PRICING MODELS FOR ISPs IN INDIA TABLE OF CONTENTS BRIEF HISTORY OF THE INTERNET 4 THE COMPONENTS OF NETWORK TECHNOLOGY 5 THE INDIAN SCENARIO 11

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1 PRICING MODELS FOR ISPs IN INDIA By Vaibhav Kumar Arun Unni Tasneen Padiath Anshu Anand Rupali Bhandari TABLE OF CONTENTS INTRODUCTION 4 BRIEF HISTORY OF THE INTERNET 4 THE COMPONENTS OF NETWORK TECHNOLOGY 5 The economic model 6 Issues involved in these interactions 7 Network Access Providers 7 Pricing for Services 8 Liability for the cost of communication 9 Network construction costs 10 Maintenance and upgrade costs 10 THE INDIAN SCENARIO 11 National backbone 11 International bandwidth 12 Satellite or fibre connectivity 12 Economic Bottlenecks 14 Legal and regulatory issues 15 DEMAND FOR INTERNET ACCESS AND USAGE 17 Components of Usage Demand 17 The Network Effect and the Marginal Benefit of Size 19

2 The Network Effects and Changes in Demand 20 PRICING BASICS 22 Background on Network Pricing 22 Pricing Alternatives 23 Flat Pricing Scheme 24 Usage based 26 Priority 27 Tiered usage 28 Congestion pricing 28 Two-part tariff 29 Future pricing schemes 29 The Precedence Model 29 The Smart Market Mechanism 30 Usage-based 31 CONGESTION 36 The Costs of Congestion 36 The Causal Model of Internet Congestion 37 Incompatibility issues 37 Privatization, Commercialization, and Massification 37 Implications & Key Issues 38 The Congestion Externality, Demand and the Marginal Social Benefit 40 The Application Data Unit (ADU) 40 CASE STUDIES 47 AOL Pricing History 47 Until December January 1995 to July July 1996 to December Since December Lessons learned 51 New Zealand and Chilean Internet Experience 51 Background 51 Pricing schemes 52 Pros and Cons of pricing methods in New Zealand and Chile 55 Conclusion 57 Interaction with Other Groups 57 Network and Path Dependent Effects 57 Human Factors 58 Collaborative Design 58 Legal and Regulatory 59 Industrial Organization 59 Inter-Organizational Design 60 Standards 60 IMPACT ON INDIAN INFRASTRUCTURE DEVELOPMENT 61

3 BIBLIOGRAPHY 66

4 Introduction In the past decade, we have all witnessed the Internet's rapid expansion, which has outgrown any other industry. We have entered an era dominated by network technology. The advancement of networking technology is bringing about the convergence of computing and communication technologies. This convergence, including technologies such as television, telephony, and computers, has in turn stimulated the reach of the innovations of the Internet. Digital video, audio, and interactive multimedia are growing in popularity and increasing the demand for Internet bandwidth. However, there has been no convergence on the economics of the Internet. While advanced information and communication technologies make the network work, economic issues must also be addressed to sustain the growth cited above and expand the scope of the network. Brief history of the Internet 1 In the 1960's, in response to the nuclear threat during the cold war, the Advanced Research Projects Administration (ARPA) of USA engaged in a project to build a reliable communication network. The network deployed as a result of this research, ARPANet, was based on packet-switching protocols, which could dynamically reroute messages in such a way that messages could be delivered even if parts of the network were destroyed. ARPANet demonstrated the advantages of packetswitching protocols, and it facilitated the communication among the research institutes involved in the project. As more universities were connected to the network, ARPANet grew quickly and soon spanned the United States. In the mid 1970's the existing protocols were replaced by the TCP/IP protocols, a fact that was facilitated by their integration into Berkeley UNIX. In the 1980's the American National Science Foundation (NFS) created several supercomputer centers around the country. The NFS also deployed a high-speed network based on Internet protocols to provide universities with remote access to the supercomputer centers. Since connection to the NFSNet was not restricted to universities with Department of Defence (DoD) contracts, the network grew dramatically as all kind of non-profit entities, as well as universities and research groups, connected to it. A nonprofit Michigan-based consortium, Michigan Educational Research and Industrial Triad (MERIT) managed NFSNet. Since Internet 1

