Google vs. the EU Explains the Digital Economy

Google’s antitrust battle with the European Union seems to be heating up. In recent weeks, the company has rebutted the European Commission’s charges that it uses its internet search engine to give its shopping services an unfair advantage over rivals, improperly uses its AdSense ad-placement service to restrict third-party websites from displaying search advertisements from Google’s competitors, and unfairly exploits the dominant position of its Android operating system with smartphone manufacturers and mobile network operators (see its November 3 and November 10 blog posts.)

We think Google’s rebuttal of the charges against its shopping and ad-placement services are effective, and it has even made some changes to its products to address issues raised by the European Union. But we think it is unlikely that Google will be able to prevail in the Android case unless it abandons its contention that E.U. authorities should adopt a U.S. perspective. Instead, it should try to persuade them that competition in the mobile space is radically different from that in traditional markets and consequently, the European Union — and the United States, for that matter — should revamp their antitrust laws.

Companies like Google operate simultaneously in multiple ecosystems, as do their competitors. As such, any analysis of competitive dynamics must be done across ecosystems — something the European Union hasn’t done. Instead, it has just focused on the mobile-operating-system market. Given that Google has a European market share of more than 90% in general internet search services, licensable smart mobile operating systems and app stores for the Android mobile operating system, E.U. antitrust authorities seem to believe that Google needs to be policed from stifling innovation in the marketplace.

In its response to the European Union, Google argues that its Android operating system has made it cheaper and faster for device manufacturers to bring devices to market, lowered prices for smartphones, and increased the distribution opportunities for apps. In other words, Google bases its reply on the prevailing perspective in the United States with respect to antitrust enforcement.

The Mobile Industry Stack

To understand the issues involved in this tussle, it is important to understand that firms like Google, Apple, Amazon, and Facebook are simultaneously competing and cooperating in multiple fronts — a phenomenon we call interlocking ecosystems. Since mobile devices play an important role in making it possible for these interlocking ecosystems to work smoothly, it is critical to understand the mobile industry stack.

The typical stack is comprised of layers of functionality, each of which delivers a unique value proposition for customers. Every layer of the stack depends on the layer below to deliver its promised function. Since the layers communicate using application program interfaces (APIs) provided by vendors operating in the layer below, those vendors that dominate one layer can use their power to control how the layer above develops. In a notorious instance, Microsoft reportedly hoped to “cut off Netscape’s air supply” by threatening to withhold crucial technical support from Intel. When a company uses its own products for each layer (e.g., Apple), the industry stack is vertically integrated. When different suppliers provide the required functionality for each layer, the leadership of the stack is divided.

Android is Google’s open-source operating system (OS), which means that it can be adopted by any device manufacturer and modified to provide different functionality. As a result, 90% of device manufacturers in Europe use Android as their OS. Some modify the OS; in those cases, it is called an Android fork.

The next layer of the stack, the application layer, is the most important for the majority of today’s consumers. People pay for, download, and use third-party applications via the Google Play Store. One of the most popular apps is Google Search, which is also the primary source of Google’s advertising revenue and therefore is vital to Google’s business model.

Google requires mobile-device manufacturers to sign an “anti-fragmentation agreement,” which states that manufacturers that want to pre-install Google proprietary apps (including Google Play Store and Google Search) on its devices cannot include Android forks on those same devices. Consequently, device manufacturers that adopt the Google stack must bundle both Google Search and Google Play, which essentially locks out the other search engine providers and store fronts. In other words, while Google supports divided technical leadership for part of the stack, it tightly controls the applications layer.

From a stack perspective, Google provides free functionality at a lower level of the stack and makes up for it by charging for the higher-level functionality. To subsidize the free Android OS, Google has ensured that consumers provide data and exclusively use its search application (supported by paid advertising) in the higher layer.

From Google’s perspective, this approach has the benefit of increasing efficiency in the mobile industry stack. Google has at once freed device manufacturers from having to invest in developing complex operating systems, allowed them to focus on their core competence of designing and manufacturing of devices, and thereby lower their costs. As Kent Walker, Google’s senior vice president and general counsel, argues, Android has made it cheaper and faster for device makers to bring new devices to market. At the same time, Google suggests, it has enabled consumers to benefit immensely by falling device prices, access to a variety of devices, and ease of use of thousands of apps.

Competition Policy: U.S. vs. E.U.

Google’s argument relies heavily on the prevailing American perspective of competition policy. In the United States, legal precedents, as well as enforcement efforts, approach competition policy with consumer welfare as its lodestar. This approach argues that promoting efficiency with which firms operate leads to enhanced consumer welfare since improved efficiency leads to lower costs which in turn leads to lower prices. In that context, preserving competition in the marketplace is only a means to an end. As one observer puts it, “efficiencies are the goal; competition is the process.” By this logic, Google’s approach to the mobile stack is efficiency enhancing whereby consumers benefit.

