The Free Market Argument For Net Neutrality

from the market-failure dept

On Thursday of this week, the FCC will vote to undo the 2015 Open Internet Order. While the FCC insists that this will just be bringing back the internet to the regulatory framework it had prior to 2015, that is not true. It will be changing the very basis for how the internet works and doing so in a dangerous way. Starting on Tuesday, a bunch of organizations are teaming up for a massive #BreakTheInternet protest. Please check it out. The post below is designed to answer many of the questions we've received about "free markets" v. "regulations" on net neutrality, and why we believe that the 2015 rules are consistent with the beliefs of those who support free market solutions.

I've already written about some of the reasons why I changed my mind about net neutrality rules, in which I mentioned that my standard position is to be pretty skeptical of government intervention in innovative markets. But many of the people I know who are opposing net neutrality -- including FCC Chair Ajit Pai -- like to couch their opposition in "free market" terms. They talk about the "heavy hand of regulation" and "getting government out" of the internet and stuff like that. But as far as I can tell, this is a twisted, distorted understanding of both the telco world and how free markets operate. So, for those folks, let's dig in a bit and explore the free market argument for net neutrality. And, I should note, this is clearly not the argument that many people supporting net neutrality are making, but this is why I think that even those of us who still believe in free markets helping innovation should still support rules for net neutrality.

To start with, this is also not the anarchist's argument for net neutrality (or the "AnCap's" argument). If you don't believe the government should ever do anything, well, then nothing is going to convince you. However, if you believe that in cases of market failure, the government has a role, then do keep on reading. As the famous (and very "free market") economist Milton Friedman wrote:

The need for government in these respects arises because absolute freedom is impossible. However attractive anarchy may be as a philosophy, it is not feasible in a world of imperfect men. Men's freedoms can conflict, and when they do, one man's freedom must be limited to preserve another's as a Supreme Court Justice once put it, "My freedom to move my fist must be limited by the proximity of your chin."

And here, there's an argument that what the broadband players are attempting to do to the internet, is very much the equivalent of punching everyone in the face -- by being able to effectively block, diminish, silence people and organizations from expressing themselves or taking part in the public communications networks that we all rely on these days. If you believe that being able to participate on the internet is a right that people should have -- and that their abilities to participate and contribute to society are massively limited when the internet is blocked or diminished, then removing net neutrality represents a threat to those rights. That doesn't mean that the internet should be heavily regulated, but as we'll see below, under certain specific conditions, to make sure that freedom and a free market exists, a few light touch rules can absolutely make sense -- and even the staunchest free market supporters have long recognized that to be the case.

Even if you believe that the government should almost always keep out of a market, because the solution is often worse than whatever market failure it's trying to solve -- keep reading, because I'll try to address that argument as well. If we accept that there are cases of market failure, and the government might need to step in, then it's important to recognize what are the characteristics of market failure, and what are the possible remedies that serve to protect a free market, while minimizing the risks associated with government intervention (such as picking winners and losers, regulatory capture, etc.).

Of course, a classic type of market failure is cases where there is what's known as a natural monopoly. This is a case where there are high infrastructure costs and/or related barriers to entry, and where the economies of scale suggest that one giant player will or should dominate. These often (though not always!) lead to public utilities as a solution. The idea here is that it doesn't make sense to have multiple parties building out repetitive infrastructure, as it's costly and limits the economies of scale. So, roads are one example of this. We don't want competing private companies constructing roads, because that's inefficient and would lead to non-compatible systems and under-utilization of the roads of many parties. This is also the case with phone lines. You don't want every company that wants to become a phone company to have to string up redundant wires to every building, as it would overcrowd telephone poles, be extra costly, and diminish the economies of scale. In short: it's wasteful.

Guess what other market has many of the characteristics of a natural monopoly? Broadband internet. The infrastructure costs are quite high, and it is wasteful if every provider has to build out the entire infrastructure to every building, doing the same work as multiple other companies. That, again, would lead to really inefficient results. You would have overbuilt, redundant infrastructure, which would be wasteful, while limiting the economies of scale that would benefit those same providers. This does not mean that we should automatically turn broadband into a public utility, however. Some of us still believe that the solution here should be to build out the infrastructure, but make sure there's widespread competition at the service level. This is not how it's set up now (in most places), but ideally could be done by laying dark fiber, and letting any service provider drop in their own equipment to offer service over that fiber (this beats the "wholesale" model that some places currently use, which still gives too much power to the single dominant provider).

