A Fresh Analytical Start at the FCC…

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The Federal Communications Commission is at a crossroads.  Burdened with implementing laws designed for a market structure of a bygone era—and with little prospect of a comprehensive legislative update on the horizon—incoming FCC Chairman Tom Wheeler faces a daunting task to adapt and modernize the agency’s approach to regulation so that we can remove, in President Obama’s words, those rules which have “outlived their usefulness.  Equally as important, Mr. Wheeler has the related and no less daunting task of re-establishing the FCC’s credibility with the industry, Capitol Hill, the courts and (most importantly) the public as the “expert” agency which not only uniquely understands the complex economics of communications industries, but also knows how and when to apply this knowledge to achieve Congress’s (sometimes incompatible) policy goals as articulated in the Communications Act.  While the list is long as to where Mr. Wheeler could start, Mr. Wheeler should begin by having the agency “step-up” its analytical game, being motivated by its legal obligation to implement its own statutory mandate and not the mandate applicable to other agencies.  This means that any analytical “re-boot” will require Mr. Wheeler to resist calls to adopt the boilerplate competitive analysis used by the Department of Justice and the Federal Trade Commission.

But in the words of the late/great Dean Martin, “Hold on there, Professor.”  Isn’t a call for a rejection of the widely-accepted traditional antitrust-type of market power analysis just a little bit strange?  Actually, the answer is “no.”  As my paper entitled Separating Politics from Policy in FCC Merger Reviews: A Basic Legal Primer of the “Public Interest” Standard amply demonstrates, it is black letter law that all the FCC must do, in the exercise of its responsibilities, is “make findings related to the pertinent antitrust policies, draw conclusions from the findings, and weigh these conclusions along with other important public interest considerations.  (Emphasis supplied.)  The FCC is a regulator, not an antitrust authority, so the textbook antitrust-type of analysis does not answer the fundamental question before the agency—i.e., the FCC must inquire not only about the state of competition, if relevant, but also about whether a welfare-enhancing regulatory solution to any observed problem is feasible.    Accordingly, if the FCC is to modernize itself successfully, then the question the FCC must ask is not whether market power is present per se, but whether the costs of further regulatory intervention exceed the benefits.  

For example, it is entirely legitimate for the FCC to decide that no feasible regulatory solution exists, whether there is market power or not.  The Commission may also conclude that consumers are better served by fewer competitors than many (see, e.g., the FCC’s recent efforts to hold a reverse auction for universal service support)—an option that is completely foreign to the head-counting antitrust agencies who generally believe that more firms automatically equal lower prices.  We must all remember that the FCC regulates industries that typically have very high fixed and sunk costs, and this often leads to relatively concentrated equilibrium market structures.  Indeed, the agency was created, in part, to deal with problems of natural monopoly, and to allocate very scarce resources (spectrum) among industry players.  Price will typically exceed marginal cost in such markets, in some cases by a large margin, but this need not be a sign of poorly functioning market.  Markups are required for survival.  However, even though few competitors are likely to be the norm in communications markets, given the high fixed and sunk costs required for entry, few firms may actually be an indication of intense competition.  The antitrust authorities aren’t setup to deal with relatively few competitors, and they certainly don’t know how to deal with markets that no firm wishes to serve, but this is the routine reality at the FCC.  In the 1992 Cable Act, for example, the FCC is required to deregulate the prices of cable television operators in any market where the Hirschman-Herfindahl Index or “HHI” is less than or equal to 7,450.  In contrast, the DOJ has convulsions if the HHI isn’t less than 2,500.  As a result, the case law makes clear that the FCC is entirely free to disregard the Department of Justice’s recommendation when circumstances warrant.  (See, e.g., the seminal case of U.S. v. FCC, where the Department of Justice tried to block a satellite joint venture but the FCC allowed it to proceed.)

Let me give you just two recent examples where I think the FCC should have “sown their own oats” in this regard.

