The AT&T deal drew the wrath of both the Justice Department and the FCC, which ultimately proved fatal. Does a similar fate await Verizon?

Ah, you say – there’s no real comparison. Unlike the proposed AT&T/T-Mobile merger, Verizon’s acquisition doesn’t involve the acquisition of millions of subscribers from a competitor, increasing market concentration in the wireless market.

But the deals do have one big thing in common: In both, the primary objective was to cope with the looming scarcity of spectrum. For without more bandwidth, neither carrier will be able to deliver on the promise of whiz-bang wireless broadband services such as high definition movies anytime, anywhere.

To be sure, the problem here is not precisely a shortage of spectrum per se, but a shortage created by the wasteful allocation of spectrum today. If Washington were so inclined, it could free up a ton of spectrum for more valuable uses. That includes spectrum now warehoused by government for low-value tasks and spectrum assigned to commercial interests – notably local TV stations – that no longer make much use of it. The process would be pretty simple: auction the spectrum to the highest bidders (perhaps with a share of the proceeds going to legacy holders), and then allow it to be traded like any other valued resource.

This is an old, but important, idea, one first suggested by Nobel economics laureate Ronald Coase back in 1959. And it’s one that has taken on greater urgency in recent years, both because the technology of spectrum-hungry broadband mobile has arrived in the form of tablets and smartphones, and because Washington desperately needs revenue. (We’re talking tens of billions here.) But the politics of spectrum allocation remain gridlocked, as competing interests push and shove for advantage.

So AT&T and Verizon, the number one and two players in the American wireless market, resorted to end-runs around the problem – that is, to buying spectrum from other carriers or merging to make more efficient use of the partners’ combined holdings. If the AT&T/T-Mobile combination had survived the legal gauntlet, it could have become the largest U.S. wireless provider, with as much as one-third of the market. But the emphasis here is on the word “theory.” The merger might or might not have reversed T-Mobile’s sinking fortunes – which is why its parent company, Deutsche Telekom, has signaled its intent to leave the U.S. market, with or without a merger deal.

The upshot is that it’s far from self-evident that AT&T would have remained first in subscribers for long in a post-merger market. Verizon’s rollout of 4G, the holy grail of mobile excellence, is expected to cover more than 200 million Americans by the end of this year — compared with roughly 70 million for AT&T. Moreover, the proposed Verizon deal includes cross-marketing with the cable companies’ retail stores, yet another advantage in this most visible of consumer markets.

But the merger succumbed to implacable opposition from the trustbusters at Justice and the micromanagers at the FCC. Both agencies argued that the merger would give AT&T more latitude to raise prices. And neither apparently put much weight on AT&T’s need for additional spectrum if it is to offer viable competition for Verizon in a 4G world.

If this were 1951 instead of 2011, a time when self-satisfied American mega-companies like GM set the pace for global industrial innovation, we’d have more sympathy for the government’s tilt against market concentration. But as the Verizon gambit makes clear, this is anything but a static contest. AT&T and Verizon are living in uncertain times in which they must run to stay in place. That doesn’t mean the risk of monopoly power is as dead as the Oldsmobile. But it does mean that discretion in managing markets really has become the better part of valor.

As we see it, Washing has three options. The first is to drastically limit what firms like Verizon and AT&T can do to improve their service offerings, with obvious short-term consequences in terms of slowing the roll out of 4G. The second is to break through interest-group gridlock and leaven competition in the wireless market with a lot more spectrum – the best option, surely, but probably a political non-starter at the moment. The third option, and the probably the best under the circs, is to look favorably upon telecom deals that promise more efficient use of currently available spectrum on the premise that the vitality of innovation means more to consumers than the potential downside of greater market concentration.

Does that mean giving free passes to the telecom giants? Hardly. But it would mean a change in priorities at Justice and the FCC in which the agencies used their legal leverage to minimize concentration in regional wireless market without undermining the potential for more efficient use of spectrum.

