Access Pricing: Theory and Practice

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ACCESS PRICING: THEORY AND PRACTICE

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ACCESS PRICING: THEORY AND PRACTICE

Edited by RALF DEWENTER Helmut-Schmidt-University Hamburg, Hamburg, Germany and JUSTUS HAUCAP Ruhr-University of Bochum, Bochum, Germany

Amsterdam • Boston • Heidelberg • London • New York • Oxford Paris • San Diego • San Francisco • Singapore • Sydney • Tokyo

Elsevier Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK First edition 2007 Copyright © 2007 Elsevier B.V. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13: 978-0-444-52803-2 ISBN-10: 0-444-52803-2 For information on all Elsevier publications visit our website at books.elsevier.com Printed and bound in The Netherlands 07 08 09 10 11

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Contents

List of Contributors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv Preface and Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix Chapter 1 Access Pricing: An Introduction . . . . . . . . . . . . . . . . 1 Ralf Dewenter and Justus Haucap 1.1 Introduction to the Introduction 2 1.2 Access to Networks: Concepts and Issues 4 1.2.1 Essential facilities 4 1.2.2 One-way access 6 1.2.3 Two-way access (interconnection) 7 1.3 Access Pricing: Theory 7 1.4 Access Pricing: Practice 9 1.4.1 The retail-minus approach 11 1.4.2 The efficient component pricing rule 11 1.4.3 Cost-based concepts 13 1.4.4 Capacity-based pricing and price caps 15 1.4.5 Institutions 16 1.5 Contents of this Book: Theory 18 1.5.1 One-way access pricing 18 1.5.2 Two-way access pricing 22 1.5.3 Access pricing and multihoming 24 1.6 Contents of this Book: Practice 26 1.6.1 Applications to specific markets 26 1.6.2 Policy 31 1.7 Conclusion 34 References 35

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Contents

PART I – ONE-WAY ACCESS PRICING

39

Chapter 2 Access Pricing and Infrastructure Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Joshua S. Gans 2.1 Introduction 42 2.2 Model of Investment Timing 43 2.2.1 Investment costs 44 2.2.2 Investment benefits 44 2.2.3 Socially optimal timing 45 2.3 No Access Regulation 46 2.3.1 Motives for access 46 2.3.2 Motives for investment 47 2.3.3 Negotiations over access 49 2.3.4 Equilibrium investment timing 50 2.3.5 Summary 52 2.4 Access Price Regulation 52 2.4.1 ‘Small’ seekers 53 2.4.2 Two ‘large’ firms 54 2.4.3 Summary 58 2.5 Practical Issues 58 2.5.1 Optimal usage charges 58 2.5.2 Access holidays 60 2.6 Conclusion 62 References 63 Chapter 3 Network Financing with Two-Part and Single Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Axel Gautier 3.1 Introduction 66 3.1.1 Model overview and results 68 3.1.2 Related literature 70 3.2 Model 71 3.2.1 Demand, costs and information 71 3.2.2 Regulation 72

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3.2.3 Timing of the events 73 3.2.4 Benchmark: the regulated monopoly case 74 3.3 Optimal Access Charges 75 3.3.1 The entrant’s entry and supply decisions 75 3.3.2 Two-part tariff 76 3.3.3 Single tariff 79 3.4 Comparisons 81 3.4.1 Market structure 81 3.4.2 Welfare 82 3.5 Concluding Remarks 83 Appendix 85 A3.1 Proof of proposition 3.2 85 A3.2 Proof of proposition 3.3 87 A3.3 Proof of proposition 3.4 88 References 89 Chapter 4 Unbundling the Local Loop: One-way Access and Imperfect Competition . . . . . . . . . . . . . . 91 Paul W. J. de Bijl and Martin Peitz 4.1 Introduction 92 4.2 Policy on Local-Loop Unbundling in Telecoms 95 4.2.1 Unbundling in the EU 95 4.2.2 Unbundling in the US 97 4.3 Regulatory Theory with Full Participation 99 4.4 Regulatory Theory with Partial Participation 107 4.5 Discussion and Conclusion 114 References 116 PART II – TWO-WAY ACCESS PRICING

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Chapter 5 On the Role of Access Charges Under Network Competition . . . . . . . . . . . . . . . . . . . . . . . . . 121 Stefan Buehler and Armin Schmutzler 5.1 Introduction 121 5.2 Linear Retail Prices 124

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Contents

5.2.1 5.2.2 5.2.3 5.2.4

Assumptions 124 Comparative statics 128 Are retail prices strategic complements? 130 Do higher access charges shift out the reaction curves? 132 5.3 Simplifying Assumptions: How do they Affect the Role of Access Charges? 133 5.3.1 Full-coverage networks 134 5.3.2 Full-coverage networks and balanced calling pattern 136 5.4 Nonlinear Retail Tariffs 138 5.4.1 Assumptions 139 5.4.2 Comparative statics 141 5.5 Extensions and Conclusions 145 References 146 Chapter 6 Access Pricing Under Cost Asymmetry in Telecommunications . . . . . . . . . . . . . . . . . . . . . . . . 149 Viktória Kocsis 6.1 Introduction 150 6.2 Model for Linear Tariffs 153 6.2.1 Cost structure and access fee 153 6.2.2 Demand structure and consumer surplus 154 6.2.3 Price competition 157 6.2.4 Comparison and policy implications 158 6.3 Competition in Two-Part Tariffs 160 6.3.1 Demand structure and consumer surplus 161 6.3.2 Price competition 162 6.3.3 Comparison and policy implications 164 6.4 Conclusions 167 Appendix 168 A6.1 Proofs 168 A6.2 Simulation results 172

Contents

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A6.2.1 Comparison according to parameter values 172 A6.2.2 Comparison according to access fee 173 References 175 PART III – Access Pricing and Multihoming

177

Chapter 7 Interconnection Competition with Multiple Network Subscription . . . . . . . . . . . . . . . . . . . . . . . . . 179 Roger K. Alexander 7.1 Introduction 180 7.1.1 Background to new analysis framework 180 7.1.2 Organization of this chapter 182 7.2 Consumer Utility Model Setup 183 7.2.1 Consumer discrete subscription choice model 184 7.2.2 Direct measurable utility from network subscription 193 7.3 Network Competition – Dual Network Subscriptions 199 7.3.1 Network marginal costs and price competition model 199 7.3.2 Network calling pattern 200 7.3.3 Two-stage network competition 201 7.4 Network Competition Modelling: Linear Pricing 209 7.4.1 Equilibrium price–access charge relationship 209 7.5 Conclusion 216 7.5.1 Summary and general findings 216 7.5.2 Future areas of study 218 Appendix 218 A7.1 Dual network subscription example 218 References 227 Chapter 8 Platform Competition with Endogenous Multihoming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Roberto Roson 8.1 Introduction 229 8.2 The Model Structure 233

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Contents

8.2.1 Assumptions and definitions 233 8.2.2 Profit maximization 238 8.3 A Numerical Simulation of Platform Competition 242 8.4 Concluding remarks 246 References 247 PART IV – Application to Specific Markets

249

Chapter 9 Network Ownership and Optimal Tariffs for natural Gas Transport . . . . . . . . . . . . . . . . . . . . . . . 251 Kåre P. Hagen, Hans Jarle Kind and Jan Gaute Sannarnes 9.1 Introduction 251 9.2 A Simplified Model for Transportation of Gas 255 9.2.1 Fully integrated network 256 9.2.2 Separation of ownership between transportation network and extraction and marketing activities 265 9.3 Conclusion and Discussion 270 Appendix 272 A9.1 Existence of equilibrium 272 A9.2 Downstream competition with firms located outside the country 274 References 275 Chapter 10 Mobile Termination . . . . . . . . . . . . . . . . . . . . . . . . . . 277 Harley Thompson, Olivier Renard and Julian Wright 10.1 Introduction 277 10.2 Literature Review 280 10.3 Theoretical Model 285 10.3.1 Model derivation 285 10.3.2 Model solution 290 10.4 Model Calibration 292 10.4.1 Colombian fixed-to-mobile arrangements 292 10.4.2 Calibration methodology 293 10.4.3 Data for Colombia 293

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10.5 Welfare Analysis 294 10.6 Conclusions and Future Directions 299 References 301 Chapter 11 Incentives to License Virtual Mobile Network Operators (MVNOs) . . . . . . . . . . . . . . . . . . . . . . . . . 303 Ralf Dewenter and Justus Haucap 11.1 Introduction 303 11.2 What are MVNOs? 306 11.3 Regulatory Approaches and Emergence of MVNOs 309 11.4 The Model 313 11.4.1 Cournot competition 313 11.4.2 Bertrand competition 316 11.4.3 Stackelberg competition 320 11.5 Summary and Policy Conclusions 322 References 323 PART V – Policy

325

Chapter 12 Antitrust and Sector-Specific Regulation in the European Union: The Case of Electronic Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 Alexandre De Streel 12.1 Introduction 328 12.2 A Broad Picture 329 12.2.1 Substantive law 329 12.2.2 Institutional design 335 12.3 Competition Law 339 12.3.1 Ex post competition law 339 12.3.2 Ex ante competition law: mergers and joint ventures 345 12.3.3 Appraisal of the application of antitrust in the electronic communications sector 348

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Contents

12.4 Sector Regulation 350 12.4.1 Ex ante sector regulation 350 12.4.2 Appraisal of the application of sector regulation 353 12.5 Optimal Balance between Rules and Coordination between Institutions 358 12.5.1 The optimal balance between antitrust and sector regulation 358 12.5.2 The optimal institutional coordination 362 12.6 Conclusion 363 Appendix 365 References 368 Chapter 13 Efficient Regulation of Dynamic Telecommunications Markets and the New Regulatory Framework in Europe . . . . . . . 373 Pio Baake, Ulrich Kamecke and Christian Wey 13.1 Introduction: The New Regulatory Framework in the European Union 374 13.2 Dynamic Competition 379 13.2.1 Schumpeter’s competition through innovation 380 13.2.2 Incentives to innovation 387 13.2.3 The role of competition 391 13.2.4 Intermediate conclusion 394 13.3 Dynamic Competition in Telecommunications Markets and Traditional Regulation 395 13.3.1 New networks: structures and demand for DSL accesses 396 13.3.2 Investment, downstream markets and strategies for the network operator 397 13.3.3 Competition to construct new networks 402 13.3.4 Traditional regulation: cost-based network access 406

Contents

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13.4 Regulation of New Markets 407 13.4.1 New markets 408 13.4.2 Regulation 411 13.4.3 Incentive effects: infrastructure-based competition 414 13.5 Summary 417 References 418 Chapter 14 Are Vertically Integrated DSL Providers Squeezing Unaffiliated ISPs (And Should We Care)? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421 Robert W. Crandall and Hal J. Singer 14.1 Introduction 422 14.2 The Role of Regulation in Promoting ISPs 424 14.2.1 Computer I and II decisions 425 14.2.2 Choice of global service provider regulation 427 14.2.3 Reciprocal compensation game 428 14.3 What Did Internet Service Contribute to Economic Value? 430 14.3.1 The value-added of unaffiliated internet service providers in the dial-up era 430 14.3.2 The value-added of intermediaries in the broadband era 432 14.4 Issues for Competition Law 440 14.4.1 Price squeeze allegations 442 14.4.2 The conditions under which a price squeeze harms consumers 445 14.4.3 The relationship between a price squeeze and cross subsidy 450 14.5 Conclusion 455 References 456 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .461


List of Contributors Roger K. Alexander The Senbazuru Group, LLC Rockville, USA Pio Baake

Department of Economics Humboldt University at Berlin Berlin, Germany German Institute for Economic Research (DIW) Berlin, Germany

Paul W. J. de Bijl

TILEC Tilburg University Tilburg, Netherlands

Stefan Buehler

University of St. Gallen St. Gallen, Switzerland Socioeconomic Institute University of Zurich Zurich, Switzerland

Robert W. Crandall

The Brookings Institution Washington, DC, USA

Ralf Dewenter

Department of Economics Helmut-Schmidt-University Hamburg Hamburg, Germany

Joshua S. Gans

Melbourne Business School University of Melbourne Melbourne, Australia

Axel Gautier

Universitaires Saint Louis Bruxelles, Belgium

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List of Contributors

Kåre P. Hagen

Department of Economics Norwegian School of Economics and Business Administration Bergen, Norway

Justus Haucap

Department of Economics Ruhr-University of Bochum Bochum, Germany

Ulrich Kamecke

Department of Economics Humboldt University at Berlin Berlin, Germany

Hans Jarle Kind


Victória Kocsis

Corvinus University of Budapest Budapest, Hungary Tinbergen Institute Amsterdam, Netherlands

Martin Peitz

School of Business Administration International University in Germany Bruchsal, Germany

Olivier Renard

Charles River Associates Melbourne, Australia

Roberto Roson

Department of Economics Università Ca’ Foscari di Venezia Venice, Italy

Jan Gaute Sannarnes


List of Contributors

Armin Schmutzler

Socioeconomic Institute University of Zurich Zurich, Switzerland

Hal J. Singer

Criterion Economics Washington, DC, USA

Alexandre de Streel

University of Namur Namur, Belgium

Harley Thompson

Charles River Associates Sydney, Australia

Christian Wey

Department of Economics Humboldt University at Berlin Berlin, Germany German Institute for Economic Research (DIW) Berlin, Germany CEPR, London, UK

Julian Wright

Faculty of Arts and Social Sciences National University of Singapore Singapore

xvii


Preface and Acknowledgements

Access to essential facilities or the so-called bottlenecks has become the key public policy issue for the liberalization of network industries such as telecommunications, electricity, rail, and so on. Still, access prices are not only important for competition in formerly monopolistic industries, but also for industries where competition has long been established such as payment and credit card networks or mobile telecommunications. As the latter industries have also come under closer scrutiny by regulatory agencies and competition authorities, this book is dedicated to the analysis of access pricing in theory and practice. The extended introduction introduces the key concepts and issues including a brief explanation of the essential facility concept as well as the distinction between one-way and two-way access. While Parts I and II deal with the theory of one-way and two-way access pricing, respectively, Part III focuses on the newly emerging theory of access pricing with multihoming. Parts IV and V address the practice side and focus on industry-specific applications and special problems (Part IV) as well as public policy issues (Part V). Our primary debt is, of course, to the authors of the chapter of this book. Most chapters of this book were written on our invitation, but we have also sourced a number of chapters via a Call for Papers. For the selection of the chapters included in this book, we have relied on a number of referees, whose help is most gratefully acknowledged. These include Roger Alexander, Stefan Buehler, Tommy Staahl Gabrielson, Martin Peitz, and Roberto Roson. And we would also like to thank Jeroen Loos at Elsevier, as it was him who had the initial idea for this volume and who supported us in this endeavour. Finally, we thank Hannah Enste, Jutta Kehrer, and Silke Werner at the Ruhr-University of Bochum, who patiently helped with the

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Preface and Acknowledgements

technical production of this volume. Of course, the usual disclaimers apply, none of the people mentioned here is responsible for any mistakes. RALF DEWENTER JUSTUS HAUCAP

Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 1

Access Pricing: An Introduction RALF DEWENTER Helmut-Schmidt University, Hamburg JUSTUS HAUCAP Ruhr-University of Bochum

Contents 1.1 INTRODUCTION TO THE INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 ACCESS TO NETWORKS: CONCEPTS AND ISSUES . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Essential facilities 1.2.2 One-way access 1.2.3 Two-way access (interconnection) 1.3 ACCESS PRICING: THEORY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 ACCESS PRICING: PRACTICE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4.1 The retail-minus approach 1.4.2 The efficient component pricing rule 1.4.3 Cost-based concepts 1.4.4 Capacity-based pricing and price caps 1.4.5 Institutions 1.5 CONTENTS OF THIS BOOK: THEORY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 One-way access pricing 1.5.2 Two-way access pricing 1.5.3 Access pricing and multihoming 1.6 CONTENTS OF THIS BOOK: PRACTICE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.6.1 Applications to specific markets 1.6.2 Policy 1.7 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2 4 4 6 7 7 9 11 11 13 15 16 18 18 22 24 26 26 31 34 35

2

Ralf Dewenter and Justus Haucap

1.1 INTRODUCTION TO THE INTRODUCTION

Within the twenty years spanning from 1985 to 2005, one of the major areas of microeconomic reform has been the privatization, liberalization, and de- and re-regulation of network-based industries such as telecommunications, electricity, gas, and rail, among others. Building on the theory of contestable markets (see Baumol et al., 1982) and the so-called disaggregated approach to regulation (see, e.g., Knieps, 2003), the paradigm has shifted from regulation to competition. While traditionally the emphasis has been on the regulation of prices for final consumers to prevent the exploitative abuse of market power, the focus has shifted towards the regulation or supervision of charges for access to monopolistic bottlenecks to prevent obstructive or exclusionary abuse (which is, of course, ultimately also exploitative). The basic idea is that, while some facilities constitute resistant natural monopolies, many upstream or downstream markets are potentially competitive. Actual competition, however, can often only emerge if new competitors are granted access to monopolistic bottlenecks. While traditionally competition was prevented over the entire industry, including all upstream and downstream markets, so that final retail prices had to be regulated, competition is now facilitated in many upstream and downstream markets so that, at least in theory, only wholesale prices for access products need to be subject to ex ante regulation. Of course, the principal problem of network access is not really new. As early as 1912 the US Supreme Court ruled in the by now famous Terminal Railroad case that the Terminal Railroad Association of St. Louis (TRASL), which owned the only railroad bridge over the Mississippi river in St. Louis, had to grant access to the bridge for other competitors. Whether or not this case actually constituted what has become known as the essential facility doctrine (see Lipsky and Sidak, 1999; Pitofsky et al., 2002), the so-called access problems have become at least of major importance for the reforms of network industries. The reforms of network-based industries have been guided by the fundamental insight that market liberalization is not always the same

Chapter 1 – Access Pricing: An Introduction

3

as market deregulation. While liberalization implies the removal of barriers to entry for new competitors, deregulation refers to the reduction of government intervention in market processes (see, e.g., Vogelsang, 2003; Dewenter and Haucap, 2004; Haucap and Marcus, 2005). In order to facilitate competition and market entry in network industries, re-regulation of access is often necessary so as to liberalize the market. Put differently, without regulatory intervention market entry would often hardly be possible and, therefore, any envisaged liberalization of formerly monopolistic industries would not be successful. However, network access and the according access prices are not only an important issue within recently liberalized network industries, but also for markets which have in many instances always been open to (at least some) competition such as ATM networks (see McAndrews, 2003), payment systems (see Baxter, 1983; Evans and Schmalensee, 2005), media markets (see Anderson and Gabszewicz, 2005; Dewenter, 2004), or mobile telecommunications (see Gruber, 2005; Kruse, 2004), among others. While the essential facility doctrine has been central for the liberalization of network industries and most prominently telecommunications, as a result of the MCI/AT&T case (1983), a number of high-profile cases have concerned other industries. Apart from MCI/AT&T, landmark cases are undoubtedly Associated Press (1944/45), Otter Tail Power (1973), Hecht/Pro-Football (1978) and Aspen Skiing (1985) in the US and London European/SABENA (1988), Magill TV/ITP/BBC/RTE (1988/1991), British Midland/Aer Lingus (1992), Sealink I (1992) and Sealink II (1993), Port of Rodby (1993) and Oscar Bronner (1998) in the European Union, but more recent cases such as the US Supreme Court’s Trinko decision (2004) or the IMS Health case (2004) in Europe have also involved substantial debate among economists and legal scholars alike. The great attention paid by both the general public and the media as well as the academic community underlines the significance and importance of access pricing issues. This book is dedicated to the analysis of access pricing theory and practice. A brief introduction to key concepts and issues will

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be given in the remainder of this introductory chapter. This will include a brief explanation of the essential facility concept as well as the distinction between one-way and two-way access. We will also briefly survey the main contributions within the literature on access pricing theory and practice, before we introduce the various chapters of this book in more detail. The book is structured in five parts. While parts I and II deal with the theory of one-way and two-way access pricing, respectively, part III focuses on the newly emerging theory of access pricing with multihoming. Parts IV and V address the practice side and include applications to certain industries and/or special problems (Part IV) as well as policy matters (Part V).

1.2 ACCESS TO NETWORKS: CONCEPTS AND ISSUES 1.2.1 Essential facilities

The notion of a certain facility being essential for competitors and, thereby, an essential facility is originally not based on an economic concept. It rather has its origin in US antitrust law, namely the Terminal Railroad case (1912) mentioned above, which may also be the reason why there is no universally accepted definition of an essential facility among economists. However, there is widespread agreement among economists that mandatory access to a firm’s facilities should only be granted if the following four criteria are met (see, e.g., Lipsky and Sidak, 1999): (1) The facility must be controlled by a firm with significant market power. (2) (Potentially) competing firms must lack a realistic ability to reproduce the facility. (3) Access to the facility is necessary in order to compete in a related upstream or downstream market. (4) It must be feasible to provide access to the facility.


5

Table 1.1 gives an overview over typical essential facilities in various industries. The extent to which a facility is truly essential is not always clear and in the end also an empirical question. There are a number of reasons why a facility may not be duplicable, one being legal restrictions and another, quite importantly, natural monopoly characteristics paired with specific investments (sunk costs). Hence, the question is whether the cost function is subadditive in the relevant area of the demand curve. Of course, in small markets the equilibrium number of firms operating at minimum efficient scale will be smaller than in larger markets so that in smaller markets more segments will constitute essential facilities. For example, on a small island, power generation may be a natural monopoly while it may not be a natural monopoly in larger markets. Therefore, it is not Table 1.1 Examples for essential facilities in various industries Industry

Essential facility

Competitive markets

Telecommunications

Local loop (fixed-line) Termination (under Calling-party pays) Transmission network Distribution network Rail tracks Stations (possibly) Pipeline system Water extraction (possibly)

Trunk network Calls and services Retailing Generation Retailing Passenger and freight transport Treatment Water extraction (possibly) Retailing Treatment Gas extraction (possibly) Gasholder (possibly) Retailing Collection Consolidation Presorting Delivery (in urban areas) Slots (possibly) Aviation services (possibly) Non-aviation services

Electricity Rail transport Water

Wastewater Gas

Pipeline System Pipeline system Gasholder (possibly)

Postal services

Local delivery network (possibly in rural areas) PO boxes (possibly)

Airports

Slots (possibly) Aviation services (possibly)

6


possible to come up with universal claims or general statements about what constitutes an essential facility and what does not, as the existence of an essential facility always depends on circumstances such as market size. Similarly, natural monopolies may erode over time due to the development of new technologies (such as WiFi or cable modems in telecommunications) or changes in prices for input factors.

1.2.2 One-way access

An incumbent firm’s facility can be considered essential if firms in a related upstream or downstream market cannot offer services without having access to that essential facility. In case of one-way access other firms need access to the incumbent firm’s bottleneck facility to be able to compete, while the incumbent’s services do not depend on the entrant’s facilities. That is, a vertically integrated incumbent can compete in the retail market on its own feet and a vertically separated owner of the facility can offer wholesale services only without being dependent on other firms’ facilities. In contrast, firms in related upstream or downstream markets depend on access to the incumbent’s essential facility. Hence, one-way access refers to a monopoly input provided by an incumbent which may be either vertically integrated and, therefore, also a competitor or vertically separated and, therefore, only an input supplier. The literature on access pricing, however, concentrates on vertically integrated operators which also compete in the downstream market (see, e.g., Vogelsang, 2003) while the literature on vertical relations and input price discrimination often also considers vertically separated firms (see, e.g., Rey and Tirole, 2006). Sometimes one-way access is also referred to as vertical interconnection (see Noam, 2002). Examples for one-way access are, among others, access to unbundled local loop services in fixed line telephony, to rail tracks, to electricity distribution and transmission networks, and to gas pipelines.


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1.2.3 Two-way access (interconnection)

While one-way access refers to vertical interconnection, two-way access describes a situation where two competing firms grant access to each other’s essential facilities, which is therefore also called horizontal interconnection or simply interconnection. Horizontal interconnection is typically granted between competing networks such as competing mobile telecommunications operators which have to terminate calls on each other’s networks (mobile termination) or competing banks which grant each other access to their ATM networks. In cases where non-competing firms grant each other access to their respective bottlenecks, two-way access is also referred to as parallel interconnection. Examples include international roaming in mobile telecommunications and international postal services.

1.3 ACCESS PRICING: THEORY

From a welfare economic perspective, the main objective of an access regime is to ensure economic efficiency, which comprises three interdependent elements: • productive efficiency, meaning that firms adopt the least-cost method of production; • allocative efficiency, meaning that resources are employed to produce those goods and services that provide the maximum benefit to society. In an ideal world without transaction costs, allocative efficiency implies that the incremental or marginal cost of producing an additional unit of any good or service just equals consumers’ willingness to pay for this unit; and • dynamic efficiency, meaning that firms invest and innovate at an optimal rate and point in time, and hence improve quality, increase productivity and lower costs over time, so that the social surplus is not necessarily maximized at a given point in time, but over a time period.

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As Laffont and Tirole (1994, 1996) have shown, welfare is maximized under Ramsey pricing, subject to the constraint that the regulated firm’s profits are not negative. This result does not only hold for a static environment, but can, in principle, also be applied in a dynamic context (see Laffont and Tirole, 2000, p. 67). There are several extensions to this model, some of which are discussed by Laffont and Tirole (2000, p. 67 et sqq.). From a competition policy perspective the main risk associated with one-way access is foreclosure. A vertically integrated operator may face strong incentives to deny rivals access to essential facilities at reasonable prices. The dominant firm may exclude competing final product suppliers from the retail market by charging entrypreventing access charges or by other anti-competitive measures. Even if the incumbent sets access prices that facilitate some entry, these charges may be excessive and lessen competition by raising rivals’ costs. And even if the network operator does not integrate into the retail market, an unconstrained natural monopoly network operator may abuse its market power and charge monopoly prices for network access (also see Armstrong et al., 1996). While foreclosure is the main problem associated with one-way access, a major problem associated with two-way access is collusion. This does not imply that foreclosure cannot be a problem among competing networks relying on two-way access. Quite in contrast, especially if networks are very asymmetric in size (e.g., a number of large incumbents vis-à-vis a small entrant), the larger networks may face strong incentives to deny small firms access so that the risk of foreclosure remains a policy issue (see, e.g., De Bijl and Peitz, 2002; Carter and Wright, 2003; Peitz, 2005). However, collusion may be an additional policy issue regarding two-way access. The basic idea is that competing networks can directly influence the other networks’ (perceived) marginal cost by increasing their termination or delivery charges. Hence, networks can increase each other’s costs so that a different raising rivals’ cost effect occurs than under one-way access. While, under two-way access, competition may be softened because the networks increase each other’ costs, the essential facility operator can unilaterally increase other firms’


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costs only under one-way access. Seminal contributions to the theory of two-way access are Laffont et al. (1998a, 1998b), Armstrong (1998) and Carter and Wright (1999), who develop the canonical interconnection model. While initially the focus of the literature on access pricing has been on allocative and productive efficiency considerations in a static environment, more recently the literature has also analyzed dynamic efficiency issues such as the effects of different pricing regimes on investment and innovation incentives (see, e.g., Gans, 2001). Another more recent development is the analysis of access pricing in two-sided markets. Detailed surveys of the access pricing literature are provided by Laffont and Tirole (2000), Armstrong (2002) as well as Vogelsang (2003). The relationship between investment and access regulation is extensively discussed in Valletti (2003), Chang et al. (2003), Peitz (2003), and Cave and Vogelsang (2003). Finally, the recent developments in the newly emerging theory on two-sided markets are surveyed by Rochet and Tirole (2006), Evans and Schmalensee (2005), and Roson (2004).

1.4 ACCESS PRICING: PRACTICE

As briefly noted above, optimal access prices under one-way access are quasi-efficient Ramsey prices. While an unregulated monopolist may actually follow the principles of Ramsey pricing when choosing its tariff structure, the resulting pricing will, at best, reflect Ramsey pricing in their structure, but not in the price level. The monopolistic price will almost always exceed Ramsey prices (unless the surplus of the monopoly producer just equals the fixed cost). Hence, a global price cap, as proposed by Laffont and Tirole (2000), may solve the problem of excessive pricing, while at the same time enabling the monopolist to choose a Ramsey pricing structure. However, as Hoeffler (2006) has correctly pointed out, a vertically integrated monopolist which faces competition in related upstream or downstream markets will also deviate from Ramsey prices in their structure, as the elasticity of the individual firm’s residual demand

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may be almost completely unrelated to the elasticity of the market demand curve and an integrated monopolist may face incentives to foreclose related upstream or downstream markets. While a possible solution to the latter problem appears to be (at least at first sight) vertical disintegration or unbundling, the owner of a vertically separated monopolistic bottleneck still has incentives to set monopoly rates and to price-discriminate between different buyers so that a need for regulatory surveillance remains. In addition, vertical separation has its own costs, such as decreasing investment incentives (see, e.g., Buehler, 2005). Moreover, for two-way access problems vertical separation is usually not a viable option, as it is often not feasible to vertically separate wholesale and retail activities. Therefore, charges for bottleneck access are often regulated. In fact, the now common solution to deal with vertically integrated monopolists is to regulate their access prices. Unfortunately though, there are several practical problems that prevent Ramsey price regulation. Most importantly, the information requirements are rather burdensome, as regulators would have to collect information on marginal cost, price elasticities of demand, and cross-price elasticities (super-elasticties). Therefore, less complicated access pricing rules have been usually applied in practice. The most prominent methods are: • • • • •

charges based on the incumbent’s retail prices (‘retail minus’) the efficient component pricing rule (ECPR), cost-based access charges, capacity-based charges, and price cap regulation.

Since price cap regulation and capacity-based charges can both be combined with either the ECPR or cost-based access charges, the two most prominent alternatives are charges based on the incumbent’s retail price (of which the ECPR can be considered a special version) and cost-based charges such as (total element) or (total service) longrun incremental costs, (TE)LRICs or (TS)LRICs, respectively (see Gasmi et al., 2002; ERG, 2004; Gans and King, 2004).


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1.4.1 The retail-minus approach

Under the so-called retail-minus rule, access prices are not based on some measure of an incumbent’s cost plus some mark-up, but rather based on its retail prices from which some amount (e.g., for the avoided retail cost) is deducted. This rule is often discussed and also applied in the context of so-called resale obligations, which require incumbent operators to facilitate resale of their own products and services by competing firms, for example, to enable competitors to replicate an incumbent’s product bundles. While retail-minus rules are relatively easy to implement and to enforce (even though non-price discrimination may become an issue), the rule’s major drawback regarding access prices for essential facility services is its allocative inefficiency if retail prices are left unregulated. As the European Regulators Group (ERG) has put it: ‘The retail-minus approach is – without retail price regulation – not able to bring down excessive access prices to a cost-oriented level. As the wholesale price is calculated as the retail price minus the cost of an efficient undertaking, an excessive retail price will automatically feed into an excessive wholesale price (or vice versa)’ (ERG, 2004, p. 84).

1.4.2 The efficient component pricing rule

A special form of the retail-minus approach is the ECPR, sometimes also called the Baumol–Willig rule, which was first proposed by Willig (1979) and Baumol (1983) and later popularized by Baumol and Sidak (1994a, 1994b). Sometimes the expressions ECPR and retail-minus approach are also used as synonymous for the same access pricing rule (see, e.g., ERG, 2004, p. 84). Under the ECPR access charges are based on the monopolist’s opportunity cost of providing access, including any forgone (monopoly) profit. Expressed in terms of the so-called margin rule the access charge should be set equal to the price usually charged for the retail service less the cost not incurred when interconnecting a rival instead of selling retail services. The opportunity cost

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expression states that the optimal access fee equals the marginal cost of providing the network service plus the profit forgone when not selling the retail service but interconnecting a rival. As can be easily checked, the two expressions are equivalent. The logic behind the ECPR is that only those producers that are at least as efficient in producing a particular service as the incumbent monopolist can enter the market. Any access price lower than the ECP will lead to ‘excessive’ entry by inefficient rivals. As the ECPR has a strong focus on productive efficiency, it also encourages investment in bypass facilities and innovation to overcome network bottlenecks. From a public policy point of view, this might actually lead to overinvestment and ‘unnecessary’ duplication of parts of a given network. Apart from guaranteeing productive efficiency, the ECPR has a second major advantage: the informational requirements it imposes on regulatory authorities are comparatively low. Basically, the ECP is the price at which an incumbent would grant access to its network on a voluntary basis. If the incumbent is reimbursed for any monopoly profit lost, the monopoly firm will be indifferent between granting access to rivals and selling retail services to customers. Hence, the information requirements are low and there is little need for regulatory ex ante intervention. In this respect, the ECPR might be considered to be consistent with what has been called a lighthanded regulatory regime. However, even if the monopolist’s price for the final retail product was based on marginal cost pricing, the ECPR only holds as a firstbest pricing principle if the following additional assumptions are met as well: • the monopolist’s and the rivals’ retail products are perfect substitutes; • the production technology exhibits constant returns to scale; and • rival producers do not have any market power (see Armstrong et al., 1996). While the ECPR ensures productive efficiency, its validity as an optimal rule in terms of allocative efficiency depends on final product


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price regulations ensuring the absence of monopoly rents (see Baumol and Sidak, 1994a, p. 108). Hence, the question arises as to whether it is practical to implement the ECPR and to simultaneously regulate the incumbent’s retail prices in order to avoid monopoly pricing. If, however, the incumbent’s retail prices are not held down to competitive levels, the ECPR most likely leads to grave allocative inefficiencies, at least in static environments. In more dynamic environments, where non-temporary market power is rare, the ECPR can be helpful to prevent anti-competitive bundling of services offered in competitive markets and products offered by firms that have market power.

1.4.3 Cost-based concepts

A different approach to regulate access prices is to set cost-based charges. In the simplest textbook theories, prices set at marginal cost ensure efficiency. One problem, however, is that for natural monopolies marginal cost-based prices lead to deficits, while prices based on average cost induce allocative inefficiencies. Moreover, in reality firms usually offer more than a single product so that common costs have to be allocated somehow. Put differently, the calculation of a multiproduct firm’s average cost is not feasible. One way to avoid the latter problem is to use incremental costs. While marginal costs arise with marginal output changes, incremental costs arise with larger output variations. Incremental costs (i.e., long-run incremental costs, LRICs) are all costs that are associated only with the production of a specific service. Put differently, the LRICs are the costs that a producer would avoid if a specific product (or some other increment) would no longer be produced. Therefore, incremental costs also include the fixed costs which are specific to the particular increment under consideration (e.g., a particular service). Note that only in case of a firm producing a single product (or service) LRICs would be equal to stand-alone costs. The difference between short-run and long-run costs is that in the former there are fixed costs, while in the latter fixed costs do not

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exist, as all factors of production are assumed to be variable. Hence, in the long run production can be optimized (as everything can be varied) so that production of a given output takes place at minimum cost levels, as would be the case in perfectly contestable markets. The difference between TSLRICs and TELRICs is that TELRICs do not refer to the products produced (or services provided) by a firm, but to the incremental costs associated with given network elements such as the local loop. TELRIC has been introduced by the Federal Communications Commission (FCC) in connection with the US 1996 Telecommunications Act. Compared to TSLRIC the advantage of TELRIC is that with an element-based approach there are typically less common costs than considering products or services. In general though, the differences between TELRIC and TSLRIC should be rather small when compared to the other differences between costbased and pricing rules.1 While the basic idea behind LRIC-based pricing is that LRIC prices can ‘simulate competition’ (see, e.g., Belfin and Lukanowicz, 1999), this only holds if rather special and unrealistic assumptions are met. Quite in contrast, it is often argued that one shortcoming of regulating access prices on an incremental cost basis is that LRIC prices are only efficient if a number of rather unrealistic conditions hold so that in reality LRIC regulation may induce inefficiencies (see, e.g., Hausman, 1999, 2001). For example, economies of scale and scope must not exist, which, of course, almost never holds for essential facilities. Similarly, LRIC prices would only evolve even in competitive markets if there were no sunk costs. As soon as specific investments are necessary (as in most network industries) and, therefore, sunk costs result, competition will be less than perfect (even though markets may still be very competitive) so that prices will deviate from marginal costs or LRIC. Nevertheless, LRIC prices are frequently adopted by regulatory authorities, especially for telecommunications markets, even though 1

For a more detailed analysis of the differences between TELRICs and TSLRICs see Gans and King (2004).


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there is now reasonably widespread agreement among economists that LRIC prices hardly induce efficiency (see, e.g., Sappington, 2005). There are two main reasons why cost-based pricing is still so prominent (also see Vogelsang, 2003): • any mark-up would result in double marginalization, and • higher access charges tend to dampen competition in downstream markets. Furthermore, cost-based regulation is often not truly based on a long-run cost standard. For example, in telecommunications often a so-called ‘scorched node’ approach is used in calculating cost. In contrast to a so-called ‘scorched earth’ or greenfield approach, some elements (e.g., the number and/or locations of network switches) are considered to be fixed under a scorched node approach so that some cost drivers are not variable. This, however, implies that the cost concept used is not really a long-run cost concept as some factors of production are not considered variable. One reason for the deviations from pure theory that we observe in practice is that one of the main practical problems in the determination of cost-based access fees is to find an adequate measurement for costs. As prices determine quantities which in turn determine average and also incremental costs there is an endogeneity problem. Other problems include the adequate time horizon to be considered, how to account for historical decisions and productive inefficiencies, and how to provide appropriate investment incentives. In fact, these issues have been the subject of numerous public consultations by regulatory authorities (see, e.g., IRG, 2000) and are beyond the scope of this book.

1.4.4 Capacity-based pricing and price caps

Capacity-based prices are a special form of two-part tariffs (see Vogelsang, 2003). In contrast to usual two-part tariffs, the fixed part is proportional to the capacity available for a specific firm, while

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the variable part is the standard usage fee set to equal marginal cost. Furthermore, a second usage fee is introduced which is applied after the capacity limit has been reached. This second variable price component is sufficiently high so as to prevent usage beyond the capacity purchased. Due to this ‘capacity constraint’ there are only limited economies of scale in the downstream market as is usually the case with two-part tariffs. Moreover, capacity-based pricing can be used to ‘split’ a natural monopoly into smaller parts. These smaller parts may then compete with each other. Capacity-based pricing is particularly appropriate in industries with high capacity costs due to high peaks. Therefore, it is, for example, common in gas markets and telecommunications markets (see OECD, 2004). Capacity-based pricing can also be combined with price caps. A monopolist may be allowed to set its access prices within a global price cap which includes both access and retail prices (see Laffont and Tirole, 2000). If the monopolist chooses a high access price, downstream prices have to be relatively low. If, in contrast, the access price is set at a relatively low level, prices for services in downstream markets set by the monopolist may be rather high. Now, however, competitors can set lower prices as the monopolist’s access prices have to be low. While the incentives for foreclosure are reduced, there is still an incentive to prevent entry in upstream markets if downstream price discrimination is allowed and possible. The monopolist may now choose a high access price upstream, while applying price discrimination in downstream markets in order to maximize profits. Separate price caps for upstream and downstream services may provide a solution to this problem. This may explain why, in practice, global price caps are a rather rare instrument when regulating access prices (see OECD, 2004).

1.4.5 Institutions

Apart from pricing issues, the reorganization of the institutional framework in many network industries has also led to research questions on the appropriate governance structures. From an


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institutional economics perspective, there are at least four interdependent questions: (1) What kind of rules should govern a market and which remedies should be applied to correct for market failures (e.g., sectorspecific versus general rules)? (2) When should these rules be enforced (ex ante or ex post)? (3) Which institution should have the mandate to monitor the market and to enforce the rules (a sector-specific regulator or a general competition authority, a national or a supra-national institution)? (4) How should the enforcement agency be structured internally and what incentives should the agency face? Even though it is often (but not always) the case that sector-specific agencies enforce sector-specific rules ex ante, while general competition authorities enforce general rules ex post, this is by no means necessary. Other institutional frameworks are possible as well. Market surveillance can be either based on (a) sector-specific or (b) general rules, which can be enforced by (i) sector-specific or (ii) general agencies (1) ex ante or (2) ex post.2 Furthermore, different rules can be applied to different aspects within the same industry. For example, merger control is often conducted ex ante by general competition authorities according to general rules, but it may also be conducted by the same agency according to sector-specific rules (e.g., for media markets). Similarly, access rules may be based on general competition law (such as Section 2 of the Sherman Act or Article 82 EU), enforced by general competition authorities, or on sector-specific rules laid down in sector specific-laws (such as a Telecommunications Act) which may again be administered by sector-specific regulators or general regulatory agencies. Furthermore, regulatory and competition authorities may be merged such 2 We can furthermore distinguish between frameworks which use (1) per-se-rules and those that apply a rule-of-reason standard, and (2) whether the burden of proof rests with the enforcement agency or the market participants involved.

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as Australia’s ACCC. While these institutional aspects give rise to interesting research questions, especially from an institutional economics perspective, this book will mainly (but not exclusively) focus on the first of the four questions outlined above, that is, on the question which rules should be applied in order to maximize social welfare. In the following, let us describe the contents of the book in more detail.

1.5 CONTENTS OF THIS BOOK: THEORY 1.5.1 One-way access pricing

Part I consist of three chapters on one-way access problems. First, Joshua Gans (Chapter 2) examines the effects of access price regulation on investment incentives. Next, Axel Gautier (Chapter 3) analyzes optimal pricing schemes and network financing when market structure is endogenous, and finally, Paul de Bijl and Martin Peitz (Chapter 4) consider local loop unbundling in telecommunications markets. A potential consequence of regulating access to natural monopolies is that the incentives for infrastructure investment may be reduced. Since investment and innovation are key drivers for productivity growth (see, e.g., Roeller and Waverman, 2001), concerns may arise that access regulation can negatively affect infrastructure investment, productivity growth, efficiency and economic growth. Moreover, a trade-off between allocative and dynamic efficiency is usually thought to arise in determining the optimal access regime and charges for access to monopolistic bottlenecks. The chapter by Joshua Gans on access pricing and infrastructure investment synthesizes the existing literature on access price regulation and its impact on infrastructure investment. Using a duopoly model of investment timing based on Katz and Shapiro (1987), the impact of access price regulation on socially optimal investment timing is analyzed. In addition, various policies to stimulate investment incentives


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such as access holidays and mandatory investment negotiations are considered. Starting from a benchmark without access regulation Joshua Gans examines the motives for access and investment, before the equilibrium investment timing is analyzed when firms negotiate over access in the absence of regulation. Depending on the firms’ symmetry, investment timing can either be delayed or brought forward relative to the social optimum. If firms are asymmetric or, more exactly, if only the ‘large’ firm can invest into infrastructure, investment will be delayed since the innovator can earn monopoly profits over a longer period. However, if both firms are sufficiently large so that both can undertake their own infrastructure investments, an investment race may result in investments being undertaken ‘too early’ relative to the social optimum. Hence, in situations where monopolistic bottlenecks are not regulated, markets are not only characterized by a lack of downstream competition, but possibly also by inefficient investment patterns. In order to compare these results with a world with access price regulation, Joshua Gans assumes that under an access regulation regime first the regulatory authority chooses a (two-part) access tariff before, in a second stage, infrastructure investments are realized, and, thirdly, access is purchased by competitors. Again, the results depend on the firms’ symmetry: if only one firm can invest, access prices should be set so as to secure both investment and access. This is achieved through cost-sharing – each firm bears the costs proportionally to its profit share, which means that the optimal fixed access fee is proportional to the ratio between the non-investing firm’s profit and total industry profits. If, in contrast, two large (i.e., symmetric) firms compete in the market, both firms should pay, in the social optimum, the same fixed access fee so that they both carry the same share of the total infrastructure cost. In this case, access fees also have to be set so as to prevent a wasteful investment race between the two firms. Joshua Gans also examines optimal variable (usage-based) charges and access holidays. With respect to optimal usage-based charges, these should be set so as to secure the firms’ participation, while

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fixed access fees are determined by relative profit levels. Since the fixed charge is set to ensure optimal timing usage-based charges do not necessarily have to equal marginal cost but they may eventually exceed these. Finally, if for some reason optimal access prices cannot be implemented, another way to ensure the optimal timing of investment are access holidays. Similar to patents, access holidays guarantee temporary monopoly profits, thereby stimulating investment. Overall, Joshua Gans’ model demonstrates that investment and competition do not need to be strictly conflicting policy objectives, as access charges can be set in a way that fosters investment and simultaneously ensures competition in downstream markets. At the same time, the chapter also shows that optimal access prices do not equal marginal cost in upstream markets. Quite on the contrary, as with Ramsey pricing, optimal access prices may exceed marginal costs once investment incentives are taken into account. In the third chapter, Axel Gautier addresses a related question, as he analyzes the optimal regulatory pricing schemes and network financing when the downstream market structure is endogenous. More specifically, the focus is on access to an existing infrastructure owned by a vertically integrated incumbent operator and entry by a potential competitor in the downstream market when regulators have imperfect information about the entrant’s cost. While the regulator is assumed to determine all access conditions, the incumbent’s supply, and public contributions to network financing (so that the infrastructure costs are only partly born by the incumbent), the regulatory authority has to choose either a linear or two-part access tariff under incomplete information about the entrant’s productive efficiency. Since high access charges can prevent entry even if the newcomer is more efficient than the incumbent, the regulator has to choose an optimum access charge level and structure. As Axel Gautier shows, a two-part tariff should be chosen if the incumbent operates at a high cost, while a linear tariff should be chosen if the incumbent is rather efficient (and its production cost low).


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In a game where the regulator first designs a regulatory contract including either a two-part or a single part tariff, before the newcomer learns its costs and decides on entry in the second stage and, finally, the incumbent (behaving as a Stackelberg leader) and the entrant decide on their quantities, Axel Gautier demonstrates that full efficiency (the first best) can neither be reached under a single- nor under a two-part tariff. Neither tariff structure can guarantee entry of an efficient newcomer, due to a trade-off between the promotion of entry (and, thereby, competition) and efficient infrastructure financing in the presence of incomplete information about costs. While a single-part tariff distorts both the entry decision and the entrant’s supply decision in the direction of ‘too much’ entry and competition, the two-part access tariff only distorts the entry decision. Therefore, the regulator should only choose a single-part tariff if two-part tariffs do not induce enough entry. The fourth chapter, authored by Paul de Bijl and Martin Peitz, finally analyzes local loop unbundling (LLU) in telecommunications markets. In recent times, LLU has become more important due to the emergence and diffusion of ‘voice over Internet protocol’ (VoIP) telephony which has the potential to further intensify competition, especially in fixed-line telephony markets. Chapter 4 first describes the regulatory policies towards LLU in Europe and the US before Paul de Bijl and Martin Peitz analyze the effects that LLU regulation can have. In order to distinguish between saturated and unsaturated markets, the analysis is divided into two parts: first, saturated markets with full participation are analyzed before growing markets with lower penetration rates are examined. The focus of the analysis is on the socially optimal lease price for unbundled local loop access, which is fixed by a regulatory authority in a situation where a vertically integrated and a non-integrated firm compete in prices in a downstream market with horizontal product differentiation. With full participation, the non-integrated operator’s profits are neutral toward regulation, as any change in the access charge is passed through to consumers. However, the vertically integrated firm benefits from an increase, since its revenues are increasing with

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higher access charges. Market shares are not affected by the access price though. Analyzing investments into quality (which shifts the profit function), Paul de Bijl and Martin Peitz show that a higher access price leads to higher profits and, therefore, also to more investment and, thus, to higher quality. For their analysis of unsaturated markets in which total demand depends on prices, Paul de Bijl and Martin Peitz assume that only the non-integrated firm can offer additional services which are bundled to its core product. The market, therefore, consists of two segments, with the first being competitive and the second characterized by captive customers. As a consequence, market shares are no longer neutral to price changes and, accordingly, the non-integrated firm’s profits are no longer neutral with respect to the access price. As the authors show, for relatively low levels of the captured customers’ demand elasticity, a relatively small change in the access price may still result in a relatively large change in the retail price. In summary, the authors can demonstrate that, in their model, LLU cannot foster competition in saturated markets, as under full participation unbundling is neutral to both the entrant’s profits and the market shares. However, for markets with partial participation, LLU can foster competition so that the authors suggest to use local loop unbundling for market segments such as broadband Internet access where full market penetration has not been reached yet.

1.5.2 Two-way access pricing

Part II of the book is dedicated to two-way access problems and consists of two chapters. First, in the book’s fifth chapter Stefan Buehler and Armin Schmutzler deal with the relationship between collusive behavior and two-way access pricing, before Viktória Kocsis, in Chapter 6, focuses on access pricing under cost asymmetry in telecommunications which has become a major issue in mobile telecommunications markets. As described above, one major problem with two-way access is that network operators may eventually use access fees to establish


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collusion in retail markets. In this vein, Stefan Buehler and Armin Schmutzler analyze the impact of the access charge structure on variable retail prices and subscriber charges, and they address the question of whether or not collusive behavior in access markets is a likely outcome, using a reduced-form approach. As the authors show, a crucial condition for the use of access prices as an instrument to facilitate collusion is that retail prices are strategic complements and, furthermore, that an increase in the access charge shifts out the firm’s reaction curve. However, as Stefan Buehler and Armin Schmutzler also show, these assumptions do not necessarily hold for network competition with two-way access. Hence, it is at best unclear whether the collusion argument is unconditionally valid. More importantly, the collusion argument is usually supported by rather strong assumptions such as full coverage (full participation) and balanced calling patterns (firms’ symmetry), while unambiguous results cannot be obtained if these rather strong assumptions are violated. Extending the analysis to non-linear retail prices, it is shown, again, that the effects from an increase in access charges on (twopart) retail prices are not unambiguous. The same holds for model extensions regarding (1) heterogeneous consumers and (2) price differentiation with respect to internal and external calls. Overall, this contribution clarifies that rather strong assumptions are needed to support the collusion hypothesis. The results obtained by Stefan Buehler and Armin Schmutzler rather suggest that collusion on access charges with two-way network competition is less common. Given these findings and accounting for other factors such as information asymmetries (especially for the regulator) or Ramsey pricing, there is little theoretical support for the regulation of two-way access prices in order to prevent collusion. In Chapter 6 Viktória Kocsis addresses supply side asymmetries and their implications for two-way access fees. Her model is based on the assumptions that an entrant has a cost advantage, as later market entry permits the application of more efficient technologies, and that both network operators charge linear access fees for termination services on each other’s network.

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Starting with linear retail tariffs, retail prices are demonstrated to increase with the difference between termination rates. Accordingly, welfare decreases as the difference between termination rates increases. Hence, an asymmetric regulation of termination rates may be welfare enhancing if operators differ in their costs with inefficient operators being allowed to charge higher termination rates than efficient ones. Analyzing two-part retail tariffs, the standard profit neutrality result of access fees in a symmetric equilibrium no longer holds. Furthermore, a decrease in the more efficient firm’s termination rate increases the less efficient firm’s profits and increases consumer surplus. Again asymmetric regulation would maximize welfare.

1.5.3 Access pricing and multihoming

An important characteristic of network competition that has been neglected for a long time is the subscribers’ opportunity to join more than one network, that is, consumers are able to multihome. Of course, multihoming is not possible and, therefore, not reasonable to assume for every network industry, but it is important for specific sectors such as mobile telephony, payment systems, and various Internet services. Interestingly, it is a priori not clear whether multihoming fosters or softens competition between rival networks. Part III provides two chapters on this emerging issue. While Roger Alexander focuses, in Chapter 7, on telecommunications markets, Chapter 8, authored by Roberto Roson, deals with two-sided markets more generally. A completely new framework to analyze two-way network competition in telecommunications markets is developed by Roger Alexander in his chapter on interconnection competition with multiple network subscriptions. Using a cross-nested logit consumer choice model, he considers both interconnection competition between more than two networks and multiple network subscriptions. A key aspect of this analysis is the existence of call substitution. Consumers can choose between single-homing and multihoming


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based on their utility derived from calls made and received. Consumers’ utility can be observed utility, such as net utility from making and receiving calls, calling differences across network types, and calling utility differences. Furthermore, Roger Alexander assumes that there is also non-observable utility derived from attributes such as customer care and billing support, and various service offerings. In a model with full consumer participation, non-discriminatory single retail pricing, linear access pricing, linear marginal costs for call origination and termination, and fixed costs, the analysis first focuses on dual network subscription. As a result, even if networks are highly differentiated, retail prices may equal marginal cost. Since multihoming allows customers to substitute calls over one network by calls over another network, even small price changes force competitors to respond in own prices. Multihoming, therefore, fosters competition. Using a numerical simulation of a cross-nested logit model, the relationships between retail prices and access charges are analyzed more closely. As in the single-homing case, retail prices increase in access prices, so that there are still incentives to raise each other’s costs due to tacit collusion on access charges. Furthermore, even with a low calling demand elasticity (and high substitutability across networks), multihoming leads to more intense competition in retail markets, and this effect strengthens with the number of dual network subscribers. In fact, even with only a limited number of customers multihoming, competition may increase. From a public policy perspective, it is interesting to observe that the effects of dual network subscription (or, more exactly, the effects of multihoming) on retail market competition are more pronounced than regulating access charges down to marginal cost levels. The gains from fostering multihoming can therefore be much more substantial than those from regulating access charges. In Chapter 8, Roberto Roson addresses the issue of platform competition with endogenous multihoming, using a general two-sided market framework. Building on a model of the credit card industry both sides of the market (i.e., both merchants and consumers) are assumed to have the option to multihome. That is, merchants can

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subscribe to more than one credit card system which they accept, and consumers can carry more than one credit card. However, given that multihoming does not only provide benefits, but also carries costs, the question arises whether or to what extent the two market sides actually join more than one platform. To analyze optimal multihoming decisions, Roberto Roson uses a coordination game, assuming duopolistic competition between two differentiated platforms. If consumers transact once with every merchant and decide to join none, one, or both platforms while platforms use non-linear pricing where consumers and merchants pay both membership and transaction fees, profit maximizing platforms will choose optimal price vectors that are special versions of the Lerner rule. Comparison of a Nash pricing game and a cooperative cartel game with the help of numerical simulations shows that consumers are charged more for transactions than merchants. This is because consumers are able to choose the payment instrument when multihoming exists on both sides of the market. As expected, with price competition all prices decrease and welfare increases for consumers and merchants when compared to the cartel situation. Overall, the degree of multihoming is positively affected by low cost of and high benefits from joining a network. The degree of competition among platforms, in contrast, has an ambiguous effect on endogenous multihoming. In general, multihoming tends to be asymmetric with regard to merchants and customers. When one side is multihoming intensively, the other market side is not likely to multihome to a high degree.

1.6 CONTENTS OF THIS BOOK: PRACTICE 1.6.1 Applications to specific markets

Since access pricing is essential for various network industries with different characteristics, general results do not necessarily hold at large. There are some industry-specific peculiarities which have to


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be embraced when considering specific markets. Part IV, therefore, deals with specific market analyses. First, Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes (Chapter 9) consider natural gas markets, while Harley Thompson, Olivier Renard and Julian Wright (Chapter 10) as well as Ralf Dewenter and Justus Haucap (Chapter 11) study special issues connected with mobile telecommunications markets. Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes analyze pricing for one-way access to gas transportation networks. The aim of their chapter is to determine welfare maximizing tariffs when natural gas is exported to foreign countries, as it is the case in Norway and other gas-producing countries. A key assumption of the analysis is that a vertically integrated firm owning a transportation network competes with a non-integrated third party. While the integrated producer is partly state-owned, the third party is privately owned (partly by domestic owners and partly by foreign owners). Since the integrated firm is at least partly stateowned, gas revenues reduce the need to raise taxes. Finally, due to the existence of capacity constraints, both producers compete in quantities. If both producers serve two independent downstream gas markets and the integrated producer is partly state-owned while the non-integrated producer is partly foreign-owned, national welfare is maximized if the access price for the transportation network exceeds marginal transportation cost. If the third party is fully domestically owned, national welfare is maximized if access prices equal marginal cost. However, if the third party is completely under foreign ownership, the optimal access charge equals the monopoly rate. The reasoning behind these results is that access pricing is a feasible way to extract profits from foreign owners instead of raising taxes. Assuming that foreign and domestic consumers compete in the same downstream market, the above results change. If the nonintegrated firm is fully domestically owned and the integrated producer a private firm, access prices are optimally set according to the efficient component pricing rule. Again, in case of public ownership of the integrated network, the access price is higher and serves

28


as indirect taxation. However, the access price is still below the monopolistic access price. The subsequent analysis of the unbundling of transportation network and production, as prescribed by the EU Gas Market Directive, is based on the assumption that the gas transportation network is a monopolistic bottleneck which needs to be regulated. In this context, Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes consider two different regimes: first, a regulatory framework with differentiated tariffs for gas producers and secondly, a regulatory regime without price differentiation. As a result (under price differentiation) optimal access prices follow a modified Ramsey pricing rule taking into account public and foreign ownership. Without access price differentiation, in contrast, the access price set by the regulator is in between the Ramsey prices, and welfare decreases. In summary, a mark-up on marginal transportation costs may be superior to an access price set equal to marginal costs, as national taxation may be both distorting and incomplete. Increasing the access price allows to extract profits from foreign owners. A disintegration of upstream and downstream facilities can increase welfare if regulators can set differentiated access prices. In their chapter on mobile termination, Harley Thomspon, Olivier Renard and Julian Wright (Chapter 10) consider a typical mobile telecommunications market. This chapter’s objective is to analyze welfare effects from lowering fixed-to-mobile termination charges in markets with partial mobile penetration. For this purpose, an extension of Wright’s (1999) model is developed and the extended model is calibrated using data from the Colombian mobile telecommunications market. In contrast to most of the existing literature, the chapter provides an analysis for an arbitrary number of mobile operators which all directly compete with each other in prices, offering both horizontally and vertically differentiated products. Furthermore, a single nonintegrated fixed-line operator exists, and consumers place mobile-tomobile, fixed-to-mobile, and mobile-to-fixed calls. While the number of fixed-line customers is fixed, mobile markets are characterized by partial participation. The termination charge for mobile-to-mobile


29

calls is assumed to equal marginal cost by mobile operators, and the termination charge for mobile-to-fixed calls is set by a regulator at termination costs. While mobile operators are free to charge an arbitrary termination fee to fixed-line operators, retail prices for fixed-to-mobile calls (including origination costs and a mark-up) are regulated. Calibrating this model using data from the Colombian mobile telephony market Harley Thomspon, Olivier Renard and Julian Wright show that, starting from current Colombian charges, an increase in termination charges results in increasing profits, higher fixed-tomobile traffic, and higher penetration rates. Moreover, welfare is maximized by doubling termination charges. The reasoning behind these results is the low penetration rate in Colombia and the so-called waterbed effect. Higher termination charges induce lower mobile retail prices, which in turn increases penetration. Therefore, setting termination charges at marginal cost may be welfare reducing, especially with low penetration rates. In our own chapter on the incentives to license mobile virtual networks operators (MVNOs) we analyze whether or not mobile network operators (MNOs) are likely to open their networks for MVNOs voluntarily. Put differently, we analyze whether there is a need for regulation to facilitate entry of MVNOs at all and, if so, under what circumstances this regulation may be beneficial. As we use a rather broad definition of MVNOs, our analysis is not restricted to MVNOs, but can be expanded to service providers and enhanced service providers. In contrast to other parts of the literature, we do not restrict our analysis to either full or intermediate or thin MVNOs. Instead, we analyze MVNOs in a similar vein to the literature on divisionalization, that is, we examine MVNOs as mobile service providers that offer mobile services, but do not operate a separate physical mobile network. In our chapter we analyze MVNO entry under Cournot, Bertrand and Stackelberg competition. Assuming that MNOs are able to extract the entire profit from potential entrants (the MVNOs), we first demonstrate that under Cournot competition MNOs always have an incentive to license a positive number of MVNOs if the mobile

30


retail market is sufficiently large and the fixed costs establishing MVNO agreements is not prohibitively high. Moreover, the larger the retail market (and the lower the fixed cost) the more MVNOs will be licensed. Even though MNOs would be jointly better off if they would collectively deny access for MVNOs, each operator individually increases its profit by granting access, resulting in a prisoners’ dilemma. If operators compete over prices instead of quantities and offer differentiated products, results strongly depend on both the degree of product differentiation and market structure. A monopolistic MNO only has an incentive to grant access if the new services provided are only weak substitutes. In a duopoly, however, both MNOs are willing to enter into MVNO agreements already with a smaller degree of product differentiation. Finally, if more than two competing MNOs exist, there is always an incentive to provide MVNO network access, even for homogeneous products (i.e., perfect substitutes). Finally, if MNOs collectively act as Stackelberg leaders versus any MVNOs (which may well be a realistic assumption for most mobile telecommunications markets, given the sequential licensing procedures in many contries), we can establish that MNOs do not have any incentive to grant access if services are homogeneous. The reason is that the total profit from providing mobile retail services and from granting access decreases, as soon as the first MVNO enters. As MVNOs act as Stackelberg followers, their market share and profit is too small to compensate even one single firm for the profit lost due to intensified retail competition. However, if services are sufficiently differentiated (i.e., MVNOs offer new services) similar results as under Bertrand competition can be obtained. A higher degree of product differentiation leads to market entry even under Stackelberg competition. In summary, the question whether or not MNOs are likely to voluntarily grant MVNOs access to their networks strongly depends on factors such as market size, market structure, market conduct, fixed cost, product differentiation, and the share of profits an MNO is able to extract from an MVNO entrant.


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1.6.2 Policy

Part V consists of three chapters. First, Alexandre de Streel (Chapter 12) provides an analysis of the relationship between European competition policy and national sector-specific regulation. Subsequently, Pio Baake, Ulrich Kamecke and Christian Wey (Chapter 13) develop a regulatory framework to deal with new markets in Europe, focusing on access to broadband Internet services, and finally, Robert Crandall and Hal Singer (Chapter 14) analyze the potential for vertically integrated DSL providers foreclosing the market for Internet services and driving unaffiliated Internet service providers off the market. The aim of Alexandre de Streel’s chapter on antitrust and sectorspecific regulation of access in the European Union is threefold. First, the European Commission’s competition policy during 1995– 2005 regarding the abuse of a dominant position is reviewed, with a focus on electronic communications and services markets. Second, sector-specific regulation of market power based on the significant market power (SMP) concept is discussed. And thirdly, similarities and differences between European Union competition policy and national sector-specific regulation are examined. With respect to European Union competition policy it is useful to distinguish, again, between one-way and two-way access. With one-way access, both exploitative abuses and exclusionary abuses are important public policy concerns. While exploitative abuse refers to excessive pricing, exclusionary abuse aims at excluding rivals from the market. In case of two-way access, the main concern is excessive pricing either due to collusion or due to market power associated with ‘competitive’ bottlenecks and/or network effects. In addition, merger control is an important but often neglected area of public policy in electronic communications markets, including policies towards both joint ventures and (full) mergers. As Alexandre de Streel outlines a prerequisite for sector-specific regulation is the existence of SMP. Once an operator has been designated to have SMP, the operator can be obliged to grant access. This includes all types of essential facilities, for example, fixed-line and

32


wireless networks as well as physical and non-physical infrastructure. In these cases, different methods of access price regulation can be imposed. In his analysis of the relationship between competition policy and regulation, Alexandre de Streel argues that regulation can no longer be seen as independent from competition law, but as ‘a part of a broader set of tools based on competition analysis principles’. Therefore, de Streel stresses the importance of good regulatory design and of ‘getting the institutions’ right in designing a consistent regulatory framework, taking account of the interdependence between competition policy and regulation. A hotly debated policy issue is the adequate regulation of newly emerging markets. If specific investments are necessary to provide new services and if these investments carry risks, designing a framework that provides adequate investment incentives for dynamic competition to evolve is not trivial. As there is a risk that the regulation of new markets may prevent or at least reduce investment incentives, Pio Baake, Ulrich Kamecke and Christian Wey (Chapter 13) propose a dynamic regulatory approach for new markets, especially focusing on investment incentives. In their chapter, the authors first review the (Schumpeterian) concept of dynamic competition which emphasizes the role of innovations. According to the idea of ‘creative destruction’ monopoly phases of a market should be followed by phases of effective competition, as innovations emerge and competitors contest monopoly positions. Consequently, dynamic efficiency rather than static efficiency should be the focus of public policy interventions. More precisely, the role of temporary monopoly profits is stressed as they provide incentives for innovative activity. Pio Baake, Ulrich Kamecke and Christian Wey then discuss particular problems of dynamic competition in newly emerging markets, focusing on DSL broadband access. The authors develop a regulatory approach for new markets, concentrating on markets for telecommunications services, where the vertical industry structure tends to increase risks and uncertainties for innovators, rendering a standard cost-based regulation inappropriate.


33

The authors recommend to first leave new markets unregulated for a period of four years in order to protect investment and innovation incentives. After that period a modified SSNIP (small but significant and non-temporary increase in price) test is proposed to test for the existence of a separate new market. If a separate new market does exist, the authors suggest that regulatory authorities analyze whether there is a tendency towards competition. More exactly, it is recommended that, after six years, regulatory bodies should analyze whether or not there is competing infrastructure, after eight years, regulators should analyze whether or not competitors have gained significant market shares; and after ten years, it should be examined whether the market is characterized by non-temporary significant market power. If all of these tests fail, that is, if there is no competing infrastructure emerging and if existing competitors have not gained significant market shares or if there is a tendency towards significant market power, ex ante regulation is recommended. Finally, the authors recommend that after twelve years authorities return to the standard SMP test. It is argued that this framework protects investment incentives in an adequate manner, as innovators and competitors can be certain that profits will not be regulated away. The last chapter of our book focuses on the demand for broadband Internet, which has increased dramatically during the past few years, as broadband Internet increasingly replaces narrowband services. With a decreasing number of Internet service providers, access to upstream markets has come under closer scrutiny of regulatory authorities, as it appears to be essential for downstream market competition that the remaining non-integrated Internet service providers have access to broadband networks. Robert Crandall and Hal Singer now analyze the impacts that a price-squeeze by a vertically integrated DSL provider may have on the foreclosure of non-integrated Internet service provider. As Robert Crandall and Hal Singer demonstrate a profitable prizesqueeze strongly depends on factors such as the profitability of wholesale and retail markets, the possibility to attract customers from displaced Internet service providers, and the value of additional

34


services offered by DSL providers. Overall, a price-squeeze can only be a public policy concern if integrated providers have both market power in downstream markets as well as the incentive to foreclose the market for rivals. Furthermore, Robert Crandall and Hal Singer argue that raising rivals’ cost strategies could harm consumers only under conditions which are not satisfied for broadband Internet access markets, and similarly, that there is no evidence for cross-subsidies between the wholesale and the retail market that could lessen consumer surplus. Consequently, the case for a regulatory intervention is argued to be weak. Overall, the authors suggest that prize-squeezes are not a major concern for broadband Internet access. Competition is argued to be sufficiently intense to maximize consumer welfare, and lower wholesale rates for DSL services are not expected to affect competition in an adverse manner.

1.7 CONCLUSION

The chapters contained in this book summarize and extend the various developments on the subject of access pricing in both the academic literature and public policy. While many chapters use illustrations from some particular industry, the common theme is that firms need access to other firms’ networks or (essential) facilities in order to compete in upstream or downstream market. Therefore, regulation and competition do not need to contradict themselves. Quite on the contrary, some regulation may be necessary in order to facilitate competitive entry and competition to develop. While this is almost common sense among academic economists and policy makers alike, there is a vivid debate about what regulatory instruments are best suited to achieve productive, allocative and dynamic efficiency and where the limits of efficient regulatory intervention are. The following chapters will contribute to this debate and, hopefully, also stimulate further research in this important area.


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REFERENCES Anderson, S. and J.J. Gabszewicz (2005): ‘The media and advertising: A tale of two-sided markets’, CEPR Working Paper 5223, CEPR, London. Armstrong, M. (1998): ‘Network interconnection in telecommunications’, The Economic Journal 108: 545–564. Armstrong, M. (2002): ‘The theory of access pricing and interconnection’, in Cave, M.E., S.K. Majumdar and I. Vogelsang (eds), Handbook of Telecommunications Economics, Vol. 1, Elsevier, Amsterdam, 297–384. Armstrong, M., C. Doyle, and J. Vickers (1996): ‘The access pricing problem: A synthesis’, Journal of Industrial Economics 44: 131–150. Baumol, W.J. (1983): ‘Some subtle issues in railroad deregulation’, International Journal of Transport Economics 10: 341–355. Baumol, W.J., J.C. Panzar and R.D. Willig (1982): Contestable Markets and the Theory of Industry Structure, Harcourt Brace, New York. Baumol, W.J. and J.G. Sidak (1994a): Toward Competition in Local Telephony, MIT Press, Cambridge, MA. Baumol, W.J. and J.G. Sidak (1994b): ‘The pricing of inputs sold to competitors’, Yale Journal on Regulation 11: 171–202. Baxter, W.F. (1983): ‘Bank interchange of transactional paper: Legal and economic perspectives’, Journal of Law and Economics 26: 541–588. Belfin, R. and M. Lukanowicz (1999): Positionspapier der Telekom-Control zum Ansatz der Forward Looking Long Run Incremental Costs zur Berechnung von kostenorientierten Zusammenschaltungsentgelten, Vienna, January 1999. Buehler, S. (2005): ‘The promise and pitfalls of restructuring network industries’, German Economic Review 6: 205–228. Carter, M. and J. Wright (1999): ‘Interconnection in network industries’, Review of Industrial Organization 14: 1–25. Carter, M. and J. Wright (2003): ‘Asymmetric network interconnection’, Review of Industrial Organization 22: 27–46. Cave, M. and I. Vogelsang (2003): ‘How access pricing and entry interact’, Telecommunications Policy 27: 717–727. Chang, H., H. Koski and S.K. Majumdar (2003): ‘Regulation and investment behaviour in the telecommunications sector: Policies and patterns in the US and Europe’, Telecommunications Policy 23: 677–699. De Bijl, P. and M. Peitz (2002): Regulation and Entry into Telecommunications Markets, Cambridge University Press, Cambridge. Dewenter, R. (2004): Essays on interrelated media markets, Nomos Verlag, Baden-Baden. Dewenter, R. and J. Haucap (2004): ‘Die Liberalisierung der Telekommunikationsbranche in Deutschland: Bisherige Erfolge und weiterer Handlungsbedarf’, Zeitschrift für Wirtschaftspolitik 53: 374–393. ERG (2004): ERG Common Position on the Approach to Appropriate Remedies in the New Regulatory Framework, ERG, Brussels. Evans, D.S. and R. Schmalensee (2005): ‘The industrial organization of markets with two-sided platforms’, NBER Working Paper 11603, NBER, Washington, D.C.

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Gans, J. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gans, J. and S. King (2004): ‘Comparing alternative approaches to calculating long-run incremental costs’, Working paper, Melbourne Business School. Gasmi, F., D.M. Kennet and J.J. Laffont (2002): Cost Proxy Models and Telecommunications Policy: A New Empirical Approach, MIT Press, Cambridge, MA. Gruber, H. (2005): The Economics of Mobile Telecommunications, Cambridge University Press, Cambridge. Haucap, J. and J.S. Marcus (2005): ‘Why regulate? Lessons from New Zealand’, IEEE Communications Magazine 43 (11): 15–16. Hausman, J.A. (1999): ‘The effect of sunk costs in telecommunications regulation’, in Alleman, J. and E. Noam (eds), The New Investment Theory of Real Options and its Implication for Telecommunications Economics, Kluwer Academic Publishers, Boston, 191–204. Hausman, J.A. (2001): ‘Regulation by TSLRIC: Economic effects on investment and innovation’, in Sidak, J.G., C. Engel und G. Knieps (eds), Competition and Regulation in Telecommunications, Kluwer Academic Publishers, Boston, 51–68. Hoeffler, F. (2006): ‘Monopoly prices versus Ramsey-Boiteux prices: Are they ‘similar’, and: Does it matter?’, Journal of Industry, Competition, and Trade 6: 27–43. IRG (2000): Principles of Implementation and Best Practice Regarding FL-LRIC Cost Modelling, online at: www.bundesnetzagentur.de/media/archive/1399.pdf Katz, M. and C. Shapiro (1987): ‘R&D rivalry with licensing or imitation’, American Economic Review 77: 402–420. Knieps, G. (2003): ‘Sector-specific regulation of German telecommunications’, in Madden, G.G. (ed.), The International Handbook of Telecommunications Economics, Vol. 3: World Telecommunications Markets, Edward Elgar, Cheltenham, 383–399. Kruse, J. (2004): ‘Competition in mobile communications and the allocation of scarce resources: The case of UMTS’, in Buigues, P. and P. Rey (eds), Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, 185–212. Laffont, J.J. and J. Tirole (1994): ‘Access pricing and competition’, European Economic Review 38: 1673–1710. Laffont, J.J. and J. Tirole (1996): ‘Creating competition through interconnection: Theory and practice’, Journal of Regulatory Economics 10: 227–256. Laffont, J.J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Laffont, J.J., P. Rey and J. Tirole (1998a): ‘Network competition: I. Overview and nondiscriminatory pricing’, RAND Journal of Economics 29: 1–37. Laffont, J.J., P. Rey and J. Tirole (1998b): ‘Network competition: II. Price discrimination’, RAND Journal of Economics 29: 38–56. Lipsky, A.B. and G.J. Sidak (1999): ‘Essential facilities’, Stanford Law Review 51: 1187– 1248. McAndrews, J.J. (2003): ‘Automated teller machine network pricing: A review of the literature’, Review of Network Economics 2: 146–158. Noam, E. (2002): Interconnecting the Network of Networks, MIT Press, Cambridge, MA. OECD (2004): Access Pricing in Telecommunications, OECD, Paris.


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Peitz, M. (2003): ‘On access pricing: Theory and European practice’, Telecommunications Policy 27: 729–740. Peitz, M. (2005): ‘Asymmetric access price regulation in telecommunications’, European Economic Review 49: 341–358. Pitofsky, R., D. Patterson, and J. Hooks (2002): ‘The essential facilities doctrine under U.S. antitrust law’, Antitrust Law Journal 70: 443–462. Rey, P. and J. Tirole (2006): ‘A primer on foreclosure’, forthcoming in Armstrong, M. and R.H. Porter (eds), Handbook of Industrial Organization, Vol. 3, Elsevier, Amsterdam. Rochet, J.C. and J. Tirole (2006): ‘Two-sided markets: A progress report’, Mimeo, forthcoming in RAND Journal of Economics. Roeller, L.-H. and L. Waverman, (2001): ‘Telecommunications infrastructure and economic development: A simultaneous approach’, American Economic Review 91: 899–923. Roson, R. (2004): ‘Two-sided markets: A tentative survey’, Review of Network Economics 4: 142–160. Sappington, D. (2005): ‘On the design of input prices: Are TELRIC prices ever efficient?’, Working Paper, University of Florida. Valletti, T. (2003): ‘The theory of access pricing and its link with investment incentives’, Telecommunications Policy 27: 659–675. Vogelsang, I. (2003): ‘Price regulation of access to telecommunications networks’, Journal of Economic Literature 41: 830–862. Willig, R. (1979): ‘The theory of network access pricing’, in Trebing, H.M. (ed.), Issues in Public Utility Regulation, Michigan State University Public Utilities Papers, East Lansing, MI, 109–152. Wright, J. (1999): ‘International telecommunications, settlement rates, and the FCC’, Journal of Regulatory Economics 15: 267–291.


PART I

One-Way Access Pricing



CHAPTER 2

Access Pricing and Infrastructure Investment JOSHUA S. GANS University of Melbourne, Melbourne

Contents 2.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 MODEL OF INVESTMENT TIMING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Investment costs 2.2.2 Investment benefits 2.2.3 Socially optimal timing 2.3 NO ACCESS REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Motives for access 2.3.2 Motives for investment 2.3.3 Negotiations over access 2.3.4 Equilibrium investment timing 2.3.5 Summary 2.4 ACCESS PRICE REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 ‘Small’ seekers 2.4.2 Two ‘large’ firms 2.4.3 Summary 2.5 PRACTICAL ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Optimal usage charges 2.5.2 Access holidays 2.6 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42 43 44 44 45 46 46 47 49 50 52 52 53 54 58 58 58 60 62 63

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2.1 INTRODUCTION

Much of the literature on the regulation of access to natural monopoly infrastructure concerns the setting of simple linear prices. In this regard, issues involve the vertically integrated nature of some firms, multi-product issues, incentives for cost reduction and, in some cases, the recovery of fixed investment costs.1 Of course, in regulatory circles the main issue that arises concerns the impact of access regulation on investment incentives. Put simply, it is argued that, in many network and infrastructure industries, productivity comes from new investment and access regulation, to the extent that it reduces the returns on such investment, harms overall efficiency. Some recent papers have taken this notion very seriously. Noting that these issues are a staple on the literature on innovation incentives, in a series of papers, Gans and Williams (1999), Gans (2001) and Gans and King (2004a) have considered the impact of access regulation on the timing of infrastructure investment.2 They find that access pricing regulation can actually improve investment timing outcomes and that it is not simply the case that such regulation has a dampening effect. Given this, this chapter considers that set of models and nests them within a common treatment of investment incentives. In so doing, it generalizes some of their results; especially with regard to the treatment of asymmetries between firms. As such, the hope is that some of the insights gained from that literature can be made more accessible to regulators and practitioners interested in access regulation. The chapter proceeds as follows. First, in Section 2.2, I introduce a simple model of investment timing based on the innovation model of Katz and Shapiro (1987). In Section 2.3, I then consider what happens when there is no access regulation as a means 1

See Armstrong, et al. (1994) and Laffont and Tirole (1999) for excellent treatments. Valletti and Cambini (2005) also look at investment in an access context. They consider how interconnection regulation in telecommunications impacts upon investments in quality by both networks. In contrast, this chapter is concerned with one-way access pricing situations with a single bottleneck provider. 2

Chapter 2 – Access Pricing and Infrastructure Investment

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of providing a benchmark from which to assess access regulation. Section 2.4 then considers optimal access pricing. It does so by modeling that pricing as a two-part tariff. The principle insight is that the fixed charge in that tariff can be used to control investment timing. Moreover, the ultimate form of the charges paid resembles a fully distributed cost methodology. Section 2.5 then considers the role of usage charges in determining investment incentives and also whether access holidays – that is, fixed periods for which an investor is free of any regulation – can improve investment outcomes. A final section concludes and offers suggestions for future research.

2.2 MODEL OF INVESTMENT TIMING

In many situations, policy-makers consider infrastructure investment as a simple ‘invest or not’ decision. In reality, however, the relevant margin is not if an investment will take place but when. The concern of infrastructure providers is that unfavorable or uncertain regulation may unduly delay investment. This is, of course, also a concern for policy-makers. However, they must consider not only the timing of investment by providers but also the timing of investment by access seekers – who deliver further benefits to consumers. Given this, here I present a model of investment timing. To keep things simple, assume that there are only two firms using a particular infrastructure asset. I distinguish between two cases. The first is where both firms may conceivably become the provider; in this case, we have the potential for infrastructure investment competition. The second is where only one firm is a potential provider; that is, an infrastructure investment monopoly. This may arise because the other firm is wealth-constrained, capital markets are imperfect or there are other constraints on investment by them. In any case, our focus is on the timing of investment by the first firm to invest. As will be demonstrated, while it might be possible for the second firm to duplicate the facility, this will not occur in equilibrium. Thus, I term the first investor as the provider, P, and the other firm as the seeker, S.

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Joshua S. Gans

2.2.1 Investment costs

The model here is based on the dynamic R&D model of Katz and Shapiro (1987), who examine a model with discrete time periods of length but explore continuous-time solutions as → 0. In each period, firms make a decision as to invest or wait. It is assumed that there is no delay between a decision to invest and the appearance of the infrastructure. A firm investing at date T incurs a current cost of investment of FTerT , where the discount rate = e−r and FT is the present value, viewed from time 0 of investment expenses. It is assumed that these costs of infrastructure investment decline due to technical progress. In this case, dFTerT /dT < 0 and d2 FTerT /dT 2 > 0. Let F be the limit of current investment costs as T → and F0 be the cost of investment at time 0. A functional form that satisfies these properties is: FT = F0 e−T (where > r) with investment costs declining exponentially. It is also assumed that the asset does not deteriorate over time or with usage (avoiding the need to consider re-investment and maintenance incentives). Finally, as the focus is on the recovery of fixed investment costs, it is assumed that use of the infrastructure involves a zero marginal cost.

2.2.2 Investment benefits

The following notation describes firm flow profits from investment for firm i ∈ 1 2

• i : duopoly profits for firm i if no investment takes place; • m i : monopoly profits for firm i if it has exclusive access to infrastructure;3 • 0: profits if the rival firm has exclusive access; 3

That is, these are the profits a provider would earn if access to its infrastructure was neither mandated nor regulated.


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• ci : duopoly profits to firm i net of fixed access charges if both firms have access to infrastructure and the access seeker pays a unit price equal to a. The following natural relationship is assumed to hold between these payoffs: The flow of consumer surplus under each of these market structures is as follows: • s: consumer surplus if no investment takes place; • S m : consumer surplus if a firm has exclusive access to infrastructure (regardless of who that firm is); • S c a: consumer surplus if both firms have access to infrastructure the seeker pays a unit price equal to a. where it is assumed that S c a > S m ≥ s m S c a + c1 a + c2 a > S m + max m 1 2 ≥ s + 1 + 2 ≥ 0

Therefore, the infrastructure is socially valuable and achieves its optimum under a duopoly rather than monopoly. 2.2.3 Socially optimal timing

The social planner solves the following problem: T max T a

s + 1 + 2 e

−rt

dt + S c a + c1 a

0

T

+ c2 ae−rt dt − FT

(2.1)

or 1 1 max s + 1 + 2 1 − e−rT + S c a + c1 a T a r r c −rT + 2 ae − FT

(2.2)

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Joshua S. Gans

The solution to this, (T SO aSO ), satisfies the first-order conditions: S c − s + 2 c1 + c2 − 1 − 2 = −F T SO erT

S c aSO + c1 aSO + c2 aSO =0

a

SO

(2.3) (2.4)

Note that, given that marginal costs of infrastructure access are zero, it may be the case that aSO < 0. It is assumed that S c aSO − s + 2 c1 aSO + c2 aSO − 1 − 2 > rF so that T SO is finite. 2.3 NO ACCESS REGULATION

As a benchmark to evaluate the benefits of access regulation, it is useful to begin by considering the equilibrium outcomes in the absence of such regulation. As will be demonstrated below, no access regulation does not imply a lack of access. Nonetheless, there are several dimensions in which an unregulated outcome fails to achieve the social optimum.

