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Predatory pricing and foreclosure in telecommunications
Predatory pricing and foreclosure in telecommunications
Steven Globerman
The growing worldwide trend towards deregulation in the teiecommunications industry is raising concerns about anticompetitive behaviour by the dominant carriers. This article reviews some of these concerns and gives examples of alleged anticompetitive behaviour by Canadian carriers. The author assesses the conditions under which predatory activities and foreclosure are likely to occur, and concludes that they may be made even more likely by regulation. He offers an evaluation of some aiternatlve policy approaches. Keywords: Competition; panies; Canada
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The author is with the Faculty of Business Administration, Simon Fraser University, Burnaby, BC, Canada V5A 1 S6 (Tel: 2913708). An earlier version of this article was presented at the Second Bell Canada Economics Conference, Hull, Quebec, 17-19 December 1984. The author thanks various participants for helpful comments. He also thanks an unidentified referee for many useful suggestions. ‘Deregulation has reached an advanced state in almost all sectors of the US telecommunications industry, and it is currently gathering momentum in the UK, Canada and Japan. For example, a competitive long-distance carrier, Mercury, has been allowed entry into the market in the UK. The ‘privatization’ of Nippon Telephone is apparently a first step towards allowing market competition in Japan. And in Canada, the Canadian Radio-Television and Telecommunications Commission (CRTC) is (at the time of writing) evaluating an application by Canadian NationalCanadian Pacific (CNCP) Telecomcontinued on p 320
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Under comprehensive rate-of-return regulation of an industry such as telecommunications. issues concerning ‘fair competition’ are not especially relevant, since the behaviour of common carriers is tightly circumscribed by the regulator. At the same time. unregulated firms tend not to confront regulated firms in direct competition. The growing worldwide trend towards deregulation in the telecommunications industry is, therefore, bringing into more prominent focus concerns about the prices charged and conditions of access set by so called dominant carriers. ’ With deregulation, common carriers and a variety of competitors are increasingly confronting each other in markets for products and services which either are completely unregulated or allow some dimension of competition - such as pricing - to proceed in an unregulated fashion. As a consequence, allegations of actual (or potential) anticompetitive actions traditionally associated with complex oligoloply industrial structures have featured prominently in the debate surrounding the economic effects of telecommunications deregulation. Two broad categories of anticompetitive behaviour are especially prominent in the debate. One concerns predatory actions that might be taken by dominant carriers to eliminate or contain the growth of rivals. A second concerns the implementation of policies designed by extant suppliers to ‘foreclose’ markets to would-be entrants. Policies designed as predatory or to foreclose share a common characteristic: the dominant firm absorbs specific costs (or forgoes revenues) in the short run to generate (or preserve) even greater revenues in the longer run. The purpose of this article is to evaluate the relevance of expressed concerns about predatory behaviour and foreclosure in the context of the telecommunications industry. Specifically, these concerns will be reviewed in some detail and some examples of alleged anticompetitive behaviour by Canadian carriers will be provided., A theoretical assessment will be made of the conditions under which such actions are more or less likely to occur. An important conclusion of this assessment is that predatory actions and foreclosure may be rendered more likely by regulation. The fourth section contains a qualified evaluation of alternative policy approaches to deal with these threats. While the primary focus is on the competitive environment in Canada, the US
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experience appropriate.
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continued from p 379 munications to offer switched message toll service in competition with the common carriers. For a review of changing regulatory policy on a worldwide basis, see Luigi Montella. ‘Global competition and EEC policy in telecommunidations’, Telecommunications Policy, Vol 8, September 1984, pp 205-212. *A relatively recent definition of natural monopoly conditions is provided in William J. Baumol, ‘On the proper cost tests for natural monopoly in a multiproduct industry’, American Economic Review, Vol 67, December 1977, pp 809-822. 3See, for example, John S. McGee, ‘Predatory pricing revisited’, The Journal of Law and Economics, Vol XXIII, October 1980, pp 289-330. ‘See Patricia Lush, ‘B.C. tel rivals decry sales below the market price of subsidized equipment’, The Globe and Mail, 5 June 1984, p 83. ‘See William A. Brock and David S. Evans, ‘Predation: a critique of the government’s case in U.S. vs. AT&T’, in D.S. Evans, ed, Breaking Up Bell: Essays on industrial Organization and Regulation, North Holland, New York, 1983, pp 41-59. 6For an overview of recent models of price and non-price forms of predation, see Steven Salop, ‘Introduction’ in Steven C. Salop, ed, Strategy, Predation and Anfitrust Analysis, Federal Trade Commission, Washington, DC, September 1981, pp l-42.
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The traditional view of the telephone industry was that. in the absence of a monitoring agent, the prices charged by the monopoly common carrier would be ‘too high’ from the perspective of social efficiency. At the same time, there was no substantive concern that the common carriers would seek to bar the entry of competitors, since the premise was widespread that the industry was a natural monopoly. That is, natural cost-based barriers to entry made it unnecessary for common carriers to expend resources in order to erect ‘artificial’ barriers.’ In many respects. recent economic, technological and regulatory changes have almost completely reversed the traditional ‘natural monopoly’ concerns. Specifically. a widely expressed contemporary worry is that established telephone companies will set specific prices that are ‘too low’ - by some relevant social efficiency standard-in order to continue monopolizing markets that are structurally competitive. This broad concern about predatory pricing has been treated extensively (and contentiously) in the economics literature? however, there are certain unique features of the telecommunications industry (discussed below) which critics of deregulation argue will make the practice of predatory pricing more likely in the telephone industry. In recent years, allegations have been made that the terminal divisions of the major Canadian common carriers - Bell Canada and British Columbia Telephone - frequently price below cost in order to take market shares away from their competitors. It is suggested by some that revenues from ‘non-competitive’ activities are used to subsidize below-cost pricing in the terminal equipment market.” Similar allegations have been raised in both the USA and Canada regarding discounts on bulk services such as Telpak. Specifically, it is argued that such services are priced below cost in order to discourage large subscribers from taking the discount services of other common carriers.’ Price is only one of a number of instruments that so called dominant firms could use to eliminate or discipline rivals. Another is the installation of excess capacity so that the dominanl firm is in a position to ‘flood’ the market with output in the event of competitive entry. There is also potential for the dominant firm to provide ‘excessive’ levels of service or to saturate the market with new product and service offerings in order to displace or contain rivals.” Non-price predatory behaviour has been alleged (among other sectors) in the terminal equipment market - specifically, that the equipment divisions of established carriers provide ‘excessive’ levels of service. Again, costs that are not directly recovered in the terminal equipment market are presumably covered by net revenues earned in the carrier’s regulated businesses. Notwithstanding the variety of potential predatory tools, current concerns about predatory behaviour in the telecommunications industry focus primarily on price rather than on other potential instruments. While predatory behaviour can have the effect of intimidating not only existing rivals, but also would-be entrants. activities designed to prevent entry into a market are more typically discussed under the heading of foreclosure. In this regard, the telephone companies are
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7See Brock and Evans, op cif, Ref 5. ‘This argument has also been put forth to explain AT&T’s dominance in the terminal equipment market prior to divestiture. See Joseph P. Fuhr, Jr, Competition in the terminal equipment market after carterfone’, The Antitrust Bulletin, Vol XXVIII, Fall 1983, pp 889898. ‘While the regulator in Canada has continued to affirm the separation between telephone carriage and content, the line between basic and enhanced telephone service is blurring rapidly. Hence, complaints raised by suppliers of enhanced services are likely to increase in the future. See Jonathan Chevreau, ‘Group seeks to avoid abuses of lnet trial’, The Globe and Mail, 8 July 1983, p Bl 1. “See Dan Westell. Cellular radio firms’ interconnection talks hit snag’, The Globe and Mail, 28 October 1984, p 814. “For a discussion of the US experience, see Brock and Evans, op tit, Ref 5.
