Regulation’s Hidden Perils

By Marina Krakovsky

Government plays a crucial role in ensuring successful markets, says Wharton’s Gerald Faulhaber. Online and elsewhere, that’s easier said than done. 

In the summer of 2006, the nation’s largest Internet service providers duked it out with the likes of Google, Yahoo, and Microsoft over proposed laws that could forever change the economics of both their industries. The battle, fought on Capitol Hill and in the op-ed pages, raged over “net neutrality,” the push to prevent Verizon and Comcast from introducing multitiered pricing for broadband Internet services. Wharton’s Gerald Faulhaber, Professor of Business and Public Policy, Management, and Law, seemed above the fray, coolly and logically unraveling the issues. But that’s not to say he has no opinion.

The argument of the Internet purists — that we should treat every bit of data the same — “is impossibly easy to knock down,” says the former AT&T executive and veteran of such debates.

Suppose someone has a heart attack and the paramedics whisk him off to the ER, says Faulhaber. En route, they hook him up to a cardiac monitor, which uses wi-fi to transmit the ECG to the hospital. The setup’s a marvel of the modern Internet, unimagined by the network’s founders. “But guess what? A bunch of teenage boys are downloading the latest Pamela Anderson video.” In a genuinely democratic, bit-is-a-bit-is-a-bit world, the potentially life-saving ECG has no priority over Ms. Anderson’s video. Equally urgent and valuable are spam, viruses, and worms. But, in fact, customers want their ISPs to block spam, Faulhaber points out. The purists don’t have a case.

Faulhaber systematically dismantles the practical pro-neutrality arguments, too — more on that later — and in so doing hits on some of his favorite themes, especially regulation and anti-trust. After studying the weak evidence that discriminatory pricing is actually occurring, he wrote in a 2007 paper, “If net neutrality is the solution, what exactly is the problem? What exactly is it that needs to be fixed? At this point, it would appear that the problems are all potential problems, not actual problems.”

From the Telecom Industry to Academia

He first became interested in these issues at Bell Laboratories in the 1960s. As a freshly minted mathematics grad Faulhaber helped develop real-time switching systems for the phone company. After earning his master’s in math, he moved into operations research, applying queuing theory and congestion theory to make the phone network run more efficiently. In those days, the Bell System enabled scientists and engineers to pursue their pet projects and even earn advanced degrees on the company’s dime, but the government had begun to ask whether the Bell monopoly was the right way to organize the telephone industry.

That question sparked Faulhaber’s interest in the economics of the networks, and, while still a Bell Labs employee, he went on to earn a PhD in economics from nearby Princeton. He then joined a new applied economics group within Bell Labs; the only social scientists among hundreds of hard scientists, the economists were an object of envy and suspicion. “How come they’re getting all this attention when the physicists and engineers are pulling the system together?” some asked. So after the government’s painful breakup of Ma Bell, many blamed the company’s woes on the economists, Faulhaber recalls, “who came in with their flapdoodle ideas about competition.”

One of Faulhaber’s landmark papers gleans lessons about effective and ineffective policy from the federal government’s checkered attempts to regulate telecom services. “Generally people think if you don’t like something that’s happening, you can pass a law to make it stop,” he says. “But the fact is, some laws are unenforceable — or enforceable at large cost.” That’s what happened when, in an early attempt to force AT&T to open up long distance to competition, the Federal Communications Commission (FCC) mandated that AT&T lease its private lines to other carriers, such as MCI and Sprint. There were all sorts of ways AT&T’s local access providers could subvert this rule, hampering potential competitors without catching the eye of regulators. In general, says Faulhaber, “if what you want a company to do is easily measured, and it’s easy to see when the law’s been violated, and there’s no tricky stuff involved” — that’s when you can pass effective laws. If, on the other hand, the technology or the relationship you’re trying to control is too complex, regulations can create more problems than they solve.

A major unintended consequence: encouraging firms to engage in what economists call “rent-seeking,” or focusing on regulatory moves and countermoves, Faulhaber says. “Once you set up a system where it pays to complain — which is what regulation does — everybody complains about everybody else. This goes on all the time at the FCC. The telephone companies do it; the cellular companies do it. That’s how the game is played.”

