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Market-oriented open network provision
INFORMATION ECONOMICS AND POLICY
ELSEVIER
Information Economics and Policy 7 (1995) 283-296
Market-oriented open network provision C h a r l e s B. B l a n k a r t ~*, G / i n t e r K n i e p s b
~'lnstitut f iir 6ffentliche Wirtschaft und Wirtschaftspolitik, Humboldt-Universitdt zu Berlin, Spandauer Strafle 1. D-10178 Berlin, Germany hlnstitut f iir Verkehrswissenschaft und Regionalpolitik, Albert-Ludwigs-Universi#it Freiburg, Europaplatz 1. D- 79085 Freiburg, Germany Received 12 December 1994; accepted 19 May 1995
Abstract Network externalities and market power due to economies of scale and sunk costs may cause a public demand for standardization of network access. There is, however, no guarantee that public institutions supplying standardization are interested in correctly matching this demand. Often it comes to overstandardization. The authors argue therefore that standards for standard setters are required and they show how such standards could be designed.
Key words: Open network provision; Network access; Standardization policies J E L Classification: L51; L96
1. Free trade in services F r e e t r a d e in services b e t w e e n E U m e m b e r c o u n t r i e s is o n e of the c e n t r a l p o s t u l a t e s of the T r e a t y of R o m e of 1957 and its follower the T r e a t y of M a a s t r i c h t of 1992. A service supplier must be e n t i t l e d to m o v e from m e m b e r state A to m e m b e r state B to provide a service, or a service d e m a n d e r located in m e m b e r state B must be allowed to c o n s u m e a service in m e m b e r state A a n d vice versa. For m a n y services, h o w e v e r , such a c h a n g e in location is not necessary since they can be supplied in the o t h e r * Corresponding author. Tel. 030-2468-271, fax 030-2468-297. The authors are indebted to two anonymous referees and to their colleagues Pio Baake and Bernhard Wieland for helpful comments. 0167-6245/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved S S D I 0167-6245(95)00006-2
284 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 country by use o f networks. Hence networks are of utmost importance for the freedom of trade in services. With network services we mean markets such as rail transport, air transport, road transport, electricity, gas, telecommunications and postal services. Some of these services have become tradeable to some extent across national borders in recent years. International courier services compete with public post offices and with private remailers on the international level. Similarly, telecommunications services are provided internationally by private and public companies, although the physical backbones are mostly still owned and operated by national telecommunications monopolies. But in other network services international competition is still small or negligible. In railroads, e.g., French TGV-trains must not run on German rails and G e r m a n ICE-trains are not allowed to provide services on their own account on the French rail network. Such international trade is often inhibited under the pretext of incompatibility o f technical standards. ICE trains allegedly cannot run into main terminals in France because of their size. T h e r e are two ways to interpret such network incompatibilities. The first is that standards emerging from decentralized action are voluntary, accidental and therefore incompatible. The other is that in a decentralized system of decision making standards are deliberately chosen to forestall competition. Each actor tries to enforce its exclusive standard in order to prevent through-traffic by third parties and to force network users to enter into a new contractual arrangement when passing from one network to the other. Both hypotheses suggest government intervention. The first leads to the conclusion that standards should be mandatory instead of voluntary. The second wants standards to be open instead of exclusive. In terms of policies, the first requires more co-ordination and the second more control of market power. We shall see below that these two issues are the main determinants of the demand for public standardization policy. They have to be confronted with the supply of public standardization. Standards are produced by institutions such as markets, committees, or public authorities working according to their particular rules. It is therefore not evident whether and how far they tend to match the demand for standardization. If standardization is for example trusted to bureaucracies, it may very well end in an overstandardization (see e.g. Blankart and Knieps, 1993a, p. 46). We want to show, therefore, that the supply side of standardization must not be overlooked. As a first step in this direction we propose standards for standard setters. These rules should not prescribe positively how to set standards and hence merely raise the additional question of who controls the standard setters of the standard setters. We rather think of negative rules limiting the field of activities of standard setters.
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In Section 2 we shall analyze the market for network access rights and the incentives to trade such rights. Section 3 gives a closer examination of this market and indicates potential fields for a public standardization policy. A dynamic view of the public standardization problem is given in Section 4. Section 6 confronts these findings with actual network regulation in the E U and Section 5 concludes with an outlook on the E U concept of Open Network Provision (ONP).
2. The market for network access rights
International trade in network services requires the interconnection and interoperability of the underlying network structures. This can be done by markets, committees, or by government intervention. Before recurring to the latter two we should first inquire how far the former are able to solve the problems of interconnection and interoperability. A pragmatic point of departure is that network access represents (at least potentially) a private property. The owner has the right to exclude 'trespassers'. Both private property and exclusion principle are good preconditions for the market to work. Individuals can engage in trade for network access rights. Two main motives may promote trade: complementarity and reciprocity. If a supplier can extend his services from his own into another network by interconnection, he and the network provider both benefit from complementarity. Reciprocity arises when two owners of network structures open their networks mutually so that the effects of complementarity accrue to both. In spite of these incentives to engage in trade there are also obstacles preventing market participants (firms or consumers) from trade. On the d e m a n d side network externalities may lead participants to cluster on different network islands with different network technologies. Network externalities arise whenever the utility U~ of a network user not only depends on the technology T of the network, but also on the number of its users S, where Ui(S, T) < Ui(S', T)
for S < S'. From this inequality, one is inclined to infer that all individuals tend towards the same technology. This should be especially the case if preferences for various technologies are absent. If, however, there is for example incomplete information on the preferences for technologies among individuals, i.e. individuals do not have as common knowledge that the adoption of a technology is also beneficial for the other individuals given that all are switching, clustering on different network islands may occur. The
286 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 m a r k e t m a y therefore be unable to fulfil its co-ordination function, especially if a larger n u m b e r of participants is involved 1. Difficulties with trade in network services may also arise from the supply side o f the market. Often network services exhibit economies of scale. M o r e services can be produced at lower costs. Hence we expect m a r k e t power, in particular if networks are established under sunk costs. I n d e e d network externalities and economies of scale are the basic reasons behind the m a r k e t imperfections described at the outset of this p a p e r (insufficient co-ordination and market power). They are also implicitly shared by the E U authorities pleading for an active policy of O N P (see e.g. E u r o p e a n Commission, 1994, pp. 67-68). In the next section we shall, however, show that they are not sufficient for justifying g o v e r n m e n t intervention in networks generally. We shall draw 'scenarios' where neither the co-ordination problem nor the m a r k e t power problem will arise and where standardization by governments such as the application of O N P regulations are unnecessary. In other scenarios only the co-ordination p r o b l e m will occur, and standardization may be agreed upon in committees or other non-profit institutions. Scenarios suggesting government intervention, in contrast, are those where market power can be exerted due to economies of scale in combination with sunk costs.
