Margit Vanberg, Analyzing the cost characteristics of the logical layer of the Internet in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 81 - 84

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
81 relevant output region paired with irreversible investments, there are no monopolistic bottlenecks in the market for Internet application services. In conclusion, both the content layer and the applications layer of Internet service provision are competitive. There are no substantial economies of scale in these markets that could give rise to monopolistic network elements. According to the disaggregated regulatory approach, sector-specific regulation cannot be justified in these layers of Internet service provision. 5.4 Analyzing the cost characteristics of the logical layer of the Internet A large part of costs on the logical layer of Internet service provision can be attributed to the skilled personnel employed for network management and interconnection negotiations. The wage costs of personnel are part of variable costs and consequently do not substantiate stable market power. Possible sources of large fixed investments on the logical layer are Internet Exchanges, routers, and software. Therefore, the cost characteristics of these network elements are important to look at in more detail. Operation of Internet Exchanges68 Internet Exchange Points (IXPs) are shared interconnection points, where carriers meet for the purpose of exchanging Internet traffic.69 The primary service provided by an Internet Exchange (IX) is a central switching platform and a pre-provisioned fiber mesh often comparable to a local area network, to which carriers can connect their own equipment in order to realize interconnections with other carriers. Secondary services of IXs include help in establishing contacts between carriers, for instance by establishing mailing lists of carriers present at the IX. Carriers can gain efficiency from interconnecting at IXs, because interconnection at IXs minimizes the cost for building fiber to the location of several peering points. Furthermore, an IX offers the opportunity for direct interconnection between networks when the amount of traffic between the two networks would not have warranted a bilateral interconnection. Smaller carriers also use IXs to bundle traffic in order to negotiate a joined agreement for interconnection with larger carriers and thereby better the commercial terms of the contract (Hussain, 2002). There are economies of scale in providing IX services. Firstly, the cost of the shared infrastructure at the IX falls with the number of carriers supplied by it. Secondly, a smaller number of IXs in a given area is more efficient because the benefit of 68 I am grateful to Arnold Nipper, the technical manager of the DE-CIX, in Frankfurt Germany, for an interview, which provided extensive background knowledge for this section on IXPs. The DE-CIX is an IX organized by the Association of the German Internet Economy (; site last visited on Feb. 15, 2008). 69 The European Internet Exchange Association has an informative website on Internet Exchange Points (; site last visited on Feb. 15, 2008). 82 membership at an IX rises with the number of carriers interconnected there. It is difficult to assess when these economies of scale are exhausted. Easier to determine is the fact that providing IX services does not require making substantial sunk investments. The collocation space on which IX infrastructure is set up can be rented and therefore is not a fixed investment into IX service provision. Investments into equipment installed at the IX are reversible. The equipment installed at such central network nodes is generally high-end equipment. It can be moved to another location and be reconfigured to fulfill other functions within a network. The only sunk costs of operating an IX consist of the costs, which arise from installing the equipment at the IX. IXs are generally organized by a cooperative of several ISPs. The sunk costs for installation are therefore shared among several carriers and are subsequently relatively low compared to the investment into equipment. These easy entry conditions into providing IX services ensure that there is no market power associated with the operation of an IX. Routers Routers perform different tasks depending on their place in the network hierarchy (see section 3.4.4 on routing above). Investments into routers utilized in lower network levels are small compared to investments into the high-end equipment which is used in higher network levels. The difference in costs reflects the requirements placed on routers concerning their capacity for handling large routing tables within a given time interval. High-level routers are characterized by their ability to process larger routing tables faster. High investment costs into routers may facilitate economies of scale on the logical layer of Internet service provision, especially on the higher levels of the Internet hierarchy. In order to be able to determine whether routers are potentially monopolistic bottlenecks it is important to know whether the investments into routers are sunk. According to the Yankee Group, routing platforms are replaced every 18 to 24 months (Yankee Group, 2002: 4). The capital costs of routers as well as the installation and configuration costs can therefore be counted among the variable costs of Internet service provision. Variable costs factor in the calculation of both incumbent carriers and carriers contemplating to enter the market, such that there is no value to incumbency arising from previous investments into routing capabilities. Furthermore, there exists a second-hand market for used routers, such that routers do not loose their current worth upon exiting the market. Cisco, the leading manufacturer of high-end routers, for instance offers to buy back used routers for its Cisco Authorized Refurbished Equipment program.70 Through this program new entrants to the market have the opportunity of buying certified and supported equipment without having to invest into the most expensive technology. In summary, there is no market power associated with routing facilities. 