Access Pricing: Theory and Practice

ACCESS PRICING: THEORY AND PRACTICE

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ACCESS PRICING: THEORY AND PRACTICE

Edited by RALF DEWENTER Helmut-Schmidt-University Hamburg, Hamburg, Germany and JUSTUS HAUCAP Ruhr-University of Bochum, Bochum, Germany

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Elsevier Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK First edition 2007 Copyright © 2007 Elsevier B.V. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13: 978-0-444-52803-2 ISBN-10: 0-444-52803-2 For information on all Elsevier publications visit our website at books.elsevier.com Printed and bound in The Netherlands 07 08 09 10 11

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Contents

List of Contributors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv Preface and Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix Chapter 1 Access Pricing: An Introduction . . . . . . . . . . . . . . . . 1 Ralf Dewenter and Justus Haucap 1.1 Introduction to the Introduction                          2 1.2 Access to Networks: Concepts and Issues                 4 1.2.1 Essential facilities                                4 1.2.2 One-way access                                  6 1.2.3 Two-way access (interconnection)                 7 1.3 Access Pricing: Theory                                  7 1.4 Access Pricing: Practice                                 9 1.4.1 The retail-minus approach                        11 1.4.2 The efficient component pricing rule              11 1.4.3 Cost-based concepts                             13 1.4.4 Capacity-based pricing and price caps             15 1.4.5 Institutions                                      16 1.5 Contents of this Book: Theory                          18 1.5.1 One-way access pricing                          18 1.5.2 Two-way access pricing                          22 1.5.3 Access pricing and multihoming                  24 1.6 Contents of this Book: Practice                          26 1.6.1 Applications to specific markets                  26 1.6.2 Policy                                          31 1.7 Conclusion                                            34 References                                                 35

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PART I – ONE-WAY ACCESS PRICING

39

Chapter 2 Access Pricing and Infrastructure Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Joshua S. Gans 2.1 Introduction                                           42 2.2 Model of Investment Timing                            43 2.2.1 Investment costs                                 44 2.2.2 Investment benefits                              44 2.2.3 Socially optimal timing                          45 2.3 No Access Regulation                                  46 2.3.1 Motives for access                               46 2.3.2 Motives for investment                          47 2.3.3 Negotiations over access                         49 2.3.4 Equilibrium investment timing                    50 2.3.5 Summary                                       52 2.4 Access Price Regulation                                52 2.4.1 ‘Small’ seekers                                  53 2.4.2 Two ‘large’ firms                               54 2.4.3 Summary                                       58 2.5 Practical Issues                                        58 2.5.1 Optimal usage charges                           58 2.5.2 Access holidays                                 60 2.6 Conclusion                                            62 References                                                 63 Chapter 3 Network Financing with Two-Part and Single Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Axel Gautier 3.1 Introduction                                           66 3.1.1 Model overview and results                      68 3.1.2 Related literature                                70 3.2 Model                                                 71 3.2.1 Demand, costs and information                   71 3.2.2 Regulation                                      72

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3.2.3 Timing of the events                             73 3.2.4 Benchmark: the regulated monopoly case          74 3.3 Optimal Access Charges                                75 3.3.1 The entrant’s entry and supply decisions          75 3.3.2 Two-part tariff                                  76 3.3.3 Single tariff                                     79 3.4 Comparisons                                           81 3.4.1 Market structure                                 81 3.4.2 Welfare                                         82 3.5 Concluding Remarks                                   83 Appendix                                                   85 A3.1 Proof of proposition 3.2                          85 A3.2 Proof of proposition 3.3                          87 A3.3 Proof of proposition 3.4                          88 References                                                 89 Chapter 4 Unbundling the Local Loop: One-way Access and Imperfect Competition . . . . . . . . . . . . . . 91 Paul W. J. de Bijl and Martin Peitz 4.1 Introduction                                           92 4.2 Policy on Local-Loop Unbundling in Telecoms           95 4.2.1 Unbundling in the EU                           95 4.2.2 Unbundling in the US                           97 4.3 Regulatory Theory with Full Participation                99 4.4 Regulatory Theory with Partial Participation            107 4.5 Discussion and Conclusion                           114 References                                             116 PART II – TWO-WAY ACCESS PRICING

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Chapter 5 On the Role of Access Charges Under Network Competition . . . . . . . . . . . . . . . . . . . . . . . . . 121 Stefan Buehler and Armin Schmutzler 5.1 Introduction                                       121 5.2 Linear Retail Prices                                 124

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5.2.1 5.2.2 5.2.3 5.2.4

Assumptions                               124 Comparative statics                         128 Are retail prices strategic complements?        130 Do higher access charges shift out the reaction curves?                                132 5.3 Simplifying Assumptions: How do they Affect the Role of Access Charges?                           133 5.3.1 Full-coverage networks                      134 5.3.2 Full-coverage networks and balanced calling pattern                              136 5.4 Nonlinear Retail Tariffs                            138 5.4.1 Assumptions                               139 5.4.2 Comparative statics                         141 5.5 Extensions and Conclusions                        145 References                                             146 Chapter 6 Access Pricing Under Cost Asymmetry in Telecommunications . . . . . . . . . . . . . . . . . . . . . . . . 149 Viktória Kocsis 6.1 Introduction                                      150 6.2 Model for Linear Tariffs                           153 6.2.1 Cost structure and access fee                 153 6.2.2 Demand structure and consumer surplus                                    154 6.2.3 Price competition                           157 6.2.4 Comparison and policy implications           158 6.3 Competition in Two-Part Tariffs                    160 6.3.1 Demand structure and consumer surplus                                    161 6.3.2 Price competition                           162 6.3.3 Comparison and policy implications           164 6.4 Conclusions                                      167 Appendix                                              168 A6.1 Proofs                                           168 A6.2 Simulation results                                 172

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A6.2.1 Comparison according to parameter values     172 A6.2.2 Comparison according to access fee           173 References                                             175 PART III – Access Pricing and Multihoming

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Chapter 7 Interconnection Competition with Multiple Network Subscription . . . . . . . . . . . . . . . . . . . . . . . . . 179 Roger K. Alexander 7.1 Introduction                                       180 7.1.1 Background to new analysis framework        180 7.1.2 Organization of this chapter                  182 7.2 Consumer Utility Model Setup                       183 7.2.1 Consumer discrete subscription choice model   184 7.2.2 Direct measurable utility from network subscription                                193 7.3 Network Competition – Dual Network Subscriptions     199 7.3.1 Network marginal costs and price competition model                                 199 7.3.2 Network calling pattern                      200 7.3.3 Two-stage network competition               201 7.4 Network Competition Modelling: Linear Pricing        209 7.4.1 Equilibrium price–access charge relationship    209 7.5 Conclusion                                        216 7.5.1 Summary and general findings                216 7.5.2 Future areas of study                        218 Appendix                                              218 A7.1 Dual network subscription example            218 References                                             227 Chapter 8 Platform Competition with Endogenous Multihoming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Roberto Roson 8.1 Introduction                                       229 8.2 The Model Structure                                233

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8.2.1 Assumptions and definitions                 233 8.2.2 Profit maximization                        238 8.3 A Numerical Simulation of Platform Competition                                      242 8.4 Concluding remarks                               246 References                                             247 PART IV – Application to Specific Markets

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Chapter 9 Network Ownership and Optimal Tariffs for natural Gas Transport . . . . . . . . . . . . . . . . . . . . . . . 251 Kåre P. Hagen, Hans Jarle Kind and Jan Gaute Sannarnes 9.1 Introduction                                      251 9.2 A Simplified Model for Transportation of Gas        255 9.2.1 Fully integrated network                    256 9.2.2 Separation of ownership between transportation network and extraction and marketing activities                        265 9.3 Conclusion and Discussion                         270 Appendix                                              272 A9.1 Existence of equilibrium                           272 A9.2 Downstream competition with firms located outside the country                                       274 References                                             275 Chapter 10 Mobile Termination . . . . . . . . . . . . . . . . . . . . . . . . . . 277 Harley Thompson, Olivier Renard and Julian Wright 10.1 Introduction                                      277 10.2 Literature Review                                 280 10.3 Theoretical Model                                285 10.3.1 Model derivation                          285 10.3.2 Model solution                            290 10.4 Model Calibration                                 292 10.4.1 Colombian fixed-to-mobile arrangements      292 10.4.2 Calibration methodology                    293 10.4.3 Data for Colombia                         293

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10.5 Welfare Analysis                                  294 10.6 Conclusions and Future Directions                   299 References                                             301 Chapter 11 Incentives to License Virtual Mobile Network Operators (MVNOs) . . . . . . . . . . . . . . . . . . . . . . . . . 303 Ralf Dewenter and Justus Haucap 11.1 Introduction                                      303 11.2 What are MVNOs?                                306 11.3 Regulatory Approaches and Emergence of MVNOs                                       309 11.4 The Model                                       313 11.4.1 Cournot competition                        313 11.4.2 Bertrand competition                       316 11.4.3 Stackelberg competition                     320 11.5 Summary and Policy Conclusions                    322 References                                             323 PART V – Policy

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Chapter 12 Antitrust and Sector-Specific Regulation in the European Union: The Case of Electronic Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 Alexandre De Streel 12.1 Introduction                                      328 12.2 A Broad Picture                                   329 12.2.1 Substantive law                            329 12.2.2 Institutional design                         335 12.3 Competition Law                                  339 12.3.1 Ex post competition law                     339 12.3.2 Ex ante competition law: mergers and joint ventures                                  345 12.3.3 Appraisal of the application of antitrust in the electronic communications sector          348

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12.4 Sector Regulation                                 350 12.4.1 Ex ante sector regulation                    350 12.4.2 Appraisal of the application of sector regulation                                 353 12.5 Optimal Balance between Rules and Coordination between Institutions                                358 12.5.1 The optimal balance between antitrust and sector regulation                           358 12.5.2 The optimal institutional coordination         362 12.6 Conclusion                                       363 Appendix                                              365 References                                             368 Chapter 13 Efficient Regulation of Dynamic Telecommunications Markets and the New Regulatory Framework in Europe . . . . . . . 373 Pio Baake, Ulrich Kamecke and Christian Wey 13.1 Introduction: The New Regulatory Framework in the European Union                                   374 13.2 Dynamic Competition                              379 13.2.1 Schumpeter’s competition through innovation                                 380 13.2.2 Incentives to innovation                     387 13.2.3 The role of competition                     391 13.2.4 Intermediate conclusion                     394 13.3 Dynamic Competition in Telecommunications Markets and Traditional Regulation                  395 13.3.1 New networks: structures and demand for DSL accesses                              396 13.3.2 Investment, downstream markets and strategies for the network operator            397 13.3.3 Competition to construct new networks        402 13.3.4 Traditional regulation: cost-based network access                                    406

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13.4 Regulation of New Markets                         407 13.4.1 New markets                              408 13.4.2 Regulation                                411 13.4.3 Incentive effects: infrastructure-based competition                               414 13.5 Summary                                         417 References                                             418 Chapter 14 Are Vertically Integrated DSL Providers Squeezing Unaffiliated ISPs (And Should We Care)? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421 Robert W. Crandall and Hal J. Singer 14.1 Introduction                                      422 14.2 The Role of Regulation in Promoting ISPs            424 14.2.1 Computer I and II decisions                  425 14.2.2 Choice of global service provider regulation    427 14.2.3 Reciprocal compensation game               428 14.3 What Did Internet Service Contribute to Economic Value?                                           430 14.3.1 The value-added of unaffiliated internet service providers in the dial-up era            430 14.3.2 The value-added of intermediaries in the broadband era                             432 14.4 Issues for Competition Law                         440 14.4.1 Price squeeze allegations                    442 14.4.2 The conditions under which a price squeeze harms consumers                           445 14.4.3 The relationship between a price squeeze and cross subsidy                          450 14.5 Conclusion                                       455 References                                             456 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .461

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List of Contributors Roger K. Alexander The Senbazuru Group, LLC Rockville, USA Pio Baake

Department of Economics Humboldt University at Berlin Berlin, Germany German Institute for Economic Research (DIW) Berlin, Germany

Paul W. J. de Bijl

TILEC Tilburg University Tilburg, Netherlands

Stefan Buehler

University of St. Gallen St. Gallen, Switzerland Socioeconomic Institute University of Zurich Zurich, Switzerland

Robert W. Crandall

The Brookings Institution Washington, DC, USA

Ralf Dewenter

Department of Economics Helmut-Schmidt-University Hamburg Hamburg, Germany

Joshua S. Gans

Melbourne Business School University of Melbourne Melbourne, Australia

Axel Gautier

Universitaires Saint Louis Bruxelles, Belgium

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List of Contributors

Kåre P. Hagen

Department of Economics Norwegian School of Economics and Business Administration Bergen, Norway

Justus Haucap

Department of Economics Ruhr-University of Bochum Bochum, Germany

Ulrich Kamecke

Department of Economics Humboldt University at Berlin Berlin, Germany

Hans Jarle Kind

Department of Economics Norwegian School of Economics and Business Administration Bergen, Norway

Victória Kocsis

Corvinus University of Budapest Budapest, Hungary Tinbergen Institute Amsterdam, Netherlands

Martin Peitz

School of Business Administration International University in Germany Bruchsal, Germany

Olivier Renard

Charles River Associates Melbourne, Australia

Roberto Roson

Department of Economics Università Ca’ Foscari di Venezia Venice, Italy

Jan Gaute Sannarnes

Department of Economics Norwegian School of Economics and Business Administration Bergen, Norway

List of Contributors

Armin Schmutzler

Socioeconomic Institute University of Zurich Zurich, Switzerland

Hal J. Singer

Criterion Economics Washington, DC, USA

Alexandre de Streel

University of Namur Namur, Belgium

Harley Thompson

Charles River Associates Sydney, Australia

Christian Wey

Department of Economics Humboldt University at Berlin Berlin, Germany German Institute for Economic Research (DIW) Berlin, Germany CEPR, London, UK

Julian Wright

Faculty of Arts and Social Sciences National University of Singapore Singapore

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Preface and Acknowledgements

Access to essential facilities or the so-called bottlenecks has become the key public policy issue for the liberalization of network industries such as telecommunications, electricity, rail, and so on. Still, access prices are not only important for competition in formerly monopolistic industries, but also for industries where competition has long been established such as payment and credit card networks or mobile telecommunications. As the latter industries have also come under closer scrutiny by regulatory agencies and competition authorities, this book is dedicated to the analysis of access pricing in theory and practice. The extended introduction introduces the key concepts and issues including a brief explanation of the essential facility concept as well as the distinction between one-way and two-way access. While Parts I and II deal with the theory of one-way and two-way access pricing, respectively, Part III focuses on the newly emerging theory of access pricing with multihoming. Parts IV and V address the practice side and focus on industry-specific applications and special problems (Part IV) as well as public policy issues (Part V). Our primary debt is, of course, to the authors of the chapter of this book. Most chapters of this book were written on our invitation, but we have also sourced a number of chapters via a Call for Papers. For the selection of the chapters included in this book, we have relied on a number of referees, whose help is most gratefully acknowledged. These include Roger Alexander, Stefan Buehler, Tommy Staahl Gabrielson, Martin Peitz, and Roberto Roson. And we would also like to thank Jeroen Loos at Elsevier, as it was him who had the initial idea for this volume and who supported us in this endeavour. Finally, we thank Hannah Enste, Jutta Kehrer, and Silke Werner at the Ruhr-University of Bochum, who patiently helped with the

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technical production of this volume. Of course, the usual disclaimers apply, none of the people mentioned here is responsible for any mistakes. RALF DEWENTER JUSTUS HAUCAP

Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 1

Access Pricing: An Introduction RALF DEWENTER Helmut-Schmidt University, Hamburg JUSTUS HAUCAP Ruhr-University of Bochum

Contents 1.1 INTRODUCTION TO THE INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 ACCESS TO NETWORKS: CONCEPTS AND ISSUES . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Essential facilities                                                   1.2.2 One-way access                                                     1.2.3 Two-way access (interconnection)                                    1.3 ACCESS PRICING: THEORY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 ACCESS PRICING: PRACTICE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4.1 The retail-minus approach                                            1.4.2 The efficient component pricing rule                                  1.4.3 Cost-based concepts                                                 1.4.4 Capacity-based pricing and price caps                                 1.4.5 Institutions                                                         1.5 CONTENTS OF THIS BOOK: THEORY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 One-way access pricing                                              1.5.2 Two-way access pricing                                             1.5.3 Access pricing and multihoming                                      1.6 CONTENTS OF THIS BOOK: PRACTICE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.6.1 Applications to specific markets                                      1.6.2 Policy                                                              1.7 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2 4 4 6 7 7 9 11 11 13 15 16 18 18 22 24 26 26 31 34 35

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1.1 INTRODUCTION TO THE INTRODUCTION

Within the twenty years spanning from 1985 to 2005, one of the major areas of microeconomic reform has been the privatization, liberalization, and de- and re-regulation of network-based industries such as telecommunications, electricity, gas, and rail, among others. Building on the theory of contestable markets (see Baumol et al., 1982) and the so-called disaggregated approach to regulation (see, e.g., Knieps, 2003), the paradigm has shifted from regulation to competition. While traditionally the emphasis has been on the regulation of prices for final consumers to prevent the exploitative abuse of market power, the focus has shifted towards the regulation or supervision of charges for access to monopolistic bottlenecks to prevent obstructive or exclusionary abuse (which is, of course, ultimately also exploitative). The basic idea is that, while some facilities constitute resistant natural monopolies, many upstream or downstream markets are potentially competitive. Actual competition, however, can often only emerge if new competitors are granted access to monopolistic bottlenecks. While traditionally competition was prevented over the entire industry, including all upstream and downstream markets, so that final retail prices had to be regulated, competition is now facilitated in many upstream and downstream markets so that, at least in theory, only wholesale prices for access products need to be subject to ex ante regulation. Of course, the principal problem of network access is not really new. As early as 1912 the US Supreme Court ruled in the by now famous Terminal Railroad case that the Terminal Railroad Association of St. Louis (TRASL), which owned the only railroad bridge over the Mississippi river in St. Louis, had to grant access to the bridge for other competitors. Whether or not this case actually constituted what has become known as the essential facility doctrine (see Lipsky and Sidak, 1999; Pitofsky et al., 2002), the so-called access problems have become at least of major importance for the reforms of network industries. The reforms of network-based industries have been guided by the fundamental insight that market liberalization is not always the same

Chapter 1 – Access Pricing: An Introduction

3

as market deregulation. While liberalization implies the removal of barriers to entry for new competitors, deregulation refers to the reduction of government intervention in market processes (see, e.g., Vogelsang, 2003; Dewenter and Haucap, 2004; Haucap and Marcus, 2005). In order to facilitate competition and market entry in network industries, re-regulation of access is often necessary so as to liberalize the market. Put differently, without regulatory intervention market entry would often hardly be possible and, therefore, any envisaged liberalization of formerly monopolistic industries would not be successful. However, network access and the according access prices are not only an important issue within recently liberalized network industries, but also for markets which have in many instances always been open to (at least some) competition such as ATM networks (see McAndrews, 2003), payment systems (see Baxter, 1983; Evans and Schmalensee, 2005), media markets (see Anderson and Gabszewicz, 2005; Dewenter, 2004), or mobile telecommunications (see Gruber, 2005; Kruse, 2004), among others. While the essential facility doctrine has been central for the liberalization of network industries and most prominently telecommunications, as a result of the MCI/AT&T case (1983), a number of high-profile cases have concerned other industries. Apart from MCI/AT&T, landmark cases are undoubtedly Associated Press (1944/45), Otter Tail Power (1973), Hecht/Pro-Football (1978) and Aspen Skiing (1985) in the US and London European/SABENA (1988), Magill TV/ITP/BBC/RTE (1988/1991), British Midland/Aer Lingus (1992), Sealink I (1992) and Sealink II (1993), Port of Rodby (1993) and Oscar Bronner (1998) in the European Union, but more recent cases such as the US Supreme Court’s Trinko decision (2004) or the IMS Health case (2004) in Europe have also involved substantial debate among economists and legal scholars alike. The great attention paid by both the general public and the media as well as the academic community underlines the significance and importance of access pricing issues. This book is dedicated to the analysis of access pricing theory and practice. A brief introduction to key concepts and issues will

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be given in the remainder of this introductory chapter. This will include a brief explanation of the essential facility concept as well as the distinction between one-way and two-way access. We will also briefly survey the main contributions within the literature on access pricing theory and practice, before we introduce the various chapters of this book in more detail. The book is structured in five parts. While parts I and II deal with the theory of one-way and two-way access pricing, respectively, part III focuses on the newly emerging theory of access pricing with multihoming. Parts IV and V address the practice side and include applications to certain industries and/or special problems (Part IV) as well as policy matters (Part V).

1.2 ACCESS TO NETWORKS: CONCEPTS AND ISSUES 1.2.1 Essential facilities

The notion of a certain facility being essential for competitors and, thereby, an essential facility is originally not based on an economic concept. It rather has its origin in US antitrust law, namely the Terminal Railroad case (1912) mentioned above, which may also be the reason why there is no universally accepted definition of an essential facility among economists. However, there is widespread agreement among economists that mandatory access to a firm’s facilities should only be granted if the following four criteria are met (see, e.g., Lipsky and Sidak, 1999): (1) The facility must be controlled by a firm with significant market power. (2) (Potentially) competing firms must lack a realistic ability to reproduce the facility. (3) Access to the facility is necessary in order to compete in a related upstream or downstream market. (4) It must be feasible to provide access to the facility.

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5

Table 1.1 gives an overview over typical essential facilities in various industries. The extent to which a facility is truly essential is not always clear and in the end also an empirical question. There are a number of reasons why a facility may not be duplicable, one being legal restrictions and another, quite importantly, natural monopoly characteristics paired with specific investments (sunk costs). Hence, the question is whether the cost function is subadditive in the relevant area of the demand curve. Of course, in small markets the equilibrium number of firms operating at minimum efficient scale will be smaller than in larger markets so that in smaller markets more segments will constitute essential facilities. For example, on a small island, power generation may be a natural monopoly while it may not be a natural monopoly in larger markets. Therefore, it is not Table 1.1 Examples for essential facilities in various industries Industry

Essential facility

Competitive markets

Telecommunications

Local loop (fixed-line) Termination (under Calling-party pays) Transmission network Distribution network Rail tracks Stations (possibly) Pipeline system Water extraction (possibly)

Trunk network Calls and services Retailing Generation Retailing Passenger and freight transport Treatment Water extraction (possibly) Retailing Treatment Gas extraction (possibly) Gasholder (possibly) Retailing Collection Consolidation Presorting Delivery (in urban areas) Slots (possibly) Aviation services (possibly) Non-aviation services

Electricity Rail transport Water

Wastewater Gas

Pipeline System Pipeline system Gasholder (possibly)

Postal services

Local delivery network (possibly in rural areas) PO boxes (possibly)

Airports

Slots (possibly) Aviation services (possibly)

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possible to come up with universal claims or general statements about what constitutes an essential facility and what does not, as the existence of an essential facility always depends on circumstances such as market size. Similarly, natural monopolies may erode over time due to the development of new technologies (such as WiFi or cable modems in telecommunications) or changes in prices for input factors.

1.2.2 One-way access

An incumbent firm’s facility can be considered essential if firms in a related upstream or downstream market cannot offer services without having access to that essential facility. In case of one-way access other firms need access to the incumbent firm’s bottleneck facility to be able to compete, while the incumbent’s services do not depend on the entrant’s facilities. That is, a vertically integrated incumbent can compete in the retail market on its own feet and a vertically separated owner of the facility can offer wholesale services only without being dependent on other firms’ facilities. In contrast, firms in related upstream or downstream markets depend on access to the incumbent’s essential facility. Hence, one-way access refers to a monopoly input provided by an incumbent which may be either vertically integrated and, therefore, also a competitor or vertically separated and, therefore, only an input supplier. The literature on access pricing, however, concentrates on vertically integrated operators which also compete in the downstream market (see, e.g., Vogelsang, 2003) while the literature on vertical relations and input price discrimination often also considers vertically separated firms (see, e.g., Rey and Tirole, 2006). Sometimes one-way access is also referred to as vertical interconnection (see Noam, 2002). Examples for one-way access are, among others, access to unbundled local loop services in fixed line telephony, to rail tracks, to electricity distribution and transmission networks, and to gas pipelines.

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1.2.3 Two-way access (interconnection)

While one-way access refers to vertical interconnection, two-way access describes a situation where two competing firms grant access to each other’s essential facilities, which is therefore also called horizontal interconnection or simply interconnection. Horizontal interconnection is typically granted between competing networks such as competing mobile telecommunications operators which have to terminate calls on each other’s networks (mobile termination) or competing banks which grant each other access to their ATM networks. In cases where non-competing firms grant each other access to their respective bottlenecks, two-way access is also referred to as parallel interconnection. Examples include international roaming in mobile telecommunications and international postal services.

1.3 ACCESS PRICING: THEORY

From a welfare economic perspective, the main objective of an access regime is to ensure economic efficiency, which comprises three interdependent elements: • productive efficiency, meaning that firms adopt the least-cost method of production; • allocative efficiency, meaning that resources are employed to produce those goods and services that provide the maximum benefit to society. In an ideal world without transaction costs, allocative efficiency implies that the incremental or marginal cost of producing an additional unit of any good or service just equals consumers’ willingness to pay for this unit; and • dynamic efficiency, meaning that firms invest and innovate at an optimal rate and point in time, and hence improve quality, increase productivity and lower costs over time, so that the social surplus is not necessarily maximized at a given point in time, but over a time period.

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As Laffont and Tirole (1994, 1996) have shown, welfare is maximized under Ramsey pricing, subject to the constraint that the regulated firm’s profits are not negative. This result does not only hold for a static environment, but can, in principle, also be applied in a dynamic context (see Laffont and Tirole, 2000, p. 67). There are several extensions to this model, some of which are discussed by Laffont and Tirole (2000, p. 67 et sqq.). From a competition policy perspective the main risk associated with one-way access is foreclosure. A vertically integrated operator may face strong incentives to deny rivals access to essential facilities at reasonable prices. The dominant firm may exclude competing final product suppliers from the retail market by charging entrypreventing access charges or by other anti-competitive measures. Even if the incumbent sets access prices that facilitate some entry, these charges may be excessive and lessen competition by raising rivals’ costs. And even if the network operator does not integrate into the retail market, an unconstrained natural monopoly network operator may abuse its market power and charge monopoly prices for network access (also see Armstrong et al., 1996). While foreclosure is the main problem associated with one-way access, a major problem associated with two-way access is collusion. This does not imply that foreclosure cannot be a problem among competing networks relying on two-way access. Quite in contrast, especially if networks are very asymmetric in size (e.g., a number of large incumbents vis-à-vis a small entrant), the larger networks may face strong incentives to deny small firms access so that the risk of foreclosure remains a policy issue (see, e.g., De Bijl and Peitz, 2002; Carter and Wright, 2003; Peitz, 2005). However, collusion may be an additional policy issue regarding two-way access. The basic idea is that competing networks can directly influence the other networks’ (perceived) marginal cost by increasing their termination or delivery charges. Hence, networks can increase each other’s costs so that a different raising rivals’ cost effect occurs than under one-way access. While, under two-way access, competition may be softened because the networks increase each other’ costs, the essential facility operator can unilaterally increase other firms’

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costs only under one-way access. Seminal contributions to the theory of two-way access are Laffont et al. (1998a, 1998b), Armstrong (1998) and Carter and Wright (1999), who develop the canonical interconnection model. While initially the focus of the literature on access pricing has been on allocative and productive efficiency considerations in a static environment, more recently the literature has also analyzed dynamic efficiency issues such as the effects of different pricing regimes on investment and innovation incentives (see, e.g., Gans, 2001). Another more recent development is the analysis of access pricing in two-sided markets. Detailed surveys of the access pricing literature are provided by Laffont and Tirole (2000), Armstrong (2002) as well as Vogelsang (2003). The relationship between investment and access regulation is extensively discussed in Valletti (2003), Chang et al. (2003), Peitz (2003), and Cave and Vogelsang (2003). Finally, the recent developments in the newly emerging theory on two-sided markets are surveyed by Rochet and Tirole (2006), Evans and Schmalensee (2005), and Roson (2004).

1.4 ACCESS PRICING: PRACTICE

As briefly noted above, optimal access prices under one-way access are quasi-efficient Ramsey prices. While an unregulated monopolist may actually follow the principles of Ramsey pricing when choosing its tariff structure, the resulting pricing will, at best, reflect Ramsey pricing in their structure, but not in the price level. The monopolistic price will almost always exceed Ramsey prices (unless the surplus of the monopoly producer just equals the fixed cost). Hence, a global price cap, as proposed by Laffont and Tirole (2000), may solve the problem of excessive pricing, while at the same time enabling the monopolist to choose a Ramsey pricing structure. However, as Hoeffler (2006) has correctly pointed out, a vertically integrated monopolist which faces competition in related upstream or downstream markets will also deviate from Ramsey prices in their structure, as the elasticity of the individual firm’s residual demand

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may be almost completely unrelated to the elasticity of the market demand curve and an integrated monopolist may face incentives to foreclose related upstream or downstream markets. While a possible solution to the latter problem appears to be (at least at first sight) vertical disintegration or unbundling, the owner of a vertically separated monopolistic bottleneck still has incentives to set monopoly rates and to price-discriminate between different buyers so that a need for regulatory surveillance remains. In addition, vertical separation has its own costs, such as decreasing investment incentives (see, e.g., Buehler, 2005). Moreover, for two-way access problems vertical separation is usually not a viable option, as it is often not feasible to vertically separate wholesale and retail activities. Therefore, charges for bottleneck access are often regulated. In fact, the now common solution to deal with vertically integrated monopolists is to regulate their access prices. Unfortunately though, there are several practical problems that prevent Ramsey price regulation. Most importantly, the information requirements are rather burdensome, as regulators would have to collect information on marginal cost, price elasticities of demand, and cross-price elasticities (super-elasticties). Therefore, less complicated access pricing rules have been usually applied in practice. The most prominent methods are: • • • • •

charges based on the incumbent’s retail prices (‘retail minus’) the efficient component pricing rule (ECPR), cost-based access charges, capacity-based charges, and price cap regulation.

