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A free lunch for Netflix?

The video company is butting heads with ISPs over the issue of how the costs of streaming are covered. But it's hardly time for the FCC to step in, Robert Hahn and Peter Passell argue.

Editors' note: This is a guest column. See the bios of Robert Hahn and Peter Passell below.

All right, we'll say it: We love Netflix, the company that has made it so easy to watch any of thousands of movies anywhere, with hardly a moment's forethought. And we're not alone. The company boasts close to 26 million subscribers in the United States and Canada, and it recently announced plans to expand to 43 countries in Latin America and the Caribbean.


But Netflix can't succeed without a lot of help from its partners in the digital supply chain. The company is only as good as the programming it offers. And content owners are apparently inclined to drive a harder bargain these days: Netflix paid a whopping nine times as much for streaming rights in the second quarter of 2011 as it did the same quarter a year earlier.

More relevant here is Netflix's rapid shift from being a supplier of rental DVDs by mail to video-streaming delivery on demand. The company last month separated its DVD-by-mail service from its streaming business by creating a DVD-only subscription and raising the base price for the combined service by nearly 60 percent, a move that raised the ire of many subscribers.

Netflix increasingly depends on the telephone companies and cable companies to deliver entertainment via broadband Internet to computers, TVs, and mobile devices such as the iPad. Indeed, at some periods of the day, Netflix video streaming constitutes almost 30 percent of all Internet traffic in the United States during peak periods. So it's not surprising that the company is butting heads with Internet service providers--think everybody from Verizon Communications to Cox Communications to Time Warner Cable--over the issue of how the costs of streaming are covered.

To date, suppliers of wireline (as opposed to wireless) broadband have generally used the salad bar model: consumers pay a fixed monthly fee for all they choose to download. But that's changing. AT&T and Comcast are now charging according to usage above monthly caps.

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Netflix is crying foul: the last thing it wants is for subscribers, who buy their entertainment from a dozen vendors, to be counting bytes. But can the company make a case for regulatory intervention?

In principle, maybe. But it's not easy to demonstrate that broadband caps are anticompetitive. More precisely, it is far from obvious that the shift away from flat-rate pricing reflects an attempt to increase revenues that would not be possible if there were more competition among Internet service providers.

Most of the cost of providing Internet services reflects the cost of building the massive networks of cables and switches that carry the digital traffic. When a network isn't fully utilized, the cost of delivering another e-mail message--or, for that matter, all 86 episodes of "The Sopranos"--is next to nothing. Hence flat-rate pricing, in which users share the network costs with fixed monthly payments but pay nothing extra to watch another hour of James Gandolfini making mayhem, is easy to justify in economic terms.

Well, it's not that simple. Internet providers must design their systems to deliver high-quality signals at peak-use periods. Indeed, no form of content is more sensitive to congestion slowdowns than streaming video. So the most efficient pricing system would be one that charged extra for service at periods of peak demand, reflecting the reality that a good portion of network capacity is only intermittently needed.

No form of content is more sensitive to congestion slowdowns than streaming video. So the most efficient pricing system would be one that charged extra for service at periods of peak demand.

Internet providers haven't tried peak-load pricing, most probably because they believe that residential customers would find it both confusing and unfair. In fact, they fear that alienating subscribers by using any approach to tying prices to how much system capacity is used (or when). And while we can't say for sure why they're just now moving toward "two-part" pricing in which customers pay a flat rate for the first big dollop of bytes and then pay extra for greater use, our best guess is that the alternatives look worse. They must somehow find ways to pay for explosive increases in use by some customers as they join the rush to entertainment via video streaming--but without increasing monthly bills for more modest users.

That's not how David Hyman, Netflix's general counsel, sees it. He argues that competition in Internet service is inadequate and that the providers are using the growing demand for video streaming as an excuse to raise total charges.

That's a hard case to sell. If ISPs really have market power and are itching to exploit it, why switch to a pricing structure that's sure to draw the attention (and ire) of a deep-pockets, high-profile company like Netflix?

A more plausible argument is that Netflix's success has led the ISPs to covet a piece of their streaming-video business, and they're using discriminatory pricing to gain a competitive advantage in selling entertainment. Hyman notes that the systems of AT&T and Comcast exempt their own video-streaming programming from bandwidth caps, giving users a financial incentive to avoid third-party vendors such as Netflix.

Should this be allowed? The policy debate about Internet discrimination has focused on access--allowing outside content providers to use the network without paying discriminatory fees to the service provider--which is not in question here. The issue is really whether a broadband provider should be permitted to charge users by the byte but waive the fee for viewing content it is selling in competition with Netflix (or Hulu, You Tube, or others.).

Much, we think, turns on the practical impact on competitors and consumers, which under current pricing schemes doesn't appear large. For example, AT&T is charging $10 for 50GB, which amounts to less than 20 cents for a typical standard-definition movie. And that cost only kicks in beyond the 150GB cap per month, which is enough for roughly 300 hours of programming via the Internet. (High-definition programming uses more bandwidth; just how much more depends on the degree of digital-code compression.)

Of course, caps could be reduced, and fees for use above the cap could be raised, which would have a greater impact on competitors. So it makes sense for the Federal Communications Commission to keep an eye on Internet providers' pricing schemes. But there's a cost to intervention--at best, the hourly fees for battalions of regulatory lawyers, at worst deterrence to innovation. Therefore, we think that the bar should be set pretty high. In particular, price discrimination should only be the government's business, if other content providers are put at a significant disadvantage, and consumers (as opposed to content providers) suffer as a result.

Netflix, we're rooting for you--but not at the expense of hobbling innovation on the Internet.