Vanderbilt University law school Public law legal Theory Working Paper Number 02-01 Law economics Working Paper Number 02-01 Vertical Integration and Media Regulation in the New Economy Christopher S. Yoo This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection http://ssrn.com/abstract=319122
Vanderbilt University Law School Public Law & Legal Theory Working Paper Number 02-01 Law & Economics Working Paper Number 02-01 Vertical Integration and Media Regulation Christopher S. Yoo This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=319122 in the New Economy
Vertical Integration and media regulation in the ew Economy Christopher s. Yo Recent mergers and academic commentary have placed renewed focus on what has long been one of the central issues in media policy whether media conglomerates can use vertical integration to harm competition. This Article seeks to move past previous studies, which have explored limited aspects of this issue, and apply the full sweep of modern economic theory to evaluate the regulation of vertical integration in ledia-related industries. It does so initially by applying the basic stai efficiency analyses of vertical integration developed under the Chicago and post-Chicago Schools of antitrust law and economics to three industries: broadcasting, cable television, and cable modem systems. An empirical analysis reveals that the structural preconditions recognized by both Schools as necessary for vertical integration to harm competition do not exist in any of these industries. In addition, the cost structure of these industries suggests that vertical integration may well lead to efficiencies sufficient to justify allowing such integration to occur. a dynamic efficiency analysis provides additional reasons for believing that attempts to regulate vertical integration in these industries are misguided. Growing reliance on compelled access to redress the problems purportedly caused by vertical integration threatens to dampen investment incentives in technologically dynamic industries in which such incentives are particularly important. Not only does forcing a monopolist to share an input deviate from the system of well-defined property rights needed to promote efficient levels of investment, it also deprives nen entrants seeking to compete directly with the supposed monopoly bottleneck of their natural strategic partners. The Article also engages a complex web of arguments involving the extent to which technological innovation is affected by market concentration, standardization, and network externalities. A close review of the economic literature reveals f Assistant Professor of Law, Vanderbilt University Law School. This Article benefited nmensely from a workshop conducted while I was serving as a Fellow for the Center for would also like to thank Ash Bhagwat, Tim Brennan, Andy Daughety, Paul Edelman, Luke Froeb, John Goldberg, Ron Krotoszynski, Mark Lemley, Ed McCaffrey, Bob Rasmussen, Jennifer Reinganum, Jim Speta, Matt Spitzer, Eric Talley, Randall Thomas, Bob Thompson, Mark Weinstein, and Phil Weiser for their helpful comments on earlier drafts of this Article, as well as Rob Mahini, Rob Schmoll, and Paul Werner for their expert research assistance. I should also disclose that I served as a law clerk for the courts that decided State Oil Co. v. Khan, 522 U.S3(1997), and Time Warne Entertainment Co v. FCC, 93 F3d 957(D.C. Cir. 1996). The views contained in this Article are my Copyright 0 2002 Yale Journal on Regulation
Copyright © 2002 Yale Journal on Regulation Vertical Integration and Media Regulation in the New Economy Christopher S. Yoo† Recent mergers and academic commentary have placed renewed focus on what has long been one of the central issues in media policy: whether media conglomerates can use vertical integration to harm competition. This Article seeks to move past previous studies, which have explored limited aspects of this issue, and apply the full sweep of modern economic theory to evaluate the regulation of vertical integration in media-related industries. It does so initially by applying the basic static efficiency analyses of vertical integration developed under the Chicago and post-Chicago Schools of antitrust law and economics to three industries: broadcasting, cable television, and cable modem systems. An empirical analysis reveals that the structural preconditions recognized by both Schools as necessary for vertical integration to harm competition do not exist in any of these industries. In addition, the cost structure of these industries suggests that vertical integration may well lead to efficiencies sufficient to justify allowing such integration to occur. A dynamic efficiency analysis provides additional reasons for believing that attempts to regulate vertical integration in these industries are misguided. Growing reliance on compelled access to redress the problems purportedly caused by vertical integration threatens to dampen investment incentives in technologically dynamic industries in which such incentives are particularly important. Not only does forcing a monopolist to share an input deviate from the system of well-defined property rights needed to promote efficient levels of investment, it also deprives new entrants seeking to compete directly with the supposed monopoly bottleneck of their natural strategic partners. The Article also engages a complex web of arguments involving the extent to which technological innovation is affected by market concentration, standardization, and network externalities. A close review of the economic literature reveals † Assistant Professor of Law, Vanderbilt University Law School. This Article benefited immensely from a workshop conducted while I was serving as a Fellow for the Center for Communications Law and Policy at the University of Southern California Law School, as well as a workshop at the 2000 Annual Meeting of the Southeastern Association of American Law Schools. I would also like to thank Ash Bhagwat, Tim Brennan, Andy Daughety, Paul Edelman, Luke Froeb, John Goldberg, Ron Krotoszynski, Mark Lemley, Ed McCaffrey, Bob Rasmussen, Jennifer Reinganum, Jim Speta, Matt Spitzer, Eric Talley, Randall Thomas, Bob Thompson, Mark Weinstein, and Phil Weiser for their helpful comments on earlier drafts of this Article, as well as Rob Mahini, Rob Schmoll, and Paul Werner for their expert research assistance. I should also disclose that I served as a law clerk for the courts that decided State Oil Co. v. Khan, 522 U.S. 3 (1997), and Time Warner Entertainment Co. v. FCC, 93 F.3d 957 (D.C. Cir. 1996). The views contained in this Article are my own, as are any errors
