The Telecom Act, State Action, and the Realization and Prospects for Competition

1. The Telecom Act, State Action, and the Realization and Prospects for Competition George S. Ford, PhD Chief Economist Phoenix Center George.ford@phoenix-center.org

2. The Present Uncertainty • Technology, FCC actions, court decisions, and the election have created considerable uncertainty for telecommunications policy • VOIP, Cable Telephony, Broadband over Powerlines • Triennial Review Order, USTA Decision, Brand X • Election

3. A Sure Thing • Regardless of uncertainty, current focus of modern utilities policy is the promotion of competition

4. A Sure Thing • An Act [t]o promote competition and reduce regulation in order to • secure lower prices and higher quality services for American telecommunications consumers • and encourage the rapid deployment of new telecommunications technologies.

5. What is Competition? • Competition has many characteristics and definitions, but competition always requires that there be more than just one firm offering goods/services to consumers N>1

6. Benefits of Competition Innovation Price Competition => Number of Firms (N)

7. Entry by New Firms Present Future The Policy Objective: The End of the Monopoly ONE FIRM MANY FIRMS

8. How Many is Many? • There exist an equilibrium number of firms in an industry (N*). • N* is related to: • Size of the market (bigger market, bigger N) • Sunk Entry Costs (higher cost, fewer N) • Degree of Price Competition (more competition, fewer N)

9. Entry Fee (F) • Sunk Costs • Costs that cannot be recovered once incurred • Akin to a non-refundable deposit • Network Deployment • Marketing • Product Development • Regulatory Compliance • May be Endogenous • Caused by Incumbent • Caused by Regulator

10. Simple Example • Market Size (S) = $1,000,000 • Variable Cost (C) = $10 • Entry Fee (F) = $100,000 • Monopoly Price (P) = $100 • Each Additional Firm Reduces Price-Cost Margin by 10% • Monopoly Margin is $90 = $100 - $10 • 2 Firm Margin is $81 = $90 - 90(0.10) This example is a simplification of the analysis presented by Sutton in Sunk Cost and Market Structure (1991).

11. Equilibrium Number of Firms

12. S = 1,000,000 C = $10 F = $100,000 PM = $100 Competition = 10% N* = 7 S = 2,000,000 C = $10 F = $100,000 PM = $100 Competition = 10% N* = 12 Simple Example: Alternate Assumptions

13. S = 1,000,000 C = $10 F = $100,000 PM = $100 Competition = 10% N* = 7 S = 1,000,000 C = $10 F = $200,000 PM = $100 Competition = 10% N* = 4 Simple Example: Alternate Assumptions

14. S = 1,000,000 C = $10 F = $100,000 PM = $100 Competition = 10% N* = 7 S = 1,000,000 C = $10 F = $100,000 PM = $100 Competition = 20% N* = 6 Simple Example: Alternate Assumptions

15. Two Types of Entry Costs • Exogenous Entry Costs (determined outside the system) • Some costs are just a necessary component of entry, such as marketing, some legal expenses, licenses, office space, network, etc…. • Endogenous Entry Costs (determined within the system) • Incumbents can raise the entry costs, possibly through regulation • Level Playing Field Rules • Regulatory Proceedings

16. How Many is Many? • There exist an equilibrium number of firms in an industry (N*). • This equilibrium number of firms depends on: • The size of the market in expenditures (+) • The size and nature of production cost (-) • The intensity of price competition (-)

17. What Can be Done about Entry Costs? Advice from Economists • The single most important element in the design of public policy for monopoly should be the design of arrangements which render benign the exercise of market power associated with operating sunk facilities. One way to avoid the exercise of monopoly power is to have the sunk costs borne by the government or municipality … or by mandating that sunk costs be shared by a consortium. … Virtually any method will do as long as there are contractual or other arrangements that are nondiscriminatory and permit easy transfer or lease or shared use of these cost commitments. E. Bailey, AER, 71 (1981).”

18. What Can be Done about Entry Costs? Advice from Economists • One of the main points that emerges from the discussion is that sunk costs are often not pervasive in an industry, but rather are centered in a particular sector of its operations, such as airports in air transportation. By isolating the activities with which the heavy sunk costs are associated, their damaging consequences can be quarantined. By placing relations with the remainder of the industry at arm’s length … it may be possible to leave the operations of the bulk of the industry safely to the free market, drawing a regulatory net over only the segment of the activities of the industry that are inextricably associated with heavy sunk costs. Baumol, Panzar, Willig, Contestable Markets (1988), at 483.

