Basic Setup: Equilibrium Industry Structure

2. Competition After Unbundling: Entry, Industry Structure and ConvergenceGeorge FordChief EconomistPhoenix Center

3. Basic Setup:Equilibrium Industry Structure • Firms enter only if they make a profit • Entry stops when “the next firm” expects a negative profit • When entry stops, the existing number of firms is the equilibrium number of firms (N*) • No incentive to enter • No incentive to exit

4. Formal Theory N* = Equilibrium Number of Firms (symmetric)  = Weakness of Competition S = Market Size in Expenditure (isoelastic demand) E = Sunk Entry Costs Sources: Sutton, Duvall and Ford (PP10), Beard and Ford

5. The Entry Decision:Less Formal Theory • Do gross profits (d) exceed entry costs (e)? • Gross profits (d) are revenues less variable costs. • Entry costs (e) are fixed/sunk d – e 0

6. What it Means

7. Want Facilities-based Entry? • Increase Gross Profits • Reduce Entry Costs

8. Multiple Changes

9. Equilibrium Industry Structure • High Fixed and Sunk Costs allow only few firms to enter • Historically, local distribution networks for communications services have tended toward monopoly • Voice • Video

10. Factors Driving Profits (d) • Market Size (+) • Intensity of Price Competition (-) • Product Differentiation (+) • Network Overlap (-)

11. Numerical Example 1(Table 1, PCPP 21)

12. Numerical Example 2(Higher Gross Profits)

13. Factors Driving Profits (d) • Market Size (+) • Intensity of Price Competition (-) • Product Differentiation (+) • Network Overlap (-)

14. Numerical Example 3(Intensity of Price Competition)

15. Headcount and Competition • With large fixed/sunk costs, headcounts can be deceiving • A large number of firms may indicate collusion • A small number of firms may indicate intense price competition

16. Entry and Collusion(Based on Post-Convergence Example Above)

17. Factors Driving Profits (d) • Market Size (+) • Intensity of Price Competition (-) • Product Differentiation (+) • Network Overlap (-)

18. Product Differentiation and Overlap Differentiation weakens price competition. Overlap increases price competition. Price P1 P2 P3 More Differentiation Less Differentiation 50% Homes/Overlap 100% Phoenix Center Policy Paper No. 21, Figure 1.

19. Diversion:Competition and Substitution • Competition occurs between goods/services that perform a similar task for consumers • Good X is a substitute for Good Y if the demand for Good X rises when the price of Good Y rises (and vice versa)

20. Diversion:Competition and Substitution • The relationship of quantities of goods is not an indicator of substitution • Unless we already know the goods are perfect substitutes • Substitution is of degree • Airplanes, Buses, Cars, Trains all provide transportation, but we might be concerned about a monopoly over any of one of them

21. Diversion:Competition and Substitution • As long as the own-price demand elasticity is less than –1.0 (or inelastic), then a 5% price increase is profitable • Cross-price elasticities are not indicators of Antitrust markets • Large cross price elasticities are indicators of good substitution, but if own-price is not elastic enough, a significant price increase remains profitable

22. Example • Wireless Substitution and Competition, by Stephen Pociask • lnQM = -0.56 · lnPM + 1.97·lnPW+X+ • More wrong with the econometrics of this paper than I could cover in a day, much less an hour • “…the models provide compelling empirical evidence that wireless and wireline services are indeed substitute goods, and are not extraneous or complementary goods (at 15).” • This model indicates substitution (an implausibly large amount of it), but still not enough substitution to place wireless/wireline in the same market. Q is quantity, P is price, M is mobile, W is wireline, ln is the nat. logarithmic transformation, X is the means of the other variables in the model multiplied by their coefficients.

23. Types of Entry Costs (e) • Technological Entry Costs (+) • Strategic Entry Costs (+) • Regulatory Entry Costs (+) • Spillovers (-)

24. Types of Entry Costs (e) • Technological Entry Costs (+) • Entry costs that are unavoidable to provide service • Network • Operating Capital • Advertising • Building Leases • Etc…

25. Types of Entry Costs (e) • Strategic Entry Costs (+) • Entry costs that arise solely because of incumbent firm actions intended to raise entry costs • Excessive Advertising • Lock-in Contracts • Strategic Pricing