Yale Journal on Regulation Vol.19:171.2002 that the relationship between these factors is too ambiguous to support the type of simple policy inference needed to prohibit vertical integration as a regulatory matter. The Article concludes with an analysis of the intellectual and institutional obstacles for adopting a more integrated economic approach to vertical integration in these industries Introduction I. The Chain Broadcasting Rules and the Basic Economics of Vertical Integration l81 A. The Chain Broadcasting Rules: Context, Substance, and rationale 1. The Structure of the Broadcasting Industry 182 2. The Chain Broadcasting Rules 183 3. The Economic Theory Underlying the Chain Broadcasting rules 185 B. The Basic Economics of vertical Integration 187 1. The Chicago Schools Rejection of Per Se 187 2. The Post-Chicago Schools Rejection of Per C. Applying the Basic Economic framework to the Chain Broadcasting Rules 1. Concentration in the market for television 206 2. Concentration and barriers to entry in th Market for Home Delivery of Television Programming 212 3. Potential Efficiency Justifications .213 D. The Future of the Chain Broadcasting Rules.... 217 II. The 1992 Cable Act and the Dynamic Inefficiency of Compelled Access 219 A. Description of the Cable Industry and the Regulatory Restrictions on Vertical integration 1. The Structure of the Cable Industry 2. Provisions of the 1992 Cable Act Affecting Vertical Integration 3. The Economic Theory Underlying the Restrictions on Vertical Integration Contained in the 1992 Cable act 223 B. Structural Market Conditions 1. Concentration in the Market for MVPDs
Yale Journal on Regulation Vol. 19:171, 2002 172 that the relationship between these factors is too ambiguous to support the type of simple policy inference needed to prohibit vertical integration as a regulatory matter. The Article concludes with an analysis of the intellectual and institutional obstacles for adopting a more integrated economic approach to vertical integration in these industries. Introduction ............................................................................................. 174 I. The Chain Broadcasting Rules and the Basic Economics of Vertical Integration.......................................................................... 181 A. The Chain Broadcasting Rules: Context, Substance, and Rationale.........................................................182 1. The Structure of the Broadcasting Industry ..................... 182 2. The Chain Broadcasting Rules......................................... 183 3. The Economic Theory Underlying the Chain Broadcasting Rules .......................................................... 185 B. The Basic Economics of Vertical Integration .......................... 187 1. The Chicago School’s Rejection of Per Se Illegality ........................................................................... 187 2. The Post-Chicago School’s Rejection of Per Se Legality ....................................................................... 202 C. Applying the Basic Economic Framework to the Chain Broadcasting Rules .......................................................206 1. Concentration in the Market for Television Networks .......................................................................... 206 2. Concentration and Barriers to Entry in the Market for Home Delivery of Television Programming.................................................................... 212 3. Potential Efficiency Justifications.................................... 213 D. The Future of the Chain Broadcasting Rules........................... 217 II. The 1992 Cable Act and the Dynamic Inefficiency of Compelled Access ........................................................................... 219 A. Description of the Cable Industry and the Regulatory Restrictions on Vertical Integration......................220 1. The Structure of the Cable Industry................................. 220 2. Provisions of the 1992 Cable Act Affecting Vertical Integration .......................................................... 221 3. The Economic Theory Underlying the Restrictions on Vertical Integration Contained in the 1992 Cable Act ..................................... 223 B. Structural Market Conditions ..................................................226 1. Concentration in the Market for MVPDs......................... 226
Vertical Integration and Media Regulation in the New Econo 2. Concentration and Barriers to Entry into the Market for Television Networks 3. Potential Efficiency Justifications for Vertical Integration in the Cable Industry 232 4. The Special Problem of Rate Regulation 237 5. Empirical Evidence on Vertical Integration in 238 C. The Problematic Nature of compelled Access 243 1. The Relationship Between Compelled cess and Leveraging and Foreclosure 2. The Administrability of Compelled Access 244 3. Compelled Access and Dynamic Efficiency 246 D. The Future of the Vertical Integration Provisions of the 1992 Cable Act 247 Ill. Open Access to Cable Modem Systems and the New Economy Theories of Technological Change A. The Cable Modem Industry and the Open Access Debate 250 1. The Structure of the Cable Modem Industry 2. Regulatory Consideration of Open Access 251 3. The Economic Theory Underlying the Open Access debate 252 B. Structural Market Conditions 1. Concentration in the market for broadband Transport 2. Concentration and Barriers to Entry into the Market for ISPs 259 3. Potential Efficiencies from Combining Cable Modem and isp services 260 4. Post-Chicago Models of Open Access 265 5. The Empirical Evidence on Open Access 267 C. The Problematic Nature of compelled Access as a Remedy 268 D. The New Economy Arguments: The Effect of Standardization on innovation 269 1. The Tradeoff Between Standardization and Product Diversity .271 2. The Relationship Between Market Concentration and Innovation 3. Network Externalities and vertical Competition 278 173
Vertical Integration and Media Regulation in the New Economy 173 2. Concentration and Barriers to Entry into the Market for Television Networks ...................................... 230 3. Potential Efficiency Justifications for Vertical Integration in the Cable Industry........................ 232 4. The Special Problem of Rate Regulation ......................... 237 5. Empirical Evidence on Vertical Integration in the Cable Industry ............................................................ 238 C. The Problematic Nature of Compelled Access ........................243 1. The Relationship Between Compelled Access and Leveraging and Foreclosure Theory .............................................................................. 244 2. The Administrability of Compelled Access..................... 244 3. Compelled Access and Dynamic Efficiency.................... 246 D. The Future of the Vertical Integration Provisions of the 1992 Cable Act............................................................... 247 III. Open Access to Cable Modem Systems and the New Economy Theories of Technological Change.................................. 248 A. The Cable Modem Industry and the Open Access Debate......................................................................................250 1. The Structure of the Cable Modem Industry.................... 