Internet Economics

1
Internet Economics

• John Chuang
• School of Information Management Systems
• UC Berkeley
• chuang_at_sims.berkeley.edu

2
The Big Picture
Market Structure Mechanisms
Supply
Demand
Price(s)

Producer Surplus Consumer Surplus Social Surplus
Welfare (surplus)
3
Why Study Internet Economics?

• Internet has interesting economic properties
• Resource allocation
• Rule-based vs. pricing-based
• Market structures
• Interconnections
• Horizontal mergers and vertical integration
• Bandwidth markets
• Policymaking
• Sustainable competition
• Universal access

4
Outline

• Economic characteristics of the Net
• Resource allocation and pricing
• Interconnection and industrial organization

5
Economic characteristics of the Net

• Public vs. private good
• Economies of scale
• Economies of scope
• Network externalities

6
Public vs. Private Goods

• Private good
• depletable and excludable
• e.g., toothpaste, automobile
• Public good
• non-depletable and non-excludable
• e.g., national defense, clean air, lighthouses
• What about roadways, information, and the
  Internet?

7
Public vs. Private Goods

• Roadways
• non-depletable (until congestion) and
  non-excludable
• Information
• Encapsulated depletable and excludable
• Non-encapsulated non-depletable, but is it
  excludable?
• Internet
• non-depletable (until congestion), but is it
  excludable?

8
Economies of scale

• Average cost declines as output level increases
• Internet exhibits strong economies of scale
• High fixed cost
• e.g., trenching cost, up-front capital investment
• Low/zero marginal cost
• of sending an additional packet

9
Traditional Goods Services

• Q is optimal firm output
• Can support N firms if market size (QTOT) gt NQ

AC
Q
Q
QTOT
10
Infrastructure Goods Services

• High FC, low MC ? declining AC curve (economies
  of scale)
• Therefore it is socially optimal to have the
  entire market served by a single firm (natural
  monopoly)

AC
Q
QTOT
11

• A monopolist
• is a price-setter, not a price-taker
• maximizes producer surplus (profit), not consumer
  surplus
• Alternatives public utility or regulated
  monopoly
• e.g., ATT historically treated as regulated
  natural monopoly
• rate regulation
• structural regulation

12
Competition

• In a perfect competition
• all firms are price-takers
• P MC in the long run
• inefficient firms with high MC will exit market
• long term profits 0
• consumer and total surplus maximized

13
Technological Change

• Natural monopoly may not last forever
• Technological change may result in new cost
  curve same market may now be optimally served by
  multiple firms
• e.g., long distance telephony and the breakup of
  ATT in 1984

Q
QTOT
14
Economies of Scope

• Significant joint costs of production for
  multiple goods/services
• Examples
• GM plants produce sedans, SUVs, and minivans,
  etc.
• Amazon.com sells books, music, and lawn-mowers,
  etc.
• Internet supports multiple traffic types
  previously carried over different networks
  (telephony, radio, CATV, )

15
Service Differentiation
email
Best Effort
voice
16
Service Differentiation
email
Best Effort
voice
17
Why QoS?
18
Why QoS? Economists View

1. Network congestion ? negative network externality
   
2. Differing willingness-to-pay (WTP) ? quality
   differentiation allows price discrimination
3. Economies of scope cost savings (e.g.,
   statistical multiplexing)

19
Network Externalities

• Externality value (including costs and benefits)
  of a good/service not fully reflected in its
  price
• e.g., the price of an automobile does not include
  the economic impact of its potential to pollute
• Network externality value of the network is a
  function of the network size

20
Positive Network Externalities

• Value of network increases with network size
• e.g., telephones, fax machines, email clients
• Metcalfes Law the value of a network is
  proportional to the square of the number of users
  (N2)
• Reeds Law the value of network grows with the
  number of possible sub-groups that can be formed
  (2N)

21
Negative Network Externalities

• Value of network decreases with network size
• e.g., due to increased likelihood of network
  congestion
• During network congestion, each data packet
  incurs a social cost to other packets (e.g.,
  delay, packet-drop)

22
Summary

• The Internet as a public good (?)
• High fixed cost, low marginal cost (strong
  economies of scale)
• Significant joint costs (strong economies of
  scope)
• Positive/negative network externalities
  (demand-side economies/diseconomies of scale)

23
Outline

• Economic characteristics of the Net
• Resource allocation and pricing
• Interconnection and industrial organization

24
Resource Allocation Goals (Objective Functions)

• Technical efficiency
• Performance (latency, throughput) vs. cost
• Survivability (availability, redundancy) vs. cost
• Economic efficiency
• Social surplus
• Pareto efficiency
• Other objectives
• Profit (producer surplus)
• Penetration/usage s.t. cost recovery (e.g.,
  universal service)
• Equity, stability, predictability, etc.

