Wireless regulation is not about Free Market vs. Big Government (an economic perspective)

Introduction

This is a post I’ve been meaning to write for a while. With wireless industry regulation an increasingly regular topic of discussion on both Verge podcasts and Nilay’s recent article on carriers being a threat to innovation, it seemed like it’s finally time that I put this into words.

On the Verge podcasts they regularly refer to their support of increased carrier regulation as "socialist" or pro "big government". This is usually done tongue in cheek, but I think that it feeds into a general polarization of the topic that I often see in discussions about the issue. That is, people (especially those working for the wireless industry’s interests) often frame the issue as a contest between those in favor of big government vs. those in favor of a free and open market. A lot of us, perhaps intuitively, recognize that the issue isn’t that simple. However, I rarely see or hear someone articulate why opposing wireless net neutrality should not be considered favoring the free market.

So that’s what I’d like to do here, lay out the reasons why the current state of the US wireless industry is not a free and competitive market and explain how that leads to inefficient outcomes for us as consumers.

What's so great about free markets anyways?

First, let’s review what exactly a free market looks like and what makes it something that we should want the wireless industry to aspire to. After all, we don’t want free markets just because they make a good sound bite. We want them because they lead to efficient use of limited resources. In a free market producers willingly sell a product at a price above their cost of production, and consumers willingly buy a product at a price below what they would ultimately value it at. Since both parties gain from the transaction and neither has been coerced into it, wealth is created simply through exchange. Efficiency and innovation are encouraged in producers though the profit mechanism, and efficient use of the product is encouraged in consumers through increased consumer surplus (the difference between what you pay for an item and what you would ultimately value it at).

But markets aren’t perfect, and there are a number of ways in which a market can fail and lead to inefficient outcomes. The one most everyone is familiar with are monopolies, where a producer exercises their exclusive control over a product to restrict supply and extort larger prices from consumers than they would otherwise bear. For a more compressive list of potential market failures, I would recommend reading this article. In particular, I believe the US wireless industry is currently guilty of three market failures which lead to inefficient, or at the very least less efficient than it should be, use of our wireless resources.

Barriers to entry for carriers

I wanted to leave this one for last, but almost all of the other problems with the current carrier situation stem from this market failure. Simply put, no matter how much money, resources, technical expertise, and innovative ideas you have, you simply cannot create a nationwide wireless carrier to compete with big four in the US. This is because in order to do so you would need to lease wireless spectrum from the US federal government, spectrum that the US government is not selling right now.

The end result is a limited set of competitors: Verizon, AT&T, Sprint, and T-Mobile. And no matter how well regional carriers like MetroPCS run their businesses, they will never be a threat to those four at a national level because they simply don’t have access to the spectrum. Of course, if those four carriers were all fiercely competitive that might not make a difference. However, with roughly 32% and 34% market share AT&T and Verizon cannot grow the size of their businesses much further without attracting anti-trust interest from the US DOJ as was evident in AT&T’s attempt last year to purchase T-Mobile. Furthermore, with 332 million wireless subscribers in a nation of 300 million people, growing the industry’s overall subscriber base isn’t much of an option either.

That means that the growth path, for AT&T and Verizon especially, is pretty much fixed. Lock subscribers in for as long as possible and extract as much revenue per subscriber as you can.

Barriers to exit for consumers

A truly free market allows consumers to freely select amongst suppliers, so that if one supplier provides a subpar product or over charges consumers can switch to a competitor should they desire. It doesn’t take but a cursory glance at the current state of the US wireless industry to see how much the current system is set up to prevent just this situation.

For starters, everyone is well aware of 2-year contracts and cancelation fees. It’s the default way to structure your plan in the US and while most carriers offer some prepaid plans, they do a lot to discourage their use by restricting options and compatible devices. And while you’re free to bring your own, unsubsidized, device for contract free service, you’re still going to be paying for that subsidy on your monthly bill. All of this is designed to funnel customers into signing two year contracts that prevent them from moving to other carriers.

The second barrier that carriers erect to prevent you from changing suppliers is to prevent access to devices, which leads me to the third market failure.

