Wednesday, July 28, 2010

Why economics matters to strategists?

Recently, there has been a great deal of debate about the new iPhone 4, its ability to hold a signal and the quality of the AT&T network. In brief, the claim is that the antenna on the iPhone 4 is affected by being held and that AT&T has an inferior network to Verizon. And because iPhone users and detractors are often emotionally involved in their views, the framing of the problem is often not very useful to a strategist.

The economics of networks is not being considered in this debate. As smart phone users are a new category of uses and the iPhone was the first to make data usage easy, it is no surprise that AT&T has run into usage economics first.

Consider the following:

Customer usage: if you allow customers to use a much of a service as they like, they will use more of it up until the point where other constraints such as their willingness to use their phone all the time, becomes a barrier. Unlike mature markets, where saturation of usage has occurred (e.g Netflix which assumes you only have so much time to watch movies), in developing services, usage has often not yet reached a natural upper limit. In a fixed capacity network such as 3G, adding more users and making usage easier leads (surprise, surprise) to more usage.

Service provider investment: if you do the calculation on revenues per byte, voice calls are more profitable than data sessions – about two orders of magnitude more profitable. So if you are a service provider, you have the problem of expanding your network to justify less profitable usage. It’s no surprise that investment has lagged.

Next generation economics: as so often happens when people straight line their conclusions about growth, they fail to consider alternative ways of solving problems. In the case of smart phones, the alternative to using capacity on the cell tower is “diversion” or diverting traffic to alternate channels. These alternatives fall into three basic categories:

1. Public wi-fi sites
2. Home and business wi-fi sites
3. Femtocells

What all the first two have in common is that smart phones today typically offer wi-fi capabilities as well as 3G capabilities. And the speed of wi-fi is typically greater than 3G. So if you want to download a big file, it’s a good idea to do it via wi-fi.

Femtocells are less well known. They are, in effect, small base stations that provide better signal to a cell phone in a home or office, but rather than connecting to the mobile network via a public cell tower (and its backhaul), instead they link to the home or office fixed broadband that is pretty much always available at low cost and typically zero incremental cost for usage to the backbone or fixed network that connects the cell network.

Both wi-fi and femtocells divert traffic from overburdened cell towers and their backhaul and use an existing under-utilized and low cost fixed infrastructure. Because data is charged at a lower rate than voice traffic, diverting data is the most profitable from the perspective of return on capital. But voice can be diverted as well over wi-fi freeing up capacity at cell towers.

Not surprisingly, diversion is a multi-billion dollar issue for mobile companies -- unlike the difficult and time consulting process of putting up cell towers, wi-fi and femtocells require no regulatory input and are significantly cheaper (no bandwidth purchase needed, no rental fees, no backhaul costs).

Perhaps even more importantly, given that the majority of usage of cell phones occurs in the office or home, highly granular improvement in the network can be focused upon areas where most usage occurs. You can think of the use of wi-fi and femtocells as adding leaves to the branches of a tree.

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