ROLES AND LIMITATIONS OF MARKETS
2.7.1 From Regulated Public Utilities Towards Liberalized Network Industries
The emergence and evolution of markets in a dynamic environment such as communications and the Internet creates a challenging environment for competition policy and sector-specific regulation.
In the past century the state has played an important role as actor in infrastructure sectors like electricity, railroads, air transport, postal delivery and telecommunications. As a result of deregulation and privatization the traditional public utilities developed into the present network industries. Legally protected entry barriers were largely replaced by free market entry. The economics of network industries became a vibrant yet challenging field, focusing on the peculiarities of markets for network industries and generating new insights pertinent to these unique sectors (Shy, 2001; Knieps, 2015a). Cost characteristics like economies of scale, economies of scope, high fixed costs combined with low marginal costs are typical for network industries in general. A large body of research exists addressing industries with few suppliers and their market strategies (Tirole, 1988; Scherer and Ross, 1990; Carlton and Perloff, 2005). A key insight is that competition may unfold in many forms even though the general equilibrium theory of perfect competition does not hold. Market participants should exhaust the potentials of dynamic markets including the emergence of new markets, undisturbed by government interventions. Remaining market power problems are left within the competency of antitrust authorities based on general competition policy (e.g., Geroski, 1998; Katz and Shapiro, 1999; Shapiro and Varian, 1999; Shy, 2001).There are, however, peculiarities within network industries that suggest a role for governance mechanisms other than markets. Network externalities, public good aspects, and possibly failures to coordinate the systemic interdependencies in the Internet limit the ability of decentralized markets to coordinate effectively.
Other forms of governance, including government regulation, co-regulation (e.g., public-private partnerships such as computer emergency response teams in the area of cybersecurity), and self-regulation (e.g., forums such as the IETF) may be able to address these problems.In liberalized network industries the traditional goals of consumer protection and of competition policy also hold without apology. Moreover, ex ante sector-specific regulations may be justified although the goals during the past decades were to focus these interventions to minimize the scope of regulation as well as the possible distortions created by regulatory interventions. The concepts of natural monopoly and irreversible costs can be applied to help regulatory agencies localize and discipline network-specific market power. Two kinds of potential errors are associated with government intervention. A false positive or Type I error occurs when an agency intervenes although there is no need for such intervention. A false negative or Type II error arises when there is no intervention although there is a need for active competition or other type of policy. The relevance of such Type II errors cannot simply be defined away but each situation needs careful examination.
For example, owners of civil engineering infrastructure do often possess the characteristics of monopolistic bottlenecks (due to the combination of natural monopolies and irreversible costs) so that competition on the markets for network services may be impeded (Knieps, 2015a, p. 135). Type II errors can sometimes be recognized ex post and then be corrected. Unfortunately, Type I errors do not allow such self-correcting processes. Shortall and Cave (2015) provide an interesting illustration for European next-generation access markets, where regulatory decisions in some countries cemented monopolistic structures. Obviously, discretionary interventions, applied case by case, are strongly susceptible to the impact of rent-seeking activities.
Instead, the development of generic solutions seems necessary that are reasonably robust to variations in the details of individual markets and firms but applicable to classes of cases. The starting point of such a disaggregated competition and regulatory policy model should be the localization of market power. In sub-markets where market power can be localized government agencies have a clear case for regulatory intervention.2.7.2 Consumer Protection in Innovative Industries
Consumer protection issues are important in markets for Internet applications as well as Internet traffic services. This includes issues of security, deterrence of cybercrime, market transparency of price conditions, and so on. A major focus of consumer protection is on market and information transparency related to price and quality conditions. Within the traditional TCP/IP Internet the actual transmission quality remains unspecified. Depending on demand and the provided transmission capacity, quality attributes such as speed result endogenously. An ex ante quality guarantee would conflict with the best-effort slow-start congestion avoidance mechanism. If a packet is dropped because the receiver cannot handle the traffic flow the sending computer halves its rate (Jacobson, 1988). From the perspective of consumer protection a transparent provision of TCP does not raise problems even though, given the protocols implemented at routers, heavy users of capacity are favored compared to light users. Transparent contractual broadband usage restrictions as described in Wu (2003, p. 158) likewise do not raise concerns. However, intransparent ad hoc traffic management procedures aiming to reduce congestion or favoring specific applications are incompatible with consumer protection. One well-known example has been the intransparent traffic management of Comcast when interfering with its customers’ use of the peer-to peer networking protocol BitTorrent. A precondition for non-discriminatory active traffic management is the requirement that the providers make available their congestion pricing and quality differentiation strategies in a transparent manner.