5 access was subsidized by the NFS and by the non-profit entities connected to the network, economic issues such as accounting, pricing and settlements were for the most part ignored. As NFSNet grew and its potential became obvious, many for-profit entities wanted access to the Internet. Since the NFS did not want to subsidize Internet access for these private groups, it gave control of NFSNet to the nonprofit corporation Advanced networks and Services (ANS). ANS was created from resources provided by MERIT, MCI and IBM, and was free to sell Internet access to all users, both nonprofit and forprofit. Meanwhile, some for-profit backbone providers such as PSI and UUNET started selling Internet interconnection services. As the Internet became more commercialized, people began studying and experimenting with the Internet economics. In 1995, ANSNet was sold to America Online, and a new commercial Internet replaced the NFSNet-based Internet. The new Internet consists of a series of network backbones interconnected at Network Access Points (NAPs). NFS is phasing out its subsidies of the backbones but still subsidizes four NAPs: San Francisco (PacBell), Chicago (Ameritech), Washington DC (MFS) and New Jersey (Sprint). The popularization of the Internet and the perception of an imminent convergence of voice, video and data networks provided impetus to the telecommunications deregulation in At the same time, it became even more obvious that such a network convergence will require a coherent system of settlements and pricing. With the different networks being able to provide the same (or similar) services, the old telephone and cable pricing structures may become inadequate, and new structures must be created to replace the old ones. The components of network technology 2 Network services include not only those products provided by the Internet but any kind of service that is provided by or cannot be produced without the presence of a network. For example, in addition to the great amount of information goods and electronic commerce activities on the Internet, phone calls and cable TV are other examples of network services. While there exist users (buyers or consumers) to purchase the services, there will be sellers (or producers) to provide them. There are three main kinds of Services available for consumption on the network, namely, electronic commerce, information goods, and software applications distributed over the network. Users are defined as the individuals who consume 2

6 Services via the network. Network Access Providers (ISPs) are defined as the companies that provide network access to Users and Services so that they can communicate. Finally, Infrastructure is defined as the physical network infrastructure and its protocols to allow information exchange in the network. Therefore the four main components in the network services market are the Users, Network Access Providers, Infrastructure, and Services. The economic model Three parts of network technology - User, Network and Services - have interactions with each other. The Infrastructure is "embedded" in Network Access Providers because they have no direct interaction with the Users and the Services. Access of the network is "retailed" by Network Access Providers. For example, in the context of the telephone industry, the telephone companies are Network Access Providers which utilize the Infrastructure (i.e. the telephone lines) to provide Services (i.e. phone calls) to the Users (i.e. telephone customers). There are four main kinds of economic interactions in the world of network technology figure. Essentially the User can browse the web from home because the connection service provided by a Network Access Provider - more specifically, an Internet Service Provider, or ISP. The ISP in turn charges him / her a price for gaining access to the Internet. The ISP can provide this service because it rents a part of the Internet Infrastructure in order to provide network access service to Users. The ISP has to pay the company who provides the infrastructure (most likely a telephone company in this example). The homepage of the Network Service Provider is on the web because the company pays another (or possibly the same) ISP for the connection to the Internet, in order to provide this electronic commerce as a Service. Finally the User pays for this Service to buy the toy. Thus, there are economic interactions between User and Network Access Provider, Network Access Provider and Infrastructure, Network Access Provider and Services, and lastly, User and Services. Besides the economic interactions between different components, there may also be, especially in the case of Internet, economic interactions within a component. For example, there are settlement issues between different providers of the infrastructure in "pass through" traffic.