AT&T/T-Mobile Merger:  Whether or not the AT&T and T-Mobile merger should have been permitted to proceed is debatable.  I pass no judgment on the decision itself, but do not reserve judgment for the analytical methods of the DOJ and the FCC.  Using a standard Merger Guidelines antitrust analysis, the DOJ (with help from the FCC), blocked the merger between AT&T and T-Mobile.  As we demonstrated in our published paper Wireless Competition Under Spectrum Exhaust, the DOJ failed to model the effect of a capacity constraint (i.e., spectrum exhaust) on industry structure and performance (though they readily admit the industry has a capacity shortage).  Because they did not do the analysis, we did it for them, and our analysis showed that using the standard Cournot model of competition, a capacity constraint turns the standard antitrust analysis on its head—that is, under spectrum exhaust, fewer firms produce lower prices and more investment.   Even so, my frustration does not necessarily lie with the DOJ (after all, I expect them to follow the narrow-minded Merger Guidelines approach to mergers), but with the FCC who—as the expert agency over spectrum policy—should have recognized the need for such an analysis but did not conduct one.  Instead, by its own admission, the agency opted for the “traditional structural analysis used to apply the antitrust laws.”  In fact, the FCC’s “traditional” merger analysis—with its standard “small but significant and non-transitory increase in price” or “SSNIP” analysis—was more DOJ-like than the DOJ’s own review of the proposed merger.  (Notably, the economic theory supporting the SSNIP analysis is not valid under spectrum exhaust, so the FCC’s analysis of the merger was off-base in nearly every regard.)  Not to beg the question, but if the FCC brings nothing innovative to the table and instead opts to replicate the kind of static analysis used by the antitrust enforcement agency, then what’s the point of having dual review with an agency with unique expertise?  There isn’t, and that largely explains and legitimizes the complaints against the Commission, and justifies the barrage of proposals to shift the FCC’s job to the antitrust agencies.

Phoenix Forbearance Order:  Perhaps the most egregious case study I can provide where the FCC inappropriately used an antitrust-type of analysis is the agency’s Phoenix Forbearance Order.  There, applying a textbook antitrust analysis (and I use the term textbook pejoratively), the FCC imposed a new “market power” test to determine whether Qwest should be granted forbearance of certain unbundling obligations in the Phoenix metropolitan statistical area.  As we detailed extensively in our paper The Impossible Dream: Forbearance After the Phoenix Order, under the FCC’s new forbearance threshold, petitioners must show that price equals marginal cost in order to obtain regulatory relief.  Such a standard has no place in communications regulation.  Given the fundamental economics of the communications markets (high fixed/sunk costs, low marginal cost), that standard is impossible to satisfy in most (if not all) communications markets—price must exceed marginal cost. 

Section 10 forbearance is an excellent example of why the FCC can’t get lazy and sit on its antitrust haunches.  First, Section 10(a)(3) mandates that the Commission explicitly consider the “public interest” implications of its regulations.  Second, and more importantly for the present discourse, Section 10(b) requires the Commission to “consider whether forbearance from enforcing the provision or regulation will promote competitive market conditions.”  Plainly, Congress believes that the Commission’s regulation may actually be interfering with the development of a competitive market. The Commission’s antitrust approach to forbearance in the Phoenix Forbearance Order effectively ignored Section 10(b), since the agency ignored the possibility that the alleged lack of competition may the result of regulation, not a justification for it.  Forbearance under Section 10 requires a far more subtle and complex analysis than an antitrust-type of approach is capable of—this is the realm of the expert agency.  The FCC needs to step up into its assigned role and set aside its antitrust envy.  The agency’s mandate is bigger than antitrust.

What’s worse is that the Commission’s narrow antitrust approach in the Phoenix Forbearance Order leaves the industry in a lurch.  As we all know, we are undergoing the difficult task of trying to develop a cohesive analytical framework to facilitate the IP Transition.  By adopting its flawed “market power” standard for forbearance, however, the Phoenix Forbearance Order effectively renders the Commission’s most potent deregulatory tool in its arsenal—the forbearance provisions of Section 10—moot.  Accordingly, while I realize the agency is generally reluctant to reverse itself—particularly when it was upheld in court—replacing the “market power” standard in the Phoenix Forbearance Order with a standard that focuses appropriately on the costs and benefits of retaining regulation, and using a more realistic standard for competitive outcomes in the industry, is an excellent place to start.

Of course, words must be translated into deeds.  While the preceding discussion provides two tangible examples where the Commission took the wrong course, I now present for consideration two other examples where Mr. Wheeler has an immediate opportunity to right the ship upon taking office.  I outline them briefly below:

Special Access:  Last summer, the FCC released a Report and Order that would suspend, on an “interim” basis, its rules for automatic grants of pricing flexibility for special access services “in light of significant evidence” that the current deregulatory trigger—i.e., two competitors have collocated in a single Metropolitan Statistical Area (“MSA”)—is “not working as predicted.”  The Commission concedes that it “currently lack[s] the necessary data to identify a permanent replacement approach to measure the presence of competition for special access services”, so it issued a comprehensive data request (although according to a recently released document, “comprehensive” apparently means excluding cable companies).  Yet, with this data, the agency stated that it intends to “undertake a robust market analysis to assist us in determining how best to assess the presence of actual and potential competition for special access services that is sufficient to discipline prices.”  So, once again, the Commission is again seeking to use a traditional antitrust “market analysis” (i.e., head counts) to measure the level of competition as a bellwether of whether or not the FCC should grant pricing flexibility.  This is not its job; its job is to determine whether or not the benefits of regulation exceed the costs. 

