Timothy B. Lee

Timothy B. Lee, Contributor

I write about how technology shapes society

9/08/2012 @ 1:35PM |2,240 views

The Weird Economics of Utility Networks

I don’t think most people appreciate how unusual the economics of utility services like residential broadband are.

Trade economists distinguish between “tradables” like shoes and iPods and “non-tradables” like haircuts. But while you can’t ship a haircut overseas, haircuts are somewhat portable. People can easily move around within a metropolitan area, which allows them to choose from a wide variety of different hair-cutting services.

This means that hair-cutting markets are relatively “deep.” A barber in Philadelphia has several million potential customers. Any given customer in Philadelphia can choose from hundreds of barbers.

The depth of the typical market benefits customers in at least two ways. First, it means that the market can accomodate a lot of niche products that will only appeal to a tiny minority of people. Second, it makes the market hospitable to small-scale entrepreneurship. If you want to start a new barbershop, you don’t need a city-wide advertising campaign to convince thousands of people to sign up on the day you open your doors. If you can start by attracting a few dozen customers, you can then grow your business by word of mouth.

Now imagine if a town with an insane city council passed a law requiring that hair-cutting services only be provided in a special hair-cutting shack constructed in the customer’s back yard. In effect, this would eliminate the depth of the hair-cutting market. Rather than a single city-wide market for haircuts, with each barbershop having thousands of potential customers, there’d be thousands of micro-markets, each of which had just one household worth of potential customers.

Being the first to build a hair-cutting shack in a particular customer’s backyard can be pretty lucrative. It gives you a de facto monopoly on that household’s haircut business. Let’s assume that it takes 4 years worth of haircuts to recoup the costs of building a shack for a particular household. While barbers will need to raise some extra capital to build the shacks, in the long run the owner of the first shack may be able to earn big monopoly rents.

Now along comes a new barber who wants to enter the hair-cutting business, but every household already has at least one hair-cutting shack. So he needs to build hair-cutting shacks in backyards where another barber has already built one. And that’s an economically precarious situation. Remember, we assumed a monopolist needs to do 4 years worth of haircuts in order to break even. But if you build a shack in a backyard that already has another barber in it, you shouldn’t expect to get more than half of the customer’s business, on average, over the long run. Not only that, but competition will push down prices, so you’ll have to do more haircuts to recover the costs of construction. So you’ll be lucky to recover your initial investment within 8 years, and it could easily take more than a decade.

And things are even worse for the third or fourth barber who builds in a particular backyard. The fourth barber will be building in a yard that already has three barbers. He can only expect to attract 25 percent of the household’s business, and strong competition among barbers means his margins will be pretty thin. It’s hard to see how he could ever recover the costs of his investment.

The real broadband market suffers from exactly the same problem as our imaginary (and, admittedly, silly) hair-cutting market. A large fraction of the cost of offering broadband service comes from the cost of installing the “local loop” that connects a particular household to the wider world. Being the first one to install a local loop to a particular household can be extremely profitable, since it gives you a captive customer with no alternatives. As Verizon is discovering with its FiOS project, it’s much harder to turn a profit installing the second local loop; both because fewer than 50 percent of customers are likely to take the service, and because competition pushes down margins. And it’s almost impossible to turn a profit providing a third local loop, because fewer than a third of customers are likely to sign up, and even more competition means even thinner margins. Little surprise, then, that the vast majority of households have only one or two options for high-speed broadband service.


In my silly barber example, the solution is obvious: the government should repeal the law that requires a separate facility for each customer. Then each customer can travel to the barbershop that best meets his or her needs. But that solution doesn’t work for broadband, because it’s not cost-effective to dig up one customer’s local loop and give it to another customer. So my barber model is actually a pretty good description of the broadband market.

And not only broadband markets. Utility networks, such as for electricity, gas, water, and sewage, work the same way. It would be absurd for every household to be served by three sewer pipes or five power lines. A single network serving 100 percent of the customers will tend to be n times as efficient as n parallel networks each serving 1/n of the customers. So even in the absence of legal barriers to entry, we shouldn’t expect the number of options for any given household to be very large.

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  • It’s not such a silly example, Tim. It might have been This American Life, but wherever I heard it there is a trend towards “professionalizing” some vocations such as… cosmetology. For many the licensing process is odorous and they are running afoul of the law…

  • I disagree with your premise that it is very difficult to compete as a third provider of broadband services. First there was no Internet available to consumers, then the Telcos and CableCos adapted their in-place networks to provide it. This was the beginning of convergence.

