Margit Vanberg, Claims of market power in Internet service provision in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 76 - 78

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
76 5 Disaggregated analysis of the market for Internet service provision In the present chapter the disaggregated regulatory approach is applied to the market for Internet service provision. The network elements of the value chain for Internet service provision are analyzed using the criteria of the theory of monopolistic bottlenecks. If for any particular network element it can be shown that, due to economies of scale and/or scope in the relevant output region, the market for this network element is a natural monopoly and that a duplication of this network element would involve making substantial sunk investments, then sector-specific regulation is justified. The chapter is structured as follows. Section 5.1 motivates the analysis by reviewing claims of market power in Internet service provision. Section 5.2 sets up the disaggregated analysis of the network elements of Internet service provision by classifying the essential network elements into the layered model of Internet service provision presented in chapter 2. Section 5.3 scrutinizes the network elements of the applications and content layers of Internet service provision. In section 5.4 the network elements of the logical layer and in section 5.5 the network elements of the physical layer are analyzed. Section 5.6 concludes the chapter. 5.1 Claims of market power in Internet service provision Whether dominant Tier-1 ISPs can charge lower-level ISPs discriminatory transit prices or offer inferior quality of service without inducing market entry into the toplevel Internet backbone services market was at the center of the merger proceedings for the merger of two large U.S.-based telecommunications companies, MCI and Worldcom, in 1998. In its decision on this merger, the European Commission (1998) focused especially on Internet interconnection issues in the market for Internet backbone services. The Commission found a separate market for “top-level or ‘universal’ Internet connectivity” (EC, 1998: §70) and defined it by the characteristic that only top-level ISPs active on this market can offer full coverage of all users connected to the Internet. The Commission determined that the merged entity would have a combined market share of above 50 percent in the relevant market for Internet backbone services (EC, 1998: §114). The Commission feared that the merged entity would be in a position to act independently of competitors and customers and therefore imposed the divestiture of MCI’s Internet business before authorization of the merger. The Commission applied the same market definition in its assessment of the proposed merger between MCI Worldcom and Sprint in 2000 (European Commission, 2000). Again the Commission concluded, on the basis of an assessment of market shares, that the proposed merger would either create or strengthen a position 77 of dominance in the market for top-level Internet connectivity (EC, 2000: §196). The merger was declared incompatible with the common market and the functioning of the EEA agreement. For its calculation of market shares, the European Commission used data on revenues from basic Internet access services (EC, 1998: §105) and data on traffic flow between ISPs and within an ISP’s network (EC, 1998: §109). Problematic in the Commissions’ argumentation is that revenues from Internet access services reflect the relative number of attached end-users. The number of directly attached end-users is, however, not a good proxy for an ISP’s market position in the Internet backbone services market. The service traded on the backbone services market is the reachability of IP-addresses. It is not particularly important to the interconnection partner whether the offered reach is to direct customers of the network or to third-party customers. Data on traffic-flow share also cannot accurately reflect a firm’s position in the Internet backbone services market since the amount of data transmitted over the network is not necessarily proportional to the reach a network can offer in the Internet. Even more problematic for the subsequent policy discussion on the possible regulation of Internet interconnection is the fact that the Commission’s decision on the MCI Worldcom merger suggests that market shares of any kind can be used to show dominance in the Internet backbone. The argument that only a handful of Tier-1 ISPs have large market shares in the Internet backbone services market has since been used to argue “for general interconnection obligations for Internet carriers” (Speta, 2002: 228). The reason given for such interconnection obligations is: “... at least some segments of the Internet carrier market are likely to exhibit at least localized monopoly characteristics” (Speta, 2002: 271). Economic analyses, which have tried to substantiate the claim of monopoly characteristics in top-level Internet backbone services, often lack a clear distinction between the physical layer of the Internet services market and the logical layer of Internet service provision when describing where monopoly market power is located. The allegations of lower-level ISPs that they are being discriminated against by Tier-1 ISPs concern a service offered on the logical layer of Internet service provision. Nevertheless, arguments about competitive conditions in the physical network layer are regularly put forward to either substantiate or refute the claim of market power by Tier-1 ISPs. Consider for instance the following statement: “...a major backbone Internet operator does not appear overnight. These Tier-1 operators must have the financial and operational wherewithal to construct or lease and manage a nationwide network of high capacity lines. Few enterprises can amass the needed investment and skills” (Frieden, 2001: 165). A similar argument was put forward by Crémer et al. (2000: 447): “…an entrant would face important obstacles. First, it is very costly to build a large network fast.” The disaggregated analysis of the network elements of Internet service provision offered in the present chapter will systematically search for monopolistic bottlenecks in Internet service provision. If such bottlenecks are found, their location in the value chain of Internet service provision is known and can be used to formulate a 78 minimally invasive regulatory policy. For those network areas in which no monopolistic bottlenecks are found, it can be concluded that high market shares of particular carriers are not a sign of stable network-specific market power and cannot be used to justify regulation. 5.2 Essential network elements of Internet service provision The disaggregated analysis of the market for Internet service provision uses the layered model of Internet service provision developed in chapter 2. Table 5.1 classifies the most important network elements and the principle drivers of costs in this layered model. These elements are then analyzed in the subsequent sections. The content layer comprises goods and services offered via Internet applications services such as news, home-banking services, online-shopping opportunities, etc. Providers of Internet content are responsible for production of these goods and services, and for the sales and marketing activities for these goods and services. Online content is offered by a variety of firms, often with the major part of their business activities in conventional retail and services markets. Offering Internet content requires no specific Internet hardware or software; only the programming of an onlinepresence. Server capacity for the distribution of the web-page content within the Internet is bought from Internet applications providers. The applications layer comprises the applications ISPs offer to end-users of the Internet, such as E-mail services, file transfer, web-browsing, content hosting, portal services, etc. ISPs offering Internet applications operate servers on which data can be stored. Carriers offering these applications are responsible for product development, product design, and sales and marketing activities. The direct relationship with Internet end-users also encompasses functions in the area of customer support and billing activities. The logical layer comprises the network elements employed in Internet access services and Internet backbone services. These network elements support the transmission of data within and between networks on the basis of the network elements located on the physical layer. Network management functions are located on the logical layer and require the deployment of skilled personnel. Hardware elements of the logical layer are routers and switches installed at Internet exchange points and network nodes. The hardware is complemented by software for transport functions that is designed to establish logical connections, to manage the fragmentation and reassembly of data messages, the control of transmission errors and for maintaining and updating routing tables. A further critical element of the logical layer is the common address space used in Internet data transmission.

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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.