which has come to dominate telecommunications networks. In the 1980s, he went on to found the highly successful networking company 3Com Corp., in Marlborough, Mass. In 1990 he became the publisher of the trade periodical InfoWorld and an influential high-tech columnist. More recently, he has been a venture capitalist.
The foundation of his eponymous law is the observation that in a communications network with n members, each can make (n–1) connections with other participants. If all those connections are equally valuable–and this is the big “if” as far as we are concerned–the total value of the network is proportional to n(n–1), that is, roughly, n 2. So if, for example, a network has 10 members, there are 90 different possible connections that one member can make to another. If the network doubles in size, to 20, the number of connections doesn’t merely double, to 180, it grows to 380–it roughly quadruples, in other words.
The article argues that n2 is probably too high, which I think is probably true. But what nobody disputes is that network effects exist: that a network or platform with 2 million users is going to be more than twice as valuable as an Internet with a million. Or to put it another way, two networks with a million users each will be worth less than a single network with 2 million users. This has the obvious implication that, all else being equal, public policy should encourage the creation of a small number of comprehensive networks as opposed to many small, fragmented networks.
Of course, all else isn’t necessarily equal, and I’ll deal with some of the complications in future posts. But for now I want to offer an analogy that I think helps to flesh out why network effects exist and how they work. I alluded to it a couple of weeks ago: there are close parallels between the argument for interoperability between networks and the classical case for free trade between nations. Just as there are gains to trade when people from different countries can exchange goods and services, so are there gains to interoperability when the users of different networks are able to freely exchange information.
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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.
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Slashdot is reporting that Mozilla Firefox is now used by 13 percent of web users, up from 9 percent in April 2005, and 2 percent in May 2004. That’s impressive, if overdue, progress. Microsoft’s market share has dropped from 94 percent in 2004 to 83 percent today. Opera and Safari have been below 2 percent since 2004.
It’s interesting to note that FireFox has succeeded where commercial browser efforts like Opera largely failed to make a dent in Microsoft’s market share. This, it seems to me, is one of the many reasons to prefer a legal environment hospitable to open source development efforts. Microsoft may have killed Netscape using “monopolistic” tactics (personally, I think incompetence on Netscape’s part was mostly to blame) but such tactics can’t hurt a volunteer-driven effort like Mozilla, which isn’t focused on the bottom line. Having open source projects in the mix ensures there will always be some competition for the market-leading firm no matter what happens in the marketplace.
Today brings a strange WaPo article on the supposed weakness of Wikipedia because several of the original contributions on Ken Lay after his death were inaccurate, even intentionally so. The article was corrected within a few days of his death, and that, WaPo would have us believe, is a bad thing – better to not have the article at all, than to have it within a matter of days, I suppose.
Everything new is old again, it seems, and the breathtaking power of Wikipedia is already leading some to clamour for whatever is next. (How about a book, updated by experts every year or so, and sold door to door out of the trunks of chevys?)
That’s Rob Hyndman. I have to say I don’t really understand why Wikipedia gets taken in for so much criticism. Wikipedia is accurate 95 percent of the time, and it probably covers a wider range of subjects than any other publication on Earth. And it’s made available to the world for free.
Now, if you’re a journalist or an academic writing a peer-reviewed paper, you probably shouldn’t cite Wikipedia as your source. But so what? People older than 12 don’t generally cite traditional encyclopedias in their research either. Most of the time, 95 percent accuracy is more than sufficient. And if you need 100 percent efficiency, Wikipedia gives you a good starting point by giving you an idea of what to look for.
More to the point, when will the Encyclopedia Britannica entry on Ken Lay be updated to reflect his death? 18 months from now? For that matter, does EB even have an entry on Ken Lay? It’s downright bizarre to fault Wikipedia for being slightly inaccurate for a few hours, when EB provides the reader with no useful information at all until months after an important event occurs.
Pondering last month’s discussion of innovation and interoperability, it struck me that there are close parallels between that argument and the 19th-century debate over free trade. To explore this insight further, I sought the advice of my friend and budding trade scholar Dingel, who recommended that I read Against the Tide: An Intellectual History of Free Trade. I thought this passage, on page 46 of the hardcover edition, was provocative:
The term “free trade” apparently originated at the end of the sixteenth century in parliamentary debates over foreign trade monopolies. In England, royal grants giving select merchants the exclusive privilege to engage in trade with a particluar region of the world dated back to the thirteenth century. Although well established in the vocabulary of those writing on economic issues by the dawn of the seventeenth century, the term free trade initially carried a different meaning than what we now attach to it. “A free trade” was a commercial activity in which entry was unrestricted, where the liberty of the merchant to participate in trade was unhindered by exclusionary guild regulations or government grants of monopoly rights and privileges. Calls for “a free trade”–or more preceisely, “freedom to trade”–arose in an antimonoopoly movement that opposed such government restraints on either domestic or foreign commerce…
Monopoly trading companies provoked such ill feeling that those defending them either denied that they were really monopolies or justified the exlucsive grants on other grounds. Misselden, for example, agreed that such grants reduced the liberty of subjects to engage in any trade they wished, but argued that the resulting security against competitors would increase traffic aboev what it otherwise would have been, and therefore concluded that “the utility that hereby arose to the commonwealth, did far exceed that restraint of the public liberty. A common defense of foreign trade monopolies was that long-distance trade required expenditures on certain public goods, such as navigational guides or defense establishments to protect person and property abroad, and government entry restrictions were required to prevent free riders from undermining the financing of such goods. An exclusive company, for example, could raise the requisite capital to pay for these required expenditures or use their trading profits to ensure the safety of cargo, whereas interlopers who did not contribute to the fund might reduce profits and could ultimately subvert the basis for all such trade.
The parallels to contemporary intellectual property debates are obvious. We often hear the argument for expanded intellectual property made in terms of creating incentives for the creation of quasi-public goods. Professor Picker, for example, implicitly portrays those who create and use unauthorized XBox software as free riders in a manner analogous to a competing shipper who benefits from a British East India company’s lighthouse In each case, one company expends capital creating infrastructure that subsequently makes it easier for competitors to enter the field, supposedly risking the financial viability of the whole effort.
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The Technology Liberation Front is the tech policy blog dedicated to keeping politicians' hands off the 'net and everything else related to technology.