Economic FAQ about the Internet from 1994
by Jeffrey K. MacKie-Mason and Hal Varian
University of Michigan and NBER
University of Michigan
Current version: April 4, 1994
Abstract. This is a set of Frequently Asked Questions (and answers)
about the economic, institutional, and technological structure of the
Internet. We describe the current state of the Internet, discuss
some of the pressing economic and regulatory problems, and speculate
about future developments.
This paper will appear in the Journal of Economic Perspectives in the
Fall of 1994. The most current version of this paper will always be
available for anonymous ftp, gopher, or World Wide Web at
gopher.econ.lsa.umich.edu. We wish to thank the National Science
Foundation for financial support. The definitive version of the paper
is available in PostScript; this is a rough ASCII translation provided
for the convenience of those who do not have ready access to
PostScript. Hal Varian maintains a WWW archive of materials relating
to the economics of the Internet at http://gopher.econ.lsa.umich.edu.
Address. Department of Economics, University of Michigan, Ann Ar-
bor, MI 48109-1220. E-mail: [email protected] and [email protected].
Economic FAQs About the Internet
Jeffrey K. MacKie-Mason
Hal Varian
1. What is a FAQ?
FAQ stands for Frequently Asked Questions. There are dozens of FAQ
documents on diverse topics available on the Internet, ranging
from physics to scuba diving to how to contact the White House. They are
produced and maintained by volunteers. This FAQ answers questions
about the economics of the Internet (and towards the end offers some
opinions and forecasts). The companion paper in this Symposium, Goffe
(1994), describes Internet resources of interest to economists, including
how to find other FAQs.
2. Background
What is the Internet?
The Internet is a world-wide network of computer networks that use a
common communications protocol, TCP/IP (Transmission Control Pro-
tocol/Internet Protocol). TCP/IP provides a common language for inter-
operation between networks that use a variety of local protocols (Netware,
AppleTalk, DECnet and others).
Where did it come from?
In the late sixties, the Advanced Research Projects Administration (ARAPA),
a division of the U.S. Defense Department, developed the ARPAnet to
link together universities and high-tech defense contractors. The TCP/IP
technology was developed to provide a standard protocol for ARPAnet
communications. In the mid-eighties the NSF created the NSFNET in
order to provide connectivity to its supercomputer centers, and to provide
other general services. The NSFNET adopted the TCP/IP protocol and
provided a high-speed backbone for the developing Internet.
How big is the Internet?
>From 1985 to January 1994, the Internet has grown from about 200
networks to well over 21,000 and from 1,000 hosts (end-user computers)
to over two million. About 640,000 of these hosts are at educational sites,
520,000 are commercial sites, and about 220,000 are government/military
sites, while most of the other 700,000 hosts are elsewhere in the world.
NSFNET traffic has grown from 85 million packets in January 1988 to
46 billion packets in December 1993. (A packet is about 200 bytes, and
a byte corresponds to one ASCII character.) This is more than a five
hundred-fold increase in only six years. The traffic on the network is
currently increasing at a rate of 6% a month.1
What do people do on the Internet?
Probably the most frequent use is e-mail. After that are file transfer
(moving data from one computer to another) and remote login (logging
into a computer that is running somewhere else on the Internet). In terms
of traffic, about 42% of total traffic is file transfer, 17% is e-mail, and
24% is #other services#, including information retrieval programs such
as gopher, Mosaic and World Wide Web. People can search databases
(including the catalogs of the Library of Congress and scores of university
research libraries), download data and software, and ask (or answer)
questions in discussion groups on numerous topics (including economics
research). See Goffe (1994) for a catalog of network resources of interest
to economists.
3. Organization
Who runs the Internet?
The short answer is #no one.# The Internet is a loose amalgamation
of computer networks run by many different organizations in over sev-
enty countries. Most of the technological decisions are made by small
committees of volunteers who set standards for interoperability.
What is the structure of the Internet?
The Internet is usually described as a three-level hierarchy. At the bottom
are local area networks (LANs); for example, campus networks. Usually
the local networks are connected to a regional, or mid-level network. The
mid-levels connect to one or more backbones. The U.S. backbones con-
nect to other backbone networks around the world. There are, however,
numerous exceptions to this structure.
What is a regional net?
Regional networks provide connectivity between end users and the NSFNET
backbone. Most universities and large organizations are connected by
leased line to a regional provider. There are currently about a dozen
regional networks.
Some of the regional networks receive subsidies from the NSF; many
receive subsidies from state governments. A large share of their funds
are collected through connection fees charged to organizations that attach
their local networks to the mid-levels. For example, a large university
will typically pay $60,000-$100,000 per year to connect to a regional.
Who runs the regionals?
The regionals are generally run by a state agency, or by a coalition of state
agencies in a given geographic region. They are operated as nonprofit
organizations.
What are the backbone networks?
As of January 1994 there are four public fiber-optic backbones in the U.S.:
NSFNET, Alternet, PSInet, and SprintLink. The NSFNET is funded by
the NSF, and is the oldest, having evolved directly out of ARPANET,
the original TCP/IP network. The other backbones are private, for-profit
enterprises.
Why is there more than one backbone?
Due to its public funding, the NSFNET has operated under an Acceptable
Use Policy that limits use to traffic in support of research and education.
When the Internet began to rapidly grow in the late 1980s, there was
an increasing demand for commercial use. Since Internet services are
unregulated2 entry by new providers is easy, and the market for backbone
services is becoming quite competitive.
Nowadays the commercial backbones and the NSFNET backbone
interconnect so that traffic can flow from one to the other. Given the
fact that both research and commercial traffic is now flowing on the
same fiber, the NSF's Acceptable Use Policy has become pretty much
of a dead letter. The charges for these interconnections are currently
relatively small lump-sum payments, but there has been considerable
debate about whether usage-based #settlement charges# will have to be
put in place in the future.
Who runs the NSFNET?
Currently the NSF pays Merit, Inc. (Michigan Educational Research
Information Triad) to run the NSFNET. Merit in turn subcontracts the day-
to-day operation of the network to Advanced Network Services (ANS),
which is is a nonprofit firm founded in 1990 to provide network backbone
services. The initial funding for ANS was provided by IBM and MCI.
