IS250 Spring 2010 chuang@ischool.berkeley

1. Network Economics“We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

2. Routing Dollars on the Internet • O’Donnell, An Economic Map of the Internet, Telecommunications Policy Research Conference, 2002. John Chuang

3. Agenda • Today: • Economic characteristics of communication networks • Economies of scale • Network effects • Implications to industry structure and public policy • In Three Weeks: • Competition models • Monopoly, perfect competition, oligopoly • Price discrimination, switching cost • Interconnection and industry structure • Horizontal merger • Vertical integration John Chuang

4. Economics 101 • Consumer • Demand • willingness to pay • ProducerSupply • cost structure Market Structure e.g., monopoly, duopoly, perfect competition Price of Good/Service Welfare (surplus) • Producer Surplus (profit) = revenue minus cost • Consumer Surplus = valuation minus price paid • Total Surplus or Social Welfare = PS + CS John Chuang

5. Supply & Demand in the Network Context • Supply: cost of providing network service • fixed cost • marginal cost • Demand: how much users value (and are willing to pay for) the service • more difficult to quantify • need empirical measurement John Chuang

6. Economies of Scale • Communication networks exhibit strong economies of scale: • High fixed cost (e.g., trenching cost, up-front capital investment) • Low/zero marginal cost (of sending additional byte of traffic over network) • EoS: Average cost declines as output level increases John Chuang

7. Traditional Goods & Services $ • Q* is optimal firm output • If market size (QTOT) >= NQ*,then it is socially optimal for market to be served by N firms AC Q John Chuang Q* QTOT

8. Infrastructure Goods & Services $ • Strong economies of scale (high FC, low MC): AC curve declines for entire market size • Cost-efficient to have the entire market served by a single firm • “natural monopoly” AC Q John Chuang QTOT

9. A monopolist is a price-maker A monopolist maximizes profit, at the expense of consumer welfare A monopolist may become inefficient (lazy) in the absence of competition Competition instills market discipline Firms are price-takers in a competitive economy Price competition leads prices to marginal cost Inefficient firms (higher MC) exit market However, firms cannot recover fixed cost with marginal cost pricing… • Caught between a rock and a hard place? What can we do? • Public utility • Regulated monopoly John Chuang

10. 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 Q John Chuang QTOT

11. Example: Major Milestones in Telephony in U.S. • AT&T as Regulated Monopoly AT&T John Chuang

12. Monolithic Network Local Long Distance Local Tandem Switch Local Loop Central Office (CO) Class 5 Switch Customer Premise Equipment (CPE) John Chuang

13. Long Distance CompetitionEnabled by Interconnection (circa 1969-1972) • But local market still monopoly. Implications? Local Exchange Carrier (LEC) Inter Exchange Carrier (IXC) Local Exchange Carrier (LEC) Local Loop Central Office (CO) Class 5 Switch Customer Premise Equipment (CPE) MCI John Chuang

14. Divestiture of AT&T1984 • Dept. of Justice sued AT&T for anti-trust violation • Consent decree called for structural separation between local and long distance service • AT&T split up into Long Distance and seven regional bell operating companies (RBOCs, aka baby bells) • Pacific Bell, US West, Southwestern Bell, Bell South, Ameritech, Nynex, Bell Atlantic • Local markets still regulated monopolies AT&T RBOC RBOC MCI John Chuang

15. Local Access Competition1996 Telecommunications Act • Facilities-based Competition • Open access: Unbundled Network Elements AT&T RBOC RBOC MCI Cable MSO John Chuang Wireless Operator

16. Network Effects • Also known as “network externalities” or “demand-side economies of scale” • Externality: value (including costs and benefits) of a good/service not fully reflected in its price • e.g., the sticker 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 John Chuang

17. Network Effects • Value of network increases with network size • e.g., telephones, fax machines, email clients • Sarnoff: value of a network is proportional to its size (v  N) • Metcalfe’s Law: value of a network is proportional to the square of the number of users (v  N^2) • Reed: value of network grows with the number of possible sub-groups that can be formed (v  2^N) • Negative network effects possible due to congestion, telemarketers, etc. • Odlyzko and Tilly: v  N(logN) John Chuang

18. Implications • “Winner-take-all” or “tipping” dynamics • Adoption of new technologies • Subject to excess inertia • Influenced by availability and efficiency of converters John Chuang Source: Joseph, Shetty, Chuang, Stoica, Modeling the Adoption of New Network Architectures, 2007

19. Summary • Communication networks exhibit • High fixed cost, low marginal cost (strong economies of scale) • Positive/negative network effects (demand-side economies/diseconomies of scale) • Implications: • Natural monopoly; justifications for regulation or deregulation • Competition subject to tipping effects; technology transitions subject to excess inertia John Chuang