Thank You Google for Subsidizing my iPhone

Did you hear the big political news? No, not about the election 🤮

The Justice Department finally filed a lawsuit against the Google monster for anti-competitive behavior. As far as I can follow the argument, Google is being sued because, to quote Tim Robbins in Team America: World Police:

“the corporations sit there in their... in their corporation buildings, and... and, and see, they're all corporation-y... and they make money.”

Okay. Maybe there is more to it that’s worthy of serious economic analysis.

I want to discuss the two main complaints brought by the DOJ: 1) Google paid phone manufacturers for Google to be the default search engine and 2) the agreements were “exclusive” and prevented the phone manufacturers from dealing with other search engines.

My reading is that these “anti-competitive” actions help consumers. And if Google can provide customers with so much and offer such a great system that other companies (for the time being) can’t effectively compete, that’s not anti-competitive in any meaningful sense.

But first, some disclaimers. First disclaimer: This topic is hot off the press. I apologize for commenting on the news. I try not to. Even Homer nods. I promise to return to evergreen topics soon. Second disclaimer: I’m not a lawyer (big, if true). I’m ignoring the thorny legal issues and will focus on standard economic arguments about prices, quantities, surplus, etc.

With our legal disclaimers in hand, let’s work through some economics.

Let’s start with the more basic of the two complaints: Google paying to be the default search engine. Assume Apple does not directly care which search engine is the default since Apple is unlikely to lose customers based on its default search engine. But it still needs to choose a default.

So how should we think of a default option in economic terms? The simple idea of a default is that it makes the default search engine less costly and so is effectively a price discount to the marginal users to use Google over another search engine. (I like that Kevin Murphy calls this a “nudge” and shows that it is consistent with rational behavior.)

The ways that this benefits Google are complicated, but we can simply assume each user provides Google with some benefit and so has a derived demand for eyeballs. Since Apple can “deliver” eyeballs to Google, Google will be willing to pay Apple for those customers that Apple influences and so Apple can extract some money from Google for providing the eyeballs.

(Let’s ignore the little fact that the anti-competitive firm—Google— is forking over the money. One might ridiculously expect the “monopoly” to be raising prices and not paying.)

Google’s purchase of Apple’s “nudges” seems to make customers worse off. Because Apple (not Google yet) has some market power, the default changes people’s behavior relative to some benchmark where Apple just chooses the best search engine as default. (Sidebar: isn’t this just Google anyways?) All the people who want Bing as their default search engine are worse off.

Unlike some unsophisticated analysis, Apple does not control its customers but must compete for them. This payment from Google means that Apple can lower its price to better compete for consumers. This is standard; some of the payment from Google to Apple will be passed through to consumers in the form of lower prices.

To see this in the simplest model, assume the payment from Google to Apple is per-phone. Since payment is a per-unit subsidy to Apple, the price goes from P0 to P1 and quantity from Q0 to Q1. The consumer welfare gain is left as an exercise for the reader.

The evil Google is subsidizing my iPhone! Corporations… Being all corporation-y…Thanks, Google 😘

Now let’s think a little more long term. Suppose Apple develops a reputation for good quality products. People use the default more than on other phones because people trust Apple’s opinion. (I’d argue this knowledge is the unique thing that Apple sells. It is ready to go out of the box.) In that world, over time, customers become more responsive to the default search.

In the extreme, suppose everyone keeps the default. Is this bad for consumers, since they are “stuck” with whatever Apple chooses? No! Apple can now go to Google and say “We have all of these customers who will use whatever search engine we tell them to. They would even use Bing if we tell them to! Pay us even more or we will go to Microsoft.” This is not an idle threat. Microsoft has plenty of money to compete with Google.

So Apple can effectively bargain for the customers for an even larger subsidy from Google. And this is then passed onto customers through lower prices on iPhones.

This is a simplification of the problem; it’s a model. But it should give us pause about the lawsuit. If we are using a consumer welfare standard, how is paying bad for consumers?

Now let’s go on to the hard part. Part of these agreements prohibits manufacturers from dealing with Google’s competitors. As the complaint states: “In many cases, the agreements relating to mobile devices go even further, expressly prohibiting (1) the preinstallation of any rival general search services, and (2) the setting of other defaults to rival general search engines. This means that Google is the only preset default search provider preinstalled on the device.”

Now, this may give us more concern. This is explicitly about keeping certain players out of the market. That has much more of the feeling of anti-competitiveness than paying Apple and customers money.

However, there’s fair reason to believe that these exclusive contracts intensify competition, as Ben Klein and Kevin Murphy argue here. Again, it is important to see this as part of a more general system of competitive contracting, not just pricing. Apple could also sign contracts with Microsoft to default to Bing.

These agreements contractually assure Google that Apple will not turn around and do something to send customers to Microsoft. Because Apple can promise this, Google will have more of an incentive to raise its offer to Apple. Again, this type of agreement allows Apple and ultimately consumers to extract more surplus.

Now I do not mean to imply that no actions can ever be anti-competitive. Price fixing does occur. As I argued before, the real problem is that the monopoly/innovators like Google and Apple aren’t able to extract enough of the surplus they generate through a simple price.

But paying money to other firms and restraining each other’s behavior are completely natural parts of a competitive process. Google is simply offering better terms to Apple and customers than Microsoft can. That’s how competition works!