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`C U R R E N T ( H T T P : / / W W W . J O U R N A L O F E L E C T R O N I C P U B L I S H I N G . O R G / )A R C H I V E ( H T T P S : / / Q U O D . L I B . U M I C H . E D U / J / J E P / 3 3 3 6 4 5 1 . * )A B O U T ( H T T P : / / W W W . J O U R N A L O F E L E C T R O N I C P U B L I S H I N G . O R G / A B O U T . H T M L )E D I T O R S ( H T T P : / / W W W . J O U R N A L O F E L E C T R O N I C P U B L I S H I N G . O R G / E D I T O R S . H T M L )S U B M I T ( H T T P S : / / J O U R N A L O F E L E C T R O N I C P U B L I S H I N G . S U B M I T T A B L E . C O M / S U B M I T )
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`An Assessment of Pricing Mechanisms for the Internet--A
`Regulatory Imperative
`
`Journal of Electronic Publishing
`
`Volume 1, Issue 1&2, January
`
`DOI: http://dx.doi.org/10.3998/3336451.0001.103 [http://dx.doi.org/10.3998/3336451.0001.103]
`
`Presented at MIT Workshop on Internet Economics March 1995
`
`1 Introduction
`
`This paper argues that however much of an anathema the notion of regulating the Internet may be, there is a strong need
`to start putting the appropriate regulatory structures in place as the commercialized Internet moves incrementally
`towards a usage-based pricing system. Various factors such as new bandwidth-hungry applications; the massification of
`the net; the concerted entry of the telephone, cable, and software companies; and the proliferation of electronic commerce
`all imply unimaginable potential growth rates for the Internet and a resultant scarcity of bandwidth, thus making it
`imperative to put a pricing system in place that would effectively ration scarce bandwidth.
`
`As has been argued by many, a usage-based pricing system seems to be an innovative way to effectively ration scarce
`bandwidth. In this context, this paper examines the Precedence and the Smart Market models of Internet pricing. We
`note that (a) the perceived homogeneity of the Internet's load, and (b) the threat of market-power abuse through artificial
`creation of a high network load by those who control the bottleneck facilities, remain the fundamental weaknesses of
`usage-based pricing. However, given that usage- based pricing is inevitable, and that the Smart Market mechanism does
`present an innovative and a potential solution, it is important to consider the appropriate safeguards that need to be put
`in place. In this context, the paper argues that a usage based, free market pricing system needs to be combined with some
`form of regulatory oversight to protect against anti-competitive actions by the firms controlling the bottleneck facilities
`and to ensure non- discriminatory access to emerging networks.
`
`2 The Different Dimensions of Growth
`
`The Internet, which has hitherto been restricted as a resource for high level researchers and academics, is "expanding to
`encompass an untold number of users from the business, lower-level government, education, and residential sectors"
`(Bemier, 1994, p. 40). Studies done by Merit Network Inc. [1] [#n1] indicate that the Internet has grown from 217 networks
`
`in July 1988 to 32,370 networks in May 1994. The number of hosts have increased from 1,000 to over two million over
`the same period, with about 640,000 of these located at educational sites, 520,000 at commercial sites, 220,000 at
`governmental sites, and the remaining 700,000 at non-US locations. Traffic over the NSFNET backbones increased by 10
`times in three years, from 1,268 billion bytes in March 1991 to 12,187 billion bytes in May 1994. The traffic history of
`packets sent over the NSFNET shows similar exponential growth trends. As against 152 million packets in July 1988,
`60,205 million packets of information were sent over the system in May 1994; an increase of almost 400 times. [2] [#n2]
`
`These stunning growth figures are just a precursor to the boom in Internet traffic that is expected to take place in the near
`future. As will be laid out in this paper, a set of factors in combination are threatening to dwarf even these exponential
`growth rates in the near future.
`
`3 The Causal Model of Internet Congestion
`
`As illustrated in the chart, a set of forces working together are threatening to create unprecedented levels of congestion on
`the Internet. It is argued that three main factors—incompatibility of the newer applications with the Internet's
`architecture, massification of the Internet, and privatization and concomitant commercialization of the Internet—are
`responsible for an inherent change in the Internet's dynamics, thus mandating a reexamination of the economic system
`that surrounds the Internet.
