The Progress & Freedom Foundation Blog

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The FCC is considering whether to maintain, eliminate or delay further the deadline for cable companies to modify the set-top boxes they lease to customers so that they use the "CableCard" technology now visible in your local BestBuy. The cards, which you obtain from your cable provider, are security mechanisms that plug into a host of digital TVs, digital video recorders and other devices, thereby enabling those devices to read and display encrypted digital programming without obtaining a set-top box from the cable company. Cable companies and their box vendors have until this deadline (currently June 2006) to abandon what they've been doing: offering set-top boxes that don't rely on the cards to protect against theft of cable service because the security function is integrated into the set-top box. (Cable's DBS competitors are using much the same integrated technology.) Cable companies decry this looming ban on "integrated security," claiming it will impose unnecessary costs on them and their customers.

Other consumer electronics manufacturers, which have to rely on the cards for their devices, vigorously oppose any change to the deadline. These companies argue the ban on integrated security ensures that cable companies will continue helping to make the card scheme work. They also argue that maintaining the ban will encourage cable companies to negotiate fairly over technical details that will enable the cards to provide access to cable companies' "two-way" or interactive services, such as electronic programming guides and pay-per-view. Currently, the "Digital Cable Ready" devices you buy at your local retailer do not provide access to these two-way services; you can only obtain those services by obtaining a box directly from the cable company. The consumer electronics industry argues that, unless cable company boxes use the same security technology as their boxes, the FCC will fail to achieve Congress' goal of creating a fully competitive market for set-top boxes and similar "channel navigation" devices.

Thus, a classic digital age policy debate is staged: Parties on one side (in this case cable companies and their vendors) argue that competition should be allowed among suppliers of fully-integrated, multi-function technology (e.g., competition between cable companies and DBS using integrated set-top boxes). Parties on the other side (in this case other device makers) favor competition among suppliers of "modular" technology, for which one or more of the functions that might otherwise be integrated are instead provided separately under a common technical standard (e.g., CableCards). Modularity can result either from market forces or can be imposed by government mandate, such as the FCC's standard-setting efforts with respect to equipment that attaches to the telephone network.

As the cable industry and others have pointed out, there is a good argument that Congress did not mandate a "fully competitive" market for set-top boxes and other navigation devices as much as it simply instructed that consumers be given a choice to obtain those devices from folks other than the cable company. Section 629 of the Communications Act only requires the FCC "to assure the commercial availability" of these devices.

But even accepting the premise that the FCC should foster "device competition" in some ways, there are substantial questions as to whether the type of competition advocated in the proceeding is overly simplistic or is otherwise inadequate to bring consumers the full range of benefits associated with these and other digital technologies. Specifically, the current debate could benefit from a more rigorous evaluation of (1) incentives to innovate, and (2) the benefits consumers may reap if cable companies are allowed to continue their current involvement in the device market (i.e., leasing boxes to their customers that do not employ CableCards).

Schumpeterian Innovation and Mandatory Modularity

An important advantage of competition is innovation -- one of the few things on which cable and consumer electronics advocates can agree in this case. But much of the discussion of innovation before the FCC has centered on whether innovation demands that all device manufacturers (including cable companies' set-top vendors) are required to use CableCard security technology. This debate over whether device makers enjoy a "level playing field" (i.e., complete modularity) with respect to security technology has much superficial appeal, especially to regulators who must consider equity in resolving many policy questions. There are strong indications, however, that promoting equity or modularity for device makers in this context is not necessary to promote innovation for consumers and may, in fact, discourage it.

It may not be necessary to require all device makers to use CableCards to promote innovation in set-tops and other devices, given that this innovation apparently has proceeded without such a mandate. As demonstrated at trade shows and in retail stores, many devices that rely on CableCards also tout new features such as digital video recording and new program guides. Moreover, although negotiations continue over how the next generation of CableCard devices will access pay per view and other interactive services from the cable company, the remaining unresolved issues focus primarily on business issues such as content protection, rather than on technical specifications. Thus, even with respect to these critical negotiations, it has not been necessary for cable companies to start using the cards to further technical innovation.

Requiring all manufacturers to use the cards may discourage innovation to the extent it weakens market participants' incentives to compete based on new device features. As economist Joseph Schumpeter emphasized, policymakers should be concerned about the dynamic nature of competition, particularly as it involves incentives to innovate. In this case, consumer electronics advocates generally fear they are at a competitive disadvantage in bringing devices to market that rely on CableCards because these devices cannot access pay-per-view and other interactive services, which in contrast can be accessed by the boxes cable companies provide.