How much does NSFNET cost?
It is difficult to say how much the Internet as a whole costs, since it
consists of thousands of different networks, many of which are privately
owned. However, it is possible to estimate how much the NSFNET
backbone costs, since it is publicly supported. As of 1993, NSF pays
Merit about $11.5 million per year to run the backbone. Approximately
80% of this is spent on lease payments for the fiber optic lines and
routers (computer-based switches). About 7% of the budget is spent
on the Network Operations Center, which monitors traffic flows and
troubleshoots problems.
To give some sense of the scale of this subsidy, add to it the approx-
imately $7 million per year that NSF pays to subsidize various regional
networks, for a total of about $20 million. With current estimates that
there are approximately 20 million Internet users (most of whom are con-
nected to the NSFNET in one way or another) the NSF subsidy amounts
to about $2 per person per year. Of course, this is significantly less than
the total cost of the Internet; indeed, it does not even include all of the
public funds, which come from state governments, state-supported uni-
versities, and other national governments as well. No one really knows
how much all this adds up to, although there are some research projects
underway to try to estimate the total U.S. expenditures on the Internet.
It has been estimated--read #guessed#--that the NSF subsidy of $20
million per year is less than 10% of the total U.S. expenditure on the
Internet.
What is the future for a federally-funded backbone?
The NSFNET backbone will likely be gone by the time this article is
published, or soon thereafter. With the proliferation of commercial back-
bones and regional network interconnections, a general-purpose federally
subsidized backbone is no longer needed. In the new NSF awards just an-
nounced, the NSF will only fund a set of Network Access Points (NAPs),
which will be hubs to connect the many private backbones and regional
networks. The NSF will also fund a service that will provide fair and
efficient routing among the various backbones and regionals. Finally,
the NSF will fund a very-high speed backbone network service (vBNS)
connecting the six supercomputer sites, with restrictions on the users and
traffic that it can carry. Its emphasis will be on developing capabilities
for high-definition remote visualization and video transmission. The new
U.S. network structure will be less hierarchical and more interconnected.
The separation between the backbone and regional network layers of the
current structure will become blurred, as more regionals are connected
directly to each other through NAPs, and traffic passes through a chain
of regionals without any backbone transport.
What are independent providers?
Most users access the Internet through their employer's organizational
network, which is connected to a regional. However, in the past few
years a number of for-profit independent providers of Internet access
have emerged. These typically provide connections between small orga-
nizations or individuals and a regional, using either leased lines or dial-up
access. Starting in 1993 some of the private computer networks (e.g.,
Delphi and World) have begun to offer full Internet access to their cus-
tomers (Compuserve and the other private networks have offered e-mail
exchange to the Internet for several years).
Who provides access outside of the U.S.?
There are now a large number of backbone and mid-level networks in
other countries. For example, most western European countries have
national networks that are attached to EBone, the European backbone.
The infrastructure is still immature, and quite inefficient in some places.
For example, the connections between other countries often are slow or
of low quality, so it is common to see traffic between two countries that
is routed through the NSFNET in the U.S. (Braun and Claffy [1993]).
4. Technology
Is the Internet different from telephone networks?
Yes and no. Most backbone and regional network traffic moves over
leased phone lines, so at a low level the technology is the same. However,
there is a fundamental distinction in how the lines are used by the Internet
and the phone companies. The Internet provides connectionless packet-
switched service whereas telephone service is circuit-switched. (We
define these terms below.) The difference may sound arcane, but it has
vastly important implications for pricing and the efficient use of network
resources.
What is circuit-switching?
Phone networks use circuit switching: an end-to-end circuit must be
set up before the call can begin. A fixed share of network resources is
reserved for the call, and no other call can use those resources until the
original connection is closed. This means that a long silence between
two teenagers uses the same resources as an active negotiation between
two fast-talking lawyers. One advantage of circuit-switching is that
it enables performance guarantees such as guaranteed maximum delay,
which is essential for real-time applications like voice conversations. It is
also much easier to do detailed accounting for circuit-switched network
usage.
How is packet-switching technology different from circuit-switching?
The Internet uses #packet-switching# technology. The term #packets#
refers to the fact that the data stream from your computer is broken up
into #packets# of about 200 bytes (on average), which are then sent out
onto the network.3 Each packet contains a #header# with information
necessary for routing the packet from origination to destination. Thus
each packet in a data stream is independent.
The main advantage of packet-switching is that it permits #statistical
multiplexing# on the communications lines. That is, the packets from
many different sources can share a line, allowing for very efficient use
of the fixed capacity. With current technology, packets are generally
accepted onto the network on a first-come, first-served basis. If the
network becomes overloaded, packets are delayed or discard (#dropped#).
How are packets routed to their destination?
The Internet technology is connectionless. This means that there is no
end-to-end setup for a session; each packet is independently routed to
its destination. When a packet is ready, the host computer sends it
on to another computer, known as a router. The router examines the
destination address in the header and passes the packet along to another
router, chosen by a route-finding algorithm. A packet may go through 30
or more routers in its travels from one host computer to another. Because
routes are dynamically updated, it is possible for different packets from
a single session to take different routes to the destination.
Along the way packets may be broken up into smaller packets, or
reassembled into bigger ones. When the packets reach their final desti-
nation, they are reassembled at the host computer. The instructions for
doing this reassembly are part of the TCP/IP protocol.
Some packet-switching networks are #connection-oriented# (notably,
X.25 networks, such as Tymnet and frame-relay networks). In such a
network a connection is set up before transmission begins, just as in
a circuit-switched network. A fixed route is defined, and information
necessary to match packets to their session and defined route is stored in
memory tables in the routers. Thus, connectionless networks economize
on router memory and connection set-up time, while connection-oriented
networks economize on routing calculations (which have to be redone for
every packet in a connectionless network).
What is the physical technology of the Internet?
