ECONOMICS- Case

The Web’s New Monopolists

Just because Facebook and Google are innovative now doesn’t mean they won’t strangle growth

and harm us all — if we let them.

By Justin Fox

Ask Jack Dorsey, the co -founder of the social network Twitter and the mobile -payment start -up

Square, what his two companies have in common, and he has a quick answer: “They’re both

utilities.” Mark Zuckerberg might agree: he spent years trying to convince people that Facebook

is not a social network but a “social utility.”

It’s an intriguing choice of words for such of -the -moment entrepreneurs. Utilities tend to be

boring, slow -growing beasts. They also — and this is the more important point — tend to be

monop olies that are either regulated heavily by governments or owned outright by them.

Indeed, once they get beyond a certain size, technology companies do become wary of the word.

Google has been called a utility by lots of people, but you won’t hear the compa ny’s executives

using the term (at least, I couldn’t find any examples). And Zuckerberg, when asked in 2010

whether, as a utility, Facebook ought to be regulated, said he hadn’t meant the word that way at

all: “Something that’s cool can fade. But something that’s useful won’t. That’s what I meant by

utility .”

Yet there are lots of useful things in the world — clothing, breakfast, this issue of The Atlantic —

that no one would ever think of calling a utility. Yes, there is an innocuous class of computer

software known as utilities. But what companies like Twitter, Square, and Facebook — not to

mention Google, Amazon, and Apple — aspire to, and in some cases have achieved, is a status

similar to that of traditional utilities like Ma Bell. They attempt to position them selves such that

customers can’t get around them, or can’t afford to leave them. And when they succeed, they

start appearing to some customers, would -be competitors, and regulators like scary monopolies

that somebody needs to do something about.

The connec tion between attractive business opportunity and monopoly is not new. Pursuing a

“short run” monopoly, the economist Joseph Schumpeter wrote in 1942, is what profit -seeking

enterprises do — in the process, driving significant innovation and economic growth. In the

1970s, the business -school discipline of strategy arose as the study of how to build and defend

these short -run monopolies — a sort of mirror image of the antitrust classes long found in law schools. “Strategy is antitrust with a minus sign in front o f it,” says the Columbia Law School

professor Tim Wu, who has taught both subjects. That is, strategy tries to maximize what

antitrust tries to minimize.

What is new is that the path from looking for an edge to being attacked as a monopoly has gotten

a lot shorter — and that gaining a monopoly seems such a plausible goal within some of the

fastest -growing parts of the economy. Standard Oil had been in business for 36 years when the

Justice Department sued it for antitrust violations; AT&T for 97. By compariso n, Microsoft was

just 15 when federal regulators started looking into its business practices, 23 when Justice sued.

Google, a mere 14 years old, is already under antitrust investigation.

Then there’s Facebook, which turns 9 in February. The company has not yet been the target of

significant antitrust attention. But its ubiquity and reach into users’ daily lives give it a status

that — socially if not economically — really does feel like that of a monopoly utility. Every tweak

Facebook makes to its privacy setti ngs or its look sparks heated public discussion. Last summer,

the company had to agree to regular audits of its privacy policy, mandated by the Federal Trade

Commission. One even hears occasional calls (meant more as thought experiments than as

serious pol icy proposals, but still ) for it to be nationalized.

Today’s technology entrepreneurs are well aware of the tight link between profit and monopoly.

Few are as open about it as the PayPal co -founder and early Facebook investor Peter Thiel, who

has described monopoly as the natural goal of any smart tech entrepreneur. But everybody gets

the basic idea. “There’s a joke in Silicon Valley,” says the UC Berkeley economist Carl Shapiro:

“ ‘You know you’ve really made it when you’ve got antitrust problems.’ That’s the sign of

success.”

The modern theory of monopoly began its rise in the mid -1980s, when a handful of scholars —

Shapiro among them — noted some salient characteristics of a fast -growing new industry. Many

information -technology businesses, observed Stanford’ s W. Brian Arthur, benefit from

increasing returns: as they make more of something, the cost per piece keeps falling. This is

especially true of software, for which the cost per piece moves quickly to zero. (Increasing

returns had been deemed in the late 1 9th century to be the mark of a natural monopoly, an

industry that would inevitably be dominated by one entity.)

