The Antitrust Case Against Facebook, Google, -2-

Standard Oil and Co. and American Telephone and Telegraph Co. were the technological titans of their day, commanding more than 80% of their markets.

Today's tech giants are just as dominant: In the U.S., Alphabet Inc.'s Google drives 89% of internet search; 95% of young adults on the internet use a Facebook Inc. product; and Amazon.com Inc. now accounts for 75% of electronic book sales. Those firms that aren't monopolists are duopolists: Google and Facebook absorbed 63% of online ad spending last year; Google and Apple Inc. provide 99% of mobile phone operating systems; while Apple and Microsoft Corp. supply 95% of desktop operating systems.

A growing number of critics think these tech giants need to be broken up or regulated as Standard Oil and AT&T once were. Their alleged sins run the gamut from disseminating fake news and fostering addiction to laying waste to small towns' shopping districts. But antitrust regulators have a narrow test: Does their size leave consumers worse off?

That may not be true in the future: if market dominance means fewer competitors and less innovation, consumers will be worse off than if those companies had been restrained. "The impact on innovation can be the most important competitive effect" in an antitrust case, says Fiona Scott Morton, a Yale University economist who served in the Justice Department's antitrust division under Barack Obama.

Google which has spent the past eight years in the sights of European and American antitrust authorities, is hardly a price gouger. Most of its products are free to consumers and the price advertisers pay Google per click has fallen by a third the past three years. The company remains an innovation powerhouse, investing in new products such as its voice-activated assistant Google Home.

Yet Google's monopoly means some features and prices that competitors offered never made it in front of customers. Yelp Inc., which in 2004 began aggregating detailed information and user reviews of local services, such as restaurants and stores, claims Google altered its search results to hurt Yelp and help its own competing service. While Yelp survived, it has retreated from Europe, and several similar local search services have faded.

"Forty percent of Google search is local," says Luther Lowe, the company's head of public policy. "There should be hundreds of Yelps. There's not. No one is pitching investors to build a service that relies on discovery through Facebook or Google to grow, because venture capitalists think it's a poor bet."

There are key differences between today's tech giants and monopolists of previous eras. Standard Oil and AT&T used trusts, regulations and patents to keep out or co-opt competitors. They were respected but unloved. By contrast, Google and Facebook give away their main product, while Amazon undercuts traditional retailers so aggressively it may be holding down inflation. None enjoys a government-sanctioned monopoly; all invest prodigiously in new products. Alphabet plows 16% of revenue back into research and development; for Facebook it's 21% -- ratios far higher than other companies. All are among the public's most loved brands, according to polls by Morning Consult.

Yet there are also important parallels. The monopolies of old and of today were built on proprietary technology and physical networks that drove down costs while locking in customers, erecting formidable barriers to entry. Just as Standard Oil and AT&T were once critical to the nation's economic infrastructure, today's tech giants are gatekeepers to the internet economy. If they're imposing a cost, it may not be what customers pay but the products they never see.

In its youth Standard Oil was as revered for its technological and commercial brilliance as any big tech company today. John D. Rockefeller began with a single refinery in Cleveland in 1863 and over the next few decades acquired other, weaker refineries. Those that wouldn't sell, he underpriced and drove out of business. By 1904, companies controlled by Standard Oil produced 87% of refined oil output, according to Mike Scherer, a retired Harvard economist who has written extensively on antitrust.

This wasn't superficially bad for consumers. The price of kerosene, the principle refined product from oil, fell steadily as Standard Oil's market share expanded, thanks to falling crude oil prices and Standard Oil's economies of scale, bargaining power with suppliers such as railroads, and innovation, such as the Frasch-Burton process for deriving kerosene from high-sulfur oil in Ohio.

When the federal government sued to break up Standard Oil, the Supreme Court acknowledged business acumen was important to the company's early success, but concluded that was eventually supplanted by a single-minded determination to drive others out of the market.

In a 2005 paper, Mr. Scherer found that Standard Oil was indeed a prolific generator of patents in its early years, but that slowed once it achieved dominance. Around 1909 Standard's Indiana unit invented "thermal cracking" to improve gasoline refining to meet nascent demand from automobiles, but the company's head office thought the technology too dangerous and refused to commercialize it. After the Indiana unit was spun off when the company was broken up in 1911, it commercialized the technology to enormous success, Mr. Scherer wrote.