The FCC Chairman explained that the ruling would “spur investment in mobile broadband and promote competition.” We’re unconvinced. There is always a significant price to pay for this sort of detailed regulation: Rate-setting is a messy business that is guaranteed to keep an army of lawyers, lobbyists and economists fully employed. And that may be only the beginning.

Consumers might enjoy lower rates in the short run, if they’re lucky – but face a real major risk of lesser service in the long run. If the tariffs prescribed are below the levels needed to cover the fully allocated costs of maintaining the networks, the smaller carriers would have an incentive to free-ride on the majors’ existing investments rather than making their own. What’s more, the obligation to share the wealth in the future would reduce the larger carriers’ incentives to add capacity – in the end, actually undermining competition.

True, there’s always the chance that, left on their own, the big guys will abuse their dominant position. But as The Economist recently pointed out (and as we recently echoed), such hypotheticals are better addressed by the antitrust laws if and when they arise.

Yes and no. Yes, because consumers who are thinking about switching to Verizon are being put on notice that they may run into trouble using their smartphones’ most demanding capacities – notably, streaming video – at peak hours. If you don’t want to risk slowdowns, buy service from another carrier. On second thought, better just to trim your expectations:  none of the other carriers can guarantee blinding speed 100 percent of the time.

No, in the sense it is in the interest of everybody on Verizon’s network for the company to manage traffic so that nobody is denied service when it runs out of bandwidth. What else would you have Verizon do? Drop calls? Randomly block key data services like email for those at the back of the queue?

Some supporters of “net neutrality” will no doubt complain since Verizon is practicing what might be called discrimination in an effort to ration scarce bandwidth. But they’re unlikely to get a sympathetic hearing from the FCC, which would permit throttling under its proposed Internet rules. All we can ask for is transparency: If the telcos want to manage their wireless networks this way, they need to make their policies clear upfront.  The government, for its part, should work to make throttling less likely by auctioning more bandwidth to the highest bidders.

Remember when you mostly used the Internet for shopping, email and looking up stuff like the name of Sandra Bullock’s coolest movie (Speed, co-starring Keanu Reeves)? Maybe you still do. But if you’re young, or anxious to have something to talk about with your teenager, chances are you now spend a lot of time on sites like YouTube, Facebook and Skype. What’s more, most of the content (measured in bytes) is bandwidth-hungry video “streamed” in real time — not words, music and photos downloaded for perusal at your leisure.

A sea change in Internet use? More like a tsunami that’s reshaping how, where and when we get our entertainment. But it’s going to take a lot of capital, along with some fresh thinking about how to recoup that investment, to make it happen. More ominously, it’s going to take a lot of self-restraint on the part of policymakers, who will be caught in the crossfire as content providers, telecom companies and consumers fight for bigger slices of the pie.

The long heralded, but long delayed, integration of TV and the Internet is finally upon us. In the two hours between 8:00 and 10:00 PM, Netflix streaming movies and TV shows account for one-fifth (not a misprint) of all the Internet bandwidth being used in the United States. And that’s not the half of it. True Internet TV is about to go mainstream.

One reason is that the technology is catching up with the vision: TV manufacturers are introducing sets with easy access to the Internet built in. Want to watch The Devil Wears Prada? Tonight’s network shows? Or maybe a cricket match, live from New Delhi? All that programming is available on the Internet. And with the new TVs, you’ll be able to buy it on demand just as easily as you buy clothes and books on your PC. Indeed, it will soon be practical for anyone with a broadband connection to bypass cable and satellite TV entirely, watching whatever they want, when they want it, via the Internet.

Burgeoning access to video on wireless devices promises to be equally disruptive, since most of the streaming video available on computers can also be seen on smartphones and tablets. The only constraint is access to fast wireless networks. And that probably won’t remain a constraint for long: Morgan Stanley predicts that video usage will rise 66-fold between 2008 and 2013 in the United States, by the latter year representing two-thirds of all wireless data traffic.

So, what stands between consumers and video nirvana? For starters, Internet capacity will have to keep up with demand. When 20 percent of the Internet is being hogged by Netflix, fewer than one million Netflix subscribers are online. Imagine how many terabytes of data per minute will have to pass through Internet switches when 100 million Americans are watching TV (or playing high-definition video games) online.