250 2. Regulatory Consideration of Open Access ...................... 251 3. The Economic Theory Underlying the Open Access Debate.................................................................. 252 B. Structural Market Conditions ..................................................253 1. Concentration in the Market for Broadband Transport .......................................................................... 253 2. Concentration and Barriers to Entry into the Market for ISPs ................................................................ 259 3. Potential Efficiencies from Combining Cable Modem and ISP Services ................................................. 260 4. Post-Chicago Models of Open Access............................. 265 5. The Empirical Evidence on Open Access........................ 267 C. The Problematic Nature of Compelled Access as a Remedy..................................................................................... 268 D. The New Economy Arguments: The Effect of Standardization on Innovation.................................................269 1. The Tradeoff Between Standardization and Product Diversity ............................................................. 271 2. The Relationship Between Market Concentration and Innovation.......................................... 272 3. Network Externalities and Vertical Competition...................................................................... 278
Yale Journal on Regulation Vol.19:171.2002 IV. Obstacles to an Integrated Approach to Vertical Media Regulation ..285 A. Misplaced Focus on Technological Differences Rather than functional similarities 285 B. Lack of a Comprehensive Approach to the Economics of vertical Integration 290 C. Misconceived Analogies to Previous Legacy monopolies Conclusion Introduction The megamerger between America Online and Time Warner almost unquestionably represented a watershed moment in business history. Not only did it represent the largest merger the world had seen to date, the combination of Internet content and transmission under the same corporate umbrella threw the already turbulent telecommunications industry into further turmoil. The merger forced all industry players to reevaluate their business plans and prompted speculation about what other mergers might follow 2 As dramatic as the mergers impact on the business environment was, the mergers impact on the regulatory environment may have been even greater in that it breathed new life into one of the more hotly debated issues in media policy: open access" to high-speed broadband systems ntil recently, most individuals connected to the Internet via narrowband technologies, which employ conventional telephone lines to convey Internet content at speeds no greater than fifty-six thousand bits per second (56 kbps). The last several years have witnessed the arrival of broadband services, which are mainly provided via cable television systems throug cable modems and or via a special telephone-based technology known as digital subscriber lines (DSL ) These new means of transmission represent a major technological leap forward, allowing users to receive At the time the deal was announced it was valued at over $150 billion. Martin Peers et al., Media Blit: AOL, Time Warner Leap Borders to Plan a Mammoth Merger, WALL ST J, Jan 11 2000, at Al. By the time the was consummated its value had shrunk to around s100 billion, Jill Carroll, AOL-Time Warner Merger Clears FCC, WALL ST J, Jan. 12, 2001, at A3, and the deal had been eclipsed by Vodafone's acquisition of Mannesmann, Philip Shishkin Vodafone Wins EU Clearance to Acquire Mannesmann in Record $180 Billion Deal, Wa Apr. 13, 2000, at A14 See Bruce Orwall John Lippman, High Concept in Hollywood: More Web Alliances for Hollywood, WALL ST J, Jan 12, 2000,at Pulliam Paul M. Sherer, Anything Goes! Afier AOL Time Warner. Who's Next? WALL ST 11,2000,atC1 latory history of open access, see infra Subsection 174
Yale Journal on Regulation Vol. 19:171, 2002 174 IV. Obstacles to an Integrated Approach to Vertical Media Regulation........................................................................................ 285 A. Misplaced Focus on Technological Differences Rather than Functional Similarities.........................................285 B. Lack of a Comprehensive Approach to the Economics of Vertical Integration........................................... 290 C. Misconceived Analogies to Previous Legacy Monopolies............................................................................... 291 Conclusion............................................................................................... 295 Introduction The megamerger between America Online and Time Warner almost unquestionably represented a watershed moment in business history. Not only did it represent the largest merger the world had seen to date,1 the combination of Internet content and transmission under the same corporate umbrella threw the already turbulent telecommunications industry into further turmoil. The merger forced all industry players to reevaluate their business plans and prompted speculation about what other mergers might follow.2 As dramatic as the merger’s impact on the business environment was, the merger’s impact on the regulatory environment may have been even greater in that it breathed new life into one of the more hotly debated issues in media policy: “open access” to high-speed broadband systems.3 Until recently, most individuals connected to the Internet via narrowband technologies, which employ conventional telephone lines to convey Internet content at speeds no greater than fifty-six thousand bits per second (56 kbps). The last several years have witnessed the arrival of broadband services, which are mainly provided via cable television systems through cable modems and or via a special telephone-based technology known as digital subscriber lines (“DSL”). These new means of transmission represent a major technological leap forward, allowing users to receive 1 At the time the deal was announced, it was valued at over $150 billion. Martin Peers et al., Media Blitz: AOL, Time Warner Leap Borders to Plan a Mammoth Merger, WALL ST. J., Jan. 11, 2000, at A1. By the time the merger was consummated, its value had shrunk to around $100 billion, Jill Carroll, AOL-Time Warner Merger Clears FCC, WALL ST. J., Jan. 12, 2001, at A3, and the deal had been eclipsed by Vodafone’s acquisition of Mannesmann, Philip Shishkin & William Boston, Vodafone Wins EU Clearance to Acquire Mannesmann in Record $180 Billion Deal, WALL ST. J., Apr. 13, 2000, at A14. 2 See Bruce Orwall & John Lippman, High Concept in Hollywood: More Web Alliances for Hollywood, WALL ST. J., Jan. 12, 2000, at B1; Susan Pulliam & Paul M. Sherer, Anything Goes! After AOL Time Warner, Who’s Next?, WALL ST. J., Jan. 11, 2000, at C1. 3 For a complete discussion of the regulatory history of open access, see infra Subsection III.A.2
