Abstract

As consumer demand for Internet access and online services continues to grow, so does the competition for market share (i.e., subscriptions) among Internet Service Providers (ISPs). According to recent surveys consumers rate two criteria as most important when deciding to subscribe, or continue a subscription, to an ISP: • the connection quality provided to consumers by the network infrastructure. The connection quality refers to factors such as the accessibility, speed, and reliability of the Internet connection. Connection quality depends on the investments made in the ISPs network infrastructure (e.g., network bandwidth, router switching capacity, and server performance) and the number of subscribers served by that infrastructure. Decisions about connection quality affect the quality of services and, therefore, consumer demand for these services. • the price charged by the ISP for access to its Internet services. In this paper, we develop an economic model, based on the well-established model of R&D competition used by D’Aspremont and Jacquemin (1998) and Amir and Wooders (1998), to examine the trade-offs between decisions made about investments in connection quality and decisions made about pricing the services that result from these investments for firms competing in a duopoly market for Internet access and services. More specifically, we address the following research questions: • How should an ISP determine the optimal investment in connection quality (or network infrastructure)? • How should an ISP price its services and respond to changes in the investment and pricing decisions made by competing firms? • How will falling technology prices (e.g., for network bandwidth, server capacity and performance, and other infrastructure technologies) affect the optimal investment and pricing decisions by ISPs in this market? Two key findings in this analysis are that when considering a market for Internet services in which consumers are more sensitive to differences in price than differences in connection quality: • Prices charged by ISPs should be positively correlated with each other (independent of differences in connection quality) • Falling technology prices should encourage ISPs to invest more heavily in connection quality which will result in better access and service quality for consumers, but at higher prices. The results of the analyses will help decision-makers in the Internet services market better understand the implications of their investment and pricing decisions on consumer demand for services and firm profits.

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