Market Failure and Intervention

Because of the fast pace of innovation in the software industries it is advocated by some that the discipline of the market will give the optimum outcome and government intervention will only be inefficient. Many economists, mainly from the USA and drawing on free market theories originating in the Chicago School, argue against intervention on the

112 United States v Microsoft 253 F.3d (D.C. Cir 2001)

113 An OEM - Original Equipment Manufacture – makes the final product for the marketplace, examples are Ford for the car market and Apple for the computer market.

114 Ian Brown and Christopher T Marsden Regulating Code (2013 The MIT Press), 166

115 Liguo Zhang ‘Refusal to license intellectual property rights under Article 82 EC in light of standardisation context’ (2010) 32 (8) EIPR 402-411; Thomas A. Hemphill and Nicholas S. Vonortas ‘U.S. Antitrust Policy, Interface Compatibility Standards, and Information Technology’ (2005) 18 Knowledge, Technology & Policy, 134.

47 basis that the market is the best discipline. Lawyers from USA and Europe who analyse case law and rules with reference to the economic theories take a more pragmatic view of legal regulation and particularly competition law, especially concerning the new economies.¹¹⁶ They see that in practice the law is not perfect so it is best to err on the side of caution as the market may well remedy any positive errors.¹¹⁷ The theories of the Chicago School and the pragmatic views of Easterbrook¹¹⁸ have dominated the debate on whether there is a case for intervention in the new economies.

Many US and European commentators are critical of the European Commission’s approach in Microsoft. Not only was the case an undesirable extension of the ‘essential circumstances’ test but it failed to give an effective and timely remedy. The Commission was approaching the case with its ordo-liberal heritage having only recently adopted an economic effects based approach. The goal of innovation remains a policy priority and workable competition is seen as the best system for achieving an efficient market with the market as the best discipline for maintaining efficiency and encouraging innovation. Where however a lack of interoperability causes a failure in the market there may be a case for intervention to optimise innovation. IPRs are themselves an intervention in the market and if they give the wrong balance between protection for rightsholders and openness for interoperability the IPRs can themselves cause a failure in the market.

3.9 Network Effects and Market Failure

Network effects which can give rise to “network externalities” have been seen as causing a failure in the market. Network effects occur when the value of a product in a network will increase if more users subscribe to the network.¹¹⁹ Network externalities are seen as a failure of the market, as the market is influenced by outside factors.

116 Richard A Posner 'Antitrust in the New Economy' (2001) 68 Antitrust LJ 925

117 Frank H Easterbrook 'The Limits of Antitrust' (1984) 63 Tex L. Rev 1 1984-1985.

118 Ibid

119 Katz and Shapiro are attributed with defining network externalities in 1985: “There are many products for which the utility that a user derives from consumption of the good increases with the number of agents consuming the good. The utility that a given user derives from a good depends upon the number of other

48 While network effects are relevant to many computer programs, they are not as strong in the 3D CAD market. While it would be beneficial for the user if his 3D CAD system worked with others, it is not vital to the primary purpose of the system. Nevertheless network effects can cause or accentuate lock-in. Lock-in in network markets is normally the scenario where a technology wins a market because of network effects and the market is locked-in to a particular technology. The classic example of this is the Betamax v VHS battle. The market fails if the best technology does not win due to network externalities. Most of the literature argues that while dangers exist, intervention is not justified as government seldom succeeds in “picking winners”.

Consumers as well as industrial users may be affected by interoperability issues. Once consumers have bought a platform or software they may be unable to move their data.

They are “locked in”,¹²⁰ and if they have not chosen the emergent de facto market standard they are faced with the additional costs of changing to the market standard and may lose the use of their expensively acquired data. This dilemma is apparent in the new market for e-readers. At least two of the e-readers are closed systems. Users who build up a library do not know whether they can transfer it to another platform. A study commissioned by the Book Industry Study Group identified the number one complaint among consumers about e-readers as “certain e-books [are] specific to certain e-readers.” ¹²¹

Distinctions are drawn between direct and indirect network externalities. Direct effects are physical connections such as those to a telephone network. Indirect effects are other effects such as software being more plentiful, increased availability of aftercare and lower prices. Katz and Shapiro recognise that systems markets with network effects may be inefficient, and theoretically government intervention could be justified. However there is

users who are in the same network.” Michael L Katz & Carl Shapiro ’Network Externalities, Competition, and Compatibility’ (1985) 75 The American Economic Review 424

120 Carl Shapiro and Hal Varian, Information Rules - a strategic guide to the network economy, e.g. 107 (Harvard Business School Press, Harvard, 1998).

121 Dave Dickson ‘EPUB, iPAD and Content Interoperability Digital Editions’

http://blogs.adobe.com/digitaleditions/2010/01/epub_ipad_and_content_interope.html; [accessed 1 September 2010] on the Book Industry Study Group’s, “Consumer Attitudes Toward E-book Reading” (2013) Book Industry Study Group (28, Jan. 2010).

49 evidence that private institutions may have solutions to the market and the problems can be resolved without government intervention. This is desirable as governments may not have all the information they need to intervene in a beneficial manner, the “picking winners” scenario.¹²²

Liebowitz and Margolis refine Katz and Shapiro’s work on network externalities distinguishing between network effects and externalities and claim that while “network effects are common and important, network externalities are theoretically fragile and empirically undocumented”.¹²³ Network externalities were a specific type of network effect in which “the equilibrium exhibits unexploited gains from trade regarding network participation”.¹²⁴ It was said this reflects the understanding of externalities as an instance of market failure. While network effects are common there is less evidence of network externalities and this reclassification plays down market failure and the need for intervention. They conclude that after looking at the Qwerty keyboard, the VHS tape and the internal combustion engine that they are not aware of any compelling examples of market failures and the wrong choice being made “..the a priori case of network externalities is treacherous and the empirical case is yet to be presented.”¹²⁵

Where a technology becomes the norm because of network effects causing technology lock-in, the markets may be able to guide the adoption of technology efficiently and intervention may be unnecessary and even harmful. Lock-in should not however be treated as a homogenous, simplified phenomenon by looking only at relatively trivial lock-in such as the iTunes and the Querty keyboard without attempting a comprehensive definition.¹²⁶ Most literature on lock-in is concerned with lock-in in the form of “path dependency” that

122 Michael L Katz and Carl Shapiro 'Systems Competition and Network Effects' (1994) 8 The Journal of Economic Perspectives 93

123 SJ Liebowitz and Stephen Margolis ‘ Network Externalities: An Uncommon Tragedy' (1994) 8 (2) Journal of Economic Perspectives 133-150, 135

124 Ibid 135

125 Ibid 149

126 Daniel Spulber ‘Unlocking technology: antitrust and innovation’ (2008) JCLE 4(4) 915 - 966

50 suppresses the feasibility, in principle, of improvements in the path¹²⁷ does not appear to consider the problem that exists when consumers are locked-in to a technology because of the high switching costs. Consumers can however become locked-in by a particular technology without strong network effects.