The Relationship between Access Pricing
Regulation and Infrastructure Competition
Report to OPTA and DG Telecommunications
and Post
by
Brunel University
March 2001
Professor Martin Cave*
Dept of Economics & Finance Brunel University
Professor Sumit Majumdar
Imperial College Management School ir. Hendrik Rood
Technical University of Delft & Stratix Consulting Group BV
Dr Tommaso Valletti
Imperial College Management School Professor Ingo Vogelsang
Department of Economics Boston University
*Author for correspondence: Martin.Cave@brunel.ac.uk
Executive Summary Page 3
0. Introduction Page 16
1. The Theory of Access Pricing and its Linkage with Page 18 Investment Incentives.
2. Country Experiences Page 33
3. The Relationship between Access Pricing, Page 44 Regulation and Investment In the US and European
Telecommunications Sectors
4. Investment Strategies in the Netherlands Page 52
5. Conclusions Page 72
Glossary Page 83
*This report sets out our analysis and our conclusions. More detailed information, including references to the literature, further information on our econometric work and a review of investment by major firms in the Netherlands market, can be found in our Working Papers, referred to in the text.
Introduction
1. We were commissioned by the DGTP and OPTA to analyse the relationship between the regulation of access pricing and investment behaviour in the fixed telecommunications industry, in the context of the Netherlands. The key question investigated how regulatory decisions relating to the access by operators to one another’s network (especially to the network of the dominant incumbent) influence the extent of competition in the market and the form which it takes. The most prominent decisions of this type relate to the price at which access is granted, but other dimensions, such as the quality of interconnection and the eligibility of different classes of operators to buy interconnection at wholesale prices, are also important. The two key forms which competition takes are infrastructure (or facilities based) competition and service competition. In practice, however, most operators, apart from pure resellers, find themselves in a situation involving the use of a mixture of their own and other operators’ facilities.
2. In order to investigate the issue, we deployed a number of separate types of analysis:
§ first, we investigated the impact of access pricing on investment decisions from a theoretical point of view, using the existing literature relating to the impact of access pricing on industry structure in a world which has settled down to an equilibrium, but extending that analysis to the more difficult but realistic context in which competition is developing and entrants are making decisions on where and how to invest;
§ second, we used available quantitative data to analyse the relationship between investment behaviour by some or all of the firms in the industry and the access pricing régime; we were limited by the availability of data, and tested a number of different hypotheses, some of them using US state-level data and others data from EU member states or OECD countries;
§ third, we undertook three country case studies, analysing in greater depth the development of access policy, its linkages to policy objectives relating to the form of competition and its apparent effect on the development of competition;
§ fourth, we carried out a detailed analysis of the recent investment behaviour and strategies of a number of major firms in the telecommunications sector in the Netherlands. As well as KPN, these included firms pursuing a variety of entry strategies, including Versatel, Tele2, Worldcom and Cable TV companies.
4. We now set out the individual components of our analysis (paras 5 - 44) and our conclusions (paras 45-53).
How access regulation is likely to influence investments.
5. Economic theory, as well as regulatory policy, has recognised the key importance of access regulation for the development of competition. Most of the analysis has been developed within a static context, ignoring ‘real time’ interactions among the investment decisions of firms in the period of transition towards competition.
6. The static theory of access pricing can be briefly summarised. Absent complexities of the kind considered below, access prices should be set equal to marginal cost. Because of economies of scale, this may impose losses upon the access provider which cannot be subsidised from elsewhere – in which case mark-ups over marginal cost would ideally be imposed to ensure that those losses were recovered in the most efficient manner (Ramsey prices). However, telecommunications operators are often subject to regulatory restraints upon their retail tariffs, which have the effect of making some services artificially profitable and some loss making. If the sole aim were to ensure that entrants only come into the market if they are more efficient than the original supplier, they should be charged access prices which are equal to the incremental cost of the service plus the profit which the incumbent was making from the service and which it needs to cross-subsidise other services at the retail prices enforced by the regulator. In practice, regulators have generally declined to adopt the above principle, known as the efficient component pricing rule, favouring instead access pricing based upon forward looking long-run incremental costs. Forward looking costs are preferred to historic costs because technical progress lowers costs over time, and entrants in making decisions over whether to build their own infrastructures should be comparing their own forward looking costs with access charges reflecting the same calculation in relation to the incumbent. 7. Turning to a more dynamic analysis, a range of further considerations relating
to the timing and sequence of investments by incumbent and entrants must be taken into account. A firm’s decision to invest in infrastructure will be influenced by its expectation of the access pricing régime. If it is narrowly cost-based, then investment incentives will be muted. At the very least, the access pricing régime must take account of the distribution of risks between access providers and access purchasers. This allocation is changed for example, by the adoption of capacity pricing – whereby an access seeker commits to lease a given amount of capacity supplied by an access provider, rather than buy services on a per-minute basis. The purchase of capacity shifts risks from access provider to access seeker, and hence should be associated with a lower price for access.
