125
are interested in a good quality interconnection because all profit equally from a
demand-expansion effect. The elicitor of a quality degradation would suffer the
same negative demand reduction as its three rivals without a compensatory gain
from a positive quality-differentiation effect. The authors then show how the incentives to interconnect change when two of the ISPs merge and the resulting market of
three ISPs then includes one firm with an installed base of at least the size of the
combined installed bases of the other two firms. In this scenario the largest firm is
not interested in deteriorating the quality of interconnection with both of the rival
networks. However, in some circumstances, it can profit from a targeted degradation
strategy, in which it refuses good quality interconnection with one of the smaller
rivals while it continues good quality interconnection with the other rival. This conclusion depends on the non-targeted firm not offering transit services to the targeted
firm.111 The positive quality-differentiation effect will then result in the targeted firm
not attracting any new customers while the dominant firm and the non-targeted firm
gain more customers (even though the non-targeted rival profits more from the quality-differentiation effect). It was especially this result that competition authorities
relied upon in their decision on the merger by MCI and Worldcom in 1998.
7.3.2 Critique of the model by Crémer, Rey and Tirole and alternative modeling
In chapter 6 it was discussed that the results of Katz and Shapiro (1985) depend
critically on the additional assumptions in the model besides the network externalities. These additional assumptions introduce elements of market power such that the
model cannot be used to prove that network externalities lend market power to large
network operators. The same holds true for the adaptation of the Katz and Shapiro
model by Crémer, Rey and Tirole. Here also there are significant additional assumptions in the modeling set-up which lead to the result that the largest firm prefers a lower level of interconnection quality compared to its smaller rivals. Below it
is discussed whether these assumptions are relevant for the market for Internet backbone services.
Market entry conditions
First, consider the assumption of a fixed number of firms in the market. This assumption does not correspond well to the thousands of active ISPs observable in
reality. If at all, then this assumption may apply to the market for Tier-1 ISP services
in which only 5 to 10 ISPs are active. But whether this market has structural barriers
111 Crémer, Rey and Tirole (ibid., 458) argue that the dominant firm can limit the capacity of the
interface with the non-targeted network to such an extent that the capacity is only sufficient to
provide good quality interconnection for the traffic of the non-targeted network but would result in very bad interconnection quality if the traffic should grow to encompass also the traffic
of the targeted network.
125
are interested in a good quality interconnection because all profit equally from a
de and-expansion effect. The elicitor of a quality degradation would suffer the
same negative demand reduction as its three rivals without a compensatory gain
from a positive quality-differentiation effect. The authors then show how the incentives to interconnect change when t o of the ISPs merge and the resulting market of
three ISPs then includes one firm with an installed base of at least the size of the
combined installed bases of the other two firms. In this scenario the largest firm is
not interested in deteriorating the quality of interconnection with both of the rival
networks. However, in some circumstances, it can profit from a targeted degradation
strategy, in which it refuses good quality interconnection with one of the smaller
rivals while it continues good quality interconnection with the other rival. This conclusion depends on the non-targeted firm not offering transit services to the targeted
firm.111 The positive quality-differentiation effect will then result in the targeted fir
not attracting any new customers while the dominant firm and the non-targeted firm
gain more customers (even though the non-targeted rival profits more from the quality-differentiation effect). It was especially this result that competition authorities
relied upon in their decision on the merger by MCI and Worldcom in 1998.
7.3.2 Critique of the model by Crémer, Rey and Tirole and alternative modeling
In chapter 6 it was discussed that the results of Katz and Shapiro (1985) depend
critically on the additional assumptions in the model besides the network externalities. These additional assumptions introduce elements of market power such that the
model cannot be used to prove that network externalities lend market power to large
network operators. The same holds true for the adaptation of the Katz and Shapiro
model by Crémer, Rey and Tirole. Here also there are significant additional assumptions in the modeling set-up which lead to the result that the largest firm prefers a lower level of interconnection quality compared to its smaller rivals. Below it
is discussed whether these assumptions are relevant for the market for Internet backbone services.
