Summary of Phoenix Center 2006 Research Dr. George Ford Chief Economist

1. Summary of Phoenix Center 2006 Research Dr. George Ford Chief Economist 2006 Annual U.S. Telecoms Symposium Grand Hyatt Conference Center Washington DC December 6, 2006

2. An Investigation into the Influence of Retail Gas Prices on Oil Company Profits Policy Paper No. 26 Network Neutrality And Industry Structure Policy Paper No. 24 The Burden of Network Neutrality Mandates on Rural Broadband Deployment Policy Paper No. 25 2006 ResearchPolicy Papers

3. In Delay There Is No Plenty: The Consumer Welfare Costs of Franchise Reform Delay Policy Bulletin No. 13 A La Carte and “Family Tiers” as a Response to a Market Defect in the Multichannel Video Programming Market Policy Bulletin No. 14 Unnecessary Regulations and The Value of Spectrum: An Economic Evaluation of Lease Term Limits for the Educational Broadband Service Policy Bulletin No. 15 The Efficiency Risk of Network Neutrality Rules Policy Bulletin No. 16 Separating Politics from Policy in FCC Merger Reviews: A Basic Legal Primer of the “Public Interest” Standard Policy Bulletin No. 17 2006 ResearchPolicy Bulletins

4. 2006 ResearchMajor Telecom Issues Cable Competition/Franchise Reform Network Neutrality Universal Service Reform

5. Phoenix Center Policy Bulletin No. 14“In Delay There Is No Plenty”: The Consumer Welfare Cost of Franchise Reform Delay

6. POLICY BULLETIN NO. 16Cost of Franchise Reform Delay • Competition in Video Markets reduces prices, thereby benefiting consumers • Prices reductions 10% to 40%. • Franchise process deters competition, thereby a failure to reform it creates consumer welfare losses. • How big are the consumer surplus losses?

7. DCS DCS Delay POLICY BULLETIN NO. 16Cost of Franchise Reform Delay $ Consumer Surplus Gain to Consumers From Competition Time

8. DCS POLICY BULLETIN NO. 16Cost of Franchise Reform Delay $ Consumer Surplus DCS Loss to Consumers From Delay Time

9. POLICY BULLETIN NO. 16Cost of Franchise Reform Delay

10. Phoenix Center Policy Paper No. 24Network Neutrality and Industry Structure

11. POLICY PAPER NO. 24Network Neutrality and Industry Structure • Our arguments derives from a well-understood principle of industrial economics: as the products of firms become more alike, price competition intensifies. In the presence of sunk costs, intense price competition renders more highly concentrated markets. In terrestrial telecommunications, the industry is already highly concentrated (duopoly?), so increasing concentration could mean monopoly.

12. POLICY PAPER NO. 24Network Neutrality and Industry Structure • “Moving toward the other firm increases the intensity of price competition.” [J. Tirole, The Theory of Industrial Organization 1995] • “We see that [with homogeneous products] price equals marginal costs (the competitive result), while [if products are completely differentiated] price is set at the monopoly level.” [S. Martin, Advanced Industrial Economics 1993] • “Where the product or service is perceived as a commodity or near commodity, choice by the buyer is largely based on price and service, and pressures for intense price and service competition results. These forms of competition are particularly volatile []. Product differentiation, on the other hand, creates layers of insulation against competitive warfare because buyers have preferences and loyalties to particular sellers.” [M. E. Porter, Competitive Strategy 1980]

13. Equilibrium Industry Structure(Policy Papers No. 10 and 21) N* = Equilibrium Number of Firms S = Market Size (+) f = Index of Weakness of Price Competition (+) E = Sunk Entry Costs (-)

14. Policymakers should balance concerns over potential discrimination against the possibility that particular network neutrality rules may encourage very aggressive price competition that is incompatible with multiple firm supply in the face of significant sunk costs and scale economies. POLICY PAPER NO. 24Network Neutrality and Industry Structure

15. Phoenix Center Policy Paper No. 25The Burden of Network Neutrality Mandates on Rural Broadband Deployment

16. POLICY PAPER NO. 25Network Neutrality and Rural America If a regulation reduces profits, and binding regulation always impacts profits, there will be and lower profits mean less network deployment. The question is whether urban and rural areas are differentially affected by a profit-affecting regulation (such as network neutrality).

