The False Choice Between Competition and Regulation

There’s a fundamental problem: network markets naturally tend toward concentration.

By Kevin Werbach, Associate Profess of Legal Studies and Business Ethics

The hottest topic in Internet and communications policy these days is network neutrality. An intense battle rages over whether the Federal Communications Commission (FCC) should prohibit broadband providers such as Verizon, AT&T and Comcast from discriminating in their treatment of Internet content and services. A recent compromise proposal from Google and Verizon sparked howls of protest from those who felt it didn’t go far enough. Both sides, however, agreed on one thing: the challenge is to choose the lesser evil between market power and regulation.

That’s an increasingly false choice.

For roughly 20 years, there has been a consensus in the U.S. and many other countries that competition and regulation are two sides of the same coin. When one operates properly, the other is unnecessary. And given the choice, competition is the superior alternative. In practice, this has meant legal reforms to kick-start competition, coupled with a move away from traditional regulation.

The idea has great intuitive appeal. Regulation is inefficient. Market forces can discipline the behavior of firms, obviating the need for government to do so. Unfortunately, the practice never quite conformed to the theory. Experiments in deregulation of energy, telecommunications and the financial sector during the 1990s and 2000s all produced catastrophic market collapses. Moreover, while there has been substantial innovation and investment, these markets in some ways are more concentrated than ever.

This brings us to back network neutrality. When the debate about broadband regulation began 12 years ago, it focused on whether incumbent access providers should offer “open access” to independent competitors. Most of the world has since adopted a variant of this approach, but the U.S. chose not to. So today, when most Americans have only two residential broadband choices (the incumbent cable or telephone company), and some have only one, advocates argue for direct restrictions on how those providers manage their networks—to prevent discrimination. Limited competition justifies renewed regulation.

Or so the argument goes. Put aside for a moment the legitimate questions about just how competitive the broadband market really is. There’s a more fundamental problem: network markets naturally tend toward concentration. Networks generate positive externalities, known as network effects: if most of my friends are on Facebook, I’m likely to choose Facebook when joining a social networking service, even if others may have objectively better functionality. This reinforces what venture capitalists call “the 10x rule:” A new service must be 10 times better than the old one, or users won’t switch.

Moreover, unlike markets for physical goods, where large firms are dragged down by coordination costs, there are often increasing returns to scale in the digital era of cloud computing. The more searches on an Internet search engine, the more data to improve search algorithms, and the more value for advertisers. Thus, Google has maintained a market share of over 60 percent in the extremely lucrative Internet search market, despite well-funded competition from a bevy of startups and behemoths such has Yahoo! and Microsoft. And that’s a market with low-entry barriers. Broadband infrastructure, by contrast, involves massive fixed costs, making competitive entry even tougher.

Seeking competition as a justification to eliminate regulation may therefore be a false hope in these markets. However, the flip side is also true: sometimes regulation is unnecessary even where competition is limited. Despite its dominant market share, Google has a strong incentive to operate its search advertising business in the most customer-friendly way, because it only makes money when customers click through those ads. And Google’s much-mocked “Don’t Be Evil” motto represents a real element of its corporate culture, which guides its behavior. Antitrust action or other regulation of Google’s business practices may at some point be justified, but the level of competition won’t be the gating factor.

How, then, should government respond? By changing the way it thinks about regulation. Rather than try to mimic market-driven prices in situations where they believe that market forces won’t operate, regulators should emphasize other tools for influencing market performance and structure. Promoting interconnection, open standards, data availability and non-traditional options such as municipal and unlicensed wireless networks may achieve more significant results in the long run.

The reason this approach may work is that competition does develop in digitally networked markets, but it’s usually through the creation of new market segments. Google didn’t beat Yahoo! in the portal market, nor did Facebook beat Google in the search market, nor did Twitter beat Facebook in the social networking market. The major broadband providers similarly must worry about market-redefining competition, such as “over the top” Internet video cannibalizing cable TV revenues and mobile phone subscriptions cutting into voice telephone revenues, even if they enjoy a cozy oligopoly in broadband access. That creates incentives that can be harnessed.

Reasonable network neutrality rules should be part of this package, because it’s clear that the open Internet environment promotes significant economic activity, technological innovation and social benefits. That’s true regardless of the level of competition in the access market. By accepting that competition, regulation and deregulation are all means to the same ends, rather than ends in themselves, we can craft a viable policy regime for the Network Age.

Wharton Magazine - Background

Type to Search

See all results