Market entry conditions
First, consider the assumption of a fixed number of firms in the market. This assumption does not correspond well to the thousands of active ISPs observable in
reality. If at all, then this assumption may apply to the market for Tier-1 ISP services
in which only 5 to 10 ISPs are active. But whether this market has structural barriers
111 Crémer, Rey and Tirole (ibid., 458) a gue that the dominant firm n limit the capacity of the
interface with the non-targeted network to such an extent that the capacity is only sufficient to
provide good quality interconnection for the traf ic of the non-targeted network but would resul in very bad interconnection quality if the traffic should grow to encompass also the traffic
of the targeted network.
126
to entry, which justify the assumption of a fixed number of firms, is what is trying to
be proved. To start with this assumption distorts the analysis of the effects of network externalities on competition in this market.
The equilibrium results of the model by Crémer, Rey and Tirole change dramatically when the number of firms in the market is endogenized (Malueg and Schwartz:
2006). Consumers do not necessarily choose the firm with the initially larger installed base. When this firm chooses not to be compatible with it’s smaller rivals,112 and
when smaller rivals in sum have a minimum initial market share and choose to remain compatible among themselves, then, for a large set of parameter values, new
consumers will sign on to this network of smaller compatible firms in the expectation that in a dynamic market setting this network will eventually incorporate more
contacts than the single-firm network of the initial market leader.113 If payments for
interconnection were introduced, the parameter values for which the initially larger
firm would choose autarky would be even more limited because smaller firms could
share their gain from increased connectivity by offering payments to the larger firm.
The assumption that smaller rivals will remain compatible amongst one another,
in the sense that they remain interconnected, and will have a significant network
reach through this interconnection of their networks is very realistic for the Internet
backbone services market. According to Crémer, Rey and Tirole, a strategy of secondary peering among lower-level ISPs can be of only limited influence on the
backbone market, as the “setting up of new connectivity structure would involve a
lag, since one must build bilateral interconnections and test new routing procedures”
(Crémer, Rey and Tirole, 2000: 446). In reality, new interconnection agreements are,
however, entered into easily. The presence of many ISPs at Internet exchange points
and the availability of standardized contracts facilitate interconnection agreements.
Lower level ISPs can enter into secondary-peering relations simply by opening their
networks to one another’s traffic, by engaging in BGP sessions.
The only traffic that secondary ISPs will never be able to get rid off by secondary
peering and transit agreements among lower network levels is the traffic which is
destined to or originating from direct subscribers of Tier-1 ISP, when these ISPs
have no peering contracts with lower level networks and when the customers are not
multi-homed so that they cannot be reached by alternative paths. Interconnection
112 The targeted degradation scenario is not considered by Malueg and Schwartz. In a related
working paper (Malueg and Schwartz, 2002: 37) the authors argue that the parameter values
that make targeted degradation profitable to the dominant firm imply unrealistic values for
price relative to marginal cost and the consumer surplus of the median subscriber.
113 Even when the dominant network’s installed customer base is larger than the combined
installed customer bases of it’s rivals, there are parameter regions in which the rivals will be
more successful in adding new customers to their networks (Malueg and Schwartz, 2006: 9).
This is due to the customers’ expectations of market evolvement in dynamic market settings,
in which networks are expected to have a high growth potential. This conclusion is comparable to the results by Economides (1996) for a monopolist that prefers inviting market entry.
126
to entry, which justify the assumption of a fixed number of firms, is what is trying to
be proved. To start with this assumption distorts the analysis of the effects of network externalities on competition in this market.
The equilibrium results of the model by Crémer, Rey and Tirole change dramatically when the number of firms in the market is endogenized (Malueg and Schwartz:
2006). Consumers do not necessarily choose the firm with the initially larger installed base. When this firm chooses not to be compatible with it’s smaller rivals,112 and
when smaller rivals in sum have a minimum initial market share and choose to remain compatible among themselves, then, for a large set of parameter values, new
consumers will sign on to this network of smaller compatible firms in the expectation that in a dynamic market setting this network will eventually incorporate more
contacts than the single-firm network of the initial market leader.113 If payments for
interconnection were introduced, the parameter values for which the initially larger
firm would choose autarky would be even more limited because smaller firms could
share their gain from increased connectivity by offering payments to the larger firm.
The assumption that smaller rivals will remain compatible amongst one another,
in the sense that they remain interconnected, and will have a significant network
reach through this interconnection of their networks is very realistic for the Internet
backbone services market. According to Crémer, Rey and Tirole, a strategy of secondary peering among lower-level ISPs can be of only limited influence on the
backbone market, as the “setting up of new connectivity structure would involve a
lag, since one must build bilateral interconnections and test new routing procedures”
(Crémer, Rey and Tirole, 2000: 446). In reality, new interconnection agreements are,
however, entered into easily. The presence of many ISPs at Internet exchange points
and the availability of standardized contracts facilitate interconnection agreements.