Vertical Integration and Media Regulation in the New Economy Internet content at speeds exceeding one million bits per second (1 Mbps) The Federal Communications Commission("FCC )estimates that within the next four years, over one-third of all U.S. households will subscribe to ome form of broadband service 4 The concern about open access stems from one important difference between narrowband and broadband connections to the internet. In the narrowband world, customers can use their telephone lines to connect to any one of a large number of Internet service providers (ISPs) Broadband providers, in contrast, typically require their customers to employ a proprietary ISP, Competitors and observers began to raise concerns that such exclusivity arrangements had the potential to reduce consumer choice and harm competition. As a result, these parties asked the FCC to impose an"open access"requirement that would require cable modem systems to make their transmission lines available to other, non- proprietary ISPs on reasonable and non-discriminatory terms Early calls for open access fell on deaf ears. Consistent with its longstanding policy of non-regulation of computer-based services, the FCC rejected calls for imposing open access as a condition to approving AT&T's acquisition of TCI and MediaOne. Attempts to impose open access through municipal regulation were effectively blocked by a series of judicial decisions holding that the fCC has exclusive jurisdiction over the issue. Just seven months after its most recent refusal to impose open access, however, the FCC reversed course and embraced the concept of open access by conditioning its approval of the AOL-Time Warner merger on the merged company's willingness to negotiate access agreements with nd Possible Steps to Accelerate Such Deployment Pursuant to section 706 of the telec 1996,15FC.CR.20,913,20,983,·186(2000 (Second Report) [hereinafter Second Ac vices Report] 5 For example, before its collapse, Excite(@ Home, which was the largest ISP serving cable modem subscribers, was owned by such major cable modem providers as AT&T, Comcast, Cox Communications, Cablevision Systems, and Shaw Cablesystems, and was the exclusive IsP for those systems. Time Wamer, which is the second largest high-speed broadband provider, has previously required all of its users to use a proprietary ISP called RoadRunner. See Applications for Consent to the Transfer of Control of Licenses and Section 214 Authorizations from MediaOne Group, Inc Transferor, to AT&T Corp, Transferee, 15 F.C. C.R. 9816, 9863, 1 107(2000)(Memorandum Opinion and Order) [ hereinafter AT&T-MediaOne Merger 6 Applications for Consent to the Transfer of Control of Licenses and Section 214 3160, 3197-98,75(1999)(Memorandum Opinion and Order)[ hereinafter AT&T-TCl Merger AT&T-MediaOne Merger, supra note 5, at 9866, 1114-15 See, e. g, JASON OXMAN, THE FCC AND THE UNREGULATION OF THE INTERNET 8-12 No.31,jUly1999),availableathttp://www.fcc Bureaus/OPP/working_papers/oppwp31. pd 8 AT&T-TCI Merger, supra note 6, at 3205-07, 1192-96, AT&T-Me tes,at9866-73,"116-28 9 See MediaOne Group, Inc. v. County of Henrico, 257 F3d 356(4th Cir. 2001), AT&T Corp v City of Portland, 216 F3d 871(9th Cir. 2000) 175
Vertical Integration and Media Regulation in the New Economy 175 Internet content at speeds exceeding one million bits per second (1 Mbps). The Federal Communications Commission (“FCC”) estimates that within the next four years, over one-third of all U.S. households will subscribe to some form of broadband service.4 The concern about open access stems from one important difference between narrowband and broadband connections to the Internet. In the narrowband world, customers can use their telephone lines to connect to any one of a large number of Internet service providers (“ISPs”). Broadband providers, in contrast, typically require their customers to employ a proprietary ISP.5 Competitors and observers began to raise concerns that such exclusivity arrangements had the potential to reduce consumer choice and harm competition. As a result, these parties asked the FCC to impose an “open access” requirement that would require cable modem systems to make their transmission lines available to other, nonproprietary ISPs on reasonable and non-discriminatory terms.6 Early calls for open access fell on deaf ears. Consistent with its longstanding policy of non-regulation of computer-based services,7 the FCC rejected calls for imposing open access as a condition to approving AT&T’s acquisition of TCI and MediaOne.8 Attempts to impose open access through municipal regulation were effectively blocked by a series of judicial decisions holding that the FCC has exclusive jurisdiction over the issue.9 Just seven months after its most recent refusal to impose open access, however, the FCC reversed course and embraced the concept of open access by conditioning its approval of the AOL-Time Warner merger on the merged company’s willingness to negotiate access agreements with 4 Inquiry Concerning the Deployment of Advanced Telecomms. Capability to All Americans in a Reasonable and Timely Fashion, and Possible Steps to Accelerate Such Deployment Pursuant to Section 706 of the Telecomms. Act of 1996, 15 F.C.C.R. 20,913, 20,983, ¶ 186 (2000) (Second Report) [hereinafter Second Advanced Services Report]. 5 For example, before its collapse, Excite@Home, which was the largest ISP serving cable modem subscribers, was owned by such major cable modem providers as AT&T, Comcast, Cox Communications, Cablevision Systems, and Shaw Cablesystems, and was the exclusive ISP for those systems. Time Warner, which is the second largest high-speed broadband provider, has previously required all of its users to use a proprietary ISP called RoadRunner. See Applications for Consent to the Transfer of Control of Licenses and Section 214 Authorizations from MediaOne Group, Inc., Transferor, to AT&T Corp., Transferee, 15 F.C.C.R. 9816, 9863, ¶ 107 (2000) (Memorandum Opinion and Order) [hereinafter AT&T-MediaOne Merger]. 6 Applications for Consent to the Transfer of Control of Licenses and Section 214 Authorizations from Tele-Communications, Inc., Transferor, to AT&T Corp., Transferee, 14 F.C.C.R. 3160, 3197-98, ¶ 75 (1999) (Memorandum Opinion and Order) [hereinafter AT&T-TCI Merger]; AT&T-MediaOne Merger, supra note 5, at 9866, ¶¶ 114-15. 7 See, e.g., JASON OXMAN, THE FCC AND THE UNREGULATION OF THE INTERNET 8-12 (FCC Office of Plans and Policy, Working Paper No. 31, July 1999), available at http://www.fcc.gov/ Bureaus/OPP/working_papers/oppwp31.pdf. 8 AT&T-TCI Merger, supra note 6, at 3205-07, ¶¶ 92-96; AT&T-MediaOne Merger, supra note 5, at 9866-73, ¶¶ 116-28. 9 See MediaOne Group, Inc. v. County of Henrico, 257 F.3d 356 (4th Cir. 2001); AT&T Corp. v. City of Portland, 216 F.3d 871 (9th Cir. 2000)
