The Rise of the New Network Industries

Regulating Digital Platforms

Juan Montero, Matthias Finger

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000377323
• Edition: 1
• Topic: Economía
• Subtopic: Política comercial

Cutting through the confusion around the nature and implications of digitalization, this book explores the rise of the new digital networks, how they affect traditional infrastructure, and how they will eventually need to be regulated. The authors examine how digitalization affects infrastructures in telecommunications, transport, and energy, and how digital platforms establish themselves as a new network on top of and in addition to traditional ones.

Complex concepts are introduced through short and colorful stories about the founders of the most popular platforms (Google, Facebook, Skype, Uber, etc.) and how they grew to positions of power, drawing parallels with century-old traditional network industries' monopoly power (AT&T, General Electric, etc.). The authors argue that these digital platforms strongly interfere with traditional infrastructures that are heavily regulated and provide essential services for society – meaning that digital platforms should be considered as a new and much more powerful type of infrastructure and will require regulation accordingly.

A global audience of policy makers, public authorities, consultants, lawyers, students, and academics, as well as anyone with an interest in these digital platforms, will find this book enlightening and essential reading.

Part I

The Digitalization Dilemma in the Network Industries

Digitalization is disrupting the traditional network industries: communications, transport, and energy. As infrastructures are being digitalized, costs for the construction and operation of infrastructure are being reduced. Smart networks empower infrastructure owners to better manage their assets. However, digitalization also opens the door to more profound transformations.

Once an industry is digitalized, it can be disrupted by new players – the digital platforms – as they build new complementarities on top of pre-existing assets by making use of algorithms to manage the available data, whether they are generated by the company itself or not. Digital platforms build new network effects by coordinating the traditional industries in new and creative ways. We call this process “platformization.”

The network industries are being platformized as well. The infrastructures and services that are owned and operated by traditional players are increasingly intermediated by the new players in the data layer (the digital platforms) to create new and larger network effects on top of the network effects that had already been built by the traditional players in traditional network industries.

However, the ways in which network effects are built differ between the two cases. Traditional infrastructure players build network effects by pooling assets and services under one hierarchical structure that owns the infrastructures, provides the services, and coordinates them to fully exploit the complementarities among all these assets. The larger the scale, the larger the network effects, and the bigger the competitiveness of the operator. Digital platforms, by contrast, do not own the assets and do not provide the services, but merely identify the complementarities in the assets and services operated by third parties, subsequently aggregate them, intermediate them with the users, and coordinate the new ecosystem. Such aggregation, intermediation, and coordination is made in the data layer, using algorithms to exploit big data. Investment is necessary to create the network effects, but not as much as to build and integrate all infrastructure assets into one firm.

From an economic point of view, digital platforms exploit a new form of industrial organization that has been subsumed under the term “multi-sided markets.” As Silicon Valley platforms are disrupting traditional network industries, it is useful to have a better understanding of what a platform in a multi-sided market is. In this first part of our book, we will analyze some early examples of off-line platforms such as newspapers, payment cards, and videogame consoles, as well as how digitalization multiplied the relevance of multi-sided markets. We will analyze the rise of the digital platforms, particularly that of the leaders: Amazon, Google, and Facebook.

From there, we will follow with an analysis of the first cases of disruption in the music and newspaper industries. Platforms can disrupt traditional industries in different ways. We differentiate between disruption by substitution and disruption by “platformization.” There are cases of traditional players being substituted by platforms in the network industries (such as email substituting letter mail, platforms substituting traditional media, and Uber substituting taxis), but substitution is exceptional, as infrastructures are usually indispensable and platforms have no ambition to substitute existing infrastructure. On the contrary, they need the existing infrastructure, so disruption in the network industries mostly takes the form of what we call platformization. Digital platforms create their network effects on top of the pre-existing infrastructure assets and services that continue to be provided by the traditional players. These players are aggregated, intermediated, and coordinated in a new way in order to exploit new complementarities, thus creating new and larger network effects.

The risk of being “platformed” presents traditional players with the “digitalization dilemma.” Should they collaborate with platforms and offer their assets to be coordinated by the platforms in order to exploit the largest network effects possible and create new levels of efficiency, or should they refuse to work with the platforms in order to retain control of their assets and ensure that they can be properly funded and that their traditional public service objectives are met? In terms of regulation, this situation raises the question of how to deal with the new vertical relationship between traditional players and platforms.

Chapter 1

Digitalizing the Network Industries

Digitalization is transforming telecommunications, transport, and energy – the so-called network industries – but also all other infrastructures, such as water, buildings, and even green infrastructures, as it is transforming all other human activities. Sensors are being installed in infrastructures and data generated by such sensors are transmitted to the infrastructure managers, who can then use machine learning to manage infrastructures more efficiently.

Digitalization empowers infrastructure managers to reduce design, construction, and maintenance costs. Smart infrastructures are also more efficient, as they empower infrastructure managers to have a better control over supply and demand, controlling the load factor to make more efficient use of the capacity of the network.

At the same time, digitalization poses new challenges to infrastructure managers. Technology adds new costs and must be properly managed to deliver results. Customers are also empowered by the use of technology. Consequently, technology increases uncertainty, and it also generates new threats, such as in terms of security and privacy.