3. Configurations relevant to market-oriented ONP regulation O u r argument is the following: We assume that the cost function of a d e m a n d e r or supplier in a network m a r k e t can have one of three different forms. 1. It may be characterized by constant costs in which case m a n y d e m a n d e r s or m a n y suppliers or both will appear on the market. This is the competitive case (c). 2. Often, however, networks will be characterized by decreasing costs. In this case only one firm will survive on either the d e m a n d or supply side or on both sides. But as long as entry and exit are costless, the m a r k e t remains contestable. We have the case of a contestable natural monopoly (cm) which is unable to earn any m o n o p o l y rents. Such a m o n o p o l y may result out of m a r k e t process or out of a perfect bidding procedure. 3. W h e n decreasing costs arise in combination with sunk costs so that entry and in particular exit are not free, the morphology of the market will The market endogenous creation of gateways may reduce the problem of incompatibility (see e.g. David and Bunn, 1988). Nevertheless, the problem of network externalities continues to exist and hence not enough gateways may he supplied in a competitive decentralized market economy (see Blankart and Knieps, 1993b, p. 47).
C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 287 be the same as in 2 with a m o n o p o l y either on one or on both sides of the market. But it is a non-contestable natural monopoly (ncm) which may exert m a r k e t power. Given these three different forms of the cost functions and degrees of contestability, we can distinguish a m o n g nine different configurations on the supply and on the d e m a n d side as shown in the matrix in Fig. 1. Of course the empirical relevance of these different configurations may vary 2.
3.1. 7"he competitive case (c, c) In the competitive case (c, c) many demanders will be confronted with m a n y suppliers. While such a configuration may generate efficient trades if applied to normal goods, it may lead to difficulties if applied to networks. D u e to network externalities, there is a tendency for market participants to cluster a m o n g a few standards. In particular, they will be hesitant to adopt new technologies, because they fear that the other market participants will not follow. The m a r k e t may not fulfil its co-ordination function unless the firms happen to choose the same standards spontaneously (see Berg, 1989, p. 363). Such problems may arise in the market for value added network services (VANS) of telecommunications with its many different suppliers.
demand
side
(c, e)
~,cm)
(c, ncm)
(cm, c)
(cm, cm)
(cm, ncm)
(ncm, c)
(ncm, cm)
(ncm, ncm)
Fig. 1. 2The reader may notice that the oligopoly case with few demanders and/or suppliers is missing here. This is because we focus on market entry and its possible obstacles generated by networks with sunk costs.
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3.2. The contestable cases (c, cm), (cm, c), (cm, cm) Consider now the cases where one m a r k e t side is characterized by a contestable natural m o n o p o l y and the other is either competitive or also a contestable natural monopoly. One may think, e.g., of a local community which is operating a mobile radio network and which is considering one or various opportunities for establishing a long-distance connection by microwaves, or alternatively of two specialized satellite networks to be connected. In this case no government or other collective action is necessary to provide o p e n networks. The coordination problem is absent because of a monopoly on at least one side of the market. Moreover, no market power can be exerted because the m a r k e t is contestable. Potential competition fulfils the function of mitigating m a r k e t power. Finally, search by market participants can be expected to lead to a continuous i m p r o v e m e n t of the technology of the standards. Consequently, there is no role for government in this case. Compatibility standards will be set by the parties involved 3.
3.3. Non-contestable cases (cm, ncm), (ncm, cm), (c, ncm), (ncm, c), (ncm, ncm) T h e r e is a n u m b e r of cases where at least one m a r k e t side is characterized by a non-contestable natural monopoly. The other m a r k e t side may be competitive or a contestable natural m o n o p o l y or also a non-contestable natural monopoly. In all these cases the market will fulfil its co-ordination function in the sense that there is no ambiguity on the standard to be applied, though m a r k e t search for superior standards will be reduced because of the underlying non-contestability. But we can expect market p o w e r to emerge around the non-contestable natural monopoly. Consider, e.g., a domestic railroad o p e r a t o r supplying rail capacities and simultaneously rail transport services, as all national railroad companies do. The railroad o p e r a t o r will exploit its m o n o p o l y position as a standard setter vis v i s a foreign rail transport c o m p a n y and hence restrict access to its own market. A similar behavior will result when the network supplier has a legal, but not necessarily a sunk cost monopoly, such as most telephone operators in E u r o p e . Such a supplier also will forestall competition by foreign service providers, since they would infringe in his own business. It can be argued, however, that an existing network operator has no incentive to forestall another service supplier since he can squeeze all 3 Since at least one market side is characterized by a contestable natural monopoly we can avoid the strong sensitivity of the expected market structure (Nash-equilibria) in oligopoly models depending on small parameter changes in market shares, etc. (see e.g. Wiese, 1993).
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monopoly rents via network access pricing. This is so because network use and services production are strictly complementary. This conclusion, however, only holds under linear pricing. But in reality we often observe price discrimination in network services. Such a pricing policy is, however, only feasible when network operation and service provision are vertically integrated. A non-integrated service provider using the same network as the integrated network operator would destroy the power to discriminate prices, since he is not under full control of the latter (see Fremdling and Knieps, 1993, pp. 146 ft.). Hence, as long as price discrimination is exerted on the service level, we would expect that network access will not be granted voluntarily. In electricity, railroad, and in telephone services this is often the 4 case . Finally, strategic behavior may emerge in the case of ncm, ncm. Two non-contestable natural monopolies may negotiate strategically on network access without coming to an agreement on mutual network use. Maybe that non-co-operation between British Telecom and Mercury in their longdistance operations can be explained this way. In this last case government intervention m a y be justified. In particular, it should avoid standards providing strategic advantages to the n e t w o r k carrier and hampering competition in the complementary market for n e t w o r k services. The last case will be treated in somewhat more detail now.
4. The timing of standardization
Regulation of standards is not only a static problem as considered up to here, it has also a dynamic component relating to when standardization should take place, In the planning phase of a market sunk investments have not yet been made. The market is still contestable. Later on, in the production phase, investments are sunk and the market has become noncontestable. Usually regulation of standards is considered to be a problem of this latter phase. But then heavy interventions are needed to change the prevailing standards. Therefore one could think to standardize earlier, to shift the instant of standardization from the production to the planning phase. Consider, e.g., a C A T V network of a local community. In the planning phase, before investment is carried out, and the number of potential suppliers is large, a 4 Networks, however, may willingly interconnect when entrants provide only imperfect substitutes on the complementary service market and market size is enlarged (see Economides and Woroch, 1992). This, for example, has been the case in the market for value added network services, which has contributed to the growth of the market for leased lines beyond the size which could have been achieved by the monopolistic network operator.
