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.