PRICING NETWORKS or Who Pays for the String? Dai Davies, DANTE

Transcription

1 TERENA Networking Conference Lisbon, May 2000 PRICING NETWORKS or Who Pays for the String? Dai Davies, DANTE 1. Introduction Two people wish to communicate with one another. They each buy an empty cocoa tin and share the cost of a piece of string. Apart from arguing about sharing the cost of the string, the cost allocations are clear and simple. Pricing such a network is trivial. The number of people who wish to communicate grows to five. Each person now has to buy four cocoa tins and to share the cost of four pieces of string. The solution does not scale well and the arguments mount about who should pay for the string. Pricing becomes more difficult. The idea of communication is, however, popular and the number of people wishing to communicate still grows. It is now twenty. Combination theory tells us that we need 380 cocoa tins and a large ball of string. Nobody can agree how the cost of the string should be allocated, since different lengths are required to connect different pairs of cocoa tins. Another person wants to join but cannot afford the twenty cocoa tins needed. The technical model is broken and we enter the real world of network pricing. A new model is developed where each person connects to a facility which organises the interconnection between the various parties. Now all that is required is one cocoa tin per person and the cost of the string to connect to the facility. The model is simple again but new arguments emerge about who should pay for the facility. Telecommunications network pricing is essentially about resolving such cost allocation problems. This paper looks at the economic and pricing issues associated with a telecommunications network in the context of the approach adopted to solving this problem for the last three generations of pan-european research network. It considers the basis for pricing International services which applies to both the traditional telephony pricing and the Internet. There are two reasons to define the scope of this paper in this way. Firstly, International services are the most expensive to provide and, therefore, the pricing of such services is more challenging. Secondly, although the Internet is a different networking phenomenon and some of its devotees claim that it has rewritten the laws of economics as they apply to networking, reality shows it to be just another network from a pricing viewpoint. In practice, the conclusions do not just apply to International networking. However, as the scale of the network reduces so does the cost and there comes a point where the network is so small, (e.g. a Local network within a building), that the cost of organising proper pricing exceeds the benefits associated with the rational economic use of resources which pricing should encourage. 2. Approaches to Pricing Economic theory provides a number of simple and attractive models to organise pricing These are based on the marginal cost and marginal revenue of adding capacity. In practice, the precise recognition of marginal costs and marginal revenues is not easy and true pricing is a mixture of sound economic theory, intuition and black art. In the

2 2. Approaches to Pricing cont commercial world, two general approaches can be identified to the pricing of goods and services. These can be defined as Pricing by Value and Pricing by Cost. Pricing by Value sets a price so that it matches the value, as perceived by the customer, when purchasing the product. Luxury goods are an obvious example of pricing by value, as are innovative goods where the market entrant has a period of monopoly supply before competition forces prices down. The Sony Walkman and early personal computers are examples of goods that were priced by value. The alternative to Pricing by Value is Pricing by Cost. Here, the producer is forced to price on the basis of the actual costs of a product, since competition will eat away at the difference between perceived customer value and supply cost. This is the only practical option open to most suppliers in a competitive industry. Pricing can still be an extremely complicated activity since a knowledge of demand elasticity and a good understanding of marginal costs allows scope for creativity in pricing structures. But the creativity is based on an understanding of the cost structure, rather than the knowledge that perceived customer value is so much higher than the cost of supply. Consumers of networking services are often unaware of the cost of transaction at the time it is being made. The traditional telecommunications networks, the telephone network, the telex network and the telegraph network, had well established bureaucratic pricing structures which were simple structures with the basic principle of distance and duration based charging. The technology itself contained a significant amount of accounting and billing capability to support this charging regime. In contrast, the Internet has no such history of formal pricing mechanisms. The Internet developed from a research environment where the infrastructure was already funded for other purposes and, as a consequence, the Internet grew Internationally by using infrastructure which was already paid for. Consequently, there is no rational history of network pricing. 3. Basic Pricing Principles There is a simple definition of price, namely what the buyer is prepared to pay for something. In practice, this definition relates more to the barter society and to the simple models used to teach economics than to any practical experience in pricing telecommunications networks. The reality of pricing is driven by the openness of the market in which it is carried out and the cost structures associated with providing services in that market place. Historically, telecommunications markets have been monopoly markets and, as a consequence, pricing of telecommunications services has been driven by what a monopolistic market can extract from a customer. It can be argued that, if a customer is prepared to pay for a service at a certain price level, then this price level represents the value of the service to the customer. In a competitive market place, with a variety of services available, this view of pricing is not unreasonable. In the historic market for telecommunications services, with a limited range of services and typical monopolistic provision of those services, this approach to pricing came close to an illegal cartel. This was particularly the case when it came to the provision of International services.

