How AT&T and Verizon Manipulate Your Smartphone

The two kinds of Internet-access carriers, wired and wireless, have found they can operate without competing with each other. The cable industry and AT&T-Verizon have divided up the world much as Comcast and Time Warner did; only instead of, “You take Philadelphia, I’ll take Minneapolis,” it’s, “You take wired, I’ll take wireless.”

At the end of 2011, the two industries even agreed to market each other’s services. Comcast and Time Warner Cable will bundle Verizon Wireless services with their own, and by 2015 the cable companies will have the option of selling mobile services under their own brands.

The deal came about because a cable industry joint venture primarily owned by Comcast, with Time Warner Cable and Bright House Networks (another cable distributor) participating, controlled a substantial portion of public airwaves that the companies had licensed during a Federal Communications Commission auction in 2006; Verizon Wireless gets that spectrum for $3.6 billion in exchange for intertwining its business with that of Comcast and Time Warner.

This made eminent sense. In most of the areas served by Comcast and Time Warner, Verizon’s FiOS -- the only real competition for wired Internet access -- isn’t present. (Comcast and FiOS overlap in only 15 percent of Comcast’s physical market; Time Warner and FiOS overlap in just 11 percent of Time Warner’s.) By cooperating, Verizon Wireless implicitly promises not to spread FiOS service any farther, and Comcast and Time Warner promise to stay out of the wireless business. Meanwhile, much-smaller Cablevision will have to keep competing: It overlaps with Verizon FiOS installations in 40 percent of its market.

Highly Profitable

Both the wired and wireless Internet-access businesses are concentrated and highly profitable. AT&T and Verizon Wireless together control two-thirds of the wireless marketplace and generate 80 percent of its revenue, while enjoying profit margins of about 40 percent. Sprint and T-Mobile trail far behind, and the barriers to entry for any new national player are probably insurmountable.

The major wireless carriers, like the major cable distributors, have enough market power to raise prices at will: AT&T and Verizon often increase fees in concert, as in early 2010 when they required all their customers using feature phones to adopt data plans. In 2011-12, first AT&T and then Verizon Wireless ended unlimited data plans for new users and instituted overage penalties. AT&T and Verizon subscribers who bought Apple iPad tablets found that they were using up their monthly data allotments within hours and paying hefty additional fees.

Devices are central to this story. By 2012, about half of American mobile subscribers had a smartphone. In an ideal world -- one that followed the classical model of Internet access -- they could all be used like little computers to contribute to the creativity and invention that is the Internet.

This model of communications is based on a tradition of nondiscriminatory transport of information. In the 1970s and 1980s, the FCC, worried that phone companies might control nascent data-processing services, drew a line between transport (conduit) and content, and instructed the phone companies to stay in the transport box. Any devices meeting published technical standards had to be allowed to attach to the network without asking permission from the network-service provider. This model made the Internet and World Wide Web possible.

The smartphone-tablet explosion began in a radically different environment, however. In early 2007, the FCC deregulated the Internet access services they provide. Wireless voice services are still formally provided on a common-carriage basis, but the FCC has avoided imposing on them most of that regulatory scheme -- particularly price regulation.

Since then, Verizon and AT&T have found a variety of ways to ensure that only smartphones and tablets they approve can be used on their networks, that each device is tied to a particular subscriber, and that no device can easily be used on any other network.

Capacity Problem

Wireless can never match wired in capacity to download a lot of data -- for instance, to make a video call; because of interference and other constraints, there’s only so much data that can be sent through the air. A fiber-optic or cable wire is 20 to 100 times as fast as a 4G wireless connection, and as those wireless connections are shared by more people, they only get slower. Wireless carriers can’t add more spectrum, because relevant frequencies have already been allocated to others. They could speed things up by building more cellular towers, but that would be an enormous expense -- one that a provider with no competition is not eager to undertake.

In any case, the telephone companies are not trying to compete with wired Internet access. Even though most of their business assets are wires, Verizon and AT&T are focusing wholly on wireless. As Americans have dropped their land-line phones, and as the moat around the cable companies’ high-speed wired data-distribution has grown wider, there’s little payoff in digging up streets to lay fiber-optic cables.

Given the inherent capacity limitations of wireless networks, Verizon and AT&T will claim (and have claimed) that it is essential that they prioritize the tidal waves of data flowing to users’ handsets. They have to be choosy, they say, because their networks can handle only so much video traffic. This is why Verizon fought so hard in late 2010 against extending network-neutrality mandates to wireless Internet access; if the company had to treat all bits of data equally, it couldn’t charge for online video and other premium services.

And so, in the wireless world, as in the cable-distribution marketplace, the carriers can favor some kinds of data over others -- and get two streams of revenue. Subscribers pay fees not only for service and content but also for things such as network activation and early termination. And programmers will pay for the right to reach those subscribers.

Apple’s Role

Just one other oligopolist keeps the carriers on their toes: Apple, which takes a 30 percent cut of the revenue generated by its preapproved applications.

AT&T has enough subscribers to demand (at least in limited ways) that Apple treat it well. From 2007 to 2011, AT&T was able to use its enormous number of wireless subscribers to get an exclusive on the iPhone. The company also spent a great deal of money subsidizing iPhone purchases so that consumers would lock themselves into long-term contracts.

At the same time, publishers of newspapers, music, films, books and games have come to see the iPad, iPhone and similar devices as potential saviors -- as a way to reintegrate their content with a guaranteed delivery network that can track, bundle and charge for access. Between 2010 and 2011, revenue from mobile apps for the iPad tripled, to $15 billion, according to marketing research firm Gartner Inc., and will climb to almost $60 billion by 2014.

The cable distributors, particularly Comcast, have been watching the wireless world carefully, not wanting to be left behind. In 2010, Comcast found a way to hang on to subscribers who wanted to watch television on their new tablets. It dumped the Comcast brand; relabeled its “TV Everywhere” service “Xfinity”; created apps for the iPad, iPhone, Kindle Fire, Xbox and whatever else came along; and told its pay-TV subscribers that they were getting a free app. The result: a seamless, Comcast-branded experience across TV, Internet and mobile.

Subscribers took to the Xfinity iPad application at once, with more than a million downloads in a few months. And if consumers eventually decide that the speed of a conventional wired cable Internet connection is not worth what Comcast charges for it and move to a wireless connection, Comcast can still be represented by its popular content. By early 2012, Comcast’s revenue per subscriber was up to an astonishing average of $143 a month, an increase of almost 140 percent over 10 years.

Now, the communications industry is at a point of equipoise. Each of the major actors is too big for any of the others to swallow or crush. Profits are climbing, allowing the companies to pay ever-higher dividends. Cash is piling up; investment in infrastructure is down, because there is no competitive pressure to increase it. Increasingly, poor and rural people are being left behind or relegated to second-best wireless substitutes for high-speed Internet access. But those zippy iPad apps look just great.

(Susan Crawford is a contributor to Bloomberg View and a visiting professor at the Harvard Kennedy School of Government and Harvard Law School. She is a former special assistant to President Barack Obama for science, technology and innovation policy. This is the second in a series of three excerpts from her new book, “Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age,” which will be published Jan. 8 by Yale University Press. The opinions expressed are her own. Read Part 1 and Part 3.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.