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

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.

Will Cloud Computing Prices Keep Dropping to Zero, or Close to It?

Amazon Web Services has cut prices about 50 times. So will it keep doing so? Most would say “yes.” Will other suppliers such as Google and Microsoft follow suit? Most would also say “yes.”

In most industries, “ruinous” levels of competition often are said to represent a “race to zero” in terms of retail pricing, with negative implications for firm or industry sustainability.

But AWS has chosen such a strategy deliberately. AWS rationally has decided to keep cutting prices as the foundation of its business model.  

“How can that be?” is a reasonable question for any outside observer. How can a market leader in cloud computing literally price its core services at nearly zero, in either consumer (free computing, free storage, free apps)  or business markets (cloud computing, storage, apps or platform)?

After all, big data centers and the software, hardware, real estate and energy required to run them are substantial.

The business advantages of huge scale are part of the answer. Firms such as Amazon and Google count on the fact that only a few providers, with enormous scale, can afford to compete in such a market.

So gaining scale, then lowering prices, feeds a virtuous cycle where additional customers, buying more services, allow the supplier to gain even more scale and drop prices even more, attracting yet more customers.

With sufficient scale, “scope” also becomes relevant: AWS and other leading cloud computing suppliers can sell additional services and features to the customers they already have aggregated.

So even if a “race to zero” has generally been considered dangerous and unsustainable in big existing markets, it is the foundation of strategy in many new digital--and some emerging physical markets--as well.

It is hard to compete with a competitor that gives away what you sell. That, in fact, is precisely the logic often driving business strategy in the Internet realm.

That strategy is at work with voice over IP, instant messaging, online streaming video and audio, Internet access, search and most “print” content. Many would agree, but note that these all are non-tangible, digital products. That notion is correct.

In most “physical product” areas, the Internet has lead to reduced prices, or less friction, but surely not to “near zero” levels.

That, of course, is not really the issue. The issue is a competitor’s ability to destroy enough gross revenue--and strategically, profit margin--as to break the market leader’s business model.

This is a rational strategy for some new contestants because they actually have other revenue models that are enhanced when an existing supporting market is “destroyed.”

In a real sense, Apple gains business advantage when content prices are very low. That helps it sell devices enabling content consumption. Facebook and Google gain when each additional Internet user is added, since they make money on advertising.

Prices for physical good distribution do not have to reach “near zero,” only “near zero profit,” for whole markets to be disrupted.

An attacker able to create a positive and sustainable business case in a market that is perhaps smaller (in terms of overall revenue) still wins is the attacker emerges as a market leader in the reshaped market.

One example: many observers would say that the chief revenue stream for Costco, the discount groceries retailer, is membership fees, not groceries. Likewise, the business model for most movie theaters is concessions, not admission tickets.

That is one sense of the term “zero billion dollar market.”

The strategy is inherent in business models used by many leading application, device or service providers.

The difference is that the trend is extending beyond businesses that are inherently “digital.” Some see shared vehicle businesses as disrupting the automobile market on a permanent basis. Shared accommodations businesses have potential to disrupt the commercial lodging business.

Without a doubt, we will see spreading efforts to replicate such sharing models in most parts of the economy where ownership is the dominant retail model.

Suppliers of cloud computing, especially infrastructure as a service (IAAS) but even the biggests segment--software as a service--also must directly confront pricing strategies that deliberately aim to reach near-zero levels.

There are several analogies you might might apply, to Moore’s Law, marginal cost pricing or experience curves, for example. Some might say that same logic is embedded in much of the economics of the Internet as well.

The notion is that, over time, performance vastly improves while retail price either remains the same or also shrinks, not just on a per-bit or per-instance basis, but absolutely, adjusted for inflation or not.

Suppliers of network bandwidth and computer chips long have had to create or recraft businesses built on such assumptions.

The obvious business implications are stark. Many firms, in a growing range of industries, face competitors who literally base their business models on marginal cost pricing, near zero pricing or actual “free” prices.

Those competitors can do so because widespread use of the “near zero” or “zero” price function allows them to make money indirectly. For Amazon, the other way is retailing all manner of products. For Google and Facebook the other way is advertising. For Apple the other way is device sales.

In all those cases, the direct revenue contribution for one input--while important--is less important than ubiquity or huge scale as it relates to the primary revenue model.

“Zero” levels of pricing are a fundamental reality in a growing range of industries. How successfully the legacy providers can adapt always is the issue. In many cases, the answer is “we won’t be able to do so.”

Some would say that is an example of creative destruction. But it is destruction, nevertheless.