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Pricing Communication Networks: Economics, Technology and Modelling.

Costas Courcoubetis and Richard Weber


Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
*ricing Co++unication !et,or-s
WIL./#I!0.RSCI.!C. S.RI.S I! S/S0.1S
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Advisory Editors
Sheldon Ross
3epart+ent o6 Industrial .ngineering and 4perations Research, 7ni8ersity o6 Cali6ornia,
er-eley, C2 )$%20, 7S2
Richard Weber
Statistical Laboratory, Centre 6or 1athe+atical Sciences, Ca+bridge 7ni8ersity,
Wilber6orce Road, Ca+bridge, C3 0W
209.R:3ecision 0heory" 2n Introduction to 3yna+ic *rogra++ing and Se;uential
3ecisions
C924<1I/252W2<*I!.34:=ueueing !et,or-s" Custo+ers, Signals and *roduct >or+
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C47RC47.0IS<W..R:*ricing Co++unication !et,or-s" .cono+ics, 0echnology
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3.:1ulti#4b?ecti8e 4pti+i@ation using .8olutionary 2lgorith+s
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BI57!<B2!:Stochastic *rogra++ing *roble+s ,ith *robability and =uantile
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R7S0.1:2lgorith+s 6or !onlinear *rogra++ing and 1ultiple#4b?ecti8e 3ecisions
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*ricing Co++unication !et,or-s
.cono+ics, 0echnology and 1odelling
Costas Courcoubetis
Athens &niversity o' Economics and (usiness, )reece
Richard Weber
&niversity o' Cam*ridge, &+
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Library of Congress Cataloging-in-Publication Data
Courcoubetis, Costas.
*ricing co++unication net,or-s " econo+ics, technology, and +odelling < Costas
Courcoubetis, Richard Weber.
p. c+.KDWiley#Interscience series in syste+s and opti+i@ationE
Includes bibliographical re6erences and indeC.
IS! 0#$%0#&'(30#) Dal-. *aperE
(. In6or+ation technologyK>inance. 2. Co+puter net,or-sK1athe+atical +odels. 3.
3igital co++unicationsK1athe+atical +odels. I. Weber, Richard. II. 0itle. III. Series.
9330.2 .CH& 2003
3&$
0
.0$3Kdc2(
2002()(0&(
British Library Cataloguing in Publication Data
2 catalogue record 6or this boo- is a8ailable 6ro+ the ritish Library
IS! 0#$%0#&'(30#)
0ypeset in (0<(2pt 0i+es by Laser,ords *ri8ate Li+ited, Chennai, India
*rinted and bound in Areat ritain by iddles Ltd, Auild6ord, Surrey
0his boo- is printed on acid#6ree paper responsibly +anu6actured 6ro+ sustainable 6orestry
in ,hich at least t,o trees are planted 6or each one used 6or paper production.
We dedicate this boo- to 3ora and *erse6oni, the +uses o6 +y li6e DC. CourcoubetisE,
and to Richard, +y 6ather DR. WeberE.
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C8
List of Acronyms . . . . . . . . . . . . . . . . . . . . . . . CiC
A Networks 1
1 Pricing and Communications Networks . . . . . . . . . 3
(.H >urther Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Network Services and Contracts . . . . . . . . . . . . . . . . . . . . . . . 23
2.2.2 *olicing Ser8ice Contracts . . . . . . . . . . . . . . . . . . . . . . 3H
Contents
. . . . . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . .
(.( 0he 1ar-et 6or Co++unications Ser8ices . . . . . . . . . . . . . . . . . . . 3
(.(.( 0he Co++unications Re8olution . . . . . . . . . . . . . . . . . . . 3
(.(.2 Co++unications Ser8ices . . . . . . . . . . . . . . . . . . . . . . . 3
(.(.3 In6or+ation Aoods . . . . . . . . . . . . . . . . . . . . . . . . . . . $
(.(.$ Special >eatures o6 the Co++unications 1ar-et . . . . . . . . . . . '
(.2 3e8elop+ents in the 1ar-etplace . . . . . . . . . . . . . . . . . . . . . . . H
(.3 0he Role o6 .cono+ics . . . . . . . . . . . . . . . . . . . . . . . . . . . . )
(.3.( 48erpro8ision or ControlL . . . . . . . . . . . . . . . . . . . . . . . (0
(.3.2 7sing *ricing 6or Control and Signalling . . . . . . . . . . . . . . . (2
(.3.3 Who Should *ay the illL . . . . . . . . . . . . . . . . . . . . . . . (3
(.3.$ Interconnection and Regulation . . . . . . . . . . . . . . . . . . . . ($
(.$ *reli+inary 1odelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (H
(.$.( 3e6initions o6 Charge, *rice and 0ari66 . . . . . . . . . . . . . . . . (H
(.$.2 >lat Rate 8ersus 7sage Charging . . . . . . . . . . . . . . . . . . . (%
(.$.3 3yna+ic *ricing in an Internet Ca6e . . . . . . . . . . . . . . . . . (&
(.$.$ 2 1odel 6or *ricing a Single Lin- . . . . . . . . . . . . . . . . . . ()
(.' 2 Auide to Subse;uent Chapters . . . . . . . . . . . . . . . . . . . . . . . . 2(
.
. .
2.( 2 Classi6ication o6 !et,or- Ser8ices . . . . . . . . . . . . . . . . . . . . . 2$
2.(.( Layering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2$
2.(.2 2 Si+ple 0echnology *ri+er . . . . . . . . . . . . . . . . . . . . . 2'
2.(.3 Galue#added Ser8ices and undling . . . . . . . . . . . . . . . . . . 2&
2.(.$ Connection#oriented and Connectionless Ser8ices . . . . . . . . . . 30
2.(.' Auaranteed and est#e66ort Ser8ices . . . . . . . . . . . . . . . . . 32
2.2 Ser8ice Contracts 6or 0ransport Ser8ices . . . . . . . . . . . . . . . . . . . 33
2.2.( 0he Structure o6 a Ser8ice Contract . . . . . . . . . . . . . . . . . . 33
.
8iii C4!0.!0S
2.2.3 Static and 3yna+ic Contract *ara+eters . . . . . . . . . . . . . . 3%
2.3 >urther Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3)
Network !echnology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(
3.(.$ Girtual Circuits and Label S,itching . . . . . . . . . . . . . . . . . $$
3.% >urther Reading . . . . . . . . . . . . . . . . . . &2
Network Constraints and "ffective #andwidths . . . . . . . . . . . . . . . . . &3
$.( 0he 0echnology Set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . &$
$.2 Statistical 1ultipleCing . . . . . . . . . . &'
$.(' >urther Reading . . . . . . . . . . . . . . (0)
.
.
$ .
3.( !et,or- Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(
3.(.( .ntities on ,hich !et,or- Control 2cts . . . . . . . . . . . . . . . $2
3.(.2 0i+escales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3
3.(.3 9andling *ac-ets and Cells . . . . . . . . . . . . . . . . . . . . . . $3
3.(.' Call 2d+ission Control . . . . . . . . . . . . . . . . . . . . . . . . $'
3.(.H Routing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $H
3.(.% >lo, Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $&
3.(.& !et,or- 1anage+ent . . . . . . . . . . . . . . . . . . . . . . . . . '0
3.2 0ari66s, 3yna+ic *rices and Charging 1echanis+s . . . . . . . . . . . . . . '0
3.3 Ser8ice 0echnologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . '(
3.3.( 2 0echnology Su++ary . . . . . . . . . . . . . . . . . . . . . . . . '(
3.3.2 4ptical !et,or-s . . . . . . . . . . . . . . . . . . . . . . . . . . . . '3
3.3.3 .thernet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . '$
3.3.$ Synchronous Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . 'H
3.3.' 201 Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . '%
3.3.H >ra+e Relay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ')
3.3.% Internet Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . . . . H0
3.$ 4ther 0ypes o6 Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . . . . %(
3.$.( *ri8ate and Girtual !et,or-s . . . . . . . . . . . . . . . . . . . . . %(
3.$.2 2ccess Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . . . . %3
3.' Charging Re;uire+ents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . %H
3.H 2 1odel o6 usiness Relations 6or the Internet . . . . . . . . . . . . . . . . %%
. . . . . . . . . . . . . . .
%
. . . . . . . . . . . . . . . . . . .
$.3 2ccepting Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . &H
$.$ 2n .le8ator 2nalogy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . &%
$.' .66ecti8e and,idths . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . )0
$.H .66ecti8e and,idths 6or 0ra66ic Strea+s . . . . . . . . . . . . . . . . . . . )(
$.H.( 0he 2cceptance Region . . . . . . . . . . . . . . . . . . . . . . . . )$
$.% So+e .Ca+ples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . )'
$.& 1ultiple =oS Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . ))
$.) 0ra66ic Shaping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (00
$.(0 .66ecti8e and,idths 6or 0ra66ic Contracts . . . . . . . . . . . . . . . . . . (02
$.(( ounds 6or .66ecti8e and,idths . . . . . . . . . . . . . . . . . . . . . . . (03
$.(2 3eter+inistic 1ultipleCing . . . . . . . . . . . . . . . . . . . . . . . . . . . (0'
$.(3 .Ctension to !et,or-s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (0%
$.($ Call loc-ing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (0&
. . . . . . . . . . . . . . . . . . .
# "conomics 111
& #asic Conce'ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ((3
H.H >urther Reading . . . . . . . . . . . . . . . . . . (H0
1(1
Cost)based Pricing . . . . . . . . . . . . . . . . . . (H3
%.(.( >air Charges . . . . . . . . . . . . . . . (H$
C4!0.!0S iC
.
'.( Charging 6or Ser8ices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ((3
'.(.( 3e+and, Supply and 1ar-et 1echanis+s . . . . . . . . . . . . . . ((3
'.(.2 ConteCts 6or 3eri8ing *rices . . . . . . . . . . . . . . . . . . . . . . (($
'.2 0he Consu+erMs *roble+ . . . . . . . . . . . . . . . . . . . . . . . . . . . . ((H
'.2.( 1aCi+i@ation o6 Consu+er Surplus . . . . . . . . . . . . . . . . . . ((H
'.2.2 .lasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ((&
'.2.3 Cross .lasticities, Substitutes and Co+ple+ents . . . . . . . . . . . ((&
'.3 0he SupplierMs *roble+ . . . . . . . . . . . . . . . . . . . . . . . . . . . . (()
'.$ Wel6are 1aCi+i@ation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20
'.$.( 0he Case o6 *roducer and Consu+ers . . . . . . . . . . . . . . . . (20
'.$.2 0he Case o6 Consu+ers and >inite Capacity Constraints . . . . . . (23
'.$.3 3iscussion o6 2ssu+ptions . . . . . . . . . . . . . . . . . . . . . . (2$
'.$.$ *ea-#load *ricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2'
'.$.' Walrasian .;uilibriu+ . . . . . . . . . . . . . . . . . . . . . . . . . (2H
'.$.H *areto .66iciency . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2%
'.$.% 3iscussion o6 1arginal Cost *ricing . . . . . . . . . . . . . . . . . (30
'.' Cost Reco8ery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3(
'.'.( Ra+sey *rices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3(
'.'.2 0,o#part 0ari66s . . . . . . . . . . . . . . . . . . . . . . . . . . . . (33
'.'.3 4ther !onlinear 0ari66s . . . . . . . . . . . . . . . . . . . . . . . . (3'
'.H >inite Capacity Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . (3%
'.% !et,or- .Cternalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3&
'.& >urther Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($0
( Com'etition *odels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($(
H.( 0ypes o6 Co+petition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($(
H.2 1onopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($3
H.2.( *ro6it 1aCi+i@ation . . . . . . . . . . . . . . . . . . . . . . . . . . ($3
H.2.2 *rice 3iscri+ination . . . . . . . . . . . . . . . . . . . . . . . . . . ($$
H.2.3 undling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($&
H.2.$ Ser8ice 3i66erentiation and 1ar-et Seg+entation . . . . . . . . . . ($)
H.3 *er6ect Co+petition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ('(
H.3.( Co+petiti8e 1ar-ets . . . . . . . . . . . . . . . . . . . . . . . . . . ('2
H.3.2 Loc-#in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ('2
H.$ 4ligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ('$
H.$.( Aa+es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ('$
H.$.2 Cournot, ertrand and Stac-elberg Aa+es . . . . . . . . . . . . . . ('%
H.' 2 7ni6ying Social Surplus >or+ulation . . . . . . . . . . . . . . . . . . . . (H0
. . . . . . . . . . . . . . .
C Pricing
+ . . . . . . . . . . . . . . .
%.( >oundations o6 Cost#based *ricing . . . . . . . . . . . . . . . . . . . . . . . (H3
. . . . . . . . . . . . . . .
%.(.2 Subsidy#6ree, Support and Sustainable *rices . (H'
%.H >urther Reading . . . . . . . . . . . . . . . . . . . . . ()$
&.H >urther Reading . . . . . . . . . . . . . . . . . . . . . . . . . 2(&
Congestion . . . . . . . . . . . . . . . . . . . . . . . . . . 2()
).$.2 2 Congestion 1odel ,ith 3elay . . . . . . . 22)
C C4!0.!0S
. . . . . . . . . . . .
%.(.3 Shapley Galue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (%0
%.(.$ 0he !ucleolus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (%2
%.(.' 0he Second#best Core . . . . . . . . . . . . . . . . . . . . . . . . . (%2
%.2 argaining Aa+es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (%$
%.2.( !ashMs argaining Aa+e . . . . . . . . . . . . . . . . . . . . . . . (%$
%.2.2 Balai and S+orodins-yMs argaining Aa+e . . . . . . . . . . . . . (%H
%.3 *ricing in *ractice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (%%
%.3.( 48er8ie, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (%%
%.3.2 3e6initions Related to the Cost >unction . . . . . . . . . . . . . . . (%)
%.3.3 0he >ully 3istributed Cost 2pproach . . . . . . . . . . . . . . . . . (&(
%.3.$ 2cti8ity#based Costing . . . . . . . . . . . . . . . . . . . . . . . . . (&$
%.3.' LRICC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (&%
%.3.H 0he .66icient Co+ponent *ricing Rule . . . . . . . . . . . . . . . . (&&
%.$ Co+paring the Garious 1odels . . . . . . . . . . . . . . . . . . . . . . . . ()0
%.' >lat Rate *ricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ()(
. . . . . . . . . . . .
, Charging -uaranteed Services . . . . . . . . . . . . . . . . . . . . . . . . . . ()'
&.( *ricing and .66ecti8e and,idths . . . . . . . . . . . . . . . . . . . . . . . ()H
&.(.( 0he !et,or- Case . . . . . . . . . . . . . . . . . . . . . . . . . . . 20(
&.2 Incenti8e Issues in *ricing Ser8ice Contracts . . . . . . . . . . . . . . . . . 202
&.3 Constructing Incenti8e Co+patible 0ari66s 6ro+ .66ecti8e and,idths . . . 20$
&.3.( 0he 0i+e#8olu+e Charging Sche+e . . . . . . . . . . . . . . . . . 20'
&.3.2 7sing Aeneral 1easure+ents . . . . . . . . . . . . . . . . . . . . . 20%
&.3.3 2n .Ca+ple o6 an 2ctual 0ari66 Construction . . . . . . . . . . . . 20&
&.3.$ Co+petition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2(0
&.3.' 3iscouraging 2rbitrage and Splitting . . . . . . . . . . . . . . . . . 2((
&.$ So+e Si+ple *ricing 1odels . . . . . . . . . . . . . . . . . . . . . . . . . 2(2
&.$.( 0i+e#o6#day *ricing . . . . . . . . . . . . . . . . . . . . . . . . . . 2(2
&.$.2 Co+bining Auaranteed ,ith est#e66ort . . . . . . . . . . . . . . . . 2(3
&.$.3 Contracts ,ith 1ini+u+ Auarantees and 7ncertainty . . . . . . . . 2($
&.' Long#ter+ Interaction o6 0ari66s and !et,or- Load . . . . . . . . . . . . . 2(H
. . . . . . . .
. . . . . . . . . . . . .
).( 3e6ining a Congestion *rice . . . . . . . . . . . . . . . . . . . . . . . . . . 220
).(.( 2 Condition 6or Capacity .Cpansion . . . . . . . . . . . . . . . . . 222
).(.2 Incenti8e Co+patibility . . . . . . . . . . . . . . . . . . . . . . . . 222
).(.3 .Ctensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
).2 Connection ,ith >inite Capacity Constraints . . . . . . . . . . . . . . . . . 223
).3 1odels in ,hich 7sers Share Congested Resources . . . . . . . . . . . . . 22$
).3.( 2 3elay 1odel 6or a MN M <( =ueue . . . . . . . . . . . . . . . . . 22$
).3.2 Ser8ices 3i66erentiated by Congestion Le8el . . . . . . . . . . . . . 22'
).3.3 2 loc-ing 1odel . . . . . . . . . . . . . . . . . . . . . . . . . . . 22'
).$ Congestion *rices Co+puted on Sa+ple *aths . . . . . . . . . . . . . . . . 22%
).$.( 2 Loss 1odel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22&
. . . . . . . . . . . .
).$.3 idding 6or *riority . . . . . . . . . . . . . . . 230
).H >urther Reading . . . . . . . . . . . . . . . . . . . . . . 232
Charging /le0ible Contracts . . . . . . . . . . . . . . . . . 23'
(0.(0 >urther Reading . . . . . . . . . . . . . . . . . . . . . 2H0
1 S'ecial !o'ics (1
11 *ulticasting . . . . . . . . . . . . . . . . . . 2H3
((.% >urther Reading . . . . . . . . . . . . . . . . . . . . . 2%&
2nterconnection . . . . . . . . . . . . . . . . . . . . . . . 2%)
(2.3 Incenti8es 6or *eering . . . . . . . . . . . . . . . . . 2&'
C4!0.!0S Ci
. . . . . . . . . . .
).$.$ S+art 1ar-ets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
).' 2n Incenti8e Co+patible 1odel 6or Congestion *ricing . . . . . . . . . . . 23(
. . . . . . . . . . .
13 . . . . . . . . . . .
(0.( !otions o6 >airness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23%
(0.2 0he *roportional >airness 1odel . . . . . . . . . . . . . . . . . . . . . . . 23)
(0.2.( 2 *ri+al 2lgorith+ . . . . . . . . . . . . . . . . . . . . . . . . . . 2$(
(0.2.2 2 3ual 2lgorith+ . . . . . . . . . . . . . . . . . . . . . . . . . . . 2$3
(0.2.3 7ser 2daptation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2$3
(0.2.$ Stochastic .66ects and 0i+e Lags . . . . . . . . . . . . . . . . . . . 2$$
(0.2.' *roportional >airness ,ith a Congestion Cost . . . . . . . . . . . . 2$$
(0.3 2n Internet *ricing *roposal . . . . . . . . . . . . . . . . . . . . . . . . . . 2$'
(0.$ 2 1odel o6 0C* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2$%
(0.' 2llocating >lo,s by .66ecti8e and,idth . . . . . . . . . . . . . . . . . . . 2$)
(0.H 7ser 2gents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2'0
(0.% *ricing 7ncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2'$
(0.& 0he 3i66erentiated Ser8ices 2pproach . . . . . . . . . . . . . . . . . . . . . 2'H
(0.&.( *aris 1etro *ricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 2'%
(0.) 0o,ards a 1ar-et#1anaged !et,or- . . . . . . . . . . . . . . . . . . . . . 2')
. . . . . . . . . . .
. . . . . . . . . . . . . . . . . . .
((.( 0he Re;uire+ents o6 1ulticasting . . . . . . . . . . . . . . . . . . . . . . . 2H$
((.2 1ulticasting 1echanis+s at the !et,or- Layer . . . . . . . . . . . . . . . 2H'
((.3 =uality o6 Ser8ice Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2H%
((.3.( 1ulticast 2pplication Re;uire+ents . . . . . . . . . . . . . . . . . . 2H%
((.3.2 !et,or- 1echanis+s . . . . . . . . . . . . . . . . . . . . . . . . . 2H&
((.$ >lo, Control 1echanis+s . . . . . . . . . . . . . . . . . . . . . . . . . . . 2H)
((.' 0he .cono+ic *erspecti8e . . . . . . . . . . . . . . . . . . . . . . . . . . . 2%(
((.'.( 2 1odel 6or 2llocating 1ulticast and,idth . . . . . . . . . . . . 2%(
((.'.2 0he *roble+ o6 Sharing Co++on Cost . . . . . . . . . . . . . . . . 2%2
((.'.3 >or+ation o6 the 4pti+al 0ree . . . . . . . . . . . . . . . . . . . . 2%'
((.'.$ Cost Sharing and 1ulticast 0rees . . . . . . . . . . . . . . . . . . . 2%'
((.H Settle+ent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2%%
. . . . . . . . . . . .
1 . . . . . . . . . . . .
(2.( 0he 1ar-et Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2%)
(2.(.( *eering 2gree+ents . . . . . . . . . . . . . . . . . . . . . . . . . . 2%)
(2.(.2 Interconnection 1echanis+s and Incenti8es . . . . . . . . . . . . . 2&(
(2.(.3 Interconnection *ricing . . . . . . . . . . . . . . . . . . . . . . . . . 2&3
(2.2 Co+petition and Ser8ice 3i66erentiation . . . . . . . . . . . . . . . . . . . . 2&$
. . . . . . . . . . . .
(2.$ Incenti8e Contract Issues . . . . . . . 2&H
(2.H >urther Reading . . . . . . . . . . . . 2)0
(3.' >urther Reading . . . . . . . . . . . . 30H
1% Auctions . . . . . . . . . . . . . . . . 30)
($.$ >urther Reading . . . . . . . . . . . . . . . . . 330
2.H >urther Reading . . . . . . . . . . . . . . . . . . . . . . . . 33&
Cii C4!0.!0S
. . . . . . . . . . . . . . . . . . . . .
(2.' 1odelling 1oral 9a@ard . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2&%
. . . . . . . . . . . . . . . . . . . . .
1$ Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2)(
(3.( In6or+ation Issues in Regulation . . . . . . . . . . . . . . . . . . . . . . . . 2)2
(3.(.( 2 *rincipal#agent *roble+ . . . . . . . . . . . . . . . . . . . . . . . 2)2
(3.(.2 2n 2d8erse Selection *roble+ . . . . . . . . . . . . . . . . . . . . 2)H
(3.2 1ethods o6 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2)%
(3.2.( Rate o6 Return Regulation . . . . . . . . . . . . . . . . . . . . . . . 2)%
(3.2.2 Subsidy 1echanis+s . . . . . . . . . . . . . . . . . . . . . . . . . . 2)%
(3.2.3 *rice Regulation 1echanis+s . . . . . . . . . . . . . . . . . . . . . 300
(3.3 Regulation and Co+petition . . . . . . . . . . . . . . . . . . . . . . . . . . 30(
(3.$ Regulation in *ractice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
(3.$.( Regulation in the 7S . . . . . . . . . . . . . . . . . . . . . . . . . . 302
(3.$.2 Current 0rends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30'
. . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
($.( Single Ite+ 2uctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3((
($.(.( 0a-e#it#or#lea8e#it *ricing . . . . . . . . . . . . . . . . . . . . . . . 3((
($.(.2 0ypes o6 2uction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3(2
($.(.3 Re8enue .;ui8alence . . . . . . . . . . . . . . . . . . . . . . . . . 3(3
($.(.$ 4pti+al 2uctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3('
($.(.' Ris- 28ersion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3(%
($.(.H Collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3(&
($.(.% 0he WinnerMs Curse . . . . . . . . . . . . . . . . . . . . . . . . . . 3(&
($.(.& 4ther Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3()
($.2 1ulti#ob?ect 2uctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
($.2.( 1ulti#unit 2uctions . . . . . . . . . . . . . . . . . . . . . . . . . . 320
($.2.2 Co+binatorial idding . . . . . . . . . . . . . . . . . . . . . . . . . 32(
($.2.3 3ouble 2uctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
($.2.$ 0he Si+ultaneous 2scending 2uction . . . . . . . . . . . . . . . . . 323
($.2.' So+e Issues 6or 1ulti#ob?ect 2uctions . . . . . . . . . . . . . . . . 32$
($.3 2uctioning a and,idth *ipeline . . . . . . . . . . . . . . . . . . . . . . . 32%
. . . . . . . . . . . . . . . .
A''endi0 A Lagrangian *ethods for Constrained 4'timi5ation . . . . . . . . . 333
2.( Regional and >unctional Constraints . . . . . . . . . . . . . . . . . . . . . . 333
2.2 0he Lagrangian 1ethod . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
2.3 When 3oes the 1ethod Wor-L . . . . . . . . . . . . . . . . . . . . . . . . 33'
2.$ Shado, *rices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33H
2.' 0he 3ual *roble+ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33%
. . . . . . . . .
C4!0.!0S Ciii
A''endi0 # Convergence of !atonnement . . . . . . . . . . . . . . . . . . . . . . 33)
.( 0he Case o6 *roducers and Consu+ers . . . . . . . . . . . . . . . . . . . . 33)
.2 Consu+ers ,ith !et,or- Constraints . . . . . . . . . . . . . . . . . . . . . 3$0
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3$(
2nde0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3'3
*re6ace
0his boo- is about pricing issues in +odern co++unications net,or-s. Recent technology
ad8ances, co+bined ,ith the deregulation o6 the co++unication +ar-et and the
proli6eration o6 the Internet, ha8e created a ne, and highly co+petiti8e en8iron+ent 6or
co++unication ser8ice pro8iders. oth technology and econo+ics play a +a?or role in
this ne, en8iron+ent. 2s recent e8ents in the +ar-etplace +a-e clear, the success o6 a
co++unication ser8ices business is not guaranteed by ne, technology alone. 2n i+portant
part o6 any business plan 6or selling co++unications ser8ices is pricing and co+petition
issues. 0hese should be ta-en into account 6ro+ the start. 0raditionally, engineers ha8e
de8ised co++unication ser8ices ,ithout re6erence to ho, they should be priced. 0his is
because co++unication ser8ices ha8e been pro8ided by large +onopolies, ,ith guaranteed
inco+es. 0he bundling and pricing aspects o6 indi8idual ser8ices ha8e been secondary.
9o,e8er, ser8ices are no, sold in co+petiti8e +ar-ets and an i+portant part o6 the ser8ice
de6inition is ho, it should be priced. 0echnology can place se8ere restrictions on ho, this
can be done. 0he 6ollo,ing are so+e reasons ,hy the pricing o6 co++unications ser8ices
is no, eCciting to study"
(. *ricing a66ects the ,ay ser8ices are used, and ho, resources are consu+ed. 0he 8alue
that custo+ers obtain 6ro+ ser8ices depends on congestion and on the ,ay ser8ices
are priced.
2. Co++unication ser8ice contracts pro8ide 6or substantial 6leCibility. *ricing plays
an i+portant role as an incenti8e +echanis+ to control per6or+ance and increase
stability.
3. 1odern net,or-ing technology pro8ides ne, possibilities 6or producers and the
consu+ers to eCchange econo+ic signals on 6ast ti+e scales. 0his allo,s 6or the
creation o6 ne, 6leCible ser8ices that custo+ers can control and by ,hich they can
better eCpress their needs 6or ;uality. 0his ,as not possible until a 6e, years ago,
since pre8iously ser8ices ,ere statically de6ined and the net,or- operator ,as in
total in control.
$. 0here is no uni;ue ,ay to price. Issues such as O6latM 8ersus Ousage#basedM charging
ha8e i+portant e66ects on the short and long ter+ net,or- operation and its
co+petiti8e position. 0hese +ust be understood by people designing pricing policies.
'. Co+petition can be greatly in6luenced by the architecture o6 a net,or-s and the
ability o6 6e, players to control bottlenec- resources in parts o6 the net,or-, such as
the access. !e, net,or-s should be designed so that they pro8ide an open
co+petition en8iron+ent in all parts o6 the supply chain 6or ser8ices. Co+petition
and regulation issues are i+portant in todayMs co++unication +ar-et.
C8i *R.>2C.
H. Co++unication ser8ices are econo+ic goods and +ust be priced accordingly. 0here
are generic ser8ice +odels that capture aspects such as ;uality and per6or+ance and
can be used to deri8e opti+al prices in a ser8ices +ar-et. 0hey can be used to propose
tari66s ,ith the desired incenti8e properties by pricing the appropriate ser8ice contract
para+eters.
We began this boo- a6ter 6i8e years o6 research 6ocused in pricing the rich 6a+ily o6
201 ser8ices and the ne,ly e+erging Internet. We belie8e there is a need 6or a boo- that
can eCplain the pro8ision o6 ne, ser8ices, the relation o6 pricing and resource allocation
in net,or-s, and the proli6eration o6 the Internet and the debate on ho, to price it. We
ha8e had in +ind as readers graduate students and 6aculty in depart+ents o6 .lectrical
.ngineering, Co+puter Science, .cono+ics and 4peration Research, teleco+s engineers,
researchers and engineers ,ho ,or- in research and industrial laboratories, and +ar-eting
sta66 in teleco+s co+panies ,ho need to understand better the technology issues and their
relation to pricing. 4ur eCperience is that +ost o6 these people ha8e only part o6 the
bac-ground needed to 6ollo, such i+portant sub?ects. Readers ,ith engineering and 4R
bac-ground usually lac- the econo+ics bac-ground. .cono+ists usually -no, little about
co++unications technology and usually underesti+ate its i+portance. We ha8e sought to
,rite in a ,ay that all readers ,ill 6ind sti+ulating. 0he boo- should interest anyone ,ith
so+e technology and +athe+atics bac-ground ,ho ,ishes to understand the close relation
o6 co++unication net,or-s and econo+ics. 46 course, econo+ists +ay s-ip the chapters
on basic econo+ics.
When ,e started this boo-, 201 technology ,as already declining in i+portance as an
alternati8e to the Internet. 9o,e8er, there continues to be a practical de+and 6or ser8ices
such as 201 and >ra+e Relay. 0hese can be put into the sa+e generic +odel as the
pro8ision o6 W2! connecti8ity ser8ices. Si+ilar concepts ,ill apply in 6uture eCtensions
o6 Internet ser8ices that pro8ide ;uality guarantees, such as di66erentiated ser8ices and
integrated ser8ices. Conse;uently, ,e not only deal ,ith the Internet, but also ,ith e66ecti8e
band,idths and statistical +ultipleCing.
0he scope o6 this boo- is broad. It co8ers +ost o6 the concepts that are needed
to understand the relation o6 econo+ics and co++unications. We do not clai+ to
pro8ide a co+plete uni6ying 6ra+e,or-, but eCplain +any concepts that are generic to
the proble+ o6 pricing. 0his is not a Oho, to priceM recipe boo-. Rather, it eCplores
rele8ant sub?ects. It pro8ides the basic +odels and ter+inology needed 6or a non#specialist
reader to understand subtle topics ,here technology, in6or+ation and econo+ics +eet. It
eCplains the architecture o6 the co++unications +ar-et and pro8ides a si+ple and intuiti8e
introduction to net,or- ser8ices at all le8els, 6ro+ the in6rastructure to transport. We ha8e
tried to +a-e the boo- technology independent, e+phasi@ing generic ser8ice aspects and
concepts.
0he reader does not ha8e to be an eCpert in co++unications or read se8eral boo-s on
net,or-ing technology nu+bering hundreds o6 pages in order to understand these basic
concepts. 0his +ay be o6 great bene6it to a reader ,ith an econo+ics or operation research
bac-ground. 0he sa+e holds 6or readers ,ith no econo+ics bac-ground. We eCplain
rele8ant +icroecono+ic concepts in enough detail that the reader can 6ollo, +any issues in
net,or- econo+ics, ,ithout ha8ing to study ad8anced econo+ic teCtboo-s. 9o,e8er, ,e
are not econo+ists and do not clai+ to co8er all topics in net,or- econo+ics. We hope
that ,e do pro8ide the reader ,ith a use6ul su++ary o6 +any -ey issues and de6initions
in basic econo+ics. 0hose ,ho ,ish to study these ideas in +ore depth can turn to
econo+ics teCtboo-s. >or instance, our section on ga+e theory should re+ind those readers
,ho ha8e
*R.>2C. C8ii
pre8iously studied it o6 those concepts 6ro+ the sub?ect that ,e use in other parts o6 the
boo-. Readers ,ho ha8e not studied ga+e theory be6ore should 6ind that the section
pro8ides a readable and concise o8er8ie, o6 -ey concepts, but they ,ill need to loo-
else,here 6or details, proo6s and 6urther eCa+ples.
0here is no one uni6ying +odel 6or net,or- ser8ices. We pro8ide +odels 6or se8eral
ser8ices and lea8e others o6 the+ out. 0hese +odels allo, net,or- ser8ices to be priced
si+ilarly to traditional econo+ic goods. 0hese +odels can be used by net,or- engineers
as a 6ra+e,or- to deri8e prices 6or co+pleC transport ser8ices such as 201, >ra+e Relay,
I* G*!s, etc. We +odel the Internet and its transport ser8ices and discuss certain issues
o6 6airness and resource allocation based on pricing 6or congestion. 0his pro8ides a deeper
understanding o6 the 6eedbac- aspects o6 the Internet technology, and o6 the recent proposals
to pro8ide 6or a richer set o6 band,idth sharing +echanis+s. We also pro8ide the theoretical
6ra+e,or- to price contracts in ,hich para+eters can be dyna+ically renegotiated by the
users and the net,or-. >inally, ,e gi8e the reader a si+ple but thorough introduction to
so+e current acti8e research topics, such as pricing +ulticasting ser8ices, incenti8e issues
in interconnection agree+ents bet,een pro8iders, and the theory o6 price regulation. >or
co+pleteness, ,e also pro8ide a si+ple introduction to auction +echanis+s ,hich are
currently used to allocate scarce resources such as spectru+.
We hope to introduce non#specialists to concepts and proble+s that ha8e only been
accessible to specialists. 0hese can pro8ide both a practical guideline 6or pricing
co++unication ser8ices and a sti+ulation 6or theoretical research. We do not re8ie, in
eCtre+e detail the eCisting literature, although ,e pro8ide basic pointers. 2 guide to
re6erences appears at the end o6 each chapter. We see- to uni6y and si+pli6y the eCisting
state#o6#the# art by 6ocusing on the -ey concepts. We use +athe+atics to +a-e the ideas
rigorous, but ,e hope ,ithout being unnecessary detailed. 2bout &0P o6 the results in
the boo- ha8e been published else,here and 20P are ne,. 0he le8el o6 the +athe+atics is
at that o6 6irst year uni8ersity studentMs -no,ledge o6 calculus and probability, and should
be accessible to students and engineers in the 6ield. 2ppendiC 2 co8ers so+e i+portant
ideas o6 sol8ing constrained opti+i@ation proble+s using Lagrange +ultipliers. 0he boo-
has parts ,hich are +ore technology speci6ic and other parts that are +ore theoretical.
Readers can ta-e their pic-.
We ha8e 6ound it con8enient to di8ide the boo- in 6our parts. 2n o8er8ie, o6 their
contents can be 6ound at the end o6 Chapter (. *ossible course that could be taught using
this boo- are as 6ollo,s"
(. 2n introductory course on pricing" Sections (.$, 2.(, 3.2:3.3, $.(:$.', $.(0, '.2:'.$.3,
'.$.%, H.(:H.3, %.3, %.', &.(:&.$, ).(:).$, and Chapter (0.
2. 2n ad8anced course on +athe+atical +odelling and pricing" Section (.$, Chapter 2,
Sections 3.(:3.3 and 3.', Chapter $, Sections '.(:'.$, '.H, H.(:H.3, Chapters &, )
and (0.
3. 2 course on teleco+s policy issues and regulation" Chapter (, Sections 2.(, 3.2:3.H,
Chapters ' and H, Sections %.(:%.(.2, %.3:%.', Chapters (2 and (3, Sections ($.(:
($.(.3, ($.2 and ($.3.
$. 2 course on ga+e#theoretic aspects o6 pricing" Sections '.(:'.$, H.(, H.$, %.(:%.2,
Chapters ), (0, ((, Sections (2.$:(2.', (3.(, and Chapter ($.
'. 2n introductory net,or- ser8ices and technology course" Sections (.(:(.2, 2.( and
Chapter 3.
C8iii *R.>2C.
Acknowledgment
0here are +any people ,ith ,ho+ ,e ha8e en?oyed sti+ulating discussions ,hile ,or-ing
on this boo-. 0hese include especially >ran- Belly and *ra8in Garaiya, ,ho ha8e done so
+uch to inspire research ,or- on pricing co++unications. 0hey include also our partners
in the CaQh+an and 13i pro?ects, and *anos 2ntoniadis, Aareth irdsall, ob riscoe,
John Cro,cro6t, 1anos 3ra+itinos, Ioanna Constantiou, Richard Aibbens, Sandra Boen,
Robin 1ason, Aeorges *oly@os, Stelios Sart@eta-is, Gassilis Siris, Aeorges Sta+oulis and
Jean Walrand.
List o6 2crony+s
201 2synchronous 0rans6er 1ode
2R 28ailable it Rate
A* order Aate *rotocol
S* ac-bone Ser8ice *ro8ider
C2C Connection 2cceptance Control
CR Constant it Rate
C3G0 Cell 3elay Gariation 0olerance
CL* Cell Loss *robability
C*!* Calling *arty !et,or- *ays
CS Consu+er Surplus
3S 3i66erentiated Ser8ices
3W31 3ense Wa8elength 3i8ision 1ultipleCing
.C*R .66icient Co+ponent *ricing Rule
.R* .nterprise Resource *lanning
>C>S >irst Co+e >irst Ser8e
>3C >ully 3istributed Cost
I* Internet ac-bone *ro8ider
IA1* Internet Aroup 1anage+ent *rotocol
I.0> Internet .ngineering 0as- >orce
IL.C Incu+bent Local .Cchange Carrier
IS Integrated Ser8ices
IS3! Integrated Ser8ices 3igital !et,or-
IS* Internet Ser8ice *ro8ider
L2! Local 2rea !et,or-
L13S Local 1ultipoint 3istribution Ser8ice
LRIC Long Run Incre+ental Cost
12! 1etropolitan 2rea !et,or-
1C 1arginal Cost
1*.A 1o8ing *icture .Cperts Aroup
1*LS 1ulti*rotocol Label S,itching
1#.C*R 1ar-et deter+ined .66icient Co+ponent *ricing Rule
*CR *ea- Cell Rate
!2* !et,or- 2ccess *ro8ider
*9 *er 9op eha8iour
*4* *oint o6 *resence
=oS =uality o6 Ser8ice
R4C Regional ell 4perating Co+pany
CC LIS0 4> 2CR4!/1S
R>C Re;uest 6or Co++ents
RSG* Resource Reser8ation *rotocol
SCR Sustainable Cell Rate
S39 Synchronous 3igital 9ierarchy
SL2 Ser8ice Le8el 2gree+ent S1A
Statistical 1ultipleCing Aain S4!.0
Synchronous 4ptical !.0,or- SW
Social Wel6are
0.LRIC 0otal .le+ent LRIC
0C*<I* 0rans+ission Control *rotocol<Internet *rotocol
0C2 0ra66ic Conditioning 2gree+ent
7!. 7nbundled !et,or- .le+ent
7R 7nspeci6ied it Rate
73* 7ser 3atagra+ *rotocol
GR Gariable it Rate
GC Gariable Cost
GC Girtual Circuit
G*! Girtual *ri8ate !et,or-
W2! Wide 2rea !et,or-
WWW World Wide Web
JS* 2ccess Ser8ice *ro8ider
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
Part A
Networks
2
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
1
*ricing and Co++unications
!et,or-s
0his chapter describes current trends in the co++unications industry. It loo-s at 6actors that
in6luence pricing decisions in this industry, and so+e di66ering and con6licting approaches
to pricing. Section (.( is about the +ar-et 6or co++unications ser8ices. Section (.2 is
about present de8elop+ents in the +ar-etplace. Section (.3 is about issues that pricing
+ust address. Section (.$ presents so+e introductory +odelling.
161 !he market for communications services
16161 !he Communications Revolution
We are in the +idst o6 a re8olution in co++unications ser8ices. *heno+enal ad8ances in 6i#
bre optics and other net,or- technology, enhanced by the 6leCible and i+aginati8e so6t,are
glue o6 the World Wide Web ha8e gi8en net,or- users a technology plat6or+ that supports
+any use6ul and eCciting ne, ser8ices. 0he use6ulness o6 these ser8ices is +agni6ied be#
cause o6 network e,ternality. 0his is the notion that a net,or-Ms 8alue to its users increases
,ith its si@e, since each o6 its users has access to +ore and +ore other users and ser8ices.
0his is one o6 the 6acts that spurs the dri8e to,ards ,orld,ide net,or- connecti8ity and
todayMs Internet re8olution K a re8olution ,hich is changing the ,ay ,e engage in politics,
social li6e and business. It is said that the electronic#econo+y, based as it is upon co++u#
nications net,or-s that pro8ide businesses ,ith ne, ,ays to access their custo+ers, is des#
tined to be +uch +ore than a si+ple sector o6 the econo+y. It ,ill so+eday be the economy.
In a ,orld that is so thoroughly changing because o6 the i+pact o6 co++unications
ser8ices, the pricing o6 these ser8ices +ust play an i+portant role. 46 course a price +ust
be charged 6or so+ething i6 ser8ice pro8iders are to reco8er their costs and re+ain in
business. ut this is only one o6 the +any i+portant reasons 6or pricing. 0o understand
pricingMs other roles ,e +ust consider ,hat type o6 product are co++unications ser8ices
and the characteristics o6 the industry in ,hich they are sold.
1616 Communications Services
0he nu+ber o6 connections that can be +ade bet,een n users o6 a net,or- is
(
n.n (<.
0his gi8es us Metcal'-s .aw Dna+ed a6ter the in8entor o6 .thernetE, ,hich says that the
8alue o6
$ *RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
a net,or- increases as the s;uare o6 the nu+ber o6 users. It relates to the idea o6 net,or-
eCternality and the 6act that a larger net,or- has a co+petiti8e ad8antage o8er a s+aller
one, because each o6 the larger net,or-Ms users can co++unicate ,ith a greater nu+ber o6
other users. It +a-es the gro,th o6 a large custo+er base especially i+portant. With this in
+ind, a net,or- operator +ust price ser8ices attracti8ely. In this respect, co++unications
ser8ices are li-e any econo+ic good and 6unda+ental ideas o6 the +ar-etplace apply. 4ne
o6 these is that deceasing price increases de+and. Indeed, it is co++on 6or pro8iders to
gi8e a,ay net,or- access and si+ple 8ersions o6 net,or- goods 6or 6ree, so as to
sti+ulate de+and 6or other goods, build their custo+er base and 6urther +agni6y net,or-
eCternality e66ects. 0he abo8e re+ar-s apply both to +odern net,or-s 6or data
co++unication ser8ices and to the traditional teleco++unications net,or-s 6or 8oice
ser8ices, in ,hich the 6or+er ha8e their roots. 0hroughout this boo- ,e use the ter+
Oteleco++unicationsM ,hen re6erring speci6ically to telephony co+panies, ser8ices, etc.,
and use the broader and enco+passing ter+ Oco++unicationsM ,hen re6erring both to
telephony, data and Internet. It is interesting to co+pare the +ar-ets 6or these net,or-s. >or
+any years the teleco++unications +ar-et has been supplied by large regulated and
protected +onopolies, ,ho ha8e pro8ided users ,ith the bene6its o6 econo+y o6 scale,
pro8ision o6 uni8ersal ser8ice, consistency and co+patibility o6 technology, stable
ser8ice pro8ision and guaranteed a8ailability. Ser8ices ha8e de8eloped slo,lyR de+and has
been predictable and net,or-s ha8e been relati8ely easy to di+ension. *rices ha8e usually
been based upon potential, rather than actual, co+petition. In co+parison, the +ar-et 6or
+odern co++unications ser8ices is 8ery co+petiti8e and is de8eloping ;uite di66erently.
9o,e8er, the +ar-ets are ali-e in so+e ,ays. We ha8e
already +entioned that both types o6 net,or- are sensiti8e to net,or- eCternality e66ects.
0he +ar-ets are also ali-e is that in that net,or- topology restricts the population
o6 custo+ers to ,ho+ the operator can sell and net,or- capacity li+its the types and
;uantities o6 ser8ices he can o66er. oth topology and capacity +ust be part o6 the operatorMs
co+petiti8e strategy. It is help6ul to thin- o6 a co++unications net,or- as a 6actory ,hich
can produce 8arious co+binations o6 net,or- ser8ices, sub?ect to technological constraints
on the ;uantities o6 these ser8ices that can be supported si+ultaneously. Se8ere congestion
can ta-e place i6 de+and is uncontrolled. 2 central the+e o6 this boo- is the role o6
pricing as a +echanis+ to regulate access to net,or- resources and restrict congestion to
an acceptable le8el.
0raditional teleco+s and +odern data co++unications are also ali-e in that, once a net#
,or- o6 either type is built, the construction cost is largely a 'i,ed cost, and the 8ariable
oper# ating costs can be eCtre+ely s+all. I6 there is no congestion, the marginal cost o6
pro8iding a unit o6 co++unications ser8ice can be al+ost @ero. It is a rule o6 the
+ar-etplace that co+# petition dri8es prices to,ards +arginal cost. 0hus, a danger 6or the
co++unications industry is that the prices at ,hich it can sell co++unications ser8ices
+ay be dri8en close to @ero. In su++ary, ,e ha8e abo8e +ade three ele+entary points
about pricing" lo,ering price increases de+andR pricing can be used to control congestionR
co+petition can dri8e prices
to +arginal cost.
1616$ 2nformation -oods
It is interesting to co+pare co++unications ser8ices ,ith in'ormation goods, such as C3s,
8ideos or so6t,are. 0hese share ,ith co++unications ser8ices the characteristic o6 being
costly to produce but cheap to reproduce. 0he 6irst copy o6 a so6t,are product bears all the
production cost. It is a sun- cost, +ainly o6 labour. 1any 6urther copies can be produced
09. 12RB.0 >4R C4117!IC20I4!S S.RGIC.S '
at al+ost no +arginal cost, and i6 the so6t,are can be distributed on the Internet then its
potential +ar-et is the ,hole Internet and its distribution cost is practically @ero. Si+ilarly,
once a net,or- is built, it costs little to pro8ide a net,or- ser8ice, at least ,hile there is no
congestion. 0his also sho,s that in6or+ation goods and net,or- ser8ices can so+eti+es
be 8ie,ed as public goods, li-e high,ays. 2ssu+ing that the installed net,or- capacity is
8ery large D,hich is nearly true gi8en todayMs 6ibre o8erpro8isioningE, the sa+e in6or+ation
good or net,or- ser8ice can be consu+ed by an arbitrary nu+ber o6 custo+ers, increasing
its 8alue to its users Ddue to eCternalitiesE and the 8alue to society. 0his is in contrast to
traditional goods li-e oranges and po,erR a gi8en orange or -ilo,att#hour can be consu+ed
by a single custo+er and there is a cost 6or producing each such additional unit.
0he si+ilarity cannot be pushed too 6ar. We +ust not 6orget that a net,or- has a
continuing running cost that is additional to the one#ti+e cost o6 installation. 0his includes
net,or- +anage+ent operations, a+ongst ,hich accounting and billing are particularly
costly. 0he cost o6 selling a single copy o6 a piece o6 so6t,are is s+all co+pared to the
cost o6 +aintaining, +onitoring and billing a net,or- ser8ice. It is not surprising that cost,
a+ong +any other econo+ic 6actors, in6luences the e8olution o6 net,or-ing technology.
4ne reason 6or the acceptance o6 Internet technology and the Internet *rotocol DI*E is that
there it is less costly to +anage a net,or- that is based on a single uni6ying technology,
than one that uses layers o6 +any di66erent technologies.
0here are so+e lessons to be learned 6ro+ the 6act that in6or+ation goods can sell at both
lo, and high prices. Consider, 6or eCa+ple, the 6act that there are hundreds o6 ne,spaper
,eb sites, ,here entertaining or use6ul in6or+ation can be read 6or 6ree. It see+s that
publishers cannot easily charge readers, because there are +any nearly e;ui8alent sites. We
say that the product is Oco++oditi@edM. 0hey +ay 6ind it +ore pro6itable to concentrate
on di66erentiating their sites by ;uality o6 readership and use this in selling ad8ertising.
In contrast, a copy o6 a specialist so6t,are pac-age li-e 2utoCad can sell 6or thousand o6
dollars. 0he di66erence is that its custo+er base is co++itted and ,ould ha8e di66iculty
changing to a co+peting product because the learning cur8e 6or this type o6 so6t,are
is 8ery steep. Si+ilarly, 1icroso6t Word co++ands a good price because o6 a net,or-
eCternality e66ect" the nu+ber o6 people ,ho can eCchange docu+ents in Word increases
as the s;uare o6 the nu+ber ,ho use it. 0hese eCa+ples de+onstrate another i+portant
rule o6 the +ar-etplace" i6 a good is not a co++odity, and especially i6 it has co++itted
custo+ers, then it can sell at a price that re6lects its 8alue to custo+ers rather than its
production cost.
We ha8e noted that both traditional teleco+s and +odern co++unications ser8ices are
sensiti8e to net,or- topology and congestion. 0his is not so 6or an in6or+ation good. 0he
per6or+ance o6 a piece o6 so6t,are running on a personal co+puter is not decreased si+ply
because it is installed on other co+putersR indeed, as the eCa+ple o6 1icroso6t Word sho,s,
there +ay be added 8alue i6 +any co+puters install the sa+e so6t,are.
1616% S'ecial /eatures of the Communications *arket
4ne special 6eature o6 the +ar-et 6or co++unications ser8ices, that has no analogy in the
+ar-et 6or in6or+ation goods Dand only a little in the +ar-et 6or teleco++unicationsE, is
that in their +ost basic 6or+ all data transport ser8ices are si+ply +eans o6 transporting
data bits at a gi8en ;uality le8el. 0hat ;uality le8el can be eCpressed such ter+s as the
probability o6 6aith6ul trans+ission, delay and ?itter. 2 user can buy a ser8ice that the
operator intended 6or one purpose and then use it 6or another purpose, pro8ided the ;uality
H *RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
le8el is ade;uate. 4r a user can buy a ser8ice, create 6ro+ it t,o ser8ices, and thereby pay
less than he ,ould i6 he purchased the+ separately. We say +ore about the i+pact o6 such
su*stituta*ility, ar*itrage and s$litting upon the relati8e pricing o6 ser8ices in Section &.3.'.
2nother thing that +a-es co++unication transport ser8ices special is their reliance on
statistical multi$le,ing. 0his allo,s an operator to ta-e ad8antage o6 the 6act that data tra66ic
is o6ten bursty and sporadic, and so that he can indulge in so+e a+ount o6 o8erboo-ing. 9e
need not reser8e 6or each custo+er a band,idth e;ual to that custo+erMs +aCi+u+ sending
rate. Statistical +ultipleCing produces econo+y o6 scale e66ects" the larger the si@e o6 the
net,or-, the +ore o8erboo-ing that can ta-e place, and thus the si@e o6 the custo+er base
that can be supported increases +ore than proportionally to the ra, ;uantity o6 net,or-
resources. It is intuiti8e that a net,or- ser8ice that is easier to +ultipleC should incur a
lesser charge than one ,hich is +ore di66icult to +ultipleC. 0here are +any +ultipleCing
technologies and each is opti+i@ed 6or a particular type o6 data tra66ic. >or instance, S4!.0
DSynchronous 4ptical !.0,or-E is a +ultipleCing technology that is opti+i@ed 6or 8oice
tra66ic D,hich is predictable and s+oothE, ,hereas the Internet technology is opti+i@ed 6or
data tra66ic D,hich is stochastic and burstyE.
Si+ple econo+ic goods are o6ten speci6ied by a single para+eter, such as nu+ber o6
copies, ,eight, or length o6 a lease. In contrast, contracts 6or data co++unications ser8ices
are speci6ied by +any para+eters, such as pea- rate, +aCi+u+ throughput and in6or+ation
loss rate. Contracts 6or ser8ices that support +ulti+edia applications are speci6ied by
additional para+eters, such as ability to sustain bursty acti8ity, and ability and responsibility
to react to changing net,or- conditions. Since ser8ice contracts can be speci6ied in ter+s
o6 so +any para+eters, their potential nu+ber is huge. 0his co+plicates pricing. 9o, are
,e to price ser8ices in a consistent and econo+ically rational ,ayL 1oreo8er, contracts
are +ore than si+ple pricing agree+ents. >or eCa+ple, a contract +ight gi8e a user the
incenti8e to s+ooth his tra66ic. Custo+ers also bene6it because the ;uality o6 the ser8ice
can be better and lo,er priced. 0his poses ;uestions o6 ho, ,e can reasonably ;uanti6y
a custo+erMs net,or- usage and price contracts in a ,ay that +a-es pricing a +echanis+
6or controlling usage.
16 1evelo'ments in the market'lace
In the neCt t,o sections, ,e loo- at so+e i+portant 6actors that a66ect the present +ar-et
6or co++unications ser8ices. We +a-e so+e 6urther argu+ents in 6a8our o6 the i+portance
o6 pricing. We describe the conteCt in ,hich pricing decisions occur, their co+pleCity and
conse;uences. So+e o6 these issues are sub?ect to debate, and ,ill +a-e +ost sense to
readers ,ho are 6a+iliar ,ith present trends in the Internet. So+e readers +ay ,ish to s-ip
the present section on 6irst reading.
0here ha8e been t,o +a?or de8elop+ents in the +ar-etplace 6or teleco+s ser8ices" the
de8elop+ent o6 cost#e66ecti8e optical net,or- technologies, allo,ing +any light bea+s to
be pac-ed in a single 6ibreR and the ,idespread acceptance o6 the Internet protocols as the
co++on technology 6or transporting any -ind o6 digiti@ed in6or+ation. Si+ultaneously, the
Internet bubble o6 late ())0s has seen an o8eresti+ation o6 6uture de+and 6or band,idth
and o8erin8est+ent in 6ibre in6rastructure. 0ogether, these 6actors ha8e created a ne,
technology o6 such 8ery lo, cost that it threatens to disrupt co+pletely the +ar-et o6 the
traditional telephone net,or- operators, ,hose transport technologies are opti+i@ed 6or
8oice rather than data. It has also co++oditi@ed the +ar-et 6or transport ser8ices to such
an eCtent that co+panies in that business +ay not be able to reco8er costs and e66ecti8ely
co+pete.
3.G.L4*1.!0S I! 09. 12RB.0*L2C. %
4ne reason 6or this is that the Internet is a OstupidM net,or-, ,hich is opti+i@ed 6or
the si+ple tas- o6 +o8ing bits at a single ;uality le8el, irrespecti8e o6 the application
or ser8ice that generates the+. 0his +a-es the net,or- si+ple and cheap. Indeed, the
Internet is opti+i@ed to be as e66icient as possible and to obey the Oend#to#end principleM.
0o understand this principle, consider the 6unction" Oreco8ery 6ro+ in6or+ation lossM. 0his
+eans so+ething di66erent 6or 6ile trans6er and Internet radio. 0he end#to#end principle
says that i6 such a 6unction is in8o-ed rarely, and is not co++on to all data tra66ic, then
it is better to install it at the edge o6 the net,or-, rather than in each lin- o6 the net,or-
separately. Co+pleCity and ser8ice di66erentiation is pushed to the edges o6 the net,or-.
0he reduction in redundancy results in a si+pler net,or- core. Custo+er de8ices at the
edges o6 the net,or- +ust pro8ide ,hate8er eCtra 6unctionality is needed to support the
;uality re;uire+ents o6 a gi8en application.
0he 6act that the Internet is stupid is one o6 the +a?or reasons 6or its success. 9o,e8er,
it also +eans that a pro8ider o6 Internet bac-bone ser8ices Dthe Olong#haulM part o6 the
net,or-, national and internationalE is in a ,ea- bargaining position i6 he tries to clai+ any
substantial share o6 ,hat a custo+er is prepared to pay 6or an end#to#end transport ser8ice,
o6 ,hich the long#haul ser8ice is only a part. 0hat ser8ice has been co++oditi@ed, and so
in a co+petiti8e +ar-et ,ill be o66ered at near cost. 9o,e8er, as noted pre8iously, the cost
o6 building the net,or- is a sun- cost. 0here is only a 8ery s+all 8ariable cost to o66ering
ser8ices o8er an eCisting net,or- in6rastructure. 0he +ar-et prices 6or net,or- ser8ices
,ill be al+ost @ero, thus +a-ing it 8ery di66icult 6or the co+panies that ha8e in8ested in the
ne, technologies to reco8er their in8est+ents and pay their debts. 2s so+e ha8e said, the
*est network is the hardest one to make money running DIsenberg and Weinberger, 200(E.
0his OparadoC o6 the best net,or-M does not surprise econo+ists. 2s ,e ha8e already
noted, there is little pro6it to be +ade in selling a co++odity. 0he telephone net,or- is ;uite
di66erent. Custo+ers use only si+ple edge de8ices DtelephonesE. 2ll 8alue#added ser8ices
are pro8ided by the net,or-. !et,or- ser8ices are constructed ,ithin the net,or-, rather
than at the edges, and so operators can +a-e +oney by being in control. Si+ilarly, 8ideo
and tele8ision distribution use ser8ice#speci6ic net,or-s and +a-e good pro6its. 0elephone
net,or-s are opti+i@ed 6or 8oice and not 6or data. Goice strea+s are predictable in their
rates, ,hile data is inherently bursty. 3ue to the o8erspeci6ied re;uire+ents D6or reliability
and 8oice ;ualityE, the technologies 6or 8oice net,or-s DS4!.0 and S39E are an order o6
+agnitude +ore eCpensi8e than the technology 6or pro8iding si+ple bit +o8ing ser8ices
o6 co+parable band,idth, as pro8ided by the Internet using the ne, optical trans+ission
technologies. 0he eCtra ;uality per bit o66ered by telephone net,or- in6rastructures does not
?usti6y their substantially greater costs. 1oreo8er, the large net,or- capacity a8ailable +ay
let the ;uality o6 the bits pro8ided by the ne, Internet technology net,or-s approach that
pro8ided by the telephone net,or-. 7n6ortunately, these 8oice#centred technologies are not
so old as to be easily ,ritten#o66. .Cisting operators in8ested hea8ily in the+ during the late
()&0s and +id ())0s, encouraged by regulators ,ho allo,ed the+ a Oreturn on assetsM, that
is, a pro6it proportional to the assets under their control. 0his +a-es it hard 6or operators
to abandon their 8oice#centred in6rastructures and build ne, net,or-s 6ro+ scratch.
0he abo8e argu+ents suggest that net,or- operators deploying the ne, Internet o8er
6ibre technologies should be able to carry 8oice at substantially less cost than traditional
net,or- operators, and so dri8e the+ out o6 business. 0hey ,ill also be able to o66er a rich
set o6 high band,idth data ser8ices, ,hich are again cheaper 6or the+ to pro8ide.
9o,e8er, things are not entirely rosy 6or these ne, net,or- operators. 0hey ha8e
their o,n proble+" na+ely, a band,idth glut. 3uring the Internet bubble o6 the late
& *RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
())0s in8estors o8eresti+ated the gro,th in the de+and 6or data ser8ices. 0hey belie8ed
there ,ould be an unli+ited de+and 6or band,idth. 1any co+panies in8ested hea8ily in
building ne, 6ibre in6rastructures, at both the +etropolitan and bac-bone le8el. 3W31
D3ense Wa8elength 3i8ision 1ultipleCingE +ade it possible to transport and sell up to &0
+ultiple light ,a8es Dusing present technologyE on a single strand o6 6ibre. Aigabit .thernet
technologies co+bined ,ith the Internet protocols allo,ed connecti8ity ser8ices to be
pro8ided 8ery ineCpensi8ely o8er these 6ibre in6rastructures. 7sing present technologies
each light ,a8e can carry up to (0 Abps o6 in6or+ation, so that a single 6ibre can carry &00
Abps. 2lthough 3W31 is presently unecono+ic in the +etropolitan area, it +a-es sense
in the long#haul part o6 the net,or-. It has been esti+ated that there are no, o8er a +illion
route# +iles o6 6ibre installed ,orld,ide, o6 ,hich only about 'P is lit, and that to only
about &P o6 the capacity o6 the attached 3W31 e;uip+ent. 0hus there is potential 6or
8astly +ore band,idth than is needed. So+e eCperts belie8e that 6ibre is o8erpro8isioned
by a 6actor o6 ten in the long#haul part o6 the net,or-s. >urther bad ne,s is that de+and
6or data tra66ic appears to be increasing by only '0P per year, rather than doubling as so+e
had eCpected. 0he result is that the long#haul band,idth +ar-et has beco+e a
co++odity +ar-et,
in ,hich de+and is an order o6 +agnitude less than eCpected. 2 possible reason is
+iscalculation o6 the i+portance o6 co+ple+entary ser8ices. 9igh#capacity bac-bones
ha8e been built ,ithout thin-ing o6 ho, such Oband,idth 6ree,aysM ,ill be 6illed. 0he
business plans o6 the operators did not include the Oband,idth ra+psM needed, i.e. the
high#band,idth access part that connects custo+ers to the net,or-s. 0he absence o6 such
lo, priced high#band,idth net,or- access ser8ices -ept bac-bone tra66ic 6ro+ gro,ing as
predicted. esides that, transport ser8ices ha8e i+pro8ed to such an eCtent that technology
inno8ation is no longer enough o6 a di66erentiating 6actor to pro8ide co+petiti8e ad8antage.
*rices 6or band,idth are so lo, that it is no, 8ery hard 6or ne, net,or- operators to be
pro6itable, to repay the +oney borro,ed 6or installing the eCpensi8e 6ibre in6rastructure, or
to buy eCpensi8e spectru+ licenses.
.Cisting operators o6 8oice#opti+i@ed net,or-s are also a66ected. 0heir inco+e 6ro+
highly priced 8oice calls has reduced, as 8oice custo+ers ha8e +igrated to the Internet
technology o6 8oice#o8er#I* net,or-s, ,hile the de+and 6or 8oice re+ains essentially
constant. 0hey ha8e not seen a co+pensating increase in de+and 6or data ser8ices, ,hich
in any case are priced eCtre+ely lo, because o6 co+petition in that co++oditi@ed +ar-et.
So+e local ser8ice pro8iders are e8en selling data ser8ices at belo, cost because o6 their
eCpensi8e legacy net,or- technology, ,hile si+ultaneously installing the ne, I* o8er 6ibre
technology in parts o6 their net,or-s to reduce their costs. 46 course in6rastructure is not
the only cost o6 pro8iding traditional access and 8oice ser8ices. 2 larger part o6 the cost
is 6or orders, repairs, custo+er ser8ice and support. 0his cost ,ill al,ays be re6lected in
custo+ersM bills. 0hus local operators, ,ho ha8e traditionally been in a +onopoly position,
do li8e in a so+e,hat protected en8iron+ent because they ha8e a steady inco+e 6ro+ their
large and loyal base o6 telephone custo+ers. Co+petition is 6iercest in the long#haul part o6
the net,or-, ,here ne, technologies can be easily deployed, econo+ies o6 scale are great,
and +any operators co+pete.
It +ay see+ paradoCical to ha8e such se8ere sustainability proble+s in a gro,th industry
such as teleco++unications. 2lthough the pie is gro,ing, the business +odels see+ to ha8e
so+e serious 6la,s. 0his is due to +iscalculations, and because co+panies ha8e tried to
beco+e si+ultaneously both retail and ,holesale ser8ice pro8iders, ,ith the result that they
ha8e been co+peting ,ith their o,n custo+ers. So+e eCperts en8isage eCtre+e scenarios.
In one such scenario, the regulator ac;uires and controls the co+plete 6ibre in6rastructure in
09. R4L. 4> .C4!41ICS )
the 7S, and lea8es teleco+s operators to co+pete in pro8iding OedgeM ser8ices, ,hich are
better di66erentiated by inno8ation and ser8ice custo+i@ation, and hence +ore pro6itable.
4thers belie8e that the industry ,ill sel6#regulate. Cash#rich co+panies ,ill buy the ailing
teleco+s co+panies at lo, prices and enter the teleco+ +ar-et. 2s pro6it +argins are s+all,
co+panies o66ering in6rastructure and connecti8ity ser8ices ,ill consolidate so as to gain
econo+ies o6 scale. 0his suggests that hori@ontal integration +ay be +ore sensible than
8ertical integration. 4ther teleco+s co+panies +ay bene6it 6ro+ increased co+pleCity at the
edges o6 the OstupidM net,or-, and +anage this co+pleCity on behal6 o6 their custo+ers.
0his outsourcing o6 the +anage+ent o6 the co++unication assets o6 large co+panies +ay
be a substantial source o6 inco+e and a ne, business +odel in the teleco+ industry. In this
ne, ser8ice#centred industry, net,or- Dser8iceE +anage+ent so6t,are ,ill play an
increasingly i+portant role. 9o,e8er, ,e should caution that it is 8ery hard to predict
the e8olution o6 a co+pleC industry such as teleco++unications. *redictions are 8ery
sensiti8e to ti+e assu+ptions" no one -no,s ho, long it ,ill ta-e 6or ne, technologies to
dethrone old ones. Well#established ser8ices do not disappear o8ernight, e8en i6 less
eCpensi8e substitutes are a8ailable. rand na+e plays an i+portant role, as do 6actors such
as global presence, and the ability to pro8ide one#stop shopping 6or bundles o6 ser8ices.
16$ !he role of economics
We belie8e that econo+ics has +uch to teach net,or-ing engineers about the design o6
net,or-s. >irst, it has +uch to say about decentrali@ed control +echanis+s. Secondly,
,e 6eel that the design and +anage+ent o6 net,or-s should adopt a OholisticM 8ie,. We
consider these t,o points in turn.
>irst, let us note that econo+ics is traditionally used to study national econo+ies. 0hese
can be 8ie,ed as large decentrali@ed syste+s, ,hich are al+ost co+pletely go8erned by
incenti8es, rather than by strict hard,ired rules. 4n a s+aller scale, econo+ic incenti8es
also +anage the 6lo, o6 8ehicle tra66ic in a congested part o6 to,n during rush hours. .ach
dri8er esti+ates the repercussions o6 his actions and so chooses the+ in a ,ay that he
eCpects to be best 6or his sel6#interest.
0hings are si+ilar in a large net,or-, such as the Internet, in the sense that central
control tends to be relaCed and +any decisions +ust be ta-en at the edges o6 the net,or-,
both by users, and by pro8iders ,ho ha8e di66erent pro6iles and incenti8es. 0his si+ilarity
+a-es econo+ics 8ery rele8ant. Just as econo+ic theory eCplains ,hat can be achie8ed
in the national econo+y by the incenti8es o6 ,ages, taCes and prices, so econo+ic theory
is use6ul in eCplaining ho, distributed control +echanis+s, based on incenti8es such as
price and congestion le8el can be used to ensure that a co+pleC syste+ li-e the Internet
,ill per6or+ ade;uately. 2s in a national econo+y, agents are to ta-e decisions at points
,here the in6or+ation re;uired to ta-e the+ is actually a8ailable, rather than on the basis
o6 so+e central O6ull in6or+ationM about the syste+ state D,hich ,ould be i+possible to
obtain in practiceE. 0heore+s o6 econo+ics can guarantee that such distributed control
dyna+ically +o8es the syste+ to an e;uilibriu+ point ,here resources are used e66iciently,
and per6or+ance is the sa+e as i6 the solution had been obtained using 6ull in6or+ation.
!o, ,e turn to the second reason that econo+ics is rele8ant to net,or-s. .ngineers
are used to designing +echanis+s that achie8e opti+u+ syste+ per6or+ance. 0his
Oper6or+anceM is usually +easured in ter+s o6 pac-et delay, call bloc-ing, and so on.
We suggest that it is better to thin- in ter+s o6 Oecono+ic per6or+anceM, ,hich includes
the abo8e +easures, but also ,ider#ranging +easures, such as 6leCibility in the use o6 the
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0
*RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
net,or-, and the ability to adapt and custo+i@e the ser8ice to the particular needs o6 the
custo+ers. 0his econo+ic perspecti8e loo-s at the net,or- and its custo+ers as a ,hole
and de6ines syste+ per6or+ance to include the 8alue that custo+ers obtain 6ro+ using the
net,or- ser8ices. In this OholisticM approach, the custo+ers and net,or- cannot be seen as
separate entities. !et,or- +echanis+s +ust ta-e account o6 their interactions. >leCibility
suggests the use o6 incenti8e +echanis+s ,here econo+ic agents Dusers, autono+ous
in6rastructure and ser8ice pro8idersE are pro8ided su66icient in6or+ation to ta-e decisions,
each acting rationally, in his best interest. *rices are +ainly used in such +echanis+s to
con8ey in6or+ation about resource scarcity and congestion cost.
We neCt discuss se8eral issues 6or net,or-s that are essentially econo+ic ones. We begin
by loo-ing at the use o6 pricing by a net,or- operator ,ho ,ants to control congestion
and s+ooth bursty custo+er de+and. We argue that e8en i6 there is a 6ibre glut 6or the near
6uture, and ne, light ,a8es can be pro8ided at a s+all +arginal cost, there re+ains the
possibility o6 congestion, and thus a need 6or pricing Dand an understanding o6 its econo+ic
theoryE.
Ai8en all the abo8e, including the co++oditi@ation o6 the +ar-et, ,hat role re+ains 6or
pricingL In the neCt section ,e argue that e8en i6 there is a 6ibre glut 6or the near 6uture,
and ne, light ,a8es can be pro8ided at a s+all +arginal cost, the possibility o6 congestion
al,ays re+ains present. 9ence pricing re+ains use6ul to a net,or- operator ,ho ,ants to
control congestion and s+ooth bursty custo+er de+and.
16$61 4ver'rovision or Control7
2s ,e ha8e seen, there is +uch uncertainty about gro,th in de+and 6or co++unications
ser8ices. Just as it ,as once o8eresti+ated, it +ay no, be underesti+ated. It is hard 6or any
operator to predict de+and, ho, technology ,ill e8ol8e, to tell ,here the 6uture bottlenec-s
in ser8ice pro8isioning ,ill be, or to predict the price and ;uality o6 interconnection ,ith
other net,or-s.
What ,e do see is that lo,er net,or-ing costs ha8e spurred the creation o6 de+anding
ne, applications" such as the auto+atic do,nloading o6 co+plete ,eb sites, Internet radio,
outsourcing o6 bac-#o66ice applications 6or .R* D.nterprise Resource *lanningE, 8ideo
strea+ing and ne, peer#to#peer co+puting paradig+s li-e the Arid Da technology that
lets users tap processing po,er o66 the Internet as easily as electrical po,er can be dra,n
6ro+ the electric gridE, and Storage 2rea !et,or-s DS2!sE. 2n i+portant characteristic o6
these applications is that they are run by so6t,are on +achines rather than by hu+ans. We
eCpect that the 8ast +a?ority o6 6uture Internet tra66ic ,ill be generated by progra+s and
de8ices connected to the Internet. Since these can ulti+ately greatly outnu+ber hu+ans,
net,or- tra66ic has the potential to gro, eCtre+ely rapidly. It is an open ;uestion as to
,hich ,ill gro, +ore rapidly" capacity or de+and. 0he ans,er greatly a66ects the eCtent
to ,hich congestion re+ains a do+inating 6actor, the role o6 pricing and the e8olution o6
net,or- +anage+ent +echanis+s.
Let us eCa+ine this idea a bit +ore. It is reasonable to assu+e that as net,or- ser8ices
play an increasingly -ey role in the 6uture econo+y, businesses ,ill ,ant ser8ices o6 high
;uality, ,ith attributes such as lo, latency and in6or+ation loss. 9o, can the net,or-
+eet the de+and 6or high ;uality ser8ices ,ithout beco+ing o8ercongestedL 0here are t,o
possibilities. .ither the net,or- is eCtre+ely si+ple, but there is so +uch capacity that
it is ne8er congested. 4r there is less capacity, but sophisticated control +echanis+s are
used to pro8ide high ;uality ser8ices to applications that need it. 2 good analogy can be
09. R4L. 4> .C4!41ICS ((
+ade ,ith 6ree,ays. In the absence o6 any special controls a 6ree,ay can pro8ide only a
Obest#e66ortM ser8ice. 0o pro8ide a better ;uality o6 ser8ice there are t,o strategies. .ither
one can o8erdesign the 6ree,ay, by building enough lanes so that all custo+ers recei8e
the better ;uality o6 ser8ice. 4r one can build a s+aller 6ree,ay, but i+ple+ent a priority
ser8iceR perhaps a nu+ber o6 lanes are reser8ed 6or custo+ers ,ho are prepared to pay an
eCtra 6ee. oth strategies are costly, but in di66erent ,ays. =uality di66erentiation allo,s
6or price di66erentiation. 0he cost and co+pleCity in the second strategy is in ensuring that
custo+ers are charged di66erentially and that only those ,ho ha8e paid 6or the ser8ice can
use the priority lanes.
So+e co++entators belie8e that 6uture net,or-s ,ill be o8erdesigned. We see this
in todayMs local area net,or-s and personal co+puters. .Cperience sho,s that people so
8alue high responsi8eness that they are ,illing to o8erdi+ension their pri8ate net,or-s and
their co+puting plat6or+s by ta-ing ad8antage o6 the lo, cost o6 the ne, technologies.
It +ay be that si+ple o8erpro8isioning can sol8e the proble+ o6 congestion and can
be ?usti6ied by the rapidly decreasing cost o6 band,idth. ut can the ,hole net,or-
be o8erdesignedL 2lthough o8erpro8isioning +ay be reasonable in the bac-bone o6 the
net,or-, ,hich consists o6 a 6airly s+all nu+ber o6 lin-s, it +ay not be reasonable in
the +etropolitan part o6 the net,or-, and e8en less so in the access part. In the present
Internet, a large a+ount o6 6ibre capacity connects +a?or cities in the 7S and around the
,orld, but there is substantially less 6ibre installed at the access net,or- part that connects
custo+ers to the bac-bone. 0he core net,or- in6rastructure is shared by all custo+ers,
but that part o6 the in6rastructure that lies in the +etropolitan and the access net,or- is
used by +uch 6e,er custo+ers. 0his is ,here the largest cost o6 the net,or- lies. Indeed,
so+e eCperts belie8e that it ,ould ta-e t,enty to thirty ti+es as +uch ti+e and eCpense
to o8erpro8ision the 6ibre in the local part o6 the net,or- as it has ta-en to install the
present 6ibre in6rastructure in the bac-bone. >or these reasons it +ay be 8ery costly to
o8erpro8ision all o6 the net,or-.
I6 the abo8e argu+ents are correct then congestion and o8erload are al,ays dangers.
Controls ,ill al,ays be needed to sa6eguard net,or- operation. In i+ple+enting such
controls the net,or- +ust +onitor ne, connections, i+ple+ent rules 6or deciding ,hich
connections to bloc-, and then e66ecti8ely bloc- the+.
2n alternati8e to o8erpro8isioning is the second strategy" e;uip the net,or- ,ith so+e
6or+ o6 control that operates at all ti+es, e8en ,hen no o8erload occurs. 0his control can
be o6 8ariable co+pleCity, and essentially can pro8ide a controlled access to the net,or-
resources by 8arious custo+er types, allo,ing 6or ser8ice D;ualityE di66erentiation. y
opti+i@ing the operation o6 the net,or-, less capacity is needed to +eet a gi8en de+and
than is re;uired by si+ple o8erpro8isioning. 9o,e8er, it +ay be eCtre+ely costly to
deploy a ne, control +echanis+ in an eCisting net,or- i6 the +echanis+ ,as not put place
,hen the net,or- ,as originally designed. >or eCa+ple, it ,ould di66icult to ,in uni8ersal
acceptance 6or adding a ne, control +echanis+ to the eCisting Internet protocols.
1oreo8er, i6 any control is to be e66ecti8e, it +ust be co+bined ,ith appropriate tari66s so
as to attract the right custo+ers. It is a,-,ard 6or the net,or- itsel6 to di66erentiate and
assign priorities a+ongst custo+er tra66ic ,ithout ta-ing into account the actual 8alue o6
the ser8ice to the custo+ers that ,ill be a66ected.
0his last obser8ation is eCtre+ely crucial and ,ill be 6urther eCplored in Chapter '. 2s
,e see, the social 8alue o6 a syste+ is increased ,hen users are gi8en incenti8es to choose
the le8els o6 ser8ice +ost appropriate to the+. *rices can produce ?ust the right incenti8es,
and so help to ensure that custo+ers do not ,aste i+portant resources that they do not
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*RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
8alue. Indeed, pricing can be 8ie,ed as a control +echanis+ 6or sha$ing de+and. 0his
is better than bloc-ing de+and in an ad hoc ,ay. !ote that si+ple usage pricing +ay be
a su66icient control +echanis+. Consider a city su66ering 6ro+ congestion in the pro8ision
o6 par-ing spaces, but presently not charging 6or par-ing space. 1any o6 the spaces +ay
be used by people ,ho ,ould be ,illing to use public transport rather than pay a par-ing
6ee. 0he city could i+pose rules that reser8e certain places 6or speci6ic people. 9o,e8er, a
better ,ay to reduce congestion ,ould be to introduce a si+ple per#hour par-ing charge.
46 course, there is a cost to installing par-ing +eters and policing their use.
*erhaps the 6uture lies in all net,or-s being ?ust on the borderline o6 being
o8erpro8isioned, e8en in the access part. Since there is a non@ero 8ariable cost 6or pro8iding
ne, capacity Dat least e;ual to the +arginal cost o6 lighting the eCisting 6ibreE, the
only strategy that is econo+ically de6ensible is to pro8ide ?ust enough capacity so that
the +arginal cost o6 eCtra capacity e;uals the +arginal bene6it to custo+ers o6 reduced
congestion. In other ,ords, custo+ers should pay 6or the eCtra 8alue they obtain by
increasing ser8ice ;uality. 0his is the only rational business +odel 6or net,or- operators
,ho operate in a co+petiti8e en8iron+ent. It is no, interesting to thin- about +odels 6or
capacity eCpansion. Capacity should eCpand at the rate needed to guarantee so+e 6iCed
congestion le8els at all ti+es, gi8en the dyna+ics o6 the de+and. Since capacity cannot
be pro8ided in arbitrarily s+all incre+ents, congestion ,ill e8entually appear and signal
the need 6or capacity eCpansion. 0he 6acts that de+and is not predictable and capacity
eCpansion cannot be pro8ided in Oreal#ti+eM in response to e8ery increase in de+and,
suggest that pricing can ser8e an i+portant role during these transient phases by increasing
stability and reducing ;uality 6luctuations. 2s the net,or- transport ser8ice +ar-et ,ill be
constantly in such a transient phase, ,e belie8e that pricing ,ill al,ays play an i+portant
role in sa6eguarding net,or- per6or+ance.
16$6 8sing Pricing for Control and Signalling
We continue ,ith the the+e o6 pricing as a +eans o6 control, and describe the role it has
in signalling. y increasing prices an operator can reduce de+and, reduce congestion, and
ensure that ser8ices are pro8ided to the users that bene6it +ost and are +ost ,illing to pay.
4n a short ti+escale, pricing can pro8ide a type o6 6leCible policing +echanis+. 4n a long
ti+escale, it can be used as part o6 a 6eedbac- loop to stabili@e the net,or- through a sort
o6 6lo, control. Gie,ed as a control +echanis+, charging has the ad8antage that it scales
easily ,ith the si@e o6 the net,or-.
*ricing can also be 8ie,ed as a +echanis+ by ,hich the net,or- operator co++unicates
,ith his users and gi8es the+ incenti8es to use the net,or- e66iciently. y this +eans, he
can i+pro8e the 8alue o6 ser8ices to users and pro8ide stability and robustness. Con8ersely,
the ,ay that users respond to charges can tell the operator so+ething about user
pre6erences and their intended net,or- use. >or instance, a custo+erMs choice a+ongst
a +enu o6 +obile phone charging plans can signal ,hether he plans to phone +ostly
during the ,or-ing ,ee- or at the ,ee-end. 0he +obile net,or- operator can use this
in6or+ation to di+ension net,or- capacity and allocate resources ,here they are +ost
probably needed. 2 tari66 design is said to be incentive com$ati*le i6 it induces custo+ers
to choose tari66s that accurately re6lect their actual usage plans, and ,hile doing so
increases the aggregate utility o6 all users. 0here is nothing 6or a user to gain by
disguising ho, he plans to use the ser8ice. 2 user ,ho plans +ainly to call 6riends at the
,ee-end ,ill ha8e no ad8antage in choosing the tari66 designed 6or the ,or-ing ,ee-.
09. R4L. 4> .C4!41ICS (3
Clearly, it is i+portant that charges should pro8ide the right signals" both ,ith regard to
incenti8es to users and in6or+ation that can be used in net,or- control. *roperly designed
tari66s accurately con8ey in6or+ation bet,een the net,or- and its custo+ers. Charges
should be si+ple, but not si+plisticR they should be understandable, i+ple+entable and
co+petiti8e.
*rice in6or+ation that is signalled to the edges o6 the net,or- can play a signi6icant role
in pro8iding rational end#users and applications ,ith the appropriate incenti8es to control
their 6lo,s. 0his is al+ost ,hat happens in the Internet. 2s it is presently engineered, the
decision as to ,hen a user should increase or to decrease his tra66ic 6lo, is not +ade by the
Internet itsel6, but by the 0C* protocol running on the userMs co+puter. 2 +a?or tas- o6
the Internet is to send congestion signals to its users. 0he congestion signals are generated
by the userMs pac-et losses. When 0C* recei8es a congestion signal 6ro+ the net,or-, it
reduces the sending rateR other,ise it increases it. Interestingly, all users o6 the Internet
cooperate by i+ple+enting 0C* identicallyR but no one 6orces the+ to do so. 2lthough it
,ould not be tri8ial to i+ple+ent, in principle, a user +ight cheat by re,riting his so6t,are
to disobey the 0C* protocol and send at a greater rate than 0C* says he should. 0his ,ould
not be an issue i6 the congestion signals ,ere to actually i+pose a +onetary charge. 2ll a
user could do ,ould be to obser8e the rate at ,hich he is being charged 6or his lost pac-ets
and choose the rate at ,hich he ,ishes to sub+it pac-ets. 9is choice ,ould depend on
ho, +uch he is prepared to pay to run the application he is running. 0here is incenti8e
co+patibility, in that a user has no reason to pretend he 8alues band,idth di66erently than
he really does.
*ricing can also sol8e the congestion proble+. When there is congestion along a route
the users o6 that route can be +ade to see an increasing price. 0his price increases until the
users reduce the rate at ,hich they send pac-ets and congestion is reduced. Interestingly, the
Internet as it is presently designed, can be interpreted as indirectly i+ple+enting a charging
+echanis+ that treats all users e;ually and that assu+es e8ery 6lo, has e;ual 8alue. 0he
net,or- pro8ides congestion signalling and the users respond. 2lthough no actual charging
ta-es place, the 0C* protocols act as i6 the rate o6 congestion signals had the interpretation
o6 a rate o6 charges, and hence a greater rate o6 congestion signals pro8ides the incenti8e
to reduce the 6lo,. 2 current challenge is to eCtend this +echanis+ to +odels in ,hich
di66erent users ha8e di66erent utilities 6or di66erent net,or- ser8ices.
16$6$ Who Should Pay the #ill7
In the pre8ious section ,e sa, that there could be ad8antage in charging end#users o6 the
Internet, as both a 6unction o6 their sending rate and the congestion le8el o6 the net,or-.
0his is contro8ersial. 0he history o6 the telephone net,or- has sho,n that charging
according to usage reduces net,or- use since users are reluctant to incur charges. 1any
studies suggest that users o6 teleco++unications ser8ices appreciate the si+plicity and
predictability o6 6lat rate charging. /et 6lat rate charging is not 6air to all custo+ers and
can lead to a ,aste o6 resources. >or eCa+ple, in an all#you#can#eat restaurant, custo+ers
pay a 6lat 6ee, but there is an incenti8e to o8ereat.
.cono+ic theory suggests that e66iciency is greater ,hen the charge ta-es account o6
actual usage. Waste is reduced and resources are reser8ed 6or the custo+ers that 8alue
the+ the +ost. >urther+ore, to opti+i@e econo+ic e66iciency e8en 6urther, prices could
be changing dyna+ically to +ore accurately re6lect de+and. Such pricing sche+es are 6ar
+ore co+pleC than si+ple 6lat 6ee sche+es and hence raise ;uestions o6 6easibility. 7sers
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6acing such co+pleC sche+es +ay be deterred 6ro+ using the net,or- ser8ices and slo,
the eCpansion o6 the Internet. Should ,e sacri6ice short#ter+ net,or- e66iciency to increase
the eCtre+ely 8aluable long#ter+ de+and 6or ne, net,or- ser8ices and applicationsL
0here are t,o i+portant technological 6acts that play a role in ans,ering this ;uestion.
>irst, users Dindi8iduals and end#custo+ers o6 large organi@ationsE can today +a-e use o6
intelligent edge de8ices ,hich can absorb the decision co+pleCity. So6t,are running at the
user +achine can +a-e decisions about net,or- usage and absorb the co+pleCity o6 the
net,or- tari66s and the 6luctuating prices. Such an Ointelligent agentM can si+ply 6ollo,
policy rules set by the user and opti+i@e decisions at the user#net,or- inter6ace.
Secondly, todayMs technology allo,s charging to be done in co+pleC ,ays, basically
by progra++ing. It is possible to i+ple+ent charging structures in ,hich sophisticated
charges are attributed to potentially +any sta-eholders in the 8alue chain o6 the ser8ice
pro8isioning, and arrange that end#users 6ace only si+ple tari66ing structures, ,hich could
be 6lat rate.
What happens is that the end#user purchases a high#le8el ser8ice, such a contract 6or
a ,eb bro,sing and e+ail ser8ice o6 a gi8en ;uality, an Internet telephony connection,
or 8ie,ing o6 so+e +ulti+edia content. 0his generates a de+and 6or a transport ser8ice
o6 so+e ;uality. 2s 6ar as the end#user is concerned the transport ser8ice and high#le8el
ser8ice are bundled and priced as a single ser8ice. It is the pro8ider o6 the high#le8el ser8ice
,ho +ust 6ind and buy an ade;uate ;uality transport connection 6ro+ a transport ser8ice
pro8ider. It is he ,ho has to deal ,ith the co+pleCity o6 the transport tari66s and perhaps
dyna+ically 6luctuating prices and ;uality. *erhaps he ,ill use so+e sort o6 insurance
contract to protect hi+ 6ro+ eCcessi8e price 6luctuations. 4ne could e8en i+agine that
he uses 6inancial instru+ents, such as 6utures and options, to +anage the ris- in8ol8ed in
buying and selling net,or- ser8ices.
16$6% 2nterconnection and Regulation
It is to usersM ad8antage that the net,or-s o6 di66erent operators interconnect. Creating
larger net,or-s 6ro+ s+aller ones is -ey to unleashing the po,er o6 net,or- eCternalities.
Interconnection is a ser8ice pro8ided a+ong net,or-s to eCtend their ser8ices to larger
custo+er bases. Consider, 6or eCa+ple, three net,or-s, 2, and C, co8ering di66erent
geographical locations, ,ith located bet,een 2 and C. !et,or- can pro8ide
interconnection ser8ice to net,or- 2 by carrying 2Ms tra66ic that is destined 6or C, or by
ter+inating the tra66ic that originates 6ro+ 2Ms custo+ers and is destined 6or Ms custo+ers.
In the 6irst case, the custo+ers o6 2 and C bene6itR in the second case the custo+ers o6 2
and bene6it. In a broader sense, interconnection allo,s users that can be reached through
one net,or- to beco+e custo+ers o6 ser8ices pro8ided by another net,or-. I6 net,or-s
are Oper6ectlyM interconnected, then ser8ices are o66ered in a truly co+petiti8e en8iron+ent
in ,hich a custo+er is 6ree to choose the best ser8ice on o66er. 4ther,ise, the net,or- that
OphysicallyM o,ns the custo+er is in a position to restrict this choice to ser8ices o66ered
only by that net,or- and its allies. Co+petiti8e +ar-ets i+pro8e ser8ice ;uality and result
in lo,er prices, to the ad8antage o6 the consu+er. >urther details o6 interconnection are
pursued in Chapter (2.
0he pre8ious discussion suggests that it is not al,ays to a net,or- pro8iderMs ad8antage
to o66er interconnection ser8ices. y re6using or as-ing una66ordable prices 6or
interconnection, a large net,or- +ay reduce the 8alue o6 s+aller net,or-s and e8entually
6orce the+ out o6 business. In our pre8ious eCa+ple, i6 2 is s+all co+pared to then,
a6ter interconnection
09. R4L. 4> .C4!41ICS ('
,ith , his custo+ers en?oy the sa+e bene6its as the custo+ers o6 , ,hile the operating
costs o6 2 +ay be signi6icantly lo,er Dsince he has no need to +aintain a national
bac-boneE. 2 typical historical eCa+ple o6 using interconnection as a strategic tool 6or
do+inance is the case o6 the ell Syste+ in the 7S. In the early ()00s, the ell Syste+
controlled about hal6 o6 the phones in the 7S and ,as the only co+pany o66ering long#
distance ser8ice. 2s the 8alue to custo+ers o6 long#distance ser8ice increased, the ell
Syste+ re6used to o66er interconnection ser8ices to independent local telephone co+panies.
0his +ade custo+ers s,itch to the ell Syste+ ,hich e8entually beca+e the do+inant
local and long#distance carrier under the corporate na+e o6 20&0 and re+ained so until
its brea-up in ()&$.
2lthough such large natural +onopolies can be 8ery bene6icial to consu+ers, by
deploying nation,ide eCpensi8e in6rastructures and creating de 6acto interoperability
standards 6or net,or- and consu+er de8ices, e8entually they lose +o+entu+ and
beco+e superseded. 4pening the co+petition in these +onopoly +ar-ets re;uires care6ul
inter8ention by the regulator, ,ho +ust set ne, goals that clearly ta-e account o6 ne,
de8eloping technologies, the state o6 the +ar-et and its desired e8olution, the +ar-et
po,er o6 certain players and, +ost i+portantly, con8ey a ne, 8ision. 0he regulator is
the public authority responsible 6or the o8erall health o6 the teleco++unications +ar-et.
9e +ust inter8ene ,here co+petition is reduced and net,or- operators use their +ar-et
po,er in a ,ay that is not socially opti+al. 9e also uses pricing as a control. 9is ai+
is to OopenM net,or-s to co+petitors D+a-e co+ponents o6 ser8ices sold by a net,or- to
its o,n custo+ers a8ailable 6or a price to co+petitorsE, and eCert control o8er such prices
so as to induce operators to co+pete 6airly. 0rue co+petition results in net,or- resources
being used e66iciently and 6or greatest bene6it o6 the industry and users o6 co++unications
ser8ices o8erall. We return to the sub?ect o6 regulation in Chapter (3.
2 -ey to success is +oti8ating D,e use a so6ter ter+ than OobligingME net,or-s
to interconnect in order to achie8e truly co+petiti8e +ar-ets 6or co++unications and
8alue#added ser8ices. I6 success6ul, ,ith no arti6icial barriers, an enor+ous nu+ber o6
players ,ill be 6ree to unleash their creati8e and inspired product and ser8ice ideas in the
co+petiti8e in6or+ation ser8ices +ar-etplace. 9o,e8er, proble+s o6 interconnection can
be di66icult. It can be di66icult to +anage interconnection agree+ents, e.g. to o66er a ser8ice
,ith a ;uality o6 ser8ice guarantee that is respected across net,or-s. It is also di66icult to
share 6airly a+ongst net,or-s the charges that users pay. 0he econo+ic +odels that ha8e
been proposed 6or interconnection are co+pleC, and it is not ob8ious ho, to pro8ide the
right incenti8es 6or interconnection. I6 interconnection prices are unpredictable, this can
deter in8est+ent and co+petition. It can be di66icult to introduce ne, net,or- technology,
as this re;uires agree+ent and i+ple+entation e66ort by all net,or- pro8iders. >or eCa+ple,
no, that I* is the incu+bent protocol 6or the Internet, operators are reluctant to change
that technology or add ne, 6eatures.
I6 interconnection proble+s pro8e too di66icult, then net,or- operators +ay pre6er to
gro, their net,or-s 8ertically and so reduce the ris-s associated ,ith interconnecting ,ith
others and pricing bottlenec- ser8ices. *erhaps the Internet ,ill not e8ol8e to beco+e
a single net,or- that pro8ides high ;uality end#to#end ser8ice bet,een any t,o access
points. Instead, a s+all nu+ber o6 8ertically integrated pri8ate Internets +ay e8ol8e, each
guarding its custo+er base by pro8iding proprietary ser8ices that enco+pass the ,hole
range 6ro+ broadband access to content. 0o protect its custo+er base such a net,or-
+ight arti6icially degrade the ser8ices that custo+ers o6 other net,or-s recei8e. 0his can
be done by degrading the ;uality o6 interconnection ser8ices to other net,or-s. 46 course,
such a sche+e ,ill be stable only i6 custo+ers +ostly use the Internet 6or consu+ing
(
H
*RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
content rather than 6or interacting and co++unicating ,ith other custo+ers. I6 it is +ainly
co++unication and interacti8ity that is sought, then +ar-et de+and ,ill push 6or high
;uality interconnection and thus 6or a true Internet.
ut ho, 6ar should the regulator reachL .Cperts belie8e that although the I* protocol
has allo,ed the creation o6 open, interconnected net,or-s, in reality the net,or-s can
only be as open as the 8arious conduits used to reach the+. Should there be +ore
co+petition in this O6irst +ileM Dthe part o6 the net,or- that reaches indi8idual custo+ersEL
What is the best ,ay to ensure this co+petition and 6or ,hat type o6 in6rastructuresL
3o the incu+bent local telephone operators that o,n the copper local loop in6rastructure
6ace enough co+petition 6ro+ ne, technologies such as the unlicensed +ultihop ,ireless
net,or-s, the +obile ser8ice net,or-s, the lo, cost I* o8er 6ibre net,or-ing technologies
deployed by the ne, co+petitors, and the broadband capabilities o6 the cable +ode+s,
or should they be treated as still ha8ing +onopoly po,erL Should the regulator eCpand
his reach beyond the local and long#haul ,ireline net,or- to include ,ireless, cable
and 6ibre 6acilities as ,ell as 6acilities in ,hich tra66ic is +ultipleCed and de+ultipleCedL
Would such +o8es deter co+panies 6ro+ ta-ing ris-s and in8esting in in6rastructureL 9o,
should such ris-s be co+pensatedL Ai8en that the current 6ibre glut and in6rastructure
o8er pro8isioning +a-es it hard 6or co+panies to reco8er their sun- costs and pay their
debts, should the 6ibre assets o6 the teleco++unications co+panies be nationali@ed, and
these co+panies then +ade to 6ocus on using the in6rastructure to pro8ide ad8anced
8alue#added ser8icesL 4r should the regulator 6a8our hori@ontal consolidation o6 the
in6rastructure co+panies, so as to create a sustainable +ar-et o6 a 6e, playersL What
incenti8es ,ill 6acilitate the rapid introduction o6 those truly broadband ser8ices that
can only be pro8ided o8er 6ibreL 0hese are 6e, o6 the di66icult ;uestions 6aced by the
regulator.
So+e trends in +odern technology challenge traditional regulation concepts. !e,
access technologies such as ,ireless .thernet, ,hich consu+e public spectru+ ,ithout
license 6ro+ a central authority, are essentially sel6#regulating. Such ne, decentrali@ed and
sel6#+anaged net,or-s e8ol8e dyna+ically in an ad hoc 6ashion and pose ne, ;uestions 6or
regulators accusto+ed to +a-ing decisions 6or syste+s that e8ol8e on longer ti+escales.
16% Preliminary modelling
2s ,e ha8e seen, net,or- ser8ices are econo+ic goods, ,hich a net,or- pro8ides through
use o6 its resources o6 lin-s, s,itches, hard,are, so6t,are and +anage+ent syste+s. 0his
section introduces so+e o6 the basic econo+ic concepts that are use6ul in reasoning about
+ar-ets and in +a-ing pricing decisions. We loo- at so+e eCa+ples, co+pare the +erits
o6 6lat rate and usage#based charging, and identi6y so+e i+portant structural properties o6
good tari66s. We see ho, a price can be used to share a congested resource. 0hese ideas
are pursued +uch 6urther in the econo+ics tutorials o6 Chapters ' and H.
16%61 1efinitions of Charge9 Price and !ariff
4ur consistent ter+inology in this boo- is that the charge is the a+ount that is billed 6or
a ser8ice. y $rice ,e +ean an a+ount o6 +oney associated ,ith a unit o6 ser8iceR this is
used to co+pute the charge. 0he tari'' re6ers to the general structure o6 prices and charges.
2 eCa+ple o6 a tari66 is a C $T , ,here a is a price 6or setting up, $ is a price per second
6or using the ser8ice, and T is the duration o6 the connection in seconds.
*R.LI1I!2R/ 143.LLI!A (%
2 tari66 is that part o6 the contract bet,een t,o parties that speci6ies the ,ay the charge
,ill be co+puted 6or the ser8ice. Its structure can a66ect the partiesM beha8iour. Consider,
6or instance, the tari66 used to co+pute a taCi 6are. It is co++on 6or such a tari66 to be
o6 the 6or+ a C *T C c/ , ,here a is the a+ount paid at the start, and T and / are the
duration and the distance o6 the ride respecti8ely. 2 6eature o6 so+e taCi +eters is that the
+etering o6 T and / are +utually eCclusi8e" i6 the speed o6 the taCi is less than a certain
a+ount then ti+e is +eteredR other,ise distance is +etered. What incenti8es does this tari66
gi8e to the taCi dri8erL 4bser8e that i6 * is 8ery large this gi8es the dri8er an incenti8e to
prolong the duration o6 the ride, rather than to co+plete the trip ;uic-ly. 9o,e8er, i6 * is
8ery s+all there is an incenti8e to a8oid congested areas, and no taCi +ay be a8ailable in
parts o6 the city. 0he dri8ing pattern is also a66ected since, ,hen dri8ing bet,een tra66ic
lights, the dri8er has the incenti8e is to dri8e as 6ast as possible bet,een the lights and then
spend as +uch ti+e as possible ,aiting 6or red lights to turn greenR thus stop<start dri8ing
is encouraged. 2 si+ilar encourage+ent o6 OburstyM beha8iour is also encountered Dbut 6or
other reasonsE in the case o6 tra66ic contracts in co++unication net,or-s. Interestingly, the
de+and 6or taCis also in6luences the ,ay their dri8ers ,ill dri8e. I6 there is little de+and
6or taCis, as during the nights, and total / is -no,n 6ro+ pre8ious eCperience, then dri8ers
ha8e the incenti8e to +aCi+i@e duration o6 trips. 3uring the day ,hen de+and 6or taCis
is high, the 6iCed charge a, gi8es the right sort o6 incenti8eR dri8ers are encouraged to use
+ini+u+ distance routes and +ini+i@e the length o6 rides. 2part 6ro+ the stop<start dri8ing
bet,een lights, this suits the custo+er ,ell.
16%6 /lat Rate versus 8sage Charging
2n Oall#you#can#eatM restaurant pro8ides an eCa+ple o6 ho, a 6lat#6ee tari66 can gi8e the
,rong incenti8es. Since custo+ers pay one 6lat 6ee to enter the restaurant and are then 6ree
to eat as +uch as they ,ish, they tend to o8er eat. 0his ,astes 6ood D,hich is analogous
to ,asting net,or- resourcesE. Interestingly, the health o6 custo+ers also su66ers because
they are encouraged to o8er eat. 0he 6lat 6ee +ust co8er the cost o6 the a8erage custo+er
i6 the restaurant is to reco8er its cost. Light eaters ,ill 6eel cheated i6 they ha8e to pay 6or
+ore than they consu+eR the custo+er base ,ill decrease and the restaurant ,ill +a-e less
pro6it. !ote that +any Internet tari66s are presently o6 a 6lat 6ee type.
9o, can one pro8ide incenti8es that a8oid the o8ereating proble+L 2 si+ple re+edy is
to charge a custo+er 6or ,hat he actually consu+esR this happens ,hen a restaurant has an
a0 lacarte +enu. !o, each custo+er chooses the +eal that pro8ides hi+ ,ith the
greatest satis6action and 8alue#6or#+oney. 0he custo+er has co+plete control o8er his
choice o6 +eal, can see its price on the +enu and predict his charge. 7n6ortunately, the
charge is not as predictable ,hen usage#based charging is used 6or net,or- ser8ices. 2
net,or- user cannot usually predict accurately the tra66ic 8olu+e that ,ill result 6ro+ his
interaction ,ith the net,or- and so predict his charge Dthough he +ight be able to do so
i6 he ,ere using a speci6ic application, such as constant bit rate 8ideoE.
Is a si+ple usage charge enoughL I6 an a0 lacarte restaurant charges only 6or the
6ood consu+ed then there is danger that so+e custo+ers +ight occupy their table si+ply to
sociali@e and not order any 6ood. 2 tari66 that has the right incenti8es should ta-e account
o6 the 6act that resource reser8ation is costly in itsel6, independently o6 the cost o6 the actual
resources consu+ed. 0his is ,hy restaurants +a-e so+eti+es +a-e a Oco8er chargeM.
0he telephone net,or- and the present Internet are ali-e in that they transport bits at a
single ;uality. y so+e +easures the telephone net,or- pro8ides better bit ;uality, but it
(& *RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
is also +ore eCpensi8e to build. .Ctensions o6 the Internet protocols and technologies such
as 201 allo, data bits to be transported at di66erent le8els o6 ;uality. 0he relation bet,een
;uality o6 ser8ice and price is a +a?or the+e o6 this boo-. 2s ,e ,ill see, it +a-es +ore
econo+ic sense 6or custo+ers to choose bit ;ualities that are +atched to their needs, than
6or the net,or- to allocate all users the sa+e bit ;uality.
16%6$ 1ynamic Pricing in an 2nternet Cafe
2n interesting approach 6or pricing Internet access is used by a popular chain o6 Internet
ca6es in .urope DeasyInternetCa6eE. 0he price per unit ti+e that is charged 6or using a
co+puter ter+inal is not 6iCed throughout the day but 8aries dyna+ically to re6lect de+and.
2 user pays a 6iCed price 6or a tic-et, say Q3, and then gets +ore or less Internet access
ti+e, depending on the ti+e o6 day and the nu+ber o6 ter+inals that are busy at the ti+e
he buys the tic-et. 0he day is di8ided into three periods" the Opea-M period D((a+:3p+E,
the Oo66M period D(a+:)a+E, and the Onor+alM period Dall other ti+esE. In the o66 period
a tic-et buys ('0 +inutes. In other periods, the price depends upon the nu+ber o6 busy
ter+inals, n, ,here 0 n $'0. 3uring nor+al ti+e, the user recei8es ('0, (20 or
)0 +inutes as n lies in the range 0:('0, ('(:300 or 30(:$'0, respecti8ely. 3uring pea-
ti+e, the +inutes are reduced to )0, H0 or 30 +inutes, respecti8ely 6or the sa+e ranges
o6 n. D0his is not eCactly the sa+e charging sche+e as used in the stores but illustrates
the sa+e ideas.E I6 no ter+inals are a8ailable a custo+er has to ,ait 6or one to beco+e
a8ailable.
4bser8e that, although the price 6or a tic-et is 6lat, the a+ount o6 usage 8aries. 0o
obtain +ore ti+e a user can buy +ore tic-ets. What are the +erits o6 such a pricing
sche+eL Custo+ers 8alue Din addition to good co66eeE s+all ,aiting ti+e and con8enience
Do6 accessing the Internet ,hen they need it, rather than postponing it to a di66erent ti+eE.
S Setting lo,er prices 6or o66#pea- ti+es reduces de+and during pea- ti+es since
custo+ers that do not 8alue con8enience can choose a cheaper ti+e.
S 7se o6 dyna+ic prices +a-es it less probable that a custo+er +ust ,ait 6or a ter+inal.
0his is because ,hen de+and is high Di.e. there are 6e, 6ree ter+inalsE, custo+ers ,ill
spend less ti+e on#line due to the greater price per +inute. 0hey use their ti+e +ore
e66iciently by ,asting less ti+e in being connected to the Internet ,hen it is o6 no
econo+ic 8alue, and so +ore custo+ers can use the syste+.
S When there is no OcongestionM indications, i.e. n is s+all, the ti+e is not unnecessarily
reduced, o66ering the best possible 8alue to the custo+ers. 0his nice sel6#regulating e66ect
is not achie8ed by a 6lat ti+e tic-et.
S I6 the cost incurred by ,aiting is 8ery high, one +ay si+ply create one +ore usage @one,
say 6or $00 n $'0, and reduce the tic-et ti+e e8en 6urther. Such si+ple correcti8e
actions are straight6or,ard to i+ple+ent and re;uire no sophisticated analysis. Si+ilarly,
i6 the usage o6 the ter+inals is obser8ed to be rather lo, during a particular ti+e period,
one +ay increase the tic-et ti+es. Such a syste+ ,or-s 8ery +uch li-e a ther+ostat
,hich turns the burner on and o66 using 6eedbac- 6ro+ te+perature +easure+ents.
!ote that it is easier to build a ther+ostat than to sol8e the di66erential heat e;uations to
co+pute the eCact acti8ity patterns o6 the burner Dthe opti+al a8erage price independent
o6 nE.
0he botto+ line is that dyna+ic pricing, ,hich uses 6eedbac- 6ro+ the syste+, can better
control de+and 6or resources. 0he o8erall 8alue that custo+ers obtain is greater, leading
the+ to pre6er this ca6e o8er others. Indeed, the charging sche+e +ay be used to shape
de+and and resource usage and to +aCi+i@e the 8alue o6 the ser8ice to the custo+ers,
,
*R.LI1I!2R/ 143.LLI!A ()
rather than si+ply +aCi+i@ing re8enue. 0he ca6e o,ner can capture so+e o6 the eCtra
8alue creates 6or his custo+ers by raising the price o6 co66ee. .cono+ic theory suggests
that such a strategy +ay generate greater pro6it than si+ply setting prices to +aCi+i@e
re8enue 6ro+ Internet access alone.
16%6% A *odel for Pricing a Single Link
Suppose a net,or- operator o,ns a lin- bet,een 2thens and London o6 capacity C bits
per second and that the only ser8ice he sells is constant bit rate transport. Suppose that
there are N custo+ers ,ho ,ould li-e to use so+e o6 this transport capacity. 9o, +ight
C be di8ided a+ongst these usersL In other ,ords, gi8en that user i is allocated ,
i
bits per
second, ho, should the operator choose ,
(
R " " " R ,
N
, sub?ect to the constraint that they su+
to no +ore than C L
0o +a-e the proble+ +ore interesting and realistic let us re;uire that it is the technology
o6 the net,or- that +ust decide ho, the band,idth is shared, rather than the net,or-
operator directly. Suppose each custo+er has an indi8idual access pipe o6 capacity C to the
2thens:London lin-. I6 the total band,idth that the custo+ers ,ould li-e to use is less than
C , then there is no di66iculty in pro8iding each custo+er ,ith his 6ull re;uest. 9o,e8er,
since each custo+er could co+pletely 6ill the lin- ,ith his o,n tra66ic, the net,or- +ust
i+ple+ent so+e sharing policy or +echanis+ to decide ho, to share the capacity o6 the
lin- a+ong the co+peting custo+ers ,hen their total de+and eCceeds C . 0his policy could
try to share capacity O6airlyM, as de6ined in so+e technologically dependent ,ay.
Suppose the net,or- operator can co+pletely control the ,ay capacity is allocated. 4ne
o6 +any possible policies is to si+ply allocate an e;ual share o6 the band,idth to each
user, so that ,
i
3 C N N . 2 +ore sophisticated +ethod, ,hich ta-es account o6 custo+ersM
re;uests, is to use the so#called 'air shares algorithm . 2t the 6irst step o6 the algorith+ each
custo+er is allocated his re;uested band,idth or C N N , ,hiche8er is s+aller. 26ter these
allocations are +ade, any re+aining band,idth is shared in a si+ilar ,ay a+ongst the
custo+ers ,hose re;uests ,ere not 6ully satis6ied at the 6irst stepR this is done by rede6ining
the para+eters N as the nu+ber o6 re+aining custo+ers ,ith unsatis6ied re;uests and
rede6ining C as the band,idth not yet allocated. 0he algorith+ repeats si+ilarly until all
band,idth is allocated.
9o,e8er, these +ethods o6 allocating band,idth ignore the 6act that custo+ers do not
8alue band,idth e;ually. 2n allocation o6 ,
i
+ight be ,orth u
i
.,
i
< to user i . 9ere u
i
is
called the utility 'unction o6 user i . I6 the net,or- is pro8ided by a public authority then
a reasonable goal +ight be to +aCi+i@e the o8erall 8alue that custo+ers obtain by their
use o6 the net,or-. 0o do this, the net,or- operator needs its custo+ers to +a-e truth6ul
declarations o6 their utilities. In practice, it is usually i+possible to gain direct -no,ledge
o6 utility 6unctions. Let P denote the proble+ o6 +aCi+i@ing the total user bene6it. 0his is
N
P " +aCi+i@e
J
u
i
.,
i
< R sub?ect
to
N
J
,
i
C
,
(
R"""R,
N
i 3( i 3(
2n i+portant starting point 6or engineering a solution is that the 6act that i6 each u
i
is a
conca8e increasing 6unction, then there eCists a price $! such that P can be sol8ed by the
si+ple +ethod o6 setting this price, and then allo,ing each user i to choose his ,
i
to sol8e
the proble+
+aCi+i@e Tu
i
.,
i
< $! ,
i
U
D(.(E
i
i
i
i
0he 6act that there eCists a
$! to +a-e this possible 6ollo,s 6ro+ the 6act that $! is the
Lagrangian +ultiplier ,ith ,hich ,e can sol8e the constrained opti+i@ation proble+ P
Dsee 2ppendiC 2E.
Let ,
i
. $! < be the +aCi+i@ing 8alue o6 ,
i
in D(.(E, eCpressed as a 6unction o6 the
price $! . We call ,
i
. $< user i Ms demand 'unction . It is the a+ount o6 band,idth he
,ould ,ish to purchase i6 the price per unit band,idth ,ere $. 7nder our assu+ptions
on u
i
, ,
i
. $< decreases as $ increases. Let us suppose that at a price o6 0 the
custo+ers ,ould in aggregate ,ish to purchase +ore than C , and ,hen $ is su66iciently
large they ,ould ,ish to purchase less that C . It 6ollo,s that, as $ increases 6ro+ 0, the
total a+ount o6 band,idth
that the custo+ers ,ish to purchase, na+ely
*
,
i
. $<, decreases 6ro+ a 8alue eCceeding
C to,ards 0, and at so+e 8alue, say $ 3 $! , ,e ha8e
*
,
i
. $! < 3 C . y setting the price
at
$! the operator ensures that the total band,idth purchased eCactly eChausts the supply and
that it is allocated a+ongst users in a ,ay that +aCi+i@es the total bene6it to the society
o6 custo+ers ta-en as a ,hole.
0his solution to proble+ P has a nu+ber o6 desirable properties. >irst, the net,or-
need not -no, the utility 6unctions o6 the users. Secondly, the decisions are ta-en
in a decentrali@ed ,ay, each user rationally choosing the best possible a+ount o6
band,idth to buy. 0hirdly, since the price is chosen so that de+and e;uals capacity, the
net,or- technologyMs sharing policy does not inter8ene. 7sers decide the sharing a+ongst
the+sel8es, ,ith price ser8ing as a catalyst. 9ence, price ,or-s as a -ind o6 6lo, control
+echanis+ to shape the de+and.
0he operator +ay or +ay not be happy ,ith this solution. 9e has obtained a total re8enue
e;ual to $! C , ,hich o6 course e;uals $!
*
,
i
. $! <. Custo+er i is le6t ,ith a Ouser
surplusM
o6 u
i
.,
i
. $! << $! ,
i
. $! <. 0he total 8alue to society o6 the 2thens:London lin- has
been
+aCi+i@ed and then di8ided a+ongst the operator and custo+ers. 9o,e8er, it is has not
been e;ually di8ided a+ongst the custo+ers, nor in a ,ay that specially 6a8ours the operator
or ta-es account o6 his costs.
I6 our operator is not sub?ect to co+petition or regulation he +ight li-e to capture all
the bene6it 6or hi+sel6R he can do this i6 he can present each custo+er ,ith a custo+i@ed
o66er. 9e si+ply says to custo+er i , Oyou +ay buy ,
i
. $! < units o6 band,idth 6or a
penny less than u
i
.,
i
. $! << K ta-e it or lea8e itM. 7ser i is better o66 by a penny i6 he
accepts this o66er, so he ,ill do so, but the operator gains all the 8alue o6 the lin-, +inus N
pennies. I6 the operator cannot +a-e each custo+er such a ta-e#it#or#lea8e#it o66er, he still
+ight say,
Oyou +ay can ha8e any a+ount o6 band,idth you li-e, but at a price o6 $
i
per unitM. 0hat
is, he ;uotes di66erent prices to di66erent custo+ers. 2s ,e see in Section H.2.( the operator
+aCi+i@es his re8enue by ;uoting higher prices to custo+ers ,ho are less price sensiti8e.
In practice, the operator does not usually -no, +uch about his custo+ers, and it is 8ery
unli-ely that he -no,s their utility 6unctions. 1oreo8er, he cannot usually tailor prices
to indi8idual custo+ers. !onetheless, ,e ,ill 6ind that so+e charging sche+es are better
than others. So+e sche+es gi8e custo+ers a greater incenti8e to act in ,ays that +aCi+i@e
,el6are. 4ther sche+es enable the operator to obtain a greater pay+ent, thereby obtaining
a greater part o6 the lin-Ms 8alue 6or hi+sel6.
Let us ta-e the second o6 these 6irst. 0here are 8arious ,ays in ,hich the operator can
eCtract a greater pay+ent. 9e +ay present users ,ith nonlinear prices. >or eCa+ple, he can
+a-e a subscription charge, or 8ary the price per unit band,idth according to the ;uantity
a user purchases. 9e +ay o66er di66erent prices to di66erent groups o6 custo+ers De.g. ho+e
and business custo+ersE. 4r he +ay de6ine 8ersions o6 the transport ser8ice, such as day
and night ser8ice, and o66er these at di66erent prices.
i
2 A7I3. 04 S7S.=7.!0 C92*0.RS 2(
I6 the operator is constrained to sell the band,idth at a single price his ob?ecti8e 6unction
is $
*
,
i
. $<, ,hich +ay be +aCi+i@ed 6or a $ 6or ,hich not all o6 the band,idth is sold.
46 course he +ust al,ays ha8e an eye on the co+petition, on his desire to gro, his
custo+er base, and to 6und the costs o6 building, +aintaining and eCpanding his net,or-.
0hus 6ar, ,e ha8e ta-en a 8ery si+ple 8ie, o6 both the ser8ice and the net,or-. 1any
+odern ser8ices are not best pro8ided 6or by si+ply allocating the+ a constant bit rate pipe.
2 custo+erMs ser8ice re;uire+ent is better#8isuali@ed as his need to transport a strea+ o6
pac-ets, ,hose rate 6luctuates o8er ti+e. 0he custo+er +ay be able to tolerate loss o6 a
proportion o6 the pac-ets, or so+e delay in their deli8eryR he +ay be able to assist the
net,or- by guaranteeing that the rate at ,hich he sends pac-ets ne8er eCceeds a speci6ied
+aCi+u+.
Suppose that a custo+er has utility 6or a transport ser8ice that can be characteri@ed in
ter+s o6 so+e set o6 para+eters, such as acceptable +ean pac-et delay, acceptable pea-
rate, +ean rate, and so on. Chapters 2 and 3 describe ,ays that such ser8ices can be
pro8ided. Suppose there are 1 such ser8ices types and ,e label the+ (R " " " R 1 . 2s ,e
sho, in Chapter $, it can be a good approCi+ation to suppose that the supplierMs lin-
can si+ultaneously carry n
(
R " " " R n
1
connections o6 each o6 these ser8ices, at guaranteed
;ualities o6 bit trans6er, pro8ided
*
2
n
2
V
2
C , ,here V
(
R " " " R V
1
and C are
nu+bers
that depend on the burstiness o6 the sources, the lin-Ms resources and the eCtent to ,hich
statistical +ultipleCing ta-es place. 0he supplierMs proble+ is to decide ho, to charge 6or
these 1 di66erent ser8ices. !ote that proble+ P has a ne, di+ension, since the constraint
no, in8ol8es 6V
(
R " " " R V
1
g.
We continue discussion o6 this proble+ in Chapter &. 4ne +ust be cautious in applying
econo+ic +odels. *ricing is an art. !o single theory can ,eigh up all the i+portant 6actors
that +ight a66ect pricing decisions in practice. !o single prescription can su66ice in all
circu+stances. 0here are +any technology aspects that +ust be ta-en into account, such as
;uality o6 ser8ice, +ulti#di+ensional contracts, net,or- +echanis+s 6or con8eying price
in6or+ation, the capabilities to support dyna+ic prices, and the po,er and responsibility
o6 edge de8ices. It is particularly di66icult to price a good 6or ,hich custo+ers ha8e
pre6erences o8er attributes that are di66icult to +easure, such as brand na+e, ser8ice
reliability, accessibility, custo+er care, and type o6 billing. 1ar-eting strategies that ta-e
account o6 such attributes can lead to prices that see+ rather ad hoc. 0his is particularly
true in the +ar-et 6or co++unications ser8ices.
16& A guide to subse:uent cha'ters
In Chapters 2:$ o6 *art 2, ,e eCpound the 6unda+ental 6ra+e,or- and concepts that ,e
use to thin- about net,or- ser8ices. We eCplain the i+portant concepts o6 ser8ice contract
and net,or- control. 2s eCa+ples, ,e describe the ser8ices pro8ided by 201 and the
Internet. We introduce the idea o6 e66ecti8e band,idths, ,hich are the -ey to addressing
;uestions o6 pricing ser8ices that ha8e ;uality o6 ser8ice guarantees.
In Chapters ' and H o6 *art , ,e present so+e -ey econo+ic concepts that are rele8ant
to pricing. 0he +aterial in these chapters ,ill be 6a+iliar to readers ,ith a bac-ground in
econo+ics and a use6ul tutorial 6or others.
*art C is on 8arious approaches to pricing and charging 6or ser8ice contracts. !o one
approach can be applied auto+atically in all circu+stances. 0he designer o6 a charging
sche+e needs to consider the type o6 ser8ice contract that is being priced, and ,hether
the ai+ o6 pricing is 6airness, cost reco8ery, congestion control or econo+ic e66iciency.
22 *RICI!A 2!3 C4117!IC20I4!S !.0W4RBS
Chapter % describes cost#based pricing +ethods and discusses ho, such +ethods are used
in practice in the teleco++unications industry. Chapter & is concerned ,ith charging 6or
guaranteed contracts Dthose ,ith certain agreed contract para+eters, such as the pac-et
loss probabilityE. Chapter ) discusses congestion pricing. Chapter (0 is concerned ,ith
charging 6or 6leCible contracts Dthose in ,hich certain contract para+eters, such as pea-
rate, are allo,ed to change during the li6e o6 the contractE.
*art 3 concludes ,ith discussions o6 the special topics o6 +ulticasting, interconnection,
regulation and auctions DChapters ((:($E. 2uctions are o6 interest because they are o6ten
used to sell i+portant resources to the teleco+s industry. 2lso, auction +echanis+s ha8e
been proposed 6or allocating net,or- resources to users in real ti+e.
16( /urther reading
0here are +any eCcellent boo-s on the digital econo+y and on the i+pact o6 the ne,
technologies, especially the Internet. Shapiro and Garian D())&E gi8e an econo+istMs
perspecti8e on the rules that go8ern +ar-ets 6or in6or+ation goods. Belly D()))E gi8es
a ,onder6ul introduction to the Internet econo+y and the ne, concepts that apply to it.
2nother ,ell#,ritten boo- is that o6 3o,nes, 1ui and !egroponte D2000E, ,hich eCplains
the interaction bet,een the la,s o6 1etcal6 and 1oore. 0hese la,s are, respecti8ely, that
Othe 8alue o6 a net,or- increases as about the s;uare o6 the nu+ber o6 usersM, and Othe
nu+ber o6 transistors in co+puter chips doubles e8ery eighteen +onthsM. 0he ,eb pages
o6 .cono+ides D2002E and Garian D2002E contain re6erences to +any papers on issues o6
net,or- econo+ics, and pointers to other rele8ant sites.
2 great source o6 articles on the e8olution o6 the Internet and related econo+ic issues is
the ho+e page o6 4dly@-o D2002E, and a good source 6or in6or+ation on +any issues o6
the Internet teleco+s industry is 0he Coo- Report on Internet, Coo- D2002E. Isenberg and
Weinberger D200(E describe the $arado, o' the *est network " na+ely, Othe best net,or- is
the hardest one to +a-e +oney runningM.
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)

