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1992: removing the barriers.


In the four years that have elapsed since the publication of the European Commission's White Paper on `Completing the Internal Market' in June 1985 understanding of the issues involved in removing the various physical, fiscal and technical barriers to having a `single market' in Europe has developed considerably. The public debate has gone through a series of phases, starting with scepticism, strikingly translated into enthusiasm and almost euphoria during 1988, to be replaced with serious concerns about many specific areas as general principles have come to be replaced by detailed proposals by the European Commission. The member states signed the Single European Act in 1986 for a variety of motives and it is often only when explicit proposals are tabled that the conflicting objectives and detailed implications become obvious.

As a result, although the tone of the Fourth Progress Report of the Commission to the Council and the European Parliament concerning the implementation of the Commission's White Paper on the completion of the internal market (COM(89)311 final), published on 20 June this year, is optimistic, some striking reservations are expressed. `Despite the rapid progress on removing technical frontiers, the main decisions have yet to be taken to abolish the formalities applied to Intra-Community trade...[T]he the volume of Community legislation is already causing implementation problems in the Member States...of the 68 measures which should have been implemented by now only 2 have been incorporated into the national legislation in every Member State ... The Commission is concerned about the impact of this state of affairs on the credibility of the objective and on legal certainty for all involved' (paras 11-15).

This note seeks to add some flesh to these concerns by suggesting economic reasons why the path to the single market has turned out to be more complex and difficult to achieve than the enthusiasm in the White Paper, the Single European Act and the Cecchini Report on the `Costs of Non-Europe' might lead us to believe. The focus is on the area where the Commission does feel there has been some success, namely, technical harmonisation.

Our contention is that there has been an excessive preoccupation with harmonisation. Diversity forms an important part of the competitive mechanism. Standards and regulations are used to reinforce competitive advantage. Harmonised standards and regulations are required only in certain circumstances--not just health, safety and environmental to protect consumers, employees and suppliers and prevent adverse externalities but also to ensure compatibility and information. Excessive intervention may simply erode the benefits from innovation to the extent that innovative pressures in Europe are dulled. However, a delicate balance is required to permit the incentives yet prevent `regulatory capture' which enables particular firms to obtain and exploit a dominant position in the market. It is not clear that the `new approach' will automatically achieve that balance. However, it is a great improvement over its predecessor which guaranteed that insufficient harmonization would occur and that the European market would remain fragmented. It is, on the other hand, far more debatable whether European standards can be used as an instrument of positive policy to achieve an international competitive advantage. The number of significant areas where Europe can establish a standard which dominates international markets is limited. Defensive standards, designed to protect European firms from foreign competition, are far less likely to be valuable as while they may offer gains in domestic markets they will tend to cause losses in export markets.

The structure of this note is to provide a brief explanation of the `new approach' to technical harmonisation in Europe and its origins and then set out the meaning of the various concepts of standardisation and regulation. The remaining pages explore the economic issues involved and draw conclusions.

Speeding up technical harmonisation in Europe

The removal of technical trade barriers has always been an aim of the European Community, acting largely under Article 30 of the Treaty of Rome which outlaws all measures equivalent to quantitive trade barriers and using powers under Article 100. However, progress was slow. The 177 directives on technical harmonisation between March 1968 and January 1985 made only a minor dent on the thousands of the barriers that exist. Nevertheless, some measures such as the low voltage directive of 1973 were extremely important and opened up markets considerably. The overall problem, however, was that divergences between member states could only be resolved by agreeing a harmonised set of detailed regulations for the Community as a whole. This was difficult enough with six members but with twelve it would easily have proved downright impossible.

