Do we need net neutrality?

The Federal Communications Commission in the US recently announced some rule changes that will end net neutrality. What is the ‘neutral’ net? Simply put, under net neutrality, internet service providers (ISPs — the businesses that provide internet services to you and me) are not allowed to prioritise one form of internet traffic, say Netflix, over another form, say Foxtel. Should we care?


To understand the question, we need to separate the provision of internet services from the content that is delivered. For the sake of simplicity, I will include in the former the infrastructure used to deliver individually packets of data (such as switches and fibre optic cables) and services like billing and administration provided by ISPs. Content, on the other hand includes things like search results from Google and movies from Netflix.

A road analogy may be helpful. Roads, including the traffic lights and road signs, are the equivalent of the switches and cables. Cars and trucks are the equivalent of data packets, and the goods on the trucks and people in the cars are the equivalent of the content.

Content that is carried across the internet is undeniably valuable. Netflix, for example, has revenues of $2.7 billion (US$) and profits of $178 million. Facebook has revenues of $28bn and profits of $10bn. The provision of internet services is also profitable, but (in the net neutrality world, at least), much more akin to the profitability of telephone services or electricity distribution, the old-fashioned regulated utilities; that is a modest sometimes regulated rate of return, largely on investments in tangible fixed assets.

If internet service providers can prioritise particular traffic over their networks at their own discretion, they can charge content providers higher prices for delivering their content at, say, higher bandwidth. High bandwidth is particularly important for video content such as YouTube and movies. If ISPs own their own content, they can prioritise theirs over competing content.

Going back to the roads analogy. If I owned the Hume Highway, the only fast road between Sydney and Melbourne, I could charge a toll to all trucks that use the highway to pay for it. Under ‘truck neutrality’ I would charge every truck a uniform rate (ignoring, for a moment, complexities like axle weight and road wear), irrespective of the goods they are carrying. Without ‘truck neutrality’ I could charge more to trucks that carry perishable goods (say, fruit and vegetables from the Riverina), or impose lower speed limits on trucks that carry those goods. Not sure why I would do this. But suppose I decided to buy half of the Riverina orchards, and chose to impose lower speed limits (or higher prices) on trucks that served all the other farms, and the flavour of the problems that could arise begins to emerge.

Internet, cable TV and cord cutting

There is one last wrinkle in the background (more so in the US) — cable TV. Cable TV is delivered across very similar physical infrastructure to the internet. Indeed, a single cable often provides both. Cable TV has been very profitable for companies like COMCAST based, in large part, on the natural monopoly inherent in the physical cable over the last mile, monopoly control over set top boxes, and the paucity of radio frequency bandwidth for broadcast TV and, to a lesser extent, wireless internet. Cable TV companies bundle packages of programs from suppliers (such as ESPN) which typically contain a fixed set of channels catering for a customer base with heterogeneous tastes. Customers cannot choose and pay for just the two or three channels they actually watch, although they can elect to buy extra differentiated packages such as premium movie channels.

The internet allows cable TV customers to ‘cut the cord’. Cord-cutters elect to buy their video services from internet-based suppliers like Netflix or Prime. Provided there is an internet-based supplier of the video they like, they can effectively subvert the cable TV model. ESPN, which is part of every cable TV package in the US, has been particularly affected by cord-cutting viewers that are not sports fans. Net neutrality is painful for cable TV providers and their content providers; they lose TV subscribers to cord-cutting but are prevented from recovering some of that lost revenue by charging higher internet prices to cord-cutters (or to the independent internet-based providers who provide the competing content).

Does this matter?

It the ISP market was very competitive, it would not. If you don’t like your ISP throttling, say, AFL in favour of its own content, say, NBL, you could just switch to a different ISP.

But the market for ISP services does not appear to be very competitive. In the US, at least, customers have very little choice when it comes to the high-speed ISP services that are needed for high definition video (let alone two different high definition video streams delivered simultaneously to the one location). Most homes receive these service through cable. There is more choice at lower bandwidth such as ADSL, but low bandwidth ISP services are increasingly anachronistic. Wireless access is an alternative but, due to costs and scarce spectrum, not yet a good one for many consumers.

Even if ISP services are not strictly a natural monopoly, customer choice remains limited. In the US, incumbents through their lobbyists have been active in constraining further competition. States in the US are rife with barriers to infrastructure-based ISP entry. Examples range from industry-sponsored statutes that prohibit towns from developing their own cable networks, to burdensome regulations on access to ducts and poles without which entry is close to impossible.

If the cable TV company owns the only internet access to your home (or the only good one) and there is no net neutrality, they can make cord-cutting unattractive by bandwidth throttling the internet-based video services, or charging more to deliver them. Or they can make their own content (if they have any) more attractive by not charging for delivery, not counting the delivery in data caps, or by delivery at a higher bandwidth. In effect, they can use their monopoly over ISP services to preserve their cable TV revenues.

This matters because ISP pricing (or throttling, or discriminatory bandwidth allowances) that aims to frustrate cord-cutting (or to preserve an existing cable TV franchise) effectively limits consumer choice over content. That, in turn, is harmful to the development of the market for content. The gorillas in town, Netflix, Prime and YouTube, may still prosper (perhaps not as much as they should) but prospective small innovative high-bandwidth entrants are more likely to struggle.

