A Quick Note on Omitted Variable Bias

Here’s an excerpt from an introduction-to-econometrics paper written for lawyers, which I will present at the ABA Antitrust Spring meeting in DC in late March. If you are interested in reading the whole submission (a little over 4,000 words), please write me.

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Well, if that’s all regression does, you might ask, why in the heck do we need it? The answer is that many factors in addition to the challenged conduct likely affect prices in this market, and we need to control for those factors in case they changed around the time that the challenged conduct ended. Prices are typically determined as a markup over the cost of serving the customer. Suppose the seller (the defendant) in this case always imposes a markup of 50 percent over costs; in the during period, average costs were $667 and average prices were $1,000. Suppose further that costs on average declined in the after period relative to the before period by $100, bringing average costs to $567 and average prices to $850 (equal to $567 plus 0.5 x $567). We now have an independent reason—unrelated in any way to the challenged conduct—for why prices would have declined in the after period!

Suppose the analyst is unaware that costs had changed or that cost data are not available. He regresses the simple model from equation [1]. The estimated parameter on the conduct indicator comes back at $250, but we know that the parameter is biased. Technically, this means the expected value of the parameter in repeated samples will not be equal to the true value. The regression is attributing too much of the change in prices between the during and the after period to the challenged conduct. This problem is referred to in the econometrics literature as “omitted variable bias,” and it represents a major challenge for applied economists.

Here’s why: Remember that assumption on the error term in equation [1]? It required that the error term was not correlated with the conduct indicator. By omitting cost from the regression, however, we violated it. In particular, we know that costs declined remarkably right around the time that the conduct ended; hence, when the conduct was absent (present), costs were lower (higher). Without controlling for costs, B will now capture the sum of the direct effect of the conduct on prices (what we want) plus the indirect effect of the conduct on costs, which in this case is positive. So when we omit costs from the regression, our predictions of prices based on equation [1] will be worse in the presence of the conduct—that is, the error term is now correlated with the conduct indicator. In general, whenever the omitted variable (in this case, cost) is positively correlated with both the included regressor (the conduct) and the dependent variable (the price), the estimate of the included variable’s coefficient will be upwardly biased. Because this rule is hard to memorize, I’ve presented a simple table for reference below.

Correlation between omitted variable and included regressor Correlation between omitted variable and dependent variable Direction of Bias on Included Regressor
Positive Positive Upward
Negative Positive Downward
Positive Negative Downward

It bears noting that most if not all regressions ever estimated have omitted at least some explanatory variables from the equation (otherwise, there would be no error term, and the R-squared would be 100 percent). But that does not imply that the resulting parameters of the imperfect model were biased. Two conditions must be present for an omitted variable to result in a biased regression estimate: (1) the omitted variable must be a factor that explains the dependent variable; and (2) the omitted variable must be correlated with an independent variable specified in the regression. The second condition is a generalization of the phenomenon we just encountered with costs and the challenged conduct. This means that it is not sufficient for an opposing economist to merely point out that a regression is missing a key variable. For the critique to be valid, the opposing economist must demonstrate that both conditions are satisfied. One way to do this is indirectly, by providing an evidentiary basis that the allegedly omitted variable is a factor in defendant’s pricing, and that it is correlated with the conduct variable. Alternatively, the opposing economist can demonstrate omitted-variable bias directly by re-running the regression with the omitted variable included, and showing that not only does it belong in the regression (as evidenced by a statistically and economically significant effect), but also that the revised estimate of the conduct parameter is no longer statistically or economically significant or of the expected sign.

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Non-Discrimination Rules for the Internet

There is a lot to chew on in Kevin Werbach’s new piece on the FCC’s role in shaping the Internet. But one passage caught my attention:

The FCC’s first actions on the issue came under two Bush-era chairmen, but most Republicans have always been skeptical of the need for formal broadband non-discrimination rules. Ironically, that now puts them out of step with the industry. Though still opposing classification as a regulated common carrier and some of the FCC’s specific requirements, virtually every major broadband operator is on record endorsing what would have been considered strong net neutrality rules in 2004 or even 2008.

So if Republicans need prodding, let’s prod them. Here is the compromise I’m peddling:

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Wish me luck.

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2016 Broadband Capex Survey: Tracking Investment in the Title II Era

Here are the results of my 2016 domestic broadband capex survey.

screen-shot-2017-02-28-at-9-55-23-am

I’ll have a lot more to say, but here are some of the key takeaways:

(1) Of the twelve firms in the survey, eight experienced a decline in domestic broadband capex relative to 2014—the last year in which ISPs were not subject to common carrier regulations. Across all twelve firms, domestic broadband capex declined by $3.6 billion, a 5.6 percent decline relative to 2014 levels.