!et,or- Ser8ices and Contracts


It is use6ul to distinguish bet,een Ohigher#le8elM and Olo,er#le8elM ser8ices. 9igher#le8el
ser8ices are those that inter6ace directly ,ith custo+ers. Lo,er#le8el ser8ices are those
that custo+ers use indirectly and ,hich are in8isible to the+. Consider, 6or eCa+ple, the
Internet as it is used by students and sta66 o6 a uni8ersity. 4ne higher#le8el ser8ice is
e+ailR another is ,eb bro,sing. Web bro,sing uses the lo,er#le8el ser8ice o6 Internet
data transport to eCchange data bet,een usersM ter+inals and the ser8ers ,here ,eb pages
reside. 0he ;uality o6 the higher#le8el ,eb bro,sing ser8ice depends on the ;uality o6 the
lo,er#le8el transport ser8ice. 0hat is, the speed at ,hich ,eb pages ,ill be deli8ered to
users partly depends on the ;uality o6 the net,or-Ms data transport ser8ice. 0his ,ill be
speci6ied in a contract bet,een the uni8ersity and the net,or-.
2 transport ser8ice can be de6ined in +any ,ays. It can be de6ined in ter+s o6 a
guarantee to transport so+e a+ount o6 in6or+ation, but ,ithout any guarantee about ho,
long this ,ill ta-e. It can 6ully speci6y the per6or+ance that is to be pro8ided, and do
this at the start o6 the ser8ice. 2lternati8ely, it can respond to changing net,or- load
conditions, and continuously renegotiate so+e ;ualities o6 the in6or+ation trans6er ,ith
the data source. We in8estigate these possibilities in this chapter.
>inally, ,e note that the pro8ision o6 a ser8ice in8ol8es not only a 6lo, o6 in6or+ation,
but also a 6lo, o6 8alue. >lo, o6 in6or+ation concerns data transport, ,hereas 6lo, o6
8alue concerns the bene6it that is obtained. 4ne or both parties can bene6it 6ro+ the 6lo,
o6 8alue. 9o,e8er, i6 one party en?oys +ost o6 the 8alue it is reasonable that he should
pay 6or the ser8ice. >or eCa+ple, i6 an in6or+ation ser8er sends a custo+er ad8ertise+ents
then the in6or+ation 6lo, is 6ro+ ser8er to custo+er, but the 8alue 6lo, is 6ro+ custo+er
to ser8er, since it is the ad8ertiser ,ho pro6its. 0his suggests that the ser8er should pay. I6,
instead, the custo+er re;uests data 6ro+ the ser8er, then 8alue 6lo,s to the custo+er and
so the custo+er should pay. !ote that it is neither the initiator o6 the transport ser8ice, nor
the one ,ho sends in6or+ation that should necessarily pay.
0his chapter is about 8arious characteristics o6 ser8ices, independently o6 charging
issues. In Section 2.( ,e discuss a classi6ication o6 the net,or- ser8ices according
to di66erent characteristics. We also pro8ide a pri+er to present technology, in ,hich
,e eCplain the characteristics o6 the +ost co++on net,or- ser8ice technologies.
*lease note that the 6igures that ,e ;uote 6or 8arious para+eters, such as S4!.0Ms
+aCi+u+ line speed o6 (0 Abps, are continually changing. 0he concepts that ,e present
do not depend on such para+eter 8alues. In Section 2.2, ,e discuss generic issues
2$ !.0W4RB S.RGIC.S 2!3 C4!0R2C0S
related to contracts 6or net,or- ser8ices, 6ocusing on issues o6 ;uality o6 ser8ice and
per6or+ance.
61 A classification of network services
2t its +ost basic le8el a net,or- pro8ides ser8ices 6or transporting data bet,een points in
the net,or-. 0he transport ser8ice +ay carry data bet,een ?ust t,o points, in ,hich case
,e ha8e a unicast service. 4r it +ay carry data 6ro+ one point to +any points, in ,hich
case ,e ha8e a multicast service.
0he points bet,een ,hich data is carried can be inside the net,or- or at its periphery.
When a ,eb ser8er connects ,ith a userMs bro,ser then both points are at the periphery.
When an access ser8ice connects a custo+erMs ter+inal e;uip+ent to the net,or- o6
a di66erent ser8ice pro8ider then the custo+erMs point is at the periphery and the
point connecting to the di66erent ser8ice pro8iderMs net,or- is inside. When a net,or-
interconnects ,ith t,o other net,or-s then both points are inside. 0hus net,or- operators
can buy or sell transport ser8ices a+ongst the+sel8es and collaborate to pro8ide transport
ser8ices to end#points residing on di66erent net,or-s. We see all these things in the Internet.
>or si+plicity, ,e o6ten re6er to a large collection o6 cooperating net,or-s that pro8ide a
gi8en transport ser8ice as Othe net,or-M.
6161 Layering
Ser8ice layering is co++on in co++unication net,or-s. 2 higher layer ser8ice consu+es
lo,er layer ser8ices and adds 6unctionality that is not a8ailable at the lo,er layers. Ser8ices
o6 8arious layers can be sold independently, and by di66erent ser8ice pro8iders. 2n eCa+ple
o6 a higher layer ser8ice is an end#to#end transport ser8ice that connects custo+er
e;uip+ent at t,o periphery points o6 the net,or-. 0his ser8ice uses lo,er layer ser8ices,
so+e o6 ,hich are strictly internal to the net,or-R these lo,er layer ser8ices pro8ide
connecti8ity bet,een internal nodes o6 the net,or- and the access service that connects the
usersM e;uip+ent to the net,or-. 0he end#to#end ser8ice +ay perhaps add the 6unctionality
o6 retrans+itting in6or+ation lost by the lo,er#le8el ser8ices.
2 si+ple analogy can be +ade by considering a net,or- o6 three con8eyor belts. 4ne
connects node 2 to node . 0,o others connect node to nodes C and 3. Suppose that
each con8eyor belt is slotted and pro8ided ,ith 6iCed si@e bins that +o8e ,ith the belt.
*arcels are inserted into the bins so that they do not 6all o66 the belts ,hile tra8elling. In
order to pro8ide an end#to#end ser8ice 6ro+ 2 to C and 3, so+e additional 6unctionality
is needed. >or instance, bins tra8elling bet,een 2 and +ight be coloured red and blue.
*arcels arri8ing in a red bin at node are assigned by a cler- to continue their ?ourney on
the con8eyor belt 6ro+ to C, ,hereas parcels in the blue bins continue on the con8eyor
belt 6ro+ to 3. Cler-s are needed to read the destination addresses, 6ill the di66erent
colour bins on the con8eyor belt, and e+pty the bins that arri8e at nodes C and 3. 46
course there are other ,ays to build the sa+e end#to#end ser8ice, 6or instance, ,e could
use bins o6 ?ust one colour on the belt 6ro+ 2 to , but ha8e a cler- at node chec-
the destination address o6 each arri8ing parcel to decide ,hether it should neCt be placed
on belt C or 3. 2 -ey 6eature o6 this setup is the layering o6 ser8ices" one or +ore
co+panies +ay pro8ide the basic con8eyor ser8ices o6 con8eyor belts 2, C and 3,
,hile another co+pany pro8ides and +anages the bins on top o6 the con8eyor belts. /et
another co+pany +ay pro8ide the ser8ice o6 6illing and e+ptying the bins Despecially
2 CL2SSI>IC20I4! 4> !.0W4RB S.RGIC.S 2'
2'
i6 bins are a single colour and the destination address o6 the parcels +ust be chec-ed
at point E. 0hus, our setup has three layers o6 ser8ice. 0he 6irst layer is the con8eyor
ser8ice 2. In Internet ter+s it is analogous to an access ser8ice, ,hich connects the
e;uip+ent o6 custo+er 2 to the net,or- by, say, a dial#up connection. 0ypically, an
Internet ser8ice pro8ider pro8ides the other t,o layers o6 ser8ice Do6 running the con8eyors
internal to the net,or-, and +anaging and 6illing the bins on the con8eyors, including
the access partE. So+eti+es, a third party pro8ides all three layers o6 ser8ice in the
access part.
Let us illustrate these concepts in +ore depth by brie6ly describing transport ser8ice
layering in an actual eCa+ple 6ro+ the current Internet. We 8ie, the Internet as a single
net,or- using layers o6 di66erent technologies. >urther treat+ent o6 these ser8ices is
pro8ided in Section 3.3.
616 A Sim'le !echnology Primer
0he basic Internet transport ser8ice carries in6or+ation pac-ets bet,een end#points o6 the
Internet in +uch the sa+e ,ay as the post o66ice deli8ers letters. Letters that are going to
the sa+e city are sorted into large +ail bags, ,hich are loaded onto airplanes, and then
deli8ered to a central point in the destination city. 0he letters are then regrouped into the
s+aller +ail bags that post+en can carry on their routes.
Just as the post o66ice uses airplanes, 8ans and 6oot, and di66erent si@e containers and +ail
bags, so Internet transport ser8ice uses +any di66erent transport technologies. 0hese include
.thernet, 2synchronous 0rans6er 1ode D201E, Synchronous 3igital 9ierarchy DS39E,
Synchronous 4ptical !et,or- DS4!.0E, and 3ense Wa8elength 3i8ision 1ultipleCing
D3W31E. 0hese technologies are described in Sections 3.3.2:3.3.'. We introduce the basic
technologies in an in6or+al ,ay that +oti8ates their particular use.
>or the +o+ent, ,e e+phasi@e the 6act that each o6 the abo8e technologies pro8ides
a ,ell#de6ined transport ser8ice and pac-ages in6or+ation in di66erent si@e pac-ets. 0he
pac-ets o6 one ser8ice +ay act as containers 6or pac-ets o6 another ser8ice. Suppose, 6or
si+plicity, that the post o66ice transports 6iCed si@e pac-ets bet,een custo+ers. 2 transport
co+pany pro8ides a container ser8ice bet,een local post o66ices at 2 and by running
s+all 8ans o6 6iCed capacity at regular inter8als bet,een 2 and . *rior to the departure
o6 a 8an 6ro+ 2, the local post o66ice 6ills the 8an ,ith the pac-ets that are ,aiting to be
deli8ered to the post o66ice at . Such a ser8ice is a paradig+ o6 a synchronous container
service, since it operates at regular inter8als and hence o66ers a 6iCed transport capability
bet,een point 2 and . 0he S4!.0 or S39 ser8ices are eCa+ples o6 synchronous ser8ices
in co++unications net,or-s.
I6 each 8an can hold at +ost k pac-ets then the unit o6 in6or+ation trans6er bet,een
points 2 and is a container o6 si@e k. I6 a 8an departs e8ery t seconds, then the capacity
o6 the container ser8ice is kNt pac-ets per second. D>or data, ,e +easure capacity in bits
per second, or -ilobits, 1egabits or Aigabits per second.E 4bser8e that containers +ay not
be 6illed co+pletely, in ,hich case the eCtra space is ,asted. We can eCtend this type o6
synchronous container ser8ice by supposing that the transport co+pany uses larger 8ans, o6
container si@e (0k, again lea8ing e8ery t seconds. 0hese containers can be 6illed by s+aller
OsubcontainersM o6 si@es that are +ultiples o6 k, and custo+ers can rent such space in the+
Dpro8ided that the su+ o6 the si@es o6 the subcontainers does not eCceed (0kE. 0he post
o66ice could obtain the sa+e ser8ice as be6ore by renting a subcontainer ser8ice o6 si@e k.
Si+ilarly, an operator running a H22 1bps S4!.0 ser8ice bet,een points 2 and can
2H !.0W4RB S.RGIC.S 2!3 C4!0R2C0S
sell 6our distinct ('' 1bps S4!.0 connections bet,een these points Da6ter reser8ing t,o
o6 the H22 1bps to control the connectionE.
What happens i6 custo+ers cannot e66ecti8ely 6ill the s+allest si@e subcontainersL Say
the post o66ice tra66ic bet,een points 2 and has a +aCi+u+ rate o6 0"'kNt pac-ets per
second, and so can ?usti6y using containers o6 si@e at +ost 0"'k, but there are other potential
custo+ers ,ho can also use 6ractions o6 k. 0hen there is a business opportunity 6or another
operator, ,ho buys the k container si@e ser8ice 6ro+ the original operator and reser8es
space in each such container 6or his custo+ers. 0his is a O8alue#addedM ser8ice, in the sense
that he +ay reser8e a di66erent +aCi+u+ a+ount o6 space 6or each custo+er, 6ill the unused
space o6 one custo+er ,ith eCcess tra66ic o6 another custo+er, and is able to distinguish
pac-ets belonging to di66erent custo+ers ,hen the container is unpac-ed. 0he e;ui8alent
o6 this Os+art container pac-ingM ser8ice is an 201 virtual $ath ser8ice. 2 si+ple case o6
container pac-ing is to reser8e a 6iCed portion o6 the space to each custo+er. >or instance,
an 201 ser8ice pro8ider using the ('' 1bps S4!.0 ser8ice bet,een points 2 and ,
can pro8ide t,o independent 201 8irtual path connections o6 si@es '' and (00 1bps that
+ay be sold to di66erent custo+ers. asically, he can 6leCibly construct any nu+ber o6 such
6iCed band,idth bit pipes based on the actual de+and. 2gain notice that a custo+er such
as the post o66ice ,hich buys the abo8e 6iCed band,idth ser8ice +ay not 6ill the capacity o6
the ser8ice at all ti+es. 0here are +ore interesting ,ays that 201 can pac- the containers
to a8oid unused space. In these cases, the 8irtual paths do not ha8e a 6iCed static si@e but
can dyna+ically in6late or de6late according to the actual nu+ber o6 pac-ets that are being
shipped.
In the abo8e, the post o66ice plays an analogous role to I*. Since the local post o66ice at
+ay not be the 6inal destination o6 a pac-et, but only an inter+ediary, the post o66icer
at +ust loo- at each pac-et in turn and decide ,hether to deli8er it locally or 6or,ard
it to another post o66ice location. 0his is the 6unctionality o6 the I* protocol" to distinguish
pac-ets belonging to di66erent custo+ers and deli8er the+ or route the+ e66ecti8ely through
the other OI* post o66icesM. 2 custo+er deli8ering pac-ets at rando+ irregular inter8als to
the I* post o66ice Ddestined 6or so+e other custo+ersE 8ie,s the I* ser8ice as building a
6leCible Opac-et pipeM through the net,or- that does not reser8e so+e predeter+ined a+ount
o6 band,idth. !ote that such connections +ay ha8e highly 8ariable durations, and their
end#points +ay be unpredictable as 6ar as the I* ser8ice is concerned.
In its turn, the I* ser8ice pro8ider can sell a nu+ber o6 such pac-et connections bet,een
points 2 and Dor the capability 6or acti8ating such connectionsE, by +a-ing certain that
there is only a s+all probability o6 co+pletely 6illing the 6iCed band,idth ser8ice that he
purchases 6ro+ the 201 ser8ice pro8ider bet,een 2 and . !o, statistics co+e into play.
Since +ost o6 the ti+e only a s+all nu+ber o6 the I* connections ,ill be sending pac-ets
si+ultaneously, say a 6raction $ o6 the total nu+ber n, he needs only enough band,idth
bet,een 2 and to acco++odate $n sources, assu+ing that these send continuously. !ote
the large sa8ing in band,idth co+pared to ,hat he ,ould need i6 he ,ere to reser8e the
+aCi+u+ band,idth needed by each source, that is, enough band,idth 6or n such sources
instead 6or $n. 0his controlled o8erboo-ing is an e66ect o6 statistical multi$le,ing discussed
in Section $.2. It is i+portant to obser8e that 6iCed band,idth ser8ices can be used 6or
achie8ing the re8erse e66ect o6 'low isolation . >or instance, i6 the I* ser8ice needs to assign
dedicated band,idth 6or a pac-et connection bet,een 2 and , then rather than +iCing
these pac-ets ,ith I* pac-ets 6ro+ other connections in the sa+e containers, it can purchase
a dedicated container ser8ice, solely 6or carrying the pac-ets it ,ishes to isolate. Such 6lo,
isolation +ay be used to guarantee good per6or+ance, since shared containers ha8e 6iCed
2 CL2SSI>IC20I4! 4> !.0W4RB S.RGIC.S 2%
2%
I* 6lo,s
S4!.0 connection
Light path
201 8irtual path
/igure 61 2 transport ser8ice layering hierarchy. Light paths and S4!.0 DS39E pro8ide large
synchronous bit pipes. 201 6urther di8ides these pipes, and allo,s connections to use capacity that
is te+porarily unused by other connections. I* is used to establish connections bet,een arbitrary
net,or- end#points, o6 unpredicted duration and intensity.
si@e and pac-ets +ay ha8e to ;ueue at the I* stations to 6ind 6ree space in containers. 0his
congestion e66ect is reduced by o66ering such an eCclusi8e treat+ent, but co+es at an eCtra
cost. We are ready no, to proceed ,ith the Internet analogy.
In the late ())0s, +any parts o6 the Internet ,ere i+ple+ented as I* o8er 201. 201 can
run o8er S39 Dor S4!.0E, ,hich in turn can run o8er an optical net,or-. 0his transport
ser8ice layering is sho,n in >igure 2.(.
1ore speci6ically, an optical net,or- technology pro8ides a point#to#point synchronous
OcontainerM ser8ice, such as S4!.0 operating at a +aCi+u+ steady rate o6 (0 Abps. In turn,
S4!.0 pro8ides subcontainer transport ser8ices ,ith rates that are +ultiples o6 ('' 1bps.
201 is used to pro8ide 6leCible partitioning o6 such large S4!.0 containers 6or ser8ices
that re;uire 6ractions o6 this band,idth. I* is responsible 6or pac-ing and unpac-ing the
6iCed si@e band,idth ser8ices pro8ided by 201 into in6or+ation strea+s consisting o6
8ariable si@e ob?ects Dthe I* pac-ets produced by user applicationsE, ,hose resulting bit
rates are +uch s+aller and bursty. I* is a +ultipleCing technology that ObuysM such 6iCed
si@e band,idth ser8ices and +a-es a business o6 e66iciently 6illing the+ ,ith in6or+ation
strea+s that are 8ariable in both the rate and si@e o6 pac-ets. 0hus, I* and 201 can be
8ie,ed as OretailersM o6 O,holesaleM ser8ices such as S4!.0.
3i66erent parts o6 the o8erall net,or- +ay be connected ,ith di66erent container
technologies. 0he idea is to choose a technology 6or each lin- ,hose container si@e
+ini+i@es ,asted space in partially pac-ed containers. In the interior o6 the net,or- +any
tra66ic strea+s 6ollo, co++on routes and so it +a-es sense to use large containers 6or
lin-s on these routes. 9o,e8er, at the periphery o6 the net,or- it +a-es sense to use s+all
containers to transport tra66ic 6ro+ indi8idual sources. 0hus the business o6 a net,or-
operator is to pro8ide connecti8ity ser8ices by choosing appropriately si@ed containers 6or
the routes in his net,or-, and then to e66iciently pac- and unpac- the containers. 0he
Internet transport ser8ice e66iciently 6ills the large 6iCed si@e containers o6 the lo,er#le8el
ser8ices and connects t,o end#points by pro8iding a type o6 connecting OglueM.
"0am'le 61 ;2P over A!* over S4N"!< 2 concrete eCa+ple o6 transport ser8ice
layering is sho,n in >igure 2.2. In this 6igure *ro8ider ( ai+s to 6ill co+pletely his
H22 1bps container ser8ice bet,een points + and . . 9e +ay be buying a light path
ser8ice 6ro+ a pro8ider ,ho o,ns the 6ibre in6rastructure bet,een the abo8e points, in
,hich the container ser8ice could run up to (0 Abps. 9e 6ills his containers by selling
.
2& !.0W4RB S.RGIC.S 2!3 C4!0R2C0S
(00 1bps 201 G* ser8ice
I* pac-ets
A
('' 1bps containers DS4!.0E
C
(
E
) +
3
4
5
H22 1bps containers DS4!.0E
'' 1bps 201 G* ser8ice
*ro8ider (" net,or- +W., *ro8ider 2" net,or- )W3, *ro8ider 3" net,or- EW4
/igure 6 2n eCa+ple o6 transport ser8ice layering. 0ransport ser8ice *ro8ider ( operates a
H22 1bps S4!.0 ser8ice bet,een points + and . and sells ('' 1bps S4!.0 ser8ices to
custo+ers. *ro8ider 2 runs an 201 o8er S4!.0 net,or- ,ith nodes ) , 3 , and sells a (00 1bps
201 ser8ice bet,een points E and 4 to *ro8ider 3R to do this he buys a ('' 1bps S4!.0 ser8ice
6or connecting ) and 3 6ro+ *ro8ider (. *ro8ider 3 sells I* connecti8ity ser8ice to custo+ers A, (,
C and 5 by connecting his routers E and 4 using the (00 1bps 201 ser8ice
bought 6ro+ *ro8ider 2.
s+aller container ser8ices, in si@es that are +ultiples o6 ('' 1bps, such as that ,hich
connects nodes ) and 3 o6 *ro8ider 2. *ro8ider 3 sells Internet ser8ices to his custo+ers
and runs a t,o node I* net,or- bet,een routers at E and 4 . In doing this, he +ust connect
these nodes so that they can eCchange Internet data. 0his data is pac-aged in 8ariable si@e
I* pac-ets and is sporadic, ,ith a total rate not eCceeding (00 1bps. 0o connect E to 4
he buys a (00 1bps 201 Girtual *ath Di.e. a (00 1bps bit pipeE 6ro+ *ro8ider 2. *ro8ider
2 uses the 201 technology to subdi8ide the ('' 1bps S4!.0 container ser8ice bet,een
) and 3 , and so sell 6iner granularity band,idth ser8ices. >or instance, he 6ills the rest o6
the ('' 1bps containers tra8ersing the 4 to ) lin- by selling a '' 1bps 201 connection
to so+e other custo+er. !ote that i6 *ro8ider 3 has enough Internet tra66ic to 6ill ('' 1bps
containers, he can buy a pure S4!.0 ser8ice bet,een points E and 4 , i6 a8ailable. 0his
is ,hat happens in I* o8er S4!.0. I6 he has e8en +ore tra66ic, then he can buy a light
path ser8ice to connect the sa+e points, ,hich is I* o8er X. Such a ser8ice +ay pro8ide
6or (0 Abps o6 transport capability 6or I* pac-ets.
!ote that bitrate is not the only di66erentiating 6actor a+ong transport ser8ices. 0he
I* net,or- E :) allo,s any pair o6 custo+ers a+ongst AR (R C and 5 to connect 6or
arbitrarily short ti+es and eCchange data ,ithout the net,or- ha8ing to con6igure any such
connections in ad8ance. y contrast, S4!.0 Dand 201E are used 6or speci6ic point#to#
point connections that ha8e a +uch longer li8es.
>inally, each ser8ice that is sold to a custo+er has initial and 6inal parts that gi8e access
to the pro8iderMs net,or-. >or instance, in order to run the 201 ser8ice bet,een E and 4
one +ust connect E to ) and 3 to 4 . 0his access ser8ice +ay be pro8ided by *ro8ider 2
hi+sel6 or bought 6ro+ so+e third pro8ider. Si+ilarly, I* custo+er A +ust use so+e access
ser8ice to connect to the I* net,or- o6 *ro8ider 3.
616$ =alue)added Services and #undling
So+e ser8ices pro8ide +uch +ore than si+ply a data transport ser8ice. Consider a ,eb
ser8ice. It pro8ides a data transport ser8ice, but also a data processing ser8ice and a data
presentation ser8ice. 0he latter t,o ser8ices add 8alue and belong to a layer abo8e that
o6 the transport ser8ice. 0hus, the ,eb bro,sing is ,hat ,e call a valueadded service,
,hich is co+ple+entary to the net,or- transport ser8ice. Si+ilarly, an Internet telephony
ser8ice is a *undle o' services, ,hich includes a directory ser8ice, a signalling ser8ice, a
data transport ser8ice and a billing ser8ice. In Section 3.H, ,e discuss a possible +odel 6or
Internet ser8ices and eCplain the structure o6 the 8alue chain in Internet ser8ice pro8isioning.
It is i+portant to distinguish bet,een transport and 8alue#added ser8ices. 0hin- o6 a
boo-store ,hich pro8ides the 8alue#added ser8ice o6 retailing boo-s by +ail order. 2
custo+er chooses his boo-s and says ,hether he ,ishes deli8ery to be o8ernight, in t,o
business days, or by ordinary post. 9e pays 6or the boo-s and their deli8ery as a bundle, and
the boo-store contracts ,ith a deli8ery ser8ice 6or the deli8ery. 0he bundled ser8ice has
co+ponents o6 attracti8eness and ti+eliness o6 boo- o66erings, speed o6 deli8ery and price.
0he de+and 6or boo-s dri8es the de+and 6or the deli8ery ser8ice. Si+ilarly, the de+and
6or in6or+ation ser8ices dri8es the de+and 6or data transport ser8ices. 9o, a custo+er
8alues the particular content or 6unctionality o6 a co++unications ser8ice deter+ines the
charge he is prepared to pay. 46 course, this charge ,ill contain a co+ponent that re6lects
the 8alue o6 the data transport ser8ice, since transport ser8ice is ,hat a co++unications
net,or- pro8ides. In >igure 2.3 the user en?oys a 8ideo on de+and 8alue#added ser8ice.
2lthough the custo+er +ay +a-e a single pay+ent 6or the ser8ice Dto do,nload the
so6t,are re;uired, run the application and ,atch the +o8ie at a gi8en ;uality le8elE, this
pay+ent +ay be 6urther split by the 8alued#added ser8ice pro8ider to co+pensate the
transport ser8ice
pro8ider 6or his part o6 the ser8ice.
It is use6ul to 6a+iliari@e onesel6 ,ith so+e o6 the 6or+al de6initions that regulators use to
classi6y net,or- ser8ices. 0he >ederal Co++unications Co++ission D>CCE uses the ter+
in'ormation services 6or 8alue#added ser8ices, and telecommunications services 6or lo,er#
le8el transport ser8ices. 0he 0eleco++unications 2ct o6 ())H de6ines telecommunications
as Ythe trans+ission, bet,een or a+ong points speci6ied by the user, o6 in6or+ation o6
the userMs choosing, ,ithout change in the 6or+ or content o6 the in6or+ation as sent and
recei8edZ, and a telecommunications service as Ythe o66ering o6 teleco++unications 6or a
6ee directly to the public, or to such classes o6 users as to be e66ecti8ely a8ailable to the
public, regardless o6 6acilities usedZ. 2n in'ormation service is de6ined as Ythe o66ering o6 a
capability 6or generating, ac;uiring, storing, trans6or+ing, processing, retrie8ing, utili@ing,
or +a-ing a8ailable in6or+ation 8ia teleco++unicationsZ. 2ccording to these de6initions, an
application inter6ace
user
add 8alue to transport ser8ice
application progra+s
video 'layer
eCchange application data
video server
co++unications soc-et
transport ser8ice inter6ace
network
net,or- I* inter6ace
transport ser8ice
/igure 6$ 0ransport and 8alue#added ser8ices. 0he user en?oys a 8alue#added ser8ice Dsuch as
,atching a +o8ieE ,hich co+bines the transport o6 data 6ro+ the 8ideo ser8er ,ith the content
itsel6, and probably so+e additional 6unctionality 6ro+ the 8ideo ser8er Dsuch as bac-#trac-,
6ast#6or,ard and pauseE. Such an application +ay re;uire so+e +ini+u+ bitrate in order to
operate e66ecti8ely.
entity pro8ides teleco++unications only ,hen it both pro8ides a transparent trans+ission
path and it does not +anipulate the 6or+ or content o6 the in6or+ation. I6 this o66ering is
+ade directly to the public 6or a 6ee, it is called a Oteleco++unications ser8iceM. 2n entity
+ay sell an in6or+ation ser8ice as a bundle o6 teleco++unications Dthe lo,er#le8el data
transport ser8icesE ,ith content speci6ic applications such as e+ail and ,eb bro,sing Dthe
8alued#added ser8ices according to our pre8ious de6initionsE, or sell teleco++unications
separately as independent ser8ices. 2ccording to this de6inition, teleco++unications re6ers
to the lo,er end o6 the net,or- transport ser8ices, ,here the net,or- o66ers transparent
bit pipes. When, as ,ith 0C*<I*, data is processed either inside the net,or- at the routers,
or at its edges, the resulting ser8ice is closer to an in6or+ation ser8ice according to this
de6inition. In practice, in6or+ation ser8ices are +ore usually 8ie,ed as being associated
,ith content and 8alue#added applications that run at the edges o6 the net,or-. In the
Internet, such applications +anipulate the data part o6 the I* pac-ets according to the
particular application logic. !et,or- transport, such as the routing o6 I* pac-ets, is not
considered a 8alued#added ser8ice, as it is o66ered as a co++odity, using open standards.
In this boo-, ,e deal ,ith net,or- transport ser8ices that co+ple+ent these higher#le8el,
8alue#added applications. y the >CC de6initions they are Oteleco++unications ser8icesM at
lo,er layers and Oin6or+ation ser8icesM at higher layers.
616% Connection)oriented and Connectionless Services
We +ay also classi6y ser8ices by the ,ay data is trans+itted. In a connectionoriented
service, data 6lo,s bet,een t,o nodes o6 the net,or- along a O8irtualM pipe Dor a tree o6
8irtual pipes ,hen +ulticasting, ,ith duplication o6 data at the branching pointsE. 3ata
tra8els along a 6iCed route, ,ith a speci6ied rate, delay and error rate. In a connectionless
service, the data does not 6ollo, a 6iCed routing. Instead, the data is trans+itted in pac-ets,
or datagra+s. Successi8e datagra+s, tra8elling bet,een a source and destination, can ta-e
di66erent routes through the net,or-, and can su66er loss.
Connection#oriented and connectionless ser8ices +ay not be substitutable. It is +ore
di66icult, or i+possible, 6or a connectionless ser8ice to deli8er datagra+s in a regular ,ay.
0a-e, 6or eCa+ple, the postal ser8ice, ,hich is a datagra+ ser8ice. It ensures that parcels
can be sent to a destination 6ro+ ti+e to ti+e, ,ith acceptable delay. 9o,e8er, it cannot
guarantee deli8ery o6 a strea+ o6 parcels to a destination at a constant rate, say one per
hour. 0hat ,ould re;uire a connection#oriented approach in ,hich a 6lo, o6 pac-ets is
treated as a separate entity. 2 sche+atic o6 connection#oriented and connectionless ser8ices
is sho,n in >igure 2.$.
2 connection#oriented ser8ice can be used to pro8ide a type o6 deter+inistic per6or+ance
guarantee. Consider a connection and a lin- o6 the net,or- that it uses. Suppose ,e reser8e
periodically reoccurring slots o6 ti+e on this lin- 6or trans+ission o6 the connectionMs
pac-ets. It is as i6 the lin- ,ere a con8eyor belt, and a 6iCed portion o6 the belt ,ere
reser8ed 6or carrying the connectionMs pac-ets. .ach ti+e that portion co+es around one
o6 the connectionMs pac-ets can be sent. We assu+e that slots are large enough to carry an
integral nu+ber o6 pac-ets. In practice, pac-ets +ay be 6rag+ented into s+all 6iCed si@e
pieces Dcalled cells E, ,here a slot o6 the synchronous lin- Dthe beltE is large enough to hold
a cell. Slots reoccur, being part o6 larger constructs called 'rames . >or instance, a particular
connection +ight be assigned the 6irst t,o slots in a 6ra+e consisting o6 hundred slots, such
that e8ery hundred slots the connection gets the 6irst t,o slots. *ac-ets are reconstructed
at the end 6ro+ the corresponding cells. I6 the connection sends a strea+ o6 pac-ets at a
2 CL2SSI>IC20I4! 4> !.0W4RB S.RGIC.S 3(
3(
A
(
6 1bps
A
M
C
DaE
(
C
DbE
/igure 6% Connection and connectionless ser8ices. Connection#oriented ser8ices ha8e the
se+antics o6 a directed 8irtual bit pipe Dor perhaps a treeE. Connectionless ser8ices ha8e the
se+antics o6 a datagra+ ser8ice Dperhaps to +ultiple destinationsE. In DaE a connection#oriented
ser8ice connects A to ( and C ,ith a bit pipe o6 6 1bps, +aCi+u+ delay T and bit error rate r .
In DbE a connectionless ser8ice deli8ers a +essage o6 si@e M to ( and C ,ith +aCi+u+ delay T
and loss probability $.
constant rate, and su66icient ti+e slots are reser8ed on all the lin-s that it uses, then its
pac-ets ,ill arri8e at the destination at that sa+e constant rate. Such a transport ser8ice is
called a synchronous service. 2n i+portant characteristic o6 synchronous ser8ice is that the
relati8e ti+ing o6 pac-ets at the entrance is preser8ed at the eCit.
0his is in contrast to an asynchronous service, ,hich +a-es no such static allocation
o6 slots to connections. Slots are allocated on de+and, only ,hen cells are present to be
carried. 2 -ey characteristic o6 asynchronous ser8ice is that the relati8e ti+ing o6 pac-ets
at entrance and eCit is not preser8ed. 9o,e8er, ,e can ha8e reser8ation o6 resources Dat
possibly less than +aCi+u+ rateE e8en 6or asynchronous ser8ices De.g. 2R ,ith 1CR,
GR, etc.E. >or instance, ,e +ay speci6y that e8ery (00 slots, the connection should be
able to get at least one slot Di6 it has cells ,aiting to be trans6erredE. !ote that no particular
slot is reser8ed solely 6or use o6 the connection.
Continuing the con8eyor belt analogy, ,hen a pac-et is to be placed on a belt there
+ust be an e+pty slot, but speci6ic slots on the belt are not pre#allocated to connections. I6
there is contention 6or slots, then the connections +ust ,ait 6or the net,or- to assign
the+ 6ree slots. 0he net,or- does this using so+e Ocontention resolution policyM. We
de6ine synchronous networks as those that support only synchronous ser8ices. 0hey use
technology that is opti+i@ed 6or this purpose, brea-ing in6or+ation into pac-ets o6 the
si@e that can be trans+itted in a slot and then sending the+ as strea+s o6 slots ,hile
reser8ing speci6ic slots 6or each connection on the lin-s that the connection uses. In
contrast, $acket switching Dor cell switching E technology is used 6or asynchronous ser8ices.
In6or+ation is bro-en into 8ariable or 6iCed#si@ed pac-ets, called cells. 0hese are transported
in a store#and#6or,ard +anner, ,ithout preallocating any slots. .Ca+ples o6 synchronous
net,or-s are IS3! DIntegrated Ser8ices 3igital !et,or-E, S39 and S4!.0. .Ca+ples o6
asynchronous net,or-s are the Internet, >ra+e Relay and 201. !ote that a synchronous
ser8ice can be pro8ided by an asynchronous net,or- Dsuch as a CR ser8ice in 201E
by per6or+ing s+art scheduling o6 the slots. 0his is used 6or running telephony o8er
201.
Clearly, i6 custo+ers send data sporadically then a synchronous ser8ice +ay be
ine66icient, since preallocated slots can go unused. 2synchronous ser8ices are better. !ote
that because o6 the sporadic nature o6 asynchronous ser8ices it +ay be sensible 6or the
net,or- to engage in so+e sort o6 Oo8erboo-ingM ,hen assigning resources to slots. >or
instance, one +ay assign a nu+ber o6 slots that is less than ,hat ,ould be re;uired to
support the pea- rate o6 the connection.
616& -uaranteed and #est)effort Services
0here is an i+portant distinction bet,een ser8ices that do and do not co+e ,ith guarantees,
and ,hich correspondingly do and do not re;uire so+e reser8ation o6 resources. 4n the one
hand, guaranteed services co+e ,ith ;uality o6 ser8ices guarantees that are eCpressed in
ter+s o6 certain para+eters o6 the ser8iceMs per6or+ance. So+e reser8ation o6 resources is
usually re;uired i6 the guarantees are to be 6ul6illed. >or eCa+ple, a ser8ice that guarantees
a +ini+u+ trans+ission rate +ay need to reser8e capacity on a set o6 lin-s. 4n the
other hand, a ser8ice +ay +a-e no guarantees and reser8e no resourcesR in this case, the
per6or+ance o6 the ser8ice depends on the ;uantity o6 resources it is allocated, and this
allocation depends on the net,or-Ms policy and the set o6 other ser8ices that co+pete 6or
resources. Since the net,or- usually tries to pro8ide the best ;uality it can to each o6 its
custo+ers, these ser8ices are called *este''ort services .
Ser8ice guarantees +ay allo, so+e 6leCibility. >or eCa+ple, it +ight be guaranteed that
no data ,ill be lost i6 the userMs sending rate ne8er eCceeds h, but sub?ect to the net,or-
being allo,ed to 8ary the posted 8alue o6 h. >or +ore details see Section 2.2.(. 0his
type o6 6leCibility can help the net,or- to i+pro8e e66iciency by +a-ing better use o6
resources.
0he re;uest 6or a net,or- ser8ice originates at an application, and so it is the applicationMs
needs that deter+ine the type o6 connection re;uired to eCchange in6or+ation. >or eCa+ple,
a 8ideo ser8er needs a +ini+u+ band,idth to send real#ti+e 8ideo and so needs a
guaranteed ser8ice. 4ther audio and 8ideo applications can tolerate per6or+ance
degradation and can adapt their encoding and 6ra+e rates to the a8ailable band,idth. 0hey
are eCa+ples o6 elastic a$$lications. >or these, 6leCible guarantees +ay be acceptable.
!ote that an elastic application +ust -no, the band,idth that is a8ailable at any gi8en
ti+e and be able to adapt its rate, rather than ris- sending in6or+ation into the net,or-
that +ay be lost. 0hus application elasticity goes hand#in#hand ,ith the net,or-Ms ability
to signal resource a8ailability. .lastic ser8ices re;uire this signalling ability. est#e66ort
ser8ices usually do not pro8ide signalling and so elastic applications +ust i+ple+ent this
signalling 6unctionality the+sel8es Dat the application layerE. 0hus guaranteed ser8ices,
,hich pro8ide 6leCible guarantees, such as in the eCa+ple abo8e, +ay be better suited to
so+e adapti8e applications.
"0am'le 6 ;!raditional 2nternet trans'ort services< 0he Internet *rotocol DI*E is the
basic protocol by ,hich pac-et transport ser8ices are pro8ided in the Internet. It operates
as a si+ple pac-et deli8ery ser8ice. When the I* Orepresentati8eM Da piece o6 so6t,areE at
the source +achine is handed a pac-et o6 data and the address o6 a destination +achine Dan
I* addressE, it 6or,ards this pac-et tagged ,ith the I* destination address to OcolleaguesM
DI* so6t,areE running on Internet co+puters Dthe routersE. 0hese continue to 6or,ard and
route the pac-et until it reaches the I* representati8e at the destination +achine. I6 the
net,or- is congested, then pac-ets +ay be lost be6ore reaching their destination. 0his
happens ,hen a pac-et arri8es at a router and o8er6lo,s the a8ailable storage. 0his classic
I* ser8ice is a best#e66ort ser8ice, because it pro8ides no per6or+ance guarantees. 0odayMs
router i+ple+entations per+it certain I* pac-ets to recei8e priority ser8ice. 9o,e8er, no
eCplicit guarantees are pro8ided to the 6lo,s o6 such pac-ets.
0C* D0ransport Control *rotocolE and 73* D7ser 3atagra+ *rotocolE are t,o transport
ser8ices that run on top o6 the I* ser8ice, and so are denoted by 0C*<I* and 73*<I*. 0he
0C*<I* protocol pro8ides a data transport ser8ice ,ith certain per6or+ance guarantees. It
guarantees @ero pac-et loss to the user by retrans+itting pac-ets that are lost because o6
S.RGIC. C4!0R2C0S >4R 0R2!S*4R0 S.RGIC.S 33
congestion inside the net,or-. 0he basic idea is that the 0C* so6t,are OlistensM to
congestion indication signals trans+itted by the net,or- and intelligently ad?usts its sending
rate to the +ini+u+ capacity a8ailable in the lin-s along the path. 2ny lost pac-ets are
resent. 0he protocol ai+s to +ini+i@e such retrans+issions and to achie8e a high lin-
utili@ation, but it guarantees no +ini+u+ or a8erage sending rate. .ssentially, the rate at
,hich a connection is allo,ed to send is dictated by the net,or-. 0C*<I* has the
interesting property that ,hen it is used by all co+peting connections then the
band,idth o6 the bottlenec- lin-s is 6airly shared. DIn practice, connections ,ith longer
round#trip delays actually recei8e s+aller band,idth shares since they are slo,er to grab
any eCtra band,idth. 0his can ha8e se8ere repercussionsE.
2 connection using the 73*<I* protocols has no constraints, but also has no guarantees.
73* adds little 6unctionality to I*. Li-e 0C* it allo,s the recei8er to detect trans+ission
errors in the data part o6 the pac-et. It sends at a +aCi+u+ rate, irrespecti8e o6 congestion
conditions, and does not resend lost data. 73* is appropriate ,hen one ,ants to send a
s+all burst o6 data, but because o6 its short li6e, it is not ,orth,hile to set up a co+plete
0C*<I* connection. 73* is a typical eCa+ple o6 a best#e66ort ser8ice ,ith no guarantees.
>urther details o6 these protocols are pro8ided in Section 3.3.%.
6 Service contracts for trans'ort services
2 transport ser8ice is pro8ided ,ithin the conteCt o6 a service contract bet,een net,or-
and user. 2 part o6 the contract is the tari66 that deter+ines the charge. eyond this, the
contractual co++it+ents o6 the net,or- and user are as 6ollo,s. The network commits to
deliver a service with given 7uality and $er'ormance characteristics, and the user commits
to interact with the network in a given way.
I6 the user 8iolates his side o6 the contract, then the contract +ight speci6y ,hat the
net,or- should do. 0he net,or- +ight not be bound to any ;uality o6 ser8ice co++it+ent,
or it +ight restrict the ser8ice ;uality gi8en to the user. Ser8ice ;uality characteristics
include geographic co8erage, billing ser8ices, reliability, up#ti+e, response to 6ailures, help#
des- and call#centre support. Ser8ice pro8iders can di66erentiate their ser8ice o66erings by
these characteristics, and so in6luence the custo+ersM choices o6 pro8ider. !ot surprisingly,
it is o6ten hard to ;uanti6y the costs o6 pro8iding these characteristics. !o standards eCist
to constrain the de6inition o6 a ser8ice contract. It +ay be arbitrarily co+plicated and +ay
include clauses speci6ic to the custo+er.
0he part o6 the ser8ice contract that deals ,ith the 8alued#added part o6 the ser8ice can
be co+plicated, since it can concern issues that are speci6ic to the particular 8alue#added
application, such as the copyright o6 the content pro8ided. 0hroughout this boo-, ,e +ostly
choose to 6ocus on that part o6 the ser8ice contract that concerns the ;uality o6 the transport
ser8ice. We call this the tra''ic contract part o6 the ser8ice contract. >or si+plicity, ,e spea-
o6 Oser8iceM, rather than Otransport ser8iceM, ,hen the conteCt allo,s.
661 !he Structure of a Service Contract
Let us 6ocus on the tra66ic contract part o6 the ser8ice contract, i.e. the part that deals
,ith aspects o6 the transport ser8ice. In practice, this part o6 the contract can be described
independently o6 the particular net,or- technology.
2s a 6irst eCa+ple, suppose the net,or- agrees to transport cells bet,een t,o gi8en
points, at a rate no less than m, and dropping no +ore than a proportion o6 cells, $. 0he
user agrees to send cells at no greater than a rate, say h, and to access the net,or- 6or
3$ !.0W4RB S.RGIC.S 2!3 C4!0R2C0S
no longer than a +aCi+u+ ti+e ' . I6 the user sends a total o6 8 bits he ,ill be charged
a C *8 . I6 the user eCceeds his contract li+its, the net,or- ,ill pro8ide the eCcess o6 the
userMs tra66ic ,ith a 6ree and si+ple best#e66ort ser8ice, but this has no guarantees. 0he
para+eters o6 the tra66ic contract are m, $, h, ' , a and *.
!o, let us be +ore 6or+al. oth the userMs tra66ic and the ser8ice ;uality pro8ided by
the net,or- ha8e properties that can be ;uanti6ied in ter+s o6 measura*le varia*les. 0hey
include, 6or eCa+ple, the present rate at ,hich data is sent, the a8erage rate so 6ar, the
rate at ,hich cells are lost, and the a8erage delay per cell. DIn practice, +any contract
8ariables are not +easured, as it is too costly to pro8ide the necessary in6rastructure. 0his
Oin6or+ation asy++etryM can pro8ide incenti8es 6or contract 8iolation, see Chapter (2.E
Let P and 9 be predicates o8er the 8ariables, ,here P denotes a constraint on the userMs
tra66ic and 9 denotes a constraint on the per6or+ance pro8ided by the net,or-. 0hen the
ser8ice contract can be represented as P 9E 9. 0he para+eters o6 the contract are
constants used in the construction o6 P and 9. >or instance, the contract clause Oi6 the
sending rate is less than 2 1bps, then +aCi+u+ delay per pac-et is guaranteed to be less
than (0 +sM can be speci6ied as O,
(
[ 2 9E ,
2
[ (0M, ,here ,
(
, ,
2
are
8ariables and 2, (0 are constants. Conceptually, one can i+agine that the current 8alues o6
the 8ariables and constants are continuously displayed at the ser8ice inter6ace bet,een
user and net,or-.
2 ser8ice contract is so+eti+es called a "ervice .evel Agreement DSL2E. 0his
ter+inology is +ore o6ten used 6or tra66ic contracts bet,een large custo+ers and net,or-
operators, and includes para+eters speci6ying help des- and custo+er support. In practice,
SL2s are speci6ied by long teCtual descriptions and +ay contain +any a+biguities.
0he net,or-Ms contractual obligations can ta-e the 6or+ o6 either deterministic or
statistical guarantees. 2n eCa+ple o6 a deter+inistic guarantee is a strict upper bound on
delay. 2nother eCa+ple is (00P ser8ice a8ailability. Statistical guarantees can be 6ra+ed
in ter+s o6 cell loss rate, the probability o6 obtaining access to a +ode+ ban-, or the
probability that a ,eb ser8er ,ill re6use a connection due to o8erload. 0he idea that the
net,or- should +a-e so+e ser8ice le8el guarantees represents a departure 6ro+ the basic
best#e66ort +odel o6 the Internet. In .Ca+ple 2.3 ,e describe such guarantees in the conteCt
o6 a particular technology.
"0am'le 6$ ;>uality of Service< 0he 7uality o' service D=oSE pro8ided by a
transport ser8ice is de6ined in ter+s o6 the ,ay a tra66ic strea+ is a66ected ,hen
it is transported through the net,or-. 0his is typically in ter+s o6 the probability
o6 cell loss, delay, and cell delay 8ariation Dor ?itterE. I6 access to a resource is
re;uired, it +ay also include the probability that ser8ice is re6used because the
resource is not a8ailable. In the case o6 201 ser8ices Dsee Section 3.3.'E, the =oS
+easures are
Cell .oss 6atio DCLRE" the proportion o6 cells lost by the net,or-.
Cell 5elay 8ariation DC3GE" the +aCi+u+ di66erence in the delays eCperienced by t,o
di66erent cells in their end#to#end transit o6 the net,or-. C3G is also -no,n as
O?itterM.
Ma,imum Cell Trans'er 5elay D+aC C03E" the +aCi+u+ end#to#end cell delay.
Mean Cell Trans'er 5elay D+ean C03E" the a8erage end#to#end cell delay.
Minimum Cell 6ate D1CRE" the +ini+u+ rate at ,hich the net,or- transports cells.
r C
S.RGIC. C4!0R2C0S >4R 0R2!S*4R0 S.RGIC.S 3'
2 popular ,ay to speci6y a userMs contractual obligation concerning the tra66ic he sends
into a net,or- is by a leaky *ucket constraint. 0his is described in .Ca+ple 2.$. 0he
constraint is on the sourceMs pea- rate, a8erage rate and burstiness.
"0am'le 6% ;Leaky buckets< 0he leaky *ucket tra''ic descri$tor can be used to bound
the density o6 a tra66ic strea+ at a re6erence point in the net,or-. It constrains the tra66ic
strea+Ms pea- rate, a8erage rate and burstiness Di.e. the short range de8iations 6ro+ the
+ean rateE. Suppose the unit o6 tra66ic is a cell. 2 lea-y buc-et descriptor is de6ined by a
leak rate, r , and *ucket si%e, *. Let / Tt R t
0
U denote the nu+ber o6 cells o6 the tra66ic
strea+ ,hich pass the re6erence point during the inter8al Tt R t
0
<. 0he lea-y buc-et
i+poses the constraint that a con'orming tra''ic stream +ust satis6y
/ Tt R t
0
U [ .t
0
t <r C *R 6or all t \ t
0
D2.(E We call a 6lo, that con6or+s to D2.(E a .*R r <#6lo,. 2nother ,ay to understand D2.(E
is to
re,rite it as
/ Tt R t
0
U
t
0
t
[
*
t
0
t
R 6or all t \ t
0
!ote that as the ,indo, Tt R t
0
< increases in ,idth, the a8erage rate per+itted during
this ,indo, beco+es bounded abo8e by the lea- rate r , but that 6or a ,indo, ,idth o6 t
0
t the strea+ is allo,ed to produce a OburstM o6 si@e * abo8e its greatest allo,ed a8erage
a+ount o6 .t
0
t <r . Since this a+ount * can be produced ,ithin an arbitrarily s+all
ti+e ,indo,, the lea-y buc-et descriptor does per+it an arbitrarily large pea- rate. !ote
that large 8alues o6 * allo, 6or large bursts. 9o,e8er, * 3 0 places a si+ple bound on the
pea- rateR at no point can it eCceed r .
0he si+plest ,ay to police a source is by the speed o6 the access line to the net,or-.
0his si+ple +echanis+ is e;ui8alent to a lea-y buc-et ,ith * 3 0 and r e;ual to the line
rate. >igure 2.' depicts a lea-y buc-et.
1ore co+plicated contractual obligations can be speci6ied 6ro+ logical co+binations
o6 si+pler ones. In .Ca+ple 2.' the contractual obligation is speci6ied as the con?unction
o6 t,o si+ple lea-y buc-et constraints, each o6 ,hich addresses a di66erent aspect o6 the
tra66ic. Such constraints upon the userMs tra66ic are also called tra''ic descri$tors .
"0am'le 6& ;*ulti'le leaky bucket traffic descri'tor< >or tra66ic that is bursty Di.e.
,hich has phases o6 high and lo, acti8ityE, it is custo+ary to use t,o lea-y buc-ets to
speci6y con6or+ing tra66ic. 0he 6irst lea-y buc-et constrains the pea- rate and the second
lea-y buc-et constrains the ti+e 6or ,hich the source can send a burst at the pea- rate. 2n
real cell
arri8ing
r N lea- rate
Dcells<sE
8irtual cell
buc-et 6or * cells
/igure 6& 2 lea-y buc-et policer. 2 real cell is con6or+ing i6 and only i6 ,hen it arri8es there is
3H !.0W4RB S.RGIC.S 2!3 C4!0R2C0S
space in the to-en bu66er to add a 8irtual cell. 0he to-en bu66er has space 6or * 8irtual cells and is
depleted at constant rate o6 r cells<s.
( ] C3G0 ^ *CR cells
arri8ing
*CR cells
SCR cells
0 ^ SCR cells
/igure 6( 2 GR tra66ic descriptor 6or bursty tra66ic de6ined in ter+s o6 t,o lea-y buc-ets. 0he
top lea-y buc-et constrains the pea- rate. 0he botto+ buc-et constrains the burstiness. *CR 3 pea-
cell rate. SCR 3 sustainable cell rate. C3G0 3 dell delay 8ariation tolerance. 0 3 burst tolerance.
eCa+ple o6 this is the GR tra66ic descriptor sho,n in >igure 2.H. It is used to characteri@e
bursty 201 tra66ic Ddescribed in Chapter 3E.
2n arri8ing cell is con6or+ing ,hen it is con6or+ing to both lea-y buc-ets. 0he lea-y
buc-et that constrains the pea- rate is de6ined in ter+s o6 the *CR Dpea- cell rateE and
C3G0 Dcell delay 8ariation toleranceE. When C3G0 3 0, then the +ini+u+ ti+e that is
allo,ed bet,een t,o cell arri8als is (N*CR, ,hereas i6 C3G0[*CR 3 0"( Da typical caseE,
then this interarri8al ti+e +ay be te+porarily 0")N*CR. 0his allo,s so+e s+all 6luctuation
in cell in# terarri8al ti+es, but the a8erage rate at ,hich cells arri8e cannot eCceed *CR.
Si+ilarly, the lea-y buc-et that constrains burstiness is de6ined in ter+s o6 SCR Dsustainable
cell rateE and 0 Dburst toleranceE. 7sually the 8alue o6 0[SCR is a large integer,
allo,ing 6or a burst o6 cells to arri8e at greater rate than SCR. !ote that the allo,ed
duration o6 the burst increases ,ith 0 and depends on the rate at ,hich cells arri8e. Since
the a8erage rate o6 con6or+ing cells cannot eCceed SCR, this lea-y buc-et also constrains
the +ean rate o6 the source.
0he Integrated Ser8ices architecture 6or the Internet uses a si+ilar approach in its tra66ic
speci6ication D0specE. 0his is de6ined in ter+s o6 a dual lea-y buc-et Dsi+ilar to the abo8e
and ,ith C3G0 3 0E, a bound on +aCi+u+ pac-et si@e Dsince in the Internet pac-et si@es
are not 6iCed as they are in 201E, and a O+ini+u+ policed unitM m Dspeci6ying that pac-ets
s+aller than m bytes should be padded to si@e m ,hen entering the lea-y buc-etE. 0here
is also a si+ilar use o6 lea-y buc-ets in the 3i66erentiated Ser8ices architecture 6or the
Internet. >or +ore details o6 these architectures, see Section 3.3.%.
66 Policing Service Contracts
0he net,or- +ust ta-e steps to +onitor and en6orce the userMs con6or+ance to his
contractually agreed interactions ,ith the net,or-. 0his is called $olicing the contract.
>or eCa+ple, a telephone net,or- +ight ,ish to police its users 6or an agreed +aCi+u+
6re;uency o6 dialling, so as to pre8ent an o8erload o6 the signalling part o6 the net,or-.
It is necessary to say ,hat ,ill happen i6 the user 8iolates his part o6 the contract. 0his
can be speci6ied in the ser8ice contract itsel6. 4ne possibility is to speci6y that i6 there is a
8iolation then a di66erent ;uality o6 ser8ice ,ill be pro8ided. >or eCa+ple, i6 con6or+ance
o6 the userMs tra66ic strea+ is being policed by a lea-y buc-et, then a si+ple speci6ication
,ould be that i6 there is congestion in the net,or- then it can discard any non#con6or+ing
cells, either as they enter or tra8erse the net,or-. 0he net,or- could +ar- non#con6or+ing
cells, so that they can be the 6irst to be dropped ,hen congestion occurs.
46 course, there is a cost to policing and it is desirable that policing be i+ple+ented
such that it introduces lo, o8erhead and on the basis o6 +easure+ents that are easy to
+a-e. 0he user has the incenti8e to produce tra66ic that con6or+s to the contract. 4ne ,ay
to do this is by policing his o,n tra66ic prior to deli8ering it to the net,or-. When cells
are produced that do not con6or+ to the contract, these are placed in a bu66er until they
beco+e con6or+ing. 0his tra''ic sha$ing tends to s+ooth the tra66ic.
2 si+ple ,ay to pro8ide a loose 6or+ o6 policing is by charging. 0he net,or- si+ply
pro8ides an incenti8e 6or the user to respect the contract by i+posing a 8ery high charge
,hene8er he 8iolates it. 0his +ethod has the ad8antage that it acts indirectly, rather than
on a cell by cell basis. 46 course it can only ,or- i6 charges are based upon +easure+ents
o6 the userMs tra66ic that capture the contract 8iolations. 2lthough costly to i+ple+ent, the
6leCibility allo,ed by this type o6 policing +ay be o6 great 8alue to those applications that
,ould so+eti+es pre6er to pay a bit +ore, rather than see their tra66ic tri++ed by the lea-y
buc-ets. 1ulti+edia applications +ay 6all in this category. 9igh capacity net,or-s, ser8ing
large nu+bers o6 contracts, gain 6ro+ the 6act that tra66ic strea+s do not al,ays 6ully utili@e
their contracts. It is possible that the pro8ision o6 a +ore 6leCible ser8ice contract does not
change the load o6 the net,or- signi6icantly, but does greatly increase the 8alue o6 the
ser8ice to the custo+ers.
66$ Static and 1ynamic Contract Parameters
0here are +any ser8ice ;uality characteristics 6or ,hich no eCplicit guarantees are +ade in
the tra66ic contract. 0he net,or- is 6ree to address the+ in a best#e66ort ,ay, or according
to so+e other internal policy. >or eCa+ple, an Internet ser8ice pro8ider +ight +a-e no
guarantee as to the probability that a user ,ill 6ind a 6ree +ode+ ,hen he dials#in, but
operate enough +ode+s such that he recei8es 8ery 6e, co+plaints.
When ser8ice contracts do +a-e eCplicit guarantees, they can do so in di66erent ,ays.
0hese can di66er in the para+eters in ,hich they are eCpressed and the co++it+ents that
they re;uire 6ro+ the net,or-. Consider the 6ollo,ing three contracts"
Contract 2 Contract Contract C
0here ,ill be no data loss
pro8ided the rate o6 the
source stays belo,
( 1bps.
0here ,ill be no data loss
pro8ided the rate o6 the
source stays belo,
h 1bps, ,here the
net,or- can 8ary h
dyna+ically bet,een (
and 2 1bps.
0he data loss rate ,ill
be less than
0.00000(P pro8ided
the rate o6 the source
stays belo, h 1bps,
,here the user can
8ary h dyna+ically
bet,een ( and 2 1bps.
Contract 2 eCpresses a guarantee in ter+s o6 static $arameters , i.e. ones that are set at
the ti+e the contract is established and re+ain constant throughout its li6e. 0his guarantee
re;uires the net,or- to +a-e a 6ir+ co++it+ent o6 resources. 0he net,or- +ust reser8e
( 1bps 6or the ser8ice at the start o6 the contract. Contracts and C eCpress their guarantee
in ter+s o6 both static and dynamic $arameters . 3yna+ic para+eters are ones that are
updated during a contractMs li6e. Contract has a static part, guaranteeing ( 1bps. Contract
C has a static part de6ined in ter+s o6 static para+eters ( 1bps and 0.00000(P. oth ha8e
an eCtra, purely dyna+ic part, 6or eCtra rate bet,een 0 and ( 1bps. 2 signi6icant di66erence
bet,een and C is that C is lossy e8en ,ith rate belo, h 1b<s.
2part 6ro+ the loss guarantee in Contract C being statistical, the +ain di66erence bet,een
Contracts and C lies in ,ho chooses h"
(. In Contract it is the net,or- operator ,ho chooses h, perhaps as a 6unction o6
his 6luctuating spare capacity. 9e is saying to the user that he can al,ays pro8ide a
band,idth o6 ( 1bps, and so+eti+es up to 2 1bps. 0his contract ,ould suit a user
o6 an Oelastic applicationM, that is, an application that can adapt its operation to the
a8ailable net,or- resources.
2. I6 in Contract it ,ere the user ,ho ,ere to choose h, then the net,or- ,ould be
saying to the user that he can al,ays pro8ide band,idth bet,een ( and 2 1bps. I6
this is to be done ,ith a guarantee o6 no data loss, then the net,or- +ust al,ays
be able to pro8ide 2 1bps to the user. 0he only ad8antage to the net,or- is that he
can perhaps sell else,here any band,idth that the user does not use. 0hus, Contract
C is really +ore suitable ,hen h is to be chosen by the user. !o, the net,or- can
+a-e use o6 statistical +ultipleCing and o8erboo-ing to +a-e e66icient use o6 his
band,idth. !ote that it ,ould be a good idea 6or the net,or- to charge the user
according to his usage, other,ise there is no incenti8e 6or hi+ to do other than ta-e
h 3 2 al,ays.
In su++ary, ,e see that a ser8ice contract can be deco+posed into static and dyna+ic
parts. 0he net,or- +ust per+anently reser8e resources 6or the static part. It dyna+ically
reser8es resources 6or the dyna+ic part, in line ,ith the changing 8alues o6 the dyna+ic
tra66ic contract para+eters. It is i+portant to speci6y ,ho is responsible 6or changing the
8alues o6 the dyna+ic para+eters, or lay do,n procedures 6or the user and net,or- to
negotiate the+. 0he net,or- can usually in6luence the 8alue o6 the dyna+ic para+eters,
e8en i6 it cannot choose the+ directly. y pricing the dyna+ic contract para+eters, the
net,or- gi8es users the incenti8e to purchase s+aller 8alues o6 the+. 2s prices tend to
in6inity, the net,or- ends up needing to 6ul6il only the +ini+al static part o6 contract.
3epending on the pricing +echanis+s a8ailable, prices +ay 8ary o8er ti+escales o6 seconds
to +onths. >or eCa+ple, ti+e#o6#day pricing operates o8er a ti+escale o6 hours. 0he
contract para+eters +ust al,ays be a8ailable at the inter6ace bet,een the user and the
net,or-, that is, O8isibleM to the+ both.
"0am'le 6( ;A service with a 'urely dynamic 'art< 2n eCa+ple o6 a ser8ice ,ith
a purely dyna+ic part is the Internet transport ser8ice pro8ided by the 0C* protocol and
introduced in .Ca+ple 2.2. 0he 0C* so6t,are plays the role o6 a Otrusted third partyM. It runs
on the userMs co+puter and dyna+ically controls the +aCi+u+ rate, h, at ,hich the user
is allo,ed to send. 0here is an i+plicit guarantee o6 s+all pac-et loss inside the net,or-
i6 the user sends pac-ets at this rate Dalthough, in any case, the user does not notice pac-et
losses since 0C* retrans+its lost pac-etsE. 0o control h, the net,or- sends congestion
signals to the 0C* +odule. In response to the rate at ,hich these signals are recei8ed, 0C*
increases or decreases the 8alue o6 h. 0here is no guarantee on a +ini+u+ 8alue 6or h. 0he
generation o6 the congestion signals that are sent to the co+peting connections relies upon
the co+plete control o6 the net,or-. 0C* ,ill produce a 6air allocation o6 h 8alues a+ongst
the users pro8ided the 0C* +odules on di66erent co+puters all run the sa+e algorith+.
0his is a +a?or ,ea-ness, since a user could cheat by installing his o,n 8ersion o6 0C*,
,hich he has designed to obtain 6or hi+ a greater band,idth at the eCpense o6 other users.
Charging connections 6or their net,or- usage can re+edy this ,ea-ness since users that
insist upon obtaining a greater share o6 the band,idth ,ill incur a greater charge. D!ote
that thus 6ar ,e ha8e e;uated pac-et loss ,ith congestion. 0he net,or- does not generate
eCplicit signals o6 congestion, but rather the user recei8es i+plicit signals ,hen he detects
pac-et loss. In so+e net,or-s, such as those using ,ireless lin-s, pac-et loss can occur
>7R09.R R.23I!A 3)
because o6 trans+ission errors, rather than congestion. 0his can cause 0C* to reduce its
rate e8en i6 there is no congestion.E
2 ser8ice contract 6or ,hich the net,or- +a-es no guarantees ,hatsoe8er re;uires no
indi8idual resource allocation. 0his type o6 contract is used 6or best#e66ort ser8ices. 0he
net,or- has +aCi+u+ 6leCibility, since it can degrade the per6or+ance at any ti+e, ,ithout
e8en noti6ying the user. 2n eCa+ple is the 73* protocol, and +ost pro+inently, the basic
I* protocol o6 .Ca+ple 2.2. 0ypically, the net,or- does the best possible 6or the best#e66ort
ser8ices and +ay e8en choose to reser8e so+e resources so as to i+pro8e the o8erall le8el
o6 ser8ice they recei8e. 46 course the user +ay be ,illing to pay 6or a better le8el o6
ser8ice, ,ith less 6re;uent degradation in ser8ice le8el. It is certainly desirable that a user
,ho is ,illing to pay +ore should recei8e a better le8el o6 ser8ice. 0his is not possible
,ithin the present best#e66ort +odel o6 the Internet ,here connections are treated e;ually.
We turn to ideas on ho, this +ight be achie8ed in Chapter (0.
In the literature, the phrase Oguaranteed ser8iceM has o6ten been used 6or a ser8ice ,hose
per6or+ance le8el is constant during the li6e o6 the contract. We ,ould call this a ser8ice
that has only strictly static parts. Si+ilarly, the ter+ Oelastic ser8iceM has so+eti+es been
used 6or ser8ices ha8ing purely dyna+ic parts, i.e. ,ithout any a $riori co++it+ent 6ro+
the net,or-. We li-e to reser8e the ad?ecti8e OelasticM to describe applications rather than
ser8ices" an elastic a$$lication is one that can adapt its operation to the a8ailable net,or-
resources.
>inally, ,e obser8e that so+e para+eters o6 the tra66ic contract are measured $arameters
" such as the ti+e the connection starts, its duration and the total 8olu+e o6 data sent. 0hese
para+eters are -no,n only a6ter the +easure+ents ha8e been +ade. 0hey are not dyna+ic
contract para+eters, because they are not negotiated and do not act as constraints. 1easured
para+eters appear in the accounting records that su++ari@e the contractMs acti8ity. 0hey
and the rest o6 the para+eters in the contract are used to co+pute charges 6ro+ the tari66
speci6ied in the contract.
6$ /urther reading
2 si+ple tutorial on SL2s has been prepared by Gisual !et,or-s, Inc and 0elechoice
D2002E See also the si+ple article on SL2s at the ,eb site o6 20&0 D2000E. 2 rather
ad8anced slide presentation on i+portant SL2 i+ple+entation issues 6or I* net,or-s is
published by Cisco D2002bE. 0,o +ore interesting ,hite papers are those o6 Cisco D200(E
and D2002eE. So+e concrete eCa+ples o6 Ser8ice Le8el 2gree+ents 6or 201 and >ra+e
Relay can be seen at the ,eb sites o6 !ortel !et,or-s D2002aE and D2002bE.
0he concepts o6 net,or- ser8ice layering and ;uality o6 ser8ice are co8ered in the classic
net,or-ing teCtboo-s o6 Walrand D())&E, Walrand and Garaiya D2000E and Burose and Ross
D200(E. 0he latter contains an in#depth eCposition o6 the 8arious ser8ice layers that are
used to pro8ide Internet ser8ices, including the application layer. 0he 6irst t,o chapters o6
Walrand D())&E and Walrand and Garaiya D2000E can pro8ide a good introduction to
net,or- ser8ice types, layering, and 8arious technologies. 0hese also contain in#depth
+aterial on lea-y buc-ets and tra66ic policing.
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
$
!et,or- 0echnology
0his chapter concerns the generic aspects o6 net,or- technology that are i+portant in
pro8iding transport ser8ices and gi8ing the+ certain ;ualities o6 per6or+ance. We de6ine
a set o6 generic control actions and concepts that are deployed in todayMs co++unication
net,or-s. 4ur ai+ is to eCplain the ,or-ings o6 net,or- technology and to +odel those
issues o6 resource allocation that are i+portant in representing a net,or- as a production
plant 6or ser8ice goods.
In Section 3.( ,e outline the +ain issues 6or net,or- control. 0hese include the ti+escale
o8er ,hich control operates, call ad+ission control, routing control, 6lo, control and
net,or- +anage+ent. 0ari66ing and charging +echanis+s pro8ide one i+portant type o6
control and ,e turn to these in Section 3.2. Sections 3.3 and 3.$ describe in detail +any
o6 the actual net,or- technologies in use today, such as Internet and 201. We relate these
eCa+ples o6 net,or- technologies to the generic control actions and concepts described
in earlier sections. In Section 3.' ,e discuss so+e o6 the practical re;uire+ents that +ust
be +et by any ,or-able sche+e 6or charging 6or net,or- ser8ices. Section 3.H presents a
+odel o6 the business relations a+ongst those ,ho participant in pro8iding Internet
ser8ices.
$61 Network control
2 network control is a +echanis+ or procedure that the net,or- uses to pro8ide ser8ices.
0he +ore nu+erous and sophisticated are the net,or- controls, the greater and richer can
be the set o6 ser8ices that the net,or- can pro8ide. Control is usually associated ,ith the
procedures needed to set up ne, connections and tear do,n old ones. 9o,e8er, ,hile a
connection is acti8e, net,or- control also +anages +any other i+portant aspects o6 the
connection. 0hese include the ;uality o6 the ser8ice pro8ided, the reporting o6 i+portant
e8ents, and the dyna+ic 8ariation o6 ser8ice contract para+eters.
"ynchronous services pro8ided by synchronous net,or-s ha8e the si+ple se+antics o6 a
constant bit rate trans6er bet,een t,o prede6ined points. 0hey use si+ple controls and all
bits recei8e the sa+e ;uality o6 ser8ice. Asynchronous networks are +ore co+pleC. esides
pro8iding transport bet,een arbitrary points in the net,or-, they +ust handle unpredictable
tra66ic and connections o6 arbitrarily short durations. !ot all bits re;uire the sa+e ;uality
o6 ser8ice.
So+e net,or- technologies ha8e too li+ited a set o6 controls to support transport ser8ices
,ith the ;uality re;uired by ad8anced +ulti+edia applications. .8en 6or synchronous
ser8ices, ,hose ;uality is +ostly 6iCed, so+e technologies ha8e too li+ited controls to
$2 !.0W4RB 0.C9!4L4A/
+a-e it possible ;uic-ly to set up ne, connections on de+and. 2 -no,ledge o6 the 8arious
net,or- control +echanis+s is -ey to understanding ho, co++unication net,or-s ,or-
and ho, ser8ice pro8isioning relates to resource allocation. In the rest o6 the chapter ,e
+ainly 6ocus on the controls that are deployed by asynchronous net,or-s. 0hese controls
shape the ser8ices that custo+ers eCperience.
$6161 "ntities on which Network Control Acts
2 net,or-Ms topology consists o6 nodes and links. Its nodes are routers and s,itches. Its
lin-s pro8ide point#to#point connecti8ity ser8ice bet,een t,o nodes, or bet,een a custo+er
and a node, or a+ongst a large nu+ber o6 nodes, as in a 1etropolitan Aigabit .thernet.
We ta-e the notion o6 a lin- to be recursi8e" a point#to#point lin- in one net,or- can in
6act be a transport ser8ice pro8ided by a second net,or-, using +any lin-s and nodes. We
call this a O8irtualM lin-. Since lin-s are re;uired to pro8ide connecti8ity ser8ice 6or bits,
cells or pac-ets at so+e contracted per6or+ance le8el, the net,or- +ust continually in8o-e
control 6unctions to +aintain its operation at the contracted le8el. 0hese control 6unctions
are i+ple+ented by hard,are and so6t,are in the nodes and act on a nu+ber o6 entities,
the +ost basic o6 ,hich are as 6ollo,s.
Packets and cells. 0hese are the parcels into ,hich data is pac-aged 6or transport in the
net,or-. Gariable si@e parcels are called $ackets, ,hereas those o6 6iCed si@e are called
cells. Internet pac-ets +ay be thousands o6 bytes, ,hereas cells are '3 bytes in the 201
technology. 9igher le8el transport ser8ices o6ten use pac-ets, ,hile lo,er#le8el ser8ices
use cells. 0he pac-ets +ust be bro-en into cells and then later reconstructed into pac-ets.
We ,ill use the ter+ pac-et in the broad sense o6 a data parcel, unless speci6ic reasons
re;uire the ter+inology o6 a cell.
Connections. 2 connection is the logical concept o6 binding end#points to eCchange data.
Connections +ay be point#to#point, or point#to#+ultipoint 6or +ulticasting, although not
all technologies support the latter. 2 connection +ay last 6ro+ a 6e, seconds Das in the
access o6 ,eb pagesE to years Das in the connection o6 a co+panyMs net,or- to the Internet
bac-boneE. 3epending on the technology in use, a connection +ay or +ay not be re;uired.
0he trans6er o6 ,eb page data as pac-ets re;uires a connection to be +ade. In contrast,
there is no need to +a-e a connection prior to sending the pac-ets o6 a datagra+ ser8ice.
Clearly, the greater is a technologyMs cost 6or setting up a connection the less ,ell suited
it is to short#li8ed connections. 4nce a connection has been set up, the net,or- +ay ha8e
to allocate resources to handle the connectionMs tra66ic in accordance ,ith an associated
Ser8ice Le8el 2gree+ent.
4lows. 0he in6or+ation transported o8er a connection +ay be 8ie,ed as a continuous 6lo,
o6 bits, bytes, cells or pac-ets. 2n i+portant attribute o6 a 6lo, is its rate. 0his is the a+ount
o6 in6or+ation that crosses a point in the net,or-, a8eraged o8er so+e ti+e period. 0he ?ob
o6 a net,or- is to handle continuous 6lo,s o6 data by allocating its resources appropriately.
>or so+e applications, it +ay ha8e to handle 6lo,s ,hose rates are 6luctuating o8er ti+e.
We call such 6lo,s OburstyM. When net,or- resources are shared, instead o6 dedicated on a
per 6lo, basis, the net,or- +ay see- to a8oid congestion by using 'low control to ad?ust
the rates o6 the 6lo,s that enter the net,or-.
Calls. 0hese are the ser8ice re;uests that are +ade by applications and ,hich re;uire
connections to be set up by the net,or-. 0hey usually re;uire i++ediate response 6ro+ the
*
r
i
c
i
n
g