property, just as high access prices secure returns to builders of infrastructure. In both cases, the rewards to the first mover are significant. In the case of infrastructure construction, there may be advantages in being the “first entrant” relative to a subsequent entrant. This difference alerts us to a significant distinction in interactions in firm behaviour dependent upon whether the market being served is a new market, or one in which the historic operator enjoys the benefits of incumbency. In the former case, all firms are on an equal footing in terms of their history. In the latter case, there is a clear difference between the incentives faced by the incumbent, which has lower costs and enjoys considerable advantages, and those faced by entrants as a group. In our analysis below, we find examples of both cases.
9. Focussing more narrowly upon the relationship between access regulation and the form of competition, we have utilised and developed some recent work on three different forms of competition by entrants, facility based competition, local loop unbundling and carrier selection. These involve levels of infrastructure investment by entrants in descending order. If facility based competition is pursued, the analysis suggests that, even if reciprocal and cost-based termination charges are ideal in the long run, the regulator may choose to allow a higher termination charge for the entrant in order to increase the rewards for aggressive competition for market shares. It should be recognised, however, that these results hinge upon a special model. Our own attempts to extend the model have yielded similar results, also based on special assumptions. In terms of consumer welfare, in the short term increased competition should counteract the effect on costs of higher access charges. The policy will also speed up the arrival of effective competition. 10. Reviewing the theoretical literature as a whole, we identify a number of cases
in which, in a dynamic context, the optimal access pricing régime appears to depart from the simple rule of forward looking cost-based pricing. In particular, examples can be found where departures from level pricing over time appear to be desirable, because they provide necessary extra incentives to engage in facility based competition. The desirable trend in access pricing appears to be upwards over time (relative to cost). In other words, when an incumbent is established in a market, offering the entrant (or entrants) a schedule of access prices which rises over time may be desirable.
11. The form of ex post regulation of access charges has an impact on the ex ante incentives to invest in infrastructure. In the long run, cost-based access charges should be promoted. In the short run, asymmetric measures are justifiable in order to promote entrants. A distinction should be drawn between infrastructure that is already in place and investments that are not already sunk. For the former, ‘open’ (e.g. cost-based) access policies are recommended; for the latter a suitable mark-up would speed up the ‘race’ among operators to invest.
12. As part of the project, we analysed in more detail policy towards access pricing and competition in three countries, the UK, the USA and Denmark. The UK case is of particular interest because, from the start of liberalisation in 1984, the Government and regulator adopted policies specifically intended to promote infrastructure competition. This was first attempted via the duopoly policy, which gave privileged entry to a single additional operator which was subjected to network build out obligations. When the duopoly policy was abandoned in 1991, a stimulus to the construction of cable networks was introduced, in the form of a line of business restriction on telecommunications operators which prevented them from supplying entertainment service. Cable networks, by contrast, could supply both telephony and television. An additional form of entry promotion, more relevant to the concerns of this study, was embodied in the access pricing régime. Subject to time and market share limitations, entrants were entitled to an abatement in one of the charges (access deficit contributions) which they paid to BT to interconnect with BT’s network.
13. The level of interconnection charges in the UK was also significantly influenced in the 1990s by changes in costing methodology. A re-examination of BT cost allocation procedures led to a significant reduction in interconnection charges in the early 90s. Subsequently, the costing methodology used to establish interconnection charges switched from an historical cost basis to a forward looking incremental cost basis. This had the effect of reducing interconnection charges by a significant amount when the new system was introduced in 1997.
14. In keeping with the policy of promoting infrastructure competition, BT’s network services were only available at wholesale prices to the category of operators defined as having ‘relevant connectable system’ – i.e. those making significant infrastructure investments. This policy on eligibility has been maintained, although in the course of the 2001 Price Control Review, OFTEL at one stage contemplated allowing all operators, including re-sellers, to purchase BT’s network services at cost-based interconnection rates. This policy would have had the effect of bringing retail prices much more speedily into line with costs.
15. The obverse of the UK’s enthusiasm for infrastructure competition was a reluctance to embrace local loop unbundling. This resistance persisted until the late 90s when the policy of privileging infrastructure competition was effectively abandoned. As a result of the delay, the UK has encountered some difficulty in meeting EU targets for local loop unbundling.
attracted competitive access providers, but many residential markets remained monopolies. US cable TV networks were not upgraded to provided telecommunications services. Resellers were active in long distance, but not in local markets.
