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Representative terms from entire chapter:
bearer service
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31
The Economics of Layered Networks
Jiong Gong and Padmanabhan Srinagesh
Bell Communications Research Inc.
Statement of the Problem
The creation of a national information infrastructure (NII) will
require large investments in network facilities and services,
computing hardware and software, information appliances, training,
and other areas. The investment required to provide all businesses
and households with broadband access to the NII is estimated to be
in the hundreds of billions of dollars; large investments in the
other components of the NII will also be required. In The
National Information Infrastructure: Agenda for Action, the
Clinton Administration states, "The private sector will lead the
deployment of the NII."
What architectural and economic framework should guide the
private sector's investment and deployment decisions? Is the Open
Data Network (ODN) described by the NRENAISSANCE Committee1 an appropriate economic framework for
the communications infrastructure that will support NII
applications? A key component of the ODN is the unbundled bearer
service, defined to be "an abstract bit-level transport service"
available at different qualities of service appropriate for the
range of NII applications. The committee states that "bearer
services are not part of the ODN unless they can be priced
separately from the higher-level services" (p. 52). The rationale
for this requirement is that it is "in the interest of a free
market for entry at various levels" (p. 52).
What effect will the unbundled bearer service proposed by the
NRENAISSANCE Committee have on the investment incentives of network
providers in the private sector? Will carriers that invest in
long-lived assets be given a fair opportunity to recover their
costs? This paper provides a preliminary discussion of the
economics of an unbundled bearer service.
Background: Convergence and Emerging
Competition
Technological advances are rapidly blurring traditional industry
boundaries and enabling competition between firms that did not
previously compete with one another. For example, cable TV
providers in the United Kingdom (some of which are now partly owned
by U.S. telecommunications firms) have been allowed to offer
telephone service to their subscribers since 1981 and currently
serve more than 500,000 homes.2
Numerous telephone companies in the United States are currently
testing the delivery of video services to households over their
networks. In addition, new firms have recently entered markets that
were not subject to major inroads in the past. Competitive access
providers (CAPs) have begun to serve business customers in the
central business districts of many large cities in competition with
local exchange carriers (LECs), and direct broadcast satellite
services have begun to compete with cable providers. In sum, new
entrants are using new technologies to compete with incumbents, and
incumbents in previously separate industries are beginning to
compete with one another.
Page 242
Analysis
Theoretical Approaches to the
Economics of Pricing Under Differing Market Structures
In a pure monopoly, a variety of price structures may be
consistent with cost recovery, and the firm (or regulators) may be
able to select price structures that promote political or social
goals such as universal service or unbundling of raw transport. In
a competitive market, this flexibility may not exist. Under perfect
competition (which assumes no barriers to entry and many small
firms), the price per unit will be equal to the cost per unit
(where costs are defined to include the opportunity costs of all
resources, including capital, that are used in production). There
is no pricing flexibility. When neither of these pure market forms
exist, economic theory does not provide any general conclusions
regarding equilibrium price structures or industry boundaries.
While substantial progress has been made in developing game theory
and its application to oligopoly,3
no completely general results on pricing are available. This is
particularly true in the dynamic context where interdependencies
between current and future decisions are explicitly considered.
Some theoretical work in this area is summarized in Shapiro.4 An important result in game theory
asserts that no general rules can be developed: "The best known
result about repeated games is the well-known 'folk theorem.' This
theorem asserts that if the game is repeated infinitely often and
players are sufficiently patient, then 'virtually anything' is an
equilibrium outcome."5 Modeling
based on the specific features of the telecommunications industry
may therefore be a more promising research strategy.
