DRI-183 for week of 3-1-15: George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

An Access Advertising EconBrief:

George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

February 26, 2015 is a date that will live in regulatory infamy. That assertion is subject to revision by the courts, as is nearly everything undertaken these days by the Obama administration. As this is written, the Supreme Court hears yet another challenge to “ObamaCare,” the Affordable Care Act. President Obama’s initiative to achieve a single-payer system of national health care in the U.S. is rife with Orwellian irony, since it cannot help but make health care unaffordable for everybody by further removing the consumer of health care from every exposure to the price of health care. Similarly, the latest administration initiative is the February 26 approval by the Federal Communications Commission (FCC) of the so-called “Net Neutrality” doctrine in regulatory form. Commission Chairman Tom Wheeler’s summary of his regulatory proposal – consisting of 332 pages that were withheld from the public – has been widely characterized as a proposal to “regulate the Internet like a public utility.”

This episode is riven with a totalitarian irony that only George Orwell could fully savor. The FCC is ostensibly an independent regulatory body, free of political control. In fact, Chairman Wheeler long resisted the “net neutrality” doctrine (hereinafter, shortened to “NN” for convenience). The FCC’s decision was a response to pressure from President Obama, which made a mockery of the agency’s independence. The alleged necessity for NN arises from the “local monopoly” over “high-speed” broadband exerted by Internet service providers (again, hereinafter abbreviated as “ISPs”) – but a “public utility” was, and is, by definition a regulated monopoly. Since the alleged local monopoly held by ISPs is itself fictitious, the FCC is in fact proposing to replace competition with monopoly.

To be sure, the particulars of Chairman Wheeler’s proposal are still open to conjecture. And the enterprise is wildly illogical on its face. The idea of “regulating the Internet like a public utility” treats those two things as equivalent entities. A public utility is a business firm. But the Internet is not a single business firm; indeed, it is not a single entity at all in the concrete sense. In the business sense, “the Internet” is shorthand for an infinite number of existing and potential business firms serving the world’s consumers in countless ways. The clause “regulate the Internet like a public utility” is quite literally meaningless – laughably indefinite, overweening in its hubris, frightening in its totalitarian implications.

It falls to an economist, former FCC Chief Economist Thomas Hazlett of Clemson University, to sculpt this philosophy into its practical form. He defines NN as “a set of rules… regulating the business model of your local ISP.” In short, it is a political proposal that uses economic language to prettify and conceal its real intentions. NN websites are emblazoned with rhetoric about “protecting the Open Internet” – but the Internet has thrived on openness for over 20 years under the benign neglect of government regulators. This proposal would end that era.

There is no way on God’s green earth to equate a regulated Internet with an open Internet; the very word “regulated” is the antithesis of “open.” NN proponents paint scary scenarios about ISPs “blocking or interfering with traffic on the Internet,” but their language is always conditional and hypothetical. They are posing scenarios that might happen in the future, not ones that threaten us today. Why? Because competition and innovation protected consumers up to now and continue to do so. NN will make its proponents’ scary predictions more likely, not less, because it will restrict competition. That is what regulation does in general; that is what public-utility regulation specifically does. For over a century, public-utility regulation has installed a single firm as a regulated monopoly in a particular market and has forcefully suppressed all attempts to compete with that firm.

Of course, that is not what President Obama, Chairman Wheeler and NN proponents want us to envision when we hear the words “regulate the Internet like a public utility.” They want us to envision a lovely, healthy flock of sheep grazing peacefully in a beautiful meadow, supervised by a benevolent, powerful Shepherd with a herd of well-trained, affectionate shepherd dogs at his command. Soothing music is piped down from heaven and love and tranquility reign. At the far edges of the meadow, there is a forest. Hungry wolves dwell within, eyeing the sheep covetously. But they dare not approach, for they fear the power of the Shepherd and his dogs.

In other words, the Obama administration is trying to manipulate the emotions of the electorate by creating an imaginary vision of public-utility regulation. The reality of public-utility regulation was, and is, entirely different.

The Natural-Monopoly Theory of Public-Utility Regulation

The history of public-utility regulation is almost, but not quite, co-synchronous with that of government regulation of business in the United States. Regulation began at the state level with Munn vs. Illinois, which paved the way for state government of the grain business in the 1870s. The Interstate Commerce Commission’s inaugural voyage with railroad regulation followed in the late 1880s. With the commercial introduction of electric lighting and the telephone came business firms tailored to those ends. And in their wake came the theory of natural monopoly.

Both electric power and telephones came to be known as “natural monopoly” industries; that is, industries in which both economic efficiency and commercial viability chose one single firm to serve the entire market. This was the outgrowth of economies of scale in production, owing to decreasing long-run average cost of production. This decidedly unusual state of affairs is a technological anomaly. Engineers recognize it in conjunction with the “two-thirds rule.” There are certain cases in which cost increases as the two-thirds power of output, which implies that cost decreases steadily as output rises. (The thru-put of pipes and cables and the capacity of cargo holds are examples.) In turn, this implies that the firm that grows the fastest will undersell all others while still covering all its costs. The further implication is that consumers will receive the most output at the lowest price if one monopoly firm serves everybody – if, and only if, the firm’s price can be constrained equal to its long-run average cost at the rate of output necessary to meet market demand. An unconstrained monopoly would produce less than this optimal rate of output and charge a higher price, in order to maximize its profit. But the theoretical outcome under regulated monopoly equates price with long-run average cost, which provides the utility with a rate of return equal to what it could get in the best alternative use for its financial capital, given its business risk.

