A Hundred Years of Coase: Reading the Net Neutrality Order (Part II)

January 3, 2011

By Larry Downes
Technology Liberation Front

In my previous post on the FCC’s Open Internet Report and Order, I looked at the weak justification given for the new rules the Commission approved on Dec. 21, 2010

In this post, an aside on the likely costs of the rules, and in particular the costs of enforcement.

Last week was the 100th birthday of Nobel prize-winning economist Ronald Coase, a remarkable man I have had the great fortune to know personally. Among his many contributions to the field, Coase has always advocated for more empirical research and other data collection to help lead the field out of its theoretical quagmire. To that end, Coase co-founded the International Society for New Institutional Economics, and served as its first President in 1996.

Unfortunately, the FCC, which owes a great debt to Coase for his early championing of auctions for radio spectrum, does not seem to have learned much else from his work. In a section optimistically captioned, “The Benefits of Protecting the Internet’s Openness Exceed the Costs” (¶¶ 38-42), the Commission makes no effort to calculate either with any hint of rigor. Wishing away serious economic analysis, the Report simply states that “By comparison to the benefits of these prophylactic measures, the costs associated with the open Internet rules adopted here are likely small.”

The sole citation for this remarkable claim is to comments filed by Free Press, one of fifty citations to Free Press in the Report. So far as I know, Free Press does not keep economists on staff, nor did they perform any economic analysis of the benefits or costs of rules that, of course, weren’t in any case finalized until months after comments were filed.

So the belief that the costs are likely small, let alone the value of the benefits not of the open Internet but of the rules adopted to salvage it, is simply that—a belief, or, more likely, a mere hope.

The Report goes on to note that openness and no-blocking are already the “norm” and the “status quo” for broadband Internet providers (so, again, why are new rules so urgently required?), and therefore the only significant compliance cost the FCC envisions is for the new transparency rule, which will require disclosure of network management practices that consumers are imagined to use in deciding which broadband provider to choose. (See ¶¶ 39, 43, and 53-61)

The transparency rule itself, § 8.3, will be discussed in a later post. But assuming that complying with this rule represents the only significant change to existing practices by broadband Internet providers required by the new rules, it probably won’t add enormous new costs. On the other hand, this is also the rule least likely to deliver much in the way of benefits. (Just take a look at the Truth in Lending Disclosure on your last mortgage refinance or read the required FDA disclosure for a recent prescription—which you surely didn’t do before deciding to complete the transaction—to get a sense of just how useful the newly-required network management disclosure will be.)

The Nature of Enforcement

But what of the costs of enforcing the rules, or defending against a claim that a broadband Internet provider has violated them?  The Report here is eerily silent.

There are three types of actions that may be taken to enforce the rules.

First, any individual or organization may file an informal complaint, without paying any fee, through the FCC website. (¶ 153.) Though such complaints will not automatically lead to agency action, “the Enforcement Bureau will examine trends or patterns in complaints to identify potential targets for investigation and enforcement action.”

Second, under ¶ 160, the agency itself may initiate actions, perhaps based on trends or patterns it notes in the informal complaints.

The third avenue for enforcement, the filing of a formal complaint, is the most worrisome. Under § 8.12 of the Order, “Any person may file a formal complaint alleging a violation of the rules….” (emphasis added) (See also ¶¶ 154-159)

In his greatest work, “The Nature of the Firm” (1937), Coase plainly and clearly laid out his belief that business organizations exist only to the extent that their internal costs are less than the costs of using the market to perform every activity associated with the production and marketing of the firm’s products and services. The market in reality is not the magic font of perfect efficiency that theoretical economists assume in their models.Each transaction between a buyer and a seller has certain inefficiencies or costs associated with it, costs Coase referred to as “transaction costs.”

I have written in all of my books about the importance of transaction costs in understanding how the Internet—which reduces transaction costs—is putting unique pressures on the structure of firms, and there’s no need to repeat that discussion here.

But of the six categories of transaction costs Coase introduced in 1937, one that seems not to have penetrated the FCC’s analysis is the one he called “enforcement costs.” In the even the terms of a transaction are not met to the satisfaction of buyer or seller or both, various mechanisms—including arbitration, negotiation, regulators and/or the courts—must be invoked to ensure the bargain made is the bargain received.

In many cases these costs can be exorbitant; indeed, far greater than the value of the underlying transaction.To take a trivial example, a rational consumer won’t sue the maker of a rubber band that breaks the first time she uses it.

At least, that is, not when the consumer has to bear the costs of litigating the claim herself.

The loss of value from the broken rubber band is a fraction of a penny. The cost of initiating—let along prosecuting—a lawsuit would exceed that price by several orders of magnitude. And, in most situations, the most the consumer could hope to win would be the fraction of a cent. The cost of enforcing the implied promise of a working rubber band—and the seller’s cost of defending itself—are lost.  They are inefficiencies of the market, or “transaction costs.”

But what if the consumer can offload nearly all of the enforcement costs on someone else—on the FCC, perhaps, or their broadband ISP provider? If “any person” who believes something is amiss could file an open Internet complaint and pay only a small filing fee to start the machinery of enforcement, why not bring a complaint for any perceived infraction, no matter how small or, indeed, illusory?

