How the Internet Economy Works: Guns, Butter, and Bandwidth

Photograph by George Frey/Bloomberg

Most people know certain things about the Internet. They know that cables run under the sea, that wires come into your homes, and that modems carry the digital signals to your devices.

But they’ve probably never heard of Internet exchange points, and that’s where the magic of the Internet really happens.

Internet exchange points (aka IXPs) are the manufacturing floor of the Internet—that’s where bandwidth is created and deployed. And bandwidth is just like water and oil and other economic goods: If your country has a lot of it, prices fall; if it doesn’t have a surplus, prices go up. And that has a big impact on the Web companies that buy bandwidth.

The Netherlands, for example, is a large net exporter of Internet bandwidth, using only half of what it produces domestically. That means that large companies such as Disney, Google, and Netflix can buy ports there at rates that are significantly lower than in some other places and that have dropped 50 percent in the past year. But where there isn’t an Internet exchange point and competition can’t flourish, prices remain high. That’s what you see in such places as Mexico. More on that below.

Although Internet exchange points are a key building block of the Internet economy, you’d never guess it from where they’re located. They don’t remotely resemble other temples of commerce. You don’t see people standing in them yelling at each other, like you would at a stock exchange. Instead, they can be located inside a beat-up building near a railroad track. Sometimes there’s not a single human being in the vicinity.

A report I covered earlier from the OECD lays out in awesomely clear detail why Internet exchange points are so essential for every geography that values the Internet. They not only facilitate the creation of bandwidth; they also lower the cost of transit/bandwidth for businesses and consumers and help create redundant networks and limit or diminish the power of monopoly telecommunications providers.

The report does a great job explaining exactly how the Internet economy functions. Not the creation of websites and services (although the report does delve into the creation rationale for “the cloud”), but how bandwidth is created and then used. It explains why certain places have higher Internet transit costs and why it makes sense for different Internet service providers essentially to exchange traffic. It offers a compelling look at how important competition among network providers is to keeping the Internet cheap.

From the report:

“Internet exchange points (IXPs) are the source of nearly all Internet bandwidth. A country that lacks IXPs must import Internet bandwidth from other countries that do possess them. Like factories and farms, they are a primary means of producing a commodity that‘s potentially quite expensive to import.

“As a general rule, the cost of telecommunication services is the product of the speed of the service multiplied by the distance covered (i.e. speed x distance = cost). The further afield you go for your bandwidth, the more expensive, and slower, it will be. Thus it‘s always preferable to use a local IXP, to one that‘s further away.

“As a result, IXPs proliferate in areas where Internet service providers, users, and policy makers are well-informed on matters of telecommunication economics. A corollary is that a region [that] has many functioning IXPs and produces more bandwidth than it consumes can export bandwidth to other regions at a profit.”

This formula of cost as a matter of speed and distance is important to understand—and is why peering relationships are so important. Not only does a provider not have to build a network that covers every user in the world; it can exchange traffic with other providers that also don’t want to build out networks. And because most of the peering is done via handshake agreements with no money changing hands, the operational costs of sending traffic are pushed as low as the network owner can get them.

It doesn’t mean the providers don’t pay any costs, but that the multiple providers essentially are building quid pro quo relationships so everyone doesn’t need to build out a network to cover every single person who wants to be on the Internet. And while some traffic may be slightly imbalanced for some providers, it keeps prices low for end users, which means they consume more bandwidth, which is good for the whole ecosystem.

Mexico provides an example of what happens when there’s little competition, either from another bandwidth manufacturing entity or from the existence of an IXP that can help offload traffic for many providers. As the chart below shows, you get disproportionately high prices for regional transit, which can then be passed on to consumers. For example, in parts of Africa, consumers and businesses paid higher transit prices, but the construction of more submarine cables and an Internet exchange point has helped lower costs.

From the report:

“Mexico continues to lag, being by far the largest nation in the world, and the only OECD member country, to continue without any domestic Internet exchange capacity. Mexico‘s traffic continues to be exchanged largely on the East Coast of the United States, and to a lesser degree in the exchanges of its Latin American neighbors and European trading partners.

“This is a consequence of the near-universal dominance of Mexico‘s incumbent, Telmex. This situation may be on the brink of reform, as COFETEL, the Mexican regulator, has opened access to competitive long-haul circuits, has licensed a second national carrier, and is investigating the establishment of an IXP. The lack of [a] domestic traffic exchange has had a dramatically visible effect on Mexican transit pricing, relative to other economies of similar size and development.”

Outside of regions that don’t have an IXP, there are other threats to this model of how the Internet currently works and regulates itself, namely regulations at the global or national level that might clog the free-market nature of these exchanges. Interestingly this report makes a good case that even actions taken by large ISPs or backbone providers to restrict who they peer with doesn’t cause very much economic harm to the Internet as a whole. It shows how many of those choosy providers are bypassed by those they refuse to peer with and those rejected peers find another network.

Given how important broadband and Internet access is becoming to our lives and economies, the report provided a lot of good data and good news. Check it out.

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