ISP Marginal Cost Does Not Drive Consumer Prices

As the U.S. Federal Communications Commission opens an inquiry into ISP data caps, some are going to argue that such data caps are unnecessary or a form of consumer price gouging, as the marginal cost of supplying the next unit of consumption is rather low. 

Though perhaps compelling, the marginal cost of supplying the next unit of consumption is not the best way of evaluating the reasonableness of such policies.  

If U.S. ISPs were able to meet customer data demand during the COVID-19 pandemic without apparent quality issues, it suggests several things about their capacity planning and network infrastructure, and much less about the reasonableness of marginal cost pricing.

In fact, the ability to survive the unexpected Covid data demand was the result of deliberate overprovisioning by ISPs; some amount of scalability (the ability to increase supply rapidly); use of architectural tools such as content delivery networks and traffic management and prior investments in capacity as well. 

Looking at U.S. internet service providers and their investment in fixed network access and transport capacity between 2000 and 2020 (when Covid hit), one sees an increasing amount of investment, with magnitudes growing steadily since 2004, and doubling be tween 2000 and 2016.

Year	Investment (Billion $)
2000	21.5
2001	24.8
2002	20.6
2003	19.4
2004	21.7
2005	23.1
2006	24.5
2007	26.2
2008	27.8
2009	25.3
2010	28.6
2011	30.9
2012	33.2
2013	35.5
2014	37.8
2015	40.1
2016	42.4
2017	44.7
2018	47
2019	49.3
2020	51.6

At the retail level, that has translated into typical speed increases from 500 kbps in 2000 up to 1,000 Mbps in 2020, when the Covid pandemic hit. Transport capacity obviously increased as well to support retail end user requirements. Compared to 2000, retail end user capacity grew by four orders of magnitude by 2020. 

Year	Capacity (Mbps)
2000	0.5
2002	1.5
2004	3
2006	6
2008	10
2010	15
2012	25
2014	50
2016	100
2018	250
2020	1000

But that arguably misses the larger point: internet access service costs are not contingent on marginal costs, but include sunk and fixed costs, which are, by definition, independent of marginal costs. 

Retail pricing based strictly on marginal cost can be dangerous for firms, especially in industries with high fixed or sunk costs, such as telecommunications service providers, utilities or manufacturing firms.

The reason is that marginal cost pricing is not designed to recover fixed and sunk costs that are necessary to create and deliver the service. 

Sunk costs refer to irreversible expenditures already made, such as infrastructure investments. Fixed costs are recurring expenses that don't change with output volume (maintenance, administration, and system upgrades).

Marginal cost pricing only covers the cost of producing one additional unit of service (delivering one more megabyte of data or manufacturing one more product), but it does not account for fixed or sunk costs. 

Over time, if a firm prices its products or services at or near marginal cost, it won’t generate enough revenue to cover its infrastructure investments, leading to financial losses and unsustainable operations.

Marginal cost pricing, especially in industries with high infrastructure investment, often results in razor-thin margins. Firms need to generate profits beyond just covering marginal costs to reinvest in growth, innovation, and future infrastructure improvements. 

In other words, ISPs cannot price at marginal cost, as they will go out of business, as such pricing leaves no funds for innovation, maintenance, network upgrades and geographic expansion to underserved or unserved areas, for example. 

Marginal cost pricing can spark price wars and lead customers to devalue the product or service, on the assumption that such a low-cost product must be a commodity rather than a high-value offering. Again, marginal cost pricing only covers the incremental cost of producing the next unit, not the full cost of the platform supplying the product.