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WORKSHOP ON NETWORK INTERCONNECTION and COMPETITION

Goethe Universität Frankfurt am Main – May 22-23, 2012. WORKSHOP ON NETWORK INTERCONNECTION and COMPETITION. Patrick Rey. Introduction. Topics Interconnection Connectivity: quality, capacity, … Prices: interconnection fees (wholesale access charges) [Bypass, peer / transit, …]

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WORKSHOP ON NETWORK INTERCONNECTION and COMPETITION

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  1. Goethe Universität Frankfurt am Main – May 22-23, 2012 WORKSHOP ON NETWORK INTERCONNECTION and COMPETITION Patrick Rey

  2. Introduction Topics Interconnection Connectivity: quality, capacity, … Prices: interconnection fees (wholesale access charges) [Bypass, peer / transit, …] Competition Retail pricing: linear / non-linear pricing Caller pays / receiver pays regimes [Multi-homing, replication, caching, tying / bundling, …] Positive / normative analysis 1

  3. Introduction One way versus two-way interconnection One way interconnection Upstream bottleneck: input, essential facility Main concerns ex ante investment incentives / ex post vertical foreclosure access regulation Two-way interconnection Competitive bottlenecks Main concerns excessive cooperation: collusion, competition dampening, … insufficient cooperation: entry barriers 2

  4. Upstream bottleneck / downstream competition Upstream segment Monopoly segment Downstream segment Complementary Possibly competitive One-way access M C M/C 3

  5. One-way access: vertical foreclosure Conventional wisdom (leveraging market power) Bottleneck Denies / limits access to some potential users To extend its market power From the monopolized segment To the complementary segment 4

  6. Vertical foreclosure Practices Vertical integration + Refusal to deal Incompatibility High wholesale prices Tie-ins, ... No vertical integration but Exclusive dealing Price discrimination, ... M M C M C C 5

  7. Vertical foreclosure Remedies Structural Common ownership of bottleneck (Terminal RR) Break up + line of business restrictions (AT&T) Regulation of access price No discrimination among external clients (Sabena / Saphir) No discrimination between external and internal clients Transparency, accounting separation (“chinese walls”) Price linkage: ECPR access charge = final price - downstream marginal cost Open access (common carrier) Regulation of wholesale quantities (Eurotunnel) 6

  8. Vertical foreclosure Chicago schoolcritique “Only one profit”: how can the bottleneck owner earn more than one profit?” M charges Wholesale price w Franchise fee F Downstream competition Retail price p(w) = pm Profits recovered through F M C C Demand 7

  9. Vertical foreclosure Answer to the Chicago critique Incentive: restore, rather than extend market power Upstream monopolist cannot exercise monopoly power … without excluding Analogies Patent: multiplication of licenses Franchising: multiplication of franchises Hart-Tirole Brookings 1990, O’Brien-ShafferRand 1992, McAfee-Schwartz AER 1994, Rey-Vergé Rand 2004, ... [Rey-Tirole HIO 2007] 8

  10. Vertical foreclosure Model M unit cost cu 1 unit of input required for 1 unit of output unit cost cd C2 Cn C1 9

  11. Vertical foreclosure Example (“Cournot” downstream competition) Framework M offers wholesale tariffs (e.g., two-part tariffs: Ti(qi) = Fi + wiqi) EachCiorders its quantity qi and pays accordingly Ti(qi) Final price pi = P(q1 + … + qn) If wholesale contracts are public: monopoly outcome Monopolistic franchise contract w = cu, F = πm Oligopolistic franchise contractw:pC(w+cd) = pm, F = πC(w+cd) 10

  12. Vertical foreclosure Secret contracting: Opportunism Hart-Tirole (Brookings 1990) Whendealingwith a competitorC, Mhas an incentive to free-ride on the sales of the othercompetitors πM + πi~ (P(qi +Σj≠iqj) - cu – cd)qi(+ Σj≠i(Tj - cuqj)) → for each Ci, it is optimal for Ci and Mto set the quantity qi so as to “best respond” to the others’ output levels → yields Cournot outcome (quantity competition) → as the number of rivals increases, price goes down to cost (competitive pricing, no market power) 11

  13. Vertical foreclosure Variant: Bertrand downstreamcompetition O’Brien-Shaffer (Rand 1992) WhendealingwithgivenCi, M still has an incentive to free-ride on the downstreammargins of the othercompetitors πM + πi~ ( pi - cu )Di + Σj≠i(wi – cu)Dj → It is optimal for M and each competitor Cito agree on a price that “best responds” to the others’ prices → yields Bertrand outcome (price competition) 12

