Two central questions

1. Issues in TelecommunicationsTTMG 5003TCurrent Issues in telecom (II) - RegulationMarch 25, 2008John Callahan, PhD

2. Two central questions • What is the role of government in telecom? • How should governments act towards the issue of network neutrality? Issues in Telecom

3. Articles and chapter for March 25 • Anthony, Scott D., Erik A. Roth and Clayton Christensen (2002) The Policymaker’s Dilemma: The Impact of Government Intervention on Innovation in the Telecommunications Industry • Arthur, W. Brian (1996) Increasing Returns and the New World of Business • Liebowitz, S.J. and S.E. Margolis (1990) The Fable of the Keys • Ryan, Michael J. (2004) Fahrenheit 94-19?; or Rethinking the Way We Regulate Telecom Issues in Telecom

4. Five important costs definitions • Fixed cost – the cost that does not depend on output level • Variable cost – the cost which would be zero if the output level were zero • Total cost – the sum of fixed and variable costs • Average cost – total cost divided by output level • Marginal cost – the cost of one additional unit • the total cost of producing n+1 units minus the total cost of producing n units • Good reference: Cabral, Luis M.B. (2000) Introduction to Industrial Organization, The MIT Press Issues in Telecom

5. Marginal and average costs are a function of the output level of a company marginal cost $/unit economies of scale average cost dis-economies of scale units of output (by company) Issues in Telecom

6. A monopoly can occur when costs are minimized with one supplier only • Average costs continuously fall as the company gets larger • Examples of natural monopolies? • Road transportation networks? • Road construction? • Electrical power distribution? • Electrical power generation? • Telecom service delivery? • Computer operating systems? Issues in Telecom

7. Do natural monopolies exist? • Therier, Adam (1994) Unnatural monopoly: Critical moments in the development of the Bell system monopoly. CATO Journal, 14(2), 267-286. • "One of the most unfortunate phrases ever introduced into law or economics was the phrase 'natural monopoly.' Every monopoly is a product of public policy. No present monopoly, public or private, can be traced back through history in a pure form. 'Natural monopolies' in fact originated in response to a belief that some goal, or goals, of public policy would be advanced by encouraging or permitting a monopoly to be formed, and discouraging or permitting a monopoly to be formed, and discouraging or forbidding future competition with this monopoly.“ • Therier traces the development of the AT&T monopoly in the States and attributes it to government policy decisions Issues in Telecom

8. Network externalities are not new, but are more important than ever • Externalities • Positive: benefits accrued but not paid for • Negative: costs not born by originator of cost generating activity • Examples • Polluter of a river who does not pay for cleanup • Intensive health care received in the Canadian system • Network externalities • Benefits (or costs) that accrue to the members of a network because of the activities of others in the network • The network can be virtual • Examples • Fax machines, the Internet, diesel car owners, Windows users Issues in Telecom

9. Increasing returns are found in many tech markets for three reasons (Arthur 1996) • Up-front costs (economies of scale) • High initial fixed costs and low variable costs lead to decreasing average costs, i.e., economies of scale • Network effects (positive network externalities) • Individual users benefit from the increase in the number of users • Customer groove-in (customer lock-in) • Technology products typically difficult to use • There is an expensive learning curve • Customers do not want to switch • Customers don’t abandon the product easily Issues in Telecom

10. Decreasing return and increasing return economies are fundamentally different • Decreasing returns • Competitive pricing for (commodity) products • Dis-economies of scale (e.g., coffee farmers using higher ground) • No abnormal returns (rents) • Stable equilibrium • Increasing returns • Differentiated products and product pricing • Economies of scale - decreasing average costs • Positive network externalities • Abnormal returns • Unstable equilibrium • Tipping, winner-take-all markets Issues in Telecom

11. Increasing returns economics leads often to quasi-monopolies in market layers • Computing • Microsoft • Intel • ??? • Will telecom layers end up being monopolized by a single firm? Issues in Telecom

12. Do customers need to be protected from lock-in due to positive returns? • The fable of the keys – Liebowitz and Margolis (1990) • The fable • QWERTY is an inferior keyboard layout - slower • Adopted to slow down fast typists in the early days of typewriters • Positive network externalities to use of QWERTY • Customer lock-in to an inferior standard • The fact • QWERTY not slower • Customers are not locked in - especially now with electronic keyboards • The moral of the story • Customer lock-in is not as significant problem as many assume • How does the story apply to Windows? Issues in Telecom

13. Market power is the ability to sell at a price substantially above cost • Market concentration • concentration ratio • percentage of all sales contributed by the leading three or five firms in a market • Herfindahl index – sum of square of market shares • example: S1 = 56%, S2 = 33%, S3 = 11% • Herfindahl index = 0.562 + 0.332 + 0.112 = 0.44 • Monopoly > 0.6 • Oligopoly 0.2 – 0.6 • Perfect Competition < 0.2 • Theory says that market concentration leads to market power • Much regulation is aimed at blunting market power Issues in Telecom

