Obama Turned the Net Into a Neut: But It’s Getting Better!


Few subjects generate such intense reactions as net neutrality. It has become freighted with much emotional baggage, largely because it has been framed–artfully–as a matter of free choice and free speech vs. censorship and control of information by malign interests.

The Trump FCC’s announcement of its plans to reverse the Obama FFC’s 2015 net neutrality rule has led brought the issue–and the Manichean rhetoric–back to the fore.

One would hope that applying some basic economics might shed some light, and cool some of the rhetorical heat. I will give it a go.

The basic economic issue is straightforward. It is basically a matter of price discrimination, a subject that economists have analyzed and understood for years. The crucial feature of net neutrality is its ban on ISPs charging different prices for different types or categories of service. So for example, your Internet provider cannot charge higher prices for more intense consumers of bandwidth (e.g., streaming services).

Although the term “price discrimination” has bad connotations–which net neutrality supporters emphasize–it can be good, and it is difficult to identify conditions in which it is unambiguously bad compared to the real world alternative.

One reason that charging different prices for different types of customers can enhance efficiency–and why suppressing the ability to do so can be inefficient–is that the costs of providing a service can differ between customers. Some customers are more expensive to serve, or demand a differentiated service that is costlier to deliver. Providing the price signals that give the incentive to consume, produce, and invest in capacity efficiently requires price discrimination: higher cost customers should pay more than lower cost customers.

This is an issue in providing Internet services. Some services and users that consume more bandwidth, and impose greater risk of congestion on the system. A pricing structure that does not charge such users/services a higher price to reflect these higher costs induces overconsumption of these services, and imposes costs (e.g., poorer quality of service) on those who do not put such demands on the system. Furthermore, preventing ISPs from charging prices that reflect higher cost distorts their incentives to invest in more capacity, or in technologies and congestion management techniques that ease burdens on the system.

Prohibiting charging prices that vary by type of service or customer therefore results in cross-subsidization (low cost customers subsidize high cost ones), which both transfers wealth and undermines efficient allocation of resources.

Price discrimination can also occur as a result of market power. There are different “degrees” of price discrimination. To keep things simple, the most common kind is “third degree price discrimination”, in which a firm with market power who can segment customers based on their demand elasticities: less price sensitive customers pay higher prices than more elastic demanders.

It is plausible that demand elasticities for Internet services differ, and that elasticity may vary by the type of content, e.g., that the demand for streaming services is less price elastic than the demand for email or cat videos. In this case, charging a different price for streaming services vs. more mundane uses of the Internet could well be a form of 3d degree price discrimination.

It has long been known that the welfare effects of 3d degree discrimination are ambiguous: as compared to a single price for all services/customers charged by a firm facing a downward sloping demand curve, welfare (consumer plus producer surplus) or consumer surplus can be higher of lower with price discrimination. Furthermore, if a firm faces substantial economies of scale, the efficient way of covering fixed costs typically involves 3d degree price discrimination (“Ramsey Pricing”).

So one cannot say a priori that even if price discrimination by ISPs reflects market power, suppressing price discrimination improves welfare: the market power remains, and the ISP might exercise it in a way that causes welfare to be lower than if it exercises it by price discriminating.

Moreover, there is reason to doubt that a predicate for inefficient price discrimination–ISP market power–exists, or is more acute in this market than it is in many other markets where price discrimination is common (and believe me, that is pretty much every market). The days of the “last mile” monopoly are over. A very large fraction of Internet users in the US have access to multiple ISPs. Furthermore, wireless service (4G, and perhaps soon 5G services) competes with traditional cable and DSL service. Between wireless and cable, off the top of my head I can think of 8 providers that I can access. Yes, there is some overlap (e.g., ATT provides both types of service), but the number of choices most Americans have for Internet access is greater than they have for many other goods and services. Meaning that it is unlikely that market power problems are so acute in this market as to justify regulations unheard of in other markets where price discrimination is widely practiced.

I should also note that some kinds of price discrimination can unambiguously improve welfare relative to simple monopoly pricing. First degree (rare in practice) or second degree (e.g., quantity discounts, two part pricing) is superior to simple monopoly pricing. I would wager that some ISPs will adopt such efficiency enhancing price policies if freed from net neutrality restrictions.

