Daniel O'Connor

We have been a little boozy here at DisCo.  A couple of years ago myself and my colleague Matt Schruers had a mini blog symposium of sorts where we used alcoholic anecdotes to illustrate larger policy points about the nature of competition and innovation.  Last week, fellow DisCo writer Ryan Heath used a Belgian beer example to illustrate the success of crowd funding.  In this post, I turn to U.S. beer regulation and market structure as an illustrative example of a phenomenon that has plagued the tech world: out-dated regulation that artificially props up legacy middlemen and harms innovative competitors.

Against that backdrop, let’s turn our attention to a fight brewing in Florida between craft brewers and beer distributors (and the major beer brands) in the state legislature.  At the end of last week, a Florida Senate Committee approved a bill that would allow craft brewers to sell 64oz growlers to their consumers.  Presumably, the bill will soon be voted on by the full Senate.  Similar legislation is also winding its way through the Florida House.  According to the Sarasota Herald-Tribune, the bills “could make it easier for grocery stores to sell hard liquor and brew pubs to sell more of their products.”

Currently, in Florida, it is unlawful for breweries to sell half-gallon size growlers — a staple product for craft brewers seen as the “industry standard” — to consumers.  This is because Florida, like all other states (except for Washington), utilizes a “three-tiered” alcohol distribution structure where (1) wholesalers are required to sell to (2) distributors who then sell to (3) retailers.

Florida has an exception to the three-tiered system, however: A law pre-dating the rise of craft breweries, which was designed to allow beer giant Anheuser-Busch to sell beer directly to consumers in the days when they owned the Busch Gardens theme parks, allowed craft brewers to pour pints and sell cans on their premises (thus avoiding beer distributors).  Under the complex and capricious Florida beer laws, craft breweries were able to sell quarts and gallon jugs of beer, just not the popular half-gallon size.  When legislation last year looked poised to fix this curious 96 ounce exception, it was derailed by language added at the behest of beer distributors.  The new language required, among other things, craft brewers to sell their wares to distributors who would then sell it back to them (at a healthy markup, of course) before they would be able to sell them to brewery visitors!  With their typically smaller profit margins, craft brewers — who often face a daunting journey just to turn a profit — saw this unnecessary layer of costs as a threat to their businesses.  In fact, “holding the growler hostage” was merely a strategy of “Big Beer” to attack the craft brewers’ right to sell directly to consumers.  (They said so themselves.)  The craft brewers — in good disruptive innovator fashion — turned to Indiegogo to fund their lobbying efforts against big beer.

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Big data, and its effects on online markets, has been thrust into the center of the tech policy chattering class debate.  In the last few weeks, events have been held on both sides of the Atlantic focusing on the concept of big data as an entry barrier.  (The topic has also come up in speeches by FTC Commissioners [and a paper], in discussions surrounding the EU’s forthcoming Digital Single Market strategy, and is the frequent topic of recent academic writing.)  Specifically, the concept being debated is whether the accumulation of data by Internet companies hinders competition because the new entrants will not be able to compete effectively with the first mover in the marketplace.  In this post, I will address why startups and entrepreneurs should not be overly concerned.

In a stylized view of the Internet economy, as a platform (such as Google, Facebook, Amazon, Pinterest or Twitter) achieves scale and gains users, it acquires more data.  This data leads to product improvement, which leads to more users and, subsequently, more data.  The process repeats.  According to proponents of the data as a barrier to entry theory, this leads to an unbreakable positive feedback loop that makes effective competition impossible.

However plausible this argument sounds, a review of the short history of the Internet economy, which has been characterized by intense competition and frequent disruption, seems to cast doubt on the soundness of the theory.  (See Andres Lerner’s discussion of the User Scale – Service Quality feedback loop.)  Besides the common examples of Facebook overtaking Myspace and Google overtaking prior search competitors (who, at the time, were predicted to be unassailable largely on account of the User Scale – Service Quality feedback loop discussed above), a casual look at online markets illustrates how competitive the market is.  Why are online markets so competitive even though some firms are believed to have an unassailable advantage in big data?

First, this view of Internet markets is extremely simplistic.  Data is just one input of many in the process of innovation and market success.  Second, unique economic characteristics of data — such as it being non-rivalrous and the diminishing marginal returns of data — mean that the accumulation of data, as opposed to other barriers to entry like intellectual property portfolios or high-fixed capital costs, in and of itself does not function as much of a barrier at all.  When you couple these characteristics with the fact that data, and the tools to use and analyze data, are readily available from numerous third party sources, the notion of an iron-clad data feedback loop falls apart.

I’ll break this down piece by piece.