(2) The biggest drops occurred at AT&T (down $3.4 billion or 16.2 percent relative to 2014 levels) and at Sprint (down $2.4 billion or 62.7 percent relative to 2014 levels). When measuring the impact of Title II on AT&T’s domestic broadband investment, it is important to remove AT&T’s investment in DirecTV and its investment in Mexican cellular properties. A detailed explanation is provided here. Similarly, when measuring the impact of Title II on Sprint’s domestic broadband investment, it is important to ignore Sprint’s capitalization of handsets, an accounting change that occurred in the middle of the experiment. Fortunately, Sprint breaks out these “investments” separately from network investment.

(3) The biggest gains occurred at Comcast (up $1.2 billion or 19.2 percent relative to 2014 levels) and at Charter (up $884 million or 39.8 percent relative to 2014 levels). The Comcast figure excludes investment in NBCU properties (again, the hypothesis is that common carriage regulation undermines investment at the core of the network). The Charter figure requires a decomposition of the aggregated data in Charter’s pro forma, which assumes (counterfactually) that the three companies (Charter, BrightHouse, Time Warner Cable) were a single unit as of January 2015. Some analysts have argued that, by foreclosing ISPs from employing certain arrangements with edge providers, the rules cemented the status quo market structure, thereby assisting (in relative terms) dominant cable operators.

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Repealing the FCC’s New Privacy Rules Will Not Leave a Gap in Consumer Protection

The new Congress is reportedly considering repealing the privacy rules that Tom Wheeler’s Federal Communications Commission (FCC) put in place right before the presidential election. Proponents of the new rules are engaged in a furious public-relations campaign, claiming that consumers’ privacy will be violated left and right if the new rules are repealed. Frightening if true.

When it comes to using your data from web browsing and app usage, the Federal Trade Commission (FTC) has been the regulatory cop on the beat. Determined to be relevant in the digital economy, the FCC created its own, radically different set of privacy regulations targeting just Internet Service Providers (ISPs). By requiring an ISP’s customers to give permission for their data to be used, the FCC’s new privacy rules subject ISPs to a different and more restrictive set of regulations than their online advertising rivals.

The difference in the rules—“opt in” rules for ISPs versus “opt out” rules for edge providers—has significant competitive implications in the online advertising market, which is dominated by Google and Facebook. The reason is that consumers typically elect the default choice out of laziness and respect for the status quo. By making it relatively easier for edge providers to access consumers’ data, the FCC has perversely impaired the ability of ISPs to compete for online advertisers.

Not what you’d expect from an FCC Chairman who liked to chant “competition, competition, competition” as his raison d’etre.

Google and its minions are understandably upset that Congress might upend this regulatory arbitrage, and they have come out swinging. A February 20 blog post by the Electronic Frontier Foundation (EFF) in defense of the FCC’s rules begins with a breathtaking subtitle: “Cable and telephone companies are pushing Congress to make it illegal for the federal government to protect online consumer privacy.” The hyperbole doesn’t end there. EFF claims not once but twice that Congress “intends to eviscerate consumer privacy laws.”

Please. Even if the FCC’s new privacy rules are repealed, there are myriad layers of federal and state protection for consumers. None is mentioned in EFF’s blog.

Where to begin? At the federal level, the FCC has authority under section 222 of the Communications Act to prevent privacy abuses by telephone providers. Section 222 was originally designed to prevent traditional telephone companies from giving their wireless subsidiaries an unfair advantage over unaffiliated wireless companies by sharing customer information with them.

Even EFF admits that “Long ago, Congress made privacy a legal right, so that your telephone company was prohibited from using its position as your communications provider to exploit your personal information.” In case there is any doubt of the law’s relevancy in the Internet age, in 2015, the FCC’s Enforcement Bureau issued an advisory that made clear that even in absence of new privacy rules, the FCC will enforce section 222 against broadband providers.

Not content with section 222? Repeal of the FCC’s new privacy rules will not prevent the FCC from establishing a different privacy regime going forward. For example, in the name of regulatory symmetry, the new FCC could replicate the same opt-out standard used by the FTC.

Perhaps anticipating this rejoinder, EFF claims without citation to any case law or precedent that the mechanism being considered by Congress to repeal the FCC’s privacy rules “could possibly bar the FCC from enacting future consumer privacy rules even if they are more industry friendly.” Adding “possibly” after “could” seems redundant, unless there is simply no basis for making such a claim. (I’m anxious to be corrected.)

