Costs and Prices in a Modern Telecommunications Market

1. Costs and Prices in a Modern Telecommunications Market D. Mark Kennet, Ph.D. for Public Services Regulatory Commission of Armenia

2. Network Industries • Distinguish between industries that contain network infrastructure and economic networks • All public service industries have network infrastructure • Electricity • Water • Gas • Telecom • But of these, only telecom is a true network industry

3. What is a network industry? • An economic network is an industry in which the addition of a client brings both private (to the client) and public (to the other clients) benefits • Thus, demand for the service provided by the network depends on the number of other clients as well as the intrinsic value of the service • A telephone network of one client is useless; the value of the network increases to existing clients whenever a new client joins

4. The presence of these network effects influences public policy • Two major policy implications: • Universal service • Interconnection requirement • Universal service is justified by the public benefit of increasing the client base • Interconnection is essentially the same argument – interconnecting networks provide their respective clients a much larger network than they had without interconnecting

5. Regulatory policy must take network effects into account • Traditional regulation attempts to assign costs to services and then set tariffs to costs, which include a “reasonable” return • This approach may or may not be appropriate in the presence of network effects together with competition, potential or real • The structure of prices may be as important as the level; that is, a wider variety of pricing plans may prove necessary than a simple two-part tariff (rental plus usage)

6. Relevant characteristics of telecom network costs • High proportion of fixed costs • In fact, the network is essentially 100% fixed costs relative to usage • Assignment of costs to subscriber lines and usage is essentially arbitrary and depends on accounting rules • An economically ‘efficient’ tariff would be a simple flat monthly fee • Demand considerations generally make the efficient tariff unsuitable, at least as a single-price option

7. Cost concepts • Total cost • Fixed cost • Variable cost • Average cost • Marginal cost • Incremental cost • Standalone cost

8. Total cost, fixed cost, variable cost • Total cost is simply the total cost of the telephone network capable of providing the services of interest • Fixed cost is that cost that does not vary with the amount of service • Variable cost is that part of cost that varies with output • Mathematically: TC = FC + VC

9. Average cost, marginal cost, incremental cost • Average cost (AC) is just total cost divided by output • Not particularly helpful in the case of telecom, since telecoms produce multiple products • May serve as a reference point for some analyses • Marginal cost (MC) is the cost of producing an additional unit of output (e.g., the cost of an additional minute of use, line, etc.) • Many telecom situations where MC = 0 • Incremental cost (IC) is very similar to MC, except that it is often used to describe a change in the number of services offered, as in Total Service Long Run Incremental Cost (TSLRIC): TSLRIC(i) = (TC(I,i) – TC(I,0)/i

10. Standalone cost • Standalone cost is that cost which would be incurred if only the product (or group of products) of interest were being produced (without the others) • This concept is mostly used as a reference point: If a price charged for a service is greater than its standalone cost, then entry into that market is likely • Example: international long distance services, which is why most countries have liberalized this market

11. Evaluating cost concepts in telecommunications • Fixed costs: A very high percentage of total costs are fixed in telecom • Variable costs: There is no variable cost for usage (outside the peak hour), and only a small variable cost for a new access line • Marginal costs: Similar to variable costs • Incremental costs: Significant, but still very small relative to total costs

12. Aside on traffic-sensitive (TS) and non-traffic-sensitive (NTS) costs • An approximation to measuring long-run incremental cost of traffic is to separate costs into TS and NTS • TS costs could be correctly defined as those costs that change as peak busy-hour volume changes (capacity costs) • NTS costs could be correctly defined as anything else • Unfortunately, standard practice does not accord with this common-sense approach: • NTS costs are defined as those costs that can be directly attributed to a subscriber line • TS costs are anything else • This approach represents an effort to load all costs to usage, which may be politically popular but does not accord with economic efficiency

13. Comparing telecom costs to those of other infrastructure industries • All infrastructure (“network”) industries have high fixed costs • But only telecom has zero variable costs for many of its outputs • Other infrastructure industries have significant costs that vary with usage – e.g., electricity, gas, water, railroads

14. Tariffs and prices • Economics teaches us that in a competitive market, price of a good or service will be driven to marginal (or incremental) cost • The opposite of pure competition is pure monopoly. In this case, price is determined by the demand for the good or service, and output is determined at the profit maximizing point for the monopolist • Monopoly prices are always higher, and outputs always lower, than the competitive outcome • This result, for many people, justifies the regulation of monopoly: Make prices lower, and output higher

15. Problems with this approach • Regulation is costly • The efficient price is when price is set to MC, but in telecom, MC is ALWAYS less than AC, so firm will not make money • There is no theory that tells us the best way to make up the difference between MC and AC • In telecom, the notion that there is even a monopoly is doubtful

16. Is telecom a monopoly? • If we consider only fixed voice services, the answer is yes • However, studies in some countries suggest that in some populations, wireless service is substituting for fixed service, which eliminates the notion of fixed as a monopoly • The monopoly power that does exist is limited and is a result of interconnection policies and control of telephone numbers

17. Interconnection prices and monopoly power • Every telephone company is a monopoly for terminating traffic • Each company can use interconnection prices to partially control the market by making it more costly for rivals to complete calls • Thus, interconnection policy is key in any regulation scheme

18. Number portability • Once a client – especially a commercial client – has chosen a number, he does not want to change it • That gives the company that controls that number some monopoly power over that user • Number portability is a regulation that attempts to reduce that power

19. Improving telecom performance without regulating prices • Because regulation is costly, it may be desirable to at least consider how to mitigate monopolistic tendencies without it • There are several schemes that reduce the amount of price regulation • All of them depend on the use of price discrimination

20. Uniform vs. nonuniform prices • Models we have considered till now have all involved one price • However, firms can also engage in nonuniform pricing • Nonuniform prices can arise in either competitive or noncompetitive market • Competitive example: quantity discounts – it costs less to sell large quantity • Noncompetitive example: two-part tariffs for wireless operators

21. Discriminatory prices • Vary with customer and/or with quantity purchased • Not cost-based • Firm must have some market power, or prices will be driven to cost • Is market power sufficient? I.e., can any monopoly price discriminate?

