Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett

Public Policies to Encourage Cable and ISDN Residential Internet Access Sharon Eisner Gillett

Abstract policy implications of the analysis. While policy issues related to market structure have been This paper analyzes inter-firm alliances for discussed in a number of recent studies of the cable providing the home computer user with an and telephone industries, these writings have innovative new telecommunications service: a concentrated on traditional video and telephony high-speed connection to the Internet. After services.1 Popular data services such as the Internet providing an overview of the Internet access and America OnLine have emerged only recently, provider industry, it discusses the split of and the role of local infrastructure networks in competencies needed to deliver this new service, providing residential access to these services has between monopolistic infrastructure (cable and not yet received much attention. Presciently, in local telephone) companies and entrepreneurial 1983 Pool discussed the market structural issues Internet service providers. It finds that the for residential data services in general terms.2 This asymmetry in market power between the two paper builds on and updates his analysis in light of partners holds up the diffusion of this innovation, actual data technologies and services that have and can best be remedied by more open access to developed in the intervening 12 years, concluding both the subscriber and provider sides of the that more open access to cable networks, on both cable network, along with increased competition the subscriber and provider sides of the network, in all forms of local communications would accelerate the diffusion of high-speed infrastructure. residential Internet access.

1 Introduction 2 Overview of the Internet access This paper analyzes inter-firm alliances for industry providing the home computer user with an innovative new telecommunications service: a The Internet grew out of the ARPANET, a connection to the Internet at higher speeds than the research network originated by the Advanced 28.8 Kbps maximum available with ordinary Research Projects Agency (ARPA) of the U.S. telephone modems. These alliances are driven by Department of Defense. From the ARPANET’s the split of competencies required to deliver this original charter of serving the defense and innovation, between monopolistic infrastructure computer networking research communities, the (cable and local telephone) companies and Internet has grown to encompass the broader entrepreneurial Internet service providers. The research and education communities as well as paper discusses the organizational and policy issues connecting corporations and individuals. involved in the development of such alliances. In the late 1980’s, the U.S. National Science Starting from an analysis of limiting hold-ups, the Foundation (NSF) awarded contracts to establish a paper argues for regulatory changes needed to system of about a dozen regional networks. These foster the diffusion of this telecommunications networks connected academic and research innovation. institutions to the NSFNET, which at that time The paper begins with a brief overview of the served as the core “backbone” transmission facility highly dynamic Internet access industry, of the Internet.3 As the NSF relaxed its rules differentiating between the home and business (called the “Acceptable Use Policy”) governing the market segments. It discusses what capabilities use of its networks for commercial traffic, many of organizations need to provide high-speed access to the organizations operating regional networks Internet users in their homes, instead of their transitioned from not-for-profit cooperatives to offices. These competencies are then compared against existing organizational boundaries, 1 See, for example, [6] ; on p. 103, numerous highlighting the need for inter-firm alliances. econometric studies of vertical integration in the cable The framework developed in [1] is then applied industry are cited. [7] , [8] , and [9] address market structural issues in telephony. to analyze these alliances. The threat of incumbent 2 entry is analyzed from both an economic and an See [10] pp. 166-88, especially p. 175. 3 organizational perspective, building on the work of The regional networks were also referred to as “mid- [2] , [3] , [4] , and [5] . level” networks, since they logically fit between the “top” level NSFNET backbone and the local intra- The paper concludes with a discussion of the university or intra-company networks that provided the “bottom” level of connectivity to the user.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett profit-making providers of Internet connections to March 1994 and from commercial institutions. Thus were born Internet Revenue Market share the first wave of Internet access providers, each Access (in millions) (% of total with a de facto monopoly in its region.4 Provider revenue) The monopoly didn’t last long. A smaller PSI $15.4 13 number of providers are attempting to cover a UUNET $14.3 12 nationwide scope by operating interconnection Sprint $14.3 12 points in many U.S. cities.5 This strategy builds IP Resellers $11.9 10 stronger brand awareness and allows subscribers ANS $10.7 9 who travel to use the service elsewhere without Netcom $8.3 7 paying long-distance telephone charges. Although Other $44.0 37 it is risky to give examples in an environment in TOTAL $118.8m 100 which information is correct only until next week’s trade rag comes out, examples at the time of this writing include PSI, UUNET Technologies Inc., January 1995 Netcom On-Line Communications Services, Sprint Internet Revenue Market share (whose scope is actually international), and MCI.6 Access (in millions) (% of total Provider revenue) Given the explosive expansion of the Internet customer base, most access provider companies are UUNET $46.8 9.5 experiencing rapid growth, with market shares Netcom $31.2 6.4 highly fragmented and changing hands fluidly, and Sprint $29.9 5.7 many new providers emerging. The Maloff PSI $22.9 4.7 Company estimates the following revenue and share Supernet $10.4 2.1 figures for the market leaders, based on surveys of ANS $10.3 2.1 providers done nine months apart over the Internet.7 Other $369.9 69.5 TOTAL $521.4m 100 Table 1: Internet access provider market share is highly fragmented and volatile Since most of these providers are either privately held or divisions of larger companies, this financial data is difficult to verify. To illustrate the uncertainty of these figures, consider that Dun and Bradstreet’s 1994 Million Dollar Directory (1993 data) lists PSI and ANS as having $6.4 and $20 million in sales, respectively.8 The overall market growth, however, is roughly consistent with the average growth rate estimated above.9 Among the many different axes along which the different providers can be segmented, a major differentiator is whether they market to individual 4 Examples of regional networks in the northeastern U.S. are NEARNet (originally, the New England customers or only to organizations. While many of Academic and Research Network), operated by BBN the national-scope providers (e.g. Netcom, PSI) do Internet Services Inc., and JvNCnet (originally, the sell service to individuals, the largest regionals do John von Neumann Supercomputing Center network), not [13] . This has led to the emergence of a third operated by Global Enterprise Services Inc. type of company, typically a small start-up, selling 5 Some of these providers are themselves spin-offs of local access to individual, often home-based, regional networks, e.g. Performance Systems customers. Most of these companies do not offer International (PSI) from NYSERNET (the New York as full-featured a service as the bigger players, both State Educational and Research Network). in terms of customer support coverage and the 6 See [11] . The major online service providers technical nature of the Internet connection.10 These (America OnLine, CompuServe, and Prodigy) may move towards this business as well; see [12] . 7 The Maloff Company is a Michigan consultancy 8 Note that the sale of ANS to America OnLine for $35 focusing on business and the Internet. This data is million was announced in late 1994. derived from summaries of their “Internet Service 9 Provid er Marketplace Analysis” (1993-4 and 1994-5) A 10% monthly growth rate leads to a tripling (300% which are available on the Internet at increase) every 12 months; Table 1 show an annual http://www.trinet.com/maloff. Note that market increase of 250%. shares expressed by number of customers might look 10 Most of these services sell “shell accounts,” so called quite different, given the greater dollar value of because they originally forced the customer to use a corporate customers. “login shell” instead of a graphical, window -based user