In 1984, soon after the Bell System’s divesture, Faulhaber accepted an offer from Wharton. He was burned out on telecom and eager to pursue other research interests, he says, and didn’t return to serious work on telecom issues until the early 1990s, when people started looking “at this new thing called the Internet.” He was intrigued: “It relates to telecom; maybe I should look at it,” he remembers thinking. There was an interesting tension, too: the telecom industry was highly regulated, and the Internet was just the opposite — yet the two were tightly intertwined.

At the peak of the dot-com boom, Faulhaber would come to deal with this tight connection in a big way. In 2000, the FCC tapped him for a one-year post as the agency’s Chief Economist, thrusting him into an anti-trust debate about a proposed merger between AOL and Time-Warner — the biggest corporate merger in U.S. history. Naturally, the Federal Trade Commission (FTC) was deeply involved, but because of radio-license transfers, so was the FCC. The two agencies came up with strikingly different answers because, Faulhaber says, they were looking at different theories of anti-trust: bottlenecks and bandwagons.

“If some company owns a bottleneck that somebody needs access to, then anti-trust laws sometimes force that bottleneck to be opened,” explains Faulhaber. With AT&T, the government had concluded that the company’s exclusive ownership of the local-loop bottleneck gave AT&T anti-competitive advantage in long-distance service, hence the forced divestiture. Access to bottleneck facilities exists “all over anti-trust law,” adds Faulhaber — in industries as varied as railroads, funeral homes, and ski lodges. And that’s how the FTC viewed the AOL/Time-Warner merger: since Time-Warner’s cable facilities would enable AOL to easily offer broadband Internet access, AOL could end up as the only broadband provider, the FTC feared.

Under Faulhaber’s leadership, the FCC’s economists took a different tack. Instead of focusing on the cable bottleneck, they looked at AOL’s instant messaging service. Since AOL’s instant messaging customers can use the service to communicate only with other AOL customers, the service is subject to “network effects,” otherwise known as bandwagons. The idea: the network with the largest number of customers is the most valuable. As the biggest bandwagon in the online auction business, for example, eBay benefits from network effects since sellers want to do business where all the buyers are — and vice versa. With instant messaging or other communication service, several companies can interconnect — but if you’re the biggest gorilla in the business, then it’s not in your interest to connect your network to anyone else’s. Because of network effects, Faulhaber says, a powerful company can use the refusal to interoperate as an anti-competitive weapon.

The FCC’s solution was a carefully constructed condition on the merger to prevent the corporate behemoth from unfairly exploiting network effects — but without hurting the company if they did nothing wrong. “You have tremendous power in the government, and you don’t just bandy it about,” says Faulhaber.

Music as a Spacial Market

More recently, Faulhaber turned his attention to the music industry, trying to resolve this paradox: enormous competition in a field that seems monopolistic. It appears monopolistic, he says, because songwriters hold the copyright to their songs — yet there’s a huge amount of music production in our society. “So how does that work?” asks Faulhaber.

The clue, he believes, is in thinking of music as a “spatial market,” much like a string of supermarkets along a highway. From the consumer’s perspective, supermarkets should be evenly spaced along a given stretch of highway, but what actually happens is quite different and socially inefficient: competing supermarkets, in clamoring to capture as many customers as possible, tend to cluster at the half-way point. In profiting from stealing business from an existing firm, each new supermarket earns more than the social value it provides.

The glut of popular music, Faulhaber says, results from similar market dynamics. If you plot artists in a conceptual space of musical tastes — such that the Philadelphia Orchestra would be far apart from Britney Spears while Christina Aguilera would be much closer — the over-supply of pop music begins to make sense. “In big-money music, there’s a huge cost to entry,” says Faulhaber — so artists and their producers have to be strategic about where to enter. Though copyright law gives Spears a monopoly on her own music, there’s nothing stopping other artists from entering the market close to the superstar — and, as with supermarkets, there’s much incentive to do so. According to Faulhaber’s calculations, the aggregate effect is 40 to 60 percent overproduction.

