3
Where Is the Business Case?

Factors Shaping Investment In Information Infrastructure

Perceptions of business opportunities pace deployment of information infrastructure—how much money can be made, with what investment and risk, over what period of time? In and around 1993, when the administration released its National Information Infrastructure: Agenda for Action (IITF, 1993), private and public discourse seemed to reflect greater confidence concerning directions and opportunities. In 1996, however, the inputs to the NII 2000 project suggest that the only aspect of the business case for deployment on which there appears to be broad consensus is uncertainty compounded by a focus on associated risk. 1

The current uncertainty is accentuated by a combination of ongoing or anticipated transitions in technology (see Chapters 4 and 5), regulation and public policy, and industrial organization. Key technology transitions include the shift in computing power and functionality from the center to the edge of networks; the separation of services from the physical infrastructure; and the shift from analog to digital storage, transmission, and processing. The key public policy shifts relate to relaxation of regulation and other changes in competition policy, plus associated business incentives (e.g., permissible depreciation schedules). Supply and demand are complicated by regulation, which variously (1) affects who can enter which markets, the cost of interconnection, capital formation, and product and service pricing in some but not all segments of the na-



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--> 3 Where Is the Business Case? Factors Shaping Investment In Information Infrastructure Perceptions of business opportunities pace deployment of information infrastructure—how much money can be made, with what investment and risk, over what period of time? In and around 1993, when the administration released its National Information Infrastructure: Agenda for Action (IITF, 1993), private and public discourse seemed to reflect greater confidence concerning directions and opportunities. In 1996, however, the inputs to the NII 2000 project suggest that the only aspect of the business case for deployment on which there appears to be broad consensus is uncertainty compounded by a focus on associated risk. 1 The current uncertainty is accentuated by a combination of ongoing or anticipated transitions in technology (see Chapters 4 and 5), regulation and public policy, and industrial organization. Key technology transitions include the shift in computing power and functionality from the center to the edge of networks; the separation of services from the physical infrastructure; and the shift from analog to digital storage, transmission, and processing. The key public policy shifts relate to relaxation of regulation and other changes in competition policy, plus associated business incentives (e.g., permissible depreciation schedules). Supply and demand are complicated by regulation, which variously (1) affects who can enter which markets, the cost of interconnection, capital formation, and product and service pricing in some but not all segments of the na-

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--> tional information infrastructure (NII); (2) has different implications for incumbent and new-entrant enterprises; and (3) motivates some investment decisions based on anticipation that the framework will change. Shifts in industrial organization draw on both technology and policy trends and are fed by the declining costs of bandwidth, increasing consumer investment for infrastructure (cable, end nodes, information services), and surging commercial interest and activity in the Internet. Among market participants and analysts, there is agreement that markets for information and communications goods and services will grow continuously and that there is a variety of markets, with many kinds of investments, costs, revenue generation models, and buying patterns. There is also recognition that market growth is a function of cumulating purchases and uses that, in turn, build on technical foundations (e.g., expanding price-performance of microprocessor-based devices) and behavioral ones (e.g., growing comfort and sophistication in the use of personal computers (PCs)).2 Nevertheless, the lack of agreement on how much of what kind of services will likely be purchased (at a given price and time) leads alternately to hedging, experimentation, or stalling. The clearest trend is toward considerable experimentation by network, service, and content providers now and extending perhaps for another 5 years. The foundation for various experiments is a solid business case in telephony, television delivery, and (more variable) on-line services. At this time, though, corporate commitment to a complete strategy relating to network-based services appears unrealistic, and even companies that had made public strategic commitments have been backing off. For example, among the regional Bell holding companies (RBHCs), enthusiasm has diminished for video dial-tone systems, extending to cancellation, deferral, or alteration of plans for deploying video delivery systems.3 The market reaction to the Netscape initial public offering may be emblematic of the current ambivalence: despite considerable uncertainty, there is also considerable investor interest, some of it reflected in almost incredibly high initial stock prices.4 Technical, business, and regulatory uncertainty is yielding a degree of business paralysis as well as experimentation. The difficulty of expanding the market is seen in the fact that many proposed and attempted information services are alternative methods of delivering known products (e.g., (near) video on demand vs. video cassette rental). Robert Crandall of the Brookings Institution cautioned that where capital investment requirements are high, competing wireless investments may retard progress inasmuch as they drain potential revenues from new wireline facilities by targeting similar applications. By analogy, he noted that "cable evolved not in the novel ways that some of the pie-in-the-sky optimists envisioned in the 1960s and 1970s, but rather by providing us

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--> BOX 3.1 A 20-year Horizon? [W]hat is wrong with 20 years? If you look at the evolution of infrastructure, 20 year is close to a microsecond. If you look at how long it took for digital technology to roll out just into the telephone switching plant, that was a 20-year process. If you look at the development of the PC, which we tend to think of as happening overnight, that was literally a 20-year process as well. If you look at the time needed to introduce any of the fundamental technologies over the last three or four decades, it has been a 15-, 20-, or 25-year process. Indeed, if fiber optics in the home was 20 years from now, I would say that would be a revolutionarily short time, given the fact that the marketplace is going to have to pay for all of this. And if you tried to make it faster, you would probably be distorting the marketplace. You would have to do it with some sort of premature subsidies. Consequently, I am listening to the conversation and saying I do not really understand why we are bemoaning the 20-year period. We should really be rejoicing. —Howard Frank, Advanced Research Projects Agency more sports, more movies, more replays of sitcoms, and perhaps more news programs." On the other hand, comments generated by the project suggest that such variations on a theme are more likely to come from the obvious players, the existing businesses, and that newer ideas hatched by entrepreneurs may be less visible, at least at first.5 Confident of the potential for innovation, James Chiddix of Time Warner Cable observed that "there are thousands of people who will begin to put creative energy into trying to find ways to harness these technologies to find some new wonders and surprises. It is very hard to predict what those things are and what their social implications are. But I think that time is the only issue, whether it is 5 years or 20." Howard Frank of the Advanced Research Projects Agency (ARPA), reflecting on the forum discussions, maintained that 20 years seems reasonable. See Box 3.1. Information infrastructure businesses can be split roughly into two categories—facilities and services—and the investment required accordingly can be incremental or "greenfield," can support processes that are capital- or labor-intensive, or can be long- or short-lived or sunk.6 Particular investment choices will drive the amount of bandwidth available, the features that can thus be provided with the bandwidth—especially openness and symmetry giving the capacity for upstream communication—and the application services enabled for the public as a result. Caution and anxiety about the size and profitability of the market increase with the degree to which a business is dominated by facilities, and there-

