Economic Analysis of Telecom 1

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Supply and Demand Analysis in Convergent Networks

by Craig Thompson Bachelor of Engineering (Honors) University of New South Wales, 1994 SUBMITTED TO THE SLOAN SCHOOL OF MANAGEMENT IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION AT THE MASSACHUSETTS INSTITUTE OF TECHNOLOGY JUNE 2001 2001 Craig Thompson. All rights reserved The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis document in whole or in part.
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Signature of Author: _____________________________________________________________ Department of Management April 9, 2001
Certified by: ___________________________________________________________________ Charles H. Fine Chrysler LFM Professor of Management Thesis Supervisor
Accepted by: ___________________________________________________________________ Margaret Andrews Executive Director of the Sloan MBA Program
Supply and Demand Analysis in Convergent Networks

by Craig Thompson Submitted to the Sloan School Of Management on April 9, 2001 in Partial Fulfillment of the Requirements for the Degree of Master Of Business Administration
Abstract
This thesis examines the issue of bandwidth supply and demand in converging communications networks. Bandwidth is defined as the amount of data that can be transmitted in a fixed amount of time, and is usually expressed in bits-per-second. The huge growth in data communications as a result of the growth in the Internet, other public and private data networks, the continued growth in voice traffic and the potential introduction of bandwidth-intensive services such as Video-onDemand, has raised some interesting questions about the dynamics of supply and demand in the next generation of communications networks. While many estimates exist for bandwidth supply and demand, there is still confusion about the relationship between terms such as offered load, network capacity, backbone traffic and bandwidth supply. This thesis aims to discuss these topics in context with each other and introduce a model and framework for reconciling bandwidth supply and demand. Current estimates for 2002 backbone traffic range from 24,800 to 78,000 terabits/day, depending on the services covered. Estimates for traffic generated at the edge of the network are often much higher (350,000 500,000 terabits/day depending on the services covered and the definition of edge demand) as it is thought that much of the edge demand is localized and doesnt make it onto the backbone. These figures equate to an average peak hour rate of approximately 10 terabits/sec. Because of the variability of such estimates, this thesis maintains that it is more important to test scenarios and sensitivity of bandwidth to service adoption in percentage terms, and to think more about the problem in terms of the dynamics of supply and demand of individual services over a common network infrastructure.
Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved.
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Chapter 1 of the document provides a broad introduction to network communications, its growth and development in recent years and the importance of developing economic frameworks for analyzing the industry. The term bandwidth is defined and the concepts of supply and demand, as they pertain to bandwidth, are introduced. Chapter 2 provides a discussion of Bandwidth Demand. Since the term is often used quite loosely throughout the industry a standard definition has been adopted for the purposes of research and discussion in this thesis. The term Bandwidth Demand is used to describe the Edge Load, or Offered Load presented to the edge of the network. This is most commonly thought of as the load presented by end-user devices (telephones, computers, TVs) to the access level devices (routers, switches, multiplexers) of telecommunications and data networks. Possible drivers of bandwidth demand are discussed, and economic tools for describing demand are introduced. Chapter 3 follows directly from Chapter 2 and introduces an Edge Demand model that is used to forecast Edge Demand and illustrate key concepts such as services adoption, service draw, and peak vs average offered load. The model is described and the sample results are presented to illustrate the usefulness and drawbacks of such a forecasting technique. Chapter 4 expands on the concept of Bandwidth Supply. Network Capacity, used as measure of Bandwidth Supply, is discussed relative to Edge Demand. A brief introduction to networking technologies is given before discussing the drivers of Bandwidth Supply scaling. Finally, Chapter 5 attempts to reconcile the two concepts of Bandwidth Supply and Demand by using basic economic theories and tools to analyze the dynamic interaction between Supply and Demand. Given the complexity of supply and demand interaction in an industry with such a high state of flux, the two concepts of supply and demand were analyzed separately in previous chapters. This chapter attempts to link the two concepts through relatively simple supply and demand curves incorporating price data and the quantity of bandwidth demanded and supplied in local access connections.
Thesis Supervisor: Charles H. Fine Title: Chrysler LFM Professor of Management

Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 3
Acknowledgements
I would like to thank all those people that contributed to the thought process in this thesis. In particular I would like to acknowledge the contributions of Ryan Berryman, Rajeev Ram and Naresh Rao who spent a considerable amount of time discussing the issues raised in this thesis. Other people to thank include the Research Assistants and Faculty of the Microphotonics Center at MIT and my thesis advisor Professor Charles Fine. Finally I would also like to thank those people that were directly affected by the time spent bringing this thesis together, particularly my wife Lianne and family. Thank you for your tremendous support, patience and time-credit. Craig Thompson
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Table of Contents
Supply and Demand Analysis in Convergent Networks.................................................................1 Supply and Demand Analysis in Convergent Networks.................................................................2 Abstract......................................................................................................................................2 Acknowledgements....................................................................................................................4 Table of Contents.......................................................................................................................5 Figures and Tables......................................................................................................................6 Chapter 1: Introduction...............................................................................................................7 Industry Background..............................................................................................................7 The Converging Network.......................................................................................................8 What is bandwidth?................................................................................................................9 Why are Bandwidth Supply and Demand Important?..........................................................11 Current Estimates for Bandwidth Supply and Demand........................................................11 Chapter 2: Bandwidth Demand.................................................................................................16 Edge Demand and Network Capacity...................................................................................16 Drivers of Bandwidth Demand.............................................................................................17 Voice Traffic Growth...........................................................................................................25 Data Traffic Growth.............................................................................................................26 Chapter 3: Services Adoption and Growth Model....................................................................30 Results..................................................................................................................................32 Model Description................................................................................................................34 Chapter 4: Bandwidth Supply...................................................................................................38 Relationship between Edge-Demand and Network Capacity...............................................39 Traffic Penetration................................................................................................................40 Drivers of Bandwidth Supply...............................................................................................43 Chapter 5: Dynamics of Supply and Demand...........................................................................51 Defining the Market.............................................................................................................52 Calculating Price Elasticities................................................................................................53 Analyzing Supply and Demand............................................................................................60 Conclusion................................................................................................................................65 Glossary of Terms....................................................................................................................68 Appendix..................................................................................................................................69
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Figures and Tables

Figure 1: Complexity in analyzing network convergence and evolution.........................................9 Figure 2: Estimates for Bandwidth Supply and Demand..............................................................13 Figure 3: McKinsey/JP Morgan Forecast of Backbone Traffic.....................................................15 Figure 4: RHK Estimates for AT&T's traffic demand...................................................................15 Figure 5: Edge Demand and Traffic Penetration...........................................................................17 Figure 6: Internet Domain Survey Host Count..............................................................................26 Figure 7: US Growth in eCommerce.............................................................................................28 Figure 8 Potential effects of migration of spectrum usage from analog to digital services...........31 Figure 9: Bandwidth Demand Forecast.........................................................................................32 Figure 10: Average Peak demand in a Day...................................................................................34 Figure 11: Forecast input parameters for service adoption rates...................................................37 Figure 12: Mesh Network Example..............................................................................................40 Figure 13: Boundary/Cloud model - conceptual diagram.............................................................42 Figure 14: Provisioning Costs Between 1988 and 2001................................................................46 Figure 15: Scaling of Network Technologies................................................................................47 Figure 16: Carrier CAPEX spending 1996-2000E .......................................................................49 Figure 17: Dynamics of Demand Growth.....................................................................................51 Figure 18: Log-Log Graph of Local Termination Lines................................................................54 Figure 19: Graph of prices relative to total bandwidth demanded.................................................56 Figure 20: Prices for Inter-office leased line connections, 1990-2000..........................................58 Figure 21: Prices for Earthlink Broadband Services.....................................................................59 Figure 22: Steady-state Supply Curve for Service Providers........................................................61 Figure 23: Price-setting and Profit for a Service Provider with Market Power.............................62 Figure 24: Demand Shift with Supply...........................................................................................63 Figure 25: Cyclical nature of supply and demand in current telecommunications markets...........64 Table 1: Estimates for Bandwidth Supply and Demand................................................................12 Table 2: Internet Connection Speeds Market Share......................................................................20 Table 3: US High-speed Subscribers by Technology....................................................................21 Table 4: DSLs Effect on Online Activities..................................................................................22 Table 5: Traffic on U.S. long distance networks in terabytes, year-end 1999...............................25 Table 6: Average Internet Use in March 2001..............................................................................27 Table 7: US Internet/Wireless Users.............................................................................................28 Table 8: Streaming Media Growth and Reach..............................................................................29 Table 9: Peak Demand Distribution..............................................................................................33 Table 10: Cost of Optical Technology in Trans-Atlantic Cables...................................................45 Table 11: US Fiber Miles Deployment.........................................................................................48 Table 12: US Carrier Sales Growth...............................................................................................49 Table 13: Estimates of Supply and Demand Elasticity..................................................................53 Table 14: Prices of Local Termination Lines, 1990-2000.............................................................54 Table 15: Leased-line prices relative to total bandwidth demanded..............................................55 Table 16: Prices for Inter-office leased line connections, 1990-2000............................................57 Table 17: Prices for Earthlink Broadband Services.......................................................................59
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Chapter 1: Introduction
Industry Background
The idea of a convergent communications network, and the implications of such a network infrastructure, has been discussed for many years. To a certain extent the concept of a converged network infrastructure is already being played out in the backbone networks that carry a myriad of different data, voice and media traffic. The rapid development of packet switching technologies, the integration of packet and circuit-switched networks and the rise of fiber optics as a means of transporting and switching data, are some of the factors that have lead to the concept of convergent networks, and will ensure that the convergence will likely spread to the edge of the network. In general there are a number of current trends that will continue to have a significant impact of the evolution of the convergent network: 1. Convergence of different services onto single platforms; 2. Introduction of new, bandwidth intensive services (e.g. Napster, Video-on-Demand); 3. Deploying broadband access to both residential and business markets; 4. Expanding network capacity with optical networking systems; 5. Migrating the public network from a circuit-based hierarchy to a packet-based network. The communications networking industry, encompassing the telecommunications, data networking and media companies, is in a high state of flux at the present time. Many of the technologies and policies underpinning, or preventing, the evolution towards a common, competitive infrastructure are still in various stages of infancy and will continue developing for some time. This flows onto the economics of supply and demand of bandwidth. During this high state of flux, the economics are as equally challenging to define. Over time, however, it is expected that a more steady state will be reached when technologies, business practices, policies and economic models can be refined.
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The Converging Network

A Converged Network is defined as a common network infrastructure on which most or all communications services, such as voice, the Internet, digital TV, can be delivered to end-users. With the rise to prominence of the Internet, as a mainstream medium of information communication, there has been much talk about the convergence of voice and data networks towards a less-layered, data-centric model based largely on the ideals of the Internet. In the extreme of such a view, backbones at all levels of the network would be homogenous pipes of data packets aggregated at the edges of the network from service-specific access devices such as telephones, computers, TVs etc. In this respect voice traffic and TV signals are just other data streams discriminated in the network by their synchronicity, quality of service and price. While the extent to which networks will converge is highly contentious, the exploration of Voiceover-IP and streaming video over the Internet has laid the groundwork for a converging infrastructure. It is the popularity of such a vision, in various incarnations, that has prompted much of the surge of capital into research, development and commercialization of technologies that support this convergence. In turn this has prompted policy makers and economists to study the problem of a fundamentally different model of network communications. This thesis assumes that such a convergence of network services onto a common infrastructure is inevitable and much of the analysis is based on this assumption. In some ways this simplifies the problem by treating bandwidth supply and demand in its aggregate form. In most ways, however, this assumption presents problems when trying to collect data and define frameworks for thinking about a common network that doesnt really exist today. In reality a huge number of defining factors will come into play to shape the future of any network convergence including government regulation, economics and competitive forces, and technology advances.
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Figure 1: Complexity in analyzing network convergence and evolution
What is bandwidth?
Before examining bandwidth supply and demand, it is useful to define what bandwidth is. According to Webopedia, bandwidth is: The amount of data that can be transmitted in a fixed amount of time. For digital devices, the bandwidth is usually expressed in bits per second (bps) or bytes per second. For analog devices, the bandwidth is expressed in cycles per second, or Hertz (Hz).1 The term is often used quite loosely and in strict scientific terms means something slightly different. For the purposes of this thesis, the term bandwidth will be used in the context defined above since it is useful to think of both demand pull and supply capacity in terms of bits-persecond.
www.webopedia.com Page 9
Shannons Law and the Time-Bandwidth Product