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alleged to use a number of specific practices to exceptional advantage in order to prevent entry into structurally competitive markets. One such practice is regulatory foreclosure, whereby the common carrier forces would-be entrants to incur relatively large legal and related expenses in order to receive regulatory approval to offer a service.’ Since these expenditures are presumably non-recoverable. regulatory harassment is held to be an especially effective way to raise entry costs, since the cost involved will be ‘sunk’ in the event that the regulator rules in favour of the common carrier. More conventional models of market foreclosure emphasize the relevance of the integrated structure of telephone companies. Specifically. they emphasize the ability of the common carrier to deny entrants physical access to local exchanges - or, in other cases, to long-haul transmission capacity - in order to foreclose competition that directly or indirectly makes use of those facilities. This ‘chokepoint’ foreclosure argument has been implied in allegations by competitive suppliers of private line services that they are frequently harassed by delayed access to local exchanges. In other cases, competitive suppliers of terminal equipment have complained of being denied ready access to interconnection.x Recently, competitive suppliers of enhanced services have argued that (in various ways) they are at a disadvantage by having to use the local exchanges of established telephone companies. For example, suppliers of data-base information services argue that their customer information available to the telephone companies can be used by the latter in their own marketing efforts.” Another argument has been raised by competitors to the common carriers in the provision of cellular radio services who have complained about ‘unreasonable’ conditions being imposed for access to the local exchange.“’ While (at the time of writing) there is no legal competition in Canada for the provision of switched long-distance services, one can imagine that when such competition is authorized, charges of both predatory behaviour and foreclosure will surface, as they did in the USA. For example. it is argued that AT&T introduced selective discounts on those routes subject to competition from new carriers. It is also argued that AT&T made interconnection into the local exchanges artificially expensive, thereby raising the entrant’s operating costs.” Indeed, it was a concern about the potential for foreclosure that strongly contributed to the decision to create separately owned local operating companies in the USA, and to Judge Green’s position that the Bell operating companies refrain from competing in the interexchange market.
Predatory behaviour Activities such as the examples identified above share a common characteristic: the dominant firm absorbs specific costs (or foregoes revenues) in the short run to generate (or preserve) even greater revenues in the longer run. This relationship is evident in the case of predatory pricing, or in alleged cases where ‘goldplated’ services or equipment features are offered to drive out - or restrain - competition. It is less obvious in foreclosure, although attempts to foreclose by introducing regulatory delays clearly involve a direct short-run cost to the common carrier in return for an increased probability of maintaining the returns earned on its regulated activities. In other cases, such as
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‘*See McGee, op cif, Ref 3. “In the current vernacular
of Industrial organization economists, when markets are ‘contestable’, simple price predatory activities are a strategy doomed to failure. The key attribute of contestable markets is ease of entry and exit. For a seminal discussion of contestability, see W.J. Baumol, John Panzar and Robert Willig, Contestable Markets and the Theory of Industry Structure, liarcourt Brace Jovanovich. New York, 1982. For a recent critique of the contestability model, see William G. Shepherd, ‘Contestability vs. competiton’, The American Economic Review, Vol 74, September 1984, pp 572587.
‘%ee, for example, J. Fred Weston and Clement G. Krause, ‘Competition in the telecommunications and information services markets’, in Attachments and Appendices to Comments of American ‘ieleohone and Telearaoh Comoanv. CC Docket No 8%1147.lbefore the Fiieral Communications Commission, Washington, DC, 2 April 1984, pp 24-25. ‘5The basis for the following discussion is found in Brock and Evans, op cit. Ref 5.
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when access to the local (or toll) network is restricted. the common carrier foregoes specific revenues, in exchange for the (anticipated) preservation of even greater revenues. Specifically, the common carrier foregoes access and usage charges that it would collect as a ‘wholesaler’ of capacity to competitive suppliers, while presumably maintaining the revenues it earns as a retailer of specific services to subscribers. The logic underlying foreclosure strategies may therefore be seen as similar to the logic underlying predatory strategies. The practical relevance of models of predatory behaviour has been debated intensively in the literature. In particular, the likely success of predatory pricing has been questioned by many economists. The basic scepticism rests on the notion that. unless the predator enjoys a competitive advantage in the marketplace, it might never be able to recoup its early losses by pricing above marginal cost in the future.” In the limit. if quick entry and exit on the part of rivals is possible, the predator would find it essentially impossible to inflict losses on rivals through below-cost pricing, and it would be unable to recoup its own losses by charging prices above marginal cost for any length of time. Consider the following example: a product has a (constant) marginal cost of $1 per unit. A dominant firm charges $0.50 per unit for five years in order to discourage or destroy competition. It anticipates being able to charge $1.50 per unit once competitors are eliminated from the marketplace. At a 10% discount rate, it would take approximately 12 years for the predator simply to recoup the losses incurred. Obviously the predator must believe that there are durable barriers to entry in order to contemplate predatory pricing. But it is difficult to imagine such lengthy delays in entry when rivals expect to earn a 50% profit margin on sales. Without belabouring the issue, the foregoing example underscores the point that predatory pricing is an implausible strategy in the absence of inordinately high entry and exit costs.” In this regard, a number of observers have argued recently that. in most sectors of the telecommunications industry, entry and exit costs are relatively low.” Consequently, they consider the local network as the only sector in which predatory pricing is theoretically plausible. But, of course, there is no genera1 suggestion that telephone companies are attempting to price predatorily in the local segment of the network. Pretiatory
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The potential for predatory pricing in the telecommunications industry is generally held to be inherently greater than in most other industries, owing to the telephone companies’ alleged capacity to cross-subsidize competitive activities from regulated revenues. Consider the simple case where a firm produces two outputs: q’ is produced subject to common carrier regulation, while 4’ is produced and sold in unregulated markets. ” In the conventional model of predatory pricing outlined above, the firm prices q’ below marginal cost for a period and then prices above marginal cost for some indefinite period. The regulated firm’s advantage stems from the notion that - by increasing the price of q’ - the cost of predatory actions in the unregulated market can be reduced. In effect, the predator does not have to recoup the costs entirely in the competitive market. The full cost of predatory activity in the competitive market might be recouped through higher prices in the regulated market.
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Ignoring the complexities introduced by cross-price elasticity effects and cost complementarities, it is obvious that this simple cross-subsidy argument is flawed. Specifically, if the regulated firm can easily and continually obtain approval for higher (regulated) rates of return. why would it dissipate those returns in the competitive market? Why would it not simply pay higher dividends to shareholders? Furthermore, if the regulator is responsive to requests for higher regulated prices. it would be illogical for telephone company management to wait until it is losing money in market two before asking for a higher rate of return in market one. Indirect predatory behaviow
“The AverclwJohnson (AJ) effect refers to an over-capitalization bias in regulated utilities. That is, utilities use more capitalintensive methods than is economically justified, although the bias contributes to a higher return to utility shareholders. The classic article here is Harvey Averch and Lelan Johnson, ‘Behavior of the firm under regulatory constraint’, The American Economic Review, Vol52, December 1963, pp 1052-l 069.
