I’ll See Your Hayek and Raise You a Friedman

by on May 12, 2012 · 7 comments

Tim Lee responds to my last post on net neutrality by invoking one of my favorite economists, Friedrich Hayek. As a matter of logic, a perfectly price discriminating monopoly can be as efficient as a competitive industry, at least in a static sense, but Tim wonders if any firm can ever know enough to price discriminate well, and whether in a dynamic sense these outcomes can really be equated.

In short, a market involving numerous competing over-the-top video providers will be fundamentally, qualitatively different from a market in which one or two large broadband incumbents decides which video content to provide to consumers. In the long run, the open Internet is likely to offer a radically broader range of video content than any single cable company’s proprietary video service, just as is true for text and audio content today. But Eli’s model can’t accomodate this difference, because it requires us to treat content as homogenous and service providers as omniscient in order to make the math tractable.

It’s a fair point that a basic price discrimination model like a simple graph with demand and marginal cost is not going to capture the texture of economic change over time. Nevertheless, I think Tim’s criticism is misplaced, and in fact it’s in a dynamic sense that laissez-faire really shines. Here are a few reasons:

  1. Contra Tim, firms don’t need to be omniscient to price discriminate well. There are lots of techniques, such as bundling, quantity discounts, and tiering, that induce self-selection among consumers. These techniques are forms of price discrimination.
  2. The efficiency properties of price discrimination kick in if the monopolist is able to price discriminate at the low end of the price spectrum, even if it prices poorly to higher-value consumers. There is good evidence that cable companies do this well. For instance, I called Comcast 9 months ago to cancel my economy cable TV package, and they offered me a $15/month credit for a year to keep it. I’m basically getting cable TV for free. Furthermore, as Adam Ozimek pointed out on Twitter last night, almost everyone has cable TV, so the cable company must know how to price it to get low-value consumers on board.
  3. In a dynamic sense, monopoly profit can act as a prize for outcompeting everyone else. As long as competition is taking place without entry barriers or favoritism by the state, competition that admits a possibility of monopoly ex post is fiercer, more Schumpeterian, than that which does not.

Whether or not you buy the above arguments, I think my broad point in favor of laissez-faire in broadband is supported by the Hayekian view of competition, to which I am quite sympathetic. Here’s Hayek in his essay, “The Meaning of Competition,” available in Individualism and Economic Order (free pdf):

The argument in favor of competition does not rest on the conditions that would exist if it were perfect. Although, where the objective facts would make it possible for competition to approach perfection, this would also secure the most effective use of resources, and, although there is therefore every case for removing human obstacles to competition, this does not mean that competition does not also bring about as effective a use of resources as can be brought about by any known means where in the nature of the case it must be imperfect. Even where free entry will secure no more than that at anyone moment all the goods and services for which there would be an effective demand if they were available are in fact produced at the least current expenditure of resources at which, in the given historical situation, they can be produced, even though the price the consumer is made to pay for them is considerably higher and only just below the cost of the next best way in which his need could be satisfied, this, I submit, is more than we can expect from any other known system. The decisive point is still the elementary one that it is most unlikely that, without artificial obstacles which government activity either creates or can remove, any commodity or service will for any length of time be available only at a price at which outsiders could expect a more than normal profit if they entered the field.

The practical lesson of all this, I think, is that we should worry much less about whether competition in a given case is perfect and worry much more whether there is competition at all. What our theoretical models of separate industries conceal is that in practice a much bigger gulf divides competition from no competition than perfect from imperfect competition. Yet the current tendency in discussion is to be intolerant about the imperfections and to be silent about the prevention of competition. We can probably still learn more about the real significance of competition by studying the results which regularly occur where competition is deliberately suppressed than by concentrating on the shortcomings of actual competition compared with an ideal which is irrelevant for the given facts. I say advisedly “where competition is deliberately suppressed” and not merely “where it is absent,” because its main effects are usually operating, even if more slowly, so long as it is not outright suppressed with the assistance or the tolerance of the state. The evils which experience has shown to be the regular consequence of a suppression of competition are on a different plane from those which the imperfections of competition may cause. Much more serious than the fact that prices may not correspond to marginal cost is the fact that, with an intrenched monopoly, costs are likely to be much higher than is necessary. A monopoly based on superior efficiency, on the other hand, does comparatively little harm so long as it is assured that it will disappear as soon as anyone else becomes more efficient in providing satisfaction to the consumers.

Hayek’s position is my position. Let’s put aside simplistic notions of competition like “how many firms are there in the industry.” The important question is whether, as Hayek writes earlier in the essay, “only people licensed by authority [are] allowed to produce particular things, or prices [are] fixed by authority, or both.” Unless I am misreading Tim, he is at least sympathetic to using authority to forbid people from producing a particular thing, a private network, and charging what they like for its use.

