Introduction

The beautiful hills of Fiesole, above the Italian city of Florence, house the Florence School of Regulation, in the same villa where Boccaccio wrote the Decamerone seven centuries ago, where the ideas of a few Renaissance men transformed the world. Leaders in the telecoms, transport, and energy industries from all over the world regularly retreat to Fiesole with regulators, academics, and other stakeholders to discuss the regulation of the network industries. This is where we work.

Over the past years, digitalization has increasingly monopolized the debates in Fiesole. Excitement about the opportunities of the new digital technologies was mixed with apprehension about disruption by the new digital players. As professors at the Florence School of Regulation, we have witnessed the fear of the largest telecoms, transport, and electricity companies to be disrupted - or what we will later call “platformed” - by the new digital platforms.

This book builds on the debates at the Florence School of Regulation, as well as on the most solid currently available academic thinking on platforms in multi-sided markets, disruption, and, in particular, network theory. A favorite among academic economists is network effects, which are the effects that an additional user of a product has on the value of the product for the other users.

The traditional network industries are defined by network effects. Telephony provides the classic example: the value of a telephone network increases as the number of connected users increases. These are known as direct network effects. A network connecting just one user has a value of zero, while a network connecting all potential users reaches its maximum value. The same applies to all physical infrastructures: the more users share the infrastructure, the lower the cost of providing the service to each user, whether it is an electricity network, a railroad, or a postal network.

The first part of the book describes how digital platforms are also defined by the same network effects, even though this may not appear obvious from the outset. Platforms rely not only on the direct network effects identified in traditional network industries, but also on so-called “indirect network effects”: the value of a product increases for one user group when a new user of a different user group joins the network. You must have two or more user groups or sides to achieve indirect network effects, which is why these are also called two-sided or multi-sided markets. The classical example is advertising: an increase in the number of Facebook users increases the value of the product for advertisers.

Furthermore, digital platforms rely on what we call “algorithmic network effects.” Data play a fundamental role, as the interaction of the different sides in the multi-sided market is governed by algorithms that are fed with data. In turn, these algorithms improve as they are fed with more data to the point that they become predictive: based on the analysis of massive data from the past, algorithms are able to identify the most efficient complementarities between the different groups and users intermediated by the platform: In Uber’s words: “Our network becomes smarter with every trip.”

Analyzing digital platforms as network industries is not a mere academic exercise. In the following chapters, we will demonstrate how fortunes have been built by the small cluster of founders and investors in Silicon Valley that, very early and more deeply than others, understood the power of network effects in the internet era. Monetizing the network effects created by the internet was the explicit winning proposition of Thiel’s PayPal, Zuckerberg’s Facebook, and Kalanick’s Uber. It was also the reason why venture capital firms such as Sequoia, Draper, Fisher, Jurvetson, and Benchmark Capital invested in them: “We had an internal thesis that other industries might benefit from a network layer on top of them.”1 Creating a network on top of things and monopolizing value created by such a network is the winning strategy behind the digital platforms.

The first observation to be made is that platforms can grow network effect much faster if their algorithms coordinate the interaction of previously uncoordinated and fragmented assets. Platforms do not have the ambition of producing and owning the assets they coordinate. Their strategy is to identify the potential complementarities between assets, make these complementarities real, and extract the value created by such complementarities. In other words, they create a more efficient system (network) out of a formerly inefficiently organized and fragmented pool of assets. These new network industries, as we will also call these new digital platforms, can only be properly regulated if it is fully understood that platforms mediate between third parties to create value in the form of new network effects. They do not need to own the assets they coordinate. They are not the providers of the intermediated services. They coordinate. They are intermediaries.

The second observation is that this strategy will usually be disruptive for the traditional players, including the players in the traditional network industries (telecoms, transport, energy), in two very different ways. Platforms can substitute traditional players. Substitution can take place, as platforms create a digital substitute for a traditional physical service (like email for letter mail services). This is not very common, however. Substitution mostly takes place as platforms identify idle assets that can be coordinated in a new and creative form that substitutes a traditional product or service. This is the case of user-generated-content empowered by YouTube and Facebook substituting media, drivers empowered by Uber substituting taxis and so on. Traditional players are totally or partially substituted because they cannot compete with the platform and they become redundant. Of course, this is the worst nightmare for the CEO of a traditional company. Speak to a postal operator in order to understand what digitalization does.

