network economics “we know how to route packets, what we don’t know how to do is route...
TRANSCRIPT
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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Routing Dollars on the Internet
O’Donnell, An Economic Map of the Internet, Telecommunications Policy Research Conference, 2002.
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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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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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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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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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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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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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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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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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Example: Major Milestones in Telephony in U.S.
AT&T as Regulated Monopoly
AT&T
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Monolithic Network
Central Office (CO)Class 5 Switch
Tandem Switch
Local Loop
Customer PremiseEquipment (CPE)
Local LocalLong Distance
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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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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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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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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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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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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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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