Wednesday, June 12, 2002

Pricing Bandwidth Broadband providers are thinking about capping or metering customers, supposedly to stop freeloaders. But this is wrong, so let's go through the economics:

Broadband provision is a high fixed cost, low marginal cost business, so while average costs are high, marginal costs are low. Also, while service provision is cheap, each customer is expensive to get hooked-up and online, so setup charges eat into lifetime value, and hence, profitability.

The article states that "all the cash cable companies spent sinking broadband, only to see slow uptake, means they have to raise price now" is wrong in every respect. Deployed cable is a sunk cost so shouldn't figure into any pricing decision. While business often make the mistake of using fully loaded costs in pricing decisions, pricing below average cost is a signal to exit the business, not raise prices, because higher prices will just hurt profitability further. Secondly, broadband uptake is a healthy 12% per quarter, or 57% a year, which may be slow compared to fevered executive dreams in 1999 but is still pretty respectable. Given how order congestion increases the cost of adding new users to the system, and how low broadband penetration currently is, higher flat-rate prices are probably meant to slow adoption, not harvest the current installed base. When you have a small customer pool, your profit depends on adoption rate because 1) you have many more potential customers than actual customers and 2) new customers become regular customers.

The article also misses the its own internal contradition, namely that if unused capacity is why companies have to raise prices, why should they mind if a few users tie up extra bandwidth? High-use customers aren't a problem, they're just an opportunity to charge higher prices to a segment that will probably pay them. And this brings us to the real story.

One way to tackle high fixed cost, low marginal cost businesses is a two-part tariff, where you set a high entry fee to cover average cost and then price service at marginal cost. Lawyer types see this as a solution to the dead-weight loss problem, but they're wrong -- it's just another form of price discrimination. Charging higher prices to customers who value (use) the system more is just a way to increase profits.

While papers need to collect eyeballs using sensationalist headlines, the only story here is how broadband providers are price discriminating to increase profitability. File sharing is complementary to broadband access, so cable companies have no interest in hampering it. They just want their cut.

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