The War on Vertical Integration in the Digital Economy

Adam ThiererSenior Research FellowMercatus Center

November 16, 2012

Presentation before the Southern Economic Association

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Purpose of Talk

• Identify important new regulatory proposals in the field of information technology policy

• Identify common themes that unite those calls for government action

• Rebut those fears using economic / historical evidence

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This talk derived from two Mercatus Center papers …

• “Uncreative Destruction: The Misguided War on Vertical Integration in the Information Economy” (forthcoming Federal Communications Law Journal)

• “The Perils of Classifying Social Media Platforms as Public Utilities”

www.Mercatus.org/research/tech-policy

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Growing Calls for Digital Regulation• from Net neutrality & search neutrality to “API neutrality” (J.

Zittrain) & “social network neutrality” (J. Levine) & “algorithmic neutrality” (T. Gillespie)

• “social utility” or “social commons” arguments (D. Boyd, Z. Tufekci)

• “digital essential facilities” / “digital public utilities”• “separations principle” for digital economy to prevent all

possible vertical integration / power (Tim Wu)• Major push for regulation of online advertising / digital

privacy• Calls for a “Federal Search Commission” (F. Pasquale) or

“Federal Internet Commission”

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Two Emerging Themes

1. Vertical integration in information technology sector is dangerous. Based on…

– Economic power concerns (“big is bad”)– Free speech concerns (“information industries are

special”)

2. Increased government scrutiny of information platforms is necessary

– Administrative regulation (+ lots of “nudges”)– Stepped-up antitrust intervention

Two Specific Proposals Addressed in This Presentation

1. “API neutrality” – Jonathan Zittrain, The Future of

the Internet and How to Stop It (2009)

2. “Separations principle”– Tim Wu, The Master Switch

(2010)

These are the 2 most influential books being widely assigned today in cyberlaw , media studies, and digital econ courses.

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API Neutrality

API’s = application programming interface (code & standards that allow digital interoperability)

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Zittrain’s “API Neutrality” Premise

• Explicit assumption: We might need to require “API neutrality” to ensure “fair and non-discriminatory” access to certain online services or digital platforms.

• Implicit assumption: Certain social media platforms or digital devices are a sort of essential facility, public utility, or common carrier (or at least should be).

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Zittrain’s concern (part 1)• Zittrain worried that vertical foreclosure threatens

“generative” technologies or networks, which invite or allow tinkering and all sorts of creative secondary uses.

• worried about “appliancized systems,” or digital technologies or networks that discourage or disallow tinkering / interoperability.

• primary examples are proprietary devices like Apple’s iPhone or the TiVo, or online walled gardens like the old AOL or Facebook today.

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Zittrain’s concern (part 2)

• He says such devices or platforms threaten “openness” & allow easier control by either large corporate intermediaries or government officials.

• Thus, the “future of the Internet” Zittrain is hoping to “stop” is a world dominated by tethered digital appliances and walled gardens, because they are too easily controlled by other actors.

• How to accomplish? = Constrain vertical foreclosure of platforms / devices.

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Zittrain’s proposal: API Neutrality

• “Should we consider network neutrality-style mandates for appliancized systems?” he asks.– “The answer lies in that subset of appliancized systems

that seeks to gain the benefits of third-party contributions while reserving the right to exclude it later... Those who offer open APIs on the Net in an attempt to harness the generative cycle ought to remain application-neutral after their efforts have succeeded, so all those who built on top of their interface can continue to do so on equal terms.”

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API Neutrality as Adverse Possession for Digital Platforms

• Zittrain even alludes to the possibility of applying the common law principle of adverse possession more broadly in these contexts.

• users who openly occupy another’s private property can, after a lengthy period of time on that property, come to legitimately acquire (or at least share) it.= converts Facebook, Twitter & other services into a commons

• He does not make it clear when that principle would be triggered as it pertains to digital platforms

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Separations Principle

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Wu’s concerns

• Wu contends that “information monopolies” are pervasive in the information economy.