2.3.1 Motives for access

Working backwards, it is useful to consider first the motivations of an unregulated infrastructure provider to provide access. Suppose that firm i invests and that j would like access. In the absence of a regulatory mandate, access will only be granted if there is a gain from trade in so doing. Note that this gain will be motivated by two concerns: a desire to preserve monopoly profits and a desire to avoid duplication of infrastructure investment costs. It is assumed that parties negotiate over a two-part tariff with fixed payment, pi , and unit price of ai . First note that in any agreement the parties will choose ai to maximize: ci ai + cj ai . Denote this as aˆ i and observe that it will typically be above 0. This will not be the case if 1 and 2 operate in distinct markets (or sell into a perfectly competitive market; for example, for export). In this case, aˆ i = 0. In


47

such situations and environments where firms do not compete too intensely, it is entirely possible that ci âi + cj âi ≥ m i . Second, c c m note that if i âi + j âi < i , it will be profit maximizing for i to deny j access. In this case, pi = 0. However, the possibility that j might duplicate the asset will constrain this outcome. Duplication gives the potential seeker a payoff of 1/r cj 0e−rT − FT if it invests at T . Let Tˆ be the choice of T that maximizes this function; and suppose that, as will generally be the case, this is later than the date at which a stand-alone monopolist would invest. This possibility imposes an upper bound on the access charge that the seeker will accept. That is, it must be the case that pi ≤ cj âi , but if cj 0 ≥ rF this upper bound is strengthened so that, if the infrastructure investˆ ment occurs at Tˆ cj âi − pe−rT ≥ cj 0e−rT − rFT.

2.3.2 Motives for investment

Turning now to the private incentives to investment, it is possible to distinguish between two different drivers of investment timing: willingness to pay and pre-emption. Willingness to pay is a consideration of the direct private benefit from investment in the absence of any strategic concern. For firm i, if investment takes place at time Ti and they expect to receive an access price of pi at time Tj , the present value of their payoff is

Wi Ti =

Ti 0

+

i e

Tj

−rt

dt +

Tj

Ti

−rt m dt i e

ci ai + pi e−rt dt − FTi

1 1 −rTi − e−rTj = i 1 − e−rTi + m i e r r 1 c + i ai + pi e−rTj − FTi r

(2.5)

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Let Tˆ i be the value of Ti that maximizes this function, taking into account the fact that Tj might be contingent in Ti . The first-order condition for this maximization problem is (assuming that ai is independent of (Ti Tj )): ˆ

−r Ti + m i − i e

−

dTi Tˆ i c −r Tˆ j i ai + pi − m i e dTi

1 dpi Tˆ i −rTj e = −F Tˆ i r dTi

(2.6)

Indeed, if Tj = Ti , as it may in equilibrium, then ci ai + pi − i is i’s willingness to pay for the infrastructure. The second motive driving infrastructure is strategic. There is a potential value to being the first firm to invest and pre-empting the other. By investing first at time Ti i receives Wi Ti above. However, if firm j invests first, firm i may have to pay j for access. It turns out that this is always preferred by i to duplicating the facility. Moreover, it is also the case that once the infrastructure is built, there is no benefit to i from delaying its access demand. Hence, if it expects an access price of pj aj , firm i’s payoff in the event that it does not invest first is 1 LTi = ci aj − pj e−rTi r

(2.7)

where Ti is now the time that access is sought. If both firms choose to invest at the same time, then it is assumed that the provider is decided randomly so that firm i earns 1/2Wi T + Li T. Following Katz and Shapiro (1987), ‘firm i is willing to preempt at T ’ if Wi T ≥ Li T. Moreover, the assumptions on F (.) guarantee that the current pre-emption value, Wi T − Li TerT , is increasing in T ; that is, if it is worth pre-empting at some time, it is worth pre-empting at any time after that. With this in mind, the earliest pre-emption date for firm i T˜ i , is defined by Wi T˜ i = Li T˜ i or, alternatively, pi + pj = rFT˜ i er T˜ i . Thus, pi + pj is firm i’s pre-emption motive for investment. That is, the motive for pre-emption is the difference


49

between being paid an access charge and having to pay an access charge. However, this implies that the pre-emption incentives are identical for both firms, that is, T˜ i = T˜ j .

2.3.3 Negotiations over access

To consider fully what happens in the absence of access regulation, I work backwards: that is, asking first, what will be the outcome of access negotiations? To make things simple, I will label the provider as P and the seeker as S and assume that P has invested at Tp and that access is being sought at time TS ≥ TP . When P invests, it has the option of refusing access to S. As ˆ noted earlier, this will not occur if cP â + cS â ≥ m P ; where a is the level of the unit access charge that maximizes joint profits. However, even if cP â + cS â < m P P and S may come to an access agreement that involves ai = and allows P to earn m P to prevent duplication of the infrastructure. This will occur whenever cS 0 ≥ F . In this case, if it chose to by-pass P, S would earn: 1 vSSA = max cS 0e−rT − FT T r Given this, if cS 0 ≥ rF P and S will begin negotiations at TS over the access charges (p a). This negotiation takes a noncooperative form similar to Rubinstein (1982). That is, negotiations can place over time where in each period, one party is chosen at random to be the offeror and they make a take-it-or-leave-it offer to the offeree. That party either accepts the offer (in which case the game ends) or rejects it (in which case agreement is delayed, P continues to earn profits and the process is repeated in the next period). It is assumed that S can only opt out of the bargaining process when responding to an offer by P.4 4

This assumption is made in order to eliminate supergame effects (i.e., brinkmanship) and simplify the bargaining equilibrium (see Gans and Williams, 1999).

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Joshua S. Gans

This results in the following outcome: Proposition 2.1 Suppose that cS 0 ≥ rF . The above bargaining game in continuous time has a unique subgame perfect equilibrium in which the initial offeror (whether S or P) makes an offer at TS that is accepted immediately if c • pT ˜ s = min 21 cS â − cP â + m a − rvSSA erTs and P S ˆ c c m a˜ = aˆ if P â + S â ≥ P ; • pT ˜ s = −rvSSA erTS and a˜ = if cP â + cS â < m P. This proposition is an extension of Proposition 2.1 of Gans and Williams (1999). Note that in any case, S chooses to set TS = TP . That is, it seeks access as soon as the investment is built. This is because the equilibrium access charge is either independent of time or decreases in the time that access is sought, so S would earn value sooner rather than later.

2.3.4 Equilibrium investment timing

In choosing when to invest, a firm will have regard to any expected access payments, as derived in Proposition 2.1. It is perhaps easiest to focus first on the case where an access seeker is ‘small’ in the sense that it would never build the infrastructure. In this case, it is clear that vSSA = 0 and pT ˜ S = 1/2 cS â − cP â + m P if c c m ˜ s = 0 otherwise. Nonetheless, if it P â + S â ≥ P and pT chooses to seek access, S does so as soon as the infrastructure is built, that is, TSN = TP . Anticipating this, P adjusts its timing accordingly. Therefore, P chooses TP according to 1 1 c N c m m TP = arg max T p max S â+ P â+ P P e−rTp −FTP r 2 (2.8) The profit maximizing choice of TP satisfies: 1 c N c m m S â + P â + P P = −F TPN erTP max 2


51

Notice that Tˆ PN ≤ TPSA P’s stand-alone investment timing where −rTP − FTp . TPSA = arg maxTP 1r m Pe What happens when both firms can potentially become infrastructure providers? In this situation, both pre-emption and willingness to pay motivations will play a role. Let TiN be i’s investment timing SA choice if it were the only provider (as in (2.8)) and vS i the profits i would make if it bypassed j’s facility as a seeker. The following proposition characterizes the equilibrium investment timing. Proposition 2.2 Suppose that TiN ≤ TjN , then (i) if T˜ i ≤ TjN there exists a unique equilibrium outcome with investment taking place at the earlier of TiN and T˜ i ; (ii) if T˜ i > TjN and Wi TiN ≤ Li TjN there exists another equilibrium with investment taking place by firm j at TjN . This proposition is a special case of Theorem 1 of Katz and Shapiro (1987, p. 410). Pre-emption incentives determine the equilibrium if the timing choice that equates the winning and losing payoffs for each firm is earlier than either firm’s willingness to pay timing choice. It is useful to note that equilibrium timing may be delayed, be the same or accelerated relative to whether both firms were coordinating their investment timing decisions. A coordinated decision would implement timing on the basis of max max ci âi + cj âi max m i i

i

SA was sufficiently high so that the Suppose that for both firms vS i access charges were constrained to prevent the seeker from bypassing the facility. In this case, the willingness to pay timing of the preferred provider would be the same as that which would arise from a coordinated decision. However, here equilibrium timing could be earlier than this date if the motive for pre-emption is strong and it could be later than this date if the motive for pre-emption is very weak.

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2.3.5 Summary

There are several social costs arising in the no regulation case. First, when one firm is ‘small’ the investment timing will be delayed relative to the social optimum. The provider will not appropriate sufficient firm rents – let alone consumer surplus – to make the socially optimal decision. In any case, access does not equate with the achievement of maximum social surplus (which would require access and a = aSO ). Second, when both firms are ‘large’ competition amongst them potentially accelerates investment timing. It is entirely possible that in this situation, infrastructure investment could be provided too soon at too high an investment cost or with an inefficient technology. 2.4 ACCESS PRICE REGULATION

Given that, in the absence of access regulation, investment timing is not socially optimal and downstream competition will not be as intense as it may be, it is worthwhile to consider regulated access prices that could improve outcomes. In this section, it is assumed that the timing of the model is as in Fig. 2.1. The regulator chooses a two-part tariff pricing formula, both parts of which may depend on the time the infrastructure is built and the time access is sought. Knowing this the provider chooses its investment time and the seeker chooses a time to seek access. As in previous sections, it is useful to distinguish between the ‘small’ and ‘large’ seeker cases. In this section, the focus is on the setting of the fixed charge. As such we suppose that aR = 0, as this simplifies notation; specifically, if the upstream marginal costs are assumed to be zero, it means that the flow of profits (net of access revenue or payments) for any firm is the same regardless of whether it is an access seeker or access provider.5 In the next section, this condition is relaxed. Given this,

5

This is, in fact, the usage charge that would lead to a competitively neutral outcome. See Gans and King (2004b).

Chapter 2 – Access Pricing and Infrastructure Investment 0

T

TS

Regulator chooses pricing formula, (a R(.), p R(.)).

Provider invests

Access seeker, seeks access at price (a R(.), p R(.))

53

Figure 2.1 Model timeline.

through this section, for notational convenience, I set ci ≡ ci 0 and S c ≡ S c 0.

2.4.1 ‘Small’ seekers

Suppose that only one firm is large, in the sense of being able to provide the infrastructure. The no-regulation choice of investment timing is delayed relative to the socially optimal timing because P does not appropriate the full social returns from its decision. Of course, setting pR = S c aSO + cS aSO and aR = aSO would implement the social optimum. However, this would require both a subsidy and merging both firms. This does not appear to be a practical outcome. Suppose instead that, similar to the reality of the practice of access pricing, we considered solutions based on cost-sharing rather than a reallocation of benefits. Suppose that the regulated access price is of the class pR = FTS erTS ; that is, a share of the replacement cost of the infrastructure valued at the time access is sought.6 Notice that, in this case, needs to be chosen to satisfy two desires. First, that access is sought immediately and, second, the provider has appropriate incentives.

6

Gans and Williams (1999) and Gans (2001) compare methodologies based on replacement cost and historic cost. Both are equivalent if access is sought immediately but if there is some delay, they demonstrate that replacement cost creates superior investment timing incentives.

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Note that, for a given , the preferred timing for P and S are given by the following first order conditions: cp 1−

= −F TerT

and

cS = −F TerT

(2.9)

These are in agreement if and only if c c cP = S ⇒ = c S c 1− P + S

(2.10)

Therefore, each firm pays a proportion of the assessed costs equal to its share of total profits. If these use-values are observable to the regulator ex post, they can be used as part of the regulated access price. Let T C be the coordinated investment timing decision that satisfies cP + cS = −F T C erT

C

(2.11)

It is easy to confirm that Tˆ PR = T C and that Tˆ SR = TPR so that the coordinated investment timing is in fact implemented for this costsharing regime.7

2.4.2 Two ‘large’ firms

If both firms can be potential providers, then the regulated access price plays a critical role in driving competition for provision. The 7

It turns out that, in this framework, the regulator’s problem is equivalent to finding the Lindahl equilibrium in this setting. The choice of investment timing is in fact a choice regarding the level of a public good. A Lindahl equilibrium occurs when for a given cost-sharing arrangement, both firms prefer the same level of the public good; in this case, investment timing. See Gans and Williams (1999) for an extensive discussion.


55

basic idea is that even if aRi < aˆ i then competition to receive and avoid paying fixed access charges drives investment timing. Indeed, for an appropriately specified formula, piR (.), it is possible that investment timing could be socially optimal despite the fact that competition is prevailing. The key to this is to recall that for a given set of expected access charges, p1 and p2 , for all i, pre-emption timing is determined by: p1 + p2 = rFT˜ i er T˜ i , so that T˜ 1 = T˜ 2 = T˜ . On the other hand, if access is sought immediately, willingness to pay timing is determined by 1 1 Tˆ i ≡ arg max i 1 − e−rTi + ci + pi Ti e−rTi − FTi Ti r r Given this, the subgame perfect equilibria in the investment timing game are summarized in the following proposition. Proposition 2.3 Suppose that p1 and p2 are such that access is always sought immediately. Suppose, also, that Tˆ 1 < Tˆ 2 . Then, equilibrium timing is Tˆ P = minTˆ 1 T˜ . If Tˆ 1 < Tˆ 2 < T˜ , there is a second equilibrium in which 2 invests at Tˆ 2 if and only if W1 Tˆ 1 ≤ L1 Tˆ 2 . Note that it is possible that either firm could be the provider. Indeed, even where it would never be profitable for a firm to invest as a stand-alone entity, that is, m i < F , it could be profitable for them to invest as a provider of access so long as c1 + c2 > rF . Investment timing is uniquely determined by the choice of regulatory pricing formula, piR . The regulatory issue then becomes whether piR can be chosen so that TPR = T SO and TSR = TPR ? The latter condition will be satisfied so long as the value of seeking access at TPR is decreasing in TS . The following proposition derives a pricing formula that implements the socially optimal investment timing and access seeking choices.

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Joshua S. Gans

Proposition 2.4 Assume that c1 + c2 − rFT SO erT ≥ SA rmax v1 + v2SA 0 . Then there exists some weights, i (with 1 + 2 = 1, so that the following regulated prices, SO

f TS FTS erTS r+ fTS

piR TS = i S c −s + c1 −1 + c2 −2 +i result in TPR = T SO and TSR = TPR .

This proposition is proved by Gans (2001). The condition in this proposition has an intuitive interpretation. It simply allows private investment and competition to be feasible. That is, industry profits when investment takes place at the socially optimal date are positive and exceed profits if each were to duplicate the facility. The above formula achieves a socially optimal result by doing two things. First, piR TS as stated in the proposition may be decreasing in TS . However, because of the convexity of current costs in T , the seeker prefers to receive its payoff, cj − piR TS , sooner rather than waiting for a lower access price. Thus, access is sought immediately, regardless of when the infrastructure is built. This also means that a seeker’s payoff is falling the later the infrastructure is provided. Given this, each firm expects that there will be no period of earning monopoly profits following the building of the infrastructure. Given this, the pricing formula controls investment timing by manipulating each firm’s pre-emption incentives. If infrastructure is provided too late, as piR TS is decreasing, this will reduce the access revenue a provider receives. Thus, a provider’s payoff is increasing in TP . Note, however, that this means that the relative payoff to being a provider over a seeker is rising over time. What this means is that any individual firm cannot afford to wait to become the provider lest they be pre-empted to any rents from this. Competition for those rents causes investment timing to be driven solely by pre-emption concerns. From this it is easy to see how the regulated pricing formula is derived. Recall that pre-emption timing implies that: p1R T˜ +


57

p2R T˜ = rFT˜ er T˜ . The formula itself is one for which T˜ = T SO . Recall that T SO is determined by the condition: S c − s + 2 c1 + c2 − 1 − 2 = −F T SO erT

SO

(2.12)

Therefore, the pricing formula is such that ˜ S F − s + 2 c1 + c2 − 1 − 2 + F T˜ er T ˜

= p1R T˜ + p2R T˜ − rFT˜ er T

(2.13)

˜ p1 T˜ + p2 T˜ = S c − s + c1 − 1 + c2 − 2 + F T˜ er T Marginal Social Cost of Delay

+

˜

rFT˜ er T Investment Cost Recovery

(2.14)

Note that, in equilibrium, the first term is zero by definition. As such, the regulated pricing outcome involves a fixed access charge that has each firm share the costs of infrastructure provision. Equation (2.14) gives the regulator considerable choice as to the formula determining the actual price that will be charged to a given firm. What criteria should be used to select among alternative weights in Proposition 2.4? It is easy to see that if fixed charges exceed a seeker’s ongoing profits, then the seeker will not participate in the regime. For both c1 ≥ p2R and c2 ≥ p1R to be satisfied, 1 =

c1 c1 + c2

and

2 =

c2 c1 + c2

(2.15)

As in the ‘small’ seeker case, each firm pays a share in proportion to the profits they make in duopoly. In equilibrium, each firm ends up sharing in investments costs according to the same weights, i . This method of cost allocation is similar to a fully distributed cost methodology and, in equilibrium, it is indistinguishable from it.

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However, the rationale behind the allocation is solely to encourage competition in infrastructure provision. That is, the shares are set so as to make it possible for both firms to be able to pay their respective charges whenever private investment is feasible, that is, SO c1 + c2 ≥ rFT SO erT implies ci ≥ pjR for all i, j.

2.4.3 Summary

Proposition 4 demonstrates that it is possible for a regulator to use fixed access charges to induce socially optimal investment timing even when there is immediate competition. It does this by manipulating the pre-emption incentives of potential providers. If there were no such strategic motive, then it would be impossible to use an investment race to achieve timing earlier than the date that would arise for an unregulated monopolist. Indeed, the regulation potentially prevents wasteful acceleration of infrastructure investment provision.

2.5 PRACTICAL ISSUES

There are some practical issues that are worth considering when analyzing the regulation of access and its impact on investment. These include how usage charges should be determined, whether access negotiations should be mandated and whether access holidays may be used. Each of these is discussed in turn.

2.5.1 Optimal usage charges

In the above discussion, the usage component, aR , of the regulated access pricing regime was taken as given. Nonetheless, all of the previous literature on access pricing has been concerned with the level of such charges. In particular, for the complete information environment of this chapter, it has been argued that the optimal


59

usage charge should be set below upstream marginal cost to counter the effects of imperfect competition downstream (Armstrong, et al., 1996). This issue is relevant here insofar as feasibility requirement is concerned – that it is privately profitable to invest at the socially optimal time rather than delay or duplicate the facility or not invest at all. If downstream profits are insufficient for this requirement to be met, then a usage charge below marginal cost designed to lower final good prices may be undesirable. It may be better to lift the usage charge and allow some downstream profits, so that the industry as a whole breaks even. To see this, suppose that both providers are symmetric.8 It is readily apparent that aR should be as close to aSO as possible. In particular, the lower bound is defined by: c1 aR + c2 aR − SO rFT SO erT = r max v1SA + v2SA 0 . For a given aR , the earliest preemption date, T˜ , is now defined by ˜ cP aR − cS aR + 2pR = rFT˜ er T

(2.16)

This means that the socially optimal fixed charge should equal

c R 1 c F TS R FTS erTS p TS = S − s + 2 S a − + r + 2 FTS (2.17) In equilibrium, fixed charges amount to a sharing of investment costs. In contrast, the usage charges are set to ensure participation. From an industry-wide perspective, this represents an implementation of Ramsey or average cost pricing downstream, where average costs 8

This is not an innocuous assumption. If they were different, then their regulated and usage charges would be different as they would face different marginal costs as a vertically integrated provider. This, in turn, would mean that fixed charges alone would not determine investment timing and the pre-emption incentives for each firm would be different. As such, this would become a considerably more complex problem and beyond the scope of this chapter to resolve quantitatively. Nonetheless, many of the qualitative issues would continue in this case.

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include the sunk costs of investment upstream. Nonetheless, this highlights the fact that because usage charges affect the distribution of industry rents as well as their overall size, it must be taken into account when setting regulated fixed charges.

2.5.2 Access holidays

The difficult feature of the above models of access pricing is that they require regulatory commitment of the pricing formula prior to any investment taking place. The complete information problem here masks the considerable uncertainty that surrounds most investment. In this situation, regulators may be unable to commit to a specific formula or even an appropriate methodology in advance that respects uncertainty that may occur. This is a problem because it may be the case that access is only sought when the investment is ‘successful’ and not otherwise. Given this, Gans and King (2004a) demonstrate that a ‘truncation problem’ may arise whereby investors are penalized when their investment is successful and not sufficiently rewarded for risk borne. A potential solution to this is to give access providers a period of time following investment that is free of required access regulation; that is, an ‘access holiday’, Of course, as noted earlier, a provider may choose to grant access anyway. However, the point is that access, if any, will not be subject to a regulatory constraint. In this respect, an access holiday is similar to a patent. The difference, however, is that when access regulation occurs, that regulation can be optimal. Gans and King (2004a) consider a situation where that access regulation is such that social surplus is maximized and the provider’s investment returns from that point on are normal. That is, the provider is regulated in a fashion that just allows them to recover depreciated investment costs. While Gans and King (2004a) model uncertainty explicitly, here I consider a version of their model where the investment outcomes are always certain. Suppose that an investment takes place at time, TP , and that both firms are symmetric. In addition, suppose that during


61

the holiday period the provider does not grant access. The provider is granted a holiday period of and so is only subject to access regulation at time TP + . That regulation is assumed to be optimal and, as such, pR aR is set so that

1 cP aR + pR e−rt dt = cP aR + pR e−rt = FTP erTP −t r (2.18)

Thus, a provider is able to earn monopoly profits for periods but must also bear the flow of capital costs, FTP erTP 1 − e−rt , over that period. Thus, the provider’s willingness to pay incentive is determined by 1 e−rTP 1 − e−rt − FT1 − e−rt WTP = m r P

(2.19)

It is natural to suppose that, given the symmetry between firms, an access seeker will not make positive profits upon the expiry of holidays. In this case, LTS = 0. Of course, this means that the seeker is indifferent between seeking access and not doing so. To avoid complications, I assume that it seeks access immediately. What this means is that, if one firm happened to be unable to provide the infrastructure, then timing would be determined according to the timing that maximizes (2.19). It is very easy to see here that the infrastructure is provided at the time an unregulated monopolist would choose to invest. Critically, it is independent of the length of the access holiday, . This means that, in theory, the regulator could set the holiday period arbitrarily small without deterring investment timing.9 However, as Gans and King (2004a) show this is not robust to realistic changes to the model, such as to allow demand changes over time, that make profit flows depend upon time, t. Instead they demonstrate that if profits are front loaded over time (relative to the access holiday length and the rate of technological progress 9

This result appears related to Sappington and Sibly (1988).

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on investment costs), then investment may occur earlier than the monopoly timing. On the other hand, if both firms can potentially provide the infrastructure, for a given access holiday, firms will compete away the rents associated with maxTP WTP and the investment will occur earlier than it would under an unregulated monopoly. However, the investment acceleration itself will depend upon the length of the holiday. Nonetheless, in principle, so long as private rents in the industry are sufficient to cover investment costs, there exists an access holiday that implements the socially optimal (or at least second best) investment timing. Thus, access holidays play a role similar to fixed access charges although they mean that there is a delay to the advent of downstream competition.10

2.6 CONCLUSION

To date, research into the impact of access regulation on investment incentives has considered some fairly specialized models in order to (1) demonstrate that such regulation can improve investment outcomes; (2) demonstrate that there need not be a tradeoff between encouraging competition and encouraging investment; and (3) suggest that existing approaches of allocating sunk investment costs based on a fully distributed cost methodology may have, at least to a point, some grounding in economic theory. That said, we are still far from a set of pricing rules that can be reliably used in practical situations. Nonetheless, what the models to date show is that there is a methodology and approach regulators could use to consider this and that putting in place clear guidelines and commitments is surely desirable. Infrastructure investments are substantial and involve considerable risk. Adding regulatory 10

Given a choice it is better to use access pricing than an access holiday. When social welfare is concave, then it is better to spread any deadweight losses over time than put them all earlier in a concentrated manner (see Gilbert and Shapiro, 1990).


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risk is certainly a recipe for poor outcomes. Only by providing clear commitments can regulatory access rules improve upon private arrangements.

REFERENCES Armstrong, M., S. Cowan, and J. Vickers (1994): Regulatory reform: Economic analysis and British experience, MIT Press, Cambridge, MA. Gans, J. S. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gans, J. S. and S. P. King (2004a): ‘Access holidays and the timing of infrastructure investment’, The Economic Record 80: 89–100. Gans, J. S. and S. P. King (2004b): ‘Competitive neutrality in access pricing’, Working Paper, Melbourne Business School. Gans, J. S. and P. L. Williams (1999): ‘Access regulation and the timing of infrastructure investment’, The Economic Record 79: 127–138. Gilbert, R. J. and C. Shapiro (1990): ‘Optimal patent length and breadth’, RAND Journal of Economics 21: 106–112. Katz, M. L. and C. Shapiro (1987): ‘R&D rivalry with licensing or imitation’, American Economic Review 77: 402–420. Laffont, J.-J. and J. Tirole (1999): Competition in telecommunications, MIT Press, Cambridge, MA. Rubinstein, A. (1982): ‘Perfect equilibrium in a bargaining model’, Econometrica 50(1): 97–110. Sappington, D. E. M. and D. S. Sibly (1988): ‘Regulating without cost information: The incremental surplus subsidy scheme’, International Economic Review 29: 297–306. Valletti, T. M. and C. Cambini (2005): ‘Investments and network competition’, RAND Journal of Economics 36: 446–467.



CHAPTER 3

Network Financing with Two-Part and Single Tariffs AXEL GAUTIER∗ CEREC, Facultés Universitaires Saint Louis and CORE, UCL.

Contents 3.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Model overview and results 3.1.2 Related literature 3.2 MODEL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 Demand, costs and information 3.2.2 Regulation 3.2.3 Timing of the events 3.2.4 Benchmark: the regulated monopoly case 3.3 OPTIMAL ACCESS CHARGES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 The entrant’s entry and supply decisions 3.3.2 Two-part tariff 3.3.3 Single tariff 3.4 COMPARISONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Market structure 3.4.2 Welfare 3.5 CONCLUDING REMARKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A3.1 Proof of proposition 3.2 A3.2 Proof of proposition 3.3 A3.3 Proof of proposition 3.4 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66 68 70 71 71 72 73 74 75 75 76 79 81 81 82 83 85 85 87 88 89

∗ The author gratefully acknowledges the financial support from the Brussels Capital Region.

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3.1 INTRODUCTION

The need of competition in network industries (telecommunications, energy, railways, etc.) is now commonly accepted. As the network usually constitutes a bottleneck input that cannot be economically duplicated,1 competition in these industries requires that the network’s owner grants third-party access (TPA) to competitors. With TPA, competitors can apply for network capacity (for which they pay an access charge) and supply services to final consumers. Third-party access is particularly important when there is no alternative technology to reach consumers, that is, if there is no possibility to bypass the network. Since the network is a bottleneck input, the network owner has incentives to use its dominant position to monopolize downstream segments of the market (foreclosure), so that introducing competition does not suppress the need for regulation. In particular, regulating both access conditions and the access price is of prime importance.2 For example, in the European Union, it is required that the network’s owner grants nondiscriminatory access to its infrastructure3 (regulation of access conditions) or, in the UK, BT’s interconnection services are subject to access charge controls by Ofcom, an independent regulator (regulation of access prices). Access charges play two roles in TPA: first, they affect entry and supply decisions of competitors and, thereby, market structure. 1

Bottleneck inputs like rail tracks and stations, the electricity transmission grid or the local loop in telecommunications are called essential inputs (or facilities). 2 Access control is one of the proposed remedies to prevent foreclosure. Other solutions like divesture or shared ownership can also be considered (see Rey and Tirole, 2005). 3 The European directive 96/92/EC concerning the internal market in electricity imposes a nondiscriminatory tariff for the use of the transmission and distribution system; in the rail directive 2002/14/EC, it is required that ‘the charging and capacity allocation schemes should permit equal and non-discriminatory access for all undertakings.’

Chapter 3 – Network Financing with Two-Part and Single Tariffs

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Second, access charges are used to recover the network’s costs.4 In more detail, the access charge should cover the cost of using the network and part of the network’s fixed cost which includes building, maintenance and development costs. Hence, there is a twodimensional conflict between granting generous access that reduces downstream profits and the possibility of recovering the infrastructure cost. This chapter compares two types of access pricing: A two-part tariff where the fixed part aims at covering (part of) the network’s fixed cost and the variable part covers the network’s usage costs, on the one hand, and a single tariff where both usage and (part of) the infrastructure costs are covered by a per-unit access charge on the other. In both cases, the regulator trades off the degree of competition induced by the access charges and the need to finance the network. This chapter compares market structure and social welfare under these two systems. The originality of this work is to consider an endogenous market structure: The entrant’s cost condition and, thereby, its entry and supply decisions are not known ex ante by the regulator. Hence, the regulatory environment has an impact on both the competitor’s entry and supply decision. Both the two-part and the single tariff are currently used for pricing access. In Germany, DB Netz, the owner of the rail-track network should cover operation, maintenance and depreciation costs by track charges. Between 1998 and 2001, DB Netz applied a two-part tariff consisting of a fixed charge and a variable part per train-km. The fixed part aimed at covering the infrastructure cost and the variable part was kept as close as possible to usage costs. Along with the twopart tariff, a single tariff with a higher per train-km fee was available for smaller carriers. Since 2001, DB Netz has been applying a single tariff with a constant price per train-km that depends on the train’s and the tracks’ characteristics (see Link, 2003; Pittman, 2004). In

4

In addition, the access charges should induce the efficient amount of bypass (Laffont and Tirole, 2000). An issue which is not considered here since we assume that the network is an essential input, that is, an input that cannot be duplicated.

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the UK, rail users paid a track access charge consisting of a fixed annual payment and a variable track usage charge that covers usage costs to the network owner (Network Rail). In the Netherlands, the train access charge only consists of a variable fee per train-km. 3.1.1 Model overview and results

There are two firms that can potentially supply downstream services to consumers, for example, passenger rail services or long distance calls. Both firms share the same network (rail tracks or a telecommunications network) to reach consumers. The network is owned by an incumbent operator that gives TPA to a unique potential entrant. The industry regulator contracts with the incumbent and specifies the supply of the incumbent, the public contribution to the network financing and the access condition for the third party. After observing the regulatory environment, the potential entrant decides whether or not it will be active in the downstream market. If it decides to enter, it pays the access price and supplies services without being further regulated. Hence, the incumbent is fully regulated while the entrant is not. Market liberalization does not always suppress the regulation of the incumbent operators. In the passenger rail market, for example, the regulators often impose a minimum level of services to incumbent operators while entrants are not subject to the same obligations. Similarly, universal service obligations are imposed on incumbent operators in telecommunications and postal markets. The model developed in this chapter sheds light on the impact of the regulatory environment on the entry and shows how regulation should be adapted to an endogenous market structure. The framework can be easily adapted to situations where the regulator controls only the access prices and the incumbent decides on its supply of downstream services.5 5

However, if the incumbent remains the first mover, it could use its first-mover advantage to prevent entry to the downstream market in this case. Hence, regulation of the incumbent’s supply can be imposed to prevent market foreclosure.


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Regulation takes place under asymmetric information. For the regulator, a major uncertainty at the time of opening the market to competition concerns the entrant’s technology. Is the competitor more cost-effective than the incumbent operator? Throughout this chapter, we assume that, the regulator does not know whether or not the entrant is more cost-effective than the incumbent operator. Consequently, entry does not always take place. The entry decision is endogenous and depends on the regulatory environment. The cost of the network is partially covered by a transfer of costly public funds from the regulator to the incumbent. The remaining part is covered by the incumbent’s profit (if any) and the entrant’s contribution via an access charge. This chapter compares two access pricing systems: A two-part tariff, where the entrant contributes to the network financing through a fixed access charge, and a single tariff, where the entrant contributes through a per-unit access charge. In both cases, these charges aim at covering the network’s fixed cost, that is, they come in addition to marginal cost of using the network. Both the two-part and the single tariffs affect the entry decision – a larger access price deters entry – but only the single tariff distorts the supply decision of an active entrant provided that the variable part of the two-part tariff is equal to the network’s usage cost. The chapter compares welfare and the resulting market structure under the two access pricing systems. In both cases, entry is not efficient6 as an efficient entrant may not enter the downstream market. This means that the regulator optimally reduces the entry in order to increase the entrant’s financial contribution to the network’s cost. There is, however, more entry if the regulator uses a single tariff, that is, a duopoly in the downstream market is more likely in this case. The optimal access charge system depends on the incumbent’s production cost. When the incumbent has a high cost, entry is beneficial both for consumers and the entrant. In this case, a two-part

6

The market structure is inefficient if there is a positive probability that a more (a less) cost effective producer stays out (enters) the market (see Armstrong, 2001).

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tariff is preferred because (i) it does not distort the entrant’s supply decision and (ii) the regulator can raise a large contribution from the entrant through a large lump sum fixed fee. If the incumbent has a low cost, using a fixed access charge is not optimal because it deters entry too much and the regulator prefers the single tariff. The cost of public funds used to partially finance the network also influences the choice between these two pricing schemes. 3.1.2 Related literature

In this chapter, the market structure is endogenous and it depends on the regulatory environment. The chapter is therefore closely connected to the literature on the design of a private industry (Auriol and Laffont, 1992; Dana and Spier, 1992; Jehiel and Moldovanu, 2004) that considers the market structure to be a part of the regulatory environment. In these papers, the regulator is assumed to fully control the market structure, while it is not the case with TPA. In Dana and Spier, for example, firms compete ex ante for the market and, in some circumstances, they also compete ex post in the market. With TPA, competition only takes place ex post in the market. The structure of the model presented here is similar to that in Caillaud (1990), where a regulated incumbent faces the threat of entry into the downstream market but in Caillaud’s model the entrants bypass the incumbent’s input and there is no access pricing problem. Gautier and Mitra (2003) analyze TPA without bypass but they focus only on two-part tariffs for access.7 Three different kinds of access pricing formulas are proposed in the literature: efficient (Ramsey) access prices (see Laffont and Tirole, 1994, 2000), the efficient component pricing rule (ECPR) (see Willig, 1979; Baumol, 1983; Armstrong, 2001), and cost-based access prices like TSLRIC (total service long run incremental cost). Under the Ramsey approach, the regulator fixes the access and the 7

Without restricting the variable part of the tariff to be equal to the network usage cost.


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retail prices in order to maximize the social welfare while guaranteeing that the network owner breaks even. It results that, for each retail product, the associated Lerner index is inversely related to the superelasticity of the product. This approach usually takes the market structure as given, that is, it does not take into account the impact of access prices on competitors’ entry decisions. Our derivation of the optimal access charge is similar to this efficient access pricing approach, except that it does not consider the market structure as given. Moreover, we consider quantity rather than price competition in the downstream market. As an alternative to Ramsey pricing, the ECPR prescribes that the access price should be equal to the incumbent’s opportunity cost for the retail services. With this type of access pricing, (a) potential entrants can only profitably enter the market if they are more cost-efficient and (b) entry is neutral with respect to the incumbent’s profit. In this approach, entry is endogenous and the market is always served by the most efficient firm. Under some conditions, the ECPR is equivalent to Ramsey pricing (see Laffont and Tirole, 1994, 2000; Armstrong et al., 1996).8 In the model presented in this chapter, the regulator optimally departs from efficient entry. Finally, Gans (2001) studies the relationship between the access pricing and the incentive to invest into infrastructure in a dynamic context. This chapter considers the link between access prices and network financing in a static context.

3.2 MODEL 3.2.1 Demand, costs and information

Two firms, a regulated incumbent (I) and a potential entrant (E) are possibly active in the downstream market. The downstream demand 8

The optimal access charge is not equivalent to the ECPR if the entrant has market power, which is the case in this chapter.

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is given by PQ = a−bQ with a > 0, b > 0, where Q is the quantity demanded and PQ the market clearing price corresponding to Q. The firms share the incumbent’s network to supply downstream services to consumers. The network’s building (or maintenance) cost is C. Using the network involves a constant unit cost denoted . In addition, the firms produce the service at a constant marginal cost. We denote the incumbent’s and the entrant’s marginal cost by and , respectively. The regulator knows the incumbent’s cost parameters C, and . For example, the regulator could have learned the incumbent’s costs from past regulatory experiences.9 We restrict the parameter sets to C > 0, ≥ 0 and ∈ , with 0 < < < a. We call = − . At the time the regulator specifies the access conditions, it does not know entrant’s cost . This assumption captures the fact that when the regulator allows TPA to the network, it ignores whether or not potential entrants are more cost-effective than the incumbent. It is, however, common knowledge that follows a uniform distribution g over the same interval , that is, g = 1/.

3.2.2 Regulation

The regulator maximizes consumer surplus net of the transfer to the incumbent. Transfers are costly; this is captured by introducing a shadow cost of public funds ≥ 1. The regulator’s objective Q is to maximize WQ t = SQ − PQQ − t, where SQ = 0 Pxdx and t is the amount of transfer paid by the regulator to the incumbent.10 In this context, transfer t is meant to finance the infrastructure. The regulatory contract should guarantee to the incumbent at 9

Dana and Spier (1993) and Jehiel and Moldovanu (2004) have a similar hypothesis. 10 We consider a pro-consumer regulator that does not include the firms’ profits in the welfare function. Including the profits in the welfare is a source of nonconcavity in the regulatory problem (see Gautier and Mitra, 2003).


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least a zero profit (participation constraint). With the linear demand specification, we have: WQ t = b Q2 /2 − t. The regulator contracts only with the incumbent. Depending on the known cost , the regulatory contract, denoted M, specifies three variables: (1) the supply of the incumbent qi , (2) the transfer to the incumbent t, and (3) the access conditions to the network. There are two possible access charge systems: a two-part tariff in which entrant pays a fixed fee A and a per unit fee equal to the marginal cost of using the network , or a single tariff where the entrant pays + for each unit supplied in the downstream market. The per-unit fee can be decomposed in two terms: a payment for covering the costs of using the network and a payment for covering the infrastructure cost. Without loss of generality, we now set the network usage cost to zero: = 0. We assume that the access charges are independent of the entrant’s technology. This assumption is in line with the European practices that impose a non discriminatory access to third parties. With nondiscriminatory access, two types of entrant with cost and face the same entry conditions. Firms compete in quantities. The entrant’s quantity decision is taken after observing the quantity supplied by the incumbent (which is specified in M). Hence, the entrant is a Stackelberg follower in the quantity game.

3.2.3 Timing of the events

(1) The regulator observes the cost conditions of the incumbent and chooses between the single and the two-part tariff. (2) The regulator designs the regulatory contract. (3) The entrant learns its cost and observes the regulatory contract. (4) The entrant decides on entry. (5) The regulated incumbent produces the quantity specified in the regulatory contract, the entrant, if active, decides on quantity. The price is set to clear the market.

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3.2.4 Benchmark: the regulated monopoly case

Suppose that the incumbent firm does not face the threat of entry, that is, the incumbent is a monopolist. The regulatory mechanism specifies for each known ∈ a quantity transfer pair qi t chosen to maximize the welfare and that guarantees to the incumbent at least a zero profit. That is, the regulator solves: max Wqi t = b

qi t

qi 2 − t 2

subject to Pqi − qi − C + t ≥ 0 In this problem, the participation constraint is binding. Integrating the constraint in the objective function, the regulator solves: max b qi

qi 2 + Pqi − qi − C 2

The solution to this problem is: Proposition 3.1 For any known ∈ , the optimal quantity transfer pair for a monopolist is: a− , 2 − 1 b −1 a − qi . (ii) t = C − 2 − 1 (i) qi =

Proof

Take the first-order condition of the above problem.

The optimal contract that the regulator applies to a monopolist is such that (i) when there is no cost of public funds ( = 1), the market clearing price is equal to the firm’s marginal cost and the


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network cost is fully financed by public funds: t = C. (ii) When increases, the regulator raises the market price above the marginal cost and consequently reduces its transfer (t < C).

3.3 OPTIMAL ACCESS CHARGES 3.3.1 The entrant’s entry and supply decisions

In the presence of an entry possibility, the regulatory mechanism f specifies a triple: M f = qi Af tf in the two-part tariff case or M v = qiv v tv in the single tariff case for any given and commonly known marginal cost ∈ of the incumbent. The entry decision is taken after the regulator has designed the regulatory mechanism. Therefore, even if the entrant is not regulated, the regulatory mechanism affects the entry decision and the quantity supplied by the entrant. With a two-part tariff, the profit of an entrant with cost is either f

e qe M f = Pqi + qe − qe − Af if it enters the market and supplies the quantity qe , or zero if it does not enter the market. Assuming entry takes place, the entrant supplies the quantity qef ∗ M f = maxqe e qe M f . The solution to this problem is f

qef ∗ M f

a − bqi − = 2b

(3.1)

Then, entry takes place if e qef ∗ M f M f is greater than zero, that is, if f ≤ kf = Pqi − 2 bAf (3.2) kf − / is the probability of entry associated with the regulatory mechanism M f .

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Similarly, with the single tariff, the profit of the entrant is either e qe M v = Pqiv + qe − − v qe if it enters the market with quantity qe > 0, or zero otherwise. Assuming entry takes place, the entrant supplies the quantity qev∗ M v that maximizes its profit: qev∗ M v =

a − bqi − − v 2b

(3.3)

Entry takes place if e qev∗ M v M v ≥ 0, that is, if ≤ kv = Pqiv − v

(3.4)

kv − / is the probability of entry associated with the regulatory mechanism M v .

3.3.2 Two-part tariff

With the two-part tariff, the expected surplus is, for any known ∈ , ˆ f = W

1 =k qi + qef ∗ M f 2 b d = 2 f q 2 1 = b i d − tf + f =k 2 f

f

The first term is the expected consumer surplus when entry takes place, the second term is the expected consumer surplus when entry does not occur and the last, the transfer to the firm. The regulator ˆ f and selects the regulatory mechanism M f that maximizes W


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that guarantees to the incumbent at least a zero profit. Defining Pˆ f as the expected market clearing price 1 =k f P = Pqi + qef ∗ M f d = 1 = f + Pqi d =kf f

ˆf

the incumbent’s participation constraint is f Pˆ f − qi +

1 =k =

f

Af d + tf − C ≥ 0

The solution to the above problem is given in the following proposition: Proposition 3.2 M f is:

For any known ∈ , the optimal mechanism

ˆ where ˆ = 1 + 2 + − 1a /3 , (i) For ∈ , a− , 2 − 1 b f Pqi − 2 (b) Af ≥ , 4b −1 f a − qi (c) tf = C − 2 − 1 f

(a) qi =

ˆ , (ii) For ∈ a − H f , 2 − 1 b with H f ≥ in the relevant range and H f increasing and convex in , f

(a) qi =

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(b) Af =

4Pqi + − 1a − 2 , b1 + 6 2

ˆ i − qi − (c) tf = C − Pq f

Proof See Appendix A3.1.

f

kf − f A .

Increasing the access charge Af has the following impacts on welfare: first, it decreases the probability of entry and the market is therefore less competitive. As consequences, consumer surplus decreases and the expected market price Pˆ f increases, implying an increase in the incumbent’s operational profit and an associated reduction in the transfer tf . Second, the increase in the access charge increases the expected contribution of the entrant to the infrastructure financing (kf − / Af ) as long as Af does not f exceed Pqi − 2 /9b. Hence, increasing the access charge up to that point further contributes to reducing the transfer. However, the possibility of reducing the transfer by increasing the access price is limited by the fact that, at a point, further increase in Af either reduces the incumbent’s profit or deters all types of competitor to enter the market. Similarly, a decrease in the incumbent’s supply decreases consumer surplus but increases the incumbent’s profit and consequently reduces tf . The regulator then faces the following tradeoff: increasing Af f (or decreasing qi ) has a negative impact on consumer surplus but a positive impact on the incumbent’s profit, at least as long as Af is not too large. Consequently, less public funds should be invested to cover the infrastructure cost. Then, there is a clear tradeoff for the regulator between the benefit of more competition in the market (higher supply) and the cost (more public funds). When the regulator faces a relatively efficient incumbent firm, the potential benefit of entry on consumer surplus is limited because the incumbent is efficient and regulated. Moreover, the potential contribution of the entrant to the infrastructure financing is limited ˆ entry too. For these reasons, when the incumbent’s cost lies in ,


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decreases the welfare and the regulator deters the entry of all types of competitor by setting a large fixed access charge. The reason is that, in terms of consumer surplus, the benefit of allowing for entry does not compensate the cost in terms of more public funds invested to cover the increase in the incumbent’s losses. Then, in this case, the solution applied is identical to the regulated monopoly case. When the incumbent is relatively less efficient, both the benefits of entry for consumers and infrastructure financing increase, and the ˆ . However, entry regulator allows entry and kf > for ∈ is not efficient (see Proposition 3.4). Entry is limited to increase the financial contribution of the types of entrant active in the downstream market. There is a tradeoff between financing infrastructure through a larger fixed tariff and the competition induced in the downstream market. When there is a positive probability of entry, the incumbent supplies less than in the regulated monopoly case. When increases, the regulator partially replaces the incumbent’s production by the production of a more cost-effective entrant. This substitution has a positive impact on consumer surplus and on the entrant’s profit. The regulator captures part of this profit increase by setting a larger access charge Af . Finally, when public funds become more costly ( increases), the regulator increases the parameter space for which entry never occurs (ˆ increases). The regulator prefers to finance the network through higher prices and a lower transfer than through a larger contribution of the entrant. To limit the transfer of public funds, the regulator raises the price by limiting entry.

3.3.3 Single tariff

With a single tariff, the regulator maximizes the expected surplus ˆ v = W

1 =k qiv + qev∗ M v 2 b d = 2 1 = qiv 2 + d − tv b v =k 2 v

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subject to the incumbent’s participation constraint: Pˆ v −qiv +

1 =k v

qev∗ M v d+tv −C ≥ 0 = v

where 1 =k Pqiv + qev∗ M v d = 1 = + Pqiv d =kv v

Pˆ v =

Proposition 3.3 M v is:

For any known ∈ , the optimal mechanism v

a−H , (i) qiv = 2 −1 b with H v > for all ∈ and H v increasing and convex in .

(ii) v =

a−2 −1+bqiv 2 −3 6 −1

>0 kv v −1 (iii) tv = C − 2 −1 a − qiv − 1

qev∗ M v d.

Proof See Appendix A3.2.

With a single tariff, the expected market clearing price is identical to the regulated monopoly case: Pˆ v = − 1a + /2 − 1. This means the following: first, that the transfer to the network owner is smaller than in the regulated monopoly case. The transfer is reduced by 1 k v∗ v qe M d

v

v

Second, if in average consumers pay the same price than under the regulated monopoly regime, consumer surplus is higher.


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Entry takes place whenever the price without entry is higher than the entrant’s marginal cost plus the per-unit access charge. At the solution, the cost of increasing the access price (lower production by the active types of entrants and lower entry) equals its benefit (an increase in the entrant’s contribution to network financing and thereby a lower transfer).

3.4 COMPARISONS 3.4.1 Market structure

In this model, the entrant is active in the downstream market only if its marginal cost is below k. This threshold value depends on the regulatory environment. Figure 10.1 represents the market structure for all possible realizations of ∈ 2 . In region (I), the entrant is less cost-effective than the incumbent and remains out of the market. In region (II), entry does not take place even though the entrant is more cost effective. In region (III), entry occurs only if the regulator uses a single tariff. Finally, in region (IV), the entrant is active in the downstream market for both types of tariff.

φ=θ k υ(θ)

k f(θ)

I

lI

III

IV θ

θ

θˆ

θ

θ

Figure 3.1 The market structure with fixed and per-unit access charge.

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Two observations should be made. First, entry is not efficient in the sense that a more cost effective entrant is not necessarily active in the downstream market. For efficient entry, the access charge should have been such that k = . This could be achieved with a fixed access charge Af = Pqi − 2 /4b or a per-unit charge

v = Pqi − .11 The regulator (optimally) limits the entry of firms with a little cost advantage over the incumbent in order to increase the financial contribution of entering firm. Second, there is a higher probability of entry when the regulator uses a single tariff compared to the two-part tariff. With a two-part tariff, the entrant manages to cover the fixed part of the tariff only if it has a large cost advantage over the incumbent, while there is no problem of this kind with the single tariff. Hence, the single tariff generates more entry. These two observations are summarized in the next proposition. Proposition 3.4 kf = kv = , kf < kv < for all ∈ and kf < kv = . Proof

See Appendix A3.3.

3.4.2 Welfare

Before turning to the welfare comparisons, it is important to remember that if the regulator knows the entrant’s cost, it would always prefer the two-part tariff because, first, this instrument is nondistortionary and, second, it can tax all the entrant’s profit through the fixed part of the tariff. This is no longer true when the regulator is unaware of the entrant’s cost and, depending on the entrant’s marginal cost and the cost of transfers , the optimal pricing system will be either the two-part or the single tariff. We can establish that: 11

This last expression is the efficient component pricing rule (see Armstrong, 2001).


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Proposition 3.5 There exists ∗ such that (i) ˆ ≤ ∗ and (ii) the regulator prefers the single tariff for all ∈ ∗ . ˆ f and W ˆ v are both continuous Proof The welfare functions W ˆ the solution with the twoand decreasing in . Since for ∈ , part tariff is identical to the regulated monopoly case, we have ˆ f and the single tariff dominates. Define ∗ as the ˆ v ≥ W W ˆ f , by continuity of the welfare function, ˆ v = W solution of W ∗ ˆ ≥ . ˆ there is no entry if the regulator uses the two-part When ≤ , tariff. This, however, does not mean that entry is not profitable. In particular, if the regulator uses the single tariff, there is a positive probability of entry and welfare is higher. For larger values of , there is a positive probability of entry with both tariffs. We have established that up to ∗ , the single tariff is the preferred access pricing. Though we cannot prove it formally, numerical simulations show that (1) for ∈ ∗ , the two-part tariff leads to higher welfare and (2) that the cutoff point ∗ increases with the cost of public funds . For example, with the following parameters: PQ = 10 − Q, = ˆ ∗ are 1 1 when = 1, 1, = 6 and C = 2, the values of ˆ ∗ = 15 21 when = ˆ ∗ = 127 16 when = 11, ∗ ˆ = 169 252 when = 13. Hence, the parame12, and ˆ where there is entry with the two-part tariff, and ter spaces ∗ where it dominates the single tariff decreases with the cost of public funds.

3.5 CONCLUDING REMARKS

In this chapter we have shown that, depending on the incumbent’s technology and on the cost of transfer, it is optimal to use either a single tariff or a two-part tariff. The reason is that when the market structure is endogenous, both types of tariff are distortionary. The two-part tariff distorts the entry decision, while the single tariff distorts both the entry and the supply decisions of the entrant. Quantity

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distortions induced by the single tariff reduce the welfare and, hence, the regulator prefers this type of pricing only when the two-part tariff induces too little entry. When the probability of entry into the downstream market is large enough, that is, the entrant is able to recover the entry fee with its downstream profit, the regulator prefers to use an instrument that does not distort the entrant’s supply decision.12 This analysis departs from Armstrong (2001), where the access price is set to induce an efficient entry decision, and from the literature on access pricing (see, e.g., Laffont and Tirole, 1994), where the market structure is considered as given. Our analysis considers an endogenous market structure where the entry decision depends on the regulated access fee. In this context, the optimal access prices reflect the tradeoff between promoting entry and financing the infrastructure. The resulting market structure is not efficient since it could leave a producer which is more efficient than the regulated incumbent out of the market. There is another type of inefficient market structure when the regulator allows the entry of a less efficient competitor (k > ). This second kind of inefficiency could arise when the regulator does not know the incumbent’s cost parameter . In this case, the mechanism is the same modulo the fact that, from the regulator’s point of view, the cost of the incumbent is not its marginal cost but a virtual marginal cost z,13 that is the marginal cost of producing plus the marginal cost of fulfilling the incumbent’s incentive constraint. Since the virtual marginal cost is above the marginal cost, there is more entry when the regulator ignores the incumbent’s marginal cost (it simply comes from Proposition 3.4) and there could be entry of a less efficient competitor (typically it will be the case with the single access charge for high values of ).

12

More intense competition on the downstream market would limit the market power of the entrants and could be an instrument to limit the distortions induced by the single tariff. 13 If the regulator knows that is distributed according to a continuous density function f, the virtual marginal cost is z = + L, where L is the hazard function associated with the distribution f.


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However, integrating this second source of asymmetric information in the model creates nonconcavities in the problem and the solution involves a certain amount of bunching. These nonconcavities are inherent to the problems of regulation with endogenous market structure (see Caillaud, 1990; Gautier and Mitra, 2003). To keep the problem tractable, we assumed that the cost parameters of the historical operator are common knowledge. The analysis so far neglected an important issue: the incentives of the network owner for developing or expanding its infrastructure and competitors’ incentives to invest into their own network. The different access pricing formulas and the different resulting market structures generate different incentives to invest in network capacity (see Gans, 2001). Integrating this dimension into the model is an important issue for future research.

APPENDIX A3.1 Proof of proposition 3.2

Like in the monopoly case, we can integrate the binding participation constraint of the incumbent into the regulator’s objective function. The regulator’s problem is then:14

f

max b

qif Af

where qef ∗ 14

qi 2 2

+

=kf =

f

b

f∗

f∗

2qi +qe qe 2

d

f f f + Pˆ f − qi + k − A − C is given by (3.1)

When the regulator allows for entry, the probability of entry depends on two variables of the regulatory mechanism: qif and Af . As a consequence, the expected welfare is no longer quadratic as in the benchmark case but it becomes cubic. This is a potential source of nonconcavity in the problem.

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Taking the first-order condition with respect to Af , we have f ˆ Af b1 + 6 − 2 bAf a − − bqi W = = 0 Af 2 bAf (3.5) hence, f

4Pqi + − 1a − 2 A = b1 + 6 2 f

(3.6)

f

Taking the first-order condition with respect to qi , incorpof rating the value of Af given by (3.6), and solving for qi we have f

qi =

a − H f 2 − 1 b

where 2 − 1 c1 + c2 h a3 + 6 1 + 12 − 41 + 6 2 + 1 + 6 7 + 12

c1 = 27b4 2 − 1 (3.7) H f = a −

c2 =

21 + 6 27b4 2 − 1

(3.8)

h = 9a2 − 12 + 21 + 6 − 3 + 3 2 − 6a − 16 − 1 − 3 − 2 − 22 − 10 − 72 2 − 54 1 + 2

(3.9)


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We observe that h/ < 0 and h > 0 for all ∈ . Hence, H f is an increasing and convex function of . The solution is f found by replacing the optimal value of qi in (3.6). The solution is valid if kf ≥ . Taking the optimal values of f f A and qi , this condition is satisfied if 1 + 2 + − 1a ≥ ˆ = 3

(3.10)

ˆ ˆ is strictly greater than if > 1. Hence, for > 1 and ∈ , f the above solution is not valid since the associated value of k is ˆ smaller than the lowest possible entrant’s cost = . For ∈ , f the regulator maximizes the expected welfare taking k = . This corresponds to an access charge given by f

Af =

Pqi − 2 4b

(3.11)

f

Without entry, the regulator selects quantity qi and transfer tf that corresponds to the regulated monopoly case. The second-order conditions of the above problem guarantee that the solution described is indeed a maximum.

A3.2 Proof of proposition 3.3

As in Proposition 3.2, we integrate the transfer tv given by the bidding participation constraint in the objective function, which is cubic in both qiv and v . The first-order condition with respect to v gives two solutions for v : (1) v = Pqiv − , which implies a total entry ban, and (2)

v =

a − 2 − 1 + bqiv 2 − 3 6 − 1

(3.12)

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Axel Gautier

Taking the first-order condition with respect to qiv , incorporating the value of v given by (3.12), and solving for qiv gives the following solution: 2 − 1 a − H v H v = a − c1 + c2 h 2 − 1 1 a 2 − 1 − 6 − 12 + 1 − 4 20 2 c1 = 8b2 − 12 (3.13) √ 6 − 1 (3.14) c2 = 8b2 − 12

qiv =

h = 6 − 12 − 1 + 2 2 − 162 − 1

(3.15)

h/ < 0 and clearly H v is an increasing and convex function of . The solution is found by replacing the optimal value of qiv in (3.12). At that point, kv ≥ for all ∈ . The second-order conditions of the above problem guarantee that the solution described is indeed a maximum.

A3.3 Proof of proposition 3.4

(1) We first prove that kv < for all ∈ : (i) kv is increasing and convex in ; (ii) simple computation gives kv = and kv = . Hence, kv < for all ∈ . ˆ , with Similarly, kf is increasing in in the range f ˆ f f k = and k < . Hence, k < for all ∈ . ˆ where kf = , we can express (2) Ignoring the region

f theentry points as: k = f1 + f2 f3 + f4 and kv = f5 + on f6 f7 + f8 , where fi , i = 1 8, are constant depending the parameters of the model. The equation f1 + f2 f3 + f4 = f5 + f6 f7 + f8 has two roots and . is smaller or equal (when = 1) to . Given that kv + > kf + , the other root is necessarily outside the interval .


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REFERENCES Armstrong, M. (2001): ‘Access pricing, bypass and universal service’, American Economic Review, Papers and Proceedings 91: 297–301. Armstrong, M., C. Doyle and J. Vickers (1996): ‘The access pricing problem: A synthesis’, Journal of Industrial Economics 44: 131–150. Auriol, E. and J. J. Laffont (1992): ‘Regulation by duopoly’, Journal of Economics and Management Strategy 1: 507–533. Baumol, W. (1983): ‘Some subtle issues in railroad regulation’, International Journal of Transport Economics 10: 341–355. Caillaud B. (1990): ‘Regulation, competition and asymmetric information’, Journal of Economic Theory 52: 87–110. Dana, J. and K. Spier (1993): ‘Designing a private industry. Government auction with endogenous market structure’, Journal of Public Economics 53: 127–147. Gans, J. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gautier, A. and M. Mitra (2003): ‘Regulation of an open access essential facility’, CORE DP 2003/84. Jehiel, P. and B. Moldovanu (2004): ‘The design of an efficient private industry’, Journal of the European Economic Association, Papers and Proceedings 2–3: 516–525. Laffont J. J. and J. Tirole (1994): ‘Access pricing and competition’, European Economic Review 38: 1673–1710. Laffont J. J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Link, H. (2003): ‘Rail restructuring in Germany – 8 years later’, Japan Railway & Transport Review 34: 42–49. Pittman, R. (2004): ‘Russian railways reform and the problem of non-discriminatory access to infrastructure’, Annals of Public and Cooperative Economics 75: 167–192. Rey, P. and J. Tirole (2005): ‘A primer on foreclosure’, in Armstrong, M. and R. Potter (eds): Handbook of Industrial Organization, Vol. 3, Elsevier, Amsterdam. Willig, R. (1979): ‘The theory of network access pricing’, in Trebing, H. (ed.), Issues in Public Utility Regulation, Michigan State University Public Utilities Papers, 109–152.



CHAPTER 4

Unbundling the Local Loop: One-Way Access and Imperfect Competition∗ PAUL W. J. DE BIJL Tilburg University, Tilburg MARTIN PEITZ International University in Germany, Bruchsal

Contents 4.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 4.2 POLICY ON LOCAL-LOOP UNBUNDLING IN TELECOMS . . . . . . . . . . . . . . . . 95 4.2.1 Unbundling in the EU 95 4.2.2 Unbundling in the US 97 4.3 REGULATORY THEORY WITH FULL PARTICIPATION . . . . . . . . . . . . . . . . . . 99 4.4 REGULATORY THEORY WITH PARTIAL PARTICIPATION . . . . . . . . . . . . . . 107 4.5 DISCUSSION AND CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

∗ We would like to thank participants at the 2004 Conference on Applied Infrastructure Research in Berlin and, in particular, Jos Jansen for helpful comments and discussion.

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Paul W.J. de Bijl and Martin Peitz

4.1 INTRODUCTION

A major promise of the 1990s was the rollout of local access networks in telecommunications markets. Nevertheless, local network rollout has been somewhat disappointing, and at present, competition in the ‘local loop’ is hardly mature. Network rollout has been narrowly targeted; while some operators found it worthwhile to connect business districts and metropolitan areas, residential customers have hardly been exposed to entrants with their own networks. Therefore, the traditional providers of fixed voice telephony (the former incumbents) still have strong positions in the market for local access. Consumers did, however, to some extent benefit from entry made possible by ‘carrier select’ and ‘local loop unbundling’ (LLU). At present, LLU seems most promising as a means for entrants to offer broadband Internet access by using ‘digital subscriber line’ (DSL) technology. Nevertheless, as voice telephony can alternatively be implemented by using the ‘Internet protocol’ when consumers have broadband access, LLU may, in the end, also spur competition in markets for voice telephony. Thus LLU is, potentially, still an important way to stimulate competition in the (broadly defined) market for telecommunications. In telecoms, unbundling usually implies wholesale leasing of the local loop. In other markets, unbundling can be interpreted more broadly. More generally, unbundling can be seen as a method of implementing ‘one-way’ access to an incumbent’s network. Unbundling typically implies that the incumbent’s essential input (and perhaps others as well) is, at the wholesale level, ‘separated’ from its overall facilities or operations, in order to allow for commercial wholesale supply of this input. Hence, although it is typically discussed within the framework of telecommunications, it has wider relevance. In postal markets, for instance, through unbundling regulators may enforce access to the incumbent’s system for local mail delivery (access to ‘the postman’). Unbundling of the postal value chain, a notion known as worksharing, allows competitors to buy the incumbent’s delivery function, and perhaps others as well, such as the sorting of mail items. In electricity, regulators may mandate

Chapter 4 – Unbundling the Local Loop

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access to electricity companies’ local distribution networks. In financial securities trading, the book depository function (the legal records of ownership changes) may be unbundled from the broad set of clearing and settlement services.1 In this chapter we explore situations of one-way access in which an entrant, that is, the firm without the essential input, has some market power. Accordingly, there is imperfect competition between an integrated firm, the incumbent, and a nonintegrated firm. We strongly believe that such a situation often better represents the real world than situations in which there is a competitive fringe that needs to purchase the essential input from the incumbent. Indeed, the appearance of entrants on the market immediately tends to generate some discipline on incumbents, and it is crucial to understand the interactions that take place when entrants have some market power, no matter how little in the beginning. We first explore the nature of LLU when there is full consumer participation. Full consumer participation here means that total demand is perfectly inelastic with respect to price changes. Second, we explore the case of partial participation by consumers. Here, we explore the specific case that an entrant generates additional demand and that this additional demand depends on price. To analyze these situations, we present simple models of competing telecommunications networks. In the baseline model with full participation unbundling requirements are neutral to competition: they do neither affect the entrant’s profit nor its market share; this is a generalization of earlier results (see, e.g, De Bijl and Peitz, 2002). In this context we discuss investment incentives of the integrated network. Furthermore, we extend the analysis to partial consumer participation. In particular, we show that the neutrality result breaks down under partial consumer participation. This implies that regulation of unbundling requirements should be particularly concerned with market segments such as broadband access in which partial 1

In the latter example, unbundling may serve to create a central register, rather than to introduce competition.

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participation seems to be a key feature of the consumer side. Based on the analysis, we draw policy-relevant conclusions that are timely, given the rather slow progress of LLU-based entry so far. We give specific attention to the possibility of ‘voice over Internet protocol’ (VoIP) as a new technology to stimulate competition. In particular, entrants that lease local loops in order to offer broadband Internet access, widen the possibilities for voice telephony over the Internet. It should be noted that although our model is placed within the context of telecommunications, our results are more general and have applicability to other sectors as well. In fact, they have relevance to all markets where unbundling and one-way access are potential means to facilitate competition. We fear that policy discussions tend to ignore the relationship between regulation of the wholesale price of an essential input and the nature of competition in the retail market.2 Previous work on one-way access has focussed on the optimal second-best pricing (Ramsey pricing) in the context of one-way access for homogeneous services or differentiated services with a competitive fringe. The literature has also considered access price rules for given retail prices, in particular the efficient component pricing rule (ECPR) has received a lot of attention. Both these strands are thoroughly analyzed and discussed in Armstrong (2002); see also Laffont and Tirole (2000) and Vogelsang (2003). There are few papers that consider price-setting imperfectly competitive networks. Laffont and Tirole (1994) analyze the Ramsey prices in such a situation. Armstrong and Vickers (1998) show that in asymmetric market the regulator may want to use the access price to favor the more efficient firm (see also Lewis and Sappington, 1999). Foros (2004) focuses on regulation as a way to induce the integrated firm to invest efficiently and to deter it from foreclosing the market. The present chapter contributes to the access pricing debate. We highlight that the effect of access regulation on the entrant’s profit depends on whether there is full 2

Gual and Seabright (2000), a paper prepared for DGCOMP, European Commission, provides an overview of the economics of LLU, and the main regulatory challenges.


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or partial participation. We also comment on entry and investment incentives.3 The structure of this chapter is as follows. Section 4.2 provides background information on unbundling in practice. Section 4.3 revisits LLU in the case of full participation by end-users. Section 4.4 explores a straightforward case of partial participation. Section 4.5 concludes the chapter. 4.2 POLICY ON LOCAL-LOOP UNBUNDLING IN TELECOMS

To provide some institutional background, this section provides an overview of regulation and policy towards unbundling of the local loop in telecommunications markets. We focus on the situation in the European Union and in the US.4 4.2.1 Unbundling in the EU

Already before the introduction of the new regulatory framework, European regulation mandated the provision of unbundled access to the local loop.56 The general philosophy is that mandatory access 3

Typically, the literature contains a short-term analysis which ignores investment incentives (it should be acknowledged that the issue of inefficient entry has been discussed). Valletti (2003) provides a useful discussion of investment incentives. However, the theoretical literature is rather silent on the issue. One exception is Bourreau and Dogan (2005), who highlight the importance of access charges for LLU on the entrant’s incentives to invest in its own facilities. They focus on the case where access charges are not regulated. See also the discussion in De Bijl and Peitz (2002). 4 For a more elaborate overview see De Bijl and Peitz (2005). The early developments are well documented in Doyle (2000). For a recent discussion on the US, see, for example, Speta (2004). 5 European Parliament and Council (2000). See also Delgado et al. (2004, p. 170). 6 The EC defines the local loop as the ‘physical twisted metallic pair connecting the network termination point at the subscriber’s premises to the main distribution frame or equivalent facility in the fixed public telephone network’ (European Parliament and Council, 2000, p. 4).

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is an effective means to deal with persistent network monopolies, but as it reduces entrants’ incentives to innovate and invest in networks themselves, it should be gradually withdrawn as competition becomes sufficiently mature. According to the EC,7 ‘The high cost of duplicating the local access infrastructure is ruling out new market entrants. This is affecting the level of competition, which the Regulation is intended to increase by offering unbundled access to the local loop, i.e. by enabling new competitors to offer high bit-rate data transmission services for continuous Internet access and for multimedia applications based on digital subscriber line technology as well as voice telephony services.’

For example, in 2003 there were 307 agreements on fully unbundled lines throughout fifteen countries in Europe, even though they were probably mostly aiming at broadband Internet access instead of voice. However, since broadband Internet access allows for voice telephony by using VoIP and ‘voice over digital subscriber line’ (VoDSL), these unbundling agreements may become (or already are) also relevant for voice telephony. The EU average monthly rental was E11.5 and the average connection charge was E68.2 in 2003 (see European Commission, 2003, pp. 48, 60). Mandated unbundling applied only to operators that had been designated by their NRAs (national regulatory authorities) as having significant market power (SMP). Moreover, according to European legislation, access prices (the line rentals of the local loop) must be transparent, nondiscriminatory, fair, and proportionate to costs. Similarly, under the new framework, unbundled access of the local loop has become a regulatory remedy to deal with dominance (see, e.g., Buigues, 2004). If the NRA establishes SMP, it must apply appropriate remedies. This has to be done on the basis of a list of obligations formulated in the Access Directive,8 related to transparency, nondiscrimination, accounting separation, 7

Summary of legislation on unbundled access to the local loop (Regulation (EC) No 2887/2000), http://europa.eu.int/scadplus/leg/en/lvb/l24108j.htm, consulted 22-9-2004. 8 European Parliament and Council (2002).


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access (unbundled access and resale of facilities), price control and cost accounting. However, it is up to the NRA to decide which are the approporiate obligations to be imposed on operators with SMP. Access regulation can be seen as appropriate, especially in the early stages of competition, when entrants have not yet rolled out alternative infrastructures (see, e.g., the results obtained by De Bijl and Peitz, 2002). Local loop unbundling was seen by many regulators (and entrants) as a major promise for opening telecommunications markets throughout Europe, but its success has been meager so far, which is somewhat surprising (see, e.g., Delgado et al., 2004). Given that facilities-based entry has been narrowly targeted (especially at business parks and metropolitan areas), unbundled access provides, in principle, an attractive way of capturing market share beyond the reach of an operator’s connections to end-users. This is especially true as unbundled access gives entrants full control of the local loop, allowing them to configure their own services. Nevertheless, Carrier Select-based entry has been observed much more frequently, at least in markets for voice telephony.9

4.2.2 Unbundling in the US

The major event that shaped the industry in the US in the last decade was the introduction of the Telecommunications Act of 1996. It intended to promote competition, reduce regulation and stimulate the development of new technologies. In particular, the desire was to open up the market for local telecommunications, the ‘last bastion of monopoly’. Nevertheless, the Act lead to a mixed experience, to put it mildly (see, e.g., Economides, 1999).

9

See, for example, European Commission (2003). This report, while providing statistics about facilities used by entrants to offer voice telephony (particularly to residential users), only presents information about Carrier Select and Preselect, not unbundled local loops. When providing information about unbundled local loops, it applies to broadband Internet access.

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The main instruments of introducing local competition were, first, the elimination of entry barriers (e.g., legal impediments to provide telecoms services), and second, the requirement that the incumbents – the ‘Baby Bells’ that resulted from the forced breakup of AT&T in 1984 – unbundle their local networks and lease local lines to entrants. The underlying idea of the latter was that economically efficient duplication of the local access network was not feasible for entrants. As a precondition for entry by the incumbents in the market for long-distance telephony, the Act required that competition be present in local telephony. Implementing LLU has been a tough process, and it is still uncertain when the desired end-state will be reached. For instance, incumbents and entrants are required to individually negotiate interconnection agreements, subject to a public arbitration procedure in case of breakdown of the negotiations. Not only does this two-step approach easily lead to delays, unbundling requests also lead to contested proceedings before courts. At present, the implementation rules formulated by the FCC, for instance, related to the question which parts of a network must be shared with entrants and related to the lease price, remain unsettled to a large extent (see Speta, 2004, part III, C). Although the Act has, so far, not been very successful and led to many legal battles, it should be noted that, similar to the situation in the EU, some local markets do exhibit competition. Substantial competition has developed in market segments for big corporate customers and (densely populated) metropolitan areas. Also, incumbents and cable companies compete in the market for broadband Internet access (see the discussion and references in Speta, 2004, part IV). Here, the incumbents telephone networks offer DSL technology. It should be noted, however, that the unbundling requirements of the 1996 Act did not primarily aim at the latter market segments. In contrast to those market segments, the situation in suburban and rural market segments remains quite uncertain. Moreover, although the Act’s unbundling regime also apply to DSL services, the provision of broadband Internet access by entrants leasing local loops has not yet been impressive – the main competition for incumbents comes from cable companies (see Speta, 2004, part IV, A).


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To conclude this section, we note that both the rationale for unbundling as well as the disappointing experience are shared throughout the EU and in the US (although the causes may be different). It is rather difficult to assess why LLU has shown few positive results for market structure and competition in voice telephony. A possible reason is simply that lease prices are too high to encourage entrants to offer voice through LLU.10 The relatively successful move towards competition in the market for broadband Internet access can be explained by the attractiveness of market share in this market relative to the one for voice telephony. However, as a starting point for further analyses it seems to us critical to gain a better understanding of the effects of access prices on competition and the resulting market outcomes. This is what the present chapter attempts to do.

4.3 REGULATORY THEORY WITH FULL PARTICIPATION

We consider a market of two networks, one vertically integrated network (denoted as firm 1) which owns local-loop plus additional facilities (in particular, a backbone and switches) and one nonintegrated network (denoted as firm 2) which owns only a backbone and switches, and needs access to the other firm’s local loop. More generally, two firms compete with each other, while one them owns an essential facility which provides a necessary input for the production process. The price at which the integrated network sells access to the essential facility is fixed by a regulator. We call it the lease price, or line rental, and denote it by l. Network 1’s per-user cost is denoted by f1 . A local connection to an end-user comprises two components, namely a ‘local line’ and a ‘line card’, with associated costs per user f1LL and f1LC , respectively. 10

Related to the situation in the EU, Kallen and Woehrl (2003) cite officials of DG Competition of the European Commission, who explain the negative result for voice telephony by invoking incumbents’ pricing policies and NRAs’ ineffective responses to price squeezes. It should be noted, though, that Kallen and Woehrl do not subscribe to this view.

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We assume that f1 = f1LL + f1LC . When firm 2 requests unbundled access to network 1, it installs its own linecard, with a cost per user f2LC = f1LC , and uses firm 1’s local line. Accordingly, firm 2’s perceived per-user cost equals f2 = l + f1LC . There is a continuum of consumers with mass 1. Each consumer subscribes to one network, or, alternatively, purchases one unit from the operator he or she selects. Consumers have an inelastic demand for a single subscription, while their willingness to pay is assumed to be sufficiently high so that they will always make a purchase. The local network owner (firm 1) derives revenues from subscriptions and from line rental. Since the lease price of the local loop is regulated, the only strategic variable of the local network owner is the price that consumers have to pay for the services if they subscribe. We denote that price by p1 . Also, the entrant charges a price p2 to consumers that demand its services. An example for prices pi are flat rates for Internet access. Market shares si p1 p2 depend on the prices charged by both operators. It is then natural to assume that market share is decreasing in its own price and increasing in the price of the competitor. Furthermore, we assume that market shares only depend on the price difference p2 − p1 . This assumption is satisfied for quasilinear preferences when consumers have identical demand functions. With full participation, total market demand is fixed. For an example, see below. Figure 4.1 illustrates the setup of the model. Operator 1:

Access (lease price l )

local line 1 (cost f1LL) Operator 2: line card 1 (cost f1LC)

line card 2 (cost f2LC)

Subscription 1 (retail price p1)

Subscription 2 (retail price p2) Consumers (discrete choice)

Figure 4.1 The one-way access model.


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Profit functions are as follows. Firm 1’s profits can be written as 1 p1 p2 l = s1 p1 p2 p1 − f1 + 1 − s1 p1 p2 l − f1LL and firm 2’s profits as 2 p1 p2 l = s2 p1 p2 p2 − l − f2LC The property that market share changes continuously with price implies that firms have market power. Consumers do not consider the services provided by the two firms as perfect substitute and, therefore, do not necessarily go for the lower priced service. A situation with imperfect substitutes seems to be common in telecommunications and other markets. For instance, brand recognition and switching costs lead to imperfect substitutes. Also, the services by firms are often bundles of different offers and features. If firms offer different bundles, they are considered as imperfect substitutes. A special case of our general model is obtained by assuming that the networks are horizontally differentiated. Suppose, for instance, that consumers are uniformly distributed on the interval 0 1 . Firm 1 is located at location y1 = 0 on the interval, and firm 2 at y2 = 1. A consumer located at z buying from firm i incurs a disutility − yi − z. Note that a higher value of parameter corresponds to more differentiation between the networks. A consumer at z buys from firm 1 if v1 p1 p2 − z > v2 p1 p2 − 1 − z, where vi p1 p2 denotes the conditional indirect utility of a network at the ideal location z. Market shares then satisfy si p1 p2 = 21 + vi p1 p2 − vj p1 p2 /2 , where j = i. This is the simple Hotelling specification which has also been used in models on two-way access (see, e.g., Armstrong, 2002). In a more elaborate model, one could incorporate that consumers have a demand to make calls, or to have access to the Internet, in addition to the demand for a subscription. Such extensions lead to additional interactions between the operators, for instance, because there is call traffic between the networks – see De Bijl and Peitz

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(2004) for an inclusion of call traffic. Nevertheless, the present model captures the crucial strategic effects of one-way access. Operators choose prices in order to maximize profits. Consumers make purchasing decisions, based on utility maximization, after observing the prices. We are interested in an equilibrium configuration p1∗ p2∗ in which both firms do not have an incentive to change their retail prices. That is, given the competitor’s retail price, each operator maximizes its profits. Accordingly, given the equilibrium price of the competitor, the profit maximization problem of operator 1 can be written as max 1 p1 p2∗ l p1

(4.1)

while operator 2 maximizes max 2 p1∗ p2 l p2

(4.2)

Suppose that there exists a unique pair p1∗ p2∗ which solves both problems simultaneously (hence it constitutes an equilibrium). We are then interested in the way in which a change in regulatory policy affects market outcomes. Suppose that under the new regulatory regime the lease price is changed to l = l + l. We can then show that this increase in the lease price is passed through to consumers. Equilibrium market shares are unaffected and the nonintegrated network’s profit are neutral to regulation. However, the integrated network benefits two-fold: it charges higher retail prices and it receives a higher lease price for those consumers who subscribe to the competitor’s network. Consumers suffer from the lease price increase: they face higher prices by both networks. Given the new lease price l = l + l, we claim that equilibrium retail prices are p1∗∗ = p1∗ + l and p2∗∗ = p2∗ + l. Our proof consists of establishing that pi∗∗ is the solution of the maximization problem of operator i, i = 1 2.


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Operator 1: given the new lease price l , the vertically integrated network’s profit can be written as s1 p1 p2∗∗ p1 − f1 + 1 − s1 p1 p2∗∗ l + l − f1LL Profit can be rewritten as s1 p1 p2∗∗ p1 − l − f1 + 1 − s1 p1 p2∗∗ l − f1LL + l Provided that the competing operator sets p2∗∗ = p2∗ + l, market shares satisfy s1 p1 p2∗∗ = s1 p1 − l p2∗ because they only depend on price differences. Hence the vertically integrated network’s profit can be rewritten as s1 p1 − l p2∗ p1 − l − f1 + 1 − s1 p1 − l p2∗ l − f1LL + l With a change of variable p1 ≡ p1 − l, the maximization problem becomes p1 p2∗ p1 − f1 + 1 − s1 p1 p2∗ l − f1LL + l max s1 p1

(4.3)

Clearly, p1∗ is the solution to this problem because it is formally the same maximization problem as problem (4.1) except for the constant l. Since p1 ≡ p1 − l, we have shown that p1∗∗ = p1∗ + l, provided that p2∗∗ = p2∗ + l. Operator 2: given the new lease price l , the nonintegrated network’s profit can be written as s2 p1∗∗ p2 p2 − l − l − f2LC Provided that the competing operator sets p1∗∗ = p1∗ + l, market shares satisfy s2 p1∗∗ p2 = s2 p1∗ p2 − l. Hence, using the change of variable p2 = p2 − l, the maximization problem of the nonintegrated network’s profit can be written as p2 p2 − l − f2LC max s2 p1∗ p2

(4.4)

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Clearly, p2∗ is the solution to this problem because it is formally the same maximization problem as problem (4.2). Since p2 ≡ p2 − l we have shown that p2∗∗ = p2∗ + l, provided that p1∗∗ = p1∗ + l. Hence, we have established the following result: Result 4.1 With full participation, firm 2’s (the nonintegrated network) profits are neutral to the lease price of the local loop. An increase of the lease price by l is passed on to consumers oneto-one and firm 1 (the vertically integrated network) benefits from such a policy. We believe it to be useful to elaborate on the above result. A lease price increase by l works affects prices in the same way as a per-user cost increase (of the same magnitude l) that is experienced by both networks; think of an increase of the line card’s per-user cost fiLC for both firms. This can be seen as follows. The profits of operator 2 are equal to s2 p1 p2 p2 − l − f2LC + l, that is, the profit function has the same form as with a lease price l and costs f2LC + l. The profit function of operator 1 becomes 1 p1 p2 l + l = s1 p1 p2 p1 − f1 + 1 − s1 p1 p2 l + l − f1LL The profit-maximizing price p1 , when p2 is given, is determined by the first-order condition of profit maximization: s1 p1 p2 s p p p1 − f1 − 1 1 2 l + l − f1LL + s1 p1 p2 = 0 p1 p1 which is equivalent to s1 p1 p2 s p p p1 − f1 + l − 1 1 2 l − f1LL + s1 p1 p2 = 0 p1 p1 This equation is also the first-order condition of profit maximization given lease price l and costs for the linecard f1LC + l, which leads to


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a total per-user cost of f1 +l. Hence, a lease price increase is passed on to consumers in exactly the same way as a cost increase. The only difference is that the owner of the essential facility, that is, the integrated network, benefits from a lease price increase because the associated ‘downstream’ cost increase generates revenues ‘upstream’ at the essential facility. In the present context, an analysis of total surplus is straightforward. Provided that the market is symmetric, the socially desirable market share is 1/2. This is indeed implemented by the equilibrium for any lease price (such that the participation constraint of consumers is not violated and participation is indeed (perfectly) inelastic). However, if the market is not fully symmetric, strategic behavior between firms typically does not lead to an implementation of a socially optimal outcome. In particular, if one network is more attractive than the other on average, then the equilibrium market share of the less attractive network is socially excessive. A detailed analysis of asymmetric situations is certainly of interest, but here we do not explore this issue any further. To analyze investment incentives by the integrated network in the local loop we introduce a quality parameter q. Alternatively, parameter q can be interpreted as a capacity level. The former interpretation applies to both voice and Internet access, and the latter mainly to Internet access. For simplicity, we assume that an increase of this parameter shifts the profit function by a factor dq outward for given lease price and gross of costs associated to this improvement. The cost of implementing a quality or capacity improvement q > 1 is denoted by Cq with the convention C1 = 0. Also by convention, d1 = 1. We can then write the integrated network’s profits as dq1 p1 p2 l − Cq Clearly, if the lease price does not respond to the provided quality, then quality (or capacity) is chosen such that it satisfies d q1 p1∗ p2∗ l − C q = 0. If d is concave and C strictly convex, there exists a unique solution to the profit maximization problem at the investment stage at which firm 1 chooses q. Observe that a

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larger lease price leads to an increase in 1 , and hence strengthens the incentives of the integrated network to invest in the quality or capacity of the local loop. Regulatory policy should take into account that the quality of the local loop is affected by its lease price regulation. To further strengthen the investment incentives without granting large profit margins at the local loop regulators may make their lease price depend upon quality. Suppose that the regulator can commit to a schedule lq with l q > 0. Note that equilibrium market shares are not affected by the level of the lease price (see result 1 above). The first-order condition of profit maximization at the investment stage can then be written as d q1 p1 p2 l − C q + dqs1 p1∗ p2∗

dp1∗ l dl

+ 1 − s1 p1 p2 l q = 0 which reduces to d q1 p1 p2 l − C q + dql q = 0 since dp1∗ l/dl = 1. We observe that with full participation, investment incentives are affected by the shape of the lease price schedule but independent of the degree of competition in the market. Furthermore, a more sensitive lease price schedule tends to increase investments incentives. In other words, if the regulator wants to achieve a certain quality level without giving large margins in the local loop it can do so by designing a sufficiently sensitive lease price schedule. We summarize our discussion by the following result. Result 4.2 With full participation, the regulator can provide stronger incentives to invest in the quality or capacity of the local loop by increasing the sensitivity of the regulated lease price to the quality or capacity level.


