Steven Pearlstein column on Net Neutrality gets close to real issues in debate.

Steven Pearlstein, a professor at George Mason University, has published a column in the Washington Post Sunday that penetrates the phoney issues in the current debate.  All the noise at present is about neutrality, with claims that Internet Service Providers (ISPs)are discriminating and that they will destroy the Internet as we know it.  Pearlstein's column, entitled " Shades of complexity dominate the debate over "net neutrality", turns the debate to economics. which is where it belongs.

Pearlstein says:

"This is a debate that has come to be dominated by hypocrisy, half-truths and impenetrable complexities.  At one level, net neutrality is a solution to a problem that, for the moment, doesn’t exist.  ... At another level, what the net neutrality debate is really about is deciding who will pay the considerable costs of building out the infrastructure to handle all those bandwidth-hogging videos and games that we’ll be downloading from the Internet. The content providers and start-up app creators, naturally, think they shouldn’t have to pay because that would discourage their economy-disrupting innovation. The ISPs, naturally, think they will only have the money and incentive to expand their network if they can levy an extra charge on the Netflixes and the Googles who have sucked most of the value out of the Internet."

Pearlstein is correct that the fundamental issue is economic.  However, it is not merely related to the cost of building out additional infrastructure.  Rather, it relates to the manner in which the cost of the entire Internet will be recovered.  Like many other networks, the Internet is a joint product in economic terms – it has substantial fixed costs which must be recovered either from suppliers of information, or from consumers.  At present such costs are recovered from consumers.  However, there are proposals to recover some of those costs from suppliers in the form  of higher charges for greater speeds.  These are certainly reasonable proposals, but, obviously, shifting part of the burden to suppliers who had a free ride has generated opposition.  To win the argument, suppliers have camouflaged their economic interest with claims about equity, unfairness to small vendors, etc.  But remember, underneath all the propaganda is the fundamental economic issue of who should pay for the Internet.


25 years ago, I was involved in antitrust litigation with respect to how the cost of airline computerized reservation systems would be recovered.  The CRSs were the essential link between travel agents and the airlines upon which they made reservations.  The vendors, who were all airlines themselves at that time, initially recovered the costs from travel agents, but competition among the airline vendors reduced charges to them.  Therefore, with the help of government regulation requiring nondiscrimination in booking fees, they imposed substantial fees on other airlines.  Outraged, other carriers sued for over $4 billion, claiming that each CRS was a monopoly  After a three-month trial, a jury rejected this claim.

The current debate has many similarities that long-ago controversy.  I will write more about net neutrality and joint products in the future.  I may also devote another post to Pearlstein's bizarre solution to the problem – he  proposes to grant local monopolies to ISPs based upon competitive bidding.  The winning ISPs would then be able to charge monopoly prices.

Obama Proposes Regulation of the Internet to Achieve Net Neutrality

On November 10, President Obama called on the FCC to adopt regulations that would require net neutrality, or non-discrimination, in the operation of the Internet.  The Wall Street Journal today has an interesting column by Andy Kessler suggesting that this proposal would result in full-scale traditional utility-style regulation of the entire Internet.  According to Kessler, the President's call to regulate under Title II of the Federal Communications Act would give the FCC the power to regulate all aspects of Internet service, including prices.

My initial reaction was that this was an exaggeration –  in order to achieve net neutrality, all that is  required are anti-discrimination regulations.  For example, when airlines were deregulated in 1978, the statute eliminated pricing regulation for domestic air transportation, but retained the statute permitting discrimination in air transportation.  I would suggest that this is probably the goal of the administration – not full-scale regulation of the Internet.

However, it seems clear that regulation under Title II would encompass much broader forms of regulation than those required to achieve net neutrality.  This was explained in an excellent brief summary of the issue in Time Magazine.  Mr. Kessler may have a point.

FCC to Hold Hearing on Regulating Cell Phone Termination Fees

The FCC will hold a hearing tomorrow, June 11, on whether to take over jurisdiction of cell phone termination fees, which are not subject to state regulation. The major cell phone companies are, of course, in favor of this proposal, which as been promoted particularly by Verizon, because it would eliminate regulation by 50 pesky state governments, in exchange for a single regulator at the federal level. It would also preempt class actions, several of which have apparently been filed. See Wall Street Journal article, May 24, 2008.

Of course, regulation of termination fees would simply result in increased costs to consumers. Cell phone companies have justified termination fees as enabling them to offer low-cost or free cell phones to consumers. If termination fees are restricted, the costs of telephones and telephone service would undoubtedly increase. See also Open Market.org.