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--> fore by capital investment. Investments in facilities are crucial for expanding the deployment of bandwidth, while investments in services that make use of the facilities and in devices that make use of the services are lower in magnitude and shift at least some of the cost away from the facilities providers. The greatest cost—and the highest level of risk—appears to be associated with deploying access circuits, facilities serving homes. Three alternatives seem to be seen for the near-term deployment of network-based infrastructure: Some people will spend large amounts of money to take the infrastructure (especially access lines) one big step forward, installing technology we will live with for a long time; or We will live with access technology that evolves continuously, not in big jumps or after long pauses; or We cannot afford to do what companies or commentators are contemplating. 7 The remainder of this chapter outlines several issues: the investment challenges associated with evolving the NII, the role of the Internet, and alternative models for generating revenue to recover and drive future investment. A number of themes emerged from the different inputs to the project; this chapter reports, as well as comments on, some of the tone or flavor imparted by different types of facilities and service providers (and by industry analysts) to the debate on information infrastructure investments. Who said what is sometimes as meaningful as what is said at all. Investment In Facilities The Problem of How Much Bandwidth to Invest In Fiber is being deployed by many parties, setting the stage for competition, since as noted in Chapter 4, sunk investments in fiber facilities can support multiple application services. The investments are being made despite uncertainty that was captured somewhat cynically by Jack Thompson of Gnostech Incorporated when he observed: … [T]he telephone people are saying, I can't make money in telephony anymore—I have to get into cable. And the cable guys seem to be saying, I can't make any more money in cable; I have to get into telephony. So why is everybody trying to get into a business where there is no money left? J.C. Redmond et al. of GTE Laboratories address this query specifically in a white paper, noting two possibilities: either current participants can

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--> modify their networks "to handle the total communications needs of customers (voice, data, video) by relatively modest incremental investments"—fostering competition to dominate and survive—or unprecedented growth and demand for new services may occur, fostering entry into adjacent or complementary businesses. Given these possibilities, and moderated by the difference in the costs to upgrade a cable TV system to support telephony or to upgrade a telephone system to offer broadband services (Telecommunications Reports, 1995i), companies are both posturing and making actual investments in the hopes of reaping the advantages that may accrue to successful first movers. In the context of investment in facilities for access to information, the problem of whether, when, and where to gamble on fiber is emphasized by telephone companies, because deployment of fiber represents a high fixed-cost investment—creating the desire for high-volume use to recover costs.8 See Box 3.2. In telephony, despite compelling arguments for fiber in backbone facilities, the lack of local traffic volume may make deployment of fiber to the household unlikely in the near future outside of highdensity urban areas.9 For cable companies, the upgrade path to fiber is clearer. Because they already have coaxial cable networks reaching into homes, cable firms are building fiber out from the center toward homes in a hybrid architecture (see Chapter 4). Noting that net capital stock has been declining with changes in accounting measures, if not in economic terms in the telephony business, Robert Crandall underscored the need to "keep the flow of new funds coming into this sector of the economy if we hope to build these extremely risky—particularly if they are to be wireline—systems with a substantial amount of fixed costs." With a nod to the major presence of telephone companies, he estimated that "if the NII is to be built by established telephone companies with technology now under development, it would probably require a near doubling of these companies' assets." 10 The scale of the investment, combined with both competition and constraints on the nature and remuneration provided by business activities to generate revenue, poses the threat of asset stranding to telephone companies. Stewart Personick of Bell Communications Research expressed the problem in the context of sustaining demand, in a competitive environment, for two-way communications capacity: If I had to spend $30 a month personally to operate a server, and I found out that for $20 a month I could put my material on someone else's server, with a 155-megabit-per-second incoming line, redundancy, and everything else, why would I month after month pay the $30? Hal Varian of the University of California at Berkeley explained that the problem is one of survival over the long term, given the underlying economics of the business. He spun scenarios (see Chapter 6, Box 6.4) that

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--> BOX 3.2 In Search of Volume Joel Engel of Ameritech explained that "fiber is an extremely cost-effective transmission medium. It is not cost-effective because it is cheap, but because it has very high capacity. The unit cost is very low, so anywhere you can aggregate traffic, where you can share among many users, the unit cost is quite cost-effective. But, if you run fiber out to the individual subscribers, individual homes or small businesses, they do not generate enough traffic to support that cost, and they have to pay the cost of the whole thing because it is dedicated." In his white paper BellSouth's Robert Blau describes the regional Bell holding company (RBHC) environment as one in which competitive entry into the relatively lucrative exchange access and intra-LATA (local access and transport area) toll markets has both constrained RBHC traffic growth and led to lower prices, depressing growth in earnings. In addition, increases in RBHCs' fixed costs as a proportion of total costs (as may occur with upgrades) may make earnings more volatile. Jim Chiddix of Time Warner Cable spoke of his company's Full Service Network experiment in Orlando, Florida, as "an expensive project. But if there is a volume market there, the nature of the technologies that we are discussing will force prices down very quickly." John Redmond, reflecting on GTE's experiment in Cerritos, California, emphasized the need for low prices to induce use: "It was not clear that people were going to pay that much more for anything that they could get free off of the television now." Intel Corporation's Kevin Kahn related the problem to mass production in the businesses of information appliances and services: ''At the end of the day, the fewer the choices, the higher the volumes; the higher the volumes, the lower the prices, and the more ubiquitous—therefore, the more attractive as a consumer product—it is." might arise if "chronic excess capacity" were to result from "two or more broadband wires to the house providing essentially the same service." Other things being equal, there would be price wars, producers could not cover fixed investments in facilities, and there would be financial distress. Risk aversion pervades the comments and concerns expressed by the biggest players in the NII arena, the telephone companies (especially the local exchange carriers; LECs), which appear to face both high costs for the associated access circuit investments and high uncertainty in expected circuit use.11 See Box 3.3. In his white paper Robert Blau of BellSouth points out that telephone companies can and do choose to invest in apparently less risky "opportunities outside local networks," and he suggests that "decisions by Bell company managers to accelerate the introduction of advanced network gear did not have a positive effect on shareholder returns."12 His analysis points out that investment is deterred by the prospect of delays between deployment (and associated investment) and the generation of returns on that investment. (Invest-