Most of the network hardware in the Internet consists of communications
lines and switches or routers. In the regional and backbone networks, the
lines are mostly leased telephone trunk lines, which are increasingly fiber
optic. Routers are computers; indeed, the routers used on the NSFNET
are modified commercial IBM RS6000 workstations, although custom-
designed routers by other companies such as Cisco, Wellfleet, 3-Com and
DEC probably have the majority share of the market.
What does #speed# mean?
#Faster# networks do not move electrons or photons at faster than the
speed of light; a single bit travels at essentially the same speed in all
networks. Rather, #faster# refers to sending more bits of information
simultaneously in a single data stream (usually over a single communica-
tions line), thus delivering n bits faster. Phone modem users are familiar
with recent speed increases from 300 bps (bits per second) to 2400, 9600
and now 19,200 bps. Leased-line network speeds have advanced from
56 Kbps (kilo, or 10^3 bps) to 1.5 Mbps (mega, or 10^6 bps, known as
T-1 lines) in the late 80s, and then to 45 Mbps (T-3) in the early 90s.
Lines of 155 Mbps are now available, though not yet widely used. The
U.S. Congress has called for a 1 Gbps (giga, or 10^9 bps) backbone by
1995.
The current T-3 45 Mbps lines can move data at a speed of 1,400 pages
of text per second; a 20-volume encyclopedia can be sent coast to coast
on the NSFNET backbone in half a minute. However, it is important to
remember that this is the speed on the superhighway--the access roads
via the regional networks usually use the much slower T-1 connections.
Why do data networks use packet-switching?
Economics can explain most of the preference for packet-switching over
circuit-switching in the Internet and other public networks. Circuit net-
works use lots of lines in order to economize on switching and routing.
That is, once a call is set up, a line is dedicated to its use regardless of
its rate of data flow, and no further routing calculations are needed. This
network design makes sense when lines are cheap relative to switches.
The costs of both communications lines and computers have been de-
clining exponentially for decades. However, since about 1970, switches
(computers) have become relatively cheaper than lines. At that point
packet switching became economic: lines are shared by multiple con-
nections at the cost of many more routing calculations by the switches.
This preference for using many relatively cheap routers to manage few
expensive lives is evident in the topology of the backbone networks. For
example, in the NSFNET any packet coming on to the backbone has to
pass through two routers at its entry point and again at its exit point.
A packet entering at Cleveland and exiting at New York traverses four
NSFNET routers but only one leased T-3 communications line.
What changes are likely in network technology?
At present there are many overlapping information networks (e.g., tele-
phone, telegraph, data, cable TV), and new networks are emerging rapidly
(paging, personal communications services, etc.). Each of the current in-
formation networks is engineered to provide a particular type of service
and the added value provided by each of the different types was sufficient
to overcome the fixed costs of building overlapping physical networks.
However, given the high fixed costs of providing a network, the eco-
nomic incentive to develop an #integrated services# network is strong.
Furthermore, now that all information can be easily digitized the need
for separate networks for separate types of traffic is no longer necessary.
Convergence toward a unified, integrated services network is a basic
feature in most visions of the much publicized #information superhigh-
way.# The migration to integrated services networks will have important
implications for market structure and competition.
The international telephone community has committed to a future net-
work design that combines elements of both circuit and packet switching
to enable the provision of integrated services. The CCITT (an inter-
national standards body for telecommunications) has adopted a #cell-
switching# technology called ATM (asynchronous transfer mode) for
future high-speed networks. Cell switching closely resembles packet
switching in that it breaks a data stream into packets which are then
placed on lines that are shared by several streams. One major difference
is that cells have a fixed size while packets can have different sizes. This
makes it possible in principle to offer bounded delay guarantees (since a
cell will not get stuck for a surprisingly long time behind an unusually
large packet).
An ATM network also resembles a circuit-switched network in that it
provides connection-oriented service. Each connection has set-up phase,
during which a #virtual circuit# is created. The fact that the circuit is
virtual, not physical, provides two major advantages. First, it is not nec-
essary to reserve network resources for a given connection; the economic
efficiencies of statistical multiplexing can be realized. Second, once a
virtual circuit path is established switching time is minimized, which al-
lows much higher network throughput. Initial ATM networks are already
being operated at 155 Mbps, while the non-ATM Internet backbones op-
erate at no more than 45 Mbps. The path to 1000 Mbps (gigabit) networks
seems much clearer for ATM than for traditional packet switching.
When will the #information superhighway# arrive?
The federal High Performance Computing Act of 1991 aimed for a gigabit
per second (Gbps) national backbone by 1995. Six federally-funded
testbed networks are currently demonstrating various gigabit approaches.
To get a feel for how fast a gigabit is, note that most small colleges or
universities today have 56 Kbps Internet connections. At 56 Kbps it takes
about five hours to transmit one gigabit!
Efforts to develop integrated services networks also have exploded.
Several cable companies have already started offering Internet connec-
tions to their customers.4 ATT, MCI and all of the #Baby Bell# operating
companies are involved in mergers and joint ventures with cable TV and
other specialized network providers to deliver new integrated services
such as video-on-demand. ATM-based networks, although initially de-
veloped for phone systems, ironically have been first implemented for
data networks within corporations and by some regional and backbone
providers.
5. How is Internet access priced?
What types of pricing schemes are used?
Until recently, nearly all users faced the same pricing structure for In-
ternet usage. A fixed-bandwidth connection was charged an annual fee,
which allowed for unlimited usage up to the physical maximum flow rate
(bandwidth). We call this #connection pricing#. Most connection fees
were paid by organizations (universities, government agencies, etc.) and
the users paid nothing themselves.
Simple connection pricing still dominates the market, but a number of
variants have emerged. The most notable is #committed information rate#
pricing. In this scheme, an organization is charged a two-part fee. One
fee is based on the bandwidth of the connection, which is the maximum
feasible flow rate; the second fee is based on the maximum guaranteed
flow to the customer. The network provider installs sufficient capacity
to simultaneously transport the committed rate for all of its customers,
and installs flow regulators on each connection. When some customers
operate below that rate, the excess network capacity is available on a first-
come, first-served basis for the other customers. This type of pricing is
more common in private networks than in the Internet because a TCP/IP
flow rate can be guaranteed only network by network, greatly limiting its
value unless a large number of the 20,000 Internet networks coordinate
on offering this type of guarantee.
