The Economics of Competition in the Telecommunication Sector

1. The Economics of Competition in the Telecommunication Sector Lina Goussiou, OTE-NTUA National Technical University of Athens, Athens, 10-05-01 Lina Goussiou-OTE NTUA

2. Presentation Overview • Basic Economic Concepts • Regulation and Market Economy • Key factors for industry restructuring • Key characteristics of telecommunications networks and their evolution Lina Goussiou-OTE NTUA

3. Basic Economic Concepts • Economics is concerned with determining: • the most efficient way of allocating society’s limited economic resources among different possible uses • the conditions under which the market economy can lead to the optimum allocation of resources • the overall structure of market prices of goods and services that lead to the maximum satisfaction of consumers given limited and scarce resources Lina Goussiou-OTE NTUA

4. Basic Economic Concepts • Perfect competition is defined as the market where we have: • A lot of firms, where no firm is able to affect the terms of the market by itself. (price taking behavior) • Economically and physically homogeneous product • There is perfect knowledge and perfect foresight of consumers and producers. • There are no barriers to entry and exit for capital and labor • There is no-discrimination between buyers and sellers • In the short run, the typical firm takes the price (P) from the market and produces an output (Q*) that maximizes its profits (MR=MC). At Q* if P>AC the firm makes economic profits (extra profits). In the long run, those extra profits are eliminated by the entry of new firms in the market, that increase supply (S) and drive down the price until P=AC. • At equilibrium the product is produced a the minimum possible cost (technical efficiency, MC=AC), and social welfare is maximized since resources are allocated in precise accordance with consumer preferences (MC=P) Lina Goussiou-OTE NTUA

5. Theoretical perfectly competitive markets Competitive Market Competitive Firm s0 S1 MR=MC MC AC P0 D=P=AR=MR 0 P1 1 D Q0 Q1 Q Q* Q Lina Goussiou-OTE NTUA

6. Theoretical Monopoly Market • There may be only one firm in the market if there are barriers to entry due to: • Size of investment (fixed capital) • Mobility of investment (sunk costs) • Institutional (public goods) • Market power Lina Goussiou-OTE NTUA

7. Theoretical Monopoly Market • Equilibrium (profit maximization) is where MR=MC, but at that output MC not equal AC (technical inefficiency) and MC < P (economic inefficiency, under-allocation of resources). Thus there are two other possible pricing schemes • P = MC, and because there are practical difficulties to define this output, • P = AC, where normal profits are made (full cost price) • NATURAL MONOPOLY: In some industries, the downward sloping section of the AC curve extends over a very large output range (relative to total market demand). In this case it is more efficient to have one firm producing the whole output, instead of several. Lina Goussiou-OTE NTUA

8. Theoretical Monopoly Market P P* (MR=MC) P* MC AC P=MC P=AC D Q Q* MR Lina Goussiou-OTE NTUA

9. Theoretical natural monopoly firm P MC P2 AC P* Q Q* Q/2 Lina Goussiou-OTE NTUA

10. Theoretical natural monopoly firm • A single firm would be able to provide services at lower rates and with a wider coverage • A single firm would be better in achieving technical efficiency and to avoid duplication of investments and excess capacity • Economics of scale can be fully utilized to the benefit of all consumers Lina Goussiou-OTE NTUA

11. Monopoly & Regulation • Role of Regulation: to ensure that monopolies behave in accordance with the public interests and do not misuse their monopoly power • Economic Objective of Regulation: to help achieve the optimum level of production from a societal point of view, i.e. to ensure production in the desired quantities and at appropriate prices (efficient) for all consumers. Lina Goussiou-OTE NTUA

12. Telecom. Industry Restructuring • Industry was deemed to be ‘natural monopoly’ for decades • Existence of large fixed costs • Duplication of networks was neither privately profitable nor socially desirable • Deregulation and competition were introduced as a result • Growing awareness of the inefficiency of incumbent monopolists (rate of return regulation, distorted price levels and structure) • Technological change Lina Goussiou-OTE NTUA