The obligations on the Commission to act to remove non-tariff barriers have thus existed from the inception of the Community and still continue today. Where existing non-tariff barriers appear to run contrary to the Treaty the Commission has the task to investigate and to prosecute member states who fail to fulfill their obligations before the Court of Justice using the standard infringement procedure (Article 169). Where national measures block the importation of products from other member states, the member state that blocks the import must justify itself by showing that the application of the general principle of the free movement of goods is not warranted in that instance--usually by appeal to Article 36. Article 36 sets out the exceptions to Article 30 and gives member states the right to impose restrictions and prohibitions on imports, exports or goods in transit if they are `justified on grounds of public morality, public policy or public security; the protection of health and life of humans, animals and plants ... or the protection of industrial or commercial property'. Such prohibitions or restrictions are not allowed to `constitute a means of arbitrary discrimination or a disguised restriction on trade between member states'.

The Commission has used and continues to use three criteria to evaluate the justification of technical trade barriers imposed by member states to protect safety, health and the environment: causality, proportionality and substitution. Let us take these in turn using the example of the pasta purity law in Italy, France and Greece, which specified that `pasta' had to be composed of durum wheat only. This implied that a British-made pasta composed of both durum and soft wheat was not allowed to enter these countries under the name `pasta'.
 (i) Causality: a direct cause and effect relation must
 exist between the trade restrictive measure and
 the objective being pursued. Is the consumer
 `protected' by the pasta purity law? Mixed pasta
 is not a health hazard and durum pasta will not
 be driven out by its introduction. According to the
 MAC Group (1988), a substitution of 10-20 per
 cent is the most likely outcome of abolition of this

(ii) Proportionality: the trade restrictive effects of the
 measure laid down by the importing member
 state ought to be proportional to the objectives
 sought. The pasta purity law effectively
 prohibited all imports of mixed pasta. Such a strong
 measure was not required.

(iii) Substitution: if another means exists to obtain
 the objective that does not hamper trade, then
 this criterion is not met. To the extent that
 consumers need to be `protected' from mixed pasta,
 this can be accomplished through a labelling
 requirement without the adverse trade
 hampering effects.

The pasta purity laws did not meet any of these criteria yet the Commission could not get them repealed until the Court ruling of mid-1988.

There has, however, been a major breakthrough impowered by the Court rather than the Commission with the famous `Cassis de Dijon' case in early 1979 which set out the principle of `mutual recognition', whereby a product legally manufactured in a member state should be allowed uninhibited access to the rest of the internal market without modification.

This has become the basis of what is known as the `new approach' to technical harmonisation as illustrated in the `model directive' of May 1985, whereby the role of the Commission becomes that of seeking agreement on a basic set of standards for health, safety and the environment beyond which the principle of mutual recognition of compliance with other member countries' regulations and certification procedures should apply to achieve a single market. Where greater harmonisation is needed this is a matter for voluntary agreement through the European standards organisations CEN and CENELEC to whom the Commission will refer the proposal. This `new approach' predates the full 1992 programme. It includes the Mutual Information Directive in 1983 (83/189) which obliges member states to notify the Commission in advance of draft technical regulations and standards, giving firms and other authorities time to react before they are implemented. It also gives the Commission the power to delay the introduction of new national legislation by one year in order to prepare a directive to combat the trade-restricting nature of the legislation. This power has been used 30 times in response to 450 notifications. In October 1986 the Commission pointed out that a failure to notify constituted a violation of the directive and that any technical regulation which is not notified to the Commission cannot have legal effect against third parties.

Furthermore, the Commission's ability to speed up the approval of directives and to slow down the creation of technical trade barriers has been improved considerably by the introduction of the Single European Act on 1 July 1987. Article 100A permits the Council to adopt Commission directives with a simple majority vote, rather than the previously required unanimity.

Thus with a few sweeping measures it has been possible to get the Commission off the hook of needing to go through an endless process of international negotiation--endless because technological change will throw up a continuing series of new products and specifications. However, it is important to assess how much this is a real benefit because thus far one result has been to create an enormous backlog of agreements to be negotiated at CEN and CENELEC. If agreement is necessary on even a major portion of the 20,000 standards approved by the German standards institution, DIN, the process will continue well into the next century. The new approach would merely shift the failure to harmonise from an obvious position as a responsibility of the Commission to a less obvious voluntary requirement. Indeed making the change voluntary may merely lead to evasion of the problem altogether, making it possible for powerful firms to prevent agreement indefinitely.