17. Subsidy Required for 100% Homes Passed POLICY PAPER NO. 25Network Deployment C = Network cost to serve a household V = Net Value of customer h = homes passed by the network h* is homes passed by the network given C and V. $ C V 0 h* 100% Homes Passed (h), Ranked by Cost

18. Subsidy Required for 100% Homes Passed POLICY PAPER NO. 25Network Deployment with Higher Cost CR = Network cost to serve a household under Regulation V = Net Value of customer hR = homes passed by the network under Regulation $ CR C V 0 h* 100% hR Homes Passed (h), Ranked by Cost

19. CR CR hR hR POLICY PAPER NO. 25Network Deployment, Different Markets $ Cost Curve is Relatively Steep $ Cost Curve Is Relatively Flat C C V V 0 h* 100% 0 h* 100% Homes Passed (h), Ranked by Cost Homes Passed (h), Ranked by Cost

20. POLICY PAPER NO. 25Measured Impact of Regulation Our simulation shows that, on average, high-cost (more rural) markets experience larger reductions in network deployment than do low-cost (more urban) markets.

21. United-MO Very Steep Slope SBC-TX V POLICY PAPER NO. 25Network Neutrality and Rural America Relatively Flat Slope V Relatively Steep Slope V

22. POLICY PAPER NO. 25Network Neutrality and Broadband Deployment to Rural America Network neutrality rules that reduce the profitability of deploying network -- and binding regulation always reduces profit -- will reduce network deployment generally. But, this reduced deployment may be felt to a larger extent in high-cost, more rural markets.

23. Policy Bulletin No. 16The Efficiency Risk of Network Neutrality Rules

24. POLICY BULLETIN NO. 16Efficiency Risk ofNetwork Neutrality General Cost-Benefit Framework for evaluating regulated network “architectures” Analysis of the incentive to invest in cost-reducing technologies

25. POLICY BULLETIN NO. 16Cost Benefit Framework Ri= Consumer Gross Value of Network Type i Pi= Price Paid for Service of Network Type i Vi = Ri – Pi = Net Consumer Value of Network Type i

26. POLICY BULLETIN NO. 16Cost Benefit Framework Stupid Network = S Intelligent Network = I Stupid network preferred if: VS > VI RS – PS> RI – PI M = Markup over cost; C = Cost RS – MS·CS> RI – MI·CI

27. Is one architecture more desirable to consumers than another, and by how much? POLICY BULLETIN NO. 16Cost Benefit Framework RS – MS·CS> RI – MI·CI

28. Does architecture affect Industry structure and thus margins, and by how much? POLICY BULLETIN NO. 16Cost Benefit Framework RS – MS·CS> RI – MI·CI

29. Is one network more costly than another, and by how much? POLICY BULLETIN NO. 16Cost Benefit Framework RS – MS·CS> RI – MI·CI What’s it worth and what does it cost?

30. POLICY BULLETIN NO. 16Investment in Cost-Reducing Technology • Scenario • Cost reducing technology is available to a monopoly • But, the technology reduces the value of the service to consumers • Under what conditions will the firm make the investment? • The investments made if it is profitable to the firm • The investment is made only when consumer surplus rises (i.e., the lower price more than offsets the lower marginal valuation)

31. POLICY BULLETIN NO. 16Investment in Cost-Reducing Technology Voluntary investments by network firms in cost-reducing technology are welfare improving even if the technology reduces the marginal value of the services produced by the technology. Even a monopolist will make the right decision for consumers.

