Internet Economics

1. Internet Economics John Chuang School of Information Management & Systems UC Berkeley chuang@sims.berkeley.edu

2. The Big Picture Market Structure & Mechanisms Demand Supply Price(s) { Producer Surplus Consumer Surplus Social Surplus Welfare (surplus) John Chuang

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 John Chuang

4. Outline • Economic characteristics of the Net • Resource allocation and pricing • Interconnection and industrial organization John Chuang

5. Economic characteristics of the Net • Public vs. private good • Economies of scale • Economies of scope • Network externalities John Chuang

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? John Chuang

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? John Chuang

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 John Chuang

9. Traditional Goods & Services $ • Q* is optimal firm output • Can support N firms if market size (QTOT) >= NQ* AC Q John Chuang 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 John Chuang 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., AT&T historically treated as regulated natural monopoly • rate regulation • structural regulation John Chuang

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 John Chuang

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 AT&T in 1984 Q John Chuang 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, …) John Chuang

15. SLA QoS Aware Internet Service Differentiation email Best Effort voice John Chuang

16. 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 John Chuang

17. Positive Network Externalities • Value of network increases with network size • e.g., telephones, fax machines, email clients • Metcalfe’s Law: the value of a network is proportional to the square of the number of users (N^2) • Reed’s Law: the value of network grows with the number of possible sub-groups that can be formed (2^N) John Chuang

18. 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) John Chuang

19. 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) John Chuang

20. Outline • Economic characteristics of the Net • Resource allocation and pricing • Interconnection and industrial organization John Chuang

21. not necessarily aligned 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. John Chuang

22. 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 John Chuang

23. 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 John Chuang

24. Pricing Network Services • Criticism of flat-rate pricing • Tragedy-of-the-Commons • Usage-based pricing • Metering costs • Users prefer predictable bills • Marginal cost pricing • MC=0 most of the time • Congestion-based pricing • Packets bid for service • Too costly to implement • Back to flat-rate? John Chuang

25. 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 John Chuang

26. Service provider’s perspective Encourage efficient resource usage (incentive compatibility) Low cost (implementation, metering, accounting and billing) Competitive prices Cost recovery User’s perspective Fairness Predictability (reproducibility) Stability Transparency (comprehensibility) Controllability Desirable Properties of Pricing Schemes (Delgrossi and Ferrari 1999) John Chuang

27. Outline • Economic characteristics of the Net • Resource allocation and pricing • Interconnection and industrial organization John Chuang

28. Inter-exchange Carrier (IXC) Long- Distance Network Customer Premises Internet Service Providers Telephone Network Internet backbones Point of Presence Backbone Provider 1 Router INTERNET Tandem Switch Dial-Up ISP Local Exchange Carrier (LEC) Backbone Provider 2 Exchange Point DNS Router Local Egress Switch Router 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 John Chuang Customer Premise Source: M. Sirbu

29. Industrial Organization • Horizontal merger • Vertical integration/disintegration • Determinants: • Technological efficiencies • Transactional efficiencies • Market imperfections John Chuang

30. 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 John Chuang

31. 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 John Chuang

32. Vertical Integration: Telephony • Telephony was vertically-integrated industry • AT&T (Ma Bell) offered end-to-end solution • Divestiture in 1984 • Local service (the seven baby bells) • Long distance service (AT&T) • Customer premise equipment (CPE) • Removes hidden subsidies between local service (monopoly) and long distance (competitive) John Chuang

33. Vertical Integration: Internet • Different vertical components of Internet [Lehr98]: • Local access transport (LAT): PacBell, TCI (AT&T) • Retail Internet access provision (ISP): AOL, @Home • Wide area transport (WAT): AT&T, MCI-WorldCom, Sprint, Qwest, Level3 • Backbone Internet service provision (BSP): UUNET, AT&T, BBN • Note: AT&T vertically integrated across all four components John Chuang

34. Downstream Goods/Services • Internet data centers • Content distribution networks • Application service providers • Certificate authorities • Billing and payment services • Content providers John Chuang

35. 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 John Chuang

36. Unbundling the Cable Plant • TCI owns/operates cable infrastructure (LAT) • @Home offers broadband Internet access over cable (ISP) • TCI and @Home are now one integrated entity: AT&T Broadband • Enters AOL… • wants to offer retail ISP service over AT&T’s cable infrastructure, in competition with @Home service • demands unbundling and open access to cable plant • Who wins? John Chuang

37. 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 John Chuang

38. Fiber System Route Miles Source: Kende 2000 John Chuang

39. 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 CLEC’s ) • Facilities-based competition • e.g., wireless, cable, satellite, … John Chuang

40. 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) John Chuang

41. Peering Source: Kende 2000 John Chuang

42. Multilateral Peering Source: Kende 2000 John Chuang

43. Bilateral/Private Peering Source: Kende 2000 John Chuang

44. Transit Source: Kende 2000 John Chuang

45. Hot Potato Routing Source: Kende 2000 John Chuang

46. Free Riding Source: Kende 2000 John Chuang

47. UUNET Peering Policy • Need to meet following requirements to peer with UUNET (January 2001): • Interconnection Requirements • Geographic scope (> 50% of UUNET scope) • Traffic exchange ratio (not exceed 1.5:1) • Backbone capacity (> 622Mbps) • Traffic volume (> 150Mbps per direction) • Operational Requirements • 24x7 NOC, fully redundant network, implement “shortest-exit routing”, … John Chuang

48. 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, … John Chuang

49. 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, …) John Chuang

50. 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) John Chuang Source: Mindel and Sirbu 2001