The Interplay between Innovation and Competition: the Internet Case

Internet represents the speeding up factor of the integration process between networks and content known as convergence. In this process, the spreading of broadband (and ultra-broadband) networks is the condition for the distribution of services and content based on IP protocol: on its accessibility depends the development of a more competitive and socially advanced environment, that reduces the digital divide enabling as many people as possible to accede to knowledge and learning instruments. It is a complex process requiring great investments and with uncertain returns, which leads to a dilemma, that thrills economists: the relationship between innovation and competition. The dynamism of innovation markets represents undoubtedly a challenge with regard to the capability to interpret and adequate economic theory to the great changes taking place. What lies beneath this work dealing with the relationship between innovation and competition is the following fundamental question: may the need of protecting the innovator make acceptable practices usually considered to be monopolistic? And if this is the case, when is no more the obtained dominant position an innovation development factor? When does it become an income for the monopolist decreasing efficiency and social welfare? Moving from this problem, the present work tries to critically analyse the interplay between competition and innovation with respect to the impact internet had in steady industries such as telecoms and media and the further implications in the digital content environment also for new players as convergence is taking place. Introduction Internet represents the speeding up factor of the integration process between networks and content known as convergence. In this process, the spreading of broadband (and ultra-broadband) networks is the condition for the distribution of services and content based on IP protocol: on its accessibility depends the development of a more competitive and socially advanced environment, that reduces the digital divide enabling as many people as possible to accede to knowledge and learning instruments. It is a complex process requiring great investments and with uncertain returns, which leads to a dilemma, that thrills economists: the relationship between innovation and competition. The dynamism of innovation markets represents undoubtedly a challenge with regard to the capability to interpret and adequate economic theory to the great changes taking place. However, the economic theory has already faced these issues with respect to the IT sector thorough the interpretation, provided by Schumpeter, of competition theory as a process of disruptive innovation. This dynamic relationship between competition and monopoly, which characterizes innovation markets, creates the following problem: may the need of protecting the innovator make acceptable practices usually considered to be monopolistic by undertakings through legal tools like intellectual property rights? And if this is the case, when is no more the obtained dominant position an innovation development factor? When does it become an income for the monopolist decreasing efficiency and social welfare? A second set of observations will regards the capability of steady industries, such as telecoms or media, to maintain acquired positions that are based on the existence of natural monopolies or oligopolies. On the one hand, networks effects, scale economies and sunk costs (programme schedule, acquisition of rights) increase and strength entry barriers; on the other hand, a stronger resistance to innovation than to new internet native operators (Skype, Google) seems in this new contest insufficient to ensure competitive advantages, hence to potentially promote a broader competitive level (horizontal vs. vertical markets). Then, the question is whether such dynamics generate the best market efficiency (consumer welfare) or whether they move revenues from traditional operators to new subjects, the so-called aggregators/search engines (Google, Apple, You Tube). This leads to a further question: does the spreading of networks based on IP protocol, that are more and more pervasive due also to the increasing availability and offer of video content, lead to move the whole entertainment world on internet? Or, on the contrary, will traditional digitalized networks continue to have a primary role in content delivery? In other words, will they be alternative or complementary? The next step will be to understand whether the models of best operative efficiency and strong profit margin reduction related to the issue of innovation and technology discontinuity, will apply also to the video content and telecoms industries making them low cost industry as it was for music and publishing industry. With the same consequences? Innovation and regulation The idea of “regulation”, as well as its relationship with innovation, traditionally generates a deep confusion. According to the most widespread position, innovation is expected to be harmed by regulation and therefore there should be no regulative intervention on the functioning of the market even in presence of market failures at least as long as a more satisfactory result can not be obtained by regulators. Innovation certainly raises several concerns with respect to the functioning of the market. First of all, innovative activity has the inherently problem of uncertainty. It is almost impossible to predict the outcome of a particular