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contest for the best standard could be organized, and the winner would be obliged to implement it on a non-discriminatory basis. Maybe that such a contest would reduce market power in the second phase. The effect would, however, be small. For the network operator then still enjoys a monopoly with sunk costs allowing him to enforce price discrimination on the secondary service market (see above, Section 3). But an early contest could facilitate and promote interconnection and interoperability. The disadvantage is, however, that an early declaration of a standard as mandatory may be detrimental too. It reduces the incentives of the market participants to search for new and still superior technologies. Later standardization, in contrast, would allow for more market search. Often only experience and practice can reveal the best standard. Market search, however, implies in general more diversity, the emergence of different, maybe incompatible network islands. Some suppliers may find it even difficult to reach the critical mass. Sometimes it is said that gateways or adapters are a solution to incompatibility. But this is true only to some extent. Gateways require frequently large investments in man-hours and technological know-how; they are therefore often more costly than single compatible technologies. Moreover, not enough gateways may be supplied (see footnote 1). A good example from history are railroads. It is common knowledge today that a larger gauge for railroads would make the railroad systems more efficient in most parts of Europe and of the whole world. The actual standard railroad gauge is due to an early standardization by the British Parliament (see Kindleberger, 1983, pp. 384-85). Maybe that a postponed standardization had promoted a more efficient gauge, but at the cost of having rail systems with different gauges one beside the other. More intensive and more costly government interventions would have been necessary to overcome these incompatibilities and to facilitate interconnections and interoperability.
5. The behavior of regulatory authorities No regulation of standards is needed in the contestable or contestable/ competitive cases, because neither a coordination problem nor a market power problem arises. Therefore, bureaucrats should not extend their activities to those fields where markets can work. But some regulation may be required in the pure competitive and in the non-contestable cases. In the pure competitive case regulation may help to overcome the coordination problem. But such regulation is not necessarily a task for the government. In practice we often observe forms of self-regulation by producer committees or by non-profit institutions. In digital mobile radio,
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e.g., firms have been uncertain initially on the technology they should develop. Collective negotiations, however, within the GSM group have resolved this problem, and the GSM standard has emerged (see Kedaj and Hentschel, 1993). Other examples are the American National Standards Institute (ANSI) dealing with voluntary standards in matters as sizes, weights, procedures, and symbols. It promotes consensus among participants with regard to the proposed standard (see Carlton and Klamer, 1983, p. 449). A similar institution is the Deutsches Institut fiir Normung (DIN) recommending the standardization of all sorts of common technologies up to the standardization of screws and nuts. While these examples may show that non-government regulation works, it is not clear whether it works efficiently. If there is potential competition among non-governmental standard setting institutions, search for more efficient standards may take place. But this is not certain. Some of these institutions are dominated by closed producer groups forming a cartel. Often they are reluctant to adopt new technologies and remain too conservative. Others are often too open in the sense that they are unable to enforce their collective decisions on all appliers. Hence a desirable standardization cannot take place (see Blankart, 1994). This is especially the case when many firms of roughly the same size are involved and when none of them is dominant (see Kindleberger, 1983; Blankart and Knieps, 1993a). Despite these ambiguities we cannot infer that standardization by public authorities is necessarily a superior alternative. For we shall see below that government authorities have particular incentives distorting the standardization process in another way. In the non-contestable cases, however, power is involved on one or on both sides of the market. Therefore negotiations within committees and non-profit institutions are likely either not to take place upon the same footing or to involve strategic behavior on both sides (see Knieps, 1994). Therefore government interference seems to be required. Government may need its legal power to neutralize market power. This normative conclusion has, however, also a positive side which looks different and which has to be considered more in detail now. It is true that governments may be able to regulate standards where markets, committees, and non-profit institutions fail. But it is not at all guaranteed that governments will do so and that they will become active only in those cases where these institutions fail, e.g. where a public demand for standardization is expected. Governments' interest is not primarily in implementing the normative criteria of welfare economics. There is consensus among economists that they rather maximize their own utility. But it is not quite clear how this hypothesis can be applied to the problem of standardization. Stigler (1971) has argued that government regulators will be captured by the industries they should regulate, and Niskanen (1971) claims that
292 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 bureaucrats are budget maximizers. In spite of the differences of these and related theories, the overall conclusion seems to point to an overstandardization relative to the criteria derived above. To the extent that government regulators are captured by traditional network carriers, overstandardization is a tool to foreclose entry into the complementary service market. Network carriers may prefer to monopolize the service monopoly rents (e.g. Fremdling and Knieps, 1993, pp. 150-152). As far as bureaucracies are involved, their endeavor to maximize output will result in a maximization of the degree of standardization. Since higher degrees of standardization usually increase their power (e.g. Blankart and Knieps, 1993a, p. 46). In the remainder of this section we shall present four practical examples from telecommunications illustrating these hypotheses. 1. The Integrated Services Digital Network (ISDN) can be considered as a pure network infrastructure, i.e. a backbone on which various competing value added network services can be supplied. The standard required to define this pure transportation service is located on layer 1 of the OSI scheme s. This layer represents physical interconnection only. Nevertheless, the International Telegraph and Telephone Consultative Committee (CCITT) held that further service components restricting the use of ISDN should be standardized. In particular, the X.25 standard protocol originally designed for packet-switched data networks has also been introduced for basic transmission service of ISDN-networks. As a consequence, basic protocol conversions (located at layer 3) are determined by national network monopolies, reducing the market potential of ISDN for competitive suppliers of value added network services on the one hand and increasing the market power of the national PTTs on the other (see Hermann, 1993, pp. 31 ft.). The X.25 standard for ISDN was initially only a recommendation of the CCITT, but it has been transformed in a directive of the European Council later on, with the result that it became quas~-mandatory . 2. The definition of the network termination point is another example of protective standardization under ISDN. If the network termination point belongs to the customer, he is free to use the network for whatever telecommunications he likes. If it belongs to the network operator, however, the latter is able to practise price discrimination. He can charge higher prices for those who want to use the network for all kinds of ISDN services and lower prices for those who want to subscribe for only a particular service. E u r o p e a n PT-Fs have been able to enforce their interest position in •
6
s OSI (Open Systems Interconnection) is a rule for standard setters in telecommunications.It can also be interpreted as a scale for measuring the intensity of standardization. A higher layer represents a higher degree of standardization (see Blankart and Knieps, 1994, p. 119). Rat tier EG (1992): Empfehlung des Rates vom 5. Juni zur Einf/ihrung harmonisierter ISDN-Zahlungsregelungen und eines ISDN-Mindestangebots nach ONP-Grunds~itzen~ in: Amtsblatt der EG, Nr. L 200, pp. 10-19.