7 Issues involved in these interactions 3 In the economic interactions between the Network Access Providers and Users, the issues are: An efficient, feasible pricing strategy Pricing schemes that have been suggested In the economic interactions between Network Access Providers and Services, the issues are: Responsibility for collecting the tariff for network usage In the economic interactions between Network Access Providers the issues are: Is there a need for settlements between Network Access Providers? In the economic interactions between Infrastructure and Network Access Providers, the issues are: How Infrastructure should be priced in order to recover the substantial sunken cost Problem of dial-in access to the Internet Should there be settlements between Infrastructure and Network Access providers In the economic interactions between, Infrastructure Providers, the issues are: Is there a need to do settlements on "pass through" traffic How interconnection agreements should be made In the economic interactions between, User and Services, the issues are: Pricing of the service. Impact of the service to the way people live. Network Access Providers A Network Access Provider (ISP) or an Internet Service Provider (ISP) is defined as a company that provides network connections to Users and Services. ISPs can be thought of as providing access to end-users. For Network Access Providers four different relationships involving interactions with different network entities can be seen: 1. Network Access Providers and Users 2.Network Access Providers and Services 3.Network Access Providers and Network Access Providers 4.Network Access Providers and Infrastructure 3 Electronic Commerce -- An Introduction, May 1996

8 Another important interaction that affects the Network Access Providers are those between the Infrastructure providers. 1. Network Access Providers and Users ISPs usually suffer from diseconomies of scale when dealing with users. Customer support, accounting, billing and hardware maintenance all increase disproportionately with the number of users. Furthermore, anything that inconveniences the user will not be tolerated 4. Pricing, therefore, must recover the fixed and growing marginal cost but not inconvenience the users. Also, a pricing scheme should also provide incentives for both the Network Access Provider and the Users to act in a socially responsible way. Costs that ISPs incur are: Hardware and software: A ISP must recover the costs of hardware, software and customer support. The hardware and software costs will vary depending upon the type of access the ISP will support (most support also depends upon the customer's preference). Customers can choose between dialup or leased line access. Dialup service requires that the ISP purchase a terminal server, modem pool and dial-up lines. The software support costs of providing dialup service are negligible. Occasionally, the hardware must be upgraded. These upgrade costs tend to incur in large chunks rather than incrementally over time. ISPs providing leased line access are required to provide a router at either end of the leased line (one at the ISP site and one at the customer site), but terminal servers and modems are not necessary 5. The software required for leased line service is more complicated than that required for dialup service as configuration for the former case may take considerably more time. Customer support: Customer support costs can be categorised into three support types that occur over the life of the ISP/customer relationship: costs of acquiring a customer, costs for supporting an ongoing customer, and costs of terminating a customer relationship. 1. Network Access Providers and Services Pricing for Services Many Services need access to the Internet before being able to market their goods on the Information Superhighway. In this capacity, the Services are much like the 4 Hal Varian, "Economic Issues Facing the Internet", June, Padmanabhan Srinagesh, "Internet Cost Structures and Interconnection Agreements", presented at the MIT Workshop on Internet Economics, March, 1995.

9 Users above in that they need to purchase Internet access. Hence, the pricing schemes for Users can also be targeted to Services in their capacity as network user. The "advertising alternative" to pricing mentioned above would not be applicable, however, since the Services are the targets of that cost recovery model rather than the benefactors. Liability for the cost of communication It is unclear which entity, Users or Services should be liable for the communication charges. For example, if a user pays for some Service's software, who pays for the communication cost of downloading the software to the user (we are assuming in this example that downloading is the method of delivery for the software). It might be more efficient to have the ISP collect charges from the Service. This would certainly be the case if the User and the ISP did not have an existing relationship. However, the User and the ISP do have a pre-existing relationship where the User pays the ISP for network access. Therefore, the accounting and collection methods are already in place at the ISP/User level. It would seem, then, that there is no benefit from imposing the liability for communication costs onto the Services. However charging for actual usage is difficult from a practical standpoint because of the processing power that would be necessary to measure the usage. Imposing the liability for the cost of communication onto the Service would greatly simplify the accounting procedure for usage-based accounting: the server knows a priori exactly how much bandwidth is necessary to transmit each product and would simply need to add the cost to the customer's bill. Although the Service would have to initially measure the cost before selling the product, this is a one-time calculation. Further, because they know the cost beforehand they could simply include a line for cost in the User's bill for the software product. This imposes no inconvenience on the User. 2. Network Access Providers and Network Access Providers Because ISPs tend to agree that providing users with full Internet connectivity is a basic requirement, interconnection settlements between ISPs covering the case when two users with different ISPs are communicating are not necessary. The rationale is that when ISP1- user communicates with an ISP2-user, both ISPs get paid by their respective customers, so no settlement is necessary. The present practice is to sign either a multi-lateral which allow all foreign traffic to be accepted by an ISP, or several bi-lateral agreements which are agreements between two specific ISPs. Currently, 70% of the ISPs sign multi-lateral agreements; the remaining 30%

