{Contribution to the ABC} Economics and Geo-Strategy of the Digital Economy: Internet at the Age of Empires


{ Published on the ABC on Friday 20 December 2013 > http://www.abc.net.au/news/2013-12-20/rizos-the-age-of-internet-empires/5168818 }

As 2013 is drawing to a close, across many sectors analysts will try to isolate defining trends and make sense of them. In Technology, ‘Data’ and Privacy’ issues are clearly at the front of the public mind: from the year-long teaser about Google Glass preparing us to upload more information to the cloud, to Edward Snowden’s revelations about the NSA spying program telling us why we shouldn’t. There is however a less obvious, yet more defining systemic trend underneath that topic: the fact that the experiment of a free Internet designed by hackers and tinkerers has now come to a new Age. An Age of privatised Empires, with significant geo-strategic consequences for those who will fail to understand this shift. In Australia for instance, this is the defining requirement to build a National Broadband Network (NBN) combined with the right policies that will allow domestic champions to emerge and defend the ‘national interest’ in this cyber era. And the same logic applies to Europe when negotiating with the hegemonic US technology giants.

Internet took off there nearly 20 years ago with the wide dissemination of Netscape, the first web browser. Among the founding myths of this new economy was the belief that it would do away with intermediaries placing buyers and sellers face to face. Far from disappearing, new overpowerful intermediaries have actually emerged. The likes of Google, Apple, Amazon, and Facebook are causing a real creative destruction, in the way articulated by the economist Joseph Schumpeter. A process which redefines trade, modes of distribution, balances of power, and the way value is distributed. This is a puzzle for policy makers and traditional incumbent businesses all around the world.

Barbarians at the gates

For two decades the Internet has been profoundly changing the economy. And this is only a beginning. In the G20 countries, the heart of the digital economy, operated by Information and Communications Technology (ICT) organisations, is about 5 % of GDP. But the digitisation of the economy now affects a much larger number of sectors: for instance the French have calculated that ¾ of their national production is affected.

This penetration is accomplished in two ways. Firstly by realising large productivity gains through the inherent efficiency of ICTs: across sectors, businesses have become more efficient thanks to electronic orders and billing, by monitoring their production. Secondly by a significant dematerialisation of most of the value chain: entire parts become redundant because of digital processes. Just think that today you can book a flight and check-in from your mobile phone, making the role of travel agents totally redundant. In turn, advertising, tourism and the cultural industries have seen their business model deeply challenged by this digitisation.

For each sector that the digital world “cannibalises”, the modus operandi is similar: ‘barbarians’ from the Internet enter the value chain at a strategic point in direct contact with the consumers, and use the data they collect from regular and systematic monitoring of people’s activities to gain market share and cause a gradual transfer of the margin in their favour.

This is exactly what Amazon did through the power of its recommendation system built from a detailed analysis of the behaviour of its users, and a very aggressive pricing policy. This distributor shipping books from warehouses has become hegemonic in the sale of cultural products. With the spectacular consequence of putting out of business a plethora of brick and mortar players, from the small bookshop at the corner of the street, to the giant Border’s that filed for bankruptcy in the US in 2011 after its 500 stores and 20,000 employees lost the battle against online distribution.

The same happened with Apple. The couple formed by the iPod music player and the iTunes software has created a direct relationship with customers (and their bank details!). The company now dominates the online music market (2 thirds in the United States), to the point of having succeeded in imposing to record labels the prices at which they sell their songs. With the success of the iPhone and iPad, Apple is on the way to extend this rule to other producers of content, whether video or the press.

So, far from having materialised the ideal of a pure market allowing perfect competition – as its pioneers believed – the Internet has instead given birth to a juxtaposition of giant monopolies in separate market segments, which are often not in competition or only indirectly.

A winner takes all world

If the digital world tolerates so little of the competition, it is because of a specific law of its own: the network effect. The value of a good or service increases with the number of its users, even at the expense of short term profitability: the product is adopted by a critical mass of users, allowing a company to acquire a dominant position on a given market. This delivers a “winner takes all” outcome.

This is how Google has ended up dominating search, Facebook social network, YouTube video streaming, Apple online music, and Amazon e-retail.

Amazon is a fascinating case because it provides insights on how organisations achieve this. To establish its domination, the e-retailer has spent nearly 3 billion dollars between 1995 and 2003, mostly funded from its own cash-flow, before becoming profitable. Therefore, if the Internet is dominated by U.S. giants, it is not only because of the innovative spirit of the Silicon Valley they often come from, but also through unique financing facilities they benefit from. Since 1998, U.S. venture-capital firms have funded on average one digital start-up every 3 months which value has subsequently exceeded one billion dollars.

Faced with the consolidation of these monopolies, authorities responsible for enforcing competition often remained impotent. The weapon normally used by government are taxes, but they prove difficult to collect in the face of cross-border optimisation techniques deployed by those businesses. The problem also goes beyond the issue of “tax evasion”. It is illustrative of a disconnect between a ‘traditional’ regulation applied to business models it was not designed for. Those Tech giants have established their domination though services that are often free for users: Google’s search engine is free, so is Apple iTunes or the Facebook social networking software. They don’t generate direct revenues. Instead, those companies derive value in other ways, thanks to the data they collect, which allows them to sell advertising like Google and Facebook, or to become exclusive sellers of content on a locked proprietary system like Apple.

This complexity of supply underpinned by constantly evolving business models, which combine software, online services and new hardware, and which is always changing due to innovation, condemns the regulator to always be several steps behind. For example, it is only 12 years after the browser has killed its rival Netscape that the European Commission has obtained that Microsoft Internet Explorer is no longer installed by default on all computers running the operating system!

The insight is that in the last decade, the Internet has shifted from the free innovative market people still imagine. It has moved towards a juxtaposition of private empires. A situation that represents a systemic risk at a time where the number and scale of services we use from the online world has created critical dependencies. The geo-strategic stakes of the cyber age are often compared to nuclear during the cold war. Nations and businesses that find themselves relegated at the periphery of those new empires now need to operates all the levers they have – competition regulation , taxation, industrial policy, investment strategies – to preserve their chances to benefit from the next digital wave that will come with the Internet of Things, Big Data and Artificial Intelligence.

Download the PDF memo [link]:

Xavier Rizos – 15/12/2013 – Sydney


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