A legal and institutional framework for digital transformation

Who owns our data? How can the principles of free competition be protected in a digital world? Only a systematic comparison of different business models shows what's at stake for the social market economy argues Michael Hüther, director of the Cologne Institute for Economic Research, in a guest contribution for the Frankfurter Allgemeinen Zeitung.

For some time now policy-makers have been enthusiastically addressing the economic transformation known under the label "Industrie 4.0" (Industrial Internet). This political interest is understandable. Those national economies which have a higher proportion of digital business models and the accompanying infrastructure enjoy correspondingly higher incomes. The corporate world, however, has as yet neither developed a common approach to the issue nor shown any sign of investing in the breadth and depth which digital transformation requires. In the political arena, meanwhile, strategies for developing a coherent legal and institutional framework for a digitalised world are in short supply.

Digitalization opens up new business opportunities, with network integration and acceleration the two key factors. Digital technology breaks and reforges connections and contacts which have traditionally been limited to a single region; it enables business to be done with almost unlimited quantities of scale; and it extends the range and reach of all manner of economic players. Not only plant and machinery but also goods and services can be integrated into automatically functioning networks. At the same time the cost of market use is dropping. Verifiable information is more rapidly and more widely available. Supply and demand can be balanced more efficiently than previously imaginable.

Digitalization is affecting almost all areas of the economy and of society. It is disrupting the patterns of labour division, changing business models and influencing the different interfaces between sectors of the economy. Examining this process systematically serves not only to increase understanding of the structural change affecting our economy but equally to identify the challenges to our legal and institutional framework which it throws up. Without such clarification, we will lack any orientation on issues around property and data rights, regulatory sovereignty and market power.

Business models in the digital world can be identified with any one of four economic interfaces originating in the varied network of relationships between companies and consumers. Let us start with the exclusively corporate interface (business-to-business). This is where we find the concept of "Industrie 4.0", whose potential stems from the strong position of German industry in global competition. Our companies ensure their competitiveness by combining manufacturing and services. They have managed both to produce cost-effectively and to create innovative services. This explains their strong position among the world’s market leaders.

This position has been indirectly confirmed by two studies conducted by the Massachusetts Institute of Technology on the competitiveness of industry in the United States. The first, carried out in 1989 ("Made in America. Regaining the Productive Edge"), diagnosed both efficiency and quality problems which put American manufacturing well below the international standard. The second, conducted in 2013 ("Making in America. From Innovation to Market"), found that these issues have largely been resolved. Nonetheless, while in this quarter century productivity has caught up with the global standard, there has been a progressive loss of value-added and jobs in manufacturing in the United States. The reason is obvious: America’s manufacturing companies are broadly left to their own devices and must face the competition without the benefit of integration into functioning networks.

In German industry quite the opposite applies. Companies are linked to each other in value chains, production and service networks which give them enormous flexibility in tailoring services to their customers’ needs. The networks in the metal and electrical industry and the chemical industry are key factors in their success. Germany has clusters of both traditional and cutting edge industrial sectors such as are to be found in no other European economy and least of all in the United States.

This is the basis for “Industrie 4.0”. By combining classical mechanical-electronic production structures with software and information technology (cyber-physical systems) and using private cloud-computing services, a real time information chain incorporating data on customer use can be added to the value chain. Providing completely individualised (batch-size 1) products cost-effectively and anticipating faults during the production process are made possible thanks to diverse and extensive customer data enabling the identification of cause and effect. In this respect, digitalization is not conducive to scaling up but, on the other hand, opens up undreamt-of advantages in specialization. Furthermore, while some existing business models are being reinvented, this is less the result of radical changes than of many incremental steps which are the long-term consequences of earlier structural decisions.

If we now turn to the economic interface between companies and consumers (business-to-consumer), we encounter a completely different picture of economic digitalization. This sector is dominated by the internet giants of Silicon Valley, whose quantitatively virtually unlimited expansion of the business model has been accompanied by a correspondingly high stock market valuation and a strong capital base. The many everyday conveniences, both large and small, provided by these companies are limited by neither space nor culture. Their market penetration is the result of a standardization which, though it reduces complexity, forces the customer to adapt to those standards. Customisation would be costly, it would require intensive consultation and the commercial advantages of scaling would be forfeited. The processing of huge amounts of data on the use of the internet services makes it possible to recommend to individual purchasers the product most likely to satisfy their needs and desires.

In contrast to the exclusively corporate world of B2B, it is not immediately clear how the benefits to the national economy of B2C can be accurately assessed, as the internet services offered by these intermediary platforms are mostly free of charge. They are paid for indirectly by the advertisements which accompany their offerings yet this advertising revenue does not necessarily reflect the willingness of users to pay for the service itself. The consumer yield, i.e. the benefit to the users calculated as the difference between the amounts they would be willing to pay and the actual price, is not systematically included in the computation of gross domestic product, and rightly so, since the latter only takes account of transactions carried out via markets.

Appreciating the differences at these two economic interfaces protects us from errors in decision-making and a false sense of security. The intensity of the competition in the two markets is different. In the world of “Industrie 4.0” the integration of customer data can lead to dependence, which causes difficulties in respect of market power. Such dependence can arise when, for example, the data on customer use generated by one provider is prevented from being transferred to another provider by the current lack of ownership rights for machine data. This obstacle can be circumvented by drafting agreements to regulate the ownership and use of data at the sectoral level. Of course, legal action will occasionally need to be taken to prevent monopolies arising in tight markets dominated by world leaders or niche players.

