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Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014

Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

MBA 211 Game Theory - Fall 2014


Final Project: Netflix & Net Neutrality
Look Forward, Bring Sexy Back:
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

Table of contents

EXECUTIVE SUMMARY...................................................................3
BACKGROUND............................................................................... 3

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

Executive Summary TBD


Background
On November 10th 2014, President Barak Obama penned an open letter to the Federal
Communications Commission (FCC) to implement the strongest possible rules to protect Net
Neutrality. The president argued An open Internet is essential to the American economy, and
increasingly to our very way of life. By lowering the cost of launching a new idea, igniting new
political movements, and bringing communities closer together, it has been one of the most
significant democratizing influences the world has ever known. But what is Net Neutrality, and
why has the conversation recently been pushed to the fore of the countrys dialogue?
Net Neutrality is the status quo - the idea that Internet Service Providers (ISPs) should treat all
data that travels over the Internet equally. Under this concept, consumers are free to make their
own choices about what applications and services to use and are free to decide what lawful
content they want to share, create, and download.
In 2005, the FCC reclassified internet service providers from common carriers to information
services implying that there were no longer non-discrimination restriction on ISPs. In the
words of Economides and Hermlain, this allowed for the possibility of ISPs charging content
and application providers for last-mile service.
Exhibit 1 The Net Neutrality Landscape

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

Arrows represent flow of money

Exhibit 1 lays out the current Internet landscape. ISPs - such as Verizon and AT&T - act as
information carriers between the content providers and the residential customers. Residential
customers pay a fee to the content providers to access their material and pay the local internet

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk
providers for access to the Internet backbone. Content providers also pay royalties to content
creators, such as Disney, Fox, etc., depending on content agreements between the companies.
Due to the fact that most residential customers only contract with one service provider to access
the internet backbone (similar to how customers only contract with one phone company), local
ISPs tend to function like a monopoly. Importantly, while content providers and residential
customers pay a fee to access the internet backbone, ISPs do not discriminate based on the
data shared. In other words, data provided to customers from Netflix and data provided to
customers from John Morgans Game Theory blog are treated as equal and given equal priority.
Ending Net Neutrality could result in a number of changes to how the internet works. Key
changes including blocking, throttling and paid prioritization.
Blocking ISPs could block content that is not commercially affiliated with it
Throttling ISPs could speed up, and slow down, certain content at its own discretion
Paid Prioritization ISPs could charge certain content providers a fee in order to be in
the fast lane, thereby relegating non-paying providers to the slow lane.
Given the importance the Internet plays in modern life, the debate around Net Neutrality has
drawn passionate advocacy on both sides. Content providers are concerned about being priced
out of competition by bigger, well-funded competitors. Additionally, the regulators are concerned
that paid prioritization and throttling could kill innovation of future products. Conversely, ISPs
feel squeezed and would like the opportunity to price discriminate to extract more value from
content providers, who tend to be major users of bandwidth. Net Neutrality is an issue with
many disparate stakeholders that needs to be deeply scrutinized.

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

Recent History of Internet and Net Neutrality


For being a relatively new industry, the most important part of the Internets history dates back to
the last 10-15 years. One of the most important events that happened during this period, was
the de-regulation of broadband internet in 2002, when the FCC reclassified cable modem
service from Utility to Information Service.1 This step was taken in order to attract interest from
private investors, who saw this as a favorable condition to bring their cash to this industry. Later,
in 2005 the FCC adopted a Policy Statement to promote the open internet2 that contained the
following four principles that would be incorporated in their policy making activities:
(1) Consumers are entitled to access the lawful Internet content of their choice
(2) Consumers are entitled to run applications and services of their choice, subject to the
needs of law enforcement
(3) Consumers are entitled to connect their choice of legal devices that do not harm the
network
(4) Consumers are entitled to competition among network providers, application and service
providers, and content providers.
Later, in 2010 the FCC promoted the open internet order3 that further regulated in favor of Net
Neutrality, based on three main principles: (i) transparency, (ii) no blocking, and (iii) no
unreasonable discrimination. Verizon opposed this new regulation, bringing the FCC to court,
which in January 2014, ruled out favorably for the first one, stating that the FCC does not have
authority to regulate ISPs. Although the FCC didnt appeal the ruling, it has been looking for
other alternatives in order to effectively regulate ISPs, such as reclassifying them as utilities.
President Obama has been an active supporter of Net Neutrality and the FCCs role in enforcing
it, with the most recent declarations taking place in November 10, 2014:
"to put these protections in place, I'm asking the FCC to reclassifying internet service
under Title II of a law known as the Telecommunications Act. In plain English, I'm
asking them to recognize that for most Americans, the internet has become an
essential part of everyday communication and everyday life"
From the online content providers perspective, the industrys history is much more recent and
dates back to the past 5-10 years, with the industrys rise happening in the last years as the
most important players in the industry were either started or become popular:
2006: Youtube was acquired by Google for $1.65bn
2007: Netflix started streaming online content
2007: Hulu was created as joint venture between media studios: 21st Century Fox,
NBCUniversal, and The Walt Disney Company
2007: Amazon launched Unbox, which was later renamed Amazon Instant Video
2010: HBO launched HBO Go an online streaming service for existing subscribers
1 FCC classifies cable modem service as "information service" ( MCI v. FCC. 515 F2d 385), March 14,
2002
2 FCC Document # 260435A1, August 5, 2005
3 FCC Document # 10-201, December 21, 2010
6