17. The 1996 Act represents a systematic attempt to promote competition, notably through the introduction of an interconnection régime which imposed on incumbent local exchange carriers the obligation to provide unbundled network elements where technically feasible and to price them on the basis of costs, which the FCC interpreted as a forward looking incremental cost standard. In addition, cable TV companies have in recent years modernised their networks through fibre optic cables and two-way capabilities, and are now widely capable of operating broadband internet access via cable modems; increasingly, they offer narrow-band voice telephony. This process has been spearheaded by AT&T, which has sought to get into local telephony and broadband access by purchasing large cable TV companies.
18. However, the verdict on the 1996 Act has been mixed. Expectations for a quick spread of local competition had been high and were disappointed. To some extent this was due to low local service prices which, throughout most of the United States, are only loosely related to costs. In addition, it resulted from the complex nature of legal and regulatory processes in the United States, which kept the FCC’s 1996 Local Competition Order tangled up in the courts for at least three years. There is general agreement that the Act substantially reduced the predictability of regulatory decisions because, unlike its predecessor, it was untested in the courts and because it combined the qualities of being highly complicated and imprecisely formulated. Its general philosophy is to take an even-handed approach across the three alternatives of facilities-based competition, the use of unbundled local loops and reselling. 19. Our third case study is of Denmark, which liberalised its telecommunications
sector in 1996. Tele Danmark, the former monopolist, remains by far the strongest player in the Danish market. It is also the largest cable TV operator, with more than half the market. This gives it a dominant position in the local loop. Competition has largely been confined to long-distance and international markets.
20. Regulatory responsibilities for interconnection are divided between the relevant government ministry, which sets the detailed framework, including the methodologies used to calculate interconnection charges, and the NRA which approves the incumbent standard interconnection offer. Interconnection rates were initially high, and the NRA’s attempts to reduce them were tied up for a considerable period in an appeals process. Over the past 18 months, however, charges have fallen substantially, and are now broadly in conformity with EU benchmarks.
22. Data for the three countries discussed above are combined with equivalent data for the Netherlands (and the EU benchmarks) in the following table.
Objectives Pricing Principle Interconnection rates* 1 2 3
LLU**
USA Not explicit TELRIC Various Various
UK Infrastructure
Competition
LRIC 0.54 0.82 1.71 15.9
Denmark Not explicit Moving to LRIC 0.84 1.18 1.80 8.3
Netherlands Not explicit
(except LLU) Embedded Direct Cost 1.00 1.41 1.70 12.5 EU Benchmarks
Not explicit Average of best practice
0.5 0.8 1.5 -0.9 -1.5 -1.8
Not applicable
*Eurocents per minute for local, single tandem and double tandem interconnect. ** Euros per month.
23. Drawing inferences from a limited number of case studies is notoriously difficult. The UK experience shows that a persistent regulatory policy in favour of a particular form of competition can work. Experience for all three countries shows that the development of facilities-based competition, especially in the local loop, is a protracted process.
Quantitative analysis of the relation between access pricing and infrastructure competition
24. In this part of the study, we examine quantitatively the recent recordof the link between access prices and levels of investment. Ideally, we would have had access to a complete database of interconnection rates and investment levels of individual firms - or at least a breakdown between incumbent’s investments and entrants investments.
25. Unfortunately, the available data do not permit such an analysis. We were therefore forced to address a series of questions, which differed in accordance with the data available in our two major samples – US states and EU member states.
26. Using the US data, we investigated the link between investment behaviour by incumbent local exchange carriers in new technology, and the access prices charged by those carriers (for call origination or termination) to long distance carriers. The data we employed were mainly compiled by the Federal Communications Commission or the Federal/State Joint Board.
digitalisation deployment, as measured by the ratio of digital lines to total lines. If high access prices encouraged high modernisation expenditure, we would expect a positive relationship between access prices and these two dependent variables. In the event, we found that the relationship between access prices and the two dependent variables (fibre intensity and the digitalised ratio) was negative, and statistically significant in the latter case. This suggests that lower access price promotes greater employment of digital technology amongst US incumbent local operators.
