More Observations From CES…

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One of the major stories that came out of CES last week was (in the words of the Wall Street Journal) the “flood” of new Internet content and mobile devices reaching consumers’ living rooms.  In fact, this has been the story coming out of CES for the past few years.  Given such developments, it continues to puzzle me not only that the FCC refuses to announce, at least formally, that it intends to drop its ill-conceived AllVid paradigm, but that it also refuses to announce that it intends to seek to sunset Section 629 of the Communications Act altogether.

By way of quick background, Section 629 was designed to create a secondary market for set-top boxes so that consumers could simply choose to go to Best Buy and purchase their own box rather than rent their box from their cable provider.  There were a number of significant hurdles in the way of implementation, however, such as copyright issues, security concerns, diversity in network design technology, and so forth.  Setting up a retail market for a portable “plug and play” set-top box proved much harder than expected.

The Commission’s first attempt to implement Section 629 was the ill-fated CableCard experiment, which—by the Commission’s own admission—was a dismal failure, leading to increased prices and reduced network deployment.  In fact, according to one report, the FCC’s CableCard experiment wasted in excess of $1 billion with little to show for it.

Yet, not satisfied with its billion dollar policy dud, the Commission in its National Broadband Plan proposed an aggressive new “AllVid” regime, whereby the agency would mandate multichannel video program distributors (“MVPDs”) and satellite companies to provide an adapter to serve as a “common interface for connection to televisions, DVRs, and other smart video devices.”  Sound familiar?  It should.  The AllVid scheme was essentially the same plan as the failed CableCARD approach, but even more heavy handed.  “The burnt Fool’s bandaged finger goes wobbling back to the fire.”

While AllVid, like CableCard before it, may sound like a nifty idea, there was a glaring absence in the FCC’s efforts: the FCC never bothered to conduct any formal economic analysis of the nature of the service-equipment relationship in the MVPD market.  In other words, the agency never bothered to check if there was some significant defect in the incentives of cable providers that needed to be remedied by regulation, or whether regulation had any hope of improving matters.  It is no wonder their efforts have failed to date.

Given the Commission’s failure, in a paper entitled Wobbling Back to the Fire:  Economic Efficiency and the Creation of a Retail Market for Set-Top Boxes, we looked at the economics of the problem, and our findings were significant.

First, contrary to populist sentiments, our theoretical analysis revealed that the set-top box conveys no additional market power to the MVPD.  Thus, fiddling with the equipment market is not going to benefit consumers in any material way.

Second, again contrary to populist sentiments, our analysis indicates that the MVPD has no anticompetitive preference for self-supply.  If the equipment can be produced more efficiently and sold at a lower price in a competitive retail market, then the provider will embrace such a market.  The profits of the cable provider are maximized when the equipment is efficiently provided.  If we observe that the equipment is provided by the operators alone, then the presumption should be that this is the most efficient arrangement, even if imperfect in some way.

Third, we show that a government-directed commercial market for set-top boxes is unlikely to provide substantial gains in terms of lower costs, lower prices, or increased innovation.  As noted a moment ago, if the set-top box can be made cheaper and sold at a lower price, or made better and sold at the same price, then the MVPD will embrace these changes—profits would be higher.  In sum, MVPD profits and consumer surplus are aligned in this case.

So, stated another way, the commercial market envisioned by Section 629 is an inefficient market organization, and markets abhor inefficiency.  Thus, if the Commission forces its own view of a commercial market for equipment on the video industry, its efforts will fail.  The market—that is, buyers and sellers—is working against the scheme because it is inefficient.  Until the underlying economic reality changes, perhaps due to some technological innovation, attempts to implement Section 629 (CableCard, AllVid, etc.) are futile.

Given the above, is there a compelling policy reason for the Commission to continue with its quixotic attempt to try to develop a commercial retail market for set-top boxes?  Clearly no.  Indeed, the FCC has repeatedly conceded that its “separable security” approach to Section 629 is an uncontested failure; to try again with AllVid seems, at this point, to be the triumph of hope over experience.  Moreover, the video market is presently undergoing substantial transformation and experiencing rapid innovation and, as such, the timing for a regulatory-mandated technology standard could not be worse.  Similarly, forcing a commercial retail market for set-top equipment by regulatory fiat is arguably poorly motivated because providers have no demonstrated anti-competitive incentives with regard to the set-top box (to the contrary, MVPDs are strongly motivated to provide low-cost, high-feature set top equipment to consumers) and regulation is unlikely to lower price, improve quality, or increase innovation.  Heck, the Commission has even repeatedly acknowledged that its CableCARD rules increase prices and reduce network deployment.  Like it or not, until the underlying economic reality changes, the FCC’s anticipated aggressive approach to Section 629 is likely—as FCC Commissioner Robert McDowell notes—to keep the agency in “the Valley of Unattained Goals”  Section 629 has clearly (in the words of President Obama) “outlived its usefulness.”

Accordingly, if the Commission really wants to show that it is committed to removing outdated and costly rules, it is time for it to invoke the sunset provisions of Section 629 and end this debacle right now.  While the language of Section 629(e) is, admittedly, somewhat inartfully drafted, in a paper we wrote entitled Outliving its Usefulness: A Law and Economics Argument for Sunset of Section 629 we set forth what we believe to be sound economic, legal and evidentiary arguments to support a sunset of Section 629 under that section’s unique statutory provisions.  As we show in our paper, sunset hinges on the definition of “fully competitive” which, unfortunately (or fortunately, depending how you look at it), is not defined in the statute.  Looking to other portions of the statute, the economic literature and FCC jurisprudence for guidance, we proposed that the agency define “fully competitive” as a condition where market forces are sufficiently strong to eliminate the need for government regulation.  While space and time constraints prevent a full review of our paper’s findings here, using this definition we find that that there is a plausible legal and evidentiary case for sunset.  Given such an opportunity, the Commission should quickly take it.