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Integration and access regulations in telecommunications
Information Economics and Policy 15 (2003) 317–326 www.elsevier.com / locate / econbase
Integration and access regulations in telecommunications Huizhong Zhou* Department of Economics, Western Michigan University, Kalamazoo, MI 49008 -5023, USA Received July 2002
Abstract Competition in telecommunications is not only affected by the integration structure, but also by regulatory arrangements on access. We find that, under partial deregulation, where access is mandated but access rates are not regulated, the access charge and hence the price of long distance calls is lower when LECs are not integrated with IXCs than when they are integrated. However, under both complete deregulation and full regulation, competition in integration is more efficient than separation. Under all three regulation regimes, consumers are better off in integration than separation, while the firms are worse off. These results suggest that regulation on access should be formulated in conjunction with industrial or competition policy. They also indicate that a particular market structure may emerge endogenously under a given regulation regime. 2002 Elsevier B.V. All rights reserved. Keywords: Telecommunications; Access policy; Integration JEL Classification: K21; L51; L96
1. Introduction In a network economy such as telecommunications and electricity, an essential input, for example, local access in telecommunications, is often monopolized because of substantial economies of scale. In such an economy, whether or not the bottleneck provider is integrated into the downstream market will have different efficiency implications. Generally, when the bottleneck provider is prohibited from integration, there will be double marginalization unless the downstream market is *Tel.: 11-269-387-5550; fax: 11-269-387-5637. E-mail address: [email protected] (H. Zhou). 0167-6245 / 02 / $ – see front matter 2002 Elsevier B.V. All rights reserved. doi:10.1016 / S0167-6245(02)00113-0
318
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perfectly competitive. When the provider is allowed to integrate, there will be another source of inefficiency, namely monopoly leveraging (Whinston, 1990). Economides and Salop (1992) compare efficiency performance of various integration structures in a network economy where the two inputs are perfect complements. Complex integration structures have emerged and become important in industries that were previously regarded as natural monopolies as a result of deregulation, privatization and advancement of technologies. In telecommunications, for example, Bell Operating Companies in the US are now allowed to enter the long distance service, while major Inter-Exchange Carriers (IXCs) have merged with companies that have local access infrastructure, for example, AT&T with TCI and MediaOne. In the United Kingdom, the integrated British Telecom (BT) now faces competition in local access from cable TV companies and in long distance from Mercury, which relies mainly on BT’s local network for access. Thus, in telecommunications there are various market structures where both the essential input and downstream markets are oligopolistic and where competitors may or may not integrated. Cambini (2001) studies competition between vertically integrated and disintegrated networks in telecommunications. Competition outcomes in telecommunications are not only affected by integration structures, but also by regulation on access, which many believe is necessary in order to materialize network externalities under competition. As incumbents may refuse to provide access to rivals or may collude among themselves through interconnection agreements, some form of regulation should continue to play a role, even when competition emerges in the market (Laffont and Tirole, 2000). Therefore, performance of various integration structures should be evaluated under specific regulatory regimes. This short paper posits that a particular integration structure has different welfare implications under different regulatory regimes. Different regulation regimes place different constraints on firms’ decisions on access, they therefore behave differently even under the same market structure. We shall consider three regulatory regimes on access. Under one of them access charges are determined by the regulatory agency, which we call full regulation. This case reflects regulation in telecommunications in many countries. Another regime stipulates that incumbent local exchange carriers (LECs) must enter into access agreements with other telecommunications carriers and that access rates should be negotiated between the operators. This is called partial deregulation and can be viewed as a model envisaged by the US Telecommunications Act of 1996. Still another is complete deregulation, where provision of access as well as access charges is entirely carriers’ private decisions. New Zealand is in mind when one considers this case. We use Cambini’s (2001) model to evaluate welfare performance of different integration structures under the three regulatory regimes. We find that, under partial deregulation, the access charge and hence the price of long distance calls is lower in the separation structure, where LECs are not integrated with IXCs, than in integration, where they are integrated. However, under both
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complete deregulation and full regulation, competition in integration is more efficient than separation. Under all three regimes, consumers are better off in integration than separation, while the firms are worse off. That firms are more profitable in separation does not imply, however, that the separation structure will always emerge as a market equilibrium. These findings suggest that regulation on access should be formulated in conjunction with industrial or competition policy, and that regulation should take into consideration operators’ incentives to integrate or disintegrate and hence the impact on the market structure.
2. Integration under different regulation regimes
2.1. A brief description of the model Our analysis is built on Cambini’s model (2001), with a change of an equilibrium concept. Readers may refer to Cambini (2001) for details. There are 2 LECs and n22 IXCs, who may or may not integrate with the LECs. Local services from different providers are viewed as differentiated and the LECs compete in a Hotelling fashion. LEC i charges its subscribers a fixed fee Fi and collects p loc for each unit of local calls. In cases where access charges are not i regulated, it also sets the access rate a˜ i . The IXCs compete in a Cournot fashion and charge p ld k for each unit of long-distance calls. Subscribers cannot change networks once they have chosen an LEC, but may purchase long distance services from any IXCs. They have an identical quadratic utility function for the long distance calls, g Q 2 Q 2 / 2, where Q is the total calls consumed. We consider a symmetric case where carriers have the same constant marginal costs, i.e. c loc 5 2c 0 1 c 1 for local calls and c ld 5 c 0 1 c for long distance calls provided by an integrated carrier, where c 0 is the cost of initiating or terminating a call. The marginal cost of long distance calls supplied by a carrier k outside of the network i ˜ ˜ is c ld ki 5 a i 1 c, where a i is the one-way access fee charged by LEC i. Some results from Cambini (2001) that are used in this paper are presented in the Appendix A.