Yale Journal on Regulation Vol.19:171.2002 at least three unaffiliated ISPs. The breadth of the reasoning contained in its Memorandum Opinion and Order regarding the merger suggest that the FCC may be willing to consider far more sweeping action This abrupt change in policy sparked new regulatory and academic interest in open access. Not only did the FCCs decision place new importance on the Notice of Inquiry currently pending before the agency it also stimulated a new round of scholarship that raised two different types of arguments in favor of open access. The first set of arguments centered on the concern that cable modem systems would use vertical integration or other forms of exclusive dealing to harm competition in the market for ISPs. In so arguing. these scholars invoked one of the central issues of vertical integration theory--whether a company can use its monopoly power over one level of the chain of production to harm competition in another level that otherwise would have been competitive. The danger that media companies might exercise market power vertically has long been a major focus of federal media policy, having played a pivotal role in the seminal cases regarding the structural regulation of broadcastingand cable television The other set of arguments added a distinctively"New Economy twist to the debate. For example, Professors Mark Lemley and Lawrence Less ho are without question two of the leading legal scholars and technology issues, contend that open access is essential to preserving and promoting continued innovation on the Internet. Other scholars have employed such new economic tools as game theory and network economics to fashion arguments in support of open access that go far Authorizations by Time Warner, Inc and America Online, Inc Time Wamer Inc, Transferee, 16 F.C. C R 6547, 6590,.96(2001)(Memorandu and Order)[hereinafter AOL-Time Warner Merger. In so concluding, the FCC endorsed onclusion drawn by the Federal Trade Commission. See America Online Inc. Docket No. 001wL410712(F.TC. Apr 17, 2001)(Decision and Order) 11 AOL-Time Warner Merger, supra note 10, at 36-57, 1181-127 12 See Inquiry Concerning High-Speed Access to the Internet Over Cable and Othe Facilities, 15 F.C. C.R. 19, 287(2000)( 13 See, e.g, Jim Chen, The Authority to Regulate Broadband Internet Access over Cabi 16 BERKELEY TECH. L.J. 677(2001); Jerry A. Hausman et al., Residential Demand for broadband Telecommunications and Consumer Access to Unaffiliated Internet Content Providers, 18 YALE JON REG. 129(2001): Daniel L. Rubinfeld Hal J. Singer, Open Access to Broadband Networks: A Case Study of the AOL/Time Warner Merger, 16 BERKELEY TECH L. 631(2001). For a detailed re these arguments, see infra notes 310-322 and 14 NBC V United States, 319 U.S 190(1943). See generally infra text accompanying notes 512 U.S. 622(1994 ). See generally infra text accompanying notes 209-214 Lawrence Lessig, The End of End-to-End: Preserving the Architecture of the Internet in the Broadband Era, 48 UCLA L REV. 925(2001) 17 See Rubinfeld Singer, supra note 13, at 655-57. 18 See Hausman et al, supra note 13, at 161-65 176
Yale Journal on Regulation Vol. 19:171, 2002 176 at least three unaffiliated ISPs.10 The breadth of the reasoning contained in its Memorandum Opinion and Order regarding the merger suggest that the FCC may be willing to consider far more sweeping action.11 This abrupt change in policy sparked new regulatory and academic interest in open access. Not only did the FCC’s decision place new importance on the Notice of Inquiry currently pending before the agency,12 it also stimulated a new round of scholarship that raised two different types of arguments in favor of open access. The first set of arguments centered on the concern that cable modem systems would use vertical integration or other forms of exclusive dealing to harm competition in the market for ISPs.13 In so arguing, these scholars invoked one of the central issues of vertical integration theory—whether a company can use its monopoly power over one level of the chain of production to harm competition in another level that otherwise would have been competitive. The danger that media companies might exercise market power vertically has long been a major focus of federal media policy, having played a pivotal role in the seminal cases regarding the structural regulation of broadcasting14 and cable television.15 The other set of arguments added a distinctively “New Economy” twist to the debate. For example, Professors Mark Lemley and Lawrence Lessig, who are without question two of the leading legal scholars on law and technology issues, contend that open access is essential to preserving and promoting continued innovation on the Internet.16 Other scholars have employed such new economic tools as game theory17 and network economics18 to fashion arguments in support of open access that go far 10 Applications for Consent to the Transfer of Control of Licenses and Section 214 Authorizations by Time Warner, Inc. and America Online, Inc., Transferors, to AOL Time Warner Inc., Transferee, 16 F.C.C.R. 6547, 6590, ¶ 96 (2001) (Memorandum Opinion and Order) [hereinafter AOL-Time Warner Merger]. In so concluding, the FCC endorsed a similar conclusion drawn by the Federal Trade Commission. See America Online, Inc., Docket No. C-3989, 2001 WL 410712 (F.T.C. Apr. 17, 2001) (Decision and Order). 11 AOL-Time Warner Merger, supra note 10, at 36-57, ¶¶ 81-127. 12 See Inquiry Concerning High-Speed Access to the Internet Over Cable and Other Facilities, 15 F.C.C.R. 19,287 (2000) (Notice of Inquiry). 13 See, e.g., Jim Chen, The Authority to Regulate Broadband Internet Access over Cable, 16 BERKELEY TECH. L.J. 677 (2001); Jerry A. Hausman et al., Residential Demand for Broadband Telecommunications and Consumer Access to Unaffiliated Internet Content Providers, 18 YALE J. ON REG. 129 (2001); Daniel L. Rubinfeld & Hal J. Singer, Open Access to Broadband Networks: A Case Study of the AOL/Time Warner Merger, 16 BERKELEY TECH. L.J. 631 (2001). For a detailed review of these arguments, see infra notes 310-322 and accompanying text. 14 NBC v. United States, 319 U.S. 190 (1943). See generally infra text accompanying notes 42-49. 15 Turner Broad. Sys., Inc. v. FCC, 520 U.S. 180 (1997); Turner Broad. Sys., Inc. v. FCC, 512 U.S. 622 (1994). See generally infra text accompanying notes 209-214. 16 Mark A. Lemley & Lawrence Lessig, The End of End-to-End: Preserving the Architecture of the Internet in the Broadband Era, 48 UCLA L. REV. 925 (2001). 17 See Rubinfeld & Singer, supra note 13, at 655-57. 18 See Hausman et al., supra note 13, at 161-65
