Competition between telecommunications operators

EUROPEAN FXDIN&MIC European Economic

Review 41(1997) 701-711

competition between te~~co~~nications operators Jean-Jacques Laffont a*b9c, Patrick Rey a*dv *, Jean Tirole a,b2e7f aIDE& U~ive~s~f~des Sciences Sedates, 31042 To&we Cedex France b GREMAQ. Toulouse, France ’ Instifuf Uniuersitaire de France, Toulouse, France ’ L&I, Paris, France ’ CERAS (URA 2036 CNRS), Paris, France ’ MIT, Cambridge, MA, USA

Abstract Many observers of the telecommunications industry predict that regulation will soon give way to competition policy. The paper analyzes unregulated network competition, both in the mature and the transition phase of the industry. It considers competition in linear or nonlinear prices for customers, and also considers both nondisc~~n~o~ pricing and termination-based discriminatory pricing. The paper investigates whether freely negotiated

access charges are compatible with effective competition in the mature phase of the industry, and do not erect barriers to entry in the transition towards competition. Last, it analyzes the meaning and impact of the Efficient Component network competition. 0 1997 Elsevier Science B.V.

Pricing Rule in the context of

JEL classijcation: D4, K21; L.41; L.43; L.51; L96 Keywords: Antitrust law; Telecommunication: Competition

The developing likely to produce

* Co~s~nding

liberalization we observe in the telecommunications industry is substantial changes in the way the industry operates. Many

author. Tel.: (+ 33) 61128640, fax: (+ 33) 61 12 86 37; e-mail: prey.cict.fr.

OO14-2921/97/$17.00 Copyright 0 1997 Elsevier Science B.V. All rights reserved. 2’11 SOOl4-2921(97)00031-7

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observers predict that regulatory scrutiny will progressively give way to a competitive market place from which detailed regulation will have withdrawn: legislators, regulators and anti~st autho~ties all envision a tr~sition~ period followed by the substitution of competition policy for regulatory supervision. This view is for example expressed in the United Kingdom by OETEL’s consultative document of December 1994 ‘A Framework for Effective Competition’ (OFTEL, 1994), as well as in the U.S. by the February 1996 Act passed by Congress, that will facilitate entry (including entry by the long distance companies) into the regional Bell Companies’ territories in order to enhance competition in local phone service while allowing the latter to enter the long distance market once “sufficient competition has developed in the local phone market”. ’ In Europe, the industry will be fully open to competition by January 1998. The New Zealand’s ‘lighthanded’ regulatory regime, which relies on private negotiations between competitors to secure interconnection agreements, provides in that respect a test laboratory, since the regulatory authority has been abolished and the dominant firm (Telecom) and the entrants (Clear, BellSouth New Zealand) are subject only to general antitrust provisions on the abuse of dominant position and on vertical restraints. ’ Two main concerns arise in this context. First, network externalities can be achieved only if operators are interconnected. The provision of mutual access requires some form of cooperation among competitors, who must agree on modes of operation and especially on access prices; one may then fear that established networks could use their interconnection agreements to facilitate cooperation in the final market as well (collusive behavior concern). Second, it is often suggested that, during a transition period toward competition, often characterized by the presence of a large, well-es~blished do~nant network operator, entrants may be handicapped by the incumbent’s reluctance to provide access to its network on a reciprocal basis and at a reasonable price (entry deterrence concern). 3 We will

’ Cf. Congressional Quarterly (1995, p. 6): “The House and Senate have passed competing bills to promote competition and deregulation in telecommunications, both of which drew broad, bipartisan support. The two proposals (HR 1555 - H Rept 104-204 Part I; S 652 - S Rept 104-23) have the same goal: to allow all telecommunications companies to compete head to head in one another’s markets, with as little government regulation as possible”. An agreement with President Clinton, who threatened to veto the reconciliation bill, was reached in December 1995. See Schwartz (1995) and the 1996 Economic Report of the President for good accounts of the debate on teleco~u~cations reform in the U.S. ’ Section 36 of the Commerce Act may be invoked to limit access charges that a vertically integrated dominant operator can charge for the essential input. ’ In New Zealand, bitter disputes between the incumbent and the entrants suggest that satisfactory, freely negotiated interconnection agreements may not come about easily. A wide ranging consultation has been launched with the aim of promoting competition with minimal State intervention. [See the joint document of the New Zealand Ministry of Commerce and Treasury f1995).]

