The Digital Divide and Other Economic Considerations for Network Neutrality

2016 Broadband Progress Report, FCC, 2016, p. 3.

The absence of internet service in a household does not necessarily result from a physical lack of access to broadband. For a majority of households without internet, those households chose not to subscribe to the internet for various reasons such as price, a perceived lack of relevance, or a lack of digital literacy. We detail these in Sect. 2.

The 2015 OIO states “The record before us also overwhelmingly supports the proposition that the Internet’s openness is critical to its ability to serve as a platform for speech and civic engagement, and that it can help close the digital divide by facilitating the development of diverse content, applications, and services” (FCC, note 77, p. 27).

Using data from U.S. Securities and Exchange Commission (SEC) filings, Singer (2015) reports that the capital expenditure of major ISPs decreased from 2014 to 2015, including AT&T (−29%), Charter (−29%), Cablevision (−10%), and Verizon (−4%) and averaging −12% across wireline ISPs and −8% across all ISPs, including wireless ones. Singer calls this phenomenon ‘remarkable’, because such ‘capital flight’ was observed only twice in U.S. broadband history: during the 2001 dotcom meltdown and the 2009 recession. Singer (2015) considered other factors that could have resulted in ISPs’ reducing capital expenditures, including changes in GDP, consumer expenditure and ISP revenue. However, these considerations suggested a positive environment for ISPs: ISPs should have increased expenditure under these circumstances. Hence, after eliminating possible confounding factors, Singer (2015) concludes that the decrease in ISP investment may be attributed to the introduction of the Open Internet Order.

Depending on the mechanisms that the authors choose to highlight in the creation of their models, a wide variety of welfare impacts have been suggested by different authors. We hope to choose a few key models to highlight which mechanisms drive which overall conclusions that have been put forward by certain authors and comment on whether these can or should be considered in isolation of other mechanisms when making claims about overall welfare implications.

Most clearly, any models that consider only homogeneous consumers and/or do not allow end users the choice of simply opting out of the purchase of internet service, will by definition not be able to address certain aspects of the digital divide. Similarly, assumptions of homogeneous content service providers that all provide equal amounts of utility to consumers will have misleading welfare implications.

Katz (2016) provides a list of conditions that are imposed by the OIO on broadband internet access service (BIAS) providers with respect to edge providers (content, application, service and device providers). These include no blocking, no throttling, no access charges, no paid prioritization, and no unreasonable interference/disadvantage standard.

Brennan (2016, p. 6).

This holds if one ignores mobile broadband access.

Economides and Tåg (2012, p. 93) do not allow for the possibility that some consumers could choose to not have internet service: “When the market is fully covered (so everyone has Internet access), network neutrality will always increase total surplus if content providers value consumers more than consumers value content providers. The reason for the unambiguous increase is the surplus loss arising when some content providers exit when positive fees are imposed on them.” The authors state clearly that in this model they are abstracting from endogenous ISP investment, potential price discrimination by ISPs, and prioritization and congestion issues. Still, there are two further limitations implicit in this model: (1) if consumers are ot allowed to leave the market in this exercise, then there can by definition be no impact of pricing or quality on consumer participation (and thus by definition any possible negative welfare impact on consumers through their exiting of the market for internet is ignored); (2) the model’s results rely on the assumption that the social value of content to consumers increases linearly with the number of content providers: All content providers provide the exact same positive marginal value to consumers, and this marginal value does not decrease with the total number of content providers. Hence, if any content provider exits the market, consumer welfare always decreases.

Michael Powell also made this argument at the Free State Foundation's Fifth Annual Telecom Policy Conference on March 21, 2013.

Gryta and Ramachandran (2016) already noted the increased use of broadband data caps by ISPs: “Consumer complaints to the Federal Communications Commission about data caps rose to 7904 in the second half of 2015 from 863 in the first half, according to records reviewed by The Wall Street Journal under the Freedom of Information Act. As of mid-April, this year’s total was 1463.” (WSJ, April 22, 2016).

Economides and Hermalin (2012, p. 605).

Ibid.

Ibid, pp. 609–610.

Ibid, p. 619.

Ibid, p. 622.

The fact that some CSPs pay content delivery networks to help provide faster access to their content demonstrates that some CSPs find such actions to be profitable.

Katz (2016, p. 25) further points out that there are “well established conditions … under which paid prioritization facilitates entry” (emphasis in the original).

Choi and Kim (2010, p. 466) suggest that net neutrality regulations could potentially increase CSP profit margins and incentives for investment in content (since a monopolist ISP would be prevented from potentially extracting rent from CSPs for utilizing high priority channels). However, they find that the privately optimal level of rent extraction by the ISP depends negatively on the efficiency of a content provider’s R&D process and positively on the cost differentials between the two content providers. The authors conclude, “We find that the relationship between the net neutrality regulation and investment incentives is subtle. Even though we cannot draw general unambiguous conclusions, we identified key effects that are expected to play important roles in the assessment of net neutrality regulations.”

Katz (2016, pp. 10–11) has a good discussion of why banning access fees is an inefficient means of “subsidizing creativity” even if one agrees that this is socially desired. Moreover, he emphasizes that this means of subsidization likely harms end users by reducing broadband penetration and decreasing adoption.