To me, this still seems like the most logical "free market" solution to the problem of the highly concentrated, non-competitive, awful customer service broadband world we live in today. Rather than hope and pray that competition at the infrastructure level will appear like magic, just move things up a notch, and let there be competition at the service layer, while the infrastructure layer is considered (accurately) a natural monopoly.

Unfortunately, there appears to be zero appetite for this solution among policy makers, even though it would target the real problem -- the lack of competition. Given that, the current net neutrality rules represent another approach that at least carefully attempts to solve the market failure problem.

Still not convinced there's a market failure issue? Let's look at a second reason to suggest that there's a serious market failure in the broadband world: crony capitalism. For good reason, believers in free markets are greatly concerned about "crony capitalism," in which government actions pick winners and losers -- and the winners are often those corporate giants most closely connected to the government officials (hey, remember how Ajit Pai just joked about how he, a former Verizon lawyer, was a Verizon shill? That was funny...).

So, now take a quick look at who is worried about the removal of the 2015 rules. Is it the big guys? Nope. AT&T, Comcast and Verizon are positively giddy about the new rules. Facebook and Google have been pretty quiet altogether, making only token statements on the issue. None of them care. They're all well connected enough that this isn't going to bother them. Even Netflix -- who helped lead the fight last time -- has backed off the issue.

Who's actually making noise about this? Well, beyond all of you internet users, it's the smaller companies, who know they'd be in trouble. Github, Pinterest and Patreon have been urging all their users to contact Congress over net neutrality. Reddit has become net neutrality central. Automattic/Wordpress have been vocal on this issue as well. Earlier this year, over 1,000 startups told Ajit Pai not to kill net neutrality.

Take a second and think which solution is likely to help the crony capitalists, and which is likely to help the upstarts, innovators and entrepreneurs. It certainly looks like Ajit Pai's plan is a win for the crony capitalists, and a loss for innovators. So if you believe in a free market in which upstarts are able to come in and innovate, and where crony capitalism doesn't work. it certainly looks like you should support net neutrality and be against Ajit Pai's plan to destroy the rules.

And that's because the Open Internet Order of 2015 -- despite claims to the contrary by Pai and others -- is not about setting up some giant regulatory burden. There are no "compliance" costs. All it does is set some basic rules that prevent predatory practices by the giant companies.

And, believe it or not, some of the biggest supporters of free markets have recognized the need to stop such predatory practices for the sake of the free market. They've long recognized that dominant firms, with the power to discriminate, aren't just creating monopoly rents for themselves, but they are actually set up to block the functioning of a free market. That is the case with the broadband access market.

To see how this works in practice, let's take a look at the views of one of the philosopher kings of the free market: F.A. Hayek. Hayek's many works have, repeatedly, argued against government interference in most areas, quite rightly noting that it often distorts markets in dangerous ways, can limit overall benefits, and (especially) lead to things like regulatory capture. But... he has some exceptions. And many of those exceptions would appear to apply to the net neutrality debate. For example, in Law, Legislation and Liberty, in the midst of a longer discussion on why "big" is not necessarily "bad" (an argument I mostly agree with), in trying to distinguish "big" from "bad" he tries to highlight the kind of "bad" behavior he finds objectionable and worth preventing via government action. And the key to him: when businesses can discriminate and treat different customers differently for the same product -- especially on products on which the customers are dependent:

In modern society it is not the size of the aggregate of resources controlled by an enterprise which gives it power over the conduct of other people, so much as its capacity to withhold services on which people are dependent. As we shall see in the next section, it is therefore also not only simply power over the price of their products but the power to exact different terms from different customers which confers power over conduct. This power, however, is not directly dependent on size and not even an inevitable product of monopoly-although it will be possessed by the monopolist of any essential product, whether he be big or small, so long as he is free to make a sale dependent on terms not exacted from all customers alike. We shall see that it is not only the power of the monopolist to discriminate, together with the influence he may exercise on government possessing similar powers, which is truly harmful and ought to be curbed. But this power, although often associated with large size, is neither a necessary consequence of size nor confined to large organizations. The same problem arises when some small enterprise, or a labour union, which controls an essential service can hold the community to ransom by refusing to supply it.