10 sign bi-lateral agreements. The rationale above does not apply to the case of transit traffic, (or more commonly referred as "pass through" traffic), however. 3. Infrastructure and Network Access Provider Network construction costs The major network construction costs are buying and installing the links and nodes. Currently, most long haul infrastructure providers use optical fibres for their transmission links. The costs of constructing the fiber optic links include the cost of the fibers, of trenching and of labor installation. Since the cost of the fiber is relatively small compared to the total cost of installation, excess fiber is typically installed. Between 40% and 50% of the fiber installed by the typical interexchange carriers is "dark", i.e. the lasers and electronics required for transmission are not in place. Private lines can be provided out of this surplus capacity. The costs for connecting a private line include lighting up the fiber with lasers and electronics (if it is originally "dark") and customer acquisition. Maintenance and upgrade costs Although the sunken cost of network construction is substantial, once the physical infrastructure is established, the incremental cost of carrying packets is negligible. However, maintenance and upgrade costs have become a nightmare recently. The heavy telephone usage at the local loops by Internet users has imposed big problems for the telephone companies. In order to accommodate the ever-increasing network traffic, larger and faster switches are constantly replacing the old ones. This cost has been huge [but the telephone companies are not getting any compensation for carrying the extra Internet traffic. Capacity Although there are dark fibers and upcoming new technologies (such as xdsl and ATM) to increase network capacity, in short term and on a regional scale, congestion is a big and very real problem. It is not prudent to rely on the belief that the capacity can be increased indefinitely in the long run, from both the technological and economical points of view. The key therefore is to build enough infrastructure to satisfy a statistical demand, and use economic methods to manage the actual demand.

11 The Indian Scenario Like most developing countries India is also faced with the problem of being able to provide only limited access to internet services. The main cause for this is the limited infrastructure currently available in terms of telephone access. While phenomenal growth is expected ISPs may face challenges in getting enough telephone lines in the four big Indian cities - Bombay, Delhi, Bangalore and Madras from where up to 70 per cent of new ISP connection demand is expected to come. India has less than 25 million telephones and 0.7 million Internet Access for 1000 million people while it needs 150 to 200 million Telecom and Internet connections to meet the expected demand. With the new ISP policy not permitting last mile connectivity for dial-up access, this requirement will need to be met by the operators of basic telecommunications services. Past experience over the last three years has shown the requirement of access lines and their quality to be the most significant limiting factor for the growth of Internet in India. It will need to be seen how this will be overcome under the new liberalised scenario by merely increasing the number of ISPs. The forecast of online access (source: Financial Times) shows that dial-up access will remain by far the most common method of access outlining cable or ISDN access by a factor of over 10:1. Under these circumstances the policy announcement of opening up Internet access via Cable TV is not believed to provide a radical solution to the issue of access to Internet services. It will require a concerted and planned effort to meet this demand over a short time frame of less than six months. National backbone 6 Another major issue in the provision of Internet services is that of providing a national backbone for India-wide connectivity as well as inter-connection between the multiple ISPs. Under the ISP policy dispensation, a Statewide access been provided under the dialling scheme of "17222" access which connects a subscriber to the nearest ISP node. With more than 800 cities in India being available on STD/ ISD and having a high potential for growth of Internet services, the above type of access is likely to lead to a loading of the Indian trunk network which is designed for "high tariff low holding time traffic" with low paying, high holding time traffic". This will undoubtedly put considerable load on the already scarce resources and is not a long term

