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SPECIAL ISSUE

THE FEDERAL RESERVE BANK
OF CHICAGO

AUGUST 2004
NUMBER 205a

Chicago Fed Letter
The economics of standards: Public policy and market performance
by Carrie Jankowski, advanced public policy analyst, and Victor Stango, senior economist

As technology rapidly transforms many traditional sectors, the Fed and other public
service providers are increasingly concerned about standards. The process for
standards setting is complex with competing players and perspectives, and the
fundamental economic principles are not clear cut.

The payments market has
seen a transition from
checks to new electronic
payment instruments,
highlighting the need for
common interoperability
standards.

On May 13–14, 2004, the Federal Reserve
Bank of Chicago and Northwestern
University cosponsored a conference titled
“Standards and Public Policy.” The conference brought together about 40 experts
in public policy on standards, including
economists from academia, the Federal
Reserve System, and industry. This Chicago
Fed Letter summarizes the conference presentations, which focused on the economics of standards competition, committees
and standards organizations, compatibility
and standards policy, and governmental
approaches to standards policy. All papers
presented at the conference can be accessed at: www.chicagofed.org/news_ and_
conferences/conferences_and_events/2004_
standards_emerging_payments_agenda.cfm.

In his introductory remarks, Michael
Moskow, president and chief executive
officer at the Chicago Fed, emphasized
that as technology rapidly transforms
many traditional sectors, the Fed and other public service providers are increasingly concerned about standards. Moskow
noted that often the process for standards
setting is an uncertain and complex activity with competing players and perspectives. Furthermore, the fundamental
economic principles are not clear cut and
have just recently been gaining significant
attention. He pointed out that the payments market, in particular, has seen a
transition from checks to new electronic
payment instruments, highlighting the
need for common interoperability
standards. Therefore, the Fed is confronted with the particularly difficult task of

finding the proper public policy position
in the payments market, while balancing
its dual roles as public service provider and
market participant. Because the research
presented at the conference balances realworld concerns with critical academic
thinking, it may provide helpful insights
to those interested in making informed
public policy decisions on standards.
The economics of standards
competition

In the first session, Timothy F. Bresnahan,
Stanford University, presented a paper,
coauthored with Pai-Ling Yin of Harvard
Business School, that studied both economic and technical forces affecting the
diffusion of web browsers. The authors
focused their analysis on the late 1990s,
when both personal computer (PC) sales
and web use exploded.
Bresnahan noted that people were “rationally ignorant” when it came to selecting
browser software: by and large, they used
the browser that came with their computer. Hence, the primary force behind
the adoption of new browser versions was
the diffusion of new PCs, rather than any
improvements in browsers themselves. He
suggested that looking at the diffusion
process, rather than just the determinants
of a shift in technology, adds significant
insight to our understanding of the overall economics of technical change.
Marc Rysman, Boston University, presented a joint paper with Shane Greenstein,
Northwestern University, focusing on the

early 56K-modem market, to highlight the
coordination costs of resolving a standards
war. The standards war in the 56K-modem
market involved two very similar network
technologies. The standard-setting organization (SSO), the International Telecommunications Union (ITU), was apparently
helpful in resolving the conflict between
the technologies by establishing a focal
point for the industry. However, the development of focal points carries costs: in this
case, membership, meeting, submission,
and negotiation costs associated with the
standard-setting process, as well as implicit
costs that can make it difficult to reach an
effective consensus. For example, when
participants have imperfect information,
confusion and misunderstandings may delay the process. The voting environment
also has implications for the resolution
process. The ITU uses a consensus voting system. Since all firms in the market
are members, each firm can delay the
process if its own concerns are not met.
Rysman concluded that ITU acted in a
way that produced net benefits. In his
view, it is unlikely that the alternatives
of regulation or the market would have
overcome the social costs of coordination any more easily.
Next, Richard Langlois, University of
Connecticut, discussed his research on institutional structure as a competitive weapon. Specifically, he looked at the U.S.
cluster tool industry, which manufactures
the equipment used to produce semiconductors.
Competition for these tools is divided
between a large vertically integrated firm,
Applied Materials, which manufactures
according to its own specifications, and a
fragmented fringe of smaller, more specialized competitors. The fringe has responded to the competition from Applied
Materials by "creating a common set of
technical interface standards."
Rather than calling this a standards battle,
Langlois noted that it is better thought
of as a battle of alternative development
paths: the closed systemic approach of
Applied Materials versus the open modular system of the competitive fringe. He
analyzed the tradeoff between the benefits
of system innovation and internal economies of scale and scope on the one hand,
and the benefits of modular innovation

