Competition and Compatibility among Internet Servi

1August,1999&RPSHWLWLRQDQG&RPSDWLELOLW\DPRQJ,QWHUQHW6HUYLFH3URYLGHUVBy:ØysteinForosandBjørnHansen**TelenorResearchandDevelopment$EVWUDFWWeconsideratwostagegamebetweentwocompetingInternetServiceProviders(ISPs).ThefirmsofferaccesstotheInternet.Accessisassumedtobeadifferentiatedservice.Ourmodelexhibitsnetworkexternalities.InthefirststagethetwoISPschoosethelevelofcompatibility(i.e.qualityofadirectinterconnectlinkbetweenthetwonetworks).InthesecondstagethetwoISPscompeteá-laHotelling.WefindthattheISPscanreducethestage2competitivepressurebyincreasingcompatibilityduetothenetworkexternality.Thefirmswillthusagreeuponahighcompatibilityatstage1.Thisresultisnotaltered,asverticaldifferentiationisincludedinthemodel.Whenitiscostlytoinvestincompatibility,wefindthatthefirmsoverinvest,ascomparedtothewelfaremaximisinginvestmentlevel..H\ZRUGVCompatibility,Internet,Competition,Duopoly-(/FODVVLILFDWLRQ:L13;L96;L41*WearegratefultoRagnaBrekke,HansJarleKind,ToreNilssen,BjörnRuppandSeminarparticipantsatthe2ndBerlinInternetEconomicsWorkshopforveryusefuldiscussionsandcomments.**Addressforcorrespondence:TelenorResearchandDevelopment,Instituttvn23,N-2027Kjeller,Norway.E-mail:[e-mail]2,,QWURGXFWLRQWeconsidercompetitionbetweentwoISPs(InternetServiceProviders)operatinginthesamegeographicarea.TheproductfromtheseserviceprovidersisbasicallyaccesstotheInternet,andtheISPsoperatetheirownnetwork(backbone).Internetaccessisassumedtobeahorizontallydifferentiatedservicefromthecustomer’spointofview.Furthermoreweassumethattherearepositiveconsumptionexternalities.WeconsiderISPcompetitioninatwostagegamewheretwocompetingISPsinthefirststagedeterminethequalityofinterconnection(i.e.thequalityofoff-nettraffic).Thischoiceofinterconnectionqualitycanbeconsideredasachoiceofcompatibilitybetweenthenetworks.Inthesecondstage,forgivencompatibility,thetwofirmscompeteàlaHotellinginattractingcustomers.ThemotivationforthepaperistheobservationthatISPscompetinginthesamegeographicareatypicallyofferhigherqualityforon-netcommunicationascomparedtooff-netcommunication.Roughly,on-netcommunicationreferstotrafficbetweencomputers/customersconnectedtothesameISP,whileoff-netcommunicationisbetweencomputers/customersconnectedtodifferentnetworks,e.g.communicationbetweencustomerssubscribingtocompetingISPs.Therearetwopossiblecausesforthequalitydifferentialbetweenoff-netandon-nettraffic.Thefirstcauseisrelatedtocoordinationproblemsbetweenindependentfirms.Thetechnologyformeasuringbothtrafficandqualityofservice(e.g.delay)betweenISPsmaybehardtoimplement.ThesecondcauseisthatISPsmayhavestrategicincentivestodegradetheinterconnectionqualityforoff-nettraffictoacompetingISP.Inthispaperwefocusonthesecondcause,i.e.towhatextentdoISPshaveincentivestodegradeinterconnectionquality.3ThemajorityoftheliteratureonInterneteconomicsfocusesontheUS-market.Incontrast,ourpaperismotivatedbythesituationforcompetingISPsoutsideUSA.Previously,theattentionintheISP-marketsoutsideUSAhasbeendirectedtothequalityoftheconnectiontotheUS.ThequalityoflocalcommunicationbetweencompetingISPswasratherunimportantsincethemajorityoftheInternetcontentwasintheUS.Thesituationis,however,altered,andtheportionoftheInternet-trafficwhereboththesenderandthereceiverarelocatedinthesameareaisincreasing.1Thistendencyisprobablyduetonewcustomer-typesandnewservicesintheInternet.Innon-Englishspeakingcountriescontentintendedforthemass-marketmustbeproducedlocallyortranslated.Furthermore,fornewinteractiveservices,suchastelemedicine,tele-education,andvideoconferencing,alargerportionofthecommunicationareprobablybetweencustomersinthesamegeographicalareathanwhatisthecaseforconventionalInternetservicessuchasweb-browsing.Thus,thequalityoflocalinterconnectionismoreimportantseenfromtheconsumer’spointofview,andaccordingly,theimportanceoflocalinterconnectionasastrategicvariablehasincreased.Utilityfromnetworkparticipationdependsonthenumberofpotentialcommunicationpartnersandthequalityofthiscommunication.Forgivenmarketshares,thecustomer’swillingnesstopayisincreasingininterconnectionquality.Itisnotobvious,however,thatcompetingfirmswillchooseahighquality.Inthepresenceofnetworkexternalities,customerswillFHWHULVSDULEXVconsideritmoreadvantageoustochoosethelargerISPifthechosenqualityofinterconnectionisreduced.AlargeISPmayaccordinglychoosealowinterconnectionqualityinordertoincreaseitsmarketshare.1SeeMuelleretal.(1997)4TherearetoourknowledgefewpapersexplicitlyconsideringISPcompetition,butCrémer,ReyandTirole(1999),DangNguyen,andPenard(1999)andBaakeandWichmann(1998)arenotableexamples.Thestrategiceffectofinterconnectqualitydoeshoweverhavemanysimilaritieswiththestrategiceffectofinterconnectprice(forgivenquality)intelephonynetworks,seeLaffont,ReyandTirole(1998a,1998b)andArmstrong(1998).Asarguedabove,networkexternalitiesresultinastrategiceffectofinterconnectquality.SuchexternalitieswerefirstgivenatheoreticaltreatmentbyRohlfs(1974).ThestrategiceffectofnetworkexternalitiesoncompetitionwasrecognizedbyKatzandShapiro(1985),whoanalyzethestrategiesofchoosingcompatibi