  14. Vertical foreclosure Issue: which conjecture ? Rey-Vergé (Rand 2004) Symmetric conjecture → monopoly prices Passive conjectures (Hart-Tirole, O’Brien-Shaffer) Pros: tractable, reasonable (and exists) for Cournot Cons: lessreasonable for Bertrand, and inexistence pbs in that case Warybeliefs (McAfee-Schwartz AER 1994) Coincidewith passive beliefs for Cournot, not for Bertrand Less tractable (« fixed point » issue) but exists, confirmsopportunism 13

  15. Vertical foreclosure Issue: which conjecture ? Whendealingwith one competitor Ci, M still has an incentive to free-ride on the downstreammargins of the othercompetitors πM + πi~ ( pi - cu )Di + Σj≠i(wi – cu)Dj → It is optimal for M and each competitor C to agree on a price that is the “best reaction” to the others’ prices → yields Bertrand outcome (price competition) Issue: which conjecture? Passive, wary beliefs (Rey-Vergé 2004) 14

  16. Vertical foreclosure Foreclosure: restoring market power Reputation, transparency reduce scope for opportunism Vertical integration no incentive to free-ride on its own subsidiary Exclusive contracts eliminates downstream competition Nondiscrimination laws (!) eliminates opportunism RPM, buybacks, … 15

  17. Vertical foreclosure Remarks Incentive for foreclosure stronger the more competitive the downstream industry, the less competitive the upstream industry Some competition upstream generates some access Who’s “upstream”? Illustration: US gasreform (pipelines) C2 C1 M C2 C1 M 16

  18. Vertical foreclosure Efficiency defenses Benefits from vertical integration Maintaining upstream reputation Cost of increasing capacity Investment and innovation Regulation of access = regulation of rate of return Where does the market power come from? historical reasons / legal monopolies (port, airport, ...) scale economies (Otter Tail, Hecht, ...) network externalities investment / innovation 17

  19. Vertical foreclosure ECPR (Efficient Component Pricing Rule) Partial regulation: constrains price linkages For more: Rey – Tirole “A Primer on Foreclosure” (Handbook of Industrial Organization 2007) a cd • Does not prevent full exercise of market power • But allows the entry of a more efficient competitor p M C C 18

  20. Two-way access One-way versus two-way access One-way access Upstream: incumbent controls a bottleneck (e.g., local loop) Downstream: incumbent competes with rivals → essential facility doctrine, access regulation Two-way access Network operators compete for subscribers But need each other to complete calls → competitive bottlenecks 19

  21. Two-way access Cooperation or competition? Interoperability requires cooperation Standards, protocols (QoS) Interconnection agreements … between competitors “Cooperation” may prevail over “competition” Lack of cooperation from incumbents may hurt new entrants → impact of interconnection agreements on competition Connectivity decisions Interconnection charges 20

  22. Connectivity strategies Issue: whether to connect / compatibility or quality (Katz-Shapiro AER 85, Farrell-Saloner Rand 85) Snowballing, club effects (small shocks / large impact) Inertia, lock-in role of installed bases switching costs? Coordination problems positive: coordination devices normative (Pareto criterion; heterogeneity?) “one-way” interconnection backward/forward compatibility, downgraded version (read-only) 21

  23. Connectivity strategies Large networks: less eager to maintain connectivity Trade-off: degraded interconnection Has a negative direct effect (network is less attractive) Has an indirect strategic effect (rival also less attractive) Strategic effect can dominate is network is large enough Refusing / degrading interconnection (WC/MCI/Sprint) Developing closed / proprietary standards (iTunes) Large? Installed base of locked-in customers, coordination 22

  24. Connectivity strategies Framework Crémer, Rey and Tirole (JIE 2000) Demand Installed bases B1 and B2 of locked-in consumers New customers q1 and q2 value of servicesi = v[Bi + qi +θ(Bj + qj)] (v < ½) demand pi = 1 + si – q1 – q2 = 1 + v(Bi+ θBj) – (1 – v)qi– (1 – θv)qj Supply Each backbone i chooses interconnection quality θi The effective quality of connection θis the minimum of the two θi Each backbone isets capacity qi(constant unit cost c) 23

  25. Connectivity strategies Equilibrium Quantities Profits → keeping total installed base constant: quantity and profit increases with customer base advantage all the more as θdecreases 24

  26. Connectivity strategies Incentives to interconnect Larger backbone has less incentives to interconnect If connectivity is costless Smaller backbone wants perfect connectivity Larger backbone wants perfect connectivity if asymmetry is small zero connectivity otherwise 25

  27. Connectivity strategies Robustness Negotiated connectivity Asymmetric cost sharing But the larger backbone gains more from degrading connectivity than the smaller one gains from maintaining it Cournot versus Bertrand Quality of connectivity Capacity of interconnection Discouragement from delays 26