In the light of these concerns the questions we address in this note are (i) what degree of technical harmonisation is actually necessary to achieve a `single market'? (ii) what are the economic motivations to achieve or avoid technical harmonisation? (iii) how far will the `new approach' actually achieve the desired end of a single market? We also consider a further proposition that avers that standards and regulations are weapons of economic power to achieve a competitive advantage for Europe.

Standards, rules and regulations

One of the great virtues of the new approach to technical harmonisation is that it emphasises the diversity of rules, regulations and standards. There are conventionally three types of technical trade barriers: technical standards, technical regulations and testing and certification procedures. (i) Technical standards are voluntary agreed specifications regarding product form, functioning, quality, compatibility and/or interchangeability of methods, products, processes and services. They are not legally binding and are defined in the self-interest of private individuals and standardisation bodies such as AFNOR in France, DIN in Germany and BSI in the United Kingdom. An example of the quite subtle way in which trade can be hindered by standards is the case of building materials. In France insurance companies would only pay for damages, were therefore reluctant to use foreign products which have a different standard but similar quality. In the case of roofing tiles MAC(1988) concluded `Any building expert will admit this standard is overly restrictive with respect to the essential requirements it should be designed to protect.' In addition such tiles cannot be used in public works (40 per cent of the market) and imports had to undergo annual testing and certification which could last from several months to a year.

Four categories of standards are distinguished by their function: (a) information standards are a prerequisite for

(technical) communication in that they carefully

describe dimension, terminology, criteria,

measurement units and other functional and

conversion systems; (b) variety reduction standards aim to reduce the

(unnecessary) number of components or parts or

processes (or products on services); (c) compatibility standards are concerned with the

compatibility of components, complementary

products, processes, protocols or services or the

interchangeability among (competitive) parts or

products; (d) quality standards define maximum requirements

for reliability, durability of materials, processes,

products or services, including aspects of safety,

health and environmental protection. The four categories of standards may or may not be related to technical regulations and technical certification. They can operate at four levels: the firm, the country, a region of several countries and the world. (ii) Technical regulations are specifications similar to standards but differing in that they are legally binding with the purpose of serving the public interest for the objectives of health, safety and protection of consumers, workers and environment. Regulations make the importation illegal if the product does not comply with them.

Technical trade barriers caused by regulations fall into three general categories: product composition laws relating to use of a generic product name; specific ingredient restrictions; packaging and labelling laws. Technical trade barriers in the first category are created when a member state restricts the use of a generic product name, such as pasta or beer, to products produced according to a specific recipe. If products do not comply with the recipe, they may not be commercialised under the given product name, which presents obvious marketing obstacles to the producer/importer.

Specific ingredient restrictions are laws that prohibit the use of additives in certain products. An example is the prohibition of aspartame in soft drinks in France. Aspartame is a sugar substitute used in diet soft drinks in many European countries. The use of aspartame in France was illegal until March 1988, ostensibly for reasons of protecting consumer health, but industry insiders admit that this restriction was in fact the result of successful lobbying efforts by sugar producers and distributors.

Packaging and labelling laws specify requirements, which if not met, prohibit the sale of a product in a given country. These laws are often justified as means to protect consumers and the environment. In over 150 Italian municipalities restrictions against the use of plastic bottles for mineral water are justified for air pollution reasons. However, substitute measures could achieve the same end (for example, a deposit/recycling programme) and the restriction places foreign mineral water producers (mainly French) at a severe cost disadvantage compared to local producers. The well known Danish law on returnable bottles has imposed a similar transportation cost disadvantage on foreign beverage companies. (iii) Testing and certification procedures are designed to ensure conformity to exiting regulations or standards. A trade barrier is created when an importing country requires an additional certification procedure to that required in the country of origin. Examples of this type of technical trade barrier are pharmaceutical certification procedures and type approvals necessary for automobiles.

