network economics “we know how to route packets, what we don’t know how to do is route...
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Network Economics
“We know how to route packets, what we don’t know how to do is route dollars.”
-- David C. Clark
IS250Spring 2010
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John Chuang 2
Routing Dollars on the Internet
O’Donnell, An Economic Map of the Internet, Telecommunications Policy Research Conference, 2002.
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John Chuang 3
Agenda
Today:- Economic characteristics of communication networks
- Economies of scale- Network effects
- Implications to industry structure and public policy
In Three Weeks:- Competition models
- Monopoly, perfect competition, oligopoly- Price discrimination, switching cost
- Interconnection and industry structure- Horizontal merger- Vertical integration
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John Chuang 4
Economics 101
Producer
Supply• cost structure
Price of Good/Service
Market Structuree.g., monopoly, duopoly, perfect competition
Welfare (surplus)
Consumer
Demand• willingness to pay
• Producer Surplus (profit) = revenue minus cost• Consumer Surplus = valuation minus price paid• Total Surplus or Social Welfare = PS + CS
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John Chuang 5
Supply & Demand in the Network Context
Supply: cost of providing network service- fixed cost- marginal cost
Demand: how much users value (and are willing to pay for) the service- more difficult to quantify- need empirical measurement
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John Chuang 6
Economies of Scale
Communication networks exhibit strong economies of scale:- High fixed cost (e.g., trenching cost, up-front capital investment)
- Low/zero marginal cost (of sending additional byte of traffic over network)
EoS: Average cost declines as output level increases
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John Chuang 7
Traditional Goods & Services
Q* is optimal firm output If market size (QTOT) >= NQ*,
then it is socially optimal for market to be served by N firms
$
Q
AC
Q* QTOT
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John Chuang 8
Infrastructure Goods & Services
Strong economies of scale (high FC, low MC): AC curve declines for entire market size
Cost-efficient to have the entire market served by a single firm- “natural monopoly”
$
Q
AC
QTOT
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John Chuang 9
A monopolist is a price-maker
A monopolist maximizes profit, at the expense of consumer welfare
A monopolist may become inefficient (lazy) in the absence of competition
Competition instills market discipline
Firms are price-takers in a competitive economy
Price competition leads prices to marginal cost
Inefficient firms (higher MC) exit market
However, firms cannot recover fixed cost with marginal cost pricing…
Caught between a rock and a hard place? What can we do?
- Public utility- Regulated monopoly
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John Chuang 10
Technological Change
Natural monopoly may not last forever
Technological change may result in new cost curve: same market may now be optimally served by multiple firms
$
QQTOT
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John Chuang 11
Example: Major Milestones in Telephony in U.S.
AT&T as Regulated Monopoly
AT&T
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John Chuang 12
Monolithic Network
Central Office (CO)Class 5 Switch
Tandem Switch
Local Loop
Customer PremiseEquipment (CPE)
Local LocalLong Distance
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John Chuang 13
Long Distance CompetitionEnabled by Interconnection (circa 1969-1972)
Central Office (CO)Class 5 Switch
Local Loop
Customer PremiseEquipment (CPE)
MCI
Local Exchange Carrier (LEC) Local Exchange Carrier (LEC)Inter Exchange Carrier (IXC)
But local market still monopoly. Implications?
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John Chuang 14
Divestiture of AT&T1984
Dept. of Justice sued AT&T for anti-trust violation Consent decree called for structural separation between local and long distance service
AT&T split up into Long Distance and seven regional bell operating companies (RBOCs, aka baby bells)- Pacific Bell, US West, Southwestern Bell, Bell South, Ameritech, Nynex, Bell Atlantic
Local markets still regulated monopolies
RBOC
MCI
AT&TRBOC
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John Chuang 15
RBOCRBOC
Cable MSO
MCI
AT&T
Wireless Operator
Local Access Competition1996 Telecommunications Act
Facilities-based Competition Open access: Unbundled Network Elements
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John Chuang 16
Network Effects
Also known as “network externalities” or “demand-side economies of scale”
Externality: value (including costs and benefits) of a good/service not fully reflected in its price- e.g., the sticker price of an automobile does not include the economic impact of its potential to pollute
Network externality: value of the network is a function of the network size
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John Chuang 17
Network Effects
Value of network increases with network size- e.g., telephones, fax machines, email clients- Sarnoff: value of a network is proportional to its size (v N)
- Metcalfe’s Law: value of a network is proportional to the square of the number of users (v N^2)
- Reed: value of network grows with the number of possible sub-groups that can be formed (v 2^N)
Negative network effects possible due to congestion, telemarketers, etc.- Odlyzko and Tilly: v N(logN)
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John Chuang 18
Implications “Winner-take-all” or “tipping” dynamics Adoption of new technologies
- Subject to excess inertia- Influenced by availability and efficiency of converters
Source: Joseph, Shetty, Chuang, Stoica, Modeling the Adoption of New Network Architectures, 2007
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John Chuang 19
Summary
Communication networks exhibit- High fixed cost, low marginal cost (strong economies of scale)
- Positive/negative network effects (demand-side economies/diseconomies of scale)
Implications:- Natural monopoly; justifications for regulation or deregulation
- Competition subject to tipping effects; technology transitions subject to excess inertia