3 3. Basic Pricing Principles cont. Basic International services were provided by co-operation among sovereign national service providers. The transfer charging arrangements between them, whereby each service provider charged the other for use of their network represented a significant element of costs. These transfer charges, which were astronomical when compared with the actual cost provision of service, meant that, prior to liberalisation, the price of International service, in particular, bore little relation to the underlying cost. It was defined by the arbitrary transfer charging regime set up for the benefit of the network service providers. A similar regime exists in the International voice mobile service in Europe today. Pricing by Value was the natural choice of the service provider. In the world of the monopoly, this is what they achieved. Competition has the very positive effect of eroding suppliers ability to Price by Value. In their quest for market share, new entrants will undercut incumbent operators and slowly, but surely, prices will fall until they bear a closer relationship to costs. In practice, the liberalisation of the International telecommunications market in Europe had a very significant effect on the underlying price from network operators for the connectivity building blocks needed to build research networks. Table 1 shows the average costs of connectivity comparing the three Pan-European Research Networks, EuropaNET, TEN-34 (pre liberalisation) and the TEN-155 network (post liberalisation). TABLE 1 - Connectivity Costs Development Average Price Price Range 1996 EuropaNET 200 Euros/Mbit/yr 200 Euros/Mbit/yr 1997 TEN Euros/Mbit/yr Euros/Mbit/yr 1998 TEN Euros/Mbit/yr Euros/Mbit/yr The effects of liberalisation have, however, been fragmented and, looking at the range of costs of components which make up TEN-155, it is apparent that a number of countries have very considerable progress to make before infrastructure prices for telecommunications bear any real relationship to underlying costs. Table 2 emphasises this point and shows how the cost of International connectivity has developed for TEN-155. The original connectivity costs fell into three distinct groups of countries. A comparison of Year 2 pricing with Year 1, particularly looking at the range element of the tables, shows that this grouping is no longer relevant. A major distinction between Group B and Group C in Year 1 was that 155 MBps was not available in Group C. This restriction also no longer applies.

4 TABLE 2 - Year 1 and Year 2 Connectivity Costs for TEN-155 GROUP A 155 MBps Year 1 Year 2 Average 14.7 K Euros 5.57 K Euros Range K Euros K Euros Price per MBps per year at 155 MBps GROUP B 155 MBps Year 1 Year 2 Average 34.3 K Euros K Euros Range K Euros K Euros Price per MBps per year at 155 MBps GROUP C 34 MBps Year 1 Year 2 Average 62.5 K Euros K Euros Range K Euros K Euros PriceperMBpsperyearat34MBps Group A: France, Germany, Great Britain, Netherlands, Sweden, Switzerland Group B: Group C: Ungrouped: Austria, Belgium, Italy, Luxembourg, Spain Czech Republic, Greece, Hungary, Slovenia Portugal There is an additional important factor when looking at cost based pricing for telecommunications. This relates to the amount of capacity provided within the network to support the access provided. There is a minimum incremental unit for increasing network capacity. From a network customer s point of view, this minimum incremental unit is the Bit per second. In practice, within a network such as TEN-155, the minimum building block is going to be a circuit capacity of at least 10 MBps and, more realistically, 45 or 155 MBps. These are relatively large increments in capacity which, even in a liberalised market, remain expensive items. There is a need to create a balance between the capacity that is held in reserve within the network to provide for growth and performance. The cost of the spare capacity has to be paid for. TEN-155 represented a significant step forward in as much as, for the first time in a pan-european network, it was possible to provide capacity in advance of it being required. This approach has a cost, but the very significant reductions in International bandwidth costs in significant areas of Europe meant that this cost could be realistically met within the TEN-155 pricing. Thus liberalisation meant a reduction in the cost of the building blocks. Much of the costs saved were re-invested to build a bigger network that avoided having to ration capacity.

