The Economy of Standards: the 'Pros' and 'Cons' of Standards Competiti...

The Economy of Standards: the 'Pros' and 'Cons' of Standards Competition

An introduction to a comprehensive qualitative efficiency comparison using the example of payment cards

14 December 11

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General economic considerations of standards competition

The objective of this article is to present some of the fundamental economic efficiency considerations of parallel standards. The following question is central to the analysis: how can multiple parallel existing standards, within the same technological area, be fundamentally evaluated in terms of theoretical static efficiency and with respect to their dynamic effect on innovation and competition?

Since there is some confusion regarding the term standard, also caused by its increasing diversity, the applied terminology must therefore be defined. A standard represents an agreement in respect of the standardisation of products, procedures or practices. Standards are published by formal standards organisations and bodies, based on a strict consensus process. Formal standards organisations and bodies also publish specifications, which are not developed by consensus. Research now focuses on the difference between formal, industry or consortia and company specific de facto standardisation (see Blind, Gauch & Hawkins 2010 for the differences of their perceived economic impacts). In this article, the term standard will be used because the development process is of secondary importance for the general economic analysis.

In traditional economics literature, a situation in which two incompatible technological standards compete with each other is compared with an alternative situation, in which competition arises within a technology or a standard after an agreement on one standard. In the industrial organisation models upon which the theory is based, it is basically assumed that standards in competition are not compatible with each other. Consequently, a market decision on one of the two standards is required for the complete network effects to materialise. This principle highlights the significance of other actors using a technology, which allows for collaboration or communication. It is these actors who make the market decision. The theoretical models do not address the coordination of standard setting processes or the economic efficiency assessment of the selection of a standard.

These earlier models basically assume that it is not possible to achieve a stable equilibrium in the competition between two incompatible standards. The models therefore further assume that through the forces of network effects a dominant standard would emerge, which would possibly capture 100 percent of the market in the long-term. The success of the video home system (VHS) format over the competing Betamax technology is often cited as an example, because the decision of a network is not only based on the actual number of users, but also on the expectations of market results. Consequently, within a short period of time, all users can decide on a specific standard. In effect, the opposing standard loses its attraction very quickly and therefore disappears from the market if the users who originally decided on it, do not incur high switching cost. Often, the technical advantage of a standard is not the decisive factor driving the market decision, rather the expectations generated with respect to the future possibilities of using the technology or the equipment.

Ultimately, the proliferation of a standard is largely dependent on its path. This means that the actual market result is determined by the behavior and the preferences of customers and property characteristics of the current product generation, and in particular by the users' decisions in earlier periods or in the phases in which the entire market selected one of the two standards. These processes are not easily reversible, since strong network effects through a large installed user base are not necessarily compensable by a predominantly superior technology.

Since the company, which - in the commercial environment - holds the 'winning standard' anticipates a strong and long-term monopoly position, the incentives to come out on top of the 'winner takes all' game, are intensely pronounced. The investments made by commercial competitors to win the standardisation game can exceed the expected return several times over.

The alternative: settlement on one standard or on compatible standards in the cooperative space

The alternative to a competition between two incompatible standards is a settlement on one standard or on compatibility between standards in the cooperative space. In this case, the competition between incompatible standards becomes a competition within a standard, which is driven by the traditional competition parameters of price, quality, product characteristics and services in the commercial space. The decision between common and multiple standards regularly depends on how great the differences are with respect to the expected profits and the tactical options in the subsequent phase of market competition.

In the discussion regarding the 'pros' and 'cons' of standards competition, the trade-off between the static efficiency, the best allocation of resources in an economy given the set of technologies, and dynamic efficiency, which includes the development of better technologies to improve the efficiency of production over time, is obvious. In a static environment, it is fundamentally advantageous, from an economic efficiency perspective, to decide on one standard, if there is no uncertainty about which standard is the best option. The various dynamic models contrast the static efficiency gain from the immediate decision for one standard with numerous efficiency improvements, which could be gained by maintaining standards competition. The characteristics of the following parameters derived from the literature should thus be considered in order to make a comprehensive qualitative efficiency comparison between the immediate decision for one standard and the prolongation of a standards competition (Blind 2011).