Since price cap regulation and capacity-based charges can both be combined with either the ECPR or cost-based access charges, the two most prominent alternatives are charges based on the incumbent’s retail price (of which the ECPR can be considered a special version) and cost-based charges such as (total element) or (total service) longrun incremental costs, (TE)LRICs or (TS)LRICs, respectively (see Gasmi et al., 2002; ERG, 2004; Gans and King, 2004).

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1.4.1 The retail-minus approach

Under the so-called retail-minus rule, access prices are not based on some measure of an incumbent’s cost plus some mark-up, but rather based on its retail prices from which some amount (e.g., for the avoided retail cost) is deducted. This rule is often discussed and also applied in the context of so-called resale obligations, which require incumbent operators to facilitate resale of their own products and services by competing firms, for example, to enable competitors to replicate an incumbent’s product bundles. While retail-minus rules are relatively easy to implement and to enforce (even though non-price discrimination may become an issue), the rule’s major drawback regarding access prices for essential facility services is its allocative inefficiency if retail prices are left unregulated. As the European Regulators Group (ERG) has put it: ‘The retail-minus approach is – without retail price regulation – not able to bring down excessive access prices to a cost-oriented level. As the wholesale price is calculated as the retail price minus the cost of an efficient undertaking, an excessive retail price will automatically feed into an excessive wholesale price (or vice versa)’ (ERG, 2004, p. 84).

1.4.2 The efficient component pricing rule

A special form of the retail-minus approach is the ECPR, sometimes also called the Baumol–Willig rule, which was first proposed by Willig (1979) and Baumol (1983) and later popularized by Baumol and Sidak (1994a, 1994b). Sometimes the expressions ECPR and retail-minus approach are also used as synonymous for the same access pricing rule (see, e.g., ERG, 2004, p. 84). Under the ECPR access charges are based on the monopolist’s opportunity cost of providing access, including any forgone (monopoly) profit. Expressed in terms of the so-called margin rule the access charge should be set equal to the price usually charged for the retail service less the cost not incurred when interconnecting a rival instead of selling retail services. The opportunity cost

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expression states that the optimal access fee equals the marginal cost of providing the network service plus the profit forgone when not selling the retail service but interconnecting a rival. As can be easily checked, the two expressions are equivalent. The logic behind the ECPR is that only those producers that are at least as efficient in producing a particular service as the incumbent monopolist can enter the market. Any access price lower than the ECP will lead to ‘excessive’ entry by inefficient rivals. As the ECPR has a strong focus on productive efficiency, it also encourages investment in bypass facilities and innovation to overcome network bottlenecks. From a public policy point of view, this might actually lead to overinvestment and ‘unnecessary’ duplication of parts of a given network. Apart from guaranteeing productive efficiency, the ECPR has a second major advantage: the informational requirements it imposes on regulatory authorities are comparatively low. Basically, the ECP is the price at which an incumbent would grant access to its network on a voluntary basis. If the incumbent is reimbursed for any monopoly profit lost, the monopoly firm will be indifferent between granting access to rivals and selling retail services to customers. Hence, the information requirements are low and there is little need for regulatory ex ante intervention. In this respect, the ECPR might be considered to be consistent with what has been called a lighthanded regulatory regime. However, even if the monopolist’s price for the final retail product was based on marginal cost pricing, the ECPR only holds as a firstbest pricing principle if the following additional assumptions are met as well: • the monopolist’s and the rivals’ retail products are perfect substitutes; • the production technology exhibits constant returns to scale; and • rival producers do not have any market power (see Armstrong et al., 1996). While the ECPR ensures productive efficiency, its validity as an optimal rule in terms of allocative efficiency depends on final product

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price regulations ensuring the absence of monopoly rents (see Baumol and Sidak, 1994a, p. 108). Hence, the question arises as to whether it is practical to implement the ECPR and to simultaneously regulate the incumbent’s retail prices in order to avoid monopoly pricing. If, however, the incumbent’s retail prices are not held down to competitive levels, the ECPR most likely leads to grave allocative inefficiencies, at least in static environments. In more dynamic environments, where non-temporary market power is rare, the ECPR can be helpful to prevent anti-competitive bundling of services offered in competitive markets and products offered by firms that have market power.

1.4.3 Cost-based concepts

A different approach to regulate access prices is to set cost-based charges. In the simplest textbook theories, prices set at marginal cost ensure efficiency. One problem, however, is that for natural monopolies marginal cost-based prices lead to deficits, while prices based on average cost induce allocative inefficiencies. Moreover, in reality firms usually offer more than a single product so that common costs have to be allocated somehow. Put differently, the calculation of a multiproduct firm’s average cost is not feasible. One way to avoid the latter problem is to use incremental costs. While marginal costs arise with marginal output changes, incremental costs arise with larger output variations. Incremental costs (i.e., long-run incremental costs, LRICs) are all costs that are associated only with the production of a specific service. Put differently, the LRICs are the costs that a producer would avoid if a specific product (or some other increment) would no longer be produced. Therefore, incremental costs also include the fixed costs which are specific to the particular increment under consideration (e.g., a particular service). Note that only in case of a firm producing a single product (or service) LRICs would be equal to stand-alone costs. The difference between short-run and long-run costs is that in the former there are fixed costs, while in the latter fixed costs do not

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exist, as all factors of production are assumed to be variable. Hence, in the long run production can be optimized (as everything can be varied) so that production of a given output takes place at minimum cost levels, as would be the case in perfectly contestable markets. The difference between TSLRICs and TELRICs is that TELRICs do not refer to the products produced (or services provided) by a firm, but to the incremental costs associated with given network elements such as the local loop. TELRIC has been introduced by the Federal Communications Commission (FCC) in connection with the US 1996 Telecommunications Act. Compared to TSLRIC the advantage of TELRIC is that with an element-based approach there are typically less common costs than considering products or services. In general though, the differences between TELRIC and TSLRIC should be rather small when compared to the other differences between costbased and pricing rules.1 While the basic idea behind LRIC-based pricing is that LRIC prices can ‘simulate competition’ (see, e.g., Belfin and Lukanowicz, 1999), this only holds if rather special and unrealistic assumptions are met. Quite in contrast, it is often argued that one shortcoming of regulating access prices on an incremental cost basis is that LRIC prices are only efficient if a number of rather unrealistic conditions hold so that in reality LRIC regulation may induce inefficiencies (see, e.g., Hausman, 1999, 2001). For example, economies of scale and scope must not exist, which, of course, almost never holds for essential facilities. Similarly, LRIC prices would only evolve even in competitive markets if there were no sunk costs. As soon as specific investments are necessary (as in most network industries) and, therefore, sunk costs result, competition will be less than perfect (even though markets may still be very competitive) so that prices will deviate from marginal costs or LRIC. Nevertheless, LRIC prices are frequently adopted by regulatory authorities, especially for telecommunications markets, even though 1

For a more detailed analysis of the differences between TELRICs and TSLRICs see Gans and King (2004).

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there is now reasonably widespread agreement among economists that LRIC prices hardly induce efficiency (see, e.g., Sappington, 2005). There are two main reasons why cost-based pricing is still so prominent (also see Vogelsang, 2003): • any mark-up would result in double marginalization, and • higher access charges tend to dampen competition in downstream markets. Furthermore, cost-based regulation is often not truly based on a long-run cost standard. For example, in telecommunications often a so-called ‘scorched node’ approach is used in calculating cost. In contrast to a so-called ‘scorched earth’ or greenfield approach, some elements (e.g., the number and/or locations of network switches) are considered to be fixed under a scorched node approach so that some cost drivers are not variable. This, however, implies that the cost concept used is not really a long-run cost concept as some factors of production are not considered variable. One reason for the deviations from pure theory that we observe in practice is that one of the main practical problems in the determination of cost-based access fees is to find an adequate measurement for costs. As prices determine quantities which in turn determine average and also incremental costs there is an endogeneity problem. Other problems include the adequate time horizon to be considered, how to account for historical decisions and productive inefficiencies, and how to provide appropriate investment incentives. In fact, these issues have been the subject of numerous public consultations by regulatory authorities (see, e.g., IRG, 2000) and are beyond the scope of this book.

1.4.4 Capacity-based pricing and price caps

Capacity-based prices are a special form of two-part tariffs (see Vogelsang, 2003). In contrast to usual two-part tariffs, the fixed part is proportional to the capacity available for a specific firm, while

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the variable part is the standard usage fee set to equal marginal cost. Furthermore, a second usage fee is introduced which is applied after the capacity limit has been reached. This second variable price component is sufficiently high so as to prevent usage beyond the capacity purchased. Due to this ‘capacity constraint’ there are only limited economies of scale in the downstream market as is usually the case with two-part tariffs. Moreover, capacity-based pricing can be used to ‘split’ a natural monopoly into smaller parts. These smaller parts may then compete with each other. Capacity-based pricing is particularly appropriate in industries with high capacity costs due to high peaks. Therefore, it is, for example, common in gas markets and telecommunications markets (see OECD, 2004). Capacity-based pricing can also be combined with price caps. A monopolist may be allowed to set its access prices within a global price cap which includes both access and retail prices (see Laffont and Tirole, 2000). If the monopolist chooses a high access price, downstream prices have to be relatively low. If, in contrast, the access price is set at a relatively low level, prices for services in downstream markets set by the monopolist may be rather high. Now, however, competitors can set lower prices as the monopolist’s access prices have to be low. While the incentives for foreclosure are reduced, there is still an incentive to prevent entry in upstream markets if downstream price discrimination is allowed and possible. The monopolist may now choose a high access price upstream, while applying price discrimination in downstream markets in order to maximize profits. Separate price caps for upstream and downstream services may provide a solution to this problem. This may explain why, in practice, global price caps are a rather rare instrument when regulating access prices (see OECD, 2004).

1.4.5 Institutions

Apart from pricing issues, the reorganization of the institutional framework in many network industries has also led to research questions on the appropriate governance structures. From an

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institutional economics perspective, there are at least four interdependent questions: (1) What kind of rules should govern a market and which remedies should be applied to correct for market failures (e.g., sectorspecific versus general rules)? (2) When should these rules be enforced (ex ante or ex post)? (3) Which institution should have the mandate to monitor the market and to enforce the rules (a sector-specific regulator or a general competition authority, a national or a supra-national institution)? (4) How should the enforcement agency be structured internally and what incentives should the agency face? Even though it is often (but not always) the case that sector-specific agencies enforce sector-specific rules ex ante, while general competition authorities enforce general rules ex post, this is by no means necessary. Other institutional frameworks are possible as well. Market surveillance can be either based on (a) sector-specific or (b) general rules, which can be enforced by (i) sector-specific or (ii) general agencies (1) ex ante or (2) ex post.2 Furthermore, different rules can be applied to different aspects within the same industry. For example, merger control is often conducted ex ante by general competition authorities according to general rules, but it may also be conducted by the same agency according to sector-specific rules (e.g., for media markets). Similarly, access rules may be based on general competition law (such as Section 2 of the Sherman Act or Article 82 EU), enforced by general competition authorities, or on sector-specific rules laid down in sector specific-laws (such as a Telecommunications Act) which may again be administered by sector-specific regulators or general regulatory agencies. Furthermore, regulatory and competition authorities may be merged such 2 We can furthermore distinguish between frameworks which use (1) per-se-rules and those that apply a rule-of-reason standard, and (2) whether the burden of proof rests with the enforcement agency or the market participants involved.

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as Australia’s ACCC. While these institutional aspects give rise to interesting research questions, especially from an institutional economics perspective, this book will mainly (but not exclusively) focus on the first of the four questions outlined above, that is, on the question which rules should be applied in order to maximize social welfare. In the following, let us describe the contents of the book in more detail.

1.5 CONTENTS OF THIS BOOK: THEORY 1.5.1 One-way access pricing

Part I consist of three chapters on one-way access problems. First, Joshua Gans (Chapter 2) examines the effects of access price regulation on investment incentives. Next, Axel Gautier (Chapter 3) analyzes optimal pricing schemes and network financing when market structure is endogenous, and finally, Paul de Bijl and Martin Peitz (Chapter 4) consider local loop unbundling in telecommunications markets. A potential consequence of regulating access to natural monopolies is that the incentives for infrastructure investment may be reduced. Since investment and innovation are key drivers for productivity growth (see, e.g., Roeller and Waverman, 2001), concerns may arise that access regulation can negatively affect infrastructure investment, productivity growth, efficiency and economic growth. Moreover, a trade-off between allocative and dynamic efficiency is usually thought to arise in determining the optimal access regime and charges for access to monopolistic bottlenecks. The chapter by Joshua Gans on access pricing and infrastructure investment synthesizes the existing literature on access price regulation and its impact on infrastructure investment. Using a duopoly model of investment timing based on Katz and Shapiro (1987), the impact of access price regulation on socially optimal investment timing is analyzed. In addition, various policies to stimulate investment incentives

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such as access holidays and mandatory investment negotiations are considered. Starting from a benchmark without access regulation Joshua Gans examines the motives for access and investment, before the equilibrium investment timing is analyzed when firms negotiate over access in the absence of regulation. Depending on the firms’ symmetry, investment timing can either be delayed or brought forward relative to the social optimum. If firms are asymmetric or, more exactly, if only the ‘large’ firm can invest into infrastructure, investment will be delayed since the innovator can earn monopoly profits over a longer period. However, if both firms are sufficiently large so that both can undertake their own infrastructure investments, an investment race may result in investments being undertaken ‘too early’ relative to the social optimum. Hence, in situations where monopolistic bottlenecks are not regulated, markets are not only characterized by a lack of downstream competition, but possibly also by inefficient investment patterns. In order to compare these results with a world with access price regulation, Joshua Gans assumes that under an access regulation regime first the regulatory authority chooses a (two-part) access tariff before, in a second stage, infrastructure investments are realized, and, thirdly, access is purchased by competitors. Again, the results depend on the firms’ symmetry: if only one firm can invest, access prices should be set so as to secure both investment and access. This is achieved through cost-sharing – each firm bears the costs proportionally to its profit share, which means that the optimal fixed access fee is proportional to the ratio between the non-investing firm’s profit and total industry profits. If, in contrast, two large (i.e., symmetric) firms compete in the market, both firms should pay, in the social optimum, the same fixed access fee so that they both carry the same share of the total infrastructure cost. In this case, access fees also have to be set so as to prevent a wasteful investment race between the two firms. Joshua Gans also examines optimal variable (usage-based) charges and access holidays. With respect to optimal usage-based charges, these should be set so as to secure the firms’ participation, while

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fixed access fees are determined by relative profit levels. Since the fixed charge is set to ensure optimal timing usage-based charges do not necessarily have to equal marginal cost but they may eventually exceed these. Finally, if for some reason optimal access prices cannot be implemented, another way to ensure the optimal timing of investment are access holidays. Similar to patents, access holidays guarantee temporary monopoly profits, thereby stimulating investment. Overall, Joshua Gans’ model demonstrates that investment and competition do not need to be strictly conflicting policy objectives, as access charges can be set in a way that fosters investment and simultaneously ensures competition in downstream markets. At the same time, the chapter also shows that optimal access prices do not equal marginal cost in upstream markets. Quite on the contrary, as with Ramsey pricing, optimal access prices may exceed marginal costs once investment incentives are taken into account. In the third chapter, Axel Gautier addresses a related question, as he analyzes the optimal regulatory pricing schemes and network financing when the downstream market structure is endogenous. More specifically, the focus is on access to an existing infrastructure owned by a vertically integrated incumbent operator and entry by a potential competitor in the downstream market when regulators have imperfect information about the entrant’s cost. While the regulator is assumed to determine all access conditions, the incumbent’s supply, and public contributions to network financing (so that the infrastructure costs are only partly born by the incumbent), the regulatory authority has to choose either a linear or two-part access tariff under incomplete information about the entrant’s productive efficiency. Since high access charges can prevent entry even if the newcomer is more efficient than the incumbent, the regulator has to choose an optimum access charge level and structure. As Axel Gautier shows, a two-part tariff should be chosen if the incumbent operates at a high cost, while a linear tariff should be chosen if the incumbent is rather efficient (and its production cost low).

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In a game where the regulator first designs a regulatory contract including either a two-part or a single part tariff, before the newcomer learns its costs and decides on entry in the second stage and, finally, the incumbent (behaving as a Stackelberg leader) and the entrant decide on their quantities, Axel Gautier demonstrates that full efficiency (the first best) can neither be reached under a single- nor under a two-part tariff. Neither tariff structure can guarantee entry of an efficient newcomer, due to a trade-off between the promotion of entry (and, thereby, competition) and efficient infrastructure financing in the presence of incomplete information about costs. While a single-part tariff distorts both the entry decision and the entrant’s supply decision in the direction of ‘too much’ entry and competition, the two-part access tariff only distorts the entry decision. Therefore, the regulator should only choose a single-part tariff if two-part tariffs do not induce enough entry. The fourth chapter, authored by Paul de Bijl and Martin Peitz, finally analyzes local loop unbundling (LLU) in telecommunications markets. In recent times, LLU has become more important due to the emergence and diffusion of ‘voice over Internet protocol’ (VoIP) telephony which has the potential to further intensify competition, especially in fixed-line telephony markets. Chapter 4 first describes the regulatory policies towards LLU in Europe and the US before Paul de Bijl and Martin Peitz analyze the effects that LLU regulation can have. In order to distinguish between saturated and unsaturated markets, the analysis is divided into two parts: first, saturated markets with full participation are analyzed before growing markets with lower penetration rates are examined. The focus of the analysis is on the socially optimal lease price for unbundled local loop access, which is fixed by a regulatory authority in a situation where a vertically integrated and a non-integrated firm compete in prices in a downstream market with horizontal product differentiation. With full participation, the non-integrated operator’s profits are neutral toward regulation, as any change in the access charge is passed through to consumers. However, the vertically integrated firm benefits from an increase, since its revenues are increasing with

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higher access charges. Market shares are not affected by the access price though. Analyzing investments into quality (which shifts the profit function), Paul de Bijl and Martin Peitz show that a higher access price leads to higher profits and, therefore, also to more investment and, thus, to higher quality. For their analysis of unsaturated markets in which total demand depends on prices, Paul de Bijl and Martin Peitz assume that only the non-integrated firm can offer additional services which are bundled to its core product. The market, therefore, consists of two segments, with the first being competitive and the second characterized by captive customers. As a consequence, market shares are no longer neutral to price changes and, accordingly, the non-integrated firm’s profits are no longer neutral with respect to the access price. As the authors show, for relatively low levels of the captured customers’ demand elasticity, a relatively small change in the access price may still result in a relatively large change in the retail price. In summary, the authors can demonstrate that, in their model, LLU cannot foster competition in saturated markets, as under full participation unbundling is neutral to both the entrant’s profits and the market shares. However, for markets with partial participation, LLU can foster competition so that the authors suggest to use local loop unbundling for market segments such as broadband Internet access where full market penetration has not been reached yet.

1.5.2 Two-way access pricing

Part II of the book is dedicated to two-way access problems and consists of two chapters. First, in the book’s fifth chapter Stefan Buehler and Armin Schmutzler deal with the relationship between collusive behavior and two-way access pricing, before Viktória Kocsis, in Chapter 6, focuses on access pricing under cost asymmetry in telecommunications which has become a major issue in mobile telecommunications markets. As described above, one major problem with two-way access is that network operators may eventually use access fees to establish

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collusion in retail markets. In this vein, Stefan Buehler and Armin Schmutzler analyze the impact of the access charge structure on variable retail prices and subscriber charges, and they address the question of whether or not collusive behavior in access markets is a likely outcome, using a reduced-form approach. As the authors show, a crucial condition for the use of access prices as an instrument to facilitate collusion is that retail prices are strategic complements and, furthermore, that an increase in the access charge shifts out the firm’s reaction curve. However, as Stefan Buehler and Armin Schmutzler also show, these assumptions do not necessarily hold for network competition with two-way access. Hence, it is at best unclear whether the collusion argument is unconditionally valid. More importantly, the collusion argument is usually supported by rather strong assumptions such as full coverage (full participation) and balanced calling patterns (firms’ symmetry), while unambiguous results cannot be obtained if these rather strong assumptions are violated. Extending the analysis to non-linear retail prices, it is shown, again, that the effects from an increase in access charges on (twopart) retail prices are not unambiguous. The same holds for model extensions regarding (1) heterogeneous consumers and (2) price differentiation with respect to internal and external calls. Overall, this contribution clarifies that rather strong assumptions are needed to support the collusion hypothesis. The results obtained by Stefan Buehler and Armin Schmutzler rather suggest that collusion on access charges with two-way network competition is less common. Given these findings and accounting for other factors such as information asymmetries (especially for the regulator) or Ramsey pricing, there is little theoretical support for the regulation of two-way access prices in order to prevent collusion. In Chapter 6 Viktória Kocsis addresses supply side asymmetries and their implications for two-way access fees. Her model is based on the assumptions that an entrant has a cost advantage, as later market entry permits the application of more efficient technologies, and that both network operators charge linear access fees for termination services on each other’s network.

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Starting with linear retail tariffs, retail prices are demonstrated to increase with the difference between termination rates. Accordingly, welfare decreases as the difference between termination rates increases. Hence, an asymmetric regulation of termination rates may be welfare enhancing if operators differ in their costs with inefficient operators being allowed to charge higher termination rates than efficient ones. Analyzing two-part retail tariffs, the standard profit neutrality result of access fees in a symmetric equilibrium no longer holds. Furthermore, a decrease in the more efficient firm’s termination rate increases the less efficient firm’s profits and increases consumer surplus. Again asymmetric regulation would maximize welfare.

1.5.3 Access pricing and multihoming

An important characteristic of network competition that has been neglected for a long time is the subscribers’ opportunity to join more than one network, that is, consumers are able to multihome. Of course, multihoming is not possible and, therefore, not reasonable to assume for every network industry, but it is important for specific sectors such as mobile telephony, payment systems, and various Internet services. Interestingly, it is a priori not clear whether multihoming fosters or softens competition between rival networks. Part III provides two chapters on this emerging issue. While Roger Alexander focuses, in Chapter 7, on telecommunications markets, Chapter 8, authored by Roberto Roson, deals with two-sided markets more generally. A completely new framework to analyze two-way network competition in telecommunications markets is developed by Roger Alexander in his chapter on interconnection competition with multiple network subscriptions. Using a cross-nested logit consumer choice model, he considers both interconnection competition between more than two networks and multiple network subscriptions. A key aspect of this analysis is the existence of call substitution. Consumers can choose between single-homing and multihoming

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based on their utility derived from calls made and received. Consumers’ utility can be observed utility, such as net utility from making and receiving calls, calling differences across network types, and calling utility differences. Furthermore, Roger Alexander assumes that there is also non-observable utility derived from attributes such as customer care and billing support, and various service offerings. In a model with full consumer participation, non-discriminatory single retail pricing, linear access pricing, linear marginal costs for call origination and termination, and fixed costs, the analysis first focuses on dual network subscription. As a result, even if networks are highly differentiated, retail prices may equal marginal cost. Since multihoming allows customers to substitute calls over one network by calls over another network, even small price changes force competitors to respond in own prices. Multihoming, therefore, fosters competition. Using a numerical simulation of a cross-nested logit model, the relationships between retail prices and access charges are analyzed more closely. As in the single-homing case, retail prices increase in access prices, so that there are still incentives to raise each other’s costs due to tacit collusion on access charges. Furthermore, even with a low calling demand elasticity (and high substitutability across networks), multihoming leads to more intense competition in retail markets, and this effect strengthens with the number of dual network subscribers. In fact, even with only a limited number of customers multihoming, competition may increase. From a public policy perspective, it is interesting to observe that the effects of dual network subscription (or, more exactly, the effects of multihoming) on retail market competition are more pronounced than regulating access charges down to marginal cost levels. The gains from fostering multihoming can therefore be much more substantial than those from regulating access charges. In Chapter 8, Roberto Roson addresses the issue of platform competition with endogenous multihoming, using a general two-sided market framework. Building on a model of the credit card industry both sides of the market (i.e., both merchants and consumers) are assumed to have the option to multihome. That is, merchants can

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subscribe to more than one credit card system which they accept, and consumers can carry more than one credit card. However, given that multihoming does not only provide benefits, but also carries costs, the question arises whether or to what extent the two market sides actually join more than one platform. To analyze optimal multihoming decisions, Roberto Roson uses a coordination game, assuming duopolistic competition between two differentiated platforms. If consumers transact once with every merchant and decide to join none, one, or both platforms while platforms use non-linear pricing where consumers and merchants pay both membership and transaction fees, profit maximizing platforms will choose optimal price vectors that are special versions of the Lerner rule. Comparison of a Nash pricing game and a cooperative cartel game with the help of numerical simulations shows that consumers are charged more for transactions than merchants. This is because consumers are able to choose the payment instrument when multihoming exists on both sides of the market. As expected, with price competition all prices decrease and welfare increases for consumers and merchants when compared to the cartel situation. Overall, the degree of multihoming is positively affected by low cost of and high benefits from joining a network. The degree of competition among platforms, in contrast, has an ambiguous effect on endogenous multihoming. In general, multihoming tends to be asymmetric with regard to merchants and customers. When one side is multihoming intensively, the other market side is not likely to multihome to a high degree.

1.6 CONTENTS OF THIS BOOK: PRACTICE 1.6.1 Applications to specific markets

Since access pricing is essential for various network industries with different characteristics, general results do not necessarily hold at large. There are some industry-specific peculiarities which have to

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be embraced when considering specific markets. Part IV, therefore, deals with specific market analyses. First, Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes (Chapter 9) consider natural gas markets, while Harley Thompson, Olivier Renard and Julian Wright (Chapter 10) as well as Ralf Dewenter and Justus Haucap (Chapter 11) study special issues connected with mobile telecommunications markets. Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes analyze pricing for one-way access to gas transportation networks. The aim of their chapter is to determine welfare maximizing tariffs when natural gas is exported to foreign countries, as it is the case in Norway and other gas-producing countries. A key assumption of the analysis is that a vertically integrated firm owning a transportation network competes with a non-integrated third party. While the integrated producer is partly state-owned, the third party is privately owned (partly by domestic owners and partly by foreign owners). Since the integrated firm is at least partly stateowned, gas revenues reduce the need to raise taxes. Finally, due to the existence of capacity constraints, both producers compete in quantities. If both producers serve two independent downstream gas markets and the integrated producer is partly state-owned while the non-integrated producer is partly foreign-owned, national welfare is maximized if the access price for the transportation network exceeds marginal transportation cost. If the third party is fully domestically owned, national welfare is maximized if access prices equal marginal cost. However, if the third party is completely under foreign ownership, the optimal access charge equals the monopoly rate. The reasoning behind these results is that access pricing is a feasible way to extract profits from foreign owners instead of raising taxes. Assuming that foreign and domestic consumers compete in the same downstream market, the above results change. If the nonintegrated firm is fully domestically owned and the integrated producer a private firm, access prices are optimally set according to the efficient component pricing rule. Again, in case of public ownership of the integrated network, the access price is higher and serves

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as indirect taxation. However, the access price is still below the monopolistic access price. The subsequent analysis of the unbundling of transportation network and production, as prescribed by the EU Gas Market Directive, is based on the assumption that the gas transportation network is a monopolistic bottleneck which needs to be regulated. In this context, Kåre Hagen, Hans Jarle Kind and Jan Gaute Sannarnes consider two different regimes: first, a regulatory framework with differentiated tariffs for gas producers and secondly, a regulatory regime without price differentiation. As a result (under price differentiation) optimal access prices follow a modified Ramsey pricing rule taking into account public and foreign ownership. Without access price differentiation, in contrast, the access price set by the regulator is in between the Ramsey prices, and welfare decreases. In summary, a mark-up on marginal transportation costs may be superior to an access price set equal to marginal costs, as national taxation may be both distorting and incomplete. Increasing the access price allows to extract profits from foreign owners. A disintegration of upstream and downstream facilities can increase welfare if regulators can set differentiated access prices. In their chapter on mobile termination, Harley Thomspon, Olivier Renard and Julian Wright (Chapter 10) consider a typical mobile telecommunications market. This chapter’s objective is to analyze welfare effects from lowering fixed-to-mobile termination charges in markets with partial mobile penetration. For this purpose, an extension of Wright’s (1999) model is developed and the extended model is calibrated using data from the Colombian mobile telecommunications market. In contrast to most of the existing literature, the chapter provides an analysis for an arbitrary number of mobile operators which all directly compete with each other in prices, offering both horizontally and vertically differentiated products. Furthermore, a single nonintegrated fixed-line operator exists, and consumers place mobile-tomobile, fixed-to-mobile, and mobile-to-fixed calls. While the number of fixed-line customers is fixed, mobile markets are characterized by partial participation. The termination charge for mobile-to-mobile

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calls is assumed to equal marginal cost by mobile operators, and the termination charge for mobile-to-fixed calls is set by a regulator at termination costs. While mobile operators are free to charge an arbitrary termination fee to fixed-line operators, retail prices for fixed-to-mobile calls (including origination costs and a mark-up) are regulated. Calibrating this model using data from the Colombian mobile telephony market Harley Thomspon, Olivier Renard and Julian Wright show that, starting from current Colombian charges, an increase in termination charges results in increasing profits, higher fixed-tomobile traffic, and higher penetration rates. Moreover, welfare is maximized by doubling termination charges. The reasoning behind these results is the low penetration rate in Colombia and the so-called waterbed effect. Higher termination charges induce lower mobile retail prices, which in turn increases penetration. Therefore, setting termination charges at marginal cost may be welfare reducing, especially with low penetration rates. In our own chapter on the incentives to license mobile virtual networks operators (MVNOs) we analyze whether or not mobile network operators (MNOs) are likely to open their networks for MVNOs voluntarily. Put differently, we analyze whether there is a need for regulation to facilitate entry of MVNOs at all and, if so, under what circumstances this regulation may be beneficial. As we use a rather broad definition of MVNOs, our analysis is not restricted to MVNOs, but can be expanded to service providers and enhanced service providers. In contrast to other parts of the literature, we do not restrict our analysis to either full or intermediate or thin MVNOs. Instead, we analyze MVNOs in a similar vein to the literature on divisionalization, that is, we examine MVNOs as mobile service providers that offer mobile services, but do not operate a separate physical mobile network. In our chapter we analyze MVNO entry under Cournot, Bertrand and Stackelberg competition. Assuming that MNOs are able to extract the entire profit from potential entrants (the MVNOs), we first demonstrate that under Cournot competition MNOs always have an incentive to license a positive number of MVNOs if the mobile

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retail market is sufficiently large and the fixed costs establishing MVNO agreements is not prohibitively high. Moreover, the larger the retail market (and the lower the fixed cost) the more MVNOs will be licensed. Even though MNOs would be jointly better off if they would collectively deny access for MVNOs, each operator individually increases its profit by granting access, resulting in a prisoners’ dilemma. If operators compete over prices instead of quantities and offer differentiated products, results strongly depend on both the degree of product differentiation and market structure. A monopolistic MNO only has an incentive to grant access if the new services provided are only weak substitutes. In a duopoly, however, both MNOs are willing to enter into MVNO agreements already with a smaller degree of product differentiation. Finally, if more than two competing MNOs exist, there is always an incentive to provide MVNO network access, even for homogeneous products (i.e., perfect substitutes). Finally, if MNOs collectively act as Stackelberg leaders versus any MVNOs (which may well be a realistic assumption for most mobile telecommunications markets, given the sequential licensing procedures in many contries), we can establish that MNOs do not have any incentive to grant access if services are homogeneous. The reason is that the total profit from providing mobile retail services and from granting access decreases, as soon as the first MVNO enters. As MVNOs act as Stackelberg followers, their market share and profit is too small to compensate even one single firm for the profit lost due to intensified retail competition. However, if services are sufficiently differentiated (i.e., MVNOs offer new services) similar results as under Bertrand competition can be obtained. A higher degree of product differentiation leads to market entry even under Stackelberg competition. In summary, the question whether or not MNOs are likely to voluntarily grant MVNOs access to their networks strongly depends on factors such as market size, market structure, market conduct, fixed cost, product differentiation, and the share of profits an MNO is able to extract from an MVNO entrant.

