Thursday, October 16, 2014

Nobel laureate Jean Tirole's lessons for Internet industries

I am not a game theorist or an economist, but it seems that the work of economics Nobel Prize winner Jean Tirole has two Internet industry applications, one regarding two (or more) sided markets, the other in regulation of monopolies and oligopolies.

Two sided markets

The iPhone is a product for consumers and a platform
for developers. The optimal price is not obvious.

The Apple iPhone is an example of a product with a two-sided market -- they sell iPhones to end users and also profit from app sales by developers. In Econ 101 we learned that a company maximizes profit by setting a price at the point where marginal cost = marginal revenue. But, that is too simple because the iPhone is both a consumer product and a developer platform.

Apple wants to attract application developers as well as sell iPhones and the more iPhones they sell, the more attractive the platform is to developers. More developers means more apps, which means more revenue for Apple and it also makes the iPhone more attractive to end users. So, the optimal price for an iPhone is not the point at which marginal cost = marginal revenue, but something lower.

Google's pricing provides an extreme example. They supply search and other services to end users and they sell advertising. The more services they supply, the more they learn about users and the more valuable they are to advertisers. This has led them to an edge case -- they price their consumer services at zero, relying solely on revenue from advertisers.

On the other hand, they charge businesses $50 per user per year for Google Apps for Work ($120 with unlimited cloud storage). The business services have a few extra management features, but the marginal cost for a new user is essentially the same. Why the price difference? Business users can turn off ads and Google does not scan their email to learn about them. It is a one-sided market.

How about Google apps for education? There are no adds, but the service is free. Why does Google give schools a break? Students who are used to Gmail and Google Drive applications will tend to use them after they graduate, generating long run profit for Google. (They did not need a Nobel Prize for that one -- when I worked for IBM we gave universities an 80% discount on computers in order to get students used to IBM equipment and systems).

Tirole and co-author Jean-Charles Rochet give many more Internet-related examples of two-sided markets in this paper, (There is some beyond-me math in the paper, but the mini case studies near the end are straight forward).

Monopolies and oligopolies

US ISPs like Comcast are able to charge content providers
delivery fees and set high high prices for end users.

In awarding the prize, The Royal Swedish Academy of Sciences cited Tirole for clarifying "how to understand and regulate industries with a few powerful firms." Well, that sounds a lot like the network industry.

We have two regulatory conundrums in the US. The first has to do with consumer prices. The incumbent telephone and cable TV companies own the "last mile" infrastructure connecting homes and offices to the Internet, enabling them to set high prices for end users. The second is getting network operators to invest in infrastructure.

Let's consider investment infrastructure first. Joshua Gans, a professor of strategic management at the University of Toronto with close ties to Tirole notes that end-to-end connectivity requires cooperation between competing firms like Netflix and Comcast, but "if you leave firms to come up with the terms of the cooperation themselves, they are going to find a way to remove the competitive parts as well."

Gans says Tirole solved that problem "with a set of rules and practices that would regulate interconnection terms amongst telecommunications companies for decades while ensuring there were adequate incentives to compete — and not just on price — but on investment in infrastructure." His advice to US regulators: "open one of Tirole’s books; it is time you listened."

How about the consumer price problem? Gans says:
The issue in telecoms arises with what is termed the last-mile problem. You only have one set of cables or copper coming into your house. The solution adopted around the world has been to say, okay, one firm owns this cable, but what they have to do is provide access to these cables. So If I want another firm to provide me with TV or Internet, they have to allow that firm to effectively rent the cable from the other firm.
That strategy worked well in the Netherlands, according to Ad Scheepbouwer, CEO of the Dutch telephone company KPN:
In hindsight, KPN made a mistake back in 1996. We were not too enthusiastic to be forced to allow competitors on our old wireline network. That turned out not to be very wise. If you allow all your competitors on your network, all services will run on your network, and that results in the lowest cost possible per service. Which in turn attracts more customers for those services, so your network grows much faster. An open network is not charity from us, in the long run it simply works best for everybody.
But it failed in the US. Congress anticipated the same sort of infrastructure sharing when they passed the Telecommunication Act of 1996, but the incumbent operators were able to thwart that effort in courts, statehouses and local government.

This frustration was expressed by William Kennard, who, as chairman of the United States Federal Communication from 1997-2001, was charged with implementing the Telecommunications Act. Near the end of his term he said “all too often companies work to change the regulations, instead of working to change the market,” and spoke of “regulatory capitalism” in which “companies invest in lawyers, lobbyists, and politicians, instead of plant, people and customer service.” He went on to remark that regulation is “too often used as a shield, to protect the status quo from new competition -- often in the form of smaller, hungrier competitors -- and too infrequently as a sword -- to cut a pathway for new competitors to compete by creating new networks and services.”

If regulators are not able to get ISPs to share their infrastructure, there is another alternative -- government ownership of infrastructure. While the US cable and telephone companies have fought vigorously against municipal networks, they have worked well in other places, like Stockholm, where the municipal government provides wholesale infrastructure and invites retail ISPs to compete. (It is noteworthy here that FCC Chairman Tom Wheeler says he wants to invalidate state laws prohibiting local governments from providing Internet connectivity).

In a column on Tirole's contributions, fellow economics laureate Paul Krugman says that Tirole recognized that there are no comprehensive theories of oligopoly and monopoly and
Basically, [Tirole] made it OK to tell stories rather than proving theorems, and thereby made it possible to talk about and model issues that had been ruled out by the limits of perfect competition. It was, I can tell you from experience, profoundly liberating.
My guess is that the executives at companies like Apple and Google were dealing in stories, like the ones described above, without reading Tirole. Thinking about and elaborating on the story had more to do with Apple's iPhone pricing than the results of a game theoretic model. It also sounds like economists like Krugman and European regulators took Gans' advice -- they read Tirole's books.