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). 130 • The calling party pays for the connection. The receiving party does not care about the price the caller has to pay to reach him. • There is no price differential for calling customers on the same network (on-net calls) or on another network (off-net calls). • Access charges for call termination are set reciprocally. • Both networks have the same costs of production. • The probability of a call is independent of the home-network of the calling parties. This implies that given same marginal prices for on-net and off-net calls, the share of calls that originates with network 1 and terminates with network 2 will be equivalent to the market share of network 2.116 It can be shown, that when the reciprocal access charge set by the firms is not too high compared to the marginal costs of termination, and when the substitutability between the two networks is also not too high, then there exists a unique equilibrium to this model (Laffont, Rey and Tirole, 1998a: 10). In this equilibrium, the retail price is increasing in the access charge for termination. The firms can therefore use the access charge to enforce a higher retail price than would be the outcome of competition. The intuition behind this result is that if access charges are set at the level of the actual marginal costs of terminating a call, then the marginal costs of producing either an on-net call or an off-net call are the same for the originating network. If the access charges are above the marginal costs of termination, then the costs of producing an off-net call are higher than those of producing an on-net call. The higher the access charge, the higher the marginal costs of producing an off-net call. This mechanism can be used to raise the rival’s costs of production and put pressure on retail prices. For the collusion to be stable the access charge must not be too far above the marginal costs of termination and the substitutability between the networks must not be too high. Otherwise, when the access charge is set well above the marginal costs of termination, a firm has an incentive to increase its market share and avoid paying termination fees.117 If the substitutability between the networks is high, attempts to increase one’s own market share by luring the customers of the other network to switch networks will more likely be successful. The incentives to compete rather than collude in the retail market are further intensified by allowing for more complex price structures in the retail market besides identical linear prices for on-net and off-net calls. Firstly, consider the possibilities 116 This so-called “balanced calling pattern assumption” has important implications for the model. It implies that “…for equal marginal prices, flows in and out of the network are balanced – even if market shares are not” (Laffont, Rey and Tirole, 1998a: 3). When wholesale access charges are set reciprocally, this assumption implies that the wholesale interconnection payments cancel each other out. 117 Even when the net payments between the two networks are zero with reciprocal access charges and balanced calling patterns, they perceive the access charge as a marginal cost of production and will want to avoid them. 131 offered by non-linear pricing structures. By charging a two-part tariff a firm can use a lower fixed fee to increase market share while keeping the unit price on the collusive level such as not to induce a quantity expansion effect. As a result of the higher market share, the firm will have less off-net traffic and less termination charges to be paid. Non-linear pricing therefore intensifies competition (Laffont, Rey and Tirole, 1998a: 20ff.). Secondly, Laffont, Rey and Tirole show that competition is intensified when retail prices differentiate between on-net and off-net calls (Laffont, Rey and Tirole, 1998b). A defecting firm can use low on-net prices to increase its market share but keep off-net prices on the collusion level such as not to induce a quantity expansion effect which could produce an access-deficit. Application to the market for Internet backbone services The model above shows that while collusion via wholesale access charges is possible it is only stable under very restrictive assumptions. Given this information, what can be learned with respect to the market for top-tier Internet backbone services? Is it likely that Tier-1 ISPs can use their wholesale agreements to stabilize higher transit prices? Some of the assumptions of the model set-up by Laffont, Rey and Tirole fit relatively well with the market characteristics of the Internet backbone services market, at least when only the highest level of the Internet hierarchy is in focus. For instance, for Internet interconnection via peering it is true that there is no price differential between on-net and off-net connections. Furthermore, Tier-1 ISPs, as peering partners, generally set their access charges reciprocally (albeit to the level of zero). Tier-1 ISPs can also be considered to have a similar cost-structure for terminating each others connections. Lastly, the assumption of a balanced calling pattern between Tier-1 ISPs is fitting, given that they are peering partners and can therefore be assumed to have a similar customer structure. Other assumptions of the model, however, do not correspond as well to the market for Internet backbone services on the highest hierarchy level. As these assumptions are essential to the stability of the collusion equilibrium the fact that they do not correspond to the market in question is an indication that collusion in the market for top-tier transit services is difficult to maintain. Firstly, consider the assumption that every customer is connected to only one network as prerequisite for the termination monopoly. This assumption is too strong for the market for Internet backbone services, as many small ISPs and many business customers are multi-homed. Therefore, the termination monopoly in Internet interconnection is not as stable as assumed in the model by Laffont, Rey and Tirole. Next, consider the number of players in the market. It can be argued that market entry into Tier-1 Internet service provision is not free because any new entrant must reach a peering agreement with all other Tier-1 ISPs. None the less, there are already several active firms on the Tier-1 level of Internet backbone services which increases the number of potential substitutes and destabilizes any collusive agreement. Furthermore, the assumption that the receiving party of a connection does not care about the costs the calling party has to pay for the connection is not appropriate 132 in the context of Internet transport services. Businesses offering content and information on the Internet care very much about the costs their targeted customers face for reaching this content. The costs of being reached are a significant factor in their decision where to place their content on the Internet. The access charge is therefore not only indirectly but also directly a strategic element in the competition over endusers. Decisive for the stability of any collusion are the level of the access charge and the substitutability of the network offers. Between Tier-1 ISPs the access charge is generally set to the level of zero. It therefore corresponds to the prerequisite that is should not be too far above marginal costs of termination. However, for collusive purposes a termination fee would need to be introduced where there was none before. This may be more difficult than an incremental increase of an existing termination charge. Furthermore, the degree of substitutability between the transit offers of Tier-1 ISPs can be considered to be very high. This fact makes collusion interesting, but at the same time it represents a high risk of instability of any collusion because any of the Tier-1 ISPs could hope to increase its market share by offering a lower transit charge than its competitors. Lastly, consider the price structures in the market for transit services provided by Tier-1 ISPs. Transit prices generally are not differentiated according to the destination network. However, non-linear prices for transit services are the norm in the transit market. In general, a transit taker will pay a fixed fee that depends on the bandwidth by which the two networks are connected plus a variable fee for traffic exceeding a previously defined threshold. The ability to compete in two-part tariffs is a further hindrance to stable collusion in the transit market. To summarize, the prerequisites for a stable collusion are not fulfilled in the market for Tier-1 backbone services. 7.5 Conclusions The purpose of this chapter was to review the competition policy analyses that were conducted for the market for Internet service provision 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 this market. In the market for Internet services, network effects are so important that an ISP needs to be able to offer universal connectivity in order to survive in this market. The demand for universal connectivity on the logical layer is a derived demand from the demand for universal connectivity on the applications layer. To reach universal connectivity, new entrants to the Internet backbone services market will need to establish a direct or indirect transit agreement with at least one Tier-1 ISP. In their merger policy analyses conducted for this market, competition authorities feared that a merger between two of the large Tier-1