Transit Pricing Illustrates "Near Zero Pricing" Conundrum

One of the few core assumptions I always have used in my analytical work concerning the connectivity business is near zero pricing is a foundational trend for all connectivity products, as it tends to be also for computing products. Consider internet transit pricing, for example 

Back in 2014, Cloudflare estimated the cost of wide area network bandwidth as being lowest in Europe, in large part because so much internet traffic used peering rather than transit. 

source: Cloudflare

Two years later, in 2016, costs had dropped. The Middle East has the lowest WAN costs, and costs in other reasons had dropped significantly. Where Australia’s costs were as much as 20 times higher than Europe’s costs, two years later the Australian costs were six times higher than Europe’s costs. 

source: Cloudflare

None of you would be surprised if transit prices continued to fall. Transit to Sydney, for example, had declined to about $5 per Mbps, where back in 2014 prices had been about $100 per Mbps. 

source: TeleGeography

Perhaps for every problem there actually is a solution, though perhaps sometimes the answer is not what we might prefer, expect or want. Back around 1995, I ran into one of those problems.

The context was voice pricing trends. To make a long story short, the problem was a confluence of trends that all seemed to suggest voice revenues were headed south. The process of deregulation and privatization of former monopoly networks was one such early trend.

But in addition to competition, technology trends all suggested prices would drop. Among those trends: optical fiber, microwave transmission, Internet Protocol, client-server architectures, Moore’s Law and declining microprocessor and storage costs. I cannot recall whether I believed at the time that mobile communications would put pressure on voice pricing as well.

The phrase near zero pricing came to mind. The imponderable, at the time, was what would become of telecom service providers if their core product--voice--actually reached a point where retail prices were very low, very close to “zero.”

The concept would reappear about 1999 and 2000, when the phrase “bandwidth wants to be free” was bandied about. The key concept is that prices do not actually have to drop to actual zero; prices simply have to drop to “nearly zero.” If that happens, the revenue model for nearly every business has to shift. 

What was once a revenue driver becomes something more accurately described as a “feature.” The whole point is that technology makes “near zero pricing” in any number of contexts a foundation for business strategy. The key point is not that prices actually hit zero, only that they drop so precipitously that access to computing and memory no longer are constraints to what can be done.

But that’s a problem for incumbent providers who have built substantial businesses on scarcity, either scarcity of bandwidth, processing or memory. And that was the conundrum when asking what impact near zero pricing would have for telcos.

So far, the industry has dodged a bullet by creating new core revenue drivers to supplant voice services that no longer can support the industry’s business models. Mobility and internet access are key cases in point. But prices for bandwidth show the same drift to near zero that we originally saw in long distance and voice pricing. 

Marginal cost pricing is an important principle in many markets, including growing parts of the telecom business. 

Products that are "services," and perishable, are particularly important settings for such pricing. Airline seats and hotel room stays provide clear examples. Seats or rooms not sold are highly "perishable." They cannot ever be sold as a flight leaves or a day passes. So it is rational for an airline to price seats at whatever price it can get shortly before a flight departs. Or at least, that used to be the case.

These days, airlines are more likely to attempt to raise “just before departure” revenue in other ways, such as selling upgrades to roomier seats. 

Whether marginal cost pricing is “good” for traditional telecom services suppliers is a good question, as the marginal cost of supplying one more megabyte of Internet access, voice or text messaging might well be very close to zero.

Such “near zero pricing” is pretty much what we see with major VoIP services such as Skype but also increasingly for bandwidth products in general.  Whether the traditional telecom business can survive such pricing is a big question.

“Forward pricing” is related to marginal cost pricing, where suppliers price at the incremental cost of producing the next unit (marginal cost) or at some future cost when scale is obtained (forward pricing). 

In some part, the value of becoming a platform is precisely a solution for “pipe” sales in many industries. Platforms are alternative business models. They are not necessarily built on selling a particular product, much less products whose prices tend to trend inexorably towards zero.

Competition and New Technology Underpin Near-Zero Pricing Trend

It is a truism that competition and new technology, in combination, have fundamentally changed the global telecom business. We all intuitively understand that competition leads to lower prices, or that technology allows disintermediation of value chains, which removes cost. 

source: A.D. Little 

One of the few core assumptions I always have used in my analytical work concerning the connectivity business is near zero pricing is a foundational trend for all connectivity products, as it tends to be also for computing products. Consider internet transit pricing, for example 

Back in 2014, Cloudflare estimated the cost of wide area network bandwidth as being lowest in Europe, in large part because so much internet traffic used peering rather than transit. 

source: Cloudflare

Two years later, in 2016, costs had dropped. The Middle East has the lowest WAN costs, and costs in other reasons had dropped significantly. Where Australia’s costs were as much as 20 times higher than Europe’s costs, two years later the Australian costs were six times higher than Europe’s costs. 

source: Cloudflare

None of you would be surprised if transit prices continued to fall. Transit to Sydney, for example, had declined to about $5 per Mbps, where back in 2014 prices had been about $100 per Mbps. 

source: TeleGeography

Both Netflix and Microsoft business models seem to have been built on an expectation of  

near-zero pricing for a core input, computing cost for Microsoft, bandwidth cost for Netflix. 