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Today, the Wall Street Journal published an article after getting its hands on a confidential FTC memo from the now settled U.S. antitrust investigation of Google.  The document, an internal memo by the FTC’s Bureau of Competition recommending that that the Commission proceed with an antitrust case against Google for a variety of allegedly anticompetitive actions, was mistakenly released in response to a FOIA request.  The Journal also reports that the FTC’s Bureau of Economics disagreed with the Bureau of Competition, recommending that the agency not proceed with charges — a recommendation the agency ultimately followed.  Also, and perhaps most interestingly, the Bureau of Competition’s recommendation advised against proceeding with the most high-profile accusation, search bias, which is now the focus of the European Commission’s competition investigation.  As most DisCo readers probably remember, the FTC eventually voted to close its investigation of Google (and dismissed the search bias accusations outright) after the company addressed several of the practices outlined in the Bureau of Competition’s memo.

Although the WSJ article is certainly an interesting read, the fact remains that there are many checks and balances within the FTC and — with the benefit of hindsight — it is pretty clear that the Commission’s decision not to proceed on the charges of “search bias” was the right call.

Let’s look at what has happened in the marketplace since the FTC settlement.

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Günther Oettinger, the European Commissioner for Digital Economy and Society, recently gave a keynote address at the #Digital4EU Stakeholder Forum, in which he discussed the importance of a Digital Single Market in Europe and uniform Internet regulations.  He also spoke of the need for Europe to catch up in digital innovation.  Although I plan to address some controversy in the remarks, it is important to note that much of what Oettinger said was on target.  Streamlining digital rules across the 28 member states of the European Union and ensuring that Europe produces (and attracts) more programmers and IT experts will go a long way to making Europe even more competitive in the digital economy.  (I have also discussed some other issues not addressed by Commissioner Oettinger, which would also go a long way into making Europe more competitive.)

On the more worrying side, Oettinger’s speech veered fairly overtly into jingoistic territory:

The Americans are in the lead, they’ve got the data, the business models and so the power… They come along with their electronic vacuum cleaner and suck up all the data, take it back to California, process it and sell it as a service for money.

This is not surprising.  Politicians playing to a domestic audience is par for the course.  Furthermore, consumers and innovation across the world benefit from more competition, whether it comes from Silicon Valley, Berlin or Beijing.  Besides a stylized version of how Internet companies actually operate, what was misguided is the notion that using the size of European markets (the EU is the world’s biggest economy) to drive companies to adopt European regulatory standards as the de facto global standard is going to benefit European companies (whether they benefit consumers is an entirely different matter).  This was an implicit assumption underlying Oettinger’s remarks, and was made explicit in other commentary from top European politicians:

Still, said Jan Philipp Albrecht, chief negotiator for the European Parliament on the EU’s new data protection law, “If you can achieve…a standard [globally] that is somehow near…your own, then this is an advantage.”

The Wall Street Journal surmised the takeaway from this series of statements as:

Their hope: As rules such as the right to remove Web links to personal information spread, European companies would get a leg up in the next era of Internet commerce.

But is this correct? To answer that question, it is helpful to break down this line of thinking into two questions: (1) whether large markets can drive regulatory norms, and (2) whether high levels of regulation would advantage European enterprise.

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Last Wednesday, the White House released a report on “Big Data and Differential Pricing.”  The reason you have probably not heard much about it is that it was about as exciting as an Economics 201 lecture.  If you have heard about it (and you are not tenured faculty in an economics department), you may have meandered across an article such as this one, whose headline seems to imply that there is a problem that regulators need to solve.

However, if you take time to read the report, the conclusions (to the extent there are conclusions) are far more balanced and restrained.  In fact, the report notes that price differentiation is not widespread, usually beneficial, and certainly not unique to the online world.  Where differentiation is potentially problematic (not necessarily for economic reasons, but for matters of “fairness”) is in risk-based pricing markets (such as insurance, employment or credit-issuance).  But in risk-based markets, the takeaways are not unidirectional either.  In these scenarios, differential pricing is often a good thing, as it can discourage risky behavior upfront (and guard against adverse selection).  Indeed, the report recognized these types of benefits.  For example, if health insurance companies offer lower rates to non-smokers or generally healthy individuals who eat-well or exercise regularly, this can encourage healthy behavior upfront.  The report recognizes other benefits as well, such as expanding output.  To again use the health insurance market as an example, if health insurers couldn’t differentiate pricing and had to offer uniform prices, those who engage in risky behavior (e.g. smoking) would be forced to subsidize those who engage in non-risky behavior, causing fewer low-risk individuals to purchase health care plans.  Even in non-risked-based markets, differential pricing often leads to more efficient outcomes (particularly in high-fixed cost markets).

