Open Standards to Boost the Internet of Things

The Internet of Things (IoT) integrates the physical world into a computer-based system to allow objects to collect and exchange data. This inter-networking should bring improved efficiency, accuracy and economic benefits. However, many of the benefits of the IoT will occur only as a result of a widespread approach, sharing of data across the value chain and novel services. The adoption of widely accepted standards is the tool to achieve effective and efficient interoperability. The exclusion of all technologies but one might have an adverse effect on competition. Building the IoT on open standards could be the way to maintain a level playing field and promote innovation.

The IoT can build applications for smart transport, health, education, manufacturing and other sectors. It may support more responsive business models thanks to a more granular and frequent data collection that will allow firms to better assess their customers’ needs. Allowing the IoT to live up to our expectations might entail a shift in our approach to governance. If a blanket approach might not be the best solution, it is also true that no one single company, or government, can solve the issue.

The debate on whether there is the need for IoT specific regulation is ongoing and far from being settled. Some consider that the IoT world can be efficiently and effectively governed by current horizontal legislation, such as privacy, safety, environmental and competition rules. However, as a successful IoT environment demands that different devices interact, it is crucial to enable those products to communicate between each other. Hence, it seems impossible to avoid the adoption of a regulatory framework that will allow for interoperability.

Standardisation is critical in establishing a Single Market for IoT. Standards allow complementary or component products from different manufacturers to be combined or used together. They increase consumer choice, convenience and reduce costs of production. They eliminate fragmentation and will enable the emergence of the IoT ecosystem boosting innovation and reinforcing competition.

The endorsement of a particular standard is done at the expense of potentially competing technologies. However, competition in network markets is likely to result in standardisation anyway, as long term coexistence is unlikely given that a small initial advantage is apt to influence consumer expectations regarding the adoption of a specific standard. In markets with network effects, such as the IoT one, the product’s value increases the higher the number of adopters. Consequently, the network’s value increases to future adopters. Consumer expectations are often self-fulfilling and an early lead will turn in a competitive advantage difficult to overcome.

The IoT is expected to improve many aspects of our daily lives. It will influence all major economic sectors, from health to education, from transport to manufacturing. Given the total interconnection between all IoT technology, network effects will strongly influence the competitive features of the market. It seems of excruciating importance to assure that the IoT’s potential is not locked in the hands of few dominant market players.

Amazon, Apple, Google, as well as other companies already offer integrated solutions. SSOs are already working on developing standardised software layers. However, the Garten report predicts that there will not be a dominant ecosystem of platform until 2018.

Many of the existing platforms are based on a proprietary model that locks consumers into specific interface standards. Open standards seem to be preferable to proprietary solutions as they have a positive effects as regard to large scale deployment, widespread adoption and lock-in prevention. Open standards would appear to present a perfect mix of flexible multi-stakeholder arrangements. They ensure an adequate balance between the need to foster private sector innovation and the need to avoid technological lock-in or gridlock. Through the application of the principles of openness, broad consensus, transparency, availability and market-driven adoption, consortia are more likely to develop inclusive technology that more strongly adheres to the principles that are at the basis of some of the best technological innovations of our time, including the free and open Internet. With truly open specifications in place, the pathway to standardisation may also become a more smooth one.

So far the digital ecosystem has proved to be a stimulating and innovative environment, continuously delivering new inventions capable of disrupting our daily routine. For the sake of a successful, competitive and fair IoT market, it is about time for the digital world to deliver a business model that moves away from IP revenues-based models and shift to models that generate income through the delivery of innovative complementary products.

***

Dolmans, M., Standards for Standards, paper for the Joint DOJ/FTC hearings on Competition and Intellectual Property Law and Policy in the Knowledge-Based Economy, Washington DC, 22 May 2002, s4.1(a), available at: http://www.ftc.gov/opp/intellect/020522dolmans.pdf.

Dolmans, M., A Tale of Two Tragedies – A Plea for Open Standards, (2010) available at: http://www.ifosslr.org/ifosslr/article/view/46.

