RIETI Report September 2004

Multi-sided Markets and Japan's High-Tech Industries <RIETI Featured Fellow> Andrei HAGIU

Greetings from RIETI

Autumn, with its warm, sunny days and cool, comfortable nights, is a season of transition and arguably the most comfortable time of the year in Japan. From corporate governance to new market models for high-tech industry, this issue highlights how the winds of change are sweeping through the Japanese economy.

RIETI Report recently talked with Fellow Andrei Hagiu about the issue of multi-sided markets in Japan's computer-related industries and its implications for competition and intellectual property rights policy.

RIETI FELLOWS NOW

Andrei HAGIU
After completing his B.S. and M.A. in economics at the Ecole Polytechnique in Palaiseau, France, Dr. Hagiu completed his M.S. in economics and statistics at the Ecole Nationale de la Statistique et de l'Administration Economique in Malakoff, France. In 2004 he completed his Ph.D. in economics at Princeton University, writing his dissertation on two-sided markets. From 2000 to 2003, Dr. Hagiu worked as a consultant for National Economics Research Associates. His major works include "Optimal Pricing and Commitment in Two-Sided Markets"; "Two Sided Sponsored vs. Non-Sponsored Platforms, Variety of Applications and Social Efficiency"; "Monopolistic Competition in a Spatial Setting with Demand for More Than One Variety"; and "A Model of Lending to Odious Governments."

For a detailed biography, http://www.rieti.go.jp/users/andrei-hagiu/index_en.html

Interview

RIETI Report: Tell us a little bit about your academic background, research interests and how you came to work at RIETI.

Hagiu: I completed my B.S. and M.A. in economics at the Ecole Polytechnique in France and my economics Ph.D. at Princeton. My main research interests are industrial organization in high-technology industries, law, and economics, in particular competition policy and international trade. My theoretical research has been inspired by the exposure to real economic issues I have had during various internships with law and economics consulting companies and government agencies.

In 1999 I did a summer internship at the Financial Agency of the French Embassy in Tokyo, which sparked a passion for Japan and the desire to come here for a longer period of time. One of my academic advisors at Princeton recommended me to former RIETI Consulting Fellow Hidehiro Konno, who had informed him about the creation of RIETI by the Ministry of Economy Trade and Industry, and the Institute's interest in recruiting research fellows. Once I heard about RIETI, I designed one of my research projects on strategic use of intellectual property rights policy in an international context. Given my desire to work on intellectual property and international trade issues and in Japan, I could hardly have imagined a better opportunity. This is how I was able to join RIETI and the excitement of this perspective has greatly accelerated my Ph.D. dissertation work at Princeton. (I completed the degree in three and a half years.)

RIETI Report: Please tell us about some of your ongoing research projects.

Hagiu: I have recently completed a survey of the economic role of software platforms in computer-based industries with David Evans of LECG (Law and Economics Consulting Group) and Richard Schmalensee of MIT's Sloan School of Management. The survey examines industrial evolution and business models in industries such as computers, videogame consoles, personal digital assistants (PDAs), smart phones, communication networks such as "i-mode," and a few others.

We found some very interesting common features. As far as evolution goes, the majority of these industries started off with firms providing entirely integrated systems, before progressively "disintegrating" and reaching the structure we know today, i.e., revolving around multi-sided platforms, which compete for both users and producers of complements. For example, in the early days of computing, most companies would develop all of their hardware and software in-house and sell complete systems to users such as IBM's System/360 in the '60s and '70s. The advent of the PC marked a radical change: Apple, Microsoft, Sun, Novell, and others provide platforms, some pure software, some integrated with the hardware, on top of which myriad developers write applications. Another fascinating issue is pricing: all platforms we have surveyed make virtually all of their money from users, either through direct sale, or, indirectly, through license fees charged to hardware manufacturers; with one noteworthy exception: videogame console manufacturers, which have chosen to sell consoles below cost and which make profits through royalties charged to game developers.

RIETI Report: Much of your research focuses on "multisided markets." Can you explain what those are?