  28. Connectivity strategies Illustration: the WorldCom – MCI merger Crémer-Rey-Tirole JIE 2000 Pre-merger: 4 backbones (WorldCom, MCI, Sprint, GTE) all backbones have similar installed bases (1/4, say) pre-merger, all backbones aim at perfect connectivity Merger between 1 and 2 (installed bases ½,¼,¼) → three connectivity strategies: accommodation: maintain connectivity (1,1,1) global degradation (½, ½ , ½ ): never attractive targeted degradation + limit on transit (¾ , ½ ,1): attractive 27

  29. Interconnection and competition Competing, perfectly interconnected bottlenecks Wholesale: bilateral interconnection agreements Perfect connectivity (no club effect) Reciprocal termination charge (access price): a Retail: price competition Linear / non-linear (two-part) tariffs (prepaid/post-paid, subsidy) On-net pricing (friends and family) Prices for sending and/or for receiving (US/EU) 28

  30. Framework Supply Two network operators, same cost structure constant unit costs for origination, co, and termination, ct ignore here fixed costs: infrastructure, connection Total cost on-net: c = co + ct, off-net: c = co + a = c + m, where m = a – ct co + ct ct – a C1 C2 Network 1 Network 2 29

  31. Framework Demand Differentiated products (imperfect substitutes) Symmetric demand Di(p1,p2) = α(pi,pj)D(pi) Monopoly price: p1 = p2 = pM where εis the elasticity of the aggregatedemandD(p,p) 30

  32. The accounting neutrality of termination charges No direct impact on industry profit Individual profit Two sources of revenue: retail and wholesale (usage and access) Πi= (pi – c)Di(p1,p2) + Ai(m,p1,p2) Industry profit Π1 + Π2 = (p1 – c)D1(p1,p2) + (p2 – c)D2(p1,p2) does not depend on m (transfer “from one pocket to another”) 31

  33. The accounting neutrality of termination charges Individual profits If calling pattern is “balanced” (traffic proportional to market shares) The termination markup has no direct impact either Individual profit (neglecting fixed connection costs) Πi= [pi – αic –αj(c+m)] αiDi + αj αi m Dj = αi(pi – c)Di + αj αi m (Di – Di) m is thus “profit neutral” (from accounting perspective) whenever the two firms charge the same retail price (pi = pj → Di = Dj) whatever the market shares of the operators (even if asymmetric) 32

  34. The accounting neutrality of termination charges However The termination markup however indirectly affects competition Affects ARPU (profit per user) And thus the incentive to fight for market share It thus has an indirect effect on operators’ prices and profits Positive analysis impact of termination charges on operators’ behavior Impact on prices, profits, consumers, … (bill and keep?) Normative analysis Which level maximizes profits? Which level maximizes consumer surplus, social welfare, … Ramsey pricing (fixed network and connection costs) 33

  35. Termination charge as a cooperation device Linear retail prices Armstrong (EJ 1998), Laffont, Rey and Tirole (Rand 1998a) Access mark-up inflates “perceived” marginal cost Average marginal cost: ci = c +αj m Increasing m increases retail prices in any shared-market equilibrium exacerbates temptation to “take-over” the entire market Equilibrium (symmetric, imperfectly competitive) access charge is a “collusive” device: pe(m) increases with m and yet, no side payments if traffic is “balanced” but for high termination charges/high substitution, no equilibrium 34

  36. Termination charge as a cooperation device Illustration Consumer demand à la Hotelling (entire market is covered) Differentiation / “transportation cost” t (“substitution” σ = 1/2t) Constant elasticity ε(consumer surplus v(p)) Per consumer profit π(p) = (p – c)D(p) Market shares: αi = ½ + σ [v(pi) – v(pj)] Equilibrium prices Equilibrium profits π∗(m) = π(p∗(m))/2 35

  37. Termination charge as a cooperation device Access rule Social welfare / Ramsey Pricing Objective: max Welfare subject to π(p)=0 Optimal markup in retail prices, controlled by access prices Termination subsidy (m < 0, or a < ct) to foster competition Monopoly prices and profits Need a termination markup (m > 0, or a > ct) to soften competition Problem: exacerbates tensions, instable competition Note: bill and keep? 36

  38. Termination charge as a cooperation device What if firms do not coordinate their choices? Example: networks almost not substitutes Operator’s profit: Πi= (pi – c – mj/2)D(pi) + (mi/2)D(pj) Retail price: pi = pm(c + mj /2) Termination markup Maximize miDA(mi) = miD(pm(c + mi /2)) Leads to m1 = m2 = m = 2/εA(m) Akin to double marginalization … 37

