Update: There is a follow-up post available here.
Last week, I posted a reply to Alan Roth’s post over at The Hill comparing the economics of Netflix with D.C. sewage treatment. Although Mr. Roth sent his follow-up later that same day, I have not had a chance to respond until now. Here is what he said:
Thanks for your comment and for giving me the opportunity to reply and clarify. Unfortunately, I think you ARE missing something — or at least, not understanding my basic point.
For starters, despite the title of your blog entry, this has nothing to do with net neutrality. Netflix’s own CEO acknowledges as much in his shareholder letter, where he says that the FCC’s recent Open Internet order dealt with ISPs’ relationships with their retail customers, not their business arrangements with upstream wholesalers. He then goes on to make an argument about who should bear what costs.
My analogy likewise relates to the issue of equitable cost-sharing among the users of a network. And whatever you might want to say about who provides how much “value” and to whom, the fact is that the data bits in question here are largely flowing in one direction, just as the sewage being treated at Blue Plains is flowing in one direction.
You’re right that Netflix has built or rented its own lines up to the interconnection point with the local ISP — just as the suburbs have built their own sewer lines up to the interconnection points at the DC border. But the expense of taking both the data and the sewage to their ultimate destination is vastly greater in the last mile than in the first. If WASA’s retail ratepayers had to foot that whole bill themselves, you could be sure that one of two things would happen: Either DC would tell the ‘burbs, “sorry, ain’t gonna take your sh*t no more,” or DC would stop investing in its sewage treatment capacity at Blue Plains and elsewhere in its system. Or both.
Not a good outcome there. If reasonable, thoughtful people in the DC metro area have been able to agree that the sharing of capital, operating, and maintenance costs for that ultimate destination is both appropriate and economically sensible, it’s hard to believe that Netflix — which currently pays the US Postal Service hundreds of millions of dollars each year to have a postal worker deliver its DVDs to its customers’ homes — doesn’t think it should have to pay a cent to get the same end product to those homes via a different delivery infrastructure.
But I do appreciate your willingness to engage in a healthy dialogue and to allow me to draw out the analogy a little further.
Here is my reply:
I guess we’re still at an impasse on the issue of who is paying for what. In the long run, it is the customers that are paying for the total cost of service provided, both for sewage and for video on demand.
In the case of sewer services, the retail customers pay their suburban sewage provider money to make their sewage go away. They don’t really care how it happens; they just want it to happen. According to your description of the process, “how it happens” involves a two-step process: (1) the local D.C. suburb maintains the lines to local houses that first take the sewage away and (2) WASA maintains the Blue Plains facility that treats the waste. I agree with you that it is totally appropriate for WASA to require payment from local suburbs for step (2) as a “subcontractor” (probably not the technical, legal relationship, but seems to be functionally equivalent). I think we also can both agree that the suburbs probably pass on their costs for step (2) directly to their retail customers.
In the case of Netflix, however, the retail customers pay TWO entities: (1) their ISP and (2) Netflix. You are correct that a similar, two-step process occurs with the video delivery as with the sewage: (1) the ISP maintains the lines to local houses that bring the bits in and (2) Netflix maintains the servers and the connections to the “regional front doors” (to use your phrase) that provide the streaming. (Also, of course, Netflix pays the underlying content owners for the use of their works.)
Again, however, unlike with D.C. sewage, the retail customer is paying both actors directly: both the ISP and Netflix are receiving a monthly payment from the customer.
Given this state of affairs, I’m more than a little confused by your argument that the ISPs have the moral high ground in demanding payment from Netflix. All ISP’s are providing here is a connection to the wider Internet (to the “regional front doors”). Retail customers then pay Netflix for the rest because Netflix is providing the rest. On what basis do the ISP’s challenge Netflix’s contention that it “should pay only to transport its bits to a regional gateway, after which the costs of delivery to the end point would fall on others”? Doesn’t that precisely reflect how retail customers are being billed?
The only justification I can see for your position is if subsidies are involved-in other words, ISP’s are somehow lowering their retail customers’ bills for Internet service because they are paid by content providers. If that’s true, however, that is very different situation from the D.C. sewage situation to which you analogize.
Feel free to jump in with comments.
