Competition and Coordination in the Network Economy 1

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1 Competition and Coordination in the Network Economy 1 Mingzhi Li, Kai Reimers, Jinghua Huang, Guoqing Chen School of Economics and Management, Tsinghua University Abstract The network economy refers to the ecosystem that centers on the Internet. It includes the network enablers (backbone providers, Internet service providers, and the last mile providers) as well as all the market participants whose activities are critically based on the Internet. Due to the unique characteristics of the network economy, the market structures in different segments of the network economy differ greatly. The traditional beliefs held by economists that perfectly competitive markets are the most efficient may not be true in all the layers of this emerging network economy. We discuss the market structures and competition in different layers of the network economy and the roles of the government in coordinating economic interests of these segments. Keywords: Network Economy; Network Externality; Standardization; Competitive Advantage. 1 Partly supported by Tsinghua-SEMeBusiness Laboratory, Tsinghua's Soft Science and 985 Key Projects on I

2 ebusiness, and the National Science Foundation of China (No ). II

3 Competition and Coordination in the Network Economy Mingzhi Li, Kai Reimers, Jinghua Huang, Guoqing Chen With the rapid development and diffusion of the information and communications technology, the network economy is including richer and richer contents. While the backbone providers, the Internet service providers, and the last mile providers are the enablers of the network economy, broadly speaking, all the market participants whose activities are critically based on the Internet are also important market players in this emerging ecosystem. Traditional economic theory believes that perfect competition is the most efficient market structure. However, due to the unique characteristics of the network economy, this may not be true in all segments of the network economy. To coordinate economic activities and conflicting interests of these market players, the government needs to play an important role. The paper is organized as follows. In section one we discuss the new characteristics of the network economy. In section two we look at the fundamental differences in different segments of the network economy and their most appropriate market structures. Then we discuss the interrelated relationships among all the segments of the network economy and the government s role in coordinating different interests of them in III

4 section 4. The paper finishes in section five with concluding remarks and policy recommendations 1. Layers of the network economy and its characteristics The network economy refers to the ecosystem that centers on the Internet. It includes the network itself and all the economic activities that critically depend on the Internet. The major market participants of the network economy includes: the backbone providers, the Internet service providers, the last mile providers and all the firms who are using the Internet as a medium to do business. The relationships among these market players can be described as co-competitors: they are competitors but they also need each other s coordination. An end user needs to get connected to an ISP through a last mile provider, and the ISP has to get onto the Internet through a backbone provider. The Internet contents providers (ICPs) are providing the contents to the end users. A backbone is a collection of high-speed telecommunications lines (what used to be called trunk lines or simply telephone lines ) that are connected by high-speed computers. It is made up of fast fiber-optic lines that allow computers to transfer data at very high speed. Backbone service providers are those companies that maintain their own backbone lines. An Internet Service Provider (ISP) delivers access to consumers and small- to medium-sized organizations. Last Mile Providers develop, IV

5 maintain, and provide the physical connection (e.g., the telephone, cable, or wireless connections) to consumers and small- to medium-sized organizations. Internet Contents providers create a series of products, such as news, financial information, education information, music and video, games and other entertainment contents etc. Compared with the traditional industrial economy, the Internet based network economy has the following unique characteristics. Network Externalities: network externalities exist when the value of a product or service increases with the increase of the number of users. For example, when more people are using one telecom network, the price of the telecom service may decline due to economies of scale, and then all the users get benefits from the lowered price. To the network service provider, the existence of network externalities may make one big network more efficient compared to several smaller ones providing the same service. Standardization: to make the network operate smoothly, standardization is an important issue in the network economy. Industry standards typically are set by the industry leaders. AT&T used to be the builder of the US telecom industry standard before the seven baby bells were spinned off. In the early period of an industry development, it is important to have an industry standard. The China telecom used to play a similar role in the telecom industry of our country. V

6 Interconnection: Interconnection is the most important characteristics of the network economy. The virtual economy reduces transaction costs of doing business, lessen limitations due to physical distance and time constraints. Personalized Service: the Internet shortens distances between firms and consumers in the value chain and changes the traditional market structures. The firms may face the consumers directly, therefore it is much easier for them to get to know the consumers preferences and design personalized products and services. 2. Market Structures and Competition in Different Layers of the Network Economy Since the network economy has multiple layers and has different characteristics compared with traditional economy, we have to consider the uniqueness of the network economy when we consider its market structures. It is not appropriate to talk about good or bad of monopoly and competition without taking this uniqueness into consideration. We next discuss the most appropriate market structures of these different layers and characteristics of competition in them. Backbone Service Providers Oligopoly Markets The backbone owners are controlling the trunk lines of the Internet traffic. They make money out of leasing their bandwidths to ISPs or large VI