There are two fundamental reasons for the existence of technical trade barriers within the EC. The first of which is historical and philosophical differences in values among countries on the essential requirements necessary to protect public safety, health and the environment. An example of this type of trade barrier is safety requirements on electrical cutting machines in France and Germany. Dangerous moving parts on French machines are completely isolated from the operator, but in Germany the operator has more responsibility and while the moving parts are placed so as to minimise the danger and have to be clearly indicated they are not always completely isolated.

Users and specifiers of products are often reluctant to use foreign goods which conform to norms with which they are not accustomed. Much of this relates to the costs of change. The sunk costs in having a road system dedicated to driving on one particular side of the road are so great as to preclude change to the other side except in a very long time horizon.

However, to these `natural' sources of technical barriers is added the use of barriers to protect special interest groups or strategic industries. In the latter case governments have quite deliberately used selective procurement, certification policy and incompatible standards as a means of ensuring the continuing of domestic firms in key areas such as telecommunications equipment.

The new approach in Europe seeks to reduce the need for compulsory regulations and to substitute voluntary agreement on standards combined with mutual recognition of testing and certification procedures as set out in the Commission's proposals for a `modular' approach (European Commission, 1988b). Compulsion will be needed where the market fails to operate effectively, whether through exercise of dominant position, asymmetries of information or the neglect of externalities (see Vickers, 1989 for example). However behaviour is not uniform across the Community and what can be achieved by common consent and practice in one country may require legislation with tough penalties in another. The form of implementation will thus have to vary by country if it is to have an even effect in all member states.

Economics of standards

We suggested in the previous section that standards performed four main functions: information, reduction of unnecessary variety, quality improvement, compatibility. The first of these--information--is important in reducing economic inefficiency: buyers are better informed and hence able to make more appropriate decisions and producers of connecting products can find out exactly what specifications they need to meet. The welfare gains from this form of standardisation are clear. Reluctance to comply may reflect market power--ignorance forces purchasers to buy further and related products from the same producer to avoid incompatibility and repetitive testing.

Variety reduction is again an opportunity to reduce costs--not just in terms of economies of scale for the original producers--but for producers and users of components or end products where having to cover a smaller range of possible outcomes cuts the cost. Quality standards are far more purposive, deliberately trying to set targets which either avoid adverse consequences in terms of health, safety and the environment or seek to improve existing standards. Since quality is an important component of competitiveness, such a drive for higher standards can promote the products of one area relative to another. While there are clear examples of quality increasing costs in many cases it reduces them by reducing wastage, returns, repair and maintenance, etc. Furthermore it tends to increase saleability as people seek out the better product, nevertheless there will continue to be markets for lower quality items where the main feature of competition is price.

However, it is standardisation to achieve compatibility which has received greatest attention. It illustrates most clearly the gains to consumers from standardisation and also the losses to some producers from losing market power. There is a role for government intervention to balance these interests where this is not achieved by market forces. The Commission has taken the view that Europe-wide standards are necessary both because national organizations tend to support that to which they are accustomed, which reinforces rather than changes existing patterns and because current differences lead to fragmentation of the market. What is not clear is whether the new approach will achieve that appropriate balance. Therefore, in the sections which follow we examine what affects the willingness to standardise by industry, the importance of standardisation in encouraging innovation, the importance of diversity in motivating market change and the variety of experience that actually exists in European industry.

Compatibility and the gains from standardisation

Products are compatible when their design is coordinated in some way, enabling them to work together. Standards aid compatibility by providing a technical specification to which products must conform. Industries show compatibility if the components of a system produced by one firm can be used with components manufactured by any other firm. This applies, for example, in the home stereo industry where one company's tape deck can be combined with another's receiver and a third's speakers. In the home video industry on the other hand VHS video recorders cannot play cassettes recorded using the Beta format and there is considerable variation in the size of tapes. Compatibility need not be total or bi-directional, in the razor industry for example some manufacturers' blades could be used in their rivals' razors while their own razors were not compatible with their rivals' blades. These dimensions all refer to compatibility between different producers' models of the same product at the same time. Another dimension refers to successive generations of a firm's product and a third to compatibility between different products offered by a producer, like micro, mini and mainframe computers. Each dimension of compatibility has different costs and benefits associated with its achievement by standardisation. Some can only be achieved at the cost of sacrificing others.

