Why is Netflix paying Comcast?

Our group has been researching and thinking about Internet Economics for quite sometime now. Events are backing up our predictions, and they are not good for consumers.

Over 5 years ago, we published the following work, driven by at that time a PhD student of ours, Richard Ma: 

Richard T.B. Ma, Dahming Chiu, John C.S. Lui, Vishal Misra and Dan Rubenstein, On Cooperative Settlement Between Content, Transit and Eyeball Internet Service Providers, Proceedings of 2008 ACM Conference on Emerging network experiment and technology (CoNEXT 2008), Madrid, Spain, December, 2008

I am happy to answer any questions regarding the math/analysis in the paper, and the slides associated with the talk we gave are here, but in the next few lines I will try and explain the implications of the analysis.

We looked at the economic ecosystem of the Internet, using Shapley values, with cooperative game theory as the guiding principle. Our analysis revealed something interesting: it showed that the early Internet settlement model was stable and made sense. The Internet was composed of light email and web traffic between essentially symmetrical end points like educational and research institutions. ISPs were two kinds - eyeball and transit (or Tier-1). Transit ISPs provided global connectivity, and the eyeball ISPs bought bandwidth from transit ISPs. Consumers bought connectivity from the eyeball ISPs and interacted with each other, and buying bandwidth was natural. By doing bilateral settlements between the parties directly interacting, a stable solution can be arrived at. The solution lies in what is called in cooperative game theory as the core.

Things started to change when the Internet e-Commerce system started developing. Well known content providers started to emerge. The ISPs that sold bandwidth to content providers were classified as content ISPs, and CDNs can be thought of as another form of 
content ISPs. Now the Internet was generating two revenue streams - one that was provided by selling connectivity/bandwidth to the consumers and content providers, and the second was the revenue generated by the e-Commerce activities of content providers like Google, Amazon, eBay, Netflix. 

Our analysis showed that if the two revenue streams differed significantly in magnitude, then the current settlement model of the Internet was unstable. Specifically, no model that followed the simple customer-provider of bandwidth settlement model could lead to a stable solution and the solution was always outside the core. If the eCommerce revenue stream is much greater than the revenue stream from bandwidth connectivity, then the eyeball ISPs are in fact subsidizing the content providers. The eyeball ISPs should not be buying bandwidth from upstream providers, but should rather be selling access to the eyeballs that they are providing connectivity to. It predicted a reverse customer/provider relationship to emerge as well as paid-peering which is what the recent Netflix/Comcast arrangement is being called. 

If the converse is true, and the eyeball ISPs are generating a lot more revenue than the e-Commerce revenue, then again a stable solution lies in the settlement model where revenue is flowing to the content side of the equation. The eyeball ISPs should be paying the content providers to generate content, so they can sell connectivity to the consumers that want content. 

There is another form of asymmetry that makes the issue of asymmetry of revenue almost moot. And that is the asymmetry of market power, and it follows directly from our analysis. If there is no competition on the content side but there is competition on the eyeball side, then the content provider has the leverage to extract better terms for the eyeball ISP. If however, there is competition on the content side but not on the eyeball that increases the leverage that the eyeball side has on the content side. Consumers who have no choice for broadband ISPs are in some ways trapped and then it is rational for content providers to pay the eyeball providers to keep earning that revenue (which can then be passed back to the consumer of course). Consumers won't switch off broadband because Netflix is slow - there is Amazon, iTunes, Hulu just on the video side of things, and of course there is countless other "competition" that the Internet provides in the form of content. If the eyeball ISP is a monopoly, it will keep its business, Netflix performing well or not.

Our analysis predicted this, and since this is simply "paid peering", it is in no violation of network neutrality even if that concept existed and was backed by courts. This is the only way by which a solution ends up being in the core (i.e., it is stable).

The problem really is the monopoly that last mile providers have, and it cannot be fixed by regulation - only by competition. The possibility of competition in the broadband market in the US was further reduced by the announcement of the Time Warner "Cable" acquisition by Comcast "Cable". That was the subject of some follow on work that Richard and I did, and I have blogged about it here. It is also the issue that Susan Crawford has spoken about extensively, most notably in her book Captive Audience: The Telecom Industry & Monopoly Power in the New Gilded Age.