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the European and national decision making units. They have acquired the right to define network access. The Open Network Architecture (ONA) scl~eme of the USA, in contrast, intends to give as much freedom as possible to downstream users (see e.g. Lake et al., 1992/93). Consequently, network termination points are allocated to the domain of the users (see Griffiths, 1990). The European policy has been correctly criticized by the user groups and by the independent equipment producers. They say that such regulations inhibit technical progress, and the development of 'intelligent' terminal equipment in particular. 3. On the whole it seems that network regulation does not or not always take account of the market power inherent in non-contestable network monopolies. Given our examples, the capture hypothesis cannot be unambiguously rejected. But what about the hypothesis of bureaucratic power maximization? We expect that bureaucrats will extend standardization to those fields where problems of non-contestability are absent because this increases their power and their utility. Consider the example of EDIFACT (Electronic Data Interexchange for Administration, Commerce and Transport), which is actually promoted by the European Commission. EDIFACT is a standard for network services displaying structured information of daily business correspondence such as orders, delivery, notes, invoices, etc. It is a very specialized standard defining exactly the type and position of a piece of information on a message. EDIFACT must therefore be located on the topmost layer of the OSI scheme. Such a highly structured standard leaves very little room for variety and innovation. It is therefore not astonishing that various industries such as banks and automobile industry have already developed their own standards, adjusted to their own particular needs. The endeavor of the Commission to promote EDIFACT seems strange before this background. But it becomes understandable under its goal of power and influence maximization. 4. Standardization by public authorities seems to come to a halt, however, where markets are very dynamic. Consider, e.g. the market for value added network services (VANS). Here the regulatory process is too slow to keep pace with the market process and to interfere in it by standardization. This 'failure' of the regulatory process is, however, not a deficiency from a normative point of view. For the VANS market is highly contestable and does therefore not require government standardization. Hence the outcome of the,regulatory process happens to coincide with what is suggested from a normative point of view.
6. Outlook: standards for standard setters
The perspective gained up to here according to which government standardization may reflect the interests of powerful industries and of public
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bureaucrats is not very promising. In order to avoid such outcomes, more attention should be given to the rules which standard setters should observe. This also seems to be the view of the European Council, who has issued suchTguidelines for telecommunications in his ONP Framework Directive of 1990 . Art. 3 of this Directive requires that standards for ONP must be - b a s e d on objective criteria, and adequately published, non-discriminatory, -non-restrictive except for network security reasons. These guidelines function as standards for standard setters. According to Art. 2 of the Council's Directive standards can relate to technical interfaces (including the implementation of harmonized network termination points), details of harmonized usage conditions, details of harmonized tariff principles (though not on the absolute level of national rates). At first glance these conceptual standards seem quite convincing. Nevertheless our results show that a more disaggregated approach is needed to find standards for standard setters. In contestable cases no standardization of network interfaces is required. Therefore bureaucrats must be given a guideline not to extend their activities into those fields where markets can work. In the pure competitive cases, a co-ordination problem may arise when standardization is left to markets only. Committees and other nonprofit organizations should be given a chance to solve these problems. Such organizations often emerge spontaneously as an outflow of entrepreneurs' endeavor to overcome the standardization problem. Since they are voluntary, overstandardization is less likely to result than with government agencies. In non-contestable markets, however, intervention by government agencies may be unavoidable. Government's legal power is required to neutralize the market power of the participants of the standardization process. The task of government agencies should consist in setting standards in such a way that monopolistic exploitation or strategic interaction among monopolists is avoided. While such a design of a standard setting institution may work in the right direction, it may nevertheless be insufficient because government agencies often go too far and pursue the goal of bureaucratic power maximization. To avoid such developments, agencies' power should be strictly limited to the non-contestable parts of the hierarchy of standards. - t r a n s p a r e n t
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7 Council Directive of June 28, 1990 on the establishment of the internal market for telecommunications services through the implementation of open network provision (ONP) (90/387/EEC;oj L 192/1, 24.07.90). See also European Commission, 1994, pp. 70-71.
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We can think of the lowest layer of the OSI scheme 8. The standards of X.25 for ISDN, of the network termination point in ISDN, and of EDIFACT go obviously beyond this lowest layer. Mandatory standards on these higher layers of OSI typically seem to represent manifestations of the capture hypothesis or of the bureaucratic hypothesis. To put it differently, legislators should take care to set well-designed standards for standard setters. They should take account of standard setters' incentives to expand their activities without taking account of the public demand for standardization. Standards for standard setters should not positively prescribe what should be done and how. This would rise problems of the control of those who set the standards of the standard setters and so on. Negative norms are enough. Standard setters should merely be prevented to regulate in the competitive and contestable parts of the networks. It seems to us that the concept of Open Network Architecture (ONA) used in the United States comes closer to such a standard for standard setters, although a perfect regulatory framework is obviously not easy to design 9.
References Berg, S.V., 1989, The production of compatibility: Technical standards as collective goods, Kyklos 42, 361-383. Blankart, Ch.B., 1995, The meaning of voting on standardization, 84(1-2), 182-184. Blankart, Ch.B. and G. Knieps, 1993a, State and standards, Public Choice 77, 39-52. Blankart, Ch.B. and G. Knieps, 1993b, Network evolution, in: H.-J. Wagener, ed., On the theory and policy of systemic change (Heidelberg Physica) 43-50. Blankart, Ch.B. and G. Knieps, 1994, Externalit6s de r6seau, variet6 et recherche, Technologies de l'Information et Soci6t6 (TIS) 6, no. 2, 111-123. Carlton, D.W. and J.M. Klamer, 1983, The need for coordination among firms, with special reference to network industries, University of Chicago Law Review 50, no. 2, 446-465. David, P.A. and J.A. Bunn, 1988, The economics of gateway technologies and network evolution: Lessons from electricity supply history, Information Economics and Policy 3, 165-202. Economides, N.S. and G.A. Woroch, 1992, Benefits and pitfalls of network interconnection, Mimeo, Stern School of Business (New York University, New York, NY). European Commission, 1994, Green paper on the liberalization of telecommunications infrastructure and cable television networks, Part II (EC, Brussels).
8 Not only is market power to be expected mostly on the lowest layers because of sunk costs and economies of scale to he found here, but it can be expected as well that the network externality problem arises to a lesser extent on the higher layers. Hence less standardization is needed there, and scope should be given to free market search. A more detailed explanation of this disaggregated approach to standardization is given in Blankart and Knieps (1993b, 1994). 9 Some have criticized even the ONA concept for including strategic elements with negative effects on competitors. In particular, MCI has challenged the ONA plans of the Bell Operating Companies as inadequate, seeking more fundamental unbundling than the FCC has required up to date (see Lake et al., 1992/93, p. 32).
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Fremdling, R. and G. Knieps, 1993, Competition, regulation and nationalization: The Prussian railway system in the nineteenth century, Scandinavian Economic History Review 2, 127151. Griffiths, J.M., 1990, ISDN explained (Wiley and Sons, Chichester). Hermann, H., 1993, Die Standardisierungspolitik der Europ~iischen Gemeinschaft im Telekommunikationssektor: ein Beitrag zu einer marktkonformen Industriepolitik (Freiburg). Kedaj, J. and G. Hentschel, 1993, Mobilfunk Handbuch, neue Mediengesellschaft (Ulm). Kindleberger, Ch.P., 1983, Standards as public, collective and private goods, Kyklos 36, fasc. 3, 377-396. Knieps, G., 1994, Standardization: The evolution of institutions versus government intervention, in: L. Gerken, ed., Competition among institutions, Proceedings of the Friedrich August von Hayek Symposium, June 1994 (Macmillan, London) forthcoming. Lake, W.T., J.J. Nadler and K.K.C. Levy, 1992/93, Telecommunications in the United States-Breaking down the barriers, International Corporate Law, 21, supplement, December 1992/January 1993, 28-36. Niskanen, W.A., 1971, Bureaucracy and representative government (Aldine Atherton, Chicago, New York). Stigler, G.J., 1971, The theory of economic regulation, Bell Journal of Economics 2, 3-21. Wiese, H., 1993, Lern- und Netzeffekte im asymmetrischen Duopol (Heidelberg Physica).