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett small companies resell Internet access purchased Enterprise with from either a regional or national Internet provider, internal networks while relying on public infrastructure (e.g. the local dial-up telephone network) to provide the connection from their premises to the user’s computer. This segment, which is characterized by low barriers to entry, is also highly volatile and growing Internet rapidly.11 Estimates of the number of firms vary provider widely.12 An example of this type of service in the Boston area is “The World,” operated by Software Tool and Die, Inc., a low-priced service which opened its doors in 1990 and now supports 10,000 subscribers connecting through dial-up modems.13

As a comparison of Figure 1 with Figures 2 and Figure 1: Model of connections to users within 3 illustrates, the model of connections to individuals is fundamentally different from organizations connections to users within organizations. In the organizational model, the user’s computer is In contrast, when serving individuals, there is no assumed to be connected to an enterprise network, enterprise to provide either the “bottom level” and the Internet provider only needs to use physical connection or a technical support buffer. telecommunications infrastructure (often a leased Consequently, the provider targeting individual line, but sometimes a dialup telephone circuit) to subscribers not only relies much more heavily on connect once to the enterprise network, not to each public telecommunications infrastructure, but also individual computer. In addition, the organization is needs to have a much stronger capability for assumed to have internal technical support offering technical support to customers. resources, providing a centralized support interface telephone circuits for the Internet provider to deal with.

interface. The limitation arises because the customer’s computer does not run the Internet protocol suite and connect directly to the Internet ; instead, it connects to the service provider’s computer, which runs the protocol suite on its behalf, relaying data to and from Internet local the Internet. This setup limits the Internet applications provider telephone usable by customers (in particular, Mosaic cannot be supported by a shell account). While it is network technologically possible to run the Internet protocols over low-speed dial-up lines, and some providers do offer this service (called “SLIP” or “PPP” connections), it is less common because the additional overhead requires more sophisticated equipment and therefore greater expense. See [14] , p. 3, for more details. Figure 2: Telephone model of connections to 11 [13] estimates that “a big corporation would need only individual users about $40,000 to start its own Internet-provider operation.” See also [15] . 12 For example, [16] lists 47 Internet access providers, of which about 27 would fall into this segment after subtracting the approximately 20 regional and national providers; one month later, the Wall Street Journal [13] estimated the total number of providers at about 100 companies; while various lists (such as “pdial”) maintained on the Internet itself estimate closer to four or five hundred providers. 13 Telephone conversation with Chetty Ramanathan of Software Tool and Die, Inc., 12/9/94. Maloff (op cit) estimates that The World holds about a 1% share of Internet access revenue.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett

cable TV network residential Internet access has become available, it has usually been through some form of inter-firm coordination between an Internet provider and an infrastructure (cable or telephone) company. While a spate of “data over cable” trials and partnerships have been announced,18 the only commercial service offering announced to date is PSICable Internet (Internet over cable), sold by PSI in conjunction provider with Continental Cablevision in Cambridge, MA.19 On the telephone side, a small number of providers in a variety of regions (both in the U.S. and Europe) offer Internet over ISDN, including Internex, Inc. a Silicon Valley startup experiencing rapid growth in sales of Internet over ISDN, in conjunction with Figure 3: Cable model of connections to individual Pacific Bell. PSI also offers Internet connections users over ISDN in approximately 35 U.S. cities through its “InterRamp” service (Lindstrom, 1994) . While high-speed connections, ranging from 56 The nature and extent of the relationship Kilobits per second (Kbps) to 10 Megabits per between the Internet and infrastructure providers second (Mbps), are commonplace for organizations varies across these different offerings. The connecting to the Internet via leased circuits, most following sections explore the drivers shaping these individuals have until recently been limited by the relationships. speed of dialup telephone modems (ranging from 2400 bits per second to 28.8 Kbps). An annoying 3 Competencies inconvenience in the past, this limit is now a serious impediment to the use of bandwidth-hungry Table 2 compares the portfolio of competencies multimedia services, including the Internet’s and assets needed for high-speed residential popular graphical information browsing and Internet access against current organizational retrieval system known as the World Wide Web.14 boundaries. The clear split between competencies This demand pull, combined with technology push held by infrastructure and Internet providers in digital information transmission, has led in the explains why high-speed residential Internet service past year to two types of high-speed individual is typically offered under a cooperative Internet access becoming available in a few areas. arrangement of some sort. The first uses a more advanced form of dialup telephone circuit, called ISDN, that allows data transmission at rates up to 128 Kbps.15 The second uses a special type of modem to transmit and receive data over a cable television network, at rates from 500 Kbps to 10 Mbps (depending on the model and price of modem chosen). This modem can only be used over cable TV plant that has been upgraded to allow subscribers to send data, instead of just receiving broadcast signals.16 may become more of a “special customer” of the local telephone company. However, such a relationship is As Figure 2 implies, with low-speed dial-up not essential when a small provider business is first access, both the provider and customer need only to started. connect standard modems to ordinary telephone 18 See [17] and [18] . Several companies have also run lines, so no special relationship between the trials connecting schools to the Internet over cable, provider and the local telephone company is including Jones Intercable with ANS in Alexandria, 17 VA, and Media General with Sprint under the auspices necessary. In contrast, where high-speed of NSF’s Global Schoolhouse project. 19 Despite this service being announced as a commercial 14 The Web system is more commonly known by the offering at a Cambridge, MA press conference (which names of its popular user interface programs, such as I attended on March 8, 1994) . and the availability of Mosaic and Netscape. pricing and marketing literature, the service is currently unavailable to individual customers (on December 12, 15 ISDN stands for Integrated Services Digital Network. 1994, a PSI telephone sales representative informed 16 This same technology can be used to provide me that the individual service is in “beta test”). connections to on-line services such as America Current unavailability of reliable 500 Kbps cable OnLine and Prodigy. modems appears to be one of the problems. A 4 Mbps 17 As the provider grows, it needs a larger number of service is available for sale to organizations, although it connections to the local telephone network, and thus appears to have attracted few, if any, customers.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett

Table 2: Key competencies are split across technologies described in [20], such as configuring organizational boundaries Internet Protocol addresses, debugging routing Competency or asset needed Who has it problems, setting up domain names (such as Physical communication Local telephone and “mit.edu” or “ibm.com”), securing corporate connections, etc. Although this technology is infrastructure cable companies mainly in the public domain, it changes extremely Customer service Local telephone and rapidly. Thus, the ability to both track and drive organization cable companies fast-paced change has to be part of the provider’s Internet technology: organizational competence. Connectivity with rest of Internet providers Internet Technical customer support: While Internet General Internet know-how Internet providers providers have some of the same customer service Technical customer support To limited extent, capabilities as infrastructure providers (e.g. billing, Internet providers taking orders), they must also have the specific Internet over {ISDN, cable} Under development technical competence to support the Internet know-how technology used by their customers. Scaling both Marketing and sales Unclear types of customer service capabilities to large Brand name Unclear numbers of residential users is a critical challenge for the Internet providers. While alliances with infrastructure providers might help with the routine Each of these competencies is now discussed in components of customer service, the technical more detail. component requires specifically-skilled staff. Given the rapid growth of Internet services, such Physical communication infrastructure: The people are likely, at least in the short term, to be in distribution network for Internet service is 21 embodied in the fiber optic, coaxial, and copper greater demand than supply. Poor support is a cabling used to reach individual homes. This wiring pervasive customer complaint in this industry, is owned and operated by local telephone and cable especially from individuals who purchase service 20 from providers that are expanding rapidly. Thus, companies. development of a cost-effective customer support Customer service organization: Cable and organization and corresponding reputation is an telephone companies each have the organizational important strategic investment for competitive competence to serve thousands of customers in all strength and differentiation. the usual ways: billing, taking customer orders and Internet over ISDN or cable know-how: While complaints, maintaining a fleet of repair trucks and Internet technology is designed to be layered above technicians, etc. a wide variety of physical communications media, Internet technology: This capability is the knowledge of how to achieve this layering over subdivided into four components, held to varying residential communications infrastructure is degrees by Internet access providers: specialized and only now developing. Special protocols and equipment are needed, such as dial-up Connectivity with rest of Internet: The ISDN servers and cable modems. These are newly provider needs equipment to connect itself to the emerging technologies, and getting them to work rest of the Internet, consisting of one or more requires a cooperative effort between the Internet Internet Protocol routers (the Internet equivalent of and infrastructure providers. The dividing line of a telephone switch) and long-haul data circuits. responsibilities is often fuzzy. For example, if a This equipment may be owned and operated by the cable modem appears not to be working, the access provider, or the entire connection may be problem could lie anywhere from the settings on achieved through a relationship with a larger the amplifiers internal to the cable TV plant to the Internet provider reselling its service. communications protocols used to send data over General Internet know-how: Internet the network. Or, if a customer is having problems providers know how to deploy and manage the connecting to the Internet over an ISDN circuit, the problem may lie in the user’s hardware or in the circuit’s settings in the telephone company’s 20 Wireless companies should also be considered as switching office.22 Clearly, the success of a high- infrastructure providers, but wireless data is new speed residential Internet access offering is enough that I have not yet seen any Internet provide rs offering wireless Internet access. As [19] writes: 21 “Many wireless networks use different transport This point was suggested by my conversation with protocols, thereby requiring proprietary modems for Chetty Ramanathan of Software Tool and Die, op cit. specific carriers’ services. Software vendors have 22 This type of interdependence is an excellent example been slow to support wireless networks because doing of a “connection among technologies,” one of the so would require that developers write to each modem factors Teece identifies as driving operational protocol.” coordination for innovation. See [21] , p. 13.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett critically dependent on how well the partner’s customers. In this situation, which company is incentives line up to resolve problems quickly. If most likely to profit depends on the appropriability anything in the relationship leads to information of the innovation and how tightly held the hiding or finger pointing, the service offering is complementary asset is. unlikely to get very far. The Internet is a prototypical open system. As In addition to technological competence, Comer explains: Internet access providers have two ordinary The internet technology described business needs that are not currently well-filled by either themselves or infrastructure providers. in this book is an example of open system interconnection. It is Marketing and sales: Although infrastructure called an open system because, providers certainly have order-taking sales unlike proprietary communication organizations, as protected monopolies they have systems available from one not developed strong marketing arms. And Internet specific vendor, the specifications providers, typically small growing companies, are are publicly available. Thus, often understaffed and inexperienced in this area anyone can build the software [13]. In short, neither partner really has this needed to communicate across an capability. internet. More important, the entire technology has been Brand name: While cable and telephone designed to foster communication infrastructure providers are household names in between machines with diverse their familiar services (TV and telephony), it hardware architectures, to use remains to be seen whether that customer almost any packet switched recognition will transfer to innovative services such network hardware, and to as high-speed Internet access. Such a transfer, accommodate multiple computer however, is much more probable than having current operating systems.25 Internet providers quickly become household names.23 In other words, Internet technology is hardly appropriable at all. At the same time, the 4 Analysis of alliances complementary assets are quite tightly held: both Teece notes that a technological regime shift cable and (local) telephone companies hold local can create innovative opportunities for entrants that monopolies in their respective services, with 26 can only be fully realized by linking with the enormous barriers to entry. Given that complementary assets controlled by incumbents.24 combination, Teece’s framework predicts that the As Table 2 shows, high-speed residential Internet owner of the complementary asset—i.e. the cable access fits this model very well: the entrant Internet or telephone company—is much more likely to providers are poised to provide an innovative service, but require the use of the incumbent’s distribution system—residential cable and telephone networks—to deliver the innovation to 25 [20] , pp. 1-2. In [22] , pp. 7-9, Tony Rutkowski describes Internet standard-setting as an open process of trying different approaches and adopting those that 23 Because many people on the Internet use a connection work. Participation in this process is fluid and open, supplied by their workplace, even the biggest Internet and relevant technical documents are freely availa ble providers’ names are unfamiliar to a large portion of on the Internet itself. Thus the growth of the Internet the “digerati.” A more credible scenario for brand- helps to disseminate technical knowledge about the name development runs the other direction: the major Internet, fueling further growth. This open online service providers leverage their name environment is one reason the technology moves so recognition among residential computer users to quickly—partly because of efficient information diversify into selling Internet access. In fact, with distribution, and partly because participants must “race America OnLine’s purchase of ANS (formerly an to innovate”—e.g. by providing a more secure service independent Internet provider), and CompuServe’s than the current Internet standards specify—to try to recent diversifications into Internet access, this gain some form of competitive advantage, however scenario already appears to be taking shape. MCI and temporary. Sprint also have big brand-name advantages compared 26 These barriers are not only economic—the enormous to other Internet providers. None of these four cost of installing wired infrastructure—but also legal. companies are offering high-speed residential Internet The failure of telecommunications reform legislation in access, but several online companies are gaining the fall of 1994 means that many states still prohibit experience by trialing high-speed residential access to competition in local telephony. Most cable companies their online services through various alliances with operate as sole franchisees for a community; no other cable companies [17] . cable company can get permission to dig the streets, 24 See [1] and[21] , p. 13. hang wires on utility poles, etc.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett profit from the innovation.27 parties, its value is greater for the Internet provider, since the infrastructure firm is larger and more Although cable and telephone networks each bureaucratic and therefore more difficult to constitute a monopoly infrastructure, control of the navigate.31 distribution asset might be considered less tight if the two infrastructures are viewed as competing The second sunk asset is the investment in against each other in a single locale. Two realities, infrastructure-specific technological know-how. however, make this an overly idealized view. First, Expertise in getting Internet connections to work at present it is a rare community that has both ISDN over cable modems does not transfer at all to an and a suitably upgraded cable plant (the latter is ISDN environment. Once invested, an Internet especially rare). Second, and more enduring, the provider’s threat to leave the relationship in favor of two types of networks are not exact substitutes; a different technology is not terribly credible. cable can provide higher shared bandwidth at lower 28 The third asset is the networking equipment that cost, enabling services that ISDN can’t match. is specific to the chosen infrastructure (e.g. cable Because of this difference, an Internet provider may modems). This equipment is the main component prefer to work with both types of infrastructure of marginal capital cost [15] . Who owns this providers to reach customers with different service equipment is thus a key structural question for the and price preferences, instead of using each relationship. If the infrastructure provider owns it, infrastructure provider as a foil to the other. then that firm can relatively easily exit the Even in situations where the two networks do relationship and transfer its assets to a relationship co-exist, two is still a small number of competitors, with a competing Internet provider. On the other especially compared to the much more robustly hand, if the Internet provider owns the equipment, competitive Internet provider industry. Thus there the infrastructure provider has less to offer a is a fundamental asymmetry inherent in any competing Internet firm and is less likely to leave relationship between Internet and infrastructure the relationship. If it does, however, it may leave providers.29 This situation leads to the classic the Internet provider with a large stranded small-numbers bargaining problems predicted by investment.32 transaction cost theory [23]. The Internet provider, The power of the infrastructure providers is a small company in a competitive industry, is further demonstrated by a different kind of hold-up critically dependent on a complementary asset that is already occurring: not entering relationships controlled by an infrastructure provider—a large, in the first place. Customers may be asking for entrenched monopolist. Although when possible high-speed Internet over cable, but unless the local the Internet provider may try to play the two cable company decides it wants to play, Internet infrastructure providers off against each other, once providers have no power to offer this service. The an agreement has been inked, three types of situation is captured well by this quote from a relationship-specific assets lock the Internet recent newswire story: provider in, inviting opportunism.30 “It takes a lot of cable The first relationship-specific asset is the bandwidth...to run a great deal of knowledge of contacts and procedures at the data quickly down the pipeline,” partnering firm. Although this asset applies to both said Albert Young, a product manager at Cox Communications, 27 See [1] , Figure 11, p. 297. In this situation, Teece one of the nation’s largest cable suggests contracting to limit exposure, but predicts that system operators. “You could use the innovator is likely to lose to the asset holder in any that more profitably for a video case. 28 [15] explores this topic in more detail, showing that for the same average bandwidth of 128 Kbps, a cable system allowing 500 Kbps of peak bandwidth costs 31 Lest the reader underestimate the value of this asset, less to provide than an ISDN system allowing only 128 consider that many ISDN users have reported (in Kbps of peak bandwidth per subscriber. discussions on Internet newsgroups) that it typically 29 The asymmetry extends to entry barriers as well. The takes 4 phone calls to the local telephone company to capital requirements to enter residential Internet access find someone who knows what ISDN is. A firm like provision depend on router and wholesale Internet Internex, Inc., which resells Pacific Bell ISDN circuits connectivity prices [15] , both of which are dropping to create Internet connections, adds value for with improving technology and hot competition. And, customers by hiding this complexity. of course, the technical know-how is freely available. 32 An Internet provider covering a broad geographic 30 A national Internet provider may try to play off same - scope is less vulnerable to stranded investment, since it technology providers in different regions (e.g. Pacific can presumably use the same equipment in another Bell vs. Ameritech for ISDN, or TCI vs. Time Warner region. Even less risky would be to allow the customer for cable), but a local or regional provider is less likely to own this equipment. Cable companies, however, are to have this option. unaccustomed to that mode of operation.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett

channel.”33 (Ameritech) appears to be adopting this approach.36

Such incumbent entry is also supported by For ISDN, the local telephone company’s tariffs can serve a similar blocking function. ISDN pricing economic theory. As predicted by Arrow’s theory varies widely across the different Regional Bell [2], the telephone and cable companies—incumbent Operating Companies (RBOCs) and GTE service monopolists with blockaded entry—had weak areas. Some RBOCs (e.g. BellSouth, Pacific Bell) incentives to (and did not) originate the Internet have set tariffs that encourage ISDN adoption and service innovation. But now that the visible success of Internet providers has increased the certainty of use, while others (e.g. NYNEX) have set prices so this innovation, the frameworks of [3] and [4] high that they form an effective barrier to 34 predict a much greater incentive for its adoption by adoption. Not surprisingly, companies offering 37 Internet connections over ISDN are typically found incumbents. This is especially true since, far in the regions with reasonable ISDN tariffs. from cannibalizing existing services provided by the Diffusion of Internet access via ISDN would incumbents, Internet connections can have a 38 accelerate if all regions adopted aggressive ISDN synergistic effect. pricing. From an organizational perspective, however, Internet providers may be forgiven if they greet the 4.1 Incumbent entry threat of incumbent entry with a bit of skepticism. Table 3 contrasts qualitatively the environments in Teece’s theory predicts that infrastructure which Internet and infrastructure firms operate: providers will retain any profits from high-speed residential Internet access. Given the lack of Table 3: Internet and infrastructure providers appropriability of Internet technology, one operate in different environments mechanism that could lead to this outcome is for the infrastructure firm to absorb technological Environmental Internet Infrastructure competence from the partnering Internet firm, then attribute providers providers use it to enter the Internet provider business Competition Significant Very little themselves. This section discusses two issues: is this a credible threat, and if it is, should current Technology 1.5-3 years 15-20 years Internet providers be wary of entering strategic generation alliances because of it? Government role Funding Regulator stimulus 4.1.1 Is the threat credible? Firm size Small Huge

