Regulatory Analysis and the Video Franchising Debate

Jerry Brito and Jerry ElligSenior Research Fellows

Regulatory Analysis in Plain English

1. Figure out what you’re trying to do and how you’ll know you did it

2. Figure out why government needs to do it3. Figure out what level of government needs to do it4. Think about different ways to do it and find the

most effective one5. Figure out what you have to give up to do

whatever you’re trying to do6. Weigh the pros and cons

How we got here …

Cable often had monopoly franchises (but not always)

1984 Cable Act requires local franchising

1984-99: On-again, off-again price regulation

Local authority can regulate “basic” price if cable lacks effective competition (but 90% of customers buy “expanded basic”)

Franchising in 1992 Cable Act Monopoly franchises prohibited Local authority may not “unreasonably refuse” to award a

competitive franchise

Basic elements of franchising

Firm gets permission to use rights-of-way and enter market

Franchise fee (capped at 5%)

“Nonprice concessions”

Price regulation of basic service if effective competition is absent

Early 2006 …

New entrants claim franchising is still a barrierProposed federal legislationState legislationFCC proceeding FCC claims authority to define “unreasonable”

refusal to grant a franchise Sought comment on what should be considered

unreasonable

Are these unreasonable?

Monopoly based on “crowded” rights-of-wayRequire entrant to match incumbent’s capital expendituresRequire entrant to cover incumbent’s entire territoryLong delayNonprice concessions

1. Identify the outcome

Widespread agreement: consumer welfare

Possible measures: Price, quantity, variety, new services

Causation: remove barriers to entry, competitors enter, competition improves consumer welfare

Empirical support

2. Assess systemic problem

Federal law requires cable franchises

“Unreasonable” refusals and remedies not defined

GAO surveys find competitors pick markets based in part on local officials’ openness to competition

Not a problem in ALL markets, but a problem in some

Systemic problem Part II: Justifications for franchise monopoly

“Unsustainable” natural monopoly Never proven, frequently refuted Requires effective price regulation

Specific capital and risk reduction Unclear if possible in theory Never proven Requires effective price regulation

Management of rights-of-wayRequires pricing or rules, not monopolyIrrelevant for entrants already using rights-of-way

3. Federal role?

Local officials often captured by incumbent cable company

Franchise fees Public/Educational/Government (PEG) channels Free networks for local govt. Outright corruption

Some states enacted statewide franchising

Federal Cable Act is one source of the systemic problem

Local authorities’ incentives

Municipal governments discovered that they could extract substantial rents by awarding licenses on favorable terms to the applicant. In the 1960s, New York Mayor John Lindsay proclaimed cable franchises “urban oil wells beneath our city streets.” This produced a decided bias in favor of monopoly, which would improve expected returns and so raise the “bid” from prospective applicants.

-- Thomas Hazlett

Cable Television, in Handbook of Telecommunications Economics: Technology Evolution and the Internet, Vol. 2, (Sumit K. Majumdar et al. eds., Elsevier Science 2006).

4. Effectiveness of Alternatives

FCC rulemaking, federal legislation, state legislation, litigation

FCC alternatives Declare video offered by telcos is not cable Pre-empt local laws that deny franchises unreasonably

Extent of reform Introduce competition Limit/eliminate nonprice concessions Limit/eliminate franchise fees

5. Costs of franchise monopoly

Market power raises price, lowers quality

Nonprice concessions raise costs16% of capital and 11% of operating costs in 1984 surveyPEG fees on bills ≈ 1%

5% maximum franchise fee raises price

Wireline competition (FCC data 2002-04)

“Monthly rate” 12-15% lower with competition6-7% more channelsPrice per channel 19-21% lower

Digital tier 3-6% lower5-7% more digital channelsPrice per digital channel 6-12% lower

Raw averages may mislead

Some markets may be mis-classified

Need to control for other factors affecting prices

GAO study addresses both problems

US Govt. Accountability Office analyses

2004: cable rates 16 percent lower with direct wireline competition, after controlling for other factors

Paired case study finds 15-41 percent rate difference

Consistent with 20 years of government and independent research finding wireline competition lowers cable rates

