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