In the Nation's Interest

How “Net Neutrality” Would Neutralize the Internet’s Market Price System and Fail to Achieve Its “Free and Open” Goals

Diane Lim
Vice President for Economic Research

(Image from US News and World Report, Oct. 6, 2014 column by Brent Skorup)

“Net Neutrality”: an unusual case of a policy with bipartisan appeal?  In his State of the Union address and in his follow-up speeches on his “middle-class economics” agenda, President Obama has called for a “free and open internet”—suggesting the goals of both: (i) more universal access to the internet for households and businesses, (ii) an internet market that works more smoothly and efficiently.  The President’s approach to achieving these goals is to require so-called (inter)“net neutrality” in the internet service provider (ISP) market.  Tom Wheeler, chairman of the Federal Communications Commission (FCC), this week put forward “the strongest open internet protections ever proposed by the FCC” (classifying internet service provision as a public utility under Title II) to “enforce” and “ensure” net neutrality.

In an unusual display of bipartisanship, Republicans in Congress have also come along to support “net neutrality” and have introduced legislation that would require it, having in the past been divided on the issue because of the different positions that members of their constituencies—the different businesses and stakeholders—take. Congressional Republicans nevertheless take a position that is procedurally in contrast to the President’s, supporting legislative enforcement of “net neutrality” rather than the regulatory approach (via the FCC) that the Administration favors.  So both political sides are all for the notion of “net neutrality” that suggests a cheaper and more accessible internet to all (sounds great, how could we not want that?), but the Ds want a more regulatory approach (they occupy the White House, after all), while the Rs want a more legislative approach (they control Congress, after all). But as the public hype and the political debates leading up to a February 26 vote of the FCC on the issue continue, neither side (nor the general public) seems to realize that “net neutrality” is not at all equivalent to, nor even a reliable route to, a more affordable internet delivered to a broader customer base.  In seeking to remove market prices as a barrier to equal consumption of Internet services, policy makers are also throwing away the role of market prices in encouraging continued technological advances and innovation.

What is “Net Neutrality”—and why isn’t it a solution?  – “Net Neutrality” has been defined as (emphasis added) “the principle that Internet service providers and governments should treat all data on the Internet equally, not discriminating or charging differentially by user, content, site, platform, application, type of attached equipment, or mode of communication.”  The politicians talk about “net neutrality” as prohibiting behaviors that sound bad: “blocking,” “throttling,” and “paid prioritization.”  But what does that really mean, economically?

“Net Neutrality” essentially defines “data on the Internet” and “internet service provision” as a standardized product; it says you can’t charge different prices for the same product—because that would be regarded as “price discrimination.”

But different internet speeds/download times are not the same product.  So charging a higher price for higher-quality product is actually “product differentiation,” not “price discrimination.”

Here are some examples of product differentiation where people do pay more for faster technology or otherwise higher-quality versions:  iPhones (the 6 vs. the 5); Amtrak trains (Acela vs. regular); streaming music (Pandora with and without ads); Amazon Kindles (with and without ads); High-Occupancy Toll (“HOT” or more accurately described as “express”) lanes on highways where a higher toll buys access to the fast lanes; higher airline ticket prices to get “priority (fast) boarding”—even tickets to concerts or sporting events where one pays more for seats closer in.  Are these examples of “price discrimination?”  Most of us would not consider the different prices discriminatory—but merely getting the quality of product that one is willing (and able) to pay for.

If there were no “basic” versions of these products available at prices affordable to all, then they become like “luxury” goods—and a more legitimate question (than whether it’s proper to charge more for them) is whether they should be considered more “necessity” goods, and what could then be done to expand the access to the product by lower-income households.

But the answer is not to say that there may not be higher-end versions of goods and services that are already accessible to all—and certainly not that there may be higher-end versions but the sellers may not charge higher prices for those versions.

The problem with forcing “one price,” free or otherwise:  It effectively squashes or neutralizes (by zeroing out or fixing at one level) prices as the signal of value—on either the demand side (where marginal benefit is reflected in the prices consumers are willing to pay) or the supply side (where marginal cost is reflected in the prices that sellers are willing to accept):

• “Net neutrality” would neutralize signals of higher marginal benefit/demand/value-added from consumers and businesses that purchase services from ISPs.

• “Net neutrality” would neutralize (eliminate) any differential returns to ISPs to cover fixed, up-front investment costs associated with providing higher-end/cutting-edge services (as well as any extra marginal (variable) costs associated with providing such higher-end service.

Note: There are essentially two reasons in any market why the price of the product may be “high”: (i) because the product provides high marginal benefit to the consumer, and/or (ii) because the product involves high marginal cost for the producer (which consumers must, of course, be willing to pay; otherwise producers will not provide the product or service).  This is just according to the laws of supply and demand, in the market for any good or service.

Forcing the market to charge one, lower price for different qualities of the product (essentially, different products) would essentially, naturally, lead the market to provide a more standardized (same-quality) product at the single, lower price.  And that would eliminate the incentive for ISPs to develop higher-end, cutting-edge, leading-edge services and technologies; this is what causes economists on both the left (e.g., Progressive Policy Institute) and the right (e.g., the Heritage Foundation) to oppose “net neutrality,” no matter how popular the vague concept is with policymakers and the public.

So imposing “net neutrality,” as in forcing only one price, would be an ineffective and inappropriate solution to the “lack of access” concern, whether said “net neutrality” were enforced through stronger regulation (Obama’s approach) or through legislation (the Republicans’ approach).