The most-startling strategic assumption ever made by Bill Gates was his belief that horrendously-expensive computing hardware would eventually be so low cost that he could build his own business on software for ubiquitous devices. .

How startling was the assumption? Consider that, In constant dollar terms, the computing power of an Apple iPad 2, when Microsoft was founded in 1975, would have cost between US$100 million and $10 billion.

source: Hamilton Project

The point is that the assumption by Gates that computing operations would be so cheap was an astounding leap. But my guess is that Gates understood Moore’s Law in a way that the rest of us did not.

Reed Hastings, Netflix founder, apparently made a similar decision. For Bill Gates, the insight that free computing would be a reality meant he should build his business on software used by computers.

Reed Hastings came to the same conclusion as he looked at bandwidth trends in terms both of capacity and prices. At a time when dial-up modems were running at 56 kbps, Hastings extrapolated from Moore's Law to understand where bandwidth would be in the future, not where it was “right now.”

“We took out our spreadsheets and we figured we’d get 14 megabits per second to the home by 2012, which turns out is about what we will get,” says Reed Hastings, Netflix CEO. “If you drag it out to 2021, we will all have a gigabit to the home." So far, internet access speeds have increased at just about those rates.

The scary point is that prices in the telecom business seem to have a “near-zero” trend. That does not mean absolute zero, but simply prices so low users and customers do not have to think much about using the products. 

That, of course, has fundamental implications for owners of connectivity businesses. Near-zero pricing helps create demand for internet access services, even as substitutes emerge for core voice and messaging services. 

Near-zero pricing enables the construction and operation of the networks and creation of the apps and services delivered over the networks. Near-zero pricing also enables new business models that were impossible in the analog era.

"Near Zero Pricing" for Voice is Not the Problem it Appeared to be, in 1993

Perhaps for every problem there actually is a solution, though perhaps sometimes the answer is not what we might prefer, expect or want. Back around 1995, I ran into one of those problems.

The context was voice pricing trends. To make a long story short, the problem was a confluence of trends that all seemed to suggest voice revenues were headed south. The process of deregulation and privatization of former monopoly networks was one such early trend.

But in addition to competition, technology trends all suggested prices would drop. Among those trends: optical fiber, microwave transmission, Internet Protocol, client-server architectures, Moore’s Law and declining microprocessor and storage costs. I cannot recall whether I believed at the time that mobile communications would put pressure on voice pricing as well.

But in 1993 the United States had not yet passed the Telecommunications Act of 1996, which would for the first time allow multiple competitors into the fixed network local telecommunications business for the first time.

Just how far the trend might go was not so clear, but suffice it to say the phrase “near zero pricing” came to mind. The imponderable, at the time, was what would become of telecom service providers if their core product--voice--actually reached a point where retail prices were very low, very close to “zero.”

The concept would reappear about 1999 and 2000, when the phrase “bandwidth wants to be free” was bandied about.

Perhaps that was not the first illustration of a business strategy based on Moore’s Law. Perhaps one might say that Microsoft, for example, built its software business around an understanding of Moore’s Law.

Specifically, that meant designing software without regard for existing hardware performance and memory limitations. “Microsoft first shipped Excel for Windows when 80386s were too expensive to buy, but they were patient,” says Joel Spolsky.” Within a couple of years, the 80386SX came out, and anybody who could afford a $1500 clone could run Excel.”

One might argue lots of firms have implicitly or explicitly made continuing declines in the cost of computing and storage part of their business strategy as well.

“Moore’s Law was baked deeply into the founding strategy  of Electronic Arts,” says Bing Gordon.

The whole point is that technology makes “near zero pricing” in any number of contexts a foundation for business strategy. The key point is not that prices actually hit zero, only that they drop so precipitously that access to computing and memory no longer are constraints to what can be done.

But that’s a problem for incumbent providers who have built substantial businesses on scarcity, either scarcity of bandwidth, processing or memory. And that was the conundrum when asking what impact near zero pricing would have for telcos.

At the time, I could think of no reasonable answer. If the revenue source telcos depended on shrank so much, what would become of them?

Remember 1993. The web browser had just been invented. There were very few Internet hosts, not to mention few users. Voice services represented nearly all revenue for a telco.

The point is that, at the time, the notion that Internet access, not to mention “broadband” access would become a significant revenue generator for fixed network service providers was simply not conceivable.