In any particular market there may be one or more standards. They can be public, implying no private ownership rights or proprietary, entailing a private property right. A firm with a proprietary standard can then choose whether or not to restrict other firms from producing compatible products. Restriction and rent income from standards can be achieved by copyright, by embedding a standard in a product (like a computer chip) and patenting it, or simply by getting a head start on others who must take time to copy the standard. The particular characteristics of an industry will usually determine the ownership form of the standard and hence the ability of firms to extract rents from standards.

Standards can be set by different methods. There may be standardisation by decision within a single firm, or by agreement between independent firms, whether formal or informal, binding or voluntary as a result of government procurement practices or of follow-my-leader, which may be a seller or buyer, with a large market share. (For example, IBM has leadership in personal computers and Delco has chosen, as a large buyer of AM receivers, to support the Motorola C-QUAM standard.) A de facto standard may also emerge as one of a number of competing designs wins the bandwagon competition (for example, in microprocessor design). Finally, there is direct government regulation and the work of international standards organisations to achieve international compatibility.

The benefits from standardisation are usually assessed from the point of view of the consumer. However, the impact on producers must also be included in making assessments for the whole economy. A system of compatible components is like a single good characterised by positive consumption externalities. Such network externalities arise because the utility a consumer obtains from a system increases with the number of other people who consume compatible products. The larger is the network of compatible goods, the better are the possibilities of exchange, the quality of after-sales services, and the information available. When network externalities exist, consumers have to form expectations regarding the size of networks. Consumption externalities give rise to demand-side economies of scale: a given product is more attractive the larger is the base of existing consumers using that product. However, a consumer in the market today also cares about the future success of the competing products. If consumers expect a seller to be dominant they will be willing to pay more for the firm's product and it will, in fact, be dominant.

What standardisation occurs in a free market?

The new approach to technical harmonisation assigns the achievement of European standards largely to voluntary agreement in the market. It is therefore instructive to see the conditions under which standardisation is encouraged or restricted in the market.

Evidence is limited, but Lecraw (1984) has analysed the determinants of the supply and demand for standards on the basis of a sample of 252 products in Canada. The tentative results show that standards coverage increased with: (1) buyer concentration; (2) seller concentration; (3) the extent of government purchases; (4) the importance of health and safety considerations for the product; (5) the complexity of the product; (6) when the product was a producer good. Standards coverage decreased as: (a) the elasticity of demand for the product increased; (b) its advertising intensity increased; (c) its R & D intensity increased; and (d) if the product were a consumer product.

In some cases such as buyer concentration the forces are clear. As buyer concentration increases, the power of buyers as a group to enforce their desired level of standards on sellers increases and the relative cost of negotiation and enforcement decreases, as does the problem of other buyers `free-riding' on other costs of standards development. The existence of such market power is not necessarily anti-competitive. Buyers may desire standards for the products they purchase in order to increase their certainty of product quality and to be able to diversify their sources of supply.

Seller concentration on the other hand can have opposing effects on the level of development of standards. Increasing seller concentration can increase the use of standards as a means for the sellers to reduce the risks of radical technical change, to reduce competition based on variations in quality and design, to increase their ability to co-ordinate their activities, or to erect barriers to entry for new firms or for imports. Individual firms may have to be large before they can capture enough of the benefits of a standard for their product to devote resources to standards formulation themselves.

Increasing seller concentration can also decrease the use of standards if large firms see the use of standards for their product as an erosion of their competitive advantage in product differentiation, but this appears less prevalent.

This picture of countervailing forces extends to other determinants. The greater the complexity of a product, the greater may be the consumers' need for information about it and for assurance that it will function as desired. On the other hand, the more complex the product, the more difficult it is to write a standard for it. However, others are more clearly determined. The need for standards for producer goods may be higher than for consumer goods due to requirements of compatibility, interchangeability and for achieving economies of scale through rationalisation. The lower the elasticity of demand, the less likely will consumers be to switch to other products if prices rise due to the use of minimum quality standards, and hence the more willing firms may be to have quality standards for their products.

