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1 NET Institute Working Paper #09-13 September 2009 Broaban User Discrimination an the Net Neutrality Debate ong Guo University of Notre Dame Subhajyoti Banyopahyay University of Floria sing K. Cheng University of Floria The Networks, Electronic Commerce, an Telecommunications ( NET ) Institute, is a non-profit institution evote to research on network inustries, electronic commerce, telecommunications, the Internet, virtual networks comprise of computers that share the same technical stanar or operating system, an on network issues in general.

2 NET Institute 1 Working Paper September 2009 BROADBAND USER DISCRIMINATION AND TE NET NEUTRAITY DEBATE ONG GUO Department of Management, University of Notre Dame, 356 Menoza College of Business, Notre Dame, IN 46556, hguo@n.eu SUBAJYOTI BANDYOPADYAY AND SING K. CENG Department of Information Systems an Operations Management, University of Floria, 351 Stuzin all, P.O. Box , Gainesville, F 32611, shubho.banyopahyay@cba.ufl.eu, hkcheng@ufl.eu 1 The Networks, Electronic Commerce, an Telecommunications ( NET ) Institute, is a non-profit institution evote to research on network inustries, electronic commerce, telecommunications, the Internet, virtual networks comprise of computers that share the same technical stanar or operating system, an on network issues in general. 1

3 ABSTRACT The net neutrality ebate has brought out economic rationale for an against a variety of proposals of the broaban service proviers to ifferentiate between ifferent classes of users. Broaban users are characterize by the iffering amounts of content they request online, as well as their valuation for such content. A broaban service provier (BSP) has two potential instruments for user iscrimination price iscrimination an traffic prioritization (or egraation). We moel six ifferent pricing an prioritization options that cover many of the strategies that actual BSPs have aopte in the marketplace. By comparing these options, we fin that imposing net neutrality increases the BSP s profit if the BSP price iscriminates ifferent consumer groups. If net neutrality is not impose, however, the BSP might still prefer a net neutrality outcome epening on the various parameter values. These an other results will be useful both for the broaban service proviers as they mull over the introuction of the ifferent pricing strategies an for policymakers who are ealing with the net neutrality issue. Keywors: Net neutrality, Internet access pricing, congestion pricing, traffic prioritization, public policy, market regulation 2

4 Broaban User Discrimination an the Net Neutrality Debate 1. Introuction In 2007, it was inepenently verifie that the broaban Internet service provier 2 Comcast was slowing own network traffic within its servers that originate from the popular peer-to-peer (P2P) networks (McCullagh 2007). After initially enying any such behavior, Comcast efene its actions by claiming that the traffic from the P2P networks, which was ominate by just a small fraction of the total number of users, was slowing own the network traffic for the rest of the users. The Unite States Feeral Communications Commission (FCC) later eclare Comcast s actions to be illegal, thus proviing further fuel to the net neutrality ebate that is currently making the rouns in the US Congress an Senate. The issue of net neutrality receive wiesprea meia attention when some broaban service proviers like Verizon, Comcast an AT&T (among others) propose to charge popular online websites for priority elivery of the latter s content to their resiential an commercial customers (elm 2006; Walmeir 2006). The proposal encountere stiff resistance from those who were suppose to be charge, an thus erstwhile competitors like Google, Yahoo! an Microsoft were soon lobbying before the Unite States Congress to pass legislation that woul prevent the broaban service proviers from carrying out their propose plan (WSJ 2006), an thereby maintain what was terme the neutrality of the Internet (the term net neutrality itself is attribute to the Columbia aw School professor Tim Wu). This woul involve the esigning of rules that prevent network operators an ISPs from using their power over the transmission 2 ere, an in the rest of the article, we have uses the terms broaban internet service provier, broaban service provier (or BSP for short) an internet service provier (ISP) interchangeably. 3

5 technology to negatively affect competition in complementary markets for applications, content an portals (van Schewick 2007). The supporters of net neutrality believe that a maximally useful public information network aspires to treat all content, sites, an platforms equally (Wu 2003), an while a formal efinition of the operationalization of the principle oes not exist, ahn an Wallsten (2006) point out that it usually means that broaban service proviers charge consumers only once for Internet access, o not favor one content provier over another, an o not charge content proviers for sening information over broaban lines to en users. obbie intensely by both sies of the issue, the Unite States Congress is currently consiering proposals to introuce net neutrality legislation (Dunbar 2006; McCullagh an Broache 2006; Winhausen 2006). The U.S. ouse of Representatives an the Senate have hel several hearings on the subject (Representatives 2005; Senate 2006). The Feeral Trae Commission has also chime in, an has recently publishe a report that has avise a wait-anwatch approach on the matter (FTC 2007). As is to be expecte in a ebate which has implications in many ifferent areas, acaemicians too can be foun on both sies of the ebate (for a recent example of such ebate, see (van Schewick an Farber 2009)). From a technical stanpoint, the issue is as follows: the original esign philosophy of the Internet communication protocols abie by the principle that every ata packet is treate equally, so that no ata packet gets priority over another (leaing to the coinage of the term net neutrality i.e., the net is neutral in its hanling of any ata packet that passes through it). From a broaban service provier s perspective, however, priority elivery of packets for a fee makes perfect economic sense, if there happen to be intereste parties who woul pay for the service. So far, the growing literature that has analyze these economic issues of net neutrality (see for example (Economies an Tag 2007; ermalin an Katz 2007; Banyopahyay et al. 2009; Cheng et al. 2009; Guo et al. 2009)) has moele that intereste party as the content proviers who are jockeying for a position in the consumers 4

