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 IS250 Spring 2010 [email protected]

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Page 1: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

Network Economics

“We know how to route packets, what we don’t know how to do is route dollars.”

-- David C. Clark

IS250Spring 2010

[email protected]

Page 2: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

John Chuang 2

Routing Dollars on the Internet

O’Donnell, An Economic Map of the Internet, Telecommunications Policy Research Conference, 2002.

Page 3: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 4: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 5: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 6: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 7: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 8: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 9: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 10: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 11: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

John Chuang 11

Example: Major Milestones in Telephony in U.S.

AT&T as Regulated Monopoly

AT&T

Page 12: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

John Chuang 12

Monolithic Network

Central Office (CO)Class 5 Switch

Tandem Switch

Local Loop

Customer PremiseEquipment (CPE)

Local LocalLong Distance

Page 13: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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?

Page 14: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 15: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

John Chuang 15

RBOCRBOC

Cable MSO

MCI

AT&T

Wireless Operator

Local Access Competition1996 Telecommunications Act

Facilities-based Competition Open access: Unbundled Network Elements

Page 16: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 17: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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)

Page 18: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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

Page 19: Network Economics “We know how to route packets, what we don’t know how to do is route dollars.” -- David C. Clark IS250 Spring 2010 chuang@ischool.berkeley.edu

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