In my last post I told a story about the Level 3/Comcast dispute that portrays Comcast in a favorable light. Now here’s another story that casts Comcast as the villain.
Story 2: Comcast Abuses Its Market Power
As Steve explained, Level 3 is an “Internet Backbone Provider.” Level 3 has traditionally been considered a tier 1 provider, which means that it exchanges traffic with other tier 1 providers without money changing hands, and bills everyone else for connectivity. Comcast, as a non-tier 1 provider, has traditionally paid Level 3 to carry its traffic to places Comcast’s own network doesn’t reach directly.
Steve is right that the backbone market is highly competitive. I think it’s worth unpacking why this is in a bit more detail. Let’s suppose that a Comcast user wants to download a webpage from Yahoo!, and that both are customers of Level 3. So Yahoo! sends its bits to Level 3, who passes it along to Comcast. And traditionally, Level 3 would bill both Yahoo! and Comcast for the service of moving data between them.
It might seem like Level 3 has a lot of leverage in a situation like this, so it’s worth considering what would happen if Level 3 tried to jack up its prices. There are reportedly around a dozen other tier 1 providers that exchange traffic with Level 3 on a settlement-free basis. This means that if Level 3 over-charges Comcast for transit, Comcast can go to one of Level 3′s competitors, such as Global Crossing, and pay it to carry its traffic to Level 3′s network. And since Global Crossing and Level 3 are peers, Level 3 gets nothing for delivering traffic to Global Crossing that’s ultimately bound for Comcast’s network.
A decade ago, when Internet Service Retailers (to use Steve’s terminology) were much smaller than backbone providers, that was the whole story. The retailers didn’t have the resources to build their own global networks, and their small size meant they had relatively little bargaining power against the backbone providers. So the rule was that Internet Service Retailers charged their customers for Internet access, and then passed some of that revenue along to the backbone providers that offered global connectivity. There may have been relatively little competition in the retailer market, but this didn’t have much effect on the overall structure of the Internet because no single retailer had enough market power to go toe-to-toe with the backbone providers.
A decade of consolidation and technological progress has radically changed the structure of the market. About 16 million households now subscribe to Comcast’s broadband service, accounting for at least 20 percent of the US market. This means that a backbone provider that doesn’t offer fast connectivity to Comcast’s customers will be putting themselves at a significant disadvantage compared with companies that do. Comcast still needs access to Level 3′s many customers, of course, but Level 3 needs Comcast much more than it needed any single Internet retailer a decade ago.
Precedent matters in any negotiated relationship. You might suspect that you’re worth a lot more to your boss than what he’s currently paying you, but by accepting your current salary when you started the job you’ve demonstrated you’re willing to work for that amount. So until something changes the equilibrium (like an competing job offer), your boss has no particular incentive to give you a raise. One strategy for getting a raise is to wait until the boss asks you to put in extra hours to finish a crucial project, and then ask for the raise. In that situation, not only does the boss know he can’t lose you, but he knows you know he can’t lose you, and therefore aren’t likely to back down.
Comcast seems to have pursued a similar strategy. If Comcast had simply approached Level 3 and demanded that Level 3 start paying Comcast, Level 3 would have assumed Comcast was bluffing and said no. But when Level 3 won the Netflix contract, Level 3 suddenly needed a rapid and unexpected increase in connectivity to Comcast. And Comcast bet, correctly as it turned out, that Level 3 was so desperate for that additional capacity that it would have no choice but to pay Comcast for the privilege.
If Comcast’s gambit becomes a template for future negotiations between backbone providers and broadband retailers, it could represent a dramatic change in the economics of the Internet. This is because it’s much harder for a backbone provider to route around a retailer than vice versa. As we’ve seen Comcast can get to Level 3′s customers by purchasing transit from some other backbone provider. But traffic bound for Comcast’s residential customers have to go through Comcast’s network. And Level 3′s major customers—online content providers like Netflix—aren’t going to pay for transit services that don’t reach 20 percent of American households. So Level 3 is in a weak bargaining position.
In the long run, this could be very bad news for online businesses like Netflix, because its bandwidth costs would no longer be constrained by the robust competition in the backbone market. Netflix apparently got a good deal from Level 3 in the short run. But if a general practice emerges of backbone providers paying retailers for interconnection, those costs are going to get passed along to the backbone providers’ own customers, e.g. Netflix. And once the precedent is established that retailers get to charge backbone providers for connectivity, their ability to raise prices may be much less constrained by competition.
So which story is right? If I knew the answer to that I wouldn’t have wasted your time with two stories. And it’s worth noting that these stories are not mutually exclusive. It’s possible that Comcast has been looking for an opportunity to shift the balance of power with its transit providers, and the clumsiness of Level 3′s CDN strategy gave them an opportunity to do so in a way that minimizes the fallout.
One sign that story #2 might be wrong is that content providers haven’t raised much of a stink. If the Comcast/Level 3 dispute represented a fundamental shift in power toward broadband providers, you’d expect the major content providers to try to form a united front against them. Yet there’s nothing about the dispute on (for example) the Google Public Policy blog, and I haven’t seen any statements on the subject from other content providers. Presumably they’re following this dispute more closely than I am, and understand the business issues better than I do, so if they’re not concerned that suggests maybe I shouldn’t be either.
A final thought: one place where I’m pretty sure Level 3 is wrong is in labeling this a network neutrality dispute. Although the dispute was precipitated by Netflix’s decision to switch CDN providers, there’s little reason to think Comcast is singling out Netflix traffic for special treatment. In story #1, Comcast is be happy to deliver Netflix (or any other) content via a well-designed CDN; they just object to having their bandwidth wasted. In story #2, Comcast’s goal is to collect payments for all inbound traffic, not just traffic from Netflix. Either way, Comcast hasn’t done anything that violates leading network neutrality proposals. Comcast is not, and hasn’t threatened to, discriminate against any particular type of traffic. And no, declining to upgrade a peering link doesn’t undermine network neutrality.