Without going into specifics about the technical differences between the definitions of bandwidth, it is also useful to know that bandwidth is not unlimited. Claude Shannon developed Shannons Law to describe the theoretical maximum rate at which error-free digits can be transmitted over a bandwidth-limited channel in the presence of noise. This is usually expressed in the form C = W log2(1 + S /N ), where C is the channel capacity in bits per second, W is the bandwidth in hertz, and S /N is the signal-to-noise ratio. The Time-Bandwidth Product, another esoteric term of physics, is also necessary to understand the limits of bandwidth. The equation, which essentially states that the spectral width of a signal is inversely proportional to the bit-duration, ensures that there is a theoretical maximum bit-rate that can be transmitted in a bandwidth-limited domain. This produces theoretical limits of fiber capacity of between 12 and 16 Terabits per second depending on multiplexing schemes.
Bandwidth in Circuit-Switched and Packet-Switched Networks

The usage of bandwidth in circuit-switched and packet-switched networks is fundamentally different and worth defining in the context of a convergent network in which a mixture of these technologies is likely to be implemented. Packet Networks, such as the Internet, offer a single, best effort service quality. Information is broken up into packets and are transported first-come, first-served with no guarantee of success. Some packets may experience severe delays, while others may be dropped and never arrive. Different kinds of data, however, place different demands on network services. E-mail and file transfers require 100% accuracy, but can easily tolerate delay. Real-time communications on packet networks such as voice transmission or audio/video can tolerate lost packets and distortions but can only tolerate minor delays and latency. Good Quality of Service (QoS) relates to the appropriate delay, latency, and variability of data transmission for each service. Most importantly, packet networks are very efficient. Because the bandwidth is shared between many hosts or users and packets can carry a vast array of data, the utilization of the available bandwidth is very high. Circuit-switched networks such as current voice telephony networks handle the quality of service problem by assigning each call a physical circuit with fixed resources sufficient to guarantee a
minimal quality of service. One limitation of this scheme is that the amount of resources devoted to each call, or circuit, is devoted to that service for the duration of the connection regardless of whether someone is speaking or not. As discussed above, packet networks take the approach of sharing all resources, all of the time, which accommodates the wildly varying bandwidth requirements of different applications, often at the expense of QoS. Today, much of the development in networking technology revolves around hybrid approaches that use both circuit-switching and packet-switching to achieve excellent network efficiency AND guaranteed QoS. A hybrid approach to offering different resources, along with guarantees, to different users would be to allow flexible, dynamic resource reservation. A user can declare how much bandwidth, what maximal delay and what type of delay variation they require for a given session.
Why are Bandwidth Supply and Demand Important?

In recent times, many estimates of bandwidth supply and demand have been attempted. The surge in the value of communications (real and perceived), the financial returns of networking companies and corresponding investment in the industry prompted many organizations to focus on the size of the opportunity at hand. This required a solid understanding of the current and potential demand for the products of this industry expansion, the current and potential supply of these products, i.e. bits-per-second to the end-user.
Current Estimates for Bandwidth Supply and Demand

Table 1 and Figure 2 below summarizes the results of some of the network traffic studies conducted recently. There are several methodologies to estimate future demand for bandwidth. While none of these methodologies is likely to provide all the answers, each one contributes to developing a more complete picture of the future. In this section, we provide the analysis of those methodologies
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used in recent reports published by several research institutes expressing future bandwidth demand. Table 1: Estimates for Bandwidth Supply and Demand
Source and date Year Stated Estimate Units
6500074500 TBytes/month 0.33 0.99 2.78 6.11 Tbits/sec Tbits/sec Tbits/sec Tbits/sec
Equivalent Estimate Units Year

1999 1999 2000E 2001E 2002E 2003E 2004E 1733319866 Tbits/day 28512 85536 Tbits/day
Comments
Andrew Odlyzko of AT&T Research (2000) 1999 Pioneer Consulting (2000) 1999 2000E 2001E 2002E 2003E 2004E McKinsey/JP Morgan (2000)
Total US Voice and Data Traffic US Backbone Peak Hour Internetbased traffic only
Tbits/day 240192 Tbits/day 527904 Tbits/day 1029888 Tbits/day 1548288 Tbits/day US Backbone Voice and Data Traffic. Source: FCC, AT&T, UUNet, IDC
11.92 Tbits/sec 17.92 Tbits/sec
1999 2000E 2001E 2002E 2003E 2004E
90 125 184 295 509 950 803 1000 1300 1800 3100 6900 250
PBytes/month PBytes/month PBytes/month PBytes/month PBytes/month PBytes/month TBytes/day TBytes/day TBytes/day TBytes/day TBytes/day TBytes/day TBytes/month
1999 2000E 2001E 2002E 2003E 2004E 1998 1999E 2000E 2001E 2002E 2003E 1996
24000 33333 49067 78667
Tbits/day Tbits/day Tbits/day
Tbits/day 135733 Tbits/day 253333 Tbits/day 6424 8000 10400 14400 24800 55200 67 Tbits/day Tbits/day Tbits/day Tbits/day Tbits/day Tbits/day Tbits/day MCI backbone only, 20-30% market share at time US Backbone Voice and Data Traffic Based on AT&T figures
RHK Inc (1999)
1998 1999E 2000E 2001E 2002E 2003E
MCI (1996)
1996
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Figure 2: Estimates for Bandwidth Supply and Demand
Bandwidth Demand Estimates

600000 500000 Terabits/day 400000 300000 200000 100000 0
19 96 19 97 19 98 19 99 20 00 E 20 01 E 20 02 E 20 03 E 20 04 E
AT&T AT&T 2 Pioneer McKinsey/JPM RHK MCI
Year
Coffman, Odlyzko AT&T Labs, 1998

Coffman and Odlyzko predicted that while growth rates of the Internet are lower than often quoted, the natural growth rate appears to be around 100% per year. They also state that if the present trend continues, data traffic in the US will overtake voice traffic around the year 2002, and will be dominated by the Internet. In 1999 (in TeraBytes/month): US voice 48,000 Internet 10-16,000 Other Public Data Networks 2,000 Private Line 5,000 - 8,500
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Core Optical Networks, Pioneer Consulting, 2000

Pioneer used the adoption of Internet-related technologies, such as email, web and Voice-over-IP. The firm estimated that the plateau for the number of Internet users would be about two thirds of the U.S. population. The Pioneer Bandwidth Demand Model is based on content demand and it employs three variables: 1) The number of Internet applications; 2) The associated bandwidth of those Internet applications; and 3) The percentage of all online time spent on those applications. The model is based on a set of six applications: email, static web pages, dynamic web pages, IP Telephony, FTP/Telnet and multi-media applications. Each of these applications has an associated optimal bandwidth rate. The calculation for bandwidth demand is as follows: Average bandwidth required by Internet users per month = Sum of (% of all time online using app #1) x (accessible bandwidth of app#1) + + (% of all time online using app #n) x (accessible bandwidth of app#n)
Backbone! , McKinsey/JP Morgan, Sep. 2000

According to McKinsey and JP Morgan, using data from AT&T, traffic on long haul networks is expected to grow be 60% per year over the next 5 years. 80% of all traffic on the backbone will be IP-based traffic and is growing at 90-120% annually over the next few years. Internet traffic is doubling every three to six months. Voice traffic will fall to 10% or less while data traffic will climb to the remaining 90% or more.
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Most studies of data and voice networks have mostly concentrated on long-haul traffic and ignore the significant edge-load placed by local services. For example local telephone calls are estimated to comprise between 70-80% of all voice traffic. Figure 3: McKinsey/JP Morgan Forecast of Backbone Traffic
PetaBytes per month
RHK DWDM market Forecast, March 2000

Figure 4: RHK Estimates for AT&T's traffic demand
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Chapter 2: Bandwidth Demand

The following Chapter examines the issues of bandwidth demand in convergent networks and addresses the issues of demand for voice as well as data services in residential and corporate markets. The term bandwidth demand will be defined in the context of this paper and discussed in terms of the drivers of bandwidth demand, and two possible frameworks for forecasting and analyzing bandwidth demand 1) time-series forecasting using services adoption, and 2) aggregate demand forecasting using Price Elasticity of Demand, will be introduced.
Edge Demand and Network Capacity

Like bandwidth itself, the term bandwidth demand is used quite loosely and is often misused. Many of the studies that provide forecasts of bandwidth demand, are growth forecasts of backbone traffic and often fail to recognize the essential difference between backbone traffic and the Offered Load or Edge Demand of the network. Edge Demand is a measure of the traffic injected (or demanded) at the edge of the network and is usually described in terms of data rates (e.g. Gigabits per second). This load is presented to the network by all devices (phones, computers etc) connected to the network. Once the traffic enters the network it will penetrate a certain number of layers of the network (depending on traffic type, destination etc) before returning to the edge to be delivered to another device (phone, computer etc). This is shown conceptually in Figure 5 where all traffic begins at layer 0. Not all traffic reaches the backbone of a network. For example some estimates of voice traffic suggest that more than 80% of voice calls stay local. Often reports will also try to equate backbone traffic, or even edge demand with Network Capacity. This can also be misleading and will be discussed further in the Chapter on Bandwidth Supply.
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Figure 5: Edge Demand and Traffic Penetration
Drivers of Bandwidth Demand

The quantity of bandwidth being demanded is increasing. This is proven beyond doubt by various measures of voice and data network traffic. The drivers of this increasing quantity of bandwidth demanded are less well understood and often debatable. This thesis presents the following drivers contributing to bandwidth demand. Other drivers may exist but can usually be included in one of the following categories: Declining Cost/Performance of Computing Growth of Digital Information Broadband Access Adoption New Services Adoption Bandwidth Pricing Changing Culture
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Declining Cost/Performance of Computing

An oft-quoted driver of bandwidth demand is the dramatically declining cost/performance of computers. Current generations of Intel Pentium 4 processors coupled with abundant, low-cost memory, large hard disk drives holding more than 30Gbytes of data and large screen displays, has elevated the potential for information to be generated and processed at the edge of any network. Many believe that the mismatch between computing power at the edge and the capacity of those computers to connect to other computers is a fundamental driver of increasing network bandwidth. The proliferation of computer-based devices from the PDA to the car also creates demand for connectivity between those devices, as the value of the data generated becomes much greater in a network of devices.
Growth of Digital Information

In general the amount of digital information is increasing dramatically. The digitization of almost all media (digital cable, DVD, MP3s etc), the increasing number of digital devices (PCs, Mobile Phones, hand-held computers, digital cameras) and increasing average files sizes, as evidenced by the growth in popularity of digital photos, MP3 audio and video files, all contribute to increased bandwidth demand. All digital information requires processing by computing devices and in many cases requires networks of computing devices to realize their true value.
Bandwidth Pricing
Consistent with standard supply and demand theory, a downward trending price for bandwidth will cause the quantity of bandwidth demanded to increase. This is for the static case of an unchanging demand curve over time. While this is generally true, it is possible that bandwidth demand increases even under increasing prices IF the demand curve is changing position with time as shown in Chapter 5: Dynamics of Supply and Demand. What cannot be denied is that Bandwidth Pricing is an influential component of Bandwidth Demand scaling. At any one point in time it is difficult to draw conclusions from pricing data since prices may or may not be sustainable, and the dynamics of competition can blur trends. According to Jeff Kagan, recent rises in DSL and Cable prices may suggest that local providers of these
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connections have been employing Price Penetration tactics to combat increasing competition2. The slowdown in business of some competitors may have allowed incumbent carriers to raise prices to a sustainable level. In a further example, Cahners In-Stat Group, found revenues projections for backbone connections will produce a compound annual growth rate (CAGR) of 16.8 percent between 1999 and 2004. During the same time frame, the number of backbone connections will achieve a compound growth rate near 23 percent. In-Stat says the difference between the growth rates in revenue and connections can be attributed to a continued decline in the cost of bandwidth.3 This appears to assume that, in at least some cases, the declining cost of bandwidth from carrier to carrier is not being passed onto end-users. This is very important to consider, especially in oligopolies and effective-monopolies in local access services. Much work has also been done in the pricing of Internet bandwidth. Currently connection-basedpricing still dominate the market. In this (nearly) all users are charged a fixed-bandwidth fee, usually with unlimited usage. To date most connection fees were paid by organizations (universities, government agencies, etc.) and the users paid nothing themselves. Essentially the marginal packet placed on the Internet is priced at zero and no pricing mechanisms exist for pricing at the margin of available bandwidth. This has been a major contributor to early adoption of Internet technologies but maybe a barrier to continued commercialization and rapid innovation of the Internet. Pricing schemes such as Congestion Pricing and Committed Information Rate Pricing based on usage and QoS, among other things, are well documented by researchers such as Clark and Varian.4 In summary, true competition between substitutable services and penetration pricing will likely have an effect on broadband prices. Where competition exists at the end-user level, price or cost decreases are likely to be passed directly to the end-user. Where competition exists a layer behind local monopolies, or even oligopolies with incentive to avoid price competition, decreasing prices (i.e. costs to the buyer) will probably not be passed onto the end-user.
Daily Tribune, 4th May 2001. Jeff Kagan is an Atlanta-based telecom industry analyst, commentator. http://www.jeffkagan.com 3 Cahners In-Stat Group, Connecting U.S. ISPs The State of the Backbone Market, December 2000 4 David Clark, MIT. Hal Varian, UC Berkeley. Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 19
Broadband Access Adoption