There is good reason, especially in the Special Access case, to suspect that regulation will be unfruitful.  As we pointed out in our 2009 paper entitled Market Definition and the Economic Effects of Special Access Price Regulation, if geographic markets are “location specific” and supplied by a monopolist as the proponents of regulation claim, then price regulation of high capacity circuits reduces economic welfare in all instances.  Even with monopoly supply, regulation offers no improvement in economic welfare, meaning the debates over the extent of competition and profit margins in such markets are irrelevant. As we showed, the effect of regulation is mostly to transfer profits from sellers to buyers, so the special access debate appears to be largely a “quibble over rents.”  

Incentive Auctions:  Perhaps the single most pressing issue facing Mr. Wheeler is bringing the voluntary incentive auctions mandated by the Middle Class Tax Relief and Jobs Creation Act of 2012 (the “Spectrum Act”) over the goal line.  Not only is this auction widely recognized as the most complicated ever attempted, but Congress expects a hefty payday to cover the costs of repacking, FirstNet and deficit reduction.  In addition to the profound complexities of auction design and the band plan, there is a nasty fight underway over who actually gets to participate in the auction.  For example, the DOJ wants the FCC to rig the auction in favor of smaller firms, but as we show in our paper Equalizing Competition Among Competitors:  A Review of the DOJ’s Spectrum Screen Ex Parte Filing (as well as in Phoenix Center Chief Economist George Ford’s colloquy with former DOJ Chief Economist Jonathan Baker), the DOJ’s proposed intervention was long on self-promotion but remarkably short on economic legitimacy.  As just two easy examples, we first showed that the DOJ’s notion of “foreclosure value” is not a sufficient justification for designing the auction to favor Sprint and T-Mobile (as the DOJ wants the FCC to do); instead, the efficiency of an auction’s outcome should be based on relative “use value”—i.e., the present value of the future profits attributable to the use of new spectrum—and there are good reasons to suspect the use value of larger carriers exceeds that of smaller carriers. Contrary to the DOJ’s unsupported assertions, therefore, we showed that, using the antitrust agencies’ benchmark model of competition, consumers are better off when all potential bidders—including the larger carriers—are able to obtain spectrum in open auctions.  We also demonstrated that the DOJ’s proposal is inconsistent with its own depiction of how competition functions in the wireless market.  Indeed, while the DOJ continued to cling to a textbook theory that more firms automatically equal lower prices, the DOJ simultaneously conceded that U.S. mobile wireless firms are currently facing spectrum exhaust.  As noted above, research shows that when wireless firms face spectrum exhaust, an increase in the number of firms may actually lead to higher prices and lower quality.  Accordingly, when drafting the final auction rules, incoming FCC Chairman Wheeler has the opportunity not only to conduct the competitive analysis better than the DOJ but also to ask the right questions to reflect the agency’s broader statutory objectives. 

In sum, public confidence in government institutions—be it the Executive Branch, the Congress, the courts, or even independent regulatory commissions such as the FCC—is key to a functioning society and a market-based economy.  However, this confidence must be earned and, as such, it is not unreasonable to demand more responsible policymaking from the expert agency charged with implementing the nation’s communications laws.  As noted above, while the agency is burdened with implementing laws designed for a market structure of a bygone monopoly era, due to the inherent economics of the business, “few” firms will (for the foreseeable future) be the rule.  Accordingly, if we are truly going to achieve Congress’ stated desire of a “pro-competitive” and “deregulatory” communications marketplace, then the Commission is going to have to employ a more innovative analysis than a hum-drum “antitrust-type” approach can provide.  The FCC must be an expert in the economics of markets characterized by few firms (often burdened by Congress with significant social obligations), not markets characterized by many firms.

Fortunately, Mr. Wheeler brings a depth of experience to the job we have not seen in a generation and, if recent press reports prove true, he intends to bring a seasoned and well-respected team of communications personnel with him.  Let’s hope Mr. Wheeler and his leadership team will use their knowledge and experience, sprinkled with a little wisdom and restraint, to restore confidence in the FCC’s decisionmaking.

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