In the U.S. and Canada, this regulated outcome is sought by a public-utility commission via the medium of periodic hearings staged by the public-utility regulatory commission (PUC for short). The utility is privately owned by shareholders. In Europe, utilities are not privately owned. Instead, their prices are (in principle) set equal to long-run marginal cost, which is below the level of average cost and thus constitutes a loss in accounting terms. Taxpayers subsidize this loss – these subsidies are the alternative to the profits earned by regulated public-utility firms in the U.S. and Canada.

These regulatory schemes represent the epitome of what the Nobel laureate Ronald Coase called “blackboard economics” – economists micro-managing reality as if they possessed all the information and control over reality that they do when drawing diagrams on a classroom blackboard. In practice, things did not work out as neatly as the foregoing summary would lead us to believe. Not even remotely close, in fact.

The Myriad Slips Twixt Theoretical Cup and Regulatory Lip

What went wrong with this theoretical set-up, seemingly so pat when viewed in a textbook or on a classroom blackboard? Just about everything, to some degree or other. Today, we assume that the institution of regulated monopoly came in response to market monopolies achieved and abuses perpetrated by electric and telephone companies. What mostly happened, though, was different. There were multiple providers of electricity and telephone service in the early days. In exchange for submitting to rate-of-return regulation, though, one firm was extended a grant of monopoly and other firms were excluded. Only in very rare cases did competition exist for local electric service – and curiously, this rate competition actually produced lower electric rates than did public-utility regulation.

This result was not the anomaly it seemed, since the supposed economies of scale were present only in the distribution of electric power, not in power generation. So the cost superiority of a single firm producing for the whole market turned out to be not the slam-dunk that was advertised. That was just one of many cracks in the façade of public-utility regulation. Over the course of the 20th century, the evolution of public-utility regulation in telecommunications proved to be paradigmatic for the failures and inherent shortcomings of the form.

Throughout the country, the Bell system were handed a monopoly on the provision of local service. Its local service companies – the analogues to today’s ISPs – gradually acquired reputations as the heaviest political hitters in state-government politics. The high rates paid by consumers bought lobbyists and legislators by the gross, and they obediently safeguarded the monopoly franchise and kept the public-utility commissions (PUCs) staffed with tame members. That money also paid the bill for a steady diet of publicity designed to mislead the public about the essence of public-utility regulation.

We were assured by the press that the PUC was a vigilant watchdog whose noble motives kept the greedy utility executives from turning the rate screws on a helpless public. At each rate hearing, self-styled consumer advocacy groups paraded their compassion for consumers by demanding low rates for the poor and high rates on business – as if it were really possible for some non-human entity called “business” to pay rates in the true sense, any more than they could pay taxes. PUCs made a show of ostentatiously requiring the utility to enumerate its costs and pretending to laboriously calculate “just and reasonable” rates – as if a Commission possessed juridical powers denied to the world’s greatest philosophers and moralists.

Behind the scenes, after the press had filed their poker-faced stories on the latest hearings, increasingly jaded and cynical reporters, editors and industry consultants rolled their eyes and snorted at the absurdity of it all. Utilities quickly learned that they wouldn’t be allowed to earn big “profits,” because this would be cosmetically bad for the PUC, the consumer advocates, the politicians and just about everybody involved in this process. So executives, middle-level managers and employees figured out that they had to make their money differently than they would if working for an ordinary business in the private sector. Instead of working efficiently and productively and striving to maximize profit, they would strive to maximize cost instead. Why? Because they could make money from higher costs in the form of higher salaries, higher wages, larger staffs and bigger budgets. What about the shareholders, who would ordinarily be shafted by this sort of behavior? Shareholders couldn’t lose because the PUC was committed to giving them a rate of return sufficient to attract financial capital to the industry. (And the shareholders couldn’t gain from extra diligence and work effort put forward by the company because of the limitation on profits.) That is, the Commission would simply ratchet up rates commensurate with any increase in costs – accompanied by whatever throat-clearing, phony displays of concern for the poor and cost-shifting shell games were necessary to make the numbers work. In the final analysis, the name of the game was inefficiency and consumers always paid for it – because there was nobody else who could pay.

So much for the vaunted institution of public-utility regulation in the public interest. Over fifty years ago, a famous left-wing economist named Gardiner Means proposed subjecting every corporation in the U.S. to rate-of-return regulation by the federal government. This held the record for most preposterous policy program advanced by a mainstream commentator – until Thomas Wheeler announced that henceforth the Internet would be regulated as if it were a public utility. Now every American will get a taste of life as Ivan Denisovich, consigned to the Gulag Archipelago of regulatory bureaucracy.

Of particular significance to us in today’s climate is the effect of this regime on innovation. Outside of totalitarian economies such as the Soviet Union and Communist China, public-utility regulation is the most stultifying climate for innovation ever devised by man. The idea behind innovation is to find ways to produce more goods using the same amount of inputs or (equivalently) the same amount of goods using fewer inputs. Doing this lowers costs – which increases profits. But why do to the trouble if you can’t enjoy the increase in profits? Of course, utilities were willing to spend money on research, provided they could get it in the rate base and earn a rate of return on the investment. But they had no incentive to actually implement any cost-saving innovations. The Bell System was legendary for its unwillingness to lower its costs; the economic literature is replete with jaw-dropping examples of local Bell companies lagging years and even decades behind the private sector in technology adoption – even spurning advances developed in Bell’s own research labs!

