Google, Motorola, and the effects of vertical integration

Lynne Kiesling

Yesterday Google announced its purchase of Motorola Mobility, the device manufacturing half of the former Motorola. Today’s Wall Street Journal has a front page full of stories about this move, including “Bid Comes Amid Tougher Scrutiny” (You know how to read this even though it’s subscriber-only, right? Do a search at a news aggregator for the article title.) Despite being a “new industry” technology merger, this transaction actually is grounded in a long history of the economics of vertical integration, and it may provide another issue for FTC and EU regulators to analyze as they pursue their respective antitrust investigations of Google.

According to the Wall Street Journal article,

Motorola doesn’t have a dominant position in handsets. Five years ago, it sold nearly one in five cell phones worldwide; today it has just a 2.4% market share, says researcher Gartner.

Google doesn’t directly compete with Motorola. Legally, it’s more difficult for the government to successfully challenge such a “vertical” deal between two companies that aren’t direct rivals.

In vertical mergers the dominant competition issue is called vertical foreclosure — when an upstream firm (Google in this case) merges with a downstream firm (Motorola Mobility in this case), does that merger enable the upstream firm to reinforce or extend its market power and market share? And if so, does that increased market power and market share benefit consumers or not? If there are significant economies of scope, then a vertically-integrated firm may enjoy substantially lower production costs than separate upstream and downstream firms (a related issue here is reducing “double marginalization” when the demand curve is downward-sloping in both upstream and downstream markets). Also, does the vertical integration economize on transaction costs — is there a Coase “Nature of the Firm” impetus for vertical integration to lower costs? If those are the merger drivers, then the merger can improve product quality and diversity and reduce prices in ways to benefit consumers, particularly if the downstream market is a rivalrous one. I would certainly describe the mobile device market as rivalrous!

But the vertical merger story is not all rosy and welfare-enhancing. What if the merger enables the upstream firm to leverage its upstream market power into higher downstream market power by reducing availability of its product to its downstream rivals? A more concrete example may be iron ore and steel; what if a dominant iron ore producer merges with a downstream steel firm, and reduces its sales of iron ore/raises prices to the other non-related steel mills? The vertically integrated iron ore-steel firm could increase its steel production by restricting its sales of iron ore to others, and the price of iron ore to independents may increase, which would increase the vertically-integrated firm’s market share in the downstream steel market, and may lead to higher steel prices to consumers. This is called vertical foreclosure.

The concern about vertical foreclosure with Google-Motorola Mobility is access to the Android operating system and updates to it. From the Wall Street Journal article:

On Monday, several handset makers that use Android publicly welcomed the deal. But privately, some may end up questioning whether Google will grant Motorola preferential treatment. For example, Google could theoretically give Motorola its latest versions of Android exclusively, placing them at a competitive disadvantage.

One way for the Justice Department to hold Google to its promise not to discriminate against Motorola rivals would be to seek to implement a so-called “firewall” between Google and its Motorola unit.

In exchange for not challenging the deal, the Justice Department might also ask Google to sign a consent decree legally compelling it to license Android to any comers on fair, non-discriminatory terms.

This issue is one reason that the FTC and the EU may incorporate this merger into their antitrust investigations of Google. For example, as quoted in a Huffington Post article on the merger:

Others were more concerned. Gary Reback, a prominent Silicon Valley antitrust litigator, who has become a vocal critic of Google’s business practices, said that the deal deserved to be closely scrutinized.

“You’re dealing with a company that is already a monopolist, that is already under investigation for allegedly anti-competitive behavior,” he said. “By buying this, they get a huge additional dose of market power.”

At the very least, the Motorola takeover bid provides federal regulators probing Google yet another reason to subject the company to scrutiny.

Mr. Reback clearly sees this as a move that would result in vertical foreclosure, but other economists and lawyers are not as worried about such foreclosure.

I don’t see the vertical foreclosure issue as being particularly problematic here. The mobile device market is very rivalrous, with hundreds of devices and at least four different platforms (Apple iOS, Android, Blackberry, Windows, etc.). It’s also an information-rich retail market, with a lot of consumers who choose Android over Apple because they appreciate the more open Android platform to Apple’s “walled garden” approach to OS and application development; if Google tries to restrict updates preferentially to Motorola devices, that restriction is likely to trigger such “anti-walled-garden” complaints in a way that will rebound negatively on Google. Furthermore, the role of the mobile device carriers (Verizon, AT&T, Sprint, Vodafone, etc.) changes the dynamic between the operating system owner and the device manufacturer, and may add some impetus to ensuring that non-Motorola devices get the same OS updates at the same time.

Rather, I tend to agree with the analysts who say that this move is Schumpterian platform competition on a different front: patents and the threat of patent lawsuits. Last week Apple managed to block release of the Samsung Galaxy tablet in Europe because of their lawsuit alleging Samsung’s violation of Apple patents. Google’s acquisition of a large set of Android device-related patents gives them a stronger bargaining position against Apple and Microsoft specifically:

The amount of money being spent now on patent armaments is staggering. Google will spend $12.5 billion to acquire Motorola. Earlier this summer, a consortium including Apple, Microsoft, and Research In Motion, bought 6,000 Nortel patents for $4.5 billion.

For the emerging patent superpowers–Apple, Microsoft, Google–the likely end result of this nuclear build-up could be a legal stalemate that may in fact free up the giants to maneuver on the product side. While every launch may carry with it a back-room patent agreement (I’ll agree to not sue you on patent X today if you agree to not sue me on Patent Y when I launch my new thing tomorrow), the balance of power could in, in a limited way, work in favor of innovation at the large companies.

This move, too, has a long pedigree in economic history; more on that later.

Advertisements