Schumpeter (1942) first posited that imperfectly competitive markets are conducive for innovation. Accordingly, he argued that measures that are taken to reduce market concentration could reduce technical progress. Since then, much empirical literature on this topic has followed, but results have broadly been unable to either support or reject this “Schumpeterian hypothesis”. Arrow (1962) famously opposed this hypothesis because he believed that “the preinvention monopoly power acts as a strong disincentive to further innovation.” Arrow argued that, even though firms with strong monopoly power may have the ability to innovate, they would not have the incentive to do so. More recent research has demonstrated market structures in which the threat of entry can be sufficient to provide incentives for innovation by current market leaders (Peretto 1996; Tirole 1992).

Brennan (2016) points out that the FCC cited only two cases in the ten years prior to the OIO as instances that definitely would have been in violation of the 2015 OIO.

Yoo (2005) suggests that it is possible to think of ISPs as firms that operate under classic Chamberlinian monopolistic competition in which product differentiation could allow for short-run supernormal profits. Yoo notes that one way that product differentiation might exist is through protocol nonstandardization. This means that if there is sufficient heterogeneity in content application, multiple networks may “coexist simply by targeting their networks towards the needs of different subgroups […] and it [is] possible for three different last-mile networks to coexist: one optimized for traditional Internet applications such as e-mail and website access, another incorporating security features to facilitate ecommerce and to guard against viruses and other hostile aspects of Internet life, and a third that prioritizes packets in the manner needed to facilitate time-sensitive applications such as streaming media and VoIP.

Using firm-level FCC Form 477 data from June 2005 to June 2008, Connolly and Prieger (2013) find much larger rates of absolute broadband service provider entry and exit within markets defined by zip codes than can be measured when considering only the publically available data on net changes in the number of broadband firms in that market. This suggests that at the zip code level, there is far more competition (and churn by broadband providers themselves) that occurs than is generally recognized when the data involve only the total number of broadband providers that are present in a market at any one point in time. This finding holds both for disaggregated markets (zip code levels) and for the national U.S. market. Moreover, as early as 2008, FCC data suggest that 99.7% of zip codes in the U.S. had two or more providers of high-speed internet lines (FCC 2009). At the consumer level, Becker et al. (2010) note that data from 2007 and 2008 demonstrated similar rates of customer churn in broadband services as among other telecommunications services such as cable and cellphones.

If different content, are these substitutes or complements?

This positive content effect is only under certain parameters that are large enough to offset the negative ISP investment effect in their model.

Greenstein et al. (2016, p. 144) put forward the possibility that non-net neutrality may in fact help smaller CSPs, who unlike large CSPs, do not have “other means to deal with the congestion issue.” In other words, smaller CSPs that lack vast financial resources could choose to pay ISPs more for greater bandwidth to deal with data congestion, since the smaller CSPs may be unable to invest in more expensive solutions (e.g., data compression technologies, data handling algorithms). Such an option is unavailable under net neutrality.

With bundling of content, profitability increases with the addition of dissimilar content since it increases the number of subscribers (of differing tastes) who will be willing to subscribe to a particular service such as Hulu or Netflix. In particular, the economics of bundling suggests that the most profitable addition to a programming bundle is for content that is negatively correlated with content that is already offered in the bundle. As an illustration, Crawford and Cullen (2007, p. 388) simulate outcomes in an “average” cable television market to see the effects of selling channels in bundles on cable operators and on subscribers. They find that the two key factors in determining the impact of bundling on profits and welfare were “the difference between marginal cost and mean WTP [Willingness-to-Pay] for [channels] and [negative] correlation in that WTP for [channels].” This also implies that bundling will cause more niche programing to be carried (Crawford 2008).

There has also been related empirical research on playlists that are offered by radio stations. While radio stations do not create original content as do some CSPs, radio stations do choose their playlists in an attempt to maximize profits. From these studies, we observe that commonly owned stations in the same radio market do not wish to cannibalize each other and hence seek to differentiate their format and/or playlists. Sweeting (2016, p. 1) examines station airplay logs and finds that a “common owner of stations playing the same type of music in the same local radio market differentiates their playlists and their audiences increase.” In a similar vein, Chipty (2007, p. 3) examines the effect of radio ownership on content diversity with the use of cross-sectional format information as well as content information that uses data for all U.S. stations in the third quarter of 2005. Chipty finds that “Consolidation of radio ownership does not diminish the diversity of local format offerings. If anything, the market level analysis suggests that more concentrated markets have less pile-up of stations on individual format categories, and that large national radio owners offer more formats and less pile-up.” She additionally finds that “stations operating in markets with other commonly owned stations achieve higher ratings, than do independent stations.”

It is worth noting that instead of product differentiation based on song offerings, music streaming services have focused on product differentiation based on the user’s listening experience. According to Waelbroeck (2013), these differentiations include: “the quality and comfort of listening (with or without advertising); repeated listening of the same title or album; degrees of flexibility with listening on demand, interactive or semi-linear streaming; portability with playlists being transferable to smartphone.” It is however not immediately clear that the increase in consumer utility from these types of product differentiation strategies fully offsets the potential reduction in efficiency from duplication of content and (as we discuss next) possible decreased economies of scale arising from the accommodation of more CSP entrants.

This is similar to the model that was put forward by Horstmann and Markusen (1986), where protectionist trade policies lead to inefficient entry and higher average costs of production in imperfectly competitive markets.

It is worth noting that not only is this content original but also that at least some of this original content has had significant success with end consumers. It is not simply the diversity, but also the quality of content (from the end consumer’s perspective) that matters when estimating the net impact of any policy on consumer welfare.

Horstmann and Markusen (1986) provide a nice example of how government policies can lead to inefficient entry and reduced social welfare in imperfectly competitive markets.