It appears that one of the greatest drivers of bandwidth demand is the increasing adoption of broadband Internet connections. This can be seen as supply-side economics inducing a shift in the demand curve outwards. This is an important effect, discussed in more detail later in the paper. While infrastructure issues and access costs still have a strong effect on broadband penetration in the United States, there has been strong relative growth in the past six months. Recently, Nielsen/NetRatings found that the fastest growing segment of Internet connection is High Speed, which is defined as ISDN, LAN, DSL and Cable Modems. 5 Even though the most popular connection speed is still 56Kbps, lower speed modem connections (28.8/33.6Kbps) have decreased by over 20% in the last year, as shown in Table 2. Table 2: Internet Connection Speeds Market Share Internet Connection Speeds Dec. 99 vs. Dec. 00
U.S. Home Users
Dec. 1999 Speed Modem 14.4K Modem 56K High Speed*
Dec. 2000
Users Composition Users Composition Percent (000) (000) Percent Percent Change 6,085 30,912 4,725 8.3% 43.1% 42.2% 6.4% 4,842 22,960 57,898 11,705 5.0% 23.6% 59.4% 12.0% -20.4% -27.3% 87.3% 147.7%
Modem 28.8/33.6K 31,602
* Includes ISDN, LAN, cable modems and DSL Source: Nielsen//NetRatings
Table 3: US High-speed Subscribers by Technology, also shows past and forecasted data for broadband technologies. Interestingly, the US is not the fastest adopter of broadband technologies at the present time even though, overall, it contains the largest number of broadband users. According to The Strategis Group6, the largest adopter of broadband connections is Korea with a
5 6
Nielsen/NetRatings, February 2001 The Strategis Group, "Residential High-Speed Internet: Cable Modems, DSL, and Fixed Wireless," January 2001. Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 20
57.3% adoption rate of broadband connections, defined as cable modems, ADSL, satellite connections and T1/leased lines, compared with the United States with 11.1% adoption. Table 3: US High-speed Subscribers by Technology
1999 0.58 1.25 0.01 0 High-speed Subscribers by Technology (millions) 2000 2001E 2002E 2003E 2.3 5.5 6.88 9.38 4.11 7.12 9.57 11.88 0.06 0.19 0.95 1.96 0.01 0.1 0.15 0.3 2004E 11.87 14.19 3.04 0.5 2005E 14.22 16.13 4.71 0.8
DSL Cable Wireless Other
Source: The Strategis Group, except 2000 and 2001 DSL figures which are more recent figures from DSL Prime News
Some would argue that broadband connections are not drivers of increasing demand, and that it is either the adoption of new services OR the supply curve shifting out at the expense of prices, that is driving the increased use of bandwidth. It does appear true that the availability of new content and applications has driven the adoption of broadband in homes for downloading streaming video, downloading MP3s, emailing photographs and large file attachments, playing online games, and even telecommuting. Future applications hold even greater promise for broadband users, such as video-on-demand, video conferencing and home networking. Better services from Service Providers, such as selfprovisioning and dynamic QoS pricing, may also add value to broadband connections and place the Internet on par with television and radio in terms of adoption. However the debate about what drives the quantity of bits demanded appears to be a moot point since there is evidence that users of broadband Internet connections fundamentally change their usage habits as a result of faster connections, inducing users to demand higher load applications and services. According to a study by Statistical Research Inc, those with high-speed Internet access, about 75 percent reported broadband has changed their habits7. Some respondents said broadband had led them to devote more time to the Web, while others indicated that its speed allowed them to get their Internet tasks done more quickly and move on to other activities. The study also shows that broadband households are twice as likely to try downloading and streaming content from the Internet, and three to four times more likely to do so on a regular basis. For example, 49 percent of those in broadband homes have tried streaming audio, as compared to 20 percent for the US
7
Statistical Research Inc., All Things Digital, February 2001, http://www.statisticalresearch.com/press/pr021501.htm. Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 21
population. Sixteen percent of broadband households report listening to streaming audio in the past week, as compared to four percent on average. Nielsen/NetRatings and SBC Communications have also found that residential users with highspeed connections tend to increase their level of usage. In a Press Release, Nielsen/NetRatings found broadband users visit more sites, view more pages, and spend more time online, in both the number of sessions and aggregate minutes, than their dial-up counterparts. SBC's "Broadband Watch" survey found Residential DSL users are spending an average of 25 hours per week online, 61 percent more than people in dial-up households. Table 4: DSLs Effect on Online Activities DSL's Effect on Online Activities Activity Downloading MP3s Downloading video E-mailing photos
Source: SBC Communications
Performed by Performed by DSL Users Dial-Up Users 61% 64% 76% 35% 36% 62%
New Services Adoption

As mentioned previously, a point that is often debated is which is the driver of bandwidth demand, the adoption of broadband connection technologies, or the promise of new services such as video-on-demand (VoD)? This thesis maintains that it is a combination of both, since new, compelling, bandwidth-intensive applications encourage people to demand more bandwidth, and a product of a broadband connection is greater usage of the connection and further increase in demand for bandwidth. There is little doubt that once value-added, compelling network services are introduced that demand for these services and the underlying bandwidth to support these services increases. This is particularly true of services in which positive network externalities operate. So-called Metcalfs Law, named after Bob Metcalf the Inventor of Ethernet and founder of 3Com, states
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that the value of a network increases with the square of the number of users connected to the network. Most network services exhibit this sort of characteristic - none more so than basic telephone service. The introduction of new services, at all levels of the value chain, contributes to the demand for bandwidth as more users adopt these services. Some services will scale edge demand almost linearly with the number of users, e.g. basic telephone service, while a number of new services scale edge demand almost exponentially with the number of users, e.g. peer-to-peer media sharing such as Napster. As demonstrated in the Services Adoption Model later in the paper, digital media streaming and VoD are services that are likely to increase the demand for bandwidth dramatically. While the previous two years have seen a dramatic increase in the investment of technologies to build new services such as VoD, no one has been able to deliver a compelling product that has attracted a wide audience. Most say that the infrastructure (bandwidth) is not there to deliver these new services, which brings us back to questioning the driver of bandwidth demand. This is explored further in the Chapter on Bandwidth Supply. In summary, new services and the connections to support them create a positive feedback. Broadband services will be adopted without broadband connections, PROVIDED that the services are compelling, cost-effective and offer a minimal, acceptable performance for the enduser. This may drive more people to adopt high-speed connections, further providing a catalyst for new services adoption. This is intimately linked with the available supply of bandwidth to the end user and will be discussed in further detail in the chapter on Bandwidth Supply.
Changing Culture
Underpinning many of the drivers of bandwidth demand discussed above are fundamental changes in the culture and usage of network and communications. While these paradigm shifts are harder to define, it is worth discussing briefly. Research has shown that many Internet users, particularly younger users and early adopters consider Internet access to be less expendable than other fundamental services such as TV and radio.8 The Arbitron/Edison Media Research Internet Study found that one-third of Americans
8
Arbitron/Edison Media Research Internet Study and Statistical Research, Inc. Page 23
with Internet access at home would give up television if forced to choose between television and the Internet. Among those users who have ever listened to or viewed streaming media online there is an even larger shift towards the Internet 41%. According to Larry Rosen, President of Edison Media Research, "our survey shows evidence that streamies [those that use streaming media] are more sophisticated users of Internet technology and rely on it more for entertainment, work, and news." The study also found a relationship between a respondent's age and their choice of medium. Americans between the ages of 12 and 24 are more likely to give up television (47 percent) than the Internet, while more than two-thirds of Americans 25 and older would rather retain TV. According to study by Statistical Research Inc, when a user interacts with both a TV and a PC during primetime, the PC is four times more likely to hold consumers' attention than the TV.9 Eighty percent of those who use TVs and PCs simultaneously during primetime consider the computer to be their primary activity, while 18 percent cite the TV as commanding more of their awareness. While these studies do not present definitive conclusions, there are sufficient trends to suggest at least US culture is changing to become more networked and a higher consumer of information and interactive communications and entertainment. Long-term this is likely to have a significant impact on the demand for network bandwidth.
Statistical Research Inc, "The TV/PC Connection 2001" Page 24
The following section provides data on the growth of certain services in use today.
Voice Traffic Growth

The International Telecommunications Union (ITU) maintains a database providing estimates of telephone traffic for 207 countries for 1997-98, which total 2.5 x 1012 minutes per year. Adding in an estimate for the missing countries brings us to 7.5 x 1012 minutes per year, or roughly 600,000 terabytes per month. The US accounts for about 250,000 terabytes per month, of which roughly a third is modem calls. AT&T has somewhat better estimates for long-distance traffic in the US, including voice, Internet, public data networks and private lines.10 Table 5: Traffic on U.S. long distance networks in terabytes, year-end 1999
Network US voice Internet Other Public Data Networks Private Line Source: Odlyzko, AT&T Research Traffic (terabytes/month) 48,000 10,000 - 16,000 2,000 5,000 - 8,500
Voice (as well as modem and fax) traffic on the PSTN is currently growing at approximately 8% per year to about <<40,000 TB/month??>>. Estimates that include local and intrastate toll traffic rise to approximately 275,000 TB/month11. According to Peter Davidson, of Davidson Consulting, about 300 billion seconds of fax transmissions take place annually. At 45 seconds per page, this means 400 billion pages per year are faxed. At 15 Kb per page, this comes to around 6,000 terabytes of fax information per year.
10
11
Coffman and Odlyzko, AT&T Research, 1998-2000). Coffman, Odlyzko The size and growth rate of the Internet, AT&T Labs Research, 1998 Page 25
Data Traffic Growth

According to most network surveys, the public Internet is currently slightly smaller in both capacity and traffic than the switched voice network but is rapidly approaching voice traffic volume. Currently, it is believe that Internet traffic is growing at a rate of 100% per year. Figure 6, shows the growth in Internet Domains as supplied by a survey conducted by the Internet Software Consortium. The survey counts the number of IP addresses that have been assigned a name. Figure 6: Internet Domain Survey Host Count
Source: Internet Software Consortium (http://www.isc.org/)
Of particular interest: US Internet users are going online more often and staying online for longer. US users went online on an average of 15 days in March 2001, up from 14.5 days in March 2000, and 14.2 days in March 1999. They spent an average of 20.2 hours looking at Internet sites in March 2001, up from 15.9 hours last year and 12.8 hours the year before. Residential Internet use in the US is growing at about 30% a year. When residential users switch to broadband, the total volume of data accessed increases by a factor of 5-10.
By 2002 data traffic will surpass phone traffic. 12