+
e
c
h
a
n
i
s
+
s
!.0W4RB C4!0R4L $3
net,or-. When a custo+er places a call in the telephone net,or-, a 8oice circuit connection
+ust be set up be6ore any 8oice in6or+ation can be sent. In the Internet, re;uests 6or ,eb
pages are calls that re;uire a connection set#up. !ot all transport technologies possess
controls that pro8ide i++ediate response to calls. Instead, connections +ay be scheduled
long in ad8ance.
"essions. 0hese are higher#le8el concepts in8ol8ing +ore than one connection. >or
eCa+ple, a 8ideo con6erence session re;uires connections 6or 8oice, 8ideo, and the data
to be displayed on a ,hite board. 2 session de6ines a conteCt 6or controlling and charging.
$616 !imescales
4ne ,ay to categori@e 8arious net,or- controls is by the ti+escales o8er ,hich they
operate. Consider a net,or- node DrouterE connected to a transatlantic 201 lin- o6 speed
('' 1bps or +ore. 0he I* pac-ets are bro-en into '3 byte 201 cells and these arri8e
e8ery 6e, +icroseconds. 0he pac-ets that are reasse+bled 6ro+ the cells +ust be handled
e8ery 6e, tens o6 +icroseconds. >eedbac- signals 6or 6lo, control on the lin- arri8e
e8ery 6e, tens o6 +illiseconds Dthe order o6 a round trip propagation ti+e, ,hich depends
on distanceE. Re;uests 6or ne, connections Dat the 0C* layerE occur at the rate o6 a 6e, per
second Dor tenths o6 a secondE. !et,or- +anage+ent operations, such as routing table
updates, ta-e place o8er +inutes. >ro+ +illiseconds to a year are re;uired 6or pricing
policies to a66ect de+and and the lin-Ms load. Dsee >igure 3.(E.
In the neCt sections, ,e brie6ly re8ie, so+e -ey net,or- controls.
$616$ ?andling Packets and Cells
0he 6astest ti+escale on ,hich control decisions can be +ade is o6 the order o6 a pac-et
interarri8al ti+e. .ach ti+e a net,or- node recei8es a pac-et it +ust decide ,hether the
!et,or- control 6unctions 0i+escale
Selecti8e cell and pac-et discard DpolicingE,
selecti8e cell and pac-et delay DshapingE,
scheduling and priority control
D;ueueing 6unctionalityE
cell, pac-et, ti+e
>eedbac- controls D6lo, controlE
round trip
propogation ti+e
Call ad+ission control DC2CE, routing
connection
interarri8al ti+e
!et,or- +anage+ent
+inutes
*ricing policy
+onths, years
/igure $61 !et,or- control ta-es place on +any ti+escales. Cell discard decisions are +ade e8ery
ti+e a cell is recei8ed, ,hereas pricing policy ta-es place o8er +onths or years. *ricing +echanis+s
Dalgorith+s based on econo+ic +odelsE can be used 6or opti+i@ing resource sharing at all le8els o6
net,or- control.
pac-et con6or+s to the tra66ic contract. I6 it does not, then the node ta-es an appropriate
policing action. It +ight discard the pac-et, or gi8e it a lo,er ;uality ser8ice. In so+e cases,
i6 a pac-et is to be discarded, then a larger bloc- o6 pac-ets +ay also be discarded, since
losing one pac-et +a-es all in6or+ation ,ithin its conteCt obsolete. >or instance, consider
Internet o8er 201. 2n Internet pac-et consists o6 +any cells. I6 a pac-et is trans+itted
and e8en ?ust one cell 6ro+ the pac-et is lost, then the ,hole pac-et ,ill be resent. 0hus,
the net,or- could discard all the cells in the pac-et, rather than ,aste e66ort in sending
those useless cells. 0his is called Oselecti8e cell discardM.
2 crucial decision that a net,or- node +ust ta-e on a per pac-et basis is ,here to
6or,ard an inco+ing pac-et. In a connectionless net,or-, the decision is based on the
destination o6 the pac-et through the use o6 a routing ta*le. *ac-ets include net,or-#
speci6ic in6or+ation in their header , such as source and destination addresses. In the
si+plest case o6 a router or $acket switch the routing table deter+ines the node that
should neCt handle the pac-et si+ply 6ro+ the pac-etMs destination.
In a connection#oriented net,or-, the pac-ets o6 a gi8en connection 6lo, through a path
that is pre#set 6or the connection. .ach pac-etMs header contains a label identi6ying the
connection responsible 6or it. 0he routing 6unction o6 the net,or- de6ines the path. 0his is
called virtual circuit switching , or si+ply s,itching. 1ore details are gi8en in Section
3.(.$. >or,arding in a connection#oriented net,or- is si+pler than in a connectionless one,
since there are usually 6e,er acti8e connections than possible destinations. 0he net,or- as
a ,hole has responsibility 6or deciding ho, to set routing tables and to construct and tear
do,n paths 6or connections. 0hese decisions are ta-en on the basis o6 a co+plete picture
o6 the state o6 the net,or- and so are rather slo, to change. !et,or- +anage+ent is
responsible 6or setting and updating this in6or+ation.
2n i+portant ,ay to increase re8enue +ay be to pro8ide di66erent ;ualities o6 ser8ice at
di66erent prices. So in addition to +a-ing routing decisions, net,or- nodes +ust also decide
ho, to treat pac-ets 6ro+ di66erent connections and so pro8ide 6lo,s ,ith di66erent ;ual#
ities o6 pac-et delay and loss. 2ll these decisions +ust be ta-en 6or each arri8ing pac-et.
0he ti+e a8ailable is eCtre+ely shortR in 6act, it is in8ersely proportional to the speed o6
the lin-s. 0here6ore, a large part o6 the decision#+a-ing 6unctionality 6or both routing and
di66erential treat+ent +ust be progra++ed in the hard,are o6 each net,or- node.
$616% =irtual Circuits and Label Switching
Let us loo- at one i+ple+entation o6 circuit s,itching. 2 net,or- path r bet,een nodes
A and ( is a se;uence o6 lin-s l
(
R l
2
R " " " R l
n
that connect A to ( . Let (R " " " R n C ( be
the nodes in the path, ,ith A 3 ( and ( 3 n C (. 2 label#s,itched path r
a
o8er r is a
se;uence
.l
(
R a
(
<R .l
2
R a
2
<R " " " R .l
n
R a
n
<, ,ith labels a
i
R i 3 (R " " " R n. Labels are uni;ue identi6iers
and
+ay be coded by integers. Such a label#s,itched path is progra++ed inside the net,or- by
(. associating r
a
at node A ,ith the pair .l
(
R a
(
<, and at node ( ,ith .l
n
R a
n
<R
2. adding to the s,itching table o6 each o6 the inter+ediate node i the local +apping
in6or+ation .l
i [(
R a
i [(
< _ .l
i
R a
i
<, i 3 2R " " " R n.
When a call arri8es re;uesting data transport 6ro+ A to ( , a connection a is established
6ro+ A to ( in ter+s o6 a ne, label#s,itched path, say r
a
. 3uring data trans6er, node A
brea-s the large units o6 data that are to be carried by the connection a into pac-ets, assigns
the label a
(
to each pac-et, and sends it through lin- l
(
to node 2. !ode i , i 3 2R " " " R n,
s,itches arri8ing pac-ets 6ro+ input lin- l
i [(
,ith label a
i [(
to the output lin- l
i
and
l
(
l
2
l
nW(
l
n
A
( 2 3 n
a
(
a
2
a
3
a
n
(
header
/igure $6 2 label#s,itched path i+ple+enting a 8irtual circuit bet,een nodes A and (.
changes the label to the ne, 8alue a
i
, as dictated by the in6or+ation in its s,itching table,
see >igure 3.2. 2t the end o6 the path, the pac-ets o6 connection a arri8e in se;uence at node
( carrying label a
n
. 0he pair .l
n
R a
n
< identi6ies the data as belonging to connection a.
When the connection is closed, the label#s,itched path is cleared by erasing the
corresponding entries in the s,itching tables. 0hus, labels can be reused by other
connections.
ecause a label#s,itched path has the se+antics o6 a circuit it is so+eti+es called a vir
tual circuit . 4ne can also construct O8irtual treesM by allo,ing +any paths to share an initial
part and then di8erge at so+e point. >or eCa+ple, binary branching can be progra++ed in
a s,itching table by setting .l
i
R a
i
< _ T.l
2
R a
2
<R .l
k
R a
k
<U. 2n inco+ing pac-et is
duplicated on the outgoing lin-s, l
2
R l
k
, ,ith the duplicates possibly carrying di66erent
labels. 0rees li-e this can be used to +ulticast in6or+ation 6ro+ a single source to +any
destinations. Girtual circuits and trees are used in net,or-s o6 201 technology, ,here
labels are integer nu+bers denoting the 8irtual circuit nu+ber on a particular lin- Dsee
Section 3.3.'E. In a re8erse ,ay, label#s,itched paths +ay be +erged inside the net,or- to
create re8erse trees Dcalled sinktrees E. 0his is use6ul in creating a logical net,or- 6or
reaching a particular destination. Such techni;ues are used in 1*LS technology net,or-s
Dsee Section 3.3.%E. Girtual circuits and trees are also used in >ra+e Relay net,or-s Dsee
Section 3.3.HE.
$616& Call Admission Control
We ha8e distinguished best#e66ort ser8ices 6ro+ ser8ices that re;uire per6or+ance
guarantees. 2 call that re;uires a guaranteed ser8ice is sub?ect to call ad+ission control to
deter+ine i6 the net,or- has su66icient resources to 6ul6il its contractual obligations. 4nce
ad+itted, policing control ensures that the call does not 8iolate its part o6 the contract.
*olicing controls are applied on the ti+escale o6 pac-et interarri8al ti+es. Call ad+ission
control DC2CE is applied on the ti+escale o6 call interarri8al ti+es. Since call interarri8al
ti+es can be relati8ely short, ad+ission decisions +ust usually be based upon in6or+ation
that is a8ailable at the entry node. 0his in6or+ation +ust control the ad+ission policy and
re6lect the ability o6 the net,or- to carry calls o6 gi8en types to particular destinations. DIt
+ay also need to re6lect the net,or- pro8iderMs policy concerning band,idth reser8ation
and ad+ission priorities 6or certain call types.E It is not realistic to ha8e co+plete
in6or+ation about the state o6 the net,or- at the ti+e o6 each ad+ission decision. 0his
,ould re;uire eCcessi8e co++unication ,ithin the net,or- and ,ould be i+possible 6or
net,or-s ,hose geographic span +eans there are large propagation delays. 2 co++on
approach is 6or the net,or- +anage+ent to -eep this in6or+ation as accurately as
possible and update it at ti+e inter8als o6 appropriate length.
0he call ad+ission control +echanis+ +ight be si+ple and based only on tra66ic
contract para+eters o6 the inco+ing call. 2lternati8ely, it +ight be co+pleC and use data
6ro+ on#line +easure+ents Ddynamic call admission control E. Clearly, +ore accurate C2C
allo,s 6or better loading o6 the lin-s, less bloc-ing o6 calls, and ulti+ately +ore pro6it
6or the net,or- operator. 0o assess the capacity o6 the net,or- as a transport ser8ice
Oproduction 6acilityM, ,e need to -no, its topology, lin- capacities and call ad+ission
control policy. 0ogether, these constrain the set o6 possible ser8ices that the net,or- can
support si+ultaneously. 0his is i+portant 6or the econo+ic +odelling o6 a net,or- that ,e
pursue in Chapter $. We de6ine 6or each contract and its resulting connection an e''ective
*andwidth. 0his is a si+ple scalar descriptor ,hich associates ,ith each contract a resource
consu+ption ,eight that depends on static para+eters o6 the contract. Calls that are easier
to handle by the net,or-, i.e. easier to +ultipleC, ha8e s+aller e66ecti8e band,idths. 2
si+ple call ad+ission rule is to ensure that the su+ o6 the e66ecti8e band,idths o6 the
connections that use a lin- are no +ore than the lin-Ms band,idth.
In net,or-s li-e the Internet, ,hich pro8ide only best#e66ort ser8ices, there is, in
principle, no need 6or call ad+ission control. 9o,e8er, i6 a ser8ice pro8ider ,ishes to
o66er better ser8ice than his co+petitors, then he +ight do this by buying enough capacity
to acco++odate his custo+ersM tra66ic, e8en at ti+es o6 pea- load. ut this ,ould usually
be too eCpensi8e. 2n alternati8e +ethod is to control access to the net,or-. >or instance, he
can reduce the nu+ber o6 a8ailable +ode+s in the +ode+ pool. 4r he can increase prices.
*rices can be increased at ti+es o6 o8erload, or 8ary ,ith the ti+e o6 day. Custo+ers ,ho
are ,illing to pay a pre+iu+ gain ad+ission and so prices can act as a 6leCible sort o6 call
ad+ission control. In any case, prices co+ple+ent call ad+ission control by deter+ining
the ,ay the net,or- is loaded, i.e. the relati8e nu+bers o6 di66erent ser8ice types that are
carried during di66erent de+and periods.
Call ad+ission control is not only used 6or the short duration contracts. It is also used
6or contracts that +ay last days or +onths. 0hese long duration contracts are needed to
connect large custo+ers to the Internet or to interconnect net,or-s. In 6act, connection#
oriented technology, such as 201, is today +ainly used 6or this purpose because o6 its
particular suitability 6or controlling resource allocation.
$616( Routing
Routing has di66erent se+antics depending on ,hether the net,or- technology is
connection#oriented or connectionless. In connection#oriented technology, routing is
concerned ,ith the logic by ,hich net,or-Ms routers 6or,ard indi8idual pac-ets. In
connectionless technology it is concerned ,ith the logic by ,hich the physical paths 6or
connections are chosen. Let us in8estigate each case separately.
In a connection#oriented net,or-, as depicted in >igure 3.3, routing is concerned ,ith
choosing the path that a connectionMs data is to ta-e through the net,or-. It operates on
a slo,er ti+escale than policing, since it +ust be in8o-ed e8ery ti+e a ne, call arri8es.
In source routing , in6or+ation at the source node is used to +a-e si+ultaneous decisions
about call acceptance and about the path the call ,ill 6ollo,. When the load o6 the net,or-
changes and lin-s that ha8e been 6a8oured 6or routing are 6ound to ha8e little spare capacity,
then the in6or+ation that is -ept at entry nodes can be updated to re6lect the change o6
net,or- state. 4n the basis o6 the updated in6or+ation, the routing control algorith+s at the
entry nodes +ay no, choose di66erent paths 6or connections. 2gain, net,or- +anage+ent
is responsible 6or updating in6or+ation about the net,or- state.
Source routing is rele8ant to net,or-s that support the type o6 connection#oriented
ser8ices de6ined in Section 2.(.$. DIt is also de6ined, but rarely used, in datagra+ net,or-s,
by including in a pac-etMs header a description o6 the co+plete path that the pac-et is to
6ollo, in the net,or-.E Connection#oriented net,or-s ha8e the connection se+antics o6
an end#to#end data strea+ o8er a 6iCed path. 0he basic entity is a connection rather than
tra66ic contract
destination
source
X
net,or- s,itches
/igure $6$ In a connection#oriented net,or- each ne,ly arri8ing call in8o-es a nu+ber o6
net,or- controls. Call routing 6inds a path 6ro+ the source to destination that 6ul6ils the userMs
re;uire+ents 6or band,idth and =oS. Call admission control is applied at each s,itch to deter+ine
,hether there are enough resources to accept the call on the output lin-. Connection setu$ uses
signalling +echanis+s to deter+ine the path o6 the connection, by routing and C2CR it updates
s,itching tables 6or the ne, 8irtual circuit and reser8es resources. 2bo8e, X +ar-s a possible route
that is re?ected by routing control. 4low control regulates the 6lo, in the 8irtual circuit once it is
established.
indi8idual pac-ets. When a call is ad+itted, the net,or- uses its signalling mechanism
to set the appropriate in6or+ation and reser8e the resources that the call needs at each
net,or- node along the path. 0his signalling +echanis+, together ,ith the ability to reser8e
resources 6or an indi8idual call on a 8irtual circuit, is a po,er6ul tool 6or supporting
di66erent =oS le8els ,ithin the sa+e net,or-. It can also be used to con8ey price
in6or+ation.
3uring the signalling phase, call ad+ission control 6unctions are in8o-ed at e8ery node
along the connectionMs path. 0he call is bloc-ed either i6 the entry node decides that there
are insu66icient resources inside the net,or-, or i6 the entry node decides that there +ay be
enough resources and co+putes a best candidate path, but then so+e node along that path
responds negati8ely to the signalling re;uest because it detects a lac- o6 resources. 2 si+ilar
operation ta-es place in the telephone net,or-. 0here are +any possibilities a6ter such a
re6usal" the call +ay be bloc-ed, another path +ay be tried, or so+e +odi6ication +ay be
+ade to the 6irst path to try to a8oid the lin-s at ,hich there ,ere insu66icient resources.
loc-ing a call depri8es the net,or- 6ro+ eCtra re8enue and causes unpredictable delays
to the application that places the call. Call bloc-ing probability is a ;uality o6 ser8ice
para+eter that +ay be negotiated at the ser8ice inter6ace. Routing decisions ha8e direct
i+pact on such bloc-ing probabilities, since routing calls on longer paths increases the
bloc-ing probability co+pared ,ith routing on shorter paths.
In a connectionless Ddatagra+E net,or-, the reasoning is in ter+s o6 the indi8idual
pac-ets, and so routing decisions are ta-en, and opti+i@ed, on a per pac-et basis. Since
the notion o6 a connection does not eCist, a user ,ho needs to establish a connection +ust
do so by adding his o,n logic to that pro8ided by the net,or-, as ,hen the 0C* is used
to +a-e connections o8er the Internet. 0he goal +ight be to choose routes that +ini+i@e
transit delay to pac-et destinations. Routers decide on pac-et 6or,arding by reading the
pac-et destination address 6ro+ the pac-et header and +a-ing a loo-up in the routing
ta*le. 0his table is di66erent 6or each router and stores 6or each possible destination address
the neCt OhopM Drouter or the 6inal co+puterE that the pac-et should ta-e on the ,ay to
its destination. Routing tables are updated by routing protocols on a ti+escale o6 +inutes,
or ,hen an abrupt e8ent occurs. In pure datagra+ net,or-s the co+pleCity o6 net,or-
controls is reduced because no signalling +echanis+ is re;uired.
I6 pac-ets that are destined 6or the sa+e end node +ay be roughly described as
indistinguishable, as is the case in the present Internet, then there is an inherent di66iculty in
allocating resources on a per call basis. 2d+ission control on a per call basis does not +a-e
sense in this case. 2 re+edy is to add eCtra 6unctionalityR ,e see this in the architectures o6
Internet 3i66erentiated Ser8ices and Internet Integrated Ser8ices, described in Section 3.3.%.
0he eCtra 6unctionality co+es at the eCpense o6 introducing so+e signalling +echanis+s
and +a-ing the net,or- +ore co+pleC.
Routing is related to pricing since it de6ines ho, the net,or- ,ill be loaded, thus
a66ecting the structure o6 the net,or- ,hen 8ie,ed as a ser8ice 6actory. >or eCa+ple, 8ideo
connections +ay use only a subset o6 the possible routes. 4ne could en8isage +ore co+pleC
interactions ,ith pricing. >or instance, ha8ing priced di66erent path seg+ents di66erently, a
net,or- operator +ight allo, custo+ers to ObuildM 6or the+sel8es the routes that their tra66ic
ta-es through the net,or-. In this scenario, the net,or- operator releases essential aspects
o6 net,or- control to his custo+ers. 9e controls the prices o6 path seg+ents and these
directly in6luence the custo+ersM routing decisions. 2 challenging proble+ is to choose
prices to opti+i@e the o8erall per6or+ance o6 the net,or-. 4bser8e that such an approach
reduces the co+pleCity o6 the net,or-, but places +ore responsibility ,ith the users. It
is consistent ,ith the InternetMs philosophy o6 -eeping net,or- 6unctions as si+ple as
possible. 9o,e8er, it +ay create dangerous instabilities i6 there are tra66ic 6luctuations and
users +a-e uncoordinated decisions. 0his +ay eCplain ,hy net,or- operators presently
pre6er to retain control o6 routing 6unctions.
$616+ /low Control
4nce a guaranteed ser8ice ,ith dyna+ic contract para+eters is ad+itted, it is sub?ect to
net,or- control signals. 0hese change the 8alues o6 the tra66ic contract para+eters at the
ser8ice inter6ace and dictate that the user should increase or decrease his use o6 net,or-
resources. 0he ser8ice inter6ace +ay be purely conceptualR in practice, these control signals
are recei8ed by the user applications. In principle the net,or- can en6orce its 6lo, control
Oco++andsM by policing the sources. 9o,e8er, in net,or-s li-e the Internet, this is not
done, because o6 i+ple+entation costs and added net,or- co+pleCity.
In +ost cases o6 transport ser8ices ,ith dyna+ic para+eters Dsuch as the transport ser8ice
pro8ided by the 0C* protocol in the InternetE, the net,or- control signals are congestion
indication signals. 4low control is the process ,ith ,hich the user increases or decreases his
trans+ission rate in response to these signals. 0he ti+escale on ,hich 6lo, control operates
is that o6 the ti+e it ta-es the congestion indication signals to propagate through the
net,or-R this is at +ost the round trip propagation ti+e. !otice that the controls applied to
guaranteed ser8ices ,ith purely static para+eters are open#loop" once ad+itted, the
resources that are needed are reser8ed at the beginning o6 the call. 0he controls applied to
guaranteed ser8ices ,ith purely dyna+ic para+eters are closed#loop" control signals
in6luence the input tra66ic ,ith no need 6or a $riori resource reser8ation.
>lo, control +echanis+s are traditionally used to reduce congestion . Congestion can be
recogni@ed as a net,or- state in ,hich resources are poorly utili@ed and there is unaccept#
able per6or+ance. >or instance, ,hen pac-ets arri8e 6aster at routers than the +aCi+u+
speed that these can handle, pac-et ;ueues beco+e large and signi6icant proportions o6
pac-# ets o8er6lo,. 0his pro8ides a good +oti8ation to send congestion signals to the
sources be6ore the situation beco+es out o6 hand. 7sers see a se8ere degradation in the
per6or# +ance o6 the net,or- since they +ust retrans+it lost in6or+ation D,hich 6urther
increases
congestionE, or they 6ind that their applications operate poorly. In any case, congestion
results in ,aste and net,or-s use 6lo, control to a8oid it. 46 course co+plete absence o6
congestion +ay +ean that there is also ,aste because the net,or- is loaded too conser8a#
ti8ely. 0here are other tools 6or congestion control besides 6lo, control. *ricing policies or
appropriate call ad+ission controls can reduce congestion o8er longer ti+escales. I6 prices
are dyna+ically updated to re6lect congestion, then they can eCert e66ecti8e control o8er
s+all ti+escales. We consider such pricing +echanis+s in Chapter ).
>lo, control also has an i+portant 6unction in controlling the allocation o6 resources.
y sending +ore congestion signals to so+e sources than others, the net,or- can control
the allocation o6 tra66ic 6lo, rates to its custo+ers. 0hus 6lo, control can be 8ie,ed as
a +echanis+ 6or +a-ing a particular choice a+ongst the set o6 6easible 6lo,s. 0his is
i+portant 6ro+ an econo+ic perspecti8e as econo+ic e66iciency is obtained ,hen
band,idth is allocated to those custo+ers ,ho 8alue it +ost. 1ost o6 todayMs 6lo, control
+echanis+s lac- the capability to allocate band,idth ,ith this econo+ic perspecti8e
because the part o6 the 6lo, control process that decides ,hen and to ,ho+ to send
congestion signals is typically not designed to ta-e it into account. >lo, control only
6ocuses on congestion a8oidance, and treats all sources that contribute to congestion
e;ually.
>lo, control can also be 8ie,ed as a procedure 6or 6airly allocating resources to 6lo,s.
>airness is a general concept that applies to the sharing o6 any co++on good. 2n allocation
is said to be 6air according to a gi8en 6airness criterion ,hen it satis6ies certain 6airness
conditions. 0here are +any ,ays to de6ine 6airness. >or eCa+ple, proportional 6airness
e+phasi@es econo+ic e66iciency and allocates greater band,idth to custo+ers ,ho are
,illing to pay +ore. 1aC#+in 6airness +aCi+i@es the si@e o6 the s+allest 6lo,. I+plicit
in a 6airness de6inition 6or the allocation o6 band,idth is a 6unction that ta-es custo+erMs
de+ands 6or 6lo,s and co+putes an allocation o6 band,idth. 0he allocation is 6air
according to the 6airness de6inition and uses as +uch o6 the lin-sM band,idth as possible.
Ai8en the ,ay that user applications respond to congestion signals, a net,or- operator can
i+ple+ent his pre6erred criterion 6or 6air band,idth allocation by i+ple+enting appropriate
congestion signalling +echanis+s at the net,or- nodes. In Chapter (0 ,e in8estigate 6lo,
control +echanis+s that control congestion and achie8e econo+ic 6airness.
0he use o6 6lo, control as a +echanis+ 6or i+ple+enting 6air band,idth allocation relies
on users reacting to 6lo, control signals correctly. I6 a 6lo, control +echanis+ relies on the
user to ad?ust his tra66ic 6lo, in response to congestion signals and does not police hi+ then
there is the possibility he +ay cheat. 2 user +ight see- to increase his o,n per6or+ance
at the eCpense o6 other users. 0he situation is si+ilar to that in the prisonersM dile++a Dsee
Section H.$.(E. I6 ?ust one user cheats he ,ill gain. 9o,e8er, i6 all users cheat, then the
net,or- ,ill be highly congested and all users ,ill lose. 0his could happen in the present
Internet. 0C* is the de6ault congestion response so6t,are. 9o,e8er, there eCist OboostedM
8ersions o6 0C* that respond less to congestion signals. 0he only reason that +ost users
still run the standard 8ersion o6 0C* is that they are ignorant o6 the technological issues
and do not -no, ho, to per6or+ the installation procedure.
*ricing can gi8e users the incenti8e to respond to congestion signals correctly. Roughly
spea-ing, users ,ho 8alue band,idth +ore ha8e a greater ,illingness to pay the higher
rate o6 charge, ,hich can be encoded in a higher rate o6 congestion signals that is sent
during congestion periods. .ach user see-s ,hat is 6or hi+ the Obest 8alue 6or +oneyM in
ter+s o6 per6or+ance and net,or- charge. 9e +ight do this using a band,idth see-ing
application. It should be possible to -eep congestion under control, since a high enough
rate o6 congestion charging ,ill +a-e sources reduce their rates su66iciently.
So+eti+es 6lo, control +ay be the responsibility o6 the user rather than the net,or-. >or
instance, i6 the net,or- pro8ides a purely best#e66ort ser8ice, it +ay be the responsibility
o6 the user to ad?ust his rate to reduce pac-et losses and delays.
$616, Network *anagement
Network management concerns the operations used by the net,or- to i+pro8e its
per6or+ance and to de6ine eCplicit policy rules 6or security, handling special custo+ers,
de6ining ser8ices, accounting, and so on. It also pro8ides capabilities 6or +onitoring the
tra66ic and the state o6 the net,or-Ms e;uip+ent. 0he philosophy o6 net,or- +anage+ent is
that it should operate on a slo, ti+escale and pro8ide net,or- ele+ents ,ith the
in6or+ation they need to react on 6aster ti+escales as the conteCt dictates.
!et,or- +anage+ent di66ers 6ro+ signalling. Signalling +echanis+s react to eCternal
e8ents on a 8ery 6ast ti+escale and ser8e as the Oner8ous syste+M o6 the net,or-. !et,or-
+anage+ent operations ta-e place +ore slo,ly. 0hey are triggered ,hen the net,or-
ad+inistrator or control so6t,are detects that so+e reallocation or eCpansion o6 resources
is needed to ser8e the acti8e contracts at the desired ;uality le8el. >or eCa+ple, ,hen a lin-
or a node 6ails, signalling is in8o-ed 6irst to choose a de6ault alternati8e. 2t a later stage
this decision is i+pro8ed by the net,or- +anage+ent +a-ing an update to routing tables.
$6 !ariffs9 dynamic 'rices and charging mechanisms
!et,or- control ensures that the net,or- accepts no +ore contracts than it can handle
and that accepted contracts are 6ul6illed. 9o,e8er, si+ple call ad+ission control eCpresses
no pre6erence 6or the +iC o6 di66erent contracts that are accepted. Such a pre6erence can
be eCpressed through co+pleC call ad+ission control strategies that di66erentiate contract
types in ter+s o6 bloc-ing. 4r they can also be eCpressed through tari66ing and charging,
,hich +ay be 8ie,ed as a higher#le8el 6lo, control that operates at the contract le8el by
o66ering di66erent incenti8es to users. 0hey not only ensure that de+and does not eCceed
supply, but also that the a8ailable capacity is allocated a+ongst potential custo+ers so
as to +aCi+i@e re8enue or be socially e66icient Din the sense de6ined in Section '.$E.
!ote, ho,e8er, that 6or the latter purpose charges +ust be related to resource usage. We
discuss this i+portant concept in Chapter &. Charges also gi8e users the incenti8e to release
net,or- resources ,hen they do not need the+, to as- only 6or the contracts that are +ost
suited to the+, and 6or those users ,ho 8alue a ser8ice +ore to get +ore o6 it. Si+plicity
and 6leCibility are argu+ents 6or regulating net,or- usage by using tari66ing rather than
co+pleC net,or- controls. 0he net,or- operator does not need to reprogra+ the net,or-
nodes, but si+ply post appropriate tari66s 6or the ser8ices he o66ers. 0his pushes so+e o6
the decision#+a-ing onto the users and lea8es the net,or- to carry out basic and si+ple
operations.
Gie,ed as a long#ter+ control that is concerned ,ith setting tari66s, pricing policy
e+erges in an iterati8e +anner Di.e. 6ro+ a tatonne+ent as described in Section '.$.(E.
Suppose that a supplier posts his tari66s and users ad?ust their de+ands in response. 0he
supplier reconsiders his tari66s and this leads to 6urther ad?ust+ent o6 user de+and. 0he
ti+escale o8er ,hich these ad?ust+ents ta-e place is typically +onths or years. 1oreo8er,
regulation +ay pre8ent a supplier 6ro+ changing tari66s too 6re;uently, or re;uire that
changes +a-e no custo+er ,orse o66 Dthe so#called Ostatus#;uo 6airnessM test o6 Section
(0.(E. In co+parison, dyna+ic pricing +echanis+s +ay operate on the ti+escale o6 a
round trip propagation ti+eR the net,or- posts prices that 6luctuate ,ith de+and and
resource a8ailability. 0he
S.RGIC. 0.C9!4L4AI.S '(
userMs so6t,are closely +onitors the price and opti+ally ad?usts the consu+ption o6 net,or-
resources to re6lect the userMs pre6erences.
3yna+ic pricing has an i+ple+entation cost 6or both the net,or- and the custo+ers. 2
practical approCi+ation to it is timeo'day $ricing , in ,hich the net,or- posts 6iCed prices
6or di66erent periods o6 the day, corresponding to the a8erage dyna+ic prices o8er the gi8en
periods. 0his type o6 pricing re;uires less co+pleC net,or- +echanis+s. Custo+ers li-e it
because it is predictable.
It is a +isconception that it is hard 6or custo+ers to understand and to react to dyna+ic
prices. 4ne could en8ision +echanis+s that allo, custo+ers to pay a 6lat 6ee Dpossibly @eroE
and the net,or- to adapt the a+ount o6 resources allocated at any gi8en ti+e so that each
custo+er recei8es the per6or+ance 6or ,hich he pays. 4r custo+ers +ight dyna+ically
choose a+ongst a nu+ber o6 6lat rate charging structures Dsay, gold, sil8er or bron@eE and
then recei8e corresponding ;ualities o6 ser8ice. In this case prices are 6iCed but per6or+ance
6luctuates. 2lternati8ely, a custo+er +ight as- 6or a 6iCed per6or+ance and ha8e a third
party pay its 6luctuating cost. 0his is ,hat happens in the electricity +ar-et, in ,hich
generators ;uote spot prices, but end#custo+ers pay constant prices per BWh to their
suppliers. 2 custo+er +ight buy insurance against se8ere price 6luctuations. 2ll o6 these
ne, 8alue# added co++unication ser8ice +odels can be i+ple+ented easily since they
+ainly in8ol8e so6t,are running as a net,or- application.
Suppose that a net,or- ser8ice pro8ider can i+ple+ent +echanis+s that re6lect resource
scarcity and de+and in prices, and that he co++unicates these to custo+ers, ,ho on the
basis o6 the+ ta-e decisions. Ideally, ,e ,ill 6ind that as the pro8ider and users o6 net,or-
ser8ices 6reely interact, a O+ar-et#+anaged net,or-M e+erges, that has desirable stability
properties, opti+i@es global econo+ic per6or+ance +easures, and allo,s in6or+ation to
re+ain local ,here it is needed 6or decision#+a-ing. 0he tas- o6 creating such a sel6#
+anaged net,or- is not tri8ial. 0he in8ol8e+ent o6 a large nu+ber o6 entities and co+pleC
econo+ic incenti8es +a-es security issues o6 para+ount i+portance. >or instance, the
net,or- that charges its custo+ers 6or its ser8ices is only the 6inal net,or- in a 8alue chain,
,hich in8ol8es +any other transport and 8alue#added ser8ice pro8iders. .ach inter+ediate
net,or- has an incenti8e to +isreport costs and so eCtract a larger percentage o6 the
custo+er pay+ent. 0his +eans that sophisticated electronic co++erce techni;ues +ust be
used 6or security and pay+ents. !et,or- +ay try to pro8ide a ,orse ;uality ser8ice to
custo+ers o6 other net,or- pro8iders, so as to i+pro8e the ser8ice o66ered to its custo+ers
or attract the custo+ers o6 other operators. !et,or-s are no longer trusted parties, as they
are in the case o6 the large state#controlled net,or- +onopolies. !e, security and pay+ent
+odels and +echanis+s are re;uired.
$6$ Service technologies
$6$61 A !echnology Summary
0he concepts ,e ha8e +entioned so 6ar are ;uite general. In this and the 6ollo,ing section
,e discuss so+e o6 the data transport ser8ices that are standardi@ed and supported by
net,or- technologies such as the Internet and 201. Such ser8ices are used to lin- re+ote
applications and they are di66erentiated in ter+s o6 the ;uality o6 the ser8ice o66ered by the
net,or-. 0he reader ,ill recogni@e +ost o6 the generic ser8ice inter6ace aspects that ,e
ha8e introduced.
We discussed in Section 2.(.( the ideas o6 layering and o6 synchronous and asynchronous
technologies. 2t a lo,er layer, synchronous ser8ices such as S4!.0 pro8ide 6or large 6iCed
'2 !.0W4RB 0.C9!4L4A/
si@e containers, called 'rames . We +ay thin- o6 a 6ra+e as a large 6iCed si@e se;uence o6
bits containing in6or+ation about the 6ra+e itsel6 and the bytes o6 higher layer ser8ice data
that are encapsulated in the 6ra+e. Synchronous 6ra+ing ser8ices constantly trans+it 6ra+es
one a6ter the other, e8en i6 no data are a8ailable to 6ill these 6ra+es. >ra+es +ay be 6urther
subdi8ided into constant si@e sub#6ra+es, so allo,ing +ultiple synchronous connections o6
s+aller capacities to be set up.
2t a higher layer, asynchronous technologies such as I*, 201 and >ra+e Relay, brea-
in6or+ation strea+s into data pac-ets Dor cellsE that are placed in the 6ra+es Dor the
s+aller sub#6ra+esE. 0heir goal is to per6or+ statistical +ultipleCing, i.e. to e66iciently
6ill these 6ra+es ,ith pac-ets belonging to di66erent in6or+ation strea+s. 2t the lo,est
layer, these 'raming services +ay operate o8er 6ibre by encoding in6or+ation bits as light
pulses o6 a certain ,a8elength Dthe OXME. 4ther possible trans+ission +edia are +icro,a8e
and other ,ireless technologies. >or eCa+ple, a satellite lin- pro8ides 6or synchronous
6ra+ing ser8ices o8er the +icro,a8e path that starts 6ro+ the sending station and re6lects
o66 the satellite to all recei8ers in the satelliteMs 6ootprint. In contrast to S4!.0, Aigabit
and (0 Aigabit .thernet is an eCa+ple o6 a 6ra+ing ser8ice that is asynchronous and o6
8ariable si@e. Indeed, an .thernet 6ra+e is constructed 6or each I* pac-et and is trans+itted
i++ediately at so+e +aCi+u+ trans+ission rate i6 conditions per+it. 2s ,e ,ill see, since
.thernet 6ra+es +ay not depart at regular inter8als Ddue to contention resulting 6ro+ the
custo+ers using the sa+e lin-E, .thernet ser8ices +ay not pro8ide the e;ui8alent o6 a 6iCed
si@e bit pipe. Auaranteed band,idth can be pro8ided by dedicating .thernet 6ibre lin-s to
single custo+er tra66ic. >inally, note that 201 is an asynchronous ser8ice that is used by
another asynchronous ser8ice, na+ely I*. 0he I* pac-ets are bro-en into s+all 201 cells
,hich are then used to 6ill the lo,er#le8el synchronous 6ra+es.
4ur discussion so 6ar suggests that custo+ers re;uiring connections ,ith irregular
and bursty tra66ic patterns should pre6er higher layer asynchronous transport ser8ices.
2synchronous ser8ices then consu+e lo,er layer 6ra+ing ser8ices Dsynchronous or
asynchronousE, ,hich usually connect the net,or-Ms internal nodes and the custo+ers to the
net,or-. >ra+ing ser8ices consu+e seg+ents o6 6ibre or other trans+ission +edia. 4bser8e
that a custo+er ,hose tra66ic is both great and regular enough e66iciently to use large
synchronous containers, +ight directly buy synchronous ser8ices to support his connection.
Si+ilarly, large custo+ers ,ith bursty tra66ic +ay buy asynchronous container ser8ices, e.g.
.thernet ser8ices, that allo, 6urther +ultipleCing o6 the ra, 6ibre capacity.
>igure 3.$ sho,s a classi6ication o6 the 8arious transport ser8ices that ,e present in the
neCt sections. >or si+plicity ,e assu+e that the physical trans+ission +ediu+ is 6ibre. In
6act, +icro,a8e and ,ireless are also possible +edia. 0his +ay co+plicate the picture
so+e# ,hat, since so+e o6 the 6ra+ing protocols running o8er 6ibre +ay not run o8er other
+edia. Ser8ices to,ards the botto+ o6 the diagra+ o66er 6iCed si@e bit pipes o6 coarse
granularity, and the underlying controls to set up a call are at the net,or- +anage+ent
layer, i.e. do not ,or- in 8ery 6ast ti+escales. y their nature, these are better suited 6or
carrying tra66ic in the interior o6 the net,or- ,here tra66ic is ,ell aggregated. .thernet is
the only technology o66ering coarse bit pipes that +ay be shared. >ibre is Otechnology
neutralM in the sense that the higher layer protocols dictate the details DspeedE o6
in6or+ation trans+ission. Such protocols operate by trans+itting light o6 a certain
,a8elength. 3W31 is a technology that +ultiplies the 6ibre throughput by separating
light into a large nu+ber o6 ,a8elengths, each o6 ,hich can carry the sa+e ;uantity o6
in6or+ation that the 6ibre ,as able to carry
using a single ,a8elength.
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S.RGIC. 0.C9!4L4AI.S '3
!CP@2P9 81P@2P
shared band,idth
no =oS
A!*, guaranteed band,idth
/R 'inemedium granularity
S4N"!, guaranteed shared or guaranteed b,
S1? band,idth
mediumcoarse granularity
"thernet
/ibre ;with 1W1*<
/igure $6% Ser8ices to,ards the botto+ o6 this diagra+ o66er 6iCed si@e bit pipes o6 coarse
granularity, and the underlying controls 6or call set#up do not ,or- in 8ery 6ast ti+escales. Ser8ices
to,ards the top o66er 6leCible pipes o6 arbitrarily s+all granularity and s+all to @ero set#up cost that
can be established bet,een any arbitrary pair o6 net,or- edge points. >ibre is Otechnology neutralM in
the sense that the higher layer protocols dictate the details o6 in6or+ation trans+ission.
Ser8ices to,ards the top o6 the diagra+ build 6leCible pipes o6 arbitrarily s+all
granularity. 0hese are +ainly 0C*<I* and 73*<I* pipes, since the dyna+ic call set#up o6
the 201 standard is not i+ple+ented in practice. D!ote, also, that ,e ha8e denoted 201
and >ra+e Relay as guaranteed ser8ices, in the sense that they can pro8ide band,idth
guarantees by using an appropriate SL2. 0hese ser8ice ha8e +ore general 6eatures that
allo, the+ to pro8ide best#e66ort ser8ices as ,ell.E
Connections using ser8ices at the top o6 the diagra+ ha8e little or no set#up cost, and can
be established bet,een arbitrary pairs o6 net,or- edge points. 0his ?usti6ies the use o6 the I*
protocol technology 6or connecting user applications. In the present client#ser8er Internet
+odel Dand e8en +ore in 6uture peer#to#peer co++unications +odelsE, connections are
eCtre+ely unpredictable in ter+s o6 duration and location o6 origin#destination end#points.
9ence the only negati8e side o6 I* is the absence o6 guarantees 6or the dia+eter o6 the
pipes o6 the connections. Such a de6ect can be corrected by eCtending the I* protocol, or
by per6or+ing 'low isolation . 0his +eans building 6iCed si@e pipes Dusing any o6 the 6iCed
si@e pipe technologyE bet,een speci6ic points o6 the net,or- to carry the I* 6lo,s that
re;uire di66erential treat+ent. 0his is the +ain idea in the i+ple+entation o6 Girtual *ri8ate
!et,or-s described in detail in Section 3.$.( using the 1*LS technology.
We no, turn to detailed descriptions o6 the basic connection technologies.
$6$6 4'tical Networks
#$tical networks pro8ide a 6ull stac- o6 connection ser8ices, starting 6ro+ light $ath
ser8ices at the lo,est layer and continuing ,ith 6ra+ing ser8ices, such as S4!.0 and
.thernet, up to 201 and I* ser8ices. We concentrate on the lo,er layer light path ser8ices
since the higher layers ,ill be discussed in 6ollo,ing sections.
5ense Wavelength 5ivision Multi$le,ing D3W31E is a technology that allo,s +ultiple
light bea+s o6 di66erent colours DXsE to tra8el along the sa+e 6ibre Dcurrently (H to 32 Xs,
,ith H$ and &0 X in the laboratoriesE. 2 light path is a connection bet,een t,o points in
the net,or- ,hich is set up by allocating a dedicated Dpossibly di66erentE X on each lin-
o8er the path o6 the connection. 2long such a light path, a light bea+ enters the net,or-
at the entry point, using the X assigned on the 6irst lin-, continues through the rest o6 the
lin-s by changing the X at each inter+ediate node and 6inally eCits the net,or- at the
eCit point. 0his is analogous to circuit#s,itching, in ,hich the Xs play the role o6 circuit
identi6iers or o6 labels on a label#s,itched path. Lasers +odulate the light bea+ into pulses
that encode the bits, presently at speeds o6 2.' Abps and (0 Abps, and soon to be $0 Abps,
depending on the 6ra+ing technology that is used abo8e the light path layer. 4ptical signals
are attenuated and distorted along the light path. 3epending on the 6ibre ;uality and the
lasers, the light pulses need to be a+pli6ied and possibly regenerated a6ter tra8elling 6or
a certain distance. 0hese are ser8ices pro8ided internally by the optical net,or- ser8ice
pro8ider to guarantee the ;uality o6 the in6or+ation tra8elling along a light path. In an
allo$tical network , the light that tra8els along a lightpath is regenerated and s,itched at
the optical le8el, i.e. ,ithout being trans6or+ed into electrical signals.
In the near 6uture, optical net,or- +anage+ent technology ,ill allo, lightpaths to be
created dyna+ically at the re;uests o6 applications D?ust li-e dyna+ic 8irtual circuitsE. .8en
6urther in the 6uture, optical s,itching ,ill be per6or+ed at a 6iner le8el, including s,itching
at the le8el o6 pac-ets and not ?ust at the le8el o6 the light pathMs colour. 3yna+ic light
path ser8ices ,ill be appropriate 6or applications that can +a-e use o6 the 8ast a+ounts
o6 band,idth 6or a short ti+e. 9o,e8er, the 6act that optical technology is rather cheap
,hen no electronic con8ersion is in8ol8ed +eans that such ser8ices +ay be econo+ically
sensible e8en i6 band,idth is partly ,asted. *resently, lightpath ser8ices are used to create
8irtual pri8ate net,or-s by connecting routers o6 the sa+e enterprise at di66erent locations.
2n i+portant property o6 a lightpath ser8ice is trans$arency regarding the actual data
being sent o8er the lightpath. Such a ser8ice does not speci6y a bit rate since the higher
layers such as .thernet or S4!.0 ,ith their electrical signals ,ill dri8e the lasers ,hich
are also part o6 the .thernet or S4!.0 speci6ication. 2 certain +aCi+u+ bit rate +ay be
speci6ied and the ser8ice +ay carry data o6 any bit rate and protocol 6or+at, e8en
analog data. .ssentially the net,or- guarantees a +ini+u+ bound on the distortion and
the attenuation o6 the light pulses. In the case o6 a light path pro8ided o8er an all#optical
net,or-, ,here there is optical to electrical signal con8ersion 6or s,itching and
regeneration, the electro# optical co+ponents +ay pose 6urther restrictions on +aCi+u+ bit
rates that can be supported
o8er the light path.
2 dark 'i*re ser8ice is one in ,hich a custo+er is allocated the ,hole use o6 an optical
6ibre, ,ith no optical e;uip+ent attached. 0he custo+er can +a-e 6ree use o6 the 6ibre. >or
eCa+ple, he +ight supply S4!.0 ser8ices to his custo+ers by deploying S4!.0 o8er
3W31 technology, hence using +ore than a single Xs.
0here is today a lot o6 dar- 6ibre installed around the ,orld. !et,or- operators clai+ that
their bac-bones ha8e capacities o6 hundreds o6 Aigabits or 0erabits per second. Since this
capacity is already in place and its cost is sun-, one +ight thin- that enor+ous capacity can
be o66ered at al+ost @ero cost. 9o,e8er, +ost o6 the capacity is dar- 6ibre. It is costly to add
lasers to light the 6ibre and pro8ide the other necessary optical and electronic e;uip+ent.
0his +eans there is a non#tri8ial 8ariable cost to adding ne, ser8ices. 0his OhiddenM cost
+ay be one reason that applications such as 8ideo on de+and are slo, to co+e to +ar-et.
$6$6$ "thernet
.thernet is a popular technology 6or connecting co+puters. In its traditional 8ersion, it
pro8ides a best#e66ort 6ra+ing ser8ice 6or I* pac-ets, one .thernet 6ra+e per I* pac-et. 0he
6ra+ed I* pac-ets are the .thernet pac-ets ,hich can be trans+itted only i6 no other node o6
the .thernet net,or- is trans+itting. 0he trans+ission speeds are 6ro+ (0 1bps to (0 Abps
in +ultiples o6 ten Dand since the price o6 a (0 Abps .thernet adaptor card is no +ore than
2"' ti+es the price o6 a ( Abps card, the price per bit drops by a 6actor o6 6ourE. .thernet
technologies that use s,itching can pro8ide connection#oriented ser8ices that are either
best#e66ort or ha8e guaranteed band,idth. .thernet can pro8ide ser8ice o6 up to '$ 1bps
o8er ,ireless and o8er the t,isted#pair copper ,ires that are readily a8ailable in buildings.
0,isted#pair ,iring constrains the +aCi+u+ distance bet,een connected e;uip+ent to 200
+eters. >or this reason, .thernet has been used +ainly to connect co+puters that belong
to the sa+e organi@ation and ,hich 6or+ a Local 2rea !et,or- DL2!E. It is by 6ar the
+ost popular L2! technology, and +ore than '0 +illion .thernet inter6ace cards are sold
each year.
.thernet ser8ice at speeds greater than (00 1bps is usually pro8ided o8er 6ibreR this
greatly eCtends the 6easible physical distance bet,een custo+er e;uip+ent. (0 Aigabit
.thernet using special 6ibre can be used 6or distances up to $0 -+. >or this reason and its
lo, cost, .thernet technology can be e66ecti8ely used to build 1etropolitan 2rea !et,or-s
D12!sE and other access net,or-s based on 6ibre. In the si+plest case, a point#to#point
.thernet ser8ice can run o8er a dedicated 6ibre or o8er a light path ser8ice pro8ided by an
optical net,or-. In this case, distances +ay eCtend ,ell beyond $0 B+.
2n .thernet net,or- consists o6 a central net,or- node ,hich is connected to each
co+puter, router or other .thernet net,or- node by a dedicated line. .ach such edge
de8ice has a uni;ue .thernet address. 0o send a data pac-et to de8ice ( , de8ice A builds
an .thernet pac-et ,hich encapsulates the original pac-et ,ith the destination address o6 ( ,
and sends it to the central node. 0his node 6unctions as a hu* or switch. 2 hub retrans+its
the pac-et to all its connected de8ices, and assu+es a de8ice ,ill only -eep the pac-ets
that ,ere destined 6or it. 2 node starts trans+itting only i6 no pac-et is currently being
trans+itted. ecause t,o de8ices +ay start trans+itting si+ultaneously, the t,o pac-ets
can OcollideM, and +ust be retrans+itted. DIn 6act, propagation delays and 8arying distances
o6 edge de8ices +ean that collision can occur e8en i6 de8ices start trans+itting a little ti+e
apart.E Con6lict resolution ta-es ti+e and decreases the e66ecti8e throughput o6 the net,or-.
0he use o6 s,itches instead o6 hubs re+edies this de6iciency.
2 s,itch -no,s the .thernet addresses o6 the connected edge de8ices and 6or,ards
the pac-et only to the ,ire that connects to the de8ice ,ith the destination address. >or
large .thernet net,or-s o6 +ore than one .thernet net,or- node, an .thernet s,itch ,ill
6or,ard the pac-et to another .thernet s,itch only i6 the destination de8ice can be reached
through that s,itch. In this case the s,itching tables o6 the .thernet s,itches essentially
i+ple+ent 8irtual circuits that connect the edge de8ices. Such a connection +ay sustain
t,o#,ay tra66ic at the +aCi+u+ rate o6 the lin-s that connect the edge de8ices, i.e. ( 1bps
to ( Abps D(0 AbpsE. 0his +aCi+u+ rate can be guaranteed at all ti+es i6 the abo8e
physical lin-s are not shared by other 8irtual circuits. I6 a nu+ber o6 8irtual circuits share
so+e physical lin-s Dpossibly in the interior o6 the .thernet net,or-E then band,idth is
statistically +ultipleCed a+ong the co+peting edge de8ices in a best#e66ort 6ashionR see
>igure 3.'. 0his +ay be a good idea i6 such a ser8ice is pro8ided 6or data connections
that are bursty. ursty data sources 8alue the possibility o6 sending at high pea- rates,
such as (0 1bps, 6or short periods o6 ti+e. Statistical argu+ents suggest that in high speed
lin-s, statistical +ultipleCing can be eCtre+ely e66ecti8e, +anaging to isolate each data
source 6ro+ its co+petitors Di.e. 6or +ost o6 the ti+e each de8ice can essentially use the
net,or- at its +aCi+u+ capabilityE. *roprietary .thernet s,itching technologies allo, 6or
+anageable net,or- resources, i.e. 8irtual circuits +ay be di66erentiated in ter+s o6 priority
and +ini+u+ band,idth guarantees.
Connecti8ity pro8iders using the Aigabit and (0 Aigabit .thernet technology pro8ide
ser8ices +ore ;uic-ly and in +ore 6leCible incre+ents than co+petitors using the traditional
N
A
(
IS*
( R
(
R
2
IS*
2
4 C ( Abps
E 5 (00 1bps
/igure $6& 0he le6t o6 the 6igure sho,s a si+ple .thernet net,or-. N is an .thernet s,itch, and
A, (, C , 5, E , 4 are attached de8ices, such as co+puters and routers. Girtual circuit 4C has
dedicated band,idth. Girtual circuits E( and 5( share the band,idth o6 lin- N(. 0he right o6 the
6igure sho,s the architecture o6 a si+ple access net,or-, in ,hich edge custo+ers obtain a
(00 1bps .thernet ser8ice to connect the+ to the router o6 their IS*. 0he ( Abps technology is
used 6or lin-s shared a+ong +any such custo+ers.
S4!.0 technology that ,e discuss in Section 3.3.$. esides a lo,er cost per Aigabit
Dal+ost (0"( in 6a8our o6 .thernetE, .thernet net,or-s are +anaged by +ore +odern ,eb#
based so6t,are, allo,ing these ne, co+petiti8e *andwidth on demand 6eatures, ,here
band,idth incre+ents can be as lo, as a 6e, +egabits and can be pro8ided in a short
notice. 0he negati8e side is that capacity +ay be shared, as discussed pre8iously.
$6$6% Synchronous Services
Synchronous ser8ices pro8ide end#to#end connections in ,hich the user has a 6iCed rate o6
ti+e slots that he can 6ill ,ith bits. 0hey are the pri+e eCa+ple o6 guaranteed ser8ices.
.Ca+ples o6 synchronous connection#oriented ser8ices are S39, S4!.0 and IS3!. "53
and "#NET e+ploy si+ilar technologies and are typically used 6or static connections that
are set up by +anage+ent. 0he ter+ S4!.0 DSynchronous 4ptical !et,or-E is used in the
7S and operates only o8er 6ibre, ,hereas S39 DSynchronous 3igital 9ierarchyE is used in
.urope. 0hey pro8ide synchronous bit pipes in discrete si@es o6 '(.&$ 1bps Donly S4!.0E,
(''.'2 1bps, H22.0& 1bps, 2.$&& Abps and ).)'3 Abps. It is also possible to subdi8ide
these, to pro8ide s+aller rates, such as +ultiples o6 '(.&$ 1bps. In such ser8ices the ;uality
is 6iCed in a gi8en net,or- and is deter+ined by the bit error rate and the ?itter, ,hich are
usually eCtre+ely s+all. 0here is no need 6or a co+pleC tra66ic contract and policing since
the user has a dedicated bit pipe ,hich operates at a constant bit rate and ,hich he can 6ill
to the +aCi+u+. 0he net,or- has no ,ay to -no, ,hen such a pipe is not 6ull and ,hen
unused capacity could carry other tra66ic.
We ha8e already eCplained the operation o6 S4!.0 and S39 in ter+s o6 pro8iding a
constant rate o6 6iCed si@e data 6ra+es o8er the 6ibre. Such 6ra+es +ay be 6urther subdi8ided
to constant si@e sub#6ra+es to allo, the setting up o6 +ultiple synchronous connections
o6 s+aller capacities. 0hese s+aller 6ra+es +ust be +ultiples o6 the basic (''.'2 1bps
container. >or instance, a 2.$&& Abps S4!.0 lin- can pro8ide 6or a single 2.$&& Abps
S4!.0 ser8ice or 6our ser8ices o6 H22.0& 1bps, or t,o H22.0& 1bps and 6our (''.'2
1bps ser8ices. In that sense, S4!.0 and S39 can be seen as +ultipleCing technologies
6or synchronous bit strea+s ,ith rates being +ultiples o6 (''.'2 1bps.
2n i+portant ;uality o6 ser8ice pro8ided by S4!.0 and S39 net,or-s is the ability
to reco8er in the e8ent o6 6ibre disruption or node 6ailure. 0he nodes o6 S4!.0 and
S39 net,or-s are typically connected in a ring topology ,hich pro8ides redundancy by
-eeping hal6 o6 the capacity o6 the ring, the Oprotection band,idthM, as spare. I6 the 6ibre
o6 the ring is cut in one place, S4!.0 recon6igures the ring and uses the spare capacity
to restore 6ull connecti8ity ,ithin '0 +s. 0he e;uip+ent used to build the nodes o6 such
ring topology net,or-s is co+pleC and eCpensi8e co+pared to other technologies such as
Aigabit .thernet.
I6 one does not ,ant to use the S4!.0 or S39 reco8ery 6unctionality, these protocols
can be seen as si+ple synchronous 6ra+ing ser8ices o8er 6ibre. Internet routers connected
,ith 6ibre +ay use S4!.0 to de6ine the 6iCed si@e 6ra+es to be 6illed ,ith I* pac-ets
and dri8e the lasers o6 the 6ibre. 0his is the case o6 !P over "#NET , a technology used
to directly 6ill the 6ibre ,ith I* pac-ets by adding little o8erhead Das the S4!.0 6ra+es
add relati8ely 6e, eCtra bitsE. 0he big gain is that no, the co+plete band,idth o6 the
6ibre is used instead o6 -eeping hal6 o6 it spare, at the eCpense o6 6ast 6ailure reco8ery.
In this case one ,ill rely on the higher net,or- layers to do the reco8ery. In particular,
the I* routers ,ill sense the 6ailure and update the routing tables to use other routes 6or
the tra66ic. 0his +ay ta-e +uch longer than the '0 +s it ta-es 6or S4!.0 to reco8er. 2
si+ilar concept applies ,hen .thernet 6ra+es are used to 6ill ,ith I* pac-ets the 6ibre that
connects routers. #$tical !nternets are 6ibre net,or-s that use S4!.0 and .thernet in this
si+ple 8anilla 6la8our.
!"5N DIntegrated Ser8ices 3igital !et,or-E pro8ides access ser8ices ,ith dyna+ic end#
to#end call set#up capabilities. y dialling an IS3! nu+ber, a custo+er can set up a
synchronous constant bit rate pipe to other end#points o6 the IS3! net,or-. 0he ser8ice
inter6ace to the user can pro8ide three types o6 channels" the channel DH$ -bpsE is used
6or data or digiti@ed 8oice, the 3 channel D(H -bpsE is used 6or signalling to the net,or-,
and the 9 channel D3&$ -bps, ('3H -bps, or ()20 -bpsE is used li-e a channel but 6or
ser8ices re;uiring greater rates. 2 user can buy either a *asic access service or a $rimary
access service. 0he basic ser8ice pro8ides a 3 channel to the net,or- itsel6 and t,o
channels to any IS3! destination. 0he pri+ary ser8ice pro8ides one H$ -bps 3 channel
to the net,or-, and a larger nu+ber o6 channels D30 channels in .urope and 23
channels in the 7SE.
0odayMs telephony ser8ices are pro8ided by IS3! net,or-s. S39 and S4!.0 are used
at the core o6 the IS3! net,or-s to carry large nu+bers o6 8oice channels. Indeed, these
technologies ,ere initially concei8ed to carry large nu+bers o6 H$ -bps digiti@ed 8oice
circuits. 4lder telephone net,or-s e+ployed 3igital Carrier Syste+ D3CSE technology,
,hich allo,ed net,or- capacity to be di8ided into logical channels o6 di66erent bit rates,
ranging 6ro+ (.':$' 1bps D2:3$ 1bps in .uropeE. 2 custo+er could lease such a logical
channel to connect t,o locations. 0hese are the so#called leased line services , the +ost
co++on o6 ,hich are 0( D(.'$$ 1bpsE and the 03 D$$.%3H 1bpsE. In .urope they are
called .( D2.0$& 1bpsE and .3 D3$.3H& 1bpsE.
$6$6& A!* Services
201 D2synchronous 0rans6er 1odeE technology net,or-s use transport protocols that ha8e
been de8eloped by the 201 >oru+ and I07#0 DInternational 0eleco++unications 7nion
0as-6orceE. 0he 201 >oru+ is an industry consortiu+ ,hich per6or+s the standardi@ation
acti8ities 6or 201. In6or+ation is pac-aged into '3 byte cells, and these are transported
through the net,or- o8er virtual circuits , as eCplained in Section 3.(.$. 0he s+all cell si@e
+eans that it is possible to transport and s,itch strea+s o6 cells ,ith s+all delay and delay
8ariation.
201 ,as originally designed to operate in a si+ilar ,ay to the traditional telephone
net,or-. 2n application places a call to the net,or- that speci6ies both the address o6 a
re+ote application and the type o6 ser8ice re;uired. 0his is speci6ied in the ser8ice contract
6or the call. 0he net,or- uses signalling to i+ple+ent controls 6or accepting the call,
choosing the route o6 the 8irtual circuit Dor treeE, reser8ing resources, and setting para+eters
in the tables o6 the inter+ediate s,itches. 0he 8irtual circuit +ay be 8isuali@ed as a 8irtual
pipe Dor branching pipeE that is dedicated to the connectionMs tra66ic strea+. 2ppropriate
resources are allocated 6or this pipe so that the tra66ic strea+ recei8es the speci6ied ;uality
o6 ser8ice. 2s ,e ,ill see, these pipes +ay not re;uire a 6iCed band,idth. Instead, they +ay
Oin6lateM and Ode6lateM in ti+e, according to the bursts o6 data sent through the connection.
Since such 6luctuations cannot be deter+ined a $riori and occur on 6ast ti+escales, their
contract tra66ic para+eters bound the +aCi+u+ duration and 6re;uency o6 such in6lation
and de6lation and the +aCi+u+ band,idth consu+ed during each period o6 pea- operation.
0hese bounds are eCpressed by lea-y buc-ets in the tra66ic contracts o6 the connections. 0he
net,or- uses statistical +odels 6or the beha8iour o6 such pipes to decide ho, +any can
be handled si+ultaneously. 0hese issues are in8estigated in Chapter $, ,here ,e present a
+ethodology 6or deri8ing e66ecti8e band,idths 6or such contracts.
Signalling is the +ost co+pleC part o6 201. It is co++on 6or net,or- operators to
disable 201Ms 6ull signalling or to use a si+pler i+ple+entation. It is co++on to use
only per+anent 8irtual circuits or 8irtual paths Dbundles o6 8irtual circuitsE, ,hich are set
by net,or- +anage+ent rather than by signalling on custo+er re;uest. 0hese connections
re+ain in place 6or +onths or years. 0hey are +ainly used to +a-e per+anent connections
bet,een the net,or-s o6 an enterprise that has +any physical locations, or to connect
Internet routers D,hen Internet is run on top o6 201E. 0his an eCa+ple o6 a O,holesaleM
ser8ice in ,hich band,idth is sold in large contracts to large custo+ers and other net,or-
operators DIS*sE. 201 speci6ies 6i8e Onati8eM ser8ice classes 6or connectionsR they di66er
in respect to the tra66ic descriptors that are used to characteri@e the carried tra66ic and the
=oS para+eters guaranteed by the net,or-. 0his in6or+ation is part o6 the contract 6or the
particular ser8ice class. 0hese 6i8e classes are as 6ollo,s. 0he 6irst three, CR, GR#R0
and GR#!R0, are guaranteed ser8ices ,ith purely static para+eters. 2R has guarantees
,ith both static and dyna+ic para+eters, ,hile 7R is purely best#e66ort.
CBR Dconstant bit#rate ser8iceE uses the input tra66ic descriptor o6 type CR. 0his is a
si+pler 8ersion o6 the GR descriptor in .Ca+ple 2.', in ,hich only the pea- rate is
policed Dby the top lea-y buc-etE. Its =oS para+eters are cell loss and delay. 0his ser8ice
is appropriate 6or applications that generate tra66ic ,ith an al+ost constant rate and ,hich
ha8e speci6ic re;uire+ents 6or cell loss and delay. .Ca+ples are leased telephone line
e+ulation and high ;uality 8ideo. In CR an asynchronous net,or- based on 201 can
o66er the sa+e set o6 ser8ices as a synchronous net,or- Dsynchronous bit pipesE.
VBR-RT D8ariable bit#rate, real#ti+e ser8iceE uses the input tra66ic descriptor o6 type
GR. Its =oS para+eters are the sa+e as those o6 CR. Real#ti+e ser8ices are used 6or
applications such as interacti8e 8ideo and telecon6erencing ,hich can tolerate only s+all
delays. 2pplications ,ith bursty tra66ic should pre6er GR to CR i6 these ser8ices ha8e
been correctly priced. 0his is because input tra66ic ,ith a GR tra66ic descriptor can be
statistically multi$le,ed , to create a controlled Oo8erboo-ingM o6 resources. 2s ,e see in
Chapter &, this +a-es a di66erence to the tari66s o6 GR and CR. 2 CR contract ,ith
pea- rate h has an e66ecti8e band,idth o6 h ,hile a GR contract ,ith the sa+e pea- rate
generally has a s+aller e66ecti8e band,idth.
VBRRT D8ariable bit#rate, non#real#ti+e ser8iceE uses the input tra66ic descriptor o6 type
GR. Its =oS is tight 6or cell#loss, but relaCed 6or delay. It can be 8ie,ed as a relaCed
8ersion o6 GR#R0, in ,hich the net,or- is gi8en +ore 6leCibility in scheduling the cells
l
i
n
-

