Q&A: Broadband competition, innovation and net neutrality

In the context of the ongoing debate over "net neutrality," Economist Everett Ehrlich challenges claims that U.S. broadband is too slow, uncompetitive and in need of tighter regulation.

Is U.S. broadband really as slow and uncompetitive as some critics claim? Image credit: iStockphoto by Getty
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The Federal Communications Commission (FCC) is proposing new rules on so-called “net neutrality”  after a February ruling by the D.C. Court of Appeals tossed out the FCC’s first efforts to regulate Internet traffic. Among other things, the old rules would have stopped broadband companies from blocking content or charging more for faster access to the Internet. The proposed new rules, however, would allow content providers to pay more for “fast track” access. 

The debate over net neutrality is taking place in the context of a wider debate over the broadband industry’s overall competitiveness and the role of regulation. Advocates such as Roosevelt Institute fellow Susan Crawford argue that an uncompetitive broadband industry has brought consumers both poor service and high prices:

The U.S. is sinking in international rankings on fiber- optic penetration, and it now stands in 14th place…. We’ve got the most innovative people in the world, working in an increasingly information-based economy, yet our Internet service providers are subject to neither competition nor oversight.

Others, however, argue that these criticisms are overblown.

We sat down with Dr. Everett Ehrlich, who was Undersecretary of Commerce under President Bill Clinton, Executive Director of the CSIS Commission on Public Infrastructure, co-chaired by Felix Rohatyn and Warren Rudman, and President of ESC Company, an economic analysis firm. In a new report for the Progressive Policy Institute, Ehrlich argues that broadband competition is not only alive and well, too tight a regulatory hand would stifle investment and innovation. He further argues this has important implications for the ongoing conversation on net neutrality. The full report is available HERE

R3.0: You challenge the conventional wisdom on broadband in two significant ways. You first push against the notion that America is falling behind other countries such as South Korea.  Second, you challenge the idea that the American broadband industry is “uncompetitive.” What’s wrong with the claim that American broadband is slow, expensive and not broadly available?

EHRLICH:  First, I’m frightened that view is the conventional wisdom.  The data don’t support it.  [According to rankings by Akamai], the U.S. has gone from something like 22nd to the top 10, and our speeds are growing at rates that would allow them to double every three years.

R3.0:  But what about South Korea?

[“U.S. broadband] speeds are growing at rates that would allow them to double every three years.”
EHRLICH: South Korea is number one on the list. And they’re always going to be number one on the list. First, they have the best population density, which lowers the cost and improves the quality of connections. In America, running a local loop means going through a suburban neighborhood, running it over soccer fields and a strip mall parking lot. In South Korea, a local loop goes up and down the elevator shaft of a 15-story apartment building.

Folks who don’t believe it should go to South Korea and try to find a single-family, detached, owner-occupied home. It doesn’t exist.  That’s half of the Korean story. The other half is an interesting series of subsidies to encourage use. There’s a conscious government policy of encouraging people to be on broadband and subsidizes providers to offer that service.

We don’t have the land and the demographic patterns to allow us to do that, and we’re not interested in that kind of subsidization.

And as you look past South Korea and Japan, the countries that are ahead of us – Czechoslovakia, Finland, the Netherlands – are small countries with urban centers that don’t seem to be the source of any competitiveness issues we face.

R3.0: What countries make a fairer comparison?

EHRLICH: Our major trading partners. With the exception of Japan, we are way ahead of our major trading partners. Part of that is because continental Europe has a bad policy system. They have a “wholesale market” – which is really about bundling and access prices. The EU commissioner for telecom has stated quite publicly that it doesn’t work.

The paradox is that in the early part of the aughts, American broadband was behind, and it was behind because we were regulating it and discouraging investment in innovation.

R3.0:  What were we doing wrong?

EHRLICH: Most importantly, we were telling companies to invest in better infrastructure that they had to share with their competitors at government sanctioned prices.  It was the legal and economic equivalent of the parable of the little red hen.  The companies that weren’t interested in grinding the wheat or making the dough were given the regulatory right to eat the bread. When we got rid of that system, American broadband immediately rebounded.