32. Phoenix Center Breakfast Meeting: NARUC, Miami, November 2006Primer on Competitive Biddingfor Universal Service

33. To accomplish this task at the minimum economic cost of providing the relevant set of access services. To provide subsidies so that access at an affordable price is provided in areas where access would not be provided at an affordable price without the subsidies Goals of Universal Service

34. $ Capital Cost to Serve Losses R Profits h Homes Passed R = Net Revenue Why Have Universal Service?

35. $ Capital Cost to Serve Subsidy R h 100% Homes Passed R = Net Revenue How do we subsidize?Carefully

36. P+S P h hS How do we subsidize?Uncarefully Same Subsidy, Different Result. Subsidized action must be very specific and observable. $ Capital Cost to Serve Homes Passed

37. P+S P h hS How do we subsidize?Uncarefully Even if we only pay for “new” lines, we can run into problems. $ Capital Cost to Serve Homes Passed

38. Competitive Bidding and Franchise Bidding Competitive bidding is akin to a franchise bidding scheme, where franchise bidding is a competition among firms for the exclusive right to serve. The right to offer service in a market is “auctioned off” to the firm willing to offer fixed level of service at the lowest price. With scale economies, franchise bidding theoretically renders a better outcome than multi-firm competition. We get the competitive outcome with the monopoly cost structure.

39. Competitive Bidding with Subsidy Competitive Bidding is different when a subsidy is involved. The bid price (average cost) is above the “affordable” or target price. Thus, a subsidy is required.

40. Competitive Bidding with Subsidy: Example Lowest Avg Cost of Service: AC = $50 Target Price is: PT = $20 Lowest Subsidy Bid is: S = $30 PT - AC + S = 0

41. Competitive Bidding with Subsidy: Example Lowest Avg Cost of Service: AC = $50 Target Price is: PT = $20 Firm sells other stuff for margin: M = $10 Lowest Subsidy Bid is: S = $20 PT + M - AC + S = 0

42. $ ACT Per-Line Subsidy AC PT QT Quantity Franchise Bidding:With Subsidy PT = Target or Affordable Price Total Subsidy

43. $ ACQ/2 SQ/2 ACT AC S PT QT Quantity Q/2 Q/2 Subsidy Bidding:Two Firms With two equally-sized firms, the market is split. The bid, equal to ACQ/2, reflects the split. The subsidy grows substantially even if both firms are equally- and most efficient. Total Subsidy Two Firms

44. $ PM Reduction in Dead Weight Loss Demand PC QM Quantity QC Benefits of Competition Competition increases social welfare by reducing the dead weight loss of monopoly. As prices fall, consumer surplus rises faster than profits decline. Transfer of Profit to Consumer Surplus

45. $ Creation of Dead Weight Loss PS Loss of Producer Surplus Demand P MC QS Quantity Q Cost of Subsidies Gathering funds for subsidy creates distortions in other markets, leading to efficiency losses. Transfer of Consumer Surplus to Government

46. Let N be the number of entrants: DM/DN < 0 DS/DN > 0 DAC/DN > 0 Competition increases the subsidy! Let’s make soup What are the relationships of interest? PT + M – AC + S = 0 DS/DPT < 0 DS/DM< 0 DS/DAC > 0

47. Let’s make soup Consider a case where we use bidding and allow multiple winners (N>1). What happens relative to an exclusive winner? PT + M – AC + S = 0 Competition in subsidized markets increases the amount of subsidy both through margin declines and cost increases.

48. What’s competition worth? To consider what competition is worth, let’s assume AC is constant (not rising with the number of firms). Subsidy rises, harming consumers. PT + M – AC + S = 0 Margins fall, benefiting consumers.

49. $ $ These cancel Loss to Consumers Gain to Consumers PS PM Loss to Firms P PC MC D D QS Q Quantity QM QC Quantity Competition and Subsidies “Taxed” Market Subsidized Market $1 $1 This is not the usual transfer from firms to consumers as a result of competition, it is a transfer from consumers in one market to consumers (and producers) in another.

50. $ $ What are the relative sizes of these things? PS PM P PC D D QS Q Quantity QM QC Quantity Competition and Subsidies “Taxed” Market Subsidized Market