Netflix Falls Prey to Marginal Cost Fallacy & Pleads for a Broadband Free Ride

by on July 8, 2011 · 12 comments

Of all the shockingly naive and shamelessly self-serving editorials I’ve read by businesspeople in recent years, today’s Wall Street Journal oped by Netflix general counsel David Hyman really takes the cake. It’s an implicit plea to policymakers for broadband price controls. Hyman doesn’t like the idea of broadband operators potentially pricing bandwidth according to usage /demand and he wants action taken to stop it. Of course, why wouldn’t he say that? It’s in Netflix’s best interest to ensure that somebody else besides them picks up the tab for increased broadband consumption!

But Hyman tries to pull a fast one on the reader and suggest that scarcity is an economic illusion and that any effort by broadband operators to migrate to usage-based pricing schemes is simply a nefarious, anti-consumer plot that must be foiled. “Consumers and regulators need to take heed of what is happening and avoid winding up like the proverbial frog in a pot of boiling water,” Hyman warns. “It’s time to jump before it’s too late.”

Rubbish! The only thing policymakers need to do is avoid myopic, misguided advice like Hyman’s, which isn’t based on one iota of economic theory or evidence.

Hyman’s economic illiteracy is evident from the get-go. He tries to spook people with the headline, “Why Bandwidth Pricing Is Anti-Competitive.” No it isn’t. Usage-based pricing is used in countless economic sectors every day and it is overwhelming viewed by economists as a sensible way to calibrate supply and demand while ensuring costs are covered. But Hyman says the laws of economics don’t apply to broadband!  No seriously, he says:

Cable and telecom companies argue that bandwidth is a scarce resource and that imposing caps and overage fees will relieve pressure on high-speed networks. Families pay more when they use more electricity, these companies point out, so why shouldn’t households pay more if they use more bandwidth?  The analogy is a false one. Wireline bandwidth is an almost unlimited resource due to advances in Internet architecture. Adding more capacity is easy. The marginal cost of providing an extra gigabyte of data—enough to deliver one episode of “30 Rock” from Netflix—is less than one cent, and falling.

[...] Consumer access to unlimited bandwidth is good for society. It fosters innovation, drives commerce, and advances political and social discourse. Given that bandwidth is cheap and plentiful and will only grow more so with time, there is no good reason for bandwidth caps and fees to take root.

Oh my goodness. Really? Hyman appears to be suffering from a rather serious case of marginal cost fallacy: the belief that prices should, as a rule, equal marginal costs. The problem with such thinking is that it leaves zero room for investment, innovation, and other real-world dynamics that get conveniently forgotten as “fixed costs.”  Of course, if you begin with the truly outrageous claim that “bandwidth is an almost unlimited resource,” and “bandwidth is cheap and plentiful and will only grow more so with time,” then it’s only logical that you’d fall prey to this fallacy!

Meanwhile, back in the real world, economists and financial analysts will explain to you that high fixed-cost goods like broadband networks don’t just grow on trees or fall like manna from heaven. Yes, of course it is true that “consumer access to unlimited bandwidth is good for society.”  But the same is true of countless other goods that we’d all like to have access to at zero cost. But that doesn’t invalidate the fundamental laws of economics. Someone financed and built those networks and someone has to keep building and improving them. You’d never get anything built if you adopted the view that scarcity was a myth and that prices must equal marginal cost.

On that point, I was tickled to see in the online comments to Hyman’s piece that one gentleman asked, “what happens when you allow unlimited access at.. marginal cost?” and for another to say in response, “Answer: You turn into Greece.”   Quite right. There is no free lunch. Something has to pay the bills, including the broadband bills. You can’t just free-ride on the future forever by pretending that bandwidth is an abundant good and holding prices at or below marginal cost.

Once you understand these facts you can point out what’s really wrong with Mr. Hyman’s reasoning: He basically wants average costs for all consumers to go up so that his costs (or the costs of any high-bandwidth use or user) will never go up. Shameful!  Indeed, let’s just call Mr. Hyman’s editorial what it is: a blatant attempt to get government to impose price controls on broadband providers to favor his company. End of story.  He could have spared us all the sloppy economic sophistry and just told us that. It would have made it a bit easier to take him seriously.

P.S. Incidentally, Mr. Hyman’s one and only suggestion for how to deal with network demand/congestion is this: “If Internet service providers really wanted to manage traffic efficiently, they would limit speeds at peak times.” Interesting. I wonder how the Net neutrality crowd feels about Netflix’s new-found love of broadband throttling!

 

  • Milton Mueller

    Adam: Billing by the minute or the byte is crude and ultimately not sustainable in a competitive market, because the actual costs are based on peak capacity. Broadband is not gas or oil, it’s more like filling a theater. That’s not the “marginal cost” fallacy that’s the operational facts about broadband economics. There’s lots of empirical evidence showing that competition punishes metered billing of this sort. If and when BB operators resort to pure usage-based billing its a pretty good indicator that the market is no longer competitive, and conversely, the more competitive the market is the less you see of that.

