Recent revelations of troublesome content at Facebook.

The disrespectful culture that pervades Uber.

Repeated charges from the European Commission against Google and Microsoft for anti-competitive practices.

These examples of corporate bad behavior are disappointing but unsurprising. Fundamental principles of economics dictate that companies with business models like Uber and Google are likely to quickly gain, keep, and probably abuse monopoly power. The only surprise is that we haven’t seen it more often.

And yet, Uber and Google are “platform” businesses. Their primary role is to efficiently connect people who want a service with people who can provide that service with their own equipment. The value they provide to each user is the reduction of coordination costs.

Platform businesses and the network effect

Imagine standing on a sidewalk, waving at private cars, hoping that someone is headed directly to your intended destination. You might need to talk to thousands of drivers over the course of several hours, just to find the right match for a short trip. Old-timers might remember this as “hitchhiking,” which required patience, courage… and lots of walking.

Uber collects current and intended locations from millions of riders and drivers to make these matches in minutes. And Google serves a similar function for people seeking websites on the internet and those hosting the pages.

A large number of eager riders in a particular neighborhood using the Uber service at any given time creates an incentive for more drivers to jump in their cars and offer their services. They know that they will have a better chance of providing a ride and therefore generating some revenue.

Similarly, more available drivers entice potential riders to use the Uber app because it’s likely that a willing driver is conveniently nearby. As a result of these incentives, the value that any single individual receives from the Uber service is related to the number of other people—riders and drivers—who are also using that service.

In economic jargon, this is the network effect.

 

“The value that any single individual receives from the service is related to the number of other people who are also using that service.”

The dark side of power

To appreciate the power of the network effect, consider most other consumable products or services. My enjoyment of my shoes, or coffee, or legal guidance, or dry cleaning services are entirely unrelated to the number of other people who are also purchasing these items.

Indeed, the theory of the network effect only began in earnest with the invention of the telegraph, whose value for each user depended on the number of other people on the same network of wires.

Yet there is a dark side to the network effect.

Once a company that harnesses the network effect has attracted a large number of users, it becomes immune to competition from new entrants. The only way for a startup company to persuade users to abandon the incumbent—and its existing network of users—and migrate to its own service, is to add many compelling extra features. This is an expensive path, typically out of reach for startups.

For this reason, companies that harness the network effect usually enjoy “first mover advantage.” Once they have built a network of users and allowed each user to gain value from the presence of other users, these incumbents gain a monopoly. And with monopoly power comes monopoly behavior, like higher prices and poorer service.

Customers are not the only people to feel these monopolistic pains. Employees, too, face the hubris of monopoly managers. Witness Uber.

 

“With monopoly power comes monopoly behavior, like higher prices and poorer service.”

The prize for supremacy

In most of its markets, Uber holds a monopoly position over ride-hailing. But in China, where it was clearly in second place, the company retreated and ceded business to Didi Kaudi, which was formed by a merger of smaller players in reaction to Uber’s entry.

In other markets, Uber still faces competition, from the likes of Lyft in U.S. cities, BlaBla in France, Ola in India, and Grab in Southeast Asia. Competition is fierce in disputed markets—with players losing millions of dollars every day—because the prize for supremacy is so large.

Some have claimed that Uber’s cultural problems stemmed from its history of flouting insurance and employment regulations. But that conclusion ignores economics.

The network effect and the first mover advantage are not confined to Uber or to ride sharing either. Five of the world’s most valuable companies harness the network effect: Apple with its operating systems, Alphabet with the Google AdWords platform, Microsoft with Windows, Facebook with social networking, and Amazon with its e-commerce platform.

All of these platform companies have monopolistic power due to the network effect. And if Uber and Airbnb eventually become publicly traded companies, they might soon invade this high-value list, too.

A losing battle?

Regulators have battled network monopolies for decades. They broke up Ma Bell. They harassed Microsoft over its exclusion of Netscape and Facebook’s “free basics” over fears of monopolistic practices.

As platform companies become more prevalent and powerful, regulators will be hard-pressed to observe and address anti-competitive practices. Particularly because consumers of these behemoths may also be deriving additional value through the expansion of user networks. After all, the network effect benefits customers and the firms that serve them.

“As platform companies become more prevalent and powerful, regulators will be hard-pressed to observe and address anti-competitive practices.”

Investors are unlikely to curb monopolistic abuses, since their companies can raise prices and profits at will. This neglect is exacerbated by the recent trend for platform startups to delay or avoid public listings in favor of private investment. Uber’s board has taken action in anticipation of a public listing and the additional scrutiny that engenders.

Disrupting the disruptors and curbing bad behavior

Two key avenues remain for keeping platform companies focused on enlightened management and customer service.

The first is the customers themselves, ironically amplified by platform companies in social media.

Reactions to Uber’s abuses were immediate and loud on Facebook and Twitter. However, these reactions were attenuated in markets with lower penetration of social media, and in markets where Uber has already secured dominance.

The second source of externally imposed discipline is competition—not from other platform companies, but from new technologies.

Just as smartphones with embedded GPS allowed Uber to bust the monopolistic practices of taxi cabs, a new generation of software tools called blockchain might automatically facilitate the connection between eager riders and drivers without the need for an intermediary company at all.

If customers object to the inevitably monopolistic practices of a successful platform company, they will soon be able to use a collection of distributed software agents that are not controlled by any one company at all. And the same technology might eventually transform internet searching and advertising.

One way to fix a culture of disrespect is to replace it with an entity that has no culture at all.

 

 


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