Tag Archives: natural monopoly

Where are the Broadband Mutuals?

I’ve argued (here and here, for instance) against worrying too much about the monopolization of Internet access. Broadband is pretty clearly an industry in which there are increasing returns to scale, and when returns to scale are severe enough, that results in natural monopoly. There are not clear welfare gains from regulatory solutions to natural monopoly problems generally, and broadband in particular is a case where many of the problems associated with monopolization are ameliorated by price discrimination.

Nevertheless, I accept that most people are not persuaded by this logic. Let me try a different tack, explaining what I would expect to see if profit-centered monopolists were really as bad for consumers as their critics claim.

The answer can be summed up in one word: mutuals. Mutual companies are not especially common in today’s economy, but they are worth pondering at some length. Mutuals are firms in which customers, in virtue of their ongoing patronage of the firm, are also its owners. A mutual company generally has no other shareholders to please, and it does not typically distribute dividends. Instead, if it makes a profit it will distribute it to its customers in the form of lower prices in the future.

Managers at mutual companies have pretty cushy lives. They can’t earn multi-million dollar bonuses, and their salaries are capped by the firm’s charter or by state regulation. But the modest restrictions on compensation are made up for with quality of life. They don’t work too hard, maybe they spend a lot of the firm’s money on nice offices with plush carpet, and they don’t worry about squeezing every last penny out of the business.

The managers have weak incentives to maximize profit because of the firm’s distributed ownership. While in theory, customers could band together and oust the management team at the annual meeting, in practice it is hard to get 51 percent of the customers to sign and mail in their proxy forms. So instead of maximizing profit, the management team works hard to make sure the product works and nothing terrible goes wrong. As long as everything runs relatively smoothly, their jobs are secure and they can be out on the golf course at 3pm.

In some cases, weaker incentives to run the business efficiently are a feature, not a bug. As Eric Rasmusen pointed out in his excellent JLE article on mutual banks, the mutual form was popular in the financial sector before the New Deal, when federal deposit insurance largely displaced it. The reason is simple: a strong profit motive can lead to excess risk-taking, and depositors preferred that their banks be conservative. Managers at a mutual bank have an incentive to limit risk-taking because their profits are capped anyway. Why risk the assets of depositors when you have no upside? N.b., Washington Mutual, which collapsed in 2008, had actually demutualized in 1983, although it was allowed to keep its name.

Mutuals still exist today, but they are much less common. Vanguard is a familiar mutual company, though this fact is not to be confused with the product they sell, mutual funds. One reason the load on Vanguard funds is so low is that the managers have a very weak incentive to squeeze customers; instead, the firm focuses on basic, reliable service. Mutual companies are also common forms for utility companies in rural areas. Since utilities have increasing returns to scale and rural areas have low scale, the natural monopoly problem is particularly severe in this sector. Mutuals solve this problem by weakening the incentive to opportunistically charge a high price to rural consumers who have only one choice in service provider.

Incidentally, whenever someone challenges my extreme libertarianism by asking if I would privatize water service, I say yes: I would replace the regulated water monopoly with a mutual water company. Mutuals have some similarities to government-run firms, but also some important differences. They are similar in that the profit motive is weak, and that consumers frequently have to rely on voice more than exit to express their displeasure. However, if a mutual provides a truly horrific service, at some point a competing firm (perhaps a competing mutual) becomes a possibility. In that regard, mutuals are superior to government provision. Furthermore, mutuals don’t require me to bundle my purchases with a host of other products, whereas if I want to dump government provision of some good, I basically have to overthrow the state. Why should education spending be bundled with my water service?

My question, then, is predictable. If the state of broadband is so terrible, if broadband monopolists are engaging in harmful net neutrality violations, if infrastructure providers are using their market power to foreclose in the content market, where are the broadband mutuals? Why aren’t neighborhood associations setting up mutual companies to run high-speed local networks and buying transit from a competitive market of upstream providers? A little Googling shows that there are some broadband mutuals, but they operate mostly in rural areas, and they benefit from federal subsidies. Why don’t we see more of this corporate form?

Some possibilities:

  1. Economies of scale make it impossible to enter the market at all. I don’t believe this one. At a minimum, we would expect real estate developers to build new neighborhoods pre-wired for mutual Internet access if they believed that such an amenity would increase the value of the property.
  2. Regulatory barriers make it impossible in practice to enter the market. Maybe. To the extent such barriers exist, I favor removing them. But most of the critics of the broadband monopolies are not calling for deregulation; they are calling for additional regulation.
  3. The broadband monopolies are running their businesses in basically a socially efficient manner, and there is not much room for broadband mutuals to come in and provide a better product. Most observed net neutrality violations are welfare-enhancing, and most of the weird pricing schemes are forms of price discrimination used to underwrite the large fixed costs of running an ISP.

I still think the answer is #3. But if you don’t, you should be pushing to start a mutual broadband company in your neighborhood or city, not advocating for greater regulation or state-run broadband.

Saving Paid Journalism from the Internet

You may be shocked to learn that at dinner this week with a group of economists and journalists, the conversation turned to the economics of journalism. In particular, what is the future of paid journalism? As high-quality journalists face increasing competition from low-quality unpaid bloggers, the market wage for high-quality journalists will continue to fall. Putting aside whether this is a market failure (says the low-quality unpaid blogger), suppose that you really wanted to save high-quality journalism: what would you do?