Moreover, repeal of the FCC’s privacy rules will not prevent Congress from establishing a different privacy regime going forward. To the extent that Congress repeals both the FCC’s 2015 Open Internet Order and its privacy rules, the FTC would be placed firmly back in control of privacy enforcement for ISPs. Before the FCC’s reclassification of ISPs as common carriers in March 2015 took away the FTC’s authority, the FTC was the primary privacy cop on the beat for ISPs. For example, in 2014, the FTC sanctioned AT&T Mobility for its alleged failure to adequately inform its customers of its data-throttling program.

EFF argues that a recent Ninth Circuit decision stripped the FTC of its “authority to penalize cable and telephone companies if they deceive their customers, meaning the FCC is the only broadband consumer protection agency.” But Congress could eliminate the FTC’s common-carrier exception, assuming the GOP majority could convince eight Democratic Senators to overcome the filibuster rule. This would also return privacy enforcement to the FTC.

Moving beyond federal protections, several states add yet another layer of protection against potential privacy abuses by ISPs. For example, Nevada and Minnesota require ISPs to keep private certain information concerning their customers, unless the customer gives permission to disclose the information. And under California law, non-financial businesses, including ISPs, are required to disclose to customers, in writing or by electronic mail, the types of personal information sold to a third party for direct marketing purposes.

If and when the FCC’s new privacy rules are overruled, the statute that empowers the FCC to police privacy abuses by ISPs will still apply. And nothing prevents the FCC from designing a different (and more symmetric) regulatory standard. Repeal of the FCC’s new rules will simply restore the regulatory environment that existed for more than 18 months between the FCC’s reclassification decision and its privacy rules. Given the myriad layers of protections and regulatory options, the notion that repeal would leave the ISPs without any privacy regulator is patently false.

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Tracing AT&T’s Capital Expenditures Over Time

When it comes to broadband investment, AT&T is the largest Internet service provider (ISP) in the United States. So when AT&T redirects capital expenditures (capex) away from its domestic broadband operations, the whole ISP segment moves with it. This is key because policymakers are trying to figure out what happened to ISP capex since the FCC reclassified ISPs as common carriers in February 2015.

Try as Tom Wheeler might to obfuscate the facts, the relevant benchmark for comparison is 2014–the last full year in which ISPs were not subjected to common carrier regulations. In his farewell speech, Wheeler intimated that 2013 (his first year as Chairman) was the benchmark year against which any such comparisons should be made. Convenient, but wrong, as 2014 is a better predictor (relative to 2013) of 2015 and 2016 ISP investment in a world absent reclassification.

If you look at the top-line capex figures from AT&T from 2014 through 2016, it appears that capex increased (albeit slightly) from 2014 to 2016: $21.2 billion in 2014, $19.2 billion in 2015, and $21.5 billion in 2016. Title II is wonderful, right?

Wrong. There’s a problem in this comparison, and it’s similar to the one that complicates inferences about the impact of Title II on Comcast’s broadband investments. Recall that Comcast acquired NBCU, a content provider, and the deal was approved by regulators in early 2011. Fortunately, Comcast breaks out its annual capex relating to NBCU from its capex in infrastructure in its annual reports.

In the middle of 2015, AT&T acquired DIRECTV and some Mexican cellular properties. Unlike Comcast, however, AT&T does not break out capex related to these investments. To make an apples-to-apples comparison of AT&T domestic broadband capex from 2014-16, one must back out AT&T’s capex in satellite and in Mexico in 2015 and 2016. In particular, one must back out a half year of those investments in 2015, and a full year in 2016. The approximate annual capex over the last few years were $3 billion for DIRECTV and $750 million for its Mexico operations (equal to $3 billion spread over four years).

Accordingly, the best estimate for AT&T’s domestic broadband capex in 2015 is $19.2 billion (the top-line figure reported in its annual report) less $375 million in Mexico less $1.5 billion in DIRECTV, or $17.3 billion. And the best estimate for AT&T’s domestic broadband capex in 2016 is $21.5 billion (the top-line figure reported in its annual report) less $750 million in Mexico less $3.0 billion in DIRECTV, or $17.8 billion.

Relative to 2014, AT&T’s domestic broadband capex in 2015 declined by 18.2 percent ($17.3 billion versus $21.2 billion). And again relative to 2014, AT&T domestic broadband capex in 2016 declined by 16.2 percent ($17.8 billion versus $21.2 billion). Put differently, the imposition of Title II is associated with (but did not necessarily cause) an annual reduction of over $3 billion in capital in the broadband sector in each of the last two years. That’s a lot of capital to go missing.