7 enterprises. Currently China s backbone service providers include: Chinanet, UNINET CNCNET Jitong and Tietong, among which the CHINANET owned by the China Telecom is the largest. Before emergence of the other backbone providers, it almost controlled 100% of China s telecom lines. After the restructuring of China s telecom industry in 1999 and 2000, the landscape of backbone service providers market have changed dramatically. Building the Internet backbones has many similarities with that of the traditional telecom trunk lines. First, it takes a huge amount of fixed investment in setting up the basic infrastructure. Therefore there is a very high barrier to entry in this industry. Second, providing the network, telecom and telephone services has the characteristics of increasing returns to scale and economies of scale. Although the initial investment in building the network is huge, the additional cost of serving one more customer is minimal. Based on these two features, we believe that the characteristics of natural monopoly still hold in the market of backbone services providers. Although traditional economics advocates free competition, it is not likely to have a full-scale competition in this layer of the network economy due to the uniqueness of the network economy mentioned above. It is common belief that monopoly market structure has the problems of high price, low output level and causing social welfare loss. VII

8 The oligopoly market structure is more realistic in the layer of backbone service providers. Competition among several big firms may keep the prices from reaching the monopoly level and enhance the quality of services. However, the oligopoly market has such problems as collusion among firms. It is the government s role to correct market failure in the oligopoly market. ISPs High Speed, Reliable and High Value-Added Access The function of an ISP is to provide access to the network. Therefore the product and service of all the ISPs are not highly differentiated; there is also almost no barrier to entry in this industry. Such a market is unlikely to be dominated by a few large firms. The competitive advantage of ISP lies in its ability of consolidating resources and providing high speed, reliable and high value-added services. An ISP needs to build a large customer base to take advantage of network externalities and economies of scale. Recently two of China ISPs,163 and 169, were integrated into one platform. This will make better use of the ISP resources of the two previously separated platforms. The ISP 263 is also considering cooperating with Cable Networks and providing Internet access services jointly. The major ISPs in China includeying-hai-wei Oriental Netscape Netease 263 etc.. Some ISPs like 163 also provide their own VIII

9 Internet contents. We call these companies Access Service Providers (ASPs). The current problem in the ISP market is fair and equal access. Since the China Telecom owns the majority of China s Internet backbone bandwidths, most ISPs need to lease bandwidths from it. The China telecom is charging lower leasing fees to its own ISPs than to others. The issue of equal and fair access remains to be solved. ICPs Competitive Advantage Comes from Personalized product and Service It is said that the network economy is the economy of attention.. This particularly refers to the layer of Internet contents providers. By the end of 2000, there had been domain names registered, and the number of web sites had reached Fierce competition in this market makes the market of ICPs close to perfect competition. To draw attention of viewers, ICPs need to provide personalized products and services that satisfy the unique needs of the consumers. Battle of the Last Mile digital convergence of data, voice and video To be concrete, the last mile service is the physical connection from the backbone to the end user. For example it may be the segment from the local telephone exchange switches to a user s home; it could also be the part from a Local Area Network (LAN) to the end user. Currently the last IX

10 mile service is almost 100% provided by the China Telecom. With the rapid advancement of ICT technology, the last mile connection will no longer be limited to phone line. Cable line, wireless phones will break up the monopoly situation of telecom in controlling this segment of the network. The so- called digital convergence of data, voice and video networks will foster a competitive landscape in the last mile. This will not only reduce interne congestion phenomenon but also will lower the prices for Internet connection and benefit the consumers. Business Activities centered on the Internet Creating value using the new medium Besides the network enablers, the other major layer of the network economy is the businesses that live on the opportunities provided by the Internet, such as online intermediaries that provide a platform for transactions between buyers and sellers. Internet also changes the way traditional businesses are conducted. Some success stories include Dell computer s direct sale model and Cisco Systems B2B model. The success of this layer of the network economy depends on choosing the right business models and right execution. 3.The Interrelated relationship among layers of the network economy X

11 We have discussed the different layers of the network economy. In fact, these layers are not independent from each other. Coordination among them is very important. The most important characteristic of the network economy is ability of interconnection. The power of the Internet lies in its being the network of networks. Each layer is playing different roles in this huge network. If we compare the Internet backbones to the superhighway, the ISPs play similar roles as the side-roads to the highways. The ICPs are similar to the economic activities on the highways such as traffics, transportation, advertisements etc. The last miles can be compared to the numerous tracks to the buildings besides the side-roads and the highways. To fully make use of the functions of the highway systems, all the segments have to be connected smoothly; this is also the power of the Internet and the network economy. The government plays an irreplaceable role in the network economy. It needs to find balance between the interests of private parties and the social welfare, it also should get involved in the task of setting up the industry standards and regulating markets. We can learn lessons from the practices of the governments of developed countries such as the United States. To promote market efficiency, the Federal Communications Committee (FCC) of the US ordered the dissolution of AT&T in 1980s. In the most recent AOL and Time Warner merger case, the role of the XI

12 FCC can also be seen clearly. The Ministry of Information Industry of China ought to play a similar role in coordinating the interests of all the parties involved in the network economy. 4. Conclusions The network economy has new characteristics compared with the traditional industrial economy. It is made up of different layers. It is not likely to promote the market structures of perfect competition in each layer, which is also not socially efficient. Each layer of the network economy has its own appropriate market structure. The government is playing an important role in coordinating the activities and interests of all the parties involved. Reference: 1. William W. Sharkey: The Theory of Natural Monopoly. Camgridge University Press, Jean Tirole: The Theory of Industrial Organization. The MIT Press, Zhou Qi-Ren,Convergence of the three networks and competition of the networks (in Chinese) Cai Jing 1998, 11. XII