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1.6.2 Policy

Part V consists of three chapters. First, Alexandre de Streel (Chapter 12) provides an analysis of the relationship between European competition policy and national sector-specific regulation. Subsequently, Pio Baake, Ulrich Kamecke and Christian Wey (Chapter 13) develop a regulatory framework to deal with new markets in Europe, focusing on access to broadband Internet services, and finally, Robert Crandall and Hal Singer (Chapter 14) analyze the potential for vertically integrated DSL providers foreclosing the market for Internet services and driving unaffiliated Internet service providers off the market. The aim of Alexandre de Streel’s chapter on antitrust and sectorspecific regulation of access in the European Union is threefold. First, the European Commission’s competition policy during 1995– 2005 regarding the abuse of a dominant position is reviewed, with a focus on electronic communications and services markets. Second, sector-specific regulation of market power based on the significant market power (SMP) concept is discussed. And thirdly, similarities and differences between European Union competition policy and national sector-specific regulation are examined. With respect to European Union competition policy it is useful to distinguish, again, between one-way and two-way access. With one-way access, both exploitative abuses and exclusionary abuses are important public policy concerns. While exploitative abuse refers to excessive pricing, exclusionary abuse aims at excluding rivals from the market. In case of two-way access, the main concern is excessive pricing either due to collusion or due to market power associated with ‘competitive’ bottlenecks and/or network effects. In addition, merger control is an important but often neglected area of public policy in electronic communications markets, including policies towards both joint ventures and (full) mergers. As Alexandre de Streel outlines a prerequisite for sector-specific regulation is the existence of SMP. Once an operator has been designated to have SMP, the operator can be obliged to grant access. This includes all types of essential facilities, for example, fixed-line and

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wireless networks as well as physical and non-physical infrastructure. In these cases, different methods of access price regulation can be imposed. In his analysis of the relationship between competition policy and regulation, Alexandre de Streel argues that regulation can no longer be seen as independent from competition law, but as ‘a part of a broader set of tools based on competition analysis principles’. Therefore, de Streel stresses the importance of good regulatory design and of ‘getting the institutions’ right in designing a consistent regulatory framework, taking account of the interdependence between competition policy and regulation. A hotly debated policy issue is the adequate regulation of newly emerging markets. If specific investments are necessary to provide new services and if these investments carry risks, designing a framework that provides adequate investment incentives for dynamic competition to evolve is not trivial. As there is a risk that the regulation of new markets may prevent or at least reduce investment incentives, Pio Baake, Ulrich Kamecke and Christian Wey (Chapter 13) propose a dynamic regulatory approach for new markets, especially focusing on investment incentives. In their chapter, the authors first review the (Schumpeterian) concept of dynamic competition which emphasizes the role of innovations. According to the idea of ‘creative destruction’ monopoly phases of a market should be followed by phases of effective competition, as innovations emerge and competitors contest monopoly positions. Consequently, dynamic efficiency rather than static efficiency should be the focus of public policy interventions. More precisely, the role of temporary monopoly profits is stressed as they provide incentives for innovative activity. Pio Baake, Ulrich Kamecke and Christian Wey then discuss particular problems of dynamic competition in newly emerging markets, focusing on DSL broadband access. The authors develop a regulatory approach for new markets, concentrating on markets for telecommunications services, where the vertical industry structure tends to increase risks and uncertainties for innovators, rendering a standard cost-based regulation inappropriate.

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The authors recommend to first leave new markets unregulated for a period of four years in order to protect investment and innovation incentives. After that period a modified SSNIP (small but significant and non-temporary increase in price) test is proposed to test for the existence of a separate new market. If a separate new market does exist, the authors suggest that regulatory authorities analyze whether there is a tendency towards competition. More exactly, it is recommended that, after six years, regulatory bodies should analyze whether or not there is competing infrastructure, after eight years, regulators should analyze whether or not competitors have gained significant market shares; and after ten years, it should be examined whether the market is characterized by non-temporary significant market power. If all of these tests fail, that is, if there is no competing infrastructure emerging and if existing competitors have not gained significant market shares or if there is a tendency towards significant market power, ex ante regulation is recommended. Finally, the authors recommend that after twelve years authorities return to the standard SMP test. It is argued that this framework protects investment incentives in an adequate manner, as innovators and competitors can be certain that profits will not be regulated away. The last chapter of our book focuses on the demand for broadband Internet, which has increased dramatically during the past few years, as broadband Internet increasingly replaces narrowband services. With a decreasing number of Internet service providers, access to upstream markets has come under closer scrutiny of regulatory authorities, as it appears to be essential for downstream market competition that the remaining non-integrated Internet service providers have access to broadband networks. Robert Crandall and Hal Singer now analyze the impacts that a price-squeeze by a vertically integrated DSL provider may have on the foreclosure of non-integrated Internet service provider. As Robert Crandall and Hal Singer demonstrate a profitable prizesqueeze strongly depends on factors such as the profitability of wholesale and retail markets, the possibility to attract customers from displaced Internet service providers, and the value of additional

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services offered by DSL providers. Overall, a price-squeeze can only be a public policy concern if integrated providers have both market power in downstream markets as well as the incentive to foreclose the market for rivals. Furthermore, Robert Crandall and Hal Singer argue that raising rivals’ cost strategies could harm consumers only under conditions which are not satisfied for broadband Internet access markets, and similarly, that there is no evidence for cross-subsidies between the wholesale and the retail market that could lessen consumer surplus. Consequently, the case for a regulatory intervention is argued to be weak. Overall, the authors suggest that prize-squeezes are not a major concern for broadband Internet access. Competition is argued to be sufficiently intense to maximize consumer welfare, and lower wholesale rates for DSL services are not expected to affect competition in an adverse manner.

1.7 CONCLUSION

The chapters contained in this book summarize and extend the various developments on the subject of access pricing in both the academic literature and public policy. While many chapters use illustrations from some particular industry, the common theme is that firms need access to other firms’ networks or (essential) facilities in order to compete in upstream or downstream market. Therefore, regulation and competition do not need to contradict themselves. Quite on the contrary, some regulation may be necessary in order to facilitate competitive entry and competition to develop. While this is almost common sense among academic economists and policy makers alike, there is a vivid debate about what regulatory instruments are best suited to achieve productive, allocative and dynamic efficiency and where the limits of efficient regulatory intervention are. The following chapters will contribute to this debate and, hopefully, also stimulate further research in this important area.

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REFERENCES Anderson, S. and J.J. Gabszewicz (2005): ‘The media and advertising: A tale of two-sided markets’, CEPR Working Paper 5223, CEPR, London. Armstrong, M. (1998): ‘Network interconnection in telecommunications’, The Economic Journal 108: 545–564. Armstrong, M. (2002): ‘The theory of access pricing and interconnection’, in Cave, M.E., S.K. Majumdar and I. Vogelsang (eds), Handbook of Telecommunications Economics, Vol. 1, Elsevier, Amsterdam, 297–384. Armstrong, M., C. Doyle, and J. Vickers (1996): ‘The access pricing problem: A synthesis’, Journal of Industrial Economics 44: 131–150. Baumol, W.J. (1983): ‘Some subtle issues in railroad deregulation’, International Journal of Transport Economics 10: 341–355. Baumol, W.J., J.C. Panzar and R.D. Willig (1982): Contestable Markets and the Theory of Industry Structure, Harcourt Brace, New York. Baumol, W.J. and J.G. Sidak (1994a): Toward Competition in Local Telephony, MIT Press, Cambridge, MA. Baumol, W.J. and J.G. Sidak (1994b): ‘The pricing of inputs sold to competitors’, Yale Journal on Regulation 11: 171–202. Baxter, W.F. (1983): ‘Bank interchange of transactional paper: Legal and economic perspectives’, Journal of Law and Economics 26: 541–588. Belfin, R. and M. Lukanowicz (1999): Positionspapier der Telekom-Control zum Ansatz der Forward Looking Long Run Incremental Costs zur Berechnung von kostenorientierten Zusammenschaltungsentgelten, Vienna, January 1999. Buehler, S. (2005): ‘The promise and pitfalls of restructuring network industries’, German Economic Review 6: 205–228. Carter, M. and J. Wright (1999): ‘Interconnection in network industries’, Review of Industrial Organization 14: 1–25. Carter, M. and J. Wright (2003): ‘Asymmetric network interconnection’, Review of Industrial Organization 22: 27–46. Cave, M. and I. Vogelsang (2003): ‘How access pricing and entry interact’, Telecommunications Policy 27: 717–727. Chang, H., H. Koski and S.K. Majumdar (2003): ‘Regulation and investment behaviour in the telecommunications sector: Policies and patterns in the US and Europe’, Telecommunications Policy 23: 677–699. De Bijl, P. and M. Peitz (2002): Regulation and Entry into Telecommunications Markets, Cambridge University Press, Cambridge. Dewenter, R. (2004): Essays on interrelated media markets, Nomos Verlag, Baden-Baden. Dewenter, R. and J. Haucap (2004): ‘Die Liberalisierung der Telekommunikationsbranche in Deutschland: Bisherige Erfolge und weiterer Handlungsbedarf’, Zeitschrift für Wirtschaftspolitik 53: 374–393. ERG (2004): ERG Common Position on the Approach to Appropriate Remedies in the New Regulatory Framework, ERG, Brussels. Evans, D.S. and R. Schmalensee (2005): ‘The industrial organization of markets with two-sided platforms’, NBER Working Paper 11603, NBER, Washington, D.C.

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Gans, J. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gans, J. and S. King (2004): ‘Comparing alternative approaches to calculating long-run incremental costs’, Working paper, Melbourne Business School. Gasmi, F., D.M. Kennet and J.J. Laffont (2002): Cost Proxy Models and Telecommunications Policy: A New Empirical Approach, MIT Press, Cambridge, MA. Gruber, H. (2005): The Economics of Mobile Telecommunications, Cambridge University Press, Cambridge. Haucap, J. and J.S. Marcus (2005): ‘Why regulate? Lessons from New Zealand’, IEEE Communications Magazine 43 (11): 15–16. Hausman, J.A. (1999): ‘The effect of sunk costs in telecommunications regulation’, in Alleman, J. and E. Noam (eds), The New Investment Theory of Real Options and its Implication for Telecommunications Economics, Kluwer Academic Publishers, Boston, 191–204. Hausman, J.A. (2001): ‘Regulation by TSLRIC: Economic effects on investment and innovation’, in Sidak, J.G., C. Engel und G. Knieps (eds), Competition and Regulation in Telecommunications, Kluwer Academic Publishers, Boston, 51–68. Hoeffler, F. (2006): ‘Monopoly prices versus Ramsey-Boiteux prices: Are they ‘similar’, and: Does it matter?’, Journal of Industry, Competition, and Trade 6: 27–43. IRG (2000): Principles of Implementation and Best Practice Regarding FL-LRIC Cost Modelling, online at: www.bundesnetzagentur.de/media/archive/1399.pdf Katz, M. and C. Shapiro (1987): ‘R&D rivalry with licensing or imitation’, American Economic Review 77: 402–420. Knieps, G. (2003): ‘Sector-specific regulation of German telecommunications’, in Madden, G.G. (ed.), The International Handbook of Telecommunications Economics, Vol. 3: World Telecommunications Markets, Edward Elgar, Cheltenham, 383–399. Kruse, J. (2004): ‘Competition in mobile communications and the allocation of scarce resources: The case of UMTS’, in Buigues, P. and P. Rey (eds), Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, 185–212. Laffont, J.J. and J. Tirole (1994): ‘Access pricing and competition’, European Economic Review 38: 1673–1710. Laffont, J.J. and J. Tirole (1996): ‘Creating competition through interconnection: Theory and practice’, Journal of Regulatory Economics 10: 227–256. Laffont, J.J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Laffont, J.J., P. Rey and J. Tirole (1998a): ‘Network competition: I. Overview and nondiscriminatory pricing’, RAND Journal of Economics 29: 1–37. Laffont, J.J., P. Rey and J. Tirole (1998b): ‘Network competition: II. Price discrimination’, RAND Journal of Economics 29: 38–56. Lipsky, A.B. and G.J. Sidak (1999): ‘Essential facilities’, Stanford Law Review 51: 1187– 1248. McAndrews, J.J. (2003): ‘Automated teller machine network pricing: A review of the literature’, Review of Network Economics 2: 146–158. Noam, E. (2002): Interconnecting the Network of Networks, MIT Press, Cambridge, MA. OECD (2004): Access Pricing in Telecommunications, OECD, Paris.

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Peitz, M. (2003): ‘On access pricing: Theory and European practice’, Telecommunications Policy 27: 729–740. Peitz, M. (2005): ‘Asymmetric access price regulation in telecommunications’, European Economic Review 49: 341–358. Pitofsky, R., D. Patterson, and J. Hooks (2002): ‘The essential facilities doctrine under U.S. antitrust law’, Antitrust Law Journal 70: 443–462. Rey, P. and J. Tirole (2006): ‘A primer on foreclosure’, forthcoming in Armstrong, M. and R.H. Porter (eds), Handbook of Industrial Organization, Vol. 3, Elsevier, Amsterdam. Rochet, J.C. and J. Tirole (2006): ‘Two-sided markets: A progress report’, Mimeo, forthcoming in RAND Journal of Economics. Roeller, L.-H. and L. Waverman, (2001): ‘Telecommunications infrastructure and economic development: A simultaneous approach’, American Economic Review 91: 899–923. Roson, R. (2004): ‘Two-sided markets: A tentative survey’, Review of Network Economics 4: 142–160. Sappington, D. (2005): ‘On the design of input prices: Are TELRIC prices ever efficient?’, Working Paper, University of Florida. Valletti, T. (2003): ‘The theory of access pricing and its link with investment incentives’, Telecommunications Policy 27: 659–675. Vogelsang, I. (2003): ‘Price regulation of access to telecommunications networks’, Journal of Economic Literature 41: 830–862. Willig, R. (1979): ‘The theory of network access pricing’, in Trebing, H.M. (ed.), Issues in Public Utility Regulation, Michigan State University Public Utilities Papers, East Lansing, MI, 109–152. Wright, J. (1999): ‘International telecommunications, settlement rates, and the FCC’, Journal of Regulatory Economics 15: 267–291.

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PART I

One-Way Access Pricing

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Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 2

Access Pricing and Infrastructure Investment JOSHUA S. GANS University of Melbourne, Melbourne

Contents 2.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 MODEL OF INVESTMENT TIMING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Investment costs                                                    2.2.2 Investment benefits                                                  2.2.3 Socially optimal timing                                              2.3 NO ACCESS REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Motives for access                                                  2.3.2 Motives for investment                                              2.3.3 Negotiations over access                                             2.3.4 Equilibrium investment timing                                       2.3.5 Summary                                                           2.4 ACCESS PRICE REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 ‘Small’ seekers                                                      2.4.2 Two ‘large’ firms                                                   2.4.3 Summary                                                           2.5 PRACTICAL ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Optimal usage charges                                               2.5.2 Access holidays                                                     2.6 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42 43 44 44 45 46 46 47 49 50 52 52 53 54 58 58 58 60 62 63

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2.1 INTRODUCTION

Much of the literature on the regulation of access to natural monopoly infrastructure concerns the setting of simple linear prices. In this regard, issues involve the vertically integrated nature of some firms, multi-product issues, incentives for cost reduction and, in some cases, the recovery of fixed investment costs.1 Of course, in regulatory circles the main issue that arises concerns the impact of access regulation on investment incentives. Put simply, it is argued that, in many network and infrastructure industries, productivity comes from new investment and access regulation, to the extent that it reduces the returns on such investment, harms overall efficiency. Some recent papers have taken this notion very seriously. Noting that these issues are a staple on the literature on innovation incentives, in a series of papers, Gans and Williams (1999), Gans (2001) and Gans and King (2004a) have considered the impact of access regulation on the timing of infrastructure investment.2 They find that access pricing regulation can actually improve investment timing outcomes and that it is not simply the case that such regulation has a dampening effect. Given this, this chapter considers that set of models and nests them within a common treatment of investment incentives. In so doing, it generalizes some of their results; especially with regard to the treatment of asymmetries between firms. As such, the hope is that some of the insights gained from that literature can be made more accessible to regulators and practitioners interested in access regulation. The chapter proceeds as follows. First, in Section 2.2, I introduce a simple model of investment timing based on the innovation model of Katz and Shapiro (1987). In Section 2.3, I then consider what happens when there is no access regulation as a means 1

See Armstrong, et al. (1994) and Laffont and Tirole (1999) for excellent treatments. Valletti and Cambini (2005) also look at investment in an access context. They consider how interconnection regulation in telecommunications impacts upon investments in quality by both networks. In contrast, this chapter is concerned with one-way access pricing situations with a single bottleneck provider. 2

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of providing a benchmark from which to assess access regulation. Section 2.4 then considers optimal access pricing. It does so by modeling that pricing as a two-part tariff. The principle insight is that the fixed charge in that tariff can be used to control investment timing. Moreover, the ultimate form of the charges paid resembles a fully distributed cost methodology. Section 2.5 then considers the role of usage charges in determining investment incentives and also whether access holidays – that is, fixed periods for which an investor is free of any regulation – can improve investment outcomes. A final section concludes and offers suggestions for future research.

2.2 MODEL OF INVESTMENT TIMING

In many situations, policy-makers consider infrastructure investment as a simple ‘invest or not’ decision. In reality, however, the relevant margin is not if an investment will take place but when. The concern of infrastructure providers is that unfavorable or uncertain regulation may unduly delay investment. This is, of course, also a concern for policy-makers. However, they must consider not only the timing of investment by providers but also the timing of investment by access seekers – who deliver further benefits to consumers. Given this, here I present a model of investment timing. To keep things simple, assume that there are only two firms using a particular infrastructure asset. I distinguish between two cases. The first is where both firms may conceivably become the provider; in this case, we have the potential for infrastructure investment competition. The second is where only one firm is a potential provider; that is, an infrastructure investment monopoly. This may arise because the other firm is wealth-constrained, capital markets are imperfect or there are other constraints on investment by them. In any case, our focus is on the timing of investment by the first firm to invest. As will be demonstrated, while it might be possible for the second firm to duplicate the facility, this will not occur in equilibrium. Thus, I term the first investor as the provider, P, and the other firm as the seeker, S.

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2.2.1 Investment costs

The model here is based on the dynamic R&D model of Katz and Shapiro (1987), who examine a model with discrete time periods of length  but explore continuous-time solutions as  → 0. In each period, firms make a decision as to invest or wait. It is assumed that there is no delay between a decision to invest and the appearance of the infrastructure. A firm investing at date T incurs a current cost of investment of FTerT , where the discount rate  = e−r and FT is the present value, viewed from time 0 of investment expenses. It is assumed that these costs of infrastructure investment decline due to technical progress. In this case, dFTerT /dT < 0 and d2 FTerT /dT 2 > 0. Let F be the limit of current investment costs as T →  and F0 be the cost of investment at time 0. A functional form that satisfies these properties is: FT = F0 e−T (where  > r) with investment costs declining exponentially. It is also assumed that the asset does not deteriorate over time or with usage (avoiding the need to consider re-investment and maintenance incentives). Finally, as the focus is on the recovery of fixed investment costs, it is assumed that use of the infrastructure involves a zero marginal cost.

2.2.2 Investment benefits

The following notation describes firm flow profits from investment for firm i ∈ 1 2

• i : duopoly profits for firm i if no investment takes place; • m i : monopoly profits for firm i if it has exclusive access to infrastructure;3 • 0: profits if the rival firm has exclusive access; 3

That is, these are the profits a provider would earn if access to its infrastructure was neither mandated nor regulated.

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• ci : duopoly profits to firm i net of fixed access charges if both firms have access to infrastructure and the access seeker pays a unit price equal to a. The following natural relationship is assumed to hold between these payoffs: The flow of consumer surplus under each of these market structures is as follows: • s: consumer surplus if no investment takes place; • S m : consumer surplus if a firm has exclusive access to infrastructure (regardless of who that firm is); • S c a: consumer surplus if both firms have access to infrastructure the seeker pays a unit price equal to a. where it is assumed that S c a > S m ≥ s m S c a + c1 a + c2 a > S m + max m 1 2 ≥ s + 1 + 2 ≥ 0

Therefore, the infrastructure is socially valuable and achieves its optimum under a duopoly rather than monopoly. 2.2.3 Socially optimal timing

The social planner solves the following problem: T max T a

s + 1 + 2 e

−rt

 dt + S c a + c1 a

0

T

+ c2 ae−rt dt − FT 

(2.1)

or 1 1 max s + 1 + 2 1 − e−rT  + S c a + c1 a T a r r c −rT + 2 ae − FT

(2.2)

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The solution to this, (T SO aSO ), satisfies the first-order conditions: S c − s + 2 c1 + c2 − 1 − 2  = −F  T SO erT

S c aSO  + c1 aSO  + c2 aSO  =0

a

SO

(2.3) (2.4)

Note that, given that marginal costs of infrastructure access are zero, it may be the case that aSO < 0. It is assumed that S c aSO  − s + 2 c1 aSO  + c2 aSO  − 1 − 2  > rF so that T SO is finite. 2.3 NO ACCESS REGULATION

As a benchmark to evaluate the benefits of access regulation, it is useful to begin by considering the equilibrium outcomes in the absence of such regulation. As will be demonstrated below, no access regulation does not imply a lack of access. Nonetheless, there are several dimensions in which an unregulated outcome fails to achieve the social optimum.

2.3.1 Motives for access

Working backwards, it is useful to consider first the motivations of an unregulated infrastructure provider to provide access. Suppose that firm i invests and that j would like access. In the absence of a regulatory mandate, access will only be granted if there is a gain from trade in so doing. Note that this gain will be motivated by two concerns: a desire to preserve monopoly profits and a desire to avoid duplication of infrastructure investment costs. It is assumed that parties negotiate over a two-part tariff with fixed payment, pi , and unit price of ai . First note that in any agreement the parties will choose ai to maximize: ci ai  + cj ai . Denote this as aˆ i and observe that it will typically be above 0. This will not be the case if 1 and 2 operate in distinct markets (or sell into a perfectly competitive market; for example, for export). In this case, aˆ i = 0. In

Chapter 2 – Access Pricing and Infrastructure Investment

47

such situations and environments where firms do not compete too intensely, it is entirely possible that ci ˆai  + cj ˆai  ≥ m i . Second, c c m note that if i ˆai  + j ˆai  < i , it will be profit maximizing for i to deny j access. In this case, pi = 0. However, the possibility that j might duplicate the asset will constrain this outcome. Duplication gives the potential seeker a payoff of 1/r cj 0e−rT − FT  if it invests at T . Let Tˆ be the choice of T that maximizes this function; and suppose that, as will generally be the case, this is later than the date at which a stand-alone monopolist would invest. This possibility imposes an upper bound on the access charge that the seeker will accept. That is, it must be the case that pi ≤ cj ˆai , but if cj 0 ≥ rF this upper bound is strengthened so that, if the infrastructure investˆ ment occurs at Tˆ  cj ˆai  − pe−rT ≥ cj 0e−rT − rFT.

2.3.2 Motives for investment

Turning now to the private incentives to investment, it is possible to distinguish between two different drivers of investment timing: willingness to pay and pre-emption. Willingness to pay is a consideration of the direct private benefit from investment in the absence of any strategic concern. For firm i, if investment takes place at time Ti and they expect to receive an access price of pi at time Tj , the present value of their payoff is

Wi Ti  =



Ti 0

+

i e 



Tj

−rt

dt +



Tj

Ti

−rt m dt i e

 ci ai  + pi e−rt dt − FTi 

1 1 −rTi − e−rTj  = i 1 − e−rTi  + m i e r r 1 c +  i ai  + pi e−rTj − FTi  r

(2.5)

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Let Tˆ i be the value of Ti that maximizes this function, taking into account the fact that Tj might be contingent in Ti . The first-order condition for this maximization problem is (assuming that ai is independent of (Ti Tj )): ˆ

−r Ti +  m i − i e

−

dTi Tˆ i  c −r Tˆ j  i ai  + pi − m i e dTi

1 dpi Tˆ i  −rTj e = −F  Tˆ i  r dTi

(2.6)

Indeed, if Tj = Ti , as it may in equilibrium, then ci ai  + pi − i is i’s willingness to pay for the infrastructure. The second motive driving infrastructure is strategic. There is a potential value to being the first firm to invest and pre-empting the other. By investing first at time Ti i receives Wi Ti  above. However, if firm j invests first, firm i may have to pay j for access. It turns out that this is always preferred by i to duplicating the facility. Moreover, it is also the case that once the infrastructure is built, there is no benefit to i from delaying its access demand. Hence, if it expects an access price of pj aj , firm i’s payoff in the event that it does not invest first is 1 LTi  =  ci aj  − pj e−rTi r

(2.7)

where Ti is now the time that access is sought. If both firms choose to invest at the same time, then it is assumed that the provider is decided randomly so that firm i earns 1/2Wi T + Li T. Following Katz and Shapiro (1987), ‘firm i is willing to preempt at T ’ if Wi T ≥ Li T. Moreover, the assumptions on F (.) guarantee that the current pre-emption value, Wi T − Li TerT , is increasing in T ; that is, if it is worth pre-empting at some time, it is worth pre-empting at any time after that. With this in mind, the earliest pre-emption date for firm i T˜ i , is defined by Wi T˜ i  = Li T˜ i  or, alternatively, pi + pj = rFT˜ i er T˜ i . Thus, pi + pj is firm i’s pre-emption motive for investment. That is, the motive for pre-emption is the difference

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49

between being paid an access charge and having to pay an access charge. However, this implies that the pre-emption incentives are identical for both firms, that is, T˜ i = T˜ j .

2.3.3 Negotiations over access

To consider fully what happens in the absence of access regulation, I work backwards: that is, asking first, what will be the outcome of access negotiations? To make things simple, I will label the provider as P and the seeker as S and assume that P has invested at Tp and that access is being sought at time TS ≥ TP . When P invests, it has the option of refusing access to S. As ˆ noted earlier, this will not occur if cP ˆa + cS ˆa ≥ m P ; where a is the level of the unit access charge that maximizes joint profits. However, even if cP ˆa + cS ˆa < m P P and S may come to an access agreement that involves ai =  and allows P to earn m P to prevent duplication of the infrastructure. This will occur whenever cS 0 ≥ F . In this case, if it chose to by-pass P, S would earn: 1 vSSA = max cS 0e−rT − FT T r Given this, if cS 0 ≥ rF P and S will begin negotiations at TS over the access charges (p a). This negotiation takes a noncooperative form similar to Rubinstein (1982). That is, negotiations can place over time where in each period, one party is chosen at random to be the offeror and they make a take-it-or-leave-it offer to the offeree. That party either accepts the offer (in which case the game ends) or rejects it (in which case agreement is delayed, P continues to earn profits and the process is repeated in the next period). It is assumed that S can only opt out of the bargaining process when responding to an offer by P.4 4

This assumption is made in order to eliminate supergame effects (i.e., brinkmanship) and simplify the bargaining equilibrium (see Gans and Williams, 1999).