Real problems can arise when factors outside one’s control (genetic predispositions) or protected classes (race, sex, age, sexual orientation, etc.) are used to directly disadvantage consumers.  However, these problems are not unique to the online/big data world, and — as the report points out — antidiscrimination provisions of existing laws (such as the Fair Credit Reporting Act and the Civil Rights Act) already apply in these situations.

Nevertheless, some voice Orwellian fears that Internet-enabled big data might allow sellers to more precisely gauge individuals’ willingness to pay, thus transferring wealth (i.e. “surpluses” in economic terms) to producers.  This is “first degree” or “perfect” price discrimination in economic textbooks, which is hardly elaborated upon outside of theoretical models because it is virtually impossible in the real world, and — despite overblown concerns — still nearly impossible in the online world as well.

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Besides cold temperatures, inevitable musings about an Ovechkin-led Capitals being positioned to make a run at the Stanley Cup (followed by them falling off a cliff), and the occasional wayward arctic fowl, January in the District of Columbia comes with at least one constant ritual: the time honored tradition of speculating on what will be included in the State of the Union.  (And, in recent times, the SOTU-themed drinking games that flow from the anticipation… even the Washington Post has one this year).  Although some of the suspense has been dampened with media leaks and a multi-week presidential tour highlighting important SOTU themes, some surprises remain.

With political watchers fixated on what President Obama will and will not include in this year’s SOTU, I thought it was a good time for DisCo to lay out a potential tech policy roadmap for what to watch for this year in the President’s annual “setting priorities” exercise.

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Drones are leaving the U.S. for greener pastures, according to several media outlets (e.g., WSJ and Bloomberg).  In response to slow-moving U.S. domestic policy on commercial drone use, innovators are moving abroad, to jurisdictions where regulations have been updated to delineate when drones may be used in the commercial context.  (Keep in mind, we are not talking about fixed wing Predator drones with Hellfire missiles, but aircraft that are already available commercially with much of the same technology already incorporated into our mobile phones.)  Besides smaller companies actually moving abroad to places where they can sell their wares, even the likes of Google and Amazon have moved their drone testing to Australia and India, respectively.

Making matters worse, export control policies are poorly targeted, and prevent some drones made with widely available technology built in the United States from being sold overseas.  In fact, according to the Wall Street Journal, 3D Robotics — a San Diego-based company that specializes in drones with video capability — was only allowed to resume selling some of its products in a number of countries because the drones were manufactured in Mexico:

Export rules prompted 3D Robotics to temporarily halt shipments to 44 countries this spring. It has since secured a new classification from the U.S. Commerce Department, in part because it manufactures its drones in Mexico, allowing it to resume foreign sales.

And for those inclined to view this as a minor development in a niche market, at least one study predicts that allowing commercial drone use in the United States could create 100,000 new jobs and $82 billion in economic impact over the course of the next decade.

A lot of smart people have already said a lot of smart things about the drone situation, so I won’t delve too deeply into the nuances of streamlining commercial drone policy making.  Clearly, there are good reasons why commercial drones can’t take to the sky without some rules, but it is imperative that regulators move efficiently to establish a framework where, for example, a real estate agent or a surveyor can survey a property with a drone (in the same way it is currently legal for a non-commercial user to fly an off-the-shelf drone in her backyard).  That is not happening now.  According to the Department of Transportation’s own Inspector General, the FAA is likely to miss its Congressionally mandated deadline in coming up with rules that allow for the expansion of commercial drone use.

There’s a general point here worth expanding on: even if a country does everything right, creating a fertile environment for research, investment, and innovation (aka the hard stuff), innovation will nevertheless move overseas if outdated regulations impede the lawful sale or use of a product or service.  It does not matter if the United States has the brightest minds, best expertise and easiest access to venture capital; if you can’t sell, test or export drones here, then we will see those jobs and that talent go overseas to more fertile ground.  In fact, this is already happening.  And even if the FAA eventually comes up with a workable set of regulations that allow commercial drone activity, in fast moving industries — where first mover advantage is enormous — bureaucratic delays can be terminal.

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The unintended consequences of well-meaning regulation is a theme we discuss frequently here on DisCo.  (Note: This is different than cynical, anticompetitive regulations that are pushed under the guise of well-intentioned “consumer protection”, which is another recurring DisCo topic.)

In that vein, I filed comments on behalf of CCIA discussing the potential impact of new proposed regulations by the Department of Transportation aimed at requiring airlines to disclose the full cost of travel up front (instead of playing hide the ball with a litany of added fees).