12 solution. Moreover, merely providing access to the nearest ISD node does not solve the issue of connecting to more than 50 ISPs who may exist within a State. There is, thus, an urgent need to provide a common access backbone to which customers from any part of the State can dial to access any lsp Internet node. The need is, therefore, to isolate the access service from the ISP service and the content services. A national backbone can be provided by private operators in addition to those provided by DOT and VSNL, and this should form an indispensable part of the National Information infrastructure. No ISP policy would be complete without defining a national infrastructure for India-wide Internet access by multiple ISPs. International bandwidth With the operation of six gateways by VSNL, and in addition the use of optical fibre submarine cables, the bandwidth already provided by VSNL is over 80 MBPS and is adequate for meeting India s requirements with the current level of subscribers. India is also well connected with optical fibre cable systems1 with FLAG (5 Gbps per fibre), SEA-ME-WE-3 (10 Gbps per fibre) and other cables in the pipeline. Complemented by multiple satellite connectivity, no shortage is envisaged, and the requirement of all ISPs can be fully met from "day one" so far as international Internet connectivity requirements are concerned. VSNL has already prepared itself for this scenario, whereby its leased lines to the ISPs can be increased to accommodate all the new ISPs requiring connectivity via VSNL. It maybe mentioned that VSNL has today over 350 leased line circuits operating for Internet alone and is, thus, well versed with this business. Satellite or fibre connectivity It is now well known that Internet growth is not simply a growth in the number of users, web sites or customers. The real growth of Internet is now being driven by an increasing use of bandwidth-hungry applications. As per Sprint, the average message travelling over its networks is today ten times larger than it was a year ago. Users are downloading larger and larger web pages and using steadily increasing data-hungry applications such as video conferencing, LAN connectivity and enterprise networks. Within the next three years the bandwidth requirement of Internet could grow by a factor of 50 to 100, 6

13 overtaking the telephone network bandwidth by a significant margin. On the Internet backbone, the traffic is today doubling every 100 days and major backbones at peak times are suffering packet losses which can go up to 400A. The question is how will such large bandwidths be provided for India? Fortunately, VSNL s advanced planning in cable systems comes to the rescue of this urgent and pressing issue. VSNL, through its acquisition of capacity in FLAG and SEA-ME-WE-3 can ensure that the country s requirements are met for the next five years with over 30 Gbps of capacity being available. VSNL has already signed a MOU for Project Oxygen, which will be a 300 Gbps system operational in the year The increasing number of ISPs in India will drive up the bandwidth demand. This, coupled with larger bandwidth per user through the use of bandwidth-hungry applications, will make it possible to order large bandwidths. This will then provide economies of scale and make the bandwidth available at lower and lower costs. VSNL is already negotiating for much larger capacities on the optical fibre systems for Internet. India-US connectivity for a D53 (45 Mbps capacity) can today be had at US$ 150,000 per month. This is roughly the equivalent of US$7,000 per month as against an average figure of US$ 21,000 per month payable via satellite circuits to USA. It is, thus, evident that even at relatively lower levels of bandwidth utilisation, e.g., 45Mbps, the cable systems provide a price advantage of 3:1 over satellite circuits. VSNL believes that this will be a significant factor in gradually lowering the cost of Internet access for international Internet connectivity. As the bandwidth requirements increase beyond D53 to ATM levels, e.g., 155 Mbps, the cost could come down further by a factor of 2 or 3, thus reaching levels at which such bandwidths are available in developed countries. With the arena now clear for a deregulated and open playing ground for ISPs, the stage is set for the rapid growth of Internet in India. However, the growth will be critically dependent on how some of the factors such as requirement of access lines and national backbone connectivity are addressed. With the wisdom which has gone into the formulation of the new ISP policy, it is believed that these issues requiring urgent resolution will also be addressed on priority and resolved, opening up a path for multi-fold growth in Internet services in India.