What’s more, those terabytes will have to flow seamlessly: Nobody knows or cares if iTunes hiccups occasionally on music downloads. But a bottleneck lasting a few seconds could mar the experience of Avatar for tens of thousands.

Wireless system operators face the biggest challenges. In part that’s because they have so much further to go in building broadband capacity, in part because the all-you-can-eat data plans now favored by most customers will not work well as use becomes more skewed. That’s why AT&T and Verizon have switched to tiered pricing plans, and why every other wireless carrier in the U.S. will be dragged in the same direction.

Now, from technological and economic perspectives, keeping the Internet ahead of the video curve is surely manageable. There will no doubt be growing pains, as consumers face additional charges for bandwidth use and premium programming and content providers duke it out with the carriers over how to split revenue from Internet-based video. But there’s no good reason to believe the market won’t sort itself out.

No good reason, but maybe some bad ones. In particular, the government could easily be drawn into interest group battles masquerading as high-minded debates over the principles of telecommunications policy.

Should content providers be allowed to charge Internet service providers, the way they now charge cable TV and satellite companies? Or look at the carrier-content relationship from the other direction: Should service providers be allowed to charge content providers for premium video quality? Then, there are the questions raised by the fact that the lines between carriers and content providers are blurred. For example, should a wireless carrier that sells a lot of voice services be allowed to block (or charge) Internet phone companies that piggyback on their systems? Finally, should there be rules on how Internet service providers and wireless providers can charge you, the consumer, to recoup their huge investments?

No doubt, consultants in search of second homes will discover a zillion reasons for believing that, without intervention, the new, video-dominated Internet will generate windfalls for somebody. But we think the proper test is different: Are regulators likely to do a better job in promoting efficiency and growth in an industry characterized by rapidly changing technology and a need for tens of billions of dollars in capital to stoke the engine of progress?

The answer may turn on how markets evolve – in particular, whether any of the players manage to find ways to build durable barriers to competition. What does seem clear, though, is that the burden of proof should be on those who want regulation now, because the Internet TV revolution has finally arrived at your doorstep and could soon be in the palm of your hand.

(This post was also published on Forbes.com.)

But the potential for damage is quickly becoming more tangible. The rules being pressed by groups advocating what the policy wonks call “net neutrality”(see, for example, the position of Free Press) would likely deter investment and slow innovation at a time in which the Internet is rapidly changing from a text-based tool to one that offers a dazzling choice of data-heavy multimedia-based services.

Everybody agrees that online multimedia is revolutionizing communications. But the revolution is definitely a work in progress: streaming movies still occasionally break into pixel soup, and Internet phone calls all too often reverberate with echoes. The more extreme versions of net neutrality rules would bar the network operators from guaranteeing better performance to one content provider unless they offered the same service to all at no extra charge. Why, then, would the telecoms invest the billions needed to fulfill the promises of the Internet?

Why, indeed. The network operators will need to spend about $30 billion annually over the next five years – about half of it on advanced-generation wireless infrastructure for smartphones and tablets – to deliver what customers want. And they are now caught between a rock and a hard place, knowing they need the capacity, but reluctant to raise the capital without reasonable certainty of a solid return. The independent Phoenix Center for Advanced Legal & Economic Public Policy Studies estimated that simply the announcement by the FCC that it was pondering new Internet rules cut the market capitalization of cable companies by 10 percent. And what’s bad for network operators is, more often than not, bad for the rest of us. An analysis by Stratecast, a private analytical firm, estimates that the shortfall in investment could impose a $7 billion cost on the economy in the first year alone.

Broadband is sold in what economists call a “two-sided market” that creates value for two distinct groups: content providers and consumers. And, in theory, Internet service providers could raise consumer access fees enough to make up for what would amount to price controls on content side. But that’s a problematic route, too, because the resulting sticker shock would almost certainly undermine infrastructure development. Cambridge Strategic Management Group, another consulting company, concluded that attempting to recoup the costs of fiber-optic cable to households in this way would cut new demand by half.