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A subtler version of the cross-subsidy argument posits that relevant cross-subsidies from the regulated sector (one) to the unregulated sector (two) are indirect. For example, the carrier purchases equipment (or services) from its unregulated affiliate at prices above marginal cost. In turn, the latter uses the ‘quasi-rents’ earned to subsidize lower prices, or improved services, in the competitive markets it serves. The regulated affiliate in turn incorporates the higher prices paid into its rate base. If the allowable rate of return on the base equals the firm’s cost of capital, the subsidies generated for the unregulated affiliate are at the expense of the telephone subscriber. And if the allowed rate of return exceeds the regulated firm’s cost of capital. the cross-subsidy programme would directly increase the capital value of the regulated affiliate. While raising suggestive concerns, several reservations can be expressed about the indirect cross-subsidy argument. One reservation is that the regulator may not automatically approve additions to the rate base, especially when substantial capital expenditures are involved. Even if there were no difficulty in adding ‘overpriced’ equipment to the rate base, the cross-subsidy strategy described above would be profitable only if substantially higher prices could ultimately be realized on future competitive sales and/or the allowed rate of return in the regulated sector exceeded the required rate. However, there is no strong empirical support for the latter contingency. More specifically, there is no consistent evidence that the Averch-Johnson effect holds as a general phenomenon.‘” Hence, there can be no general presumption that the allowed rate of return exceeds the telephone company’s cost of capital. A second reservation relates to the desirability of dissipating quasi-rents gained from overpriced equipment sales to the regulated affiliate through underpriced competitive equipment sales. In particular, if the latter market is characterized by relatively easy entry and exit, it can be argued that the telephone company’s unregulated equipment affiliate will never be able to sustain non-competitive prices for equipment sold at arm’s length. In this case, it can be argued that the telephone company is better off paying higher dividends to its shareholders where it is successful in ‘padding’ its rate base. The implication of the foregoing discussion is that the cross-subsidy model (featuring a partially regulated telephone company) is an unlikely form of predatory behaviour under a plausible set of assumptions about the industry. Yet it is given great a priori credence by regulators and policymakers. In a related predatory model, both q’ and q* are produced and priced subject to an overall rate of return constraint. When the price of q* is December
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reduced, the firm’s overall regulated rate of return will decline below the allowable rate. other things being constant. The regulated firm then applies for an increase in the price of q’ to restore the firm’s overall return to its allowable target. Since the firm’s overall profit rate is constrained, the benefit of predatory behaviour in this case is indirect. Specifically. presuming the price elasticity of demand for 9’ exceeds that for q’, the relative price change described will result in an overall increase in the regulated firm’s volume of output and (presumably) in its rate base. This indirect predatory strategy will be profitable presuming that the firm’s allowed rate of return exceeds its cost of capital. However. as noted earlier, there is no consistent evidence that the former systematically exceeds the latter in regulated industries. Therefore. unless telephone company management is motivated by non-profit objectives, there seems no strong incentive for the fully-regulated company to act as a predator in markets where it faces competition. The qualification that management may be motivated by non-profit objectives is obviously of potential relevance when applied to common carriers. Indeed, regulatory constraints on profitability may contribute to telephone company managers being more strongly motivated by sales growth than by profitability. In this event. cross-subsidies from regulated to unregulated activities may be implemented to the extent that they contribute to faster output growth. Faster growth facilitated by predatory behaviour will be socially inefficient. since the incremental output produced by the telephone company would presumably be produced more efficiently by other firms. The relevance of ‘standard’ models of predatory behaviour to the telecommunications industry therefore turns on the empirical question of whether or not telephone company managers are primarily profit oriented. While the literature is not unequivocal on this point, the evidence clearly suggests that public sector organizations generally are less strongly motivated by prospective profits and more strongly motivated by growth prospects than their private sector counterparts. ” Extrapolating this finding to the common carrier sector. incentives for predatory behaviour in competitive segments of the telecommunications industry are enhanced by conventional rate of return regulation. ‘accidental’ predatory bchaviour might be encouraged by Moreover, regulation to the extent that regulated managers are imprecise in their cost-allocation procedures. However. rather than arguing against deregulation, these caveats support a move towards expanding the competitive sectors in which common carriers operate. Specifically, by allowing shareholders of common carriers to be residual claimants of all should focus on efficiency gains, their agents (that is, management) maximizing profits rather than on non-pecuniary objectives.
Forecloswe
“For a comprehensive review of the relevant literature, see A. Vining, ‘Mixed enterprises’, mimeo, Simon Fraser University, February 1984.
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A major reservation about conventional models of predatory behaviour is the fact that substantial up front losses must be incurred in return for a claim to an uncertain future income stream. However, where the up front losses are fairly small. exclusionary practices have greater u priori relevance. In this regard, a frequently cited concern is that competitors will be denied access to the local and long-haul segments of the network. Since this is presumably a low-cost action to the telephone company, it
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may be a highly attractive technique for blocking competition in non-regulated sectors. The first point to note in this regard is that foreclosing access to key segments of the network can be a potentially costly strategy for the telephone company. Specifically. revenues are forgone in preventing uses of the network that are derived as a demand for competitive services. It is conceivable that. in some cases. the revenues forgone may exceed the net revenues preserved by ‘handicapping’ competitors. This might be true, for example. in the case of certain enhanced services. In effect - under certain circumstances - forgone sales at the ‘wholesale’ level may more than outweigh revenues lost at the ‘retail’ level that are associated with substitution away from the services of the common carrier. With a growing proliferation of specialized usages of the telephone network. this latter qualification may be increasingly relevant. Another qualification to the ‘chokepoint’ foreclosure argument is the potential for subscribers to ‘bypass’ the network. To the extent that large business subscribers can economically justify their own networks. indirect substitution away from the services of the common carrier limits the efficacy of foreclosing network access to rival carriers. It is not possible to evaluate the current status of bypass activity. especially in Canada, where relatively little published evidence exists. But there is good reason to believe that both technological change and the growing sophistication of subscribers are diminishing the relevance of denying ‘fair’ access to the network as an exclusionary tool. Over the foreseeable future, the main concern about foreclosure is related to access to the local exchange for the provision of message toll service (MTS). One can argue that - in this area - telephone companies have both the incentive and the ability to engage in exclusionary practices. since the ‘substitution’ effect of lost MTS traffic is likely to outweigh the additional access revenues gained from compctitivc suppliers of interexchange services. This is especially true under the current rate structure which underprices access and overprices Iongdistance usage.
Policy alternatives Policymakers are considering various threats of predatory behaviour and regulated competition. They include: 0
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ways of dealing with perceived foreclosure under a regime of
Structural separation: require competitive divisions of common carriers to operate as separate subsidiaries - with separate management and overhead functions. Strict cost-accounting scrutiny of prices charged by divisions and affiliates of the common carrier. including transfer prices between regulated and unregulated affiliates or divisions. Clearly these first two options can be implemented in conjunction with each other as well as separately. Limiting the freedom of common carriers to participate in unregulated activities or proscribe such activity entirely. This option could include ‘handicapping’ the telephone company by mandating a minimum differential between its prices and the prices of its competitors, limiting its allowable scope of activities to strict transmission of voice and data, and so forth.
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“As an alternative to establishing separate subsidiaries, Swedish authorities require service providers publicly to disclose data on costs and revenues by detailed product line. See OECD, Telecommunications: Pressures and Policies for Change, Director of Information, OECD, Paris, 1983, p 98. ‘%ee Steven Globerman, ‘Economic factors in regulatory policies for the telecommunications industry’, in W.T. Stanbury, ed, Economic, Technological and Political Considerations in Deregulating the Canadian Telecommunications Industry, Institute for Research on Public Policy, Montreal, forthcoming. “‘Ibid.
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Full divestment of local exchange manner of the AT&T agreement.
