Schumpeterian Economics Of Net Neutrality

by Prashant Kulkarni - Apr 9, 2015 06:21 PM +05:30 IST
Schumpeterian Economics Of Net Neutrality

Calls for sacrificing net neutrality to facilitate internet up-gradation is a mere pretence. The real reason is the attempted defiance of Schumpeter, an urge to preserve a business model facing imminent obsolescence.

Net neutrality is the principle that Internet Service Providers (ISPs) and governments should treat all data on the internet equally. Implied is non discrimination or, differential pricing by user, content, site, platform, application, type of attached equipment, or mode of communication. Airtel’s bid to charge Over The Top (OTT) services like Whatsapp and Skype challenged this proposition and the subsequent consultation paper by Telecom Regulatory Authority of India (TRAI), is perceivably a veiled reinforcement of the same.

Economic Overview

Profit (firms) and utility (consumers) maximisation drive economic behaviour. Ergo, a constant endeavour to comprehend consumer and producer reservation prices (maximum price consumer is willing to pay and minimum price producer is disposed to sell). Indirectly, such a discovery is through inducing the target agent to ‘self select’ herself. Assume that a hardcover edition of a book is released. Some rush into buying hardcover editions at higher prices and few others prefer waiting for the release of cheaper paperback edition sometime in the future.

One’s choice therefore reveals consumer preference and utility and accordingly, enables differential pricing. Price discrimination is one of the quintessential characteristics of an imperfect competition.

In challenging the dictum of net neutrality, Telecom / Internet Service Providers (TSP/ISP) profess attempting something similar. Those who derive higher utility by using social media tools like Whatsapp, ought to pay a higher premium. Similarly, content platforms like Netflix might profit from faster networks translating into superior viewing experience. Hence, they must agree to paying a premium for the equivalent service.

ISP/TSPs are analogous to a highway, whose owner has the authority to dictate the flow of goods upstream and downstream on the highway in a manner he deems proper. Hold-out tactic might enable appropriation of the whole consumer surplus of prospective transporters and passengers. Prima facie, price premium is a potential economic rent from network users. Failure to pay leaves no option but navigating through congested corridors of the highway.

In a bid to extract increased rents, the owner might potentially offer a substitute for goods transporters. The instant case network users and content creators might be allowed to circumvent crowded roadways or networks. The offer is an exclusive highway, by-passing the existing one in lieu of higher access fees. For faster transportation, the firm may have no option but to accept these terms.

Perhaps, the congestion might induce the firm itself to request the owner to facilitate an exclusive network trading off for higher rents. Irrespective of who makes the first move, higher fees decode into exclusive highways outside of the common network.

The parallels buttress controlling key intermediate resource facilitates, monopolising both upstream as well as downstream resources in the value configuration. Internet distribution (natural monopoly) including last mile connectivity fits the bill.

Consequently, subject to their impulses, ISP/TSPs have the weight to charge for access to OTT services or engage in aggressive persuasion of content distributors to pay up for speedier transmission. The bottom line is a drop in economic surplus and in consequence societal welfare. This recapitulates the enduring skirmishes between ISPs/TSPs and content platforms, creators and users.

Price Discrimination or Schumpeterian Destruction

Nevertheless, fixation with price discrimination is at best a detour from the underlying agenda. The digression is a mere euphemism to obfuscate the venture in quest of an elixir of Schumpeterian disruptive immunity. Returning to the highway illustration, assume the owner, through design or default; administer resources both upstream and downstream. Implied, the highway is a hinge supporting the vertically integrated firm.

Over time, value chain disintermediation and specialists emerge unbundling the traditional offerings. Newbies offer products with low upfront investment, low prices and ironically use the same infrastructure sustaining the incumbent firm. Value creation shifts to downstream specialist firms commoditising the midstream highway. Neither the incumbent’s core assets nor core activities are configured to acclimatise to shifting business landscape.

The desire to preserve legacy assets coupled with reluctance towards radical re-acclimatisation render them into existential liabilities. The failure to control the highway implies a possible death for the incumbent firm. Hence, the theatre of war between entrenched and the challengers.

Apart from diminutive deviations, identical narratives abound across communication industries. Communication giants like Comcast, Verizon etc are in effect vertically integrated firms with deep-rooted interests in telecom, cable television and other related segments. In true Schumpeterian style, Netflix, Hulu etc are striking the roots of the television business, as we know it.

In India, OTT services like Whatsapp, threaten SMS services while Skype and others are out to replace voice calls with their video call services. Besides, the perceptible exigency to end net neutrality is driven by a steady shift of internet access from computers to mobiles.

The accomplishment of OTT players with cross border geographical moorings is, in part, their ability in exploiting network externalities, complex to replicate for the ISP/TSPs. In other words, contrary to the perspicacity of motivational deterrents to innovation, it is an existential crisis for telecom and cable industry players tethered to their legacy. Therefore, it is banal to find them explore ways to hold on the highway.

Differential pricing is a mere manifestation of the same. ISP/TSPs are hoping that price changes will set in motion, the economics substitution effect and alter the consumption bundle the way they desire it to be. Intentions apart, the likelihood of success is perchance understood through a fleeting look into history. Given the history of the Indian communication industry, it is perhaps the first time, but turf wars are not unusual in the US, at least.

Peek from History

In 1876, Western Union, ‘misused’ its monopoly in telegraphy, (one of the first prominent instances of violation of what we nowadays describe as net neutrality) to ensure that its candidate Rutherford Hayes got elected as the President of United States of America.