ELSEVIER
Information Economics and Policy 7 (1995) 283-296
Market-oriented open network provision C h a r l e s B. B l a n k a r t ~*, G / i n t e r K n i e p s b
~'lnstitut f iir 6ffentliche Wirtschaft und Wirtschaftspolitik, Humboldt-Universitdt zu Berlin, Spandauer Strafle 1. D-10178 Berlin, Germany hlnstitut f iir Verkehrswissenschaft und Regionalpolitik, Albert-Ludwigs-Universi#it Freiburg, Europaplatz 1. D- 79085 Freiburg, Germany Received 12 December 1994; accepted 19 May 1995
Abstract Network externalities and market power due to economies of scale and sunk costs may cause a public demand for standardization of network access. There is, however, no guarantee that public institutions supplying standardization are interested in correctly matching this demand. Often it comes to overstandardization. The authors argue therefore that standards for standard setters are required and they show how such standards could be designed.
Key words: Open network provision; Network access; Standardization policies J E L Classification: L51; L96
1. Free trade in services F r e e t r a d e in services b e t w e e n E U m e m b e r c o u n t r i e s is o n e of the c e n t r a l p o s t u l a t e s of the T r e a t y of R o m e of 1957 and its follower the T r e a t y of M a a s t r i c h t of 1992. A service supplier must be e n t i t l e d to m o v e from m e m b e r state A to m e m b e r state B to provide a service, or a service d e m a n d e r located in m e m b e r state B must be allowed to c o n s u m e a service in m e m b e r state A a n d vice versa. For m a n y services, h o w e v e r , such a c h a n g e in location is not necessary since they can be supplied in the o t h e r * Corresponding author. Tel. 030-2468-271, fax 030-2468-297. The authors are indebted to two anonymous referees and to their colleagues Pio Baake and Bernhard Wieland for helpful comments. 0167-6245/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved S S D I 0167-6245(95)00006-2
284 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 country by use o f networks. Hence networks are of utmost importance for the freedom of trade in services. With network services we mean markets such as rail transport, air transport, road transport, electricity, gas, telecommunications and postal services. Some of these services have become tradeable to some extent across national borders in recent years. International courier services compete with public post offices and with private remailers on the international level. Similarly, telecommunications services are provided internationally by private and public companies, although the physical backbones are mostly still owned and operated by national telecommunications monopolies. But in other network services international competition is still small or negligible. In railroads, e.g., French TGV-trains must not run on German rails and G e r m a n ICE-trains are not allowed to provide services on their own account on the French rail network. Such international trade is often inhibited under the pretext of incompatibility o f technical standards. ICE trains allegedly cannot run into main terminals in France because of their size. T h e r e are two ways to interpret such network incompatibilities. The first is that standards emerging from decentralized action are voluntary, accidental and therefore incompatible. The other is that in a decentralized system of decision making standards are deliberately chosen to forestall competition. Each actor tries to enforce its exclusive standard in order to prevent through-traffic by third parties and to force network users to enter into a new contractual arrangement when passing from one network to the other. Both hypotheses suggest government intervention. The first leads to the conclusion that standards should be mandatory instead of voluntary. The second wants standards to be open instead of exclusive. In terms of policies, the first requires more co-ordination and the second more control of market power. We shall see below that these two issues are the main determinants of the demand for public standardization policy. They have to be confronted with the supply of public standardization. Standards are produced by institutions such as markets, committees, or public authorities working according to their particular rules. It is therefore not evident whether and how far they tend to match the demand for standardization. If standardization is for example trusted to bureaucracies, it may very well end in an overstandardization (see e.g. Blankart and Knieps, 1993a, p. 46). We want to show, therefore, that the supply side of standardization must not be overlooked. As a first step in this direction we propose standards for standard setters. These rules should not prescribe positively how to set standards and hence merely raise the additional question of who controls the standard setters of the standard setters. We rather think of negative rules limiting the field of activities of standard setters.
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In Section 2 we shall analyze the market for network access rights and the incentives to trade such rights. Section 3 gives a closer examination of this market and indicates potential fields for a public standardization policy. A dynamic view of the public standardization problem is given in Section 4. Section 6 confronts these findings with actual network regulation in the E U and Section 5 concludes with an outlook on the E U concept of Open Network Provision (ONP).
2. The market for network access rights
International trade in network services requires the interconnection and interoperability of the underlying network structures. This can be done by markets, committees, or by government intervention. Before recurring to the latter two we should first inquire how far the former are able to solve the problems of interconnection and interoperability. A pragmatic point of departure is that network access represents (at least potentially) a private property. The owner has the right to exclude 'trespassers'. Both private property and exclusion principle are good preconditions for the market to work. Individuals can engage in trade for network access rights. Two main motives may promote trade: complementarity and reciprocity. If a supplier can extend his services from his own into another network by interconnection, he and the network provider both benefit from complementarity. Reciprocity arises when two owners of network structures open their networks mutually so that the effects of complementarity accrue to both. In spite of these incentives to engage in trade there are also obstacles preventing market participants (firms or consumers) from trade. On the d e m a n d side network externalities may lead participants to cluster on different network islands with different network technologies. Network externalities arise whenever the utility U~ of a network user not only depends on the technology T of the network, but also on the number of its users S, where Ui(S, T) < Ui(S', T)
for S < S'. From this inequality, one is inclined to infer that all individuals tend towards the same technology. This should be especially the case if preferences for various technologies are absent. If, however, there is for example incomplete information on the preferences for technologies among individuals, i.e. individuals do not have as common knowledge that the adoption of a technology is also beneficial for the other individuals given that all are switching, clustering on different network islands may occur. The
286 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 m a r k e t m a y therefore be unable to fulfil its co-ordination function, especially if a larger n u m b e r of participants is involved 1. Difficulties with trade in network services may also arise from the supply side o f the market. Often network services exhibit economies of scale. M o r e services can be produced at lower costs. Hence we expect m a r k e t power, in particular if networks are established under sunk costs. I n d e e d network externalities and economies of scale are the basic reasons behind the m a r k e t imperfections described at the outset of this p a p e r (insufficient co-ordination and market power). They are also implicitly shared by the E U authorities pleading for an active policy of O N P (see e.g. E u r o p e a n Commission, 1994, pp. 67-68). In the next section we shall, however, show that they are not sufficient for justifying g o v e r n m e n t intervention in networks generally. We shall draw 'scenarios' where neither the co-ordination problem nor the m a r k e t power problem will arise and where standardization by governments such as the application of O N P regulations are unnecessary. In other scenarios only the co-ordination p r o b l e m will occur, and standardization may be agreed upon in committees or other non-profit institutions. Scenarios suggesting government intervention, in contrast, are those where market power can be exerted due to economies of scale in combination with sunk costs.