28. A further result of interest was the relationship between modernisation investment and the number of local competitors. The results showed a negative but significant relationship between fibre intensity and the intensity of competition, and a positive but insignificant relationship for digitalisation rates. In discussion of the relationship between access pricing and modernisation expenditure, we note that it can be in the incumbent’s interests to encourage access to the network through lower access prices. By enabling lower consumer prices to be charged, a lower access charge encourages network usage; the resulting enhanced network usage promotes investment in new technology which enables productivity gains to be realised. We should emphasise, however, that this is only one possible interpretation of the results. 29. The European data cover investment expenditure at the national level whether by incumbents or entrants. Our analysis is based on correlation analysis using a small number of observations, and must be interpreted with caution. The results show that in 1997 telecommunications investments were on average higher in the European countries which adopted the ex post direct costs based method for calculating access charges. We also find that in countries where the originating access charge was higher than the EU average, telecommunication investment levels were above average. However, there is some question about the direction of causation here. It may be that higher access charges are promoting investments, presumably by entrants in the form of bypass of incumbents’ networks. Alternatively, the régime for calculating cost-based prices may also translate high levels of investment expenditure directly into higher access charges in the succeeding period. The data available do not permit us to find a way of discriminating between these alternatives.
30. Finally, we used a larger sample of OECD countries to test whether digital and fibre investment patterns at the industry level were influenced by competition. Our tentative conclusion is that competition has facilitated investment in fibre optic cable, although, given the aggregated nature of the data, we cannot tell how much of this is due to incumbents and how much is due to entrants. 31. Our analysis suggests that in the United States, lower access prices have
Access policy and investment strategy in the Netherlands
32. Following its creation in 1997, OPTA published new guidelines for interconnection in the Netherlands, which confined cost recovery to traffic sensitive costs. Shortly thereafter, any problems associated with an alleged access deficit were resolved by a rebalancing of the tariffs. There then followed a series of reductions in interconnection rates, imposed by OPTA. By 2000, interconnection rates in the Netherlands were broadly in conformity with EU benchmarks. Access disputes among operators extended beyond interconnection pricing. In addition OPTA investigated allegations of deficient capacity on KPN’s network; adjudicated on a claim for reciprocity of interconnection tariffs between KPN and other operators; and is currently undertaking an investigation into an alleged price squeeze by KPN, arising from differences in the distance-related structure of charges for interconnection and at retail level, which are said to make it impossible for competitors profitably to compete in the local call market.
33. In March 1999, OPTA published guidelines on unbundled access to the local loop. These included the feature that charges for the loop would rise progressively over a five-year transition period from historic to forward looking costs. This was designed to create increasing incentives for facilities based competition in the loop.
34. As part of our study, we investigated strategies pursued by KPN and by the major entrants in the Dutch market. In the latter category, we noted a range of investment strategies, corresponding to different initial endowments.
35. One strategy, exemplified by Tele2, initially involves minimal infrastructure investment – in this case, a switch located outside the country. The company leases lines to convey traffic to its switch, and to a high degree acts as a reseller of KPN’s service. Both the business and the residential market are addressed, and investment is primarily in marketing and billing. Tele2 is progressively adding to its investment in the Netherlands, by installing additional switches. The success of this strategy is clearly crucially dependent upon the relationship between KPN’s interconnection prices for call origination and termination, the cost of leased lines, and KPN’s retail tariff.
36. Cable companies, such as UPC, with a CATV loop already in existence, have the opportunity to upgrade that loop for broadband interconnection access and for telephony. In practice, the cable companies’ impact on the voice market has been very restricted, although they have gained significant success in selling broadband Internet access. UPC has extended its activities into the construction of switches at a regional and national level, and expanded into international switched voice and data (ATM) services. Problems over quality of service have, however, led to proposals that cable networks be opened up for access by other service providers.
Here the regulator-approved arrangements for the division of the termination rate between the ISP and the terminating operator appear to have influenced network investment. Companies such as Worldcom and Energis have found it advantageous to receive traffic from KPN at the national, rather than the regional level. This has suppressed their interest in constructing regional networks.
38. Finally, operators in Holland have been able to compete with KPN in providing xDSL services over KPN’s (rented) loop. Entrants into this market also have an incentive to construct local networks, to rent dark fibre or to purchase local switched services from others. Decisions to enter the market in the first place are likely to be influenced by OPTA’s policy with respect to the trajectory of unbundled loop prices.
39. Each of these strategies illustrates the progressive nature of entrants’ involvement with infrastructure. Cable companies already possess a local loop; their task is thus to upgrade it for broadband and interactive applications, and if appropriate, acquire national and international networks, where barriers to entry are less intense. An operator such as Tele2 can modulate its investment in switches in accordance with its expectation of the relationship between network and retail prices. Other entrants too are implementing interruptible strategies for expanding their investment networks beyond the assets in which they enjoy an initial comparative advantage. Throughout this process, KPN has participated in all markets. Its investment has grown markedly since liberalisation in 1998, particularly in transmission. Like other entrants building networks, KPN have recently announced they are planning to convert their national switched network to voice over ATM. Indeed, competition in this market may shortly become intense enough for price regulation to be unnecessary.