R3.0: How do you prove that American broadband is competitive despite the small number of providers?

If you’re waiting for 100 companies to attach wires to your house from a pole on the street, life is going to disappoint you. Moreover, you don’t want that. It would create redundancies that would probably end up raising the price of service. The real metrics ought to be what do we expect from a competitive industry, and are we getting that? And that means investment, innovation, and affordability.  And on all of those measures, industry measures up.

R3.0: Give me an example.

EHRLICH: My favorite number is who is making money and who’s not. The basic thesis of the regulatory advocates is that an uncompetitive industry is price-gouging the consumer and holding back investment. The investment numbers are clear and straightforward. We invest more than the norm for advanced industrialized industries. Part of that is that it’s harder to wire America because of land use patterns.

Companies that use the Internet are seeing rates of profit that are six times the rate of profit for Internet providers.
In [my] paper, I look at all of the Fortune 500 companies that provide broadband, from Verizon and AT&T to Frontier, and I compared them to Fortune 500 companies that use the Internet as a platform – Google, Facebook, etc.

Measured on both assets and sales, the rates of profit for the residers – people who reside on the Internet – are six times the rate of profit for the providers. It makes it really hard to argue that broadband is being priced incorrectly due to monopoly power, since the people who use it make more money than the people who provide it. This is the classic economic definition of an epochal invention – that people make more money using it than providing it.

In fact the impetus for the providers goes the opposite way from monopoly power. They’re stuck in a business model “doom loop.” They improve their signal. People invent applications and devices that use that signal and make money – six times the money. And then the signal providers have to innovate to get the consumers’ attention so that they can use the devices and the apps.

We’ll see the same model again when we get to 4K TV, the signal beyond HDTV.  It consumes bandwidth gluttonously. The broadband providers will compete, and the device and content manufacturers will come up with stuff to use the better signal. The consumer will flock to buy it, and that commoditizes the signal. Perhaps the greatest problem we face in this space is that the regulatory advocates don’t understand what’s happening.

R3.0:  Why in your view are the advocates getting it wrong?

On net neutrality: “What if in 1900 someone had run up to the first car and tried to feed it oats?”
EHRLICH: Because they’re thinking about the phone system.  What if in 1900 someone had run up to the first car and tried to feed it oats? The advocates want to turn the Internet into a phone system where there is no discrimination among different users. With the phone system there was no ability to discriminate. It was a closed circuit.

Now the system has profound intelligence that allows us not just to offer different services but to optimize performance. We already accept that in a lot of places. If your phone knows it’s not getting a lot of signal, it will take phone calls but it won’t do your email. It automatically does that. It’s non-neutral.

When you go to Google and you try to search something, you’re going to a server farm somewhere near you. If you go to Uncle Herb’s search site, you’re going to a rack somewhere in the world, and it’s going to take you longer to get there. It’s already a non-neutral world. The regulatory advocates want to take a brilliant broadband system and lower its IQ until it resembles something they used to like.

R3.0:  Isn’t there a legitimate rationale for treating the Internet like a public utility? Why shouldn’t we treat the Internet like a phone?

EHRLICH: There are a lot of things that are important and that we allow markets to deliver to us within boundaries of some kind, such as consumer protection, antitrust, competition policy and the like. There’s no denying the Internet’s importance. But it would be a mistake to say because it’s important it has to be under government control. In fact, the history of the Internet tells us that when regulation is lifted or eased, investment follows and vice versa.

“There’s no denying the Internet’s importance. But it would be a mistake to say because it’s important it has to be under government control.”
R3.0: What are some instances of where that’s happened?

EHRLICH: In the 1980s we had a boom in cable. In ’92, there was an act to regulate cable prices and the way services were delivered. And the boom stopped. When the [1996 Telecommunications] Act was passed, cable picked up again. It was given a pass in favor of lighter regulation, so regulation favored investment in cable and that was where investment went. Mere nanoseconds after the court decided that broadband was not a telephone service, Verizon committed itself to Fios.

