ATLANTA – Aug. 17, 2011 – Wholesale broadband providers can enhance their profit margins by instituting a small number of pricing “tiers,” concludes a new study by Georgia Tech College of Computing researchers, and those companies that already do so should be satisfied to learn they are likely implementing near-optimal pricing structures.

Recently U.S. Internet service providers (ISPs) have begun charging consumers based on the amount of data they send and receive. Eventually, ISPs might offer tiered pricing that charges customers depending on the time of day they send and receive traffic (as cellular providers already do) or the physical distance a user’s data must travel. Theoretically an ISP could earn the greatest profit through a near-infinite number of tiers, but the study shows that by instituting just a few tiers—perhaps three or four—the provider could realize nearly all of those profits.

To investigate the effect of tiered pricing on ISP profitability, Associate Professor Nick Feamster and his colleagues studied how charging customers different prices depending on the distance the traffic must travel would affect an ISP’s profits. They studied pricing practices in “transit” Internet service providers—essentially high-capacity service offered by large providers, often to corporate or other large consumers (such as smaller ISPs). The research is described in a paper, “How Many Tiers? Pricing in the Internet Transit Market,” to be presented at SIGCOMM 2011, Aug. 15-19 in Toronto.

“The price of Internet transit service continues to plummet as competition among major providers becomes more fierce,” Feamster said. “As a result, providers are abandoning the ‘all you can eat’ pricing model in favor of more sophisticated pricing structures that more accurately reflect the cost of carrying that traffic. When it comes to destination-based pricing, we found that ISPs indeed can maximize profits by slicing up their service offerings into multiple tiers. Fortunately, they can achieve near-optimal profit gains with only three or four tiers.”

To arrive at this finding, the research team first developed an economic model that could predict how an ISP’s profits would be affected by varying its number of pricing tiers. In developing this model, one of the major challenges is that predicting ISP profits typically requires knowledge of costs, revenue and how customer traffic demand would vary as the ISP changed its pricing strategy. The team developed a model that can predict how profits change in response to different tiered pricing strategies—armed only with knowledge of network configurations and current customer traffic demands.

“We talked to both operators and customers to find out how transit providers are pricing bandwidth,” said Ph.D. candidate Vytautas Valancius, the research paper’s primary author. “The traffic itself was the one thing we had, but we didn’t have the ISPs’ pricing, nor did we have information about the precise cost to the ISP for carrying traffic.”

ISPs could create a different pricing tier for each traffic flow, depending on its destination, but in practical application, a large number of tiers is difficult both for the ISP to manage and for customers to understand. In fact, Valancius said, just a few tiers yield nearly all of the benefit. The researchers also confirmed that transit providers whose costs for carrying traffic vary widely (depending on where it is destined) would enjoy the greatest benefit from tiered pricing.

“One of the most interesting aspects of this work is that network operators can use this model to design pricing tiers for their own customers, using only knowledge of current traffic demands,” Feamster said. “Through our conversations with network operators, we found that many ISPs’ pricing structures are still based on rough intuition, as opposed to thorough empirical analysis. We have developed the first economic model that takes real traffic data as input to understand the impact of tiered, destination-based pricing on an ISP’s profit. ISPs can use this model to either confirm their current practices or design new pricing structures.”

The study focused on how tiered pricing can benefit ISPs, but Valancius added that a future direction for the research would be to apply the same model to study tiered pricing in consumer ISPs, delving more deeply into “user surplus”, which would capture the value consumers get from the service they are receiving, relative to the price they are paying.

For more information on this and other Georgia Tech papers at SIGCOMM 2011, visit www.gtsigcomm.com.