14 Economic Bottlenecks 7 Economic Bottlenecks that limit access in developing countries are in terms of service affordability. The average expenditure per month on communications in USA is $30 which almost 90% of the households can afford. In India the situation is shown in the table below India (in 2001) Annual Household Income % of households Expense on communication* > $ % > $350 $ $ % $175- $350 $ $ % $ 70 - $175 $ $ % $ 35 - $ 70 *Assuming 7% of family income for communications The above table clearly shows that even if we take the lower US $30 per month only 1.6% of the households can afford the service, thus acting as a severe constraint in improving access to these services in the country. Also in USA a $ 360 per year revenue may justify $1000 per line Network cost and is affordable to almost 90% of households. This implies that there is no incentive to reduce cost rather the focus of R&D is not to reduce costs but to enhance basket of services and features while keeping cost constant. In developing countries even with $ 125 per year revenue, the service is affordable to only the top 30 % of households. Thus here the emphasis continues to be on reducing network costs given the market size of hundreds of millions. 7 from a paper discussd at Commsphere 2000, IIT Madras, by Prof. Ashok Jhunjhunwala

15 Network Effect % of households (cumulative) network cost per line % of households (cumulative) The above graph shows the importance of improving service affordability. Access would increase if affordability could be increased. As more number of households get access the network costs per line would come down and this circularity would continue. Thus it is imperative that service costs be brought down. Given low affordability even providing access may not be enough as the user would still have to pay call charges which might be prohibitive. Some steps to rectify this situation are being considered e.g. Government telecom service provider and soonto-be ISP Mahanagar Telephone Nigam Ltd. (MTNL) is considering waiving local phone call charges for Internet users, or bundling calling charges for its own Internet service Legal and regulatory issues Legal and regulatory challenges still arise in areas like setting of access tariffs for private ISPs, international gateways, Internet telephony, and opening up of the lastmile telecom market. The most revolutionary aspect of India's Internet policy is letting ISPs do the last mile connect and this could well be the source of litigation from basic service license holders who worry about voice over IP. On 6th November 1998 a new ISP policy was unveiled. The policy permitted unlimited number of Internet players with no licence fees for the first five years, thus setting the stage for a completely deregulated operating environment. A deregulated environment requires the most disciplined set of regulations to oversee the growth and to ensure and protect the interests of the customers and the country It will be important to ensure that no anti-competitive practices are indulged in by any of the operators, particularly those responsible for providing infrastructural facilities.

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17 Demand for Internet Access and Usage The first issue, which needs to be highlighted, is the difference between demand for Internet access, and demand for usage. This is an important distinction since "the important characteristic of Internet demand for access is that it is binary. An end user either has access or he does not. By contrast, Internet usage refers to an individuals utilisation of Internet resources once access has been obtained. The rate of data/traffic transferred in a given period will be used as the measure of Internet usage. Other methods of measuring usage could be total amounts of data transferred or hours of time connected to a service. Components of Usage Demand There are five factors, which influence demand for Internet usage. These elements are the price of usage, cross-price effects, income effects, user preferences and lastly the network effect. The network effect is a particularly important component of the demand for Internet usage and will therefore be considered separately. 1. The price of usage This can also refer to the type of pricing scheme. That is whether a flat access fee is charged - in which case the usage price is zero, or whether a usage sensitive pricing scheme is used. 2. Cross-price effects It is important to recognise the impact of both substitutes and compliments on demand for usage. In relation to Internet usage it is important to recognise that the substitutes tend not to be substitutes for Internet usage per se, but rather substitutes for different components or uses of the Internet. For example the substitutes for might include telephone and fax calls as well as postal mail. The substitute for purchasing CD's online is buying them through mail order, over the phone or via the home shopping television channels. If we therefore assume that substitutes tend to be for components of Internet usage, rather than Internet usage as a whole, the cross-price elasticity for Internet usage will then be related to the proportion of total usage made up by the substitutable component. For example, the cross-price effect on Internet usage of a rise in fax or postal mail prices will be influenced by the proportion of total Internet usage the substituted component (e.g. ) makes up. From this it may be possible to argue that the size of the cross-price elasticity between a particular substitute and total

