An Access Advertising EconBrief:
The Comcast/Time-Warner Cable Merger Bites the Dust
This week brings the news that the year’s biggest and most highly publicized merger, between cable television titans Comcast and Time-Warner Cable, has been called off. Although the decision was technically made by Comcast, who announced it on Monday, it really came from the Federal Communications Commission (FCC), whose de facto opposition to the merger became public last week. This continues a virtually unbroken string of economically inane measures taken by the Obama administration and its regulatory minions.
Theoretically, merger policy falls within the province of industrial organization, the economic specialty spawned by the theory of the firm. Actually, the operative logic had nothing whatever to do with economics. Instead, the decision was dictated by the peculiar incentives governing the behavior of government.
The high visibility of the intended merger and the huge volume of comment it spawned make it worthwhile to examine carefully. What made it so attractive to the principals? Why was it denounced so bitterly in certain quarters? Was the FCC right to oppose it?
Who Were the Principals in the Merger?
Comcast and Time-Warner Cable (hereinafter, TWC) are today the two leading firms in the so-called “pay-TV” industry. The quotation marks reflect the fact that the term has undergone several changes over the course of television history. Today it refers to two different groups of television consumers. First are subscribers to cable television, the biggest revenue source for both Comcast and TWC. Born in the 1950s and nurtured in the 1960s, cable TV fought tooth and nail to gain a toehold against “free” broadcast television. It succeeded by offering better reception from buried coaxial-cable transmission lines, more viewing choices than the “Big 3” national broadcast network channels offered on free TV and a blessed absence of commercial interruption. Its success came despite the efforts of government regulators, who forbade local cable companies from serving major metropolitan areas until the 1980s.
In the early days, municipalities were so desperate to get cable-TV that local government would offer a grant of monopoly to the first cable franchise to lay cable and promise to serve the citizenry. In return, the cable firm would have to pay various legal and illegal bribes. The legal ones came in the form of community-access and public-service channels that few watched but which gave lip service to the notion that the cable firm was serving the “public interest” and not merely maximizing profit. Predictably, these monopoly concessions eventually came back to haunt municipal government when cable firms inexorably began to raise their rates without providing commensurate increases in programming value and customer service to their customers.
Today, the contractual arrangements with cable firms survive. But the grants of monopoly are no more. In many markets, other cable firms have entered to compete with the original firms. Even more important, though, are the other sources of competitive television service. First, there is satellite TV service provided by companies like Direct TV and Dish. A satellite dish – usually located on the customer’s roof – gathers the signal transmitted by the company and provides hundreds of channels to customers. Wireless firms like AT&T and Verizon can also transmit television signals to provide television service as well. And finally, it has become possible to “stream” television signals digitally by means similar to those used to stream audio signals for songs. Consequently, a movie-streaming service like Netflix has become a potent competitor to cable television as well.
What Did Comcast and TWC Have to Gain from the Merger?
The late, great Nobel laureate Ronald Coase taught us that business firms exist to do things that individuals can’t do for themselves – or, more precisely, things that individuals find too costly to do themselves and more efficient to “import” from outsiders. Take this same logic and extend it to business firms. Firms produce some things internally and purchase other things outside the firm. Logically, the inputs they produce internally are the ones they can produce at a cost lower than the external cost of purchase, while external purchases are made when the internal cost of production is too high.
Now extend this logic even further – to the question of merger, in which one firm purchases another. Both firms have to agree to the terms, including a price, which means that both firms consider the merged operation superior to separation. The term used to denote the advantages that arise from combination is synergy – a hybrid of “synthesis” and “energy” suggesting that melding two elements produces a greater output of energy than do the individuals in isolation.
Why should putting two firms together improve on their separate efficiency? The first place to look for an answer is cost, the reason why businesses exist in the first place and the reason why they purchase inputs in the second place. The primary synergy in most mergers is elimination of duplicative functions. Because mergers themselves take time, effort and other resources to effect, there must be substantial duplication that can be eliminated in order to justify a merger on this ground alone. That is why mergers so often occur (or threaten) among similar, competing firms with similar internal structures.
This applies to Comcast and TWC. Large parts of both firms are devoted to the same function; namely, providing cable television to subscribers. A merger would still leave them with the same total territory to service. But one central office, much smaller than the combined size of both before the merger, could now handle administration for the entire territory. The largest efficiencies would undoubtedly have been available in advertising. Economies of scale would have been gained from having one advertising department handle all advertising for the merged firm. Economies of size would have been available because the much larger total of advertising would have commanded volume discounts from sellers.
