Why Do ISPs Impose Data Caps?

by on April 24, 2012 · 14 comments

There is a Senate Commerce Committee hearing today on online video, and our friends at Free Press, Consumers Union, Public Knowledge, and New America Foundation argue that it should be used to investigate ISP-imposed data caps.

If data caps had a legitimate economic justification, they might be just a necessary annoyance. But they do not have such a justification. Arbitrary caps and limits are imposed by multichannel video providers that also provide broadband Internet access, because the providers have a strong incentive and ability to protect their legacy, linear video distribution models from emerging online video competition.

As someone who uses an ISP with a data cap and who is a paid subscriber to three different online video services, you might think that I too would concerned about these caps. But to the contrary, I think there are some legitimate economic reasons ISPs might impose data caps, and I don’t see a reason to stop ISPs from setting the price and policies for the services they offer.

The first and most basic reason that ISPs might want to implement a cap is to price discriminate. The term “price discrimination” makes a lot of people uneasy because it contains the word “discrimination.” While that sounds nefarious, price discrimination usually increases economic welfare. If a firm has to charge all consumers $100/month for service, some consumers who can only afford $50/month will be left out. In contrast, if it can charge $50/month to those customers and $150/month to other customers, more customers will use the product. Price discrimination especially benefits those customers at the low end of the consumption spectrum, who would otherwise have to go without.

Comcast and AT&T have 250 GB/month caps on data usage for their residential service. Very few residential customers are likely to bump up against this cap. In fact, residential service is so adequate for most uses that some business customers might be tempted to use residential-class service. By imposing a cap on usage, ISPs are really trying to force these customers to buy their more-expensive business-class service, which does not have a usage cap. This is good for residential customers because it means that businesses are paying a greater share of the fixed costs associated with providing Internet service; business customers are cross-subsidizing residential customers.

Some people argue that price discrimination is bad because it is a sign of market power. However, relatively recent developments in the economics literature do not support automatic linkage between these two elements. Consider for instance that the most notorious price discriminators are airlines, who seem to be continuously going bankrupt! The best paper on the subject is Michael Levine’s “Price Discrimination Without Market Power” (gated published version, ungated working paper). Levine argues that firms in industries with large fixed costs or networks to maintain will be forced by competition to price discriminate to efficiently allocate their fixed costs. From this perspective, it is bans on price discrimination that can be thought of as a restraint of trade.

The second reason that ISPs might legitimately impose data caps is because it is easier for consumers than other superficially more rational approaches to handling congestion. If I were designing a bandwidth pricing scheme for homo economicus, I would impose two-part pricing. Every consumer would pay a fixed fee just to be part of the network, and then a per-bit metered fee so that they bear the costs associated with their own use. Even better, the per-bit fee would be higher when the network was more congested! However, it could be the case that such pricing imposes “mental accounting costs” on ordinary homo sapiens consumers. As Public Knowledge writes in their new paper on Internet data caps and usage-based pricing:

The strongest arguments for flat rates are best explained by the concept of “mental accounting costs.” As the world gets increasingly complicated, people are overwhelmed by the available choices and the need to devote mental efforts to sorting them out, and therefore search for simplicity. They are willing to pay extra for the peace of mind that flat rates offer them.

A 250 GB cap eliminates mental accounting costs for most consumers, relative to the two-part pricing scheme that I proposed above, while eliminating the congestion created by network hogs. My argument is not that a 250 GB cap is optimal, necessarily. ISPs probably have to do some experimentation to find solutions that strike the right tradeoff between congestion management and consumer value. But a 250 GB cap might work relatively well because Grandma doesn’t have to worry about running up her Internet bill. Nor would the vast majority of consumers, for that matter.

A third reason that ISPs might impose data caps is not actually about Internet service at all, but rather about copyright. ISPs quite understandably do not want to be the copyright police. They don’t want to get roped (further) into the ongoing battle between the content-Congressional complex and ordinary consumers. It is in ISPs’ interest, therefore, to find ways to make the content piracy problem go away without alienating the majority of their users. A 250 GB/month data cap probably strikes a nice balance for them on that score. Uncapped service would result in some users running their bit torrent clients at full speed for 23+ hours per day, consuming terabytes of data and distributing lots of copyrighted content. It would also result in further calls by policymakers and content producers for ISPs to do more with respect to copyright. By imposing a cap, ISPs eliminate the most egregious file-sharing practices without overburdening casual file-sharers and without having to monitor users directly.

