Old arguments about usage-based pricing are still wrong

by on December 21, 2012 · 612 comments

The following is a guest post by Daniel Lyons, an assistant professor at Boston College Law School who specializes in the areas of property, telecommunications and administrative law.

While much of the broadband world anxiously awaits the DC Circuit’s net neutrality ruling, consumer groups have quietly begun laying the groundwork for their next big offensive, this time against usage-based broadband pricing. That movement took a significant step forward this week as the New America Foundation released a report criticizing data caps, and as Oregon Senator Ron Wyden introduced a bill that would require the Federal Communications Commission to regulate broadband prices.

But as this blog has noted before, these efforts are misguided. Usage-based pricing plans are not inherently anti-consumer or anticompetitive. Rather, they reflect different pricing strategies through which a broadband company may recover its costs from its customer base and fund future infrastructure investment. Usage-based pricing allows broadband providers to force heavier users to contribute more toward the fixed costs of building and maintaining a network. Senator Wyden’s proposal would deny providers this freedom, meaning that lighter users will likely pay more for broadband access and low-income consumers who cannot afford a costly unlimited broadband plan will be left on the wrong side of the digital divide.

In a working paper I published with the Mercatus Center in October I had already debunked the arguments that the New America Foundation relies upon to make their case. NAF suggests that broadband providers should be unconcerned about costs because gross margins on broadband service are high, and the marginal cost of data transport is relatively low and falling. This is largely true, but also largely irrelevant. For broadband providers, as many other networked industries, the challenge is generating sufficient revenue to recover their fixed costs and fund future network investment. Broadband providers have invested over $300 billion in private capital in the past decade to build and upgrade the nation’s broadband networks. And because Internet traffic is expected to triple by 2016, analysts expect them to continue to invest $30–40 billion annually to expand and upgrade their networks.

Therefore the key broadband pricing question is not the marginal cost of transport, but the best strategy for recovering those fixed costs. The unlimited flat-rate model that New America Foundation favors is one solution, but a relatively inefficient one. As the FCC has noted, flat-rate pricing forces “all subscribers to pay the same amount for broadband service, regardless of the performance or usage of the service, would force lighter end users of the network to subsidize heavier end users.” Heavier users consume significantly more of the network’s total bandwidth each month than the average consumer. This means that light users pay a higher effective rate for broadband service, cross-subsidizing the activities of those who spend more time online.

Usage-based pricing allows broadband providers to shift more of those fixed costs onto those who use the network the most. This strategy is known to economists as price discrimination, and despite its sinister-sounding name, it is a relatively common phenomenon. Airlines routinely charge different rates to students and businessmen; movie theaters charge the average movie-goer more than children or seniors; car dealers give a better price to consumers who haggle. In each case, two customers face different prices for the same product, based on their willingness to pay. The practice is common and uncontroversial.

In the broadband industry, price discrimination can help make broadband more affordable to low-income consumers. A new paper by economist Steve Wildman explains that usage-based pricing allows broadband providers to offer cheaper entry-level broadband plans with limited data use to customers who do not need unlimited access and cannot, or will not, pay the higher flat rate for a level of service they do not need. The lower margins on these plans are offset by greater margins on higher-use plans. In that way, usage-based pricing can promote greater broadband penetration, which is one of the most important goals of the FCC’s National Broadband Plan.

The NAF Report also accuses broadband providers of using caps to create artificial scarcity, in an effort to pad profits. This seems an odd critique: under any usage-based pricing model, the broadband provider is paid according to the amount a customer uses the system. Therefore it is in the provider’s interest to get the customer to use the network more, not less. But setting aside this basic critique, NAF’s argument is misplaced. A conspiracy to create scarcity to raise rates only works if the customer has market power: otherwise consumers will simply switch to a better deal elsewhere. But if the provider has market power, there is no need to go through this hypothetical scarcity kabuki dance: the provider can simply raise the price on the unlimited flat rate plan and pocket the additional revenue.

Similarly, Senator Wyden’s bill seems focused on the risk that broadband providers will use usage-based pricing to protect legacy cable services from over-the-top competitors such as Netflix. My Mercatus report addresses this argument at length. In short, some broadband providers have incentives to use data caps to harm competitors. But antitrust law protects competition, not competitors. Vertical restraints on trade can be harmful or beneficial to consumers, depending on the context. For example, AT&T’s exclusive agreement to carry the iPhone gave it an advantage over Verizon and other wireless providers, but this vertical restraint helped consumers by jumpstarting a sleepy smartphone industry and igniting the mobile broadband revolution.

Therefore the movement against usage-based pricing is misdirected. As I have explained before, it is not usage-based pricing that is the villain, but market power—and more specifically, the misuse of market power in ways that harm consumers. Antitrust law already provides a remedy for this harm. Senator Wyden proposes a broad ex ante prohibition on almost all forms of usage-based pricing. But consumers are better protected by antitrust law’s ex post enforcement against specific harmful practices. This remedy safeguards against abuse of usage-based pricing, while allowing broadband providers the freedom to experiment with different pricing strategies in innovative ways, which ultimately gives consumers more options and makes the network more efficient.

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