Australia: What are the competition implications of digital disruption?

Last Updated: 24 April 2017
Article by Martyn Taylor
Most Read Contributor in Australia, April 2017

Digital disruption is blowing a Schumpeterian gale of creative destruction throughout the global economy. These winds of change are delivering substantial increases in consumer welfare. The glowing glass screen of a smartphone enables us to access the library of all human knowledge. We can order any imaginable good or service; literally at our fingertips.

Yet competition challenges are arising. Firms bearing the brunt of digital disruption are seeking regulatory protection. Those firms riding the winds of change are achieving significant market power. Global debate is occurring regarding the extent to which regulatory intervention is appropriate.

So what are the competition implications of 'digital disruption'? Why are competition issues arising and what can we expect in the coming years? This article provides a summary of the types of competition issues arising and some useful background and context.

A high technology ecosystem in the form of a digital platform

High technology industries have pushed the frontiers of competition law for many decades, including aerospace, robotics, electronics, biotechnology, pharmaceuticals and computer science. The competition issues with such industries are well known, associated with high innovation, high sunk costs in research and development (R&D), and high intellectual property (IP) intensity. In many high technology industries, competition has been for the market in the form of an IP right that has conferred temporary market power.

However, much of the current digital disruption is occurring at a comparatively low cost without substantial R&D expenditure. Was Marcus Persson, for example, really participating in a 'high technology' industry when he developed and sold the game of Minecraft for USD 2 billion, particularly as he reputedly coded the software in his bedroom?

The answer to the Minecraft question is that the current wave of digital disruption involves a confluence of enabling 'high technologies' that have been co-ordinated in such a way that they have facilitated low cost commercial exploitation via simplified application software.

In this manner, while the building blocks of digital disruption have involved many billions of dollars of historic R&D, a software developer can now stand on the shoulders of the R&D giants to develop and launch a particular software application. A developer can also use enabling 'building block' software applications. Such applications have opened the ability to create software to non-experts. The author's 8 year old daughter, for example, recently developed her own iPhone game at a holiday 'code camp' using enabling software.

The concept of 'digital disruption' in the 21st century can therefore be viewed as a high technology ecosystem. This ecosystem has involved high technology industries facilitating low cost innovation by creating a digital platform for consumer-friendly, mass-market software. This high technology ecosystem involves a combination of:

  • ubiquitous digitalisation of information and content into binary data, using complex coding algorithms;
  • affordable pocket supercomputers, in the form of smartphones, that are now available at low cost (even in developing markets) to provide high levels of data processing power;
  • broadband Internet communications, enabling high speed transmission of large volumes of digital data between all manner of devices anywhere on the planet;
  • sophisticated proprietary 'operating system' software that enables the functionality of sophisticated devices to be readily accessed by simplified application software;
  • user-friendly application software (known colloquially as 'apps') often now delivered at a very low or no cost to consumers in the form of a 'digital platform', such as Internet search, email, video calling, data storage and product ordering; and
  • the use of the 'digital platform' to intermediate and co-ordinate the delivery of content, services, advertising, physical product and logistics using a diverse range of business models, typically facilitated by Internet-access.

The resulting Schumpeterian gale of innovation is now sweeping sector-by-sector, industry-by-industry, market-by-market, across the globe.

The global disruptive impact of digital platforms

The ecosystem identified above is underpinned by intellectual property, in the form of computer code (i.e., software), rather than physical goods. The centrality of software to digital platforms has a range of important implications, derived from the cost characteristics, replicability and flexibility of software itself.

In August 2011, Silicon Valley venture capitalist and successful Internet entrepreneur Marc Andreessen wrote an article for the Wall Street Journal that provided insights into the future impact of software in the context of digital disruption and digital platforms, titled 'Why Software Is Eating the World'.1

Andreessen's four key insights were as follows:

Access to global market: The digital platform required to transform industries through software now works and can be delivered at global scale at an affordable cost. Software is the key that unlocks an addressable global market comprising many billions of smartphone users across the world. Andreessen commented:2

"Six decades into the computer revolution, four decades since the invention of the microprocessor, and two decades into the rise of the modern Internet, all of the technology required to transform industries through software finally works and can be widely delivered at global scale. Over two billion people now use the broadband Internet, up from perhaps 50 million a decade ago... With lower start-up costs and a vastly expanded market for online services, the result is a global economy that for the first time will be fully digitally wired—the dream of every cyber-visionary of the early 1990s, finally delivered, a full generation later."

Low overheads: Software has traditionally been expensive to create (involving high sunk costs), but inexpensive to replicate (involving a marginal cost near zero). However, once software is deployed, it may create a business without the physical overhead of existing firms, often co-ordinating existing physical resources and distribution systems. Programming tools and Internet-based (cloud) services enable the launch of software-powered start-ups without the need to invest in substantial physical infrastructure or employees.

Adaptive flexibility: Software is highly flexible and can be changed rapidly, enabling constant and continuing innovation and adaptation, creating dynamically changing business models. Digital disruption is therefore leading to an intensification of business model experimentation and an intensification of competition.