12
Jupiter Media Metrix, Apr 18 2001 Page 26
Internet Services
Table 1 shows the average activity for a Web user in March 2001, as reported by Nielsen/NetRatings Inc. Table 6: Average Internet Use in March 2001 Average Internet Use in March 2001
Combined home and work access
March Number of sessions per month Number of unique sites visited Page views per month Page views per surfing session Time spent per month Time spent during surfing session Duration of page view Active Internet universe (actually surfed) Current Internet universe
Source: Nielsen//NetRatings
February 30 19 1,051 36 16:29:30 0:32:44 0:00:55
% Change 10.0% 10.5% 6.4% -5.6% 5.1% -3.1% 0.0% 2.9% 1.8%
33 21 1,118 34 17:19:49 0:31:42 0:00:55
112.7 million 109.5 million 173.2 million 170.1 million
Wireless Internet
According to eTForecasts, by the end of 2005, the number of worldwide Internet users will nearly triple to 1.17 billion, and an increasing number of these users will be using wireless devices to go online.13
13
http://www.etforecasts.com/ Page 27
Table 7: US Internet/Wireless Users Internet Users/Wireless Users

(millions)
Year 2000 2002 2005 United States Internet Users Wireless Internet Users Worldwide Internet Users Wireless Internet Users Western Europe Internet Users Wireless Internet Users
Source: eTForecasts
135 2 414 40 95 7
169 18
214 83
673 1,174 225 148 59 730 246 168
Corporate Data and E-Commerce

Figure 7: US Growth in eCommerce
Source: Forrester Research
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According to Constat, internal corporate (intranet) traffic is growing at about 30% per year, but corporate traffic to the public Internet is growing at 100% per year.
Digital Cable and Streaming Media

According to study "Streaming at a Crossroads" by Arbitron and Edison Media Research, 36% of all Web surfers accessed some form of streaming media in November 2000, as compared to 28 percent during the same time last year. According to Nielsen-NetRatings, streaming media consumption reached an all-time high in November 2000, with 35 million Web users at home accessing streaming content, a 65 percent increase from 21 million during the same month last year. "Streaming media is one of the chief incentives prompting users to switch to high-speed Web access, which is fast becoming the must-have service in the home," said T.S. Kelly, director of Internet media strategies at NetRatings. "That said, improvements in quality, ease-of-use, and accessibility must continue if streaming consumption is to become as commonplace as broadcast or cable television." Table 8: Streaming Media Growth and Reach Streaming Media Growth and Reach
(US Home Internet Users)
Percent Nov. 1999 Nov. 2000 Growth Total Streaming Audience Total Active Internet Users Percent Reach of Streaming Audience
Source: Nielsen//NetRatings
Unique Audience 21.0m 74.0m 28% 34.7m 95.4m 36%
65%
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Chapter 3: Services Adoption and Growth Model

This chapter describes the methodology and results of a draft edge demand model based upon services adoption. This model is used to illustrate the concept of edge demand forecasting using services adoption and how the results of the model maybe used to test demand assumptions and how they impact on network capacity requirements. The model is considered a work-in-progress and will be refined over time as more and better inputs become available. Demand forecasting using service adoption rates is a popular method of forecasting that has been used in many studies of Internet and telecommunications network growth. The method is relatively easy to implement and scale. As new information becomes available, the accuracy and comprehensiveness of the model can be improved without reworking the entire model. Furthermore it utilizes tangible services and statistical information such as population growth and historical adoption rates for comparable services. However the model is not without its drawbacks. First and foremost the model does not consider the interaction of supply and demand forces, specifically price and market-setting prices for various services. The model assumes that other factors such as network supply build out, a certain level of competition and technical innovation will continue to fuel the introduction and adoption of services. While this may seem flawed, the output from a service adoption model should be viewed as an input into a supply-demand model that does include price. This will be covered further in Chapter 5: Dynamics of Supply and Demand. To date, most service adoption-based bandwidth demand models have fallen short of the mark. There are possibly a number of reasons for this: Bandwidth demand is a complex problem with many interrelated variables. Often there is a need to oversimplify the problem in order to keep the workload manageable; Hard data, to support anything but the simplest of models, is very difficult, timeconsuming and costly to collect;
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Content and services that draw on bandwidth are innumerable and few attempts have been made to identify and categorize a comprehensive list of content and services; Bandwidth studies are often delivered in the context of market verticals, or industry analysis and are therefore quite narrow in focus; and Bandwidth studies fail to separate bandwidth demand from bandwidth supply.
Many similar models will also use Internet bandwidth demand as a proxy for next-generation networks. This fails to recognize the importance of services such as Video-on-demand and digital TV on a convergent network especially when considering substitution of services and the migration from analog to digital services. This is important from a regulators point of view as well as a carriers perspective. Figure 8 shows the possible effect on bandwidth demand of migrating analog TV services to a digital network. The net result is digital bandwidth demand on a convergent network increases but total bandwidth demand decreases and analog spectrum is freed. Figure 8 Potential effects of migration of spectrum usage from analog to digital services
Bandwidth
analog
Migration from analog to digital services
digital
Compression technologies increase efficiency of bandwidth
Net Effect: bandwidth demand actually decreases
Time
It should be noted, however, that all models of this type do not help predict the impact of new technology in the future. For example, currently, analog TV demands an incredibly large amount of bandwidth in it current analog form (equivalent of > 200Mbps). In order to switch to technologies such as HDTV, the development of compression technologies is vital and could possibly drastically reduce these bandwidth requirements when they are transmitted over the digital format. Neither will this static model take into account the iterative nature of supply and
demand typical in a high tech industry. For example, when computer chips became more powerful, applications that consume greater computing power were created to absorb the spare capacity of these chips. Analogously, the same can be said for supply and demand for bandwidth.
Results
The following tables and graphs summarize the results of various scenarios run through the model. In each case the results show the Offered Load or Edge-Demand as defined in Chapter 2. This is important to understand when comparing the results of this model to forecasts presented by industry consultants and analysts, which mostly try to model backbone traffic. The exception is Pioneer Consulting, which developed an edge-demand model for Internet usage.
Offered Load
Figure 9 presents the results of four scenarios run through the Services Adoption Model. Figure 9: Bandwidth Demand Forecast
Bandwidth Demand Forecast
3600000 3100000 2600000 Terabits/day 2100000 1600000 1100000 600000 100000 1998 2000 2002 2004 2006 2008 2010 2012 Year
Base Case Low Adoption Rate of Digital TV Medium Adoption Rate of Digital TV High Adoption Rate of Digital TV
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Average vs Peak Load

Given the offered load forecast at the edge of the network, Figure 10: Average Peak demand in a Day, graphs the average peak load each hour during a day defined by the following demand distribution: Table 9: Peak Demand Distribution
Time % of Total 0000-0100 1.72% 0100-0200 1.72% 0200-0300 1.72% 0300-0400 1.72% 0400-0500 1.72% 0500-0600 1.72% 0600-0700 1.72% 0700-0800 2.79% 0800-0900 6.34% 0900-1000 6.34% 1000-1100 6.34% 1100-1200 6.34% 1200-1300 6.34% 1300-1400 5.69% 1400-1500 5.69% 1500-1600 5.69% 1600-1700 5.69% 1700-1800 5.69% 1800-1900 7.95% 1900-2000 10.18% 2000-2100 1.72% 2100-2200 1.72% 2200-2300 1.72% 2300-2400 1.72%
The Average Peak Demand is defined as the average instantaneous demand in a given hour, expressed in Terabits/sec.
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Figure 10: Average Peak demand in a Day

Forecast Average Peak Demand Each Hour in a Day (Tbits/sec)
35.00
Terabits/sec
30.00 25.00 20.00 15.00 10.00 5.00 0.00

00 00 02 010 00 0 04 030 00 0 06 050 00 0 08 070 00 0 10 090 00 0 12 110 00 0 14 130 00 0 16 150 00 0 18 170 00 0 20 190 00 0 22 210 00 0 -2 30 0
Time 2002: 2004: 2002: 2004: Base Case Base Case High Adoption of Digital TV High Adoption of Digital TV
Model Description
This model covers the continental United States only. This was done for simplicity but also because the best data is found for the US market. Both residential household and business traffic is modeled, although the model for residential services is significantly more refined. Business data is very hard to come by and many business services are difficult to define in terms of bandwidth demand, e.g. corporate database synchronization. Consumer household traffic can be easily modeled with service adoption rates as the primary driver. Service adoption generally follows a cumulative-normal distribution function and this would not be entirely consistent with how businesses adopt new technologies or increase their usage of existing services. In order to improve business traffic forecasting, additional data for business traffic is required and alternative modeling techniques should be explored to account for the unique adoption patterns experienced by business customers.
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By principally classifying various types of services that would be demanded by a business and residential users and applying a cumulative normal distribution rate of technology adoption for the penetration and usage of each respective technology, a dynamic, interactive model can be used to test bandwidth demand under various scenarios. It is important to note that the services in this model are a mixture of content (signals - data, video, TV etc) that are currently delivered over both analog and digital networks. However these services may be delivered over the digital network of the future. As pointed in the previous section, it is crucial to consider all these services, as their gradual migration into the digital media will have a severe impact on bandwidth demand. For example, analog TV could be delivered in the HDTV format and the analog phones could become digital. In contrast to many other research reports using the content demand driven methods, this model does not be restrict itself to only the digital traffic running through the telecommunications networks and Internet backbones of today, but also considers the possible substitution of these technologies.
Services
A number of services for both residential users and business users are modeled. New services can be added to the model, and some rules for service substitution have been included. The follow list presents some of the services. Sample Residential Services:
Audio / Video Telephone VoIP Wireless Telephony Video Phone Movies on Demand Streaming Video Clips Voice Messaging on Net Downloaded Movie Downloaded Video Clips Napster / Downloaded Music Digital TV Broadcast Television Webcam / Webcast Radio Broadcast IP Audio Broadcast VHS Tapes Text / Images Chat Fax Email Images Newswires Webpages Spam Magazines / Print Data Remote Backup Real-Time Data Online Applications Games Groupware/ PIM Page 35
Sample business services:

Online Applications ASP Applications Groupware/ PIM Finance and Accounting Other ASPs Transactions Online Procurement E-Commerce Finance and Accounting Online Trading Bookings, Reservations
Adoption Rates
For each of these service types within these categories, a technology diffusion curve that follows a cumulative normal distribution in the shape of an S curve has been used to model adoption. This method has been widely used and acclaimed as a reliable forecasting tool for technology adoption14. For each of these services, historical data has been used wherever possible to estimate mean time (in number of years since introduction) for 50th percentile of the population to adopt this technology and for the 16th percentile (one standard deviation from the mean) to adopt the technology. These figures serve as the mean and standard deviation of the normal distribution as shown in Figure 11. For technologies in which historical data does not exit, the inputs in the normal distribution have been estimated and sensitivities run to determine the impact of introduction date and adoption rate.
14
Rogers, Everett., -Diffusion of Innovations); Foster., R., Innovation, The Attackers Advantage ; Moore, Geoffrey A., Crossing the Chasm
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Figure 11: Forecast input parameters for service adoption rates
16% of total population below 1 68% of total population between 1 and 1
Under this framework, it has also been assumed that the plateau rates of these service types will eventually be 100% and do not face the threat of being phased out or put in another way, not crossing the chasm15. Though this may over simplify the problem, the effect can be mitigated by manipulation of the standard deviations. Average usage rate changes per user are dependent on a number of factors. In categories such as spontaneous communication, video on demand, and online interactive gaming, the category usage rates will probably depend on consumption behavior of individuals and households. On a category level, the total usage is more likely to be constant. However, within a category, such as spontaneous communication, the substitution among the individual services such as cellular phones, voice over IP, and traditional telephony depends on factors such as network effects, relative performance over price and cross price elasticity. As a result, it is believed that the average usage rates per user for newer technologies will increase as general pricing falls. To illustrate this, people will tend to change their cell-phone usage depending on price and whether technology is good enough to replace regular phones. However, the maximum number of minutes an average individual can spend on the phone has a maximum, due to sheer human capacity and there are only 24 hours in a day.
15
Moore, Geoffrey A. Crossing the Chasm Page 37
Chapter 4: Bandwidth Supply