6 mins. owever, as the aforementione Comcast example shows, the intereste party might well be some of the consumers themselves who are willing to pay a fee to have their requeste packets elivere with priority. In other wors, a ata packet traveling from its origin to its estination can be mae non-neutral by the BSP at various stages of its journey either at the supply sie, whereby the BSP charges content proviers for preferential elivery of their packets, or on the eman sie, whereby the BSP charges the iniviual consumers a fee for the priority elivery of their requeste content (or equivalently, e-prioritizes the requeste content in the absence of the fee). Figure 1 shows a schematic of the ifferent aspects of the net neutrality ebate that we just escribe. It clearly brings out the role of the BSP as the gatekeeper who can charge either the content proviers (at the left of the figure) or the consumers (at the right of the figure) for preferential elivery of requeste content. --Insert Figure 1 about here-- In this article, our focus is on the latter aspect of net neutrality, whereby we analyze the economic rationale for an against the proposals put forth by several broaban service proviers who inten to ifferentiate between ifferent classes of users. For example, the cable broaban service provier Time Warner Cable has recently starte an experiment in certain markets where they plan to charge Internet customers base on how much Web ata they consume. The experiment starte in a single market (Beaumont, TX) in the summer of 2008, an the company plans to introuce tiere pricing in several other markets in the near future. By charging a premium to the heaviest broaban users, much the same way cell phone proviers collect fees from subscribers who excee their allotte minutes, Time Warner woul upen a longstaning uniform pricing strategy among (fixe-line) Internet service proviers in the Unite States, whereby phone an cable companies have charge flat fees for unlimite access to the Web. AT&T has starte a similar experiment with its own customers, also in Beaumont, TX. As expecte, such experiments have reignite the net neutrality ebate. Proponents of net neutrality consumer avocates an online content proviers, for example have opine that that 5

7 a tiere Web-use pricing woul limit customer choice an coul stifle innovation by crimping eman for high-banwith services such as online vieo an music (Al-Chalabi 2008). owever, cable an phone companies have countere by saying that they nee the flexibility in setting prices for use of large, expensive, heavily use broaban networks, so as to effectively serve the majority of their customers an encourage greater efficiency in the way customers use capacity (Tweney 2008). As consumers spen more time online, an also use the Internet to consume various types of ata-intensive content (like music an vieo a high-efinition movie typically consumes aroun 8 GB of traffic), the ecision to charge ata consumption by volume can be expecte to have profoun implications in the way online content is consume in future. In such scenarios, heavy users can expect to spen much more than what they currently spen on the erstwhile all you can eat plans. owever, Time Warner has countere that most people are actually not ownloaing that much ata. The company's trial in Beaumont, TX, laste several months: of the 10,000 broaban customers enrolle which represente about 25% of the company's total number of consumers in Beaumont about 14% exceee their cap an ha to pay aitional fees that average about $19 a month. Time Warner Cable also iscovere that the top 25% of users consume 100 times more ata than the bottom 25% of users, suggesting an enormous gap in usage patterns. Broaban service proviers have often mentione that as more an more people ownloa TV shows an movies, particularly those in high-efinition, the broaban network infrastructure faces enormous strain. Time Warner Cable has sai its strategy is intene to alleviate some of that strain, with users self-regulating themselves uner the new plan. But critics have expresse concerns that the pricing scheme will iscourage broaban use an impee new online meia businesses before they even have a chance to flourish. The entire ebate has raise a number of unanswere questions that are of interest to researchers an practitioners alike, not to mention the regulatory agencies. While legal scholars 6

8 might ebate whether such pricing plans (as those that Time Warner an AT&T are experimenting with) or prioritization strategies (as Comcast briefly attempte) are fair on the consumers, it is an entirely separate issue whether there are economic incentives for the BSPs to pursue such strategies that go against the net neutrality principle. In other wors, facing a highly ynamic an ifferentiate ata usage patterns from ifferent classes of users, woul a BSP gain (as compare to the status quo) by employing ifferent pricing an/or packet prioritization strategies? In the first part of our analysis, we explore this issue. While the BSP might prefer not to ahere to the principles of net neutrality uner certain circumstances, such a move might be etrimental to the consumers or the society as a whole. Thus, from a social planner s perspective, the issue is somewhat ifferent: woul the abolishment of net neutrality on the eman sie result in lower consumer surplus or social welfare? Depening on that answer, the social planner might wish to regulate on the issue. In this paper, we explore these issues an moel them in an analytical framework an examine the economic impacts of user iscrimination an net neutrality from the perspectives of both the BSP an the social planner. We characterize the ynamic an ifferentiate ata eman of the en consumers by their valuations for ata consumption an their usage patterns. Specifically, we consier a stylize moel that segments the consumers into two types, (for heavy) an (light), with the -type consumers constituting a (relatively small) fraction of the entire consumer base (for example, as we point out later, AT&T characterize their heavy users constituting about 5% of the total consumer base). These two types of consumers are characterize by their valuations for ata consumption ( V an V where V V ) an their usage patterns ( an where ). We will iscuss these user characteristics in greater etail in next section. Uner the current scenario (which can be thought of as the net neutrality moel with a uniform fixe fee pricing strategy), all users are charge the same fixe price for accessing broaban content. Both types of users face similar elays while accessing their esire 7

9 content the elay arises from the fact that the users packets are service by the broaban service provier who has a fixe capacity. Facing this heterogeneous user ata eman, broaban service proviers have two potential instruments for user iscrimination price iscrimination an traffic prioritization. If the BSP is allowe to ifferentially charge its users an/or prioritize their requeste content, we explore six ifferent strategies that it might employ: 1. Broaban user traffic from ifferent user types face the same elay, an all users are charge the same fixe fee (i.e., the status quo). 2. Broaban user traffic from ifferent user types face the same elay, an ifferent types of users are charge ifferent fixe fees. 3. Broaban user traffic from ifferent user types face the same elay, an ifferent types of users are charge a two-part tariff. 4. Broaban user traffic from ifferent user types face ifferent elays, an all users are charge the same fixe fee. 5. Broaban user traffic from ifferent user types face ifferent elays, an ifferent types of users are charge ifferent fixe fees. 6. Broaban user traffic from ifferent user types face ifferent elays, an ifferent types of users are charge a two-part tariff. The first three options (where all the broaban users face the same elay for their packets) cover ifferent pricing strategies uner net neutrality (or NN for short), while the last three options cover the ifferent pricing strategies uner no net neutrality (NNN). Another way to look at these options woul be to think of the first three as representing the strategies that the BSP can aopt if it is allowe to use only price iscrimination, while the last three woul represent strategies where the BSP is allowe to use both price an traffic prioritization as iscriminating tools. These six ifferent options help us moel a broa swath of strategies that a BSP might 8