Given the gigantic size of the firms – their combined revenue would have yielded well over $80 billion – these economies alone might well have justified the merger. And that leaves out the most important reason for the merger. In times of market turmoil, mergers are often referred to as “consolidation.” This is a polite way of saying that the firms involved are girding their loins for future battle. They are fighting for their business life.
This is completely at odds with the picture painted by self-styled “consumer advocates” and government regulators. The former whine about the poor quality of service provided by Comcast to its cable subscribers, calling the company a “lazy monopolist.” By definition, a lazy monopolist doesn’t have to worry about its future – it is living off the fat of the land or, as an economist puts it, taking some of its profits in the form of leisure. (Of course, the critics can’t have it both ways – if the firm is “lazy” then it must be extracting less profit from consumers than it could if it were “aggressive.” But the act of moral posturing uses up so much mental energy that there is little left for critics to use in applying logic.) Government regulators say that Comcast and Time-Warner have so much power that, when combined, they could exclude their potential competitors from the market for “high-speed broadband.”
But the picture painted by market analysts is completely different. Comcast and TWC are leading players in a market that is beginning to wither on the vine. They are not merely providing “pay TV;” they are providing it via coaxial cable buried in the ground and via subscription. This method of providing television service will sooner or later become an endangered species – and the evidence is leaning toward “sooner.” People are beginning to “cut the cord” binding them to cable television. They are doing it in at least three ways. For years, satellite services have made modest inroads into cable markets. Now wireless companies are increasing these inroads. Finally, streaming services are promoting the ultimate heresy – people are renouncing their television sets entirely by streaming TV programming on their computers. Consumers have begun abandoning pay-TV in both 2013 and 2014; in the last year, cord-cutting to streaming TV has begun to occur in the millions.
Not surprisingly, the prime mover behind all of these threats to cable TV is cost. In the early days of cable, hundreds of channels were a dazzling novelty after the starvation diet of three major networks (with perhaps one UHF channel as an added spice). People occasionally surfed the channels just to find out what they might be missing or for something of genuine interest. Over time, though, they bore an increasing cost of holding an inventory of dozens of channels handy on the mere off-chance that something interesting might turn up. That experience gradually made the tradeoff seem less and less favorable, making the lure of a TV lineup tailored to their specific preferences and budget more attractive. Today, the prices of cable TV’s competitors will go nowhere but down.
These competitors are not only competing on the basis of price but also on the basis of product quality. Increasingly, they are now creating their own programming content. This trend began years ago with Home Box Office (HBO), which started life as a movie channel but entered the top tier of television competition when it began producing its own movies and specials. Now Netflix has followed suit and everybody else sees the handwriting on the wall.
The biggest attraction of the merger for Comcast and Time-Warner was the combined resources of the two firms, which would have given the resulting merged firm the kind of war chest it needed to fight a multi-front competitive war with all these competitors. Each of the two firms brought its own special advantages to the fight, complementing the weaknesses of the other. Comcast owns NBC, currently the most successful broadcast-TV channel and a locus of programming expertise. Another of its assets is Universal Studios, a leading film producer since the dawn of Hollywood and a television pioneer since the 1950s. TWC brings the additional heft and nationwide presence necessary to lift Comcast from regional cable-TV leader to international media player.
What is an “Industry?”
Everybody has heard the word “industry” used throughout their lives. Everybody thinks they know what it means. The federal government lists and classifies industries according to the Standard Industrial Classification (SIC) code. The SIC code defines an industry by its technical characteristics, and the definition becomes narrower as the work performed by the firms becomes more specialized. From the point of view of economics, though, there is a problem with this strictly technical approach to definition.
It has no necessary connection to economics at all.
The only economic definition of an industry related to the economic substitutability of the products produced by its members. If the products are viewed by consumers as economically homogeneous – e.g., interchangeable – then the aggregate of firms constitutes an industry. This holds true regardless of the technical features of those products. They may be physically identical; indeed, that might seem highly likely. But identical or not, their physical similarity has nothing to do with the question of industrial status.
If the goods are close substitutes, we may regard the firms as comprising an industry. How close is “close?” Well, in practice, economists usually use price as their yardstick. If significant variations in the price of any firm’s output will induce consumers to shift their custom to a different seller, then that is sufficient to stamp the output of different sellers as close substitutes. (We hold product quality constant in making this evaluation.)
This distinction – between the definition of an industry in strictly technical terms and in economic terms – is the key to understanding modern-day telecommunications, the digital universe and the Comcast/TWC merger.
Without saying it in so many words, the FCC proposes to define markets and industries in non-economic terms that suit its own bureaucratic self-interest. It does this despite the fact that only economic logic can be used when evaluating the welfare of consumers and interpreting the meaning of antitrust law.