• These “monopolists” include Facebook, Apple, Google, and even Twitter

• “Information industries . . . can never be properly understood as ‘normal’ industries;” require extensive regulation to prevent monopolistic abuse

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Wu’s proposal“A Separations Principle would mean the creation of a salutary distance between each of the major functions or layers in the information economy. It would mean that those who develop information, those who own the network infrastructure on which it travels, and those who control the tools or venues of access must be kept apart from one another.” – Wu, Master Switch, p. 304

Goal: to prevent “one layer from smothering the others” through a reinvigorated regulatory enforcement to address “the corrupting effects of vertically integrated power” in the information sectors.

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Wu’s 3 Segregated Buckets

Content• Movies / Music / Games / Software

Distribution• Conduit / Networks

Hardware• Handsets / Devices

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Separations Principle Implementation

1. FCC is primary enforcer; should block mergers & compel divestitures to prevent harms associate with vertical integration / foreclosure.

2. If FCC fails to prevent integration across categories or fail to enforce separations, FTC & DOJ step in and do so.

3. Finally, Wu also hopes industry players would adopt norms of openness and compliance and even voluntary separations.

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Wu Calls It a “Constitutional” Approach

• Wu insists that this structural remedy “is not a regulatory approach but rather a constitutional approach to the information economy” because he models it on the separation of powers found in the U.S. Constitution.

• He concedes it’s a “radical” proposal but says it is in line with earlier ideas regarding the dangers of vertical concentration and power. (Jackson, Roosevelt, etc.)

HardwareDivision

DistributionDivision

ContentDivision

Example: Apple

iPhoneiPadiPodMacs

AppleTV

iOSSafari

Content division

Apple App StoreiTunes

Example: Microsoft

HardwareDivision

ContentDivision

WindowsOfficeMicrosoft Studios (video games)Internet ExplorerHotmail

Xbox consolesSurface tabletKeyboardsMice & peripherals

Example: Amazon

HardwareDivision

DistributionDivision

ContentDivision

Amazon.comAmazon Web Services

Kindle

Amazon PublishingAmazon apps

Example: Google

HardwareDivision

DistributionDivision

ContentDivision

Google Play storeGoogle Fiber broadband network

Google searchYouTubeGoogle MapsAndroid softwareGmailChrome browser

Motorola devicesGoogle TVChromebooks

Example: Comcast

HardwareDivision

DistributionDivision

ContentDivision

Set-top boxes

Comcast broadband & video networks

NBC-Universal properties

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Responses

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Some Basic (Post-Chicago) Economics• vertical restraints & integration are very rarely

considered dangerous or illegal anymore• Traditional concerns with vertical integration have

been “essentially forgotten” by academics, agencies & courts

• vertical arrangements can increase interbrand competition, promote efficiencies & expand options

• vertical restraints and excessive foreclosure are constrained by competition from other producers (Schumpeterian creative destruction / contestability)

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Structural Separation Increasingly Frowned Upon as Remedy

• Structural separation of vertically integrated firms is a rarely used remedy in antitrust

• Sherman Act structural remedies very costly & fail to improve the competitive landscape or consumer welfare (Crandall, 2001)

• Structural separation now considered nuclear option of antitrust; absolute last resort

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Is There Really a Problem Here?

• Even Wu admits that we “live in what is in some ways an informational golden age.”

• More choices and innovation than ever flowing from this sector.

• Consumers clearly aren’t clamoring for breakups!• Vertical integration appears to be offering them

many benefits. • Schumpeterian creative destruction is alive and

well.

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Dynamic Responses to ForeclosureExcessive foreclosure has real-world trade-offs / downsides:• Might limit profit potential: Information ecosystems make

themselves more attractive to users and advertisers by providing platforms with plentiful opportunities for diverse interactions and innovations. Foreclosure can limit that.

• Reputational effects: Firms do not want to incur the wrath of those who built on top of their interfaces (or the wrath of customers, press, academics.)

