Winter 2007

Power of Ideas

Negative on Network Neutrality

Profs. Katz and Hermalin uncover subtleties in the divisive Internet access debate


With Congress now controlled by Democrats, advocates of several initiatives collectively known under the "network neutrality" banner are gearing up to lobby their cause before a more net-friendly audience of lawmakers.


But network neutrality, which calls for content providers to have equal and free access to the wires that bring the Internet to customers, could have some unintended, harmful consequences, say Haas School Professors Michael Katz and Benjamin Hermalin.


"There are benefits of variety and these network neutrality regulations would just get rid of them," says Katz, who holds the Sarin Chair in Strategy and Leadership at the Haas School. "The issues are far more subtle than people in the debate appreciate."


The acrimonious net neutrality debate centers on two issues: The first is whether providers of "last mile" Internet access services – typically phone or cable companies – should be allowed to charge Web site operators such as Google or Yahoo! a fee for faster delivery of their content. The second is whether those "last mile" companies should be allowed to charge consumers for different grades of service, similar to how cable companies offer different programming packages or how software companies sell standard and professional versions of their product.


Some network neutrality proponents have suggested legislation is necessary to prevent creating a tiered Internet for the haves and have-nots, but Katz and Hermalin disagree.


In a recent working paper titled "The Economics of Product-Line Restrictions with an Application to the Net Neutrality Debate," they show that under a single-tier system, a firm would be likely to choose to sell a product that is too expensive for a low-end customer and of lower quality than some high-end customers would otherwise have purchased if they could choose from several products.


"The notion that everyone gets the best possible product is just wrong," Katz says.


In their paper, Katz and Hermalin created a formal economic model to study the effects of restricting product lines. One surprising finding was that their model showed consumers who would otherwise have consumed a low-quality variant are priced out of the market when firms are limited to offering only one product.


"The irony is that product-line restrictions tend to harm the people at the bottom," Katz says. "In fact, we find they almost always harm the people at the bottom of the market."


That's because a firm restricted to offering only a single product makes the most money by targeting middle or high-end customers and pricing the product so that low-end customers get thrown out of the market entirely, explains Katz. But if you allow a firm to offer a range of products, they are more likely to tailor some to the high-, middle and low-end consumers, he adds.


Katz and Hermalin also find that a single-level of service leads consumers in the "middle" market to consume a higher quality product than they would have consumed if a firm offered multiple products. And consumers at the top of the market consume a lower quality product than they would have consumed if a firm offered multiple products.


In a model with only two firms, such as a local telephone company and a cable company in the network neutrality debate, a new dynamic comes into play, Katz and Hermalin found. Their model showed that restricting the number of products that two firms can offer may lead the firms to choose non-overlapping products where they would have otherwise engaged in head-to-head competition across all product variants.


"The resulting loss of competition can harm consumers," Hermalin and Katz concluded. "The conclusion we draw is that generally, these network neutrality restrictions are harmful to efficiency overall," Katz says.


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