Chapters 1and 2 examined bandwidth and the drivers that fuel the demand for bandwidth. This chapter will deal with the other side of the economic equation - the supply of bandwidth. Supply, in the context of communications networks and this thesis, is taken as the network capacity available to meet the edge-demand for bandwidth. There have been many statements made about the oversupply of bandwidth. In general this statement seems to refer to the increasing build out of fiber by CLECs and carriers carriers such as Williams Communications and 360Networks. For example 360networks has built 21,000 miles of fiber in North America and 6,200 miles in Europe, of which 12,000 miles and 3,800 miles are lit respectively. While it is quite possible that a lot of fiber remains unlit in the backbone, this should not be equated with supply. Network Capacity is determined by entire systems of fiber, networking equipment and management systems, and is generally segmented into various markets for bandwidth. Older fiber and systems may ensure an undersupply of usable network capacity in the future as next-generation services become mainstream. However, market-by-market, the supply of capacity can vary considerably. According to Keith Kennebeck of The Strategis Group, "Deployment of residential broadband is supply-side limited at this time. In order to cope with this, operators are relying more on automated subscriber installation and management tools to help overcome the bottleneck and meet this demand." Traditionally the data networking and telecommunications markets have been somewhat separated, and network capacity had to be discussed relative to the network each service ran on. The capacity of the PSTN was relative to circuit-switched voice service in which bandwidth is reserved regardless of whether it is being used or not. In this respect the capacity is how many voice calls, end-to-end connections, can be supported at once. The data networks of corporate LANs and campus networks had a capacity expressed relative to packet-switched networks, which is often a measure of the peak load the network can handle and not the number of sessions, or end-users the network can support. Since packet networks operate on a best-effort basis, additional sessions or users can be added but at the expense of congestion and lost packets. Both
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can be expressed in x-bits per second, but the measure means slightly different things from a network capacity point of view. With the possibility of convergent networks this picture becomes more complicated, as it is likely that convergent networks will be hybrid solutions employing both circuit-switching and packetswitching technologies, each employed where their relative strengths justify. Over time, however, an optimum architecture is likely to homogenize, just as the PSTN and LAN/WAN technologies have homogenized somewhat. In this case different services will be running over the same underlying infrastructure, differentiated only by their source, destination, quality of service, synchronicity etc. The consequence of this observation is that supply cannot be limited to the maximum raw bandwidth a network can handle but must take into account the intelligence of the network and its ability to differentiate services, managed traffic efficiently and provision bandwidth to maintain high utilization of available network resources.
Relationship between Edge-Demand and Network Capacity

As stated in Chapter 2, there is a difference between the bit load presented at the edge of the network, and the network capacity required to accept, transport and manage that load. Graph theory and optimization techniques have contributed significantly towards solving the problem of configuring network capacity to handle increased offered load. Network flow and flow deviation techniques provide the mathematical foundation for such optimization and topological design. If an edge load is imposed on the outside nodes of a packet network, such as that shown in Figure 12, each link should support the amount of traffic that can be placed on it from both nodes. If the edge demand is doubled, as represented by a doubling of outside nodes, then graph theory indicates that the number of lines to interconnect the set of nodes (N) is determined by N*(N1)/2, which can be simplified to N2 for large values of N. It should be noted that this simple derivation holds for packet networks where every node is connected to each node around it, theoretically. Circuit-switched networks such as the PSTN are different problems, but will not be discussed here.
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Figure 12: Mesh Network Example
The capacity required in each link is best explained by taking the simplest of networks, a single link between two nodes, if the edge demand at each node is x, then the capacity of the link should be 2x for a non-blocking architecture. However, according to Michael ODell of UUNET, the link between two major nodes is often expressed as a function of the amount of trunking capacity expressed as (bits/sec)*miles.16 This is likely because links between two major nodes maybe made up of more than one fiber and may have tributaries that feed into the trunk. ODell has stated that for the edge load to double each year in the UUNET network, the network capacity must double approximately every 4 months. This equates to a an 8-fold increase in network capacity for every doubling of edge load!
Traffic Penetration
Another interesting phenomena of network traffic, is the idea of Traffic Penetration, described by the author as the depth in which a packet or connection reaches inside the network. Figure 13 describes a model for thinking about traffic penetration. Called the Boundary-Cloud model, the network is described by a number of segments pertaining to the function of the segment and roughly associated with geography. The segments are described by clouds that are defined as homogenous sets of networks performing similar functions, and boundaries, the
16
http://www.ehto.org/canarie/internetgrowth.htm Page 40
demarcation borders between each cloud. Today these clouds can be associated with the major segments of the network often defined by carriers and equipment providers access networks, metro networks and backbone (or long-haul networks). The boundaries are the crossover points between clouds and can be thought of as a number of nodes on the boundary or the number of links between the clouds. Over time these clouds and boundaries may, and do, change as technologies change, and the functions performed in each segment change (e.g. aggregation, grooming, transport, switching) but the basic premise of the model stays the same. According to the model, 100% of traffic begins at the edge of network. This is consistent with the concept of edge-demand. In this case the edge maybe a single device, such as a phone, or a network in itself such as a corporate LAN or home network. Of that traffic, a percentage of it must leave the edge and travel into the access network before return to the edge to some other edge device such as another telephone or LAN. A certain percentage of edge traffic may also need to enter the metro network to get where it is going, and so on for backbone and international traffic. At the boundaries there are a finite number of nodes and ports that can handle the handover, designated by n*M. The interesting potential of the model lies in its ability to tie technical and economic constraints to the model in order to define the clouds and boundaries of the day. Whether these constraints are the balance between the maximum no. of ports that can be fit into a central office versus the number of subscribers in a given area who are willing to pay for such as service may be compelling.
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Figure 13: Boundary/Cloud model - conceptual diagram

w% of traffic
x% of traffic
y% of traffic
z% of traffic
100% of traffic
w = (100-x-y-z)% x = (100-w-y-z)% y = (100-w-x-z)%
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Drivers of Bandwidth Supply

This section discusses the possible drivers of Bandwidth Supply. As for bandwidth demand, a set of drivers summarizing many of the factors driving Service Providers capacity decisions are presented here. They are: Revenue Generation Cost Savings Technology Deployment Industry Regulation Capital Availability
Determining the equation for bandwidth supply is a much more complex proposition than for bandwidth demand. A complex interaction of technology, competitive, financial and regulatory decisions ensure that no one solution or model fits the industry with complete success. Particularly in convergent networks, a Service Provider must make decisions on the utilization of current, and the expansion of future infrastructure based upon: Optimal service mix on a common infrastructure to maximize revenue; Usable capacity available for the service mix proposed; The need to support existing, cash-generating services as technology platforms migrate; The cost of implementing various service mixes on a common infrastructure; Adherence of regulations from multiple regulatory bodies as the service mix diversifies.
Even so the drivers of supply will be discussed here and a simplified framework for firm supply decisions is presented in Chapter 5.
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Revenue Generation
Perhaps the most obvious drivers of bandwidth supply are financially related. First and foremost Service Providers must consider revenues and costs when making network capacity decisions. This can be considered in two parts: 1) New-entrants attempting to capture a share of increasing demand for bandwidth, and 2) Incumbents protecting existing revenues and creating new revenue streams to replace and decreasing streams. Some of the revenue-related issues include: Maintaining current high margin revenue streams. High margin will vary from carrier to carrier based on the costs of the carrier, but none-the-less a carrier must consider the effects of any spending or technology decisions on revenue streams. Furthermore a carrier must consider service cannibalization when introducing new services; Generate new revenue streams. As margins on existing services are eroded through competition or regulation, there is a need to find new revenue streams. This may involve introducing new services to the same customer base, or widening the supply base to add value to the network for new customers (see Metcalfs Law); Faster revenue turn-around. If a service provider is able to create services faster with existing infrastructure, then not only does it decrease revenue turnaround time but also increases available working capital and may reduce the need to seek new capital every 3 years. As an input to revenue, pricing is particularly important in a high fixed-cost, low marginal-cost business such as network communications. Service Providers want to avoid price competition at all costs, as it eats directly into the margin to fund prior debt or further infrastructure investment. If prices on current products cannot be maintained, and products are not greatly differentiated (e.g. long-distance leased lines), then service providers must find new higher margin services that offer differentiation. Candidates for new services such as these include 1) dynamic bandwidth provisioning, 2) leased lambdas, 3) managed services for full out-sourcing of communications needs, and dynamic pricing based on QoS. The flipside also holds if revenue cannot be generated, then spending on network capacity will decrease, as evidence in recent months.
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Cost Savings
Intimately related to revenue generation as a driver of bandwidth supply is the goal of costsaving, or more precisely spreading costs across a greater opportunity for revenue generation. Technologies such as Wavelength Division Multiplexing (WDM) have fundamentally changed the economics of optical transport. State-of-the-art long haul transmission systems currently being deployed have the potential to enable hundreds of gigabits per second to be transmitted point-topoint on a single fiber pair, and reduce the cost of capacity expansion. Table 10 shows the investment cost per Mbps of capacity on transatlantic optical transport systems going into operation between 1988 and 2000. The investment cost per Mbps of capacity fell by about a factor of 10 from 1989-1995 and from 1995-2000. Note that there does not appear to have been a significant difference in the reduction in investment cost per Mbps from the first half of the 1990s, before the adoption of WDM technology. Table 10: Cost of Optical Technology in Trans-Atlantic Cables
Source: Douglas Galbi, FCC Senior Economist
The premise is that the cost associated with extra transmission capacity in the network is more than offset by the long-term revenue opportunity. The fact that transmission equipment cost per bit/sec is decreasing rapidly substantiates this expectation. New optical systems employing optical signaling, dynamic provisioning, as well as multi-service aggregation and traffic grooming all have the potential to lower the per-bit overhead for service providers. Sycamore Networks, an optical networking systems vendor, is marketing its solutions on the premise that those same services will be delivered in real time as shown in Figure 14.
Figure 14: Provisioning Costs Between 1988 and 2001
Source: Sycamore Networks, www.sycamorenet.com
Costs, however, vary widely from segment to segment and carrier-to-carrier depending on their incumbency, the size of their network and the supplier relationships they have. For example, Metro investments are driven by cost per bit per connection rather than cost per bit per mile metrics. Unlike core networks, metro networks typically have equipment in a wide range of nonowned space and their operations costs reflect this.17 Carrier leased-line will also continue to add to the costs of providing service to end-users. Carriers, and some corporations, will typically lease capacity on backbones with leases typically running three years in duration, regardless of the present bandwidth needs. As the network becomes more and more dynamic, the carriers will increase capacity-on-demand lease arrangements to provide instant on capacity to users. This as-needed or just-in-time strategy allows the carrier to pay for only what they need.
Technology Deployment
The innovation and deployment of technology solutions can also be seen as a driver of bandwidth supply, even though many would argue that it is more of a result of increasing bandwidth supply. Developments in optical technology unquestionably have made massive increases in bandwidth possible. The migration to data-centric networks has lead to routers with a rich set of packetforwarding functions that provide 160 Gbps throughput using a box that is half the size of the typical telecom equipment rack. Figure 15 shows a diagram of networking technologies and their impact on the bandwidth available along a single fiber.
17
John Strand: AT&T jls@research.att.com Yong Xue: UUNET/WorldCom yxue@uu.net Page 46
Figure 15: Scaling of Network Technologies
Source: Ovum
A number of factors support the argument that the implementation of technology is also a driver, beyond the goal of increasing revenue or cutting costs. These factors include: Carriers attempting to stay ahead of the competition and capturing the mind share of customers will implement next-generation systems. An example of this is the move from OC-48 to OC-192 transmission systems even though the later was a much more expensive proposition. The same could occur with the move to OC-768. The first vendor to deploy a viable OC-768 system could induce the deployment of these systems; Systems becoming increasingly scalable and allowing a service provider to pay-as-theygo. The aim of this is to generate carrier spending by limiting the upfront commitment. Furthermore, Service Providers are increasingly wary of solutions that lock them into particular technologies that may not scale well. The history of SONET and ATM are examples of this; Bridging the technology gap between bleeding edge technologies and carrier-class systems. In order to implement and manage increasingly complex systems and networks, Service Providers are demanding that systems vendors provide improved system management, service introduction and better interoperability between different systems. Once these technology problems are solved, the barriers to adoption of new systems
decrease. A further example of this is the necessary deployment of new fiber before new high-speed transmission systems become feasible. According to Gambi, new fiber deployment indicates an expansion of potential capacity via both an increase in the gross volume of installed fiber and an improvement in its technological vintage. Data indicates that growth in fiber miles deployed in the U.S. has been falling for over a decade. Table 11 shows that fiber miles grew about 25% per year in the beginning of the 1990s, while they grew about 18% per year at the end of the 1990s. According to Gambi the explanation for this trend is clear: local incumbents, who currently account for about two-thirds of total fiber miles, have reduced their rate of deployment of new fiber miles. The trend in fiber miles deployed suggests that growth in potential capacity has not accelerated in the second half of the 1990s. Table 11: US Fiber Miles Deployment
Source: Kraushaar, Jonathan M., Fiber Deployment Update, End of Year 1998, Industry Analysis Division, CCB FCC
Industry Regulation
Another significant contributor to service provider capacity decisions is government regulation. The Telecommunications Act of 1996 seemed to pave the way for a new era in competition in the telecommunications industry. This, together with the rise of the Internet, was thought to ensure the unbundling of local networks and the breakdown of local monopolies held by the Baby
Bells (ILECs) for so long. In the end the act has been a mixture of success with the ILECs seemingly stronger than ever. Nonetheless this Act, and others to follow, will be important factors in the continuing development of the communications industry, especially as telecommunications, data networking and media companies converge to common ground already broken by mergers such as AOL and Time Warner.
Capital Availability
The service provider rests at the critical junction between the media value chain and the technology value chain where long-term capital expenditures must achieve a return in the form of recurring short-term service revenues. Currently, the build out of communications networks requires significant up front capital expenditure on fiber (laid or leased), networking equipment, real estate and labor, without guarantees that service fees will be sufficient to provide a return on capital. In recent bull-market years the build out of networks has been funded by a combination of junk-grade debt, equipment vendor financing and bubble-IPOs. Figure 16, shows average carrier CAPEX from 1996 to 2000 (estimated). As can be seen, there has been a CAGR of 18% during this time. Today, the reality is much more grim with funding for new and existing projects drying up as returns on capital are dramatically lower than expected. Table 12 shows sales growth for major carriers from 1999 to 2000 (estimated) to be in the order of 12%, much less than corresponding CAPEX. In order to maintain funding sources for capacity growth, service providers must be able to keep revenue growth in line with capital expenditures.
Figure 16: Carrier CAPEX spending 1996-2000E
US Carrier Capex 1996 - 00E ($351B)