    I suggest that companies break out of their self-imposed silos of service to find loads of opportunity. I believe that Verizon has not succeeded as much as they could have because Verizon has only created a “me too” service, like a cable over builder. I think that if they had created a new wireless service such as Small Cells supported by FiOS, it would be more cost effective and able to deliver innovative services, such as video content already paid for to cell phones and tablets on the go. Then they would have had a runaway hit. But that would cross the boundaries between Verizon and Verizon Wireless.

    Google Fiber in Kansas City now has the beginnings of a new network, one that is packetized rather than channelized, and offers Video programming over this network the same way they provide Internet access. Real convergence. Google has the opportunity to expand this to small-cell wireless services to offer any form of communication efficiently within their footprint. Google is not encumbered by 100+ years (telco) or even 45 (cable) or 30 years (cellular) of business precedents. Perhaps then the incumbents will wake up. As a sportscaster once said, “Showing them beats telling them.”

  • Tim, the value of networks increases geometrically while the costs increase linearly. Marginal consumption is quite wide and differentiated. Third, the competitive model has proven that much of the access will and can be subsidized or made free by 800, vpn or ad-based solutions. Fourth, there is less and less distinction between bandwidth as fixed vs mobile when one considers fiber coverage, 802.11ac and 4G. Demand will increasingly be quite transient and require that it be satisfied everywhere to sustain and grow utility value. (this goes across numerous geographic zones: inbuilding vs external, urban vs suburban vs rural. For instance will the Urban 4G dog wag the rural wireless tail finally?)

    There are many flaws in your analogy. What is clear is that vertically integrated monopolies do not, have not, and cannot scale rapidly obsoleting investment across large enough markets to be sustainable. Their pricing is almost entirely driven by average, not marginal, cost assumptions. The model in the future will be horizontal, a la the data processing world. Are and will there be monopoly bottlenecks (both physical and virtual) that regulators should be aware of and look for ways to mandate open access across horizontal layers and vertical boundary points? Yes. But I think the latter can be accomplished more via a carrot than a stick.

  • jessaustin jessaustin 1 year ago

    Would you care to rewrite this, except in English? He’s talking about the local loop, which has nothing to do with a hypothetical geometric value of a network. The only connection that matters is between the house and the headend or DSLAM closet. Everything after that you get essentially for free.

    The desire to preserve the monopolistic aspects of wired connection is the main reason the FCC continues to drag its feet on more liberal wireless regimes like white spaces.

  • That does a good job explaining why I have 2 (maybe 3?) broadband options in my city. We have cable and DSL, and I think we might have Clearwire service which I guess is 4G to the home?

    My thought though, is that how can it really be THAT expensive to string some fiber to my house?

  • Tim –
    Ten years ago, when I was there working on an RBOC merger, the FCC staff considered and advocated requiring a wholesale/retail split of the incumbent monopolist as a condition of the proposed merger. The chief economist and most of the staff were largely in support of that idea.
    That approach would have given challengers access to the local loops and avoided the waste, while promoting competition in the retail space. We never got any real feedback on why the idea was dismissed, but you can imagine the politics of such a move.
    I think there’s some value in a second network, but I’m not sure if its benefits outweigh the costs. Cable for a time had reach where DSL didn’t. Satellite went beyond both for rural folks for video. But I still like the idea of local utilities having to separate their businesses and compete as equals for retail business.

  • Ryan Kabel Ryan Kabel 1 year ago

    “Then each customer can travel to the barbershop that best meets his or her needs.”

    This is the part of the article that stuck with me the most. Could we imagine a future where each household owns it’s own local loop (the construction cost of which rolls in to one’s mortgage payment) to a neutral POP “outside the neighborhood”. Then I would have a choice of plugging my own loop in to any one of a hypothetical dozen of providers that would provide me connectivity out the internet, video services, and so on.

    Or, for that matter a situation under which the power companies in many states operate today. Many states have an electricity market where there is a separate bill for “generation” and “delivery”. It’s an accepted fact that each house will only have one power line, and all the power lines in one given neighborhood will be owned and maintained by a single company, but the power that feeds those lines can be purchased by the consumer from any one of a dozen companies.

    The incumbent is paid a highly-regulated, non discriminatory rate for it’s delivery services, while the consumer is free to choose any generation provider he may want which may bill the consumer directly at whatever price the consumer is willing to pay. Even a business a boring as electricity delivery we are starting to see some “innovative” things come out of this arrangement, e.g. premium 100% American “green” energy for a price of X, or “unlimited, free electricity every Thursday” offers from the free market generation providers.

    There’s no limit to the kinds of innovation and competition we might see unbundling the local loop from the service of the connectivity and content itself.