A more subtle effect can be identified when the platform does not substitute the traditional players, but “platformizes” them. Digital platforms identify the specific assets, products, and services produced by the traditional players, they detect new complementarities and new forms to coordinate them, which creates more value than the value previously created by the traditional system coordinator. Traditional players are not made redundant. They are always necessary to produce and maintain the underlying infrastructures and services. Fiber optic cables will always transport data, trains will always transport people, and electricity grids will always transport electricity. However, platforms displace traditional network industries players in their most relevant, albeit less tangible, role: that of creating the network effects, which are the ultimate source of value in network industries. Platformization usually starts as platforms intermediate traditional services substituting the service provider in the direct relationship with the users. Platforms use technology to reduce transaction costs and empower users to navigate a complex and fragmented supply side. Platforms are increasingly displacing traditional players as system coordinators. Platforms do not merely act as neutral matchmakers between supply and demand, but they actively nudge demand to a specific service provided by a specific supplier. They have become the new editors of a newspaper potentially formed by all the news pieces in the world. They can become the organizers of the mobility system in a city. They might even organize the electricity system in a region. They have the potential to become the system coordinators as they select, as they prioritize, and as they have the power to shape the ecosystem around them.

The book then analyzes in detail how platforms create networks on top of each network industry: first communications, then transport, and finally energy. The platform strategy is taken to the extreme when the algorithms interconnect not just random assets and services, but assets that were already structured into a network - sometimes more than a century ago, as it is the case with telephony, railways, and electricity. Platforms are disrupting the network industries, both by substituting and by platformizing the traditional infrastructure traditional players.

The parallelisms between the old and the new network industries will be underlined. The stories of Mr. Vail and AT&T, Edison and General Electric, and the role of J.P. Morgan and the “morganization” of the US network industries will be presented. The objective is to extract lessons that will help us understand the strategies of the leaders of the new network industries today. Standardization, investment ahead of demand in order to build network effects and the pursuit of monopoly power can be identified in the new network industries, just as they worked a century ago in the traditional network industries.

Then, for each of the network industries, the most relevant digital platforms will be analyzed, always from the perspective of network theory: Hotmail, Skype, WhatsApp, YouTube, Amadeus, Uber, BlaBlaCar, Tesla, and so on. We will identify the complementarities exploited by the platform, the growth strategy to make network effects real, the ways to monetize the value created, and, finally, the disruption of the traditional players. Such an analysis reveals the pervasive relevance of network effects, the similarities in how platforms active in different industries have grown to relevance, and even the repeated presence of a short list of individuals and venture capital firms implementing the same business strategy. Such similarities justify a homogenous approach to the analysis of digital platforms.

We devote particular attention to analyzing the vertical relationship between platforms and the traditional players in network industries. We will see how such vertical relationships are often determined by regulation. As traditional players are heavily regulated, platforms can often piggy-back on existing regulation to force traditional players to engage with the platforms and have their services intermediated by them. However, as platforms are becoming larger and more powerful, thanks to their larger and more powerful network effects, there are growing calls for a review of the existing regulation and the definition of a level playing field for the competition between the traditional and the new players in the network industries. We will describe how this debate is evolving in each of the network industries, both in the United States and in the European Union.

Finally, the book concludes with the study of the regulation of the new network industries, and in particular the regulation of their market power. Our main argument is that platform regulation must build, and already is building, on the experience of the regulation of the traditional network industries, particularly the pro-competition regulatory model implemented over the past 30 years in the US and more vigorously in the European Union. This should not come as a surprise, as platform regulation faces the same fundamental challenge as the traditional network industries has over the past few decades: how to reconcile the benefits derived from the full exploitation of network effects, which lead to market concentration if not monopolization, with the benefits of competition.

The apparent conundrum between network effects and competition is not new. Back when the network industries appeared during the second half of the nineteenth century, particularly when telephony and electricity networks emerged, it took around 30 years to understand the dynamics created by network effects and to design the regulatory tools to harness them. The decision back then was to monopolize the industries, to exclude competition, and either to subject the monopoly to regulatory control (in the US) or simply nationalize it (in the EU and most of the world).

More insightful has been the approach after the 1980s and the liberalization and deregulation of the network industries. We now have 40 years of experience in the exploitation of network effects in competitive markets, thanks to pro-competition regulatory frameworks. The industries have been fragmented, both horizontally, as newcomers compete with the previous monopolist, and vertically, as infrastructures have been sometimes separated, unbundled, from the provision of services over them. This has been the case in aviation, road, and maritime transport, and has been imposed in the EU on the electricity and railway industries. Regulatory tools have been put into place to reduce barriers to entry, eliminate lock-in effects, and ultimately share network effects through interoperability and network access obligations, thus somewhat avoiding the pressure towards concentration. Regulation has been adopted for each network industry in order to address the specific market failures in a proportionate way, each time developing specific institutions and procedures.