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This results in the following outcome: Proposition 2.1 Suppose that cS 0 ≥ rF . The above bargaining game in continuous time has a unique subgame perfect equilibrium in which the initial offeror (whether S or P) makes an offer at TS that is accepted immediately if   c • pT ˜ s  = min 21  cS ˆa − cP ˆa + m a − rvSSA erTs and P  S ˆ c c m a˜ = aˆ if P ˆa + S ˆa ≥ P ; • pT ˜ s  = −rvSSA erTS and a˜ =  if cP ˆa + cS ˆa < m P. This proposition is an extension of Proposition 2.1 of Gans and Williams (1999). Note that in any case, S chooses to set TS = TP . That is, it seeks access as soon as the investment is built. This is because the equilibrium access charge is either independent of time or decreases in the time that access is sought, so S would earn value sooner rather than later.

2.3.4 Equilibrium investment timing

In choosing when to invest, a firm will have regard to any expected access payments, as derived in Proposition 2.1. It is perhaps easiest to focus first on the case where an access seeker is ‘small’ in the sense that it would never build the infrastructure. In this case, it is clear that vSSA = 0 and pT ˜ S  = 1/2 cS ˆa − cP ˆa + m P  if c c m ˜ s  = 0 otherwise. Nonetheless, if it P ˆa + S ˆa ≥ P and pT chooses to seek access, S does so as soon as the infrastructure is built, that is, TSN = TP . Anticipating this, P adjusts its timing accordingly. Therefore, P chooses TP according to   1 1 c N c m m TP = arg max T p max  S ˆa+ P ˆa+ P  P e−rTp −FTP  r 2 (2.8) The profit maximizing choice of TP satisfies:   1 c N c m m  S ˆa + P ˆa + P  P = −F  TPN erTP max 2

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51

Notice that Tˆ PN ≤ TPSA P’s stand-alone investment timing where −rTP − FTp . TPSA = arg maxTP 1r m Pe What happens when both firms can potentially become infrastructure providers? In this situation, both pre-emption and willingness to pay motivations will play a role. Let TiN be i’s investment timing SA choice if it were the only provider (as in (2.8)) and vS i the profits i would make if it bypassed j’s facility as a seeker. The following proposition characterizes the equilibrium investment timing. Proposition 2.2 Suppose that TiN ≤ TjN , then (i) if T˜ i ≤ TjN there exists a unique equilibrium outcome with investment taking place at the earlier of TiN and T˜ i ; (ii) if T˜ i > TjN and Wi TiN  ≤ Li TjN  there exists another equilibrium with investment taking place by firm j at TjN . This proposition is a special case of Theorem 1 of Katz and Shapiro (1987, p. 410). Pre-emption incentives determine the equilibrium if the timing choice that equates the winning and losing payoffs for each firm is earlier than either firm’s willingness to pay timing choice. It is useful to note that equilibrium timing may be delayed, be the same or accelerated relative to whether both firms were coordinating their investment timing decisions. A coordinated decision would implement timing on the basis of   max max ci ˆai  + cj ˆai  max m i i

i

SA was sufficiently high so that the Suppose that for both firms vS i access charges were constrained to prevent the seeker from bypassing the facility. In this case, the willingness to pay timing of the preferred provider would be the same as that which would arise from a coordinated decision. However, here equilibrium timing could be earlier than this date if the motive for pre-emption is strong and it could be later than this date if the motive for pre-emption is very weak.

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2.3.5 Summary

There are several social costs arising in the no regulation case. First, when one firm is ‘small’ the investment timing will be delayed relative to the social optimum. The provider will not appropriate sufficient firm rents – let alone consumer surplus – to make the socially optimal decision. In any case, access does not equate with the achievement of maximum social surplus (which would require access and a = aSO ). Second, when both firms are ‘large’ competition amongst them potentially accelerates investment timing. It is entirely possible that in this situation, infrastructure investment could be provided too soon at too high an investment cost or with an inefficient technology. 2.4 ACCESS PRICE REGULATION

Given that, in the absence of access regulation, investment timing is not socially optimal and downstream competition will not be as intense as it may be, it is worthwhile to consider regulated access prices that could improve outcomes. In this section, it is assumed that the timing of the model is as in Fig. 2.1. The regulator chooses a two-part tariff pricing formula, both parts of which may depend on the time the infrastructure is built and the time access is sought. Knowing this the provider chooses its investment time and the seeker chooses a time to seek access. As in previous sections, it is useful to distinguish between the ‘small’ and ‘large’ seeker cases. In this section, the focus is on the setting of the fixed charge. As such we suppose that aR = 0, as this simplifies notation; specifically, if the upstream marginal costs are assumed to be zero, it means that the flow of profits (net of access revenue or payments) for any firm is the same regardless of whether it is an access seeker or access provider.5 In the next section, this condition is relaxed. Given this,

5

This is, in fact, the usage charge that would lead to a competitively neutral outcome. See Gans and King (2004b).

Chapter 2 – Access Pricing and Infrastructure Investment 0

T

TS

Regulator chooses pricing formula, (a R(.), p R(.)).

Provider invests

Access seeker, seeks access at price (a R(.), p R(.))

53

Figure 2.1 Model timeline.

through this section, for notational convenience, I set ci ≡ ci 0 and S c ≡ S c 0.

2.4.1 ‘Small’ seekers

Suppose that only one firm is large, in the sense of being able to provide the infrastructure. The no-regulation choice of investment timing is delayed relative to the socially optimal timing because P does not appropriate the full social returns from its decision. Of course, setting pR = S c aSO  + cS aSO  and aR = aSO would implement the social optimum. However, this would require both a subsidy and merging both firms. This does not appear to be a practical outcome. Suppose instead that, similar to the reality of the practice of access pricing, we considered solutions based on cost-sharing rather than a reallocation of benefits. Suppose that the regulated access price is of the class pR = FTS erTS ; that is, a share of the replacement cost of the infrastructure valued at the time access is sought.6 Notice that, in this case,  needs to be chosen to satisfy two desires. First, that access is sought immediately and, second, the provider has appropriate incentives.

6

Gans and Williams (1999) and Gans (2001) compare methodologies based on replacement cost and historic cost. Both are equivalent if access is sought immediately but if there is some delay, they demonstrate that replacement cost creates superior investment timing incentives.

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Note that, for a given , the preferred timing for P and S are given by the following first order conditions: cp 1−

= −F  TerT

and

cS = −F  TerT 

(2.9)

These are in agreement if and only if c c cP = S ⇒ = c S c 1−  P + S

(2.10)

Therefore, each firm pays a proportion of the assessed costs equal to its share of total profits. If these use-values are observable to the regulator ex post, they can be used as part of the regulated access price. Let T C be the coordinated investment timing decision that satisfies cP + cS = −F  T C erT

C

(2.11)

It is easy to confirm that Tˆ PR = T C and that Tˆ SR = TPR so that the coordinated investment timing is in fact implemented for this costsharing regime.7

2.4.2 Two ‘large’ firms

If both firms can be potential providers, then the regulated access price plays a critical role in driving competition for provision. The 7

It turns out that, in this framework, the regulator’s problem is equivalent to finding the Lindahl equilibrium in this setting. The choice of investment timing is in fact a choice regarding the level of a public good. A Lindahl equilibrium occurs when for a given cost-sharing arrangement, both firms prefer the same level of the public good; in this case, investment timing. See Gans and Williams (1999) for an extensive discussion.

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55

basic idea is that even if aRi < aˆ i then competition to receive and avoid paying fixed access charges drives investment timing. Indeed, for an appropriately specified formula, piR (.), it is possible that investment timing could be socially optimal despite the fact that competition is prevailing. The key to this is to recall that for a given set of expected access charges, p1  and p2 , for all i, pre-emption timing is determined by: p1 + p2 = rFT˜ i er T˜ i , so that T˜ 1 = T˜ 2 = T˜ . On the other hand, if access is sought immediately, willingness to pay timing is determined by 1 1 Tˆ i ≡ arg max i 1 − e−rTi  +  ci + pi Ti e−rTi − FTi  Ti r r Given this, the subgame perfect equilibria in the investment timing game are summarized in the following proposition. Proposition 2.3 Suppose that p1  and p2  are such that access is always sought immediately. Suppose, also, that Tˆ 1 < Tˆ 2 . Then, equilibrium timing is Tˆ P = minTˆ 1 T˜ . If Tˆ 1 < Tˆ 2 < T˜ , there is a second equilibrium in which 2 invests at Tˆ 2 if and only if W1 Tˆ 1  ≤ L1 Tˆ 2 . Note that it is possible that either firm could be the provider. Indeed, even where it would never be profitable for a firm to invest as a stand-alone entity, that is, m i < F , it could be profitable for them to invest as a provider of access so long as c1 + c2 > rF . Investment timing is uniquely determined by the choice of regulatory pricing formula, piR . The regulatory issue then becomes whether piR  can be chosen so that TPR = T SO and TSR = TPR ? The latter condition will be satisfied so long as the value of seeking access at TPR is decreasing in TS . The following proposition derives a pricing formula that implements the socially optimal investment timing and access seeking choices.

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Proposition 2.4  Assume that c1 + c2 − rFT SO erT ≥  SA rmax v1 + v2SA 0 . Then there exists some weights, i (with 1 + 2 = 1, so that the following regulated prices, SO

f  TS  FTS erTS r+ fTS 

piR TS  = i S c −s + c1 −1 + c2 −2 +i result in TPR = T SO and TSR = TPR .

This proposition is proved by Gans (2001). The condition in this proposition has an intuitive interpretation. It simply allows private investment and competition to be feasible. That is, industry profits when investment takes place at the socially optimal date are positive and exceed profits if each were to duplicate the facility. The above formula achieves a socially optimal result by doing two things. First, piR TS  as stated in the proposition may be decreasing in TS . However, because of the convexity of current costs in T , the seeker prefers to receive its payoff, cj − piR TS , sooner rather than waiting for a lower access price. Thus, access is sought immediately, regardless of when the infrastructure is built. This also means that a seeker’s payoff is falling the later the infrastructure is provided. Given this, each firm expects that there will be no period of earning monopoly profits following the building of the infrastructure. Given this, the pricing formula controls investment timing by manipulating each firm’s pre-emption incentives. If infrastructure is provided too late, as piR TS  is decreasing, this will reduce the access revenue a provider receives. Thus, a provider’s payoff is increasing in TP . Note, however, that this means that the relative payoff to being a provider over a seeker is rising over time. What this means is that any individual firm cannot afford to wait to become the provider lest they be pre-empted to any rents from this. Competition for those rents causes investment timing to be driven solely by pre-emption concerns. From this it is easy to see how the regulated pricing formula is derived. Recall that pre-emption timing implies that: p1R T˜  +

Chapter 2 – Access Pricing and Infrastructure Investment

57

p2R T˜  = rFT˜ er T˜ . The formula itself is one for which T˜ = T SO . Recall that T SO is determined by the condition: S c − s + 2 c1 + c2 − 1 − 2  = −F  T SO erT

SO

(2.12)

Therefore, the pricing formula is such that ˜ S F − s + 2 c1 + c2 − 1 − 2  + F  T˜ er T ˜

= p1R T˜  + p2R T˜  − rFT˜ er T

(2.13)

˜ p1 T˜  + p2 T˜  = S c − s + c1 − 1 + c2 − 2 + F  T˜ er T   Marginal Social Cost of Delay

+

˜

rFT˜ er T   Investment Cost Recovery

(2.14)

Note that, in equilibrium, the first term is zero by definition. As such, the regulated pricing outcome involves a fixed access charge that has each firm share the costs of infrastructure provision. Equation (2.14) gives the regulator considerable choice as to the formula determining the actual price that will be charged to a given firm. What criteria should be used to select among alternative weights in Proposition 2.4? It is easy to see that if fixed charges exceed a seeker’s ongoing profits, then the seeker will not participate in the regime. For both c1 ≥ p2R and c2 ≥ p1R to be satisfied, 1 =

c1 c1 + c2

and

2 =

c2 c1 + c2

(2.15)

As in the ‘small’ seeker case, each firm pays a share in proportion to the profits they make in duopoly. In equilibrium, each firm ends up sharing in investments costs according to the same weights, i . This method of cost allocation is similar to a fully distributed cost methodology and, in equilibrium, it is indistinguishable from it.

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However, the rationale behind the allocation is solely to encourage competition in infrastructure provision. That is, the shares are set so as to make it possible for both firms to be able to pay their respective charges whenever private investment is feasible, that is, SO c1 + c2 ≥ rFT SO erT implies ci ≥ pjR for all i, j.

2.4.3 Summary

Proposition 4 demonstrates that it is possible for a regulator to use fixed access charges to induce socially optimal investment timing even when there is immediate competition. It does this by manipulating the pre-emption incentives of potential providers. If there were no such strategic motive, then it would be impossible to use an investment race to achieve timing earlier than the date that would arise for an unregulated monopolist. Indeed, the regulation potentially prevents wasteful acceleration of infrastructure investment provision.

2.5 PRACTICAL ISSUES

There are some practical issues that are worth considering when analyzing the regulation of access and its impact on investment. These include how usage charges should be determined, whether access negotiations should be mandated and whether access holidays may be used. Each of these is discussed in turn.

2.5.1 Optimal usage charges

In the above discussion, the usage component, aR , of the regulated access pricing regime was taken as given. Nonetheless, all of the previous literature on access pricing has been concerned with the level of such charges. In particular, for the complete information environment of this chapter, it has been argued that the optimal

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usage charge should be set below upstream marginal cost to counter the effects of imperfect competition downstream (Armstrong, et al., 1996). This issue is relevant here insofar as feasibility requirement is concerned – that it is privately profitable to invest at the socially optimal time rather than delay or duplicate the facility or not invest at all. If downstream profits are insufficient for this requirement to be met, then a usage charge below marginal cost designed to lower final good prices may be undesirable. It may be better to lift the usage charge and allow some downstream profits, so that the industry as a whole breaks even. To see this, suppose that both providers are symmetric.8 It is readily apparent that aR should be as close to aSO as possible. In particular, the lower bound is defined by: c1 aR  + c2 aR  −  SO rFT SO erT = r max v1SA + v2SA 0 . For a given aR , the earliest preemption date, T˜ , is now defined by ˜ cP aR  − cS aR  + 2pR = rFT˜ er T

(2.16)

This means that the socially optimal fixed charge should equal

 c R  1 c F  TS  R FTS erTS p TS  = S − s + 2 S a  −  + r + 2 FTS  (2.17) In equilibrium, fixed charges amount to a sharing of investment costs. In contrast, the usage charges are set to ensure participation. From an industry-wide perspective, this represents an implementation of Ramsey or average cost pricing downstream, where average costs 8

This is not an innocuous assumption. If they were different, then their regulated and usage charges would be different as they would face different marginal costs as a vertically integrated provider. This, in turn, would mean that fixed charges alone would not determine investment timing and the pre-emption incentives for each firm would be different. As such, this would become a considerably more complex problem and beyond the scope of this chapter to resolve quantitatively. Nonetheless, many of the qualitative issues would continue in this case.

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include the sunk costs of investment upstream. Nonetheless, this highlights the fact that because usage charges affect the distribution of industry rents as well as their overall size, it must be taken into account when setting regulated fixed charges.

2.5.2 Access holidays

The difficult feature of the above models of access pricing is that they require regulatory commitment of the pricing formula prior to any investment taking place. The complete information problem here masks the considerable uncertainty that surrounds most investment. In this situation, regulators may be unable to commit to a specific formula or even an appropriate methodology in advance that respects uncertainty that may occur. This is a problem because it may be the case that access is only sought when the investment is ‘successful’ and not otherwise. Given this, Gans and King (2004a) demonstrate that a ‘truncation problem’ may arise whereby investors are penalized when their investment is successful and not sufficiently rewarded for risk borne. A potential solution to this is to give access providers a period of time following investment that is free of required access regulation; that is, an ‘access holiday’, Of course, as noted earlier, a provider may choose to grant access anyway. However, the point is that access, if any, will not be subject to a regulatory constraint. In this respect, an access holiday is similar to a patent. The difference, however, is that when access regulation occurs, that regulation can be optimal. Gans and King (2004a) consider a situation where that access regulation is such that social surplus is maximized and the provider’s investment returns from that point on are normal. That is, the provider is regulated in a fashion that just allows them to recover depreciated investment costs. While Gans and King (2004a) model uncertainty explicitly, here I consider a version of their model where the investment outcomes are always certain. Suppose that an investment takes place at time, TP , and that both firms are symmetric. In addition, suppose that during

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the holiday period the provider does not grant access. The provider is granted a holiday period of  and so is only subject to access regulation at time TP + . That regulation is assumed to be optimal and, as such, pR aR  is set so that   

  1 cP aR  + pR e−rt dt = cP aR  + pR e−rt = FTP erTP −t r (2.18)

Thus, a provider is able to earn monopoly profits for  periods but must also bear the flow of capital costs, FTP erTP 1 − e−rt , over that period. Thus, the provider’s willingness to pay incentive is determined by 1 e−rTP 1 − e−rt  − FT1 − e−rt  WTP  = m r P

(2.19)

It is natural to suppose that, given the symmetry between firms, an access seeker will not make positive profits upon the expiry of holidays. In this case, LTS  = 0. Of course, this means that the seeker is indifferent between seeking access and not doing so. To avoid complications, I assume that it seeks access immediately. What this means is that, if one firm happened to be unable to provide the infrastructure, then timing would be determined according to the timing that maximizes (2.19). It is very easy to see here that the infrastructure is provided at the time an unregulated monopolist would choose to invest. Critically, it is independent of the length of the access holiday, . This means that, in theory, the regulator could set the holiday period arbitrarily small without deterring investment timing.9 However, as Gans and King (2004a) show this is not robust to realistic changes to the model, such as to allow demand changes over time, that make profit flows depend upon time, t. Instead they demonstrate that if profits are front loaded over time (relative to the access holiday length and the rate of technological progress 9

This result appears related to Sappington and Sibly (1988).

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on investment costs), then investment may occur earlier than the monopoly timing. On the other hand, if both firms can potentially provide the infrastructure, for a given access holiday, firms will compete away the rents associated with maxTP WTP  and the investment will occur earlier than it would under an unregulated monopoly. However, the investment acceleration itself will depend upon the length of the holiday. Nonetheless, in principle, so long as private rents in the industry are sufficient to cover investment costs, there exists an access holiday that implements the socially optimal (or at least second best) investment timing. Thus, access holidays play a role similar to fixed access charges although they mean that there is a delay to the advent of downstream competition.10

2.6 CONCLUSION

To date, research into the impact of access regulation on investment incentives has considered some fairly specialized models in order to (1) demonstrate that such regulation can improve investment outcomes; (2) demonstrate that there need not be a tradeoff between encouraging competition and encouraging investment; and (3) suggest that existing approaches of allocating sunk investment costs based on a fully distributed cost methodology may have, at least to a point, some grounding in economic theory. That said, we are still far from a set of pricing rules that can be reliably used in practical situations. Nonetheless, what the models to date show is that there is a methodology and approach regulators could use to consider this and that putting in place clear guidelines and commitments is surely desirable. Infrastructure investments are substantial and involve considerable risk. Adding regulatory 10

Given a choice it is better to use access pricing than an access holiday. When social welfare is concave, then it is better to spread any deadweight losses over time than put them all earlier in a concentrated manner (see Gilbert and Shapiro, 1990).

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risk is certainly a recipe for poor outcomes. Only by providing clear commitments can regulatory access rules improve upon private arrangements.

REFERENCES Armstrong, M., S. Cowan, and J. Vickers (1994): Regulatory reform: Economic analysis and British experience, MIT Press, Cambridge, MA. Gans, J. S. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gans, J. S. and S. P. King (2004a): ‘Access holidays and the timing of infrastructure investment’, The Economic Record 80: 89–100. Gans, J. S. and S. P. King (2004b): ‘Competitive neutrality in access pricing’, Working Paper, Melbourne Business School. Gans, J. S. and P. L. Williams (1999): ‘Access regulation and the timing of infrastructure investment’, The Economic Record 79: 127–138. Gilbert, R. J. and C. Shapiro (1990): ‘Optimal patent length and breadth’, RAND Journal of Economics 21: 106–112. Katz, M. L. and C. Shapiro (1987): ‘R&D rivalry with licensing or imitation’, American Economic Review 77: 402–420. Laffont, J.-J. and J. Tirole (1999): Competition in telecommunications, MIT Press, Cambridge, MA. Rubinstein, A. (1982): ‘Perfect equilibrium in a bargaining model’, Econometrica 50(1): 97–110. Sappington, D. E. M. and D. S. Sibly (1988): ‘Regulating without cost information: The incremental surplus subsidy scheme’, International Economic Review 29: 297–306. Valletti, T. M. and C. Cambini (2005): ‘Investments and network competition’, RAND Journal of Economics 36: 446–467.

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Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 3

Network Financing with Two-Part and Single Tariffs AXEL GAUTIER∗ CEREC, Facultés Universitaires Saint Louis and CORE, UCL.

Contents 3.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Model overview and results                                          3.1.2 Related literature                                                    3.2 MODEL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 Demand, costs and information                                       3.2.2 Regulation                                                          3.2.3 Timing of the events                                                3.2.4 Benchmark: the regulated monopoly case                              3.3 OPTIMAL ACCESS CHARGES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 The entrant’s entry and supply decisions                              3.3.2 Two-part tariff                                                      3.3.3 Single tariff                                                         3.4 COMPARISONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Market structure                                                     3.4.2 Welfare                                                            3.5 CONCLUDING REMARKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A3.1 Proof of proposition 3.2                                              A3.2 Proof of proposition 3.3                                              A3.3 Proof of proposition 3.4                                              REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66 68 70 71 71 72 73 74 75 75 76 79 81 81 82 83 85 85 87 88 89

∗ The author gratefully acknowledges the financial support from the Brussels Capital Region.

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3.1 INTRODUCTION

The need of competition in network industries (telecommunications, energy, railways, etc.) is now commonly accepted. As the network usually constitutes a bottleneck input that cannot be economically duplicated,1 competition in these industries requires that the network’s owner grants third-party access (TPA) to competitors. With TPA, competitors can apply for network capacity (for which they pay an access charge) and supply services to final consumers. Third-party access is particularly important when there is no alternative technology to reach consumers, that is, if there is no possibility to bypass the network. Since the network is a bottleneck input, the network owner has incentives to use its dominant position to monopolize downstream segments of the market (foreclosure), so that introducing competition does not suppress the need for regulation. In particular, regulating both access conditions and the access price is of prime importance.2 For example, in the European Union, it is required that the network’s owner grants nondiscriminatory access to its infrastructure3 (regulation of access conditions) or, in the UK, BT’s interconnection services are subject to access charge controls by Ofcom, an independent regulator (regulation of access prices). Access charges play two roles in TPA: first, they affect entry and supply decisions of competitors and, thereby, market structure. 1

Bottleneck inputs like rail tracks and stations, the electricity transmission grid or the local loop in telecommunications are called essential inputs (or facilities). 2 Access control is one of the proposed remedies to prevent foreclosure. Other solutions like divesture or shared ownership can also be considered (see Rey and Tirole, 2005). 3 The European directive 96/92/EC concerning the internal market in electricity imposes a nondiscriminatory tariff for the use of the transmission and distribution system; in the rail directive 2002/14/EC, it is required that ‘the charging and capacity allocation schemes should permit equal and non-discriminatory access for all undertakings.’

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Second, access charges are used to recover the network’s costs.4 In more detail, the access charge should cover the cost of using the network and part of the network’s fixed cost which includes building, maintenance and development costs. Hence, there is a twodimensional conflict between granting generous access that reduces downstream profits and the possibility of recovering the infrastructure cost. This chapter compares two types of access pricing: A two-part tariff where the fixed part aims at covering (part of) the network’s fixed cost and the variable part covers the network’s usage costs, on the one hand, and a single tariff where both usage and (part of) the infrastructure costs are covered by a per-unit access charge on the other. In both cases, the regulator trades off the degree of competition induced by the access charges and the need to finance the network. This chapter compares market structure and social welfare under these two systems. The originality of this work is to consider an endogenous market structure: The entrant’s cost condition and, thereby, its entry and supply decisions are not known ex ante by the regulator. Hence, the regulatory environment has an impact on both the competitor’s entry and supply decision. Both the two-part and the single tariff are currently used for pricing access. In Germany, DB Netz, the owner of the rail-track network should cover operation, maintenance and depreciation costs by track charges. Between 1998 and 2001, DB Netz applied a two-part tariff consisting of a fixed charge and a variable part per train-km. The fixed part aimed at covering the infrastructure cost and the variable part was kept as close as possible to usage costs. Along with the twopart tariff, a single tariff with a higher per train-km fee was available for smaller carriers. Since 2001, DB Netz has been applying a single tariff with a constant price per train-km that depends on the train’s and the tracks’ characteristics (see Link, 2003; Pittman, 2004). In

4

In addition, the access charges should induce the efficient amount of bypass (Laffont and Tirole, 2000). An issue which is not considered here since we assume that the network is an essential input, that is, an input that cannot be duplicated.

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the UK, rail users paid a track access charge consisting of a fixed annual payment and a variable track usage charge that covers usage costs to the network owner (Network Rail). In the Netherlands, the train access charge only consists of a variable fee per train-km. 3.1.1 Model overview and results

There are two firms that can potentially supply downstream services to consumers, for example, passenger rail services or long distance calls. Both firms share the same network (rail tracks or a telecommunications network) to reach consumers. The network is owned by an incumbent operator that gives TPA to a unique potential entrant. The industry regulator contracts with the incumbent and specifies the supply of the incumbent, the public contribution to the network financing and the access condition for the third party. After observing the regulatory environment, the potential entrant decides whether or not it will be active in the downstream market. If it decides to enter, it pays the access price and supplies services without being further regulated. Hence, the incumbent is fully regulated while the entrant is not. Market liberalization does not always suppress the regulation of the incumbent operators. In the passenger rail market, for example, the regulators often impose a minimum level of services to incumbent operators while entrants are not subject to the same obligations. Similarly, universal service obligations are imposed on incumbent operators in telecommunications and postal markets. The model developed in this chapter sheds light on the impact of the regulatory environment on the entry and shows how regulation should be adapted to an endogenous market structure. The framework can be easily adapted to situations where the regulator controls only the access prices and the incumbent decides on its supply of downstream services.5 5

However, if the incumbent remains the first mover, it could use its first-mover advantage to prevent entry to the downstream market in this case. Hence, regulation of the incumbent’s supply can be imposed to prevent market foreclosure.

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Regulation takes place under asymmetric information. For the regulator, a major uncertainty at the time of opening the market to competition concerns the entrant’s technology. Is the competitor more cost-effective than the incumbent operator? Throughout this chapter, we assume that, the regulator does not know whether or not the entrant is more cost-effective than the incumbent operator. Consequently, entry does not always take place. The entry decision is endogenous and depends on the regulatory environment. The cost of the network is partially covered by a transfer of costly public funds from the regulator to the incumbent. The remaining part is covered by the incumbent’s profit (if any) and the entrant’s contribution via an access charge. This chapter compares two access pricing systems: A two-part tariff, where the entrant contributes to the network financing through a fixed access charge, and a single tariff, where the entrant contributes through a per-unit access charge. In both cases, these charges aim at covering the network’s fixed cost, that is, they come in addition to marginal cost of using the network. Both the two-part and the single tariffs affect the entry decision – a larger access price deters entry – but only the single tariff distorts the supply decision of an active entrant provided that the variable part of the two-part tariff is equal to the network’s usage cost. The chapter compares welfare and the resulting market structure under the two access pricing systems. In both cases, entry is not efficient6 as an efficient entrant may not enter the downstream market. This means that the regulator optimally reduces the entry in order to increase the entrant’s financial contribution to the network’s cost. There is, however, more entry if the regulator uses a single tariff, that is, a duopoly in the downstream market is more likely in this case. The optimal access charge system depends on the incumbent’s production cost. When the incumbent has a high cost, entry is beneficial both for consumers and the entrant. In this case, a two-part

6

The market structure is inefficient if there is a positive probability that a more (a less) cost effective producer stays out (enters) the market (see Armstrong, 2001).

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tariff is preferred because (i) it does not distort the entrant’s supply decision and (ii) the regulator can raise a large contribution from the entrant through a large lump sum fixed fee. If the incumbent has a low cost, using a fixed access charge is not optimal because it deters entry too much and the regulator prefers the single tariff. The cost of public funds used to partially finance the network also influences the choice between these two pricing schemes. 3.1.2 Related literature

In this chapter, the market structure is endogenous and it depends on the regulatory environment. The chapter is therefore closely connected to the literature on the design of a private industry (Auriol and Laffont, 1992; Dana and Spier, 1992; Jehiel and Moldovanu, 2004) that considers the market structure to be a part of the regulatory environment. In these papers, the regulator is assumed to fully control the market structure, while it is not the case with TPA. In Dana and Spier, for example, firms compete ex ante for the market and, in some circumstances, they also compete ex post in the market. With TPA, competition only takes place ex post in the market. The structure of the model presented here is similar to that in Caillaud (1990), where a regulated incumbent faces the threat of entry into the downstream market but in Caillaud’s model the entrants bypass the incumbent’s input and there is no access pricing problem. Gautier and Mitra (2003) analyze TPA without bypass but they focus only on two-part tariffs for access.7 Three different kinds of access pricing formulas are proposed in the literature: efficient (Ramsey) access prices (see Laffont and Tirole, 1994, 2000), the efficient component pricing rule (ECPR) (see Willig, 1979; Baumol, 1983; Armstrong, 2001), and cost-based access prices like TSLRIC (total service long run incremental cost). Under the Ramsey approach, the regulator fixes the access and the 7

Without restricting the variable part of the tariff to be equal to the network usage cost.

