How the internet and its pricing really work


Today an op-ed by John Sununu and Harold Ford Jr. of "Broadband For America" (a group of cable companies and other ISPs which says it is really a grass-roots organization) declared that the net needs a better pricing model for what Netflix is doing. For a group of ISPs, they really seem to not understand how the internet works and how pricing works, so I felt it was worthwhile to describe how things work with a remarkably close analogy. (I have no association with Netflix, I am not even a customer, but I do stream video on the net.)

You can liken the internet to a package delivery service that works somewhat differently from traditional ones like the postal service or FedEx. The internet's pricing model is "I pay for my line to the middle, and you pay for your line to the middle and we don't account for the costs of individual traffic."

In the package model, imagine a big shipping depot. Shippers send packages to this depot, and it's the recipient's job to get the package from the depot to their house. The shippers pay for their end, you pay for your end, and both share the cost of creating the depot.

Because most people don't want to go directly to the depot to get their packages, a few "last mile" delivery companies have sprung up. For a monthly fee, they will deliver anything that shows up at the depot addressed to you directly to your house. They advertise in fact, that for the flat fee, they will deliver as many packages as show up, subject to a fairly high maximum rate per unit of time (called bandwidth in the internet world.) They promote and compete on this unlimited service.

To be efficient, the delivery companies don't run a private truck from the depot to your house all the time. Instead, they load up a truck with all the packages for your neighbourhood, and it does one delivery run. Some days you have a lot of packages and your neighbours have few. Other days you have few and they have a lot. The truck is sized to handle the high end of the total load for all the neighbours. However, it can't handle it if a large number of the neighbours all want to use a large fraction of their total load on the same day, they just didn't buy enough trucks for that, even though they advertised they were selling that.

This is not unreasonable. A majority of the businesses in the world that sell flat rate service work this way, not just internet companies. Though there are a few extra twists in this case:

  • The last mile companies have a government granted franchise. Only a couple can get permission to operate. (In reality -- only a few companies have got permission to have wires strung on poles or under the street.)
  • Some of the last mile companies also used to be your exclusive source for some goods (in this case phone service and TV) and are concerned that now there are competitors delivering those things to the customers.

The problem arises because new services like Netflix suddenly have created a lot more demand to ship packages. More than the last mile companies counted on. They're seeing the truck fill up and need to run more trucks. But they proudly advertised unlimited deliveries from the depot to their customers. So now, in the op-ed, they're asking that companies like Netflix, in addition to paying the cost of shipping to the depot, pay some of the cost for delivery from the depot to the customer. If they did this, companies would pass this cost on to the customer, even though the customer already paid for that last mile delivery.

The op-ed's fundamental mistake is that it talks about Netflix not paying for the last mile delivery with the implication that they are freeloading. But the customers are the ones ordering the movies, and they are the ones who already paid for that delivery. This is unlike the traditional delivery service, where the sender pays for both legs of the delivery, and adds that shipping cost into the price of the product. The members of Broadband for America want to be paid both ways.

Companies like Netflix have been efficient, and put their own shipping centers very close to the central depot. That makes it cheap for them to drop of a huge volume of packages. They aren't free riding, they're being efficient.

To start charging twice breaks the very important pricing model the internet was built on. I've argued that the internet cost contract was actually the internet's greatest invention, the thing that made it rule the data networking world.

It's hard not to imagine a conflict of interest here. The cable companies that are members of Broadband for America make a lot of their money selling TV and movie services to their customers. Now Netflix is doing the same, and the customers like it so much that it's a double threat -- the customers are using more capacity than the cable companies planned for, and they're using it to buy from a competitor.

The solution for this is not easy, however. It's not unreasonable to ask the customers who want to make the heaviest usage pay more for higher-service tiers. And some will argue that doing this by billing the sender, who passes on the cost, is a reasonable way to do that. But that means only well-financed senders can play, and it stomps on the great innovation breeding ground that the internet cost contract engendered.


“I pay for my line to the middle, and you pay for your line to the middle and we don’t account for the costs of individual traffic.”

Brad, this statement is a bit inaccurate. The middle shipping depot (Internet backbone) consists of multiple depots, and Netflix is only paying one of the depots (Level3) for their line. Who should pay for the extra traffic caused between the depots and other costs due to that? That's the main problem here. You are right that, Neflix is already efficiently distributing with CDNs (like Akamai), but that's not enough.

P.S. I am not supporting the cable companies, obviously we are all overpaying and we are paying a flat price for the supposedly "unlimited" bandwidth.

The backbone is accounted for here. Today, the "middle" is a set of peering points. If you are connected to one peering point and your user to another, something pays for the transit between the peering points. Who this is depends on how important they are (small ISPs tend to pay for transit and big ISPs are at most of the peering points and try to get others to pay if they can.)

But with Netflix (and the big CDNs) they are already connecting to those points, and I believe they pay for transit traffic where needed. I don't know about their particular arrangement but correct me if I'm wrong here.

The point though is that for every internet packet there are two ends, and unless it's spam, both ends want the traffic and share the cost of it. It is the viewer that wants the netflix data. Netflix only wants the customer's money. The viewer has gone to their ISP and said, "Here's money, you make sure I can exchange packets with everybody who peers with you, and that had better be everybody important or I go elsewhere." Not, "Here's some money, but if I do a lot of packets with somebody you peer with, you can squeeze them for more."

Agree that user is already paying Comcast for the unlimited bandwidth, and Comcast can't simply ask Netflix to pay them. The problem comes here with Netflix's deal with Level3, should Level3 pass up some of that money to Comcast as they clearly are peering with them?

There are already payments made. I don't know what the deals are because they keep those deals secret, but typically both sides will agree to carry each other's data at no cost or they will pay each other depending on where the data is coming from.

The problem here is that ISPs is already getting paid by us (the customer) and they already have some kind of deal with the back-bone. Netflix pays the backbone to carry their data and then (depending on what the contract says) the backbone pays the ISP for netflix (and anyone they host).

Now the ISPs want to charge netflix directly as well. It's not charging double, it's charging triple.

Do you have a similar opinion on the throttling of heavy users of mobile data networks? Or do you think an entirely different model is at play there?

The model is the same on mobile, and the problem is the same. If the carrier promises unlimited then they have to be ready for what that means. One carrier is slowing down your bandwidth once you hit a cap, which seems reasonable to me if it is what they need to manage the network and not just a revenue extraction tool.

The problem in mobile of course is that there are only 4 players and soon will be only 3, and they are all big so you don't get the innovation that real competition brings.

I think one important refinement to this an analogy is that the last-mile companies are (despite their oligopoly) locked in fierce competition, because the cost of buying a truck or repaving your street to let really heavy trucks drive on it or building the truck garages is enormous in comparison to the cost of just operating the truck fleet from day to day. So they want as many customers as possible, and are terrified that making the customer pay extra for a higher overall level of service (ha!) will cause customers to desert them for a competitor after the investments to serve that customer have been made.

So if they want to maintain their profit margins and their executive salaries (and their investment in new infrastructure) they need a new source of revenue.

Oh, yeah, and another vote that the peering thing is a red herring. If comcasts wants to negotiate with Level 3 about how much who pays whom, they're welcome to do it. But there's no "should" on either side.

Yes, in some places there is competition, though there are many places where you don't have much choice of broadband ISP. But I would not call it fierce. The companies still act like the big monopolies they are used to being. You don't get real competition with 2-3 players, you need at least 4 and ideally a lot more.

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