b
a
n
d
,
i
d
t
h
o6 strea+s. >or eCa+ple, it +ight assign s+aller priority to the cells o6 so+e strea+s or
bu66er +ore cells.
!BR Da8ailable bit#rate ser8iceE. 0his ser8ice deli8ers cells at a +ini+u+ rate speci6ied
as part o6 the ser8ice contract para+eter MC6 D+ini+u+ cell rateE. It also pro8ides the
user ,ith the 8alue o6 the +aCi+u+ allo,ed rate h.t <. 0his 8alue is updated dyna+ically
by the end#user so6t,are in response to congestion signals sent by the net,or-. 0he user
+ust send at a rate less than h.t < 6or +ini+al cell loss to occur inside the net,or-. 0he
net,or- polices the user to pre8ent hi+ eCceeding h.t <. 9ence the guarantee has a static
part o6 1CR and a dyna+ic part o6 h.t <#1CR. 0he net,or- is assu+ed to 6airly share
any re+aining capacity a+ongst the co+peting connections and to deli8er cells as 6ast as
possible. 2pplications ,hich con6or+ to the 6lo, control signals and correctly update h.t <
should eCpect to lose only a s+all proportion o6 cells.
"BR Dunspeci6ied bit#rate ser8iceE. 0his is a purely best#e66ort ser8ice ,hich re;uires no
co++it+ent 6ro+ either the user or net,or-. 0here is no 6eedbac- in6or+ation to tell the
user to increase or decrease his rate.
>igure 3.H illustrates ho, a lin- is 6illed ,ith 201 tra66ic.
$6$6( /rame Relay
>ra+e Relay is a pac-et s,itched net,or- technology operating at speeds o6 no +ore than
$' 1bps and using 8irtual paths to connect end#points o8er long ti+e durations Dstatic
instead o6 dyna+ic connectionsE. 0he tra66ic contracts 6or such 8irtual paths are si+ilar to
201#GR, ,ith the additional 6eature that they pro8ide +ini+u+ throughput guarantees
in ter+s o6 a Co++itted In6or+ation Rate DCIRE that is speci6ied in the contract. 2 tra66ic
contract 6or a 8irtual path uses para+eters DT
c
R (
c
R (
e
E, ,ith the 6ollo,ing +eanings"
S Co++itted urst Si@e D (
c
E" the net,or- guarantees to transport (
c
bytes o6 data in each
inter8al o6 duration T
c
. 0his guarantees CIR 3 (
c
N T
c
.
S .Ccess urst Si@e D (
e
E" the +aCi+u+ nu+ber o6 bytes abo8e (
c
that the net,or- ,ill
atte+pt to carry during each T
c
.
0he net,or- operator can statistically +ultipleC +any 8irtual paths in the core o6 the
net,or- by assu+ing that custo+ers do not use all their CIR at all ti+es. 9ence, in
practice, the CIR co++it+ent o6 the net,or- +ay be o6 a statistical nature depending
on the o8erboo-ing per6or+ed by the operator. 4perated properly, o8erboo-ing should
only occur 6or the (
e
part o6 the contract.
2R ] 7R tra66ic
CR ] GR tra66ic
ti+e
/igure $6( 2n eCa+ple o6 ho, a lin- is 6illed by tra66ic o6 8arious ser8ices types. CR and GR
ha8e priority, ,hile 2R and 7R use the re+aining band,idth.
>ra+e Relay is presently used by +any enterprises to connect nu+bers o6 local area
net,or-s at physically separate locations into a single I* net,or-, and to connect to the
Internet. 0he I* routers o6 the local area net,or-s are interconnected using >ra+e Relay
8irtual paths ,ith the appropriate SL2s. 0his is a case in ,hich >ra+e Relay technology
is used to pro8ide Girtual *ri8ate !et,or- ser8ices, as in the case o6 201 and 1*LS.
In +any cases, di66erent 8irtual paths are established 6or carrying 8oice. In order to a8oid
routing 8oice calls to re+ote internal locations through the public 8oice net,or-, such calls
are redirected through the pri8ate data net,or- D8oice is pac-eti@ed and sent o8er the >ra+e
Relay net,or-E. In this case, an ade;uate CIR +ust be reser8ed in the SL2, and i6 the sa+e
8irtual path is used 6or both 8oice and data so+e priority +echanis+ +ust be a8ailable 6or
the 8oice tra66ic, so that it 6alls into the co++itted part o6 the contract, and hence 8oice
pac-ets are rarely discarded due to policing ,hen trans+itted together ,ith data pac-ets.
>ra+e Relay net,or-s are 6re;uently i+ple+ented ,ithin 201 net,or-s, but used only
6or the access ser8ice to the net,or-, i.e. to connect the custo+er to the net,or-. In this
case, a >ra+e Relay SL2 is translated to an 201 SL2 6or the 8irtual path o6 the
connection, and >ra+e Relay pac-ets sent by the sending end o6 the connection are bro-en
into 201 cells ,hich are carried 6urther by the 201 net,or- along the 8irtual path. 2t the
recei8ing end, the net,or- reasse+bles the >ra+e Relay pac-ets 6ro+ the 201 cells.
$6$6+ 2nternet Services
0he Internet *rotocol DI*E is the basic protocol by ,hich pac-et transport ser8ices are
pro8ided in the Internet. It operates as a si+ple pac-et deli8ery ser8ice. 0he reader should
re6er to .Ca+ple 2.2, ,here ,e ha8e already described its basic ,or-ings.
0C* and 73* are t,o transport ser8ices that run on top o6 the I* ser8ice. 0hey
are denoted as 0C*<I* and 73*<I*. 0hese ser8ices ha8e representati8es Dso6t,areE that
runs only on user +achines. Let us no, describe these in greater detail than ,e ha8e
in .Ca+ple 2.2. 2n application A that ,ishes to use 0C* transport ser8ices to send a
6ile to an application ( , residing on a di66erent co+puter Dco+puter ( E, +ust ta-e the
6ollo,ing steps. >irst, it +ust 6ind the I* address o6 co+puter ( . !eCt, it +ust hand the
6ile and the address o6 ( to the local 0C* representati8e. 0his representati8e establishes a
connection ,ith his peer representati8e in co+puter ( , ,hich is identi6ied by so+e ne,
connection identi6ier, say by choosing an unused tag c. 0he connection is established by the
0C* representati8es eCchanging special OsignallingM pac-ets using the I* ser8ice. 4nce the
connection is established and c is -no,n to both, the local 0C* representati8e brea-s the
6ile into s+aller pac-ets, tags each pac-et ,ith the connection identi6ier c Dand a se;uence
nu+ber 6or detecting losses, see the 6ollo,ing discussionE, and hands this 0C* pac-et to the
I* representati8e, together ,ith the I* destination address. 0his representati8e 6ollo,s the
steps described abo8e, i.e. it builds an I* pac-et containing the abo8e 0C* pac-et, tagged
,ith the destination I* address, and then 6or,ards it to the I* net,or-. 0he I* representati8e
at the destination +achine e8entually recei8es these I* pac-ets, eCtracts their content Dthe
0C* pac-etsE and deli8ers the+ to the 0C* representati8e. 0he 0C* representati8e reads the
connection identi6ier, and deli8ers the data in the pac-et to the application that is recei8ing
data 6ro+ the abo8e connection. 73* is si+pler than 0C* by not re;uiring the connection
set up phase.
2 connection using the 73*<I* protocols has no constraints, but also no guarantees. It
sends pac-ets Di.e. the 73* representati8e brea-s 6iles into pac-ets and hands the+ to the
I* representati8eE at a +aCi+u+ rate, irrespecti8e o6 congestion conditions, and does not
resend lost data. Li-e 0C*, 73* adds so+e in6or+ation to the data pac-ets that allo,s the
recei8er to detect i6 so+e bits ,here changed, i.e. i6 the recei8ed pac-et is corrupt. In the
Internet, this ser8ice is used to send s+all bursts o6 data 6or ,hich, because o6 their short
li6e, it ,ould not be ,orth,hile to set up a co+plete 0C*<I* connection. 73* also +a-es
sense ,hen, as 6or real#ti+e audio and 8ideo, there is no 8alue in resending data. 73* is
a typical eCa+ple o6 a best#e66ort ser8ice ,ith no guarantees. It adds +ultipleCing ser8ices
to the basic pac-et transport ser8ice o66ered by I*.
!he !CP Protocol
0C* ,or-s as 6ollo,s. 2 net,or- connection +ay send tra66ic into the net,or- only ,hen
the protocol allo,s. 0he protocol states that the +aCi+u+ nu+ber o6 bytes that +ay be
sent ,ithout being ac-no,ledged +ust not eCceed the 8alue o6 the ,indo, si@e W . >or
si+plicity assu+e that pac-ets each carry the sa+e nu+ber o6 bytes. .ach 0C* pac-et
carries its o,n se;uence nu+ber. When the recei8er D,hich is our shorthand 6or Othe
0C* so6t,are at the recei8er end o6 the connectionME recei8es a pac-et it sends bac- an
ac-no,ledg+ent pac-et ,ith the se;uence nu+ber o6 the last pac-et that ,as recei8ed
in correct se;uence. >or instance, suppose pac-ets 0:(00 are recei8ed in se;uence. I6
pac-et (0( arri8es neCt, the ac-no,ledg+ent ,ill be (0(, but i6 pac-et (02 arri8es neCt,
out o6 se;uence, then the ac-no,ledg+ent ,ill again be (00. 0his allo,s the sender to
detect pac-et losses. Indeed, i6 the sender recei8es a nu+ber o6 consecuti8e identical
ac-no,ledg+ents, then it assu+es a pac-et loss and resends the corresponding pac-et.
0he si@e o6 the ,indo, W constraints the nu+ber o6 pac-ets that can be sent beyond those
that ha8e been ac-no,ledged. >or instance, i6 the latest ac-no,ledg+ent recei8ed by the
sender is (00 and W 3 2, then the sender is allo,ed to send pac-ets (0( and (02. 0he
si@e o6 W controls the Da8erageE rate h at ,hich pac-ets are sent. It is easy to see that i6
the round trip delay o6 the connection Dthe ti+e 6or a pac-et to reach the recei8er plus the
ti+e o6 the ac-no,ledg+ent to tra8el bac- to the senderE is T, then the rate o6 pac-ets is
bounded abo8e by W NT. 0his holds since W is the +aCi+u+ nu+ber o6 pac-ets that the
sender can input to the net,or- during a ti+e o6 T, ,hich is the ti+e it ta-es to recei8es
the 6irst ac-no,ledg+ent.
0he actual rate h that is achie8ed +ay be less than W NT. 0his is because at so+e
bottlenec- lin- the net,or- has less band,idth than h a8ailable 6or the connection. In this
case, pac-ets o6 the connection ,ill ;ueue at the bottlenec- lin-. When this happens, the
sa+e rate could be achie8ed 6or a s+aller W . 0hus, i6 W is chosen too s+all, it +ay
unnecessarily constrain the rate o6 the connection. 9o,e8er, i6 W i6 chosen too large there
,ill be unnecessary ;ueueing delays inside the net,or-. 0he ideal 8alue o6 W achie8es the
+aCi+u+ a8ailable rate h
+aC
, ,ith the +ini+u+ possible pac-et delay. 0his occurs 6or
W 3 h
+aC
NT. 9o,e8er, the proble+ is to choose W ,hile h
+aC
is un-no,n at the edges o6
the net,or-. 0his is ,here the intelligence o6 0C* co+es in. It searches continuously 6or
the appropriate 8alue o6 W . It starts ,ith W s+all and increases it rapidly until it detects
that its pac-ets start ;ueueing inside the net,or-. 2 signal that its pac-ets are ;ueueing is a
pac-et loss. When this occurs, W is decreased to hal6 its pre8ious 8alue. Subse;uent to this,
W is allo,ed to increase linearly in ti+e until a ne, loss occurs. In particular, W increases
by approCi+ately (N W pac-ets e8ery ti+e an ac-no,ledg+ent pac-et is recei8ed. 0his
procedure repeats until the connection runs out o6 data to send. In +any i+ple+entations,
the routers eCplicitly send congestion signals, so as to pre8ent pac-et losses. 2 router +ay
detect eCcessi8e ;ueue build#up and send pac-ets to signal congestion to the contributing
connections, or it +ay e8en decide pree+pti8ely to discard selected pac-ets be6ore it is
crippled by congestion. In any case, the sources running 0C* react by hal8ing their ,indo,
si@es ,hene8er they recei8e a congestion signal.
!he economics of 2P
0he high econo+ic 8alue o6 I* is due to its co+ple+entarity regarding +ost other transport
ser8ices and custo+er applications. .Ca+ples o6 co+ple+entary goods are bread and
cheese. 0he better the ;uality o6 the cheese, the +ore bread is consu+ed. 0he reason
is that bread co+ple+ents cheese in +ost recipes, and hence increasing the 8alue o6 cheese
increases the 8alue o6 bread. Si+ilarly, i6 +ore types o6 cheese that go ,ell ,ith bread
beco+e a8ailable, this again increases the econo+ic 8alue o6 bread. ut ,here are the
si+ilarities ,ith I*L
We ha8e already discussed in >igure 3.$ that I* is a protocol Dperhaps the only one
in practiceE that can run on top o6 all other transport technologies such as 201, >ra+e
Relay, S4!.0, .thernet and pure light paths. In that sense, it is co+ple+entary to these
technologies. Its added 8alue is the e66icient pro8ision o6 end#to#end connections o6 arbitrary
duration bet,een any end#points on the globe. 4nce in6or+ation is con8erted into I*
pac-ets, these can run o8er any access and lin- technology connecting the I* routers. 0his
is the de6inition o6 a truly o$en technology . Installing I* does not constrain ,hich other
technologies should be used in the lo,er layers. 2 si+ilar argu+ent holds 6or applications,
i.e., 6or the layers abo8e I* Di+plicitly assu+ing 0C*<I* and 73*<I*E. 2ny application that
is ,ritten to cope ,ith the -no,n I* de6iciencies Dlac- o6 predictable ;uality and ser8ice
guaranteesE, is a co+ple+entary good ,ith I* and enhances its econo+ic 8alue. 0he +ore
such applications are ,ritten, the +ore 8aluable I* beco+es. 0he other side o6 the coin
is that a -iller application that is inco+patible ,ith I* ,ill reduce its econo+ic 8alue by
enhancing the 8alue o6 other protocols that should substitute 6or I*. 9o,e8er, eCperience
is that I* is ,ell accepted and such inco+patible ser8ices do not sho, up at either the
application or net,or- layer.
We re+ind the reader that 201 in its 6ull 6unctionality, ,hich allo,s the end#to#end
connection o6 custo+er applications through dyna+ically s,itched 8irtual circuits, ,as a
substitute technology 6or I* ,hen introduced in the +id#())0s. 7n6ortunately, it ,as also a
substitute 6or .thernet in the local area net,or-s. 0his ,as its ,ea-ness" the already large
installed base o6 .thernets, connecting +illion o6 co+puters, and the higher price o6 201
net,or- cards +ade 201 hard to ?usti6y. In co+parison, I* is a co+ple+ent to .thernet.
0his co+ple+entarity has helped I* do+inate the +ar-et and beco+e the uni8ersal standard
o6 end#to#end connecti8ity. 7n6ortunately, there are li+itation to I* that reduce its econo+ic
8alue, as ,e see in the neCt section.
Some limitations of the 'resent 2nternet
4ur discussion so 6ar +a-es it clear that the present Internet, through 0C* and 73*,
pro8ides t,o types o6 ser8ice ,hose ;uality in ter+s o6 the band,idth pro8ided to
co+peting connections is unpredictable. 0he share o6 band,idth that a connection obtains
at any gi8en ti+e depends on the nu+ber o6 its acti8e co+petitors. >urther+ore, all
connections are treated e;ually by the net,or- in that they recei8e the sa+e rate o6
congestion signals ,hen congestion occurs. Such e;ual treat+ent is not econo+ically
?usti6ied and results in a set o6 ser8ices that is rather poorly di66erentiated. 7nless the
net,or- happens to be lightly loaded, users cannot use it to run applications that re;uire
;uality o6
ser8ice guarantees and tight control on either delay or cell loss rate. Such guarantees are
needed to transport 8oice and 8ideo, or 6or a high degree o6 interacti8ity. >urther+ore, the
si+ple 6lat pricing structure that is traditionally associated ,ith this sort o6 resource sharing
does not pro8ide any incenti8es 6or applications to release eCpensi8e resources that can be
used by applications that need the+ +ore and are ,illing to pay 6or the+. asically, the
present Internet does not pro8ide the 6leCibility 6or a user that needs +ore band,idth to get
+ore band,idth by paying an appropriate a+ount. .cono+ic theory suggests that ser8ice
di66erentiation increases the 8alue o6 the net,or- to its users by allo,ing the+ to choose
the ser8ices that suit the+ best, rather than being 6orced to use a Oone si@e 6its allM ser8ice.
Increasing the 8alue o6 the net,or- ser8ices to custo+ers is -ey to increasing re8enue and
-eeping custo+ers loyal.
2s an eCa+ple, consider the proble+ o6 trans+itting 8ideo content at t,o encoding
rates. Suppose that 6or a lo, and high ;uality ser8ices one needs band,idths o6 ' -bps and
30 -bps, respecti8ely. 9o, could an IS* pro8ide both ser8icesL 2ssu+ing that the net,or-
treats connections e;ually, the total load o6 the net,or- +ust be -ept lo, enough that any
connection can obtain ,ith high probability at least 30 -bps. Suppose +ost o6 the 8ideo
custo+ers re;uest the lo, ;uality ser8ice, and that the total 8ideo tra66ic is only a part o6
the o8erall tra66ic. I6 the IS* ,ants to lea8e open the possibility o6 supplying high#;uality
8ideo, he +ust allo, only a li+ited nu+ber o6 custo+ers to use the net,or- Dby so+e
ad+ission control sche+eE, e8en i6 +ost o6 the+ are not using 8ideo. 0he only ,ay this
can be ?usti6ied is i6 the re8enue o6 the 6e, high 8ideo ;uality custo+ers is so great that it
pays to re6use ser8ice to other custo+ers so that the load o6 the net,or- is -ept lo, enough.
In practice, this opportunity cost +ay be prohibiti8e, and the IS* ,ill pre6er to o66er only
the lo, ;uality ser8ice and -eep his net,or- highly loaded. ut then he loses the re8enue
6ro+ the high#;uality custo+ers. 0he only ,ay to obtain this re8enue is i6 he can o66er
the high#;uality ser8ice and also -eep the net,or- highly loaded. 9e can achie8e this by
using eCtra net,or- controls that di66erentiate the resource share that di66erent connections
obtain. 2 crucial and di66icult ;uestion is ,hether the cost o6 such controls can be ?usti6ied
by the eCtra re8enue the net,or- obtains. 9o,e8er, cost is not the only reason that the
Internet is slo, to adopt changes.
Introducing ne, +echanis+s that +ay i+pro8e the per6or+ance o6 the Internet is
co+plicated 6or +any di66erent reasons. >irstly, they +ay not pro8ide 8isible i+pro8e+ents
i6 they are applied in only part o6 the Internet. !o single authority ad+inisters the Internet
and unani+ous decisions +ay be unrealistic due to the large nu+ber o6 net,or- pro8iders
in8ol8ed. Secondly, there are +any doubts about the scalability o6 8arious ne, approaches
and about the stability o6 the net,or- i6 changes are +ade. 0he +aCi+ Oi6 itMs not bro-en,
donMt 6iC itM has +any adherents ,hen so +any businesses depend on the Internet.
1oreo8er, it is di66icult to +a-e s+all scale eCperi+ents in loading ne, so6t,are at the
net,or- nodes ,ithout s,itching the+ o66. >inally, so+e eCperts belie8e that capacity ,ill
al,ays be so abundant that traditional I* technology ,ill be ade;uate. 9o,e8er, as ,e
ha8e discussed in Section (.3.(, there are indications that 6ree band,idth ,ill not re+ain
unused 6ore8er. and,idth is consu+ed by so6t,are running on +achines rather than by
hu+ans, and there is no upper bound on the band,idth an application +ay re;uire.
2pplications are digital goods ,hich cost al+ost @ero to reproduce and distribute.
0here eCist a nu+ber o6 proposals to enhance present Internet +echanis+s to pro8ide
ser8ices o6 di66erent =oS. 0hese proposals include architectures 6or Integrated Ser8ices DISE,
3i66erentiated Ser8ices D3SE and 1ultiprotocol Label S,itching D1*LSE. 0he procedure
6or producing such proposals is interesting. 2t their initial stage the proposals appear in
public docu+ents called Internet 3ra6ts. 0hese are discussed and re6ined by ,or-ing groups
o6 the Internet .ngineering 0as- >orce DI.0>E. 26ter being discussed openly in the Internet,
they beco+e Internet R>Cs. 0hese can be re;uired or proposed standards 6or the Internet
co++unity, or si+ply in6or+ational. >or eCa+ple, the I* R>C is a re;uired standard,
,hereas the .C! R>C is a proposed standard.
1ifferentiated Services ;1S<
Consider the 6ollo,ing si+ple idea. 3e6ine a s+all nu+ber o6 tra66ic classes, say gold, sil8er
and bron@e, eCpressing the di66erent le8els o6 ser8ice Don a per pac-et basisE a8ailable at the
net,or- nodes. >or instance, routers +ay ha8e three priority le8els 6or ser8ing inco+ing
I* pac-ets, or +ay be able to allocate di66erent percentages o6 the lin- band,idth. .ach I*
pac-et tra8elling in the interior o6 the net,or- is classi6ied ,hen it 6irst enters the net,or-
as belonging to one o6 these classes and recei8es a tag that identi6ies its class. Custo+ers
that connect to the net,or- speci6y in their contracts ho, the data they send to the net,or-
should be classi6ied. >or instance, the 8ideo con6erencing tra66ic +ight be speci6ied 6or gold
class, ,eb tra66ic sil8er class, and all other tra66ic bron@e class. 0he contract also speci6ies in
ter+s o6 lea-y buc-ets the +aCi+u+ a+ount that can be sent in each o6 the abo8e classes.
0he net,or- -no,s the a8erage total load in each class and allocates resources inside the
net,or- so that the ;uality o6 ser8ice obser8ed by the tra66ic in each class is at the desired
le8el. >or eCa+ple, pac-ets in the gold class are delayed by at +ost (0 +s ,hile tra8elling
on any end#to#end path o6 the net,or-. Such an architecture presents a clear i+pro8e+ent
o8er the traditional single#class Internet, ,hile a8oiding co+pleC net,or- controls such as
signalling on a per connection basis.
0his is an eCa+ple o6 a 3i66erentiated Ser8ices D3SE I* net,or-. 0he net,or- decides on
the ser8ice di66erentiation it ,ill support and then posts prices ,hich re6lect ser8ice ;uality
and de+and. 7sers choose in their contracts ho, to classi6y their tra66ic based on these
prices and the a8erage per6or+ance pro8ided in each class. !ote that this architecture does
not pro8ide hard guarantees on per6or+ance, but only on an a8erage basis. 0his is because
the net,or- allocates resources to the 8arious classes using so+e a8erage historical data,
rather than on a ,orst#case basis. I6 all users decide to send data at the +aCi+u+ rate
allo,ed by their contracts then the net,or- ,ill be o8erloaded. 0he co+pleCity o6 the
approach is -ept +ini+al. 4nly the routers at the periphery o6 the net,or- Dthe ingress
nodes in the 3S ter+inologyE need to classi6y tra66ic and establish contracts ,ith
custo+ers. 3S contracts are established by +anage+ent and last as long as the custo+er is
connected to the net,or-, rather than 6or ?ust the ti+e o6 an indi8idual ,eb connection. In
the interior o6 the net,or- the i+ple+entation o6 3S is si+ple. 2 router decides ho, to
route a pac-et by loo-ing at its destination address and the tag identi6ying its class. Such a
routing policy is easy to i+ple+ent. 0his is an i+portant departure 6ro+ the traditional
circuit#s,itching +odel, in ,hich a s,itch applies a di66erent policy on a per connection
D8irtual circuitE basis. In 3S such O+icroM 6lo, in6or+ation is Orounded upM. Indi8idual
connection 6lo,s are aggregated into a s+all set o6 +uch larger 6lo,s Dthe 'low
aggregates in the 3S ter+inologyE. 0his coarser in6or+ation in6luences control decisions.
Co+pleCity is reduced at the eCpense o6 control. 2ll +icro 6lo,s in the sa+e class are
treated e;ually.
0he ,ea-ness o6 3S is its inability to o66er hard =oS guarantees. 2 3S ser8ice contract
,ith a custo+er pro8ides a reasonable description o6 the tra66ic that ,ill enter the net,or- at
the gi8en ingress point, but +ay not speci6y its destinations. 9ence the net,or- +ust +a-e
in6or+ed guesses, based on historic in6or+ation, as to ho, each contract ,ill contribute to
the tra66ic o6 the 8arious net,or- lin-s. 0his lac- o6 in6or+ation +a-es e66ecti8e resource
pro8isioning eCtre+ely di66icult. >or the sa+e reason, ad+ission control Dat the contract
le8elE is di66icult. 0he net,or- +ay end up being o8erloaded and, e8en +ore interestingly,
a lo, ;uality class +ay outper6or+ a higher ;uality one. 0his can happen i6 +ore custo+ers
than anticipated subscribe to the high ;uality class, 6or ,hich the net,or- ad+inistrator had
reser8ed a 6iCed a+ount o6 resources. Lo,er ;uality classes +ay o66er better per6or+ance
i6 their load is su66iciently lo,. 46 course, i6 pricing is done correctly, such situations ought
not occur. ut the net,or- +anager has a co+pleC tas-. 9e +ust construct the right pricing
plan, esti+ate the resulting de+and 6or the 8arious classes, guess the tra66ic on the 8arious
routes o6 the net,or-, and assign resources. esides the 6act that there are too +any control
8ariables Dprices, resources, and so onE, there are no 6eedbac- +echanis+s in8ol8ing the
user Daside 6ro+ 0C*E. 0he pro8ider can only +easure the net,or- utili@ation and
dyna+ically increase<decrease capacity to sol8e te+porary o8erload proble+s. 3S is
concei8ed to be +anaged in slo, ti+escales relati8e to the ti+escale o6 changes in
net,or- load.
Let us in8estigate in +ore detail the contract structure and the i+ple+entation o6 3S. In
contrast to 201, in ,hich ser8ices are de6ined 6or single unidirectional point#to#point
connections, the scope o6 a di66erentiated ser8ice is broader and includes large tra''ic
aggregates consisting o6"
S +ultiple connections Di.e. all connections that send ,eb tra66ic to a particular set o6
destinations, all Internet telephony calls, and so onER
S tra66ic generated at an entry point A and going to a set o6 eCit points Dpossibly singleton,
or including all possible destinationsE.
9ence, a tra66ic aggregate +ay be speci6ied by a predicate o6 the 6or+ all pac-ets in
connections o6 types a, *, c that are destined to net,or-s , , y, %. .ach 3S net,or-, being
a 5" domain, can de6ine its o,n internal tra66ic aggregates and the ,ay to handle these in
ter+s o6 ;uality o6 ser8ice. 0his +ay be part o6 its business strategy. 0ra66ic aggregates are
uni;uely identi6ied by I* pac-ets carrying special tags Dthe O3S codepointsME. 0he periphery
o6 the net,or- is responsible 6or +apping inco+ing tra66ic to the tra66ic aggregates that 6lo,
in the interior Dthe OcoreME o6 the net,or-. 0his is done by appropriately tagging inco+ing
pac-ets be6ore they enter the core. Such inco+ing tra66ic can originate either 6ro+ end
custo+ers or 6ro+ other 3S do+ains, see >igure 3.%. In either case, there is a ser8ice
inter6ace and a contract in8ol8ed.
0he ser8ice inter6ace speci6ication o6 3S is called a "ervice .evel Agreement DSL2E Dsee
>igure 3.&E. It +ainly consists o6 a Tra''ic Conditioning Agreement D0C2E that speci6ies
3S do+ain ( 3S do+ain 2
egress node
ingress node
egress node
SL2s at 3S ser8ice inter6aces
/igure $6+ 0he -ey concepts o6 the 3S architecture. 3S do+ains are responsible 6or pro8iding
ser8ice di66erentiation to the tra66ic that tra8els through their core. Inco+ing 6lo,s are assigned by
the ingress nodes to the tra66ic aggregates that tra8el in the core o6 the net,or-, according to the
contract Dthe SL2E that speci6ies ho, such tra66ic should be handled. >lo,s in the sa+e tra66ic
aggregate are treated e;ually by the net,or- and recei8e the sa+e =oS. 0ra66ic eCits at egress nodes
and is either ter+inated at edge de8ices or continues its ?ourney through other net,or-s, possibly o6
the 3S type. 3i66erent 3S do+ains are 6ree to de6ine their tra66ic aggregates and the ser8ice ;uality
supported.
tra66ic
conditioners
0C22
3s( classi6ied pac-et
tra66ic
classi6ier
to the net,or- core
0C2(
discarded
tra66ic
aggregate
3S
code point
tra66ic already
classi6ied 6ro+
another 3S do+ain
( 3S(
2 3S2
3 3S3
$ 3S$ best e66ort
/igure $6, 3i66erentiated ser8ices architecture. 2 node o6 the 3S do+ain per6or+s t,o basic
operations. 0he 6irst is classi'ication " e8ery inco+ing pac-et is assigned to the rele8ant 0C2 on the
basis o6 3S codepoint. 0he second is conditioning " 6or e8ery 0C2 there is logic that uses the lea-y
buc-et descriptors 6or policing, and assigns the con6or+ing pac-ets to the internal tra66ic aggregate
that +eets the =oS re;uire+ents o6 the 0C2. 0his is done physically by tagging pac-ets ,ith the
appropriate tag Dthe 3S codepointE. 2 pac-et +ay be +ar-ed or discarded. 9ere there are 6our such
tra66ic aggregates. 0ra66ic that eCceeds its 0C2 or is not eCplicitly speci6ied in a 0C2, is called
de6ault tra66ic and is +apped to best e66ort.
the ser8ice class to be pro8ided and the part o6 the input tra66ic that should recei8e such
ser8ice. 2n eCa+ple o6 a 0C2 is O8ideo connection tra66ic at rates less than 2 1bps
should be assigned to the gold tra66ic aggregate, ,eb tra66ic at rates less than 2' -bps
should be assigned to the sil8er tra66ic aggregate, and all other tra66ic should be assigned
to the bron@e tra66ic aggregateM. 2 0C2 6or tra66ic entering 6ro+ another 3S do+ain could
contain the clause Ogold class input tra66ic not eCceeding $ 1bps should be assigned to the
gold tra66ic aggregate, all other tra66ic should be assigned to the bron@e tra66ic aggregateM.
0he SL2 also contains other ser8ice characteristics such as a8ailability and reliability
Drerouting capabilities in case o6 6ailuresE, encryption and authentication, +onitoring and
auditing, and pricing and billing. 0he =oS corresponds to the per6or+ance para+eters
o66ered Ddelay, loss, throughputE, ,hile tra66ic descriptors in the 0C2 are again to-en
buc-ets. !ote that =oS re;uire+ents +ay be directly translated to the identity o6 the internal
tra66ic aggregates that supports such =oS. *art o6 the 0C2 speci6ication is the ser8ice to be
pro8ided to non#con6or+ing pac-ets. 0he architecture o6 3S at an ingress node is depicted
in >igure 3.&.
SL2s can be static or dyna+ic, although only static ones are presently i+ple+ented.
3yna+ic SL2s can change 6re;uently because o6 tra66ic and congestion le8el 8ariation or
changes in the price o66ered by the pro8ider. Such dyna+ically changing SL2s should
be con6igured ,ithout hu+an inter8ention, using the appropriate so6t,are and protocols
Dintelligent agents and band,idth bro-ersE.
0he nodes o6 the net,or- pro8ide pac-ets ,ith local 6or,arding ser8ices. 0o reason in
an i+ple+entation independent 6ashion, a set o6 Ohigh#le8elM 6or,arding ser8ices has been
standardi@ed in the 3S conteCt, ,here such a ser8ice is called a *er#9op eha8iour D*9E.
*9s are characteri@ed in ter+s o6 the e66ects they ha8e on the tra66ic and not by their
i+ple+entation details. When a pac-et arri8es at a node, the node loo-s at the tag o6 the
pac-et and ser8es it by using a +apping 6ro+ tags to *9s, ,hich is uni;uely de6ined
throughout the net,or-. 2t the net,or- boundary, ne,ly arri8ing pac-ets o6 a particular
SL2 are 6irst policed using the tra66ic descriptors o6 the 0C2, and then +ar-ed ,ith the
corresponding tag o6 the ser8ice negotiated in the 0C2 Dthe =oS part o6 the 0C2 deter+ines
the tag and hence the *9 to be recei8ed inside the do+ainE. !ote that a pac-et tra8ersing
+ultiple 3S do+ains +ight need to be re#+ar-ed so as to use the ser8ices that ha8e been
negotiated in a gi8en do+ain.
.Ca+ples o6 *9s Da nu+ber o6 ,hich are being standardi@edE are .Cpedited >or,arding
D.>E D8ery s+all delay and lossE and 2ssured >or,arding D2>E. .> guarantees a +ini+u+
ser8ice rate, say 2 1bps, at each lin- in the core. It pro8ides the tra66ic aggregate that is
ser8ed by .> ,ith a 6or+ o6 OisolationM 6ro+ the other tra66ic aggregates. 0he isolation is
lost i6 this tra66ic aggregate in a gi8en lin- eCceeds 2 1bps. 0hen it ,ill ha8e to co+pete
,ith the other classes 6or the eCtra capacity, ,hich +ay not be a8ailable. 0he net,or-
operator can guarantee =oS by -eeping the +aCi+u+ rate in the .> class less than 2 1bps
on e8ery lin- o6 the net,or-. 2> is +ore co+pleC. It di8ides tra66ic into 6our ser8ice classes,
each o6 ,hich is 6urther subdi8ided into three subclasses ,ith di66erent drop precedences.
.ach ser8ice class +ay ha8e a dedicated a+ount o6 band,idth and bu66er, and a di66erent
priority 6or ser8ice. When congestion occurs in a class, pac-ets are dropped according to
their drop precedence 8alue. 0here are rules 6or pac-ets changing drop precedence ,ithin
a class. It is up to the net,or- operator to control the delay and loss rate in each o6
these classes by 8arying the a+ount o6 dedicated resource and controlling the load by
ad+ission control.
In contrast to .> and 201, the =oS in 2> is relati8e rather than ;uantitati8e. 2
+oti8ation 6or such ;ualitati8e de6initions ste+s 6ro+ the 6acts that *9 de6initions can
be related Din 3S this corresponds to a O*9 groupME due to i+ple+entation constraints.
>or eCa+ple, *9( corresponds to pro8iding higher priority lin- access to the pac-ets,
,hereas *92 pro8ides lo,er priority access. 0hese *9s are related since the
per6or+ance o6 *92 depends on the a+ount o6 tra66ic assigned to *9(, and only
a ;ualitati8e di66erentiation can be +ade. 2 0C2 can use ;ualitati8e de6initions o6 =oS 6or
its con6or+ing and non#con6or+ing tra66ic respecti8ely, by assigning it to such related
*9s. In order to support a gi8en set o6 SL2s each node o6 the net,or- +ust decide
ho, to allocate its resources to ser8e the 8arious *9s. 0his is a non#tri8ial proble+
unless ser8ices ,ith ;uantitati8e guarantees are only pro+ised 6or point#to#point tra66ic
aggregates. 4nly then are the inter+ediate nodes -no,n and can appropriate resource
reser8ations be +ade. 0he +anage+ent o6 the resources at the nodes o6 the net,or-
typically occurs on slo, ti+escales Dsince SL2s should not change 6re;uentlyE and it is the
responsibility o6 the net,or- +anager Dor o6 the Opolicy ser8ersM ,ho are +eant to ha8e the
intelligence to i+ple+ent a particular +anage+ent policy ,ithin the 3S do+ainE.
0he strength o6 3S is scala*ility. 2lthough the nu+ber o6 connections gro,s ,ith the
nu+ber o6 users, the nu+ber o6 tra66ic aggregates 6or ,hich ser8ices are di66erentiated need
not gro, as 6ast. 0his is because aggregates correspond to connection types rather than
indi8idual connections. 0he ,ea-nesses o6 3S are DaE its loose ;uality guarantees, DbE the
di66icult tas- that the net,or- has in reser8ing resources that can guarantee ;uality Dho,
can one guarantee a one#to#+any contract ,hen O+anyM re6ers to all possible destinationsLE,
and DcE the i+possible tas- 6or users to chec- that the net,or- -eeps its part o6 the contract.
asically, 3S is the si+plest ,ay to di66erentiate ser8ices ,ith the least a+ount o6 net,or-
control. !et,or- +anage+ent is in8ol8ed in setting and acti8ating contracts bet,een the
users and the periphery o6 the net,or-.
sender
net,or- recei8er
Ser8ice inter6ace N \ 0spec, Rspec`
$
0spec N Dr, *E, $, M, m
r
/igure $6. Bey concepts o6 integrated ser8ices architecture. 0,o types o6 ser8ice are o66ered. O>or
guaranteed ser8icesM there is an upper bound on pac-et delay. >or Ocontrolled load ser8icesM pac-ets
recei8e the sa+e ser8ice that they ,ould in an uncongested best#e66ort net,or-. 0spec consists o6 a
dual lea-y buc-et GR tra66ic descriptor ,ith C3G0 3 0 and speci6ications o6 the +aCi+u+ si@e
o6 datagra+s allo,ed to cross the inter6ace and a +ini+u+ datagra+ si@e to ,hich s+aller
datagra+s are rounded up 6or policing purposes. Rspec is usually decided by the recei8er and
consists o6 the +ini+u+ band,idth to be reser8ed by all nodes in the path. 0his +ini+u+
band,idth is co+puted so as to pro8ide deter+inistic guarantees 6or +aCi+u+ delay and @ero
pac-et loss. 0spec is de6ined 6or both Auaranteed =uality and Control Load ser8ices. Rspec is
de6ined only 6or Auaranteed =uality ser8ices.
2ntegrated Services ;2S<
0he IS architecture is conceptually si+ilar to the end#to#end ser8ice architecture o6 201
and can si+ilarly pro8ide a controlled le8el o6 ser8ice to indi8idual net,or- connections
Dstatic and dyna+icE. *resently, t,o types o6 ser8ices are speci6ied in R>Cs, in addition
to a de6ault best#e66ort ser8ice. 0hese are Auaranteed =uality ser8ice and Controlled Load
ser8ice. In both, a ser8ice contract is agreed at connection set up ,hich 6ollo,s the general
concepts introduced in this chapter. 0his consists o6 a tra66ic descriptor, called 0spec D0 6or
0ra66icE, and a =oS co++it+ent called Rspec DR 6or Reser8edE Dsee >igure 3.)E.
0he =oS pro8ided by Auaranteed =uality ser8ices is de6ined in ter+s o6 @ero loss and a
deter+inistic upper bound 6or the end#to#end pac-et delay Dthe 8alue o6 this upper bound
being chosen by the indi8idual applicationE. >or the Controlled Load ser8ices, the =oS
is de6ined as the Oper6or+ance 8isible to applications recei8ing best#e66ort ser8ice under
unloaded conditionsM. 0his is an i+precise de6inition ,hich lea8es roo+ 6or a net,or-
ser8ice pro8ider to +anage and di+ension his net,or- in a ,ay that eCploits statistical
+ultipleCing and to load his net,or- su66iciently to co+pete ,ith other pro8iders ,ho
o66er si+ilar ser8ice. 2 ,ay to i+ple+ent Control Load is to co+bine it ,ith 3S. 2 tra66ic
aggregate in the core o6 the net,or- is dedicated to control load tra66ic and is allocated a
6iCed a+ount o6 resource. 7sing ad+ission control based on the 0spec part o6 the contract,
the net,or- operator +a-es certain that the load in this O8irtual net,or-M stays belo, so+e
desired le8el.
In the case o6 Auaranteed =uality ser8ices, the actual =oS re;uested D+aCi+u+ pac-et
delayE is not speci6ied eCplicitly, but is i+plicit in the 8alue o6 ( , the +ini+u+ band,idth
that should be reser8ed to all nodes along the path ta-en by pac-ets o6 the connection.
0his is the 6s$ec in the IS ter+inology, and includes a slac- ter+ to allo, 6or so+e
o8erboo-ing. 0he choice o6 ( is +ade by the recei8er using a +athe+atical 6or+ula that
relates the +aCi+u+ delay bound ,ith the 8alues in Ts$ec, ( , and so+e other para+eters
o6 the syste+ D,hich are either -no,n or are guessedE. 0his +ay be done as 6ollo,s" the
sender sends a +essage ,ith 0spec to,ards the destination. 0his +essage collects rele8ant
net,or- in6or+ation 6ro+ each node in the path, such as propagation delays o6 the 8arious
lin-s. When it reaches the recei8er, it contains all the necessary in6or+ation 6or the recei8er
to co+pute the a+ount o6 band,idth that +ust be reser8ed. 0he recei8er eCplicitly sol8es
the proble+ Oho, +uch ( should be reser8ed at all nodes in the path so that the ,orst#case
delay is less than d ,hen the source is policed ,ith the lea-y buc-ets in Ts$ec and the
lin-s in the path contribute a total propagation delay d
$ro$
LM D,here clearly ,e +ust ha8e
d
$ro$
\ d E. !ote that the recei8er is the controlling party 6or the le8el o6 =oS. 0his is
consistent ,ith +any applications such as recei8ing audio or 8ideo. 4nce the 8alue o6 5 is
co+puted, a +essage ,ith its 8alue is sent bac- to the sender, suggesting to each node in
the path that it reser8e the abo8e a+ount o6 band,idth 6or the connection. .ach node can
also co+pute the a+ount o6 bu66er that +ust be dedicated to the connectionMs tra66ic so that
@ero loss occurs D,hich can be done by -no,ing Ts$ec and ( E. I6 the necessary band,idth
and bu66er can be allocated, then the node replies positi8ely and the sa+e operation is
per6or+ed at node neCt closest to the sender. I6 so+e node cannot reser8e the necessary
resources, the call is bloc-ed Das in 201E. I6 the resulting delay is unacceptable Ddue to
,rong guesses, 6or eCa+pleE, then the 8alues o6 Ts$ec and 6s$ec can be renegotiated.
Since IS re;uires resource reser8ation and per6or+ance guarantees, it +ust also be sub?ect
to policing. 2t the edge o6 the net,or-, inco+ing tra66ic is policed to con6or+ to Ts$ec,
and non#con6or+ing tra66ic is assigned the de6ault best#e66ort ser8ice.
RSG* DResource Reser8ation *rotocolE is a signalling protocol that allo,s 6or the
i+ple+entation o6 the IS ser8ice architecture D+ainly 6or the Auaranteed =uality ser8icesE,
by sending +essages ,ith Ts$ec to,ards the recei8ers and posting the resource reser8ation
re;uests bac-,ards to,ards the sender. 0hese +essages can carry all the necessary
in6or+ation 6or IS to ,or- properly. 2s a signalling protocol it re;uires less co+pleCity
in the net,or- nodes co+pared to 201. It does not need to speci6y routing in6or+ation
6or setting up 8irtual circuits DIS uses the already eCisting I* routing tables 6or routing
pac-etsE. 2lso, the state o6 a connection at a router is Oso6tM, in the sense that it is the
responsibility o6 the recei8er to continuously re+ind routers that the connection is still
acti8e, since other,ise the reser8ed band,idth is released. 0here is no eCplicit connection
tear#do,n signalling phase. 46 course, there is the cost that the net,or- +ust ser8e all
these OI a+ ali8eM +essages.
In su++ary, the strength o6 IS is its ability to pro8ide strict ;uality guarantees. 0he
,ea-ness is scalability" ,hen the nu+ber o6 connections gro,s, the signalling per6or+ed
by RSG* beco+es o8erly eCpensi8e. 2 possible ,ay to co+bine 3S ,ith IS is to use 3S
in the bac-bone o6 the Internet and IS at the access le8el. 0he bac-bone pro8ides si+ple
ser8ice di66erentiation and is protected 6ro+ signalling o8erhead. Signalling at the local
le8el ensures congestion#6ree access to the bac-bone and scales better ,ith the si@e o6 the
net,or-. >or this to ,or-, the bac-bone +ust be o8erpro8isioned ,ith band,idth.
*ulti'rotocol Label Switching
Label s,itching, introduced in Section 3.(.$, is a net,or- technology 6or creating label
s,itched paths and trees ,ith dedicated resources. 0he -ey idea o6 Multi$rotocol .a*el
"witching D1*LSE is to progra+ in the s,itching 6abric o6 the net,or-, one sin-#tree
per destination Dor set o6 destinationsE, and use these trees to carry tra66ic aggregates that
ha8e the sa+e destination, or that tra8el through so+e co++on part o6 the net,or-. 0his
techni;ue achie8es 'low isolation and reduces the bad e66ects o6 uncontrolled statistical
+ultipleCing that is co++on in I* net,or-s. 7sing such direct OtunnelsM 6or sending pac-ets
to a destination has the ad8antage o6 being able to guarantee per6or+ance, since the net,or-
can dedicate resources to ser8ing the tra66ic. 4nce these tunnels are in place, a router that
needs to 6or,ard a pac-et +ay choose to use such a tunnel instead o6 6or,arding the pac-et
to the neCt router. 46 course such a choice eCists only i6 a tunnel to the particular destination
is a8ailable, and i6 the pac-et is in the tra66ic aggregate 6or ,hich the net,or- uses this
special ser8ice.
46 course, it +ay not be possible to construct such sin- trees 6or e8ery possible
destination in the Internet Dalthough it +ay be possible in pri8ate I* net,or-sE. 1*LS is
+ainly used in the core o6 the Internet ,here each router i at the periphery o6 the core is
responsible 6or handling the tra66ic to and 6ro+ a speci6ic set o6 net,or-s N
i
. .ach such
edge router i has an established label#s,itched path 'rom each other edge router, and is also
the sin- o6 a tree o6 paths ,hich connect all +e+bers o6 N
2
to it. When an edge router i
detects the start o6 a 6lo, o6 pac-ets ,hich re;uire a speci6ic ;uality o6 transport ,ith a
destination o6 a net,or- in the responsibility o6 router i , it 6or,ards the pac-ets through the
corresponding prede6ined label s,itched path Do6 ,hich there +ay be +ore than one 6or the
sa+e destination, ,ith di66erent ;uality o6 ser8ice para+etersE. 4ther,ise, the 6lo, is
treated as ordinary I* 6lo, and pac-ets are 6or,arded to the neCt I* router inside the core.
In general, these ideas can be used 6or tra66ic aggregates o6 arbitrary de6initions Dnot
only those based on the pac-etMs I* destination addressE, such as 8ideo tra66ic, or other
tra66ic that is considered o6 higher priority. 0he net,or- +anager +ust 6irst design these
high#;uality 1*LS tunnels, progra+ the+ into the net,or- in6rastructure, and then speci6y
the tra66ic aggregate that should use the 1*LS ser8ice. 9ence, at each entry node one +ust
6irst associate each tra66ic aggregates ,ith a corresponding label s,itched path originating
at that node. 3uring operation,
S each pac-et o6 the tra66ic aggregate is assigned a 6or,arding label identi6ying the entry
o6 the pathR
S at each node, the 6or,arding label o6 an inco+ing pac-et is used to loo-#up DaE the
neCt#hop node, DbE the ser8ice discipline to be used 6or 6or,arding the pac-et Dli-e the
*9 in 3SE, and DcE the replace+ent label.
0his 6or,arding in6or+ation that de6ines the path and the assigned resources is stored in
each node by a protocol that is used during path creation. 0his procedure essentially
i+ple+ents a 8irtual circuit. Indeed, i6 the underlying net,or- node technology is 201, it
can directly use the 201 signalling to set and +anage the corresponding 8irtual circuit. DIn
6act, 201 signalling need not be usedR it can be e+ulated by sending I* pac-ets ,ith the
analogous in6or+ation.E 4r since 8irtual circuits are o6 a long lasting nature, +anage+ent
procedures +ay be used instead o6 signalling. Labels correspond to 8irtual circuit
identi6iers. 1*LS allo,s 6or creating and +anaging 8irtual circuits o8er net,or- node
technologies that are not necessarily 201 but are 1*LS#capable.
1*LS is a technology 6or i+ple+enting ser8ice di66erentiations ,ithin the sa+e net,or-.
It is consistent ,ith 3S architecture concepts and o66ers better control o6 =oS in the
net,or- core. 0his is because i6 resource allocation is done appropriately then di66erent
tra66ic aggregates that 6lo, through di66erent 1*LS tunnels do not interact. 9o,e8er, i6
resources are shared a+ongst such tunnels, rather than dedicated, it +ay not be possible to
o66er ;uantitati8e =oS guarantees. 9ence, 1*LS technology cannot sol8e the =oS proble+
unless properly deployed.
2n i+portant application o6 1*LS is the creation o6 +any virtual networks o8er the
sa+e physical net,or- in6rastructure. Since routers that are not connected ,ith direct lin-s
in the actual I* net,or- +ay be directly connected through 1*LS tunnels o6 arbitrary
capacity, one +ay design an Oo8erlayM I* net,or- ,ith lin-s o6 controllable capacity. 0his
net,or- can be used to pro8ide a single pri8ate enterprise ha8ing +any locations ,ith a
409.R 0/*.S 4> S.RGIC.S %(
virtual $rivate network, or to carry high#priority tra66ic. In principle, a net,or- +ay support
+any di66erent ;uality le8els by i+ple+enting a nu+ber o6 such parallel 8irtual net,or-s,
one 6or each ;uality le8el.
$6% 4ther ty'es of services
$6%61 Private and =irtual Networks
.nterprises that are spread o8er geographically re+ote locations o6ten ,ish to connect
their net,or-s at 8arious locations into one ,ide area $rivate network so co+puters at
all locations can co++unicate and share applications and in6or+ation ser8ices. *ri8ate
net,or-s +ay use internal addressing sche+es and eCercise co+plete control o8er their
resources. *resently, pri8ate net,or-s are built using I* technology, and can be seen
as pri8ate Internets. 2 pri8ate net,or- at a local le8el can be built by installing L2!s
and interconnecting the+ ,ith I* routers. 0hings are rather +ore interesting at the
,ide area le8el.
0o create a ,ide area pri8ate net,or-, an enterprise has to interconnect the routers that
it o,ns at di66erent locations. In theory, it +ight build the necessary co++unication lin-s
itsel6, 6or instance, by installing 6ibre and co++unication e;uip+ent. 2lthough this gi8es
the enterprise co+plete control o6 the in6rastructure, it is too i+practical or eCpensi8e.
2lternati8ely, the enterprise can 8ie, a lin- as a co++unications ser8ice and outsource
the pro8ision o6 this lin- to a net,or- ser8ice pro8ider. 0he outsourcing can ta-e place
at di66erent le8els. 2t the lo,est le8el, the net,or- ser8ice pro8ider +ay pro8ide Ora,M
in6rastructure, such as dar- 6ibre, or e8en install ne, 6ibre in conduit space rented by the
enterprise. 0he enterprise +ust then pro8ide all the other layers o6 technology necessary.
2t a neCt le8el, the ser8ice pro8ider +ight pro8ide the lin- ser8ice by o66ering a lightpath,
or a guaranteed band,idth synchronous ser8ices such as S4!.0, or a leased line. Aoing
e8en 6urther, he +ight pro8ide an asynchronous ser8ice, such as an 201 or >ra+e Relay
8irtual path, or .thernet o8er optical. >inally, he could connect the routers o6 the enterprise
to his o,n I* net,or- and eCchange pac-ets using the I* datagra+ ser8ice o6 his net,or-.
In the list o6 solutions abo8e the ser8ice pro8ider has increasing opportunity to +a-e
+ore e66icient use o6 resources, ,hile the enterprise custo+er has decreasing control o8er
net,or- resources and the ;uality o6 ser8ice. >or instance, synchronous ser8ices re;uire the
net,or- ser8ice pro8ider to allocate 6iCed a+ounts o6 resources, ,hile >ra+e Relay and
201 per+it statistical +ultipleCing. 2t the eCtre+e, best#e66ort .thernet and I*
connecti8ity +ay o66er no guarantees on ser8ice ;uality. In practice, the ter+ 8irtual
Private Network DG*!E is used 6or pri8ate net,or-s in ,hich the lin- outsourcing is
substantial and occurs at a le8el abo8e the use o6 synchronous ser8ices. We re6er to such a
net,or- as a OJ G*!M, ,here J stands 6or the lin- ser8ice technology De.g. an 201
G*!E. 46 course there are security issues in8ol8ed in outsourcing lin- pro8ision, but
these can be addressed by the
appropriate security protocols.
G*! ser8ices ha8e proli6erated because it costs a large net,or- operator little to
i+ple+ent G*! ser8ices. 0his is due to the large +ultipleCing capability o6 his net,or-.
1oreo8er, instead o6 re;uesting constant rate contracts 6or their 8irtual paths, custo+ers
+ay buy tra66ic contracts that ta-e ad8antage o6 the bursty nature o6 their data tra66ic.
0here is also a sa8ing in the nu+ber o6 inter6ace cards Dsee >igure 3.(0E. 4utsourcing the
operation o6 the ,ide area net,or- can be seen as a step 6or outsourcing larger parts o6 the
I0 o6 the enterprise to third parties. 2 high#band,idth G*! allo,s 6or the concentration
o6 critical applications and in6or+ation Dintranet and eCtranet ,eb ser8ers, data basesE at a
6
%2 !.0W4RB 0.C9!4L4A/
6
(
6
3
(
leased lines
6
3
6
2
6
$
6
2
6
$
DaE DbE
6
(
8irtual path
6
3
6
(
datagra+
6
3
net,or-
201 net,or-
6
2
6
$
6
2
6
$
DcE DdE
/igure $613 So+e possible 8irtual pri8ate net,or-s. In DaE ,e sho, the logical net,or- that
connects the 6our routers o6 the enterprise custo+er. It consists o6 siC lin-s. In DbE ,e i+ple+ent this
net,or- using leased linesR ,e need siC leased lines and $ [ H inter6ace cards Deach leased line
needing 6our cards, i.e. each end o6 the line, ,e need one card 6or the custo+erMs router and one
card 6or the net,or- e;uip+ent to ,hich it is connectedE. In DcE ,e i+ple+ent the G*! using a
connection#oriented ser8ice Dsuch as 201E and replace each leased line ,ith a per+anent 8irtual
pathR ,e no, need $ [ 2 inter6ace cards Done 6or each router and one 6or the 201 net,or-
pro8iderMs e;uip+ent to ,hich this router connectsE. In part DdE ,e i+ple+ent the G*! using a
datagra+ I* net,or-R ,e still need $ [ 2 inter6ace cards. In DcE and DdE the access ser8ice to the
net,or- nodes +ay be obtained 6ro+ a third party ser8ice pro8ider. In theory, the logical net,or- in
DaE can be constructed by using only three circuits in DbE and DcE, enough to pro8ide 6ull connecti8ity.
In practice, graphs ,ith greater connecti8ity are constructed 6or reliability and per6or+ance.
s+all nu+ber o6 ,ell#guarded and reliable data centre sites. 4bser8e that band,idth is a
substitute 6or storage or processing.
I* G*!s o66er great 6leCibility to the ser8ice pro8ider, but +ay pro8ide no per6or+ance
guarantees to the custo+er using the ser8ice. 0his is si+ply because the G*!Ms data tra66ic
is treated the sa+e as all other I* tra66ic in the pro8iderMs net,or-. 0here are a nu+ber o6
solutions that in8ol8e 6lo, isolation and ser8ice di66erentiation at the I* le8el, ,hich need
to be deployed in the net,or- o6 the pro8ider to o66er G*! SL2s ,ith =oS guarantees.
0he +ost popular is 1*LS Dsee Section 3.3.%E. G*! SL2s loo- 8ery si+ilar to the SL2s
used in 3S, ,here one +ust consider a di66erent SL2 6or connecting each re+ote location
to the I* net,or- o6 the pro8ider. Such SL2s also include upper bounds on pac-et delays
,hile tra8elling in the I* net,or- o6 the pro8ider, pac-et loss probabilities, and encryption
ser8ices so that no one can read or alter the datagra+s. *resent net,or- +anage+ent tools
allo, the ser8ice pro8ider to o66er a 8isual ser8ice inter6ace to its G*! custo+ers, that
allo,s the+ to trac- the per6or+ance o6 their tra66ic and chec- the 8alidity o6 the SL2.
>inally, ,e re+ar- that the enterprise +ay itsel6 be a large net,or- operator, but one
,hose physical net,or- does not reach certain geographical areas. 0o be co+petiti8e and
o66er 6ull co8erage, it +ay be +ore econo+ical 6or this enterprise to lease in6rastructure
6ro+ other pro8iders than to eCtend his net,or- to co8er the areas he does not already reach.
9e ,ill outsource his need 6or lin-s to pro8iders ,ho 6ocus on the ,holesale in6rastructure
+ar-et and ,ho sell eCisting 6ibre or install ne, state#o6#the#art 6ibre on de+and. 0heir
business is one o6 installing conduits across continents and oceans, each conduit being
able to carry a cable o6 (2:(200 optical 6ibres. 1ost o6 the conduits are e+pty and can
be 6illed on de+and relati8ely ;uic-ly. 0he in6rastructure pro8ider deploys enough optical
a+pli6ication and regeneration points to allo, co+plete outsourcing o6 the optical net,or-
operation. 2n in6rastructure pro8ider +ust be Ocarrier neutralM since he sells ser8ices to
co+peting carriers Di.e. the large teleco+s operators ,ho o66er transport ser8ices to s+aller
net,or- operators and IS*sE. 0hey also run large data centres that are connected to their
6ibre in6rastructure. 0hese data centres host ser8ices that can interconnect the di66erent
teleco+s operator carriers and other band,idth#critical custo+er applications.
$6%6 Access Services
0he speci6ic locations at ,hich custo+ers can connect to an IS* or other 8alue#added
ser8ice pro8ider are called Points #' Presence D*4*sE. 0he *4* contains a router o6 the
IS*Ms bac-bone. 2n access service pro8ides a connection 6ro+ custo+er , to the *4* o6
ser8ice pro8ider / . 0he custo+er +ay not directly pay the access ser8ice pro8ider 6or this
ser8ice, but +ay pay the IS* 6or a bundle consisting o6 access and 8alued#added ser8icesR
the IS* is then responsible 6or trans6erring a pay+ent to the access ser8ice pro8ider.
In the case o6 Internet ser8ice, the access ser8ice connects the custo+erMs co+puter
to the router o6 the IS*. 0he access ser8ice can be dyna+ic or Oal,ays onM. It can be
o6 a connection#oriented type Dsuch as an 201 8irtual circuitE or o6 a datagra+ type
Dli-e an .thernet ser8iceE. 9ence, all the attributes introduced earlier applyR there +ay
be so+e +ini+u+ band,idth guarantees, or the connection +ay be purely best#e66ort.
2lso the ser8ice +ay be asy++etric in ter+s o6 per6or+ance. >or instance, Internet users
tend to recei8e +ore in6or+ation 6ro+ the net,or- Ddo,nstrea+E than they send to the
net,or- Dupstrea+E. 0hus, they place greater 8alue on ser8ices that o66er a high do,nstrea+
bit rate. 4ther custo+ers +ay 8alue things di66erently" 6or eCa+ple, a custo+er ,ho
operates a pri8ate ,eb site or o66ers so+e 8alue#added ser8ice. 2lthough access ser8ices are
conceptually si+ple, they ha8e +any intricacies and play a do+inant role in +aintaining
co+petition in the co++unications +ar-et.
Consider the case o6 +any access ser8ice pro8iders DJS*sE and +any IS*s. In a
co+petiti8e IS* +ar-et an end#custo+er should be able to connect to any o6 the co+peting
IS*s. In addition, co+petition in access ser8ices should i+ply that a user can choose both
his JS* and the IS*. I6 IS*s create 8ertical +ar-ets, each ,ith his o,n JS*, then the
;uality o6 the access ser8ice +ay be a decisi8e 6actor in a custo+erMs choice o6 the IS*. In
the ,orst case, a single JS* controls the IS*s to ,hich a custo+er can connect. 4b8iously,
co+petition can be assured by ha8ing +any access ser8ice pro8iders, so that no one JS*
do+inates the +ar-et. 7n6ortunately this is di66icult in practice. 0he in6rastructure needed to
pro8ide high#;uality access ser8ices is 8ery eCpensi8e and hard to deploy. 0his is because
the total length o6 the lin-s o6 the access net,or- is +any orders o6 +agnitude greater
than the si@e o6 the bac-bones o6 all net,or- operators added together. 9ence, it is highly
i+probable that +ore than one operator ,ill e8er install an access in6rastructure Dsuch as
optical 6ibreE in any one geographic area. 4nce such in6rastructure is in place, e8en i6 it is
o6 the older generation o6 telephone net,or- copper local loop, it deters the introduction o6
any co+petiti8e in6rastructure, unless that in6rastructure is easy and ineCpensi8e to install.
Wireless technologies such as L13S Dlocal +ultipoint distribution ser8iceE are lo, cost,
6ast to deploy, and do co+pete in per6or+ance ,ith the ser8ices pro8ided o8er the local
loop. 0here are t,o possible re+edies to the lac- o6 co+petition in the access ser8ice
+ar-et. 0he 6irst is regulation" the operator o6 the access in6rastructure is re;uired to
+a-e it
a8ailable to his co+petitors at a reasonable price. 0his is the ,ell#-no,n Ounbundling o6
the local loopM, ,hich has been applied to the access part o6 the telephone net,or-, and
,hich could also be applied to access net,or-s o6 cable, ,ireless and 6ibre. 0he second
re+edy is the condominium 'i*re model , in ,hich large custo+ers such as co++unities
,ith schools, hospitals, libraries, and so on, deploy their o,n co++on 6ibre access
net,or-s, independently o6 a carrier. We say +ore about this in Section (3.$.2. 0he +odel
beco+es co+plete by ha8ing the access net,or- ter+inate in special carrier#independent
locations, so#called telecom hotels , ,hich can contain the *4*s o6 +any carriers, IS*s
and other 8alue#added ser8ice pro8iders. 0he beauty is that the access cost is eCtre+ely
lo,, since it is shared by the +any parties in8ol8ed. !o single party can control the
in6rastructure and so arti6icially raise prices or in6luence co+petition.
We ha8e already +entioned that the pro8ision o6 access ser8ice +ay re;uire purchase
o6 so+e lo,er#le8el ser8ices 6ro+ another party. Let us eCa+ine the business +odel 6or
pro8iding broadband access using the 3igital Subscriber Loop D3SLE technology. 0his
technology uses special +ode+s to create a digital t,o#,ay pipe o6 +any +egabits o8er the
copper ,ires o6 the local telephone loop. 0his pipe operates in parallel ,ith the traditional
telephone ser8ice, using the sa+e ,ires. 2 possible scenario 6or pro8iding an access ser8ice
is sho,n in >igure 3.((.
telephone
net,or- 2
DIL.CE
telephone
net,or-
DIL.CE
IS* ( IS* 2
R R
router
telephone
net,or-
s,itch
*4*
JS* (
*4*
JS* 2
local o66ice
o6 *S0!
data connection
telephone
connection
copper ,ire
custo+er
3SL +ode+
/igure $611 2n architecture 6or pro8iding co+petiti8e access and 8alue#added ser8ices o8er the
local loop. 0,o co+peting access ser8ice pro8iders DJS*sE connect custo+ers to the *4*s o6 t,o
IS*s. 0he 6irst part o6 an access ser8ice data connection uses the 3SL +ode+s o8er the local loop
Da 3SL21 in 3SL ?argonE to connect to the *4* o6 the custo+erMs JS*. 0he access ser8ice
continues to the custo+erMs IS* by sharing the pipe that connects the *4*s o6 the JS* and IS*.
0he ;uality o6 the access ser8ice depends on both parts. I6 the latter part is shared in a best#e66ort
6ashion a+ongst all the connections that ter+inate to the sa+e IS*, it +ay be a bottlenec-. Si+ilar
concepts apply 6or telephony ser8ice. 0he 6irst dial#tone is pro8ided by the local telephone net,or-
s,itch, ,hich subse;uently +ay continue the connection to the *4* belonging to the 8oice net,or-
o6 the custo+erMs 8oice ser8ice pro8ider. !ote that the JS*sM e;uip+ent +ust be located in the sa+e
place as the e;uip+ent that ter+inates the local loop.
0he JS* +ust rent 6ro+ the local telephone co+pany both the local loop and collocation
space 6or his e;uip+ent. 9e +ust also buy transport ser8ices to connect his *4* to the
IS*s. I6 the local telephone co+pany is running its o,n JS* and<or IS* ser8ices, it has
the incenti8e to create un6a8ourable +ar-et conditions 6or the co+peting JS*. 2lthough
the regulator can control the rental price o6 the local loop, it is hard 6or hi+ to control
other subtle issues. 0hese include the price and true a8ailability o6 collocation space, the
ti+ely deli8ery o6 local loop circuits, the +aintenance o6 these circuits and the trac-ing
o6 +al6unctions. 0hese sa+e issues also arise in other access technologies and sho, the
intricacies o6 the underlying business +odels. 0hey pro8ide reasons 6or deploying
co+peting local loop technologies, such as the use o6 ,ireless +ode+s to connect usersM
co+puters to the *4* o6 their JS*s.
0he si+plest 6or+ o6 access to the IS*s *4* is by dial#up, i.e. a direct telephone
net,or- connection. 0he reader +ight thin- that this does not in8ol8e any inter+ediate
ser8ice pro8ider other than the telephone net,or-. 9o,e8er, to a8oid unnecessary ,aste o6
telephone net,or- resources, the calls to the IS*Ms *4* are ter+inated at the periphery o6
the telephone net,or-, on so+e access pro8iderMs *4* Din8isible to the user, si+ilar to the
architecture in >igure 3.((E. 0hese are ter+inated through a data network to the IS*Ms *4*.
Such access ser8ices are +easured by the 8olu+e o6 dial#up call +inutes carried, and are
pro8ided by third parties to the IS*s. In an e8en +ore interesting business +odel, such third
parties deploy the e;ui8alent o6 a circuit#s,itched telephone net,or- that is i+ple+ented
o8er a pure I* net,or-. 0his net,or- recei8es 6ro+ a local telephone net,or-, telephone
calls Dor any type o6 circuit#s,itched ser8ice a telephone net,or- supports, such as 0(
and 03E, routes the+ through the data net,or- by trans6or+ing 8oice in6or+ation into I*
pac-ets, and 6inally ter+inates the+" either directly to the recei8ing custo+ersM co+puters
i6 these are connected to the I* net,or-, or con8erts the I* pac-ets bac- into telephone
calls that are carried through the last part o6 the telephone net,or- to reach the recei8ing
custo+erMs telephone. 0he points o6 con8ersion bet,een the telephone and the data net,or-
are called gate,ays. 0his is the business +odel o6 8oice o8er I* ser8ices. Such a ser8ice
pro8ider +ust either run his o,n I* net,or- or outsource this part to so+e IS* in the 6or+
o6 an I* G*! ,ith the appropriate SL2s to guarantee lo, delays 6or 8oice pac-ets. !ote
that this access ser8ice architecture allo,s an IS* to ha8e a s+all nu+ber o6 *4*s, not
necessarily located in the 8icinity o6 its custo+ers.
4ur business +odels can be carried 6urther 6or access net,or- in6rastructures other than
the local telephone loop. >or instance, ,ireless .thernet and cellular +obile ser8ices can be
used instead o6 the traditional telephone net,or-. 2 6eature shared by +ost access ser8ices
is resource scarcity. 0he JS*Ms G*! +ay be restricted in t,o places. 0he 6irst is bet,een
the end#custo+er and the JS*Ms *4*. *resent access technologies o8er copper, cable or
,ireless restrict the a8ailable band,idth to the order o6 6e, 1bps. 0he second is bet,een
the *4*s o6 the JS* and IS*. I6 the +ar-et is not co+petiti8e, such a pro8ider has the
incenti8e to +ultipleC a large nu+ber o6 connections and so reduce the band,idth share
o6 indi8idual users. Suppose a and * are, respecti8ely, the dedicated band,idths 6ro+ the
JS*Ms *4* to the end#custo+er and JS*Ms IS*. I6, on a8erage, n custo+ers ha8e acti8e
connections Dusing the Internet ser8iceE, then as data connections are bursty * +ay be less
than na. Choosing the appropriate * 6or a gi8en custo+er base is part o6 the business
strategy o6 the JS*. 9o,e8er, discouraging users 6ro+ abusing the ser8ice is essential. 2ny
choice o6 * assu+es a statistical pattern o6 usage. I6 so+e users Oo8ereatM by consu+ing
close to a, then the rest o6 the users +ay obtain s+all band,idth shares on a regular basis.
2 policing 6unction can be achie8ed through usage charges ,hich pro8ide users ,ith the
right
incenti8es. >lat access charges +ay cause unnecessary resource consu+ption and se8ere
per6or+ance degradations.
7sers ,ho access the 8alue#added ser8ices pro8ided by a ser8er in the IS*Ms net,or-,
obser8e the end#to#end per6or+ance o6 these ser8ices. 0he per6or+ance depends upon +any
6actors, ,hich are di8ided bet,een the access ser8ice, the transport ser8ice inside the IS*Ms
net,or-, and the ser8er itsel6. 2n IS* ,ho ,ishes to pro8ide ser8ices that are di66erentiated
in ter+s o6 transport ;uality needs to ta-e into account all such 6actors, not only those he
can directly control. Co+plete control o6 the ;uality o66ered o8er such a co+pleC 8alue
chain is possible i6 the IS* and the JS* are the sa+e entity, o,ning also the in6rastructure
that is used to connect the end custo+ers to the JS*Ms *4*. Such 8ertically integrated
co+panies, ,ho 6ill all the bloc-s o6 the 8alue chain 6ro+ content to access, can obtain
do+inant +ar-et position due to the i+pro8ed ser8ice ;uality they can deli8er. >urther+ore,
they can create strong custo+er loc-#in and re6use other IS*s access to their custo+ers.
y controlling interconnection ,ith other net,or-s, they can degrade the per6or+ance
their custo+ers obtain ,hen accessing ser8ers in other IS* net,or-s. 0his +ay create a
O,alled gardenM en8iron+ent, controlled by an oligopoly. 0he high entry cost is a barrier
to entry, and 6urther enhances the oligopoly structure. 2s ,e ha8e seen, possible re+edies
are regulation o6 the access net,or- ser8ices and the creation o6 access net,or-s that are
o,ned by custo+ers.
$6& Charging re:uirements
0here are se8eral practical re;uire+ents that +ust be +et by any ,or-able sche+e 6or
charging 6or net,or- ser8ices. We +ay group these re;uire+ents under the three headings
o6 DaE the end#user ,ho pays the charges, DbE the ser8ice pro8ider ,ho de6ines the charges,
and DcE the underlying technology that is used to produce the charge. Recipients o6 charges
tend to 6a8our charges that are $redicta*le, trans$arent and audita*le.
2 charge is predictable i6 a user -no,s in ad8ance ,hat the total cost o6 using the ser8ice
,ill be. >or eCa+ple, +any phone custo+ers in the 7S pay a 6lat +onthly 6ee 6or unli+ited
local telephony usage. Studies sho, that custo+ers en?oy the 6act that they ha8e security
against the ris- o6 high bills, and that they use telephone ser8ices +ore than in places ,here
a s+all usage charges is added to the +onthly 6ee. 2lthough this type o6 6lat pricing can
lead to a ,aste o6 resources, it does encourage the 6ast proli6eration o6 other ser8ices that
generate i+portant social 8alue. >lat rate pricing o6 Internet access encourages custo+ers
to spend +ore ti+e on the Internet. 0his has so+e negati8e e66ects in ter+s o6 congestion,
but it speeds up the acceptance o6 ne, electronic co++erce ser8ices.
It is interesting to co+pare the ,ay in ,hich consu+ers pre6er to be charged 6or
co++unications and electricity. Why is it that custo+ers accept usage#based charging 6or
electricity but see+ to pre6er 6lat rate charges 6or co++unications ser8ices such as Internet
access and telephonyL 2 possible eCplanation is that the 8alue o6 a BWh o6 electricity
is transparent. 9o,e8er, the 8alue o6 a Byte o6 Internet data is un-no,n, since a user
consu+es it indirectly as a result o6 higher#le8el application. *erhaps users ,ould be ,illing
to pay in proportion to the a+ount o6 ser8ice consu+ed. 2nother obser8ation concerns the
s+aller degree o6 control a user has o8er his consu+ption o6 co++unication resources,
co+pared to, say, his consu+ption o6 6ood in a restaurant. In a restaurant, the custo+er
controls the order and can accurately predict the bill. In the case o6 Internet access ,ith a
usage charge, the control o6 resource consu+ption is in the hands o6 the application once
it is started. >or eCa+ple, ,hen a con8ersation starts, the duration cannot be -no,n at
the start. 0his +ay eCplain ,hy ris-#a8erse users pre6er 6lat rate charges, e8en i6 6or the
2 143.L 4> 7SI!.SS R.L20I4!S >4R 09. I!0.R!.0 %%
%%
sa+e le8el o6 consu+ption they actually pay +ore on a8erage. While the abo8e +ay ha8e
con8inced the reader that usage charges are to be a8oided, technology can pro8ide eCcellent
argu+ents 6or the+. Consider 6or eCa+ple the eCtre+e case o6 usage charges ,here prices
are dyna+ic, i.e. change in ti+e to re6lect de+and. In this conteCt, it +ay be i+practical 6or
end#user to control both his spending rate and his ser8ice ;uality Dsay +easured in ter+s
o6 the achie8ed in6or+ation rateE. 3oes this i+ply that dyna+ic pricing should ne8er be
considered as a pricing alternati8eL 0he ans,er is not clear. It is 8ery plausible that the
co+puters o6 usersM end#syste+s could run so6t,are that +a-es opti+al choices on their
behal6. Such Ointelligent agentsM ,ould -no, their O+asterMsM pre6erences, and try to o66er
the+ the best price 6or 8alue. In this conteCt co+pleC charging sche+es ,ith better resource
control could beco+e practical.
Let us turn to so+e o6 the other aspects o6 charging. 0ransparent charges are ones
that are detailed in an ite+i@ed bill, rather than being bundled. 0he bill eCplains the total
a+ount spent and helps a user decide i6 a particular ser8ice pro8ides 8alue 6or +oney. 2
charging syste+ is auditable i6 the pro8ider can, ,hen re;uested, pro8e the 8alidity o6 the
charges he has +ade by tracing the+ to their origin. Ser8ice pro8iders also i+pose
i+portant re;uire+ents on charging syste+s. Since ser8ice pro8isioning o6ten de6ines a
co+pleC 8alue chain, in ,hich +any business entities contribute to the end ser8ice and so
de6ine and share the resulting charges, the charging syste+ +ust be 6leCible enough to
allo, the de6inition o6 rich business scenarios. !e, tari66s and ser8ices +ust be easily
progra++ed ,hile the appropriate ser8ice usage para+eters +ust also be easy to
access. 2 good eCa+ple is +ulticasting. 2 sender trans+its in6or+ation to a nu+ber o6
recei8ers. 3epending on the speci6ic business +odel, the sender +ust charge the recei8ers
Das in the case o6 8ideo broadcastE, the sender +ust pay the recei8ers Das in the case o6
targeted ad8ertise+entE, or they +ust share the charge. 0he charging syste+ should allo,
the i+ple+entation o6 all these business +odels and any degree o6 ser8ice bundling.
$6( A model of business relations for the 2nternet
In Sections 2.(.3 and 3.$.2, ,e described the interesting but co+pleC business relations
that can e8ol8e in a large net,or- li-e the Internet. In this section ,e pro8ide a si+ple
+odel ,hich characteri@es the 8arious interactions o6 the business entities that o66er ser8ices
in todayMs Internet. It can ser8e as a starting point 6or understanding the co+pleC ser8ice
pro8isioning en8iron+ent. We begin by describing the hierarchical structure o6 todayMs
Internet, as sho,n in >igure 3.(2.
0his hierarchical access structure allo,s Olong distanceM tra66ic to 6lo, through the
bac-bone and Olocal tra66icM to use the regional IS* net,or-s. It also pro8ides 6or tra66ic that
uses the bac-bone to be ade;uately +ultipleCed so as to 6ill the large transport containers
as described in Section 2.(.3. !et,or- 2ccess *oints D!2*sE are the ter+ination points
o6 the access net,or- used by the regional IS*s to access the net,or-s o6 the ac-bone
Ser8ice *ro8iders DS*sE. S*s ha8e either installed their o,n physical 6ibre optic net,or-
bac-bones, or lease in6rastructure 6ro+ in6rastructure pro8iders. 0he capacity o6 the already
installed 6ibre in6rastructure Dassu+ing 6ibres lit at 32 ,a8elengths at (0 AbpsE is esti+ated
to be close to (3 0bps, and the announced capacity 6or the near 6uture is )00 0bps
Dassu+ing planned 6ibres lit at (H0 ,a8elengths at (0 Abps, as o6 200$E.
(
0he business
+odel o6
(
Such calculations +ay hide i+portant in6or+ation since they do not include the distance o8er ,hich such 6ibre
is lit Dsince the cost o6 lighting 6ibre depends on distanceE. 2lso, not all planned 6ibre ,ill be lit due to the high
%& !.0W4RB 0.C9!4L4A/
bac-bone ser8ice pro8ider 2
bac-bone ser8ice pro8ider
pri8ate !2*
pri8ate
peering
!2*
regional IS*
regional IS*
local IS*
local IS*
" router
end custo+ers
/igure $61 0he hierarchical structure o6 the Internet. 0he concept o6 a !et,or- 2ccess *oint
D!2*E ,as introduced as a prere;uisite 6or the co++erciali@ation o6 the Internet in ())'. 2
co+petiti8e +ar-et in the pro8ision o6 bac-bone Internet ser8ices is achie8ed through
carrier#independent !2*s, at ,hich regional IS*s can 6reely interconnect to their choice o6
ac-bone Ser8ice *ro8ider DS*E.
!2*s is to pro8ide the necessary in6rastructure 6or i+ple+enting the SL2s o6 the transport
ser8ices sold by S*s to the IS*s, and a+ongst S*s the+sel8es. *eering agree+ents are
interconnection agree+ents bet,een S*s that are pro8ided 6or 6ree on a +utually
bene6icial basis Dsee Chapter (2E. 0o pro8ide the abo8e ser8ices, a !2* consists o6 highly
secure and reliable local area net,or-s, interconnecting at eCtre+ely high speeds the routers
Dthe *4*sE o6 the consu+ers Dthe IS*sE and the producers Dthe S*sE o6 the transport
ser8ices. 0he !2* +anager can connect these *4*s ,ith 8ariable si@e bit#pipes as speci6ied
in the SL2s. Such SL2s are usually charged according to the pea- rate allo,ed by the
abo8e pipe, and the !2* recei8es a ser8ice 6ee. In +any cases it +ay act as a band,idth
bro-er. In this case, the !2* buys such bac-bone capacity 6ro+ +any S*s in a
,holesale 6ashion and resells it to its retail IS* custo+ers. 4ne +ay en8ision a trend in
,hich !2*s act as 8irtual S*s by selling transparent bac-bone connecti8ity Dor e8en
G*! ser8icesE to the IS*s or directly to large custo+ers. Such a business +odel reduces
the +ar-et po,er o6 the S*s in 6a8our o6 the !2*s. SL2s bet,een the !2* and the
S*s, or bet,een the !2* and the IS*s, +ay be dyna+ic, re6lecting +ar-et de+and
and a8ailability. Such SL2s +ay also deploy dyna+ic price +echanis+s, such as
auctions, to de6ine the +ar-et price 6or band,idth. 0o pro+ote co+petition bet,een
!2*s 6or IS* custo+ers, the access net,or- +ust +a-e it easy 6or an IS* to s,itch !2*s.
1etropolitan area net,or-s based on optical net,or- technologies can easily pro8ide this
6leCibility. 2lternati8ely, the IS*Ms *4* +ay be located in a carrier#independent 6acility
ha8ing 6ibre connecti8ity to the 8arious !2*s. 0he reader has no, all the concepts needed
to de6ine a si+ple +odel 6or the 8alue chain
in Internet ser8ices. We can classi6y the business entities that contribute to Internet ser8ice
pro8isioning in t,o layers, na+ely, the in'rastructure layer and the !nternet service layer .
2n entity in the in6rastructure layer pro8ides si+ple ser8ices to entities in the Internet
ser8ice layer, such as the rent or lease o6 net,or- e;uip+ent, point#to#point connecti8ity
Dbearer ser8icesE, and ser8ices such as billing, technical support, and call#centre ser8ices.
y this de6inition, an 201 net,or- operator is an in6rastructure pro8ider ,ho sells bit pipes
cost and the ;uestionable de+and. 2 probable 6igure ad?usted by the present spending rate 6or lighting 6ibre is
2 143.L 4> 7SI!.SS R.L20I4!S >4R 09. I!0.R!.0 %)
%)
)' 0bps.
D8irtual pathsE to IS*s. 2n IS* uses these bit pipes to connect the routers o6 his net,or-.
!ote that such an in6rastructure pro8ider +ay buy optical net,or- ser8ices 6ro+ another
in6rastructure pro8ider ,ho sells point#to#point light paths or dar- 6ibre.
0he in6rastructure layer also contains an access net,or- ser8ice pro8ider ,ho uses
3SL technology o8er copper ,ires, 6ibre, satellite, cellular or ,ireless L2! technology,
to pro8ide a bit pipe connection bet,een the end#user e;uip+ent and a net,or- node.
We ha8e seen eCa+ples o6 such in6rastructure ser8ices in our pre8ious discussions. 2n
i+portant point is that in the present co++unications +ar-et, such in6rastructure ser8ices
are not pro8ided by 8ertically integrated +onopolies, but by a large nu+ber o6 co+peting
operators. 0his co+petiti8e +ar-et is -ey 6or the cost#e66ecti8e pro8ision o6 continuously
upgraded net,or- in6rastructures deploying the latest trans+ission technologies.
0he entities in the Internet ser8ice layer pro8ide and consu+e Internet ser8ices, ,here by
an Internet ser8ice ,e +ean any ser8ice that is pro8ided by the Internet so6t,are Drunning
on net,or- nodes connected using the in6rastructure ser8icesE, 6ro+ lo, le8el net,or-
ser8ices Dsuch as I* ser8ice, RSG* ser8ice and di66ser8E to application and 8alue#added
in6or+ation ser8ices. 0he ser8ices in this layer +ight be 6urther subdi8ided into 6our types,
re6lecting ,hether the nature o6 the ser8ice is distribution or content.
(. Trans$ort Provider " pro8ides the in6rastructure 6or 6or,arding I* pac-ets. Speci6ic
cases include
S !nternet "ervice Provider " connects his custo+ers Dend#users, end#user net,or-sE
to each other and to the Internet bac-bone. Such a ser8ice includes pro8iding
custo+ers ,ith net,or- addresses Dstatic or dyna+icE. 1ore general 6or+s o6 such
ser8ices are the Girtual *ri8ate !et,or-s. IS*s also o66er their custo+ers higher#
le8el in6or+ation ser8ices such as e#+ail, electronic co++erce, instant +essaging
and in6or+ation DportalE or co++unity ser8ices. 0hese help to di66erentiate their
ser8ice and create custo+er loc-#in. Custo+ers beco+e used to the user#6riendly
custo+i@ed ,ay that the IS* pro8ided so6t,are allo,s the+ to access Internet
ser8ices. 2lso an IS* +ay see- to persuade its custo+ers to use in6or+ation and e#
co++erce ser8ices supplied by its a66iliated content and ser8ice pro8iders. Such a
pre6erential treat+ent can be en6orced by designing the net,or- so that these
ser8ices can be accessed ,ith s+aller delays than ser8ices o66ered outside the IS*s
net,or-.
S (ack*one "ervice Provider " runs a high#capacity net,or-, has connections to other
S*s through !2*s, and connects IS*s to the bac-bone. y connecting to a single
S*, an IS* obtains connecti8ity to the rest o6 the Internet.
2. 5ata Centre Provider " pro8ides the co+puting en8iron+ent that hosts the content
and the applications o,ned by the In6or+ation *ro8iders. .Ca+ples o6 such
en8iron+ents are 8ideo ser8ers and +assi8e ser8er 6ar+s ,hich i+ple+ent the
Internet ser8ice layer architecture Dclient#ser8er, three tier architecture, dyna+ic
content creationE 6or pro8iding in6or+ation ser8ices upon re;uest. >or per6or+ance
reasons such pro8iders are directly connected to the Internet bac-bone or to access
net,or-s. Since such co+puting en8iron+ents can 8ie,ed as +erely in6rastructure, a
3ata Centre *ro8ider +ay ,ell be classi6ied as o66ering in6rastructure layer ser8ices.
2nother use o6 data centres is to host points o6 presence o6 IS*s, S*s, and other
teleco+s operators. In this case, the data centre +ay play the role o6 a !2* and is
called a telecom hotel . 0he ability to directly connect Dusing 6ibreE the co+puting
en8iron+ent that hosts the applications to the bac-bones o6 the S*s and IS*s is
-ey to i+pro8ing access
per6or+ance. 2lso, as already discussed, such architectures allo, co++unication and
in6or+ation ser8ice pro8iders to co+pete 6or custo+ers. 2s 6or in6rastructure ser8ice
6or connecti8ity, data centre ser8ices +ay be layered. 2t the lo,est layer, a custo+er
+ay rent 6loor space and si+ple po,er reliability. .nhanced ser8ices include added
security and reliability 6eatures, and connecti8ity to IS*s ,ith bac-up 6eatures. 2t a
higher layer, there are ser8ers and s,itches that occupy the abo8e 6loor space, and
,hich the 3ata Centre *ro8ider can rent to his custo+ers. 3i66erent ser8ice layers
+ay be pro8ided by di66erent business entities.
3. !n'ormation Provider " pro8ides the content and the applications broadly described
as 8alue#added ser8ices. Such a pro8ider rents space and C*7 cycles 6ro+ a 3ata
Centre *ro8ider, and uses one or se8eral 0ransport *ro8iders to connect ,ith other
Ser8ice *ro8iders and .nd#7sers. .Ca+ples o6 In6or+ation *ro8iders are"
S A$$lication "ervice Provider " leases to custo+ers the use o6 so6t,are applications
that he o,ns or rents. .Ca+ples o6 such applications are ,,,#ser8ers 6or ,eb
hosting, databases, and the co+plete outsourcing o6 business I0 operations. 2n
2S* rents space 6ro+ a 3ata Centre *ro8ider, and o6ten these t,o types o6 ser8ice
are o66ered by the sa+e business entity.
S Content Provider " produces, organi@es, +anages and +anipulates content such as
8ideo, ne,s, ad8ertise+ents and +usic. When such ser8ices are +ore ad8anced,
including the ability 6or easily searching and purchasing a broad category o6 goods
and ser8ices, they are called $ortal services .
S Content 5istri*utor " +anages content pro8ided by Content *ro8iders in net,or-
caches located near the .nd#7sers. 2n .nd#7ser ,ho accesses the content o6 a
re+ote ,eb site ,ill recei8e the sa+e content 6ro+ the local cache, instead o6
ha8ing to go through the ,hole Internet. Such ser8ices i+pro8e the per6or+ance
o6 ,eb sites, specially ,hen users access +ulti+edia in6or+ation that re;uires
high band,idth, or they access large 6iles. Caches are located as near as possible
to the access net,or-, so to a8oid bottlenec-s and guarantee good per6or+ance.
2 Content 3istributor is responsible 6or regularly updating the in6or+ation stored
in the caches to re6lect accurately the content o6 the pri+ary ,eb site. 0he ;uality
o6 a content distribution ser8ice i+pro8es ,ith the nu+ber o6 cache locations the
pro8ider uses. 1ore locations i+ply a lo,er a8erage distance 6ro+ an .nd#7ser to
such a cache. !ote that Content 3istributors allo, 6or in6or+ation to be accessed
locally instead o6 using the Internet bac-bone. In this respect they are in direct
co+petition to ac-bone Ser8ice *ro8iders. 2 local IS* buying ser8ices 6ro+
a large Content 3istributor +ay ,orry less about transport ;uality through the
bac-bone. Such co+petition is greatly in6luenced by the relati8e prices o6 storage
and band,idth.
S !nternet 6etailer " sells products such as boo-s and C3s on the Internet.
S Communication "ervice Provider " runs applications that o66er co++unications
ser8ices such as Internet 0elephony, e+ail, 6aC and instant +essaging.
S Electronic Market$lace Provider " runs applications that o66er electronic en8iron#
+ents 6or per6or+ing +ar-et transactions. In such e#co++erce en8iron+ents busi#
nesses ad8ertise their products and sell these using +ar-et +echanis+s si+ulated
electronically.
2 143.L 4> 7SI!.SS R.L20I4!S >4R 09. I!0.R!.0 &(
&(
$. End&ser " consu+es in6or+ation ser8ices produced by the In6or+ation *ro8iders, or
uses the ser8ices o6 a 0ransport *ro8ider to connect to other .nd#7sers. 9e can be
an indi8idual user or a pri8ate organi@ation.
A #usiness Pers'ective
0he 6unda+ental reason the Internet has been a catalyst 6or the generation o6 such a
co+pleC and co+petiti8e supply chain 6or ser8ices is that it is an open standard and ser8es
as a co++on language. It allo,s ne, ser8ices to be deployed, and no#one has to see-
per+ission 6ro+ anyone to inno8ate. 0here are no o,ners o6 the Internet. In that respect
it presents a 6unda+ental challenge to the legacy syste+s such as the telephone net,or-.
0he basic conceptual di66erence is that these net,or-s de6ine and restrict the ser8ices that
can eCist. Inno8ation +ust co+e 6ro+ the net,or- operator instead o6 the i++ensely rich
co++unity o6 users and potential entrepreneurs. 0he Internet is a general purpose language
6or co+puters to co++unicate by eCchanging pac-ets, ,ithout speci6ying the ser8ice 6or
,hich these pac-ets are used. 0his decoupling o6 net,or-ing technology 6ro+ ser8ice
creation is 6unda+ental to the Internet re8olution and its econo+ic 8alue. 0he di66erence
bet,een the Internet and the telephone or cable net,or- can be co+pared to that bet,een
high,ays and rail,ays. 0he o,ner o6 a high,ay does not constrain beyond 8ery broad
li+its o6 si@e and ,eight ,hat +ay tra8el on it. 2 8ehicle need not 6ile a tra8el plan and
it can enter or lea8e the high,ay as it chooses. !o central control is eCercised. I6 a tra66ic
?a+ occurs, 8ehicles re#route the+sel8es, si+ilarly as do I* pac-ets in the Internet.
2 last obser8ation concerns 8ertical integration. It is natural 6or a 6ir+ that pro8ides
ser8ices in the abo8e 8alue chain to see- greater control in order to obtain a larger part
o6 the total re8enue. 0he less 6rag+ented is ser8ice pro8isioning, then the +ore control
a 6ir+ can obtain. We ha8e already +entioned that another 6actor that encourages such
8ertical integration is the pro8ision o6 end#to#end ser8ice ;uality. 0he ser8ice pro8ider that
controls the interaction ,ith the custo+ers +ay ha8e the +ost ad8antageous position due
to custo+er loc-#in. 0his position is +ainly held by application and content pro8iders.
>or other business entities in the 8alue chain a +a?or concern is that their ser8ices are not
co++oditi@ed. So 8ertical integration bet,een IS*s, access pro8iders and content pro8iders
has +any ad8antages. It creates large econo+ies o6 scope 6or the content pro8ider by gi8ing
hi+ ne, channels 6or distributing di66erent 8ersions o6 his content, 6or ad8ertise+ent, and
6or creating strong custo+er co++unities. It also allo,s hi+ to control the ;uality o6 the
distribution, and guarantees hi+ so+e +ini+u+ +ar-et share Dthe custo+ers ,ith ,ho+
he is 8ertically integratedE.
4ne ,ay 6or the access and transport ser8ice pro8iders to strengthen their bargaining
position ,ith content pro8iders is by increasing their custo+er base. 2ccess pro8iders
using broadband technologies such as cable or ,ireless can sell their custo+ers a bundle o6
ser8ices consisting o6 6ast Internet access and 8ideo. 9a8ing a large custo+er base allo,s
these pro8iders to negotiate lo, rates 6or content 6ro+ content pro8iders such as cable and
tele8ision channels. In +ost cases the cost o6 the content is a substantial part Dabout $0PE
o6 the operating cost o6 the access net,or-.
2 6inal issue is the a+ount o6 ris- in8ol8ed in deploying ne, ser8ices and generating
de+and. Certain parts o6 the 8alue chain, such as the deploy+ent o6 ne, 6ibre#optic
net,or-s, in8ol8e higher ris-s. 4thers are less ris-y. >or eCa+ple, steady re8enues are
al+ost guaranteed to the 6e, telephone co+panies that control the local loop because o6
their near +onopoly position. 9o,e8er, these co+panies are o6ten o8erly ris-#a8erse, due
&2 !.0W4RB 0.C9!4L4A/
to their past +onopoly history, and this reduces their ability to inno8ate and co+pete
e66ecti8ely in the ne, ser8ices +ar-ets.
$6+ /urther reading
Re6erences 6or the Internet and other co++unication technologies are the classic
net,or-ing teCtboo-s Walrand D())&E, Walrand and Garaiya D2000E and Burose and Ross
D200(E. 0he latter 6ocuses +ore on the Internet ser8ices, ,hereas the other t,o co8er the
co+plete spectru+ o6 co++unication technologies and net,or- control +echanis+s.
Ra+as,a+i and Si8ara?an D())&E gi8es 6ull co8erage o6 optical net,or- technology issues,
,hile Ca+eron D200(E pro8ides a high#le8el introduction to issues o6 +odern optical
net,or-s, including condo+iniu+ 6ibre and access net,or-s.
Substantial in6or+ation can also be 6ound on#line. >or instance, Cisco D2002cE pro8ides
a 6ull co8erage o6 +a?or co++unications technologies D8isit Cisco D20026E 6or a 6uller
set o6 topicsE, ,hile Cisco D2002dE and Cisco D2002gE ser8e as a si+pler introduction to
-ey net,or-ing concepts. We encourage the ad8anced reader to 6ind in Cisco D2002aE an
eCa+ple o6 the detailed =oS capabilities o6 so6t,are that runs on net,or- ele+ents and
pro8ides =uality o6 Ser8ice. It discusses in depth issues such as congestion control,
policing, tra66ic shaping and signalling.
.Ccellent starting points 6or obtaining net,or- technology tutorials are Web *ro6oru+
D2002E and the sites o6 net,or- +aga@ines such as Co++,eb D2002E. Si+ilarly, Webopedia
D2002E pro8ides an eCplanation o6 +ost Internet technology concepts, and lin-s 6or 6urther
detailed in6or+ation. 4ther use6ul sites are OAuide to the InternetM D7ni8ersity o6 2lbany
Libraries D2002EE, and the ,eb pages o6 1acBie#1ason and Whittier D2002E.
Standards 6or the Internet are de8eloped by the Internet .ngineering 0as- >orce DI.0>E.
0he o66icial re6erences are the 6e7uests 'or Comments DR>CsE, ,hich are published by
the Internet 2rchitecture oard, and start, as their na+e suggests, as general re;uests
6or co++ents on particular sub?ects that need standardi@ation. 0his is precisely the open
+entality o6 the Internet, ,hich can be su++ari@ed as" Orough consensus and running
codeM. 0he R>Cs can be 6ound in the ,eb pages o6 R>C .ditor D2002E and Internet
R>C<S03<>/I<C* 2rchi8es D2002E. 0,o interesting in6or+ational R>Cs are I(((0 DI2
*rotocol StandardsE and I(((& D0he 9itchhi-ers Auide to the InternetE. et,een 2pril ()H)
and July 2002 there ,ere o8er 3,300 R>Cs. 2n interesting source 6or in6or+ation on the
e8olution o6 the Internet teleco+s industry is 0he Coo- Report on Internet, Coo- D2002E.
In6or+ation on 201 >oru+ acti8ities can be 6ound at the ,eb site o6 the 201 >oru+
D2002E, including appro8ed technical speci6ications and de6initions o6 ser8ices. In6or+ation
on G*! ser8ices is a8ailable at the sites o6 the 8arious e;uip+ent 8endors and ser8ice
pro8iders. >or eCa+ple, Cisco D2002hE pro8ides a good introduction to security issues.
In6or+ation on the So6ts,itch concepts and the con8ergence o6 circuit s,itched and data
net,or- ser8ices can be 6ound in the International So6ts,itch Consortiu+ ,eb page,
So6tS,itch D2002E.
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
%
!et,or- Constraints and .66ecti8e
and,idths
0his chapter concerns the technological constraints under ,hich net,or-s operate. Just as a
+anu6acturing 6acility produces goods by consu+ing input 6actors, so a co++unication
net,or- pro8ides co++unications ser8ices by consu+ing 6actors such as labour and
interconnection ser8ices, and by leasing e;uip+ent and si+pler co++unications ser8ices.
We ,ish to e+phasi@e the i+portance o6 ti+escales in ser8ice pro8isioning. In the short
run, a net,or-Ms si@e and capabilities 6or ser8ice pro8isioning are 6iCed. In the long run,
the net,or- can adapt its resources to the a+ounts o6 ser8ices it ,ishes to pro8ide. >or
eCa+ple, it +ight purchase and install +ore optical 6ibre lin-s. 0he cost +odels o6 Chapter
% use incre+ental cost to e8aluate the costs o6 ser8ices and are based upon a
consideration
o6 net,or- operation o8er long ti+escales.
Inno8ations, such as electronic +ar-ets 6or band,idth using auctions, are beginning to
per+it so+e short run changes in ser8ice pro8isioning through the buying and selling
o6 resources. 9o,e8er, on short ti+escales o6 ,ee-s or +onths, both the si@e o6 the
net,or- and its costs o6 operation +ust usually be ta-en as 6iCed. 4n short ti+escales,
co++unications ser8ices rese+ble traditional digital goods, in that they ha8e nearly @ero
+arginal cost, but a 8ery large co++on 6iCed cost.
*rices can be used as a control to constrain the de+and ,ithin the production capability
o6 the net,or-" that is, ,ithin the so#called technology set. I6 one does this, then the
consu+er de+and and structure o6 the technology set deter+ine prices. In this chapter
,e pro8ide tools that are use6ul in describing the technology sets o6 net,or-s that o66er the
ser8ices and ser8ice contracts described in Chapter 2. 0he eCact speci6ication o6 such a
technology set is usually not possible. 9o,e8er, by assessing a ser8iceMs consu+ption o6
net,or- resources by its e''ective *andwidth , ,e can +a-e an accurate and tractable
approCi+ation to the technology set.
1ore speci6ically, in Section $.( ,e de6ine the idea o6 a technology set, or acceptance
region. Section $.2 describes the i+portant notion o6 statistical +ultipleCing. Section $.3
concerns call ad+ission control. Section $.$ introduces the idea o6 e66ecti8e band,idths,
using an analogy o6 6illing an ele8ator ,ith boCes o6 di66erent ,eights and 8olu+es. We
discuss ?usti6ications 6or e66ecti8e band,idths in ter+s o6 substitution and resource usage.
0he general theory o6 e66ecti8e band,idths is de8eloped in Section $.'. .66ecti8e band#
,idth theory is applied to the pricing o6 transport ser8ice classes in Section $.H. 9ere ,e
&$ !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
su++ari@e the large N asy+ptotic, the notion o6 an operating point, and interpretations o6
the para+eters s and t that characteri@e the a+ount o6 statistical +ultipleCing that is possi#
ble. 0his section is +athe+atically technical and +ay be s-ipped by reading the su++ary
at the end. In Section $.% ,e ,or- through eCa+ples. In Section $.& ,e describe ho, the
acceptance region can be de6ined by +ultiple constraints. In Section $.) ,e discuss ho,
8arious ti+escales o6 burstiness a66ect the e66ecti8e band,idth and the e66ects o6 tra66ic
shap# ing. So+e o6 the +any subtleties in assigning e66ecti8e band,idths to tra66ic
contracts are discussed in Section $.(0. 46ten, a use6ul approach is to co+pute the
e66ecti8e band,idth o6 the ,orst type o6 tra66ic that a contract +ay produce. So+e such
upper bounds are co+# puted in Section $.((. 0he speci6ic case o6 deter+inistic
+ultipleCing, in ,hich ,e re;uire the net,or- to lose no cells, is addressed in Section
$.(2. >inally, Section $.(3 presents so+e eCtensions to the general net,or- case, and
Section $.($ discusses issues o6 bloc-ing.
%61 !he technology set
In practice, a net,or- pro8ides only a 6inite nu+ber o6 di66erent ser8ice types. Let ,
i
denote
the a+ount o6 ser8ice type i that is supplied, ,here this is one o6 k types, i 3 (R " " " R k.
2 -ey assu+ption in this chapter is that the 8ector ;uantity o6 ser8ices supplied, say
, 3 .,
(
R " " " R ,
k
<, is constrained to lie in a technology set , / . 0his set is de6ined by
the pro8ider, ,ho +ust ensure that he has the resources he needs to pro8ide the ser8ices he
sells. It is i+plicit that each ser8ice has so+e associated per6or+ance guarantee and so
re;uires so+e +ini+u+ a+ount o6 resources. 0hus, , lies in / D,hich ,e ,rite , 2 / E i6
and only i6 the net,or- can 6ul6il the ser8ice contracts 6or the 8ector ;uantity o6 ser8ices , .
!ote that here ,e are concerned only ,ith the constraints that are i+posed by the net,or-
resourcesR ,e ignore constraints that +ight be i+posed by 6actors such as the billing
technology or +ar-eting policy.
3i66erent +odels o6 +ar-et co+petition are naturally associated ,ith di66erent opti+i@a#
tion proble+s. 0his is discussed 6ully in Chapter H. In a +onopoly +ar-et it is natural to
consider the proble+ o6 +aCi+i@ing the +onopolistMs pro6it. In a +ar-et o6 per6ect co+#
petition it is natural to consider proble+s o6 +aCi+i@ing social ,el6are. In both cases, the
proble+s are posed under the constraint , 2 / . 1odels o6 oligopoly concern co+petition
a+ongst a s+all nu+ber o6 suppliers and lead to ga+es in ,hich the suppliers choose
production and +ar-eting strategies sub?ect to the constraints o6 their technology sets.
Let , be the 8ector o6 ;uantities o6 k supplied ser8ice types. 2 general proble+ ,e ,ish
to sol8e is
+aCi+i@e ' ., < R sub?ect to g., < [ 0 D$.(E
, X0
0he ob?ecti8e 6unction ' ., < +ight be the supplierMs pro6it, or it +ight be social ,el6are.
9ere / 3 6, " g., < [ 0g, ,here the ine;uality is to be read as a 8ector ine;uality,
eCpressing m constraints o6 the 6or+ g
i
., < [ 0, i 3 (R " " " R m. It is natural that the
technology set be de6ined in this ,ay, in ter+s o6 resource constraints and constraints on
guaranteed per6or+ance. We suppose that ' ., < is a conca8e 6unction o6 , . 0his is
+athe+atically con8enient and reasonable in +any circu+stances. Without loss o6
generality, ,e assu+e that all the ser8ice types consu+e resources and hence that the
technology set is bounded.
!ote that, 6or a synchronous net,or-, the technology set is straight6or,ard to de6ine. 0his
is because each ser8ice that is pro8ided by the net,or- re;uires a 6iCed a+ount o6
band,idth throughout its li6e on each o6 the lin-s that it trans8erses. 0here6ore, in ,hat
6ollo,s, ,e 6ocus on ser8ices that are pro8ided o8er asynchronous net,or-s. In
&' !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
asynchronous net,or-s
* *
S020IS0IC2L 17L0I*L.JI!A &'
the lin-s are analogous to con8eyor belts ,ith slots, and slots are allocated to ser8ices on
de+and Dsee the discussion in Section 2.(.$E. We suppose that there is 6inite bu66ering at
the head o6 each lin-, ,here cells can ,ait 6or slots in ,hich to be trans+itted.
%6 Statistical multi'le0ing
Let us consider a ser8ice contract ,ith a =oS re;uire+ent that the tra66ic strea+ should
su66er a +aCi+u+ Cell Loss *robability DCL*E. We use the ter+ Ocell lossM, instead
o6 Oin6or+ation lossM or Opac-et lossM, to +a-e i+plicit a con8enient, but not essential,
assu+ption that in6or+ation is bro-en into s+all cells o6 e;ual si@e. 2 ser8ice pro8ider can
guarantee CL* 3 0 si+ply by ensuring that on e8ery lin- the su+ o6 the pea- rates o6 all
the connections carried on the lin- is less than the lin-Ms capacity. In other ,ords, 6or each
net,or- lin- he ta-es a constraint o6 the 6or+
k J
,
i
h
i
[ C D$.2E
i 3(
,here ,
i
is the nu+ber o6 connections o6 type i that use the lin-, h
i
is the +aCi+u+ rate
o6 cells that the ser8ice contract allo,s to ser8ice type i , and C is the capacity o6 the lin-.
2lthough such a constraint +a-es sense 6or synchronous net,or-s, in ,hich connections are
allocated 6iCed a+ounts o6 band,idth during their li6eti+es, e;ual to their pea- rates h
i
,
it +ay not +a-e sense 6or asychronous net,or-s, ,here connections are allocated
band,idth only ,hen there is data to carry. I6 the ser8ice pro8ider o6 such a net,or- uses
D$.2E to de6ine the technology set he does not +a-e e66icient use o6 resources. 9e can do
better by +a-ing use o6 statistical multi$le,ing , the idea o6 ,hich is as 6ollo,s. 0ypically,
the rate o6 a tra66ic strea+ that uses ser8ice type i 6luctuates bet,een 0 and h
i
, ,ith so+e
+ean, o6 say m
i
. 2t any gi8en +o+ent, the rates o6 so+e tra66ic strea+s ,ill be near their
pea-s, others near their +ean and others near 0 or s+all. I6 there are +any tra66ic strea+s,
then the la, o6 a8erages states that the aggregate rate is 8ery li-ely to be +uch less than
i
,
i
h
i
R indeed, it should be close to
i
,
i
m
i
. I6 one is per+itted an occasional lost cell,
say CL* 3 0"00000(, then it should be possible to carry ;uantities o6 ser8ices substantially
in eCcess o6 those de6ined by D$.2E. Instead, ,e +ight hope 6or so+ething li-e
k J
,
i
V
i
[ C D$.3E
i 3(
,here m
i
\ V
i
\ h
i
. 0he coe66icient V
i
is called an e''ective *andwidth
.
Statistical +ultipleCing is possible ,hen tra66ic sources are bursty and lin-s carry +any
tra66ic strea+s. 2 +odel o6 a lin- is sho,n in >igure $.(. 2 lin- can be unbu66ered, or it can
ha8e an input bu66er, to help it acco++odate periods ,hen cells arri8e at a rate greater than
the lin- band,idth, C . Cells are lost ,hen the bu66er o8er6lo,s. I6 ,e can tolerate so+e
cell loss then the nu+ber o6 connections that can be carried can be substantially greater
,
(
,
k
( N bu66er si@e
C N capacity
Dband,idthE
/igure %61 0he Call 2d+ission Control DC2CE proble+. Ai8en the state o6 the syste+ in ter+s o6
the acti8e tra66ic contracts and a history o6 load +easure+ents, should a ne, tra66ic contract o6 type
i be ad+ittedL
&H !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
than the nu+ber that can be carried i6 ,e re;uire no cell loss. I6 there is ?ust a single type o6
source then ,
pea-
3 C N h
(
and ,
stat.
3 C NV
(
,ould be the nu+ber o6 strea+s that could
be carried ,ithout and ,ith statistical +ultipleCing, respecti8ely. Let us de6ine the
statistical multi$le,ing gain 6or this case as
S1A
,
stat.
3
,
pea-
h
(
3
V
(
Clearly, it depends upon the CL*. In .Ca+ple $.(, the statistical +ultipleCing gain is a 6actor
o6 al+ost '. 0he special case o6 re;uiring CL* 3 0 is usually re6erred to as deterministic
multi$le,ing .
"0am'le %61 ;Statistical multi'le0ing< Consider a discrete#ti+e +odel o6 an unbu66ered
lin- that can carry )'0 cells per epoch. 0here are , identical sources. In each epoch each
source produces bet,een 0 and 6i8e cellsR suppose the nu+ber is independently distributed
as a bino+ial rando+ 8ariable (.'R 0"2<. 0hus, h 3 ' and ,
pea-
3 )'0N' 3 ()0. 0he
+ean nu+ber o6 cells that one source produces is m 3 ' [ 0"2 3 (, and the nu+ber
o6 cells that )00 sources produce is approCi+ately nor+al ,ith +ean )00 and 8ariance
0"2 [ 0"& [ )00. >ro+ this ,e calculate that the probability that )00 sources should
produce +ore than )'0 cells in a slot is about 0.0000(''. 0hus 6or a CL* o6 ("'' [ (0
a'
, ,e can ta-e ,
stat.
3 )00 and there is a statistical +ultipleCing gain o6 )00N()0 3 $"%$.
0his gain increases as the capacity o6 the lin- increases. >or eCa+ple, i6 C is +ultiplied
ten6old, to
)'00, then )3(% sources can be +ultipleCed ,ith the sa+e CL* o6 0.0000(''. 0he S1A
is no, )3(%N()00 3 $")0. 2s C tends to in6inity the S1A tends to hNm 3 '.
2s ,e ,ill see in Section $.(2, so+e +ultipleCing gain is possible e8en i6 ,e re;uire
CL* 3 0. >or eCa+ple, i6 sources are policed by lea-y buc-ets and lin-s are bu66ered,
then it is possible to carry +ore connections than ,ould be allo,ed under the pea- rate
constraint o6 D$.2E.
%6$ Acce'ting calls
Consider a net,or- co+prising only a single lin-. Suppose that contracts speci6y eCact
tra66ic types and that there are ,
i
contracts o6 type i , ,ith i 3 (R " " " R k. Suppose that the
only contract obligation is the =oS constraint CL* [ $, 6or say $ 3 (0
a&
. 0he
technology set A, ,hich ,e also call the acce$tance region , is that set o6 , 3 .,
(
R " " " R ,
k
< corresponding
to ;uantities o6 tra66ic types that it is possible to carry si+ultaneously ,ithout 8iolating this
=oS constraint Dsee >igure $.2E. !ote that the technology set is de6ined i+plicitly by the
=oS constraint. Later ,e sho, ho, to +a-e eCplicit approCi+ations o6 it.
2s eCplained in Sections 2.2.3 and 3.(.', Call Admission Control DC2CE is a +echanis+
that ensures that , re+ains in A. It does this by re?ecting calls 6or ne, ser8ice connections
through the net,or- that ,ould ta-e the load o6 acti8e calls outside A. 0hus the acceptance
region and C2C are inti+ately related. In practice, ho,e8er, it is hard to -no, A precisely
and so ,e +ust be conser8ati8e. In i+ple+enting a particular decision rule 6or C2C, ,e
-eep the load , ,ithin a region, say A
0
, that lies inside the true acceptance region, A. >or
instance, a possible rule C2C rule is to accept a call only so long as D$.2E re+ains satis6iedR
this ,ould correspond to ta-ing A
0
as the triangular region near the origin in >igure $.2.
0his rule is 8ery conser8ati8e. 0he =oS constraint is easily satis6ied, but the net,or- carries
6e,er calls and obtains less re8enue than it ,ould using a +ore sophisticated C2C. 0his
,
2
PDo8er6lo,E N $
acceptable
PDo8er6lo,E b $
C2C based on
pea- cell rate
A
0,0
not acceptable
PDo8er6lo,E c $
,
(
/igure %6 0he acceptance region proble+. 9ere there are k 3 2 tra66ic types and ,
i
sources o6 in
types i . We are interested in -no,ing 6or ,hat .,
(
R ,
2
< is CL* [ $, 6or say $ 3 (0
a&
. 0he
triangular region close to the origin is the acceptance region de6ined by ,
(
h
(
C ,
2
h
2
[ C , ,hich
uses the pea- cell rates and does not ta-e ad8antage o6 the statistical +ultipleCing.
rule is an eCa+ple o6 a static C2C, since it is based only on the tra66ic contract para+eters
o6 calls, in this case h
(
R " " " R h
k
. In contrast, ,e say that a C2C is dyna+ic ,hen it is
based both on contract para+eters and on#line +easure+ents o6 the present tra66ic load.
It is desirable that the decision rule 6or C2C should be si+ple and that it should -eep ,
,ithin a region that is near as possible to the ,hole o6 A, and so there be e66icient use o6
the net,or-. When ,e de6ine A
0
in ter+s o6 a C2C rule ,e can call A
0
the Oacceptance
regionM o6 that C2CR other,ise acceptance region +eans A, the eCact technology set ,here
the =oS constraints are +et.
Suppose that as ne, connections are ad+itted and old ones ter+inate the +iC o6 tra66ic
re+ains near a point ,! on the boundary o6 A. We call ,! the o$erating $oint . We ,ill
shortly see that the acceptance region can be ,ell approCi+ated at ,! by one or +ore
constraints li-e D$.3E, and this constant V
i
can be co+puted o66#line as a 6unction o6 ,! ,
the source tra66ic statistics, the capacity, bu66er si@e and =oS re;uired.
I6 a net,or- has +any lin-s, connected in an arbitrary topology, then call ad+ission is
per6or+ed on a per route basis. 2 route speci6ies an end#to#end path in the net,or-. 2
ser8ice contract is ad+itted o8er that route only i6 it can be ad+itted by each lin- o6 the
route. 0his +ay loo- li-e a si+ple eCtension o6 the single lin- case. 9o,e8er, the tra66ic
that is generated by a contract o6 a certain type is accurately characteri@ed by the tra66ic
contract para+eters only at the entrance point o6 the net,or-. 4nce this tra66ic tra8els inside
the net,or-, its shape changes because o6 interactions ,ith tra66ic strea+s that share the
sa+e lin-s. In general, tra66ic strea+s +odelled by stochastic processes are characteri@ed
by +any para+eters. 9o,e8er, 6or call acceptance purposes, ,e see- a single para+eter
characteri@ation, na+ely the V
i
in constraint D$.3E. We call V
i
an e66ecti8e band,idth since
it characteri@es the resource consu+ption o6 a tra66ic strea+ o6 type i in a particular
+ultipleCing conteCt. In the neCt sections ,e sho, ho, to deri8e e66ecti8e band,idths.
We consider their application to net,or-s in Section $.(3. >inally, in Section $.($, ,e
suppose that a C2C is based on D$.3E. What then is the call bloc-ing probabilityL We
discuss bloc-ing in Section ).3.3.
%6% An elevator analogy
0o introduce so+e ideas about e66ecti8e band,idths ,e present a s+all analogy. Suppose
an ele8ator Dor li6tE can hold a nu+ber o6 boCes, pro8ided their total 8olu+e is no greater
than 8 and their total ,eight is no greater than W . 0here are k types o6 boCes. oCes
o6 type i ha8e 8olu+e 8
i
and ,eight ,
i
. Let 8 3 .8
(
R " " " R 8
k
< and , 3 .,
(
R " " " R ,
k
<. Suppose .8
i
R ,
i
< 3 .2R '< and .8
2
R ,
2
< 3 .$R (0<. Clearly the ele8ator can e;ually
,ell
carry t,o boCes o6 type i as one boC o6 type 2 , since .$R (0< 3 2 [ .2R '<. ut ,hat
should one say ,hen there is no integer n such that .8
i
R ,
i
< 3 n [ .8
2
R ,
2
<L 0his is the
;uestion posed in >igure $.3.
It depends upon ,hether the ele8ator is 6ull because o6 8olu+e or because o6 ,eight.
Suppose that boCes arri8e rando+ly and ,e place the+ in the ele8ator until no +ore 6it. Let
,
i
denote the nu+ber o6 boCes o6 type i . I6 at this point the +aCi+u+ 8olu+e constraint
is acti8e, then
k J
,
i
8
i
3 8 R
i 3(
k J
,
i
,
i
\ W
i 3(
and the e66ecti8e usage is the 8olu+e o6 the boC. 2t such a point ,e could substitute one
s+all set o6 boCes 6or another s+all set o6 boCes pro8ided their total 8olu+es are the sa+e.
We suppose these sets are s+all enough that ,e are in no danger o6 8iolating the +aCi+u+
,eight constraint. We then say that a boC o6 type i has e66ecti8e band,idth 8
i
. 0his is
sho,n in the le6t o6 >igure $.$.
2lternati8ely, the ele8ator +ight 6ill at a point ,here the +aCi+u+ ,eight constraint is
acti8e. *erhaps this is usually ,hat happens in the a6ternoon, ,hen hea8ier boCes arri8e.
0hen, again,
k J
,
i
8
i
\ 8 R
i 3(
k J
,
i
,
i
3 W
i 3(
and the e66ecti8e usage is the ,eight o6 the boC. We then say the e66ecti8e band,idth is ,
i
.
w
i
,
i
In ,hat sense is
N n ^ L
w
i
,
i
w
2
,
2
W,8
/igure %6$ 0he ele8ator can carry a total ,eight o6 at +ost W and 8olu+e at +ost 8 . 2 boC o6
type i has ,eight ,
i
and 8olu+e 8
i
. 2 boC o6 type i has n ti+es the relati8e e66ecti8e usage o6 a
boC o6 type 2 i6 ,e are indi66erent bet,een pac-ing ( boC o6 type i or n boCes o6 type 2 .
d
i
w
i
\ W, d
i i
N 8
d
i
w
i
N W, d
i i
\ 8
/igure %6% 2t the le6t the ele8ator is 6ull because the 8olu+e o6 the boCes is 8 . 0he e66ecti8e
resource usage o6 a boC o6 type i is 8
i
. 2t the right the ele8ator is 6ull because the ,eight o6 the
boCes e;uals W . 0he e66ecti8e resource usage o6 a boC o6 type i is ,
i
.
i
i
i
i
i
0hus, the relati8e e66ecti8e usage o6 a boC depends on ,hether the +aCi+u+ 8olu+e or
+aCi+u+ ,eight constraint is acti8e. We +ight ,rite these si+ultaneously as
k J
,
i
V
i
[ C
a
i 3(
and de6ine V." " " < 3 .V
(
." " " <R " " " R V
k
." " " << and C
a
." " " < as 6unctions o6 , , 8, ,, 8 and
W . I6 these 8ariables are such that the +aCi+u+ 8olu+e constraint is acti8e then V 3 8
and C
a
3 8 . ut i6 they are such that the +aCi+u+ ,eight constraint is acti8e, then V
3 , and C
a
3 W . 0hat is,
.VR C
a
< 3
D
.8R 8 <
*
as
i
*
,
i
8
i
3 8 R
*
*
,
i
,
i
\ W
.,R W <
i
,
i
8
i
\ 8 R
i
,
i
,
i
3 W
2t the point o6 the intersection o6 the t,o constraints, both e66ecti8e band,idths D8olu+e
and ,eightE are rele8ant, but not all substitutions are possible. 0he -ey point is that the
e66ecti8e band,idths depend upon -no,n para+eters o6 the boC types, .8
i
R ,
i
<, and on the
capacities, 8 R W . 0hey also depend on the operating point , , since i6 ,e are gi8en the
8alues o6 , 6or a 6ull ele8ator ,e can deter+ine ,hich constraint is acti8e.
0here are 8arious ,ays this operating point +ight be reached. It could be, as ,e ha8e
i+agined so 6ar, that ,e si+ply 6ill the ele8ator ,ith boCes as they arri8e. Which o6 the
t,o constraints beco+es acti8e depends upon the rates at ,hich the di66erent types o6 boC
arri8e. 0his +ight depend on the ti+e o6 the day. 2lternati8ely, ,e +ight accept and re?ect
o66ered boCes so as to 6ill the ele8ator in a particular ,ay. 2lternati8ely, ,e +ight charge
boCes 6or use o6 the ele8ator. 0he +ore ,e charge the boCes o6 type i , the s+aller ,ill be
their rate o6 arri8al.
I+agine that there are k agents, one associated ,ith each boC type. 2gent i obtains
bene6it u
i
.,
i
< ,hen the ele8ator carries ,
i
boCes o6 type i . Suppose ,e ,ish to steer the
operating point to +aCi+i@e the su+ o6 these utilities, i.e. to +aCi+i@e ' 3
*
u
i
.,
i
<. Let
,! be the point on the boundary o6 A that does this. 2ssu+ing that each u
i
is a conca8e
6unction, one can sho, that i6 only the +aCi+u+ 8olu+e constraint is acti8e at ,! then there
eCists a scalar X such that u
0
.,!
i
< 3 X8
i
6or all i . I6 only the +aCi+u+ ,eight constraint
is acti8e then there eCists so+e scalar e such that u
0
.,!
i
< 3 e,
i
6or all i . I6 both
constraints are acti8e, then there are X and e such that u
0
.,!
i
< 3 X8
i
C e,
i
6or all i .
Let $
i
3 X8
i
, 3 e,
i
or 3 X8
i
C e,
i
, in line ,ith the three possibilities described
abo8e. 0hen the point ,! , at ,hich ' is +aCi+i@ed ,ithin A, can be characteri@ed as
the
solution to k proble+s, the i th o6 ,hich is to +aCi+i@e Tu
i
.,
i
< a $
i
,
i
U o8er ,
i
. !ote
that these k proble+s decouple and can be sol8ed in a decentrali@ed 6ashion. 0he i th
proble+ is to be sol8ed by agent i . 9e see-s to +aCi+i@e his net bene6it, gi8en that the
price per boC o6 type i is $
i
. 0hus the proble+ o6 +aCi+i@ing the 6unction ' can be
sol8ed in a decentrali@ed 6ashion, ,ithin a +ar-et 6or ser8ices ,here this opti+al price
8ector ,ill be deter+ined. 4bser8e that in +ost cases, $
i
N $
2
e;uals V
i
NV
2
, so prices are
proportional to e66ecti8e band,idths. 0his is the +ain +oti8ation 6or using e66ecti8e
band,idths in pricing. !ote that in the original +odel, ,
i
denoted the nu+ber o6 boCes o6
type i that are placed
in the ele8ator. We can eCtend the +odel and assu+e that the ele8ator ta-es one unit o6 ti+e
6or each trip. !o, ,
i
denotes the rate at ,hich boCes o6 type i are ser8ed. We can +a-e
the analogy to net,or-s by thin-ing o6 ser8ices as boCes and the net,or- as an ele8ator.
0his is a 8alid analogy since ser8ices consu+e net,or- resources, o6 ,hich net,or-s ha8e
6inite a+ounts. I6 it ta-es ti+e T
i
to co+plete a ser8ice o6 type i and such ser8ice re;uests
f
, 3,
arri8e at a rate o6 ,
i
per T
i
units o6 ti+e, then the +ean nu+ber o6 ser8ices o6 type i in
the net,or- ,ill be ,
i
. D0his 6ollo,s 6ro+ .ittle-s .aw , ,hich says that the +ean nu+ber
o6 ?obs in the syste+, . , e;uals the product o6 arri8al rate, X, and +ean ti+e spent in
the syste+, W , i.e., . 3 XW R this translates here to ,
i
3 .,
i
N T
i
<T
i
E. 2s abo8e,
posting prices that a66ect arri8al rates can sol8e the proble+ o6 +aCi+i@ing a utility
6unction that captures the 8alue o6 the ser8ices to the custo+ers. 2 si+ilar obser8ation
applies to the interpretation o6 , in D$.(E. I6 each ser8ice is priced ,ith an appropriate
price $
i
, then the +ar-et ,ill 6ind an e;uilibriu+ at the solution o6 this opti+i@ation
proble+. 2gain, such prices should be proportional to the e66ecti8e band,idths o6 the
ser8ices.
!ote that it is 8alid to +a-e this si+ple translation 6ro+ ,
i
as a nu+ber o6 boCes to an
arri8al rate o6 boCes only i6 the boCes arri8e regularly, i.e., eCactly e8ery T
i
N,
i
ti+e units.
I6, ho,e8er, boCes arri8e irregularly, say according to a stochastic process, and ,
i
is only an
a8erage arri8al rate, then the instantaneous rate o6 arri8ing boCes can occasionally eCceed
the a8erage 8alue. So, i6 the ele8ator is 6ull so+e arri8ing boCes +ay be bloc-ed 6ro+ being
ser8ed. We discuss +odels that ta-e account o6 such bloc-ing e66ects in Sections $.($ and
).3.3
%6& "ffective bandwidths
We ha8e seen in the ele8ator eCa+ple o6 Section $.$ that a -ey notion in assessing resource
usage is substitution. Let us eCplore this in a +ore general ,ay. Suppose the technology
set is de6ined by , X 0 and g
i
., < [ c
i
, i 3 (R " " " R m. 2ssu+e g
i
., < is nondecreasing
in each co+ponent o6 , . In the ele8ator eCa+ple g
i
is linear in , . Suppose g
i
.,! < 3 c
i
is
the uni;ue binding constraint at point ,! . 0hen Dby 0aylorMs theore+E a change o6 ,! to
,! C S changes the 8alue o6 the le6t#hand side o6 this constraint to
g
i
.,! < C S
(
F g
i
NF ,
(
C g g g C S
k
F g
i
NF ,
k
?
, 3,!
C
o.S<
D,here o.S< denotes a ter+ that is s+all co+pared to S" eCplicitly, o.S<N?S? _ 0 as ?S? _
0E. So, ,e satis6y the binding constraint to ,ithin o.S< i6
S
(
F g
i
NF ,
(
C g g g C S
k
F g
i
NF ,
k
?
, 3,!
3 0
0hus, it is natural to de6ine the e''ective *andwidth o6 contract 2 as V
2
3 F g
i
NF ,
2
f
. It
can again be 8ie,ed as a substitution coe66icient, because i6 ,e let the nu+ber o6 type (
contracts, ,
(
, increase by hNV
(
and the nu+ber o6 type 2 contracts, ,
2
, decrease by hNV
2
and hold all other co+ponents o6 , constant, then the constraints o6 the technology set are
still satis6ied to ,ithin o.h<.
0he abo8e analysis suggests a +ethod 6or constructing the e66ecti8e band,idths 6ro+
-no,ledge o6 the acceptance region. 7n6ortunately, it is hard to deter+ine A in practice,
since its boundary can be 6ound only by eCperi+entation at a 8ery large nu+ber o6 points.
In the neCt section ,e present an approach 6or deri8ing the V
(
R " " " R V
k
6ro+ statistical
characteristics o6 the sources.
0he pre8ious discussion suggests that ,e can interpret e66ecti8e band,idths as de6ining
a local linear approCi+ation to the boundary o6 the technology set at the operating point
,! . In >igure $.' t,o constraints de6ine A. 4ne is linear and one is nonlinear. Suppose
the operating point is on the boundary o6 the nonlinear constraint, g
(
[ c
(
. 0hen
f
, 3,
*
2
,
2
V
2
3
*
2
,!
2
V
2
de6ines a hyperplane that is tangent to g
(
3 c
(
at the
operating
point ,! , ,ith V
2
3 F g
(
NF ,
2
f
. 9ere V depends on ,hich constraint is binding and this
depends on the operating point ,! . !o, a local approCi+ation to the boundary o6 g
(
., < [
c
(
.>>.C0IG. 2!3WI309S >4R 0R2>>IC S0R.21S )(
2 N ( 2 2
f
, 3,
2 3(
,
2
' N constant
g
(
N c
(
tangent to ' and g
(
"
,
d
k
, a N Ci
A
g N c
2 2
,
(
/igure %6& 0he acceptance region A is de6ined by t,o constraints. 2t the operating point ,! ,
,hich achie8es the +aCi+u+ o6 ' in A, the acti8e constraint is g
(
., < [ c
(
and so the
e66ecti8e
band,idths ,ill be o6 the 6or+ V
2
3 F g
(
NF ,
2
f
. !ote that the proble+ o6 +aCi+i@ing ' sub?ect
to
*
k
2 3(
,
2
V
2
[ C
a
, ,here C
a
3
*
k
,!
2
V
2
, is also sol8ed at ,! . 0hus, ,e can use si+pler
e66ecti8e band,idth constraints, in place o6 the actual acceptance region constraints, in posing the
opti+i@ation proble+.
at the operating point ,! is the hyperplane
k k J
,
2
V
2
[ C
a
R de6ining C
a
"3
J
,!
2
V
2
D$.$E
2 3(
2 3(
I6 the operating point ,! ,as de6ined by +aCi+i@ing ' o8er A, then this line is also
tangent to a contour o6 ' at this point. 0he proble+ o6 +aCi+i@ing ' sub?ect to D$.$E is
sol8ed also at ,! . 0hus, 6or the purposes o6 identi6ying ,! , or +oti8ating users to
choose ,! in a decentrali@ed ,ay, the approCi+ation in D$.$E to the boundary o6 A is as
good as the true constraint g
(
., < [ c
(
.
%6( "ffective bandwidths for traffic streams
0he technology set 6or transport ser8ices depends on the in6or+ation that is a8ailable
about the connections. We loo- 6irst at the case in ,hich ,e ha8e a 6ull description o6 each
connectionMs tra66ic. In subse;uent sections, ,e consider the +ore realistic case that the only
in6or+ation a8ailable about a connection is its ser8ice contract. 0he +aterial o6 this section
is +athe+atically intricate and so+e readers +ay ,ish to s-ip to the su++ary at the end.
We consider the si+ple proble+ o6 deter+ining the nu+ber o6 contracts that can be
handled by a single s,itch. 0he s,itch has a bu66er o6 si@e ( and ser8es C cells per
second in a >irst Co+e >irst Ser8e D>C>SE 6ashion. In practice, s,itches +ay re;uire
+ore sophisticated +odelling than >C>S in order to capture the e66ects o6 the sophisticated
scheduling +echanis+s that are used 6or di66erentiated ser8ices. Suppose the =oS is de6ined
only in ter+s o6 the CL*, or e;ui8alently in ter+s o6 the probability that the content o6
the bu66er eCceeds a certain le8el. Constraints concerned ,ith eCceeding +aCi+u+ delay
bounds can also be +odelled this ,ay Dsee .Ca+ple $.%E. 9o,e8er, it is reasonable to
6ocus on CL* because in present s,itch design this is +ore i+portant than a8erage delay.
*resent designs use s+all bu66ers 6or real ti+e ser8ices. 0his -eeps the +aCi+u+ delay
s+all. .8en i6 large bu66ers are used, the CL* is usually already greater than ,e ,ish to
per+it be6ore the si@e o6 the delay beco+es i+portant.
Suppose that there are k classes o6 tra66ic ,hose statistics are -no,n. We consider =oS
)2 !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
constraints that are either deter+inistic DCL* 3 0E or probabilistic, say CL* \ (0
a&
.
2
2s be6ore ,
i
denotes the nu+ber o6 sources in class i . 0he technology set is the set
o6 all .,
(
R " " " R ,
k
< 6or ,hich the =oS constraints are not 8iolated. It depends upon the
in6or+ation a8ailable in ad8ance D-no,ledge o6 the actual source statistics, the lea-y buc-et
constraints o6 the contractsE, dyna+ic in6or+ation Don#line +easure+entsE, and on the =oS
constraints.
Let /
2
T0R t U be the nu+ber o6 cells produced by a bursty source o6 type 2 in a ,indo, o6
length t seconds. Suppose that at the operating point ,! only a single constraint is binding,
and it is o6 the 6or+ a log.CL*< [ . 0hen the e66ecti8e band,idth o6 a source o6 type
2 is de6ined, D6or 8alues o6 the s$ace $arameter s and the time $arameter t , ,hich are
de6ined belo,E, as
(
V
2
.sR t < 3
st
log
E
h
e
s /
2
T0Rt U
i
D$.'E
In Section $.', ,e sho,ed that the binding constraint at the operating point ,!
approCi+ated by the linear constraint
can be
,here C
a
3
*
,!
2
V
2
.sR
t <.
k J
,
2
V
2
.sR t < [ C
a
D$.HE
2 3(
We e+phasi@e that the e66ecti8e band,idth o6 a tra66ic strea+ is a 6unction o6 its
+ultipleC#
ing conteCt. 0his is 6ully su++ari@ed in the 8alue o6 the para+eters s and t . 0o deter+ine
the e66ecti8e band,idth constraint, one +ust 6irst 6ind the 8alues o6 these para+eters. 0hey
depend upon the operating point, ,! , the lin- para+eters, .CR ( <, and the per+itted
CL*. In 6act, de6ining .CR ( < in D$.)E, as an asy+ptotic 8alue o6 log.CL*<, it 6ollo,s
that
d d
s 3
d (
R st 3
dC
D$.%E
oth para+eters also ha8e physical interpretations and in principle could be Oobser8edM
in the syste+. 0o interpret t , ,e note that there are +any ,ays in ,hich the bu66er o6 the
s,itch can 6ill and o8er6lo,. 2n i+portant heuristic, ,hich one can +a-e precise using the
+athe+atical theory o6 large de8iations, is that ,hen a rare e8ent such as bu66er o8er6lo,
occurs, it occurs in its +ost probable possible ,ay. 0he ti+e para+eter t corresponds to
the +ost probable ti+e o8er ,hich the bu66er 6ills during a busy period in ,hich o8er6lo,
occurs Dsee >igure $.HE. 2s ,e ha8e said, this +ost probable ti+e to o8er6lo, depends
bu66er
rate
(
t
(
t
t
ti+e
/igure %6( 0he operating point para+eter t corresponds to the +ost probable ti+e o8er ,hich the
bu66er 6ills during a busy period in ,hich o8er6lo, occurs. 9ere the source rate 8aries on t,o
ti+escales and t
2
is +ore rele8ant to o8er6lo, than is t
(
. 0his is because it is ,hen the source
produces at a high rate 6or a relati8ely long ti+e, o6 order t
2
, that the bu66er o8er6lo,s. 3uring such
a long ti+e, 6luctuations on the t
(
ti+escale are e8ened#out and do not contribute to the o8er6lo,.
_
2
(
2
_(
2
(
e
upon the si@e o6 the bu66er, the CL* and the precise +iC o6 tra66ic that is +ultipleCed at
the operating point. I6 any o6 these change, then the +ost probable ti+e to o8er6lo, also
changes. >or eCa+ple, t tends to @ero as the si@e o6 bu66er, ( , tends to @ero.
0he 8alue o6 the space para+eter s Dperhaps +easured in k*
a(
E +easures the degree
to ,hich ad8antage can be gained 6ro+ statistical +ultipleCing. In particular, 6or lin-s
,ith capacity +uch greater than the su+ o6 the +ean rates o6 the +ultipleCed sources,
s tends to @ero and V
2
.sR t < approaches the +ean rate o6 a source o6 type 2 De.g.
as
li+
s 0
Ts
a(
log.
(
e
as
C
2
e
*s
< 3
(
.a C *<, 6or a source producing either a or *, ,ith e;ual
probabilities, in a ,indo, o6 length t E. >or lin-s ,ith capacity not +uch greater than the
su+
o6 the +ean rates o6 the sources, there can be little statistical +ultipleCing gain. Intuiti8ely,
bu66ering is crucial and increasing the si@e o6 the bu66er ,ill +a-e a large reduction in
the CL*, and thus s 3 d Nd( ,ill be large. 2s s _ (, ,e 6ind that V
2
.sR t < tends
to
a 8alue, say V
2
.(R t <
3
/
!
2
T0R t UNt ,
,here
/
!
2
T0R t U 3 sup6a " P . /
2
T0R t U X a< `
0g,
i.e., the least upper bound on the 8alue that /
2
T0R t U ta-es ,ith positi8e probability
De.g. as li+
s
Ts
a(
log.
(
e
as
C
2
*s
< 3 +aC6aR *gE. >or sources that do not ha8e
+aCi+u+ pea- rates, such as a Aaussian one, /
!
2
T0R t U 3 (. !ote that this gi8es the
appropriate e66ecti8e band,idth 6or Odeter+inistic +ultipleCingM Di.e. 6or CL* 3 0E, since i6 *
2
,
2
V
2
.(R t < [ C , ,here t is gi8en the 8alue that +aCi+i@es the le6t#hand side o6
this ine;uality, then
*
2
,
2
/
2
T0R t U [ Ct ,ith probability ( 6or all t . We pursue this 6urther in
Section $.(2.
0here is also a +athe+atical interpretation 6or s. Conditional on an o8er6lo, e8ent
happening, the e+pirical distributions o6 the inputs ?ust prior to that e8ent di66er 6ro+ their
unconditional distributions. >or eCa+ple, they ha8e greater +eans than usual and reali@e a
total rate o6 C C (Nt o8er the ti+e t . 0he so#called OeCponentially tilted distribution ,ith
para+eter sM, speci6ies the distribution o6 the sourcesM +ost probable beha8iour leading up
to an o8er6lo, e8ent.
0he single constraint D$.HE is a good approCi+ation to the boundary o6 the acceptance
region i6 the 8alues o6 s and t re+ain 6airly constant on that boundary o6 A and so V
2
.sR t <
does not 8ary +uch. In practice, the 8alues o6 , +ight be eCpected to lie ,ithin so+e s+all
part o6 the acceptance region boundary Dperhaps because the net,or- tries to -eep , near
so+e point ,here social ,el6are or re8enue is +aCi+i@edE. In this case it is only i+portant
6or D$.HE to gi8e a good approCi+ation to A on this part o6 its boundary.
0he +oti8ation 6or the abo8e approach co+es 6ro+ a large de8iations analysis o6 a +odel
o6 a single lin-. 9ere ,e si+ply state the +ain result. Let C be the capacity o6 the lin-
and ( be the si@e o6 its bu66er. Suppose the operating point is , Ddropping the bar 6or
si+plicityE. Consider an asy+ptotic regi+e in ,hich there are O+any sourcesM, in ,hich
lin- capacity is C 3 NC
.0<
, bu66er si@e is ( 3 N (
.0<
, the operating point is , 3 N,
.0<
, and N tends to in6inity. It can be sho,n that
li+
(
log.CL*. N <<
N _( N
j
k
I
3 sup in6
st
J
,
.0<
V
2
.sR t < a
s
g
t C ( D$.&E
t X0
s X0
2
2 3(
C
.0<
.0<
0his holds under ;uite general assu+ptions about the distribution o6 /
2
T0R t U, e8en i6
it has hea8y tails. 0hus ,hen the nu+ber o6 sources is large ,e can approCi+ate
.(N N < log CL*. N < by the right#hand side o6 D$.&E. 1a-ing this approCi+ation and
then +ultiplying through by N , ,e 6ind that a constraint o6 the 6or+ CL*. N < [
e
a
is
approCi+ated by
j
k
I
a .CR ( < "3 sup in6
t X0
s X0
st
J
,
2
V
2
.sR t < a s.Ct C
( <
2 3(
[ a D$.)E
!ote also that D$.%E is obtained 6ro+ D$.)E by ta-ing deri8ati8es ,ith respect to ( and
C . 0he en8elope theore+ says that s and t can be treated as constant ,hile ta-ing
these deri8ati8es. DIt is the theore+ that i6 4 .a< 3 +aC
y
' .aR y< ' .aR y.a<<, then
d4 .a<Nda 3 F ' .aR y<NF a ?
y 3 y .a <
E.
%6(61 !he Acce'tance Region
0he constraint o6 D$.)E can be re,ritten as the union o6 an in6inite nu+ber o6 constraints,
one 6or each t X 0, and each ta-ing the 6or+
g
t
., < [ a D$.(0E
,here
j
k
I
g
t
., < 3 in6
s X0
st
J
,
2
V
2
.sR t < a s.Ct C
( <
2 3(
D$.((E
We can interpret g
t
., < as the logarith+ o6 the probability that o8er6lo, occurs and that it
does so o8er a ti+e t . 9ence i6 , satis6ies D$.)E then the logarith+ o6 the probability o6
o8er6lo, during a period o6 length t is no +ore than a , 6or all t .
Let A
t
3 6, " g
t
., < [ a g. Since it is the +ini+u+ o6 linear 6unctions o6 , ,
the right#hand side o6 D$.((E de6ines a conca8e 6unction o6 , and so each A
t
is the
co+ple+ent o6 a con8eC set Dre6er to 2ppendiC 2 6or de6initions o6 conca8e and con8eC
6unctions and con8eC setsE. 0he acceptance region is A 3 k
t
A
t
, as eCe+pli6ied in >igure
$.%. !ote that since D$.)E is an asy+ptotic approCi+ation o6 the true CL*, the region A is
an asy+ptotic
n
2
A
t
(
A
t
2
A
t
3
,
A
0,0
n
(
/igure %6+ 0he structure o6 an acceptance region 6or t,o types o6 calls. 0he acceptance region, A,
is the intersection o6 the co+ple+ents o6 the 6a+ily o6 con8eC sets A
t
, parts o6 ,hose northeast
boundaries are sho,n 6or three 8alues o6 t . It +ay be neither con8eC nor conca8e. We illustrate a
local approCi+ation at so+e boundary point ,! using e66ecti8e band,idths. 9ere, the e66ecti8e
band,idths are de6ined by the tangent to the boundary o6 A
t
(
at ,! .
S41. .J21*L.S )'
f
,
a
approCi+ation o6 the true acceptance region 6or a gi8en 6inite N . It beco+es +ore eCact
as N increases. *ractical eCperi+ents sho, eCcellent results 6or N o6 the order o6 (00.
Suppose ,! is the operating point in A and g
t
., < [ a is the constraint that is binding
at this point. 0hen t achie8es the supre+u+ in D$.)E. Let s be the in6i+i@er in the right
hand
side o6 D$.((E. 0hen F g
t
NF ,
2
f
3 !
3 st V
2
.sR t < and so, as abo8e, g
t
., < [ a has a
linear
approCi+ation in the neighbourhood o6 ,! o6
k k
st
J
,
2
V
2
.sR t < [ st
J
,!
2
V
2
.sR t < 3 s.Ct C ( < a
2 3(
3i8iding by st , ,e ha8e
k
2 3(
(
g J
,
2
V
2
.sR t < [ C
a
R ,here C
a
3 C C (
2 3(
t s
D$.(2E
0he linear constraint in D$.(2E gi8es a good approCi+ation to the boundary o6 the
acceptance region near ,! i6 the 8alues o6 s and t ,hich are opti+i@ing in D$.)E do not
change 8ery +uch as , 8aries in the neighbourhood o6 ,! . We can eCtend this idea
6urther to obtain an approCi+ation 6or the entire acceptance region by approCi+ating it
locally at a nu+ber o6 boundary points. 4pti+i@ing the selection o6 such points +ay be a
highly nontri8ial tas-. 2 si+ple heuristic ,hen the s and t do not 8ary ,idely o8er the
boundary o6 the acceptance region is to use a single point approCi+ation. 4ne should
choose this point to be in the OinterestingM part o6 the acceptance region, i.e. in the part
,here ,e eCpect the actual operating point to be. 4ther,ise one +ay choose so+e centrally
located point such as the intersection o6 the acceptance region ,ith the ray .(R (R " " " R (<.
In practice, points on the acceptance region and their corresponding s and t can be
co+puted using D$.)E. We start ,ith so+e initial point , near 0 and -eep increasing all its
co+ponents proportionally until the target CL* is reached.
Let us su++ari@e this section. We ha8e considered the proble+ o6 deter+ining the
nu+ber o6 contracts that can be handled by a single s,itch i6 a certain =oS constraint is
to be satis6ied. We ta-e a +odel o6 a s,itch that has a bu66er o6 si@e ( and ser8es C cells
per second in a 6irst co+e 6irst ser8e 6ashion. 0here are k classes o6 tra66ic, and the s,itch
is +ultipleCing ,
2
sources o6 type 2 , 2 3 (R " " " R k. We de6ine the Oe66ecti8e band,idthsM o6
source type 2 by D$.'E. 0his is a +easure o6 the band,idth that the source consu+es and
depend upon the para+eters s and t . 2s s 8aries 6ro+ 0 to (, it lies bet,een the +ean
rate and pea- rate o6 the source, +easured o8er an inter8al o6 length t . 2rri8ing cells are
lost i6 the bu66er is 6ull. We consider a =oS constraint on the cell loss probability o6 the
6or+ CL* [ e
a
, and sho, that a good approCi+ation to this constraint is gi8en by the
ine;uality in D$.)E. 0he approCi+ation beco+es eCact as ( , C and ,
2
gro, to,ards in6inity
in 6iCed proportions. >or this reason, D$.)E is called the O+any sources approCi+ationM. 2t a
gi8en Ooperating pointM, ,! , the constraint has an approCi+ation that is linear in , , gi8en
by D$.(2E, ,here s and t are the opti+i@ing 8alues in D$.)E ,hen ,e put , 3 ,! on the
right# hand side. 0he linear constraint D$.(2E can be used as an approCi+ation to the
boundary o6 the acceptance region at ,! . We can interpret t as the +ost probable ti+e
o8er ,hich the bu66er 6ills during a busy period in ,hich o8er6lo, occurs.
%6+ Some e0am'les
In so+e cases the acceptance region can be described by the intersection o6 only a 6inite
)H !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
nu+ber o6 A
t
s. We see this in the 6irst t,o eCa+ples.
2
2 (
2
2
2
2 2
l
"0am'le %6 ;-aussian in'ut< Suppose that /
2
T0R t U is distributed as a Aaussian rando+
8ariable ,ith +ean e
2
t and 8ariance l
2
t . >or eCa+ple, let /
2
T0R t U 3 e
2
t C l
2
(.t <,
,here (.t < is standard ro,nian +otion. 0hen
(
h
s / Tt R0U
i
(
e 2 ts Cl
2 2
2
V.sR t < 3
st
log E
e
3
st
log e
2
t s N2
3 e
2
C l
2
sN2
!ote that V is independent o6 t . 2lso, it tends to in6inity as s increases. 0his is because
the Aaussian source does not ha8e a 6inite pea- rate. When sources o6 k di66erent types are
+ultipleCed, the acceptance region, A, is de6ined by D$.)E, ,hich is
sup in6
h
st
*
k
3
,
2
.e
2
C l
2
sN2< a s.Ct C ( <
i
[ a
t X0
s X0
0he in6i+u+ ,ith respect to s occurs at s 3 .C C (Nt a
*
2
,
2
e
2
<N
*
2
,
2
l
2
. 0his
gi8es
A to be de6ined by
(
g
k