The bottom line is that off the top of my head, I can think of three legitimate and sensible reasons for ISPs to impose caps. I’m not saying that any one of these is the answer; the real answer might be a combination of these and other reasons. I have no doubt that our friends have the best of intentions, but their claim that data caps have no possible legitimate economic justification suggests to me that either they don’t know much about economics or they’re not trying very hard.

  • Tom Lee

    I certainly agree that ISPs need some way of allocating the scarce resource of bandwidth — your first and third arguments can apply to any such allocation scheme (including metering).  Insofar as this is about caps specifically, only the second argument is relevant.  And although telcos would certainly like you to believe that their customers prefer relatively opaque pricing (and indeed, perhaps the flaws of human psychology mean that they think they do), the experience of utility consumption in just about every other area (water, gas, electricity) seems like pretty strong evidence that people can deal with the idea of metering.

    Caps are one way of allocating a scarce resource.  But as you point out, they’re obviously economically inefficient — they’re a form of crude rationing, and to the extent that anyone defends them, it seems to be out of a fairly blunt pro-business tribal orientation.  Yes, they are arguably simpler to express to customers.  But is that why ISPs favor them?  Or is it the fact that they allow for a large amount of chicanery around what services will actually be delivered — advantages like being able to sell services that aren’t consumed, and a naturally rising price level (as technology improves and the cap level remains constant)?

    Bottom line: caps are a crude instrument, and there’s no particular reason to think that customers can’t be trusted to comprehend and respond to price signals.

  • Powell-san

    Excellent article explaining that there are rational explanations for differentiated pricing models.  Basic economics that are so often ignored

  • http://elidourado.com/ Eli Dourado

    Tom, I think you’re being a little dishonest here. I’m not arguing that “customers can’t be trusted to comprehend and respond to price signals.” I’m happy for broadband access to be metered if that’s what customers prefer. But is there evidence that consumers in fact would prefer to be metered, rather than having a cap imposed that almost none of them will hit?

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  • Harold Feld

    Now it is my turn to observe that this is theoretical and requires greater factual  investigation. I grant you are responding to the statement in the Free Press letter (which we joined) rather than to our White Paper, but I will point out that our rather lengthy analysis of these possible rationales in our white paper gives reason to be suspicious of these justifications and concludes that greater transparency would be highly desirable.

    While I must agree with Powell-san that basic economics is often ignored, I don’t think we did so here. I simply note that, at some point, empirical data is needed to separate the possible answers from the real world answer.

  • hgh

    Firms are generally free to price as they wish. They have no obligation to justify their price structures or price levels except in extremely limited circumstances, such as as part of a defense to an antitrust case.

    The empirical data being sought here, explanations for why a firm chose or did not choose a certain price structure or usage allowance, is likely to seen as competitively sensitive/proprietary information. It is difficult to see how, outside of litigation with confidentiality protections, any firm would be able voluntarily to release such data without violating fiduciary duties to shareholders and others. Unless the government or a private plaintiff decides that there is potential violation of law, and can get past a motion to dismiss, these data are unlikely to be furnished.

  • http://elidourado.com/ Eli Dourado

    Harold, in your letter with Free Press, you are not attempting to “separate the possible answers from the real world answer.” You are making an unequivocal claim that data caps do not have a legitimate economic justification. To claim now, after I have shown that there are indeed several theoretical justifications for data caps, that more information is needed is to move the goalposts.

    If you now believe that more information is needed, I would welcome a retraction of your signature from the Free Press letter.

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  • http://twitter.com/johnjmcdonald John McDonald

    Since most ISPs operate as a near-monopoly with local government support, they basically fit the definition of the circumstances.  Due to the natural monopoly-like state of broadband deployment, it makes a whole lot of sense to treat it as any other utility.  The problem is when some cities in NC tried to do this, lobbyists bought enough state votes to ban the “unfair competition” utility companies would bring to the table.

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  • Tom Lee

    No, and in fact I think there’s reason to expect that customers, when asked, will say they prefer caps. But this has more to do with status quo bias rather than utility maximization. So yes, it may be paternalistic to say that despite expressed preferences it would be great to move toward metering, which is more economically efficient and could enable beneficial competition in the marketplace, but here I am saying it. I think the long track record of metered utilities argues strongly that once people understand a metering scheme to be the norm, it doesn’t bother them a bit (nobody’s clamoring to have the water company move to “basic”, “pro” and “extreme” pricing tiers, after all).

    I’ll also mention that there’s plenty of evidence of many consumers preferring pay-as-you-go mobile service; in this country it’s confounded by the lower SES and consequent higher prices of that end of the market (a bit of a chicken and egg problem), but obviously most of Europe gets by fine with metered/prepaid.

