Network interconnection and competition Patrick Rey

Network interconnection and competition Patrick Rey IE Business School and Fundación Ramón Areces Madrid, 5 April 2011

Introduction • Topics • Interconnection (wholesale level) • connectivity (capacity, QoS agreements, net neutrality) • access prices (termination charges) • Competition (retail level) • linear/nonlinear tariffs (large/small consumers) • on-net pricing (club effects) • caller pays/receiver pays principles (consumers/websites) • [entry / investments] • Positive / welfare analysis Network interconnection and competition

Connectivity strategies • Issue: whether to connect / compatibility or quality (Katz-Shapiro AER 85, Farrell-Saloner Rand 85) • Snowballing, club effects (small shocks / large impact) • Inertia, lock-in • role of installed bases • switching costs? • Coordination problems • positive: coordination devices • normative (Pareto criterion; heterogeneity?) • “one-way” interconnection backward/forward compatibility, downgraded version (read-only) Network interconnection and competition

Connectivity strategies • Large networks are less eager to maintain connectivity • Trade-off: degraded interconnection • has a negative direct effect (network is less attractive) • has an indirect strategic effect (rival also less attractive) • Strategic effect can dominate is network is large enough • refusing / degrading interconnection (WC/MCI/Sprint) • developing closed / proprietary standards (iTunes) • Large? Installed base of locked-in customers, coordination Network interconnection and competition

Connectivity strategies • Illustration: the WorldCom – MCI merger Crémer-Rey-Tirole JIE 2000 • Pre-merger: 4 backbones (WorldCom, MCI, Sprint, GTE) • all backbones have similar installed bases (1/4, say) • pre-merger, all backbones aim at perfect connectivity • Merger between 1 and 2 (installed bases ½,¼,¼) → three connectivity strategies: • accommodation: maintain connectivity (1,1,1) • global degradation (½, ½ , ½ ): never attractive • targeted degradation + limit on transit (¾ , ½ ,1): attractive Network interconnection and competition

Interconnection and competition • One-way versus two-way access • One-way access • upstream: incumbent controls a bottleneck (e.g., local loop) • downstream: incumbent competes with rivals → essential facility doctrine, access regulation • Two-way access • network operators compete for subscribers • but need each other to complete calls → competitive bottlenecks Network interconnection and competition

Interconnection and competition • Cooperation or competition? • Interoperability requires cooperation • standards, protocols (QoS) • interconnection agreements • … between competitors • “cooperation” may prevail over “competition” • lack of cooperation from incumbents may hurt new entrants → impact of interconnection prices on retail competition Network interconnection and competition

Mobile to mobile termination • Competing bottlenecks • Wholesale: bilateral interconnection agreements • perfect connectivity (no club effect) • reciprocal termination charge (access price): a • Retail: price competition • linear / non-linear (two-part) tariffs (prepaid/post-paid, subsidy) • on-net pricing (friends and family) • prices for sending and/or for receiving (US/EU) Network interconnection and competition

Framework co + ct ct – a C1 C2 Network 1 Network 2 • Cost structure • Origination and termination costs: co , ct • Reciprocal access charge a • on-net cost: c = co + ct • off-net cost: c = co + a = c + m, where m = a – ct Network interconnection and competition

Linear retail pricesArmstrong (EconJ 1998), Laffont-Rey-Tirole (Rand 1998) • The access charge as a “collusive” device • Access mark-up m= a – ct inflates the “perceived” marginal cost average marginal cost for network i: ci = c + αj m • In (symmetric, imperfectly competitive) equilibrium price based on perceived cost : p = pe(c + m/2) • If access prices are set unilaterally: double marginalization • If bilateral negotiation of a reciprocal charge: collusive device a high enough termination mark-up sustains monopoly prices • Note: no termination revenue or deficit if “balanced pattern” • [even if asymmetric market shares: α1 α2 m = α2α1 m …] • Compare with “bill and keep” Network interconnection and competition

Non-linear (two-part) tariffsLaffont-Rey-Tirole (Rand 1998) • Two-part tariff (Fi,pi) • Termination mark-up still drives up usage prices pi = ci = c + αj m • But competition for subscribers dissipates profits • “waterbed effect” (Paul Geroski for F2M termination) • lower fixed fees, handset subsidies, … • If total demand is elastic • access charge is “neutral” for profit → termination charge no longer acts as a collusive device • but decreases consumer surplus / total welfare (wrong signal) Network interconnection and competition