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--> BOX 3.3 Risk Aversion and Investment in Circuits Business says you spend money where you think you can make money. You do not spend money today to make money 25 years from now. —Edmond Thomas, NYNEX Science and Technology Inc. Even in a noncompetitive environment, if you invest the capital significantly before the revenues come in, you are in deep trouble, because typically the interest that you have to pay when you borrow the money is about equal to the rate of return when the revenue starts coming in. When there is a 2- or a 3-year gap in between those two events, you never catch up. —Joel Engel, Ameritech If shareholders believe that risk-adjusted returns on investment in advanced network technologies will remain competitive with returns on alternative investment opportunities, then those technologies will be deployed and the new service features they make possible will be brought to the market in a timely manner. If, on the other hand, shareholders do not regard prospective returns on network investment to be high enough to compensate for risk incurred, then lesser amounts of discretionary capital spending will be committed to new network technologies. —Robert Blau, BellSouth Corporation ment advisors Alex. Brown & Sons Inc. (1995), however, have recommended against considering earnings as the key valuation metric for online service providers because they are "investing heavily ahead of expected revenues"; revenue (subscriber) growth and projected cash flow are better indicators. Other financial analysts reportedly expect delayed returns and advise postponing profits in the interest of investing for growth and position (Higgins, 1995b).) Investment posture also reflects the nature of the business; the degree of optimism and the aggressiveness of investment prospects voiced by contributors to the NII 2000 project varied with the speaker's affiliation. Leslie Vadasz of Intel Corporation related the differences in attitudes about financing to the differences in culture between the computing and communications sectors: "I go to computer meetings, and we don't talk about how much we are going to invest in this, or how much return we are going to get on that. We don't ask, Is there a market? Is there no market? We run as fast as we can." Vadasz expressed concern that absent comparable attitudes among telecommunications providers, "the capability of the access device is going to go up, and up, and up, and up, and the

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--> bandwidth available for a [public switched] network environment is not going to keep up with it." The conservatism voiced by telephone company executives corresponds to their observed pace of investment; the impatience voiced by computer companies, among others, begs the question of whether a different outlook, combined with prudent investment strategy, might accelerate deployment. Yet cultural differences do reflect some fundamental differences in the computing and communications markets, such as the greater uncertainty in communications markets; differences in market power and industry structure (e.g., monopolies may be slower to innovate); and regulatory constraints, all of which contribute to a tendency of communications providers not to run as fast as many computer firms.13 Federal Licenses as an Influence on Deployment of New Wireless Systems In contrast to the uncertainties regarding deployment of wireline facilities, the minimum investment in facilities for wireless cellular and personal communication service (PCS; also paging and other mobile radio) systems is more or less determined by spectrum licensing build-out requirements and by competitive pressures.14 15 Licenses do not obviate the risks associated with investment (and arguably could increase them to the extent that deployment proceeds faster than apparent demand would justify). Industry representatives privately acknowledge great uncertainty regarding the evolution of wireless systems, as noted by one project reviewer: "The industry is growing so fast and in so many directions that few people really have a grasp of the whole." One indicator is the reported scaling back by licensees (0.5 MHz) of interactive video and data services of their expectations for the original target markets. Moreover, while attempting to reconceptualize the services they can offer and reduce financial risks, they may transmit only test signals to meet Federal Communications Commission requirements—an illustration of the fact that investment and deployment do not necessarily add up to commercial service availability (see Arlen, 1995a; and Mills, 1995b). Although cellular license holders were not allowed to bid for PCS licenses in their own territory, the two markets are expected to co-evolve, with the PCS share of the combined market increasing and interoperability

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--> growing to help sustain the cellular market base.16 A key positioning element was the success of the top broadband PCS license winners in aggregating bids to achieve nationwide geographic coverage and contiguous spectrum coverage. Private mobile services (including those for police and fire protection and the growing industry for unit-to-unit communications for personal and business use) already support tens of millions of units in service worldwide, with leading-edge technologies in use and planned. While regional small wireless systems involve industrywide and major-city investments on the order of $20 billion,17 space-based satellite systems aimed at provision of global telephony (voice and data) include Teledesic's $9 billion, 840-satellite, low-earth-orbit system; Hughes Communications' $3 billion, 8-satellite system; Motorola's 66-satellite Iridium system; and many more (Samuels, 1995; Cole, 1995). These global systems will be able to provide "cellular-like" service throughout the United States. The white paper by Robert Blau cites a WEFA Group forecast that suggests that excess capacity will result from commercial wireless investments.18 However, since some unused capacity is normal for lumpy infrastructure investments, the key unknown is the size and duration of the gap between capacity and demand. Investing to Achieve Infrastructure Generality Compounding the problem of how much bandwidth to invest in is the problem of deciding to what extent that bandwidth should be provided in a general and flexible form. Decisions about providing for generality affect deployment of services, over and above deployment of facilities. See Box 3.4. The computer industry designs and builds computers that are used for a wide range of applications, not just for a single predetermined application such as word processing. Uncertainty about the eventual application forces the development of devices with general and flexible characteristics. As discussed in Chapter 4, the Internet similarly attempts to be a general infrastructure that can support a range of applications. This generality provides insurance against the unpredictability of demand. A specific example that came up in several discussions at the workshop and forum was whether it was justifiable to install significant bandwidth for traffic from the user into the network, usually discussed as upstream, back-channel, or symmetric bandwidth. Symmetry is a quality inherent in telephony (albeit with limited bandwidth). A related issue is the extent to which the capabilities of the network should be provided in an open manner. Open interfaces may stimulate the creation of new applications but may also open the door to unwelcome competition. At the forum and in

