Phoenix Center Conference

1. Phoenix Center Conference Robert Willig October 1, 2004

2. Agenda (i) • In these times of telecom revolution, we’ve got to get it right. • Last mile is still bottleneck – maybe not for very long, but still. • Special access shows major monopoly power, and is bottleneck too – evidence from natural experiment. • Overarching competitive problem of access

3. Agenda (ii) • Access as competitive problem is not unique, and recognition is bipartisan. • Anticompetitive incentives & opportunities. • Forms of predation are not unlikely here. • Unbundling @ TELRIC good solution to save intramodal competition. • TELRIC concept is the competitive price

4. Agenda (iii) • Unbundling @ TELRIC does not depress investment. • No inconsistency in policy between saving intramodal competition and fostering telecom revolution with its possible intermodal competition. • Fostering competition needs fast commitment to change in inter-carrier compensation for competitive neutrality, reduction of regulatory risk and efficiency.

5. Gotta Get It Right • Set the policy structure so that the right, but highly unpredictable, decisions are made by real competition in the markets that link consumer wannas with technological possibles. • Don’t, as policy officials, aspire to decide on what should be user prices, services and supply technologies. • Particularly crucial when, as now, what’s at stake includes where telecom is going, what roles will it play in society, and what substantial facilities’ investments will be made.

6. Still Last Mile Bottleneck? • How ready will public be to switch from wireline voice to VOIP in sufficient % to control loop pricing – in 2 years? 4 years? • How ready will public be to switch from wireline voice to cellular in sufficient % to control loop pricing – in 2 years? 4 years? • How independent of ILEC local services will be non-ILEC affiliated cellular carriers if they are a principal source of competition? • What are the odds that deregulation will be in the pubic interest in 2 years? • Let’s get policy right for either unpredictable possibility!

7. Monopoly Power Over Special Access • Structural analysis – shares and entry barriers make market power clear for most of market. ILECs have 90%++ --- Scale economies and sunk costs here make substantial entry barriers. Absolute cost disadvantages substantial too. • Natural experiment of FCC Pricing Flexibility Order – Phase II rate freedom for about 50 MSAs where triggers are met (based on % wire centers with colocation, as proxy for SA entry possibilities) – no rate declines and 10 – 35+% continuing rate increases relative to where still caps. (over $5 billion overall) Meanwhile, book and forward looking costs steadily down since 1995. SA rates 200% -- 400% of TELRIC and way above historic costs. Substantial market power revealed! • Special access is bottleneck for business services – over 90% of buildings served by IXC’s have only ILEC fiber access -- + entry barriers.

8. Why Public Utility Regulation?The Three Leg Test: 1. Natural Monopoly in relevant market • two options cost too much 2. High barriers to entry • sunk costs and scale economies together deter any entry 3. Sufficient demand for significant monopoly profit or rent • Competition cannot work • Private supply best nevertheless • Regulate to mimic competition

9. Bottleneck BI A a Competition stage Pe Pi DI De V ci ce Consumer market Telecom Electricity Railroads Gas and Oil Pipelines CATV Airport Rights CRS IP ATMs Copy Machine Parts OS and Applics Pubs and Beer Rockets and Satellites Main Frame Parts Physicians and Labs Automobile Radios

10. Anticompetitive Vertical Practices • Bottleneck is opportunity • Incentives? versus “one-lump” theory. • Regulation gives incentives inadvertently • Price discrimination • Diminution of competition in non-coincident markets • Removal of competitive constraint on bottleneck

11. Predation • Use of bottleneck to enlarge monopoly power is a form of predation, or “exclusionary vertical conduct.” Not garden variety “price predation.” • Hallmarks are market power upstream, causation of increase in market power by making competition from active and potential rivals ineffective and intent as revealed by conduct. • Sacrifice test – would conduct make sense for bottleneck holder “but for” the harm to competition? • Vertical anticompetitive price squeeze can well be such a form of predation. (eg access price above downstream retail price, or leaving too little pricing room for efficient rival)

12. Policies to Consider • Vertical separation [Bell, Electrics, pipelines, MS? Intuit, Rocket-Sat., Merger---] • Change Regulatory Mechanism [US RR’s prices] CAPs and freezes • Mandate “Equal Access” “ONA,” unbundling AT WHAT PRICES?? • Cost-based Regulation of Access Prices [US Telecom Policy Act of 1996] • Reactive Regulation of Access Prices [Antitrust litigation US RR’s] WHAT STANDARDS??