Full participation / waterbed effect Demand side Full participation α1 + α2 = 1 Balanced calling pattern each user calls all users with equal probability demand for calls per subscriber is q(p), indirect utility v(p) → variable surplus is wi = v(pi) – Fi Horizontal differentiation à la Hotelling (differentiation t) → operator i 's market share is αi = 1/2 + (wi - wj)/2t 11 Network interconnection and competition

Full participation / waterbed effect Termination rate does not affect industry profit Usage price to average marginal cost: p = c + m/2 Termination revenue dissipated on fixed fee: F = f + t – m/2 Consider stealing a caller from network rival network retail profit: neutral since price p∗ covers average cost c + m/2 termination between own subscribers: saves & loses mq∗/2 termination from rival’s subscribers: brings mq∗/2 → net gain of mq∗/2: the fixed-fee is reduced by this amount Industry profit is independent of m: 2Π = t 12 Network interconnection and competition

On-net pricingLaffont-Rey-Tirole (Rand 1998), Gand-King (EconL 2001) • Reintroduces club effects • Perfect connectivity • But, for same prices, users favour larger networks • Similar to compatibility / connectivity analysis • Fiercer competition among similar networks • Profits are maximal for a termination charge … below cost • However, also exacerbates the risk of “tipping” Network interconnection and competition

Receiver pays regimeLaffont-Marcus-Rey-Tirole (Rand 2003) • Two types of users • Mobile in the US: senders/callers vs receivers/callees • Internet: websites send traffic / consumers receive it • Two prices • price for receiving traffic pr, demand Dc(pr) • price for sending traffic ps, demand Dw(ps) → volume of traffic (“balanced pattern”) Dc(pr) x Dw(ps) Network interconnection and competition

Receiver pays regimeLaffont-Marcus-Rey-Tirole (Rand 2003) • The off-net cost pricing principle • For network i πi = (pis + pir – c)DiwDic (on-net) + (pir + a – ct)DjwDic (incoming off-net) + (pis –a – co)DiwDjc (outgoing off-net) = [pis – (co + a)]DiwDc + [pir – (ct – a)]DicDw • Under perfect competition, prices reflect off-net costs ps = co + a, pr = ct – a Network interconnection and competition

Receiver pays regimeLaffont-Marcus-Rey-Tirole (Rand 2003) • Pretty robust principle • Arbitrary number of networks • Mixed traffic patterns • Customer cost heterogeneity: cost ctk, cok for group k • Quality of service: pr+ =ct+ – a, ps+ = co+ + a • Welfare implications (Ramsey pricing) Network interconnection and competition

Policy puzzle • Theory: when networks compete in non-linear tariffs • Profits are not affected by the termination charge • LRT Rand 1998 • heterogeneous users (Dessein Rand 2003, Hahn IJIO 2004) • Or maximal for termination charges at or below cost • Gans-King EL 2003 • elastic demand (Dessein Rand 2003, Schiff RNE 2008) • asymmetric networks Carter-Wright (RIO 2003) • Practice • Operators favour termination rates above cost • While regulators push for low rates • EU recommendation: termination rates at LRIC by 2012 • France: from 14,94/17,89 c€/mn in 2004 to 3,0 / 3,4 in January 2011 Network interconnection and competition

GLIDE PATH Network interconnection and competition

Revisiting MTM termination • Link between FTM and MTM rates Armstrong and Wright 2008 • Arbitrage (“hedgehogs”) / regulatory policies • FTM: partial waterbed effect / double marginalization (unilateral setting) • Asymmetric competition and entry barriers Cazalda-Valletti 2008, Hoernig 2007 (predation), Lopez-Rey 2009 • Users’ expectations Lopez-Hurkens 2010 • Here: demand heterogeneity (heavy / light users) call imbalance and different participation elasticities Network interconnection and competition

Main insightsJullien-Sand Zantman-Rey (2010) Assume that consumers exhibiting traffic deficit … have also a more elastic participation large users churn but always participate small users mostly receive calls and may not participate pre-pay/post-pay, large/small users in post-pay, teenagers... Then profits are maximal for MTM termination rates above cost welfare is maximal for MTM termination rate also above cost but below the level that maximizes profits 20 Network interconnection and competition