In fact, even dial-up Internet access was at such a low level it was not tracked by some firms at the time, such as the Organization for Economic Cooperation and Development.

Fixed network service providers continue to face challenges, to be sure. But the answer to the problem of near zero pricing for voice has been answered, at least for the moment. New revenues from Internet access and video entertainment, not to mention diversification into mobile services, have staved off declining voice revenues.

I couldn’t see that at the time. So near zero pricing for voice has not been catastrophic. It is a problem, but not an unsolvable problem, as difficult as it was in 1993 to foresee the future.

And that's the problem with predictions: we tend to be bound by an inability to see futures that are shaped by other unknown or unrecognized trends and developments.

                     Number of Websites in Existence

Will AI Disrupt Non-Tangible Products and Industries as Much as the Internet Did?

Most digital and non-tangible product markets were disrupted by the internet, and might be further disrupted by artificial intelligence as well. Non-tangible products are goods or services that cannot be physically touched or held.  

These products  provide value through experiences, expertise, or access, rather than a physical object. Services including legal advice, consulting, haircuts, car washes, travel experiences provide examples. 

So do content products such as e-books, software, online courses, music downloads and video games.

Intellectual property such as patents, trademarks, copyrights, as well as financial Instruments such as stocks, bonds or insurance policies, are examples of intangible products. 

For many of us, internet access and data processing, though supported by very-real tangible platforms, might also be considered intangible products. One uses internet access, but the service is intangible. One uses platforms to process data, but those physical platforms are not the product. Rather, insights, perspectives, discussions, communications and documentation are common outputs and the “products” of the platforms. 

Business models for intangible products have been reshaped by the internet, and stand to be disrupted by AI as well, though the mechanisms might differ. 

In part, the internet disrupted value chains by attacking distribution costs and methods. AI is more likely to disrupt non-tangible product value by altering content production costs and methods. 

But digital technology--and AI--reshape the ways non-tangible products are produced, distributed and consumed.

When analog products are transformed into digital products, they can be replicated and distributed at minimal cost. So scalability grows dramatically, explaining why Netflix can operate globally in a way that legacy media content companies have found difficult. 

New distribution platforms also are possible, as online marketplaces connect creators with customers directly and globally, with fulfillment often possible on-demand. 

Marketing also shifts to online and targeted vehicles, though true for tangible and intangible services, with greater importance on customer experience issues.  

The overall impact of internet mechanisms has been to put pressure on non-tangible product business models, as competition is easier. AI should have many of the same effects.  

Of course, many intangible products have both minimal marginal costs (the cost of producing one additional unit) but also high sunk costs. Connectivity networks, water and electrical networks provide examples. Other networks--such as transportation networks--might also have similar characteristics: high sunk costs to produce the first unit, but low to relatively-low marginal costs for supplying additional units. 

That might suggest the ability to use marginal cost or forward pricing, both of which account for volume or network effects.

Marginal cost pricing sets the price equal to the marginal cost. For most digital goods, this translates to near-zero pricing, as replicating and distributing the product incurs minimal extra expense. But recovery of the sunk costs means that, in practice, marginal cost pricing is rare, even for non-tangible products. 

Forward pricing uses the concept of setting current prices with a view to future expected production costs, as when scale effects occur. 

Traditional pricing models often focus primarily on current production costs (materials, labor) to determine the initial price. Forward pricing takes a longer-term view, factoring in the expectation that production costs will likely decrease as the technology scales up (more units are produced).

Another possible related concept is near-zero pricing, where digital products can take advantage of Moore’s Law impact on the cost of digital infrastructure (computation, memory, bandwidth), and therefore the cost of producing and distributing digital products. 

Near-Zero Pricing: This strategy sets a very low price, often free, to attract a large user base. Revenue can then be generated through advertising, in-app purchases, or freemium models (free basic version with premium features for a fee). Near-zero pricing works best for products with network effects, where value increases with more users (e.g., social media platforms).

Gates and Hastings were Right: Near-Zero Pricing Matters

The most-startling strategic assumption ever made by Bill Gates was his belief that horrendously-expensive computing hardware would eventually be so low cost that he could build his own business on software for ubiquitous devices. .

How startling was the assumption? Consider that, In constant dollar terms, the computing power of an Apple iPad 2, when Microsoft was founded in 1975, would have cost between US$100 million and $10 billion.

source: Hamilton Project

The point is that the assumption by Gates that computing operations would be so cheap was an astounding leap. But my guess is that Gates understood Moore’s Law in a way that the rest of us did not.

Reed Hastings, Netflix founder, apparently made a similar decision. For Bill Gates, the insight that free computing would be a reality meant he should build his business on software used by computers.

Reed Hastings came to the same conclusion as he looked at bandwidth trends in terms both of capacity and prices. At a time when dial-up modems were running at 56 kbps, Hastings extrapolated from Moore's Law to understand where bandwidth would be in the future, not where it was “right now.”