The aim of this rulemaking is noble and economically sound. Econ 101 tells us that competition works best when certain conditions are present.  One of those conditions is that “perfect information” is available to consumers and producers.   The principle is that markets work best when everyone involved knows the full price up front and can assess their options before purchasing.  (Obviously, “perfect” is an ideal on one side of a continuum.)  In fact, this is an area where all sides of the political spectrum should agree — at least in theory.  Narrow rules that increase pricing (and quality of service) transparency would help the free market work better, and decrease the need for regulation, as consumers would be better able to discipline market participants with their consumption decisions.  In English that translates to: if airlines are screwing consumers on price or quality, and consumers know that up front, they can purchase a ticket on another airline, making that airline less likely to screw customers.   Hence, the “disciplinary power” of a well functioning market.  (Now, it is an entirely different debate as to whether the airline market is competitive enough given the recent wave of airline consolidation and the market’s unique structure, but that is an argument beyond the scope of this post.  No matter how competitive that market is right now, it is difficult to argue with the contention that better pricing information up front will make it work better.)

However, while “open data” is a good thing, regulations that go further than requiring a standardized output of raw data, governing how data is displayed by third parties, would be unwise.  As the growth of the Internet economy has illustrated, the packaging and display of information to consumers is an important sector of economic activity where new participants and innovation currently abound.  Locking in a particular type of display or presentation would slow growth and harm competition in the metasearch market.

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In June, when I wrote about the release of Amazon’s new smartphone, I promised a more comprehensive article about the competitive dynamics of the mobile ecosystem.  While tech journalists tend to fixate on new releases from household name companies such as Amazon’s Fire Phone, it is all too easy to miss the big picture.  Emerging markets pose the biggest threat to the current market leaders and promise to be incubators of disruptive innovations.

Although much of the focus in the developed world remains on the competition between Google’s Android and Apple’s iOS, a host of plucky competitors are targeting emerging markets.  And for good reason.  Not only is the smartphone adoption rate growing nearly twice as fast in emerging markets as it is in more established markets, certain characteristics make it easier for new platforms to establish a foothold in emerging markets, as the market research firm GSMA Intelligence stressed in a recent report:

Emerging markets represent the largest unrealised source of new mobile Internet subscribers.  Given that smartphone penetration is nascent, the take-up and use of mobile data is rising, lock-in mechanisms have yet to kick in for incumbents and subsidies are less prevalent, the markets present more fertile ground for challenger platforms.

In a nutshell, the advantages held by established competitors like Google and Apple don’t necessarily carry over into emerging markets.  The market structures and desired uses of mobile technology differ greatly in markets such as China, Vietnam and India than from those in the US, Europe, Japan and South Korea.

The most obvious reason for this is simply that the smartphone penetration rate is much lower in emerging markets, therefore less people are committed to a particular mobile platform.  Furthermore, characteristics such as price point and unique local content and services are the more important considerations for new users in those markets where lock-in factors, such as prior purchases, subsidized contracts and large mobile app suites, don’t factor in purchasing decision to nearly the same extent they do in more advanced markets.  Low price and local market customization are areas where smaller competitors can compete against industry leaders.

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DisCo readers may be familiar with a recurring theme pitting incumbents versus disruptive innovators. But new research seems to suggest that the relationship isn’t always adversarial.

The Knowledge@Wharton blog has an article about a soon to released paper by three professors, David Hsu, Matthew Marx and Joshua Gans, which illustrates that disruptive startups do not just compete with market leaders, but often partner with them as well.  The authors use the automated speech recognition (ASR) market as their test case, as the frequent technological disruptions in the field make it a paradigmatic industry to study; similar to Clayton Christensen’s disk drive market.

The study finds that 60% of the firms in the ASR market started out competing in the marketplace while 38% cooperated with market leaders (2% had a “hybrid” approach).  However, the blog notes that breaking it down by firms using a “disruptive” approach versus an “existing technologies” approach tells a slightly different story.

The researchers find that early adopters of disruptive technology were much less likely to cooperate with incumbents, with only 21% doing so, compared with 36% of start-ups whose businesses were based on existing technologies. But early adopters or disruptors were more likely to switch from a competitive to a cooperative strategy: 12.7% did so, versus 7.8% for non-disruptors. (The switch from a cooperative to a competitive strategy was not meaningfully different between the two groups.)

The authors use their research to give advice to startups: be open early on to the possibility that your competition/cooperation strategy could change over time.

The study’s authors also have advice for incumbents: it may be useful to let the disruptive startups slug it out among themselves and license/acquire/partner with the winner, rather than trying to develop the disruptive technologies in house.  As one of the authors of the study notes, predicting a winner is difficult:

You sort of have to predict the future. What we’re saying is, you don’t have to predict the future. There may be 30 start-ups out there trying different disruptive or potentially disruptive technologies. So, you can take this wait-and-see approach.

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