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--> BOX 3.4 Investment for Generality The real question is, are we going to have enough capacity in this basic hardware infrastructure and some of the supporting application software that makes possible differentiation so that we can have appropriate differentiation where it is needed? —Steven Wildman, Northwestern University The most important characteristic of the NII from the perspective of users is probably the flexibility to accommodate new applications in the future, most of which we cannot anticipate today … [allowing] application developers to target a broad set of NII infrastructure and terminals with new applications without having to deal with an exponentially growing set of new cases as new technologies are developed, but rather … develop generic applications that can target the entire infrastructure and all of the terminals out there, no matter whether they are wireless PDA[personal digital assistant]-type devices or desktop supercomputers or standard telephony devices. That is not very easy to achieve. It requires a very careful definition of architecture, and scalability of applications to the capabilities of terminals and to the capabilities of the transmission infrastructure. One of the key characteristics is the capability to deploy new applications without any modifications to the network itself. Because once you require modifications to the network, then that puts a huge obstacle, economic and otherwise, in the way of new applications. —David Messerchmitt, University of California at Berkeley I would like to see systems that allow upstream bandwidth from individual homes to be considerably higher …, and then deal with the aggregate upstream bandwidth on the HFC [hybrid fiber coaxial cable] system, for example, as a traffic engineering problem. If we do a fixed static allocation of upstream bandwidth, we have precluded any reasonable way of saying, "I am going to put a media server in my home because I have a really clever idea for serving media on the Internet." On the other hand, if it is strictly a question of doing traffic analysis on a deployed system, and then deploying additional spectrum or changing the bandwidth reservations around in order to increase the upstream bandwidth when it becomes available, then that is a much more hopeful situation. … I have some difficulty believing that in a system with 125 homes you are going to find 125 Web suppliers that are running full media out of their homes. What I have no difficulty believing is that you will find, within the relatively near-term future, some people out there who are doing that. If the allocations are static, such people are precluded from running full media out of their homes. If the allocations are dynamic allocations, then it is reasonable to experiment and to let people have that kind of outbound bandwidth while others are simply sitting there, pointing and clicking with their infrared control, and we will not have precluded part of the space for purposes of experimentation. —Kevin Kahn, Intel Corporation

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--> his white paper, David Clark of the Massachusetts Institute of Technology related observations from the Internet environment to the evolution of the telephone system (see Chapter 4), describing its process of opening up certain interfaces: The reason we want to look at architecture is that the decision to provide an interface, both in a technical sense—whether to implement it at all—or in a business perspective—whether to open it—is in fact a critical business decision. … If you open an interface, then that is where your competitors show up. Providing for such openness may have broader business ramifications as well. For example, the steering committee noted some concern in the business community lest open access for new services be invoked as political grounds to force provision of mature services in an open way. (Some cable providers, for instance, have expressed the concern that providing open access services such as the Internet might establish a precedent suggesting that video services should be similarly open. The extreme form of this concern is fear that the eventual consequence of open access to specific service platforms will be the imposition of a common carriage status on all services.) Openness and bandwidth symmetry were focal points of discussion in the January workshop; the inability of people to quantify markets for these qualities seems to lead to market trials and deployment plans with limited openness and limited upstream bandwidth. Overall, comments by representatives of various industries suggested that more closed and proprietary service packages seemed to offer more promise for profits, a view anecdotally supported by reports that Wall Street attaches higher value to ventures with some element of proprietary, differentiating technology. Other participants, notably those associated with the computer hardware and software industries, suggested that the open nature of the Internet model may provide more stimulation for innovation. Uncertainty about the market looms large when it comes to forecasting demand for general infrastructure qualities and associated services. Considerable skepticism is expressed by telecommunications industries and industry analysts about the demand for symmetric communication. 19 Observed Graham Mobley of Scientific-Atlanta: What will the consumer really want to do with the interactive services, and how much is he willing to pay? There have been projections that show that, with interactive services, you could probably increase revenues by a factor of two between broadcast and incremental interactive services. On the other hand, nobody really knows what those interactive services are yet. Therefore, cable systems are not sure how much cost and investment to put into providing full interactivity.

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--> sizes to make investments in intra-organizational network-related infrastructure (devices, local area networks, support, and so on), internalizing relevant costs. Dependence on consumer-owned PCs raises two concerns, as noted in Chapter 2. The first is affordability. At $2,000 and perhaps three to six times the cost of a television set, the average PC system is beyond the reach of many consumers, who may need to depend on access via large institutions (places of work, employers, schools, government agencies, libraries) or public kiosks. A second concern is upgrading home equipment to match changing service capabilities .60 Contributors involved with television made many observations about the long lives of television sets in homes, not least because consumers lack the investment incentive provided to businesses under the tax code to depreciate expenses for tax purposes. One middle ground might come from more versatile software, but there is debate on this point. Queried Stewart Personick, "Is there a model that people will get used to the idea that these things are really disposable and throw them out every 3 to 5 years? Is the model that service providers will subsidize them like wireless cellular telephones, and it will be possible to get a new one for $29? … The theoretical solution of a programmable [and therefore upgradable] box is not very likely." Service-provider ownership of access devices is one response, illustrated by leased set-top boxes provided by cable companies or by the bundling (without separate fee) of equipment with services (see the discussion above of the embedded or domain-specific service model). Yet that path raises other concerns, such as the incentives for multiple service operators to minimize functionality to contain costs or the incentives to minimize generality to preserve profits via control over services. The Access Subscription Model The access subscription model is best described by the cable TV and on-line information and communications (including Internet access) providers; it can also be seen in flat-rate telephony (so much per month for unlimited calls). In both cases the cost to the information consumer is an attachment charge. That charge may include lease of reception equipment (e.g., set-top box) by the service provider.61 Unlike the usage-based fee services, in this model one pays a flat-rate fee, usually on a monthly basis, for access to the facilities and information. Of course, illustrating the fact that these models are not pure, cable charges do reflect some offset from advertising revenues to providers, and they may relate to pay-per-view and/or premium services as well as the basic package. In the