Networks that offer committed information pricing generally have
enough capacity to meet the entire guaranteed bandwidth. This is a
bit like a bank holding 100% reserves, but is necessary with existing
technology since there is no commonly used way to prioritize packets.
For most usage, the marginal packet placed on the Internet is priced at
zero. At the outer fringes there are a few exceptions. For example, several
private networks (such as Compuserve) provide email connections to the
Internet. Several of these charge per message above a low threshold. The
public networks in Chile and New Zealand charge their customers by the
packet for all international traffic. We discuss some implications of this
kind of pricing below.
6. What economic problems does the Internet face?
If you have read this far in the article, you should have a good basic
understanding of the current state of the Internet--we hope that most of
the questions you have had about the how the Internet works have been
answered. Starting here we will move from FAQs and #facts# towards
conjectures and FEOs (firmly expressed opinions).
How can the Internet deal with increasing congestion?
Nearly all usage of the Internet backbones is unpriced at the margin.
Organizations pay a fixed fee in exchange for unlimited access up to
the maximum throughput of their particular connection. This is a clas-
sic problem of the commons. The externality exists because a packet-
switched network is a shared-media technology: each extra packet that I
send imposes a cost on all other users because the resources I am using
are not available to them. This cost can come in form of delay or lost
(#dropped#) packets.
Without an incentive to economize on usage, congestion can become
quite serious. Indeed, the problem is more serious for data networks than
for many other congestible resources because of the tremendously wide
range of usage rates. On a highway, for example, at a given moment a
single user is more or less limited to either putting zero or one cars on the
road. In a data network, however, single user at a modern workstation
can send a few bytes of e-mail or put a load of hundreds of Mbps on
the network. Within a year any undergraduate with a new Macintosh
will be able to plug in a video camera and transmit live videos home to
mom, demanding as much as 1 Mbps. Since the maximum throughput on
current backbones is only 45 Mbps, it is clear that even a few users with
relatively inexpensive equipment could bring the network to its knees.
Congestion problems are not just hypothetical. For example, conges-
tion was quite severe in 1987 when the NSFNET backbone was running
at much slower transmission speeds (1.5 Mbps). Users running interac-
tive remote terminal sessions were experiencing unacceptable delays. As
a temporary fix, the NSFNET programmed the routers to give terminal
sessions (using the telnet program) higher priority than file transfers
(using the ftp program). (See Goffe (1994) paper for a description of
telnet and ftp.)
More recently, many services on the Internet have experienced se-
vere congestion problems. Large ftp archives, Web servers at the Na-
tional Center for Supercomputer Applications, the original Archie site
at McGill University and many services have had serious problems with
overuse. See Markoff (1993) for more detailed descriptions.
If everyone just stuck to ASCII email congestion would not likely
become a problem for many years, if ever. However, the demand for
multi-media services is growing dramatically. New services such as
Mosaic and Internet Talk Radio are consuming ever-increasing amounts
of bandwidth. The supply of bandwidth is increasing dramatically, but
so is the demand. If usage remains unpriced is is likely that there will
be periods when the demand for bandwidth exceeds the supply in the
foreseeable future.
What non-price mechanisms can be used for congestion control?
Administratively assigning different priorities to different types of traffic
is appealing, but impractical as a long-run solution to congestion costs
due to the usual inefficiencies of rationing. However, there is an even
more severe technological problem: it is impossible to enforce. From
the network's perspective, bits are bits and there is no certain way to
distinguish between different types of uses. By convention, most standard
programs use a unique identifier that is included in the TCP header (called
the #port# number); this is what NSFNET used for its priority scheme in
1987. However, it is a trivial matter to put a different port number into the
packet headers; for example to assign the telnet number to ftp packets
to defeat the 1987 priority scheme. To avoid this problem, NSFNET kept
its prioritization mechanism secret, but that is hardly a long-run solution.
What other mechanisms can be used to control congestion? The
most obvious approach for economists is to charge some sort of usage
price. However, to date, there has been almost no serious consideration
of usage pricing for backbone services, and even tentative proposals for
usage pricing have been met with strong opposition. We will discuss
pricing below but first we examine some non-price mechanisms that have
been proposed.
Many proposals rely on voluntary efforts to control congestion. Nu-
merous participants in congestion discussions suggest that peer pressure
and user ethics will be sufficient to control congestion costs. For example,
recently a single user started broadcasting a 350-450Kbps audio-video
test pattern to hosts around the world, blocking the network's ability to
handle a scheduled audio broadcast from a Finnish university. A leading
network engineers sent a strongly-worded e-mail message to the user's
site administrator, and the offending workstation was disconnected from
the network. However, this example also illustrates the problem with
relying on peer pressure: the inefficient use was not terminated until after
it had caused serious disruption. Further, it apparently was caused by
a novice user who did not understand the impact of what he had done;
as network access becomes ubiquitous there will be an ever-increasing
number of unsophisticated users who have access to applications that
can cause severe congestion if not properly used. And of course, peer
pressure may be quite ineffective against malicious users who want to
intentionally cause network congestion.
One recent proposal for voluntary control is closely related to the 1987
method used by the NSFNET (Bohn, Braun, Claffy, and Wolff (1993)).
This proposal would require users to indicate the priority they want each
of their sessions to receive, and for routers to be programmed to maintain
multiple queues for each priority class. Obviously, the success of this
scheme would depend on users' willingness to assign lower priorities to
some of their traffic. In any case, as long as it is possible for just one
or a few abusive users to create crippling congestion, voluntary priority
schemes that are not robust to forgetfulness, ignorance, or malice may be
largely ineffective.