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consider the two concerns in turn, by discussing successively the role of access charges in mature and immature phases of network competition. 4 Although we will focus here on telecommunications networks, where interconnection agreements are most common, it should be acknowledged that similar issues may arise in other network industries. For example, interconnections between transportation networks suppose some form of coordination on schedules and route choices, and may involve some agreements on prices as well. Payment cards and ATM networks also involve some cooperation among banks in the determination of ‘access fees’ (called ‘interchange fees’). However, although some of our insights may carry over to other competing network industries, one should be wary of hasty generalizations. While the need for cooperation among producers competing on complementary segments exists in many industries, each industry has its own specific technology and rules governing interconnection agreements. In the apparently similar situation of banks’ ATM networks, for example, the mutual access contributions exhibit a different pattern: the interconnection bill paid by a bank to other banks depends on the number of its subscribers (as in telecommunications), but also on the other banks’ investments in ATMs (which in general need not be proportional to these banks’ market shares). Remark.

2. The mature phase of network competition Consider a situation where two telecommunications operators provide a full range of services, and assume that the two operators: (i) have symmetric cost structures and full coverage, so that all customers can choose between the two operators (this corresponds to the ‘mature’ industry assumption); (ii) are interconnected, so that subscribing to one operator allows to call subscribers from the other network. We will assume that serving a customer involves a fixed cost f of servicing her, a marginal cost q, per call at the originating and terminating ends of the call and a marginal cost c1 in between. The total marginal cost of a call is thus c = 2 cO+ c,. Also, we will assume that consumers have a constant elasticity demand, q = peq, and that the networks are differentiated a la Hotelling, so that for given net surpluses prices w1 and w2 offered by the two networks, market shares are given by

(1) where (+ is an index of substitutability between the two networks. For instance,

4 See Laffont et al. (1996a.b) for a detailed analysis. Armstrong of the insights.

(1996) independently

provided some

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under nonlinear, nondiscriminatory pricing, wi = u(pi), where u(p) denotes the consumer net surplus for a retail price p. 5 Typically, those two networks will compete for subscribers but, at the same time, will have to agree on mutual access conditions for cross-networks communications. These access conditions will in general involve quality standards, access prices, and so on. For the sake of exposition, we will assume here ‘perfect’ access quality, and focus on the impact of access charges. In practice, access charges usually consist in an interconnection price paid for each unit of communication terminating on the other network: that is, the caller’s operator does not incur the marginal cost c,,, but instead has to pay its rival a marginal access price, a. These access charges can be set either by mutual agreement, or unilaterally (each network setting the price to access its own network), or else can be subject to regulatory scrutiny. In the latter case, the regulatory intervention can take the form of a price cap, or of regulatory rules such as reciprocity, ECPR, etc. We will first consider the case of given, reciprocal access charges (a, = a2 = a) and examine (retail> price competition for this given common access price a. We will discuss afterwards the impact of alternatives ways of setting access charges. Also, retail price competition can take different forms: uniform linear prices, nonlinear prices or discriminating prices for which the price of a call depends on whether the call terminates on the same or the rival network. We successively discuss these various alternatives. 2.1. Uniform price competition Let us thus assume that access charges are given and symmetric, and furthermore assume here that networks compete in linear prices. In such a context, operator i’s profit is given by ~ii=i(P1,P2)[R(Pi>-f] where

+Ai(PIvP2)*

R( pi) = (pi - c)q( pi)

scribers, whereas Ai(Pl, q( pi)] denotes the access munications. An increase (market share effect), but (retail revenue efSect) as

denotes

(2)

the revenue

P2) = “i(Plv

PzXl

-

generated ai(Pl,

pz)Xa

by internal - C,)[q(pj)

sub-

revenue (or deficit) generated by cross-networks cornin the final price generally decreases the market share increases the retail revenue generated by each customer long as the retail price does not exceed the monopoly