40. As well as investigating the investment strategy of individual entrants, we also produced estimates of where the bulk of investment in telecommunications in the Netherlands was occurring in 2000. For this purpose, we identified four layers in the value chain – transmission, routing/switching, application services and information services, and six locational variants – home/office (which we ignore in the analysis that follows), local, regional, national, continental and intercontinental. This classification is helpful because it enables us to map the process of progressive expansion of an entrant’s activities described above, but it also enables us to examine the balance of investment as between KPN on one hand and connectivity of entrants on the other. It should be born in mind, however, that, with the general exception of KPN, we have been forced to rely upon estimates, because of limitations in the detail of financial reporting by most entrants.
have been made in national and local transmission networks in the regulated parts of the telecommunications infrastructure.
Home/Office Local Regional National Continental Intercontinental Information Services Application Services Routing/ Switching Transmission Investment level KPN dominates investment Investment KPN/entrants on par KPN minor investor in marketsegment
42. In summary, entrants seem to have made limited investments in regional transmission and switching. Entrants have roughly matched KPN’s investment expenditure in the following areas:
§ local transmission where entrants are investing in extensions to the local loop (including ADSL), and cable operators are investing in two-way cable network and others are laying fibre,
§ local switching, due particularly to the large demand for cable modems, § national transmission where Versatel and others are making large scale
investments in new networks,
§ national switching where both KPN and entrants are investing substantially in packet and circuit switches, encouraged by the growth of Internet dial-up traffic.
43. Finally, we address the question of the degree to which the observed patterns of entrants’ investment have been influenced by access policy. The most obvious respects in which this has occurred have been noted: the concentration at the national level of entrants’ investment in facilities to deal with dial-up internet traffic; the logic underlying the rising trajectory of local loop prices; and the relationship between interconnection and retail prices. The first is an observed (probable) effect, the second is more in the way of an intended, or (at best) a delayed one, as other parties have only recently become interested in renting loops; and the impact of the third is under investigation by OPTA in its ‘price squeeze’ inquiry. More generally, we have noted the very clear progressive nature of entrants’ strategies and it is on the linkage between these and access pricing policy which we explore in our conclusions.
have had an influence on investment strategy in the case of dial-up internet services, but the picture is much less clear elsewhere.
Conclusions
45. In this section we seek to synthesise the sometimes conflicting implications of the four strands of analysis set out above, in order to draw a conclusion on the relationship between incentives to invest in infrastructure and the access pricing régime. Our starting point is that the notion derived from a naive and static analysis, that low access prices are bad for infrastructure competition and high access prices are good for it, is mistaken – or at least over simplistic in the era where telecommunications markets have been newly liberalised. In traditional markets such as voice, the historic operator has huge incumbency advantages, and the problem of motivating first and subsequent entrants is an acute one. In markets for new services, such as high band-width interned access, there is no incumbency at the retail level, but the incumbent’s loops may still be, initially at least, a necessary input for other operators. For the same reason, it is mistaken to believe that a simple rule such as access prices based upon long run incremental cost will always maximise social welfare, or even achieve the much sought after neutrality between incumbent and entrants and between infrastructure and service competition. This is because the advantages enjoyed by incumbents may require compensation in the form of low (or rising) access charges to competitors and because, in the case of investments to provide new services, higher returns may be justified as a means of ensuring rewards to ‘first movers’.
46. What we have drawn attention to instead is the key role played by the two separate dynamics. The first is the dynamic of competition between providers of network services, and the second is the dynamic process through which a particular entrant progressively establishes itself in business.
47. Our largely theoretical analysis of the first dynamic has drawn attention to the importance of the relationship between investment and the rewards which it brings. In the case where a new type of asset is being created, and by definition there is no incumbent, there may be a case for enhancing the rewards to participants in the race to build it, in the hope that this will spark competition for the prize in the tournament. Where an incumbent is in place, and the focus is on incentives for a second or subsequent mover, then some form of subsidy may be necessary or desirable. One possible, although less than ideal, method of achieving this objective is by subsidising the price of inputs into the second mover’s production process, one of which is likely to be the incumbent’s network services.
entrant’s absolute revenues. Hence the high level of vulnerability of entrants to the access pricing régime.