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retail prices in order to maximize the social welfare while guaranteeing that the network owner breaks even. It results that, for each retail product, the associated Lerner index is inversely related to the superelasticity of the product. This approach usually takes the market structure as given, that is, it does not take into account the impact of access prices on competitors’ entry decisions. Our derivation of the optimal access charge is similar to this efficient access pricing approach, except that it does not consider the market structure as given. Moreover, we consider quantity rather than price competition in the downstream market. As an alternative to Ramsey pricing, the ECPR prescribes that the access price should be equal to the incumbent’s opportunity cost for the retail services. With this type of access pricing, (a) potential entrants can only profitably enter the market if they are more cost-efficient and (b) entry is neutral with respect to the incumbent’s profit. In this approach, entry is endogenous and the market is always served by the most efficient firm. Under some conditions, the ECPR is equivalent to Ramsey pricing (see Laffont and Tirole, 1994, 2000; Armstrong et al., 1996).8 In the model presented in this chapter, the regulator optimally departs from efficient entry. Finally, Gans (2001) studies the relationship between the access pricing and the incentive to invest into infrastructure in a dynamic context. This chapter considers the link between access prices and network financing in a static context.

3.2 MODEL 3.2.1 Demand, costs and information

Two firms, a regulated incumbent (I) and a potential entrant (E) are possibly active in the downstream market. The downstream demand 8

The optimal access charge is not equivalent to the ECPR if the entrant has market power, which is the case in this chapter.

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is given by PQ = a−bQ with a > 0, b > 0, where Q is the quantity demanded and PQ the market clearing price corresponding to Q. The firms share the incumbent’s network to supply downstream services to consumers. The network’s building (or maintenance) cost is C. Using the network involves a constant unit cost denoted . In addition, the firms produce the service at a constant marginal cost. We denote the incumbent’s and the entrant’s marginal cost by  and , respectively. The regulator knows the incumbent’s cost parameters C,  and . For example, the regulator could have learned the incumbent’s costs from past regulatory experiences.9 We restrict the parameter sets to C > 0,  ≥ 0 and  ∈   , with 0 <  <  < a. We call  =  − . At the time the regulator specifies the access conditions, it does not know entrant’s cost . This assumption captures the fact that when the regulator allows TPA to the network, it ignores whether or not potential entrants are more cost-effective than the incumbent. It is, however, common knowledge that  follows a uniform distribution g over the same interval   , that is, g = 1/.

3.2.2 Regulation

The regulator maximizes consumer surplus net of the transfer to the incumbent. Transfers are costly; this is captured by introducing a shadow cost of public funds ≥ 1. The regulator’s objective  Q is to maximize WQ t = SQ − PQQ − t, where SQ = 0 Pxdx and t is the amount of transfer paid by the regulator to the incumbent.10 In this context, transfer t is meant to finance the infrastructure. The regulatory contract should guarantee to the incumbent at 9

Dana and Spier (1993) and Jehiel and Moldovanu (2004) have a similar hypothesis. 10 We consider a pro-consumer regulator that does not include the firms’ profits in the welfare function. Including the profits in the welfare is a source of nonconcavity in the regulatory problem (see Gautier and Mitra, 2003).

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least a zero profit (participation constraint). With the linear demand specification, we have: WQ t = b Q2 /2 − t. The regulator contracts only with the incumbent. Depending on the known cost , the regulatory contract, denoted M, specifies three variables: (1) the supply of the incumbent qi , (2) the transfer to the incumbent t, and (3) the access conditions to the network. There are two possible access charge systems: a two-part tariff in which entrant pays a fixed fee A and a per unit fee equal to the marginal cost of using the network , or a single tariff where the entrant pays  +  for each unit supplied in the downstream market. The per-unit fee can be decomposed in two terms: a payment  for covering the costs of using the network and a payment  for covering the infrastructure cost. Without loss of generality, we now set the network usage cost to zero:  = 0. We assume that the access charges are independent of the entrant’s technology. This assumption is in line with the European practices that impose a non discriminatory access to third parties. With nondiscriminatory access, two types of entrant with cost  and  face the same entry conditions. Firms compete in quantities. The entrant’s quantity decision is taken after observing the quantity supplied by the incumbent (which is specified in M). Hence, the entrant is a Stackelberg follower in the quantity game.

3.2.3 Timing of the events

(1) The regulator observes the cost conditions of the incumbent and chooses between the single and the two-part tariff. (2) The regulator designs the regulatory contract. (3) The entrant learns its cost  and observes the regulatory contract. (4) The entrant decides on entry. (5) The regulated incumbent produces the quantity specified in the regulatory contract, the entrant, if active, decides on quantity. The price is set to clear the market.

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3.2.4 Benchmark: the regulated monopoly case

Suppose that the incumbent firm does not face the threat of entry, that is, the incumbent is a monopolist. The regulatory mechanism specifies for each known  ∈   a quantity transfer pair qi  t chosen to maximize the welfare and that guarantees to the incumbent at least a zero profit. That is, the regulator solves: max Wqi  t = b

qi  t

qi 2 − t 2

subject to Pqi  −  qi  − C + t ≥ 0 In this problem, the participation constraint is binding. Integrating the constraint in the objective function, the regulator solves: max b qi 

qi 2 + Pqi  − qi  − C  2

The solution to this problem is: Proposition 3.1 For any known  ∈   , the optimal quantity transfer pair for a monopolist is: a− , 2 − 1 b −1 a − qi . (ii) t = C − 2 − 1 (i) qi  =

Proof

Take the first-order condition of the above problem.



The optimal contract that the regulator applies to a monopolist is such that (i) when there is no cost of public funds ( = 1), the market clearing price is equal to the firm’s marginal cost  and the

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network cost is fully financed by public funds: t = C. (ii) When increases, the regulator raises the market price above the marginal cost and consequently reduces its transfer (t < C).

3.3 OPTIMAL ACCESS CHARGES 3.3.1 The entrant’s entry and supply decisions

In the presence of an entry possibility, the regulatory mechanism f specifies a triple: M f  = qi  Af  tf  in the two-part tariff case or M v  = qiv  v  tv  in the single tariff case for any given and commonly known marginal cost  ∈   of the incumbent. The entry decision is taken after the regulator has designed the regulatory mechanism. Therefore, even if the entrant is not regulated, the regulatory mechanism affects the entry decision and the quantity supplied by the entrant. With a two-part tariff, the profit of an entrant with cost  is either f

e qe M f   = Pqi  + qe  − qe − Af  if it enters the market and supplies the quantity qe , or zero if it does not enter the market. Assuming entry takes place, the entrant supplies the quantity qef ∗ M f   = maxqe e qe M f  . The solution to this problem is f

qef ∗ M f  

a − bqi  −  =  2b

(3.1)

Then, entry takes place if e qef ∗ M f   M f   is greater than zero, that is, if  f  ≤ kf  = Pqi  − 2 bAf  (3.2) kf  − / is the probability of entry associated with the regulatory mechanism M f .

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Similarly, with the single tariff, the profit of the entrant is either e qe M v   = Pqiv  + qe  −  − v  qe if it enters the market with quantity qe > 0, or zero otherwise. Assuming entry takes place, the entrant supplies the quantity qev∗ M v   that maximizes its profit: qev∗ M v   =

a − bqi  −  − v   2b

(3.3)

Entry takes place if e qev∗ M v   M v   ≥ 0, that is, if  ≤ kv  = Pqiv  − v 

(3.4)

kv  − / is the probability of entry associated with the regulatory mechanism M v .

3.3.2 Two-part tariff

With the two-part tariff, the expected surplus is, for any known  ∈   , ˆ f  = W

1  =k  qi  + qef ∗ M f  2 b d  = 2 f q 2 1  = b i d − tf  + f  =k  2 f

f

The first term is the expected consumer surplus when entry takes place, the second term is the expected consumer surplus when entry does not occur and the last, the transfer to the firm. The regulator ˆ f  and selects the regulatory mechanism M f  that maximizes W

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that guarantees to the incumbent at least a zero profit. Defining Pˆ f  as the expected market clearing price 1  =k  f P  = Pqi  + qef ∗ M f  d  = 1  = f + Pqi d  =kf  f

ˆf

the incumbent’s participation constraint is f Pˆ f  − qi  +

1  =k  =

f 

Af d + tf  − C ≥ 0

The solution to the above problem is given in the following proposition: Proposition 3.2 M f  is:

For any known  ∈   , the optimal mechanism

ˆ where ˆ = 1 + 2  +  − 1a /3 , (i) For  ∈   , a− , 2 − 1 b f Pqi  − 2 (b) Af  ≥ , 4b −1 f a − qi  (c) tf  = C − 2 − 1 f

(a) qi  =

ˆ  , (ii) For  ∈  a − H f  , 2 − 1 b with H f  ≥  in the relevant range and H f  increasing and convex in , f

(a) qi  =

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(b) Af  =

4Pqi  +  − 1a − 2 , b1 + 6 2

ˆ i  − qi  − (c) tf  = C − Pq f

Proof See Appendix A3.1.

f

kf  −  f A .  

Increasing the access charge Af  has the following impacts on welfare: first, it decreases the probability of entry and the market is therefore less competitive. As consequences, consumer surplus decreases and the expected market price Pˆ f  increases, implying an increase in the incumbent’s operational profit and an associated reduction in the transfer tf . Second, the increase in the access charge increases the expected contribution of the entrant to the infrastructure financing (kf  − / Af ) as long as Af  does not f exceed Pqi  − 2 /9b. Hence, increasing the access charge up to that point further contributes to reducing the transfer. However, the possibility of reducing the transfer by increasing the access price is limited by the fact that, at a point, further increase in Af  either reduces the incumbent’s profit or deters all types of competitor to enter the market. Similarly, a decrease in the incumbent’s supply decreases consumer surplus but increases the incumbent’s profit and consequently reduces tf . The regulator then faces the following tradeoff: increasing Af  f (or decreasing qi ) has a negative impact on consumer surplus but a positive impact on the incumbent’s profit, at least as long as Af  is not too large. Consequently, less public funds should be invested to cover the infrastructure cost. Then, there is a clear tradeoff for the regulator between the benefit of more competition in the market (higher supply) and the cost (more public funds). When the regulator faces a relatively efficient incumbent firm, the potential benefit of entry on consumer surplus is limited because the incumbent is efficient and regulated. Moreover, the potential contribution of the entrant to the infrastructure financing is limited ˆ entry too. For these reasons, when the incumbent’s cost lies in   ,

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decreases the welfare and the regulator deters the entry of all types of competitor by setting a large fixed access charge. The reason is that, in terms of consumer surplus, the benefit of allowing for entry does not compensate the cost in terms of more public funds invested to cover the increase in the incumbent’s losses. Then, in this case, the solution applied is identical to the regulated monopoly case. When the incumbent is relatively less efficient, both the benefits of entry for consumers and infrastructure financing increase, and the ˆ . However, entry regulator allows entry and kf  >  for  ∈  is not efficient (see Proposition 3.4). Entry is limited to increase the financial contribution of the types of entrant active in the downstream market. There is a tradeoff between financing infrastructure through a larger fixed tariff and the competition induced in the downstream market. When there is a positive probability of entry, the incumbent supplies less than in the regulated monopoly case. When  increases, the regulator partially replaces the incumbent’s production by the production of a more cost-effective entrant. This substitution has a positive impact on consumer surplus and on the entrant’s profit. The regulator captures part of this profit increase by setting a larger access charge Af . Finally, when public funds become more costly ( increases), the regulator increases the parameter space for which entry never occurs (ˆ increases). The regulator prefers to finance the network through higher prices and a lower transfer than through a larger contribution of the entrant. To limit the transfer of public funds, the regulator raises the price by limiting entry.

3.3.3 Single tariff

With a single tariff, the regulator maximizes the expected surplus ˆ v  = W

1  =k  qiv  + qev∗ M v  2 b d  = 2 1  = qiv 2 + d − tv  b v  =k  2 v

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subject to the incumbent’s participation constraint: Pˆ v −qiv +

1  =k  v

qev∗ M v  d+tv −C ≥ 0  = v

where 1  =k  Pqiv  + qev∗ M v  d  = 1  = + Pqiv d  =kv  v

Pˆ v  =

Proposition 3.3 M v  is:

For any known  ∈   , the optimal mechanism v

a−H  , (i) qiv  = 2 −1 b with H v  >  for all  ∈   and H v  increasing and convex in .

(ii) v  =

a−2 −1+bqiv 2 −3 6 −1

>0  kv  v −1 (iii) tv  = C − 2 −1 a − qiv  − 1 

qev∗ M v  d.

Proof See Appendix A3.2.



With a single tariff, the expected market clearing price is identical to the regulated monopoly case: Pˆ v  =  − 1a + /2 − 1. This means the following: first, that the transfer to the network owner is smaller than in the regulated monopoly case. The transfer is reduced by 1  k  v∗ v qe M  d

   v

v

Second, if in average consumers pay the same price than under the regulated monopoly regime, consumer surplus is higher.

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Entry takes place whenever the price without entry is higher than the entrant’s marginal cost plus the per-unit access charge. At the solution, the cost of increasing the access price (lower production by the active types of entrants and lower entry) equals its benefit (an increase in the entrant’s contribution to network financing and thereby a lower transfer).

3.4 COMPARISONS 3.4.1 Market structure

In this model, the entrant is active in the downstream market only if its marginal cost  is below k. This threshold value depends on the regulatory environment. Figure 10.1 represents the market structure for all possible realizations of   ∈   2 . In region (I), the entrant is less cost-effective than the incumbent and remains out of the market. In region (II), entry does not take place even though the entrant is more cost effective. In region (III), entry occurs only if the regulator uses a single tariff. Finally, in region (IV), the entrant is active in the downstream market for both types of tariff.

φ=θ k υ(θ)

k f(θ)

I

lI

III

IV θ

θ

θˆ

θ

θ

Figure 3.1 The market structure with fixed and per-unit access charge.

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Two observations should be made. First, entry is not efficient in the sense that a more cost effective entrant is not necessarily active in the downstream market. For efficient entry, the access charge should have been such that k = . This could be achieved with a fixed access charge Af  = Pqi  − 2 /4b or a per-unit charge

v  = Pqi  − .11 The regulator (optimally) limits the entry of firms with a little cost advantage over the incumbent in order to increase the financial contribution of entering firm. Second, there is a higher probability of entry when the regulator uses a single tariff compared to the two-part tariff. With a two-part tariff, the entrant manages to cover the fixed part of the tariff only if it has a large cost advantage over the incumbent, while there is no problem of this kind with the single tariff. Hence, the single tariff generates more entry. These two observations are summarized in the next proposition. Proposition 3.4 kf  = kv  = , kf  < kv  <  for all  ∈   and kf  < kv  = . Proof

See Appendix A3.3.



3.4.2 Welfare

Before turning to the welfare comparisons, it is important to remember that if the regulator knows the entrant’s cost, it would always prefer the two-part tariff because, first, this instrument is nondistortionary and, second, it can tax all the entrant’s profit through the fixed part of the tariff. This is no longer true when the regulator is unaware of the entrant’s cost and, depending on the entrant’s marginal cost  and the cost of transfers , the optimal pricing system will be either the two-part or the single tariff. We can establish that: 11

This last expression is the efficient component pricing rule (see Armstrong, 2001).

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Proposition 3.5 There exists ∗ such that (i) ˆ ≤ ∗ and (ii) the regulator prefers the single tariff for all  ∈  ∗ . ˆ f  and W ˆ v  are both continuous Proof The welfare functions W ˆ the solution with the twoand decreasing in . Since for  ∈   , part tariff is identical to the regulated monopoly case, we have ˆ f  and the single tariff dominates. Define ∗ as the ˆ v  ≥ W W ˆ f , by continuity of the welfare function, ˆ v  = W solution of W ∗ ˆ   ≥ . ˆ there is no entry if the regulator uses the two-part When  ≤ , tariff. This, however, does not mean that entry is not profitable. In particular, if the regulator uses the single tariff, there is a positive probability of entry and welfare is higher. For larger values of , there is a positive probability of entry with both tariffs. We have established that up to ∗ , the single tariff is the preferred access pricing. Though we cannot prove it formally, numerical simulations show that (1) for  ∈ ∗  , the two-part tariff leads to higher welfare and (2) that the cutoff point ∗ increases with the cost of public funds . For example, with the following parameters: PQ = 10 − Q,  = ˆ ∗  are 1 1 when = 1, 1,  = 6 and C = 2, the values of  ˆ ∗  = 15 21 when = ˆ ∗  = 127 16 when = 11,   ∗ ˆ   = 169 252 when = 13. Hence, the parame12, and  ˆ  where there is entry with the two-part tariff, and ter spaces  ∗   where it dominates the single tariff decreases with the cost of public funds.

3.5 CONCLUDING REMARKS

In this chapter we have shown that, depending on the incumbent’s technology and on the cost of transfer, it is optimal to use either a single tariff or a two-part tariff. The reason is that when the market structure is endogenous, both types of tariff are distortionary. The two-part tariff distorts the entry decision, while the single tariff distorts both the entry and the supply decisions of the entrant. Quantity

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distortions induced by the single tariff reduce the welfare and, hence, the regulator prefers this type of pricing only when the two-part tariff induces too little entry. When the probability of entry into the downstream market is large enough, that is, the entrant is able to recover the entry fee with its downstream profit, the regulator prefers to use an instrument that does not distort the entrant’s supply decision.12 This analysis departs from Armstrong (2001), where the access price is set to induce an efficient entry decision, and from the literature on access pricing (see, e.g., Laffont and Tirole, 1994), where the market structure is considered as given. Our analysis considers an endogenous market structure where the entry decision depends on the regulated access fee. In this context, the optimal access prices reflect the tradeoff between promoting entry and financing the infrastructure. The resulting market structure is not efficient since it could leave a producer which is more efficient than the regulated incumbent out of the market. There is another type of inefficient market structure when the regulator allows the entry of a less efficient competitor (k > ). This second kind of inefficiency could arise when the regulator does not know the incumbent’s cost parameter . In this case, the mechanism is the same modulo the fact that, from the regulator’s point of view, the cost of the incumbent is not its marginal cost  but a virtual marginal cost z,13 that is the marginal cost of producing plus the marginal cost of fulfilling the incumbent’s incentive constraint. Since the virtual marginal cost is above the marginal cost, there is more entry when the regulator ignores the incumbent’s marginal cost  (it simply comes from Proposition 3.4) and there could be entry of a less efficient competitor (typically it will be the case with the single access charge for high values of ).

12

More intense competition on the downstream market would limit the market power of the entrants and could be an instrument to limit the distortions induced by the single tariff. 13 If the regulator knows that  is distributed according to a continuous density function f, the virtual marginal cost is z =  + L, where L is the hazard function associated with the distribution f.

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However, integrating this second source of asymmetric information in the model creates nonconcavities in the problem and the solution involves a certain amount of bunching. These nonconcavities are inherent to the problems of regulation with endogenous market structure (see Caillaud, 1990; Gautier and Mitra, 2003). To keep the problem tractable, we assumed that the cost parameters of the historical operator are common knowledge. The analysis so far neglected an important issue: the incentives of the network owner for developing or expanding its infrastructure and competitors’ incentives to invest into their own network. The different access pricing formulas and the different resulting market structures generate different incentives to invest in network capacity (see Gans, 2001). Integrating this dimension into the model is an important issue for future research.

APPENDIX A3.1 Proof of proposition 3.2

Like in the monopoly case, we can integrate the binding participation constraint of the incumbent into the regulator’s objective function. The regulator’s problem is then:14

f

max b

qif  Af 

where qef ∗ 14

qi 2 2

+

 =kf  =

f

b

f∗

f∗

2qi +qe qe 2

d

  f f f + Pˆ f  − qi  + k − A  − C  is given by (3.1)

When the regulator allows for entry, the probability of entry depends on two variables of the regulatory mechanism: qif  and Af . As a consequence, the expected welfare is no longer quadratic as in the benchmark case but it becomes cubic. This is a potential source of nonconcavity in the problem.

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Taking the first-order condition with respect to Af , we have  f ˆ Af b1 + 6  − 2 bAf  a −  − bqi  W = = 0  Af  2 bAf  (3.5) hence, f

4Pqi  +  − 1a − 2  A  = b1 + 6 2 f

(3.6)

f

Taking the first-order condition with respect to qi , incorpof rating the value of Af  given by (3.6), and solving for qi  we have f

qi  =

a − H f  2 − 1 b

where  2 − 1 c1 + c2 h a3 + 6 1 + 12  − 41 + 6 2 + 1 + 6 7 + 12 

c1 = 27b4 2 − 1 (3.7) H f  = a −

c2 =

21 + 6  27b4 2 − 1

(3.8)

h = 9a2  − 12 + 21 + 6  − 3 + 3 2 − 6a − 16 − 1 − 3 − 2 − 22 − 10 − 72 2  − 54 1 + 2 

(3.9)

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We observe that h/ < 0 and h > 0 for all  ∈   . Hence, H f  is an increasing and convex function of . The solution is f found by replacing the optimal value of qi  in (3.6). The solution is valid if kf  ≥ . Taking the optimal values of f f A  and qi , this condition is satisfied if 1 + 2  +  − 1a  ≥ ˆ =  3

(3.10)

ˆ ˆ is strictly greater than  if > 1. Hence, for > 1 and  ∈   , f the above solution is not valid since the associated value of k  is ˆ smaller than the lowest possible entrant’s cost  = . For  ∈   , f the regulator maximizes the expected welfare taking k  = . This corresponds to an access charge given by f

Af  =

Pqi  − 2  4b

(3.11)

f

Without entry, the regulator selects quantity qi  and transfer tf  that corresponds to the regulated monopoly case. The second-order conditions of the above problem guarantee that the solution described is indeed a maximum.

A3.2 Proof of proposition 3.3

As in Proposition 3.2, we integrate the transfer tv  given by the bidding participation constraint in the objective function, which is cubic in both qiv  and v . The first-order condition with respect to v  gives two solutions for v : (1) v  = Pqiv  − , which implies a total entry ban, and (2)

v  =

a − 2 − 1 + bqiv 2 − 3  6 − 1

(3.12)

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Taking the first-order condition with respect to qiv , incorporating the value of v  given by (3.12), and solving for qiv  gives the following solution:  2 − 1 a − H v  H v  = a − c1 + c2 h 2 − 1 1 a 2 − 1 − 6 − 12 + 1 − 4 20 2  c1 = 8b2 − 12 (3.13) √ 6 − 1  (3.14) c2 = 8b2 − 12

qiv  =

h = 6 − 12 − 1 + 2 2 − 162 − 1

(3.15)

h/ < 0 and clearly H v  is an increasing and convex function of . The solution is found by replacing the optimal value of qiv  in (3.12). At that point, kv  ≥  for all  ∈   . The second-order conditions of the above problem guarantee that the solution described is indeed a maximum.

A3.3 Proof of proposition 3.4

(1) We first prove that kv  <  for all  ∈  : (i) kv  is increasing and convex in ; (ii) simple computation gives kv  =  and kv  = . Hence, kv  <  for all  ∈  . ˆ  , with Similarly, kf  is increasing in  in the range  f ˆ f f k  =  and k  < . Hence, k  <  for all  ∈   . ˆ where kf  = , we can express (2) Ignoring the region  

 f theentry points as: k  = f1 + f2 f3 + f4  and kv  = f5 + on f6 f7 + f8 , where fi , i = 1    8, are constant depending  the parameters of the model. The equation f1 + f2 f3 + f4  =  f5 + f6 f7 + f8  has two roots  and  .  is smaller or equal (when = 1) to . Given that kv  +  > kf  + , the other root  is necessarily outside the interval   .

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REFERENCES Armstrong, M. (2001): ‘Access pricing, bypass and universal service’, American Economic Review, Papers and Proceedings 91: 297–301. Armstrong, M., C. Doyle and J. Vickers (1996): ‘The access pricing problem: A synthesis’, Journal of Industrial Economics 44: 131–150. Auriol, E. and J. J. Laffont (1992): ‘Regulation by duopoly’, Journal of Economics and Management Strategy 1: 507–533. Baumol, W. (1983): ‘Some subtle issues in railroad regulation’, International Journal of Transport Economics 10: 341–355. Caillaud B. (1990): ‘Regulation, competition and asymmetric information’, Journal of Economic Theory 52: 87–110. Dana, J. and K. Spier (1993): ‘Designing a private industry. Government auction with endogenous market structure’, Journal of Public Economics 53: 127–147. Gans, J. (2001): ‘Regulating private infrastructure investment: Optimal pricing for access to essential facilities’, Journal of Regulatory Economics 20: 167–189. Gautier, A. and M. Mitra (2003): ‘Regulation of an open access essential facility’, CORE DP 2003/84. Jehiel, P. and B. Moldovanu (2004): ‘The design of an efficient private industry’, Journal of the European Economic Association, Papers and Proceedings 2–3: 516–525. Laffont J. J. and J. Tirole (1994): ‘Access pricing and competition’, European Economic Review 38: 1673–1710. Laffont J. J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Link, H. (2003): ‘Rail restructuring in Germany – 8 years later’, Japan Railway & Transport Review 34: 42–49. Pittman, R. (2004): ‘Russian railways reform and the problem of non-discriminatory access to infrastructure’, Annals of Public and Cooperative Economics 75: 167–192. Rey, P. and J. Tirole (2005): ‘A primer on foreclosure’, in Armstrong, M. and R. Potter (eds): Handbook of Industrial Organization, Vol. 3, Elsevier, Amsterdam. Willig, R. (1979): ‘The theory of network access pricing’, in Trebing, H. (ed.), Issues in Public Utility Regulation, Michigan State University Public Utilities Papers, 109–152.

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Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 4

Unbundling the Local Loop: One-Way Access and Imperfect Competition∗ PAUL W. J. DE BIJL Tilburg University, Tilburg MARTIN PEITZ International University in Germany, Bruchsal

Contents 4.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 4.2 POLICY ON LOCAL-LOOP UNBUNDLING IN TELECOMS . . . . . . . . . . . . . . . . 95 4.2.1 Unbundling in the EU                                               95 4.2.2 Unbundling in the US                                               97 4.3 REGULATORY THEORY WITH FULL PARTICIPATION . . . . . . . . . . . . . . . . . . 99 4.4 REGULATORY THEORY WITH PARTIAL PARTICIPATION . . . . . . . . . . . . . . 107 4.5 DISCUSSION AND CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

∗ We would like to thank participants at the 2004 Conference on Applied Infrastructure Research in Berlin and, in particular, Jos Jansen for helpful comments and discussion.

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4.1 INTRODUCTION

A major promise of the 1990s was the rollout of local access networks in telecommunications markets. Nevertheless, local network rollout has been somewhat disappointing, and at present, competition in the ‘local loop’ is hardly mature. Network rollout has been narrowly targeted; while some operators found it worthwhile to connect business districts and metropolitan areas, residential customers have hardly been exposed to entrants with their own networks. Therefore, the traditional providers of fixed voice telephony (the former incumbents) still have strong positions in the market for local access. Consumers did, however, to some extent benefit from entry made possible by ‘carrier select’ and ‘local loop unbundling’ (LLU). At present, LLU seems most promising as a means for entrants to offer broadband Internet access by using ‘digital subscriber line’ (DSL) technology. Nevertheless, as voice telephony can alternatively be implemented by using the ‘Internet protocol’ when consumers have broadband access, LLU may, in the end, also spur competition in markets for voice telephony. Thus LLU is, potentially, still an important way to stimulate competition in the (broadly defined) market for telecommunications. In telecoms, unbundling usually implies wholesale leasing of the local loop. In other markets, unbundling can be interpreted more broadly. More generally, unbundling can be seen as a method of implementing ‘one-way’ access to an incumbent’s network. Unbundling typically implies that the incumbent’s essential input (and perhaps others as well) is, at the wholesale level, ‘separated’ from its overall facilities or operations, in order to allow for commercial wholesale supply of this input. Hence, although it is typically discussed within the framework of telecommunications, it has wider relevance. In postal markets, for instance, through unbundling regulators may enforce access to the incumbent’s system for local mail delivery (access to ‘the postman’). Unbundling of the postal value chain, a notion known as worksharing, allows competitors to buy the incumbent’s delivery function, and perhaps others as well, such as the sorting of mail items. In electricity, regulators may mandate

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access to electricity companies’ local distribution networks. In financial securities trading, the book depository function (the legal records of ownership changes) may be unbundled from the broad set of clearing and settlement services.1 In this chapter we explore situations of one-way access in which an entrant, that is, the firm without the essential input, has some market power. Accordingly, there is imperfect competition between an integrated firm, the incumbent, and a nonintegrated firm. We strongly believe that such a situation often better represents the real world than situations in which there is a competitive fringe that needs to purchase the essential input from the incumbent. Indeed, the appearance of entrants on the market immediately tends to generate some discipline on incumbents, and it is crucial to understand the interactions that take place when entrants have some market power, no matter how little in the beginning. We first explore the nature of LLU when there is full consumer participation. Full consumer participation here means that total demand is perfectly inelastic with respect to price changes. Second, we explore the case of partial participation by consumers. Here, we explore the specific case that an entrant generates additional demand and that this additional demand depends on price. To analyze these situations, we present simple models of competing telecommunications networks. In the baseline model with full participation unbundling requirements are neutral to competition: they do neither affect the entrant’s profit nor its market share; this is a generalization of earlier results (see, e.g, De Bijl and Peitz, 2002). In this context we discuss investment incentives of the integrated network. Furthermore, we extend the analysis to partial consumer participation. In particular, we show that the neutrality result breaks down under partial consumer participation. This implies that regulation of unbundling requirements should be particularly concerned with market segments such as broadband access in which partial 1

In the latter example, unbundling may serve to create a central register, rather than to introduce competition.