“We took out our spreadsheets and we figured we’d get 14 megabits per second to the home by 2012, which turns out is about what we will get,” says Reed Hastings, Netflix CEO. “If you drag it out to 2021, we will all have a gigabit to the home." So far, internet access speeds have increased at just about those rates.

As frightening as it might be for executives and shareholders in the telecommunications industry, a bedrock assumption of mine about dynamics in the industry is that, over time, retail prices for connectivity services also will trend towards zero.

“Near-zero pricing” does not mean absolute zero (free), but only prices so low there is no practical constraint to using the services, just as prices of computing appliances trend towards lower prices over time, without reaching actual “zero.”

source. DrPeering

Communications capacity might not be driven directly by Moore’s Law, but it is affected, as chipsets power optical transmitters, receivers, power antenna arrays, switches, routers and all other active elements used by communications networks.

Also, at least some internet access providers--especially Comcast--have been increasing internet access bandwidth  in recent years almost directly in line with what Moore’s Law would predict.

If that is the case, the long-term trend should be that speed doubles about every 18 months. Service providers have choices about what to do, but generally try and hold prices the same while doubling the speed at that same price (much as PC manufacturers have done).

In that case, what changes is cost-per-bit, rather than posted price. But an argument can be made that actual retail prices actually have dropped, as well. According to the U.S. Bureau of Labor Statistics, prices for internet services and electronic information providers were 22 percent lower in 2018 versus 2000.

That is not always so obvious for any number of reasons. Disguised discounting happens when customers buy service bundles. In such cases, posted prices for stand-alone services are one thing; the effective prices people pay something else.

Also, it matters which packages people actually buy, not simply what suppliers advertise. Customers do have the ability to buy faster or slower services, with varying prices. So even when posted prices rise, most people do not buy those tiers of service.

And promotional pricing also plays a role. It is quite routine to find discounted prices offered for as much as a year.

The point is that, taking into account all discounting methods and buyer habits, what people pay for internet access has arguably declined, even when they are buying more usage.

source: ITU

To be sure, the near-zero pricing trend applies most directly to the cost per bit, rather than the effective retail price. But the point is that use of internet bandwidth keeps moving towards the point where using the resource is not a constraint on user behavior.

And that is the sense in which near-zero pricing matters: it does not constrain the use of computing hardware or communications networks for internet access.

Gates and Hastings have built big businesses on the assumption that Moore’s Law changes the realm of possibility. For communications services providers, there are lessons.

As Gates rightly assumed big businesses could be built on a widespread base of computers, and Hastings assumed a big streaming business could be based on low-cost and plentiful bandwidth, so service providers have to assume their future fortunes likewise hinge on owning assets in the app, device or platform roles within the ecosystem, not simply connectivity services.

Near-zero pricing matters.

Even as a "Platform," Telcos Would Not Escape Near Zero Pricing

The reality of very low and declining per-unit prices is well attested in the connectivity business. Many suggest a way out of the conundrum is for at least some connectivity providers to transform themselves as platforms. 

Ignore for the moment whether this is generally possible, and to what extent. 

Life as a platform would ultimately be based on very low per-unit prices. In fact, as many platforms feature zero marginal cost, they also tend towards near zero pricing. 

Virtually all platforms feature lower prices per unit than rival pipe businesses, for a number of reasons. Typically making extensive use of internet and computing resources to radically lower transaction and information discovery costs, etailing platforms inevitably push cost out of retail transactions. Platforms reduce friction. 

In other cases, platforms are able to mobilize and put into commercial use assets that otherwise lie fallow. Uber provides a good example. Personally-owned vehicles tend to sit parked and unused 95 percent of the time. Uber allows those otherwise idle assets to be put to commercial use. 

And though firms often are urged to become platforms, few actually can do so, and not for reasons of technology deployment, skill or type of product. Successful platforms are relatively rare because they require scale, and few businesses can afford to invest to scale. 

Most firms in the connectivity business will not be able to transform as platforms, leaving only other possible options. If one believes that prices for telecom products are destined to keep declining, or that more for the same price is the trend, then there are a couple of logical ways to “solve” such problems. 

Firms might try to gain scale to lower unit costs, change the cost model in other ways to enhance profitability, exit the business or change the game being played. Moving “up the stack,” across the ecosystem or into new or adjacent roles within the value chain can “change the game.” That is the strategy behind Comcast and AT&T moving into the content ownership business, or moves by other tier-one service providers into new lines of business outside the connectivity core. 

That is one way to attempt to escape the trap of marginal cost pricing, which might be the connectivity industry’s existential problem. 

But it also is reasonable to assume that even a successful shift to a platform model will be based on near zero marginal cost, and near zero pricing. The reason is simply that most platforms also feature near zero pricing.