Interoperability Obligations in Digital Markets: Boon or Bane for Market Contestability?

In an effort to ensure contestability in digital markets, policy makers worldwide discuss whether interoperability obligations are an appropriate regulatory tool to achieve these goals. In particular, policy makers have proposed horizontal interoperability obligations for messenger services and social networks, which would require the incumbent network to be interoperable with a rival network. The key feature of such horizontal interoperability is that it allows sharing of direct network effects, and similar regulation has been in place for telecommunications networks for decades. However, the paper presented in this ZEW Research Seminar shows that in the context of digital services, horizontal interoperability obligations can be a harmful remedy. The main reason for this assessment is that in the context of fast-paced digital markets, services compete and differentiate themselves by innovating with respect to new features, which runs counter to attempts to standardize services. Interoperability, by contrast, requires standardization and a relatively steady environment. Thus, only a low level of interoperability can be achieved for digital services. This is dangerous because consumers will still gravitate to the larger network in order to take advantage of the full richness of features. At the same time, horizontal interoperability lowers the incentives of consumers to multi-home services, which is a powerful driver for contestability. The authors develop a dynamic multi-period model, which formalizes the trade-off between the (imperfect) sharing of network effects and reduced incentives to multi-home, and show that for a large of range of parameters, mandated interoperability impedes the ability of a more efficient entrant network to supplant the less efficient dominant network. The results have immediate implications for the ongoing policy debate and suggest that horizontal interoperability obligations should not be included in the recent proposals to regulate dominant online platforms.