Network effects in two sided markets: challanges in merger regulation

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Network effects in

two-sided markets 2012.12.17. Challenges in merger regulation

Central European University

Term paper for the course Competition policy: Economics in Applying European Competition Law

Author: Bertalan Papp

Summary

In my paper I present the underlying economic theory of two-sided

markets and its implications to the assessment of mergers involving

indirect network effects. The major case of the Google/DoubleClick

merger raised a particular concern regarding the potential non-

horizontal foreclosure of competitors, an allegation which was

grounded in two-sided market theory. Despite the sound theoretical

substantiation of the concern, the competition authorities involved (the

EC and the FTC) eventually cleared the case. The case nevertheless

provides a fine example of how the two-sided nature of a market may

alter the tools required for proper competitive assessment. As an

aggravating factor, this nature was taken into proper consideration by

the authorities; however they concluded that the necessary conditions

for it to become harmful were not fulfilled.

Table of contents

I. Introduction .................................................................................. 1

II. Two-sided market theory .............................................................. 2

III. Google/DoubleClick merger ........................................................... 5

Online advertising industry structure ................................................... 5

Competitive environment ................................................................... 8

Theories of harm .............................................................................. 9

The role of network effects ............................................................... 10

Merger assessment .......................................................................... 11

IV. Conclusion ................................................................................. 13

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I. Introduction

The Google/DoubleClick merger was the first major case of concentration

subsequent to the European Commission’s adoption of Non-Horizontal

Merger Guidelines. It covered horizontal, vertical and conglomerate merger

effects also. Following a thorough investigation at the same time and in

cooperation with the Federal Trade Commission, the EC has cleared the

merger arriving at the same conclusion as the FTC, i.e. the merger is

unlikely to significantly impede competition on the online advertising market.

Among some other concerns, the case raised the particular question of

unilateral non-horizontal merger effects. Potential foreclosure either in the

ad serving or the ad intermediation market, stemming from indirect network

effects internalized by the merged entity, may restrict competition and

enable the merged entity to raise prices above competitive level to the

detriment of consumers. The assessment of these levels however must

depend on firm consideration of the proper relevant market on which the

infringement might occur, a requirement that is difficult to fulfill in dynamic

markets like online advertising and internet publishing content.

The market definition must provide solid grounds for the theory of harm, in

particular because of the further analytical difficulties arising from the two-

sided nature of the market. Unless these difficulties are addressed with well-

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suited theories and the methods based on them, the outcome of the

investigation eventually might harm consumer welfare and allocative

efficiency.

The paper focuses on the potential exclusion strategies the merged entity

might use to raise rivals’ cost, thus barriers to entry or expansion by

leveraging market power from the ad serving markets to the market of ad

intermediaries, or vice versa. The resulting foreclosure might tip the market

toward monopolization due to indirect network effects. There are three main

conditions for this to happen, which were extensively analyzed and finally

dismissed by the authorities. Section II provides a brief overview of two-

sided market theory; Section III summarizes the Google/DoubleClick merger

case according to the authorities’ investigation with a focus on the role of

network effects in merger assessment; and Section IV concludes.

II. Two-sided market theory

In the following I give an outline of the economics of two-sided markets in

order to provide a theoretical background for the subsequent review of the

competition policy analysis. According to the general definition we can

identify a two-sided – in general terms multi-sided – market by the

particular characteristic of having at least two separate groups of

consumers, whose utility associated with the usage of the platform that

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connects them is positively affected by the presence of consumers on the

other side of the market (see Rochet – Tirole, 2003; Roson, 2005; Evans –

Schmalensee, 2005; Armstrong, 2006). Put it simply, the groups provide

each other with network benefits. Due to these indirect network externalities

their demand and consumption not only depends on the internal

characteristics of the product, but also on their valuation of the other group’s

extent. The markets with network externalities present are mostly organized

by such platforms that enable two sides to interact with each other.