innovative project as well as the effects of an innovation on the market. Further, once an innovation, which is nothing else than a new idea, is generated, in theory it could be freely used by anyone since innovation is a public good, that is it is non rival in use and non excludable. “Non rival in use” means that one can consume it without any risk of reducing its consumption by another individual. “Non excludability” refers to the fact that it is difficult, if not impossible, to impede someone from consume the good even if s/he has not paid for it. Therefore it is likely to imply or to represent a market failure. However, as noted by Geroski (2005), this likelihood increases if another characteristic of new knowledge is considered: while the reproduction of innovation is costless, its production is expensive since all the costs required to generate new knowledge are fixed and usually sunk. Two further considerations descend from this last argument: first, there must be a sufficiently large market to allow the recovery of fixed costs; and second, given that the costs of reproducing innovation are absent, “prices could, and probably should, fall to zero” 2. All the above-mentioned difficulties can provide a justification for regulative interventions and in particular for intellectual property rights. In fact, if the outcome of an innovative activity was predictable, the most effective and efficient way to foster innovation, would be only to subsidize directly innovators. This would provide the necessary incentives to invest in the production of new knowledge eliminating the threats to competition represented by the monopoly power IP rights convey to innovators. But, unfortunately, this is not the case and, traditionally, to solve these problems you resort to property rights which grant to their owners certain exclusive rights on the new knowledge for a specific period of time during which for innovators becomes possible the recoupment of the investments made. In practice, this leads to the establishment of a monopoly for property rights holders in the employment of the new innovation. The main idea is that only some monopoly power would allow to set prices above variable costs covering fixed costs, hence without the promise of it, undertakings would have insufficient incentives to engage innovative activity. Intellectual property rights and competition The interaction between competition and intellectual property rights law has always been a field of discussion given that these two areas of law show, at the same time, points of convergence and divergence. On the one hand, they pursue the same stated “common purpose of promoting innovation and enhancing consumer welfare” 3 as they both aim at eliminating market failures and, therefore, fostering social welfare. On the other hand, they adopt different, if not even opposite, approaches to reach the common goal: competition law persecutes any conduct that distorts the competitive game, whereas property rights result in a staggering of the market functioning by creating legal monopolies. Usually, the discussion centres around the proper length of property rights and the difficulty of weighing the costs of IP rights due to the creation of some monopoly power against their incentive impact. Intellectual property rights last for a fixed period of time, which is determined without taking into consideration the costs borne by innovators or the benefits, in terms of social welfare, produced by their innovations. Although you can accept to restrict competition to some degree in order to protect incentives to innovate, when does this system cease being a factor of innovation development and become just a monopolistic income resulting in a social welfare and efficiency decrease? In fact, the regime of property rights embodies a set of possible negative effects, which can even produce the opposite goal of the system itself, namely inhibiting innovation. Commonly existing knowledge gives impulse to the generation of new ideas, therefore the possibility for innovators of accessing existing knowledge becomes crucial in order to sustain the process of innovation and make it more efficient. The problem is that innovators sometimes can affect the production of future new ideas by protecting, thorough property rights, the new knowledge embodied in their product, service or process. This general difficulty can be seen as an “anticommons problem” 4. In fact, as observed by Geroski (2005), every innovator resorts to a common domain of public knowledge on whose access or use no one can impose restrictions. Moreover problems of congestion will never arise in the public domain because, as stated above, knowledge is “non rival in use” and “non excludable”, hence any attempt to limit or control the access to it lacks a real rationale. Property rights entails further concerns with respect to complex innovations. In fact, when an innovation involves different fields of technology, its creator will needs to relate with existing property rights holders, who might hamper the new innovation, for instance exploiting their bargaining power in negotiations with the innovator in order to get as much as possible of the expected returns for its creator. Moreover, IP rights holders are essentially free to foresee almost any type of licensing provisions on those who would like to employ their innovation. Of course, this system drives innovator to develop primarily those kinds of innovations that fall under the protection granted by property rights. These types of innovations