Margit Vanberg, The implicit price for peered interconnection in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 119 - 122

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
119 the peering partner are reached).104 Furthermore, in a transit relationship one party pays the other party for delivery of its data traffic from and to the rest of the Internet. Transit services can be bought from transit givers at any available point of network interconnection. Transit fees must cover at least the costs of the network resources into which a transit provider has invested to be able to offer transit services in addition to the interconnection fees which the transit giver pays to third parties for the termination of the transit takers traffic. A transit giver must further try to cover some of its overhead costs by a mark-up on the incremental costs of providing the transit service. In practice, transit fees are typically two-part tariffs. A flat-fee is charged, which varies depending on the bandwidth of the pipe connecting the two networks and the arranged peak throughput of data on this pipe. A variable fee is charged for traffic in excess of this agreed level, generally charged on the basis of Megabits per second (Mbps). The transit giver therefore has the opportunity to price-differentiate in the market for Internet backbone services. A transit taker will pay a lower average price if more traffic is sent via a particular interconnection and if the amount of traffic sent over this interconnection is correctly predicted beforehand. For inelastic demand, often characterized by a short-term need to shift traffic to a new transit provider, the average price paid will be higher. Such price differences should not be taken as evidence of significant market power by the transit giver. The need to cover the substantial overhead costs in this market force the transit giver to find ways of implementing surcharges on marginal costs, that can cover the overhead costs of production. 7.2.3 The implicit price for peered interconnection Peering generally involves no monetary compensation for using the peering partner’s network. There is, however, an “implicit price for peered interconnection” (Elixmann and Scanlan, 2002: 47), namely the cost of providing the reciprocal service for one’s peering partner. In order to understand which interconnection services ISPs consider equal, one must understand how traffic exchange among peering partners is organized. Generally, peering partners interconnect their networks at several dispersed geographic locations. The practice which decides where traffic is handed off to the peering partner has tellingly been called “hot potato routing” (Kende, 2000: 5ff.). Traffic is passed on to the peering partner at the nearest point of exchange to the origin of the communication.105 The bits of data are then transported to the receiving user on the receiving user’s network. Figure 7.1 illustrates this principle. ISP 1 and ISP 2 are interconnected by Routers R1, R2, and R3 at three different geographical locations. To deliver a data stream from a user connected to ISP 1 via Host 1 (H1) to the user connected to ISP 2 via 104 See section 3.5.1 above. 105 This convention also makes sense, considering that the physical geographic location of the receiving host is known only to the home network of the receiving host. 120 Host 4 (H4), ISP 1 hands off the data packages to ISP 2 at the closest point of interconnection to the origin of the packet flow, thus via router R1. ISP 2 then carries the data packages for the longest distance between the two hosts. When the user at Host 4 returns data packages to the user at Host 1, then ISP 2 passes these on to ISP 1 via router R3. ISP 1 then carries the data for the longest distance on the return trip. Figure 7.1: Hot potato routing Source: Based on Kende (2000:42) When the geographic extent of the networks of two ISPs are comparable, and when the end-users connected to the ISPs are similar with respect to the data flows they initiate and receive, then ISP 1 and ISP 2 will carry roughly the same amount of traffic for roughly the same distances as a result of a peering agreement. It is interesting to note, that under these circumstances the number of users connected to the ISPs is irrelevant.106 If, however, ISP 2 had a network of smaller geographic cover- 106 If ISP 1 had more Internet-users than ISP 2, then traffic flows between the two networks would still be balanced, when the probability of communication between all users is the same, and when the geographic extent of the networks is the same (Economides, 2005: 381). Con- ISP 2 R1 R2 R3 H3 H4 H2H1 ISP 1 121 age than ISP 1, then ISP 1 would have to carry the traffic further on its own network before having the opportunity to hand the traffic off to ISP 2. ISP 2 would then profit disproportionately from the peering agreement. Furthermore, if ISP 2’s customers had more outbound than inbound traffic flow, for instance if ISP 2 had many content servers on its network which receive only small packages containing content requests but send out large volumes of data, then ISP 1 would carry a larger data volume on its network on the return trip than ISP 2 had carried for the content requests. ISP 1 would then need to invest more into the bandwidth of its network without compensation by ISP 2. Again, ISP 2 would profit disproportionately from a peering agreement. These examples illustrate that a change in the relative geographic extent of the networks or in the product portfolio of the peering partners (which would attract different types of customers) can result in an unequal distribution of the advantages from a peering