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Straight Talk Media & Entertainment

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If you thought that market failures that can be addressed through regulation were confined to the world of telcos and their physical networks and services, think again.

Regulators scrutinizing (and, where relevant, regulating) OTT services are not simply leveling the playing field with telcos; they are also aiming to reduce barriers to entry in the internet services market and guarantee that today's start-ups enjoy the same favorable conditions that Google, Facebook, and Amazon faced when they took their first steps in the market.

If 2016 was the year when regulators started to look at online platforms to identify potential market failures they could intervene on, 2017 is shaping up as the year when competition issues around these platforms start to be tackled. Under existing competition law, financial penalties and remedies can be applied to a company and its day-to-day activity. In recent cases, the European Commission (EC) has imposed fines on Facebook and Google of €100m ($114m) and a staggering €2.4bn ($2.8bn), respectively. Facebook was not clear with the EC on its capabilities to share data across the WhatsApp and Facebook platforms, despite the conditions agreed at the time of the merger; Google was found to favor its own comparison shopping services over others, thereby undermining any competition.

In both cases, regulators made clear references to "network effects." Going forward, network effects will be a key competition issue to address. Should existing competition law measures not work, there could be a new strand of "in advance" (i.e. ex-ante) regulation around them, as regulators move toward an approach in which big data is seen as a barrier to market entry.

There are three reasons why this is the case:

  • Network effects are vital to internet service success, but they also cause customer lock-in. Connecting vendors and users with one another, online platforms thrive on the existence of "network effects," whereby an increase in scale is itself the basis of a further increase in the scale of an actor in a given market. Facebook, for instance, has grown because of individuals' desire to join their friends on a platform and communicate more easily with them. As more people join a platform, advertisers and content providers become more interested in the potential audience on that platform. Network effects are a key part of a platform's success, but they also cause customers to become increasingly locked in: Social network users tend to communicate through one single platform; users of Uber or Airbnb will be less willing to explore alternatives, because most drivers or hosts are on the respective dominant platform.

  • Regulators will continue to protect competition as a driver of innovation. Despite the rapid and continuous evolution of technology markets, regulators continue to care about two main things: fostering competition and protecting consumers. When they are not satisfied that the market delivers on these two fronts autonomously, their intervention is almost guaranteed. Telecoms regulators have for decades ensured that access to bottlenecks is as open as possible, in order to foster competition and create incentives to innovate. In the same way, the EC and other regulators are now committed to ensuring that today's start-ups can grow in the same favorable environment in which today's giants started flourishing 10–15 years ago. They are still figuring out how to do this most effectively.

  • Data might not be scarce, but it still creates a competitive advantage. In theory, data assets could be an infinite resource; nothing prevents businesses from collecting data and building increasingly large and comprehensive (and in turn, insightful) data sets. The more data a company already has available, the better placed it is to offer innovative and powerful services, thereby undermining competition from new entrants. Regulators are increasingly mindful of this aspect, particularly when they analyze data-driven mergers based on the potential of combining companies' data assets. This is because the increase in scale and scope of data can become an unsurmountable barrier for challengers.

We expect that these forces will result in the following trends:

  • Regulators have identified network effects as a competition problem, and will act to tackle it. This has been evident in recent cases such as the EC vs. Facebook and the EC vs. Google. When the EC fined Facebook €100m in May 2017, it made clear that the decision had no link with any data protection investigation carried out by authorities in EU member states at the time. Similarly, the ruling of dominance (and consequent fine) on Google was justified by the presence of network effects contributing to create a barrier to entry. The issue has also emerged in regulators' position papers, which have gone to great lengths in categorizing network effects. In a workshop held in 2016, the US Federal Trade Commission identified four categories of network effects. The Dutch government reached a similar conclusion, albeit adopting different criteria, when it outlined a distinction between single-sided and multisided platforms, within which "direct" and/or "indirect" network effects can be generated.

  • Online platforms will keep exploiting network effects for as long as regulation allows. Regardless of the increasingly intense scrutiny under which regulators are putting them, online platforms will continue to rely on network effects, simply because this is a key part of their business model. It is a simultaneous cause and consequence of their growth; therefore, it is the reason for their profit, as well as the justification for further investment. Also, it is apparent that regulators have not yet identified the most effective way to deal with this kind of issue. While the €2.4bn fine on Google looks staggering, it amounts to a small percentage of the company's annual revenue. Even more crucially, the EC has not yet been able to say how it will monitor Google's compliance with the obligation to stop favoring its own comparison services, despite its intention to review the company's behavior in 90 days' time after the ruling. In other words, regulators are undergoing a period in which they are following a trial-and-error approach, which could buy the internet giants some time.

  • Regulators in the EU must be mindful of the unintended effects of regulation. Although the EC has issued repeated statements signaling the intention to create a favorable environment for online platforms, it will have to be careful and avoid overregulating. It is quite telling that the region where regulators have been more active is also one in which platforms have a weaker presence. Currently, most online platforms are based either in Asia or in the US, where they have been able to tap into receptive markets and enjoy relatively light regulation. Europe has so far been much less vibrant as a market for homegrown platforms compared to Asia and the US. Crucially, regardless of the number of potential consumers that can be reached in Europe, significantly fewer platforms have been started or are based there. The European market is currently about five times smaller than Asia, and nearly 20 times smaller than the US. A flexible approach to licensing and related rules could be one of the boosts this markets needs to flourish in the EU.

Straight Talk is a weekly briefing from the desk of the Chief Research Officer. To receive this newsletter by email, please contact us.

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