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Internet users have suffered collateral damage in tussles over paid peering between large ISPs and large content providers. The issue will arise again when the FCC considers a new net neutrality order. In this paper, we model the effect of paid peering fees on broadband prices and consumer surplus. We first consider the effect of paid peering on broadband prices. ISPs assert that paid peering revenue is offset by lower broadband prices, and that ISP profits remain unchanged. Content providers assert that paid peering fees do not result in lower broadband prices, but simply increase ISP profits. We adopt a two-sided market model in which an ISP maximizes profit by setting broadband prices and a paid peering price. To separately evaluate the effect on consumers who utilize video streaming and on consumers who don’t, we model two broadband plans: a basic plan for consumers whose utility principally derives from email and web browsing, and a premium plan for consumers with significant incremental utility from video streaming. Our result shows that the claims of the ISPs and of the content providers are both incorrect. Paid peering fees reduce the premium plan price; however, the ISP passes on to its customers only a portion of the revenue from paid peering. We find that ISP profit increases but video streaming profit decreases as an ISP moves from settlement-free peering to paid peering price. We next consider the effect of paid peering on consumer surplus. ISPs assert that paid peering increases consumer surplus because it eliminates an inherent subsidy of consumers with high video streaming use by consumers without. Content providers assert that paid peering decreases consumer surplus because paid peering fees are passed onto consumers through higher video streaming prices and because there is no corresponding reduction in broadband prices. We simulate a regulated market in which a regulatory agency determines the maximum paid peering fee (if any) to maximize consumer surplus, an ISP sets its broadband prices to maximize profit, and a content provider sets its video streaming price. Simulation parameters are chosen to reflect typical broadband prices, video streaming prices, ISP rate of return, and content provider rate of return. We find that consumer surplus is a uni-modal function of the paid peering fee. The paid peering fee that maximizes consumer surplus depends on elasticities of demand for broadband and for video streaming. However, consumer surplus is maximized when paid peering fees are significantly lower than those that maximize ISP profit. However, it does not follow that settlement-free peering is always the policy that maximizes consumer surplus. The direct peering price depends critically on the incremental ISP cost per video streaming subscriber; at different costs, it can be negative, zero, or positive.
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