An important consequence of this market structure is that the price set to a

respective group influences both the demand of the consumers directly

concerned, and the demand of the consumers at the other side of the

platform who face a separate price. This character of the pricing decision

results in a unique optimization problem for the owner of the platform, who

sets the respective prices: beside the level of prices, their relative size, that

is their structure also matters in “getting both sides of the market on board”

(Rochet – Tirole, 2003).

Competitive prices of platforms therefore – even in theory – might diverge

from marginal costs, taking on zero or even negative values. The evolution

of price structures is rather determined by the own-price elasticity of the

consumer groups, and the underlying direction and effect of indirect network

externalities conveyed in these elasticities (Evans – Schlamensee, 2005). As

a consequence, pricing strategies may result in a disproportionately higher

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price set to the group with the relatively lower price elasticity (profit center).

This higher price however only ensures the presence of the other group with

the relatively higher elasticity (loss leader), by at least in part paying for

their usage of the intermediary platform (Rochet – Tirole, 2003).

From a competition policy point of view, network effects and two-sided

markets are particularly interesting, because the involved industries show a

tendency toward concentration (Evans - Schlamensee, 2007; Filistrucchi,

2011). Despite the economies of scale gained through concentration, a

merger may lead to higher market power and consequently a more

independent conduct, therefore higher price margins. It is not

straightforward to tell however, whether this is due to the increased demand

that is associated with a higher level of utility from consumption (which can

be derived both from the usage and the utilization of the platform, i.e. the

extent of the separate groups); or an exploitation of excessive market

power. The tools for market definition and competitive assessment therefore

must be tailored to the inherent characteristics of two-sided markets –

otherwise the investigation would possibly arrive at false conclusions (Evans

– Noel, 2007).

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III. Google/DoubleClick merger

Online advertising industry structure

In the following I draft the industry structure for online advertising in time of

the merger, based on the information that the investigation of both the

Federal Trade Commission and the European Commission has revealed

(Baye et al., 2008; Brockhoff et al., 2008, European Commission, 2008;

Federal Trade Commission, 2008; RBB, 2008). As the two authorities’ final

verdicts were in harmony, based on their jointly concluded evaluation I

present not only the industry structure, but later its performance and the

merger assessment also.

Online advertising is assumed to constitute a different market from

advertising in other types of media due to its unique level of targeting

efficiency. The industry consists of providers of advertising space, i.e. online

publishers, and the advertisers, who – possibly alongside with other offline

types – purchase online ad space to reach consumers (see Figure 1 for an

outline of the industry structure). Google is a major provider of online

advertising space, who also provides online advertising intermediation

services, therefore is deemed as an integrated publisher. At the time of the

merger DoubleClick was a leading provider of standalone advertisement

serving technology: a service, which ensures that the advertising appears in

compliance with the agreed upon terms on the purchased space. Ad serving

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has an additional parallel function: advertiser-side and publisher-side

services provide the customers of ad service with the measurement and

tracking of information, i.e. the monitoring of the performance of the

advertisement.

Online advertisements however are rather differentiated: the two broad

categories are simple text ads and display ads. There is differentiation also

with regards to the targeting of the advertisement: it can be put to place

based on search queries; according to the context of the publisher

environment on which it appears; the targeted user’s behavioral track

Figure 1. Online advertising industry structure

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record; or other characteristics like geographic location or the actual time.

Google specializes in text ads targeted according to search queries on its

search platform and contextual targeting of text ads on third party

publishers sites. DoubleClick on the other hand typically provides ad serving

technology as an input for the placement of display advertisements.

Not only advertisements but the advertisement space available is also

differentiated by its quality, and consequently by its distribution channel: the

more valuable online space of large publishers, i.e. the premium inventory is

usually distributed directly and mostly without the intermediation of ad

networks, while the less valuable, i.e. remnant inventory is usually sold

through these intermediaries. Beside ad networks acting as distribution

channels, ad services acting as tools are also different according to the type

of the advertisement: display ads require differentiated service technology

relative to simple text ads.