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--> access subscription model there is a basic assumption that use time is not a cost factor. For example, in basic cable service, the basic investment and the cable signal delivered over it are there: if 100 or 1,000 subscribers tune in, there is no infrastructure cost element to factor into the price. Pay-perview cable, on the other hand, equates to the usage-based fees model, in which the owner of the information or intellectual asset wants to recover the cost or value of that asset by charging for its use. A key question with this model is the nature of the service itself. If it is essentially a commodity, it is hard for a firm to remain competitive if each provider offers essentially the same service. Thus, cable provider prospects are affected by the introduction of direct broadcast satellite (delivering cable-like programming) and on-line service provider prospects by the burgeoning entry into Internet access, including entry by providers offering little added value but low prices. Payment Models and the Internet Phenomenon As discussed at the forum, many economic projections relating to the NII seem to be building on the experience of the Internet. The Internet today embodies an infrastructure of sizable dimension, with perceived values in many areas of science, education, government, and commerce. It was built to one set of economic principles and is in transition to another set of economic principles, with all the attendant angst. In the recent past, the wide-area backbone of the Internet was provided through a contract from the National Science Foundation (NSF), reflecting the origins of the Internet as a research project within the U.S. government (primarily the Advanced Research Projects Agency of the Department of Defense and the NSF-funded use of the Internet in support of the academic and research community). But with the expansion of the Internet beyond these uses, and the entrance onto the scene of commercial providers, the NSF orchestrated a transition away from its backbone onto a fully commercial, competitive set of backbone providers. This transition has now occurred, and there are a number of Internet service providers that offer wide-area Internet service, as well as regional and local providers. Consequently, payment for services by users is increasing, through subscription services offering Internet access, while federal support (historically targeted to members of the research, education, and library communities but often overestimated by both beneficiaries and observers) via NSF is being restructured to further precipitate the maturation and commercialization process. This second-stage transition, like the larger development of the commercial market for Internet access, is still unfolding; financing for Internet access in research, education, and libraries contin-

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--> ues to be a source of uncertainty and concern, as do other, technical and business, aspects of commercialization. The Internet brings a unique perspective to this discussion from the unusual economic environment in which it exists. Fundamentally we have a very valuable and effective artifact and network of providers and systems that have been assembled according to a social benefit model. The costs of the infrastructure have been borne by the institutions, both governmental and private, that have desired the connectivity and services that the Internet provides. The information providers on the Internet likewise have contributed their intellectual assets and ideas freely, and the user or customer base in fact disdains, as evidenced by the tradition of ''flaming," attempts by commercial enterprises to breach the free-flowing and noncommercial etiquette observed on the network. Based on this model, commercial interests have begun to take root, the growth and exploitation of the Web being perhaps the prime example. The steering committee heard discussions reflecting a wide range of visions about how the Internet could be used in support of business. Some project participants spoke of the Internet as a vehicle among businesses: for electronic purchasing or joint design projects among several companies. Some project participants spoke of business needs that involved broad access to small business sites: offices of retail stockbrokers, insurance agents, or doctors. Some spoke of needing access to the home in support of their business: "telework," retailing, or home health care. And some believed that access to the consumer in the home was the business. As discussed in this report, these different visions have different implications for the business model and modes of payment, and for the needed infrastructure deployment. But the basic Internet services and functions can be provided in all these cases. Notes 1.   As Robert Crandall of Brookings noted: "[T]he number of competing technologies is growing and … the ultimate winner or winners is not known or even likely knowable at this time. … However one interprets the recent technological and economic developments in this sector, it is quite clear that building versions of the NII is not becoming less risky." 2.   Growth conforms to a diffusion model characteristic of network markets, often modeled with an S-shaped curve. 3.   See Telecommunications Reports (1995n). According to one assessment that focuses on technical difficulties, "Interactive fare from the Bells that combines video and telecommunications seems unlikely to reach even one quarter of U.S. households until well after the year 2000." See also Computerworld (1995). Even for some companies willing to make the investment, business case analysis suggests that break-even points will be reached only after 9 to 10 years, if at all.

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-->     Concerns raised by cable companies netted this response from U S West: "The key is not whether U S West or any other local exchange carrier can predict video dial-tone revenues and costs with any certainty—they cannot—but whether other telecommunications users will be harmed as a result of allowing LECs to provide video dial-tone service." See Telecommunications Reports (1994). 4.   "Here was a company with negative earnings, $17 million in half-year sales—and a market capitalization of $2.2 billion at the close of August 9." See Hardy (1995), p. 206. 5.   The problems of measuring and tracking new products and industries are well known; typically, relevant activities have to achieve some degree of scale or volume to be captured in reliable statistics. 6.   Note that for existing entities there are investments to maintain or replace existing plant and equipment as well as investments for upgrades and growth, implying some need to net out what is investment for growth or upgrading. 7.   The telephone companies, of course, would say that they do continuous upgrades, but the last 100 yards has not changed, in part because of regulatory constraints. They still offer the same service, and (again reflecting regulation) they still have very long depreciation cycles. 8.   Stewart Personick of Bell Communications Research explained that alternatives for local exchange facilities investment are sensitive to relatively small (5 to 10 percent) differences in assumptions ("take" rates, actual applications, geographic density, supplier pricing). 9.   John Redmond of GTE and Edmond Thomas of NYNEX drew from their companies' experiences and concerns to make similar observations. Also, there is some evidence that LEC supply of T-3 lines is growing, nurtured by falling prices that include discounts for fiber channel terminations rather than copper. See Rohde (1995b). 10.   However, it is not clear whether recent or prospective changes may reflect enhanced productivity of capital in telephony, which would imply an ability to produce more with less capital than historically; similarly, it would be interesting to compare investment and productivity in wireless and/or competitive access businesses to those qualities in conventional wireline telephony. 11.   In the report New Age Media II (Friedman, 1994), analysts with the investment firm of Bear Stearns predict that LEC investments in fiber deployment within the local loop will ultimately surpass cable company investments. Choices between hybrid fiber coaxial cable (HFC) and fiber to the curb (FTTC) architectures depend on firms' estimates of likely rates of subscription among the homes passed by the system. (Current penetration for cable television is about 60 percent of homes passed and for the telephone is nearly 100 percent.) Deployment of a new HFC network with full telephone-switching and video-delivery capabilities is estimated to cost about $1,000 per home passed (see the white paper by Stewart Personick). The cost to deploy only the basic transport infrastructure of an HFC transport network, excluding telephone and video, is estimated by Ameritech at approximately $300 per home passed (see the white paper by Joel Engel regarding Ameritech's plans filed with the Federal Communications Commission to deploy an HFC network in its service area). However, upgrading an existing coax network to HFC is estimated by Wendell Bailey and James Chiddix