  • http://paul-lockett.co.uk/clamshell/clamshell.php?u=lockett Paul Lockett

    I’m a bit unsure about the intended implication of the last sentence:

    “I wonder how the Net neutrality crowd feels about Netflix’s new-found love of broadband throttling!”

    It almost seems to be implying that throttling is at odds with net neutrality, which, of course, it isn’t.  Only the throttling of a subset of traffic would fail to be neutral.

  • http://www.techliberation.com Adam Thierer

    Paul… That depends upon who you ask in the Net neutrality movement. Some (like Free Press) have implied that any throttling is some how per se bad and should regulated. 

  • http://paul-lockett.co.uk/clamshell/clamshell.php?u=lockett Paul Lockett

    Free Press is not an organisation I’m familiar with, but their definition doesn’t imply that throttling in itself is at odds with neutrality:

    “Net Neutrality means no discrimination. It prevents Internet Service
    Providers from speeding up or slowing down Web content based on its
    source, ownership or destination.”

    They may, of course, argue that throttling is somehow bad per se, as you suggest, but they don’t appear to be doing it on the grounds of net neutrality.

  • Wayne Crews

    Government continues to make it possible, by being there to ask, for content and infrastruture to artificially remain enemies rather than re-configure fluildly to resolve such transitory problems via the capital markets and otherwise.  Ironically the “infrastructure” that gets to grow is the political/bureaucratic one rather than the physical networks. Great job Adam, the pretended confusion over marginal cost is cocking up lots of industries.  

  • http://www.techliberation.com Adam Thierer

    Milton, I must say I am somewhat shocked by your flat rejection of usage-based pricing and your insistence that it implies anti-competitive markets.  Usage-based schemes are used a variety of competitive sectors. 

    Moreover, what Mr. Hyman is assuming here is most certainly a variant of marginal cost fallacy and I’m not sure how you could say otherwise. 

    I hope you rethink your position.

  • cryptozoologist

    i would be happy to use a protocol that throttled itself down a bit during peak times and opened up during low demand times.  this would require downloading and watching later rather than streaming.

  • http://bennett.com/blog Richard Bennett

     The op-ed was laughable with respect to the cost claims. The cost of bandwidth is a function of distance. The claim he made is based on what Netflix pays for bandwidth over a few week in a data center or IX, but ISPs have to move the packets that Netflix generates an average of 400 miles, over a plant that needs constant maintenance and constant upgrades. The ISP networks are currently faced with increases in demand that outstrip Moore’s Law.

    The claim that off-peak bandwidth is free is not exactly true, but is close to true, however. There’s an argument to be made that off-peak doesn’t need metering, but that doesn’t help Netflix since their product is strictly a peak load application. Peak load time is also increasing as more people shift from highly efficient TV broadcast viewing to the much more resource intensive unicast model that Netflix requires. Essentially, Netflix loads a cable network 1000 times more intensively than standard TV broadcasting does.

    So in the end the op-ed combined faulty cost analysis with an irrelevant observation about peak and off-peak costs. It was quite silly.

  • http://pulse.yahoo.com/_IZ5BM5GNLA54OADSWGSXAMA7SY Jay

    Hasn’t net neutrality been a false herring this entire time?

    If we had a healthy broadband market, where AT&T didn’t have control of the market through FCC duopoly laws…

    If we had more than six major stars in the area…

    If there were a such thing as fair pricing, wouldn’t we have faster bandwidth and more innovative services than JUST netflix?

  • Polaris4me2002

    Come on, Internet service is one of the most profitable businesses out there. It cost the cable company just a few dollars per customer to add it to the cable plant but they charge $40 a month for the service. Put a time of use surcharge on it if the 7 to 11pm Netflix load really does cause some congestion but it really is a to cheap to meter service.

  • http://twitter.com/nicoflores nico flores

    A thought-provoking post, but I’m not sure I buy the argument. There are two marginal costs here: one related to increases in bandwidth use, the other to additional subscribers. You can charge higher than MC in the second sense (i.e. high base subs fees) while sticking to MC in the first (i.e. low per-GB rates). If extra bandwidth is undifferentiated from consumers’ perspective, P=MC might be a competitive outcome. 

    Also, the bandwidth in question has to do with more people using bandwidth more of the time, and not wanting more bandwidth than their last-mile can take. This means that the costs for ISPs may well be mainly variable and not fixed, as they may be able to just buy/lease the missing bandwidth upstream competitively and at short notice. In other words, the investment point wouldn’t apply as much.

    Would love to hear your thoughts.

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