and external economies of standardization on the other.
While this case provides an interesting
example of an industry where diverse approaches to standardization may coexist,
the industry is starting to change. Langlois
noted that the industry may see a transformation to a more common structure,
where "several larger firms adhere to
common standards and become broadly compatible systems integrators which
outsource manufacturing to specialized
suppliers of subsystems."
Neil Gandal, Tel Aviv University and
Michigan State University, presented joint
research with Nataly Gantman, Tel Aviv
University, and David Genesove, Hebrew
University and Center for Economic
Policy Research, that focused on the interaction between patenting and standardization committee participation in the U.S.
modem industry. Gandal explained that
network effects are inherent in the modem market because Internet users and
Internet service providers benefit as more
adopt compatible technology; furthermore, interoperability is crucial for the
seamless transmission of data.
Gandal noted that while over 200 companies in this market attended standardization meetings from 1990 to 1999, and
around the same number received patents
from 1976 to 1999, only 45 firms did both.
Using statistical tests, they show that while
patenting is predicted by participation in
earlier standardization meetings, meetings
participation is not predicted by earlier
patenting. One possible explanation for
this finding is that firms with pending, but
not yet granted, patents attend the committee to have the standard incorporate
their intellectual property. There are, of
course, other possible explanations as
well – which the authors are continuing
to explore.
Charles Steinfield, Michigan State University, presented a joint study with Rolf
Wigand, University of Arkansas, M. Lynne
Markus, Bentley College, and Gabe
Minton, Mortgage Bankers Association of
America, focused on vertical information
systems (IS) standards in the U.S. mortgage
industry. These standards may address
product identification, data definitions,
standardized business documents, and/
or business process sequences.

Their case study identifies three processes
as important in this standard-setting environment: the way that the standardization
process is structured to facilitate participation and consensus, the approaches
used to promote adoption of open standards, and the steps taken to ensure the
ongoing maintenance and integrity of the
standard. The authors’ results emphasize
the importance of company and individual incentives to contribute to the process,
formal and informal governance mechanisms used to minimize conflict and reach
consensus, inclusive and proactive policies
regarding membership, limited scope of
standardization activities, explicit intellectual property rights policy, and efforts
to institutionalize the entire standardization process into a formal structure.
Committees and standards
organizations

In the following session, Joel West, San
Jose State University, presented a paper on
open standards. West defined a standard
as “open” if the “rights to the standard
[are] made available to economic actors
other than [the] sponsor.” He indicated
that this transfer can occur if rights are
waived or conceded, licensed to other
organizations, or are unprotectable. He
pointed out that while “open” product
compatibility standards are often viewed
as socially optimal, the reality is that not
all “open” standards are really open. His
paper defines different measures for
openness and their implications for adoption, competition, and public policy.
West argued that it is important to determine who has access to the standard, including customers, complementers, and
competitors. Next, it is necessary to decipher what rights are made available to
those who have access to the standard,
such as creating the specification and
using the specification in development
and in practice. Overall, access to the
standard can be limited through membership requirements on the creator side
or use rights on the user side.
West suggested that policymakers could
address the deficiencies in openness in
several ways, including direct regulation,
procurement, intellectual property law,
and competition policy.
Josh Lerner, Harvard Business School,
presented a joint paper with Jean Tirole,

