Participants and Statements. Participants of Net Neutrality Debate are currently divided in two. Those against it are represented by network operators such as AT\&T and Verizon in the United States\footnote{Nippon Telegraph and Telephone in Japan and similar companies around the world share parallel arguments. The US case will be cited several times because most of the debate have occurred there.}. Their message point the necessity of a efficient use of the network to guarantee optimal levels of investment; consequently, different kinds of discriminatory schemes should be allowed. On the other hand, an eclectic group of members represent the counterpart. They are formed by firms such as Google, Yahoo, eBay, Amazon, entertainers, free speech group, among others. Their message points to create a regulation such that "internet's value added will not be threatened". The definition of "valued added" clearly is not unique given the heterogeneity of their group members.
Those against net neutrality present three arguments. First, network operators need to make substantial investments to keep up with a growing demand for old and new services. Old services mainly represents emails, web browsing and video\footnote{Must exclude live video as it heavily depends on the Quality of the Service (QoS). Recall traditional video performance is attached to buffer performance.} and depends on the average performance of the service. For example, what matters when someone downloads a file is the average rate of downloading, not its variance. New services, such as VoIP services from Vonage or Skype, are heavier in terms of network use, and depend as much on the average as on the variance of service performance. For example, imagine a surgery where one of the doctors is not physically there but uses internet, the service will be low if the voice take several seconds to reach its destiny.
Second, if network operators cannot fully exploit their investment, then other firms will appropriate their returns. Economic literature know this as the \emph{holdup problem} and it received a lot of attention in the last thirty years\footnote{See Grossman \& Hart (1988) and Tirole (1999), and Che \& Sakovic (2004) for further advances.}. Third, end-user experience will be enhanced by allowing network operators discriminate, any sort of misbehavior could be fixed with antitrust policies.
Those in favor of net neutrality present four arguments. First, if network operators need to make significant investments, then allowing discrimination is not the best way to raise the money, alternative funding schemes could be created to cover new network installing cost. Additionally, if network operators anticipated these costs, then service providers and end-users have paid already part of the cost. Second, internet's value added greatly depends on service providers investments; this imply for example that workers now are more productive not only because there is a network, but because Google allows them to be more efficient. Consequently, if network operators discriminate, service providers incentives to invest will be distorted too\footnote{A hidden assumption, which is true in this case, is that service providers cannot reach end-users without going through network operators}. Service providers will face a \emph{holdup problem}. Third, many sorts of discrimination may arise without any regulation; some types of discrimination are worst than others. For example, network operators will be able to discriminate among content, among services, among service providers, and among end-users; free speech groups advocate to not allow content or end-user discrimination. Fourth, what is really going on is that network operators want a bigger participation in internet's value added. In the remaining of this section net neutrality arguments will be disentangled in greater detail so to provide the necessary intuition upon which construct the models.
Internet Layers and End-to-End Design. Following Ganley \& Allgrove (2006), internet can be divided in three layers. The first one, labeled as \emph{content layer}, contains all meaningful information or statements sent, shared or stored by end-users, i.e. individuals, firms, etc., using the internet. The second, labeled \emph{logical layer}, contains all algorithms or standards, i.e. TCP/IP, HTTP, HTML, used to transport elements from the content layer through the network. And the third, labeled as \emph{physical layer}, represents all tangible objects that connect end-users to internet, and a specific end-user with another end-user. By construction, each layer is different from the other two.
Network operators discrimination might affect each layer, that complexifies net neutrality debate. Each layer have it's particular regulatory concerns. Within the \emph{content layer}, the impact of discrimination over intelectual property rights (IPR) have received most of the attention. Here, network operators responsibility boils down to help enforce IPR and treat all content as equal\footnote{Obviously this depend on the definition of ``equal''. For example, this definition need not be the same for a free speech group than for Google. See Felten (2006) for further discussion.}. \emph{Logical layer} regulatory issues concentrate on technologies upon which internet relies. Network operators have made significant advances in this area, now they are more capable to control internet traffic than before. As discrimination naturally arises as a threat is striking net neutrality debate have not spent enough time analyzing related issues. Finally, \emph{physical layer} regulatory issues represent most of net neutrality debate. Arguments are eclectic, they go from government traffic monitoring, and recent encrypting technologies, to how implement municipal WiFi at low cost.
Net neutrality debate is focused on the logical and physical layers. \emph{Content layer} regulatory concerns are set aside for two reasons. First, reviewing the debate IPR enforcement is not a main topic, and also its impossible to talk about ``equal'' content treatment without assuming a previous definition of ``equality''. Second, the most interesting economic phenomena is the impact of network operators and service providers investment over the logical and physical layers.
Before explaining the role of investment on the net neutrality debate it is necessary to spend a paragraph giving some intuition on how the network works.
The network is experiencing a natural evolution which creates new economic questions. Originally the net was conceived as a pipe that carries information packages from one point to the other, this is know as the \emph{end-to-end} design. Given the original net have no counter measures that account for traffic congestion or security issues\footnote{The original network cannot protect itself against viruses.} the natural step for network operators was to make the net ``smarter''. As this type of investment is not the same as building a ``bigger pipe'', the interesting economic question is to study the new tradeoff between efficiency and alleviating the \emph{holdup problem} of the network operator.
Network Operator Tools. To provide a sharper economic intuition four point should be emphasized. First, network operators can discriminate without using new technologies. Second, new discrimination methods do not equally affect all services and/or service providers. Third, given that network operators are in a two-sided market framework, and given that service providers can only reach end-users through network operators, the latter can sell to the former end-users information so to reduce information rents. And finally, writing and enforcing anti-discrimination rules is not an easy task.