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-->     in their white paper as much less costly, at about $120 to $130 per home passed. This would give cable television operators, who already have coaxial cable networks, a substantial lead in deploying HFC. The review by the steering committee of network deployment plans by cable and telephone firms tends to bear this out. A July 1994 analysis by financial analysts at Veronis, Suhler & Associates estimated capital costs for deploying a new fiber-optic cable television network as being between $1,200 and $1,800 per household. They identify the cost of file servers and set-top boxes for two-way communications as variables that may drive the network cost higher than these estimates. As discussed in the white paper by Bailey and Chiddix, however, these are incremental costs; while the cost of building the basic transport infrastructure must be incurred completely before any services can be carried, incremental investments supporting interactivity and video on demand can be incurred gradually, while market demand for services builds. 12.   Blau presents an "inverse relationship between the ratio of network investment to operating cash flow from local telephone operations, and total shareholder return." It is not clear how much this analysis takes into account varying conditions among the regional Bell holding companies examined, including different initial capital stock, different geography, and other factors that might lead to variation in investment requirements and behavior. 13.   Robert Blau of BellSouth and Howard Frank of the Advanced Research Projects Agency noted the constraints on accounting rates for depreciation and amortization and for other sources of return on investment in wireline telephony. 14.   Note that wireless systems suggest a very different concept of facilities investment than do wireline systems. The public is a provider of spectrum, the use of which is licensed to the service provider, who in turn invests in transmission and other systems. Due to growing demand for spectrum resources, the Federal Communications Commission recently adopted rules to reallocate spectrum below 512 MHz. See Private Radio docket 92-235, cited in Wireless Messaging Report (1995b). The personal communication service (PCS) auctions represent a departure from past spectrum allocation practices, in which the public has arguably given away spectrum rights (in the form of operating permits for broadcasters) and in implicit exchange for performance obligations, to one where license fees imply greater private payment for use of scarce spectrum. Broadband PCS licenses grant broadcast rights to a pair of 25-MHz channels. Two licenses were auctioned off for each of 51 major cities, and carriers paid an average of about $15 per person (the maximum was almost $32 per person) for the licenses—a price that covered the right to launch a network, with construction and other operating costs over and above an additional expense. According to one calculation, with 50 million PCS customers, the cost per customer would be $154 to the provider, versus $1,500 if there were only 5 million customers in 5 years. See Wireless Messaging Report (1995d). See the white paper by Peter Huber et al. for a description of the nature and economics of licensing. 15.   Similar licensing rules will likely affect the digitization of television broadcasting by setting a date for the termination of analog transmission. In the broadcasting area, the problem is not one of local access, given essential saturation of

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-->     the market, but rather quality and other features of the service. The essential investment issues relate to movement to digital systems and eventually to advanced television (ATV) service(s). See Information & Interactive Services Report (1995a) and Telecommunications Reports (1995a,b,c,d,f,h,k,l, and m). Note that positive government reactions to PCS auctions has fed proposals to auction digital television spectrum. 16.   See Wireless Messaging Report (1995d,e). Wireless data and local area network offerings are expected to help fuel the wireless market. See Wireless Messaging Report (1994). 17.   This estimate is for a 5-year period, for nationwide major-player PCS networks, and includes license acquisition ($7.7 billion), radio and switching equipment, construction and installation, site acquisition and leasing, system design and engineering, and relocating current users. See Naik (1995a). 18.   "[O]ver the next ten years, increases in network capacity available on commercial wireless communications systems (e.g., cellular telephone, PCS, etc.) will be large enough to accommodate not only natural growth in demand for mobile telephone services, but also nearly all narrowband voice and data traffic carried over wireline networks …" (see Blau's paper). 19.   For example, a recent alliance among NYNEX Corp., Pacific Telesis Group, and Bell Atlantic Corp., doing business as Tele-TV Systems, announced plans in September 1995 to provide wireless cable television delivery via Thomson Consumer Electronics Inc. set-top boxes that will offer at least 120 channels but support only limited interactivity (Trachtenberg and Robichaux, 1995). 20.   See, for example, the white paper by Jiong Gong and Padmanabhan Srinagesh. 21.   See Clark (1995b). Band further notes that if Microsoft's set-top operating system were to become a de facto standard, there would be no entity or authority that could enforce the availability or fair terms of its licensure. However, since an operating system is just code, a new or compatible one could be written. The recent antitrust investigations of Microsoft suggest that the threat of enforcement action might itself motivate broader access. Microsoft's reported plans and actions relating to Microsoft Network, its interconnection with the Internet, and its development of nonstandard extensions to its Web browser supported by its new content creation tool ("Internet Studio") appear consistent with Band's characterization. Although the introduction of Microsoft Network inspired various strategic responses by other on-line service providers, it did not command an initial market share as high as some had expected, and Microsoft's strategy is subject to change. Those expectations are a measure of the uncertainty and volatility that characterize the on-line service arena. See Clark (1995c). 22.   This was a theme at the January workshop, and it is addressed regularly in the business press, conferences, and various policy forums. One bold perspective offered by Charles R. Morris and Charles H. Ferguson (now marketing Web-based products) is as follows: "In general, however, we feel that companies tend to underestimate the opportunities for increasing the space for proprietary architectures, in part, no doubt, because of two decades of often thoughtless propaganda for 'open' nonproprietary systems." See Morris and Ferguson (1993).