22. Market power and price discrimination • Market power is not sufficient • Suppose monopoly tries to price discriminate. Then • It will try to sell to each individual customer on demand curve, but • Customers on low end of demand curve will attempt to resell to customers on high end, reducing monopoly profit • Firm must be able to eliminate resale in order to price discriminate

23. Resale • Resale won’t occur when the costs exceed the benefits • Some goods can’t be resold – e.g., a filling in my tooth • In other cases transaction costs may be too high – e.g., perishable goods, extra taxes, extra shipping costs • A firm wishing to price discriminate will try to find ways to raise the cost of resale

24. Ways of raising resale costs • Bundling • Adulteration • Vertical integration

25. Bundling • Basic idea: goods that can be resold easily are bundled with goods that cannot • Examples • Warranties/product support bundled with product • Restaurants bundle atmosphere with food service

26. Adulteration • Basic idea: Render commodity unfit for resale • Examples • Additive to rubbing alcohol makes it undrinkable • No.2 heating oil is less filtered than diesel fuel, so it can’t be used as transport fuel • Telco uses same facility to deliver both high-value data services and low-value emergency services, rendering high-value services not resellable for other purposes

27. Vertical integration • Basic idea: Control downstream suppliers as well as current market • Example • Telco has local monopoly on wireline access • It wants to sell at low price to LD and analog wireless supplier, but at high price to digital wireless • Solution: Buy all three downstream firms

28. How price discrimination raises profit • Price discrimination enables producer to earn some or all of consumer surplus • Firm is able to charge high prices to high-demand customers, low prices to low-demand customers

29. Price discrimination, graphically Price Profit with perfect price discrimination Demand Profit under uniform price MC MR Quantity

30. Types of price discrimination • First degree: Perfect price discrimination; firm captures all consumer surplus • Second degree: Average price paid varies with quantity purchased • Third degree: Price varies by customer type

31. First degree price discrimination • Example: goods sold at auction • Another example: housing market • An interesting note: Markets under perfect price discrimination have the same welfare properties as pure competition and the allocation of resources is Pareto optimal

32. Second degree price discrimination • Example: quantity discounts, declining block rates • Virtually all markets have second degree price discrimination to some extent

33. Third degree price discrimination • Example: airline tickets • Another example: wireless plans • A firm must find a way to allow customers to sort themselves out into sub-markets in order for this to work • Airlines accomplish this by requiring advance purchase for cheap tickets • Wireless customers self-select based on expected usage

34. Nonlinear pricing • Basically, this is a form of second degree pd • Generally takes the form of a two-part tariff • Other approaches include multi-part tariff, declining block rate

35. Nonlinear pricing, graphically expenditure Total expenditure (slope = marginal Expenditure) Average expenditure quantity

36. Contrasting 2nd and 3rd degree pd • For successful 3rd degree pd, the producer must • Be able to identify different demands • Have information on those demands • Prevent resale • For successful 2nd degree pd, the producer must • Prevent resale • Keep down the number of small purchasers • But doesn’t have to identify different groups

37. Tie-ins as pd • A form of bundling where two separable commodities sold together • E.g., radio with batteries • Or shoes with shoelaces • Minimum price for goods sold separately constrained by minimum demand, but by summed minimum demand when sold together

38. Tie-in example

39. Tie-in example, continued • If firm sold products separately, and wanted to max profits, it would charge $8 for A and $2 for B, for a total profit of $20 • If firm bundles the products, it can charge $11 for the A-B bundle, and still sell to both customers for total profit of $22

40. Caveats • Note that if both customers valued B at $3, there is no difference between the tie-in profit max and the separated sale profit max • In general, customers must be heterogeneous in taste over all products for tie-ins to work • In general, there must be monopoly power in both markets for tie-ins to work

41. Simplest approach • Accept that while competition in the industry may not be perfect, it does exist between wireless and wireline operators • Regulation is thus unnecessary; operators will offer a variety of pricing plans in order to attract clients • These plans will lead to a desirable outcome because of price discrimination

42. Caveats for simple approach • Approach may not work if one operator has already taken both fixed and wireless operations • In general, very strong competition policy at the very least would be required to have any hope of making this work • This approach would still require a careful regulation of interconnection

43. A less simple – but still light-handed – approach • In this approach, the regulated firm is free to set prices, but subject to a cap placed on the pricing of a bundle of services • The cap is adjusted downward according to a formula that depends on productivity • The approach is designed to elicit “optimal” price discrimination since the firm can adjust prices to reflect varying demand elasticities

44. Conclusion • Telecom regulation is complex • Telecom shares some characteristics of other infrastructure industries, but there are important differences • Regulators should strive to interfere as little as possible but work toward improving industry performance