My answer was what I’ll call a super-paywall. Paywalls get trashed a lot on the Internet with good reason: they don’t raise much money and they annoy people who aren’t subscribers. But here’s the thing: everyone is doing paywalls wrong.

The important thing to realize is that there is a network externality associated with paywalls. Recall the logic of bundling. On average (using some not-so-heroic assumptions), adding an item to a pre-existing bundle raises profits relative to the case where the bundle and the item are sold separately. Paywalls, therefore, are characterized by increasing returns to scale. Putting aside the costs of management and organization (herding journalists), the minimum efficient scale is infinitely large. This is the state of affairs that we typically call “natural monopoly.”

But we don’t observe a monopoly paywall. Instead, we observe a lot of little paywalls; this is very inefficient and not surprisingly seems to be unprofitable. Exacerbating the problem is that the mini-paywalls each bundle content that is related, the value for which is positively correlated. Optimal price discrimination with bundling occurs when you offer content that is negatively correlated in value, so the New York Review of Books and NASCAR magazine should be bundled together.

So the way to save paid journalism is to put all journalism together behind a single paywall. Individual pieces could be sold separately (mixed bundling is slightly more profitable), but the optimal price of stand-alone journalism would be high. Most people who consume journalism of any sort would be subscribers to the super-paywall.

Since the super-paywall is more profitable than the status quo, there is in principle some way of dividing the pie in which all contributors are better off. It’s not clear exactly what formula or criteria should be used to pay people. It would take some entrepreneurship. Since most readers subscribe to the super-paywall, it might be difficult for a writer to make a go of it solo, so there would be some leeway with getting the pay right, but not a lot.

The biggest change from the status quo is that the super-paywall would no longer be able to serve as a certification of content quality. If you read something in a reputable publication, you know that the story bears some resemblance to the truth, that it has been fact-checked, etc. The paywall itself would need to not just allow, but actively recruit, all the crappy bloggers that are currently making life difficult for paid journalism. Consequently, it would need non-existent standards. The key to making this all work is to bring the low-quality work behind the paywall so that the price difference at the margin between high-quality and low-quality journalism is zero.

You could imagine that within the super-paywall, sub-publications exist; authors that mutually certify each others’ work, that apply high-quality journalistic standards, etc. These sub-publications could perform the certifying function, but payment would come not from subscription sales, it would come from whatever royalty is worked out with the super-paywall.

The bottom line is that high-quality journalism is not going to do well in competition with low-quality journalism when there is a big marginal price difference. The beauty of bringing low-quality journalism behind the paywall is that it levels the price differential. It’s funny; high-quality journalists seems to have thought all along that the way to compete against the blogs is to differentiate themselves. In fact, the better solution is to bring the blogs back with them behind the super-paywall. As the saying commonly misattributed to Sun Tzu (see, fact checking!) goes, “Keep your friends close, and your enemies closer.”

I'm not Afraid of Facebook

A lot of pixels have been spilled in the last week about how Facebook has seized control of the Internet with their new API initiatives. This is supposedly troubling: unlike Google, Facebook might be evil, the hand-wringers say. But even if Facebook is able to monopolize a large segment of our time on the Internet, I’m not worried. I have one simple reason: social networking is a network industry (seems obvious, no?).

Let me preface my argument by reiterating that there is a lot about Facebook that I don’t like. I hate the “walled garden” approach, and would prefer that decentralized protocols like those used in Google Buzz take off. I’m not a cheerleader for Facebook or its strategy by any means. Nevertheless, I don’t think Internet users have much to fear.

The way to start thinking about network effects is to think about fax machines. A fax machine is absolutely useless if you are the only one who has one. It’s only when other people have fax machines that they become useful. A fall in the price of fax machines has two effects. First, it will induce people to buy more fax machines—this is the ordinary demand effect of moving along the demand curve. Second, because people are buying more fax machines, fax machines become more useful, which increases demand for fax machines—the demand curve shifts out, amplifying the effect of the price drop on quantity. Since the effect is amplified, the true demand curve, the one that takes this into account, is very “flat” or elastic.

Facebook accounts are like fax machines—they are only useful if other people have them. There is the same positive feedback effect of price on quantity. As a thought experiment, imagine that Facebook started charging $10/month for access. My intuition is that many people get more than $10/month of value out of Facebook, and therefore would be willing to pay the fee. However, a lot of marginal users would drop the service. The fact that a lot of users would drop the service would make Facebook less useful to those people who remained; they may no longer get $10/month worth of value out of Facebook if half their friends weren’t on it any more.

I’m not suggesting that Facebook is going to start charging a fee for access. But nevertheless, elastic demand plays a role in how it relates to its users. For instance, one way of cashing in on the service’s popularity would be to plaster it with interstitial ads. This would be kind of like charging a “price” for the service. Why doesn’t Facebook do this? Elastic demand. And elastic demand places limits on the amount of “evil” that Facebook can do, or at least the amount of wealth it can transfer from its users to itself.

Finally, think about network effects and monopoly. Goods and services that exhibit network effects are going to tend toward monopoly (at least if the network effect applies to the good or service directly, and not the protocol, as with fax machines). We should not be surprised that Facebook is becoming huge; if it wasn’t huge, something else would be huge. That’s just how these industries work. But with very elastic demand, having lots of users doesn’t translate into a large monopoly rent. And meanwhile, Google has a strong incentive to ensure that the Facebook tax is not very high.

So my advice is stop worrying and enjoy your consumer surplus. Facebook is not good or evil—it is profit-oriented and faces a serious demand constraint due to the nature of its own product.