Disruptive potential: In industries with a heavy real-world component such as oil and gas, the software revolution is primarily an opportunity for incumbents. But in many industries, new software ideas are enabling software-based start-ups to enter existing industries leading to an intensification of competition. Andreesson commented:3

"My own theory is that we are in the middle of a dramatic and broad technological and economic shift in which software companies are poised to take over large swathes of the economy. More and more major businesses and industries are being run on software and delivered as online services—from movies to agriculture to national defence."
"Many of the winners are Silicon Valley-style entrepreneurial technology companies that are invading and overturning established industry structures.Over the next 10 years, I expect many more industries to be disrupted by software, with new world-beating Silicon Valley companies doing the disruption in more cases than not."

Based on forecasts from Silicon Valley, software-driven digital disruption is likely to next hit the finance, energy, healthcare and logistics sectors. Meanwhile, the Schumpetarian gale is already raging in retailing, telecoms, media and transport, involving such software-driven brands as Amazon, Skype (Microsoft), WhatsApp (Facebook), Netflix and Uber.

Big data and the information revolution

In conjunction with the rise of software-based companies, digital disruption is also being powered by the information revolution – known colloquially as 'big data'.

The term 'big data' has existed for many decades and, likewise, data analytic capabilities have existed for many decades. What has dramatically changed over the last few years is the velocity, variety and volume of data. Some 90% of the world's data has been created in the last few years. As Neelie Kroes, previous European Commissioner for the Digital Agenda and Vice-President of the European Commission, noted in a key speech in March 2014:4

"Now we stand facing a new industrial revolution: a digital one. With cloud computing its new engine, big data its new fuel. Transporting the amazing innovations of the internet, and the internet of things. Running on broadband rails: fast, reliable, pervasive... Take all the information of humanity from the dawn of civilisation until 2003 - nowadays that is produced in just two days."

Data storage costs have also dropped to the extent that data storage is no longer a significant cost concern for many businesses. Meanwhile, computer processing capability has increased such that it is possible to process 'big data' in order to extract high quality competitive information. Neelie Croes used the following metaphor in her speech:

"That is the magic to find value amid the mass of data. The right infrastructure, the right networks, the right computing capacity and, last but not least, the right analysis methods and algorithms help us break through the mountains of rock to find the gold within."

Software-driven digital platforms often involve business models that utilise data processing capability to deliver goods and services that are more tailored to the personal needs of particular consumers. In the 21st century, customer information is a strategic business asset and valuable commodity that may give a digital platform a competitive edge over its rivals.

Bearing the analysis in mind, the question arises whether unique competition issues arise in the context of digital disruption that may not otherwise arise in other high technology industries. This question is answered by the table on the next page – drawing insights from the economics of information industries.

As can be seen from the table, digital disruption has many unique characteristics giving rise to competition implications. While Microsoft famously argued that the rapid rate of disruptive innovation is sufficient to prevent anti-competitive harm (because market power is only transitory), it is also clear that the potential extent of imperfect competition in Internet-based markets will give rise to regulatory pressures and competition issues for many decades to come.

Competition implications of digital disruption

Characteristics of digital disruption Competition implication
Unsettling of social norms

Innovative business models may be subject to complaints based on the unsettling of social norms, raising wider societal questions.

Many societal issues arising from digital platforms have not yet been fully resolved by policy-makers.

For example, to what extent should personal information gathered by smartphones remain private?

Should personalised Internet newsfeeds be sacrosanct from commercial or political adjustment and manipulation?

Alex Chisholm, Chief Executive of the United Kingdom (UK)'s Competition and Markets Authority, commented in a speech in December 2014 as follows:7

"Until our societal and political processes have digested these questions more fully, competition authorities will have to play a more modest role on these wider questions – shining a light on competition trade-offs and consequences for the quality of the consumer experience".

Regulatory barriers to entry

Extant regulation may create barriers to entry or favour a legacy business model.

Taxi licensing sits uneasily with Uber's 'ride sharing' model.

Smartphone-based payment systems face a maze of financial market regulation.

Competition policy favours regulation that does not discriminate in favour of particular business models or incumbent technologies.

Where regulation impedes legitimate market entry, competition policy promotes deregulation and regulatory reform .

Rent-seeking incumbents Market entry by disruptive businesses places intense pressure on existing businesses. Rent-seeking and competition complaints are a common response. However, such complaints may also be legitimate.

Regulators must determine whether the market entry is a manifestation of competition or involves anti-competitive conduct or potentially both.

The investigation of Google by the European Commission, for example, raises such challenges.

Bundling, tying and leveraging The market entrant may use an entry strategy that utilises existing markets in which it has high market power – effectively leveraging its market power across different markets. The so-called Internet 'browser wars' between Netscape and Microsoft over the period 1997-2002 are illustrative of a bundling strategy in which a market entrant could leverage its market power between different markets.
Amplifying of market power

Proprietary software can be used to deny access to a device or other software functionality, creating strategic bottlenecks.8

Apple's iStore, for example, has become a key gateway in the utilisation of the iPhone.