Annual Growth
38% 23%
18% Cagr (96-99) (96-9 Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved.
23% $80B $110B $80B
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10%
$65B
1999
2000E 1999
US$B
IXCs ILECs CLECs ISPs MSOs WSPs TOTAL Adjusted*
1999A
$89 $112 $29 $18 $37 $35 $320 $290
2000E
$93 $117 $45 $30 $40 $40 $365 $325
Change
$4 $5 $16 $12 $3 $5 $45 $35
Source: RHK Inc, 2001. * Adjusted figures account for double counting.
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Chapter 5: Dynamics of Supply and Demand

So far the paper has dealt with the ideas of Bandwidth Supply and Demand somewhat independently of each other. The reality is that these two concepts are highly interlinked and cannot be treated separately. An important question in relation to the adoption of new services arises out of this observation: Is the adoption of new services (bandwidth demand) driven by the demand for these new services in themselves, or driven by the availability of network capacity (bandwidth supply) to support these services? In the Services Adoption Model, an edge demand is forecast using a linear time-series model to test various scenarios of services adoption. The adoption of these services is modeled using normally-distributed adoption curves and does not take into account the cost of delivering the services and thus the level of adoption as a function of the prices of the services. In effect, the bandwidth demand was forecast assuming that the supply and/or the demand curves move out over time, as illustrated below in Figure 17. Figure 17: Dynamics of Demand Growth S
$P
D D q1 q2 q3 Q
While the Services Adoption Model is useful for scenario analysis of edge demand, there is little or no facility to model the interaction between demand and supply through price. According to Lanning and ODonnell in a period of sustained price declines [as anticipated with bandwidth], applications-based forecasts will be unreliable. Dramatically lower prices can cause fundamental changes in the mix of applications and, hence, demand.18 In order to properly
18
A Taxonomy of Communications Demand, Steve G. Lanning, Shawn R. ODonnell and W. Russell Neuman, September 1999. Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 51
understand the interaction between the supply and demand sides of the bandwidth problem, it is necessary to develop an economic model that includes price relative to an aggregate quantity of bandwidth. However, it is very difficult and complex to model bandwidth supply and demand using a linking mechanism such as price. The author is aware of one model developed by the Communications Research Unit (CRU) of the Australian Government that makes an attempt to link supply and demand in a multi-dimensional model. For the time being this is outside the scope of the work conducted in this paper but will be discussed at the end. Rather, a simplified model using twodimensional supply and demand curves will be presented to give some insight into the dynamics of bandwidth supply and demand. One of the fundamental concepts used to define 2D supply-demand curves is Price Elasticity. The Price Elasticity relative to supply or demand, measures the % change in quantity supplied or demanded for each % change in price. In its simplest form, this allows the economist to determine the slope of the curves presented in Figure 17. This is useful for examining the effect of moving supply and demand curves over time and the various effects of monopolistic and oligopolistic markets that exist in network communications. What this model is not useful for is modeling and forecasting aggregated quantities of supply and demand, since this requires comprehensive and accurate supply and demand data for every service and capacity substitute in a convergent network.
Defining the Market

The dynamics of bandwidth supply and demand, best described by the price elasticities of supply and demand or the slope of the supply and demand curves, can vary dramatically with service mix. In this chapter bandwidth supply and demand will be discussed relative to the market for local access leased-line connections. These are used since it is easiest to conceptualize the concepts of supply (the connection speed) and demand (the services demanded) at this level of the network. Furthermore, while local exchange carriers offer a large variety of services and connections, it is the local connections and leased-line services that have been the most important on a revenue basis, and the price trends for these rate elements are a good indication of overall price trends for local exchange carriers.19
19
Growth in the New Economy: U.S. Bandwidth Use and Pricing Across the 1990s, Douglas A. Galbi Page 52
Going forward, it will be useful and necessary to calculate demand elasticity for aggregated demand. Some argue that this is not feasible where services are sufficiently differentiated from each other according to such parameters as QoS, synchronicity and content. Lanning and ODonnell argue that the convergence of the telecommunications industry will allow consumers to see disparities in costs, forcing service providers to eliminate or justify price differentials of different bits running over the same infrastructure.
Calculating Price Elasticities

Data used for calculating Price Elasticities of bandwidth, such as price trends and network capacities, is very difficult to come by since very little data is publicly available. Table 13: Estimates of Supply and Demand Elasticity displays examples of Price Elasticities calculated by third parties for various markets. Attempts at calculating Price Elasticity of Supply and Demand for local bandwidth, have been attempted below using data from various sources. Table 13: Estimates of Supply and Demand Elasticity
Product Generic Transport Bandwidth Long-distance Voice ATM Circuit Bandwidth Router Bandwidth Switch-router Bandwidth Circuit-switched voice Bandwidth Internet Bandwidth Non-internet data Broadcast Information (TV etc)
Price Elasticity Estimate -1.05 to -1.1 1.1 -1.2 to -1.66 -1.03 to -1.06 -1.36 to -1.72 -0.1 to -0.2 -1 to -3 -0.3 to -1 -0.5
Source Original Source Lanning/O'Donnell FCC Lanning/O'Donnell FCC Lanning/O'Donnell Lanning/O'Donnell Lanning/O'Donnell CRU - Australian Government CRU - Australian Government CRU - Australian Government CRU - Australian Government
Furthermore, establishing price and cost trends for leased lines can be very difficult since prices vary widely and are often negotiated individually with customers.20 As stated by Galbi Describing price trends for local exchange carriers leased line offerings involves important standardization, weighting, and aggregation issues. For example, with different volume, term,
Senior Economist, Competitive Pricing Division, FCC, December 2000. http://www.tpeditor.com/contents/2001/galbi_tablesandcharts.htm 20 Growth in the New Economy: U.S. Bandwidth Use and Pricing Across the 1990s, Douglas A. Galbi Senior Economist, Competitive Pricing Division, FCC, December 2000. http://www.tpeditor.com/contents/2001/galbi_tablesandcharts.htm Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 53
zone, and distance plans, US West has in the year 2000 435 different rates for fixed and per mile monthly charges for inter-office DS3 circuits.18
Price Elasticity of Demand: Local Bandwidth

Table 14 shows price trends for local connection terminations of leased lines, i.e. the connections between the carrier central office and a customer premise in a metro area. This pricing is expressed in $/month/Mbps and does not include a per-mile charge. Therefore it is considered an indication of customers willingness to pay for connection speed. This data has been graphed on a log-log scale in Figure 18 to give a representation of a demand curve. From this curve, the Price Elasticity of Demand for leased-line terminations is approximately 2.35 (elastic). Table 14: Prices of Local Termination Lines, 1990-2000
Connection Speed (Kbps) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 128 $300.00 $295.00 $305.00 $294.00 $299.00 $319.00 $319.00 $320.00 $311.00 $323.00 $320.00 1500 $123.00 $118.00 $112.00 $112.00 $102.00 $96.00 $98.00 $102.00 $96.00 $97.00 $99.00 44700 $18.00 $27.00 $25.00 $22.00 $23.00 $24.00 $25.00 $27.00 $28.00 $30.00 $32.00
Source: Douglas A. Galbi, Senior Economist FCC, using data from Bell Atlantic and US West.
Figure 18: Log-Log Graph of Local Termination Lines

Price vs Connection Speed
1990 $1,000.00 P ($/month/Mbps) 1991 1992 1993 $100.00 1994 1995 1996 $10.00 100 1000 Q (Kbps) 10000 100000 1997 1998 1999 2000
As a comparison, price data was graphed as a function of estimated ILEC leased-line bandwidth in use, as shown in Table 15: Leased-line prices relative to total bandwidth demanded and Figure
1
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19. This was derived from two different sets of data, one presenting Total Bandwidth Demanded for each year between 1990 and 2000, and the other showing average prices for ILEC leased-lines between 1990 and 2000. The correlation is for determining the slope of the curve only and should not be viewed as the definitive demand curve for this market. Table 15: Leased-line prices relative to total bandwidth demanded
Total Bandwidth Demanded in ILEC Leased Lines (Gbps) Price for Leased Lines ($/month) 475 683 835 1010 1380 2362 2693 3461 5150 7407 56 Kbps $140.76 $135.55 $117.13 $78.33 $54.37 $65.57 $50.39 $47.37 $51.79 $52.74 1500 Kbps $286.50 $261.00 $265.50 $204.00 $184.50 $171.00 $174.00 $177.00 $171.00 $169.50
Source: Combination of data from Douglas A. Galbi, Senior Economist FCC, using data from Bell Atlantic and US West. http://www.tpeditor.com/contents/2001/galbi_tablesandcharts.htm.
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Figure 19: Graph of prices relative to total bandwidth demanded
Price vs Total Bandwidth Demanded (ILEC Leased Lines)

$300.00
Price ($/month) 56 Kbps 1500 Kbps Power (1500 Kbps) Power (56 Kbps)
$250.00 $200.00 $150.00 $100.00 $50.00 $0.00 0 2000 4000 6000 8000
Bandwidth (Gbps)
As can be seen, the demand function is quite elastic as the adoption of leased-line services reaches 8 Tbps. This is consistent with the graph in Figure 18.
Price Elasticity of Supply: Local Bandwidth