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participation seems to be a key feature of the consumer side. Based on the analysis, we draw policy-relevant conclusions that are timely, given the rather slow progress of LLU-based entry so far. We give specific attention to the possibility of ‘voice over Internet protocol’ (VoIP) as a new technology to stimulate competition. In particular, entrants that lease local loops in order to offer broadband Internet access, widen the possibilities for voice telephony over the Internet. It should be noted that although our model is placed within the context of telecommunications, our results are more general and have applicability to other sectors as well. In fact, they have relevance to all markets where unbundling and one-way access are potential means to facilitate competition. We fear that policy discussions tend to ignore the relationship between regulation of the wholesale price of an essential input and the nature of competition in the retail market.2 Previous work on one-way access has focussed on the optimal second-best pricing (Ramsey pricing) in the context of one-way access for homogeneous services or differentiated services with a competitive fringe. The literature has also considered access price rules for given retail prices, in particular the efficient component pricing rule (ECPR) has received a lot of attention. Both these strands are thoroughly analyzed and discussed in Armstrong (2002); see also Laffont and Tirole (2000) and Vogelsang (2003). There are few papers that consider price-setting imperfectly competitive networks. Laffont and Tirole (1994) analyze the Ramsey prices in such a situation. Armstrong and Vickers (1998) show that in asymmetric market the regulator may want to use the access price to favor the more efficient firm (see also Lewis and Sappington, 1999). Foros (2004) focuses on regulation as a way to induce the integrated firm to invest efficiently and to deter it from foreclosing the market. The present chapter contributes to the access pricing debate. We highlight that the effect of access regulation on the entrant’s profit depends on whether there is full 2

Gual and Seabright (2000), a paper prepared for DGCOMP, European Commission, provides an overview of the economics of LLU, and the main regulatory challenges.

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or partial participation. We also comment on entry and investment incentives.3 The structure of this chapter is as follows. Section 4.2 provides background information on unbundling in practice. Section 4.3 revisits LLU in the case of full participation by end-users. Section 4.4 explores a straightforward case of partial participation. Section 4.5 concludes the chapter. 4.2 POLICY ON LOCAL-LOOP UNBUNDLING IN TELECOMS

To provide some institutional background, this section provides an overview of regulation and policy towards unbundling of the local loop in telecommunications markets. We focus on the situation in the European Union and in the US.4 4.2.1 Unbundling in the EU

Already before the introduction of the new regulatory framework, European regulation mandated the provision of unbundled access to the local loop.56 The general philosophy is that mandatory access 3

Typically, the literature contains a short-term analysis which ignores investment incentives (it should be acknowledged that the issue of inefficient entry has been discussed). Valletti (2003) provides a useful discussion of investment incentives. However, the theoretical literature is rather silent on the issue. One exception is Bourreau and Dogan (2005), who highlight the importance of access charges for LLU on the entrant’s incentives to invest in its own facilities. They focus on the case where access charges are not regulated. See also the discussion in De Bijl and Peitz (2002). 4 For a more elaborate overview see De Bijl and Peitz (2005). The early developments are well documented in Doyle (2000). For a recent discussion on the US, see, for example, Speta (2004). 5 European Parliament and Council (2000). See also Delgado et al. (2004, p. 170). 6 The EC defines the local loop as the ‘physical twisted metallic pair connecting the network termination point at the subscriber’s premises to the main distribution frame or equivalent facility in the fixed public telephone network’ (European Parliament and Council, 2000, p. 4).

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is an effective means to deal with persistent network monopolies, but as it reduces entrants’ incentives to innovate and invest in networks themselves, it should be gradually withdrawn as competition becomes sufficiently mature. According to the EC,7 ‘The high cost of duplicating the local access infrastructure is ruling out new market entrants. This is affecting the level of competition, which the Regulation is intended to increase by offering unbundled access to the local loop, i.e. by enabling new competitors to offer high bit-rate data transmission services for continuous Internet access and for multimedia applications based on digital subscriber line technology as well as voice telephony services.’

For example, in 2003 there were 307 agreements on fully unbundled lines throughout fifteen countries in Europe, even though they were probably mostly aiming at broadband Internet access instead of voice. However, since broadband Internet access allows for voice telephony by using VoIP and ‘voice over digital subscriber line’ (VoDSL), these unbundling agreements may become (or already are) also relevant for voice telephony. The EU average monthly rental was E11.5 and the average connection charge was E68.2 in 2003 (see European Commission, 2003, pp. 48, 60). Mandated unbundling applied only to operators that had been designated by their NRAs (national regulatory authorities) as having significant market power (SMP). Moreover, according to European legislation, access prices (the line rentals of the local loop) must be transparent, nondiscriminatory, fair, and proportionate to costs. Similarly, under the new framework, unbundled access of the local loop has become a regulatory remedy to deal with dominance (see, e.g., Buigues, 2004). If the NRA establishes SMP, it must apply appropriate remedies. This has to be done on the basis of a list of obligations formulated in the Access Directive,8 related to transparency, nondiscrimination, accounting separation, 7

Summary of legislation on unbundled access to the local loop (Regulation (EC) No 2887/2000), http://europa.eu.int/scadplus/leg/en/lvb/l24108j.htm, consulted 22-9-2004. 8 European Parliament and Council (2002).

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access (unbundled access and resale of facilities), price control and cost accounting. However, it is up to the NRA to decide which are the approporiate obligations to be imposed on operators with SMP. Access regulation can be seen as appropriate, especially in the early stages of competition, when entrants have not yet rolled out alternative infrastructures (see, e.g., the results obtained by De Bijl and Peitz, 2002). Local loop unbundling was seen by many regulators (and entrants) as a major promise for opening telecommunications markets throughout Europe, but its success has been meager so far, which is somewhat surprising (see, e.g., Delgado et al., 2004). Given that facilities-based entry has been narrowly targeted (especially at business parks and metropolitan areas), unbundled access provides, in principle, an attractive way of capturing market share beyond the reach of an operator’s connections to end-users. This is especially true as unbundled access gives entrants full control of the local loop, allowing them to configure their own services. Nevertheless, Carrier Select-based entry has been observed much more frequently, at least in markets for voice telephony.9

4.2.2 Unbundling in the US

The major event that shaped the industry in the US in the last decade was the introduction of the Telecommunications Act of 1996. It intended to promote competition, reduce regulation and stimulate the development of new technologies. In particular, the desire was to open up the market for local telecommunications, the ‘last bastion of monopoly’. Nevertheless, the Act lead to a mixed experience, to put it mildly (see, e.g., Economides, 1999).

9

See, for example, European Commission (2003). This report, while providing statistics about facilities used by entrants to offer voice telephony (particularly to residential users), only presents information about Carrier Select and Preselect, not unbundled local loops. When providing information about unbundled local loops, it applies to broadband Internet access.

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The main instruments of introducing local competition were, first, the elimination of entry barriers (e.g., legal impediments to provide telecoms services), and second, the requirement that the incumbents – the ‘Baby Bells’ that resulted from the forced breakup of AT&T in 1984 – unbundle their local networks and lease local lines to entrants. The underlying idea of the latter was that economically efficient duplication of the local access network was not feasible for entrants. As a precondition for entry by the incumbents in the market for long-distance telephony, the Act required that competition be present in local telephony. Implementing LLU has been a tough process, and it is still uncertain when the desired end-state will be reached. For instance, incumbents and entrants are required to individually negotiate interconnection agreements, subject to a public arbitration procedure in case of breakdown of the negotiations. Not only does this two-step approach easily lead to delays, unbundling requests also lead to contested proceedings before courts. At present, the implementation rules formulated by the FCC, for instance, related to the question which parts of a network must be shared with entrants and related to the lease price, remain unsettled to a large extent (see Speta, 2004, part III, C). Although the Act has, so far, not been very successful and led to many legal battles, it should be noted that, similar to the situation in the EU, some local markets do exhibit competition. Substantial competition has developed in market segments for big corporate customers and (densely populated) metropolitan areas. Also, incumbents and cable companies compete in the market for broadband Internet access (see the discussion and references in Speta, 2004, part IV). Here, the incumbents telephone networks offer DSL technology. It should be noted, however, that the unbundling requirements of the 1996 Act did not primarily aim at the latter market segments. In contrast to those market segments, the situation in suburban and rural market segments remains quite uncertain. Moreover, although the Act’s unbundling regime also apply to DSL services, the provision of broadband Internet access by entrants leasing local loops has not yet been impressive – the main competition for incumbents comes from cable companies (see Speta, 2004, part IV, A).

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To conclude this section, we note that both the rationale for unbundling as well as the disappointing experience are shared throughout the EU and in the US (although the causes may be different). It is rather difficult to assess why LLU has shown few positive results for market structure and competition in voice telephony. A possible reason is simply that lease prices are too high to encourage entrants to offer voice through LLU.10 The relatively successful move towards competition in the market for broadband Internet access can be explained by the attractiveness of market share in this market relative to the one for voice telephony. However, as a starting point for further analyses it seems to us critical to gain a better understanding of the effects of access prices on competition and the resulting market outcomes. This is what the present chapter attempts to do.

4.3 REGULATORY THEORY WITH FULL PARTICIPATION

We consider a market of two networks, one vertically integrated network (denoted as firm 1) which owns local-loop plus additional facilities (in particular, a backbone and switches) and one nonintegrated network (denoted as firm 2) which owns only a backbone and switches, and needs access to the other firm’s local loop. More generally, two firms compete with each other, while one them owns an essential facility which provides a necessary input for the production process. The price at which the integrated network sells access to the essential facility is fixed by a regulator. We call it the lease price, or line rental, and denote it by l. Network 1’s per-user cost is denoted by f1 . A local connection to an end-user comprises two components, namely a ‘local line’ and a ‘line card’, with associated costs per user f1LL and f1LC , respectively. 10

Related to the situation in the EU, Kallen and Woehrl (2003) cite officials of DG Competition of the European Commission, who explain the negative result for voice telephony by invoking incumbents’ pricing policies and NRAs’ ineffective responses to price squeezes. It should be noted, though, that Kallen and Woehrl do not subscribe to this view.

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We assume that f1 = f1LL + f1LC . When firm 2 requests unbundled access to network 1, it installs its own linecard, with a cost per user f2LC = f1LC , and uses firm 1’s local line. Accordingly, firm 2’s perceived per-user cost equals f2 = l + f1LC . There is a continuum of consumers with mass 1. Each consumer subscribes to one network, or, alternatively, purchases one unit from the operator he or she selects. Consumers have an inelastic demand for a single subscription, while their willingness to pay is assumed to be sufficiently high so that they will always make a purchase. The local network owner (firm 1) derives revenues from subscriptions and from line rental. Since the lease price of the local loop is regulated, the only strategic variable of the local network owner is the price that consumers have to pay for the services if they subscribe. We denote that price by p1 . Also, the entrant charges a price p2 to consumers that demand its services. An example for prices pi are flat rates for Internet access. Market shares si p1  p2  depend on the prices charged by both operators. It is then natural to assume that market share is decreasing in its own price and increasing in the price of the competitor. Furthermore, we assume that market shares only depend on the price difference p2 − p1 . This assumption is satisfied for quasilinear preferences when consumers have identical demand functions. With full participation, total market demand is fixed. For an example, see below. Figure 4.1 illustrates the setup of the model. Operator 1:

Access (lease price l )

local line 1 (cost f1LL) Operator 2: line card 1 (cost f1LC)

line card 2 (cost f2LC)

Subscription 1 (retail price p1)

Subscription 2 (retail price p2) Consumers (discrete choice)

Figure 4.1 The one-way access model.

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Profit functions are as follows. Firm 1’s profits can be written as 1 p1  p2  l = s1 p1  p2 p1 − f1  + 1 − s1 p1  p2 l − f1LL  and firm 2’s profits as 2 p1  p2  l = s2 p1  p2 p2 − l − f2LC  The property that market share changes continuously with price implies that firms have market power. Consumers do not consider the services provided by the two firms as perfect substitute and, therefore, do not necessarily go for the lower priced service. A situation with imperfect substitutes seems to be common in telecommunications and other markets. For instance, brand recognition and switching costs lead to imperfect substitutes. Also, the services by firms are often bundles of different offers and features. If firms offer different bundles, they are considered as imperfect substitutes. A special case of our general model is obtained by assuming that the networks are horizontally differentiated. Suppose, for instance, that consumers are uniformly distributed on the interval 0 1 . Firm 1 is located at location y1 = 0 on the interval, and firm 2 at y2 = 1. A consumer located at z buying from firm i incurs a disutility − yi − z. Note that a higher value of parameter corresponds to more differentiation between the networks. A consumer at z buys from firm 1 if v1 p1  p2  − z > v2 p1  p2  − 1 − z, where vi p1  p2  denotes the conditional indirect utility of a network at the ideal location z. Market shares then satisfy si p1  p2  = 21 + vi p1  p2  − vj p1  p2 /2 , where j = i. This is the simple Hotelling specification which has also been used in models on two-way access (see, e.g., Armstrong, 2002). In a more elaborate model, one could incorporate that consumers have a demand to make calls, or to have access to the Internet, in addition to the demand for a subscription. Such extensions lead to additional interactions between the operators, for instance, because there is call traffic between the networks – see De Bijl and Peitz

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(2004) for an inclusion of call traffic. Nevertheless, the present model captures the crucial strategic effects of one-way access. Operators choose prices in order to maximize profits. Consumers make purchasing decisions, based on utility maximization, after observing the prices. We are interested in an equilibrium configuration p1∗  p2∗  in which both firms do not have an incentive to change their retail prices. That is, given the competitor’s retail price, each operator maximizes its profits. Accordingly, given the equilibrium price of the competitor, the profit maximization problem of operator 1 can be written as max 1 p1  p2∗  l p1

(4.1)

while operator 2 maximizes max 2 p1∗  p2  l p2

(4.2)

Suppose that there exists a unique pair p1∗  p2∗  which solves both problems simultaneously (hence it constitutes an equilibrium). We are then interested in the way in which a change in regulatory policy affects market outcomes. Suppose that under the new regulatory regime the lease price is changed to l = l + l. We can then show that this increase in the lease price is passed through to consumers. Equilibrium market shares are unaffected and the nonintegrated network’s profit are neutral to regulation. However, the integrated network benefits two-fold: it charges higher retail prices and it receives a higher lease price for those consumers who subscribe to the competitor’s network. Consumers suffer from the lease price increase: they face higher prices by both networks. Given the new lease price l = l + l, we claim that equilibrium retail prices are p1∗∗ = p1∗ + l and p2∗∗ = p2∗ + l. Our proof consists of establishing that pi∗∗ is the solution of the maximization problem of operator i, i = 1 2.

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Operator 1: given the new lease price l , the vertically integrated network’s profit can be written as s1 p1  p2∗∗ p1 − f1  + 1 − s1 p1  p2∗∗ l + l − f1LL  Profit can be rewritten as s1 p1  p2∗∗ p1 − l − f1  + 1 − s1 p1  p2∗∗ l − f1LL  + l Provided that the competing operator sets p2∗∗ = p2∗ + l, market shares satisfy s1 p1  p2∗∗  = s1 p1 − l p2∗  because they only depend on price differences. Hence the vertically integrated network’s profit can be rewritten as s1 p1 − l p2∗ p1 − l − f1  + 1 − s1 p1 − l p2∗ l − f1LL  + l With a change of variable  p1 ≡ p1 − l, the maximization problem becomes p1  p2∗  p1 − f1  + 1 − s1  p1  p2∗ l − f1LL  + l max s1   p1

(4.3)

Clearly, p1∗ is the solution to this problem because it is formally the same maximization problem as problem (4.1) except for the constant l. Since  p1 ≡ p1 − l, we have shown that p1∗∗ = p1∗ + l, provided that p2∗∗ = p2∗ + l. Operator 2: given the new lease price l , the nonintegrated network’s profit can be written as s2 p1∗∗  p2 p2 − l − l − f2LC  Provided that the competing operator sets p1∗∗ = p1∗ + l, market shares satisfy s2 p1∗∗  p2  = s2 p1∗  p2 − l. Hence, using the change of variable  p2 = p2 − l, the maximization problem of the nonintegrated network’s profit can be written as p2  p2 − l − f2LC  max s2 p1∗  p2

(4.4)

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Clearly, p2∗ is the solution to this problem because it is formally the same maximization problem as problem (4.2). Since  p2 ≡ p2 − l we have shown that p2∗∗ = p2∗ + l, provided that p1∗∗ = p1∗ + l. Hence, we have established the following result: Result 4.1 With full participation, firm 2’s (the nonintegrated network) profits are neutral to the lease price of the local loop. An increase of the lease price by l is passed on to consumers oneto-one and firm 1 (the vertically integrated network) benefits from such a policy. We believe it to be useful to elaborate on the above result. A lease price increase by l works affects prices in the same way as a per-user cost increase (of the same magnitude l) that is experienced by both networks; think of an increase of the line card’s per-user cost fiLC for both firms. This can be seen as follows. The profits of operator 2 are equal to s2 p1  p2 p2 − l − f2LC + l, that is, the profit function has the same form as with a lease price l and costs f2LC + l. The profit function of operator 1 becomes 1 p1  p2  l + l = s1 p1  p2 p1 − f1  + 1 − s1 p1  p2 l + l − f1LL  The profit-maximizing price p1 , when p2 is given, is determined by the first-order condition of profit maximization: s1 p1  p2  s p  p  p1 − f1  − 1 1 2 l + l − f1LL  + s1 p1  p2  = 0 p1 p1 which is equivalent to s1 p1  p2  s p  p  p1 − f1 + l − 1 1 2 l − f1LL  + s1 p1  p2  = 0 p1 p1 This equation is also the first-order condition of profit maximization given lease price l and costs for the linecard f1LC + l, which leads to

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a total per-user cost of f1 +l. Hence, a lease price increase is passed on to consumers in exactly the same way as a cost increase. The only difference is that the owner of the essential facility, that is, the integrated network, benefits from a lease price increase because the associated ‘downstream’ cost increase generates revenues ‘upstream’ at the essential facility. In the present context, an analysis of total surplus is straightforward. Provided that the market is symmetric, the socially desirable market share is 1/2. This is indeed implemented by the equilibrium for any lease price (such that the participation constraint of consumers is not violated and participation is indeed (perfectly) inelastic). However, if the market is not fully symmetric, strategic behavior between firms typically does not lead to an implementation of a socially optimal outcome. In particular, if one network is more attractive than the other on average, then the equilibrium market share of the less attractive network is socially excessive. A detailed analysis of asymmetric situations is certainly of interest, but here we do not explore this issue any further. To analyze investment incentives by the integrated network in the local loop we introduce a quality parameter q. Alternatively, parameter q can be interpreted as a capacity level. The former interpretation applies to both voice and Internet access, and the latter mainly to Internet access. For simplicity, we assume that an increase of this parameter shifts the profit function by a factor dq outward for given lease price and gross of costs associated to this improvement. The cost of implementing a quality or capacity improvement q > 1 is denoted by Cq with the convention C1 = 0. Also by convention, d1 = 1. We can then write the integrated network’s profits as dq1 p1  p2  l − Cq Clearly, if the lease price does not respond to the provided quality, then quality (or capacity) is chosen such that it satisfies d q1 p1∗  p2∗  l − C  q = 0. If d is concave and C strictly convex, there exists a unique solution to the profit maximization problem at the investment stage at which firm 1 chooses q. Observe that a

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larger lease price leads to an increase in 1 , and hence strengthens the incentives of the integrated network to invest in the quality or capacity of the local loop. Regulatory policy should take into account that the quality of the local loop is affected by its lease price regulation. To further strengthen the investment incentives without granting large profit margins at the local loop regulators may make their lease price depend upon quality. Suppose that the regulator can commit to a schedule lq with l q > 0. Note that equilibrium market shares are not affected by the level of the lease price (see result 1 above). The first-order condition of profit maximization at the investment stage can then be written as d q1 p1  p2  l − C  q + dqs1 p1∗  p2∗ 

dp1∗ l dl

+ 1 − s1 p1  p2  l q = 0 which reduces to d q1 p1  p2  l − C  q + dql q = 0 since dp1∗ l/dl = 1. We observe that with full participation, investment incentives are affected by the shape of the lease price schedule but independent of the degree of competition in the market. Furthermore, a more sensitive lease price schedule tends to increase investments incentives. In other words, if the regulator wants to achieve a certain quality level without giving large margins in the local loop it can do so by designing a sufficiently sensitive lease price schedule. We summarize our discussion by the following result. Result 4.2 With full participation, the regulator can provide stronger incentives to invest in the quality or capacity of the local loop by increasing the sensitivity of the regulated lease price to the quality or capacity level.

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4.4 REGULATORY THEORY WITH PARTIAL PARTICIPATION

We extend our previous setup to include partial participation so that total demand depends on prices. The perhaps easiest way to do so is to assume that the services offered by the nonintegrated network leads to a market expansion. This can be motivated by seeing the nonintegrated network operator as a firm which can offer unique services (bundled into its product) which are desired by a certain group of consumers. The integrated network owner does not provide these tailored services and, therefore, cannot cater to the tastes of these consumers. Formally, we consider a market consisting of two segments. In the first segment, the integrated and the nonintegrated network are competitors. Segment 1 corresponds to the market analyzed in the previous segment. In segment 2 only the nonintegrated network is active. The nonintegrated network is assumed not to be able to price discriminate between the two segments. Clearly, in such a setup we should expect the neutrality result that firm 2’s profits do not depend on the lease price, to break down. Furthermore, the integrated network has now (at least locally) some incentive not to inflate the lease price, if it were able to set it itself. The reason is that the higher the lease price, the higher the retail price set by the nonintegrated network, but this implies a reduction of demand for segment 2, which in turn reduces firm 1’s access revenues. Additional demand for the product offered by the nonintegrated network is denoted by ap2 , which is a decreasing function of operator 2’s retail price. This function reflects the heterogeneous willingness-to-pay of consumers in the captive segment.11 Obviously, this demand does not depend on the retail price of the integrated network, operator 1. 11

Note that heterogeneity is more likely to be relevant in the captive segment than in the competitive segment because in the competitive segment consumers can choose among alternative offerings so that they are more likely to be satisfied with one of them than in a monopoly situation.

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The profit maximization problem of the integrated network becomes max s1 p1  p2 p1 − f1  + 1 − s1 p1  p2 l − f1LL  p1

+ ap2 l − f1LL 

(4.5)

Note that the third term in the sum is not affected by the decision of the integrated network. Consequently, the first-order condition is the same as in the previous section. The profit maximization problem of the nonintegrated network is maxs2 p1  p2  + ap2  p2 − l − f2LC  p2

(4.6)

An equilibrium p1∗  p2∗  has to satisfy the system of first-order conditions s p∗  p∗  s1 p1∗  p2∗  ∗ p1 − f1  + s1 p1∗  p2∗  − 1 1 2 l − f1LL  = 0 p1 p1   s2 p1∗  p2∗  ap2∗  + p2∗ − l − f2LC  + s2 p1∗  p2∗  + ap2∗  = 0 p2 p2 (4.7) Suppose there is a unique solution to this system. Now consider a change in the lease price. We first show that generically the profit neutrality result for the nonintegrated network breaks down. Result 4.3 With partial participation, profit of the nonintegrated network are generically not neutral to the lease price of the local loop and the equilibrium demand of the integrated firm s1 depends on the lease price l. Proof Proof by contradiction. Suppose that after a change in the lease price of l, equilibrium retail prices are p1∗∗ = p1∗ + l and

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p2∗∗ = p2∗ +l. Then, in equilibrium, the first-order condition of profit maximization for the non-integrated firm is   s2 p1∗∗  p2∗∗  ap2∗∗  + p2∗ + l − l + l − f2LC  p2 p2 + s2 p1∗∗  p2∗∗  + ap2∗∗  = 0 which can be rewritten as   s2 p1∗  p2∗  ap2∗∗  + p2∗ − l − f2LC  + s2 p1∗  p2∗  + ap2∗∗  = 0 p2 p2 Comparing this equation with (4.7) it must hold that   ap2∗ + l ap2∗  − p2∗ − l − f2LC  + ap2∗ + l − ap2∗  = 0 p2 p2 Generically this equation is violated.12



Clearly, it would be desirable to know in which way the equilibrium outcome changes. To answer this question in more detail, it is useful to consider for a moment the case that the nonintegrated network could price discriminate between the two segments. In the noncaptive market segment, the analysis of Section 4.2 applies. Hence, prices have the same price levels as prices derived in the previous section; we denote these prices as p1C∗ and p2C∗ . In its captive market segment, the nonintegrated network then would solve the following maximization problem maxp2 ap2 p2 − l − f2LC . Hence, it would set the monopoly price p2M in this segment which satisfies a p2M p2M − l − f2LC  + ap2M  = 0 or −

12

p2M − l − f2LC 1  = a p2M p2M /ap2M  p2M

For instance, if a is linear the lease price is never neutral.

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This is the well-known inverse elasticity rule. Suppose the price elasticity of demand in the captive segment is a constant with   > 1 (derived from ap2  = kp2 ). The inverse elasticity rule can be rewritten such that the profit-maximizing price is a linear function of the lease price: p2M =

1 l + f2LC  1 − 1/ 

Changes in the lease price by l translate into an increase of the price charged to the captive consumers by 1 − 1/ l. Hence, the price p2M increases always by more than l (since   > 1).13 In the limit as   goes to 1, we have lim →1 1 − 1/  =  and the smaller the demand elasticity the more sensitive reacts the price to a lease price increase. The monopoly price in segment 2, p2M , may be higher or lower than the equilibrium price in segment 1. To fix ideas we call the former situation a ‘high-value situation’ because overall there is a sufficient number of consumers attaching high value to the product of firm 2, (i.e., consumers with a willingness-to-pay above p2C∗ ) so that the nonintegrated network optimally sets its price above p2C∗ . We call the latter situation a ‘low-value situation’ because overall there is an insufficient number of consumers attaching high value to the product of firm 2, so that the network optimally sets its price below p2C∗ . An alternative interpretation would be to look at the (imperfectly) competitive segment. Then the former situation can be called a competitive situation because competition in segment 1 is sufficiently strong to lead to an equilibrium price below the monopoly price in the captive segment. Similarly, the latter situation can be called an uncompetitive situation. In any case the captive segment is added value for the nonintegrated network (and for the integrated network, provided the lease price is above costs).

13

This holds more generally since demand at the profit-maximizing price is always elastic, that is,   > 1.

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In our setup in which the nonintegrated network cannot pricediscriminate between segments the qualitative results for the equilibrium prices depend on whether we are in a high-value or a low-value situation. From the definition of a high-value situation it follows that the profit maximizing price p2 given p1∗ is between the equilibrium price in the competitive segment p2C∗ and the monopoly price in the captive segment p2M . Hence, in a high-value situation if networks offer strategic complements, equilibrium prices in our nondiscrimination setup are higher than equilibrium prices in the competitive segment in the setup with price discrimination.14 This implies that in a high-value situation the integrated network necessarily benefits from the existence of a captive segment because its profits in the competitive segment are higher than without the captive segment. The reason is that firm 1 can increase p1∗ . In addition, it makes revenues from selling wholesale-access to consumers in the captive segment of the nonintegrated network. In a low-value situation equilibrium prices in our nondiscrimination setup are lower than equilibrium prices in the competitive segment in the setup with price discrimination. How does the lease price affect equilibrium outcomes? First note that the qualitative result that a lease price increase leads to higher retail prices is robust to the introduction of partial participation. Formally, the result is shown by the fact that the best response of both firms is shifted outward by a lease price increase, that is, 2 i / pi l > 0, provided that networks offer strategic complements. We also address the question whether the retail price increase is more pronounced under partial than under full participation. Suppose that initially we are in a low-value situation, that is, p2M is less 14

Note that in standard models of price competition with differentiated products, firms offer strategic complements (see, e.g., Vives, 1990 and Milgrom and Roberts, 1990; for an application of the theory to telecommunications markets see Peitz, 2005). Consequently, best responses ri are upward sloping. Comparing partial to full participation is a comparative statics exercise. Introducing a captive segment makes the best-response of nonintegrated network 2 rotate clockwise at the point  p1  p2M , where  p1 is defined by r2  p1  = p2M .