19. Goal of the Telecom Act of 1996 “to eliminate the monopolies” (Verizon v. FCC) “reorganize markets deliberately” is an “end in itself” (Verizon v. FCC)

20. The Act’s Strategy Wholesale Segment Wholesale Vertically Integrated Local Exchange Retail Market for Telecom Plant (UNEs) Retail Segment

21. Why do we need an Act? • Industry Structure in the Local Exchange Markets tends toward monopoly • Economies of Density • Sunk Costs (risk) • First-mover advantages (i.e., municipal barriers to entry) • Timing of entry expenditures and realization of revenues • Product Differentiation (i.e., incumbent already has all the customers) • Vertical Integration (entry must occur at retail and wholesale level)

22. The Act’s Strategy Wholesale Segment N* > 0, ???? Entry economics of retail changed dramatically with unbundling and interconnection, since sunk network costs were “quarantined.” Entry economics of wholesale have improved due to technology and law, but the change is more subtle. Retail Segment N* > 0, Relatively Easy Where did they get this idea? …

23. Where Did They Get This Idea? • Number of Toll Carriers in Year 2001 = 805 • >900 now • Trends Report, IXCs plus resellers • Number of Nationwide Toll Networks in Year 2001 • AT&T • MCI-Worldcom • Sprint • Global Crossing (Ret. MS < 1%) • Williams (Ret. MS < 1%) • Qwest (Ret. MS < 3%) • Broadwing (Ret. MS < 1%) • Level 3 (Ret. MS < 1%) About 100:1 Ratio of Retail to Wholesale Firms in Long Distance About half of the wholesale firms are bankrupt (N > N*)

24. Getting More Wholesalers, Facilities-Based Entry • How do we get more wholesalers (networks)? • In long distance, all but the three largest long distance networks were built to serve other companies’ demands, not the own-demand of the network owner. • End-users don’t demand network, telecommunications firms do. • ILECs will serve their end-users with their own network, so entrant’s have no demand. • Entrant demand is from the non-incumbents serving end users (so, we should encourage this).

25. Non-Incumbent Demand for Network • Retail LECs (RLECs) accumulate market share for the Wholesale LECs (WLEC or ADCo). • RLECs want multi-firm supply • ILECs (today) are reluctant suppliers (full price is higher than wholesale price) • Facilities-based entry on a meaningful scale is made more possible with successful RLECs • RLECs cannot all be expected to deploy their own facilities • Consider market structure in long distance (100:1 Retail/wholesale)

26. Non-Incumbent Demand for Network • If we don’t have unbundling building as a means to build a demand for alternative network, how will this demand develop?

27. How to Use the Theory at Work • Is the proposed policy going to increase or decrease the market available to potential entrants?

28. How to Use the Theory at Work: Example • FCC Restriction on availability of unbundled switching in Top 50 MSAs. • An Empirical Examination of the Unbundled Local Switching Restriction, Z-Tel Policy Paper No. 3, March 2002. • Does Unbundling Really Discourage Facilities-Based Entry? An Econometric Examination of the Unbundled Local Switching Restriction, Z-Tel Policy Paper No. 4, February 2002. • Mandated Access and the Make-or-Buy Decision: The Case of Local Telecommunications Competition, T. R. Beard, G. S. Ford, and T.M. Koutsky, QREF Forthcoming.

29. How to Use the Theory at Work • Is the proposed policy going to increase the cost of entry, particularly those costs that cannot be recovered? • Is the policy debate itself raising entry costs? • Am I, as a regulator, allowing the incumbent to raise entry costs or contributing to the problem?

30. How to Use the Theory at Work • Is the proposed policy affecting the intensity of price competition? • Price cuts are generally a good thing, but there are price cuts that can harm the competitive process • Is the price cut intended to squash nescient entry?

31. How to Use the Theory at Work: Implications • Given the large entry costs of facilities-based entry, it is unreasonable to expect a large number of entrants. • Observed entry does not imply successful entry, and does not imply further entry is feasible (there is an equilibrium N).