Music executives aren’t concerned with this excess, as long as there are enough profits to go around. But they warn that free music file-sharing could make music production unprofitable and ultimately destroy their industry — just as piracy did to Hong Kong’s film industry. Faulhaber doesn’t buy it. Not only are the insiders’ estimates of piracy inflated, he says, but because of the oversupply, musicians could use a little disincentive to entry. His stunning policy conclusion: legalizing Internet file-sharing is probably a good idea.

If that’s surprising coming from a self-described “freemarket guy,” Faulhaber lands more squarely in the propertyrights camp when he riffs on net neutrality. He sees the term as something of a red herring, obscuring the real issues. The first, of course, is pricing. Google and Yahoo are outraged at the prospect of the telcos’ “double-charging” for Internet access — that is, charging Google and Yahoo on one end and end users on the other.

But if the content providers are incensed, it’s only because they’re not used to doing business in two-sided markets, says Faulhaber. Such markets are not new — just look at credit card companies, which in one form or another collect fees from both merchants and cardholders. Moreover, it’s not at all certain that the content providers would be charged. Cable companies, Faulhaber points out, “pay huge amounts of money to ESPN” because customers desperately want the sports channel. Google has similar clout: just try to run an ISP without Google, says Faulhaber. The current “all-you-can-eat” pricing for Internet services is nothing more than an artifact of a simple Internet that no longer exists. “Did God tell us this was how it was going to be?” he asks, adding that we shouldn’t be surprised if the Internet evolves like other two-sided markets.

The Future of Net Competition

The thornier problem with variable pricing — the one that scares people of all political stripes — is that the telcos would be able to use their tremendous market power in one business to cripple their competitors in another. Comcast, after all, provides much more than broadband Internet; to promote its own digital-voice service, the company might use pricing to disadvantage competition. And the current move toward Internet Protocol Television (IPTV) — TV applications delivered over an IP platform, either open (such as the Internet) or closed—may heat up the debate as several video-on-demand platforms compete for viewers on TV, computer, and mobile phone screens.

As Faulhaber wrote in a 2007 paper “Net Neutrality: The Debate Evolves,” “…perhaps the most important policy action that we can take, and that is encouraging and enabling more competition into the broadband ISP market. It is unlikely that dozens of competitors can be supported, but surely more than two are feasible.”

That’s because anti-trust laws already exist to deal with such problems, so if Google believes that Comcast is behaving anti-competitively, it can file an anti-trust suit. “What you don’t want to do is to construct a big regulatory edifice.”

That sounds like a typical laissez-faire sentiment, but Faulhaber insists he has no inherent bias against regulation. “I have a builtin bias for competition,” he says. “It’s important that we have government laws to help protect competition, and that’s precisely what anti-trust does.”

“The government has an enormously important role in establishing an infrastructure in which companies operate well or poorly, and I’m a firm believer that public policy can have a very beneficial effect on things,” he says. “I’m not sure it always does.”

Marina Krakovsky is a San Francisco Bay Area journalist.

Gerald R. Faulhaber

Professor of Business and Public Policy, management, and Law

PhD, Princeton University, 1975; MA, Princeton University, 1974; MS, New york University, 1964; AB, Haverford College, 1962

Research Areas

Spectrum policy for wireless telecommunications; network neutrality for the internet, file sharing and fair use copyright; telecommunications; regulation; industrial organization; applied microeconomics

Recent Consulting

Spectrum Policy, Vodaphone; Postal Service Reorganization, U.S. Postal Service; Merger Analysis, U.S. Dept of Justice; Telecommunications issues, Verizon; Health care strategies, Wellpoint Health Networks; Latin American telecommunications privatization, World Bank; Banking industry, Deloitte & Touche.

Academic Positions Held

Wharton: 1984-present. University of Pennsylvania: 2005-present (Law School). Previous appointment: New York University. Visiting appointments: INSEAD (France), Princeton University, Tsinghua University (Peoples’ Republic of China)

Other Positions

Chief Economist, Federal Communications Commission, 2000-01; Director, Strategic Planning and Financial management, AT&T, 1982-83; Director, Microeconomic Studies, AT&T, 1978-82; Research Head, Economic Modeling and Financial Research Department, Bell Telephone laboratories, Inc., 1975-77; Supervisor, Economic Modeling, Bell Telephone Laboratories, Inc., 1968-75; Technical Staff, Bell Telephone Laboratories, Inc., 1962-68

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