Why Competition Is So Weak in Digital Markets: Massimo Motta Lecture Notes


Why is the influence of Google, Apple, Facebook, Amazon and Microsoft so great? Can traditional antitrust policy deal with them? Why are users at risk? Massimo Motta, Research Professor at ICREA-Universitat Pompeu Fabra and at the Barcelona Graduate School of Economics, former Chief Competition Economist of the European Commission, explained in his lecture the key features of today's digital markets. A video of the lecture and the professor’s presentation are available here.

In our core economics classes, we teach students that free markets have the ability to self-correct. If there is a firm with great market power that can set high prices and make impressive profits, then other players will want to enter such an attractive market. Competition will begin, and as a result, to the benefit of consumers, prices will decrease, and quality will remain high. However, in reality, this is an overly optimistic view of the markets and things do not always work this way. I see five reasons why markets fail to self-correct or do this insufficiently, all of which are highly relevant to digital markets.

1. Economies of scale. Digital markets are characterized by high fixed and sunk costs. If you decide to enter such a market, you will need to make huge investments, that means overcoming all difficulties in raising financing and taking on all the associated risks.

To understand how important economies of scale can be in digital markets, you can look at the example of Google. As the US Department of Justice points out in its lawsuit against the company, the best work of search algorithms requires as much data as possible. So the more users you have, the more data you get and the better your search engine's algorithms work. At the same time, the better a search engine works, the more attractive it is for users. This turns out to be a vicious circle that is very difficult for new players to break.

2. Network effects. When they are present, the value that the user receives from a particular service increases as the audience of the service grows. Network effects can be direct, as in the case of social networks or messengers: people want to communicate with each other, and the more users a social network or a messenger have, the more useful they become for people. Network effects can also be indirect: for example, if the majority of people use the same operating system, such as Microsoft Windows, then more developers will tend to make programs specifically for that system, and this will be beneficial for Windows users.

By the way, it is particularly because of the importance of network effects that many companies in digital markets first focus on creating the largest possible user base and are ready to provide their product or service for free. And only having acquired a large audience, they start monetizing, for example, forcing users to pay for the premium version of the product or start taking money from advertisers.

3. Two-sided externalities. This is a special case of network effects, when your product or service has several different groups of users and the network effects for each of them are mutually reinforcing. For example, the more users visit digital platforms like eBay or Amazon, the more sellers will want to offer their products there, and vice versa. A vicious circle is again created, from which firms with a large user base benefit, while new players and smaller companies suffer.

4. Switching costs. If you want to switch from one service to another, change the application or the operating system, the transition can be associated with psychological or transactional costs. In some cases, they are artificial because companies do not want to lose customers. There are many examples of such situations in digital markets: for example, few users switch from iPhone to Android phones and vice versa.

5. Behavioral biases. We know that people do not always behave like ideally rational agents. Consumers often show cognitive limitations and distortions.

- Default option: for example, if certain apps are installed by default on your smartphone, you are more likely to use them, even if there are more convenient and efficient ones on the market. Google spends billions of dollars getting gadget manufacturers to install its default browser or search engine;

- Exposed position (Prominence): most people rarely go beyond the first or the first three lines in search results, let alone scrolling to the end of the first page;

- Impatience: if people are impatient, they pay more attention to the benefits that they can get right here and now. As a result, they agree to paid subscriptions, and then forget or are too lazy to cancel them.

All groups of obstacles for market entrants that were described above are characteristic of digital markets to an unprecedented extent. They offer huge economies of scale, incredible network effects and two-sided externalities, significant switching costs and behavioral biases. And in fact, the current dominant players are protected by all these factors. If a company is protected from competition from new entrants, it can increasingly afford to behave like a monopolist. What can the state do in this respect?

First, different types of regulatory interventions are needed. For example, a government may impose requirements for the seamless portability of data from one digital platform to another, or for the compatibility of different operating systems. European regulators are already trying to introduce such measures. Second, more active antitrust enforcement is needed, although antitrust alone cannot solve all the competition problems in digital markets. Antitrust investigations can last for years, and during this time the firms which they were supposed to protect from monopolists, can go bankrupt and forever leave the market. So when the decision is finally made, there will be no one to protect. For example, this is exactly what happened with the investigation against the Google Shopping service in Europe, which has been going on for 11 years.

Regulators could also use more effective instruments. For example, initiating investigations not only when companies are directly suspected of illegal actions, but when they see that the markets are not working properly. Equally important are laws and measures aimed at protecting user data, ensuring privacy, and increasing the transparency of digital giants.