Competition on Price and Quality in Cloud Computing

The public cloud "infrastructure as a service" market possesses unique features that make it difficult to predict long-run economic behavior. On the one hand, major providers buy their hardware from the same manufacturers, operate in similar locations and offer a similar menu of products. On the other hand, the competitors use different proprietary "fabric" to manage virtualization, resource allocation and data transfer. The menus offered by each provider involve a discrete number of choices (virtual machine sizes) and allow providers to locate in different parts of the price-quality space. We document this differentiation empirically by running benchmarking tests. This allows us to calibrate a model of firm technology. Firm technology is an input into our theoretical model of price-quality competition. The monopoly case highlights the importance of competition in blocking "bad equilibrium" where performance is intentionally slowed down or options are unduly limited. In duopoly, price competition is fierce, but prices do not converge to the same level because of price-quality differentiation. The model helps explain market trends, such the healthy operating profit margin recently reported by Amazon Web Services. Our empirically calibrated model helps not only explain price cutting behavior but also how providers can manage a profit despite predictions that the market "should be" totally commoditized.