contract and lead the party which profits less by the arrangement to terminate the contract. This shows that the observation that an ISP is terminating peering agreements does not suffice as evidence of anti-competitive behavior. If termination of a contract were not allowed (as some ISPs have demanded from the competition authorities), infrastructure investments would degenerate at the rate at which some ISPs would practice “backbone-free-riding”107 at the costs of other ISPs. If competition policy forbade positive settlement fees in interconnection contracts, then this would lead to under-investment in network infrastructure (Little and Wright, 2000). Milgrom et al. (2000) emphasize a further prerequisite which must be fulfilled before ISP on the highest level of the Internet hierarchy will agree to enter into a peering contract. Peering on the top-level of the Internet hierarchy is a trustworthy job. The interconnection hierarchy of the Internet is structured around the fact that Tier-1 ISPs have no default route for traffic they cannot deliver. If a Tier-1 ISP does not know where to deliver a data packet sent to it, then the packet is discarded. Thereore, should a Tier-1 ISP (unknowingly) announce incorrect routes to its peering partners, this can destabilize Internet traffic delivery on a global scale. Other routers will incorporate the incorrect information into their routing tables automatically. There is no quick self-correction mechanism by which an erroneous entry made by a Tier-1 ISP is discovered. Such errors need to be uncovered by network management staff and removed manually. Therefore peering on the Tier-1 level of sider, for instance, the following example: Suppose a network with 1,000 attached users interconnects with a network with 100 attached users. If every user corresponds once with every other user, then the smaller network transmits 100 x 1,000 contacts to the larger network, amounting to 100,000 contacts. The larger network transmits 1,000 x 100 contacts to the smaller network, therefore also 100,000 contacts. Thus, if the data volume that the users send to one another is roughly equal, then the traffic carried by the large and the small network is the same, as long as the types of users are the same across the networks and as long as the operators have networks of similar geographic extent. 107 This term was coined by Baake and Wichmann (1998: 2). 122 the Internet hierarchy is only entered into with interconnection partners considered trustworthy. In conclusion, ISPs will enter into peering agreements only when their prospective peering partners have a network of similar geographic extension and have invested into comparable network bandwidth which can guarantee an equivalent level of quality of service. Furthermore, ISPs generally require traffic flows to be roughly similar. For this it is not important to have the same number of customers, only the same type of customers. Lastly, Tier-1 ISPs require peering partners to be particularly trustworthy in the sense that their personnel is knowledgeable in resolving routing problems quickly and correctly.108 The above analysis shows that a transit interconnection requires far less investments into network infrastructure as well as human resources than peering does. Since a transit contract also offers universal connectivity, whereas peering offers only limited coverage of the Internet, a smaller ISP will often find it less costly to pay for transit services in order to reach universal connectivity than to meet the network requirements necessary to peer with several ISPs of higher hierarchy levels. Peering is therefore not always preferred to transit interconnection, even though it generally involves no monetary compensation for the exchange of traffic. Transit fees are justified by the fact that transit givers invest more into their network infrastructure than transit takers. 7.3 Dominance on Tier-1 level The preceding section focused exclusively on an ISP’s decision on whether to interconnect with another ISP via a peering or a transit agreement. It was shown that the differences in the terms for peering or transit are not driven by the number of IPaddresses an interconnection partner offers access to. Rather, factors such as the type of customer mix and the relative geographic extent of the two networks were shown to be important. The focus now turns to an ISP’s principal decision on whether to interconnect with another ISP at all. For this decision the network reach provided by a potential interconnection partner is of fundamental importance. The ultimate goal of network interconnection is to provide universal connectivity. All ISPs not active on the highest level of the Internet hierarchy need at least one transit agreement with a Tier-1 ISP or with an ISP that has such a transit interconnection. Tier-1 ISPs know 108 The above conclusion is supported by the “Settlement-Free Interconnection Principles” which Level 3, considered to be a Tier-1 ISP by several recent sources (i.e. D’Ignazio and Giovannetti, 2006: 18; Ermert, 2005), publishes on line (, site last visited on Nov. 16, 2006). In these principles the company states that it will consider peering only with firms which have a network similar to that of Level 3 in terms of size, reach, scale, diversity and reliability. More specifically, the guidelines call for a comparable number of private interconnection points, for “a general balance of inbound and outbound traffic” and “sufficient capability, processes and tools to assure adequate interconnection and routing quality.”

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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.