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7 Competitive effects of network externalities in the context of the Internet
The focus of the present chapter is on the strong network externalities associated
with Internet service provision and their effect on competition in Internet backbone
services. In chapter 5 it was shown that there are no monopolistic bottleneck network elements in Internet backbone services. From the point of view of the theory of
monopolistic bottlenecks ex-ante sector-specific regulation cannot be justified on the
logical layer of Internet service provision.
If no monopolistic bottleneck network element can be found, competition authorities can analyze a particular market to ascertain whether general competition policy
intervention into a market is deemed necessary. The market for Internet service
provision was analyzed by competition authorities in the context of the merger
proceedings regarding the merger of Worldcom and MCI in 1998 and the failed
merger of MCI/Worldcom and Sprint Corporation in 2000. The focus in these analyses was on the strong network externalities in the market for Internet service provision. The general discussion of network externalities in chapter 6 shows that in
many market constellations firms have incentives to voluntarily cooperate in order
to internalize positive network externalities. These incentives are especially strong
when customers have heterogeneous preferences, when products are differentiated
and when the possibility for compensation between the firms is given. With respect
to the network externalities in the market for Internet service provision, competition
authorities doubted that competitive forces in the market were strong enough to cope
with a merger of two of the four largest firms in the market for Internet backbone
services.
The analyses conducted in the context of the merger proceedings in the market for
Internet backbone services are reviewed in the present chapter in order to determine
whether the disaggregated analysis of the market for Internet service provision captured all relevant aspects of competition in Internet service provision which should
be included in a comprehensive examination of the question whether sector-specific
regulation is justified in the market for Internet service provision. Of course, the
focus of the competition policy analyses reviewed below was not to localize market
power which would justify regulation. However, the findings with respect to the
functioning of competition in Internet service provision should be accounted for in
the present analysis.
The chapter is structured as follows: Section 7.1 discusses the network externalities in the applications layer of Internet service provision and how they relate to the
logical layer of Internet service provision. Section 7.2 reviews the terms of interconnection between ISPs in competitive interconnection markets. Section 7.3 reviews
the literature on interconnection incentives of ISPs with a focus on the singledominance case. Section 7.4 analyzes whether Tier-1 ISPs as a group could success-
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fully form a stable collusion on the market for transit services and thereby collectively discriminate ISPs on lower hierarchy levels (collective dominance). Section 7.5
concludes the chapter.
7.1 Network effects in Internet service provision
The Internet, as a classical communications network, belongs to the class of goods
which exhibit positive external benefits in consumption. Direct external effects are
due to the fact that the utility of belonging to the Internet community is directly
related to the number of other people and services that can be reached via the Internet. Indirect network effects result from the fact that the more people use Internet
services, the more applications and complementary products are offered to Internet
users.
The utility derived from the consumption of any network good can be decomposed into a so-called network effect, resulting from the number of people reachable
via the network, and a so-called technology effect, resulting from the technological
characteristics of the network the user is connected to (Blankart and Knieps, 1992:
80). In the context of Internet service provision the network effect can be expected
to dominate the technology effect because users are more likely to give up benefits
from a preferred technology for a wider reach in the Internet.
One way of maximizing the benefits from the network effect in Internet services
is to have only one network supply its services to all users. This would, however,
imply that consumers can derive no benefits from competition among ISPs over
price, product or service quality. As an alternative to a single large network, network
interconnection among otherwise independent network operators can allow that
users enjoy the positive network externalities associated with a single network while
benefiting from product diversity in product dimensions other than network size.
Indeed, the principal attraction of the Internet is that because of interconnection
among ISPs anyone connected to the Internet is reachable by all other users of the
public Internet, irrespective of the home ISPs these users subscribe to. Internet users
expect this universal connectivity from their ISP, that is, the ability to reach all destinations reachable on the public Internet. For universal connectivity all networks
need to be either directly or indirectly connected to one another. The strong network
effect experienced on the retail level of Internet services provision therefore translates into a demand for Internet interconnection by ISPs on the logical layer of Internet service provision. Still, an ISP’s incentives for interconnection may be contradictory, when on the one hand an ISP wants to offer universal connectivity to its
customers and therefore will seek to interconnect with rival networks, but on the
other hand it could try to gain a competitive advantage by refusing to interconnect
with some ISPs, thereby keeping them out of the market and trying to lure the customers of these ISPs to its own network instead.
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7.2 Terms of interconnection among IP-based networks in a competitive market
environment
The interconnection of networks has three aspects. Firstly, a logical interconnection
of the networks needs to define which services are to function across the network
boundaries and at which quality. Secondly, a physical interconnection between the
network infrastructures needs to be established. Lastly, the ISPs need to negotiate
how the costs of the physical interconnection and the costs for the traffic transmission via this interconnection ought to be split.
The advantage of the TCP/IP standard is that two IP-based networks can agree to
use the TCP/IP protocol and thereby define much of what the logical interconnection
parameters will be. ISPs can negotiate further quality of service parameters which
they want to guarantee across network boundaries. Advanced services, such as realtime Voice over Internet Protocol (VoIP) capabilities or television over Internet
Protocol services can, for instance, be offered only to users within one and the same
network by running additional protocols on top of the standard TCP/IP protocols.102
They can however, also be offered across network boundaries, if the ISPs agree to
guarantee the required quality parameters.
Negotiations over physical interconnection as well as the financial terms of network interconnection need to address the following questions: 1) where to establish
the location of the interconnection, 2) how to cover the costs of the network infrastructure which physically connects the two networks and 3) how the two networks
ought to split the costs for traffic transmission to and from the other’s network. The
following subsections present the typical financial agreements for Internet transport
services today.
7.2.1 Costing and pricing of Internet transport services
Early interconnection of IP-based networks in the NSFNET era functioned basically
without monetary compensation between the connecting parties. The rationale may
have been that traffic flows could be expected to be roughly symmetrical. More
importantly, however, the funding for the network infrastructure at this time was in
most cases provided by the government. Network administrators therefore considered the effort to install complex traffic metering dispensable. This situation changed fundamentally, when the National Science Foundation reduced funding and
networks had to become self-supporting. It was especially important for the newly
emerging commercial ISPs to operate cost-effectively. Network costs needed to be
recovered according to some cost-causation principle. It is no coincidence that inter-
102 See, for instance, Buccirossi et al. (2005). See also section 9.3 in which the implications of
the more recently developed technologies for quality of service differentiation among networks are discussed. According to Marcus (2006b: 34) these technologies are already widely
deployed for controlling the quality of service within networks.
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References
Zusammenfassung
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.