Estimating the Price of Internet Services.

The Internet Market:-

The Internet Market PlayersThe key players in the internet market includes the Suppliers (Operators), the Consumers (Users) and the Regulators. The suppliers are mainly Telco Operators with infrastructure to buy and resale international bandwidth and redistribute it to the local consumers – the internet users. The Regulator is mandated to ensure that there is a level playing field between the competing suppliers and that the users' interests are not compromised.

(Walrand 2008) gives a diagram that shows how these three players inter-relate across the Operators Network as shown below:

(Fig. 1)The users purchase (Demand) internet services from the internet Service Providers at given Prices. The Revenue accrued is then used to invest in the Operators network by way of expansion. This is because the more users a particular network has, the more congestion that network is likely to suffer - resulting in degraded quality of service (QoS). A service provider who fails to address the capacity or quality of service issues is likely to lose the users to competition.

(Walrand 2008)clearly captures these closed looped interactions and goes further to identify their respective knowledge domains as Economic, Regulatory and Technological. She argues that the performance of communication networks (QoS) has been studied extensively but with little regard to how this is links into the Economic and the Regulatory layers.

(Courcoubetis & Weber 2003) had earlier made a similar observation when they said that traditional engineers often develop communication services without reference to how they should be priced. They however argued that Pricing and Competition issues are worthy of study, because:

- pricing affects how service is provided, and how resource is consumed- pricing mechanism provides incentives to control performance and increase stability- pricing mechanism allows more flexible service and efficient resource usage- Competition and regulation issues are important especially for control of bottleneck resource

The background and fundamental principles necessary to model the pricing of communication services is largely borrowed from these two sources and is summarized below. This knowledge scope will provide the justification for the eventual group of variables – conceptual framework - that will then be adopted and simulated using the System Dynamics framework.

The Market Player Objectives.Typically, the Operators aim to increase or maximize their “Supplier Surplus” that is their Profit – subject to their Network Capacities.

Supplier Surplus = Revenue – Cost of Supply, where Revenue = Unit Price x Quantity of (x) amount of Services ConsumedCost of Supply = Cost of Supplying (x) amount of Services.

The Users aim to increase or maximize their “Consumer Surplus” that is their Net Benefit – subject to their budgetory constraints.

Consumer Surplus = Utility – Market Price where

Utility = the unit price users is willing to pay for the serviceMarket Price = the actual price of the service offered in the market.

The Regulator aims to increase or maximize the “Social Surplus” that is the total benefit for both the consumers and suppliers in the market.

Social Surplus = Supplier Surplus + Consumer Surplus.

The Internet Market Structure.

The main commodity in the internet market is Internet Bandwidth. Typcially, a supplier would purchase the bandwidth in bulk from international markets (in Europe/US) and resale in the local market – under the traditional Wholesaler->Retailer->Consumer market structure. The wholesale bandwidth supplier is known as the Internet Gateway Provider (IGP), while the retail bandwidth provider is known as the Internet Service Provider (ISP), who interconnects with the consumer or users to the internet.

In the early, 2000s this market structure was strictly demarcated along the Wholesale/Retail/Consumer paradigm and the wholesale IGP were not allowed to play in the retail ISP markets and vice-versa. Currently however, the international and local practice by regulators is to provide the so called “converged” license regime that allows an Operator to be both a wholesaler and retailer of internet bandwidth

Market TypesCostas Courcoubetis, Richard Weber(2003) says that the final internet price offered in the market depends on two things – the market type and the objective of the price setter. The three market types are Monopoly, Perfect Competition and Oligopoly.

Prior to the turn of the century, most operators were government monopolies - whereby only one operator was allowed to operate within a given national economy. The current and international trend is towards perfect competition environments where many operators are encouraged to play in the internet

market and none is dominant enough to control prices. However, due to the high capital investment nature of the telecommunication markets, most national economies exhibit oligopoly types of telecommunication markets – whereby only two to three players are operating or become dominant in the market.

Rationale for Setting the Internet Price The Market, Supplier and the Regulator are the three entities that can set prices of the internet service – with the Consumer being able to only respond to the same. The table below summarizes the price objectives of these entities within different market conditions.

The Market setting the PriceThe table below shows the objective of price setting within a free, open and competitive market environment.

Price Setter: -Perfect Market

Market Type Price Objectives Constraint

Perfect Competition

Price gravitates towards an equilibrium value, where the supply meets demand

Subject to User uptake or Price elasticity (Supply & Demand dynamcs)

Subject to Market Failure:- Network Externalities

Subject to Network Capacities & Marginal Costs

In situations where there are many suppliers and many users (Perfect Competition), the price of goods and services will tend towards a value that is the most efficient in terms of cost of production and user uptake or utility. Basically, each supplier will offer a price to the user and await the user's response in terms of uptake of the internet service.