In fact, a number of voluntary mechanisms are in place today. They
are somewhat helpful in part because most users are unaware of them,
or because they require some programming expertise to defeat. For
example, most implementations of the TCP protocols use a #slow start#
algorithm which controls the rate of transmission based on the current
state of delay in the network. Nothing prevents users from modifying
their TCP implementation to send full throttle if they do not want to
behave #nicely.#
A completely different approach to reducing congestion is purely
technological: overprovisioning. Overprovisioning means maintaining
sufficient network capacity to support the peak demands without notice-
able service degradation.5 This has been the most important mechanism
used to date in the Internet. However, overprovisioning is costly, and
with both very-high-bandwidth applications and near-universal access
fast approaching, it may become too costly. In simple terms, will the cost
of capacity decline faster than the growth in capacity demand?
Given the explosive growth in demand and the long lead time needed
to introduce new network protocols, the Internet may face serious prob-
lems very soon if productivity increases do not keep up. Therefore, we
believe it is time to seriously examine incentive-compatible allocation
mechanisms, such as various forms of usage pricing.
How can users be induced to choose the right level of service?
The current Internet offers a single service quality: #best efforts packet
service.# Packets are transported first-come, first-served with no guaran-
tee of success. Some packets may experience severe delays, while others
may be dropped and never arrive.
However, different kinds of data place different demands on network
services. E-mail and file transfers requires 100% accuracy, but can easily
tolerate delay. Real-time voice broadcasts require much higher bandwidth
than file transfers, and can only tolerate minor delays, but they can
tolerate
significant distortion. Real time video broadcasts have very low tolerance
for delay and distortion.
Because of these different requirements, network routing algorithms
will want to treat different types of traffic differently--giving higher
priority to, say, real-time video than to e-mail or file transfer. But in
order to do this, the user must truthfully indicate what type of traffic he
or she is sending. If real-time video bit streams get the highest quality
service, why not claim that all of your bit streams are real-time video?
Cocchi, Estrin, Shenker, and Zhang (1992) point out that it is useful
to look at network pricing as mechanism design problem. The user can
indicate the #type# of his transmission, and the workstation in turn reports
this type to the network. In order to ensure truthful revelation of prefer-
ences, the reporting and billing mechanism must be incentive compatible.
The field of mechanism design has been criticized for ignoring bounded
rationality of human subjects. However, in this context, the workstation
is doing most of the computation, so that quite complex mechanisms may
be feasible.
What are the problems associated with Internet accounting?
One of the first necessary steps for implementing usage-based pricing
(either for congestion control or multiple service class allocation) is to
measure and account for usage. Accounting poses some serious prob-
lems. For one thing, packet service is inherently ill-suited to detailed
usage accounting, because every packet is independent. As an exam-
ple, a one-minute phone call in a circuit-switched network requires one
accounting entry in the usage database. But in a packet network that
one-minute phone call would require around 2500 average-sized pack-
ets; complete accounting for every packet would then require about 2500
entries in the database. On the NSFNET alone over 40 billion packets
are being delivered each month. Maintaining detailed accounting by the
packet similar to phone company accounting may be too expensive.
Another accounting problem concerns the granularity of the records.
Presumably accounting detail is most useful when it traces traffic to
the user. Certainly if the purpose of accounting is to charge prices
as incentives, those incentives will be most effective if they affect the
person actually making the usage decisions. But the network is at best
capable of reliably identifying the originating host computer (just as
phone networks only identify the phone number that placed a call, not
the caller). Another layer of expensive and complex authorization and
accounting software will be required on the host computer in order to
track which user accounts are responsible for which packets.6 Imagine,
for instance, trying to account for student e-mail usage at a large public
computer cluster.
Accounting is more practical and less costly the higher the level of
aggregation. For example, the NSFNET already collects some informa-
tion on usage by each of the subnetworks that connect to its backbone
(although these data are based on a sample, not an exhaustive accounting
for every packet). Whether accounting at lower levels of aggregation is
worthwhile is a different question that depends importantly on cost-saving
innovations in internetwork accounting methods.
Does network usage need to be priced?
Network resources are scarce, and thus some allocation scheme is re-
quired. We explained above why voluntary and technological allocation
mechanisms are unlikely to remain satisfactory. Various forms of usage
pricing have desirable features for congestion control, and are likely to be
equally desirable for allocating multiple service classes in an integrated
services network.
In any case, voluntary schemes will require substantial overprovision-
ing to handle the burstiness of demand, and the wide range of bandwidths
required by different applications. Excess capacity has been subsidized
heavily--directly or indirectly--through public funding. While provid-
ing network services as a zero marginal price public good probably made
sense during the research, development and deployment phases of the
Internet, it is harder to rationalize as the network matures and becomes
widely used by commercial interests. Why should data network usage be
free even to universities, when telephone and postal usage are not?7
Indeed, the Congress required that the federally-developed gigabit
network technology must accommodate usage accounting and pricing.
Further, the NSF will no longer provide backbone services, leaving the
general purpose public network to commercial and state agency providers.
As the net increasingly becomes privatized, competitive forces may ne-
cessitate the use of more efficient allocation mechanisms. Thus, it appears
that there are both public and private pressures for serious consideration
of pricing. The trick is to design a pricing system that minimizes trans-
actions costs.
What should be priced?
Standard economic theory suggests that prices should be matched to costs.
There are three main elements of network costs: the cost of connecting
to the net, the cost of providing additional network capacity, and the
social cost of congestion. Once capacity is in place, direct usage cost is
negligible, and by itself is almost surely is not worth charging for given
the accounting and billing costs.8
Charging for connections is conceptually straightforward: a connec-
tion requires a line, a router, and some labor effort. The line and the
router are reversible investments and thus are reasonably charged for on
annual lease basis (though many organizations buy their own routers).
Indeed, this is essentially the current scheme for Internet connection fees.
Charging for incremental capacity requires usage information. Ide-
ally, we need a measure of the organization's demand during the expected
peak period of usage over some period, to determine its share of the incre-
mental capacity requirement. In practice, it might seem that a reasonable
approximation would be to charge a premium price for usage during pre-
determined peak periods (a positive price if the base usage price is zero),
as is routinely done for electricity. However, casual evidence suggests
that peak demand periods are much less predictable than for other utility
services. One reason is that it is very easy to use the computer to schedule
some activities for off-peak hours, leading to a shifting peaks problem.9
In addition, so much traffic traverses long distances around the globe
that time zone differences are important. Network statistics reveal very
irregular time-of-day usage patterns (MacKie-Mason and Varian (1994)).
