This Compass Lexecon report – which can be found here – argues that standards can lead to significant efficiencies: they not only solve coordination problems, they also seem to promote more rapid innovation than would otherwise be the case. Whether standards accelerate innovation depends greatly on who the ‘gatekeeper’ to the technology is. Among possible ‘gatekeepers’, the most pro-competitive one are voluntary standard setting organisations (SSOs). SSOs and the licensing arrangements they support enable a “market for technology,” in which smaller and specialized technology providers can thrive. As a result, competition authorities should be loath to interfere with the contractual arrangements that underpin the functioning of SSOs, should as clauses regarding FRAND terms.

In more detail, the paper is structured as follows:

The paper begins with an overview of why standards are valuable. Standards help certain industries achieve scale, giving users and suppliers the confidence to buy or make compatible products. While not exclusive to the IT sector, the ‘economics of many information technology industries strongly favor the emergence of a single standard. Such industries often have strong economies of scale and scope, as it costs next to nothing to provide information to more consumers. Network effects, in which users gain value from the presence of other users on the network, are often important too, whether through direct effects (the more people are on Facebook the more each subscriber benefits) or indirect (the more people use Windows, the more software developers will produce applications for Windows).’

The second section identifies the various institutional frameworks through which standards may emerge, and the respective advantages and disadvantages of each frameworks. The authors identify three main frameworks:

  • Under a first institutional framework, a standard might simply “emerge” and become a de facto standard for the industry ( ‘de facto standards). Typically, such a standard will be under the proprietary control of a single company. Operating systems used on personal computers provide an example of this type of standard. The great majority of PCs continue to run Microsoft’s operating system, which can work with hardware and applications produced by multiple suppliers. However, the operating system and its development is still under the control of a single company, Microsoft. Apple is a player in the PC industry which runs an even more closed operating system – that O/S must run on Apple hardware and exerts significant control over the applications that run on its systems.

The near-universality of a standard can provide great benefits through network effects and economies of scale. However, there are downsides to proprietary control over the standard. Firstly, it is possible that the standard technology would be better with a more collaborative approach. Secondly, the standard owner has economic power that enables it to monopolize other layers of the supply chain. Whether that power is used or not, this perception can make other firms reluctant to invest in connecting products, for fear that the standard owner might make a change rendering those products incompatible or even start competing with them by providing those products itself.

  • Secondly, standards can be sponsored by governments. However, the history of government standard development – e.g. TV broadcasting or the early days of mobile telephony – shows that competition and innovation can often be stifled in this case. Government-sponsored standards are usually driven by protectionist concerns which lead to uncompetitive industries.
  • Thirdly, standards may emerge through voluntary collaboration between experts from many different companies in the context of SSOs. In general, SSOs allow for the participation of both innovators (technology providers) and implementers (firms that will manufacture the products containing the patented technology). Innovators normally receive license fees payable on Fair, Reasonable and Non-Discriminatory (“FRAND”) terms for the technology that is declared essential to the implementation of the standard.

The authors’ empirical study of the mobile telephony sector leads them to the conclusion that the collaborative, voluntary standard development process in this industry led to a more competitive market structure than would have been possible if the standards had had a single proprietary owner or had been set by the government. This is because many firms supply technology into the standards in the context of SSOs. With more innovators participating “upstream,” competing to provide the technology and then collaborating in the resulting standard, there are more independent sources of ideas, and there can be more competition and specialization than would otherwise be the case. Such a system makes it easier for many different innovators to contribute to a huge technological system (such as the mobile wireless network) and – crucially – be rewarded for it. Licensing of intellectual property rights creates what has been called a “market for technology” in which firms buy and sell the rights to use innovations rather than the products embodying them.

The third section looks at the importance of IP rights for the successful operation of SSOs. They begin by explaining that the proliferation of patents in the mobile telephony sector has not prevented innovation, but has instead led to a boom in new technologies and developments. What is more, while economists have often regarded R&D as a strategic tool by which larger firms keep smaller rivals out of their industry – like advertising or the promotion of brands –, the existence of licensable IP rights  within an SSO seems to lead to greater research by smaller firms, which investments can be rewarded directly through licensing.

Licensing is essential to this development. Standards promote R&D because the smaller innovator does not need separately to demonstrate its ownership of the technology rights through bilateral negotiations. With standardized technologies there can be multiple implementers of an innovation, making it more likely that innovators will be rewarded for their creativity and hard work.

The fourth section looks at the role that SSO’s play in bringing these outcomes about, and argues that interventions by competition authorities that interfere with the applicable contractual and IP rules should be cautious, if not best avoided.

In practice, SSOs solve problems of timing and commitment. An innovator invests time and money in a new technology and then must either implement itself or seek a deal with an implementer. If a company is small, or multiple IP rights are necessary to market a product, the innovator’s bargaining power may be weak. The implementer knows that the innovator’s costs are sunk, and hence the innovator is likely to accept a worse deal – maybe so bad that her investment costs will not be recovered. However, if the innovator fears this outcome in advance, it will most likely not invest, leading to a loss for both parties. This problem is known as hold-out, or reverse hold-up.

It therefore makes sense to negotiate before the investment has taken place. However, innovation is uncertain and it is unclear what will value will be. One solution to this dilemma is for the innovator and the implementer to merge together into a single integrated firm. An alternative solution is to agree to the broad rules of how a licensing negotiation will be conducted in advance, without agreeing to a specific number.

This is why SSOs typically require innovators to commit to FRAND licensing terms when innovators declare their inventions to be essential to the implementation of a standard. All the participants in the SSO commit to this rule in order to provide one another with the certainty required to invest – the rule is a commitment device, which is essential because after investment has taken place, each side would prefer a deal that does not reward the other’s investment. The problem with FRAND agreements is that the price for licensing is not set. In the case of a contract, with well-defined rates agreed in advance, if a side appeals to a public authority to break the contract, that authority should treat such an application with great scepticism. Yet, in the area of IP licensing such calls to break the agreement ex-post are common – perhaps because the inevitable uncertainty of invention requires that terms be less specific than they would be in a contract.

Superficially, it is very attractive for a competition authority to intervene to prevent (for example) the holder of some intellectual property rights embodied in a standard from insisting on a particular license fee from manufacturers of equipment that use that standard (Note: this is the hold-up theory that justifies most competition interventions). Nonetheless, it would be poor public policy to accept such appeals, as this would damage the confidence that innovators will be rewarded fairly which underpins SSOs and is so crucial to promote innovation.

Comment:

In developing its arguments, this paper provides a useful overview – and an easy to follow summary – of the state of the art regarding the importance of standards and how they come about. This is without prejudice to the fact that the paper has been commissioned by a party with significant interest in the Report’s conclusions taking a certain slant.

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