Margit Vanberg, Compatibility standards in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 111 - 114

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
111 likelihood that firms reach a mutually beneficial compatibility agreement, even when they are of substantially different initial size.100 Public policy for competitive markets featuring network externalities The above discussion shows that cooperation is likely in competitive markets with substantial network externalities when (1) consumer tastes vary, (2) when firms have the possibility to differentiate their services (not only in network size, but also along technological and qualitative characteristics) and (3) when compensation for compatibility is possible. Side-payments should not be interpreted as reflecting market power. Rather, they redistribute the gains from network compatibility in a way that all firms are better off. In conclusion, there are many reasons for firms in competitive markets to voluntarily agree on compatibility when strong network externalities are present. It is not possible to derive a general justification for interventions by competition policy in the presence of network externalities. If competition authorities consider it necessary to intervene into a competitive market on the grounds of market power caused by strong network externalities, they need to prove for this particular case that the above mentioned prerequisites for compatibility are not fulfilled, and that there exists a large firm which is abusing its market position, earning above competitive profits. 6.3.4 Compatibility standards Before network services can become compatible across network boundaries technological requirements will have to be fulfilled. How do firms decide on a standard to which all compatible networks have to conform? One can differentiate between three general mechanisms by which compatibility between firms can be reached. The first is standardization by multilateral agreement. For this the firms convene in standardization committees charged with reaching a consensus on a particular product standard. The second mechanism is a unilateral predetermination of a particular standard by a leading firm in the industry. The remaining firms either adopt this standard or employ adapters or gateway technologies in order to make their products compatible to the standard set by the industry leader. Lastly, an industry standard can be imposed by governmental decree. 100 Compensation here refers strictly to payments made in order to induce the other party to agree on a common standard. These payments have to be differentiated clearly from payments which are compensation for costs incurred by the other party as a consequence of the compatibility. For example, if one network offers another network free licenses for its software products in order to induce it to agree to interconnect this can be considered a side-payment. When, however, payments flow in direct relation to the costs of achieving compatibility, such as transportation compensation for the costs incurred in terminating one another’s traffic, then these payments do not reflect side-payments. 112 Multilateral vs. unilateral standardization by industry participants When governmental intervention is not deemed appropriate then either multilateral or unilateral determination will fix the industry standard. Multilateral standardization aspires to a consensual decision by all affected parties. This makes a multilateral standardization process very political and drawn-out. The advantage of such multilateral agreements, on the other hand, is that they are more likely to come to a sustainable solution. Unilateral choice of a standard, in comparison, is most likely quicker. The standard may however not be adopted readily, should conflicts arise between several players wanting to take on the role of market leader. In the end, incompatible standards may prevail. Farrell and Saloner (1988) compare coordination by explicit communication in standardization committees and standardization by unilateral predetermination of a standard. They assume a situation in which all active firms prefer standardization over incompatibility, regardless of the standard that is finally agreed upon. In finitely repeated games committees are shown to dominate unilateral standardization because they are more likely to achieve coordination. Only a hybrid system, in which both standardization by committees and standardization by unilateral action are possible, is more efficient than standardization by multilateral agreement alone. This is so because the threat of pre-emptive action by the industry leader entices committees to work more effectively such that agreement is reached sooner. In conclusion, when markets are considered either actively or potentially competitive, then private solutions to the standardization problem can be expected. In these cases standardization committees often take on the important task of information dissemination in the market. Public policy should therefore allow and even encourage standardization committees. This is in contrast to traditional competition policy, which is skeptical towards joint decisions taken by members of the same industry, suspecting collusive and anti-competitive behavior. In markets featuring network externalities competition policy must, however, respect the difference between welfare-enhancing standardization and anti-competitive collusion. Standardization by governmental decree When government intervention into a market with network externalities is deemed appropriate then government control of market power will generally also involve standardization by governmental decree. A fundamental problem with standardization decisions by the government is the fact that the politicians charged with the standardization do not necessarily have the best interest of consumers and producers in the market in mind. Governments generally delegate standardization tasks to bureaucracies that are closer