2
.
*
k 2
X
sup
t X0
a
2
t C C (Nt a
*
2 3(
,
2
e
2
2 3(
,
2
l
2
[ a
in ,hich the supre+u+ ,ith respect to t is achie8ed by
(
t 3
C a
*
2
,
2
e
2
!ote that the +ost li-ely ti+e o8er ,hich bu66er o8er6lo, occurs is the sa+e ti+e that it
,ould ta-e 6or a 6ull bu66er to e+pty ,hile being 6ed ,ith ne, input at the a8erage rate o6
*
2
,
2
e
2
. So D$.)E is ?ust
k J
,
2
g
e
2
C l
2
sN2

[ C
C
(
g


t
( a
s
D$.(3E
2 3(
0he e66ecti8e band,idth is e
2
C l
2
sN2, ,here s 3 2.C a
*
2
,
2
e
2
<N
*
2
,
2
l
2
. !ote that
the e66ecti8e band,idth depends upon C , and on the operating point through the +ean and
8ariance o6 the superi+posed sources.
0hings are rather special in this eCa+ple. 26ter substitution 6or s and t and si+pli6ication,
D$.(3E beco+es
k J
,
2
g
e
2
C
2 3(

2
2 (
2
[ C D$.($E
0hus, the acceptance region is actually de6ined by ?ust one linear constraint. .Cpressions
D$.(3E and D$.($E are the sa+e because s 3 N ( is constant on the boundary o6 the
acceptance region. In 6act, this acceptance region is eCactly the region in ,hich CL* [ e
a
,
2
i.e. the asy+ptotic approCi+ation is eCact. 0his is because the Aaussian input process is
in6initely di8isible Di.e. /
2
T0R t U has the sa+e distribution as the su+ o6 N i.i.d. rando+
8ariables, each ,ith +ean e
2
N N and 8ariance l
2
N N K 6or any N E. 0here6ore the li+it
in
D$.&E is actually achie8ed.
"0am'le %6$ ;-aussian in'ut9 long range bursts< Let us calculate the e66ecti8e
band,idth o6 a Aaussian source ,ith autocorrelation. 0his is interesting because positi8e
t
t
_(
t
3
t
t
2
2
autocorrelation produces a process ,ith long range bursts. In the pre8ious t,o eCa+ples
,e ha8e constructed a +odel in continuous ti+e. !o, let us assu+e that ti+e is discrete,
i.e. ,ith epochs t 3 (R 2R " " " . Suppose /
i
represents the contribution o6 the source in the
i th ti+e inter8al and 6 /
(
R /
2
R " " " g is a se;uence o6 Aaussian rando+ 8ariables ,ith
+ean
e, 8ariance l
2
and autoco8ariance 6unction .k< D,hich is not to be con6used ,ith the
logarith+ o6 the CL*E. 0hen ,e ha8e V.sR t < 3 e C l
2
sN2,
,here
t l
2
3 8ar
t
_
J
/
i
i 3(
3 t l
2
C 2T.t a (< .(< C .t a 2< .2< C g g g C .t a
(<U
!otice that li+
t
l
2
3 , ,here is the so#called OindeC o6 dispersionMR one can
sho, that ,hen the su+ con8erges,
*
(
a(
.k<. I6 there is positi8e autocorrelation
then l
2
` l
2
, and so the e66ecti8e band,idth is greater than it ,ould be 6or an uncorrelated
Aaussian process ,ith the sa+e 8ariance. Si+ilarly, i6 l
2
\ l
2
the e66ecti8e band,idth is
less.
"0am'le %6% ;#rownian bridge model of 'eriodic sources< In this eCa+ple the
acceptance region is described by ?ust t,o linear constraints.
Consider a periodic source ,hich produces a burst o6 si@e m
2
at ti+es & , & C (, & C 2,
" " " , ,here & is uni6or+ly distributed on the inter8al T0R (U. Consider the superposition
o6 ,
2
such sources, ,ith 8alues o6 & chosen independently. It is a rando+ process ,hose
8alue increases 6ro+ 0 to ,
2
m
2
o8er the inter8al T0R (U. 2t each ti+e t bet,een 0 and
( the probability that any one source has already produced its burst is t . It 6ollo,s that
the tra66ic produced by the superposition by ti+e t [ ( has a distribution o6 m
2
ti+es a
bino+ial distribution o6 (.,
2
R t <R the distribution o6 this ;uantity is approCi+ately nor+al,
,ith +ean ,
2
m
2
t and 8ariance ,
2
m
2
t .( a t <. In 6act, the superposition tends to that o6
m
2
ti+es a ro,nian +otion that starts at 0 and is conditioned to reach ,
2
at ti+e (.
0his suggests that ,e consider a di66erent type o6 source ,hose superposition is eCactly
this.
.ach o6 these sources is o6 the 6or+
/
2
T0R t U 3 m
2
bt c C m
2
: .t a bt
c<
,here : .t <, 0 [ t [ (, is the standard ro,nian bridge ha8ing : .t < n N .t R t .( a t
<<. Superi+posing ,
2
such sources is an approCi+ation 6or superi+posing ,
2
actual
bursty periodic sources. 2s in .Ca+ple $.2, one can co+pute V
2
.sR t < 3 m
2
C m
2
s ' .t <T(a
' .t <UN2t , ,here ' .t < 3 t a bt c is the 6ractional part o6 t . 0he acceptance region
turns out to be
A 3 k
t
A
t
3 A
0"'
k A
(
, ,here A
(
and A
0"'
3 are the sets o6 , satis6ying the
6ollo,ing t,o constraints"
k J
,
2
m
2
[ C D$.('E
2 3(
k
J
,
2
g
m
2
C m
2
[ ( C C D$.(HE
2 3(
2
2 (
Constraints D$.('E and D$.(HE correspond to .sR t < 8alues o6 .0R (< and .2 N (R (N2<,
respecti8ely. >or instance, i6 D$.('E is the acti8e constraint, there is enough bu66er to absorb
the te+porary bursts DeCpressed in D$.(HEE, but these bu66ers 6ill in6initely slo,ly since the
i
a8erage input rate ObarelyM eCceeds the ser8ice capacity. I6 D$.(HE is acti8e, then the +ost
probable ti+e o8er ,hich the bu66er produces o8er6lo,s is hal6 ,ay through each period.
ro,nian bridge inputs are in6initely di8isible processes so, as in .Ca+ple $.2, the abo8e
acceptance region is eCact 6or a si+ple ;ueue 6ed by ro,nian bridge inputs.
"0am'le %6& ;4n)off sources< Consider a source that alternates bet,een on and o66 states.
When it is on it sends at constant rate h and ,hen it is o66 it sends at rate @ero. 0he
successi8e lengths o6 ti+e that it spends in the on and o66 states are T
on
and T
o66
,
respecti8ely, ,hich can be either deter+inistic or rando+. Let $
on
denote the probability
that the source is on. I6 m is the +ean rate o6 the source, then $
on
3 mN h. 0he e66ecti8e
band,idth o6 this on#o66 source has a si+ple 6or+ ,hen the ti+e para+eter t is s+all
co+pared ,ith T
on
and T
o66
. 0his is typical i6 the bu66er is s+all. In this case, there is
only a 8ery s+all probability that the source is both on and o66 during a ,indo, o6 length
t . 0hus, ,ith high probability / T0R t U, ,hich is the contribution o6 the source in a ,indo,
o6 si@e t , ta-es only t,o 8alues" @ero i6 the source is o66 and ht i6 the source is on, ,ith
respecti8e probabilities ( a mN h and mN h. 0hen D$.'E beco+es
(
hg
m

m
sht
i
V
on#o66
.mR h< 3
st
log ( a
h
C
h
e
D$.(%E
0his eCpression illustrates so+e o6 the properties o6 s +entioned in Section $.H. 2s s
approaches @ero, the e66ecti8e band,idth approaches the +ean rate o6 source. 2s s tends
to in6inity, the e66ecti8e band,idth tends to the pea- rate o6 the source. 0he e66ecti8e
band,idth is an increasing 6unction o6 s and thus ta-es 8alues bet,een the +ean and the
pea- rate. S+aller 8alues o6 s correspond to +ore e66icient +ultipleCing.
"0am'le %6( ;*arkov modulated source< Let us ta-e the +odel o6 an on#o66 source in
.Ca+ple $.'. Let the successi8e lengths o6 ti+e that the source spends in the on and o66
states be i.i.d. eCponential rando+ 8ariables ,ith +eans T
on
and T
o66
. 0his +odel has been
used to +odel 8oice and 8ideo tra66ic. It can also be used to +odel the acti8ity during a
,eb bro,sing session.
We can generali@e this +odel to one ,ith e8en +ore than t,o statesR suppose there are m
states, m X 2. Suppose that in state i the source sends at rate e
i
. 0he state changes
according to a continuous#ti+e 1ar-o8 process ,ith -no,n transition +atriC, i.e. the
holding ti+e in state i is eCponentially distributed, say ,ith +ean (NX
i
, and gi8en that
the state is i , the neCt state ,ill be 2 ,ith probability P
i 2
.
0he nice thing about this class o6 +odels is that it is possible to calculate the e66ecti8e
band,idth Dat least nu+ericallyE. Let /
i
T0R t U be the tra66ic produced o8er T0R t U,
conditional on the source starting in state i . In brie6, the e66ecti8e band,idth is
co+puted 6ro+ the +o+ent generating 6unction o6 the /
i
T0R t U, say '
i
.t < 3 E eCp.s /
i
T0R t U<. 0hen it is not hard to see that
5
t
'
i
.t < 3 e
aX
i
t
e
s e
i
t
C
0
e
s e
i
u
X
i
e
aX
i
u
*
2
P
i 2
'
2
.t a u< du
Let '
a
.%< be the Laplace trans6or+ o6 '
i
.t <. 0he integral abo8e is a con8olution
integral and so ,e easily 6ind
'
a
(
g
m a
i
.%< 3
%
C X
i
a se
i
( C
*
2 3(
P
i 2
'
2
.%<
17L0I*L. =4S C4!S0R2I!0S ))
4ne can, in principle, sol8e this set o6 linear e;uations and then in8ert the Laplace
trans6or+s.
Consider the special case o6 an on#o66 source, ,ith o66 and on phases that are
eCponentially distributed ,ith +eans (NX
0
and (NX
(
, respecti8ely, and ta-ing e
0
3 0
and pea- rate
e
(
3 h. We 6ind, a6ter so+e algebra,
' .t < 3 E
5
t
eCp s
0
X
, .s<ds 3
X
(
X
0
C X
(
'
0
.t <
C
X
0
X
0
C X
(
'
(
.t <
X
(
_
2
C X
0
._
2
a sh<
e
_
(
t
3
._
2
a _
(
<.X
0
C X
(
<
C
aX
(
_
(
C X
0
.sh a _
(
<
e
_
2
t
._
2
a _
(
<.X
0
C X
(
<
,here _
(
, _
2
are the t,o roots o6 _
2
C .X
0
C X
(
a X
0
h<_ a X
0
h 3 0.
2 discrete ti+e +odel is e8en easier. Suppose that the state changes at each epoch
according to the transition +atriC . $
i 2
<. 0hen the e66ecti8e band,idths satis6y the set o6
linear recurrences
'
i
.t < 3 e
s e
i
*
2
$
i 2
'
2
.t a (<R t 3 (R
2R " " "
0hese recurrences ha8e been success6ully used to +a-e nu+erical co+putations o6 e66ecti8e
band,idth 6unctions.
%6, *ulti'le >oS constraints
2s in Section $.', the idea o6 e66ecti8e band,idths eCtends to +ultiple =oS constraints.
0he acceptance region is then the intersection o6 the acceptance regions de6ined by each
constraint. .ach constraint +ight correspond to a di66erent +anner o6 o8er6lo,. 0he
e66ecti8e band,idth o6 a strea+ is de6ined by the constraint that is acti8e. .Ca+ple $.%
de+onstrates ho, +ultiple constraints +ay result 6ro+ the scheduling +echanis+ o6
priority ;ueueing.
"0am'le %6+ ;Priority :ueueing< 4ne ,ay to gi8e di66erent ;ualities o6 ser8ice to di66erent
classes o6 tra66ic is by priority ;ueueing. Suppose that tra66ic classes are partitioned into
t,o sets, 1
(
and 1
2
. Ser8ice is >C>S, eCcept that a class in 1
(
is al,ays gi8en priority o8er
a class in 1
2
. >or i 2 1
(
there is a =oS guarantee on delay o6 the 6or+
P .delay ` (
(
NC < [ e
a
(
>or all sources there is a =oS guarantee on CL* o6
CL* [ e
a
2
0his gi8es the t,o constraints g
(
., < [ 0 and g
2
., < [ 0, ,here , is the 8ector o6
the nu+bers o6 sources o6 the di66erent types. 0he acceptance region is no, the
intersection o6 the acceptance regions corresponding to each o6 the constraints. 2ssu+e
that on the
OinterestingM part o6 each constraint the 8alues o6 s and t do not 8ary ,idely, being s
i
R t
i
6or
constraints i 3 (R 2. 0hen, by approCi+ating each constraint globally using D$.(2E
calculated at a single appropriately chosen point, ,e obtain the e66ecti8e band,idth
approCi+ations o6 the constraints
J
,
2
V
2
.s
(
R t
(
< [ +
(
and
J
,
2
V
2
.s
2
R t
2
< [ +
2
D$.(&E
2 2 1
( 2 2 1
(
T 1
2
(00 !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
2
(
t t
,
2
CL* b e
Wo
* Ddelay ` (
(
<C E b e
Wg
,
A
0,0
,
(
/igure %6, 2n acceptance region de6ined by t,o constraints. 0here are t,o classes o6 tra66ic. 0he
8ertical constraint is due to a guarantee on the delay o6 priority tra66ic. 0he second constraint is due
to a guarantee on the CL* 6or both tra66ic types, and is approCi+ated by a linear constraint at the
operating point ,! Dsho,n dottedE.
,here
(

+
(
"3 C C
(
(

(

(
a
s
(
(

and +
2
"3 C C
2
(

2

a
s
2
>or eCa+ple, suppose 1
(
3 6(g, 1
2
3 62g. 0hen ,e ha8e
,
(
V
(
.s
(
R t
(
< [ +
(
and ,
(
V
(
.s
2
R t
2
< C ,
2
V
2
.s
2
R t
2
< [ +
2
I6 +
(
NV
(
.s
(
R t
(
< \ +
2
NV
(
.s
2
R t
2
< then the acceptance region ta-es the 6or+ illustrated
in >igure $.&. !ote that this approCi+ation o6 the technology set is less accurate i6 the
8alues o6 s and t 8ary signi6icantly along each constraint. 0hen one +ight approCi+ate
each constraint by tangent hyperplanes at +ore than one boundary point. 0he -ey
obser8ation is that our approCi+ations ,ill al,ays be o6 the 6or+ D$.(&E but ,ith a larger
nu+ber o6 constraints.
%6. !raffic sha'ing
It is a characteristic o6 broadband +ulti+edia and data tra66ic that its rate can 6luctuate
,idely. 0hese 6luctuations can occur at 8arious superi+posed 6re;uencies, as illustrated
in the right hand part o6 >igure $.H. .ach 6re;uency o6 6luctuation de6ines a ti+escale o6
burstiness, i.e. an order o6 ti+e o8er ,hich signi6icant changes are obser8ed in the rate o6
the source, ,hen this is a8eraged o8er ti+e periods o6 the sa+e si@e. In >igure $.H, such
changes in the rate are obser8ed on ti+escales o6 order t
(
and t
2
Dand there +ay be e8en
larger ti+escales, but these do not sho, up in the s+all snapshot ta-enE. Suppose ,e are at
an operating point, ,here a CL* guarantee is ?ust satis6ied and no +ore tra66ic can be
pac-ed in the lin-. We can as-, on ,hat ti+escales are 6luctuations +ost li-ely to cause
bu66er o8er6lo,L In other ,ords, ,hich aspects o6 the tra66ic +a-e it hard to +ultipleC it and
hence contribute to its e66ecti8e band,idthL Si+ilar ;uestions ,ere posed in Section $.$
,hen ,e deter+ined e66ecti8e band,idths 6or the boCes that ,ere to be pac-ed in an
ele8ator.
>or a constraint on the technology set that is de6ined in ter+s o6 a constraint on CL*, the
e66ecti8e band,idth o6 a source depends on the ti+escales o6 the sourceMs burstiness that
signi6icantly contribute to the e8ent o6 bu66er o8er6lo,. Clearly, 6luctuations on di66erent
ti+escales do not contribute e;ually, since those on short ti+escales +ay be absorbed by
the bu66er. 0his e66ect is captured in the de6inition o6 the e66ecti8e band,idth in D$.'E. y
c
e
l
l
s

i
n

e
p
o
c
h
0R2>>IC S92*I!A (0(
letting V.sR t < depend upon the total contribution o6 the source in a ,indo, o6 length o6
ti+e t , ,e O6ilter outM the 6luctuation that occur in ti+escales s+aller than t . >or eCa+ple,
in >igure $.H the ti+escale t
(
is absorbed by the bu66er and is not re6lected in the e66ecti8e
band,idth o6 the source. 9ere t
2
is the do+inant ti+escale o6 burstiness that constraints
the syste+R ,ithin t
2
, the ti+escale t
(
contributes its +ean rate. In other ,ords, i6 ,e ,ere
to replace our source by one obtained by a8eraging it o8er a ti+escale o6 t
(
, this ,ould
ha8e no e66ect on the +ultipleCing and it ,ould neither increase or decrease the CL*.
0ra66ic shaping can be used to reduce high 6re;uency 6luctuations and produce s+oother
tra66ic. 2 typical tra66ic shaper consists o6 a large bu66er that is ser8ed at a rate s+aller
than the pea- rate o6 the strea+, or o6 a bu66er that is co+bined ,ith a lea-y buc-et that
holds the part o6 tra66ic that is non#con6or+ing ,ith the tra66ic contractR see Section 2.2.2.
4ne +ay design the shaper to add delays o6 the sa+e order o6 +agnitude as the ti+escales
o6 the 6luctuations to be s+oothed. 2nother ,ay to i+ple+ent a shaper is to collect the
tra66ic that arri8es e8ery t ti+e units and then trans+it it during the neCt t ti+e units at
a constant rate. 0his rate ,ill di66er during each period, re6lecting the 8ariable 8olu+e o6
data to be trans+itted. 0he abo8e discussion eCplains the e66ects o6 shaping +echanis+s on
the e66ecti8e band,idth o6 the resulting tra66ic. When bu66ers in the net,or- are large Dand
hence t is largeE, then only substantial tra66ic shaping can reduce the e66ecti8e band,idth
o6 the input tra66ic. 9o,e8er, 6or real#ti+e tra66ic using s+all bu66ers, a +oderate a+ount
o6 tra66ic shaping can drastically reduce the e66ecti8e band,idths and thereby increase the
+ultipleCing capability o6 the net,or-.
Let us loo- at so+e data 6or real tra66ic. >igure $.) sho,s a (000 epoch trace 6ro+ a
1*.A#( encoded 8ideo o6 "tar Wars, each epoch being $0+s. !ote the di66erent ti+escales
o6 burstiness. >igure $.(0 plots an esti+ate o6 the e66ecti8e band,idth 6unction 6or this trace.
4bser8e that as either t beco+es s+all or s beco+es large, the e66ecti8e band,idth
increasesR this corresponds to the source beco+ing +ore di66icult to +ultipleC. 0he
eCplanation is si+ple. 0he ti+e a8eraging that ta-es place in the bu66er in ,hich this
particular strea+ is being +ultipleCed s+oothes s+all tra66ic bursts. In particular, it
s+oothes all 6luctuation ta-ing place on ti+escales less than t . 0he larger is t , the +ore the
6luctuations are absorbed and so the resulting trace can be +ultipleCed as easily as a
s+oother trace in ,hich these 6luctuations ha8e been a8eraged#out. .8entually, ,hen t is
large enough, the trace is no +ore di66icult to +ultipleC than a constant bit rate source o6
the sa+e +ean. S+all 8alues o6 t occur ,hen the bu66er is s+all, in ,hich case, the
a8eraging e66ect is negligible, and so the tra66ic is +ore di66icult to +ultipleC. 0his +eans a
greater e66ecti8e band,idth. Si+ilarly, ,hen the lin- capacity decreases, s increases, and
the 8alue o6 the e66ecti8e band,idth
200
('0
(00
'0
0
'000
'200 '$00 'H00 '&00 H000
/igure %6. urstiness can be seen in this trace o6 (000 epochs o6 a 1*.A#( encoded 8ideo o6
"tar Wars. .ach epoch is $0 +s.
(02 !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
e
6
6
e
c
t
i
8
e

b
a
n
d
,
i
d
t
h

D
1
b
p
s
E
2.'
2
(.'
(
0.'
0
0.0(
(
0.(
W(
0
0.'
(
(.'
2
t DsecsE
0.00(
0.000(
sDk* E
/igure %613 .66ecti8e band,idth o6 1*.A#( tra66ic. !ote that 6or di66erent 8alues o6 s and t ,
corresponding to di66erent +ultipleCing conteCts, the e66ecti8e band,idth o6 the 1*.A tra66ic
strea+ can di66er 6ro+ about 0.' to 2.' 1bps.
increases, again capturing the increased di66iculty in +ultipleCing. !ote that 6or di66erent
8alues o6 s and t , corresponding to di66erent +ultipleCing conteCts, the e66ecti8e band,idth
can di66er substantially.
%613 "ffective bandwidths for traffic contracts
We ha8e assu+ed thus 6ar that the source statistics are 6ully -no,n and so eCact e66ecti8e
band,idths can be co+puted. In practice, this is not the case. 0he net,or- -no,s only the
tra66ic contract o6 the re;uested ser8ice. 0his contract only partly characteri@es the tra66ic
source, 6or eCa+ple, through the lea-y buc-et constraints. 0his poses a proble+. I6 only
the tra66ic contract is -no,n, ,hat e66ecti8e band,idths should be used 6or call acceptanceL
0here are se8eral possibilities. .ach has its ad8antages and disad8antages"
(. I6 the net,or- operator can tell ,hich application generates the tra66ic, and that
application produces tra66ic ,ith -no,n statistics, then he can use the actual e66ecti8e
band,idth o6 that type o6 tra66ic. 7sually, ho,e8er, this in6or+ation is not a8ailable.
2. I6 the tra66ic contract is used only by applications o6 a -no,n general type Dsuch
as 8ideoE, then one can use the typical e66ecti8e band,idth 6or the tra66ic o6 that
type o6 application. 0his concept o6 an Oa8erageM e66ecti8e band,idth is used in 6lat
rate charging. 0he idea is that t,o applications that use the sa+e contract should be
charged the sa+e, i.e. on the basis o6 an a8erage e66ecti8e band,idth 6or this contract
type, irrespecti8e o6 ,hether they generate identical tra66ic.
3. I6 8ery little in6or+ation is -no,n about the source, then it can be reasonable to use
the greatest e66ecti8e band,idth, say V! , that is possible under the ser8ice contract,
i.e. the band,idth o6 the tra66ic that is +ost di66icult to +ultipleC, gi8en the
constraints placed upon that tra66ic by the ser8ice contract. 0his is a conser8ati8e
approach that results in net,or- resources being underutili@ed. 9o,e8er, it is the
only approach that enables the net,or- to i+ple+ent hard ;uality o6 ser8ice
guarantees. We pursue this idea in Section $.((.
k +

47!3S >4R .>>.C0IG. 2!3WI309S (03
$. 4ne can +odi6y the abo8e approach to one o6 dyna+ic call acceptance by using
in6or+ation that is obtained by +onitoring the actual syste+. 4ne uses actual
+easure+ents o6 the per6or+ance on the lin-s o6 the net,or- to deter+ine the actual
a+ount o6 spare capacity a8ailable and then decides ,hether to accept a ne, contract
on the basis o6 this in6or+ation and a ,orst#case +odel o6 the ne, call.
Such a decision can depend on the duration o6 the ne, call and the ti+e that it ta-es 6or the
a8ailable capacity to change. It could be that there is a8ailable capacity because a +a?ority
o6 the acti8e calls are sending tra66ic at less than their +ean rates. In this case, the eCisting
load ,ill tend to increase as +ore sources beco+e acti8e at greater rates, although so+e
o6 the+ +ay ter+inate and depart.
4bser8e that lac- o6 in6or+ation about call statistics results in resource underutili@ation
and poor ;uality o6 ser8ice pro8isioning. I6 the net,or- has better in6or+ation about the
resource usage statistics o6 a ne, call, then it can better +ultipleC and load the net,or-
+ore e66iciently. 0his eCplains ,hy a net,or- operator ,ishes to ha8e a good idea o6 the
tra66ic pro6iles o6 his custo+ers. ut ho, can he obtain better in6or+ation than that
a8ailable through the tra66ic contractL Since this in6or+ation is to be used to accept or to
re?ect a call, it +ust be a8ailable at the ti+e the call is set up. 4ne ,ay to obtain +ore
in6or+ation is through pricing. 0he net,or- posts a set o6 possible tari66s 6or the sa+e
tra66ic contract, each one resulting in a di66erent charge, depending on the tra66ic that is
actually generated during the contract. 2ssu+ing the user has so+e in6or+ation about the
tra66ic he ,ill generate, he chooses the tari66 that +ini+i@es his eCpected charge. 9is tari66
choice there6ore re8eals i+portant in6or+ation to the net,or- operator, ,ho can use this
in6or+ation to obtain a better approCi+ation o6 the e66ecti8e band,idth. 0his is an eCa+ple
o6 incenti8e co+patible pricingR ,hen users opti+i@e their tari66 choices the net,or-
operator gains in6or+ation that allo,s hi+ to better load and +ore e66iciently run the
net,or- as a ,hole.
%611 #ounds for effective bandwidths
Suppose that a connection is policed by +ultiple lea-y buc-ets, ,ith a set o6 para+eters
h 3 6.m
k
R f
k
<, k 3 (R " " " R + g. Let m be the +ean rate o6 the connection. We are
interested in the greatest e66ecti8e band,idth, say V! .mR h<, that is possible 6or connection
,hose tra66ic contract has these lea-y buc-et para+eters and ,hose +ean rate is m. In
practice, V! .mR h< can be eCtre+ely di66icult to calculate eCactly, as ,e are in e66ect trying
to deter+ine a ,orst#case stochastic process. ut ,e can easily gi8e a si+ple
approCi+ation 6or V! .mR h<, ,hich nicely sho,s ho, 8arious ti+escales relate to bu66er
o8er6lo,. Since the tra66ic source
is policed by lea-y buc-ets, the +aCi+u+ a+ount o6 tra66ic /
!
T0R t U that could be
produced in a ti+e inter8al o6 length t is
/
!
T0R t U [ 3 .t < "3 +in 6m
k
t C f
k
g
D$.()E
3(R"""R
4ne can sho, that E eCp.s / T0R t U< is +aCi+i@ed sub?ect to E/ T0R t U 3 mt and / T0R t U
[ 3 .t < by the distribution in ,hich / T0R t U e;uals 0 or 3 .t < ,ith probabilities ( a mt N
3 .t < and mt N 3 .t <, respecti8ely. 46 course there +ay not be actual tra66ic, con6or+ing
,ith the abo8e lea-y buc-ets, 6or ,hich / T0R t U has this distribution, and this is ,hy ,e
are only obtaining an upper bound on V! .mR h<. 0his upper bound is
(
V! .mR h< [
st
log
t
m

( C
3
.t <
e
s 3 .t <
X
a (
g
3 V=
sb
.mR h< D$.20E
We call the right#hand side o6 D$.20E the sim$le *ound.
(0$ !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
3
* ] $t
ht
*
t
(
t
/igure %611 2 dual lea-y buc-et policer. 3epending on the 8alue o6 t , a di66erent lea-y buc-et
a66ects the sourceMs +aCi+u+ contribution, 3 .t <, and hence the e66ecti8e band,idth.
In V=
sb
.mR h< ,e can see the e66ects o6 lea-y buc-ets on the resource usage.
.ach
lea-y buc-et .m
k
R f
k
< constrains the burstiness o6 the tra66ic on a particular ti+escale. 0he
ti+escale o6 burstiness that contributes to bu66er o8er6lo, is deter+ined by the indeC k that
achie8es the +ini+u+ in D$.()E. We discuss this issue 6urther at the end o6 this section.
Consider the practical case o6 a dual lea-y buc-et .hR 0< and .m R f <. 3 .t < is sho,n
in
>igure $.((. I6 t is s+all, then 3 .t < 3 ht and the bound D$.20E reduces to
(
V=
on#o66
.mR h< 3
st
log
h
m
( C
h
.e
sht
a (<
i
D$.2(E
We re6er to this as the ono'' *ound, ,hich ,e ha8e already +et in D$.(%E. 0his bound is
8alid 6or any 8alue o6 t , since it is the e66ecti8e band,idth o6 an on#o66 source ,ith pea-
rate h and +ean rate m ,hich can produce arbitrarily long bursts. Such a source does not
co+ply ,ith the .m R f < lea-y buc-et ,hich restricts the length o6 such bursts and so is
,orse than the ,orst possible source that is co+pliant ,ith the abo8e tra66ic contract.
I6 one ,ants to obtain +ore accurate upper bounds on the e66ecti8e band,idth, one has to
use co+pleC co+putational procedures to deter+ine the ,orst#case tra66ic. In general, the
,orst#case tra66ic depends not only on the contract para+eters, but also on the para+eters
s and t . In +any cases, the ,orst#case tra66ic consists o6 bloc-s o6 an in8erted 0 pattern
,hich repeat periodically or ,ith rando+ gaps, as sho,n in >igure $.(2. 0he si@es o6 the
bloc-s and gaps depend on the 8alues o6 s and t . 0his is a general 6or+ o6 eCtre+e tra66ic
,hich, gi8en the lea-y buc-et constraints, alternately sends at the +aCi+u+ rate and at
a lesser rate Dthough not necessarily @eroE. While sending at the lesser rate it accu+ulate
to-ens so that it can again send at the +aCi+u+ rate.
t p N
b
hWr
h
r
t
on
N 2t
t
o66
(0' !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
/igure %61 *eriodic pattern 6or the in8erted 0 approCi+ation to a ,orst#case tra66ic.
t
(
3 fN.h a m<, t
o66
3 T.2t a t
(
<m C t
(
hUNm a 2t
.
e
3.0.R1I!IS0IC 17L0I*L.JI!A (0'
2s an eCa+ple, ,e consider the periodic pattern sho,n in >igure $.(2. Let /
T0R t U
denote the load produced by the in8erted 0 pattern in t epochs. 0his gi8es the inverted T
a$$ro,imation 6or the e66ecti8e band,idth bound,
(
V= .mR h< 3
st
log
E
h
s / T0Rt U
i
D$.22E
0he eCpected 8alue on the right#hand side o6 D$.22E can be co+puted analytically, under
the assu+ption that the start o6 the in8erted 0 pattern is uni6or+ly distributed ,ithin an
inter8al o6 length t
on
C t
o66
, ,here t
on
3 2t .
0he abo8e in8erted 0 approCi+ation is 8alid ,hen the ti+e para+eter t is large co+pared
to the ti+e 6or ,hich the lea-y buc-et per+its the source to send at its pea- rate hR denote
this ti+e by t
(
3 fN.h a m<. I6 t is +uch s+aller than t
(
, then ,orst case tra66ic is a si+ple
on#o66 source, 6or ,hich t
on
3 t
(
and t
o66
3 t
on
hNm a t
on
. In this case, the source operates
only at the eCtre+es, sending at 6ull speed or not at all and a reasonable approCi+ation o6
the ,orst#case e66ecti8e band,idth is gi8en by D$.2(E.
Which lea-y buc-et is +ost constraining o6 the e66ecti8e band,idth produced by a tra66ic
contractL 0he bound in D$.20E suggests that it depends on the ti+escale t . 0his is deter+ined
by the net,or-. Ai8en t , the bound 6or the e66ecti8e band,idth depends only upon the lea-y
buc-et that achie8es +in
k3(R"""R+
6m
k
t C f
k
g 6or the particular t that constrains the +aCi+u+
contribution 3 .t <. 0his suggests that a ,orst#case source 6or the abo8e contract is hard to
+ultipleC because o6 burstiness that is controlled +ainly by this lea-y buc-et. Changing the
8alue o6 other lea-y buc-ets ,ill not signi6icantly reduce the di66iculty o6 +ultipleCing the
source. 9o,e8er, s+oothening that reduces burstiness can reduce the e66ecti8e band,idth.
Consider a source that is policed by t,o lea-y buc-ets .hR 0<R .m R f <. In >igure $.((,
,e plot 3 .t <. >or 8alues o6 the para+eter t less than t
(
3 fN.h a m< the lea-y
buc-et ,hich constrains the pea- rate is do+inant. >or t ` t
(
, the lea-y buc-et .m R f <
do+inates. 0he physical eCplanation is that i6 burstiness on s+all ti+escales is causing
o8er6lo,s, Dperhaps because there are s+all bu66ers in the net,or-E, then reducing the
pea- rate o6 these 6luctuations ,ill reduce the cell loss. I6 bu66ers are large, then rapid
6luctuations are absorbed by the bu66er and there is no ad8antage in reducing the pea- rate.
9o,e8er, reducing the length o6 the long bursts ,ill reduce cell loss. 0hese bursts are
controlled +ainly by the second lea-y buc-et.
%61 1eterministic multi'le0ing
0he case o6 deterministic multi$le,ing is one in ,hich ,e re;uire no cell loss, so that
3 (. 4ur e66ecti8e band,idth theory suggests that s 3 ( D,hich is consistent ,ith
3 ( in D$.(2EE. 0he e66ecti8e band,idth o6 a source o6 type 2 is V
2
.(R t < 3 /
!
2
T0R t U
Nt . 4bser8e that the e66ecti8e band,idth o6 a source does not depend on the
co+plete
distribution 6unction, but only on the
,ith positi8e probability.
/
!
2
T0R t U, the +aCi+u+ 8alue that /
2
T0R t U
ta-es
Let us deri8e the 6or+ o6 the acceptance region 6or sources policed by lea-y buc-ets.
Suppose that each type o6 source is policed by a single lea-y buc-et. 2 source o6 type 2
is guaranteed to satis6y the condition
/
2
T0R t U [ m
2
t C f
2
R 6or all t
D$.23E 2ssu+e that there is positi8e probability o6 arbitrarily near e;uality in D$.23E
6or all
ti+e ,indo,s t . 2n eCa+ple o6 a source that can do this is one that in6initely o6ten
(0H !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
repeats the 6ollo,ing pattern o6 three phases" it stays o66 6or ti+e f
2
Nm
2
Dto e+pty the
to-en bu66erE, then produces an instantaneous burst o6 si@e f
2
, and then stays on at rate
m
2
6or a ti+e that is eCponentially distributed ,ith +ean (. It is not hard to see that 6or
all S ` 0, there is a positi8e probability that such a source ,ill produce a burst o6 si@e
f
2
,ithin the inter8al T0R S< and then re+ain on at rate m
2
o8er TSR t U, so ensuring that
in the inter8al T0R t U the nu+ber o6 cells recei8ed are at least f
2
C .t a S<m
2
. 0his
i+plies
that V
2
.(R t < 3 /
!
T0R t UNt 3 m
2
C f
2
Nt . So, 6ollo,ing the notation 6ro+ Section
$.H.(, as
_ ( also s _ (, and A
t
3 6, " g
t
., < [ a g
reduces to
k J
,
2
.m
2
t C f
2
< [ tC C
(
2 3(
0his in6inite set o6 hyperplanes is do+inated by t,o eCtre+e ones. 0hat is, k
t
A
t
3 A
0
k A
(
, ,here A
(
and A
0
are regions de6ined, respecti8ely, by
k J
,
2
m
2
[ C
and
2 3(
k J
,
2
f
2
[ ( D$.2$E
2 3(
0here is a nice interpretation o6 these e;uations. >or each constraint there are so+e
do+inant e8ents that cause the ;uality o6 ser8ice constraint to be critically satis6ied. I6
the 6irst constraint is acti8e, o8er6lo, occurs because each source o6 type 2 contributes at
its +aCi+u+ allo,ed a8erage rate m
2
. I6
*
2
m
2
,ere to eCceed C by a 8ery s+all
a+ount,
say h, then a bu66er o6 any si@e ,ould e8entually 6ill, though 8ery slo,ly. 2s h tends to
0 ,e thin- o6 the bu66er 6illing, but o8er in6inite ti+e ,hen h 3 0, hence t 3 (. I6 the
second constraint is acti8e, o8er6lo, occurs because all sources produce bursts at eCactly
the sa+e ti+e. In this case, a bu66er o6 si@e ( 6ills in @ero ti+e and hence t 3 0. !ote that
the e66ecti8e band,idth is de6ined as m
2
or f
2
, depending upon ,hich constraint is acti8e
at the operating point D,hich can be co+pared to the ,
2
and 8
2
o6 the ele8ator analogyE.
0he case o6 +ultiple lea-y buc-et constraints is +ore co+pleC, but the results are si+ilar.
It turns out that one gets an acceptance region bounded by a 6inite nu+ber o6 linear
constraints, each o6 ,hich corresponds to a particular ,ay that the bu66er can 6ill. We
,ill brie6ly in8estigate the particular case o6 adding a pea- rate constraint, i.e. each source
o6 type 2 satis6ies
/
2
T0R t U [ +in6h
2
t R m
2
t C f
2
gR 6or all t
D$.2'E In this case, 6ollo,ing the pre8ious reasoning, the e66ecti8e band,idth o6 a source
o6 type
2 is
V
2
.(R t < 3 /
!
2 k
T0R t UNt
3
m
h
2
6or 0 [ t [ t
2
D$.2HE
m
2
C f
2
Nt 6or t X t
2
,here t
2
3 f
2
N.h
2
a m
2
<. !ote that at ti+e t
2
there is a s,itch in the constraining
(0% !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
lea-y buc-et. 2t that ti+e, the lea-y buc-et constraining the +aCi+u+ contribution /
!
T0R t U o6
the source s,itches 6ro+ .h
2
R 0< to .m
2
R f
2
<.
In the case 2 3 (R 2, and assu+ing that t
(
\ t
2
, the acceptance region is de6ined by
,
(
h
(
C ,
2
h
2
[ C C (Nt 6or 0 [ t [ t
(
,
(
m
(
C ,
2
h
2
[ C C . ( a ,
(
f
(
<Nt 6or t
(
[ t [
t
2
,
(
m
(
C ,
2
m
2
[ C C . ( a ,
(
f
(
a ,
2
f
2
<Nt 6or t
2
[ t
D$.2%E
2
t
.J0.!SI4! 04 !.0W4RBS (0%
0hese +ust hold 6or all t . ut as the reader can 8eri6y, it is enough that they hold 6or
t 3 t
(
, t 3 t
2
and t 3 (. 0he corresponding constraints beco+e
,
(
h
(
C ,
2
h
2
[ C C (Nt
(
,
(
.m
(
C f
(
Nt
2
< C ,
2
h
2
[ C C
(Nt
2
,
(
m
(
C ,
2
m
2
[
C
!ote, again, that depending upon ,hich constraint is acti8e at the operating point, there is
a uni;ue description 6or the ,ay the bu66er 6ills and the ti+e that it ta-es. I6 the operating
point lies on the 6irst constraint then the bu66er 6ills by all sources producing at their pea-
rates o8er T0R t
(
U, and the bu66er beco+ing 6ull at ti+e t
(
D,hich is the ti+e at ,hich sources
o6 the 6irst type o6 +ust reduce their rates to m
(
E. I6 the second constraint is acti8e then the
bu66er 6irst 6ills at ti+e t
2
, by 6illing at rate ,
(
h
(
C ,
2
h
2
a C ` 0 until ti+e t
(
, and then
at rate ,
(
m
(
C ,
2
h
2
a C ` 0 6ro+ t
(
to t
2
. I6 the last constraint is acti8e, then the long#
run a8erage rate o6 the input e;uals C and the bu66er 6ills in6initely slo,ly.
0he abo8e eCa+ples generali@e to +ore lea-y buc-ets. 2gain, one has to chec- a 6inite
set o6 e;uations, si+ilar to D$.2%E, at a 6inite nu+ber o6 ti+es at ,hich di66erent lea-y
buc-ets beco+e acti8e by constraining the +aCi+u+ contribution o6 the sources.
%61$ "0tension to networks
We ha8e seen ho, to co+pute the e66ecti8e band,idths o6 a 6lo, that is +ultipleCed at one
bu66ered s,itch. ut is this any use in the conteCt o6 a net,or-L Clearly, the statistics o6 the
6lo, change as it passes through s,itches o6 the net,or-, since the interdeparture ti+es o6
cells 6ro+ a s,itch are not the sa+e as their interarri8al ti+es. Can the e66ecti8e band,idth
still characteri@e the 6lo,Ms contribution to rare o8er6lo, e8ents in the net,or-L >ortunately,
the ans,er is yes. 4ne can sho, that in the li+iting regi+e o6 +any sources, in ,hich
the nu+ber o6 inputs increases and the ser8ice rate and bu66er si@e increase proportionally
as in D$.&E, the statistical characteristics and e66ecti8e band,idth o6 a tra66ic strea+ are
essentially unchanged by passage through the s,itch. 0o see this intuiti8ely, obser8e that
as the scaling 6actor N increases, the aggregate o6 all the tra66ic strea+s loo-s +ore and
+ore li-e a constant bit rate source, o6 a rate less than the s,itch band,idth, NC. 0his
+eans that ,ith a probability approaching ( the bu66er is e+pty o8er the 6iCed inter8al
o6 ti+e during ,hich any one gi8en tra66ic source is present. 0hus ,ith probability also
approaching (, the input and output processes are identical o8er the ti+e that a tra66ic source
is present. !ote that these are li+iting results" they hold in the li+it as the capacity o6 the
lin-s beco+e larger. 0his assu+ption is realistic in the conteCt o6 the eCpanding capacity
o6 todayMs broadband net,or-s.
7sing this result ,e can describe the technology set o6 the net,or- as 6ollo,s. Let . be
a set o6 lin-s and 6 be a set o6 routes. Write 2 2 r i6 route r uses lin- 2 . 2ssu+e each
route is associated ,ith a uni;ue tra66ic contract type. DWe allo, t,o routes to be identical
in their path through the net,or- and di66er only in contract type.E Let ,
r
be the nu+ber
o6 contracts using route r . Let (
2
and C
2
denote as be6ore the resources o6 lin- 2 .
0he technology set is then de6ined by a set o6 constraints li-e
J
,
r
V
r
.s
2
R t
2
< [ C
a
3 C
2
C
(

(
2
a
2
2

s
2
2 2 . R D$.2&E
r " 2 2r
2
,hich says that the su+ o6 the e66ecti8e band,idths o6 connections that use lin- 2 +ust
not eCceed C
a
.
(0& !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
J
!ote that, although the e66ecti8e band,idth 6unction V
r
.gR g< is the sa+e along the entire
route o6 a tra66ic strea+, this does not i+ply that the e66ecti8e band,idth is the sa+e on
all lin-s. 0his is because para+eters o6 the operating point +ay 8ary along the lin-s o6
the path, so that .s
2
R t
2
< depend on the lin- 2 . ut do ,e eCpect these para+eters to
8ary ,idely inside the net,or-L 0here are econo+ic argu+ents that suggest not.
Suppose that the +arginal cost o6 adding so+e eCtra bu66er in a lin- o6 the net,or- is
*, and the +arginal cost o6 adding eCtra capacity is a. 0hen i6 the +ost econo+ical s,itch
con6iguration is used, ,e +ust ha8e t
2
3 aN*, independently o6 the lin-. 0o pro8e this
consider the constrained opti+i@ation proble+
+ini+i@e aC
2
C *(
2
R sub?ect to
2
.C
2
R (
2
< 3
a
(
2
RC
2
2
2t the opti+u+ ,e +ust ha8e a
a(
F
i
NF C
i
3 *
a(
F
i
NF (
i
, or else it ,ould be possible
to reduce the cost. 0he result then 6ollo,s by D$.%E.
So 6ar as s
2
is concerned, i6 total bu66er space is allocated through the net,or- to
+ini+i@e the total CL*, i.e. +ini+i@e
*
2

2
.C
2
R (
2
< sub?ect to
*
2
(
2
3 ( , then the
solution is
,here s
2
3 F
2
NF (
2
is constant. It is unli-ely that things are so opti+i@ed, but in any case
i6 all lin-s ha8e substantial capacity, s
2
,ill be uni6or+ly s+all, as eCperi+ental results
con6ir+. 0he i+plication o6 the abo8e is that it is reasonable to assu+e that each tra66ic
strea+ in a net,or- can be assigned a uni;ue e66ecti8e band,idth, that is independent o6
it route and o6 the other 6lo,s. 2 +ore re6ined analysis could ta-e account o6 the precise
8alues o6 the para+eters s and t along the path o6 the tra66ic strea+, and use 8alues 6or the
e66ecti8e band,idth that depend on the particular lin-.
%61% Call blocking
2t the end o6 Section $.3 ,e ,ondered ,hat the e66ects o6 bloc-ing ,ould be i6 connections
arri8e ,ith rates that ha8e stochastic 6luctuations and ,e adopt a call ad+ission control
based on D$.3E. 0here is no, a cost due to bloc-ed calls. It is reasonable to assu+e that
,hen a ser8ice re;uest is re6used there is so+e cost to the re;uester, ,hile ,hen it is
accepted so+e positi8e 8alue in generated. We 6or+ulate and analy@e such a +odel in
Section ).3.3, +easuring bloc-ing in ter+s o6 the call bloc-ing probability. 0his
probability depends on the technology set o6 the net,or- and the rates o6 arri8al o6 the
8arious connection types Dthe ser8ice re;uestsE. In this section ,e see ho, such bloc-ing
probabilities +ay be calculated 6ro+ the para+eters o6 the syste+.
Suppose there are 1 types o6 connection. 2 connection o6 type r is associated ,ith a
route r and connections o6 this type arri8e as a *oisson process o6 rate X
r
and endure
6or an a8erage ti+e o6 (Ne
r
. Let $
r
be the bloc-ing probability 6or a connection o6
type r . Let ,
r
.t < denote the nu+ber o6 connections o6 type r that are acti8e at ti+e
t . 0hese connections place a load on lin- 2 o6 V
2r
,
r
.t <. 9ere V
2r
is the
e66ecti8e band,idth o6 a connection o6 type r on lin- 2 . It e;uals 0 i6 the connection
does not use lin- 2 .
y LittleMs La, Dstated in $.$E, the a8erage nu+ber o6 connections o6 type r that ,ill
be acti8e is the product o6 the arri8al rate 6or this type and its a8erage holding ti+e, i.e.
.( a $
r
<X
r
Ne
r
. Let m
r
3 X
r
Ne
r
. 0hen it is necessary to ha8e, 6or all lin-s 2
,
j I
E
J
V
2r
,
r
.t < 3 V
2r
.( a $
r
<m
r
[ C
2
r " 2 2r
r " 2 2r
m
m
r
r
r
>7R09.R R.23I!A (0)
0his places so+e restriction on the bloc-ing probabilities. 9o,e8er, it does not ta-e account
o6 the statistical 6luctuations.
0o be +ore accurate ,e could reason as 6ollo,s. 0he probability distribution o6 the
nu+ber o6 calls in progress is
q., < 3 ) .C <
a(
/
r
,
r
r
,
r
_
R ,here ) .C < 3
J
/
, " A, [C
r
,
r
r
,
r
_
Consider the proble+ o6 6inding the +ost li-ely state, o8er A, [ C . 0his is e;ui8alent
to +aCi+i@ing
*
.,
r
log m
r
a log r _<. y StirlingMs approCi+ation, this ob?ecti8e
6unction
can be approCi+ated by
*
.,
r
log m
r
a .,
r
C 0"'< log ,
r
C ,
r
<. 0a-ing ,
r
C 0N' q ,
r
,
and
using Lagrange +ultipliers to sol8e this constrained +aCi+i@ation proble+, ,e can sho,
that there eCist (
i
s such that
J
m
r
V
r 2
/
.( a (
i
<
V
ri
3
C
2
i6 (
2
`
0
D$.2)E
r " 2 2r
i 2r
[ C
2
i6 (
2
3 0
9ere, (
i
can be interpreted as the bloc-ing probability 6or a unit o6 e66ecti8e band,idth on
lin- i . 0his 6or+ula has a si+ple interpretation. It is as i6 each such unit has a probability o6
bloc-ing that is independent o6 other such units on the sa+e lin- and other lin-s. Clearly,
this is not so. 9o,e8er, it +oti8ates a deter+ination o6 the $
r
s as the solution o6
( a $
r
3
/
.( a (
i
<
V
ri
R 6or all r D$.30E
i 2r
_
(
2
3 E
J
m
r
V
r 2
.( a $
r
<R C
2
r "r 2 2
R 6or all 2 D$.3(E
9ere, E .m R C < is .rlangMs 6or+ula 6or the bloc-ing proportion o6 calls lost at a single
lin- o6 capacity C ,hen they arri8e at rate X and hold 6or an a8erage ti+e (Ne, ,ith m 3
XNe,
m
C
,
C
E .m R C < 3
J
C _
n30
m
n
D$.32E
n_
It can be sho,n that a solution to D$.3(E:D$.3(E eCists and is uni;ue. 0he approCi+ation
beco+es +ore eCact the as the routes passing through each lin- beco+e +ore di8erse and
,e ta-e a large N li+it Di.e. C 3 NC
.0<
, ,
r
3 ,
.0<
N E.
%61& /urther reading
0he 6irst atte+pt to de6ine e66ecti8e band,idths and approCi+ate the cell loss probabilities
,as in the early ())0s. 0he +ost elaborate de6initions ,ere based on large bu66er
asy+ptotics, that ha8e pro8ed to be less accurate than the de6initions using the O+any
sourcesM Dlarge N E asy+ptotic, ,hich has e8entually gained ,ide acceptance. Large bu66er
asy+ptotics did not capture the +ultipleCing e66ects due to a large nu+ber o6 independent
sources being +ultipleCed, but only the e66ects due to the bu66ers. Rele8ant re6erences
6or large bu66er asy+ptotics and the corresponding e66ecti8e band,idths are de Geciana,
4li8ier and Walrand D())3E, .l,alid and 1itra D())3E, de Geciana and Walrand D())'E,
Courcoubetis and Weber D())'E, Courcoubetis, Besidis, Ridder, Walrand and Weber D())'E.
((0 !.0W4RB C4!S0R2I!0S 2!3 .>>.C0IG. 2!3WI309S
2 classic paper on the calculation o6 the o8er6lo, probabilities in ;ueues handling +any
sources is that o6 2nic-, 1itra and Sondhi D()&2E. 0his paper +oti8ated +uch subse;uent
research in the 6ield. Weiss D()&HE 6irst deri8ed the large syste+ asy+ptotic 6or on#o66
sources. 0he large syste+ asy+ptotic in D$.&E that leads to the e66ecti8e band,idth 6or+ulas
,as independently pro8ed by ot8ich and 3u66ield D())'E, Si+onian and Auilbert D())'E
and Courcoubetis and Weber D())HE. 2 re6ine+ent o6 this asy+ptotic using that ahadur#
Rao approCi+ation is due to Li-hano8 and 1a@u+dar D()))E. So+e early re6erences 6or
the e66ecti8e band,idth concept are 9ui D()&&E, Courcoubetis and Walrand D())(E, Belly
D())(aE and Aibbens and 9unt D())(E. 2n eCcellent re6erence 6or the theory o6 the e66ecti8e
band,idths is Belly D())HE.
>or a re8ie, o6 the ro,nian bridge +odel in Section $.$, see 9a?e- D())$E. 0he proo6
that the acceptance region gi8en in D$.(HE is eCact 6or a si+ple ;ueue 6ed by ro,nian
bridge inputs can be 6ound in Belly D())HE. 0he 1ar-o8 +odulated source +odel o6
Section $.H has played an i+portant role in theoretical and practical de8elop+ents. 2nic-,
1itra and Sondhi D()&2E sho, ho, to calculate the probabilities o6 bu66er o8er6lo,. >urther
details o6 the deri8ation o6 the e66ecti8e band,idth 6or this +odel can be 6ound in
Courcoubetis and Weber D())HE. 0he +aterial in Section $.) is ta-en 6ro+ Courcoubetis,
Siris and Sta+oulis D()))E and Courcoubetis, Belly and Weber D2000E. Calculation o6 the
e66ecti8e band,idths 6or real tra66ic traces 6irst appeared in Aibbens D())HE. 0he use o6
e66ecti8e band,idth concepts 6or di+ensioning net,or- lin-s and 6or sol8ing other tra66ic
engineering proble+s is eCplained in Courcoubetis, Siris and Sta+oulis D()))E. 0his
includes eCperi+ental results that 8alidate our e66ecti8e band,idth de6inition. Siris D2002E
+aintains a nice ,eb site on large de8iation techni;ues and on#line tools 6or tra66ic
engineering. 0he eCtension o6 the single lin- +odels and the application o6 the asy+ptotics
to net,or-s in Section $.(3 is due to Wischi- D()))E. Section $.($ su++ari@es ideas 6ro+
Belly D())(bE and D())(cE. 1ore re6ined asy+ptotics 6or the bloc-ing probabilities are
described by 9unt and Belly D()&)E. .Ctensions o6 the +odel to include priorities can be
6ound in erger and Whitt D())&E.
Issues o6 call#ad+ission control are treated in Courcoubetis, Besidis, Ridder, Walrand
and Weber D())'E, Aibbens, Bey and Belly D())'E, Arossglauser and 0se D()))E and
Courcoubetis, 3i+a-is and Sta+oulis D2002E.
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
Part #
"conomics
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
&
asic Concepts
.cono+ics is concerned ,ith the production, sale and purchase o6 co++odities that are in
li+ited supply, and ,ith ho, buyers and sellers interact in +ar-ets 6or the+. 0his and the
6ollo,ing chapter pro8ide a tutorial in the econo+ic concepts and +odels that are rele8ant
to pricing co++unications ser8ices. It in8estigates ho, pricing depends on the assu+ptions
that ,e +a-e about the +ar-et. >or eCa+ple, ,e +ight assu+e that there is only one sole
supplier. In 6or+ulating and analysing a nu+ber o6 +odels, ,e see that prices depend on the
nature o6 co+petition and regulation, and ,hether they are dri8en by co+petition, the pro6it#
+aCi+i@ing ai+ o6 a +onopoly supplier, or the social ,el6are +aCi+i@ing ai+ o6 a
regulator.
Section '.( sets out so+e basic de6initions and describes so+e 6actors that a66ect pricing.
It de6ines types o6 +ar-ets, and describes three di66erent rationales that can pro8ide guid#
ance in setting prices. Section '.2 considers the proble+ o6 a consu+er ,ho 6aces prices
6or a range o6 ser8ices. 0he -ey obser8ation is that the consu+er ,ill purchase a ser8ice up
to an a+ount ,here his +arginal utility e;uals the price. Section '.3 de6ines the proble+
o6 supplier ,hose ai+ is to +aCi+i@e his pro6it. Section '.$ concerns the proble+ that
is natural 6or a social planner" that o6 +aCi+i@ing the total ,el6are o6 all participants in
the +ar-et. We relate this to so+e i+portant notions o6 +ar-et e;uilibriu+ and e66iciency,
noting that proble+s can arise i6 there is +ar-et 6ailure due to eCternalities.
7n6ortunately, social ,el6are is achie8ed by setting prices e;ual to +arginal cost. Since
the +arginal costs o6 net,or- ser8ices can be nearly @ero, producers +ay not be able to
co8er their costs unless they recei8e so+e additional lu+p#su+ pay+ent. 2 co+pro+ise is
to use Ra+sey pricesR these are prices ,hich +aCi+i@e total ,el6are sub?ect to the
constraint that producers co8er their costs. We consider these in Section '.'. Section '.H
considers +aCi+i@ing social ,el6are under 6inite capacity constraints. Section '.% discusses
ho, custo+er de+and can be in6luenced by the type o6 net,or- eCternality that ,e
+entioned in Chapter (.
0he reader o6 this and the 6ollo,ing chapter cannot eCpect to beco+e an eCpert in all
econo+ic theory that is rele8ant to setting prices. 9o,e8er, he ,ill gain an appreciation o6
6actors that a66ect pricing decisions and o6 ,hat pricing can achie8e. In later chapters ,e use
this -no,ledge to sho, ho, one +ight deri8e so+e tari66s 6or co++unications ser8ices.
&61 Charging for services
&6161 1emand9 Su''ly and *arket *echanisms
Co++unication ser8ices are 8aluable econo+ic co++odities. 0he prices 6or ,hich they
can be sold depend on 6actors o6 de+and, supply and ho, the +ar-et operates. 0he -ey
(($ 2SIC C4!C.*0S
players in the +ar-et 6or co++unications ser8ices are suppliers, consu+ers, and regulators.
0he de+and 6or a ser8ice is deter+ined by the 8alue users place upon it and the price they
are ,illing to pay to obtain it. 0he ;uantity o6 the ser8ice that is supplied in the +ar-et
depends on ho, +uch suppliers can eCpect to charge 6or it and on their costs. 0heir costs
depend upon the e66iciency o6 their net,or- operations. 0he nature o6 co+petition a+ongst
suppliers, ho, they interact ,ith custo+ers, and ho, the +ar-et is regulated all ha8e a
bearing on the pricing o6 net,or- ser8ices.
4ne o6 the +ost i+portant 6actors is co+petition. Co+petition is i+portant because
it tends to increases econo+ic e66iciency" that is, it increases the aggregate 8alue o6 the
ser8ices that are produced and consu+ed in the econo+y. So+eti+es co+petition does not
occur naturally. In that case, regulation by a go8ern+ent agency can increase econo+ic
e66iciency. y i+posing regulations on the types o6 tari66s, or on the 6re;uency ,ith ,hich
they +ay change, a regulator can arrange 6or there to be a greater aggregate ,el6are than
i6 a do+inant supplier ,ere allo,ed to produce ser8ices and charge 6or the+ ho,e8er he
li-es. 1oreo8er, the regulator can ta-e account o6 ,el6are di+ensions that suppliers and
custo+ers +ight be inclined to ignore. >or eCa+ple, a regulator +ight re;uire that so+e
essential net,or- ser8ices be a8ailable to e8eryone, no +atter ,hat their ability to pay.
4r he +ight re;uire that encrypted co++unications can be deciphered by la, en6orce+ent
authorities. 9e could ta-e a Olong ter+ 8ie,M, or adopt policies designed to +o8e the +ar-et
in a certain desirable direction.
&616 Conte0ts for 1eriving Prices
In Section (.$.( ,e de6ined the ,ords OchargeM, Otari66M and OpriceM. We said that a custo+er
pays charges 6or net,or- ser8ices, and a charge is co+puted 6ro+ a tari'' . 0his tari66 can
be a co+pleC 6unction and it can ta-e account o6 8arious aspects o6 the ser8ice and perhaps
so+e +easure+ents o6 the custo+erMs usage. >or eCa+ple, a telephone ser8ice tari66 +ight
be de6ined in ter+s o6 +onthly rental, the nu+bers o6 calls that are +ade, their durations,
the ti+es o6 day at ,hich they are +ade, and ,hether they are local or long#distance
calls.
2 $rice is a charge that is associated ,ith one unit o6 usage. >or eCa+ple, a +obile
phone ser8ice pro8ider +ight operate a two$art tari'' o6 the 6or+ a C *, , ,here a is a
+onthly 6iCed#charge Dor access chargeE, , is the nu+ber o6 +inutes o6 calling per +onth,
and * is the price per +inute. >or a general tari66 o6 the 6or+ r ., <, ,here , is the a+ount
consu+ed, probably a 8ector, price +ay depend on , . Ai8en that , is consu+ed, the price
o6 one +ore unit is $ 3 F r . , <NF , . I6 r ., < 3 $
`
, 6or so+e price 8ector $, then r ., <
is a linear tari'' . 2ll other tari66 6or+s are nonlinear tari''s .
(
>or instance, a C *, is a
nonlinear tari66 DpriceE, ,hile *, is a linear tari66 DpriceE.
In thin-ing about ho, price are deter+ined, there are t,o i+portant ;uestions to ans,er"
DaE ,ho sets the price, and DbE ,ith ,hat ob?ecti8eL It is interesting to loo- at three di66erent
ans,ers and the rationales that they gi8e 6or thin-ing about prices. 0he 6irst ans,er is that
so+eti+es the +ar-et that sets the price, and the ob?ecti8e is to +atch supply and de+and.
Supply and de+and at gi8en prices depend upon the supplierMs technological capacities, the
costs o6 supply, and the ho, consu+ers 8alue the ser8ice. I6 prices are set too lo, then there
(
In the econo+ics literature, the ter+inology linear $rice or uni'orm $rice is co++only used instead o6 a linear
tari66, and nonlinear $rice instead o6 a nonlinear tari66. In this case, price re6ers i+plicitly to the total a+ount
paid 6or the gi8en ;uantity, i.e. the total charge.
C92RAI!A >4R S.RGIC.S (('
,ill be insu66icient incenti8e to supply and there is li-ely to be unsatis6ied de+and. I6 prices
are set too high then suppliers +ay o8er#supply the +ar-et and 6ind there is insu66icient
de+and at that price. 0he OcorrectM price should be O+ar-et#clearingM. 0hat is, it should be
the price at ,hich de+and eCactly e;uals supply.
2 second rationale 6or setting prices co+es about ,hen it is the producer ,ho sets prices
and his ob?ecti8e is to deter potential co+petitors. I+agine a ga+e in ,hich an incu+bent
6ir+ ,ishes to protect itsel6 against co+petitors ,ho +ight enter the +ar-et. 0his ga+e
ta-es place under certain assu+ptions about both the incu+bentMs and entrantsM production
capabilities and costs. We 6ind that i6 the 6ir+ is to be secure against ne, entrants seducing
a,ay so+e o6 its custo+ers, then the charges that it +a-es 6or di66erent ser8ices +ust
satis6y certain constraints. >or eCa+ple, i6 a 6ir+ uses the re8enue 6ro+ selling one product
to subsidi@e the cost o6 producing another, then the 6ir+ is in danger i6 a co+petitor can
produce only the 6irst product and sell it 6or less. 0his ,ould lead to a constraint o6 no
cross#subsidi@ation.
2 third rationale 6or setting prices co+es about ,hen a principal uses prices as a
+echanis+ to induce an agent to ta-e certain actions. 0he principal cannot dictate directly
the actions he ,ishes the agent to ta-e, but he can use prices to re,ard or penali@e
the agent 6or actions that are or are not desired. Let us consider t,o eCa+ples. In our
6irst eCa+ple the o,ner o6 a co++unications net,or- is the principal and the net,or-
users are the agents. 0he principal prices the net,or- ser8ices to +oti8ate users to choose
ser8ices that both +atch their needs and a8oid ,asting net,or- resources. Suppose that
he +anages a dial#in +ode+ ban-. I6 he prices each unit o6 connection ti+e, then he
gi8es users the incenti8e to disconnect ,hen they are idle. 9is pricing is said to be
incentive com$ati*le. 0hat is, it pro8ides an incenti8e that induces desirable user response.
2 charge based only on pricing each byte that is sent ,ould not be incenti8e co+patible
in this ,ay.
In our second eCa+ple the o,ner o6 the co++unications net,or- is no, the agent. 2
regulator ta-es the role o6 principal and uses price regulation to induce the net,or- o,ner
to i+pro8e his in6rastructure, increase his e66iciency, and pro8ide the ser8ices that are o6
8alue to consu+ers.
0hese are three possible rationales 6or setting prices. 0hey do not necessarily lead to the
sa+e prices. We +ust li8e ,ith the 6act that there is no single recipe 6or setting prices that
ta-es precedence o8er all others. *ricing can depend on the underlying conteCt, or conteCts,
and on contradictory 6actors. 0his +eans that the practical tas- o6 pricing is as +uch an art
as a science. It re;uires a good understanding o6 the particular circu+stances and intricacies
o6 the +ar-et.
It is not straight6or,ard e8en to de6ine the cost o6 a good. >or eCa+ple, there are +any
di66erent approaches to de6ining the cost o6 a telephone handset. It could be the cost o6 the
handset ,hen it ,as purchased Dthe historical costE, or its opportunity cost Dthe 8alue o6
,hat ,e +ust gi8e up to produce itE, or the cost o6 the replacing it ,ith a handset that has
the sa+e 6eatures Dits +odern e;ui8alent asset costE. 2lthough, in this chapter, ,e assu+e
that the notion o6 the cost is una+biguously de6ined, ,e return to the issue o6 cost
de6inition in Chapter %.
In this chapter ,e re8ie, the basic econo+ic concepts that are needed to understand
8arious conteCts 6or de6ining prices. We 6ocus on de6ining the 8arious econo+ic agents that
interact in a +ar-etplace. In the 6ollo,ing chapter ,e analy@e 8arious co+petition
scenarios. We begin by considering the proble+ that a consu+er 6aces ,hen he +ust decide
ho, +uch o6 each o6 a nu+ber o6 ser8ices to purchase.
((H 2SIC C4!C.*0S
u
i
u
i
i 2
N
&6 !he consumerAs 'roblem
&661 *a0imi5ation of Consumer Sur'lus
Consider a +ar-et in ,hich n custo+ers can buy k ser8ices. 3enote the set o6 custo+ers
by N 3 6(R " " " R ng. Custo+er i can buy a 8ector ;uantity o6 ser8ices , 3 .,
(
R " " " R ,
k
< 6or
a pay+ent o6 $., <. Let us suppose that $., < 3 $
`
, 3
*
2
$
2
,
2
, 6or a gi8en 8ector
o6
prices $ 3 . $
(
R " " " R $
k
<. 2ssu+e that the a8ailable a+ounts o6 the k ser8ices are unli+ited
and that custo+er i see-s to sol8e the proble+
,
i
. $< 3 arg +aC
h
., < $
`
,
i
D'.(E
,
9ere u
i
., < is the utility to custo+er i o6 ha8ing the 8ector ;uantities o6 ser8ices , . 4ne
can thin- o6 u
i
., < as the a+ount o6 +oney he is ,illing to pay to recei8e the bundle that
consists o6 these ser8ices in ;uantities ,
(
" " " R ,
k
.
It is usual to assu+e that u
i
.g< is strictly increasing and strictly conca8e 6or all i . 0his
ensures that there is a uni;ue +aCi+i@er in D'.(E and that de+and decreases ,ith price.
I6, +oreo8er, u.g< is di66erentiable, then the +arginal utility o6 ser8ice 2 , as gi8en by
F u
i
., <NF ,
2
, is a decreasing 6unction o6 ,
2
. We +a-e these assu+ptions unless ,e
state other,ise. 9o,e8er, ,e note that there are cases in ,hich conca8ity does not hold.
>or eCa+ple, certain 8ideo coding technologies can operate only ,hen the rate o6 the 8ideo
strea+ is abo8e a certain +ini+u+, say ,
a
, o6 a 6e, +egabits per second. 2 user ,ho
,ishes to use such a 8ideo ser8ice ,ill ha8e a utility that is @ero 6or a rate , that is less
than ,
a
and positi8e 6or , at ,
a
. 0his is a step 6unction and not conca8e. 0he utility
+ay increase as , increases abo8e ,
a
, since the ;uality o6 the displayed 8ideo increases
,ith the rate o6 the encoding. 0his part o6 the utility 6unction +ay be conca8e, but the
utility 6unction as a ,hole is not. In practice, 6or coding sche+es li-e 1*.A, the utility
6unction is not precisely a step 6unction, but it rese+bles one. It starts at @ero and increases
slo,ly until a certain bit rate is attained. 26ter this point it increases rapidly, until it
e8entually reaches a +aCi+u+ 8alue. 0he 6irst part o6 the cur8e captures the 6act that the
coding sche+e cannot ,or- properly unless a certain bit rate is a8ailable.
0he eCpression that is +aCi+i@ed on the right#hand side o6 D'.(E is called the consu+erMs
net *ene'it or consumer sur$lus ,
CS
i
3 +aC
h
., < $
`
,
i
,
It represents the net 8alue the consu+er obtains as the utility o6 , +inus the a+ount paid
6or , . 0he abo8e relations are su++ari@ed in >igure '.(.
0he 8ector ,
i
. $< is called the demand 'unction 6or custo+er i . It gi8es the ;uantities
,
i
3 .,
i
R " " " R ,
i
< o6 ser8ices that custo+er i ,ill buy i6 the price 8ector is $. 0he
aggregate
( k
demand 'unction is , . $< 3
*
,
i
. $<R this adds up the total de+and o6 all the users at
prices $. Si+ilarly, the inverse aggregate demand 'unction, $., <, is the 8ector o6 prices at
,hich the total de+and is , .
Consider the case o6 a single custo+er ,ho is choosing the ;uantity to purchase o6 ?ust
a single ser8ice, say ser8ice 2 . I+agine that the ;uantities o6 all other ser8ices are held
constant and pro8ided to the custo+er 6or no charge. I6 his utility 6unction u.g< is conca8e
and t,ice di66erentiable in ,
2
then his net bene6it, o6 u., < $
2
,
2
, is +aCi+i@ed ,here it
is stationary point ,ith respect to ,
2
, i.e. ,here F u . , <NF ,
2
3 $
2
. 2t this point, the
+arginal increase in utility due to increasing ,
2
is e;ual to the price o6 2 . We also
((% 2SIC C4!C.*0S
see that the custo+erMs inverse demand 'unction is si+ply $
2
.,
2
< 3 F u . , <NF ,
2
. It is the
price at ,hich
,
09. C4!S71.RMS *R4L.1 ((%
utility uD,E
$,
+aCi+i@ed net bene6it
N +aCTuD,E W $,U
0 ,D$E ,
/igure &61 0he consu+er has a utility u., < 6or a ;uantity , o6 a ser8ice. In this 6igure, u., < is
increasing and conca8e. Ai8en the price 8ector $, the consu+er chooses to purchase the a+ount
, 3 , . $< that +aCi+i@es his net bene6it Dor consu+er surplusE. !ote that at , 3 , . $< ,e ha8e
F u . , <NF , 3 $.
Q
CSD$E
$
upD,E
$,
0 ,D$E ,
/igure &6 0he demand curve 6or the case o6 a single custo+er and a single good. 0he deri8ati8e
o6 u., <, denoted u
0
., <, is do,n,ard sloping, here 6or si+plicity sho,n as a straight line. 0he area
under u
0
., < bet,een 0 and , . $< is u., . $<<, and so subtracting $, Dthe area o6 the shaded
rectangleE gi8es the consu+er surplus as the area o6 the shaded triangle.
he ,ill purchase a ;uantity ,
2
. 0hus, 6or a single custo+er ,ho purchases a single ser8ice
2 , ,e can eCpress his consu+er surplus at price $
2
as
5
,
2
. $
2
<
CS. $
2
< 3
0
$
2
., < d, $
2
,
2
. $
2
<
D'.2E
We illustrate this in >igure '.2 Ddropping the subscript 2 E.
We +a-e a 6inal obser8ation about D'.(E. We ha8e i+plicitly assu+ed that the Dper unitE
prices charged in the +ar-et are the sa+e 6or all units purchased by the custo+er. 0here are
+ore general pricing +echanis+s in ,hich the charge paid by the custo+er 6or purchasing
a ;uantity , is a +ore general 6unction r ., <, not o6 the 6or+ $
`
, . >or instance, prices
+ay depend on the total a+ount bought by a custo+er, as part o6 nonlinear tari66s, o6 the
sort ,e eCa+ine in Section H.2.2. 7nless eCplicitly stated, ,e use the ter+ OpriceM to
re6er to the price that de6ines a linear tari66 $
`
, .
0he reader +ay also ,onder ho, general is D'.(E in eCpressing the net bene6it o6 the
custo+er as a di66erence bet,een utility and pay+ent. Indeed, a +ore general 8ersion is
as 6ollo,s. 2 custo+er has a utility 6unction 8.,
0
R , <, ,here ,
0
is his net inco+e Dsay in
dollarsE, and , is the 8ector o6 goods he consu+es. 0hen at price $ he sol8es the proble+
,
i
. $< 3 arg
n
+aC 8.,
0
$
`
, R , < " $
`
, a ,
0
o
((& 2SIC C4!C.*0S
In the si+ple case that the custo+er has a 7uasilinear utility 'unction , o6 the 6or+
8.,
0
R , < 3 ,
0
C u., <, and assu+ing his inco+e is large enough that ,
0
$
`
, ` 0
at the opti+u+, he +ust sol8e a proble+ that is e;ui8alent to D'.(E. It is 8alid to assu+e a
;uasilinear utility 6unction ,hen the custo+erMs de+and 6or ser8ices is not 8ery sensiti8e
to his inco+e, i.e. eCpenditure is a s+all proportion o6 his total inco+e, and this is the
case 6or +ost -no,n co++unications ser8ices. In our econo+ic +odelling, ,e use these
assu+ptions regarding utility 6unctions since they are reasonable and si+pli6y signi6icantly
the +athe+atical 6or+ulas ,ithout reducing the ;ualitati8e applicability o6 the results.
&66 "lasticity
Conca8ity o6 u.g< ensures that both , . $< and $., < are decreasing in their argu+ents,
or as econo+ists say, downward slo$ing . 2s price increases, de+and decreases. 2
+easure o6 this is gi8en by the $rice elasticity o' demand . Custo+er i has elasticity o6
de+and 6or ser8ice 2 gi8en by
S
2
3
F ,
2
. $<NF $
2
, N $ 2 2
,here, 6or si+plicity, ,e o+it the superscript i in the de+and 8ector ,
i
, since ,e re6er to
a single custo+er. 0hus
(,
2
,
2
3
($
2
S
2
$
2
and elasticity +easures the percentage change in the de+and 6or a good per percentage
change in its price. Recall that the in8erse de+and 6unction satis6ies $
2
., < 3 F u . , <NF ,
2
. So the conca8ity o6 the utility 6unction i+plies F $
2
., <NF ,
2
a 0 and S
2
is negati8e.
2
2s ?S
2
? is greater or less than ( ,e say that de+and o6 custo+er i 6or ser8ice 2 is
respecti8ely elastic or inelastic. !ote that since ,e are ,or-ing in percentages, S
2
does
not depend upon the units in ,hich ,
2
or $
2
is +easured. 9o,e8er, it does depend on
the price, so ,e +ust spea- o6 the Oelasticity at price $
2
. 0he only de+and 6unction 6or
,hich elasticity is the sa+e at all prices is one o6 the 6or+ , . $< 3 a$
S
. 4ne can
de6ine other +easures o6 elasticity, such Oinco+e elasticity o6 de+andM, ,hich +easures
the responsi8eness o6
de+and to a change in a consu+erMs inco+e.
&66$ Cross "lasticities9 Substitutes and Com'lements
So+eti+es, the de+and 6or one good can depend on the prices o6 other goods. We de6ine
the cross elasticity o' demand , S
2 k
, as the percentage change in the de+and 6or good 2 per
percentage change in the price o6 another good, k. 0hus
F ,
2
. $<NF
$
k
and
S
2 k
3
,
2
N $
k
(,
2
,
2
3
S
2 k
($
k
$
k
(() 2SIC C4!C.*0S
2
2uthors disagree in the de6inition o6 elasticity. So+e de6ine it as the negati8e o6 ,hat ,e ha8e, so that it co+es
out positi8e. 0his is no proble+ pro8ided one is consistent.
09. S7**LI.RMS *R4L.1 (()
ut ,hy should the price o6 good k in6luence the de+and 6or good 2 L 0he ans,er is
that goods can be either su*stitutes or com$lements . 0a-e, 6or eCa+ple, t,o ser8ices o6
di66erent ;uality such as GR and 2R in 201. I6 the price 6or GR increases, then
so+e custo+ers ,ho ,ere using GR ser8ices, and ,ho do not greatly 8alue the higher
;uality o6 GR o8er 2R, ,ill s,itch to 2R ser8ices. 0hus, the de+and 6or 2R ,ill
increase. 0he ser8ices are said to be substitutes. 0he case o6 co+ple+ents is eCe+pli6ied
by net,or- 8ideo transport ser8ices and 8ideo con6erencing so6t,are. I6 the price o6 one
o6 these decreases, then de+and 6or both increases, since both are needed to pro8ide the
co+plete 8ideo con6erencing ser8ice.
>or+ally, ser8ices 2 and k are substitutes i6 F ,
2
. $<NF $
k
` 0 and co+ple+ents i6
F ,
2
. $<NF $
k
\ 0. I6 F ,
2
. $<NF $
k
3 0, the ser8ices are said to be independent.
Surprisingly,
the order o6 the indices 2 and k is not signi6icant. 0o see this, recall that the in8erse
de+and 6unction satis6ies $
2
., < 3 F u . , <NF ,
2
. 9ence F $
2
., <NF ,
k
3 F $
k
., <NF ,
2
,
and so the de+and 6unctions satis6y
F ,
2
. $<
F $
k
3
F ,
k
. $<
F $
2
&6$ !he su''lierAs 'roblem
Suppose that a supplier produces ;uantities o6 k di66erent ser8ices. 3enote by y 3
. y
(
R " " " R y
k
< the 8ector o6 ;uantities o6 these ser8ices. >or a gi8en net,or- and
operating +ethod the supplier is restricted to choosing y ,ithin so+e set, say ; , usually
called the technology set or $roduction $ossi*ilities set in the econo+ics literature. In
the case o6 net,or-s, this set corresponds to the acceptance region that is de6ined in
Chapter $.
Pro'it, or $roducer sur$lus , is the di66erence bet,een the re8enue that is obtained 6ro+
selling these ser8ices, say r . y<, and the cost o6 production, say c. y<. 2n independent
6ir+ ha8ing the ob?ecti8e o6 $ro'it ma,imi%ation , see-s to sol8e the proble+ o6
+aCi+i@ing the pro6it,
q 3 +aC
[
r . y< c.
y<
a
y2;
2n i+portant si+pli6ication o6 the proble+ ta-es place in the case o6 linear $rices , ,hen
r . y< 3 $
`
y 6or so+e price 8ector $. 0hen the pro6it is si+ply a 6unction o6 $, say q.
$<, as is also the opti+i@ing y, say y. $<. 9ere y. $< is called the su$$ly 'unction , since it
gi8es the ;uantities o6 the 8arious ser8ices that the supplier ,ill produce i6 the prices at
,hich they can be sold is $.
0he ,ay in ,hich prices are deter+ined depends upon the pre8ailing +ar-et +echanis+.
We can distinguish three i+portant cases. 0he nature o6 co+petition in these three cases
is the sub?ect o6 Chapter H. I6 the supplier is a mono$olist, i.e. the sole supplier in an
unregulated mono$oly , then he is 6ree to set ,hate8er prices he ,ants. 9is choice is
constrained only by the 6act that as he increases the prices o6 ser8ices the custo+ers are
li-ely to buy less o6 the+.
I6 the supplier is a s+all player a+ongst +any then he +ay ha8e no control o8er $. We
say he is a $rice taker . 9is only 6reedo+ is in choice o6 y. 0his is a co++on scenario in
practice. In such a scenario, the supplier sells at gi8en linear prices, ,hich are independent
o6 the ;uantities sold. 0his is also the case 6or a regulated mono$oly , in ,hich the price
8ector $ is 6iCed by the regulator, and the supplier si+ply supplies the ser8ices that the
+ar-et de+ands at the gi8en price $.
(20 2SIC C4!C.*0S
2 +iddle case, in ,hich a supplier has partial in6luence o8er $, is ,hen he is in
co+petition ,ith ?ust a 6e, others. In such an econo+y, or so#called oligo$oly , suppliers
co+pete 6or custo+ers through their choices o6 $ and y. 0his assu+es that suppliers do
not collude or 6or+ a cartel. 0hey co+pete against one another and the +ar-et prices o6
ser8ices e+erge as the solution to so+e noncooperati8e ga+e.
&6% Welfare ma0imi5ation
Social ,el6are D,hich is also called social surplusE is de6ined as the su+ o6 all usersM
net bene6its, i.e. the su+ o6 all consu+er and producer surpluses. !ote that ,eighted
su+s o6 consu+er and producer surpluses can be considered, re6lecting the reality that a
social planner<regulator<politician +ay attach +ore ,eight to one sector o6 the econo+y
than to another. We spea- interchangeably o6 the goals o6 social ,el6are +aCi+i@ation,
social surplus +aCi+i@ation, and Oecono+ic e66iciencyM. 0he -ey idea is that, under certain
assu+ptions about the conca8ity and con8eCity o6 utility and cost 6unctions, the social
,el6are can be +aCi+i@ed by setting an appropriate price and then allo,ing producers and
consu+ers to choose their opti+al le8els o6 production and consu+ption. 0his has the great
ad8antage o6 +aCi+i@ing social ,el6are in a decentrali@ed ,ay.
We begin by supposing that the social ,el6are +aCi+i@ing prices are set by a super8ising
authority, such as a regulator o6 the +ar-et. Suppliers and consu+ers see these prices and
then opti+ally choose their le8els o6 production and de+and. 0hey do this on the basis o6
in6or+ation they -no,. 2 supplier sets his le8el o6 production -no,ing only his o,n cost
6unction, not the consu+ersM utility 6unctions. 2 consu+er sets his le8el o6 de+and -no,ing
only his o,n utility 6unction, not the producersM cost 6unctions or other custo+ersM utility
6unctions. Indi8idual consu+erMs utility 6unctions are pri8ate in6or+ation, but aggregate
de+and is co++only -no,n.
Later ,e discuss per6ectly co+petiti8e +ar-ets, i.e., a +ar-ets in ,hich no indi8idual
consu+er or producer is po,er6ul enough to control prices, and so all participants +ust be
price ta-ers. It is o6ten the case that once prices settle to 8alues at ,hich de+and +atches
supply, the social ,el6are is +aCi+i@ed. 0hus a per6ectly co+petiti8e +ar-et can so+eti+es
need no regulatory inter8ention. 0his is not true, ho,e8er, i6 there is so+e 6or+ o6 +ar-et
6ailure, such as that caused by eCternalities. In Section '.% ,e see, 6or eCa+ple, ho, a
+ar-et ,ith strong net,or- eCternality e66ects +ay re+ain s+all and ne8er actually reach
the socially desirable point o6 large penetration.
In the re+ainder o6 this section, ,e address the proble+ 6aced by a social planner ,ho
,ishes to +aCi+i@e social ,el6are. In Sections '.$.( and '.$.2 ,e sho, that he can o6ten
do this by setting prices. Section '.$.3 loo-s at the assu+ptions under ,hich this is true
and ,hat can happen i6 they do not hold. Section '.$.$ ,or-s through a speci6ic eCa+ple,
that o6 pea- load pricing. Sections '.$.' and '.$.H are concerned ,ith ho, the plannerMs
ai+ can be achie8ed by +ar-et +echanis+s and the sense in ,hich a +ar-et can naturally
6ind an e66icient e;uilibriu+. Social ,el6are is +aCi+i@ed by +arginal cost pricing, ,hich
,e discuss in Section '.$.%.
&6%61 !he Case of Producer and Consumers
We begin by +odelling the proble+ o6 the social planner ,ho by regulation can dictate the
le8els o6 production and de+and so as to +aCi+i@e social ,el6are. Suppose there is one
producer, and a set o6 consu+ers, N 3 6(R " " " R ng. Let ,
i
denote the 8ector o6 ;uantities
u
i
u
i