5 This formulation assumes that the ‘differentiation’ of the two networks influences the subscription decision, rather than the usage. This seems reasonable to model competition between wireless and wireline networks, for example, but may be less appropriate when the differentiation concerns, say, the quality of communications: in that case, the volume of calls itself would depend on the quality of the network (as well as on the quality of the network to which the callee belongs). Also, we will assume throughout the paper that all consumers choose to be connected to a network, and that, at a given price, a customer is as likely to call any other customer whether she belongs or not to the same network (isotropic calling pattern).

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level; however, since such a price increase decreases the volume of calls generated by the network’s subscribers (while having no impact on the calls received from the rival’s subscribers), it is likely to also increase the access revenue (or decrease the access deficit) generated by cross-networks communications (access revenue effect). Whereas the first two effects illustrate the classic trade-off common to any form of oligopolistic competition, the latter effect is specifically due to the presence of access charges, and gives further incentives to increase retail prices. This access revenue effect is higher when access charges are high, but also when market shares are close to each other (so that the proportion of cross-networks communications is high). This access revenue effect creates a factor of instability of competition between the networks. Indeed, if the access charge is high, this effect pushes the final price upwards (possibly higher than the monopoly level) in any shared market equilibrium. But when prices are very high, and if networks are sufficiently close substitutes, each operator has an incentive to undercut its rival and comer the market. But a cornered market configuration cannot be an equilibrium either, since then: (i) either one network makes a positive profit, in which case the other could mimic it and obtain part of this profit; or (ii) no network makes a profit, in which case a network could obtain positive profit by raising its price and generating access revenue (by charging a price high enough, it gets a small market share but induces its own subscribers to call less, and thus generates an access surplus). But this access revenue effect makes also the access charge an instrument of tacit collusion. As just noted, because of this effect, at a shared-market equilibrium the retail equilibrium price increases with the access charge. The symmetric equilibrium price is given by (using Mai/Mpi = u v’( pi) = - gq( pi)): p-(c+y) P

= $-2U[R(P)

4)

(3)

and is thus increasing with the access charge a (at least, as long as the retail price is below the monopoly price>. There is thus a level for the access charge which induces the monopoly price as a non-cooperative ‘competitive’ equilibrium. [This ‘collusive’ level can be checked to increase with the substitutability of the networks - it is more difficult to sustain monopoly prices when competition is more intense - and to decrease with the fixed cost of connection - a higher fixed cost lowers the per customer profit and thus the competition for market share.] In contrast, the access price which would be necessary to induce socially optimal prices (namely, Ramsey prices) is smaller than the marginal cost of access. 2.2. Competition

in two-part tariffs

Assume now that the two operators can offer two-part tariffs to their subscribers. They can then avoid double marginalization and set marginal prices that

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reflect their own perceived marginal costs, using the fixed (subscriber) fees to recover any share of consumer surplus that is compatible with competitive pressure. High access charges will still lead to high marginal retail prices, however, since they affect the marginal cost of the internal subscribers’ communications, which on average is c + crj(a - ca). The tension between excessive marginal prices and the temptation of undercutting thus remains and still generates, for high access charges and high substitutability, an instability of competition between the two networks. However, the impact of the access charge a on the intensity of competition is a priori less obvious than in the case of uniform price competition. Since marginal prices now simply reflect marginal costs, it only remains to analyze the determination of fixed fees. But whereas an increase in the fixed fee adversely affects the market share and raises the retail revenue from the subscribers, the impact on the access revenue is less clear, since the fixed fee does not affect the volume of calls. In particular, although it might still affect the access revenue through changes in relative market shares, this effect will not arise in a symmetric equilibrium, since marginal prices are then equal and cross-networks communications exactly balance. The access revenue effect thus disappears and, since this effect is the only one directly related to the access charge, the access charge no longer is a collusive device. More precisely, in a symmetric equilibrium prices are both equal to p = c + (a - c,)/2; given those prices, and whatever the fixed fees F, and F2 charged by two operators, there is no access revenue or deficit since Ai( p, p) = 0; operator i’s per-customer profit is 7~~= (p - c)q( p) + Fi whereas its market share is given by ~~~=1/2+a[(~(p)-<.)-(v(p)-F;)]=1/2-o(F,-F,). Thus operator