10 employ uner an in the absence of net neutrality. Depening on the characteristics of users valuations for content an their usage patterns, ifferent types of pricing an traffic prioritization regimes yiel ifferent profits for the BSP. owever the optimal choice for the BSP might not coincie with that of a policymaker who intens to maximize the total social surplus. The results of the analysis shoul therefore be useful both for the broaban service proviers as they mull over the introuction of the ifferent pricing/prioritization strategies in an age where consumers increasingly get their information an entertainment online, an for policymakers who might wish to regulate the BSPs practice of user iscrimination in orer to maximize social surplus. We fin that with net neutrality in place, the BSP woul prefer to charge a two-part tariff for Internet access, but without net neutrality, a BSP may choose to charge a uniform price an egrae heavy users or else charge a higher price to high type users for preferential elivery of their ata packets, epening on the characteristics of users valuations for content an their usage patterns. Without net neutrality in place, we fin that egraing the experience of the heavy users increases social welfare. Finally, we also ientify conitions uner which the BSP s user iscrimination choice eviate from the social optimum. The last result helps establish the criteria uner which the social planner might wish to regulate the BSP s actions in orer to maximize the social surplus. The remainer of the paper is organize as follows: In next section, we propose a stylize moel of the BSP s pricing mechanisms in the context of net neutrality. We then analyze the BSP s pricing options uner net neutrality (Section 3), followe by a similar analysis of the BSP s pricing options in the absence of net neutrality (Section 4). This enables us to compare the ifferent alternatives an examine the joint impact of pricing an traffic prioritization mechanisms from the perspectives of the BSP (Section 5) an the social planner (Section 6) respectively. Section 7 conclues with a summary of our finings an some irections for future research. 9

11 2. The Moel We assume a monopolist BSP who provies Internet access to the en consumers. While the monopoly assumption is a simplification in some geographies, it is to be note that unlike many other countries, the extent of competition in the local broaban services market is very limite in the Unite States, so much so that in many places, a single broaban service provier is often a e facto monopolist (ausman et al. 2001; Economies 2008). Some of the factors leaing to this scenario are the high switching costs inuce by long-term service contracts an by incompatible broaban technologies between cable an phone companies. Further, many customers are not qualifie for DS broaban services from phone companies because they excee the maximal istance limit from the phone company s nearest switching office, making the cable operators the only feasible broaban service proviers in several local markets (Turner 2007). Thus, in aition to proviing the benefit of making the analysis tractable, the assumption closely reflects the reality of local broaban services in the U.S. market. To moel the eman for broaban Internet access service, we consier a unit mass of en consumers. As mentione earlier, we assume that there are two types of users: a fraction of -type consumers an 1 fraction of -type consumers. igh-type users request more content (the requeste rate of ata packets by the two user types are given by an respectively, where ) an have higher valuation for that content ( V V ) than the owtype users. Consiering the consumers heterogeneous eman patterns, the BSP may charge a uniform fixe fee ( F ) per unit time to all consumers; ifferent fixe fees ( F an F ) per unit time to ifferent types of consumers; or a usage-base fee ( p ) per packet to consumers for Internet access, a pricing strategy that has been alreay employe in some Scaninavian countries (Economist 2003; Banyopahyay an Cheng 2006). Since the consumers are service by the 10

12 BSP which has a fixe network infrastructure capacity, the former encounter a isutility while they wait for the packets to arrive. The consumers utility function thus takes the following form: Vi wi F, if the BSP charges a uniform fixe fee ui V i wi Fi, if the BSP charges ifferential fixe fee Vi wi F i p, if the BSP charges two-part tariff (1) where i or an w i is the elay cost for type i consumers. Consumers request ata from various websites an the requeste ata packets are transmitte through the BSP s network. We moel the congestion in the network after (Menelson 1985; Banyopahyay an Cheng 2006), an accoringly, consumers request for ata packets follows a Poisson process with arrival rate an for -type an -type consumers respectively. The gross valuations the two types of consumers receive are enote by V an V. Consumers face a elay cost ue to network congestion uring the ata transmission process. The BSP s capacity is fixe an enote by. As note in the afore-mentione literature, we assume an M/M/1 queue to moel the ata transmission service provie by the BSP uner net neutrality. Then the time that a ata packet spent in the system is 1 (when net neutrality is enforce, i.e., when no packet has priority over another) an the corresponing elay cost is where is the elay parameter that captures the unit cost of elay for consumers waiting for the content to arrive from the websites. We summarize all the notations in Table 1. --Insert Table 1 about here-- The elay cost for the consumers uner net neutrality is: wi, i or 1 (2) In the absence of net neutrality, the BSP may prioritize ata traffic base on user types. In this context, we note that the technology to iscriminate packets an streamline Internet traffic 11