Massachusetts Institute of Technology and
Industrial Economic Institute, focusing on
how sponsors of a standard choose which
SSO will certify their technology. Lerner
posed a situation in which certifiers
(SSOs) vary in terms of “toughness,”
where tougher SSOs are less likely to ratify the standard; ratification increases consumer adoption, which benefits sponsors.
This toughness may be offset, however,
by the extent to which an SSO is attuned
to the sponsor’s interests. Sponsors’ choices among SSOs are affected by these factors, as well as the inherent strength or
quality of the standard.
Lerner said that in general, sponsors of
weaker standards will choose more credible SSOs. Stronger standards allow the
sponsor to have more control over the
certified standard, that is, make fewer
concessions. In general, users benefit
when the sponsor has a stronger downstream presence. Lerner also suggested
that standards competition induces sponsors to apply to more credible SSOs. In
addition, his research model shows that
regulation cannot improve on private
choices in the case of mildly strong standards, and that partial regulation reduces
social welfare when standards are strong.
Tim Simcoe, University of California,
Berkeley, presented his research examining the time it takes SSOs to reach consensus on new standards. He studied the
Internet Engineering Task Force (IETF)
—the organization that issues the technical standards used to operate the Internet.
The period of his analysis, between 1992
and 2000, is interesting because “rapid
commercialization of the Internet led to
some dramatic changes in its size, structure, and demographic composition.”
Simcoe examined the relationship between the composition of IETF committees and the time to reach consensus. He
described several factors that influence
the time it takes to reach consensus, including: the number of participants on
a committee of the underlying technology and its interdependency with other
standards, the set of design alternatives
available to the committee, the economic
significance of the specification, and the
rules governing the consensus decisionmaking process.

Simcoe showed that there was a significant
slowdown in IETF standard setting between 1992 and 2000. Over this period,
the median time from first draft to final
specification more than doubled, growing
from seven to 15 months. He stated that
cross-sectional variation in size, complexity, and indicators of distributional conflict for individual working groups or
proposals explains only a small portion of
the overall slowdown. He attributes the
remaining increases to “changes in
IETF-wide culture and bottlenecks in
the later stages of the review process.”
Then, Carl Cargill, Sun Microsystems,
presented a paper coauthored with Sherri
Bolin, The Bolin Group, on recent trends
in the organization and performance of
SSOs. Cargill noted that over the last
decade, the standard-setting process as
embodied by many SSOs has become dysfunctional. He noted two sources for this
deterioration. First, it is too easy for private-sector entities to form SSOs and
“stack” them with members from organizations with similar interests. This results in
over proliferation of SSOs organized by
competing interests, which is not much
better than market-based competition between standards and may even be worse.
Second, Cargill noted that the U.S. government has been remiss in not defining
clear jurisdictional and procedural rules
for SSOs.
Cargill suggested a policy remedy for the
latter problem in particular. He recommended that the government establish
clearer and more open rules for membership and participation in SSOs. He feels
that such a change will reduce the incentives for over proliferation in SSO
formation.
Compatibility and standards policy

In the next conference session, Jeff
MacKie-Mason, University of Michigan,
and Janet Netz, ApplEcon, L.L.C., presented a paper on using interface standards as
an anti-competitive strategy at the component level. These authors presented a new
strategy called “one-way” standards and
discussed the conditions under which it
can be anti-competitive.
While economists often assume that standards reduce barriers to entry, consortia

can create entry barriers through a number of avenues: delaying publication of the
standard to gain a first-mover advantage;
manipulating standards to require other
firms to use royalty-bearing intellectual
property; and creating “one-way” standards. The last barrier drew the most
attention from the authors.
In this strategy, a consortium creates an
extra technology layer or a “translator.” If
the consortium publishes the information
necessary to manufacture compliant
components on only one side of the translator, it can move the boundary separating
systems away from mix-and-match competition and exclude competition on the
private side—while appearing open by
enabling component competition on the
public side.
Joe Farrell, University of California,
Berkeley, discussed the appropriateness
of government policies that force compatibility between competing systems or
standards. Such compatibility shifts the
level of competition from the “system”
to the individual components that comprise the standard.
Farrell noted that despite considerable attention devoted to this issue, the overall
benefits of shifting compatibility to the
component level remain ambiguous. In
many cases, systems competition can be
quite beneficial. Owners of systems often
have strong incentives to pursue aggressive
Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2004 Federal Reserve Bank of Chicago
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Prior written permission must be obtained for
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ISSN 0895-0164