Vertical Integration and Media Regulation in the New Economy beyond any of the rationales advanced in prior debates about vertical integration in media-related industries. To date, no one has undertaken a comprehensive evaluation of the economic arguments surrounding these issues. Media scholars have historically analyzed the problems associated with vertical integration in largely non-economic terms. It is only in recent years that scholars have begun to bring the insights of the burgeoning economic literature on vertical integration to bear on the regulation of media industries. while providing a welcome and useful starting point for exploring these issues, these initial economic studies have ultimately proven to be somewhat incomplete in that they have either limited their focus to a single communications technology or have concentrated only on certain economic schools of thought without taking the full sweep of modern vertical integration theory into account. The need to come to grips with the full range of issues raised by the literature on vertical integration is likely to grow even more onerous in the near future. As Professors Joseph Kearney and Thomas Merrill have observed, calls for open access in the communications sector are part of a new emerging paradigm that the This Article focuses solely on the ue to media-related industries. As a lo not discuss telephone-related technologies, whic underlay the 1982 breakup of AT&T, see United States v. AT&T Co., 552 F Supp. 131 (DD C. 1982), affd, 460 U.S. 1001(1983), as well as the provisions of the Telecommunications Act f 1996 that prohibited the former Bell Operating Companies that did not yet face local competitio from entering the long distance market, see 47 U.S.C. $271(Supp. Ill 1997). For insightful discussions of the continuing influence of concerns about vertical on curren licy, see Timothy J. Brennan, Does the Theory Behind U.S. v. AT&T Still Apply Today?, 40 ANTITRUST BULL. 455(1995); and Paul L Joskow Roger G. Noll, The Bell Doctrine: Applications in Telecommunications, Electricity, and Other Nenwork Industries, 51 STAN. L. REV. 1249(1999) Most analyses have focused on whether vertical structural regulations violate the First Amendment. E. g, THOMAS G. KRATTENMAKER LUCAS A JR REGUL BROADCAS PROGRAMMING(1994); Benjamin M. Compaine, The Impact of Ownership on Content: Does It Matter 13 CARDOzo ARTS ENT. L.J. 755(1995); Jonathan W. Emord, The First An Invalidity of FCC Ownership Regulations, 38 CATH. U. L. REV. 401(1989). 21 See David Waterman ANDrEw A. WEISS. VERTICAL INTEGRATION IN CABLE TELEVISION (1997); Ashutosh Bhagwat, Unnatural Competition?: Applying the New Antitrust Learning to Foster Competition in the Local Exchange, 50 HASTINGS LJ. 1479(1999); Jim Chen, The Last Picture Show(On the Twilight of Federal Mass Commumications Regulation), 80 MINN. L REV. 1415(1996), David D. Haddock Daniel D. Polsby, Bright Lines, the Federal Commmunications Commission's Duopoly Rule, and the Diversity of voices, 42 FED COMM. L.J. 331(1990), John E. Cable Bundling, 52 HASTINGS LJ. 891(2001 ), John E Lopatka Michael G. Vita, The Must-Carry Decisions: Bad Law, Bad Economics, 6 SUP. CT. ECON. REV. 61(1998); James W. Olson lawrence J. Spiwak, Can Short-Term Limits on Strategic Vertical Restraints Improve Long-Term Cable Industry Market Performance?, 13 CARDOZO ARTs ENT L.J. 283(1995); James B Speta, Handicapping the Race for the Last Mile?: A Critique of Open Access Rules for Broadband Platforms, 17 YALE J.ON REG. 39(2000)[hereinafter Speta, Handicapping]; James B Speta, The Vertical Dimension of cable Open Access, 71 U COLO. L REv.975(2000)[hereinafter Speta, Vertical Dimension
Vertical Integration and Media Regulation in the New Economy 177 beyond any of the rationales advanced in prior debates about vertical integration in media-related industries.19 To date, no one has undertaken a comprehensive evaluation of the economic arguments surrounding these issues. Media scholars have historically analyzed the problems associated with vertical integration in largely non-economic terms.20 It is only in recent years that scholars have begun to bring the insights of the burgeoning economic literature on vertical integration to bear on the regulation of media industries.21 While providing a welcome and useful starting point for exploring these issues, these initial economic studies have ultimately proven to be somewhat incomplete in that they have either limited their focus to a single communications technology or have concentrated only on certain economic schools of thought without taking the full sweep of modern vertical integration theory into account. The need to come to grips with the full range of issues raised by the literature on vertical integration is likely to grow even more onerous in the near future. As Professors Joseph Kearney and Thomas Merrill have observed, calls for open access in the communications sector are part of a new emerging paradigm that they 19 This Article focuses solely on the economics unique to media-related industries. As a result, I do not discuss telephone-related technologies, which tend to be natural monopolies and which do not require large, up-front sunk costs in content. In so doing, I do not mean to suggest that vertical integration in the telephone industry is unimportant. On the contrary, it is now well-known that such concerns underlay the 1982 breakup of AT&T, see United States v. AT&T Co., 552 F. Supp. 131 (D.D.C. 1982), aff’d, 460 U.S. 1001 (1983), as well as the provisions of the Telecommunications Act of 1996 that prohibited the former Bell Operating Companies that did not yet face local competition from entering the long distance market, see 47 U.S.C. § 271 (Supp. III 1997). For insightful discussions of the continuing influence of concerns about vertical integration on current telephone policy, see Timothy J. Brennan, Does the Theory Behind U.S. v. AT&T Still Apply Today?, 40 ANTITRUST BULL. 455 (1995); and Paul L. Joskow & Roger G. Noll, The Bell Doctrine: Applications in Telecommunications, Electricity, and Other Network Industries, 51 STAN. L. REV. 1249 (1999). 20 Most analyses have focused on whether vertical structural regulations violate the First Amendment. E.g., THOMAS G. KRATTENMAKER & LUCAS A. POWE, JR., REGULATING BROADCAST PROGRAMMING (1994); Benjamin M. Compaine, The Impact of Ownership on Content: Does It Matter?, 13 CARDOZO ARTS & ENT. L.J. 755 (1995); Jonathan W. Emord, The First Amendment Invalidity of FCC Ownership Regulations, 38 CATH. U. L. REV. 401 (1989). 21 See DAVID WATERMAN & ANDREW A. WEISS, VERTICAL INTEGRATION IN CABLE TELEVISION (1997); Ashutosh Bhagwat, Unnatural Competition?: Applying the New Antitrust Learning to Foster Competition in the Local Exchange, 50 HASTINGS L.J. 1479 (1999); Jim Chen, The Last Picture Show (On the Twilight of Federal Mass Communications Regulation), 80 MINN. L. REV. 1415 (1996); David D. Haddock & Daniel D. Polsby, Bright Lines, the Federal Communications Commission’s Duopoly Rule, and the Diversity of Voices, 42 FED. COMM. L.J. 331 (1990); John E. Lopatka & William H. Page, Internet Regulation and Consumer Welfare: Innovation, Speculation, and Cable Bundling, 52 HASTINGS L.J. 891 (2001); John E. Lopatka & Michael G. Vita, The Must-Carry Decisions: Bad Law, Bad Economics, 6 SUP. CT. ECON. REV. 61 (1998); James W. Olson & Lawrence J. Spiwak, Can Short-Term Limits on Strategic Vertical Restraints Improve Long-Term Cable Industry Market Performance?, 13 CARDOZO ARTS & ENT. L.J. 283 (1995); James B. Speta, Handicapping the Race for the Last Mile?: A Critique of Open Access Rules for Broadband Platforms, 17 YALE J. ON REG. 39 (2000) [hereinafter Speta, Handicapping]; James B. Speta, The Vertical Dimension of Cable Open Access, 71 U. COLO. L. REV. 975 (2000) [hereinafter Speta, Vertical Dimension]