Later, in discussing how the real evil of monopoly is to crowd out competition, he notes how the power to discriminate can be used in such a fashion:

... the power to discriminate, can in many ways be used to influence the market behaviour of these others, and particularly to deter or otherwise influence potential competitors.

Hayek admits that this is a tricky problem to solve. He admits that some monopolists may, indeed, provide better overall service, but we should be careful where there are situations where they might restrict competition -- and thus, he notes that there may even be cases where "rules of conduct" should be put forth to prevent such discrimination:

... since the power of the monopolist to discriminate can be used to coerce particular individuals or firms, and is likely to be used to restrict competition in an undesirable manner, it clearly ought to be curbed by appropriate rules of conduct.

Specifically, he notes that "aimed discrimination intended to enforce a certain market conduct should clearly be prohibited." This all certainly can be read as recognition that a system like the FCC's 2015 Open Internet Order would match. The open internet order was not heavy-handed regulation (contrary to Pai's statements). It merely prevents discriminatory behavior by those services that the public now depends on, where they have little to no choice in alternative providers. And thus, under such conditions, Hayek sees that "rules of conduct" with clear prohibitions can make sense. Admittedly, he does then say that -- unlike the 2015 rules -- he's not convinced making the rules a "punishable offense" would make sense, but rather would prefer a system where breaking such rules would become "the basis of a claim for damages."

But, either way, even Hayek recognizes that while in most cases, government rules are a bad idea, in certain very specific cases, they can make sense. And a key area where that does make sense is where you have companies with the power to discriminate in anti-competitive ways that could distort the market. And while Hayek's suggestion that making the punishment for breaking such rules be civil damages from those injured, I'd argue that this would actually be a less effective situation in the internet access market. Because, if you're in a situation where a giant internet access provider, such as a Comcast, Verizon, or AT&T decides to throttle or discriminate in some way that harms a provider, it's most likely going to be a smaller provider -- such as an internet startup. Such a startup is unlikely to have the means, or the time, to then take the giant broadband provider to court, and fight against that company's well-paid lawyers that such discrimination should lead to damages.

Indeed, this is part of the usefulness of the 2015 rules: they are simple and straightforward, making it easy for broadband providers to follow them (no throttling, no blocking, no paid prioritization) without increasing the transaction costs of protecting the innovative edge providers.

Now, let's go back to Milton Friedman, whom we'd mentioned in the opening. In his Capitalism and Freedom, he discusses "technical monopolies," by which he means natural monopolies as we discussed above. Friedman notes that he believes that these happen very infrequently, and even in some cases it's best to leave such markets unregulated because over time, markets will shift and what may be a natural monopoly today may not be one in the long term. He uses railroads as an example, pointing out that while they initially had a natural monopoly, over time things like airplanes and highways eroded that -- while also noting that the attempt to regulate railroads created terrible regulatory capture. And he's right, that most of the time, it is not necessarily a good idea for the government to get involved. But, he argues that there are times when the situation is such that leaving things alone for a natural monopoly will create too much harm:

The choice between the evils of private monopoly, public monopoly, and public regulation cannot, however, be made once and for all, independently of the factual circumstances. If the technical monopoly is of a service or commodity that is regarded as essential and if its monopoly power is sizable, even the short run effects of private unregulated monopoly may not be tolerable, and either public regulation or ownership may be a lesser evil.

He discusses various examples, but notes that, in the end, you need to weigh the costs and benefits:

Our principles offer no hard and fast line how far it is appropriate to use government to accomplish jointly what it is difficult or impossible for us to accomplish separately through strictly voluntary exchange. In any particular case of proposed intervention, we must make up a balance sheet, listing separately the advantages and disadvantages. Our principles tell us what items to put on the one side and what items on the other and they give us some basis for attaching importance to the different items. In particular, we shall always want to enter on the liability side of any proposed government intervention, its neighborhood effect in threatening freedom, and give this effect considerable weight. Just how much weight to give to it, as to other items, depends upon the circumstances. If, for example, existing government intervention is minor, we shall attach a smaller weight to the negative effects of additional government intervention.