Digital platforms raise similar challenges, as network effects always lead to market concentration: digital oligopolies or, in some cases, digital monopolies thanks to a winner-takes-all dynamic. This is a pervasive phenomenon in the platform economy. As Eric Schmidt, Google’s ex-CEO, put it: “All big successes in the Internet century will embody large platforms that get better and stronger as they grow.”2 Peter Thiel, the don of the so-called PayPal mafia, has exposed the situation even more bluntly: “Monopoly is therefore not a pathology or an exception. Monopoly is the condition of every successful business.”3

Authorities around the world, led by the European Union, are considering the adoption of a new regulatory framework to govern digital platforms. There is a role for antitrust authorities, and EU authorities in particularly are increasingly active on this front. But there is also a growing consensus around the idea that further regulation will be necessary. Antitrust fines will not modify the market structure. They will not increase competition. They will not modify the industry structure once an oligopoly or a monopoly has emerged. The experience of the pro-competition regulation in the traditional network industries shows the way. We propose considering the role of platforms as intermediaries, and imposing upon platforms more of the types of obligations which were traditionally imposed upon intermediaries. We believe that platforms act like what we call superintermediaries, which would recommend reinforcing such traditional types of obligations.

During the early days of the internet it was advanced that technology would create a utopia of disintermediated, non-hierarchical, peer-to-peer interactions between humans in commercial, political, and all other human relations. This was encapsulated in the “Declaration of the Independence of Cyberspace” issued in 1996: “We will create a civilization of the Mind in Cyberspace. May it be more humane and fair than the world your governments have made before.”4

Twenty years later, it has become obvious that reality evolved in a very different way. Effectively, the most fundamental effect of digitalization has been the creation of new forms of coordination of human activities. Algorithms enable new and more sophisticated forms for human beings and their organizations to interact with each other and with the world around them. In other words, algorithms support the creation of increasingly complex technological systems engaging a growing number of persons and organizations. Digital platforms are at the center of this transformation, and it is undeniable that they are creating major benefits for users and for society as a whole, as we will describe in this book. This is what lies behind the terminology and the theoretical framework developed by economists for the analysis of digital platforms. This is what lies behind network effects and multi-sided markets.

The power of traditional intermediaries and gatekeepers has certainly diminished, if not vanished. We will describe how the music record industry and newspapers lost their role as gatekeepers or system coordinators, while new gatekeepers - the digital platforms -have emerged, concentrating a previously unknown amount of power. Facebook has more advertising revenue than all newspapers in the world combined. It is expected that in 2021 Google will have more advertising revenue than all the TV networks in the world combined. The same evolution could be under way in transport and energy.

This evolution might have come as a surprise for Californian techno-optimists, but it was fully in line with the previous conclusions of scholars of large technological systems, namely the network industries. Sociologists and historians had already identified that “Inventors, organizers, and managers of technological systems mostly prefer hierarchy, so the systems over time tend towards a hierarchical structure.”5 Founders, investors and managers of digital platforms prefer a centralized hierarchical system that enables them to capture at least part of the value created by the different types of network effects. Building platforms requires large investments and certainly entails a large risk, but both have to be rewarded. Highly centralized platforms give an extraordinary power to their managers as system coordinators. A handful of platforms have a key role in the communications industries around the world, and the transport and energy industries might evolve in the same direction as platforms are in the position to grow larger network effects than traditional players. Being industries of general interest for the well-being of citizens and society, necessary for trade and even a preconditions for democratic participation, the regulation of the new network industries cannot be further delayed.

Notes

  • 1 Bill Gurley, Partner in Benchmark Capital, in Lashinsky, A. (2017). Wild Ride. Inside Uber’s Quest for World Domination. Penguin, New York, p. 102.
  • 2 Schmidt, E. & Rosenberg, J. (2014). How Google Works. John Murray (Publishers), London.
  • 3 Thiel, P. (2014). Zero to One. Notes on Startups, of How to Build the Future. Virgin Books, New York, p. 34.
  • 4 Barlow, J. P. ( 1996). Declaration of the Independence of Cyberspace, retrieved from www.eff.org/ es/cyberspace-independence
  • 5 Hughes, T. P. (1987). The Evolution of Large Technological Systems. The Social Construction of Technological Systems. New Directions in the Sociology and History of Technology. MIT Press, Boston, 2nd ed. 2012, p. 49.

Part I

 
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