Rebooting Digital Market Power

By David Teece & Henry Kahwaty¹

I. Introduction

The European Commission is considering legislative proposals to address the perceived market power of online platforms. The proposals include the use of ex ante rules to require certain conduct and prohibit various other types of conduct without an assessment of the effects on consumer or overall welfare in any specific case. The assumption is that large firms have market power, and this market power causes anticompetitive outcomes. Competition policy – and government policy more broadly – are often based on a static view of industries and markets – a snapshot in time – rather than being viewed as part of a dynamically evolving ecosystem. This applies to the Digital Markets Act currently under consideration and the proposed ex ante remedies.

Under a static view of an industry or model of a market, the technologies available to firms are fixed or given, and rivals make decisions on price and/or innovation investment when deciding how to compete in the narrowly circumscribed “product market.” Future innovation driven changes in markets, or possibly even market redefining innovations and the potential development of entirely new markets, play only a peripheral role in the analysis. This analytical frame of reference may be sufficient in some markets or industries where market opportunities depend on competitors’ size, or where innovation capabilities are limited, but in digital industries, adopting a static frame of reference misses key dimensions of competition.

There is a great deal of focus now on adapting competition policy to the digital economy, and the Digital Markets Act under consideration is one possible approach. Standard and familiar tools, developed over decades, are used to analyze competition in industrial and other markets, and are also commonly applied directly to the digital economy to diagnose concerns and prescribe interventions. But this approach risks missing the fundamental nature of digitally enabled competition. In the digital economy, while static competition may drive incremental innovation, it is the threat and potential for market redefining innovation that drives dynamic competition.

II. Dynamic Competition

Dynamic competition is fierce rivalry between firms to develop new products or services, new means of delivering services to consumers, new business models to combine assets in different ways, and new production techniques.² This innovation competition can come directly or indirectly from entities active in an industry or in an adjacent one, and it can also come from entirely unexpected entrants, including new businesses.

Innovation competition is critical to economic performance because it drives productivity growth and economic value creation. Examples of this include the development of vaccines in medicine and the development of refrigeration for food storage in the house and during transportation. Magnetic resonance imaging both substituted for and complemented decades old x-rays. Jet airplanes substituted for and complemented propeller airplanes, both internal combustion and gas turbines. 5G mobile wireless is a step function improvement over 4G/LTE.

Innovation can be incremental or fundamental and radical, leading to entirely new categories of products or services, new and better business models, or new production techniques. Disruptive innovation can have large effects on markets and the products and services available to consumers and can be driven by existing firms or new entrants.

Netflix, for example, disrupted the creation and distribution of video content to consumers in numerous countries. It started in the 1990s as a mail-order service for DVD rentals. Consumers would order DVDs that they would receive by mail and then return through the mail after viewing. As a new entrant, its business model disrupted the video rental stores that occupied local street corners at the time. It now has about 200 million subscribers streaming content in 190 countries around the world and has dramatically changed video distribution and related markets – disrupting the businesses of large cable television providers and even affecting the theatrical exhibition of new, feature-length films.

III. The Digital Economy

The digital economy is very dynamic, and this dynamism is driven by the creation of the internet and the developments in microprocessors, memory, and optical fiber. Digital businesses have developed new products and services and developed new ways of delivering services to consumers, often through the use of new business models. Think of the feature rich communication services offered by apps on a cell phone, including arranging accommodations via Airbnb, ride-hailing via Lyft, food delivery via Deliveroo, or playing music via Spotify. By bypassing traditional channels and leveraging technological innovations, the digital economy has grown the overall productive capacity of the economy.

Leading businesses and new digital entrants compete with each other in a myriad of ways, leading to dynamic competition with various entities trying to out-innovate each other. Virtual (personal) assistants such as Amazon’s Alexa, Apple’s Siri, Google’s Google Assistant, and Microsoft’s Cortana are pushing the boundaries of search. Sony, Facebook, and Microsoft are pushing the boundaries of Virtual Reality. Apple now challenges Intel in microprocessors and outpaces all of Switzerland in timepieces.³ Netflix rivals most of Hollywood in terms of both audience and content.⁴

Innovators, however, need not be large businesses, and disruptions can come from entrants that start with no scale in the market. As the Netflix example shows, size is no protection from competition in digitally enabled markets. Successful businesses in digital commerce need to maintain their innovative activity or they will be overtaken by other, more nimble and creative rivals.

IV. Competition Policy Tools and Dynamic Settings

A fundamental concept in competition law and economics is market power. How do you measure market power in the digital economy? Standard measures like mark-ups over cost have little meaning when services are offered to consumers for free, and market shares may have little meaning in dynamic settings. Market shares are often based on revenue, but revenue-based market shares are not informative when services are provided for free or in exchange for data. If competition is driven by rivalry among ecosystems, such as Android and Apple’s iOS together with the hardware, software, and services from many businesses that are associated with them, defining markets around a component of an ecosystem and calculating market shares for that component would miss much of the vibrancy of the competition between the ecosystems.⁵

In the merger context, for example, market shares need to be forward-looking because the analysis is usually about predicting the effects of a potential transaction in the future.⁶ Market shares that are snapshots of the present or compilations of the past are often assessed in the light of future projections and the competitive constraints arising from rivals, including any “mavericks” currently active in the market. Such projections may not mean much in digital markets when innovation is on-going and entry can come not only from adjacent markets but also from other areas entirely.