13. Telecom. Industry Restructuring • Incumbent operators are being privatized • Markets have been largely regulated • Proliferation of services & multiplication of networks • Large number of actual or potential players • Shift of regulatory focus from incentive regulation to economic efficiency Lina Goussiou-OTE NTUA

14. Cost Characteristics • Very large fixed investment costs, part of which is sunk costs • Economies of scale: reduced unit costs with increased output • Economies of scope: cost savings related to supplying a number of services by the same firm • Economies of density:reduced network costs per connection with increased density of connections • Structural elements of a network • Access Network • Switching • Transmission Lina Goussiou-OTE NTUA

15. Structural Elements of a network • Access Network: Connects the user’s terminal to a local switch (twisted pair of cooper wire, coaxial cables, optical fibres). By far the most expensive part of the network • Switching: The switching function is performed at the exchanges (local, transit) by automatic, computer controlled equipment. The next costly function after access network. The vast majority of switching costs are in local exchanges. • Transmission: cables, radio-links and satellites connecting transit exchanges, as well as electronic equipment (transmitters, repeaters, etc). Not as significant in the total cost picture as access and switching costs Lina Goussiou-OTE NTUA

16. Trends in investment costs • Transmission • Optical fibre cables have reduced the cost of cables substantially • Prices for copper wires are relatively stable, but new compressing techniques are increasing its capacity • At present it is not economical to replace installed copper cable in the access network • Switching • Prices for electronic equipment have decreased rapidly and are expected to continue declining in the future • Value added services and intelligent services introduce new types of costs to network operators and leads to an increased share of costs for processing and value added components • Development costs are usage independent fixed costs, but they are not regular sunk costs Lina Goussiou-OTE NTUA

17. Trends in investment costs • Although investment costs are becoming cheaper, the level of investments in telecom services is growing rapidly and capital costs still constitute a substantial share of total costs of production • Decreasing cost trends reduce the economic lifetime of installed capacity. Investment must be depreciated at a faster rate and profitability requirements must be raised • Development of broadband services is closely related to reductions in costs of transmission. However, substantial demand will increase the demand for transmission capacity, and will bring up the costs for access and switching as a result of major network upgrades • Digitalization increases economies of scope for provision of facilities, but reduces economies of scope for service provision Lina Goussiou-OTE NTUA

18. Demand Characteristics • Saturation levels for basic telephony • Fast growing diversified demand for an increasing range of services • New services need to establish a critical mass of network subscribers • Growing segmentation between user groups in terms of markets, services and interests • Changing demand conditions result in different cost and market structures for the different customer groups Lina Goussiou-OTE NTUA

19. Competitive Evolution • Entry into Local/LD/Intl Markets • Facilities based • Resale • Unbundling • Alternative Reform Paths • US, UK, NZ, Europe Lina Goussiou-OTE NTUA

20. Issues for competitive era • Provision and scope of USO • Interconnection is crucial for the development of effective competition and to provide access to bottlenecks • Residential access network still presents significant barriers to entry, LLU • Entry of efficient competitors • Coordination of investments in facilities and new technologies • Duplication of networks • Preservation of competition on some segments when another segment is monopolized • Competition in telecommunications does no come about as easily as in other sectors Lina Goussiou-OTE NTUA

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23. Technological Attributes • the routing of service • the location of bottleneck • the storability of output • the speed of technological change • the proliferation of networks • PSTNs, Cable companies, Competitive access provider, Mobile operators, LAN linking computers, ISP Lina Goussiou-OTE NTUA

24. Key Characteristics of Telecom Networks Telecom Networks differ from other network industries: • in their technological attributes • in their cost & demand characteristics • in the pace of regulatory reform and industrial restructuring Lina Goussiou-OTE NTUA

25. Role of Technical Change • Changing structures of network costs • Development of broadband services • Lifetime of equipment is reduced • Digitalization • Satellite and cellural Lina Goussiou-OTE NTUA