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In the USA, the Federal Communications Commission has decided to enforce separate costing and accounting by requiring AT&T to participate in competitive markets only through a separate subsidiary. In the UK, changes in legislation will lead the supplier to establish separately accounted subsidiaries for the purpose of participating in terminal equipment markets, while Canadian regulatory authorities are currently examining whether structural separation of telephone company affiliates engaged in competitive activities should be required.lx An evaluation of these or other policy proposals to deal with perceived threats of predatory behaviour and foreclosure requires an assessment of the empirical relevance of potential competitive problems in a deregulated environment. The assessment, in turn. hinges largely on whether or not one believes that markets for telecommunications services are workably competitive (or contestable). Elsewhere 1 have argued that Canadian markets for enhanced services and terminal equipment are structurally (and behaviourally) competitive. Specifically, interconnect companies in Canada, as well as suppliers of valueadded services, have grown rapidly in number over the past few years and have taken a substantial share of the market from divisions of the established common carriers. Quality-adjusted prices of subscriber equipment have declined dramatically. while product features and new services have proliferated. ” I have also argued that relaxation of specific regulatory restrictions in areas of reselling and sharing, competitive access to satellite capacity and more liberal licensing of microwave channels for voice communication would go a long way towards making the long-distance market workably competitive.“’ In this framework, regulation enhances rather than diminishes concerns about predatory activities. The current rate structure in which prices for various network services bear no strict relationship to their costs virtually ensures that competitors will charge telephone companies with practising predatory pricing once the latter begin their inevitable move toward rate rebalancing. An implication is that rate rebalancing would further mitigate the relevance of predatory pricing as a competition policy issue. The above discussion of several simple predation models indicated that the linkage between the local exchange and competitive network services constituted perhaps the greatest single incentive to predatory behaviour, especially in view of a potential Averch-Johnson bias. Since access to the local network is also the single most significant ‘chokepoint’ in terms of possible foreclosure. separation of the local exchange from other network-related services may be a socially beneficial policy. Whether the separation should be accounting-based, structured along the lines of separate subsidiaries or structured as a mandated divestment, constitutes an important and controversial policy issue. Obviously
in this short article, it is only possible briefly to identify and evaluate the major considerations relevant to the issue. Two points might be made. First, accounting-based evaluations of the ‘fairness’ of prices charged - for either inter-company or intra-company exchanges are bound to be fraught with contention and (furthermore) are unlikely to be reliable guides to socially efficient prices. This stems not only from inevitable arbitrariness in allocating overhead costs of both a fixed and
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variable nature, across products and over time, but also from the fact that accounting costs assume static demand and cost functions. while management is presumably concerned with maximizing over long-run demand and cost functions. These shortcomings are only mitigated - not eliminated - by the ‘separate subsidiary solution’, especially since common ownership of the various affiliates will perpetuate an incentive to predatory behaviour, if there is a reasonable prospect of succeeding. Second, a requirement to establish separate subsidiaries will impose social costs in terms of increased overhead expenditures and the sacrifice of potential economies of scale. These latter costs would presumably be even greater in the case of full divestment.” In addition, the divestment solution would introduce a variety of once-and-for-all ‘deadweight’ costs associated with organizational changes in the common carrier, changes in billing procedures and the like. The divestment alternative would, however, be relatively effective in eliminating the incentives for predatory behaviour and foreclosure described above. Whether the benefits of divestment in Canada - or in the USA for that matter - are worth the costs is arguable. Certainly divestment is a fairly radical structural policy for Canada, which (to this point) has favoured behavioural approaches to competition policy, such as the imposition of rigorous cost-separation principles. An aversion to structural competition remedies is illustrated by the fact that the Canadian government has yet to overturn a merger on grounds of competition policy. Furthermore, divestment would certainly generate an explosive conflict between the federal government and provincial governments in Ontario, Quebec and British Columbia, the jurisdictions in which Bell Canada and British Columbia Telephone operate. In other provinces, where telephone companies are outside of the federal regulator’s jurisdiction, litigation between different levels of government can be expected to result from any significant federal initiative to divest local access facilities from other network and off-network activities. In the absence of a clear commitment to move local subscriber charges closer to cost. it is difficult to imagine that enthusiastic investors will emerge to take ownership of local exchanges.”
Conclusions *‘The apparent willingness of some telephone companies to establish separate subsidiaries suggests that these costs may be fairly modest for certain activities, such as terminal attachment sales. At the same time, the competitive benefits of the separate subsidiary solution are also likely to be modest. A sacrifice of economies of scope and scale also potentially characterizes a policy that requires common carriers to forbear from certain activities. Furthermore, the latter policy may well move a market away from being contestable. **Unlike the US situation, there are currently no plans in Canada to implement local access charges. Furthermore, the subsidy to local subscribers (in relative terms) is substantially larger in Canada than in the USA.
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Virtually all economists would agree that the most effective remedy to concerns about predatory activities and foreclosure, per se, is structural divestment; however, it is much less clear that divestment (as an overall policy) offers net social benefits. In any case, political opposition in Canada to a divestment policy is likely to be overwhelming. As a practical matter, divestment does not appear to be a viable, if desirable, policy approach. On the other hand, while problems associated with implementing cost separation or structural separation (ie, mandating separate subsidiaries) are relatively benign, the associated benefits are questionable. In particular, it is unclear that these steps - of themselves - will significantly reduce incentives to predatory behaviour and foreclosure or enhance the ability of regulators to detect exclusionary behaviour. At the same time, there are potentially significant costs in terms of forgone economies of scale and scope, although these latter costs may be much December
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itI telecommur~ications significant than some telephone company executives have suggested. It can be argued that focused regulation of economic activity at the local exchange level - until such time as this sector is workably competitive - may be the most desirable policy of the alternatives available. Specifically, ensuring that an Averch-Johnson-based incentive for predatory behaviour does not exist is presumably within the current mandate of the regulator. This madate could presumably be carried out more effectively if the regulator’s resources were not dissipated examining and evaluating the ‘fairness’ of prices of individual services. In like manner, ensuring fair access to the local exchange can be subsumed within the existing regulatory structure. While estimating costs of success will be an important component of this exercise, it is a relatively focused activity that does not seemingly require structural separation, nor the elaborate cost-accounting framework suggested by the Cost Inquiry conducted by the Canadian Radio-Television and Telecommunications Commission.” Given the pace of technological developments. local bypass alternatives for large businesses will soon constrain the market power of the telephone company vis-cj-vis this set of customers. Large apartment dwellers are also in the (technological) position of taking some advantage of such alternatives. While a substantial erosion of the natural monopoly feature of the local network is still some ways off, it is coming. The erosion in the long-distance market is proceeding much faster, and the activities of cross-border resellers will promote the erosion of the market even if Canadian regulators and telephone companies kick and scream against them.‘” These trends suggest that structural and accounting separations are in danger of becoming solutions in search of a problem. less
23See K.L. Wyman, Report of the Inquiry Officer with Respect to the Inquiry into Telecommunications Carriers ’ Costing and Accounting Procedures: Phase III - Costing of Existing Services, CRTC, Ottawa, 30 April 1984. 24While a recent decision by the regulator allows cross-border resellers to continue operating, rate restructurings by common carriers have reduced the competitiveness of resellers. Specifically, British Columbia Telephone was granted permission to raise short-haul rates to the USA, while substantially lowering long-haul rates. See Lawrence Sunees. ‘CRTC allows call resellers to stay open’, The Globe and Mail, 6 December 1984, p Bl.