2.2. Partial deregulation of access Let us first consider a regime where provision of access is mandated yet access charges are privately negotiated. We call this regime partial deregulation to distinguish it from the one discussed later in which access is not mandated. Under this regime all independent IXCs have access to the LECs’ networks, and the prices and access charges are determined through market competition. It turns out that the equilibrium under this regime is the same one under what Cambini (2001) calls complete deregulation. This equilibrium cannot be characterized as one under complete deregulation, because, as we shall show later, the integrated networks will price squeeze independent IXCs out of the market if access is not mandated.
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From Cambini (2001), the equilibrium one-way access charge under integration is higher than non-integration, namely: 3sg 2 c 0 2 cd g 2 c0 2 c s a˜ * 5 c 0 1 ]]]] . c 0 1 ]]] 5 a˜ * n17 n12 Solving the Cournot models under integration and separation, given the access charges a and as a˜ s * , respectively, we find that: 4sg 2 c 0 2 cd 2sg 2 c 0 2 cd ld ld s s p (a˜ * ) 5 c 0 1 c 1 ]]]] . c 0 1 c 1 ]]]] 5 p (a˜ * ) n17 n12 It follows that each consumer makes less long-distance calls under integration than non-integration, that is, Q *i , Q si * . Since the price exceeds the marginal cost in oligopoly, a greater equilibrium quantity represents greater social welfare. Therefore, welfare under separation is higher than under integration, as the equilibrium quantities and the costs of local calls are the same in both cases. (A formal proof is presented in the Appendix A.) This result is different from Cambini (2001). In the course of a wide-ranging and stimulating analysis of integration and separation, Cambini (2001) mistakenly concluded that competition between integrated networks is Pareto superior to separation. The error stems from a combination of a failure to include the profits of the independent long-distance providers into welfare and miscalculations of the network’s profits and consumer surpluses. The profit earned by a long-distance operator k from subscribers in 2 2 network j (k ± j) is p ld under integration, which is kj 5sg 2 c 0 2 cd /(n 1 7) ld s 2 smaller than p kj 5sg 2 c 0 2 cd 2 /(n 1 2) under separation. Moreover, the profits of an integrated network i are 1 /(4s ) 1 p ijld , while those of a non-integrated LEC are s1 /(4s ). Thus the profits of an integrated network are smaller than 1 /(4s ) 1 p ld kj , the combined profits of an LEC and an IXC under separation. Therefore, the producers are worse off under integration. The consumer surplus, on the other hand, is higher under integration. The correct calculation is as follows. We denote CS and CS s the consumer surplus under integration and separation, respectively, then:
F
1 1 ld CS 5 v loc 1 ](Q *i )2 2 ] 2 p loc 1 f 2sa˜ * 2 c 0dsQ *i 2 q *ii d 2 p ld i ii 1 p ij 2 4s
G
and
F
G
1 1 CS s 5 v loc 1 ](Q si * )2 2 ] 2 p loc 1 f 2sa˜ s * 2 c 0d Q si * i 2 4s
where the first term in CS and CS s is the surplus from local calls, the second term, the surplus from long-distance calls, while the terms in the square brackets are the fixed fees paid by subscribers. Following the expressions that are listed in Appendix A, we have:
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321
1 ld CS 2 CS s 5 ]sQ *i d 2 1sa * 2 c 0dsQ *i 2 q *ii d 1 p ld ii 2 p ij 2 1 2 ]sQ si *d 2 1sa s * 2 c 0d Q si * 2 2 1 n 1 3 2 3(n 2 1) 4 5 ] ]] 1 ]]]2 1 ]] 2 n17 n17 (n 1 7)
F G S D FS D 1 2S]]D G(g 2 c 2 c) n17 2
2
0
F
S
1 n 2 ] ]] 2 n12
n D 1 ]]] sg 2 c 2 cd (n 1 2) G 2
2
2
0
4n 1 33 5 ]]]]]2 sg 2 c 0 2 cd 2 . 0 (n 1 2)(n 1 7) That separation is more efficient than integration under this partial regulation is because of monopoly leveraging on top of double marginalization under integration. Under the separation structure, monopolization of access causes only double marginalization. Under integration, while double marginalization is still in effect, the integrated monopoly has also an incentive to extend its market power to the downstream market so that it can have an advantage in competing with rivals. By raising the access charge from a˜ s * , the integrated network raises the costs of the outside long distance providers and reduces their output, which allows its own long distance operation to produce more and earn greater profits. Since separation is more profitable for the firms under the partial regulation, non-integrated LECs have little incentives to integrate forward. However, if LECs are integrated, as in many countries outside of the United States, the fact that the combined profits of a disintegrated network and its spun-off long-distance firm are greater than the profits of an integrated network does not imply that divesture of the long-distance operation will be an equilibrium strategy of integrated LECs. We shall show that, if an integrated network deviates unilaterally from the equilibrium in integration under mandatory access by spinning off its long-distance operation, it will lose market share to its integrated rival. Let i be the deviating (disintegrated) network and denote k the long-distance operator that is spun off from network i. The deviating network sets aˆ i as its access rate. As the quantities of local calls are the same in both networks as a result of the two-part tariff, we compare only welfare generated by the long-distance service. Welfare within network i is: 1 ˜ ˆ id 1 p ld Wi 5 ]fusQ isaˆ idd 1saˆ i 2 c 0d Q isaˆ id 1 p ld ki sa kj sa *dg 2 ld ˆ i ) 1 p kj where p ld (a˜ * ) is the profits that the spun-off firm can earn and hence ki (a