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4.4 REGULATORY THEORY WITH PARTIAL PARTICIPATION

We extend our previous setup to include partial participation so that total demand depends on prices. The perhaps easiest way to do so is to assume that the services offered by the nonintegrated network leads to a market expansion. This can be motivated by seeing the nonintegrated network operator as a firm which can offer unique services (bundled into its product) which are desired by a certain group of consumers. The integrated network owner does not provide these tailored services and, therefore, cannot cater to the tastes of these consumers. Formally, we consider a market consisting of two segments. In the first segment, the integrated and the nonintegrated network are competitors. Segment 1 corresponds to the market analyzed in the previous segment. In segment 2 only the nonintegrated network is active. The nonintegrated network is assumed not to be able to price discriminate between the two segments. Clearly, in such a setup we should expect the neutrality result that firm 2’s profits do not depend on the lease price, to break down. Furthermore, the integrated network has now (at least locally) some incentive not to inflate the lease price, if it were able to set it itself. The reason is that the higher the lease price, the higher the retail price set by the nonintegrated network, but this implies a reduction of demand for segment 2, which in turn reduces firm 1’s access revenues. Additional demand for the product offered by the nonintegrated network is denoted by ap2 , which is a decreasing function of operator 2’s retail price. This function reflects the heterogeneous willingness-to-pay of consumers in the captive segment.11 Obviously, this demand does not depend on the retail price of the integrated network, operator 1. 11

Note that heterogeneity is more likely to be relevant in the captive segment than in the competitive segment because in the competitive segment consumers can choose among alternative offerings so that they are more likely to be satisfied with one of them than in a monopoly situation.

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The profit maximization problem of the integrated network becomes max s1 p1 p2 p1 − f1 + 1 − s1 p1 p2 l − f1LL p1

+ ap2 l − f1LL

(4.5)

Note that the third term in the sum is not affected by the decision of the integrated network. Consequently, the first-order condition is the same as in the previous section. The profit maximization problem of the nonintegrated network is maxs2 p1 p2 + ap2 p2 − l − f2LC p2

(4.6)

An equilibrium p1∗ p2∗ has to satisfy the system of first-order conditions s p∗ p∗ s1 p1∗ p2∗ ∗ p1 − f1 + s1 p1∗ p2∗ − 1 1 2 l − f1LL = 0 p1 p1 s2 p1∗ p2∗ ap2∗ + p2∗ − l − f2LC + s2 p1∗ p2∗ + ap2∗ = 0 p2 p2 (4.7) Suppose there is a unique solution to this system. Now consider a change in the lease price. We first show that generically the profit neutrality result for the nonintegrated network breaks down. Result 4.3 With partial participation, profit of the nonintegrated network are generically not neutral to the lease price of the local loop and the equilibrium demand of the integrated firm s1 depends on the lease price l. Proof Proof by contradiction. Suppose that after a change in the lease price of l, equilibrium retail prices are p1∗∗ = p1∗ + l and


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p2∗∗ = p2∗ +l. Then, in equilibrium, the first-order condition of profit maximization for the non-integrated firm is s2 p1∗∗ p2∗∗ ap2∗∗ + p2∗ + l − l + l − f2LC p2 p2 + s2 p1∗∗ p2∗∗ + ap2∗∗ = 0 which can be rewritten as s2 p1∗ p2∗ ap2∗∗ + p2∗ − l − f2LC + s2 p1∗ p2∗ + ap2∗∗ = 0 p2 p2 Comparing this equation with (4.7) it must hold that ap2∗ + l ap2∗ − p2∗ − l − f2LC + ap2∗ + l − ap2∗ = 0 p2 p2 Generically this equation is violated.12

Clearly, it would be desirable to know in which way the equilibrium outcome changes. To answer this question in more detail, it is useful to consider for a moment the case that the nonintegrated network could price discriminate between the two segments. In the noncaptive market segment, the analysis of Section 4.2 applies. Hence, prices have the same price levels as prices derived in the previous section; we denote these prices as p1C∗ and p2C∗ . In its captive market segment, the nonintegrated network then would solve the following maximization problem maxp2 ap2 p2 − l − f2LC . Hence, it would set the monopoly price p2M in this segment which satisfies a p2M p2M − l − f2LC + ap2M = 0 or −

12

p2M − l − f2LC 1 = a p2M p2M /ap2M p2M

For instance, if a is linear the lease price is never neutral.

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This is the well-known inverse elasticity rule. Suppose the price elasticity of demand in the captive segment is a constant with > 1 (derived from ap2 = kp2 ). The inverse elasticity rule can be rewritten such that the profit-maximizing price is a linear function of the lease price: p2M =

1 l + f2LC 1 − 1/

Changes in the lease price by l translate into an increase of the price charged to the captive consumers by 1 − 1/ l. Hence, the price p2M increases always by more than l (since > 1).13 In the limit as goes to 1, we have lim →1 1 − 1/ = and the smaller the demand elasticity the more sensitive reacts the price to a lease price increase. The monopoly price in segment 2, p2M , may be higher or lower than the equilibrium price in segment 1. To fix ideas we call the former situation a ‘high-value situation’ because overall there is a sufficient number of consumers attaching high value to the product of firm 2, (i.e., consumers with a willingness-to-pay above p2C∗ ) so that the nonintegrated network optimally sets its price above p2C∗ . We call the latter situation a ‘low-value situation’ because overall there is an insufficient number of consumers attaching high value to the product of firm 2, so that the network optimally sets its price below p2C∗ . An alternative interpretation would be to look at the (imperfectly) competitive segment. Then the former situation can be called a competitive situation because competition in segment 1 is sufficiently strong to lead to an equilibrium price below the monopoly price in the captive segment. Similarly, the latter situation can be called an uncompetitive situation. In any case the captive segment is added value for the nonintegrated network (and for the integrated network, provided the lease price is above costs).

13

This holds more generally since demand at the profit-maximizing price is always elastic, that is, > 1.


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In our setup in which the nonintegrated network cannot pricediscriminate between segments the qualitative results for the equilibrium prices depend on whether we are in a high-value or a low-value situation. From the definition of a high-value situation it follows that the profit maximizing price p2 given p1∗ is between the equilibrium price in the competitive segment p2C∗ and the monopoly price in the captive segment p2M . Hence, in a high-value situation if networks offer strategic complements, equilibrium prices in our nondiscrimination setup are higher than equilibrium prices in the competitive segment in the setup with price discrimination.14 This implies that in a high-value situation the integrated network necessarily benefits from the existence of a captive segment because its profits in the competitive segment are higher than without the captive segment. The reason is that firm 1 can increase p1∗ . In addition, it makes revenues from selling wholesale-access to consumers in the captive segment of the nonintegrated network. In a low-value situation equilibrium prices in our nondiscrimination setup are lower than equilibrium prices in the competitive segment in the setup with price discrimination. How does the lease price affect equilibrium outcomes? First note that the qualitative result that a lease price increase leads to higher retail prices is robust to the introduction of partial participation. Formally, the result is shown by the fact that the best response of both firms is shifted outward by a lease price increase, that is, 2 i / pi l > 0, provided that networks offer strategic complements. We also address the question whether the retail price increase is more pronounced under partial than under full participation. Suppose that initially we are in a low-value situation, that is, p2M is less 14

Note that in standard models of price competition with differentiated products, firms offer strategic complements (see, e.g., Vives, 1990 and Milgrom and Roberts, 1990; for an application of the theory to telecommunications markets see Peitz, 2005). Consequently, best responses ri are upward sloping. Comparing partial to full participation is a comparative statics exercise. Introducing a captive segment makes the best-response of nonintegrated network 2 rotate clockwise at the point p1 p2M , where p1 is defined by r2 p1 = p2M .

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than the competitive price under discrimination p2C∗ . Then, as argued above the equilibrium price must be p2∗ < p2C∗ . Consider now an increase in the lease price. With the (constant) elasticity greater than 1, the price in the captive segment p2M increases by more than l. As shown in Section 4.3, the price in the competitive segment increases exactly by l. Hence, it is possible that we move from a low-value situation to a high-value situation. In other words, if the elasticity is sufficiently low (but greater than 1), then a lease price increase leads to a regime shift from a low-value situation to a highvalue situation. Hence, the presence of a captive segment amplifies the retail price increase. Starting from an initial situation in which prices are below the competitive price under discrimination, after a lease price increase they will be set above the corresponding prices if demand is sufficiently inelastic. Result 4.4 Suppose that the initial situation is a low-value situation. Then a retail price increase following from a lease price increase is greater with partial participation than with full participation, given that the demand in the captive segment is not too elastic. Clearly, if the initial situation is a high-value situation, the final situation after a lease price increase will also be a high-value situation. Similarly, for a lease price reduction: either we move from a high-value situation to a low-value situation or we remain in a low-value situation. Note that the level of the lease price is not welfare-neutral as it was in the case of full participation. A higher lease price translates into higher retail prices. This does not affect consumer participation in the competitive segment but it reduces consumer participation in the competitive segment. The markup charged by firm 2 leads to a deadweight loss. From a social point of view any retail price above the social costs f1LL + f2LC is detrimental to social welfare. Since firms have market power, firm 2 charges a mark-up over its perceived marginal costs l + f2LC . Hence, if the optimal regulation in a market in which firm 2 does not have market power (e.g., because it forms a competitive fringe together with other firms) implies that


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the lease price should be equal to costs, the optimal regulation in a market in which firm 2 does have market power is to set the lease price below costs. With respect to welfare in the captive segment and ignoring other welfare effects, optimal lease price regulation would have the property that the lease price is below costs and the resulting equilibrium price of firm 2 given this lease price is equal to costs f1LL + f2LC . Are there additional welfare effects which have to be considered? There is no welfare loss due to higher prices in the competitive segment due to inelastic demand. Hence, the lower lease price would be neutral to market share if firm 2 could price discriminate. However, without discrimination best responses are no longer symmetric. Also, a change in the lease price affects the firms’ best response functions differently. It depends on the exact change to determine whether firm 1 or firm 2 gains market share in the competitive segment after a change in lease price. We can summarize the discussion up to this point by the following statement. Result 4.5 Suppose that the welfare effects of the captive segment dominate welfare effects in the competitive segment if they go in different directions. A regulator who only controls the lease price optimally sets its lease price below costs to control for the market power of firm 2. We can elaborate on this by considering a lease price increase that leads from a low-value to a high-value situation. For this consider the special case that the slope of firm 1’s best response is globally greater than 1 (note that this is a natural assumption to make in the present context). If this is the case then in equilibrium with the initial lease price the equilibrium lies below the 45 line in the price space p1 p2 , that is, p1 > p2 in equilibrium and consequently s1 < s2 . In a high-value situation the reverse holds and consequently s1 > s2 . From a social point of view, the optimal market share is 1/2 in the competitive segment (provided that the market is symmetric). Then a low lease price tends to lead to a socially excessive market share of the nonintegrated network whereas a high lease price tends to lead to a socially excessive market share of the integrated network.

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Laffont and Tirole (1994) consider a similar market environment in which also firm 2 enjoys market power. They are interested in the structure of Ramsey prices, that is, the welfare-maximizing access and retail prices under the constraint that firms do not make losses. They show that the Ramsey pricing formulas in a market in which firm 2 does not have market power has to be modified. Since the retail price of firm 2 tends to be too high, the access price should reflect this type of inefficiency and therefore has to be set lower. Finally, we would like to comment on investment and entry incentives. Clearly, if there are sunk costs to enter the industry, the regulator may have to guarantee a positive level of operating profits to the entrant. Clearly, ignoring strategic interaction in the competitive segment, a lower lease price leads to a higher profit of firm 2 in the captive segment because it can serve those consumers at a lower cost. In this sense a lower lease price stimulates entry. At the same time, a lower lease price tends to lead to lower retail prices overall since it makes firm 2 less interested in high prices in the captive segment. This indirect effect then leads to a lower profit of firm 2. Also, we can consider firm 1’s incentive to invest in quality, where firm 1 takes into account the dependence of lease price on quality. Here result 2, which is shown under full participation, appears to be robust to the addition of a captive segment for the nonintegrated firm.

4.5 DISCUSSION AND CONCLUSION

In this chapter, we extended existing insights on unbundling of the local loop in telecommunications markets to a more general setting. The extensions were in two dimensions: first, partial consumer participation, and second (more generally), imperfect competition. In particular, we looked at the effects of increases of the lease price of the local loop on retail prices. In addition, we derived implications related to the network operator’s incentives to invest in quality or capacity of local connections to end-users. The kind of insights we obtained can be useful for policy makers and regulators, as our chapter complements discussions on efficiency-based


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approaches (focusing on efficient use of existing networks) and costbased approaches (focusing on efficient investment in new networks) to regulation of LLU.15 Although the analysis was framed in a telecommunications setting, the results have a more general applicability, extending to other markets as well. Further research should identify exactly when and to what extent this type of results apply to other sectors. For example, in sectors such as post and electricity it makes sense to model the particular characteristics of these markets, which may lead to more detailed results. We believe that the analysis of one-way access situations that lead to imperfect competition in the retail market, such as in the model that we explored, needs further consideration. Our results, which focused on the effects of the access price on retail competition, provide some flavor of a broader research program. In future work we plan, for instance, to consider VoIP in more depth. As remarked in the introduction, an interesting feature of broadband Internet access is that it allows for competition in voice telephony through VoIP. Whereas VoIP is sometimes implemented as a peer-to-peer application on end-users’ computers (e.g., Skype), there exist also providers of VoIP that use ‘gateways’ to interconnect to the PSTN, that is, the public telephony network (an example of such a provider is Vonage in the US). The latter type of VoIP allows its users to connect to all (including ‘traditional’) telephony customers. Because of their different business model, such providers may provide very different pricing structures than those offered by former incumbents, which moreover face regulatory constraints on their pricing strategies. Thus, it may happen that a VoIP provider, offering a flat-rate scheme, competes with a telecommunications operator offering a two-part tariff. A more general question related to the discussion above, which features prominently in current policy discussions, is whether a new technology, that allows entrants to make innovative use of

15

See Gual and Seabright (2000) for a discussion of these approaches.

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unbundling agreements, should be regulated or not. With regard to VoIP in particular, an important question is whether a provider of VoIP services should be put under the regulatory umbrella or not.16 Accordingly, it may be interesting to introduce asymmetric constraints on possible strategies, in particular with respect to retail pricing and quality requirements, that can be chosen by the integrated and nonintegrated firm, and analyze how welfare is affected.

REFERENCES Armstrong, M. (2002), The theory of access pricing and interconnection, in: M. Cave, S. Majumdar , and I. Vogelsang (eds), Handbook of Telecommunications Economics, Amsterdam, North Holland, 295–384. Armstrong, M. and J. Vickers (1998), The access pricing problem with deregulation: A note, Journal of Industrial Economics 46, 115–121. Bourreau, M. and P. Dogan (2005), Unbundling the local loop, European Economic Review 49, 173–199. Buigues, P.A. (2004), The competition policy approach, in: P.A. Buigues and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA, 9–26. De Bijl, P.W.J. and M. Peitz (2002), Regulation and Entry into Telecommunications Markets, Cambridge University Press, Cambridge, UK. De Bijl, P.W.J. and M. Peitz (2004), Dynamic regulation and entry in telecommunications markets: A policy framework, Information Economics and Policy 16, 411–437. De Bijl, P.W.J. and M. Peitz (2005), Local loop unbundling in Europe: Experience, prospects and policy challenges, Communications and Strategy 57, 33–57. Delgado, J., J. Fehrenbach, and R. Klotz (2004), The price of access: The unbundling of the local loop in the EU, in: P.A. Buigues and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA, 169–182. Doyle, C. (2000), Local loop unbundling and regulatory risk, Journal of Network Industries 1, 33–54. Economides, N. (1999), The Telecommunications Act of 1996 and its impact, Japan and the World Economy 11, 455–483.

16

In the US, for instance, the Internet Policy Working Group of the Federal Communications Commission tries to identify the policy issues that arise as telecommunications moves to Internet-based platforms.


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European Commission (2003), Technical Annexes of the Ninth Report on the Implementation of the Telecommunications Regulatory Package, Commission Staff Working Paper, COM (2003) 715 final, SEC (2003)1342, 19.11.2003, Brussels. European Parliament and Council (2000), Regulation (EC) No 2887/2000 of the European Parliament and of the Council of 18 December 2000 on unbundled access to the local loop, Official Journal of the European Communities L 336, 30.12.2000, 4–8. European Parliament and Council (2002), Directive 2002/19/EC of the European Parliament and of the Council of 7 March 2002 on access to, and interconnection of, electronic communications networks and associated facilities (Access Directive), Official Journal of the European Communities L 108, 24.4.2002, 7–17. Foros, O. (2004), Strategic Investments with spillovers, vertical integration and foreclosure in the broadband access market, International Journal of Industrial Organization 22, 1–24. Gual, J. and P. Seabright (2000), The economics of local loop unbundling, paper prepared for DGCOMP (European Commission), University of Navarra and University of Cambridge. Kallen, B. and R.-G. Woehrl (2003), Local loop unbundling a failed model for local competition? The German experience, presentation prepared for the International Telecommunications Society 14th European Regional Conference, 23–24 August, Helsinki. Laffont, J.-J. and J. Tirole (1994), Access pricing and competition, European Economic Review 38, 1673–1710. Laffont, J.-J. and J. Tirole (2000), Competition in Telecommunications, MIT Press, Cambridge, MA. Lewis, T.R., and D.E.M. Sappington (1999), Access pricing with unregulated downstream competition, Information Economics and Policy 11, 73–100. Milgrom, P. and J. Roberts (1990), Rationalizability, learning, and equilibrium in games with strategic complementarities, Econometrica 58, 1255–1277. Peitz, M. (2005), Asymmetric access price regulation in telecommunications markets, European Economic Review 49, 341–358. Speta, J.B. (2004), Deregulating telecommunications in internet time, Washington & LEE Law Review 61, 1063–1154. Valletti, T. (2003), The theory of access pricing and its linkage with investment incentives, Telecommunications Policy 27, 659–675. Vives, X. (1990), Nash equilibrium with strategic complementarities, Journal of Mathematical Economics 19, 305–321. Vogelsang, I. (2003), Price regulation of access to telecommunications networks, Journal of Economic Literature 41, 830–862.


PART II

Two-Way Access Pricing



CHAPTER 5

On the Role of Access Charges Under Network Competition STEFAN BUEHLER University of Zurich and University of St. Gallen ARMIN SCHMUTZLER University of Zurich

Contents 5.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5.2 LINEAR RETAIL PRICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 5.2.1 Assumptions 124 5.2.2 Comparative statics 128 5.2.3 Are retail prices strategic complements? 130 5.2.4 Do higher access charges shift out the reaction curves? 132 5.3 SIMPLIFYING ASSUMPTIONS: HOW DO THEY AFFECT THE ROLE OF ACCESS CHARGES? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 5.3.1 Full-coverage networks 134 5.3.2 Full-coverage networks and balanced calling pattern 136 5.4 NONLINEAR RETAIL TARIFFS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 5.4.1 Assumptions 139 5.4.2 Comparative statics 141 5.5 EXTENSIONS AND CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

5.1 INTRODUCTION

The problem of setting the ‘right’ access charge in the telecommunications industry has been analyzed extensively. There appears to

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Stefan Buehler and Armin Schmutzler

be a broad consensus that access charges need to be regulated in the case of one-way access, where the incumbent monopolist controls an essential facility (e.g., the local fixed network) and competes with entrants in related markets (e.g., long-distance services).1 In contrast, the debate on the problem of two-way access is far from settled. This problem arises in more mature industries, where the incumbent faces competitors that have deployed their own network facilities, so that mutual access is required to place calls to all subscribers. In this setting, it is less than obvious that access charges should be regulated, as competition for end-users may, at least in principle, discipline both access and retail prices. In two seminal papers, Armstrong (1998) and Laffont et al. (1998a) – henceforth abbreviated by ALRT – have put forward a formal framework for analyzing the role of access charges under two-way network competition. One of the key findings of these papers is that the access charge may serve as an ‘instrument of collusion’ when networks compete in linear retail prices. To some extent, this result is intuitive: increasing the access charge is equivalent to increasing the competitor’s perceived marginal cost, thereby softening competition in the retail market. This ‘raise-each-other’s-cost effect’ (Laffont and Tirole 2000, p. 190) might suggest that access charges should also be regulated in the case of two-way network competition.2 Based on the ALRT framework, a number of contributions surveyed in Laffont and Tirole (2000), Armstrong (2002), Vogelsang (2003), and Peitz et al. (2004) have emphasized that the collusive role of access charges is less robust than one might think.3 In particular, if retail tariffs are nonlinear and/or customers are heterogenous, 1

See for example, Laffont and Tirole (2000, Chapters 3 and 4) for a survey of the relevant issues. 2 Note that the usage of the word ‘collusion’ in this context is debatable, as it neither refers to an explicit agreement nor to implicit collusion in a repeated game sense: higher access charges merely move the industry to an equilibrium with both higher retail prices and profits. 3 See, for example, Gans and King (2001), Schiff (2002), Carter and Wright (2003), Dessein (2003, 2004), and Armstrong (2004).

Chapter 5 – On the Role of Access Charges

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it is far from obvious that usage fees are increasing in access charges (Dessein, 2003). Thus, even when firms are free to set access prices themselves, they do not necessarily price above marginal costs. In the present chapter, we aim to clarify the role of access charges under network competition with two-way access, using a reducedform approach. Because we focus on comparative statics issues, we need a less restrictive structure than usual in this literature. We retain the following key features of the various models considered in the literature that are motivated by the real world: (i) facing access charges, firms set their retail prices; (ii) facing retail prices, consumers take their subscription decisions; (iii) the calling pattern, that is, the number of internal and external calls initiated in each network, is a function of both the size of the two networks and the retail price charged by that network. We do not, however, impose some of the simplifying assumptions that are routinely applied in the literature. Instead, we start out more generally and then discuss to what extent assumptions familiar from the literature bias the results. Our findings support the view that the collusive role of access charges is generally not very robust. We argue that this nonrobustness is associated with the underlying economics of two-way network competition rather than the various simplifying assumptions made for studying specific models. Below, we first consider the case of linear retail prices. For this setting, we confirm that (i) even in cases where higher access charges do increase equilibrium retail prices, the raise-each-other’s cost intuition is incomplete (for reasons to be discussed below); (ii) it is not evident that higher access charges increase retail prices, so that collusion based on inflated access charges might not be a concern to begin with. Put differently, we show that it is neither clear that higher access prices shift out reaction curves in the retail price game, nor that reaction curves are upward sloping. We then demonstrate that the standard assumptions of full coverage networks and balanced calling patterns tend to support the collusive role of access charges, without making it robust. We also show that retail prices definitely increase under either of the following (rather extreme)

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assumptions: (i) networks are symmetric; (ii) the total number of subscribers and the number of subscribers to each network are fixed. We then move on to nonlinear retail prices. Laffont et al. (1998a) and Dessein (2003) argue that if networks compete in two-part retail tariffs, an increase of the access charge still increases the variable component of the two-part tariff, but also lowers the fixed component so as to just offset any effects on profits. Again, we aim to clarify the intuition behind this result and its limitations using our reducedform framework. To this end, we formulate a general comparative statics result that leads to the desired conclusion. We then show that the required conditions are fairly intuitive, but may well be violated in reasonable cases. The remainder of the chapter is organized as follows. Section 5.2 introduces our reduced-form model for linear retail prices. Section 5.3 discusses how two simplifying assumptions familiar from the literature, full coverage networks and balanced calling patterns, affect the comparative statics with respect to access charges. Section 5.4 extends the analysis to nonlinear retail tariffs. Section 5.5 discusses further extensions and concludes.

5.2 LINEAR RETAIL PRICES

In this section, we introduce a reduced-form model of two-way network competition with linear retail prices, imposing very little structure on the demand for calls within and across networks. We consider more specific models familiar from the literature in the next section.

5.2.1 Assumptions

Consider a reduced-form model of two-way network competition with the following structural elements: • Cost structure There are two networks with identical cost structure. There is a marginal cost c0 per call at the originating and


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terminating end of a call and c1 in between. Total marginal cost is thus given by c ≡ 2c0 + c1 , as in Laffont et al. (1998a).4 There is a fixed cost Ki of operating network i. • Demand structure The networks are differentiated and compete in retail prices. We abstract both from the type of network differentiation and the details of the consumers’ subscription decisions and simply assume that there is a well-defined demand function for each of the various types of calls. More specifically, let i j = 1 2 j = i. Then Dii pi pj denotes the demand for calls initiated and terminated in network i. Similarly, Dij pi pj denotes the demand for calls initiated in network i and terminated in network j. Suppose that each of these demand functions is twice continuously differentiable. The profit function of network i is thus given by i pi pj = pi − c Dii pi pj + pi − aj − c1 − c0 Dij pi pj + ai − c0 Dji pi pj − Ki

(5.1)

where ai and aj denote the access charges set by network i and j, respectively, that is, the prices to be paid for terminating a call initiated in the competing network. Even though we shall formulate our main comparative statics result in terms of the reduced-form demand functions Dii and Dij , it will be useful to decompose these functions into (i) the number of subscribers, and (ii) the number of calls initiated by each subscriber. We therefore introduce the following notation: Notation 5.1 (demand with linear tariffs) For i j = 1 2 i = j we let ni pi pj denote the number of subscribers to network i. 4

In our framework, it would be straightforward to incorporate asymmetric marginal costs. However, doing so would make the notation more cumbersome, without changing the results.

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ii pi pj ≡ mii ni pi pj nj pi pj pi denote the Further, let m ij pi pj ≡ number of internal calls per subscriber and m mij ni pi pj nj pi pj pi the number of external calls per subscriber to network i. Then, the demand functions can be written as ii pi pj Dii pi pj ≡ ni pi pj · m ij pi pj Dij pi pj ≡ ni pi pj · m Understanding the demand functions Dii and Dij thus amounts to understanding the relation between retail prices and (a) the individuals’ subscription decisions (represented by ni and nj ), and (b) the ij respectively). Note that number of calls per subscriber ( mii and m ii for internal calls depends not only on the a subscriber’s demand m price pi per call, but also on the number of subscribers to each network: a customer of a large network i will place more internal calls ii depends than a customer of a small network. Hence, indirectly m on pj as well as pi since pj affects the numbers of customers in both networks and thus the calling pattern of each subscriber to network i. As a result, the total effect of a change in the retail price pi on the ii , is given by number of internal calls per subscriber, m mii mii mii ni mii nj = + + pi pi ni pi nj pi

(5.2)

and similarly for the effect on external calls, mij /pi . The total effect of a change in the competitor’s retail price pj on the number of internal calls per subscriber is given by mij mij ni mij nj = + pj ni pj nj pj

(5.3)

and similarly for mii /pj . We maintain the following assumptions on the components of demand.


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Assumption 5.1 (demand properties) The components of demand satisfy the following properties: (i) (ii) (iii) (iv) (v)

ni mii and mij are differentiable functions. ni /pi < 0 ni /pj > 0, mii /ni > 0 mii /nj ≤ 0, mii /pi < 0 mii /pj > 0, and mij /pi < 0

Assumption (i) is made for notational convenience only. The remaining assumptions are plausible properties of the demand components. Assumption (ii), for instance, reflects the substitution effect associated with an increase of a network’s retail price.5 Property (iii) formalizes the notion that an increase in the size of a network should increase (decrease) the number of internal calls per subscriber in this (the competitor’s) network. Property (iv) reflects substitution effects for internal calls. Finally, property (v) states that the demand for external calls per subscriber is downward sloping. Note that Assumption 5.1 implies that mii 0 pj

mij /pj . We illusbut no corresponding statement on mij /pi and trate the ambiguity for mij /pj using (5.3). By Assumption 5.1(ii), ni /pj > 0 and nj /pj < 0, whereas the signs of the remaining partials are not determined. Under the reasonable condition that the number of external calls per subscriber is increasing in the size of both networks (mij /ni > 0 mij /nj > 0) – more subscribers to network i are likely to place more calls to network j, and more

5

In the absence of a full coverage assumption (see Section 5.3.1 for details), the second part of this assumption is not quite as natural: In principle, because an increase in pj reduces nj , it might also make subscription to network i less attractive.

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subscribers to network j make it more likely that subscribers want to place calls to network j – the sign of mij /pj is ambiguous.6 Our next assumption is made for convenience and requires that the components of demand are separable. Assumption 5.2 (separability) arable in retail prices, that is,

The demand components are sep-

ij ij 2 m 2 m 2 ni = 0 = 0 and = 0 pi pj pi pj pi pj Note that Assumption 5.2 does not imply separability of the demand functions Dii and Dij themselves.7 Finally, since we want to focus on comparative statics, we need to assume that an equilibrium exists. It is well known from specific models of two-way network competition that the existence of equilibrium is not assured, especially if access charges and the substitutability of networks are high.

5.2.2 Comparative statics

We now carry out comparative statics with respect to access prices. The analytical framework put forward by ALRT suggests that by ‘raising each others’ cost’, access charges may serve as collusive devices. Very roughly, the following intuition might appear plausible: by making access to its network more costly, both firms shift out the competitor’s reaction curve. If retail prices are strategic complements, indirect effects reinforce the direct effects. Though this story bears a grain of truth (Laffont and Tirole 2000, p. 189), it is

6 7

The arguments for mij /pi are analogous. For instance, under Assumption 5.2, we have 2 Dii mii ni n mii = i + pi pj pj pi pi pj


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both misleading and incomplete. First, it ignores the role of access charges as a means of generating revenue. Second, it neglects some special characteristics of network competition, suggesting that retail prices are strategic substitutes in the demand function rather than complements. Once these issues are taken into account, it is neither obvious that higher access charges shift out reaction curves nor that indirect effects work into the ‘right direction’. Nevertheless, we start with a simple result that formalizes the intuitive argument for collusion laid out above by giving sufficient conditions for equilibrium retail prices to be increasing in access charges.8 Proposition 5.1 (linear tariffs) Suppose that for i j = 1 2 i = j retail prices are strategic complements, that is, Dij 2 Dij 2 i D 2 Dii = ii + + pi − c + pi − aj − C1 − c0 pi pj pj pj pi pj pi pj + ai − c0

2 Dji ≥ 0 pi pj

(5.4)

(i) If, in addition to (5.4), reaction curves shift outwards, that is, Dji 2 j Dji 2 i = ≥ 0 and =− > 0 pi ai pi pj ai pj

(5.5)

then the equilibrium of the price game is increasing in ai . (ii) If, in addition to (5.4) both firms face the same access price a and Dji Dij 2 i − > 0 = pi a pi pi

(5.6)

then the equilibrium of the price game is increasing in a. 8

The proposition is formulated for a unique equilibrium of the price game. It generalizes to equilibrium sets as in Milgrom and Roberts (1990).

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Proof Results (i) and (ii) follow immediately from Milgrom and Roberts (1990, Theorem 5): Condition (5.4) guarantees that the game is supermodular; conditions (5.5) and (5.6) make sure that it satisfies increasing differences in pi pj , with = ai or a, respectively. Result (i) guarantees that both retail prices increase when either firm raises its access charge. The result is thus directly relevant for cases where firms themselves choose access charges – cooperatively or noncooperatively – and compete in the retail market, highlighting the collusive role of access charges. Result (ii) concerns the effects of a simultaneous increase in both access prices. It pertains to the important case where either the regulatory regime requires access charges to be reciprocal (as, e.g., in the US) or the network operators negotiate symmetric access charges. We now explore whether the sufficient conditions for a collusive role of access charges ((5.4)–(5.6)) are likely to be satisfied. 5.2.3 Are retail prices strategic complements?

In standard models of oligopolistic price competition, there is a natural force towards strategic complementarity of pricing decisions: if the competitors produce substitutes, a higher price of firm j increases the demand of firm i. Thus, a price increase of firm i becomes more attractive as it applies to a greater number of inframarginal consumption units. The strategic complementarity of pricing decisions breaks down only if the demand function itself has negative cross-partials, that is, if prices are strategic substitutes in the demand function, and this effect is sufficiently strong. For network competition models with two-sided access, there are two natural reasons why strategic complementarity in retail prices may be violated, so that 2 i /pi pj < 0 at least for some prices: (i) The products offered by different networks are not necessarily substitutes, that is, the demand for calls offered by network i does not necessarily increase with an increase in network j’s retail price.


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(ii) The retail prices may be strategic substitutes in the demand functions, that is, the cross-partials of the demand functions may be negative. First consider reason (i). Observe that by Assumption 5.1 n m Dii ii i + ni ii > 0 =m pj pj pj

(5.7)

that is, the demand for internal calls is unambiguously increasing in the competitor’s retail price. The effect on the demand for external calls, Dij mij n ij i + ni =m pj pj pj

(5.8)

however, is less clear: the first term is positive by Assumption 5.1(ii), but the second term has an ambiguous sign, so that it is not guaranteed that Dij /pj > 0. Intuitively, higher competitor prices might have a negative effect on the size of the competitor’s network and thereby reduce the number of outgoing calls. Nevertheless, (5.7) and (5.8) together suggest that the total effect on demand (Dii /pj + Dij /pj ) is likely to be positive, supporting strategic complementarity in retail prices. Consider now reason (ii). On the one hand, a familiar force towards strategic complementarity is present: as Dii /pj > 0, a higher competitor price increases own demand for internal calls, which makes a price increase more valuable. On the other hand, it is important to note that there is a natural force towards a negative cross-partial for the demand function Dii in spite of our separability assumption on the underlying demand components. Using Assumptions 5.1 and 5.2, as well as the decomposition given in (5.7), we obtain 2 Dii n mii ni mii = i + < 0 pi pj pj pi pi pj

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which is unambiguously negative. Intuitively, an increase in the competitor’s retail price increases both the number of own subscribers and the volume of internal calls per subscriber. The same is true for a reduction in own retail price. Thus, with a higher competitor price, the positive effect of an own price reduction on demand per subscriber applies to a greater customer base, so that the demand-enhancing effect of the price reduction is more pronounced. Similarly, the positive effect on the subscriber number applies to a greater call volume per subscriber. The argument for the remaining cross partials is again less clearcut. For instance, we obtain 2 Dij mij ni mij n = i + pi pj pj pi pi pj which has an ambiguous sign: we know that ni /pj > 0 ni /pi < 0 by Assumption 5.1(ii), but mij /pi and mij /pj have ambiguous signs. A similar result holds for 2 Dji /pi pj . Summing up, our reduced-form model of network competition with linear retail prices incorporates the standard argument for the strategic complementarity of pricing decisions: If a higher competitor price increases the total demand for calls originating in network i, then own price increases are more valuable. There is, however, at least one natural countereffect: A higher competitor price exacerbates the negative demand effects of an increase in own price, yielding an incentive to reduce own price.

5.2.4 Do higher access charges shift out the reaction curves?

The strategic complementarity of pricing decisions in the retail market helps support the argument for collusion among network operators. However, it is not a necessary condition for retail prices to be increasing in access charges. As long as higher access charges shift out reaction curves, both retail prices will go up even if retail prices are strategic substitutes, unless the indirect effects from downward


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sloping reaction curves are very strong. Conversely, if higher access prices shift reaction curves inward, retail prices are likely to fall. In the following, we show that the latter case may arise in the present setting. We first suppose that only one firm’s access price, ai , increases. This implies an outward shift of firm i’s reaction curve if Dji 2 i = ≥ 0 pi ai pi

(5.9)

That is, if a higher retail price induces more incoming calls, then setting a higher retail price is a reasonable response to a higher access charge. As we argued before, however, this condition may be violated (see (5.8)). Next, we ask whether it is natural to expect firm j’s reaction curve to shift outwards when the competitor raises its access price. Such an outward shift occurs if the following condition holds: 2 j Dji =− > 0 pj ai pj

(5.10)

Equation (5.10) requires that the demand for network j’s outgoing calls falls as it raises its retail price. Then, the increasing costs of access to network i make it attractive for network j to curb demand for external calls by increasing its retail price pj . As argued before, it is not obvious that Dji /pj is negative. Summing up, it is not clear that increases in access charges shift out the reaction curves of both firms.

5.3 SIMPLIFYING ASSUMPTIONS: HOW DO THEY AFFECT THE ROLE OF ACCESS CHARGES?

Our above findings indicate that changes in access charges have subtle effects on retail prices. In particular, they suggest that the collusive role of access charges is not very robust even when retail

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prices are linear. We now want to explore to what extent the following two crucial assumptions familiar from the literature affect the role of access charges under network competition (see Vogelsang, 2003, p. 846): (i) full coverage networks and (ii) balanced calling patterns.

5.3.1 Full-coverage networks

In the ALRT framework, the focus is on mature industries where network competition involves competition between two full-coverage networks (see, e.g., Laffont et al., 1998a, p. 5), and all consumers subscribe to one of the networks. This implies that the total number of subscribers is fixed, that is, ni pi pj + nj pi pj ≡ n

(5.11)

Therefore, retail prices only affect the networks’ market shares

i pi pj ≡

ni pi pj n

i j = 1 2 i = j

(5.12)

but not the total number of subscribers (i.e., the ‘size’ of the market). This simplification tends to support the collusive role of access charges, without eliminating the ambiguities entirely. Too see this, note that if (5.11) holds, we immediately have ni /pi = −nj /pi We can thus rewrite (5.3) as mij n = i pj pj

mij mij − ni nj

(5.13)

which is positive by Assumption 5.1(ii) if and only if the expression in the bracket is positive. One might argue that this condition is likely to be satisfied, since it essentially requires that the number of external calls per subscriber increases more strongly in own network


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size than it increases in the competitor’s network size (the own effect dominates the cross effect).9 If this condition is satisfied, we have mij /pj > 0, which reinforces the positive effect of an increase in network j’s retail price on network i’s total demand, that is, the full-coverage assumption supports the strategic complementarity of retail price decisions. However, the full-coverage assumption does not eliminate the natural countereffect associated with the negative cross-partial of internal calls. Similar arguments show that the full-coverage assumption makes it more likely (but cannot guarantee) that an increase in the access charge shifts out the competitor’s reaction curve. Summing up, the full-coverage assumption tends to support the collusive role of access charges, but does not guarantee a positive relation between access charges and retail prices. The ambiguities concerning the collusive role of access charges disappear, however, if we are willing to make a more extreme assumption and fix not only the total number of subscribers, but also the number of subscribers to each network. Making this assumption is equivalent to ignoring subscription decisions, which could be justified on the grounds of prohibitive switching costs in a very short-term perspective. In this simpler setting, our earlier concerns about strategic complementarity and the shifting of reaction curves disappear. To see this, consider the strategic complementarity condition (5.4). The potential countereffect of the competitor’s retail price on external calls, Dij /pj , is zero by ij assumption: if pj does not affect ni and nj , it cannot affect m either. Second, all demand functions are now separable in retail prices, as ni /pi = ni /pj = 0 by assumption. Therefore, condition (5.4) is always satisfied with equality. As to the conditions (5.9) and (5.10) assuring that increases in access charges

9

It should be noted, however, that in this particular case, it is not a foregone conclusion that the own effect dominates the cross effect: the demand for external calls per subscriber should be expected to increase in the number of subscribers to both networks, and without further assumptions on how subscribers choose networks, it is perfectly conceivable that the cross effect dominates.

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shift out the reaction curves, we have 2 i /pi ai = Dji /pi = 0, since pi does not affect nj Furthermore, by Assumption 5.1(v), 2 j /pj ai = −Dji /pj = −nj mji /pj > 0 Therefore, access charge increases unambiguously shift out the reaction curves of the competitors.

5.3.2 Full-coverage networks and balanced calling pattern

Another common simplification in the literature is to require a socalled balanced calling pattern.10 This means that, at retail prices pi = pj , inbound and outbound calls are balanced. According to Laffont et al. (1998a, p. 3), who used the assumption as a ‘good first approximation’ to the possibly complex routing of calls within and across networks, balanced calling patterns also mean that the ‘percentage of calls originating on a network and completed on the same network (“on-net calls”) is equal to the fraction of consumers subscribing to the same network.’

We now want to explore how this assumption affects the role of access charges for network competition. We maintain the fullcoverage assumption from Section 5.3.1, so that i = ni pi pj /n.11 Using the notation of Laffont et al. (1998a), our reduced-form demand functions then read Dii pi pj = 2i pi pj qpi

(5.14)

Dij pi pj = i pi pj 1 − i pi pj qpi

(5.15)

where qpi denotes the call volume per subscriber to network i, with q pi < 0. Note that the call volume per subscriber is a function of 10

Vogelsang (2003, p. 847) uses the terminology ‘isotropic calling pattern’ instead. With the balanced calling pattern assumption, calculations for the reduced-form model become tedious when the total number of subscribers is endogenous.

11


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pi alone, whereas in our reduced-form model above, it is a function of both pi and pj 12 It is straightforward to show that these assumptions do not resolve the ambiguities outlined above. For instance, consider the strategic complementarity condition (5.4). Using (5.14) and (5.15), we have

Dii = 2 i i qpi > 0 pj pj

(5.16)

Dij

= i 1 − 2 i qpi pj pj

(5.17)

While (5.16) is always positive, (5.17) is positive by Assumption 5.1(ii) for a small network ( i < 1/2 and negative for a large network ( i > 1/2). That is, from a large network’s point of view, the products offered by the different networks are no substitutes. Furthermore, some of the cross-partials of demand may be negative. More specifically, we have i i 2 Dii =2 qpi + i q pi < 0 (5.18) pi pj pj pi 2 Dij

= i 1 − 2 i q pi − 2 i i qpi pi pj pj pj pi

(5.19)

Condition (5.18) indicates that 2 Dii /pi pj is always negative, whereas the sign of 2 Dij /pi pj is ambiguous (see (5.19)). Thus, the strategic complementarity condition may well be violated. 12 In a paper closely related to Laffont et al. (1998a), Dessein (2003) combines the assumptions of full-coverage and balanced calling patterns with a more flexible demand structure where subscribers may be heterogeneous in the sense that there are light and heavy users initiating call volumes kL qpi and kH qpi respectively, with kL < kH He finds that in this setting the equilibrium price is still increasing in the access charge (Proposition 5.1). If, however, the calling pattern is unbalanced, the impact of an increase in the access charge on the equilibrium price may be reversed (Proposition 5.2). See Section 5.5 for a discussion of consumer heterogeneity in our reduced-form model.

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Furthermore, reaction curves do not generally shift out when access charges increase. To see this, note that Dji i 2 i = = 1 − 2 i qpj pi ai pi pi 2 j Dji

=− = − i 1 − 2 i qpj − i j q pj pj ai pj pj That is, raising the access charge and increasing the retail price is complementary only from a large network’s point of view ( i > 1/2). A small network ( i < 1/2), in turn, will not be willing to increase its retail price in response to an increase in its own access charge. To understand this, recall that setting a higher retail price is a reasonable response to a higher access charge if it induces more incoming calls. Under the assumptions of full-coverage networks and balanced calling patterns, increasing the retail price will induce more incoming calls only for a large network, whereas a small network must reduce the retail price to induce more incoming calls. Interestingly, all of the above ambiguities disappear when networks are symmetric ( i = j = 1/2). In this case, all relevant derivatives are either zero or strictly positive, so that the conditions of Proposition 5.1 are satisfied. In particular, the diverging interests of small and large networks in setting retail prices in response to changes in access charges are perfectly aligned, and increasing access charges (weakly) shifts out reaction curves.

5.4 NONLINEAR RETAIL TARIFFS

We now introduce a reduced-form model of two-way network competition with nonlinear retail tariffs that incorporates the ALRT framework as a special case.


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5.4.1 Assumptions

Suppose that the networks simultaneously offer two-part retail tariffs of the form Ti q = Fi + pi q where Fi is a subscriber charge and pi is the per-unit usage fee. Following Laffont et al. (1998a), we denote the variable gross surplus of a subscriber to network i by umii mij and the corresponding variable net surplus by vpi ≡ max umii mij − pi mii + mij mii mij

Accounting for the subscriber charge, the net surplus offered to subscribers of network i is wi ≡ vpi − Fi For a fixed retail price pi , there is a one-to-one correspondence between the subscriber charge Fi and the net surplus wi so that we can view the networks as simultaneously choosing pi and wi . Also, we confine ourselves to the case of reciprocal access charges ai = aj ≡ a. Thus, we write the profit function of firm i as i wi wj pi pj = pi − cDii wi wj pi + pi − a − c1 − c0 ×Dij wi wj pi + a − c0 Dji wi wj pj +ni vpi − wi − Ki We shall provide a comparative statics result for this reduced form below, but we shall also refer to the following decompositions of the demand functions. Notation 5.2 (demand with nonlinear tariffs) For i j = 1 2 i = j we let ni wi wj denote the number of subscribers to network i.

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ii wi wj pi ≡ mii ni wi wj nj wi wj pi denote Further, let m ij wi wj pi ≡ the number of internal calls per subscriber and m mij ni pi pj nj pi pj pi the number of external calls per subscriber to network i. Then, the demand functions can be written as ii wi wj pi Dii wi wj pi ≡ ni wi wj · m ij wi wj pi . Dij wi wj pi ≡ ni wi wj · m The net surpluses wi wj thus both determine the customers’ subscription decisions and affect the number of calls per subscriber, whereas the retail prices pi pj only affect the number of calls per subscriber. The total effect of a change in the net surplus wi on the ii is given by number of internal calls per subscriber, m mii mii ni mii nj = + wi ni wi nj wi and similarly for mii /wj The total effect of a change in the competitor’s net surplus wj on the number of external calls is mij mij ni mii nj = + wj ni wj nj wj and similarly for mij /wi We adapt Assumptions 5.1 and 5.2 from above in the following way: Assumption 5.1 (demand properties) The components of demand satisfy the following properties: (i) ni mii and mij are differentiable functions, (ii) ni /wi > 0 ni /wj < 0, (iii) mii /ni > 0 mii /nj < 0, (iv) mii /pi < 0, and (v) mij /pi < 0


141

Assumption 5.2 (separability) The demand components are separable in retail prices and net surpluses, that is, 2 ni = 0 wi wj ii 2 m = 0 pi wi

ij 2 m ii 2 m = 0 and = 0 wi wj wi wj ij 2 m = 0 pi wi

5.4.2 Comparative statics

We now discuss how changes in access charges affect subscriber charges and usage fees. To some extent, the intuition will parallel the case of linear pricing. However, there is added complexity from the interaction of usage fees pi and subscriber charges Fi (or equivalently, net surpluses wi ). The following three arguments are key for the notion that both usage fees and net surpluses should be increasing in access charges. (i) Setting a higher access charge a increases the marginal benefits from an increase in the usage fee pi . (ii) Other things being equal, charging a higher usage fee pi increases the marginal profitability from setting a higher net surplus wi (by lowering the subscriber charge Fi ). Intuitively, a network charging a high usage fee benefits more from a larger customer base which it obtains thanks to a low subscriber charge. (iii) The different players’ decision variables, which are now twodimensional (usage fee and net surplus), are strategic complements. Thus, a firm’s optimal response to an increase of the usage fee and an increase of the net surplus of the competitor involves increasing its own usage fee and increasing its own net surplus (i.e., reducing its own subscription charge). Using these arguments, the following response to an access charge increase appears plausible. First, by (i), the direct effect of a higher

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access charge is to increase usage fees. Second, by (ii), if firms increase their usage fees, they should reduce subscriber charges. Third, by (iii), these adjustments of both firms to higher access charges reinforce each other. The intuition is slightly incomplete, however, as one must also take the direct effect of higher access charges on subscription charges into account. Unfortunately, neither the standard monopoly nonlinear pricing problem, nor the linear access pricing model of Section 5.2 offers guidance for the sign of this effect. Next, we therefore state a comparative statics result that contains a suitable condition on this direct effect as well as formalizations of (i)–(iii) above, and then discuss the plausibility of these conditions. Proposition 5.2 (two-part tariffs) For the reduced-form model with two-part retail tariffs, suppose the following conditions hold for i j = 1 2 i = j: 2 i 2 i (i) ≥ 0 ≥ 0 api awi 2 i (ii) ≥ 0 pi wi 2 i 2 i 2 i 2 i ≥0 ; ≥ 0 ≥ 0 ≥ 0. (iii) pi pj pi wj wi pj wi wj Then, an increase in the access charge a leads to an increase in the equilibrium values of p1 p2 and w1 w2 Proof By (i), each objective function i pi pj wi wj a has increasing differences in pi wi a. By condition (ii), the objective functions are supermodular in pi wi . By condition (iii), they also satisfy increasing differences in pi pj wi wj . Taking (ii) and (iii) together, the game is supermodular. Thus, applying Milgrom and Roberts (1990, Theorem 5) yields the result. We now clarify to what extent the conditions of Proposition 5.2 are likely to hold.


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First, consider the direct effects in (i) given by Dij 2 i =− >0 api pi

and

Dji Dij 2 i = − awi wi wi

The direct effect of access charges on usage fees is always positive as higher usage fees lead to less outgoing calls by Assumption 5.1(v).13 The direct effect of access charges on net surpluses is less obvious. In the model proposed by Laffont et al. (1998a), this effect turns out to be zero, as demand functions are given by Dji = i wi wj 1 − i wi wj qpj Dij = i wi wj 1 − i wi wj qpi so that Dji /wi = Dij /wi for pi = pj Second, consider the within-player effects (ii). Even without using the demand decomposition, we obtain a somewhat lengthy expression for the relevant cross-partial: Dij D 2 Dii 2 i = ii + pi − c + pi wi wi pi wi wi + pi − a − c1 − c0

2 Dij n + i v pi pi wi wi

(5.20)

Rather than considering each term in (5.20), we highlight some major effects. There are clear forces supporting the idea of complementarity between high usage fees and high net surpluses. For instance, we unambiguously have n m Dii ii + ni ii > 0 = im wi wi wi 13

The indirect effects from the linear pricing model are no longer present, because subscriptions only depend on prices via net surpluses.

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Intuitively, this reflects the idea that with a high net surplus, the total number of subscribers and thus the volume of internal calls will be high, so that the per-unit profits resulting from a higher usage fee apply to a greater customer base. However, there are also counter-effects. For instance, arguments as in Section 5.2 show that n mii 2 Dii = i pi wi wi pi is likely to be negative: a higher net surplus leads to more subscriptions. Thus, the reduction in internal calls resulting from a higher usage fee has a particularly strong negative demand effect, as it applies to a greater number of subscribers. More interestingly, there is a negative subscription charge effect that is specific to the nonlinear case ni /wi v pi < 0: when wi is high, firm i has a large number of subscribers. Increasing the usage charge means that the firm will be able to extract a smaller subscription charge from each customer. This effect is particularly pronounced when the number of subscribers is large. Finally, consider strategic interactions. First note that 2 i /pi pj = 0, which is in line with condition (iii). The remaining cross-partials, however, are typically ambiguous. For instance, Dij D 2 Dii 2 i = ii + pi − c + pi wj wj pi wj wj + p − a − c1 − c0

2 Dij n + i v pi pi wj wj

(5.21)

is very similar to (5.20), except that the derivatives are taken with respect to wj rather than wi . Typically, however, derivatives with respect to wi and wj have different signs, which makes it unlikely that 2 i /pi wj and 2 i /pi wi have the same sign. Summing up, there is some support for the intuitive notion that higher access charges tend to both increase usage fees and decrease subscriber charges. However, higher access charges may have positive direct effects on fixed fees 2 i /awi ≤ 0 even though this


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is not the case in the model proposed Laffont et al. (1998a). Further, the strategic complementarity of the players’ two-dimensional decision vectors is not obvious. While this does not itself imply that the conclusions of Proposition 5.2 do not hold – after all, these conditions are merely sufficient rather than necessary – it does at least warn us that straightforward intuitive reasoning may not apply under two-sided network competition. 5.5 EXTENSIONS AND CONCLUSIONS

We finally discuss two important extensions of the ALRT framework that have been studied in the literature: (i) customer heterogeneity (Dessein 2003) and (ii) price discrimination based on call termination (Laffont et al., 1998b). First, note that the extension to heterogeneous customers is straightforward, as our reduced-form demand functions Dii and Dij , i j = 1 2 i = j are perfectly consistent with customer heterogeneity: suppose that there are t types of customers indexed by k = 1 t Let nki denote the number of type k customers subscribing kii and m kij denote the number of internal to network i. Similarly, let m and external calls, respectively, per subscriber of type k. Then, the k k ii and demand for internal and external calls is given by D ≡ ii k nii m k k ij , respectively. Since Propositions 5.1 and 5.2 are forDij ≡ k ni m mulated in terms of reduced-form demand functions, they also apply when customers are heterogenous. Therefore, the ambiguities with respect to possible collusion over inflated access charges still emerge in this more general case, even after extending our assumptions on the demand components to all t types of customers. Second, consider the case where networks charge different retail prices for internal and external calls. Following Laffont et al. (1998b), we denote the retail price of network i for internal calls by pi and the price for external calls by pi 14 Clearly, we cannot 14

In the case of nonlinear retail tariffs, network i also sets a subscriber charge Fi (as in Section 5.4).

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simply reinterpret Propositions 5.1 and 5.2 to understand the sufficient conditions for retail prices to be increasing in access charges in such a setting. Our above analysis suggests though that collusion over inflated access charges is unlikely to be a robust phenomenon in this more general setting, as it is inherently nonrobust even in the special case where pi ≡ pi .15 Summing up, this chapter provides a reduced-form analysis of the role of access charges under two-way network competition with linear and nonlinear retail prices. Retaining the key features of network competition models but imposing less structure, we derive sufficient conditions for usage fees to be increasing (and subscriber charges to be decreasing) in access charges. We show that these conditions are difficult to satisfy without making rather strong assumptions on the demand for calls within and across networks, suggesting that implementing collusion by inflating access charges is likely to be nonfeasible. Our results extend Dessein’s (2003) earlier finding that making the analytical framework more general does not restore the collusive effect of a high access charge.

REFERENCES Armstrong, M. (1998): ‘Network interconnection in telecommunications’, Economic Journal 108: 545–564. Armstrong, M. (2002): ‘The theory of access pricing and interconnection’, in: Cave, M., S. Majumdar and I. Vogelsang, (eds.), Handbook of Telecommunications Economics, Elsevier, Amsterdam, 295–384. Armstrong, M. (2004): ‘Network interconnection with asymmetric networks and heterogeneous calling patterns’, Information Economics and Policy 16: 375–390. Carter, M. and J. Wright (2003): ‘Asymmetric network interconnection’, Review of Industrial Organization 22: 27–46. Dessein, W. (2003): ‘Network competition in nonlinear pricing’, RAND Journal of Economics 34: 593–611. Dessein, W. (2004): ‘Network competition with heterogeneous customers and calling patterns’, Information Economics and Policy 16: 323–345.

15

Laffont et al. (1998b, p. 40), for instance, find that ‘raising each other’s cost does not promote collusion’ in their model with price discrimination.


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Gans, J. and S. King (2001): ‘Using bill and keep interconnect arrangements to soften competition’, Economics Letters 71: 413–420. Laffont, J.J., P. Rey and J. Tirole (1998a): ‘Network competition I: Overview and nondiscriminatory pricing’, RAND Journal of Economics 29: 1–37. Laffont, J.J., P. Rey and J. Tirole (1998b): ‘Network competition II: Price discrimination’, RAND Journal of Economics 29: 38–56. Laffont, J.J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Milgrom, P. and J. Roberts (1990): ‘Rationalizability, learning, and equilibrium in games with strategic complementarities’, Econometrica 58: 1255–1277. Peitz, M., T.M. Valletti and J. Wright (2004): ‘Competition in telecommunications: An introduction’, Information Economics and Policy 16: 315–321. Schiff, A. (2002): ‘Two-way interconnection with partial consumer participation’, Networks and Spatial Economics 2: 295–315. Vogelsang, I. (2003): ‘Price regulation of access to telecommunications networks’, Journal of Economic Literature 41: 830–862.



CHAPTER 6

Access Pricing Under Cost Asymmetry in Telecommunications VIKTÓRIA KOCSIS∗ Corvinus University of Budapest, Hungary

Contents 6.1 6.2

INTRODUCTION MODEL FOR LINEAR TARIFFS 6.2.1 Cost structure and access fee 6.2.2 Demand structure and consumer surplus 6.2.3 Price competition 6.2.4 Comparison and policy implications 6.3 COMPETITION IN TWO-PART TARIFFS 6.3.1 Demand structure and consumer surplus 6.3.2 Price competition 6.3.3 Comparison and policy implications 6.4 CONCLUSIONS APPENDIX A6.1 PROOFS A6.2 SIMULATION RESULTS A6.2.1 Comparison according to parameter values A6.2.2 Comparison according to access fee REFERENCES

150 153 153 154 157 158 160 161 162 164 167 168 168 172 172 173 175

∗ The author thanks Mark Armstrong, Paul de Bijl, Gergely Csorba, Ferenc Forgó, András Gömöri, Maarten Janssen and Patrick Rey for their comments and recommendations.

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Viktória Kocsis

6.1 INTRODUCTION

Since the mid-1990s, the deregulation of telecommunications – formerly seen as a natural monopoly – has played an important role within policy-making and in the economics literature. At the beginning of the millennium a new framework for communications networks was introduced, designed to harmonize European regulation in order to reduce entry barriers and facilitate effective competition for the benefit of consumers. Under the new regulatory regime, each country is required to establish a national regulatory authority to monitor competition in communications markets and define the relevant market segments. Furthermore, they should decide whether an operator has significant market power (SMP) in a particular segment and assess the appropriate regulatory obligations. On the basis of the EU communications directive on access and interconnection,1 wholesale voice call termination has already been defined as a relevant market in most of the European countries, since each operator is a monopolistic provider for its respective bottleneck and charges an access fee for usage. The termination charge set by the SMP operators is regulated on the basis of termination cost. Nevertheless, several asymmetries can be observed on telecommunications markets, and these asymmetries require an individual consideration of each firm with regard to regulation. The questions which arise are whether all firms should be regulated in the same way, more precisely based on their termination cost, or whether regulation should favor some firms. In the latter case, the question is, of course, which firm should be favored over the other and why. Therefore, in this chapter we focus on a specific market asymmetry and seek to find an argument for or against the current access price regulation. Liberalizing telephony markets has provided opportunity for new entry. Firms that entered the market later had the opportunity to 1

See European Parliament and Council (2002).

Chapter 6 – Access Pricing Under Cost Asymmetry

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introduce a more recent technology which implies a lower cost of servicing (i.e., supply side advantage). In this chapter, we focus on this cost asymmetry and aim to find the answer to the following questions: is a cost-based access fee desirable, or does an asymmetric access price regulation lead to higher welfare? What is the effect of access price regulation on firms’ profits and on consumer surplus? We formalize a market with two firms, which have already built their own networks providing full coverage, and which compete for consumers with horizontally differentiated products. The firms are interconnected: they have to pay a two-way access fee for call termination; each firm maximizes its profit setting retail price(s) simultaneously and noncooperatively. In the first part of the chapter, we present a model for linear telephony demand and for uniform linear retail prices. We obtain quartic and asymmetric first derivatives, therefore, the main results are based on simulations. Studying the effects of different access fees, we find that the two firms’ preferences over the access fee are divergent, and industry profits increase with the more efficient firm’s profit, so that a side payment to the less efficient firm could compensate for an access fee which is against its interest. On the other hand, a successful regulatory policy allows a positive access markup for the less efficient firm since it favors this firm (intensifies competition) and consumers. Extending the model to the case of competition in two-part tariffs, where each firm sets a uniform per-minute charge and a fixed fee at the same time, we find that firms set their per-minute prices equal to their perceived marginal costs and compete for consumers with fixed fees. As for the effects of changing access fees, the profit-neutrality property of the symmetric equilibrium no longer holds true and we claim similar policy implications to the linear pricing scheme. This chapter is an extension of the common symmetric models of network interconnection and competition. The first articles published on this topic are Armstrong (1998) and Laffont et al. (1998), in which the authors analyze the problem of two-way access pricing in the setup of a symmetric cost structure,

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uniform pricing and reciprocal (equal) access fee. The main and principally cited results of their articles are that (i) under linear retail pricing, the price increases in the access fee and, therefore, the access fee may be an instrument of collusion, and (ii) under two-part tariffs, since profit is independent of the access fee, any kind of regulatory policy has no effect on firms’ profits. This profit-neutrality property is confirmed in a more general setup by Dessein (2004) and Hahn (2004), who assume consumer heterogeneity in terms of demand for calls and calling pattern. Carter and Wright (2003) and Peitz (2005) consider an asymmetric market with two-par tariffs in the presence of a demand side asymmetry, called brand loyalty, and leave the other segments (for instance costs) symmetric. In the case of reciprocal access fees, Carter and Wright state that the firm with brand loyalty prefers the socially optimal cost-based access fee and if brand loyalty is sufficiently strong, the other firm has the same preference. Therefore, a successful regulator should only require a reciprocal access fee and let the incumbent set it. Peitz emphasizes the use of a nonreciprocal access fee, since an asymmetric access price regulation which allows positive access markup for the entrant can be socially more desirable: it favors the entrant and increases consumer surplus at the same time. de Bijl and Peitz (2002, 2004) focus on the same type of asymmetry although they analyze the market in a dynamic set up and use simulation to support the previous theoretical results. They find that, independent from the type of access price regulation, the asymmetry among firms lessens over time; the entrant’s profit and consumer surplus increase and finally a symmetric equilibrium emerges. In their 2004 article, they extend their model including asymmetrical marginal costs and derive from their simulations results which are similar to their previous findings. The structure of the present chapter is as follows. In Section 6.2, we define all the terms and conditions which are used in this chapter and then present a model with uniform linear tariffs under linear demand for calls; in Section 6.3, we derive the equilibrium for nonlinear tariffs. In Section 6.4, we conclude. The proofs and simulation results appear in the Appendix section.


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6.2 MODEL FOR LINEAR TARIFFS

First we present a model in which we assume a market with linear demand for telephony consumption and seek to find arguments in the interest of implementing asymmetric access fees. Furthermore, this section defines the most important terms and introduces the assumptions used in this chapter; other versions presented will be expressed in terms of deviation from this setup.

6.2.1 Cost structure and access fee

Consider a market with two networks indexed by i = 1 2. To avoid Bertrand competition and to measure the effect of different pricing schemes on market shares, we assume that firms compete for consumers by means of a horizontally differentiated service on a segment 0 1; that is we consider the model for product differentiation à la Hotelling (1929). We assume maximal product differentiation, namely the firms are located at the two ends of the segment (x1 = 0 x2 = 1). Each firm incurs three types of costs: (i) Connection-independent cost. For instance, this could be the fee for a license or the cost of building up and improving facilities. These costs will be considered in the model as sunk costs. (ii) Connection-dependent but traffic-independent cost. This is the fixed cost fi of serving a consumer and, without loss of generality, we assume that the fixed cost is the same for both firms, that is, f1 = f2 = f . (iii) Traffic-dependent cost. This is a unit cost ciO of originating and ciT of terminating a call. For simplicity we assume that ciO = ciT = ci0 . We define the cost asymmetry in the level of marginal costs. Assume that firm 2 is more efficient, that is, 0 ≤ c20 < c10 and denote c ≡ c20 − c10 the difference in termination costs.

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The networks are interconnected, which means that, if a consumer subscribed to a firm originates a call, this call may be terminated on the rival firm’s network. In this case, the firm has to purchase access to ensure that its subscribers are able to call all consumers independent from their service provider and, therefore, the firm has to pay an access fee for each unit call terminated on the rival’s network. In the model, network i charges a per-unit access charge i for terminating its rival’s call and pays j per-unit fee to network j for terminating its call on network j. We assume that the access fee is not a decision variable of the firm but determined by regulation. Hereafter, we denote ≡ 2 − 1 . On the basis of the above definitions, the unit cost of a call can be determined depending on its origination and termination. If a call is originated and terminated on the same network (i.e., on-net call), say in network i, the total unit cost is equal to ci ≡ 2ci0 . However, if a call is originated in network i but terminated on network j (i.e., off-net call), network i incurs a unit cost of ci0 + j , and if a call of network j is terminated on network i, network i’s unit cost is equal to ci0 − i . To measure the deviation of the access fee from the termination cost, we use an access markup term which is i − ci0 . In case of a positive access markup, the access fee is larger than the termination cost, and in case of a negative access markup the termination cost exceeds the access fee.

6.2.2 Demand structure and consumer surplus

A consumer faces a two-step problem: in the first step he decides on whether or not to connect to a network, and in the second step he chooses the quantity of telecommunications services to be consumed. Consumers are homogeneous in the sense that each consumer receives the same fixed surplus of being connected (v0 ), and all consumers have the same utility function uq for telephony consumption. On the other hand, consumers are heterogeneous since they have different a priori preferences: a consumer values a service more when it is ‘closer’ to his preference. Let x denote the characteristic


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(location) of the consumer on the segment 0 1 and assume that the consumers are uniformly distributed on this segment. As the preference of a consumer is different from the characteristics of service supplied by the networks (i.e., different location), the consumer has to pay ’transportation cost’ (t > 0) which measures the disutility of not being a consumer of the ideal firm. Larger the t, the more differentiated the networks, that is, the less strong the substitutability between networks. We assume that t is the same for all consumers and the total transportation cost is a linear function of the distance. Applying these assumptions, the total utility of a consumer subscribed to firm i is equal to v0 − t x − xi + uq − pi q where 1. v0 is assumed to be high enough to provide full consumer participation in the market; 2. the second term represents the total transportation cost since the consumer travels a distance of x − xi , where xi denotes the location of the firm, which can be 0 or 1; 3. pi denotes the uniform retail price set by firm i. A price is uniform if a company does not differentiate prices depending on which network a call is terminated on; and 4. uq is the utility from telephony consumption q and is considered quadratic, that is,2 uq = q −

q2 2

therefore the demand function for telephony consumption is linear: qp = 1 − p. 2 We use a simple quadratic utility function because it fulfils the general assumptions; moreover, it makes the analysis easier since a linear demand function can be derived from the first order condition of utility maximization. We might also set up a more general model using the utility function uq = aq − bq 2 /2; however, this generality does not modify the main results.

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The sum of the first two terms measures the utility of being connected (traffic-independent surplus), and the sum of the last two terms measures the utility from telephony consumption (trafficdependent surplus). We can solve the consumer’s two-step problem by backward induction. In the second step, given the retail prices, a consumer decides about telephony consumption. The variable net surplus gained from consumption is as follows: vp = max uq − pq = q

1 − p 2 2

In the first step, a consumer chooses a network. The optimal network share of firms can be determined by finding a consumer, located in , who is indifferent between the networks, that is, v0 − t + vp1 = v0 − t1 − + vp2 Then , the network share of firm 1, is p1 p2 =

1 + vp1 − vp2 2

where = 1/2t is the measure of substitution. The inverse ratio between and t means that the larger the transportation cost, that is, the more ‘painful’ it is to be further away from the ideal network, the weaker the substitution between the networks. Let i denote firm i’s market share; in addition, we know that i is a function of the prices and 1 + 2 = 1. Introduce the notation vi ≡ vpi and qi ≡ qpi as well. In the model, we use the assumption of a ‘balanced calling pattern’, which means that each consumer, independent from the network he is subscribed to, is equally likely to be called by any other consumer. This implies that in case of homogenous consumers, the fraction of calls originating in a network which terminate on


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the other network is proportional to the latter network’s market share. For a given s = p1 p2 strategy profile, the total consumer surplus can be defined in the following way: Ss = 1 v1 + 2 v2 − D 1 where D measures the average disutility originating from the difference between the a priori preferences of consumers and the characteristics of services offered by the networks. Or, in other words, the function D· is the average traveling cost between the location of consumers and firms which is for any equal to 1 1− 1 2 + 1 − 2 D = + 1 − = 2 2 2 2 2

6.2.3 Price competition

We model the market as a noncooperative game in strategic form and seek to find a unique Nash equilibrium.3 There are two firms in the market with the previously described characteristics competing for consumers by choosing a price profile s = p1 p2 and at the same time maximizing their profit function: i s = i pi − ci qi − f + i j i − ci0 qj − j − ci0 qi (6.1) where the first part measures the retail profit from telephony consumption and the second part comprises benefits and costs derived from providing access to its rival and using its rival’s facilities (called access profit). In the Nash equilibrium, firm i maximizes its

3

The Nash equilibrium is defined for instance in Vega-Redondo (2003), p. 39.

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profit function (6.1) according to its price pi given the rival’s price pj , subject to 0 ≤ pi ≤ 1 0 ≤ i ≤ 1

i = 1 2

0 ≤ i Since the access profit depends on i j qi which is a fifth-degree function of pi , the first derivatives of the profit function are quartic, and therefore – and in our model only in case of linear prices – it is not possible to find a closed-form solution for the reaction functions and for the equilibrium prices. Moreover, the second derivatives are cubic, which makes the specification of equilibrium conditions very complicated. To avoid this calculation problem, we have used simulations,4 and from the results we derive conclusions about the existence of the equilibrium and about policy implications.

6.2.4 Comparison and policy implications

We find that for a very large cost difference and access markup and very strong substitution, there exists no equilibrium, which is a robust result of Armstrong (1998) and Laffont et al. (1998). Moreover, firm 2 has lower cost and for this reason it always sets a lower price and if its cost advantage is high enough, it might corner the market. Denote v ≡ v2 − v1 . A monopoly equilibrium can emerge if the following condition holds: v1 +

1 1 ≤ v2 ⇔ v ≥ 2 2

However, the cornering condition requires extreme cost difference (see the left edge of Figure 6.1 in Appendix A6.2.1); therefore, we

4

For simulations we used Mathematica 5.0.


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will solely focus on the more general case, namely the shared-market equilibrium. Another characteristic of the equilibrium is that the closer the cost difference is to zero, the closer the equilibrium is to the symmetric case (see Figure 6.1 in Appendix A6.2.1). The most important and most controversial point in the analysis is the determination of the access fee. As we discussed in the introduction, the relevant questions are whether to impose cost-based access fee regulation on both firms, or whether to allow for one firm to set an access fee containing a positive markup. As before, the main results for policy makers are derived from simulations. Let us use the difference in access fees ( ) for the policy implications, and assume that firm 1 is subject to a cost-based access fee. The equilibrium prices increase in and as a consequence, the net surplus a consumer receives decreases, thus lowering consumer surplus (see Figures 6.2 and 6.4 in Appendix A6.2.2). The intuition behind the increasing equilibrium prices is the following. As we discussed earlier, the less efficient firm 1 sets a higher price and supplies fewer telephone calls, or in other words, it faces a net inflow of calls. If increases (i.e., a larger 2 ), it meets a larger perceived marginal cost and for a given market share it has to undergo a larger per-consumer access deficit (or smaller access profit); therefore, the total access profit can be reduced by decreasing the product of market shares ( 1 2 ). Since 1 2 is smaller if the difference in market shares is larger, firm 1 is interested in moving away from the symmetric case, which can be achieved by a smaller market share and therefore a higher retail price. The more efficient firm 2 has the same preference over its own price change, although from exactly the opposite point of view. It wants to lower the net outflow of calls to raise the per-consumer access profit, which can be obtained in a more symmetric market by decreasing its market share and therefore charging a higher retail price. As another consequence, firm 2 gets higher per-consumer retail profit, and since firm 1 is interested in lowering its market share, firm 2 obtains higher total retail profit.

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Despite the increasing prices, if is larger, firm 2 receives a higher and increasing equilibrium profit, while firm 1 receives a lower and decreasing profit. This means that the two firms have divergent preferences over the access fee (see Figure 6.3). The industry profit changes in the same direction as the more efficient firm’s profit: it can offer a side-payment to the less efficient firm to compensate for a larger . Welfare changes in the same direction as consumer surplus. That is, a smaller (either a lower 2 or a higher 1 ) is more favorable for society (see Figure 6.4). As a policy implication, we find that the more efficient firm should not be allowed to charge an access fee exceeding its termination cost, while the less efficient firm may be allowed to do so.

6.3 COMPETITION IN TWO-PART TARIFFS

This section analyzes network interconnection and competition in two-part tariffs. In the symmetric models of Armstrong (1998) and Laffont et al. (1998), they obtain a profit-neutrality result, that is, the firms’ profit is independent of the access fee and equal to the Hotelling profit. Since the firms are indifferent over the access price, the cost-based access fee which is the socially optimal solution might be carried through. Emphasizing the asymmetric characteristic of telecommunications market, Peitz (2005) analyzes a situation in the presence of a demand-side asymmetry emerging from the incumbent’s stronger reputation or the lack of information about the entrant’s servicing quality. He claims that in this case the entrant might be allowed to charge an access fee larger than its termination cost since this policy increases its profit and consumer surplus. In this section, we look for the equilibrium in the presence of a cost asymmetry, and, with the expectation of asymmetric access pricing, answer the following question: what is the socially optimal access charge?


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6.3.1 Demand structure and consumer surplus

The consumers’ utility and demand functions are the same as those set in Section 6.2. However, in the present model each network offers a two-part tariff; therefore, a consumer of network i making q units of call pays Ti q = mi + pi q where mi is the fixed fee, for example, the monthly charge of usage, and pi is the per-minute charge. As a consequence, the net surplus a consumer obtains from subscribing to network i is equal to wpi mi = vpi − mi The network shares can be determined by finding the consumer, located in , who is indifferent between the two networks. This indifference means that wp1 m1 − t = wp2 m2 − t1 − From this expression, firm 1’s network share is ˆ 1 ˆs =

1 + wp1 m1 − wp2 m2 2

where = 1/2t is the measure of substitution and sˆ = p1 m1 p2 m2 is a possible price profile of the firms. Henceforth, denote vi ≡ vpi , qi ≡ qpi wi ≡ wpi mi and 1 ≡ w1 w2 =

1 + w1 − w2 2

For a given sˆ strategy profile the consumer surplus is the following: Sˆs = ˆ 1 ˆs w1 + ˆ 2 ˆs w2 − D ˆ 1 ˆs

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where D measures the average disutility originating from the difference between the a priori preferences and the characteristics of services.

6.3.2 Price competition

Firm i’s profit function is as follows: i ˆs = ˆ i ˆs pi − ci qi + mi − f + ˆ i ˆs ˆ j ˆs i − ci0 qj − j − ci0 qi To simplify the profit maximization, we rewrite the profit function of firm i using a modified strategy profile s = p1 w1 p2 w2 . Since with this modification the market share i is only the function of w1 w2 , the profit function becomes quadratic in pi : i s = i pi − ci qi + vi − wi − f + i j i − ci0 qj − j − ci0 qi

(6.2)

Hereafter, denote Ai ≡ i − ci0 qj − j − ci0 qi firm i’s per-consumer access profit. We intend to find the Nash equilibrium, in which each firm maximizes its profit functions (6.2) according to its price and the offered net surplus simultaneously, subject to 0 ≤ pi ≤ 1 0 ≤ wi

i = 1 2

0 ≤ i ≤ 1 0 ≤ i The first-order conditions of profit maximization are i = i −pi + ci + j j − ci0 = 0 pi


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and i = pi − ci qi + vi − f − wi − i − 2 wi − wj Ai = 0 wi

The first-order condition according to wi is quartic, therefore the equilibrium cannot be given in the regular closed form. However, the first-order condition according to pi is linear for non-negative market shares; therefore, the following proposition can be claimed about the equilibrium and its properties.5 Proposition 6.1 If Ai
c20 ), firm 1’s perceived marginal cost also increases, therefore, it sets a more higher per-minute price (p = c − 2 2 − c20 ).


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The difference between firms’ market shares is the following: =

−4 c 1 − 1 c1 − 2 c2 3 + c 2

which is positive for reasonable termination costs: 1 c1 + 2 c2 < 1

(6.6)

meaning higher market share for firm 2. Since each firm charges its perceived marginal cost as a perminute price, it gets zero profit from calls originating in its own network: the profit arises from the connection dependent profit and from incoming calls. Therefore, the difference in equilibrium profits is closely related to the difference in fixed fees, which in the case of a cost-based access fee is equal to

4 m c (6.7) = 1 − 1 c1 − 2 c2 1 −

c 2 + 3 This expression can be either negative or positive, so it is not obvious which firm sets a higher fixed fee. Under condition (6.6), the first two parts of (6.7) are negative, so that the sign of (6.7) depends on the last term. This term is positive for a relatively large cost difference or relatively strong substitution: c 2 > 1/

(6.8)

thus (6.7) is negative or in other words firm 2 sets smaller fixed fee. The intuition behind this result is the following. Firm 2 suffers a negative per-consumer access profit (A2 = c q1 < 0); therefore, its interest is to lower the total access profit and raise the total retail profit – that is, to move further away from the symmetric case. Since firm 2 has a larger market share, it wishes to increase its market share further by two means: by setting the per-minute price and the fixed fee properly. According to condition (6.8), because of its cost

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advantage, firm 2 can set a sufficiently small per-minute price so as to sufficiently increase its market share. Moreover, due to more intensive competition firm 2 has to compete for consumers by setting a smaller fixed fee than its rival without losing too much retail profit. In the opposite case, when the cost difference is relatively small or competition is less fierce (c 2 < 1/ ), firm 2 sets a higher fixed fee than firm 1 in order to receive a higher retail profit without losing consumers. The same argument can be applied to the difference between total profits. If the cost difference is relatively large or there is strong substitution between the firms’ services, as a result of a smaller fixed fee, firm 2 loses on retail profit and since it also faces negative access profit, it makes a lower total profit than firm 1. In the case of a lower cost difference, firm 2 is able to compensate its access deficit with a higher retail profit gained by a higher fixed fee. In order to analyze the effect of the access fee on equilibrium profits, we allow for the more efficient firm to slightly deviate from the cost-based access fee. In this case a small access markup does not affect the equilibrium market shares6 , so that the above results remain unchanged. According to this result, in a neighborhood of cost-based access fee i /2 = 0 holds. Applying this shows that the effect of an increment in 2 on equilibrium profits can be measured by the following derivatives: 1 = 21 2 c − q1 < 0 2 2 =c0 2 2 = 22 q1 > 0 2 2 =c0 2

Using these expressions, we state that profit-neutrality of the symmetric equilibrium no longer holds: the less efficient firm’s profit

6

The proof is similar to the proof in of lemma 1 in Peitz (2005), p. 356.


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decreases, and the more efficient firm’s profit increases in response to an increase in 2 . Peitz (2005) analyzes a market in case of symmetric costs and under a demand side asymmetry caused by the earlier entry of a company and realized in extra utility for its consumers (called brand loyalty). He claims that in this case consumer surplus increases as the late entrant is allowed to use an access markup. In our case, when there is no demand-side asymmetry but only the supply side asymmetry caused by different costs, we find a similar result: the consumers are better off with a lower access fee for the more efficient firm (or higher access fee for the less efficient firm), that is, the less advantageous firm might differ from cost-based access fee in the interest of consumers while its profit also increases. The smaller the cost difference, the smaller is the effect that the access fee has on profits and consumer surplus. The previous results are summarized in the following proposition:7 Proposition 6.2 In case of asymmetric costs, when costs are reasonable, that is, 1 c1 + 2 c2 < 1 and 2 < c10 , in a neighborhood around cost-based access fees a decrease in the more efficient firm’s access price gives rise to higher profit for the less efficient firm and higher consumer surplus. The smaller the cost difference, the closer is the equilibrium to the symmetric case where firms are indifferent with regard to an access fee change.

6.4 CONCLUSIONS

In the present chapter, we have analyzed network interconnection and competition under a supply side asymmetry, when one firm is more efficient and operates at a lower marginal cost. In contrast to the symmetric model, the two firms have divergent preferences over the access fee difference. As preceding papers show, in case 7

The proof is given in Appendix A6.1.

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of a demand-side asymmetry, a firm which has entered the market later may be allowed to set a higher access fee than its termination cost, thus resulting in a higher profit for itself and larger consumer surplus. We emphasize a supply-side asymmetry and find similar results: a positive access markup for the less efficient firm can make this firm and the consumers better off. As the results show, the access fee based on termination cost does not necessarily provide the socially optimal solution, since positive discrimination of a disadvantaged firm may intensify competition and increase consumer surplus. However, in a symmetric market where these asymmetries are eliminated, a cost-based access fee can provide a socially optimal outcome. As for the implementation of these results, it would be required to report precisely the costs and to analyze whether there are other types of asymmetries in the market. This chapter presented a model for telecommunications markets where operators have full coverage. The two-way access pricing is, therefore, applicable in mobile telephony, in local telecommunications and in the dynamically developing Internet market. However, in these markets operators do not always establish their own network, but they provide services through the rivals’ bottlenecks. In these cases, an analysis extended to other types of entry, namely local-loop unbundling and carrier select, would refine the results and their policy implications.

APPENDIX A6.1 PROOFS

Proof of Proposition 6.1 Suppose that profit function (6.2) is twice continuously differentiable. The first-order conditions of profit maximizations are i = i −pi + ci + j j − ci0 = 0 pi


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and i = pi − ci qi + vi − f − wi − i − 2 wi − wj Ai = 0 wi

where Ai = i − ci0 qj − j − ci0 qi is firm i’s per-consumer access profit. From these conditions we get the equilibrium values stated in the proposition: pi = ci + j j − ci0 mi = f + i − j j − ci0 qi + i − j Ai

1 i = + vi − vj + j j − cj0 qi − i i − ci0 qj 2 3 + cj0 − ci0 1 q1 + 2 q2 2 1 i = i + Ai

For the existence of the equilibrium, the following second-order conditions (SOCs) should hold: (i) 2 i = − i < 0 pi2 which holds if i > 0 and 2 i /pi2 = 0 if firm j corners the market. (ii) 1 2 i = −2 1 + Ai < 0 ⇔ Ai < 2

wi which states that the SOC according to wi holds if and only if for a given the per-consumer access profit is small enough or if is small so that there is weak substitution between the networks.