Any reader who suspects this writer of exaggeration is invited to peruse the literature of industrial organization and regulation. One nagging question should be dealt with forthwith. If the demerits of public-utility regulation were well recognized by insiders, how were they so well concealed from the public? The answer is not mysterious. All of those insiders had a vested interest in not blowing the whistle on the process because they were making money from ongoing public-utility regulation. Commission employees, consultants, expert witnesses, public-interest lawyers and consumer advocates all testified at rate hearings or helped prepare testimony or research it. They either worked full-time or traveled the country as contractors earning lucrative hourly pay. If any one of them was crazy enough to launch an expose of the public-utility scam, he or she would be blackballed from the business while accomplishing nothing – the institutional inertia in favor of the system was so enormous that it would have taken mass revolt to effect change. So they just shrugged, took the money and grew more cynical by the year.

In retrospect, it seems miraculous that anything did change. In the 1960s, local Bell companies were undercharging for local service to consumers and compensating by soaking business and long-distance customers with high prices. The high long-distance rates eventually attracted the interest of would-be competitors. One government regulator grew so fed up with the inefficiency of the Bell system that he granted the competitive petition of a small company called MCI, which sought to compete only in the area of long-distance telecommunications. MCI was soon joined by other firms. The door to competition had been cracked slightly ajar.

In the 1980s, it was kicked wide open. A federal antitrust lawsuit against AT&T led to the breakup of the firm. At the time, the public was dubious about the idea that competition was possible in telecommunications. The 1990s soon showed that regulators were the only ones standing between the American public and a revolution unlike anything we had seen in a century. After vainly trying to protect the local Bells against competition, regulators finally succumbed to the inevitable – or rather, they were overrun by the competitive hordes. When the public got used to cell phones and the Internet, they ditched good old Ma Bell and land-line phones.

This, then, is public-utility regulation. The only reason we have smart phones and mobile Internet access today is that public-utility regulation in telecommunications was overrun by competition despite regulatory opposition in the 1990s. But public-utility regulation is the wonderful fate to which Barack Obama, Thomas Wheeler and the FCC propose to consign the Internet. What is the justification for their verdict?

The Case for Net Neutrality – Debunked

As we have seen, public-utility regulation was based on a premise that certain industries were “natural monopolies.” But nobody has suggested that the Internet is a natural monopoly – which makes sense, since it isn’t an industry. Nobody has suggested that all or even some of the industries that utilize the Internet are natural monopolies – which makes sense, since they aren’t. So why in God’s name should we subject them to public-utility regulation – especially since public-utility regulation didn’t even work well in the industries for which it was ideally suited? We shouldn’t.

The phrase “net neutrality” is designed to achieve an emotional effect through alliteration and a carefully calculated play on the word “neutral.” In this case, the word is intended to appeal to egalitarian sympathies among hearers. It’s only fair, we are urged to think, that ISPs, the “gatekeepers” of the Internet, are scrupulously fair or “neutral” in letting everybody in on the same terms. And, as with so many other issues in economics, the case for “fairness” becomes just so much sludge upon closer examination.

The use of the term “gatekeepers” suggests that God handed to Moses on Mount Olympus a stone tablet for the operation of the Internet, on which ISPs were assigned the role of “gatekeepers.” Even as hyperbolic metaphor, this bears no relation to reality. Today, cable companies are ISPs. But they began life as monopoly-killers. In the early 1960s, Americans chose between three monopoly VHF-TV networks, broadcast by ABC, NBC and CBS. Gradually, local UHF stations started to season the diet of content-starved viewers. When cable-TV came along, it was like manna from heaven to a public fed up with commercials and ravenous for sports and movies. But government regulators didn’t allow cable-TV to compete with VHF and UHF in the top 100 media markets of the U.S. for over two decades. As usual, regulators were zealously protecting government monopoly, restricting competition and harming consumers.

Eventually, cable companies succeeded in tunneling their way into most local markets. They did it by bribing local government literally and figuratively – the latter by splitting their profits via investment in pet political projects of local politicians as part of their contracts. In return, they were guaranteed various degrees of exclusivity. But this “monopoly” didn’t last because they eventually faced competition from telecommunication firms who wanted to get into their business and whose business the cable companies wanted to invade. And today, the old structural definitions of monopoly simply don’t apply to the interindustry forms of competition that prevail.

Take the Kansas City market. Originally, Time Warner had a monopoly franchise. But eventually a new cable company called Everest invaded the metro area across the state line in Johnson County, KS. Overland Park is contiguous with Kansas City, MO, and consumers were anxious to escape the toils of Time Warner. Eventually, Everest prevailed upon KC, MO to gain entry to the Missouri side. Now even the cable-TV market was competitive. Then Google selected Kansas City, KS as the venue for its new high-speed service. Soon KC, MO was included in that package, too – now there were three local ISPs! (Everest has morphed into two successive incarnations, one of which still serves the area.)

Although this is not typical, it does not exhaust the competitive alternatives. This is only the picture for fixed service. Americans are now turning to mobile forms of access to the Internet, such as smart phones. Smart watches are on the horizon. For mobile access, the ISP is a wireless company like AT&T, Verizon, Sprint or T-Mobile.