13 has been available at minimal cost, an we therefore assume that there is no aitional expense incurre by the BSP to implement a mechanism that enables preferential elivery of content (Cheng et al. 2009). We use a two-class priority queue to moel the BSP s ata transmission service. If both -type an -type consumers receive the same priority for their traffic, then the congestion cost an the corresponing utility function woul remain the same as in equation (2). owever, if -type consumers receive higher priority while -type consumers receive lower priority, then the elay costs for the two types are as follows: w, w 1 (3) On the other han, if -type consumers receive higher priority while -type consumers receive lower priority, then the elay costs for the two types are given by the following expressions: w, w (4) In terms of pricing, the BSP may charge a uniform fixe fee to all consumers or charge ifferent fixe fees to ifferent types of consumers for Internet access. The potential regulation of net neutrality limits the BSP from selectively prioritizing the Internet traffic. In the absence of net neutrality, the BSP can also iscriminate against ifferent types of consumers through traffic prioritization. In the next two sections, we moel these scenarios. 3. Net Neutrality In this section, we analyze three potential pricing structures for the BSP uner net neutrality uniform fixe fee, ifferential fixe fees an charging a two-part tariff. Option NN1: Uniform fixe fee uner net neutrality Uner net neutrality all consumers receive the same priority an therefore face the same congestion for ata transmission. The most simple an common pricing mechanism for the BSP 12

14 is to charge a uniform fixe fee for all consumers. The BSP s profit maximization problem is formulate as follows: max FNN1 NN1 F NN1 s.t. V FNN1 0 i 1 V FNN1 0 ii 1 (5) Constraint (i) is the participation constraint for -type consumers an constraint (ii) is the participation constraint for -type consumers. Since V V, the BSP will charge a fixe access fee that is high enough to just keep the -type consumers to participate, i.e., F NN1 V, an the BSP then receives a corresponing profit of 1 NN1 NN1 F V. 1 The corresponing consumer surplus, efine as the sum of the utility of all consumers, is given by CS 1 NN1 V F V 1 NN1 F 1 NN1 V V, an the social welfare, efine as the sum of both the BSP s profit an consumer V. 1 surplus, is SW CS V 1 NN1 NN1 NN1 Option NN2: Differential fixe fees uner net neutrality It is easy to see that this option reuces to the option NN1 above. This is because the BSP has just one service offering at its isposal, an therefore will not be able to ifferentiate between the two classes of users by using ifferent prices (if the two user types are offere two ifferent price 13

15 points, the -type users will always choose the lower price, as woul the -type users). The formal statement of the BSP s profit maximization problem is as follows: max F 1 F FNN2_, FNN2_ NN2 NN2_ NN2_ s.t. V FNN2_ 0 i 1 V FNN2_ 0 ii 1 V F V FNN2_ iii NN2_ 1 1 V F V FNN2_ iv NN2_ 1 1 (6) Constraints (i) an (ii) are participation constraints for -type an -type consumers respectively. Constraints (iii) an (iv) are incentive compatibility constraints for -type an -type consumers respectively. Constraint (iii) can be reuce to FNN2_ FNN2_ an Constraint (iv) can be reuce to FNN2_ FNN2_. So FNN2_ FNN2_. As a result, uner net neutrality Option NN2 can be reuce to Option NN1 with F F V. 1 NN2 NN2_ NN2_ The corresponing consumer surplus will still be V V will be given by SW V 1 NN2 CSNN2 V. 1, an the social welfare Option NN3: Two-part tariff uner net neutrality Uner this option, the BSP charges a two-part tariff for Internet access a lump-sum fee F an a per-unit charge p. Uner net neutrality, the BSP cannot prioritize any user s requeste content. The BSP s profit maximization problem is: 14

16 max F 1 p FNN3, pnn3 NN3 NN3 NN3 s.t. V FNN3 pnn3 0 i 1 V FNN3 pnn3 0 ii 1 (7) Constraint (i) is the participation constraint for -type consumers an constraint (ii) is the participation constraint for -type consumers. By solving the BSP s problem (see Appenix A for erivation etails), we fin when the two types of consumers valuations for ata consumption are comparable (we enote this as Case NN3_1, with the exact criterion being V V ), the BSP will charge a positive lump-sum fee 1 F NN3_1 V V 1 an a positive usage-base fee p NN3_1 V V ; however, if the two types of consumers iffer significantly in their valuations for their requeste content (or more precisely, if V V, 1 which we enote as Case NN3_2), the BSP will charge a zero lump-sum fee an rely only on usage-base fee: consumer surpluses are CS NN3_2 FNN3_2 0 an p NN3_2 CSNN3_1 0 an 1 V. The corresponing 1 V V. The resulting social 1 welfare is SW SW V 1 NN3_1 NN3_2 V. Note that uner 1 Case NN3_1, the entire consumer surplus is extracte away completely by the BSP. 15

17 4. No Net Neutrality (NNN) In this section, we consier the BSP s three pricing options (uniform fixe fee, ifferential fixe fees an two-part tariff) uner NNN. In the absence of any net neutrality regulation, broaban service proviers have one extra set of instruments to iscriminate between en users: the BSP may assign ifferent priorities to ifferent types of traffic. Technically, BSPs first ientify the ata estination by inspecting ata packets transmitte through the network. The BSPs then either charge the same access fee for both two types an owngrae ata transmission for heavy users (-type consumers in our moel) or charge a higher access fee an then assign a higher priority for the ata packets requeste by -type consumers. Just as we analyze the pricing strategies uner NN, we now look into the three analogous pricing regimes uner NNN. Option NNN1: Uniform fixe fee uner no net neutrality When the BSP charge a uniform price to both types of the consumers, it has the incentive to assign a lower priority to ata packets from -type users because of their heavy use of the share banwith. The BSP s ecision problem can be formulate as: max FNNN1 NNN1 F NNN1 s.t. V FNNN i V FNNN1 0 1 ii (8) Constraint (i) is the participation constraint for -type consumers (reflecting their higher wait times in the prioritize queue) an constraint (ii) is the participation constraint for -type consumers. Notice that we assume V 1 1 to ensure that this scenario is feasible. Both constraints give upper bouns for the access fee erive the equilibrium by comparing the two upper bouns. F NNN1. We can 16

18 Case NNN1_1: If V V, i.e., V V 1 1 1, then F V 1. The corresponing consumer surplus is NNN1_1 NNN1_1 CS NNN1_1 1 V F 1 V F 1 1 NNN1_1 +1 V V. 1 1 The expression for social welfare is SW CS NNN1_1 NNN1_1 NNN1_1 NNN1_1. V 1 V Case NNN1_2: If V V 1 1 1, then F V. NNN1_2 NNN1_2 The corresponing consumer surplus is CS NNN1_2 1 V F V F 1 1 NNN1_2 NNN1_2 17