26. Types of Entry Costs (e) • Regulatory Entry Costs (+) • Rules that raise entry costs above technological entry costs • Build-out Requirements • Gold-plating Networks • Entry Fees • E911 and other social programs • If socially-desirable, there may be a trade-off between entry and the provision of the service (e.g., E911)

27. Types of Entry Costs (e) • Spillovers (-) • Spillovers exist when a firm can use existing assets to enter related markets. • This firm has lower entry costs than a firm without existing assets that can be leveraged into a related market • Network (DSL over Copper; Cable Broadband over Coax; Fiber over existing rights-of-way; customer relationships)

28. Numerical Example 1(Table 1, PCPP 21)

29. Numerical Example 4(Reduced Entry Costs)

30. Spillovers and Convergence • Convergence is relevant only when it reduces entry costs. • Effects of convergence are generally limited to firms with existing assets that can be “spilled over” into related markets.

31. Numerical Example 5(Spillovers and Convergence) No Entry

32. Equilibrium Industry Structure:Summary • There will be few local networks • So, rig the game in favor of entry by new firms and expansion by existing firms into related market • Eliminate regulatory entry barriers • Impede strategic entry barriers • Expand markets

33. Phoenix Center Policy Paper No. 22The Consumer Welfare Cost of Cable “Build-Out” Rules

34. Build-Out Rules • Unambiguously Bad for Entrants • May be good for Consumers • May be good for Incumbents • But can’t be good for both Consumers and Incumbents at the same time • Why do both policymakers and incumbents advocate for build-out rules?

35. Build-Out Rule:Graphical Explanation Price homes ordered by capital cost e(h) e(h): Entry Cost for home i r(h): Expected Revenue for home i r(h) H Homes/Overlap Phoenix Center Policy Paper No. 22, Figure 1.

36. Free Entry Equilibrium Price homes ordered by capital cost Profits from Entry e(h) w t v r(h) h* H Homes/Overlap

37. With Build-Out Rule Price homes ordered by capital cost Profits from Entry y e(h) Losses from Entry u v r(h) z x H Homes/Overlap

38. With Build-Out Rule:The Monopoly’s Decision Price homes ordered by capital cost Profits from Entry r(h) Losses from Entry e(h) The monopolists decision to build-out is entirely different than an entrants. Entrant’s r(h) H Homes/Overlap

39. Build-out Rule:Matrix of Preferred Outcomes Phoenix Center Policy Paper No. 22, Table 1.

40. FCC on Build-out Rules “build-out requirements are of central importance to competitive entry because these requirements impact the threshold question of whether a potential competitor will enter the local exchange market at all.” FCC No. 97-346 (1997)

41. Simulation Phoenix Center Policy Paper No. 22, Table 2. Assumptions: Entrant market share = 35%. Price decline for 100% overlap is 20%.

42. Simulation:Effect of Market Share

43. Simulation:Build-out and Investment

44. Simulation:Build-out, Consumers and Incumbents

45. Defection • What happens if some communities abandon the build-out rule when others maintain it? • Defection raises the defector’s relative profitability, increasing the prospects for deployment sooner (rather than later, if ever) • With 25% defection rates, average increase in profit rank is 38 positions (out of 100)

46. In Defense of Build-out Rules • NCTA • Incumbent cable firms cross-subsidize low value areas with profits from high-value areas • Entry in high-value areas only depletes source of cross subsidy, threatening upgrades/expansion in low value areas • Entrants should have to build-out too, regardless of whether it deters entry

47. In DefenseThe Monopoly’s Decision Price homes ordered by capital cost Profits from Entry e(h) Losses from Entry Profits offset losses for Monopoly build-out. r(h) H Homes

48. In DefenseEntry with Uniform Price Price homes ordered by capital cost Profits from Entry e(h) Losses from Entry Profits insufficient to cover losses. But, entrant does not enter (50-50 split of the market). r(h) Entrant’s r(h) H Homes/Overlap

49. In DefenseEntry with Market Segmentation Price homes ordered by capital cost Profits from Entry e(h) Losses from Entry rmonop With markets segmented, higher price in uncontested segment reduces loss, increases profit. rcomp Entrant’s r(h) H Homes/Overlap

50. Evaluation of Defense • Cable network is sunk • As long as revenues exceed the incremental cost of the network (programming, maintenance), there is no incentive to abandon the network • According to NCTA, upgrades are done at the edge of the network, so initial capital cost of network are somewhat irrelevant