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(iii) Since 2 i 2 i = = − i j − ci0 pi wi wi pi therefore

2 2

i 1 2 i 2 i 0 2 + Ai > ⇔ i j − ci < 2 pi wi

pi2 wi2 This condition holds if i is close to ci0 which allows only a small access market. Proof of Proposition 6.2 The structure of the proof originates in Peitz (2005), who applied the methodology of supermodular games and monotone comparative statics of the equilibrium. Assume that firm 1 is subject to cost-based access fee, and firm 2 can freely set its access charge. Substituting the equilibrium prices (6.5) into the modified profit function (6.2) we find a pseudo-profit function: ˆ i w1 w2 pj = i v ci + j j − ci0 − wi − f + j i − ci0 qj from which the first derivative according to wi is ˆ i = v ci + j j − ci0 − wi − f + j i − ci0 qj wi + i j − ci0 q ci + j j − ci0 − 1 − i − ci0 qj If the second derivative according to wj is positive, the slope of the pseudo-reaction curve is positive (i.e., strategic complements), and if the second derivative according to 2 is also positive, the reaction


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curve moves outward in response to an increase in 2 , which means that the net equilibrium surplus increases with 2 . First consider the first derivative of firm 1’s pseudo-profit: ˆ 1 = v c1 + 2 2 − c10 − w1 − f w1 + 1 2 − c10 q c1 + 2 2 − c10 − 1 The second derivative according to w2 is equal to 2 ˆ 1 = 1 − 2 − c10 q c1 + 2 2 − c10 w1 w2 For any 2 < c10 this cross-derivative is positive, which means that firm 1’s best response function is upward sloping. Let us analyze the second derivative: 2 ˆ 1 = − q c1 + 2 2 − c10 + 1 2 2 − c10 w1 2 Since for reasonable costs (i.e., 1 c1 + 2 c2 < 1) the following expression is negative: 4 c 1 − 1 c1 − 2 c2 < 0 is positive meaning that firm 2 has a higher market share. Therefore, as an effect of a larger 2 , the second derivative is negative, thus moving firm 1’s reaction curve inward. This shift of reaction curve entails a lost in consumers benefit. Consider now firm 2’s first derivative function: ˆ 2 = v c2 − 1 c − w2 − f + 1 2 − c20 q1 w2 − 2 c q c2 − 1 c + 1 + 2 − c20 q1

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The cross-derivative according to w1 is equal to 2 ˆ 2 = c q1 + q c2 − 1 c − 2 + 2 2 − c20 q1 + 1 w2 w1 which is positive – in the neighborhood of cost-based access fee – if the cost difference is small: 0 − c 2 q1 + 1/ 2 2 c < q1 + q c2 − 1 c − 2 The second derivative according to 2 is equal to 2 ˆ 2 = − q1 w2 2 which is negative for reasonable costs (see the argument above). As a result of a larger 2 , firm 2’s reaction curve moves inward, thus resulting in lower surplus for consumers.

A6.2 SIMULATION RESULTS

In this section we show some results from simulations: first we illustrate a comparison for varying cost differences, then for different access fees.

A6.2.1 Comparison according to parameter values

In the following figure we present the difference in net surplus of consumers buying from different firms for decreasing disparity in termination costs. In the example c20 = 001

= 10 t = 005

f = 0


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0.06 0.05 0.04 Δv

0.03 0.02 0.01 0 –0.0779 –0.07

–0.06

–0.05

–0.04 Δc

–0.03

–0.02

–0.01

0

Figure 6.1 Difference in net surplus of consumers, decreasing c .

and, for simplicity, we assume that the firms are subject to an access fee on the basis of termination cost. In Figure 6.1 we indicate c on the horizontal axis and v on the vertical axis.

A6.2.2 Comparison according to access fee

To compare the effect of different access fees, we fixed the following parameter values: c10 = 002 c20 = 001 = 10 f = 0 1 = 002 In this case, the more efficient firm sets a cost-based access fee, and only firm 2’s access fee is changing. If = 0, then the access fees are reciprocal, and if = −001, both firms set a cost-based access fee. In Figures 6.2–6.4, equilibrium prices (pi∗ ), consumer surplus (S), profits (individual and industry, i and ≡ 1 + 2 , respectively) and social welfare (W ) are shown. In these figures we indicate on the horizontal axis and the above-mentioned equilibrium values on the vertical axis.

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Viktória Kocsis p1*,

p2*

0.095 0.09 0.085

0.08 0.075 0.07 –0.02

–0.01

0.00

0.01

0.02

0.03

0.04

0.05

0.04

0.05

ΔT

Figure 6.2 Equilibrium prices, increasing .

π1,

π2,

π

0.06 0.05 0.04 0.03 0.02 0.01 0 –0.02

–0.01

0.00

0.01

0.02

0.03

Δτ

Figure 6.3 Maximal individual and industry profit, increasing .

Chapter 6 – Access Pricing Under Cost Asymmetry S,

175

W

0.47 0.46 0.45 0.44 0.43 0.42 0.41 0.4 –0.02

–0.01

0.00

0.01

0.02

0.03

0.04

0.05

Δτ

Figure 6.4 Consumer surplus and social welfare, increasing .

REFERENCES Armstrong, M. (1998). Network interconnection in telecommunications. Economic Journal 108, 545–564. Carter, M. and J. Wright (2003). Asymmetric network interconnection. Review of Industrial Organization 22, 27–46. de Bijl, P. and M. Peitz (2002). Regulation and Entry Into Telecommunications Markets. Cambridge University Press. de Bijl, P. and M. Peitz (2004). Dynamic regulation and entry in telecommunications markets: A policy framework. Information Economics and Policy 16, 411–437. Dessein, W. (2004). Network competition with heterogeneous customers and calling patterns. Information Economics and Policy 16, 323–345. European Parliament and Council (2002). Directive 2002/19/EC of 7 march 2002 on access to, and interconnection of, electronic communications networks and associated facilities (Access Directive). Official Journal L 108, 7–20. Hahn, J.-H. (2004). Network competition and interconnection with heterogeneous subscribers. International Journal of Industrial Organization 22, 611–631. Hotelling, H. (1929). Stability in competition. Economic Journal 39, 41–57. Laffont, J.-J., P. Rey, and J. Tirole (1998). Network competition: I. Overview and nondiscriminatory pricing. RAND Journal of Economics 29, 1–37. Peitz, M. (2005). Asymmetric access price regulation in telecommunications markets. European Economic Review 49, 341–358. Vega-Redondo, F. (2003). Economics and the Theory of Games. Cambridge University Press.


PART III

Access Pricing and Multihoming



CHAPTER 7

Interconnection Competition with Multiple Network Subscription ROGER K. ALEXANDER∗ The Senbazuru Group, Rockville

Contents 7.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 7.1.1 Background to new analysis framework 180 7.1.2 Organization of this chapter 182 7.2 CONSUMER UTILITY MODEL SETUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 7.2.1 Consumer discrete subscription choice model 184 7.2.2 Direct measurable utility from network subscription 193 7.3 NETWORK COMPETITION – DUAL NETWORK SUBSCRIPTIONS . . . . . . . . 199 7.3.1 Network marginal costs and price competition model 199 7.3.2 Network calling pattern 200 7.3.3 Two-stage network competition 201 7.4 NETWORK COMPETITION MODELLING: LINEAR PRICING . . . . . . . . . . . . . 209 7.4.1 Equilibrium price–access charge relationship 209 7.5 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 7.5.1 Summary and general findings 216 7.5.2 Future areas of study 218 APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 A7.1 Dual network subscription example 218 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227

∗

I would like to acknowledge Chris Snyder and John Kwoka for their prior assistance, guidance, and discussion.

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7.1 INTRODUCTION

Today telecommunications technologies have emerged that have the potential to greatly expand the number of alternatives for implementing local access voice and data communications networks. In particular, wireless (fixed and mobile), cable television, and even broadband power line systems offer viable alternatives to the infrastructure offered by previous monopoly wireline network operators. Of particular interest as these technologies expand is the issue of regulation and competition in the provision of local access network services.1 With the entry of facility-based access providers, regulation emphasis shifts to the conditions and mechanisms of bilateral interconnection or ‘two-way’ access among network providers (see Laffont and Tirole, 2000, Chapter 5). In addition, competition will include not just a single network choice but also the potential ability of users to subscribe to multiple networks and to substitute calling demands across these subscriptions. Beyond voice and access networks, the issue of two-way network competition among interconnected networks will also be particularly important in the emerging areas of electronic mail and messaging infrastructures as well as more traditional areas of interconnected bank ATM networks, airline systems (which allow passengers affiliated to one airline’s programme to use a competing airline’s service in completing a trip to a given destination) and among credit card networks (as cited by Laffont et al., 1998a). For these types of networks, multiple network subscription is also particularly relevant.

7.1.1 Background to new analysis framework

Using Hotelling (1929) based models, a consistent finding of the prior research on two-way network interconnection (see Armstrong,

1

See Woroch (2002) for a survey of the economic analysis of competition in markets for local telecommunications services.

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1998; Laffont et al., 1998a; and Carter and Wright, 1999), is that freely negotiated access pricing, which determines the price that one network charges another for the completion of calls on its network, provides a mechanism for collusion over retail prices even in the presence of retail price regulation. Since the access charge influences the network’s marginal cost per call it affects the network’s profit-maximizing retail price. Each network can therefore raise its competitor’s cost by increasing the price it charges for call completions, allowing higher retail prices to be maintained. Laffont et al. (1998a) refer to this as the raise-each-other’s cost mechanism. Higher marginal costs lead to higher equilibrium prices under linear pricing with a sufficiently high access charge, ultimately permitting a monopoly equilibrium price to be achieved. This conclusion regarding the collusive effect of access charges has been shown to hold for a number of variants of the basic Hotelling interconnection model with two competing networks (see Dessein, 1999 and Hahn, 2004) and to hold under assumptions of a fully covered market (where all consumers are subscribed) as well as under conditions of partial consumer participation (see Schiff, 2002). What the current research does in recognizing the reality of multiple access network options is establish a more general framework model to address the dual effects of horizontal network subscription competition as well as the potential for multiple network subscription2 and resultant call substitution across networks. This work is intended to answer the question of whether prior conclusions still hold when the additional element of call substitution is introduced within a multiple network subscription environment. For the cross-nested logit (CNL)3 /constant elasticity of substitution (CES) model developed in this study, the following linear

2

Jeon et al. (1998) provide an analysis of network interconnection competition in which dual network subscription is considered but rely on a model setup in which customers subscription to one network is exogenous. 3 Doganoglu and Tauman (1998, 2002) have applied a logit model to analyse network subscription competition but do not consider extensions to a cross-nested logit and the mechanisms for simultaneous subscription to more than one network.

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pricing results are derived through analysis and simulation of network competition between networks: • For horizontally differentiated networks, access charges remain an instrument of tacit collusion even when consumers can subscribe to more than one network. • For low calling demand elasticity, the ability of consumers to subscribe to more than one network makes competition more vigorous than single network-only subscription, independent of the degree of network differentiation. (1) The market becomes more competitive as calling substitutability across networks increases. (2) The market becomes more competitive as network subscription utility encourages more consumers to be dual network subscribers. • The primary competitive benefit of dual network subscription can be realized after only a limited percentage of subscribers become dually subscribed. • Once a sufficient level of dual network subscription is achieved, high call substitutability across networks results in a competitive market environment even for highly (horizontally) differentiated networks. (1) If calling is highly substitutable across networks, there is greater competitive benefit to fostering increased dual network subscription than seeking optimal access charge setting.

7.1.2 Organization of this chapter

The remainder of this chapter is organized as follows. Section 7.2 provides an overview of the general interconnection model including the CNL tree structure used to specify discrete network subscription choices and the CES calling model used to derive the continuous calling demand and the utility obtained from a given network subscription choice. Section 7.3 provides an example of how the generalized model is applied to the analysis of two interconnected


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networks with dual network subscription. Section 7.4 considers the network competition analysis for the case of linear pricing using the developed model CNL/CES model under assumptions equivalent to those applied in prior studies. Section 7.5 provides results obtained from the model’s application to linear pricing. Section 7.6 offers conclusions and a general summary of the major insights of the new model.

7.2 CONSUMER UTILITY MODEL SETUP

This analysis is based on a discrete-/continuous-choice model in which the discrete network subscription choice and continuous calling demand both flow from the same underlying consumer utility maximization decision (see Hanemann, 1984). Consumers face a discrete-choice problem in selecting their network subscription from a set of alternatives that include single or multiple network combinations. For each subscription alternative, the consumer considers the fixed utility derived from the horizontal attributes of the networks comprising the alternative as well as the variable utility that would be derived by maximizing calling utility across the individual networks within the alternative. The discrete choice of network subscription alternatives4 in the developed analysis framework is based on a CNL model,5 which allows consumers to make discrete choices involving one or more of the competing networks. The analytic CNL model is used to create nests of interrelated subscription alternatives representing feasible discrete consumer choices, ranging from ‘no network subscription’ 4

Note: The use of a discrete choice model for the selection of network subscription is an appropriate specification given that the choice alternatives are substitute goods without complementarities. 5 The CNL model was introduced by McFadden (1978) and has been extensively developed and applied in the transportation studies area (see Wen and Koppelman, 2001; Ben-Akiva and Bierlaire, 1999; Bierlaire, 2001; and others). See Bierlaire (2001) for a review and analysis of the general class of CNL models.

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to different ‘single network subscription’ to ‘simultaneous subscription’ to ‘multiple networks’. A CES calling utility specification provides the mechanism for consumers to evaluate the maximization of calling utility when faced with a subscription alternative that allows calling on multiple networks. The CES specification also provides the flexibility to incorporate a measure of the calling differences across network types. The resulting consumer maximizing calling demands and call flow across networks derived from the CNL/CES model drive differentiated network competition in the same way as calling demands and call flows derived from a Hotelling based model.

7.2.1 Consumer discrete subscription choice model

Random utility theory, introduced through models proposed by Luce (1959) and Tversky (1972) provides a framework that can capture both the observable, deterministic components of network subscription utility as well as the unobservable (from the network/firm’s perspective) consumer-specific random components (see Anderson et al., 1992 and Ben-Akiva and Bierlaire, 1999). The utility that the consumer derives from a given subscription alternative can therefore be fully consistent with individual utility maximization even though the firms’ decisions are based on probabilistic distributions of consumer responses. The economically rational consumer chooses a subscription alternative that maximizes total received calling and noncalling utility. In the developed model, the observable (from the network’s perspective), measurable attributes of a network subscription alternative are those related primarily to calling – calls made and received. The unobserved, nonmeasurable attributes are specific to the individual consumer whose taste varies and who may also have limited understanding or awareness of the unique characteristics or offerings of particular network.


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The observable, calling related utility applies equally to all consumers and are captured within the CES utility specification, including: • net utility derived from making calls at the price(s) charged by the network(s); • net utility derived from receiving calls at the price charged by the network; • calling differences across network types (captured by CES substitution parameter); and • calling utility differences6 across network types (captured by CES distribution parameter). The nonobservable attributes of utility that relate to individual consumers’ tastes may include elements such as: • preference for certain customer care and billing support offerings; • differing awareness of network service offering based on the effectiveness of network advertising; • preference for the range of service plans and offerings; • preference for the availability of different models of user products; and • preference for the range of other services that may be offered as part of a network ‘bundle’. It is through these unobservable (horizontal) attributes that a distribution of individual subscription choices results even when all consumers in the population are offered the same set of network subscription alternatives. 7.2.1.1 Random utility model

Each consumer’s network subscription decision is based on choosing the network or network combination that provides the highest utility.

6

In terms of the range of environments, opportunities for service access, or overall access grade of service (GOS).

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Therefore, the probability that network alternative i is chosen by the nth consumer from the choice set C of subscription alternatives, is given by PiC = PV˜ in ≥ V˜ jn

∀ j ∈ C

That is, PiC = PV˜ in = max V˜ jn j

Here the total conditional utility that the nth subscriber derives from subscribing to the ith network combination alternative, V˜ in , is a random variable given by V˜ in = V i + ni ∀i ∈ C, where V i is the observed or measurable utility derived from subscription to the ith network combination alternative. This utility component is independent of individual user tastes and applies equally to all consumers, and ni is the random element that captures the unobserved, idiosyncratic tastes of individual subscribers with regard to their preference for the collective ‘characteristics’ of a given network subscription alternative. ni is extreme value type (Gumbel)7 distributed which closely approximates the normal density.

7

The general formula for the probability density function of the Gumbel (maximum) distribution is given by fx =

1 −x−¯x/ −e−x−¯x/ e e

where x is the location parameter and is the scale parameter. The Gumbel (extreme value type) probability distribution for the random error terms leads to the logit family of distributions that provide closed-form probabilities of subscribing to each of the discrete network subscription alternatives (see Ben-Akiva and Lerman, 1985, Chapter 5).


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7.2.1.2 Application of CNL model to network subscription

The multinomial logit model (see Mc Fadden, 1978 and Ben-Akiva and Lerman, 1985) provides a basis for modelling the choice of discrete subscription alternatives where the unobserved random terms are independent, identically Gumbel distributed. With such an error (random) term distribution, the probability that a consumer chooses alternative i within the choice set C is specified by the multinomial logit (MNL) PiC =

expV i j∈C expV j

where V i is the total measurable utility associated with a particular alternative. However, the fact that the MNL imposes the restriction that the distribution of the random error terms is independent and identical over alternatives creates a problem for its application to multiple network subscription choice. For multiple network subscriptions where alternatives include one or more single network subscription components, the independent, identically distributed assumption for random error terms will not hold. For certain applications, the limitation of the MNL model can be addressed by logically partitioning the choice set to reflect the correlation between alternatives. The nested logit (NL) model (Ben-Akiva, 1973) is obtained when the alternatives of the overall choice set C are partitioned of into several nests Ck such that C = Ck and Ck ∩ Ci = ∀k = i k

where the choice set, C, is partitioned into subsets or nests having several observable or unobservable characteristics in common such that the random error terms across nests are independent and identically distributed (see Ben-Akiva and Lerman, 1985, Chapter 10). However, for multiple network subscription where different alternatives can include individual network components, it is not possible to

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unambiguously assign different subscription alternatives to different, independent nests. The CNL model (McFadden, 1978 and Small, 1987), on the other hand, where alternatives may belong to more than one nest, overcomes the limitation of the MNL and NL models.8 With the CNL model, for each alternative i and nest m, parameter im represents the degree of membership of the alternative within the nest. These parameters and the cross-nesting of alternatives allows for covariance between alternatives with contributions from each of the choice subsets in which the alternatives are jointly nested. 7.2.1.2.1 Multiple network subscription – CNL tree structure The CNL subscription model will be capable of supporting the range of subscription options available in environments where consumers have a choice of one or more network types. A tree structure of the discrete choices is defined by partitioning choices on the basis of network type where nests are formed by grouping alternatives according to a given individual network type (where a single alternative can belong to more than one nest). The only restriction in this easy, logical segmenting of subscription alternatives is that subscription to more than one network of a given type is not a feasible subscription alternative.9 An example is given below. 7.2.1.2.2 Example tree structure based on common elemental network type Consider the case of network competition in which the different network types may include, for example, (i) fixed wireline networks,

8

The CNL model has been shown to belong to the class of generalized extreme value (GEV) models by Bierlaire (2001) and hence, as shown by McFadden (1978), is consistent with random utility maximization. 9 This restriction does not have any significant impact on the nesting approach but is related to the CES calling utility specification where the substitution parameter reflects the degree of calling substitutability across network types. To address requirements for modelling competition that involves subscription to multiple networks that may be of the same type, a new subtype can be defined that groups the networks with common attributes.


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i wireless networks, (iii) cable networks, etc. Let N = (ii) i mobile i i N1 N2 Ns be the set of s type-i networks. We can, for example, consider an access environment with a single wireline (type 1) network, two competing mobile (type 2) networks, and a single cable (type 3) network. That is,

N 0 = no network subscription N 3 = N13 N 2 = N12 N22

N 1 = N11

7.2.1.2.2.1 Type-1 network subscriptions nest All network subscription alternatives that include subscription to a type-1 N 1 network will form part of a common correlated choice set. This will include single, dual or even triple network subscriptions. The alternatives that make up this type-1 nest will thus include: 1 • single network subscriptions: N 1 = N 1 1; 2 1 2 1 2 • dual network N = N1 N1 N1 N2 and N11 N 3 = subscriptions: N 1 N11 N13 ; and • triple network subscriptions: N11 N13 N 2 = N11 N13 N12 N11 N13 N22 .

The type-1 nest will therefore be comprised of six alternatives. The logic of this partitioning structure is that for consumers interested in selecting a subscription that possesses the attributes of a type-1 network, there are multiple options (which are correlated with each other along the dimensions of the type-1 network attributes). 7.2.1.2.2.2 Type-2 network subscriptions nest All network subscription alternatives that include subscription a type-2 N 2 network will form part of a common correlated choice set. This will include single, dual or triple network subscriptions. The alternatives that make up this type-2 nest will thus include: 2 2 • single network subscriptions: N 2 = N 1 1N22 ; 1 2 1 2 • dual network subscriptions: N N = N1 N1 N1 N2 and N13 N 2 = 1 3 2 3 2 N1 N1 N1 N2 ; and • triple network subscriptions: N11 N13 N 2 = N11 N13 N12 N11 N13 N22 .

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This nest will therefore be comprised of eight alternatives each having a single type-2 network subscription. 7.2.1.2.2.3 Type-3 network subscriptions nest All network subscription alternatives that include subscription to a type-3 N 3 network will form part of a common correlated choice set. This will include single, dual or triple network subscriptions. The alternatives that make up this type-3 nest will thus include: 3 • single network subscriptions: N 3 = N 1 3; 2 3 2 3 2 • dual network subscriptions: N1 N = N1 N1 N1 N2 and N11 N 3 = 1 3 N1 N1 ; and • triple network subscriptions: N11 N13 N 2 = N11 N13 N12 N11 N13 N22 .

This nest will therefore be comprised of six alternatives each having an elemental type-3 network subscription. Figure 7.1 illustrates graphically the tree structure for the available discrete, single and multiple network subscription alternatives. In addition to being able to nest network subscription alternatives on the basis of network type, covariances across subscription alternatives are incorporated through the fractional weights, im . 7.2.1.2.2.4 Membership allocation of cross-nested alternatives The only constraint to be observed is that im , representing the degree of membership of alternative i in nest m, has to be given by 0 ≤ im ≤ 1 (see Ben-Akiva and Bierlaire, 1999 and Wen and Koppelmann, 2001). With alternatives nested on the basis of a common network type, fractional allocation of alternatives can therefore be logically assigned according to the number of networks that comprise the subscription alternative. For example, if the subscription alternative is comprised on a single network, then im = 1. Where the subscription alternative is comprised of two networks and will therefore belong to two nests, then im = 1/2. Similarly, for an nth order subscription combination alternative, in each nest in which it appears, im = 1/n. The rationale for such a membership allocation is the assumption of an equal weighting of importance to the attributes offered by each individual network. Where a subscription

Type 3

α63 N13 N22N11

α53 N13 N12 N11

α43 N13 α33 N13 N22

N12

α23 N13 N11

α13 N13

Type 2

α82 N22 α72 N12 α62 N22 α52 N12 N11N13

N11N13

N13

N13

Type 1

α42 N22

α32 N22

N11

N11

α22 N22 α12 N12

No subscription

α61 N11

α51 N11

α41 N11

α31 N11

α21 N11

N22N13

N12N13

N13

N22

N12

Figure 7.1 Network subscription alternatives including fractional cross-nested components.

α21 N11

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alternative includes n networks, the effect of that network combination on the selection of any of its component single network alternatives will be 1/nth that of the single network subscription alternative itself. Such a network combination will also be present within n nests, thereby allowing each subscription alternative to be uniformly weighted within the full discrete choice tree. 7.2.1.2.3 Network subscription probabilities For the nth consumer, the utility associated with each network subscription alternative i is given by (see Ben-Akiva and Bierlaire, 1999) n V˜ im = V i + in + mn + ln im /m

where V i is the observed, measurable component of utility for ith subscription alternative, in is a component of the unobserved utility and is independent, identically Gumbel distributed, mn is the unobserved component of utility associated with alternatives of the mth nest and are also assumed to be independent and identically Gumbel distributed with scale parameter m . The error terms in and mn are assumed independent. The parameter reflects the correlation or degree of substitutability or horizontal differentiation among the nests of alternatives (defined along the dimension of different network types) while m reflects the correlation or degree of substitutability among alternatives within the nest Cmn . These parameters will be indicative of the degree of differentiation between network alternatives. The smaller the values of and m , the greater the degree of horizontal network differentiation. The measure of variance among alternatives within a nest, m , can differ across nests but must satisfy the requirement that 0 ≤ /m ≤ 1 (i.e., the heterogeneity of preferences at the lower branches (network types) are at least as great as within the nested branches).10

10

Note: the CNL model may be ‘normalized from the top’ where the scale parameter is set to 1. Alternatively, normalization from the bottom can be used where m = 1 for all nests where that is appropriate to the choices considered.


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Therefore, once the tree of subscription alternatives and associated measurable utility for each alternative has been defined, the CNL model allows a direct determination of the probability that a consumer chooses a particular alternative. Where the full set of discrete choices available to the nth consumer, Cn , has been partitioned into m nests, Cmn , and where for each alternative i, the parameter im 0 ≤ im ≤ 1 represents the degree of membership of alternative i within nest m, the probability that the nth consumer chooses the subscription alternative i (single or multiple network) is given by PiCn =

M

PCmn Cn PiCmn

m=1

where PCmn Cn =

expV Cmn M expV Cjn

j=1

expm V in PiCmn = im km expm V kn k∈Cmn

and V Cmn is the expected value of the maximum of the utilities given by the alternatives within the mth nest. That is, V Cmn =

1 ln expm V kn m k∈Cmn km

7.2.2 Direct measurable utility from network subscription

The consumer is an economic agent that derives a gross surplus from making (and receiving) calls and therefore optimizes over the volume of calls made on each of the networks of its subscription alternative. The following sections define the components of V i , the

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deterministic, measurable network subscription utility component of V˜ in , the individual consumer utility random variable (from the perspective of the network). In its general form, the measurable net utility that a consumer derives from the network subscription alternative i, is given by Vi =

vj + Voi p1 p2 pt −

j∈i

Fj

j∈i

where vj is the fixed utility derived from having connectivity through network j within the subscription alternative i,11 Voi p1 p2 pt is the net indirect utility derived from originating (making) calls on the available networks within the subscription alternative i, given the price per call charged by each network, and Fj is the cost of subscribing to each network j within the subscribed network combination alternative. t is the total number of networks to which the consumer can potentially subscribe (i.e., number of network types). 7.2.2.1 Fixed utility from network connectivity

A fixed utility value is associated connectivity for each network to which a consumer is subscribed. This value will capture the associated utility benefits from having network connectivity. For the specified network utility model, a scalar value of vj = Aj for j = 1 2 t defines the utility from connectivity to a particular network. A value v0 = 0 is assigned for consumers that are not subscribed to any network. Where networks differ, based on elements of vertical differentiation, such as considerations of ’brand loyalty’ (as analysed by Carter and Wright, 1999), or the added utility from mobile network subscription, network-specific values of vj can be applied. 11

It is arguable that the fixed utility from network subscription is not linearly additive with a multinetwork subscription. It may, for example be given by maxj vj . The scalar parameter allows a flexible specification that can weight the utility from each network.


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Where a subscription alternative is comprised of subscription to multiple networks, the consumer obtains a weighted sum of the network connectivity utility. The consumer thus derives a fixed subscription utility given by j∈i vj where 1/g < ≤ 1 and g is the number of networks that comprise subscription alternative i. 7.2.2.2 Net utility from calls originated

A general CES form is used to specify the utility derived from making calls when a consumer is subscribed to one or more networks. This specification allows the model to address calling substitution across network types. It is also well defined for positive levels of calling and is continuous, differentiable, monotonic and strictly quasiconcave. The CES specification also allows the model to incorporate calling differences across network types. The CES substitution parameter reflects the imperfect call substitutability between network types unlike the homogeneity of calling assumed in Hotteling-based models. For each subscription alternative, the utility (variable gross surplus) derived solely from making calls is given by uq1 qk qt =

t

/

qi

i=1

where qk is the calling demand generated on kth network of a given subscription alternative, is the CES substitution parameter for making calls across multiple subscribed networks and is the CES returns-to-scale parameter for calling. As shown below, this form will apply for single or multiple network subscriptions. 7.2.2.2.1 CES calling utility elasticity of substitution parameter The substitution parameter, , provides a measure of the substitutability of calling between each of the networks to which a consumer is subscribed. The closer is to 1, the higher the elasticity

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of substitution. For = 1, calling on different networks will be perfect substitutes. For the developed network competition model, the elasticity of substitution for calling on different network types (when subscribed to multiple networks) will be limited to the range 0 < ≤ 1.12 In practice, access on different network types will be highly substitutable → 1. 7.2.2.2.2 CES calling utility returns-to-scale parameter The CES returns to scale parameter provides an important measure of the consumers’ preference for calling. By defining the returns from increased calling, this parameter determines the consumers’ elasticity of demand for calling on the subscribed networks. The range of values of can be derived, given the assumption that the marginal utility of calling on any network will be positive ceteris paribus and that consumers will become satiated from making calls. Calling satiation implies diminishing marginal utility from increased calling. These assumptions therefore require that

uq1 qk qt >0 qi 2 uq1 qk qt s 2 − 1 − 1

for <

Proposition 7.1 With single network subscription sd = 0, when access charge is equal to the marginal cost of call termination a = c, the linear price markup over marginal cost of calling (origination and termination), will be a function of the degree of horizontal differentiation among the competing networks.


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For sd = 0, it follows that 1 1 s p − 2c = 1 + a − c p p −1 p Hence, when access charge is equal to the marginal cost of call termination a = c, it follows that 1 p − 2c = p p Hence for the case of single network only subscription sd = 0 and a fully covered market, at the (symmetric) equilibrium, p = s +

p qp 4

where

1 s = − −1

and

s1 =− qp p1 4

Therefore, with single network subscription only, where a = c, it follows that p − 2c/p = 1/p where 0 < p < . Hence p > 2c even when access charge is not a collusive instrument. That is, there is a price markup that is supported as a result of the horizontal network differentiation. Corollary 7.1 With single network subscription only, the greater the horizontal differentiation among competing networks, the greater will be the equilibrium price markup when access charge is equal to marginal cost of call termination. Since p/ > 0, it follows that the price markup over marginal cost when a = c is dependent on the degree on network differentiation, , where a lower value of reflects an increased network differentiation. The intuition for this result is that increased network differentiation makes consumers less likely to

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switch from the network that more closely provides to their idiosyncratic tastes. This increases the market power of the networks and provides increased friction to network competition, thereby allowing for higher equilibrium price markups above marginal cost. Proposition 7.2 With dual network subscription sd > 0 when access charge is equal to the marginal cost of call termination a = c, if calling across networks is perfectly substitutable, → 1 (i.e., there is no difference in calls made on either network), the interconnection market will be purely competitive with price equal to the marginal cost of calling (origination and termination). With dual network subscription, when access charge is equal to the marginal cost of call termination a = c, the price markup is a function of call substitutability as well as (horizontal) network differentiation. That is, p − 2c/p = 1/p where for dual network subscription (Alexander, 2003), s sd p = + s + sd s s + sd d s sd p − + s + sd p p where s and d are the elasticities of demand for single and dual network subscribers, respectively, on the subscribed network(s): 1 − − 1 − − 1 and d = > s for < s = − −1 2 − 1 − 1 Hence, it follows that as → 1 d → and therefore for a finite level of dual network subscription sd > 0 p → as → 1. Therefore, for dual network subscription, where a = c, it follows that as → 1 p − 2c/p → 0. That is, the profit-maximizing equilibrium price approaches the marginal cost per call (at a = c) even if the networks are highly differentiated. The intuition for this result is that high call substitutability implies that network revenues can change significantly due


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to price change even if market share does not change significantly. Call substitutability therefore provides an additional competitive element that forces networks to respond to price changes by its competitor even if market share is not significantly affected by the price change. The net result is re-energized price competition even for highly differentiated networks. 7.4 NETWORK COMPETITION MODELLING: LINEAR PRICING

A principal focus of this chapter has been on the recognition that consumers have the opportunity to subscribe to multiple networks for the provision of local access services. This significantly affects the competitive environment previously analysed in the literature on access pricing. Under linear pricing, the ability of consumers to subscribe to multiple networks increases the effective elasticity of demand faced by the competing networks and leads to a more competitive market environment. This section presents the results of a numerical simulation model used to investigate and confirm this proposition. 7.4.1 Equilibrium price–access charge relationship

Using simulation of the CES/CNL competition model, the following results were obtained for the direct relationship between the reciprocal access charge and the individual firm’s profit-maximizing equilibrium price p∗ under network competition when dual network subscription is supported. The case of dual network subscription sd > 0 is also compared with the results of single network only subscription sd = 0 to determine the conditions under which dual network subscription makes the market more competitive. 7.4.1.1 Single network only subscription

Figure 7.3 illustrates the relationship between the firm’s profitmaximizing price, p∗ , and the reciprocal access charge, a, for the

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case in which consumers subscribe to a single network only. This figure confirms the main result of the prior access pricing literature regarding the relationship between access charges and the noncooperative profit-maximizing linear prices. That is, for access charge, a, close to the marginal cost of call termination, c, and network substitutability not too high,17 p∗ /a > 0. An increase in the reciprocal access charge can therefore be used to increase the firms’ profit-maximizing equilibrium price. The value of the access charge determines the networks’ effective marginal cost per call, therefore as shown by Laffont et al. (1998a), Armstrong (1998), and others, by negotiating sufficiently high reciprocal access charges, under retail price competition, can achieve a price markup above marginal costs. The particular numerical result in Figure 7.3 is based on a model setup in which the marginal cost or call origination (or termination) is ci = 01 and the consumer elasticity of demand for calling is such that the joint firm monopoly price is p∗ = 10. This single network subscription linear pricing relationship is, however, robust to the parameter specifications of the CNL/CES model. As discussed in the prior literature, the setting of access charges provides a mechanism to maintain network prices above marginal

Equilibrium price, p *

1 0.8 0.6 0.4 0.2 0 0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a

Figure 7.3 Profit-maximizing symmetric equilibrium price as function of access charge (single network subscription only).

17

That is, substitutability must not be so high that the network that charges the lower price will obtain all subscribers.


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costs since at a symmetric equilibrium any attempt by one network to increase its market share by reducing its price will result in a net inflow of calls to that network. If the access charge is set above the marginal cost of call completion, the net inflow of calls will result in a net access deficit, which acts as a countervailing force to a unilateral decrease of the equilibrium price. 7.4.1.2 Single versus dual network subscription competition

Figure 7.4 illustrates the networks’ profit-maximizing price p∗ as a function of access charge when consumers are able to subscribe to one or both networks. As in the case of single network subscription only (also shown), increases in the reciprocal access charge allow the competing networks to raise the market equilibrium price. That is, p∗ /a > 0 for sd > 0. While the result in Figure 7.4 is based on a specified set of model parameter assumptions relatively high call substitutability across networks = 08, relatively low consumer elasticity of demand = 02, and the specified network substitutability values = 50 and m = 200, it is representative of the effect of dual network subscription on access network competition. The CNL/CES model setup shows that where call substitutability between networks is high and consumer demand elasticity low (consistent with expectations for telecommunications access networks), dual network subscription leads to a more competitive environment than that assumed by


1 Single Network Subscription Only

0.8 0.6 0.4

Single & Dual Network Subscription

0.2 0 0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a

Figure 7.4 Profit-maximizing symmetric equilibrium price as function of access charge.

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single network only subscription, for any given level of network substitutability (where ≤ m ). The introduction of dual network subscription and the ability of consumers to substitute calling across the networks is shown to make the market more competitive. The high degree of call substitutability and the existence of dual network subscribers allows many subscribers the option of substituting calling demand across networks. Therefore, at any symmetric equilibrium, a price decrease by one network will result in a higher fraction of the calls made by dually subscribed consumers being shifted on that network. This will occur even if calling demand for single network subscribers and the network subscription shares of single and dual network subscribers do not change significantly. A higher access charge will therefore be required to counter the revenue benefits of the increased calling demand and hence eliminate the incentive that the firm has to unilaterally reduce price. Claim 1 With dual network subscription, the access charge continues to be an instrument of tacit collusion. Provided the equilibrium p1 = p2 = p∗ a exists, then p∗ a increases with a. Claim 2 For low calling demand elasticity, dual network subscription makes market more competitive than ‘single network only’ subscription, independent of the degree of network differentiation. Intuition For single network subscription, a firm that reduces price has a net call outflow, which incurs an access charge this has the effect of raising average cost per call and acts as a countervailing force. The firm with the higher price only experiences a decrease in profits due to reduced market share while calling per subscriber remains unaffected. The increased access revenues also offset the potential profit loss. Countervailing forces that make price deviations from equilibrium less likely therefore impacts both firms. With dual network subscription and highly substitutable calling, the call outflow phenomena is similar but in this case the firm with higher calling price may suffer a significant drop in calling demand (due to reduced calling by dual subscribers on that network) due to reduced


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friction of call substitution. This creates the tendency for a resultant competitive lowering of prices. The firm that lowers price also has a greater incentive to undercut since the potential increase in calling demand due to call substitutability is much greater even if network differentiation does not result in a significant change in market shares. Therefore, while the effects of access charges under dual network subscription are similar to the single network case (supporting increases in equilibrium prices), they are undermined by the lower friction of the calling demand substitution that can occur. These effects support the following claims that are substantiated through the simulation modelling presented below: Claim 3 With dual network subscription, market becomes more competitive as calling across networks becomes more substitutability ( → 1). Claim 4 With dual network subscription, market becomes more competitive as the percentage of dual network subscribers increase (sd → 1). However, the primary competitive benefit of dual network subscription can be realized after only a limited percentage of subscribers become dually subscribed. Claim 5 For a sufficiently high level of dual network subscription, high call substitutability across networks results in a competitive market environment even for highly differentiated networks. That is, there is greater competitive benefit to fostering dual network subscription than seeking optimal, marginal cost-based access charges. Where consumers are dually subscribed, the model specifies that the fixed utility obtained from network subscription is given by (see Section 7.2.2.1) j∈i vj , where 1/g < ≤ 1 (g = 2 for dual network subscription). In the current model is assumed that = 075 implying that the fixed subscription utilities are not fully additive with dual network subscription. Figure 7.5 illustrates three cases in which the fixed (exogenous) utility from network subscription is varied to influence the fraction of dual network subscribers at equilibrium. In the model setup, (a) v1 = v2 = −025, (b) v1 = v2 = 0, and (c)

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(a) 1 Single Network Subscription Only

0.8

ρ = 0.75

0.6 0.4 Dual Network Subscription ρ = 0.99

0.2

MC = 2c = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a


(b) 1 Single Network Subscription Only

0.8

ρ = 0.75


0.2

MC = 2c = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a


(c) 1 0.8

Single Network Subscription Only

ρ = 0.75

0.6 0.4 0.2

Dual Network Subscription ρ = 0.99

MC = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a

Figure 7.5 Profit-maximizing symmetric equilibrium price as function of access charge. Dual network subscribers – (a) ∼4 per cent, (b) ∼33 per cent, and (c) ∼100 per cent.

v1 = v2 = 075, leading to dual network subscription shares (over the illustrated range of access charges) of (a) sd ∼ 5 per cent, (b) sd ∼ 33 per cent, and (c) sd ∼ 100 per cent. The figures illustrate the cases of dual network subscription with call substitutability of = 075


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and = 099. The equivalent single network only subscription case is also shown. Figure 7.6 repeats the analysis given by Figure 7.5 but in this case the competing networks are assumed to be more highly differenti-


(a) 1 Single Network Subscription Only

0.8

ρ = 0.75


0.2

MC = 2c = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a


(b) 1 Single Network Subscription Only

0.8

ρ = 0.75

0.6 0.4 0.2


MC = 2c = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a


(c) 1 Single Network Subscription Only

0.8

ρ = 0.75

0.6 0.4 0.2


MC = 2c = 0.2

0 0

0.05

0.1 (a = c )

0.15

0.2

0.25

0.3

0.35

0.4

Access charge, a

Figure 7.6 Profit-maximizing symmetric equilibrium price as function of access charge. Dual network subscribers – (a) ∼35 per cent, (b) ∼30 per cent, and (c) ∼99 per cent.

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ated ( = 25 versus the prior assumption of = 50). Based on the increased network differentiation, the conditions (a) v1 = v2 = −025, (b) v1 = v2 = 0, and (c) v1 = v2 = 075 leads to dual network subscription shares (over the illustrated range of access charges) of (a) sd ∼ 35 per cent, (b) sd ∼ 30 per cent, and (c) sd ∼ 99 per cent. As noted from the comparison of Figures 7.5 and 7.6, increased network differentiation primarily affects the level of price markup with access charge for single network only subscription where the vertical intercept of the price–access charge curve is dependent on , the measure of the degree of horizontal differentiation between networks, which in turn increases the effective overall calling demand elasticity faced by each network. The dominant competitive effects of call substitutability in the case of dual network subscription results in no significant change in level of price markup due to increased network differentiation. From the comparison of (b) and (c) in each of the figures, it is seen that the primary benefit of dual network subscription is largely realized for sd ∼ 30 per cent and does not change appreciably even as the market moves to the case in which all consumers are dually subscribed.

7.5 CONCLUSION 7.5.1 Summary and general findings

This chapter has introduced a new modelling approach to the analysis of competition among interconnected networks. The developed framework is based on a tractable, analytic CNL discrete choice model with CES continuous calling demand. A key element of the model is its ability to extend beyond prior Hotelling based approaches to analyse competition between more than two networks. The model also incorporates the element of dual or multiple simultaneous network subscription, which recognizes that in the current and future two-way network interconnection environments, consumers


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do, and will, choose to subscribe to more than one of the competing network options. With dual network subscription, there are now three dimensions along which the calling demand generated by consumers on a given network is affected. These are: (1) inherent consumer preference for making calls, which is reflected in the consumer’s elasticity of demand for calling; (2) subscription substitutability (differentiation) between networks; and (3) call substitutability between networks when subscribed to multiple networks. When calling demand elasticity is low, as in the case of local network access service, call substitutability between networks provides an important mechanism that can make competition between networks more vigorous. With high call substitutability across networks, markets therefore can be very competitive even with a limited fraction of dual network subscribers and even against a background of highly (horizontally) differentiated networks. The analysis and modelling results have confirmed that under linear pricing, coordinated access charges continues to be an instrument of collusion allowing competing networks to achieve higher equilibrium calling prices. However, with dual network subscription, increased call substitutability between competing network types will unambiguously intensify competition and reduce the equilibrium prices that can be achieved for a given access charge relative to the ‘single network only’ subscription case. Based on the potential to significantly shift calling revenues, the full competitive benefits of dual network subscription in conjunction with high call substitutability can be almost fully realized even when the percentage of dual network subscribers is modest and networks highly differentiated. For regulators, the principal message is that the gains from fostering dual network subscription and promoting quality standards to making calling more substitutable will be much greater in terms of promoting more rigorous competition than the emphasis on the setting of marginal cost access charges. Even for modest levels of dual network subscription, the competition enhancing benefits will significantly undermine the markup achievable through higher access charges.

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7.5.2 Future areas of study

The ability of the developed network competition model framework to support multiple network subscription will be very important in allowing the framework to be applied to many of the other areas of interconnection competition cited in the literature, such as ATM and credit card networks, airline networks or potential future electronic email or messaging networks. In these environments the existence of multiple network subscription is already an inherent reality. To add to the practical application of the new modelling framework, econometric analysis of the local access network environment can also be undertaken to derive appropriate values for important competition parameters within the model.18 In particular, econometric analysis will be able to establish the measures of differentiation between network types and measures of call substitutability across different competing network options. Other additional-study areas will include extending the analysis by relaxing some of the assumptions that were used to bound the current effort. For example, the model can be adapted to apply to the assessment of discriminatory pricing (for on- and off-net calls), the introduction of heterogeneous consumer types and associated multiple network tariffs, and the incorporation of the ‘called-party pays’ principle and the consequent utility from calls received as part of the consumer utility maximization.

APPENDIX A7.1 Dual network subscription example

The generalized CNL/CES model can be directly applied to network competition between two interconnected networks of different types. The discrete choice network subscription alternatives with dual net18

Along the lines of that undertaken by Train et al. (1987).


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work subscription are: (i) no network subscription, (ii) subscription to network 1 (type 1) only, (iii) subscription to network 2 (type 2) only, and (iv) subscription to network 1 and network 2. A7.1.1 Two-network model subscription alternatives

Figure 7.7 illustrates the tree of network subscription alternatives based on the proposed CNL decision model. The nested elements reflect alternatives that have a common network type. In the case of nest m1, the common element is based on the attributes associated with network 1 (type 1). For nest m2 it is based on the common attributes associated with network 2 (type 2). The dual network subscription alternative belongs to both nests. Figure 7.8 illustrates the measurable components of utility associated with the various nested and cross-nested alternatives. For the utilities specified in Figure 7.8, the nest membership allocations are such that 1 = 2 = 1 since the single network subscription alternatives are each represented within a single (network type) nest. The scale parameter m of the Gumbel distributed error terms for the two sets of nested subscription alternatives is assumed to be equal. The observable or measured utility derived from subscription to network

Type 2

Network 2

Dual Network

α2N12 N11

N12 {Nest m2}

Type 1

Network 1

N11

No Subscription

Dual Network

α1N12 N11 {Nest m1}

Figure 7.7 Model of dual network subscription alternatives.

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Type 2

Type 1

No Subscription V0

Network 2 V2 + [In α2 ]/μm

Dual Network

Network Dual 1 Network

Vd + [In αd ]/μm

V1 + [In α1]/μm

{Nest m2}

Vd + [In αd ]/μm {Nest m1}

Figure 7.8 Utility associated with nested and cross-nested subscription alternatives.

i is V i for i = 0 1 2 d, where d refers to dual subscription and i = 0 refers to no network subscription. For the nth consumer, the probability of selecting network subscription alternative i within nest mi is given by im expm V i k∈Cm km expm V k

PiCmi =

The probability of selecting (a subscription alternative from) nest mi among the available choice set is given by expV Cmn PCmi C = M expV Cjn j=1 Based on the analysis derived by Ben-Akiva and Lerman (1985), the expected value of the maximum of the utilities for the nested alternatives, network 1 subscription and dual network subscription (nest m1), and network 2 subscription and dual network subscription (nest m2), is given, respectively, by Em1 =

1 ln i expm V d + 1 expm V 1 m


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and Em2 =

1 ln d expm V d + 2 expm V 2 m

where the degree of correlation between subscription options within a given nest, m , is based on having a given network type in common and is assumed to be the same for both nests. That is, the probability of selecting alternatives in nest m1 among the available subscription alternatives (see Figure 7.8) is given by PCm1 C =

expEm1 expEm1 + expEm2 + expV 0

where Em1 and Em2 are as given above. Similarly, the probability of selecting alternatives in nest m2 among the available subscription alternatives (see Figure 7.8) is given by PCm2 C =

expEm2 expEm1 + expEm2 + expV 0

The fraction of consumers choosing a particular subscription alternative can be derived from these selection probabilities. A7.1.1.1 Probability of dual network subscription The probability of dual network subscription is therefore given by

PdC =

PCmi CPdCmi

m1 m2

For the nth consumer, the probability of selecting dual network subscription within nest m1 is given by PdCm1 =

d expm V d d expm V d + 1 expm V 1

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Similarly, the probability of selecting dual network subscription within nest m2 is given by

PdCm2 =

d expm V d d expm V d + 2 expm V 2

Therefore, PdC = PdCm1 PCm1 C + PdCm2 PCm2 C

d expm V d = d expm V d + 1 expm V 1 expEm1 expEm1 + expEm2 + expV 0

d expm V d + d expm V d + 2 expm V 2 expEm2 expEm1 + expEm2 + expV 0 A7.1.1.2 Probability of subscription to network 1 only The probability of subscription to network 1 is given by

P1C = P1Cm1 PCm1 C

1 expm V 1 = d expm V d + 1 expm V 1 expEm1 expEm1 + expEm2 + expV 0


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A7.1.1.3 Probability of subscription to network 2 only The probability of subscription to network 2 only is given by

P2C = P2Cm2 PCm2 C

2 expm V 2 = d expm V d + 2 expm V 2 expEm2 expEm1 + expEm2 + expV 0 A7.1.1.4 Probability of not subscribing to any network The probability of not subscribing to any network is given by P0C = P0, where P0 is the probability of selecting the no subscription alternative (see Figure 7.8). That is,

expV 0 P0C = expEm1 + expEm2 + expV 0

Network competition analysis uses the above network subscription probabilities in conjunction with the associated calling demands to derive consumer and network behavior (see Section 7.3). A7.1.2 Two-network model subscription utility

The consumer maximization of net variable surplus for the case of subscription to both network 1 and network 2 is given by /

max uq1 q2 − p1 q1 − p2 q2 = max q1 + q2 q1 q2

q1 q2

− p1 q1 − p2 q2

It follows that the calling demands when subscribed to both networks is given by 1/1/−1 p1 1/ −1 q1 p1 p2 =

− / −1 p1 / −1 + p2 / −1

on network 1

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and q2 p1 p2 =

1/1/−1 p2 1/ −1

− / −1 p1 / −1 + p2 / −1

on network 2

Where a consumer is subscribed to a single network only, the calling demands are given by 1/−1 1 p1 1/−1 on network 1 q1 p1 = and 1/−1 1 p2 1/−1 on network 2 q2 p2 = The variable net consumer surplus from making and receiving calls when subscribed to both networks is given by Vd p1 p2 = Vod p1 p2 , where the subscript d refers to the ‘dual’ network subscription alternative. That is,

1 − 1 1/−1 p1 / −1 Vd p1 p2 =

−1/ −1

/ −1 + p2 Where a consumer is subscribed to a single network only, the net consumer surplus from making and receiving calls is given by

1 − V1 p1 =

1/−1

1 /−1 p1


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and

1 − V2 p2 =

1/−1

1 p2 /−1

for subscription to network 1 or network 2, respectively. A7.1.3 No network subscription

The conditional indirect utility from not subscribing to any network is given by V˜ 0k = V 0 + 0 k where V 0 = v0 + V0 = 0 Note: To address the case in which all consumers are subscribed to one or both networks, the ‘no network subscription’ option may be removed from the subscription alternatives available to consumers. Alternatively, the fixed level of utility from network subscription can be specified to be sufficiently high so that the fraction of consumers choosing not to subscribe to either network approaches zero. A7.1.4 Subscription to network 1 only

The conditional indirect utility from subscribing to network 1 only is given by V˜ 1k = V 1 + k1 where V 1 = v1 + V1 p1 − F1

1 − 1 1/−1 /−1 p1 = v1 + − F1

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A7.1.5 Utility from subscription to network 2 only

The conditional indirect utility from subscribing to network 2 only is given by V˜ 2k = V 2 + k2 where V 2 = v2 + V2 p2 − F2

1 − 1 1/−1 /−1 p2 = v2 + − F2 A7.1.6 Utility from subscription to network 1 and network 2

The conditional indirect utility from subscribing to both network 1 and network 2 is given by V˜ dk = V d + kd where V d = v1 + v2 + Vd p1 p2 − F1 − F2 That is,

1 − 1 1/−1 V d = v1 + v2 +

−1/ −1

p1 / −1 + p2 −1 − F1 − F2


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REFERENCES Alexander, R. K. (2003): ‘A tractable cross-nested logit model for evaluation of two-way interconnection competition with multiple network subscription’, Ph.D. Dissertation, George Washington University, Washington, DC. Anderson, S., A. de Palma and J. F. Thisse (1992): Discrete Choice Theory of Product Differentiation, MIT Press, Cambridge, MA. Armstrong, M. (1998): ‘Network interconnection in telecommunications’, Economic Journal 108: 545–564. Ben-Akiva, M. (1973): ‘Structure of passenger travel demand models’, Ph.D. Dissertation, Department of Civil Engineering, MIT Press, Cambridge, MA. Ben-Akiva, M. and M. Bierlaire (1999): ‘Discrete choice methods and their applications to short-term travel decisions’, in Hall, R. (ed.), Handbook of Transportation Science, Kluwer, Boston, 5–34. Ben-Akiva, M. and S. Lerman (1985): Discrete Choice Analysis: Theory and Applications to Travel Demand, MIT Press, Cambridge, MA. Berger, U. (2003): ‘Two-way interconnection and the collusive role of the access charge’, Working Paper, Mimeo, http://ideas.repec.org/p/wpa/wuwpio/0303011.html, as of: 10 January 2006. Bierlaire, M. (2001): ‘A theoretical analysis of the cross-nested logit model’, Report RO-011218, Ecole Polytechnique Federale de Lausanne, Department of Mathematics, Lausanne, Switzerland. Carter M. and J. Wright (1999): ‘Interconnection in network industries’, Review of Industrial Organization 14: 1–25. Carter M. and J. Wright (2003): ‘Asymmetric network interconnection’, Review of Industrial Organization 22: 27–46. Dessein, W. (1999): ‘Network competition in nonlinear pricing’, Working Paper, Mimeo, Université Libre de Bruxelles and GREMAQ, Université de Toulouse. Doganoglu, T. and Y. Tauman (1998): ‘Network competition and access charge rules’, Working Paper, Mimeo SUNY at Stony Brook and Tel-Aviv University. Doganoglu, T. and Y. Tauman (2002): ‘Network competition and access charge rules’, The Manchester School 70: 16–35. Gans, J. S. and S. P. King (2001): ‘Using ‘Bill and Keep’ interconnect arrangements to soften network competition’, Economics Letters 71: 413–420. Graitson, D. (1982): ‘Spatial competition a la Hotelling: A selective study’, Journal of Industrial Economics 31: 13–25. Hahn, J. (2004): ‘Network competition and interconnection with heterogeneous subscribers’, International Journal of Industrial Organization 22: 611–631. Hanemann, W. (1984): ‘Discrete/continuous models of consumer demand’, Econometrica 52: 541–561. Hotelling, H. (1929): ‘Stability in Competition’, Economic Journal 39: 41–57. Jeon, S., G. H. Wang and C.-H. Yoon (1998): ‘A model of interconnection between land and mobile networks’, Working Paper, Sogang University, Chung-Ang University and Korea University. Laffont, J.-J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA.

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Laffont, J.-J., P. Rey and J. Tirole (1998a): ‘Network competition: I. Overview and nondiscriminatory pricing’, RAND Journal of Economics 29: 1–37. Laffont, J.-J., P. Rey and J. Tirole (1998b): ‘Network competition: II. Price discrimination’, RAND Journal of Economics 29: 38–56. Luce, R. (1959): Individual Choice Behavior: A Theoretical Analysis, Wiley, New York. McFadden, D. (1978): ‘Modelling the choice of residential location’, in Karlquist, A. et al. (eds), Spatial Interaction Theory and Residential Location, Elsevier, Amsterdam, 75–96. Schiff A. (2002): ‘Two-way interconnection with partial consumer participation’, Networks and Spatial Economics 2: 295–315. Small, K. (1987): ‘A discrete choice model for ordered alternatives’, Econometrica 55: 409–424. Train, K. E., D. L. McFadden and M. Ben-Akiva (1987): ‘The demand for local telephone service: A fully discrete model of residential calling patterns and service choices’, RAND Journal of Economics 18: 109–123. Tversky, A. (1972): ‘Elimination by aspects: A theory of choice’, Psychological Review 79: 281–299. Wen, C.-H. and F. Koppelmann (2001): ‘The generalized nested logit model’, Transportation Research B 35: 627–641. Woroch, G. A. (2002): ‘Local network competition’, in Cave, M., S. K. Majumdar and I. Vogelsang (eds), Handbook of Telecommunications Economics, Elsevier, Amsterdam, 641–716.


CHAPTER 8

Platform Competition with Endogenous Multihoming∗ ROBERTO ROSON Università Ca’ Foscari di Venezia, Venice

Contents 8.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 8.2 THE MODEL STRUCTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 8.2.1 Assumptions and definitions 233 8.2.2 Profit maximization 238 8.3 A NUMERICAL SIMULATION OF PLATFORM COMPETITION . . . . . . . . . . . 242 8.4 CONCLUDING REMARKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

8.1 INTRODUCTION

In two-sided markets, two (or more) parties need access to a common platform to initiate a transaction or interaction. The capability and willingness to join the platform depend on (1) the number of joining agents on the opposite side and (2) the access price applied to each party. Examples of two-sided markets are: computer operating systems, real estate agencies, scientific journals, payment systems, media, etc. ∗ Justus Haucap provided useful comments on an earlier draft of this work. The usual disclaimer applies.

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The number of agents on the opposite market side matters because more agents means more potential interactions, or a better match in searching a partner. In this sense, we can speak of bilateral network externalities. Access prices on each side matter because agents cannot realize a full pass-through of cost margins. This is due to the existence of membership fees, independent of transaction volumes, or of specific contractual restraints (e.g., nondiscrimination rules in credit cards). Because of this, the market equilibrium is affected by both the aggregate price level, chosen by the platform, and the price structure (Rochet and Tirole, 2004). Two-sided markets have been the subject of a recent literature, mainly stemmed from the study of credit cards and media industries.1 This literature has initially focused on monopolistic platforms, and on their act of balancing prices ‘to get both sides on board’. Competition between platforms has been tackled only recently (Armstrong, 2004; Rochet and Tirole, 2003; Guthrie and Wright, 2003; Schiff, 2003; Caillaud and Jullien, 2003; Hagiu, 2004; Chakravorti and Roson, 2004; Manenti and Somma, 2004; Gabszewicz and Wauthy, 2004). One special difficulty of dealing with platform competition is given by the fact that agents can often join more than one platform (multihoming). For example, consumers may carry, and merchants may accept, more than one credit card for payment. Computer users may install a Windows or a Linux operating system on their PCs, or both. Software developers may write applications for Windows, Linux, or both. People may have one or more than one SIM card from different operators, on their mobile phones. Web pages may be written using a code that allows sophisticated graphical content to be appropriately displayed in one, or multiple, browser environments. Multihoming involves costs and benefits. Among costs: fixed costs for learning, searching, adapting to the alternative platform; variable 1

It could be argued that other two-sided markets had been studied in the past (e.g., shopping malls). General principles of two-sided markets, however, have not been investigated in a general and systematic way though.

Chapter 8 – Platform Competition with Endogenous Multihoming 231

transaction costs (possibly different between platforms); plain membership fees. Among benefits: higher acceptance rate, better market penetration, possibility of choice of the preferred platform during a transaction. Agents should choose between single and multihoming (or, more precisely, on how much to multihome) by comparing costs and benefits. Analyses of multihoming markets, however, are complicated by two elements. First, some of the costs and benefits are endogenously determined in a market equilibrium. For instance, competing platforms may use price instruments to attract customers. In doing so, they do not only affect market shares, but also the extent of multihoming behaviour. Second, customer choices are interdependent. Consider this trivial example: consumers choosing products of different brands. If all brands are offered in two or more shops (multihoming), each consumer needs to visit only one shop to have the whole range available (single-homing). If the shops are located quite close to each other, it may also be possible that brands are sold exclusively in one of the shops (single-homing), and consumers would then visit more shops (multihoming). Sellers multihome if buyers single-home, but buyers multihome if sellers single-home. Although emerging multihoming patterns are clearly an equilibrium aspect in many two-sided markets, this issue has not yet been thoroughly addressed in the literature, mainly because of the need of retaining analytical tractability. Most papers on platform competition have either predetermined which market side single- or multihomes (based on empirical evidence for specific industries), or the papers have adopted specific assumptions (typically, homogeneity in some parameters, symmetry) that allows one to anticipate which market side will eventually multihome.2 2 For example, if agents on one side are all similar, we know that they will end up by making the same choices. In equilibrium, they will either all singlehome on the same platform, or they will all multihome. A more sophisticated formulation has been adopted in a recent paper by Armstrong and Wright (2004), where conditions for specific homing configurations are derived beforehand and introduced as model assumptions.

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The question which side multihomes (possibly both), why and how much, is not a merely theoretical issue. As an example, consider the striking differences that exist between the American and European markets for credit cards. In North America, consumers typically carry several credit cards, although one of them is prevalently used (see Rysman, 2004). In Europe, most consumers adopt one credit card, or none, and most merchants accept all major credit cards, or none. Explaining these differences in terms of market competition is a challenging task. Which fundamental characteristics of the two markets may explain this outcome? Are these patterns time persistent, as one would expect in the presence of network externalities? Is there any role played by market imperfections and barriers to competition? May a shift in policy regime produce an abrupt change in the qualitative characteristics of the market? What are the implications of market integration and increased international competition? As a further example, consider the penetration of Linux in the market for PC operating systems. This is a market dominated by the Microsoft Windows family. However, many users have recently started using Linux. Most of them have done that by partitioning the hard disk, thereby retaining both environments. The advantage of increased software availability, compatibility, and flexibility is being weighted against the implicit cost of reducing the hard disk space for Windows native programs. But, what will happen in the future? Will Linux become a serious alternative to Windows, or will it continue living side by side with the dominant standard? In this chapter, we introduce and discuss a model of duopoly competition, with endogenous multihoming, between payment card networks. The case of payment cards is chosen because the model is derived from Chakravorti and Roson (2004), but most concepts can be readily extended to other two-sided markets. Whereas the latter paper predetermines which market side single-homes (the consumers) and which market side – potentially – multihomes (the merchants), the model introduced here allows for endogenous singlemultihoming on both sides. To this end, we adopt an approach similar to Hermalin and Katz (2004). Contrary to them, we assume ex ante which market side (the consumers) has the right to choose


the payment instrument when both sides multihome. On the other hand, we consider two aspects that have been neglected in their model: (1) the existence of two-sided network externalities, and (2) the possible existence of fixed costs and benefits. The chapter is structured as follows. In the next section, a general theoretical framework is specified, in which the multihoming pattern stems from the equilibrium of a sequential game, in which platforms choose prices first, and agents select which platform(s) to join afterwards. Since equilibria for these games cannot, in general, be specified as closed form solutions, section three provides some illustrative numerical simulations, shedding light on the implications of various assumptions on the market equilibria and homing configurations. An ending section draws some final remarks.

8.2 THE MODEL STRUCTURE 8.2.1 Assumptions and definitions

There are: a set S of consumers (shoppers), a set M of merchants, two payment networks (1 and 2). Each consumer makes one transaction (buys one good) with each merchant,3 using cash or one of the two payment instruments. For a payment instrument to be used, both sides must have adopted the corresponding ‘platform’. When both sides have joined both platforms, the consumer decides which instrument is used. Except for the right of selecting the network under reciprocal multihoming, the two sides are symmetric. Each agent on each side s ∈ S m ∈ M is associated with a vector of (potential) benefits bs = B1s b1s B2s b2s ∈ 4 or bm = B1m b1m B2m b2m ∈ 4 . Benefits Bik i = 1 2 k = s m express the utility (possibly negative), derived by the mere ownership of a payment instrument (e.g., status), whereas

3

This assumption, often adopted in the literature, rules out ‘business stealing’ motivations for the adoption of credit cards by merchants.

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bik express transaction benefits, obtained every time a transaction is carried out on a specific platform. Networks apply, to both sides, a membership fee P (possibly zero or negative) and a transaction fee p. This is a simple form of nonlinear pricing which, as we shall see later, allows to price discriminate among different classes of customers, according to their multihoming behaviour. Networks also incur fixed per-member costs C and transaction costs c. In short, they select a vector of prices pi = Pis pis Pim pim on the basis of costs Cis cis Cim cim . Consumers belong to five categories. First, some consumers do not join any platform and use cash only. Their utility is normalized to zero W0 = 0. Some other consumers carry only card 1, and use it whenever they find a merchant who has joined platform 1. Let us define their utility as (Rochet and Tirole, 2004) W1 = B1s − P1s + b1s − p1s m1 + m12

(8.1)

where m1 stands for the number of merchants accepting, in addition to cash, only card 1, and m12 for the number of merchants accepting both payment instruments. The symmetric definition of utility for consumers joining only platform 2 is W2 = B2s − P2s + b2s − p2s m2 + m12

(8.2)

There are also fourth and fifth categories, including those consumers who carry both cards. Here we make a distinction between those who prefer to use card 1 when a choice is possible, because a merchant has joined both platforms, and those who would rather select card 2. Utility for these groups is defined as W121 = B1s − P1s + b1s − p1s m1 + m12 + B2s − P2s + b2s − p2s m2 (8.3) W122 = B1s − P1s + b1s − p1s m1 + B2s − P2s + b2s − p2s m2 + m12 (8.4)


Each consumer belongs to the category in which her utility is highest. Formally, let us define a partition of the set of consumers in the following way: Definition 8.1 A utility maximizing partition (UMP) of the set of consumers is defined as H s p1 p2 Gm = 0 1 2 121 122 where Gm is a partition of the set of merchants, determining m1 m2 m12 , and i = s Wi ≥ Wj

∀j = i

i j ∈ 0 1 2 121 122

Let us also define ni = cardi as the number of consumers in each subset.

On the basis of the definition above, it could be possible for a consumer to belong to more than one category, when utilities in two or more groups match. For all practical applications of the model, however, we shall assume that consumers of this type are equally split among the categories for which utility is equal.4 We adopt a similar framework for the merchant side. The only difference is that here we have four, instead of five, categories, because merchants are assumed not to choose the payment instrument under bilateral multihoming. Again, we can normalize to zero the utility of cash-only merchants: V0 = 0. For the remaining three cases, let us define utility as V1 = B1m − P1m + b1m − p1m n1 + n121 + n122

(8.5)

V2 = B2m − P2m + b2m − p2m n2 + n121 + n122

(8.6)

V12 = B1m − P1m + b1m − p1m n1 + n121

(8.7)

+ B2m − P2m + b2m − p2m n2 + n122 4

This implies that the intersection between any two subsets is the empty set, whereas the union of all subsets is the entire set of consumers.

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We can define a UMP for merchants as: Definition 8.2 A utility maximizing partition (UMP) of the set of merchants is defined as H m p1 p2 Gs = 0 1 2 12 where Gs is a partition of the set of consumers, determining n1 n2 n121 n122 , and

i = m Vi ≥ Vj

∀j = i

i j ∈ 0 1 2 12

Let us also define mi = card i as the number of merchants in each subset.

Notice that the partition of consumers can be identified on the basis of a partition of merchants and vice versa. Quite naturally, let us define a configuration in which partitions of the two sets are mutually consistent: Definition 8.3 A consistent dual partition (CDP) is defined as H s p1 p2 Hm Hm p1 p2 Hs

As in most coordination games, there can be multiple CDP for given prices. For example, suppose that all agents are homogeneous and platforms apply equal prices (but not too high). There are two possible configurations: in both, only one platform is used to carry out transactions.5 This is because network externalities produce a special type of economies of scale, which may easily bring about corner solutions. Here, however, we are considering platforms that provide differentiated services, so that if differentiation is sufficiently strong and agents are heterogeneous in terms of benefits, both platforms can be active in a CDP. Furthermore, as noted also by Armstrong and Wright (2004), network externalities and differentiation create opposite effects. The higher the degree of differentiation, the more the

5

The other one could still be joined if membership benefits are high enough.


individual decisions are based on agent-specific parameters, rather than on expectations about other agents’ choices. Also notice that the existence of multiple CDP is linked to the presence of fixed costs and benefits. To see this, suppose that, for one side k of the market, both B1k B2k , and P1k P2k are zero. Then, utility of k-type agents would still depend on the magnitude of the opposite side network, but their decision about joining or not a certain platform would not. Indeed, platform i would be joined whenever bik > pik . If adoption choices on one side do not depend on the opposite side’s choices, multiple CDP cannot occur. Prices are determined by profit-maximizing platforms. Profits for the two platforms are given by 1 = P1s − C1s n1 + n121 + n122 + P1m − C1m m1 + m12

(8.8)

+ p1s + p1m − c1 n1 + n121 m1 + m12 + n122 m1 2 = P2s − C2s n2 + n121 + n122 + P2m − C2m m2 + m12

(8.9)

+ p2s + p2m − c2 n2 + n122 m2 + m12 + n121 m2 Notice that profits depend on specific partitions of consumer and merchant sets. It is natural, then, to assume that these partitions are determined by the selected prices, and are mutually consistent. More precisely, let us define a game in the following way: Definition 8.4 A card multihoming game (CMG) is defined as a game in which platforms choose prices p to maximize profits, and demand for platform services is implicitly defined by a CDP associated with the same prices. In a noncooperative CMG each platforms aims at maximizing profits, while taking the prices of other platforms as given. The equilibrium of the game is a Nash equilibrium. In a cooperative CMG, instead, prices are jointly determined, in order to maximize the sum of profits for all platforms.

When benefits for consumers and merchants, and costs for platforms, are symmetrically distributed, we can speak of a symmetric CMG. A symmetric equilibrium for a symmetric CMG (cooperative or noncooperative) is the one in which platform prices are equal.

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Because of the possible existence of multiple CDP, a CMG can have multiple equilibria. In this case, the issue of equilibria selection could emerge in some practical applications. Criteria for selecting among alternative equilibria are extensively discussed in the literature. For example, one requirement could be that a candidate equilibrium be robust to small deviations, or errors in expectations. Another possibility is to rule out candidate equilibria that are welfare-inferior for all the coordinating agents.

8.2.2 Profit maximization

Without loss of generality, consider the point of view of platform 1 in the profit maximization problem. Demand for platform 1 stems from consumers and merchants in five groups: 1 121 122 1 12 . However, consumers in 1 and 121 affect the platform profits in the same way, so we can define a new subset 1+ = 1 ∪ 121 , where n1+ = n1 + n121 . As summarized in Table 8.1, consumers in 1+ interact with merchants in 1 and 12 , whereas consumers in 122 only interact with merchants in 1 . Platform 1 selects a vector of four prices p1 = P1s p1s P1m p1m , to address the four categories of agents. Within each category, however, there is some redundancy between membership fee and transaction fees. This is because there is no uncertainty, and members of all groups are supposed to know how many interactions will be realized in equilibrium. Since the global price, which is eventually paid, is the sum of membership fee and the product between transaction fee and total number of transactions, utility for each agent could be kept constant if the two fees are changed appropriately, so as to keep the global price constant. Table 8.1 Platform interaction types

1 121 122

1

12

• • •

• •


Nonetheless, because of the equality between agent types and price instruments,6 membership and transaction fees can be fine-tuned, so as to achieve the ‘right’ (profit-maximizing) global prices for all the four groups, as the following proposition states: Proposition 8.1 Assume that benefit distributions for merchants and consumers are such that the profit function for platform 1 is concave in prices. Then, profit is maximized when the following four conditions hold: P1s − C1s + m1 + m12 p1s − c1 − p1m m1 + m12 p1s + P1s m P m /n1+ + n122 + m12 P1m /n1+ + 1 1 m1 + m12 p1s + P1s 1 = n1+

(8.10)

P1m − C1m + n1+ + n122 p1m − c1 − p1s n1+ + n122 p1m + P1m

(8.11)

n1+ P1s /m1 + m12 + n122 P1s /m1 n1+ + n122 p1m + P1m 1 = m1 1 P1s − C1s + m1 p1s − c1 − p1m − P1m /n1+ + n122 = s s m1 p1 + P1 n122 (8.12) +

1 P1m − C1m + n1+ p1m − c1 − p1s − P1s /m1 + m12 = m m n1+ p1 + P1 m12 (8.13)

6

Of course, this holds true only if the four sets 1 1+ 1 12 are all nonempty. If not, price redundancy would still occur.

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where n1+ P1s P1s n1+ n122 P1s n122 = − P1s n122 n1+ = −

m1 P1m P1m m1 m12 P1m m12 = − m P1 m12 m1 = −

Proof Define the ‘global prices’ faced by the four groups of agents as P˜ n1+ = P1s + p1s m1 + m12 P˜ n122 = P1s + p1s m1

P˜ m1 = P1m + p1m n1+ + n122 (8.14) P˜ m12 = P1m + p1m n1+

and rewrite the profit function as 1 = P˜ n1+ + P˜ m1 − c1 n1+ m1 + P˜ n122 + P˜ m1 − c1 n122 m1 (8.15) + P˜ n1+ + P˜ m12 − c1 n1+ m12 − C1s n1+ + n122 − C1m m1 + m12 Take partial derivatives of 1 w.r.t. n1+ n122 m1 m12 , and equalize them to zero. Introduce standard definitions of own-price elasticity, using n1+ n122 m1 m12 as quantities. Next, plug back global prices with membership and transaction fees. Notice that elasticity defined in terms of global price equals elasticity defined in terms of membership fee, for example, n1+ = −

n1+ P1s n1+ P˜ n1+ = − P1s n1+ P˜ n1+ n1+

Interpretation of first-order conditions (8.10)–(8.13) is quite simple. They are special versions of the Lerner’s inverse elasticity rule. This rule states that a profit-maximizing entity sets prices so that the


marginal markup (the profit share in the price of the last unit sold) equals the inverse of the own-price demand elasticity. In this case, consumers and merchants should be viewed as quantity units. Consider the left-hand sides of (8.10)–(8.13). On the denominator, we found total revenue obtained from an agent in one of the sets 1+ 122 1 12 . This includes the fixed fee P and the transaction fee p multiplied by the number of interacting agents on the opposite market side. On the numerator, we have per-member profits. They include three components. First, there is the margin between fixed fee and fixed costs. Second, we have transaction profits. Adding one more agent to a group allows expanding total transactions by a number equal to the size of the interacting parties. Every time a transaction is carried out, a price p can be charged, and a transaction cost c is paid. However, as stressed by Rochet and Tirole (2004), the relevant cost concept in a two-sided market is the opportunity cost, which should include (as a negative term) the transaction price that can be charged to all members of the opposite side, when a new customer is served. Here, this negative cost component does not only include the direct transaction price p, but also a share of the membership fee P, as it can be seen by defining ‘per-transaction global prices’: P1s P˜ n1+ = + p1s m1 + m12 m1 + m12 P1m P˜ m1 = + p1m n1+ + n122 n1+ + n122 P˜ n122 Ps = 1 + p1s m1 m1 Pm P˜ m12 = 1 + p1m n1+ n1+

(8.16)

Elasticities on the right-hand side can take different values, depending also on the competing platforms’ behaviour. In a

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Bertrand–Nash equilibrium, for example, the elasticity should be computed by changing one platform membership fee, while keeping the prices of the other platform(s) fixed. In a cooperative equilibrium, instead, elasticities should be computed on the basis of simultaneous price changes. Of course, in the latter case, elasticities would be smaller, thereby determining higher profit markups in equilibrium. Looking at the numerators of (8.10)–(8.13), one can see that profits can be raised in four different ways, corresponding to the four different price instruments available. On the other hand, all prices are interdependent. For example, suppose that, starting from an equilibrium state, one elasticity for one type of agent increases. This calls for higher profits for that type of agents, which could be achieved by raising at least one of the four prices appearing on the numerator of the corresponding first-order condiition. However, once any of these prices is touched, other prices should also be adjusted to restore equality in the other optimality conditions. Typically, this requires a compensating variation of fixed and variable fees. Finally, notice that prices determined through (8.10)–(8.13) may well be so high that some of the sets 1+ 122 1 12 may be empty. For example, for sufficiently high membership fees, there could be no multihoming consumers or merchants.

8.3 A NUMERICAL SIMULATION OF PLATFORM COMPETITION

To obtain some insights about the functioning of market competition, and its implications in terms of platform adoption, let us present some results of numerical simulation experiments.7 We consider two scenarios. In both, production costs for platforms are equal and set to C1s = C2s = C1m = C2m = 05 and c1 = c2 = 005. The total number of both merchants and consumers is normalized to 7

These experiments have been carried out with Mathematica. Original simulation files are freely available from the author.


one. As in Chakravorti and Roson (2004), we consider a Nash CMG game of price competition versus a cooperative cartel, fixing prices for the two platforms. In addition, we focus on symmetric CDP dual partitions in the identification of the game equilibrium. We select symmetric equilibria for two reasons. First, when facing equal platform prices, it is reasonable to assume that agents form expectations in which networks are somehow ‘balanced’. Second, because of the way these equilibria have been numerically determined,8 they must be, at least, ‘locally stable’ in terms of CDP partitions. In the first case, platforms are differentiated in four dimensions: membership benefits for consumers, membership benefits for merchants, transaction benefits for consumers, transaction benefits for merchants. We assume that all four distributions for the two platforms are uniformously and independently distributed in the interval [0,1]. In other words, each consumer gets a draw bs = B1s b1s B2s b2s and each merchant gets a draw bm = B1m b1m B2m b2m , where all components are taken at random, independently, in the interval [0,1], with equal probability for all values in the interval. Given prices, consumers and merchants are allocated in a dual consistent partition (DCP) on the basis of which platform profits can be computed. Profit maximization, under the two market structures, gives rise to the equilibria described in Table 8.2, where prices and sets are displayed for the two cases of cooperative cartel equilibrium (first row) and competitive Nash duopoly (second row). Because merchants and consumers are very heterogeneous in terms of membership and transaction benefits, we can find some agents in all of the nine categories. Multihoming is more diffused among consumers,9 given the additional advantage of having the right to select the preferred platform, when multihoming occurs on both sides. 8

In practice, this has been obtained by numerical iterations, where UMPs for consumers and merchants have been computed in sequence, starting from an arbitrary partition in which agents were uniformously distributed among the subsets. In this case, since platform prices are equal in equilibrium (because of cost symmetry), the partitions are symmetric as well. 9 To obtain the total number of multihoming consumers, n121 has to be doubled.

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Table 8.2 Descriptive variables for collusive and competitive equilibria (case A) Pis 0.72 0.70

pis

Pim

pim

i

n0

ni

n12i

m0

mi

m12

0.17 0.14

0.73 0.70

0.13 0.12

0.216 0.213

0.341 0.295

0.254 0.264

0.076 0.089

0.332 0.283

0.269 0.281

0.130 0.156

Despite the fact that consumers and merchants have identical benefit distributions, we can see that prices are not the same for the two sides. In particular, consumers are charged more per transaction: a fact that may be interpreted as a consequence of their platform selection power under reciprocal multihoming. Indeed, if prices for merchants and consumers would be the same, consumers would achieve higher utility levels, on average. The cartel and, to a lesser extent, the duopolistic platforms succeed in capturing part of this extra potential welfare. When competition is introduced (row 2), all prices fall and welfare increases for both consumers and merchants. Chakravorti and Roson (2004) demonstrate that this result of welfare gains for both sides,10 due to platform competition, is a general one. Here we can see what this implies in terms of homing partitions, with less agents not joining any platform, and more agents in all other categories. Table 8.3 shows the own-price elasticities for the four interacting groups of each platform i j, computed by inserting the values of Table 8.2 in the first order conditions (8.10)–(8.13). Let us now consider a second, alternative case. We take the simplifying assumption of fixing all benefits for all agents at 0.5, except for Table 8.3 Own-price elasticities for the four groups (case A) ni+ 0.722 0.725

10

mi

nijj

mij

0.692 0.700

0993 1045

0.851 0.887

More precisely, non-negative welfare variations.


the transaction benefits for the consumers associated with the second platform b2s ,11 which continue to be uniformously distributed in [0,1]. This means that: (1) all merchants are identical, so they must end up by making the same choices, and (2) consumers are heterogeneous in one dimension (platform-specific transaction benefits).12 Furthermore, as in the first scenario, platforms are symmetric and set equal prices in equilibrium, both in the cartel and in competition. Under these conditions, consumers do not multihome. If there are no intrinsic benefits in joining one platform rather than another, a consumer would multihome only if there is a probability that its preferred card is not accepted by some merchants. But this would imply that merchants make different adoption choices, which is impossible in this case. Therefore, either the market for consumers is equally split between the two platforms, like in a symmetric Hotelling model, or only platform 2 is used by less than a half of all consumers.13 This second case cannot emerge under competition, because profits of the first platform would be zero if no consumers join platform 1 and no transactions take place on it.14 It turns out that, under the set of parameters considered here, it is better to serve all consumers for the cartel as well. Therefore, all consumers single-home and half of them adopt each platform. This outcome has strong implications for the merchants. Since the number of consumers on each platform is fixed (0.5), the merchants’ problems of joining the two platforms are separable (since utility is additive). As long as the number of consumers stays fixed, each platform is a monopolist on the merchant side, even under platform competition. As such, it can extract all merchants’ surplus, and merchants will all multihome. 11

Or, alternatively, with the first platform. A similar setting has been analyzed by Armstrong and Wright (2004). 13 That is, by those having sufficiently high transaction benefits associated with this platform. 14 In principle, a platform could still be sold, because of membership benefits. Here, however, membership costs and benefits take the same value (0.5), so there are no profit margins. 12

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Table 8.4 Descriptive variables for collusive and competitive equilibria (case B) Pis 0.72 0.68

pis

Pim

pim

i

n0

ni

n12i

m0

mi

m12

0.27 0.20

0.66 0.66

0.17 0.17

0.467 0.410

0 0

0.5 0.5

0 0

0 0

0 0

1 1

Table 8.4 shows the simulation results, using the same format of Table 8.2. We can see that homing partitions are as expected, and do not change between cartel and duopoly. Remarkably, competition has no effect on the prices faced by merchants, and platforms compete only on the consumer side. Merchant surplus is fully extracted, and merchants are almost indifferent between joining and not joining any of the two platforms. When these results are compared with those of case A, we can see that the lower degree of heterogeneity among agents in case B is reflected in, on the one hand, higher platform profits and, on the other, a more significant impact of the introduction of competition in the market. Because many sets in the homing partitions are empty, some price instruments are redundant, and there is a continuum of market equilibria for the same CDP (so Table 8.2 shows just one of the many possible equilibria). Any price combination satisfying the two relationships P m + 05 ∗ pm = 0745 = 066 + 05 ∗ 017 and P s + ps = 099 = 072 + 1 ∗ 027 (for the cartel), or P s + ps = 088 = 068 + 1 ∗ 020 (for the competitive duopoly), identifies an equilibrium as well.

