Spillovers and Network Neutrality

21 Pages Posted: 22 Jan 2012

See all articles by Christiaan Hogendorn

Christiaan Hogendorn

Wesleyan University - Department of Economics

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Date Written: August 15, 2010


In September 2009, FCC Chairman Julius Genachowski proposed two new principles for Internet policy, nondiscrimination and transparency. Nondiscrimination is the key element of the policy known as “network neutrality” and declares that the telephone and cable companies (Internet Service Providers, or ISPs) that provide local broadband Internet service may not “block or degrade lawful traffic” or “pick winners.” The ensuing rule-making process2 has brought forth a vigorous debate, and one of the most prominent economic issues in that debate is the nature and extent of “spillovers” or “externalities” that come from household broadband Internet service.

If positive spillovers are large and can cause market failure – the question we discuss here – they become an important underlying economic justification network neutrality regulation. Spillover benefits do not accrue to those making the decisions, and thus the decisions may not be optimal from society’s point of view. If ISPs begin new types of discriminatory practices, this would be a significant, discrete change in the economic configuration of the Internet. Among other things, this would cause large changes in the spillovers emanating from the Internet.

The nature of Internet spillovers is not so different from the spillovers from many older infrastructure services. Telecommunications and other networks have been I thank Menachem Spiegel and other participants of the Rutgers Center for Research in Regulated Industries Eastern Conference, Skytop, PA May 2010.

Federal Communications Commission, In the Matter of Preserving the Open Internet and Broadband Industry Practices, Notice of Proposed Rulemaking, GN Docket No. 09-191; WC Docket No. 07-52, October 2009. regulated as common carriers to prevent their private interests of discrimination hurting their public benefits from spillovers. (Noam 1994) The relationship of open access and network neutrality regulations to common carriage is complex (Hogendorn 2005), but the basic purpose is still to prevent discrimination.

The practices addressed by network neutrality include (i) an ISP offering content providers the ability to have their traffic prioritized over other providers’ traffic, (ii) an ISP preferring one service or one set of applications over others, or (iii) an ISP choosing to block or slow a service or set of services. Clearly any of these would be a large change from current practice, but the question is why that should be a public policy concern. The reason is that the ISP would choose it preferred services or its differential prices based on the private valuations of those services. That is, the ISP will base its preferred services and fees on what it can privately appropriate from the content provider’s revenue (which could be advertising revenue or subscription or product prices to consumers).

There are a many standard economic results that suggest such preferences and pricing will be efficient, but they require that the private values be consistent with public values. That is, the preferences and prices set by the ISP would have to include any public values beyond the pure private revenue of the content provider including the future potential of the content.

This chapter suggests three main reasons for a divergence. First, the Internet is a general purpose technology (GPT), which means that it is an input into a wide range of uses across the economy. This means that the applications of content providers often have public values in excess of their private value. Second, the Internet, as the name suggests, is a network of networks, which means that network effects are rampant throughout all Internet-associated products. These take time to grow and they accrue to users beyond the content provider, so the dynamic, public value is likely to be higher than the static, private value. Third, the Internet is an innovation-spawning technology, so that almost all of its content is rapidly changing and developing, adding new value. This means that the static value of content may be much less than the dynamic value, since successful development will cause a future increase in value.

The chapter is organized as follows. Section 2 discusses the relevant economic concepts of surplus and externalities, paying particular attention to the difference between marginal and inframarginal externalities which have sometimes been confused in the network neutrality debate. Sections 3, 4, and 5 address the three main sources of spillovers that are relevant here: general purpose technology, network effects, and innovation. Each of these sections establishes three main points about the spillovers: that they are relevant to the Internet, that they are likely to be large, and most important, that there is an inverse relationship between privately appropriable surplus and public benefits through spillovers. Section 6 discusses whether competition between ISPs ameliorates the market failures, and section 7 concludes.

Suggested Citation

Hogendorn, Christiaan, Spillovers and Network Neutrality (August 15, 2010). TPRC 2010, Available at SSRN: https://ssrn.com/abstract=1989169

Christiaan Hogendorn (Contact Author)

Wesleyan University - Department of Economics ( email )

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