Before you can assess market shares, you need to know “shares of what”? Markets are defined as a tool to assist with the assessment of market power. They should capture the nature of the competitive situation facing businesses.⁷ Competition analysis typically views suppliers offering similar or identical products as being close competitors that place constraints on each other, and markets are defined around the supplies of these similar products or services. But if a fundamental driver of competition in the digital economy is innovation to offer new, potentially market redefining services, tools designed to define markets for industrial products will miss this core element of competition, especially if innovation may come from a range of different sources. A market defined in a manner that does not take primary methods of competition into account can no longer meaningfully inform competition enforcement or public policy.

Proposed new policy frameworks include abandoning measures of market power and instead focusing on size, with policy interventions targeted at the largest digital platforms because bigger platforms are viewed as wielding disproportionately more power in markets characterized by network effects and ‘winner-takes-all/most’ competitive dynamics. Competition law and economics has long recognized, however, that while size may be easy to measure, large firms can lack market power or face significant competition. One must remember that market power, not size, is a gating characteristic for successful market intervention. With vibrant dynamic competition, even a “winner-take-all/most” outcome is only temporary as entities look for means to develop better, more convenient, or higher value offerings for consumers, while seeking to displace the incumbent platforms (even if these platforms are “large” as measured by the number of users or some other metric).

In the absence of meaningful measures of market power, analysis should focus on traditional antitrust concepts based on evaluating the core competitive capabilities of the firm or firms involved and determining how scarce these resources are. In manufacturing, the key assets may be specific types of production facilities, and these may be few in number and difficult to replicate. This approach could be applied to the digital economy. It is conceivable that there are impossible to replicate advantages; where these are found, they are usually due to some form of government restriction.

Market power held by players in the digital economy due to their prior dynamic capabilities and strategic investments are not inherently objectionable, in the same way that a government granted exclusivity on patented technology is not objectionable. The rewards to successful innovation are what incentivizes innovative efforts, which benefits inventors, drives productivity growth, and develops and expands the broader economy. The policy question is whether there are barriers to dynamic competition, and, if so, what are they?

The key strategic assets and competitive strengths in the digital economy are the features that drive dynamic capabilities and investments in innovation: access to data scientists and programmers, deep R&D capabilities, creativity, an innovation culture, visionary management, willingness to adopt innovative business models,⁸ and a supportive policy and investment environment more generally. While the mix of assets and the strategic vision and other factors differ across firms, these assets are not bottlenecks in the traditional antitrust sense.

V. Conclusion

Innovation is critical for economic advancement and growth and is the key handmaiden of competition in the digital economy. While the proposals under consideration may on the surface appear to be targeting the market power of “gatekeeper” platforms, by failing to take into account the dynamic nature of the digital economy and the competition that flows from innovation, these proposals may instead serve only to limit the potential for future disruptive innovation and dynamic competition in the European economy. It would be tragic and ironic if the European authorities were to cripple innovation and competition in the name of advancing them. More static competition but less dynamic competition means anemic competition overall, less innovation, reduced productivity growth, lower wages, and lower growth in the overall economy. The risk of mistakes is high when the competitive dynamics of the digital economy at issue are poorly or only partially understood.

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1 Prof. David Teece is the Thomas Tusher Professor of Global Business and director of the Tusher Initiative for the Management of Intellectual Capital at the Haas School of Business at the University of California, Berkeley, and Chairman and Principal Executive Officer of Berkeley Research Group, LLC. Dr. Henry Kahwaty is Managing Director of Berkeley Research Group, LLC. This article was written as part of a forthcoming report prepared for the Computer & Communications Industry Association.

2 Ellig, Jerry and Daniel Lin, “A Taxonomy of Dynamic Competition Theories,” in Dynamic Competition and Public Policy – Technology, Innovation, and Antitrust Issues, Jerry Ellig (ed.), Cambridge University Press, 2001, p. 18.

3 “Apple now sells more watches than the entire Swiss watch industry,” The Verge, February 5, 2020, available at https://www.theverge.com/2020/2/5/21125565/apple-watch-sales-2019-swiss-watch-market-estimates-outsold.

4 “Who Are the Biggest Spenders in Entertainment?,” Observer, January 7, 2020, available at https://observer.com/2020/01/disney-netflix-apple-amazon-content-budgets/.

5 For a discussion of these issues, see Expert Group for the Observatory on the Online Platform Economy, “Progress Report: Work stream on Measurement & Economic Indicators” (2020), § 2.2.

6 Feinstein, Deborah, L., “The Forward-Looking Nature of Merger Analysis,” Business Law Today, August 2014, p. 1.

7 See Commissioner Mario Monti, “Market Definition As A Cornerstone of EU Competition Policy,” October 5, 2001.

8 Teece, David J., “Reflections on ‘Profiting from Innovation,’” Research Policy, Vol. 35, 2006.