are in fact the most profitable ones since, thanks to property rights, innovators can earn very high profits. But, innovators have no incentive to invest these gains into further innovative activity. In fact one could think that, thanks to monopoly profits assured by the IP rights regime, firms would be able to further invest in innovation without dipping into retained profits. Even if you can not deny this argument, it does not mean that monopolists will always have such behaviour because this reasoning fails to face the critical problem represented by incentives. The key point is the distinction between “sustaining innovations” and “disruptive innovations”. The former are those which improve an existing product, service or process developing the existing skills of undertakings; the latter implies the creation of something different from any previously product, service or process, hence they require firms to develop new skills. That being so, we can expect companies with a well established position to choose sustaining innovations rather than disruptive ones as these will ensure the protection of firms’ market power without introducing any revolutionary, hence destabilizing, change for firm themselves. The internet case The Internet can be surely seen as a disruptive innovation that has revolutionized the commerce introducing new business models and changing the way vendor and consumers interact. Technological innovation has undermined the traditional structure of the media, that is characterized by the correspondence between the means of transmission and content conveyed, and the division in different sectors separately regulated. In this new scenario, content has became independent from the physical support and available in ways never experienced before and on multiple devices and platforms. This phenomenon is called convergence. The spread of Internet and broadband has certainly accelerated this process known as convergence and its hyper-growth has confronted companies, consumers as well as authorities with new challenges. The key factor becomes the availability of content, therefore producers and rights’ holders play an increasingly central role and the result is a new structure of the processes of production, distribution and use of content in a digital environment, which is perfectly summed up by the paradigm “anywhere, anytime and on any device”. The amount of content and information we can access today is infinitely greater than what we had for example 10 years ago, but the value generated by the distribution of content is now significantly lower than in 2000. This transformation of the traditional structure of the communication system effects the whole media system (publishing and radio, television and film, from music to video games). As a result, the historical oligopolistic and vertically integrated market structure is being questioned in favour of a configuration more similar to the one of the production chain that is characterized by the participation of a multiplicity of actors. For example, by 2015 over 255 million users worldwide will have downloaded and used mobile applications and tablets (IPAD, etc.). Meanwhile, the revenues from mobile applications, including payments, will grow to 23 billion U.S. dollars in less than 5 years. This is an incredible result if you consider that the value of global recorded music sales in 2009 was U.S. $ 17 billion, a figure that was reached after 100 years of life. Initially, the digitization process has involved the market entry of operators coming from adjacent sectors, which have exploited the opportunity presented by the convergence combined with a generally strong position on end users to enter the market. In view of a reduction of the business volume due to the saturation of the traditional components (vocals), telecommunications operators have decided to offer data and video services (triple and quadruple play). But telcos have faced both cultural and operational problems, that led to a strategic repositioning with respect to the supply of television content. However, the most controversial consequence of the growth of technology and the Internet is the emergence of a new type of operator: the so-called aggregators. These operators have used the technological leverage to enter the business of content distribution, taking advantage of the following characteristics: • the ability to act as interface; • the knowledge of the key components of the sector such as the Internet; • the ability to reduce or eliminate investment costs (infrastructure and content rights); • the ability to cut down transaction costs. They exploit their know-how to collect, organize and offer the content available on the web to an undifferentiated audience of Internet users. The strengths of aggregators are the knowledge of the key components of the sector such as the Internet and the related ability to reduce, through the potentialities offered by the network, the cost of investing in infrastructure or content. These characteristics have led to the success of companies born in the Internet environment, such as Google, Yahoo, Amazoon, that carry out mainly the business of content aggregation competing with traditional publishers and broadcasters and basing their business model on the monetization of third-party content. As the Internet economy grows, these new operators become more and more embedded in the internet experience. However, from content providers’ perspective, the Internet could be more of a danger than an opportunity since the