Thus, if your concern is that ISPs exercise market power by price discrimination, suppressing price discrimination is not the best way to tackle the problem: attack the market power directly by reducing entry barriers or antitrust actions against ISPs. Furthermore, it is not at all clear that price discrimination in this market is driven primarily by market power, given the competitive conditions in the market. Lastly, and perhaps most importantly, attempting to squelch (at best ambiguously inefficient) market power driven price discrimination also precludes efficiency enhancing price discrimination based on differences in service/customer cost. Doing so imposes substantial costs.

For all these reasons, I conclude that net neutrality is (a) a solution to a non-existent problem, and (b) can do positive harm by preventing the development of efficient pricing systems that give appropriate incentives to consume and invest in system capacity, and to optimize its use.

Another aspect of the net neutrality rule is to prevent ISPs from favoring its content (which it either produces, or buys from others) over that supplied by independent parties.  Again, a necessary condition (but definitely not a sufficient one) for this to be a problem is ISP market power, which as noted above is unlikely to be a particularly serious issue. Furthermore, it is typically not in the interest of a downstream firm with market power to restrict its customers’ access to upstream product. Offering suboptimal product variety reduces the demand for the putative monopolist’s services, which reduces its profit. It is typically more profitable for the monopolist to offer the optimal product variety, and profit by charging a higher monopoly price.

There are some rather contrived models in which vertical restrictions (e.g., tying or exclusive dealing) can be used to lever market power from one good to another: the practical applicability of these models is dubious at best, as some of the modelers themselves acknowledge. But there is also an extensive literature (much of it originating in Chicago in the 1960s, including seminal contributions by my thesis advisor Lester Telser) showing that such vertical restrictions are usually efficiency-enhancing responses to some incompleteness in property rights or information problem. Indeed, in US antitrust law, horizontal restrictions (e.g., cartels) receive far more scrutiny that vertical ones, precisely because academic research on the potential efficiency enhancing effects of vertical restrictions, and the difficulty of using them to increase monopoly power, has informed antitrust policy–under administrations of both parties I might add. (As an aside, this makes the Trump DOJ challenge of the Time Warner-ATT deal somewhat strange, and intellectually at odds with the FCC’s move against net neutrality.)

In sum, I favor jettisoning net neutrality. No, I do not believe that the ISP market is perfectly competitive, but that is a red herring. Even acknowledging the possibility of imperfect competition in that market (although I do believe fear thereof is overblown), net neutrality is not the right way to address it, and indeed, might actually mean that market power is exercised in a way that reduces efficiency. In other words, the Obama FCC wanted to fight ISP market power in the worst way–and it did!

So if net neutrality is an inefficient policy, why did it prevail in the US, at least for a while? That is, what is the political economy of net neutrality?

Well, Chicago has a lot to say about this as well. Indeed, the work of another of my former advisors–Sam Peltzman–is directly on point. Sam’s amazing 1976 JLE article “Towards a More General Theory of Regulation” has an important, but widely overlooked prediction: regulation is likely to occur in industries where there are substantial differences in costs of serving different customers, and that regulated price structures suppress these cost differences. That is, regulated price structures cross-subsidize high cost customers. As Sam put it: “cross—subsidization follows a systematic pattern in which high cost customer groups are subsidized by low cost customers.” And: “The important contribution of politics is to suppress economically important distinctions and substitute for these a common element in all prices.”

That is net neutrality in a nutshell. Put simply, the Obama FCC bought political support Google, Facebook, Amazon, Microsoft, Netflix, et al by implementing a policy that cross subsidized their services. They used the political system to push regulation that suppresses economically important distinctions.

This result is less surprising from a political economy/public choice perspective than the Trump administration’s reversal of net neutrality. My first stab at an explanation is that this reflects the fact that a Trump administration can never expect to obtain political support from these companies, and can doesn’t really have to fear additional opposition: they already hate him with the heat of 1000 suns. So why  not stiff them?

Karma is a bitch, eh?

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

Visit: Streetwise Professor

6 Comments on Obama Turned the Net Into a Neut: But It’s Getting Better!

  1. Hi, your argument is moot.

    There is nothing preventing an ISP from slowing down or stopping a user’s access to ALL internet services when they have exceeded a set amount of usage. This is called data capping.