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the income that network i gets when selling it. Welfare generated by the long distance service in network j is: 1 ˜ ˆ id 1 p ld Wj 5 ]fusQ jsa˜ *dd 1sa˜ * 2 c 0dsQ jsa˜ *d 2 q jjsa˜ *dd 1 p ld ji sa jj sa *dg 2 where a˜ * is the equilibrium access rate under integration charged by the nondeviating network j. We claim that Wi can never be greater than Wj . An easier way of demonstrating this is to show that Wi 2 Wj is negative even if aˆ i maximizes Wi 2 Wj . To maximize Wi 2 Wj is equivalent to maximizing u(Q i (aˆ i )) 1 (aˆ i 2 ˆ i ) 5 p ld ˆ i ). The solution turns out to be a˜ s * , the equilibrium c 0 ) Q i (aˆ i ), as p ld ki (a ji (a access charge in the case of separation. Straightforward calculations, which is presented in the Appendix A, yield: 1 (4n 1 33)sg 2 c 0 2 cd 2 Wi 2 Wj 5 2 ] ]]]]]]] ,0 2 (n 1 2)(n 1 7)2 Therefore, network j is able to offer more surplus to its subscribers by charging a lower fixed fee than network i, and the deviating network i will end up losing market share and hence profits. This is because part of the increased welfare created by a lower access fee charged by the disintegrating network will be captured by the competing network j and other IXCs. The surpluses remaining within network i, including consumer surplus and the profits of the spun-off operator, will be smaller than the total surpluses enjoyed by a rival integrated network. Therefore, under partial regulation where access is mandated, disintegration is not likely to emerge as a market equilibrium if both networks are integrated.
2.3. Complete deregulation of access If access is completely deregulated, will an integrated LEC enter into access agreements with other long distance service providers? And will it have an incentive to merge with an IXC if an LEC is currently not integrated? We address the first question first. We shall show that, if access is not mandatory, accommodation of independent IXCs by providing access cannot be an equilibrium. For given that the other network j provides access to outside long distance operators, network i can mimic everything that takes place in network j except access. Instead, it refuses access and supplies all long distance calls to its subscribers. Thus everything will be the same except that network i will earn extra profits that go to independent IXCs in network j, which enables network i to lower its fixed fee and expand its market share. Actually, foreclosing the market and selling long distance calls at the marginal cost is a dominant strategy of an integrated network under complete deregulation. Given the market share of a particular integrated LEC i and any possible vertical structures and access and pricing strategies of its
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rivals, if LEC i refuses to provide access to other long-distance operators and offers long distance service to its subscribers by itself, all consumer and producer surpluses created are kept ‘within’ the network. Marginal cost pricing creates the largest possible total surpluses, which means, with a two-part tariff, LEC i gets the highest profits after giving a certain level of net surplus to its subscribers. Any strategies other than foreclosure and marginal pricing will generate less total surpluses in network i and hence less profits to LEC i after allowing for its subscribers the same level of net surplus, which is necessary for maintaining the market share. Following this argument, any network that fails to foreclose and offer long distance service by its integrated operator at the marginal cost will either earn lower profits or lose market share. Therefore, integration and foreclosure will emerge as a dominant strategy equilibrium under complete deregulation of access. Integration under complete deregulation of access, though resulting in exclusion, is more efficient than non-integration. Moreover, exclusion in this particular case is not in violation of anti-competition laws. Both the long distance and access prices are set at the marginal costs. Interestingly, this efficient outcome is a consequence of nonlinear pricing rather than existence of potential entrants, as contestable market arguments may suggest. Because of the two-part tariff and homogeneity of consumers, competition between the networks becomes a matter of maximization of the sum of consumer and producer surpluses, including total surpluses generated in the long distance market. Even though there were no potential entrants in the long distance market, the two networks would still set the prices at the marginal costs. Similarly due to the two-part tariff, foreclosure and marginal pricing becomes a dominant strategy of each network. Therefore there do not exist difficulties to commit a particular foreclosure strategy, as is found in the foreclosure literature (Ordover et al., 1992). Consumers gain most under complete deregulation of access. The integrated networks are worse off under complete deregulation than partial deregulation that mandates access. The integrated network’s profits are 1 /(4s ) under complete deregulation, while it can earn 1 /(4s ) 1 p ld kj when access is mandated, as we have shown earlier. Therefore, integrated networks may lobby for mandated access, which will enable them to commit to not engaging in fierce competition in the local exchange market.