Heavy and light users Light users Do not call but receive calls Elastic (symmetric) subscription demand βi = β(Pi,Pj) aggregate demand βT(P) = 2βi(P,P) is decreasing in P replacement ratio γ(P) = ∂β2(P,P)/∂P1╱(-∂β1(P,P)/∂P1)∈ [0,1[ Heavy users Total participation of 1 + βT → heavy users’ surplus becomes wi = (1+ βT)v(pi) – Fi (they benefit from being able to call more light users Full participation → operator i 's market share is αi = 1/2 + (wi - wj)/2t 21 Network interconnection and competition

Equilibrium: heavy users Symmetric equilibrium Network i 's profit is equal to Πi = αi[(1+βT)(pi - c)q(pi) – (αJ+ βj)mq(pi) + Fi – f] + (αi+βi)αjmq(pj) + βi(Pi - φ) The usage price maximizes the surplus from trade (LRT) p1 = p2= p∗ = c + m/2; q∗ = q(p∗) The equilibrium subscription fees are then F∗ = f + t + (βT - 1)mq∗/2 22 Network interconnection and competition

Intuition Consider stealing a caller from network rival network No light user (βT = 0) net gain of mq∗/2 the fixed-fee is reduced by this amount With light users (β1 = β2 = βT/2 > 0), the reduction is smaller loses termination revenue from own light users: (βT/2)mq∗ the fixed fee is augmented by this amount 23 Network interconnection and competition

Equilibrium: light users Network i's profit then writes as Πi = (1/2)[F∗ - f + (1/2 + βi)mq∗ + (βi - βj)(m/2)q∗] + βi(Pi - φ) Optimizing with respect to Pi amounts to maximize G(Pi,Pj) = (Pi - C) βi(P1,P2) – C∗βj(P1,P2) C = φ - 3mq∗/4 represents the direct opportunity cost of attracting light users, net of the benefits from calls received on-net (half the charge) and off-net (full charge) C∗ = mq∗/4 represents the opportunity cost of the rival’s light users corresponding to the termination deficit (the price charged for calling these light users covering only half of the termination charge) 24 Network interconnection and competition

Equilibrium: light users Equilibrium subscription for light users where ε(P) denotes the own price elasticity of light users' subscription demand 25 Network interconnection and competition

Impact of termination rates Increasing the termination rate has two effects intensifies competition for light users via two channels waterbed : light users generate larger net termination revenue opportunity cost : preventing the other network from attracting a light user saves on termination costs reduces competition on the heavy users the cost of losing a heavy user to competitor is weakened by the larger termination revenue that the calls to light users will generate (again because there is no equivalent volume of calls from light users to this heavy user) 26 Network interconnection and competition

Equilibrium profit The operators’ profit is 2Π∗ = t + (P∗ - φ + mq∗)βT(P∗) P∗ depends on m only through access revenue r = mq∗ → the operators’ profit depends only on the access revenue r and is maximal when the termination markup is at monopoly level mR = argmaxm mq(c+m/2) 27 Network interconnection and competition

Equilibrium surplus Light users' surplus is increasing in access revenue r Effect on heavy users is ambiguous heavy users' net variable surplus is SH = (1+ βT)v(p∗) – f – t – (βT - 1)mq∗/2 → increasing the termination rate raises network externalities from light users (through r = mq∗ and βT) but also raises usage prices: p∗ = c + m/2 → for m small, increasing m raises heavy users' surplus if light users' subscription demand is very elastic or if heavy users' usage surplus is not very elastic → total welfare is maximal for a termination markup that is positive but smaller than the monopoly level 28 Network interconnection and competition

Extension: on-net/off-net With on-net/off-net price discrimination the analysis is similar with additional effects usage price = marginal cost (on-net and off-net) revenue from light users' received calls is smaller (no gain from on-net calls) tariff-mediated network effects intensify competition on heavy users additional effect of light users on tariff-mediated network effects Welfare is maximal for a positive termination mark-up Profit is maximal for a termination mark-up that may be smaller or even negative 29 Network interconnection and competition

Extension: FTM termination rate Each subscriber generates an extra revenue from FTM termination waterbed effect on both users both subscription fees decrease reduction can be larger for either type of user the presence of light users … limits the waterbed effect on heavy users industry profit increases 30 Network interconnection and competition

Conclusion The level of termination rate has contrasted effects on the intensity of competition for different types of consumers high termination rates benefit small users due to more competition than even the waterbed effect suggests high termination rates reduce the intensity of competition for large users Consistent theory explaining a positive effect of TR on profit Regulation is useful but the rate should be set above cost How much above costs? → need for empirical work Effect of Receiver Pays Principle? 31 Network interconnection and competition

Network interconnection and competition Patrick Rey