25
Rule-Based Resource Allocation

• Example TCP Congestion Control
• All hosts reduce transmission rate when there is
  congestion
• Some TCP-unfriendly implementations ignore
  congestion signal

0.5Mb/s
1Mb/s
0.5Mb/s
0.5Mb/s
26
The Role of Prices

• Allocate resources to maximize economic
  efficiency
• Serve as feedback signals
• Help users make efficient consumption choices
• Help provider make optimal capacity expansions

27
Pricing Network Services

• Criticism of flat-rate pricing
• Tragedy-of-the-Commons
• Usage-based pricing
• Metering costs
• Users prefer predictable bills
• Marginal cost pricing
• MC0 most of the time
• Congestion-based pricing
• Packets bid for service
• Too costly to implement
• Back to flat-rate?

28
QoS and Pricing

• QoS Pricing
• Multi-class network requires differential pricing
  scheme
• Otherwise all users select best service class
• How about use differential pricing to implement
  QoS itself?
• Paris Metro Pricing

29
Desirable Properties of Pricing Schemes

• Service providers perspective
• Encourage efficient resource usage (incentive
  compatibility)
• Low cost (implementation, metering, accounting
  and billing)
• Competitive prices
• Cost recovery

• Users perspective
• Fairness
• Predictability (reproducibility)
• Stability
• Transparency (comprehensibility)
• Controllability

(Delgrossi and Ferrari 1999)
30
Outline

• Economic characteristics of the Net
• Resource allocation and pricing
• Interconnection and industrial organization

31
Internet Service Providers
Customer Premises
Internet backbones
Telephone Network
Point of Presence
Backbone Provider 1
Router
INTERNET
Tandem Switch
Dial-Up ISP
Local Exchange Carrier (LEC)

Backbone Provider 2
Exchange Point
DNS
Router
Router
Local Egress Switch
Local Ingress Switch
Remote ISP
Server
Packet Network
Content Provider
Local Loop
Router
Analog Modem
xDSL Modem
Firewall
Headend
Cable Network
Cable Modem
Corporate LAN
Customer Premise
Source M. Sirbu
32
Industrial Organization

• Horizontal merger
• Vertical integration/disintegration
• Determinants
• Technological efficiencies
• Transactional efficiencies
• Market imperfections

33
Vertically Related Markets

• Upstream/downstream relationship
• Examples
• Detroit steel v. automobile
• Software OS v. applications
• Telephony local v. long distance
• Internet physical transport v. access v.
  content/services

34
Vertical Integration

• Good
• economies of scope savings
• internalize transaction costs
• reduce prices increase total welfare
• Bad
• if one component is monopolistic
• foreclose competition in other component

35
Vertical Integration Telephony

• Telephony was vertically-integrated industry
• ATT (Ma Bell) offered end-to-end solution
• Divestiture in 1984
• Local service (the seven baby bells)
• Long distance service (ATT)
• Customer premise equipment (CPE)
• Removes hidden subsidies between local service
  (monopoly) and long distance (competitive)

36
Vertical Integration Internet

• Different vertical components of Internet
  Lehr98
• Local access transport (LAT) PacBell, TCI (ATT)
• Retail Internet access provision (ISP) AOL,
  _at_Home
• Wide area transport (WAT) ATT, MCI-WorldCom,
  Sprint, Qwest, Level3
• Backbone Internet service provision (BSP) UUNET,
  ATT, BBN
• Note ATT vertically integrated across all four
  components

37
Downstream Goods/Services

• Internet data centers
• Content distribution networks
• Application service providers
• Certificate authorities
• Billing and payment services
• Content providers