Glander, M., Open Standards, Policy Aspects and Legal Requirements, European Competition Journal Vol.6, Iss. 3, 2010.

Ghosh, R.A., An Economic Basis for Open Standards, (2005), p. 4 available at:
https://www.intgovforum.org/Substantive_1st_IGF/openstandards-IGF.pdf.

Kim, D., Lee, H., and Kwakc, J., Standards as a driving force that influences emerging technological trajectories in the converging world of the Internet and things: An investigation of the M2M/IoT patent network, Research Policy Volume 46, Issue 7, September 2017, pp. 1234-1254.

Regulation (EU) n. 1025/2012 of the European Parliament and of the Council of 25 October 2012 on European standardisation

Organisation for Economic Co-operation and Development, The Internet of Things: seizing the benefits and addressing the challenges, Background report for Ministerial Panel 2.2., Working Party on Communication Infrastructures and Services Policy, 2016, p. 12, available at: http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=DSTI/ICCP/CISP(2015)3/FINAL&docLanguage=En.

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Vertical mergers are not necessarily competition law friendly

The vertical integration of producers of complementary products or services results in no loss of direct competition as they operate at different levels of the supply chain. On the one hand, vertical mergers are likely to produce efficiency gains because they give rise to a direct incentive to reduce prices and/or improve quality. On the other hand, they can create market power, either by coordinated or unilateral effects, which may result in detriment to consumers. Competitive and anticompetitive effects of a vertical merger arise from the same source: the creation of cost asymmetries between the integrated firm and its rivals. Whether the deal will result in detriment to consumers, it depends on whether it will be greater the market power increase or the reduction in cost of the integrated firm.

Substitution vs. complementarity

Horizontal mergers involve producers of substitute products and are likely to cause anticompetitive effects because substitute products have a positive cross-price elasticity: if product A’s price increases, the demand of product B will rise as some customers will switch to the latter. Because post-merger some of the lost sales are internalised, a horizontal merger creates an incentive to raise prices.
Conversely, the relationship between complementary products is characterised by a negative cross-price elasticity: the sales of both products will increase following the reduction of either’s price. If producers of complementary products merge, this beneficial effect is internalised providing an additional incentive to lower prices. This externality effect is not restricted to prices: any improvements of quality, promotion or distribution will produce a positive effect. Because the integrated firm will act to maximise profits across the two lawyers of the chain, prices will decrease and output will rise. Vertical mergers are presumed to be pro-competitive; indeed, the main rational behind a vertical merger is the achievement of efficiencies rather than the increase of market power. However, in limited circumstances the cost asymmetries produced by the integration can result in the foreclosure of competitors and eventually lead to higher prices. The competition concerns created by vertical mergers are similar to those put forward in abuse of dominance cases: the integrated firm might have the ability to foreclose rivals in downstream and/or upstream markets, might act to raise rivals’ costs or weaken their offering by bundling, discriminating or refusing to supply.

Anti-competitive effects of vertical mergers

Efficiencies can create cost asymmetries between the merged firm and its non-integrated rivals, which can eventually lead to an increase of the integrated firm’s market power as a result of:
(i) the loss of attractiveness as a substitute of rivals’ products, either because they are of lower quality, more expensive or because competitors are excluded from the market or prevented entry (unilateral effect); or
(ii) the increased likelihood of coordinated conduct (coordinated effects).

The change of incentives and constraints following the vertical integration can rise rivals’ costs (input foreclosure) or reduce their revenues (customer foreclosure). Moreover, vertical integration can make it easier for firms to coordinate or evade regulatory obligations.

Input foreclosure
To engage in anticompetitive input foreclosure, a firm needs to have the ability and the incentive to foreclose and its behaviour must result in detriment to consumers.
The merged entity will be able to engage in input foreclosure only if it controls an important input to downstream rivals. If it will either stop supplying competing downstream firms or will do so at a higher price, the cost of downstream rivals may be negatively affected and, as a consequence, their prices will increase. The restriction could also prevent a new entry, and hence the vertically integrated firm will preserve significant market power upstream. The downstream prices will either increase or fall, depending on whether dominates the cost or the market power effect of integration. In conclusion, the overall effect on consumers is ambiguous.