Since I know that Tim is fond of quoting Milton Friedman, I’ll point out that Friedman’s position on natural monopoly is also consistent with my own. Here he is in Capitalism and Freedom:

When technical conditions make a monopoly the natural outcome of competitive market forces, there are only three alternatives that seem available: private monopoly, public monopoly, or public regulation. All three are bad so we must choose among evils. … I reluctantly conclude that, if tolerable, private monopoly may be the least of the evils.

If society were static so that the conditions which give rise to a technical monopoly were sure to remain, I would have little confidence in this solution. In a rapidly changing society, however, the conditions making for technical monopoly frequently change and I suspect that both public regulation and public monopoly are likely to be less responsive to such changes in conditions, to be less readily capable of elimination, than private monopoly.

My reading of Friedman is that he became even more hostile to competition policy over time, as economists discovered new, efficient rationales for illegal practices and analyzed cases, like United Shoe and Coors, where the government and the courts got it wrong.

[UPDATE] Tim did not find the preceding Friedman quotation impressive, so here is a more forceful one from later in his life, supporting my claim that he became more hostile to competition policy over time:

My own views about the antitrust laws have changed greatly over time. When I started in this business, as a believer in competition, I was a great supporter of antitrust laws; I thought enforcing them was one of the few desirable things that the government could do to promote more competition. But as I watched what actually happened, I saw that, instead of promoting competition, antitrust laws tended to do exactly the opposite, because they tended, like so many government activities, to be taken over by the people they were supposed to regulate and control. And so over time I have gradually come to the conclusion that antitrust laws do far more harm than good and that we would be better off if we didn’t have them at all, if we could get rid of them.

[/UPDATE]

Whatever the shortcomings of my view of efficiency, I know dozens of economists even more steeped in the work of Hayek than I am. I can’t think of a single one who would support a government-imposed top-down net neutrality policy framework. For Tim to argue for such a policy on Hayekian grounds seems to me to be quite a stretch.

  • http://twitter.com/binarybits Timothy B. Lee

    Eli, with all due respect, I think you’re still using an unhelpfully simplified economic model. Your model assumes that a firm is producing a relatively homogenous product with high fixed costs and high variable costs, and asking what pricing strategy will maximize welfare. I agree with you that under those assumptions price discrimination can work well.

    But the point is that the product Comcast delivers is not homogenous. The YouTube video “Charlie Bit My Finger” and the TV program “Mad Men” have both been watched by hundreds of millions of people, but the process of producing and distributing them is radically different. A vertically integrated video platform is unlikely to deliver “Charlie Bit My Finger” to users because the transaction costs of negotiating carriage exceeds the benefits the producers would get. Hence, if vertical integration had prevented the emergence of Internet video a decade ago, 400+ million users would have been deprived of the opportunity to watch it.
    I don’t see any way your economic model can account for this kind of difference, which is qualitative rather than merely quantitative. Vertical integration doesn’t just affect “how much” output and who gets paid for it, it also has powerful effects on the kinds of content and services that get produced. And in my view, that’s more important in the long run. By itself, Charlie Bit My FInger isn’t so important, but YouTube the platform is tremendously important.

    Maybe you disagree and think we should ignore YouTube-like innovations and focus on maximizing the production of content like “Mad Men.” But if that’s your position you need to actually make your case. It’s not persuasive to simply adopt an economic model that implicitly assumes that “Mad Men” is the only kind of content that exists.

  • http://twitter.com/binarybits Timothy B. Lee

    By the way, it’s hard to imagine a weaker endorsement of a policy than “I reluctantly conclude that, if tolerable, private monopoly may be the least of the evils.” I count at least three caveats, suggesting an extremely tentative conclusion and a willingness to change his mind depending on the specific circumstances.

  • http://elidourado.com/ Eli Dourado

    What interest do you think Comcast has to prevent me from watching “Charlie Bit My Finger” on YouTube?

    I’m happy to agree that amateur content is extremely valuable. But so what? I don’t think as you do that heterogeneous content affects the analysis of price discrimination for network usage.

  • http://elidourado.com/ Eli Dourado

    Since you were unimpressed, I added a more forceful Friedman quotation.

  • http://twitter.com/binarybits Timothy B. Lee

    Man, I’m doing a terrible job of explaining this point. I’m going to have to think about this some more.

  • http://entitledtoanopinion.wordpress.com TGGP

    That first bolded sentence from Hayek is quite long and poorly put together.

  • Pingback: What Kinds of Content Would a Selfish, Unregulated Cable Monopolist Block?

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