Two sets of data have been used to calculate Price Elasticities of Supply of local leased lines. The first set of data is from inter-office connections between carrier central offices or POPs, and includes links up to 45Mbps. The second set of data is from an ISP providing connection services to small and medium businesses and residential customers and covers connection speeds up to 1.5Mbps. It should be noted that both of these data sets contain demand-side data, i.e. prices paid for leased-line service. Supply-side data (i.e. network operator costs for specific services) appears almost impossible to come by. The use of this data is discussed further below. The data given in Table 14 is from two established local carriers Bell Atlantic, now part of Verizon, and US West, now part of Qwest. Together these two companies account for about onethird of RBOC lines.19 While network providers other than local incumbents have been active in supplying domestic bandwidth, new local network providers earned about 12% of total local leased line revenues in the U.S. in 1998. Even if this has increased dramatically, which is
1
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probably hasnt given the fallout in telecom companies recently and the continued strength of ILECs, the data above provides a reasonable representation of local leased-line services. Furthermore the rates covered in Table x2 accounts for about 85% of revenue associated with leased lines from the two carriers. Hence the trends apparent in those tables give a fairly complete picture of the aggregate price trends for ILEC leased line services.21 Table 16: Prices for Inter-office leased line connections, 1990-2000, shows prices in $/month for three different speed inter-office leased-line connections offered by Local Exchange Carriers. Because inter-office prices are determined by connection speed (bps) and a per-mile charge, these prices have been used as a very rough proxy for connection costs, and thus the supply function. This logic is questionable but is presented as a rough guide for determining supply elasticity only and should not be considered the relative supply curve. The data has been graphed on a log-log scale in Figure 20. From the data, it appears that prices decreased noticeably from 1990-1994 but only slightly (on average) from 1994-2000. This is shown on the log-log graph as the curve migrating downwards over time. The price elasticities, taken from the slopes of the log-log curves, come to approximately 1.0 (inelastic) for 128kps1.5Mbps connections, and 2.5 (elastic) for higher speed connections. Table 16: Prices for Inter-office leased line connections, 1990-2000
Connection Speed (Kbps) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 128 $20.36 $19.97 $17.93 $15.49 $17.16 $17.93 $18.44 $17.67 $19.08 $18.82 $18.31 1500 $286.50 $261.00 $265.50 $204.00 $184.50 $171.00 $174.00 $177.00 $171.00 $169.50 $168.00 44700 $722.80 $850.64 $807.73 $724.59 $802.37 $766.61 $738.89 $735.76 $747.83 $781.80 $767.50
Source: Douglas A. Galbi, Senior Economist FCC, using data from Bell Atlantic and US West.
21
Growth in the New Economy: U.S. Bandwidth Use and Pricing Across the 1990s, Douglas A. Galbi Senior Economist, Competitive Pricing Division, FCC, December 2000. http://www.tpeditor.com/contents/2001/galbi_tablesandcharts.htm Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 57
Figure 20: Prices for Inter-office leased line connections, 1990-2000
Price vs Connection Speed

$1,000.00 Price ($/month) 1990 1991 1992 1993 $100.00
General Trend 1990-2000
1994 1995 1996 1997 100000 1998 1999 2000
$10.00 100 1000 10000
Connection Speed (Kbps)
The difference in elasticity between high-speed vs low-speed services shown in the graph maybe explained by one of two things either 1) the prices are not relative to costs across the range of connection speeds (e.g. margins for higher-speed services are higher than for lower-speed services). According to Brett Leida22, in monthly tariffs for leased lines, the distance component is typically more heavily weighted for higher capacity links, or 2) the prices are relative to costs, but the supply constraint for lower-speed services (e.g. CO aggregator capacity) is greater than for higher-speed services which can justify a truck-roll to install the extra capacity. Table 17 shows current prices in $/year for leased-line data connections supplied by Earthlink, an ISP providing high-speed connections to business and residential customers. Again, given the nature of the pricing structure, these prices have been used as a rough proxy for network costs associated with setting up the connections, i.e. fixed installation charge covering labor and overhead and increasing charge based on connection speed. Again, this was considered acceptable since the data is only being used to estimate price elasticities. The data has been plotted on a linear scale in Figure 21. As can be seen from the graph, the price elasticities vary along the supply curve, from approximately 0.5 (inelastic) for lower-speed connections to 1.4 (somewhat elastic) for higher-speed connections.
22
B. Leida A cost model of Internet service providers: Implications for Internet telephony and yield management, M.S. thesis, MIT, 1998. Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 58
Table 17: Prices for Earthlink Broadband Services
PORTSPEED SET-UP FEE 56 $500.00 128 $1,000.00 256 $1,000.00 384 $1,000.00 512 $1,000.00 1500 $1,000.00
12 MONTHS $240.00 $410.00 $520.00 $640.00 $860.00 $1,200.00
TOTAL COST $740.00 $1,410.00 $1,520.00 $1,640.00 $1,860.00 $2,200.00
Source: Earthlink Website, 05/02/01, http://www.earthlink.net/
Figure 21: Prices for Earthlink Broadband Services

12 month cost vs Connection Speed (Earthlink)
$2,500.00 $2,000.00 Price $/year $1,500.00 $1,000.00 $500.00 $0.00 0 500 1000 1500 2000 Conne ction Speed (Kbps)
Fixed Cost Variable Cost Total Cost
In general, it appears as if the Elasticity of Supply is inelastic for low-speed services and elastic for high-speed services. Given the questionable logic of the supply elasticity, the data will be deemed inconclusive and the nature of the supply curve will be discussed further below.
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Analyzing Supply and Demand

The following section discusses a framework for thinking about the interaction of supply and demand in Service Provider networks. Again, supply and demand is relative to a service or set of services, but the relative dynamics of the supply and demand should be somewhat consistent across services.
Costs, Revenues and Profits

In building a model of supply and demand, it is important to gain an understanding of the costs involved in delivering the bandwidth products to market. There are three main costs to consider: fixed costs, variable costs and marginal costs. While cost data from service providers is difficult to find, there are a few observations to note: Fixed costs are considered very high due to the large capital investment in equipment, real estate, labor and (current) fixed-cost leased lines required to establish service; Variable costs include transaction costs (e.g. accounting and billing costs), which are considered reasonably high, administrative costs and some labor. However, relative to the fixed costs, the variable costs are considered low; Once capacity is in place marginal costs are also considered low and possibly declining with capacity as administrative costs are spread over the capacity; Once a certain capacity is in place, i.e. steady-state supply, a short-term supply constraint is present. The elasticity of supply is inconclusive from the data in the previous section. However given the statements above, it is assumed that the steady-state supply curve can be represented by low or declining marginal cost up to a fixed network capacity supply constraint as shown in Figure 22.
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Figure 22: Steady-state Supply Curve for Service Providers
P ($/bp s)
Short-term capacity constraint
Marginal cost asymptotic to zero
Q (X bps) In regards to pricing: According to Gambi bandwidth prices, perhaps with the exception of T1 prices, have not reduced significantly in recent years despite predictions of price erosion.23 This is in contrast to price indices from Ratexchange, a bandwidth exchange with strong US operations, which showed a 39% decline in its price index for DS-3 circuit on major US east-west routes from June 1998 to Sept 1999.24 In general it is accepted that raw bandwidth prices will decline dramatically as they are commoditized. In general the following observations appear to hold: Prices are largely set by monopolistic or oligopolistic firms, and therefore only weakly signal broad industry conditions and expectations; Monopoly pricing still dominates at the local access level as a result of barriers to local unbundling of the network; Firms, particularly at the local access level, are able to heavily price discriminate by customer segmentation; Firms with high fixed, sunk costs and low marginal costs have a strong incentive to avoid direct price competition;
23
Growth in the New Economy: U.S. Bandwidth Use and Pricing Across the 1990s, Douglas A. Galbi Senior Economist, Competitive Pricing Division, FCC, December 2000. 24 RateExchange, http://www.ratexchange.com/ Supply and Demand Analysis in Convergent Networks 2001 Craig Thompson. All rights reserved. Page 61
Currently there is little opportunity for competitive differentiation, especially across ALL services offered, although this is expected to change with current innovations in service aware technologies;
Service Providers face a reasonably elastic demand curve as evidence by data in the previous section and work conducted by others.
Given the observations about pricing and the demand curve facing Service Providers, a Service Provider will seek to profit maximize in much the same manner as a monopolist. This is shown Figure 23. The recurring operating profit for the service(s) is shaded. Figure 23: Price-setting and Profit for a Service Provider with Market Power
Marginal Revenue Curve
P ($/bp s)
Elastic Demand Curve
Marginal Cost Curve
Q (X bps)
Note that the firm has an incentive to expand its capacity as demand grows, and that there will generally be an over-supply of bandwidth without affecting price. This is consistent with observations noted throughout the thesis. Carriers will also exhibit a great amount of price discrimination in order to capture as much of the consumer surplus as possible. This is evidenced by volume discounts and pricing differentiation between business and consumer segments. As competition enters the market, the supply curve for the local market moves out and the marginal revenue curve is shared between the competitors.
The supply-demand scenario above is for steady-state capacity facing a steady-state demand curve. Chapters 2 and 3 discussed a growing demand for bandwidth, while Chapter 4 talked alluded to heavy investment in next-generation networks by Service Providers. Given the need to convert a high fixed-cost capital investment into a recurring revenue stream, how do service provider combat declining prices with a growing demand for bandwidth? A mechanism is proposed in Figure 24. Figure 24: Demand Shift with Supply
P ($/bps )
Demand Curve
Step 2 Step 1 Marginal Cost Curve
Q (X bps) Here, a Service Provider may try to induce demand by increasing supply. This is shown as a movement of the capacity constraint portion of the marginal cost curve outward (Step 1). As new, compelling services are created to take advantage of the new capacity, the demand curve shifts outward (2). It should be noted that the supply curve is likely to move out much further, for a given service or set of services, when an individual Service Provider expands capacity, as opposed to new entrants expanding capacity. This is a direct result of product differentiation and fragmentation of the market for bandwidth services. Since marginal cost is very close to zero, the carrier can use this strategy to substantially increase its operating profits. The carrier will make these investments based on the net present value of
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the expected operating profit and the expected life of the equipment before replacement.25 It is critical that the life of the capital equipment be estimated properly, as it is the primary determinant of value in this scenario. If innovation makes the current equipment obsolete and new competition emerges, the carrier may need to replace the equipment sooner than expected, resulting in a loss of value for the project. Without competition, the carrier will try to stick with older technology unless new equipment actually adds new capacity that would induce additional demand. This has been demonstrated by the ILEC carriers investments in ISDN and T1s and their reluctance to adopt newer technologies until new competition forced them to invest in DSL technology. Perhaps another way to look at it is a monopolist or firm with market power is encouraged to invest in new technologies to maintain capacity and market share, and therefore market power. If an ILEC has market power, than this game can be played quite effectively. Figure 25: Cyclical nature of supply and demand in current telecommunications markets
Steady-state supply + Elastic Demand. e.g. ILECs Demand curve shifts out, dominant player(s) captures market share New Entrants provide new capacity. e.g. CLECs
New Supply induces demand via new services
Incumbent response. Increase supply to maintain revenues. e.g. ILECs roll out DSL
Supply curve begins to shift. Induces some demand
25
Ryan Berryman, MIT Sloan, May 2001. Page 64
Conclusion
This thesis has reviewed the concepts of supply and demand as they pertain to bandwidth in convergent networks. A draft model for estimating and analyzing edge demand has been presented, and a framework for thinking about the interaction of supply and demand facing Service Providers has been developed. Bandwidth demand appears to be driven by a number of factors including: The declining cost/performance of computing and the proliferation of computing devices is generating data that is increasingly more valuable in a network of such devices; The tremendous growth of digital information requiring processing by computers and networks of computers; The pricing of bandwidth. Elastic demand ensures that bandwidth demand scales dramatically with decreasing prices; Broadband access adoption increases the bandwidth demanded by changing users online habits. Users of broadband technologies such as DSL and Cable tend to have a higher usage of bandwidth-intensive applications; New services adoption. Provided that the value of the application is realizable with current access speeds, than new bandwidth-intensive applications can encourage users to adopt high-speed services, thus increasing their usage of bandwidth; Finally, an underlying cultural change is demonstrated by a gradual shift to on-line media away from traditional media such as television, radio and print. This is most apparent is younger users. Drivers of bandwidth supply (i.e. network capacity) will cause new entrants to enter the market, and incumbents to increase their network capacity. For example, increased opportunity for revenue generation can induce new competition and lead to pressure on prices and the incumbents share of marginal revenue. The drivers of bandwidth supply include:
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Revenue Generation: Whether it is a new entrant trying to capture a share of increasing demand, or an incumbent attempting to protect current revenues or generate new revenue streams, the investment in network capacity is directly related to revenue strategies;
Cost Savings: In order to achieve economies of scale and scope Service Providers are investing in new technologies, such as DWDM, that scale network capacity and potentially reduce the cost of providing bandwidth;
Technology Deployment: The need for some carriers to maintain a technology edge, and the desire to bridge technology gaps will possibly lead to greater investment in new supply provided by such technologies as OC-768;
Industry Regulation: has already proved that it can have a dramatic effect on the competitive landscape of the communications industry; Capital Availability: market forces ultimately decide how much capital is available to invest in network capacity.
Given these drivers of supply and demand, an interesting dynamic arises at the interface of supply and demand. In the case of the majority of Service Providers in a monopoly or oligopoly situation, a static demand curve ensures that as new competition enters the market, the marginal revenue curve is shared between more players. An incumbent is then encouraged to protect market share by investing in network capacity. In many cases it seems that a shifting out of the supply curve can induce a shift in the demand curve, in relation to the cyclical nature of the drivers listed above, thus helping to maintain revenues and market power for the incumbent. This decision, however, must still be dependent on the NPV of the investment, which is a function of the CAPEX and subsequent recurring revenues generated by the CAPEX. There are further observations that should be pointed out in this thesis. The first is that the communications market is highly fragmented with more product differentiation than is obvious at first. Therefore generalized observations about a bandwidth glut are should be localized to particular sections of the market, and are often short-lived. Second is the evidence that demand for bandwidth appears reasonably elastic. The cyclical nature of the market supply and demand ensures that capacity over and under-supply is also cyclical and is determined heavily by the market power held by the incumbents.
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The third observation is that Service Providers play an important role in the development or destruction of new services that generate bandwidth demand. Unless new services are compelling enough to generate revenues with current technology than investment in the infrastructure to support the growth of these services will not occur. Alternatively, if incentives exist (e.g. new competition), incumbent Service Providers can induce the adoption of new services and shift the demand curve by investing in additional network capacity. Finally, estimates for the growth in network edge demand are
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Glossary of Terms
ILEC CLEC IXC DWDM ISP SONET Incumbent Local Exchange Carrier. Also includes RBOCs or Baby Bells. e.g. Verizon Competitive Local Exchange Carrier. Essentially the new entrants since the 1996 Telecom Act. e.g. XO Communications. Inter-Exchange Carrier. Mostly long-distance carriers, e.g. AT&T Dense Wavelength Division Multiplexing Internet Service Provider. e.g. AOL Synchronous Optical Network, a standard for optical networking.
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Appendix
Selected screen shots of Services Adoption Edge Demand Model. Example Adoption Rates for Services: Residential Users
Linear Bandwidth Demand Model