However, engaging in a foreclosure strategy involves a profit sacrifice, i.e. the lost margins on the sales of products to downstream competitors that are not made post-merger. Only if the benefits outweigh the costs, the integrated firms will have the incentives to engage in foreclosure. The empirical analysis assessing the trade-off between costs and benefits involves, inter alia, the assessment of upstream and downstream margins as well as the propensity of consumers to switch and the reaction of competitors.

If, as a result of the foreclosure, rivals’ price increases, costumers will switch to the integrated firm’s product: the greater the switching rate, the greater the benefits will be since the merged entity will earn both the wholesale and the retail margin on those additional sales. However, the merger will harm consumers and, hence will be considered anticompetitive, only if it allows for a price increase possible given the reduced competition.

The merger will not cause anticompetitive effects unless the competing upstream firms are capacity-constrained, or less efficient, or if branding is important since, in these cases, the downstream firms may find it difficult to obtain equivalent input at pre-merger price. Competition concerns are unlikely to arise also if the upstream product represents only a small proportion of the overall retail price because, in these instances, even a substantive price increase would be unlikely to affect the final price. Similarly, the greater is the incentive for the downstream firms to absorb the price increase, the less effective will be a foreclosure strategy.

Customer foreclosure
If before the merger the downstream firm was a significant market player, and following the integration it stops purchasing from upstream rivals, the latter’s average costs of supply might increase because of the reduction in sales. If customer foreclosure results in exit (from higher average costs) or reduced competitive vigour (from increased marginal costs), the competitive constraints that upstream competitors exert on the upstream division of the integrated firm will be reduced, leading to greater market power upstream and higher input prices. It is a concern only when the vertical merger involves a firm that is an important customer that enjoys significant market power in the downstream market, i.e. it has the ability to foreclose.

Only in certain instances consumers are harmed. There are competition concerns, only if, by denying access, the wholesale price to non-integrated downstream firms increases leading to reduced competition downstream and hence higher retail margins. Competition concerns may also arise when the integrated firm is successfully winning sales from its upstream competitors and the upstream market is characterised by significant economies of scale, since customer foreclosure can lead to higher input prices. In general, customer foreclosure is anticompetitive only if there is a significant customer in the downstream market with large market share, the input suppliers are subject to significant economies of scale, and the upstream firms are not able to expand sales to other downstream firms.

Enhanced likelihood of collusion
Vertical mergers can make it easier for firms to engage in tacit or express collusion since it might facilitate the exchange of pricing and other competitively sensitive information in either the input or output market, or it can eliminate a disruptive buyer or enhance market transparency. The greater the benefit of the downstream division from raising the costs of its rivals, the greater the incentive for the integrated firm to coordinate pricing upstream. However, the coordinated effects are likely to be significant only if either the upstream or the downstream market is conducive to coordination.

Evading price regulation
If the upstream market is regulated, but the downstream market is not, by integrating, the upstream monopolist can realise its monopoly profit in the downstream market. This is possible by either discriminating other downstream players or engaging in cost misallocation. At the same time, a downstream monopolist active in a regulated market could integrate and use transfer pricing to evade its regulatory constraint and earn the monopolist profit upstream. If the integrated firm engages in discrimination, it will disadvantage its downstream rivals by reducing the quality of the input or raising competitors’ costs. This relaxes the competitive constraints played by downstream competitors and hence, the integrated firm will be able to increase prices. If the regulated price upstream is cost-based, the integrated firm will have the incentive to have its downstream costs attributed to its upstream division so that it relaxes the price constraints in the upstream market and increases its profits downstream. As it occurs with cost misallocation, the market power and profits are realised by the unregulated entity. These strategies are of concern because they result in greater exercise of market power and produce inefficiencies.