And that, unfortunately, is exactly the kind of incentive system created by the Order.

The existence of the new open Internet rules, of course, may operate as a deterrent against the behaviors they prohibit. But it is also likely that the agency will be called upon to enforce the rules against broadband access providers who are accused of violating them. The enforcement costs can be significant—including the costs to the agency itself (that is, to the taxpayers), as well as to the companies accused, rightly or wrongly, of violations.

Bizarrely, the Report makes no mention of the costs of enforcement or their potential impact on the cost-benefit analysis that is dispensed with so quickly. Yet the rules as written are likely to introduce substantial enforcement costs, as evident by looking at the mechanisms for making and resolving complaints. (¶¶ 151-160).

The Danger of a Private Right of Action

In legal terms, the ability of any individual to initiate an enforcement action is known as a private right of action.Federal law grants very few such broadly-written rights. There are, of course, hundreds of millions of American consumers, and giving all of them the right to initiate a formal proceeding that the government and the complained-of party must address can generate enormous costs.

You believe a medication advertised on television has a side-effect on some patient.  You suspect the actions of a far-off manufacturer create environmental hazards in another state.  Your car pulls to the left when you drive on certain roads.  While there are avenues both private and public to bring such concerns to the attention of the potentially-responsible regulators and private parties, there is no private right of action that allows you to file a formal complaint with the federal government–a complaint that must be answered line by line.

But that is precisely what the new rules allow. Regardless of the merits or specifics of a complaint, “the defendant must submit an answer.” In cases where the “facts” are disputed, “a thorough analysis of the challenged conduct might require further factual development and briefing.” (¶ 156) Moreover, “the broadband provider must answer each claim with particularity and furnish facts, supported by documentation or affidavit, demonstrating reasonableness of the challenged practice.” (¶ 157)

In resolving formal complaints, “the Commission will draw on resources from across the agency—including engineering, economic, and legal experts—to resolve open Internet complaints in a timely manner.” (¶ 159)

These are the general comments in the Report. Specific “pleading requirements” laid out in the Order provide the procedures for filing complaints, answers and replies, conducting discovery, developing and supporting legal arguments, verifying facts and documents submitted, and the like. (§§ 8.13-8.17) These sections are in fact far longer and more detailed than the rules themselves, and in essence create a system of adjudication that is similar to the most complex cases brought in federal court.

For example, any broadband provider served with a complaint must respond within 20 days, and must respond to each and every fact referenced in the complaint, supported with documentation including affidavits, legal authority, and other evidence. The Commission “may specify other procedures,” including hearings and oral arguments, and “may require the parties to submit any additional information it deems appropriate for a full, fair, and expeditious resolution of the proceedings, including copies of all contracts and documents reflecting arrangements and understandings alleged to violate” the rules.

Again, a party filing a formal complaint can be any person or organization so long as they have a good faith belief that the broadband provider has violated the rules. (They need not themselves be a customer of the broadband provider.)

Since the kind of blocking and traffic discrimination the rules prohibit can only be distinguished from “reasonable network management” practices (or indeed, behavior that may appear to involve ISP activity but which may simply be a function of overall network conditions at any given time) by reference to detailed discovery, we can expect a lot of complaints to be filed that will turn out not to reveal violations of the rules.

Since consumers aren’t likely to know with any certainty that the behaviors they observe are in fact violations of the rules without extensive and technically complicated discovery, in other words, any slow-down, hiccup, temporary outage or other network artifact that appears to suggest interference will constitute a good faith belief that a violation has occurred, and therefore put the broadband provider (and the FCC) to the cost of demonstrating otherwise.

Is your Internet connection acting up today? Did it take a long time to watch the latest YouTube video? Did you have trouble finding the website you were looking for? Could be that your ISP is blocking or otherwise discriminating against particular content, so perhaps you should submit a formal complaint to the FCC just in case.

All the costs will be borne by others—the provider on the one hand and the FCC on the other.

It’s not Just Money that’s Being Wasted

Such an open-ended grant of standing to “any person,” whether for good or for evil, cannot be squared with the belief that “the costs associated with the open Internet rules adopted here are likely small.” Even if no violation of the rules is ever found—even if no broadband provider ever interferes illegally with the open Internet in the future—providers and the agency will find themselves buried under mountains of complaints, all of which must be investigated and responded to…within 20 days of the filing, no less.

It isn’t just money that will be wasted. The process of enforcement could undermine basic Constitutional protections as well. If a complaint alleges that a broadband provider is interfering with traffic—perhaps on an on-going basis—in ways that violate the rules, the FCC will of necessity analyze large volumes of traffic to determine if a service is being blocked or unreasonably discriminated against. And that means not just looking at traffic patterns but, of course, at the contents of the packets themselves.

The FCC, in other words, in the name of enforcement, will be looking at the Internet behavior not only of the person making the complaint but perhaps of many other customers of the same provider or other providers for comparison.

Economists were clearly absent from discussions about the cost of the rules. But one would have thought at least that civil libertarians would pause at new rules that, in the name of an open and transparent Internet, give the FCC the ability to observe traffic—to perform deep packet inspection—that in any other context would require federal officers to obtain a search warrant based on probable cause of a crime.

But no.  So far, not a peep.

Next: the final rules and what they “preserve.”

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