Another trait that characterized many technology businesses, these same scholars observed, was

lock -in, or prohibitive switching costs. Compani es that committed to getting their mainframe

computers from, say, IBM would eventually find switching to another provider hugely expensive

and disruptive. (Later, with the PC, Microsoft was able to shift the lock -in from hardware to

software.)

But most int riguing of all was the enormous power of network effects. A telephone “without a

connection at the other end of the line … is one of the most useless things in the world,” AT&T

President Theodore N. Vail wrote in the company’s annual report in 1908. “Its v alue depends on

the connection with the other telephone — and increases with the number of connections.” In

1980, Bob Metcalfe, an inventor trying to persuade people to buy his $5,000 Ethernet cards,

which connected computers in a local area network, came up with a formula that expressed the value of a network as the number of connections squared. The specifics of “Metcalfe’s Law”

have frequently been challenged, but the basic idea that networks add value exponentially as they

grow has not.

For society as a w hole, though, these phenomena can have a dark side. In a famous paper, the

Stanford economic historian Paul David described in 1985 how the ubiquitous QWERTY

keyboard layout had been devised mainly to prevent jamming of primitive typewriter

mechanisms. Lat er, as typewriters improved, there were repeated attempts to supplant QWERTY

with configurations that allowed for faster typing. But by then the layout’s high switching costs

had made it an impregnable standard. Economic forces, wrote David, “drove the ind ustry

prematurely into standardization on the wrong system .”

Brian Arthur borrowed the term path dependence from physics to describe this predicament, and

wove it into an alarming story about how technology standards develop and get locked in even

when the re may be better options. The saga of Sony’s Betamax, which purportedly delivered

better picture quality but lost out to VHS as the dominant videocassette, was told and retold.

Research by other economists soon muddied the tales of both VHS and QWERTY — they may

not have been such obviously inferior technologies after all. But the behavior of Microsoft,

which by the early 1990s was using its market power to shove aside innovative competitors like

Apple, WordPerfect, and Lotus, certainly seemed like an example of technology heading down

the wrong path.

In May 1998, professing to be heavily influenced by Arthur’s work, Assistant Attorney General

Joel Klein sued Microsoft. The central offense involved Netscape, the maker of a new kind of

software called a browser that was used to navigate a new communications network called the

Internet. As it had done before, Microsoft built a copycat product, Internet Explorer, and used its

operating -system dominance to wrest control of the market.

The trial that ensued was such a headline -grabbing sensation that it is remarkable how few

people even remember the outcome (I didn’t until I looked it up). Microsoft lost the case

decisively in U.S. district court, where Judge Thomas Penfield Jackson ordered that it be split in

two. T hat wasn’t the end, though. Jackson had openly criticized Microsoft in interviews, and the

court of appeals blasted his behavior as “rampant disregard” for judicial ethics, vacated parts of

Jackson’s ruling, and handed the case over to a different judge. M icrosoft was still found to have

violated the law, but the remedy fell far short of a breakup or even serious punishment.

There were reasonable economic arguments for leaving the company be. In its 2001 ruling

vacating Jackson’s decision, the appeals court described the quandary at the heart of the case.

Citing the literature on network effects, the judges acknowledged that, in some tech markets,

“once a product or standard achieves wide acceptance, it becomes more or less entrenched.” That

made software co mpanies a bit like utilities — where competition is not “within the field” but “for

the field.” On the other hand, citing Schumpeter at some length, the judges noted that, in

technologically dynamic markets, “such entrenchment may be temporary, because innov ation

may alter the field altogether.” For the next few years, Schumpeter looked like a pretty good guide. Microsoft continued to mint

money from Windows and Office, but it missed out on almost every new digital opportunity.

Apple rose from its deathbed on the strength of better products and a new way of selling music

online.

Then there was the Internet, which seemed mainly to reward upstarts that built good products.

Google, the first of these upstarts to break through in the new millennium, hardly looked like a

trust worth busting. By and large, it didn’t make use of network effects. It also didn’t lock users

in. Yes, Google enjoyed increasing returns to scale. But if another company were to come along

with a dramatically better search technology (just as Google once did), it might well take over

the market.

Other businesses that arose in Google’s wake, however, did focus on creating network effects.