The FCC’s Rationale for Ordering a Hearing on the Comcast/TWC Merger
Comcast decided to pull the plug on its proposed merger with TWC because the FCC’s announced decision to hold a regulatory hearing on the merger was a signal of the agency’s intention to oppose it. (The power of the federal government to legally coerce citizens is so great than innocent defendants commonly plead guilty to criminal charges in order to minimize penalties, so it is not strange that Comcast should surrender preemptively.) It is natural to wonder what was behind that opposition. There are two answers to that question. The first answer is the one that the agency itself would have provided in the hearing and that already been provided in statements made by FCC Chairman Thomas Wheeler. That answer should be considered the regulatory pretext for opposition to the merger.
For years, another regulatory agency – the Federal Trade Commission (FTC) – passed both formal and informal judgment on antitrust law in general and business combinations in particular. The FTC even provided a set of guidelines for what mergers would be viewed favorably and unfavorably. The guidelines looked primarily at what industrial-organization economists called industry structure. That term refers to the makeup of firms existing within the industry. Traditionally, this field of economics studies not only industry structure – the number of firms and the division of industry output among them – but also the conduct of existing firms – competition might be fierce, lackadaisical or even give way to collusive attempts to set price – and their actual performance – prices, output and product quality might be consistent either with competitive results or with monopolistic ones. But the FTC concerned itself with structural attributes of the market when reviewing proposed mergers, to the exclusion of other factors. It calculated what were known as concentration ratios – fractions of industry output produced by the leading handful of firms currently operating. If the ratio was too high, or if the proposed merger would make it too high, then the merger would be disallowed. When feeling particularly esoteric, the agency might even deploy a hyper-scientific tool like the “Herfindahl-Hirschman Index” of industry concentration as evidence that a merger would “harm competition.”
In our case, the FCC needed a rationale to stick its nose into the case. That was provided by President Obama’s insistence on the policy of “net neutrality” as he defined it. This policy contended that the leading cable-TV providers were “gatekeepers” of the Internet by virtue of their local monopoly on cable service. In order to give their policy a semblance of concreteness – and also to make the FCC look as busy as possible – the agency established a policy that the top pay-TV firm could control no more than 30% of the “total” market. This criterion is at least loosely reminiscent of the old FTC merger guidelines – except for the fact that the FTC merger guidelines had a tenuous relationship with economic theory and logic. Here, the FCC’s policy as much to do with astrology as it does with economics; e.g., roughly zero in both cases. But, mindful of the FCC’s rule and in order to keep its merger hopes alive, Comcast sold enough of its cable-TV properties to Charter Communications to reduce the two companies’ combined pay-TV holdings to the 30% threshold.
In order to create the appearance of being progressive in the technical as well as the political sense, the FCC set itself up as the guardian of “high-speed broadband service.” For years leading up to the merger announcement, the FCC’s definition of “high-speed” was a speed greater than or equal to 4 Mbps. But after the merger announcement, the FCC abruptly changed its definition of the “high-speed market” to 25 Mbps. or greater. Why this sudden change? Comcast’s sale of cable-TV assets had circumvented the FCC’s 30% market threshold, so the agency now had an incentive to invent a new hurdle to block the merger. The faster broadband-speed classification had the effect of including fewer firms, thereby making its (artificially defined) market smaller than before. In turn, this made the shares of existing firms higher. Under this revised definition – surprise, surprise! – the Comcast/TWC merger would have given the resulting firm 57% of this newly defined “market” rather than the 37% it would previously have had.
Still, most industry observers figured that Comcast’s divestiture sale to Charter Communications, combined with what Holman Jenkins of The Wall Street Journal called “Comcast’s vast lobbying spending and carefully cultivated donor ties with the Obama administration”, would see the merger over the regulatory hurdles. Clearly, they reckoned without the determination of FCC Chairman Wheeler.
What Was the Actual Motivation of the FCC in Frustrating the Comcast/TWC Merger?
Regulators regulate. That is the explanation for the FCC’s de facto denial of the Comcast/TWC merger. It is the bureaucratic version of Descartes’s “I think, therefore I am.” After over a century of encroaching totalitarianism, it is only gradually dawning on America that big government is dedicated solely to the proposition that government of, by and for itself shall not perish from the Earth.