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than the competitive price under discrimination p2C∗ . Then, as argued above the equilibrium price must be p2∗ < p2C∗ . Consider now an increase in the lease price. With the (constant) elasticity greater than 1, the price in the captive segment p2M increases by more than l. As shown in Section 4.3, the price in the competitive segment increases exactly by l. Hence, it is possible that we move from a low-value situation to a high-value situation. In other words, if the elasticity is sufficiently low (but greater than 1), then a lease price increase leads to a regime shift from a low-value situation to a highvalue situation. Hence, the presence of a captive segment amplifies the retail price increase. Starting from an initial situation in which prices are below the competitive price under discrimination, after a lease price increase they will be set above the corresponding prices if demand is sufficiently inelastic. Result 4.4 Suppose that the initial situation is a low-value situation. Then a retail price increase following from a lease price increase is greater with partial participation than with full participation, given that the demand in the captive segment is not too elastic. Clearly, if the initial situation is a high-value situation, the final situation after a lease price increase will also be a high-value situation. Similarly, for a lease price reduction: either we move from a high-value situation to a low-value situation or we remain in a low-value situation. Note that the level of the lease price is not welfare-neutral as it was in the case of full participation. A higher lease price translates into higher retail prices. This does not affect consumer participation in the competitive segment but it reduces consumer participation in the competitive segment. The markup charged by firm 2 leads to a deadweight loss. From a social point of view any retail price above the social costs f1LL + f2LC is detrimental to social welfare. Since firms have market power, firm 2 charges a mark-up over its perceived marginal costs l + f2LC . Hence, if the optimal regulation in a market in which firm 2 does not have market power (e.g., because it forms a competitive fringe together with other firms) implies that

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the lease price should be equal to costs, the optimal regulation in a market in which firm 2 does have market power is to set the lease price below costs. With respect to welfare in the captive segment and ignoring other welfare effects, optimal lease price regulation would have the property that the lease price is below costs and the resulting equilibrium price of firm 2 given this lease price is equal to costs f1LL + f2LC . Are there additional welfare effects which have to be considered? There is no welfare loss due to higher prices in the competitive segment due to inelastic demand. Hence, the lower lease price would be neutral to market share if firm 2 could price discriminate. However, without discrimination best responses are no longer symmetric. Also, a change in the lease price affects the firms’ best response functions differently. It depends on the exact change to determine whether firm 1 or firm 2 gains market share in the competitive segment after a change in lease price. We can summarize the discussion up to this point by the following statement. Result 4.5 Suppose that the welfare effects of the captive segment dominate welfare effects in the competitive segment if they go in different directions. A regulator who only controls the lease price optimally sets its lease price below costs to control for the market power of firm 2. We can elaborate on this by considering a lease price increase that leads from a low-value to a high-value situation. For this consider the special case that the slope of firm 1’s best response is globally greater than 1 (note that this is a natural assumption to make in the present context). If this is the case then in equilibrium with the initial lease price the equilibrium lies below the 45 line in the price space p1  p2  , that is, p1 > p2 in equilibrium and consequently s1 < s2 . In a high-value situation the reverse holds and consequently s1 > s2 . From a social point of view, the optimal market share is 1/2 in the competitive segment (provided that the market is symmetric). Then a low lease price tends to lead to a socially excessive market share of the nonintegrated network whereas a high lease price tends to lead to a socially excessive market share of the integrated network.

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Laffont and Tirole (1994) consider a similar market environment in which also firm 2 enjoys market power. They are interested in the structure of Ramsey prices, that is, the welfare-maximizing access and retail prices under the constraint that firms do not make losses. They show that the Ramsey pricing formulas in a market in which firm 2 does not have market power has to be modified. Since the retail price of firm 2 tends to be too high, the access price should reflect this type of inefficiency and therefore has to be set lower. Finally, we would like to comment on investment and entry incentives. Clearly, if there are sunk costs to enter the industry, the regulator may have to guarantee a positive level of operating profits to the entrant. Clearly, ignoring strategic interaction in the competitive segment, a lower lease price leads to a higher profit of firm 2 in the captive segment because it can serve those consumers at a lower cost. In this sense a lower lease price stimulates entry. At the same time, a lower lease price tends to lead to lower retail prices overall since it makes firm 2 less interested in high prices in the captive segment. This indirect effect then leads to a lower profit of firm 2. Also, we can consider firm 1’s incentive to invest in quality, where firm 1 takes into account the dependence of lease price on quality. Here result 2, which is shown under full participation, appears to be robust to the addition of a captive segment for the nonintegrated firm.

4.5 DISCUSSION AND CONCLUSION

In this chapter, we extended existing insights on unbundling of the local loop in telecommunications markets to a more general setting. The extensions were in two dimensions: first, partial consumer participation, and second (more generally), imperfect competition. In particular, we looked at the effects of increases of the lease price of the local loop on retail prices. In addition, we derived implications related to the network operator’s incentives to invest in quality or capacity of local connections to end-users. The kind of insights we obtained can be useful for policy makers and regulators, as our chapter complements discussions on efficiency-based

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approaches (focusing on efficient use of existing networks) and costbased approaches (focusing on efficient investment in new networks) to regulation of LLU.15 Although the analysis was framed in a telecommunications setting, the results have a more general applicability, extending to other markets as well. Further research should identify exactly when and to what extent this type of results apply to other sectors. For example, in sectors such as post and electricity it makes sense to model the particular characteristics of these markets, which may lead to more detailed results. We believe that the analysis of one-way access situations that lead to imperfect competition in the retail market, such as in the model that we explored, needs further consideration. Our results, which focused on the effects of the access price on retail competition, provide some flavor of a broader research program. In future work we plan, for instance, to consider VoIP in more depth. As remarked in the introduction, an interesting feature of broadband Internet access is that it allows for competition in voice telephony through VoIP. Whereas VoIP is sometimes implemented as a peer-to-peer application on end-users’ computers (e.g., Skype), there exist also providers of VoIP that use ‘gateways’ to interconnect to the PSTN, that is, the public telephony network (an example of such a provider is Vonage in the US). The latter type of VoIP allows its users to connect to all (including ‘traditional’) telephony customers. Because of their different business model, such providers may provide very different pricing structures than those offered by former incumbents, which moreover face regulatory constraints on their pricing strategies. Thus, it may happen that a VoIP provider, offering a flat-rate scheme, competes with a telecommunications operator offering a two-part tariff. A more general question related to the discussion above, which features prominently in current policy discussions, is whether a new technology, that allows entrants to make innovative use of

15

See Gual and Seabright (2000) for a discussion of these approaches.

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unbundling agreements, should be regulated or not. With regard to VoIP in particular, an important question is whether a provider of VoIP services should be put under the regulatory umbrella or not.16 Accordingly, it may be interesting to introduce asymmetric constraints on possible strategies, in particular with respect to retail pricing and quality requirements, that can be chosen by the integrated and nonintegrated firm, and analyze how welfare is affected.

REFERENCES Armstrong, M. (2002), The theory of access pricing and interconnection, in: M. Cave, S. Majumdar , and I. Vogelsang (eds), Handbook of Telecommunications Economics, Amsterdam, North Holland, 295–384. Armstrong, M. and J. Vickers (1998), The access pricing problem with deregulation: A note, Journal of Industrial Economics 46, 115–121. Bourreau, M. and P. Dogan (2005), Unbundling the local loop, European Economic Review 49, 173–199. Buigues, P.A. (2004), The competition policy approach, in: P.A. Buigues and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA, 9–26. De Bijl, P.W.J. and M. Peitz (2002), Regulation and Entry into Telecommunications Markets, Cambridge University Press, Cambridge, UK. De Bijl, P.W.J. and M. Peitz (2004), Dynamic regulation and entry in telecommunications markets: A policy framework, Information Economics and Policy 16, 411–437. De Bijl, P.W.J. and M. Peitz (2005), Local loop unbundling in Europe: Experience, prospects and policy challenges, Communications and Strategy 57, 33–57. Delgado, J., J. Fehrenbach, and R. Klotz (2004), The price of access: The unbundling of the local loop in the EU, in: P.A. Buigues and P. Rey (eds), The Economics of Antitrust and Regulation in Telecommunications: Perspectives for the New European Regulatory Framework, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA, 169–182. Doyle, C. (2000), Local loop unbundling and regulatory risk, Journal of Network Industries 1, 33–54. Economides, N. (1999), The Telecommunications Act of 1996 and its impact, Japan and the World Economy 11, 455–483.

16

In the US, for instance, the Internet Policy Working Group of the Federal Communications Commission tries to identify the policy issues that arise as telecommunications moves to Internet-based platforms.

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European Commission (2003), Technical Annexes of the Ninth Report on the Implementation of the Telecommunications Regulatory Package, Commission Staff Working Paper, COM (2003) 715 final, SEC (2003)1342, 19.11.2003, Brussels. European Parliament and Council (2000), Regulation (EC) No 2887/2000 of the European Parliament and of the Council of 18 December 2000 on unbundled access to the local loop, Official Journal of the European Communities L 336, 30.12.2000, 4–8. European Parliament and Council (2002), Directive 2002/19/EC of the European Parliament and of the Council of 7 March 2002 on access to, and interconnection of, electronic communications networks and associated facilities (Access Directive), Official Journal of the European Communities L 108, 24.4.2002, 7–17. Foros, O. (2004), Strategic Investments with spillovers, vertical integration and foreclosure in the broadband access market, International Journal of Industrial Organization 22, 1–24. Gual, J. and P. Seabright (2000), The economics of local loop unbundling, paper prepared for DGCOMP (European Commission), University of Navarra and University of Cambridge. Kallen, B. and R.-G. Woehrl (2003), Local loop unbundling a failed model for local competition? The German experience, presentation prepared for the International Telecommunications Society 14th European Regional Conference, 23–24 August, Helsinki. Laffont, J.-J. and J. Tirole (1994), Access pricing and competition, European Economic Review 38, 1673–1710. Laffont, J.-J. and J. Tirole (2000), Competition in Telecommunications, MIT Press, Cambridge, MA. Lewis, T.R., and D.E.M. Sappington (1999), Access pricing with unregulated downstream competition, Information Economics and Policy 11, 73–100. Milgrom, P. and J. Roberts (1990), Rationalizability, learning, and equilibrium in games with strategic complementarities, Econometrica 58, 1255–1277. Peitz, M. (2005), Asymmetric access price regulation in telecommunications markets, European Economic Review 49, 341–358. Speta, J.B. (2004), Deregulating telecommunications in internet time, Washington & LEE Law Review 61, 1063–1154. Valletti, T. (2003), The theory of access pricing and its linkage with investment incentives, Telecommunications Policy 27, 659–675. Vives, X. (1990), Nash equilibrium with strategic complementarities, Journal of Mathematical Economics 19, 305–321. Vogelsang, I. (2003), Price regulation of access to telecommunications networks, Journal of Economic Literature 41, 830–862.

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PART II

Two-Way Access Pricing

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Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 5

On the Role of Access Charges Under Network Competition STEFAN BUEHLER University of Zurich and University of St. Gallen ARMIN SCHMUTZLER University of Zurich

Contents 5.1 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5.2 LINEAR RETAIL PRICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 5.2.1 Assumptions                                                        124 5.2.2 Comparative statics                                                  128 5.2.3 Are retail prices strategic complements?                               130 5.2.4 Do higher access charges shift out the reaction curves?                 132 5.3 SIMPLIFYING ASSUMPTIONS: HOW DO THEY AFFECT THE ROLE OF ACCESS CHARGES? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 5.3.1 Full-coverage networks                                              134 5.3.2 Full-coverage networks and balanced calling pattern                    136 5.4 NONLINEAR RETAIL TARIFFS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 5.4.1 Assumptions                                                        139 5.4.2 Comparative statics                                                  141 5.5 EXTENSIONS AND CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

5.1 INTRODUCTION

The problem of setting the ‘right’ access charge in the telecommunications industry has been analyzed extensively. There appears to

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be a broad consensus that access charges need to be regulated in the case of one-way access, where the incumbent monopolist controls an essential facility (e.g., the local fixed network) and competes with entrants in related markets (e.g., long-distance services).1 In contrast, the debate on the problem of two-way access is far from settled. This problem arises in more mature industries, where the incumbent faces competitors that have deployed their own network facilities, so that mutual access is required to place calls to all subscribers. In this setting, it is less than obvious that access charges should be regulated, as competition for end-users may, at least in principle, discipline both access and retail prices. In two seminal papers, Armstrong (1998) and Laffont et al. (1998a) – henceforth abbreviated by ALRT – have put forward a formal framework for analyzing the role of access charges under two-way network competition. One of the key findings of these papers is that the access charge may serve as an ‘instrument of collusion’ when networks compete in linear retail prices. To some extent, this result is intuitive: increasing the access charge is equivalent to increasing the competitor’s perceived marginal cost, thereby softening competition in the retail market. This ‘raise-each-other’s-cost effect’ (Laffont and Tirole 2000, p. 190) might suggest that access charges should also be regulated in the case of two-way network competition.2 Based on the ALRT framework, a number of contributions surveyed in Laffont and Tirole (2000), Armstrong (2002), Vogelsang (2003), and Peitz et al. (2004) have emphasized that the collusive role of access charges is less robust than one might think.3 In particular, if retail tariffs are nonlinear and/or customers are heterogenous, 1

See for example, Laffont and Tirole (2000, Chapters 3 and 4) for a survey of the relevant issues. 2 Note that the usage of the word ‘collusion’ in this context is debatable, as it neither refers to an explicit agreement nor to implicit collusion in a repeated game sense: higher access charges merely move the industry to an equilibrium with both higher retail prices and profits. 3 See, for example, Gans and King (2001), Schiff (2002), Carter and Wright (2003), Dessein (2003, 2004), and Armstrong (2004).

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it is far from obvious that usage fees are increasing in access charges (Dessein, 2003). Thus, even when firms are free to set access prices themselves, they do not necessarily price above marginal costs. In the present chapter, we aim to clarify the role of access charges under network competition with two-way access, using a reducedform approach. Because we focus on comparative statics issues, we need a less restrictive structure than usual in this literature. We retain the following key features of the various models considered in the literature that are motivated by the real world: (i) facing access charges, firms set their retail prices; (ii) facing retail prices, consumers take their subscription decisions; (iii) the calling pattern, that is, the number of internal and external calls initiated in each network, is a function of both the size of the two networks and the retail price charged by that network. We do not, however, impose some of the simplifying assumptions that are routinely applied in the literature. Instead, we start out more generally and then discuss to what extent assumptions familiar from the literature bias the results. Our findings support the view that the collusive role of access charges is generally not very robust. We argue that this nonrobustness is associated with the underlying economics of two-way network competition rather than the various simplifying assumptions made for studying specific models. Below, we first consider the case of linear retail prices. For this setting, we confirm that (i) even in cases where higher access charges do increase equilibrium retail prices, the raise-each-other’s cost intuition is incomplete (for reasons to be discussed below); (ii) it is not evident that higher access charges increase retail prices, so that collusion based on inflated access charges might not be a concern to begin with. Put differently, we show that it is neither clear that higher access prices shift out reaction curves in the retail price game, nor that reaction curves are upward sloping. We then demonstrate that the standard assumptions of full coverage networks and balanced calling patterns tend to support the collusive role of access charges, without making it robust. We also show that retail prices definitely increase under either of the following (rather extreme)

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assumptions: (i) networks are symmetric; (ii) the total number of subscribers and the number of subscribers to each network are fixed. We then move on to nonlinear retail prices. Laffont et al. (1998a) and Dessein (2003) argue that if networks compete in two-part retail tariffs, an increase of the access charge still increases the variable component of the two-part tariff, but also lowers the fixed component so as to just offset any effects on profits. Again, we aim to clarify the intuition behind this result and its limitations using our reducedform framework. To this end, we formulate a general comparative statics result that leads to the desired conclusion. We then show that the required conditions are fairly intuitive, but may well be violated in reasonable cases. The remainder of the chapter is organized as follows. Section 5.2 introduces our reduced-form model for linear retail prices. Section 5.3 discusses how two simplifying assumptions familiar from the literature, full coverage networks and balanced calling patterns, affect the comparative statics with respect to access charges. Section 5.4 extends the analysis to nonlinear retail tariffs. Section 5.5 discusses further extensions and concludes.

5.2 LINEAR RETAIL PRICES

In this section, we introduce a reduced-form model of two-way network competition with linear retail prices, imposing very little structure on the demand for calls within and across networks. We consider more specific models familiar from the literature in the next section.

5.2.1 Assumptions

Consider a reduced-form model of two-way network competition with the following structural elements: • Cost structure There are two networks with identical cost structure. There is a marginal cost c0 per call at the originating and

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terminating end of a call and c1 in between. Total marginal cost is thus given by c ≡ 2c0 + c1 , as in Laffont et al. (1998a).4 There is a fixed cost Ki of operating network i. • Demand structure The networks are differentiated and compete in retail prices. We abstract both from the type of network differentiation and the details of the consumers’ subscription decisions and simply assume that there is a well-defined demand function for each of the various types of calls. More specifically, let i j = 1 2 j = i. Then Dii pi  pj  denotes the demand for calls initiated and terminated in network i. Similarly, Dij pi  pj  denotes the demand for calls initiated in network i and terminated in network j. Suppose that each of these demand functions is twice continuously differentiable. The profit function of network i is thus given by   i pi  pj  = pi − c Dii pi  pj  + pi − aj − c1 − c0 Dij pi  pj  + ai − c0  Dji pi  pj  − Ki 

(5.1)

where ai and aj denote the access charges set by network i and j, respectively, that is, the prices to be paid for terminating a call initiated in the competing network. Even though we shall formulate our main comparative statics result in terms of the reduced-form demand functions Dii and Dij , it will be useful to decompose these functions into (i) the number of subscribers, and (ii) the number of calls initiated by each subscriber. We therefore introduce the following notation: Notation 5.1 (demand with linear tariffs) For i j = 1 2 i = j we let ni pi  pj  denote the number of subscribers to network i. 4

In our framework, it would be straightforward to incorporate asymmetric marginal costs. However, doing so would make the notation more cumbersome, without changing the results.

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ii pi  pj  ≡ mii ni pi  pj  nj pi  pj  pi  denote the Further, let m ij pi  pj  ≡ number of internal calls per subscriber and m mij ni pi  pj  nj pi  pj  pi  the number of external calls per subscriber to network i. Then, the demand functions can be written as ii pi  pj  Dii pi  pj  ≡ ni pi  pj  · m ij pi  pj  Dij pi  pj  ≡ ni pi  pj  · m Understanding the demand functions Dii and Dij thus amounts to understanding the relation between retail prices and (a) the individuals’ subscription decisions (represented by ni and nj ), and (b) the ij  respectively). Note that number of calls per subscriber ( mii and m ii for internal calls depends not only on the a subscriber’s demand m price pi per call, but also on the number of subscribers to each network: a customer of a large network i will place more internal calls ii depends than a customer of a small network. Hence, indirectly m on pj as well as pi  since pj affects the numbers of customers in both networks and thus the calling pattern of each subscriber to network i. As a result, the total effect of a change in the retail price pi on the ii , is given by number of internal calls per subscriber, m  mii mii mii ni mii nj = + +  pi pi ni pi nj pi

(5.2)

and similarly for the effect on external calls,  mij /pi . The total effect of a change in the competitor’s retail price pj on the number of internal calls per subscriber is given by  mij mij ni mij nj = +  pj ni pj nj pj

(5.3)

and similarly for  mii /pj . We maintain the following assumptions on the components of demand.

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Assumption 5.1 (demand properties) The components of demand satisfy the following properties: (i) (ii) (iii) (iv) (v)

ni  mii and mij are differentiable functions. ni /pi < 0 ni /pj > 0, mii /ni > 0 mii /nj ≤ 0, mii /pi < 0 mii /pj > 0, and mij /pi < 0

Assumption (i) is made for notational convenience only. The remaining assumptions are plausible properties of the demand components. Assumption (ii), for instance, reflects the substitution effect associated with an increase of a network’s retail price.5 Property (iii) formalizes the notion that an increase in the size of a network should increase (decrease) the number of internal calls per subscriber in this (the competitor’s) network. Property (iv) reflects substitution effects for internal calls. Finally, property (v) states that the demand for external calls per subscriber is downward sloping. Note that Assumption 5.1 implies that  mii <0 pi

and

 mii > 0 pj

mij /pj . We illusbut no corresponding statement on  mij /pi and  trate the ambiguity for  mij /pj using (5.3). By Assumption 5.1(ii), ni /pj > 0 and nj /pj < 0, whereas the signs of the remaining partials are not determined. Under the reasonable condition that the number of external calls per subscriber is increasing in the size of both networks (mij /ni > 0 mij /nj > 0) – more subscribers to network i are likely to place more calls to network j, and more

5

In the absence of a full coverage assumption (see Section 5.3.1 for details), the second part of this assumption is not quite as natural: In principle, because an increase in pj reduces nj , it might also make subscription to network i less attractive.

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subscribers to network j make it more likely that subscribers want to place calls to network j – the sign of  mij /pj is ambiguous.6 Our next assumption is made for convenience and requires that the components of demand are separable. Assumption 5.2 (separability) arable in retail prices, that is,

The demand components are sep-

ij ij 2 m 2 m 2 ni = 0 = 0 and = 0 pi pj pi pj pi pj Note that Assumption 5.2 does not imply separability of the demand functions Dii and Dij themselves.7 Finally, since we want to focus on comparative statics, we need to assume that an equilibrium exists. It is well known from specific models of two-way network competition that the existence of equilibrium is not assured, especially if access charges and the substitutability of networks are high.

5.2.2 Comparative statics

We now carry out comparative statics with respect to access prices. The analytical framework put forward by ALRT suggests that by ‘raising each others’ cost’, access charges may serve as collusive devices. Very roughly, the following intuition might appear plausible: by making access to its network more costly, both firms shift out the competitor’s reaction curve. If retail prices are strategic complements, indirect effects reinforce the direct effects. Though this story bears a grain of truth (Laffont and Tirole 2000, p. 189), it is

6 7

The arguments for  mij /pi are analogous. For instance, under Assumption 5.2, we have 2 Dii mii ni  n  mii = i +  pi pj pj pi pi pj

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both misleading and incomplete. First, it ignores the role of access charges as a means of generating revenue. Second, it neglects some special characteristics of network competition, suggesting that retail prices are strategic substitutes in the demand function rather than complements. Once these issues are taken into account, it is neither obvious that higher access charges shift out reaction curves nor that indirect effects work into the ‘right direction’. Nevertheless, we start with a simple result that formalizes the intuitive argument for collusion laid out above by giving sufficient conditions for equilibrium retail prices to be increasing in access charges.8 Proposition 5.1 (linear tariffs) Suppose that for i j = 1 2 i = j retail prices are strategic complements, that is, Dij 2 Dij 2 i D 2 Dii = ii + + pi − c + pi − aj − C1 − c0  pi pj pj pj pi pj pi pj + ai − c0 

2 Dji ≥ 0 pi pj

(5.4)

(i) If, in addition to (5.4), reaction curves shift outwards, that is, Dji 2 j Dji 2 i = ≥ 0 and =− > 0 pi ai pi pj ai pj

(5.5)

then the equilibrium of the price game is increasing in ai . (ii) If, in addition to (5.4) both firms face the same access price a and Dji Dij 2 i − > 0 = pi a pi pi

(5.6)

then the equilibrium of the price game is increasing in a. 8

The proposition is formulated for a unique equilibrium of the price game. It generalizes to equilibrium sets as in Milgrom and Roberts (1990).

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Proof Results (i) and (ii) follow immediately from Milgrom and Roberts (1990, Theorem 5): Condition (5.4) guarantees that the game is supermodular; conditions (5.5) and (5.6) make sure that it satisfies increasing differences in pi  pj  , with = ai or a, respectively.  Result (i) guarantees that both retail prices increase when either firm raises its access charge. The result is thus directly relevant for cases where firms themselves choose access charges – cooperatively or noncooperatively – and compete in the retail market, highlighting the collusive role of access charges. Result (ii) concerns the effects of a simultaneous increase in both access prices. It pertains to the important case where either the regulatory regime requires access charges to be reciprocal (as, e.g., in the US) or the network operators negotiate symmetric access charges. We now explore whether the sufficient conditions for a collusive role of access charges ((5.4)–(5.6)) are likely to be satisfied. 5.2.3 Are retail prices strategic complements?

In standard models of oligopolistic price competition, there is a natural force towards strategic complementarity of pricing decisions: if the competitors produce substitutes, a higher price of firm j increases the demand of firm i. Thus, a price increase of firm i becomes more attractive as it applies to a greater number of inframarginal consumption units. The strategic complementarity of pricing decisions breaks down only if the demand function itself has negative cross-partials, that is, if prices are strategic substitutes in the demand function, and this effect is sufficiently strong. For network competition models with two-sided access, there are two natural reasons why strategic complementarity in retail prices may be violated, so that 2 i /pi pj < 0 at least for some prices: (i) The products offered by different networks are not necessarily substitutes, that is, the demand for calls offered by network i does not necessarily increase with an increase in network j’s retail price.

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(ii) The retail prices may be strategic substitutes in the demand functions, that is, the cross-partials of the demand functions may be negative. First consider reason (i). Observe that by Assumption 5.1 n  m Dii ii i + ni ii > 0 =m pj pj pj

(5.7)

that is, the demand for internal calls is unambiguously increasing in the competitor’s retail price. The effect on the demand for external calls, Dij  mij n ij i + ni =m  pj pj pj

(5.8)

however, is less clear: the first term is positive by Assumption 5.1(ii), but the second term has an ambiguous sign, so that it is not guaranteed that Dij /pj > 0. Intuitively, higher competitor prices might have a negative effect on the size of the competitor’s network and thereby reduce the number of outgoing calls. Nevertheless, (5.7) and (5.8) together suggest that the total effect on demand (Dii /pj + Dij /pj ) is likely to be positive, supporting strategic complementarity in retail prices. Consider now reason (ii). On the one hand, a familiar force towards strategic complementarity is present: as Dii /pj > 0, a higher competitor price increases own demand for internal calls, which makes a price increase more valuable. On the other hand, it is important to note that there is a natural force towards a negative cross-partial for the demand function Dii  in spite of our separability assumption on the underlying demand components. Using Assumptions 5.1 and 5.2, as well as the decomposition given in (5.7), we obtain 2 Dii n  mii ni  mii = i + < 0 pi pj pj pi pi pj

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which is unambiguously negative. Intuitively, an increase in the competitor’s retail price increases both the number of own subscribers and the volume of internal calls per subscriber. The same is true for a reduction in own retail price. Thus, with a higher competitor price, the positive effect of an own price reduction on demand per subscriber applies to a greater customer base, so that the demand-enhancing effect of the price reduction is more pronounced. Similarly, the positive effect on the subscriber number applies to a greater call volume per subscriber. The argument for the remaining cross partials is again less clearcut. For instance, we obtain 2 Dij mij ni  mij n  = i +  pi pj pj pi pi pj which has an ambiguous sign: we know that ni /pj > 0 ni /pi < 0 by Assumption 5.1(ii), but  mij /pi and  mij /pj have ambiguous signs. A similar result holds for 2 Dji /pi pj . Summing up, our reduced-form model of network competition with linear retail prices incorporates the standard argument for the strategic complementarity of pricing decisions: If a higher competitor price increases the total demand for calls originating in network i, then own price increases are more valuable. There is, however, at least one natural countereffect: A higher competitor price exacerbates the negative demand effects of an increase in own price, yielding an incentive to reduce own price.

5.2.4 Do higher access charges shift out the reaction curves?

The strategic complementarity of pricing decisions in the retail market helps support the argument for collusion among network operators. However, it is not a necessary condition for retail prices to be increasing in access charges. As long as higher access charges shift out reaction curves, both retail prices will go up even if retail prices are strategic substitutes, unless the indirect effects from downward

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sloping reaction curves are very strong. Conversely, if higher access prices shift reaction curves inward, retail prices are likely to fall. In the following, we show that the latter case may arise in the present setting. We first suppose that only one firm’s access price, ai , increases. This implies an outward shift of firm i’s reaction curve if Dji 2 i = ≥ 0 pi ai pi

(5.9)

That is, if a higher retail price induces more incoming calls, then setting a higher retail price is a reasonable response to a higher access charge. As we argued before, however, this condition may be violated (see (5.8)). Next, we ask whether it is natural to expect firm j’s reaction curve to shift outwards when the competitor raises its access price. Such an outward shift occurs if the following condition holds: 2 j Dji =− > 0 pj ai pj

(5.10)

Equation (5.10) requires that the demand for network j’s outgoing calls falls as it raises its retail price. Then, the increasing costs of access to network i make it attractive for network j to curb demand for external calls by increasing its retail price pj . As argued before, it is not obvious that Dji /pj is negative. Summing up, it is not clear that increases in access charges shift out the reaction curves of both firms.

5.3 SIMPLIFYING ASSUMPTIONS: HOW DO THEY AFFECT THE ROLE OF ACCESS CHARGES?

Our above findings indicate that changes in access charges have subtle effects on retail prices. In particular, they suggest that the collusive role of access charges is not very robust even when retail

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prices are linear. We now want to explore to what extent the following two crucial assumptions familiar from the literature affect the role of access charges under network competition (see Vogelsang, 2003, p. 846): (i) full coverage networks and (ii) balanced calling patterns.