2.4. Full regulation of access If the access charge is regulated and set above the marginal cost, then integration is socially preferred to separation. For under separation all long distance providers face the official access charge, while under integration, the integrated long distance operators face the lower actual marginal cost, resulting in higher total output. However, under full regulation the profits of an integrated LEC are lower than the combined profits of a non-integrated LEC and an independent
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IXC. Calculations similar to previous sections show that the profits of an o o integrated network are 1 /(4s ) 1 p ld kj (a ), where a is the official access rate, while s o the combined profits of a non-integrated LEC and an IXC are 1 /(4s ) 1 p ld kj (a ). ld o ld s o Now p kj (a ) , p kj (a ), because the integrated long-distance operator produces more than the independent operators, resulting in lower profits for the independent operators in integration than in separation. Therefore, if separation is the status quo, the more efficient outcome of integration is not likely to emerge as a result of market competition.
3. Conclusions We’ve found that competition in integration where the local access providers also compete in the long distance market is more efficient than competition in separation under both complete deregulation and full regulation of access, but less efficient under partial deregulation where access is mandated. In the latter case integration is less efficient because the integrated networks exercise monopoly leveraging in addition to monopoly pricing of its essential input. Under all three regulation regimes, consumers are better off under integration than separation, while producers are worse off. In competing for market shares, the networks are compelled to reduce the fixed fees, conceding more profits to their subscribers. As the integrated networks also earn profits from providing long distance service to their own subscribers, they have stronger incentives to compete for market shares. But then fierce competition for market shares in integration ends up giving more surpluses to subscribers. The findings that welfare implications of integration and network’s incentives to integrate or disintegrate are different under various regulation regimes suggest that industrial and competition policy should be consider together with regulatory arrangements. They also indicate that a particular market structure may emerge endogenously under a given regulation regime.
Appendix A We first list some results derived from Cambini’s (2001) model, which will help readers go through calculations presented in the text and Appendix A. We denote D ; g 2 c 0 2 c for ease of expression. n13 Q j (a˜ * ) 5 ]] D n17 n Q i (a˜ s * ) 5 ]] D n12
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S D 4D (a˜ * ) 5S]]D n17 D D sa˜ d 5S]] n12
D ˜ p ld kj (a * ) 5 ]] n17
325
2
2
p ld jj p ld kj
s
s*
2
1 a˜ s * 2 c 0 5 ]] D n12 3 a˜ * 2 c 0 5 ]] D n17 n21 Q j (a˜ * ) 2 q jj (a˜ * ) 5 ]] D n17 A.1. Welfare comparison between integration and separation under partial deregulation Under integration there are two integrated networks, each of which earns ld 1 /(4s ) 1 p ld ij , and n 2 2 independent long-distance firms, each of which earns p ij . Under separation each of the two networks earns 1 /(4s ), while each of the n s independent long-distance firms earns p ld . Therefore the difference in profits is: ij s
ld DP 5 nsp ld ij 2 p ij d
F
D2 D2 5 n ]]]2 2 ]]]2 (n 1 7) (n 1 2)
G
5n(2n 1 9) 5 2 ]]]]] D2 (n 1 2)2 (n 1 7)2 Adding up the change in consumer surplus that we derived in the text and DP, we have: (n 1 2)(4n 1 33) 2 5n(2n 1 9) 2 2(n 2 3)(3n 1 11) 2 ]]]]]]]]] D 5 2 ]]]]] D ,0 2 2 (n 1 2) (n 1 7) (n 1 2)2 (n 1 7)2 A.2. Calculation of Wi 2 Wj Dropping off D 2 , the difference Wi 2 Wj has the same sign as essentially reduced to
S
S
D
2 1 n 1 n 1 ] ]] 1 ]] ? ]] 1 ]] 2 n12 n12 n12 n17 2 3 n21 4 2 ]] ? ]] 2 ]] , n17 n17 n17
S
D
n13 D 2 ]12 S]] D n17 2
2
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326
which is essentially reduced to 1 1 ] n 2 (n 1 7)2 1 n(n 1 7) 1 (n 1 2)2 2 ](n 1 3)2 (n 1 2)2 2 2 2 3(n 2 1)(n 1 2)2 2 16(n 1 2)2 5 2 4n 2 2 41n 2 66 5 2 (n 1 2)(4n 1 33)
References Cambini, C., 2001. Competition between vertically integrated networks. Information Economics and Policy 13 (2), 137–165. Economides, N., Salop, S.C., 1992. Competition and integration among complements, and network market structure. Journal of Industrial Economics 40 (1), 105–123. Laffont, J.-J., Tirole, J., 2000. Competition in Telecommunications. MIT Press, Cambridge, MA. Ordover, J., Saloner, G., Salop, S., 1992. Equilibrium vertical foreclosure: Reply. American Economic Review 82 (3), 698–703. Whinston, M., 1990. Tying, foreclosure, and exclusion. American Economic Review 80 (4), 837–859.