19 1 1 V V, 1 1 an the corresponing social welfare is given by the following expression: SW CS NNN1_2 NNN1_2 NNN1_2. V 1 V Option NNN2: Differential fixe fees uner no net neutrality Uner this option, the BSP charges a higher price for higher quality of the ata transmission service through the Internet. Specifically, the BSP woul offer the Internet access service with congestion cost at a fixe price F NNN2_ to -type consumers an the Internet access service with congestion cost 1 at a fixe price F NNN2_ to - type consumers. The BSP s profit maximization problem is then as follows: max F 1 F FNNN2_, FNNN2_ NNN2 NNN2_ NNN2_ s.t. V FNNN2_ 0 i V FNNN2_ 0 ii 1 (9) V FNNN2_ V FNNN2_ iii 1 V FNNN2_ V FNNN2_ iv 1 Constraint (i) is the participation constraint for -type consumers an constraint (ii) is the participation constraint for -type consumers. Notice that we assume 18

20 V 1 to ensure the feasibility of this outcome. Constraints (iii) an (iv) are incentive compatibility constraints for -type an -type consumers respectively. Constraint (iii) can be reuce to F NNN2_ FNNN2_ 1. Constraint (iv) can be reuce to F NNN2_ FNNN2_ 1. Therefore, F NNN2_ FNNN2_ 1. From constraint (i), we get F NNN2_ V. From constraint (ii), we get F NNN2_ V. 1 Since V V 1 1, F NNN2_ V, F NNN2_ V, an NNN2 FNNN2_ 1 FNNN2_ V. The corresponing consumer surplus is 1 19

21 CS NNN2 V F NNN2_ 1 V F V V 1 welfare is given by SW NNN2_ CS NNN2 NNN2 NNN2. V 1 V 1, an the social Option NNN3: Two-part tariff uner no net neutrality Uner this scenario, the BSP charges the -type consumers a two-part tariff to ensure a preferential elivery of their ata packets, while the -type consumers are charge only a lumpsum fee for their ata elivery (which involves a higher elay). The BSP s ecision problem can be formulate as: max FNNN3, pnnn3 F NNN3 NNN3 NNN3 s.t. V FNNN3 pnnn3 0 i p V FNNN3 0 1 ii V FNNN3 pnnn3 V FNNN3 1 iii V FNNN3 V 1 FNNN3 pnnn3 iv (10) Constraint (i) is the participation constraint for -type consumers an constraint (ii) is the participation constraint for -type consumers. Constraints (iii) an (iv) are incentive compatibility constraints for -type an -type consumers respectively. Constraint (iii) can be reuce to 20

22 p NNN3 1 1 Constraint (iv) can be reuce to p NNN So p NNN Substituting back to constraint (i) gives F NNN3 V. 1 Constraint (ii) implies F NNN3 V. 1 So F NNN3 V 1 an 2 1 NNN3 FNNN3 pnnn3 V The corresponing consumer surplus is CS V F p NNN3 NNN3 NNN3 1 V F V V 1 1 NNN3.. Therefore the social welfare is SW CS NNN3 NNN3 NNN3 V 1 V. 1 21

23 Base on the BSP s pricing an traffic prioritization strategies, the BSP has six options an we summarize these six options in the Table 2. --Insert Table 2 about here-- In the previous two sections, we have analyze the BSP s six options involving pricing an (uner NNN) ifferent priorities for ifferent user classes. In the next section, we compare these ifferent options, an thus explore the conitions uner which the BSP might choose any one of them. 5. The BSP s Choices In this section we stuy the effects of pricing structure an traffic prioritization on the BSP s profit. The BSP s preference for pricing structure uner net neutrality (choice between three options NN1, NN2, NN3) Uner net neutrality, the BSP is limite to just the pricing mechanisms to iscriminate between the ifferent user types. Comparing the BSP s three pricing options (NN1, NN2 an NN3) uner net neutrality yiels an. This result is summarize NN3_1 NN1 NN2 NN3_2 NN1 NN2 in the following proposition. Proposition 1: (BSP s preferre pricing structure uner net neutrality) Uner net neutrality, the BSP prefers a two-part tariff. Proof: See Appenix B. The BSP s preference for pricing structure uner no net neutrality (choice between three options NNN1, NNN2, NNN3) In the absence of net neutrality, the BSP may either charge the same price to both types of consumers an set a lower priority to ata packets from -type consumers (NNN1), or charge a higher price an set a higher priority to -type consumers (NNN2), or charge -type consumers a usage-base fee to get a higher priority (NNN3). The first option yiels profit levels 22

24 NNN1_1 V 1 if V V or NNN1_2 V 1 1 if V V The secon an thir option generates the same profit level for the BSP, i.e., V NNN2 NNN Comparing the three options, we fin that if V V then i.e., when -type consumers value their requeste content more NNN1_1 NNN2 NNN3 than the -type consumers beyon a threshol, the BSP benefits from charging the same price to both types an assigning a lower priority to traffic from -type consumers. If on the other han V V 1 1 1, then NNN1_2 NNN2 NNN3., i.e., when -type consumers an -type consumers have similar valuation for content, the BSP prefers to charge a higher price an in return offer preferential elivery to the ata packets from the -type consumers. This leas to our next proposition. Proposition 2: (BSP s preferre pricing structure uner no net neutrality) (i) If V V 1 1 1, NNN1 NNN1_1 NNN2 NNN3 ; (ii) If V V, ; NNN1 NNN1_2 NNN2 NNN3 23