The economic analysis of competition among network service
providers (NSPs) is further complicated by the presence of
externalities and excess capacity. Call externalities arise because
every communication involves at least two parties: the
originator(s) and the receiver(s). Benefits (possibly negative) are
obtained by all participants in a call, but usually only one of the
participants is billed for the call. A decision by one person to
call another can generate an uncompensated benefit for the called
party, creating a call externality. Network externalities arise
because the private benefit to any one individual of joining a
network, as measured by the value he places on communicating with
others, is not equal to the social benefits of his joining the
network, which would include the benefits to all other subscribers
of communicating with him. Again, the subscription decision creates
benefits that are not compensated through the market mechanism. It
has been argued that the prices chosen by competitive markets are
not economically efficient (in the sense of maximizing aggregate
consumer and producer benefits) when externalities are present.6
It has also been argued that "[i]ndustries with network
externalities exhibit positive critical mass—i.e., networks of
small sizes are not observed at any price."7 The consequent need to build large
networks, together with the high cost of network construction
(estimated by some to be $13,000 to $18,000 per mile for cable
systems8), implies the need for
large investments in long-lived facilities. The major cost of
constructing fiber optic links is in the trenching and labor cost
of installation. The cost of the fiber is a relatively small
proportion of the total cost of construction and installation. It
is therefore common practice to install "excess" fiber. According
to the Federal Communications Commission, between 40 percent and 50
percent of the fiber installed by the typical interexchange
carriers is "dark"; the lasers and electronics required for
transmission are not in place. The comparable number for the major
local operating companies is between 50 percent and 80 percent. The
presence of excess capacity in one important input is a further
complicating factor affecting equilibrium prices and industry
structure.
To summarize: a full economic model of the networking
infrastructure that supports the NII would need to account for at
least the following features:
•
Oligopolistic competition among a few large
companies that invest in the underlying physical communications
infrastructure;
•
Network and call externalities at the virtual
network level; and
•
Large sunk costs and excess capacity in underlying
transmission links.
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An analysis of the optimal industry structure is well beyond the
scope of this paper; it is a promising area for future research.
This paper focuses on implications of two of these issues
(oligopolistic competition and sunk cost with excess capacity) for
industry structure and the unbundled bearer service. The Internet
is used as a case study to illustrate trends and provides a factual
background for future analyses. This paper provides a description
of the current Internet industry structure, current Internet
approaches to bundling/unbundling and reselling, some recent
examples of the difficulties raised by resale in other
communications markets, and the increasing use of long-term
contracts between customers and their service providers. The
implications for the unbundled bearer service are drawn.
Layered Networks
The Internet is a virtual network that is built on top of
facilities and services provided by telecommunications carriers.
Until recently, Internet service providers (ISPs) located routers
at their network nodes and interconnected these nodes (redundantly)
with point-to-point private lines leased from telecommunications
companies. More recently, some ISPs have been moving from a private
line infrastructure to fast packet services such as frame relay,
switched multimegabit data service (SMDS), and asynchronous
transfer mode (ATM) service. Specifically, among the providers with
national backbones,
•
PSI runs its IP services over its frame relay
network, which is run over its ATM network, which in turn is run
over point-to-point circuits leased from five carriers;
•
AlterNet runs part of its IP network over an ATM
backbone leased from MFS and Wiltel;
•
ANS's backbone consists of DS3 links leased from
MCI; and
•
SprintLink's backbone consists of its own DS3
facilities.
CERFnet, a regional network based in San Diego, uses SMDS
service obtained from Pacific Bell to connect its backbone nodes
together.9
These examples reveal a variety of technical approaches to the
provision of IP transport. They also show different degrees of
vertical integration, with Sprint the most integrated and AlterNet
the least integrated ISP in the group listed above. The variety of
organizational forms in use raises the following question: Can ISPs
with varying degrees of integration coexist in an industry
equilibrium, or are there definite cost advantages that will lead
to only one kind of firm surviving in equilibrium? The answer to
this question hinges on the relative cost structures of integrated
and unintegrated firms. The costs of integrated firms depend on the
costs of producing the underlying transport fabric on which IP
transport rides. The cost structures of unintegrated firms are
determined in large part by the prices they pay for transport
services (such as ATM and DS3 services) obtained from
telecommunications carriers. These prices, in turn, are determined
by market forces. More generally, the layered structure of data
communications services leads to a recursive relationship in which
the cost structure of services provided in any layer is determined
by prices charged by providers one layer below. In this layered
structure, a logical starting point for analysis is the lowest
layer: the point-to-point links on which a variety of fast packet
services ride.
Competition at the Bottom Layer
For illustrative purposes, consider a common set of services
underlying the Internet today. At the very bottom of the hierarchy,
physical resources are used to construct the links and switches or
multiplexers that create point-to-point channels. In the emerging
digital environment, time division multiplexing (TDM) in the
digital telephone system creates the channels out of long-lived
inputs (including fiber optic cables). The sunk costs are
substantial.