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Steven Globerman
The growing worldwide trend towards deregulation in the teiecommunications industry is raising concerns about anticompetitive behaviour by the dominant carriers. This article reviews some of these concerns and gives examples of alleged anticompetitive behaviour by Canadian carriers. The author assesses the conditions under which predatory activities and foreclosure are likely to occur, and concludes that they may be made even more likely by regulation. He offers an evaluation of some aiternatlve policy approaches. Keywords: Competition; panies; Canada
Telephone
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The author is with the Faculty of Business Administration, Simon Fraser University, Burnaby, BC, Canada V5A 1 S6 (Tel: 2913708). An earlier version of this article was presented at the Second Bell Canada Economics Conference, Hull, Quebec, 17-19 December 1984. The author thanks various participants for helpful comments. He also thanks an unidentified referee for many useful suggestions. ‘Deregulation has reached an advanced state in almost all sectors of the US telecommunications industry, and it is currently gathering momentum in the UK, Canada and Japan. For example, a competitive long-distance carrier, Mercury, has been allowed entry into the market in the UK. The ‘privatization’ of Nippon Telephone is apparently a first step towards allowing market competition in Japan. And in Canada, the Canadian Radio-Television and Telecommunications Commission (CRTC) is (at the time of writing) evaluating an application by Canadian NationalCanadian Pacific (CNCP) Telecomcontinued on p 320
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Under comprehensive rate-of-return regulation of an industry such as telecommunications. issues concerning ‘fair competition’ are not especially relevant, since the behaviour of common carriers is tightly circumscribed by the regulator. At the same time. unregulated firms tend not to confront regulated firms in direct competition. The growing worldwide trend towards deregulation in the telecommunications industry is, therefore, bringing into more prominent focus concerns about the prices charged and conditions of access set by so called dominant carriers. ’ With deregulation, common carriers and a variety of competitors are increasingly confronting each other in markets for products and services which either are completely unregulated or allow some dimension of competition - such as pricing - to proceed in an unregulated fashion. As a consequence, allegations of actual (or potential) anticompetitive actions traditionally associated with complex oligoloply industrial structures have featured prominently in the debate surrounding the economic effects of telecommunications deregulation. Two broad categories of anticompetitive behaviour are especially prominent in the debate. One concerns predatory actions that might be taken by dominant carriers to eliminate or contain the growth of rivals. A second concerns the implementation of policies designed by extant suppliers to ‘foreclose’ markets to would-be entrants. Policies designed as predatory or to foreclose share a common characteristic: the dominant firm absorbs specific costs (or forgoes revenues) in the short run to generate (or preserve) even greater revenues in the longer run. The purpose of this article is to evaluate the relevance of expressed concerns about predatory behaviour and foreclosure in the context of the telecommunications industry. Specifically, these concerns will be reviewed in some detail and some examples of alleged anticompetitive behaviour by Canadian carriers will be provided., A theoretical assessment will be made of the conditions under which such actions are more or less likely to occur. An important conclusion of this assessment is that predatory actions and foreclosure may be rendered more likely by regulation. The fourth section contains a qualified evaluation of alternative policy approaches to deal with these threats. While the primary focus is on the competitive environment in Canada, the US
1985 Butterworth
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experience appropriate.
is obviously
highly
relevant
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to where
The broad issues
continued from p 379 munications to offer switched message toll service in competition with the common carriers. For a review of changing regulatory policy on a worldwide basis, see Luigi Montella. ‘Global competition and EEC policy in telecommunidations’, Telecommunications Policy, Vol 8, September 1984, pp 205-212. *A relatively recent definition of natural monopoly conditions is provided in William J. Baumol, ‘On the proper cost tests for natural monopoly in a multiproduct industry’, American Economic Review, Vol 67, December 1977, pp 809-822. 3See, for example, John S. McGee, ‘Predatory pricing revisited’, The Journal of Law and Economics, Vol XXIII, October 1980, pp 289-330. ‘See Patricia Lush, ‘B.C. tel rivals decry sales below the market price of subsidized equipment’, The Globe and Mail, 5 June 1984, p 83. ‘See William A. Brock and David S. Evans, ‘Predation: a critique of the government’s case in U.S. vs. AT&T’, in D.S. Evans, ed, Breaking Up Bell: Essays on industrial Organization and Regulation, North Holland, New York, 1983, pp 41-59. 6For an overview of recent models of price and non-price forms of predation, see Steven Salop, ‘Introduction’ in Steven C. Salop, ed, Strategy, Predation and Anfitrust Analysis, Federal Trade Commission, Washington, DC, September 1981, pp l-42.
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The traditional view of the telephone industry was that. in the absence of a monitoring agent, the prices charged by the monopoly common carrier would be ‘too high’ from the perspective of social efficiency. At the same time, there was no substantive concern that the common carriers would seek to bar the entry of competitors, since the premise was widespread that the industry was a natural monopoly. That is, natural cost-based barriers to entry made it unnecessary for common carriers to expend resources in order to erect ‘artificial’ barriers.’ In many respects. recent economic, technological and regulatory changes have almost completely reversed the traditional ‘natural monopoly’ concerns. Specifically. a widely expressed contemporary worry is that established telephone companies will set specific prices that are ‘too low’ - by some relevant social efficiency standard-in order to continue monopolizing markets that are structurally competitive. This broad concern about predatory pricing has been treated extensively (and contentiously) in the economics literature? however, there are certain unique features of the telecommunications industry (discussed below) which critics of deregulation argue will make the practice of predatory pricing more likely in the telephone industry. In recent years, allegations have been made that the terminal divisions of the major Canadian common carriers - Bell Canada and British Columbia Telephone - frequently price below cost in order to take market shares away from their competitors. It is suggested by some that revenues from ‘non-competitive’ activities are used to subsidize below-cost pricing in the terminal equipment market.” Similar allegations have been raised in both the USA and Canada regarding discounts on bulk services such as Telpak. Specifically, it is argued that such services are priced below cost in order to discourage large subscribers from taking the discount services of other common carriers.’ Price is only one of a number of instruments that so called dominant firms could use to eliminate or discipline rivals. Another is the installation of excess capacity so that the dominanl firm is in a position to ‘flood’ the market with output in the event of competitive entry. There is also potential for the dominant firm to provide ‘excessive’ levels of service or to saturate the market with new product and service offerings in order to displace or contain rivals.” Non-price predatory behaviour has been alleged (among other sectors) in the terminal equipment market - specifically, that the equipment divisions of established carriers provide ‘excessive’ levels of service. Again, costs that are not directly recovered in the terminal equipment market are presumably covered by net revenues earned in the carrier’s regulated businesses. Notwithstanding the variety of potential predatory tools, current concerns about predatory behaviour in the telecommunications industry focus primarily on price rather than on other potential instruments. While predatory behaviour can have the effect of intimidating not only existing rivals, but also would-be entrants. activities designed to prevent entry into a market are more typically discussed under the heading of foreclosure. In this regard, the telephone companies are
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Predatory
7See Brock and Evans, op cif, Ref 5. ‘This argument has also been put forth to explain AT&T’s dominance in the terminal equipment market prior to divestiture. See Joseph P. Fuhr, Jr, Competition in the terminal equipment market after carterfone’, The Antitrust Bulletin, Vol XXVIII, Fall 1983, pp 889898. ‘While the regulator in Canada has continued to affirm the separation between telephone carriage and content, the line between basic and enhanced telephone service is blurring rapidly. Hence, complaints raised by suppliers of enhanced services are likely to increase in the future. See Jonathan Chevreau, ‘Group seeks to avoid abuses of lnet trial’, The Globe and Mail, 8 July 1983, p Bl 1. “See Dan Westell. Cellular radio firms’ interconnection talks hit snag’, The Globe and Mail, 28 October 1984, p 814. “For a discussion of the US experience, see Brock and Evans, op tit, Ref 5.
