Economics Makes a Welcome Return in the Forthcoming BDS Order…

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As part of his efforts to increase transparency at the Federal Communications Commission, Chairman Ajit Pai recently posted a draft order in advance of this week’s April Open Meeting which purports largely to deregulate Business Data Services (“BDS”)—also known as Special Access services—in areas where incumbent providers face competition.  While Chairman Pai’s predecessor, Tom Wheeler, sought to substantially expand the regulation of BDS, his efforts were frustrated by a record (including his own outside peer review) that did not support his penchant for aggressive regulatory action.  Rather than fight economic theory and the available evidence, the Draft Order reveals that Chairman Pai is embracing them both and choosing instead a more deregulatory path.

Setting aside the particulars of the new rules (which have not been voted on yet), I’m hopeful that the conceptual underpinnings of the Draft Order signal a watershed in how the Commission makes policy.

First, in determining when and when not to regulate, the Draft Order asks the right question.  As detailed in my paper Section 10 Forbearance: Asking the Right Questions to Get the Right Answers, deciding whether to deregulate a service involves a single, simple question: is society made worse off if a regulation is eliminated?  The Draft Order embraces this correct approach, choosing a deregulatory threshold “that will be more effective than our legacy regulatory regime in ensuring rates, terms, and conditions are just and reasonable (¶ 111).”  Choosing to regulate or deregulate depends only on whether the regulations are beneficial (on net) under actual market conditions, whatever those conditions may be.  Comparing the actual state of competition to some desired (and perhaps unrealistic) level of competition has no bearing on the decision; the Commission does not choose the level of competition, it chooses whether to regulate.

Second, the Draft Order adopts a more sophisticated and accurate view of the economics of telecommunications markets than the Commission has used in the past.  Citing Phoenix Center research and embracing the standard definition, the Draft Order defines market power to exist when “pricing exceed competitive levels (¶ 14).”  When fixed/sunk costs are high, the number of competitors will be relatively small, since firms only enter when there are profits.  Still, absent collusion, a few competitors render the competitive price for the given supply- and demand-side conditions, and it is this competitive price (and not marginal cost pricing) that is the relevant standard for measuring market power in telecommunications market.  As the Draft Order recognizes (at ¶ 117), holding out for four or five competitors in a market than can, given demand and costs, can support only two is permitting wishful thinking to drive policy.

Third, in light of the more enlightened economic approach, price controls are eliminated in the Draft Order when there is “either one competitive provider with a network within a half mile from a location served by an incumbent LEC or a cable operator’s facilities in the same census block as a location with demand (¶ 111).”  In effect, the Draft Order sets duopolistic competition as the deregulatory threshold.  In choosing this competitive threshold, the Draft Order embraces competition rather than intervention as the regulating force.  Today, there are no formal barriers to competition outside of the underlying economics of providing service (i.e., costs).    If there are excessive profits, entrants are attracted.  If no firm is willing to enter, then there are insufficient profits to draw an additional entrant.  As the Draft Order observes,

“active supply occurs most rapidly in locations where the most profits are likely to be obtained, including where, for example, the transition to packet-based services is most valued, or put another way, active supply is most likely to occur where the costs of missing competition are greatest. Equally, active supply is most likely to be postponed where the benefits of additional competition are small, because the potential profit gained from extending supply is small (¶ 114).”

With free entry, it is entry that restrains market power, so the absence of entry likely implies market power is not excessive.  The half-mile supply-side boundary proposed by the Draft Order ensures that the costs of entry are not so high as to protect undue market power.

Also, deregulation in the presence of duopoly is consistent with Congress’ views on deregulation and competition.  In Section 623 of the 1992 Cable Act, for instance, Congress required the Commission to forbear from price regulation when a cable market is “effectively competitive,” which the statute defines as a market “served by at least two unaffiliated” video providers.  According to Congress, the cost-benefit risks of price controls are no longer warranted when there are two competitors.  In fact, the Commission’s estimate of the proper regulated rate was based on duopolistic competition.  While BDS does not fall under Title VI of the statute, the effective competition standard speaks directly to how Congress trades off regulation and competition.

Moreover, embracing duopolistic competition as sufficient to remove price controls is a much-needed retreat from the Commission’s 2010 Phoenix Forbearance Order that characterized duopoly as unsatisfactory.  The Phoenix Forbearance Order was a poorly-reasoned decision based a profound lack of understanding of the economics of telecommunications markets.  The final BDS order is an excellent opportunity to clear up the erroneous logic of that order, though I wish the language of the Draft Order was more forceful in doing so.

In all, the Draft Order strikes a good balance and draws its decisions from a better understanding of telecommunications economics.  For those interested in a more detailed discussion, the underlying economic logic of the Draft Order is covered in the Phoenix Center’s papers, How (and How Not) to Measure Market Power Over Business Data Services and Competition After Unbundling: Entry, Industry Structure and Convergence.  As these papers show—both of which rely on the most basic of economic concepts from modern Industrial Economics applied to the telecommunications industry—the number of competitors is not a meaningful indicator of market power or a basis for continued regulatory intervention.  In fact, few competitors may be an indicator of aggressive price competition, rather than a lack of it.  What our papers also demonstrate and the Draft Order appears to recognize (though it could be more explicitly stated) is that the number of competitors in a market, just like market price, is an equilibrium outcome.  This advance in the economic understanding of telecommunications markets—especially if laid out more fully in the final BDS order—could significantly improve the Commission’s policy-making.

So kudos to Chairman Pai:  for the first time in a long while, it’s nice to see some decent economics practiced at the Commission once again.