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`GUEST TEK EXHIBIT 1018
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`Figure 1
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`3.1 Incompatibility issues
`New network applications are all tending to require heavy bandwidth in near-real time. As Bohn et al. note, "one may
`argue that the impact of the new, specifically real-time, applications will be disastrous: their high bandwidth- duration
`requirements are so fundamentally at odds with the Internet architecture, that attempting to adapt the Internet service
`model to their needs may be a sure way to doom the infrastructure" (p . 3).
`
`Their technical characteristics and, consequently, their demand on the network are very different from the more
`conventional, traditional electronic communication and data transfer applications for which the Internet has been
`designed. [3] [#n3] While conventional electronic communication is typically spread across a large number of users, each
`
`with small network resource requirements, newer applications such as those with real-time video and audio require data
`transfers involving a continuous bit stream for an extended period of time, along with network guarantees regarding end-
`to-end reliability. Even though the data-carrying capacity of the networks is constantly being enhanced through upgrades
`in transmission capacity and switching technology, current developments in communication software, especially those
`related to multimedia, are creating network applications that can consume as much bandwidth as network providers can
`supply (Bohn, Braun, Claffy, & Wolff, 1994).
`
`Multimedia Netscape applications, Internet fax, and Internet radio are becoming large users of resources (Love, 1994).
`Russell (1993) reports that while only 2.4 kbps are required for communication of compressed sound, 3840 kbps are
`required for CD quality stereo sound. Real-time video needs bandwidth ranging from 288 kbps to 2000 kbps, while
`studio quality non-real time video could require up to 4000 Kbps. HDTV requirements range from 60,000 to 120,000
`Kbps. [4] [#n4] Bohn et al. (1994) report that many videoconferencing applications require 125 kbps to 1 Mbps. Although
`
`compression techniques are being developed, the requirements are still substantial CUSeeMe, developed at Cornell
`University uses compression, yet its requirements are in the region of l00 kbps.
`
`In essence, the trend is towards applications that are, first, heavy bandwidth consumers and second, require near real-
`time transmission—both characteristics that are essentially incompatible with the inherent architecture of the Internet.
`
`3.2 Privatization, Commercialization, and Massification
`Simultaneously, we are witnessing a privatization of the Internet's facilities, increasing commercialization of the net, and
`a political agenda promoting the rapid deployment of the NII. All these are resulting in a massification of the Internet, as
`it becomes easier to get "wired" in. The bottom line implication is that the demand for bandwidth is possibly rising
`beyond current levels of supply.
`
`Prior to 1991, the net's physical infrastructure was government-owned and operated. On December 23,1992, the NSF
`announced that it will cease funding the ANS TS backbone in the near future. The Clinton Administration's thrust on
`private-sector investment in the NII implies that very soon, possibly by 1996, the Internet's facilities will be largely
`privatized. In 1994, the NSF announced that the developing architecture of the Internet would utilize four new Network
`Access Points (NAPS), and the contracts for operating them were awarded to Ameritech, PacBell, MFS, and Sprint. In
`addition, MCI has been selected to operate the Internet's new very high speed backbone (vBNS).
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`The traditional telecommunication companies operating in a nearly saturated and increasingly competitive domestic
`market, are turning their focus towards advanced data services, a market where the "number of data relationships is
`growing at more than four times the number of voice relationships" (Campbell, 1994, p. 28). Spurred on by the promise of
`the NII, a variety of communication companies are getting into the act. "(T)elephone companies, cable companies,
`information service companies, television networks, film studios, and major and software vendors are all maneuvering to
`ensure that they are well positioned to profit from the NII in general and the Internet in particular" (Business Editors,
`1994).
`
`Of all these players, the telephone, software, and cable companies are in a position to strongly affect one critical aspect of
`market: accessibility. User-friendly software, enhanced services, and marketing skills are together likely to have a dual
`effect: one, allow computer literate users who have been to date outside the periphery of the net the opportunity to
`connect, and two, drive the development of user-friendly tools of navigation, which would have a multiplier effect on both
`network usage and the number of people who would be able to navigate through the Internet effectively and access
`desired information bases productively .
`
`Bernier (1994) reports that the telephone and the cable companies have already rolled out their plans for the Internet. In
`March 1994, AT & T announced a national InterSpan frame relay service and Internet Connectivity options, both dial-up
`methods for accessing the Internet. MCI offers access over its frame relay services. Sprint, which offers a nationwide
`Internet access service along with providing international Internet connections, is now offering ATM access to the net.