The NN websites stridently maintain that “most Americans have only a single ISP.” This is nonsense; a charitable interpretation would be that most of us have only a single cable-TV provider in our local market. But there is no necessary one-to-one correlation between “cable-TV provider” and “ISP.” Besides, the state of affairs today is ephemeral – different from what is was a few years ago and from what it will be a few years from now. It is only under public-utility regulation that technology gets stuck in one place because under public-utility regulation there is no incentive to innovate.

More specifically, the FCC’s own data suggest that 80% of Americans have two or more ISPs offering 10Mbps downstream speeds. 96% have two or more ISPs offering 6Mbps downstream and 1.5 upstream speeds. (Until quite recently, the FCC’s own criterion for “high-speed” Internet was 4Mbps or more.) This simply does not comport with any reasonable structural concept of monopoly.

The current flap over “blocking and interfering with traffic on the Internet” is the residue of disputes between Netflix and ISPs over charges for transmission of the former’s streaming services. In general, there is movement toward higher charges for data transmission than for voice transmission. But the huge volumes of traffic generated by Netflix cause congestion, and the free-market method for handling congestion is a higher price, or the functional equivalent. That is what economists have recommended for dealing with road congestion during rush hours and congested demand for air-conditioning and heating services at peak times of day and during peak seasons. Redirecting demand to the off-peak is not a monopoly response; it is an efficient market response. Competitive bar and restaurant owners do it with their pricing methods; competitive movie theater owners also do it (or used to).

Similar logic applies to other forms of hypothetically objectionable behavior by ISPs. The prioritization of traffic, creation of “fast” and “slow” lanes, blocking of content – these and other behaviors are neither inherently good nor bad. They are subject to the constraints of competition. If they are beneficial on net balance, they will be vindicated by the market. That is why we have markets. If a government had to vet every action by every business for moral worthiness in advance, it would paralyze life as we know it. The only sensible course is to allow free markets and competition to police the activities of competitors.

Just as there is nothing wrong or untoward with price differentials based on usage, there is nothing virtuous about government-enforced pricing equality. Forcing unequals to be treated equally is not meritorious. NN proponents insist that the public has to be “protected” from that kind of treatment. But this is exactly what PUCs did for decades when they subsidized residential consumers inefficiently by soaking business and long-distance users with higher rates. Back then, the regulatory mantra wasn’t “net neutrality,” it was “universal service.” Ironically, regulators never succeeded in achieving rates of household telephone subscription that exceeded the rate of household television service. Consumers actually needed – but didn’t get – protection from the public-utility monopoly imposed upon them. Today, consumers don’t need protection because there is no monopoly, nor is there any prospect of one absent regulatory intervention. The only remaining vestige of monopoly is that remaining from the grants of local cable-TV monopoly given by municipal governments. Compensating for past mistakes by local government is no excuse for making a bigger mistake by granting monopoly power to FCC regulators.

Forbearance? 

The late, great economist Frank Knight once remarked that he had heard do-gooders utter the equivalent words to “I want power to do good” so many times for so long that he automatically filtered out the last three words, leaving only “I want power.” Federal-government regulators want the maximum amount of power with the minimum number of restrictions, leaving them the maximum amount of flexibility in the exercise of their power. To get that, they have learned to write excuses into their mandates. In the case of NN and Internet regulation, the operative excuse is “forbearance.”

Forbearance is the writing on the hand with which they will wave away all the objections raised in this essay. The word appears in the original Title II regulations. It means that regulators aren’t required to enforce the regulations if they don’t want to; they can “forebear.” “Hey, don’t worry – be happy. We won’t do the bad stuff, just the good stuff – you know, the ‘neutrality’ stuff, the ‘equality’ stuff.” Chairman Wheeler is encouraging NN proponents to fill the empty vessel of Internet regulation with their own individual wish-fulfillment fantasies of what they dream a “public-utility” should be, not what the ugly historical reality tells us public-utility regulation actually was. For example, he has implied that forbearance will cut out things like rate-of-return regulation.

This just begs the questions raised by the issue of “regulating the Internet like a public utility.” The very elements that Wheeler proposes to forbear constitute part and parcel of public-utility regulation as we have known it. If these are forborne, we have no basis for knowing what to expect from the concept of Internet public-utility regulation at all. If they are not, after all, forborne – then we are back to square one, with the utterly dismal prospect of replaying 20th-century public-utility regulation in all its cynical inefficiency.

Forbearance is a good idea, all right – so good that we should apply it to the whole concept of Internet regulation by the federal government. We should forbear completely.

DRI-241 for week of 11-9-14: The Birth of Public-Utility Regulation

An Access Advertising EconBrief:

The Birth of Public-Utility Regulation

Today’s news heralds the wish of President Obama that the Federal Communications Commission (FCC) pass strict rules ensuring that internet providers provide equal treatment to all customers. This is widely interpreted (as, for example, by The Wall Street Journal front-page article of 11/11/2014) as saying that “the Federal Communications Commission [would] declare broadband Internet service a public utility.”

More specifically, the Journal’s unsigned editorial of the same day explains that the President wants the FCC to apply the common-carrier provisions of Title II of the Communications Act of 1934. Its “century-old telephone regulations [were] designed for public utilities.” In fact, the wording was copied from the original federal regulatory legislation, the Interstate Commerce Act of 1887; the word “railroad” stricken and “telephone” was added to “telegraph.”