New York University’s Institute for Public Integrity, a champion of net neutrality, concedes that strict rules would erode network operators’ revenues, but suggests that government make up the difference with subsidies for broadband infrastructure. But why adopt policies that require government bucks for investment that the private sector could shoulder itself? The idea seems particularly unappealing (and politically implausible) in an era of large and rapidly escalating budget deficits.

Don’t get us wrong: regulatory vigilance is the price of healthy markets in Internet services. It’s possible, for example, that one vertically integrated telecom that sells both broadband services and broadband content – say, movies on demand – would have incentives to deliver inferior services or charge extortionate rates to a competing movie provider.

But we don’t need price controls or blunt non-discrimination rules to guard against such abuses. Congress could give the FCC the job of addressing the grievances of alleged victims of discrimination on a case-by-case basis – the method the FCC and other enforcement agencies have successfully used to protect consumers in other markets while leaving room for innovation and growth. Indeed, congressional middle-roaders – notably Olympia Snowe – appear to be headed in this direction.

With net neutrality decisions on hold until the November elections, policymakers have some breathing room to ponder a sensible compromise. Somebody needs to guard the store against felons. But it’s clear that giving the FCC the task of deciding what the store sells, to whom, and at what price would be an expensive mistake.

(This post was also published on Forbes.com.)

For the first time, companies with very different interests have found common ground on basic principles for regulating Internet access. But the limited nature of the accord only underscores the remaining differences between the two titans on the issue of prioritizing traffic.

Start with the good news. Verizon and Google agreed that wireless network operators should be permitted to manage traffic more or less as they see fit. Score one for the telcos – and, in our view, consumers, too.

They also agreed that Internet users should be allowed to send and receive lawful content and services, run lawful apps, and connect the devices of their choice to the Internet as long as they don’t harm the network. That’s just established business practice – chicken soup for the speechwriters. It can’t hurt, though, to dish up another bowl.

But they didn’t make much headway on the nettlesome issue of whether networks should be allowed to charge more for better service. Verizon wants the option. And so do we, because it is in the interest of consumers to give the broadband providers strong incentives to invest in next-generation technology. Google offers some wiggle room here – but not much.

The joint statement says that “Prioritization of Internet traffic would be presumed inconsistent with the non-discrimination standard, but the presumption could be rebutted.” We think (and Hahn, Litan and Singer’s research has concluded [Download Here]) that this is probably too high an economic hurdle. Why, for example, assume that paying more for better service is probably bad for consumers? Nobody questions the logic of letting United Airlines charge more to ride in the front of the plane.

On the positive side, the proposal does recognize the logic of allowing network managers to prioritize different kinds of Internet traffic – say, to ensure adequate download speeds for streaming high-definition video. It also allows for additional, differentiated services that can’t exist without priority access. So, maybe life-and-death activities like remote robotic surgery do have a future on the Internet, after all.

It’s nice to see that Verizon and Google are talking turkey. But there’s no getting past the reality that they are far from finding common ground on the core issues.

In 2007, Comcast, the giant cable company and Internet service provider, faced a marketing problem. A relatively small number of subscribers were hogging huge swaths of bandwidth, as they traded movies and music with others. (Some of the exchange was legal, some of it probably not.) Comcast responded by limiting upload speeds for customers using peer-to-peer networks.

After an investigative reporter from the Associated Press caught the company blocking a transfer of the King James Bible using BitTorrent (leading one blogger to ask, “Why does Comcast hate Jesus?” a couple of advocacy groups, Free Press and Public Knowledge, filed a complaint with the FCC. The agency ordered Comcast to stop.

Three years later, in Comcast v. FCC (PDF), a federal appellate court reversed the FCC’s order. But the court simply ruled that the FCC had overstepped its jurisdiction; it never addressed the legality of Comcast’s behavior.

Comcast, it’s worth noting, could have dealt with its peer-to-peer problem by switching to a pricing model that charged according to use. But the company feared that customers were wed to salad-bar-style pricing and would bolt at the change. Thus, apparently for competitive reasons, Comcast chose instead to block the offending traffic.

