Diversification, Market Entry, and the Global Internet Backbone

This paper investigates how buyer demand for supplier diversification shapes entry incentives and market structure, using the global undersea fiber-optic cable industry as the empirical setting. The research question has two parts: first, how much of observed cable entry and surplus generation is attributable to buyers’ diversification motives rather than standard price competition; and second, whether market forces produce too much or too little diversification relative to the social optimum.

The empirical setting spans 2005–2021 and covers the worldwide network of undersea cables that carries more than 98% of all international internet traffic. Cables fail frequently — hundreds of faults per year — and industry professionals confirm that “no customer would buy capacity on a single cable.” The median monthly price for a 10Gbps lease fell from $55,500 in 2005 to $2,200 in 2021, and the number of active cables roughly doubled over the sample period.

The authors use proprietary data from TeleGeography covering cable characteristics (construction costs, capacity, landing points, entry dates), quarterly bandwidth prices at the city-pair level, annual used bandwidth at the country-pair level, and 168 documented cable faults. Markets are defined as country-pairs in calendar quarters.

The theoretical model begins with a representative buyer who splits bandwidth purchases equally across n symmetric cable operators to minimize expected disruption costs. Because disruption shocks are i.i.d. across cables, adding suppliers reduces the variance of realized bandwidth delivery, lowering the required over-provisioning buffer. This generates a “market expansion” channel: entry increases aggregate demand holding prices fixed, not just through price competition. The aggregate demand equation takes log-linear form with cable count indicators alongside price and demand shifters.

The structural model adds a dynamic oligopoly game where firms make entry and exit decisions as a non-stationary Markov Perfect Equilibrium, with Cournot competition in each period. The three-step estimation procedure recovers: (1) price elasticities and diversification parameters from an IV demand regression using electricity generation cost shares as instruments; (2) marginal costs from firms’ first-order conditions; (3) entry and fixed costs from a nested pseudo-likelihood (NPL) estimator, supplemented by construction cost data to separately identify entry costs given the near-absence of observed exits.

Key demand results: the IV price elasticity is −1.36. The market expansion effect is large and exhibits decreasing marginal returns — entry of a second cable expands demand by as much as a 28.3% price decrease; a third cable is equivalent to a 19.3% price decrease; an eighth cable is equivalent to a 7.5% price decrease. The demand model achieves R² = 95%.

The first counterfactual removes the diversification channel entirely (entry raises competition only). Without diversification, cable investment falls by 12%. The net present value of total surplus per market over the sample period averages $1.11 billion under the observed equilibrium; supplier diversification accounts for 11% of total surplus and 27% of consumer surplus.

The second counterfactual quantifies two opposing distortions relative to the social optimum. Business-stealing creates excessive entry (entrants reduce incumbents’ output), while diversity effects create insufficient entry (marginal entrants generate surplus through diversification they cannot fully capture). At end-of-sample (2021-Q4), diversity distortions in terms of number of entrants range from 54% to 125% of the business-stealing distortion. Business-stealing tends to dominate for most markets, producing moderately excessive entry. Relative to the market outcome, total surplus under the social planner’s solution is on average 10% higher: 53% of this welfare gap is attributable to diversity effects and 47% to business-stealing effects. These findings hold across market heterogeneity in entry costs, market size, and demand growth.

The paper concludes that profit-maximizing suppliers fail to fully internalize diversification-related social benefits, and that targeted entry subsidies would pass cost-benefit tests in settings where diversity distortions dominate.

Q: What is the core mechanism by which supplier diversification expands demand? A: When buyers split purchases across n cable operators whose disruption shocks are i.i.d., adding a supplier reduces the variance of realized delivered bandwidth. The buyer therefore needs to hold a smaller over-provisioning buffer to achieve the same expected level of used bandwidth B. This lowers the effective cost of a given quantity of used bandwidth, shifting the aggregate demand curve outward. As the number of suppliers grows to infinity, the expected disruption cost converges to zero.

Q: How large is the market-expansion effect of diversification empirically? A: The effect is large but exhibits decreasing marginal returns. Entry of a second cable expands demand by as much as a 28.3% price reduction holding prices fixed; the third cable is equivalent to a 19.3% price reduction; and the eighth cable is equivalent to a 7.5% price reduction. All cable-count coefficients are positive and statistically significant in the IV demand model.

Q: How is price endogeneity addressed in the demand estimation? A: Bandwidth prices are instrumented using the marginal cost of electricity generation — specifically, country-level electricity generation shares (coal, gas, oil) interacted with quarterly commodity price series for coal, gas, and oil (Brent crude, Australian coal price, EU natural gas price). The first-stage results indicate electricity costs are strong predictors of bandwidth prices. Accounting for endogeneity raises the price elasticity from an OLS level to −1.36 in absolute value, consistent with the expected direction of OLS bias.

Q: What share of cable investment and surplus is attributable to diversification motives? A: In the counterfactual where the diversification channel is eliminated — entry raises competition and lowers prices but provides no diversification benefit — cable investment falls by 12%. Under the observed equilibrium, the net present value of total surplus per market over 2005–2021 averages $1.11 billion; supplier diversification accounts for 11% of this total surplus and 27% of consumer surplus.

Q: How are the two distortions — business-stealing and diversity — defined and separated? A: Business-stealing distortion arises because entrants reduce incumbents’ outputs and revenues, so private entry benefits exceed social benefits, leading to excessive entry. Diversity distortion arises because entrants create surplus for buyers through diversification but cannot fully capture it without perfect price discrimination (following Spence (1976) and Mankiw and Whinston (1986)), leading to insufficient entry. The authors disentangle these by comparing: (i) the social planner’s solution (eliminates both distortions), and (ii) a coordinated entry solution maximizing producer surplus (eliminates only business-stealing). The residual gap between the two identifies the diversity distortion.