Pro-competitive effects of vertical mergers

Vertical integration enhances coordination between the upstream and downstream firms. The most evident positive effect of vertical integration is that the merged entity will no longer pay a wholesale price that includes a mark-up over marginal cost: it will transfer the input internally at only marginal cost. Hence, vertical integration solves the problem of double marginalisation and can allow for an immediate price reduction.
Efficiency gains are not limited to costs and price reductions; they also include improvements in quality, increased variety, and innovation leading to new products.

From an empirical point of view, those efficiencies are found to outweigh possible anticompetitive effects in most contexts. However, in limited circumstances, vertical mergers can indirectly generate anticompetitive concerns as a result of changes in constraints and incentives.

***

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010.

Church, J., The Impact of Vertical and Conglomerate Mergers on Competition, European Commission, 2006, available at: http://bookshop.europa.eu/en/the-impact-of-vertical-and-conglomerate-mergers-on-competition-pbKD7105158/.

Church, J., Vertical Mergers, in Issues in Competition Law and Policy, Vol. 2, p. 1455, ABA Section of Antitrust Law, 2008, available at SSRN: https://ssrn.com/abstract=1280505.

Gunnar, N., Jenkins, H., and Kavanagh, J., Economics for Competition Lawyers, Oxford University Press, 2016.

RBB, The efficiency-enhancing effects of non-horizontal mergers, 2005, available at: http://ec.europa.eu/DocsRoom/documents/3667/attachments/1/translations/en/renditions/native.

Rosengren, E.S., and Meehan, J.W., Antitrust policy and vertical mergers, in New England Economic Review, 1995, pp. 27-38.

Is economics helpful when it comes to cartels?

Economics implies that cartels are inherently unstable and so should be short-lived because they price above the Nash equilibrium. However, the evidence is cartels are often long-lived.

When players interact for an infinite number of times, as do firms in real markets, they can escape the short-run Nash equilibrium of the Prisoner Dilemma. In the context of infinite interaction, a collaborative behaviour becomes sustainable depending on the benefits of cheating, the credibility of the punishment’s threat and the discount factor.
“Punishment” refers to the reaction of non-cheating firms to an infringement of the collusive agreement: non-cheaters will move away from the cartel equilibrium towards a more competitive equilibrium, so that the cheater’s profit is reduced. Stability of the cartel is ensured by a punishment mechanism that makes the benefits derived from deviation smaller than the benefits of keeping colluding. An effective punishment mechanism should be strong enough to deter cheating, but also credible. It is in every cartel member’s interest to set the punishment mechanism as high as possible, but credibility follows from each non-cheating firm’s interest to implement it if a breach actually occurs. The punishment mechanism should hurt the cheating firm more than the non-cheating ones; hence, it must correspond to the latter’s profit-maximising behaviour.

Economics’s contribution to anti-cartel enforcement

Ex ante, economics can be used to prevent the formation of cartels by prohibiting mergers that would ease collusion. As tacit and explicit collusion rest on the same economic principles, the criteria used to identify tacit collusion in merger review processes can provide guidance also for the detection of explicit collusion.

Ex post, competition law enforcement can benefit from economic analysis because the latter can provide evidence:

  1. on the plausibility that an industry is/was cartelised, i.e. it can
    a) suggest where to look for a cartel, and
    b) reveal whether, given the characteristics of the market, the cartel
    allegation is credible; and
  2. on the impact that a cartel has had in the market.

Unfortunately economics is unable to establish with certainty whether a market is cartelised: economic models can be employed as screening devices, but further investigation will always be necessary.

Likelihood of collusive behaviours

Economics can help identify markets that are prone to cartelisation and establish whether the cartel allegation is credible given the market’s characteristics. However, economists tend to reject the idea of prosecuting cartels on economic grounds only because patterns of prices under collusion and competition are often similar; moreover, economics cannot distinguish between no collusion and unsuccessful collusion, and it cannot distinguish between tacit and overt collusion.