L&=cY~GT~= [l/2-cr(F,-F;)][(p-c)y(p) = [l/2

(4)

i’s overall profit is

- C(7ri - 9rj)] 7ri,

+Fi] (5)

leading in equilibrium to the standard Hotelling profit, rH = 1/4a. An increase in the access charge thus leads to an increase in the retail marginal price, reflecting the increase in the marginal cost perceived by each operator, and thus to a decrease in consumption, but does not affect the operators’ profits. Of course, all the traditional reasons which make nonlinear prices difficult to design efficiently (incomplete information on consumers’ tastes, negative redistributional effects of fixed fees), to the extent that they cannot be overcome by menus of tariffs, are likely to restore partially the tacit collusion effect of high access charges. Note lastly that, although retail prices are always lower with two-part tariffs than with linear prices, since two-part tariffs eliminate or at least reduce the scope for double marginalization, equilibrium profits need not be lower than under uniform pricing: they are lower if the access charge is close to the level which sustains monopoly prices with uniform pricing competition, but higher otherwise.

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based on call termination

If networks are allowed to charge different on-net and off-net prices, they will do so since their perceived marginal costs are different for those two types of communications: an operator incurs the true marginal cost for on-net calls, but has to pay an access mark-up or subsidy on off-net calls. As a result, prices will be higher for off-net calls than for on-net calls, assuming for the purpose of the analysis that the access charge exceeds the marginal cost of access. Allowing for such termination-based discrimination does not however suffice to eliminate the already noted instability of price competition: high access charges still lead to high (off-net) prices in any shared-market equilibrium, which again creates an incentive to undercut the rival and corner the market; and cornered-market equilibria, as earlier, cannot be sustained. Whereas higher access charges clearly lead to higher off-net prices, the impact on on-net prices is a priori less obvious. First, note that the access revenue effect described above now primarily concerns off-net prices, and not on-net prices. Thus the access charge has no direct effect on the determination of on-net prices. However, since an increase in the access charge leads to higher off-net prices, it indirectly alters the first two effects, in a way that can be shown to lead to a decrease in on-net prices; an increase in the access charge may even lower the average price and the profits: 6 the wedge between on-net and ofS_net prices is detrimental to consumption eficiency, but may intensify competition, with ambiguous welfare effects. In particular, if the two networks are poor substitutes and if there is a mark-up on access, social welfare may be higher under price discrimination than under uniform pricing. Building on this analysis, we can now discuss the case where the operators are allowed both to offer two-part tariffs and to price discriminate according to where calls terminate. Marginal prices then reflect again marginal costs: the marginal price for on-net calls equals the true marginal cost, whereas the marginal price for off-net calls equals the perceived marginal cost, including the access mark-up. The presence of a mark-up in the access charge thus again imposes an inefficiency, since it creates a wedge between on-net and off-net marginal prices (note that this wedge is based on the difference between perceived marginal costs, not actual marginal costs). The analysis is otherwise similar to the case of two-part tariffs without price-discrimination: when setting the fixed fee, an operator takes into account the impact on its market-share and on the revenue generated from its customers but, since marginal prices include incurred access charges, it will not consider any impact on the access revenue (except, possibly, for the impact on relative market shares, which may affect how many calls it receives from the other network, but this does not appear in symmetric equilibria, where cross-networks

6font

et al. (1996b).

