Margit Vanberg, Typical cost and demand characteristics of network industries in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 18 - 20

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
18 from the fact that this number roughly quadrupled since March 2000 (309 million users) and is more than ten times the number of users in the second half of 1997 (100 million). Africa, Latin America and the Middle East are currently experiencing the fastest usage growth. In the more developed regions of the world the growth in registered sites and users may level out soon, but Internet applications are still showing growth rates in large orders of magnitude. Forrester Research is, for instance, predicting that E-commerce volume in Europe will more than double between 2006 and 2011.4 The process of network convergence Not only are Internet applications becoming ubiquitous, the Internet technology is gaining in importance in comparison to other communications technologies as well. There is a general understanding in the industry that the Internet is the communications platform on which other communications and media networks will converge, and that this network convergence will be completed in the near future. So-called next generation networks (NGNs) are generally defined as communications networks based on the Internet Protocol which support multiple services, especially telecommunications, Internet, and broadcasting of television and radio. The advantages of network convergence are seen in the lower costs of operating a single network for several uses as well as in the convenience for end-users who can receive a multitude of services from one provider. 1.2 The role of sector-specific regulation or competition policy in the Internet Because of its importance for business activity as well as for private consumption, the stability of the Internet is a top-priority for policymakers worldwide. Since the network characteristics of the Internet underscore its closeness to other regulated network industries, especially the telecommunications markets, it is an obvious candidate for government intervention. Competition authorities already watch over this market critically, and legislators have on several occasions appraised the need for sector-specific legislation for Internet markets. The following two subsections describe the cost and demand characteristics that are typical for network industries and explain why these have been used to argue for government intervention into network industries in general and in the Internet in particular. 1.2.1 Typical cost and demand characteristics of network industries Generally, network industries such as telecommunications, electricity and transportation have in common that the production of their services is based on a network 4 See,id,29529,nodeid,82.html; site last visited on Feb. 15, 2008. 19 infrastructure. The supply of network infrastructures is characterized by significant bundling advantages. Networks are typically made up of various transmission lines and network nodes at which these transmission lines are interconnected. Generally, a user of a network service requires an exclusive point-to-point interconnection between its location and the nearest point of presence of the network at which transmission signals can be entered into the network. Up to this point, several lines of geographically close users can share a common ductwork. On the next network level, the transmission signals transported over the separate local lines can be multiplexed onto a single transmission line such that from there on the transmission signals of several users are transported via one line. Network sectors are therefore characterized by significant bundling advantages, especially in higher network levels. This leads to the typical cost-side characteristics of network industries: high fixed costs for the initial installation of the network but falling average costs per user and comparatively low marginal costs of production. Large fixed costs together with relatively low marginal costs of production lead to economies of scale. Economies of scale favor larger firms over smaller rivals since an increase in the capacity of the network requires disproportionately less inputs by larger firms. Therefore a large firm has lower long-run average costs for each produced unit as compared to smaller firms. Furthermore, because network industries tend to have fluctuating demand over time (for instance, peak demand during specific daytimes and low use at night) operators which serve more customers statistically realize a better utilization of their capacity. Lastly, if it is also less costly for a single firm to produce multiple outputs than for several specialized firms to produce these outputs, then the production is also characterized by economies of scope. Large multi-product operations also have more opportunities to cover the large common costs of the network infrastructure by price differentiation strategies than specialized firms. Substantial economies of scale and scope can be an indication of natural monopoly characteristics of a market. A market is considered a natural monopoly when a single firm can produce the market output at lower costs than several firms. A second notable characteristic of many network industries is that demand is characterized by so-called network externalities. In communications networks, a user’s utility is positively related to the number of other users on the network since the possibilities for interaction are increased with new users. The addition of a new user increases the willingness to pay of existing users in the network. The network benefits favor larger firms that can offer more utility from network externalities over smaller firms. Natural monopoly on the cost side, as well as network externalities on the demand side are traditionally viewed as sources of market failure (Viscusi et al., 2000: 314). In monopoly markets there is a conflict between productive and allocative efficiency. Productive efficiency requires that the resources devoted to producing a given output are minimized. In a natural monopoly, productive efficiency is generally achieved because there is a single producer in the market. Allocative efficiency requires that all resources are allocated to their most productive usage. In competitive markets, prices which conform to marginal costs of production achieve allocative 20 efficiency. In monopolies, the competitive pressures which drive prices towards marginal costs often do not exist.5 Monopoly therefore often does not lead to allocative efficiency. Network externalities are viewed as a source of market failure because new entrants to the market need to gather a minimum number of users on their network in order to be able to offer the network benefits necessary to attract customers. Below this so-called critical mass of users the service will not be viable in the market. It has been argued that the need to reach a critical mass may constitute a barrier to entry in network markets. 1.2.2 Current regulation concerns in the Internet Allocative and productive inefficiencies which result from market failures can sometimes justify government interventions into free markets. The typical cost and demand characteristics of network industries are the reason that these industries were historically either state-owned and -operated or that private operations were subjected to sector-specific price and entry regulations. So far, the Internet, even though a network industry, has evolved mostly unregulated. At the time the dissemination of the Internet reached a significant level, both economic theory and public policy were very reserved with respect to the regulation of network industries. The deregulation of the closely related telecommunications industry was just underway. This contributed to a hands-off mentality with respect to regulating the Internet.6 Meanwhile, about two decades of experience in the deregulation of telecommunications services has lead to a more differentiated approach to the issue of regulation/deregulation in network industries. While there is a general understanding that regulation should be phased out as competition increases, there is also a widespread belief that there remain network areas which are not likely to become competitive soon, and that regulation might be of importance here. In consequence, there is an active interest in the regulation of network industries and demands for regulation of Internet service provision come up regularly. Beginning with the merger proceedings of two of the four largest firms in the market for Internet backbone capacity, Worldcom and MCI, in 1998 and the failed merger of MCI/Worldcom and Sprint Corporation in 2000, economists have produced a large amount of literature discussing the role of general competition policy in Internet interconnection.7 The main question dealt with in this literature is whether 5 Only in the case of a contestable natural monopoly is the monopolist under competitive pressure and cannot realize above-competitive profits over an extended time period. 6 In the U.S., for instance, Internet services were counted among the “information services,” which are not subject to common carrier regulation (Kende, 2000: 13). 7 Early articles on the role of antitrust and regulation in Internet markets are Crémer et al. (2000), Kende (2000), Milgrom et al. (2000), Foros and Hansen (2001), and Frieden (2001). Economides (2005) provides a more recent overview.

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Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.