The substitution between these differentiated forms of advertising is

assessed to be limited, therefore separate markets for text and display ads

are suggested. It is more so, because a significant part of online advertising

sales is attributable to large publishers (premium inventory) and is

contracted directly with large advertisers. Only the remaining part of

advertising space (remnant inventory of large publishers or small publishers’

ad space) is made use of through ad networks. The exact market definition

however was eventually left open by the EC, mainly due to the relatively

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new and dynamically developing industry context. On the other hand the

FTC concluded that both search ads and non-search ads, and direct sales

and intermediated sales are constituting a separate relevant market

respectively. As for geographic markets the advertising market is nationally

and linguistically limited, while the two-sided market for intermediation is

concluded to be at least Europe-wide.

Although Google and DoubleClick were not direct competitors due to these

differentiation considerations and the limited nature of substitutability, at the

level of distribution, Google competes with such intermediaries to which

DoubleClick’s ad serving technology is an input.

Competitive environment

Google is an integrated player in the online advertising industry, possessing

its own advertising intermediation network (AdSense/AdWords) that

provides search and contextual ad services to purchasers of Google’s

advertising space and also for other advertisements. The main competitors

of Google’s leading position in online search advertising are Yahoo! and

Microsoft. On the market for intermediation these companies has active own

subsidiaries.

DoubleClick is the leading provider of ad serving technologies. Its main

competitors are aQuantive/Atlas (advertiser side), 24/7 Real

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Media/OpenAdStream and AdTech/AOL (publisher side). These companies

are concluded to exert effective competitive pressure, supported by

historically present switching propensity and declining prices in spite of the

increasing demand.

Theories of harm

Although there were various concerns raised related to horizontal merger

effects, the investigation concluded that the parties were not engaged in

direct competition and did not impose any significant competitive constraint

on each other pre-merger. As the focus of my paper is on indirect network

effects arising from the two-sided nature of the market, I leave the

presentation of horizontal effect assessment and concentrate on non-

horizontal effects. Non-horizontal merger effects may include the foreclosure

of rivals by constraining access to key competitive assets. By raising costs

directly to those customers who use DoubleClick’s advertiser- or publisher-

side services; or indirectly to intermediary competitors of Google’s AdSense

platform, the merged entity might be able to restrict or exclude competitors.

As for the direct price increase, concern were raised that a potential increase

in either the publisher-side or advertiser-side service of DoubleClick would

raise the cost of selling or purchasing display advertising space, so that

advertisers or publishers may switch from display to text advertising,

therefore the usage of Google’s integrated product. Another possible way of

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leveraging market power from one market to another is to offer bundled or

tied services of AdSense and DoubleClick. As a consequence consumers of

DoubleClick would at least in part switch from intermediary competitors to

AdSense. These theories of harm however were explicitly depending on the

presumption of the significant market power of DoubleClick that can be

leveraged to the intermediary market.

The role of network effects

To all articulated theories of harm, there was a severe aggravating factor

underlying, which had to be analyzed extensively in the course of the

investigation; namely the impact of network effects. Due to the presence of

indirect network externalities in the two-sided intermediary market the

above outlined restrictions to competition may induce a tipping effect. As the

success of a platform is mainly driven by the extent of the respective groups

to which it provides access, it enables the merged entity to raise rivals’ cost

by depriving them of this access, and therefore of the ability of performing

an intermediary function that could compete with the quality of Google’s.

This is so because both publishers and advertisers appreciate the increased

probability and expected value of the matching provided by the intermediary

platform. The barriers to entry and expansion constituted by the attractive

potential of a network stem from the critical size of the network. In turn it

would result in a potential to raise prices unilaterally. This effect might

eventually marginalize competing platforms as a result of the concentration,

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leaving Google with the dominant position in the market for intermediation

and sale of search and contextual advertising.