There are at least four network service providers with national
fiber optic networks that serve all major city-pairs.10 Each of these providers has invested
in the fiber and electronics required to deliver point-to-point
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channel services, and, as was stated above, each has substantial
excess capacity. The cost structure of providing channels includes
high sunk costs of construction, the costs of lasers and
electronics needed to light the fiber, costs of switching, the high
costs of customer acquisition (marketing and sales), costs
associated with turning service on and off (provisioning, credit
checks, setting up a billing account, and so on), costs of
maintaining and monitoring the network to assure that customer
expectations for service are met, costs of terminating customers,
and general administrative costs. The incremental cost of carrying
traffic is zero, as long as there is excess capacity.
If all owners of national fiber optic facilities produced an
undifferentiated product (point-to-point channels) and competed
solely on price, economic theory predicts that they would soon go
out of business: "With equally efficient firms, constant marginal
costs, and homogeneous products, the only Nash equilibrium in
prices, i.e., Bertrand equilibrium, is for each firm to price at
marginal cost."11 If this theory is
correct,12 firms could recover the
one-time costs of service activation and deactivation through a
nonrecurring service charge, and recover ongoing customer support
costs by billing for assistance, but they would not be able to
recover their sunk cost. Industry leaders seem to be aware of this
possibility. As John Malone, CEO of TCI, stated, "We'll end up with
a much lower marginal cost structure and that will allow us to
underprice our competitors."13
The history of leased line prices in recent years does reveal a
strong downward trend in prices. According to Business
Week,14 private line prices have
fallen by 80 percent between 1989 and 1994, and this is consistent
with Bertrand competition. During the same period there has been a
dramatic increase in the use of term and volume discounts. AT&T
offers customers a standard month-to-month tariff for T1 service
and charges a nonrecurring fee, a fixed monthly fee, and a monthly
rate per mile. Customers who are willing to sign a 5-year contract
and commit to spending $1 million per month are offered a discount
of 57 percent off the standard month-to-month rates. Smaller
discounts apply to customers who choose shorter terms and lower
commitment volumes: a 1-year term commitment to spend $2,000 per
month obtains a discount of 18 percent. The overall trend toward
lower prices masks a more complex reality. "There are two types of
tariffs: 'front of the book' rates, which are paid by smaller and
uninformed large customers, and 'back of the book' rates, which are
offered to the customers who are ready to defect to another carrier
and to customers who know enough to ask for them. The 'front of the
book' rates continue their relentless 5 to 7 percent annual
increases."15 In 1994 AT&T filed
over 1,200 special contracts, and MCI filed over 400.16
There are some theoretical approaches that address the issues
discussed above. Williamson's discussion of nonstandard commercial
contracting17 as a means for sharing
risk between the producer and consumers is relevant to the term
commitments described above. In addition to risk reduction,
long-term contracts reduce customer churn, which often ranges from
20 to 50 percent per year in competitive telecommunications
markets.18 As service activation and
termination costs can be high, reduction of churn can be an
effective cost-saving measure.
There appears to be an empirical trend toward term/volume
commitments that encourage consumers of private line services to
establish an exclusive, long-term relationship with a single
carrier. There is little published information on long distance
fast packet prices. According to one source, none of the long
distance carriers or enhanced service providers (e.g., CompuServe)
tariff their frame relay offerings. Some intra-LATA tariffs filed
by local exchange carriers do offer term and volume (per PVC)
discounts, and the economic forces that give rise to term/volume
commitments for private lines have probably resulted in term/volume
commitments for long-distance, fast-packet services as well.
Competition among Internet Service
Providers
The effect of term/volume commitments in private lines and fast
packet services affects the cost structures of ISPs that do not own
their own transport infrastructure. It may be expected that large
ISPs that lease their transport infrastructures will sign multiyear
contracts, possibly on an exclusive basis, with a single carrier.
These providers will then have sunk costs, as they will have
minimum payments due for a fixed period to their carriers.