Structural and behavioural markers represent – complementary – screening tools; they identify suspicious behaviours, but cannot provide hard evidence of collusion. Indeed, they could produce false positives, or negatives, because they cannot distinguish between tacit and express collusion or because market players can evade them. Moreover, not all noncompetitive behaviours infringe competition law.

Estimation of the cartel’s effect on the market

Economics is useful to assess the cartel’s effects on the market. The actual cartel’s impact is of relevance for damages actions, but it can also have a bearing on the size of the fine imposed.

The harm suffered by the direct purchaser of a cartelised product has three elements: (i) the direct effect – the quantity of product purchased multiplied by the increase in price as a result of the cartel; (ii) the output effect – the increase in the purchaser’s selling price that is a likely consequence of its input prices increasing, leads to a reduction in the demand for its products; and (iii) the passing-on effect, which occurs when the direct purchaser raises its selling price in response to the increase in output costs, therefore reducing the harm it suffers

The consequence of a cartel on the market can be estimated by understanding what would have happened absent the wrongful conduct: the claimant’s position during the cartel is compared to the position that he would have been in “but for” the anti competitive behaviour. The difference between the claimant’s profits in the counterfactual world to the one in the cartelised scenario is the amount of compensatory damages due to the claimant. To estimate the counterfactual profit we need to know, or estimate, the following:

  1. the amount of the overcharge;
  2. how much lower would have been the selling price at the lower input costs; and
  3. the level of sales occurred at this lower price.

Direct evidence can be useful to quantify the damage; however, economists have developed different helpful tools to carry out the calculation. Comparator-based methods assume that the counterfactual scenario is representative of the likely non-infringement scenario and that the difference between the infringement data and the data chosen as a comparator is due to the infringement. Cost-based methods estimate the non-infringement price by using some measure of production costs per unit and adding a mark-up for a profit that would have been reasonable in a competitive market. Financial methods compare the counterfactual profitability and the actual profitability of the claimant or the defendant. These approaches can estimate the likely non-infringement scenario but cannot delineate it with certainty and precision.

 

In conclusion, even though economic cannot provide hard core evidence of collusion, it is a useful tool to detect cartels and understand their effects in the market. However, the quality of the answers economics can provide is only as good as the data available and as appropriate as the approach chosen.

***

Ayers, I., How cartels punish: a structural theory of self-enforcing collusion, in Columbia Law Review, 1987, pp. 295-325.

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010.

Friedman, J.W, A non-cooperative equilibrium for supergames, in Review of economic studies, 1971, pp. 1-12.

Harrington, J.E. Jr., Behavioral screening and the detection of cartels, EUI-RSCAS/EU Competition 2006 – Proceedings, 2006

When the market definition/market share approach does not work to assess market power

Traditionally, competition authorities start their assessment by identifying the competitive scene, i.e. the relevant market, which includes the firm’s product and potential substitutes. They then calculate market shares to decide whether the firm(s) under scrutiny has enough market power to benefit from the adoption of an anticompetitive strategy. 

However, when market shares are not a strong indication of market power, market definition is least useful. Difficulties arise in products differentiated markets since market boundaries are problematic to draw; as well as in bidding markets, in markets with networks, and in highly dynamic and innovative market. This is so because competition might be “for the market” rather than “in the market.” Moreover, when market concentration has no strong links to the economic theory by which competition would allegedly be harmed, market definition is also of limited help.

From an economic point of view, the assessment of market power does not always require the identification of the relevant market. Economists prefer to focus on the level of competition in the market and to gather and assess evidence in the way that best sheds light on the competition question at hand. To better serve the purpose of competition law analysis, economists have developed techniques that allow the direct assessment of market power, some of which are discussed below.

Direct evidence of the effects of a firm’s behaviour might better answer the question at hand. Indeed, sometimes it might be enough to establish that the firm’s price is too high compared to its marginal cost, or that its economies of scales are so great that no one can replicate them, and hence compete effectively. Past events in the market, such as recent mergers, the entry, expansion or exit of market players and their effects on prices, are likely to be very informative regarding the potential competitive effects of future occurrences in the market.