3. Configurations relevant to market-oriented ONP regulation O u r argument is the following: We assume that the cost function of a d e m a n d e r or supplier in a network m a r k e t can have one of three different forms. 1. It may be characterized by constant costs in which case m a n y d e m a n d e r s or m a n y suppliers or both will appear on the market. This is the competitive case (c). 2. Often, however, networks will be characterized by decreasing costs. In this case only one firm will survive on either the d e m a n d or supply side or on both sides. But as long as entry and exit are costless, the m a r k e t remains contestable. We have the case of a contestable natural monopoly (cm) which is unable to earn any m o n o p o l y rents. Such a m o n o p o l y may result out of m a r k e t process or out of a perfect bidding procedure. 3. W h e n decreasing costs arise in combination with sunk costs so that entry and in particular exit are not free, the morphology of the market will The market endogenous creation of gateways may reduce the problem of incompatibility (see e.g. David and Bunn, 1988). Nevertheless, the problem of network externalities continues to exist and hence not enough gateways may he supplied in a competitive decentralized market economy (see Blankart and Knieps, 1993b, p. 47).
C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 287 be the same as in 2 with a m o n o p o l y either on one or on both sides of the market. But it is a non-contestable natural monopoly (ncm) which may exert m a r k e t power. Given these three different forms of the cost functions and degrees of contestability, we can distinguish a m o n g nine different configurations on the supply and on the d e m a n d side as shown in the matrix in Fig. 1. Of course the empirical relevance of these different configurations may vary 2.
3.1. 7"he competitive case (c, c) In the competitive case (c, c) many demanders will be confronted with m a n y suppliers. While such a configuration may generate efficient trades if applied to normal goods, it may lead to difficulties if applied to networks. D u e to network externalities, there is a tendency for market participants to cluster a m o n g a few standards. In particular, they will be hesitant to adopt new technologies, because they fear that the other market participants will not follow. The m a r k e t may not fulfil its co-ordination function unless the firms happen to choose the same standards spontaneously (see Berg, 1989, p. 363). Such problems may arise in the market for value added network services (VANS) of telecommunications with its many different suppliers.
demand
side
(c, e)
~,cm)
(c, ncm)
(cm, c)
(cm, cm)
(cm, ncm)
(ncm, c)
(ncm, cm)
(ncm, ncm)
Fig. 1. 2The reader may notice that the oligopoly case with few demanders and/or suppliers is missing here. This is because we focus on market entry and its possible obstacles generated by networks with sunk costs.
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3.2. The contestable cases (c, cm), (cm, c), (cm, cm) Consider now the cases where one m a r k e t side is characterized by a contestable natural m o n o p o l y and the other is either competitive or also a contestable natural monopoly. One may think, e.g., of a local community which is operating a mobile radio network and which is considering one or various opportunities for establishing a long-distance connection by microwaves, or alternatively of two specialized satellite networks to be connected. In this case no government or other collective action is necessary to provide o p e n networks. The coordination problem is absent because of a monopoly on at least one side of the market. Moreover, no market power can be exerted because the m a r k e t is contestable. Potential competition fulfils the function of mitigating m a r k e t power. Finally, search by market participants can be expected to lead to a continuous i m p r o v e m e n t of the technology of the standards. Consequently, there is no role for government in this case. Compatibility standards will be set by the parties involved 3.
3.3. Non-contestable cases (cm, ncm), (ncm, cm), (c, ncm), (ncm, c), (ncm, ncm) T h e r e is a n u m b e r of cases where at least one m a r k e t side is characterized by a non-contestable natural monopoly. The other m a r k e t side may be competitive or a contestable natural m o n o p o l y or also a non-contestable natural monopoly. In all these cases the market will fulfil its co-ordination function in the sense that there is no ambiguity on the standard to be applied, though m a r k e t search for superior standards will be reduced because of the underlying non-contestability. But we can expect market p o w e r to emerge around the non-contestable natural monopoly. Consider, e.g., a domestic railroad o p e r a t o r supplying rail capacities and simultaneously rail transport services, as all national railroad companies do. The railroad o p e r a t o r will exploit its m o n o p o l y position as a standard setter vis v i s a foreign rail transport c o m p a n y and hence restrict access to its own market. A similar behavior will result when the network supplier has a legal, but not necessarily a sunk cost monopoly, such as most telephone operators in E u r o p e . Such a supplier also will forestall competition by foreign service providers, since they would infringe in his own business. It can be argued, however, that an existing network operator has no incentive to forestall another service supplier since he can squeeze all 3 Since at least one market side is characterized by a contestable natural monopoly we can avoid the strong sensitivity of the expected market structure (Nash-equilibria) in oligopoly models depending on small parameter changes in market shares, etc. (see e.g. Wiese, 1993).
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monopoly rents via network access pricing. This is so because network use and services production are strictly complementary. This conclusion, however, only holds under linear pricing. But in reality we often observe price discrimination in network services. Such a pricing policy is, however, only feasible when network operation and service provision are vertically integrated. A non-integrated service provider using the same network as the integrated network operator would destroy the power to discriminate prices, since he is not under full control of the latter (see Fremdling and Knieps, 1993, pp. 146 ft.). Hence, as long as price discrimination is exerted on the service level, we would expect that network access will not be granted voluntarily. In electricity, railroad, and in telephone services this is often the 4 case . Finally, strategic behavior may emerge in the case of ncm, ncm. Two non-contestable natural monopolies may negotiate strategically on network access without coming to an agreement on mutual network use. Maybe that non-co-operation between British Telecom and Mercury in their longdistance operations can be explained this way. In this last case government intervention m a y be justified. In particular, it should avoid standards providing strategic advantages to the n e t w o r k carrier and hampering competition in the complementary market for n e t w o r k services. The last case will be treated in somewhat more detail now.
4. The timing of standardization
Regulation of standards is not only a static problem as considered up to here, it has also a dynamic component relating to when standardization should take place, In the planning phase of a market sunk investments have not yet been made. The market is still contestable. Later on, in the production phase, investments are sunk and the market has become noncontestable. Usually regulation of standards is considered to be a problem of this latter phase. But then heavy interventions are needed to change the prevailing standards. Therefore one could think to standardize earlier, to shift the instant of standardization from the production to the planning phase. Consider, e.g., a C A T V network of a local community. In the planning phase, before investment is carried out, and the number of potential suppliers is large, a 4 Networks, however, may willingly interconnect when entrants provide only imperfect substitutes on the complementary service market and market size is enlarged (see Economides and Woroch, 1992). This, for example, has been the case in the market for value added network services, which has contributed to the growth of the market for leased lines beyond the size which could have been achieved by the monopolistic network operator.