Integration and access regulations in telecommunications Huizhong Zhou* Department of Economics, Western Michigan University, Kalamazoo, MI 49008 -5023, USA Received July 2002
Abstract Competition in telecommunications is not only affected by the integration structure, but also by regulatory arrangements on access. We find that, under partial deregulation, where access is mandated but access rates are not regulated, the access charge and hence the price of long distance calls is lower when LECs are not integrated with IXCs than when they are integrated. However, under both complete deregulation and full regulation, competition in integration is more efficient than separation. Under all three regulation regimes, consumers are better off in integration than separation, while the firms are worse off. These results suggest that regulation on access should be formulated in conjunction with industrial or competition policy. They also indicate that a particular market structure may emerge endogenously under a given regulation regime. 2002 Elsevier B.V. All rights reserved. Keywords: Telecommunications; Access policy; Integration JEL Classification: K21; L51; L96
1. Introduction In a network economy such as telecommunications and electricity, an essential input, for example, local access in telecommunications, is often monopolized because of substantial economies of scale. In such an economy, whether or not the bottleneck provider is integrated into the downstream market will have different efficiency implications. Generally, when the bottleneck provider is prohibited from integration, there will be double marginalization unless the downstream market is *Tel.: 11-269-387-5550; fax: 11-269-387-5637. E-mail address: [email protected] (H. Zhou). 0167-6245 / 02 / $ – see front matter 2002 Elsevier B.V. All rights reserved. doi:10.1016 / S0167-6245(02)00113-0
318
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perfectly competitive. When the provider is allowed to integrate, there will be another source of inefficiency, namely monopoly leveraging (Whinston, 1990). Economides and Salop (1992) compare efficiency performance of various integration structures in a network economy where the two inputs are perfect complements. Complex integration structures have emerged and become important in industries that were previously regarded as natural monopolies as a result of deregulation, privatization and advancement of technologies. In telecommunications, for example, Bell Operating Companies in the US are now allowed to enter the long distance service, while major Inter-Exchange Carriers (IXCs) have merged with companies that have local access infrastructure, for example, AT&T with TCI and MediaOne. In the United Kingdom, the integrated British Telecom (BT) now faces competition in local access from cable TV companies and in long distance from Mercury, which relies mainly on BT’s local network for access. Thus, in telecommunications there are various market structures where both the essential input and downstream markets are oligopolistic and where competitors may or may not integrated. Cambini (2001) studies competition between vertically integrated and disintegrated networks in telecommunications. Competition outcomes in telecommunications are not only affected by integration structures, but also by regulation on access, which many believe is necessary in order to materialize network externalities under competition. As incumbents may refuse to provide access to rivals or may collude among themselves through interconnection agreements, some form of regulation should continue to play a role, even when competition emerges in the market (Laffont and Tirole, 2000). Therefore, performance of various integration structures should be evaluated under specific regulatory regimes. This short paper posits that a particular integration structure has different welfare implications under different regulatory regimes. Different regulation regimes place different constraints on firms’ decisions on access, they therefore behave differently even under the same market structure. We shall consider three regulatory regimes on access. Under one of them access charges are determined by the regulatory agency, which we call full regulation. This case reflects regulation in telecommunications in many countries. Another regime stipulates that incumbent local exchange carriers (LECs) must enter into access agreements with other telecommunications carriers and that access rates should be negotiated between the operators. This is called partial deregulation and can be viewed as a model envisaged by the US Telecommunications Act of 1996. Still another is complete deregulation, where provision of access as well as access charges is entirely carriers’ private decisions. New Zealand is in mind when one considers this case. We use Cambini’s (2001) model to evaluate welfare performance of different integration structures under the three regulatory regimes. We find that, under partial deregulation, the access charge and hence the price of long distance calls is lower in the separation structure, where LECs are not integrated with IXCs, than in integration, where they are integrated. However, under both
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complete deregulation and full regulation, competition in integration is more efficient than separation. Under all three regimes, consumers are better off in integration than separation, while the firms are worse off. That firms are more profitable in separation does not imply, however, that the separation structure will always emerge as a market equilibrium. These findings suggest that regulation on access should be formulated in conjunction with industrial or competition policy, and that regulation should take into consideration operators’ incentives to integrate or disintegrate and hence the impact on the market structure.
2. Integration under different regulation regimes
2.1. A brief description of the model Our analysis is built on Cambini’s model (2001), with a change of an equilibrium concept. Readers may refer to Cambini (2001) for details. There are 2 LECs and n22 IXCs, who may or may not integrate with the LECs. Local services from different providers are viewed as differentiated and the LECs compete in a Hotelling fashion. LEC i charges its subscribers a fixed fee Fi and collects p loc for each unit of local calls. In cases where access charges are not i regulated, it also sets the access rate a˜ i . The IXCs compete in a Cournot fashion and charge p ld k for each unit of long-distance calls. Subscribers cannot change networks once they have chosen an LEC, but may purchase long distance services from any IXCs. They have an identical quadratic utility function for the long distance calls, g Q 2 Q 2 / 2, where Q is the total calls consumed. We consider a symmetric case where carriers have the same constant marginal costs, i.e. c loc 5 2c 0 1 c 1 for local calls and c ld 5 c 0 1 c for long distance calls provided by an integrated carrier, where c 0 is the cost of initiating or terminating a call. The marginal cost of long distance calls supplied by a carrier k outside of the network i ˜ ˜ is c ld ki 5 a i 1 c, where a i is the one-way access fee charged by LEC i. Some results from Cambini (2001) that are used in this paper are presented in the Appendix A.