DOJ approves Sirius/XM merger

The Department of Justice today issued a statement that it had closed its investigation of the Sirius -- XM Radio merger without taking action, finding that there was no evidence that the merger would substantially reduce competition. It found that the parties did not substantially compete with each other with respect to existing customers (because each customer has a sunk cost of the equipment he has installed in his car). With respect to new customers, the Department stated:

"For potential new subscribers, past competition has resulted in XM and Sirius entering long-term, sole-source contracts that provide incentives to all of the major auto manufacturers to install their radios in new vehicles. The car manufacturer channel accounts for a large and growing share of all satellite radio sales; yet, as a result of these contracts, there is not likely to be significant further competition between the parties for satellite radio equipment and service sold through this channel for many years."

Most important, it found that the market for retail competition was not limited to the providers of satellite radio. It said:

"In the retail channel, where the parties likely would continue to compete to attract new subscribers absent the merger, the Division found that the evidence did not support defining a market limited to the two satellite radio firms that would exclude various alternative sources for audio entertainment, and similarly did not establish that the combined firm could profitably sustain an increased price to satellite radio consumers."

The merger still has to gain the approval of the Federal Communications Commission.

FCC Imposes Three Billion in Costs on Cell Phone Companies without Economic Analysis

The Federal Communications Commission has, with little advance notice, issued a new regulation requiring all cell phone towers, no matter where located, to have a backup power supply of at least eight hours. An Associated Press article today describes the regulation, the opposition of wireless operators, and a stay issued by the DC Circuit Court of Appeals pending oral argument, which is scheduled for May.

The rule results from the proceedings of an independent commission set up by the FCC to study communications problems that arose during Hurricane Katrina. The recommendation for backup power was one of many made by the commission and considered by the agency in a rulemaking proceeding. In July, 2007, the Commission issued a final rule in the proceeding instituting a nationwide regulation requiring backup power for cell phone companies and other communications providers. (72 F.R. 37655) Several organizations petitioned for reconsideration because the regulation violated the Administrative Procedure Act (72 F.R, 57879), and then filed petitions for review with the appellate court, when their claims were rejected.

The striking thing about the rulemaking is that there is absolutely no discussion of economics, even though the rule imposes enormous costs on the industry. The AP article notes that there are 210,000 cell towers and roof-mounted cell sites nationwide, and quotes one industry estimate that the per-site price will be up to $15,000. This suggests an outer range of costs imposed by the regulation amounting to $3,150,000,000. Some towers already have backup power, so the final results would probably not be this high. But, nevertheless, one would hope that an agency would undertake some economic analysis to weigh the proposed benefits against the costs of the regulation.

The proposed rule is also a nationwide bludgeon that does not seem necessary. There are undoubtedly some cell phone towers that overlap others. I recall looking at a tower map on the Internet with respect to my home in suburban Washington, and finding that I was within the range of five different towers. To all of these require emergency backup power? Moreover, there are many towers in rural areas where there would be relatively little damage from loss of service. Does every tower along Interstate 25 in northern New Mexico require backup power?

There is also no consideration of the relative risk of a natural disaster. There may be a risk of hurricanes along the Gulf and East coasts, and earthquakes on the West Coast, but the vast middle of the country is quite stable, with only occasional flooding and tornadoes. Only in Washington would a regulator think that a uniform national law is required.

Sirius -- XM Radio -- Why Won't Anyone Simply Tell the Truth

The FCC has had the proposed merger between Sirius Satellite Radio and XM Radio under consideration for almost a year. As in the most major regulatory proceedings, parties and economists have filed numerous lengthy papers, and all parties have beaten the bushes for support from Congressman, trade associations, and local governments. Yet the proceeding is somewhat unusual in that the major arguments of both sides are based upon totally false premises. Rather than admit they are failing businesses, Sirius and XM have been forced to argue that they will provide superior service as a consolidated entity. Since this argument is of dubious validity, they have fallen back on a promise to provide a broader range of prices for consumers by breaking up each supplier's current single monthly price structure into various levels so that consumers could choose packages that would include fewer channels than they have now.

The arguments of the opponents, led by the National Association of Broadcasters, appear equally specious. In order to defeat the merger, they have to argue that there is a separate satellite radio product market in which Sirius and XM would obtain a monopoly. If this were true, there is no reason for NAB to even be in the case, since its members supposedly do not compete with the satellite broadcasters. Of course, this is not the case, and the market includes satellite radio, local broadcasters, iPods and Internet.