Facebook’s business is built entirely around them — its value for users resides in the presence of

other users , period. As you build up an online identity on Facebook, the costs of switching to

another network rise, too. Other, less universally ambitious businesses, from Yelp to Evernote to

Airbnb, similarly have tried to establish themselves at the center of uniq ue new ecosystems. And

in recent years — with Gmail, Google Places, the Chrome browser, the Android smartphone

operating system, and other products — Google has been trying increasingly hard to build a

network that customers will find tough to abandon.

So what, if anything, should we do about all these budding monopolists? The prevailing attitude

among regulators over the past decade has been: very little. One reason is that firms don’t always

know how to transform the network effects they’ve been creating into empire -entrenching

profits. Microsoft’s approach — charging for its software — is not open to most of today’s firms, at

least not at first. To build a network big enough to exploit, you usually need to offer something

for free. So we get lots of “freemium ” businesses that charge only heavy users. We get Apple,

which has learned to build networks around music and movies and apps, but makes most of its

money selling the devices that access those networks. We get Amazon, which is building similar

networks aro und books and other media, and is selling its devices for no profit. And we get

Google and Facebook, which have such staggering numbers of users that they are able, by smart

targeting, to make serious money selling ads — although so far they’ve had less succ ess with ads

on mobile devices than on computers. With the situation so dynamic and uncertain, we may be

tempted just to shrug and let the market take us where it will.

But to assume that this hyperfast Schumpeterian capitalism is the new normal, and that

government or civic action can only get in the way, is to ignore or misread history. (If you need

to do some remedial reading, as I did, I recommend Tim Wu’s The Master Switch and Richard

R. John’s Network Nation .) We have repeatedly seen new communication s technologies go from

open and chaotic to closed and, in many cases, censored. This happened with newspapers, radio,

TV, movies, even the telephone system. Just because the Internet has succeeded in blowing up

some of these established communications mono polies and oligopolies doesn’t mean it won’t

create its own.

Declaring that the new utilities of the Internet age thus require regulation can be problematic. As

Wu puts it, “Regulation is often a way to keep a dominant firm in place.” At this stage, a set of rules on how search engines are supposed to work would probably just entrench Google. But

other tools are available. We can, for example, agree on principles of how the online world

should develop. The best -known of these is “network neutrality” — the ide a, coined by Wu, that

broadband providers shouldn’t be allowed to favor some Internet businesses over others. Still

incipient is the principle, espoused by the open -source advocate Doc Searls and others, that

customer data should belong to customers rather than to retailers, social networks, search

engines, and the like. Third -party providers should store your information, and share it only

when you want them to. This would lower your switching costs, and could upend the business

models of Google, Facebook, and others that profit from hoarding user data. It might also deliver

a better consumer experience at a lower cost.

And let’s not forget antitrust enforcement. It is now fashionable to dismiss it as pointless — look

what happened with Microsoft . But look mo re closely, and it’s possible to spin a credible tale of

antitrust lawyers enabling disruption and innovation. The Justice Department may have given up

its 13 -year struggle with IBM in 1982, but pressure from Washington helped push the company

to unbundle its software from its hardware, speeding the development of an independent

software industry. The 1980s breakup of AT&T created fertile ground for the growth of the

Internet. The spectacular rise of Google and Facebook, and the resurgence of Apple, were

po ssible at least in part because Microsoft didn’t feel free to strangle them as it had Netscape a

decade before.

The virtual world is so new that it still seems boundless, and its continued exploration and

colonization are providing new tools and new entert ainments for us all, along with great fortunes

for the explorers and colonizers. Yet, if we are inattentive, today’s landgrabs could crowd out

opportunity, innovation, and even economic growth in the future. It’s one thing to acknowledge

that the way ahead is uncertain, and that what looks like a permanent monopoly today might be

roadkill tomorrow. It is quite another to assume that everything will work out for the best as long

as market forces are allowed to work their magic.

So all praise to today’s would -be utilities and monopolies, as they try to build enterprises that

own their markets and that we can’t do without. But when they actually succeed, don’t think we

shouldn’t be sniffing around in their business. At a certain point, it becomes our business, too.

This article available online at:

http://www.theatlantic.com/magazine/archive/2013/01/the -webs -new -monopolists/309197/