Total wealth transfers

$8.4 billion67.4 millionN.A.Total all markets

$96 million3.4 million$2.33+ Franchise fees

$16 million3.4 million$0.39Nonprice concessions

Markets with wireline competition

$8.3 billion22.5 million

(digital)$5.00

(digital)+ Market Power - Digital

$8.2 billion64 million$9.83+ Franchise fees

$5.8 billion64 million$7.56+ Nonprice concessions

$5.5 billion64 million$7.10

Market Power – Basic, extended, equipment

Markets without wireline competition

Wealth TransferSubscribersMonthly Price ChangeEffect

Understanding unseen consumer costs

Higher prices = fewer consumers subscribe

These consumers lose difference between what the service is worth to them and what they would have paid for it

Loss is big when demand is sensitive to price; 1% price increase causes 1.5-3% reduction in video subscribers

Reduced competition also reduces quality (# channels)

Total cost to consumers

$10.4 billion$8.4 billion$2 billion28.1 millionTotal all markets

$102 million$96 million$5.8 million413,000+ Franchise fees

$16.2 million$16 million$160,00069,000Nonprice concessions

Markets with wireline competition

$10.3 billion$8.3 billion$2 billion4.8 (channels)+Quality effect

$10 billion$8.3 billion$1.6 billionN.A.+ Market Power – Digital

$9.8 billion$8.2 billion$1.6 billion28 million+ Franchise fees

$6.8 billion$5.8 billion$964 million21 million+ Nonprice concessions

$6.3 billion$5.5 billion$850 million20 millionMarket Power –

Basic, extended, equipment

Markets without wireline competition

Total consumer cost

Wealth Transfer

Forgone consumer surplus

∆ in no. of subscribersEffect

Absence of competition costs municipalities (e.g., expanded basic only)

Current: 64 million subs. x $45.52 x 12 x .05 = $1.7 billion

Competition: 84 million subs. x $38.42 x 12 x .05 = $1.9 billion

Local govts. forego $200 million on expanded basic

Govt. loses revenue whenever the elasticity of demand for the service > 1.

Sensitivity Analysis

$10.43 billion$8.48 billion$1.95 billion30.1 million1 1 .5 p e r c e n t

p r ic e e f f e c t

All MVPD subscribers$9.53 billion$7.62 billion$1.91 billion32.1 million

1 1 .5 p e r c e n t p r ic e e f f e c t

Mutatis mutandis$10.87 billion$8.42 billion$2.45 billion35.1 million

= E la s t ic it y-2 .5

$9.99 billion$8.42 billion$1.58 billion21.1 million = E la s t ic it y

-1 .5

Change in assumption$10.43 billion$8.42 billion$2.01 billion28.1 millionB a s e lin e

T o t a lc o n s u m e r c o s t

W e a lt hT r a n s f e r

F o r g o n ec o n s u m e r s u r p lu s

∆ # in o fs u b s c r ibe r s

6. Net Benefits and Incidence

Liberalization of franchising generates net benefits (increase in consumer surplus + increase in producer surplus for cities)

Cable companies lose wealth transfer, gain some profit on expanded sales, worse off on net

Local govts. retained their wealth transfers and got to tax a larger market

Local officials have fewer opportunities to extract private rents from entrants

What we recommended

Refusal is unreasonable if based on natural monopoly, risk reduction, or rights-of-way management unsupported by overwhelming empirical evidence that monopoly is necessary

“Nonprice concessions” unrelated to cable system are unreasonable

Excessive delay in making decision (120 days?) is unreasonable

Aspects of “level playing field” laws are unreasonable Capital expenditures equal to incumbent Serve all of incumbent’s area Buildout requirement faster than incumbent’s actual buildout

Require franchise authority to explain reasons for denying franchise in writing

What the FCC Did

Franchise deemed granted if negotiations go too long 90 days if applicant already uses public right-of-way 6 months otherwise

Unreasonable build-out requirements are unreasonable refusals to grant franchise

Contributions to Peg operating costs count toward 5% franchise fee limit

Note: Our calculation assesses benefits of liberalization, not necessarily all attributable to the FCC’s action