Whether the firms that supply Internet hardware and software should face restrictions on the use of their property is an important and controversial policy issue. Advocates of ―net neutrality—including President Obama and the current FCC majority—believe that owners of broadband distribution systems (hardware used to distribute Internet and video services) and producers of certain must-have video content should be subject to prophylactic regulation transcending present-day antitrust law enforcement. Their objective is to protect the free and open culture of the Internet from efforts to foreclose or limit competition in the provision of content, including online video services, which they see as potential competition to older video distribution methods.
In the economic terms used in debates on competition policy, the concern is with vertical integration which may give firms both the opportunity (through denial of access or price discrimination) and incentive (increased profit) to restrict competition. Antitrust laws already provide tools to deal with such concerns, as illustrated by the antitrust breakup of the old Bell System, designed to remedy precisely these offenses. But, except in merger cases, antitrust usually is an ex post remedy. Do ―new economy industries have characteristics that make vertical integration so potentially pernicious that ex ante regulation is justified? Or do ―new economy industries on the contrary exhibit features that make ex ante regulation futile or even dangerous?
The air in Washington is alive with contending voices taking sides on these issues. I engage the debate first by attempting to deconstruct the terms ―vertical integration and ―new economy; which turn out to be surprisingly elusive concepts. I briefly review theoretical and empirical work on vertical integration as it relates to antitrust policy, especially in ―new economy industries. I assume that the policy objective is to promote welfare. My goal is to identify circumstances in which vertical integration creates suspicion of adverse welfare effects sufficient to justify prophylactic (ex ante) regulation.
The paper‘s central point is that virtually every production process in the economy is vertically integrated, and economics predicts changes in the extent of vertical integration—that is, changes in the boundaries of the firm—in response to changes in relative prices, technology, or institutions. Both vertical integration and changes in the extent of vertical integration are benign characteristics of efficient, dynamic, competitive markets.
While there is no shortage of theoretical models in which vertical integration may be harmful, most such models have restrictive assumptions and ambiguous welfare predictions—even when market power is assumed to be present. Empirical evidence that vertical integration or vertical restraints are harmful is weak, compared to evidence that vertical integration is beneficial—again, even in cases where market power appears to be present. Thus, it is reasonable to conclude that prophylactic regulation is not necessary, and may well reduce welfare. Sound policy is to wait for ex post evidence of harm to justify interventions in specific cases. Net neutrality is an unfortunate idea.