Europe Economics’ View of Costs of Mobile Networks: Oftel’s Response

1. Europe Economics’ View of Costs of Mobile Networks: Oftel’s Response Geoffrey Myers Senior Economic Adviser, Oftel ONP Committee Meeting, 10 April 2002 1

2. Europe Economics’ View • One key aspect of Europe Economics’ report is addressed…. • Cost of coverage is a large ‘joint cost’ • ‘common cost’ in Oftel’s terminology • implies major issue about economically efficient recovery of common cost across different mobile services 2

3. Summary of Oftel’s Rebuttal • Properly analysed, joint/common costs are small • EE’s approach is contrived and leads to highly misleading cost figures 3

4. Mobile Network Costs - Some Key Features 4

5. Radio Network • Underlying cost function of the radio network is constant returns to scale • eg to double traffic capacity in an area, double number of sites and costs • Capacity added in modular ‘lumps’ 5

6. ‘Coverage’ Costs (i) • “Coverage is the capability or option to make a single call from any point of the network at a point in time” • EE report, page 21 (emphasis added) • Great majority of so-called ‘coverage’ costs provide traffic-handling capacity • more than 80% (in UK) 6

7. ‘Coverage’ Costs Capacity costs comprise: macrocell equipment (by far largest part of costs), TRXs, backhaul, BSCs etc Source: Oftel’s LRIC Model, 2001 7

8. ‘Coverage’ Costs (ii) • So-called ‘coverage’ costs only large because of modularity of initial traffic capacity deployment • In absence of modularity, such capacity costs of ‘coverage’ would be (approx) zero for coverage purposes 8

9. ‘Coverage’ Costs (iii) • So contrived and misleading to treat initial traffic capacity as coverage costs or as joint/common costs • Should be treated as being incremental to traffic • in same way as all other traffic capacity 9

10. Europe Economics’ Contrived View 10

11. Costs of Base Station Capacity (simplified but realistic view) Cost 20 Cost of minimum capacity deployment Apparent LRIC origination (5) Apparent LRIC termination (5) 15 15 20 Traffic origination volume (10) termination volume (10) Note: Simplifications are use of illustrative figures; and smoothing modularities beyond initial capacity deployment. 11

12. Overstated Common Costs (i) • Europe Economics’ approach: • LRIC of each of origination and termination is apparently 5 • joint/common costs are apparently 15, given by cost of coverage • So adding up these costs gives 25 • 5 + 5 + 15 • But total cost is only 20 12

13. Overstated Common Costs (ii) • So, even accepting EE’s approach, size of joint/common costs is less than costs of coverage • equals 10 not 15 in illustrative example (10 = 20 - 5 - 5) • But even this revised level of joint/ common costs is highly misleading…. 13

14. Apparent Average Incremental Cost Below Marginal Cost (i) • Europe Economics’ approach: • LRIC of each service is apparently 5 • so LRAIC is apparently 0.5 (= 5  10) • But marginal cost is 1 • at traffic levels beyond 15 • MC greater than apparent LRAIC 14

15. Apparent Average Incremental Cost Below Marginal Cost (ii) • Marginal cost above average cost seems to imply diseconomies of scale • But there aren’t! • False implication suggests fundamental flaw in analysis 15

16. Marginal Cost Pricing • In example, if prices set equal to marginal cost, all costs would be recovered • So there would be no fixed, joint or common costs 16

17. Common Costs and Traffic Levels (i) • Where traffic levels are above the minimum capacity… • Capacity cost of coverage does not give rise to any fixed, joint or common costs • ie marginal cost pricing gives full cost recovery • What happens in practice? 17

18. Common Costs and Traffic Levels (ii) • In UK mobile networks most base station sites are traffic-driven • All (or nearly all) in Vodafone’s and Cellnet’s networks • Still some coverage-driven rural sites in networks of Orange and One2One • but rural sites are only about 20% of total sites 18

19. Conclusions 19

20. Summary of Conclusions (i) • Long run marginal cost close to average cost in UK mobile networks • so marginal cost pricing gives (close to) full cost recovery • Joint/common costs between services are small • eg 5% or less in 900 MHz networks • Not surprising since radio network displays constant returns to scale 20

21. Summary of Conclusions (ii) • EE’s analysis is contrived and misleading view of costs • fails to recognise that >80% of so-called ‘coverage’ costs are costs of traffic 21

22. Oftel Papers • For further details, see Oftel papers to Competition Commission inquiry into Calls to Mobile • Network Common Costs • Oftel’s Response to Operators’ Comments on Oftel’s LRIC model • http://www.oftel.gov.uk/publications/mobile/ctm_2002/index.htm 22

23. Oftel’s Mobile Network Cost Model • Available at http://www.analysys.com/ukmobilelric • Model in Excel 2000 • Documentation Calls to Mobile\ONP_10April_slides_final 23