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contest for the best standard could be organized, and the winner would be obliged to implement it on a non-discriminatory basis. Maybe that such a contest would reduce market power in the second phase. The effect would, however, be small. For the network operator then still enjoys a monopoly with sunk costs allowing him to enforce price discrimination on the secondary service market (see above, Section 3). But an early contest could facilitate and promote interconnection and interoperability. The disadvantage is, however, that an early declaration of a standard as mandatory may be detrimental too. It reduces the incentives of the market participants to search for new and still superior technologies. Later standardization, in contrast, would allow for more market search. Often only experience and practice can reveal the best standard. Market search, however, implies in general more diversity, the emergence of different, maybe incompatible network islands. Some suppliers may find it even difficult to reach the critical mass. Sometimes it is said that gateways or adapters are a solution to incompatibility. But this is true only to some extent. Gateways require frequently large investments in man-hours and technological know-how; they are therefore often more costly than single compatible technologies. Moreover, not enough gateways may be supplied (see footnote 1). A good example from history are railroads. It is common knowledge today that a larger gauge for railroads would make the railroad systems more efficient in most parts of Europe and of the whole world. The actual standard railroad gauge is due to an early standardization by the British Parliament (see Kindleberger, 1983, pp. 384-85). Maybe that a postponed standardization had promoted a more efficient gauge, but at the cost of having rail systems with different gauges one beside the other. More intensive and more costly government interventions would have been necessary to overcome these incompatibilities and to facilitate interconnections and interoperability.
5. The behavior of regulatory authorities No regulation of standards is needed in the contestable or contestable/ competitive cases, because neither a coordination problem nor a market power problem arises. Therefore, bureaucrats should not extend their activities to those fields where markets can work. But some regulation may be required in the pure competitive and in the non-contestable cases. In the pure competitive case regulation may help to overcome the coordination problem. But such regulation is not necessarily a task for the government. In practice we often observe forms of self-regulation by producer committees or by non-profit institutions. In digital mobile radio,
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e.g., firms have been uncertain initially on the technology they should develop. Collective negotiations, however, within the GSM group have resolved this problem, and the GSM standard has emerged (see Kedaj and Hentschel, 1993). Other examples are the American National Standards Institute (ANSI) dealing with voluntary standards in matters as sizes, weights, procedures, and symbols. It promotes consensus among participants with regard to the proposed standard (see Carlton and Klamer, 1983, p. 449). A similar institution is the Deutsches Institut fiir Normung (DIN) recommending the standardization of all sorts of common technologies up to the standardization of screws and nuts. While these examples may show that non-government regulation works, it is not clear whether it works efficiently. If there is potential competition among non-governmental standard setting institutions, search for more efficient standards may take place. But this is not certain. Some of these institutions are dominated by closed producer groups forming a cartel. Often they are reluctant to adopt new technologies and remain too conservative. Others are often too open in the sense that they are unable to enforce their collective decisions on all appliers. Hence a desirable standardization cannot take place (see Blankart, 1994). This is especially the case when many firms of roughly the same size are involved and when none of them is dominant (see Kindleberger, 1983; Blankart and Knieps, 1993a). Despite these ambiguities we cannot infer that standardization by public authorities is necessarily a superior alternative. For we shall see below that government authorities have particular incentives distorting the standardization process in another way. In the non-contestable cases, however, power is involved on one or on both sides of the market. Therefore negotiations within committees and non-profit institutions are likely either not to take place upon the same footing or to involve strategic behavior on both sides (see Knieps, 1994). Therefore government interference seems to be required. Government may need its legal power to neutralize market power. This normative conclusion has, however, also a positive side which looks different and which has to be considered more in detail now. It is true that governments may be able to regulate standards where markets, committees, and non-profit institutions fail. But it is not at all guaranteed that governments will do so and that they will become active only in those cases where these institutions fail, e.g. where a public demand for standardization is expected. Governments' interest is not primarily in implementing the normative criteria of welfare economics. There is consensus among economists that they rather maximize their own utility. But it is not quite clear how this hypothesis can be applied to the problem of standardization. Stigler (1971) has argued that government regulators will be captured by the industries they should regulate, and Niskanen (1971) claims that
292 C.B. Blankart, G. Knieps / Information Economics and Policy 7 (1995) 283-296 bureaucrats are budget maximizers. In spite of the differences of these and related theories, the overall conclusion seems to point to an overstandardization relative to the criteria derived above. To the extent that government regulators are captured by traditional network carriers, overstandardization is a tool to foreclose entry into the complementary service market. Network carriers may prefer to monopolize the service monopoly rents (e.g. Fremdling and Knieps, 1993, pp. 150-152). As far as bureaucracies are involved, their endeavor to maximize output will result in a maximization of the degree of standardization. Since higher degrees of standardization usually increase their power (e.g. Blankart and Knieps, 1993a, p. 46). In the remainder of this section we shall present four practical examples from telecommunications illustrating these hypotheses. 1. The Integrated Services Digital Network (ISDN) can be considered as a pure network infrastructure, i.e. a backbone on which various competing value added network services can be supplied. The standard required to define this pure transportation service is located on layer 1 of the OSI scheme s. This layer represents physical interconnection only. Nevertheless, the International Telegraph and Telephone Consultative Committee (CCITT) held that further service components restricting the use of ISDN should be standardized. In particular, the X.25 standard protocol originally designed for packet-switched data networks has also been introduced for basic transmission service of ISDN-networks. As a consequence, basic protocol conversions (located at layer 3) are determined by national network monopolies, reducing the market potential of ISDN for competitive suppliers of value added network services on the one hand and increasing the market power of the national PTTs on the other (see Hermann, 1993, pp. 31 ft.). The X.25 standard for ISDN was initially only a recommendation of the CCITT, but it has been transformed in a directive of the European Council later on, with the result that it became quas~-mandatory . 2. The definition of the network termination point is another example of protective standardization under ISDN. If the network termination point belongs to the customer, he is free to use the network for whatever telecommunications he likes. If it belongs to the network operator, however, the latter is able to practise price discrimination. He can charge higher prices for those who want to use the network for all kinds of ISDN services and lower prices for those who want to subscribe for only a particular service. E u r o p e a n PT-Fs have been able to enforce their interest position in •
6
s OSI (Open Systems Interconnection) is a rule for standard setters in telecommunications.It can also be interpreted as a scale for measuring the intensity of standardization. A higher layer represents a higher degree of standardization (see Blankart and Knieps, 1994, p. 119). Rat tier EG (1992): Empfehlung des Rates vom 5. Juni zur Einf/ihrung harmonisierter ISDN-Zahlungsregelungen und eines ISDN-Mindestangebots nach ONP-Grunds~itzen~ in: Amtsblatt der EG, Nr. L 200, pp. 10-19.