From a strictly economic perspective, the threat These environmental differences lead to of entry from infrastructure providers—especially telephone companies—is very real. To provide Internet connections to subscribers over ISDN, the negotiation between the Internet provider and the local Internet provider must connect its equipment (e.g. telephone company. 36 its Internet router) to the local telephone network. See [25] . It is not a coincidence that Ameritech is one This connection generally involves expensive leased of the more ISDN-conversant RBOCs, nor that it is one of the four telephone companies (Pacific Bell, circuits. If the provider equipment were located on Sprint, and MFS are the other three) recently awarded the same premises as the telephone network (i.e. in contracts from the National Science Foundation to telephone company central offices), the service manage the network interconnection points of the could be offered much more cheaply. Co-location newly-restructured Internet. is clearly an option for the telephone company; 37 The certainty of the innovation extends to estimates of whether it is an option for Internet providers is less diffusion rates. For example, given the puny size of the clear.35 In any case, at least one telephone company Internet access market relative to the infrastructure market (an estimated $100 million for Internet vs. $80 billion for telephony and $20 billion for cable), should an infrastructure provider bother with it? If the Internet 33 From November 30, 1994 Bloomberg newswire, market is expected to continue tripling in size every reporting on the Western Cable Show in Anaheim, CA. year (10% monthly growth rate), the infrastructure 34 See, for example, [24] . Per-minute usage fees are provider may feel rushed to get in on the ground floor often part of ISDN pricing, discouraging residential of a market that will be big soon. Alternatively, if the usage. infrastructure provider thinks the 10% growth rate is a 35 Co-location rights are often hotly contested, but usually short-lived fad, the “endpoint” market may appear too encouraged by regulatory policy; see [7] , p. 262. small to be important. As the Internet’s astonishing Most cases have involved competitive access growth continues over ever more years, it becomes providers, who are accustomed to courtrooms and ever more difficult to dismiss as a limited fad. regulatory proceedings; most Internet service providers 38 For example, customers may order a second ordinary are less comfortable in this arena. At the least, telephone line, an ISDN circuit, or new cable service in securing these rights will require a contractual order to gain access to the Internet.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett significant differences in organizational culture and Internet access is a likely scenario, while success capability. For example, regulation fosters a of that entry is much less likely. It is quite possible mentality of always looking over your shoulder to that some nimble Internet providers will establish keep the regulator happy, as opposed to creative, effective capability in marketing, customer support rapid innovation.39 Skepticism about the ability of and reputation well before the infrastructure large, bureaucratic infrastructure firms to play in providers learn to move quickly enough to be the fast-moving Internet industry—including either serious contenders. Given that the on-line service growing or attracting and retaining the necessary providers already have strong name recognition, engineering talent—is well-founded.40 they appear to be especially well positioned should they pursue the Internet provider market. Other The packet-switching communications important contingencies to track would be: technology used in the Internet is also an architectural innovation. It uses the same • The lifting of the long-distance restrictions on components as telephony—switching and the RBOCs, which would further encourage transmission—but configures them into a different telephone company entry into Internet services type of system: best-effort, variable-performance by allowing full integration; packet delivery instead of the highly-reliable, guaranteed-performance circuit switching used by • MCI’s potential entry into local telephony. telephony [20]. As [5] shows, it can be difficult for MCI has provided Internet circuits for many established firms to transition to a new architecture, years and has strong Internet expertise. If they because of the many architectural assumptions built were to start providing local telephone service into the existing organization. This transition will as well as long-distance, they could be the only be even more difficult for cable companies, who player owning all the competencies listed in must also acquire component expertise in switching Table 2 and thus extremely well-positioned to and bi-directional transmission.41 offer high-speed residential Internet access.42

