Tag Archives: industrial organization

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.

Net Neutrality: More Complicated Than You Think

On the technology sites I frequent, TechCrunch and Hacker News, there has been an uproar over Google’s joint proposal with Verizon, in which traditional Internet service providers would be subject to net neutrality regulation and wireless providers would not. I think the outrage over Google’s alleged betrayal of Internet users is ill founded. Most of the criticism I’ve seen is not informed by a serious attempt to grapple with economic reality. The real story is much more complicated. It’s so complicated, in fact, that I’m not sure I can make any rigorous statements about net neutrality, but I will try to outline some of the issues.

Let’s start with the most important question: why did Google decide to start being evil? People seem to actually be asking this childish question. The answer, of course, is that good and evil is not a useful framework for analyzing Google’s actions (though if they open concentration camps I will take this back). Google is motivated by profit. It faces incentives. I outlined Google’s strategy for profit-maximization in A Theory of Google. The basic conclusion of that post is that Google benefits from widespread, cheap, and high-quality access to the Internet.

If that’s true, then why doesn’t Google support net neutrality for wireless providers? <sarcasm>It’s almost as though they haven’t given this any thought.</sarcasm> Except that their chief economist is Hal Varian, who is one of the top scholars of the industrial organization of information-intensive markets and coauthor of one of the seminal books of the field, Information Rules. Varian and his fellow Googlers must have some reason to believe that net neutrality could hinder the development of the wireless Internet (though it appears not all of the rank-and-file are on board).

The first step to understanding the economics of net neutrality is to recognize the large fixed costs that accompany any network industry. The presence of large fixed costs means that the simple price-equals-marginal-cost condition for efficiency no longer applies. If all customers were charged MC, the firm would go out of business. It could not cover its large fixed costs. Even if the costs were sunk, the firm would “go out of business” at the margin, refraining from adding capacity on which it would only lose money. In general, large fixed costs imply that price and/or quality discrimination is a necessary feature of an efficient equilibrium (that is, if consumers do not all have identical demand). Read Michael Levine to see how this is the case even in competitive markets!

Another feature of industries with high fixed costs is that they tend to be monopolized or at least highly concentrated. Economists use the term “natural monopoly” to refer to those cases in which the monopolization is due purely to fixed costs and not to any coercive factor. In fact, traditional ISPs, in addition to being natural monopolies, are also coercively monopolized due to municipal franchises that grant them exclusivity. They therefore do not face even potential entry into their markets. A monopolist ISP might favor its own properties on the web, which is what worries net neutrality advocates. But if the monopolist ISP is free to charge whatever prices it wishes for its service, it can’t gain from pushing its own properties, or at least not at the consumer’s expense. Its incentive is to make the Internet as valuable as possible for its consumers so that it can maximize its profits on its monopoly. Remember the logic of double marginalization. If the municipal franchise results in regulated prices, then the monopolist ISP may have a strong reason to favor its own content. It leverages its monopoly position to reap profits through unregulated content rather than regulated Internet service.

A third factor intrinsic to Internet service is congestion. Transferring data on a network reduces the ability of others to do the same. This is a negative externality that can be remedied through a Pigovian tax, or better yet, through a Coasian solution. After all, property rights are well defined and transactions are already occurring. The externality can be resolved by a change in the terms of the contract.

The challenge, then, if you are socially benevolent, is to find a way (1) to efficiently incentivize investment in Internet service infrastructure, (2) to minimize the ill effects of the tendency of the industry to be monopolized, and (3) to reduce congestion, thereby making existing bandwidth capacity maximally valuable. This is not easy. The efficient solution would be something like the following. Consumers would pay for Internet service in two parts. First, they would pay an access fee, which varies from consumer to consumer in proportion to how much they value the Internet. Second, they would pay for the data they consume on a metered basis, with peak rates being higher than off-peak rates to efficiently allocate traffic. There would be no restrictions on the price or quality of service, though violations of service agreements would be prosecuted as fraud. Because the value of Internet service to consumers vastly exceeds the fixed costs associated with running an ISP, my intuition is that all monopolistic municipal charters should be abrogated and all markets contestable.