This includes traffic service classes and related quality guarantees as well as prices, including penalties in case the contracted transmission qualities are not delivered.Consumer protection is also relevant in markets for applications and services, for example guaranteed Voice-over-IP quality. Whereas in the past quality characteristics have been specified based on ITU standards, in the future an evolutionary search for heterogeneous end-to-end qualities can be expected. The role of data protection and individual privacy may become an even greater challenge for the future developments towards the Internet of Things (Klein and Rao, 2014). See also Chapter 12 by Ian Brown in this volume.
2.7.3 Competition and Antitrust Policy in Innovative Industries
Important antitrust cases in innovative industries have been the IBM and the Microsoft cases (Fisher et al., 1983; Fisher, 2000a, 2000b; Economides, 2001) and the various cases against Google in the USA and the EU (see Chapter 9 by Haucap and Struhmeier, this volume). A controversial question has been whether traditional antitrust analysis is also applicable to innovative industries or whether their dynamic nature would exempt them from such scrutiny. However, despite the difficulties to operationalize workable competition in dynamic industries, ‘To do otherwise is to provide a license to destroy competition under the excuse that a firm is innovative’ (Fisher, 2000a, p. 564). Controversial questions during these long-lasting cases have been whether and at which layers (components, hardware, services) market power could be identified and if so whether such market power had been extended to complementary activities using bundling as a tying strategy, whether predatory pricing strategies had been applied, as well as the role of predatory inventions.
A key lesson from these cases is that market power is very difficult to establish. The definition of the relevant markets and their boundaries, the definition and measurement of market shares, and the role of entry barriers are highly controversial and complex issues without clear-cut answers.
Due to the innovational dynamics, market boundaries are blurring, entry strategies by competing platforms become important and innovative product design is hard to distinguish from strategic innovations intended to thwart competition. Even if market power could be identified (e.g., IBM’s 360 series computer generation or Microsoft’s operating system) traditional antitrust instruments cannot identify the abuse of market power. For example, anti-competitive price setting on the browser markets with high fixed and low variable costs cannot be identified with the traditional Areeda-Turner and other tests.2.7.4 Regulation in Innovative Industries
Similar to the role of antitrust policy in innovative markets the labeling of a network industry as innovative can by no means serve as a blanket justification for absence of market power regulation. The relevant questions are in which part of a network industry network specific market power continues to exist after liberalization and how adequate regulatory instruments could be designed that are not conflicting with the evolution of network dynamics. The role of sector-specific market power regulation in network industries changed over time in response to the degree of market opening.
It is useful to differentiate between the phases of ‘static regulation’, ‘comparative static regulation’ and ‘dynamic regulation’. Whereas during the period of legal entry barriers, static regulation and the control of market power subject to given technological constraints was the predominant approach, during the period of gradual entry deregulation comparative static approaches were applied to take into account technological change when applying adaptions to regulatory instruments. In the meantime ‘dynamic regulations’ evolved, taking into account proper incentives for innovations and related investments in an environment of gradual network evolution and facilitating dynamic efficiency (Bauer and Bohlin, 2008, p. 38). With the emergence of new markets, network-specific market power becomes less severe. To the extent that technological progress leads to active competition, the area of monopolistic bottlenecks is shrinking and potential market power regulations should be phased out. Ex ante regulation of access to ducts and conduits may be justified if alternative infrastructure platforms are not available (Blankart et al., 2007, p. 425). The case for intervention to promote a specific network access technology is much less clear where pathdependent upgrading strategies are an outcome of entrepreneurial decisions (Knieps and Zenhausern, 2015).
2.8