8.4 CONCLUDING REMARKS

In two-sided markets with multiple platforms, agents can join none, one, or many platforms, depending on prices and adoption choices made by potential partners on the other side. This chapter provides a general theoretical framework, in which homing partitions are conceived as one aspect of market equilibrium, rather than being set ex ante, through ad hoc assumptions.


The emergence of a specific equilibrium partition is a consequence of: (1) the structure of costs and benefits, (2) the degree and type of heterogeneity among agents, (3) the intensity of platform competition. Relatively high transaction-independent costs, or relatively low transaction-independent benefits, reduce the likelihood of multihoming. Multihoming on one side makes multihoming on the other side less likely. Agent heterogeneity makes coordination problems less severe and equilibrium partitions more stable. Platform competition creates a downward pressure on prices, but its implications in terms of multihoming are ambiguous. As mentioned in the introductory section, real markets are characterized by very diverse homing patterns, even within markets for the same good or service. The analysis conducted so far can help in understanding which factors are at the basis of these differences. Therefore, empirical research could be directed to gauging the relative importance of potential explanatory factors in specific markets. Findings on the determinants of platform adoption would have important policy implications, in several different contexts. For example, understanding why one side singlehomes, and the other side multihomes, could allow forecasting whether or not changes in policy, or technology, will alter key qualitative characteristics of a two-sided market in the future.

REFERENCES Armstrong, M. (2004): ‘Competition in two-sided markets’, paper presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse. Armstrong, M. and J. Wright (2004): ‘Two-sided markets, competitive bottlenecks and exclusive contracts’, Mimeo, University College, London, and National University of Singapore. Caillaud, B. and B. Jullien (2003): ‘Chicken & egg: Competition among intermediation service providers’, RAND Journal of Economics 24: 309–328. Chakravorti, S. and R. Roson (2004): ‘Platform competition in two-sided markets: The case of payment networks’, Federal Reserve Bank of Chicago Working Paper 2004–09, July. Gabszewicz, J. J. and X. Y. Wauthy (2004): ‘Two-sided markets and price competition with multi-homing’, Working paper, CORE, Louvain-la-Neuve University. Guthrie, G. and J. Wright (2003): ‘Competing payment schemes’, Working Paper No. 0311, Department of Economics, National University of Singapore.

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Hagiu, A. (2004): ‘Optimal pricing and commitment in two-sided markets’, paper presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse. Hermalin, B. E. and M. L. Katz (2004): ‘Your network or mine? The economics of routing rules’, paper presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse. Manenti, F. M. and E. Somma (2004): ‘Plastic clashes: Competition among closed and open systems in the credit card industry’, paper presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse. Rochet, J.-C. and J. Tirole (2003): ‘Platform competition in two-sided markets’, Journal of European Economic Association 1: 990–1029. Rochet, J.-C. and J. Tirole (2004): ‘Two-sided markets: An overview’, Working paper, IDEI University of Toulouse. A preliminary version was presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse, January. Rysman, M. (2004): ‘An empirical analysis of payment card usage’, paper presented at ‘The Economics of Two-Sided Markets’ conference held at the University of Toulouse. Schiff, A. (2003): ‘Open and closed systems of two-sided networks’, Information Economics and Policy 15: 425–442.

PART IV

Application to Specific Markets



CHAPTER 9

Network Ownership and Optimal Tariffs for Natural Gas Transport KÅRE P. HAGEN, HANS JARLE KIND AND JAN GAUTE SANNARNES Norwegian School of Economics and Business Administration, Bergen

Contents 9.1 9.2

9.3 A9.1 A9.2

INTRODUCTION A SIMPLIFIED MODEL FOR TRANSPORTATION OF GAS 9.2.1 Fully integrated network 9.2.2 Separation of ownership between transportation network and extraction and marketing activities CONCLUSION AND DISCUSSION APPENDIX EXISTENCE OF EQUILIBRIUM DOWNSTREAM COMPETITION WITH FIRMS LOCATED OUTSIDE THE COUNTRY REFERENCES

251 255 256 265 270 272 272 274 275

9.1 INTRODUCTION

Norway is a major producer of natural gas in the European gas market. A miniscule part of the production is used domestically and mainly for industrial purposes. Hence, the national interests in the gas sector are almost completely aligned with export interests. The selling of natural gas in the downstream market used to be separated from the upstream production. A centralized body representing all

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gas producers on the Norwegian shelf in the North Sea conducted the bargaining with respect to new sales contracts before decisions had been made as to what gas fields were to supply the gas. The sold volumes were then allocated to productions fields according to production efficiency criteria after the sales contracts had been concluded. This way of organizing the gas sector was conducive to maximum bargaining power in the downstream market and overall cost efficiency in the upstream production. The customers were typically large distribution companies so that the gas was sold on a wholesale basis. This model was ruled out by EU’s Gas Market Directive which was adopted in Norwegian legislation as of 1 January 2002. The purpose of the directive is to open the common gas market for competition through common rules for transmission, supply and storage of natural gas. An important part of the directive deals with measures aiming at securing access to the existing transmission network on nondiscriminatory terms for third parties without transportation facilities. The transportation facilities had earlier been reserved solely for the network owners. However, according to the directive, large customers and gas producers without their own pipelines are to be considered legible to access the gas transmission network on equal footing with the facility owners on conditions that do not distort the competition in the downstream market. In a supplementary directive from June 2003 these conditions are defined more precisely to mean that tariffs are to be applied objectively without discrimination between system users. A neutral treatment of access to the network for third parties is facilitated by separating selling and transportation roles. In compliance with the directive the network has therefore been reorganized as a separate joint venture, and an independent system operator has been established with assignment of transportation rights as one of its main tasks. The network is to be operated under the constraint that tariff revenues equal total network costs. As a natural resource in limited supply there is an economic rent associated with the extraction of gas. Until the adoption of the Gas Market Directive the Norwegian policy had been that this rent should

Chapter 9 – Network Ownership and Optimal Tariffs

253

be harvested on the production fields and not in the transportation network. When the network was owned by the developers of the gas field, this issue was not very important as the transportation costs were considered an integral part of the total investment and operating costs of the gas fields in question. With the separation between transportation and selling of gas the problem of optimal tariffs has become an important issue, in particular with respect to the pricing policy towards third parties. Clearly, if the economic rents from gas extraction were fully appropriable in the producing country, it would be first best optimal to price the use of the transportation facilities at marginal cost. This would maximize the contribution from the gas sector to the domestic value added. However, for various reasons the domestic appropriation of the economic rents is incomplete. An important shortcoming in this respect is that economic rents are rarely taxed fully in the producing country in so far as there is foreign ownership in domestic gas production. Moreover, multinationals can channel part of the rents out of the domestic tax jurisdiction through transfer pricing and internal financial transactions. Also, foreign customers with a strong bargaining position may get hold of some of the rents through exerting monopsony power which has become more likely in the new regime with gas companies selling their gas independently of each other. Hence, the present chapter is based on the explicit assumption that the producer country cannot capture fully the resource rent from gas production, and the main issue is whether the tariff rates for gas transport can serve as an imperfect substitute for a theoretically perfect but not fully implementable national tax on economic rents. We also assume that the domestic taxation is generally distorting so that there is a premium on public revenue. The transportation facilities can be seen as inputs in the production and distribution of gas, and a markup on marginal transportation costs will then be in the nature of an indirect tax on this particular input. An important result in the theory of taxation says that in a fully optimal tax system it will not be optimal to have distorting

254


taxes on inputs in production.1 From the tax perspective the issue is then whether an input tax levied through the transportation tariffs can be an imperfect substitute when the economic rents cannot be fully taxed through a lump sum tax on pure profits. There is an extensive related literature on optimal access pricing, see, for example, Laffont and Tirole (1994). Cremer and Laffont (2002) as well as Cremer et al. (2003) discuss optimal access pricing in the natural gas pipeline sector. Cremer et al. (2003) examine optimal tariffs in a competitive market, while Cremer and Laffont (2002) discuss pricing of transport under perfect as well as imperfect competition. Common to these papers is that the optimal policy considers both consumer and producer interests while the present chapter examiner optimal tariffs from the perspective of net export values and taxpayer interests. Our chapter is also related to Vickers (1995) and Lee and Hamilton (1999). They analyse optimal one-way access prices for a natural monopoly in the upstream market with Cournot competition in the downstream market. Vickers compares optimal access prices under vertical separation and vertical integration and discusses whether a regulated monopolist should be allowed to also operate in the downstream market. Lee and Hamilton study how to use the downstream market structure to regulate a vertically integrated monopolist. In Section 9.2 we set forth a simplified economic model for analysing these issues and discuss optimal tariffs in the case where the transport facilities are fully owned by a national gas producer, possibly with some public ownership share. Some special cases, such as independent end-user markets, scarce capacity and competition between the network owner and third parties in the end-user market, are considered. Section 9.3 examines the consequences for the optimal tariffs in the case that the network is considered an independent entity. That means separation between extraction and selling of gas, on the one hand, and transportation, on the other. This 1

Diamond and Mirrless (1971a, 1971b).


255

is motivated by the EU policy that all network users should face nondiscriminatory tariffs and access conditions.

9.2 A SIMPLIFIED MODEL FOR TRANSPORTATION OF GAS

We consider a context where the transportation infrastructure is owned by a vertically integrated gas producer that serves the end-user market in a foreign country. There is also a gas producer without any transportation infrastructure of its own, and which depends on access to the established network in order to sell its gas. The non-facility based producer will be referred to as the third party, denoted by the subscript T, and the vertically integrated network firm is denoted N. The profit levels of the two firms are T and N , respectively. The third party is privately owned, possibly by foreigners. More specifically, a share 0 ≤ ≤ 1 of the profits of the third party accrues to private domestic owners and a share 1 − to foreigners. The network firm is fully domestically owned, but we assume that a share 0 ≤ ≤ 1 of the firm belongs to the government. Public revenues from gas activities reduce the need to raise public revenues through general taxation, and the marginal social cost of raising tax revenue is k ≥ 0. The value of the surplus accruing to the home country is thus given by W = T + 1 + kN

(9.1)

We do not explicitly consider national income taxation of the two gas companies and their owners. Since the depletion capacity of developed gas fields is limited, it seems reasonable to assume that the firms compete in quantities.2 2 Intuitively, we are appealing to a game a la Kreps and Scheinkman (1983), where firms choose capacities prior to the stage we are analysing. To a large extent, the capacity constraints facing different gas producers are common knowledge in the industry. Moreover, major capacity changes are both time consuming and expensive.

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The gas sales of the network owner and the third party are denoted by xN and xT , respectively, with corresponding downward-sloping (inverse) demand curves pN = pN xN xT and pT = pT xT xN . The activity related costs in the gas sector consist of two parts. The first part, to be denoted cia xi , measures the costs of gas extraction and of accessing the transportation pipeline. This term depends solely on the producer’s own volume. The other part is the transportation cost, which may depend on the transported volumes of both parties, and will be denoted cit xi xj i j = N T. Total transportation costs are thus equal to C t ≡ cNt xN xT + cTt xN xT . This means that the marginal cost of transporting company i’s gas is MCit ≡ C t/ xi = cit / xi + cjt / xi , where the term cjt / xi may be interpreted as a cost externality. This externality may, for instance, be due to the fact that it is necessary to activate compressors in order to increase the pressure if too much gas is fed into the pipeline. This will increase the marginal costs for transporting gas for both producers. The price that company i has to pay for transporting one unit of its gas is i . Company i thus pays a marginal transport price which is higher than marginal costs if i > MCit , while it pays less than marginal costs if i < MCit .3 It should be noted that firm N perceives

N as an immaterial transfer price unless it is forced to run the network and the downstream subsidiary as independent units (see Section 9.3).

9.2.1 Fully integrated network

Downstream profit for producer N is equal to pN xN xT xN − N xN − cNa xN , while its network profit is N xN + T xT − cNt xN xT + cTt xN xT . The internal price N is irrelevant if the firm maximizes 3

A substantial part of the variable transportation costs is made up of loss of energy in the pipeline which varies positively with the distance between the location of the input and terminal point of the gas shipment. The transportation element in the cost function may therefore not be symmetric in the volumes of the two shipping parties.


257

the sum of network income and downstream profit. In this case we may therefore write its object function as N = pN xN xT xN − cNa xN + cNt xN xT + T xT − cTt xN xT (9.2) We further have T = pT xT xN xT − cTa xT − T xT

(9.3)

We consider a two-stage game where the government sets the tariff rate at stage 1, and the two firms compete in quantities at stage 2. Appendix A9.1 discusses necessary and sufficient conditions for the existence of a unique and stable equilibrium. Letting CN xN xT ≡ cNa xN + cNt xN xT we can solve for the last stage to find p C ct N = pN + xN N − N − T ≡ 0 xN xN xN xN ca p T = pT + xT T − T − T ≡ 0 xT xT xT Totally differentiating N in (9.2) with respect to T yields pN CN cTt dxN dN = pN + xN − − d T xN xN xN d T pN CN cTt dxT + T + xN − − + xT xT xT xT d T where we have used the fact that CN / xT = cNt / xT . At the profitmaximizing volume for the network owner the term in the squared brackets vanishes, so that we have dN pN CN cTt dxT = T + xN − − + xT (9.4) d T xT xT xT d T

258


Similarly, we have, for the third party, dT p dx = xT T N − xT d T xN d T

(9.5)

At stage 1 an internal solution for an optimal tariff is obtained by solving dW/d T = 1 + kdN /d T + dT /d T = 0. The firstorder condition then takes the form pN cNt cTt dxT 1 + k T + xN − − + xT xT xT xT d T pT dxN − xT = 0 (9.6) + xT xN d T It should be noted that the qualitative results we arrive at, also hold if firms N and T compete with other firms producing outside the country (see Appendix A9.2). To get an intuitive feeling for what condition (9.6) tells us, we will consider some special cases. 9.2.1.1 Market independence

Assume first that the two downstream markets are independent, so that pN / xT = pT / xN = 0. For the moment we disregard capacity constraints. Defining T = −dxT /d T T /xT as the elasticity of demand for gas transport with respect to the tariff rate, we can rewrite eqn (9.6) as

T − cTt / xT + cNt / xT 1 + k − 1 =

T 1 + k T

(9.7)

Condition (9.7) is an ownership adjusted version of the inverse elasticity rule (the Lerner index). Assume that the third party is fully domestically owned = 1 and that the government has no shares in the network company = 0. It is then immediately seen that the optimal tariff rate for transporting the third party’s gas equals the


259

marginal transportation costs, including the marginal cost externality for the net owner’s own transport cNt / xT . From condition (9.7) we also see that it is socially optimal for the government to set the tariff rate above total marginal transportation costs if the third party is partly owned by foreigners or if the network company is partly owned by the government. Indeed, for = 0 monopoly pricing is socially optimal irrespective of whether the government has ownership shares in the network company (note that the interests of the government and the network owner coincide if = 0). If the government has a positive ownership in the transportation network and k > 0, it is optimal to charge the third party a price in excess of the total marginal cost also in the case that the company is fully domestically owned. The reason for this is that the social value of shifting one unit of profit from T to N is k, or k/1 + k if measured in units of the social value of N’s profits. More generally, the term 1 + k − /1 + k can be interpreted as the optimal downscaling factor on the relative monopoly markup. As the marginal cost of taxation goes to infinity k → or → 0, the optimal downscaling factor approaches unity (implying that monopoly pricing is socially optimal at the national level). Proposition 9.1 Assume that the firms operate in independent downstream markets. It is then optimal for the government to set the tariff rate above marginal national transportation costs if • the third party is partly owned by foreigners < 1, and/or • the network company is partly owned by the government and there is a positive cost of public funds k > 0.

9.2.1.2 Scarce capacity

To the extent that scarce capacity is showing up as increasing marginal transportation costs, this is taken care of in the optimal pricing rule (9.7). We therefore assume that there is an absolute

260


¯ and we maintain the assumption that capacity limit given by K, the downstream markets are independent, pN / xT = pT / xN = 0. Moreover, the gas of both producers is assumed to be symmetric from a capacity point of view. The problem is then to maximize (9.1) ¯ subject to the constraint that xN + xT ≤ K. The first order conditions for the network owner’s own transport and pricing of the third party’s transport are given by 1 pN − CN / xN + cTt / xN + /1 + k = (9.8) pN N

T − cTt / xT + cNt / xT + /1 + k 1 + k − 1 = (9.9)

T 1 + k T where N ≥ 0 is the price elasticity of the demand for gas in the downstream market and ≥ 0 is the shadow price of capacity. From (9.8) and (9.9) we see that scarce capacity has the same effect on the relative markups for the network owner and the third party as a uniform increase in the marginal transportation costs for both shippers’ use of transportation capacity. Hence, it does not make any difference for the optimal tariff whether the network capacity on the margin is enlarged by increasing the pressure through costly compressors or demand is decreased through an increase in the markup factor. Since the network owner and the third party compete for scarce capacity, their willingness to pay for capacity must in either case match the scarcity value in addition to the variable cost.4 Intuitively, the imputed shadow price should be increased until the capacity restriction is fulfilled. The numerical value of the shadow price is therefore determined in optimum. Solving for the optimal prices yields 1 CN cTt + + 1 + k pN = 1 − 1 xN xN T

The shadow price is divided by 1 + k in order to have it denominated in the social value of the network owner’s profit.

4


T =

1 1 1 − 1+k− 1+k

T

261

cNt cTt + + 1 + k xT xT

Thus, the rationing of scarce capacity is handled through an equal calculated capacity cost increment for the two shippers. The calculated cost of using scarce capacity increases with the government’s share in the network’s profit when the social value of profits accruing to the government is larger than one. The effect on the optimal tariff rate depends on the markup factor. Assuming that the demand for transportation of both the network owner and the third party has the same price elasticity in the relevant interval, the optimal markup factor will be largest for the network owner when > 0. The reason for this is that with national owner interests in the third party, part of the efficiency costs due to scarce capacity is borne by domestic owners, which in itself is an argument for a lower tariff rate. For the network owner the shadow cost of scarce capacity is added to the cost base which is subject to a monopolistic markup. In that sense its scarcity cost is borne by the foreign end-users. When the third party is owned by foreigners, it will be optimal to charge a full monopoly markup also for the third party’s use of the network. With equal elasticities the price effect from scarce capacity will then be the same for both users. This means that it will be optimal to exert fully the market power both as to the foreign owners of the non-facility based third party as well as to the foreign consumers of the network company. 9.2.1.3 Competition between the network owner and the third party in the end-user market for gas

We now assume that the network owner and the third party compete for consumers in the end-user market. This means that the two markets are connected, so that gas delivered by the producer without transportation facilities is a (possibly imperfect) substitute for gas delivered by the integrated producer. In this case it follows from

262


(9.6) that the first-order condition for the socially optimal tariff can be written as t c ct pT dxN N

T − xT + xN − xN p − x xT 1+k T xN dxT 1 + k − 1 T T = (9.10)

T 1 + k T The expression in the parenthesis on the left-hand side of (9.10) is the total incremental national costs of transporting another unit of T’s gas. In addition to the pure transportation costs, which are captured by the two first terms in the bracket, we must now correct for the price effects of a marginal increase in xT . More specifically, an increase in xT reduces the price that the network owner can charge in the end-user market pN / xT < 0. This is a cost for the producer country, and is captured by the third term.5 At the same time a higher xT means that the network owner will reduce its output dxN /dxT < 0, and the partial effect of this is that pT increases. This positive indirect price effect for firm T represents a gain for the producer country if domestic residents own shares in the firm > 0. However, the term has to be divided by 1 + k in order to make it comparable with costs incurred by the network owner. Solving (9.10) with respect to T yields t 1 pN pT dxN cT cNt + − xN − xT

T = 1 x x x 1 + k x dx 1 − 1+k− T T T N T 1+k T (9.11) where 1 1−

5

1+k− 1 1+k T

If the firms produce imperfect substitutes, it would be optimal for the regulator to tax export in order to reduce downstream competition. All else equal, this export taxation motive is stronger the closer substitutes are the goods. As this is well known from literature of international trade, we do not focus on this particular tariff motive.


263

is a markup on net total incremental costs in the optimum tariff formula. This is in the nature of a monopoly markup, except for the demand elasticity being inflated by the factor 1 + k/1 + k − ≥ 1. With no foreign shares in firm T = 1, and the vertically integrated network firm N being fully privately owned = 0, the markup factor equals one. In that case the optimum tariff formula simplifies to the expression in the parenthesis on the right-hand side of (9.11). Hence,

cTt cNt pN pT dxN

T = + − xN − xT xT xT xT xN dxT

(9.12)

Equation (9.12) says that the third party should pay a tariff equal to total marginal costs, taking the price effects in the end-user market into account. This tariff formula may be interpreted as the efficient component pricing rule (ECPR) in our setting with quantity competition in the downstream market. The rule is consistent with national export efficiency in the gas industry, since the third party will find it profitable to transport gas if, and only if, this contributes to increased national welfare. However, we see from condition (9.11) that with a positive public ownership in the transportation network > 0 and a premium on public revenue k > 0 it will enhance domestic welfare to extract some of the resource rent through the transportation tariff, even though this will distort the efficient composition of the national gas export. The profit maximizing rate for a private network monopoly is given by6

1

T = 1 − 1/ T

cNt pN cTt + − xN xT xT xT

(9.13)

Technically, irrespective of the monopoly solution is given by setting = 0 in (9.11).

6

264


Comparing (9.13) with (9.11) we see that there are generally two reasons why an independent profit-maximizing monopoly would charge a too high tariff rate as compared with the nationally optimal one if > 0. The first is that the markup used by the monopoly is too high from a national point of view if the downstream rival is at least partially owned by domestic residents. The second is that the monopoly uses a higher base for its markup than a social planner would do, since the private monopoly does not take into account the positive indirect price effect for firm T (cf. the discussion above). The difference between the monopoly tariff and the socially optimal tariff is particularly large in the special case where = 1 and = 0, since the elasticity in that case is irrelevant for the socially optimal tariff rate. However, if > 0 (and k > 0) the regulator finds it optimal that N has a relatively high profit, since this reduces the need for taxation elsewhere in the economy. Consequently, it will be socially optimal to exert some monopoly power in order to indirectly tax private sector profits through the transportation tariff, and more so the higher the foreign ownership share in firm T. The extent to which the monopoly power should be exercised by the government depends on the elasticity T . In any case, the monopoly tariff will always be higher than the socially optimal one. For example, with T = 2 and = k = 05, we can use eqns (9.11) and (9.13) to find that the optimal monopoly markup factor will be 100 per cent on marginal costs compared to the socially optimal markup which is 11 per cent. Proposition 9.2 Assume that the transportation network is owned by an unregulated vertically integrated private monopoly. Then the monopoly tariff rate will be higher than the nationally optimal one both because the monopoly applies a too high markup factor and because the markup is calculated on a too high cost base. Corollary 9.2 If the integrated network company as well as the third party are fully owned by private domestic owners, the nationally optimal tariff rate takes the form of a generalized version of the ECPR.


265

9.2.2 Separation of ownership between transportation network and extraction and marketing activities

The offshore network for transportation of natural gas is a prime example of a natural monopoly. In the North Sea more than 90 per cent of the costs for the infrastructure are fixed and sunk. This renders the transportation network an essential facility which it is neither commercially nor socially worthwhile to duplicate, everything else equal. Thus, the network owner has some market power over third parties that need access to the transportation network. The fact that the integrated gas producer has a monopoly on the transportation facility and competes with non-facility based producers in the enduser markets may be unfortunate from a competitive point of view. Clearly, competitive neutrality is best served by unbundling the transportation network from upstream production and downstream market activities. Generally, separation of networks from production and market activities has also been a policy stance taken by the European Union to the effect that networks within railways, telecom and gas should be organized in such a way that the services of the natural network monopoly do not interfere with the competitive services depending on access to these networks. The conditions for access to the network services should then be regulated as they are supposed to be natural monopolies. We assume that the transportation company is subject to a cost plus regulation. This means that total revenue should cover variable and fixed costs including a regulated return on the investments, but no profits in excess of that. Thus, cost recovery requirement will be a budget constraint. We consider two varieties of this regulation. One is where the regulatory agency is free to differentiate the tariff rate for the two gas companies, and the other is where the two companies are to be faced with equal tariff rates. 9.2.2.1 Differentiated tariff rates

We let F denote total fixed costs in the transportation network including the regulated returns to invested capital. Then the budget

266


constraint takes the form

N xN − cNt xN xT + T xT − cTt xT xN − F = 0

(9.14)

and the profit levels of the companies are N = pN xN xT xN − cNa xN − N xN

(9.15)

T = pT xT xN xT − cTa xT − T xT Socially optimal tariffs now maximize W = 1 + kN + T , subject to (9.14) and (9.15). Letting C t / xj ≡ cjt / xj + cit / xj i j = N T i = j denote total marginal costs (including marginal external costs) of transporting gas for each shipper, the first-order condition for optimum tariff rates can be written as

C

N − x

t

N

p dx p 1+kxN xN dx T +xT x T C t dxT T N N + + T − x dx v T

N

N =

v − 1 + k 1 v

N

(9.16)

and p p dx 1+kxN xN +xT x T dxN C t C t dxN T N T

T − x + N − x dx + v T

N

T

T =

v− 1 v T

(9.17)

where v is the shadow price of the budget constraint. The first two terms in the numerator of (9.16) and (9.17) reflect the marginal contribution to fixed costs in the network company from a marginal increase in the transportation of gas for N and T, respectively. The third term in (9.16) is the indirect effects on profits accruing to national owners due to the cross-price effect in the two end-user markets from a marginal increase in the transportation of


267

gas for company N. The effect on N’s profits is adjusted for the marginal welfare effects from reduced public revenue due to public ownership, while the effect on T’s profits is adjusted for the national ownership share. These effects on national profits have to be divided by the shadow price v in order to make them commensurable with the social value of profits in the transportation company. We can interpret the last term in the numerator on the left-hand side of (9.16) and (9.17) as the marginal social costs due to the price effects assessed at the national level of shipping an additional unit of gas for companies N and T, respectively. The optimal social markups on these marginal social costs are 1 1−

v−1+k 1 v

N

and

1 1−

v− 1 v T

for the two tariffs, respectively. Clearly, if the two companies have only private and national owners, that is, = 1 = 0, then pricing according to marginal social costs is socially optimal if v = 1 and the transportation capacity is not scarce. On the other hand, if T is fully owned by foreigners, then monopoly pricing of transportation allocated to that company would be optimal regardless of whether the profit constraint is binding or not. In the present model the monopoly profit in the transportation company will accrue to the owners of the domestically owned company through reduced tariffs.7 One may think of the profit margin in relation to marginal social costs implicit in the transportation tariffs, as an indirect tax on the use of transport capacity in order to finance fixed costs for the infrastructure. With equal price elasticities in the demand for transport and a positive public ownership in the gas company N, the optimal indirect tax rate (as a percentage of the tariff rate) will be larger for company T with solely private owners if there is an extra premium k > 0 on public revenue. The reason for this is that the One might imagine that this could lead to N < cNt / xN + cTt / xN , which may violate regulation against cross subsidies.

7

268


indirect tax on N reduces the producer surplus and hence the profits accruing to the government. Thus, part of the excess burden from this indirect tax is borne by the taxpayers. In this sense one gets a sort of double taxation; partly because of the efficiency loss due to reduced profits and partly because this leads to increased distorting taxation in the rest of the economy. With foreign ownership in T part of the excess burden of financing the fixed costs through a tariff on that firm is borne by foreigners. This strengthens the arguments for tariff discrimination in favour of N. Proposition 9.3 Assume that the network is run as a separate firm and is subject to cost plus regulation. Then the nationally optimal tariff rates take the form of Ramsey prices, modified by public and foreign ownership shares. We consider a numerical example: Assume that N = T = 15 and cross elasticities are zero, v = 2 k = 05 = 05, and = 1, so that both companies have only national owners. Optimal markups will in this case be 1.33 and 1.5 for N and T, respectively. With = 0, the optimal markup on T increases to 3, which is a 200 per cent increase of the marginal transportation costs.

9.2.2.2 Equal tariff rates

We now assume that the regulatory agency is imposing a requirement of equal treatment as to the conditions for access to the transportation network irrespective of the shipper’s ownership structure. Equal treatment is here assumed to require equal tariff rates related both to private versus public and domestic versus foreign ownership of the shipping companies. We retain the assumption that the transportation company is subject to a rate of return regulation, which in the static case is equivalent to a budget constraint. Observing that all terms with pN / xN and pT / xT vanish by the envelope property of profit maxima, the first-order condition for an


269

optimal tariff rate can now be written as t

t

C C + xT pvT / xN dxN − x + 1+kxNv pN / xT dxT

− x N T +

d

d

v − 1 dxT v − 1 + k 1 dxN + = v

N d

v T d

(9.18)

The left-hand side of condition (9.18) is a weighted average of the relative social profit margins in the two companies, with the marginal capacity demand reactions with respect to changes in the tariff rate as weights, while the right-hand side is a weighted sum of the inverse of the direct price elasticities. The optimal common tariff is between the optimally differentiated tariffs. In order to see this clearly, assume that the marginal transportation costs are the same for the two shippers, and that cross-price effects between the two gas markets are zero. Letting dX/d = dxN /d + dxT /d denote total reduction in demand for transport induced by a marginal increase in the tariff rate, and letting MCt denote the common marginal transportation cost, condition (9.18) simplifies to v − 1 + k 1 dxN /d

v − 1 dxT /d

− MCt = +

v

N dX/d

v T dX/d

(9.19) If the price elasticities of demand are not too different from what they were in the case with optimal tariff discrimination, we see that the optimum profit margin relative to tariff rate in the transportation company is a weighted average of the corresponding margin rates in the case with rate discrimination. With a common tariff rate it will be less attractive to tax the foreign owners in company T through the tariff rate as parts of the efficiency costs are imposed on the domestically owned company with public ownership. In that sense part of the excess burden from taxing foreign owners through the tariff is borne by domestic taxpayers.

270


Proposition 9.4 Assume that the network firm is run as a separately owned company and is required to charge nondiscriminatory tariffs. Then the optimal tariffs will be in between the optimally differentiated tariffs, and a larger deadweight cost from financing the network is to be borne by the gas producing country. We consider a numerical example. We return to the former example and assume that company N accounts for a share of the total response in the demand for transportation capacity to a marginal increase in the tariff rate, and company T for 1 − . As before, we assume that N = T = 15 v = 2 k = 05 = 05, and is 1 or 0. Solving (9.19) with respect to yields = MCt /067 + 008 for = 1 and

= MCt /033 + 042 for = 0. In both cases the optimal common tariff rate will be in between the optimum company-specific tariff rates in the case with third-degree price discrimination, and the size of this common monopoly markup depends on N’s share in the total demand response. The larger the N’s response, the smaller the optimal markup on marginal transportation costs. With = 1 the optimal markup is 1.33 for = 1 and 1.5 for = 0, which are the optimum tariff rates with tariff discrimination.

9.3 CONCLUSION AND DISCUSSION

In the present chapter we have discussed optimal tariffs from a national perspective for transportation of natural gas for gas shippers without own transport facilities in a setting where the national gas production in its entirety is exported to end-user markets abroad. An underlying assumption for the analysis is that the national appropriation of the resource rent through national taxation is incomplete and the issue is to what extent it would be optimal to harvest some of the rents through the tariff rates for gas transport. In the situation where the transportation network is owned by an integrated national gas producer, it is shown that optimal tariffs towards third parties depend on the ownership structure in the integrated transportation company as


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well as in the non-facility based gas company. More precisely, there are two features of ownership that are decisive for the optimal tariff. One is the public ownership share in the integrated transport company which in the case of a premium on public revenue calls for a tariff in excess of the marginal transportation costs. This is due to the fact that one unit of profit has a higher social value in the network company than in the privately owned company. The other is the foreign ownership share in the privately owned company that depends on access to the network for its gas transport. A markup on transportation cost is in that case an indirect way of appropriating rents accruing to foreigners. Indeed, the optimal tariff approaches the monopoly tariff as the foreign ownership share approaches 100 per cent. An integrated national gas producer controlling the transportation network and exerting monopoly power in the pricing of third party access is certainly not in accordance with EU’s gas market directive laying down conditions conducive to a more competitive gas market. One step in this direction is to debundle the transportation activity from the producing and selling activities. Accordingly, we have examined optimal tariffs in a scenario where the network is run as a separate entity subject to a rate of return regulation. Again, for the above-mentioned reasons it is optimal to discriminate the optimal tariff between the fully domestically owned shipper with a public share and a fully privately owned shipper with possibly some foreign owner interests. In this case the optimal tariffs may be seen as Ramsey prices and the markups as indirect taxes that are used to finance fixed costs for maintaining and operating the network (inclusive of regulated profits). If nondiscriminatory terms for the access of third parties to the network are to be interpreted as equal tariffs for all shippers, the optimal tariffs will be in between the optimally differentiated tariffs. This regulation will of course mean a welfare loss to the gas exporting country as a larger part of the excess burden has to be borne by nationals in the capacity of taxpayers as well as recipients of profits from the gas sector. The above analysis is partial in that it has been conducted from the point of view of producer interests. Consumer interests have only been taken into account indirectly through their role as taxpayers.

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In a setting where the gas is also consumed domestically, consumer interests have to be taken into account more directly. However, it is well known that the difference between Ramsey prices and monopoly prices is primarily with respect to the price level while relative profit margins are the same. Thus, including consumer interests is not likely to change the structure of the optimal tariffs derived in Section 9.2.2, where the transportation network is subject to a budget constraint. This insight indicates that our results are qualitatively valid also for other regulated network industries. The model is partial in other respects as well. Most notably, we have considered the transportation system as a separate activity rather than as an integral part of the total value chain. In the long run, transportation tariffs might affect both optimum depletion policies and gas market strategies. An interesting extension of the model would be to consider a case with multinational companies operating gas fields in different countries and competing in end-user markets. The motivation for the present chapter has been the particular features of the Norwegian gas market and the EU Gas Market Directive. However, we believe that the qualitative results should also be valid for other regulated network industries in which there are significant public and foreign ownership shares. In networks like electricity, telecommunications, water and railways, for instance, the government still has considerable ownership interest in most countries. Also, the ownership of these industries has become increasingly multinational, not the least due to WTO investment agreements. Hence, our analysis should apply also in these contexts.

APPENDIX A9.1 EXISTENCE OF EQUILIBRIUM

Suppose that the goods are imperfect substitutes. With a fully integrated network (Section 9.2.1) we have N = pN xN xT xN + T xT − C˜ N xN xT

(9.20)


273

where C˜ N xN xT ≡ cNa xN + cNt xN xT + cTt xN xT , and T = pT xT xN xT − C˜ T xT

(9.21)

where C˜ T xT ≡ cTa xT + T xT . From (9.20) and (9.21) we have the following first-order condition for firm j = T N: pj C˜ j j = xj + pj − = 0 xj xj xj We assume that the second-order condition for each firm is negative: 2 j xj2

2 pj 2 C˜ j pj =2 + xj 2 − 2 < 0 xj xj xj

We further require that 2 pj pj 2 C˜ j 2 j = + xj − −1

Note that 2 C˜ T / xT xN = 0. Technically, to be sure that the two reactions curves cross we must require that pN 0 0 > C˜ N 0 0/ xN pT 0 0 > C˜ T 0/ xT (each firm would prefer a positive output if the rival does not produce), and Rj xim > 0 (if one firm supplies monopoly output, the other firm would also have positive production).

8 9

274


Assuming that 2 C˜ j / xj2 ≥ 2 C˜ j / xj xi (which in the present context means that the network owner’s marginal costs increase at least as fast in its own output as in that of the downstream rival), it follows that Rj xi > −1 if

2 pj 2 pj pj pj 1 < − 2 x − xj j xj xi xj xi xj2 which, loosely speaking, amounts to requiring that the demand functions are not too convex (or sufficiently concave if 2 pj / xj xi < 0. Finally, eqn (9.6) defines welfare optimum if d2 W/d T2 < 0, or d2 N d2 T < − 1 + k d T2 d T2 Otherwise, welfare optimum will be given by a corner solution where

T = 0 or where T is so high that firm T is completely foreclosed from the market. The conditions for a stable and unique equilibrium in the cases considered in Section 9.2.2 are similar.

A9.2 DOWNSTREAM COMPETITION WITH FIRMS LOCATED OUTSIDE THE COUNTRY

Suppose that producers N and T compete with m other firms in the downstream market, but that these firms produce gas in one or more other countries. If the network is fully integrated, we must modify eqns (9.4) and (9.5) to, respectively, m dN pN dxi pN CN cTt dxT = T + xN − − + xT − d T xT i=1 xi dxT xT xT d T and

m dT pT dxi pT dxN = xT + − xT d T xN d T i=1 xi d T


275

Solving the first-order condition (cf. eqn (9.6)) 1 + k

d dN + T = 0 d T d T

(9.22)

we find

T −

cTt xT

ct

+ xN − xN

T

pN xT

−

m

pN dxi i=1 xi dxT

xT − 1+k

pT dxN xN d T

+

m

pT dxi i=1 xi d T

T =

1 + k − 1 1 + k T

which corresponds to (9.10). Moreover, it is straightforward to show that also the qualitative results obtained in Section 9.2.2 hold if firms N and T face competition from firms producing gas in other countries.

REFERENCES Cremer, H. and J.-J. Laffont (2002): ‘Competition in gas markets’, European Economic Review 46: 928–935. Cremer, H., F. Gasmi, and J.-J. Laffont (2003): ‘Access to pipelines in competitive gas markets’, Journal of Regulatory Economics 24: 5–33. Diamond, P. A. and J. A. Mirrless (1971a): ‘Optimal taxation and public production. I: Production efficiency’, American Economic Review 61: 8–27. Diamond, P. A. and J. A. Mirrless (1971b): ‘Optimal taxation and public production. II: Tax rules’, American Economic Review 61: 261–278. Kreps, D. and J. Scheinkman (1983): ‘Quantity precommitment and Bertrand competition yield Cournot outcomes’, Bell Journal of Economics 14: 326–337. Laffont, J.-J. and J. Tirole (1994): ‘Access pricing and competition’, European Economic Review 38: 1673–1710. Lee, S. H. and J. H. Hamilton (1999): ‘Using market structure to regulate a vertically integrated monopolist’, Journal of Regulatory Economics 15: 223–248. Vickers, J. S. (1995): ‘Competition and regulation in vertically related markets’, Review of Economic Studies 62: 1–17.


Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Published by Elsevier B.V.

CHAPTER 10

Mobile Termination HARLEY THOMPSON∗ and OLIVIER RENARD† ∗ Charles River Associates International, Sydney † Charles River Associates International, Melbourne JULIAN WRIGHT National University of Singapore, Singapore

Contents 10.1 INTRODUCTION 10.2 LITERATURE REVIEW 10.3 THEORETICAL MODEL 10.3.1 Model derivation 10.3.2 Model solution 10.4 MODEL CALIBRATION 10.4.1 Colombian fixed-to-mobile arrangements 10.4.2 Calibration methodology 10.4.3 Data for Colombia 10.5 WELFARE ANALYSIS 10.6 CONCLUSIONS AND FUTURE DIRECTIONS REFERENCES

277 280 285 285 290 292 292 293 293 294 299 301

10.1 INTRODUCTION

Regulators in Australia, Japan, the United Kingdom and many other countries in Europe have regulated mobile termination rates reflecting concerns about the high level of these charges and the resulting high fixed-to-mobile retail prices. In Latin American countries,

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despite success in expanding mobile telephony, the relatively high charges imposed by mobile phone operators on fixed-line networks to accept calls have led to recent calls for regulatory intervention. For example, regulatory agencies in Colombia, Panama, Uruguay and Argentina have included mobile termination in their agenda. Theoretical support for the possibility that fixed-to-mobile prices may be set too high comes from theoretical models provided by Armstrong (2002), Gans and King (2000) and Wright (2002). This theory is based on the simple idea that mobile operators have a monopoly on terminating calls to their customers from fixed-line callers, which they will exploit by setting high fixed-to-mobile termination charges. Wright (1999, 2002) analyses a positive implication of such high termination charges. Competition to collect this lucrative termination revenue drives mobile operators to set low mobile charges, so as to attract subscribers to their network and thereby collect more termination revenue. Through competition, the revenue from termination may be largely passed back to mobile consumers. In situations where mobile participation is limited, this can spur more people to get mobile phones, which provides positive spillovers both to fixed-line users and other mobile phone users.1 Thus, in markets with incomplete cellular penetration it is not clear whether current termination charges, even if above cost, are set too high. Wright (1999) provides a numerical example to show that with partial mobile penetration, the socially optimal termination charge could in fact be many times the costs. This chapter builds on this approach by calculating the welfare effects of lowering termination charges in a selected Latin American country by calibrating a theoretical model to market conditions in Colombia. Countries such as 1

There is also an indirect mechanism by which high termination charges can increase mobile subscriptions, which has not previously been noted. An increase in fixed-to-mobile termination charges increases fixed-to-mobile retail prices, which increases the demand for mobile subscription from people who want to call mobile subscribers that are away from a landline, but want to avoid the high fixed-tomobile prices.

Chapter 10 – Mobile Termination

279

Colombia are of interest since they involve markets where (a) mobile penetration is still quite low – less than 30 per cent for most Latin American countries2 and (b) policymakers are considering regulating for lower termination charges. The theoretical model that is calibrated is similar to Wright (1999) but extends his model in several dimensions. First, the model here allows for any number of mobile firms to compete. This is done using a generalized product differentiation framework in which all mobile operators compete directly with all others (unlike the Salop model), and they need not to be symmetric. Second, the model captures the realistic aspect that firms set two-part tariffs, but still markup unit prices above cost. This is modelled by allowing consumers to vary in their intensity of demand, while restricting firms to offer a single two-part tariff. This reflects the fact that firms may want to keep their pricing plans relatively simple even in the face of heterogeneous consumers. Third, the model is matched to actual data from Colombia. We calibrate the model using recent data on the Colombian market. The relevant data are the mobile penetration rate, the number of mobile firms and their market shares, the costs of service provision (unit costs and annual rentals for mobile-to-mobile, mobile-to-fixed and fixed-to-mobile services) and the elasticities of demand for each call type. The simulation results show that consumer surplus,3 fixed-tomobile traffic and mobile penetration are all increasing functions of the termination charge in the region of the current termination charge ±5 cents. However as the termination charge continues to increase consumer surplus begins to decline. This is because, as termination charges increase, at some point, the positive impact on termination profits the impact on expanding mobile penetration weakens, while the negative impact on higher fixed-to-mobile prices becomes more significant. The point at which total consumer surplus is maximized is around 7 cents above the current termination charge. A similar 2

Chile and Mexico have the highest mobile penetration rates but still less than 50 per cent. 3 The sum of consumer surplus from mobile and fixed-line consumers.

280


effect occurs for fixed-to-mobile traffic, which initially rises due to the impact of rising mobile penetration rates but then falls due to falling fixed-to-mobile demand caused by rising fixed-to-mobile prices. Surprisingly, fixed-to-mobile traffic is actually maximized at around 6 cents above the current termination charge, consistent with strong positive spillovers from greater mobile penetration on fixed line users. The rest of the chapter is laid out as follows. In Section 10.2 we briefly review the main literature on fixed-to-mobile termination charging, discussing along the way the idea that ‘receiver pays’ which is sometimes touted as an alternative (light-handed) policy to regulating termination charges. Section 10.3 presents our theoretical model. Data and the calibration exercise are given in Section 10.4, while Section 10.5 presents the results and welfare analysis. Section 10.6 briefly concludes and offers some directions for future research.

10.2 LITERATURE REVIEW

In this section we review the recent literature that analyses fixedto-mobile call termination.4 We start by reviewing the theoretical literature on the socially optimal level of the fixed-to-mobile termination charge, and models which explain how unregulated mobile operators should in theory set fixed-to-mobile termination charges. We then offer our perspective on a recent literature which promotes the idea that receiver pays as an alternative to regulating fixed-tomobile termination charges. Armstrong (1997) noted the high price of fixed-to-mobile calls in the UK (in July 1996 the average per-minute retail charge for fixed-to-mobile calls was around 25 pence) and provided a simple model of fixed-to-mobile calls to examine the socially optimal level 4

See Gans et al. (forthcoming) for a more general literature survey on mobile telephony.


281

of these charges. In a model of perfectly competitive mobile operators, he shows that the socially optimal termination charge should be set below cost to the extent to which the price of fixed-to-mobile calls involves a margin above the termination cost (to avoid double marginalization). Also, it should be set below cost to the extent to which mobile subscribers get utility from receiving calls (to internalize the externality to call receivers), but it should be set above cost to the extent this affords a subsidy to mobile subscribers which encourages more mobile subscription (since this benefits fixed-line consumers, who can now make more fixed-to-mobile calls). Wright (1999) considers (numerically) a model of partial mobile penetration which has the first and third feature discussed above. In addition, by capturing imperfect competition in the mobile sector and allowing for mobile-to-mobile calls, he captures two additional effects to those noted by Armstrong. In this setting, a subsidy to mobile subscribers from high termination charges means that existing cellular subscribers as well as fixed-line subscribers benefit from being able to call new mobile subscribers who join because of subsidized subscription charges. Efficiency is also enhanced by abovecost termination charges given an imperfect competition between mobile operators. This ‘monopoly subsidy’ effect works in the other direction to that on the fixed-to-mobile side where low termination charges help reduce the monopoly markup on fixed-to-mobile prices and thereby increase efficiency. Wright takes into account all these effects. Using a numerical example he finds that the socially optimal termination charge can be several times the cost when the mobile penetration rate is around 50 per cent. Gans and King (2000), Wright (1999, 2002), and Armstrong (2002) model how competing mobile operators want to set their termination charges to a single fixed-to-mobile operator. These models assume a given number of fixed-to-mobile subscribers who choose the number of fixed-to-mobile calls.5 Gans and King consider the

5

The fact that fixed and mobile subscribers do not jointly determine the number of fixed-to-mobile calls is broadly consistent with the fact that in equilibrium it is the fixed-line caller that pays for the call.

282


case in which the fixed-line network can set differential fixed-tomobile prices depending on which mobile operator the calls terminate on, but where consumers are ignorant about which mobile network they are calling. Wright (1999) makes a formally equivalent assumption that a uniform fixed-to-mobile price is set. Armstrong (2002) and Wright (2002) consider fixed-to-mobile prices that can differ depending on which mobile network is called. In all cases, competing mobile operators set their termination charges at, or even above, the level that a single (monopoly) mobile operator would choose to charge to the fixed-to-mobile network. In these models, mobile operators neither internalize the profits of the fixed-to-mobile network nor the surplus of fixed-to-mobile callers when setting their termination charges. Rather they seek to maximize termination profits, if only so they can provide the maximum subsidy to their subscribers. There are, however, some reasons why the resulting termination rates may not be so high (or too high). Armstrong (2002) considers the case in which mobile subscribers internalize the benefits of those calling them (e.g., they might care about the price their friends and family pay to call them). This makes mobile subscribers less inclined to join a network that offers cheap subscription only because it is expensive for others to call the network.6 In this setting, mobile carriers will have less incentives to set high termination charges. Similarly, as mobile penetration increases, mobile-to-mobile calls will increasingly be an important substitute for fixed-to-mobile calls. If consumers are charged too much for making fixed-to-mobile calls they will simply make mobile-to-mobile calls instead. This substitution possibility should help constrain the ability of the fixed-line operator to mark up fixed-to-mobile calls. To the extent to which

6

Such subscribers may still join a cheaper network funded by high fixed-to-mobile termination charges since they can always take advantage of cost-based mobileto-fixed prices to call back fixed-to-mobile callers. This tends to make fixed-tomobile demand more elastic, and the monopoly fixed-to-mobile termination charge lower.


283

mobile-to-mobile calls are cost based, this will also undermine the ability of mobile carriers to raise their fixed-to-mobile termination charges much above cost. Essentially, fixed-to-mobile demand will become more elastic, lowering the monopoly termination charge towards cost.7 The monopoly pricing in call termination is heightened by an asymmetric regulatory approach. Typically, the fixed-line network has to terminate mobile calls at cost while mobile operators are free to set termination charges for fixed-line calls. To the extent to which the fixed-line network has bargaining power, perhaps because mobile operators also require services from it (and these services are not regulated), the resulting negotiated termination charges should be lower than that predicted by the Armstrong, Gans and King, and Wright models. It is worth noting that even if mobile operators do set termination charges at the monopoly level, their bottleneck over mobile termination does not imply that mobile operators have market power. Since market power is defined as the ability of firm(s) to profitably set a price above the competitive level, and since in this setting perfectly competitive mobile operators may set the same termination charges as a single monopoly operator, by definition operators cannot be said to have any market power in call termination. Instead, market power is more usefully defined over the full range of retail services that the operators provide in which case it will relate to the general competitiveness of the mobile sector. A related literature to that discussed above considers receiver-pays as an alternative approach to dealing with the monopoly call termination problem (see Doyle and Smith, 1998; Crandall and Sidak, 2004; and Littlechild, 2004). The idea is that by charging receivers directly mobile operators do not need to charge high termination charges, and so the call termination problem is avoided. For instance, Doyle and Smith consider a setup in which the fixed-to-mobile caller pays 7

This also suggests the analysis of mobile-to-mobile termination charges may be quite closely tied to that of fixed-to-mobile termination.

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a price equal to the normal price of a fixed-line call. The mobile subscriber receiving the call makes up the difference between the posted price of a fixed-to-mobile call set by the mobile operator and the lower charge paid by the fixed-line caller. They argue that under this receiver pays principle (RPP) prices will be lower. Crandall and Sidak (2004) and Littlechild (2004) go further, promoting ‘receiver pays’ as a light-handed alternative to regulating termination charges. However, it is not clear from this literature how allowing receivers to pay solves the call termination problem, without some other explicit or implicit regulatory intervention (such as that considered by Doyle and Smith). In fact, if the models of Armstrong, Gans and King, and Wright are extended to allow receivers to also pay this would not change the incentive of mobile operators to set termination charges at the monopoly level. Put simply, whether mobile operators can charge their subscribers for receiving calls, or just for subscription, does not change their general incentive to charge the fixed-line network for terminating calls to its customers. Given that ‘for RPP countries generally the termination charge is negligible or zero’ (Littlechild, 2004), this suggests that some other aspect of these receiver-pays regimes is effectively regulating termination charges to zero. Seen in this light, the proponents of receiver pays regimes are actually promoting even more drastic regulation of termination charges – to set them to zero. In fact, it may be better to think of ‘receiver pays’ as the outcome rather than cause of low termination charges. Regulation of zero termination charges in a competitive mobile sector will lead mobile operators to charge receivers for incoming calls to recover their marginal costs of receiving calls. In contrast, with high termination charges, operators would not want to charge their subscribers for receiving calls, since this will reduce the number of calls they terminate and their termination revenue (as say their subscribers turn off their phones, or shorten their conversations). Thus, ‘caller pays’ will endogenously arise when high termination charges are allowed, while ‘receiver pays’ will endogenously arise when low termination charges are regulated.


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10.3 THEORETICAL MODEL

In this section we detail the theoretical model used for our welfare analysis of fixed-to-mobile termination charges. It is closest to the model presented in Wright (1999) but extends his model to allow for any number of mobile firms to compete using a generalized product differentiation framework and to allow for heterogeneous consumer demand for calls. The first extension allows us to handle the fact that, in the Colombian market, there are three competing mobile firms. It can be applied to other markets with more than three firms. The second extension is important since it helps to explain why unit prices are set above marginal cost even though firms set two-part tariffs, which seems to be the case. Wright’s model was based on the Hotelling model. Rather than extending his model to allow for J firms using the Salop model, which assumes that each firm only competes directly with its two closest competitors, we instead use an extension that allows all mobile operators to compete directly with all others. This puts firms on the vertexes of a J − 1-dimensional simplex with consumers uniformly distributed along the edges of this simplex. Brand loyalty (or asymmetry in operators) is modelled in the same way as Wright so that consumers’ utility has an operator- (or brand-) specific effect (which differs across each operator but in the same way for all consumers). The model thus combines both vertical and horizontal differentiation with J -firm competition in a tractable way.

10.3.1 Model derivation

We consider a market comprising j = 1 J mobile-telephony firms and a single nonintegrated fixed-line firm. Each mobile firm chooses the level of its rentals and its unit prices to maximise profit given the prices and rentals of its competitors. The services provided by the firms are purchased by i = 1 N consumers. Consumers are differentiated by their preference for each mobile firm and by their willingness to pay for mobile calls.

286


The utility functions of consumers comprise two main components: (i) utility arising from making telephone calls (‘call-related benefits’); and (ii) utility arising from subscribing to a particular mobile network operator (‘network benefits’). These two factors are combined additively and are summed across consumers to yield total consumer benefits. Consumers make three types of calls involving mobile firms: mobile-to-mobile calls, mobile-to-fixed calls and fixed-to-mobile calls. For a given consumer the utility derived from mobile-to-mobile calls depends not only on the desired number of call minutes made but also on the number of other mobile subscribers that can be reached. Therefore, we write the utility function of a representative consumer as ui q = ai q −1/

(10.1)

where ai ∼ U amin amax with 0 ≤ amin < amax < and > 1 is the price elasticity of demand. The term is the mobile telephone penetration rate (defined below) and q is the quantity of mobile-tomobile call minutes demanded by one mobile subscriber to another subscriber. The variable ai allows the utility derived from a given quantity of call minutes to vary across consumers. Given prices, consumer i’s demand for services from mobile firm j solves m wij = maxui q − pj q q

which yields the demand function ai qij = pj

(10.2)

(10.3)

where pj is the unit price of mobile-to-mobile calls and = − 1/. The maximized benefit accruing to the representative consumer


287

from making calls to other mobiles, wim , is given by substituting (10.3) into (10.2) which gives m wij

= ai

pj

−1 −1

(10.4)

The number of fixed subscribers is assumed to be constant. As in the mobile-to-mobile case, the representative consumer’s utility function for mobile-to-fixed calls is assumed to be of the form ui q = ai q −1/

(10.5)

where q is the quantity of mobile-to-fixed call minutes demanded per year by one mobile subscriber and the other parameters are as described above. Note that the assumption of a constant number of fixed subscribers means that the utility function does not need to be multiplied by (or equivalently, the penetration rate is effectively equal to one for fixed subscribers). The corresponding demand function for mobile-to-fixed calls is f = qij

ai pjf

(10.6)

and the maximized benefit accruing to the consumer is f wij = ai

pjf

−1 −1

(10.7)

where pjf is the unit price of mobile-to-fixed calls. Subscribers to fixed lines are assumed to demand Q minutes of fixed-to-mobile calls to each mobile user. The demand function for fixed-to-mobile calls is Q = B1 − B2 P

(10.8)

288


where P is the unit price and B1 B2 > 0 are known parameters. As discussed above, the representative consumer’s benefit from mobile subscription is modelled via a generalization of the standard Hotelling model to the case of J firms, with the firms arranged around the vertices of a simplex and consumers distributed uniformly along the edges. Normalizing the total distance along the edges of the simplex to 1, and noting that there are JJ − 1/2 such intervals, the length L of any single interval is L = 2/JJ − 1

(10.9)

To model network benefits we attribute to the position of consumer i located between any two firms a subjective benefit from subscription to either of the two firms. Letting xi→j ∈ 0 L be a position index measuring the distance between consumer i and firm j, the firm-specific network benefit of consumer i can be written as i = j − txi→j

(10.10)

where j is the maximum possible benefit to consumer i from subscribing to firm j (corresponding to xi→j = 0) and t > 0 is a parameter determining the rate at which this benefit declines as the consumer moves away from firm j. The total benefit accruing to consumer i from subscribing to firm j is then the sum of network and call-related benefits: m f + wij − rj + i Uj xi ai = wij ⎡ ⎤ −1 −1 a

a = ⎣ i + i − rj ⎦ + j − txi→j pj pjf

(10.11) where rj is the annual rental rate charged by mobile firm j to each subscriber.


289

Given the choices of consumers, firms maximize profits with respect to their decision variables (mobile-to-fixed and mobile-tomobile per-minute prices and annual rental rates) subject to the prices and rentals of other firms. Revenues accrue to the firms through unit prices and rentals charged as well as through charges levied on other firms for the termination of calls from other firms. Costs accrue through the costs of originating calls (assumed to be fixed) and the charges levied by other firms for terminating calls. Table 10.1 gives costs and revenues for mobile firm j. The unit price charged by mobile firms to other mobile firms for terminating calls is assumed to be set equal to the cost c. This means that mobile-to-mobile termination makes no net contribution to mobile firm’s profits. While this may not be a realistic assumption in practice, it is used to focus on the role of the fixed-to-mobile termination charge. The termination charge set by the fixed-line operator for mobile-to-fixed calls is assumed to be set by regulation at the corresponding termination cost. Table 10.1 Costs and revenues for mobile firm j Mnemonic

Description

Classification

Pj

Unit price charged to subscriber i by mobile firm j for call to mobile firm k = j Unit price charged to subscriber i by mobile firm j for call to fixed firm Rental charge (non-call-related) by mobile firm j to subscriber i Unit price charged to fixed firm by mobile firm j for terminating calls which originate on the fixed firm Unit cost incurred by mobile firm j to originate a call to another firm (either fixed or mobile) Unit cost incurred by mobile firm j to terminate a call from another firm (either fixed or mobile) Unit cost charged to mobile firm j by fixed firm to terminate a call originated on mobile firm j Unit cost incurred by fixed firm to originate a call made to a mobile firm Per-customer cost to mobile firm j of non-call-service provision

Revenue

pjf rj Aj

c

C

F

Revenue Revenue Revenue

Cost

Cost

Cost

290


Given these assumptions, the profit function of firm j, assuming that the fixed-line operator is nonintegrated, is given by

j = nj rj − F + Aj − cQ N f m f pj − 2cqij + pj − c − Cqij · Ii∈j +

(10.12)

i=1

where nj is the number of consumers subscribing to firm j and Ii∈j is an indicator function taking the value 1 if a consumer i subscribes to firm j and zero otherwise. The unit price of fixed-to-mobile calls is set by regulation at P = C + A + , where is a fixed retail markup. This form assumes that higher termination charges are fully reflected in higher fixed-to-mobile prices, a feature consistent with the pricing arrangements in Colombia, as will be discussed. The market penetration rate is defined as the number of consumers subscribing to mobile firms as a proportion of the total number of consumers J 1 = n N j=1 j

(10.13)

10.3.2 Model solution

Given the decision variables z = p1 pJ p1f pJf r1 rJ and model parameters amin amax t 1 J B1 B2 solving the model involves firms maximizing their profits given the choices of consumers. To perform this optimization, a grid of N points is generated over the space amin amax × 0 1 to represent the consumers in the model and their attributes a x. The grid is constructed so that the minimum distance d between any pair of consumers in the x-direction is equal to the minimum distance between any pair of consumers in the a-direction, and consumers extend to a distance d/2 from the edge of the space.


291

Each firm’s profits, given market shares, prices and rentals, are computed as follows: For each consumer i and firm j if Uij xi ai z > 0 Uij xi ai z > Uik xi ai z for all firms k = j, then consumer i is assigned (‘subscribes’) to firm j. Once this condition has been checked for every consumer i = 1 N j is computed from (10.12) and the optimization problem

f r/j (10.14) max j p/j p/j pj pjf rj

is solved for each j until profits are maximized for each firm. Since the profit function depends on Ii∈j and nj , which in turn depend on z through (10.11), these values have to be determined for each iteration of (10.14). To do this, we define an index variable l (initialized at l = 1) and choose an arbitrary starting value for the market penetration rate l−1 ∈ 0 1. Then the market shares corresponding to this value of are determined as follows: (i) For each i and j, if Uij xi ai l z > 0 Uij xi ai l z > Uik xi ai l z for each firm k = j then set Ij i = 1, otherwise set Ij i = 0. (ii) For each firm j set nj l = Ij i i

and compute the market penetration rate J 1 n l l = N j=1 j

292


(iii) If l − l − 1 > tol for some tol > 0 (chosen to be 1 × 10−3 in simulations) set l = l + 1 and return to (i). Otherwise set = l and nj = nj l. The number of consumers is set at N = 64 800. This is, to some extent, arbitrary, simulation sizes between 50 and 100 000 provide a reasonable tradeoff between numerical accuracy and computation time.

10.4 MODEL CALIBRATION

This section explains the data based on the case of Colombia, and the calibrated benchmark parameter values resulting from the calibration exercise.

10.4.1 Colombian fixed-to-mobile arrangements

In Colombia, mobile network operators set the retail fixed-to-mobile price P and the fixed network operator charges the mobile network operators for the cost of origination. This is different from the arrangements used in European countries, Australia and New Zealand, where fixed operators set the fixed-to-mobile retail price and are charged for mobile termination access (at the termination rate). While the two arrangements are different from a licensing point of view,8 they are essentially equivalent for the purpose of this chapter. To see this consider the following example: Assume that, under both arrangements, fixed origination is regulated at C. In the European example, assume that the mobile network operator charges A for mobile termination and the fixed operator charges P = A + C. In this way, by choosing A, the mobile network 8

That is, with respect to who owns the call and who has the commercial freedom to price differentiate.


293

operator also chooses the retail fixed-to-mobile price. In the Colombian example, the mobile network operator chooses the retail fixedto-mobile price P and pays a (regulated) fixed origination. So by setting a retail fixed-to-mobile price, the mobile network operator implicitly sets a ‘termination charge’ on its network.

10.4.2 Calibration methodology

Given the N consumers and J firms, costs F c and C, and the markup , calibration of the model involves choosing values for the parameters amin amax t 1 J to ensure that, for our chosen country, the simulated model generates prices, rentals, market shares ni / i ni and market penetration rates observed in practice.9 To do this, we first compute the (numerical) derivatives of the target variables with respect to the calibrating parameters. Then an iterative scheme is used to find the set of parameters that best match the target variables to the observations. Given the near-linearity of the model, iterative schemes employing a single computation of the Jacobian can be used.

10.4.3 Data for Colombia

To calibrate the model we use annual data on rentals so that demand is measured on an annual basis. The data for the fixed and mobile telephony markets in Colombia are10 : 1 J = 3 mobile firms, 1 fixed firm (regulated) – these three mobile operators are Colombia Movil, Comcel and Bellsouth (now Telefonica);

9

These variables are referred to as target variables. Some of this information is taken from ‘Informe Tercer Trimestre – Julio a Septiembre de 2004’ available at http://www.mincomunicaciones.gov.co/

10

294


2 N = 423 million consumers, 8.4 million of whom own a mobile phone ( = 20 per cent mobile penetration rate); 3 Market shares are n1 = 475 million (56.5 per cent market share), n2 = 267 million, (31.8 per cent) and n3 = 098 million (11.6 per cent); 4 plausible assumptions for unit costs are C = $005 and c = $010; 5 A = $021 fixed-to-mobile termination rate for all firms (average of current termination charges). This termination rate is computed as a weighted average of fixed-to-mobile retail prices ($0.26) minus the fixed origination costs ($0.05); and 6 the annual per subscriber cost is set at F = $36. This is based on an estimated fixed cost of $3 per month, which was inferred from the fact that most mobile operators have a minimum spend policy of roughly $4 per month. Given these data, the calibrated parameter values, using the procedure described in Section 10.4.1, are (in rounded values): 1 amin = 10 amax = 35, 2 1 = 670 2 = 190 3 = 65 3 t = 8000. For simplicity we report results for the symmetric case – that is, where all three firms are of the same size. At a termination charge of A = $021, this implies firm-specific parameters of 1 = 2 = 3 = 215 to obtain a simulated penetration rate of 20 per cent. The simulation results in the symmetric case are similar to those obtained for the asymmetric case using the parameter values reported above. The reason for using the symmetric case is that it is more computationally stable for relatively small values of N and hence provides a more robust base case for reporting model results.

10.5 WELFARE ANALYSIS

This section shows the impact on welfare of changing termination charges using the Colombia model. We start by just looking at the impact on the demand for fixed-to-mobile calls, and on the


295

mobile penetration rate. We then turn to looking at broader measures of welfare. In each case, we consider simulation output using the calibrated parameters for a range of termination rates. The simulated mobile penetration rate increases approximately linearly from 16.5 per cent to 28 per cent as the fixed-to-mobile termination charge is increased from 10 to 50 cents (Figure 10.1). As the fixed-to-mobile termination charge is increased, total fixedto-mobile revenues and profits increase (Figure 10.2). Competition amongst mobile firms to collect this lucrative termination revenue drives mobile operators to set low mobile retail prices (some combination of unit prices and rentals) to attract subscribers to their network, thereby collecting more termination revenues. This leads to more people subscribing to mobile phones and to greater 30% 25% 20% 15% 10% 0.1

0.2

0.3

0.4

0.5 A

Figure 10.1 Mobile penetration rate.

Profit /subscriber ($)

0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.1

0.2

0.3

0.4

0.5 A

Figure 10.2 Total fixed-to-mobile profits.

296


usage of these phones which provides positive spillovers both to fixed-line users and to other mobile phone users, since they can now call more people who are away from their fixed line. The total quantity of fixed-to-mobile traffic increases in the termination charge until it reaches 27 cents, and declines thereafter (Figure 10.3). The reason for this effect is that initially the increase in mobile penetration causes an increase in total fixed-to-mobile call minutes through the network effect which offsets the (negative) effect of increased fixed-to-mobile prices on the quantity demanded. However, eventually the latter effect dominates as prices continue to increase, causing fixed-to-mobile traffic to decline. Consumer surplus is defined as the aggregation of each individual’s utility from mobile services plus the surplus from fixed-tomobile calls. In the discrete setting we use, the utility from mobile services is obtained by summing the utilities of the consumers who decide to participate, defined as those for which IU > 0 = 1. The fixed-line surplus is given by the area under the demand curve above the market price P. Summing these two terms we have N J 1 CS = Uxi ai · IU > 0 + QB1 /B2 − P nj 2 i=1 j=1 N J 1 = Uxi ai · IU > 0 + nj B12 /B2 − 2B1 P + B2 P 2 2 j=1 i=1 (10.15) Customer MOU per year

105 100 95 90 85 80 75 70 0.1

0.2

0.3

0.4

Figure 10.3 Total fixed-to-mobile traffic.

0.5 A


297

500 490 480 470 460 450 440 430 420 410 400 0.1

0.2

0.3

0.4

0.5 A

Figure 10.4 Total consumer surplus (fixed plus mobile).

Figure 10.4 shows the variation in consumer surplus with the fixedto-mobile termination rate. Total surplus to mobile consumers increases with the mobile penetration rate, reflecting the positive impact of higher termination charges (and revenues) being passed back to mobile customers through competition between mobile operators (Figure 10.5).11 Initially, this increase in termination charges also increases the surplus of fixed-to-mobile callers. This is because, despite higher prices, fixed-to-mobile subscribers can now make more calls (due to more people having mobile phones) and this effect initially dominates. 165 145 125 105 85 65 0.1

0.2

0.3

0.4

Figure 10.5 Mobile consumer surplus.

11

This pass-back is in terms of rentals rather than unit prices.

0.5 A

298


However, as termination charges continue to rise, fixed-line consumers start to become worse off as a result of higher termination charges and there is a tradeoff between fixed-line and mobile customers.12 The net effect of this tradeoff is that total consumer surplus is maximized when termination charges are set at 28 cents. The total profit for mobile operators is increasing over the range of termination charges considered, reflecting increased subscription and increased termination revenues. Eventually, higher termination charges lower fixed-to-mobile traffic, and profits will peak, which in our setting occurs at a price well above 50 cents. As predicted by economic theory, this is at a level of the termination charge above that which maximizes welfare. Total welfare, the sum of profits and consumer surplus, is shown in Figure 10.6. Total welfare is maximized at a termination charge of around 48 cents. More interesting is the result that, contrary to the prediction of economic theory, the current level of termination charges (21 cents) is actually below the level that maximizes mobile operators’ joint profits, suggesting that firms are not maximizing their joint profits in setting termination charges. Moreover, the current charge is even lower than the level that maximizes welfare. One explanation is that Index 1.4 1.3 1.2 1.1 1 0.9 0.8 0.1

0.2

0.3

0.4

0.5

Figure 10.6 Total welfare.

12 In practice, mobile customers may also be fixed-line customers, which is why a focus on total consumer surplus is relevant.


299

allowing for substitution between fixed and mobile calls implies that the profit maximizing termination charge is actually substantially lower than that predicted by our calibrated model. Alternatively, perhaps the threat of regulatory intervention or the bargaining power of the fixed operator constrain the mobile operators from setting (joint) profit maximizing termination charges.

10.6 CONCLUSIONS AND FUTURE DIRECTIONS

In this chapter we have analysed the implications of changing fixedto-mobile termination charges for a calibrated model of the Colombian mobile market. We did this by extending the existing models that analyse the setting of fixed-to-mobile termination charges to allow for several realistic features. Specifically, we allowed for heterogeneous consumer demand for making calls which lead firms to set two-part tariffs in which unit prices exceeded marginal cost. We also allowed for competition between three mobile operators rather than the more standard duopoly assumption. Our main new finding is that starting from the current level of termination charges, increasing termination charges has a positive impact on both mobile and fixed-line subscribers as well as the profits of the industry. This reflects both the low level of mobile penetration to start with (around 20%) and that the current level of termination charges appears to be well below the level that maximizes the mobile operators’ joint termination profits. Higher termination charges result in lower mobile rentals and higher mobile participation. Under these circumstances, the result is a strong positive spillover to fixed-line users and other mobile phone users since they can now call more people who are away from their fixed line. We find that starting from current levels it takes a 33 per cent increase in termination charges to maximize consumer surplus and at least a doubling of termination charges to maximize welfare. Based on our modelling, calls to regulate lower termination charges from current levels appear to be a step in the wrong direction. For instance, setting termination to cost would result in a 5 per cent

300


reduction in consumer surplus and a 12 per cent reduction in welfare. Even fixed-to-mobile consumers will be made worse off as their ability to obtain surplus from calling mobile customers is curtailed by the lack of mobile customers. Of course, these results are based on the current low levels of mobile participation in Colombia. As penetration rates approach the high levels seen in many OECD countries the effects uncovered here will become less important. In light of our findings, further research could explore the possible reasons for why mobile operators here appear to be setting their termination charges below the level which maximizes their joint profits. Other interesting policy issues to explore include the impact of setting mobile-to-mobile termination charges above cost and the impact of the above-cost fixed-to-mobile termination rates on the incentives to set mobile-to-mobile termination charges. These issues seem particularly relevant in countries with low mobile penetration rates given that high fixed-to-mobile prices but relatively low mobile-to-mobile prices may further stimulate mobile phone demand as people obtain mobile phones so as to avoid high fixed-to-mobile phone prices. This last point raises a possible direction for future research, a richer model that can incorporate substitution between fixed-tomobile and mobile-to-mobile calls. In this regard, we conclude by outlining what we see as a useful (conceptually at least) framework to model the issue of fixed-to-mobile termination. Consider starting with the assumption that, within a given population, people want to call each other randomly (whether they call, and for how long, of course, will depend on prices). Then add to this a new feature – assume that people are, for some fraction of the time, at home (or at the office) and so can use a landline and the remainder of the time are away from home (or office) and so can only make or receive a call on a mobile phone. Then by specifying consumers’ utility function for making calls, and adding some heterogeneity across consumers, one can endogenously derive consumers’ demand for each type of call (fixed-to-mobile, mobile-to-mobile, mobile-to-fixed) as well as subscription even if the underlying utility from all types of calls is assumed to be the same.


301

This has two nice features compared to the existing literature. First, rather than assuming some given fixed-to-mobile demand and mobile-to-mobile demand as we did in this chapter, the demands for the different types of calls are determined endogenously. This is important once we allow for substitution possibilities, say between fixed-to-mobile and mobile-to-mobile, as it can both reduce the incentive for operators to set high fixed-to-mobile termination charges (due to substitution away from fixed-to-mobile calls) and also increase the welfare benefits of high fixed-to-mobile termination charges (by inducing greater mobile subscription in order to substitute away from fixed-to-mobile calls). Second, from a welfare perspective, it handles the fact that the people who have to pay the cost of high fixed-to-mobile charges when termination charges are set high will be some of the same people who benefit from low mobile subscription charges. The second extension to the modelling framework would then be to allow the number (or length of) fixed-to-mobile calls to be jointly determined by caller and receiver, taking into account that both callers and receivers obtain some utility from calls (see Jeon et al., 2004). This would allow us to consider the possibility that networks can charge consumers directly for making and receiving calls, providing a very general framework in which to consider the mobile call termination problem. Such a framework would allow a more complete picture of the effects of high fixed-to-mobile termination charges to be obtained, and allow issues such as comparisons of receiver-pays and callerpays regimes to be addressed at the same time.

REFERENCES Armstrong, M. (1997): ‘Mobile telephony in the U.K.’, Regulation Initiative Discussion Paper No. 15, London Business School. Armstrong, M. (2002): ‘The theory of access pricing and interconnection’, in Cave, M., S. Majumdar and I. Vogelsang (eds), Handbook of Telecommunications Economics, Vol. 1, Elsevier, Amsterdam, 295–384. Crandall, R. W. and J. G. Sidak (2004): ‘Should regulators set rates to terminate calls on mobile networks?’, Yale Journal of Economics 21: 261–314.

302


Doyle, C. and J. Smith (1998): ‘Market structure in mobile telecoms: Qualified indirect access and the receiver pays principle’, Information Economics and Policy 10: 471–488. Gans, J. S. and S. P. King (2000): ‘Mobile network competition, customer ignorance and fixed-to-mobile call prices’, Information Economics and Policy 12: 301–327. Gans, J. S., S. P. King and J. Wright (2005): ‘Wireless Communications’, in Cave, M., S. Majumdar and I. Vogelsang (eds) Handbook of Telecommunications Economics, Vol. 2, Elsevier, Amsterdam. Jeon, D.-S., J.-J. Laffont and J. Tirole (2004): ‘On the receiver pays principle’, RAND Journal of Economics 35: 85–110. Littlechild, S. (2006): ‘Mobile termination charges: Calling party pays versus receiving party pays’, Telecommunications Policy 30(5–6): 242–277. Wright, J. (1999): ‘Competition and termination in cellular networks’, Working Paper, Centre for Research in Network Economics and Communications, University of Auckland. Wright, J. (2002): ‘Access pricing under competition: An application to cellular networks’, Journal of Industrial Economics 50: 289–315.


CHAPTER 11

Incentives to License Virtual Mobile Network Operators (MVNOs)∗ RALF DEWENTER Helmut-Schmidt University Hamburg, Hamburg JUSTUS HAUCAP Ruhr-University of Bochum, Bochum

Contents 11.1 11.2 11.3 11.4

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 WHAT ARE MVNOs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 REGULATORY APPROACHES AND EMERGENCE OF MVNOs . . . . . . . . . . 309 THE MODEL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 11.4.1 Cournot competition 313 11.4.2 Bertrand competition 316 11.4.3 Stackelberg competition 320 11.5 SUMMARY AND POLICY CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

11.1 INTRODUCTION

A vivid debate about the intensity of competition in mobile telecommunications markets has recently emerged in many jurisdictions. Given that radio spectrum is a scarce ressource which limits the ∗

The authors thank Tobias Hartwich for a critical review of the manuscript.

304


number of mobile network operators (MNOs) that can use their own radio spectrum to provide services, one idea has been to require MNOs to sell or lease spare spectrum capacities to so-called mobile virtual network operators (MVNOs), that is, operators that provide mobile communications services without their own radio spectrum. One aspect of this policy debate is on the appropiate regulatory framework: should MNOs be required by regulation to open up their network for MVNOs and if so, under which terms and conditions? Or, are the MNOs’ incentives to rent out their spare capacities sufficient to facilitate entry by MVNOs? In January 2006, for example, the European Commission has answered the latter question with a no and endorsed a measure proposed by the Spanish national regulator, CMT, to regulate access to the networks of the three Spanish MNOs (Telefónica, Vodafone and Amena) by MVNOs (see European Commission, 2006). Both the European Commission and the Spanish regulator CMT consider the current state of competition in the Spanish mobile telecommunications market as to be unsatisfactory, and both authorities expect MVNOs to intensify competition in that market. A related question has recently emerged in Austria when one of the then four incumbent MNOs (called one) opened up its network for the first Austrian MVNO, Tele2. The three other incumbent MNOs complained to the regulatory authority that the introduction of further competitors would be a violation of license conditions and had to be regarded as a hold-up on their specific investment into network infrastructure. Hence, one (as well as all other MNOs) should be prevented from entering into access agreeements with potential MVNOs to safeguard the MNOs’ specific investments. Put differently, when enabling MVNOs to enter into a mobile communications market there is a trade-off between facilitating competition in services, on the one hand, and providing incentives to invest into network infastructure, on the other. In fact, this trade-off has been exlored with respect to MVNOs in the academic literature by Foros et al. (2002) who analyze the interdependence between voluntary and mandatory roaming agreements on the one hand, and cooperative and noncooperative investment in network coverage on the

Chapter 11 – Incentives to License Virtual Mobile Network Operators 305

other. They find that investment levels decrease when the quality of access provided to the virtual operator by the investing firms (i.e., the facilities-based competitors) increases. Nevertheless, they show that welfare increases if an MVNO is allowed to enter, but investment decisions should be allowed to be taken cooperatively between firms. Complementary to the work on investment incentives by Foros et al. (2002) is the paper by Kim and Park (2004) who analyze the optimal (linear) access charge between MNOs and MVNOs when the products offered are either complements or substitutes. As they show, the linear access charges should exceed marginal costs if MVNOs offer substitutes while the access charges should be below marginal cost if the MVNO offers complements. While both Foros et al. (2002) and Kim and Park (2004) focus on different aspects of market entry by MVNOs, they also both take the MVNOs entry as exogeneous. Most of the policy debate, however, circles around the question of whether incumbent MNOs should be required at all to mandatorily open their networks for MVNOs. Hence, the focus of our chapter will be on the question whether or not MNOs may voluntarily grant network access to MVNOs. To our knowledge, this question has not been thoroughly analyzed in the academic literature, even though there have been some economic policy papers (see, e.g., Kiesewetter, 2002 and Ergas et al., 2005) and some case studies (see, e.g., Dorabialski and Morawski, 2004) on this matter. In order to fill this gap, this chapter will provide a microeconomic analysis of incumbent MNOs’ incentives to provide network access to MVNOs under various modes of market competition. As we will show in this chapter, the MNOs’ incentives to voluntarily provide network access and invite MVNOs onto their network critically depend on two issues: First, the mode of competition and, second, the degree of product differentiation. Generally, MNOs will voluntarily provide network access if the services offered by the candidate MVNOs are sufficiently differentiated, as with a high degree of product differentiation the revenue effects outweigh the competition (or cannibalization) effects. Furthemore, we can show that MNOs will always invite MVNOs onto their network under Cournot competition

306


if the market is sufficiently large, even if MVNOs offer homogeneous products. In contrast, the incentives to voluntarily grant MVNO access are lower under Bertrand competition and decline even further under Stackelberg competition. Under Bertrand and Stackelberg competition, voluntary MVNO access is only granted if the services offered by MVNOs are sufficiently differentiated. The remainder of this chapter is organized as follows. In Section 11.2 we will provide an overview over various MVNO definitions and business models before Section 11.3 discusses the rationales underlying the regulation of MVNO access. In addition, Section 11.3 provides an overview over the emergence of MVNOs in various countries. Our model is presented and analyzed in Section 11.4, before Section 11.5 summarizes our findings and draws conclusions.

11.2 WHAT ARE MVNOs?

While the literature on the economic effects of MVNOs is relatively thin, there is a wide range of definitions offered in the literature. In fact, the questions of what constitutes an MVNO and how to define MVNOs appear to be a major issue of debate, at least in the business literature (see, e.g., Telelektronikk (2001), Maitland et al., 2002 and Anderson and Williams, 2004). The discussions about the appropriate definition of an MVNO are also a result of the lack of any such definition in most jurisdictions’ legislation (see, e.g., Kiesewetter, 2002, p. 1 and Detecon, 2005, p. 13). Among the various MVNO definitions offered in the literature, the International Telecommunications Union (ITU) has defined an MVNO as an operator that provides mobile communications services to users without its own airtime and government-issued licenses (ITU, 2001). In the UK, Oftel (now: Ofcom) has defined it as an organization providing customers with mobile phone services without owning any airtime (see Oftel, 1999) and Hong Kong’s OFTA has defined a mobile virtual network operator (MVNO) as an entity that provides


mobile telecommunications services to customers through interconnection with and access to the radiocommunications infrastructure of a Mobile Network Operator (MNO) (see OFTA, 2002). According to the Finnish Ministry of Transport and Communications (2005, p. 11) the difference between mobile network operators (MNOs) and mobile virtual network operators (MVNOs) is that the latter lease the right of use of radio infrastructure from the licensed mobile network operators. However, MVNOs have their own SIM card that is independent from the MNO’s SIM card, they can have their own numbering resources and also some infrastructure, their own brand and pricing schemes, and their own mobile services. MVNOs can also establish their own interconnection agreements with other network operators. Similarly, Detecon (2005, p. 3) notes that a straightforward formulation defines an MVNO as a company that does not own a mobile spectrum license but sells mobile services under its own brand name, network code and SIM cards using a licensed mobile operator’s radio network (Detecon, 2005, p. 3). The call routing of an MVNO that uses a maximum of own mobile communications infrastructure is depicted in Figure 11.1. However, as is also pointed out in the literature, this broad definition of an MVNO is not always applicable to all MVNO business models deployed in diverse countries with different regulatory systems. While some MVNOs operate their own core network infrastructure including switching, home location register, billing, customer care, value added services platforms and intelligent network systems, other MVNOs simply repackage network operators’ services and issue their own SIM cards by relying almost completely on the host network’s facilities with a little product differentiation. These operators are sometimes also referred to as (enhanced) service providers. Accordingly, Ergas et al. (2005) diffentiate between three types of MVNO models: • full MVNOs, which provide their own network core including a mobile switching center (MSC); • intermediate MVNOs, which acquire a switched service, but either provide their own home location register (HLR) or share a jointly owned HLR with an MNO; and

308


EIR OMC

AUC

HLR Mobile network

BSS VLR

ME

SIM

BTS

BSC

(G)MSC

MVNO roaming customer EIR PSTN AUS MVNO

HLR

(G)MSC VLR

Possible MVNO call routing

Figure 11.1 MVNO call routing, (Source: Kim and Park (2004)).