Virtual bottlenecks raise the same issues of potential discrimination and excessive pricing as physical bottlenecks.

Control of resource bottlenecks can be used to raise rivals' costs or deny functionality.

Multi-sided markets

Disruptive business models often involve matching of buyers (as a service provided to buyers) with sellers (as a service provided to sellers), creating 'two-sided markets'.9

In multi-sided markets, the more price-sensitive service may be cross-subsidised by the less price sensitive service, potentially increasing barriers to entry.

Multi-sided markets may accentuate network effects and facilitate leveraging of market power.

Complications may arise, for example, where one service is fully cross-subsidised by another service so is effectively free.

Google's free Internet search product, for example, is cross-subsidised by AdWords advertising revenue.

Disinter-mediation

Internet-based business models have altered the ability of businesses to bundle and unbundle through the value chain, creating significant changes in product offerings and distribution models.

Accordingly, business model competition is increasing.

Businesses that historically offered a bundled offering (e.g. pay TV over home cable), are now facing competition from unbundled offerings (e.g., pay TV over any Internet device), and vice versa.

Questions of access, exclusivity, foreclosure and bundling may arise.

Network effects and 'winner takes most' tipping

In information-based industries, network effects are common. The more users of a service, the greater the benefit gained by other users, creating demand-side economies of scale.

Markets that are subject to network effects may be subject to 'tipping'.

A firm with an early advantage may be selected disproportionately by new customers, creating a 'winner takes all' (or 'winner takes most') consequence that tips towards a monopoly.

When faced with network effects, a market entrant would need an innovation of sufficient magnitude to dislodge the industry leader.

An example is the rapid substitution of SMS phone messaging by WhatsApp in some markets.

Social media and communications software are particularly susceptible to network effects, including Facebook, LinkedIn, Twitter, WhatsApp and Skype.

Network effects are amplified by compelling 'walled' exclusive content.

Globalisation of markets

Internet-based e-commerce is often blind to national borders, enabling a firm in Country A to supply over the internet to a consumer in Country B.

As a consequence, markets are becoming more globalised and competitive.10

Services are being reconstituted around market segments that have a need for a differentiated product.

However, many of those market segments are orders of magnitude larger than they used to be, involving supply into global markets.

Platform-based competition

The owner or operator of the platform may own or create only one piece of the ecosystem.

Many complementary products may be added to the ecosystem for the digital platform to be popular with consumers.

Digital platform owners and operators may seek to secure access to exclusive content and features (including IP), thereby preventing the establishment of competing platforms.

IP rights may be fiercely defended.

High switching costs

Platforms often include disincentives to customer churn, including restrictions on porting digital content.

Free cloud storage may act as a 'lock in' to a particular digital platform.

Switching costs for consumers may be high, including forfeiture of existing valuable content.

For example, an iPhone is effectively bundled with iTunes-purchased digital content.

Path dependency and first mover advantages

High-tech markets are often highly "path dependent"— market winners can be determined by the order in which companies act.

A first mover can benefit from 'tipping' and 'winner takes most' network effects.11

A company, or a small number of companies, can rapidly obtain and sustain a significant market share that can be hard to reverse.

Given tipping effects, there may be substantial 'first mover' advantages.

Standardised products and inter- operability

A standard itself may exhibit path-dependency and tipping effects, such as the QWERTY keyboard.

Complications arise where a technology is protected by intellectual property rights.

Where inter-operability issues arise, the owner of the favoured standard may possess substantial market power, as demonstrated by historic litigation over access to software source code.

Realisation of synergies

Combining complementary assets enhances innovation capabilities and thus spurs innovation.

Complex devices such as an iPhone, for example, incorporate multiple physical components, substantial intellectual property, and sophisticated software.

Pro-competitive mergers and business practices allow for the more efficient combination of complementary assets.

In the context of digital disruption, a merger could facilitate the realisation of a highly innovative product.

Footnotes

1 M Andreesson "Why Software Is Eating The World", The Wall Street Journal, 20 August 2011.
2 Ibid.
3 Ibid.
4 N Croes "The data gold rush", Speech by the European Commissioner for the Digital Agenda and Vice-President of the European Commission, Europe Data Forum, Athens, 19 March 2014.
5 Ibid.
6 United States v Microsoft (Microsoft III), 253 F.3d 34 (D.C.Cir. 2001)
7 A Chisholm "Giants of digital: Separating the signal from the noise and the sound from the fury" Speech by CMA Chief Executive, CRA Competition Conference, Brussels, 10 December 2014.
8 T Wu "In the Grip of the New Monopolists - Do away with Google? Break up Facebook? We can't imagine life without them—and that's the problem" The Wall Street Journal, 13 November 2010.
9 HA Shelanski "Information, Innovation and Competition Policy for the Internet" (2013)1 61 University of Pennsylvania Law Review 1663.
10 United States Antitrust Modernisation Commission, "Report and Recommendations", April 2007.
11 SJ Liebowitz & SE Margolis "Path Dependence, Lock-in, and History" (1995) 11(1) Journal of Law, Economics and Organisation 205-26.

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