The story of AT&T is similar. It owed its early growth and dominant market position to Alexander Graham Bell's 1876 patent for the telephone. After the related patents expired in the 1890s, new exchanges sprung up in countless cities to compete.

Competition was a powerful prod to innovation: Independent companies, by installing twisted copper lines and automatic switching, forced AT&T to do the same. But AT&T, like today's tech giants, had "network effects" on its side.

"Just like people joined Facebook because everyone else was on Facebook, the biggest competitive advantage AT&T had was that it was interconnected," says Milton Mueller, a professor at the Georgia Institute of Technology who has studied the history of technology policy.

Early in the 20th century, AT&T began buying up local competitors and refusing to connect independent exchanges to its long-distance lines, arousing antitrust complaints. By the 1920s, it was allowed to become a monopoly in exchange for universal service in the communities it served. By 1939, the company carried more than 90% of calls.

Though AT&T's research unit, Bell Labs, became synonymous with groundbreaking discoveries, in telephone innovation AT&T was a laggard. To protect its own lucrative equipment business it prohibited innovative devices such as the Hush-a-Phone, which kept others from overhearing calls, and the Carterphone, which patched calls over radio airwaves, from connecting to its network.

After AT&T was broken up into separate local and long-distance companies in 1982, telecommunication innovation blossomed, spreading to digital switching, fiber optics, cellphones -- and the internet.

Just as AT&T decided what equipment could be used on the nation's telephone systems, Google's search algorithms determine who can be found on the internet. If you searched for a toaster online in the mid 2000s, Google would probably have taken you to comparison shopping sites such as Nextag. They pioneered features such as showing consumer ratings in search results, how popular a product was and how prices had changed over time, recalls Gary Reback, an antitrust lawyer who represented several competitors against Google.

But when Google launched its own comparison business, Google Shopping, those sites found themselves dropping deeper into Google's search results. They accused Google of changing its algorithm to favor its own results. The company responded that its algorithm was designed to give customers the results they want. "If consumers don't like the answer that Google Search provides, they can switch to another search engine with just one click," executive chairman Eric Schmidt told Congress in 2011.

At that same hearing Jeffrey Katz, then the chief executive of Nextag, responded, "That is like saying move to Panama if you don't like the tax rate in America. It's a fake choice because no one has Google's scope or capabilities and consumers won't, don't, and in fact can't jump."

In 2013 the U.S. Federal Trade Commission concluded that even if Google had hurt competitors, it was to serve consumers better, and declined to bring a case. Since then, comparison sites such as Nextag have largely faded.

Last year the European Commission went in the other direction and fined the company $2.9 billion and ordered it to change its search results.

The different outcomes hinge on whether reduced competition is seen as natural and benign, or deliberate and malign. In new industries, smaller players are frequently bought up or vanquished by deeper-pocketed, more-innovative rivals. Google's general counsel, Kent Walker, wrote in response to the European Commission decision that even as smaller sites have retreated, Amazon has grown to become a huge player in comparison shopping. Internet platforms have high fixed and minimal operating costs, which favors consolidation into a few deep-pocketed competitors. And the more customers a platform has, the more useful it is to each individual customer -- the "network effect."

But a platform that confers monopoly in one market can be leveraged to dominate another. Facebook's existing user base enabled it to become the world's largest photo-sharing site through its purchase of Instagram in 2012 and the largest instant-messaging provider through its purchase of WhatsApp in 2014. It is also muscling into virtual reality through its acquisition of Oculus VR in 2014 and anonymous polling with its purchase of TBH last year.

What Facebook doesn't acquire, it copies. Snap Inc.'s Snapchat, a fast-disappearing photo and video sharing app hugely popular with teenagers, was widely seen as a challenger to Facebook. But in 2016, Facebook introduced its own Snapchat-like feature, Stories, on Instagram, which now has more users and advertisers than Snapchat. That has undercut Snap's growth and profits by reducing the number of new users "interested in trying Snap for the first time," says Peter Stabler, an analyst at Wells Fargo.