• thin MVNOs, which only provide additional applications and content and which are little different from pure resellers or service providers. These thin MVNOs are often also labelled enhanced service providers (see, e.g., Kiesewetter, 2002). The borders between these three different types of MVNOs are illustrated in Figure 11.2. While it is important to keep the different meanings of the expression ‘MVNO’ in mind when discussing both business opportunities on the one hand, and regulatory approaches and economic efficiency implications on the other, we will simplify matters for the purpose of our analysis in this chapter. In the following, we will not distinguish between thin, intermediate and thick MVNOs, service providers and resellers. Instead, we rather treat all these models as being dependent on access to an MNO’s network infrastructure, as the focus of our analysis is on the question of whether

Chapter 11 – Incentives to License Virtual Mobile Network Operators 309 EIR

Voicemail AUC SMSC HLR

IN

Prepaid VAS ‘thin’ MVNO Intermediate MVNO

MS ME

BTS

SIM

VLR (G)MSC

RAC

PSTN

Air interface OMC MS: ME: SIM: BSS: BTS: RAC: AUC:

Mobile station Mobile equipment Subscriber identity module Base station subsystem Base transceiver station Radio access controller Authorisation center

OMC: (G)MSC: HLE: VLR: EIR: PSTN:

Full MVNO

Operations and maintenance centre (Gateway) mobile switching center Home location register Visitor location register Equipment identity register Public switched telephone network

Figure 11.2 Borders between different types of MNVOs (Source: Ergas et al., 2005).

MNOs will voluntarily open their network for MVNOs. Our analysis is quite general and also applies to service providers and other business models that have to rely at least to some degree on an MNO’s network infrastructure. For simplicity, we will refer to all of these business models as MVNOs. In fact, this treatment is in line with much of the literature and reflects the fact that, from the user point of view, all except the licensed mobile network operators are virtual operators because they do not have their own network (also see Ministry of Transport and Communications Finland, 2005, p. 10).

11.3 REGULATORY APPROACHES AND EMERGENCE OF MVNOs

Regulatory approaches towards MVNOs differ quite substantially between jurisdictions. This concerns both the requirements that MVNOs themselves face as well as the access obligations put onto

310


MNOs (see Ergas et al., 2005 and Kiesewetter, 2002). While, for example, Ireland, Denmark and Hong Kong have made specific regulatory provisions for MVNOs, several Nordic countries require MNOs to provide network access in quite general terms. Other countries such as the USA, the UK, Australia and New Zealand have no access obligations. In Germany, MNOs are required by regulation to enter into wholesale agreements with the so-called service providers (who basically act as resellers). Differences in regulation also exist with respect to the MVNOs’ treatment. For example, some jurisdictions that mandate MVNO access require MVNOs to undertake some minimum investement into their own mobile infrastructure while others have very little infrastructure requirements.1 The underlying rationale of mandating MVNO access is twofold (see Ergas et al., 2005). First, MVNOs may increase retail competition as a consequence of which prices may decrease and mobile penetration and the quantity of services supplied increase. For example, the European Commission (2006) argues that ‘MVNOs can boost competition with tangible benefits for consumers in terms of lower prices’. Furthermore, there is usually a presumption among the advocates of regulated MVNO access that MVNOs may offer innovative service bundles and also facilitate downstream innovations by incumbent MNOs in response to an MVNO’s market entry. And second, the so-called ladder of investment theory states that new entrants slowly climb up a ladder of investment if they can enter a market without burdensome investment requirements. Put differently, the idea is that an entrant first enters an industry without much specific investment, offering services only. Once the entrant has acquired a certain threshold number of customers he may invest into its own infrastructure in order to be less dependent on the incumbent and to offer a wider range of services (see, e.g., Cave

1

For example, OFTA and the ODTR require that MVNOs establish their own home location register (HLR) and their own mobile switching center (MSC), see Ergas et al. (2005, footnote 15).


and Vogelsang, 2003). Following this line of reasoning, regulated MVNO access may spur investment by new entrants. On the other hand, incumbents’ investment incentives are likely to decrease if they have to share their facilities with competitors. Since forced access reduces the rents that an incumbent can appropriate from its investment, the incentives to invest will decrease so that mandated MVNO access may reduce investment by incumbent operators. Hence, the overall effect of regulating MVNO access on investment is not clear. When MVNO access is provided for by regulation it is not surprising that MVNOs have emerged as competitors in markets for mobile communications services. However, even in the absence of mandatory access provisions MVNOs have successfully entered the industry in many jurisdictions. By now, MVNOs or similar business models exist in almost all jurisdictions with liberalized mobile telecommunications markets. Tables 11.1 and 11.2 provide an overview of market entry by MVNOs in various countries. Table 11.1 MVNOs in selected countries Country Australia Austria Belgium Canada Denmark Estonia Finland France Germany Hong Kong Ireland Latvia Liechtenstein Lithuania Luxembourg Malaysia The Netherlands New Zealand Norway

Wholesale relationships 29 3 29 6 14 3 10 13 32 6 4 1 1 2 1 2 36 1 13

MVNOs

ESPs

1 1 3 6 4 2 5 9 13 0 3 0 1 2 1 2 6 1 12

28 2 26 0 10 1 5 4 19 6 1 1 0 0 0 0 30 0 1

312


Table 11.1 (Continued) Philippines Poland Portugal Russia Singapore Slovenia South Africa Spain Sweden Switzerland Taiwan Ukraine United Kingdom United States

1 5 3 2 1 2 1 4−5 23 5 2 2 27 60

1 3 3 2 1 1 1 3−4 20 3 2 2 24 50

0 2 0 0 0 1 0 1 3 2 0 0 3 10

MVNO – Mobile Virtual Network Operator. ESP – Enhanced Service Provider. Source: www.takashimobile.com/mvno.html,7 January 2006.

Table 11.2 MVNOs and host networks in selected countries Country

Operator

Austria

one tele.ring mobilkom T-Mobile Austria Base Mobistar Proximus H3G Sonofon TDC Mobil Telia Mobile∗ Elisa Finnet TeliaSonera Bouygues Orange SFR

Belgium Denmark

Finland France

Market share (4Q/2003)

Relationships

20 9 44 28 16 32 52 0 24 53 23 30 17 53 16 48 36

2 1 0 0 25 1 1 0 3 11 0 1 3 3 3 4 5

Chapter 11 – Incentives to License Virtual Mobile Network Operators 313 Table 11.2 (Continued) The Netherlands

Portugal Switzerland UK

KPN Mobile Orange Telfort T-Mobile Vodafone Optimus TMN Vodafone Swisscom Sunrise Orange Orange T-Mobile Vodafone O2

39 10 12 15 24 23 48 29 62 20 18 26 26 24 25

11 3 19 0 3 1 1 1 2 1 2 2 7 4 4

∗

Telia Mobile’s market shares include those of Orange Denmark, which was acquired by Telia Mobile in 2004.

Source: http://www.mobileisgood.com.

Given that MVNOs have emerged in many jurisdictions even though regulatory approaches differ widely, let us now analyze the conditions for market entry by MVNOs (or similar business models) in more detail. For that purpose, the following section will develop and analyze a microeconomic model of MVNO entry.

11.4 THE MODEL 11.4.1 Cournot competition

Let us start by considering a homogeneous duopoly situation where we initially have two symmetric MNOs (labelled firm 1 and firm 2), which compete in quantities. We assume that the inverse demand for mobile telecommunications services is linear and given by p = A − bQ, where p is the price and Q the total quantity provided by all firms in the market. Both MNOs can enter into access agreements with MVNOs, that is, they can license MVNOs to provide mobile telecommunications services using the respective MNO’s network. The MVNOs are free in their pricing decisions and also compete

314


with their host networks in Cournot fashion. Let us also assume that the two MNOs can extract the entire surplus from their MVNOs by setting two-part tariffs. This means that we assume that there are many potential MVNOs competing for access to the MNOs’ networks so that the MNOs have the entire bargaining power and submit take-it-or-leave-it offers to potential MVNOs. Finally, let n denote the number of symmetric MVNOs roaming on network 1 and m denote the according number of MVNOs roaming on network 2. Hence, the total quantity is given by Q = q1 + q2 +

n i=1

qi +

m

qj

j=1

Also assume that there is a fixed cost f of establishing an MVNO agreement and providing network access to the MVNO. However, let us assume for reasons of simplicity that the marginal cost of providing mobile telecommunications sevices are zero. Given the linear inverse demand function and assuming that the two MNOs can extract the entire surplus from their MVNOs firm 1’s equilibrium profit under Cournot competition is given by its own profit plus the profits extracted from its n MVNOs, the total of which is given by 1 =

1 + nA2 − nf bn + m + 32

(11.1)

Accordingly we can write down firm 2’s profit by substituting n by m. Maximizing 1 with respect to the number of MVNOs, n, and solving for the symmetric equilibrium values with m = n, we find that the profit maximizing number of MVNOs is given by 1 m = n = A2/3 bf−1/3 − 3 2

(11.2)

∗ ∗ √Now it is straightforward to calculate that for all A > A with A ≡ 3 3bf there will be a positive number of MVNOs. That means, the


profit maximizing number of MVNOs, n∗ = m∗ , is strictly larger than zero if the market is not ‘too small’. If the mobile communications market is sufficiently large (as measured by A) the two MNOs will voluntarily provide MVNOs with access to their network. Similarly, we can calculate a critical f ∗ ≡ A2 /27b. For all f < f ∗ the two MNOs will voluntarily provide access to their network. That is, the fixed cost of establishing MVNO arrangements must not be too high for MVNOs to emerge without regulatory intervention. If the fixed cost is sufficiently low MNOs will voluntarily enter into roaming agreements with MVNOs, even without any regulatory intervention. It is also straightforward to observe that the two MNOs will enter into the more MVNO roaming agreements the larger the mobile telecommunications market’s size (as measured by A) and the lower the fixed cost of establishing MVNO arrangements, f . The situation described resembles a Prisoners’ Dilemma. Both MNOs would be better off not if they would jointly deny MVNOs access to their networks. In this case, the two MNO’s profit would be given by expression (11.1), which is strictly smaller than the firm’s duopoly profit in the absence of any MVNOs, D m = n = 0 = A2 /9b, for all m n > 0. However, for each operator it is a dominant strategy to open up its network for MVNOs if A > A∗ and f < f ∗ . If MNOs cannot collude about access provisions (which has been the suspicion in Spain, see European Commission, 2006), both MNOs will license MVNOs, thereby increasing competition, lowering prices and both the firms’ individual as well as joint industry profits. In fact, this result resembles the finding of the literature on divisionalization under Cournot competition as developed by Corchón (1991), Polaski (1992), Baye et al. (1996) and GonzálezMaestre, (2000). As we know from this literature and the literature on horizontal mergers under Cournot competition (see Salant et al., 1983), the incentives to divest or to divisionalize are even stronger the less concentrated the industry is. Hence, MNOs’ incentives to offer MVNOs access to their neworks are even stronger if there are more than two incumbent MNOs. Similarly, the incentives to offer MVNOs access increase if products are not homogenous but differentiated. With

316


product differentiation competition between MVNOs and MNOs is softer so that MNOs are even more inclined to provide access to their networks, as the cannibalization effect is smaller. The MNOs’ incentives to offer MVNO agreements decrease, however, if the MNOs cannot extract their MVNOs’ full profit. If, for example, MNOs can only extract some fraction ∈ 0 1 of an MVNO’s profit the MNOs, incentives to grant network access are reduced. Put differently, for < 1 the critical level of market demand A which makes an MVNO agreement profitable for an MNO is strictly larger than A∗ while the critical fixed cost level f associated with establishing an MVNO agreement is strictly smaller than f ∗ . Nevertheless, it is straightforward to show that there are critical levels A∗∗ and/or f ∗∗ , which make MVNO agreements profitable for the MNOs where A∗∗ is decreasing in and f ∗∗ is increasing in . The higher the percentage of an MVNO’s profit that the MNO can extract, the lower is the critical size of market demand, A, and the higher is the critical fixed cost level, which would just make an MVNO arrangement unprofitable for the MNO.

11.4.2 Bertrand competition

Having demonstrated that MVNO access is unlikely to be denied under Cournot competition (unless there is collusion), let us turn to the question how the results change if mobile telecommunications service providers compete in prices instead of quantities. As we know from the literature on horizontal mergers, mergers are always profitable under Bertrand competition if products are differentiated and the number of firms is fixed (see Deneckere and Davidson, 1985). This result would suggest that divisionalization, and accordingly access provision to MVNOs, is not profitable under Bertrand competition. However, this result is based on the assumption that divisionalization does not lead to further product differentiation or, viewed from the opposite perspective, that market concentration does not lead to less product differentation. One of the main arguments put forward in favour of MVNO business models, however, is that MVNOs may increase


product differentiation. Hence, we will assume that MVNOs introduce new varieties into the market which otherwise would not exist. Let us now denote the number of incumbent MNOs as M and the total number of licensed MVNOs as V and assume that the inverse demand function faced by firm 1 is given by p1 = A − bq1 − b

M

qi +

i=2

V

qj ,

(11.3)

j=1

so that firm 1’s residual demand can be written as A1 − − p1 1 + N − 2 +

q1 = b 1 − 1 + N − 1

N

i=2 pi

,

(11.4)

where N ≡ M + V . Keeping in mind that MVNOs are assumed to be free to set prices independent from their host networks, an MNO will set its price to maximize its profit which, after rearranging the first-order conditions, yields the following equilibrium price pi =

1 − A 2 + N − 3

∀i

(11.5)

Now let us first assume that there are initially no MVNOs (i.e., N = M) and consider the incentives of an MNO to ‘invite’ an MVNO onto its network. In the initial situation without MVNOs the MNOs’ profits are given by i =

1 − 1 + M − 2 A2 b 1 + M − 1 2 + M − 32

∀i

(11.6)

To analyze whether an MNO finds it profitabe to invite an MVNO onto its network let us compare firm i’s profit for N = M and for N = M + 1. Assuming again that firm i can extract the entire profit

318


from an MVNO the MNO firm i strictly profits from inviting an MVNO if i M < 2i M + 1 or 1 − 1 + M − 2 A2 b 1 + M − 1 2 + M − 32 1 − 1 + M + 1 − 2 A2 2i M + 1 if > 0, where ≡ 2 + M − 22 1 +

M1 + M − 2 − 21 + M − 12 22 + M − 32 . As it is not possible to find a numeric solution for = 0, it is helpful to plot as presented in Figure 11.3, where we have plotted for ∈ 0 1 and M ∈ 1 3 Whenever > 0, MNOs do not have any incentive to open their network for MVNOs. This is the case when products are close substitutes ( is large) so that the competitive effect of MVNOs would be strong. If, however, is small so that competition is soft as products are not close substitutes, MNOs profit from additional MVNOs so that we would expect them to voluntarily open their network for MVNO access. For example, suppose there is a monopoly MNO which could invite a differentiated MVNO onto its network. Comparing the 3

Δ0 1 0

0,1

0,2

0,3

0,4

0,5

0,6

0,7

θ Figure 11.3 (M, )

0,8

0,9

1


monopolist’s profit with a duopoly profit when products are differentiated (i.e., i M and 2i M + 1 for M = 1), we find that the monopolist strictly benefits from inviting an MVNO if < 061171. Hence, the MVNO has to offer sufficiently differentiated services in order to provide sufficient benefits for a monopoly MNO. Similarly, we can compare i M and 2i M + 1 for M = 2. Again, an MNO profits from inviting an MVNO if products are sufficiently differentiated, in this case < 0714 43. Hence, a smaller degree of product differentiation is necessary under a duopoly situation to make MVNO arrangements profitable for an incumbent MNO. Finally, as soon as at least three incumbents MVNOs offer their services, the MNOs will always have strictly positive incentives to provide network access to MVNOs for < 1. Increasing the number of firms from three to four (i.e., three MNOs and one MVNO) will strictly increase the host network’s profit if it can extract the MVNO’s entire surplus. Of course, if the host MNO cannot extract the MVNO’s entire surplus, the same arguments hold as put forward in the case of Cournot competition. The smaller the share of the MVNO’s profit that the host network can extract the lower the incentive to offer MVNO arrangements. Similarly, the incentives to contract with MVNOs decrease as the fixed cost of contracting with and arranging for MVNOs increase. Unfortunately, calculating the optimum number of MNVOs proves to be difficult, as the complexity of the problem becomes too high to find even numerical solutions. Nevertheless, even though we cannot determine the optimum number of MVNOs that duopoly MNOs would invite onto their networks, we have shown that even under Bertrand competition MNOs can have sufficient incentives to offer network access for MVNOs. This is especially so once there are at least three MNOs. While MNOs in monopoly or duopoly markets will only grant MVNOs access if these are sufficiently differentiated, MVNOs will always be granted access once there are three competing MNOs and the fixed costs of arranging for MVNOs are not prohibitive. While the role for regulation appears to be rather limited once there are three or more

320


MNOs, there may be a role for regulation in duopoly or monopoly markets.

11.4.3 Stackelberg competition

So far we have assumed that all firms make their decisions simultaneously. This assumption, however, may not be an appropriate reflection of the reality in mobile communications markets where some firms were licensed earlier than others. In order to account for this sequentiality of moves, let us in the following consider a modified Stackelberg model. Suppose that in the first stage M MNOs simultaneously choose quantities before they can decide to open their network for V MVNOs which act as Stackelberg followers relative to the M MNOs. Also let us start the analysis by assuming that products are homogeneous and that the inverse demand function is linear again with p = A − bQ. Given that the M MNOs, who act as Stackelberg leaders vis-á-vis the V MVNOs, compete in Cournot fashion within the group of MNOs, an MNO’s quantity will be given by qL =

A M + 1b

(11.7)

Assuming that the V MVNOs also compete in Cournot fashion within their group even though they act as Stackelberg followers vis-á-vis the group of MNOs, an MVNO’s quantity will be given by qF =

A M + 1V + 1b

Without any MVNO V = 0 the M MNOs compete in Cournot fashion so that their profit is given by A2 L = M + 12 b

(11.8)


If now one of the MNOs ‘invites’ V MVNOs to use its network the retail prices drops to p=

A M + 1 V + 1

and, assuming again that the host MNO can extract the MVNOs’ entire profits, the host MNO obtains a total profit of A A A +V HOST = M + 1b M + 1V + 1b M + 1 V + 1 =

2V + 1A2 M + 12 V + 12 b

(11.9)

Comparing (11.8) and (11.9) it is clear that the host MNO’s profit decreases when granting network access. The MVNOs’ competitive effect on the retail market outweighs the additional revenue generated from any number of MVNOs. As MVNOs act as followers their market share and their profit are too small to compensate the host network for the decrease in price that the MVNOs induce. Hence, in contrast to Cournot competition the incumbent MNOs’ incentives to grant MVNOs network access completely vanish under Stackelberg competition. As this result shows, voluntary MVNO agreements may be completely eliminated if MNOs have a first-mover advantage and if MVNOs have a significant impact on price, but only small profits to compensate the host MNO. Of course, this result is relaxed once we consider the case of product differentiation. For example, if we consider the case with two incumbent MNOs and one potential MVNO one can show that the host network benefits from entry by a MVNO (assuming that the host network can appropriate the MVNO’s entire surplus) if < 0715 3. Hence, as in the case of Bertrand competition, products have to be sufficiently differentiated so that an MVNO’s market entry does not lead to such an intensive degree of competition that the competitive effect on the MNO’s price level outweighs the additonal revenues obtained from the MVNO.

322


11.5 SUMMARY AND POLICY CONCLUSIONS

As we have shown in this chapter, MNOs’ incentives to voluntarily provide network access and invite MVNOs onto their network critically depend on two things: First, the mode of competition and, second, the degree of product differentiation. Generally, MNOs will voluntarily provide network access if the services offered by the candidate MVNOs are sufficiently differentiated, as with a high degree of product differentiation the revenue effects outweigh the competition (or cannibalization) effects. Furthermore, MNOs will always invite MVNOs onto their network under Cournot competition if the market is sufficiently large, even if MVNOs offer homogeneous products. In contrast, the incentives to voluntarily grant MVNO access are lower under Bertrand competition and decline even further under Stackelberg competition. Under Bertrand and Stackelberg competition, voluntary MVNO access is only granted if the services offered by MVNOs are sufficiently differentiated. From a policy perspective, our findings imply that firms may not always voluntarily grant MVNO access as the simple Cournout model would predict. If firms compete in prices or if firms move sequentially (which may not be too bad a reflection of reality, given that licenses to operate mobile telecommunications networks have been granted sequentially in almost all jurisdictions), MNOs may not face proper incentives to host MVNOs. This means that even in the absence of any collusive behaviour firms may find it individually rational (i.e, profit maximizing) not to grant MVNo access, as the simple Stackelberg model has demonstrated. In this case, there may be a role for regulatory intervention in order to boost competition. When calling for regulatory intervention, however, one should keep in mind that our model is a static one which does not consider investment, but assumes that the necessary infrastructure is given. If, however, investment incentives need to be considered as well (which is, of course, necessary from a dynamic efficiency perspective), the model presented here needs to be augmented. Therefore, we think that the integration of investment decisions into our model provides an interesting topic for further research.

Chapter 11 – Incentives to License Virtual Mobile Network Operators 323 REFERENCES Anderson, J. and B. Williams (2004): ‘Unbundling the mobile value chain’, Business Strategy Review 15: 51–57. Baye, M., K. Crocker, and J. Ju (1996): ‘Divisionalization, franchising, and divestiture incentives in oligopoly’, American Economic Review 86: 223–236. Cave, M. and I. Vogelsang (2003): ‘How access pricing and entry interact’, Telecommunications Policy 27: 717–727. Corchón, L. (1991): ‘Oligopolistic competition among groups’, Economics Letters 36: 1–3. Deneckere, R. and C. Davidson (1985): ‘Incentives to form coalitions with Bertrand competition’, RAND Journal of Economics 16: 473–486. Detecon (2005): ‘Scanning the MVNO opportunity: Business model vs reality’, Detecon Opinion Paper, May 2005. Dorabialski, W. and L. Morawski (2004): ‘Competition or entry deterrence: The case of Poland’s first MVNO’, Working Paper, Warsaw University. Ergas, H., P. Waters, and M. Dodd (2005): ‘Regulatory approaches to mobile virtual network operators (MVNOs)’, in Vodafone (ed.) Regulating access to networks, Vodafone Policy Paper No. 3, Vodafone, London, 10–15. European Commission (2006): ‘Commission endorses, with comments, Spanish regulator’s measure to make mobile market more competitive’, Press Release, IP/06/97, Brussels, 31 January 2006. Foros, ., B. Hansen, and J. Y. Sand (2002): ‘Demand-side spillovers and semi-collusion in the mobile communications market’, Journal of Industry, Competition and Trade 2: 259–278. González-Maestre, M. (2000): ‘Divisionalization and delegation in oligopoly’, Journal of Economics and Management Strategy 9: 321–338. ITU (2001): ‘Mobile virtual network operators’, ITU: Geneva. Kiesewetter, W. (2002): ‘Mobile virtual network operators: Ökonomische Perspektiven und regulatorische Probleme’, WIK Diskussionsbeitrag 233, WIK: Bad Honnef. Kim, B. W. and S. U. Park (2004): ‘Determination of the optimal network charge for the mobile virtual network operator system’, ETRI Journal 26: 665–668. Maitland, C. F., J. M. Bauer and R. Westerveld (2002): ‘The European market for mobile data: Evolving value chains and industry structures’, Telecommunications Policy 26: 485–504. Ministry of Transport and Communications Finland (2005): ‘MVNO pricing structures in Finland’, Publications of the Ministry of Transport and Communications 21/2005, Helsinki, February 2005. OFTA (2002): ‘Mobile virtual network operators (MVNOs)’, OFTA, Hong Kong, March 2002. Oftel (1999): ‘Mobile virtual network operators: Oftel inquiry into what MVNOs could offer consumers’, Oftel London, June 1999. Polaski, S. (1992): ‘Divide and conquer: On the profitability of forming independent rival divisions’, Economics Letters 40: 365–371. Salant, S., S. Switzer, and R. Reynolds (1983): ‘Losses due to merger: The effects of an exogenous change in industry structure on Cournot-Nash equilibrium’, Quarterly Journal of Economics 48: 185–200. Telektronikk (2001): ‘Mobile virtual network operators’, Telektronikk 97, (4/2001), 1–123.


PART V

Policy



CHAPTER 12

Antitrust and Sector-Specific Regulation in the European Union: The Case of Electronic Communications ALEXANDRE DE STREEL University of Namur, Belgium and European University Institute, Florence

Contents 12.1 INTRODUCTION 12.2 A BROAD PICTURE 12.2.1 Substantive law 12.2.2 Institutional design 12.3 COMPETITION LAW 12.3.1 Ex post competition law 12.3.2 Ex ante competition law: mergers and joint ventures 12.3.3 Appraisal of the application of antitrust in the electronic communications sector 12.4 SECTOR REGULATION 12.4.1 Ex ante sector regulation 12.4.2 Appraisal of the application of sector regulation 12.5 OPTIMAL BALANCE BETWEEN RULES AND COORDINATION BETWEEN INSTITUTIONS 12.5.1 The optimal balance between antitrust and sector regulation 12.5.2 The optimal institutional coordination 12.6 CONCLUSION APPENDIX REFERENCES

328 329 329 335 339 339 345 348 350 350 353 358 358 362 363 365 368

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12.1 INTRODUCTION

To guarantee access and effective competition in the electronic communications sector (i.e., the infrastructures for the services of the Information Society such as fixed telephony network, mobile telephony network, Internet connections, cable TV and satellite connections), public intervention in the European Union mainly takes place with two instruments that have converged over time.1 On the one hand, there is the antitrust law that has been applied extensively to become a sort of ‘regulatory antitrust’.2 On the other hand, there is the sector regulation whose mode of intervention has been aligned on antitrust law methodologies to become a sort of ‘preemptive competition law’.3 Such evolution is interesting because it questions the (remaining) differences between both instruments and their optimal coordination and because the regulation of electronic communications is the most advanced and might be transposed to other networks industries (energy, railways or even possibly financial services).4 This paper studies this evolution in the following way. Section 12.2 gives a broad picture of the substantive and the institutional issues. Section 12.3 goes into more depth on the application of both branches of antitrust law (ex post and ex ante) since the last fifteen years. Section 12.4 deals with sector regulation since its last modification three years ago. Section 12.5 tries to propose an efficient balance between both instruments as well as an optimal coordination between the different institutions in charge. Finally, Section 12.6 provides a conclusion.

1

Contrast with the tendency in the US where there is no such convergence; see Geradin and Sidak (2005). 2 To adopt the expression of Cave and Crowther (2005) and de Streel (2004). 3 To adopt the expression of Buiges (2004). 4 As suggested by the then Competition Commissioner Mario Monti (2003).

Chapter 12 – Antitrust and Sector-Specific Regulation

329

12.2 A BROAD PICTURE 12.2.1 Substantive law

In the European electronic communications sector,5 public authorities rely on several instruments to discipline competitive behaviours, as shown in Table 12.1: (1) competition law that applies to electronic communications, as to any sector of the economy6 and that may be Table 12.1 Competition law and sector regulation7 Competition law – ex post

Competition law – ex ante

Objective Maintain competition Increase competition → Market structure is broadly satisfactory Burden of proof to intervene

1. Market definition 2. Dominant 3. Anticompetitive conduct: agreement or abuse of dominance (high)

Remedies Mainly behavioural Fines Private damages

Sector regulation/ Significant market power (SMP) regime Increase competition Mimic competition → Market structure is not satisfactory

1a. Notified concentration 1a. Market selection 1b. Market definition (very high) 2. Significant impediment to effective Competition 1b. Market definition 2. SMP = dominance (low) (Conduct (Conduct presumed) presumed) Mainly structural

Mainly behavioural

Note: The shadow area is the triggering factor for each legal instrument.

5

For the definition of electronic communication network and service, see article 2 of the Framework Directive. 6 Case 41/83 Italy v. Commission (British Telecommunications I) [1985] ECR 873. Indeed, the application of sector regulation does not remove antitrust jurisdiction: Commission Access Notice, para 22. The situation is more nuanced in the US where the Supreme Court decided that, when sector regulation has been applied, competition laws should not be applied in addition: Verizon v. Trinko 540 U.S. 682 (2004). On the different of approaches, see Larouche (2006). 7 This table is adapted from a presentation that Pierre Larouche made at an ETNO workshop in October 2005.

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divided into two branches (ex post competition law that punishes anticompetitive behaviours (agreements and abuses of dominant position),8 and ex ante competition law that prevents anticompetitive behaviours (mergers and autonomous full function joint ventures));9 (2) sector regulation that always applies ex ante to prevent anticompetitive behaviour.10 On the one hand, competition law has one main objective which has become prevalent over time and is the maximization of consumer welfare.11 This implies that competition law aims at

8

Articles 81 and 82 EC and Council regulation 1/2003 of 16 December 2002 on the implementation of the rules on competition laid down in articles 81 and 82 of the Treaty, O.J. [2003] L 1/1, herein Regulation 1/2003. 9 Council regulation 139/2004 of 20 January 2004 on the control of concentrations between undertakings, O.J. [2004] L 24/1, herein Merger Regulation. 10 The sector regulation has been radically reformed in 2003 and is now mainly made of four harmonization directives adopted under Article 95 EC: Directive 2002/21/EC of the European Parliament and of the Council of 7 March 2002 on a common regulatory framework for electronic communications networks and services (Framework Directive), O.J. [2002] L 108/33; Directive 2002/20/EC of the European Parliament and of the Council of 7 March 2002 on the authorization of electronic communications networks and services (Authorisation Directive), O.J. [2002] L 108/21; Directive 2002/19/EC of the European Parliament and of the Council of 7 March 2002 on access to, and interconnection of, electronic communications networks and services (Access Directive), O.J. [2002] L 108/7; Directive 2002/22/EC of the European Parliament and of the Council of 7 March 2002 on universal service and users’ rights relating to electronic communications networks and services (Universal Service Directive), O.J. [2002] L 108/51. It is also made of one liberalization directive adopted under Article 86 EC: Commission directive 2002/77/EC of 16 September 2002 on competition in the markets for electronic communications networks and services, O.J. [2002] L 249/21. 11 In general, on the objectives of European competition law, see the contributions in Ehlermann and Laudati (1998). This package of Directives is due to be revised in 2008–2009: see the preliminary orientations of the European Commission in Communication from the Commission of 29 June 2006, on the Review of EU Regulatory Framework for electronic communications networks and services, COM(2006) 334.


331

efficiencies (allocative, productive and dynamic) on the market by ensuring the competitive structure is maintained and possibly even strengthened.12 To achieve those goals, an antitrust authority applies ex post competition law in several steps: (1) it starts by defining the relevant market according to the small but significant nontransitory increase in price (SSNIP) or the ‘hypothetical monopolist test’;13 (2) it then determines whether one or several undertakings have sufficient market power (in particular a single or joint dominant position, which is a level of market power sufficient to behave to an appreciable extent independently of competitors, customers, and ultimately consumers);14 (3) finally, the authority determines whether the undertakings with market power have committed an anticompetitive practice (agreement or unilateral abuse). If it is this case, the authority imposes a fine and/or behavioural remedies (to put an end to the anticompetitive practice) or structural remedies if necessary and proportionate.15 A national court may also provide for private damages.16 Thus, an intervention under ex post competition law is triggered by an anticompetitive conduct.

12

See in particular, Case T-87/05 Energias de Portugal v Commission [2005] ECR II-0000, para 91 where the Court of First Instance accepted that European competition law (in the case merger control) may be used to increase the level of competition in the market. 13 Commission notice on the definition of relevant market for the purposes of community competition law, O.J. [1997] C 372/5. For an application to the electronic communication sectors, see Commission Guidelines of 9 July 2002 on market analysis and the assessment of significant market power under the community regulatory framework for electronic communications networks and services, OJ [2002] C 165/6, herein Commission Guidelines on market analysis, para 33–69. 14 Case 27/76 United Brands v Commission [1978] ECR 207; Case 85/76 HoffmanLa Roche v Commission [1979] ECR 461; Case T-342/99 AirTours v. Commission [2002] ECR II-2585, para 62; Guidelines on market analysis, paras 70 to 106. 15 Article 7 of regulation 1/2003. 16 Case C-453/99 Courage and Crehan [2001] ECR I-6297.

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Antitrust authority applies ex ante competition law in several steps. (1a) A concentration should be first notified when fulfilling certain criteria and should not be enforced before antitrust approval.17 (1b) The authority then defines market according to the SSNIP economic methodology. (2) It also determines whether the concentration would significantly impede effective competition (in particular by creating a single or collective dominant position).18 Such assessment is done in two phases. After the first phase, the authority decides if it does not have serious doubts that the concentration would impede effective competition, or conversely, it opens a second phase of investigation.19 After this second phase, the authority decides whether the concentration would significantly impede effective competition or not.20 If the authority has doubts or thinks that the concentration would indeed impede competition, the notifying parties may propose during the first phase and/or the second phase remedies that should remove all competitive concerns (the remedies should preferably be structural, although they may be behavioural provided they affect the structure of the market).21 Otherwise, the authority prohibits the merger. Thus, an intervention under ex ante competition is triggered by a notified concentration which significantly impedes effective competition. On the other hand, sector regulation has three objectives: promotion of effective competition, the internal market, and the users’ interest.22 However, the law gives important margin of discretion to the regulatory actors on the ranking of those objec17

A concentration should be notified to the European Commission when (1) it is a merger or an autonomous full function joint venture and (2) it reach certain threshold of worldwide and European turnover: Articles 1 and 3 of the Merger Regulation. 18 Article 2 of the Merger Regulation. 19 Article 6 of the Merger Regulation. The first phase is of 25 or 35 working days. 20 Article 8 of the Merger Regulation. The second phase is of 95 or 105 working days. 21 Case T-102/96 Gencor v Commission [1999] ECR II-753, para 319; Case C-12/03P Tetra Laval v Commission [2005] ECR I-0000, para 86. 22 Article 8 of the Framework Directive.


333

tives that may be contradictory and on the means to achieve them. In particular, the law does not decide whether the regulators should actively promote the development of infrastructure (e.g., broadband connections) as a soft industrial policy marker23 or merely control the market as a hard trustbuster.24 The part of sector regulation that deals with market power mainly aims to ensure efficiency by favouring competitive market structure or by mimicking the results of a competitive market structure.25 To achieve those goals, a regulatory authority follows three steps when imposing obligations on the operators.26 (1a) It starts by selecting markets where sector regulation would be more efficient than antitrust to solve competition problems.27 In practice, it does so according to three cumulative criteria (high permanent and nonstrategic entry barriers, no competitive dynamics behind these barriers and inefficiency of antitrust remedies to solve the competitive problems).28 (1b) Then, it delineates the boundaries of the selected markets according to antitrust methodologies (the

23

As suggested in Communication from the Commission of 1 June 2005, i2010 – A European Information Society for growth and employment, COM(2005) 229. 24 On those ambiguities in objectives, see Granham (2005, pp. 8–14) and Hocepied and de Streel (2005, pp. 147–154). 25 European Regulators Group Revised Common Position of May 2006 on the approach to appropriate remedies in the new regulatory framework, ERG (06) 33, herein ERG Revised Common Position on remedies, Chapter 4. 26 On those steps, see Buiges (2004), Cave (2004), Garzaniti (2003, chapter 1), Krüger and Di Mauro (2003), and de Streel (2004). 27 Recital 27 of the Framework Directive. 28 Recitals 9–16 of the Commission Recommendation 2003/311 of 11 February 2003 on relevant product and service markets within the electronic communications sector susceptible to ex ante regulation, OJ [2003] L 114/45, herein Commission Recommendation on relevant markets. This Recommendation should be revised in 2007: see the preliminary view of the European Commision in Draft Commission Recommendation of 28 June 2006 on relevant product and service markets within the electronic communications sector susceptible to exante regulation (second edition), SEC (2006) 837.

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SSNIP or hypothetical monopoly test).29 (2) It determines also whether an operator enjoys a single or collective dominant position or could leverage a dominant position from a closely related market.30 (3) If it is the case, it imposes proportionate regulatory remedies to be chosen from a menu provided in the directives (transparency, nondiscrimination, accounting separation, compulsory access and price control). It may also impose any other type of remedy (even structural ones like divestiture) with the prior agreement of the Commission.31 Thus, an intervention under sector regulation is triggered by a market that has the characteristics where competition law remedies would be insufficient. Sector regulation has been aligned to antitrust methodologies because it was supposed to meet several good governance principles.32 It makes the regime more flexible and based on solidly grounded economic principles that ensure regulatory decisions closer to the reality of the market. And this increased flexibility would not be at the expense of legal certainty (as decisions will be based on more than forty years of antitrust case-law), nor harmonization (as NRAs’ decisions are based on legal principles that are strongly Europeanized). The system was also deemed to ensure a progressive removal of obligations as competition develops in the different markets (market-by-market sunset clauses) and facilitates the transition towards the mere application of competition law when sector regulation will no longer be necessary. 29

Article 15 of the Framework Directive; Commission Recommendation on relevant market; Commission Guidelines on market analysis, paras 33–69. 30 Articles 14 and 16 of the Framework Directive; Commission Guidelines on market analysis, para 70–106; Revised European Regulators Group Working Paper of September 2005 on the SMP concept for the new regulatory framework, ERG (03) 09rev3. 31 Articles 8–13 of the Access Directive (for the remedies regarding the wholesale markets); articles 16–19 of the Universal Service Directive (for the remedies regarding the retail markets); and ERG Revised Common Position on remedies. 32 Buiges (2004) and Cave (2004).


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European courts 230 EC

Commission DG Infso + DG Comp

230 EC

234 EC

234 EC

Commission DG Comp

ECN

ERG 15 DR

226 EC 7 FWD

226 EC 11 DR Art. 81,82,86 EC National courts 4 FWD

NRA

NCA 3,16 FWD

Figure 12.1 Relationship between regulatory actors.36 Straight line: strict control; Dotted line: loose control; EC: EC Treaty; 226 EC: infringement procedure against a Member State; 230 EC: annulment procedure against the Commission; 234 EC: preliminary ruling question; FWD: Framework Directive 2002/21; DR: Decentralisation Regulation 1/2003; ERG: European Regulators Group; ECN: European Competition Network (Telecom Working Group); NRA: National Regulatory Authority; NCA: National Competition Authority.

12.2.2 Institutional design

To implement such instruments, many institutions are involved as illustrated in Figure 12.1. On the one hand, the main actors in applying antitrust are the twenty-five National Competition Authorities (NCAs), the European Commission, and the national courts. Ex post antitrust may generally be applied concurrently by the Commission (its Competition

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Directorate General),33 the NCAs,34 and the national courts.35 Ex ante antitrust is applied exclusively by the Commission if the concentration has a community dimension37 or by NCAs if the concentration does not have such community dimension. To ensure checks and balances and efficient decisions, the NCAs are under the control of several authorities. At national level, they are controlled by the national courts as any interested party may appeal an NCA decision.38 At the European level, NCAs are under the double control of the Commission which may decease an NCA before it adopts a final decision to ensure the consistency of the application

33

Article 4 of regulation 1/2003. Note that the Commission may only intervene when the trade between member states is susceptible to be affected by the allegedly anticompetitive practice: Guidelines of the Commission of 30 March 2004 on the effect on trade concept contained in Articles 81 and 82 of the Treaty, O.J. [2004] C 101/81. 34 Article 5 of regulation 1/2003 and each specific national competition law. In some member states, the NRAs have concurrent powers with the NCAs to apply ex post antitrust in the electronic communications sector; see, for instance, the UK: Office of Fair Trading Guidelines of December 2004 on Concurrent application to regulated industries. 35 Article 6 of regulation 1/2003 and each specific national competition law. 36 For simplicity, I do not include the role of the National Ministries, the CoCom and the Council. 37 Article 2 of the Merger Regulation. In some circumstances, the Commission may refer back to a NCA a concentration with community dimension: articles 4 and 9 of the Merger Regulation. 38 The organization of such appeal procedure is left to the member state according to their procedural autonomy, but should be effective according to the general principles of European law derived from article 10 EC: Case C-276/01 Steffensen [2003] ECR I-3755, para 60; Case C-453/99 Courage and Crehan [2001] ECR I-6297, para 29; Case C-255/00 Grundig Italiana [2002] ECR I-8003. Note that the Commission may help the national courts in their interpretation of European antitrust: article 15 of the regulation 1/2003 and Commission Notice of 30 March 2004 on the cooperation between the Commission and the courts of the EU member states in the application of articles 81 and 82 EC, O.J. [2004] L 101/54.


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of antitrust law across member states,39 and which may initiate an infringement procedure at the Court of Justice against a member state whose NCA violated European law.40 NCAs also face peer pressure through their participation in the European Competition Network,41 which has a specific working group on telecommunications matters. Finally, the NCAs which have the characteristics of a tribunal (such as a body established by law, permanent, independent, applying the rule of law and whose jurisdiction is compulsory, procedure is inter partes) may directly ask preliminary questions to the Court of Justice on the interpretation of European law.42 In this sense, the NCAs are under the direct supervision of the Court of Justice. In this part, The Commission is controlled by the European courts where its decisions may be appealed.43 The courts examine whether the procedures have been respected, the substantive law (e.g., the concept of dominance) has been correctly interpreted, the facts have been correctly established and no manifest errors in the economic assessment of those facts have been done.44 Thus, at the top of the pyramid lie the European courts whose case-law should be respected by all administrative and judicial

39

Article 11(6) of the regulation 1/2003 and paras 50–57 of the Commission Notice of 30 March 2004 on cooperation within the Network of Competition Authorities, O.J. [2004] C 101/43. 40 Article 226 EC, as applied in Case 103/88 Fratelli Costanzo v Commune de Milano [1989] ECR I-1839. 41 Commission Notice of 30 March 2004 on cooperation within the Network of Competition Authorities, O.J. [2004] C 101/43. 42 Article 234 EC. According to these criteria, a preliminary question from the Spanish NCA was accepted in Case C-67/91 Dirección General de Defensa de la Competencia v Asociación Española de Banca Privada and others (Spanish Banks) [1992] ECR I-4785, but a question from the Greek NCA was refused in Case C-53/03 Syfait and Others v GlaxoSmithKline [2005] ECR I-0000. 43 Article 230 EC. 44 Case C-12/03P Tetra Laval v Commission [2005] ECR I-0000, para 39. See Vesterdorf (2005).

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national and European authorities according to the principle of the primacy of European law.45 In this context, the national courts may refer preliminary ruling question to the Court of Justice.46 On the other hand, sector regulation is applied concurrently by the NRAs47 and by the national courts. To ensure checks and balances and efficient decisions, the NRAs are under the control of several authorities. At the national level, they should cooperate closely with the NCAs as SMP assessment involves antitrust methodologies,48 hence are under the scrutiny of the antitrust authorities. In addition, NRAs are controlled by the national courts whose organization is left to the member states but the European law provides that appeal body should take into account the merits of the case.49 At the European level, the NRAs are under a triple control50 of the Commission first, the Commission reviews (in a preventive manner) in two phases all NRAs’ draft decisions affecting trade between member states and may veto part of them when violating European law;51 second the Commission may take (in a repressive manner) to the Court of Justice a member

45

Case 6/64 Flaminio Costa v ENEL [1964] ECR 585. Article 234 EC. 47 Article 3 of the Framework Directive. 48 Articles 3 and 16 of the Framework Directive. Guidelines on market analysis, para 135. 49 Article 4 of the Framework Directive, Lasok (2005). 50 Hocepied and de Streel (2005). 51 Article 7 of the Framework Directive and Commission Recommendation 2003/561 of 23 July 2003 on notifications, time limits and consultations provided for in Article 7 of Directive 2002/21/EC of the European Parliament and of the Council of 7 March 2002 on a common regulatory framework for electronic communications networks and services, OJ [2003] L 190/13. After the first phase of one month, the Commission may merely comment on the compatibility of the NRA draft decision with EU law, or if it has doubts it may open a second phase review. After this second phase review of two months, the Commission may (but is not obliged to) veto the NRA draft decision if it violates EU law. 46


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states whose NRA violated European law;52 third the Commission may take an antitrust decision that would be an indirect critique of the regulator’s policy.53 NRAs also face peer pressure through their participation in the European Regulators Group (ERG).54 However, contrary to their antitrust counterparts, the NRAs may not ask preliminary questions to the Court of Justice because of their obvious administrative nature.55 Again at the top of the pyramid lie the European courts whose case-law should be respected by all administrative and judicial national and European authorities.

12.3 COMPETITION LAW 12.3.1 Ex post competition law

12.3.1.1 Substantive issues

(1) The mode of intervention and the type of cases taken At the European level, the mode of intervention of the Commission in the electronic communications sector was based on broad sectoral approach, which is different from the interventions in the other sectors of the economy based on a case-specific approach. In fact,

52

Article 226 EC (see note 40). However, until now, the all infringement actions related to violation of European law by a national legislator and not by an NRA. 53 Articles 81, 82, 86 EC. This was the case in the decision Deutsche Telekom, cited in the Appendix of this paper. 54 Commission decision of 29 July 2002 establishing the European Regulators Group for Electronic Communications Networks and Services, O.J. [2002] L 200/38, as modified by Commission decision of 14 September 2004, O.J. [2004] L 293/30. See the website of ERG: http://erg.eu.int. 55 Case C-256/05 Telekom Austria [2005] ECR I-0000, paras 10–11; and para 45 of the Opinion of Advocate General Geelhoed in Case C-462/99 Connect Austria Gesellschaft für Telekommunikation v Telekom-Control-Kommission, and Mobilkom Austria [2003] ECR I-5197.

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the Commission behaves more like an industrial regulator than a mere antitrust authority. Thus, it adopted three general guidelines,56 which explained how antitrust rules would apply to some competitive problems and were not based on a stock of previous individual cases: in 1991, on the application of competition rules to the telecommunications sectors;57 in 1998, on the application of antitrust rules to access agreement;58 and in 2000, on the application of antitrust rules to the compulsory access of the local loop (i.e., the last mile of the network where the economies of scale and scope are the largest).59 The Commission also conducted six sector enquiries or quasisector enquiries where the Commission sent questionnaire to all the operators to better understand the dynamics of the marketplace and possibly identify anticompetitive practices:60 in 1997, on the high prices for international calls;61 in 1998, on the high prices for fixed-

56

Guidelines have also been used in other network industries like the postal sector: Notice from the Commission on the application of the competition rules to the postal sector and on the assessment of certain state measures relating to postal services, O.J. [1998] C 39/2. 57 Commission Guidelines on the application of EEC Competition rules in the telecommunications sector, O.J. [1991] C 233/2. 58 Commission Notice of 31 March 1998 on the application of competition rules to access agreements in the telecommunications sector, O.J. [1998] C 265/2, hereinafter Access Notice. 59 Communication from the Commision of 26 April 2000 on the unbundled access to the local loop, O.J. [2000] C 272/55. 60 Sector enquiries are based on article 17 of regulation 1/2003. In quasisector enquiries, no formal sector enquiry were opened, but questionnaires were sent to all operators of the market segment under review. On these enquiries: Choumelova and Delgado (2004). 61 IP/97/1180 of 19 December 1997; IP/98/763 of 13 August 1998; IP/99/279 of 24 April 1999.


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to-mobile calls;62 in 1999, on the delivery of leased lines;63 in 2000, on the high prices for mobile international roaming,64 and on the refusal to give access to the local loop;65 in 2004, on the sales of sports rights to 3G and Internet.66 In a second stage and on the basis of the information collected during the sector enquiries, the Commission opened several individual cases.67 So far, all cases cover pricing practices that were either exploitative (excessive prices) or exclusionary (price squeeze or predatory pricing). They took on average two to three years to be decided and most of them have been settled informally. As a consequence of this approach, there has been few formal decision, hence the case-law in the sector is relatively poor. However, the few decisions should not hide the fact that Commission intervention has been more intense in electronic communication sector than in the other sectors of the economy (Table 12.2).

62

IP/98/141 of 10 February 1998; IP/98/707 of 27 July 1998; IP/98/1036 of 26 November 1996: IP/99/298 of 4 May 1999. 63 IP/99/786 of 22 October 1999; Working Document of the Commission services of 8 September 2000 on the initial results of the leased lines sector inquiry; IP/00/1043 of 22 September 2000; IP/02/1852 of 11 December 2002. 64 IP/00/111 of 4 February 2000; Working Document of Commission services of 13 December 2000 on the initial findings of the sector inquiry into mobile roaming charges. 65 IP/00/765 of 12 July 2000. Report done by Squire-Sanders-Dempsey, Legal Study on Part II of the Local Loop Sectoral Inquiry, February 2002, available at http:// www.europa.eu.int/comm/competition/antitrust/others/sector_inquiries/local_loop/. 66 IP/04/134 of 30 January 2004. Concluding Report of the Commission of 21 September 2005 on the Sector Inquiry into the provision of sports content over third generation mobile networks. 67 For an overview of the cases: Garzaniti (2003, chapter 6).

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Table 12.2 Commission abuse of dominant cases Market segment

Exclusionary pricing

Exploitative pricing

Fixed narrowband

– Price squeeze between – Excessive accounting rates: interconnection charges and OTE, ETP, Austria Telekom, retail business tariffs: DT 199668 Finland, Telecom Italia, Ireland, Portugal69

Fixed broadband

– Price squeeze between full unbundling charges and retail ADSL tariffs: DT 2003 – Price squeeze between shared access charges and retail access tariffs: DT 200470 – Predatory retail ADSL price: Wanadoo 2003 – Price squeeze between national/regional bitstream and ADSL tariffs: Telefonica 200671

Leased lines

Mobile

– Excessive prices for international leased lines: Belgium, Italy, Spain 200272 – Price squeeze between mobile termination charges and retail mobile tariffs: KPN 200273

– Excessive mobile termination: Germany and Italy 199974 – Excessive wholesale roaming charges: O2 and Vodafone UK 2004,75 T-Mobile and Vodafone Germany 2005.76

Note: The cases in italics have led to a formal decision of the Commission and are cited in the Annex.

68

Against Deutsche Telekom: IP/96/543 of 25 June 1996 and IP/96/975 of 31 October 1996. 69 IP/99/279 of 24 April 1999. 70 IP/04/281 of 1 March 2004. 71 MEMO/06/91 of 22 February 2006. 72 IP/02/1582 of 11 December 2002. 73 IP/02/483 of 27 March 2002. 74 IP/99/298 of 4 May 1999. 75 IP/04/994 of 26 July 2004. 76 IP/05/161 of 10 February 2005.


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At the national level, more decisions have been taken than at the European level, although the interventions of the NCAs vary significantly across countries.77 For instance, the French Competition Council has been extremely active, in particular in opening of the local access market to stimulate broadband development78 and condemning cartel in the mobile segment.79 In general, most cases relate to exclusionary pricing practices. (2) The remedies imposed In the majority of the cases, the Commission imposed behavioural remedies in the form of reducing of excessive price or ending a price squeeze. In some cases, the Commission went further and used ex post antitrust cases to speed up liberalization in the member states that were the most reluctant to open their markets.80 No Member State has ever imposed a full structural separation of the incumbent, but the United Kingdom has recently in an unprecedented move imposed a quasi-structural separation of BT as a quid pro quo not to open an antitrust market investigation.81

77

For a summary of some cases, see International Competition Network (2006, Appendix 1) and for a description of national price squeeze cases: Geradin and O’Donoghue (2005). 78 Bourreau (2003). Competition Council Decision 00-MC-01 of 18 February 2002, 9Telecom/France Telecom I, upheld by the Appeal Court of Paris decision in 30 March 2000; Competition Council Decision 04-D-18 of 13 April 2004, 9Telecom/France Telecom II, upheld by the Appeal Court of Paris in 11 January 2005; Competition Council Decision 05-D-59 of 7 November 2005, 9Telecom/France Telecom III. 79 Competition Council Decision 05-D-65 of 30 November 2005. 80 For instance, the Commission closed the DT 1996 case on the conditions that the German government opened its telecommunications markets. 81 Ofcom Final statements of 22 September 2005 on the strategic review of the telecommunications and undertakings in lieu of a reference under the Enterprise Act 2002.

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12.3.1.2 Institutional issues

At European level, the vertical relationship between the Commission and the NCAs followed the approach set in the Cooperation Notice: cases were decided by the best-placed authority and the Commission took only cases with sufficient European interest.82 The diagonal relationship between the Commission and the NRAs was complementary and followed the approach described in the Access Notice: priority was given to the NRAs.83 Thus, if the NRAs were able to intervene, these cases have been passed to them,84 although the Commission maintains a control over the regulators.85 If the NRAs were not able to act, the cases usually have been settled by the Commission or, more exceptionally, a formal decision was adopted.86 At the national level, the transversal relationship between the NCAs and the NRAs was also complementary. For instance, the Dutch NCA intervened in mobile termination regulation when the NRA’s decision had been quashed by a national court for lack of jurisdiction.87 However, there may also be a conflict between the approach of NRA and the one of the NCA. For instance, the Italian NCA condemned Telecom Italia for a regulatory price squeeze case.88 82

Commission Notice of 30 March 2004 on cooperation within the Network of Competition Authorities O.J. [2004] C 101/43. 83 Commission Access Notice, paras 26–32. 84 For instance, for cases for excessive fixed retention rates and fixed termination rates have been dealt by the NRAs and only closed by the Commission when prices decreased sufficiently. 85 For instance in the decision Deutsche Telekom, the Commission condemned a regulated operator (that enjoyed some discretion within the regulatory limit to reduce the abusive practice) as the Commission disagreed with the national regulator. For a critique of this decision, Geradin (2004, pp. 1549–1552), Larouche (2006) and Petit (2005, pp. 194–195). 86 Commission decision Wanadoo. 87 OPTA and NMa press release 03–50 of 5 December 2003. 88 AGCM decision of 16 November 2004, annulled in by a national court May 2005.


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12.3.2 Ex ante competition law: mergers and joint ventures


(1) The type of cases notified In the electronic communications sector, several cases have been notified and decided by the Commission due to the reshaping of the industrial landscape in the aftermath of liberalization.89 In the mid-1990s when telecom markets were progressively opened to competition, national incumbents set up joint ventures to offer enhanced international services to multinationals (e.g., Atlas joint venture between France Telecom and Deutsche Telekom).90 At the turn of the twenty-first century when consolidation of ICT industries took place, WorldCom (renamed MCI and recently bought by Verizon) was the leader in the restructuring of the Internet market by acquiring many rivals companies (e.g., acquisition of MCI and then Sprint). Similarly, Vodafone was the leader of the restructuring of the mobile markets by acquiring many rivals (e.g., acquisition of Airtouch of the US and then Mannesmann of Germany). At the same time when convergence was taking place, Internet and telecom companies merge or form joint venture to offer fully converged services (e.g., merger between AOL and Time Warner between Vivendi and Seagram).91 More recently, there has been a consolidation in the pay-TV industry (e.g., NewsCorp buying Telepiu to form Sky Italia).92 Today, incumbents from Western Europe are buying smaller foreign operators (e.g., Telefonica of Spain buying the English mobile operator O2), especially in Eastern Europe.

89

For a description of those cases, see Garzaniti (2003, chapter 8), Le Blanc and Shelanski (2003), and de Streel (2004). 90 FT and DT extend this joint venture with Sprint of the US in Global One. See also the Concert joint venture between BT and MCI, and the Unisource joint venture between Telia of Sweden, KPN of the Netherlands and Swiss Telecom. 91 See also decision Vadafone/Vizzavi/Canal+. 92 See also decision Sogecable/ViaDigital.

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However, except in the Nordic country,93 there has been no fullfledged merger between incumbents because the customer demand is not yet Europeanized, the regulations vary significantly across countries and the governments are reluctant to accept such consolidation for reasons of economic patriotism. (2) The remedies imposed The types of remedies imposed have been diverse. The Commission imposed structural remedies that stimulate infrastructure competition (e.g., cable divestiture) for the parties to lose their dominant position on the traditional markets and their ability to leverage and foreclose entry in emerging markets.94 As the effects of these measures could only take place with time, they were complemented by behavioural remedies aiming at forcing access to key facilities (e.g., content, fixed telecom infrastructure, mobile infrastructure, technical services for pay-TV or interactiveTV services). As illustrated in Table 12.5 in the Appendix, the Commission has been more severe (read interventionist) in the electronic communications sector than in the economy as a whole because it blocked 2.2 per cent of the operations (instead of 0.6 per cent on average) and imposed remedies in 8.4 per cent of the cases (instead of 7 per cent on average). This is due to several reasons. The first reason was to prevent a dangerous circle of self-reinforcing market power between related markets, whereby parties leverage their power from established markets (e.g., the local loop) to secure a dominant position on emerging markets (e.g., the digital interactive service) and, in turn, leverage back from the emerging market to strengthen their power on 93

Merger between Telia of Sweden and Telenor of Norway later abandoned, and merger between Telia of Sweden and Sonera of Finland. 94 Sometimes, such ex ante antitrust remedies have paved the way for the future regulation. For instance, compulsory access to local loop was imposed in 1999 in the Telia/Telenor decision and taken over one year later by sector regulation: European regulation 2887/2000 of the European Parliament and of the Council of 18 December 2000 on unbundled access to the local loop, O.J. [2000] L 336/4.


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the established markets.95 The second reason of the strict stance of the Commission was to support the liberalization program of the Commission. For instance, in the early joint ventures between incumbents to provide enhanced international services like Atlas, the member states concerned were encouraged to accelerate liberalization in order to make a clearing under conditions of the alliances possible. The dynamics of the process thus created a parallelism of interest in accelerating liberalization between incumbents (in order to have their alliances cleared), member states (in order to allow the development of the potential of their national markets) and the Commission (in order not to be obliged to block new services and new technologies).96 The third reason of the strict stance of the Commission was to ensure noneconomic policy objectives, such as pluralism in the media in the merger involving content related services like AOL/TimeWarner.97 Note, however, that sector regulation has been taken into account when deciding the appropriate remedies. Thus, the Commission imposed more lenient remedies or no remedy when the behaviours of the parties to a joint venture were under strict control of a sectorspecific authority and there were less risk of abuse and leverage.98

95

This vicious circle is particularly worrying in ICT sector for three reasons at least. First, several markets are only emerging and their development should not be controlled by a particular company. Second, these markets are evolving very quickly and any anticompetitive behaviour could have rapid and irreversible effects. Third, most of the markets are characterized by network effects, that lead to path dependency with early developers (first-mover advantage) becoming dominant by capturing new growth (bandwagon affect) so inefficient solution may be adopted: see Monti (2000). 96 Ungerer (2001) referring to the decisions Atlas and GlobalOne. 97 Arino (2004). 98 For instance, the Commission imposed less remedy in Concert joint venture between BT and MCI that were strictly controlled by the English and American NRA than in Atlas joint venture between FT and DT that was not controlled by NRA. Such approach is in line with the case-law: Joined Cases T-374/94, T-375/94, T-384/94, T-388/94 European Night Services and Others v Commission [1998] ECR II-3141, para 221. Note that such an approach is not followed in

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12.3.2.2 Institutional issues

The vertical relationship between the Commission and the NCAs was weak because the role of the former in controlling merger was much more important than the one of the later as most major cases were of European dimension, hence were the exclusive competence of the Commission. However, some important cases were referred back to the NCAs, for example, the merger Sogecable/Via Digital99 decided by the Spanish authority. The diagonal cooperation between the Commission and the NRAs has also been less intense than under ex post antitrust because of the short deadlines to decide a merger case. However, the situation improved over time and can be seen now as complementary as the Commission relied on the NRA to implement merger remedies100 or has taken the market analysis of the NRA into account when deciding whether a merger would be anticompetitive.101

12.3.3 Appraisal of the application of antitrust in the electronic communications sector

Regarding the use of antitrust, its expansive role in the electronic communications sector has been criticized. Veljanovski (2001) argues that the merger approach has been too stringent because

sector regulation where the NRA should assess a dominant/SMP position without taking account of the regulation in place on the analysed operator for the obvious reason of alleviating a vicious circle of lifting regulation only because there was regulation: Commission decision of 20 February 2004, case FI/2003/24–26 (markets 4 and 6) and Commission decision of 17 May 2005, case DE/2005/144 (market 9). 99 Commission decision of 14 August 2002, Sogecable/Via Digital, M. 2845, upheld in joined cases T-346/02 and T-347/02 Cableuropa v Commission [2003] ECR II-0000. This case was very similar to the NewsCorp/Telepiu merger. 100 Decision Newscorp/Telepiu, para 259. 101 Commission decision of 19 September 2003, Vodafone/SinglePoint, M. 3245, para 24.


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economic literature102 shows that anticompetitive leverage is more rare than lawyers would think. Larouche (2000) argues that competition law has been stretched beyond its reasonable limits and the institutional and legitimacy settings of antitrust do not justify its quasiregulatory role.103 More generally, American authors like Audretsch et al. (2001), Evans and Schmalensee (2001), Katz and Shelanski (2004), or Posner (2001) emphasize the dynamic characteristics of the industries and the necessary adaptation of antitrust policy.104 However, given the history of the sector, an interventionist stance of antitrust in the electronic communications sector might be justified on static grounds (because dominant position is pervasive in the sector) as well as on dynamic grounds (because these dominant positions are often the result of past legal protection and not of private investment decisions taken in a competitive environment and whose incentives should be preserved).105 Moreover, in sectors where effective competition does not yet exist but is possible in the future, there may be a case for antitrust to actively promote entry of competitors that are equally efficient than the incumbents, or even less efficient competitors, for two related reasons: on a overall market perspective, it may pay in the long run to have many actors competing, and on a individual firm perspective, efficiency may increase over time as the customer bases and the operation scales increases.106 Therefore, there may be an economic case for a ‘different antitrust’ in sector where dominant position due to previous incumbency is prevalent. Yet, it should always be justified with 102

Rey and Tirole (2003). Although the Court of First Instance has implicitly admitted this quasiregulatory role in Case T-87/05 Energias de Portugal v Commission [2005] ECR II-0000, para 91. 104 This has been recently implicitly recognized by the Court of First Instance in case T-328/03 O2 Germany v Commission [2006] ECR II-0000, para 110. 105 Fingleton (2006) and Motta and de Streel (2006, pp. 109–112). 106 Conseil de la Concurrence français (2003,p. 72) and the Annex of ERG Revised Common Position on remedies. 103

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sound economic reasoning (which was not always the case in the merger control so far) and it should be strictly limited to the network industries that were developed under legal monopoly protection and not be extended to other sectors of the economy.107

12.4 SECTOR REGULATION 12.4.1 Ex ante sector regulation


(1) The market segments regulated On the basis of the three criteria to select market susceptible to sector regulation (i.e., high permanent and nonstrategic entry barriers, no competitive dynamics behind these barriers and inefficiency of antitrust remedies to solve the competitive problems), the Commission has proposed the NRAs to analyse eighteen markets (seven retail and eleven wholesale markets).108 In general, the Commission identified mainly upstream access markets because there is no barrier (or only low barriers) to enter the retail markets when wholesale regulation is efficient.109 On the fixed voice segment, the Commission selected two retail access markets (residential and business customers), four retail services markets (same segmentation residential/business; and segmentation between local/national and international services), and three wholesale markets (call origination, transit and

107

Moreover, the argument for a more interventionist competition law is weaker when there is a strong sector regulation as in this case, the authorities may rely on sector regulation instead of antitrust to achieve efficiency on the market. 108 Commission recommendation 2003/311 of 11 February 2003 on relevant product and service markets within the electronic communications sector susceptible to ex ante regulation, OJ [2003] L 114/45. 109 In fact, the retail markets have been identified more for historical reasons than for economical reasons.


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call termination)110 adding up to the whole connection between two customers. On the fixed broadband data segment, the Commission identified two wholesale access markets: access at the local loop level and access at the bitstream level, which is somewhat further up in the network.111 On leased lines segment, the Commission identified one retail market (the minimum set of leased lines which corresponds to five types of leased up to 2 Mbits),112 and two wholesale markets (terminating and trunk segments), which adds up to the whole connection between two customers. In the mobile segment, the Commission identified three wholesale markets: access and call origination as well as termination, which are the two ends of the mobile network,113 and international roaming, which presents specific economic problems.114 In the broadcasting segment, the Commission identified only one wholesale market for broadcasting transmission. In general, the NRAs have followed such market definitions, sometimes segmenting further the market defined by the Commission (in particular for the broadcasting market) and sometimes adding new markets (Table 12.3).115

110

The termination market is defined on each individual network because the ‘calling-party pays’ principle creates an externality between the caller (who ultimately pays the termination charge but does not choose the terminating network) and the called party (who chooses such network but does not pay the charge). 111 Local loop refers to the physical circuit connecting the network termination point at the subscriber’s premises to the main distribution frame (MDF) or equivalent facility in the fixed public network (article 2(e) of the Access Directive). Bitstream Access refers to the provision of transmission capacity between an end-user connected to a telephone connection and the point of handover to the new entrant (Recommendation from the Commission of 26 April 2000 on unbundled access to the local loop, OJ [2000] C 272/55). 112 Commission decision 2003/548 of 24 July 2003 on the minimum set of leased lines with harmonized characteristics and associated standards referred to in article 18 of the Universal Service Directive, O.J. [2003] L 186/43. 113 See note 110. 114 See note 64. 115 Communication from the Commission of 6 February 2006 on Market Reviews under the EU Regulatory Framework: Consolidating the internal market for electronic communications, COM(2006) 28.

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Table 12.3 Markets susceptible to sector regulation

Fixed voice

Retail markets

Wholesale markets

1. Access for residential 2. Access for nonresidential 3. Local and/or national services for residential 4. International services for residential 5. Local and/or national services for nonresidential 6. International services for nonresidential

8. Call origination 9. Call termination on individual public networks 10. Transit

Fixed narrowband data

Idem 8

Fixed broadband data

11. Unbundled access (including shared access) to metallic loops and subloops 12. Wholesale broadband access

Fixed dedicated access

7. Minimum set of leased lines

13. Terminating segments 14. Trunk segments

Mobile voice

15. Access and call origination 16. Call termination on individual public networks 17. International roaming

Broadcasting

18. Broadcasting transmission services

(2) The remedies imposed Although, the NRAs have the choice between a list of five remedies (transparency, nondiscrimination, accounting separation, compulsory access and price control) and the obligation to only choose the proportionate ones, they impose in general the full suite of them on all markets, and in particular price control at forward looking long-term incremental cost.116 Most regulators apply the ladder of investment which consists of regulating the different rungs of an imaginary investment ladder (i.e., retailing, IP Networks, backhaul, DSLAM, local loop) and only removing

116

Ibidem.


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regulation of one rung when entrants have climbed that rung.117 Thus, the policy aims not only to create a level-playing field but also to actively support entrants. As a consequence, the NRAs regulate almost all markets of the long Commission list, with only few exceptions like some retail services markets and the wholesale fixed transit and mobile access (see Table 12.7 in the Appendix). 12.4.1.2 Institutional issues

The horizontal relationships between the NRAs have clearly been reinforced with the creation of the ERG, but are still insufficient to create a single market for electronic communications. In the vertical relationship between the Commission and the NRAs, the influence of the former has been considerable: it starts the SMP process by defining the markets to be analysed by the NRAs and usually such definitions are followed by NRAs and has already veto five draft decisions (without counting several draft decisions that have been withdrawn to alleviate such veto).118

12.4.2 Appraisal of the application of sector regulation

After more nearly three years of implementation, the new sector regulation which was more based on theoretical thinking than practical experience has not fully delivered the good governance principles it pursued.119 In particular, the principles of proportionality and legal 117

Cave and Vogelsang (2003); Cave (2006); ERG Broadband market competition report of May 2005, ERG(05) 23. 118 See Table 12.7 of the Appendix. In addition, the Commission gives substantive indications in the prenotification meetings held with the NRAs to discuss in advance any controversial issue. 119 The principles were: flexibility, transparency, technological neutrality, harmonization, proportionality, and legal certainty. For an overview of the state of implementation of the sector regulation: Communication from the Commission of 20 February 2006, European Electronic Communications Regulation and Markets 2005 (11th Implementation Report), COM(2006) 68.

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certainty are no achieved. Indeed, there is an increase of regulation as more market segments are regulated and more operators are regulated on each segment. At this stage, I can not prove that regulators have intervened beyond the optimal level because that would require a clear and articulated definition of optimal regulation as well as a full cost-benefit that has not be done until now and is outside the scope of this paper.120 However, it is a fact that the never-ending expansion of regulation does not match to the deregulatory rhetoric of the European and national legislators and regulators. Also the strategies of the regulatory actors are not sufficiently clear in particular for the emerging markets (do they want to push for infrastructure-based competition of service-based competition, do they want short-term competition or long term competition, do they want to do industrial policy or not). One reason of such failure is the lack of clear objectives in the law and the inability or unwillingness of the regulators to arbitrate between conflicting priorities. The legislator tried to hide the question of objectives and escape those conflicts by aligning sector regulation with antitrust methodologies. However, such methodologies do not evacuate the fundamental regulatory questions and worse, they add difficulties.121 The main difficulty is that standard antitrust principles were developed for antitrust practice in stable industries and need adaptations to be applicable in the context of the sector regulation for dynamic markets. First, standard antitrust principles are mainly suited to horizontal markets but need to be substantially modified to deal with vertical chains of production 120

In particular, some argue that the ladder of investment has had a positive effect on investment and long term competition: Cave (2006) and ERG Broadband market competition report of May 2005, ERG(05) 23 whereas other argue that it is not the case: Oldale and Padilla (2004) and Hausman and Sidak (2005). 121 Larouche (2002) Note also that antitrust principles are insufficient to base sector regulation because they detect all kinds of market power and are not able to screen the subset among them – hard core market power – that justify regulation. Thus, mere antitrust principles should be completed by other elements that have nothing to do with antitrust principles, that is, the three selection criteria.


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(which is the main focus of sector regulation).122 For instance, standard antitrust principles would not by themselves be capable of defining a derived non-merchant wholesale market123 and there is risk that the different services making a production chain are choked up in numerous artificially narrow antitrust markets.124 Second, standard antitrust principles are suited to stable industries where competition is mainly in price but need to be adapted to deal with innovation and the Schumpeterian creative destruction competition.125 Third, standard antitrust principle are suited to onesided markets but need to be adapted to deal with two-sided markets where there are strong interactions between each side of the markets.126 In addition to this difficulty, there are several other drawbacks and risks with the alignment on antitrust principles. First, the use of a legal concept is always linked to the objective of the legal rule for which it is used. As the objectives of antitrust and sector regulation may differ (recall that the objective antitrust is the maximization of long term consumer welfare, whereas the objectives 122

Larouche (2000, pp. 203–211) and Richards (2006, pp. 206–209). Although the Court of Justice admitted that the antitrust methodology may be used to define a hypothetical non-merchant wholesale market in Case C-418/01 IMS Health v NDC Health [2004] ECR I-0000, para 44. 124 This will become more problematic as the industry moves towards newgeneration networks. According to the International Telecommunications Union, a new-generation network is ‘a packet based architecture fostering the provisioning of existing and new/emerging services through a loosely coupled, open and converged communications infrastructures’. 125 Audrestch et al. (2001), Dobbs and Richards (2004), Evans and Schmalensee (2001). For instance, some monopoly power defined with static method may in fact increase welfare when it is necessary to increase innovation and when it is constrained by the threat of other innovation and creative destruction. 126 Gual (2003), Evans (2003), and Rochet and Tirole (2004). When markets are two-sided, regulators should not only look at the level of the price on each side of the market, but also at the structure of the price between the different sides. In other words, it may be efficient that one side is charged below whereas the other side is charged above costs (cf. a heterosexual disco where usually women pay less and men more than the cost of entry). 123

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of sector regulation may be broader), the interpretation of a same antitrust concept may also differ creating legal confusion and uncertainty.127 Second, antitrust principles are complex and have been under significant reform recently, moving from a legalistic formbased approach towards a more economic effects-based approach.128 Third, and linked to institutional issues, antitrust principles do not constrain the NRAs very much in their actions (as many NRAs adapt them quite flexibly) but they do constrain the Commission in its comment under the Article 7 review of NRAs’ draft decisions (as the Commission always looks at the impact of its comments on its pending and future antitrust cases). Therefore, critics propose to base sector regulation on the concept of bottleneck.129 Indeed, the first best might be to base sector regulation on specific concept (like bottleneck) to alleviate confusion between antitrust and sector regulation objectives and to be simpler to apply. However, there is already an implicit notion of bottleneck in the current sector regulation at the market selection step130 and the complementary use of antitrust concepts is probably a second best option in the European context because indeed, it ensures a 127

See the different interpretations of price squeeze in antitrust law and in sector regulation proposed by Grout (2002). Similarly, the first president of the French Supreme Court argues that a similar legal antitrust concept may be interpreted differently depending of the objectives of the legal instruments for which it is used: Canivet (2006, p. 5). 128 Communication from the Commission of 20 April 2004, A pro-active Competition Policy for a Competitive Europe, COM(2004) 293. 129 Larouche (2000, pp. 359–403), Richards (2006, p. 220), and Squire-Sanders and Analysys (1999, p. 147). The UK regulator Ofcom decided during its strategic review to base its equality of access regulation on enduring economic bottlenecks which are defined as ‘the parts of the network where there are little prospects for effective and sustainable competition in the medium term’. It comprises wholesale line rental; metallic path facility, IPStream and backhaul extension service: Ofcom final statements of 22 September 2005 on the strategic review of the telecommunications, at para 4.6. 130 Recital 27 of the Framework Directive as interpreted by recitals 9–16 of the recommendation on relevant markets. See also the reference to bottlenecks made in Recital 13 of the Access Directive.


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more economic approach and some harmonization between NRAs that the use of new specific concepts may guarantee. However, it is important that antitrust concepts do not evacuate the question of objectives as it is the case today and that their underlying economic theories are adapted to the dynamic characteristics of the sector. A second reason for the regulatory failure is that the institutional design has not been sufficiently thought through by the European legislature. In general, regulatory authorities do not have incentive to deregulate because of the well-established problems of state bureaucracy implying that authorities have a tendency to increase their activities131 and the regulatory brakes of the current law (national appeal and Commission review) are not efficient enough. More critically, NRAs do not have incentives to take into account the dynamic side of competition (investment, innovation) but only the static side (evolution of price, number of competitors) because the indicators on which they are evaluated are mainly static (level of price, concentration index).132 In other words, NRAs are performing relatively well with regard to their incentives, but such incentives are not aligned with the long-term welfare of the consumers. Thus, there is a need to better adapt those incentives by evaluating the NRAs on more dynamics indicators and by reinforcing the regulatory brakes.

131

The tendency to overregulate because of state bureaucracy may be counterbalance by a tendency to underregulate in the countries where NRAs are captured by the incumbents. 132 See the yearly Commission implementation reports, available at http: //europa.eu.int/information_society/policy/ecomm/implementation_enforcement/ index_en.htm More dynamic indicators are currently being designed by the British NRA to evaluate the impact of the strategic review: Ofcom statement of 8 February 2006 on evaluating the impact of the strategic review of telecommunications.

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12.5 OPTIMAL BALANCE BETWEEN RULES AND COORDINATION BETWEEN INSTITUTIONS 12.5.1 The optimal balance between antitrust and sector regulation

12.5.1.1 Market failures in electronic communications

After having analysed the use of antitrust law send sector regulation in practice, I now turn to what could be the optimal coordination between those two branches of law. To address such issue, I should first recall the rationale of public intervention in the sector. Public authorities should aim to maximize the welfare of their citizens and markets are supposed to be the best means to ensure such welfare maximization. Thus, governments should intervene only when the mere functioning of the markets does not deliver this objective. Economists distinguish between three types of market failure.133 (1) The first market failure is the presence of excessive market power (e.g., a monopoly operator) which may lead to excessive price or too little innovation. Excessive market power is caused by legal and economic entry barriers or by anticompetitive behaviours. The concept of economic entry barriers is controversial in the literature with two opposing views.134 The narrow (Stiglerian) view limits the barriers to the absolute cost advantages of the incumbents (e.g., access to best outlet in town, or consumer switching costs) but excludes all entrants’ costs that have also been borne by the incumbents (e.g., high fixed and sunk costs). The broad (Bainian) view extends the concept of barriers to all factors that limit entry and enable incumbents to get a supranormal profit, hence includes absolute cost advantages but also economies of scale and scope. (2) The

133

Here I follow the definition of the International Competition Network (2006, p. 4), which considers that market failure occurs when resources are misallocated or allocated inefficiently (i.e., this includes misallocation in both static and dynamic sense), resulting in loss value, wasted resources, or some nonoptimal outcome. 134 McAfee et al. (2004).


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second market failure is the presence of an externality (like network externality or tariffs-mediated externality) which may lead to underconsumption in case of positive externality and overconsumption in case of negative externality.135 (3) The third market failure is the presence of information asymmetries (e.g., the absence of knowledge of the price) which may lead to under- or overconsumption. In telecommunications, the two first categories lead to the standard distinction between (1) the one-way access (or access model) which concerns the provision of bottleneck inputs by an incumbent network provider to new entrants and (2) two-way access (or the interconnection model) which concerns reciprocal access between two networks that have to rely upon each other to terminate calls.136 In addition, each type of market failure may be structural and result from the supply and demand conditions of the market, or may be behavioural and artificially (albeit rationally) ‘manufactured’ by the firms, leading to the matrix shown in Table 12.4.137 Since the decline of the structure–conduct–performance paradigm in industrial economics, it is now recognized that nonstrategic and strategic market failures are closely linked together and that structure influences conduct as much as conduct influences structure. However, it remains possible (and useful when choosing between the different instruments of public intervention) to identify the causes of the nonefficient market results and to distinguish between structural and behavioural market failures.

135

For instance, less than the optimal number of customers may decide to join a network if new customers are not compensated, when joining the network, for an increase in the welfare they create for the already existing customers. The ERG defines the network externality as ‘the effect which existing subscribers enjoy as additional subscribers join the network which is not taken into account when this decision is made’: ERG Revised Common Position on remedies, p. 127. 136 See Armstrong (2002), Laffont and Tirole (2000), and Vogelsang (2003). 137 Several potential behavioural market failures have been identified by the ERG in its Revised Common Position on remedies at Chapter 2.

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Table 12.4 Market failure susceptible to public intervention.138 Structural/nonstrategic

Behavioural/strategic

Excessive market power

Cell 1 – Bainain entry barriers: High and sunk fixed with uncertainty – Stiglerian entry barriers: Important absolute cost advantages (e.g., switching costs) – Legal barriers → One-way access (access model)

Cell 2 – Reinforcement of dominance – Vertical leveraging – Horizontal leveraging

Externality

Cell 3 – Network effects – Two-sided markets → Two-way access (interconnection model)

Cell 4 – Strategic network effects (e.g., loyalty program or tariff mediated externality

Information asymmetry

Cell 5

Cell 6

12.5.1.2 Choice between competition law and sector regulation

To tackle these different market failures, public authorities dispose of several legal instruments (in particular competition law, sector regulation, consumer law) that they must combine in the most efficient way. Specifically, to find the appropriate balance between competition law and sector regulation, regulators should determine the main differences between both instruments, confront them with the market failures to be dealt with and accordingly decide which instrument is the most efficient in solving the market failure. 138

This table is only a stylized and static view of the market reality that is more a starting point to raise the relevant questions than a checklist to provide definitive answers on the scope of public intervention. Telecommunications markets are intrinsically dynamic and a rationale based on static view may lead to inappropriate and overinclusive public intervention. For instance, a high level of market power does not always lead to long term inefficiencies justifying intervention.


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According to the present author,139 the two principal and related substantive differences are that (1) sector regulation mainly deals with unsatisfactory market structures whereas competition law deals with unsatisfactory firms’ behaviours, and (2) the burden of proof for sector regulation to intervene on the selected markets140 is lower than in the case of antitrust law. The main institutional difference is that (3) sector regulation is only applied by national authorities, whereas antitrust law is applied by European authorities as well (the Commission). Because of the first difference (related to structure and behaviours), it is efficient that sector regulation deals with structural market failures and competition law deals with behavioural ones. Because of the second difference (related to the burden of proof), it is efficient that the factor used to select markets for regulation is set at a very high level because once a market area is selected, intervention is relatively easy. In other words, the regulation should focus on market where the risks of type I errors (false condemnation) are low and the risks of type II errors (false acquittal) are high.141 This is especially important because the costs of type I errors are large in dynamic markets.142 Taking both arguments together, any 139

On the differences between sector regulation and antitrust law, see also Laffont and Tirole (2000, pp. 276–279), Katz (2004), and Temple Lang (2006). Many authors consider the main difference is that antitrust law aims at maintaining the level of competition whereas sector regulation aims at increasing the level of competition. According to the present author, the difference is not always verified in practice as some antitrust decisions (in particular merger decisions) and that has been endorsed the Community courts. 140 The burden of proof for sector regulation to intervene is high when all steps of Table 12.1 are considered, but is low when steps 1a and 1b are passed. 141 I link here the burden of proof to intervene with the risks and the costs of type I and type II errors, following the tradition of the Chicago School recently revived by inter alia Evans and Padilla (2004). 142 Hausman (1997) valued the delay of the introduction of voice messaging services from late 1970s until 1988 at US$ 1270 million per year by 1994, and the delay of the introduction of mobile service at US$ 100 000 million, large compared with the 1995 US global telecoms revenues of $180 000 million/year.

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possible regulation should limited to cells 1 and 3 of Table 12.4, that is, structural market failures due to excessive market power and externalities. Because of the third difference (related to institutional design), it might be justified that antitrust law applies in addition to sector regulation when NRAs have not performed their tasks adequately.143

12.5.2 The optimal institutional coordination

An optimal coordination between the many institutions involved in the regulation of the electronic communications is primordial given the overlapping jurisdictions between several authorities, hence the risks of forum shopping by complainants, increased regulatory costs, or conflicting decisions.144 First, the mechanisms for horizontal coordination between the NCAs of the twenty-five member states (i.e., the European Competition Network and the important role of the Commission as primus inter partes) are sufficient given their already strong European attitude. However, the mechanisms for horizontal coordination among the NRAs of the twenty-five member states (i.e., ERG) are insufficient because they are much less Europeanized than their antitrust counterparts.145 Thus, coordination mechanisms between national

143

That was the case in the decision Deutsche Telekom. However, it is a better institutional design that regulatory decisions are controlled by judicial bodies (a national court or ultimately the European Court of Justice) instead of an antitrust authority: Larouche (2005, p. 175) and Petit (2005, p. 198). 144 On the need for coordination see: Larouche (2005, pp. 166–170), and Petit (2005, pp. 182–187). 145 This is partly due to the fact that most NCAs have been created after that the Commission has played a substantial role in applying and modelling the competition law, whereas NRAs have been created before that the Commission play an active role in modelling the sector regulation.