Competition at this level will then be similar to competition at
the lower level, and we may expect to see term/volume contracts
emerge in the Internet. A quick survey of Internet sites shows this
to be the case. For
Page 245
example, in January 1995, AlterNet offered customers with a T1
connection a 10 percent discount if they committed to a 2-year
term. Global Connect, an ISP in Virginia, offers customers an
annual rate that is 10 times the monthly rate, amounting to a 17
percent discount for a 1-year commitment. There are many other
examples of this sort.
The Internet is beginning to resemble the private line market in
one other aspect: prices are increasingly being viewed as
proprietary. ISPs that used to post prices on their ftp or Web
servers now ask potential customers to call for quotes. Presumably,
prices are determined after negotiation. This development mirrors
the practice of long-distance carriers to use special contracts
that are not offered on an open basis at the "front of the book"
but are hidden at the back.
Economics of Resale
Kellogg, Thorne, and Huber19
describe the history of the Federal Communication Commission's
decision on resale and shared use. Noam20 analyzed the impact of competition
between common carriers and contract carriers (including systems
integrators and resellers) and concluded that common carriage
cannot survive the competitive struggle. Recent events lend some
credence to this view. According to one recent study, "resold long
distance services will constitute an increasing portion of the
total switched services revenue in coming years, growing at a
compound annual growth rate of 31 percent from 1993 to
1995.… The number is expected to rise to $11.6 billion, or
19.2 percent of the estimated total switched services market in
1995."21 The growth of resale in the
cellular market suggests that there are equally attractive resale
opportunities in this market.22 In
the Internet, some ISPs charge resellers a higher price than they
charge their own customers.23 Other
ISPs, such as SprintLink, make no distinction between resellers and
end users. Facilities-based carriers have had a rocky relationship
with resellers, and courts have often been resorted to by both
carriers and resellers.24
The pricing model that is emerging appears to resemble rental
arrangements in the real estate market. In the New York City area,
low-quality hotel rooms are available for about $20 per hour. Far
better hotel rooms are available for $200 per day (which is a large
discount of 24 times $20). Roomy apartments are available for
monthly rentals at much less than 30 days times $200/day. And
$6,000 per month can be used to buy luxury apartments with a
30-year mortgage. Term commitments are rewarded in the real estate
market, where sunk costs and excess capacity are (currently) quite
common. The telecommunications industry appears to be moving in the
same direction. Contracts are not limited to five-year terms; MFS
and SNET recently signed a 20-year contract under which MFS will
lease fiber from SNET,25 and Bell
Atlantic has a 25-year contract with the Pentagon.26 The term structure of contracts is
an important area for empirical and theoretical research.
Implications for Unbundled Bearer
Services
Unbundled bearer services have much in common with common
carriage: both approaches facilitate greater competition at higher
layers (in content, with common carriage, and in enhanced services
of all types with the bearer service). The dilemma facing
policymakers is that, if Noam is right, competition in an
undifferentiated commodity at the lower level may not be feasible.
In his words: "The long-term result might be a gradual
disinvestment in networks, the reestablishment of monopoly, or
price cartels, and oligopolistic pricing."27 Thus policies promoting competition
in the provision of unbundled bearer services among owners of
physical networks may ultimately fail. The market may be moving
toward contract carriage based on term/volume commitments and
increasing efforts at differentiation, and away from the ideal of
an unbundled bearer service. Should unbundled bearer services be
aligned with this trend by being defined as a spectrum of
term/volume contracts? The competitive mode that is emerging is
quite complex, and the effects of unbundling in this environment
are hard to predict.
Page 246
Conclusions
This paper does not suggest specific architectures or policies
for the emerging NII. It identifies some difficult economic
problems that may need to be addressed. These are the familiar ones
related to resale and interconnection, with the added complication
of competition among multiple owners of geographically coextensive
physical networks. This paper has provided references to recent
developments in telecommunications markets and identified strands
in the economics literature that are relevant to the central issues
raised by the bearer service.
There is an urgent need for a clearer economic analysis of these
issues, and it is critical that the analysis pay close attention to
the realities of competition and evolving competitive strategy.
Three specific areas appear particularly promising:
•
Empirical analysis of evolving price structures
that quantifies the movement from pricing by the minute (the
original Message Toll Service) to pricing by the decade (contract
tariffs);
•
Game theoretic models of competition in long-term
contracts with sunk costs; and
•
Experimental approaches to network economics.28
Notes
1. Computer Science and Telecommunications
Board, National Research Council. 1994. Realizing the
Information Future: The Internet and Beyond. National Academy
Press, Washington, D.C.