5.3.1 Full-coverage networks

In the ALRT framework, the focus is on mature industries where network competition involves competition between two full-coverage networks (see, e.g., Laffont et al., 1998a, p. 5), and all consumers subscribe to one of the networks. This implies that the total number of subscribers is fixed, that is, ni pi  pj  + nj pi  pj  ≡ n

(5.11)

Therefore, retail prices only affect the networks’ market shares

i pi  pj  ≡

ni pi  pj   n

i j = 1 2 i = j

(5.12)

but not the total number of subscribers (i.e., the ‘size’ of the market). This simplification tends to support the collusive role of access charges, without eliminating the ambiguities entirely. Too see this, note that if (5.11) holds, we immediately have ni /pi = −nj /pi  We can thus rewrite (5.3) as  mij n = i pj pj



 mij mij −  ni nj

(5.13)

which is positive by Assumption 5.1(ii) if and only if the expression in the bracket is positive. One might argue that this condition is likely to be satisfied, since it essentially requires that the number of external calls per subscriber increases more strongly in own network

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size than it increases in the competitor’s network size (the own effect dominates the cross effect).9 If this condition is satisfied, we have  mij /pj > 0, which reinforces the positive effect of an increase in network j’s retail price on network i’s total demand, that is, the full-coverage assumption supports the strategic complementarity of retail price decisions. However, the full-coverage assumption does not eliminate the natural countereffect associated with the negative cross-partial of internal calls. Similar arguments show that the full-coverage assumption makes it more likely (but cannot guarantee) that an increase in the access charge shifts out the competitor’s reaction curve. Summing up, the full-coverage assumption tends to support the collusive role of access charges, but does not guarantee a positive relation between access charges and retail prices. The ambiguities concerning the collusive role of access charges disappear, however, if we are willing to make a more extreme assumption and fix not only the total number of subscribers, but also the number of subscribers to each network. Making this assumption is equivalent to ignoring subscription decisions, which could be justified on the grounds of prohibitive switching costs in a very short-term perspective. In this simpler setting, our earlier concerns about strategic complementarity and the shifting of reaction curves disappear. To see this, consider the strategic complementarity condition (5.4). The potential countereffect of the competitor’s retail price on external calls, Dij /pj , is zero by ij assumption: if pj does not affect ni and nj , it cannot affect m either. Second, all demand functions are now separable in retail prices, as ni /pi = ni /pj = 0 by assumption. Therefore, condition (5.4) is always satisfied with equality. As to the conditions (5.9) and (5.10) assuring that increases in access charges

9

It should be noted, however, that in this particular case, it is not a foregone conclusion that the own effect dominates the cross effect: the demand for external calls per subscriber should be expected to increase in the number of subscribers to both networks, and without further assumptions on how subscribers choose networks, it is perfectly conceivable that the cross effect dominates.

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shift out the reaction curves, we have 2 i /pi ai = Dji /pi = 0, since pi does not affect nj  Furthermore, by Assumption 5.1(v), 2 j /pj ai = −Dji /pj = −nj mji /pj  > 0 Therefore, access charge increases unambiguously shift out the reaction curves of the competitors.

5.3.2 Full-coverage networks and balanced calling pattern

Another common simplification in the literature is to require a socalled balanced calling pattern.10 This means that, at retail prices pi = pj , inbound and outbound calls are balanced. According to Laffont et al. (1998a, p. 3), who used the assumption as a ‘good first approximation’ to the possibly complex routing of calls within and across networks, balanced calling patterns also mean that the ‘percentage of calls originating on a network and completed on the same network (“on-net calls”) is equal to the fraction of consumers subscribing to the same network.’

We now want to explore how this assumption affects the role of access charges for network competition. We maintain the fullcoverage assumption from Section 5.3.1, so that i = ni pi  pj /n.11 Using the notation of Laffont et al. (1998a), our reduced-form demand functions then read Dii pi  pj  = 2i pi  pj qpi 

(5.14)

Dij pi  pj  = i pi  pj 1 − i pi  pj qpi 

(5.15)

where qpi  denotes the call volume per subscriber to network i, with q  pi  < 0. Note that the call volume per subscriber is a function of 10

Vogelsang (2003, p. 847) uses the terminology ‘isotropic calling pattern’ instead. With the balanced calling pattern assumption, calculations for the reduced-form model become tedious when the total number of subscribers is endogenous.

11

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pi alone, whereas in our reduced-form model above, it is a function of both pi and pj 12 It is straightforward to show that these assumptions do not resolve the ambiguities outlined above. For instance, consider the strategic complementarity condition (5.4). Using (5.14) and (5.15), we have 

Dii = 2 i i qpi  > 0 pj pj

(5.16)

Dij 

= i 1 − 2 i qpi  pj pj

(5.17)

While (5.16) is always positive, (5.17) is positive by Assumption 5.1(ii) for a small network ( i < 1/2 and negative for a large network ( i > 1/2). That is, from a large network’s point of view, the products offered by the different networks are no substitutes. Furthermore, some of the cross-partials of demand may be negative. More specifically, we have    i  i 2 Dii  =2 qpi  + i q pi  < 0 (5.18) pi pj pj pi 2 Dij 

 

= i 1 − 2 i q  pi  − 2 i i qpi  pi pj pj pj pi

(5.19)

Condition (5.18) indicates that 2 Dii /pi pj is always negative, whereas the sign of 2 Dij /pi pj is ambiguous (see (5.19)). Thus, the strategic complementarity condition may well be violated. 12 In a paper closely related to Laffont et al. (1998a), Dessein (2003) combines the assumptions of full-coverage and balanced calling patterns with a more flexible demand structure where subscribers may be heterogeneous in the sense that there are light and heavy users initiating call volumes kL qpi  and kH qpi  respectively, with kL < kH  He finds that in this setting the equilibrium price is still increasing in the access charge (Proposition 5.1). If, however, the calling pattern is unbalanced, the impact of an increase in the access charge on the equilibrium price may be reversed (Proposition 5.2). See Section 5.5 for a discussion of consumer heterogeneity in our reduced-form model.

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Furthermore, reaction curves do not generally shift out when access charges increase. To see this, note that Dji  i 2 i = = 1 − 2 i qpj  pi ai pi pi 2 j Dji 

=− = − i 1 − 2 i qpj  − i j q  pj  pj ai pj pj That is, raising the access charge and increasing the retail price is complementary only from a large network’s point of view ( i > 1/2). A small network ( i < 1/2), in turn, will not be willing to increase its retail price in response to an increase in its own access charge. To understand this, recall that setting a higher retail price is a reasonable response to a higher access charge if it induces more incoming calls. Under the assumptions of full-coverage networks and balanced calling patterns, increasing the retail price will induce more incoming calls only for a large network, whereas a small network must reduce the retail price to induce more incoming calls. Interestingly, all of the above ambiguities disappear when networks are symmetric ( i = j = 1/2). In this case, all relevant derivatives are either zero or strictly positive, so that the conditions of Proposition 5.1 are satisfied. In particular, the diverging interests of small and large networks in setting retail prices in response to changes in access charges are perfectly aligned, and increasing access charges (weakly) shifts out reaction curves.

5.4 NONLINEAR RETAIL TARIFFS

We now introduce a reduced-form model of two-way network competition with nonlinear retail tariffs that incorporates the ALRT framework as a special case.

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5.4.1 Assumptions

Suppose that the networks simultaneously offer two-part retail tariffs of the form Ti q = Fi + pi q where Fi is a subscriber charge and pi is the per-unit usage fee. Following Laffont et al. (1998a), we denote the variable gross surplus of a subscriber to network i by umii  mij  and the corresponding variable net surplus by vpi  ≡ max umii  mij  − pi mii + mij   mii mij

Accounting for the subscriber charge, the net surplus offered to subscribers of network i is wi ≡ vpi  − Fi  For a fixed retail price pi , there is a one-to-one correspondence between the subscriber charge Fi and the net surplus wi  so that we can view the networks as simultaneously choosing pi and wi . Also, we confine ourselves to the case of reciprocal access charges ai = aj ≡ a. Thus, we write the profit function of firm i as i wi  wj  pi  pj  = pi − cDii wi  wj  pi  + pi − a − c1 − c0  ×Dij wi  wj  pi  + a − c0  Dji wi  wj  pj  +ni vpi  − wi  − Ki  We shall provide a comparative statics result for this reduced form below, but we shall also refer to the following decompositions of the demand functions. Notation 5.2 (demand with nonlinear tariffs) For i j = 1 2 i = j we let ni wi  wj  denote the number of subscribers to network i.

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ii wi  wj  pi  ≡ mii ni wi  wj  nj wi  wj  pi  denote Further, let m ij wi  wj  pi  ≡ the number of internal calls per subscriber and m mij ni pi  pj  nj pi  pj  pi  the number of external calls per subscriber to network i. Then, the demand functions can be written as ii wi  wj  pi  Dii wi  wj  pi  ≡ ni wi  wj  · m ij wi  wj  pi . Dij wi  wj  pi  ≡ ni wi  wj  · m The net surpluses wi  wj  thus both determine the customers’ subscription decisions and affect the number of calls per subscriber, whereas the retail prices pi  pj  only affect the number of calls per subscriber. The total effect of a change in the net surplus wi on the ii  is given by number of internal calls per subscriber, m  mii mii ni mii nj = +  wi ni wi nj wi and similarly for  mii /wj  The total effect of a change in the competitor’s net surplus wj on the number of external calls is  mij mij ni mii nj = +  wj ni wj nj wj and similarly for  mij /wi  We adapt Assumptions 5.1 and 5.2 from above in the following way: Assumption 5.1 (demand properties) The components of demand satisfy the following properties: (i) ni  mii and mij are differentiable functions, (ii) ni /wi > 0 ni /wj < 0, (iii) mii /ni > 0 mii /nj < 0, (iv) mii /pi < 0, and (v) mij /pi < 0

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Assumption 5.2 (separability) The demand components are separable in retail prices and net surpluses, that is, 2 ni = 0 wi wj ii 2 m = 0 pi wi

ij 2 m ii 2 m = 0 and = 0 wi wj wi wj ij 2 m = 0 pi wi

5.4.2 Comparative statics

We now discuss how changes in access charges affect subscriber charges and usage fees. To some extent, the intuition will parallel the case of linear pricing. However, there is added complexity from the interaction of usage fees pi and subscriber charges Fi (or equivalently, net surpluses wi ). The following three arguments are key for the notion that both usage fees and net surpluses should be increasing in access charges. (i) Setting a higher access charge a increases the marginal benefits from an increase in the usage fee pi . (ii) Other things being equal, charging a higher usage fee pi increases the marginal profitability from setting a higher net surplus wi (by lowering the subscriber charge Fi ). Intuitively, a network charging a high usage fee benefits more from a larger customer base which it obtains thanks to a low subscriber charge. (iii) The different players’ decision variables, which are now twodimensional (usage fee and net surplus), are strategic complements. Thus, a firm’s optimal response to an increase of the usage fee and an increase of the net surplus of the competitor involves increasing its own usage fee and increasing its own net surplus (i.e., reducing its own subscription charge). Using these arguments, the following response to an access charge increase appears plausible. First, by (i), the direct effect of a higher

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access charge is to increase usage fees. Second, by (ii), if firms increase their usage fees, they should reduce subscriber charges. Third, by (iii), these adjustments of both firms to higher access charges reinforce each other. The intuition is slightly incomplete, however, as one must also take the direct effect of higher access charges on subscription charges into account. Unfortunately, neither the standard monopoly nonlinear pricing problem, nor the linear access pricing model of Section 5.2 offers guidance for the sign of this effect. Next, we therefore state a comparative statics result that contains a suitable condition on this direct effect as well as formalizations of (i)–(iii) above, and then discuss the plausibility of these conditions. Proposition 5.2 (two-part tariffs) For the reduced-form model with two-part retail tariffs, suppose the following conditions hold for i j = 1 2 i = j: 2 i 2 i (i) ≥ 0 ≥ 0 api awi 2 i (ii) ≥ 0 pi wi 2 i 2 i 2 i 2 i ≥0 ; ≥ 0 ≥ 0 ≥ 0. (iii) pi pj pi wj wi pj wi wj Then, an increase in the access charge a leads to an increase in the equilibrium values of p1  p2  and w1  w2  Proof By (i), each objective function i pi  pj  wi  wj  a has increasing differences in pi  wi  a. By condition (ii), the objective functions are supermodular in pi  wi . By condition (iii), they also satisfy increasing differences in pi  pj  wi  wj . Taking (ii) and (iii) together, the game is supermodular. Thus, applying Milgrom and Roberts (1990, Theorem 5) yields the result.  We now clarify to what extent the conditions of Proposition 5.2 are likely to hold.

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First, consider the direct effects in (i) given by Dij 2 i =− >0 api pi

and

Dji Dij 2 i = −  awi wi wi

The direct effect of access charges on usage fees is always positive as higher usage fees lead to less outgoing calls by Assumption 5.1(v).13 The direct effect of access charges on net surpluses is less obvious. In the model proposed by Laffont et al. (1998a), this effect turns out to be zero, as demand functions are given by Dji = i wi  wj 1 − i wi  wj qpj  Dij = i wi  wj 1 − i wi  wj qpi  so that Dji /wi = Dij /wi for pi = pj  Second, consider the within-player effects (ii). Even without using the demand decomposition, we obtain a somewhat lengthy expression for the relevant cross-partial: Dij D 2 Dii 2 i = ii + pi − c + pi wi wi pi wi wi + pi − a − c1 − c0 

2 Dij n + i v pi   pi wi wi

(5.20)

Rather than considering each term in (5.20), we highlight some major effects. There are clear forces supporting the idea of complementarity between high usage fees and high net surpluses. For instance, we unambiguously have n  m Dii ii + ni ii > 0 = im wi wi wi 13

The indirect effects from the linear pricing model are no longer present, because subscriptions only depend on prices via net surpluses.

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Intuitively, this reflects the idea that with a high net surplus, the total number of subscribers and thus the volume of internal calls will be high, so that the per-unit profits resulting from a higher usage fee apply to a greater customer base. However, there are also counter-effects. For instance, arguments as in Section 5.2 show that n  mii 2 Dii = i pi wi wi pi is likely to be negative: a higher net surplus leads to more subscriptions. Thus, the reduction in internal calls resulting from a higher usage fee has a particularly strong negative demand effect, as it applies to a greater number of subscribers. More interestingly, there is a negative subscription charge effect that is specific to the nonlinear case ni /wi  v pi  < 0: when wi is high, firm i has a large number of subscribers. Increasing the usage charge means that the firm will be able to extract a smaller subscription charge from each customer. This effect is particularly pronounced when the number of subscribers is large. Finally, consider strategic interactions. First note that 2 i /pi pj = 0, which is in line with condition (iii). The remaining cross-partials, however, are typically ambiguous. For instance, Dij D 2 Dii 2 i = ii + pi − c + pi wj wj pi wj wj + p − a − c1 − c0 

2 Dij n + i v pi   pi wj wj

(5.21)

is very similar to (5.20), except that the derivatives are taken with respect to wj rather than wi . Typically, however, derivatives with respect to wi and wj have different signs, which makes it unlikely that 2 i /pi wj and 2 i /pi wi have the same sign. Summing up, there is some support for the intuitive notion that higher access charges tend to both increase usage fees and decrease subscriber charges. However, higher access charges may have positive direct effects on fixed fees 2 i /awi ≤ 0 even though this

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is not the case in the model proposed Laffont et al. (1998a). Further, the strategic complementarity of the players’ two-dimensional decision vectors is not obvious. While this does not itself imply that the conclusions of Proposition 5.2 do not hold – after all, these conditions are merely sufficient rather than necessary – it does at least warn us that straightforward intuitive reasoning may not apply under two-sided network competition. 5.5 EXTENSIONS AND CONCLUSIONS

We finally discuss two important extensions of the ALRT framework that have been studied in the literature: (i) customer heterogeneity (Dessein 2003) and (ii) price discrimination based on call termination (Laffont et al., 1998b). First, note that the extension to heterogeneous customers is straightforward, as our reduced-form demand functions Dii and Dij , i j = 1 2 i = j are perfectly consistent with customer heterogeneity: suppose that there are t types of customers indexed by k = 1  t Let nki denote the number of type k customers subscribing kii and m kij denote the number of internal to network i. Similarly, let m and external calls, respectively, per subscriber of type k. Then, the k k ii and demand for internal and external calls is given by D ≡ ii k nii m  k k ij , respectively. Since Propositions 5.1 and 5.2 are forDij ≡ k ni m mulated in terms of reduced-form demand functions, they also apply when customers are heterogenous. Therefore, the ambiguities with respect to possible collusion over inflated access charges still emerge in this more general case, even after extending our assumptions on the demand components to all t types of customers. Second, consider the case where networks charge different retail prices for internal and external calls. Following Laffont et al. (1998b), we denote the retail price of network i for internal calls by pi and the price for external calls by  pi 14 Clearly, we cannot 14

In the case of nonlinear retail tariffs, network i also sets a subscriber charge Fi (as in Section 5.4).

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simply reinterpret Propositions 5.1 and 5.2 to understand the sufficient conditions for retail prices to be increasing in access charges in such a setting. Our above analysis suggests though that collusion over inflated access charges is unlikely to be a robust phenomenon in this more general setting, as it is inherently nonrobust even in the special case where pi ≡  pi .15 Summing up, this chapter provides a reduced-form analysis of the role of access charges under two-way network competition with linear and nonlinear retail prices. Retaining the key features of network competition models but imposing less structure, we derive sufficient conditions for usage fees to be increasing (and subscriber charges to be decreasing) in access charges. We show that these conditions are difficult to satisfy without making rather strong assumptions on the demand for calls within and across networks, suggesting that implementing collusion by inflating access charges is likely to be nonfeasible. Our results extend Dessein’s (2003) earlier finding that making the analytical framework more general does not restore the collusive effect of a high access charge.

REFERENCES Armstrong, M. (1998): ‘Network interconnection in telecommunications’, Economic Journal 108: 545–564. Armstrong, M. (2002): ‘The theory of access pricing and interconnection’, in: Cave, M., S. Majumdar and I. Vogelsang, (eds.), Handbook of Telecommunications Economics, Elsevier, Amsterdam, 295–384. Armstrong, M. (2004): ‘Network interconnection with asymmetric networks and heterogeneous calling patterns’, Information Economics and Policy 16: 375–390. Carter, M. and J. Wright (2003): ‘Asymmetric network interconnection’, Review of Industrial Organization 22: 27–46. Dessein, W. (2003): ‘Network competition in nonlinear pricing’, RAND Journal of Economics 34: 593–611. Dessein, W. (2004): ‘Network competition with heterogeneous customers and calling patterns’, Information Economics and Policy 16: 323–345.

15

Laffont et al. (1998b, p. 40), for instance, find that ‘raising each other’s cost does not promote collusion’ in their model with price discrimination.

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Gans, J. and S. King (2001): ‘Using bill and keep interconnect arrangements to soften competition’, Economics Letters 71: 413–420. Laffont, J.J., P. Rey and J. Tirole (1998a): ‘Network competition I: Overview and nondiscriminatory pricing’, RAND Journal of Economics 29: 1–37. Laffont, J.J., P. Rey and J. Tirole (1998b): ‘Network competition II: Price discrimination’, RAND Journal of Economics 29: 38–56. Laffont, J.J. and J. Tirole (2000): Competition in Telecommunications, MIT Press, Cambridge, MA. Milgrom, P. and J. Roberts (1990): ‘Rationalizability, learning, and equilibrium in games with strategic complementarities’, Econometrica 58: 1255–1277. Peitz, M., T.M. Valletti and J. Wright (2004): ‘Competition in telecommunications: An introduction’, Information Economics and Policy 16: 315–321. Schiff, A. (2002): ‘Two-way interconnection with partial consumer participation’, Networks and Spatial Economics 2: 295–315. Vogelsang, I. (2003): ‘Price regulation of access to telecommunications networks’, Journal of Economic Literature 41: 830–862.

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Access Pricing: Theory and Practice Edited by Justus Haucap and Ralf Dewenter © 2007 Elsevier B.V. All rights reserved.

CHAPTER 6

Access Pricing Under Cost Asymmetry in Telecommunications VIKTÓRIA KOCSIS∗ Corvinus University of Budapest, Hungary

Contents 6.1 6.2

INTRODUCTION                                                        MODEL FOR LINEAR TARIFFS                                         6.2.1 Cost structure and access fee                                      6.2.2 Demand structure and consumer surplus                           6.2.3 Price competition                                                6.2.4 Comparison and policy implications                               6.3 COMPETITION IN TWO-PART TARIFFS                                6.3.1 Demand structure and consumer surplus                           6.3.2 Price competition                                                6.3.3 Comparison and policy implications                               6.4 CONCLUSIONS                                                         APPENDIX                                                              A6.1 PROOFS                                                                A6.2 SIMULATION RESULTS                                                A6.2.1 Comparison according to parameter values                         A6.2.2 Comparison according to access fee                               REFERENCES                                                          

150 153 153 154 157 158 160 161 162 164 167 168 168 172 172 173 175

∗ The author thanks Mark Armstrong, Paul de Bijl, Gergely Csorba, Ferenc Forgó, András Gömöri, Maarten Janssen and Patrick Rey for their comments and recommendations.

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6.1 INTRODUCTION

Since the mid-1990s, the deregulation of telecommunications – formerly seen as a natural monopoly – has played an important role within policy-making and in the economics literature. At the beginning of the millennium a new framework for communications networks was introduced, designed to harmonize European regulation in order to reduce entry barriers and facilitate effective competition for the benefit of consumers. Under the new regulatory regime, each country is required to establish a national regulatory authority to monitor competition in communications markets and define the relevant market segments. Furthermore, they should decide whether an operator has significant market power (SMP) in a particular segment and assess the appropriate regulatory obligations. On the basis of the EU communications directive on access and interconnection,1 wholesale voice call termination has already been defined as a relevant market in most of the European countries, since each operator is a monopolistic provider for its respective bottleneck and charges an access fee for usage. The termination charge set by the SMP operators is regulated on the basis of termination cost. Nevertheless, several asymmetries can be observed on telecommunications markets, and these asymmetries require an individual consideration of each firm with regard to regulation. The questions which arise are whether all firms should be regulated in the same way, more precisely based on their termination cost, or whether regulation should favor some firms. In the latter case, the question is, of course, which firm should be favored over the other and why. Therefore, in this chapter we focus on a specific market asymmetry and seek to find an argument for or against the current access price regulation. Liberalizing telephony markets has provided opportunity for new entry. Firms that entered the market later had the opportunity to 1

See European Parliament and Council (2002).

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introduce a more recent technology which implies a lower cost of servicing (i.e., supply side advantage). In this chapter, we focus on this cost asymmetry and aim to find the answer to the following questions: is a cost-based access fee desirable, or does an asymmetric access price regulation lead to higher welfare? What is the effect of access price regulation on firms’ profits and on consumer surplus? We formalize a market with two firms, which have already built their own networks providing full coverage, and which compete for consumers with horizontally differentiated products. The firms are interconnected: they have to pay a two-way access fee for call termination; each firm maximizes its profit setting retail price(s) simultaneously and noncooperatively. In the first part of the chapter, we present a model for linear telephony demand and for uniform linear retail prices. We obtain quartic and asymmetric first derivatives, therefore, the main results are based on simulations. Studying the effects of different access fees, we find that the two firms’ preferences over the access fee are divergent, and industry profits increase with the more efficient firm’s profit, so that a side payment to the less efficient firm could compensate for an access fee which is against its interest. On the other hand, a successful regulatory policy allows a positive access markup for the less efficient firm since it favors this firm (intensifies competition) and consumers. Extending the model to the case of competition in two-part tariffs, where each firm sets a uniform per-minute charge and a fixed fee at the same time, we find that firms set their per-minute prices equal to their perceived marginal costs and compete for consumers with fixed fees. As for the effects of changing access fees, the profit-neutrality property of the symmetric equilibrium no longer holds true and we claim similar policy implications to the linear pricing scheme. This chapter is an extension of the common symmetric models of network interconnection and competition. The first articles published on this topic are Armstrong (1998) and Laffont et al. (1998), in which the authors analyze the problem of two-way access pricing in the setup of a symmetric cost structure,

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uniform pricing and reciprocal (equal) access fee. The main and principally cited results of their articles are that (i) under linear retail pricing, the price increases in the access fee and, therefore, the access fee may be an instrument of collusion, and (ii) under two-part tariffs, since profit is independent of the access fee, any kind of regulatory policy has no effect on firms’ profits. This profit-neutrality property is confirmed in a more general setup by Dessein (2004) and Hahn (2004), who assume consumer heterogeneity in terms of demand for calls and calling pattern. Carter and Wright (2003) and Peitz (2005) consider an asymmetric market with two-par tariffs in the presence of a demand side asymmetry, called brand loyalty, and leave the other segments (for instance costs) symmetric. In the case of reciprocal access fees, Carter and Wright state that the firm with brand loyalty prefers the socially optimal cost-based access fee and if brand loyalty is sufficiently strong, the other firm has the same preference. Therefore, a successful regulator should only require a reciprocal access fee and let the incumbent set it. Peitz emphasizes the use of a nonreciprocal access fee, since an asymmetric access price regulation which allows positive access markup for the entrant can be socially more desirable: it favors the entrant and increases consumer surplus at the same time. de Bijl and Peitz (2002, 2004) focus on the same type of asymmetry although they analyze the market in a dynamic set up and use simulation to support the previous theoretical results. They find that, independent from the type of access price regulation, the asymmetry among firms lessens over time; the entrant’s profit and consumer surplus increase and finally a symmetric equilibrium emerges. In their 2004 article, they extend their model including asymmetrical marginal costs and derive from their simulations results which are similar to their previous findings. The structure of the present chapter is as follows. In Section 6.2, we define all the terms and conditions which are used in this chapter and then present a model with uniform linear tariffs under linear demand for calls; in Section 6.3, we derive the equilibrium for nonlinear tariffs. In Section 6.4, we conclude. The proofs and simulation results appear in the Appendix section.

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6.2 MODEL FOR LINEAR TARIFFS

First we present a model in which we assume a market with linear demand for telephony consumption and seek to find arguments in the interest of implementing asymmetric access fees. Furthermore, this section defines the most important terms and introduces the assumptions used in this chapter; other versions presented will be expressed in terms of deviation from this setup.

6.2.1 Cost structure and access fee

Consider a market with two networks indexed by i = 1 2. To avoid Bertrand competition and to measure the effect of different pricing schemes on market shares, we assume that firms compete for consumers by means of a horizontally differentiated service on a segment 0 1; that is we consider the model for product differentiation à la Hotelling (1929). We assume maximal product differentiation, namely the firms are located at the two ends of the segment (x1 = 0 x2 = 1). Each firm incurs three types of costs: (i) Connection-independent cost. For instance, this could be the fee for a license or the cost of building up and improving facilities. These costs will be considered in the model as sunk costs. (ii) Connection-dependent but traffic-independent cost. This is the fixed cost fi of serving a consumer and, without loss of generality, we assume that the fixed cost is the same for both firms, that is, f1 = f2 = f . (iii) Traffic-dependent cost. This is a unit cost ciO of originating and ciT of terminating a call. For simplicity we assume that ciO = ciT = ci0 . We define the cost asymmetry in the level of marginal costs. Assume that firm 2 is more efficient, that is, 0 ≤ c20 < c10  and denote c ≡ c20 − c10 the difference in termination costs.

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The networks are interconnected, which means that, if a consumer subscribed to a firm originates a call, this call may be terminated on the rival firm’s network. In this case, the firm has to purchase access to ensure that its subscribers are able to call all consumers independent from their service provider and, therefore, the firm has to pay an access fee for each unit call terminated on the rival’s network. In the model, network i charges a per-unit access charge i for terminating its rival’s call and pays j per-unit fee to network j for terminating its call on network j. We assume that the access fee is not a decision variable of the firm but determined by regulation. Hereafter, we denote  ≡ 2 − 1 . On the basis of the above definitions, the unit cost of a call can be determined depending on its origination and termination. If a call is originated and terminated on the same network (i.e., on-net call), say in network i, the total unit cost is equal to ci ≡ 2ci0 . However, if a call is originated in network i but terminated on network j (i.e., off-net call), network i incurs a unit cost of ci0 + j , and if a call of network j is terminated on network i, network i’s unit cost is equal to ci0 − i . To measure the deviation of the access fee from the termination cost, we use an access markup term which is i − ci0 . In case of a positive access markup, the access fee is larger than the termination cost, and in case of a negative access markup the termination cost exceeds the access fee.

6.2.2 Demand structure and consumer surplus

A consumer faces a two-step problem: in the first step he decides on whether or not to connect to a network, and in the second step he chooses the quantity of telecommunications services to be consumed. Consumers are homogeneous in the sense that each consumer receives the same fixed surplus of being connected (v0 ), and all consumers have the same utility function uq for telephony consumption. On the other hand, consumers are heterogeneous since they have different a priori preferences: a consumer values a service more when it is ‘closer’ to his preference. Let x denote the characteristic

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(location) of the consumer on the segment 0 1 and assume that the consumers are uniformly distributed on this segment. As the preference of a consumer is different from the characteristics of service supplied by the networks (i.e., different location), the consumer has to pay ’transportation cost’ (t > 0) which measures the disutility of not being a consumer of the ideal firm. Larger the t, the more differentiated the networks, that is, the less strong the substitutability between networks. We assume that t is the same for all consumers and the total transportation cost is a linear function of the distance. Applying these assumptions, the total utility of a consumer subscribed to firm i is equal to v0 − t x − xi  + uq − pi q where 1. v0 is assumed to be high enough to provide full consumer participation in the market; 2. the second term represents the total transportation cost since the consumer travels a distance of x − xi , where xi denotes the location of the firm, which can be 0 or 1; 3. pi denotes the uniform retail price set by firm i. A price is uniform if a company does not differentiate prices depending on which network a call is terminated on; and 4. uq is the utility from telephony consumption q and is considered quadratic, that is,2 uq = q −

q2  2

therefore the demand function for telephony consumption is linear: qp = 1 − p. 2 We use a simple quadratic utility function because it fulfils the general assumptions; moreover, it makes the analysis easier since a linear demand function can be derived from the first order condition of utility maximization. We might also set up a more general model using the utility function uq = aq − bq 2 /2; however, this generality does not modify the main results.

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The sum of the first two terms measures the utility of being connected (traffic-independent surplus), and the sum of the last two terms measures the utility from telephony consumption (trafficdependent surplus). We can solve the consumer’s two-step problem by backward induction. In the second step, given the retail prices, a consumer decides about telephony consumption. The variable net surplus gained from consumption is as follows: vp = max