W.L>2R. 12JI1I520I4! (2(
o6 k ser8ices consu+ed by consu+er i . Let , 3 ,
(
C g g g C ,
n
denote the total de+and,
and let c., < denote the producerMs cost to produce , . 0he social ,el6are Dor surplusE, ", is
the total utility o6 the ser8ices consu+ed +inus their cost o6 production, and so is ,ritten
" 3
J
u
i
.,
i
< c., <
i 2 N
Since the social planner ta-es an o8erall 8ie, o6 net,or- ,el6are, let us label his proble+
as
SYSTEM " +aCi+i@e
J
u
i
.,
i
< c., < R sub?ect to , 3 ,
(
C g g g C ,
n
, R,
(
R"""R,
n
i 2 N
2ssu+e that each u
i
.g< is conca8e and c.g< is con8eC.
3
0hen SYSTEM can be sol8ed
by use o6 a Lagrange +ultiplier $ on the constraint , 3 ,
(
C g g g C ,
n
. 0hat is, 6or the
right 8alue o6 $, the solution can be 6ound by +aCi+i@ing the Lagrangian
. 3
J
u
i
.,
i
< c., < C $
`
., ,
(
g g g ,
n
<
i 2 N
6reely o8er ,
(
R " " " R ,
n
and , . !o, ,e can
,rite
. 3 CS C q D'.3E
,here
CS 3
J h
.,
i
< $
`
,
i
i
and q 3 $
`
, c., <
i 2 N
In D'.3E ,e ha8e ,ritten . as the su+ o6 t,o ter+s, each o6 ,hich is +aCi+i@ed o8er
di66erent 8ariables. 9ence, 6or the appropriate 8alue o6 the Lagrange +ultiplier $ Dalso
called a dual 8ariableE, . is +aCi+i@ed by +aCi+i@ing each o6 the ter+s indi8idually. 0he
6irst ter+ is the aggregate consumers- sur$lus , CS. >ollo,ing the pre8ious obser8ation, the
consu+ers are indi8idually posed the set o6 proble+s
CONSUMER
i
" +aCi+i@e
h
.,
i
< $
`
,
i
i
R i 3 (R " " " R n
D'.$E
,
i
0he second ter+ is the producerMs pro6it, q . 0he producer is posed the proble+
PRODUCER " +aCi+i@e
h
$
`
, c., <
i
D'.'E
,
0hus, ,e ha8e the re+ar-able result that the social planner can +aCi+i@e social surplus
by setting an appropriate price 8ector $. In practice, it can be easier 6or hi+ to control the
dual 8ariable $, rather than to control the pri+al 8ariables , R ,
(
R " " " R ,
n
directly.
0his price controls both production and consu+ption. 2gainst this price 8ector, the
consu+ers +aCi+i@e their surpluses and the producer +aCi+i@es his pro6it. 1oreo8er,
(22 2SIC C4!C.*0S
3
0his is typically the case ,hen the production 6acility cannot be eCpanded in the ti+e 6ra+e o6 re6erence, and
+arginal cost o6 production increases due to congestion e66ects in the 6acility. In practice, the cost 6unction +ay
initially be conca8e, due to econo+ies o6 scale, and e8entually beco+e con8eC due to congestion. In this case,
,e i+agine that the cost 6unction is con8eC 6or the output le8els o6 interest.
2
2
i N
Q
uD,E W cD,E
up
$
cp
cD,E
,D$E
/igure &6$ 2 si+ple illustration o6 the social ,el6are +aCi+i@ation proble+ 6or a single good.
0he +aCi+u+ is achie8ed at the point ,here the custo+erMs aggregate de+and cur8e u
0
intersects
the +arginal cost cur8e c
0
.
6ro+ D'.$E:D'.'E ,e see that pro8ided the opti+u+ occurs 6or 0 \ ,
i
\ (, this price
8ector satis6ies
F u
i
.,
i
<
F ,
i
3
F c . , <
F ,
2
3
$
2
"
0hat is, prices e;ual the supplierMs marginal cost and each consu+erMs marginal utility at
the solution point. We call these prices marginal cost $rices. 2 graphical interpretation o6
the opti+ality condition is sho,n in >igure '.3.
We ha8e called the proble+ o6 +aCi+i@ing social surplus the SYSTEM proble+ and
ha8e seen that price is the catalyst 6or sol8ing it, through decentrali@ed solution o6
PRODUCER and CONSUMER
i
proble+s. 0he social planner, or regulator, sets the price
8ector $. 4nce he has posted $ the producer and each consu+er +aCi+i@es his o,n net
bene6it Do6 supplier pro6it or consu+er surplusE. 0he producer auto+atically supplies , i6
he belie8es he can sell this ;uantity at price $. 9e +aCi+i@es his pro6it by ta-ing , such
that 6or all 2 , either
$
2
3 F c . , <NF ,
2
, or ,
2
3 0 i6 $
2
3 0. 0he social planner need only regulate the
priceR the price pro8ides a control +echanis+ that si+ultaneously opti+i@es both the
de+and and le8el o6 production. We ha8e assu+ed in the abo8e that the planner attaches
e;ual ,eight to consu+er and producer surpluses. In this case, the a+ount paid by the
consu+ers to the producer is a purely internal +atter in the econo+y, ,hich has no e66ect
upon the resulting social surplus.
0he sa+e result holds i6 there is a set M o6 producers, the output o6 ,hich is controlled
by the social planner to +eet an aggregate de+and at +ini+u+ total cost. 7sing the sa+e
argu+ents as in the case o6 a single producer, the +aCi+u+ o6
" 3
J
u
i
.,
i
<
J
c
2
. y
2
<
sub?ect to
*
2
,
i
3
*
2 2
M
i 2 N
y
2
, is achie8ed by
2 2 M
$
h
3 F u
i
.,
i
<NF ,
i
3 F c
2
. y
2
<NF y
2
R 6or all hR iR 2
D'.HE
h h
In other ,ords, consu+ers beha8e as pre8iously, and e8ery supplier produces an output
;uantity at ,hich his +arginal cost 8ector is $.
2terative 'rice adBustmentC network and user interaction
9o, +ight the social planner 6ind the prices at ,hich social ,el6are is +aCi+i@edL 4ne
+ethod is to sol8e D'.HE, i6 the utilities and the cost 6unctions o6 the consu+ers and the
J
,
2
2
2
producers are -no,n. 2nother +ethod is to use a sche+e o6 iterati8e price ad?ust+ent.
In steps, the social planner ad?usts prices in directions that reduce the +is+atch bet,een
de+and and supply. 0his does not re;uire any -no,ledge about the utilities and cost
6unctions o6 the +ar-et participants.
Suppose that 6or price 8ector $ the induced aggregate de+and is , . $< and the aggregate
supplier output is y. $<. 3e6ine the e,cess demand as %. $< 3 , . $< y. $<. Let prices
ad?ust in ti+e according to a rule o6 the 6or+
$*
i
3 )
i
.%
i
.
$<<
,here )
i
is so+e s+ooth sign#preser8ing 6unction o6 eCcess de+and. 0his process is -no,n
as tatonnement , and under certain conditions $ ,ill con8erge to an e;uilibriu+ at ,hich
%. $< 3 0. See 2ppendiC .( 6or a proo6 that this tatonne+ent con8erges.
0atonne+ent occurs naturally in +ar-ets ,here producers and consu+ers are price ta-ers,
i.e. in ,hich they sol8e proble+s o6 the 6or+ PRODUCER
2
and CONSUMER
i
. *roducers
lo,er prices i6 only part o6 their production is sold, and raise prices i6 de+and eCceeds
supply. 0his occurs in a co+petiti8e +ar-et as discussed in Section H.3.
In practice, social planners do not use tatonne+ent to obtain econo+ic e66iciency, due
to the high ris- o6 running the econo+y short o6 supply, or generating ,aste due to
o8ersupply. 2nother issue 6or the tatonne+ent +echanis+ is the assu+ption that producers
and consu+ers are truth6ul, i.e., that they accurately report the solutions o6 their local
opti+i@ation proble+s PRODUCER
2
and CONSUMER
i
. 1ore sophisticated approaches that
address these issues and +ay actually be used by a regulator are discussed in Chapter (3.
&6%6 !he Case of Consumers and /inite Ca'acity Constraints
2 si+ilar result can be obtained 6or a +odel in ,hich custo+ers share so+e 6inite net,or-
resources. 0his is typical 6or a co++unication net,or-s in ,hich resources are 6iCed in the
short run. *rices can again be used both to regulate resource sharing and to +aCi+i@e social
e66iciency. >or the +o+ent, ,e gi8e a 6or+ulation in ,hich the concept o6 a resource is
abstract. So+e +oti8ation has already been pro8ided in the ele8ator analogy o6 Section $.$.
0he ideas are gi8en 6uller treat+ent and +ade concrete Chapter &.
Suppose n consu+ers share k resources under the 8ector o6 constraints
2
a C
2
R 2 3 (R " " " R k
i 2 N
Let us de6ine SYSTEM as the proble+ o6 +aCi+i@ing social surplus sub?ect to this
constraint"
SYSTEM " +aCi+i@e
J
u
i
.,
i
< sub?ect to
J
,
i
a C
2
R 2 3 (R " " " R k
,
(
R"""R,
n
i 2
N
i 2 N
Ai8en that u
i
.g< is conca8e, this can be sol8ed by +aCi+i@ing a Lagrangian
k
_
. 3
J
u
i
.,
i
<
J
$
2
J
,
i
C
2
i 2 N
2 3( i 2 N
6or so+e 8ector Lagrange +ultiplier $ 3 . $
(
R " " " R $
n
<. 0he +aCi+u+ occurs at the
sa+e point as ,ould be obtained i6 custo+ers ,ere charged the 8ector o6 prices $, i.e. i6
custo+er i to be posed the proble+
CONSUMER
i
" +aCi+i@e
j I
u
i
.,
i
<
J
$
2
,
i
,
i
2
!ote that $
2
3 F.+aC
,
. <NF C
2
. 0hat is, $
2
e;uals the +arginal increase in aggregate
utility ,ith respect to increase o6 C
2
. 2s abo8e, there is a tatonne+ent Dan iterati8e
+ethodE 6or co+puting $ Dsee Section .2E.
&6%6$ 1iscussion of Assum'tions
Rela0ing concavity
0hus 6ar in this section ,e ha8e assu+ed that utility and cost 6unctions are conca8e
and con8eC respecti8ely. 0his ensures that the ob?ecti8e o6 the SYSTEM proble+ is a
conca8e 6unction. 9ence it can be sol8ed by +aCi+i@ing a Lagrangian. >ortunately, these
assu+ptions hold in +any circu+stances. Consu+ers usually ha8e decreasing +arginal
utility 6or a good, and +arginal costs o6 production are usually increasing.
I6, ho,e8er, the utility 6unction is con8eC, or perhaps sig+oid Da tilted S#shapeE, then it
+ight be that u.C N2< C u.C N2< \ u.0< C u.C <. 0he social ,el6are +aCi+i@ing
allocation o6 band,idth C bet,een t,o identical users is to gi8e one o6 the+ all o6 the
band,idth and the other nothing. 0his allocation could be achie8ed ,ith an auction or by
a,arding the band,idth by lottery. 9o,e8er, it cannot be achie8ed by a classical pricing
+echanis+. 0here are eCa+ples in ,hich it is possible to +aCi+i@e social ,el6are using
nonlinear prices, but not by using linear ones. In >igure '.$ the user de+ands the
socially opti+al ;uantity C ,hen he 6aces a nonlinear charge o6 the 6or+ g., < 3 A
i6 , \ ,
0
and g., < 3 A C ., ,
0
< $ i6 , X ,
0
, 6or so+e ,
0
and $ e;ual to the
slope o6 the utility
cur8e at C .
Problems with tatonnement
Certain 6or+s o6 utility 6unction can gi8e di66iculty ,ith the con8ergence o6 the tatonne+ent
process. Suppose a userMs utility 6unction is conca8e and increasing. Suppose it is linear
bet,een t,o 8alues, say ,
(
and ,
2
, and $, is the gradient o6 the line bet,een these t,o
points. 0hen i6 the price is $ the purchase o6 any a+ount bet,een ,
(
and ,
2
+aCi+i@es the
userMs net bene6it. 9o,e8er, a 8ery s+all change in price 6ro+ ?ust belo, $ to ?ust abo8e
$ can 6lip the de+and 6ro+ abo8e ,
2
to belo, ,
(
.
Si+ilarly, i6 a utility 6unction increases linearly 6ro+ 0 to ( and then 8ery ;uic-ly beco+es
nearly 6lat a6ter ( , a s+all decrease in price can cause the de+and to ?u+p 6ro+ ( to 0.
8ntruthful declarations
We ha8e assu+ed thus 6ar that all consu+ers are too s+all to a66ect prices. I6 this is not the
case, then a user ,ho lies about his utility 6unction +ight ha8e an ad8antage. Consider a
gD,E
sig+oid
uD,E
A
0 ,
0
C
/igure &6% I6 a user has a sig+oid utility 6unction then ,el6are can be +aCi+i@ed using nonlinear
pricing. 0he user can be +ade to de+and the socially opti+al ;uantity, say C , by being 6aced ,ith
a nonlinear charge o6 the 6or+ g., < 3 A i6 , \ ,
0
and g., < 3 A C ., ,
0
< $ i6 , X ,
0
, 6or
so+e ,
0
, ,here $ is e;ual to the slope o6 the u., < at , 3 C . 4bser8e that there is no linear price
6or ,hich the user ,ill de+and C .
+ar-et o6 ?ust t,o users, ,hose utilities 6or , units o6 band,idth are both u., < 3 log.(C ,
<. 0,o units o6 band,idth are to be sold. 0he supplier starts ,ith a high price and
decreases it until he 6inds the price at ,hich all the band,idth is sold. I6 both users are
truth6ully +aCi+i@ing their net bene6its at each price, then the band,idth is sold at price
$ 3 (N2. .ach user buys ( unit o6 band,idth and has a net bene6it o6 log.2< (N2.
9o,e8er, suppose 7ser 2 cheats. 7ser ( D,ho is truth6ulE buys at price $ his net#bene6it#
+aCi+i@ing a+ount,
(N $ (. ut at each price $ that is greater than (N2 S, 7ser 2 purchases less than the
a+ount re;uired 6or all t,o units to be sold, i.e. he deliberately buys less than 3 (N $. 0he
seller -eeps decreasing his price. >inally, ,hen the price is $ 3 (N2 S, 7ser ( buys (N $ (
and 7ser 2 no, buys 3 (N $. 7ser 2 obtains net bene6it o6 log.$ (N $< .3 (N $<
$ and this eCceeds log.2< (N2 6or $ 3 (N2 S and S su66iciently s+all. So 7ser 2
obtains a greater net bene6it by lying.
!he case of digital goods and network e0ternalities
In our social ,el6are +aCi+i@ation proble+ ,e assu+ed that +arginal utility is decreasing
and +arginal cost is increasing. 0his +ay not be true ,hen selling goods ,ith the sort o6
net,or- eCternality e66ects +entioned in Section (.(.(. In this case the shape o6 the de+and
and cost 6unctions are re8ersed. >irst note that the a8erage cost per unit o6 production
decreases ,ith the a+ount sold, since the +arginal cost o6 producing one +ore digital copy
is @ero. 2lso note that as +ore ite+s are sold they are o6 greater 8alue to the custo+ers,
and so they +ay be ,illing to pay a higher price. >or +ore details on the construction o6
such de+and cur8es see Section '.% and >igure '.&.
&6%6% Peak)load 'ricing
0he -ey result o6 Section '.$.( is that social surplus is +aCi+i@ed by +arginal cost pricing.
2 6or+ o6 +arginal cost pricing is also opti+al in circu+stances o6 so#called $eakload
$ricing . Suppose that de+and 6or a ser8ice is greater during pea- hours, lesser during o66#
pea- hours, and the cost depends on both the a+ounts consu+ed and the +aCi+u+ a+ount
consu+ed. >or eCa+ple, consider a production 6acility ,hose capacity +ust be great enough
to +eet de+and during the period o6 +aCi+u+ de+and. 0he cost o6 operating the 6acility
during any gi8en period depends both on the le8el o6 production during that period and on
the +aCi+u+ o6 production le8els o8er all periods.
Consider the pro8ision o6 a single type o6 ser8ice that is consu+ed during each o6 T
periods. 3e+and in period t depends upon t and on the prices o8er all periods
,
t
3 ,
t
. $
(
R " " " R $
T
<
0hus, ,e +odel the idea that a greater price during one period can shi6t de+and to other
periods. Suppose that the total cost o6 operating the 6acility ta-es the 6or+
c.,
(
R " " " R ,
T
< 3 a
J
,
t
C * +aC
,
t
t
t
0he proble+ o6 6inding consu+ption le8els and the corresponding prices that +aCi+i@e
social ,el6are can be ,ritten as
+aC
,
(
R"""R,
T
R+
sub?ect to ,
t
a + 6or all t .
j
I
u.,
(
R
" " " R
,
T
<
a
J
,
t
*+
t
t
i M
a
Suppose that ,hen social ,el6are is +aCi+i@ed there is a single pea- period. 2 nars8e
application o6 the idea o6 +arginal cost pricing suggests that prices should be de6ined by
the relations such as
$
t
3
aR ,
t
\ +
a C *R ,
t
3 +
In other ,ords, the price in each period should re6lect the +arginal increase in the
production cost ,hen the production le8el in that period is increased. 9o,e8er, the truth is
+ore subtle. 0here +ust be a sharing o6 the rental cost, *, o8er a nu+ber o6 periods, all o6
,hich achie8e the pea- rate o6 operation, i.e. the opti+al prices ta-e the 6or+
aR ,
t
\ +
$
t
3
a C y
t
R ,
t
3 +
,here
*
y
t
3 *. 0he 6act that social ,el6are is +aCi+i@ed by prices o6 this 6or+ 6ollo,s
by consideration o6 the Lagrangian
. .,
t
R %
t
R + I y< 3 u.,
(
R " " " R ,
T
< a
J
,
t
*+
J
y
t
.,
t
C %
t
+ <
t t
,here %
t
X 0, y
t
3 0 i6 ,
t
H3 + .
0he opti+al prices can be constructed in the 6ollo,ing ,ay. Start by charging a per unit
o6 capacity in each period. Consider the de+and ,
t
.aR " " " R a<, t 3 (R " " " R T , and choose
the period ,ith the largest de+and, say period i . Start charging this period ,ith so+e
a+ount y
i
in addition to a, i.e. $ 3 .aR " " " R a C y
i
R " " " R a<R let y
i
start at @ero and
gradually increase. 0he de+and ,
i
,ill decrease. 0he de+ands in other periods ,ill
increase or decrease, as they are substitutes or co+ple+ents. Beep increasing y
i
until
either y
i
3 *, or the de+and in so+e other period e;uals ,
i
. I6 y
i
3 * is reached 6irst,
then period i should be charged the entire rental cost o6 *. 4ther,ise, let M be the set o6
periods o6 pea- load, i.e. M 3 arg +aC6,
(
R " " " R ,
T
g. Beep increasing the co+ponents y
2
,
2 2 M , such that de+and decreases e;ually in all periods 2 2 M R add +ore periods to M
as other periods also beco+e pea- load periods. Stop ,hen the re8enue produced by the
pea- load periods
e;uals the rental cost, i.e. ,hen
*
2
y
i
3 *.
&6%6& Walrasian ":uilibrium
We no, turn to t,o i+portant notions o6 +ar-et e;uilibriu+ and e66iciency. 0he -ey
points in this and the neCt section are the de6initions o6 Walrasian e;uilibriu+ and *areto
e66iciency, and the 6act that they can be achie8ed si+ultaneously, as su++ari@ed at the end
o6 Section '.$.H. 0he reader +ay ,ish to s-ip the proo6s and si+ply read the de6initions,
su++ary and re+ar-s about eCternalities and +ar-et 6ailure that introduce the theore+s.
We begin ,ith an concept o6 a +ar-et in co+petiti8e e;uilibriu+. Suppose that initially
each participant in the +ar-et is endo,ed ,ith so+e a+ount o6 each o6 k goods. *articipant
i has initial endo,+ents _
i
3 ._
i
R " " " R _
i
<. Suppose the price o6 good 2 is $
2
, so the
( k
+onetary 8alue o6 the participantMs endo,+ent is $
`
_
i
. I6 this participant can sell so+e
o6 his goods and buy others, he ,ill do this to sol8e the proble+
+aCi+i@e u
i
.,
i
< sub?ect to $
`
,
i
$
`
_
i
D'.%E
,
i
,here u
i
.,
i
< is his utility 6or the bundle ,
i
. 3enote the solution point by ,
i
. $R $
`
_
i
<,
i.e. his pre6erred bundle o6 goods, gi8en price 8ector is $ and initial endo,+ent has
+onetary
2
i i
i i
8alue $
`
_
i
. !ote that ,e are considering a si+pli6ied econo+y in ,hich there is no
production, ?ust eCchange. .ach participant is e66ecti8ely both consu+er and supplier. !ote
that actual +oney +ay not be used. *rices eCpress si+ple eCchange rules bet,een goods"
i6 $
i
3 k$
2
then one unit o6 good i can be eCchanged 6or k units o6 good 2 . 4bser8e that
D'.%E does not depend upon actual price scaling, but only on their relati8e 8alues.
With ,
i
3 ,
i
. $R $
`
_
i
<, ,e say that ., R $< is a Walrasian e7uili*rium 6ro+ the
initial endo,+ent _ 3 6_
i
g i6
J
,
i
. $R $
`
_
i
< a
J
_
i
D'.&E
i i
that is, i6 there is no eCcess de+and 6or any good ,hen each participant buys the bundle
that is opti+al 6or hi+ gi8en his budget constraint. It can be pro8ed that 6or any initial
endo,+ents _ there al,ays eCists a Walrasian e;uilibriu+ 6or so+e price 8ector $. 0hat
is, there is so+e $ at ,hich +ar-ets clear. In 6act, this $ can be 6ound by a tatonne+ent
+echanis+ Da 6act ,e can pro8e along si+ilar lines as in 2ppendiC .(E. 0he Walrasian
e;uilibriu+ is also called a com$etitive e7uili*rium , since it is reached as participants
co+pete 6or goods, ,hich beco+e allocated to those participants ,ho 8alue the+ +ost.
0hroughout the 6ollo,ing ,e assu+e that all utilities are increasing and conca8e, so that $
is certainly nonnegati8e and the ine;ualities in D'.%E and D'.&E are sure to be e;ualities at
the e;uilibriu+. .;ui8alently, under this assu+ption, ., R $< is a Walrasian e;uilibriu+ i6
(.
*
,
i
3
*
_
i
.
2. I6 ,!
i
is pre6erred by participant i to ,
i
, then $
`
,!
i
` $
`
,
i
.
&6%6( Pareto "fficiency
We no, relate the idea o6 Walrasian e;uilibriu+ to another solution concept, that o6 Pareto
e''iciency . We say that a solution point Dan allocation o6 goods to participantsE is *areto
e66icient i6 there is no other point 6or ,hich all participants are at least as ,ell o66 and at
least one participant is strictly better o66, 6or the sa+e total a+ounts o6 the goods. In other
,ords, it is not possible to +a-e one participant better o66 ,ithout +a-ing at least one
other participant ,orse o66. 1athe+atically, ,e say as 6ollo,s.
0he allocation ,
(
R " " " R ,
n
is not *areto e66icient i6
there eCists ,!
(
R " " " R ,!
n
R ,ith
*
,!
i
3
*
,
i
R
D'.)E
such that u
i
.,!
i
< X u
i
.,
i
< 6or e8ery i ,
and at least one o6 these ine;ualities is strict"
7nli-e social ,el6are, *areto e66iciency is not concerned ,ith the su+ o6 the
participantsM utilities. Instead, it characteri@es allocations ,hich cannot be strictly i+pro8ed
Oco+ponent,iseM. In the 6ollo,ing t,o theore+s ,e see that Walrasian e;uilibria can
be e;uated ,ith *areto e66icient points. We assu+e that the utility 6unctions are strictly
increasing and conca8e and there are no +ar-et 6ailures. 0he 6ollo,ing theore+ says that
a +ar-et econo+y ,ill achie8e a *areto e66icient result. It holds under the assu+ption
that D'.%E is truly the proble+ 6aced by participant i . In particular, this +eans that his
utility +ust depend only the a+ounts o6 the goods he holds, not the a+ounts held
by others or their utilities. So there +ust be no unpriced eCternalities or in6or+ation
asy++etries. 0hese +ean there are +issing +ar-ets Dthings unpricedE, and so#called +ar-et
6ailure.
i i
i 2
` ,
2
h
i i
2
2
f
i 2
l
f
!heorem 1 ;first theorem of welfare economics< I6 ., R $< is a Walrasian e;uilibriu+
then it is *areto e66icient.
Proof Suppose , is not *areto e66icient. So there is a ,!
6or ,hich lines 2:$ o6
state+ent D'.)E hold. y assu+ption that ,
i
is the pre6erred bundle o6 participant i , ,e
ha8e u
i
.,!
i
< X
i
$
`
,!
i
a u
i
.,
i
< X
i
$
`
,
i
6or all i , ,here X
i
` 0 is the Lagrange
+ultiplier
o6 the budget constraint in the opti+i@ation proble+ D'.%E that is sol8ed by participant i .
Co+bining these, ,e ha8e $
`
,!
i
$
`
,
i
X 0, 6or all i , ,ith at least one o6 these a
strict
ine;uality. Su++ing on i , ,e ha8e $
`
*
,!
i
` $
`
*
,
i
. Since $ X 0, this can happen
only i6
*
,!
i
*
i
6or so+e 2 . 0his contradicts the assu+ption in the second line
o6 D'.)E.
!heorem ;second theorem of welfare economics< Suppose _ is a *areto e66icient
allocation in ,hich _
i
` 0 6or all iR 2 . 0hen there eCists a $ such that ._R $< is a Walrasian
e;uilibriu+ 6ro+ any initial endo,+ent _
!
such that
*
_!
i
3
*
_
i
, and $
`
_!
i
3 $
`
_
i
i i
6or all i .
Proof I6 _ is *areto e66icient then any allocation that +a-es u
i
.,
i
< ` u
i
._
i
< 6or so+e i
+ust +a-e u
2
.,
2
< \ u
2
._
2
< 6or so+e 2 . So , 3 _ sol8es the proble+
+aCi+i@e
m
+in u
i
.,
i
< u
i
._
i
<
i
R sub?ect to
J
,
i
3
J
_
i
,
i
i i
,ith a +aCi+i@ed 8alue o6 0. !ote that , 3 _ satis6ies
*
,
i
a
*
_!
i
. 0he
abo8e
+aCi+i@ation proble+ is e;ui8alent to
+aCi+i@e t
t R,
sub?ect to
J
,
i
a
J
_
i
R and u
i
.,
i
< u
i
._
i
< X t R 6or all
i .
i i
y the conca8ity o6 u
i
, this proble+ can be sol8ed by +aCi+i@ing the Lagrangian
_
. 3 t C
J
X
i
T t C u
i
.,
i
< u
i
._
i
<U C $
`
J
_
i

J
,
i
i i i
o8er , and t , 6or so+e +ultipliers X
i
X 0 and $
i
X 0. y the assu+ption that _
i
` 0 the
+aCi+u+ ,ith respect to ,
i
+ust occur at a stationary point, and so at , 3 _, ,e +ust
ha8e
F u
i
f
X
i
F ,
i
f
2
f
,
i
3_
i
X
X
$
2
3 0 D'.(0E
y conca8ity o6 u
i
, ,e ha8e that 6or all i and any , such that $
`
,
i
a $
`
_!
i
,
( (
i i
u
i
.,
i
< a u
i
._
i
<
C
$
`
.,
i
_
i
< 3 u
i
._
i
<
C
i
$
`
.,
i
_! < a u
i
._ <
i
0hus ._R $< de6ines a Walrasian e;uilibriu+.
2
2
!
2
0
!ote also that D'.(0E i+plies
F u
i
NF ,
i
F u
i
0 NF ,
i
R 6or all iR i
0
R 2R 2
0
F u
i
NF ,
i
3
F u 0 NF ,
i
0
2
0 i
2
0
0his +a-es senseR since i6 it ,ere not so, then participants i and i
0
could both be better o66
by eCchanging so+e a+ounts o6 goods 2 and 2
0
.
Alternative 'roof We ha8e said at the end o6 Section '.$.' that gi8en any initial endo,+ent
_! there eCists a $R , such . $R , < is a Walrasian e;uilibriu+. Suppose _ is a *areto
point
and let , 3 , . $R $
`
_! < 3 , . $R $
`
_<. !o, 6or each i the bundle ,
i
is pre6erred to
bundle
_
i
at prices $. ut this pre6erences cannot be strict 6or any i , else _ ,ould not be a *areto
point. 0hus 6or all i , _
i
is as ?ust as good 6or participant i as ,
i
, and so . $R _< is a
Walrasian e;uilibriu+ 6or initial endo,+ents _.
!otice that, gi8en any initial endo,+ent _
!
such that
*
_!
i
3
*
_
i
, i.e.
_!
and _
i i
contain the sa+e total ;uantity o6 each good, ,e can support a *areto e66icient _ as the
Walrasian e;uilibriu+ i6 ,e are allo,ed to 6irst +a-e a lu+p su+ redistribution o6 the
endo,+ents. We can do this by redistributing the initial endo,+ents _ to any _, such that
b
_
i ` i
_ 3 _, but other _
$
`
b 3 $ _ 6or all i . 46 course, this can be done tri8ially by ta-ing b b
+ay be easier to achie8e in practice. >or eCa+ple, ,e +ight 6ind it di66icult to redistribute
a good called OlabourM. I6 there is a good called O+oneyM, then ,e can do e8erything by
redistributing that good alone, i.e. by subsidy and taCation. We ,ill see this in Section '.'.(
,hen ,e suggest that to +aCi+i@e social ,el6are there be a lu+p#su+ trans6er o6 +oney
6ro+ the consu+ers to the supplier to co8er his 6iCed cost.
Let us no, return to the proble+ o6 social ,el6are +aCi+i@ation"
+aCi+i@e
J
u
i
.,
i
< R sub?ect to
J
,
i
a _
2
6or all 2
D'.((E
,
2
i i
>or _
2
3 C
2
this is the proble+ o6 Section '.$.2. We can +a-e the 6ollo,ing state+ent
about its solution.
!heorem $ .8ery social ,el6are opti+u+ is *areto e66icient.
Proof 2s ,e ha8e seen pre8iously, assu+ing that the u
i
are conca8e 6unctions, this type
o6 proble+ is sol8ed by posting a price 8ector $, such that at the opti+u+ F u
i
NF ,
i
3 $
2
6or all 2 . Suppose the solution point is ,! . It satis6ies the constraint on the right hand
side o6 D'.((E and also sol8es 6or e8ery i 2 N the proble+ o6 +aCi+i@ing u
i
.,
i
< sub?ect
to $
`
,
i
a $
`
,!
i
. D!ote that in sol8ing such a proble+ ,e ,ould ta-e a Lagrangian
o6 . 3 u
i
.,
i
< X
i
. $
`
,
i
C % $
`
,!
i
< and then 6ind that ta-ing , 3 ,! , % 3 0 and
X
i
3 ( +aCi+i@es . and satis6ies the constraint.E 0hus, .,! R $< is a Walrasian
e;uilibriu+ 6or the initial 8ector o6 endo,+ents ,! 3 .,!
(
R " " " R ,!
n
<. y 0heore+ (, ,!
, C
is also a *areto point.
>inally, note that ,e can cast the ,el6are +aCi+i@ation proble+ o6 Section '.$.( into
the abo8e 6or+ i6 ,e i+agine that the producer is participant (, and the set o6 consu+ers is
N 3 62R " " " R ng. In the initial endo,+ent, no consu+er has any a+ount o6 any good, and
producer has a 8ery large endo,+ent o6 e8ery good, say _
(
. So the constraint in D'.((E is
(
*
i 2 N
,
i
a _
(
. We ta-e u
(
.,
(
< 3 c._
(
,
(
<, noting that this is a conca8e
increasing
i 2
N
6unction o6 ,
(
i6 c is con8eC increasing. 2t the opti+u+ ,e ,ill ha8e ,
(
C
*
,
i
3 _
(
.
0hus, D'.((E is si+ply
_
+aCi+i@e
J
u
i
.,
i
< c
J
,
i
,
2
R"""R,
n
i 2
N
i 2 N
0here6ore, ,e can also conclude that 6or this +odel ,ith a producer, the sa+e conclusions
hold. In su++ary, these conclusion are that there is a set o6 relationships bet,een ,el6are
+aCi+a, co+petiti8e e;uilibria and *areto e66icient allocations"
(. Co+petiti8e e;uilibria are *areto e66icient.
2. *areto e66icient allocations are co+petiti8e e;uilibria 6or so+e initial endo,+ents.
3. Wel6are +aCi+a are *areto e66icient.
0he i+portance o6 these results is to sho, that 8arious reasonable notions o6 ,hat
constitutes
Oopti+al production and consu+ption in the +ar-etM are consistent ,ith one another. It can
be 6ound by a social planner ,ho control prices to +aCi+i@e social ,el6are, or by the
Oin8isible handM o6 the +ar-et, ,hich acts as participants indi8idually see-ing to +aCi+i@e
their o,n utilities.
&6%6+ 1iscussion of *arginal Cost Pricing
We ha8e seen that +arginal cost pricing +aCi+i@es econo+ic e66iciency. It is easy to
understand and is 6ir+ly based on costs. 9o,e8er, there can be so+e proble+s. >irst,
+arginal cost prices can be di66icult to co+pute. Secondly, they can be close to either @ero
or in6inity. 0his is a proble+ since co++unication net,or-s typically ha8e 6iCed costs
,hich +ust so+eho, be reco8ered.
0hin- o6 a telephone net,or- that is built to carry C calls. 0he +ain costs o6 running
the net,or- are 'i,ed costs Dsuch as +aintenance, loans repay+ents and sta66 salariesE,
i.e. in8ariant to the le8el o6 usage. 0hus ,hen less than C calls are present the short#run
+arginal cost that is incurred by carrying another call is near @ero. 9o,e8er, it the net,or-
is critically loaded Dso that all C circuits are busyE, then the cost o6 eCpanding the net,or-
to acco++odate another call could be huge. !et,or- eCpansion +ust ta-e place in large
discrete steps, in8ol8ing large costs D6or increasing the trans+ission speed o6 the 6ibre, or
adding eCtra lin-s and s,itchesE. 0his +eans that the short#run +arginal cost o6 an eCtra
call can approach in6inity.
2 proper de6inition o6 +arginal cost should ta-e account o6 the ti+e 6ra+e o8er ,hich
the net,or- eCpands. 0he net,or- can be considered to be continuously eCpanding Dby
a8eraging the eCpansion that occurs in discrete stepsE, and the +arginal cost o6 a circuit is
then the a8erage cost o6 adding a circuit ,ithin this continuously eCpanding net,or-. 0hus
+arginal cost could be interpreted as longrun +arginal cost.
2nother di66iculty in basing charges on +arginal cost is that e8en i6 ,e -no, the
+arginal cost and use it as a price, it can be di66icult to predict the de+and and to
di+ension the net,or- accordingly. 0here is a ris- that ,e ,ill build a net,or- that is
either too big or too s+all. 2 prag+atic approach is to start conser8ati8ely and then
eCpand the net,or- only as de+and ?usti6ies it. *rices are used to signal the need to
eCpand the net,or-. 4ne starts ,ith a s+all net,or- and ad?usts prices so that de+and
e;uals the a8ailable capacity. I6 the prices re;uired to do this eCceed the +arginal cost o6
eCpanding the net,or-, then
C4S0 R.C4G.R/ (3(
additional capacity should be built. Ideally, this process con8erges to a point, at ,hich
charges e;ual +arginal cost and the net,or- is di+ensioned opti+ally.
>inally, let us co++ent on the 6act that ,e ha8e been analysing a static +odel. In
practice, the de+and 6or net,or- ser8ices tends to increase o8er ti+e, and so ,e +ight
li-e to ta-e a dyna+ic approach to the proble+ o6 building a net,or- and pricing ser8ices.
I6 ,e ,ere to di+ension a net,or- to operate reasonably o8er a period, then ,e +ight
eCpect that at the start o6 the period the net,or- ,ill be under utili@ed, ,hile to,ards the
end o6 the period the de+and ,ill be greater than the net,or- can acco++odate. 2t this
point, the 6act that high prices are re;uired to li+it the de+and is a signal that it is ti+e
to eCpand the net,or-. 9o,e8er, e8en in a dyna+ic setting, one can e;uate co+petiti8e
e;uilibriu+ and ,ith *areto e66iciency.
&6& Cost recovery
4ne o6 the +ost i+portant issues 6or a net,or- operator is cost reco8ery. In +any cases, the
prices that +aCi+i@e social ,el6are +ay generate inco+e 6or the supplier that is less than
his cost o6 pro8iding the ser8ices. 9o,e8er, i6 he raises prices in an arbitrary 6ashion this
+ay signi6icantly reduce the social ,el6are. In this section ,e discuss the tradeo66 bet,een
reco8ering costs and +aCi+i@ing social ,el6are and loo- at charging +ethods that ta-e the
cost reco8ery issue into account.
&6&61 Ramsey Prices
2 ,ea-ness o6 +arginal cost pricing is that it +ay not allo, the supplier to reco8er his
costs. I6 he is 8ery large and operates ,ith econo+ies o6 scale, i.e. costs that increase
less than proportionately ,ith output le8el, then his +arginal cost can be 8ery s+all. 0he
re8enue he ,ould obtain under +arginal cost pricing could 6ail to reco8er his 6iCed costs
o6 operation Dsuch as property taCes, interest on loans and +aintenanceE. In other ,ords,
social ,el6are is +aCi+i@ed at a point ,here q \ 0. 0here are 8arious ,ays in ,hich to
o8erco+e this proble+. 0he si+plest is to +a-e a lu+p#su+ trans6er o6 +oney 6ro+ the
consu+ers to the supplier that is e;ual to the supplierMs 6iCed cost and then price ser8ices
at +arginal cost.
2 second ,ay is to consider +aCi+i@ation o6 a ,eighted ob?ecti8e 6unction, ,hich by
ta-ing 0 \ \ ( places less ,eight on consu+er surplus than supplier pro6it. 7sing the
notation o6 Section '.$.(, ,e see- to +aCi+i@e
W 3 q C .( <CS
3
J
$
2
,
2
c., < C .( <
J
u
i
.,
i
<
D'.(2E
2
3 .( <
i
Dj I
J
u
i
.,
i
< c., <
C
i

(
j
IE
J
$
2
,
2
c., <
2
0he ter+ in curly brac-ets is nearly the sa+e as the Lagrangian ,e ,ould use to sol8e a
proble+ o6 +aCi+i@ing " sub?ect to a constraint q 3 ( , 6or so+e ( ` 0, i.e.
. 3
J
u
i
.,
i
< c., < C
X
i
(32 2SIC C4!C.*0S
j
I
J
$
2
,
2
c., < (
2
6or so+e +ultiplier X. 0he proble+s are e;ui8alent 6or X 3 N.( <.
2
2
$
2

2
2
i
$
2

i
i
,
$
!o, ,e ,ish to 6ace the consu+ers ,ith a price 8ector $ such that W is +aCi+i@ed ,hen
each consu+er indi8idually +aCi+i@es his net bene6it. 0hus, consu+er i ,ill +aCi+i@e
u
i
.,
i
< $
`
,
i
, choosing ,
i
such that F u
i
NF ,
i
3 $
2
. 3i66erentiating D'.(2E ,ith
respect to
$
h
, ,e ha8e
F W
,h C
J
$
2
F ,
2
J
F c . , < F
,
2

C .( <
J
F u
i
F ,
i
F $
h
3
0
2
F $
h
F c
F ,
2
2
F ,
2
(
F $
h
iR 2
F ,
i
F $
h
3 ,
h
F
C
J
2
S
h2
2
D'.(3E
2
,here ,e use F u
i
NF ,
i
3 $
2
and F ,
2
NF $
h
3 F ,
h
NF $
2
. 9ere S
h2
is a cross elasticity o6
the
aggregate de+and 6unction, , . $< 3
*
,
i
. $<.
>or the +aCi+u+ o6 W ,e re;uire F W NF $
h
3 0. So in the general case, the $
2
are
6ound by sol8ing a co+plicated set o6 e;uations. In the special case that ser8ices are
independent Di.e. S
i 2
3 0, 6or i H3 2 E, ,e ha8e
F c
F ,
2
D'.($E
$
2
3
S
i
*rices o6 the 6or+ o6 D'.($E are -no,n as 6amsey $rices. We -no, that the price elasticity
o6 de+and, S
i
, is al,ays negati8e. So i6 ser8ices are independent, as ,e ha8e i+agined
abo8e, the Ra+sey prices are abo8e +arginal cost prices. 0his +eans that the de+and
is reduced belo, the 8alue at ,hich social ,el6are is +aCi+i@ed. Recall that an inelastic
good is one 6or ,hich the de+and is relati8ely insensiti8e to price changes, i.e. ?S
i
? is s+all.
0hus, Ra+sey pricing has the e66ect o6 pricing inelastic goods ,ell abo8e their +arginal
costsR these goods tend to subsidi@e goods ,hose de+and is +ore price sensiti8e.
I6 6or so+e 8alue o6 ,e ha8e q 3 0, then ,e ha8e 6ound the prices that +aCi+i@e
social ,el6are, sub?ect to the supplier reco8ering his costs. 4bser8e that 6or 3 ( ,e are
si+ply +aCi+i@ing q , and obtain the prices at ,hich a +onopolist +aCi+i@es his pro6it Das
,e see again in Section H.2.(E.
It is interesting to ,or- through an eCa+ple 6or the special case that de+and cur8es are
linear and the +arginal cost is constant, say c., < 3 ,
`
MC . Suppose that the
;uantities
de+anded under +arginal cost pricing are ,
MC
R " " " R ,
MC
. >igure '.' sho,s this 6or t,o
(
n
custo+ers, each de+anding a di66erent good, ,hose de+and cur8es happen to intersect the
+arginal cost cur8e at the sa+e point. >ro+ D'.($E ,e ha8e that the Ra+sey price $
i
, is
gi8en by . $
i
MC
i
<N $
i
3 NS
i
. Since ,
i
. $< is linear, so that d,
i
Nd$ 3 V
i
, say,
,e ha8e S
i
3 V
i
$
i
N,
i
. 2lso, V
i
3 .,
MC
,
i
<N. $
i
MC
i
<. 26ter eli+inating S
i
and
V
i
,
,e 6ind
,
i
,
MC
MC
i

3
C (
6or all i
0hus, the ;uantities de+anded under Ra+sey pricing de8iate in e;ual proportion 6ro+
those de+anded under +arginal cost pricing. In the special case sho,n in >igure '.', in
,hich t,o custo+ers ha8e the sa+e de+and at +arginal cost pricing, i.e., ,
MC
3 ,
MC
,
( 2
the ;uantities de+anded under Ra+sey pricing are also e;ual.
$
Q
$
2
$
i
,
i
D$E
,
2
D$E
,i N ,2
,
i 2
MC
N ,
MC
/igure &6& Ra+sey pricing 6or t,o independent goods, ,ith constant +arginal cost that is the
sa+e 6or both goods, and linear de+and 6unctions. I6 the ;uantities de+anded under +arginal cost
pricing are e;ual, then the ;uantities de+anded under Ra+sey pricing are also e;ual. 0he Ra+sey
price 6or the +ore inelastic good ,ill be greater.
I6 ser8ices are not independent ,e ha8e 6ro+ D'.(3E that the Ra+sey prices are the
solution o6 the set o6 e;uations
F c
J
2

F ,
2
S
h2
3 R h 3 (R " " " R n D'.('E
2
$
2
So Ra+sey prices can be belo, +arginal cost i6 so+e ser8ices are co+ple+ents Di.e.
S
i 2
\ 0E. >or eCa+ple, i6 n 3 2, and the elasticities are constant, ,ith 8alues o6 S
(
3 2,
S
2
3 ' and S
(2
3 3, then ,e can easily calculate that $
(
\ F c NF ,
(
and $
2
` F c NF ,
2
. 2s an illustration o6 this, consider a case o6 t,o ser8ices, say 8oice and 8ideo. 0here
is de+and 6or 8oice alone, 6or 8ideo alone, and 6or 8oice and 8ideo pro8ided as a single
telecon6erencing ser8ice. In this case, 8oice and 8ideo are co+ple+ents. Let MC
(
and MC
2
be the +arginal costs and also the initial prices 6or 8oice and 8ideo respecti8ely, and
suppose that the net,or- needs to reco8er so+e 6iCed cost. 2ssu+e that the de+and 6or
8oice is price inelastic, ,hile the de+and 6or the telecon6erencing ser8ice is 8ery price
elastic. In this case, it is sensible 6or the net,or- operator to raise the price $
(
6or 8oice
abo8e MC
(
to reco8er a substantial part o6 the cost. ut no, the price 6or the
8ideocon6erencing ser8ice beco+es $
(
C MC
2
` MC
(
C MC
2
, ,hich ,ill reduce
signi6icantly the de+and o6 the price#elastic 8ideocon6erencing users. 0o re+edy that, the
price $
2
o6 8ideo should be set belo, MC
2
, so that $
(
C $
2
re+ains close to MC
(
C
MC
2
.
Ra+sey prices are linear tari66s and re;uire -no,ledge o6 properties o6 the +ar-et de+and
cur8es. It turns out that, by using +ore general nonlinear tari66s, one +ay be able to obtain
*areto i+pro8e+ents to Ra+sey prices, i.e. obtain higher social ,el6are ,hile still co8ering
costs. >or instance, selling additional units at +arginal cost can only i+pro8e social ,el6are.
!ote that in this case prices are non#uni6or+. 2s ,e see in Section '.'.3, such tari66s are
superior, but re;uire +ore detailed -no,ledge o6 the de+and, and can only be used under
certain +ar-et conditions.
&6&6 !wo)'art !ariffs
0,o other +ethods by ,hich a supplier can reco8er his costs ,hile +aCi+i@ing social
,el6are are two$art tari''s and +ore general nonlinear prices. 2 typical t,o#part tari66
is one in ,hich custo+ers are charged both a 'i,ed charge and a usage charge. 0ogether
these co8er the supplierMs reoccurring 'i,ed costs and marginal costs . !ote the di66erence
bet,een reoccurring 6iCed costs and nonrecurring sunk costs . Sun- costs are those ,hich
ha8e occurred once#6or#all. 0hey can be included in the 6ir+Ms boo- as an asset, but they do
not ha8e any bearing on the 6ir+Ms pricing decisions. >or eCa+ple, once a 6ir+ has already
spent a certain a+ount o6 +oney building a net,or-, that a+ount beco+es irrele8ant to
its pricing decisions. *rices should be set to +aCi+i@e pro6it, i.e. the di66erence bet,een
re8enue and the costs o6 production, both 6iCed and 8ariable.
Suppose that the charge 6or a ;uantity , o6 a single ser8ice is set at a C $, . 0he proble+
6or the consu+er is to +aCi+i@e his net bene6it
u., < a $,
9e ,ill choose , such that F u NF , 3 $, unless his net bene6it is negati8e at this point,
in ,hich case it is opti+al 6or hi+ to ta-e , 3 0 and not participate. 0hus a custo+er
,ho buys a s+all a+ount o6 the ser8ice i6 there is no 6iCed charge +ay be deterred 6ro+
purchasing i6 a 6iCed charge is +ade. 0his reduces social ,el6are, since although OlargeM
custo+ers +ay purchase their opti+al ;uantities o6 the ser8ice, +any Os+allM custo+ers
+ay drop out and so obtain no bene6it. 4bser8e that, ,hen $ 3 MC , once a custo+er
decides to participate, then he ,ill purchase the socially opti+al a+ount.
9o, should one choose a and $L Choosing $ 3 MC is de6initely sensible, since this ,ill
+oti8ate socially opti+al resource consu+ption. 4ne can address the ;uestion o6 choosing
a in 8arious ,ays. 0he critical issue is to +oti8ate +ost o6 the custo+ers to participate and
so add to the social surplus. I6 one -no,s the nu+ber o6 custo+ers, then the si+plest thing
is to di8ide the 6iCed cost e;ually a+ongst the custo+ers, as in the eCa+ple o6 >igure '.H.
I6, under this tari66, e8ery custo+er still has positi8e surplus, and so continues to purchase,
then the tari66 is clearly opti+alR it achie8es +aCi+u+ social ,el6are ,hile reco8ering
cost. I6, ho,e8er, so+e custo+ers do not ha8e positi8e surplus under this tari66, then their
nonparticipating can lead to substantial ,el6are loss. *articipation +ay be greater i6 ,e
i+pose 6iCed charges that are in proportion to the net bene6its that the custo+ers recei8e,
or in line ,ith their inco+es.
Q
MC
AC
$AC
4
,D$E
,i ,
/igure &6( In this eCa+ple the +arginal cost is constant and there is a linear de+and 6unction,
, . $<. 2 t,o part tari66 reco8ers the additional a+ount 4 in the supplierMs cost by adding a 6iCed
charge to the usage charge. 2ssu+ing N custo+ers, the tari66 +ay be 4 N N C , M C . 9o,e8er,
a custo+er ,ill not participate i6 his net bene6it is negati8e. 4bser8e that i6 the a8erage cost cur8e
AC 3 MC C 4 N, is used to co+pute prices, then use o6 the resulting price $
AC
does not
+aCi+i@e social ,el6are. 28erage prices are eCpected to ha8e ,orse per6or+ance than t,o part
tari66s using +arginal cost prices.
!ote that such di66erential charging o6 custo+ers re;uires so+e +ar-et po,er by the
operator, and +ay be illegal or i+possible to achie8e" a teleco+s operator cannot set t,o
custo+ers di66erent tari66s 6or the sa+e ser8ice ?ust because they ha8e di66erent inco+es.
9o,e8er, he can do so+ething to di66erentiate the ser8ice and then o66er it in t,o 8ersions,
each ,ith a di66erent 6iCed charge. Custo+ers ,ho are attracted to each o6 the 8ersions are
,illing to pay that 8ersionMs 6iCed charge. Such price discri+ination +ethods are eCa+ined
in +ore detail in Section H.2.2.
.cono+ists ha8e used 8arious +athe+atical +odels to deri8e opti+u+ 8alues 6or a and
$. 0hey assu+e -no,ledge o6 the distribution o6 the 8arious custo+er types and their
de+and 6unctions. Such +odels suggest a lo,er 6iCed 6ee and a price abo8e +arginal cost.
2 lo,er a +oti8ates +ore s+all custo+ers to participate, ,hile the eCtra cost is reco8ered
by the higher $. Re+e+ber that s+all custo+ers do not +ind paying +ore than +arginal
cost prices, but cannot a66ord a paying a high 6iCed 6ee. 4ther +odels assu+e a 6iCed cost
per custo+er and a 8ariable cost that depends on usage. 0his is the case 6or setting up an
access ser8ice, such as 6or telephony or the Internet. 3epending on the particular +ar-et,
a and $ +ay be abo8e or belo, the respecti8e 8alues o6 the 6iCed custo+er cost and the
+arginal cost o6 usage.
&6&6$ 4ther Nonlinear !ariffs
Aeneral nonlinear tari66s can be 6unctions o6 the 6or+ r ., <, ,here , is the a+ount
consu+ed by the custo+er. Starting ,ith r .0< 3 0 they retain the nice property o6 Ra+sey
prices, that custo+ers ,ho ha8e lo, 8aluations 6or the ser8ice can participate by paying an
arbitrarily s+all a+ount. 0he opti+al r ., < +ay ha8e both con8eC and conca8e parts.
2 general property is that the custo+er purchasing the largest ;uantity 7 sees a
+arginal charge r
0
.7 < e;ual to +arginal cost. In +any practical situations, r ., < is a
conca8e 6unction. In this case, the price per unit drops ,ith the ;uantity purchased, a
property -no,n as 7uantity discounts . In practice, s+ooth tari66s are approCi+ated by
*lock tari''s . 0hese are tari66s in ,hich the range o6 consu+ption is split into inter8als,
,ith constant per unit prices.
2 +ore interesting class o6 nonlinear tari66s are o$tional two$art tari''s . 0he custo+er
is o66ered a choice o6 tari66s, 6ro+ ,hich he is 6ree to choose the one 6ro+ ,hich his charge
,ill be co+puted. 9e +ay re;uired to choose either be6ore or a6ter his use o6 the ser8ice.
2 set o6 + optional t,o#part tari66s is speci6ied by pairs .a
k
R $
k
<, k 3 (R " " " R + .
Since custo+ers sel6#select, under plausible assu+ptions on +ar-et de+and, these tari66s
+ust satis6y a
k
a a
kC(
and $
k
X $
kC(
, k 3 (R " " " R + (, thereby de6ining a conca8e
nonlinear tari66. 2n opti+al choice o6 these coe66icients o6ten has $
+
is e;ual to +arginal
cost. 2 nice 6eature o6 optional tari66s is the 6ollo,ing. Ai8en a + #part optional tari66, ,e
can al,ays construct a + C (#part tari66 that is not *areto in6erior. 0his is because the
addition o6 one +ore tari66 gi8es custo+ers +ore choice, and so they can eCpress better
their pre6erences. 0he coe66icients o6 the ne, tari66 can be easily tuned to co8er the
supplierMs costs. 0ari66s o6 this type are co++only used to charge 6or 6iCed#line and
+obile telephone ser8ices. In the 6ollo,ing eCa+ple, ,e sho, ho, to one can i+pro8e on
linear prices by adding one optional t,o#part tari66.
"0am'le &61 ;Adding an o'tional two)'art tariff< 4ur initial tari66 consists o6 the
Ra+sey prices $
6
. We assu+e that custo+er types ha8e linear parallel de+and 6unctions,
distributed bet,een a s+allest ,
+in
. $< and a largest ,
+aC
. $<R see >igure '.%. >or
si+plicity, also assu+e that ,e ha8e a constant +arginal cost o6 production MC . Let us
6irst construct a *areto
4
,
+aC
D$E
,
M
D$E
A
(
3
2
C
,
+in
D$E
M
3
M
E 5
Q
$
6
MC ] t
MC
,
M( ,
(
,
M2
,
2
,
/igure &6+ 0he design o6 an optional tari66. 0he de+and 6unctions o6 the 8arious custo+er types
are linear, parallel, and distributed bet,een a s+allest ,
+in
. $< and a largest ,
+aC
. $<. 2n optional
tari66 E
(
C $
(
, is added to the Ra+sey prices $
6
. We start ,ith E
(
3 A( 5 E and $
(
3 MC .
0his tari66 appeals to custo+ers ,ith de+and 6unction o6 ,
M
or +ore, increases social ,el6are since
they consu+e +ore and balances costs. y 6urther decreasing E
(
, and slightly increasing $
(
to MC
C h, ,e induce custo+er type M to use the optional tari66 and produce a ,el6are gain o6 3
M
. 0his
is substantially greater than the ,el6are loss o6 3
2
that arises because the larger custo+er consu+er
slightly less.
i+pro8e+ent by adding an optional tari66 E
(
C $
(
, , $
(
3 MC , targeted at the
largest custo+ers. We should co+pute the E
(
so that such custo+ers are indi66erent
bet,een the old and ne, tari66s, ,hile i6 they s,itch, their contribution to the co++on cost
Don top o6 their actual consu+ption costE re+ains the sa+e. Clearly, i6 ,e succeed, ,e
obtain a net i+pro8e+ent since the custo+ers using the optional tari66 ,ill consu+e +ore
and hence obtain a larger surplus Da6ter +a-ing it a tiny bit +ore attracti8e to the+E. 0his is
in line ,ith a general result, stating that a necessary condition 6or second degree price
discri+ination to increase ,el6are is that output rises as a conse;uence.
2s sho,n in >igure '.%, the custo+ers ,ith greatest de+and 6unction +a-e a contribution
to the co++on cost, at the consu+ption le8el ,
(
3 ,
+aC
. $
6
<, o6 ) , e;ual to the area
o6 A( 5 E , and they obtain a surplus, C "
(
, e;ual to the area o6 4A ( . y o66ering the
ne, optional tari66, ,ith E
(
3 ) , these custo+ers 6ind it +ore pro6itable to use the ne,
tari66 and increase their consu+ption to ,
2
, since their surplus beco+es C "
(
C (C 5.
0hey +a-e the sa+e contribution to the co++on cost, but their surplus increases by the
area (C 5. 9ence, it is a *areto i+pro8e+ent. ut things are e8en better than that. 1ore
large custo+ers ,ill pre6er the ne, tari66 since their surplus is greater. 0he s+allest
custo+er type that ,ill s,itch Dbeing ?ust indi66erent bet,een doing so or notE is the one
,ith de+and 6unction ,
M
. $<, passing through M , the +idpoint o6 (5. 2ll such
custo+er types ha8e increased their consu+ption, so there is a clear ,el6are gains.
1oreo8er, their contributions to the co++on cost are greater than be6ore, ,hich lea8es
the net,or- ,ith a net pro6it. 0his suggests that E
(
could be 6urther reduced to bring
pro6its to @ero ,hile +oti8ating e8en s+aller custo+ers to s,itch. >or si+plicity assu+e
that this co+pensation is already per6or+ed and the +arginal custo+er type ,ho is
indi66erent to s,itch is M .
(
S
i 2
N
i N
>I!I0. C2*2CI0/ C4!S0R2I!0S (3%
4bser8e that ,e can +a-e custo+er type M s,itch by decreasing E
(
by S, in ,hich
case ,e +ust increase $
(
by a s+all a+ount h Do6 the order SE to co+pensate 6or the loss
o6 inco+e 6ro+ the other custo+ers. 0he net ,el6are gain by ha8ing M s,itch is the area
o6 the shaded trape@oid 3
M
Dconsu+ption ,ill increase 6ro+ ,
M (
to ,
M 2
. 9o,e8er,
there is a ,el6are loss since custo+ers that ha8e already s,itched ,ill consu+e a bit less
due to the higher price MC C h. .ach such custo+er type ,ill produce a ,el6are loss e;ual
to the shaded triangle 3
2
. Since 3
M
is substantially larger than 3
2
D,hich is o6 order SE,
it pays to continue decreasing E
(
and increasing $
(
until these e66ects co+pensate one
other.
&6( /inite ca'acity constraints
0he proble+ o6 reco8ering costs also arises ,hen there is a 6inite capacity constraint.
Consider the proble+ o6 +aCi+i@ing social surplus sub?ect to t,o constraints" re8enue
+atches cost and de+and does not eCceed C . I+agine that there is a set o6 custo+ers
N , a single good, and it is possible to charge di66erent custo+ers di66erent prices 6or this
good. Let ,
i
be the a+ount o6 the good allocated to custo+er i Dso ,
i
3 ,
i
, say, ,here
,
i
denoted a 8ector o6 goods in pre8ious sectionsE. 2ssu+ing, 6or si+plicity, that their
de+and 6unctions are independent, the rele8ant Lagrangian can be ,ritten as
J
5
,
i
$
i
. y<dy
c
_
J
,
i
i 2 N
0
C X
(
i 2 N
j _I
$
`
, c
J
,
i
i 2 N
C X
2
j I
C
J
,
i
i 2 N
D'.(HE
It is con8enient to de6ine ,rite 3 X
(
N.( C X
(
< and e 3 X
2
N.( C X
(
<. 0he 6irst
order conditions no, beco+e

[
$
i
( C
i
3 c
0
C eR i 2 N D'.(%E
4bser8e that the price that should be charged to custo+er i depends on his de+and
elasticity. 0he +ini+u+ price that he +ight be charged D,hen 3 0, i.e. no cost reco8ery is
en6orcedE is the +arginal cost aug+ented by addition o6 the Lagrange +ultiplier, e 3 X
2
Dthe shado, price associated ,ith the capacity constraintE. !ote that X
2
` 0 ,hen the
capacity constraint is acti8e, i.e. ,hen the opti+al total a+ount allocated ,ould be greater
i6 the capacity C ,ere to increase.
2 si+ilar result is obtained ,hen ,e sol8e the pro6it +aCi+i@ation proble+ under
capacity constraints. 2lthough pro6it +aCi+i@ation is eCa+ined in Section H.2.(, ,e present
the corresponding results to sho, the si+ilar 6or+ o6 the resulting prices.
In the case o6 pro6it +aCi+i@ation, ,e ,ant to +aCi+i@e the net pro6it $
`
, c.
*
,
i
<
sub?ect to the constraint that
*
2
,
i
a C . >or this proble+, the Lagrangian is
,ith 6irst order conditions
_
$
`
, c
J
,
i
i 2 N
_
C e C
J
,
i
i 2 N
D'.(&E
(
[
$
i
( C
S
i
3 c
0
C eR i 2 N D'.()E
(3& 2SIC C4!C.*0S
i
S
2gain, the +arginal cost is aug+ented by addition o6 the Lagrange +ultiplier Dshado,
costE arising 6ro+ the capacity constraint. !ote that the constraint +ay not be acti8e i6 the
+aCi+u+ occurs ,here
*
,
i
\ C . >inally, obser8e that i6 the +arginal cost is @ero, then
(
[
$
i
( C
i
3 e D'.20E
!otice that prices are proportional to the shado, cost. 0he +ar-up in the price charged to
custo+er i is deter+ined by the elasticity o6 his de+and.
&6+ Network e0ternalities
0hroughout this chapter, ,e ha8e supposed that a custo+erMs utility depends only on the
goods that he hi+sel6 consu+es. 0his is not true ,hen goods eChibit net,or- eCternalities,
i.e. ,hen they beco+e +ore 8aluable as +ore custo+ers use the+. .Ca+ples o6 such goods
are telephones, 6aC +achines, and co+puters connected to the Internet. Let us analy@e a
si+ple +odel to see ,hat can happen.
Suppose there are N potential custo+ers, indeCed by i 3 (R " " " R N , and that custo+er
i is ,illing to pay u
i
.n< 3 ni 6or a unit o6 the good, gi8en that n other custo+ers ,ill
be using it. 0hus, i6 a custo+er belie8es that no one else ,ill purchase the good, he
8alues it at @ero. 2ssu+e also that a custo+er ,ho purchases the good can al,ays return
it 6or a re6und i6 he detects that it is ,orth less to hi+ that the price he paid. We ,ill
co+pute the de+and cur8e in such a +ar-et, i.e. gi8en a price $ 6or a unit o6 the good,
the nu+ber o6 custo+ers ,ho ,ill purchase it. Suppose that $ is posted and n custo+ers
purchase the good. We can thin- o6 n as an e;uilibriu+ point in the 6ollo,ing ,ay" n
custo+ers ha8e ta-en the ris- o6 purchasing the good Dsay by ha8ing a strong prior belie6
that n ( other custo+ers ,ill also purchase itE, and at that point no ne, custo+er ,ants
to purchase the good, and no eCisting purchaser ,ants to return it, so that n is stable 6or
the gi8en $. Clearly, the purchasers ,ill be custo+ers N n C (R " " " R N . Since there
are custo+ers that do not thin- it is pro6itable in this situation to purchase the good,
there +ust be such an Oindi66erentM custo+er, 6or ,hich the 8alue o6 the good e;uals the
price. 0his should be custo+er i 3 N n, and since u
i
.n< 3 $ ,e obtain that the
de+and at price $ is that n such that n. N n< 3 $. !ote that in general there are t,o
8alues o6 n 6or ,hich this holds. >or instance, 6or N 3 (00 and $ 3 (H00, n can be
20 or &0.
In >igure '.& ,e plot such a de+and 6unction 6or N 3 (00. >or a $ in the range o6
0:2'00 there are, in general, three possible e;uilibria, corresponding to the points 0, A and
( Dhere sho,n 6or $ 3 )00E. *oint 0 is al,ays a possible e;uilibriu+, corresponding to the
prior belie6 that no custo+er ,ill purchase the good. *oints A and ( are consistent ,ith
prior belie6s that n
(
and n
2
custo+ers ,ill purchase the good, ,here $.n
(
< 3 $.n
2
< 3 $.
9ere, n
(
3 (0, n
2
3 )0. I6 $ ` 2'00 then only 0 is a possible e;uilibriu+. Si+ple
calculations sho, that the total 8alue o6 the custo+ers in the syste+ is n
2
.2 N n C (<N2,
,hich is consistent ,ith 1etcal6eM La, Dthat the total 8alue in a syste+ is o6 the order n
2
E.
It ,ould lengthen our discussion unreasonably to try to speci6y and analyse a 6ully
dyna+ic +odel. 9o,e8er, it should be clear, in6or+ally, ,hat one +ight eCpect. Suppose
that, starting at A, one +ore custo+er Dsay the indi66erent oneE purchases the good. 0hen the
8alue o6 the good increases abo8e the posted price $. 2s a result, $ositive 'eed*ack ta-es
place" custo+ers ,ith s+aller indices -eep purchasing the good until point ( is reached.
0his is no, a stable e;uilibriu+, since any perturbation around ( ,ill tend to +a-e the
!.0W4RB .J0.R!2LI0I.S (3)
2'00
price
2000
('00
$ N 1C
$DnE
(000 A (
'00
0
0 n
(
n
n
2
(00
/igure &6, 2n eCa+ple o6 a de+and cur8e 6or N 3 (00 ,hen there are net,or- eCternalities.
Ai8en a price $, there are three possible e;uilibria corresponding to points 0, A and (, a+ongst
,hich only 0 and ( are stable. 4bser8e that the de+and cur8e is increasing 6ro+ 0, in contrast to
de+and cur8es in +ar-ets ,ithout net,or- eCternalities, ,hich are usually do,n,ard sloping.
syste+ return to ( . Indeed, starting 6ro+ an initial point n that is belo, Dor abo8eE n
2
,ill result in custo+ers purchasing Dor returningE the good. 0he 6e, custo+ers le6t abo8e
n
2
ha8e such a s+all 8alue 6or the good Dincluding the net,or- eCternality e66ectsE that
the price +ust drop belo, $ to +a-e it attracti8e to the+. 2 si+ilar argu+ent sho,s that
starting belo, n
(
,ill reduce n to @ero.
0hese si+ple obser8ations suggest that +ar-ets ,ith strong net,or- e66ects +ay re+ain
s+all and ne8er actually reach the socially desirable point o6 large penetration. 0his type o6
market 'ailure can occur unless positi8e 6eedbac- +o8es the +ar-et to point ( . 9o,e8er,
this happens only ,hen the syste+ starts at so+e su66iciently large initial point abo8e n
(
.
0his +ay occur either because enough custo+ers ha8e initially high eCpectations o6 the
e8entual +ar-et si@e Dperhaps because o6 success6ul +ar-etingE, or because a social planner
subsidi@es the cost o6 the good, resulting in a lo,er posted price. When $ decreases, n
(
+o8es to the le6t, +a-ing it possible gro, the custo+er base 6ro+ a s+aller initial 8alue.
0hus, it +ay be sensible to subsidi@e the price initially, until positi8e 6eedbac- ta-es place.
4nce the syste+ reaches a stable e;uilibriu+ one can raise prices or use so+e other +eans
to pay bac- the subsidy.
0hese conditions are 6re;uently encountered in the co++unications +ar-et. >or instance,
the ,ide penetration o6 broadband in6or+ation ser8ices re;uires lo, prices 6or access
ser8ices Daccess the Internet ,ith speeds higher than a 6e, 1bpsE. ut prices ,ill be lo,
6or access once enough de+and 6or broadband attracts +ore co+petition in the pro8ision o6
such ser8ices and +oti8ates the de8elop+ent and deploy+ent o6 +ore cost#e66ecti8e access
technologies. 0his is a typical case o6 the traditional Ochic-en and eggM proble+_
>inally, ,e +a-e an obser8ation about social ,el6are +aCi+i@ation. Suppose that in our
eCa+ple ,ith N 3 (00, the +arginal cost o6 the good is $. I6 ,e co+pute the social ,el6are
".n<, it turns out that its deri8ati8e is positi8e at n
2
6or any $ that intersects the de+and
cur8e, and re+ains positi8e until N is reached. 9ence, it is socially opti+al to consu+e
e8en +ore than the e;uilibriu+ ;uantity n
2
. In this case, +arginal cost pricing is not
opti+al, the opti+al price being @ero. 0his suggests that ,hen strong net,or- eCternalities
are present, opti+al pricing +ay be belo, +arginal cost, in ,hich case the social planer
should subsidi@e the price o6 the good that creates these eCternalities. Such a subsidy could
be reco8ered 6ro+ the custo+ersM surplus by taCation.
($0 2SIC C4!C.*0S
&6, /urther reading
2 good teCt 6or the +icroecono+ics presented in this chapter is Garian D())2E. 2 sur8ey o6
the econo+ics literature on Ra+sey pricing and nonlinear tari66s in the teleco++unications
+ar-et is in 1itchell and Gogelsang D())(E. Issues related to net,or- eCternalities and
the e66ects o6 positi8e 6eedbac- are discussed in .cono+ides and 9i++elberg D())'E
and Shapiro and Garian D())&E. 2 re8ie, o6 basic results on Lagrangian +ethods and
opti+i@ation is in 2ppendiC 2
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
(
Co+petition 1odels
Chapter H introduces three +odels o6 +ar-et co+petition. 0heir conse;uences 6or pricing
are discussed in the Sections H.2:H.$. In Section H.( ,e de6ine three +odels 6or a +ar-et"
+onopoly, per6ect co+petition and oligopoly. Section H.2 loo-s at the strategies that are
a8ailable to a +onopoly supplier ,ho has prices co+pletely under his control. Section H.3
describes ,hat happens ,hen prices are out o6 the supplierMs control and e66ecti8ely
deter+ined by Othe in8isible handM o6 per6ect co+petition. Section H.$, considers the +iddle
case, called oligopoly, in ,hich there is no do+inate supplier, but the co+peting suppliers
are 6e, and their actions can a66ect prices. Within this section, ,e present a brie6 tutorial on
so+e +odels in ga+e theory that are rele8ant to pricing proble+s. Section H.' concludes
,ith an analysis o6 a +odel in ,hich a co+bination o6 social ,el6are and supplier pro6it is
to be +aCi+i@ed.
(61 !y'es of com'etition
0he +ar-et in ,hich suppliers and custo+ers interact can be eCtraordinarily co+pleC.
.ach participant see-s to +aCi+i@e his o,n surplus. 3i66erent actions, in6or+ation and
+ar-et po,er are a8ailable to the di66erent participants. 4ne i+agines that a large nu+ber
o6 co+pleC ga+es can ta-e place as they co+pete 6or pro6it and consu+er surplus.
0he 6ollo,ing sections are concerned ,ith three basic +odels o6 +ar-et structure and
co+petition" +onopoly, per6ect co+petition and oligopoly.
In a +onopoly there is a single supplier ,ho controls the a+ount o6 goods produced.
In practice, +ar-ets ,ith a single supplier tend to arise ,hen the goods ha8e a production
6unction that eChibits the properties o6 a natural +onopoly. 2 +ar-et is said to be a natural
mono$oly i6 a single supplier can al,ays supply the aggregate output o6 se8eral s+aller
suppliers at less than the total o6 their costs. 0his is due both to production economies o'
scale Dthe a8erage cost o6 production decreases ,ith the ;uantity o6 a good producedE and
economies o' sco$e Dthe a8erage cost o6 production decreases ,ith the nu+ber o6 di66erent
goods producedE. 1athe+atically, i6 all suppliers share a co++on cost 6unction, c, this
i+plies c., C y< g c., < C c. y<, 6or all 8ector ;uantities o6 ser8ices , and y. We say
that c.g< is a su*additive 'unction. 0his is 6re;uently the case ,hen producing digital
goods, ,here there is so+e 6iCed initial de8elop+ent cost and nearly @ero cost to reproduce
and distribute through the Internet.
In such circu+stances, a larger supplier can set prices belo, those o6 s+aller co+petitors
and so capture the entire +ar-et 6or hi+sel6. 4nce the +ar-et is his alone then his proble+
is
($2 C41*.0I0I4! 143.LS
essentially one o6 pro6it +aCi+i@ation. In Section H.2 ,e sho, that a +onopolist +aCi+i@es
his pro6it DsurplusE by ta-ing account o6 the custo+ersM price elasticities. 9e can bene6it by
discri+inating a+ongst custo+ers ,ith di66erent price elasticities or pre6erences 6or
di66erent ser8ices. 9is +onopoly position allo,s hi+ to +aCi+i@e his surplus ,hile
reducing the surplus o6 the consu+ers. I6 he can discri+inate per6ectly bet,een custo+ers,
then he can +a-e a ta-e#it#or#lea8e it o66er to each custo+er, thereby +aCi+i@ing social
,el6are, but -eeping all o6 its 8alue 6or hi+sel6. I6 he can only i+per6ectly discri+inate,
then the social ,el6are ,ill be less than +aCi+al. Intuiti8ely, the +onopolist -eeps prices
higher than socially opti+al, and reduces de+and ,hile increasing his o,n pro6it.
1onopoly is not necessarily a bad thing. Society as a ,hole can bene6it 6ro+ the large
production econo+ies o6 scale that a single 6ir+ can achie8e. Inco+patibilities a+ongst
standards, and the di66ering technologies ,ith ,hich disparate suppliers +ight pro8ide a
ser8ice, can reduce that ser8iceMs 8alue to custo+ers. 0his proble+ is eli+inated ,hen a
+onopolist sets a single standard. 0his is the +ain reason that go8ern+ents o6ten support
+onopolies in sectors o6 the econo+y such as teleco++unications and electric po,er
generation. 0he go8ern+ent regulates the +onopolyMs prices, allo,ing it to reco8er costs
and +a-e a reasonable pro6it. *rices are -ept close to +arginal cost and social ,el6are is
al+ost +aCi+i@ed. 9o,e8er, there is the danger that such a Obene8olentM +onopoly does
not ha8e +uch incenti8e to inno8ate.
2 price reduction o6 a 6e, percent +ay be insigni6icant co+pared ,ith the increase o6
social 8alue that can be obtained by the introduction o6 co+pletely ne, and li6e#changing
ser8ices. 0his is especially so in the 6ield o6 co++unications ser8ices. 2 inno8ation is +uch
+ore li-ely to occur in the conteCt o6 a co+petiti8e +ar-et.
2 second co+petition +odel is per6ect co+petition. 0he idea is that there are +any
suppliers and consu+ers in the +ar-et, e8ery such participant in the +ar-et is s+all and
so no indi8idual consu+er or supplier can dictate prices. 2ll participants are price ta-ers.
Consu+ers sol8e a proble+ o6 +aCi+i@ing net surplus, by choice o6 the a+ounts they buy.
Suppliers sol8e a proble+ o6 +aCi+i@ing pro6it, by choice o6 the a+ounts they supply.
*rices naturally gra8itate to,ards a point ,here de+and e;uals supply. 0he -ey result in
Section H.3 is that at this point the social surplus is +aCi+i@ed, ?ust as it ,ould be i6 there
,ere a regulator and prices ,ere set e;ual to +arginal cost. 0hus, per6ect co+petition is
an Oin8isible handM that produces econo+ic e66iciency. 9o,e8er, per6ect co+petition is not
al,ays easy to achie8e. 2s ,e ha8e noted there can be circu+stances in ,hich a regulated
+onopoly is pre6erable.
In practice, +any +ar-ets consist o6 only a 6e, suppliers. 4ligopoly is the na+e
gi8en to such a +ar-et. 2s ,e see in Section H.$ there are a nu+ber o6 ga+es that
one can use to +odel such circu+stances. 0he -ey results o6 this section are that the
resulting prices are sensiti8e to the particular ga+e 6or+ulation, and hence depend upon
+odelling assu+ptions. In a practical sense, prices in an oligopoly lie bet,een t,o
eCtre+es" these i+posed by a +onopolist and those obtained in a per6ectly co+petiti8e
+ar-et. 0he greater the nu+ber o6 producers and consu+ers, the greater ,ill be the
degree o6 co+petition and hence the closer prices ,ill be to those that arise under
per6ect co+petition.
We ha8e +entioned that i6 supply to a +ar-et has large production econo+ies o6 scale,
then a single supplier is li-ely to do+inate e8entually. 0his +ar-et organi@ation o6 O,inner#
ta-es#allM is all the +ore li-ely i6 there are net,or- eCternality e66ects, i.e. i6 there are
econo+ies o6 scale in de+and. 0he +onopolist ,ill tend to gro,, and ,ill ta-e ad8antages
o6 econo+ies o6 scope to o66er +ore and +ore ser8ices.
S
$
14!4*4L/ ($3
(6 *ono'oly
2 +onopoly supplier has the proble+ o6 $ro'it ma,imi%ation . Since he is the only supplier
o6 the gi8en goods, he is 6ree to choose prices. In general, such DunitE prices +ay be
di66erent depending on the a+ount sold to a custo+er, and +ay also depend on the identity
o6 the custo+er. Such a 6leCibility in de6ining prices +ay not be a8ailable in all +ar-et
situations. >or instance, at a retail petrol station, the price per litre is the sa+e 6or all
custo+ers and independent o6 the ;uantity they purchase. In contrast, a ser8ice pro8ider
can personali@e the price o6 a digital good, or o6 a co++unications ser8ice, by ta-ing
account o6 any gi8en custo+erMs pre8ious history or special needs to create a 8ersion o6 the
ser8ice that he alone +ay use. So+eti+es ;uantity discounts can be o66ered. 2s ,e see
belo,, the +ore control that a 6ir+ has to discri+inate and price according to the identity
o6 the custo+er or the ;uantity he purchases, the +ore pro6it it can +a-e. e6ore
in8estigating three types o6 price discri+ination, ,e start ,ith the si+plest case, in ,hich
the +onopolist is allo,ed to use only linear prices Di.e. the sa+e 6or all unitsE uni6or+
across custo+ers.
(661 Profit *a0imi5ation
2s in Chapter ', let ,
2
. $< denote the de+and 6or ser8ice 2 ,hen the price 8ector 6or a
set o6 ser8ices is $. 2 +onopoly supplier ,hose goal is $ro'it ma,imi%ation ,ill choose to
post prices that sol8e the proble+
+aCi+i@e
$
j
I
J
$
2
,
2
. $< a c., <
2
0he 6irst#order stationarity condition ,ith respect to $
i
is
,
i
C
J
$
2
F ,
2
J
a
F c F ,
2
3 0 DH.(E
2
F $
i
2
F ,
2
F $
i
I6 ser8ices are independent, so that S
i 2
3 0 6or i H3 2 , ,e ha8e, as in D'.($E, ta-ing 3 (,
g
(