But government can still play a role. To figure out just what role and what kinds of policies are warranted, we need to consider: (i) whether the private market on its own leads to undesirable results, (ii) whether there are public policy options that are likely to provide more benefit than harm on such problems, and (iii) whether the public is willing to bear the costs or tradeoffs involved in the policy.

Here are some aspects of the private internet service market where one could argue that private market outcomes don’t perfectly align with societal goals:

• Not available everywhere (geographically);

• Not accessible/affordable to lower-income households;

• Too costly for start-up/small businesses that rely on internet services as an intermediate input (But note: Is this problem really a market “failure,” or rather an appropriate market signal that the start-up’s product is not worth enough to consumers relative to the true costs of producing—that technological progress must continue and prices of technology fall a bit more for those products to become worthwhile for our society to produce?  Only if those businesses would produce something of social value in excess of private value should we conclude that government needs to “correct” the externality by subsidizing the costs of production).

If the need to correct a market failure or other appropriate role for government policy is identified, are there some better-targeted public policy options either to address those distributional/access concerns (geographically and to lower-income households) or to encourage those start-up businesses that are currently “priced out” of the Internet Service Provider (ISP) market?

• Government could subsidize and invest in bringing supply to those geographic areas currently without access.

• Government could subsidize lower-income households’ purchases of basic internet services; (Note: This is very different from bringing down the price of all households’ and businesses’ ISP purchases at all levels of quality).

If there is demonstrated social (spillover benefit) value in the production of so-called “edge” services that purchase ISP (content providers, app developers), then the government should subsidize/give tax breaks to such businesses for their ISP costs.  But even in that unlikely event, it would not follow that the appropriate public prescription is to subsidize/give tax breaks to all businesses and all households for all their ISP costs.

At the same time, some behavior in the private sector may be deemed undesirable from a national interest standpoint and require government intervention to keep the market working efficiently and equitably:

• There could be negative discriminatory/coercive pricing behavior:  the degrading of service quality to force customers to pay more to get to an adequate, base-level of services.  If this is what “throttling” and “blocking” essentially does, it may fall in a grey area between product differentiation and price discrimination but may be deemed socially unacceptable (and not just the mere flip side of “paid prioritization,” perhaps breach of contract is not giving customers the service they paid for, or charging two customers different prices for the same product), in which case regulation and/or legislation could prohibit or limit such behavior.  Of course, the challenge will be how to define and identify the bad practice in a precise and enforceable way.

• One possible approach: Government enforces (via regulation and/or legislation) some basic standard for internet service provision (ISP) that’s not at the cutting/leading edge of ISP technology but at some median/moderate level that’s considered perfectly adequate (as opposed to “degraded” so much as to be useless). 

• It’s not clear that the lower-quality end of the ISP market is even a public policy concern, however.  “Degraded” internet service may just be a disparaging label these days for technology that realistically may be perfectly adequate as a basic level of internet service to which everyone should have access—because such basic internet access is necessary for all Americans (no matter their income level, no matter where they live) to have better access to necessities of life, like public services, education, and jobs, for example.  Do we all need to have ultra-fast downloads of movies at low cost for the internet market to be deemed “fair” and “equitable?”  Does the fact that the “worst” internet technology these days allows far more ease of access to far more information than the “best” did just a few years ago not matter?  How should we define every citizen’s “basic rights” to internet services—according to the leading edge of the technology, or according to a median or more basic level of technology?

We need to recognize costs and tradeoffs in whatever public policy approach we take:

• Subsidies and investments cost money; as a result, there would be less government funds available for other spending, or more tax revenue would need to be raised (either now or in future, if subsidies were deficit financed today);

• Regulation would impose greater burdens on some businesses, so we would have to weigh those greater burdens against better functioning of the market (and specific benefits to other businesses) that the regulation is designed to achieve.

The industry positions in this debate turn out to be predictable.  Businesses aren’t exactly arguing for or against net neutrality in the public interest, even if they’d like the public to think that.

• Pro-“Net Neutrality” businesses: 

o Those “edge” technology businesses that rely on internet services as an intermediate input and who want the prices they or their customers pay for Internet services to come down or at least stay low.  (These include content providers such as streaming video sites, app developers whose apps require fast connection speeds.)

o But also, more surprisingly, Internet Service Provider (ISP) companies themselves (so-called “core” technology businesses) who may already be relatively constrained via regulations and/or their own innovative capacity such that prohibiting “paid prioritization” on the entire industry would bring their competitors’ innovative capacity and productivity down and hence “level the playing field.”

• Anti-“Net Neutrality” businesses:

o The ISPs who are truly on the leading edge of the technologies and who are currently profiting from a large customer base (households and businesses) and the higher prices customers pay for the higher-end technologies they deliver; also, those large ISPs who provide their own content and want to be able to prioritize/favor their own content to gain a competitive advantage against their competitors.

So let’s step back from the “net neutrality” bandwagon and think more carefully about how the internet market functions and ways in which government intervention would be productive.  We (policymakers, businesses, consumers) need to stop throwing around the “net neutrality” concept like it’s a nice-sounding, easy solution to whatever is socially undesirable about how the internet market currently functions—or worse yet, using the “net neutrality” argument “for the public good” in a disingenuous way to get cheaper internet for ourselves.  We need to examine more closely: Where is the free market underperforming? Is there a case for government to help?  And are we as a society willing to pay for those policies, whether in real dollars or in reduced technical progress, innovation, or consumer choice?

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