If sellers compete on the basis of product differentiation through high advertising outlays, they may tend to resist standards for their products that would reduce their ability to differentiate their products in the eyes of consumers. Moreover, advertising may provide the buyer with enough information on product quality and performance to make having a standard unnecessary. The causality may also run the other way: if a standard exists, advertising expenditures may be lower. Lastly, the higher the R & D intensity, the faster the pace of technical change may be and the more difficult it may be to write product standards that will not soon become obsolete. If a strategy of product differentiation accompanies increased R & D intensity, firms in industries with high R & D intensity may resist standards for their products, since standards may decrease their ability to compete via product differentiation.

The evidence in Europe tends to support these views. Three of the background papers to the Cecchini Report (Emerson et al, 1988) by Nerb, MAC and GEWIPLAN relate directly to technical barriers. The first is a survey of business views on the importance of such barriers by industry and the second two are detailed studies, each of six industries. They show very clearly that these barriers are most important where there is public purchasing, as for telecommunication equipment, and where health and safety considerations are significant such as for vehicles, pharmaceuticals, food and tobacco and precision and medical equipment. In areas such as textiles and clothing, standardisation and regulatory differences no longer have a major impact on trading patterns. However, governments feel very strongly about food-stuffs and regulate rather than allowing voluntary standards to emerge. In pharmaceuticals the control is even tighter and authorisation is typically required. While automobiles may give the impression of a lack of barriers this is not because of inherent similarity of behavior among the member states but because the large majority of essential characteristics have already been harmonised. The achievement in lowering barriers in this case coupled with the success of the Low Voltage Directive (which was very much the precursor of the new approach) must give considerable hope of further progress in removing technical obstacles to trade within the Community.

The role of property rights

Given these forces will the market achieve an efficient degree of standardisation? Katz and Shapiro (1985, 1986a, b) argue that this depends on whether there are well-defined property rights to the technologies.

In the absence of property rights, free entry into the supply of a technology will lead to marginal cost pricing. Where there are network externalities the benefit a consumer derives from the use of a good is an increasing function of the number of other consumers purchasing compatible items. With external benefits the competitive equilibrium is inefficient because consumers ignore the network effects on other consumers when making their consumption decisions, hence biasing the market towards non-standardisation.

When, nevertheless, standardisation does occur, an inefficient standard may be chosen. This is likely to occur where there are complex technologies which display increasing returns to adoption, in that the more they are adopted, the more experience is gained with them and the more they are improved. A technology that by chance gains an early lead in adoption may with increasing returns eventually `corner' the market of potential adopters, with the other technologies becoming `locked out' even though that technology might have inferior long-run potential (Arthur, 1989). The QWERTY typewriter keyboard is a case of historical events leading to a strategic, first-mover advantage, with the more efficient Dvorak keyboard being locked out (David, 1985).

The Commission thus faces a conflict between the promotion of free competition and the protection of a firm's proprietary interest in the fruits of R&D. The importance of the establishment of European property rights has been recognised and is a key feature of the 1992 programme.

In the presence of property rights or other entry barriers to the supply of a technology, a supplier will be willing to make investments in the form of aggressive pricing to establish the technology, because such investments can later be recouped by pricing in excess of marginal costs. But it is not possible to claim that first-mover advantage will always prevail. The technology that will be superior tomorrow may have a strategic advantage benefitting a second mover. Indeed, if consumers are forward looking an industry can get locked into a newer and supposedly superior technology too soon--an experience commonly found on abandoning manual systems for `superior' computerised systems.

There is no reason to expect the market system to deliver the optimal outcome. Firms with large existing networks or with good reputations for being a market share leader may influence consumer expectations so much that their incompatible standard may come to prevail. This amounts to a disincentive for compatibility, even when welfare is increased by the move to compatibility. In contrast, firms with small networks or weak reputations will tend to favour compatibility, even in cases where the social costs of compatibility outweigh the benefits. There is a clear role for an effective system of property rights.