F c
$
i
( C
i
3
F ,
i
4ne can chec- that this is e;ui8alent to saying that +arginal re8enue should e;ual +arginal
cost. 0his condition is intuiti8e, since i6 +arginal re8enue ,ere greater Dor lessE than
+arginal cost, then the +onopolist could increase his pro6it by ad?usting the price so that the
de+and increased Dor decreasedE. Recall that +arginal cost prices +aCi+i@e social ,el6are.
Since S
i
\ 0 the +onopolist sets a price 6or ser8ice i that is greater than his +arginal cost
F c . , <NF ,
i
. 2t such prices the ;uantities de+anded ,ill be less than are socially
opti+al
and this ,ill result in a loss o6 social ,el6are.
4bser8e that the +arginal re8enue line lies belo, the +arginal utility line Dthe de+and
cur8eE. 0his is illustrated in >igure H.(, ,here also ,e see that social ,el6are loss occurs
under pro6it +aCi+i@ation.
I6 ser8ices are not independent then ,e ha8e, as in D'.('E,
F c
J
2
a
F ,
2
2
$
2
S
i 2
3 a( R 6or all i
2s already re+ar-ed in Section '.'.(, i6 so+e ser8ices are co+ple+ents then it is possible
($$ C41*.0I0I4! 143.LS
that so+e o6 the+ sold at less than +arginal cost.
pro6it N $
Q
+arginal re8enue
,el6are loss
$
m
+arginal cost
de+and
,
m
,
MC
,
/igure (61 2 pro6it +aCi+i@ing +onopolist ,ill set his price so that +arginal re8enue e;uals
+arginal cost. 0his +eans setting a price higher than +arginal cost. 0his creates a social ,el6are
loss, sho,n as the area o6 the shaded triangle.
(66 Price 1iscrimination
2 supplier is said to engage in $rice discrimination ,hen he sells di66erent units o6 the sa+e
ser8ice at di66erent prices, or ,hen prices are not the sa+e 6or all custo+ers. 0his enables
hi+ to obtain a greater pro6it than he can by using the sa+e linear price 6or all custo+ers.
*rice discri+ination +ay be based on custo+er class De.g. discounts 6or senior citi@ensE,
or on so+e di66erence in ,hat is pro8ided De.g. ;uantity discountsE. Clearly, so+e special
conditions should hold in the +ar-et to pre8ent those custo+ers to ,ho+ the supplier sells
at a lo, unit price 6ro+ buying the good and then reselling it to those custo+ers to ,ho+
he is selling at a high unit price.
We can identi6y three types o6 price discri+ination. With 'irst degree $rice
discrimination Dalso called $ersonali%ed $ricing E, the supplier charges each user a di66erent
price 6or each unit o6 the ser8ice and obtains the +aCi+u+ pro6it that it ,ould be possible
6or hi+ to eCtract. 0he consu+ers o6 his ser8ices are 6orced to pay right up to the le8el at
,hich their net bene6its are @ero. 0his is ,hat happens in >igure H.2.
0he +onopolist e66ecti8ely +a-es a Ota-e it or lea8e itM o66er o6 the 6or+ Oyou can ha8e
;uantity , 6or a charge o6 eM. 0he custo+er decides to accept the o66er i6 his net bene6it
is positi8e, i.e. i6 u., < a e X 0, and re?ects the o66er other,ise. 9ence, gi8en the 6act that
the +onopolist can tailor his o66er to each custo+er separately, he 6inds 8ectors , R e ,hich
Q
Q
pro6it N 3
3 3
( (
Q
pro6it N H
3
(
( 2 3 $
no. units sold
( 2 3 $ ( 2 3 $
/igure (6 2 +onopolist can increase his pro6it by price discri+ination. Suppose custo+er 2
8alues the ser8ice at Q3, but custo+ers , C and 3 8alue it only at Q(. 0here is @ero production
cost. I6 he sets the price $ 3 Q3, then only one unit o6 the good is D?ustE sold to custo+er 2 6or Q3.
I6 he sets a uni6or+ price o6 $ 3 Q(, then 6our units are sold, one to each custo+er, generating Q$.
I6 the seller charges di66erent prices to di66erent custo+ers, then he should charge Q3 to custo+er 2,
and Q( to custo+ers , C and 3, gi8ing hi+ a total pro6it o6 QH. 0his eCceeds Q$, ,hich is the
+aCi+u+ pro6it he could obtain ,ith uni6or+ pricing.
14!4*4L/ ($'
i
sol8e the proble+
+aCi+i@e
, Re
j
I
J
e
i
a c., <
i
sub?ect to u
i
.,
i
< X e
i
6or all i DH.2E
2t the opti+u+ F c . , <NF ,
i
3 u
0
.,
i
<, and hence social surplus is +aCi+i@ed.
9o,e8er, since the consu+er surplus at the opti+u+ is @ero, the ,hole o6 the social
surplus goes to the producer. 0his discussion is su++ari@ed in >igure H.3.
4ne ,ay a seller can personali@e price is by approaching custo+ers ,ith special
o66ers that are tailored to the custo+ersM pro6iles. *resent Internet technology aids such
personali@ation by +a-ing it easy to trac- and record custo+ersM habits and pre6erences.
46 course, it is not al,ays possible to -no, a custo+erMs eCact utility 6unction. Learning
it +ay re;uire the seller to +a-e so+e special e66ort Dadding costE. Such Oin6or+ationalM
cost is not included in the si+ple +odels o6 price discri+ination that ,e consider here.
In second degree $rice discrimination , the +onopolist is not allo,ed to tailor his o66er
to each custo+er separately. Instead, he posts a set o6 o66ers and then each custo+er can
choose the o66er he li-es best. *rices are nonlinear, being de6ined 6or di66erent ;uantities.
2 supplier ,ho o66ers O;uantity discountsM is e+ploying this type o6 price discri+ination.
46 course his pro6it is clearly less than he can obtain ,ith 6irst degree price discri+ination.
Second degree price discri+ination can be reali@ed as 6ollo,s. 0he charge 6or ;uantity ,
is set at e., < D,here , +ight range ,ithin a 6inite set o6 8alueE and custo+ers sel'select
by +aCi+i@ing u
i
.,
i
< a e.,
i
<, i 3 (R " " " R
n.
Consider the case that is illustrated in >igure H.$DaE. 9ere custo+er ( has high de+and
and custo+er 2 has lo, de+and. 2ssu+e 6or si+plicity that production cost is @ero. I6 the
+onopolist could i+pose 6irst degree price discri+ination, he ,ould +aCi+i@e his re8enue
by o66ering custo+er ( the deal O,
(
6or A C ( C C M, and o66ering custo+er 2 O,
2
6or
AM. 9o,e8er, under second degree price discri+ination, both o66ers are a8ailable to the
custo+ers and each custo+er is 6ree to choose the o66er he pre6ers. 0he co+plication is
that although the lo, de+and custo+er ,ill pre6er the o66er O,
2
6or AM, as the other o66er is
in6easible 6or hi+, the high de+and custo+er has an incenti8e to s,itch to O,
2
6or AM, since
he +a-es a net bene6it o6 ( D,hereas accepting O,
(
6or A C ( C C M +a-es his net bene6it
@eroE. 0o +aintain an incenti8e 6or the high de+and custo+er to choose a high ;uantity,
the +onopolist +ust +a-e a discount o6 ( and o66er hi+ ,
(
6or A C C . It turns out that the
Q
o66er O, 6or AM
A
+arginal cost
,D$E
,
/igure (6$ In 6irst degree price discri+ination the +onopolist eCtracts the +aCi+u+ pro6it 6ro+
each custo+er, by +a-ing each a ta-e#it#or#lea8e#it o66er o6 the 6or+ Oyou +ay ha8e , 6or A
dollarsM. 9e does this by choosing , such that u
0
., < 3 c
0
., < and then setting A 3 u., <. In the
eCa+ple o6 this 6igure the de+and 6unction is linear and +arginal cost is constant. 9ere A is the
area o6 the shaded region under the de+and 6unction , . $<.
Q
Q
,
(
D$E
,
(
6or A ] ( ] C
,
2
6or A
(
,
2
D$E
,
(
6or A ] C ] 5
,
2
6or A
(p
A
A
C
5
C
MC N 0
,
2
,
(
,
DaE
,
2
,
(
,
DbE
/igure (6% Second degree price discri+ination 6or a lo, and a high de+and custo+er. >or
si+plicity the +arginal cost o6 production is @ero. Ai8en the o66ers in DaE, custo+er ( Dthe OhighM
de+and custo+erE ,ill choose the o66er intended 6or custo+er 2 Dthe Olo,M de+and custo+erE,
unless he is o66ered O,
(
6or A C C dollarsM. 0he net bene6it o6 custo+er ( is the shaded area. 0his
+oti8ates the producer to decrease ,
2
and +a-e an o66er as in DbE, ,here (
0
C 5 \ (. 0he
opti+u+ 8alue o6 ,
2
achie8es the +ini+u+ o6 (
0
C 5, ,hich is the a+ount by ,hich the
producerMs re8enue is less than it ,ould be under 6irst degree price discri+ination.
+onopolist can do better by reducing the a+ount that is sold to the lo, de+and custo+er.
0his is depicted in >igure H.$DbE, ,here the o66ers are ,
(
6or A C 5 C C , and ,
2
6or A.
0here is less pro6it 6ro+ the lo, de+and custo+er, but a lo,er discount is o66ered to the
high de+and custo+er, i.e. in total the +onopolist does better because (
0
C 5 \ ( . 0he
opti+u+ 8alue o6 ,
2
achie8es the +ini+u+ o6 (
0
C 5, ,hich is the a+ount by ,hich the
producerMs re8enue is less than it ,ould be under 6irst degree price discri+ination.
1ore generally, the +onopolist o66ers t,o or +ore o6 8ersions o6 the ser8ice, each o6
,hich is priced di66erently, and then lets each custo+er choose the 8ersion he pre6ers. >or
this reason second degree price discri+ination is also called versioning . 2s illustrated
abo8e, one could de6ine the 8ersions as di66erent discrete ;uantities o6 the ser8ice, each o6
,hich is sold at a di66erent price per unit. So+e general properties hold ,hen the supplierMs
creates his 8ersions opti+ally in this ,ay" DiE the highest de+and custo+er chooses the
8ersion o6 lo,est price per unitR DiiE the lo,est de+and custo+er has all his surplus
eCtracted by the +onopolistR and DiiiE higher de+and custo+ers recei8e an in'ormational
rent . 0hat is, they bene6it 6ro+ ha8ing in6or+ation that the +onopolist does not Dna+ely,
in6or+ation about their o,n de+and 6unctionE.
=uantity is not the only ,ay in ,hich in6or+ation goods and co++unications ser8ices
can be 8ersioned. 0hey can be also be 8ersioned by ;uality. Interestingly, in order to create
di66erent ;ualities, a pro8ider +ight deliberately degrade a product. 9e +ight add eCtra
so6t,are to disable so+e 6eatures, or add delays and in6or+ation loss to a co++unications
ser8ice that already ,or-s ,ell. !ote that the poorer ;uality 8ersion +ay actually be the
+ore costly to produce. 2nother tric- is to introduce 8arious 8ersions o6 the products at
di66erent ti+es. Gersioning allo,s 6or an approCi+ation to personali@ed prices. 2 8ersion
o6 the good that is ade;uate 6or the needs o6 one custo+er group, can be priced at ,hat
that group ,ill pay. 4ther custo+er groups +ay be discouraged 6ro+ using this 8ersion
by o66ering other 8ersions, ,hose speci6ic 6eatures and relati8e pricing +a-e the+ +ore
attracti8e. Co++unication ser8ices can be price discri+inated by the ti+e o6 day, duration,
location, and distance.
In general, i6 there is a continuu+ o6 custo+er types ,ith gro,ing de+and 6unctions
the solution to the re8enue +aCi+i@ation proble+ is a nonlinear tari66 r ., <. Such tari66s
can be s+ooth 6unctions ,ith r .0< 3 0, ,here the +arginal price $ 3 r
0
., < depends
on
i
S
J
the a+ount , that the custo+er purchases. In +any cases, r ., < is a conca8e 6unction and
satis6ies the property that the greatest ;uantity sold in the +ar-et has a +arginal price e;ual
to +arginal cost. 4bser8e that this holds in the t,o custo+er eCa+ple abo8e. 0he largest
custo+er consu+es at a le8el at ,hich his +arginal utility is e;ual to +arginal cost, ,hich
is @ero in this case.
0he idea o6 third degree $rice discrimination is market segmentation . y +ar-et
seg+ent ,e +ean a class o6 custo+ers. Custo+ers in the sa+e class pay the sa+e
price, but custo+ers is di66erent classes are charged di66erently. 0his is perhaps the +ost
co++on 6or+ o6 price discri+ination. >or eCa+ple, students, senior citi@ens and business
pro6essionals ha8e di66erent price sensiti8ities ,hen it co+es to purchasing the latest 8ersion
o6 a 6inancial so6t,are pac-age. 0he idea is not to scare a,ay the students, ,ho are highly
price sensiti8e, by the high prices that one can charge to the business custo+ers, ,ho are
price insensiti8e. 9ence, one could use di66erent prices 6or di66erent custo+er groups Dthe
+ar-et seg+entsE. 46 course, the seller o6 the ser8ices +ust ha8e a ,ay to di66erentiate
custo+ers that belong to di66erent groups D6or eCa+ple, by re;uiring sight o6 a student id
cardE. 0his eCplains ,hy third degree price discri+ination is also called grou$ $ricing .
Suppose that custo+ers in class i ha8e a de+and 6unction o6 ,
i
. $< 6or so+e ser8ice.
0he +onopolist see-s to +aCi+i@e
n
+aC
J
$
i
,
i
. $
i
< a
c
6,
i
.g<g
i 3(
n
_
J
,
i
. $
i
< i 3(
2ssu+ing, 6or si+plicity, that the +ar-et seg+ents corresponding to the di66erent classes
are co+pletely separated, the 6irst order conditions are
$
i
.,
i
< C $
0
.,
i
<,
i
3
c
0
n
_
J
,
i
i 3(
I6 S
i
is the de+and elasticity in +ar-et i , then these conditions can be ,ritten as
g
(

n
_
$
i
.,
i
< ( C
i
3 c
0
,
i
i 3(
DH.3E
0hese results are intuiti8e. 0he +onopolist ,ill charge the lo,est price to the +ar-et
seg+ent that has the greatest de+and elasticity. In >igure H.' there are t,o custo+ers
classes, ,ith de+and 6unctions ,
(
. $< 3 H a 3 $ and ,
2
. $< 3 2 a 2 $. 0he solution to
DH.3E ,ith the right hand side e;ual to (N2 is $
(
3 'N$ and $
2
3 3N$, ,ith ,
(
3 )N2
and ,
2
3 (N$. 2t these points, S
(
3 a'N3, S
2
3 a3.
0he +ar-et seg+ent that is +ost price inelastic ,ill be charged the highest price. Si+ilar
results hold ,hen the +ar-ets are not independent and prices in6luence de+and across
+ar-ets.
2 si+ple but cle8er ,ay to i+ple+ent group pricing is through discount coupons. 0he
ser8ice is o66ered at a discount price to custo+ers ,ith coupons. It is ti+e consu+ing to
collect coupons. 4ne class o6 custo+ers is prepared to put in the ti+e and another is not.
0he custo+ers are e66ecti8ely di8ided into t,o groups by their price elasticity. 0hose ,ith
a greater price elasticity ,ill collect coupons and end up paying a lo,er price.
It is interesting to as- ,hether or not the o8erall econo+y bene6its 6ro+ third degree price
discri+ination. 0he ans,er is that it can go either ,ay. *rice discri+ination can only ta-e
place i6 di66erent consu+ers ha8e une;ual +arginal utilities at their le8els o6 consu+ption,
Q
$
(
$
2
, D$ E
,
(
D$
(
E
2 2
,
2
,
( ,
/igure (6& In third degree price discri+ination custo+ers in di66erent classes are o66ered di66erent
prices. y DH.3E the +onopolist +aCi+i@es his pro6its by charging +ore to custo+er classes ,ith
s+aller de+and elasticity, ,hich in this eCa+ple is custo+er class (.
,hich is DgenerallyE bad 6or ,el6are. ut it can increase consu+ption, ,hich is good 6or
,el6are. 2 necessary condition 6or there to be an increase in ,el6are is that there should
be an increase in consu+ption. 0his happens in the eCa+ple o6 >igure H.'. 0here are t,o
+ar-ets and one is +uch s+aller than the other. I6 third degree price discri+ination is not
allo,ed, then the +onopolist ,ill charge a high price and this ,ill discourage participation
6ro+ the s+all +ar-et. 9o,e8er, i6 third degree price discri+ination is allo,ed, he can
set the sa+e price 6or the high de+and +ar-et, and set a lo, price 6or the lo, de+and
+ar-et, so that this +ar-et no, participates. I6 his production cost is @ero, the +onopolist
increases his surplus and users in the second +ar-et obtain a non@ero surplusR hence the
o8erall surplus is increased.
(66$ #undling
We say that there is *undling ,hen a nu+ber o6 di66erent products are o66ered as a single
pac-age and at a price that di66ers 6ro+ the su+ o6 the prices o6 the indi8idual products.
undling is a 6or+ o6 8ersioning.
Consider t,o products, A and ( , 6or ,hich t,o custo+ers C
(
and C
2
ha8e di66erent
,illingness to pay. Suppose that C
(
is prepared to pay Q(00 and Q('0 6or A and ( ,
respecti8ely, and C
2
is prepared to pay Q('0 and Q(00 6or A and ( , respecti8ely. I6 no
personali@ed pricing can be eCercised, then the seller +aCi+i@es his re8enue by setting
prices o6 Q(00 6or each o6 the products, resulting in a total re8enue o6 Q$00. Suppose no,
that he o66ers a ne, product that consists o6 the bundle o6 products A and ( 6or a price o6
Q2'0. !o, both custo+ers ,ill buy the bundle, +a-ing the re8enue Q'00. .ssentially, the
bundle o66ers the second product at a s+aller incre+ental price than its indi8idual price.
!ote that Q'00 is also the +aCi+u+ a+ount the seller could obtain by setting di66erent
prices 6or each custo+er, i.e. by per6ect price discri+ination.
It is interesting that bundling reduces the dispersion in custo+ersM ,illingness to pay 6or
the bundle o6 the goods. >or each o6 the goods in our eCa+ple, there is a dispersion o6 Q'0
in the custo+ersM ,illingness to pay. 0his +eans that o8erall lo,er prices are needed to
sell the goods to both custo+ers. !o, there is no dispersion in the custo+ersM ,illingness
to pay 6or the bundle. oth are ,illing to pay the sa+e high price. 0his is the ad8antage
o6 creating the ne, product. In general, opti+al bundles are co+positions o6 goods that
reduce the dispersion in custo+ersM ,illingness to pay.
undling is co++on in the ser8ice o66erings o6 co++unication pro8iders. >or instance, it
is usual 6or an IS* to charge its subscribers a +onthly 6lat 6ee that includes an e+ail
account,
the hosting o6 a ,eb page, so+e a+ount o6 on#line ti+e, per+ission to do,nload so+e
;uantity o6 data, +essaging ser8ices, and so on. I6 each ser8ice ,ere priced indi8idually,
there ,ould be substantial dispersion in the usersM ,illingness to pay. y creating a bundle,
the ser8ice pro8ider decreases the dispersion in pay and can obtain a greater re8enue.
(66% Service 1ifferentiation and *arket Segmentation
We ha8e discussed the notion o6 +ar-et seg+entation, in ,hich the +onopolist is able to set
di66erent prices 6or his output in di66erent +ar-ets. ut can the +onopolist al,ays seg+ent
the +ar-et in this ,ayL So+eti+es there is nothing to stop custo+ers o6 one +ar-et 6ro+
buying in another +ar-et. 2t other ti+es the +onopolist can construct a barrier to pre8ent
this. 2s ,e ha8e said, he +ight sell discounted tic-ets to students, but re;uire proo6 o6
student status. Let us in8estigate these issues 6urther.
We ha8e said that one ,ay to create +ar-et seg+entation is by service di''erentiation
and 8ersioning. 0his is acco+plished by producing 8ersions o6 a ser8ice that cannot 6ully
substitute 6or one another. .ach ser8ice is speciali@ed 6or a targeted +ar-et seg+ent. >or
eCa+ple, thin- o6 a co+pany that produces alcohol. 0he +ar-ets consist o6 custo+ers that
use alcohol as a phar+aceutical ingredient and custo+ers that use it as 6uel to light la+ps.
0he +anu6acturer can seg+ent the +ar-et by adding a che+ical adulterant to the alcohol
that pre8ents its use as a phar+aceutical. I6 this +ar-et is the least price#elastic, then he
,ill be able to charge a greater price 6or the phar+aceutical alcohol than 6or the la+p 6uel.
!ote that the +arginal cost o6 producing the products is nearly the sa+e. 0he la+p alcohol
+ight actually be a bit +ore eCpensi8e, since it in8ol8es addition o6 the adulterant.
0his type o6 price discri+ination is popular in the co++unications +ar-et. 0he net,or-
operator posts a list o6 ser8ices and tari66s and custo+ers are 6ree to choose the ser8ice#
tari66 pair they li-e better. Gersioning o6 co++unication ser8ices re;uires care and +ust
ta-e account o6 substitution e66ects such as arbitrage and tra66ic splitting. 2rbitrage occurs
,hen a custo+er can +a-e a pro6it by buying a ser8ice o6 a certain type and then
repac-aging and reselling it as a di66erent ser8ice at +ar-et prices. >or instance, i6 the price
o6 a 2 1bps connection is less than t,ice the price o6 a ( 1bps connection, then
there +ay be a business opportunity 6or a custo+er to buy a nu+ber o6 2 1bps
connections and beco+e a supplier o6 ( 1bps connections at lo,er prices. 7nless there is a
substantial cost in reselling band,idth, such a pricing sche+e has serious 6la,s since no
one ,ill e8er ,ish directly to buy a ( 1bps connection. 2 si+ilar danger can arise 6ro+
tra66ic splitting. 0his ta-es place ,hen a user splits a ser8ice into s+aller ser8ices, and pays
less this ,ay than i6 he had bought the s+aller ser8ices at +ar-et prices. In our si+ple
eCa+ple, the price o6 a popular
2 1bps ser8ice could be +uch higher than t,ice the price o6 ( 1bps ser8ices. In general,
there is cost to 6irst splitting and then later reconstructing the initial tra66ic. 4ne +ust ta-e
these issues into account ,hen constructing prices 6or ser8ice contracts. >inally, ,e re+ar-
upon the role o6 content in price discri+ination. 7sually, it is practically i+possible to +a-e
prices depend on the particular content that a net,or- connection carries, 6or instance, to
di66erently price the transport o6 6inancial data and leisure content. 0he net,or- operator
is usually not allo,ed to read the in6or+ation that his custo+ers send. In any case, data
can be encrypted at the application layer. 0his +eans that it is usually not possible to price
discri+inate on the basis o6 content.
In general, ser8ice contracts are characteri@ed by +ore para+eters than ?ust the pea-
rate, such as the +ean rate and burstiness. 0his ,ea-ens the substitution e66ects since it
is not al,ays clear ho, to co+bine or split contracts ,ith arbitrary para+eters. ut the
+ost e66ecti8e ,ay to pre8ent substitution is by ;uality o6 ser8ice di66erentiation. Consider
a si+ple eCa+ple. 2 supplier +ight o66er t,o ser8ices, one ,ith s+all delay and losses,
and one ,ith greater delay. 0his ,ill di8ide the +ar-et into t,o seg+ents. 4ne seg+ent
consists o6 users ,ho need high ;uality 8ideo and +ulti+edia ser8ices. 0he other consists
o6 users ,ho need only e#+ail and ,eb bro,sing. 3epending on the di66erence in the t,o
+ar-etMs de+and elasticities, the prices that the supplier can charge per unit o6 band,idth
can di66er by orders o6 +agnitude, e8en though the +arginal costs o6 production +ight be
nearly the sa+e Dproportional to the e66ecti8e band,idth o6 the ser8ices, see Section $.HE.
.8en i6 the supplier can pro8ide the lo,er ;uality ser8ices at a ;uality that is not too
di66erent 6ro+ the high ;uality ones, it can be to his bene6it arti6icially to degrade the lo,er
;uality ser8ice, in order to +aintain a seg+entation o6 the +ar-et and retain the re8enue
o6 custo+ers in the 6irst +ar-et, ,ho +ight other,ise be content ,ith the cheaper ser8ice.
9o, about the consu+erL Can he bene6it 6ro+ ser8ice di66erentiation, or is it only a
+eans 6or a pro6it#see-ing producer to increase his pro6itL 0he ans,er is that it depends.
2 good rule o6 thu+b is to loo- at the change in the ;uantity o6 ser8ices consu+ed. I6 the
introduction o6 ne, 8ersions o6 a ser8ice sti+ulates de+and and creates ne, +ar-ets, then
both consu+er surplus and producer surplus are probably increased. 0he eCistence o6 +ore
8ersions o6 ser8ice helps consu+ers eCpress their true needs and pre6erences, and increases
their net bene6its. 9o,e8er, the cost o6 di66erentiating ser8ices +ust be o66set against this.
In net,or-s, ser8ice di66erentiation is o6ten achie8ed by gi8ing so+e custo+ers priority,
or reser8ing resources 6or the+. What +a-es the proble+ hard is that the ser8ice pro8ider
cannot co+pletely de6ine the 8ersions o6 the ser8ices a $riori, since ;uality 6actors +ay
depend on the nu+bers o6 custo+ers ,ho end up subscribing 6or the ser8ices. In the neCt
eCa+ple ,e illustrate so+e o6 these issues.
"0am'le (61 ;Loss model with service differentiation< Consider the 6ollo,ing +odel,
,hich ,e ,ill +eet again in Section ).$.(. Suppose the users o6 a trans+ission channel
are di8ided in t,o classes, each o6 si@e n. .ach user produces a strea+ o6 pac-ets, as a
*oisson processes o6 rate X. 0i+e is di8ided into unit length slots, so that in any gi8en slot
the nu+ber o6 pac-ets that a user produces is distributed as a *oisson rando+ 8ariable ,ith
+ean X. 2t +ost 3C pac-ets can be ser8ed per slot by the channel and eCcess pac-ets are
lost. Let C 3 nc, 6or so+e gi8en c. 7sers o6 the t,o classes ha8e di66erent costs 6or lost
pac-ets, o6 a
(
and a
2
per pac-et respecti8ely, ,here a
(
` a
2
. Let /
(
and /
2
be
*oisson rando+ 8ariables o6 +ean nX. I6 users share the channel and are treated on an
e;ual basis then the eCpected cost per lost pac-et is .a
(
C a
2
<N2 and so the eCpected cost
per slot is
.(N2<.a
(
C a
2
< E T /
(
C /
2
a 3C U
C
,here T, U
C
denotes +aC6, R
0g.
Suppose a greater part o6 the channel is reser8ed 6or the high#cost users. I6 channels o6
si@es 2C and C are reser8ed 6or the users o6 class ( and 2 respecti8ely, the cost is
a
(
E T /
(
a 2C U
C
C a
2
E T /
2
a C U
C
I6 n is large and a
(
is 8ery large co+pared to a
2
then this scenario has s+aller cost. 0his
6ollo,s 6ro+ the 6act that D6or large nE" 2 E T /
(
a 2C U
C
\ E T /
(
C /
2
a 3C U
C
. D*roo6 o6
this 6act is tedious and ,e o+it it here.E 9ence, creating t,o 8ersions o6 the ser8ice and
ha8ing each custo+er class use the appropriate ser8ice 8ersion increases social ,el6are.
ut ho,
can ,e discourage lo,#cost custo+ers 6ro+ using the higher ;uality ser8iceL We assu+e
there is no higher authority to dictate custo+ersM choicesR each custo+er si+ply chooses
,hiche8er ser8ice he ,ants.
*.R>.C0 C41*.0I0I4! ('(
2 price can be used to pro8ide the right incenti8es co+patibility constraints. 0he net,or-
sets up the t,o channels and puts a price o6 $ on the channel ,ith capacity 2C Dthe other
is 6reeE. 0his $ is chosen such that
a
(
E T /
(
a 2C U
C
C nX$ \ a
(
E T /
2
a C U
C
and
a
2
E T /
(
a 2C U
C
C nX$ ` a
2
E T /
2
a C U
C
2ssu+ing that n is large, these conditions ensure that it is a !ash e;uilibriu+ Das de6ined
in Section H.$.(E 6or all class ( users to select the 6irst channel and all class 2 users to select
the second channel. D!ote that at this operating point, the rate o6 cost 6or a single custo+er
o6 class ( ,ho uses the 6irst channel is a
(
E T /
(
a 2C U
C
Nn C X$, and i6 he s,itches to
the
second channel his cost beco+es a
(
E T /
0
a C U
C
N.n C (<, ,here
/
0
is *oisson ,ith +ean
2
.n C (<X. >or large n this cost is 8ery close to a
(
E T /
2
a C U
C
2
Nn.E
0hat is, there is no incenti8e 6or any class ( user to use the second channel, or 6or a class
2 user to use the 6irst channel. 0his can be co+pared ,ith the si+ilar *aris 1etro pricing
o6 Section (0.&.(.
!o, consider a priority +odel. 0here is a single channel that can ser8e up to C pac-ets
per slot. y paying $ per pac-et a user can ensure that his pac-ets are not lost unless all
pac-ets that are not lost belong to users ,ho are also paying $ per pac-et. 4ne can chec-
that there is a $ ,hich +a-es it a !ash e;uilibriu+ 6or all class ( users to pay 6or this
priority treat+ent, ,hile class 2 users do not. Social ,el6are is i+pro8ed i6
.(N2<.a
(
C a
2
< E T /
(
C /
2
a C U
C
` a
(
E T /
(
a C U
C
C a
2

E T /
(
C /
2
a C U
C
a E T /
(
a C U
C
g
i.e. i6
.(N2<.a
(
a a
2
<

2 E T /
(
a C U
C
a E T /
(
C /
2
a C U
C
g
\ 0
0his is again true as n gets large.
(6$ Perfect com'etition
We ha8e discussed the case o6 a +ar-et that is in the control o6 a pro6it#see-ing +onopolist.
0he ?ob o6 a regulator is to obtain 6or the +ar-et the bene6its o6 the +onopolistMs lo, costs
o6 production, but ,hile +aCi+i@ing social surplus. 2 regulator could i+pose prices in
a +ar-et ,ith the ai+ o6 +aCi+i@ing social surplus, sub?ect to suppliers being allo,ed
to +a-e certain pro6its. 9o,e8er, regulation can be costly and i+per6ect. It +ay also be
di66icult 6or a regulator to encourage a +onopolist to inno8ate and to o66er ne, ser8ices
and products. Interestingly, the goals o6 the regulator can be achie8ed by increasing the
co+petition in the +ar-et.
I6 there is no supplier or custo+er in the +ar-et ,ho is so do+inant that he can dictate
prices, then social surplus can still be +aCi+i@ed, but by the e66ect o6 $er'ect com$etition .
.8ery participant in the +ar-et is s+all. 2s a conse;uence he assu+es that prices are
deter+ined by the +ar-et and cannot be in6luenced by any o6 his decisions, i.e. he is a
price ta-er. Consu+er i sol8es a proble+ o6 +aCi+i@ing his net surplus, by de+anding ,
i
,
,here F u
i
.,
i
<NF ,
i
3 $. Supplier 2 sol8es a proble+ o6 +aCi+i@ing his pro6it, by
('2 C41*.0I0I4! 143.LS
supplying
y
2
, ,here F c
2
. y
2
<NF y
2
3
$.
i (
2 (
i (
, g
8
When e;uilibriu+ prices are reached, the aggregate de+and, say
*
n
3
,
i
, e;uals the
aggregate output, say
*
m
3
y
2
. I6 this ,ere not so, then so+e supplier ,ould not be able
to sell all he produces and ,ould ha8e the incenti8e to 6ind a custo+er 6or his surplus by
reducing his price to ?ust belo, the +ar-et priceR or he could produce less, reducing his
cost. 0he circu+stance in ,hich de+and e;uals supply is called market clearance. 2t the
prices at ,hich the +ar-et clears, F u
i
NF ,
i
3 F c
2
NF y
2
3 $R ,e recogni@e this as
precisely the condition 6or +aCi+i@ation o6 the social surplus
N M
" 3
J
u
i
.,
i
< a
J
c
2
.
y
2
<
sub?ect to the constraint
*
N
3
i 3(
i
*
M
2 3(
2 3(
y
2
. 2s ,e ha8e seen in Section '.$.(, the
prices at ,hich +ar-ets clear can be obtained by a tatonne+ent, i.e. an iterati8e price
ad?ust+ent.
(6$61 Com'etitive *arkets
In a +ar-et ,ith per6ect co+petition, suppliers act as com$etitive 'irms . 2 co+petiti8e
6ir+ ta-es prices as gi8en and decides ,hether to participate in the +ar-et at the
gi8en prices. Ai8en a +ar-et price $, the 6ir+ co+putes the opti+al le8el o6 output
y
a
3 arg +aC
y
T $y a c. y<U and participates by producing y
a
i6 it +a-es a positi8e
pro6it, i.e. i6 +aC
y
T $y a c. y<U ` 0.
Suppose the cost 6unction has the 6or+ c. y< 3 4 C c
8
. y<. 0he participation
condition beco+es $y
a
X 4 C c
8
. y
a
<, and since $ 3 c
0
. y
a
<, the 6ir+ ,ill participate i6
the opti+al
production y
a
is such that
c
0 a
4 C c
8
. y
a
<
8
. y < X
y
a
i.e. i6 at y
a
the +arginal cost is at least as great as the a8erage cost. 0his is sho,n in
>igure H.H. 0he +ini+u+ 8alue o6 $ 6or ,hich such a condition is +et is called the
minimum $artici$ation $rice o6 the 6ir+. !ote that the participation price depends on
,hether c.g< denotes the 6ir+Ms short#run or long#run cost 6unction. In the long#run, a
6ir+ can reorgani@e its production processes opti+ally 6or a gi8en production le8el and 6ind
it pro6itable to participate at a lo,er price than is pro6itable in the short#run.
9o, +any 6ir+s ,ill participate in a co+petiti8e +ar-etL Clearly, as +ore 6ir+s enter,
+ore output is produced, and 6or this eCtra output to be consu+ed prices +ust decrease.
0his suggests that the nu+ber o6 6ir+s ,ill reach an e;uilibriu+ in ,hich i6 one +ore 6ir+
,ere to participate in the +ar-et the price ,ould drop belo, the +ini+u+ participation
price o6 the 6ir+s. 0he e66ect o6 entry on prices is sho,n in >igure H.%.
(6$6 Lock)in
In practice, the per6ect co+petition conditions +ay not be achie8ed because o6 lockin
e66ects. Loc-#in occurs both because custo+ers pay a switching cost to change pro8iders,
and because it is costly 6or pro8iders to set up to ser8e ne, custo+ers. 9ence, e8en
though an alternati8e pro8ider +ay o66er prices and ;uality +ore attracti8e than those
o6 a custo+erMs eCisting pro8ider he +ay choose not to s,itch since he ,ill not gain
o8erall. 0he e66ect o6 loc-#in is that prices ,ill be higher than +arginal cost, and so allo,
Q
MC N cp D,E
AC N
4 ] c D,E
,
$u
A8C N
c D,E
,
,
/igure (6( In a co+petiti8e +ar-et 6ir+s +ust ta-e prices as gi8en. 9ere MC, AC and A8C are
respecti8ely the +arginal cost, a8erage cost and a8erage 8ariable cost cur8es. Suppose that i6 6ir+
participates in the +ar-et it has a 6iCed cost 4 , plus a 8ariable cost o6 c
8
., < 6or producing , .
Ai8en a price $, the 6ir+ co+putes its opti+al production le8el, , , by +aCi+i@ing its pro6it
$, a c
8
., < a 4 . 0his gi8es MC 3 c
0
., < 3 $. 0he 6ir+ starts producing only i6 it can +a-e a
pro6it.
0his gi8es a participation condition o6 $, X 4 C c
8
., <, or e;ui8alently, MC X AC, or $ X $4 . I6
the
6iCed cost 4 is sun-, i.e., has already occurred, then the participation condition is A8C X AC.
Q
y
(
D$E
$
(
$
2
$
k
$u
y
2
D$E
y
3
D$E
y
$
D$E
y
k
D$E
+ini+u+
participation price
de+and
,
/igure (6+ >or a gi8en de+and, the e;uilibriu+ price decreases as +ore 6ir+s enter the +ar-et.
9ere, y
i
. $< is the total a+ount that ,ill be supplied to the +ar-et ,hen i identical 6ir+s co+pete
and the o66ered price is $. When i 6ir+s are in the +ar-et the price $
i
that pre8ails occurs at the
intersection o6 y
i
. $< and the de+and cur8e. 0his li+its the nu+ber o6 6ir+s that enter, since they
do so only i6 the price is su66iciently high. 9ere, at +ost k 6ir+s ,ill enter the +ar-et.
ser8ice pro8iders to obtain positi8e pro6its 6ro+ custo+ers. .Ca+ples o6 s,itching costs
in co++unications include the cost o6 changing a telephone nu+ber, an e+ail account, or
,eb site addressR the costs o6 installing ne, so6t,are 6or +anaging net,or- operationR the
costs o6 setting up to pro8ide access ser8ice.
In +ass +ar-ets, such as telephony and Internet ser8ices, e8en s+all s,itching costs can
be eCtre+ely signi6icant. 2 pro8ider can +a-e signi6icant pro6its 6ro+ loc-#in and net,or-
eCternalities, and so +ay see- to gro, his net,or- rapidly in order to obtain a large
custo+er base. Since loc-#in reduces the e66ects o6 co+petition and discourages ne, 6ir+s
6ro+ entering the +ar-et, a regulator +ay see- to reduce its e66ects. 0,o eCa+ples o6
regulatory +easures that do this are the re;uire+ents that telephone nu+bers be portable
Di.e. that custo+ers can -eep their telephone nu+ber ,hen they s,itch pro8idersE, and that
custo+ers +ay choose a long#distance ser8ice pro8ider independently o6 their local access
pro8ider.
0he e66ects o6 loc-#in can be ;uanti6ied by obser8ing that, in addition to the cost o6
pro8iding ser8ice, a producer can obtain 6ro+ a custo+er eCtra re8enue that is e;ual to
his s,itching cost. We can see this ,ith the 6ollo,ing si+ple argu+ent. Suppose that in
e;uilibriu+ there are +any ser8ice pro8iders, each ,ith his o,n custo+er base. *ro8ider
i charges custo+ers $
i
per +onth o6 subscription and has 8ariable +onthly cost o6 c per
custo+er. It costs a custo+er s to s,itch pro8iders. Suppose that to entice custo+ers to
s,itch, pro8ider i o66ers a one#ti+e discount o6 d
i
to a ne,ly ac;uired custo+er. Let (00r P
be the +onthly interest rate. Ai8en a pro8ider i , suppose 2 is the pro8ider to ,ho+ it is best
6or custo+ers o6 i to s,itch i6 they do s,itch. In e;uilibriu+, no custo+er can bene6it by
s,itching 6ro+ i to 2 , and i cannot increase his charge abo8e $
i
,ithout losing custo+ers
to 2 . So ,e +ust ha8e,
$
i
C
$
i
$
2
r
3 $
2
a d
2
C s C
r
2lso, 2 +ust be pro6itable i6 custo+ers s,itch to hi+, but he cannot lo,er $
2
D,hich ,ould
entice custo+ers to s,itch to hi+ 6ro+ i E ,ithout beco+ing unpro6itable. So
$
2
a c
0hese i+ply
. $
2
a c< a d
2
C
r
3 0
. $
i
a c< C
$
i
a c
r
3 s
6or all i . 0his says that the that the present 8alue o6 a custo+er e;uals his s,itching cost,
and $
i
3 c C rsN.( C r < 6or all i .
4ne can easily generali@e this si+ple result to the case ,here cost and ;uality also di66er.
Suppose that 7
i
is the 8alue obtained by a custo+er using the ser8ice in net,or- i D,hich
di66ers ,ith i because o6 ser8ice ;ualityE, and c
i
is the cost o6 ser8ice pro8isioning in this
par# ticular net,or-. !o,, the discount d
i 2
o66ered by net,or- 2 +ay depend on the net,or-
i to ,hich the custo+er initially belongs. Si+ple calculations along the pre8ious lines sho,
that
$
i
a c
i
C
$
i
a c
i
r
3 s C
g
7
i
a 7
2
C
7
i
a 7
2

r
a
g
c
i
a c
2
C
c
i
a c
2

r
0he second ter+ on the right#hand side is the present 8alue o6 the ;uality di66erence o6
the ser8ices pro8ided by net,or-s i and 2 , and the third ter+ is the present 8alue o6 the
di66erence in their operating costs. 4bser8e that i6 the ;uality di66erence e;uals the cost
di66erence, then net,or-s i and 2 +a-es the sa+e net pro6it per custo+er.
(6% 4ligo'oly
In practice, +ar-ets are o6ten only partly regulated and partly co+petiti8e. 2 co+petiti8e
+ar-et o6 a s+all nu+ber o6 suppliers is called an oligo$oly . 0he theory o6 ga+es is ,idely
used as a tool to study and ;uanti6y interactions bet,een a s+all nu+ber o6 co+peting
6ir+s. In this section ,e describe a 6e, si+ple +odels. 0he theory o6 oligopoly in8ol8es
ideas o6 e;uilibria, cartels, punish+ent strategies and li+it pricing. 2n i+portant
+ethodology 6or oligopolies is auctions, a sub?ect ,e ta-e up in Chapter ($.
(6%61 -ames
0he reader should not be surprised ,hen ,e say that +any o6 the ideas and +odels in this
boo- can be 8ie,ed as ga+es. 0he players o6 these ga+es are net,or- ser8ice suppliers,
custo+ers and regulators. Suppliers co+pete ,ith suppliers 6or custo+ers. Custo+ers
4LIA4*4L/ (''
co+pete ,ith suppliers to obtain ser8ices at the best prices. Regulators co+pete ,ith
suppliers o8er the di8ision o6 social surplus.
0he si+plest sort o6 ga+e has ?ust t,o players. .ach player chooses a strategy, i.e. a rule
6or ta-ing the actionDsE that are a8ailable to hi+ in the ga+e. 2s a 6unction o6 the playersM
strategy choices, each player obtains a $ayo'', i.e. a re,ard D,hich +ay be positi8e or
negati8eE. In a %erosum game one playerMs re,ard is the other playerMs loss. 0he ,ell#
-no,n scissors#stone#paper ga+e is an eCa+ple o6 a @ero#su+ ga+e. In this ga+e each
player chooses one o6 three $ure strategies " scissors, stone or paper. Scissors beats paper,
,hich beats stone, ,hich beats scissors. I6 they bet Q( the ,inner gains Q( and the loser
loses Q(.
It is ,ell -no,n that a playerMs eCpected re,ard in the scissors#stone#paper ga+e
is +aCi+i@ed by using a randomi%ed strategy , in ,hich ,ith probabilities o6 (N3 he
rando+ly chooses each o6 the three possible $ure strategies " scissors, stone or paper.
3enote this strategy as l . ecause the situations o6 the players are sy++etric and the
ga+e is @ero#su+, the eCpected re,ard o6 each player is @ero ,hen each uses the opti+al
strategy l .
1any real li6e ga+es ha8e +ore than t,o players and are not @ero#su+. In +ar-ets,
both suppliers and custo+ers obtain a positi8e re,ard, other,ise the +ar-et could not
eCist. 0hus, a +ore general type o6 ga+e is one in ,hich +any players choose strategies
and then re,ards are allocated as a 6unction o6 these strategy choices. 0he su+ o6 these
re,ards +ay be positi8e or negati8e, and di66erent 6or di66erent strategy choices. >or t,o
players, the theory o6 such ga+es is si+ple. 2ssu+ing that players +ay rando+i@e o8er
their pure strategies, ,ith arbitrary probabilities, then there al,ays eCists a uni;ue pair o6
strategy choices Dpossibly o6 rando+i@ed strategiesE, such that neither player can do better
i6 he de8iates 6ro+ his strategy. 0his is the idea o6 a Nash e7uili*rium , ,hich eCtends to
ga+es ,ith +ore than t,o players, Dalthough ,ith +ore than t,o players an e;uilibriu+
+ay not eCistE. >or+ally, .l
(
R " " " R l
n
< is a !ash e;uilibriu+ o6 a n#player ga+e, i6 player
i cannot do better by de8iating 6ro+ strategy l
i
so long as player 2 uses strategy l
2
, 6or
all 2 H3 i . >or eCa+ple, in the scissors#stone#paper ga+e, .lR l < is the !ash e;uilibriu+.
I6 one player adopts the strategy l , then the other player has an eCpected re,ard o6 0
under all possible pure strategies, and so there is no incenti8e 6or hi+ to do other than
also use the strategy l .
2n eCa+ple o6 a ga+e that is not @ero#su+ is the $risoners- dilemma ga+e. In this ga+e
t,o burglars, ,ho ha8e together co++itted a robbery, ha8e been arrested and i+prisoned
by the police, and each can choose ,hether or not to betray the other ,hen inter8ie,ed.
.ach o6 the t,o prisoners iR 2 has a8ailable t,o pure strategies" OcooperateM and Ode6ectM. 2
prisoner ,hose strategy to cooperate ,ith the other prisoner re6uses to gi8e e8idence during
the interrogation. 9o,e8er, i6 his strategy is to de6ect, he helps the police incri+inate the
other prisoner and is re,arded by being granted so+e better treat+ent. .ach prisoner +ust
choose his strategy prior to the interrogation.
0he game matri, describing the possible outco+es sho,n in 0able H.(. 2n ele+ent .aR *<
indicates that prisoner ( obtains a bene6it o6 a ,hereas prisoner 2 obtains *. *risoner (
chooses the actions indeCing the ro,s ,hile prisoner 2 chooses the actions indeCing the
colu+ns o6 the +atriC. >or instance i6 prisoner ( chooses to cooperate ,hile prisoner 2
de6ects, they obtain 0 and 3 units o6 bene6it respecti8ely. 4bser8e that the strategy Ode6ect#
de6ectM is the only !ash e;uilibriu+. 2lthough the ?oint strategy Ocooperate#cooperateM
generates a higher bene6it to both, it is not a !ash e;uilibriu+, since i6 *risoner ( -no,s
that *risoner 2 ,ill cooperate then he ,ill do better by de6ecting. In 6act, this ga+e is
i
('H C41*.0I0I4! 143.LS
!able (61 0he ga+e +atriC o6 the
prisonersM dile++a ga+e. 0he only
!ash e;uilibriu+ is 6or both prisoners to
de6ect
i \ 2 cooperate de6ect
cooperate 2,2 0,3
de6ect 3,0 (,(
dominance solva*le, i.e. each player has a pure strategy, na+ely Ode6ectM, that is better 6or
hi+ than all his other pure strategies, regardless o6 ,hat pure strategy is chosen by his
opponent.
2n interesting case o6 the prisonersM dile++a occurs in the case o6 a $u*lic goods . Such
goods ha8e the property that one custo+erMs consu+ption does not reduce the a+ount
a8ailable to the other custo+ers. >or instance consider the case o6 a radio or 0G broadcast
channel o6 capacity ( . In this case, each custo+er consu+es ( indi8idually ,ithout
reducing the a+ount o6 capacity a8ailable to the other custo+ers. Si+ilar situations occur in
the case o6 street lights, 6ree,ays and bridges and in6or+ation that can be duplicated at @ero
cost. In 6act, a custo+er bene6its 6ro+ the presence o6 other custo+ers since they can share
,ith hi+ the cost o6 pro8iding the public good. 0his produces a proble+ 6or the underlying
ga+e, in that a custo+er can reason that he need not contribute to the co++on cost o6
the good i6 others ,ill pay 6or it any,ay. 0his is -no,n as the 'ree rider $ro*lem , i.e. a
custo+er eCpects other custo+ers to pay 6or a good 6ro+ ,hich he also deri8es bene6it. I6
all custo+ers reason li-e this, the public good +ay ne8er be pro8ided, ,hich is clearly a
socially undesirable outco+e. Such a situation is 6re;uently encountered in co++unications
,hen +ulticasting is in8ol8ed, and hence deser8es a +ore detailed discussion.
Suppose that t,o custo+ers ha8e utility 6unctions o6 the 6or+ u
i
. ( < C ,
i
, ,here (
is the total a+ount o6 the public good purchased Dthe band,idth o6 the broadcast lin-E,
and ,
i
is the +oney a8ailable in the ban-, i 3 (R 2. Custo+er i pays 6or *
i
units o6 the
public good, hence ( 3 *
(
C *
2
. 2ssu+e that each starts ,ith so+e initial budget ,
0
and that the co++on good cost ( per unit. 0hen, the opti+al strategy o6 player i
assu+ing that
custo+er 2 ,ill purchase a *
2
a+ount o6 public good is
+aC u
i
.*
i
C *
2
< C ,
0
a
*
i
*
i
i
4ne can sho, by doing the co+plete analysis o6 this ga+e that i6 one o6 the custo+ers, say
custo+er i , has a consistently higher +arginal utility 6or the public good Di.e. u
0
.C < ` u
0
.C <
i 2
6or all C X 0E, then the e;uilibriu+ strategy is 6or custo+er 2 to get a 6ree ride 6ro+
custo+er i . Custo+er i pays 6or the public good and custo+er 2 si+ply bene6its ,ithout
contributing. 2s a result, the public good ,ill be a8ailable in a lesser ;uantity than the
socially opti+al one.
We can also construct a si+ple ga+e in ,hich the e;uilibriu+ is 6or the public good
not to be purchased at all. Suppose the good is a8ailable in only t,o discrete ;uantities, *
and 2*, and each custo+er pays 6or either * or @ero. >or si+plicity assu+e that the t,o
custo+ers are identical, and that their utility 6unction satis6ies
0
"3 u.*< C ,
0
a * \

(
"3 u.0< C ,
0
\
2
"3 u.2*< C ,
0
a * \
3
"3 u.*< C ,
0
. 0he 6irst ine;uality states
4LIA4*4L/ ('%
that it is unecono+ical 6or a single custo+er to pro8ide * o6 the public good i6 the other
custo+er pro8ides 0. 0he last ine;uality +oti8ates 6ree riding as ,e ,ill see. We can easily
('& C41*.0I0I4! 143.LS
!able (6 2 ga+e o6 purchasing a public good.
9ere
0
\
(
\
2
\
3
. 3ue to 6ree#ridding, the
e;uilibriu+ strategy is not to purchase the public
good
i \ 2 contribute * contribute 0
contribute *
2
R
2

0
R
3
contribute 0
3
R
0

(
R
(
,rite this as a prisonersM dile++a ga+e, see 0able H.2, in ,hich OcooperateM and Ode6ectM
correspond to contributing a * or 0 respecti8ely o6 the public 4ne can easily chec- that
again Ode6ect#de6ectM is the e;uilibriu+ strategy, and so the public good is not purchased
at all.
0here are +any other eCa+ples o6 the prisonersM dile++a in real li6e. 2 +ulti#player
8ersion arises ,hen ser8ice pro8iders co+pete o8er the price o6 a ser8ice that they all
pro8ide. y 6or+ing a cartel they +ight all set a high price. ut i6 they cannot bind
one another to the cartel then none can ris- setting a high price, 6or 6ear another 6ir+
,ill undercut it. 9o,e8er, i6 the ga+e is a re$eated game, rather than a oneshot game,
a cartel can be sel6#sustaining. 0he ga+e is to be repeated +any ti+es and each player
tries to +aCi+i@e his a8erage re,ard o8er +any identical ga+es. In the cartel ga+e it is
a !ash e;uilibriu+ strategy 6or all 6ir+s to adopt the strategy" Oset the high price until a
co+petitor sets the lo, price, then subse;uently set the lo, priceM. !o 6ir+ can increase
its ti+e#a8erage re,ard by de8iating 6ro+ this strategy. 0hus the cartel can persist and it
+ay re;uire a regulator to brea- it.
In subse;uent chapters ,e discuss related notions o6 cost#sharing and bargaining ga+es
DChapter %E, the principal#agent +odel in interconnection and regulation DChapters (2
and (3E, and auctions DChapter ($E. In these +ore general ga+es there +ay be +any
!ash e;uilibriu+, or there +ay be none. I6 there are +any, then it can be help6ul to
introduce additional concepts to choose the e;uilibriu+ at ,hich the ga+e is actually
Osol8edM.
(6%6 Cournot9 #ertrand and Stackelberg -ames
We neCt turn to ga+es that +odel co+petition a+ongst a s+all nu+ber o6 ser8ice pro8iders.
0here are t,o cases to consider. In the so#called Cournot model " each supplier announces
as his strategic choice the ;uantities o6 ser8ices that he intends to supply. *rices ad?ust in
response to the aggregate supply, so that all the production can be sold, and each supplier
obtains a proportionate a+ount o6 the consu+ersM outlay.
In the second case, o6 the so#called (ertrand model , each supplier announces the prices
he intends to charge, and then custo+ers buy ser8ices ,ith pre6erence 6or lo,er prices.
oth +odels are ga+es that are played in a single round. .ach player +ust decide ,hat
to do ,ithout -no,ing ,hat other players ,ill do. 0his ga+e has a si+ple solution in
the case o6 t,o suppliers ,ith di66erent +arginal costs c
(
\ c
2
, ,hich are -no,n to both
suppliers. 0here is a continuu+ o6 !ash e;uilibria ,ith $
2
2 .c
(
R c
2
U and $
(
3 $
2
a S,
6or in6initesi+ally s+all S. 0o see this, note that gi8en that *layer ( chooses $
(
, ,ith
$
(
` c
(
, *layer 2 cannot undercut *layer ( on price ,ithout incurring a loss, so he has no
incenti8e to de8iate 6ro+ $
2
. Ai8en *layer 2 chooses $
2
, *layer ( +aCi+i@es his pro6it by
ta-ing $
(
?ust less than $
2
. 9ence supplier ( ,ill al,ays ,in, ,ith a net bene6it e;ual to
2 2
2
(
2
2
4LIA4*4L/ (')
approCi+ately $
2
a c
(
per unit sold. 0o choose a+ongst these e;uilibria ,e note that no
player ,ill ,ish to o66er a price that is less than his +arginal cost. >or *layer 2, $
2
3 c
2
do+inates the strategy $
2
3 $
0
6or all $
0
\ c
2
, i.e., the 6irst strategy is as good or better
than the second, 6or all 8alues o6 $
(
. 0hus, by i+posing the constraint $
2
X c
2
, ,e
conclude
that . $
(
R $
2
< 3 .c
2
a SR c
2
< is the e;uilibriu+ solution o6 the
ga+e.
We can also analyse the Cournot +odel. 0o illustrate so+e i+portant properties o6 the
resulting prices, ,e eCa+ine the si+plest case o6 t,o co+peting 6ir+s ,ho produce the
sa+e product. I6 6ir+ i produces output at le8el ,
i
, then the total le8el o6 production is
, 3 ,
(
C ,
2
and the resulting price in the +ar-et ,ill be $., <.
1odelling this as a one#shot ga+e, each 6ir+ +ust choose an a+ount o6 output to be
produced, and then, as a 6unction o6 both choices, recei8e a pay#o66 Dthat is his net bene6itE.
Clearly, the net bene6it o6 6ir+ i can be ,ritten
q
(
.,
(
R ,
2
< 3 $.,
(
C ,
2
<,
i
a c
i
.,
i
<
,here c.,
i
< is his cost 6or producing ;uantity ,
i
. 2 !ash e;uilibriu+ in this ga+e is a
pair o6 outputs ,
a
R ,
a
,ith the property that i6 6ir+ i chooses ,
a
then there is no
incenti8e
( 2 i
6or 6ir+ 2 to choose other than ,
a
, ,here iR 2 2 6(R 2gR i H3 2 . 0his i+plies the 6irst
order
conditions
F q
(
. ,
(
R ,
2
<NF ,
(
3 $.,
(
C ,
2
< C $
0
.,
(
C ,
2
<,
(
a c
0
.,
(
< 3 0
F q
2
. ,
(
R ,
2
<NF ,
2
3 $.,
(
C ,
2
< C $
0
.,
(
C ,
2
<,
2
a c
0
.,
2
< 3 0
0hese conditions de6ine 6or each 6ir+ i its reaction curve ,
i
.,
2
<, that is, its opti+al choice
o6 output as a 6unction o6 its belie6 about the other 6ir+Ms output ,
2
. 0he !ash e;uilibriu+
is the intersection o6 these cur8es. >or eCa+ple, suppose ,
i
is to be chosen ,ithin the
inter8al T0R (U, the in8erse de+and cur8e is $.,
(
C ,
2
< 3 ( a .,
(
C ,
2
<, and c
i
.,
i
< 3
0.
0hen ,
i
.,
2
< 3
(
.( a ,
2
< and the !ash e;uilibriu+ is at .,
(
R ,
2
< 3 .
(
R
(
<. 4ne can
sho,
2 3 3
that under reasonable assu+ptions on the de+and cur8e Dsuch as conca8ityE, the abo8e
e;uilibriu+ is al,ays stable. 0hat is, i6 the ga+e is played in +any rounds and players
alternate in choosing their output based on the pre8ious output o6 the other player, then
their outputs ,ill con8erge to the !ash e;uilibriu+ point. 0his is illustrated in >igure H.&.
(
2
,
2
(
D( W , E
2
0
0
,
2 ( (
,2
(
(H0 C41*.0I0I4! 143.LS
D(E
(
,
D2E
,
D(E
3
/igure (6, I6 the Cournot ga+e is played in +any rounds and players alternate in choosing their
output based on the pre8ious output o6 the other player, then their outputs ,ill con8erge to the !ash
e;uilibriu+ point. 9ere the in8erse de+and cur8e is $., < 3 ( a , and both players ha8e @ero costs
o6 production. Ai8en that *layer ( produces ,
.(<
, *layer 2 ,ill produce ,
.(<
. Ai8en that *layer 2
( 2
produces ,
.(<
, *layer ( ,ill produce ,
.2<
, and so on, ,ith ,
.n<
R ,
.n<
_
(
.
2 ( ( 2 3
i
i
2
(
(
i
(
2
In the case o6 n co+peting 6ir+s, the 6irst order conditions at e;uilibriu+ can be
re,ritten as
$., < .( C ,
i
N, S< 3 c
0
.,
i
< DH.$E
,here S is the price elasticity. I6 all 6ir+s ha8e sa+e cost 6unction the solution ,ill be
sy++etric and
$., < .( C (NnS< 3 c
0
., Nn< DH.'E
In this case the price is proportional to +arginal cost. 0he +ar-up depends upon the de+and
elasticity and con8erges to @ero as the nu+ber o6 co+peting 6ir+s increases to in6inity. 0his
is consistent ,ith ,hat ,e -no, about the econo+ic e66iciency o6 per6ect co+petition. y
co+parison, in the ertrand +odel, ,ith e;ual and constant +arginal costs, the co+petiti8e
e;uilibriu+ is independent o6 the nu+ber o6 co+peting 6ir+s and at a price e;ual to
+arginal cost.
In duo$oly Di.e. a +ar-et ,ith t,o 6ir+sE, the "tackel*erg model is interesting. 0his ga+e
is played in t,o steps. In the 6irst step one player +a-es a +o8e, and in the second step the
other player +o8es, ta-ing account o6 the 6irst playerMs +o8e. 0he ga+e can be played ,ith
either $rice leadershi$ or 7uantity leadershi$. Suppose 6ir+ ( is the leader, ,ho co++its
to price $. 2s abo8e, suppose ,
i
2 T0R (U, , . $< 3 ( a $, but let c
i
.,
i
< 3 ,
2
. >ir+ 2
is the 6ollo,er. 9e ,ill ta-e the leaderMs price as gi8en, undercutting it by an in6initesi+al
a+ount and choosing his output le8el, ,
2
, to +aCi+i@e $,
2
a ,
2
, gi8ing ,
2
3 $N2. >ir+
( sees residual de+and o6 ( a 3 $N2. 4ne can chec- that he +aCi+i@es his pro6it by
ta-ing $ 3 &N(' and ,
(
3 3N(', ,hence ,
2
3 $N('. In this eCa+ple, the 6ollo,er does
better than the leader.
In the ga+e o6 ;uantity leadership 6ir+ ( co++its to supply a ;uantity ,
(
. >ir+ 2
obser8es this and then chooses to supply ,
2
. We continue ,ith the +odel abo8e, but ta-e
c
i
.,
i
< 3 0. 4ne can chec- that 6or any ,
0
2 T0R (U, a !ash e;uilibriu+
is
m
( 0 0
,
(
3 ,
0
R ,
2
3 2
.( a ,
(
< R i6 ,
(
3 ,
(
( a ,
0
R i6 ,
(
H3 ,
0
( (
>ir+ 2 threatens 6ir+ ( ,ith the threat" Ochoose ,
(
3 ,
0
or I ,ill 6lood the +ar-et and
spoil it 6or us bothM. 0hus there is a continuu+ o6 !ash e;uilibria. 9o,e8er, not all threats
are actually credible. >or instance, 6or ,
0
3 (, 6ir+ 2 is threatening 6ir+ ( ,ith the threat"
Oi6 you donMt 6lood the +ar-et, I ,illM. It is hard to see ,hy this threat ,ould be +ade.
It ,ould certainly not be carried out, since i6 6ir+ ( does not choose ,
(
3 (, 6ir+ 2 has
a better response than ,
2
3 ( a ,
(
. 0o 6ind a solution a+ongst the continuu+ o6 !ash
e;uilibriu+ ,e rule out incredible threats. 0o do this, ,e consider the subga+e that is
presented to 6ir+ 2 once 6ir+ ( has chosen his output le8el ,
(
. 0he best response o6 6ir+ 2
is to choose ,
2
to +aCi+i@e ,
2
.( a ,
(
a ,
2
<, i.e., ,
2
.,
(
< 3
(
.( a ,
(
<. 0hus 6ir+ (
should
choose ,
(
to +aCi+i@e ,
(
.( a ,
(
a ,
2
.,
(
<<, ,hich gi8es ,
(
3 (N2. 0hus the strategy
pair
,
(
R ,
2
< 3 .
(
R
(
< is a !ash e;uilibriu+ 6or both the ,hole ga+e, and the subga+e that
is
2 $
presented to 6ir+ 2 once 6ir+ ( has chosen his output le8el. In general, ,e say that a set o6
strategies is a su*game $er'ect e7uili*rium i6 it is a !ash e;uilibriu+ o6 the ,hole ga+e
and e8ery subga+e. In the abo8e ga+e, 6ir+ ( does better than he does in the Cournot
ga+e and 6ir+ 2 does ,orse. 2lso, the leader does better than the 6ollo,er. 3epending on
the particular circu+stances, +a-ing the 6irst +o8e +ay or +ay not gi8e an ad8antage.
$
$
i
a
(6& A unifying social sur'lus formulation
Consider the proble+ o6 +aCi+i@ing the social ,el6are, sub?ect to the constraint that the
sup# plierMs pro6it is at least q . 0his can be 6or+ulated as the proble+ o6 +aCi+i@ing a
Lagrangian
. ., R X< 3 Tu., < a c., <U a
X
j I
q C c., < a
J
,
2
$
2
., <
2
,here u., < is the +aCi+u+ utility Dsu++ing o8er all custo+ersE obtained by consu+ing
in total , , and c., < is the +ini+u+ cost Dshared by the producersE o6 producing , .
Suppose
both u., < a c., < and
*
2
,
2
$
2
., < a c., < are conca8e in , . 0hen there eCists 6or
each
q , so+e nonnegati8e 8alue o6 X such that the solution to the constrained proble+ occurs
,here . is +aCi+i@ed. y ta-ing 3 XN.( C X<, this is at the sa+e , that sol8es
+aCi+i@e
,
Dj
I
J
,
2
$
2
., < a c.,
<
2
C .( a <
j IE
u., < a
J
,
2
$
2
., <
2
DH.HE
,here 0 g g (. I6 3 0 ,e ha8e the proble+ o6 +aCi+i@ing social ,el6are. I6 3 ( ,e
ha8e the proble+ o6 +aCi+i@ing producer pro6it. 0hus can be interpreted as a +easure
o6 the supplierMs +ar-et po,er. 2s in Section '.'.( ,e 6ind that the +aCi+u+ is ,here
F c
J
2
a
F ,
2
S
i 2
3 a DH.%E
2
$
2
>or independent goods D,hen cross#elasticities are @eroE, this e;uation is the sa+e as that
6or Ra+sey prices in D'.($E,
F c
F ,
i
DH.&E
$
i
3 a
S
i
4bser8e that DH.'E can be also obtained 6ro+ DH.&E by setting 3 (Nn. 0his suggests that
the 6or+ o6 prices resulting 6ro+ oligopoly ga+es can so+eti+es be obtained by so+e
other 6or+ulation in ,hich social ,el6are is +aCi+i@ed sub?ected to constraints on supplier
pro6its. 0his sho,s the broad applicability o6 the 6or+ o6 prices in DH.%E and DH.&E.
(6( /urther reading
2 good teCt 6or +uch o6 the +icroecono+ics presented in this chapter is Garian D())2E.
Aa+e theory is a 8ery rich sub?ect and ,e ha8e only touched upon so+e 8ery basic
ideas. 1ore about ga+e theory and +odels o6 co+petition can be 6ound in Garian D())2E
and in+ore D())2E. 0he boo-s by Barlin D()')E and Luce and Rai66a D()'%E +a-e
good introductory reading. .at,ell et al. D()&)E contains +any interesting articles. 1ore
introductory +aterial can be 6ound in the course lecture notes o6 Weber D())&E and Weber
D200(E. 4sborne and Rubenstein D())$E can be consulted 6or so+e ad8anced +aterial.
Slade D())$E considers the ;uestion at the end o6 Section H.'" O3o 6ir+s pursuing sel6ish
ob?ecti8es and beha8ing strategically act as i6 an agent ,ere +aCi+i@ing a 6ictitious#
ob?ecti8e 6unctionLM
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
Part C
Pricing
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
+
Cost#based *ricing
0his chapter is about prices that are directly related to cost. We begin ,ith the
proble+ o6 6inding cost#based prices that are 6air or stable under potential co+petition
DSections %.( :%.2E. We loo- 6or types o6 prices that can protect an incu+bent against entry
by potential co+petitors, or against bypass by custo+ers ,ho +ight 6ind it cheaper to
supply the+sel8es. We eCplain the notions o6 subsidy#6ree and sustainable prices. Such
prices are robust against bypass. Si+ilar notions are addressed by the idea o6 the second#
best core. 0he ai+ no, di66ers 6ro+ that o6 +aCi+i@ing econo+ic e66iciency. We see that
Ra+sey prices, ,hich are e66icient sub?ect to the constraint o6 cost reco8ery, +ay 6ail
sustainability tests.
In Section %.3 ,e ta-e a di66erent approach and loo- at practical issues o6 constructing
cost#based prices. !o, ,e e+phasi@e necessary and si+plicity. *rices are to be co+puted
6ro+ ;uantities that can be easily +easured and 6or ,hich accounting data is readily
a8ailable. 2n approach that has 6ound +uch 6a8our ,ith regulators is that o6 >ully
3istributed Cost pricing D>3CE. 0his is a top#do,n approach, in ,hich costs are attributed
to ser8ices using the 6ir+Ms eCisting cost accounting records. It ignores econo+ic e66iciency,
but has the great ad8antage o6 si+plicity.
Section %.3.' concerns the Long#Run Incre+ental Cost approach DLRICE. 0his is a
botto+#up approach, in ,hich the costs o6 the ser8ices are co+puted using an opti+i@ed
+odel 6or the net,or- and the ser8ice production technologies. It can co+e close to
i+ple+enting subsidy#6ree prices. We co+pare >3C and LRIC in Section %.$, 6ro+ the
8ie,point o6 the regulator, ,ho ,ishes to balance the ai+s o6 encouraging e66iciency and
co+petition, and o6 the +onopolist ,ho ,ould li-e to set sustainable prices. 0he regulator
+ay pre6er the accounting#based approach o6 >3C pricing because it is Oauto+aticM and
auditable. 9o,e8er, it +ay obscure old and ine66icient production technology or the 6act
that the net,or- has been ,rongly di+ensioned. 0hese proble+s can be re+edied by the
LRIC approach, but it is +ore costly to i+ple+ent.
>lat rate pricing is the sub?ect o6 Section %.'. In this type o6 pricing a custo+erMs charge
does not depend on the actual ;uantity o6 ser8ices he consu+es. Rather, he is charged the
a8erage cost o6 other custo+ers in the sa+e custo+er group. We discuss the incenti8es that
such a sche+e pro8ides and their e66ects on the +ar-et.
+61 /oundations of cost)based 'ricing
In Chapters ' and H ,e considered the proble+ o6 pricing in a conteCt in ,hich social
,el6are +aCi+i@ation is the o8erall ai+. We posed opti+i@ation proble+s ,ith uni;ue
(H$ C4S0#2S.3 *RICI!A
i N
solutions, each achie8ed by uni;ue sets o6 prices. 9o,e8er, ,el6are +aCi+i@ation is not
the only thing that +atters. 2 6ir+Ms prices +ust ensure that it is pro6itable, or at least
that it co8ers its costs. Cost#based pricing 6ocuses on this consideration. 7n6ortunately, a
6unda+ental di66iculty in de6ining cost#based prices is that ser8ices are usually produced
?ointly. 2 large part o6 the total cost is a co++on cost, ,hich can be di66icult to
apportion rationally a+ongst the di66erent ser8ices. 4ne can thin- o6 se8eral ,ays to
do it. So although cost#based prices +ay reasonably be eCpected to satis6y certain
necessary conditions, they di66er 6ro+ ,el6are#+aCi+i@ing prices in that they are usually
not uni;ue.
4ne necessary condition that cost#based prices ought reasonably to satis6y is that o6
6airness. So+e custo+ers should not 6ind the+sel8es subsidi@ing the cost o6 pro8iding
ser8ices to other custo+ers. I6 so, these custo+ers are li-ely to ta-e their business
else,here. 0his +oti8ates the idea o6 su*sidy'ree $rices . 2 second reasonable necessary
condition is that prices should be de6ensi8e against co+petition, discouraging the entry o6
co+petitors ,ho by posting lo,er prices could capture +ar-et share. 0his +oti8ates
the idea o6 sustaina*le $rices . I6 prices do not re6lect actual costs or they hide costs
o6 ine66icient production then they in8ite co+petition 6ro+ other 6ir+s. Since custo+ers
,ill choose the pro8ider 6ro+ ,ho+ they belie8e they get the best deal, a ga+e ta-es place
a+ongst pro8iders, as they see- to o66er better deals to custo+ers by deploying
di66erent cost 6unctions and operating at di66erent production le8els. *rices +ust be
subsidy#6ree and sustainable i6 they are to be sta*le $rices , that is, i6 they are to sur8i8e
the co+petition in this ga+e.
Interestingly, the set o6 necessary conditions that ,e +ight li-e to i+pose on prices can
be +utually inco+patible. 0hey can also be in con6lict ,ith the ai+ o6 +aCi+i@ing social
,el6are +aCi+i@ation, since they restrict the 6easible set o6 operating points, so+eti+es
reducing it to a single point.
+6161 /air Charges
Consider the proble+ o6 a single pro8ider ,ho ,ishes to price his ser8ices so that they
co8er their production cost and are 6air in the sense that no custo+er 6eels he is subsidi@ing
others. 7n6air prices lea8e hi+ susceptible to co+petition 6ro+ another pro8ider, ,ho has
the sa+e costs, but charges 6airly. Custo+ers +ight e8en beco+e producers o6 their o,n
ser8ices.
Let N 3 6(R 2R " " " R ng denote a set o6 n custo+ers, each o6 ,ho+ ,ishes to buy so+e
ser8ices. >or T that is a subset N , and let c.T < denote the +ini+al cost that could by
incurred by a 6acility that is opti+i@ed to pro8ide precisely the ser8ices desired by the set
o6 custo+ers T . We call this the standalone cost o6 pro8iding ser8ices to the custo+ers in
T . 2ssu+e that because o6 econo+ies o6 scale and scope this cost 6unction is su*additive.
0hat is, 6or all dis?oint sets T and & ,
c.T T & < c.T < C c.& <
D%.(E In the ter+inology o6 cooperati8e ga+es, c.g< is called a characteristic 'unction .
0he ser8ice pro8ider ,ants to share the total cost o6 pro8iding the ser8ices a+ongst the
custo+ers in a +anner that they thin- is 6air. Suppose he charges the+ a+ounts c
(
R " " " R c
n
.
Let us 6urther suppose that he eCactly co8ers his cost, and so
*
2
c
i
3 c. N <. 0he charges
are said to su*sidy 'ree i6 they satis6y the 6ollo,ing t,o tests"
i
S 0he charge +ade to any subset o6 custo+ers is no +ore than the stand#alone cost o6
pro8iding ser8ices to those custo+ers,
J
c
i
c.T <R 6or all T a N D%.2E
i 2T
S 0he charge +ade to any subset o6 custo+ers is at least the incre+ental cost o6 pro8iding
ser8ices to those custo+ers,
J
c
i
X c. N < c. N n T <R 6or all T a N
D%.3E
i 2T
0he reason these conditions are interesting is that i6 either D%.2E or D%.3E is 8iolated, then
a ne, entrant can attract dissatis6ied custo+ers. I6 D%.2E is 8iolated, then a 6ir+ producing
only ser8ices 6or T and charging only c.T < could lure a,ay these custo+ers. Si+ilarly, i6
D%.3E is 8iolated, then a 6ir+ producing only the ser8ices needed by N n T could charge less
6or these ser8ices than the incu+bent 6ir+. 0his happens because the incu+bent uses part
o6 the re8enue obtained 6ro+ selling ser8ices to N n T to pay 6or so+e o6 the cost o6 the
ser8ices ,anted by T . !eCt, ,e in8estigate certain 8ariations and re6ine+ents o6 the abo8e
concepts.
+616 Subsidy)free9 Su''ort and Sustainable Prices
Let re6or+ulate the ideas o6 the pre8ious section to circu+stances in ,hich charges are
co+puted 6ro+ prices. Suppose that a set o6 n ser8ices is N 3 6(R " " " R ng and an incu+bent
6ir+ sells ser8ice i in ;uantity ,
i
, at price $
i
, 6or a total charge o6 $
i
,
i
. Suppose that ,
i
is gi8en and does not depend on $ 3 . $
(
R " " " R $
n
<. We call $ a su*sidy'ree $rice i6
it satis6ies the t,o tests
J
$
i
,
i
c.T <R 6or all T a N D%.$E
i 2T
J
$
i
,
i
X c. N < c. N n T <R 6or all T a N
D%.'E
i 2T
Ine;ualities D%.$E and D%.'E are respecti8ely the standalone test and incrementalcost test .
0hey ha8e natural interpretation si+ilar to D%.2E and D%.3E. >or instance, i6 D%.$E is 8iolated
then a ne, 6ir+ could set up to produce only the ser8ices in T and sell these at lo,er
prices than the incu+bent. !ote that, by putting T 3 N , these tests i+ply
*
$
i
,
i
3 c. N <.
0hus the producer +ust operate ,ith @ero pro6it. 2lso, prices +ust be abo8e +arginal costR
to see this, consider the set T 3 6i g, i+agine that ,
i
is s+all and apply the incre+ental
cost test.
"0am'le +61 ;Subsidy)free 'rices may not e0ist< Consider a net,or- o66ering 8oice and
8ideo ser8ices. 0he cost o6 the basic in6rastructure that is co++on to both ser8ices is (0
units, ,hile the incre+ental cost o6 supplying (00 units o6 8ideo ser8ice is 2 units and
the incre+ental cost o6 supplying (000 units o6 8oice is ( unit. 0o be subsidy#6ree, the
re8enues r
(
.(00< and r
2
.(000< that are obtained 6ro+ the 8ideo and the 8oice ser8ices
+ust satis6y
2 r
(
.(00< (2R ( r
2
.(000< ((R r
(
.(00< C r
2
.(000< 3 (3
0hus, assu+ing that there is enough de+and 6or ser8ices, possible prices are 0"00H units
per 8oice ser8ice and 0"0% units per 8ideo ser8ice. !ote that such prices are not uni;ue
and they +ay not e8en eCist 6or general cost 6unctions. Suppose three ser8ices are pro#
duced in unit ;uantities ,ith a sy++etric cost 6unction that satis6ies D%.(E. Let c.6i g< 3 2"',
c.6iR 2 g< 3 3"', and c.6iR 2R kg< 3 '"', ,here iR 2R k are distinct +e+bers o6 6(R 2R 3g. 0hen
,e +ust ha8e 2 $
i
2"', 6or i 3 (R 2R 3, but also $
(
C $
2
C $
3
3 '"'. So there
are no subsidy#6ree prices. 0he proble+ is that econo+ies o6 scope are not increasing, i.e.
c.6iR 2R kg< c.6iR 2 g< ` c.6iR 2 g< c.6i g<.
9o, can one deter+ine i6 D%.$E and D%.'E are +et in practiceL 2ssu+e that a 6ir+ posts its
prices and +a-es a8ailable its cost accounting records 6or the ser8ices. It +ay be possible
to chec- D%.'E by co+puting and then su++ing the incre+ental costs o6 each ser8ice in
T Dthough this only approCi+ates the incre+ental cost o6 T because ,e neglect co++on
cost that is directly attributable to ser8ices in T E. Condition D%.$E is hard to chec-, as it
i+agines building 6ro+ scratch a ne, 6acility that is speciali@ed to produce the ser8ices in
the set T . 0his cost cannot in general be deri8ed 6ro+ the cost accounting in6or+ation o6
the 6ir+ ,hich produces the larger set o6 ser8ices N . In practice, one tries to approCi+ate
c.T <, as ,ell as possible gi8en the a8ailable in6or+ation.
0here is another possible proble+ ,ith the abo8e tests. 2lthough indi8idual outputs +ay
pass the incre+ental cost test, co+binations o6 outputs +ay not. >or eCa+ple, suppose
N 3 6(R 2R 3g. It is possible that the incre+ental cost test can be satis6ied 6or e8ery single
good, i.e. 6or T 3 6i g, 6or all i , but not 6or T 3 62R 3g. 0his could happen i6 there is a 6iCed
co++on cost associated ,ith ser8ices 2 and 3, in addition to their indi8idual incre+ental
costs, and each such ser8ice is priced at its incre+ental cost. 0hus, the tests can be di66icult
to 8eri6y in practice.
In de6ining subsidy#6ree prices ,e assu+ed that ser8ices are sold in large -no,n
;uantities Dthe ,
i
s in D%.$E and D%.'EE using uni6or+ prices, as happens ,hen incu+bent
co++unications 6ir+s supply the +ar-et. In practice, indi8idual custo+ers consu+e s+all
parts o6 each ,
i
and a coalition o6 custo+ers +ay 6eel that it can Osel6#produceM its ser8ice
re;uire+ents at lo,er cost. In this case, it is reasonable to re;uire D%.2E and D%.3E. Clearly,
such a Oconsu+er subsidy#6reeM price condition i+poses restrictions on the cost 6unction. >or
instance, i+agine a single ser8ice has a cost 6unction ,ith increasing a8erage cost. Selling
the ser8ice at its a8erage cost price 8iolates D%.3E i6 indi8idual custo+ers re;uest less than
the total that is produced, although D%.$E and D%.'E are tri8ially satis6ied 6or N 3 6(g. 2n
appropriate de6inition is the 6ollo,ing. Let us no, ,rite c., < as the cost o6 pro8iding
ser8ices in ;uantities .,
(
R " " " R ,
n
<. We say the 8ector $ is a su$$ort $rice 6or c at , i6 it
satis6ies the t,o conditions
!ote these i+ply
*
J
$
i
y
i
c. y< R 6or all y , D%.HE
i 2 N
J
$
i
%
i
X c., < c., %< R 6or all % , D%.%E
i 2 N
$
i
,
i
3 c., <. We can co+pare the+ to D%.2E and D%.3E. >or eCa+ple,
i 2 N
D%.HE i+plies that one cannot produce so+e o6 the de+and 6or less than it is sold. 0hey
i+ply D%.$E and D%.'E Dbut are +ore general since they deal ,ith arbitrary sub#;uantities o6
the 8ector , , instead o6 loo-ing ?ust at subsets o6 ser8ice typesE, and hence a support price
has all the nice 6airness properties +entioned abo8e. 2 last concern is ,hether such prices
0
i
are achie8able in the +ar-et, ,here de+and is a 6unction o6 price. Suppose $ is the 8ector
o6 support prices 6or , and, +oreo8er, , is precisely the ;uantity 8ector that is de+anded
at price $. We call such prices anonymously e7uita*le $rices . Clearly, i6 they eCist, these
ha8e a 8ery good theoretical clai+ 6or being an intelligent choice o6 cost#based prices.
2f 'rices affect demand
y allo,ing de+and to depend upon price, ,e introduce subtle co+plications. Custo+ers
+ay 6eel badly treated e8en i6 the incre+ental cost test in D%.%E is passed. >or eCa+ple,
i6 t,o ser8ices are substitutes then introducing one o6 the+ as a ne, ser8ice can reduce
the de+and 6or the other and the re8enue it produces. *rices +ay ha8e to increase i6 ,e
are still to co8er costs and this could +ean that the price o6 the pre#eCisting ser8ice has
to increase. 0his runs counter to ,hat ,e eCpect" that adding a ne, ser8ice should allo,
prices o6 pre#eCisting ser8ices to decrease because o6 econo+ies o6 scope in 6acility and
e;uip+ent sharing. I6 the prices o6 pre#eCisting ser8ices increase then custo+ers o6 these
ser8ices ,ill 6eel that they are subsidi@ing the cost o6 the ne, ser8ice.
0o see this, let T be a subset o6 N , and de6ine $
0
3 (, i 2 T , and $
0
3 $
i
, i H2
T .
i i
0hus, under price 8ector $
0
,e do not sell any o6 the ser8ices in T Dbecause their prices
are in6initeE. I6 ser8ices in T are substitutes 6or those in N n T , then ,e can ha8e, Drecalling
$
i
3 $
i
6or i 2 N n T E,
J
$
0 0
i 2 N nT
i
,
i
. $ < `
J
i 2 N
nT
$
i
,
i
. $<
i.e. ,hen $
0
is replaced by $, the introduction o6 ser8ices in T reduces the de+and 6or Dand
re8enue earned 6ro+E ser8ices in N n T . !oting that
*
$
i
,
i
. $< 3
*
$
i
,
i
. $<
*
i 2 N
nT
i 2 N
i 2T
$
i
,
i
. $<, ,e see that it is possible 6or c.g< to be such that
J
$
i
,
i
. $< ` c., . $<< c., . $
0
<< `
J
$
i
,
i
. $<
J
$
0
,
i
. $
0
<
i 2T
i 2
N
i 2 N nT
9ere the incre+ental cost test D%.%E is passed Dby the le6t hand ine;ualityE, but net additional
re8enue does not co8er additional costs Dthe right hand ine;ualityE. 0hus, the additional
costs +ust be co8ered Dat least in partE by increasing the charges le8ied on custo+ers ,ho
,ere happy ,hen only ser8ices in N n T ,ere o66ered, rather than only +a-ing charges to
custo+ers ,ho purchase ser8ices in T . 0hese 6or+er set o6 custo+ers +ay 6eel that they
are subsidi@ing the later set o6 custo+ers, and that these ne, ser8ices decrease the o8erall
e66iciency o6 the syste+. We conclude that, as a +atter o6 6airness bet,een custo+ers, the
second test condition D%.%E should ta-e account o6 de+and, and reason in ter+s o6 the net
incre+ental re8enue produced by an additional ser8ice, ta-ing account o6 the reduction o6
re8enue 6ro+ other ser8ices. In other ,ords, ser8ices are 6airly priced i6 ,hen ser8ice i is
o66ered at price $
i
the custo+ers o6 the other ser8ices 6eel that they bene6it 6ro+ ser8ice i .
0hey are happy because the prices o6 the ser8ices they ,ant to buy decrease. 0his is called
the net incremental revenue test . Let us loo- at an eCa+ple.
"0am'le +6 ;Net incremental revenue test< Suppose a 6acility costs C and there is no
8ariable cost. It initially produces a single ser8ice ( in ;uantity ,
(
3 a at price $
(
3 C Na.
0hen, a ne, ser8ice is added, at no eCtra cost, and at a price $
2
that is ?ust a little +ore
than 0. 2s a result, de+and 6or ser8ice 2 increases at the eCpense o6 de+and 6or ser8ice
(. 0o co8er the cost, $
(
+ust increase, +a-ing e8en +ore custo+ers s,itch to ser8ice 2.
2t the end, suppose that an e;uilibriu+ is reached ,here $
(
3 (0C Na, ,
(
3 0"(a and
,
2
3 0")a C *. !ote that, by our pre8ious de6inition, these prices are subsidy#6ree, and
Dal+ostE all the re8enue is collected by charging 6or ser8ice (. 0hese custo+ers Dthe ones
le6t using ser8ice (E are right to co+plain that they subsidi@e ser8ice 2, since they see their
prices increase a6ter the addition o6 the ne, ser8ice. Indeed, choosing such a lo, price
6or ser8ice 2 results in an o8erall re8enue reduction i6 prices o6 eCisting ser8ices are not
allo,ed to increase. 2 6air price ,ould be to choose $
2
in such a ,ay that the o8erall
net re8enue D-eeping the other prices, i.e. $
(
, 6iCedE ,ould increase. 0hen, the @ero pro6it
condition +ay be achie8ed by reducing the other prices and hence bene6iting the custo+ers
o6 the other ser8ices. In our eCa+ple, suppose that by setting $
2
3 $
(
and -eeping $
(
at
its initial 8alue, ,
(
beco+es aN2 and ,
2
3 aN2 C *N2. In other ,ords, hal6 the custo+ers
o6 ser8ice ( 6ind ser8ice 2 to suit the+ better at the sa+e price, and so s,itch. 0here are
also ne, custo+ers that li-e to use ser8ice 2 at that price. 0hen the net re8enue increase
beco+es $
(
*N2 ` 0R so it is possible to decrease $
(
and allo, custo+ers o6 ser8ice ( to
bene6it 6ro+ the addition o6 ser8ice 2.
>inally, consider a +odel o6 potential co+petition. I+agine an incu+bent 6ir+ sets prices
to co8er costs at the de+anded ;uantities, i.e.
J
$
i
,
i
. $< X c., . $<<
D%.&E
i 2 N
Suppose a co+petitor ha8ing the sa+e cost 6unction as the incu+bent tries to ta-e a,ay
part o6 the incu+bentMs +ar-et by posting prices $
0
,hich are less 6or at least one ser8ice.
Suppose ,
E
. $R $
0
< is the de+and 6or the ser8ices pro8ided by the ne, entrant ,hen
he and the incu+bent post prices $
0
and $ respecti8ely. Suppose that there is no $
0
and
,
0
such that
J
$
0 0 0 0
0 E 0
i 2 N
i
,
i
X c., < R and $
i
\ $
i
6or so+e i R and , , . $R $ < D%.)E
0hat is, there is no ,ay that the potential entrant can post prices that are less than the
incu+bentMs 6or so+e ser8ices and then ser8e all or part o6 the de+and ,ithout incurring
loss. *rices satis6ying this condition are called sustaina*le $rices. We ha8e yet one +ore
O6airness testM by ,hich to ?udge a set o6 prices.
0he abo8e +odel +oti8ates the use o6 sustainable prices in contestable +ar-ets. 2
+ar-et is contesta*le ,hen lo, cost Ohit#and#runM entry and eCit are possible, ,ithout
gi8ing enough ti+e to the incu+bent to react and ad?ust his prices or ;uantities he
sells. Such lo, barrier to entry is reali@ed by using ne, technologies such as ,ireless,
or ,hen the regulator prescribes that net,or- ele+ents can be leased 6ro+ incu+bents
at cost.
In the idea o6 sustainable prices ,e again see that price stability is related to e66iciency.
I6 prices are sustainable, a ne, entrant cannot ta-e a,ay +ar-et share i6 his cost 6unction
is greater than that o6 the incu+bent. 9ence sustainable prices discourage ine66icient entry.
9o,e8er, i6 a ne, entrant is +ore e66icient than the incu+bent, and so has a s+aller
cost 6unction, then he can al,ays ta-e a,ay so+e o6 the incu+bentMs +ar-et share by
posting lo,er prices. 0hus an incu+bent cannot post sustainable prices i6 he operates ,ith
ine66icient technologies.
It can be sho,n that 6or his prices to be sustainable, an incu+bent 6ir+ +ust 6ul6il a
+ini+u+ o6 three necessary conditions"
C
(. 9e +ust operate ,ith @ero pro6its.
2. 9e +ust be a natural +onopoly DeChibit econo+ies o6 scaleE and produce at +ini+u+
cost.
3. 9is prices 6or all subsets o6 his output +ust be subsidy 6ree, i.e. 6ul6il the stand#alone
and incre+ental cost tests.
0he last re+ar- pro8ides one +ore +oti8ation to use the subsidy#6ree price tests to detect
potential proble+s ,ith a gi8en set o6 prices.
Ramsey 'rices
7n6ortunately, there is no straight6or,ard recipe 6or constructing sustainable prices.
Constructing socially opti+al prices that are sustainable is e8en harder. 9o,e8er, under
conditions that are 6re;uently encountered in co++unications, Ra+sey prices can be
sustainable. Recall that Ra+sey prices +aCi+i@e social ,el6are under the constraint o6
reco8ering cost. 2gain ,e see a connection bet,een co+petition and social e66iciency" in
a contestable +ar-et, i.e. under $otential com$etition, incu+bents ,ill be +oti8ated to use
prices that +aCi+i@e social e66iciency ,ith no need o6 regulatory inter8ention.
9o,e8er, Ra+sey prices are not al,ays sustainable. 0hey are certainly not sustainable
i6 any ser8ice, say ser8ice (, is priced belo, its +arginal cost and there are econo+ies o6
scale. 0o see this, note that re8enue 6ro+ ser8ice ( does not co8er its o,n incre+ental cost
since by conca8ity o6 the cost 6unction ,
(
$
(
\ ,
(
F c NF ,
(
\ c., < c..0R ,
2
R " " " R ,
n
<<.
So a supplier ,ho co+petes on the sa+e set o6 ser8ices and ,ith the sa+e cost 6unction can
+ore than co8er his costs by electing not to produce ser8ice (. 26ter doing this, he can
slightly lo,er the prices o6 all the ser8ices that are priced abo8e their +arginal costs, so as
to obtain all that de+and 6or hi+sel6 and yet still co8er his costs.
"0am'le +6$ ;Ramsey 'rices may not be sustainable< Whether or not Ra+sey prices
are sustainable can depend on ho, ser8ices share 6iCed costs, i.e., on the econo+ies o6
scope. Consider a +ar-et in ,hich there are custo+ers 6or t,o ser8ices. 0he producerMs
cost 6unction and de+and 6unctions 6or the ser8ices are
(N2 (N2
(0
$
c.,
(
R ,
2
< 3 2',
(
C 20,
2
C 4 R ,
(
. $< 3 ,
2
. $< 3
.(0 $<
2
0he Ra+sey prices are sho,n in 0able %.(. When the 6iCed cost 4 is H the Ra+sey prices
are not sustainable e8en though they eCceed +arginal cost. 0he re8enue 6ro+ ser8ice 2 is
(H)"$' and this is enough to co8er the su+ o6 its o,n 8ariable cost and the entire 6iCed
cost, a total o6 (H2"%H. 0his +eans that a pro8ider can o66er ser8ice 2 at a price less than the
Ra+sey price o6 2"%H and still co8er his costs. In 6act, he can do this 6or any price greater
than 2"H2. 9o,e8er, i6 the 6iCed cost is 30 this is no, great enough that it is i+possible to
co8er costs by pro8iding ?ust one o6 the ser8ices alone at a lo,er price.
(
9ence, in this case,
the Ra+sey prices are sustainable. 0he lesson is that Ra+sey prices +ay be sustainable i6
all ser8ices are priced abo8e +arginal cost and the econo+ies o6 scope are great enough.
(
0he other possibility 6or a ne, entrant is to pro8ide both ser8ices at lo,er prices. ut it is i+possible to lo,er
both prices and still co8er costs. I6 all prices are lo,er the consu+er surplus +ust increase. Since ,e re;uire
the producer surplus to re+ain nonnegati8e, and it ,as @ero at our Ra+sey prices, this ,ould i+ply that the
social ,el6are K ,hich is the su+ o6 consu+er and producer surpluses K ,ould increaseR this +eans ,e could
not ha8e been at the Ra+sey solution.
!able +61 Ra+sey prices +ay or +ay not be sustainable
> 3 H > 3 30
i 3 ( i 3 2 i 3 ( iN2
Ra+sey price, $
i
3.(& 2.%H 3.$H 2.H$
3e+and, ,
i
'%.'& H(.$$ ''.(& '&.)H
1arginal cost (.H' (.2& (.H& (.30
Re8enue, ,
i
$
i
(&3.02 (H).$' ()(.02 (%&.2H
Gariable cost (&).%0 ('H.%H (&'.%( ('3.'%
Gariable cost C 4 ()'.%0 (H2.%H 2('.%( (&3.'%
0o sho, ho, the eCistence o6 co++on cost plays a 8ital role in the sustainability o6
Ra+sey prices, ,e can construct a si+ple eCa+ple out o6 >igure '.'.
"0am'le +6% ;Common cost and sustainability of Ramsey 'rices< Suppose that t,o
ser8ices are produced ,ith sa+e stand#alone cost 6unction A C *, . >irst, consider the
case in ,hich there is no econo+y o6 scope, and hence the total cost is the su+
o6 the stand#alone cost 6unctions. Since both ser8ices are produced at e;ual ;uantities
,
i
3 ,
2
3 , ,e ha8e , . $
i
C $
2
< 3 2. A C *, < ,hich i+plies , $
i
\ A C *, \
,$
2
. ut A C *, is the stand#alone cost 6or ser8ice 2 , ,hich 8iolates the
sustainability conditions.
!o, suppose that there are econo+ies o6 scope and the 6iCed cost A is co++on to both
ser8ices. 0hen , . $
i
C $
2
< 3 A C 2*, , and since $
i
` * ,e obtain ,$
2
C *, \ A C 2*, .
0his i+plies ,$
2
\ A C *, , ,hich is the stand#alone cost 6or ser8ice 2 . 9ence, the
eCistence o6 co++on cost is 8ital 6or Ra+sey prices to be sustainable. 4bser8e that, in this
particular case, any a+ount o6 co++on cost, A, ,ill +a-e Ra+sey prices sustainable. In
general, as suggested by .Ca+ple %.3, large 8alues o6 A ensure sustainability.
+616$ Sha'ley =alue
Let us no, lea8e the sub?ect o6 prices and return to the si+ple +odel at the start o6 the
chapter, in ,hich cost is to be 6airly shared a+ongst n custo+ers. 0he pro8iderMs charging
algorith+ could be coded in a 8ector 6unction ,hich di8ides c. N < as .c
(
R " " " R c
n
<
3
g

(
. N <R " " " R
n
. N <
g
. Let us suppose that .T < is de6ined 6or an arbitrary subset T a
N ,
and codes the ,ay he ,ould di8ide the cost o6 c.T < a+ongst the +e+bers o6 the subset
T i6 he ,ere to pro8ide ser8ices to only this subset o6 custo+ers. Clearly, .6i g< 3 c.6i g<
being the stand#alone cost 6or ser8ing only custo+er i .
Suppose that T a N and iR 2 are distinct +e+bers o6 T . I6
2
.T <
2
.T n 6i g< `
0, then custo+er 2 pays +ore than he ,ould pay i6 custo+er i ,ere not being ser8ed.
9e +ight argue this ,as un6air, unless custo+er i can counter#argue that he is at least
as disad8antaged because o6 custo+er 2 . ut then i6 custo+er i is not to 6eel aggrie8ed
then he +ust see si+ilarly that custo+er 2 is at least as +uch disad8antaged. *utting this
all together re;uires

i
.T <
i
.T n 6 2 g< 3
2
.T <
2
.T n 6i g<
D%.(0E
4n the other hand, i6
2
.T <
2
.T n 6i g< \ 0, then custo+er 2 is better o66
because custo+er i is also being ser8ed. Custo+er i +ight 6eel aggrie8ed unless he
bene6its at least as +uch 6ro+ the 6act that custo+er 2 is present. ut then custo+er
2 ,ill 6eel
4rder
2, , C
2
(