Though, it ignored telephone industry to begin with, it reversed its course soon and using Edison prototypes waged an all out battle against Alexander Graham Bell and his team. However, Western Union innovations were designed to supplement telegraphy rather than cannibalise, a process adopted much later to counteract television.

A black swan event of attempted hostile takeover of Western Union compelled Western Union to abandon telephony in favor of Bell with guarantee that the latter would not challenge its monopoly in the telegraph industry.

In the late 1890s and early 1900s, the US telecom industry, Bell Telephony (later AT&T), though dominant, had to contend with ‘independents’ which comprised mainly of local farmers and entrepreneurs catering to the vast under-populated countryside. These ‘independents’ were the forerunners of the contemporary social media.

In comparison to the current high access fees for spectrum allocation, distribution infrastructure, land acquisition, these ‘independents’ set up their easy and cost effective facilities by running simple galvanised wires over poles erected on the fences of the farm thus, developing rudimentary forms of telecom network (not unlike the development of India’s cable television network). Faced with increasing anti-trust pressure, AT&T’s Theodore Vail responded by submitting AT&T to government oversight, telecom network being treated as common carrier, allowing interconnection between the ‘independent’ networks and Bell telecom infrastructure.

The Kingsbury Commitment created numerous localized ‘benevolent monopolies’ in the telecom industry, one of the earliest successes for the incumbents and possibly in retrospection, affected industry innovation.

In the initial years of radio, sale of radio sets determined the revenues for radio stations. RCA owned the radio patents, thus, facilitating setting up NBC. Within a short time, the revenue models saw a shift from emphasizing sale of radio sets to advertisements. In a series of legal battles, David Sarnoff (Sarnoff) of RCA unseated AT&T to emerge as undisputed king of the Amplitude Modulated (AM) radio industry.When Frequency Modulated (FM) radio endangered AM driven network, Sarnoff opening multiple fronts ensured FM remain confined to the periphery.

Ironically FM was sought to be developed by Sarnoff and team to iron out inefficiencies in AM. A byproduct besides the demise of numerous ‘independents’ was the tragic suicide of Edwin Armstrong, the founder of FM Radio.

Sarnoff fashioned radio industry into a vertically integrated eco-system with RCA monopolising radio sets and NBC-CBS duo controlling radio station network. Later, with radio becoming susceptible to television, Sarnoff lobbied successfully with the regulators to ban what he termed as ‘untested’ and ‘unproven’ television technology till such time it was proved reliable. Ironically, in the sanctuary of free market economy, the government was entrusted to decide when a product or technology might be ready for sale.

Furthermore, regulatory capture, deep financial resources, denial of financial investment to independent developers, all aided Sarnoff to shape a ‘neutered’ television industry without unsettling the nucleus of the radio network. Only decades later, was Ted Turner able to overwhelm the terrestrial television model.

All these instances exemplify similar modus operandi. A fragmented industry followed by shake-out, industry consolidation often through state legislation and executive actions than market actions. A long period of regulated monopoly reign, new Schumpeterian disruptors arise imperiling the status quo, long wars of attrition, at times Goliath wins with active state connivance, but when David does triumph, it shakes the industry drastically. Yet, in course of time, David becomes the new Goliath repeating the same cycle. Constant victories by David assure Schumpeterian growth, Goliathian victories a long age of incremental innovation just sufficient to sustain their dominance. Contemporary net neutrality battles therefore, did not originate in a vacuum but constitute an element of a continuum.

Concluding Remarks

Solutions then and now are sought in state intercessions. Tactics remain modeled on their predecessors in seeking government intervention to perpetuate their dominance. Moreover, their desire to see internet as ‘non-common carrier’ indicates towards the fact that the wheel has turned a cycle.

The challengers some of which are trillion or billion dollar giants want common carrier treatment. Past disruptors were individuals or small organisations with little financial backing. Currently, ISPs/TSPs may not have the financial clout of Google and its compatriots, yet enjoy resources that put spanner in the plans of Google, Facebook, Netflix etc.

It would be erroneous to assume that the need for net neutrality is for Google and similar well established companies. The struggle is for flourishing of the hundreds of content creators and users for whom the increasing returns of the internet has resulted in economic empowerment. These creators, developers and users are the spokes of capitalist ventures spreading the forces of the market far and wide. YouTube, Facebook, Twitter, E-Bay, Amazon, WhatsApp etc all began life as spokes, aided by Cerf’s ‘permission less innovation’ and accomplished a makeover into hubs of the digital economy.

The next generation of ‘digipreneurial’ spokes is found among the prospective entrepreneurs, not merely in the Silicon Valleys of the world, but across the distant geographical backyards of the globe. The sheer numbers of apps developed each day stand proof to this fact. Net neutrality empowers and fosters digitally facilitated and culturally vital entrepreneurial spirits imperative for the success of market forces.

Legislative or executive interventions might help in the short to mid run but in the long run, to avoid ‘westernunionization’ of their fate, the telecom service providers will have to reinvent and not sit back lobbying for ‘net non neutrality’. Calls for sacrificing net neutrality to facilitate internet up-gradation is a mere pretence. The real reason is the attempted defiance of Schumpeter, an urge to preserve a business model facing imminent obsolescence. Efforts to legislatively resuscitate these antiquated models will only serve disempowering the digitally emancipated in taking their due place in the economic pyramid.

Prashant Kulkarni teaches economics, a digital economy and globalization at a leading B-School. His area of interest lies in dissecting resource contestations and human behavior at the intersections of digitization, urbanization and globalization.
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