It is likely too soon, however, to tell whether CableCard devices are, indeed, disfavored by consumers. In the meantime, any concerns among manufacturers regarding the attractiveness of their devices relative to cable company set-top boxes presumably has heightened, rather than lessened, device makers' incentives to innovate to compensate for their perceived disadvantage. Thus, even if consumer electronics companies are correct that requiring cable companies to use the cards will "hold cable's feet to the fire" in the negotiations over interactive services, such "feet holding" also could reduce the pressure on device makers to innovate generally. Moreover, requiring cable companies to use the cards will sink further investment into this technology, which could delay the industry's evolution to cheaper and better approaches to security predicted by cable and device companies alike. These approaches include the possibility of using devices that prevent theft of cable service by allowing cable companies to download (and frequently update) security software to these devices.

Given these considerations, leveling the playing field with respect to use of CableCards seems less likely to promote innovation than maintaining the freedom consumers currently enjoy to select from a diversity of devices. Such freedom enables consumers to vote with their wallets on how device makers should allocate resources to improve these devices over time.

Complementary Relationships and Consumer Benefits

Innovation incentives aside, the type of competition argued before the FCC in this area casts unnecessary aspersions on cable companies' involvement in the set-top box market through their close relationships with select vendors and other activities. The suggestion is that cable companies will use their strong position in the market for multichannel video service (which they share primarily with DBS) somehow to monopolize the market for set-tops and other channel navigation devices. But as antitrust and other economic scholars long have argued, such relationships between complementary markets do not of themselves threaten competition and, indeed, may yield important consumer benefits, except in certain circumstances.

In this case, for example, cable companies' close relationships with a few vendors have permitted them to work through technical and other issues so as to enable at least those set-top boxes to access interactive services, presumably without unreasonable risk of cable service theft. Moreover, these close relationships have facilitated giving consumers the attractive option of leasing their set-top boxes from the cable company, rather than buying them. Such benefits are to be expected; with respect to complementary markets like these in which greater consumer demand in one market tends to drive up demand in the other market, firms often will act on incentives to act in ways that ultimately benefit consumers.

There are important exceptions to this general rule, of course. These exceptions have been detailed by scholars such as former FCC Chief Economist Joseph Farrell of U.C. Berkeley and Phil Weiser of the University of Colorado School of Law. But with respect to the FCC's ban on integrated security for cable set-top boxes, it seems unlikely that such exceptions would apply.

Some of these exceptions likely would be inapplicable on their face. For example, one exception theorizes that a company with a strong position in a market in which retail prices are regulated may attempt to participate in a related, complementary market in a way that reduces consumer welfare. This tracks the theory under which the Department of Justice sued to break up AT&T (e.g., the theory that a firm with a strong position in a regulated market may try to extract economic benefits from "new" related markets because regulation prevents the firm from extracting similar benefits in its regulated core market). Unlike local telephone service rates, however, cable service rates generally are not regulated. Thus, cable companies would not be induced to engage in harmful behavior in the device market based solely on rate regulation in their core market.

Other exceptions seem unlikely to apply largely by operation of statute. In theory, cable companies might try to dominate the device market by threatening to prevent devices from connecting to their networks, thereby discouraging future investment and innovation by device makers. Cable companies, again in theory, could engage in such behavior based on their currently perceived economic self-interest. Or a cable company could prevent use of devices entirely based on fears that regulators will not let it stop allowing such use once it has started, or based on fears that allowing use of navigation devices will sound like such a good idea that regulators will be more inclined to require cable to permit use of devices with other services, such as cable modem service. But cable companies have no choice in whether they deal with navigation device makers or not; under section 629, cable companies must allow these devices to be used with their systems -- a mandate that remains in effect whether or not cable companies are eventually required to rely on CableCard technology.

The remaining exceptions seem unlikely to apply based on a combination of the foregoing reasons and the fact that cable companies face competition in their core video business, particularly from DBS and eventually from video content sources on the Internet. Device makers have some ability to re-direct their energies and innovations away from cable and toward creating new features that will entice more consumers to rely less on cable and more on those competing sources of video. This limits cable companies' ability to extract more profits from device makers by, say, providing better terms to some parties than to others (i.e., engage in "price discrimination"). Simply put, if cable companies set terms that remain onerous, they will thereby encourage device makers and potentially cable's own customers to turn to DBS and other potential competitors. And cable could suffer such competitive punishment even to the extent it overlooked its own self-interest in fostering a competitive market for cable navigational devices that might have stimulated demand for cable service.

Conclusion

None of this analysis wholly precludes consumer electronics advocates from demonstrating that they have raised valid competitive questions with respect to delaying or eliminating the deadline for the CableCard mandate. And certainly, none of this analysis should suggest that the FCC's response answer to these questions should result in broader government intervention than is currently contemplated to promote the richer concept of competition sketched here; indeed, many of the concerns expressed above tend to favor a more minimalist approach, which would take Congress at its (literal) word when it instructed the FCC to promote the "availability" of channel navigation devices from sources other than the cable company.

This brief analysis does suggest, however, that the FCC should -- before it decides what to do -- demand that the parties better explain the potential effect of the agency's decision on innovation and other consumer benefits, so that the FCC's decision can fully reflect what competition means in this digital age.