14. Market failure and regulatory response • Pareto efficiency • An allocation of goods or income among individuals is Pareto efficient if there is no other allocation that can make at least one individual better off without making any other worse off • A market fails if it does not allocate goods or incomes Pareto efficiently • Causes • Market power • Externalities innate to the market • Public goods • Consumption of the good by one individual does not reduce the amount of the good available for consumption by others; and no one can be effectively excluded from using that good (e.g., law enforcement, clean air) • Potential responses by the state to market failure • Live with it • Regulate • Nationalize (or enter the market, e.g., Petrocan) Issues in Telecom

15. There are many forms of telecom regulation • Prescribed offerings • Universal service requirements • Service quality requirements, standards • Unbundling access to facilities • Geographic scope limits • RBOCs • Bell Canada in Ontario and Quebec • Business line limits • RBOCs kept out of long distance before 1996 • Limits on cross-subsidization, anti-trust and competitive policies • Price maximums • Limits on local connection charges • Tend to be reduced if costs lowered significantly • Profit maximums • Rates of return maximums • Become minimums as well Issues in Telecom

16. Product pricing is regulated for all companies • Price discrimination • Charging different customers different prices for essentially the same product • Price differentiation is natural and not illegal • Airline ticket sales • Book prices in India • U.S. Robinson-Patman Act of 1936 • Price discrimination is illegal if it “effectively lessens competition” • Three primary legal arguments that render most price discrimination immune from successful legal challenge • You are allowed to set lower prices that result from lower costs • You are allowed to set differential prices to meet the competition • Differential pricing is questionable only if it “lessens competition’ • Predatory pricing – against the law • Practice of cutting prices below marginal cost to drive out competition so that prices can subsequently be raised again Issues in Telecom

17. Rethinking the way we regulate telecom (Ryan 2004) • CRTC stuck between regulation and competition • Achievement of a fully competitive market is one of nine objectives for the CRTC under the Telecommunications Act • The Act is built on a presumption in favor of regulation • Everything is regulated unless and until the Commission decides to "forbear“ • By contrast, the EU reverses the presumption • Permits regulation only where it can be demonstrated that a lack of effective competition requires regulatory intervention • Limits that intervention to what is necessary to remedy the problem identified. Issues in Telecom

18. All companies are regulated by competition policy provisions • U.S Sherman Act of 1890 • Illegal to “monopolize” a market • U.S. Clayton Act of 1914 • Prevents mergers likely to “substantially lessen competition” • U.S. FCC regulations refer to the “public interest” • Government can respond to monopoly in four ways • Do nothing, its is not illegal to have a monopoly only to “monopolize” • Attack the monopoly (Microsoft) • Directly regulate the monopoly (telecommunications) • Nationalize Issues in Telecom

19. Politicians have asymmetric incentives as regulators • Regulation often brought in during periods of economic crisis • Politicians often seen as addressing a pressing problem if they increase regulation • Significant political gain • Long term costs to producers and consumers either not clear, or not primary during period of crisis • Little political cost Issues in Telecom

20. Motivation and ability – fig. 7(Scott, Roth and Christensen 2002) Issues in Telecom

21. How government affects innovation(Scott, Roth and Christensen 2002) • Shapes incentives, modifying motivation • Rate of return regulation lowers motivation • Price caps raise motivation • Controls access to resources, affecting ability • Public policy rights, trade policy • Spectrum control • Creates or releases barriers to customers, affecting ability • Controlling ability of new entrants to access customers • minimum standards prevent innovators offering simple poor performing technologies to less demanding customers over the PSTN • Controlling ability of incumbents to offer new products to their customers • AT&T not permitted to sell voice mail services in the 70s • Affects the natural progression from interdependence to modularity, affecting ability and modifying motivation • Forced access to local loop • Late arrival of CPE to the system Issues in Telecom

22. Motibility framework - fig. 10 (Scott, Roth and Christensen 2002) Issues in Telecom

23. 5 important issues in using the motibility framework • Increasing motivation – interpreting signal from noise • If the gov’ts address market noise, “artificial” motivation can result • “Artificial” motivation can encourage gaming or other unintended consequences • Gov’ts and capital markets need patience to allow artificial motivation to morph into actual motivation • The double edged sword of motivation • Asymmetry: increased motivation for one class of companies decreases motivation for others • Giving ability – useful? • Without motivation, granting ability is useless • With motivation, entrepreneurs develop abilities Issues in Telecom

24. 5 important issues in using the motibility framework (cont’d) • The modularity test – blocking • If modularity has not arrived yet, new entrants at a disadvantage • Big difference between legal and technical abilities • What to do in a dilemma? • Efforts almost always fail • Concentrate on 1 or 2 underlying problems, hope that entrepreneurs find a way around other problems • Create policies that accelerate disruption – allow firms to move from adjacent markets (i.e., do nothing) Issues in Telecom

25. What position should the government take on network neutrality? Issues in Telecom

26. What, if any, role does regulation play in open source? • Revisit previous overheads and ask this question Issues in Telecom

27. Next • Gate 0 thesis proposal presentations • Tuesday April 1 and 8 • Exam review sessions • Tuesday April 15 • Exam • Saturday April 19 • Deadlines for business plan and Gate 0 proposal write-up? Issues in Telecom