  39. Non linear pricing Networks compete in several dimensions Prepaid: handset subsidies Packages: handset subsidies, monthly fees, sms, internet, … Remark: Three-part tariffs for mobiles Jenssen (2002) price volume 38

  40. Non linear pricing Implications: “waterbed” / two-sided effects Higher termination charges increase ARPU Raises retail prices Enhances retail profit per subscriber even if transfers cancel out But this, in turn, increases competition for subscribers lower fixed fees larger handset subsidies, … Divergent effects on usage prices and subscription fees Profits: ambiguous impact overall Consumer surplus and welfare: participation versus usage 39

  41. Non linear pricing Competition in subscription fees and usage prices Laffont, Rey and Tirole (Rand 1998a) Two-part tariff Ti(q) = Fi + piq Consumers Care only about net value of package wi = v(pi) – Fi Demand Di(p1,p2) = α(wi,wj)D(pi) Operators Connection cost f Per consumer profit πi = (pi – c) D(pi) + Fi – f Total profit Πi = αiπi + αj αi m [D(pj) – D(pi)] 40

  42. Non linear pricing Usage prices reflect “perceived” marginal cost Profit can be expressed as Πi = αi [ v(pi) + (pi – ic – αjm) D(pi) – f – wi ] + αj αi mD(pj) Keeping net surpluses (and thus market shares) constant It it optimal to maximize joint surplus v(pi) + (pi – ic – αjm) D(pi) – f Leads to pi = c + αjm In any symmetric equilibrium p1 = p2 = c + m/2 41

  43. Non linear pricing Higher usage prices imply lower subscription fees Illustration: Hotelling α(wi,wj) = ½ + σ(wi– wj) = ½ – σ(Fi– Fj) Given p1 = p2 = c + m/2 Choosing Fi amounts to choosing πi = (m/2)D(c + m/2) + Fi – f Market shares α(πi, πj) = ½ – σ(πi– πj) Profit Πi = α(πi,πj) πi = (½ – σ(πi– πj)) πi “Profit neutrality” In equilibrium π1 = π2 = πH = 1/2σ … whatever m “full” waterbed effect 42

  44. Non linear pricing Heterogeneous users Heavy / light users Dessein (Rand 2003), Hahn (IJIO 2004) Subscription fees do not fully extract user surplus Can still have profit neutrality Different degrees of competition Dessein (IEP 2004) Suppose competition is fiercer for heavy users Then profits are higher for below-cost termination charges The converse holds as well 43

  45. Non linear pricing Endogenous participation Heterogeneous demand for subscription Dessein (Rand 2003) Networks favour below-cost termination charges Consumers and society favour above-cost termination charges 44

  46. On-net pricing Termination-based price discrimination Laffont, Rey and Tirole (Rand 1998b) When operators charge different prices for off/on-net calls the access charge affects only off-net calls introduces club effects despite interconnectivity Potential problems Price distortions Tipping Less concern for “coordination” Access mark-ups increase incentive to build market share 45

  47. On-net pricing Competition in usage prices Two prices pi (on-net calls) and p’i (off-net calls) Consumer response Surplus wi= αiv(pi) + αjv(p’i) Market shares αi = α(wi,wj) = ½ + σ(wi– wj) Define Mi = ½ + σ(wi– wj); then If M1 , M2 > 0, unique shared-market response αi = Mi/(M1 + M2) If Mi > 0 > Mj, unique cornered-market response (only i is active) If M1 , M2 < 0, unique stable response αi = Mi/(M1 + M2) [plus two unstable cornered-market responses] 46

  48. On-net pricing Competition in usage prices Retail equilibrium Prices reflect marginal cost Symmetric equilibrium on-net pricing Distorts consumption decisions But results in tougher competition Benefits consumers when degree of substitution is small 47

  49. On-net pricing Competition in usage prices and subscription fees Consumer response Surplus wi= αiv(pi) + αjv(p’i) – Fi Market shares αi = α(wi,wj) = ½ + σ(wi– wj) As a result αi= ½ – σ’(Fi– Fj), where σ’ = σ / { 1 – 2σ [v(c) – v(c+m)] } Retail equilibrium Usage prices set at perceived costs: p = c, p’ = c + m Fixed fees: F – f = 1/2σ – [v(c) – v(c+m)] (decrease with m) Profits higher for termination charges below cost Gans and King (EL 2001) Welfare highest for cost-based termination charges 48

  50. On-net pricing In practice: on-net “friends and family” Magnitude? Share of traffic is between friends “local” clubs versus interlocking relations Coordination among friends? If perfect coordination All friends and family on the same network, avoid off-net prices Back to non-discrimination case If no coordination? 49

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