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alleged to use a number of specific practices to exceptional advantage in order to prevent entry into structurally competitive markets. One such practice is regulatory foreclosure, whereby the common carrier forces would-be entrants to incur relatively large legal and related expenses in order to receive regulatory approval to offer a service.’ Since these expenditures are presumably non-recoverable. regulatory harassment is held to be an especially effective way to raise entry costs, since the cost involved will be ‘sunk’ in the event that the regulator rules in favour of the common carrier. More conventional models of market foreclosure emphasize the relevance of the integrated structure of telephone companies. Specifically. they emphasize the ability of the common carrier to deny entrants physical access to local exchanges - or, in other cases, to long-haul transmission capacity - in order to foreclose competition that directly or indirectly makes use of those facilities. This ‘chokepoint’ foreclosure argument has been implied in allegations by competitive suppliers of private line services that they are frequently harassed by delayed access to local exchanges. In other cases, competitive suppliers of terminal equipment have complained of being denied ready access to interconnection.x Recently, competitive suppliers of enhanced services have argued that (in various ways) they are at a disadvantage by having to use the local exchanges of established telephone companies. For example, suppliers of data-base information services argue that their customer information available to the telephone companies can be used by the latter in their own marketing efforts.” Another argument has been raised by competitors to the common carriers in the provision of cellular radio services who have complained about ‘unreasonable’ conditions being imposed for access to the local exchange.“’ While (at the time of writing) there is no legal competition in Canada for the provision of switched long-distance services, one can imagine that when such competition is authorized, charges of both predatory behaviour and foreclosure will surface, as they did in the USA. For example. it is argued that AT&T introduced selective discounts on those routes subject to competition from new carriers. It is also argued that AT&T made interconnection into the local exchanges artificially expensive, thereby raising the entrant’s operating costs.” Indeed, it was a concern about the potential for foreclosure that strongly contributed to the decision to create separately owned local operating companies in the USA, and to Judge Green’s position that the Bell operating companies refrain from competing in the interexchange market.
Predatory behaviour Activities such as the examples identified above share a common characteristic: the dominant firm absorbs specific costs (or foregoes revenues) in the short run to generate (or preserve) even greater revenues in the longer run. This relationship is evident in the case of predatory pricing, or in alleged cases where ‘goldplated’ services or equipment features are offered to drive out - or restrain - competition. It is less obvious in foreclosure, although attempts to foreclose by introducing regulatory delays clearly involve a direct short-run cost to the common carrier in return for an increased probability of maintaining the returns earned on its regulated activities. In other cases, such as
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‘*See McGee, op cif, Ref 3. “In the current vernacular
of Industrial organization economists, when markets are ‘contestable’, simple price predatory activities are a strategy doomed to failure. The key attribute of contestable markets is ease of entry and exit. For a seminal discussion of contestability, see W.J. Baumol, John Panzar and Robert Willig, Contestable Markets and the Theory of Industry Structure, liarcourt Brace Jovanovich. New York, 1982. For a recent critique of the contestability model, see William G. Shepherd, ‘Contestability vs. competiton’, The American Economic Review, Vol 74, September 1984, pp 572587.
‘%ee, for example, J. Fred Weston and Clement G. Krause, ‘Competition in the telecommunications and information services markets’, in Attachments and Appendices to Comments of American ‘ieleohone and Telearaoh Comoanv. CC Docket No 8%1147.lbefore the Fiieral Communications Commission, Washington, DC, 2 April 1984, pp 24-25. ‘5The basis for the following discussion is found in Brock and Evans, op cit. Ref 5.
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when access to the local (or toll) network is restricted. the common carrier foregoes specific revenues, in exchange for the (anticipated) preservation of even greater revenues. Specifically, the common carrier foregoes access and usage charges that it would collect as a ‘wholesaler’ of capacity to competitive suppliers, while presumably maintaining the revenues it earns as a retailer of specific services to subscribers. The logic underlying foreclosure strategies may therefore be seen as similar to the logic underlying predatory strategies. The practical relevance of models of predatory behaviour has been debated intensively in the literature. In particular, the likely success of predatory pricing has been questioned by many economists. The basic scepticism rests on the notion that. unless the predator enjoys a competitive advantage in the marketplace, it might never be able to recoup its early losses by pricing above marginal cost in the future.” In the limit. if quick entry and exit on the part of rivals is possible, the predator would find it essentially impossible to inflict losses on rivals through below-cost pricing, and it would be unable to recoup its own losses by charging prices above marginal cost for any length of time. Consider the following example: a product has a (constant) marginal cost of $1 per unit. A dominant firm charges $0.50 per unit for five years in order to discourage or destroy competition. It anticipates being able to charge $1.50 per unit once competitors are eliminated from the marketplace. At a 10% discount rate, it would take approximately 12 years for the predator simply to recoup the losses incurred. Obviously the predator must believe that there are durable barriers to entry in order to contemplate predatory pricing. But it is difficult to imagine such lengthy delays in entry when rivals expect to earn a 50% profit margin on sales. Without belabouring the issue, the foregoing example underscores the point that predatory pricing is an implausible strategy in the absence of inordinately high entry and exit costs.” In this regard, a number of observers have argued recently that. in most sectors of the telecommunications industry, entry and exit costs are relatively low.” Consequently, they consider the local network as the only sector in which predatory pricing is theoretically plausible. But, of course, there is no genera1 suggestion that telephone companies are attempting to price predatorily in the local segment of the network. Pretiatory
hehavioiir
throicgh
gross-slihsidizirlg
The potential for predatory pricing in the telecommunications industry is generally held to be inherently greater than in most other industries, owing to the telephone companies’ alleged capacity to cross-subsidize competitive activities from regulated revenues. Consider the simple case where a firm produces two outputs: q’ is produced subject to common carrier regulation, while 4’ is produced and sold in unregulated markets. ” In the conventional model of predatory pricing outlined above, the firm prices q’ below marginal cost for a period and then prices above marginal cost for some indefinite period. The regulated firm’s advantage stems from the notion that - by increasing the price of q’ - the cost of predatory actions in the unregulated market can be reduced. In effect, the predator does not have to recoup the costs entirely in the competitive market. The full cost of predatory activity in the competitive market might be recouped through higher prices in the regulated market.
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Ignoring the complexities introduced by cross-price elasticity effects and cost complementarities, it is obvious that this simple cross-subsidy argument is flawed. Specifically, if the regulated firm can easily and continually obtain approval for higher (regulated) rates of return. why would it dissipate those returns in the competitive market? Why would it not simply pay higher dividends to shareholders? Furthermore, if the regulator is responsive to requests for higher regulated prices. it would be illogical for telephone company management to wait until it is losing money in market two before asking for a higher rate of return in market one. Indirect predatory behaviow
“The AverclwJohnson (AJ) effect refers to an over-capitalization bias in regulated utilities. That is, utilities use more capitalintensive methods than is economically justified, although the bias contributes to a higher return to utility shareholders. The classic article here is Harvey Averch and Lelan Johnson, ‘Behavior of the firm under regulatory constraint’, The American Economic Review, Vol52, December 1963, pp 1052-l 069.