This theoretically plausible presumed tipping effect however depends on the

ability and incentives of the merged entity to engage in a unilateral price

increase or certain exclusionary strategies. The profitable and effective price

raise is dependent on three main factors: (i) the presence of effective

competition in the display advertisement service market and the associated

market power of DoubleClick; (ii) the extent of network externalities

prevailing in the market for advertisement intermediation (iii) the price share

of display ad service in total cost of display advertising and the closeness or

distance of substitution between display and text advertising.

Merger assessment

The proposed theories of harm are refuted mostly based on these factors. As

revealed by the investigation, there is effective competition constraining the

conduct of DoubleClick in the ad serving market. Both entry and competition

exerts sufficient competition constraints to leave no potential for the merged

entity to increase its prices. The theory of harm in two-sided markets also

raised the question of single- or multi-homing behavior of the publishers’

and the advertisers’ group. In case single-homing is typical among

costumers, intended foreclosure succeeds with higher probability due to the

higher switching costs. It is crucial therefore in assessing potential

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foreclosure and the resulting monopolization to investigate whether

participation in either of the two markets is exclusive or binding. The

authorities’ investigation revealed that in case of intermediary services multi-

homing is more typical as there are no significant initial fixed costs attached

to joining another ad network. Therefore it is implied that consumers are

both able and willing to participate in more than one intermediary service,

moreover they have already demonstrated to do so. In the presence of

multi-homing, the indirect network effects – coming from the large extent of

a customer base either on the publisher or the advertiser side – are

alleviated; thus Google becoming the dominant player due to the

concentration, and gaining ability to foreclose intermediary competition is

deemed to be unlikely.

Incentives to foreclose are also concluded to be limited due to the fierce

competition constraints exerted by alternative advertisement service

solutions. Although the price of ad serving represents a substantial part of

intermediation costs, the investigation revealed that ad serving and

intermediation together constitute only a small share of the total advertising

costs of advertisers and also of the total advertising profits of purchasers.

Therefore even a relatively large increase in the price of ad serving would

only lead to negligible alteration in advertising consumption, be it a diversion

from display to text advertisements or the diversion within text

advertisements from one intermediary network to another.

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IV. Conclusion

It was the explicit aim of Google’s acquisition of DoubleClick to attract

additional publishers and increase the sales of its intermediary platform

AdSense through the better utilization of their remnant advertisement space

inventories. This however, is only the consequence of a business rationale

driven by strong economies of scale and synergies stemming from indirect

network effects. This would possibly give way to pro-competitive effects in

form of lower prices or improved quality of the intermediation service. The

question from a competition policy point of view therefore was whether the

merged entity became able to foreclose its competitors through leveraging

market power from the ad service market; and would this conduct have

anti-competitive effect outweighing the potential pro-competitive gains.

Owing to the two-sided nature of the intermediary market, the investigation

had to take account of unconventional considerations: intermediary services

were deemed to be prone to tipping into monopolization. In case of strong

evidence was found on both the ability and incentives of the merge entity to

engage in anti-competitive foreclosure, this would aggravate the impact a

conduct that would enhance the market power of Google’s AdSense by

raising rivals’ costs. The risen theories of harmed however relied on strong

assumptions regarding the market power of DoubleClick on the ad serving

market, i.e. the level of switching costs; the incentivizing effects of indirect

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network externalities and the significance of the share of costs attached to

ad serving and intermediation within total advertising activity.

As a result of a thorough investigation taking account of the special two-

sided nature of the market the authorities concluded that DoubleClick was

not in a position to substantially exercise its market power as the switching

costs were assessed to be sufficiently low, while ad serving represented only

a small share of total advertising costs. As for the indirect network effects,

the presence of a typical multi-homing behavior alleviated the potential to

monopolize the intermediation market through the tipping as a consequence

of the concentration in question. The final verdict concluded that these

above factors render the merger unlikely to restrict competition to the

detriment of consumers, while providing an instructive example of the role of

network effects in merger assessment.

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