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John Chuang 2
The Big Picture
Supply
Price(s)
Market Structure & Mechanisms
Welfare (surplus)
Demand
Producer SurplusConsumer SurplusSocial 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
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Outline
Economic characteristics of the Net Resource allocation and pricing Interconnection and industrial
organization
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Economic characteristics of the Net Public vs. private good Economies of scale Economies of scope Network externalities
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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?
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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?
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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
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Traditional Goods & Services
Q* is optimal firm output Can support N firms if market
size (QTOT) >= NQ*
$
Q
AC
Q* QTOT
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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”)
$
Q
AC
QTOT
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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
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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
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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
$
QQTOT
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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, …)
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Service Differentiation
Best Effort
SLA
QoS AwareInternet
voice
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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
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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)
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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)
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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)
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Outline
Economic characteristics of the Net Resource allocation and pricing Interconnection and industrial
organization
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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.
not necessarily aligned
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Rule-Based Resource Allocation
Example: TCP Congestion Control- All hosts reduce transmission rate when
there is congestion- Some TCP-unfriendly implementations
ignore congestion signal
1Mb/s0.5Mb/s0.5Mb/s0.5Mb/s
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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
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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?
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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
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Desirable Properties of Pricing Schemes
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
(Delgrossi and Ferrari 1999)
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Outline
Economic characteristics of the Net Resource allocation and pricing Interconnection and industrial
organization
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LocalExchangeCarrier(LEC)
Router
Dial-Up ISP
INTERNET
BackboneProvider 1
Router
Customer Premise
TandemSwitch
Inter-exchangeCarrier (IXC) Long-
Distance Network
Corporate LAN
Firewall
AnalogModem
ContentProvider
Server
Router
Remote ISP
Point of Presence
xDSLModem
CableModem
Packet Network
HeadendCable Network
Local Loop
DNS
Local Ingress Switch
Exchange Point
Router
Internet Service ProvidersCustomer Premises
Internet backbonesTelephone Network
Local Egress Switch
BackboneProvider 2
Source: M. Sirbu
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Industrial Organization
Horizontal merger Vertical integration/disintegration Determinants:
- Technological efficiencies- Transactional efficiencies- Market imperfections
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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
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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
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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)
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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
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Downstream Goods/Services
Internet data centers Content distribution networks Application service providers Certificate authorities Billing and payment services Content providers
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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
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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?
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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
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Fiber System Route Miles
010,00020,00030,00040,00050,000
AT
&T
Spr
int
MC
I*
Wo
rldC
om
Qw
est
IXC
Will
iam
s
Leve
l 3
1995 1997 1999E
Source: Kende 2000
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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, …
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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)
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Peering
Backbone A
Backbone B
Backbone C
Peering
Source: Kende 2000
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Multilateral Peering
Backbone A
Backbone B
Backbone C
NAP
Source: Kende 2000
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Bilateral/Private Peering
Backbone A
Backbone B
Backbone C
Source: Kende 2000
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Transit
Backbone A
Backbone B
Backbone C
Transit
Source: Kende 2000
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Hot Potato Routing
ISP X
Request
Response
Backbone A
Backbone BISP Y
WestCoast
EastCoast
Source: Kende 2000
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Free Riding
Backbone BISP Y
ISP XBackbone A
Request
Response
WestCoast
EastCoast
Source: Kende 2000
John Chuang 50
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”, …
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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 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, …)
John Chuang 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
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Example: NY-London DS3, US$/month, 1-year contract
Source: RateXchange
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Commoditization Trend Lines
Commodity Timing
Crude OilOTCFutures MarketDerivatives
Late 1970’s19831985
Natural GasOTC
-Between Pipelines-Intermediaries
Futures MarketDerivatives
Early 1970’sMid 1980’s19901991
ElectricityOTC
-Between Utilities-Intermediaries
Futures MarketDerivatives
Late 1960’sEarly 1990’sMid 1990’sMid 1990’s
Source: RateXchange
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Commoditization Trend Lines
Commodity Timing
TelecomOTC
-Between Utilities-Intermediaries
Futures MarketDerivatives
Late 1980’sMid 2000
TBDTBD
Source: RateXchange
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Other Markets?
Distributed processing (P2P)- SETI@Home, entropia, Popular Power
Distributed storage/caching Distributed object services
