Remarks of Dr. Larry F. Darby

How “Cozy” is the BB Duopoly?

PFF Congressional Seminar:

“Broadband Competition: Is the Glass Half Empty or Half Full?

Delivered on June 12, 2009

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Thank you.

· I want summarize some results of our ongoing work, from a consumer welfare perspective, What kinds of tests for market failure should suffice to warrant imposition of common carrier regulation in this sector?.

· The late senator Daniel Moynihan observed that folks are entitled to their own opinions, but not their own facts. So it is in the debate over private and public sector roles in the National Broadband Policy.

· In the next few minutes I will add some facts to some widely expressed opinions on one issue in that debate: the importance of (duopoly) market structure in the provision of broadband services.

First some opinions:

Opinion Number One. The FCC has allowed a cozy duopoly of telephone and cable companies to dominate the broadband access market…The reliance on this cozy duopoly has been disastrous for the United States…Consumers pay too much for too little.” (CFA)

Two. [Broadband] Prices are well above cost-plus reasonable profit; investment is withheld until absolutely needed; innovation is actively discouraged; and consumer welfare suffers. (CFA, CU)

Three. “…when a market has fewer than the equivalent of six equal-sized competitors, the market just doesn’t function properly. The FCC has ignored the mountains of evidence that our broadband markets are concentrated, anti-competitive, and fundamentally broken. (Free Press)

No matter how you interpret these opinions they say: “Nevermind what kinds of market conduct we observe or performance we can measure, the problem is in the structure; the duopoly; the cozy duopoly. (I looked up cozy to make sure I did not mischaracterize the suggestion. My Thesaurus suggests warmth and ease, contentment and comfort, family like intimacy, close association, discreet and cautious attitudes, connivance.)

These are opinions. But we obliged to ask: “Where’s the Beef?” What are the facts.

No reasonable, objective, well informed observer would suggest any form of collusion between cable and telco BB providers (every indication is that they are aggressive rivals in the voice market, in the data market and in the TV market marketplace and on many policy issues such as franchising and access to programming); or that there is no innovation in the sector (switching, transmission, digitization, bandwidth expansion) ; or that firms are “rationing” capacity (Wall Street suggests the contrary); or restricting supply in order to fetch higher prices (firms expanding output in response to demand) ; or to discriminate in ways to create market power; or that there is excessive profit in the sector (I will return to that in a moment).

The economic case for common carrier regulation is sometimes refers to two events of market conduct (Madison River service denial and Comcast traffic management); or international differences, but proponents’ case for regulation ultimately turns on market structure – duopoly. In fact, the principal corporate force behind the call for common carrier regulation explicitly stated as much:

The broadband problem….. “is the market itself, rather than in a roster of actual and potential “bad acts.” In other words, the flaw is structural, not behavioral.”” (Google)

With that in mind let me review with you quickly from six different perspectives some facts about duopoly and its threat, without regard to conduct or performance, to economic welfare. These views are 1) the neoclassical industrial organization view, 2) views from game theorists, 3) Outcomes from experimental economics, 4) evidence from other sectors served by two dominant firms, 5) what competition policymakers have to say and 6) some evidence of performance of the BB duopoly. These contrast sharply from the views expressed in law journals and Net Neutrality advocates.

1. Neo Classical Industrial Organization View. A fair assessment of scholarly work on the topic suggests no support for equating duopoly with market failure. The author of one well know textbook concluded his review as follows: “Economists have developed literally dozens of oligopoly pricing theories – some simple, some marvels of mathematical complexity. This proliferation of theories is mirrored by an equally rich array of behavioral patterns actually observed…Casual observation suggests that virtually anything can happen….” Indeed the only conclusion from oligopoly theory is that it is inconclusive.

On the Structure-Conduct-Performance framework more generally, it is well established that it may be a useful way to organize and describe our research, but that there are no reliable cause and effect relationships observable. In short, structure does not predict either conduct or performance and cannot alone provide a basis for government action.

2. Game Theory “ The reviewer for the IO survey concluded: Having warned the reader at the outset that there are many theories of oligopoly, I am left with the task of identifying the lessons learned from the collection of models discussed above…What we are in need of most now are further tests of the empirical validity of these various theories of strategic behavior.” (A clear concession of the indeterminancy of game theory models, and I might add of the work of what I call the Post Chicago Conjectures about strategic behavior.) But, we should not be surprised. Over forty years, and thousands of articles in journals of law or economics, ago, Nobel Winner Stigler wrote: “No one has the right, few the ability, to lure economists into reading another article on oligopoly theory without some advance indication of its alleged contribution.

