Paul Krugman Finally Gets It Wrong

The blogosphere’s been abuzz with Google’s decision to terminate Reader services this July. Paul Krugman sees the end of private Internet utilities as we know it:

First, it’s a well-understood though not often mentioned point that even in a plain-vanilla market, a monopolist with high fixed costs and limited ability to price-discriminate may not be able to make a profit supplying a good even when the potential consumer gains from that good exceed the costs of production. Basically, if the monopolist tries to charge a price corresponding to the value intense users place on the good, it won’t attract enough low-intensity users to cover its fixed costs; if it charges a low price to bring in the low-intensity user, it fails to capture enough of the surplus of high-intensity users, and again can’t cover its fixed costs.

What Avent adds is network externalities, in which the value of the good to each individual user depends on how many others are using it […] they mean that if the monopolist still doesn’t find it worthwhile to provide the good, the consumer losses are substantially larger than in a conventional monopoly-pricing analysis.

So what’s the answer? As Avent says, historical examples with these characteristics — like urban transport networks — have been resolved through public provision. It seems hard at this point to envision search and related functions as public utilities, but that’s arguably where the logic will eventually lead us.

I’ve been meaning to blog about my opinions on the Facebook online privacy debate and this seems like a pretty good opportunity to bite. It’s also particularly interesting (for me) because rarely is it that I disagree with Krugman’s opinions. In less polarized times, I’m sure we would find far more space for dispute but, today, when most politicians seem mad and the path forward is clear, there is broad consensus among most (a nominal GDP targeting offering a fine example to this effect).

The import of Krugman’s argument is that Google Reader which, unlike the search itself, is used very intensely by a rather small group of people can’t price even nominal sums without driving away the mass, who will refuse to pay more than a nominal fee.

Krugman assumes pretty standard microeconomic theory wherein a monopolist has limited ability to segregate the market. The problem doesn’t arise as much from the fact that users are unwilling to pay a decent fee, but that users are unwilling to pay. This requires the assumption of irrational behavior that is entirely contrary to the analysis he uses.

The wonder, and preponderance, of most online services comes from the perceived freeness of the service. And, because we’ve grown very accustomed to the idea of free goods, the idea of paying for basic Internet services seems even more nonsensical. So the decision Google faces is “to charge or not to charge”.

Furthermore, the assumption that Google Reader is a monopoly is wrong. While it would be easy to think so, considering its widespread use and robust network effects, Google actually operates more under what I would call contestable markets, wherein firms cannot earn economic profit. According to Wikipedia, William Baumol describes such a firm for which “there exist markets served by a small number of firms, which are nevertheless characterized by competitive equilibria (and therefore desirable welfare outcomes) because of the existence of potential short-term entrants.”

In the Internet it would not take long for users to make the switch to another service (because of perceived irrationality and relatively low entry costs), therefore Google Reader operates under the threat of competition. This is a potent force for social welfare. Note that Facebook and Google Search are probably less “threatened” by outside competition because of huge brand names compounded with relatively larger costs to entry.

Much of the blogosphere has already moved to other alternatives, because they always existed, delivering a threat to Google’s market power.

This allows me to make a somewhat rough segue into an interesting topic: Facebook and data. Newspapers of such repute as the International Herald Tribune have run stories describing privacy as a justifiable concern, even reaching the possibility that Facebook pay an annual fee of $50 dollars to each user.

Actually, Facebook is just a perfect example of the erosion of economic frictions, and the benefits unlocked. For one, everyone knows which data they give to Facebook: the truly paranoid don’t use it. Facebook which provides a value of, say, $300 dollars a year to each user (which is my reservation price). By trading data I consider very irrelevant to my security, such as relationship status, birthdate, location, and number of friends I earn my reservation price in value.

Effectively, Facebook allows one easily trade data for money. This used to be much harder. Many online portals that allow users to watch free movies (aside from torrents, of course) require clients to fill out a “survey” for various organizations. After filling three surveys which took time to submit, were weathered with millions of disgusting pop-ups, the user was granted his wish: two hours of free TV.

Facebook offers a much cleaner and, dare I say, safer way to trade this information for value. We are all willing to give up a certain level of information. Until today, there was no efficient way to interface the information market. Facebook is that conduit. Indeed, users also benefit from tailored advertisements, if they pay attention at all.

Ultimately Krugman, in suggesting that the future of such utilities (as they really are) lies in the public sector ignores that both Google and Facebook are highly profitable. Yes, Reader by itself is not profitable, but the same network effects he uses to derive his argument drive remarkable margins from the search portal itself in form of targeted advertisements. Further, even if Reader were to shut down, it is just not a societally important service that requires government intervention. Google’s decision is strategic, not microeconomic. The financial costs in providing Reader are low though, conversely, the reputational cost of not providing it is very high!

Public utilities are monopolistic because the minimum efficient scale far exceeds the total demand in a community, presenting large barriers to entry and removing any room for threat. None of Krugman’s logic is wrong. The assumption that Reader is a monopoly is. Perhaps we’ve found a robust example of contestable markets.