13. Bottleneck Access Prices for Efficient and Fair Competition should permit efficient suppliers to prevail in the market while discouraging inefficient supply incumbents and entrants should pay the same price for the same bottleneck service (if costs are unequal then parity of mark-ups)

14. Revenues from Bottom-Up Economic Costs Approach May Be Less Than “Regulatory Rev. Requirements” DUE TO: • Common and fixed costs • regulatory burdens • inadequate depreciation • inefficiencies in operations • overearnings • imprudent investments • cross-subsidies from regulated to non-regulated activities ____________________________________________ Competitively neutral (externalized) solutions or Top-Down Approach

15. Cost Concepts for Competitive Prices • Long run costs – like TELRIC – are forward looking from today, cost minimizing, and unconstrained by the firm’s past investment decisions. • Short run (and medium run) costs are still cost-minimizing looking forward from today, but – unlike long run costs – reflect a planning period in which investments in long-lived assets inherited from the past remain sunk.

16. Short run costs include all forward-looking new expenditures needed during the planning period. • They also might include capital costs on the inherited sunk assets themselves. • Economists have identified three alternative approaches to the valuation of the sunk assets with corresponding costs.

17. One Approach: No Value for Sunk Assets with No Opportunity Costs • Since the investment is sunk, there is no opportunity cost of using it. (That is, if you decide not to use the assets, no costs of their financing are thereby saved or avoided; likewise, if you decide to use them, there are no additional such costs that result.) • Short run costs, so defined, are necessarily equal to or less than long run costs. • This follows because in the short run scenario, one way to produce the same outputs would be to ignore the sunk assets and buy all inputs fresh. Hence, if the owner of the sunk assets elects to continue using them (as incumbent carriers typically do), doing so must be as cheap as, or cheaper than, starting fresh.

18. The Reproduction Cost Approach • The reproduction cost approach values sunk assets according to book with physical-life based depreciation. • If the enterprise unconstrained by any sunk assets would efficiently choose exactly the same assets that had been chosen historically, then SRC = LRC. • If intervening technological progress and other changes in economic circumstances would change those choices, then the appraised value of those sunk assets is less than their reproduction cost. So a measure of short run cost that includes their reproduction cost is systematically biased upward. • That is why this approach violates economic logic.

19. Economic Valuation of Sunk Assets • The economic approach would assign costs to the inherited sunk assets according to their appraised value. • The appraised value of the assets is the savings their use would permit an enterprise in the business, as compared to not using the assets and starting fresh. • If the sunk assets were not used at all, the enterprise would incur long run costs. • Since the appraised value makes the enterprise indifferent between using the sunk assets or not, this standard leaves the enterprise with SRC = LRC. • So TELRIC yields calculated costs that are the short run or “real costs” based on economic valuation of sunk assets!!!!

20. example • Book cost of old sunk assets is $1.0/year • Forward costs of using the old with efficient additions is $.5/year • Costs of same services from new efficient facilities is $1.25/year. • Appraiser would revalue old sunk assets to have cost of capital of $.75. • Competitive price is $1.25/year and smart supplier uses old assets this way.

21. This Profound Fact Has Been Known Since at Least 1970!!! • "If the economic value were correctly stated on the books the addition of gross return on that net book value to the variable costs of operating the old plant would produce a cost of service exactly equal to that of a new plant."  •       Alfred Kahn, Economics of Regulation, page 121 (1970). 

22. Pricing Based on such Costs is Compensatory • Current prices are based on current efficient costs with efficient long-run choices of assets. • The expected decline from original value to current value of sunk assets is included in economic depreciation, and thus in prices. • The chances that actual declines in value will deviate from the expected are risk factors in the cost of capital. • This is all so in competitive pricing and in efficient pricing based on economic costs.

23. TELRIC Dominates • TELRIC is a superior regulatory approach • Minimizes misincentives to over spend and cross-subsidze • Historic cost and “real” cost methods produce sharp misincentives that are costly for consumers and anticompetitive.

24. Telecommunications Act of 1996 and Infrastructure Investment: Empirical Evidence Robert Willig Princeton University William Lehr MIT John Bigelow Princeton Economics Group Stephen Levinson AT&T (formerly)

25. Does TA96 unbundling reduce ILEC incentives to invest? • Investment Deterrence Hypothesis • TA96 unbundling reduces ILEC investment • Denies ILEC opportunity for fair return on investment • Encourages CLEC “free-riding” on ILEC infrastructure • Competitive Stimulus Hypothesis • TA96 & unbundling enable & foster CLEC competition • Competition drives innovation, lowers prices, • and expands markets • ILEC and CLEC investment increases

26. Key Issue -- Since TA96 Unbundling So Important to Competition • Local facilities still largely natural monopolies. • ILECs still protected by substantial entry barriers • Cable still far from competitive in telephony and business broadband ….. DBS also. • So unbundling only way to foster competition in services that utilize local plant, and in subsequent facilities deployment. • Access to UNEs at TELRIC prices could be salient force for movements to competitively efficient pricing, along with competitively neutral measures for public purposes.