Lower level ISPs can enter into secondary-peering relations simply by opening their
networks to one another’s traffic, by engaging in BGP sessions.
The only traffic that secondary ISPs will never be able to get rid off by secondary
peering and transit agreements among lower network levels is the traffic which is
destined to or originating from direct subscribers of Tier-1 ISP, when these ISPs
have no peering contracts with lower level networks and when the customers are not
multi-homed so that they cannot be reached by alternative paths. Interconnection
112 The targ ted d gradation scenario is not c nsidered by Malueg and Schw rtz. In r lated
working paper (M lueg and Schwartz, 2002: 37) the authors argue that the parameter values
that mak targ ted degradation p ofitable to the dominant firm imply unrealistic values for
price relative to marginal cost and the consumer su plus of the med an subscriber.
113 Even when the dominant network’s in talled custome base is larger than the combined
installe custom r bases of it’s rivals, there are parameter regions in which the rivals will be
more successful in dding new customers to their networks (M ueg and S hwartz, 2006: 9).
This is du to the customers’ expectations f market evolvement in dynamic market settings,
in which networks are expected to have a high growth potential. This conclusion is comparable to the results by Economides (1996) for a monopolist that prefers inviting market entry.
127
agreements are historically grown and peering was more common at the beginnings
of the Internet. Some secondary ISPs therefore continue to have peering with a limited number of the top-level ISPs. They can use these peering relationships to offer
transit services to other lower-level ISPs. Considering also that many subscribers of
Internet services are multi-homed (i.e. subscribe to several networks) it becomes
clear that the Internet reach provided to the customers of the lower-level ISPs can be
increased significantly by coordination on the lower hierarchy levels. Elixmann and
Scanlan (2002: 111) argue that the proportion of traffic in the Internet which can
theoretically be routed via secondary peering has increased. Lower-level ISPs may
be less dependent on Tier-1 ISPs than suggested in some of the literature.
Product differentiation
Secondly, consider the assumption made by Crémer, Rey and Tirole that customers
do not have individually differing preferences for technology characteristics of the
network they subscribe to. This assumption does not correspond well to the reality
of a large degree of product differentiation observable among ISPs. On the Internet
backbone services market, ISPs offer their services to other ISPs, to web-hosting
services, to large business users and to private end-users. They offer different service levels according to their customers’ needs and they offer their services at diverse locations, again according to their customers’ needs. An ISP that would hope
to make the market tip in its favor would have to cater to all customers in the market. This may not be the most profitable market strategy in a world of customer
heterogeneity. ISPs that focus on particular customer groups have comparative
advantages in supplying the types of services that these customers prefer. In this
case, the proper theoretical reference model may be that ISPs are supplying components of systems rather than competing systems. In such markets, compatible products (as, for instance, interconnected networks) cater to the needs of particular
customers. Competition between the products is not as strong as in a market of competing systems because the possibility to make profits is often increased by compatibility (see Economides, 1989 and Einhorn, 1992). When product differentiation
is introduced into the model set-up it can be shown that in any shared market equilibrium both firms profit from a higher interconnection quality because competition in
other product dimensions becomes less aggressive when firms offer the same positive network externality effect to their customers (Foros and Hansen, 2001).114 General analysis on the compatibility incentives of providers of differentiated network
goods come to comparable results (Doganoglu and Wright, 2006).
Switching costs
There are other critical assumptions in the model by Crémer, Rey and Tirole which
do not correspond to the characteristics of the Internet backbone services market.
114 In this model there is also no installed customer base. This fact of course also has an important impact on the results of the model. This aspect is in the focus of a model structure by
Economides (2005) which is discussed below.
128
Firstly, consider the assumption that installed bases are locked-in. In reality, switching ISPs is not difficult for end-users or ISPs. Only the cancellation period of their
contract may delay the reaction for some weeks. Larger customers such as firms and
ISPs are often multi-homed, that is, they connect to more than one ISP at any given
time. This is important for the ISP to be able to guarantee its contractual service
level vis-à-vis its customers. It is also a signal that traffic can be diverted quickly
from one ISP to another without large transaction costs involved. The fact that
switching is relatively easy increases the competition between Internet backbone
service providers.