Other competition policy concerns arise in connection with scalable consumer-based business models. On the one hand, generating large amounts of data has the advantage of enabling the expansion of services or the creation of new applications for customers. Exclusive possession of data temporarily gives an internet company a strong market position and if it has a corresponding customer reach renders it particularly attractive for online advertising. This in turn further strengthens its market position. On the other hand, these often densely concentrated digital markets are subject to the creative destruction wrought by fierce competition, ensuring that the position of the market leader can be effectively challenged.

Nor should we forget that scaling and network effects affect not only demand but also costs. Against the gain in data and information provided by new users must be set the cost of analysing that data, adapting services or even developing and launching completely new ones. Moreover, experience shows that learning curve effects do not last indefinitely. The challenge which these intermediary platforms pose for competition policy comes in three forms: firstly, the expansion of business models by combining digital services with offerings of operating systems, hardware and the like; secondly, the concomitant transfer of power from the original markets to those above or below them in the value chain; and, thirdly, the regulation advantage they enjoy over comparable traditional providers (telecommunications, television, radio).

Intermediary platforms also play a key role in the economic interface between consumers (consumer-to-consumer). Digitalization makes it possible to give old ideas a commercial new lease of life. Consumers make agreements with other consumers whereby they temporarily transfer the right to use their property or offer services. Once purely local phenomena such as ride- and flat sharing agencies have burgeoned into the global markets of the sharing or collaborative economy. The sharing of goods by allowing third parties temporary access to them has attained global significance thanks to platforms such as Airbnb and Uber. Fintech has opened up opportunities for private direct financing while new database structures such as Block chain have enabled self-organizing global transfers between strangers without the mediation of a bank.

These new platforms create not only the technical wherewithal for transacting deals securely but also facilitate the necessary confidence-building, with user-reviews, accessible and unalterable histories of transactions, and transparent analyses by the platform operators providing the requisite testimonials. What is exciting from an economic point of view is that the constant availability of comprehensive information about supply and demand in a specific market makes it possible to balance them efficiently.

Politically, the new quality of these solutions raises the question as to whether, and to what extent, regulation should, and can, ensure fair relations between the new and the traditional markets. In a sense, the sharing economy can be understood as a driver for reviewing current rules and opening up over-protected markets. Safety (as in ride-sharing), liability for disturbing third parties (as in flat sharing) and risk (as in the case of the private bank borrowing) are all factors which require an appropriate regulatory framework. By creating additional business opportunities and thus enlarging existing markets, the sharing economy largely keeps itself out of the competition watchdogs’ sights.

Finally, we need to take a look at that economic interface where consumers have entered into a new dialogue with the corporate sector (consumer-to-business). The reference, of course, is to big data: the voluntary or involuntary – and at all events often unconsidered - generation of data when using digital services. In conducting their transactions or playing their games, users simultaneously enable the service providers to enrich their user-profiles, identify malfunctions and system weaknesses more easily and improve their diagnostic methods, thus creating a basis for optimizing existing or developing new business opportunities.Where this data reflects the user’s personality, the downside is obvious. Although information gleaned from personal data can render the steering of free market processes more efficient, it can also materially affect personal rights and put individual sovereignty at risk. Despite the introduction of the "right to be forgotten" in the General Data Protection Regulation adopted by the European Parliament in April this year, this dilemma has yet to be resolved. Even responsible citizens must be able to take the transparency of data-use for granted; informational self-determination is a fundamental right.

Examining these four economic interfaces makes clear how different the business models based on digitalization are. Behind this variety lies the fact that, despite so much radical innovation, the effects of earlier decisions and structures, often going back a long way, continue to be felt. The concern often voiced in this country that, in view of the dominance of the American internet companies, German business has missed the boat and can no longer pursue an independent approach has little basis in fact. This becomes all the clearer when one sees the difficulties these US tech giants have in understanding the German industrial model and responding to its complexity with customised rather than standardised solutions.

Over and above the need for action on competition and regulatory policy at the four interfaces described above, there is a real need to develop a digital legal and institutional framework. This would make it possible to transfer the fundamental principles of our existing economic order - private property, freedom of contract and legal liability - to a world in which the key economic categories are data sovereignty, data ownership, data transfer and platform markets. Making the resulting standards effective will require a European agenda: it will not work at the national level. The Digital Single Market 2.0 is the EU’s central project for the future. Here it will be essential to clarify in principle the legal status of machine-generated data, to analyse the cross-market leveraging of market power, to observe the weakening of market position by potential competition more extensively than before and, finally, to address the societal requirements necessary to balance the free market.

Creating a digital economic order is a matter of fundamental importance. A consistent institutional and legal framework, firmly anchored in our society, creates the very confidence which itself serves as a factor of production. Our economic system, our Social Market Economy, is one which combines economic efficiency with social security and societal progress. To ensure that we continue to succeed in this, the different time patterns and speeds must be coordinated. Thanks to global networks operating in real time, digitalization is one huge acceleration programme. A socially responsible free-market economy needs time to organise compensation for those affected by this dynamic economic transformation. While the core of our economic order - the three fundamentals referred to above - must be consolidated, at the margins it must be made more flexible. Accelerated change requires certainty. The key to this is informational self-determination.

The threat to the public sphere from self-referential communities in the social networks and from deliberately biased and distorted information must be taken equally seriously. A humane economic order such as ours needs the public to provide effective standards of economic responsibility. If our society disintegrates into a multitude of communities seeking refuge in the isolation of self-defined truths, it will become increasingly difficult to meet this requirement. "The limits of community" (Helmuth Plessner) would then have been reached. The public sphere, with its critical but respectful dialogue, would lose its ability to mediate conflicts and find appropriate and relevant solutions. In this respect, digital transformation is extending not only our scope to inform, decide and act but also our responsibility for the public sphere.