(
C
(
0otal 2 ' ((
aggrie8ed unless he bene6its at least as +uch 6ro+ custo+er i Ms presence. So again, ,e
+ust ha8e D%.(0E.
Surprisingly, there is only one 6unction ,hich satis6ies D%.(0E 6or all T a N and
iR 2 2 T . It is called the "ha$ley value, and its 8alue 6or player i is the eCpected incre+ental
cost o6 pro8iding his ser8ice ,hen pro8ision o6 the ser8ices accu+ulates in rando+ order.
It is best to illustrate this ,ith an eCa+ple.
"0am'le +6& ;Sharing the cost of a runway< Suppose three airplanes 2, , C share a
run,ay. 0hese planes re;uire (, 2 and 3 -+ to land. So a run,ay o6 3 -+ +ust be built.
9o, +uch should each payL We ta-e their re;uire+ents in the siC possible orders. Cost is
+easured in units per -ilo+eter.
2dds cost
2, C, ( 0 2
, 2, C 0 2 (
, C, 2 0 2 (
C, 2, 0 0 3
C, , 2 0 0 3
So they should pay 6or 2NH, 'NH and ((NH -+, respecti8ely.
!ote that ,e ,ould obtain the sa+e ans,er by a calculation based on sharing co++on
cost. 0he 6irst -ilo+eter is shared by all three and so its cost should be allocated
as .(N3R (N3R (N3<. 0he second -ilo+eter is shared by t,o, so its cost is allocated as
.0R (N2R (N2<. 0he last -ilo+eter is used only by one and so its cost is allocated as
.0R 0R (<. 0he su+ o6 these 8ectors is .2NHR 'NHR ((NH<. 0his happens generally. Suppose
each custo+er re;uires so+e subset o6 a set o6 resources. I6 a particular resource is re;uired
by k custo+ers, then Dunder the Shapley 8alue paradig+E each ,ill pay one#kth o6 its cost.
0he intuition behind the Shapley 8alue is that each custo+erMs charge depends on the
incre+ental cost 6or ,hich he is responsible. 9o,e8er, it is subtle, in that a custo+er is
charged the eCpected eCtra cost o6 pro8iding his ser8ice, incre+ental to the cost o6 6irst
pro8iding ser8ices to a rando+ set o6 other custo+ers in ,hich each other custo+er is
e;ually to appear or not appear.
0he Shapley 8alue is also the only cost sharing 6unction that satis6ies 6our aCio+s,
na+ely, D(E all players are treated sy++etrically, D2E those ,hose ser8ice costs nothing are
charged nothing, D3E the cost allocation is *areto opti+al, and D$E the cost sharing o6 a su+
o6 costs is the su+ o6 the cost sharings o6 the indi8idual costs. >or eCa+ple, the cost
sharing o6 an airport run,ay and ter+inal is the cost sharing o6 the run,ay plus the cost
sharing o6 the ter+inal. 0he Shapley 8alue also gi8es ans,ers that are consistent ,ith other
e66iciency concepts such as !ash e;uilibriu+.
0he Shapley 8alue need not satis6y the stand#alone and incre+ental cost tests, D%.2E and
D%.3E. 9o,e8er, one can sho, that it does so i6 c is su*modular , i.e. i6
c.T k & < C c.T T & < c.& < C c.T < R 6or all T R & a N
D%.((E 0he reader can pro8e this by loo-ing at the de6inition o6 the Shapley 8alue and
using
an e;ui8alent condition 6or sub+odularity, that ta-ing the +e+bers o6 N in any order,
say iR 2R kR " " " R v , ,e +ust ha8e
c.6i g< X c.6iR 2 g< c.6 2 g< X c.6iR 2R kg< c.6 2R kg< X g g g X c. N < c. N 6i g<
!ote that choosing T and & dis?oint sho,s that sub+odularity is consistent ,ith c.g< being
subadditi8e, i.e. D%.(E.
+616% !he Nucleolus
0he Shapley 8alue has gi8en us one ,ay to allocate charges and it is +oti8ated by a nice
story o6 argu+ent and counterargu+ent. 9o,e8er, there are other stories ,e can tell. Let
us call c an im'utation o6 cost Di.e., an assign+ent o6 costE i6
J
c
i
3 c. N < and c
i
c.6i g< R 6or all i
i 2 N
0hat is, the pro8ider eCactly co8ers his costs and no custo+er is charged +ore than his
stand#alone cost.
We no, suggest a reasonable condition that the i+putation c should satis6y. Suppose
that 6or all i+putations c
0
and subsets T a N such that
*
c
0
\
*
c
i
there eCists
so+e & a N Dnot necessarily dis?oint 6ro+ T E such that
i 2T i i 2T
J
c
0
J J
i
J
i 2&
i
`
i 2&
c
i
and
i 2&
c
0
c.& < `
i 2T
c
i
c.T <
So i6 a set o6 custo+ers T pre6ers an i+putation c
0
Dbecause their total charge is lessE, then
there is al,ays so+e other set o6 custo+ers & ,ho can ob?ect because
S under c
0
the total charge they pay is +ore, i.e.
*
c
0
`
*
c
i
, and
i 2& i i 2&
S they pay under c
0
a greater incre+ent o8er their stand#alone cost, c.& <, than T pays
under c o8er its stand#alone cost, c.T <.
so & argues that T should not ha8e a cost#reduction at & Ms eCpense.
0hen c is said to be in the nucleolus Do6 the coalitional ga+eE. It is a theore+ that
the nucleolus al,ays eCists and is a single point. 0hus the nucleolus is a good candidate
6or being the solution to the cost#sharing proble+. In the run,ay#sharing eCa+ple, the
nucleolus is .(N2R (R 3N2<. !ote that it is not the sa+e as the Shapley cost allocation o6
c 3 .2NHR 'NHR ((NH<. 0he 6act that c is not the nucleolus can be seen by ta-ing T 3 6 (R C
g and c
0
3 .3NHR 'NHR (0NH<. 0here is no & that can ob?ect to this.
What ,ould ha8e happened i6 ,e had si+ultaneously tried to satis6y the conditions o6
both the nucleolus and Shapley OstoriesM L 0he ans,er is that there ,ould be no solution.
0he lesson in this is that O6airM allocations o6 cost cannot be uni;uely#de6ined. 0here are
+any de6initions ,e +ight choose, and our choice should depend on the sort o6 un6airnesses
that ,e are trying to a8oid. We no, end this section ,ith a 6inal story.
+616& !he Second)best Core
0hus 6ar ,e ha8e +ostly been allocating cost ,ithout paying attention to the bene6it that
custo+ers obtain. Surely, it is 6air that a custo+er ,ho bene6its +ore should pay +ore. We
end this section ,ith a cost sharing proble+ that ta-es account o6 the bene6it that custo+ers
obtain.
i 3(
coalition
"
(
2
N
/igure +61 0he second#bestS core. 0he +onopolist 6iCes $ s.t. $
`
, c., < X 0, ,here , is the
aggregate de+and, , 3
*
N
,
i
. $<, and c., < is the cost o6 producing , . 0he entrant targets a
subset o6 custo+ers " ,ho he ,ishes to ,oo. 9e chooses $
"
s.t. . $
"
<
`
,
"
c.,
"
< X 0, ,here
,
"
3
*
i "
,
i
. $
"
<, and such that the incenti8e co+patibility condition holds, C "
i
. $
"
< X C "
i
.
$<,
6or
2
all
i
2 ". We say $ is in the second#best core i6 an entrant has no such
i
possibility.
Suppose any subset o6 a set o6 custo+ers N is 6ree to bypass a +onopolist by producing
and supplying the+sel8es ,ith goods, at a cost speci6ied by the sub#additi8e cost 6unction
c D,hich is the sa+e as the +onopolistMs cost 6unctionE. 0his subset +ust choose a price
,ith ,hich to allocate the ?ointly produced goods a+ongst its +e+bers. 2 price 8ector $ is
said to be in the second*est core i6 there is no strict subset o6 custo+ers " ,ho can choose
prices $
0
so that they co8er the costs o6 their de+ands at price $
0
and all +e+bers o6 "
ha8e at least the net bene6it that they did under $. We eCpress this as the re;uire+ent that
* *
i
g*
i
g
i 2 N
2
$
2
,
2
. $< X
c
i 2 N
, . $<
and there is no " m N , and $
0
such that both
* *
2
,
i 0
g*
i 0
g
i "
i 2"
2
$
0
2
. $ < X c
, . $ <
2
and
u
i
.,
i
. $
0
<<
*
2
$
0
,
i
. $
0
< X u
i
.,
i
. $<<
* $
2
,
i
. $< R 6or all i 2 "
2 2 2 2
See also, >igure %.(.
We can see that 6ro+ the ,ay that second#best core prices are constructed that they are
also Ra+sey prices. 0hey +aCi+i@e the net bene6it o6 the custo+ers in the set N sub?ect
to cost reco8ery, ,hich is also ,hat Ra+sey prices do. 9o,e8er, although Ra+sey prices
al,ays eCist 6or the large coalition, they +ay be unstable, since s+aller coalitions +ay be
able to pro8ide incenti8es 6or custo+ers to lea8e the large coalition. 9ence second#best
core prices +ay not eCist.
0here is a subtle di66erence in the assu+ptions underlying sustainable prices and second#
best core. In the second#best core +odel a custo+er ,ho is a +e+ber o6 a coalition " +ust
buy all his ser8ices 6ro+ the coalition and nothing 6ro+ the outside. So a success6ul entrant
+ust be able to co+pletely lure a,ay a subset o6 custo+ers, ". 0his is in contrast to the
sustainable price +odel, ,here a custo+er +ay buy ser8ices 6ro+ both the +onopolist and
the ne, entrant.
0his di66erence +eans that sustainable prices are ;uite di66erent to second#best core
prices. *rices that are stable in the sense o6 the second#best core +ay not be stable i6 a
custo+er is allo,ed to split his purchases. 2lso, prices that are not sustainable because a
co+petitor +ay be able to price a particular ser8ice at a lesser price +ay be stable in the
second#best core sense, since the net pro6it o6 custo+ers that s,itch to the ne, entrant
can be less. In the second#best core +odel custo+ers +ust buy bundles o6 ser8ices and the
price o6 the bundle o66ered by the entrant could be +ore.
In conclusion to this section, let us say that ,e ha8e described a nu+ber o6 criteria by
,hich to ?udge ,hether custo+ers ,ill see a proposed set o6 costs as 6air, and presenting
i
no incenti8e 6or bypass or sel6#supply. 2nony+ously e;uitable prices are attracti8e, but
they +ay not eCist. We ,ould not li-e to clai+ that one o6 these +any criteria is the
+ost practical or use6ul in all circu+stances. Rather, the reader should thin- o6 using these
criteria as possible ,ays o6 chec-ing ,hat proble+s a proposed set o6 prices +ay or +ay
not be present.
+6 #argaining games
2nother approach to cost#sharing is to let the custo+ers bargain their ,ay to a solution.
+661 NashAs #argaining -ame
Suppose that the cost o6 supplying , is c., <, , 2 / . 9ere, , is the +atriC , 3 .,
i 2
<,
,here ,
i 2
is the ;uantity o6 ser8ice 2 supplied to custo+er i . Custo+er i is to pay a portion
o6 the cost, c
i
. Let us code all possible allocations o6 output and cost as y 2 ; , ,here
y 3 ., R c
(
R " " " R c
n
<, ,ith , 2 / and
*
c
i
3 c., <. Suppose that, a6ter ta-ing into
account
the cost he pays, custo+er i has utility at y o6 u
i
. y<. 0he custo+ers are to bargain their
,ay to a choice o6 point u in the set & 3 6.u
(
. y<R " " " R u
n
. y<< " y 2 ; g, ,hich ,e call
the
*argaining set . It is reasonable to suppose that & is a con8eC set, since i6 u and u
0
are in
& then the utilities o6 any point on the line bet,een the+ can be achie8ed Din eCpected
8alueE by rando+i@ing bet,een u and u
0
.
0o begin, suppose that there are ?ust t,o players in the bargaining ga+e. In6inite rounds
o6 bargaining are to ta-e place until a point in & is agreed. 2t the 6irst round, player (
proposes that they settle 6or .u
(
R u
2
< 2 & . *layer 2 can accept this, or +a-e a
counterproposal
.8
(
R 8
2
< 2 & at the second round. !o,, player ( can accept that proposal, or +a-e a ne,
proposal at the third round, and so on, until so+e proposal is accepted. We assu+e that
both players -no, & . !ote that only proposals corresponding to points on the northeast
boundary o6 & need be considered, i.e. the players should restrict the+sel8es to *areto
e66icient points o6 & .
Rounds are s +inutes apart. Let us penali@e procrastination by saying that i6 bargaining
concludes at the nth round, then the utility o6 player i is reduced by a +ultiplicati8e 6actor o6
eCp. .n (<s
i
<. I6
(
and
2
di66er then the players ha8e di66erent urgencies to settle.
!ote that this ga+e is stationary ,ith respect to ti+e, in the sense that at e8ery odd
nu+bered round both players see the sa+e ga+e that they sa, at round (, and at e8ery e8en
nu+bered round they see the sa+e ga+e that they sa, at round 2. 0hus player ( can
decide at round
( ,hat proposal he ,ill +a-e at e8ery odd nu+bered round and +a-e eCactly the sa+e
proposal e8ery ti+e, say .u
(
R u
2
<. Si+ilarly, player 2 can decide ,hether he ,ill e8er
accept this proposal, and i6 not, ,hat he ,ould propose at the e8en nu+bered rounds, say
.8
(
R 8
2
<. !o, there is no point in player ( +a-ing a proposal that he -no,s ,ill not be
accepted. So, gi8en 8
2
, he +ust choose u
2
X e
s
2
8
2
. ut he need not o66er +ore than
necessary 6or his proposal to be accepted, and so he does best 6or hi+sel6 ta-ing a u
such that u
2
3 e
s
2
8
2
. Si+ilar reasoning 6ro+ the 8ie,point o6 player 2 i+plies that 8
(
3 e
s
(
u
(
.
In su++ary,
u
2
3 e
s
2
8
2
and 8
(
3 e
s
(
u
(
D%.(2E
Let u and 8 be the t,o points on the boundary o6 & 6or ,hich D%.(2E holds. 2 possible
strategy 6or player 2 is to propose .8
(
R 8
2
< and accept player (Ms proposal i6 and only i6 he
,ould get at least u
2
. 2 possible strategy 6or player ( is to propose .u
(
R u
2
< and
accept
i
i
2RA2I!I!A A21.S (%'
Du
(
, u
2
E
u
2
bargaining solution point
Duu
(
, uu
2
E
D
(
,
2
E
&
u
(
u
2
N
(
,
2
N constant
u
(
/igure +6 !ashMs argaining ga+e. 0,o players o6 e;ual bargaining po,er are to settle on a
point in & . 0he !ash bargaining solution is at the point in & ,here the product u
(
u
2
is +aCi+i@ed.
player 2Ms proposal i6 and only i6 he ,ould get at least 8
(
. 0he reader can chec- that this
is a pair o6 e;uilibriu+ strategies, in the sense that player i can do no better i6 he changes
his strategy ,hile player 2 Ms strategy re+ains 6iCed, 2 H3 i . 0he e;ualities in D%.(2E
also i+ply that 6or all s,
u
(N
(
(N
2
(N
(
(N
2
(
u
2
3 8
(
8
2
"
0his +eans that the t,o points lie on a cur8e ,here u
(N
(
u
(N
2
is constant. Recall that s is
( 2
the nu+ber o6 +inutes bet,een rounds o6 bargaining. We see 6ro+ D%.(2E that as s _ 0,
u
i
and 8
i
tend to the sa+e 8alue, say b . 2ssu+ing & is a closed and con8eC set, b +ust
u
i
u
be the point on the boundary o6 & at ,hich u
(N
(
u
(N
2
is +aCi+i@ed. >igure %.2 illustrates
( 2
this 6or
(
3
2
3 (. .;ui8alently, ,riting ,
i
3 (N
i
, this is ,here u 2 & +aCi+i@es
,
(
log u
(
C ,
2
log u
2
. !ote that i6 player ( has less urgency to settle, i.e.,
(
\
2
, then
he has the stronger bargaining position, ,hich is re6lected in log u
(
being +ultiplier by a
greater ,eight than is log u
2
. 0here is a +ore subtle analysis that one can +a-e o6 this ga+e
to pro8e that the solution ,e ha8e 6ound is also the uni;ue subga+e per6ect e;uilibriu+.
I6 there are +ore than t,o players, then it is reasonable to as- that at the solution point
b b u
n
<, ,e should ha8e that 6or each pair i and 2 the 8alues o6 b R b
+aCi+i@e
u 3 .u
(
R " " " R b u
i
u
2
u
(N
i
(N
2
u , k iR 2 . 0his condition is satis6ied i6 ,e ta-e u
i
u
2
sub?ect to u 2 & and u
k
3 b
k
H3
b
as the point in & ,here
*
,
i
log u
i
is +aCi+i@ed. We ,ill +eet this again, as O,eighted
proportional 6airnessM, in Section (0.(.
0he Nash *argaining solution is usually de6ined ,ith
i
the sa+e 6or all i . 2dditionally,
,e suppose that i6 bargaining brea-s do,n then the players obtain utilities d
(
R " " " R d
N
. 0he
solution to the !ash bargaining ga+e .d R & < says that
u should be chosen in & to +aCi+i@e
N /
.u
i
d
i
< D%.(3E
i 3(
0he generali@ation in ,hich u should +aCi+i@e
=
.u
i
d
i
<
,
i
co+es 6ro+ i+agining that
i6 u is chosen then there are actually ,
i
players ,ho accrue bene6it u
i
. 0hus the choice o6
u
i
a66ects ,
i
players and the choice o6 u
2
a66ects ,
2
players. I6 ,
i
` ,
2
there is +ore
Obargaining po,erM in6luencing the choice o6 u
i
than u
2
. 0here are se8eral other ,ays to
+oti8ate the solution D%.(3E, including the 6ollo,ing aCio+atic approach.
(%H C4S0#2S.3 *RICI!A
Let ' .d R & < be a 6unction that deter+ines the agree+ent point o6 the bargaining ga+e
.d R & <. 0hat is, u 3 ' .d R & <. It is de6ined as ' .d R & < 3 d i6 they cannot agree.
0he players +ight at least agree that ' should be consistent ,ith the 6ollo,ing OrulesM.
Rather surprisingly, i6 they do, then one can pro8e that D%.(3E +ust characteri@e ' "
(. Pareto o$timality. I6 ' .d R & < 3 u, then there can be no 8 2 & such that 8 X
u and 8
i
` u
i
6or at least one i . In other ,ords, the agree+ent point +ust be on
the boundary o6 & .
2. "ymmetry. I6 d
(
3 g g g 3 d
N
and & is sy++etrical about the line u
(
3 g g g 3 u
N
,
then '
(
.d R & < 3 g g g 3 '
N
.d R & <.
3. .inear invariance. I6 any player, say (, decides to de6ine a di66erent point as his point
o6 0 utility, and<or to linearly rescale the units in ,hich he +easures his utility, then
the bargaining solution is essentially unchanged. It beco+es trans6or+ed in the
natural ,ay. 0hat is, i6 d
0
3 .a C*d
(
R d
2
R " " " R d
N
< and &
0
3 6.a C*u
(
R u
2
R " " " R u
N
< " u 2 & g, then '
(
.d
0
R &
0
< 3 a C *'
(
.d R & <, '
2
.d
0
R &
0
< 3 '
2
.d R & <, 2 3
2R " " " R N .
$. !nde$endence o' irrelevant alternatives. I6 & m &
0
, ' .d R &
0
< 3 u and u 2 & ,
then ' .d R & < 3 u. 0his says that i6 the set & is increased to &
0
and u is the solution
,ithin &
0
, but u happens to lie in & , then it +ust also be the solution 6or the
bargaining ga+e .d R & <.
"0am'le +6( ;A merger of two firms< Suppose 6ir+ ( is a cable operator ,ho pro8ides
both cable local access and cable 0G content. Suppose 6ir+ 2 is a pro8ider o6 an Internet
portal ser8ice. oth ha8e custo+ers and they intend to +erge, since they eCpect the +erger
o6 the t,o businesses to be ,orth +ore than they are separately. Suppose that separately
they are ,orth d
(
and d
2
, and together they ,ill be ,orth d
3
, ,here d
3
` d
(
C d
2
. 9o,
+uch should the 8alue o6 the ne, 6ir+ be distributed 6airly a+ongst the o,ners o6 the t,o
6ir+s at +ergerL 0he !ash bargaining paradig+ suggests that they should recei8e u
(
R u
2
,
,here these +aCi+i@e .u
(
d
(
<.u
2
d
2
<, sub?ect to u
(
C u
2
3 d
3
Dassu+ing both o,ners
ha8e linear utilitiesE. 0his gi8es u
i
3 d
i
C .d
3
d
(
d
2
<N2, i 3 (R 2.
>or eCa+ple, suppose d
(
3 (0, d
2
3 20 and d
3
3 $0. 0he !ash solution is u 3 .('R 2'<.
.ach gets hal6 o6 the added#8alue. !ote that this is the sa+e as in the Shapley allocation.
>ir+ ( ,ould be considered to bring d
(
or d
3
d
2
depending on ,hether he adds 8alue
6irst or second. 0he a8erage o6 these is d
(
C .d
3
d
(
d
2
<N2.
+66 Dalai and SmorodinskyAs #argaining -ame
46 course, there are other reasonable aCio+s that could be agreed. Suppose rule $ o6 the
aCio+s speci6ying the solution o6 the !ashMs bargaining ga+e is replaced by a +onotonicity
condition ,hich says that i6 & is increased then no one +ust be ,orse o66. 1ore precisely,
use instead the rule
'. Monotonicity. Suppose & m &
0
, and 6or all i
sup6u
i
" u 2 &
0
g 3 sup6u
i
" u 2 & g
and 6or 2 H3 i
sup6u
2
" u
i
X t R u 2 &
0
g X sup6u
2
" u
i
X t R u 2 & gR 6or all t
0hen '
2
.d R &
0
< X '
2
.d R & < 6or all 2
*RICI!A I! *R2C0IC. (%%
H3 i .
(%& C4S0#2S.3 *RICI!A
0his is the +alai and "morodinsky *argaining game. It turns out that there is precisely
one ,ay to satis6y aCio+s (:3 and '. Let m
i
3 sup6u
i
" u 2 & g and m 3 .m
(
R " " " R m
N
<. 0hen ' .d R & < +ust be the point in & on the line ?oining d to m ,hose .uclidean
distance to m is least.
Consider again .Ca+ple %.H. 0he !ash solution is u 3 .('R 2'<. 0he Balai and
S+orodins-y solution is u 3 .(HR 2$<. Just as ,e sa, in our discussion o6 Shapley 8alue
and nucleolus solutions, there can be +ore than one solution concept. !ote that there is no
solution concept that obeys all the OreasonableM aCio+s (:'.
+6$ Pricing in 'ractice
1any +ethodologies ha8e been proposed 6or assigning costs to ser8ices. 1ost o6 the+
6ollo, basic co++on principles and are +oti8ated by the re;uire+ents o6 6airness and
stability that ha8e been +entioned in Section %.(. 0hey di66er in the details o6 ho, they
de6ine and assign costs. We start ,ith a brie6 o8er8ie, o6 the practical proble+s and
+ethodologies. We eCa+ine 8arious types o6 cost, the accounting bases 6or de6ining costs,
and +ethods 6or +apping the costs o6 input 6actors to costs o6 ser8ices.
+6$61 4verview
In the pre8ious sections ,e ha8e characteri@ed the properties that prices should possess i6
they are to be stable under co+petition. 9o,e8er, this has not pro8ided us ,ith a recipe
6or constructing prices. In practice, ,e do not -no, the co+plete cost 6unction. 0hat is,
,e do not -no, the cost o6 producing any arbitrary bundle o6 ser8ices. We -no, only
the current cost o6 producing the bundle o6 ser8ices that is presently being sold. 2nother
practical di66iculty is that +ost o6 the cost +ay be co++on cost, ,hich cannot be attributed
to any particular ser8ice so 6ar as the accounting records sho,. >or eCa+ple, accounting
records +ay not sho, part o6 a +aintenance cre,Ms cost as attributed to pro8iding a 8ideo#
con6erencing ser8ice. 7sually only a s+all part o6 the total cost is co+prised o6 6actors
that can be attributed to a single ser8ice. 0his is a +a?or proble+ ,hen trying to construct
cost#based prices.
In practice, ,e can identi6y so+e -ey principles that are closely related to concepts o6
6airness. 0hese include the principles o6 cost causation Dthe cost o6 a ser8ice should be
related as +uch as possible to the cost o6 the 6actors that are consu+ed by the ser8iceE,
o*2ectivity Dthe cost o6 the ser8ice should be related to the cost 6actors in an ob?ecti8e ,ayE,
and trans$arency Dthe cost o6 a ser8ice should be related to the cost 6actors in a clear and
6or+ulaic +anner, and so that it can be easily chec-ed 6or possible inconsistenciesE.
0he 6irst t,o o6 these principles are di66icult to i+ple+ent since, as ,e ha8e co++ented
abo8e, the accounting records usually attribute only a s+all part o6 the total cost to
indi8idual ser8ices, and so the greatest part o6 the cost, i.e., the co++on cost, +ay be
unattributed. 4ne solution is to +a-e each ser8ice pay 6or part o6 the co++on cost. 0his is
the >ully 3istributed Cost D>3CE approach that ,e in8estigate in Section %.3.3.
7n6ortunately, the di8ision o6 the co++on cost a+ongst the ser8ices is rather ad hoc. Since
co++on cost accounts 6or a large proportion o6 the cost, prices can be Ocoo-edM in +any
,ays, +a-ing certain prices arti6icially large or s+all.
0he de6inition o6 subsidy#6ree prices suggests that a reasonable ,ay to construct the
price o6 a ser8ice Dactually a lo,er bound on the priceE is to calculate the incre+ental
cost o6 the ser8ice. 0his clearly includes the directly attributable cost 6ro+ the accounting
c
>3C
c
>3C
*RICI!A I! *R2C0IC. (%)
records. 2lthough the su+ o6 the incre+ental costs o6 the ser8ices still lea8es so+e co++on
cost unaccounted 6or, this part o6 the co++on cost is +uch s+aller than that ,hich is le6t
o8er a6ter considering only the directly attributed costs. 0his restricts the range that possible
prices +ay ta-e i6 they are to a8oid cross#subsidi@ation. Let us see this through an eCa+ple.
Suppose that a 6actory produces t,o tourist sou8enirs, one o6 ,ood and one o6 bron@e.
0he only 6actors that are directly attributed to the production o6 the sou8enirs are the
;uantities o6 ,ood and bron@e consu+ed, say W and ( , ,ith respecti8e costs c.W < and
c. ( <. 4ther 6actors that are used in producing the sou8enirs are considered to be co++on
cost. 0hese are ;uantities o6 labour and electricity, say . and E , ,ith costs c.. < and c. E
<. 0here is a single accounting record 6or each, and no in6or+ation on ho, to attribute
these costs to the production o6 the sou8enirs. 9o, should ,e split the o8erall cost so
as to
de6ine the cost o6 each productL
I6 ,e use >3C, ,e +ust 6ind a ,ay to split the co++on cost, i.e, ,e +ust de6ine the
coe66icients
l
and
e
, ,hich in turn de6ine the cost o6 production o6 ,ooden and bron@e
sou8enirs to be
,
., < 3 c.W < C
l
c.. < C
e
c. E <
*
. y< 3 c. ( < C .(
l
<c.. < C .(
e
<c. E <
,here , and y are the ;uantities o6 ,ooden and bron@e arti6acts produced. !ote that i6 the
cost o6 labour and electricity are substantial co+pared to the cost o6 ,ood and bron@e, then

l
and
e
play a signi6icant role in deter+ining the ite+sM prices D,hich are 6ound 6or each
product by di8iding the cost o6 production by the nu+ber o6 ite+s producedE. 0his approach
can produce prices that are not subsidy#6ree. >or instance, suppose ,e ta-e
l
3
e
3 0.
0hen the cost o6 the bron@e sou8enirs that +ust be reco8ered is c. ( < C c.. < C c. E <,
and this probably eCceeds than the stand#alone cost o6 producing the sa+e ;uantity o6
bron@e sou8enirs on their o,n.
0here are 8arious approaches to reducing the a+ount o6 unattributed co++on cost. 0hey
are o6 8arying di66iculty and cost o6 i+ple+entation. 0he incre+ental cost approach needs
to calculate the di66erence bet,een the cost o6 the 6acility that produces both types and
the cost o6 the 6acility that produces a single type. Suppose that c
,R*
., R y< is the cost o6
a 6acility that can produce both types and it operates at production le8els , R y. Si+ilarly,
c
,
., < and c
*
. y< are the costs o6 6acilities that are opti+i@ed to produce only ,ooden
or bron@e arti6acts at production le8els, , and y, respecti8ely. 0hen the incre+ental costs
are
c
incr incr
,
., < 3 c
,R*
., R y< c
*
. y< R c
*
. y< 3 c
,R*
., R y< c
,
., <
D%.($E
0he proble+ is that the accounting records hold only the actual cost c
,R*
., R y<.
.8aluating c
,
., < or c
*
. y< re;uires creati8e thin-ing. Could ,e use c
,R*
., R 0< instead
o6 c
,
., <L 0he ans,er is probably not. 0he 6actory ,as built to produce the products
si+ultaneously, and +any design decisions ,ere ta-en to opti+i@e the ?oint production.
0his i+plies that c
,R*
., R 0< is greater than c
,
., <. 1oreo8er, calculations o6 c
,R*
., R 0<
6ro+ the accounting records +ay be 8ery inaccurate. 0his is because the only ;uantity that
is related to producing ,ooden sou8enirs and is easy to co+pute 6ro+ accounting records
is c
,R*
., R y< c. ( <. 9o,e8er, c
,R*
., R y< c. ( < is greater than c
,R*
., R 0<, because it
includes all the co++on cost Delectricity and labourE as i6 both sou8enirs ,ere produced
in ;uantities , R y Dsince ,eM8e only subtracted the directly attributable costE. 7sing c
,R*
.,
R y< c. ( < as a proCy 6or c
,
., < in D%.($E ,ill lead to an underesti+ate o6 the
(&0 C4S0#2S.3 *RICI!A
incre+ental cost o6 bron@e sou8enirs and to an o8eresti+ate o6 the stand#alone cost o6
,ooden sou8enirs.
0here are t,o solutions to this proble+. 0he 6irst is the so#called *ottomu$ a$$roach ,
in ,hich each stand#alone cost is co+puted 6ro+ a +odel o6 the +ost e66icient 6acility
that speciali@es in the production o6 that one product, using current technology. 0hus, ,e
construct c
,
., < and c
*
. y< 6ro+ scratch, by building +odels o6 6ictitious 6acilities
that produce ?ust one or the other o6 these products. 0his contrasts ,ith the approach o6
>3C, ,hich is a to$down a$$roach , in that it starts 6ro+ the gi8en cost structure o6 the
eCisting 6acility and atte+pts to allocate the cost that has actually incurred to the 8arious
products. 0he +ethodology o6 LRICC, ,hich ,e +ention later, has been traditionally
associated ,ith a botto+#up approach.
0he second solution is to adopt a to$down a$$roach, but atte+pt to reduce the
unaccounted#6or co++on cost. 4ne ,ay to do this is to re6ine the accounting records,
-eeping +ore in6or+ation on ho, the co++on cost is generated. 0here are se8eral ,ays
to do this. 0he activity*ased costing approach de6ines se8eral inter+ediate acti8ities that
contribute to the production o6 the end products.
.Ca+ples o6 acti8ities related to co++unication net,or-s are repair, operation, net,or-
+anage+ent, consu+er support, and so on. 0he cost o6 each such acti8ity can be co+puted
6ro+ accounting in6or+ation about the a+ounts o6 the input 6actors that are consu+ed by
each acti8ity, usually gathered through ;uestionnaires. >or eCa+ple, ,e ,ould -eep trac-
o6 ho, +any +an#hours o6 labour are used 6or repair. 0his allo,s 6or a large part o6 the
cost o6 labour to be attributed to speci6ic acti8ities and so be subtracted 6ro+ the co++on
cost Dthough so+e co++on cost ,ill al,ays re+ainE.
!o,, since each acti8ity could be contributing to the production o6 a nu+ber o6 end
products, ,e need to say 6or each product ,hat percentage o6 each acti8ity this product
consu+es. 0his can be done 6airly accurately by +onitoring the operation o6 the 6acility,
and logging appropriate in6or+ation. 0his acti8ity#based approach is a re6ine+ent o6 the
>3C approach. y drastically reducing the unaccounted#6or co++on cost, it reduces the
inaccuracy that ste+s 6ro+ the ad hoc splitting o6 that cost.
In the 6ollo,ing sections ,e re6ine so+e o6 the abo8e concepts. We start by pro8iding
use6ul de6initions concerning the 8arious types o6 cost 8ie,ed 6ro+ di66erent perspecti8es.
+6$6 1efinitions Related to the Cost /unction
In this section ,e re+ind the reader o6 se8eral i+portant de6initions and concepts
concerning the cost 6unction that ,e use in our pricing approach.
0he cost o6 a particular ser8ice can be di8ided into direct cost and indirect cost . 3irect
cost is the part o6 the cost that is solely attributed to the particular ser8ice and ,ill cease to
eCist i6 the ser8ice is not produced. Indirect cost is other cost that is related to the pro8ision
o6 the ser8ice. 0he 6ollo,ing should be noted"
S 2 cost +ay ha8e a direct relation ,ith a ser8ice, but no accounting in6or+ation is -ept
to ;uanti6y it. Such a cost can beco+e direct cost by re6ining the accounting syste+.
S 2 cost +ay arise 6ro+ the pro8ision o6 a group o6 ser8ices and there +ay be a logical
,ay to speci6y the percentage o6 the cost that is related to the pro8ision o6 each ser8ice.
0his is called an indirectly attri*uta*le cost . >or eCa+ple, consider a telephone s,itch
that is used by both local and long#distance calls. 4ne could +easure the nu+bers o6
calls o6 each type that use the s,itch, and di8ide the cost o6 the s,itch proportionally
bet,een the+.
S 2n unattri*uta*le cost is one that cannot be straight6or,ardly di8ided a+ongst the
ser8ices. 2n eCa+ple is the cost o6 the co+panyMs +anage+ent.
0he ;uantity Dand hence costE o6 a speci6ic 6actor +ay be 6iCed, or it +ay 8ary ,ith the
a+ount o6 ser8ice produced. 0he 'i,ed cost o6 a ser8ice is the su+ o6 all 6actor costs that
re+ain constant ,hen the ;uantity o6 the ser8ice changes. >or eCa+ple, the cost o6 the
buildings +ay be a 6iCed cost in pro8iding long#distance calls. 8aria*le cost is the cost o6
those 6actors ,hose ;uantities depend on the a+ount o6 the ser8ice produced. >or eCa+ple,
in producing ,ooden sou8enirs, the cost o6 ,ood is a 8ariable cost. !ote that direct and
indirect cost 6actors can contribute to either the 6iCed or the 8ariable cost o6 a ser8ice.
Is the cost o6 the building really a 6iCed costL I6 a 6ir+ reduces its output, then it +ight
rent a s+aller building and reduce its costs. 0hus ,hether a cost is 6iCed or 8ariable
depends upon the ti+e 6ra+e o8er ,hich the 6ir+ is allo,ed to re#opti+i@e its production
capabilities. In the short run, reducing output ,ill not allo, 6or re#opti+i@ation o6 6acilities
and so the cost o6 the present 6acilities is a 6iCed cost. In the long run it is 8ariable cost.
0his suggests that ,e de6ine the shortrun incremental cost 6or an increase in output o6 (,
as the increase in total production cost re;uired 6or this increase in output ,hen the 6ir+
+ay not re#opti+i@e its production procedures. Si+ilarly, the longrun incremental cost
is the increase in cost re;uired ,hen the 6ir+ +ay re#opti+i@e its production procedures.
Clearly the long#run incre+ental cost is al,ays less than the short#run incre+ental cost.
0he Dshort#run or long#runE +arginal cost is the incre+ental cost ,hen (, is 8ery s+all.
In the sa+e ,ay, consider a ser8ice that is produced in an a+ount , . We can de6ine the
short and the long#run incre+ental cost o6 this ser8ice as the di66erence bet,een the cost o6
producing it in an a+ount , and not at all. !ote that ,hen de6ining subsidy#6ree prices ,e
did not +ention the type o6 the incre+ental cost in8ol8ed. 7sing long#run incre+ental cost
restricts the possible prices to a s+aller inter8al and re6lects +ore accurately the situation
in a co+petiti8e +ar-et in ,hich 6ir+s can reorgani@e and re#opti+i@e their production
6acilities to beco+e +ore e66icient. 0his is the rational 6or using long#run incre+ental
cost in D%.($E.
2nother use6ul notion is average cost R it is obtained by di8iding the cost by the ;uantity
o6 ser8ice produced. In general, the short#run a8erage cost decreases due to econo+ies o6
scale, but beyond a certain le8el o6 production it increases because 6actors that cannot be
changed in the short run produce ine66iciencies De.g. lac- o6 space at the production 6acility
produces congestionE.
In +any cases, ,hen ,e tal- about cost reco8ery in the conteCt o6 a regulated 6ir+, ,e
do not i+ply that the 6ir+ +ust +a-e @ero accounting pro6its but that it +ust +a-e @ero
econo+ic pro6its. 0he cost ,hich +ust be reco8ered through prices re6ers to the econo+ic
cost o6 the 6ir+. 0hat +eans that the total cost that should be reco8ered includes, apart 6ro+
the cost registered in the accounting boo-s o6 the 6ir+, also a reasonable rate o6 return on
the capital e+ployed. 0he inclusion o6 this reasonable pro6it +argin +a-e it possible 6or
the co+pany to i+pro8e, to +a-e ne, in8est+ents and also to co+pensate its shareholders.
9o,e8er, this return is not as such to per+it the co+pany to create super pro6its, but only
pro6its that e;ual to the econo+ic cost o6 capital or, in other ,ords, the opportunity cost o6
capital under the speci6ic ris- conditions.
?istoric and current costs
2n accounting syste+ can use historic cost or current cost to assign costs to 6actors.
9istoric cost is easier to use since it is the actual a+ount paid to purchase the 8arious
6actors De;uip+ent, etcE. Such in6or+ation is readily a8ailable in the accounting records o6
the 6ir+. 0ogether ,ith depreciation in6or+ation it can be used to co+pute the yearly cost
o6 the e;uip+ent.
Current cost Dthe eCact ter+inology being Ocurrent cost 6or +odern e;ui8alent assetsME is a
co+pletely di66erent notionR it re6lects the cost o6 the e;uip+ent i6 it ,ere bought today. Cur#
rent cost can be hard to de6ine since technological inno8ation +a-es older e;uip+ent obso#
lete. !e, e;uip+ent ,ould be +ore capable and e66icient. 4ne should ta-e this into account
and rescale cost appropriately. >or eCa+ple, i6 ne, s,itches ha8e double the capacity o6 in#
stalled s,itches then the current cost o6 an installed s,itch ,ould be hal6 that o6 a ne, one.
7sing current costs 6or co+puting the depreciation o6 net,or- e;uip+ent leads to lo,er
prices than using historic costs, due to technology i+pro8e+ents. 0his is a +ain reason they
are 6a8oured by regulators. 4bliging a 6ir+ to use prices based on current costs +oti8ates
the 6ir+ to +aintain and operate an e66icient net,or-, using state#o6#the#art technology,
since other,ise cost reco8ery +ay not be possible. 2 proble+ ,ith current costs is that
they are not directly a8ailable in the accounting syste+ o6 the 6ir+ and +ust be constructed
by specialists. In that sense, accounting syste+s based on current costs are not as ob?ecti8e
and can be audited only by eCperts Dand hence are less OauditableME.
Interestingly enough, in so+e cases, historic costs +ay lead to lo,er prices_ We see
this ,hen co+puting prices 6or renting the use o6 the local loop to co+petitors that ,ould
li-e to sell high#band,idth access ser8ices o8er the local loop Dthe copper ,ire pair that
connects the pre+ises o6 custo+ers to the telephone net,or-E. DSee also the discussion
about unbundling in Section %.3.'E. In +ost locations the local loop net,or- belongs to
eCisting incu+bent operators Dtelephone co+paniesE, is +any years old and is already
largely depreciated. 4n a historic cost basis the price o6 renting the local loop ,ould be
nearly @ero. 0his contrasts ,ith the price that should be charged i6 a current cost basis is
used. 2lthough ne, technology, such as 6ibre and ,ireless, can help to reduce costs and
i+pro8e per6or+ance, the cost o6 the access ser8ice in such a net,or- +ay be substantially
greater than the incu+bent operatorMs historic cost. Should the regulator be pre6er lo,er
prices and hence use o6 historic costsL 2lthough these can increase co+petition and lead
to lo,er prices to consu+ers, they ha8e so+e serious dra,bac-s. 0hey do not pro8ide
incenti8es 6or alternati8e access net,or-s o6 ne,er technologies to be built by other
operators, since such net,or-s ,ill ha8e to charge higher prices Dbased on current costsE,
and so be less co+petiti8e. 2lso such lo, prices +ay not pro8ide enough incenti8es to the
incu+bent operator to i+pro8e and +aintain the access net,or-, and the ;uality o6 the
ser8ices sold ,ill probably deteriorate. >or these reasons, regulators pre6er the use o6
current costs 6or pricing such ser8ices, e8en i6 these lead to higher prices.
!ote that botto+#up +odels are naturally co+bined ,ith current costs Dsince the net,or-
+odel is built 6ro+ scratchE, ,hile top#do,n +odels such as >3C are naturally co+bined
,ith historic costs 6ound in the accounting records. In the neCt sections ,e in8estigate
+ethodologies 6or assigning costs to ser8ices.
+6$6$ !he /ully 1istributed Cost A''roach
We ha8e already +entioned that a 8irtue o6 the >ully 3istributed Cost D>3CE approach is
its si+plicity in directly relating prices to in6or+ation that is a8ailable in the accounting
and billing syste+ o6 the 6ir+. Such in6or+ation can be easily chec-ed 6or its accuracy,
,hich +a-es an >3C costing +odel audita*le. 0he idea o6 the >3C approach is to si+ply
di8ide the total cost that the 6ir+ incurs a+ongst the ser8ices that it sells. 0his can be
+ade a +echanical process" a progra+ ta-es the 8alues o6 the actual costs o6 the 8arious
operating 6actors and co+putes 6or each ser8ice its corresponding portion o6 the total cost.
0he para+eters o6 the progra+ are the coe66icients used to di8ide the costs o6 the input
6actors a+ongst the ser8ices produced.
i
( 2 Ser8ices
0.& 0.2
0.$ 0.H
( 2 3 $ ' H
input 6actors
co++on cost
pool (
co++on cost
pool 2
/igure +6$ In the >3C approach the cost o6 input 6actors are assigned to ser8ices. >or eCa+ple,
ser8ice ( is assigned 0"& o6 the cost 6actors in the 6irst cost pool and 0"$ o6 the cost 6actors in the
second cost pool. 0he di66erent co++on cost pools and the coe66icients 6or sharing the cost o6 the
co++on 6actors are de6ined by the designer o6 the syste+.
0he >3C approach is illustrated in >igure %.3. 0he idea is to put all the cost o6 6actors
that are not uni;uely identi6ied ,ith a single ser8ice into a nu+ber o6 co++on cost pools.
Since only a s+all part o6 the cost is directly attributable to a single ser8ice +ost o6 the cost
,ill be co++on cost. !eCt, one de6ines coe66icients to apportion the co++on cost a+ong
the ser8ices, in a ,ay that +ay depend on the particular co++on cost pool. Since there
is no other in6or+ation a8ailable in the accounting syste+ Das in the case o6 an acti8ity
based +odel in8estigated neCtE, such a 6unction +apping cost 6actors to cost o6 ser8ices is
constructed in a rather ad hoc ,ay.
>or+ally, suppose ser8ice i is produced in ;uantity y
i
and has a 8ariable cost GC
i
. y
i
<
that is directly attributable to that ser8ice. 0here is a shared cost SC. y<, y 3 . y
(
R " " " R y
n
<, that is attributable to all ser8ices, and ,hich 6or si+plicity ,e assu+e is assigned to
a single cost pool. 0he price 6or the ;uantity y
i
o6 ser8ice i is de6ined to be its cost, i.e.
$
i
. y
i
< 3 GC
i
. y
i
< C
i
SC.
y<
,here
*

i
3 (. 0he price per unit is de6ined as $
i
3 $
i
. y
i
<N y
i
. 0he
i
s +ay
be chosen in 8arious ,ays" as proportions o6 8ariable costs, ;uantities supplied, or
re8enue,
i.e. proportional to GC
i
. y
i
<, y
i
or y
i
$
i
.
Clearly, once the coe66icients
i
are de6ined, then the construction o6 the prices is tri8ial
and can be done auto+atically using accounting data. 0his a8oids building a +odel o6
the 6acility 6ro+ scratch as re;uired by the botto+#up +odels. 3ue to its si+plicity and
the ability to audit the price constructing procedure, >3C pricing has been popular ,ith
net,or- operators and regulators, at least in the early days o6 the price regulation process
in the co++unications +ar-et.
9o,e8er, there are a nu+ber o6 proble+s ,ith >3C pricing. >irst, there is no reason
that the prices constructed are in any sense opti+al or stable. 2 +a?or reason is that the
coe66icients 6or apportioning the co++on cost 6actors are constructed in so+e arbitrary
,ay, ,ithout ta-ing into account i+portant in6or+ation about the operation o6 the 6acility.
Second, these prices hide potential ine66iciencies o6 the net,or- such as eCcess capacity,
out#o6#date e;uip+ent, ine66icient operation, bad routing and resource allocation. 0his is
because there is no ,ay to trac- do,n the actual reasons that certain prices 6or ser8ices
are eCceedingly high.
0he re6ine+ent o6 the >3C +odel through the de6inition o6 acti8ities helps to lin-
+ore accurately a larger part o6 the co++on cost to particular ser8ices, and so i+pro8es
0
,
l
0
0
0
0
0
0
0
the subsidy#6ree properties o6 the resulting pricing sche+e. 2lso ,hen a price is higher
than anticipated, one can, in principle, trace the acti8ities in8ol8ed and 6ind potential
ine66iciencies. 46 course, there is al,ays the possibility that prices +ay be arti6icially high
due to the particular choice o6 the apportioning coe66icients in splitting the co++on acti8ity
cost. 0he 6ollo,ing eCa+ple helps to clari6y this issue and +oti8ate the acti8ity#based
+odel described in +ore detail in Section %.3.$.
Consider, as abo8e, a 6acility that produces ,ooden and bron@e sou8enirs, ,ith the cost
6unction
c. y
,
R y
*
< 3 s
'
,
'
C s
l
.,
l
C a
,
y
,
C a
*
y
*
< C s
,

,
y
,
C s
*

*
y
*
D%.('E
,here s
'
is the per unit cost o6 the 6iCed 6actor ,
'
De.g., the cost o6 the buildingE, s
l
is the
per unit cost o6 the labour 6actor, s
,
, s
*
are the per unit costs o6 ,ood and bron@e
respecti8ely,
0
is the 6iCed a+ount o6 labour that is consu+ed independently o6 the production De.g.
secretarial supportE, a
,
and a
*
are coe66icients that relate the le8els o6 production o6 the
sou8enirs to the a+ount o6 consu+ed labour that is directly attributed to the production,
and
,
and
*
relate these le8els o6 production to the a+ount o6 ra, +aterials consu+ed.
!ote that s
'
,
'
C s
l
,
l
is a 6iCed cost, ,hereas .s
l
a
,
C s
,

,
< y
,
C .s
l
a
*
C s
*

*
< y
*
is
a
8ariable cost.
Consider 6irst the case o6 si+ple >3C pricing ,ithout acti8ity de6initions and no eCplicit
accounting in6or+ation on ho, labour e66ort is spent. In this case, GC. y
,
< 3 s
,

,
y
,
, GC. y
*
< 3 s
*

*
y
*
, the co++on cost is the re+aining part SC. y
,
R y
*
< 3 s
'
,
'
C s
l
.,
l
C
a
,
y
,
C a
*
y
*
<, and the >3C prices are o6 the 6or+
$
,
. y
,
< 3 s
,

,
y
,
C
,
Ts
'
,
'
C s
l
.,
l
C a
,
y
,
C a
*
y
*
<U
D%.(HE
$
*
. y
*
< 3 s
*

*
y
*
C .(
,
<Ts
'
,
'
C s
l
.,
l
C a
,
y
,
C a
*
y
*
<U
D%.(%E
!o, suppose t,o acti8ities are de6ined, related to the production o6 the sou8enirs. In
each acti8ity, there is eCact accounting o6 the labour e66ort re;uired 6or the production o6
each sou8enir. !o, GC. y
,
< 3 .s
l
a
,
C s
,

,
< y
,
, GC. y
*
< 3 .s
l
a
*
C s
*

*
< y
*
, and
the
co++on cost is reduced to SC. y
,
R y
*
< 3 s
'
,
'
C s
l
,
l
. 0he resulting >3C prices are
$
,
. y
,
< 3 .s
l
a
,
C s
,

,
< y
,
C
,
.s
'
,
'
C s
l
,
l
<
D%.(&E
$
*
. y
*
< 3 .s
l
a
*
C s
*

*
< y
*
C .(
,
<.s
'
,
'
C s
l
,
l
<
D%.()E
We can +a-e the 6ollo,ing obser8ations"
(. 0he prices in the si+ple >3C approach less accurately relate prices to actual costs.
Suppose, 0 q a
,
\\ a
*
. 0hat is, ,ooden sou8enirs are eCtre+ely easy to
construct and the greater part o6 labour e66ort is spent on bron@e sou8enirs. Let there
be e;ual sharing o6 the co++on cost, so 3 (N2. 0hen the price o6 ,ooden
sou8enirs in D%.(HE subsidi@es the production o6 bron@e sou8enirs as it pays 6or a
substantial part o6 the labour 6or +a-ing the+. 0his cross#subsidi@ation disappears in
D%.(&E.
2. Suppose that the 6acility is built ine66iciently and that the a+ount o6 building space
is larger than ,ould be re;uired i6 ne, technologies ,ere used. 0his 6act is hidden
in both D%.(HE and D%.(&E. 9o,e8er, i6 one de8elops a botto+#up +odel 6or the
6acility, the corresponding 6actor in this +odel ,ill be less, say ,
'
N2. 0his ,ill
reduce the corresponding prices $
,
. y
,
< and $
*
. y
*
<. 0his discrepancy bet,een
the prices obtained by the top#do,n and the botto+#up +odel indicates the eCistence
o6
ine66iciencies in the ,ay the 6ir+ operates. In general, it is not straight6or,ard to trac-
do,n the eCact reason 6or such ine66iciencies. 0his is because running these +odels
produces sets o6 nu+bers instead o6 nicely shaped 6unctions that one can easily
understand and co+pare. I6 ,e re6ine the cost +odel by introducing +ore acti8ities
this can help us to better understand the relation bet,een the cost o6 ser8ices and
input 6actors.
3. Consider the price o6 ,ooden sou8enirs. 0he 8ariable part o6 the price in D%.(&E is a
better approCi+ation o6 the long#run incre+ental cost o6 producing the a+ount y
,
o6
,ooden sou8enirs than the 8ariable part in D%.(HE. 0he reason that it +ay not be e;ual
to the long#run incre+ental cost is that i6 only one sou8enir is produced, then the
co++on cost could be reduced Dperhaps a s+aller 6acility is needed, or one secretary
,ill su66ice rather than t,oE. 7n6ortunately, this reduction cannot be eCtracted 6ro+
the accounting data. 4nce again, one +ust construct a O8irtualM +odel o6 a 6acility
that is speciali@ed in constructing only bron@e sou8enirs, so that one can subtract the
appropriate cost. 0his again sho,s the ,ea-ness o6 the top#do,n +odels that are the
basis o6 >3C pricing.
2s ,e ha8e already re+ar-ed, >3C is naturally co+bined ,ith historic costs. 0his is
because accounting data concerns the 6ir+Ms actual costs. It is not i+possible to use current
costs, but this re;uires +odi6ications to the accounting syste+ as discussed earlier.
+6$6% Activity)based Costing
2 top#do,n approach 6or assigning actual costs to net,or- ser8ices that is ,ell#accepted
in practice is sho,n in >igure %.$. It is based upon a hierarchy o6 6our le8els and is a
re6ine+ent o6 the traditional >3C approach. 0he botto+ le8el consists o6 the input 6actors
that are consu+ed by the net,or- operator, such as salaries o6 personnel, depreciation Uo6
net,or- ele+ents, cost o6 capital, depreciation o6 buildings and 8ehicles, +ar-eting cost,
o8erhead, po,er consu+ption, and the cost o6 renting ra, band,idth. 3epreciation is the
yearly esti+ate o6 the cost o6 asset usage and corresponds to the decrease o6 asset 8alue
( 2 3
Ser8ices
( 2 !et,or- ele+ents
( 2 2cti8ities
( 2 3
$ ' H Input 6actors
/igure +6% 0he cost o6 input 6actors can be assigned to ser8ices in a hierarchical 6ashion. 0he
lo,est le8el are input 6actors that are consu+ed by the net,or- operator, such as labour and
depreciation o6 net,or- ele+ents. 0he neCt le8el consists o6 labour#intensi8e acti8ities that are
re;uired 6or the net,or- to operate and produce ser8ices. 0he neCt le8el consists o6 the net,or-
ele+ents such as the routers, s,itches and lin-s. 0he last le8el consists o6 ser8ices. Input cost 6actors
are allocated to net,or- ele+ents and acti8ities. 2cti8ities Dacti8ity costsE are allocated to net,or-
ele+ents or directly to ser8ices. 0he cost o6 net,or- ele+ents is allocated to each ser8ice in
proportion to its use by that ser8ice. 7sually the cost o6 a ser8ice also includes the cost o6 capital it
e+ploys. 2 crucial decision, besides the de6inition o6 the acti8ities, is the de6inition o6 the
coe66icients to apportion the costs o6 one le8el to the neCt le8el up.
during a yearMs operation. 0he goal is to apportion these cost ele+ents to the ser8ices that
the net,or- pro8ides.
0he neCt le8el is the acti8ity le8el. 2cti8ities are labour#intensi8e processes that are
re;uired 6or the net,or- to operate and produce ser8ices. 7sually, an acti8ity has a
,ell#de6ined purpose, such as +aintaining certain e;uip+ent, +anaging net,or- ele+ents,
operating the co++unications lin-s, supporting certain custo+er ser8ices, or operating the
business. 7sing in6or+ation about ti+e spent that sta66 spend on each acti8ity, one de6ines
coe66icients that allo, the cost o6 the input 6actors D+ostly labourE to be shared a+ongst
the acti8ities. y this procedure the accounting syste+ is enriched ,ith a speci6ication o6
higher#le8el acti8ities and their relations ,ith the basic cost 6actors.
0he neCt le8el up consists o6 net,or- ele+ents such as routers, s,itches and trans+ission
lin-s. 0he cost o6 each net,or- ele+ent is co+puted by apportioning the input 6actors that
are related to the particular ele+ent De;uip+ent depreciation, po,er consu+ption, space
rent, etc.E, and the acti8ities that are concerned ,ith the operation and +anage+ent o6 the
net,or- ele+ent. 0hese include input 6actors and acti8ities that ha8e a broader scope and
are o6 the co++on cost type, such as general eCpenses and co+pany +anage+ent cost.
0he cost o6 these +ust be apportioned in an ad hoc ,ay. 2n eCa+ple is the salaries o6 the
+e+bers o6 the board o6 the co+pany. 0his o8erhead cost +ight allocated in proportion
to the other costs that ha8e been assigned +ore rationally. So+eti+es such o8erhead costs
can be directly attributed to ser8ices. 0he gathering o6 both acti8ity costs and all other costs
Dsuch as depreciation to net,or- ele+entsE is usually called net,or- costing.
0he idea so 6ar is that the co+plete cost o6 the net,or- should be allocated to the 8arious
ele+ents o6 the net,or- and to acti8ities that only deal ,ith the pro8ision o6 ser8ices. >or
instance, a particular router ,ill be assigned a cost that su+s its depreciation cost, po,er
consu+ption, space rent, and the cost o6 all the acti8ities Dand hence indirectly the input
6actorsE that contribute to its operation, such as +anage+ent and +aintenance. Custo+er
support is an acti8ity that purely relates to ser8ices rather than net,or- ele+ents. 2lthough
so+e o6 the co++on cost ,ill al,ays be allocated in a rather ad hoc +anner, the use
o6 acti8ity#based costing can greatly reduce the need 6or it. In co+puting the cost o6 an
acti8ity, one care6ully accounts 6or the a+ounts o6 the 6actors that it consu+es, and so
reduces the unaccounted#6or co++on cost. 0raditional +odels 6or co+puting the cost o6
ser8ices +ight consider the co+plete labour cost as co++on cost, and so allocate it to
the net,or- ser8ices in a co+pletely ad hoc ,ay. 0he de6inition o6 acti8ities pro8ides the
rele8ant in6or+ation to allocate such cost +ore accurately.
0he last le8el is the ser8ice le8el. Ser8ices Dsuch as local and long#distance calling,
leased lines, interconnection, I* connecti8ity, and so onE are sold to custo+ers. 0hey +a-e
use o6 the net,or- ele+ents and the ser8ice related acti8ities. 4nce again, ,e +ust de6ine
coe66icients to apportion the costs o6 net,or- ele+ents and Dnon net,or- ele+ent relatedE
acti8ities a+ongst the ser8ices they support. >or eCa+ple, the access ser8ice to a custo+er
uses the copper ,ires that connect the custo+er to a concentrator D,hich is located at the
street le8el and ser8es custo+ers on the sa+e streetE. It also uses the cable Dor 6ibreE that
connects the concentrator to the s,itch at the pre+ises o6 the net,or- pro8ider. 9ence,
the net,or- ele+ent related cost o6 the ser8ice to the custo+er includes the cost o6 the
copper ,ires D,hich are not used by othersE, and o6 part o6 the cost o6 the concentrator, the
cable and the input port o6 the s,itch, and the +anage+ent and support acti8ities related to
these net,or- ele+ents D,hich are used by othersE. 0o co+pute the total cost o6 the access
ser8ice one +ust also apportion the cost o6 acti8ities such as custo+er support, +ar-eting
and co+pany +anage+ent. So+e o6 these acti8ities are easier to apportion than others De.g.
one +ay be able to esti+ate the proportion o6 ti+e that the custo+er support sta66 gi8e to
the access ser8iceE. Clearly, the cost o6 the ser8ice depends on the nu+ber o6 custo+ers
that share the co++on cost and so is custo+er#dri8en.
Si+ilarly, local telephone ser8ice uses +any net,or- ele+ents that are also used 6or other
ser8ices. >or eCa+ple, lin-s and s,itches are also used 6or long#distance and international
calls. 4ne ,ould li-e to say ,hat percentage o6 the use o6 these ele+ents is due to local
telephone ser8ice. 0his can be done by de6ining a +easure o6 usage, such as call#+inutes.
4ne +easures the total nu+ber o6 call#+inutes that each net,or- ele+ent pro8ides, and
then co+putes a call#+inute cost 6or that net,or- ele+ent by di8iding the cost o6 the
net,or- ele+ent by this nu+ber o6 call#+inutes. 0he cost o6 pro8iding a telephone call
is co+puted by su++ing the call#+inute costs that it consu+es at all net,or- ele+ents
it uses. ecause call routing is not 6iCed and it ,ould be 8ery eCpensi8e to account 6or
each callMs particular route through the net,or-, this is o6ten done on an a8erage basis.
0his +oti8ates the usual tari66 6or telephone ser8ice" the constant part Dthe +onthly rentalE
re6lects the cost o6 the access ser8ice, and the 8ariable part, co+puted 6ro+ call#+inutes,
re6lects the cost o6 carrying the telephone calls through the net,or- o6 the ser8ice pro8ider.
We +a-e t,o co++ents about the abo8e approach. >irst, it hides potential ine66iciencies
o6 the net,or- pro8ider. .8en i6 a net,or- ele+ent is underutili@ed, its cost is co+pletely
shared by the ser8ices that use it and there is no incenti8e 6or the pro8ider to i+pro8e
its e66iciency. I6 the pro8ider ,ere only allo,ed to reco8er the cost o6 a net,or- ele+ent
in proportion to its actual utili@ation, he ,ould ha8e a clear incenti8e to i+pro8e the
e66iciency o6 his net,or- Dby better routing, resol8ing potential bottlenec-s, reselling spare
capacity, and so onE. 0his highlights a -ey di66erence in the botto+#up and top#do,n
approaches. In the top#do,n approach, the cost o6 the eCisting 6acility is allocated a+ongst
the ser8ices sold. In the botto+#up approach, a +odel o6 the 6acility is constructed. 0his
+odel uses state#o6#the art technologies and opti+ally di+ensions the 6acility, in so+e
cases ta-ing into account the topology and structure o6 the eCisting net,or-. It is used
to deri8e the cost o6 the net,or- ele+ents and o6 the corresponding ser8ices. *rices
that arise 6ro+ a botto+#up approach pro8ide incenti8es 6or i+pro8ing the e66iciency
o6 the net,or-. 0hey also enhance co+petiti8eness by pre8enting entry by ine66icient
co+petitors. 0his is one reason that regulators suggest botto+#up +odels 6or pricing
net,or- ser8ices.
0he second co++ent concerns the inade;uacy o6 using acti8ity#based costing Dor any
>3C costing type o6 +odelE 6or deter+ining the incre+ental cost o6 a ser8ice. 0he proble+
is that a top#do,n approach pro8ides 6or an one#,ay 6unction that ta-es as inputs the
incurred input 6actor costs and the coe66icients 6or apportioning the costs in the 8arious
le8el o6 the +odel, and co+putes the costs o6 the 8arious ser8ices. It does not pro8ide
the +eans to ans,er the ;uestion Oi6 ser8ice a ,ere not produced, ,hat ,ould the cost o6
producing the rest o6 the ser8ices beM L 0o ans,er this ;uestion, one +ust go bac-,ards
and chec- all the cost 6actors that contribute to the cost o6 the gi8en ser8ice. 0o esti+ate
the reduction o6 each such cost 6actor i6 ser8ice a is not produced one +ust be able to
deter+ine the 6raction o6 the cost that ,as allocated to the ser8ice ,hich is 8ariable and
the 6raction that is 6iCed. Clearly, one should reduce the cost 6actor only by the 8ariable
a+ount, and reapportion the 6iCed part a+ong the ser8ices that continue to be pro8ided.
0his in6or+ation is not a8ailable in traditional accounting syste+s and is rather co+pleC
to obtain. Recent trends sho, that +any large co++unication co+panies are in 6a8our o6
constructing such ad8anced top#do,n costing +odels that allo, the accurate calculation o6
incre+ental costs, +ainly due to auditability re;uire+ents i+posed by regulators and 6or
co+paring the resulting prices. 1ost o6 these +odels e+ploy current costs instead o6 the
traditionally used historic costs.
+6$6& LR2C]
We ha8e already discussed i+portant properties o6 6airness and stability that prices should
possess. *rices based on LRICC share the nice properties o6 subsidy#6ree prices, are close
to the prices that ,ould pre8ail in an actual contestable +ar-et and send econo+ic signals
that pro+ote e66icient 6or,ard#loo-ing in8est+ent decisions.
0he -ey notions ,e ,ill use in this section are the long#run incre+ental cost DLRICE o6 a
ser8ice, and the stand#alone cost DS2CE o6 a ser8ice. We re+ind the reader the de6inition o6
the long#run incre+ental cost through an eCa+ple, in ,hich ,e also introduce LRICC. We
also assu+e, as typical in co++unications, that the cost 6unctions o6 the 6ir+s that produce
ser8ices eChibit econo+ies o6 scope Dby the eCistence o6 co++on costE.
Consider a 6ir+ that o66ers ;uantities y
(
and y
2
o6 ser8ices ( and 2. Let the cost 6or this
+iC be c. y
(
R y
2
<. 0he LRIC 6or ser8ice ( is de6ined as LRIC. y
(
< 3 c. y
(
R y
2
< c. y
2
<,
,here c. y
2
< is de6ined 6or a 6acility ,hose production plan is opti+i@ed to produce only
type 2 ser8ice Di.e. i6 ,e stop production o6 ser8ice (, then ,e ha8e enough ti+e to
opti+i@e the production plan to produce only y
2
o6 ser8ice 2E. Si+ilarly, the S2C o6 a
ser8ice is the cost 6or building and operating a 6acility that produces only that ser8ice.
Since in the de6inition o6 the S2C ,e do not ta-e account o6 econo+ies o6 scope in
producing a larger nu+ber o6 ser8ices, ,e ha8e that LRIC. y
(
< S2C. y
(
<.
0he +oti8ation 6or using LRIC as a basis 6or constructing prices is the idea o6 subsidy#
6ree
prices o6 Section %.(.2. 0he +ethodology 6or i+ple+enting LRIC is based on constructing
botto+#up +odels 6ro+ ,hich to co+pute c. y
(
R y
2
<, c. y
(
< and c. y
2
<. We ha8e
already +entioned that in a botto+#up +odel the net,or- is designed 6ro+ scratch using
the +ost cost#e66ecti8e technologies. 0he cost o6 the ser8ices is co+puted by apportioning
the cost o6 the net,or- ele+ents Dsi+ilarly as in the acti8ity#based approachE, and by
adding the cost o6 labour and the rest o6 the o8erheads as a si+ple +ar-up on the cost o6
the in6rastructure. Such a +ar-up 6ollo,s the trends obser8ed in actual net,or-s.
2 proble+ ,ith using LRIC. y
(
< as a price 6or the ;uantity y
(
o6 ser8ice ( is that the
su+ o6 the prices constructed according to LRIC ,ill not in general co8er the production
cost. >or eCa+ple,
LRIC. y
(
< C LRIC. y
2
< 3 c. y
(
R y
2
< C Tc. y
(
R y
2
< c. y
(
<
c. y
2
<U
c. y
(
R y
2
<
as the ter+ in s;uare brac-ets is in general negati8e. So+e a+ount o6 co++on 6iCed cost is
not reco8ered. 2 ,ay to re+edy this is to distribute this a+ount o6 co++on cost a+ongst
the prices o6 the ser8ices. Since there are +any ,ays to distribute this co++on cost, ,e
i+pose the 6urther constraint that the resulting price, $. y
i
< should satis6y
LRIC. y
i
< $. y
i
< S2C. y
i
<
D%.20E
and the su+ o6 the prices e;ual the total cost. 0his approach is -no,n as LRICC , and is
a practical application o6 D%.$E and D%.'E.
It is natural to use current cost ,ith LRICC because the ai+ is to construct prices that
,ould pre8ail in a co+petiti8e +ar-et. 0he use o6 current rather than historic costs does not
pass on the ine66iciencies o6 the operator due to high historical costs and ine66icient out#o6#
date technologies. >urther+ore, it pro8ides incenti8es 6or i+pro8ing e66iciency, since this is
the only ,ay the operator can +a-e so+e pro6it at these prices. 2lso, the botto+#up nature
o6 the +odel +a-es such costs a natural candidate to be used as inputs.
0he use o6 LRICC has also disad8antages. 0raditional accounting syste+s do not pro8ide
any in6or+ation that can be used by an LRICC +odel, and hence such +odels +ust be built
6ro+ scratch. 2lso, prices based on LRICC are hard to audit as ,e ha8e discussed earlier.
0his +oti8ated the recent de8elop+ent o6 LRICC syste+s based on top#do,n +odels using
current costs Dsee the discussion in Section %.3.$E.
0here is another 6airness perspecti8e on the use o6 LRICC. Consider an incu+bent local
eCchange carrier DIL.CE ,ho is 6orced to unbundle part o6 his net,or-, e.g. the part that
accesses his custo+ers. 0he concepts o6 IL.Cs and unbundling are discussed in +ore detail
in Section (3.3 and Section (3.$.(.
7nbundling re;uires the incu+bent to sell the ser8ices o6 the access net,or- in a stand#
alone +anner, instead o6 selling the+ in co+bination ,ith other ser8ices Dsuch as local and
long distance telephonyE. .Ca+ples o6 such ser8ices are the physical layer consisting o6 the
copper ,ires that 6or+ the local loop bet,een the pre+ises o6 the custo+ers and the local
eCchange o6 the carrier, and the ra, band,idth that can be pro8ided by C3SL +ode+s
operating o8er the copper local loop ,ires.
0he price o6 the unbundled access ser8ice +a-es a big di66erence to co+petition 6ro+
other pro8iders. I6 it is 8ery high, then co+petitors ,ill pre6er to build their o,n access
net,or-, ,hich is 8ery costly and ris-y. I6 the price is lo,, then there ,ill be 6ierce
co+petition in pro8iding higher le8el ser8ices o8er the access net,or-, but the incu+bent
,ill ha8e no incenti8e to upgrade the access net,or- or i+pro8e its ;uality, and other
operators ,ill ha8e no incenti8e to build access net,or-s using alternati8e ne, technology.
9o, should such prices be de6inedL Regulators ha8e proposed the use o6 LRICC Dsee
discussion on historic 8s. current costs in Section %.3.2E. ut is this 6air to the incu+bent
operatorL
I6 the incu+bent is re;uired to rent ele+ents o6 the access net,or- to his co+petitors
then he ,ill be unable to use these ele+ents to pro8ide the ser8ices he presently sells
to his custo+ers D,hich he is probably doing at a high pro6itE. 0hus, unbundling has an
opportunity cost 6or the incu+bent. LRICC penali@e the incu+bent 6or ine66iciencies, but
does not ta-e account o6 his historic costs, or this opportunity cost. 0o be 6air, should
not the price include this opportunity costL In the neCt section ,e describe a pricing
sche+e that has been proposed as an alternati8e to LRICC , and ,hich does ta-e account
o6 the incu+bentMs opportunity cost. 0his is -no,n as the .66icient Co+ponent *ricing
Rule D.C*RE 6or net,or- ele+ents. 2s ,e ,ill see, such a pricing sche+e has serious
ine66iciencies co+pared to LRICC.
+6$6( !he "fficient Com'onent Pricing Rule
0he .66icient Co+ponent *ricing Rule D.C*RE is an alternati8e to LRICC that does ta-e
account o6 the incu+bentMs opportunity cost. 7n6ortunately, .C*R has se8ere incenti8e
proble+s and +ust be used ,ith care. 0his section should be seen as a case#study that
de+onstrates that a pricing rule that loo-s plausible at the 6irst sight +ay be 8ery inade;uate
in particular situations.
Consider a ser8ice A( o66ered by an incu+bent by +eans o6 t,o net,or- ele+ents, A
and ( , as sho,n in >igure %.'.
!e, entrants in the abo8e +ar-et possess only ele+ent ( and so re;uire ele+ent A in
order to pro8ide ser8ice A( . >ro+ their 8ie,point, ele+ent A is the bottlenec- to pro8iding
ser8ice A( . >or eCa+ple, A +ight be the local#loop part o6 a telephone connection and (
(
( (
(
( (
Long distance
net,or- o6 ne, IL.C
a Ser8ice A
* c
Ser8ice (
2ccess net,or-
Long distance
net,or- o6 ne, entrant
/igure +6& 0he .66icient Co+ponent *ricing Rule 6or pricing net,or- ser8ices. Ser8ice A connects
a to *R ser8ice ( connects * to c and ser8ice A( connects a to c. 2ccording to the .C*R an
incu+bent should charge 6or A a rental price o6 $
A
3 $
A(
c
(
3 c
A
C . $
A(
c
A
c
(
<,
,here $
i
, c
i
are the price and cost o6 pro8iding a unit o6 ser8ice i . !ote that $
A
is the cost o6
ser8ice A plus the pri8ate opportunity cost to the incu+bent o6 not o66ering a unit o6 ser8ice A(.
+ight be the ,ide area net,or- part. Let c
A
and c
(
be the costs o6 ele+ents A and ( in
pro8iding a single unit o6 A( . Let $
A(
be the price the incu+bent charges its custo+ers
6or a unit o6 A( .
26ter unbundling, the ne, entrant should be able to o66er ser8ice A( , by renting ele+ent
A 6ro+ the incu+bent. 2ccording to the .66icient Co+ponent *ricing Rule the incu+bent
should change a rental price o6
$
A
3 $
A(
c
(
3 c
A
C . $
A(
c
A
c
(
<
!otice that, in this case, the incu+bent recei8es c
A
plus his pro6it 6or pro8iding a unit o6
A( . 0hat is, he recei8es both the cost o6 pro8iding ele+ent A and the opportunity cost he
incurs through being unable to o66er a unit o6 A( because he has gi8en up a unit o6 A. In
.C*R, this opportunity cost is de6ined 6or e;ui8alent ser8ices" a long#distance custo+er o6
the incu+bent ,ill beco+e a long#distance custo+er o6 the ne, entrant.
>or eCa+ple, i6 c
A
3 Q0"'0 and c
(
3 Q0"$0 and $
A(
3 Q("20 Di.e. there is a
pro6it o6 Q0"30E, then $
A
3 Q0"&0. !otice that this e;uals the su+ o6 c
A
and the pro6it
o6 the incu+bent.
0he +ain +oti8ation 6or the .C*R is that a ne, entrant can only sur8i8e in the +ar-et
i6 he is e66icient in producing ( , i.e. i6 he produces ( at a cost c
0
that is no +ore than
c
(
. 4ther,ise, he ,ill ha8e to price A( as $
A
C c
0
3 $
A(
c
(
C c
0
` $
A(
, and be
unco+petiti8e against the eCisting price. 0hus .C*R deters ine66icient entrants. 9o,e8er,
this +ay be the only good thing that can be said o6 .*CR. 2gainst it can be said the
6ollo,ing"
(. It reduces the pro6it o6 e66icient entrants by including the pri8ate opportunity cost
o6 the incu+bent in the rental price o6 A. I6 the incu+bent is ine66icient, then this
a+ounts to a taC on the entrants. Let us see this in detail. 2ssu+e that the ne, entrant
is e66icient ,ith c
0
a pro6it o6 c
(
c
0
\ c
(
. 0hen by undercutting the incu+bentMs prices by S he +a-es
S instead o6 $
A(
S c
A
c
0
, i6 he ,ere ?ust paying 6or the
actual cost o6 A. 0he di66erence o6 these t,o ter+s is the pri8ate opportunity cost o6
the incu+bent $
A(
c
A
c
(
, and has a 6or+ o6 a taC paid by the ne, entrant to
the incu+bent.
2. It guarantees the incu+bentMs pro6it +argin through inclusion o6 his pri8ate
opportunity cost. .8en ,hen the incu+bent is ine66icient, he is guaranteed the sa+e
inco+e. Repeating the pre8ious argu+ent, an e66icient entrant posts a price $
A(
S
and gets all the +ar-et A( . >or each unit o6 ser8ice he pays the incu+bent $
A(
c
(
.
So the incu+bent continues to +a-e the sa+e pro6it as be6ore on e8ery unit o6 ser8ice
that the ne, entrant sells. Since the ne, entrant is 6orced to lo,er prices 6or A( in
order to obtain +ar-et share, de+and ,ill increase, ,hich translates into increased
pro6its 6or the incu+bent. 2n ine66icient incu+bent sees his pro6its increasing instead
o6 being pushed out o6 the +ar-et_
3. It does not pro8ide any +oti8ation 6or esti+ating accurately the cost o6 the ele+ent
A. 9ence .C*R perpetuates the historic costs o6 the incu+bent in this part o6 the
net,or-.
$. 0he incu+bent has no incenti8e to be +ore e66icient and reduce c
A
. 9o,e8er, a
reduction in c
(
,ill increases the rental price o6 A.
'. Since .C*R deters certain entrants, it can increase the incu+bentMs +ar-et share o6
pro8ision o6 the A( ser8ice. 0his +ay lead to a reduction in the +arginal cost o6 ( ,
through econo+ies o6 scale, and thus increase the rental price o6 A, thereby 6urther
reducing co+petition.
H. I6 the true costs are not easily obtained then the incu+bent +ay clai+ that the cost
o6 A is greater than c
A
D,ithout a66ecting his total cost c
A
C c
(
ER this increases
the rental price o6 A. 9e essentially achie8es double cost reco8ery.
%. 0here are ad+inistrati8e proble+s, because the sa+e net,or- ele+ent +ay ha8e to
be rented at di66erent prices, depending on the ser8ice 6or ,hich it is e+ployed.
0his +eans the .C*R can produce price discri+ination and that it can be 8ery
co+plicated to deter+ine the price $
A
. >or eCa+ple, i6 the ne, entrant ,ants to use
A 6or pro8iding local ser8ice o8er the access net,or-, the opportunity cost ,ill be
di66erent.
0o conclude, the .C*R is inconsistent ,ith the typical goals o6 a regulator because it
does not lead to price decrease, is not cost#based, and can lead to price discri+ination.
+6% Com'aring the various models
Let us su++ari@e so+e ad8antages and disad8antages o6 the pricing sche+es
introduced in the last sections. 0he ad8antages o6 >3C based prices that use historic
costs are
S they are easier to de8elop since they are based on linear relations ,ith the actual cost
in6or+ation and are easier to understand by accountantsR
S they are based on accounting data that are retrie8ed and -ept any ,ay in the in6or+ation
syste+ o6 the 6ir+R
S they are easy to audit by regulators.
0he disad8antages o6 such prices are that"
S they do not pro8ide incenti8es 6or i+pro8ing the e66iciency o6 the pro8ider and deploying
ne,er technologies since they co8er his 6ull historic costR
S they are not al,ays based on causal relations but depend on arbitrarily chosen coe66icients
6or sharing the non directly attributable costR hence these do not re6lect the actual
cost o6 ser8ices. 0his proble+ can be reduced i6 one uses the acti8ity#based costing
sche+e.
>L20 R20. *RICI!A ()(
LRICC co+bined ,ith botto+#up +odels using current costs has the ad8antages that"
S it generates prices that are subsidy#6ree, hence stable and in +any cases econo+ically
e66icientR
S since it is not based on historic costs, it does not include ine66iciencies that are due to
decisions +ade in the past, and pro8ides the right co+petiti8e signals to the +ar-etR
and the disad8antages that
S it is hard to de8elop due to the co+pleCity o6 the botto+#up +odels and the large a+ounts
o6 in6or+ation needed to input the right para+eters to the +odelsR
S since these prices are not based on traditional accounting procedures, accountants 6ind
the+ hard to understand.
It +ust be clear to the reader by no, that top#do,n +odels are based on actual costs
,hile botto+#up +odels deal ,ith hypothetical syste+s and hence ser8e 6or di66erent
purposes. LRICC prices that are based on top#do,n +odels using current costs do not
ha8e auditability disad8antages but still hide potential ine66iciencies in the net,or-. 0hey
are presently 6a8oured by regulators as the ,ay that incu+bent operators should construct
prices 6or ,holesale ser8ices that are sold to co+petitors. Such syste+s tend to displace the
older generation o6 costing syste+s based on >3C. 0raditional LRICC based on botto+#up
+odels results in e8en lo,er prices, and is +ainly used to detect net,or- ine66iciencies.
0his is the case i6 the prices constructed by the top#do,n and botto+ up +odels di66er
signi6icantly.
+6& /lat rate 'ricing
In 'lat rate $ricing the total charge that a custo+er pays 6or a ser8ice contract is 6iCed at the
ti+e the contract is purchased. 0hat is, it is deter+ined a $riori, e8en though the actual cost
o6 the contract to the ser8ice pro8ider can only be -no,n a $osteriori, i.e. at a later ti+e,
,hich +ight be only at the end o6 the contract. >or eCa+ple, i6 a connection consu+es
resources ,hich cannot be predicted at the ti+e its contract is +ade then the cost o6 the
contract cannot be -no, a $riori. In +ost cases, prices re6lect so+e a8erage concept o6 cost
ta-en o8er all the contracts in the past history o6 the syste+. .Ca+ples o6 6lat rate contracts
include 6lat#6ee Internet access ,ith a +onthly 6ee that depends upon access speed, dining
at an Oall#you#can#eatM restaurant, and charging a GR 201 ser8ice according to its tra66ic
contract para+eters ,ithout ta-ing account o6 the actual band,idth used.
0here are t,o ad8antages that ha8e led to the ,ide use o6 6lat 6ees. >irst, a 6lat 6ee
is si+ple to i+ple+ent. Second, custo+ers o6ten pre6er the predictability o6 a 6lat 6ee.
9o,e8er there are also serious dra,bac-s. >lat rate pricing tends to produce high social
cost because o6 the ,aste o6 resources. It is unstable under co+petition because i6 light
users subsidi@e hea8y users, the light users are li-ely to s,itch to a co+petitor ,ho o66ers
the+ a 6airer pricing sche+e. It is easy to see that 6lat rate charging +ay produce prices
that are not subsidy#6ree in the senses o6 Section %.(. 9o,e8er, since 6lat rate is ,idely
used in practice, it deser8es a detailed discussion and clari6ication o6 its ine66iciencies. 0o
+a-e things +ore concrete, ,e use the eCa+ple o6 6lat#6ee Internet access and use a si+ple
econo+ic +odel to capture +ost o6 the essential aspects.
Consider the case o6 a ser8ice pro8ider ,ho pro8ides Internet access by selling custo+ers
contracts 6or a 6iCed access speed at a 6lat +onthly 6ee o6 $
6lat
. 0he resource consu+ed
by a custo+er during one +onth is approCi+ated by , , the total +onthly 8olu+e o6 bytes
"W N A W W
A
Ap
W
W p
,aste
6lat
6lat
6lat
()2 C4S0#2S.3 *RICI!A
Q
Q
"W N A
A
MC
MC
,i ,
6lat
7
$ N MC
,i ,
6lat
,
6
p
lat
7
6lat price D $ N 0E
/igure +6( Social ,aste under 6lat rate pricing. I6 a user is charged a price $ 3 MC then he
consu+es ,
a
and the social ,el6are is the area A. 9o,e8er, i6 he is charged a 6lat price, say $ 3 0,
then he has no incenti8e to reduce his consu+ption and so consu+es ,
6lat
. 0his +a-es the social
,el6are A W ,here W is social ,aste. 0hus charging only a 6lat 6ee encourages social ,aste. >or
a de+and 6unction ,ith a greater de+and, so the de+and at $ 3 0 is ,
0
, the social ,aste o6 W
0
is
e8en greater.
o6 inbound tra66ic that he recei8es 6ro+ the Internet.
2
0he +onthly cost to the pro8ider is
a C *8, ,here 8 is the total 8olu+e o6 inbound Internet tra66ic. 2ssu+e custo+ers ha8e
indi8idual de+and 6unctions, ,hich are linear, start 6ro+ the sa+e point on the price aCis
and end at the point .,
i
R 0<, on the +onthly 8olu+e aCis, ,here ,
i
is the +aCi+u+
a+ount a custo+er o6 type i can consu+e at price @ero.
>irst ,e sho, that 6lat rate pricing encourages social ,aste. Consider a custo+er o6 type
i , but o+it 6or si+plicity the superscript i in the notation that 6ollo,s. 0he opti+al price
under ,hich social ,el6are is +aCi+i@ed is the +arginal cost MC 3 *, ,hich results in
a social surplus e;ual to the area o6 A, the upper triangle in the le6t part o6 >igure %.H.
I6 the custo+er is 6aced ,ith a 6lat#6ee charge, he has no incenti8e to reduce his resource
consu+ption and consu+es up to his +aCi+u+ possible le8el, i.e., ,
6lat
. In this case the
consu+erMs utility is the area o6 the triangle bounded by the de+and line, and the social
cost o6 its pro8ision *,
6lat
. 0his reduces the opti+al social surplus 8alue A by the a+ount
W R ,e call W the social ,aste that is induced by the 6lat rate price. 0his is sho,n in the
right part o6 >igure %.H, ,hich also suggests that social ,aste increases ,ith the 8alue o6 the
+aCi+u+ resource consu+ption ,
6lat
. !ote that ,
6lat
+ay 8ary 6or di66erent custo+er types
due to their di66erent +aCi+u+ net,or- access speeds or ti+e a8ailable 6or Internet access.
Consider no, a 6lat 6ee that is co+puted to co8er the 8ariable cost o6 the net,or-.
Suppose ,e co+pute the a8erage a+ount ,!
6lat
consu+ed under 6lat 6ee pricing and then
charge all custo+ers 6or that a+ount. 0his is illustrated in >igure %.%, ,here it is assu+ed
that custo+er types are uni6or+ly distributed in ter+s o6 +aCi+u+ resource consu+ption.
In this case, since the charge is e;ual to *,!
6lat
. 0hose ,ho consu+e less than ,!
6lat
6ind it
unpro6itable to participate and choose to end their contracts. 0his is because their utility 6or
using the ser8ice is less than ,hat they +ust pay. Suppose ,e continue this argu+ent in
+any rounds. In each round the 6lat 6ee is updated to re6lect the ne, a8erage consu+ption
cost a6ter so+e custo+er types ha8e le6t. .8entually, only the hea8iest users o6 the ser8ice
,ill re+ain. Clearly, the custo+er base is greatly reduced. I6 pro6its are a +ar-#up o6 total
8alue o6 contracts this ,ill also greatly reduce pro6its.
It is interesting to analy@e the Internet 6lat rate pricing eCa+ple 6ro+ the perspecti8es o6
6airness and price stability introduced pre8iously. 2ssu+e that the 6iCed cost o6 the pro8ider
2
2s present practice suggests, typical users o6 the Internet +ostly do,nload in6or+ation instead o6 uploading.
Q
>lat rate charge
MC
,
6lat
Dlo,E
,
6lat
Da8erageE ,
6lat
DhighE
/igure +6+ Cross subsidi@ation ,ith a 6lat 6ee. Suppose a 6lat 6ee is charged, su66icient to co8er the
cost o6 a8erage usage, i.e. 6ee3 ,
6lat
MC . 9o,e8er, ha8ing paid that 6ee, a lo, users ,ill consu+e
,
6lat
.lo,< and 6ind that he has negati8e net bene6it. Ai8en this, he ,ill chose not to buy 6ro+ this
ser8ice pro8ider.
is shared e;ually a+ong its N custo+ers, i.e. each one pays a 6lat 6ee o6 aN N C *,!
6lat
.
We can no, obser8e the 6ollo,ing"
S >lat rate pricing is not subsidy#6ree, since high consu+ing custo+ers are charged belo,
their incre+ental cost. 0his is the case i6 the 6iCed cost is shared a+ong +any custo+ers
and hence *,!
6lat
.hi gh< ` aN N C *,!
6lat
.
S I6 the 6iCed cost a is s+all enough then 6lat rate prices are neither sustainable or in the
second#best core. >or eCa+ple, suppose a 3 0. I6 a ne, pro8ider o66ers contracts priced
at *,!
6lat
S to users that consu+e less than ,!
6lat
, then he ,ill attract those users and
cause the prices o6 the incu+bent to collapse, since under these price the incu+bent can
no longer reco8er his costs. 0he ser8ice di66erentiation can be e66ected by the ne,
entrant using si+ple policing +echanis+s ,hich restrict users that consu+e abo8e their
contract le8els. In Chapter & ,e in8estigate se8eral related issues and discuss ,hy
subsidy#6ree prices are desirable. 2 si+ilar result ,ill be obtained i6 the ne, entrant
charges its custo+ers proportionally to the actual a+ounts o6 ser8ice they consu+e.
4ne ,ay to reduce the bad e66ects o6 6lat rate pricing is 6or the contract to restrict the
range allo,ed to the resource usage, 8. 0his produces prices that are 6airer to indi8idual
custo+ers. >or eCa+ple, instead o6 de6ining a contract 6or ,hich 8 can be any,here in
the inter8al T0R M U, one could de6ine m contracts, such that the i th contract li+its 8 to the
inter8al T0R k
i
U, ,here 0 \ k
(
\ g g g \ k
m
\ M . .ach o6 these contracts is priced on a
6lat rate basis. 0o en6orce the contract constraints, the ser8ice pro8ider +ust police the
usersM tra66ic" i6 a custo+er eCceeds the +aCi+u+ resource usage allo,ed by his contract,
then he +ust be bloc-ed 6ro+ using +ore o6 the ser8ice. Clearly, a custo+er has an
incenti8e to predict as accurately as possible his resource usage and purchase the cheapest
contract that acco++odates his needs. >or custo+ers ,ith lo, 8ariance, and hence
predictable resource usage, this sche+e can ,or- ,ell, and it clearly reduces social ,aste
and cross#subsidi@ation bet,een hea8y and light users. 9o,e8er, i6 a custo+er 6inds usage
too di66icult to predict because o6 large 8ariance o6 8, and bloc-ing is costly Dhe cannot
a66ord to be precluded 6ro+ using the ser8ice ,hen he needs toE, then he +ay ha8e to
purchase the largest contract. Consider a custo+er ,ith a lo, a8erage, say 0"( M , but
,ith a non#negligible probability to consu+e M , and ,ho cannot a66ord bloc-ing. 0his
custo+er +ay need to buy the largest contract T0R M U, and ,ill 6eel that he is not charged
6airly, since he pays the sa+e a+ount as a custo+er ,ho al,ays uses M .
i
9o,e8er, i6 8 has a large 8ariance, +easured ,ithin a large period T 3
*
T
i
, but its
contribution in a s+aller sub#period T
i
is predictable gi8en the a8ailable in6or+ation o6
the custo+er at that ti+e, then it +ay be pre6erable 6or the custo+er to purchase a ne,
contract in e8ery sub#period. 0his +ay be a good strategy i6 the o8erhead o6 purchasing and
acti8ating contracts is negligible 6or the net,or- and its custo+ers. In general, 6orcing the
custo+er to choose a single contract type, instead o6 allo,ing hi+ to dyna+ically s,itch
contracts according to his actual needs, reduces the o8erall 8alue he obtains 6ro+ using the
net,or-. >or eCa+ple, a light user +ight occasionally bene6it 6ro+ using a larger contract,
,ith greater ser8ice ;uality. Since subscribing to the larger contract +ay be eCceedingly
eCpensi8e, this custo+er ,ill subscribe to the s+all contract and lose the capability o6
higher ;uality. 9ence denying contract 6leCibility reduces social ,el6are.
!ote, also, that policing a contract +ay re;uire so+e +easure+ents, and this increases
the i+ple+entation cost. 9o,e8er, this cost is generally less than the costs o6 the
+easure+ents, accounting and billing in8ol8ed in usage charging. 46ten, policing is
done auto+atically by the line access speed that connects the custo+er to the net,or-.
0he pre8ious discussion suggests that the policing that +ay be re;uired to reduce the
bad e66ects o6 6lat rate pricing can greatly reduce custo+er 6leCibility, especially 6or those
custo+ers ,ith bursty resource usage re;uire+ents. 0his de6iciency can be alle8iated i6 the
charge 6or a contract has a usage co+ponent. >or eCa+ple, instead o6 per6or+ing Ohard
policingM, by dropping pac-ets and bloc-ing usage, ,e +ight per6or+ Oso6t policingM, by
si+ply +easuring usage and +a-ing the custo+er pay eCtra i6 he eCceeds ,hat his contract
allo,s. I6 the custo+erMs cost o6 bloc-ing is substantial, then he +ay pre6er to pay this
eCtra charge occasionally. 9e +ight e8en buy insurance against such an e8ent 6ro+ a
third party. Such Oso6tM +echanis+s increase the 8alue o6 the ser8ice to custo+ers, and so
increase social ,el6are. 0hey are stable because custo+ers end up paying +ore closely 6or
the resources consu+ed.
+6( /urther reading
0he boo- o6 1itchell and Gogelsang D())(E contains co+prehensi8e treat+ent o6
theoretical aspects o6 cost#based pricing. 0he net incre+ental re8enue test is due to au+ol
D()&HE. 2cti8ity based costing is discussed in the boo- o6 9ilton, 1aher and Selto D2003E.
2 thorough discussion o6 the +erits o6 LRIC 6or pricing access net,or- ser8ices is
in .cono+ides D2000E. >or de6initions o6 the .C*R see Willig D()%)E and au+ol
D()&3E. 0he ine66iciency o6 .C*R is discussed by .cono+ides D())%E. 0he discussion on
6lat rate pricing is based on .dell and Garaiya D()))E.
Introductory +aterial on bargaining and cooperati8e ga+es can be 6ound in the course
lecture notes o6 Weber D200(E. 0he bargaining ga+e is due to !ash D()'0E, and its treat+ent
as a co+petiti8e ga+e is due to 5euthen D()30E and Rubinstein D()&2E. 0he 8ariation o6
Section %.2.2 is that o6 Balai and S+orodins-y D()%'E. >or 6urther details ,e reco++end
the boo-s o6 Luce and Rai66a D()'%E, Barlin D()')E, .at,ell et al. D()&)E, in+ore D())2E
and 4sborne and Rubenstein D())$E.
Pricing Communication Networks: Economics, Technology and Modelling.
Costas Courcoubetis and Richard Weber
Copyright 2003 John Wiley & Sons, Ltd.
IS!" 0#$%0#&'(30#)
,
Charging Auaranteed Ser8ices
In Section 2.(.' ,e de6ined a guaranteed ser8ice as one 6or ,hich there is a contract
bet,een the ser8ice pro8ider and the custo+er. 0his contract speci6ies obligations 6or both
parties. 0he ser8ice pro8ider agrees to pro8ide a ser8ice ,ith certain ;uality para+eters so
long as the custo+erMs tra66ic satis6ies certain constraints.
In general, a contract 6or a guaranteed ser8ice +ay allo, so+e 6leCibility. Certain contract
para+eters, such as +aCi+u+ pea- rate, +ay be renegotiated and allo,ed to change their
8alues during the li6e o6 the ser8ice. >or eCa+ple, the contact +ight speci6y that the net,or-
guarantees no in6or+ation loss so long as the user sends at no +ore than a +aCi+u+ rate
o6 h 1bps. 0he 8alue o6 h +ay be renegotiated at the beginning o6 e8ery +inute to be
so+e 8alue bet,een ( and 2. 0hus there is a part o6 the contract ,hich guarantees no cell
loss at a rate o6 (. 2ny eCtra rate abo8e this +ust be negotiated. 4ne possibility is that
the eCtra rate +ust be bought in a band,idth auction. 0his auction is run by the net,or-
operator so as to better utili@e spare capacity. 2 second possibility is that the operator posts
a price $.t < and lets the user choose ho, +uch band,idth in eCcess o6 ( he ,ishes to buy.
9e sets $.t < to re6lect the present le8el o6 congestion in the net,or-. Seeing $.t <, the user
+ust choose the a+ount o6 band,idth in eCcess o6 ( he ,ould li-e.
Chapter (0 is about charging 6leCible contracts and pricing +ethodology that gi8es users
incenti8es to +a-e such choices opti+ally. 9o,e8er, in this chapter ,e restrict attention
to guaranteed ser8ices ,hose contracts do not allo, the users such 6leCibility. We suppose
that all contract para+eters are statically de6ined at the ti+e the contract is established.
.;ui8alently, ,e restrict attention to that portion o6 the contract ,hich has no 6leCibility
and 6or ,hich the net,or- is bound to pro8ide so+e +ini+al re;uire+ents, -no,n at the
ti+e the contract is established and persisting throughout its li6e. In the eCa+ple abo8e, this
portion o6 the contract is the obligation to pro8ide a ( 1bps rate at no cell loss. We use
ideas o6 pre8ious chapters to de8elop a theory o6 charging 6or such contracts. We do this in
8arious econo+ic conteCts, such as the +aCi+i@ation o6 the social ,el6are or the supplierMs
pro6it. 1ost interesting guaranteed ser8ices ha8e contracts that speci6y +ini+u+ ;ualities
o6 ser8ice that the net,or- +ust pro8ide, such as +ini+u+ throughput rate, +aCi+u+
pac-et delay or +aCi+u+ pac-et loss rate. 0his +eans that the net,or- +ust reser8e
resources to +eet the re;uire+ents o6 the acti8e ser8ice contracts, and i6 net,or- resources
are 6inite, the net,or- +ust operate ,ithin its technology set. Recall 6ro+ Chapter $ that
the technology de6ines the set o6 ser8ices and their ;uantities that it is ,ithin the
net,or-Ms capability to pro8ide at one ti+e. In this chapter ,e analyse, in di66erent
econo+ic conteCts, the
()H C92RAI!A A72R2!0..3 S.RGIC.S
6or+ o6 prices that result 6ro+ considering the particular structure o6 the constraints o6
technology sets.
2n i+portant distinction bet,een ser8ice contracts 6or co++unications ser8ices and
so+e other econo+ic co++odities is that the 6or+er do not speci6y 6ully the resources
that are re;uired to produce a unit o6 output. >or eCa+ple, the resources that are re;uired
to produce a particular +odel o6 personal co+puter are 6iCed be6ore its +anu6acturing
starts, ,hereas a connection ,hose ser8ice contract speci6ies only an upper bound on the
connectionMs +aCi+u+ rate +ay use bu66er and band,idth in a ,ay that can only be
-no,n to the net,or- once the connection ends. 0he 6act that so+e in6or+ation is -no,n
only Oa posterioriM, rather than Oa prioriM, +a-es the proble+ o6 pricing ser8ice contracts
;uite co+pleC. We ,ill see that by including co+ponent o6 usage in the tari66 ,e can
produce a charge that +ore accurately re6lects the actual resource consu+ption. 0his type
o6 charge can pro8ide a custo+er ,ith the incenti8e to change his prospecti8e net,or-
usage in a ,ay that bene6its o8erall syste+ e66iciency. *erhaps he +ight s+ooth his tra66ic
and +a-e it less bursty, or use so+e sort o6 co+pression sche+e to reduce its total 8olu+e.
I6 there is no usage co+ponent in the charge then custo+ers ha8e no incenti8e to conser8e
resourcesR instead, they +ay be ,aste6ul o6 resources and beha8e in ,ays that reduce the
o8erall e66iciency and capacity o6 the net,or-. We argue that 6lat rate pricing can lead to
eCactly this sort o6 ,aste, and that pricing +ethods ,hich include a usage charge are to be
pre6erred.
Chapter $ presented the concept o6 an e66ecti8e band,idth as a proCy 6or the ;uantity
o6 net,or- resources consu+ed by a bursty connection. In Section &.( ,e discuss +ar-et
+odels 6or ,hich it is or is not appropriate to use e66ecti8e band,idths as the basis 6or
pricing net,or- connections. In Section &.2 ,e in8estigate the +ore co+pleC proble+ o6
constructing tari66s 6or ser8ice contracts. We discuss the pros and cons o6 6lat rate pricing
and gi8e ?usti6ications 6or using tari66s that ta-e account o6 actual net,or- resource usage
and charge proportionally to e66ecti8e band,idths.
2s ,e see in Section &.3, it is i+portant that the tari66s 6or ser8ice contracts be incenti8e
co+patible. 2 net,or- can be +ore co+petiti8e and 6airer to its users i6 it presents the+
,ith a range o6 tari66s, each o6 ,hich is intended 6or a speci6ic user type. In the si+plest
case, a net,or- +ight o66er t,o di66erent tari66s" one 6or hea8y users and one 6or light users
Das ,e did in .Ca+ple '.'.3E. 0he net,or- cannot pre8ent a hea8y user 6ro+ choosing the
tari66 that is intended 6or light users, but it can construct the tari66s so that hea8y users pay
less on a8erage i6 they choose the tari66 that is intended 6or the+, rather than the tari66 that is
intended 6or light users. 0his gi8es users the incenti8e to +a-e choices that are in6or+ati8e
to the operator, ,ho can tell ,hether the a custo+erMs consu+ption o6 net,or- resource
is +ore li-ely to be hea8y or light, be6ore any resources are actually consu+ed. 0his
in6or+ation can help the operator to di+ension and operate his net,or- +ore e66iciently,
6or the bene6it o6 all his custo+ers. 2t the end o6 Section &.3 ,e eCplain the co+petiti8e
ad8antage o6 such tari66s, and consider so+e related proble+s o6 arbitrage and splitting.
Section &.$ describes three si+ple pricing +odels that +a-e use o6 this type o6 pric#
ing. Section &.' presents a si+ple eCa+ple to illustrate the long#ter+ interaction bet,een
tari66ing and the load on the net,or-.
,61 Pricing and effective bandwidths
2 si+ple eCa+ple ,ill illu+inate the relationship bet,een the prices 6or ser8ices and their
e66ecti8e band,idths. Suppose a net,or- operator o66ers t,o contract types to his custo+ers
*RICI!A 2!3 .>>.C0IG. 2!3WI309S ()%
and ,ishes to choose a point ,ithin his technology set that +aCi+i@es his custo+ersM total
utility, u.,
(
R ,
2
<. 9ere ,
i
is the ;uantity o6 the ser8ice contract i that he supplies. Suppose
that the opti+u+ point is achie8ed 6or so+e prices $ 3 . $
(
R $
2
<. 2t these prices the
de+and , . $< 3 .,
(
. $<R ,
2
. $<< is a 6easible point in his technology set. !ote that ,
+ust be on the boundary o6 the technology set. I6 it is not, then a decrease in prices ,ill
increase , and hence u Das it is nondecreasing in ,
(
R ,
2
E. Recall also that the in8erse
de+and 6unction satis6ies F u NF ,
i
3 $
i
, i 3 (R 2. 0hat is, prices are the deri8ati8es o6
u. !o, on the boundary o6 the technology set there is a possible substitution o6 ser8ices
that is de6ined by the e66ecti8e band,idth hyperplane that is tangent to the setMs boundary
at the operating point , . 0he net,or- operator can substitute s+all ;uantities o6 ser8ice
types i and 2 6or one another, in ;uantities h and hV
i
NV
2
respecti8ely, and still be
6easible. Can such a change D,hich in practice is reali@ed by perturbing pricesE increase the
8alue o6 uL 0he ans,er lies in the 8alues o6 the partial deri8ati8es o6 u. 0heir ratio
pro8ides a rate o6 substitution 6or ser8ices ,hich lea8es the utility unchanged. Recalling
that these partial deri8ati8es are the prices, ,e see that unless the ratio o6 prices e;uals the
ratio o6 the e66ecti8e band,idths o6 the ser8ices, one can 6ind a 6easible perturbation o6 ,
that strictly increases the utility.
Suppose, 6or instance, that near to , the custo+ers bene6it (0 ti+es as +uch 6ro+ a s+all
increase in the ;uantity o6 ser8ice ( as 6ro+ the sa+e increase in the ;uantity o6 ser8ice 2.
0hat is, F u NF ,
(
3 (0 F u NF ,
2
. 2gain recall that F u
i
NF ,
i
3 $
i
, so $
(
3 (0 $
2
. 0hen u
can be increased by ,
(
_ ,
(
C h unless this re;uires ,
2
to be decreased by (0 h or
+ore, i.e. unless V
(
NV
2
X (0. Si+ilarly u can be increased by increasing ,
2
_ ,
2
C h
unless this re;uires ,
(
to be decreased by hN(0 or +ore, i.e. unless V
(
NV
2
[ (0. 0his
+eans that the coe66icients o6 substitution in the Onet,or