5 4. Price Structures Price structures are important from two points of view. They are important from the point of view of the network supplier in as much as, in a competitive market, the price structure should reflect the underlying cost structure. They are also important from the point of view of the customer, in as much as the price structure needs to be understandable and affordable. The price structures for the Research networks directly relate the cost of connectivity bought from network operators with the price charged to the connected customers since they are procured and operated by a purchasing consortium. In the past, pre-liberalisation International bandwidth prices across Europe did not vary particularly significantly. Table 1 shows the historic difference in cost between the most expensive and cheapest bandwidth. Bandwidth prices were only related to speed of circuit operation in a predictable way, whereby there were some economies of scale in purchasing larger bandwidth capacities. This has changed with liberalisation. In reality, experience with TEN-155 has shown that liberalisation only actually occurs when there are three or more suppliers for a particular connection. A duopoly of supply merely results in minor price reductions. Network pricing structure, pre-liberalisation, was, therefore, a very simple structure that related price to access capacity. This simple model, which was based on geographic differences in price of bandwidth of no more than a factor of 2, failed completely in the context of TEN-155 where, in its first year of operation, the difference in price between the cheapest and most expensive bandwidth was a factor of over 10. The first attempt at pricing TEN-155 had to reflect a geographic element in the price structure. The differences between the cheapest and the most expensive connectivity were so great that to average them would have discouraged some countries from taking part in the network. The first year pricing was, therefore, based on a combination of access capacity and geography and pricing was defined to reflect this combination of factors. The Year 1 pricing model for TEN-155 shared the entire network cost among the network users on the basis of access capacity and their location in Europe. Figure 1 shows this approach. The development of competition in the European market in Year 2 (2000) of TEN-155 was such that the divergence of price for the different geographies of Europe became even greater and so a more precise pricing mechanism was needed. The difference between pricing Year 1 and Year 2 of TEN-155 was that the pricing for Year 1 was defined before the topology had been finalised. Once the topology had been defined, the ensuing logic dictated the creation of a high speed core connecting those parts of the network where bandwidth was cheaper. It was felt reasonable that these core costs, which were a benefit to all the connected networks, should in some fair sense be shared out among the networks and the Year 2 pricing model moved away from a simple sharing of the total costs on the basis of geography and access capacity. A new model was developed which consisted of a two part price. One part was geography independent, but defined by access speed, the second part was geography dependent and was defined by access speed indexed telecommunications costs for a particular country. Figure 2 illustrates this approach. The balance between the geography dependent and the geography independent element of pricing is important. A correct balance will allow network upgrades to be carried out without altering the price structure. At this balance marginal revenues balance marginal costs. It was empirically determined that this balance was achieved with approximately 60% of the

6 4. Price Structures cont total costs shared on a geography independent basis. Figure 3 shows the effect of varying the percentage of cost shared on a geographically independent basis at varying access speeds. Unsurprisingly as the allocation of costs shared on a geographic basis increases so does the divergence between the cheapest and the most expensive access. What is interesting from Figure 3 is the very significant divergence in price as the percentage of costs shared on a geographically independent basis decreases. 5. Future Developments in the Market There is a major investment programme in pan-european networks being carried out by a significant number of telecommunications operators. This will promise real choice and competition on the principal European routes. It is likely that this competition will move the pricing of telecommunications services completely away from Pricing by Value to Pricing by Cost. This, in general, will represent good news for the users of such services. There has been much speculation about this development and consultants have made significant amounts of money talking about the fact that bandwidth will be free in the future. Another word which is widely used in terms of telecommunications services is commodity. Both of these words tend to imply that nobody will have to pay for connectivity in the future. This perspective is overflowing with naive optimism. The investments required to build such networks run into the Billions of Euros. In addition, bandwidth prices, which currently represent around 90% of total network costs, will certainly drop but the equipment required to support these capacities is becoming increasingly expensive as speeds of operation rise. The suppliers of this equipment operate in a semi monopolistic market, in the same way that provision of services used to be, thus prices of hardware remain extremely high. It will be ironic, if having been freed from the restrictions of monopoly in connectivity, European research networks are hit by the de-facto monopoly in hardware. The other important factor which will affect pricing in the future is geography. Although geography is a factor in pricing today it is nothing to do with the underlying cost of service as all of the International prices that we see in Europe bear little relationship to underlying costs, even now. In a market which is truly cost based, geography will play a very significant role in as much as the underlying cost of implementing major fibre optic networks on a pan- European scale is the cost of building the network itself, which is distance dependent. Areas, such as the Nordic region, which, historically, have been relatively competitive and where prices, although significantly lower than in other parts of Europe, were still nevertheless unrelated to cost will be more expensive in relative terms in the future. This raises one of the fundamental questions in terms of network pricing, namely the geographic reach of the network. A second example in the context of Europe will be global connectivity. The current arrangements, whereby most European countries have independent connections to other world regions, will not survive in a cost based pricing environment. Individual States in the USA have never felt the need for this nationalist expression of connectivity and it is no more realistic in Europe. As a consequence, as is the case for the West and East

