Since the first dot-com boom, unmetered Internet access has been the industry standard. But recently, usage-based billing has been staging a comeback. Comcast instituted a bandwidth cap in 2008, and some other wired ISPs, including AT&T, have followed suit. In 2010, three of the four national wireless carriers—Sprint is the only holdout—switched from unlimited data plans to plans featuring bandwidth caps.

To many people, the argument for metered bandwidth seems intuitive and obvious. Bandwidth is a scarce resource, and advocates argue that usage-based pricing encourages efficient network use and ensures that heavy users pay their "fair share."

Yet the economics of metering aren't as simple as they might appear. Companies are often surprised by how well flat-rate billing schemes work. Customers love them, and flat-rate billing encourages more intensive use of networks that sit idle most of the time.

Network providers insist that they are simply trying to cope with rapidly rising demand for bandwidth. But critics charge that the trend toward bandwidth caps is driven by more sinister motives, especially in the residential broadband market. In this story we'll examine the economics of metering and try to explain why it has suddenly come back into vogue.

The economics of metering

Bandwidth is perishable. You can't save it now to use later. As a result, most networks are heavily congested at some times and well below capacity at others. During periods of peak demand, bandwidth is scarce and each additional user imposes costs on others. The rest of the time, bandwidth is plentiful and adding an additional user to the network is almost costless.

That means that monthly bandwidth consumption is a crude way to measure a user's contribution to congestion. For example, residential broadband networks tend to experience peak demand in the evening, when people are at home watching videos. Customers who generate most of their traffic at other times of day—for example, a woman who works from home and generates most of her traffic during the day, or a teenager who downloads large files from BitTorrent late at night—might generate a lot of traffic, but have a negligible effect on other users.

Metering encourages users to minimize their network use at all times, even if the network has plenty of spare capacity most of the day. While usage-based billing schemes may help reduce congestion at peak periods, it wastefully discourages people from using the network the rest of the time.

And usage-based billing has other costs. Tracking usage, charging users, and dealing with customer questions and complaints costs network providers money.

Mental accounting costs

Perhaps the biggest disadvantage to usage-based pricing is that customers hate it. A study written by Andrew Odlyzko and others and released last week by Public Knowledge finds that many consumers have a surprisingly strong preference for flat-rate billing. For example, "some of the most careful studies of user preferences had been done by AT&T in the 1970s, in attempting to move customers from flat rates to metered ones for local service. To the surprise of AT&T managers, telecom economists, and regulators, these studies revealed that most light users—who would have saved money with UBP—continued with flat rates."

A key factor behind users' decisions to stick with flat rates was "decision fatigue." Many users were willing to pay a premium to avoid worrying about whether they were wasting money by spending too much time on the phone.

Early online service providers had the same experience. One of the first online services to offer a flat-rate option was AT&T's WorldNet. Tom Evslin, who was running WorldNet at the time, reports that customers would typically switch to the $19.95 flat-rate option when their monthly charges reached about $12 per month. And surprisingly, "their usage (as measured by time online) did not increase, so they were simply paying extra to satisfy their preference." The flat-rate plan was a win-win deal for both AT&T and its customers.

Competition from AT&T forced AOL to adopt its own flat-rate option. AOL CEO Steve Case has said that AOL's hourly billing scheme was one of its most unpopular features. According to one story recounted in the PK report, "Case had heard from one AOL member who insisted that she was being cheated by AOL's hourly rate pricing. When he checked her average monthly usage, he found that she would be paying AOL more under the flat-rate price of $19.95. When Case informed the user of that fact, her reaction was immediate. 'I don't care,' she told an incredulous Case. 'I am being cheated by you.'"

This might seem irrational if we assume that keeping track of usage is costless. But it isn't; people are willing to pay extra to avoid the "mental accounting costs" of metered schemes.

Indeed, concerns about "mental accounting costs" likely explain why most usage-based billing schemes recently have adopted usage caps rather than trying to charge a fixed per-minute rate. If usage caps are set high enough that most users never reach them, then the average user can treat the service as if it were unlimited.

Competition concerns

Indeed, that was precisely Comcast's argument when it instituted its 250GB bandwidth cap in 2008. It argued that this limit was so generous that most users would never have to think about it.

Since then, network speeds and the supply of high-definition video content have increased, and the bandwidth cap hasn't budged. The 250GB limit adopted in 2008 is still in place.

Comcast portrays its bandwidth cap as so generous that only "extremely high data users" need to worry about it. But Odlyzko and his co-authors note that "Comcast's own estimate for the amount of data required to replace its pay-television offering with an over-the-top competitor is 288GB per month." That suggests that a typical Comcast cable user who decided to "cut the cord" and consume an equivalent amount of content on Netflix, Amazon Instant, or other online streaming services would be at risk of having his Internet access cut off.

"The nature of the competitive threat posed by usage-based pricing flows from the fact that most service providers offer both Internet access services and applications such as video and voice that rely upon (or can rely upon) that Internet access," the PK authors write. "Although flat fee pricing might help maximize Internet access service revenue, doing so could potentially undermine application revenue."

In other words, the broadband cap may have less to do with managing congestion on Comcast's data network than with making over-the-top video services like Netflix and Hulu unattractive for heavy television users who are the most lucrative customers for Comcast's paid video services.

The authors propose several measures that can help to ensure that usage-based pricing is only used to deal with actual congestion problems rather than a way to stymie competitive services. They call for greater transparency regarding data caps. They want carriers to disclose more information about how the caps are determined and enforced, and they want users to have a reliable way to tell how much bandwidth they've consumed in a month.

They also call for more "granular" metered policies. Because congestion is only a problem at certain times of the day, they argue that usage-based billing should only be in effect at those times. Cell phone companies have long followed this approach for voice minutes—users are given a certain number of minutes each month for use during business hours. Cell phone providers offer unlimited voice minutes on nights and weekends when congestion isn't a problem. Public Knowledge argues that a similar strategy would work well for broadband networks.