Real Talk on Net Neutrality

by on May 9, 2012 · 659 comments

A lot of people are talking about this New York Times article on net neutrality, which highlights the effect on Netflix of Comcast launching its own video platform on the Xbox that is exempt from Comcast’s bandwidth limitations. While this policy may indeed result in more customers for Comcast’s video services and fewer for Netflix’s in the short run, I don’t think that critics are seriously thinking through the economics of Internet service before they speak.

The economics of running a large ISP is one of fixed costs. When you introduce large fixed costs, a lot of consumers’ ordinary economic intuition becomes worse than useless. If Comcast incurs a lot of fixed costs from building a network, someone has to pay for it. Suppose that the fixed cost is currently divided between TV subscription and advertising revenue and Internet service revenue. If Comcast’s TV revenues collapse because everyone is switching to Netflix, where will Comcast get the revenue to pay its high fixed costs? You guessed it, they will have to raise the price of Internet service.

To give a dramatically oversimplified example, suppose that TV service and Internet service each cost $50/month and Comcast has $90/customer/month in fixed costs and $10/customer/month in TV content licensing costs. If all of Comcast’s customers drop TV service and switch to Netflix, which costs $8/month, Comcast loses its $10/month licensing expense but it still has $90/month in fixed costs for maintaining its network. It will have to raise the price of its Internet service to $90/month to recover those costs. Consumers will now pay $90/month to Comcast for Internet service and $8/month to Netflix for TV service, for a total of $98/month, which is $2 less than they were paying before.

However, Comcast’s “non-neutral” Xbox service could improve on this for some customers, assuming that customers are heterogeneous. Suppose that critics’ worst fear comes true and I am the only Comcast customer to switch from Comcast video to Netflix. Then Comcast’s pricing does not have to change, I pay $58/month, and other customers continue paying $100/month, just as they were before. This pricing policy is great for me, the most elastic customer. If you are a Netflix subscriber, therefore, you benefit from Comcast’s non-neutral Xbox service.

But what about the inelastic customers? They have to pay more. However, it is economically efficient—and this can be proven rigorously—for the less elastic customers to pay a higher share of the fixed cost. Given that we’re going to have a network with a large fixed cost, the question we should be asking is, “What is the most efficient way of paying that fixed cost?” And the answer is, in many cases, in a non-neutral way.

The bottom line is that there is a lot of wishful thinking when it comes to net neutrality. In many respects, it reminds me of the simpleton’s dream of à la carte cable, as if pricing of $0.50/channel in a bundle of 100 channels can be extended to customers buying only 5 channels. Fools! You must pay the fixed cost somehow. And the best, most efficient way of splitting up this fixed cost is not equally, and certainly not at taxpayer expense, which is completely unfair to taxpayers who do not value the service, but inversely with demand elasticity. This means the network should always be non-neutral to some extent, balanced of course against our willingness to pay more as consumers for a neutral Internet.

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