Most fundamentally, however, digitalization poses a threat to the position of the current infrastructure managers in the overall value chain. Digitalizing infrastructure paves the way for new data players, the digital platforms, and transforms the structure of the market. Network industries can now evolve into multi-sided markets, to be coordinated by the new data intermediaries. Digital platforms can use technology to become coordinators of infrastructure assets, in all network industries. As a result, traditional players could end up providing commoditized services as simple intermediaries to a digital platform, which will extract most of the value from the industry.

1.1 Network Industries

It is common to define telecommunications, transport, energy, and some other activities such as water and waste management, as network industries.¹ They all share common traits: relying on physical assets, usually referred to as infrastructures.² What is specific to network industries compared to other types of infrastructures such as buildings is that infrastructures in the network industries connect different points in space. Thus, physical assets in the network industries can be classified into two types: links and nodes. Links are the connections between two points, such as fiber-optic cables, rail tracks, air routes, electricity cables, or water pipes. Nodes are the points where links intersect, such as telecom switches, train stations, airports, transformers, or water pumping and cleaning stations. Assets are structured as a network, hence the term network industries.

Network industries require massive investment for the construction and maintenance of these infrastructures and such investments are usually sunk costs, as they cannot be recovered in case of market exit. They are also characterized by substantial returns to scale in production: the larger the scale of production, the lower the costs per unit. Although these are features can also be found in many other industries, network industries typically constitute an extreme example of sunk costs, also called asset specificity.

The physical assets in the network industries are used to convey different items. Telecom networks transport data encrypted in electronic signals. Transport networks convey passengers and goods. Energy networks convey electricity, gas, heat, hydrogen, and so on. Historically, the management of these networks and the provision of services on top of them were mostly bundled into a single organization, as it is typically the case in telecoms, rail, and electricity; in other network industries they were part of different organizations, as in air, road, and maritime transport. More recently, regulation, especially in the European Union, has come to impose a vertical separation (also called unbundling) between network infrastructures on the one hand and services on the other, such as in the case of electricity, gas, and railways. This has led to a distinction between an underlying infrastructure layer and a service layer on top of it.

Other than the management of the infrastructure and the provision of services, there is a third function in the network industries that tends to be overlooked. This is the role of coordinating the different elements of the network to make them complementary, a function that is often called “systems coordination.” Historically, the network industries were born from investments in isolated assets, such as a telephone line connecting a few houses, a rail track connecting two towns, an electricity system serving a factory or a tram company. Only over time were these proliferating fragmented assets coordinated into a network of complementary assets; in many parts of the world this was done through nationalization as part of establishing a nation-state’s essential infrastructures. This coordination role includes standardizing the infrastructures to make them interoperable and coordinating the services in the form of schedules, rate structures, and so on. This coordination role is sometimes formalized, such as in aviation, where, for security and national sovereignty reasons, the air traffic control function is assigned to a specific organization, the so-called air navigation service provider. In most cases, however, coordination occurs within the organization.

As the infrastructures and the services layers are being coordinated to make them complementary, the coordinated system exhibits increasing returns to scale in consumption, which are commonly called network effects or network externalities: the larger the scale of consumption, the larger the benefits per unit. In other terms, the value of the service is determined by the number of users.³ The relevance of network effects is the defining feature of the network industries and, as such, it is intrinsically dependent upon the successful coordination of the different elements that constitute the networked system. Thus, network effects are central to network industries.

It has been almost a century since economists identified the role of the firm as system coordinator. In 1937, in “The Nature of the Firm,”⁴ one of the most quoted economic papers in history, Coase explained that, “outside the firm, price movements direct production, which is coordinated through a series of transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-coordinator, who directs production.”The reason for this substitution is the high transaction costs in the market, which are mostly linked to poor information and uncertainty. The higher the transaction costs in the market, the larger the production that would be integrated and coordinated within the firm and the bigger the firm would become. Transaction costs were identified as the very reason for firms to exist.

Network industries might be the ultimate example of firms as system coordinators. In these industries, coordination was achieved by integrating the complex and often costly assets into a single entity under the hierarchical control of the entrepreneur-manager, so as to create scale but also network effects by making the optimal complementary use of the different elements of the infrastructure system. Furthermore, concentration ensured the full exploitation of economies of scale (in the supply side) and of the network effects (in the demand side). This is how the different network industries became (public) monopolies in most countries during the first decades of the twentieth century.

Regulation was adopted to foster scale and concentration. The very same institution of the corporation was made possible by the authorization to create legal persons and the adoption of sophisticated legislation to govern them. Capital accumulation was facilitated by new legislation on banking and stock-exchanges. Regulation was later adopted in order to govern the negative effects of industrial firms: antitrust rules to protect competition, sector-specific regulation to control monopolistic network industries, labor laws to govern the relationships between corporations and workers, consumer protection legislation, public service regulation, and so on.

In recent decades, two fundamental evolutions have taken place: globalization and liberalization in the network industries. In general terms, this model of industrial organization has been taken to the extreme by globalization, which ha...