It also encourages the development of business structures that probably have little to do with efficiency and more to do with preservation of profits from declining franchises such as mergers between ISPs and cable TV content providers. Economists call this rent dissipation; I am willing to spend most or all of my monopoly profits [wastefully] on preserving that monopoly.

Investment and innovation

Under this view, removing net neutrality or failing to enforce it can cause harm. But are their also benefits from abandoning net neutrality sufficient to make such a measure worthwhile?

The businesses that oppose net neutrality, which include Comcast, Charter, AT&T, and Verizon, who collectively provide three quarters of the 95 million internet subscribers in the US, broadly argue that regulating the internet to enforce net neutrality will frustrate investment and innovation.

The investment argument cannot simply be about ISP and content co-ownership. An ISP that is neutral as to content is free to own content, just not to prefer its own content over its own network. If there are scope economies between content and ISP provision, then this will translate into higher returns on investment for combined businesses, greater incentives to invest and innovate and, perhaps, lower prices or higher quality for customers. But this would happen even in a net-neutral world.

The greater incentives to invest and innovate must therefore derive from the ability of the ISP to price discriminate between content, not simply from co-ownership. To be clear what this means; there must be some efficiency gain (that delivers more innovation and investment) from the ISP itself charging content providers different prices to access their customers, rather than leaving that decision to their ISP customers themselves (exercised by choosing different price versus bandwidth offerings).[1]

There are undoubtedly markets in which this type of behaviour is beneficial. Nintendo invented the PlayStation. To make it a commercial success, it needed games (software). It developed its own because that ensured some games would be available at launch, without which the innovative PlayStation would surely have failed. In economics, the requirement for software to run on the games platform is an example of a vertical externality — the value of the PlayStation was dependent upon the extent of activity elsewhere in the supply chain, the software development level, and vice versa. One might expect an innovator of hydrogen-powered cars to take a similar stance on hydrogen production and filling stations, or an innovator of electric vehicles on battery production.

Vertical integration by Nintendo into games software development was an effective means of ensuring the existence of this vertical externality did not impede development. And in the current context, Nintendo was free to charge third party software developers different prices to access the PlayStation (or to be included in the PlayStation sales bundle). Vertical integration and price discrimination between own and third-party vertical transactions is sometimes essential for successful innovation.

Perhaps, then, the ISP is the PlayStation and the content the games, and some valuable innovation will arise because the ISP can price discriminate by content type. We don’t know of course because innovation, by its nature, is hard to predict, but there are reasons to be sceptical. The provision of ISP services is not as obviously risky as an initial investment in the PlayStation. Profitable investment or further investment in ISP services, and profitable investment or further investment or innovation in content, are not obviously co-dependent in the same way as the PlayStation and games software. And even if there is some co-dependency, it is not obvious why this cannot be realised by differential pricing by the content inventor to the final customer (i.e. without the ISP acting as a price discriminating intermediary).

ISP services are relatively mature, so it is doubtful that ISPs will be the engine of innovation. Abandoning net-neutrality, which might be an appropriate measure if ISPs were expected to be the main source of innovation, is a troubling measure if innovation is predominantly by companies in the content space and ISPs are vertically integrated into content provision. To go back to the road example, would innovation in agriculture in the Riverina towards low irrigation crops be fostered by price discrimination on the Hume Highway?

From my perspective, the benefits of abandoning net neutrality are probably illusory, speculative at best. The risks substantial.

Net neutrality in Australia

Australia does not have net neutrality. Foxtel Play is not metered for Telstra ISP customers (Foxtel Now is). Some ISPs do not meter ABC’s iView. The Conversation web site says that “net neutrality is an honourable aspiration, but the Australian internet service provider market has thrived and innovated without it.[2]

Really? Do we know what the Australian internet would look like with net neutrality? There might be fewer data caps, for example, as discriminatory metering is ineffective without data caps (throttling still works). Telstra’s ADSL network being open to competitors has resulted in ISP competition, but not based on infrastructure, with little differentiation in service offerings and at bandwidths that are, frankly, jaded. The NBN doesn’t inspire much confidence in a diverse and competitive future. Where ISP differentiation is content-based (i.e. based on different sets of unmetered analogues of free to air or pay TV), why is this more valuable to customers than all content unlinked to your choice of ISP?

I cut the cord. I miss UK MasterChef and English Rugby Union. But I don’t miss them so much that I want to pay for endless Simpson’s re-runs and international darts (others may prefer darts and the Simpsons). I will agree with The Conversation’s prognosis when I can buy my favourites from the content producers on a pay per program basis without the rest of the Foxtel baggage, and perhaps even watch them again at no extra charge.

The infrastructure, technology and modes of payment are all in place. The content models are not. If net neutrality brings this nearer, as I think it should, I would welcome it. And who knows, it may even be more efficient!


[1]             This also deals with the issue of ‘Skype’ versus ‘Bittorrent’ where, some would argue, ISPs should be able to discriminate between the two services to maximise the utilisation of the underlying infrastructure. But surely this is better handled by pricing bandwidth and bandwidth reliability to the final customer and configuring the network to meet those contractual commitments, not by content discrimination.


29 December 2017