Alternatively, market power can be assessed directly by calculating the Lerner Index, which predicts the price-marginal cost margin and reveals the firm’s ability to raise prices above short-run marginal costs. However, in many industries the competitive price is not equal to short-run marginal costs. Moreover, the Lerner Index is not applicable to firms producing multiple products – the majority – and it assumes that the firm is competing according to a static short-run non-cooperative Nash equilibrium – but this will often not be the case.

Another way to identify market power is to observe the way firms and industries react to variation in marginal costs. This can be done, for example, by focusing on the residual demand estimation, which measures the ability of a firm to raise prices by reducing output after taking into account the demand responses of buyers and the supply responses of its competitors. The residual demand curve is the horizontal difference between the market demand curve and the total supply of all other firms. 

As the exercise of market power follows from demand inelasticity, a firm holds market power and can increase prices when buyers do not have good demand substitutes. If demand is not highly elastic, the exercise of market power can be directly observed by looking at the competitive price or competitive industry output. If costs have not changed, the most plausible explanation for any observed variation in the market price is that the demand elasticity has altered while firms were exercising market power.

A fourth technique to assess directly market power relies on the assumption that firms may behave differently when cooperating than when they compete. If data regarding multiple types of behaviours is available, econometricians will assess whether the specific shift in prices can be better explained by two types of behaviours rather than one.

Lastly, the effects that a merger can have in a market can be directly assessed by focusing on consequent price changes rather than increases in market shares. Merger simulations and pricing pressure tests are more suited to assess deals in products differentiated markets than the market definition/market shares approach.

Merger simulation directly calculates how much the price will increase post-merger by first modelling the nature of competition in the pre-merger scene and then combining this data to predict the post-merger scenario. Merger models can play an important role in the assessment of the effects post-merger marginal cost reductions have on prices, but they cannot represent the only basis for a competition authority’s final decision, as they omit important parts of the competitive effects analysis, such as entry, buyer power, product repositioning and changes in the mode of competition post-merger. 

When closeness of competition is the central issue, market shares are not necessarily indicative, while diversion rations directly assess the issue. Diversion rations calculate the percentage of lost volumes that are captured by another product following a unilateral price increase. If combined with margin data, diversion ratio can perform so-called price-pressure tests, which can assess the change in pricing incentives post-merger – and, at instances, the magnitude of the price change. The firm’s net incentive to raise prices after the merger is identified by comparing its incentive to increase prices due to lost competition against the opposing incentive to decrease prices due to cost savings.

In conclusion, depending on the type of behaviour under scrutiny and the available data, it is not always necessary or useful to delineate the relevant market to establish if a firm is able to exercise market power. The choice towards one or the other method should be dictated by the structure of the industry under scrutiny and the legal question at hand, rather than by the certainty that market definition is the best tool available.

***

Baker, J.B. and Bresnahan, T.F., Estimating the residual demand curve facing a single firm, in International Journal of Industrial Organisation 6 (1988), pp. 283-300.
Baker, J.B. and Bresnahan, T.F., Empirical methods of identifying and measuring market power, in Antitrust Law Journal, Vol. 61, No. 1 (Summer 1992), pp. 3-16.

Bishop, S. and Walker, M., The economics of EC competition law: concepts, application and measurement, University Edition, Sweet and Maxwell, 2010

Kamerschen, D.R. and Kohler, J., Residual demand analysis of the ready-to-eat breakfast cereal market, in The Antitrust Bulletin, Winter 1993, pp. 903-942.

Aside

An Introduction to EU Competition Law*

As freak legislation, the antitrust laws stand alone. Nobody knows what it is they forbid.”

Isabel Paterson


  WHAT IS COMPETITION POLICY?

Competition policy deals with the organisation of domestic market economics. It aims to allocate resources in the most efficient way.

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Aside

Dive into Competition Law

THE ORIGINS AND AIMS OF COMPETITION POLICY

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.”

 A. Smith, Wealth of Nations 

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