See Table 1: Relevant parameters for an efficiency analysis, their characteristics and the corresponding efficient solution (Blind 2011)

Parameter Characteristic Efficient Solution
Preference for network effect high one standard
low multiple standards
Local network effect high multiple standards
low one standard
Heterogeneity of preferences high multiple standards
low one standard
Costs of development and maintenance of standard high one standard
low multiple standards
Uncertainty about technical quality  high competition
low one standard
Length of technology life cycle high competition
low one standard
Development potential (incl. converter) high competition
low one standard
Uncertainty about future user preferences high competition
low one standard

 

The above mentioned eight parameters were identified based on the review of the theoretical literature regarding the comparison between the agreement on one standard and the configuration of standards competition. To allow a better understanding of the model, a qualitative efficiency comparison is carried out, for illustrative purposes, using the example of standardisation in the area of payment cards.

An example of a qualitative efficiency comparison using the example of standards competition in the case of payment cards

To clarify: the following example simply serves to highlight the principles of a qualitative efficiency comparison underlying a decision whether to develop common standards or whether to allow for competition of standards. This example should not be read as an academic analysis of the cards market including all its complexities. The example relies on assumptions made for the sake of explaining the model. The example differentiates as regards the term 'customer' (demand side), which in the cards domain are: (1) consumers making payments with cards, and (2) businesses accepting card payments (merchants).The specific question covered by this basic qualitative efficiency comparison is whether work should be undertaken in the cooperative space to achieve open, free and compatible standards, which would allow for interoperability in the Single Euro Payments Area () cards market.

Based on the parameters used in the comparison, the following 'pros' for unified card standards, or - more precisely - interoperable cards standards, could be identified:

For the consumers using and the merchants accepting payment cards, standards allowing for interoperability throughout the cards market would certainly be the most attractive solution in the short term. The efficiency gains resulting from network effects would allow consumers to use their payment card across 32 countries with the same ease and convenience as in their home country, whereas the merchants would benefit from increased competition between the different providers servicing card-accepting merchants.

The alternative of multiple, and most likely not interoperable, standards would at least make it more difficult for consumers to use their payment card across . This second option is certainly not preferable, but technologically and economically feasible.

If there are strong regional preferences and regionally concentrated transactions, i.e. local network effects, then the lack of interoperability in the cards market could be justified. In this context, the term local is synonymous with 'national'. The use of cards within 'national technology isles' only could be justified, at least from the perspective of consumers, in case of strong local (national) network effects. This scenario would however be incompatible with the concept of creating one domestic euro payments market spanning all 32 countries.  It is also assumed that within there will be an increased rate of cross border transactions and consequently a diminishing relative relevance of these local (national) network effects in the long term. Furthermore, a certain level of heterogeneity of preferences in relation to card payments still exists, but is assumed to disappear, again in the long term, with the completion of . Last but not least, the scenario of 'national technology isles' would deprive merchants from taking advantage of increased competition between service providers that should result from -wide interoperable standards.

On the demand side, high uncertainty about future user preferences might also justify multiple standards. In the case of payment cards however, the variants in user preference is assumed to be rather limited, i.e. consumers and merchants mainly ask for compatibility and security of the cards. Requests for additional features do not seem to be very high. Consequently, the demand for multiple standards resulting from uncertainties on the demand side is rather limited.

Based on the parameters used in the comparison, the following 'cons' against a uniform standard and most likely an interoperable solution could be identified:

The costs of development and maintenance are certainly arguments against the maintenance of a variety of standards. There might however be a degree of uncertainty about the technical quality of the possible future standards. The higher the uncertainty about the performance of the technologies behind the various standards, the stronger the rationale for having multiple and most likely not interoperable solutions - at least until the competition reveals the superiority, attractiveness and acceptance of optimal solutions.