Monopsony/oligopsony on device demand

While most people are familiar with monopolies, the inverse situation of limited consumers, known as monopsony and oligopsony, can also cause market distortions. At first glance it might seem that we’re far away from this problem. After all, there are 330 million handset customers in the US aren’t there? But in actuality, very few of us actually purchase phones from handset suppliers. It’s the carriers who purchase the phones and then bundle them with their contracts. So instead of handset manufacturers providing features that end consumers want, they’re providing features that the carriers dictate to them (such as locked bootloaders, Wi-Fi only video calling, removal of Google Wallet, or included carrier specific software, just to name a few).

Of course the biggest "feature" that carriers require handset manufacturers to include is to not sell their handsets on other carriers. By tightly controlling the availability of devices on theirs’ and others’ networks carriers enforce the first two market failures I mentioned, first by creating more barriers to switching providers, and second by preventing smaller regional carriers from getting access to the newest handsets. Apple and Samsung are two of the few handset makers with enough pull that carriers can’t dictate exclusivity terms. But smaller handset makers routinely have to cave to carrier demands of exclusive handsets, branding, or software packages in order to get carriers to put their device as an option on subsidized contracts.

It says a lot that Google has tried twice to circumvent this process (first with the Nexus One, then with the open devices provision in the 700mhz spectrum auction) and failed both times. Despite what you may have thought of the Nexus One as a device, it completely failed at its initial goal. It never even made it onto Verizon, instead getting rechristened as the Droid Incredible. And while the open device provision made it into the 700mhz auction, enforcement has been completely nonexistent.

Results

It's one thing to point to these flaws in the current structure of the wireless industry, but what is the actual harm being done? In the beginning of this article I pointed out that market failures would lead to inefficient allocation of resources, or at the very least less efficient than what they should be.

Based on the specific market failures I outlined above we would expect to see the following:

  • Less innovation in wireless broadband and service packages due to the limited competition among suppliers

Two wireless industry mainstays that I think are the clearest examples of an anticompetitive market are separate data buckets for different devices on already capped plans and exorbitantly high pricing on text messages relative to other data. Both of these "services" are essentially just extra charges for the carrier to release an arbitrary restriction on something that they've already sold you once. A competitive carrier that was more interested in luring customers than upsetting existing revenue streams could go a long ways by upsetting any one of these standard practices. Their continued presence in all four big carriers' service plans says a lot about the level of competitiveness in the industry.

  • Under supply of services and devices, and at higher prices for customers due to barriers to switching providers

We're all familiar with the limited availability of specific devices on individual carriers. Five years after the iPhone launched, you still can't get one on contract on T-Mobile. Does anyone think that this has anything to do with Apple not wanting to sell phones to T-Mobile customers? Additionally, consider the gradual repeal across Verizon, AT&T, T-Mobile of unlimited data plans. As customers become more locked in, carriers can extract higher and higher prices for the same services. Lastly, witness the increasingly long delays for OTA software updates. While device makers bear some of the blame here, the carriers are increasingly a factor as well. With customers already locked in for 2 years with a new device, the carrier has little to no incentive to spend additional money pushing updates to their phone.

  • Reduced profits to device makers and under supply of devices due to the oligopsony power of the carriers

This is difficult to prove without specific data on device makers profit levels. However, I think that it is telling that both Google and Microsoft avoiding the wireless industry cut wireless broadband from both of their most recent tablet announcements. So while we may not see an under supply of tablet devices, we are likely to see an under supply of tablet devices with mobile broadband capability.

Conclusion

In conclusion, the wireless industry in the US shows classic signs of either a market failure. An entrenched set of producers leverages their position to limit outside competition. This in turn allows them to limit supply and options for consumers, driving up prices, while at the same time dictating demand for their own suppliers, the handset makers. All of this is cyclical as well. Locked in consumers even further limit competition from regional carriers, which gives the big four even more control over handset makers, etc… And of course all of this is completely aside from the issue of regulatory capture. After all, we already have a government body whose function is supposedly, at least in part, to ensure that we don’t get into a situation like we are currently in.

In the end what we have is anything but a free, open, and competitive market. And whatever you might think the solution to our current situation may be, please don’t make the mistake of framing it as that vs. the free market, and don’t let others get away with trying to do so either.