The price the supplier offers takes into consideration the cost of producing that service as well as the profit margin anticipated.

Supplier Profit/Surplus= P(x) -C(x) where

P(x) is the unit price offered for the service of quantity x C(x) the unit costs for producing the service amounting to x quantities

The Price, P offered must exceed the Cost, C of production for the Supplier to remain profitable and stay in business. The amount of quantities, x taken up by the users depends on the user's value or utility for the service and the price offered.

Whereas the supplier aims to maximize profits, the user aims to maximize his net benefit or surplus.

User Surplus = U(x) – P(x) where

U(x) is the user's utility or the unit price he is willing to pay for x amount of the service. P(x) is the unit price offered for the service of quantity x

The supplier’s objective is to maximize the profit and the user’s objective to maximize his surplus is in constant conflict such that an initial price offered by a supplier will generate a demand response (based on price elasticity) that informs or signals the supplier to either increase or decrease the price offer. If the initial price was too high, the users will refuse to participate in the market since the price will exceed their utility. The supplier will therefore be left with goods or supplies that no one is consuming and he will immediately try to entice or stimulate usage by way of reducing prices. This behaviour eventually leads to a stable price value known as the equilibrium price where the supply is equal to the demand – a market clearance situation.

In a perfectly competitive market, the price arrived at is therefore determined by the laws of supply and demand - with competing suppliers aiming at maximizing their profits by driving down their cost of production rather than by attempting to increase their prices. Recalling

Supplier Profit/Surplus= P(x) -C(x)

It is evident that that if Price, P is constant and the lowest possible since no supplier wants to lose the market to the competitor through a higher price, then the only way profit can be maximized is by reducing the costs of production, C. Innovation, efficiency, high productivity, zero tolerance to wastage thus becomes the hallmark of a supplier operating in a free, open and competitive market. Similarly, the user also benefits since recalling that:

User Surplus = U(x) – P(x)

Given a fixed utility, U, the continued dropping of Price, P results in the increase of the user benefit or surplus.

Rationale for modeling Perfectly Competitive Market A perfectly competitive market is therefore a Regulator's dream come true since it is the answer to the regulatory objective of maximizing the Social Surplus - namely maximizing both the Suppliers profit and the Users Surplus.

Social Surplus = Supplier Surplus + Consumer Surplus

A perfectly competitive market automatically arrives at this regulatory solution without any intervention and purely under market dynamics of supply and demand. Whereas a perfect market is theoretical and rarely exists in practice, the initial simulated system dynamics model will assume the internet market in Kenya is perfectly competitive in order to map out the ideal situation. Subsequently, the initial model will be tweaked to provide extemded models that reflect and match the realities of the market.

The Supplier/Operator Setting the PriceThe table below shows the objectives and market conditions that influence the pricing decisions of a an Operator in the market.

Price Setter: -Supplier

Market Type Price Objectives

Constraint

Monopoly Maximise Profit/Surplus

Subject to Regulatory pressure and Network Capacities

Oligopoly Maximise Profit/Surplus

Subject to Regulatory pressure and Network Capacities

Perfect Market/ Competition

Maximise Profit/Surplus

Supply & Demand dynamics

Marginal CostsTable 1

A supplier enjoying the benefit of a monopoly may select prices that maximize profits without due regard to the user benefits. A monopolistic supplier does not face the risk of losing customers who would otherwise go for the service to another supplier. A monopolistic supplier will therefore tend to exploit consumers by setting a “take-it” or “leave-it” high price that leads to fewer but high paying customers participating in the consumption of the service. A monopoly therefore requires the intervention of a regulator to moderate the price offered with a view to ensuring a fair price that allows more users to participate in the service – hence increasing both the user and the supplier surplus.

An oligopoly market is one having limited suppliers and limited regulatory interventions. The supplier objectives remain the same – that of maximizing profit. However, given the limited competition, the risk exists that the suppliers may collude and defeat competitive pressures by setting negotiated prices designed to serve only supplier but not user interests. This form of situation creates cartels in the market that the regulator should be aware of. Typically, the Regulator would identify cartel pricing and often intervenes by setting Price-caps for the market. A Price-cap is a ceiling price calculated by the regulator and enforced in the market such that suppliers may not charge services beyond it.

Model to estimate Internet Price.