When the assumption of a locked-in customer base is relaxed, it can be shown
that the initially dominant network has an incentive to keep up a high quality of
interconnection (Economides, 2005: Appendix). A degradation of interconnection
quality with one of the smaller rivals would lead to a loss of universal connectivity
that would result in a severe demand response by the installed customer base and
therefore to revenue and profit loss.
Crémer, Rey and Tirole argue that multi-homing may even increase the incentive
to degrade interconnection quality for a large ISP. They assume that the demand
reduction effect, which results from a decrease in interconnection quality, is relatively less pronounced when more customers are multi-homed and can reach users
of other networks over alternative connections (Crémer, Rey and Tirole, 2000: 465).
What they do not consider is that if customers use their alternative interconnection
agreements, then they can shift most or all of their demand away from the network
with reduced interconnection quality. A significant demand reduction can therefore
be the result of customers having alternative providers of interconnectivity.
Demand
In the model by Crémer, Rey and Tirole network externalities are depicted by a
demand function which is linear in the number of customers which can be reached
via the network. In reality, the number of customers attached to any ISP is intransparent to users. There are thousands of active ISPs and it is nearly impossible for an
end-user to know roughly how many customers are connected to these ISPs, let
alone know which particular user can be reached by which particular ISP. Because
the connections and interconnections in the Internet are so intransparent, Economides (2005) argues that it is not the number of customers reachable via a network that
users are interested in, but rather whether a network offers universal connectivity or
not. A high network coverage, once it is below universal connectivity, is a significant quality reduction from the point of view of the end-user because Internet users
cannot know which single connections they will value highly in the future and
which ISP is likely to include these connections in a world of limited connectivity.
Economides (2005: 400) assumes that “…no network, however large, can afford not
to offer universal connectivity.”
It is true that some sites receive far more traffic than other sites and that it is extremely important for an ISP to provide good quality interconnection to these highly
frequented destinations (i.e. web servers with popular content). However, an ISP
129
cannot use sole access to popular content to act as a counterbalance for reduced
overall connectivity. Content providers would not accept a reduced reachability. If
the dominant ISP had exclusive connectivity to a popular website, then the owner of
this website would demand to be reachable universally. If the ISP degrades interconnection with some parts of the Internet, then the owner of the website will move
its content to ISPs which continue to have good interconnectivity with the entire
Internet.
7.4 Collusion on the Tier-1 level
Only Tier-1 ISPs can guarantee universal connectivity without relying on a transit
offer. The preceding section showed that one Tier-1 alone cannot successfully refuse
interconnection with other ISPs or raise interconnection prices in the hopes of ousting competitors from the market. The transit offers of Tier-1 ISPs are perfect substitutes. Absent any collusive practices there is intense competition in this market.
This fact provides the Tier-1 ISPs with a motive to collude on the market for transit
services. If all Tier-1 ISPs acted simultaneously in increasing prices for transit services, then lower level ISPs would have no alternative transit provider from whom to
buy universal connectivity services. And no new provider of universal connectivity
could enter the market as long as the Tier-1 ISPs would successfully foreclose this
market by not entering into any new peering agreements. The question analyzed in
the present section is whether Tier-1 ISPs can organize a stable collusion in the
wholesale market in order to collectively raise the price of transit services?
There is a literature on two-way access in telecommunications markets which
analyzes whether cooperation on the wholesale level can help enforce collusion on
the retail level.115 A two-way access scenario is given when customers connect to
only one network, such that the two networks reciprocally need access to each
other’s customers on the wholesale level. Termination in this scenario is comparable
to a monopolistic bottleneck. The application of this literature has mostly been to
voice telephony markets, for instance, mobile telephony or reciprocal international
termination. Considering that ISPs have a termination monopoly whenever customers exclusively connect to their network only, the models may, however, also be
applicable to the market for Internet backbone services. If a large fraction of endusers are connected to only one network, then ISPs may have the possibility to
collude on the retail market.
The assumptions that are necessary for successful collusion in a market with reciprocal termination are:
• There is no free market entry.
• There are no capacity limitations.
• Every customer connects to only one network.
115 The seminal articles in this research are Laffont, Rey and Tirole (1998a and 1998b).
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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.