Hagiu: Basically, multisided markets are markets where firms must attract two or more groups of customers in order to succeed. The simplest illustration of this is matchmaking services. Obviously, to make money from a matchmaking service, it does no good to attract only men; you need women too. And you might need to offer incentives to one side - say, women - to create a functioning market. So, matchmaking services usually charge women less than they charge men.

There are many examples of two-sided industries: credit cards (consumers and merchants), securities exchanges (buyers and sellers), shopping malls (shoppers and stores), media platforms (advertisers and viewers) and, of course, all the platforms mentioned above. Interestingly enough, with the exception of videogame console makers, none of them charge software developers for the right to design compatible applications; in fact, they subsidize their work by hosting developer conferences, offering software development tools, and so forth. Rather, they make money from the end-users, who place more value on a platform the more applications it gives them access to.

By contrast, in the video games industry, companies like Sony and Nintendo actually sell consoles to the end-user below cost. They make their profits from the royalties game software developers pay for the right to run programs on their platforms. This is, to my mind, a very interesting empirical finding and I am currently working on providing a theoretical framework for better understanding how these industries work and for conducting enlightened public policy toward them.

NTT DoCoMo's i-mode is another good example of a multi-sided market. DoCoMo brings together mobile users and third-party content providers of various services (games, news, shopping, et cetera), and takes a percentage of the revenue generated. This creates a virtuous circle which economists call a "positive indirect network effect": the more services i-mode can offer, the more customers it draws, which, in turn, attracts more service providers, and so on. The huge growth of i-mode in Japan and the exploding worldwide popularity of smart phones as a way of accessing the Internet and other services show how powerful this business model is.

However, this type of two-sided platform also raises interesting competition policy issues, as illustrated by the lawsuits brought against Nintendo at the beginning of the 1990s regarding its strict licensing policies with respect to game developers and, more recently, similar complaints by would-be i-mode content providers, who allege that DoCoMo is restricting their access to users. A quick efficiency defense is, of course, the problem of quality: as a platform, you want to make sure people will not free-ride on the entire system's reputation by invading it with low-quality content, or games, or whatever the platform provides access to. This is another issue I am currently exploring in my research.

RIETI Report: Much of your work deals with competition policy. What are your thoughts on Japan's efforts to strengthen its antimonopoly law in recent years?

Hagiu: One striking feature in Japan is that its antitrust authority, the Fair Trade Commission, has traditionally been very weak. Whereas the U.S. Department of Justice's Antitrust Division has brought thousands of cases in the United States, Japan's FTC has launched maybe a couple dozen cases - since 1949.

Part of the reason for this is Japan's economic development model in the 20th century. The Japanese government is renowned for having engaged in a policy of selective industrial intervention. Many industries were dominated by cartels (originating in the well-known keiretsu), which were legitimized by the government (MITI in particular). Recent economic studies (most importantly an article published this summer by Professors Michael Porter and Mariko Sakakibara) have pointed out that the Japanese industries which were "cartelized" and in which competition was weak or nonexistent were in fact those industries in which Japan was not successful internationally. However, there is no denying that the very peculiar competition environment in Japan, combined with the strong tendency toward intervention by the government, has always been at odds with the basic principles of competition policy as articulated in the U.S., for example. The recent economic stagnation and the realization that old methods of spurring industrial development are no longer as effective as in the past have prompted Japan to be more concerned with competition issues, i.e., to give more power to the FTC to adopt and enforce principles of antitrust law similar to the ones used in the U.S. and the EU. This new trend is illustrated by a very recent proposal to revise the Antimonopoly Law.

A related aspect which I find fascinating is the way in which Japan's high-tech industries differ from those of other countries. For example, in spite of Japan's position as a worldwide leader in consumer electronics, the country has no stand-alone software industry to speak of. There is no equivalent of an Apple or a Microsoft in Japan. The main reason is the deeply-rooted keiretsu structure encountered in many industries here, which has led to insurmountable fragmentation. Virtually all software is produced internally and separately within each keiretsu: on the one hand, this has proven very successful in coming up with highly customized and efficient solutions for each business; on the other hand, it has resulted in inefficient duplication of efforts at the national level and a lack of common standards, which has hindered the rise of an independent software industry and thwarted well-intended initiatives by the METI to create common software platforms (the Sigma and Tron projects). Also, it does not help that workers tend to remain within one company or one group for their entire career so that there is no labor and technological mobility as in, say, Silicon Valley. The only exception is, of course, videogames.