27. United States Telecom Association, et al. v. Federal Communications Commission and United States of America “There are plainly two sides to the effects on investment of ubiquitously available UNEs at Commission-mandated prices. . . . The question is how such investment compares with what would have occurred in the absence of the prospect of unbundling, . . ., an issue on which the record appears silent. Although we can’t expect the Commission to offer a precise assessment of disincentive effects (a lack of multiple regression analyses is not ipso facto arbitrary and capricious) we can expect at least some confrontation of the issue and some effort to make reasonable trade-offs. . . .”

28. Economic Logic Supports the Competitive Stimulus Hypothesis Over the Investment Deterrence Hypothesis • Under TELRIC principles, UNE rates give ILECs adequate incentives to invest since they cover risks and economic depreciation. • CLECs paying such compensatory UNE rates are not “free-riders” whose anticipation deters investment by the ILECs.

29. UNEs can allow a CLEC to overcome entry barriers to build a customer base and then transition to its own facilities. • CLECs have strong reasons to invest in their own facilities to avoid dependence on their rival ILECs once they have the scale. • Such competitive threats give ILECs added incentive to improve their networks in order to avoid losing customers to new entrants.

30. Principal Empirical Questions • What is the relationship between pricing of UNEs and investment in network infrastructure by ILECs? • Investment Deterrence Hypothesis: Positive • High UNE prices discourage utilization by CLECs. • Less utilization by CLECs encourages ILEC investment. • Competitive Stimulus Hypothesis: Negative • High UNE prices discourage entry by CLECs. • Reduced competition attenuates ILEC incentives to invest. • ANSWER: The estimated relationship is negative.

31. More Principal Empirical Questions • Do the data support the mechanism of the competitive stimulus hypothesis? • Is there a negative relationship so that lower UNE prices encourage CLEC activity? • Is there a positive relationship between CLEC activity as a driver of ILEC investment? • ANSWER: YES & YES -- Together these effects show how lower UNE prices stimulate ILEC investment.

32. Structural Form Equations

33. Reduced Form Equation

34. Data • Investment Data • ILECs: FCC ARMIS reporting system • State by state • Largest ILECs (BOCs) • CLECs: Generally not available • Many CLECs privately held. • Many are part of larger entities, and investment in telecom network infrastructure is not consistently reported in sufficiently disaggregated form. • Measures of CLEC activity are available • Number of firms active by state. • Counts of Zip Codes within states with CLEC service.

36. Exhibit 1 shows ILEC investment has negative and statistically significant relationship with UNE price. • Reduced form relationship accounts for over 77% of state to state variation in ILEC investment. • ILEC investment increases with Labor Force share in FIRE, Population Growth, Average Revenue • ILEC investment decreases with TELRIC

37. Exhibit 2 shows: Relationship between number of CLECs and UNE price is negative and statistically significant. Relationship between ILEC investment and number of CLECs is positive and statistically significant. • Approximately 75% of variation in ILEC investment explained, and 45% of variation in number of CLECs. • Both relationships are statistically significant overall at a high confidence level. • ILEC investment increases with Population Growth and Average Revenue, and decreases with TELRIC • Relationship between number of CLECs and TSR Discount is positive and statistically significant at 90%.

38. So policies to assure competitive access to bottlenecks at competitive prices are: • helpful, not dangerous to investment • likely necessary for consumer protection. • What do we need to prepare for fuller competition? • Reform intercarrier compensation

39. Intercarrier Compensation • Contributions to universal service funding must be competitively neutral. • What should be equivalence scale??? • Opportunities for receipt of universal service support must be competitively neutral -- who is an ETC? – targeting? • Terminating access fees should be curtailed – even if monopoly power over local customers erodes with intermodal competition, terminating access still has much more monopoly power – payer has less control than called • Do-not-call list, caller id, call duration, calling relationships all move cost causation toward called party. • Most costs at originating and terminating ends not volume sensitive. MOVE TO MORE COMPLETE SLC!