Firms may disagree on the desirability of making their products compatible as the move to compatibility may increase the profits of some while lowering the profits of others. In these circumstances some mechanism must be established if compatibility is to be achieved, for example, side payments among firms in the form of licensing fees or compensation for the expenses of making the products compatible.

Take the case of two basic technologies between which compatibility can be achieved. Compatibility may arise through the joint adoption of an industry standard, where firms act together to make their products compatible with one another or through the construction of an adapter, where a firm unilaterally can act to make its product compatible with those of another network. When the firms cannot make side payments and when the compatibility mechanism is an industry standard, the products of a given set of firms will be made compatible if and only if all of the firms joining the standard benefit from its creation. Allowing cost sharing will raise the likelihood of the firms choosing compatibility.

When the compatibility mechanism is an adapter and side payments are infeasible, the products of two firms will be made compatible and the adapter will be constructed if at least one firm earns increased profits from compatibility, assuming that the firm that constructs the adapter is the only one to bear the cost.

When side payments are feasible, the firms will make their products compatible and adopt an industry standard if and only if the change in the profits of firms that can make side payments to one another exceeds the joint costs of compatibility. The sufficient condition for achieving compatibility is that the joint profits rise.

Thus we can see that the private decisions over whether to achieve compatibility will depend on the decision locus, whether firms can act unilaterally or if consensus is required and on the feasibility of side payments. Public policy can influence both of these features. Patent and copyright laws are a significant determinant in this respect.

Standardisation and innovation

This first-mover problem extends to innovation (Farrell and Saloner, 1985, 1986 a, b). In the presence of compatibility benefits, a user who switches to a new superior technology cannot obtain its full benefit unless other current users also switch and new users adopt the new technology. This creates a Prisoners' Dilemma problem. A firm will not wish to move unless it is followed even if it has a clear benefit if all firms move. To avoid the problem it would be necessary to have unanimity among firms and complete information but normally information is not complete and a firm will be uncertain whether it would be followed if it switched.

A new standard is less likely to be adopted the greater costs of incompatibility while change takes place and the larger the installed base. The importance of installed base can provide an incentive for predatory pricing. If a seller with market power faces a threat of competitive entry by a new technology, it may be worthwhile reducing prices temporarily in order to make its installed base large enough for its market power to become invulnerable, at which time it can raise its prices again without inducing entry.

Where there are no new users so that the new network is built up through old users switching to the new technology, switching may be delayed. The firm may not consider a switch until some costly capital good needs replacing anyway. Indeed, even if users unanimously favour a switch, each user may prefer the other to switch first. As Farrell and Saloner (1987) colourfully put it: Like penguins who must enter the water to find food, they often delay doing so because they fear the presence of predators. Each would prefer another to test the waters first.

Standardisation and anticompetition

In industries which constitute parts of a vertically integrated chain of system-compatible components, survival and success are not necessarily the result of superior performance, but may be determined by the possession and exercise of power to set the rules. A dominant integrated-system firm in the industry sets the rules under which potential competitors can enter and survive in the peripheral equipment and software markets (Adams and Brock, 1982). The critical rules are those that govern product design. The nature of these rules is determined by industry structure and, in particular, firm specialisation or integration on the one hand and market concentration on the other hand. By introducing incompatibilities the monopolist can impede rivals without having to suffer the losses of price cutting.

The monopolist's control of the rules of the game across the industry's markets includes the power to regulate the rate, direction, timing and source of commercially viable innovation. Control of product design standards enables the monopolist to block the pioneering effort of rivals. Here the problem is the monopoly control of innovation by others. Therefore, market acceptance is an inherently defective criterion by which to evaluate relative progress and innovativeness.