Yale Journal on Regulation Vol.19:171.2002 believe is effecting a"grand transformation " in the way that policy makers are approaching all regulated industries As a result. i believe that the time has come to undertake a more systematic review of the economics of vertical integration and acces regimes in order to explore the extent to which the insights provided support or undercut recent attempts to regulate the vertical market structure of the various media industries. Only by bringing together all of the various threads of vertical integration theory can we understand the way that the different parts of the theory interact with one another The basic organization of this Article is to use the major conceptual trands in the economic literature on vertical integration to analyze previous attempts to regulate vertical integration in three different segments of the communications universe-broadcasting, cable television, and high-speed broadband. Part I uses the FCCs first attempt to address the issues raised by vertical integration-the Chain Broadcasting Rules to review the basic economics of vertical integration even the most cursory reading of the economic literature reveals that issues surrounding ertical integration have proven to be quite controversial, as the Harvard School approach to industrial organization, which tended to regard vertical integration as illegal per se, gave way to the Chicago School of antitrust law and economics which tended to regard vertical integration as more benign. The Chicago Schools call for treating vertical integration as legal per se has in turn inspired the development of the post-Chicago School 22 See generally Joseph D. K Thomas w. Merrill, The Grand Transformation of Regulated Industries Law, 98 COLUM. L REV. 1323, 1340-57(1998) 23 This Article is the first step in what I hope will be a comprehensive critiq medium as a universe unto itself. As a result, policy debates tended to focus on the economics associated with the particular means of transmission at issue and the First Amendment implications of the communications being transmitted. technological ce. however. is altering media economics in fundamental ways that make the previous technological orientation untenable. My long- rm goal is to begin thinking about media reg major regulatory approaches taken with regard to each of the existing communications technologies and determining the extent to which the lessons contained in each can serve as a model of regulation for the others. This Article focuses on the characteristic that I believe dominates the approach to gulating cable television (i.e, concerns about the vertical exercise of market power). Subsequent papers will focus on the common carriage and scarcity/diversity paradigms associated with telephony and broadcasting. 24 As scholars have frequently noted, firms can achieve many of the same benefits vertical contractual restraints. As a result, the insights are quite similar. See RoGER D. blair L. KASERMAN. LAW AND ECONOMICS OF VERTICAL INTEGRATION AND CONTROL 20 SON, MARKETS& HIERARCHIES 29-30, 35-37(1975); Andy M. Chen Keith N ylton, Procompetitive Theories of vertical Control, 50 HASTINGS L.J. 573, 583-85, 587, 590-91 (1999). For more detailed analysis of the tegration, see BLair KaseRman, supra, at 52-82: PAUL MILGROM JOHN ROBERTS, ECoNOMICS ORGANIZATION AND MANAGEMENT 552-69(1992), and JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION 173-81(1988) 178
Yale Journal on Regulation Vol. 19:171, 2002 178 believe is effecting a “grand transformation” in the way that policy makers are approaching all regulated industries.22 As a result, I believe that the time has come to undertake a more systematic review of the economics of vertical integration and access regimes in order to explore the extent to which the insights provided support or undercut recent attempts to regulate the vertical market structure of the various media industries.23 Only by bringing together all of the various threads of vertical integration theory can we understand the way that the different parts of the theory interact with one another. The basic organization of this Article is to use the major conceptual strands in the economic literature on vertical integration to analyze previous attempts to regulate vertical integration in three different segments of the communications universe—broadcasting, cable television, and high-speed broadband. Part I uses the FCC’s first attempt to address the issues raised by vertical integration—the Chain Broadcasting Rules— to review the basic economics of vertical integration.24 Even the most cursory reading of the economic literature reveals that issues surrounding vertical integration have proven to be quite controversial, as the Harvard School approach to industrial organization, which tended to regard vertical integration as illegal per se, gave way to the Chicago School of antitrust law and economics, which tended to regard vertical integration as more benign. The Chicago School’s call for treating vertical integration as legal per se has in turn inspired the development of the post-Chicago School, 22 See generally Joseph D. Kearney & Thomas W. Merrill, The Grand Transformation of Regulated Industries Law, 98 COLUM. L. REV. 1323, 1340-57 (1998). 23 This Article is the first step in what I hope will be a comprehensive critique and reconceptualization of media regulation. Previous scholarship in this area has tended to take each medium as a universe unto itself. As a result, policy debates tended to focus on the economics associated with the particular means of transmission at issue and the First Amendment implications of the communications being transmitted. Technological convergence, however, is altering media economics in fundamental ways that make the previous technological orientation untenable. My longterm goal is to begin thinking about media regulation in a more integrated manner by examining the major regulatory approaches taken with regard to each of the existing communications technologies and determining the extent to which the lessons contained in each can serve as a model of regulation for the others. This Article focuses on the characteristic that I believe dominates the approach to regulating cable television (i.e., concerns about the vertical exercise of market power). Subsequent papers will focus on the common carriage and scarcity/diversity paradigms associated with telephony and broadcasting. 24 As scholars have frequently noted, firms can achieve many of the same benefits through vertical contractual restraints. As a result, the insights are quite similar. See ROGER D. BLAIR & DAVID L. KASERMAN, LAW AND ECONOMICS OF VERTICAL INTEGRATION AND CONTROL 20, 82 (1983); OLIVER E. WILLIAMSON, MARKETS & HIERARCHIES 29-30, 35-37 (1975); Andy M. Chen & Keith N. Hylton, Procompetitive Theories of Vertical Control, 50 HASTINGS L.J. 573, 583-85, 587, 590-91 (1999). For more detailed analysis of the extent to which vertical restraints can simulate vertical integration, see BLAIR & KASERMAN, supra, at 52-82; PAUL MILGROM & JOHN ROBERTS, ECONOMICS, ORGANIZATION AND MANAGEMENT 552-69 (1992); and JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION 173-81 (1988)