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A subtler version of the cross-subsidy argument posits that relevant cross-subsidies from the regulated sector (one) to the unregulated sector (two) are indirect. For example, the carrier purchases equipment (or services) from its unregulated affiliate at prices above marginal cost. In turn, the latter uses the ‘quasi-rents’ earned to subsidize lower prices, or improved services, in the competitive markets it serves. The regulated affiliate in turn incorporates the higher prices paid into its rate base. If the allowable rate of return on the base equals the firm’s cost of capital, the subsidies generated for the unregulated affiliate are at the expense of the telephone subscriber. And if the allowed rate of return exceeds the regulated firm’s cost of capital. the cross-subsidy programme would directly increase the capital value of the regulated affiliate. While raising suggestive concerns, several reservations can be expressed about the indirect cross-subsidy argument. One reservation is that the regulator may not automatically approve additions to the rate base, especially when substantial capital expenditures are involved. Even if there were no difficulty in adding ‘overpriced’ equipment to the rate base, the cross-subsidy strategy described above would be profitable only if substantially higher prices could ultimately be realized on future competitive sales and/or the allowed rate of return in the regulated sector exceeded the required rate. However, there is no strong empirical support for the latter contingency. More specifically, there is no consistent evidence that the Averch-Johnson effect holds as a general phenomenon.‘” Hence, there can be no general presumption that the allowed rate of return exceeds the telephone company’s cost of capital. A second reservation relates to the desirability of dissipating quasi-rents gained from overpriced equipment sales to the regulated affiliate through underpriced competitive equipment sales. In particular, if the latter market is characterized by relatively easy entry and exit, it can be argued that the telephone company’s unregulated equipment affiliate will never be able to sustain non-competitive prices for equipment sold at arm’s length. In this case, it can be argued that the telephone company is better off paying higher dividends to its shareholders where it is successful in ‘padding’ its rate base. The implication of the foregoing discussion is that the cross-subsidy model (featuring a partially regulated telephone company) is an unlikely form of predatory behaviour under a plausible set of assumptions about the industry. Yet it is given great a priori credence by regulators and policymakers. In a related predatory model, both q’ and q* are produced and priced subject to an overall rate of return constraint. When the price of q* is December
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reduced, the firm’s overall regulated rate of return will decline below the allowable rate. other things being constant. The regulated firm then applies for an increase in the price of q’ to restore the firm’s overall return to its allowable target. Since the firm’s overall profit rate is constrained, the benefit of predatory behaviour in this case is indirect. Specifically. presuming the price elasticity of demand for 9’ exceeds that for q’, the relative price change described will result in an overall increase in the regulated firm’s volume of output and (presumably) in its rate base. This indirect predatory strategy will be profitable presuming that the firm’s allowed rate of return exceeds its cost of capital. However. as noted earlier, there is no consistent evidence that the former systematically exceeds the latter in regulated industries. Therefore. unless telephone company management is motivated by non-profit objectives, there seems no strong incentive for the fully-regulated company to act as a predator in markets where it faces competition. The qualification that management may be motivated by non-profit objectives is obviously of potential relevance when applied to common carriers. Indeed, regulatory constraints on profitability may contribute to telephone company managers being more strongly motivated by sales growth than by profitability. In this event. cross-subsidies from regulated to unregulated activities may be implemented to the extent that they contribute to faster output growth. Faster growth facilitated by predatory behaviour will be socially inefficient. since the incremental output produced by the telephone company would presumably be produced more efficiently by other firms. The relevance of ‘standard’ models of predatory behaviour to the telecommunications industry therefore turns on the empirical question of whether or not telephone company managers are primarily profit oriented. While the literature is not unequivocal on this point, the evidence clearly suggests that public sector organizations generally are less strongly motivated by prospective profits and more strongly motivated by growth prospects than their private sector counterparts. ” Extrapolating this finding to the common carrier sector. incentives for predatory behaviour in competitive segments of the telecommunications industry are enhanced by conventional rate of return regulation. ‘accidental’ predatory bchaviour might be encouraged by Moreover, regulation to the extent that regulated managers are imprecise in their cost-allocation procedures. However. rather than arguing against deregulation, these caveats support a move towards expanding the competitive sectors in which common carriers operate. Specifically, by allowing shareholders of common carriers to be residual claimants of all should focus on efficiency gains, their agents (that is, management) maximizing profits rather than on non-pecuniary objectives.
Forecloswe
“For a comprehensive review of the relevant literature, see A. Vining, ‘Mixed enterprises’, mimeo, Simon Fraser University, February 1984.
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A major reservation about conventional models of predatory behaviour is the fact that substantial up front losses must be incurred in return for a claim to an uncertain future income stream. However, where the up front losses are fairly small. exclusionary practices have greater u priori relevance. In this regard, a frequently cited concern is that competitors will be denied access to the local and long-haul segments of the network. Since this is presumably a low-cost action to the telephone company, it
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may be a highly attractive technique for blocking competition in non-regulated sectors. The first point to note in this regard is that foreclosing access to key segments of the network can be a potentially costly strategy for the telephone company. Specifically. revenues are forgone in preventing uses of the network that are derived as a demand for competitive services. It is conceivable that. in some cases. the revenues forgone may exceed the net revenues preserved by ‘handicapping’ competitors. This might be true, for example. in the case of certain enhanced services. In effect - under certain circumstances - forgone sales at the ‘wholesale’ level may more than outweigh revenues lost at the ‘retail’ level that are associated with substitution away from the services of the common carrier. With a growing proliferation of specialized usages of the telephone network. this latter qualification may be increasingly relevant. Another qualification to the ‘chokepoint’ foreclosure argument is the potential for subscribers to ‘bypass’ the network. To the extent that large business subscribers can economically justify their own networks. indirect substitution away from the services of the common carrier limits the efficacy of foreclosing network access to rival carriers. It is not possible to evaluate the current status of bypass activity. especially in Canada, where relatively little published evidence exists. But there is good reason to believe that both technological change and the growing sophistication of subscribers are diminishing the relevance of denying ‘fair’ access to the network as an exclusionary tool. Over the foreseeable future, the main concern about foreclosure is related to access to the local exchange for the provision of message toll service (MTS). One can argue that - in this area - telephone companies have both the incentive and the ability to engage in exclusionary practices. since the ‘substitution’ effect of lost MTS traffic is likely to outweigh the additional access revenues gained from compctitivc suppliers of interexchange services. This is especially true under the current rate structure which underprices access and overprices Iongdistance usage.
Policy alternatives Policymakers are considering various threats of predatory behaviour and regulated competition. They include: 0
0
0
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ways of dealing with perceived foreclosure under a regime of
Structural separation: require competitive divisions of common carriers to operate as separate subsidiaries - with separate management and overhead functions. Strict cost-accounting scrutiny of prices charged by divisions and affiliates of the common carrier. including transfer prices between regulated and unregulated affiliates or divisions. Clearly these first two options can be implemented in conjunction with each other as well as separately. Limiting the freedom of common carriers to participate in unregulated activities or proscribe such activity entirely. This option could include ‘handicapping’ the telephone company by mandating a minimum differential between its prices and the prices of its competitors, limiting its allowable scope of activities to strict transmission of voice and data, and so forth.
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“As an alternative to establishing separate subsidiaries, Swedish authorities require service providers publicly to disclose data on costs and revenues by detailed product line. See OECD, Telecommunications: Pressures and Policies for Change, Director of Information, OECD, Paris, 1983, p 98. ‘%ee Steven Globerman, ‘Economic factors in regulatory policies for the telecommunications industry’, in W.T. Stanbury, ed, Economic, Technological and Political Considerations in Deregulating the Canadian Telecommunications Industry, Institute for Research on Public Policy, Montreal, forthcoming. “‘Ibid.