This is not a legacy anyone should be proud of. I’ll be back with my full survey of the top 12 ISPs shortly. Stay tuned.

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Since posting the piece, Alex Byers of Politico asked me via Twitter about the impact of Project VIP on AT&T’s capex, which ended in 2014. It’s true that VIP caused a boost in capex. But AT&T’s guidance to investors in November 2012 was that capex would return to normal, “pre-VIP levels.” AT&T’s average capex from 2010-12 was $20.5 billion, which vastly exceeds the $17.3 to $17.8 billion range estimated above.

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Motley Fool Reporter Gets Fooled by CFA Study

Motley Fool’s Daniel B. Kline reported yesterday that, according to a new study by the Consumer Federation of America (CFA), “Four huge companies that control 70% of the digital communications sector have been using their market power to overcharge the typical household about $45 a month.” Alarming if true.

In yet another display of #TechReporting, Motley Fool issued what amounts to a press release for a public interest group clamoring for price regulation. All of CFA’s claims are taken at face value, and the reporter couldn’t be bothered to interview an economist for independent assessment of CFA’s methodology.

Here’s what Kline would have learned had he reached out to this economist: CFA’s finding that Internet service providers (ISPs) and wireless operators overcharge customers lacks economic rigor and is without merit.

Kline reports that for broadband and video bundles, evil ISPs overcharge customers to the tune of $25 per household per month. AT&T and Verizon reportedly overcharge wireless customer $10 per telephone line. At two lines per household, customers are overpaying by $45 per month (equal to the alleged $25 overcharge on broadband and video plus 2 x the alleged $10 overcharge on wireless telephony).

What is the basis for CFA’s $25 broadband overcharge? Kline doesn’t tell us in his press release. But a cursory look at the CFA study, which runs over 200 pages to create the veneer of serious scholarship, shows that the number derives from an arbitrary reduction in broadband prices needed to drop the EBITDA margin for Comcast’s broadband service to 40 percent, the same margin earned by Comcast’s cable video service. That’s it. Even if this method made sense for Comcast (and it does not), why Comcast’s margin differential reflects the overcharge for every ISP in America is never explained.

The CFA study offers a second justification for the $25 overcharge, in case the first one didn’t grab you:

In other words, removing the excess [broadband revenue] would split the surplus between producers and consumers. To put this in perspective, as shown in Figure V-6, cash flow per subscriber has increased by over $50 per month since the early days of high-speed data offerings by cable operators. A reduction of $25 per month would have split the increasing surplus between producers and consumers. (CFA Study at 170) (emphasis added).

This is not how overcharges are estimated.

Typically, an economist will find some competitive benchmark price that is not contaminated by the conduct being challenged (in the case, the exercise of alleged monopoly power). Or regressions are used to isolate the impact of the conduct on prices. But in arriving at its “EBITDA-based estimate of overcharges,” the CFA study simply waives its hands, solves for the broadband price that would yield the competitive EBITDA margin (with Comcast’s cable video as the benchmark), and appeals to an invented equity of splitting the surplus.

The basis for the $10 overcharge on by evil wireless operators is just as arbitrary. Here the CFA study computes the differential in EBITA per subscriber per month between AT&T and T-Mobile. Just as cable video served as the “competitive benchmark” in the broadband overcharge model, T-Mobile plays the “competitive benchmark” for wireless telephony. But there is no reason why all wireless carriers should earn the lowest EBITDA in the industry. T-Mobile might be operating at razor thin margins just to steal share and to overcome AT&T’s and Verizon’s inherent network advantages. CFA would have the reader believe that 100 percent of the margin differential is attributable to ill-gotten market power.

This is not to say that the broadband industry is perfectly competitively supplied in every neighborhood in America. Cable operators have been shown to drop prices significantly in the presence of overbuilder competition or fiber-based Gigabit entry, implying a certain degree of pricing power in select areas. But CFA’s claim that every broadband operator in America overcharges to the tune of $25 per month is completely unsubstantiated. Ditto for the claim on wireless overcharges.

CFA can do better than this. And so can tech reporters.

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You Had Me At Autopilot, Elon

Tesla Model X copy

There’s no better way to announce your arrival than the unfurling of the Model X’s Falcon Wings.

 

“You can take your hands off the wheel now.”

“Holy crap. Can I take a picture?”

“Not if you plan to share it.”