  • Tom Lee

    Perhaps a shorter response: I don’t think there’s much evidence that customers have meaningful preferences about pricing schemes, other than favoring the status quo, whatever it might be.

  • http://twitter.com/davidrees davidrees

    Eli,

    I appreciate your theoretical reasons for the caps and while I think might be reasonable and plausible, I think they account for, at most, 10% of the reasoning behind the caps.

    I believe cable companies are afraid that the internet is eroding their television delivery model – not just in terms of people using Hulu and Netflix, but in terms of attention. The less we pay attention to television, the less advertising we watch. When we use the internet, we see all sorts of ads, but our ISP gets no cut of that revenue. A few years back, some ISPs were trying to do ad injection and other forms of deep packet inspection and injection and they got slapped by the FCC.

    I have a family of 5 people and we all use the internet to play games, surf the web and consume media. I am an ogre when it comes to banning bit-torrent and other shady practices – we have 3 Steam accounts, a Tivo, Xbox Live, a Wii, multiple Android and portable consoles, etc – all told I have over 15 devices on my home network.

    I just hit my 250GB cap with 8 days left in the month. I got a web page telling me to call Suddenlink – which I did. After you exceed your bandwidth 3 times, they start charging you $10 for 50GB.

    I am actually 100% OK with this policy – we usually hit just under 400GB per month so I told them great – just throw 3 extensions on there, I’ll pay the extra $30 per month and we can all go on being happy.

    Not so fast. They absolutely will not do that. Everytime I hit 80% of my cap, I get the “please call your mommy at the ISP and ask her if you can have another cookie” page. This is infuriating!

    So when I hit 200GB (half way through each month), everything comes to a screeching halt and I have to call in and ask for more. Not only that, but I have to do this every 50GB. This is not a plan that was devised to make more money or to let heavy users pay their “fair share”. This is a soviet style plan designed to inconvenience, dissuade and discourage usage.

    Suddenlink makes the analogy that “if there are 100 cars on the road, but someone has a really large car, it makes it hard for everyone else”. They completely miss the point that larger cars use more gas and people pay more gas tax to cover their greater usage. A better analogy would be the government telling everyone that they can only buy a Prius. Setting aside the assault on individual choice, how is a family of 5+ tall people supposed to deal with that?

    Well that is what’s happening with bandwidth caps. How about a rider where I can add more people to my ISP contract? Say $20/mo and I can add an extra user and get an extra 100GB?

    It actually got interesting as I talked to 5 people at Suddenlink. The sales rep told me I could purchase an additional low end 1.5Mbit account and add the bundled 150GB of data to my existing plan for $25/mo. Fantastic – lets do it!

    20 minutes later, they admitted that they could not add that extra service to my account. I was transferred to someone who told me I should go from the 20Mbit cable connection to the 107Mbit connection which would more than double my cost ($55 to $111) and only give me 350GB of transfer.

    I don’t need FASTER internet, I just need MORE internet! Imagine Ford selling you a car that can only travel 250 miles per month. When you complain, they then try to sell you a car that’s five times faster for twice the money but still only lets you drive 350 miles per month.

    There are only two ways to assess this approach to the market: Their either insane or they have a hidden motive (I’m leaning towards both).

    Finally, they told me that I could order another connection and when you have 2 connections, they actually no longer meter your data transfer. Now the crazy part is, you can’t just pay for the service, you actually have to install it. Yes, you have to get a modem, have them come out, hook it up, activate it, etc.

    I don’t need a second connection or a second modem. I don’t need Bugatti Veyron download speeds when I already have Chevy Camaro download speeds. I just need more miles. I need more usage and I need a solution that does not make me feel like everyone at the cable company has gone insane.

    The most interesting part of this experience was, when I pointed this out – when I said “look, I’m a customer, I want to buy more service and I don’t want to call you every week to do it because that is unreasonable for me and it’s unprofitable for you, all I got was weird side stepping comments like “I’m sorry you feel this way” or “I can understand how you might not understand the benfits of this system” etc.

    Finally, I called a competitor – Time Warner. They offer uncapped cable internet at speeds of 10Mbit. That’s not as fast as I would like, but it’s fast enough that I could live with it. It costs less but I’m not a cost sensitive buyer – I’m service and performance sensitive buyer and for some reason, that I cannot fathom, a company in the United Stated of America is unwilling to sell me more access to their infrastructure product unless I call ans ask their permission every week. This isn’t America, this is madness!

     

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