Q: What is the net direction and magnitude of distortion in equilibrium market structure? A: At 2021-Q4, for most markets, business-stealing dominates, leading to moderately excessive entry. Diversity distortions in number of entrants range from 54% to 125% of the business-stealing distortion across markets. Relative to the market outcome, the social planner’s solution yields average total surplus that is 10% higher. Of that welfare gap, 53% is attributable to diversity effects and 47% to business-stealing effects.

Q: How do market characteristics affect which distortion dominates? A: The paper analyzes cross-market heterogeneity and identifies market features — including the size of entry costs, market size, and the rate of demand growth over time — as determinants of whether insufficient diversification or excessive entry is the binding distortion. Markets with higher entry costs or slower demand growth are more likely to exhibit insufficient diversification.

Q: How are entry costs identified given the near-absence of cable exits in the data? A: Because exit events are rare in a nascent industry — only a handful of exits observed, mostly after 2020 — entry and fixed costs cannot be separated by exit decisions alone. The authors address this by using cable-level construction cost data from TeleGeography to estimate entry costs outside the dynamic model. With entry costs in hand, firms’ optimal entry decisions identify fixed costs. Scrap values are normalized to zero, consistent with industry reports that retired cables are typically abandoned on the seabed.

Q: What role does the non-stationarity of the market environment play in the model? A: The data covers the industry’s earliest growth phase, with demand growing by roughly three orders of magnitude (used bandwidth from 5 Tbps in 2005 to 2,886 Tbps in 2021) and prices falling by a factor of roughly 25. The authors use a non-stationary Markov Perfect Equilibrium concept in which strategies and transition functions are indexed by time, aligning with the treatment of high-tech commodities in Igami (2017).

Q: What are the policy implications of the findings? A: Because profit-maximizing suppliers do not fully internalize the diversification-related social benefits of entry, entry rates can be sub-optimal from a welfare perspective when diversity distortions dominate. The authors suggest targeted entry subsidies would pass cost-benefit tests in such cases. For antitrust analysis, regulators who ignore the demand-expansion effect of incremental suppliers may incorrectly judge a market as sufficiently competitive. In merger review, authorities must account for firms’ private incentives to provide diversification to reach accurate welfare conclusions.

Q: How does the paper verify that diversification demand is not a spurious empirical artifact? A: Several checks support the causal interpretation. The estimated demand parameters are consistent with the predictions of the consumer-level utility maximization problem derived analytically: decreasing marginal returns to diversification and a positive relationship between the number of suppliers and demand. The demand model achieves R² = 95%, suggesting limited unobserved confounders. Additionally, 78% of cable faults involve only a single cable, confirming that disruptions are geographically isolated and that cross-cable diversification provides genuine insurance value.

Q: What are the main data limitations acknowledged by the authors? A: The authors cannot observe cable-level revenue or market shares, nor contracts between buyers and sellers; only aggregate country-pair used bandwidth is observed. Price coverage is not comprehensive — TeleGeography collects prices on a voluntary basis from dozens of providers. The cable faults dataset (168 faults) represents only a subset of total faults, as collection focuses on publicly disclosed events. The demand model also does not explicitly account for substitution patterns across firms due to lack of firm-level market share data, though the high R² partly mitigates this concern.

Diversification (in this paper’s sense): Buyers’ practice of splitting bandwidth purchases across multiple cable operators to reduce exposure to idiosyncratic disruption risk. Diversification across n cables with i.i.d. disruption shocks reduces the variance of realized delivered bandwidth and lowers the required over-provisioning buffer, making the effective cost of a given usage level B a decreasing function of n.

Market Expansion Effect: The channel through which entry of additional cable suppliers raises aggregate demand holding prices fixed. This occurs because each additional supplier reduces disruption risk, allowing buyers to demand more used bandwidth for the same price. It is distinct from the conventional competition channel (entry lowering prices).

Diversity Distortion: The tendency toward insufficient entry arising because marginal entrants generate consumer surplus through diversification benefits but cannot fully capture this surplus absent price discrimination. Follows Spence (1976) and Mankiw and Whinston (1986).

Business-Stealing Distortion: The tendency toward excessive entry arising because entrants reduce incumbents’ output and revenues, creating a gap between private and social returns to entry.

Non-Stationary Markov Perfect Equilibrium: The equilibrium concept used for the dynamic entry game, in which strategies and equilibrium selection rules are indexed by calendar time to accommodate substantial secular trends in demand and costs — as opposed to a stationary MPE which assumes a stable long-run distribution.

Used Bandwidth vs. Purchased Bandwidth: Used bandwidth B is the amount the buyer is committed to delivering (to downstream customers or for internal use). Purchased bandwidth Q is what the buyer actually contracts for across all cables; Q > B because the buyer holds an over-provisioning buffer against disruption risk. The ratio B/Q is a decreasing function of the disruption cost parameter gamma and an increasing function of the number of suppliers n.

Nested Pseudo-Likelihood (NPL) Algorithm: The baseline estimator for the dynamic game, following Aguirregabiria and Mira (2007). It iterates on the best-response mapping to impose equilibrium restrictions. The authors supplement NPL with two-step estimators (1-PML, 1-MD) and the spectral algorithm of Aguirregabiria and Marcoux (2021), which solves for the root of a nonlinear system using a quasi-Newton method and is robust to fixed-point instability.