49. Our analysis of entrants’ strategies in the Netherlands points to the progressive nature of their involvement in infrastructure. Typically, each has a strategic asset, which might be a cable network, or facilities for the construction of a national network, or a relationship with an international operator, or simply marketing and retailing expertise. Capitalising on these assets, entrants can readily identify areas where they can replicate the incumbent’s assets or (in the case of a new service) be the first to install them. During this initial period they are heavily reliant upon the incumbent’s network services. However, if the signs from the initial investment are favourable, then the entrant will expand the scope of its activities – obviously choosing those areas where the assets are fairly easily replicable. Thus a cable operator will build its own national network rather than relying on leased lines from the incumbent, or a firm which was initially a reseller will install more switches. 50. Although the identity of easily replicable assets will differ from operator to
operator, it is clear that some services are particularly difficult to replicate. In the case of traditional telecommunications services, it is difficult or even impossible for an entrant to replicate call termination. In the case of entrants without a local loop, call origination will be particularly difficult to replicate – although new technological developments, such as wireless local loop, can change the situation materially.
51. This analysis leads to the not unexpected conclusion that the way to promote infrastructure competition is to make available easy and inexpensive access to the assets of the incumbent which are replicable only with difficulty. At the outset this might include a large number of assets, which initially are complements to the entrant’s investment, but with time become substitutes. It is this proposition which underlies, for an entrant’s dynamic, the logic of a time-variant access pricing principle, under which the prices of certain network resources provided by the incumbent are initially set below cost, and then at, or even above cost. Such a policy clearly goes directly against the interests of the incumbent, which will seek above all to maintain a high price for access to its non-replicable assets, thereby both weakening the entrant and/or making it less likely that the entrant will invest in more readily replicable, but lower priced, assets. This logic can be applied in any case where a competitor, or competitors, are entering markets predominantly served by the incumbent - of which there are many examples in the Netherlands.
with new technologies, to serve their own differentiated markets and to benefit from any efficiency advantages which they may have vis à vis the incumbent. This policy clearly has the advantage of consistency with regulatory requirements.
53. The alternative, and more nuanced, policy which we have identified is to have a time varying schedule of access prices – more precisely for access prices to rise over time relative to incremental costs. This régime gives entrants benefits at the start of their operation, when they have replicated only a few of the incumbent’s assets, and an incentive progressively to extend their own infrastructure. We have seen examples of this approach in the form of the UK’s interconnection policy in the early 90s and OPTA’s pricing of unbundled local loops. There may be legal objectives to this approach, on the ground that it involves a departure from the strict requirement of forward-looking cost-based pricing. But there are obvious difficulties in enforcing strict adherence to such a rule in a period of transition from one cost accounting régime to another. The approach may also be accused of involving discrimination. Provided prices only varied over time, and were uniform among operators at any given time, we believe this charge can be resisted, as there is no universal requirement for an even recovery of common costs over time.
In September 2000, OPTA and the DGPT selected the authors to undertake a project analysing the relationship between investment behaviour and regulation in the telecommunications sector.
The request for proposals made it clear that the main aim of the project was to investigate the relationship between the regulation of access and incentives on the part of operators in the Dutch market (both KPN and entrants) to undertake investments in infrastructure – in other words, the key issue is the relationship between competition among service providers using principally the incumbent’s infrastructure and competition among infrastructure operators and the influence of the regulators on these processes. The project has both positive and normative components. The former revolve around establishing the impact of different forms of regulation (especially of access) on the nature of the competitive process in telecommunications; the latter requires an evaluation of alternative possible outcomes, and hence the identification of a ‘best policy’. We emphasised in our proposal that the data would not support a rigorous and conclusive statistical analysis of the relationships between regulation and investment, and that the evaluation of alternative policies inevitably relies heavily upon judgement.
It was agreed that the coverage of the project would be confined to fixed-link telecommunications network and services, on the basis that, to date, the level of competition between fixed and mobile was limited, with the consequence that the factual ‘record’ was confined to that situation. For the same reason, detailed consideration of new broadband delivery networks would be omitted, although we have considered adaptation of existing networks to provide broadband services. The invitation to tender and our proposal envisaged breaking down the factual and analytical content of the project into a number of building blocks. It would be on the basis of these that conclusions would be formed. This report is structured in broadly the same way:
- Section 1 sets out the theoretical foundation of the analysis, first with respect to access pricing and then with respect to incentives to invest in infrastructure. - Section 2 presents a historical and qualitative account of the development of
the framework of access regulation and of competition in three countries – the U.K., the U.S.A. and Denmark.
- Section 3 presents a statistical analysis of international evidence relating to the impact of access pricing and other regulatory variable on infrastructure investment, using both US state-level data and OECD data.
- Section 4 gives an analysis of the investment, market and related strategies of KPN and of key entrants into the Dutch market, chosen to reflect different approaches.
Section 1. THE THEORY OF ACCESS PRICING AND ITS LINKAG E WITH INVESTMENT INCENTIVES.