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--> 23.   Patrick McGovern, chairman of International Data Group, a market research enterprise, was quoted in an interview as saying that "the Airline Guide is more valuable than the airlines. … TV Guide was sold for $2.5 billion, [making it] more valuable than any TV network." 24.   According to one reviewer who provided many insights into advertising, "Branding was originally a way of identifying the manufacturer of a product so that consumers who liked it could repurchase it with the assurance of ongoing similarity. This became necessary because in a mass production economy, the manufacturer and the ultimate consumer of his product were separated by several layers of distribution. They never saw each other. But branding too has entered the virtual world. A product in action, whether it be soap, soup, automobiles, airline tickets, or financial services, is not the object seen at retail. There it is inert and frequently meaningless. Coffee is just a can with words on it. Soap is only a package with words on it. An airplane or car is a mechanical object. But as commercial information, these products become services. Soap is seen making clothes clean. Brewed coffee in a cup makes family breakfasts joyous. Automobiles are seen in motion. Airplanes become the site of friendly service. Commercial information has provided these objects with valuable 'brand personalities,' which are wrapped around products to prevent their commoditization." 25.   See Clark (1995a), Elliott (1995b,c), and Goldman (1995). See Barboza (1995) for a discussion of the Internet as a medium for advertising. 26.   Many newspapers have closed or consolidated. Magazines have had to fight harder to maintain circulation and advertising revenue despite their attempts at greater relevance. Radio formats have changed. "Talk shows" are the beginning of audio interactivity. Network broadcast television is finding it more and more difficult to find programs with a mass common denominator. "Mass mail" has become inefficient and its irrelevance has earned it the unhappy descriptor of "junk mail." The growing public ability to consume information and related services at home, rather than going out for them, is reflected in pay-per-view television, with more than 1 million homes willing to pay $50 to view Mike Tyson's return to prizefighting. In the future, "opening nights" or "you are there'' political, sporting, and cultural events may well create enormous new revenues. 27.   Kessler (1995) noted that "the fundamental values of broadcasting licenses have topped. … As PC screens become more televisual, they will attract still more eyeballs. … TV is not dead, but its economic model is subject to revision." 28.   CSTB has tracked this shift in perspective through a series of briefings and discussions revolving around its 1994 report Realizing the Information Future through major industry meetings (e.g., NCTA '95) and the activities associated with the NII 2000 project, which further engaged key industry leaders. 29.   See Anthes (1995a), Blodgett (1995), Gillin (1995), and Messmer (1995b). 30.   Personal communication, Cathy Medich, executive director, Commerce-Net. SmartValley and the associated Bay Area Multimedia Technology Alliance also provide infrastructure and technology support for applications development, feeding the proliferation of software-based services. 31.   For example, Intuit has contracted with several banks to use its Quicken software for individuals to transfer money between accounts, pay bills, and extract

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-->     account data for use on PCs. Actual transactions will be processed through a service unit. See Flynn (1995). 32.   Evaluating the actual volume of Internet, Web, and on-line service use is notoriously difficult. "[I]n cyberspace, … on-line firms massage membership figures, cloak their calculation methods in secrecy, snipe at rivals' claims and make their numbers impossibly hard to compare" (Sandberg, 1995c). 33.   According to Crandall, "There is a huge incentive already to figure out how to make interactivity work, and then to provide interactive services. … Until there is a breakthrough, so that we all have interactive devices in our homes, I suspect that the major media types are simply not going to get terribly interested in it. The appeal is still to have things going through distribution channels such as HBO, motion picture theaters, whatever, because that's where the hardware is today." 34.   See Liebowitz and Margolis (1994) for a discussion of the literature on and definitions of network effects and related phenomena, as well as work by Economides (1994) and Economides and White (1994). 35.   For a discussion of fax, see Economides and Himmelberg (1995); see also Economides (1994). Discussion of "killer apps" also appeared to be a proxy for some of the concerns about the need for greater ease of use for more advanced forms of information infrastructure. Cautioned Northwestern's Steven Wildman, "What's really going to slow things down or what has to come along is the development of a human infrastructure making it possible to take advantage of the new capabilities." According to Wildman, existing market trials illustrate the difficulties of integrating hardware, software, and human infrastructure at the provider and consumer ends. Quincy Rodgers of GI held out more hope, observing that increasing bandwidth provides "incentives to make the user interface as friendly as possible, because, in order to get back the investment that he has made in his network, [the provider] has got to have as many users as possible." 36.   See Rigdon (1995b), Sandberg (1995b), and Wireless Messaging Report (1995a). Some observers note that the Web phenomenon may be less than reported: "Getting onto the Internet with your home computer is a lot like sex in junior high school: far more people talk about it than actually do it" (Mossberg, 1995). 37.   The Windows '95 experience may be instructive: beyond the early adopters, who are usually willing to pay for the incremental investment needed to try new software, are the average consumers who may be interested in trying the product on a current machine and may require a sizable investment to upgrade memory, and so on; others may combine software and new PC investments. See Farrell and Shapiro (1992) for a discussion of the diffusion of several consumer electronics technologies. They note, for example, that consumer acceptance of color television lagged broadcaster implementation until sufficient programming became available, pointing to the multifaceted nature of the diffusion process in that case. 38.   "Commonalities," they continue, "include standard or conventional interfaces, protocols, reference architectures, and common building blocks from which applications can be constructed to deliver information services to end users."