How can Regulators establish the fair price for charging internet services? How can regulators deal with the issue of Users claiming on one hand that they are over charged and the Operators on the other hand claiming that their prices are competitive and fair? Qian & Rouskas (2010) attempt to answer this question by using both the economic and the game theories.

Using the economic theory of supply and demand, Qian & Rouskas (2010) estimated the Cost, C of producing and distributing bandwidth. They also estimate the Utility or willingness of Users to pay for the bandwidth using the Pareto Distribution function. This probability distribution function has estimates for the Utility function based on different types of bandwidth Usage.

Utility, U(x) = λ * x^ γ

where both Lamda & Gamma are selected to match Internet Usage behaviour of some American market. Lamda λ = 9Gamma γ= 0.5x = the bandwidth under use

The values for Kenya will require an analysis of the Internet User behaviour of the Kenyan internet market in terms of what amount of minimum and maximum bandwidth Kenyans are demanding and their corresponding frequencies.

Cost, C(x) = µ*xwherePico µ = 0.05x = the bandwidth under use.

Having known the Utility and the Cost functions, the Regulator can then estimate the Social Surplus for each category of bandwidth used.

The expected functions would follow the pattern below.

Social surplus, User Surplus and Operator Surplus as from Qian & Rouskas (2010) above.

Bargain Power.Once the Social Surplus is estimated,the Regulator can then use game-theory which is that branch of decision theory that describes mathematically how decisions are made in situation of conflicting objectives between two or more players.

Where Y1 = the User SurplusY2 = Operator SurplusU=User Utility/value for X bandwidthC=Cost of proding X bandwidth of Internet service P1 =Price User pays for ServicesP2 = Price Operator receives for ServiceP(high) = Highest Price user willing to pay for X bandwidth of serviceP(low) = Lowest Price Operator is willing to accept to provide the service.G= Gap between what User Pays (P1) and what Operator Receives (P2)-the transaction cost.

In a simplified case where the the transaction cost, G is zero, then the Price, P1 paid by the User the the same as Price, P2 received by the Operator. Both players, User and Operator will eandevour to maximize their surplus based on their bargaining power, B. The bargaining power is the relative ability of each player to influence the setting of prices.

Let the User bargaining power be B, where 0<B<=1, and the Operator bargaining power will be (1-B) In other words, when User bargaining power is 1, (maximized) then the Operator bargaining power will be minimized i.e. (1-B=0) and vice versa. This Bargain situation will mathematically define the market situations of Monopoly, Oligopoly and in Perfect Competition I.e

Monopoly, B=0, User has no bargaining power. Operator maximizes his SurplusOligopoly, B= 0.5, both User and Operator share bargaining power, both share the Social SurplusPerfect Competition, B=1, User has full bargaining power, and maximize his Surplus.

Since both players (User and Operator) are trying to maximize their surplus, the problem becomes one of optimization i.e. how to establish a price that increases or leaves both of them happy – given certain conditions such as the cost of providing services (Cost C)and the capacity or willingness of the users to pay for these services (Utility, U)

This problem was solved by the mathematician JF Nash (1950) who formulated the problem as

Maximize the Nash Product, N= Y1^(B) * Y2 ^(1-B) subject to the constraints Y1 +Y2 <= U-C-GY1 >=U-P(high)Y2>=P(low)- C

With the optimum price being described below.

Essentially, the Price P1, paid by the User is given by the equationP1=(1-B)U + B(C+G)and Price P2, received by the Operator is given by the equationP2=(1-B)(U-G) + BC

In cases where the transaction cost, G, is put to Zero (for simplicity) then the Optimal price charged would be:P= P1=P2 = (1-B)U+BC.

Where B is the Bargaining Power of the User, U is the Utility of the User for X amount of BandwidthC is the Cost of Providing the X amount of Bandwidth

Results:Applying data from an American market (San Diego Internet Exchange point, 2010), the following

Optimal Price values were calculated as being the Optimized Prices for Internet Services.

Graphically

Same data interpolated for the Kenyan Market.

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Utility(Ksh)Cost(Ksh)Price, P (Monopoly)Price,P (Competition)Price, P(Oligopoly)

Bandwidth (GB)

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Conclusion.This presentation, introduces regulators to mechanisms of calculating the optimized prices that are expected to be at play in a the various market environments (Monopoly, Oligopoly or Perfect Competition). The work is still in progress with the aim of using actual Kenyan data within the mathematical formulations and extending the solution to cater for simulated impact of the various prices on multiple market variables such as Bandwidth Capacities, Operator Revenues and Internet Penetration.

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Utility(Ksh)Cost(Ksh)Price, P (Monopoly)Price,P (Competition)Price, P(Oligopoly)

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