32. How to Use the Theory at Work: Implications • Facilities-based entry will occur when few facilities (low entry costs) can serve large demands (large market size) • E.g., dedicated trunks to big businesses • Facilities entry occurs when there is a large size to entry costs ratio

33. How to Use the Theory at Work: Implications • Minimum market share for a facilities-based local provider of mass market local service is large, suggesting high concentration in that market. • Facilities based entrant for mass market will require large market share (20 - 50%). • Where will a potential facilities based entry get 20-50% market share?

34. How to Use the Theory at Work: Summary • What does this do the market size available to entrants? • What does this do to entry costs?

35. FCC Order: Bad Economics • Larger fixed and sunk costs imply that fewer firms are able to survive profitably in the industry (TRO, ¶ 80). OK • If more facilities-based carriers have entered the market than can be supported by market demand, creating overcapacity and generating low prices, none of the carriers may be profitable (TRO, ft. 320). OK

36. FCC Order: Bad Economics • Limiting our high-capacity loop triggers to only one competitor runs the risk of failing to accommodate unusual circumstances unique to that single provider that may not reflect the ability of other competitors to similarly deploy. Establishing a higher number, for example three, would likely render our high-capacity loop triggers meaningless for the many customer locations where the potential aggregate customer demand would never support more than two competitive alternatives to the incumbent LEC (TRO, ft. 974).

37. FCC Order: Bad Economics • if there is no collocation space available for additional competitive LEC equipment, further competitive entry may be impossible (TRO, ¶ 503).

38. FCC Order: Bad Economics • We find that the presence of facilities-based competitors is the best indicator that requesting carriers are not impaired (TRO, ¶ 498).

39. FCC Order: Bad Economics • evidence of actual deployment indicates barriers to entry can be overcome (TRO, 331) • We establish the number of competitors to the incumbent LEC necessary to satisfy each trigger for high-capacity loops subject to a finding of impairment at two in order to ensure that multiple competitive entry at each location is feasible (TRO, ¶ 330).

40. The Act • An Act [t]o promote competition and reduce regulation in order to • secure lower prices and higher quality services for American telecommunications consumers • and encourage the rapid deployment of new telecommunications technologies.

41. Lower Prices, Higher Quality? • PHOENIX CENTER POLICY BULLETIN No. 8: The $10 Billion Benefit of Unbundling: Consumer Surplus Gains from Competitive Pricing Innovations (27 January 2004).

42. Investment • George S. Ford and Lawrence J. Spiwak, The Positive Effects of Unbundling on Broadband Deployment, PHOENIX CENTER POLICY PAPER NO. 19 (September 2004). • PHOENIX CENTER POLICY BULLETIN No. 6: UNE-P Drives Bell Investment - A Synthesis Model (17 September 2003) • PHOENIX CENTER POLICY BULLETIN No. 5:  Competition and Bell Company Investment in Telecommunications Plant: The Effects of UNE-P (Originally released 9 July 2003 and updated 17 September 2003) • PHOENIX CENTER POLICY BULLETIN No. 4: The Truth About Telecommunications Investment after the Telecommunications Act of 1996 (24 June 2003).

43. Investment • Mandated Access and the Make-or-Buy Decision: The Case of Local Telecommunications Competition, T. R. Beard, G. S. Ford, and T.M. Koutsky, December 2002. • Pursuing Competition in Local Telephony: The Law and Economics of Unbundling and Impairment, T. R. Beard, R. B. Ekelund Jr., and G.S. Ford, Journal of Law, Technology, and Policy, Spring 2004. • Unbundling and Facilities-Based Entry by CLECs: Two Empirical Tests, G. S. Ford and M. D. Pelcovits, July 2002.

44. MARKET L S = 1,000,000 C = $10 F = $400,000 PM = $100 Competition = 10% N* = 2 MARKET D S = 1,000,000 C = $10 F = $100,000 PM = $100 Competition = 10% N* = 7 Extension: Consolidation and Entry

45. MARKET L N* = 2 MARKET D N* = 7 MARKET L+D S = 2,000,000 C = $10 F = $500,000 PM = $100 Competition = 10% N* = 3 Extension: Consolidation and Entry Bundling pulls the entire market to the most concentrated element of it. Assumes no scale or scope economies.

46. How to Use the Theory at Work: An Extension • Simple economics tells us that a bundled local/LD/Data market will be more concentrated than the long distance market, but potentially less concentrated than the local market.