A recent Bloomberg Business editorial is an implicit rationale for the FCC’s action. The editor marvels at how only recently it seemed that the forces of cable-TV darkness had the upper hand and were poised with their jackboots on the throats of consumers the world over. But then, with startling suddenness, cable’s position now seems wholly tenuous as it is beset on all sides with uncertainty. And who should we thank for this sudden reversal? Why, the FCC, of course, whose wise regulation has turned the tide. Instead of crediting competitive forces with making the FCC’s action unnecessary if not a complete non sequitur, the editorial gives the credit to the FCC for creating circumstances that preexisted and in which the agency had no hand.
One of Milton Friedman’s famous characterizations of bureaucracy compared it to the flight leader of a covey of ducks who, upon discovering that the remainder of his V-formation have deserted him and are flying off in a different direction, scrambles to get back in front of the V again. By denying the merger, the FCC has re-positioned itself to claim credit for anything and everything that competition has accomplished so far and will accomplish in the future. If it had done nothing, regulation would have had to cede credit to market forces. By doing something – even something as crazy, useless and downright counterproductive as frustrating a potentially beneficial merger – the FCC has not only set itself up for future benefits, it has also fulfilled the first goal of every government bureaucracy.
It has justified its existence.
All this would have been true even if the FCC’s pre-existing commitment to net neutrality has not forced it to twitch reflexively every time the words “high-speed broadband” arise in a policy context. As it is, the agency was compelled to invent a “policy” for regulating a market that will soon be the most hotly competitive arena in the world – unless the federal government succeeds in wrestling competition to a standstill here as it did in telecommunications in the 1990s.
Why are Economic Theory and Logic Absent from the FCC’s Actions in the Comcast/TWC Merger?
Begin with a few matter-of-fact sentences from Forbes magazine’s summary of the merger. “Comcast and TWC do not directly compete with each other… and there is no physical overlap in the areas in which these companies offer services.” Competitors such as Direct-TV, Dish, AT&T, Verizon and Netflix have “reduced the Importance of the cable-TV market and given its customers other alternatives… Hence this merger would not significantly impact the choices available to the consumers in the service areas of these two companies.”
Forbes’ point was that old-time opposition to mergers by agencies like the FTC was based on the simplistic premise that when competitors merge, there is one few competitor in the market – which is then one step closer to monopoly. When there were few competitors to begin with, this line of thinking had a certain naïve appeal, even though it was wrong. But when the merging companies weren’t competitors in the first place, even this rather flimsy rationale evaporates. And this holds just as true in the so-called “market for high-speed broadband” as it does for the market for pay-TV. Why? Because President Obama and FCC Chairman Wheeler have anointed the cable companies as the gatekeepers of that “market,” and the only markets they can be the gatekeepers of are those same local markets in which Comcast and Time-Warner weren’t competitors before the merger announcement. Therefore the merger couldn’t have affected developments there, either.
The end-in-view of all economic activity is consumption. Consumers – the people who watch TV in whatever form – would not have been harmed or adversely affected by the merger. The consumer advocated who cite the bad service given by Comcast to its customers seem to have taken the view that the remedy for this offense is to make sure that nothing good happens to Comcast from now on. They apparently expect that the merger would have reduced the total volume of employment by the two firms – which it undoubtedly would – and that this would on its face have made customer service even worse – which it most certainly would not have done. Government never ceases to object to budget cuts and predict even worse customer service when they are implemented, but bigger government never produced better customer service. Only competition does that – and the merger was a desperate attempt to prepare for and cope with competition.
The FCC’s imaginary market for high-speed broadband and its 30% threshold were as irrelevant to market competition as the price of tea in Ceylon. The entire digital universe is inventing its way around the anachronistic gatekeeper function performed by local cable firms. (The Wall Street Journal‘s editors couldn’t help reacting in amazement to the FCC’s announcement: “Is anybody at the FCC under 40?” Today it is only the senior-citizen crowd that is still tethered to desktop computers for Web access.)
Why Should the Man in the Street Be Expected to Embrace a Merger Between Large Corporations?
It has been estimated that the sum of mankind’s knowledge has increased more since 2003 than it did since the dawn of human history up to that point. Given the breakneck advance of learning, we cannot expect to comprehend the meaning and benefit of all that goes on around us. Instead, we must choose between the presumptive value of freedom and the restraining hand of government. We owe most of what we value to freedom and private initiative. It is genuinely difficult to identify much – if anything – that government does adequately, less alone brilliantly.
This straightforward comparison, rather than complex mathematics, econometrics or “he said, she said” debates between vested interests should sway us to side with freedom and free markets. The average person shouldn’t “embrace” a corporate merger because he or she shouldn’t evaluate the issue on the basis of emotion. The merger should have been “tolerated” as an exercise of free choice by responsible adults – period.