In other words, Mr. Obama wants to resurrect enabling regulatory legislation that is a century and a quarter old and apply it to the Internet.

We might be pardoned for assuming that the original legislation has been a rip-roaring success. After all, the Internet has revolutionized our lives and the conduct of business around the world. The Internet has become a way of life for young and old, from tribesmen in central Africa to dissidents from totalitarian regimes to practically everybody in developed economies. If we’re now going to entrust its fate to the tender mercies of Washington bureaucrats, the regulatory schema should presumably be both tried and true.

Public-utility regulation has been tried, that’s for sure. Was it true? And how did it come to be tried in the first place?

 

Natural Monopoly: The Party Line on Public-Utility Regulation

 

Public-utility regulation is a subset of the economic field known as industrial organization. Textbooks designed for courses in the subject commonly devote one or more chapters to utility regulation. Those texts rehearse the theory underlying regulation, which is the theory of natural monopoly. According to that theory, the reason we have (or had) regulated public utilities in areas like gas, electricity, telegraphs, telephones and water is that free competition cannot long persist. Regulated public utilities are greatly preferable to the alternative of a single unregulated monopoly provider in each of these fields.

The concept of natural monopoly rests on the principle of decreasing long-run average cost. In turn, this is based on the idea of economies of scale. Consider the production of various economic goods. All other things equal, we might suppose that as all inputs into the production process increase proportionately, the total monetary cost of production for each one might do so as well. Often it does – but not always. Sometimes total cost increases more-than-proportionately, usually because the industry to which the good belongs uses so much of a particular input that expansion bids up the input’s price, thereby increasing total cost more-than-proportionately.

The rarest case is the opposite one, in which total cost increases less-than-proportionately with the increase in output. Although at first thought this seems paradoxical, there are technical factors that occasionally operate to bring it about. One of these is the engineering principle known as the two-thirds rule. In certain applications, such as the thru-put in a pipeline or the contents of containers used by ocean-going freight vessels, the volume varies as the two-thirds power of the surface area of the surrounding enclosure. In other words, when the pipe grows larger and larger, the amount that can be transmitted through the pipe increases more-than proportionately. When the container is made larger, the amount of freight the container can hold increases more than proportionately. The economic implication of this technical law is far-reaching, since the production cost is a function of the size of the pipe or the container (surface area) while the amount of output is a function of the thru-put of the pipe or amount of freight (volume). In other words, this exactly describes the condition called “economies of scale,” in which output increases more-than-proportionately when all inputs are increased equally. Since average cost is the ratio of total cost to output, the fact that the denominator in the ratio increases more than the numerator causes the ratio to fall, thus producing decreasing average total cost.

Why does decreasing average cost create this condition of natural monopoly? Think of unit price as “average revenue.” Decreasing average cost allows a seller to lower price continuously as the scale of output increases. This is important because it suggests that the seller who achieves the largest scale of output – that is, grows faster than competitors – could undersell all others while still charging a viable price. The textbooks go on to claim that after driving all competitors from the field, the successful seller would then achieve an insurmountable monopoly and raise its price to the profit-maximizing point, dialing its output back to the level commensurate with consumer demand at that higher price. Rather than subjecting consumers to the agony of this pure monopoly outcome, better to compromise by settling on an intermediate price and output that allows the regulated monopolist a price just high enough to attract the financial capital it needs to build, expand and maintain its large infrastructure. That is the raison d’etre of public-utility regulation, which is accomplished in the U.S. by an administrative law process involving hearings and testimony before a commission consisting of political appointees. Various interest groups – consumers, the utility company, the commission itself – are legally represented in the hearings.

Why is the regulated price and output termed a “compromise?” The Public Utility Commission (PUC) forces the company to charge a price equal to its average cost, incorporating a rate of profit sufficient to attract investor capital. This regulatory result is intermediate between the outcomes under pure monopoly and pure competition. A profit-maximizing monopoly firm will always maximize profit by producing the rate of output at which marginal revenue is equal to marginal cost. The monopolist’s marginal revenue is less than its average revenue (price) because every change in price affects inframarginal units, either positively or negatively, and the monopolist is all too aware of its singular status and the large number of inframarginal units affected by its pricing decisions. Under pure competition, each firm treats price as a parameter and neglects the tiny effect its supply decisions have on market price; hence price and marginal revenue are effectively equal. Thus, each competitive firm will produce a rate of output at which price equals marginal cost, and the total output resulting from each of these individual firm decisions is larger – and the resulting market price is lower – than would be the case if a single monopoly firm were deciding on price and output for the whole market. The PUC does not attempt to duplicate this pure competitive price because it assumes that, under decreasing average cost, marginal cost is less than average cost and a price less than average cost would not cover all the utility firm’s costs. Rather than subsidize these losses out of public funds (as is commonly done outside of the U.S. and Canada

), the PUC allows a higher price sufficient to cover all costs including the opportunity cost of attracting financial capital.

How well does this theoretical picture of natural monopoly fit industrial reality? Many public-utility industries possess at least some technical features in common with it. Electric and telephone transmission lines, natural-gas pipelines and water pipe all obey the two-thirds rule. This much of the natural monopoly doctrine has a scientific basis. On the other hand, power generation (as opposed to transmission or transport) does not usually exhibit economies of scale. There are plenty of industries that are not regulated public utilities despite showing clear scale economies – ocean-going cargo vessels are one obvious case. This is enough to provoke immediate suspicion of the natural-monopoly doctrine as a comprehensive explanation of public-utility regulation. Suffice it to say that scale economies seldom dominate the production functions even of public-utility goods.