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Full divestment of local exchange manner of the AT&T agreement.
from other network
services
in the
In the USA, the Federal Communications Commission has decided to enforce separate costing and accounting by requiring AT&T to participate in competitive markets only through a separate subsidiary. In the UK, changes in legislation will lead the supplier to establish separately accounted subsidiaries for the purpose of participating in terminal equipment markets, while Canadian regulatory authorities are currently examining whether structural separation of telephone company affiliates engaged in competitive activities should be required.lx An evaluation of these or other policy proposals to deal with perceived threats of predatory behaviour and foreclosure requires an assessment of the empirical relevance of potential competitive problems in a deregulated environment. The assessment, in turn. hinges largely on whether or not one believes that markets for telecommunications services are workably competitive (or contestable). Elsewhere 1 have argued that Canadian markets for enhanced services and terminal equipment are structurally (and behaviourally) competitive. Specifically, interconnect companies in Canada, as well as suppliers of valueadded services, have grown rapidly in number over the past few years and have taken a substantial share of the market from divisions of the established common carriers. Quality-adjusted prices of subscriber equipment have declined dramatically. while product features and new services have proliferated. ” I have also argued that relaxation of specific regulatory restrictions in areas of reselling and sharing, competitive access to satellite capacity and more liberal licensing of microwave channels for voice communication would go a long way towards making the long-distance market workably competitive.“’ In this framework, regulation enhances rather than diminishes concerns about predatory activities. The current rate structure in which prices for various network services bear no strict relationship to their costs virtually ensures that competitors will charge telephone companies with practising predatory pricing once the latter begin their inevitable move toward rate rebalancing. An implication is that rate rebalancing would further mitigate the relevance of predatory pricing as a competition policy issue. The above discussion of several simple predation models indicated that the linkage between the local exchange and competitive network services constituted perhaps the greatest single incentive to predatory behaviour, especially in view of a potential Averch-Johnson bias. Since access to the local network is also the single most significant ‘chokepoint’ in terms of possible foreclosure. separation of the local exchange from other network-related services may be a socially beneficial policy. Whether the separation should be accounting-based, structured along the lines of separate subsidiaries or structured as a mandated divestment, constitutes an important and controversial policy issue. Obviously
in this short article, it is only possible briefly to identify and evaluate the major considerations relevant to the issue. Two points might be made. First, accounting-based evaluations of the ‘fairness’ of prices charged - for either inter-company or intra-company exchanges are bound to be fraught with contention and (furthermore) are unlikely to be reliable guides to socially efficient prices. This stems not only from inevitable arbitrariness in allocating overhead costs of both a fixed and
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Predarory pricing and foreclosure
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variable nature, across products and over time, but also from the fact that accounting costs assume static demand and cost functions. while management is presumably concerned with maximizing over long-run demand and cost functions. These shortcomings are only mitigated - not eliminated - by the ‘separate subsidiary solution’, especially since common ownership of the various affiliates will perpetuate an incentive to predatory behaviour, if there is a reasonable prospect of succeeding. Second, a requirement to establish separate subsidiaries will impose social costs in terms of increased overhead expenditures and the sacrifice of potential economies of scale. These latter costs would presumably be even greater in the case of full divestment.” In addition, the divestment solution would introduce a variety of once-and-for-all ‘deadweight’ costs associated with organizational changes in the common carrier, changes in billing procedures and the like. The divestment alternative would, however, be relatively effective in eliminating the incentives for predatory behaviour and foreclosure described above. Whether the benefits of divestment in Canada - or in the USA for that matter - are worth the costs is arguable. Certainly divestment is a fairly radical structural policy for Canada, which (to this point) has favoured behavioural approaches to competition policy, such as the imposition of rigorous cost-separation principles. An aversion to structural competition remedies is illustrated by the fact that the Canadian government has yet to overturn a merger on grounds of competition policy. Furthermore, divestment would certainly generate an explosive conflict between the federal government and provincial governments in Ontario, Quebec and British Columbia, the jurisdictions in which Bell Canada and British Columbia Telephone operate. In other provinces, where telephone companies are outside of the federal regulator’s jurisdiction, litigation between different levels of government can be expected to result from any significant federal initiative to divest local access facilities from other network and off-network activities. In the absence of a clear commitment to move local subscriber charges closer to cost. it is difficult to imagine that enthusiastic investors will emerge to take ownership of local exchanges.”
Conclusions *‘The apparent willingness of some telephone companies to establish separate subsidiaries suggests that these costs may be fairly modest for certain activities, such as terminal attachment sales. At the same time, the competitive benefits of the separate subsidiary solution are also likely to be modest. A sacrifice of economies of scope and scale also potentially characterizes a policy that requires common carriers to forbear from certain activities. Furthermore, the latter policy may well move a market away from being contestable. **Unlike the US situation, there are currently no plans in Canada to implement local access charges. Furthermore, the subsidy to local subscribers (in relative terms) is substantially larger in Canada than in the USA.
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Virtually all economists would agree that the most effective remedy to concerns about predatory activities and foreclosure, per se, is structural divestment; however, it is much less clear that divestment (as an overall policy) offers net social benefits. In any case, political opposition in Canada to a divestment policy is likely to be overwhelming. As a practical matter, divestment does not appear to be a viable, if desirable, policy approach. On the other hand, while problems associated with implementing cost separation or structural separation (ie, mandating separate subsidiaries) are relatively benign, the associated benefits are questionable. In particular, it is unclear that these steps - of themselves - will significantly reduce incentives to predatory behaviour and foreclosure or enhance the ability of regulators to detect exclusionary behaviour. At the same time, there are potentially significant costs in terms of forgone economies of scale and scope, although these latter costs may be much December
1985
Predatory pricing and foreclosure
itI telecommur~ications significant than some telephone company executives have suggested. It can be argued that focused regulation of economic activity at the local exchange level - until such time as this sector is workably competitive - may be the most desirable policy of the alternatives available. Specifically, ensuring that an Averch-Johnson-based incentive for predatory behaviour does not exist is presumably within the current mandate of the regulator. This madate could presumably be carried out more effectively if the regulator’s resources were not dissipated examining and evaluating the ‘fairness’ of prices of individual services. In like manner, ensuring fair access to the local exchange can be subsumed within the existing regulatory structure. While estimating costs of success will be an important component of this exercise, it is a relatively focused activity that does not seemingly require structural separation, nor the elaborate cost-accounting framework suggested by the Cost Inquiry conducted by the Canadian Radio-Television and Telecommunications Commission.” Given the pace of technological developments. local bypass alternatives for large businesses will soon constrain the market power of the telephone company vis-cj-vis this set of customers. Large apartment dwellers are also in the (technological) position of taking some advantage of such alternatives. While a substantial erosion of the natural monopoly feature of the local network is still some ways off, it is coming. The erosion in the long-distance market is proceeding much faster, and the activities of cross-border resellers will promote the erosion of the market even if Canadian regulators and telephone companies kick and scream against them.‘” These trends suggest that structural and accounting separations are in danger of becoming solutions in search of a problem. less
23See K.L. Wyman, Report of the Inquiry Officer with Respect to the Inquiry into Telecommunications Carriers ’ Costing and Accounting Procedures: Phase III - Costing of Existing Services, CRTC, Ottawa, 30 April 1984. 24While a recent decision by the regulator allows cross-border resellers to continue operating, rate restructurings by common carriers have reduced the competitiveness of resellers. Specifically, British Columbia Telephone was granted permission to raise short-haul rates to the USA, while substantially lowering long-haul rates. See Lawrence Sunees. ‘CRTC allows call resellers to stay open’, The Globe and Mail, 6 December 1984, p Bl.
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