Internet regulation at the FCC: No longer ‘economics-free’ zone

Federal Communications Commission Chairman Ajit Pai’s Restoring Internet Freedom proposal slated for a vote at the commission’s December meeting demonstrates that broadband regulation at the FCC is no longer an “economics-free zone.”

That tongue-in-cheek term was coined by Timothy Brennan, who served as the FCC’s chief economist when the previous administration in 2015 imposed public-utility style regulation on all Internet service providers (in FCC parlance, Title II regulation). He later said he really meant only that a fair amount of the economics in that order was “wrong, unsupported, or irrelevant.”

That’s hardly reassuring.

In contrast, Pai’s draft order returning to a light-touch framework (or Title I, as we say) is well-grounded in economic research on public utility and network economics. By my count, the draft order cites 35 peer-reviewed economics journal articles, versus just six in the 2015 order. And looking at what are perhaps the two most significant decisions in the order — the reclassification of broadband from Title II to Title I, and allowing broadband providers to charge for higher-priority service — they are clearly well grounded in economic research.

{mosads}Reclassification. Treating broadband as a Title II common carrier service puts a future commission in a position to regulate prices and prescribe unbundling requirements. This threat is deterring investment. And this investment is essential to closing the digital divide and increasing broadband competition.

The underlying economic theory is straightforward and familiar to any student of regulatory economics. Building a high-speed broadband network is an expensive investment. Once that network is built, however, regulators face political pressure to regulate prices and/or impose unbundling requirements that prevent the network owner from earning a competitive return on its investment. If the regulator cannot credibly commit to refrain from this kind of action, the resulting risk increases the firm’s cost of capital, thus discouraging investment in the network.

There are good reasons for broadband providers to believe that a future FCC could renege on its 2015 promises to forbear from price regulations and unbundling obligations. The 2015 order claimed to forbear from price regulation but also banned paid prioritization of traffic by broadband Internet service providers — effectively imposing a zero price regulation. It also only refrained from imposing ex ante price regulation but left the door open to after-the-fact price regulation. And until 2005 the FCC obligated telephone companies to lease the portion of the local loop used for DSL service to competitors at regulated rates. Rate regulation and unbundling requirements aren’t theoretical.

Further, the empirical studies in the record that most carefully control for other factors suggest that Title II regulation depresses Internet service provider investment, broadband deployment, and subscribership. There are no similar controlled studies in the record that demonstrate Title II has affected investment by content providers.

Paid prioritization. The draft order considers whether content providers should be able to pay broadband providers for a higher quality of service and finds that so-called paid prioritization of Internet traffic can either benefit or harm consumers, depending on the specific facts and circumstances of the situation. This conclusion should be no surprise, since economic theory rarely finds that the optimal price for a valuable service is always zero!

The draft order’s analysis is based on well-reasoned economic theory and finds that paid prioritization can increase overall economic welfare. Specifically, it can do this by encouraging greater network investment by broadband providers and allocating broadband capacity more efficiently. 

Paid prioritization could also lead broadband subscription prices to be lower than they otherwise would be. That’s because competition for subscribers could force broadband providers to pass some of the revenues they would earn from content providers back to consumers in the form of lower monthly subscription prices.

Opponents of paid prioritization argue that it would impede entry by new content providers who could not afford to pay for a higher quality of service. But the economics literature indicates that paid prioritization can also increase entry and output by content providers that are highly dependent on high-quality service. In other contexts where practices similar to paid prioritization are used, such as grocery stores selling shelf space, the main purpose of the practice is to help introduce new products. Thus, paid prioritization could actually increase competition among content providers.

A blanket ban on paid prioritization sacrifices all of these benefits (more investment, lower prices, and new services) to prevent some anticompetitive abuses — such as a broadband provider offering a “fast lane” for its own services at a lower price than it charges competing services. But the draft order takes a better approach and relies upon antitrust to police anticompetitive abuses. Antitrust’s “rule of reason” seeks to identify whether the net effects of a challenged practice on consumers are positive or negative — precisely the type of analysis needed to assess whether paid prioritization should be allowed in a particular case.

For all of these reasons, the Restoring Internet Freedom draft order is a triumph of mainstream economics over the 2015 order’s “wrong, unsupported, or irrelevant” economics.

Jerry Ellig is chief economist at the Federal Communications Commission.