How might congestion be priced?
We have elsewhere described a scheme for efficient pricing of the con-
gestion costs (1994a,b). The basic problem is that when the network is
near capacity, a user's incremental packet imposes costs on other users
in the form of delay or dropped packets. Our scheme for internalizing
this cost is to impose a congestion price on usage that is determined by
a real-time Vickrey auction. Following the terminology of Vernon Smith
and Charles Plott, we call this a #smart market.#
The basic idea is simple. Much of the time the network is uncon-
gested, and the price for usage should be zero. When the network is
congested, packets are queued and delayed. The current queuing scheme
is FIFO. We propose instead that packets should be prioritized based on
the value that the user puts on getting the packet through quickly. To do
this, each user assigns her packets a bid measuring her willingness-to-pay
for immediate servicing. At congested routers, packets are prioritized
based on willingness-to-pay. In order to make the scheme incentive-
compatible, users are charged not their own willingness-to-pay, however,
but the packet price of the lowest priority packet that is admitted to the
network. It is well-known that this mechanism provides the right incentives
for truthful revelation.
This scheme has a number of nice features. In particular, not only do
those with the highest cost of delay get served first, but the prices also
send the right signals for capacity expansion in a competitive market for
network services. If all of the congestion revenues are reinvested in new
capacity, then capacity will be expanded to the point where its marginal
value is equal to its marginal cost.
What are some problems with a smart market?
Prices in a real-world smart market cannot be updated continuously.
The efficient price is determined by comparing a list of user bids to the
available capacity and determining the cutoff price. In fact, packets arrive
not all at once but over time, and thus it would be necessary to clear the
market periodically based on a time-slice of bids. The efficiency of this
scheme, then, depends on how costly it is to frequently clear the market
and on how persistent the periods of congestion are. If congestion is
exceedingly transient then by the time the market price is updated the
state of congestion may have changed.
A number of network specialists have suggested that many customers--
particularly not-for-profit agencies and schools--will object because they
do not know in advance how much network utilization will cost them.
We believe that this argument is partially a red herring, since the user's
bid always controls the maximum network usage costs. Indeed, since we
expect that for most traffic the congestion price will be zero, it should be
possible for most users to avoid ever paying a usage charge by simply
setting all packet bids to zero.10 When the network is congested enough
to have a positive congestion price, these users will pay the cost in units
of delay rather than cash, as they do today.
We also expect that in a competitive market for network services, fluc-
tuating congestion prices would usually be a #wholesale# phenomenon,
and that intermediaries would repackage the services and offer them at
a guaranteed price to end-users. Essentially this would create a futures
market for network services.
There are also auction-theoretic problems that have to be solved. Our
proposal specifies a single network entry point with auctioned access.
In practice, networks have multiple gateways, each subject to differing
states of congestion. Should a smart market be located in a single,
central hub, with current prices continuously transmitted to the many
gateways? Or should a set of simultaneous auctions operate at each
gateway? How much coordination should there be between the separate
auctions? All of these questions need not only theoretical models, but
also empirical work to determine the optimal rate of market-clearing and
inter-auction information sharing, given the costs and delays of real-time
communication.
Another serious problem for almost any usage pricing scheme is
how to correctly determine whether sender or receiver should be billed.
With telephone calls it is clear that in most cases the originator of a call
should pay. However, in a packet network, both #sides# originate their
own packets, and in a connectionless network there is no mechanisms
for identifying party B's packets that were solicited as responses to a
session initiated by party A. Consider a simple example: A major use
of the Internet is for file retrieval from public archives. If the originator
of each packet were charged for that packet's congestion cost, then the
providers of free public goods (the file archives) would pay nearly all
of the congestion charges induced by a user's file request.11 Either
the public archive provider would need a billing mechanism to charge
requesters for the (ex post) congestion charges, or the network would
need to be engineered so that it could bill the correct party. In principle
this problem can be solved by schemes like #800#, #900# and collect
phone calls, but the added complexity in a packetized network may make
these schemes too costly.
How large would congestion prices be?
Consider the average cost of the current NSFNET: about $106 per month,
for about 42,000 x 10^6 packets per month. This implies a cost per packet
(around 200 bytes) of about 1/420 cents. If there are 20 million users of
the NSFNET backbone (10 per host computer), then full cost recovery
of the NSFNET subsidy would imply an average monthly bill of about
$0.05 per person. If we accept the estimate that the total cost of the U.S.
portion of the Internet is about 10 times the NSFNET subsidy, we come
up with 50 cents per person per month for full cost recovery. The revenue
from congestion fees would presumably be significantly less than this
amount.12
The average cost of the Internet is so small today because the tech-
nology is so efficient: the packet-switching technology allows for very
cost-effective use of existing lines and switches. If everyone only sent
ASCII email, there would probably never be congestion problems on
the Internet. However, new applications are creating huge demands for
additional bandwidth. A video e-mail message could easily use 10^4 more
bits than a plain text ASCII e-mail with the #same# information content
and providing this amount of incremental bandwidth could be quite ex-
pensive. Well-designed congestion prices would not charge everyone the
average cost of this incremental bandwidth, but instead charge those users
whose demands create the congestion and need for additional capacity.
How should information services be priced?
Our focus thus far has been on the technology, costs and pricing of
network transport. However, most of the value of the network is not in
the transport, but in the value of the information being transported. For
the full potential of the Internet to be realized it will be necessary to
develop methods to charge for the value of information services available
on the network.
There are vast troves of high-quality information (and probably equally
large troves of dreck) currently available on the Internet, all available as
free goods. Historically, there has been a strong base of volunteerism
to collect and maintain data, software and other information archives.
However, as usage explodes, volunteer providers are learning that they
need revenues to cover their costs. And of course, careful researchers
may be skeptical about the quality of any information provided for free.
Charging for information resources is quite a difficult problem. A
service like Compuserve charges customers by establishing a billing ac-
count. This requires that users obtain a password, and that the information
provider implement a sophisticated accounting and billing infrastructure.