2.2. Partial deregulation of access Let us first consider a regime where provision of access is mandated yet access charges are privately negotiated. We call this regime partial deregulation to distinguish it from the one discussed later in which access is not mandated. Under this regime all independent IXCs have access to the LECs’ networks, and the prices and access charges are determined through market competition. It turns out that the equilibrium under this regime is the same one under what Cambini (2001) calls complete deregulation. This equilibrium cannot be characterized as one under complete deregulation, because, as we shall show later, the integrated networks will price squeeze independent IXCs out of the market if access is not mandated.
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From Cambini (2001), the equilibrium one-way access charge under integration is higher than non-integration, namely: 3sg 2 c 0 2 cd g 2 c0 2 c s a˜ * 5 c 0 1 ]]]] . c 0 1 ]]] 5 a˜ * n17 n12 Solving the Cournot models under integration and separation, given the access charges a and as a˜ s * , respectively, we find that: 4sg 2 c 0 2 cd 2sg 2 c 0 2 cd ld ld s s p (a˜ * ) 5 c 0 1 c 1 ]]]] . c 0 1 c 1 ]]]] 5 p (a˜ * ) n17 n12 It follows that each consumer makes less long-distance calls under integration than non-integration, that is, Q *i , Q si * . Since the price exceeds the marginal cost in oligopoly, a greater equilibrium quantity represents greater social welfare. Therefore, welfare under separation is higher than under integration, as the equilibrium quantities and the costs of local calls are the same in both cases. (A formal proof is presented in the Appendix A.) This result is different from Cambini (2001). In the course of a wide-ranging and stimulating analysis of integration and separation, Cambini (2001) mistakenly concluded that competition between integrated networks is Pareto superior to separation. The error stems from a combination of a failure to include the profits of the independent long-distance providers into welfare and miscalculations of the network’s profits and consumer surpluses. The profit earned by a long-distance operator k from subscribers in 2 2 network j (k ± j) is p ld under integration, which is kj 5sg 2 c 0 2 cd /(n 1 7) ld s 2 smaller than p kj 5sg 2 c 0 2 cd 2 /(n 1 2) under separation. Moreover, the profits of an integrated network i are 1 /(4s ) 1 p ijld , while those of a non-integrated LEC are s1 /(4s ). Thus the profits of an integrated network are smaller than 1 /(4s ) 1 p ld kj , the combined profits of an LEC and an IXC under separation. Therefore, the producers are worse off under integration. The consumer surplus, on the other hand, is higher under integration. The correct calculation is as follows. We denote CS and CS s the consumer surplus under integration and separation, respectively, then:
F
1 1 ld CS 5 v loc 1 ](Q *i )2 2 ] 2 p loc 1 f 2sa˜ * 2 c 0dsQ *i 2 q *ii d 2 p ld i ii 1 p ij 2 4s
G
and
F
G
1 1 CS s 5 v loc 1 ](Q si * )2 2 ] 2 p loc 1 f 2sa˜ s * 2 c 0d Q si * i 2 4s
where the first term in CS and CS s is the surplus from local calls, the second term, the surplus from long-distance calls, while the terms in the square brackets are the fixed fees paid by subscribers. Following the expressions that are listed in Appendix A, we have:
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321
1 ld CS 2 CS s 5 ]sQ *i d 2 1sa * 2 c 0dsQ *i 2 q *ii d 1 p ld ii 2 p ij 2 1 2 ]sQ si *d 2 1sa s * 2 c 0d Q si * 2 2 1 n 1 3 2 3(n 2 1) 4 5 ] ]] 1 ]]]2 1 ]] 2 n17 n17 (n 1 7)
F G S D FS D 1 2S]]D G(g 2 c 2 c) n17 2
2
0
F
S
1 n 2 ] ]] 2 n12
n D 1 ]]] sg 2 c 2 cd (n 1 2) G 2
2
2
0
4n 1 33 5 ]]]]]2 sg 2 c 0 2 cd 2 . 0 (n 1 2)(n 1 7) That separation is more efficient than integration under this partial regulation is because of monopoly leveraging on top of double marginalization under integration. Under the separation structure, monopolization of access causes only double marginalization. Under integration, while double marginalization is still in effect, the integrated monopoly has also an incentive to extend its market power to the downstream market so that it can have an advantage in competing with rivals. By raising the access charge from a˜ s * , the integrated network raises the costs of the outside long distance providers and reduces their output, which allows its own long distance operation to produce more and earn greater profits. Since separation is more profitable for the firms under the partial regulation, non-integrated LECs have little incentives to integrate forward. However, if LECs are integrated, as in many countries outside of the United States, the fact that the combined profits of a disintegrated network and its spun-off long-distance firm are greater than the profits of an integrated network does not imply that divesture of the long-distance operation will be an equilibrium strategy of integrated LECs. We shall show that, if an integrated network deviates unilaterally from the equilibrium in integration under mandatory access by spinning off its long-distance operation, it will lose market share to its integrated rival. Let i be the deviating (disintegrated) network and denote k the long-distance operator that is spun off from network i. The deviating network sets aˆ i as its access rate. As the quantities of local calls are the same in both networks as a result of the two-part tariff, we compare only welfare generated by the long-distance service. Welfare within network i is: 1 ˜ ˆ id 1 p ld Wi 5 ]fusQ isaˆ idd 1saˆ i 2 c 0d Q isaˆ id 1 p ld ki sa kj sa *dg 2 ld ˆ i ) 1 p kj where p ld (a˜ * ) is the profits that the spun-off firm can earn and hence ki (a