It will be interesting to see how Japan's high-technology industries fare in the near future. Indeed, given the current trend towards convergence of various consumer electronics products, software platforms and the content they support tend to become more and more important and valuable, whereas it is more and more difficult to make money on hardware (the rise of other Asian competitors accelerates this process). Hence, it is not clear how Japan's economy can continue to successfully compete internationally without strong standards and platforms, rather than disparate products.

Perhaps sensing this problem, and despite its earlier failures in the software industry, METI has decided to try again, although in a very different way. It has just agreed to take part in an open-source software development consortium with China and South Korea. The stated goal of the project is to "reduce dependence on foreign software companies" and spur the development of internationally successful domestic software industries. Each side has its reasons for wanting to participate. For Japan and Korea there is the desire to involve large companies in the development of software: without the economies of scale that such large companies offer, it will be very difficult to get an Asian software industry off the ground. China, on the other hand - which for now seems to be the Asian leader in open-source - is a at a very different development stage and is seizing every opportunity to create successful and profitable industries; it is also trying to reduce its dependence on outsiders.

The challenge, of course, will be to come up with a profitable model for open-source software. Up to now, open source has worked best as a complement to traditional proprietary software. Nobody has figured out a way yet to make money solely from open-source. Where is the incentive to develop and commercialize a product without some sort of property rights (patents in this case)? This brings us to the key issue of intellectual property. On the one hand, Japan is very concerned about IP protection, especially in its economic relations with China; on the other hand, and somewhat paradoxically, it has agreed to cooperate with China in a project which, by definition, is not very IP rights-intensive. It will be very interesting to see how this economic partnership develops.

RIETI Report: Are there any other areas of research you are planning to pursue in the future?

Hagiu: There are so many things I would like to learn about on this side of the Pacific, I don't know if I will have time for all of them! One thing that interests me a great deal is the more general question of China's economic development and its impact on the region. I am hoping to start some informal discussion sessions with researchers from the Keidanren and RIETI that might lead to some interesting research ideas in this area.

**************

For your reference
Hot Issues "Information technology"
http://www.rieti.go.jp/en/special/hot-issues/categories/it.html

EVENTS INFORMATION

RIETI Policy Symposium Announcement*****

"Emerging Patterns of Corporate Governance among Japanese Firms - Converging to Any Specific Model?" October 20 (Wed.), 2004
For information, please see: http://www.rieti.go.jp/en/events/04102001/info.html

For a comprehensive list of past and upcoming RIETI events, see http://www.rieti.go.jp/en/events/index.html

Brown Bag Lunch Seminars

Coming Soon
==========
All BBLs run 12:15 - 13:45, unless otherwise stated.

9/30: Robert A. MADSEN, Senior Fellow, Center for International Studies, Massachusetts Institute of Technology
"Japan's Incipient Transformation"

10/06: NEMOTO Yoichi (Director, Regional Financial Cooperation Division, International Bureau, Ministry of Finance)
"Currency and Monetary Cooperation in East Asia"

BBL Reports
==========
"Japanese-Style-Management. Has It Survived? Will It Survive?"
Featuring a transcript of the speech delivered by Ronald DORE on September 8, 2004, and the Q&A session that followed
http://www.rieti.go.jp/en/events/bbl/04090801.html

For a complete list of past and upcoming BBL Seminars, see http://www.rieti.go.jp/en/events/bbl/index.html


Fellow titles and links in the text are as of the date of publication.

For questions or comments regarding RIETI Report, please contact the editors.

RIETI Report is published monthly.

This month's featured article

Multi-sided Markets and Japan's High-Tech Industries <RIETI Featured Fellow> Andrei HAGIU

Andrei HAGIU Fellow, RIETI

Event Information

For a complete list of past and upcoming event information.

Symposiums

Workshops

BBL Seminars

Fellow titles and links in the text are as of the date of publication.

For questions or comments regarding RIETI Report, please contact .

RIETI Report is published monthly.