The Myth of the Birth of Public-Utility Regulation – and the Reality

 

In his classic article, (“Hornswoggled! How Ma Bell and Chicago Ed Conned Our Grandparents and Stuck Us With the Bill,” Reason Magazine, February 1986, pp. 29-33), author Marvin N. Olasky recounts the birth of public-utility regulation. When “angry consumers and other critics call for an end to [public-utility] monopolies, choruses of utility PR people and government regulators recite the same old story – once upon a time there was competition among utilities, but ‘the public’ got fed up and demanded regulation… Free enterprise in utilities lost in a fair fight.”

As Olasky reveals, “it makes a good story, but it’s not true.” It helps to superimpose the logic of natural monopoly theory on the scenario spun by the “fair fight” myth. If natural-monopoly logic held good, how would we expect the utility-competition scenario to deteriorate?

Well, the textbooks tell us that the condition of natural monopoly (decreasing long-run average total cost) allows one firm to undersell all others by growing faster. Then it drives rivals out of business, becomes a pure monopoly and gouges consumers with high prices and reduced output. So that’s what we would expect to find as our “fair-fight” scenario: dog-eat-dog competition resulting in the big dog devouring all rivals, then rounding on consumers, whose outraged howls produce the dog-catching regulators who kennel up the company as a regulated public utility. The problem with this scenario is that it never happened. It is nowhere to be found in the history books or contemporary accounts.

Oops.

Well, somebody must have said something about life before utility regulation. After all, it was only about a century ago, not buried in prehistory. If events didn’t unfold according to textbook theory, how did public-utility regulation happen?

Actually, conventional references to the pre-regulatory past are surprisingly sparse. More to the point, they are contradictory. Mostly, they can be grouped under the heading of “wasteful competition.” This is a very different story than the one told by the natural monopoly theory. It maintains that competitive utility provision was a prodigal fiasco; numerous firms all vying for the same market by laying cable and pipe and building transmission lines. All this superfluous activity and expenditure drove costs – and, presumably, prices – through the roof. Eventually, a fed-up public put an end to all this competitive nonsense by demanding relief from the government. This is the scenario commonly cited by the utility PR people and regulators, who care little about theory and even less about logical consistency. All they want is an explanation that will play in Peoria, meeting whatever transitory necessity confronts them at the moment.

Fragmentary support for this explanation exists in the form of references to multiply suppliers of utility services in various markets. In New York City, for example, there were six different electricity franchises granted by one single 1887 City Council resolution. But specific references to competitive chaos are hard to come by, which we wouldn’t expect if things were as bad as they are portrayed.

Could such a situation have arisen and persisted for the 20-40 years that filled the gap between the development of commercial electricity and telephony and the ascendance of public-utility regulation in the decade of the 1920s? No, the thought of competitive firms chasing their tails up the cost curve and losing money for decades is implausible on its face. Anyway, we have gradually pieced together the true picture.

The Reality of Pre-Regulatory Utility Competition

 

Marvin Olasky pinpoints 1905 as a watershed year in the sage of public utilities in America. That year a merger took place between two of the nation’s largest electric companies, Chicago Edison and Commonwealth Electric. Olasky cites a 1938 monograph by economist Burton Behling, which declared that prior to 1905 the market for municipal electricity “was one of full and free competition.” Market structure bore a superficial resemblance to cable television today in that municipalities assigned franchise rights for service to corporate applicants, the significant difference being that “the common policy was to grant franchises to all who applied” and met minimum requirements. Olasky describes the resulting environment as follows: “Low prices and innovative developments resulted, along with some bankruptcies and occasional disruption of service.”

That qualification “some bankruptcies and occasional disruption of service” raises no red flags to economists; it is the tradeoff they expect to encounter for the benefits provided by low prices and innovation. But it is integral to the story we are telling here. The anecdotal tales of dislocation are the source of the historical scare stories told by later generations of economic historians, utility propagandists and left-wing opportunists. They also provided contemporaneous proponents of public-utility regulation with ammunition for their promotional salvos.

Who roamed the utility landscape during the competitive years? In 1902, America Bell Co. had about 1.3 million subscribers, while the independent companies who competed with it had over 2 million subscribers altogether. By 1905, Bell’s industry leadership was threatened sufficiently to inspire publication of a book entitled How the Bell Lost its Grip. In Toledo, OH, an independent company, Home Telephone Co., began competing with Bell in 1901. It charged rates half those of Bell. By 1906, it had 10, 000 subscribers compared to 6,700 for the local Bell Co. In the states of Nebraska and Iowa, independent company subscribers outnumbered those of Bell by 260,000 to 80,000. Numerous cities held referenda on the issue of granting competitive franchises for telephone service. Competition usually won out. In Portland, OR, the vote was 12,213 to 560 in favor of granting the competitive franchise. In Omaha, NE, the independent franchise won by 7,653 to 3,625. A national survey polled 1,400 businessmen on the issue; 1,245 said that competition had or could produce better phone service in their community. 982 said that competition had forced their Bell company to improve its service.