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the European and national decision making units. They have acquired the right to define network access. The Open Network Architecture (ONA) scl~eme of the USA, in contrast, intends to give as much freedom as possible to downstream users (see e.g. Lake et al., 1992/93). Consequently, network termination points are allocated to the domain of the users (see Griffiths, 1990). The European policy has been correctly criticized by the user groups and by the independent equipment producers. They say that such regulations inhibit technical progress, and the development of 'intelligent' terminal equipment in particular. 3. On the whole it seems that network regulation does not or not always take account of the market power inherent in non-contestable network monopolies. Given our examples, the capture hypothesis cannot be unambiguously rejected. But what about the hypothesis of bureaucratic power maximization? We expect that bureaucrats will extend standardization to those fields where problems of non-contestability are absent because this increases their power and their utility. Consider the example of EDIFACT (Electronic Data Interexchange for Administration, Commerce and Transport), which is actually promoted by the European Commission. EDIFACT is a standard for network services displaying structured information of daily business correspondence such as orders, delivery, notes, invoices, etc. It is a very specialized standard defining exactly the type and position of a piece of information on a message. EDIFACT must therefore be located on the topmost layer of the OSI scheme. Such a highly structured standard leaves very little room for variety and innovation. It is therefore not astonishing that various industries such as banks and automobile industry have already developed their own standards, adjusted to their own particular needs. The endeavor of the Commission to promote EDIFACT seems strange before this background. But it becomes understandable under its goal of power and influence maximization. 4. Standardization by public authorities seems to come to a halt, however, where markets are very dynamic. Consider, e.g. the market for value added network services (VANS). Here the regulatory process is too slow to keep pace with the market process and to interfere in it by standardization. This 'failure' of the regulatory process is, however, not a deficiency from a normative point of view. For the VANS market is highly contestable and does therefore not require government standardization. Hence the outcome of the,regulatory process happens to coincide with what is suggested from a normative point of view.
6. Outlook: standards for standard setters
The perspective gained up to here according to which government standardization may reflect the interests of powerful industries and of public
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bureaucrats is not very promising. In order to avoid such outcomes, more attention should be given to the rules which standard setters should observe. This also seems to be the view of the European Council, who has issued suchTguidelines for telecommunications in his ONP Framework Directive of 1990 . Art. 3 of this Directive requires that standards for ONP must be - b a s e d on objective criteria, and adequately published, non-discriminatory, -non-restrictive except for network security reasons. These guidelines function as standards for standard setters. According to Art. 2 of the Council's Directive standards can relate to technical interfaces (including the implementation of harmonized network termination points), details of harmonized usage conditions, details of harmonized tariff principles (though not on the absolute level of national rates). At first glance these conceptual standards seem quite convincing. Nevertheless our results show that a more disaggregated approach is needed to find standards for standard setters. In contestable cases no standardization of network interfaces is required. Therefore bureaucrats must be given a guideline not to extend their activities into those fields where markets can work. In the pure competitive cases, a co-ordination problem may arise when standardization is left to markets only. Committees and other nonprofit organizations should be given a chance to solve these problems. Such organizations often emerge spontaneously as an outflow of entrepreneurs' endeavor to overcome the standardization problem. Since they are voluntary, overstandardization is less likely to result than with government agencies. In non-contestable markets, however, intervention by government agencies may be unavoidable. Government's legal power is required to neutralize the market power of the participants of the standardization process. The task of government agencies should consist in setting standards in such a way that monopolistic exploitation or strategic interaction among monopolists is avoided. While such a design of a standard setting institution may work in the right direction, it may nevertheless be insufficient because government agencies often go too far and pursue the goal of bureaucratic power maximization. To avoid such developments, agencies' power should be strictly limited to the non-contestable parts of the hierarchy of standards. - t r a n s p a r e n t
-
-
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7 Council Directive of June 28, 1990 on the establishment of the internal market for telecommunications services through the implementation of open network provision (ONP) (90/387/EEC;oj L 192/1, 24.07.90). See also European Commission, 1994, pp. 70-71.
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We can think of the lowest layer of the OSI scheme 8. The standards of X.25 for ISDN, of the network termination point in ISDN, and of EDIFACT go obviously beyond this lowest layer. Mandatory standards on these higher layers of OSI typically seem to represent manifestations of the capture hypothesis or of the bureaucratic hypothesis. To put it differently, legislators should take care to set well-designed standards for standard setters. They should take account of standard setters' incentives to expand their activities without taking account of the public demand for standardization. Standards for standard setters should not positively prescribe what should be done and how. This would rise problems of the control of those who set the standards of the standard setters and so on. Negative norms are enough. Standard setters should merely be prevented to regulate in the competitive and contestable parts of the networks. It seems to us that the concept of Open Network Architecture (ONA) used in the United States comes closer to such a standard for standard setters, although a perfect regulatory framework is obviously not easy to design 9.
References Berg, S.V., 1989, The production of compatibility: Technical standards as collective goods, Kyklos 42, 361-383. Blankart, Ch.B., 1995, The meaning of voting on standardization, 84(1-2), 182-184. Blankart, Ch.B. and G. Knieps, 1993a, State and standards, Public Choice 77, 39-52. Blankart, Ch.B. and G. Knieps, 1993b, Network evolution, in: H.-J. Wagener, ed., On the theory and policy of systemic change (Heidelberg Physica) 43-50. Blankart, Ch.B. and G. Knieps, 1994, Externalit6s de r6seau, variet6 et recherche, Technologies de l'Information et Soci6t6 (TIS) 6, no. 2, 111-123. Carlton, D.W. and J.M. Klamer, 1983, The need for coordination among firms, with special reference to network industries, University of Chicago Law Review 50, no. 2, 446-465. David, P.A. and J.A. Bunn, 1988, The economics of gateway technologies and network evolution: Lessons from electricity supply history, Information Economics and Policy 3, 165-202. Economides, N.S. and G.A. Woroch, 1992, Benefits and pitfalls of network interconnection, Mimeo, Stern School of Business (New York University, New York, NY). European Commission, 1994, Green paper on the liberalization of telecommunications infrastructure and cable television networks, Part II (EC, Brussels).
8 Not only is market power to be expected mostly on the lowest layers because of sunk costs and economies of scale to he found here, but it can be expected as well that the network externality problem arises to a lesser extent on the higher layers. Hence less standardization is needed there, and scope should be given to free market search. A more detailed explanation of this disaggregated approach to standardization is given in Blankart and Knieps (1993b, 1994). 9 Some have criticized even the ONA concept for including strategic elements with negative effects on competitors. In particular, MCI has challenged the ONA plans of the Bell Operating Companies as inadequate, seeking more fundamental unbundling than the FCC has required up to date (see Lake et al., 1992/93, p. 32).
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