Unfortunately for Google, the E.U. antitrust enforcers have a slightly different perspective. They, too, start off with consumer welfare as the long-run goal, but they insist that moves by rivals that could be efficiency enhancing in the short run could be detrimental in the long run, especially if those moves could thwart technological innovation and competition. In other words, E.U. authorities put more stress on what one might call dynamic efficiency in markets.

The differing U.S. and E.U. antitrust perspectives can lead to different outcomes when confronted with the same set of facts. For example, in the case of the proposed merger between GE and Honeywell, U.S. antitrust authorities gave it a go-ahead based on projected cost efficiencies whereas the E.U. authorities denied it since it has the potential to lower competition in the long run.

In the case of mobile operating system, the European Union makes three arguments, all of which have the notion of dynamic efficiency at their core.

One, the European Union argues that since “Google has made the licensing of the Play Store on Android devices conditional on Google Search being pre-installed and set as default search service,” rival search engines are not able to get a foothold in the devices sold in the European Union. Moreover, it has also reduced the incentives of manufacturers to pre-install competing search apps, as well as the incentives of consumers to download such apps. This is important because the European Union’s research has shown that consumers rarely change or delete pre-installed apps (unless the pre-installed app is of particularly poor quality). In other words, Google’s approach reduces the likelihood of future competition in search.

Two, the European Union argues that Google’s “anti-fragmentation agreement” also has the effect of reducing dynamic efficiency. It says: “Google’s conduct prevented manufacturers from selling smart mobile devices based on a competing Android fork, which had the potential of becoming a credible alternative to the Google Android operating system. In doing so, Google has also closed off an important way for its competitors to introduce apps and services, in particular general search services, which could be pre-installed on Android forks.”

Three, in the European Union’s view, Google reduces dynamic efficiency through its moves to grant significant financial incentives to some of the largest smartphone and tablet makers as well as mobile network operators to persuade them to exclusively pre-install Google Search on their devices. Again, this has the effect of denying competing search devices a toehold in the market.

Incidentally, none of these arguments is novel or without merit. The European Union has before it instances where similar issues played out to the detriment of dynamic efficiency in other markets. For instance, in its dealings with PC manufacturers in the early 1980s, Microsoft used a seemingly innocuous pricing approach to ensure that manufacturers had no incentives to install a rival operating system. This led to Microsoft achieving a near-monopoly position that has lasted to this day. Moreover, Google itself has demonstrated how keen it is to preserve its ability to collect data through its search engine. It has used its dominant position to ban the privacy app called Disconnect from its Play Store since the app can shield users against invisible tracking tools. Through its anti-fragmentation agreement, Google can probably ensure that the privacy app does not get any traction in the market.

How Google Should Respond

Based on Microsoft’s experience with European Union in the context of its browser and more recent decisions that the European Union has made with respect to other firms in the context of mergers and acquisitions, it is unlikely that Google will prevail in the E.U case if its persists with its present arguments.  Google, however, could argue that one of the E.U. assumptions about competition is flawed.

E.U. authorities claim that Android is dominating the mobile OS market. While it is true that Google is dominating the OS market, OS is only one part of several ecosystems in the digital universe. For example, in the home-automation market, Amazon, Apple, Google, and Microsoft are all competing for market share. The OS layer is only a small part of the overall solution. The conversational layer (functional layer of the stack that allows consumers to talk to machines and execute commands) is currently dominated by Amazon and Apple. There are thousands of such ecosystems, and Google is certainly not dominating all of them.

Google is one of the digital titans, a group that includes, Alibaba, Amazon, Apple, Baidu, Facebook, and Tencent. These companies use their digital superiority to participate in countless ecosystems by investing in RD, developing partnerships, or by using APIs in shrewd and unexpected ways. In doing so, they may dominate one market and, at the same time, be a new entrant in a different market. They apply their data assets, algorithms, third-party developers, and managerial and engineering talent across multiple ecosystems.

We live in a world where companies compete by being part of an ecosystem, a world where the winners can change at any time because there are always newer, shinier, and more innovative solutions in the works. Regulators are making a mistake by simply looking at one ecosystem and declaring Google the winner. That is like declaring a Super Bowl winner based on the team that scored the most points in the first quarter of the season opener! This approach doesn’t account for adjustments and improvements made by the opposing team or by future opponents.

Note how this argument takes EU’s dynamic efficiency concerns and turns them around. The key question to ask is this: Do we seek to preserve dynamic efficiency at each ecosystem separately or do we seek to preserve it at the intersection of multiple ecosystems? There are no easy answers to this question. Still, it will have the effect of making the E.U. competition authorities to think more deeply and give Google an out.

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