• Opportunistic entry / “leapfrogging” effects: Locking down platforms can spur more entry and innovation as other app developers and users seek out more open, pro-generative alternatives.

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Apple case study

• Apple was originally entirely closed to 3rd party development but quickly reversed itself and opened its iPhone platform

• The result was an outpouring of innovation. Customers in more than 123 countries had downloaded more than eighteen billion apps from Apple’s App Store at a rate of more than 1 billion apps per month as of late 2011

• no obvious incentive for Apple to completely foreclose third-party development now, especially as its application ecosystem is a key element of Apple’s success in the smartphone and tablet sectors.

• + huge pressure from Android, Microsoft, Apple & others

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Remember AOL-TW?Part 1: IM Interoperability Fears

• A decade ago, similar angst surrounded AOL’s growing power in the instant-messaging (IM) marketplace.

• Many feared AOL would monopolize the market and exclude competitors by denying interconnection.

• Markets evolved quickly to offer choices & interoperability.

• Today, anyone can download free chat clients to manage IM services from multiple services, all within a single interface, essentially making it irrelevant which chat service your friends use.

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Remember AOL-TW?Part 2: Internet Access Fears

• Vertical integration of AOL narrowband Net access + Time Warner content led to fears of “new totalitarianism” & “corporate Big Brother”

• But AOL-TW totally missed the broadband & search revolutions

• Merger produced zero synergies but massive losses (over $100 billion within 2 ½ yrs)

• Voluntary vertically separated in 2009

Web Portals / Early Search

AOLCompuServe

ProdigyGeocities

LycosGo.com

AskJeeves

Social Networking PlatformsFirst

GenerationSecond

Generation

Six Degrees FacebookFriendster LinkedIn

Live Journal Google+MySpace Twitter

SearchGoogle

Microsoft BingYahoo!

AskDuckDuckGo

Blekko

Evolution of Web Portals to Search & Social Networking

The Rise & Fall of Video Game Platforms

Video Game ConsolesFirst Era Second Era Third Era

Magnavox (Odyssey) Nintendo (NES / N54) Sony (PlayStation)Atari (2600) Sega (Genesis / Dreamcast) Microsoft (Xbox)

Mattel (Intellivision) Atari (Jaguar) Nintendo (Wii)Coleco (ColecoVision) Apple (Pippin)

+ a vibrant PC & smartphone gaming market exists now, too.

Evolution of the Computing Value Chain (1975 – 2012)

Source: Horace Dediu, Asymco

Source: Horace Dediu, Asymco

Smartphone Platform Competition (2009-present)

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Likely Consequenes of RegulationAPI neutrality or a separations principle…• would send signal to digital entrepreneurs that their platforms

are theirs in name only and could be coercively commoditized once they are popular enough.

• would significantly undermine the firm’s right and ability to control one of its most valuable assets (perhaps its only monetizable asset).

• would create massive marketplace uncertainty and constitute a serious disincentive to future innovation / investment

• could force paywalls / prices to go up for consumers or choices to be diminished.

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Conclusions• Even if some platform owners vertically integrate or move to

some sort of walled garden, there is no reason to classify such a move as anticompetitive foreclosure or illegal leveraging.

• Because many digital providers do not charge for the services they provide, some limited steps to lock down their platforms or vertically integrate might help them earn a return on their investments by better monetizing traffic on their own platforms.

• Marketplace experimentation in search of a sustainable business model should not be made illegal.

• We should instead continue to place our faith in the dynamic nature of digital markets and the unprecedented Schumpeterian change we’ve already seen.

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And oh, by the way, the economics don’t really matter!

Whether API neutrality or separations principle…• Likely impossible to enforce these regimes

globally; easy to relocate.– These firms are going to vertically integrate

somewhere; it might as well be here in the U.S.!• Also, huge 1st Amendment (free speech) & 5th

Amendment (takings) issues here.– courts would like rule all this unconstitutional