It is misleading to think network operators discrimination is a recent phenomena. Without a ``smart'' network, network operators have incentives to offer different contracts to different service providers. Such contracts could specify minimum Quality of Service (QoS), or storing data in different regions so to reduce average downloading rates, or subcontract with regional phone companies to improve specific area network performance. Thus, net neutrality regulation will not necessarily prevent discrimination.
Recent improvements at the logical and physical layer allow network operators to deeply inspect information packages that go through the net\footnote{See \footnotesize{'Cisco Service Control: A Guide to Sustained Broadband Profitability' at www.democraticmedia.org/PDFs/CiscoBroadbandProfit.pdf}.}. In particular, network operators can discriminate with respect to the sender, receiver, size or type of service. Effects of discrimination is not the same across all types of services, for example, discrimination with QoS will make VoIP, i.e. Skype, slower relative to search engines services, i.e. Google\footnote{The former care equally on the average and variance of downloading rate, the later is concerned just with the average.}. Thus, a wide range of new strategic behaviors arise. For example, if the network operator also offers traditional phone services, think for instance in AT\&T or France Telecom, they will have strong incentives to reduce QoS so to make VoIP services less attractive.
Network operators can manipulate information structure between service providers and end-users. It is intuitive to believe there are significant transaction costs between service providers and end-users that network operators alleviate. Then, following Rochet \& Tirole (2006a), network operators face a two-sided market. Information becomes an important asset to network operators in case service providers suffer from asymmetries of information with end-users. That explains the attempt of both parties to obtain as much information as possible from end-users. It is a non-trivial task to analyze the way information acquisition affect strategic behavior\footnote{In a two-sided market framework even service providers and end-users have incentives to collude and pursue legal actions to reduce network operator rents. This behavior need not be welfare enhancing.}.
A regulatory commission will face the usual adverse selection and moral hazard problems. In other words, even if all relevant economic trade-offs to net neutrality debate are clearly identified implementing the regulation could become very costly. Consider for example\footnote{Example inspired on Felten (2006).} enforcing a minimum QoS given 4 network operators. Assume that firm A announces he provides a QoS bellow the minimum, that firm B announce the opposite but in reality tries to behave as firm A, that firm C announces he provides a QoS above the minimum but he erroneously pursue actions that mimic firm A, and that firm D announces he will provide a QoS above the minimum but external factors make him behave as firm A. The regulatory commission will have a hard time differentiating firm B from C or D.
Investment. Investment is an essential and unexplored factor to understand net neutrality debate. To pursue an economic analysis several remarks arise. First, both network operators and service providers make "valuable" investments. Second, the debate winner will dominate innovation in internet. Third, assumptions about how investments affect the overall economy are needed.
Service provider investment play a key role in internet's value added. A nice feature of internet until know is the possibility entrants can compete with incumbents if their investment is ``valuable enough''. For example, the success of Google or YuTube was possible because they exploited a new market, but also because the \emph{hold-up problem} was mild enough to make the right investment level. This feature is know in the net neutrality debate as \emph{Competition in the merits}. It is argued that network operators discrimination should avoid affecting service provider investment incentives.
Network operators investment is two-fold. In one hand, there is a substantial fix cost that represents enlarging the previous network; this will be labeled as ``bigger pipe'' investment. On the other hand, the new network must be replaced by a more reliable, safer and flexible network; this will be labeled as ``smart pipe'' investment. Notice both kinds of investment do not share the same nature, the first could be understood as a one big fix cost, while the second could be made periodically. Finally, as ``smart pipe'' investment also contributes to internet's value added\footnote{Though this is a crucial remark, emerging literature only attributes value added to service providers investment.}, net neutrality regulation should account for not distorting network operators investment incentives.
The second remark suggests net neutrality debate is the dispute over innovation in internet\footnote{See Felten (2006) for further intuition.}. Network operators provide innovations by searching for technologies which make the net ``smarter'', service provider investments provide innovations at the end of the net which enhance end-user experience . Who ever ``wins'' the ebate will have a lead on innovation race in internet. Therefore, in the heart of net neutrality debate we face a double hold-up problem that affects internet's value added. The novel feature of this problem is that it happens in a two-sided market framework.
If both investments are value added sources, how value added is produced? This leads to the last remark. From a policymaker viewpoint is crucial to know how investments affect overall economic behavior. Unfortunately, theory itself cannot answer this question. From hereon it will be assumed network operators investment can only affect their cost structure and service providers cost structure. On the other hand, service provider investment will only affect end-user experience.
Brief Summary of Conclusions. Four remarks should be kept for the rest of this report. First, there are two groups in the debate. The ones in favor of regulation are those who use the net, the ones against regulation are those who build and manage the net. The users of the net seek to maintain the statu-quo, while the net operators argue they need to make an efficient use of it.
Second, NN debate will progress when the effects of network operator discrimination practices are well understood. There will be effects on the physical network if NN regulation distort network operators incentives of ``bigger pipe'' investments. There will be effects on innovation on technology if NN regulation distort incentives of ``smart pipe'' investments.
Third, at the heart of NN debate there is the discussion on how incentives to investment will be distorted. If regulation guarantee service providers and network operator will keep their investment returns, then the double holdup problem will be alleviated. Enforceability of NN regulation is not a trivial issue.
Finally, network operators have many tools to discriminate service providers. This opens the question whether enforcing NN regulation is too costly or not.
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