`Several Bell regional companies are getting into the act. US West offers end users access to two Internet providers via its
`frame relay services. Pacific Bell in collaboration with InterNex Information Services, now offers Internet connections,
`while Ameritech has won a contract to be one of the four Network Access Providers. They plan to offer Internet protocol
`pipes over their frame relay, switched multi-megabit data service. Many cable operators are also getting into the market.
`Continental Cablevision and Jones Intercable are using cable modems hooked onto their coaxial lines to bring broadband
`Internet connections to businesses and homes. Continental, a Boston- based cable company, launched a service in M arch
`in collaboration with Performance Systems International, the national Internet access providers, to bring high bandwidth
`service to residences and businesses in Boston. [5] [#n5]
`
`The bottom line implication is that the number of Internet users is going to increase manifold, as opportunities to
`interconnect with the network become ubiquitous through the efforts of the telephone, software, and cable companies,
`and as user-friendliness and utility of the applications develop further.
`
`4 Implications & Key Issues
`
`The implication of these forces—the incompatibility of the new bandwidth hungry applications, infusion of new users, and
`the privatized and commercialized nature of the Internet—is that the demand on network resources will increase
`exponentially, and will possibly be much more than the supply of bandwidth. As network resources become scarcer and as
`the system is driven towards a free-market model, resource rationing through a change in the pricing system is inevitable.
`
`The key issue is that the pricing mechanism should be able to (a) preserve the inherent discursive nature of the net, (b)
`send the right signals to the marketplace, and also (c) be flexible and adaptive to changes brought about through
`technology, political initiatives, and software development.
`
`4.1 Pricing Alternatives
`The major fear in some quarters is that the present system of flat-rate, predictable pricing for a fixed bandwidth
`connection will be replaced by some form of vendor preferred, usage-based metered pricing Users feel that the Internet
`should continue to function primarily as a vast, on-line public library from where they can retrieve virtually any kind of
`information at minimal costs.
`
`According to some, a transition to metered-usage would make the NII "like a Tokyo taxi, so that for every passenger who
`takes a ride on the national data superhighway, the first click of the meter will induce severe economic pain and the pain
`will increase with each passing minute" (Judith Rosall, International Data Corporation's Research Director quoted in
`Business Editors, 1994).
`
`Consumer advocacy groups opposing metered pricing usage of the Internet [6] [#n6] feel that the NSF should create a
`
`consumer advisory board to help set pricing and other policies for the network to ensure that the free-flow of information
`and democratic discourse through Internet listserver and fileserver sites is preserved and enhanced. In addition to the
`fear that a popular discussion would have to pay enormous amounts to send messages to its members, it is feared that
`usage based pricing would introduce a wide range of problems regarding the use of ftp, gopher, and mosaic servers, since
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`the providers of the "free" information would be liable to pay, at a metered rate, the costs of sending the data to those who
`request for it. This would have a negative effect on such information sites, and would eliminate many such sources of free
`information.
`
`In essence, the argument is that usage based pricing would imply severe economic disincentives to both users and
`providers of "free" information, and would therefore destroy the essentially democratic nature of the Internet.
`
`4.2 The Arguments against Flat-rate Pricing
`The paper argues that flat-rate pricing in the current context of the Internet is likely to run into severe problems.
`Paradoxical as it may sound, the continuance of flat rate pricing is likely to severely impair the current discursive nature
`of the Internet.
`
`The basic role of a pricing mechanism is to lead to an optimal allocation of scarce resources, and to give proper signals for
`future investments. The mechanism in place should lead to the optimization of social benefits by ensuring that scarce
`resources are utilized in such a manner as to maximize productivity in ways society thinks fit. As Mitchell (1989) notes,
`"in a market economy, prices are the primary instrument for allocating scarce resources to their highest valued uses and
`promoting efficient production of goods and services'' (p. 195). One critical issue however is the basis on which an
`appropriate pricing scheme can be designed.