Since the investment for payment cards, and other devices used to facilitate card payments, faces a longer life cycle than other information technology-based consumer goods, the decision for a specific standard has a longer lasting implication. Consequently, an erroneous choice in favour of an inferior solution produces inefficiencies for a rather long period of time. Therefore, it can be justified to bear the costs of competing and probably not interoperable standards for a longer period, until the competition reveals with more certainty the superior standard. This standard should then solely be implemented for the whole life cycle of the devices used to facilitate card payments.

If the technological progress in the area of cards is rather dynamic and promising, the early decision for one specific or a set of interoperable standard(s) could deprive the supply side from reaping the benefits of future innovations. These uncertainties on the supply side would therefore support the existence of multiple, and most likely not interoperable, standards for a longer period of time.

Summarising the 'pros' and 'cons' according to this set of criteria, no final conclusion can ultimately be drawn. At first glance, the arguments for common standards, allowing for interoperability in the cards market, are overwhelming. It should be considered however, to grant some flexibility, including not perfectly interoperable solutions, in order to make use of technological progress in the payment card technologies and possible advancement in the applications.

The analysis in this particular case has to also take into consideration that creating a for cards based on common interoperable standards seems to be a political mandate, which, or so we assume, is based on a well substantiated rationale.

Prof. Dr. Knut Blind is Professor of Innovation Economics at the Faculty of Economics and Management at the Berlin University of Technology. He also holds the endowed chair of standardisation at the Rotterdam School of Management of the Erasmus University and is leading the new research group 'Public Innovation' at the Fraunhofer Institute of Open Communication Systems in Berlin.

Related link(s):

http://www.inno.tu-berlin.de/menue/home/parameter/en/

http://www.rsm.nl/home/faculty/academic_departments/technology_and_innovation/faculty/faculty/blind

http://www.fokus.fraunhofer.de/en/elan/wir_sind/themen/public_innovation/index.html

Blind (2011); An economic analysis of standards competition: The example of the ISO ODF and OOXML standards, Telecommunications Policy Volume 35, Issue 4, May 2011, Pages 373-381 http://www.sciencedirect.com/science/article/pii/S0308596111000218

Blind et al. (2010): How stakeholders view the impacts of international ICT standards, Telecommunications Policy Volume 34, Issue 3, April 2010, Pages 162-174 http://www.sciencedirect.com/science/article/pii/S0308596109001293

Related articles in this issue:

ISO 20022 Message Standards: Too Many Flavours? Domestic specifications of the SEPA data formats risk preventing market harmonisation

Beyond the Hype: Making Mobile Payments Work. 'Mobile Contactless SEPA Card Payments Interoperability Implementation Guidelines' and second edition of 'EPC White Paper on Mobile Payments'

Paper Invoice - Thy Days are Numbered. A further progress report on electronic invoicing

Related articles in previous issues:

On Innovation

A Closer Look at Innovation in Retail Payments. Central bank research in preparation: a report on first findings of working group established by the Committee on Payment and Settlement Systems ( Newsletter, Issue 11, July 2011)

Innovacompegration (This is Not a Typo). Reflections on the best approach to innovation, integration and competition in payments ( Newsletter, Issue 10, April 2011)

On Market Integration

Arrested Development. Inconsistencies between European Commission´s objectives threaten to hamper SEPA progress ( Newsletter, Issue 11, July 2011)

Light at the End of the (Harmonisation) Tunnel. 'Third Progress Report on the State of SEPA Migration' prepared by the European Commission Services confirms: mandatory end dates for migration to pan-European payment instruments are required ( Newsletter, Issue 11, July 2011)

More Europe is Needed, Not Less. Lessons learnt from the financial crisis ( Newsletter, Issue 10, April 2011) 

SEPA in the Context of the Financial Crisis. Retail payments business proves to be resilient ( Newsletter, Issue 7, July 2010)

Every Road Has Got to End Somewhere: the Need for a SEPA Migration End Date. Re-emphasised by the European Central Bank ( Newsletter, Issue 2, April 2009)

On Bananas and the Integration of Euro Payments. The SEPA commitment of EU governments [see, in particular, the section headlined 'SEPA - much ado about nothing?' on the importance of European Union financial integration as outlined by the European Central Bank] ( Newsletter, Issue 2, April 2009)



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