38
Unbundling the Local Loop

• RBOCs (e.g., Pacific Bell) own the local loop
  infrastructure and offers local phone/DSL service
• Telecom Act of 1996 requires RBOCs to unbundle
  services from local loop access
• Motivation allow competitive local exchange
  carriers (CLECs, e.g., Covad, Northpoint) to
  compete against the incumbents
• Difficult to implement/enforce not sustainable

39
Unbundling the Cable Plant

• TCI owns/operates cable infrastructure (LAT)
• _at_Home offers broadband Internet access over cable
  (ISP)
• TCI and _at_Home are now one integrated entity ATT
  Broadband
• Enters AOL
• wants to offer retail ISP service over ATTs
  cable infrastructure, in competition with _at_Home
  service
• demands unbundling and open access to cable plant
• Who wins?

40
Horizontal Merger

• Proposition Economies of scale
• Example Internet Backbone
• MCI-WorldCom (1998)
• WorldCom-Sprint (2000 abandoned)
• Objection concentration leads to market power
• Larger network has less incentive to
  interconnect, or to maintain a high quality
  interconnection
• Larger network has negotiation power over smaller
  networks

41
Fiber System Route Miles
Source Kende 2000
42
Horizontal Merger

• Example 2 Local loop
• Seven Baby Bells Merging
• SBC PacBell Ameritech
• Nynex BellAtlantic
• Bell South
• US West
• 1996 Telecom Act unbundling and open access
• competition in local exchange (e.g., Covad,
  Northpoint and other CLECs )
• Facilities-based competition
• e.g., wireless, cable, satellite,

43
Network Interconnection

• Network externalities motivate network operators
  to interconnect
• Different types of interconnection
• Peering
• Multilateral
• Bilateral (or private)
• Transit
• Issue of settlement
• Peer settlement-free sender-keep-all (SKA)

44
Peering
Source Kende 2000
45
Multilateral Peering
Source Kende 2000
46
Bilateral/Private Peering
Source Kende 2000
47
Transit
Source Kende 2000
48
Hot Potato Routing
Source Kende 2000
49
Free Riding
Source Kende 2000
50
UUNET Peering Policy

• Need to meet following requirements to peer with
  UUNET (January 2001)
• Interconnection Requirements
• Geographic scope (gt 50 of UUNET scope)
• Traffic exchange ratio (not exceed 1.51)
• Backbone capacity (gt 622Mbps)
• Traffic volume (gt 150Mbps per direction)
• Operational Requirements
• 24x7 NOC, fully redundant network, implement
  shortest-exit routing,

51
Interconnection Issues

• Peer or transit?
• Size (market share) important
• Why multilateral peering fails?
• Tragedy-of-the-Commons
• What about advanced services?
• Inter-domain multicast, inter-domain QoS, content
  peering,

52
Markets

• Bandwidth Markets
• Bandwidth is perishable
• Bandwidth as tradable commodity
• Contract terms
• What Diameter of pipe (Mbps)
• Where city A to city B
• When/how long
• Other quality metrics (drop rates, latency, )

53
Bandwidth Exchanges

• Two basic functions
• Facilitate financial transaction
• Facilitate physical delivery of traded BW
• Three types of exchanges
• Sole seller of bandwidth (e.g., Enron, Williams)
• Neutral facilitator of member trading (e.g.,
  Band-X, RateXchange)
• Member-managed exchange (e.g., Bandwidth
  Financial Corporation, Commerex)

Source Mindel and Sirbu 2001
54
Example NY-London DS3, US/month, 1-year contract
Source RateXchange
55
Commoditization Trend Lines
Commodity Timing
Crude Oil OTC Futures Market Derivatives Late 1970s 1983 1985
Natural Gas OTC Between Pipelines Intermediaries Futures Market Derivatives Early 1970s Mid 1980s 1990 1991
Electricity OTC Between Utilities Intermediaries Futures Market Derivatives Late 1960s Early 1990s Mid 1990s Mid 1990s
Source RateXchange
 
56
Commoditization Trend Lines
Commodity Timing
Telecom OTC Between Utilities Intermediaries Futures Market Derivatives Late 1980s Mid 2000 TBD TBD
Source RateXchange
 
57
Other Markets?

• Distributed processing (P2P)
• SETI_at_Home, entropia, Popular Power
• Distributed storage/caching
• Distributed object services