`
`Given that the marginal cost of sending an additional packet of information over the network is virtually zero once the
`transmission and switching infrastructures are in place, marginal cost pricing in its simplistic form is inapplicable. Cost-
`based return on investment (ROI) pricing is both not feasible, given the multiplicity of providers who would have to chip
`in to bring about an end-to-end service, and inefficient, given the chronic problem of allocating joint costs. [7] [#n7] A "what
`
`the market can bear" policy would be likely to have unforeseen implications, especially if the markets are not competitive
`in each and every segment of the network.
`
`The principle that is most likely to be effective in this scenario is a modified version of the marginal cost approach, where
`the social costs imposed by the scarcity of bandwidth—the bottleneck resource—is taken into consideration. Bandwidth
`being the speed at which data is transmitted through its networks, its scarcity implies delays due to network congestion.
`This then is the social cost that needs to be incorporated into any efficient pricing scheme.
`
`4.3 The Costs of Congestion
`The packet-switching technology of the TCP/IP protocol embedded in the Internet has an essential vulnerability to
`congestion. A single user, overloading a sub-regional line that connects to the regional level network, can overload several
`nodes and trunks, and cause delays or even data loss due to cell or frame discarding for other users. The specific manner
`in which the problem manifests itself depends on the protocols used, and on whether the network is simply delaying or
`actually discarding the information (Campbell, 1994). Since backbone services are currently allocated on the basis of
`randomization and first-come-first-served principle, users now pay the costs of congestion through delays and lost
`packets (Varian & MacKie-Mason, 1994). [8] [#n8] The problem is likely to become even worse as Power PCs such as a
`
`$2000 Macintosh AV combined with a $500 camcorder would enable an undergraduate to send real-time video to friends
`on another continent, by pumping out up to 1 megabyte of data per second onto the Internet, thus tying up a T l line
`(Bohn et al., Love).
`
`The cost of congestion on the Internet is therefore a tangible problem, and not merely the pessimistic outpourings of a
`band of dystopians. Some have argued that it does not matter if users fill up their leased line, and even less the manner in
`which they do so (Tenney, telecomreg, 4 May 1994, 18:42:09). However, the Internet is not designed to allow most users
`to fill their lines at the same time. Also, as new applications such as desktop videoconferencing and new transport services
`such as virtual circuit resource reservation come in, it will become more and more necessary for the network to provide
`dedicated and guaranteed resources for these applications to operate effectively (England, telecomreg, 7 May, 1994
`08:04:26). In the Internet system, which is essentially designed for connectionless network services, the requirement of
`bandwidth reservation implies that an incompatible class of service needs to be provided over it, thus necessitating costs
`in developing added functionality to its edges (Pecker), and in decreasing its overall efficiency.
`
`In essence, the changing nature of network traffic implies a social cost, largely due to this inherent incompatibility
`between new applications and the Internet architecture. There is a social cost imposed by those who are making unlimited
`use of the newer bandwidth-hungry, incompatible applications. This cost is being borne by others in the form of delays
`and data dropouts while making use of the more traditional applications such as email, ftp, and gopher. [9] [#n9] The flat-
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`rate pricing mechanism is therefore inefficient in sending out corrective signals to minimize social costs and as a resource
`allocator since it can hardly be argued that the social benefits of a democratic discourse are less beneficial to society than
`an undergraduate sending out real-time video to his friends. [10] [#n10]
`
`There is a potential danger here. Continuance of the current pricing system may result in a situation where the new
`applications drive out traditional uses. The inherent bias of flat-rate pricing, whereby heavy users are subsidized by light
`users, is a threat to the more traditional forms of net usage as applications requiring heavy bandwidth are coming of age.
`It is however clear that a new form of pricing scheme needs to be developed in order to ensure that the net retains part of
`its original character as it evolves into a more potent and futuristic medium of communication.
`
`4.4 The Pricing Options
`At the far end of the spectrum is pure usage-based pricing. Given the shortfalls of the flat-rate based scheme, it seems
`certain that there will eventually be "prices for Internet usage, and the only real uncertainty will be which pricing system
`is used" (Love).
