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

John Chuang2 Routing Dollars on the Internet  O’Donnell, An Economic Map of the Internet, Telecommunications Policy Research Conference, 2002.

John Chuang3 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

John Chuang4 Economics 101 Producer Supply cost structure Price of Good/Service Market Structure e.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

John Chuang5 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

John Chuang6 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

John Chuang7 Traditional Goods & Services  Q* is optimal firm output  If market size (Q TOT ) >= NQ*, then it is socially optimal for market to be served by N firms $ Q AC Q*Q TOT

John Chuang8 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 Q TOT

John Chuang9  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

John Chuang10 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 $ Q Q TOT

John Chuang11 Example: Major Milestones in Telephony in U.S.  AT&T as Regulated Monopoly AT&T

John Chuang12 Monolithic Network Central Office (CO) Class 5 Switch Tandem Switch Local Loop Customer Premise Equipment (CPE) Local Long Distance

John Chuang13 Long Distance Competition Enabled by Interconnection (circa ) Central Office (CO) Class 5 Switch Local Loop Customer Premise Equipment (CPE) MCI Local Exchange Carrier (LEC) Inter Exchange Carrier (IXC)  But local market still monopoly. Implications?

John Chuang14 Divestiture of AT&T 1984  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&T RBOC

John Chuang15 RBOC Cable MSO MCI AT&T Wireless Operator Local Access Competition 1996 Telecommunications Act  Facilities-based Competition  Open access: Unbundled Network Elements

John Chuang16 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

John Chuang17 Network Effects  Value of network increases with network size -e.g., telephones, fax machines, 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)

John Chuang18 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

John Chuang19 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