Even if you think that something as important broadband Internet must be under some kind of social control, you have to square that view with the reality across time and place that regulations actively and almost literally disturb investment in innovation. Europe has the system that regulatory advocates prefer, and the Europeans are actively seeking a way to abandon it because they are lagging behind the U.S., as my paper shows.

R3.0: Let’s take a specific example of something that was widely seen as an abuse of market power in the wireless space, which is the exclusive arrangement between AT&T and Apple for the iPhone. In a forthcoming paper, you argue that the AT&T/Apple deal actually spurred competition. Can you explain that?

EHRLICH: It’s amazing that people say there’s something bad about Apple offering the first iPhones only through AT&T. They offered the chance to other companies, and other companies didn’t want it. The relationship with Apple moved AT&T up the charts in terms of subscribers and revenue. It wasn’t a lifesaver, but it was a tremendous boost for AT&T and their competition with other wireless providers.

R3.0: But that’s exactly what the critics say – that it gave AT&T an unfair advantage.

EHRLICH: But it wasn’t unfair. The other companies had the opportunity to do what AT&T did.

Remember, competition doesn’t just divide the pie but helps grow it. The relationship with Apple allowed AT&T to win customers and create new users. Someone used AT&T wireless for the first time when a really interesting device suddenly appeared. It did what we want competition to do. It forced the other firms to respond with investments to improve their service and win customers back. That’s competition. If it jumps out of a tree and bites you on the neck, you should recognize what it is.

Competition doesn’t just divide the pie but helps grow it.” 
Had the iPhone been available to all comers, it could have established a monopoly position that made it the chokepoint for all applications and services. Instead because they chose that path with AT&T, there was a market for other systems, like Android. So the AT&T relationship not only strengthened competition among the signal providers, it strengthened competition among the device manufacturers and the applications and services that reside on the service. It was a win-win.

R3.0: Turning to net neutrality, the regulatory advocates argue that net neutrality is a way to spur competition too. You disagree.

EHRLICH: This is a really a business conflict that’s dressed up as a policy conflict. The big websites like neutrality because it allows consumers to subsidize them. Google and the other large sites don’t pay for the congestion they cause.

When you pay for the access to send an email to your aunt in Topeka, you’re subsidizing the big content providers in the same way that a guy in a Honda on the interstate is subsidizing the 18-wheel rigs that don’t pay their fair share for the wear and tear on the roads.

And then of course there’s the idea that if we make them pay their fair share, it would end up being paid for by the consumer. That’s like arguing that the newspaper would be cheaper if we didn’t let advertisers pay to be in it. The Internet is ultimately a two-sided market. Signal providers attract users so they can see the content. And it attracts content so they can meet the users. Like a newspaper that gets readers so it can go to advertisers and advertisers can go to readers. Or like the stock market, which attracts investors to get listings and gets listings to attract investors. When you say that one side of that market has to be shut down, that’s what net neutrality is, you’re telling the other side that they have to pay all of the cost. It’s like the cost of a newspaper if you didn’t allow advertising or the cost of stock trades if you didn’t allow listing fees.

R3.0: With the courts having rejected net neutrality, what’s next?

EHRLICH: The only way to keep the regulatory dream alive is to define the Internet as a telephone service, and that fails the Frank Zappa test – the cow don’t make ham. The FCC has the opportunity to sit down with the providers and ask them what they are planning. That would be the most forward-thinking and productive kind of regulation possible.

The advocates talk about “permission to innovate,” but when the government gives permission to innovate through regulation, that seems much more dangerous and much more deleterious, than any other system that would allow the discipline of markets.

You can’t write right. So instead we write rules. And rules are brittle and have unintended consequences. We should be thinking instead about how we get to right.

Everett Ehrlich’s report, “The State of U.S. Broadband: Is It Competitive? Are We Falling Behind” is available HERE

 

 

 

 

Image credit:  iStockphoto.com/Getty Images

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