Household Adoption Assumptions
Required Speed Data Volume (Mb/s) per Unit (Mbits) Audio / Video Telephone VoIP Wireless Telephony Video Phone Movies on Demand Streaming Video Clips Voice Messaging on Net Downloaded Movie Downloaded Video Clips Napster / Downloaded Music Digital TV Broadcast Television Webcam / Webcast Radio Broadcast IP Audio Broadcast VHS Tapes Audio Tapes Text / Images Chat Fax Email Images Newswires Webpages Spam Magazines / Print Data Remote Backup Real-Time Data Online Applications Games MS Office.NET Groupware/ PIM Massive Multi-Player Games Other ASPs Transactions SETI@Home / Centrata Shopping Banking Online Trading Auctions 0.064 0.008 0.008 3 3 1.5 na na na na 3 200 0.1 0.032 0.004 5 na 3.84 0.48 0.48 180 21,600 360 0.48 21,600 360 32,768 180 12,000 6 1.92 0.24 0 0 Year of Introduction 1900 2000 1984 2008 2002 1999 1999 2002 1998 1999 2001 1945 1999 1920 1998 1980 1970 Year of 16% Adoption 30.00 3.00 12.00 12.00 11.00 6.00 3.00 6.00 6.00 4.00 5.80 20.00 4.00 6.00 8.00 4.00 4.00 Year of 50% Adoption 40.00 7.00 19.00 19.00 15.00 15.00 8.00 15.00 15.00 8.00 8.00 40.00 6.00 9.00 12.00 10.00 7.00
0.5 0.2 1.6 8 4 3.2 1.6 0
1997 1980 1990 1997 1997 1997 1997 1900
6.00 10.00 4.00 2.00 2.00 2.00 2.00 2.00
12.00 35.00 12.00 5.00 5.00 5.00 5.00 16.00
4 24
1999 1999
6.00 10.00
10.00 20.00
128k-6m
7.68 234 24 16 16
1995 2002 1999 1998 2002
1.00 2.00 5.00 6.00 5.00
15.00 6.00 10.00 100.00 7.00
0.8 8 8 8 0.8
2000 1997 1997 1997 1998
13.00 4.00 4.00 4.00 7.00
25.00 10.00 10.00 10.00 15.00
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Effective No. Business Users

Total Small Businesses Total Medium Businesses Total Enterprise Total Education Total Government and Agency Total Effective Business Users 5 20 800 100 50 10200.0 42.0 6.5 27.0 200.0 69,740 2000 Text / Images Chat Fax Email Images Newswires Webpages Spam Online Research Data Remote Backup and Synch Real-Time Data Transfer Online Applications ASP Applications Groupware/ PIM Finance and Accounting Other ASPs Transactions Online Procurement E-Commerce Finance and Accounting Online Trading Bookings, Reservations 0 3,822 11,065 0 5,693 21,750 0 442 8,199 35,627 8,199 0 1,639 11,427 49,802 11,427 0 4,864 15,423 61,252 15,423 0 11,675 20,182 68,672 20,182 6,361 5,632 53,935 58,675 58,675 58,675 58,675 69,740 10310.2 42.5 6.6 27.3 202.2 70,493 2001 8,577 6,824 59,309 68,889 68,889 68,889 68,889 70,493 10421.5 42.9 6.6 27.6 204.3 71,255 2002 11,305 8,199 63,726 71,158 71,158 71,158 71,158 71,255 10534.1 43.4 6.7 27.9 206.6 72,024 2003 14,573 9,771 67,212 72,022 72,022 72,022 72,022 72,024 10647.8 10762.8 43.8 44.3 6.8 6.9 28.2 28.5 208.8 211.0 72,802 73,588 Number of Effective Business Users 2004 2005 18,382 11,550 69,886 72,802 72,802 72,802 72,802 72,802 22,705 13,545 71,914 73,588 73,588 73,588 73,588 73,588
4,659 2,506
7,448 3,142
11,305 3,905
16,323 4,812
22,462 5,879
29,530 7,123
1,587 34,870 11,065 11,065 1,587
4,709 59,309 15,976 15,976 11,184
11,305 69,633 21,985 21,985 35,627
22,222 71,927 28,903 28,903 60,597
36,401 72,800 36,401 36,401 71,146
50,883 73,588 44,058 44,058 73,489
Aggregated Demand: Residential Users

2000 Audio / Video Telephone VoIP Wireless Telephony Video Phone Movies on Demand Streaming Video Clips Voice Messaging on Net Downloaded Movie Downloaded Video Clips Napster / Downloaded Music Digital TV Broadcast Television Webcam / Webcast Radio Broadcast IP Audio Broadcast VHS Tapes Audio Tapes Text / Images Chat Fax Email Images Newswires Webpages Spam Magazines / Print Data Remote Backup Real-Time Data Online Applications Games MS Office Groupware/ PIM Massive Multi-Player Games ASPs Transactions SETI@Home / Centrata Shopping Banking Online Trading Auctions Total (Tb / day) 7,762.70 644.97 1,419.92 2.34 937.18 3,585.92 140.40 325.96 2001 7,858.33 701.38 3,157.18 6.70 1,880.63 9,120.88 61,005.22 341.07 465.93 2002 7,954.35 759.28 1,503.67 6,335.55 13.77 145.33 3,432.11 20,254.51 257,036.19 545.09 578.66 Bandwidth Demand 2003 2004 8,049.66 818.23 5,212.62 11,560.78 24.34 664.77 5,747.54 39,568.66 564,503.01 732.11 695.52 8,144.16 3.73 877.86 14,512.53 19,357.44 39.15 2,398.44 8,923.86 68,641.98 835,963.28 922.88 824.82 2005 8,241.08 24.96 938.17 32,873.92 30,062.73 57.89 6,915.72 12,995.19 106,962.43 1,065,070.13 1,116.86 966.95 2006 8,338.81 81.02 998.64 61,647.45 43,780.38 79.19 16,218.74 17,944.54 151,605.66 1,301,004.86 1,303.69 1,120.75 -
69.02 0.02 456.85 249.04 323.46 34.57 -
95.09 0.02 637.90 416.81 756.71 66.22 -
125.48 0.02 850.06 583.33 1,439.89 107.37 -
161.71 0.03 1,085.07 717.27 2,302.69 151.96 -
203.90 0.03 1,332.34 803.84 3,215.35 194.50 -
251.81 0.04 1,581.55 850.74 4,074.77 233.32 -
304.74 0.05 1,823.28 874.39 4,836.87 269.78 -
0.00 -
0.00 -
0.00 -
0.01 -
0.79 -
34.21 -
31.78 10.79 53.93 215.70 0.20 16,265
44.16 17.61 88.07 352.29 0.32 87,013
60.63 26.77 133.85 535.38 0.43 302,422
82.25 38.64 193.21 772.83 0.56 643,083
110.29 53.15 265.77 1,063.08 0.73 967,853
146.24 69.87 349.35 1,397.38 0.92 1,275,183
191.73 87.99 439.93 1,759.71 1.15 1,614,748
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Economic Analysis of Telecom 1

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Supply and Demand Analysis in Convergent Networks

Signature of Author: _____________________________________________________________ Department of Management April 9, 2001

Supply and Demand Analysis in Convergent Networks

Thesis Supervisor: Charles H. Fine Title: Chrysler LFM Professor of Management

Figures and Tables

The Converging Network

Figure 1: Complexity in analyzing network convergence and evolution

Shannons Law and the Time-Bandwidth Product

Bandwidth in Circuit-Switched and Packet-Switched Networks

Why are Bandwidth Supply and Demand Important?

Current Estimates for Bandwidth Supply and Demand

Equivalent Estimate Units Year

11.92 Tbits/sec 17.92 Tbits/sec

1999 2000E 2001E 2002E 2003E 2004E

24000 33333 49067 78667

Tbits/day Tbits/day Tbits/day

RHK Inc (1999)

1998 1999E 2000E 2001E 2002E 2003E

Figure 2: Estimates for Bandwidth Supply and Demand

Bandwidth Demand Estimates

AT&T AT&T 2 Pioneer McKinsey/JPM RHK MCI

Coffman, Odlyzko AT&T Labs, 1998

Core Optical Networks, Pioneer Consulting, 2000

Backbone! , McKinsey/JP Morgan, Sep. 2000

PetaBytes per month

RHK DWDM market Forecast, March 2000

Chapter 2: Bandwidth Demand

Edge Demand and Network Capacity

Figure 5: Edge Demand and Traffic Penetration

Drivers of Bandwidth Demand

Declining Cost/Performance of Computing

Growth of Digital Information

Broadband Access Adoption

Dec. 1999 Speed Modem 14.4K Modem 56K High Speed*

Modem 28.8/33.6K 31,602

* Includes ISDN, LAN, cable modems and DSL Source: Nielsen//NetRatings

DSL Cable Wireless Other

New Services Adoption

Statistical Research Inc, "The TV/PC Connection 2001" Page 24

Voice Traffic Growth

Data Traffic Growth

Source: Internet Software Consortium (http://www.isc.org/)

Jupiter Media Metrix, Apr 18 2001 Page 26

February 30 19 1,051 36 16:29:30 0:32:44 0:00:55

33 21 1,118 34 17:19:49 0:31:42 0:00:55

112.7 million 109.5 million 173.2 million 170.1 million

Table 7: US Internet/Wireless Users Internet Users/Wireless Users

673 1,174 225 148 59 730 246 168

Corporate Data and E-Commerce

Source: Forrester Research

Digital Cable and Streaming Media

Unique Audience 21.0m 74.0m 28% 34.7m 95.4m 36%

Chapter 3: Services Adoption and Growth Model

Migration from analog to digital services

Compression technologies increase efficiency of bandwidth

Net Effect: bandwidth demand actually decreases

Average vs Peak Load

Figure 10: Average Peak demand in a Day

30.00 25.00 20.00 15.00 10.00 5.00 0.00

Sample business services:

Figure 11: Forecast input parameters for service adoption rates

16% of total population below 1 68% of total population between 1 and 1

Moore, Geoffrey A. Crossing the Chasm Page 37