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regulators should be reinforced, possibly with the creation of a European regulatory authority. Second, the mechanisms for vertical coordination between the Commission and the NCA (i.e., possibility of decease of the Commission and infringement procedures) are sufficient. However, the mechanisms for coordination between the Commission and the NRAs (i.e., Commission review and infringement procedure) are insufficient because they are weaker than those antitrust coordination mechanisms and yet NRAs are less Europeanized. Thus, they should be strengthened to achieve an internal market for electronic communications. Third, the mechanisms for transversal coordination between the NCA and the NRA of a specific country need to be reinforced in most of the member states. There is no optimal model as such relationships depend very much on the institutional characteristics of each country,146 but improvements may be achieved by integrating the NRA inside the NCA (as done in New Zealand) or by having a clearer division of tasks between authorities.147 Fourth, the mechanisms for diagonal coordination between the Commission and the NRA of each member state need to be clarified, possibly by a better division of tasks between authorities.

12.6 CONCLUSION

To conclude, Antitrust authorities are justified to intervene more strictly in electronic communications sector (or more generally network industries), but their interventions should always be based on sound economic rationale and the same extensive approach should not permeate other sectors of the economy.

146

International Competition Networks (2006, pp. 26–29). Larouche (2005, p 176) proposes, on the basis of the experience so far, that the Commission and the NCAs would be in charge of the assessment of dominance, whereas the NRAs would be in charge of the choice of remedies.

147

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Sector regulation is justified to be aligned on antitrust principles because of the institutional structure of the European Union, but it is only a second best, and alignment of concepts should not lead to an alignment of objectives. Indeed, the antitrust principles should neither be mystified (Même la plus belle fille du monde ne peut donner que ce qu’elle a) nor demonized. These are like economic glasses to be put by a public authority, no more, no less. They do not evacuate the fundamental regulatory questions to be solved (what type of competition the regulator is aiming for? what is the timeframe of regulatory intervention?) and do not pre-empt on the objectives to be followed. Sector regulation and competition law are converging but some important divergences remain, in particular regarding the burden of proof and the institutions in charge. Such divergences should determine the scope of sector regulation which should only be applied when more efficient than antitrust, that is, when costs and the risks of type I errors are small and the costs and the risks of type II errors are large. Sector regulation should respect good governance principles: flexibility, objectivity, transparency, harmonization, proportionality (in particular regulatory creep should be alleviated) and legal certainty. NRAs should be cautious not to automatically extend a regulatory approach suited for infrastructures laid down under legal monopoly conditions to new Schumpeterian infrastructures and should be less hypocritical about their actions (and not invoke the mantra of deregulatory rhetoric when they are increasing regulation for good or for wrong/poor reasons). The institutional design should be better taken into account when establishing the rules148 and in particular the transversal coordination between regulatory authorities with overlapping competences should be developed.

148

See in general Sapir (2004).


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APPENDIX Table 12.5 Statistics of merger cases Electronic communications cases149

All cases Total 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 TOTAL

12 63 60 58 95 110 131 172 235 292 345 335 279 212 249 313 2661 100%

With remedies 0 6 7 2 4 6 3 9 16 27 40 23 15 17 16 15 206 7.0%

Prohibition 0 1 0 0 1 2 3 1 2 1 2 5 0 0 1 0 19 0.6%

Total 0 1 3 3 6 14 12 15 26 28 56 43 17 9 13 29 275 9.3% 100%

With remedies

Prohibition

0 0 0 0 0 0 1 1 2 5 9 2 1 2 0 0 23

0 0 0 0 1 2 0 0 2 0 1 0 0 0 0 0 6

8.4%

2.2%

Source: European Commission.

149

This comprises the cases under NACE code I.64.20 (telecommunications) and O.92.20 (radio and television activities).

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Table 12.6a List of ex ante decisions with remedies, under Merger Regulation and Article 81 EC (as of April 2006) Case

Date

No.

Legal basis ∗

Publication ∗∗

Eirpage BT/MCI Atlas Phoenix/Global One RTL/Veronica/Endemol II BT/MCI (II) Unisource Obligations repealed in Unisource (II) Uniworld WorldCom/MCI NC/Canal+/CDPQ/ BankAmerica BT/AT&T TPS Upheld in Metropole Cégétel+4 Vodafone/AirTouch AT&T/MediaOne Télécom Développement BiB/Open Telia/Telenor Orange/Mannesmann TelekomAustria/Libro BSkyB/KirchPayTV Upheld in ARD BT/Esat EADS Vodafone/Mannesmann Vodafone/Vizzavi/Canal+ FranceTelecom/Orange AOL/TimeWarner Vivendi/Canal+/Seagram YLE/TDF/Digita Pirelli/Telecom Italia Modification remedies Telia/Sonera NewsCorp/Telepiù DaimlerChrysler/DT UK Network sharing Network Sharing Rahmenvertrag

18 Oct. 1991 27 July 1994 17 July 1996 17 July1996 17 July 1996 14 May1997 29 Oct. 1997 29 Dec. 2000 29 Oct. 1997 8 July 1998 3 Dec. 1998

32.737 34.857 35.337 35.617 M. 553 M. 856 35.830 36.841 35.738 M. 1069 M. 1327

81.3 EC 81.3 EC 81.3 EC 81.3 EC 8.2 MR 8.2 MR 81.3 EC

O.J. O.J. O.J. O.J. O.J. O.J. O.J. O.J. O.J. O.J.

30 March 1999 3 March 1999 18 Sept. 2001 20 May 1999 21 May 1999 23 July 1999 27 July 1999 15 Sept. 1999 13 Oct. 1999 20 Dec. 1999 28 Feb. 2000 21 March 2000 30 Sept. 2003 27 March 2000 11 April 2000 12 April 2000 20 July 2000 11 Aug. 2000 11 Oct. 2000 13 Oct. 2000 21 June 2001 20 Sept. 2001 5 Aug. 2002 10 July 2002 2 April 2003 30 April 2003 30 April 2003 16 July 2003

JV. 15 36.237 T-112/99 36.592 M. 1430 M. 1551 36.581 36.539 M. 1439 M. 1760 M. 1747 JV. 37 T-158/00 M. 1838 M. 1745 M. 1795 JV. 48 M. 2016 M. 1845 M. 2050 M. 2300 M. 2574

8.2 MR 81.3 EC

M. 2803 M. 2876 M. 2903 38.370 38.369

6.2 MR 8.2 MR 8.2 MR 81.3 EC 81.3 EC

81.3 EC 8.2 MR 6.2 MR

81.3 EC 6.2 MR 6.2 MR 81 EC 81.3 EC 8.2 MR 6.2 MR 6.2 MR 6.2 MR

[1991] [1994] [1996] [1996] [1996] [1997] [1997] [2001] [1997] [1999]

L L L L L L L L L L

306/23 223/36 239/23 239/57 294/14 336/1 318/1 52/30 318/24 116/1

O.J. [1999] L 90/6 ECR [2001] II-2459 O.J. [1999] L 218/14

O.J. [1999] L 218/24 O.J. [1999] L 312/1 O.J. [2001] L 40/1

ECR [2003] II-XXX 6.2 6.2 6.2 6.2 6.2 8.2 6.2 6.2 6.2

MR MR MR MR MR MR MR MR MR

O.J. [2001] L 268/28

IP/02/1183

O.J. O.J. O.J. O.J.

[2004] [2003] [2003] [2004]

L L L L

110/73 300/62 200/59 75/32

Cat∗∗∗

2 1 1 1 3 1 1 1 1 1 1 3 1 2 1 1 3 1 2 1 3 1 2 3 2 3 3 3 1 1 3 3 2 2


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Table 12.6a (Continued) Partly annulled in O2 Germany Telenor/Canal+ Telefonica/O2 T-Mobile/tele.ring

2 May 2006

T-328/03

29 Dec. 2003 10 Jan. 2006 26 April 2006

38.287 M. 4035 M. 3916

ECR [2006] II-XXX 81.3 EC 6.2 MR 8.2 MR

3 2 2

Table 12.6b List of ex ante decisions – prohibition Case

Date

No.

Legal basis

Publication

Cat

MSG Media Service

9 Nov. 1994

M. 469

8.3 MR

O.J. [1994] L 364/1

3

Nordic Satellite Distribution RTL/Veronica/Endemol (I) Upheld in Endemol Bertelsmann/Kirch/ Premiere Appeal removed Deutsche Telekom/BetaResearch MCIWorldCom/Sprint Annulled in MCI WorldCom

19 July 1995

M. 490

8.3 MR

O.J. [1996] L 53/20

3

20 Sept.1995 28 April 1999 27 May 1998

M. 553 T-221/95 M. 993

8.3 MR

3

8.3 MR

O.J. [1996] L 134/32 ECR [1999] II-1299 O.J. [1999] L 53/1

27 May 1998

T-123/98 M. 1027

8.3 MR

O.J. [1999] L 53/31

3

28 June 2000 28 Sept. 2004

M. 1741 T-310/00

8.3 MR

O.J. [2003] L 300/1 ECR [2004] II-XXX

1

3

Table 12.6c List of ex post decisions (Article 82 EC) Case

Date

No.

Legal basis

Publication

British Telecom Upheld in, BT Deutsche Telekom Appeal pending Wanadoo Appeal pending

10 Dec. 1982 20 March 1985 21 May 2003

29.877 41/83 37.451 T-271/03 38.233 T-340/03

82 EC

O.J. [1982] L 360/36 ECR [1985] 873 O.J. [2003] L 263/9

16 July 2003

82 EC 82 EC

Cat

1 1 1

∗ 6.2 MR: Merger Regulation, remedies in phase I; 8.2 MR: Merger Regulation, remedies in phase II; 81.3 EC: EC Treaty, individual exemption. ∗∗ If no mention, the decision is published on the web site of DG Competition. ∗∗∗ Category 1: Fixed (including Internet or cable) or fixed and mobile services; category 2: Mobile services; category 3: Content-related services.

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Table 12.7 SMP analysis in the twenty-five member states (as of April 2006) A T

B E

C Y

D E

D K

E E

E L

E S

F I

F R

H U

I E

I T

L T

L U

M T

N L

P L

P T

S E

S I

S K

C Z

U K

1 2 3 4

V

5 6

V

7 8 9 10

V V

11 12 13 14 15

V

16 17 18

Legend

Regulation No regulation SMP designation, but remedies not yet decided Not yet decided V: Commission veto Statistics: phase I without comments: 33 per cent; phase I with comment: 65 per cent; phase II accepted: 0.6 per cent; phase II vetoed: 1.5 per cent.

REFERENCES Arino, M. (2004): ‘Competition law and pluralism in European digital broadcasting: Addressing the gaps’, Communications & Strategies 57: 97–128. Armstrong, M. (2002): ‘The Theory of access pricing and interconnection’, in Cave M., S. Majumdar, and I. Vogelsang (eds), Handbook of Telecommunications Economics v. 1, North-Holland, 295–384.


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Audretsch, D. B., W. J. Baumol and A.E. Burke (2001): ‘Competition policy in dynamic markets’, International Journal of Industrial Organization 19: 613–634. Bourreau, M. (2003): ‘Local loop unbundling: The French case’, Communications & Strategies 49: 119–135. Buiges, P. (2004): ‘A Competition policy approach’, in P. Buiges and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications, E. Elgar, 9–26. Canivet, G. (2006): Approache comparée Europe/Etats-Units sur les rapports entre le droit de la régulation et le droit de la concurrence dans les industries da réseaux: le point de vue du juge, Presented at the Conference Balancing Antitrust and Regulation in Network Industries. Cave, M. (2004): ‘Economic aspects of the new regulatory regime for electronic communication services’, in P. Buiges and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications, E. Elgar, 27–41. Cave, M. (2006): ‘Encouraging infrastructure competition via the ladder of investment’, Telecommunications Policy 30: 223–237. Cave, M. and P. Crowther (2005): ‘Pre-emptive competition policy meets regulatory antitrust’, European Competition Law Review 26: 481–490. Cave, M. and I. Vogelsang (2003): ‘How access pricing and entry interact’, Telecommunications Policy 27: 717–727. Choumelova, D. and J. Delgado (2004): ‘Monitoring competition in the telecommunications sector: European Commission Sector Enquiries’, in P. Buiges and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications, E. Elgar, 269–284. Conseil de la Concurrence français (2003): ‘Etudes thématiques: L’orientation des prix vers les coûts’, in Rapport d’activités 2002, 67–88. Dobbs, I. and P. Richards (2004): ‘Innovation and the new regulatory framework for electronic communications in the EU’, European Competition Law Review 25: 716–730. Ehlermann, C. D. and L. L. Laudati (1998): European Competition law Annual 1997: The Objectives of Competition Policy, Hart. Evans, D. and R. Schmalensee (2001): ‘Some economic aspects of antitrust analysis in dynamically competitive industries’, NBER Working Paper 8268. Evans, D. S. (2003): ‘The antitrust economics of multi-sided platform’, Yale Journal on Regulation 20: 325–381. Evans, D. S. and A. J. Padilla (2004): ‘Designing antitrust rules for assessing unilateral practices: A neo-Chicago approach’, CEPR Discussion Paper 4625. Fingleton, J. (2006): ‘Demonopolizing Ireland’, in C.D. Ehlermann and I. Atanasiu (eds), European Competition Law Annual 2003: What is an Abuse of Dominant Position?, Hart, 53–68. Garnham, N. (2005): ‘Contradiction, confusion and hubris: A critical review of European Information Society Policy’, ENCIP Paper. Garzaniti, L. (2003): Telecommunications, Broadcasting and the Internet: EU Competition Law and Regulation, 2nd edn, Sweet & Maxwell. Geradin, D. (2004): ‘Limiting the scope of article 82 of the EC Treaty: What can the EU learn from the US Supreme Court’s judgement in Trinko in the wake of Microsoft, IMS, and Deutsche Telekom’, Common Market Law Review 41: 1519–1553. Geradin, D. and R. O’Donoghue (2005): ‘The concurrent application of competition law and regulation: The case of margin squeeze abuses in the telecommunications sector’, Journal of Competition Law and Economics 1: 355–425.

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Geradin, D. and J. G. Sidak (2005): ‘European and American approaches to antitrust remedies and the institutional design of regulation in telecommunications’, in M. Cave, S. Majumdar, and I. Vogelsang (eds), Handbook of Telecommunications Economics, v. 2, North-Holland, 518–556. Grout, P. A. (2002): ‘Competition law in telecommunications and its implications for common carriage of water’, CMPO Working Paper 02/056. Gual, J. (2003), ‘Market definition in the telecoms industry’, CEPR Working Paper 3988. Hausman, J. A. (1997): ‘Valuing the effect of regulation on new services in telecommunications’, Brookings Papers: Microeconomics: 1–38. Hausman, J. A. and J. G. Sidak (2005): ‘Did mandatory unbundling achieve its purpose? Empirical evidence from five countries’, Journal of Competition Law and Economics 1: 173–245. Hocepied, C. and de Streel A. (2005): ‘The ambiguities of the European electronic communications regulation’, in E. Dommering and N. van Eijk (eds), The Round Table Expert Group on Telecommunications Law, University of Amsterdam, 139–190. International Competition Network (2006): Working Group on Telecommunications Services, Report to the Fifth Annual Conference in Cape Town. Katz, M. L. (2004): ‘Antitrust or regulation? US public policy in telecommunications markets’, in P. Buiges and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications, E. Elgar, 243–259. Katz, M. L. and H. A. Shelanski (2004): ‘Merger policy and innovation: Must enforcement change to account of technological change?’, NBER Working Paper 10710. Krüger, R. and L. Di Mauro (2003): ‘The article 7 consultation mechanism: Managing the consolidation of the internal market for electronic communications’, Competition Policy Newsletter 3: 33–36. Laffont, J. J. and J. Tirole (2000): Competition in Telecommunications, MIT Press. Larouche, P. (2000): Competition Law and Regulation in European Telecommunications, Hart. Larouche, P. (2002): ‘A closer look at some assumptions underlying EC regulation of electronic communications’, Journal of Network Industries 3: 129–149. Larouche, P. (2005): ‘Co-ordination of European and Member State Regulatory Policy: Horizontal, vertical and transversal aspects’, in D. Geradin, R. Munoz, and N. Petit (eds), Regulatory Authorities in the EC: A New Paradigm for European Governance, E. Elgar, 164–179. Larouche, P. (2006): ‘Contrasting legal solutions and comparability of the EU and US experiences’, Presented at the Conference Balancing Antitrust and Regulation in Network Industries. Lasok, K. P. E. (2005): ‘Appeals under the new regulatory framework in the electronic communications sector’, European Business Law Review 16: 787–801. Le Blanc, G. and H. Shelanski (2003): ‘Telecommunications mergers in the EU and US: A comparative institutional analysis’, in F. Lévêque and H. Shelanski (eds), Merger Remedies in American and European Union Competition Law, E. Elgar, 172–207. McAfee R., H. G. Mialon, and M. A. Williams (2004): ‘What is a barrier to entry’, American Economic Review 94(2): 461–465. Monti, M. (2000): ‘Competition and information technologies’, Speech 18 September. Monti, M. (2003), ‘Competition and regulation in the new framework’, Speech 15 July.


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Motta, M. and A. de Streel (2006): ‘Excessive pricing and price squeeze in European competition law’, in C.D. Ehlermann and I. Atanasiu (eds), European Competition Law Annual 2003: What is an Abuse of Dominant Position?, Hart, 91–125. Oldale, A. and A. J. Padilla (2004): ‘From state monopoly to the ‘investment ladder’: Competition policy and the NRF’, in Bergman M. (ed.), The Pros and Cons of Antitrust in Deregulated Markets, Swedish Competition Authority, 51–77. Petit, N. (2005): ‘The proliferation of national regulatory authorities alongside competition authorities: A source of jurisdictional confusion’, in D. Geradin, R. Munoz, and N. Petit (eds), Regulatory Authorities in the EC: A New Paradigm for European Governance, E. Elgar, 180–212. Posner, R. (2001): Antitrust Law, 2nd edn, University of Chicago Press. Rey, P. and J. Tirole (2003): ‘A primer on foreclosure’, in M. Armstrong and R. Porter (eds), Handbook of Industrial Organization v. III, North-Holland, forthcoming. Richards, P. (2006): ‘The limitations of market-based regulation of the electronic communications sector’, Telecommunications Policy 30: 201–222. Rochet, J. C. and J. Tirole (2004): Two-Sided Markets: An Overview, Mimeo. Sapir, A. (2004): An Agenda for Growing Europe, Oxford University Press. Squire-Sanders-Dempsey and Analysis (1999): Consumer demand for telecommunications services and the implications of the convergence of fixed and mobile networks for the regulatory framework for a liberalized EU market, Study for the European Commission. de Streel, A. (2004): ‘Remedies in the electronic communications sector’, in D. Geradin (ed.), Remedies in Network Industries: EC Competition Law vs. Sector-specific Regulation, Intersentia, 67–124. Temple Lang J. (2006): ‘Competition policy and regulation: Differences, overlaps, and constraints’, Presented at the Conference Balancing Antitrust and Regulation in Network Industries. Ungerer, H. (2001): ‘Use of EC competition rules in the liberalisation of the European union’s telecommunications sector’, Speech 6 May. Veljanovski, C. (2001): ‘EC antitrust in the new economy: Is European commission’s view of the network economy right?’, European Competition Law Review 22: 115–121. Vesterdorf, B. (2005): ‘Standard of proof in merger cases: Reflections in the light of recent case law of the community courts’, European Competition Journal 1. Vogelsang, I. (2003): ‘Price regulation of access to telecommunications networks’, Journal of Economic Literature XLI: 830–862.



CHAPTER 13

Efficient Regulation of Dynamic Telecommunications Markets and the New Regulatory Framework in Europe∗ PIO BAAKE Deutsches Institut für Wirtschaftsforschung (DIW), Berlin ULRICH KAMECKE Humboldt University, Berlin CHRISTIAN WEY Deutsches Institut für Wirtschaftsforschung (DIW), Berlin Technische Universität Berlin CEPR, London

Contents 13.1 INTRODUCTION: THE NEW REGULATORY FRAMEWORK IN THE EUROPEAN UNION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373 13.2 DYNAMIC COMPETITION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379 13.2.1 Schumpeter’s competition through innovation 379 13.2.2 Incentives to innovation 386 13.2.3 The role of competition 390 13.2.4 Intermediate conclusion 394

∗

We thank Ralph Georg Woehrl and Axel Wehmeyer for valuable comments. We also acknowledge financial support by Deutsche Telekom for the research project ‘Neue Märkte unter dem neuen Rechtsrahmen’ carried out by DIW Berlin and Humboldt University at Berlin.

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13.3 DYNAMIC COMPETITION IN TELECOMMUNICATIONS MARKETS AND TRADITIONAL REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395 13.3.1 New networks: structures and demand for DSL accesses 396 13.3.2 Investment, downstream markets and strategies for the network operator 397 13.3.3 Competition to construct new networks 401 13.3.4 Traditional regulation: cost-based network access 406 13.4 REGULATION OF NEW MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407 13.4.1 New markets 408 13.4.2 Regulation 411 13.4.3 Incentive effects: infrastructure-based competition 414 13.5 SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418

13.1 INTRODUCTION: THE NEW REGULATORY FRAMEWORK IN THE EUROPEAN UNION

The liberalization of European telecommunications markets abolished the state monopolies and opened markets to competition. All telecommunications markets were placed under sector-specific regulation and the supervision of a national regulatory authority; for instance, in Germany by the Regulierungsbehörde für Telekommunikation und Post (RegTP – the regulatory authority for Postal Services and Telecommunications). Right from the beginning it was clear that competition will not come overnight. As European regulators abstained from imposing structural remedies (as, e.g., the 1984 breakup of AT&T into a long-distance operator and seven regional Bell operating companies in the US), price and access regulations have become important regulatory instruments to ensure the development of competition at various levels. Similar to the ‘ladder of investment’ idea of Martin Cave and Ingo Vogelsang,1 it was assumed that ex ante regulation of the former monopoly would be necessary to kick-start competition – first at the service and later at the infrastructure level. Accordingly, access regulation to the network of the former monopoly operator has 1

See Cave and Vogelsang (2003) for this idea which has also been formulated in Cave and Prosperetti (2001). See Oldale and Padilla (2004) for a recent critique.

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been a primary concern. Moreover, the intention was to create effective competitive structures within telecommunications markets, and then, to review the possibility of removing specific telecommunications markets from ex ante regulation and placing those markets under the supervision of general competition law. The question how to phase out regulatory supervision has gained new momentum with the implementation of the new regulatory framework in the EU.2 The new regulatory framework takes account of the rapid pace of technological progress by providing a uniform legal framework that covers the convergence of telecommunications, media, and information technologies (see EU Framework Directive 2002/21/EC, recital 5). Moreover, it aims at bringing the regulation of electronic markets into line with the principles of European competition law.3 A critical aspect of the new framework is that telecommunications markets are no longer lumped together under the supervision of the regulatory authority. Instead, specified criteria first have to be applied to define markets, which may become candidates for ex ante regulation in a further procedural step. Figure 13.1 illustrates the multistage procedure under the new regulatory framework. In the first stage, the list of markets is defined in accordance with the European Commission’s recommendation on 2

The new regulatory framework mainly consists of EU directives 2002/19/EC to 2002/21/EC: directive 2002/21/EC on a common regulatory framework for electronic communications networks and services (OJ L 108 of 24 April 2002, p. 33), also known as the ‘Framework Directive’; directive 2002/20/EC on the authorization of electronic communications networks and services (OJ L 108 of 24 April 2002, p. 21), known as the ‘Authorisation Directive’; and directive 2002/19/EC on access to, and interconnection of, electronic communications networks and associated facilities (OJ L 108 of 24 April 2002, p. 7), known as the ‘Access Directive’. The new legal framework also includes two further directives, the so-called ‘Universal Service Directive’ and the ‘Data Protection Directive’; however, these are of subordinate importance to our study. 3 See ‘Commission guidelines on market analysis and the assessment of significant market power under the Community regulatory framework for electronic communications networks and services’ (2002/C 165/03) published in the Official Journal of the European Communities C 165/6, 11 July 2002.

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No

No sector-specific regulation

Yes

Market analysis by SMP test

No

No SMP regulation

Yes Sector-specific regulation

Figure 13.1 The decision-making process.

relevant product and service markets (EC(2003) 497). It requires selecting those markets which cannot be expected to generate effective competition and are therefore candidates for some sort of sectorspecific regulation. Precisely, recital 9 of the recommendation sets out the definition of markets susceptible to ex ante regulation, as follows:4 In identifying markets in accordance with competition law principles, recourse should be had to the following three criteria. The first criterion is the presence of high and nontransitory entry barriers whether of structural, legal or regulatory nature. However, given the dynamic character and functioning of electronic communications markets, possibilities to overcome barriers within a relevant time horizon have also to be taken into consideration when carrying out a prospective analysis to identify the relevant markets for possible ex ante regulation. Therefore the second criterion admits only those markets the structure of which does not tend towards effective competition within the relevant time horizon. The application of this criterion involves examining the state of competition behind the barriers of entry. The third criterion is that application of competition law alone would not adequately address the market failure(s) concerned. (Recital 9 to the recommendation on relevant product markets; 2003/211/EC)

4

See ‘Commission recommendation of 11 February 2003 on relevant product and service markets within the electronic communications sector susceptible to ex ante regulation in accordance with directive 2002/21/EC of the European Parliament and of the Council on a common regulatory framework for electronic communication networks and services’ (2003/311/EC), published in the Official Journal of the European Union L 114/45, 8 May 2003.


The recommendation specifies three criteria all of which have to be satisfied for a certain market to be included in the list: (1) There must be ‘high and nontransitory’ structural or legal barriers to entry. (2) There must be no tendency towards effective competition within a certain time horizon. (3) The market failure cannot be addressed with competition law alone. It is noteworthy that the recommendation explicitly refers to the dynamic character of markets and requires an assessment of their tendency towards competition.5 Moreover, in an Annex the recommendation specifies seven retail markets and eleven wholesale markets that should be subjected to market analysis by the national regulatory authorities. Those markets not explicitly included in the list will not be subjected to any market analysis and will therefore not come under sector-specific regulation (unless particular circumstances justify regulation by national authorities). Having defined the relevant product and service markets, the second step is to examine the competitive intensity in those markets. If effective competition is absent, then the national regulatory authority must put firms with substantial market power under sector-specific regulation (see Art. 16(4) of the Framework Directive). An important issue determining the effectiveness of the new legal framework is the adjustment of the list of relevant markets over time and the associated problem of how new markets should be treated. Recital 15 to the recommendation on relevant product and service markets states: Furthermore, new and emerging markets, in which market power may be found to exist because of ‘first-mover’ advantages, should not in principle be subject to ex-ante regulation.

5

Referring to Germany, the Telekommunikationsgesetz (TKG) amended in 2003 states in a similar way in article 10 that markets should only be subject to ex ante regulation where they do not display any longer-term tendency towards competition.

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The protection of ‘first-mover’ advantages as a reason to exclude new markets from the list of relevant product and service markets is closely related to the objective of the Framework Directive to encourage ‘efficient investment in infrastructure, and promoting innovation’ (see Art. 8 (2c) of the Framework Directive).6 The concept of ‘new and emerging markets’ introduced by the new regulatory framework explicitly recognizes the need to guarantee first-mover advantages so as to protect innovation incentives, and hence the development of new infrastructures. While this approach intends to rule out any ex ante regulation for new markets, there is still ample scope for discretion. Moreover, the new regulatory framework leaves many questions unanswered which are important for making it operational and effective. In particular: 1. What is a new and emerging market and how can it be distinguished from more mature markets? 2. What degree of ‘first-mover’ advantage is desirable in terms of efficient investment in infrastructure and innovation? 3. How should the development of new markets towards effective competition be assessed and reviewed? To answer these questions, it is necessary to keep in mind that new markets pose different regulatory challenges when compared with existing networks and infrastructures. Whereas, in the latter case, infrastructure investments have already been made, this is typically not the case with new markets. The concept of new markets or new infrastructures, therefore, highlights the interdependencies between regulation and private investment incentives – an issue which was barely considered explicitly by the former regulatory framework.

6

A similar reasoning is stated in the explanation to article 14 (review of market definition and analysis) of Germany’s new TKG, p. 87, it is stated: ‘New markets are not therefore automatically subject to supervision by the Bundeskartellamt [the Federal Cartel Office], but should first be reviewed by the RegTP – in conjunction with the Bundeskartellamt – for their need for regulation under the TKG.’


The key to understanding the regulation of new markets is, therefore, the difference between static and dynamic market power. In this study we focus on the relationship between regulation and investment incentives to derive principles for an efficient regulatory treatment of new markets. For this purpose we explore the economics of innovative markets, which allows us to derive policy concepts that should govern the implementation of the new regulatory framework in the EU. Our study, therefore, aims at providing guidance to considerable discretion thrown up by the new legal framework. The focus is on network-based innovations, which are exposed to particular risks not generally taken into account by a static approach to the regulation of entry.7 We proceed as follows. Section 13.2 describes the main insights of dynamic competition theory. Section 13.3 applies the theoretical principles of dynamic competition to the case of DSL-broadband infrastructure and elaborates on the associated regulatory tradeoffs. Based on these theoretical considerations, Section 13.4 derives a regulatory framework for new markets. Finally, Section 13.5 summarizes the findings of the study.

13.2 DYNAMIC COMPETITION

The starting point of (almost) all theories of dynamic competition are the ideas developed by Joseph A. Schumpeter, who pioneered the research on the economic principles that govern technological change and economic development. His thoughts start with the observation that capitalism has led to an unusually long period of constant economic growth, and that economists have been unable to offer any explanations for this phenomenon. 7

Most of the economic principles can, of course, be applied to other innovations such as new services. However, markets for services are typically characterized by much lower investment requirements and smaller barriers to market entry.

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Although Schumpeter developed two central hypotheses to explain the dynamics of the economy, his thoughts suffer from the fact that they lack any normative concept which could be used to assess the dynamics of industries. An additional problem of his reflections is that they do not contain a precise description of the incentive systems that determine firms’ investment decisions. In the following we provide a brief outline of Schumpeter’s main hypotheses, and we indicate how the gaps of his theory can be filled out with insights based on modern economic theory.

13.2.1 Schumpeter’s competition through innovation

13.2.1.1 The two Schumpeterian hypotheses

According to Schumpeter’s first theory (which we will refer to as ‘S1’), developed in his early work ‘The theory of economic development’ (1934),8 innovative entrepreneurs determine economic development. He describes an economy in which markets have reached a competitive equilibrium. Then, an entrepreneur sees an opportunity to make huge profits with a drastic innovation. He markets his innovation and thereby disturbs the competitive equilibrium. The other businesses are forced to adjust their business models or drop out of the market, and after a transition phase the economy reaches a new competitive equilibrium. Economic development thus takes the form of ‘creative destruction’, with temporary monopolies formed, only to be eroded as competitors manage to catch up. The lesson of this reasoning is that effective catching-up competition (or, in German, Verfolgerwettbewerb) offers the best protection against permanent monopolization of markets. Thirty years later, Schumpeter developed a second theory of economic growth – which we abbreviate as ‘S2’ – in his book ‘Capitalism, socialism, and democracy’ (1950). Again, as in his early theory,

8

For the German version see Schumpeter (1918/1964).


an innovation creates a competitive advantage, but now Schumpeter assumes that this leadership lays the foundation for a competitive advantage in the quest for the next innovation. Consequently, subsequent innovations almost inevitably come from the first innovative firm so that competitors gradually lose the capacity to keep up with latest technological developments. As a result, the economy does not return to a competitive equilibrium, but evolves into a system of monopolies which eventually come to dominate all markets.9 Schumpeter therefore provides us with three key insights: (1) He established that investigating the economic principles governing economic development and technological change are of paramount importance for identifying the best economic system. According to Schumpeter, technological progress and the creation of new markets are the main sources of competitiveness and general prosperity,10 while problems of static efficiency are more or less irrelevant. (2) Schumpeter formulated the theory of stepwise economic development, with small businesses exploiting their freedom within the competitive equilibrium to give a decisive impetus to this development. Such successful innovators reach a temporary monopoly position, but effective competitors will eventually catch up, and ensure that monopolies remain a temporary phenomenon. (3) Schumpeter developed the counter hypothesis, that innovations by larger and more powerful companies gain ever greater importance for economic development. In this scenario, small 9

The only thing that people can set against the power of these monopolies is democratic control, meaning that industrialized countries must inevitably turn themselves into socialist states – a prospect that Schumpeter did not relish. 10 Thus, Schumpeter (1950) writes that the reality of a capitalist economy is essentially different from the static price-theory model of economic theory. The most important form of competition is then not competition within a market with established technologies, production processes and industry structures, but competition for new products, technologies, sources of supply and organizational models.

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companies catch up, and competition would become of minor importance for economic development while large firms would be the decisive forces for technological progress. Unfortunately, large parts of Schumpeter’s work take a ‘bird’s eye view’: while he does succeed in sketching the key features of a theory of economic development, the details are left open. His descriptions are however sufficient for an initial definition of the essential characteristics of real innovations. For example, innovations are characterized by the fact that they meet consumers’ needs in a revolutionary new way. This idea roughly corresponds to Arrow’s definition of a drastic innovation, where the innovator himself has no competitors even if he offers his products at monopoly prices.11 Schumpeter’s ideas, however, remain unsuited in two important aspects as a basis for any systematic discussion of when and how the state should intervene in this process. First, Schumpeter does not offer any carefully worked out normative concept. He regards continuous growth as a successful outcome of an economic system that requires explanation, and describes creative destruction as a mechanism for growth, but he does not examine whether this mechanism sometimes entails rather too much destruction or too much parallel development effort, and whether this innovative activities could be further enhanced by political measures. In his second theory, he describes socialism as the inevitable historical response to the S2 developments, again without discussing whether other developments might be politically possible and more desirable. Second, Schumpeter’s works describe an innovation mechanism without specifying how innovations arise, and which role social incentive systems might play in this process. Hence, the entrepreneurs in the early work of Schumpeter are struck at irregular intervals by inspirations pointing to new inventions or innovations that can be marketed successfully. They go ahead with 11

See Tirole (1988) for a summary of Arrow’s innovation theory and a survey on more recent developments in the field of industrial organization.


these innovations without considering whether they themselves will pocket the surplus from marketing the innovation. The monopolists of Schumpeter’s later work also grow by virtue of the increased recognition that comes to them, and which causes their lead over their competitors, without considering whether slightly more sophisticated regulatory mechanisms might not give a capitalist system a chance after all. Therefore, before we can address the issue of efficient regulation in a situation of dynamic competition, we must first develop a normative concept which allows us to identify the value and the essential characteristics of innovations.

13.2.1.2 Normative concepts

When assessing a potential innovation from a social point of view, the social costs of the innovation have to be compared with its social benefits. The social costs generally correspond to the commercial costs; but it is much harder to assess the benefits of an innovation, as all present and future benefits, in favorable and unfavourable historical circumstances, have to be taken into account, and, of course, it is very difficult if not impossible to take account of future returns fraught with such uncertainty. Nevertheless, it is at least conceptually quite clear what tradeoffs need to be considered in such an assessment. Gains from trade consist of profits (producer surplus) and consumer surplus. An efficient allocation of resources within an economy exploits all profitable opportunities for exchange, and such a situation is the generally accepted welfare standard in competition policy. In formulating a standard for evaluating innovations, two aspects are of critical importance: first, the distribution of the total surplus from the exchange of goods between consumers and producers, and second, the problem of deadweight loss. There are two reasons why it makes sense to weight consumer surplus and producer surplus equally, and not to give prominence to

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consumer surplus as typically assumed in merger control.12 First of all, focusing solely on consumer surplus never makes sense conceptually, as this would lead to interventions even in cases where the neo-classical competitive equilibrium had been reached in a static setting. Secondly, in dynamic environments, the assessment must focus on the goal of promoting technological and economic progress which makes an equal weighting of producer surplus also politically desirable.13 An increase in producer surplus arising from innovations goes hand in hand with technological progress and enhances the competitiveness of domestic companies, which – last but not least – secures jobs. The welfare tradeoffs in Schumperter’s two dynamic theories are therefore, the following: As the dynamic process is described in S1 as a sequence of situations of perfect competition, temporary welfare losses caused by a temporary monopoly position have to be compared with the welfare gains consisting of short-term producer surpluses and long-term consumer surpluses. In the S2 scenario, an innovative monopolist takes over the whole market for ever, so that technological progress is associated with higher producer surplus and consumer surplus but also, because of the permanent monopoly position, with long-term welfare reductions resulting from deadweight losses.

12

In both European and US merger controls, efficiency gains are only taken into consideration where they benefit consumers, from which we may conclude that the regulators regard consumer surplus as critical (for safeguarding of efficiency within the EU, see the new Regulation on the control of concentrations between undertakings, (EC) No. 802/2004, 7 April 2004; for the situation in the US, see notes by Gellhorn and Kovacic, 1994). As no consumer standard can be derived from the classical studies of efficiency, regulatory failures (Besanko and Spulber, 1993) and industry lobbying (Neven and Roeller, 2005), and the avoidance of international conflict (Haucap, et al., 2004) are offered as possible explanations for this order of priorities. 13 This view is also mirrored in Germany’s new TKG, Art. 2 Sect. 2, which contains the goal of ‘promoting efficient investment in infrastructure and supporting innovation.’


13.2.1.3 Innovations

A true innovation is characterized by the fact that it changes the technology, and hence the knowledge, available to all companies within the economy. Such a change occurs in two stages: first, a technological or organizational innovation is formulated at a theoretical level and its effectiveness is demonstrated, possibly by means of a prototype; then its commercial viability in the marketplace has to be proven. Only when market participants can see that an output can be generated from a particular combination of inputs does this insight pass into the general economic knowledge of a society. The second stage is often underrated, as clever entrepreneurs can become very rich with apparently little ‘intellectually advanced’ input.14 This criticism reminds one of the story of ‘Columbus’s egg’, in which it was suggested that it was no great achievement to keep sailing further and further west without even finding what you were looking for.15 This mistaken denigration is generally explained by the fact that the relevant contribution to the investment problem is reduced while people behave as if the innovation itself (the increase in general knowledge) were a fait accompli. Certainly, it is no great achievement to sail west if you already know that there is a continent there, and the production of imperfect software, the automobile production line or the mass-marketing of goods do not justify an inconceivably large income if you already know how to arrange such things. But the real achievement consists in the innovation provided to society by these entrepreneurs, expressed at a theoretical level in the expansion of knowledge available to all. 14

Common accusations are that Bill Gates, for all his great success, has merely implemented existing technical know-how badly, and that IKEA sells only relatively badly made furniture. 15 In German schools the story is told of a discussion in which Columbus challenged his opponents to stand an egg on end on the table. When nobody was able to do this, he took the egg and tapped it hard (but not too hard) on the table, where it remained standing with its shell smashed. When those present reacted indignantly ‘We could have done that!’, Columbus simply replied, ‘Yes, but I actually did it’.

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This achievement is often impossible without substantial investment, which may only partly serve to increase general knowledge. For example, Henry Ford actually had to build a factory in which cars were produced on a production line to demonstrate the cost savings resulting from this method of production. At the same the construction of a factory is also a completely ‘normal’ investment decision undertaken every day by prudent entrepreneurs on the basis of reasonable profit projections. Market failures in firms’ investment and innovation decisions arise because general knowledge is a public good provided by private entrepreneurs as part of the innovation process, and because the entrepreneur cannot appropriate the full surplus of expanding the knowledge available to society. The interaction between a complicated investment problem and the enhancement of general knowledge explains why no one has so far been able to give a convincing account of the most favourable economic environment to stimulate innovation. Not unsurprisingly, Schumpeter himself was unable to decide between his two competing hypotheses S1 and S2. Hayek (1944) formulated the thesis that the greatest strength of the capitalist system lies in the fact that distributed knowledge is efficiently aggregated in markets. However, this thesis was not made accessible to careful analysis, and offers no convincing reason why a hierarchically structured company should not be better in consolidating technical know-how than a market system, while Williamson’s provocative notion of the superiority of larger organizations provides some objective support for S2.16 Neither can empirical research provide a convincing answer to this question. The bibliography compiled by Scherer and Ross (1990) rather gives the impression that innovations can be divided into ‘American’ and ‘Japanese’ innovations, where the former are well protected by patents and other intellectual property rights and are marketed by small dynamic companies, while the latter innovations are developed within large companies or cooperative projects and

16

In the well-known Williamson puzzle, he asks: ‘Why can a large company not do everything that a group of small companies can do, and more?’ (Williamson, 1985, p. 149).


protected only by secrecy. As these studies only consider the consolidated success of innovations, they also remain salient about the causes of innovations and the question whether small or large companies can offer the ‘more creative environment’.

13.2.2 Incentives to innovation

For a better understanding of the complex tradeoffs outlined above, we need to look more closely at the role competition plays in the development process. Our discussion is based on two efficient benchmark solutions, which do not of course represent reality but are intended to clarify the problem. 13.2.2.1 Innovation and market failure

From the perspective of a company, the problem of investment is this. Before an R&D project is launched, the potential innovator tries to weigh the opportunities from the project against the risks. Of course, both costs and returns are uncertain. While the ongoing costs of an R&D project can generally be well planned, it is typically uncertain at what point the project will be successfully completed. There is however much greater uncertainty about the returns to be made in the market after the completion of the project. Specifically, for a project with the potential for real innovation (in the Schumpeter sense), the return will typically fluctuate between zero (in the case of failure), and many times the value of the company (in the case of a great success). As the chance of a positive net profit is not very large, a positive expected profit is only possible if the potential profits in the event of success can also be very large. This means that the probability of a company investing in such a risky project is perceptibly influenced by just how high these very high profits may be, in the event of success: where companies hope to achieve a permanent monopoly in a large market, the expected surplus may make even an almost hopeless project appear attractive; on the other hand, where companies cannot even realize the competitive profit, because

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excessive competition or regulation does not allow to compensate for the ex ante risk, the decision may even go against projects with a high expected return. A successful R&D project creates or increases the willingness to pay of the company’s customers, and the company will typically be in a position to use some of this additional cash flow to cover the costs of the innovation. Of course, there is a hypothetical competitive equilibrium for this problem too. In this state of competitive equilibrium, ‘contingent claims’ are handled, and if a substantial part of the uncertainty relates to whether a successful innovation is possible, this equilibrium will include prices that have to be paid today for goods that will only exist next year, if a development project is successful. For example, there may be a contract today for the supply tomorrow of a product that has only a 10 per cent chance of being developed and delivered. For this contract, the customer would pay today (with linear technology) the expected costs of manufacturing the products, including the necessary investment costs.17 However, it is clear that if the development were successful, this contract would be worth much more next year than today, and even in a situation of perfect competition, could no longer be defined by the actual production and development costs. As usual, this fictitious competitive equilibrium maximizes the surplus arising from the investment problem, and monopoly power would (as usual) distort the decisions taken by producers and consumers in an inefficient way. The efficiency of such a hypothetical competitive solution is also not distorted by fixed costs associated with the innovation.18 Free entry into a market in which the competing companies have no 17

Of course, this fictional example entails other assumptions that are not presented in detail here. 18 The limited descriptive significance of this equilibrium is made clear in the essay by Radner (1979), in which he shows that a competitive equilibrium in a dynamic model represents an equilibrium of ‘plans, process and price expectations’. While it is possible to imagine plans being drawn up in a rational manner and prices reaching equilibrium, an equilibrium of mutually compatible plans and price expectations is certainly not an apt description of economic reality.


influence on prices may result in the longer term in efficient investment decisions by the active companies. The investment problem alone does therefore not lead to market failure, and can hence not justify state intervention. Such a classical market failure will, however, arise where there is a real innovation, as the resulting increase in general knowledge is a public good that can never be efficiently provided by competition. In the economy with contingent claim contracts described above, this would mean that knowledge of the new technology is shared by all potential suppliers, while one company bears the entire development costs. Consumers who have purchased a contingent claim do not then profit from the success, as the resulting competition tends to depress market price rapidly to the level of the actual production costs. It is clear that there cannot be an efficient competitive equilibrium, even in theory. In this case, the buyers of the contingent claims are (also) buying a public good, which leads to a well-known under-investment problem. The theory of dynamic competition examines possible privatesector solution to this difficult allocation problem. It typically presumes that incentives to enhance general knowledge can be created by the possibility of monopolistic exploitation, for example by the granting of patents or by some sort of secrecy. Such solutions allow for a temporary ‘deadweight loss’ as greater profits increase firms’ incentive to provide public goods.19 13.2.2.2 Appropriability

In the following we will step aside from a framework in which a first-best allocation is theoretically possible. Instead, we consider the (more realistic) constellation in which a static market failure in the form of deadweight losses is accepted in order to reduce the 19

This connection is postulated throughout the literature on dynamic competition (Aghion and Howitt, (1998) and Grossman and Helpman, (1997)). The example from Hellwig and Irmen (2001) of innovations in competition, with its assumption of strictly convex technologies, also allows a minimum surplus of this kind.

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risk of a dynamic market failure. In this ‘second best world’, economic policy has to seek a balance between incentives for innovation and the corresponding protection of the innovator on the one hand, and consumer surplus and the associated opening of the market to competition on the other hand. When striking this balance policy makers have to consider several tradeoffs. Suppose, as a benchmark case, that an innovator could absorb the whole surplus associated with an innovation (by using a perfectly discriminating price mechanism), so that the private and social innovation incentives are perfectly aligned. Of course, this perfect monopolist is also a purely theoretical construct, as ‘perfect appropriability’ of all surpluses is not even theoretically possible, for the following reasons: 1. The required perfect price discrimination must inevitably fail because of lack of perfect information.20 2. Markets with monopoly power suffer from vertical externalities (e.g., problems from complementary investments). 3. In (new) markets, asymmetries of information lead to problems of market organization (particularly hold-up problems; see Williamson (1985)). 4. In monopoly markets, X-inefficiency (inefficient absorption of surpluses by management and employees).21 These factors can disrupt the innovation process under a monopolistic market structure in the long run. Hence, each of the problems mentioned can be used to explain why it is not sensible to entrust economic welfare to a monopolist, and therefore, an efficient development can not be expected when monopoly power is permanent. 20

For example, various ‘impossibility theorems’ show that private information on personal cash flow is not generally published in such a way as to guarantee an efficient decision. 21 X-inefficiencies may grow with the relative market power of companies – for example, because of the owner–manager control problem – and so directly reduce the incentives for innovation (see also Martimort and Verdier, (2004)).

Chapter 13 – Efficient Regulation of Dynamic Telecommunications 391 13.2.3 The role of competition

We have shown that neither perfect competition nor permanent monopoly can be expected to generate efficient economic development. However, we also argued that monopoly power in dynamic setting is desirable to some degree to overcome the underinvestment problem associated with the public good character of innovations. We will now examine the role of competition in the innovation process which can induce additional innovation incentives. 13.2.3.1 Efficient innovations

In order to examine the effects of competition, we first need to distinguish between ‘catching-up’ competition and competition (based on innovation) for the market itself. In the first case, the competitors try to win back the monopoly market from the successful innovator; in the second, they try to monopolize the market themselves. These two aspects of competition are closely linked, as the intensity of competition within the market determines the innovator’s monopoly profits, and with that, the intensity of competition to innovate. If we look at the list of problems in a monopoly market, the most striking are the serious long-term efficiency problems. In the early phase of a monopolistic market, a company is still concentrating on establishing and expanding its power, and of course, exploiting it. Although these activities lead to inefficient outcomes, they are entirely desirable in our context, as they provide the rewards for successful innovations. Conversely, frictions that prevent the monopolist from exploiting his market power are problematic at this stage, as they often lead to welfare losses on both sides of the market when rents from exchange cannot be realized. In the long run, problems also arise from the fact that monopolists tend to depart from maximizing their profits, but allow well organized employees to pocket part of the monopoly surplus by means of inefficient rent-seeking activities. This not only eliminates part of the surplus, but also slows down or disrupts the innovative activity in the first place. Because of these inefficiencies associated with monopoly power, it is desirable

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that strong catch-up competition erodes the innovator’s monopoly after a certain period. Competition for innovation also plays a major role. It determines the innovative effort that companies put into trying to achieve a monopoly position. Whereas a monopolist will maximize his expected profits, the competing companies will invest beyond this maximum profit in the quest for successful innovation. Of course, there is again a good chance that resources will be squandered. In many R&D projects, the competing companies try to make decisive advances by similar methods, resulting in a wasteful duplication of effort. The incentive for innovation may also be so large that competing companies aim too high and, problems of appropriability notwithstanding, actually invest too much in innovation.22 Usually, however, a variety of approaches are required to increase the probability of success, so that effective competition for innovations is an essential element of a dynamically efficient competition structure. 13.2.3.2 Efficient development

The discussion thus far has been largely restricted to the incentives for a single innovation. However, the economic development depends on several such successive innovation. We now discuss how this repetitive process of innovation steps may affect our results. Of course, it is not possible to derive a general rule for the optimal length of monopolistic exploitation as the overall social surplus stream resulting from innovations varies widely. We, therefore, focus on the issue of asymmetric market structures, which inevitably arise when one firm was successful in the last innovation step and therefore, holds a particularly strong market position during the subsequent development phase. 22 The literature on R&D in conditions of uncertainty indicates both a positive and a negative correlation between R&D spending and market structure. The consensus however is that the speed of progress increases with the number of firms involved (see, e.g., the literature on patent races, Reinganum, (1989); for a summary, see Tirole, (1988) or Martin, (1993)).


The most significant asymmetry arises from advantages enjoyed by the ‘strong’ company as a result of its earlier successes. These include the real cost advantages when researching and developing further knowledge, which led Schumpeter to his S2 hypothesis, and which should be used in an efficient development process. These advantages must be rigorously distinguished from the disadvantages of artificially erected barriers to market entry, which any successful innovator wants to use to protect his market position. Such barriers to market entry may also result in an S2 development, but in this case the development is not efficient. A desirable development would occur if there was a ‘level playing field’, on which competitors for the next stage of innovation were not placed at a anticompetitive disadvantage. Another serious problem arises if a dominant company has an excessive potential to leap-frog new developments in a new market.23 The successful innovator may then try to safeguard his supremacy by perfecting his own ‘leap-frog’ technology, even though he does not need it. He then becomes a fast-second innovator, preventing further innovation by the credible threat that it will be rapidly overhauled. This deprives potential competitors of any incentive for innovation, and further development in the market is completely controlled by the dominant company. This problem may become so serious that competition within the market is blocked completely. On the other hand, we see less of a problem in the business stealing effect discussed in the literature, which arises when the new innovator appropriates surpluses from the former innovation. This effect implies that entrants typically have a greater incentive for innovation than the dominant company, because they can capture some of the former monopolist’s rents. It is easy to show that a strong ‘business stealing’ effect combined with a relatively small contribution to 23

As an example, we could mention Microsoft, which many commentators have accused of not being innovative itself, but which has perfected the art of appropriating innovations by others.

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overall social surplus can induce outsiders to overinvest.24 However, as this counters the appropriability problem and distortions in favour of the dominant company, we consider the business stealing effect as rather unproblematic.25

13.2.4 Intermediate conclusion

This section has shown how the desirable state of dynamic competition should look like. Neither perfect competition nor permanent monopoly is likely to produce efficient development. It is best for the dynamics of development if monopolistic phases are followed by the restoration of effective competition. In monopoly phases, innovators are being rewarded for their efforts in enhancing general knowledge, and contrary to the usual intuition which relies on static considerations, exploitation of innovators’ monopoly power is desirable and not harmful. Of course, this leads to a temporary abandonment of static efficiency, but it generates an improvement in dynamic efficiency from the accompanying incentive to innovate. However, the exploitation should be terminated at the point where the static efficiency losses dominate, as X-inefficiency and excessively slow development may result in long-run misallocations of resources. In the innovation phase, several firms should compete for the next innovation, without excessive asymmetries distorting the incentives to innovate. Only when there is a natural advantage to the innovator from the preceding development phases is an asymmetrical market structure desirable. Otherwise, it is better if a ‘level playing field’ can be created before the next stage of innovation. The 24

This resulting overinvestment is based on the simple fact that, while successful innovators can appropriate part of the resulting monopoly surplus, from a macroeconomic point of view this is merely a redistribution of surpluses and not a source of additional surpluses. 25 These contrary effects are not considered in the standard models, which means that the adverse impact of the appropriation effect is grossly exaggerated.


follow-up phase should not start too early, and above all, the dominant company from the previous phase should not be able to engage unfair activities against new competitors. A symmetric starting position in the competition for innovation is not desirable if the process of innovation can be better run by established suppliers than by outsiders. In this case, permanent monopoly positions may evolve, which are initially efficient and therefore not problematic. If, however, the natural advantage of the monopolist in the innovation process is vanishing, then it should be possible for cost-efficient outsiders to enter into these markets again. It is clear that government can influence this desirable development process with many different policy measures. Patent law guarantees a state-protected monopoly position, and cartel law specifies the extent to which exploitative practices by dominant companies will be tolerated in the early phase of the market, and whether ‘leap-frogging’ campaigns by dominant companies are prohibited. An effective regulatory authority can help to ensure that markets return to a state of symmetric competition after a monopolistic phase, or even implement a competition-like market solution through regulation, if such a process does not start on its own. The outline of such a desirable regulatory policy for the telecommunications sector is set out in the next two sections. First, we will discuss the particular problems of dynamic competition in this sector, before suggesting a regulatory mechanism to provide a satisfactory solution to the problems presented.

13.3 DYNAMIC COMPETITION IN TELECOMMUNICATIONS MARKETS AND TRADITIONAL REGULATION

In this section, we will analyse dynamic competition where new networks are introduced in telecommunications markets. We will relate this specifically to investment in DSL broadband accesses for private households. Although the problem here is not so much the development of new technologies, we can use this case to identify quite precisely the tradeoffs described in the preceding section.

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The first section will describe a simplified model to represent the relevant markets. This will present the structural features and essential aspects of demand that are characteristic of broadband networks. In the second section, we will examine the incentives for a unregulated company to invest, based on the assumption that there is no competition. This is to highlight the dynamic aspects and the role of uncertainties about trends in demand and costs. At the forefront of the analysis are the relevant markets and their vertical integration, as well as possible investment strategies for the network operator. The impact that competition for the construction of new networks may have on companies’ investment behaviour will be investigated in the third section. In the last section, we will present the effects of traditional cost-based regulation on corporate investment behaviour.

13.3.1 New networks: structures and demand for DSL accesses

For broadband networks, and especially for DSL accesses for private households, we must first distinguish between the different infrastructure levels, the connection to the Internet, and the provision of services/applications. Here, the DSL access and connection to the ISPs (internet service providers) constitutes a first level of infrastructure. The ISPs provide the onward connection to the Internet, accessing the Internet backbone as a second level of infrastructure. The actual services and applications also cover the content and communication facilities provided over the Internet. These include the services and/or applications (e.g., content, e-mail functionality or other communications platforms) provided by the ISPs.26 The key point with this structuring of the various levels or markets is that the consumers value only the services and/or applications as goods. DSL accesses, connection to the ISPs and onward connections

26

Formally, we are talking about a vertical integration between ISPs and providers of services and applications.


and transfers are merely delivery services. Although this observation may appear trivial, it leads to two important conclusions. First, demand for the use of the infrastructure and for connection services can be directly inferred from demand for the corresponding services and applications. Second, there are interdependencies between all markets, which are relevant to a dynamic model. Hence, there is a direct positive correlation between the demand for DSL accesses and connection services and the provision of services. In this situation, it is clear that the uncertainty surrounding the demand for access to new and potentially more powerful networks is also substantially affected by the development of new services. New networks may offer higher transmission capacity, but where this is not used by new services, it will not induce any (significantly) higher willingness to pay by consumers. However, in the case of DSL access, it should be noted that higher download speeds (in comparison with ISDN lines) imply a greater willingness to pay for DSL access. But the limited data transfer capacity of ISDN lines means that new services such as download options for music or films, facilities for online gaming or enhanced real-time applications are either impossible or burdened with unattractively long download times. From the point of view of the consumer, new and more powerful networks, whose capacity is not used by new services, are initially seen as perfect substitutes for existing networks. New networks only become potentially attractive with the provision of new services and – where there are direct network effects – with their increasing diffusion.

13.3.2 Investment, downstream markets and strategies for the network operator

The observation that the demand for DSL accesses is a derived demand implies that the construction of new networks involves a complex investment problem even if competition is disregarded. Apart from future trends in costs and competing networks such as cable TV and wireless networks (WiFi and WiMax), the development

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of new services and applications, as well as the market structure and the degree of vertical integration in these downstream markets must also be taken into account. This raises a number of strategic problems, partly attributable to the fact that pricing behaviour and investment decisions at the different market levels are interdependent. Indirect network effects, free-rider behaviour, double marginalization and holdup problems (these aspects are covered in more detail below) also imply that investment decisions diverge further than what is socially ideal as compared to the case in markets where downstream markets have no importance. 13.3.2.1 Uncertainties about costs

The thoughts set out in Section 13.2 can be applied directly to the effects associated with uncertainty about the future development of costs. The essential points to be considered in deciding the amount, timing and type of investment in turn depend on a comparison of projected profits and costs. Formally, the calculation is based on an option value approach: where investment costs follow an unpredictable but in general downward trend, the optimal time for a one-off investment is the point at which the projected profit from an immediate investment equals the value of the option to place the investment in the following period. In relation to socially ideal investment decisions, it follows that investments are then always made too late, or sub-optimal investment options are chosen, where the investing company cannot appropriate all the returns. Although this uncertainty surrounding the future development of costs does not induce any significant telecommunications-specific distortions, this is not true for the possible effects of the vertical integration of different markets. 13.3.2.2 Downstream markets

In order to grasp the various consequences of vertical integration, we must first draw a distinction between investment and pricing decisions.


In terms of investment decisions, the positive correlation between the demand for accesses, connections and services or applications implies that the investment decisions of the different companies are also interdependent. This is especially important where the construction of new networks, the provision of connections and the development and provision of new services are linked to fixed costs. As investment decisions in the individual markets are also determined by the level of demand, so-called indirect network effects arise. The greater the number of connected consumers, the more profitable the development of, for example, new services will be. Conversely, as the number of available services increases so does the demand for accesses. These mutual feedback effects mean that the investment decisions of individual companies produce positive external effects to the benefit of the upstream and/or downstream markets. In terms of the companies’ investment decisions, these indirect network effects lead to problems of coordination and free-rider behaviour. Individual service providers will not base their investment decisions on positive external effects in favour of the network operator. The same applies to the providers of connection services, that is, the ISPs. They too will not take into account, when additional investments are required, that their own investments will increase the overall attractiveness of the new network and so help to speed up its diffusion. This problem is exacerbated by the uncertainty surrounding the provision of new services and/or networks. Particularly in the initial phase, where the number of accesses to the new network is still relatively small, investments in the development of, for example, new services are quite risky. The success of these investments is determined not only by direct acceptance of consumers, but also by the expected speed with which the new network will be constructed. This expectation is critically affected by investments by the network operator and the development of other new services. Individual service providers carry a relatively high level of investment risk especially in the early phases, and so may have an incentive to delay their own developments until the new network has reached a

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certain size. This free-rider behaviour leads to delayed investment and an insufficiently high level of investment overall.27 The last observation also includes negative effects with regard to investment incentives for the network operator. The larger the network required for the development of new services, the greater the initial investment required to construct the network. However, as the success of this investment remains uncertain because it cannot be foreseen at the outset whether new services will become available at all, the relevant risk to the network operator only increases. If we analyse pricing behaviour, the argument follows a very similar pattern. In a situation of imperfect competition for (new) services and applications or connection services, there will inevitably be price markups and hence double marginalization.28 The negative impact on the willingness to pay for access to the new network is not taken into account here. Where the access to, and the use of, the new network are also associated with investments or sunk costs on the consumer’s side (for DSL accesses, these may be investments in the necessary modems or other hardware), this effect may be amplified by the holdup problem. After investments in the access are undertaken they are no longer relevant from the consumer’s point of view. With prices of new services or connections at a relatively high level, DSL access may therefore leave consumers worse off. Ex ante consumers’ willingness to pay for the access will thus decrease, which again increases the necessary investment and risk for the network provider.29 Taken together, these observations show that while free-rider behaviour, double marginalization and possible holdup problems 27

It is questionable whether this resulting underinvestment can be reversed by competition in the markets for services creating incentives for pre-emptive investment. 28 Access prices, or charges for the transmission of data, that have to be paid by the ISPs to the network operator, place a lower limit on the tariffs charged by the ISPs, but not an upper limit. 29 Nor can this problem be solved by the vertical integration of all network and service providers.


may be brought about by various market structures, they arise at the level of services as well as connections. In both cases, there are negative effects on corporate investment incentives. By reducing consumers’ willingness to pay for access to the network, the factors just mentioned increase both the necessary volume of investment and the associated risk for the network operator. 13.3.2.3 Strategies for the network operator

These negative effects on the network operator lead us to look for strategies to prevent or to reduce the problems cited above. With respect to the free-rider behaviour that affects investments, these strategies may involve increased vertical integration, including alliances between network operators, ISPs and service providers. As tools for internalizing positive external effects, vertical integrations may lead to an increase in investment in downstream markets and hence reduce the initial risk associated with the introduction of new networks. Double margins and holdup problems can be prevented by competition at the level of ISPs and service providers. The narrower the range of prices that can be set by individual providers in the downstream markets, the smaller the consumers’ risk of being worse off as a result of access to the new network.30 The key point here is that, although the strategies mentioned above may increase the incentives for the network operator to invest, the gap between corporate and socially efficient investment decisions on the construction of new networks ultimately remains as before. It will actually tend to be larger than in other markets. Although competition in downstream markets, for example – particularly through the provision of access for competing ISPs – may be seen as a mechanism for preventing double margins, it also reduces 30

The effect of competition on the holdup problem also reflects the fact that price discrimination is harder to enforce in a competitive situation.

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the scope for the integrated supplier to absorb future consumer surpluses.31

13.3.3 Competition to construct new networks

If we extend the preceding analysis to competition to construct new networks, two questions come to the fore. First, what effects does competition have on companies’ incentives to invest, and how should these be assessed from a normative point of view? Second, can there be efficiency-reducing distortions to the advantage of large established companies, and do these also have the long-term effect of reducing well-being? 13.3.3.1 Investment incentives in competition

Given the uncertainties set out above and the exacerbated problem of appropriability brought about by the integration of different markets, it is clear that competition can have an especially positive impact where it increases the incentives to construct competing infrastructures. Although it must be acknowledged that this outcome means that every duplication of infrastructure investment actually reduces wealth initially, positive effects then emerge from possible competition strategy aspects – provided these lead to higher levels of investment and hence to the more rapid construction of new networks. At the same time, competition may have a positive impact on downstream markets and on consumer expectations as to the future growth of the networks. In order to examine the potential strategic behaviour of competing network operators, it is appropriate to interpret competition in building new networks as competition for the market itself. The 31

Theoretically, this relates to the second-sourcing incentive for a monopoly company (see Farrell and Gallini, (1988); and Economides, (1996)).


incentives for the companies to invest are then increased not only by the incentive to secure a large market share as early as possible – this point may be seen as analogous to the considerations that apply to the patent race, as well as the associated pre-emption incentives. Another aspect is the opportunity for companies to offer competitors access to their network, and so reduce the incentive to build their own network. The issues to be considered here concern the higher investment costs of more rapid construction, and the potential reduction in prices for consumer accesses. Against this are the returns from access charges payable by the competitors, and higher profits from a more prolonged monopoly position. If these positive effects prevail, then granting access may slow down the (subsequent) construction of competing networks, but the ex ante incentives for the monopolist to invest will also increase (on this so-called replacement effect, cf. Gans, 2001; and Hori and Mizuno, 2004). Similarly, positive effects feed back to downstream markets for services, and hence on the expectations of consumers with regard to the attractiveness of joining the network. If competing networks are constructed with correspondingly high incentives to invest, both service providers and consumers can count on a rapid diffusion. The incentive to develop new services will increase, and the resulting changes to consumer expectations will have a positive effect on their willingness to pay for new accesses. While service providers are driven mainly by expectations as to future trends in network size, consumers also benefit from the fact that competition can solve the holdup problems mentioned above. The point is that as long as the investments required by consumers (modems, etc.) are not companyspecific, that is, they can still be used with a different provider, competition reduces the likelihood of an access making consumers worse off ex post. Whether competition results in dynamically efficient investment options being chosen, or whether it induces excessively fast network construction and hence too high a level of investment, cannot be resolved in a general study. The same is true for the strategic incentives to slow down the construction of competing networks by granting access. From a normative point of view, conflicting

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effects will also arise here, relating to the avoidance of unnecessary investment costs and a postponement of infrastructure-based competition.

13.3.3.2 Asymmetrical starting positions

We obtain a similarly ambivalent result when we look at the possible effects of asymmetrical starting positions of competing companies. Asymmetries may be the result of different degrees of vertical and horizontal integration, and different levels of market shares in existing networks. These differences become relevant when we look at the necessary investments, the possibility of bundled products in the end-user markets, potential switching costs to consumers, and anticompetitive strategies by integrated companies. It is immediately apparent that the necessary investments are determined not only by the technological features of the new networks but also by a possible fallback to existing networks. In the case of DSL accesses, for example, access to the last mile and the provision of suitable collocation facilities are essential prerequisites for entering into competition with the established providers. If regulatory provisions in this area ensure identical starting conditions, that is, competing companies have the same access to so-called legacy network elements, differences between existing network structures do not initially have any distorting effect on the competition to build new networks. Slightly different conclusions emerge if we take into account the effects of bundled products and potential switching costs for consumers. Both aspects favour established providers and so may distort competition to connect consumers to new networks. For a normative assessment, various perspectives are relevant again. First, given the extensive regulation of accesses and onward connections to traditional telecommunications networks, similarly bundled products can also be offered by competing


companies.32 Advantages to established companies will only exist, however, where additional products are linked to additional investments. Second, it is a moot point how far asymmetrical starting positions really lead to further inefficiencies. Where, for example, consumers prefer to obtain new accesses from established providers, considerations of efficiency suggest that new networks should be built by the same providers. Possible negative effects from asymmetrical starting positions only emerge when we consider strategically motivated differences in investment incentives, and anticompetitive strategies by established providers. On the one hand, business-stealing aspects with respect to existing networks may lead to inefficiently high investment incentives to other providers not integrated vertically and/or horizontally. On the other hand, replacement effects and pre-emption incentives related to possible bundling might imply higher investment costs to established companies.33 We must also mention anticompetitive strategies, for example, with respect to the choice of contract periods and informal measures that may be used to reduce the quality of competing products (e.g., waiting times or inaccurate information on the time of access to the subscriber line). These also distort incentives to invest and so tip the incentive to build new networks towards established or integrated companies. It is therefore hard to tell in general terms what efficiency losses may be associated with competition between asymmetrically placed companies. The above-mentioned advantages of higher investment incentives in competitive conditions do suggest that competition to construct new networks increases dynamic efficiency. This is especially true when we take into account the vertical structure of the different markets and the resulting uncertainties and additional distortions. The more serious the problem of a lack of appropriability 32

Projected technological advances, such as Internet telephony, reinforce this trend. 33 Cf. also Hoppe and Lee (2003). In a dynamic model with durable goods, they show that low initial prices impede the competition to innovate in subsequent periods, and that the established company can then secure a lasting monopoly.

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of returns, and the greater the negative effects of free-rider behaviour, possible double marginalization and potential holdup problems, the sooner increased investment incentives from infrastructure-based competition result in an increase in dynamic efficiency.

13.3.4 Traditional regulation: cost-based network access

Although the preceding argument relates to the analysis of the relatively special case of the introduction of DSL accesses for households, it supports the essential findings of the analysis set out in Section 13.2. Appropriability problems and other telecommunications-specific distortions indicate that any treatment or regulation of new markets that aims at dynamic efficiency must focus on investment incentives for companies. Traditional regulation, based on considerations of static efficiency and built on a system of cost-based regulation of entry, is not calculated to achieve this, as we will show. If new networks are subject to regulation of entry based on observed costs, the logic of static efficiency issues is applied directly to dynamic problems. It is clear at the outset that not all aspects relevant to corporate investment calculations can be taken into account here. This is especially true for the crucial ex ante uncertainties about risks, which, of course, cannot be incorporated in observed ex post costs. For one thing, the access prices anticipated by the investing company are lower than the ex ante relevant prices. Moreover, competitors themselves obtain a risk-free option to use new networks/infrastructures when they have not undertaken any investment of their own or if they have only invested at a point where the new network’s success is relatively assured.34 34

Similar conclusions are reached by Hausman (1997), Hausman and Sidak (1999), and Hazlett and Havenner (2003). For new networks, the dynamic regulation of access prices proposed by Cave and Vogelsang (2003) and Cave (2003) following the ‘ladder of investment’ theory results in a one-sided distribution of risk to the detriment of the regulated company: progressive increases in access prices mean that competitors – who have not been forced to invest – have a risk-free exit option.


Traditional ex ante regulation implies that, although investing companies bear the whole risk of constructing new networks, the value of these networks is drastically reduced if they succeed.35 As this effect also carries over via the pricing mechanism to companies whose networks are not subject to any direct regulation, the investment incentives are reduced not only for potentially market-dominant companies, that is, companies who play a ‘first-mover’ role in the introduction of new networks, but also for possible competitors. Cost-based regulation of entry – even where it is only imposed on (future) market-dominant companies – does not only aggravate the problem of appropriability but also defeats the aim of creating structurally secure (i.e., infrastructure-based) competition. The key point is that neither the relevant uncertainties nor the essential incentives for ‘leap-frogging’ competition within the market are adequately covered by this type of regulation.

13.4 REGULATION OF NEW MARKETS

The example of DSL accesses and the likely effects of cost-based regulation of entry mentioned above make it clear that safeguarding dynamic efficiency requires different yardsticks and regulatory systems than are needed to ensure purely static efficiency. To address this problem, we will start by proposing a general approach to controlling new markets. We will then discuss a possible form of regulation for these markets. The starting point for our proposal is the protection of investment incentives and the attempt to find a suitable way of regulating new markets that promotes infrastructure-based competition. To achieve this goal, we suggest that the decision whether new markets should be subject to sector-specific regulation should not be based solely on the standard SMP test or a similar short-term test of

35

This is especially significant where the ex ante projected value is critically determined by the profits at the top end of the distribution.

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effective competition.36 We rather propose that new markets should only be regulated whenever there is also no longer-term tendency towards competition. After a general description of this approach, we discuss the desirable incentive effects of our proposal.37

13.4.1 New markets

Although it is, in general, extremely difficult to give a precise definition of a new market, we may take as the necessary condition for a new market the existence of an innovation, that is, an increase in general knowledge regarding the possibilities of manufacturing or distributing goods or services. The innovation does not necessarily have to be backed up by a patent or other protected right; the essential feature is that the innovation should have a ‘certain significance’. Patents and other protected rights are therefore neither necessary nor sufficient for the existence of a new market. In the simplest case, a new market will exist where essential needs can be met by the innovation that could not be satisfied before.38 However, because there are substitutes available for almost any product, this requirement is too narrow, and raises the question as to when a product is sufficiently different from all other products in the

36

The SMP test is used to establish whether one or more companies hold significant market power. 37 All the timings given should be read as possible approximations. A precise definition of the theoretically optimum solution is faced with the same sort of difficulties that arise in determining optimum patent periods. Here, we have to take account not only of a number of different innovations, but also of complex risks and potentially differing market structures and competitive situations. Therefore, even formal models can only be based on estimates and deliver approximations rather than exact solutions. 38 Although, for example, MS-DOS was not the first software developed for IBM PCs, it was the first system to combine the advantages of a PC with the facility to access an IBM mainframe online or offline. This advantage made the system into a new market, because a high proportion of buyers in the early years were looking for just this benefit.


same group to constitute a new market. Moreover, a new ‘market segment’ can also emerge when an innovation fills significant gaps in the space of substitutable products.39 Another situation in which a new market may emerge is the case where needs can be satisfied much better or cheaper. Consumers that will only demand a product when the price has dropped by a considerable amount will then – if we ignore income effects – satisfy other needs that require substantially lower expenses. But even when income effects are taken into account, drastic price reductions may change the market in such a way that one my find a new market, as additional consumer needs are satisfied.40 A final difficulty arises when innovations are brought to completion in a number of successive steps. Each individual step does often not create a new market, or not even perhaps a significant innovation. If we look at the cumulative effect of the steps, however, we may find in many cases that a new market has after all developed over a certain period. To get a better understanding of these problems and criteria for defining new markets, we propose the following modification to the SSNIP test.41 It should examine whether the needs satisfied in the market in which the innovation occurred have also been adequately satisfied before. This means looking at an ‘old’ market, in which the needs in question were satisfied a certain time (e.g., four years) ago, and answering this question taken from the SSNIP test: what percentage of consumers in the new market would revert to the prod39

For example, even before the introduction of the kiwi fruit, there were fruits in Europe not too far removed from a kiwi fruit either in taste or in nutritional value. 40 In the earlier example of Henry Ford’s car factory, the Model T was qualitatively barely different from other cars of the period. However, it was so much cheaper that a car could meet many new needs of the purchaser that previously had to be satisfied by other means of transport. We believe therefore that even this kind of drastic price reduction, from a certain threshold, should be considered as a ‘new market’. 41 The SSNIP test measures the change in demand caused by a ‘small but significant and nontemporary increase in price’. It is generally used to capture the price elasticity of demand.

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ucts of the old market if the prices of the products available four years ago fell in real terms (i.e., adjusted for inflation) by 20 per cent (= 4 × 5 per cent)? In a new market this value should be small, and we can surely talk of a new market if less than 20 per cent of customers would revert to the old products.42 On the other hand, if more than 80 per cent of customers would revert to the old products in the event of such a price decrease we can surely state that there is no new market. Between these extremes, the answer to the question depends on other aspects of the change. For example, it is important to know how many of the customers that would not revert to the old products have been able to meet their needs in the old market at all. This test, with the necessary condition that new markets can only arise on the basis of innovations, can clearly be used to resolve all the problems set out above. If the new market satisfies needs that were not satisfied before, then, of course, no consumers will revert to the old products. This should always be the case where the innovations constitute fundamentally new products or networks associated with new services and/or applications. In cases where there have been similar products before, the test may clarify whether there has been a marginal or a drastic change to the market, as the change would have to be drastic for a 20 per cent price reduction not to trigger a massive return of consumers to the old products. New markets are then based either on enhanced product features or the observation that although similar products are available, they are being offered at substantially lower prices (the price differences must be at least 20 per cent), and so potentially new market segments are being served. Together with the necessary condition that new markets can only emerge in conjunction with innovations, this would then cover all cases in which new markets – the Model T Ford for example – emerge out of process innovations.43 42

This will also apply where relatively close substitutes have been developed for the new market. For example, alternative options for broadband access have no bearing on how many DSL customers would return to ISDN if the price dropped by 20 per cent. 43 Price reductions without innovations cannot lead to the emergence of new markets.


In the case of phased innovation processes, a fair assessment can then be made, because it will also refer to four-year-old products and not to products of an earlier (more or less distant) stage of development. The last two points in particular, that is, the definition of new markets arising from process-based cost and price reductions and the treatment of phased innovations, bring two problems into focus. First, we must establish the point at which new products are introduced, that is, the point at which the new market starts to emerge. Second, it is unclear how new an innovation needs to be to fulfill the necessary condition for the possible emergence of new markets. While we can answer the first question in a relatively pragmatic way by taking the date of the first commercial availability of the new product or the first application of new processes, the second question leaves a certain amount of room for interpretation. On the analogy of the approach to granting patents, we might insist that, for example, process innovations must be associated with significant technical changes and hence at least potentially likely to lead to relevant efficiency gains or cost reductions. Similarly, as a minimum requirement for product innovations, we might mention new technical features. With sequential innovations, this would have the additional advantage that only the cumulative effect of enhancements would be relevant for the existence of a new market – the relevant reference market is the market four years ago. In contrast to patents, this would then place clear limits on the abuse of ‘artificial’ new markets, as the economic importance of the innovation would be assured by the modified SSNIP test.

13.4.2 Regulation

Based on this definition of new markets, we will now discuss how new markets should be regulated. We will concentrate on the tradeoff that arises where, as with patent protection, the desired level of technical and commercial innovation will not occur without short and medium-term protection of investment incentives, while at the same time there may be a danger of successful innovations leading

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to undesirable positions of permanent power in the new markets (as in S2). We will start by assuming that – where the necessary criteria for the emergence of new markets have been met, that is, where innovations are present – there should be no regulatory intervention. After the first four years, the question is then what powers the regulatory authority should be given. For developments that have not resulted in a new market, the existing regulatory framework can be applied. Here, it is usually enough to update the price regulation or extend the existing rules to cover ‘new’ products in the market. However, if the SSNIP test indicates that there is a new market, there will typically be a conflict between static and dynamic efficiency. On the one hand, the market is still so new that we must assume that the innovator holds a dominant position; on the other hand, to pass the modified SSNIP test, the market has developed to the point where detectable static inefficiencies must force intervention by any responsible regulatory authority. As the investment required for the successful innovation has already been undertaken at this point, there is no real short-term reason to avoid such intervention. However, it is important for dynamic efficiency that the innovation should pay for itself in the marketplace, which means that at this stage, the dominant company in the new market should still be protected. It is therefore important for the state to establish a regulatory framework in which an active regulatory authority can be credibly restrained during this phase of the market. The regulatory authority should only intervene in the case of permanent market domination. In the following four years, the market should therefore be examined to determine whether and to what extent competition is likely to arise. The decisive question for an assessment of the development at this stage is then whether we can expect the natural dominance of the innovator in the new market to be attacked by competitors in the foreseeable future. In order to formulate the necessary mechanisms for defining the intervention criteria, we must first define the normal course of events in an unregulated market. We suggest that effective competition


within a new market should have eliminated this natural dominance after twelve years, and the regulatory authority should then take action in accordance with the usual static regulatory principles if there still is a situation of dominance according to the SMP test. In the period between the emergence of a new market and the transition to static regulation, priority should also be given to the goal of developing a market with effective competition. During this time, the regulatory authority should observe whether the structure of a new market is developing in such a way that the attainment of effective competition in the period in question remains a possibility, that is, there is a tendency towards competition. In this period, therefore, it is not the current market structure but the projected structure twelve years after the emergence of the market that will determine whether to intervene. Of course, such a projection is fraught with uncertainty, particularly in the initial period after the establishment of a new market, and in the first two years the mere development of competing infrastructure will be reason enough to desist from active regulation. In the next two years, the emerging competition must then register significant gains in market share for there to be a realistic chance in the last two years that intervention will not ultimately be necessary. We therefore suggest that, during this period, there should be a review of developments every two years. The tests used to identify a tendency towards competition could be: 1. Six years after the innovation, it should be possible to observe the development of competing infrastructure. 2. Eight years after innovation, the competitors should have gained a significant and growing market share. This process of increasing market share, if sustained at the same rate for the next four years, should result in a market share of over 30 per cent. 3. Ten years after innovation, the current market structure should permit a fairly reliable forecast of whether the next two years will see a situation in which regulation according to the SMP test is no longer necessary.

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If it is established at any of these points that the tendency towards competition defined according to the relevant criteria does not exist, the market will be subjected to the existing regulation, with the proviso of course that the analysis of regulatory instruments should take account of whether the market is still evolving.44 After another two years, a definitive review should be carried out to determine whether the market satisfies the SMP test and should be regulated (see Figure 13.2). This approach considers not only the investment incentives for innovative companies, but also telecommunications-specific aspects. For example, the initial period of four years should allow enough time for the introduction of new products. This is important, as the value of the new network infrastructure is dependent on investment at the level of services. If new markets have actually developed, regulation will only set in after six years – assuming there is no discernable tendency towards competition. This does grant potentially market-dominant companies a monopoly position for a limited time, as a suitable profit level has to be allowed as an incentive to invest; where advantages of size result in new and/or permanent monopolies a time limit on this monopoly position seems entirely justified, given the need for dynamic efficiency.45

13.4.3 Incentive effects: infrastructure-based competition

Aside from the observations discussed above, the proposed mechanism produces a number of other positive incentive effects. This applies particularly to competition to introduce new networks. First, in the first six years, in which there is no regulation of new markets, investments by all companies, including competitors, are 44

As the SMP test is weaker than the test of whether there is a tendency towards competition, it follows that the SMP test will inevitably produce a positive result and that the market will be regulated. 45 See also the concept of access holidays proposed by Gans and King (2003). Bourreau and Dogan (2005) have voiced criticism of the effects of sunrise clauses.

Chapter 13 – Efficient Regulation of Dynamic Telecommunications 415 After 4 years

New market (SSNIP)

No

Allocate to existing market

Yes After 6 years

Competing infrastructure?

No

Regulation

Yes After 8 years

Clear, growing market shares?

No

Regulation

Yes

After 10 years

Forecast: signif. market power?

Yes

Regulation

No After 12 years

Significant market power?

Yes

Regulation

No

No regulation

Figure 13.2 Regulation of new markets.

protected. Their investment incentives are actually increased by the fact that regulation will only be applied in those cases where no tendency towards competition has emerged. When the construction of individual networks indicates a tendency towards competition, these networks are protected against depreciation by a potential regulation of access in favor of the dominant provider.46 This gives

46

Cf. discussion in Section 13.3.4.

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an additional value to investments in the construction of individual networks so that investment incentives increase. This simple reasoning stands up relatively well against strategic considerations by competitors, as shown by the observation that noninvestment by more than one potential competitor is not a stable equilibrium. If one or more companies dissent from such an arrangement and build their own networks, the other companies will be in danger of losing the risk-free option of regulated access. The networks of the dissenting companies will however be protected against any resulting depreciation. Collusive agreements – implicit or explicit – on strategic delay or withdrawal of individual investments do not constitute an equilibrium. A broadly similar argument also shows that strategies to prevent competition for potential dominant companies may actually lose value. If dominant companies inhibit the development of competing infrastructure they must expect to be faced with regulatory intervention.47 The alternative to the resulting permanent depreciation of their networks is (infrastructure-based) competition. Which of these variants is preferable from the companies’ point of view depends on various factors; the fundamental option is to avoid future regulation, but this cannot lead to a situation in which avoidance of competition is more attractive. In summary, the proposed regulatory process does not only involve protecting initial investments. The decision to subject new markets to regulation only if no tendency towards competition can be discerned after six to eight years or one company has significant market power after twelve years, requires more than internal competition in the shape of competing infrastructures being developed. This regulation also serves to reduce the incentive for dominant companies to inhibit infrastructure-based competition by the application of appropriate strategies. 47

Although this observation may also mean that established companies withhold investments, to avoid future regulation, this risk is lessened by the fact that the investment incentives of competing companies are increased.

