The Net Neutrality Debate Reduced To A Cocktail Napkin

In 1974, economist Arthur Laffer famously sketched a curve on a cloth napkin at a restaurant to inform tax policy. More recently, economist Alex Tabarrok employed a similar tactic to inform patent policy. Some economic problems simply defy prose.

The “Laffer Curve,” which depicted a simplified relationship between tax rates and tax revenues, was designed to assist Ford Administration officials in determining the revenue-maximizing tax rate. Given the complexity in implementing a net-neutrality regime, FCC Chairman Tom Wheeler similarly could benefit from a simplified chart to determine the investment-maximizing Internet regulation. Having typed for 20-odd years and thereby having lost all fine-motor skills, I apologize in advance for my artwork.

Net neutrality napkin

Depending on which of the two graphs best depicts the likely investment response by the Internet ecosystem to changes in regulation, the Chairman could support a heavy- or light-touch approach to implementing a net-neutrality regime.

The FCC recognizes the importance of investment in shaping Internet policy, as expressed by its recent Open Internet Notice of Proposed Rulemaking:

We seek comment on the current role of the Internet’s openness in facilitating innovation, economic growth, free expression, civic engagement, competition, and broadband investment and deployment. Particularly, we seek comment on the role the open Internet rules have had in investment in the broadband marketplace—networks and edge providers alike. We are similarly interested in understanding the role that the open Internet may play in the promotion of competition or in identifying barriers to infrastructure investment that an open Internet may eliminate or lessen. 

As is customary in Washington, extreme voices have dominated the net-neutrality debate, emphasizing what investment they consider to be paramount.

On one extreme, the netizens advocate heavy-handed regulation to protect investment at the “edge” of the network by content and application providers. Writing in the Washington Post, Nancy Scola articulated this edge-centric ethic, suggesting that without strict net neutrality rules in place, “young entrepreneurs eventually give up. And knowing of their struggles, the next generation of would-be online entrepreneurs doesn’t even bother trying.”

On the other extreme, the libertarians advocate that the FCC play no role in regulating the Internet. They fret that even the slightest regulation will discourage investment at the “core” of the network by Internet service providers (ISPs). As a reflection of this core-centric ethic, the House Judiciary Committee held a hearing last week on why antitrust laws, enforced by the Federal Trade Commission, were sufficient to protect edge providers.

The libertarian’s view was rejected by the D.C. Circuit in Verizon v. FCC. The Court determined that some regulation is justified to promote the “virtuous cycle” of investment by edge providers, which in turn spurs investment at the core:

The Commission’s finding that Internet openness fosters the edge-provider innovation that drives this ‘virtuous cycle’ was likewise reasonable and grounded in substantial evidence . . . This conclusion finds ample support in the economic literature on which the Commission relied . . . The record amassed by the Commission contains many similar examples, and Verizon has given us no basis for questioning the Commission’s determination that the preservation of Internet openness is integral to achieving the statutory objectives set forth in Section 706 [of the Telecommunications Act of 1996].

The Court went on to explain that ISPs “could act in ways that would ultimately inhibit the speed and extent of future broadband deployment.” The Court also determined that ISPs, if left to their own devices in establishing pay-for-priority arrangements, would not internalize any “resultant harms to innovation” by edge providers. Finally, the Court found that ISPs “have the technical and economic ability to impose such [investment-deterring] restrictions.”

But how much regulation is needed to trigger this “virtuous cycle”? The answer is that the optimal amount of regulation should maximize the sum total of investment at the edge and the core. In the spirit of neutrality, the FCC should consider a dollar of investment at the edge to generate the same social benefit as a dollar of investment at the core. Although the “virtuous cycle” theory embraced by the Court suggests that edge investment could be given more weight in the FCC’s calculus, there are positive spillovers associated with core investment as well, and there is no objective way to determine the relevant weights.

Because most adults, including economists, cannot visualize what the sum of two curves looks like, a napkin is unavoidable. Scroll back up to the top of this blog. In both graphs, the vertical axis is the amount of investment, and the horizontal axis is the amount of regulation. The red curve depicts edge investment as a function of regulation (more is better), and the blue curve depicts core investment as a function of regulation (less is better). The black curve depicts the sum total of core and edge investment for any level of regulation.

The graph in the left pane depicts a world in which both edge and core investment is sensitive to the amount of regulation, but edge investment is more so. Thus, while core investment slowly declines with more FCC oversight, edge investment drops dramatically as regulation is withdrawn. In this world, the optimal policy is a heavy-handed approach, such as common carriage under Title II, which maximizes total investment (and happens to maximize edge investment).

The graph in the right pane depicts a world in which neither type of investment is sensitive to the level of regulation except at the extremes. Core investment is generally robust unless regulators overreach, and edge investment can be counted on except when regulators fall asleep. In this case, the optimal policy is a light-touch approach, such as Section 706, which maximizes total investment at the expense of a little edge and a little core investment (relative to their maximum levels).

How should the Chairman decide which of these two worlds best captures the facts on the ground? There is scant empirical evidence of the “elasticity” of edge investment with respect to a change in regulation, as the Internet is a nascent industry and the regulatory protections for edge providers have hardly changed. In comparison, the elasticity of core investment to changes in other types of regulation, such as mandatory unbundling, has been empirically studied. But again, the type of rules being contemplated here—such as a no-blocking rule or the equal treatment of packets—are a bit novel. Indeed, the D.C. Circuit was persuaded by “the absence of evidence that similar restrictions of broadband providers had discouraged infrastructure investment.”

It defies logic to believe that an app developer operating out of her parent’s garage is going to throw in the towel because NetflixGoogle, or some other edge behemoth entered into a voluntary, for-pay arrangement with an ISP; there are other, more significant obstacles standing in her way. Further, the service needs of a startup are very different from the needs of an established content provider with tens of millions of customers. This suggests that edge investment will not drop precipitously in response to a modest reduction in regulation. If I am right, then the right pane of the graph should guide policy.

Notwithstanding this intuition, in the absence of empirical evidence about likely investment responses, the FCC Chairman should preserve his flexibility. A light-touch approach, in which the agency draws on its authority under Section 706, would do just that it. If I am wrong about what motivates an edge entrepreneur, and if edge investment instead were to fall precipitously under a light-touch approach—that is, the left pane captures the real world—then the agency could always apply the “commercially reasonable” standard under Section 706 in a more restrictive manner (so long as it permitted some room for bargaining between edge providers and ISPs).

In contrast, starting with a heavy-handed Title II approach could risk substantial core investment without generating any offsetting incremental investment at the edge. Under the “mother-may-I” approach of Title II, it is much harder to ratchet down regulation. For example, Title II could entail a rate-setting process for edge- or customer-facing offerings by ISPs; once a regulated rate is established, a new proceeding would be needed to adjust it. Because Title II would limit the FCC’s flexibility in the face of such uncertainty over investment responses, the better approach is the light-touch of Section 706.

Under a light-touch approach, both core and edge providers would be asked to make a modest sacrifice in exchange for the greater good. Barring the unlikely event in which the left panel depicts reality, total investment would be maximized, and the regulator’s flexibility to adjust the rules in response to investment reactions would be preserved.

Now can I have my napkin back?


Twitter: @halsinger

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