Phillip Green

FINA 6387
3 May 2015

Effect of a New Entrant on an Oligopoly Market

Introduction
For years in most cities throughout the United States, accessing the Internet was done through a
very small number of service providers. In addition, the largest internet service providers, like Comcast
and Time Warner, dont typically compete in the same markets. There are many economic reasons for
this market structure, but it meant that over the years, U.S. internet speed rates consistently lagged
behind other developed countries, especially technology centric ones like Japan and South Korea. Most
recently, however, there has been a new entrant to the market.
In 2012, Google announced that it would be installing fiber optic internet and television in
Kansas City. The new service included a fiber optic, gigabit internet connection and cable television
access. The new speeds offered were 500 times greater than the current average offered by ISPs in
Kansas City. So the question becomes, what impact, if any at all, did a new entrant have on a market
currently dominated by duopolies and oligopolies?
Background
Technological Background
The internet was originally developed by researchers at the Defense Advanced Research
Projects Agency (DARPA) in 1966 in an effort to send and receive voice data over a secure network
called ARPANET. With this network design, several colleges throughout the country began creating
nodes. A team at UCLA in 1969 was the first in the United States, followed by UC Santa Barbara and
the University of Utah following next. The universities involved were looking at ways to electronically
send packets of information to each from these connected nodes. In October of 1972, a conference was
held in which this new technology was showcased to the public along with a new application: electronic
mail. It is important to note that at this point, speeds of ARPANET were 50.0 kilobits per second or kbps,
and bits per second would go on to be the standard of measurement for the overall speed of a network.
With these three basic nodes in place, a communication protocol called TCP was developed to
help standardize how packets were sent when new nodes that were installed. In addition to academic
and governmental research, Xerox was also working on network protocols during the same time period.
Bob Metcalfe of Xerox PARC in 1973 designed the local area network, or LAN, that allowed for the
integration of personal computers onto the network.
This development allowed for the flourishing of the internet in the 1980s. The expansion and
adoption of this new form of communication led to management issues for nodes. To combat this, a
numeric system was created and each network was assigned a host name that corresponded to this
number. While, originally, there were a fairly limited number of hosts, this soon grew to be too
cumbersome for a single table full of host names and numbers. The rise of independently managed LANs
meant that a new naming system had to be developed. This came in the form of the Domain Name
System (DNS) which was developed by Paul Mockapetris at USC. According to the Internet Society
website, the DNS permitted a scalable distributed mechanism for resolving hierarchal host names into
an internet address (Internet Society).
By 1985, the Internet had a broad installation among the defense research community and
academia and was mainly used for electronic communication. Further, it was realized that in order for
the Internet to grow the current networks needed to be funded and expanded without the need for
government financial assistance. To help in this, the federal government decided upon several policies.

Firstly, it settled on a single communications protocol, TCP/IP. Secondly, it shared common

infrastructure costs with businesses and universities, such as trans-ocean connections. Thirdly, they
encouraged commercial companies to expand their networks via the allowance of DARPA internet
architecture in the hope that this would result in lower costs due to economies of scale. Finally, the
government developed acceptable use policies for the further development by commercial companies
on the Internet infrastructure backbone.
By 1995, the government had defunded these programs in favor of private, commercial
development; however, between 1985 and 1995, speeds and the number of nodes had increased from
six, 56 kbps nodes to 21, 45 Mbps nodes. Today, there are over 29,000 networks operating in the United
States and more than 50,000 internationally, including the International Space Station. All of the current
national internet ISPs grew from this commercialization of government networks. A brief history can be
seen in the timeline in Exhibit 1 (Internet Society).
Exhibit 1: Technological Timeline of the Internet Infrastructure

Legislative Background
In addition to the technological history of the Internet, a look at the legislative history is also
necessary to understanding the current market structure. The legislation and oversight of electronic
communications can be seen as early as 1913, where AT&T, a telephone company at the time, was being
charged with antitrust suits by the government. It wasnt until 1934, however, that the government
would authorize the creation of the Federal Communications Commission (FCC) which governs
electronic transmissions such as telephony, radio, and now internet services.
For nearly 50 years, AT&T enjoyed a telephone monopoly across the United States due to
business practices that were limited via their access to long-distance infrastructure. By the mid-1980s,
AT&T had lost another antitrust lawsuit and was required to divest regional telephone carriers and local
carriers were barred from manufacturing telecommunications equipment. During this period, Cable use
increased and was regulated by local jurisdictions. Rapidly rising rates in this market in the late 1980s
caused the federal government to intervene with the Cable Television Consumer Protection Act in 1992.
It was then that the FCC regulated prices and required content providers to make their channels
available to competitors.
Just about the time that the Internet was rapidly expanding in the mid-1990s in the U.S., the
Clinton administration was drafting the Telecommunications Act of 1996. This piece of legislation was
responsible for classifying how the government interacted with the various forms of electronic