    Nearly all internet users stream video over the internet as this is has become a common usage of the internet. Certainly some users download a highly significant amount of data. Many ISPs have placed data caps to limit this.

    I am already able to pay my ISP more money if I want higher speeds.

    Why change regulation when the ISPs already have the power?

    What is the advantage to the consumer that ending net neutrality will bring? I see none.

    ISPs are profiting just fine currently with net neutrality in place, and the internet works too. Why change it?

  2. I think this article disingenuously downplays the market power of “last mile” ISPs. Wireless and satellite providers don’t count as competition for stationary home and office usage; nobody’s going to Netflix & chill on a 3G network with data caps.

    My mother-in-law lives in Woodland Hills, a middle class neighborhood in wealthy, coastal-elite Los Angeles, and she has exactly one choice for hard-wire, “last mile” Internet service: Time Warner. Where I live, we have two. And that’s the Big City.

    Nobody’s out there laying new cable to the door; the up-front investment barrier to entering that market is obviously far too high for new players. It doesn’t make sense to treat this market as if it had the same competitive dynamics as other markets. Consolidation and the leveraging of monopoly power is the name of the game for the last mile Internet service industry.

    Also, the smugness of the author’s closing sentence betrays the tribal feelings beneath his otherwise technocratic argument.

  3. The guy who wrote this article simply has no clue how internet works, how broadband pipelines work, or how corporations can control and lessen competition with net neutrality gone. Like most old republicans attacking bitcoin because they are clueless on how it all works and is superior. You are talking about corporations making the law, but you are backwards, verizon wants NEutrality gone for their own self interest you half wit old man, you have to be brain dead to not see the lobbyist corruption here, as the fcc guy is litetally an ex verizon crony. Clueless tepublicans talkin tech, please learn tech before you sound so clueless talking about how internet companoes operate, you guys dont have a clue.. i am a computer networking grad, by the way, so you kind of got schooled here, boy.

  4. The political will to create cross-subsidization occurs when the general public believes access to services or goods to be a necessity, and when at least some high-cost customers would otherwise not be able to obtain them. Utilities like electricity, water, sewage, garbage collection and, now, internet service and health insurance all fall under that rubric. I live in the Rocky Mountain West where this is particularly true of water and internet service. Would be customers in my large town, Mr. Pirrong, near a larger metropolitan area, had a choice of three internet service providers, one DSL, one cable, one satellite, none of them particularly reliable, and each having enough monopolistic power over its market segment that all were both pricey and not particularly interested in customer service. I’m not sure how you would lower barriers to entry to make the market attractive enough for the kind of investment required to compete with these companies, and outlying and rural areas have it worse. We solved the problem by creating a municipal fiber network that both lowered prices, I’m sure through cross-subsidization, and yielded a much, much faster, absolutely reliable service. Meanwhile, with net neutrality firmly in place, you say you have lots of choice and fast service, I would guess in a large metropolitan area that is part of a high density corridor, like the northeast, the area around Chicago, etc, where there are huge numbers of customers and large markets to compete in.

    The benefits of cross-subsidization never seem to be apparent to those whose immediate well-being doesn’t depend on it, but ask any of the overwhelming number of citizens of my town who elected to join the municipal ISP, the people statewide who don’t have to choose between water and rent, and the many Americans, some quite close to me, who didn’t have, and needed, health insurance before Obamacare, and the societal gains to be realized from some forms of cross-subsidization might come across. They also might be of greater value to the nation as a whole than the market efficiencies arising out of price discrimination.

  5. The problem with all the arguments surrounding net neutrality miss the basic foundation: the US public developed and paid for the Internet – not ATT, not Verizon, not any of the ISPs. All they did was lay the last mile, for as little as they could get away with by reuse. Investment? BS. Opportunity given by the American taxpayers, now subjugated and claimed by monopolies, that offer no competition to the vast majority of Americans.

  6. Bait and Switch
    Sure, higher cost services should merit a higher price, and lower cost a lower price. No argument. However, everyone already pays by bandwidth. All the ISP’s offer is bandwidth. If you’re a streaming service, you pay more because you use more bandwidth. Everyone wins. Net neutrality is about not allowing ISP’s to charge more based on the content, or to preferentially charge based on the provider. Doing so affects the consumer unfairly.

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