July 15

What drives the economics of networks?

Telecoms

1  comments

What would you say are the economic characteristics of the telecoms industry’s most unique asset?  How can operators create value at the network layer?

fasp4 framework space - economics of networks

“The network” is often seen as the key telco asset.  And with good reason:  thousands of companies can create content, write apps, distribute video – but only telecom operators can manage the delivery of all that content across space and time.  As Martin Geddes says, only telcos can sell “absence of delay in the delivery of information goods at a distance”.  But have we really fully understood the economics of networks and the connectivity business?

In my FASP4 framework, I call this the “Space” layer. Whilst the “Place” layer is about getting the infrastructure to a particular place, the Space layer is about connecting up these different places.  Following my discussion of the “Place” layer, this post continues my walk-through of the basics of the FASP4 framework and acts as an introduction to the main economic and business characteristics of this “Space” layer.

At its heart, this business is about efficiently managing a shared, spatially-distributed technology platform.

It’s a node business. Investments in this shared, spatially-distributed technology platform are generally be measured in peak capacity per node (typically Gbit/s, perhaps simultaneous users).

Value comes from optimising the allocation of the platform’s capacity. You have a shared resource so the key is to share it out in the most economically efficient away. Concretely, this means maximising utilisation whilst prioritising the highest-value customer outcomes. Competitive advantage comes from economically efficient management.

It’s a medium innovation business. The overall network investment cycles tend to be in 5-7 year range. This is the timeframe for new standards achieve to commercial maturity and the economics of networks to take a step change. Of course, there is a frenzy of ‘sustaining’ technological innovation going on as equipment vendors improve on their products, but fundamental change to the core products of network connectivity happens at a more moderate pace.

It’s a moderate risk business.  There is a minimum level of scale required to drive utilisation levels to a profitable point.  Costs are largely fixed and revenues depend on adoption and usage, creating a degree of business risk.  Moreover, there can often be overcapacity in the market, due to new entrants or a recent technological upgrade. When cellular companies upgraded from 2G to 3G, for example, the new networks were empty. Overcapacity can lead to undisciplined price-dumping to “fill the network” at the expense of industry profitability.

The cost driver is the cost of delivering a certain installed capacity at each node.  Costs go up when you expand the number of nodes (geographic expansion) or when you increase capacity at your existing nodes.  The economics of networks are such that costs are not dependent on traffic delivered but on capacity installed.

You are selling timely delivery of data across a shared, contended, resource.  Whilst at the FASP4 Place layer we were selling “uncontended” assets (e.g. a fibre strand), we are now, at the Space layer, selling usage on a resource that is shared across many customers. The key is to optimise the monetization of this shared resource. There are two levers here – keeping utilisation consistently high (to maximise the overall volume of data delivered), and maximising revenue per unit volume. Easy to say than to do I know, but that will be a subject for a future post!

So success can be measured in “revenue per total installed capacity”. In other words, we want to drive “revenue yield” on what is fundamentally a fixed cost base. Fundamentally we are buying capacity but selling volume. It is that mismatch that the drives economics of networks, and ultimately the opportunity and risk for the network operator (at the FASP4 Space layer).

Discussion starters

So “Space” is a node business, all about efficient management of a shared resource (the network): maximising utilisation whilst prioritising the highest-value customer outcomes.

As we review this summary of FASP4 Space layer characteristics, a number of things might jump to mind. For example,

  • If value in the Space layer comes from efficient allocation of the platform’s capacity to the highest-value customer outcomes, then how far does “best efforts broadband” contribute to that goal? What else is needed?
  • “revenue per total installed capacity” is a metric that we could call “economics of density”: it’s not so much raw scale that is important, as demand relative to your footprint.  But as we know from Metcalfe’s law, the value of a network grows exponentially with the network’s reach (number of nodes).  So is it density or reach that is most important?

Do you agree with my summary of the Space layer of the FASP4 framework? Would you add additional insight or nuances about the economics of networks?

About the author 

Richard Medcalf

Strategist, consultant and business leader with 15 years experience in helping companies thrive in an Internet world. Formerly a partner in strategy consultancy Analysys Mason; now at Cisco Systems, developing new strategic partnerships with leading telecoms players.

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  1. Richard,

    Competitive digital networks over the past 30 years have proven that we need to rethink our approach to pricing to clear supply and demand.

    Value based pricing has nothing to do with maximizing the price of a given unit of capacity. Rather value based pricing finds the highest value usage of that capacity. This might mean, paradoxically, the lowest unit cost.

    We are taught early on that networks suffer from high upfront fixed costs. What we’ve seen on the other hand is exactly the opposite. Today’s wireless network 5yr TCO is 13% capex and 87% opex.

    So we need to focus on marginal cost of networks at every layer and boundary point ex ante to arrive at optimal pricing which clears supply and demand, rather than average cost driven pricing models that attempt to clear supply and demand ex post.

    We need to flip around our perspective of networks from a supply to a demand oriented model. It’s not build it and they will come, rather build it to where we know the demand will be. That’s the single biggest differentiator between the silo-ed, edge, access providers (ISPs) and the core, horizontal, relatively open, content and application providers (OTT).

    Michael

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