Some conclusions for the single market

The experience of the 1960s and 1970s shows that the process of getting common regulations and standards is a very difficult one. Since there are three sets of costs from changing existing behaviour, first that of changing existing non-compatible products, second the need for producers to change their processes/products and last the change in market power, it is not surprising that there is resistance from those who lose. The social advantages of standardisation will not necessarily lead to voluntary agreement between producers. However, we have shown that standardisation can slow the process of change and indeed can lock in inefficient technologies.

It is not clear that allowing the market to decide on whether standards should emerge and what they should be will provide an efficient answer for particular products. In particular, Europe does not operate alone. To a large extent standards are an international concern and the major sellers in the European market can easily be foreign, not European, producers. Hence in many cases it may be appropriate for European and international standards to be compatible. However, because standards convey and alter market power the process of their introduction is part of the competitive process. If agreements can be reached more quickly in industries where there are first-mover advantages then those producers will gain. But quicker movement does not ensure first-mover advantages nor agreement on standards that are optimal for purchasers. The system of trying to reach quick agreement on European `prestandards' (ENVs) (see (COM (88)314 final) for example) increases the change that such first-mover advantages as do exist can be grasped.

This debate is clearly illustrated by HDTV. Japanese standards have been established ahead of European standards but those standards will both impose costs on European consumers, because of lack of compatibility with current TV systems, and will result in a considerable loss of market power for European producers, who will have to change and lose the benefits of much existing R&D. Yet with SECAM and the various PAL systems the problems of incompatible standards were clearly illustrated in the introduction of colour TVs. The smaller the market the easier `regulatory capture' is by the major producers, but the larger the market the more difficult it is for producers to establish standards. It is possible therefore that there is some optimal market size in establishing standards taking account of both the competitive position of producers and the interests for consumers. Europe may not be the right size for some products.

It is clear that the areas over which agreement is necessary or desirable vary by the particular industry or even process or product. HDTV is an unusually important decision. Having to remove existing technical barriers between European countries at the same time as continuing the development of new standards under international competition puts an administrative strain on the system. Delays in agreeing European standards will obviously perpetuate existing barriers, but faster progress achieved by the market power of particular countries' systems will not necessarily provide an optimal outcome for consumers as it will tend to mean that the costs of change will fall more on smaller countries and on smaller producers. However, where sunk costs are high, change will inevitably be slow and in some cases never take place.

This is not an area where decision-making can be completed by the end of 1992 nor would it be optimal to achieve it in such a short time even if it were feasible. Because of the advantages of compatibility a process of transition which tends to allow progressive change will be beneficial. Allowing the continuation of variety subject to market pressures under the new approach to technical harmonisation is clearly desirable where it responds to the variety in consumer tastes but it is complicated because there are benefits to existing producers of perpetuating differences even where there is no such consumer gain.

The new system is not complete. With different means of obtaining safety requirements in the member states and different enforcement systems the rate of change of existing practices will vary. Further progress will have to be made in these areas as well before technical harmonisation can be properly achieved. Mutual recognition of certification requires a good flow of information and the confidence that processes in other centres are carried out properly. In the same way declaration of conformity with standards by companies following German practice will only work if firms follow those rules conscientiously. As soon as national authorities do not believe such declarations, extra checking will be justified which can arrest the process of harmonisation. With lags in prosecution, firms may seek short-run advantage from abusing the system and declaring conformity where it does not exist.

The new approach is a major and welcome step forward but it does not remove the difficulties purely by removing direct detailed responsibility for European standardisation from the Commission. The economic forces which affect standardisation are not changed and the problems of balance between public benefits and private returns to producers remain. The considerable complexity of the electromagnetic compatibility proposal shows that the new approach directives are not always as simple as was hoped. Having agreements for the whole of Western Europe not only permits reductions in costs but also reduces the scope for individual companies or cartels to `capture' their domestic standards organisations. Nevertheless in the bargaining process to widen European standards it is clear that the power and enthusiasm of the bargainers also varies and will hence affect the European standards that are eventually agreed.
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Author:Gevel, Ad van de; Mayes, David G.
Publication:National Institute Economic Review
Date:Aug 1, 1989
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