A theory of Google

Via Eli Dourado, this deserves to be quoted in full:

Why does Google give out so much cool stuff for free? I have a simple theory, based on the concept of double marginalization.

Double marginalization is pretty easy to understand. Imagine that people travel by boat down a river from point A to point B. There is nothing useful in between these points; the only point of going down the river is to get from A to B. Between A and B, the river is divided into two segments, each with a separate owner, each of which erects a toll booth. People who are considering going down the river make their decision to do so on the basis of the sum of the tolls. As a result, if the upstream owner raises his toll, it has a negative effect on the downstream owner in the form of decreased traffic and revenue.

If the downstream owner also owns the upstream segment, its profits will be more than the combined profits of the separate segment owners. In addition, under joint ownership, the total amount of tolls will be lower, so consumers of the river will be better off. But here is the key to understanding Google: if the downstream owner can destroy the upstream owner’s toll booth, it has the same effect as if he owned both segments. In either case, there is just one toll booth, and the amount of the toll is set to the profit-maximizing amount.

Think about the Internet as composed of two complementary goods, broadly defined: access and content. Assume, quite reasonably, that Google has some market power in content monetization. Other companies have market power in the access industry. When most people buy a computer, they pay the Apple or Microsoft tax (or both). To get online, you pay your local (usually monopoly) cable company. On your cell phone, you are locked into a two-year contract.

Content monetization is the downstream industry, and access is the upstream industry. Google doesn’t have to take over the upstream industry to increase its profits; it just has to destroy their toll booth. By disrupting complementary industries and making them more competitive, Google is increasing their profits in their downstream industry.

A lot of Google’s projects make sense when viewed from this angle. Google Docs is an attempt to reduce the Microsoft tax. Android is an attempt to reduce the Apple tax. Google’s participation in the spectrum auction a couple years ago (and lobbying of the FCC to require open access) was an attempt to reduce phone carrier market power. Google Voice is the next iteration of that attempt. Ditto for selling phones without contracts. Google Buzz is an attempt to disrupt Facebook’s market power. Google’s recent plans to build a fiber network is an attempt to go after local ISP monopolies.

The point is that Google doesn’t have to dominate any of these industries to be successful, provided that they dominate content monetization. They merely have to make these industries more competitive, lowering the barriers to consuming a lot of content online.

The broader lesson is that monopolies will provide public goods in complementary industries, meaning that they are not as economically harmful as a static analysis would suggest. This is something that policymakers and government agencies should keep in mind as they prosecute firms for antitrust violations.

First published Jul 6, 2011