In sum, entry of infrastructure providers into 4.1.2 Should Internet providers be wary? 39 Regulation can also impose transaction costs; for While the Internet providers involved in example, Ameritech’s Internet offering has to contract alliances to offer high-speed Internet access should out the long-distance portion of Internet transport, since RBOCs are not allowed to offer long-distance be aware of their infrastructure partner’s strong telecommunications. The regulatory legacy is a factor incentive to use them for technology transfer as well. Although local telephone companies are leading to eventual competition, they should not use currently allowed to offer information services (such as this as an excuse to opportunistically hide Internet), they were prohibited from doing so from information. Given how non-appropriable general 1984-92 by the Modified Final Judgment that settled Internet know-how is anyway, the risk of the U.S. government’s antitrust case against AT&T relationship (and thus service offering) failure from [26]. Deciding to offer Internet service—for a opportunism is far greater than the risk of sharing telephone or cable company, since both are subject to regulation—thus requires not only an adjustment to the information. Instead, both parties should new reality, but also a belief that this reality will stick concentrate on cooperating to make the around long enough to make the investment infrastructure-specific technology work, and to worthwhile. Given the massive political swings back provide excellent customer service and technical and forth in Washington over the last 20 years, this support, so that their reputations are enhanced by belief may be hard to come by at times. the offering. 40 A bearish indicator in this regard is the small number of decision makers in infrastructure firms who have or use full Internet connections. Some Internet services 5 Policy implications (e.g. navigating the World Wide Web) are so different from users’ existing mental models of computer Up this point, the analysis has masked some services that their value and power, while trivial to important differences by assuming that both cable demonstrate, can be difficult to explain and understand and telephone companies control their respective in the abstract. Thus an infrastructure provider might infrastructure assets equally tightly. In fact, two easily fail to grasp the importance of technology regulatory differences give the cable companies transfer from an Internet partner, much as IBM tighter control. First, unlike telephone companies, managers, most of whom did not have or use their own PCs, failed to grasp the significance of the architectural shift toward desktop computing [27] . 42 Sprint could also be similarly positioned, but appears to 41 Giving subscribers the ability to ta lk as well as listen be concentrating more on selling wholesale Internet to involves several significant engineering challenges, resellers than retail Internet to individuals. MCI has including noise ingress and contention schemes for approval to offer local telephone service in four states shared access. The technology to address these issues and has filed for approval in six more, but is initially is still in an era of ferment, with multiple candidates concentrating on serving business, not residential, vying to become a dominant design. customers [28] .

