Will the Digital Economy Change the Rules of the Game in the World Economy?

A central prerequisite for a functioning market economy is that there are many companies and many consumers. In this case, nobody has market power, which can be used to the detriment of others. The digital economy could change the situation. Special features in the cost structure and characteristics of digital goods can cause monopolies. The resulting superstar firms are able to increase their profits at the expense of consumers and employees.

Digital economy – what is it all about?

Digital goods in a digital economy are primarily software (including entertainment software), content (music, films, information goods), technologies for transmission in the communications market (e-mail, Internet, data transfer) and all consulting and services associated with these products.

New consumption concepts in the form of the “Sharing Economy” are associated with these goods. Here, consumer goods are shared by several users with the help of a digital network. Examples include ridesharing such as Uber, car-sharing networks and rental platforms. The “Sharing Economy” is therefore closely related to the concept of the platform economy. Electronic or digital platform markets are platforms that connect two or more groups of market players and enable market transactions that would have significantly higher costs without this platform.

From an economic point of view, digital products differ from conventional products in central aspects. This applies both to production technology features – and the associated cost structure – as well as to specific features in the use of these products.

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High fixed costs and low marginal costs

Digital goods and the networks required for their transmission are often characterised by high fixed costs. The construction of networks (e.g. telephone and broadband) is generally associated with very high initial costs. The development of operating systems and application software also involves high fixed costs. The duplication and delivery of a computer program, a CD or a piece of music, however, often takes place via a download and is therefore associated with very low or even no variable costs (cf. Varian, pp. 24-26). In extreme cases, digital goods can even be duplicated without additional costs. In this context Jeremy Rifkin speaks of a “Zero Marginal Cost Society” (cf. Rifkin).

With this cost constellation, an increase in production volume causes a decrease in average costs. As a result, the company offering the largest quantity has the lowest average costs and can therefore charge the lowest price. Economists speak of a natural monopoly in this case.

Network effects

Another special feature of digital goods and the platforms is their network character. In the case of products that have the character of network goods, the benefits for consumers depend on the size of the network. The more participants there are in a telephone network, a social network or an online exchange, the more attractive it is for people to join the correspondingly large network.

At the end of a competition, the company with the largest rail or telephone network or the largest number of subscribers wins out. The result is a “Winner-takes-all” market, on which only one company prevails. The result is again a monopoly.

Customer retention through high switching costs

The creation of market power and monopolies in the digital economy is further encouraged by the fact that companies can make it more difficult to switch to another supplier by increasing the costs of this switch. Switching costs can take different forms. For example, if registering with an online retailer requires a lot of information and is therefore time consuming, a user may stay with his retailer even if the desired product is five percent cheaper with another online retailer. If a PC user uses a particular application software that took him a long time to learn, he will not easily switch to another software, even if it is of higher quality and has lower running costs.

Customer retention through high switching costs is called the lock-in effect. In many cases, high switch-over costs prevent customers from switching to a product that is of the same quality and costs less. This can mean that competitors cannot establish themselves even though they have better products at better prices.

Why are monopolies a problem?

Monopolies are an economic and social problem for at least four reasons.

1. Monopolies demand higher prices because they have no competition. Higher prices lower consumer’s purchasing power and hence reduce consumption opportunities.
2. A monopolist, even as the sole buyer, has a market power with which it can lower the prices for inputs and wages. There are indications that the emergence of superstar firms such as Google, Apple, Amazon, Facebook and Uber is depressing wages or wage increases (cf. Autor et al. 2017, p. 25f.).
3. Without competition there is no need for a monopolist to improve the qualityof his products and to lower the prices of his products through technological progress. The central advantage of the market economy for consumers – an improved supply of products at lower prices – thus does not arise.
4. Economic power can become political power. Superstar firms play an important role as employers and taxpayers. This increases the likelihood that political decision-makers will listen to these companies and their partial interests.

Implications for economic policy

A key economic policy challenge is to prevent the exploitation of market power. The traditional instruments of antitrust policy quickly reach their limits.

• This starts with the definition of the relevant market: in order to determine whether a company has market power that intervention by the antitrust authorities is necessary, the relevant market must be defined geographically. However, this definition is difficult if the Internet ensures that the relevant market tends to be global.
• It also raises the question of who should tame global monopolies.
• Finally, a central instrument of competition policy, the dismantling of a natural monopoly, is no longer applicable. It would not make sense, for example, to divide Facebook into several providers for different regions, because this would eliminate the advantage of large numbers of participants.

Nevertheless, the problems must be solved. Otherwise, few global monopolies can increase their profits at the expense of consumers and employees.

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Literature

David Autor et al., The Fall of the Labor Share and the Rise of Superstar Firms, NBER Working Paper Series, Working Paper 23396. Cambridge, MA 2017 (https://economics.mit.edu/files/12979).

Rifkin, J.: Zero Marginal Cost Society, New York 2014.

Varian, H. R.: Economics of Information Technology, Berkeley 2001 (Revised: March 2003) (http://people.ischool.berkeley.edu/~hal/Papers/mattioli/mattioli.pdf).