However, one of the advantages of the Internet is that it is so
decentralized: information sources are located on thousands of different
computers. It would simply be too costly for every information provider to
set up an independent billing system and give out separate passwords to
each of its registered users. Users could end up with dozens of different
authentication mechanisms for different services.
A deeper problem for pricing information services is that our tra-
ditional pricing schemes are not appropriate. Most pricing is based on
the measurement of replications: we pay for each copy of a book, each
piece of furniture, and so forth. This usually works because the high
cost of replication generally prevents us from avoiding payment. If you
buy a table we like, we generally have to go to the manufacturer to buy
one for ourselves; we can't just simply copy yours. With information
goods the pricing-by-replication scheme breaks down. This has been a
major problem for the software industry: once the sunk costs of software
development are invested, replication costs essentially zero. The same is
especially true for any form of information that can be transmitted over
the network. Imagine, for example, that copy shops begin to make course
packs available electronically. What is to stop a young entrepreneur from
buying one copy and selling it at a lower price to everyone else in the
class? This is a much greater problem even than that which publishers
face from unauthorized photocopying, since the cost of replication is
essentially zero.
There is a small literature on the economics of copying that examines
some of these issues. However, the same network connections that ex-
acerbate the problems of pricing #information goods# may also help to
solve some of these problems. For example, Cox (1992, 1993) describes
the idea of #superdistribution# of #information objects# in which access-
ing a piece of information automatically sends a payment to the provider
via the network. However, there are several problems remaining to be
solved before such schemes can become widely used.
What is required for electronic commerce over the Internet?
Some companies have already begun to advertise and sell products and
services over the Internet. Home shopping is expected to be a major ap-
plication for future integrated services networks that transport sound and
video. Electronic commerce could substantially increase productivity
by reducing the time and other transactions costs inherent in commerce,
much as mail-order shopping has already begun to do. One important re-
quirement for a complete electronic commerce economy is an acceptable
form of electronic payment.13
Bank debit cards and automatic teller cards work because they have
reliable authentication procedures based on both a physical device and
knowledge of a private code. Digital currency over the network is more
difficult because it is not possible to install physical devices and protect
them from tampering on every workstation.14 Therefore, authentication
and authorization most likely will be based solely on the use of private
codes. Another objective is anonymity so individual buying histories can-
not be collected and sold to marketing agencies (or Senate confirmation
committees).
A number of recent computer science papers have proposed protocols
for digital cash, checks and credit, each of which has some desirable
features, yet none of which has been widely implemented thus far. The
seminal paper is Chaum (1985) which proposed an anonymous form of
digital cash, but one which required a single central bank to electronically
verify the authenticity of each #coin# when it was used. Medvinsky and
Neuman (1993) propose a form of digital check that is not completely
anonymous, but is much more workable for widespread commerce with
multiple banks. Low, Maxemchuk, and Paul (1994) suggest a protocol
for anonymous credit cards.
What does the Internet mean for telecommunications regulation?
The growth of data networks like the Internet are an increasingly impor-
tant motivation for regulatory reform of telecommunications. A primary
principle of the current regulatory structure, for example, is that local
phone service is a natural monopoly, and thus must be regulated. How-
ever, local phone companies face ever-increasing competition from data
network services. For example, the fastest growing component of tele-
phone demand has been for fax transmission, but fax technology is better
suited to packet-switching networks than to voice networks, and faxes
are increasingly transmitted over the Internet. As integrated services net-
works emerge, they will provide an alternative for voice calls and video
conferencing, as well. This "bypass" is already occurring in the advanced
private networks that many corporations, such as General Electric, are
building.
As a result, the trend seems to be toward removing of barriers against
cross-ownership of local phone and cable TV companies. The regional
Bell operating companies have filed a motion to remove the remaining
restrictions of the Modified Final Judgement that created them (with
the 1984 breakup of ATT). The White House, Congress, and the FCC
are all developing new models of regulation, with a strong bias towards
deregulation (for example, see the New York Times, 12 January 1994, p. 1).
Internet transport itself is currently unregulated. This is consistent
with the principal that common carriers are natural monopolies, and
must be regulated, but the services provided over those common carriers
are not. However, this principal has never been consistently applied
to phone companies: the services provided over the phone lines are
also regulated. Many public interest groups are now arguing for similar
regulatory requirements for the Internet.
One issue is "universal access," the assurance of basic service for all
citizens at a very low price. But what is "basic service"? Is it merely
a data line, or a multimedia integrated services connection? And in
an increasingly competitive market for communications services, where
should the money to subsidize universal access be raised? High-value
uses which traditionally could be charged premium prices by monopoly
providers are increasingly subject to competition and bypass.
A related question is whether the government should provide some
data network services as public goods. Some initiatives are already un-
derway. For instance, the Clinton administration has required that all
published government documents be available in electronic form. An-
other current debate concerns the appropriate access subsidy for primary
and secondary teachers and students.
What will be the market structure of the information highway?
If different components of local phone and cable TV networks are dereg-
ulated, what degree of competition is likely? Similar questions arise
for data networks. For example, a number of observers believe that by
ceding backbone transport to commercial providers, the federal govern-
ment has endorsed above-cost pricing by a small oligopoly of providers.
Looking ahead, equilibrium market structures may be quite different for
the emerging integrated services networks than they are for the current
specialized networks.
One interesting question is the interaction between pricing schemes
and market structure. If competing backbones continue to offer only
connection pricing, would an entrepreneur be able to skim off high-value
users by charging usage prices, but offering more efficient congestion
control? Alternatively, would a flat-rate connection price provider be
able to undercut usage-price providers, by capturing a large share of low-
value #baseload# customers who prefer to pay for congestion with delay
rather than cash? The interaction between pricing and market structure
may have important policy implications, because certain types of pricing
may rely on compatibilities between competing networks that will enable
efficient accounting and billing. Thus, compatibility regulation may
be needed, similar to the interconnect rules imposed on regional Bell
operating companies.
