Photo: AFP
Photo: AFP

The ambiguous economics of Net neutrality

There is as yet no consensus among economists about Net neutrality

The raging debate on Net neutrality can be enriched with a dose of economics.

One useful starting point is the pioneering work on platform markets by the French economist Jean Tirole, who won the 2014 Nobel Prize. Platform markets are also described as two-sided markets. Consider the market for credit cards. The credit card company has two sets of clients: the merchant establishments that accept cards, and consumers who use cards.

Each side has a stake in the growth of the other. A consumer will sign on to use a credit card only if he knows that most restaurants in his city will accept it, while the restaurant owners will agree to accept credit cards only if they are sure that they are being used widely in the city. One side reinforces the other: volume growth on one side generates volume growth on the other side. This is akin to what economists describe as a network effect.

A usual market does not display network effects: a farmer who sells his tomatoes to a supermarket has no interest in how many customers that supermarket has. Platform markets thus have unique structures that help shed light on the ongoing debate about Net neutrality. A useful overview of two-sided platform markets was provided by Boston University economist Marc Rysman in the summer 2009 issue of the Journal of Economic Perspectives (mintne.ws/1yy1BSq).

The entire Net neutrality debate can be seen through the prism of such platform markets. After all, the telecom company providing Internet access deals with two sides: content providers and consumers. A fine analysis of digital networks as two-sided markets was made by the splendidly named Nicholas Economides of the Stern School of Business and the Swedish economist Joacim Tag (mintne.ws/1aA8XsJ).

Pricing decisions in such two-sided markets involve interesting strategic choices: how should each side be treated? Tirole has shown that the elasticity of demand on the two sides of the platform market matters a lot, as can be seen in one of the slides from his Nobel Prize acceptance lecture (mintne.ws/1aA92Nl).

What this means in practice is that the company in the middle will drop prices in that side of the market where demand is more responsive to price changes and increase prices in that side of the market where demand is less responsive to price changes. Or, the side that has inelastic demand in effect subsidises the side with elastic demand.

Ask yourself why a newspaper is sold below cost to readers while advertisers are charged a premium; or why a software company tries to make the operating system attractive to developers while charging users a stiff price.

Such a differentiated pricing strategy is similar to what is described by regulation economists as Ramsey pricing, or the inverse elasticity rule. It is named after the brilliant Cambridge polymath Frank Ramsey (mintne.ws/1cz0eJ5), who made seminal contributions to economics, mathematics and philosophy before he died in 1930 at the age of 26.

The Ramsey pricing rule is that the extra a monopolist will charge above his marginal costs is inversely proportional to the elasticity of demand. The Ramsey pricing insight has relevance to the Net neutrality debate (and this is a good time to flag an issue that will appear later in this article, whether the market for Internet access is competitive or monopolistic).

The debate is not so much about the different pricing strategies on the two sides of a platform market, but strategic decisions by the platform owner (the telecom companies that are gatekeepers to the Internet) to offer differential access to different players on the same side of the market. This can be done either using prices or privileged access or both. There are several nuanced issues involved here. Economists have not been able to agree on whether moving away from the principles of Net neutrality is welcome or not.

In a paper published in 2009, Robin S. Lee from the Stern School of Business and Tim Wu of the Columbia University Law School have defended the zero-price principle (mintne.ws/1aA9Q4P), under which an Internet service provider is prevented from charging an extra fee to a content provider to access the customers of the telecom company.

Lee and Wu have argued that the pricing dynamics of the Internet business are similar to those in other two-sided markets, and that the absence of extra fees to be paid by content creators helps the entry of new content creators. Net neutrality nurtures a rich digital ecosystem. That is the basic argument being made by most defenders of Net neutrality in India right now.

Other economists have disagreed with this position. Gernot Pehnelt has argued in a recent essay (mintne.ws/1HbaaDQ) that Net neutrality can come in the way of the growth of quality services. “In a strictly neutral Internet, low-value, elastic applications such as P2P (peer-to-peer) file sharing or YouTube videos are likely to crowd out quality-sensitive services because the demand for high-value, quality-sensitive applications will decrease if the quality of service cannot be maintained due to congestion." A more technically rich argument against Net neutrality by Pehnelt can be found in an October 2008 paper, The Economics of Net Neutrality Revisited (mintne.ws/1CP1eix).

The issue of network congestion mentioned above is important. Defenders of a network that is not neutral usually argue that the extra money the Internet service providers will get from content providers will help fund better Internet infrastructure for the future. So breaking away from Net neutrality actually benefits all users in the long run by giving telecom companies a financial incentive to build better infrastructure.

But some game theorists have questioned this claim. They use a motoring analogy. The Internet is like a highway. The cars are like packets of data. What the telecom companies are in effect saying is that they will pick a car stuck in the gridlock and bring it to the front of the queue, as long as that car driver is ready to pay a premium. The question is: does such an arrangement create strong incentives for the Internet service providers to maintain network congestion so that some are ready to pay to get ahead?

Three game theorists—H. Kenneth Cheng and Subhajyoti Bandyopadhyay of the University of Florida, and Hong Guo of the University of Notre Dame—developed a model of strategic interaction between the various players in the digital economy. One of their main conclusions was that, except for some specific cases, service providers have greater incentives to invest in network infrastructure when there is Net neutrality (mintne.ws/1GOB4Tv). Otherwise Internet service providers will have a stake in keeping networks gridlocked.

The three game theorists also say: “Depending on parameter values in our framework, consumer surplus either does not change or is higher in the short run. When compared to the baseline case under Net neutrality, social welfare in the short run increases if one content provider pays for preferential treatment, but remains unchanged if both content providers pay."

The highway analogy can also be extended in a dynamic setting. It is not just a question of what one content provider does, but how his competitors react. Actually, the best solution for all content providers is to cooperate by refusing to pay for premium access, but they will in fact all defect or cheat by paying a premium. Students of game theory will recognize this as a classic prisoner’s dilemma (mintne.ws/1Hx86qn): all content providers will pay up and then pass the extra costs to consumers when they would actually be collectively better-off not paying an extra charge.

One key issue for regulators is whether moving away from Net neutrality increases or reduces social welfare. In one of the most comprehensive reviews on the economics of Net neutrality, Florian Schuett of Tilbrug University provides a succinct rule: “The crucial condition for a zero-price rule to be welfare enhancing is that consumers value additional content providers more highly than content providers value additional consumers." Think about it.

A lot also depends on whether the Internet service provider is a monopolist or not (and remember that Ramsey pricing traditionally deals with a monopolist). One influential argument against Net neutrality was provided by Nobel laureate Gary Becker, Dennis Carlton of the Chicago Booth School and Hal S. Sider of Compass Lexicon, in a paper published in the Journal of Competition Law and Economics (mintne.ws/1yy3DC4).

They argue that stiff competition between broadband providers creates “strong incentives to retain subscribers by providing services and pricing models that promote consumer welfare". And they add that any reduction in such competition can be dealt with under existing antitrust laws in the US rather than overall Net neutrality.

There is as yet no consensus among economists about Net neutrality. But their work does help frame the issues with greater clarity. What is the economics of two-sided markets? Does the zero-price principle add to social welfare? Will a move away from Net neutrality foster or strangle innovation? What impact could such a move have on future investments in network infrastructure? And is the market for Internet access competitive or will a few players have strong incentives to foster network congestion?

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