So my friends, I’m left to describe this occasion with mere words.

The Model X was hurling towards a sharp bend on the Dulles Toll Road at around 55 miles per hour (mph). I test drove the most powerful package, the P90D, which goes from 0 to 60 mph in 3.2 seconds with the “Ludicrous” option. As we neared the turn, I lifted my hands off the steering wheel, and I placed my life in the hands of Autopilot.

What happened next was nothing short of miraculous: The car hugged the dotted lane separator, curving safely away from the barrier. I felt like a kid taking his first ride on a roller coaster.

The next trick was the lane change.

“Hit the left turn signal.”

“That’s it?”

And like that, the Model X patiently waited for traffic to pass on my left, and then changed lanes. Mind blowing.

“Now come back into the right lane, and turn on the right turn signal.”

I obliged but nothing happened. Why didn’t we move onto the shoulder? Because the Autopilot can tell the difference between a dashed line and a solid line. It will never cross the latter. The car has eyes and it processes everything it sees, including speed-limit signs.

Autopilot is a $2,500 upgrade on the base model. It includes an autoparking feature that was equally impressive. The Model X spots a parking space, turns away from the space, and then backs in seamlessly. No mortal could execute this maneuver, at least not this quickly.

Worried about the Falcon doors opening up on the car next door? Yeah, Tesla thought of that too. If you park too close to a neighbor—indeed, so close that the front doors won’t open—the rear doors make a snap calculation: If rear exit is impossible, the doors won’t open; if rear exit is possible, then the Falcon doors will adjust their upward trajectory to avoid hitting the car next door. These guys have thought of everything.

The base unit of the Model X, called the 60D, starts at $74,000. It has the identical power as the next model up (the 75D), but travels 37 fewer miles on a full charge (200 versus 237 miles). The salesman confessed that the 200-mile estimate for the 60D is the distance under ideal circumstances, and that I should expect something closer to 167 miles per full charge under normal circumstances. To get the extra 37 miles of capacity for the 75D, Tesla wants an additional $9,000, which works out to $243 per extra mile of capacity.

But here’s the kicker: If you get the 60D, and then regret your decision, Tesla will upgrade the car for $500 plus the $9,000 upgrade package. And if you’re worried about resale values, Tesla will peel off the 60D decal and replace it with a 75D. (I’m inclined to get the 60D and incur the $500 penalty if I underestimated my demand for distance.) The reason why the upgrade is so cheap is that Tesla doesn’t have to change any hardware; instead, it simply unlocks the last ten percent of capacity on the same battery with a software change.

For my purposes, the chance of going over 167-200 miles in a day is remote. I’ll charge the battery nightly at my home. Unlike the old iPhone batteries, charging the Tesla battery daily does no harm, even when the battery is not fully discharged when the charging begins.

For longer trips, the Model X’s navigation system plans the route and displays the Tesla charging stations along the way. The national map in the store created the appearance that Tesla has blanketed the country. But when we plotted a trip from Tysons Corner to Baltimore, I was surprised to learn of only a single Tesla charging station (located in Bethesda) along the route. This is unacceptable, but the salesman assured me that another station was planned in Laurel. He also insisted that the Model X can charge at non-Tesla stations, so long as I buy a converter.

The default seat arrangement in the Model X is five seats, with three seats in the second row. Five of us (plus the salesman) tried to cram into a seven-seat configuration and it was a disaster. No one was willing to sit in the third row, and folks were even complaining about the second row. This is a design flaw: The center of the Model X is too small to cram a wall of three seats into the second row. The six-seat configuration is ideal, with two captain seats in the second row, opening up space in the second and third rows.

So how much will a decently decked out Model X 60D set you back? The version I designed has $12,000 of upgrades, including $1,500 for the pearl white multi-coat paint, $2,500 for the black nappa leather seating, $3,000 for the six-seat interior, $2,500 for Autopilot plus Autopark, and $2,500 for smart-air suspension (required for for the six-seat configuration). The smart-air suspension automatically lifts the car a few inches during heavy snowfall.

If a friend owns a Tesla, you can get a $1,000 rebate referral code. But that just defrays the $1,200 delivery charge. So you’re looking at about $86,000 all in.

Relative to other luxury SUVs, the Model X can be rationalized with the expected fuel savings (about $8.31 for every 100 miles driven at current gas prices), a $7,500 income tax credit, your time saved on refueling and oil changes, and your smaller carbon footprint. And when the Falcon wings rise in your driveway, I suspect a neighbor (or four) will rush to the Tesla dealership. And you can’t put a price on that!

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