The introduction of competition into formerly monopolised activities in communications, energy and transport has led to a large volume of theoretical work on access pricing issues, as governments and regulatory bodies have been confronted with the practical necessity to set the terms and conditions on which competitors have access to the historical operator’s facilities, and on which reciprocal access to entrants’ facilities should be granted.
A major concern underlying regulatory intervention in setting the terms and conditions of access or interconnection pricing is that a vertically integrated incumbent may be able to foreclose entry by denying to its competitors the access to its network which they require. At the same time, features of the process of setting retail prices in the sector - for example requirements to price services uniformly, even when there are cost differences, or cross-subsidies imposed on the incumbent from one service to another, have to be taken account of in access pricing in order to ensure competitive parity among firms.
Most of this analysis has taken place in a static context, or on the basis of limited or even casual consideration of the effects of access pricing on investment incentives, and hence upon the evolution of the competitive process in the industry. In telecommunications, infrastructure competition is likely to take the form of competition among a relatively small number of networks. Expectations of the level of access pricing over time will thus generate a range of possibly interdependent investment decisions taken by firms. This aspect of the process which has not been extensively analysed, is the subject of the second half of this section.1
A. Access pricing
In telecommunications, most inter-connection disputes arise in a context in which the access provider is the historic operator, which is active in all traditional telecommunications markets – i.e. vertically integrated across the provision of lines, local calls, and long distance and international calls. Nonetheless, it is helpful to begin our review of access pricing principles within the context of an access provider which is not vertically integrated. It will then be possible to add the complexities associated with integration.
The case of vertical separation
Consider an upstream firm, providing access to a downstream sector that in turn sells to the final users. The access price has to be regulated to induce firms to take efficient decisions and to attain levels of production in the interest of consumers. The main difference between the regulation of a standard monopolist (i.e. when final prices are regulated) and the regulation of access considered here, is that downstream firms have interrelated demand for access, a feature that would not be present among final users.
In order to provide one unit of final good, downstream firms need one unit of the upstream input that is produced by the bottleneck owner at a unit cost c0 in change of a unit access charge denoted by a. The bottleneck owner also incurs into a fixed cost F. Note that F can be interpreted as the set up cost of the network, or some other costs deriving from social obligations that cause losses to the bottleneck provider.
If all firms in the competitive sector are similar (in terms of technology and thus of costs) and their products are identical, firms undercut each other until price competition drives to zero all extra profits in the final market. The price charged to final users ends up equal to the marginal cost of each firm, which amounts to the sum of the access charge and any other cost incurred in order to transform the intermediate good. If we denote by c all the other unit costs (except from the unit access charge), the final price would be p = a + c. The lower the access charge, the lower the final prices and the higher the total quantity consumed by the end-users.
Without any other source of distortion in the functioning of the market, the best that could be done is to follow a marginal rule: the price to the final user should be set equal to the marginal cost of production. The resulting allocation is said to achieve what is known as the first best. Since the access price should thus be set equal to the marginal cost of production (a = c0) and given that the downstream sector is perfectly competitive, the consumer price would be in the end p = c0 + c, and the consumers’ willingness-to-pay would be equal to the total marginal cost of production. By adopting a marginal rule, the incumbent would not recover the fixed costs. If this loss cannot be paid for by direct subsidies, then the next reference situation (second best) is to set the access charge such that fixed costs are recovered on average. If, however, the access product is used to produce a range of goods with different characteristics, then the fixed costs are more efficiently recovered by Ramsey prices, whereby the mark-up on the marginal cost of access is inversely proportional to the price elasticity of demand of the forward service into which it is an intermediate input.
While Ramsey charges are attractive conceptually, they are not always politically or legally easy to implement. First, there could be distributional concerns. Household purchasing services in inelastic demand should pay more only if this is acceptable after taking into account equity considerations. Second, it is important to check if these Ramsey prices are feasible. Indeed, discriminating among different downstream firms according to the elasticities of demand of the services they supply may, in many countries, raise problems with anti-trust or sector-specific legislation. Even more fundamentally, in order to implement Ramsey prices, a great deal of information is required. The regulator should know the cost of the regulated firm and also the different elasticities of demand. This kind of information is more likely to be in the regulated firm’s hands rather than the regulator’s. Hence there are additional constraints arising from asymmetric information between the regulators and its regulated industries (more on this later).
given level of resources scarcity) and productive efficiency (the cheapest cost, for a given output mix). These have to be addressed quite commonly and regulators have to understand the impact of possible adjustments in access charges. Access prices are an integral part of the cost structure of downstream firms and firms operating in an imperfect market can reduce the direct linkages between final prices and cost structures. Concerns arise mainly in two contexts that need to be tested by regulators:
• when the degree of effective competition in the downstream market is restricted through the presence of a dominant player, and
• when the level of entry costs in this downstream market is high in comparison to the potential benefits of additional entry.