`
`4.4.1 The Telephone Pricing Model
`One form of usage based pricing would be to use the system of posted prices as in telephony. One way to do this would be
`to adopt the telephone model of computing interLATA prices, where the cost of Internet usage is based on the distance
`between the sender and the receiver, and on the number of nodes through which data need to travel before they reach
`their destination. This however would be difficult to implement given the inherent nature of the connectionless net
`technology, which is based on redundancy and reliability, where packets are routed by a dynamic process through an
`algorithm that balances load on the network, while giving each packet alternative routes should some links fail (Varian &
`MacKie-Mason, 1993, p. 3). The associated accounting problems are also enormous. In addition, the sender would prefer
`that packets are routed through a minimum number of nodes in order to minimize costs, while the algorithm in the
`Internet would base its calculations on the concept of redundancy and reliability, and not necessarily on the fewest links
`or the lowest costs.
`
`The telephone model of pricing is not likely to work for another reason. Posted prices are not flexible enough to indicate
`the state of congestion of the network at any given moment (Varian & MacKie-Mason, 1993, p . 19). As we have seen
`earlier, congestion in the network can peak from an average load very quickly depending on the kind of application being
`used. Also, time-of day pricing means that unused capacity at any given moment cannot be made available at a lower
`price whereby it would be beneficial to some other users. Conversely, at moments of congestion, the network stands to
`lose revenue because users who are willing to pay higher amounts than posted rates are being crowded out of the network
`through the randomized first-in-first-out (FIFO) process of network resource allocation.
`
`In essence, the system of posted fixed prices implies multiple problems: while it does not allow for revenue maximization
`under the "market can bear" philosophy or lead to optimal capacity utilization, it also does not address the social costs of
`congestion because it cannot allow for prioritization of packets. It is thus clear that the answer to the Internet's pricing
`problem does not lie at either ends of the pricing spectrum defined by flat-rate pricing and pure usage based pricing, but
`possibly in an innovative approach.
`
`4.4.2 Innovative Pricing Models
`Two innovative pricing schemes have been suggested recently. Bohn et al. have proposed the "Precedence" model, while
`Varian & MacKie-Mason have developed the "Smart Market" mechanism.
`
`4.4.2.1 The Precedence Model
`
`The Precedence model proposes "a strategy for the existing Internet, not to support new real-time multi-media
`applications, but rather to shield ... the existing environment from applications and users whose behavior conflicts with
`the nature of resource sharing" (Bohn et al., p. 4). The authors propose that criteria be set to determine the priority of
`different applications, which will then be reflected in the IP precedence field of the different data packets. Packets would
`receive network priority based on their precedence numbers. In the event of congestion, rather than rely on the current
`randomized decision, the Precedence model presents a logical basis for deciding which packets to send first and which to
`hold up or drop. While noting that their proposed system is vulnerable to users tinkering with precedence fields, the
`authors feel that this approach would "gear the community toward the use of multiple service levels, which ... (is) the
`essential architectural objective" (p. 10).
`
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`

`However, this model has some inherent weaknesses. Given that the Precedence model rests on priority allocation of
`packets, the central issue is how these priorities will be set and who will set them. There seems to be an inherent
`assumption of an increased governmental role in regulating content, and as Varian and MacKie-Mason point out, "Soviet
`experience shows that allowing bureaucrats to decide whether work shoes or designer jeans are more valuable is a deeply
`flawed mechanism" (1994, p . 16).
`
`The system would also require continuous updating of the priority schemes as newer products and applications become
`available. Real time video may be assigned a lower priority than ftp, but it is possible that the video transfer of data is
`concerned with an emergent medical situation. Application- based priority will be limiting, and it would not be possible to
`define each and every usage situation in a dynamic environment.
`
`Also, the model relies heavily on the altruism of net users, and the correct reporting and non-tinkering with precedence
`fields by computer-savvy netters. The continuing survival of such a system is at odds with current social trends.
`
`4.4.2.2 The Smart Market Mechanism
`
`Proposing the Smart Market mechanism as a possible model to price Internet usage, Varian & MacKie-Mason (1994)
`suggest a dynamic bidding system whereby the price of sending a packet varies minute-by-minute to reflect the current
`degree of network congestion. Each packet would have a "bid" field in its header wherein the user would indicate how
`much he is willing to pay. Packets with higher bids would gain access to the network sooner than those with lower bids, in
`the event of congestion. The authors acknowledge that this mechanism is preliminary and tentative and is only one
`approach to implementing efficient congestion control; moreover, it would only ensure relative priority without being an
`absolute promise of service.