Vertical Integration and Media Regulation in the New Economy which has renewed scholarly interest in the ways that vertical integration can harm competition Although the scope of disagreement among these approaches remains significant, what I find most interesting is the extent to which consensus exists on certain issues. In particular, a review of the literature reveals that the Chicago School and post-Chicago models both begin from the premise that certain structural conditions must exist before vertical integration can pose any threat to competition. Furthermore, Chicago School and post Chicago theorists generally agree that vertical integration may lead to efficiencies that may justify vertical integration even when the market structure creates some anti-competitive dangers. An application of this basic framework to the broadcast television industry suggests that the emphasis on preventing vertical integration is fundamentally misguided since the relevant markets are not structured in a way that would permit any firm to use vertical integration to harm competition. The analysis shows, moreover, that the cost structure of producing television programming is such that vertical integration is likely to lead to the realization of significant efficiencies. While it is true that game theory network economics. and innovation-based models do indicate that vertical integration can sometimes harm competition, a close analysis of the formal models reveals that such anti-competitive effects arise only under particular circumstances. As a result, although these analyses provide strong support for rejecting the Chicago Schools call for treating vertical tegration as legal per se and insisting that vertical arrangements remain subject to antitrust scrutiny under the rule of reason, they do not support the imposition of categorical regulatory rules that would, in essence, render vertical integration illegal without any analysis of the facts of a particular case. Such an outcome would be tantamount to a return to the rule of per se illegality associated with the now-discredited Harvard School approach Part Il uses an analysis of vertical integration in the cable television industry to extend the analysis further. In addition to applying the framework developed in Part I, this Part also discusses the problematic Ra spelled access as a remedy. Unlike conventional antitrust nature of com remedies, which seek to break up the monopoly power, access remedies simply demand that the monopoly bottleneck be shared, a result that doe not necessarily lead to the reductions in price and increases in quantity required to enhance static efficiency. Access remedies cause even greater roblems in terms of dynamic efficiency. The central problem is that forcing a monopolist to share an input rescues other firms seeking access to that input from having to develop alternative sources of supply. Access remedies thus can entrench the existing monopoly by depriving firms interested in competing with the monopoly of their natural strategic
Vertical Integration and Media Regulation in the New Economy 179 which has renewed scholarly interest in the ways that vertical integration can harm competition. Although the scope of disagreement among these approaches remains significant, what I find most interesting is the extent to which consensus exists on certain issues. In particular, a review of the literature reveals that the Chicago School and post-Chicago models both begin from the premise that certain structural conditions must exist before vertical integration can pose any threat to competition. Furthermore, Chicago School and postChicago theorists generally agree that vertical integration may lead to efficiencies that may justify vertical integration even when the market structure creates some anti-competitive dangers. An application of this basic framework to the broadcast television industry suggests that the emphasis on preventing vertical integration is fundamentally misguided since the relevant markets are not structured in a way that would permit any firm to use vertical integration to harm competition. The analysis shows, moreover, that the cost structure of producing television programming is such that vertical integration is likely to lead to the realization of significant efficiencies. While it is true that game theory, network economics, and innovation-based models do indicate that vertical integration can sometimes harm competition, a close analysis of the formal models reveals that such anti-competitive effects arise only under particular circumstances. As a result, although these analyses provide strong support for rejecting the Chicago School’s call for treating vertical integration as legal per se and insisting that vertical arrangements remain subject to antitrust scrutiny under the rule of reason, they do not support the imposition of categorical regulatory rules that would, in essence, render vertical integration illegal without any analysis of the facts of a particular case. Such an outcome would be tantamount to a return to the rule of per se illegality associated with the now-discredited Harvard School approach. Part II uses an analysis of vertical integration in the cable television industry to extend the analysis further. In addition to applying the framework developed in Part I, this Part also discusses the problematic nature of compelled access as a remedy. Unlike conventional antitrust remedies, which seek to break up the monopoly power, access remedies simply demand that the monopoly bottleneck be shared, a result that does not necessarily lead to the reductions in price and increases in quantity required to enhance static efficiency. Access remedies cause even greater problems in terms of dynamic efficiency. The central problem is that forcing a monopolist to share an input rescues other firms seeking access to that input from having to develop alternative sources of supply. Access remedies thus can entrench the existing monopoly by depriving firms interested in competing with the monopoly of their natural strategic