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et al. /European

calls again exactly balance). collusive device. 7 2.4. The detemination

Economic Review 41 (1997) 701-711

Hence again, the access charge cannot be used as an

of access charges

We have assumed so far that access charges were reciprocal (a, = a2) and exogenously given. We now analyze various ways to set those access charges. From a normative point of view, the best choice would consist in an access charge leading to retail prices equal to the Ramsey price, i.e., the lowest price that is compatible with the operators’ budget constraints. [Note that, in themselves, access charges only serve redistribution purposes and thus have no direct impact on total economic welfare. *I The socially optimal level of the access charge depends on the nature of retail competition: as already mentioned, under uniform pricing competition, the reciprocal access charge leading to the Ramsey prices is lower than the access cost c,,. In contrast, if the operators can discriminate among customers via, say, perfectly tailored two-part tariffs, then, since then marginal retail prices reflect marginal costs, it is socially optimal to set access charges equal to the access cost cO. These desirable levels for the access charges are likely to differ from those that the operators would like to choose. If the operators could agree on mutual access charges, then under uniform pricing competition (or provided that two-part tariffs and other non-linear retail pricing policies do not allow the operators to perfectly discriminate among their subscribers), the operators would incorporate a mark-up in their access charges, since higher access charges weaken retail competition and lead to higher retail prices (a high enough access charge even leads the ‘competing operators’ to set retail prices at the monopoly level). Note that if access charges are determined non cooperatively, the situation can get even worse, because of a standard double marginalization problem: each operator has an incentive to increase its access charge over the level that would sustain monopolistic retail prices, since it fails to take into account the resulting reduction in its rival’s profits. This double marginalization problem is clearest when the networks do not compete for market share, that is, when networks are very differentiated. But as substitution increases, and competition for customers exerts a downward pressure on the retail price, this competition may also induce networks to jack their access price up in order to force their rival to raise its retail price and lose market share. Lastly, let us briefly examine the implications of alternative regulatory interven-

’ A local increase of the access charge actually reduces equilibrium profits; see Laffont et al. (1996b). ’ In particular, in any symmetric equilibrium, each operator receives as much as it pays its rival, and the access revenue is zero as long as the access charges are reciprocal. Nevertheless, as stressed by the above analysis, the level of this reciprocal access charge still affects the competitive behavior of the operators, and thus has a real impact on economic welfare.

J.-J. Laffont et al. f

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tions such as the efficient component pricing rule (ECPR). This rule imposes a ceiling on the access price charged by a network to its competitors, that depends on the final price charged by the network on the competitive segment: the access price charged by the network should not exceed the network’s price on the competitive segment minus the network’s cost on that segment. In other words, the access charge should not exceed the opportunity cost for the network of losing a call on the retail segment. An alternative approach to ECPR is the ~imputation methodology’, according to which a bottleneck owner should be required to provide monopoly service elements at the price it imputes to its own competing services (subject to a budget constraint on the corn~~~ve segment to be interpreted as resulting from ‘accounting separation’), that is the difference between retail price and marginal cost on the retail segment (Hausman, 1994). ’ It should first be pointed out that ECPR has no obvious inte~retation in ‘two-way bottlenecks’ situations such as discussed here. In particular, while there is no difference between the opportunity cost and the imputation methodologies in the standard context in which they are applied (single bottleneck giving access to a potentially competitive segment), their philosophies and implications differ when applied to network competition. Also, the very notion of ‘bottleneck’ may vary according to whether an Ed post or an ex anfe perspective is adopted. Ex post, that is after consumers have joined a network, both the originating and terminating ends are bottlenecks; each is monopolized by a network and is essential to the completion of a call. Ex ante, that is before consumers have joined a network, the complementary segments are (imperfectly) competitive. It is thus not clear how ECPR is likely to be interpreted by regulators and courts in the context of network competition, and then investigate its impact on competition. lo A first inspection seems however to suggest that ECPR may soften price cu~~e~~~iun.Suppose first that the networks agree on an access price and then pick their retail prices subject to ECPR: then the networks can sustain monopoly prices by initially agreeing to a high access charge, namely, by choosing a mark-up in the access charge that exactly reflects the monopoly retail mark-up; in effect, ECPR

