Kellogg World Winter 2010

Kellogg Insight: Questioning cost

Shane Greenstein investigates why consumers are still paying so much for broadband Internet service

By Katharine Gammon

  Shane Greenstein

After a new technology is introduced, there is usually a predictable decrease in price as it becomes more common. That has been true for laptops, digital cameras, personal computers and computer chips. Has the price of broadband Internet followed the same pattern? Kellogg Professor Shane Greenstein decided to find out.

Greenstein and co-author Ryan McDevitt, an assistant professor at the University of Rochester and a Northwestern University graduate, analyzed the contracts of 1,500 DSL and cable service providers from 2004 to 2009. They found evidence of only a very small price drop, between 3 and 10 percent, nothing like the rates of price decrease that characterize the rest of the electronic world.

Many observers believe broadband prices have stagnated largely due to the concentrated market structure. Other factors have also concentrated broadband supply, including economies of scale and regulatory rules. In most urban markets, only two wireline providers supply the vast majority of homes, and the remainder are served by a range of wireless Internet providers. Revenue from homes makes up 70 to 80 percent of revenue in the wireline Internet access market, while business demand makes up the rest.

“So if you were in such a market as a supplier, why would you initiate a price war?” asks Greenstein, the Elinor and H. Wendell Hobbs Professor of Management & Strategy. Without the likelihood of new entrants into the home market, suppliers can compete by slowly increasing quality but keeping prices the same. According to Greenstein, quality is where providers channel their competitive urges.

Meanwhile, once companies have installed the lines, their costs are far below prices. “At that point, it becomes very profitable,” Greenstein says. A company might spend around $100 per year to “maintain and service” the connection, but people are paying nearly that amount every other month. Greenstein says that it is not surprising that prices were high during the buildout phase in the early and mid-2000s, since the firms were trying to recover their costs. “However, we are approaching the end of the first buildout, so competitive pressures should have led to price drops by now, if there are any. Like many observers, I expected to see prices drop by now, and I am surprised they have not.”

The 21st century started out with broadband representing just 6 percent of the total revenue from Internet services, and that figure had grown to 72 percent by 2006. Greenstein and McDevitt based their consumer price index on data from the second half of the decade, from 2004 to 2009, when the use of broadband exploded.

They began by poring over 1,500 contracts from different years and services, including both stand-alone agreements and bundled contracts, in which a user combines Internet with cable television and/or phone service. They found that, even though prices stayed relatively constant, the quality of service rose through the years. For example, in 2004 the median cable modem contract price was about $45. By 2009, the median contract cost $53 but the upload bandwidth speed was more than twice as fast.

The most surprising discovery, Greenstein says, is that national decisions are being made without the type of data that he created in the consumer price index. “As an observer of communications policy in the U.S., I find it shocking sometimes how often government makes decisions by the seat of its pants,” he says.

Without real data and statistics, decisions are based solely on who has better arguments — in essence, a debate. A better consumer price index will help produce better decisions for the future of the Internet and its users.



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