My friend and fellow PhD student Ryan Decker (who I’m hoping will some day join me in blogging so that I can put stuff up more than once a year) has pointed out to me that a lot of the commentary by econo-pundits on the Comcast/Time Warner isn’t really consistent with the modern economic view of vertical mergers. Thus, even though I’m in the depths of PhD research hell, I couldn’t help but take this opportunity to write a little.
Much of what I’ve seen on the Internet starts from the premise that the merger will directly further Comcast’s monopoly power as a cable provider and an ISP. However, Comcast and Time Warner do not compete for subscribers in any geographic territory. To the extent that the cable providers provide their services at prices above those that would prevail in a more competitive market or offer worse service, they do so as a result of the monopoly power that they already have. Since they don’t compete with each other for consumers, the merger will not reduce direct horizontal competition.
Now, in the last 25 years or so, economic research has shown that vertical restraints, including vertical mergers, exclusive dealing, tying, etc. can sometimes be used as a mechanism to maintain or further monopoly power. In fact, the applied theory paper I’m currently working on as a potential dissertation topic is a theoretical model of anticompetitive exclusive dealing. (Self-Promotion Alert: A simple version of the model can be found here). Given that most of the concerns voiced by econo-pundits have to do with the vertical aspect of the merger and I have already addressed the issue of horizontal monopoly in the cable industry, I will now consider the issue from the perspective of the modern economic literature on vertical restraints.
There are essentially two mechanisms of potential vertical harm from the merger in terms of price theory, assuming that the merged firm has monopoly power as a cable provider/ISP:
(1) The merger would increase Comcast’s monopoly power in the content market allowing it to charge higher prices for its content.
(2) The merger would allow Comcast to increase its prices as an ISP/Cable provider by curtailing competition from other ISPs or Cable providers.
Although the idea that Comcast seeks to monopolize the content market to increase its prices is a popular one, this mechanism of anticompetitive harm lies on a weak foundation. The essential problem is this: consumer demand for Internet or cable is purely for the bundle of distribution and content that makes its way through the supply chain to consumers. From the standpoint of economic theory, Comcast sets its prices with respect to the consumer demand curve and treats the content as a cost. The content providers then set their prices based on Comcast’s demand for their services which is clearly derived from underlying consumer demand.
Now consider Comcast’s profit maximization problem. Comcast is already a monopolist so it increases its price until any further price increases actually reduce profits. All things equal, Comcast would like to serve the people that it chases out of the market with its high prices, but since that would undermine its monopoly price, it simply lets those consumers go. Now note that in the context of a content merger, the willingness to pay of the consumers does not change. Consumer’s demand is the same as it has always been and both Comcast and the content providers are taking advantage of this willingness to pay to the maximum extent they can. However, what’s key to note is that the upstream content providers’ profit maximization is actually interfering with Comcast’s ability to serve more consumers by increasing the price at which Comcast can provide the content. If Comcast acquires the upstream content producers, it effectively lowers its acquisition cost; and a monopolist responds to lower costs with lower prices! A very general property of monopoly pricing is that prices are increasing in costs (for the mathematically inclined, a very elegant little proof of this can be seen on p. 66-67 of Jean Tirole’s textbook The Theory of Industrial Organization).
Again, the key is that the willingness to pay of the consumers’ never changes so Comcast already takes advantage of that to the maximum extent it can. Any further imposition on consumers will simply reduce its profits. Actually, consumers are better off as a result of the reduction of the effective cost of providing the service. Thus, as far as content is concerned, given the monopoly pricing principle discussed above, the merger should actually lead to lower, not higher prices (considering, for the moment, only this factor).
With respect to (2) modern economic literature has indicated that such stories are very plausible in theory and thus we must evaluate this issue based on the particular circumstances of the merger. Economic literature has identified a number of mechanisms whereby such behavior has anticompetitve consequences:
For a few of my favorite examples see: Salop and Scheffman (1984), Whinston (1990), Rasmusen, Ramseyer, and Wiley (1991), Segal and Whinston (2000), Simpson and Wickelgren (2007), and of course my research.
Cutting through the math involved in these models, the basic concern would be that Comcast uses the merger to acquire content essential to entering the market for the provision of ISP services. In other words, the concern here would be that Comcast would use its advantageous position over content to block the entry of firms who would compete in providing access to the Internet.
Why is this situation fundamentally different than the foreclosure of content situation? The key here is that in the absence of the conduct by the monopolist, the market structure would be more competitive.
So this analysis suggests that the question of whether to allow the merger is largely about whether it is empirically plausible that this merger will facilitate Comcast/Time Warner’s ability to block entry by ISPs. I do not know all the details of the merger and so I am hesitant to make an absolute pronouncement that the merger is good or bad. However, for the following reasons I am somewhat dubious that foreclosure of competitors in distribution is a concern at this point.
As far as Cable is concerned, there are already competitive alternatives in the form of DirecTV, Dish, FiOS, U-Verse. It is difficult to imagine that anyone would enter the market solely a cable provider since I think everyone agrees that the future is Internet, so the question now becomes: will the Time Warner merger help Comcast to prevent the entry of a new ISP?
Certainly at the moment, it doesn’t seem likely. Comcast is obligated to share NBC with its rivals and it has already made extension of the NBC merger conditions part of the deal. Also, Comcast is only merging with Time Warner Cable so while it may gain some regional sports programming, it won’t gain access to much more as far as I am aware.
In the future, as wireless Internet improves, company’s providing Internet over spectrum may become a viable competitor to Comcast.* It is these entrants who would be the most in danger, but I’m not sure if this merger really involves enough content to be the pivotal factor in such an arrangement. I should note that in all of the models discussed above, the assumption is that the rival absolutely must have the input—that is Comcast would need to have content that is essential for a competitor to gain competitive traction (In that sense, Comcast owning ESPN would raise larger concerns). Also, once a rival does successfully enter, Comcast’s incentives as a content provider suddenly change as it now has to co-exist as a competitor it now makes more money selling its content to other ISPs. Thus, it would seem that the only potential harm is if Comcast can totally block other ISPs from entering its markets at all. Once entry occurs, Comcast’s profit maximization calculation changes.
There’s a lot more to say about this merger and the related issue of Net Neutrality that I’ll try to address soon, but I think this provides a good start to understanding the merger in terms of the modern economic literature on monopoly. At the moment, it seems to me, the scale tips in favor of allowing the merger, but I’m open to hearing coherent economic arguments to the contrary (what does not make sense is to oppose the merger because you hate Comcast and Time Warner, or because the resulting merged company is “big”).
*Next year an unprecedented double auction is set to occur which will facilitate the transfer of wireless spectrum from broadcasters to wireless Internet providers like AT&T, Sprint, Verizon, and T-Mobile. With efficient allocation of spectrum and the development of LTE-A and then 5G technology it seems quite possible that wireless spectrum providers will become viable competitors to wireline ISPs like Comcast. One reason not to interfere in the market at this point is then to allow this process to advance and then set out the appropriate regulatory structure once we have more of a feel for what ISP landscape looks like. At the moment, the primary constrains to entry into the ISP market are not issues of content, but scarcity of spectrum and technology.