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk
Started in 1997 as a movie rental company, Netflix initially operated under a traditional pay per
rental model, but soon in 1999 started disrupting the market by offering unlimited DVD rentals
using a monthly subscription model. Later in 2007, when they delivered its billionth DVD, the
Company introduced its online streaming service that has allowed it a very rapid growth in the
U.S. and worldwide. As of July, 2014 the company operated in more than 50 countries and had
around 50 million subscribers, out of which around 70% are in the U.S. But the growth in users
has also come with a significant increase in the amount of bandwidth that is used for streaming
the online video, resulting in a fight between Netflix and the main ISPs, where the first one
blames the second one for discriminating and slowing down their streaming traffic. Comcast and
Verizon are two of the players with whom the company has held public fights that have received
wide media coverage, but with whom Netflix finally settled on interconnection agreements that
grant them faster connections to the ISPs networks (Comcast by the beginning of 2014, Verizon
by the end of the first semester). As it can be seen in the following exhibit, the improvement in
the users download speeds is evident and almost immediate after the deals were done.
Exhibit 2 - Netflixs speed on Comcast and Verizons networks4

But these agreements raise the question on how much power the ISPs already have and to
what extent they can use it to force content providers to pay additional fees to have fast access
to their infrastructure. In this example, although Netflix initially opposed to pay for high-speed
access, it finally had to agree in order to preserve customer satisfaction levels. This
dissatisfaction was expressed by Netflixs CEO, Reed Hastings during an interview on May,
20145:
Comcast is paid for 10 megabits or 50 megabits for about $30-80. Consumers
deserve to get those speeds they pay for and Comcast is responsible for the delivery
of those speeds. Comcast would like to charge us and then also charge the consumer.
4 Team analysis, using data from: http://ispspeedindex.netflix.com/
5 http://www.washingtonpost.com/blogs/the-switch/wp/2014/07/11/netflix-ceo-qa-picking-a-fightwith-the-internet-service-providers/
7

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk
Thats great for their business and I dont blame them for trying. But I dont think thats
the right way to set it up.

Main Players in the Industry


On the one hand, the content providers is a highly concentrated market where Netflix is the
market leader accounting for 34% of the download bandwidth, followed by Youtube with a 13%
share. Hulu, Amazon and iTunes, the next three players, account for approximately 10% of the
total share.
Exhibit 3 Content providers market share6

Fixed Access bandwith usage Northamerica 2013

Other; 22%
Netflix; 34%

Facebook; 2%
MPEG; 3%
BitTorrent; 3%
SSL; 3%

YouTube; 13%

12%
iTunes; 4% HTTP;
AmazonVideo;
2% Hulu; 2%

From a revenue perspective, Netflix is also the market leader followed closely by Youtube with
similar revenue, and by Hulu, a much smaller player in the current market. Youtubes business
model based on free content, gives the company the highest margins amongst its close
competitors that have to incur in costs to pay for the content they stream.
Exhibit 4 Content providers market share7

2013, $Bn
Revenue

Netflix
4.4

Youtube
3.5

Hulu
1.0

6 Sandvine 2013 Global Internet Phenomena Report available at:


https://www.sandvine.com/downloads/general/global-internet-phenomena/2013/2h-2013-globalinternet-phenomena-report.pdf
7 COGS for Youtube and Hulu based on market analysts estimates

Look Forward Bring Sexy Back | Final Project: Netflix & Net Neutrality | 12/06/2014
Qais Al Shihabi, Andrew Meyers, Sharif Karmally, Juan Zarruk

(-) COGS
Gross profit
Margin

3.1
1.3
30%

2.0
1.5
43%

0.7
0.3
30%

The market for ISPs, is even more concentrated with the top 3 players controlling approximately
70% of the total users, with Comcast leading over its competitors.
Exhibit 5 ISPs market share8

Broadband Market Share by users, Sept. 2013

Others; 17%
Frontier; 2%
Charter; 5%

Comcast+TWC; 38%

CenturyTel; 7%
Verizon; 11%
AT&T; 20%

Exhibit 6 Content providers market share9

2013, $Bn
Revenue
(-) COGS
Gross profit
Margin

Comcas
t
10.3
4.2
6.1
59%

AT&T
8.4
5.9
2.4
29%

Verizon
6.1
3.4
2.7
44%

Other/Regulator
Regulatory Fees
$Comcast paid a fine of $16/share in 2009 for NN violations

8 http://www.digitalcrazytown.com/2014/02/comcast-twc-broadband-reach-could-be.html
9 COGS for Youtube and Hulu based on market analysts estimates