to individual industries. As Blankart and Knieps (1993: 46) put it, there is no “...democratic link between those who define and enforce standards and those who are subject to standards.” Bureaucrats, other than members of government, do not depend on being re-elected every term. Rather, they can pursue goals such as maximizing their influence and budget, which may not be related to optimally serving the interests of the general electorate. Bureaucrats are likely to be especially susceptible to rent-seeking such that the firm willing and able to invest 113 into rent-seeking behavior, i.e. the firm with market power, can use the bureaucrats to pursue its own agenda. Furthermore, for reasons of self-legitimization, the bureaucrats have an interest to extend their realm of action beyond the market areas affected by market power. Because of these problems with governmental standard-setting it is important that general competition policy defines rules that limit the realm in which public standard setters are allowed to become active. If governmental standards are deemed necessary, there should be limitations concerning how deep standardization by bureaucrats may go. Blankart and Knieps (1993: 40ff.) suggest that network services are technological systems of many interrelated components that form a technological hierarchy. Standardization can be applied to any subset of these components. Since standards built on one another in the same way that technological components are part of a logical structure, one can speak of various degrees of standardization where the standardization of basic technological functions is a prerequisite for a “deeper standardization,” involving also the specialized functions higher up in the technological hierarchy. With this view, standardization becomes a gradual process. From the point of view of affected firms there is a diminishing marginal return to standardization. Adopting a basic standard offers higher marginal benefits than joining a higher-level standard because basic standards have a wider dissemination. Using a compatible basic standard is a prerequisite for many interactions with horizontally/vertically related firms, whereas compatible higher-level standards, specialized to specific applications, are required only seldom and only in interactions with specific partners. Because the positive network effects of adopting a uniform basic standard are clearly more important than the network effects of a uniform standard for advanced applications, Blankart and Knieps (1992: 84) argue that government regulation should be confined to basic standards. To counteract the tendency of bureaucracies to tend to interfere too much rather than too little, the standardization of advanced applications should not be allowed. Of course, the practical implementation of this rule hinges on the assumption that basic functions can be identified. Blankart and Knieps (1994: 459) argue that with regard to network services, basic functions are often tied to the physical layer of network services, whereas applied functions are tied to the applications layer. A further indication as to whether a function can be counted among the basic functions is the expected dissemination of the standard within the industry. A standard with a wide dissemination regulates basic functions applied by many market participants. Standards with limited dissemination are for particular functions and are not used widely.101 101 In a later paper, Knieps (1995: 294) suggests an even more restrictive alternative. Here he argues that governmental activities can be limited to the regulation of access to monopolistic bottlenecks alone. In his view, reducing the market power of the bottleneck owner by price and quality control should suffice to eliminate the monopolist’s incentive to prevent coordinated standardization activities in multilateral committees. 114 6.4 Conclusions This survey of the literature on network externalities was by far not comprehensive. The papers chosen do, however, show the representative themes which play a role in the analysis of how market processes are affected by network externalities. The theories reviewed indicate that market processes very often generate novel ways for coordinating users and firms – especially in markets with heterogeneous consumers and product differentiation. Calling to mind the various impediments to governmental institutions in implementing efficient policy (i.e. Buchanan, 1987; Blankart and Knieps, 1993: 46), the above discussion suggests that in many realistic market environments the spontaneous market order has a comparative advantage in internalizing network externalities as compared to administered policy. To support government intervention as a means of internalizing network externalities requires strong evidence that the many ways by which market participants can solve the information problem are not functional under particular circumstances, as for instance in the case of an uncontestable natural monopoly. In the remaining cases, government-imposed standards cannot outperform standardization committees, because competition authorities do not have nearly enough information on the preferences of consumers and firms, and they cannot foresee the technological developments in the market. Furthermore, even if competition authorities had as much information as the members of a standardization committee, they do not have the instruments at hand that allow a market-oriented aggregation of the preferences (such as side-payments resorted to by firms). Instead, competition authorities are likely to be the target of rent-seeking behavior by firms with high stakes in the standardization decision. Therefore, the only role for government is to apply general competition policy in a way that allows for the formation of standardization committees comprised by representatives of the industry involved.

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Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.