communications that existed. The bill was divided up into telecommunications services and information
services, each of which was regulated in a very different manner.
The telecommunications service continued to be regulated via the Modification of Final
Judgement portion of the Federal Communications Act of 1934. This segment was highly regulated and
had a significant amount of competition in the industry, but importantly, did not include electronic
communications such as cable and broadband internet. The law treated these two segments very
differently. For telecommunications, the law prohibited states from allowing local monopolies and
required an interconnectedness between competitors on state regulated prices and terms & conditions.
Finally, and importantly, the Act allowed for local competitors to buy excess capacity on telephone
networks and resell it in a process called unbundling (Ehrlich).
The information services section of the 1996 Act was very different. The goal of the current FCC
chairman at that time was an emphasis on deregulating the industry in an attempt to foster innovation
and growth. Telephone and cable companies saw an opportunity here and began pouring money into
high-speed internet access and converting old analog telephone services into new digital technologies
(Ehrlich).
Further, attempts by the FCC to regulate portions of the information services section of the law
have been, until recently, successfully challenged by the major cable and Internet providers in court. For
instance, in 2010 the FCC ordered Comcast to make transparent their Network Management Practices.
This is the process by which the company manages how it allows for individuals and companies to utilize
the service and how their information is transferred over the network. Comcast responded by taking the
FCC to court and won a decision in their favor. Most recently, however, the FCC has made major
changes in the way that they regulate the ISPs by requiring that they follow a set of stipulations called
the Open Internet Rules, or more commonly referred to as Net Neutrality. While the implementation of
these rules is still contested, the effects are believed to foster competition among the industry (FCC).
Market Structure
In understanding the market prior to Googles entrance, it is important to understand the
overall structure of the industry. There are two different subsections of the Internet. There is the
Internet Backbone, which consists of the physical infrastructure and fiber optic lines that connect the
country and the last mile of service where the actual ISP operates. All information, regardless of
service provider is sent through these route points. Currently there are only nine Tier 1, Internet
backbone companies out there. Exhibit 2 shows is a list of the current U.S. Tier 1 companies (Mountain
Areas Information Network).
Exhibit 2: Tier 1 U.S. Internet Companies
Name
Sprint
XO Communications
Zayo Group
CenturyLink
Verizon Enterprise Solutions
AT&T
Level 3 Communications
Cogent
GTT

HQ Location
United States
United States
United States
United States
United States
United States
United States
United States
U.S./Italy

Autonomous System (AS) Number

1239
2828
6461
209/3561
701/702/703
7018
3356/3549
174
3257

A map of the Internet backbone can be seen in Exhibit 3 below.

Exhibit 3: Tier 1 Internet Nodes in the United States

From there, companies purchase access to these data points and are called Tier 2 or Tier 3 companies.
Tier 2 companies have partial ownership of a network node, but purchase a majority of their usage
through another provider. Tier 3 companies have no ownership of the backbone and purchase all
Internet usage through other backbone companies and are only responsible for the last mile of
connectivity to the end-user. The companies that we are focused on in for this paper are the mainly the
Tier 3 companies, which are more commonly referred to as Internet Service Providers, or ISPs. These
ISPs are the companies that we are interested in understanding the entrance of a new company
(Mountain Areas Information Network).
Economic Analysis
Market Analysis
While Internet access across the United States has significantly increased in the last 20 years,
the number of companies that provide this valuable service are relatively few, especially considering the
operating margins for these services. In 2015, Time Warner Cable was reported to have a 97 percent
profit margin on its High-Speed Internet Service (Kushnick). When it comes to service providers,
Houston, for instance and the fourth largest city in the United States, only has five options for Internet.
Another example is the city of Austin which only had two, AT&T and Time Warner, at least until very

recently. To answer why there are so few ISPs, we will need to look at the, frankly, significant barriers to
entry that exist in this market.
Firstly, there is the sheer cost of developing the physical infrastructure needed to reach the end
customer. While overall access is purchased from Tier 1 backbone suppliers, the last mile of usage,
required to reach the end-customer must be installed by the ISP. For instance in the last decade, Verizon
has spent over $23 Billion on upgrading its network to customers to fiber optic (Finley). This significant
cost means that there are very few options for companies looking to enter this market. It takes a very
large existing firm or a huge amount of startup capital just to compete on a city level.
Secondly, there is a defacto monopoly in areas when it comes to telephone poles and other
public right-of-ways. In places like Austin, AT&T owns approximately 20 percent of all the utility poles
around the city, with the remaining percentage owned by the city. This means that AT&T can effectively
block competitors from accessing certain areas of the city. For companies like Google that are trying to
enter the market and increase competition, they must go before the city legislature in an attempt to
force AT&T to give them access or broker a deal directly with their potential competitors. One caveat to
this situation is that under federal law, Google would be guaranteed access to these poles if the
company qualified as a telecom or cable provider, but to date, Google would have to pay AT&T for
access. Being reclassified would mean greater regulation for the company, but might be one of the only
ways to consistently, and with far less effort and cost, gain access to the current infrastructure of the
last mile (Brodkin).
Finally, the government and corresponding legislature inhibit competition in this space. The
main ISPs out there have, over the years, been able to successfully lobby legislatures to pass laws that
restrict competition. For instance, a Kansas bill was put forth in 2014 that would have restricted local
municipalities from offering Internet service to areas not reached by the major ISPs. As another
example, Texas prohibits municipalities and municipal electric utilities from offering
telecommunications services to the public either directly or indirectly through a private
telecommunications provider (Brodkin).
What this means is that there is little incentive by local ISPs to compete on price or speed.
Typically, capital expenditures are only made to expand into new markets or when current
infrastructure needs repair. At this point, new markets take the form of more rural areas of the United
States, where there is significantly less population density and costs for reaching that last mile are
larger. In an effort to control costs, these major ISPs will install older, better established Internet
technology, such as copper-based coaxial wire or Digital Subscriber Lines (DSL) instead of the newer
fiber optic lines. What this means to those areas is a jump from non-broadband internet, such as dial-up,
to broadband speeds, with little incentive for companies to install the more expensive fiber optic lines.
Exhibit 4 showcases the current maximum speeds offered by the major ISPs in the United States (FCC).