Legally Sociable 
Joel – I’m entirely sympathetic with your argument and you have it exactly right. There is kind of an elephant in the room, however, with some of the most vocal last-mile ISPs. What’s got them in an uproar is that their capacity planning models didn’t account for the recent explosion of video consumption (by some accounts, Netflix accounts for 20% of ALL internet traffic during prime time – really a breathtaking volume) and the agreements they have with customers are hard or painful to break. So what’s really going on here is that the usage models of end users are changing in ways that puts dramatically more pressure on last mile providers than they had planned for. It’s not that the ISP’s can’t support it, they don’t WANT to support it unless someone pays them more and they’re trying to pick Netflix’s pocket rather than make their customers pay more. (Their customer agreements may have sticking points in this area, I don’t really know.)They like their margins and their ability to oversubscribe their capacity and they don’t want to make the capital investment to upgrade their capacity unless someone other than the ISPs will pay for it.
Bottom line, the discussion about about Netflix, net neutrality, etc is really just an enormous head fake on the part of last mile ISPs who didn’t anticipate the right usage models and are looking for someone else to pay for their mistake.
They need to man-up and redo their customer contracts/terms and charge based on utilization, or they need to pay the freight to increase the capacity of their last mile infrastructure (if that’s even needed. These companies are not required to provide visibility on their actual utilization so there’s a lot that just has to be taken on faith. I’ve always thought the SEC should make the companies report on their network utilization in detail because it’s the only way to really understand their business and anticipate their financial demands.) Either way blaming Netflix for their own short-sightedness seems like the ultimate in chutzpah.
Anyway – I enjoy reading your blog. Hope you’re well.
Keith
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Joel, I’m not sure these blog-a-logs survive very long in cyberspace, or that anyone is still reading our very animated exchange, but I thought I’d post a belated response to your Feb. 17th comment. (My apologies for being so tardy — it’s just been a busy couple of weeks at my “real job.”)
Neither one of us are economists, so I suppose we could go on indefinitely arguing the fine points of “who pays for what” without either of us ever coming around to the other’s point of view. My main points, however, remain these:
1) A small fraction of Internet users are consuming a huge portion of the available bandwidth on any given evening by downloading and/or streaming Netflix video content. See this article — http://www.wired.com/epicenter/2010/10/netflix-instant-accounts-for-20-percent-of-peak-u-s-bandwith-use/ — for confirmation of that phenomenon.
2) Enormous amounts of capital investment on the part of both ISPs and backbone providers are required to deliver that Netflix service reliably, while also providing adequate bandwidth for the other 98% of Internet users who are logged on simultaneously for their own various reasons. And as more and more users begin using their broadband connections for streaming video, satisfactory service will require even more investment. And that doesn’t even begin to take into account the huge sums needed to bring broadband to the (mostly very rural) areas of the country that are currently unserved and that presumably would like to enjoy the same online benefits that we city dwellers have.
3) Creating a sound business case for those enormous capital investments requires that someone pay for them. In my view, requiring 98% of end users to subsidize a small handful of mega-users isn’t the right way to generate those capital funds, especially when price is already one obstacle to greater broadband adoption. (About one-third of people who could access broadband now don’t take it!) Admittedly, some form of usage-based pricing might solve that problem — but based on what I’ve seen from my vantage point here in DC, you can bet that howls of protest from that tiny group of bandwidth hogs will drown out any rational discussion of what’s fair to the other 98%.
4) It isn’t just me who sees Netflix as conducting this unfair “subisidization” campaign. See this analysis too — http://www.digitalsociety.org/2011/01/netflix-lobbying-for-broadband-consumers-to-subsidize-netflix/.
5) When Netflix has been paying $600-700 million annually to the US Postal Service to deliver DVDs through the mail, one would think they would see some value to sharing in the costs of building out that expensive broadband infrastructure by agreeing to share in a fair proportion of the costs their own service is imposing. But instead, they seem to want to offload all those costs onto the 98% of consumers who AREN’T using their services, as the same time as they work on getting out of the mail delivery business — thereby saving themselves hundreds of millions of dollars each year.
Joel, it seems you and I should be able to agree on the end result we both want — a strong, robust, and high-capacity broadband infrastructure that serves everyone’s needs. But instead of working to figure out how best to get there, we find ourselves arguing about a subsidiary question that reminds me of that famous dialogue from an old Marx Brothers film, where Groucho finds himself negotiating with a beautiful woman over how they might spend the night together:
Groucho: Would you sleep with me for a million dollars?
Pretty lady (laughing): Of course I would!
Groucho: Would you sleep with me for $10?
Pretty lady: Certainly not! What do you take me for?
Groucho: We’ve already established that. Now we’re just haggling over the price.
🙂
Alan
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BTW, it’s late and I’ve got to get prepared for our monthly DC Water and Sewer Authority Board meeting tomorrow morning. Re-reading your Feb. 17th comment above is helping me get focused on that job too. 🙂
Best,
Alan
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