Streetwise Professor

Last week the Chairman of the Federal Communications System announced that the FCC will pursue net neutrality regulation by subjecting the Internet to Title II of the Federal Cable and Telecommunications Act. This will essentially treat the Internet as a utility, rather than as an information service as has been the case since 1996. Like telecoms, Internet Service Providers would effectively become common carriers subject to a panopoly of restrictions on the prices they can charge and their ability to control access to their infrastructures.

The issue is an extremely complex one, and moreover, one that has been subjected to a barrage of simplistic, propagandistic, rhetoric. To cut through the rhetoric to see the economics, I recommend this article by Gary Becker, Dennis Carlton, and Hal Sider.

Becker, Carlton, and Hal characterize the goals of net neutrality as follows:

In the FCC’s view,

its proposed net neutrality rules would “prohibit a broadband Internet access provider from discriminating against, or in favor of, any content, application or service.” Broadband access providers would be prohibited from: (1) prioritizing traffic and charging differential prices based on the priority status; (2) imposing congestion-related charges; (3) adopting business models that offer exclusive content or that establish exclu- sive relationships with particular content providers; and (4) charging content providers to access the Internet based on factors other than the bandwidth supplied. [References omitted.]

In a nutshell, NN rules and Title II would limit the pricing policies of ISPs, limit their ability to regulate access to their networks, and limit their ability to vertically integrate upstream or downstream (e.g., by purchasing content providers).

The motivation for all of this is a belief that the broadband industry is not competitive, and that price discrimination, access limitations, and vertical integration are means of exercising market power to the detriment of consumers downstream and suppliers of content upstream.

As Becker et al point out, however, evidence that competition is weak is lacking. Most consumers have choices of broadband providers, and the development of wireless services such as 4G is increasing consumer choice.  (Personally, I would estimate that I have gone from relying 100 percent on wired access to 50 percent wired-50 percent wireless. The focus of Facebook and other social media and content suppliers on mobile indicates how important wireless is becoming.) Moreover, there is considerable switching of suppliers, which is further indication of competition.

Further, as a general matter, price discrimination is often-one might say usually-welfare enhancing when there products are differentiated and the costs of these products differ. Different forms of content utilize different amounts of bandwidth. Services vary in their need for speed (e.g., streaming vs. ordinary web-browsing vs. email). It is more costly to deliver bandwidth-intensive services. Limiting the ability to charge prices that reflect differences in cost and value lead to misallocations in the use of existing bandwidth capacity, and tend to reduce incentives to invest in capacity. Moreover, the “two-sided” nature of the Internet tends to make price discrimination welfare-improving. (This paper by Weismen and Kulick makes the very useful distinction between “differential pricing” and “price discrimination.” The former is based on differences in cost, the latter on differences in demand elasticity across customers.) In addition, when there are strong economies of scale, price discrimination (e.g., Ramsey pricing) can be a first-best or second-best way of allowing producers to cover fixed costs.

Put differently, net neutrality/common carrier access treats the internet as a commons which limits the use of prices to allocate scarce resources. Yes there can be cases in which this is beneficial (as in a textbook natural monopoly, but sometimes not even then), but suppressing the price system and price signals is usually a horrible idea. The rebuttable presumption should be that we rely more, not less, on prices to allocate scarce resources and provide incentives to consume, produce, and invest. Net neutrality betrays a strong animus to the price system and the use of prices to allocate resources.

Vertical arrangements are also frequently looked on with deep suspicion. I wrote about this a lot in the context of exchange ownership of clearing some years ago. But usually vertical arrangements, including restrictive contracts and vertical integration, are contractual means to address inefficiencies in price competition. They are typically ways of internalizing externalities or constraining opportunistic behavior. Moreover, they are often particularly important in information-intensive goods, because of the difficulties of enforcing property rights in information and the pervasiveness of free riding on information goods.

Some of the horror stories NN advocates tell involve an ISP denying access to a service or content downstream consumers value high: usually the story involves a small startup proving a bandwidth intensive service that can’t afford to pay premium access charges. But in a world where venture capital and other forms of funding is constantly on the lookout for the next big thing, these concerns seem vastly overblown. Moreover, permitting ISPs to own content providers is one way of addressing this issue. The demand for ISP services is derived from the value customers get from the content and services an ISP delivers. It is self-defeating for them to exclude truly valuable content because it reduces demand, and they have incentives to structure pricing and terms of access and vertical arrangements with content providers to maximize value. If there are gains from trade, in a reasonably competitive market there are strong forces pushing entities at all segments of the value chain to reap those gains.