7 5. Future Development in the Market cont coasts of North America those countries where inter-continental connectivity lands are, in principle, advantaged when compared with land locked countries in Europe. The final issue which is of importance in the development of the market is the growing requirement for guaranteed Quality of Service. The basic Internet service, the so called best efforts IP service, only offers the possibility of connection between communicating parties. There are no guarantees associated with it and, on an International scale, quality is not a word typically associated with Internet service. In TEN-155 a Managed Bandwidth Service is provided which offers guaranteed quality. This raised a new challenge for pricing services. The solution adopted in TEN-155 was to devise a pricing approach similar to that used for electricity with the cost being defined in terms of the MBps per hour. Thus the total cost of network usage was based on the product of the bandwidth consumed and the time for which it was consumed. The further development of Quality of Service, including IP based Quality of Service, will provide new challenges for the pricing of networks. 6. Conclusion Pricing of the succeeding generations of pan-european research networks has always been based on the underlying cost of the connectivity bought from network operators that is used to build the network. This connectivity cost was, and remains, the dominant cost in networking. In the pre-liberalised market, where bandwidth was rationed by the network operators, the cost of bandwidth across Europe did not vary significantly and so a simple model of pricing based on the access capacity to the network was viable. With the liberalisation of the European market place, and the beginning of real competition, connectivity prices in some regions of Europe have started to approach the underlying cost of providing them. The picture is, however, patchy and the variations in price of connectivity across Europe have increased to the point where geographically independent pricing of a pan-european network is no longer realistic. Thus, both access capacity and the geographic location where that access capacity is delivered are factors in pricing networks today. The liberalisation has had the beneficial effect of enabling network design to be based on good telecommunications principles and the current generation of network, TEN-155, has a shared core built from capacity where this is cheapest. Pricing of TEN-155 has evolved to recognise that there are significant shared costs which should be reflected in the geography independent element of price, but has maintained the simple model of access capacity as a charging mechanism. For guaranteed Quality of Service, TEN-155 has introduced the concept of charging by time and volume in a way analogous to electricity pricing. The increasing liberalisation of the European market place means that connectivity costs will be based on the underlying cost of providing such connectivity. This underlying cost is essentially heavily dependent on distance and typically insensitive of speed of connectivity. The new challenge will be to fairly and equitably share costs on the basis of a topology defined by economics but recognising, as did the early networkers with

8 6. Conclusion cont. their cocoa tins, that you are building a network and sharing network costs is never easy. The addition of quality, a much needed innovation, will further challenge those pricing networks in the 21 st Century.

9 Figure 1: - TEN-155 Year 1 Cost Sharing Total Shared Cost Figure 2: - TEN-155 Year 2 Cost Sharing Access Core

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11 Figure 3 TEN 155 Price Divergence Year 2 Annual subscription vs allocation of access costs to shared core costs 155 min Annual subscription (KEuro) max 45 single min 45 single max 0 20% 40% 50% 60% 80% % allocation access costs to shared core 10 single min