While the satellite radio providers may not meet the definition of "failing business" under the antitrust laws, it is clear that they are failing. The business model on which they were based in the mid-90s has been blown to smithereens by the iPod, and the availability of free local radio has restricted their ability to price their services to achieve a profit. If people want to listen to unlimited music, they can simply plug their iPod into the radio unit on their dashboard or in their home. The potential for satellite radio outside the automobile has been destroyed by the growth of the Internet, which has made hundreds of radio stations from all over the world available to individuals in their homes. As a consequence, the potential for satellite radio has fallen far short of initial expectations.

Both Sirius and XM have suffered enormous losses over the past several years:

Net Loss

($ millions)

Sirius XM

2004 $712 $615

2005 862 666

2006 1,104 719

In the first nine months of 2007, Sirius improved to a loss of only $399 million, while XM lost only $298 million in the first six months of its fiscal year. Sirius's accumulated deficit over its lifetime is $4.23 billion.

Why haven't they made the "failing business" argument? It may be that they don't technically comply with the antitrust definition, because they may have to show that they make good faith efforts to find other purchasers. More likely, they do not want to admit defeat because that would make it extremely difficult to raise enough money to limp along in business.

The product market arguments in opposition to the merger are equally specious. The applicant's argument was as follows:

As of December 31, 2006, XM and Sirius combined had approximately 14 million subscribers. One study predicts this will grow to 25 million by the beginning of 2010, and others have projected similar growth. Although satellite radio has proven to be an appealing and popular new product, the current 14 million subscribers pales in comparison to terrestrial radio’s approximately 230 million weekly listeners (and is also dwarfed by Internet radio’s 72 million monthly listeners). Both companies offer many channels of music and a range of other programming, including national and international news, sporting events, and talk shows. Both also offer consumers a variety of ways to access this programming, including in their cars, on their computers, at home, and in a portable capacity. Despite strong initial growth, satellite radio’s market penetration remains quite limited: A recent Arbitron study found that satellite radio accounted for just 3.4 percent of all radio listening, spread out among the approximately 300 channels that XM and Sirius combined currently offer. (Sirius -- XM Application, pages 22-23)

In response, the NAB said:

As the American Antitrust Institute has explained, terrestrial radio is not a substitute for satellite DARS. As a preliminary matter, it is important to recognize that terrestrial radio is not a single entity in the local markets in which each radio broadcaster competes. Rather, each local market consists of multiple terrestrial radio licensees competing vigorously with each other. With respect to channels and content, local broadcast stations (individually or collectively) cannot offer the hundreds of channels offered by satellite DARS providers. Nor can they provide geographically continuous service; each licensee serves a limited geographic area and there is no local radio owner with nationwide coverage. They also do not offer the range of out-of-town sports programming or niche programming offered by satellite DARS, and cannot offer the kind of risqué programming offered by satellite DARS, which is unconstrained by indecency regulation.

Moreover, it is significant that terrestrial radio is a free, rather than subscription, service. If satellite DARS and terrestrial radio were substitutable products, it would defy common sense for anyone to pay $12.95 or any other price if they could get an essentially equivalent product for free. Satellite radio subscribers may also listen to terrestrial radio but that is because it is always there for free as another, different or complementary listening option, not because the subscriber is “switching” from one substitutable service to another. As Sirius CEO Mel Karmazin has pointed out, “satellite radio subscribers are heavy listeners to radio in general, and spend even more time listening to AM/FM radio than they do satellite programming.” (NAB Motion to Deny, pages 13 – 14)

One can only say that the NAB argument is pretty weak. I know from my own experience as a Sirius subscriber that I listen to both satellite and terrestrial radio when driving around in my car. I listen to Sirius classical and country music stations, but switch to AM radio for talk radio programs, and to FM for a particular country music station that I like. Certainly, both satellite and terrestrial radio compete for my patronage. NAB is really arguing that satellite has different types of programs. However, the product -- radio -- is still the same. NAB seems to be arguing that, in order to be competitive, each local radio station would have to offer multiple channels. There is no basis for such a claim -- there can be dozens of radio stations in an area that, together, and offer a wide variety of radio programming.

In addition, free terrestrial radio would seem to be a pricing constraint upon satellite radio. Both satellite companies provide service that is worth $12.95 per month, but neither has been able to raise the price. Since both are losing such large amounts of money, you would think that they would be raising their prices in lockstep. Instead, both have stuck with $12.95 for at least a couple of years. If they raise that price much higher, they would probably lose customers who would cancel contracts and go back to terrestrial radio.

It will be interesting to see how FCC disposes of this case. It would be a much simpler proceeding if Sirius and XM would simply admit their financial difficulties.

[note: since this is my first substantive post,it is clear that I need to do more about font sizes and columns. I can only say that this is a learning process and offer my apologies.]