Suppressing price signals and limiting the ability to craft creative arrangements to capture gains from trade are bad ideas, except under exceptional circumstances. So color me deeply skeptical on NN. Other features inherent in intrusive regulatory systems like Title II due to public choice considerations only deepen that skepticism. Such systems are extremely conducive to rent seeking. Though usually sold as ways to enhance competition, in practice they are typically exploited by incumbents to restrict competition. They tend to be strongly biased against innovation-precisely because much innovation of the creative destruction variety is intensely threatening to incumbents who have an advantage in influencing regulators. Classical Peltzman-Becker models of regulation show that regulators have an incentive to suppress cost-justified price differentials in order to redistribute rents, thereby creating distortions.

Other than that, NN and Title II are great.

If the substance isn’t bad enough, the process is even worse. FCC Chairman Tom Wheeler was originally leaning towards a less intrusive approach to net neutrality that would avoid dropping the Title II bomb. But Obama orchestrated a campaign behind the scenes to pressure an ostensibly independent agency to go all medieval (or at least all New Deal) on the Internet. Obama added to the backstage pressure with a very public call for intrusive regulation that put Wheeler and the other two Democrats on the Commission in an impossible position. (Another illustration of the consequences of Presidential elections: it’s not just the commander that matters, but the anonymous foot soldiers and the camp followers too.)

Yes, part of Obama’s insistence reflected his beliefs: after all, he is a big government control freak. And yes, part reflects the fact that some of his biggest supporters and donors are rabid NN supporters-primarily because they will benefit if they don’t have to pay the full cost that they impose.

But what convinced Obama to make this a priority was his personal vanity and his determination to engage in political warfare by pursuing initiatives that he can implement unilaterally without Congressional involvement. Read this and weep:

While Obama administration officials were warming to the idea of calling for tougher rules, it took the November elections to sway Mr. Obama into action.

After Republicans gained their Senate majority, Mr. Obama took a number of actions to go around Congress, including a unilateral move to ease immigration rules. Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit.

Soon, Mr. Zients paid his visit to the FCC to let Mr. Wheeler know the president would make a statement on high-speed Internet regulation. Messrs. Zients and Wheeler didn’t discuss the details, according to Mr. Wheeler.

Mr. Obama made them clear in a 1,062-word statement and two-minute video. He told the FCC to regulate mobile and fixed broadband providers more strictly and enact strong rules to prevent those providers from altering download speeds for specific websites or services.

In the video, Mr. Obama said his stance was confirmation of a long-standing commitment to net neutrality. The statement boxed in Mr. Wheeler by giving the FCC’s two other Democratic commissioners cover to vote against anything falling short of Mr. Obama’s position.

That essentially killed the compromise proposed by Mr. Wheeler, leaving him no choice but to follow the path outlined by the president.

Read this again: “Senior aides also began looking for issues that would help define the president’s legacy. Net neutrality seemed like a good fit.” So to achieve a legacy, the Narcissist in Chief decides to interfere with the most successful, innovative industry of the past half-century, and perhaps ever.

What, screwing up the health care industry isn’t enough of a legacy?

I guess not. No price is to high to pay to stick it to the evil Republicans. And if you get stuck too, well, omelet, eggs, and all that. You are expendable when there’s a legacy at stake.

What comes out of the FCC as a result of Obama’s arm-twisting will be a beginning, not an end. It will no doubt set off a flurry of legal challenges.(Among lawyers and lobbyists, as always in such things, there is much rejoicing.)  Congress may get involved, and although Obama can block anything for the next two years, it  may take longer than that to finalize the rules (look at how long it is taking to get a simple-by-comparison position limit rule through the CFTC), and a new president in 2017 might not be so enamored with burnishing Barry’s legacy. Well, one can hope, can’t one? Looking for silver linings here.

I had thought that old school Progressive and New Deal style regulation had been largely discredited in the 70s and 80s. Indeed, Democrats (including Carter and Ted Kennedy) played vital roles in dismantling regulations in transportation in particular. But Obama is going all back to the future, and attempting to impose a regulatory paradigm that was all the rage when men all wore fedoras to what is arguably the most dynamic and innovative industry ever. Because, legacy.