There's nothing wrong with copying, especially if the copy is better than the original. Snapchat's app was originally difficult to use, says Mr. Stabler, and "you can't discount [Facebook's] quality of execution." Moreover, even as Facebook copies its competitors, it continues to expand and enhance its own services such as Pages, which 70 million businesses world-wide have used to design their own webpages on Facebook.

Snap's shares have sunk below the price at which the company went public last March as losses have mounted, which won't encourage new entrants. Once a company like Google or Facebook has critical mass, "the venture capital looks elsewhere," says Roger McNamee of Elevation Partners, a technology-focused private-equity firm. "There's no point taking on someone with a three or four years head start."

Amazon hasn't yet reached the same market share as Google or Facebook but its position is arguably even more impregnable because it enjoys both physical and technological barriers to entry. Its roughly 75 fulfillment centers and state-of-the art logistics (including robots) put it closer, in time and space, to customers than any other online retailer.

The company says size makes it possible to deliver millions of items free of shipping charges to isolated communities with little retail presence. Amazon makes that network available to third-party merchants who pay a 15% commission and, typically, a $3 pick-pack-and ship-fee, says Greg Mercer, founder of Jungle Scout Inc. which advises third-party merchants how to sell on Amazon. "We have tons of examples of small entrepreneurial-type people who are really good at creating new inventions but have no idea how to distribute to the masses," he says. "They create products and Amazon can take care of the rest."

As the dominant platform for third-party online sales, Amazon also has access to data it can use to decide what products to sell itself. In 2016 Capitol Forum, a news service that investigates anticompetitive behavior, reported that when a shopper views an Amazon private-label clothing brand, the accompanying list of items labeled "Customers Who Bought This Item Also Bought," is also dominated by Amazon's private-label brands. This, it says, restricts competing sellers' access to a prime marketing space

Mr. Mercer says he doesn't see Amazon favoring its own products, and indeed his own firm helps merchants target profitable niches on Amazon. Nonetheless, he says many would prefer to sell through their own sites, but with so many shoppers searching first on Amazon, they feel they have little choice.

In the face of such accusations, the odds of regulatory action -- for now -- look low, largely because U.S. regulators have a relatively high bar to clear: Do consumers suffer?

"We think consumer welfare is the right standard," Bruce Hoffman, the FTC's acting director of the bureau of competition, recently told a panel on antitrust law and innovation. "We have tried other standards. They were dismal failures."

Still, Ms. Scott Morton notes, "the consumer welfare standard covers today and tomorrow," and the potential loss of innovation is something both the law and the courts can and have weighed in an antitrust case. The Justice Department sued Microsoft to protect an innovation, the internet browser, remained a potential competitor to Microsoft's monopoly over the user's interface with the personal computer.

What would remedies look like? Since Big Tech owes its network effects to data, one often-proposed fix is to give users ownership of their own data: the "social graph" of connections on Facebook, or their search history on Google and Amazon. They could then take it to a competitor.

A more drastic remedy would be to block acquisitions of companies that might one day be a competing platform. British regulators let Facebook buy Instagram in part because Instagram didn't sell ads, which they argued made them different businesses. In fact, Facebook used Instagram to engage users longer and thus sell more ads, Ben Thompson, wrote in his technology newsletter Stratechery. Building a network is "extremely difficult, but, once built, nearly impregnable. The only possible antidote is another network that draws away the one scarce resource: attention." Thus, maintaining competition on the internet requires keeping "social networks in separate competitive companies."

How sound are these premises? Google's and Facebook's access to that data and network effects might seem like an impregnable barrier, but the same appeared to be true of America Online's membership, Yahoo's search engine and Apple's iTunes store. All saw their dominance recede in the face of disruptive competition. If someone launched a clearly superior search engine, social network or online store, consumers could switch more easily than they could telephone or oil companies a century ago. Microsoft has long dominated desktop operating systems but has failed to extend that dominance to internet search or to mobile operating systems.

It's possible Microsoft might have become the dominant company in search and mobile without the scrutiny the federal antitrust case brought. Throughout history, entrepreneurs have often needed the government's help to dislodge a monopolist -- and may one day need it again.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

January 16, 2018 12:07 ET (17:07 GMT)