This is the fifth in a series of posts by Chris Riley, Free Press Policy Counsel, to summarize the primary policy recommendations made in recent comments submitted to the Federal Communications Commission in its open Internet proceeding. Today’s topic: business models.

Investment is one of the most heavily debated issues in the open Internet proceeding. What regulatory paradigm will lead to the most private sector investment? Although the government plays a major role in building our national communications infrastructure, private investment supplies a lot of the capital to lay the wires and build the towers, investment that often pays off handsomely for investors. There’s a lot of rhetoric bandied about here, including the classic trope that “all regulation discourages investment,” which does not accurately reflect how communications markets work.

When thinking about investment in the Internet, it helps to separate out two pieces – investment by network operators in the underlying facilities, and investment by content and applications companies in the Web sites and software tools that we use. The Internet relies on both of these investments – without either, we are worse off. There’s also a bit of a zero-sum game at work here, because discrimination by network operators, even if it could increase investment in facilities, would reduce investment by the content and applications companies. But the main argument made in our filing with the FCC is even more direct: Network operators won’t have an incentive to invest in their facilities if they are allowed to discriminate, so open Internet rules will not discourage investment. The “discouraging investment” argument is nothing but a scare tactic to dissuade the FCC from passing strong rules to protect the open Internet.

The fallacious argument offered by network operators is this: Discriminatory practices permit them to invest in “new business models” that will increase their revenue. They seem to suggest (despite the absence of a competitive market) that rather than pocket this extra revenue or distribute it in the form of shareholder dividends, they will instead use it to increase their investments in network infrastructure, at least by enough to offset any reduction in investment by content and applications companies as a result of discriminatory practices.

Discrimination Delusion

A close look at the market and the business models reveals this line of reasoning to be nothing more than a great “discrimination delusion.” The true purpose of engaging in discriminatory practices is not to create new revenue streams, but to protect existing ones – the traditional phone and cable services that now face competition from innovative Internet-based voice and video offerings.

There are three possible types of business models based on discrimination, and none of them would make the Internet a better place. Even where these models can successfully raise network operator revenue, the increase is unlikely to be substantial. These plans also produce powerful incentives to reduce investment in the network, and little to no incentive to expand network coverage or lower service price.

Pay for Play

Under the first category of business models – “pay for play” – network operators charge third-party content and applications providers fees above and beyond normal transit costs to permit their traffic to be routed through their network. Recalling an old and well-known quote from former AT&T CEO Ed Whitacre, this business model will prove ineffective at raising revenue because so much of the Internet’s value to consumers lies in its content and applications, not in its underlying facilities.

Insofar as its value lies in the content that travels through it, the Internet resembles cable television systems, where the network operator actually pays the content company for the right to carry the content. The cable model of networks paying for content, rather than the “pay for play” model of content companies paying for carriage, is far more sensible, realistic and likely to prevail. In fact, the pay-for-content model is already in use on the Internet today – ESPN offers Internet content, ESPN360, exclusively where the network operator pays a premium for carriage. So in the long run (if not the short), a “pay for play” model will not result in a new revenue stream for network operators, and may in fact cost them money and thus raise users’ Internet connection costs even more.

Pay for Priority

The second category, “pay for priority,” involves selling priority treatment for some content or applications. As we have argued elsewhere, prioritization only works in an environment of widespread congestion, where speeding up some traffic slows down other traffic. A priority service has value only in this environment, but additional investment by network operators would reduce congestion, and thus the potential value of the add-on service. So, network operators able to offer “pay for priority” services would have an incentive to avoid investment, to maximize the potential value of such services.

Additionally, the network operator can only offer a few prioritization deals. The more deals that are made, the less the priority given, because more content would move through the same narrow lane, slowing everything down. An increase in the number of priority customers thus lowers the value of a potential prioritization service, and lowers the revenue that can be made from each deal. After a limited number of these deals, no more can be made without rendering them all worthless – so there’s a tight cap on the amount of revenue this strategy can generate.

In other words, the financial benefits of “pay for priority” models are dubious and will discourage rather than encourage investment in network facilities. It just doesn’t add up to a better network or to more investment.

Vertical Prioritization

In the final category of business models, “vertical prioritization,” a network operator prioritizes its own content and application offerings, avoiding any deals with third parties. Under this model, the network operator has no new revenue streams. Instead of new revenue, vertical prioritization allows the network operator to insulate its existing offerings from competition.

Insulating old business models from competition is a recipe for stagnation and higher consumer prices, not for investment in network facilities and economic growth. Network operators can even reduce their investments and allow their network to grow more congested, while maintaining or raising rates for their affiliated content and applications (and especially for their legacy phone and cable businesses), because then theirs are the only offerings that work.

Ultimately, abandoning the open Internet would create an environment where network operators can more easily and will likely reduce network investment. Closing the Internet would drive network operators to manage and seek to wring profit from scarcity, not to invest in capacity to meet Internet user demand. We would face a less robust, and less interesting, Internet – and a smaller financial pie of which the network operators would have a much larger share.