pricing policies that benefit consumers.
System competition can also intensify
price competition relative to component
competition. Despite these possibilities,
Farrell expressed the opinion that component competition is more often more efficient than system competition. This is
largely because component competition
increases consumers’ choices.

Cabral noted that their model is only appropriate for extreme specifications of
policymakers’ preferences. In reality, policymakers typically fall somewhere in between completely impatient and perfectly
patient. Furthermore, Cabral suggested
that policymakers do not always choose the
superior standard given their preferences.

to digital; however, their preference for
television is very strong. So, Ottaviani noted, according to his model, if the UK
government were to issue a credible date
commitment for the termination of analog services, it would likely meet its
objective for the transition; however,
the government has not done so.
Conclusion

Luis Cabral, New York University, presented a joint study with Tobias Kretschmer,
London School of Economics. In this paper, the authors focused on a policymaker’s
choice between competing standards. They
also considered the timing of intervention.

Marco Ottaviani, London Business School,
presented a paper coauthored with Jerome
Adda, University College London, which
models the public policy issues surrounding the transition from the analog to digital television standards in the UK. This
case presents a typical coordination problem; that is, viewers’ adoption depends on
broadcasters’ and manufacturers’ support
for the digital platform, which in turn depends on viewer adoption. Ottaviani stated that policymakers can affect the speed
of digital television diffusion through
controlling the quality of the signals and
the content of public services broadcasters, providing subsidies to various users in
the digital equipment market, or setting
a firm switch-off date for the analog signal.

Cabral said that policymakers may be impatient, caring solely about the welfare of
current adopters of a standard, or patient,
caring exclusively about the welfare of future adopters. In this paper, the authors
assumed that the policymaker can affect
the system in terms of what standard is
chosen. When a policymaker is very impatient, the authors showed that it is optimal
to act promptly and support the leading
standard. It is better for a patient policymaker, however, to delay intervention and
eventually support the lagging standard.

Ottaviani’s model used survey data with
stated preferences for television characteristics by UK consumers. The UK government would prefer to switch off analog
services sometime between 2006 and
2010. By that date, most consumers would
need digital TVs or digital set-top boxes.
The results from the estimated model
showed that more than 95% of viewers
would adopt digital technology before a
perceived switch-off date, if they viewed it
to be inevitable. In general, consumers
face high costs in switching from analog

1

The concluding remarks represent the authors’ interpretations and do not necessarily reflect the views of all of the conference participants.

Chicago Fed Letter

Government approaches to
standards policy

Standards have become increasingly important as a way of spurring technological
change, enabling better products and services to be produced in the marketplace.
As a whole, the case studies and research
presented at this conference suggested
that the operations of markets in the current anti-trust environment were successful in producing beneficial standards; that
is, no broadly recognized difficulties were
identified. Some participants further supported this conclusion by highlighting
that it would not be easy to change this
system or design a new regime that would
work better than the current one. There
have been some cases, however, where
standards were manipulated to the advantage of certain market participants, often
in areas where rights to intellectual property were not well defined. Taken together, the work presented at this conference
lays a foundation for those wishing to better understand the processes governing
the evolution of standards.1

FEDERAL RESERVE BANK OF CHICAGO
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From a policy standpoint, Farrell noted
further difficulties. He mentioned that
even if policymakers favor component
competition, implementing policies to
dissolve systems can be problematic. In
summary, Farrell said that many key issues involving compatibility policy remain
unresolved.


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