25 (iii) If V V NNN1 NNN1_2 NNN2 NNN3, Proof: See Appenix C. The BSP s overall preference for pricing structure (choice between the six options NN1, NN2, NN3, NNN1, NNN2, NNN3) In this subsection we aress the question of what woul be the equilibrium outcome if the BSP is given all six user iscrimination options. Proposition 3 summarizes the comparison result of all six options. Proposition 3: (BSP s overall preferre pricing structure) There are two potential preferre pricing structures for the BSP: NN3 or NNN1, epening on the parameter values. Proof: See Appenix D. We illustrate these results by aopting some real-life parameter values. AT&T has recently estimate that their top 5% of users (in terms of usage) account for about 40% of the total traffic, i.e., 0.05 an (Tweney 2008). Using these parameter values, Figure 2 epicts the BSP s overall preferre pricing/prioritization strategy for such a traffic pattern in the V V space. The BSP prefers an NN3 outcome (two-part tariff with equal priority) in the shae area an it prefers an NNN1 outcome (uniform fixe fee with low priority for heavy users) in the un-shae area. The area marke by the bol lines represents the feasible parameter space. The ifferent intercepts C 0, C 1, etc. on the two axes (the precise values of these intercepts have been efine at the beginning of the Appenices) an the straight lines emanating from them represent the ifferent regions (marke by numbers 1 through 7) in the parameter space within which we have to consier the optimal regime choice for the BSP. 24

26 --Insert Figure 2 about here A ifferent traffic pattern woul change the slope of the line that has the intercept of C 0, but woul not materially change the nature of the outcome there woul still be some regions where the BSP woul opt for the NN3 outcome an the rest of the feasible region where the BSP woul opt for the NNN1 outcome. 6. The Social Planner s Preference for Pricing Structure As outline before, the choice of the social planner with regars to the pricing/prioritization regime might be at os with that of the BSP, since social welfare is the sum of the BSP s profit an the consumers surplus. Note that since the consumers payments for the broaban services are effectively internal transfers as far as the calculation of the social welfare is concerne, the only measurable effect of the consumers on the social welfare comes from their valuation an the isutility that they attribute towars the congestion. The social planner s preference for pricing structure uner net neutrality (NN1, NN2, NN3) In this subsection, we examine the social planner s preference for ifferent pricing structures uner net neutrality by comparing the social welfare levels when the BSP aopts the three pricing structures. The following proposition summarizes the analysis. Proposition 4: (Social planner s preferre pricing structure uner net neutrality) When net neutrality is in place, social welfare is the same for one-level fixe fee, two-level fixe fee, an two-part tariff, i.e., SWNN1 SW NN2 =SWNN3. This is expecte, since the effect of pricing is internalize, an there are no other effects to consier, as traffic prioritization is not allowe uner net neutrality. 25

27 The social planner s preference for pricing structure uner no net neutrality (NNN1, NNN2, NNN3) In this subsection, we examine the social planner s preference for ifferent pricing structures uner no net neutrality by comparing the social welfare levels when the BSP aopts the three pricing structures. Propositions 5 an 6 summarize the results. Proposition 5: (Social planner s preferre pricing structure uner no net neutrality) Without net neutrality, the social planner always prefers the BSP charging a uniform fixe fee while owngraing heavy users, i.e., SW NNN1 >SWNNN2 SWNNN3. Proof: See Appenix E. The social planner s overall preference for pricing structure (NN1, NN2, NN3, NNN1, NNN2, NNN3) Proposition 6: (Social planner s overall preferre pricing structure) SW NNN1 >SWNN1 SWNN2 SWNN3 SWNNN2 SWNNN3 Proof: See Appenix F. Differences between the BSP s an the social planner s preferences Base on Proposition 1-6, we can see the BSP has incentive to eviate in its pricing choice from the social optimum. We summarize the ifferences in Proposition 7. Proposition 7: (The BSP s eviation from social optimum) The BSP s preference iffers from the social planner s preference uner two scenarios: (1) V V V an ; an 26

28 (2) V V 1 an V V V. 1 1 Proof: See Appenix G. The above set of results is very interesting in the context of the net neutrality ebate. As we mentione in the introuction, all the extant literature that covers the economic aspects of the net neutrality ebate have concentrate on the supply sie of the equation (i.e., the issue whether the BSP shoul charge content proviers for the priority elivery of their content), an the results in such analyses have shown that for almost all parameter values, the BSP woul prefer an NNN outcome over an NN outcome, even though from a social planner s perspective, an NN outcome woul be preferable (see for example (Cheng et al. 2009)). In such situations, it woul often make sense for the social planner to regulate net neutrality on the supply sie. When we however concentrate on the eman sie of the net neutrality ebate, we fin that while there are once again scenarios uner which the social planner woul eviate from the BSP s choice, the eviation is towars an NNN outcome: the social planner woul rather have the BSP choose to egrae the quality of the heavy users (an thereby opt for a no net neutrality outcome), but instea the BSP ens up choosing a two-part tariff that falls uner the ambit of net neutrality. This represents a ilemma for the social planner: while he can ecie between enforcing a net neutrality regime an not enforcing it, he however cannot enforce that the BSP chooses a NNN outcome when it is given the choice. The results also help illustrate the complexity of the net neutrality ebate. While there is growing evience that a net neutrality regime might be preferable when it comes to charging content proviers, the results in this paper illustrate that there are conitions uner which NNN might be the preferre outcome when it comes to charging consumers for preferential elivery of their requeste packets. As some inustry observers have recently commente, the same network 27