Chapter 13 – Efficient Regulation of Dynamic Telecommunications 417 13.5 SUMMARY

The starting point for this study was the question of how regulatory intervention affects dynamic competition and how it should be designed to achieve dynamic efficiency. To answer these questions, we have chosen a relatively basic approach, starting with an examination of how dynamic competition works. The discussion of the two Schumpeterian hypotheses and the sources of market failure in dynamic markets then showed that one important issue is whether market structures will evolve with more and more new and innovative companies, or conversely, with increasing degrees of monopolization. Similarly, the results concerning the incentives to innovate were also mixed with relative complex and contradictory effects emerging. Aside from the fundamental problem of appropriability, strategic motives as, for instance, pre-emption incentives play a crucial role. With regard to telecommunications markets – and especially markets for new networks – we noted that the vertical structure (and associated complementarities between services and infrastructure) tends to increase the risks and uncertainties for innovating firms. A standard, cost-based regulatory system, which may be optimal in a static environment, necessarily reduces firms’ investment incentives because it does not properly take into account the risks the investor has to bear; or, more precisely, the need for high rewards in successful states that have a small ex ante probability. Cost-based access regulation unfolds an additional negative effect on rival firms’ investment incentives and, therefore, tends to hinder catch-up competition, which is essential for generating competition in telecommunications markets based on a dispersed ownership of infrastructure. A regulatory system should, therefore, take into account the incentives to develop (new) competing infrastructures in order to achieve dynamic efficiency. If new networks are exempted from any regulation for a certain period of time, this will secure potentially high profits for the first innovator. In addition, it also increases the investment incentives of potential competitors. The decisive point is then to determine how new markets should be defined and/or demarcated.

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As it is not possible ex ante to predict how, for example, the provision of new services and applications, and hence the access to new networks, will develop, we propose to impose restrictions on new markets only after four years from the date of emergence of the market. The development of the new market should then be monitored every two years with a view to the emergence of effective competition, and with an ever-increasing emphasis on structural competition. This series of successive development tests concludes after no more than twelve years in the existing SMP test. If, however, there is no discernable trend towards significant competitive structures the market will be subjected to sector-specific control at an earlier stage. This approach not only takes account of the risk-laden innovation problem of the investing company; it also generates positive incentives for competitors to invest into competing infrastructures. The reason for this is that competitors investing on their own behalf may generate effective competition and thereby avoid the need for any future regulation of the market. Moreover, the incentive to free ride on the innovator’s investments is also mitigated by the rather long review process. Finally, the threat of regulation, if no effective competition emerges, counters possible incentives of the innovator to protect its monopoly by entry-deterring strategies. These incentive effects depend crucially on a strict adherence by the regulatory authority to the proposed regulation scheme. In order to implement the proposed regulatory system, it is necessary for the European Commission to define potentially new markets, which can then be subjected by the national regulatory authorities to the proposed development tests – and not to a short-term test of projected market power such as the SMP test.

REFERENCES Aghion, P. and P. Howitt (1998): Endogenuous Growth, MIT Press, Cambridge, MA. Besanko, D. and D. Spulber (1993): ‘Contested mergers and equilibrium antitrust policy’, Journal of Law, Economics, and Organization 9: 1–29.

Chapter 13 – Efficient Regulation of Dynamic Telecommunications 419 Bourreau, M. and P. Dogan (2005): ‘Unbundling the local loop’, European Economic Review 49: 173–199. Cave, M. (2003): ‘Remedies for broadband services’, University of Warwick, Mimeo. Cave, M. and L. Prosperetti (2001): ‘European telecommunications infrastructures’, Oxford Review of Economic Policy 17: 416–431. Cave, M. and I. Vogelsang (2003): ‘How access pricing and entry interact’, Telecommunications Policy 27: 717–727. Economides, N. (1996): ‘Network externalities, complementarities, and invitation to enter’, European Journal of Political Economy 12: 211–233. Farrell, J. and N. Gallini (1988): ‘Second sourcing as a commitment: Monopoly incentives to attract competition’, Quarterly Journal of Economics 103: 673–694. Gans, J. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Melbourne Business School, University of Melbourne, Mimeo. Gans, J. and S. King (2003): ‘Access holidays for network infrastructure investment’, Agenda 10: 163–178. Gellhorn, E. and W. Kovacic (1994): Antitrust Law and Economics in a Nutshell, West Publishing, St. Paul. Grossman, G. and E. Helpman (1997): Innovation and Growth in the Global Economy, MIT Press, Cambridge, MA. Haucap, J., F. Mueller and C. Wey (2004): ‘How to reduce conflicts over international antitrust?’, in: Voigt, S., M. Albert and D. Schmidtchen (eds), International Conflict Resolution – Conferences on New Political Economy, Vol. 23, Mohr Siebeck, Tuebingen, 307–338. Hausman, J. (1997): ‘Valuation and the effect of regulation on new services in telecommunications’, Brookings Papers on Economic Activity: Microeconomics, Vol. 1997, 1–38. Hausman, J. and G. Sidak (1999): ‘A consumer-welfare approach to the mandatory unbundling of telecommunications networks’, The Yale Law Journal 109: 417–505. Hayek, F. A. (1944): ‘The use of knowledge in society’, American Economic Review 35: 519–530. Hazlett, T. and W. Havenner (2003): ‘The arbitrage mirage: Regulated access prices with free entry in local telecommunications markets’, Review of Network Economics 2: 440–450. Hellwig, M. and A. Irmen (2001): ‘Endogenous technical change in a competitive economy’, Journal of Economic Theory 101: 1–39. Hoppe, H. and H. Lee (2003): ‘Entry deterrence and innovation in durable goods monopoly’, European Economic Review 47: 1011–1036. Hori, K. and K. Mizuno (2004): ‘Network investment and competition with access-tobypass’, Faculty of Economics, Ritsumeikan University, Mimeo. Martimort, D. and T. Verdier (2004): ‘The agency cost of internal collusion and Schumpeterian growth’, Review of Economic Studies 71: 1119–1141. Martin, S. (1993): Advanced Industrial Economics, Blackwell, Oxford. Neven, D. and L.-H. Roeller (2005): ‘Consumer surplus vs. welfare standard in a political economy model of merger control’, International Journal of Industrial Organization 23: 829–848. Oldale, A. and A. J. Padilla (2004): ‘From state monopoly to the “Investment ladder”: Competition policy and the NRF’, in: Swedish Competition Authority (ed.), The Pros and

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Cons of Antitrust in Deregulated Markets, Swedish Competition Authority Stockholm, 51–77. Radner, R. (1979): ‘Rational expectations equilibrium: Generic existence and the information revealed by prices’, Econometrica 47: 655–678. Reinganum, J. F. (1989): ‘The timing of innovation: Research, development, and diffusion’, in: Schmalensee, R. and R. Willig (eds), Handbook of Industrial Organization, Vol. 1, Elsevier, Amsterdam, 849–908. Scherer, F. and D. Ross (1990): Industrial Market Structure and Economic Performance, 3rd edn, Mifflin, Boston. Schumpeter, J. (1918/1964): Theorie der wirtschaftlichen Entwicklung: Eine Untersuchung über Unternehmergewinn, Kapital, Kredit, Zins and den Konjunkturzyklus, 1st edn 1918, 6th edn 1964, Duncker & Humblot, Berlin. Schumpeter, J. (1950): Capitalism, Socialism and Democracy, 3rd edn, Harper, New York. Schumpeter, J. (1934): The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle, Harvard University Press, Cambridge. Tirole, J. (1988): The Theory of Industrial Organization, MIT Press, Cambridge, MA. Williamson, O. E. (1985): The Economic Institutions of Capitalism, The Free Press, New York.


CHAPTER 14

Are Vertically Integrated DSL Providers Squeezing Unaffiliated ISPs (And Should We Care)?∗ ROBERT W. CRANDALL Brookings Institution, Washington HAL J. SINGER Criterion Economics, Washington

Contents 14.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 14.2 THE ROLE OF REGULATION IN PROMOTING ISPs . . . . . . . . . . . . . . . . . . . . . 424 14.2.1 Computer I and II decisions 425 14.2.2 Choice of global service provider regulation 427 14.2.3 Reciprocal compensation game 428 14.3 WHAT DID INTERNET SERVICE CONTRIBUTE TO ECONOMIC VALUE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 14.3.1 The value-added of unaffiliated internet service providers in the dial-up era 430 14.3.2 The value-added of intermediaries in the broadband era 432 14.4 ISSUES FOR COMPETITION LAW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440 14.4.1 Price squeeze allegations 442 14.4.2 The conditions under which a price squeeze harms consumers 445 14.4.3 The relationship between a price squeeze and cross subsidy 450 14.5 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456

∗

The authors wish to thank Evan Leo for his valuable comments and Brian O’Dea for his research on the early regulation of ISPs.

422

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14.1 INTRODUCTION

During the formative years of the Internet, there were thousands of Internet service providers (ISPs) offering dial-up service to dispersed telephone subscribers over traditional telephone lines. Over time, this service became concentrated in a handful of large ISPs, including America Online, Juno, MSN, and EarthLink. These carriers were successful for two reasons. First, they provided a higherquality service – for example, by offering higher ratios of modems per subscriber – which was important in the dial-up Internet era. Second, these ISPs bundled premium content with their access service. In the late 1990s, however, narrowband ISPs were decimated by the migration to higher-speed broadband services. By June 2004, 30.1 million US residential and small business customers – or about one-third of Internet subscribers – subscribed to a broadband service. (Federal Communications Commission (FCC), 2004) This shift to broadband has forced dial-up service providers to consolidate and exit the market unless they find some way to provide broadband services over someone else’s network. In an attempt to promote competition and broadband deployment, the FCC and other telecommunications regulators have responded to the decline of the ISPs and attempted to design policies that would breathe life into these companies. Although these independent ISPs were instrumental in narrowband (dial-up) Internet access, the same cannot be said for their contribution to the growth of broadband. In this article, we explain that the dial-up model cannot be replicated in the broadband era – that is, independent broadband ISPs simply do not currently contribute to the value of the service. If these companies have valuable content to offer broadband subscribers, they can make it available to subscribers without mandated access to the broadband service providers’ networks. Currently, there is simply no reason to worry about access to unaffiliated content on the Internet. Broadband is thriving without independent ISPs. ‘Open access’ to the network, access to content, and price squeezes have been studied by several academics. (see, e.g., Wu, 2003;

Chapter 14 – Are Vertically Integrated DSL Providers

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Yu, 2004; Farrell and Wesier, 2003; Woroch, 2002; and Lemley and Lessig, 2001). In general, these analyses conclude that structural separation of the wholesale DSL transport from retail service divisions of the high-speed ISP is counterproductive because of the economies of scope in delivering a quality service (see, e.g., Crandall and Sidak, 2002). Vertical relationships, whether through ownership or close contractual relationships, allow network providers to develop innovative products that complement current products in a manner that can be advantageous to platform providers (even duopolists) and consumers. Mandatory access for multiple unaffiliated ISPs simply creates unnecessary transactions costs, leaves upstream concentration intact, and decreases the incentives for a firm to invest in or develop alternative networks. The issue of ‘open access’ is intimately related to standard antitrust concept of a ‘price squeeze’, because mandatory access is meaningless without designating a regulated access price (Geradin and O’Donoghue, 2005). The level of that access price has become the major bone of contention between independent ISPs and network platform owners. Does the regulated access price provide sufficient operating margins for rival ISPs or do these prices ‘squeeze’ them because the resultant retail margins are too small? We conclude that an antitrust price squeeze test, while providing some information about the welfare of an equally efficient retailer of DSL services, yields no information about consumer welfare. Our conclusions are similar to those that emerge from the research on bundled loyalty rebates (see Greenlee et al., 2004, pp. 11–12; Nalebuff, 2004, pp. 1–3). In those cases, courts have looked to various ‘attribution tests’ to determine whether an unaffiliated provider of the tied product could keep the customer whole (by absorbing 100 per cent of the monopolist’s rebate across the tying and tied products) yet still earn a profit. But the attribution test only provides information about the welfare of an equally efficient rival. The attribution test does not provide any information about whether consumers are harmed by the introduction of reduced prices through bundled services. In that context, consumer harm depends on whether the price of the tying product when it is purchased separately after the bundle

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is introduced exceeds the independent monopoly price of the tying product (see Greenlee et al., 2004). It is equally flawed to use a predation framework to analyse the effect of a price squeeze on consumer welfare. In particular, the conditions under which consumers are harmed as a result of a price squeeze may not be satisfied even though unaffiliated downstream rivals are not able to earn a profit given the relationship between access prices and retail prices.

14.2 THE ROLE OF REGULATION IN PROMOTING ISPs

Internet service providers did not begin to grow significantly until late 1994 with the birth of the World Wide Web (see Koch, 1997). The confluence of the Internet and the growth of personal computers gave rise to a new business of providing Internet access to the mass market. Although regulators did not create unaffiliated ISPs, they indirectly created the structure of the ISP industry and thereby heavily subsidized their entry. In particular, regulators determined that certain network functions should not be provided by the owners of local networks, and that the ISPs’ connections to the network should be priced at ordinary, generally flat-rated business service rates. This subsidized pricing of access allowed ISPs to be treated like end-users as opposed to rival carriers. In contrast to the broadband era, investment in new infrastructure was not needed for narrowband access. Hence, the coordination problem between infrastructure development and access provision was postponed, allowing for greater segmentation. The rise of ISPs coincided with a number of other favourable regulatory decisions that conferred special advantages upon ISPs, such as the exemption of ISPs from payment of access charges, arbitrage opportunities created by asymmetrical reciprocal compensation regulations, and the limitations placed on the local Bell telephone companies by the AT&T decree. Therefore, the widespread growth of unaffiliated ISPs was not entirely a product of free-market forces, but was rather the product of strong regulatory intervention.


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14.2.1 Computer I and II decisions

In 1971, the FCC issued a decision on the regulation of telecommunications operators engaging in data processing services.1 The decision, which is referred to as ‘Computer I’, ordered that those services that were purely data processing would not be regulated, and those services that were purely telecommunications would continue to be regulated. (Kellogg et al., 1992) As for those services that were a mixture of both, the decision allowed the Commission to make ‘ “ad hoc evaluations” with respect to “hybrid services” to determine on which side of the line [the services] fell’ (Kellogg et al., 1992). The final FCC decision and subsequent appellate court decision2 prohibited telephone companies from providing data processing services except through separate subsidiaries (Kellogg et al., 1992, p. 544). After Computer I, advancements in technology, such as digital telephone networks, forced the Commission to make a great number of ad hoc determinations. Therefore, nine years later, the FCC issued another decision on the matter, Computer II.3 This decision limited telephone operators from engaging in ‘enhanced services’, which were defined as anything other than ‘basic services’ such as switching and transmission (see Kellogg et al., 1992, p. 548). To engage in the enhanced services, a telephone operator (primarily AT&T) would have to establish a separate subsidiary with separate accounting, employees, equipment, and facilities (see Kellogg et al., 1992, p. 549). As a result, regulators artificially provided an opportunity for ISPs by protecting them from competition with the logical and efficient providers of such services – namely, integrated

1

Regulatory and policy problems presented by the interdependence of computer and communications services and facilities, final decision and order, 28 FCC 2d 267 (1971) [hereinafter Computer I]. 2 GTE Service Corp. v. FCC, 474 F.2d 731 (8th Cir. 1973). 3 Amendment of § 64.702 of the Commission’s rules & regulations, second computer inquiry, 77 FCC2d 384 (1980) [hereinafter Computer II].

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telephone companies.4 The structural separation requirements of Computer II were relaxed in 1986 when the FCC ruled that telephone operators did not have to structure an affiliated ISP as a separate subsidiary.5 Under Computer III 6 , a telephone operator who elected to integrate an ISP into its operations, however, had to generate and follow a detailed Comparatively Efficient Interconnection (CEI) plan that ensured unaffiliated ISPs with access to everything the affiliate received at the same terms and conditions (see Cannon, 2001). Subsequently, when AT&T was broken up, the Bell Operating Companies’ (BOCs’) CEI plans had to be approved by the FCC a requirement that, by the FCC’s own admission, placed a ‘substantial burden on the BOCs’ and ‘has sometimes hampered the BOCs in their introduction of new intraLATA information services’. During the second stage of Computer III, the FCC required the BOCs to develop and implement Open Network Architecture (ONA) plans. The FCC defined ONA as ‘the overall design of a carrier’s basic network services to permit all users of the basic network, including the information services operations of the carrier and its competitors, to interconnect to specific basic network functions and interfaces on an unbundled and equal-access basis’.7 Had the Ninth 4

In other countries, telephone companies developed their own ISPs and even entered as ISPs in other countries. 5 In re Amendment of sections 64.702 of the Commission’s rules and regulations (third computer inquiry), and policy and rules concerning rates for competitive common carrier services and facilities authorizations thereof, communications protocols under section 64.702 of the Commission’s rules and regulations, report and order, 104 FCC2d 958 (1986). In the decision, the FCC explicitly acknowledged that the structural separation requirements of Computer II rendered the Bell operating companies ‘unable to organize their operations in the manner best suited to the markets and customers they serve’. Id. at ¶ 89, at 1007. 6 Computer III further remand proceedings: Bell operating company provision of enhanced services, CC Dkt. No. 95-20, 14 FCC Rcd. 4289, ¶¶ 4, 22 (1999) [hereinafter Computer III]. The pre-approval process for CEI plans was abandoned by the FCC in 1999. 7 Computer III, ¶ 8 n. 15.


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Circuit Court of Appeals not vacated the ONA rules, the BOCs would have been permitted to provide integrated enhanced services without filing service-specific CEI plans once the FCC approved their ONA plans (see Cannon, 2001, pp. 14–16). In response to the court’s decision, the FCC reverted to the CEI rules – requiring a BOC to post a CEI plan if it wished to offer enhanced services (see Cannon, 2001, p. 3).

14.2.2 Choice of global service provider regulation

Section 271 of the Telecommunications Act of 1996 continued the AT&T decree’s restriction on the ability of the regional Bell telephone companies to provide interLATA and information services until they were declared to be in compliance with the ‘checklist’ of market opening requirements detailed in section 251 of the Act.8 In 1999, the FCC classified the service provided by regional Bell telephone companies to ISPs as an ‘interstate’ service.9 As a result, the Bell companies that had not obtained section 271 approval had to rely on separate global service providers (GSPs) to provide the interLATA portions of their dial-up Internet service in that state. The Bell companies were thus required to allow their Internet customers to choose their own GSP, and had to pay that GSP to carry their customers’ data traffic to the Internet backbone. These requirements prevented the Bell companies from providing customers with end-to-end Internet access services and Internet backbone capacity. By artificially preventing the Bell companies from realizing efficiency gains from the end-to-end provision of Internet access, regulators destroyed a natural competitive advantage of the local telephone companies vis-à-vis ISPs in the provision of Internet services, 8

47 USC § 271 (1996). Implementation of the local competition provisions in the Telecommunications Act of 1996, Intercarrier compensation for ISP-bound traffic, FCC No. 99-38 (rel. 26 February 1999).

9

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thereby broadening the scope of opportunity for ISPs past what would exist in a freely competitive market.

14.2.3 Reciprocal compensation game

The 1996 Telecommunications Act requires local carriers to compensate one another for terminating calls through a system of ‘reciprocal compensation’. In particular, whatever carrier A charges for terminating a call that originates on carrier B’s network would also be paid by carrier A for terminating a call on B’s network. An efficient or market-based framework for reciprocal cost recovery would likely be based on cost causation (see Banerjee and Ros, 2000). That is to say, the carrier or service provider who generates the cost of a call would be responsible for paying that cost. As a result, when an ISP customer dials in to the Internet, he is acting as a customer of the ISP, and it is therefore the ISP that is generating the cost of carrying the customer’s data traffic over the local telephone company network. As Aniruddha Banerjee and Agustin Ros of NERA explain: In a cost-causative view of an Internet call, the ILEC subscriber makes that call as a customer of the ISP, not of the originating ILEC (or even the CLEC serving the ISP). The ILEC and the CLEC simply provide interconnection or access-like functions to help the Internet call on its way, just as they might provide originating or terminating switched access to help an IXC carry an interstate long-distance call. Therefore, with the proper network view of interconnection, an ISP-bound call is analogous to ILEC–IXC interconnection (switched access) rather than ILEC–CLEC interconnection. This implies, in turn, that the proper form of inter-carrier compensation should be usage-based charges paid by the ISP to all local carriers – the ILEC and the CLEC alike – that facilitate delivery of Internet calls to the ISP” (Banerjee and Ros, 2000, p. 15).

Regulators, however, structured the reciprocal compensation system in a manner that allowed ISPs to benefit from artificially high termination charges negotiated between incumbents and the new competitive local exchange carriers (CLECs). Incumbent telephone company subscribers who enrolled in an ISP service and dialed their ISP’s number were considered to be originators of calls on the ILEC


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network. If the ISP established a CLEC solely for the purpose of ‘terminating’ the calls that originated on the ILEC network, it could reap huge revenues from the unbalanced traffic routed to the ISP (see Banerjee and Ros, 2000). ILECs were thus forced to pay large sums of money to CLECs that provided no real function. They simply were a transit point through which Internet-bound traffic from an ILEC’s network moved to ISPs. In a more rational world, an ISP would have been required to compensate the ILEC for the burden placed on their switching systems by the ISP customers’ Internet traffic, which was considerable because Internet ‘calls’ are much longer than the typical voice call. Instead, the regulators mandated that ILECs pay the ISPs’ related local carriers for terminating this ISP traffic. This economically illogical regulatory framework forced ILECs to subsidize the provision of Internet service by ISPs. When this form of regulatory arbitrage was subsequently brought to an end by regulators who began to understand what they had created, Dave McClure, president and CEO of the US Internet Association, lamented: This reciprocal compensation – an arcane monetary exchange between telephone companies for termination of calls in one another’s service area – had been touted since 1996 as a means for ISPs to extract free and lucrative payments from their telephone companies. Unfortunately, some ISPs based their financial performance on these payments. As the payments end, so do the ISPs (McClure, 2003, p. 1).

The amount of money that flowed to the ISPs through reciprocal compensation payments was staggering. The Wall Street Journal reported that in 2001, BellSouth made $300 million in reciprocal compensation payments, SBC spent $800 million, and Verizon spent $1000 million (see Dodd, 2002). Had these charges instead been levied on ISPs to compensate the ILECs for having to increase their switching capacity, the ISPs would have paid these carriers $2100 million instead of receiving $2100 million. Thus, the reciprocal compensation subsidy may have been more than $4000 million per year in these three ILEC territories in 2001.

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14.3 WHAT DID INTERNET SERVICE CONTRIBUTE TO ECONOMIC VALUE?

Whatever the reason for the evolution of independent or ‘unaffiliated’ ISPs, they may have contributed substantial value added in the narrowband era. However, the primary source of this value added in the narrowband era has been rendered obsolete in the broadband age. The ISPs’ own lobbyists have long conceded that the business models of many, if not most, ISPs could not survive in the absence of regulatory intervention. For example, in 2000, when Illinois was preparing to rewrite its telecommunications laws, American ISP Association Executive Director Sue Ashdown argued that a law that freed Ameritech from traditional state regulation would destroy Illinois-based ISPs (see Van, 2000, p. C2)

14.3.1 The value-added of unaffiliated internet service providers in the dial-up era

Dial-up ISPs perform three basic functions: installing the modem banks that allow subscribers to connect to the Internet through the telephone network, providing the connections from these modem banks to the Internet backbone, and providing content and web hosting. Although the first two functions are essential to the provision of dial-up Internet services, neither is particularly difficult, and unaffiliated ISPs do not possess an efficiency advantage in fulfilling those functions. The services provided by dial-up ISPs could surely be provided at least as efficiently by vertically integrated telephone operators. ISPs deliver little, if any, incremental value in the provision of dial-up access (beyond that which could be delivered by the Regional (RBOC) itself). 14.3.1.1 Installing modem banks

ISPs establish points of presence (POPs) in geographic service areas. A POP is a large bank of modems at a central location (see Enzer,


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2006). POPs are connected to other POPs by fiber optic connections to form a backbone. Although some ISPs run their own fiber optic lines between POPs, most simply lease capacity on the backbone to interconnect their own POPs and to connect to the larger Internet. Consumers dial into their ISP’s local POP over their ILEC’s telephone lines, and from there are connected to the Internet. POPs can thus be thought of as mini-networks of Internet users. The modem bank is typically the only telecommunications infrastructure operated by the ISP.10 14.3.1.2 Providing connections to the internet backbone

Providing consumers with connections to the Internet backbone is a very basic process, as The Economist describes: Providing [customers] with some software, a telephone number they can dial from their computer, and a link to the Internet is so simple that a technically literate teenager can offer such a service from a bedroom – as some have (The Economist, 1997).

The provision of connections to the Internet backbone does not require significant specialized knowledge or advanced technical skill. As a result, the provision of connections to the Internet backbone is a commoditized service that should, in a freely-operating market, generate no more than a competitive return on capital for any business that engages in it. 14.3.1.3 Providing content and web hosting

In addition to basic access to the Internet, numerous ISPs provide their own content and advanced services. America Online, for example, offers exclusive news and sports content to subscribers, as well 10

Major ISPs also deployed asynchronous transfer mode (ATM) switches in their backbone networks to forward traffic across all interfaces. See, for example, Techweb (2006).

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as parental controls. Many ISPs offer services such as free web hosting and multiple e-mail addresses. An ISP will typically offer such services as a means to provide additional value to consumers and to distinguish itself from other ISPs and carriers.

14.3.2 The value-added of intermediaries in the broadband era

In the broadband world, the local network companies – incumbent telephone companies and cable television companies – not the ISPs, provide the physical connection to the Internet. These local networks deploy their own modem banks, provide the requisite upstream and downstream capacity, and connect the modem banks to the Internet backbone. Once these modifications are deployed, there is no need for an ISP to connect the customer to the Internet. As a result, ISPs are largely confined to dial-up services, unless regulators mandate that network carriers share their networks with the ISPs. Although a number of ISPs have attempted to provide broadband access over the local carriers’ networks, there is little opportunity for ISPs to add any real value (other than marketing) to such broadband provision. Indeed, in early 2005, AOL was forced to cite in television advertisements its antispam software as the most compelling reason why a cable modem or DSL customer should subscribe to ‘AOL Over Broadband’ on top of the Internet service that is already provided with their high-speed connection. 14.3.2.1 The installation of DSLAMs and the changing role of ISPs

Although the points of interface between broadband customers and the carrier networks are created by modem banks (CMTSs for cable modem and DSLAMs for DSL), DSLAMs are often installed directly into the high-frequency portion of DSL-capable loops (see Franklin, 2006a, 2006b; Cable-Modem.net, 2006; and Newton, 2001, p. 228). In such situations, the need for modem banks is eliminated. Given that the second function of ISPs (providing a connection from


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the modem banks to the Internet backbone) is little more than a standardized ‘commodity’ service that can be provided by the telephone company, and that consumers attach little value to the ISPs’ third function (providing content and web hosting) when so much content is available on the Internet, it is all but impossible for unaffiliated ISPs to generate any real incremental value in the provision of broadband Internet access. Moreover, the proliferation of the ‘bring your own access’ models by large ISPs, such as AOL, suggests a lack of significant economies between providing content and providing access, and implies that stand-alone content providers are not impaired without subsidized access to DSL transport. 14.3.2.2 The demise of Excite@Home

In the early days of broadband, many operators tried to replicate the narrowband model by using ISPs that were separate from the network provider. This experiment largely failed. But having an affiliated ISP proved to be of little value, as demonstrated by the case of Excite@Home, the ISP affiliated with broadband network owners AT&T, Comcast, and Cox. All three cable firms originally owned and used Excite@Home exclusively to supply broadband Internet connectivity.11 Initially the cable firms paid Excite@Home 35 per cent of the monthly access fees paid by subscribers (see Scanlon, 2001, n. 20 and Olavsrud, 2001). In August 2001, however, Comcast and Cox announced that they planned to terminate their distribution agreements with Excite@Home the following year.12 One month later, in September 2001, Excite@Home filed for bankruptcy (see Whitman, 2001). In December 2001, AT&T terminated its relationship with Excite@Home and began to provide high-speed cable access 11

Excite@Home also had distribution agreements with other cable firms, including Cablevision Systems, Rogers, and Shaw (Scanlon, 2001). 12 At Home Corp., 2001 Form 10-Q at 23 (19 November 2001). Together, Comcast and Cox accounted for 30 per cent of Excite@Home’s consolidated revenues. Id.

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directly to consumers (see Lieberman, 2002). AT&T, Comcast and Cox abandoned Excite@Home because they decided that Excite@Home’s large investments in content were not highly valued by consumers and the cable companies simply decided that they could offer broadband connectivity at a lower cost than Excite@Home was able to provide it. Communications analysts have provided two explanations for what went wrong with Excite@Home. The first is that Internet content and advanced services do not necessarily generate the synergies that many had anticipated. As Mavis Scanlon of Telephony explained: @Home fell prey to the prevailing view [in 1999] that delivering content and related services, in addition to providing broadband access, was the way to go to attract advertisers. To that end, the company made several outrageously expensive acquisitions for content and e-commerce services companies(Scanlon, 2001, n. 35).

In the late 1990s, analysts had predicted exponential growth in online advertising. Instead, advertisers’ demand for banner advertisements declined due to limited consumer response to these advertisements. According to eMarketer, online advertising decreased from $8200 million in 2000 to $6000 million in 2002, and only rebounded to $7300 million in 2003 (see Delaney, 2004, p. B1). Because of its heavy focus on content and advanced services, Excite@Home was especially vulnerable to the implosion of the Internet advertising market in 2000 and 2001.13 Indeed, Excite@Home eventually sold Excite.com in November 2001 for $10 million, less than two-tenths of 1 per cent of the $6700 million @Home had paid to acquire the web portal in 1999 (see Fitchard, 2001). The second reason offered by analysts for Excite@Home’s failure is the relatively uncomplicated nature of provision of high-speed Internet service by cable operators or telephone companies. Although agreements with ISPs may have appeared to make sense when there 13

At Home Corp., 2000 Form 10-K at 9 (20 August 2001).


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was a widespread belief that consumers and advertisers valued content highly, once that belief was exposed to be false, much of the perceived value of having an ISP simply evaporated. Bob Gessner, president of Massillon Cable of Ohio, stated in early 2001 that he had discovered that setting up broadband access was not that difficult: ‘It’s computer science, not rocket science’ (Scanlon, 2001, n. 35). Over time, an increasing share of broadband customers began to install their own modems, further simplifying the task of delivering broadband connectivity.14 Gessner pointed out that providing Internet service himself, rather than relying on an ISP, was attractive because ‘[w]e get to keep all the money.’15 14.3.2.3 The revealed preferences of unregulated cable providers

If unaffiliated ISPs truly added significant economic value to endusers of Internet, one would expect cable companies to contract freely with unaffiliated ISPs for the provision of cable modem service. As Blair Levin, analyst at Legg Mason and former FCC chief of staff, stated: ‘I believe there is a price point that would create an incentive for any cable operator to carry any ISP. But whether that is an acceptable price point for the ISP is a hard question’ (Long, 2003). Yet cable firms have traditionally either offered Internet service themselves, or affiliated with a single ISP, such as Roadrunner or Excite@Home, to provide Internet service. Cable firms have been reluctant to open their networks to multiple ISPs. Federal regulators such as former FCC commissioner William Kennard strongly hinted that continued failure by the cable firms to offer consumers ‘ISP choice’ would result in open access regulation 14

See, for example, Q2 2004 Cox Communications Inc. Earnings Conference Call, Fair Disclosure Wire, 29 July 2004 (“while [high-speed Internet] connects are up more than 20% this quarter versus the second quarter last year, our installation truck roles for the quarter are only up 2%. Higher sell-in and customer self installation are contributing to our success.”). 15 Id.

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of the sort that telephone companies encountered under the 1996 Telecom Act: Now, I know that Wall Street is pressuring you to execute on your broadband promises. And that upgrading your systems is a massive and complex undertaking. But if you ignore this access issue for now, or worse, if you stonewall it, I fear that you will regret it. Don’t underestimate the power of this issue to capture the attention, and the ire, of American consumers. Engage this issue. Pay attention to it. Demonstrate that the marketplace can work. And be alert to the lessons of history. Remember the lessons of the Cable Act of 1992, when your industry went into denial and paid a heavy price (Kennard, 1999).

The implied threat of federally-mandated open access provides a strong encouragement to cable operators to make visible progress in instituting ‘open access’. Cable DataCom News reported in October 2002 that cable firms ‘are striving to prove that they’ll happily add outside ISPs on their own’ because the companies are ‘fearful’ of mandatory open access policies (see Breznick, 2002a). As a condition of merger approval, AOL Time Warner was forced to open its network to unaffiliated ISPs. Using ‘enormous pressure’, (Peers and Petersen, 2000, p. A3)16 the Federal Trade Commission (FTC) told AOL that it would block its merger with Time Warner unless it agreed to a contract with independent ISPs (see Cha, 2000, p. E1). When the FCC finally approved the merger in January 2001, the order required ‘that AOL Time Warner shall not restrict the ability of any current or prospective ISP customers to select and initiate service from any unaffiliated ISP which, pursuant to a contract with AOL Time Warner, has made its service available over AOL Time Warner’s cable facilities (“Participating ISP”)’.17 Following

16

‘Time Warner signed the deal under enormous pressure from the Federal Trade Commission, whose review of the pending AOL–Time Warner combination focused heavily on how easily Time Warner would open its cable systems to rival Internet services’. 17 Applications for consent to the transfer of control of licenses and section 214 licenses Time Warner Inc. and America Online, Inc., transferors to AOL Time Warner Inc., transferee, CS docket No. 00–30, memorandum option and order, 16 FCC Rcd 6547, 318 (2001).


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the merger, AOL Time Warner reluctantly opened its network in cities across the United States to EarthLink and other unaffiliated ISPs.18 The efforts of some cable firms ‘voluntarily’ to open their networks to multiple ISPs have been slow and sporadic, suggesting that they are primarily motivated by the current political considerations rather than any compelling economic rationale. Bruce Leichtman, president and principal analyst of Leichtman Research Group stated: ‘I would say, in general the agreements [that exist between cable companies and ISPs] are for political reasons’ (Long, 2003). The threat of federal open-access mandates and merger conditions appears to have played a major role in the decisions of AT&T Broadband and Comcast to open their networks to selected ISPs (see Breznick, 2002a, n. 49).19 AT&T Broadband reached a ‘multiple Internet service provider agreement’ with EarthLink in March 2002 for the launch of EarthLink high-speed service over AT&T Broadband’s network in Seattle and New England (see EarthLink, 2002a). AT&T Broadband has also signed agreements with NET1Plus in New England and Internet Central in Seattle (see EarthLink, 2002b). AT&T Broadband’s decisions to offer multiple ISPs over its cable lines, however, occurred only after it entered into merger discussions with Comcast in November 2000 (see Reuters, 2001). Comcast has taken very few steps towards opening its network infrastructure to unaffiliated ISPs. The company signed an open

18

See Earthlink press releases in broadband category at http://www.earthlink.net/ about/press/category/#broadband (containing press releases about new service over Time Warner cable systems in numerous cities, such as San Diego and Bakersfield, California). 19 (stating of AT&T Broadband and Comcast’s decision to open certain parts of their network that it ‘didn’t hurt that federal regulators are now reviewing Comcast’s proposed purchase of AT&T Broadband’, and that given the government’s imposition of open-access requirements in the AOL Time Warner merger it is not surprising that ‘AT&T and Comcast have accelerated the pace of their ISP-choice efforts, after years of dragging their feet’).

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access deal with Juno in November 2000 – the same month it began talks with AT&T Broadband – but did not begin offering Juno service until May 2002 – six months before consummating its acquisition of AT&T’s broadband unit (see Reuters, 2001; Wagner, 2002a; AT&T, 2002, form 8-K, p. 1 of 3 December 2002). Even then, Juno was only made available to high-speed subscribers in Indianapolis and Nashville (see Breznick, 2002a, n. 49). Finally, in August 2002, Comcast reached an ISP agreement with AOL Time Warner that would permit AOL to offer service over portions of its broadband network at a cost to AOL of $35–40 per Comcast subscriber plus a percentage of advertising and e-commerce revenues from those subscribers (see Wagner, 2002b). The AOL agreement, which was freely entered into by the two parties, only granted AOL access to ten million homes in Comcast’s service area over the first two years. Furthermore, given the per-subscriber cost paid by AOL, it is likely that AOL would have to charge consumers substantially more for cable modem service delivered over Comcast’s network than Comcast’s own ISP brand charges (see Breznick, 2002b). Charter and Cox, the two major cable operators that were not involved in merger proceedings, have moved even more slowly in opening their networks to unaffiliated ISPs. In 2001, Cox loudly trumpeted its high-speed cable-based ISP trial with unaffiliated ISPs EarthLink and AOL in El Dorado, Arizona (see Cox, 2001). The trial lasted six months and involved only 50 customers (see Cox, 2001). No agreement was reached between Cox and either EarthLink or AOL as a result of the trial, and the issue quietly faded from the national spotlight. Charter Communications reached an agreement with EarthLink in September 1998 to jointly offer high-speed cable modem service across Charter’s service area (see EarthLink, 1998). As of 2003, however, Charter had reached an agreement for cable access resale with only one unaffiliated ISP, Iserv, and the agreement only applied to two markets in Michigan (see Breznick, 2002a, n. 34). Apparently, the cable operator prefers offering direct access to the Internet though its Charter Pipeline service (see Charter Communications, 2003).


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14.3.2.4 Financial analysis of broadband ISPs

If ISPs impose price discipline on incumbent DSL providers, then ISPs might offer a valuable role for high-speed customers – even when they do not offer other value-added services. It is difficult for a firm to impose price discipline, however, when that firm spends more than 100 per cent of its expected margin on customer acquisition. For example, Covad’s ratio of direct selling expenses to direct broadband ISP customers was $508 in 2004.20 EarthLink, another large US ISP that advertises heavily on television, unfortunately does not separate its customer acquisition costs into broadband and dial-up customers. We performed a breakeven analysis based on EarthLink’s actual recurring costs and revenues while serving as a broadband ISP, based on a study undertaken for it during recent litigation. As Table 14.1 shows, Earthlink’s monthly recurring cost in 2003 was roughly $30.19 per customer, including a $25 wholesale price for access to the incumbent’s loop. If the retail price of DSL service was $35 per month, then the ISP’s monthly margin was only $4.81 per customer (equal to $35.00 less $30.19). Using this margin, an assumption of no churn, a weighted average cost of capital (WACC) of 7.8 per cent for ISPs, and a terminal Table 14.1 Monthly recurring cost for a US ISP ($US) Wholesale access price for loop Transport Remote access server Email Customer premises equipment Customer support Total

2300 077 007 001 076 558 3019

Source: Expert report of Dr August H. Ankum on behalf of EarthLink, Earthlink Inc. v. SBC Communications Inc., at ¶ 24.

20

As of 31 December 2004, Covad had approximately 78 600 broadband lines in service through its direct channel. Covad’s selling, general and administrative expenses as of December 31, 2004 were $39 984 000. See SEC (2005, pp. 5 and 43).

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value of 50 per cent of cash flows in the fifth year, the present discounted value (PDV) of a DSL customer for an unaffiliated ISP over a five-year period is equal to $260.51. Under these assumptions, an unaffiliated ISP will break even by spending $260.51 or less to acquire a new broadband customer. But if we use Earthlink’s actual annual churn rate of 48 per cent,21 the PDV of a DSL customer for an ISP over a five-year period falls to $78.16. Given Covad’s customer acquisition costs in 2004, this analysis suggests that Covad has overpaid for new customers. These results clearly lead one to ask: why was Covad (and presumably other ISPs) willing to spend so much to acquire new customers, particularly if doing so prevented them from underpricing the incumbent DSL provider? The classic principal–agent paradigm might provide a framework to understand this phenomenon. Managers of new telecommunications firms might not represent the best interests of shareholders. The massive securities fraud committed by WorldCom’s managers lends credence to the proposition that telecommunications managers can profit even when their shareholders incur large losses. On the other hand, managers of a broadband ISP might overpay to establish brand name recognition with the sole purpose of exploiting a temporary ‘bubble’ in ISP share prices, hoping to negotiate a sale of the entire enterprise before the bubble bursts. Although this might be a legitimate business model in other contexts, it is not likely the model that regulators had in mind when designing a system of mandatory unbundling.

14.4 ISSUES FOR COMPETITION LAW

The economics of unaffiliated broadband ISP services that we detailed above depend in part on the price at which network access is provided to these ISPs by the network companies. Some of these 21

See EarthLink (2003, SEC Form 10-K, filed 15 March 2004, p. 19, citing average monthly churn in excess of 4 per cent).


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ISPs have alleged that incumbent telephone companies have engaged in price squeezes so as to preserve their market power in the downstream market.22 But do these incumbents have downstream market power that they could exercise against consumers? We begin by reviewing the conditions under which such a refusal to deal with ISPs could harm consumer welfare, and then relate those conditions to a price squeeze. Before subsidizing entry with mandatory access prices or nondiscrimination rules, regulators should carefully consider the gains associated with lowering the price for access to the telephone-company networks, which is called ‘DSL transport’. Based on our review of the value added of unaffiliated ISPs in Part III, we expect these gains to be small. To the extent that unaffiliated ISPs have no plans to evolve into facilities-based providers, a lower wholesale access price would not increase facilities-based competition at the margin. And to the extent that unaffiliated ISPs cannot afford to lower end-user prices, lowering the wholesale rate will not lead to lower end-user prices. Finally, as discussed below, neither DSL providers nor cable modem providers have attempted to monopolize broadband content,

22

A central question in antitrust jurisprudence and scholarship is whether, as a theoretical matter, predatory pricing is a rational strategy for a firm to undertake. A related question is whether, as an empirical matter, predatory pricing ever actually occurs. See, for example, Joskow and Klevorick (1979), who propose a two-tier test that courts could use to evaluate predation claims; Williamson (1977), who argues that, when firm behaviour is considered over time, predatory pricing is a viable strategy because predatory firms will be able to establish a credible predatory commitment, deter potential entrants, and recoup losses); Areeda and Turner (1975, who conclude (1) that sales below reasonably anticipated short-run marginal costs or average variable costs should be deemed predatory pricing, and (2) that predatory pricing is unlikely to succeed or be tried because a predatory firm will not be able to recoup its losses in most cases). Also see also Areeda and Hovenkamp (1999, pp. 224–230), who report recent judicial discussion of predatory pricing, as well as Lott (1999), who explains that while predation by private enterprises is implausible, predation by public enterprises is not.

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which suggests that even less restrictive policies, such as nondiscrimination rules for access to content, might not be necessary.

14.4.1 Price squeeze allegations

In 2002, PacWest, DirecTV Broadband, and XO Communications complained to the FCC that SBC’s monthly rate for DSL-based Internet access service in California had fallen to a level that was below SBC’s wholesale rate for last-mile access and ATM transport, and that this relationship created a price squeeze.23 These complaints raised questions of whether SBC’s wholesale access rate was too high relative to its retail rate for DSL customers. Clearly, a low DSL retail rate generates consumer welfare gains in the short run. The relevant policy question is whether, by forcing rival DSL providers to exit the market or operate more efficiently, the incumbent DSL provider could recoup lower short-term retail prices with higher retail prices in the future? To understand this allegation, we must study separately the factors that influence a DSL provider’s retail rate and its wholesale rate for DSL transport. If a DSL provider is setting its wholesale rate according to a variant of the efficient component pricing rule,24 then it charges a rate that preserves its profit margins when serving the end-user directly, equal to pr − cr − cw

(14.1)

where pr is the retail price for DSL, cr is the marginal retail cost of providing DSL to end-users, and cw is the marginal wholesale cost 23

PacWest Comments at pp. 26–29; DirectTV Broadband Comments at pp. 4–7. For a review of the efficient component pricing rule see Sidak and Spulber (1998, pp. 283–304). Efficient component pricing allows for the recovery of fixed costs as well, in which case the cost terms in the formulas would represent average variable cost.

24


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of DSL transport.25 The profits associated with selling DSL at the wholesale level is pw − cw

(14.2)

Setting (14.1) equal to (14.2) and solving for the wholesale rate yields pw = pr − cr

(14.3)

Hence, to maintain its profits, a vertically integrated DSL provider sets its wholesale access rate equal to the forgone retail margin. Assume that the unaffiliated ISP charges below the prevailing retail price for DSL and its marginal cost of retailing are kr . Then its profits can be written as pr − − pw − kr

(14.4)

Substituting (14.3) into (14.4) yields pr − − pr − cr − kr = cr − kr −

(14.5)

Equation (14.5) tells us that, unless the retail cost savings cr − kr generated by the unaffiliated ISP retailer exceed the reduction in retail price needed to lure the customer away from the incumbent DSL provider, there is no room for profit at the retail level for the entrant. Should this rival profit condition, which generally is not satisfied if there are economies of scope between the incumbent’s wholesale and retail activities, make the vertically integrated DSL provider liable for harming the competitive process? The answer to this question

25

Wholesale DSL service allows the retailer to use the ILEC’s transport facilities between the ILEC’s DSL equipment and the serving ATM switch. ISPs combine these services with other functionalities to offer end-user subscribers DSL-based Internet access services.

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depends on the extent to which a vertically integrated DSL provider wields power over its retail price of DSL, pr , or its retail costs, cr , in eqn (14.3), or both the retail price and retail costs. Clearly, the incumbent DSL provider has some influence over its retail costs. It could choose to advertise less, or it could choose to invest in technologies that would decrease its retail costs in future periods, but such considerations seem small compared to the potential effects of the incumbent’s power over price. If the incumbent is a pure price taker in the end-user market, then it would be difficult to manipulate its access pricing formula in such a way that unaffiliated ISPs would incur losses conditional on entry. By contrast, if the incumbent is a price setter in the end-user market, then it has some degree of freedom in foreclosing rivals. Of course, one could argue that the DSL provider, even if it lacks market power in the downstream market, is always free to cut its end-user prices in such a way that unaffiliated ISPs cannot earn a profit. But a firm without market power in the downstream market has no incentive to set its wholesale prices (equal to the retail price minus its retail costs) so that unaffiliated retailers will be driven from the market due to a price squeeze unless there are economies of scope in delivering other services to the retained customer. As Damien Geradin and Robert O’Donoghue note in their article on price squeezes, ‘both [price squeezes and pure predation] require that the conduct in question is likely to have an exclusionary effect on competitors; in particular whether the exit of rivals would allow profitable exploitation of market power in future [periods]’ (Geradin and O’Donoghue, 2005, n. 5). Hence, it would be irrational for an incumbent DSL provider that lacked market power in the downstream market to employ a price squeeze, because such a tactic, even if successful in discouraging retail-based DSL competition, could not induce exit by cable modem companies and other facilities-based providers. Stated differently, the incumbent DSL provider may lack the requisite market power to recoup its short-term losses in future periods by raising its retail price. These competitors would remain, depriving the incumbent DSL provider of any ability to raise the price of its DSL service.


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The short-term revenues lost from a price squeeze could never be recovered in future periods. Finally, the assumption of efficient component pricing requires that the access price and the retail price move in the same direction. Indeed, according to eqn (14.3), the derivative of the access price with respect to a change in the retail price is unity. If one relaxes that access pricing assumption, however, then it is possible to conceive of a strategy whereby the vertically integrated DSL provider increases its access price but maintains or even decreases its retail price. As Geradin and O’Donoghue explain, the profitability of such a strategy depends on whether the reduction in revenues from wholesale access can be offset by additional downstream customer revenues (see Geradin and O’Donoghue, 2005). This calculus depends on (1) the relative profitability of the wholesale and retail divisions of the vertically integrated DSL provider, (2) the extent to which the vertically integrated provider can capture the displaced customers, and (3) the value of other services that the firm offers these customers. However, because US cable modem firms and other facilities-based downstream rivals would capture a large share of these displaced customers – as of June 2004, the market share of US cable providers was 57 per cent (see FCC, 2004, Table 1) – DSL providers have less of an incentive relative to a downstream monopolist to exclude unaffiliated ISPs by increasing the access price only.

14.4.2 The conditions under which a price squeeze harms consumers

In the previous section, we explained why it is doubtful that incumbent DSL providers are acting anti-competitively by refusing to deal with unaffiliated retailers. If the unaffiliated retailer can provide the retail service at a lower cost, then the incumbent should voluntary enter into an agreement. Setting aside the issue of intent, it is still theoretically possible that the access pricing decision by the incumbent DSL provider, which might appear as a refusal to deal from the entrant’s perspective, somehow weakens competition in the retail

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sector, and thereby generates higher prices. Hence, we must evaluate whether the conditions for consumer harm are satisfied – even if the anticompetitive intent is lacking. Industrial organization economists have studied vertical restraints for several decades.26 Vertical restraints include several potentially anticompetitive strategies, including refusals to deal, exclusive territory contracts with buyers, tie-ins, exclusionary covenants not to sell to rival producers, and incompatibility of complementary products. Because a price squeeze is a special case of a general refusal to deal, the conditions under which a price squeeze might decrease consumer welfare are no different than the conditions under which a general refusal to deal might decrease consumer welfare. For several decades, economists rejected the notion that vertical restraints could result in incremental consumer harm. In the 1990s, a new school of thought emerged on the issue of vertical restraints that offered some exceptions to the traditional approach. Professors Janusz Ordover, Garth Saloner, and Steven Salop were the first economists to model formally the vertical foreclosure calculus (see, e.g., Ordover et al., 1990, pp. 133–142). Under certain conditions, the authors found that the diminished upstream competition caused by vertical foreclosure may increase the downstream market share of the integrated firm and support a higher downstream price and increased profits.27 More recent scholarship has refined the ‘raising rival’s costs’ models so as to narrow the circumstances under which policy intervention

26

For a review of the literature on vertical restraints during the 1980s see, for example, Tirole (1988, pp. 193–198). 27 Despite the fact that there is some degree of competition at both the upstream and downstream levels, an equilibrium with foreclosure can occur if: (1) the downstream firms’ revenues are decreasing in the price of the input (i.e., if the price of the final good does not increase as fast as the quantity demand of the final good falls), and (2) the nonintegrated upstream firms do not have sufficient incentive to raise prices to the nonintegrated downstream firms (otherwise, the nonintegrated downstream firms will lose so much share that they will have an incentive to merge with upstream firms).


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is warranted.28 There are two specific cases where the current analysis indicates that the need may exist, on grounds of consumer welfare maximization, for regulatory intervention to compel a vertically integrated firm to deal with a rival: market preservation or market extension. With respect to market preservation, in addition to a demonstration of market power in some relevant market, consumer harm depends on (1) network effects in the consumption of the complementary good and (2) the possibility that the unaffiliated downstream provider might eventually compete directly or indirectly in the upstream market (see Carlton, 2001, p. 668). For example, a producer of an operating system with market power might bundle its operating system with Internet browsers in an attempt to prevent middleware providers from evolving into rival operating system producers. A second case of potential consumer harm involves a vertically integrated firm attempting to extend its market power from the upstream market into the downstream market. The classic case is that of a monopoly resort, which ties the purchase of rooms to the purchase of meals, and thereby drives unaffiliated restaurants on the island out of business. Because the island natives do not rely on the resort for accommodations, those natives may be incrementally harmed by the resort’s policy to the extent that unaffiliated restaurants are put out of business. In addition to a demonstration of market power in the upstream market, consumer harm from market extension depends on (1) the existence of a set of customers who do not perceive the products in the upstream and downstream markets to be complements and (2) significant scale economies in the production of the complementary good (see Carlton, 2001, p. 666). The second condition could be generalized to include other economies such as economies of learning. 28

In the static foreclosure models, the advantage of the vertically integrated firm derives from its ability to force unaffiliated downstream providers to face market power in purchasing the upstream good, and the inability of the upstream and downstream unaffiliated firms to write an efficient contract (see Carlton, 2001).

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Even when these conditions for harm are satisfied, it is still possible that the benefits of vertical integration exceed the social costs. There are many benefits of vertical integration in network industries. Whenever the wholesale and retail markets are not characterized by perfect competition, vertical integration eliminates the so-called ‘double marginalization’ problem and thereby allows consumers to achieve the lowest prices possible. This stipulates that, so long as broadband ISPs must earn a margin, the end-user of broadband Internet access service will be subject to two markups: one by the broadband transport provider and a second by the ISP.29 Other benefits of vertical integration include the coordination of investment and production decisions, accountability of product quality, greater ability to offer bundled services, and the avoidance of the divisibility of intangible assets.30 For a competitive service such as broadband Internet access, these sources of cost savings are passed on almost one-for-one to the end-user. As explained earlier, most DSL providers do not possess market power in the market for broadband Internet access services and therefore cannot possess market power in any purported market for broadband transport.31 According to the FCC’s own data, RBOCs controlled less than 36 per cent market share in the provision of broadband Internet access services as of June 2004 (see FCC, 2004, Table 1). This serves as a valid proxy for an RBOC’s in-region market share in the provision of broadband transport given that competitors accounting for more than 57 per cent of the market (mainly cable operators) do not rely on an RBOC’s broadband transport. Although a large market share does not necessarily imply market power, a small market share surely implies the lack of market power. 29

Absent a nondiscrimination requirement, an RBOC would not impose a markup on its affiliated broadband ISP. 30 For a review of these benefits from vertical integration see Crandall and Sidak (2002). 31 This analysis in no way implies that there is a separate market for broadband transport. It is not necessary to analyze whether there exists such a narrow market because SBC would not have market power in that market.


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In particular, an RBOC does not have a sufficient base of customers to leverage infra-marginal gains from a price increase to offset the losses from marginal customers that would substitute to an alternative broadband network (see, e.g., Crandall et al., 2002). Moreover, some ISPs such as EarthLink also purchase broadband transport from cable companies such as Time Warner and Comcast,32 and are pursuing other alternatives such as fixed wireless networks.33 Hence, ISPs do not have to purchase broadband transport from the RBOC and therefore are not without a marketplace remedy for any excessive transport price. Because this market power condition is necessary for either case (market extension and market preservation), the ISPs’ claims of predation, even if true, would not result in consumer harm. Even assuming, contrary to fact, that an RBOC did possess market power in the provision of broadband transport, the facts still do not satisfy the necessary conditions for consumer harm for either market extension or market preservation. With respect to market preservation, an ISP is unlikely to try to leverage its position into the provision of broadband transport by investing in the requisite network infrastructure. Hence, eliminating those ISPs would not assist an RBOC in preserving any alleged market power in the provision of broadband transport services on a wholesale basis. With respect to market extension, there is no evidence that there are significant economies of scale in the resale of DSL service to end-users (the first condition).34 Unless some minimum viable scale is proven to exist – that is, a scale of operations below which an

32

EarthLink, Inc., Hoover’s Company Profiles, 2 June 2004 (‘The company, which has more than 1 million broadband subscribers, also offers cable access through an agreement with Time Warner Cable and over Comcast Cable’s system’.). 33 In 2002, EarthLink acquired the assets of wireless Internet access provider OmniSky. Id. In 2003, EarthLink funded trials of high-speed fixed wireless and power-line networks, including a test with Con Edison in New York (see Schoenberger, 2004, 46a). 34 This is not to say that there are no economies of scale in the provision of broadband transport.

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unaffiliated broadband ISP would be driven out of business – it would be impossible for an RBOC to induce exit by reducing the output of a broadband ISP. Finally, the ‘island natives’ condition does apply in the instant case (the second condition). Every DSL customer perceives the RBOC transport to be a complement to the DSL service. Unlike the island native who did not need the resort for accommodations, there does not exist a potential DSL customer that perceives the DSL transport to be superfluous to the consumption of DSL service. In summary, because none of the conditions for consumer harm is satisfied in the instant case, there is no legitimate economic concern. Refusing to deal with unaffiliated ISPs would neither protect an RBOC’s market position in the provision of broadband transport, nor enable it to acquire market power in the provision of broadband Internet access service.

14.4.3 The relationship between a price squeeze and cross subsidy

In this section, we analyse the relationship between a price squeeze and cross-subsidy. To the extent that a price squeeze requires downstream losses for the vertically integrated DSL provider, a crosssubsidy analysis might shed light on the source of the subsidy (see Geradin and O’Donoghue, 2005, p. 15 in notes).35 Of course, an unaffiliated broadband ISP might not be able to earn a profit due to its inferior cost structure, which implies that downstream losses for the vertically integrated firm do not always go hand in hand with a price squeeze. In 2004, EarthLink filed a complaint with the FCC alleging that SBC had engaged in a cross-subsidy. The complaint contained many

35

‘Applying a cross-subsidy analysis would therefore simply have the effect of requiring a competition authority or plaintiff to show that the source of the funds to support the downstream losses is the profitable upstream market, i.e., a causal connection, in addition to having to satisfy all the other conditions for a margin squeeze.’).


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of the same allegations of the earlier price squeeze complaints, including the claim that SBC’s retail price in relation to its wholesale access price did not allow unaffiliated ISPs to earn a positive margin. Interestingly, the cross-subsidy complaint did not contain an allegation of market power, on the apparent theory that crosssubsidy did not depend on proof of market power. As we explain below, however, a cross-subsidy claim relies on the existence of a regulated market, which is tantamount to proof of market power. In this section, we compare the two allegations from an economic perspective. Does a price squeeze imply that the incumbent DSL provider is setting its retail DSL rate below its average variable cost of providing DSL? Stated differently, whenever an entrant cannot earn a profit when reselling DSL service, must it also be the case that the incumbent cannot earn a profit when serving the end-user? Referring back to eqn (14.5), assuming efficient component access pricing, a price squeeze occurs whenever cr − kr − < 0. By comparison, a cross-subsidy occurs whenever the incumbent’s retail price for DSL service is less than the sum of the incumbent’s marginal wholesale and retail costs: pr − cr − cw < 0

(14.6)

Consider the case where the entrant is equally efficient, the incremental retail costs are zero cr = kr = 0, and the discount to lure a subscriber away from the incumbent is positive > 0. Clearly, the condition for price squeeze is satisfied. But is the incumbent incurring a loss to achieve the price squeeze? So long as the retail price for DSL exceeds the wholesale costs, condition (14.6) is not satisfied, as the incumbent earns a profit when serving the end-user. Hence, price squeeze does not imply cross-subsidy. If both conditions (14.5) and (14.6) are satisfied, then it must also be the case that pr − cr − cw < 0 < + kr − cr

(14.7)

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or after simplifying pr − cw < kr +

(14.7 )

Assuming that the entrant and the incumbent are equally efficient in terms of retail costs cr = kr , then eqn (14.7) simplifies further to pr − cw − cr <

(14.7 )

Equation (14.7 ) tells us that if the price squeeze and cross-subsidy conditions are both satisfied, it must be the case that, assuming an equally efficient rival, the price reduction needed to lure the customer away from the incumbent must exceed the incumbent’s margin when dealing directly with the end-user. Finally, efficient component pricing appears to negate the possibility that wholesale margins subsidize the retail service. Assuming efficient component pricing pw = pr − cr , eqn (14.6) becomes pw + cr − cr − cw = pw − cw < 0

(14.8)

Equation (14.8) tells us that if the incumbent is earning negative margins when dealing directly with the end-user, and if the incumbent is using efficient component pricing, then the incumbent must also earn negative wholesale margins. Hence, the use of efficient component pricing makes cross-subsidy from the wholesale division to the retail division impossible. Although cross-subsidy may be possible in the face of efficient component pricing, it cannot come from positive margins earned in the wholesale division. Several economists, including a former FCC cheif economist and current Professor at the Wharton School, and Gerald Faulhaber, have examined the theoretical conditions under which the prices charged by a multiproduct firm are subsidy-free (see, e.g., Faulhaber, 1975). There are two tests for the absence of a cross-subsidy: (1) the incremental cost test and (2) the standalone cost test. To satisfy the incremental cost test, incremental revenues from a service or a combination of services must exceed incremental costs of that service


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or combination of those services. To satisfy the stand-alone cost test, incremental revenues from a service or a combination of services must be equal to or less than the stand-alone costs of that service or combination of those services. Under certain conditions – namely, when revenues equal economic costs – the incremental cost test and the stand alone cost test yield the same answer to the question of cross-subsidy. It bears emphasis that DSL services are not subject to a binding regulatory constraint in which total revenues are equal to total costs. In particular, the sum of the revenues from an RBOC’s retail DSL services and its wholesale DSL transport services are not constrained by an overall regulatory revenue requirement. Although there are two tests for cross-subsidy generally, when applied to a nonregulated service, only one of the two tests – namely, the incremental cost test- is relevant (see Faulhaber, 2002, p. 3).36 Hence, in the context of DSL service, it is appropriate to invoke the stand-alone cost test as evidence of cross-subsidy.37 Even under the irrelevant stand-alone cost test that applies to a carrier subject to regulated revenue requirement, the incumbent carrier would need to replicate a large portion of its local telephone network – and therefore incur a large portion of its network costs – if it were to offer DSL transport in isolation. Hence, under that test, the complainant would have to provide evidence that the incumbent’s DSL service – either alone or in combination with other services – generates revenues that were in excess of its total network standalone costs. Under the more appropriate incremental-cost test for carriers not subject to a regulated revenue constraint, the complainant must be careful not to confuse the incumbent’s incremental cost of wholesale service with the incumbent’s price of wholesale access. To estimate the vertically integrated DSL carrier’s incremental cost of

36

‘The focus of cross-subsidy analysis shifts entirely to the [incremental cost] tests; the [stand-alone cost] tests are not helpful under conditions of positive economic profits’. 37 EarthLink Reply at 48 ¶ 52.

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wholesale service, it is necessary to estimate the stand-alone cost of providing local telephone service, wholesale DSL service, and retail DSL service, as there are shared costs in providing those services in combination. In particular, Faulhaber defines the incremental cost of providing a given service as the stand-alone cost of providing all services less the stand-alone cost of providing all services save the service in question (see Faulhaber, 2002, p. 1). Applied here, the incremental cost of providing DSL transport would be as follows: Incremental cost of DSL transport = Stand-alone cost of telephone DSL transport and retail DSL service less the Stand-alone cost of telephone service and retail DSL service

(14.9)

As eqn (14.9) makes clear, the complainant must calculate the standalone cost of providing all three services and the stand-alone cost of providing the two other services that share the same platform (retail DSL and local telephone service) to estimate the incremental cost of DSL transport. The incremental-cost test would be violated if, for any service, the retail price was less than its incremental cost. Finally, it is improper to add the incumbent’s price of DSL transport to the estimated average variable retail costs.38 The incumbent’s price for DSL transport is not relevant to the calculation of the incumbent’s incremental cost of providing DSL transport per eqn (14.9) because it exceeds the incremental cost of such service, and therefore does not inform the determination of whether the incumbent is pricing its retail DSL service below the incumbent’s incremental cost of providing DSL to the end-user. Stated differently, the issue is not whether the unaffiliated retailer can earn a sufficient margin to cover its own costs; the issue is whether the vertically integrated DSL provider is pricing its retail DSL service below its own incremental 38

Affidavit of Dr August H. Ankum on behalf of EarthLink, Inc. at 14 ¶ 26 (filed 12 July 2004) [hereinafter Ankum Aff.]


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cost of providing retail DSL service. But even when satisfied, the incremental cost test, like the price squeeze test (and the attribution test in the bundled rebate literature), does not provide any information about whether consumers are harmed. As explained above, consumer harm depends on a different set of criteria (such economies of scale in DSL retail or the likelihood that a pure reseller might evolve into a facilities-based carrier), which determine whether the unaffiliated retailer constrains, either currently or in the future, the end-user price of DSL. Unless those other criteria are established, the consumer harm associated with the alleged cross-subsidy or a price squeeze is zero.

14.5 CONCLUSION

In a purely deregulated, competitive environment, unaffiliated broadband ISPs would likely suffer the same fate as other intermediaries in the Internet age. ISPs have existed, in large part, because DSL providers were obligated to sell critical economic inputs below cost, forced to comply with costly and burdensome regulations, and prevented from offering certain valuable services to customers. The removal of those obligations should not create an antitrust obligation for DSL providers to keep unaffiliated ISPs on economic life support in the broadband era. We have demonstrated that a price squeeze might occur even when incumbent DSL providers lack any anticompetitive intent or market power. The cross-subsidy allegation deserves the same level of economic scrutiny as its price squeeze cousin. Because the conditions for consumer harm are not satisfied in the case of broadband Internet access, and because ISPs do not offer any value-added in the broadband era, regulators should not be overly concerned with generating synthetic retail competition. Competition between facilities-based high-speed Internet providers should be sufficient to maximize consumer welfare. Lowering the wholesale rate for DSL transport would not stimulate facilities-based entry by ISPs, nor would it lower end-user prices, as unaffiliated

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ISPs cannot afford to decrease prices given their customer acquisition costs and, even if they lowered their prices, DSL providers would not likely respond. Finally, less invasive approaches such as nondiscrimination provisions are likely unnecessary, as neither DSL nor cable modem providers appear interested in monopolizing broadband content.

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Index abuse (of market power) 2, 8, 31, 329–31, 342, 347, 411 ACCC 18 access charge (or access price) 3, 8–14, 16, 18–20, 22–3, 25, 27–8, 32, 47–8, 52–4, 56, 66, 68–71, 78, 81, 84, 94, 96, 99, 114–15, 123, 128–30, 133, 150–2, 160, 167, 201, 229–30, 254, 400, 406, 423–4, 439, 441, 445 access charge (or access price) and entry 8, 11, 20–3, 66–71, 75–6, 78–9, 81–4, 87, 181–2, 305, 424 Access Directive 96, 330, 334, 351, 375 access fee 12, 15, 19–20, 23–4, 84, 150–4, 159–60, 164–8, 170, 172–3, 201, 433 access holiday 19–20, 43, 58, 60–2, 414 access obligation 309–10 access regulation 9, 18–19, 42–3, 46, 49, 52, 60–2, 94, 97, 356, 374 airports 5 allocative efficiency 7, 9, 12, 18, 34, 331, 383 antitrust 4, 31, 327–9, 331–41, 343, 346, 348–50, 354–7, 358–62, 363–4, 441 appropriability 389–90, 392, 394, 402, 405–7, 417

asymmetric information 69, 85 asymmetry 22, 149–53, 160, 167–8, 285, 360, 393 ATM 3, 5, 7, 180, 218, 431, 442–3 Australia 18, 277, 292, 310–11 Austria 304, 311–12, 339, 342, 366 balanced calling patterns 23, 123–4, 134, 136–8 barriers to entry 3, 98, 150, 333, 350, 358, 360, 376–7 Baumol–Willig rule 11 Bertrand competition 29–30, 153, 242, 306, 316, 319, 321–2 book depository function 93 bottleneck 2, 6–7, 10, 12, 18–19, 28, 31, 42, 66, 150, 168, 283, 356, 359 broadband 22, 31–4, 92–4, 96–9, 115, 180, 333, 342–3, 351–4, 379, 395–6, 410, 422, 424, 430, 432–42, 448–50, 455–6 business-stealing effect 393–4, 405 bypass 12, 51, 66–7, 70 calibration 280, 292–3 caller pays (CPP) 283–4 Canada 311 capacity-based pricing/price 15–16 capacity constraint 16, 27, 255, 258 captured customers 22 carrier select 92, 97, 168

462 cartel 26, 243–6, 343, 378, 395 collusion 8, 23, 25, 31, 122–3, 129, 132, 145–6, 152, 181–2, 212, 217, 316 Colombia 28–9, 278–9, 285, 290, 292–4, 299–300 common cost 13–14 Comparatively Efficient Interconnection (CEI) 426 competition law 17, 32, 328–31, 332–3, 339, 345, 349–50, 360–3, 364, 375–7, 440 competitive equilibrium 380–1, 384, 388–9 competitive fringe 93–4, 112 consumer surplus 24, 34, 45, 52, 72, 76–80, 151–2, 154, 157, 159–61, 164, 167–8, 173, 175, 198, 224, 279, 296–300, 383–4, 390, 402 consumer welfare 34, 332, 357, 423–4, 441–2, 446–7, 455 coordination 236, 247, 328, 358, 362–4, 399, 424, 448 cost allocation 57 cost asymmetry 22, 149, 151, 153, 160 cost-based regulation 15, 32, 396, 406–7 Cournot competition 29, 254, 305, 313–16, 319–22 Court of Justice 337–9, 355, 362 coverage 23, 123–4, 127, 134–8, 151, 168, 304 creative destruction 32, 355, 380, 382 credit cards 25–6, 180, 218, 230, 232–3

Index cross-nested logit 24–5, 181 customer heterogeneity 145 deadweight loss 62, 112, 383–4, 389 deregulation 3, 150, 354, 357, 364, 455 derived demand 198, 397 discrete/continuous consumer utility 44, 100, 182–4, 186–8, 190, 192–3, 216, 218, 296 discrimination 6, 11, 16, 111–13, 145–6, 168, 199, 252, 268–70, 390, 401 DSL (digital subscriber line) 31–4, 92, 96, 98, 342, 379, 395–7, 400, 404, 406–7, 410, 423, 432–3, 439–45, 448–51, 453–6 dynamic efficiency 7, 9, 18, 32, 34, 322, 394, 405–7, 412, 414, 417 efficiency 7, 9, 12–13, 15, 18, 20–1, 32, 34, 42, 114, 252, 261, 263, 268–9, 281, 308, 322, 333, 349–50, 381, 384, 388, 391, 394, 402, 405–7, 411–12, 414, 417, 427, 430 efficient component pricing rule (ECPR) 11–13, 27, 70, 82, 94, 263–4, 442, 445, 452 efficient entry 71, 82, 84 electricity 2, 5–6, 66, 92–3, 115, 272 emerging markets 32, 346, 354, 377–8

Index entry 3, 8, 12, 16, 20–1, 23, 29–30, 34, 67–71, 73–6, 78–9, 81–5, 87–8, 92, 94–5, 97–8, 114, 150, 167–8, 180, 304–5, 310–11, 313, 321, 333, 346, 349–50, 355, 358, 360, 376–7, 379, 388, 393, 406–7, 418, 424, 441, 444, 455 entry barriers, see barriers to entry essential facility/essential input 2–6, 8, 11, 66–7, 92–4, 99, 105, 122, 265 Europe 3, 21, 31, 96–7, 232, 277, 345, 356, 409 European Commission 31, 94, 96–7, 99, 304, 310, 315, 332, 335, 365, 375, 418 European Regulators Group 11, 333–4, 335, 339 ex ante 2, 12, 17, 33, 67, 70, 232, 246, 328–30, 336, 345–6, 350, 366–7, 374–8, 388, 400, 403, 406–7, 417–18 ex ante competition law 330–2, 345–8 cases 345 remedies 346 ex ante regulation 2, 33, 333, 350, 374–8, 407 ex post 17, 54, 70, 328–31, 335, 339, 343, 348, 367, 403, 406 ex post competition law 331–3, 339–43 cases 341 objectives 330–2 price squeeze 343–4 remedies 343, 346–50, 352, 359

463 external calls 23, 123, 126–7, 131, 133–5, 140, 145 fast-second innovator 393 FCC 14, 98, 422, 425–7, 435–6, 442, 445, 448, 450, 452 financial securities trading 93 first-mover advantage 68, 321, 347, 377–8 fixed cost 9, 13, 25, 30, 67, 69, 125, 153, 164, 200, 202, 204–5, 230, 233, 237, 241, 265–8, 271, 294, 314–16, 319, 388, 399, 442 fixed-to-mobile termination 28, 278, 280, 282–3, 285, 289, 294–5, 299, 300–1 foreclosure 8, 16, 33–4, 66, 68, 446–7 France 311–12, 345 free-rider behavior/free riding 398–401, 406, 418 full coverage networks 123–4, 134–8 gas 2, 5–6, 16, 27–8, 251–6, 258, 261–74, 274–5 Germany 67, 310–11, 342, 345, 349, 367, 374, 377–8, 384 hold-up problem 390 Hong Kong 306, 310–11 imperfect competition 59, 93, 114–15, 254, 281, 400 infrastructure-based competition 354, 406, 407, 414–16

464 innovation 9, 12, 18, 32–3, 42, 310, 355, 358, 380–90, 391–2, 408–12, 418 institutional design 335–9, 357, 362 internal calls 126–7, 131–2, 135, 140, 144, 145 Internet 21–2, 24, 31, 33–4, 92, 94, 96–101, 105, 115, 168, 328, 341, 345, 396, 405, 422, 424, 430–40, 442, 447–50, 455 investment 5, 9–10, 12, 14, 15, 18–20, 22, 32–3, 41–63, 93, 95, 105–6, 114, 115, 253, 265, 272, 304–5, 310–11, 322, 349, 352–3, 357, 374, 378–80, 384–91, 395–407, 411–12, 414–18, 424, 434, 448 investment incentives 10, 15, 18, 20, 32–3, 42–3, 62, 93, 95, 105–6, 305, 311, 322, 378–9, 402–4, 405–7, 411, 414–17 isotropic calling pattern 136 ISP (Internet service provider) 31, 33, 396, 421–56 Italy 329, 342 Japan 277, 386 ladder of investment 310, 352, 354, 374, 406 Latin America 278–80 leap-frog technology 393 legacy network elements 404 level playing field 353, 393–4 liberalization 2–3, 68, 330, 343, 345, 347, 374

Index linear retail prices 23, 122, 124–33, 151 local access networks 92, 98, 180, 209, 218, 343 local loop 5–6, 14, 18, 21–2, 66, 91–116, 168, 341, 346, 351 long-run incremental cost (LRIC) 10, 13–15 mandatory access 4, 95, 311, 423, 441 market definition 329, 351, 378 market failures 358–60, 377, 387–9 market power 2, 4, 8, 12–13, 31, 33–4, 71, 84, 93, 96, 101, 112–14, 150, 208, 261, 265, 283, 329, 331, 346, 354, 358, 360, 375, 377, 379, 391, 408, 415–16, 418, 441, 444, 447–9, 451 market structure 18, 20, 30, 45, 66–71, 81–2, 83–5, 99, 243, 254, 329, 333, 361, 392, 394, 398, 401, 408, 413, 417 media 3, 17, 229–30, 347, 375 Mexico 279 mobile network operator (MNO) 29–30, 286, 292–3, 303–22 mobile penetration 28, 278–82, 294–6, 300, 310 mobile telecommunications 3, 7, 22, 27, 28, 30, 168, 279, 282, 287–8, 295, 304, 306, 307, 313, 315, 316, 320 mobile termination 7, 28, 277–301, 342, 344

Index mobile virtual network operator (MVNO) 29–30, 304, 306–7, 312 monopoly 6, 8–13, 19–20, 27, 32, 42–6, 56, 61–2, 74–5, 79–80, 83, 85, 87, 97, 107, 109–11, 142, 150, 158, 163, 180–1, 210, 259, 261, 263–5, 267, 270–5, 278, 281–4, 319–20, 334, 350, 355, 358, 364, 374, 381–2, 384, 387–8, 390–2, 394–5, 414, 418, 424, 447 multihoming 4, 24–6, 229–47 MVNO access 306, 310–11, 316, 318, 322 National Competition Authority 335 National Regulatory Authority 150, 374, 377 natural monopoly 2, 5–6, 8, 13, 16, 18, 42, 150, 254, 265 net surplus 139–41, 143–4, 156, 159, 161–2, 164, 172–3, 197 Netherlands 68, 311, 313, 345 network effects 31, 347, 360, 398, 399, 447 network externalities 199, 230, 232–3, 236, 359 network interconnection 151, 160, 167, 180–1, 199, 216 network interconnection competition 151, 160, 167, 181, 199 new markets 31–3, 351, 377–9, 381, 390, 393, 406, 407–16, 418 new regulatory framework 95, 333, 334, 373–418

465 New Zealand 292, 310–11, 363 nonconcavity 72, 85 nondiscrimination (in access) 66, 73, 96, 111, 199, 230, 252, 255, 270, 334, 352, 441–2, 448, 456 nonlinear retail prices 23, 124, 138, 146 North America 232 OECD 16, 300 Ofcom/Oftel 66, 306, 343, 356 off-net call 154, 163, 199, 202–3, 218 on-net call 136, 154, 163, 201–3, 218 one-way access 6, 18–22, 27, 31, 91–116, 122, 254, 360 open access 422–3, 435–7 Open Network Architecture (ONA) 426–7 penetration rate 21, 29, 279–80, 286–7, 291, 293, 294–5, 297, 300 pipelines 5, 6, 252, 254, 256, 438 platform adoption 242, 247 platform competition 25, 229–47 postal markets 68, 92 postal service 5, 7 pre-emption 47–9, 51, 55–6, 58, 403, 405, 417 predation 341, 342, 424, 441, 444, 449 premium content 422 price cap 9–10, 15–16 price discrimination 6, 16, 111, 145, 199, 270, 390

466 price squeeze 33–4, 99, 341–3, 344, 356, 422–4, 441, 442–55 privatization 2 product differentiation 21, 30, 153, 279, 285, 305, 307, 316, 317, 319, 321, 322 productive efficiency 7, 9, 12, 20, 34, 331 public fund 69–70, 72, 74–5, 78–9, 83, 259 radio spectrum 304 rail 2, 5–6, 66–8, 265, 272, 328 raise-each-other’s-cost effect 122–3 raising rivals’ cost 8, 34, 446 Ramsey pricing/price 8, 9, 20, 23, 28, 70–1, 94, 114, 268, 271, 272 reaction curves 123, 128–9, 132–3, 135–6, 138, 170–2 receiver pays (RPP) 280, 283–4, 301 reduced-form approach 23, 124 RegTP 374, 378 regulatory framework 28, 31–2, 95, 304, 332–5, 338, 351, 362, 373–418, 429 relevant market 150, 331, 333, 356, 377, 396, 447 remedy 96, 334, 347, 352, 449 rent-seeking 391 replacement effect 403, 405 retail-minus 11 retail price 2, 10, 11, 13, 16, 22, 23, 29, 71, 94, 100, 102, 107–8, 111–12, 114, 122, 123, 124–33, 138–41, 145–6, 151, 155–6, 159, 163, 181,

Index 199, 210, 277–8, 294, 295, 321, 424, 439, 442–5, 451, 454 roaming 7, 304, 308, 314–15, 341–2, 351–2 sector enquiry 340 sector regulation 328, 329, 332, 338, 347, 350–7, 358–60, 364 bottlenecks 2, 6, 7, 10, 12, 18, 19, 28, 31, 42, 66, 150, 168, 283, 356–7, 359 burden of proof 17, 329, 361, 364 ladder of investment 310, 352, 354, 374, 406 objectives 20, 330, 332, 347, 354, 355–6, 364 relevant markets 150, 331, 333, 356, 376, 377, 396, 447 remedies 17, 66, 96, 331, 333–5, 343, 346–7, 352, 365, 366–7, 374 sector-specific regulation 31, 327–68, 374, 376–7, 407 service provider 29, 31, 33, 154, 307–10, 312, 316, 396, 399, 401, 403, 422, 424, 427–8, 430–2, 437 significant market power (SMP) 4, 31, 33, 96–7, 150, 329, 331, 334, 338, 353, 369, 376, 407–8, 413–16, 418 simulation 25, 26, 83, 151–2, 158, 159, 172, 182, 209, 213, 233, 242–6, 279, 292, 294–5 single tariff 65–88 SMP test 33, 376, 407–8, 413–14, 418

Index social surplus 7, 52, 60, 392, 394 Spain 312, 315, 342, 345 SSNIP test 409, 411, 412 Stackelberg competition 21, 29–30, 73, 306, 320–1 strategic complements 23, 111, 128, 129, 130–2, 141, 170 strategic substitutes 129, 130, 132, 273 structural separation 343, 423, 426 subscriber charge 23, 139, 141–2, 144–6 subscription decisions 123, 125–6, 135, 140, 185 subsidy 53, 164, 281–2, 429, 450–5 sunk cost 5, 14, 60, 114, 153, 358, 400 superelasticity 71 supermodular 130, 142, 170 switching costs 101, 135, 358, 360, 404 Switzerland 312, 313 symmetric 19, 24, 59–60, 105, 113, 124, 130, 138, 151–2, 159–60, 165–8, 207, 210, 212, 214–15, 233–4, 237, 243, 245, 256, 260, 279, 294, 313–14, 395 telecommunications 2–3, 5, 6, 7, 14–18, 21–2, 24, 27–8, 30, 32, 42, 66, 68, 92–3, 95, 97, 101, 111, 114–15, 121, 149–75, 180, 211, 272, 303–4, 306, 311, 313–16, 322, 337, 340, 343, 359, 373–418, 425, 427, 428, 430, 440

467 Telecommunications Act 14, 17, 97, 427–8 TELRIC 14 Terminal Railroad 2, 4 termination 5, 7, 8, 23–4, 28–9, 95, 145, 150–1, 153–4, 160, 164–5, 168, 172–3, 199, 206–8, 210, 277–301, 342, 344, 351–2, 428–9 termination charge 28–9, 150, 278–84, 289–90, 293–301, 342, 351, 428 third-party access 66, 271 transaction cost 7, 231, 234, 241, 247 TSLRIC 14, 70 two-part retail tariffs 24, 124, 139, 142 two-part tariff 15–16, 20–1, 43, 46, 52, 67, 69–70, 73, 75, 76–9, 82–3, 115, 124, 142, 151–2, 160–7, 198, 279, 285, 299, 314 two-sided market 9, 24, 25, 231–2, 241, 246, 247, 355, 360 two-way 4, 7, 8, 10, 22–4, 31, 101, 122–4, 128, 138, 146, 151, 168, 180, 216, 360–1 two-way access 4, 7, 8, 10, 22–3, 31, 101, 122–3, 151, 168, 180, 360–1 unbundling 10, 18, 21–2, 28, 92–9, 114, 116, 168, 265, 342, 440 United Kingdom (UK) 66, 68, 277, 280, 306, 310, 312, 336, 343, 356, 366, 368

468 universal service obligation 68 USA 232, 310, 312, 436 usage fee 16, 123, 139, 141–4, 146 vertical integration 254, 396, 398, 401, 448 vertical separation, see structural separation

Index voice over Internet protocol (VoIP) 21, 94, 96, 115–16 water 5, 272 welfare analysis 280, 285, 294–9 wholesale price 2, 11, 94, 439, 444 X-inefficiency 390, 394

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