2. "Cable TV Moves into Telecom Markets,"
Business Communications Review, November, 1994, pp.
43–48.
3. A recent text is Fudenberg, Drew, and
Jean Tirole, 1992, Game Theory, MIT Press, Cambridge,
Mass.
4. Shapiro, Carl. 1988. "Theories of
Oligopoly Behavior," Chapter 6 in Handbook of Industrial
Organization, Richard Schmalensee and Robert Willig (eds.).
North Holland, Amsterdam, pp. 400–407.
5. Fudenberg, Drew, and Jean Tirole. 1988.
"Noncooperative Game Theory," Chapter 5 in Handbook of
Industrial Organization, Richard Schmalensee and Robert Willig
(eds.). North Holland, Amsterdam, p. 279.
6. These externalities are discussed in
some detail in Mitchell, Bridger, and Ingo Vogelsang, 1991,
Telecommunications Pricing: Theory and Practice, Cambridge
University Press, Cambridge, England, pp. 55–61.
7. Economides, Nicholas, and Charles
Himmelberg. 1994. "Critical Mass and Network Size," paper presented
at the Twenty-second Annual Telecommunications Policy Research
Conference, October.
8. Yokell, Larry J. 1994. "Cable TV Moves
into Telecom Markets," Business Communication Review,
November, pp. 43–48.
9. A fuller description of these networks
can be obtained from their Web pages. The URLs are
http://www.psi.com, http://www.alter.net, http://www.sprint.com,
and http://www.cerf.net.
10. These networks are shown on a pull-out
map in Forbes ASAP, February 27, 1995.
11. Shapiro, Carl. 1988. "Theories of
Oligopoly Behavior," Chapter 6 in Handbook of Industrial
Organization, Richard Schmalensee and Robert Willig (eds.).
North Holland, Amsterdam.
12. An example of an alternative
theoretical approach is found in Sharkey, William, and David
Sibley, 1993, "A Bertrand Model of Pricing and Entry," Economic
Letters, pp. 199–206.
13. Business Week. 1995. "Brave
Talk from the Foxhole," April 10, p. 60.
14. Business Week. 1994. "Dangerous
Living in Telecom's Top Tier," September 12, p. 90.
15. Hills, Michael T. 1995. "Carrier
Pricing Increases Continue," Business Communications Review,
February, p. 32.
16. Ibid.
17. Williamson, O.E. 1988. "Transaction
Cost Economics," Chapter 3 in Handbook of Industrial
Organization, Richard Schmalensee and Robert Willig (eds.).
North Holland, Amsterdam, pp. 159–161.
18. See FCC Docket 93-197, Report and
Order, 1.12.95, page 8 for statistics on AT&T's churn in the
business market. See also Ko, David, and Michael Gell. n.d. "Cable
Franchise Growth in the U.K.," memo, University of Oxford, for
churn in the U.K. cable market.
19. Schmalansee and Willig (eds.), op.
cit., pp. 610–614.
20. Noam, Eli. 1994. "Beyond
Liberalization II: The Impending Doom of Common Carriage,"
Telecommunications Policy, pp. 435–452.
21. Telecommunications Alert
13(2):6.
Page 247
22. Forbes. 1995. "Restless in
Seattle," March 27, p. 72.
23. For example, AlterNet's policy in
January 1995 was as follows: "Because wholesale customers use more
of our backbone facilities and because they also place greater
demands on our staff, we charge more for our wholesale
services."
24. For example, see Telecommunications
Reports. 1994. "Oregon Jury Decides Against AT&T in
Reseller Case," July 4, p. 34, and "AT&T Sues Reseller for
Unauthorized Trademark Use," November 7, p. 26.
25. Telco Business Report, February
14, 1994, p. 4.
26. Ray Smith, CEO of Bell Atlantic, in an
interview in Wired, February 1995, p. 113.
27. Noam, op. cit., p. 447.
28. Plott, Charles, Alexandre Sugiyama,
and Gilad Elbaz. 1994. "Economics of Scale, Natural Monopoly, and
Imperfect Competition in an Experimental Market," Southern
Economic Journal, October, pp. 261–287.