7. Further Reading
We have written two papers that provide further details on Internet tech-
nology, costs, and pricing problems (1994a, 1994b). In addition, a longer
and more up-to-date version of this paper is available as a World Wide Web
(WWW) document, with hypertext links to many related papers and data
sources. This file can be found at http://gopher.econ.lsa.umich.edu.
Scott Shenker and his colleagues have written two papers dealing
with pricing problems and the use of mechanism design to deal with
them (Cocchi et al. [1992], Shenker [1993], Cocchi, Estin, Shenker, and
Zhang [1991]). Huberman (1988) is a book that discusses computer
networks as market economies.
Partridge (1993) has written an excellent book for a general audience
interested in network technology now and in the near future. For a
detailed discussion of computer networking theory and technologies, see
Tanenbaum (1989). The best detailed treatment of the emerging ATM
technology is de Prycker (1991), but ATM is evolving so quickly that it
is already somewhat dated, and something better may be available by the
time this article is published.
References
Bohn, R., Braun, H.-W., Claffy, K., and Wolff, S. (1993). Mitigating the
coming Internet crunch: Multiple service levels via precedence.
Tech. rep., UCSD, San Diego Supercomputer Center, and NSF.
Braun, H.-W., and Claffy, K. (1993). Network analysis in support of
internet policy requirements. Tech. rep., San Diego Supercomputer
Center.
Chaum, D. (1985). Security without identification: Transaction systems
to make big brother obsolete. Communications of the ACM, 28(10),
1030-1044.
Cocchi, R., Estin, D., Shenker, S., and Zhang, L. (1991). A study of
priority pricing in multiple service class networks. In Proceedings
of Sigcomm '91. Available from:
ftp:ftp.parc.xerox.com/pub/net-research/pricing-sc.ps.
Cocchi, R., Estrin, D., Shenker, S., and Zhang, L. (1992). Pricing in
computer networks: Motivation, formulation, and example. Tech.
rep., University of Southern California.
de Prycker, M. (1991). Asynchronous Transfer Mode : Solution for
ISDN. Ellis Horwood, New York.
Goffe, W. (1994). Internet resources for economists. Tech. rep., Univer-
sity of Southern Mississippi. To appear in Journal of Economic
Perspectives Symposium. Available at gopher:niord.shsu.edu.
Huberman, B. (1988). The Ecology of Computation. North-Holland,
New York.
Low, S., Maxemchuk, N. F., and Paul, S. (1994). Anonymous credit cards.
Tech. rep., AT&T Bell Laboratories, Murray Hill, NJ. Available at
ftp://research.att.com/dist/anoncc/anoncc.ps.Z.
MacKie-Mason, J. K., and Varian, H. (1993). Some economics of the
internet. Tech. rep., University of Michigan.
MacKie-Mason, J. K., and Varian, H. (1994). Pricing the internet. In
Kahin, B., and Keller, J. (Eds.), Public Access to the Internet.
Unknown, Unknown.
Markoff, J. (1993). Traffic jams already on the information highway.
New York Times, November 3, A1.
Medvinsky, G., and Neuman, B. C. (1993). Netcash: A design for practical
electronic currency on the Internet. In Proceedings of the First
ACM Conference on Computer and Communications Security New York. ACM
Press. Available at:
ftp://gopher.econ.lsa.umich.edu/pub/Archive/netcash.ps.Z.
Partridge, C. (1993). Gigabit Networking. Addison-Wesley, Reading, MA.
Shenker, S. (1993). Service models and pricing policies for an integrated
services internet. Tech. rep., Palo Alto Research Center, Xerox
Corporation.
Tanenbaum, A. S. (1989). Computer Networks. Prentice Hall, Engle-
wood Cliffs, NJ.
Footnotes
The authors wish to acknowledge support from National Science Foundation.
1 Current NSFNET statistics are available by anonymous ftp from
nic.merit.edu.
2 Transport of TCP/IP packets is considered to be a #value-added service#
and as such is not regulated by the FCC or state public utility commissions.
3 Recall that a byte is one ASCII character.
4 Because the cable network is one-way, these connections use an
#asymmetric# network connector that brings the input in through the TV cable
at 10 Mbps, but sends the output out through a regular phone line at about
14.4 Kbps. This scheme may be popular since most users tend to download more
information than they upload.
5 The effects of network congestion are usually negligible until usage is
very close to capacity.
6 Statistical sampling could lower costs substantially, but its
acceptability depends on the level at which usage is measured--e.g., user or
organization--and on the statistical distribution of demand. For example,
strong serial correlation can cause problems.
7 Many university employees routinely use email rather than the phone to
communicate with friends and family at other Internet-connected sites.
Likewise, a service is now being offered to transmit faxes between cities
over the Internet for free, then paying only the local phone call charges
to deliver them to the intended fax machine.
8 See MacKie-Mason and Varian (1993).
9 The single largest current use of network capacity is file transfer,
much of which is distribution of files from central archives to distributed
local archives. The timing for a large fraction of file transfer is
likely to be flexible. Just as most fax machines allow faxes to be
transmitted at off-peak times, large data files could easily be
transferred at off-peak times--if users had appropriate incentives to
adopt such practices.
10 Since most users are willing to tolerate some delay for email, file
transfer and so forth, most traffic should be able to go through with
acceptable delays at a zero congestion price, but time-critical traffic
will typically pay a positive price.
11 Public file servers in Chile and New Zealand already face this problem:
any packets they send in response to requests from foreign hosts are
charged by the network. Network administrators in New Zealand are concerned
that this blind charging scheme is stifling the production of information
public goods. For now, those public archives that do exist have a sign-on
notice pleading with international users to be considerate of the
costs they are imposing on the archive providers.
12 If revenue from congestion fees exceed the cost of the network, it would
be profitable to expand the size of the network.
13 In our work on pricing for network transport (1994a, 1994b), we have
found that some form of secure electronic currency is almost surely
necessary if the transactions costs of accounting and billing are to be low
enough to justify usage pricing.
14 Traditional credit cards are unlikely to receive wide use over a data
network, though there is some use currently. It is very easy to set up an
untraceable computer account to fraudulently collect credit card numbers;
fraudulent telephone mail order operations are more difficult to arrange.
|