29 neutrality rules that ensure higher social welfare by prohibiting the BSP from charging online content proviers might actually protect banwith hogs at the expense of Internet users with average usage patterns (McDougall 2008). While the iscussion might not be that clear-cut as our stylize moel might suggest (for example, some commentators have pointe to the fact that these banwith hogs often help promote innovation on the Internet see for example (Al-Chalabi 2008)), but we o hope that our results help promote the richness of the iscourse on a very important subject that might well etermine how online content is accesse in the future. 7. Conclusion The ebate of net neutrality an the potential regulation of net neutrality may funamentally change the ynamics of ata consumption an transmission through the Internet. In contrast to the extant literature that has looke at the problem from the supply perspective, in this paper, we look at the issue from the eman perspective. We examine the economic impact of net neutrality on the BSP an the society as a whole, if the former is not allowe to either prioritize or egrae the elivery of content to one class of users. We consier scenarios with an without net neutrality an analyze the problem of the monopoly broaban service provier trying out ifferent pricing an prioritization strategies. We fin that the impact of net neutrality epens on both the characteristics of the Internet ata consumption market an the BSP s pricing strategies. We fin that with net neutrality in place, the BSP woul prefer to charge a two-part tariff for Internet access, but without net neutrality, a BSP may choose to charge a uniform price an egrae heavy users or else charge a higher price to high type users for preferential elivery of their ata packets epening on the characteristics of users valuations for content an their usage patterns. Interestingly, we fin that without net neutrality in place, egraing the experience of the heavy users increases social welfare, a practice that was recently banne by the FCC. The joint impact 28

30 of both pricing an net neutrality uner the framework of our moel has potentially very important policy implications. We ientify conitions uner which the BSP s user iscrimination choices eviate from the social optimum. The last result helps illustrate the social planner s ilemma: even though he might ecie not to enforce net neutrality, there will still be scenarios uner which the BSP woul opt for a net neutrality solution that woul be socially sub-optimal. The involve nature of the problem an the surfeit of relevant parameters meant that we ha to consier a stylize moel in orer to get analytical closure. In particular, we i not consier one issue that has been raise by some commentators that of the possibility that a select few power users within a network have positive externalities that help other users an the BSP in the long run(al-chalabi 2008). While the veracity of such a claim can be ebate, we think that future research can consier simulating the presence of such users within a network, an thus xamine the fallouts of their presence. 29

31 Figures an Tables Content Proviers Internet Backbone Broaban Service Provier at local loop En Consumers Charge content proviers Charge consumers Figure 1: Schematic to show the two ifferent aspects of the net neutrality ebate. The heart of the net neutrality ebate is at the local loop of the BSP. ere, the BSP can charge either the content proviers or the en consumers in orer to make a ata packet non-neutral 30

32 V C C 4 C 3 C 2 C 1 0 C V C 0 Notes: (a) The area marke by the bol lines represents the feasible parameter space ( V C, an V C, an V V where C an C are efine in the appenix). (b) The BSP s preferre option is: NNN1_1 for region 1, NN3_2 for region 2, NN3_1 for region 3, NNN1_1 for region 4, NNN1_2 for region 5, NN3_1 for region 6, an NN3_1 for region 7. (c) The shae areas correspon to the regions where the BSP s preference is ifferent from the social planner s preference. Figure 2: The BSP s overall preference for pricing structure an how it iffers from the social planner s preference 31

33 Notation, V, V F F, p w, F w u, u Description Percentage of -type consumers Table 1: ist of Notations Rate of content requeste from -type an -type consumers in packets per unit of time The gross value function of retrieving content for -type an -type consumers respectively A uniform fixe fee per unit of time charge by the BSP to en consumers Fixe fees charge to -type an -type consumers respectively Unit price per packet for ata packet transmission Consumers elay cost (congestion cost) for -type an -type consumers respectively Capacity of the BSP in packets per unit of time Consumers elay parameter that converts the elay for consumers waiting for the content to arrive from the websites to the unit cost of elay per unit of time The utility function for -type an -type consumers respectively The BSP s profit, i NN1, NN2, NN3, NNN1, NNN2, NNN3 i CS i Consumer surplus, i NN1, NN2, NN3, NNN1, NNN2, NNN3 SW i Social Welfare, i NN1, NN2, NN3, NNN1, NNN2, NNN3 32

34 Table 2: The BSP s Six Options Options Net Neutrality NN1 NN2 NN3 F V 1 NN1 NN1 CSNN1 V V Results SWNN1 V 1V 1 F F V 1 NN2 NN2_ NN2_ CSNN2 V V SWNN2 V 1V 1 Case NN3_1: If F NN3_1 V V, 1 V V, p 1 NN3_1 V 1 V 1 CSNN3_1 0 SWNN3_1 V 1V 1 Case NN3_2: If FNN3_2 0, NN3_2 p NN3_1 V V, 1 NN3_2 1 V 1 1 V 1 V V V V CS NN3_2 1 SWNN3_2 V 1V 1 33

35 No Net Neutrality NNN1 NNN2 NNN3 Case NNN1_1: If V NNN1_1 NNN1_1 V F V , +1 CSNNN1_1 V V 1 1 SWNNN1_1 V 1 V Case NNN1_2: If V V, 1 1 NNN1_2 FNNN1_2 V CSNNN1_2 1 V V 1 1 SWNNN1_2 V 1 V F NNN2_ V, F NNN2_ V NNN2 FNNN2_ 1 FNNN2_ V 1 V V CSNNN2 SWNNN2 V 1 V 1 FNNN3 V 1 1 pnnn NNN3 FNNN3 pnnn3 V 1 V V CSNNN3 SWNNN3 V 1 V 1 34

36 Appenices In orer to simplify the proofs, we introuce the following notations. Define C 1 1 C 1 C C C C C We know that C2 C3 C4 C Next we show C1 C2 as below. C since C

37 The intersection between V V V C 1 0 an V V V C 1 1 V is The intersection between V V V C 1 0 an V C 1 1 is V C since C

38 Appenix A: Solution of Formulation (7) Option NN3 In Formulation (7), from (i), we get FNN3 V p 1 NN3. From (ii), we get FNN3 V p 1 NN3. We consier two cases: Case 1: p NN3 V V. Then V p V p 1 NN3 1 NN3. So constraint (i) is bining, i.e., FNN3 V p 1 NN3. Substituting into the objective function gives V 1 1 pnn3. The optimal solution is F NN3 V V, 1 NN3 V 1 V. 1 p NN3 V V, an Case 2: p NN3 V V. Then V p V p 1 NN3 1 NN3. So constraint (ii) is bining, i.e., FNN3 V p 1 NN3. Substituting into the objective function gives V 1 pnn3. 37