Now we can see why. Verizon, which is about to roll out its version of 4G high-speed wireless-data service, says it is planning to charge according to use. Verizon is worried that 4G will make it so convenient to move huge video files over wireless links that it would face a Comcast-like problem, if it didn’t charge by the bucket of data.

Meanwhile, AT&T has beaten Verizon to the punch, announcing that new iPhone customers will pay by the megabyte. (Existing customers with all-you-can-eat plans will be allowed to keep them.)

Verizon’s admission immediately brought forth criticism from the blogosphere. And the FCC wasn’t far behind: it is already preparing new regulations to prevent “bill shock“–you know, when dad finds out that little Jennifer has downloaded every episode of “True Blood” and “The Vampire Diaries,” and stuck him with a $400 cell phone bill.

The irony, of course, is that Comcast ran afoul of the FCC, in part, for failing to use tiered pricing to ration bandwidth. Now, apparently, Verizon has caught the FCC’s attention by deciding to charge according to usage.

The FCC may do no more than require carriers to notify customers when they’ve exceed their allotted megabytes–something AT&T is apparently planning to do, even without a nudge from Washington. Still, we’d much prefer that the FCC stay out of data-service-pricing decisions altogether, letting the carriers adjust to changing technology and market conditions.

Telecommunications markets don’t always get it right. But we doubt that the regulators could do better.

(This blog post was published earlier on CNET.)

That decision would require prior approval from the FCC for Verizon and AT&T simply to lease spectrum capacity from SkyTerra. The regulators didn’t explain their reasoning. But the only rationale for this restriction that might pass a sniff test is that limiting the two largest wireless companies’ access to more spectrum would serve consumers by increasing competition or by speeding the development of technology. This case has not been made. And until somebody does, we wish the FCC would cease and desist.

But the CEOs are plainly not naïve about the risks of what amounts to a Manhattan Project for broadband: “The Internet has thrived in an environment of minimal regulation. While our two companies don’t agree on every issue, we do agree generally as a matter of policy that the framework of minimal government involvement should continue.”

Schmidt and Seidenberg hit the nail on the head. We just hope they really mean it – and that the FCC has the inclination and political will to manage this massive undertaking with a light hand.

From the perspective of free-market economists, discrimination can be bad or good. Everyone grants, for example, that charging people with dark skin more for airline tickets than those of lighter hue would be wrong. But a policy of charging people more for tickets that are refundable or don’t require advance purchase or don’t demand a Saturday night stay makes it possible to fill empty seats and has dramatically increased the productivity of the airline industry.

So where does discrimination in the quality (and price) of Internet service fit in? Should broadband providers be permitted to offer higher speed, more reliable service – say for applications like telemedicine or securities transactions – and charge more for it? Recently, one of us (Hahn) along with Robert Litan and Hal Singer [Download Here] tried to reframe the debate in terms that mesh with both economic efficiency and fairness. The goal of an anti-discriminatory policy, they argued, ought to be equality of opportunity, not equality of outcome. Accordingly, it should be possible to sell better service for more money, but not possible to deny premium service to those willing to pay for it.

To demonstrate that discrimination is undesirable from society’s perspective, then, a content provider (like regulation2point0.org, to choose one at random) ought to be able to show that:

• the offending broadband service provider offered better terms to one of its affiliates than we got.
• these better terms could not be justified, based on underlying costs.
• the inferior terms the provider did offer put us at a competitive disadvantage.
• the consumers of content were harmed by the discriminatory action.

Actually, this test may amount to overkill. In a January 14 submission [Download Here] to the FCC on behalf of Verizon, economists Gary Becker and Dennis Carlton argued that antitrust enforcement alone should be sufficient to cope with market-distorting Internet discrimination. And, if it proved insufficient in practice, very limited regulation would be all that’s needed.

Those, by the way, who want to read a very different opinion on the subject, should check out Nick Economides’ January FCC testimony [Download Here] on behalf of Google.

Stay tuned: with heavy hitters (intellectual and financial) on both sides, this debate is likely still in its infancy.