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the income that network i gets when selling it. Welfare generated by the long distance service in network j is: 1 ˜ ˆ id 1 p ld Wj 5 ]fusQ jsa˜ *dd 1sa˜ * 2 c 0dsQ jsa˜ *d 2 q jjsa˜ *dd 1 p ld ji sa jj sa *dg 2 where a˜ * is the equilibrium access rate under integration charged by the nondeviating network j. We claim that Wi can never be greater than Wj . An easier way of demonstrating this is to show that Wi 2 Wj is negative even if aˆ i maximizes Wi 2 Wj . To maximize Wi 2 Wj is equivalent to maximizing u(Q i (aˆ i )) 1 (aˆ i 2 ˆ i ) 5 p ld ˆ i ). The solution turns out to be a˜ s * , the equilibrium c 0 ) Q i (aˆ i ), as p ld ki (a ji (a access charge in the case of separation. Straightforward calculations, which is presented in the Appendix A, yield: 1 (4n 1 33)sg 2 c 0 2 cd 2 Wi 2 Wj 5 2 ] ]]]]]]] ,0 2 (n 1 2)(n 1 7)2 Therefore, network j is able to offer more surplus to its subscribers by charging a lower fixed fee than network i, and the deviating network i will end up losing market share and hence profits. This is because part of the increased welfare created by a lower access fee charged by the disintegrating network will be captured by the competing network j and other IXCs. The surpluses remaining within network i, including consumer surplus and the profits of the spun-off operator, will be smaller than the total surpluses enjoyed by a rival integrated network. Therefore, under partial regulation where access is mandated, disintegration is not likely to emerge as a market equilibrium if both networks are integrated.
2.3. Complete deregulation of access If access is completely deregulated, will an integrated LEC enter into access agreements with other long distance service providers? And will it have an incentive to merge with an IXC if an LEC is currently not integrated? We address the first question first. We shall show that, if access is not mandatory, accommodation of independent IXCs by providing access cannot be an equilibrium. For given that the other network j provides access to outside long distance operators, network i can mimic everything that takes place in network j except access. Instead, it refuses access and supplies all long distance calls to its subscribers. Thus everything will be the same except that network i will earn extra profits that go to independent IXCs in network j, which enables network i to lower its fixed fee and expand its market share. Actually, foreclosing the market and selling long distance calls at the marginal cost is a dominant strategy of an integrated network under complete deregulation. Given the market share of a particular integrated LEC i and any possible vertical structures and access and pricing strategies of its
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rivals, if LEC i refuses to provide access to other long-distance operators and offers long distance service to its subscribers by itself, all consumer and producer surpluses created are kept ‘within’ the network. Marginal cost pricing creates the largest possible total surpluses, which means, with a two-part tariff, LEC i gets the highest profits after giving a certain level of net surplus to its subscribers. Any strategies other than foreclosure and marginal pricing will generate less total surpluses in network i and hence less profits to LEC i after allowing for its subscribers the same level of net surplus, which is necessary for maintaining the market share. Following this argument, any network that fails to foreclose and offer long distance service by its integrated operator at the marginal cost will either earn lower profits or lose market share. Therefore, integration and foreclosure will emerge as a dominant strategy equilibrium under complete deregulation of access. Integration under complete deregulation of access, though resulting in exclusion, is more efficient than non-integration. Moreover, exclusion in this particular case is not in violation of anti-competition laws. Both the long distance and access prices are set at the marginal costs. Interestingly, this efficient outcome is a consequence of nonlinear pricing rather than existence of potential entrants, as contestable market arguments may suggest. Because of the two-part tariff and homogeneity of consumers, competition between the networks becomes a matter of maximization of the sum of consumer and producer surpluses, including total surpluses generated in the long distance market. Even though there were no potential entrants in the long distance market, the two networks would still set the prices at the marginal costs. Similarly due to the two-part tariff, foreclosure and marginal pricing becomes a dominant strategy of each network. Therefore there do not exist difficulties to commit a particular foreclosure strategy, as is found in the foreclosure literature (Ordover et al., 1992). Consumers gain most under complete deregulation of access. The integrated networks are worse off under complete deregulation than partial deregulation that mandates access. The integrated network’s profits are 1 /(4s ) under complete deregulation, while it can earn 1 /(4s ) 1 p ld kj when access is mandated, as we have shown earlier. Therefore, integrated networks may lobby for mandated access, which will enable them to commit to not engaging in fierce competition in the local exchange market.