`
`The Smart Market mechanism has great theoretical potential as a basis for implementing usage-based pricing. By
`charging for priority routing during times of congestion, traffic that does not claim priority status, such as a large Internet
`mailing list of a listserv conference. would travel for free during off-peak hours. During congestion, users would bid for
`access and routers would give priority to packets with the highest bids. A great deal of consensus will be required along
`the network for smooth functioning and to ensure that priority packets are not held up .
`
`Users will be billed the lowest price acceptable under the routing "auction," and not necessarily the price that they have
`indicated as their bid. A user would thus pay the lower amount between his bid and the bid of the marginal user, which
`will be necessarily lower than the bids of all admitted packets. As a result, the Varian and MacKie-Mason model ensures
`that while everyone would have the incentive to reveal his or her true willingness to pay, there are systemic incentives to
`conserve on scarce bandwidth while simultaneously allowing effectively free services to continue.
`
`5 Discussion: Building a Case for Regulation
`
`We argue that although the dynamic bidding mechanism is very attractive as a theoretical basis for pricing usage, it
`renders the system wide open to potential abuse by those who control the system bottlenecks. A case is therefore made for
`establishing some form of regulatory oversight to ensure against anti-competitive activities and abuse of market- power.
`In essence, this paper argues that a usage-based pricing scheme needs to be combined with some form of regulatory
`oversight that aims at making the access of emerging networks to the Internet open and nondiscriminatory, and that the
`firms which control the bottleneck facilities in the emerging structure do not indulge in anti-competitive behavior. [11] [#n11]
`
`Interestingly, in the Internet debate, we seem to have lost sight of the fact that dynamic pricing of network services has
`been advanced and debated earlier. The notion of dynamic rates for pricing network services as a mechanism to balance
`loads, limit congestion, and avoid the high costs of adding capacity, has been advanced in the past (Mitchell). Vickrey
`(1981) proposed that telephone networks could manage their congestion during peak-load times by alerting subscribers
`through a higher pitched dialing tone and charging premium rates for calls made at those times. Mitchell notes that as the
`local networks of telephone systems evolve into broadband systems and become even more capital-intensive, the gains
`from allocating capacity dynamically on demand will be larger. Dynamic pricing would enable higher overall use of
`network capacity, while allowing price-sensitive users to access telephone services at lower prices on a dynamic and daily
`basis.
`
`5.1 The Weakness of the Dynamic Bidding Model
`The essential weakness of the Smart Market proposal as a stand-alone, free market pricing system that does not need any
`regulatory oversight for its proper implementation lies in its assumptions, summarized below.
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`5.1.1 Perceived Homogeneity
`First, the model proposes to price the scarce network resource based on the perceived network load. Prima facie, it seems
`that a uniform load factor is presumed across all points of the network on which basis bandwidth is priced. However, this
`is simply not true. The Internet is not a homogeneous network. The load factor and the resultant level of congestion is
`going to be very different along the different nodes/switches/lines between the sender and the receiver.
`
`It may be argued that the price of sending a message can be based on the most congested point of the network. However,
`the path that a packet will take cannot be predicted with any degree of certainty . It is thus close to impossible to base
`pricing on an algorithm related to the network load at the most congested point of the network along the path that the
`packets have to traverse in order to be able to reach their destination.
`
`Also, network load is unpredictable, and is prone to sudden peaks and troughs. It is entirely possible that the load at a
`particular node changes rapidly and the bid is simply not good enough to receive priority from that node at that moment,
`even though it might have been so earlier. It may be argued that through consensus a system could evolve where
`"regional" congestion is calculable, and the price determined on the basis of an algorithm that considers all possible
`routings and all possible levels of network loads. However, given the diversity of the Internet and the multiple levels of
`players, this sounds extremely far-fetched and difficult to achieve without any neutral, oversight agency.
`
`5.1.2 Manipulation of network load
`Second, and more importantly, a pricing system based on network load opens itself up to potential abuse by those who
`control the facilities at the system bottlenecks. It may be argued that any system would be vulnerable to abuse, but the
`anonymity of data transferred along the Internet would make this system especially vulnerable: for example,
`unscrupulous firms in control of the various nodes would have both the incentive and ability to manipulate the network
`load to keep it artificially high so as to create an upward pressure on the price of network usage. Given that marginal costs
`are almost zero, the firm would attempt to maximize revenue. It can do this by tracking network usage and artificially
`keeping the network load