Column: Regulating the digital economy

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December 04, 2015 1:22 AM

Only when there is clear concern for the consumer can intervention be deemed to be appropriate

A theory of economic growth focused on innovation has come to the fore. Empirical studies from across the world also support a positive linkage between technological innovation and economic growth of nations. This theory, dating back to Joseph Schumpeter (1942), postulates that economic growth comes from within the economic system and is not merely an adaptation to external factors. Such a growth is not only based on capital accumulation, but also on the innovative capacity spurred by appropriable knowledge and technological externalities. Discontinuous bursts of innovative investment by the entrepreneurs constitute the autonomous cause of economic growth.

In this dynamic context, above-normal profits reward innovation, thus leading to surplus values that cannot be present otherwise. This emphasis on the dynamic aspects of change, the recognition of the central role of the entrepreneur, is in direct conflict to the price theory’s focus on static consumer surplus and competition regulation’s traditional preoccupation with consumer choice. There are counters to this argument as well—both theoretical and empirical. These models assert the traditional view, that the incentive to invent is less under monopolistic than under competitive conditions. The costs of innovation are high, a competitor has the economic benefit of receiving the technology from a prior invention without incurring the costs, while a monopolist has a “strong disincentive for further innovation.” However, the empirical results are country- and product-specific and for certain products, the Schumpeterian paradigm may hold. For instance, in hi-tech sectors (such as hardware, software, pharmaceuticals, biotechnology), firms compete mainly by innovating or the innovation intensity of capital is greater in these industries.
One such burst of innovative investment in recent years has been seen in the meteoric rise and continuing success of internet-based markets and e-commerce platforms. The leaders in this innovative race have acquired substantial market power and this market leadership position of a few firms in this space has spurred a debate among academics and policy-makers alike: Do internet markets foster competition or do they facilitate market monopolisation or, at least, concentration?

There is enough theoretical and empirical evidence that competition in hi-tech markets is dynamic in the Schumpeterian sense: It takes place as competition for the market in a so-called “winner-takes-all race”. Thus, competition tends to come from subsequent rivals.
The “winner takes all” phenomena occurs as many Internet markets operate as multi-sided platforms, where a platform operator brings two different groups of customers together, for example buyers and sellers or “users” and advertisers. The platform aims to become the most efficient way these two distinct groups can transact – essentially performing the role of an intermediary. A market is typically called a two-sided or even multi-sided if indirect network effects are of major importance. Indirect network effects only arise indirectly if the number of users on one side of the market attracts more users on the other market side. The idea of indirect network effects is very simple: A higher number of sellers and an increased variety of goods offered, in turn, make the trading platform more attractive for more potential buyers. These positive effects imply that the more the number of participants on one side of the market, higher are the benefits to participants on the other market side. However, due to this platform markets may be more concentrated than other industries, as most consumers would flock to the larger players leaving small players competitively unviable. Thus, the conduct of firms operating in multi-sided markets will often be competitively ambiguous, because the same features that yield market power might help achieve optimal scale/demand side efficiencies. Moreover, competition between several platforms may not be necessarily beneficial to the consumer when compared to monopolistic market structures. So these markets, lead to totally opposite result with innovation and concentration being positively related and in direct conflict with the “traditionalist” view.

It is this conflict that makes the choice of regulatory incentives for regulating the digital economy extremely difficult. What market conditions are best for fostering innovation is one of the most heated discussions in economic circles in recent years. This conflict is also apparent in the jurisprudence coming from the United States. In the face of conflicting theories and empirical evidence, judgments seem to be driven by the ideological underpinnings of the government of the day—Republicans relying on the self-correcting nature of markets and Democrats being more interventionist.

Shall the choice of competition rules in India be also guided by some ideological underpinnings or there are some bright line rules that can guide regulatory philosophy? The normative basis of regulating the digital economy will finally depend on what ideology the Indian regulatory governance subscribes to. If it considers concentrated markets, by their very nature, to be undesirable, then an interventionist approach would be adopted and competition rules would impose visions of an ideal market upon economic agents. But if the regulators ascribe to a dynamic view of competition, concentrated markets will have to be traded off for consumer benefit. One guiding principle that can perhaps be adopted is that only when there are clearly identified concerns to the consumer can an intervention be deemed to be an appropriate regulatory response—and even then only to a degree proportionate to the concern. Regulatory response should exclusively target objectionable activities that hurt consumers (and not protecting some competitors), leaving other pro-competitive conduct that benefits consumers unregulated. This may translate into: Watch, look for evidence of consumer harm, be ready for action. But do nothing till then. After all, regulators are the watchers upon the wall, the guardians of the realm of economic freedom; they may take no part in the battles of markets.

The author is an associate professor of economics, University of Delhi

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