39 Case 21: V V. The optimal solution is 1 F NN3 V V, 1 NN3 V 1 V. 1 p NN3 V V, an Case 22: V V. The optimal solution is 1 FNN3 0, p NN3 1 V 1 (Since V V, V V V V pnn3 V V.) 1 NN3 1 V. 1 The above cases can be summarize as: Case NN3_1: If V V, i.e., 1 V V V C0, 1 F NN3_1 V V, 1 p NN3_1 V V, NN3_1 V 1 V. The corresponing consumer surplus is 1 38

40 CSNN3_1 V FNN3_1 pnn3_ V FNN3_1 pnn3_1 0 1 Therefore the social welfare is SWNN3_1 NN3_1 CSNN3_1 V 1 V. 1 Case NN3_2: If V V, i.e., 1 V V V C0, 1 FNN3_2 0, p NN3_2 NN3_2 1 V, 1 1 V. 1 The corresponing consumer surplus is CS V F p NN3_2 NN3_2 NN3_2 1 1 V FNN3_2 p 1 1 V 1V V 1 1. V V 1 Therefore the social welfare is 39 NN3_2 SWNN3_2 NN3_2 CSNN3_2 V 1 V. 1

41 Appenix B: Proof of Proposition 1 Now we move on proving Proposition 1. Comparing the BSP s three options uner net neutrality, we know V NN1 NN2 1. Then we compare NN1 an NN2 to NN3. If V V, i.e., 1 V V V C0, 1 NN3 NN3_1 V 1 V. 1 V V V Since 1 1 1,. NN3_1 NN1 NN2 If V V, i.e., 1 V V V C0, 1 NN3 NN3_2 1 V 1 V 1 NN1 NN2 since

42 Appenix C: Proof of Proposition 2 Comparing the BSP s three options uner no net neutrality, we know NNN2 NNN3 V Then we compare NNN2 an NNN3 to NNN1.. If V V 1 1 1, i.e., V V V C3, then NNN2 NNN1_1 1 V V So. NNN1_1 NNN2 NNN3 0. If V V 1 1 1, i.e., V V V C3, then NNN2 NNN1_2 2 1 V V V V 41

43 V V V V C. 1 Since C1 C3, we get if V V C, 1 NNN1_2 NNN2 NNN3 ; If V C1 V V C3,. NNN1_2 NNN2 NNN3 Summarizing the results, we have: if V V C3, ; if NNN1 NNN1_1 NNN2 NNN3 V C V V C, 1 3 NNN1 NNN1_2 NNN2 NNN3 ; if V V C1,. NNN1 NNN1_2 NNN2 NNN3 42

44 Appenix D: Proof of Proposition 3 From the results of Proposition 1 an Proposition 2, we know: uner net neutrality, V If V C0, V V If V C0, V. 1 NN NN3_1 1 NN NN3_2 Uner no net neutrality, If V V C3, then If V C1 V V C3, 1 V. 1 NNN NNN1_2 If V V C, 1 NNN NNN2 NNN3 V NNN NNN1_1 Consiering the BSP s overall preference, there are six cases: V Case (i): If V C0 an V V C3, then V 1 ; V ; NNN NN NNN1_1 NN3_1 V V 1 V 1 1 V V 1 1 V V 1 1 V If V C 4 V V C0 1 1, then. NNN1_1 NN3_1 V V C V V C an V C0, then If 3 4 NNN1_1 NN3_1. 43

45 V Case (ii): If V C0 an V C1 V V C, then 3 NNN NN NNN1_2 NN3_1 V V 1V V V V V If V C V V V C an V V C0, then. NNN1_2 NN3_1 V V C V V C an V C0, then If 1 2. NNN1_2 NN3_1 V Case (iii): If V C0 an V V C, then NNN NN NNN2 NN3_1 V V 1V V V 1 1 V V 0. So. NN3_1 NNN2 V Case (iv): If V C0 an V V C3, then NNN NN NNN1_1 NN3_2 44

46 1 V V V 1 1 V If V C, 0 V V C3, an V V 1 1 1, then NNN1_1 NN3_2 is also where the line. Notice V V V C 1 0 intersects the line V V V C V If V C0, V V C3, an V 1 1 1, then. NNN1_1 NN3_2 V Case (v): If V C0 an V C1 V V C, then NNN NN NNN1_2 NN3_2 V V 1 V V 45

47 If V V, i.e., V 1 V , then. NNN1_2 NN3_2 If V V, i.e., V 1 V , then. NNN1_2 NN3_2 V Case (vi): If V C0 an V V C, then NNN NN NNN2 NN3_2 1 1 V V 1 1 V V V So. NN3_2 NNN2 46

48 Appenix E: Proof of Proposition 5 Comparing social welfare uner NNN1, NNN2, an NNN3 gives SWNNN2 SWNNN3 V 1 V. 1 Since SWNNN1_1 SWNNN1_2 V 1 V SWNNN2 SWNNN1_1 1 1, Therefore SW NNN1 >SWNNN2 SWNNN

49 Appenix F: Proof of Proposition 6 Recall SW =SW SW V 1 NN1 NN2 NN3 V an 1 SWNNN1 V 1 V >SWNNN2 SWNNN3 V 1 V 1 Since SW NN SWNNN2 1 0, SWNN1 SWNNN SW >SW SW SW SW SW., NNN1 NN1 NN2 NN3 NNN2 NNN3 48

50 Appenix G: Proof of Proposition 7 From Proposition 6, we know that the social planner always prefers NNN1. From Proposition 3, we know that uner the following two scenarios: (1) V V V an ; (2) V V 1 an V V V, the BSP prefers NN3 an therefore the 1 1 BSP woul eviate from the social planner s preferre option. 49