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett cable companies are not legally required to be the ISDN technology. common carriers.43 Thus, aside from being more geographically available than upgraded cable Thus, without regulatory changes to mitigate the networks, ISDN service can also be procured for a current situation of monopolistic hold-up by lower transaction cost: an Internet provider and its infrastructure providers, the diffusion of high-speed customers can purchase ISDN lines on a tariff (i.e. residential Internet access is unlikely to keep pace public price) basis, instead of the Internet provider with the overall Internet diffusion curve.46 The being forced to enter a contractual negotiation.44 analysis in this paper suggests two regulatory Second, cable networks, unlike current policies that can improve the chances of this telephone networks, are not subject to the kinds of innovation becoming a more widespread reality: open access rules that allow any approved, • Encouragement of all forms of competition in subscriber-owned equipment to be plugged into the local infrastructure provision; network. This is one reason why the cable modem market is less mature and competitive than the • Application of open access principles to cable telephone modem and ISDN equipment markets. It networks. is also a reason why an Internet provider assumes greater relationship-specific asset risk in an 5.1 Local infrastructure competition alliance with a cable company: with ISDN, the To reduce the monopoly power of the cable and subscriber assumes more risk by owning a major local telephone infrastructure providers vis a vis component of the ISDN-specific Internet Internet service providers, state regulators should equipment. not only allow but also encourage all forms of local This analysis explains two empirical infrastructure competition. This competition may observations of the current marketplace: come from a variety of local distribution technologies, not all of which may be suitable for 1. Internet over cable is typically based on a more Internet access (e.g. direct broadcast satellite), but contractual arrangement than Internet over whose combined effect on market power should ISDN;45 lead to a more favorable negotiation for the Internet service provider. 2. Internet over ISDN, while nowhere near as Developments in those technologies that are available as ordinary dial-up Internet, is much suitable for Internet access will be important for more available than Internet over cable. This Internet service providers to track. Two -way result is partly a consequence of the first wireless networks are a good example. Because observation, as well as the greater maturity of wireless networks require less physical infrastructure and disruption, they have much lower 43 A common carrier is obligated to provide transmission barriers to entry than cable and wired telephone services in a non-discriminatory fashion to anyone who technologies. When the federal government’s wants to purchase them; see [6], p. 59. One could spectrum auctions are completed, several such argue that the extremely high complexity of ISDN networks are supposed to be licensed to compete counterbalances its common carriage status, for against each other in any given area. This example by making available only a particular set of development should translate into new business ISDN options that happens to be incompatible with the opportunities for residential Internet service subscriber’s equipment. However, standards do finally appear to be emerging for data transmission over providers. ISDN, such as the “Intel blue” configuration described Incumbent infrastructure providers integrating in [29]. upwards into Internet service should also be 44 Not only is a contractual negotiation more effort, but a considered as a form of competition to be negotiation stacked in favor of the other party (as the encouraged. As the analysis above has shown, these analysis in this paper has suggested) is an even less appealing prospect. firms face a number of internal challenges on the 45 road to becoming fast-moving and innovative PSICable is based on a contractual agreement enough to succeed in this market. Regulators can between PSI and Continental Cablevision. In contrast, InterRamp (PSI’s Internet over ISDN offering) is help by reducing the restrictions that keep these almost completely independent of the telephone firms looking over their shoulders, such as the companies; PSI supplies the customer with the name long-distance restrictions that make it more of a contact at the appropriate local telephone difficult for a local telephone company to offer a company, who is supposedly knowledgeable because PSI has previously mailed that person information about the service. In between these two extremes is 46 This prediction assumes that consumer demand is Internex, Inc., which has a standard reseller agreement elastic enough to be reduced by the higher prices that (i.e. a “lightweight” contract, without much need for will necessarily be charged for high-speed access, both negotiation) with Pacific Bell, and handles the ordering because of its more complex technology and the of ISDN service on behalf of the customer. monopoly power of the infrastructure providers.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett full line of Internet service.47 The extreme of open access on the provider side would be common carriage, an impractical goal for 5.2 Open access to cable networks the existing cable industry [6, 10]. A more appropriate goal is application to the cable industry Increased competition alone will not address all of the kind of open interconnection rules—such as the problems identified in the analysis above; open co-location rights and availability of unbundled access to local infrastructure is also needed, on billing services—that have been developed under both the provider and subscriber sides of the the FCC’s umbrella Open Network Architecture. network. Open access is much further advanced in These rules would not in any way prevent cable local telephony than in the cable industry. On the companies from vertically integrating into content, subscriber side, since the early 1980’s customers just as they do not prevent telephone companies have been able to attach their own telephone from selling telephone service instead of pure bit equipment to the network, resulting in a wide transmission. However, they would make it easier variety of benefits [26] . This ability has been a for Internet service providers to gain access to critical factor in the success of data transmission cable channels. over ordinary telephone modems and is currently helping to drive the diffusion of a plethora of ISDN- Two key differences between Internet and video compatible computer networking equipment. On services make easier access particularly important. the provider side, the FCC’s Computer Inquiry III in First, the “content” that the Internet provider has to 1986 established Open Network Architecture offer (i.e. access to the Internet) is presumably (ONA) as a goal, and regulatory policies since then desirable to the customer, but not unique to that have been evolving to incorporate the principles of provider; in contrast, the uniqueness of video unbundling of services (such as billing and content gives its owners more power relative to transport) and co-location of competing providers cable infrastructure providers. Second, the large at telephone company Central Offices.48 number of channels envisioned for the future consists mainly of downstream channels; upstream These principles have not been applied at all to channels, required for Internet service, remain cable networks, which, as the analysis in this paper scarce. Thus, the argument that a multi-channel has shown, has hindered the development of the future makes open access less important must be “Internet over cable” innovation. Open access on examined critically in light of this requirement. the subscriber side would accelerate the technological development of cable modems and In the short term, adoption of Internet access over cable will have to take place within the existing lower the providers’ risks by distributing among regulatory framework. A first step in this direction subscribers the cost of a large portion of the might be use of the Public, Educational, and necessary equipment. On the provider side, open Government (PEG) channels available to municipal access would strengthen the Internet provider’s 50 position relative to the cable firm, so that more cable franchising authorities. These channels are Internet providers would be willing to ink contracts. sometimes used to provide data networking between municipal institutions (e.g. town government On the subscriber side, the cable industry has offices, libraries, and schools), and could fought against open access using many of the same potentially be used to connect these same technological “it will destroy the network” institutions to the Internet. These channels are not, arguments that the telephone industry used to block however, designated for residential services. the connection of customer-owned devices to the network for many years.49 Given that the predicted problems did not come to pass in telephony, it is 6 Conclusion clear that mechanisms other than provider A less lopsided relationship between Internet ownership of subscriber equipment—such as and infrastructure providers helps to spur the standardization, FCC equipment approvals, and diffusion of high-speed residential Internet service. software-based authorization—can successfully Access to local ISDN telephone networks—on both solve network safety and security problems. In this the subscriber and provider sides—has been more context, it becomes difficult to take seriously the open than access to local cable networks, which has cable industry’s arguments against open subscriber favored the development of subscriber equipment access. and services for Internet access over ISDN vs. cable. 47 Further detail on this point can be found in [8] , pp. 117-20. 48 See [7], p. 226, and [6], pp. 79-80. Where physical co- 50 See [6] , pp. 8 and 62-5. Under current federal cable location is impractical, regulators have sometimes law (The Cable Television Consumer Protection and adopted “virtual co-location” through special tariffs. Competition Act of 1992), municipal cable franchise 49 A summary of these arguments can be found in [30], authorities can negotiate the use of channels for public, pp. 62-63. educational, and governmental purposes.

Encouraging Cable and ISDN Internet Access Proc. INET '95 S.E. Gillett

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Author Information Sharon Eisner Gillett is completing her MS in MIT’s Technology and Policy Program and her MBA from MIT’s Sloan School of Management. Since 1992 she has been a Research Assistant with MIT’s Research Program on Communications Policy and the Telemedia, Networks, and Systems Group of MIT’s Laboratory for Computer Science. Her research has focused on local telecommunications economics, Internet access, and universal service. Sharon earned her AB in Physics from Harvard-Radcliffe. From 1982-92 she worked at BBN Communications Corp. and Thinking Machines Corp. She can be reached at MIT RPCP, E40-236, One Amherst St., Cambridge, MA 02139, USA, (617) 253-4138.