If that’s the ideal world, it’s not clear whether net neutrality brings us closer to it or further from it. Because we do not observe the ideal pricing structure, net neutrality regulations hamper firms’ ability to ease congestion by de-prioritizing what they believe is the lower-value traffic (remember, if optimal pricing exists, congestion is self-regulating). On the other hand, because some firms are coercive monopolies and face regulated pricing, net neutrality can improve welfare by taking away an inefficient monopoly rent.

Perhaps the most subtle way that net neutrality could be harmful is by aiding collusion between ISPs. If the firms have a sunk investment in infrastructure, regulations that make it more difficult to recover the value of new investments will discourage entry and expansion. Existing firms can carve up the current market and keep prices artificially high.

Google’s position, that traditional ISPs should be regulated and wireless ones should not, is defensible. Competition is more vigorous in the wireless sector than in the wired, and pricing is less regulated. Furthermore, the wireless industry is further from optimal capacity, so we ought to be sensitive to the incentives to invest.

I don’t mean to endorse Google’s proposal; rather, I wish to suggest that critics take the time to learn something about what it is they are criticizing. It’s dismaying to me that so many non-economists think they understand the effects of net neutrality. Skim some of TechCrunch’s recent posts on the topic: they are, frankly, asinine. It reminds me of a quotation from Murray Rothbard:

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.

Should Schools be Run like Law Firms?

There’s a lot of money in education. According to an article a friend posted on Twitter yesterday, Philadelphia spends $400,000 per classroom of 25 students per year. Other cities are similarly lavish.

In spite of this spending, urban public schools are usually terrible. There is no simple solution to this problem (read Bill Easterly — 1, 2 — and insert “learning” and “education” for “growth” and “development”), but reflecting on the exorbitant amounts of money on the table helped me focus on the incentive problems encountered by the education industry. I realized that similar problems have been solved by law firms.

Imagine that there are two kinds of performance measures. One loosely correlates with what it is that we want from our agents and is publicly verifiable. Because this performance measure is publicly verifiable, we can use it as a basis for writing contracts or regulations or whatever. The second performance measure correlates more strongly with what it is that we want, but is verifiable only by people with specialized skill, such as fellow-agents.

This describes the situation in both education and law. In both fields, there are simple metrics that are publicly verifiable that loosely capture what it is we want from workers. In education, examples are test scores and graduation rates; in law, it’s billable hours. Nevertheless, the attempt to rely on these metrics alone to motivate production are doomed to failure: they do not correlate closely enough with what we actually want, quality education or legal services. The incentives are to game the system, to teach to the test, to bill too many hours, etc.

Fellow-agents are capable of evaluating each other on another basis, one which by assumption correlates more strongly with what we want from them. Left to their own devices, they will shy away from doing so, because it is unpleasant to evaluate others, potentially hurting feelings and rocking the boat. This is the problem that law firms have solved. They have done so by organizing as partnerships. Because a partner’s pay is dependent on the quality of the work done by the other partners and employees, there is an incentive to engage in mutual monitoring to ensure that one’s co-workers are in fact doing quality work.

Would mutual monitoring work in schools? I think so. Teachers know who the other good teachers are. Because schools are typically run in a top-down fashion and answer to external authorities, there is an incentive to keep this information private. But if schools were organized on the law firm model and teachers could keep the surpluses generated by quality improvements, I predict that there would be a lot of quality improvements. A prerequisite for this approach is that quality improvements generate surpluses; schools organized on this model would need to be private.

The partnership approach to school organization would solve some other problems as well. First, much of the money spent on education today is captured by administrators. This is true in both private and public schools. The partnership form makes agents sensitive to the amount wasted on administration. This increases the resources available to actually educate people. Second, mutual monitoring will improve teacher quality in three ways: by discarding bad teachers, by motivating existing teachers to excellence, and by drawing new talent into a higher-paying profession. Higher quality teachers, with higher marginal products, will earn more pay in market equilibrium. To the extent that complaints about “low” teacher pay are valid, adopting the partnership form should address them.

When discussing incentive problems, economists often talk about the mistake of rewarding what is measurable at the expense of what you actually want, which is often not measurable. Incentives, that is, can be too strong. Test scores and graduation rates are measurable, and the results of attempts to enact measurement-based accountability in education have been disappointing. The insight of the literature on partnerships is that you can reward on the basis of quality dimensions that are not precisely measurable. Organizing schools as partnerships might have a significant effect on the quality of education they produce.