And this brings up the next important point. The actual "intervention" in the 2015 Open Internet Order are, indeed, quite minimal. What has struck me in rereading many different texts, by a variety of free market economists on issues related to natural monopolies, is their almost universal failure to imagine the kind of light touch "regulation" set up by the 2015 order. Indeed, nearly all of them talk about rate setting, taxation or even public ownership as the only viable regulatory options (and then go on to discuss the problems with each). But it's important to note that the 2015 net neutrality rules explicitly block the FCC from engaging in any of these practices.

Instead, the rules are almost surprisingly mild, given the argument that broadband access is a natural monopoly and a market failure. There is no rate setting. There is no taxation. There is no public ownership. There is merely a prohibition on a few activities (blocking, throttling, paid prioritization) that are deemed to do significantly more harm than good in cutting off competition, innovation and freedom of expression.

And that brings us back around to the questions of where and how we want free markets to thrive. There are many different levels of the economy, and if you have strong infrastructure that is built so that anyone has access, then that creates the parameters for strong free market competition for goods and services built on top of that infrastructure. Take the road system, for example. While you may have some extreme folks in the AnCap camp who believe that even roads should be privatized, it does not take a PhD in economics to realize the harm that might cause. Making roads more costly to use would limit usage. The power of some companies to "own" the roads would likely limit the types of businesses and retail operations that could make use of those roads. Shipping would be more expensive. Commuting would be more expensive. The amount of innovation and competition that could be built on top of the infrastructure layer would become more expensive. Thus, while you might have a free market in "roads" you would limit or destroy the free market of every business that relies on roads (which is a significant portion of the economy). And that leaves out the silliness of a having a free market in roads, because who wants competition on different roads?

The same is true of the internet. In giving the big broadband access providers the ability to put up tollbooths on the internet, you significantly limit the free market on the internet. You limit the ability of smaller upstarts to innovate and get online. You make it much more difficult for competition among those edge providers and services. Indeed, such a world only creates more incentives for a few giant internet companies (think: Google, Facebook, Amazon) since those will be the only ones who can go toe-to-toe with the access providers and negotiate deals. The end result is that while you may have a free market in "broadband," you lose it on all of the (more valuable, more important) services built on the internet. And, as with roads, the entire concept is silly. We should have a free and open network, at much faster speeds, such that we can get more experimentation, more competition, and more of a free market among edge providers and services on the internet.

Indeed, when you get competition at layers above the infrastructure layer, you actually make the infrastructure more valuable. The weird conceit of AT&T, Verizon and Comcast, in pushing for the policies that they want, is that it is the network itself that is the value, and that the edge providers/internet services that everyone uses are somehow getting a "free ride." But that ignores the reality. It's the various services, whether it's Techdirt or Reddit or Github or Pinterest or Airbnb or YouTube or Snapchat or whatever else you use, that make the network itself valuable. Allowing more of a free market at that level helps make the underlying network itself that much more valuable as well.

The broadband companies take offense to the idea that they're just supplying "dumb pipes," but dumb pipes with a healthy competitive market of services built on those dumb pipes is more valuable for everyone. It's more valuable for the end users. It's more valuable for the edge service providers. And, importantly, it's more valuable for the infrastructure providers themselves, even if they somehow fail to recognize that.

In the end, the free market case for net neutrality rules is that it stops a clear natural monopoly market failure, with very lightweight rules that merely serve to ensure that there's much more robust and widespread free market competition among edge providers, in a manner that makes the entire ecosystem more valuable. Taking away those rules, as Ajit Pai and his friends would like to do, creates a non-free market. It enables crony capitalism, where a few giant corporations effectively control the central infrastructure on which the public is dependent, with almost no oversight and no prevention of discrimination or abuse. That will lead to less innovation, less competition and less value (though, more rent extraction by those giant providers).

So, yes, even if you consider yourself a free market believer, who worries about government intervention, you should still be supportive of the 2015 Open Internet Rules, while quite concerned about Pai's plan to role them back. What he's pitching is not a free market, but a locking down of the market to favor a few corporate cronies.

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Filed Under: ajit pai, broadband, competition, economics, f.a. hayek, fcc, free market, market failure, milton friedman, natural monopolies, net neutrality, open internet