Friday, February 03, 2006
Thinking Strategically About a Tiered Internet
I haven't talked much about the telco's latest tiered strategy. The reason is that I think it's unfortunately, deeply out of touch with economic reality. Now, to buy my argument, you will have to accept my assumption that bandwidth isn't relatively scarce (even though the US might suck relative to the rest of the universe). If you do accept that assumption, then while telcos may dream of restructuring their industries around artificial scarcity, the truth is that tiered service will help neither their margins nor their strategic position.
There are two reasons. First, consider simple market dynamics. Unless all telcos collude, the dominant strategy will always be price competition. Unless all agree to maintain the roughly the same tier pricing now matter what the outcomes for each, the competitor with the lowest returns will always choose to defect, and compete on price. This, in turn, alters the payoffs for the rest, and price wars will erupt.
Second, even if all telcos do collude, and begin to exert market power over the rest of the value chain, the dominant strategy for downstream players is to simply vertically integrate (by, for example, acquiring a telco). Doing so immediately breaks the statics of collusion, commoditizes bandwidth again, and forces the remaining telcos to shift to price competition.
Given these dynamcis, even if telcos do shift to tiered pricing, while they may see incremental gains from price discrimination, competition will simply continue to force the total margins of a differentiated bundle of services lower, as it has been doing. The reason is straightforward: there is no real or natural scarcity to underpin supernormal returns to price discrimination based strategies for telcos.
Strategically, the most likely outcome is simply for telcos to unbundle: to divest lower-margin, lower-growth businesses (like many fixed-line businesses), and focus on higher-margin, high-growth businesses (like mobile, etc). Who would acquire fixed-line businesses? Economically, those players that can subsidize them with complementary services - like Google.
Is this kind of acquisition possible? Looking at relative market caps and growth rates, it's (barely) within the realm of possibility for a Google to bid for a telco, and well within the realm of possibility for Google to acquire fixed-line assets (like it's slowly been doing).
I think the problem is that telcos don't participate in the value chain. Although retail products are being sold at the ISP storefront, there is no technical or business model for margin and participation. This forces telcos to reassess how profit is derived from their service and react with tiered models or other reactionary claims such as "charging content providers" that we've seen recently.
I created a lengthy explanation of this phenomeon as part of Om Malik's posting Just Say (No)thing
. I'd be curious about your reaction.
There are two analogies for the role of telcos. Are they like a trucking firm, providing transport of commercial goods and requiring payment only for transport? Or, are they like Walmart, providing infrastructure, local promotion and local monetization in exchange for margin on products they sell.
Or, are they some new breed of retail channel operative that is different than those we see in virtually every other retail value chain?
I think content providers need to start viewing telcos as a valuable part of the retail channel instead of as adversaries. Bandwidth is not a plentiful resource. It is expensive, requires huge investments, and is controlled by a select group who, based upon their motives to obtain greater margins, may decide that network neutrality is no longer a good idea.
True, vertical competition from companies like Google may distract us. But, what will Google do? Perhaps try to integrate delivery into the retail channel and take margins on content and advertising? Hmmm. I bet so.