A Theory of Google

Why does Google give out so much cool stuff for free? I have a simple theory, based on the concept of double marginalization.

Double marginalization is pretty easy to understand. Imagine that people travel by boat down a river from point A to point B. There is nothing useful in between these points; the only point of going down the river is to get from A to B. Between A and B, the river is divided into two segments, each with a separate owner, each of which erects a toll booth. People who are considering going down the river make their decision to do so on the basis of the sum of the tolls. As a result, if the upstream owner raises his toll, it has a negative effect on the downstream owner in the form of decreased traffic and revenue.

If the downstream owner also owns the upstream segment, its profits will be more than the combined profits of the separate segment owners. In addition, under joint ownership, the total amount of tolls will be lower, so consumers of the river will be better off. But here is the key to understanding Google: if the downstream owner can destroy the upstream owner’s toll booth, it has the same effect as if he owned both segments. In either case, there is just one toll booth, and the amount of the toll is set to the profit-maximizing amount.

Think about the Internet as composed of two complementary goods, broadly defined: access and content. Assume, quite reasonably, that Google has some market power in content monetization. Other companies have market power in the access industry. When most people buy a computer, they pay the Apple or Microsoft tax (or both). To get online, you pay your local (usually monopoly) cable company. On your cell phone, you are locked into a two-year contract.

Content monetization is the downstream industry, and access is the upstream industry. Google doesn’t have to take over the upstream industry to increase its profits; it just has to destroy their toll booth. By disrupting complementary industries and making them more competitive, Google is increasing their profits in their downstream industry.

A lot of Google’s projects make sense when viewed from this angle. Google Docs is an attempt to reduce the Microsoft tax. Android is an attempt to reduce the Apple tax. Google’s participation in the spectrum auction a couple years ago (and lobbying of the FCC to require open access) was an attempt to reduce phone carrier market power. Google Voice is the next iteration of that attempt. Ditto for selling phones without contracts. Google Buzz is an attempt to disrupt Facebook’s market power. Google’s recent plans to build a fiber network is an attempt to go after local ISP monopolies.

The point is that Google doesn’t have to dominate any of these industries to be successful, provided that they dominate content monetization. They merely have to make these industries more competitive, lowering the barriers to consuming a lot of content online.

The broader lesson is that monopolies will provide public goods in complementary industries, meaning that they are not as economically harmful as a static analysis would suggest. This is something that policymakers and government agencies should keep in mind as they prosecute firms for antitrust violations.

29 replies to “A Theory of Google

  1. Adam

    When a simple theory gets you a lot of mileage they call it “elegant”.

    Some data points for your theory: a great post on Android’s business model, and Android devices are on track to overtake the iPhone in percentage of mobile web browsers.

    Also, not only are the aiming to provide direct alternatives to Microsoft access points–in both Chrome and the forthcoming Chrome OS–but they actually attempt to directly intrude into IE’s space with Chrome Frame.

    Yeah, I think that’s a really elegant explanation for Google’s general strategy. Good stuff.

  2. C Betley

    “monopolies will provide public goods in complementary industries” up to the point where their revenue from their downstream sales equals the revenue obtained from providing public goods to leading individuals downstream.

    An adjustment to the model but not an overthrow.

  3. Siva Vaidhyanathan

    Great post. Very helpful. But please explain why the concluding paragraph follows from the previous? Why are monopolies “not as economically harmful as a static analysis would suggest.”? Are you saying harm in the central market (say, price-fixing in Web advertising) is mitigated by increased competition in ancillary markets (mobile, browser, email, applications, etc)? Is that necessarily and generally true, or just true in the case of Google?

  4. strivan

    Google develops tools to collect data. But information itself costs nothing. To create wisdom you have to analyze that data and rethink it. It is what Google actually is doing….

  5. Eli Post author

    Siva, yes, I am saying that looking only at the monopolized market overstates the inefficiency of a monopoly. A monopoly will disrupt a complementary market to the point where the marginal benefit of doing so equals the marginal cost. This is *generally* true. In practice, it is most likely to occur extensively in markets where marginal cost is low, such as technology, pharmaceuticals, and media.

  6. Dare Obasanjo

    I’m confused by the conclusion to this article, that monopolies aren’t so bad if they force down the profits of competitors in complementary markets. Isn’t this known as “dumping” in some jurisdictions and considered harmful in the long term?

  7. Eli Post author

    Dare, it’s not exactly dumping, and in any case dumping does not have net harmful economic effects. Those who complain about it are pure special interests.

  8. Floris

    “If the downstream owner also owns the upstream segment, its profits will be more than the combined profits of the separate segment owners.”
    Why do you make this assumption? Economies of scale? It might be true, but there’s absolutely no basis given in your theory why this would be the case. And since this is a very important premise for your theory, it’s quite a weak point.

  9. Eli Post author

    Floris, it’s not an assumption; it is a standard result in economics, as long as the firms face downward sloping demand. It’s not based on economies of scale. Consult any textbook on “double marginalization.”

  10. Brandon Weinberg

    Great job Eli. I enjoyed reading your post. You probably know this but just in case chr1sa has linked to it on his Twitter.

  11. Floris

    Ah, a “standard result in economics”. It’s only a theory and should be treated as such and not be used as the only basis for your own theory. There is also research that disagrees about double marginalization. Maybe the fact that in reality it’s not always more profitable to integrate vertically should have been a clue…

  12. G Tang

    This is a brilliant concept, great work!

    Can I take your permission please to re-create this article?(not copy but just use the concepts)?

  13. Eli Post author

    Floris, that makes no sense. There is no research that “disagrees” with the idea of double marginalization. Firms do not always face downward-sloping demand, so it does not always apply, but where it applies it is not in dispute. I agree that it is not always more profitable to integrate vertically; I am going to have a discussion with my readers on why this is so in a couple days. Stick around, you might learn something.

    G Tang, you don’t need permission to paraphrase someone else’s ideas, but I would appreciate credit and a link back if you don’t mind.

  14. ed park

    Much of this argument is also found in the book Free. Bottom line, you can leverage the internet to be very disruptive to more capital or hardware based companies. Another way to put it, software can disrupt hardware platforms (G’s nexus one phone to me is really just android distribution).

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  16. Dotcream

    Why does Google give out so much cool stuff for free?
    I like the idea of double toll booth, and the idea that google has the power to destroy the upstream toll booth.
    But, I didn’t see the existence of toll booth at google side in this article also.

    Should I think that Google destroyed both toll booths?

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