Obviously, one option open to the Bell (and Edison electric) companies was to cut prices to meet competition. But because Bell and Edison were normally the biggest company in a city or region, with the most subscribers, this price cut was much more costly to them than it was to a smaller independent because the big company had so many inframarginal customers. Consequently, these leading companies looked around for alternative ways of dealing with pesky competitors. The great American rule of thumb in business is: If you can’t beat ’em, join’em; if you can’t beat ’em or join ’em, bar ’em.

The Deadly Duo: Theodore Vail and Samuel Insull

 

Theodore Vail was a leading America business executive of the 19th century. He was President of American Bell from 1880 to 1886, and then later rejoined the Bell system when he became an AT&T board member in 1902. Vail commissioned a city-by-city study of Bell’s competitive position. It persuaded him that Bell’s business strategy needed overhauling. Bell’s corporate position had been that monopoly was the only technically feasible arrangement because it enabled telephone users in different parts of a city and even different cities to converse. As a company insider conversant with the latest advances, Vail knew that this excuse was wearing thin because system interconnections were even then becoming possible. Competition was eating into Bell’s market share already, and with interconnection on the horizon Vail knew that Bell’s supremacy would vanish unless it was revitalized.

The idea Vail hit upon was based upon the strategy employed by the railroads about fifteen years earlier. In order to win public acceptance for the special government favors they had received, the roads commissioned puff pieces from free-lance writers and bribed newspaper and magazine editors to print them. Vail expanded this technique into what later came to be called “third-party” editorial services; he employed companies for the sole purpose of producing editorial matter glorifying the Bells. One firm earned over $100,000 from the Bell companies while simultaneously earning $84,000 per year to place some 13,000 favorable articles annually about electric utilities. (These usually appeared as what we would now call “advertorials” – unsigned editorials containing citing no source.) The companies did not formally acknowledge their link with utilities, although it was exposed in investigative works such as 1931’s The Public Pays by Ernest Gruening.

Vail combined this approach with another original tactic borrowed from the railroads – the pre-emptive embrace of government regulation. Political scientist Gabriel Kolko provided documentation for his thesis that the original venture in federal-government regulation, the Interstate Commerce Commission Act of 1887, was sponsored by the railroads themselves as a means of cartelizing the industry and suppressing the troublesome competitive forces that had bankrupted one railroad after another by producing price wars and persistent low rates for freight. The public uproar over differential rates for long hauls and short hauls gave both railroads and regulators the necessary excuse to claim that competition had failed and only regulation could provide “just and reasonable rates.” Not surprisingly, the regulatory solution was to impose fairness and equality by requiring railroads to raise the rates for long hauls to the level of short-haul rates, so that all shippers now paid equal high rates per-mile.

Vail was desperate to suppress competition from independent phone companies, but knew that he would then face the danger of lawsuits under the embryonic Sherman Antitrust Act, which contained a key section forbidding monopolization. The only kind of competition Vail approved of was “that kind which is rather ‘participation’ than ‘competition,’ and operates under agreement as to prices or territory.” That is, Vail explicitly endorsed cartelization over competition. Unfortunately, the Sherman Act also contained a section outlawing price collusion. Buying off the public was clearly not enough; Vail would have to stave off the federal government as well. So he sent AT&T lobbyists to Washington, where they successfully achieved passage of legislation placing interstate telephone and telegraph communications under the aegis of the ICC.

Vail feared competition, not government. He was confident that regulation could be molded and shaped to the benefit of the Bells. He knew that the general public and particularly his fellow businessmen would take a while to warm up to regulation. “Some corporations have as yet not quite got on to the new order of things,” he mused. By the time Vail died in 1920, that new order had largely been established thanks to the work of Vail’s contemporary, Samuel Insull.

Insull emigrated from England in 1881 to become Thomas Edison’s secretary. He rose rapidly to become Edison’s strategic planner and right-hand man. At Edison’s side, Insull saw firsthand the disruptive effects of innovation on markets when competition was allowed to function. Insull made a mental note not to let himself become the disruptee. With Edison’s blessing, Insull took the reins of Chicago Edison in 1892. His tenure gave him an education in the field of politics to complement the one Edison had given him in technology. In 1905, he merged Chicago Edison with Commonwealth Electric to create the nation’s leading municipal power monopoly.

Like Vail, Insull recognized the threat posed by marketplace competition. Like Vail, Insull saw government as an ally and a tool to suppress his competitors. Insull’s embrace of government was even warmer than Vail’s because he perceived its vital role to be placating and anesthetizing the public. As Olasky put it, “Insull argued that utility monopoly… could best be secured by the establishment of government commissions, which would present the appearance of popular control.”

The commission idea would be sold to the public as a democratic means of establishing fair utility rates. Sure, these rates might be lower than the highest rates utility owners could get on their own, but they would certainly be higher than those prevailing with competition. And the regulated rates would be stable, a sure thing, not the crap shoot offered by the competitive market. In a 1978 article in the prestigious Journal of Law and Economics, economic historian Gregg Jarrell documents that the first states to implement utility regulation saw rising prices and profits and falling utility output, while states that retained competitive utility markets had lower utility prices. Jarrell’s conclusion: “State regulation of electric utilities was primarily a pro-producer policy.”

Over the years, this trend continued, even though utility competition died off almost to the vanishing point. Yet it remained true that those few jurisdictions that allowed utility competition – usually phone, sometimes electric – benefitted from lower rates. This attracted virtually no public attention.