2.4. Full regulation of access If the access charge is regulated and set above the marginal cost, then integration is socially preferred to separation. For under separation all long distance providers face the official access charge, while under integration, the integrated long distance operators face the lower actual marginal cost, resulting in higher total output. However, under full regulation the profits of an integrated LEC are lower than the combined profits of a non-integrated LEC and an independent
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IXC. Calculations similar to previous sections show that the profits of an o o integrated network are 1 /(4s ) 1 p ld kj (a ), where a is the official access rate, while s o the combined profits of a non-integrated LEC and an IXC are 1 /(4s ) 1 p ld kj (a ). ld o ld s o Now p kj (a ) , p kj (a ), because the integrated long-distance operator produces more than the independent operators, resulting in lower profits for the independent operators in integration than in separation. Therefore, if separation is the status quo, the more efficient outcome of integration is not likely to emerge as a result of market competition.
3. Conclusions We’ve found that competition in integration where the local access providers also compete in the long distance market is more efficient than competition in separation under both complete deregulation and full regulation of access, but less efficient under partial deregulation where access is mandated. In the latter case integration is less efficient because the integrated networks exercise monopoly leveraging in addition to monopoly pricing of its essential input. Under all three regulation regimes, consumers are better off under integration than separation, while producers are worse off. In competing for market shares, the networks are compelled to reduce the fixed fees, conceding more profits to their subscribers. As the integrated networks also earn profits from providing long distance service to their own subscribers, they have stronger incentives to compete for market shares. But then fierce competition for market shares in integration ends up giving more surpluses to subscribers. The findings that welfare implications of integration and network’s incentives to integrate or disintegrate are different under various regulation regimes suggest that industrial and competition policy should be consider together with regulatory arrangements. They also indicate that a particular market structure may emerge endogenously under a given regulation regime.
Appendix A We first list some results derived from Cambini’s (2001) model, which will help readers go through calculations presented in the text and Appendix A. We denote D ; g 2 c 0 2 c for ease of expression. n13 Q j (a˜ * ) 5 ]] D n17 n Q i (a˜ s * ) 5 ]] D n12
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S D 4D (a˜ * ) 5S]]D n17 D D sa˜ d 5S]] n12
D ˜ p ld kj (a * ) 5 ]] n17
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2
2
p ld jj p ld kj
s
s*
2
1 a˜ s * 2 c 0 5 ]] D n12 3 a˜ * 2 c 0 5 ]] D n17 n21 Q j (a˜ * ) 2 q jj (a˜ * ) 5 ]] D n17 A.1. Welfare comparison between integration and separation under partial deregulation Under integration there are two integrated networks, each of which earns ld 1 /(4s ) 1 p ld ij , and n 2 2 independent long-distance firms, each of which earns p ij . Under separation each of the two networks earns 1 /(4s ), while each of the n s independent long-distance firms earns p ld . Therefore the difference in profits is: ij s
ld DP 5 nsp ld ij 2 p ij d
F
D2 D2 5 n ]]]2 2 ]]]2 (n 1 7) (n 1 2)
G
5n(2n 1 9) 5 2 ]]]]] D2 (n 1 2)2 (n 1 7)2 Adding up the change in consumer surplus that we derived in the text and DP, we have: (n 1 2)(4n 1 33) 2 5n(2n 1 9) 2 2(n 2 3)(3n 1 11) 2 ]]]]]]]]] D 5 2 ]]]]] D ,0 2 2 (n 1 2) (n 1 7) (n 1 2)2 (n 1 7)2 A.2. Calculation of Wi 2 Wj Dropping off D 2 , the difference Wi 2 Wj has the same sign as essentially reduced to
S
S
D
2 1 n 1 n 1 ] ]] 1 ]] ? ]] 1 ]] 2 n12 n12 n12 n17 2 3 n21 4 2 ]] ? ]] 2 ]] , n17 n17 n17
S
D
n13 D 2 ]12 S]] D n17 2
2
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which is essentially reduced to 1 1 ] n 2 (n 1 7)2 1 n(n 1 7) 1 (n 1 2)2 2 ](n 1 3)2 (n 1 2)2 2 2 2 3(n 2 1)(n 1 2)2 2 16(n 1 2)2 5 2 4n 2 2 41n 2 66 5 2 (n 1 2)(4n 1 33)
References Cambini, C., 2001. Competition between vertically integrated networks. Information Economics and Policy 13 (2), 137–165. Economides, N., Salop, S.C., 1992. Competition and integration among complements, and network market structure. Journal of Industrial Economics 40 (1), 105–123. Laffont, J.-J., Tirole, J., 2000. Competition in Telecommunications. MIT Press, Cambridge, MA. Ordover, J., Saloner, G., Salop, S., 1992. Equilibrium vertical foreclosure: Reply. American Economic Review 82 (3), 698–703. Whinston, M., 1990. Tying, foreclosure, and exclusion. American Economic Review 80 (4), 837–859.