117 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. 118 connection agreements changed dramatically at the time of the privatization of the Internet, and that at the same time concerns regarding the possibility of anticompetitive interconnection agreements started to be intensely analyzed by competition authorities and competition economists. The costs of providing Internet transport services include the access costs to network resources of the physical layer as well as the costs of switches and routers, the costs for transmission software and the costs for employed staff. These costs are driven by the geographic extent of the network as well as by the bandwidth of the links making up the network.103 Most of these costs are long-run variable costs. The short-run marginal costs for any particular product or service provided over a given infrastructure are close to zero. As is typical for network services, most of the costs involved in Internet transport services are also overhead costs, meaning that they cannot be allocated to the incremental costs of particular products and services. The pricing for Internet backbone services therefore necessarily does not reflect shortrun marginal costs or even long-run incremental costs of the service. In general, the price of a particular product must cover at least the long-run incremental costs of this product. If these are not covered then, from an economic point of view, the product should not be produced. In addition, the entire set of products and services offered must cover all overhead costs of production, that is, all costs which cannot be allotted to the incremental costs of a particular product or service. To cover their considerable overhead costs, ISPs must use pricing strategies that calculate mark-ups on the incremental costs, which allocate the overhead costs to particular products and services according to the price elasticity of demand for these products and services. The elasticity of demand for Internet backbone services depends on the possibilities for substitution. To offer universal connectivity, a network provider can combine the components 1) own network services, 2) network services from peering partners, and 3) network services from transit partners. These components are interchangeable to a degree and the amount used will depend on the costs of each of these services. With network interconnection, an ISP can avoid building out its own network to particular regions and customer groups, instead profiting from the network investments made by the interconnection partners. The following two subsections look at the pricing of transit and peering interconnection respectively. 7.2.2 The price for transit interconnection The main difference between interconnection by a transit contract and interconnection by peering is the degree of coverage of the Internet offered by either transit (complete coverage) or peering (only the direct customers and transit customers of 103 Transmission links can be leased. Leased lines are priced by their length and by the capacity of the pipe. The larger the extent of the network, the more switches and routers are needed. The costs for employees also rise with the geographical extent of the network.