9 The Clear-T&corn decision of New Zealand’s highest court (the Privy Council of the House of Lords in London) provides a good example of the application of the ECPR. In its dispute with Clear Communications, New Zealand Telecom, the dominant operator, argued that it was entitled to recover its oddity cost when setting its intereonn~tion charge. While the Court of first hearing had ruled in favor of Telecom and the Court of Appeal in Clear’s favor, the Privy Council finally decided that the use of ECPR by Telecom was lawful under section 36 of the Commerce Act. This endorsement of BCPR by the Privy Council has been controversial, if only because the rule was designed to apply to a regulated environment (as William Baumol pointed out in testimonies), whereas little is known about the impact of ECPR in an industry where retail prices are not regulated. [See Laffont and Tirole (1994, 1996) for an assessment of the optimality of ECPR under retail price regulation, and Baumol et al. (19%) for a further discussion.] I0 See Laffont et al. (1996al for a detailed analysis of possible adaptations of the ECPR to the case of competing networks.

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then actually preuents the operators from lowering their prices below the monopoly level. In other words, in the case of an ex ante agreement, a high access charge is under ECPR a commitment to charge a high retail price. Suppose now that the two networks set their access and retail prices simul~eously. Then under ECPR, setting a high access charge requires setting a high retail price and therefore facing the prospect of a low market share. A network thus cannot undercut and gain market share without providing its competitor with a windfall gain on access.

3. Entry in network competition We now discuss the issue of entry in a transition period. As mentioned, the main concern here is that an already well-established network operator may be reluctant to provide potential entrants with access to its network at a reasonable price. To examine the setting and impact of access charges in such an immature phase of network competition, assume that there are two network operators, a wellestablished one, with full coverage, and another, the entrant, which has initially no coverage and must incur an investment cost related to the coverage it is planning to offer. It is well-known that a ‘large’ network has little incentive to make itself compatible with other smaller ones; similarly here, if the entrant’s coverage is small, the incum~nt network has an incentive to refuse interconnection, since in the absence of interconnection it can comer the market at a profitable price, maybe even at the monopoly price. Hence, if interconnection agreements are freely negotiated, the incumbent will then have an incentive to delay indefinitely the reach of an agreement. [On the other hand, if an agreement has to be reached, the entrant has an incentive to overinvest in coverage in order to reduce the incumbent pre-agreement profit and thus to reach a better deal.] Similarly, if interconnection is mandated but each operator is left free to set its access charge, the incumbent has an incentive to set its own access charge at a prohibitive level, as this constitutes a standard ‘raising rival’s cost’ strategy. This suggests that imposing reciprocity in the setting of access charges may be a particularly good idea when entry or coverage is at stake, that is, when the industry is still in an immature phase of network competition. However, reciprocity will not in general suffice to prevent entry deterrence. If for example the incumbent can discriminate between its monopoly territory and the competitive territory, it can still effectively block entry even under a reciprocity rule by insisting on a high access charge, and a high retail price for off-net communications. In effect, by discouraging its own subscribers to call the other network (a strategy the entrant cannot follow if its coverage is small), it avoids paying high access charges to its rival. Hence, even though formally the access charges are reciprocal, termination-based price discrimination allows the incumbent to block

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entry as effectively as if it could freely set its own access charge: a high access charge has basically the same impact as a lack of interconnection. A reciprocity rule for the access charge, coupled with a ban on termination-based discrimination, may still not suffice to generate the most desirable outcome: if the access charge is reciprocal, and the incumbent cannot price discriminate between its monopoly territory and the competitive territory, it is easy to check that the entrant has an incentive to under-invest in coverage (or other dimension of quality) in order to soften competition. The reason is that when the entrant has a small coverage, the incumbent has a large captive market, which induces him to maintain high prices. Hence, if a reciprocal access price is mandated, the entrant may not be handicapped by its smaller coverage but it may indeed elect to maintain a small coverage for strategic reasons. We conclude that the setting of a reciprocal access charge by an incumbent $rm can be a powelful instrument to blockade entry as long as entrants cannot quickly achieve a high coverage of the market.

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