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--> 39.   For example, secure electronic commerce has motivated a variety of standardization activities. See, for example, the discussion of "S/MIME, a specification that combines the Multi-purpose Internet Mail Extensions standard and RSA Data Security Inc.'s security algorithm, the Public Key Cryptography Standards (sic)" in Timmins (1995). 40.   Netscape is also facilitating Internet service provider access (see Booker, 1995b; Corcoran, 1995b; and Information & Interactive Services Report, 1995b), as are some PC vendors (see Zelnick, 1994). 41.   Cauley (1995b) and Information & Interactive Services Report (1995c). For other examples, see Robichaux (1995a) and Ziegler (1995c). 42.   In an analogous setting, banks are finding value in forming alliances with telephone companies in a kind of vertical integration: "Banks transmit huge amounts of data. Phone lines carry lots of data. So, why shouldn't bank own this means of production, just as it owns branch offices. …" Although decreasing transaction costs may be the initial motivator, both partners often develop new lines of business. One bank, for example, has plans to use "mobile phones and a network of temporary computer kiosks to provide financial advice" to millions of tourists. NYNEX and Chase Manhattan recently unveiled a system to "handle payments over new interactive television systems" (Bray and Carroll, 1995). Alternatively, direct links between retailers and manufacturers may diminish the role of banks; the directionality of the outcome, although constrained by regulations (themselves subject to change), is not entirely clear. See Bray and Carroll (1995). 43.   AT&T's Mahal Mohan describes in a white paper how the expansion of bandwidth in telephony is being accompanied by a steady expansion of service offerings in circuit-switched voice (and data) networks, including 800-number and other related services involving intranetwork databases, plus directory services and specialized security services. According to Mohan, "Currently these features are offered in rudimentary form as part of data and multimedia services, often to a limited base of users," but their deployment is expected to expand "rapidly over the next several years … supporting a broader user base." 44.   Recent FCC action reversing plans to require separate per-channel charges has helped to lower the effective ISDN charges, although state regulatory decisions remain critical. See Betts and Anthes (1995), Fitzgerald (1995), and Andrews (1995a). ISDN remains imperfectly available, as noted in a recent commentary: "So why isn't ISDN as popular as, say, cable TV? There's still the half of the country that can't get it. Even if you are entitled to order the service, you will probably have to suffer through several phone company order-takers before you find one who knows what you are talking about. Also, your Internet service provider may not have ISDN at its end. Another hangup is the fact that you can't enjoy ISDN's benefits without replacing some of your hardware and software. And then there are the technical glitches. Although ISDN is supposed to be a standardized service, there are subtle local variations…" (see Shaffer, 1995). 45.   Bell Atlantic is taking this tack to experiment with "wireless cable"; see Mills and Farhi (1995).

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--> 46.   See the white paper by Robert Powers et al. 47.   For example, Baumol and Sidak (1994a, p. 202) observed that in network markets "… regulators must ensure that access prices enable the incumbent firm to remain financially solvent. The price of access, in other words, must cover not only the incumbent's incremental cost of providing access, but also the opportunity cost that such provision of access implies for the incumbent's ability to cover its common fixed costs, including its regulatory obligations to provide universal service." Tye (1994) adds that how this is achieved may depend not only on regulation but also on contractual arrangements between interconnecting parties, which themselves may be guided by regulation. More generally, there is considerable discussion in economic and antitrust legal literature about the applicability of the concept of an essential facility—to which access (as through interconnection) may be required. Problems relate to defining and measuring the quality of being essential and to the side effects (including discouragement of investment by free-riders) of compulsory access. See, for example, Areeda (1990). 48.   For an in-depth discussion of interconnection pricing, see Brock (1995). 49.   Schwartz explained that in New York, NYNEX and TCG have a relationship for exchange of local traffic using a capacity-based port charge, where loops and ports are unbundled and the inbound traffic is about a quarter of the outbound traffic. 50.   Issues raised in regulatory proceedings include whether incumbents or competitors have higher costs for terminating calls. See Telco Competition Reports (1994a,b). 51.   The interplay between network architecture and pricing strategy was the theme of an interdisciplinary panel on the topic "Architecture and Economic Policy: Lessons from the Internet" at the 1995 Telecommunications Policy Research Conference. As discussed there, economic theory presents principles for pricing goals and tactics; network architecture affects the feasibility and desirability (in terms of impacts on use and implications for provisioning) of alternative pricing approaches; and discussion among network architects and economists can contribute to better design of network enhancements to support flexible pricing policies. 52.   A related challenge is adjusting traditional marketing strategies to the emerging on-line culture. Retailers who have enjoyed success on the Web appear to be those who pass savings on to the customer (as much as 10 to 20 percent below store prices) and who open themselves to "intelligent agents" used by consumers to search out Web sites with the best bargains. Other, less successful, on-line merchants often resist the use of such agents, believing global comparison shopping presents a major threat. See Rigdon (1995a). 53.   There is some evidence that consumers prefer the flat-rate model. "When you're fooling around on-line and you're worried about minutes ticking by, you simply don't use it as much. … You see pennies going by your eyeballs." The implications of various pricing schemes for the future of multimedia communications are drawing service providers, users, and regulators into an ongoing debate; see Mills (1995a). 54.   Since many subscribers use more than one service, the number of on-line

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-->     service accounts (approximately 11.3 million as of late-1995) overstates the number of households (Arlen, 1995b,c; 1996). By contrast, note that the increase between 1993 and 1994 in pager subscriptions was about 7 million (Wireless Messaging Report, 1995c). 55.   See Corcoran (1995a), New York Times (1995), Singletary (1995), Rohde (1995a), Report on Electronic Commerce (1995a), Hansell (1995a), and O'Brien (1995). According to Citibank's advertising flyer for this service, there is a "free" 800-number modem line; customers can move money between accounts, check balances, check whether checks have cleared, pay bills, and obtain stock quotes without charge. Citibank has reported some 100,000 subscribers through the third quarter of 1995 (see Arlen, 1995b). 56.   The concern here is with the business relationship; from a technical point of view, it is reasonable and even desirable for the credit card protocols not to be bound to a particular communications solution (i.e., a particular type of communications technology and therefore a particular class of provider). 57.   See Booker (1995a) and Sullivan-Trainor (1995). 58.   Perhaps because of difficulties guaranteeing cost recovery, they conclude that cable-delivered interactive services will be a choice available to only about 2.5 million households by 1998, but will accelerate and reach 40 million households by 2005. 59.   While there is much discussion about interactive television (broadcast and cable), that alternative is not likely to rival services delivered via PCs between now and the year 2000. However, whereas with cable the providers make investments and spread costs among subscribers, with direct broadcast satellite (DBS) consumers bear substantial capital costs up front. Market research data suggest that consumers spent between $0.5 and $1 billion on digital DBS receivers in their first year of availability (Communications Daily, 1995d). This compares to a total U.S. business local-area network investment of approximately $5 billion (see Chapter 5 section, "Data Communications"). See Markoff (1994), Landler (1995), and Shenon (1995). 60.   Some argue, however, that relatively modest levels of capability may be sufficient to support basic access; this is part of the argument behind the case for universal access to electronic mail as a first step in broader universal information infrastructure access (see, for example, Anderson et al., 1995). 61.   As discussed at the January workshop, whether set-top boxes should continue to be leased or be made available for purchase is a matter of debate within the cable industry.