Insull realized that the popularity of competition was just as big an obstacle as its reality in the marketplace. So he slanted his public-relations to heighten the public’s fear of socialism and promote utility regulation as the alternative to a government-owned, socialized power system. Insull foresaw that politicians and regulators would need to use the utility company as a whipping boy by pretending to discipline it severely and accusing it of cupidity and greed. This would allow government to assume the posture of a stern guardian of the public welfare and champion of the consumer – all the while catering to the utility’s welfare behind closed doors. Generations of economists became accustomed to seeing this charade performed at PUC hearings. Their cynicism was tempered by the fact that these same economists were earning handsome incomes by specializing as consultants to one of the several interested parties at those hearings. Over the years, this iron quadrangle of interested parties – regulators, lawyers, economists and “consumer advocates” – became the staunchest and most reliable defender of the public-utility regulation process. Despite the fact that these people were in the best position to appreciate the endless waste and hypocrisy, their self-interest blinded them to it.

Insull enthusiastically adopted the promotional methods pioneered by the railroads and imitated by Theodore Vail. One of his third-party firms, the Illinois Committee on Public Utility Information, was led by Insull subordinate Bernard J. Mullaney. The Committee distributed 5 million pieces of pro-utility literature in the state in 1920 and 1921. Mullaney carefully cultivated the favors of editors by feeding them news and information of all kinds in order to earn a key quid pro quo – publication of his press releases. This favoritism went as far as providing the editors with free long-distance telephone service as an in-kind bribe. Not to be overlooked, of course, is that most traditional of all shady relationships in the newspaper business – buying ads in exchange for preferential treatment in the paper. Electric companies, like the Bells, were prodigious advertisers and took lavish advantage of it. In eventual hearings held by the Federal Trade Commission and the Federal Communications Commission, testimony and exhibits revealed that Bell executives had newspaper editors throughout the West and Midwest in their pockets.

Over the years, as public-utility regulation became a respected institution, the need for big-ticket PR support waned. But utilities never stopped cultivating political support. The Bell companies in particular bought legislators by the gross, challenging teachers’ unions as the leading political force in statehouses across the nation. When the challenge of telecommunications deregulation loomed, the Bells were able to stall it off and postpone its benefits to U.S. consumers for a decade longer than those enjoyed abroad.

Profit regulation left utilities with no profit motive to innovate or cut costs. This caused costs to inflate like a hot-air balloon. Sam Insull realized that he could make a healthy profit by guaranteeing his market, killing off his competition and writing his profit in stone through regulation. Then he could ratchet up real income by “gold-plating the rate base” – increasing salaries and other costs and forcing the ratepayers to pay for them. Ironically, he ended up going broke despite owning a big portfolio of utilities. He borrowed huge sums of money to buy them and expand their operations. When the Depression hit, he found that he couldn’t raise rates to service the debt he had run up. He was indicted, left the country, returned to win acquittal on criminal charges but died broke from a heart attack – just one more celebrated riches-to-rags Depression-era tale.

The lack of motivation made utilities a byword for inefficiency. Bell Labs invented the transistor, but AT&T was one of the last companies to use it because it still had vacuum tubes on hand and had no profit motivation to switch and no competitive motivation to serve its customers. An AT&T company made the first cell phone call in 1946, but the technology withered on the vine for 40 years because the utility system had no profit motivation to deploy it. Touch-tone dialing was invented in 1941 but not rolled out until the 1970s. Bell Labs developed early high-speed computer modems but couldn’t test high-speed data transmission because regulators hadn’t approved tariffs (prices) for data transmission. The list goes on and on; in fact, the entire telecommunications revolution began by accident when a regulator became so fed up with AT&T’s inefficiency that he changed one regulation in the 1970s and allowed one company called MCI to compete with the Bells. (We owe Andy Kessler, longtime AT&T employee and current hedge-fund manager, for this litany of innovative ineptitude.)

What is Net Neutrality All About?

 

Today, the call for “net neutrality” by politicians like President Obama is a political pose, just as the call for public-utility regulation was a century ago. Robert Litan of the
Brookings Institution has pointed out the irony that slapping a Title II common-carrier classification on broadband Internet providers would not even prevent them from practicing the paid prioritization of buyers that the President complained of in his speech! Indeed, for most of the 20th century, public utilities practiced price discrimination among different classes of buyers in order to redistribute income from business users to household users.

The Internet as we know it today is the result of an unimpeded succession of competitive innovations over the last three decades; i.e., the very “open and free Internet” that the New York Times claims President Obama will now bestow upon us. Net neutrality would bring all this to a screeching halt by imposing regulation on most of the Web and taxes on consumers. Today, the biggest chunk of phone bills goes to pay for a charge for “universal service,” a redistributive tax ostensibly intended to make sure everybody had phone service. Yet before the proliferation of cell phones, the percentage of the U.S. population owning televisions – which were unregulated and benefitted from no “universal service” tax – was several percentage points higher than the percentage owning and using telephones. In reality, the universal service tax was used to perpetuate the regulatory process itself.

In summary, then, the balance sheet on public utilities shows they were plotted by would-be monopolists to stymie competition and enlist government and regulators as co-conspirators. The conspiracy stuck consumers with high prices, reduced output, mediocre service, high excise taxes and – worst of all – stagnant innovation for decade after decade. All this is balanced against the dubious benefit of stability – the sort of stability the U.S. economy has shown in the last five years.

A similar future awaits us if we treat the Internet’s imagined ills with the regulatory nostrum called net neutrality.