70 See:, site last visited Feb. 16, 2008. 83 Software71 Router software and TCP/IP software is generally purchased in combination with a router and upgraded at least as regularly as the hardware. Furthermore, software is scaled to individual demand, such that a small ISP with a simple network has far lower software costs than a Tier-1 ISP with more responsibilities in its network. Investments into software can therefore be counted among the variable costs of Internet service provision, such that they cannot be the source of substantial sunk costs. Management of IP-address space The provision of Internet access services and Internet backbone services requires a common address space used and recognized by all ISPs offering Internet services to the public. TCP/IP protocols and routing protocols use IP addresses to identify machines attached to the Internet. For humans pronounceable names are easier to use and remember. For this purpose the Domain Name System (DNS) was invented, an Internet directory which translates IP addresses into pronounceable domain names and E-mail addresses. Both, IP-address space and domain name space are managed and granted by the Internet Cooperation for Assigned Names and Numbers (ICANN). ICANN is an independent, non-profit standardization organization. It is responsible for specifying the rules for assigning IP-addresses and domain names. It also defines the manner in which assigned names and addresses are made public within the Internet. The need for a standardized system with central control for the management of IP addresses stems from the fact that the Internet is a dynamic system with thousands of machines added to and removed from the Internet daily. In such a dynamic environment it is essential that there is a single authority, which can grant the right to attach to a machine a unique identifier that will be understood by the rest of the Internet immediately. It is not possible to have active competition in IP-address management. Section 6.3.4 discusses when voluntary organization of standardization among industry representatives is likely and when it may be necessary to have a government authority impose an industry standard. In the case of IP-address assignment, ICANN originated from a U.S. government initiative. This is due to the fact that the Internet itself originated from U.S. government projects. Since 1998 it is an independent institution that is managed by an internationally representative board of directors. Summary logical layer None of the network elements of the logical layer show the characteristics of a monopolistic bottleneck. While there are economies of scale in network management, in Internet exchange services and in higher-level routing capabilities, there are no substantial sunk costs associated with these network elements. The conclusion from 71 See web pages of Cisco (; site last visited on Feb. 15, 2008) for an example of software for IP services. 84 the perspective of the disaggregated regulatory approach with respect to the logical layer is that there are no network elements which can substantiate market power. There is no justification for regulation on the logical layer of Internet service provision. 5.5 Analyzing the cost characteristics of the physical layer of the Internet Network economics shows that monopolistic bottleneck network areas are most likely to be found on the physical layer of network service provision. The physical layer by far encompasses the largest investments necessary for Internet service provision. This is not because of high costs for purchasing transmission lines, but rather because of the substantial expenditures for the first-time installation of these lines. The large investment cost associated with building a network infrastructure can give rise to economies of scale and scope in the market. Furthermore, the installation costs, such as digging trenches and laying cable, are sunk upon entering the market. The physical layer therefore has a high potential of substantiating stable market power. Figure 5.1 illustrates the physical layer of Internet service provision. Figure 5.1: Stylized illustration of the physical layer Point of Presence: Access point to the ISPs network Point of Interconnection between the networks of the incumbent carrier and the ISP Long-distance communications infrastructure of the ISP PoP POI En d U se rs L a rg e cu st o m er Retail leased lines PoP POI Local loops Incumbent‘s long-distance comm. infrastr. Collocation sites

Chapter Preview



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.