18 Internet usage is likely to be low, although this would need to be confirmed through empirical study. The price of compliments also has an impact on the demand for Internet usage. The compliments to Internet usage are not just the costs of computer equipment required, but also the cost of the users time. An increase in time saving computer applications will increase a users demand for usage since for any given amount of time they will be able to get more valuable usage from that time. 3. The Income Effects Income also affects demand for Internet usage. It is suggested that Internet usage is a normal good. That is, it rises with income. But if the rise in income is associated with a rise in the users wage rate or hours of employment this increases the value placed on time by the user. They may therefore be more prepared to pay for a substitute (such as a conventional telephone call), than wait for the level of congestion on the Internet to decline to a level where the user can utilise real time audio applications without degradations in quality. Thus under some circumstances Internet usage may be considered an inferior good. 4. User Preferences and other miscellaneous factors Consumer preferences are used to account for differences not attributable to the above factors or to the network effect. Changing demographics is one factor impacting the demand for usage. However it is possible to imagine a wide range of other factors which could alter consumer preferences and have an impact on the demand for usage. For example, changes in the weather may induce users to stay indoors and use the Internet rather than undertake activities outdoors, whilst a popular television show may reduce the demand for Internet usage at that time. 5. The Network Effect The final component of demand is the network effect. The network effect refers to the situation where "the value of the good increases with the expected number of units to be sold." Network effects can be either direct or indirect. It is the direct network effect, which has an impact on the demand for Internet usage. Direct network effects arise as the result of the effect a new user has on the benefits received by the existing network users. The positive network effect will be focussed on, although the impact of negative network effects will also be considered. The operation of the network effect is best explained by the simple example of the telephone or fax networks. In the extreme case where there are zero users of the network, there is no benefit in being connected since there is no-one to talk to! However as the network grows, the benefits to an individual of becoming connected increase since there are more people to communicate with. As the network size

19 increases, so does the benefits to participants since "a new user joining the network increases the range of choice open to other members." The same may be argued to exist in relation to use of the Internet. The more WWW sites, or users on the Internet Relay Chat (IRC) network, the greater the benefit a user can expects to receive. The Network Effect and the Marginal Benefit of Size 8 Figure 1 below is a graphical representation of a possible relationship between network size, Marginal Private Benefit (MPB) and Marginal Social Benefit (MSB). In Figure 1, Marginal Benefit (MB) is drawn on the vertical access and network size on the horizontal. In the context of the Internet, network size could refer to the number of users connected to the Internet or the number of WWW sites accessible by Internet users, the choice depending on the particular problem one wishes to analyse. It is important then to remember, that in this analysis network size does not refer to the physical capacity of the network. The model to be developed in this essay also assumes that increases in network size do not result in changes in the physical capacity of the network. For all network sizes up to N* the marginal benefit of increased size is positive. This reflects the earlier explanation of larger network size creating more 'goods'. Furthermore, the MSB curve is drawn above the MPB for all network sizes less than 8

20 N* due to the presence of the external benefits which existing network users receive from new users joining the network. Examining the shape of the marginal benefit curves it can be seen that initially the marginal benefit is positive and increasing due to the increasing benefits from expanding the network. Eventually however the marginal benefit reaches a maximum after which the marginal benefit of increased size begins to diminish. The diminishing marginal benefit observed in Figure 1 may be due to a number of influences. Although some activities may require a certain critical mass to exist, increased size beyond this level may not contribute significant gains. Internet shopping is a possible example. Although a certain number of Internet users may be necessary for on-line shopping to become viable the gains once this critical point has been reached may begin to fall. Increased network size may also lead to higher levels of 'spamming' and other antisocial behaviour, which may reduce the marginal benefit of increased size. Similarly, increased network size can produce the Internet equivalent of highway traffic jams, again acting to reduce the benefits of increased size. The problem of congestion is significant enough that it will be examined in more detail later. Eventually the effects of these negative factors may actually change the network externality from being a positive to a negative. The Network Effects and Changes in Demand 9 Examine the relationship between network size and the demand for Internet usage. In developing this new explanation it will be necessary to use the simplifying assumption relating to the relationship between the network effect and demand. The assumption made is that all users value the network effect equally and therefore that the increased willingness to pay due to the presence of the network effect "is the same for each unit sold, irrespective of its position on the demand curve.". This is significant since it means that the network effect shifts the demand curve without altering its slope. Since the demand for Internet usage is based on the benefits received, where the increase in network size produces a positive marginal benefit this will result in an increase in demand. When the increase in size produces a negative marginal benefit then this will result in a decrease in demand. Figure 2 illustrates this relationship. 9

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