Chapter 1
Will Smart Pricing Finally Take Off?

ANDREW ODLYZKO

1.1 Introduction

Will smart pricing dominate telecommunications? We certainly do see growth in sophisticated pricing in many areas of the economy. Congestion charges for cars entering central business districts and “smart” electric meter deployments are spreading. Airlines are even beginning to auction seat upgrades [1]. And there is no shortage of desire for smart pricing in telecommunications. For a survey of recent developments, see Reference 2. Many new technological developments, such as software-defined networking (SDN), are touted as facilitating differentiated services and differentiated pricing. The overwhelming consensus of the industry, as well as of the research community, and of regulators, is that flat rates are irrational. Thus, for example, in 2011, Jon Leibowitz, the then-Chairman of the US Federal Trade Commission could not “quite understand why something like metering hasn't taken off yet.” (See Reference 3 for references to this and similar recent quotes, as well as for a summary of the arguments in favor of flat rates.)

Yet there are reasons for caution in the rush to smart pricing. After all, the modern consensus about its desirability is not new. It goes back centuries, to the days of snail mail. Furthermore, industry has often either stumbled onto flat or almost flat rates, or been forced into them, all against its will, and ended up benefiting. Thus, for example, US wireless service providers have been boasting of the low per-minute voice call revenues that reign in United States, much lower than in most of the world. What they universally neglect to mention is that these low prices are the result of the success of the block-pricing plan introduced by AT&T Wireless in 1998, which also eliminated roaming and long-distance charges. This plan, the result not of a careful study of historical precedents or the economics of communications but rather the fruit of a desperate carrier looking for a way to gain customers, was widely derided but proved unexpectedly popular. It forced the rest of the industry to follow suit with similar plans and led to large increases in voice usage (see, e.g., the chart in Reference 4). The end result is that the United States has the world's highest per-subscriber voice usage, yielding those low average per-minute prices that the industry boasts of. Probably not coincidentally, US wireless service providers are among the world's most profitable. This story, and others similar to it, should make one cautious about rushing to follow the industry consensus. This is true even when such a consensus is fortified by scholarly studies, because those tend to be even more biased towardfine-grained pricing. The telecom industry and telecom researchers have historically been notorious for not understanding what is in the industry's own interests.

The traditional preoccupation with smart pricing is likely to be reinforced by the economics of telecom. Contrary to common opinion, it is not all that capital intensive. As is demonstrated in Section 1.8, telecom is simply not in the same category as such large and important industries as electricity or roads when it comes to the ratio of capital investment to revenues. Telecom is primarily about service, customer inertia, and territorial strategic plays (where the territories may be physical or virtual).

Although the telecom industry is not very capital intensive, communications is extremely valuable and any society is willing to pay astonishing amounts for it. As an example, by some measures, the United States spends almost 50% more on telecom services than it does for electricity. (See Section 1.5 for more data and references.) Furthermore, in spite of all the complaints from the industry about its supposedly impoverished state, there appears to be very large profits in many parts of it. As this passage is being written in the summer of 2013, Verizon is in the process of buying out Vodafone's 45% stake in the Verizon Wireless unit for $130 billion. This means that the whole of Verizon Wireless is being valued at almost $300 billion. As will be shown in Section 1.9, that is about four times the cost of replacing all the tangible assets of that enterprise. It is also almost enough to replace the entire US telecom infrastructure, both wireless and wired, with the latter redone in fiber. This is anomalous by traditional standards, but then, as will be discussed in Section 1.9, the entire economy is behaving anomalously, with very high corporate profits, low interest rates, and low capital investment. Whether this is a temporary aberration, or whether we are in a new economic era, remains to be seen. However, telecom is very much in the mainstream of this historically unusual behavior, and so many traditional yardsticks of financial performance may not apply.

While the telecom industry has often been blind to profitable opportunities, it has always been aware that high profits are possible. However, it has usually faced difficulties in using their favorite methods for profit extraction because of various combinations of legal and regulatory constraints and the peculiar nature of demand for communication services. Table 1.1 shows an approximation of current prices paid by users for varying amounts of data from various services.

Table 1.1 Price per Megabyte

This table demonstrates the main problem faced by telecom. The most valuable information can often be conveyed in just a few bits. Thus, for example, in the early days of postal services, when receivers paid on delivery, information would often be transmitted in the form of small modifications in the address. The addressee would then scan the envelope, figure out what the message was, and refuse to accept (and pay for) the letter.

Practices from two centuries ago may seem irrelevant, but in fact they are very instructive, as the basic economic issues have always been the same, even as technology has changed drastically, cf. [5]. Thus, for example, today, we have the telecom industry investing heavily in deep packet inspection. In the past, post offices had employees hold letters up against burning candles to make sure that there were no enclosures that were subject to extra fees. The basic incentive is to extract as much value as possible, and that usually requires fine-grained pricing to achieve successful price discrimination. But usually, in communication as well as in transportation, limits are placed on what service providers are allowed to do. The net neutrality debate is just another instance of the ancient conflict between economic efficiency and fairness in markets [6]. Giving unfettered control of any critical service to any provider, or an oligopoly of providers, either de jure or de facto (by allowing natural monopoly mechanisms to operate), is equivalent to abolishing property rights with the usual negative impacts on innovation and efficiency. Hence, we have almost always had constraints, such as those of common carriage. The real question is about the appropriate level of constraints.

Public talk of capacity limits is often just a public relations measure, designed to overcome opposition to service provider strategies. Thus, for example, in early 2013, Michael Powell, the President of the US cable industry association [and former Chairman of the Federal Communications Commission (FCC)] admitted, contradicting many earlier declarations by a variety of executives and experts, that “cable's interest in usage-based pricing was not principally about network congestion, but instead about pricing fairness” [7]. Whenever business leaders talk of “fairness,” it is generally safe to assume that they are really after extracting more revenues through differential pricing. This is neither a novel nor is it nefarious. In fact, differential pricing was and is at the core of regulatory economics, as it can be used to promote social welfare, and has been frequently mandated by governments. However, historically, the degree of price discrimination that was allowed varied depending on economics, with more discrimination being allowed when the costs of providing those services have been large [8]. The question for the near future is whether modern telecom should be allowed more power to discriminate. Further, even if it is given that power, one should consider whether it would be wise to use it. The right answer depends on the balance between growth in demand and improvements in technology.

The main problem, past, present, and future, that is faced by telecom is that the most valuable information usually requires just a few bits to convey. Thesecond main problem is that because of technological progress, transmission capacity is growing. Thus the industry is faced with the challenge of persuading users to pay for big pipes when the additional value that enlarging those pipes provides is not all that high. (There are arguments that the value of transmission capacity, as well as that of computing power and storage, should be measured on a logarithmic scale, so that going from what is now a slow 1 Mbps link to a 1 Gbps one corresponds only to an increase in value from 6 to 9, cf. [9].) At the moment, that additional...