Rate Regulation Run Amok: Lessons for Net Neutrality

Readers of this blog who follow the net neutrality debate will recognize an important case called Cellco, cited repeatedly in the D.C. Circuit’s January decision to gut key provisions of the FCC ’s Open Internet Order that smacked of heavy-handed rate regulation.

In Cellco, the D.C. Circuit blessed the FCC’s 2011 Data Roaming Order, which established the terms by which wireless broadband providers should contract for data roaming. Importantly, the Court approved a light-touch approach to adjudicating roaming disputes: Rather than set a roaming rate by fiat, the Data Roaming Order granted the parties the freedom to negotiate towards a “commercially reasonable” roaming rate.

To ensure that his agency’s revised Open Internet Order survives scrutiny by the same court, the Chairman of the FCC, Tom Wheeler, has imported the “commercially reasonable” language from the Data Roaming Order to establish the terms under which content providers and Internet service providers (ISPs) should contract for priority delivery. I’ve written about his proposal glowingly here.

Not everyone agrees with my assessment. Proponents of strong net neutrality such as Netflix and Kickstarter claim that the current proposal would permit the development of “fast lanes” for content companies that could afford priority delivery. They seek to steer the Chairman toward heavy-handed rate regulation, which would bar any contracting for priority delivery by effectively setting its rate at $0.

While net neutrality garners press attention, similar efforts by competitors are underway to steer the FCC toward heavy-handed rate regulation for roaming disputes. In particular, they are trying to convert the “commercially reasonable” standard embraced in the Data Roaming Order into de facto rate regulation. And they have brought out the big guns.

Writing on behalf of T-Mobile, Dr. Joseph Farrell, former chief economist of the FCC and currently professor of economics at UC Berkeley, has proposed a new standard for determining whether a roaming rate is “commercially reasonable.” According to Professor Farrell, any roaming rate, expressed on a per-megabyte (MB) basis, that substantially exceeds the access provider’s retail rate for the incremental MBs used while roaming should be looked at with suspicion.

To make his proposal concrete, consider Sprint’s current wireless offering at $50 per month. Assuming the average wireless broadband user consumes 1,700 MB of data per month, Sprint’s roaming rate should not exceed three cents per MB (equal to $50 divided by 1,700 MB).

Not only would Professor Farrell’s proposal constitute heavy-handed rate regulation of the kind rejected by the Court, it would also impose the wrong rate. To see why, consider the following hypothetical:

Sprint competes with T-Mobile (as well as AT&T T -1% and Verizon) for business customers in Whatever, USA. To commute downtown, suburbanites ride a bus across a bridge that is covered by Sprint, AT&T and Verizon, but is not covered by T-Mobile. Although T-Mobile’s license covers the bridge, T-Mobile chooses not to build out its network there. Assume further that the typical commuter consumes five percent of her daily consumption of MB on the bridge. And most important, no commuter would ever subscribe to a wireless carrier that did not cover the bridge.

Does your wireless carrier cover this bridge?
Does your wireless provider cover this bridge?

By providing bridge coverage to T-Mobile via roaming, Sprint creates a new option for commuters that did not previously exist. It is now possible for a commuter who previously would have opted for Sprint, to now opt instead for T-Mobile. Is it any wonder why Sprint is reluctant to cut a roaming deal in this circumstance?

Sprint’s margins that are put in play via the roaming agreement are not just the margins associated with the commuter’s MB usage over the bridge. Instead, the entirety of Sprint’s retail margin is put in play! Accordingly, it would be perfectly commercially reasonable for Sprint to demand to be compensated for its forgone retail margins when setting its roaming rate.

At margins of roughly 40 percent, that would mean a $20 roaming fee per subscriber per month (equal to 0.4 x $50 per month). But if Sprint asked for anything more than $2.50 per subscriber per month (equal to 0.05 x 1,700 MB x 3 cents per MB), Sprint’s offer would violate Professor Farrell’s proposed standard. In other words, the roaming rate that would make Sprint indifferent between serving the customer indirectly (via a roaming agreement) and directly (as a retailer) is eight times T-Mobile’s asking price!

And herein lies the harm from rate regulation: Wireless providers made massive investments in broadband networks under the belief that those retail margins would provide a sufficient return on investment; dilute those margins too aggressively and the investments disappear. The access seeker sits back and then wants to cherry pick that investment at regulated rates rather than build the network itself. Yet an explicit goal of the Data Roaming Order was to provide incentives to “those providers to invest and deploy advanced data networks, and avoid potential disincentives for those providers to invest.”

Investment incentives are particularly important because wireless carriers are continually upgrading their networks. 4G is just the current flavor, but it followed 3G, and it will soon be followed by 5G, which might just serve as a viable alternative to wireline access technologies such as cable modem. If only wireless investment were complete, it might be possible to construct an economic model showing that Professor Farrell’s proposed solution maximized short-term consumer welfare. But when an industry is as dynamic as wireless, investment is never complete, and attempts to appropriate “sunk” investment will surely backfire.

To be fair, allowing access providers to capture the forgone retail margin may not be wise policy when retail markets are monopolized. But that is not the case here: The effective price per MB on U.S. wireless networks declined from $0.25 in 2008 to less than $0.05 by 2012. Retail competition among four national providers ensures that the voluntary access rates do not reflect monopoly rents.

So what is the lesson for net neutrality? Competitors are lobbying the FCC to set a regulated price for roaming, with little concern for investment effects. With the same recklessness, certain content providers are lobbying the FCC to set the regulated price for priority delivery at zero. In both instances, the FCC should refrain from getting embroiled in rate regulation.

The Chairman should stick with his original net neutrality proposal. ISPs and content providers should be free to contract for priority delivery pursuant to a commercially reasonable standard. Under such a standard, special arrangements for affiliated websites could be barred. And an ISP that tried to reduce the speeds of its standard offering—with the introduction of a “slow lane”—would be presumptively in violation of the standard. But there would be no regulated price for priority delivery.

If the FCC is dragged into rate regulation in these important cases, the incentives for private-sector investment will be undermined and, when the current flavor of technology is locked in place, broadband consumers will suffer.

Follow me on twitter @halsinger

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