3. Experimental Economics The behavior of oligopolists in general and duopolists in particular has been the subject of considerable interest and analysis by experimental economists. A recent survey article identified more than 150 published papers dealing with one or more different experiments designed to test the market behavior (mainly price and quantity of output) of oligopolists – mainly duopolists – under more than 500 different parameter constellations.

On the issues here today, the results can be easily summarized:

• Duopoly behavior is highly circumstantial;
• Conduct and performance vary along a continuum bounded by perfect competition and perfect monopoly;
• Many of the experiments had indeterminate outcomes;
• Many of the results were weak and not significant statistically; and, finally
• A surprising number of the outcomes were inconsistent with received theory and our economic intuition.

4. Evidence from other sectors served by two dominant firms. Duopoly (top two firms with 80% or more share of the relevant market) is surprisingly common in the general economy. It is everywhere in small to medium sized communities and in rural areas in particular. And, it is quite common among well known national brands. We have identified about 30 duopolies and are examining the “effectiveness of rivalry” in them and more particularly any evidence market failures sufficient to warrant substantial government involvement in constraining or obligating market behavior. These include:

• Moodys and S&P
• Fed Ex and UPS
• Pepsi and Coke
• Macys and Gimbel Department stores
• Home Depot and Lowes
• Kodak and Fuji Film
• MCI and AT&T in the early days
• Lexis/Nexis and WestLaw
• Dish Network and Direct TV
• Air Canada and Westjet in the Canadian Air transport market
• Gillette and Wilkinson Sword
• AirBus and Boeing

Are these markets perfect and without flaws? Are they replicas of the BB duopoly? Of course not. But a fair assessment of the usual indices of market conduct (behavior toward rivals and consumers) and performance (profits, progress, innovation, etc.), there is no support for the proposition that duopoly requires government intervention. There may be such evidence, but it is not in the behavior of duopolists in other sectors.

5. Views of competition policymakers? Our paper cites numerous quotes from DoJ, from FTC, from European and Asian competition policy authorities, as well as to judicial language from the Supremes and lower courts. But, the bottom line is the absence of a scintilla of support for connecting market structure per se to unacceptable performance.

6. Some evidence of performance of the BB duopoly. We have adduced lots of evidence about the actual performance of the BB duopoly of telcos and cable, but

finance-chart

Excessive profits? Margins of BB suppliers in line with the S and P 500 for 2008 and on average for the past five years.

Excessive returns to shareholders? Returns on invested capital for BB suppliers are well below the S&P average for 2008 and on average for the last five years.

Suppressing investment? Broadband duopolists ploughing back over 60% of cash flow from operations into capital expenditures. That is well above the average from our sample of S and P 500 companies. The two largest BB investors in 2008 (VZ and T) combined for about five times the amount provided to NTIA and RUS in the BB stimulus package.

Jobs? BB suppliers use substantially more labor for dollar of output than the S and P average. Thus, a shift of revenue to the BB access provider sector from others will create more jobs, which of course is precisely the point of the BB stimulus package.

There is more. But, we have not been able to find economic evidence of conduct or performance measures that suggest market failure or signal what kinds of regulations might improve BB performance.

What are the implications of all this?

First, our message to believers and advocates of the view that duopoly is the problem is drawn from Casey Stengel. You should as we have “Look it up!” There is no evidence to support a structuralist view of the need for common carrier regulation. The evidence we find suggests the Scotch Verdict: Case not proven.

Markets are imperfect, but so too are government regulatory programs. Again, you can look it up. In our paper we emphasize the differences in type one and type two errors, that is the costs or regulating too much v. regulating too little. This work paired with the findings of others who have studied the costs of regulation suggests that imperfect government is likely to be more costly to consumers than the market imperfections they are designed to address.

Our work has implications for ex post v. ex ante regulation. In English, between passing rules to ensure that nothing bad happens vs. waiting to address market failures one by one as they arise. (In that regard I refer you to the well reasoned FTC staff report.)

We have found nothing of consequence to support a case for common carrier regulation based on market structure, nor on international comparisons, nor on two or three instances of market conduct. Commonsense suggests that it must be based on a thorough consumer welfare oriented cost-benefit analysis of the conduct and performance of markets AND of the well known infirmities of government efforts to manage competitive processes.