possibility to distribute and exchange content across digital platforms makes possible the delivery of any content without the legitimate owners being able to exercise effective control. A further problem arises from the increasingly frequent conflict between the free and unlimited access to content and the need expressed by network operators to manage Internet traffic on their infrastructure to avoid congestion. This contrast has placed at the center of the debate on the future of the internet the issue of network neutrality requires that Internet service providers do not discriminate between sources of data. The issue of network neutrality showed a technical problem, whose solution is connected to the identification of the proper balance between the bandwidth (and network) to be devoted to services that need to be managed and the part of the bandwidth that should continue to provide Internet access according to the principle of the best effort. This balance is particularly important in two respects: (i) protection of consumers’ freedom to access content (legal) on the Internet without restrictions; (ii) protection of the operators’ right of obtaining a remuneration for the services offered on the web. You should also take into consideration two opposing interests: those of ISPs or content providers to deliver their content as many users as possible, and that of network operators to restrict the portion of the network for the best effort since the profitable services are offered in the managed network. At the basis of the principle of technological neutrality lies the need to promote consumer welfare, that is the possibility to gain access to content without discrimination between the transmission networks. Numerous conflicts between users’ right to free content access and copyrights have arisen from the overlapping of these different interests. Moreover, the current battle between copyright and freedom of expression is fostered by the new opportunities created by technological progress, and, as a result, the role of copyright is at the centre of a continuous debate. Tensions among media companies over copyright issues are becoming more and more frequent. In general, the current battle sets content providers against online distributors of their content. The main front in the online copyright conflict regarding video mainly involves Google. The American search giant has often been under fire from broadcasters over its video portal YouTube, the most popular video-sharing website in the world, where it is often possible to watch TV series or well-known programmes, even though they are copyrighted. A range of lawsuits have been filed by major media companies, such as Viacom and the main Italian and French private television channels Mediaset and TF1, against YouTube for its presumed illegal use of their content; or the Spanish case of Teleçinco against YouTube, which has seen the search giant coming out winning. Conclusions Ultimately, what we are seeing is a calling into question of the traditional value chain as a result of the disruptive technology of the Internet. All those who prevailed in the traditional (analogue) world, are now competing in an open field trying to maintain and take advantage of their rents, even in terms of privileged access to policy decisional centres acquired over the years. It is natural, if not even inevitable, that this is happening in Italy as elsewhere in Europe. Those who have had so far control content (majors, content providers) or acted as a mediator (editors, broadcasters) of course try all means to tackle these new emerging rivals, which threaten to cripple a sector that has been strongly downsized by piracy and disintermediation of the web world. The same occurs on the side of connectivity providers (ISPs, telcos), which hoped to be the new dominant players, but as it occurred for the digital television, they pay the lack of familiarity and expertise in the creative talents industry. It seems clear that the new players, the aggregators, will come increasingly into conflict with traditional operators and you can not exclude in the future a more comprehensive alliance in the world of television and digital content between those who want to use the Internet to increase or at least maintain their influence on their users (media, telecommunications) against those who have used the Internet as a springboard to conquer new markets and new consumers. In this context, where discontinuity and innovation are still likely to create/recreate monopolies, even no longer limited by geographic markets, there is a clear need for a level playing field and thus a still central role for regulation (i.e. net neutrality, copyright). Doubts regard the fact that solutions to be implemented with current instruments may come too late or still be inadequate with respect to such radical, rapid and disruptive changes. Notes 1 This paper was presented at the 2010 SIDE-ISLE Annual Conference in Bolzano on December the 10th. 2 P.A. Geroski, “Intellectual Property Rights, Competition Policy and Innovation: Is There a Problem?”, Script-ed, 2:4, 2005, p. 423. 3 US FTC and DOJ, Antitrust Guidelines for Licensing of Intellectual Property”, 1995, par. 1. 4 This expression was coined by Michael Heller, who defined “Anticommons property as a property regime in which multiple owners hold formal or informal rights of exclusion in a scarce resource”. See, M.Heller, “The Tragedy of Anticommons: Property in the Transition from Marx to Markets”, Harvard Law Review, 111(3), 1998, pp. 621-668.