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In March 1872, Oil Creek, Pennsylvania, was about to erupt into physical war. It was the far more intense equivalent of the January 2014 Net Neutrality debacle, but driven by real collusion rather than legislative activity making collusion possible.
Word had leaked out that the largest oil refiners and railroads, masterminded by Thomas Scott of the Pennsylvania railroad and John D. Rockefeller of Standard Oil, had formed the South Improvement Company to entrench the large refiners and railroads at the expense of their smaller competitors.
The scheme proposed three important terms:
- The official rate per barrel from Cleveland to New York would be $2.56, but South Improvement would receive a $1.06 rebate.
- The railroads would also pay South Improvement $1.06 per barrel of oil shipped that was not produced by South.
- The railroads would also give reports of the shipping destinations, costs and dates of all of South’s competitors.
The first two are the most important and contentious terms to consider. The first term is a “rebate.” This is effectively a volume discount, and would be considered perfectly reasonable by modern economic standards.
The second term is a “drawback.” This means that Standard was paid for their competitors’ shipping oil. Rather than competitors getting the volume discount, the rail companies would effectively route that discount to Standard. This term was and still is considered by many to be purely anticompetitive and economically unjustified.
The scheme proposed doubling the advertised shipping rates, but the uprisings stopped the plan short, and there was never a single barrel of oil shipped under the scheme. The irony was that the scheme broke down under uprisings and protests orchestrated by a conglomeration of large New York-based refiners that hadn’t been let in on the deal. If the New York refiners had been let in, it would have likely gone through. Standard was later able to orchestrate many such schemes throughout its history. The results were arguably good for consumers, by driving down prices — and perhaps even for the oil industry in the long run — but devastating to competitors.
Standard’s actions and secret transport deals helped its kerosene price to drop from 58 cents to 26 cents from 1865 to 1870. Competitors disliked the company’s business practices, but consumers liked the lower prices.
Common carriers
Om Malik sparked an interesting debate about “common carriers,” a term that goes back to the railroad era. The fundamental question is whether volume discounts are okay, or whether everyone should pay the same rates.
Re/code also published an interesting Q&A with law professor Susan Crawford on the topic of how the notion of common carriers supposedly protects smaller competitors.
Again — it’s like ESPN. Facebook and Google are powerful enough that the providers need them more than they need the cable guys. So they know they’ll be able to make all the deals they want. They’re not so worried about the fate of the next Google, or the next Facebook.
From The Verge:
Since 1980, the FCC has divided communication services into basic and enhanced categories; phone lines, with their “pure” transmission, are basic, while services like web hosting, which process information, are enhanced. Only basic services are subject to what are known as common carrier laws, which stop carriers from discriminating against or refusing service to customers.
It’s all about how we define “fair,” and what constitutes “discriminating against or refusing service to customers.” As consumers, we value economies of scale — we expect lower prices when we buy in bulk, for example, at the grocery store. What we expect in the micro, we must concede in the macro. Deal terms can certainly stray into the land of purely anticompetitive practices, and this distinction is easy to see in the aforementioned case of the railroad rebates versus drawbacks.
Economies of scale and the path of least resistance
Google, Netflix and Amazon benefit from economies of scale. If I ship two packages a year, and Amazon ships two billion packages, does it really make sense for UPS to charge me the same rates? It has been a bit surprising to see really successful investors glossing over natural economies of scale.
Highly fragmented competition is not necessarily better. Search is arguably better with Google than it was before with a fragmented set of inferior services. There was a tremendous amount of attention on regulating Microsoft’s perceived monopoly in the late 1990s. Bill Gates said that technology changes fast, and Microsoft had to be relentless to navigate the new crises of innovation that would pop up every few years. He seems prescient in this 1996 interview with Charlie Rose:
The business is more competitive than they’re giving it credit for, and it is a challenge. I don’t see any room for complacency … that’s our greatest enemy. We ship software products, and we try to improve them. As long as the business is changing … there’s only one clear winner, and that’s the customer. We’re all just fighting to get our message across and get these new products out as fast as we can.
Sure enough, Microsoft arguably did become complacent, and that resulted in the well-documented shift in power from Microsoft to Apple and Google. Anyone seen an antitrust discussion centered on Microsoft recently?
The risk of regulation encouraging vertically integrated monoliths
In imposing regulation on infrastructure consumed by massive and powerful businesses, we would be wise to be careful about forcing such businesses into unnatural economics at their scale. These businesses often have the capital, power and capability to create their own infrastructure. Overregulation can encourage even larger vertically integrated monoliths.
Suppose you want to compete with Amazon, and you want Amazon to pay the same UPS rates you pay. It may make sense for Amazon to acquire UPS, or build a competitor to achieve rates that are more natural at their scale. You might have to ship your packages through a freight company owned or operated by Amazon, and you have an even bigger problem. Suppose you want to compete with Netflix, and you don’t want them to enjoy an economic advantage commensurate with the huge percentage of North America streaming traffic they drive. They may consider acquiring or starting an ISP in order to get more natural economics. You may have to stream your video over Netflix pipes, and you have an even bigger problem.
Vertical integration like this isn’t necessarily anticompetitive. Amazon, for example, runs AWS, but doesn’t appear to have engaged in anticompetitive practices with prospective competitors who run on AWS. Nevertheless, the scenarios above could be more undesirable for competition than the initial unregulated scenarios. Regulation in these matters is not as simple as protecting the little guy against the big guy; it involves a complicated set of economic tradeoffs and can often exacerbate the very problems it seeks to protect against.
Bradford Cross is CEO of Prismatic. Follow him @bradfordcross.
This article originally appeared on Recode.net.
