By Jeffrey Krauss,
President of Telecommunications
and Technology Policy
The FCC has finally seen the light and lifted the prohibition against innovation by AOL in its Instant Messaging (AIM) service. AOL will now be allowed to provide video instead of just text AIM. The FCC's justification for this change in policy is a little weak, but that's because the original justification for imposing it was misguided and didn't understand the marketplace realities of the service. It was a bad policy to begin with, so we won't quibble about the reasoning that was used to eliminate it.

The FCC imposed the prohibition against advanced IM technology when it approved the merger between AOL and Time Warner. The complaint at that time, early 2001, was that AIM had more than 65 percent of the IM market, and was refusing to interconnect with other IM providers, notably Microsoft and Yahoo.

The FCC's visiting economists (they were on one-year sabbaticals from universities) led the charge against AIM, wrongly comparing today's IM market to the local telephone marketplace of 100 years ago. That was when the local telephone monopolies were born. Initially, there were competing local phone companies. They didn't interconnect with one another. That meant you could call friends and relatives who subscribed to the same phone service as you. You couldn't call friends and relatives who subscribed to the other phone service in town. Unless, of course, you subscribed to both. But that was expensive. The FCC was established in 1934, and the Communications Act of 1934 gives the FCC the power to require telephone carriers to interconnect. But by then it was too late–there was only one phone company left in each town.

The economists talk about "network externalities." Adding a new member to a communications network typically creates a benefit for other members, because they derive a greater value by being able to send calls to and receive calls from the new member. Networks with large positive network externalities are subject to "tipping," where the dominant network provider increases its dominance because its network, having more subscribers, is more valuable for new subscribers to join. In its 2001 decision, the FCC wrongly said that Instant Messaging exhibits positive network externalities, and that tipping was more likely to occur when AOL merged with Time Warner, because Time Warner's cable subscribers were more likely to use AIM than competing IM services.

The FCC said that it would lift the prohibition against video IM and other advanced IM technologies when one of two things happened. First, AIM could interconnect with competing IM services. Second, it could show that there has been a material change in circumstance since 2001.

AIM has not interconnected with other IM services. There has been little progress in achieving an interoperability standard for IM services. And that's just as well. IM services can carry and transfer viruses. AOL has claimed that ensuring security is the major stumbling block in reaching an interoperability standard. After the Internet experience with Blaster and SoBig in August, I will be perfectly happy if the Microsoft IM service is never allowed to interconnect with AIM.

Instead, AOL argued that circumstances had changed. The company said that it no longer had 65 percent of the IM market, that it was down below 60 percent. Moreover, its market share was steady or falling, not rising, as would be the case when network externalities were significant and tipping was occurring.

So the FCC agreed, and decided to lift the ban. This is where I said that the justification was weak. A change in market share from 65 percent to 60 percent is hardly a material change.

The FCC used that particular approach to lift the ban because it finally recognized that the policy was misguided, and this was the simplest way to eliminate it. It was misguided for two reasons. First, it stifled the deployment of improved technology. Any time a government agency makes a decision to try to stop technological development, it faces a strong burden to show that the harms from that technology outweigh the benefits. The FCC never met that burden. Moreover, it ignored its own statute. Section 7 of the Communications Act says that the policy of the United States is to encourage the provision of new technologies and services, and those in opposition must show that the new technologies or services are harmful to the public interest. The FCC's 2001 decision ignored that part of the law entirely.

But even more to the point, Instant Messaging does not exhibit strong network externalities. That's because I don't really care if my friend subscribes to AOL Instant Messaging, Microsoft Instant Messaging, Yahoo IM, or any other. All of them provide free subscriptions. All of them provide free software. This is not the same as local phone service a century ago, where you had to sign up for two costly subscriptions, with two sets of wires, and two sets of holes in your wall. I can just as easily carry on simultaneous messaging sessions with two friends who subscribe to two different IM services as with two friends who both subscribe to AIM.

Contrary to the text of the FCC's decision, the material changes were not in the IM market–they were that the academic economists went back to their universities, and the FCC's own staffers finally understood the IM market.

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