Exhibit 4: Nationwide Maximum Advertised ISP speeds

Analysis of a New Entrant

Google, Inc. is primarily an advertising with more than 70 percent of revenues originating from
advertising sales. For a company like this that relies on the Internet for the continued operations of its
business, it makes sense that they would be interested in ensuring the proliferation and enhancement of
the Internet. The better access people have to their product, the more money they stand to make. I
believe that this is one of the major reasons that Google decided to become an ISP in certain cities. As
shown in Exhibit 5, they saw a general trend where broadband Internet speeds were fairly flat over the
last 15 years (Horn).
Exhibit 5: U.S. Historical Broadband Speed Trends

To combat this trend, Google began offering a 1 gigabit per second (Gbps), or 1000 Mbps,
Internet connection to certain select cities. Currently, the average Internet speed for the entire United
States is 37.02 Mbps according to NetIndex.com (Ookla Net Index). This means that Google would be
offering a product nearly 30 times faster than the current average. The first city to be chosen was Kansas
City, a relatively small city of just over 450,000 people. Shortly after, Google announced that it would be
offering its Gigabit Internet service in four other cities, including the much larger market of Austin,
Texas.
The cost Google was offering this service at was $70 a month for Internet and then an additional
$30 a month for basic cable TV channels. Prior to their entrance in the Austin market, AT&T only sold a
20 Mbps Internet service bundled with TV for roughly $200 a month, according to Austin consumers. So
the question is, what effect has this had on a market with relatively few players (Reardon).
What is reported is that where AT&T is directly competing with Google, they are raising the
speeds to match or compete better and are lowering costs. For instance, in Austin, AT&T raised speeds
from a maximum of 20 Mbps to 300 Mbps. In addition, they lowered their monthly fees from $200 to
$100 in order to directly match Google. Also, they were able to do this with very little delay after the
announcement from Google and before their competition could actually implement the new service.
The same was true for Kansas City where AT&T has matched prices and speeds (Canon).
In economic terms, where there are entrants of new firms into imperfectly competitive, or
oligopolistic, markets we should expect to see an increase in the total quantity produced and a decrease
in the equilibrium price charged. In addition, for every firm that enters the market, we should expect to
see a drop in the profit margins of these firms as they increase competition between firms. This is
exactly what we see happening with the Internet Service Providers in these markets. While Google could
have decided to enter the market and charge a premium for their service, as a new entrant, they
decided to charge a low price in an effort to take market share from those companies that either could
not, or would not, fully compete on speed and price.
There is one final item to note in terms of the competitive landscape: Where Google has
entered, not all companies have been able to compete. For instance, Time Warner offers Internet
service in both Kansas City and Austin, but has not yet been able to respond to the increased offerings of
its other competitors. To date it hasnt lowered its price nor dramatically increased their speeds.
Conclusion
After looking at all of the information, it is fairly obvious that Google entering the broadband
Internet market has been a boon for the average consumer. They have received significantly better
speeds and lower prices as a result of the increased competition. It is worth noting, however, that there
are very few companies inside the United States that could even attempt to imitate what Google is
doing. Their significant profits in other markets and political power means that they afford to invest in
an entrenched market with high barriers to entry. In addition, new regulations are being implemented
by the FCC which might mean that Google, and other new firms, are better able to compete in an
increasing number of markets. If the FCC ends up reclassifying the Internet as a telecommunications
service, there is a distinct possibility that the last mile of service could be significantly more
competitive in the coming years, as more firms enter the market driven largely by huge profit margins
and the legislative barrier to entry is reduced. This might be similar to the power market that currently
exists in Texas, where there are a few power generation companies, but many competitive power
distribution firms. If this happens, I think we could continue to see speeds continue to rise and
comparable prices continue to drop as we move from an oligopoly market to a more competitive one.

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