The optimal regulatory decision to address these two types of concern will often drive the access charge in opposite directions. First, a firm that has some market power in the downstream market is able to add a mark up to its own marginal cost, leading to the double marginalisation problem. The appropriate response is to decrease the cost of inputs, including access prices, provided that the problem of recovering the bottleneck fixed costs can be solved.
Second, imperfect competition and market power in the downstream sector can arise from technology constraints. Downstream firms may have to incur fixed costs that are non-recoverable (set up costs). Since each downstream firm has to pay an entry cost that is sunk, the concern arises that too many firms may enter. Thus, when downstream firms also incur set up costs, the regulator may decide that a higher access price than suggested by average cost pricing can be instrumental in reducing excess entry in response to high retail prices and the waste of duplicated resources in the production of homogeneous goods. On the other hand, if entry brings about the benefit of product variety (heterogeneous final goods) the previous argument on wasteful duplication is diluted.
Vertical integration
The fact that the bottleneck owner is allowed to compete against other firms means that there is a danger that the incumbent will set access charges which make further entry difficult. In a limiting situation, the integrated incumbent may even deny access on reasonable terms. This reasoning may suggest that the access price should be set low, in order to contrast the anti-competitive attitude of the incumbent. However, if the access price is set too low, inefficient entry may occur. Moreover, if fixed costs are involved in the bottleneck, the regulator should ask how much the entrants should contribute to repay the fixed cost of a service that they use in order to supply their customers. Since vertical integration with liberalisation is the quintessential structure for the analysis of the access pricing problem, we will go into the details of several relevant cases.
the incumbent. In a nutshell, the optimal theoretical access charge can be rewritten as:
(2) a = direct cost + Ramsey term
Optimal access charges are derived together with the prices of final goods. Every customer participates to the recovery of fixed costs. In order to reduce distortions, customers of services that are not price sensitive are required to contribute more to such recovery. For example, if demand for calls from fixed to mobile users is less elastic than for long distance calls, then the access service of call origination should have a higher mark-up when requested by a mobile operator to terminate mobile calls, than when sold to an operator to provide long-distance calls.
Alternatively, the access pricing problem may arise in a context in which the regulation of access price is separated from users’ prices. Supposing that the final product prices are already fixed, then access price has no effect on allocative efficiency. The regulator may still be concerned with cost recovery and productive efficiency, that is to say with efficient entry and cost minimisation. The pricing policy that concentrates only on productive efficiency is the popular and controversial ECPR (Efficient Component Pricing Rule) also known as the Baumol-Willig rule, the imputation rule, the margin rule, or the parity-pricing formula. The rule is very simple and states that when final products are homogeneous and the market is contestable, the access charge should be equal to the difference between the final price and the marginal cost on the competitive segment:
(3) a = p – c1 = c0 + (p – c0 – c1)
ECPR can be read in many equivalent ways:
• As a margin rule, it says that the margin of the incumbent in the final market (p -a) should be equal to its marginal cost in the downstream activity (c1).
• As a parity principle, the bottleneck owner imputes itself for the bottleneck input the same price at which entrants buy the input.
• A potential entrant, would find it profitable to enter only if it is viable, that is if total unit cost is less or equal than the final price: p≥a+ cE ⇒ cE ≤c1. In this respect, the rule sends the ‘right’ signal to new entrants. Entry is profitable only for those firms that are more efficient than the incumbent in the downstream activity.
• Alternatively, the rule says that the access charge should be equal to the direct cost of providing cost (c0) + the opportunity cost of providing access. The
opportunity cost is (p - c0 - c1) since this is the reduction in the incumbent’s profit
caused by the provision of access. Entry does not alter the bottleneck cost recovery since the rule is neutral for the incumbent’s revenue.
In words, ECPR gives this basic message:
The simplicity of the formula explains in part its popularity. Revenue neutrality for the incumbent, on the other hand, is also the criticism made by opponents: if the incumbent is earning supernormal profits, they will continue to be earned also in presence of potential entrants. In this respect, the rule guarantees monopoly rents! However, the observation is not completely appropriate because ECPR assumes that final prices are optimally set. More serious is the criticism that ECPR becomes irrelevant precisely in the proper context developed by its proponents. In fact, if the entrant is more efficient than the incumbent, all downstream production is delegated to the entrant: the incumbent disappears from the downstream sector, the industry becomes in practice vertically separated and the bottleneck owner’s regulated price is irrelevant. If the entrant is less efficient, it will never produce so that the industry is in practice fully integrated and the access price becomes irrelevant.
Even in a context where the incumbent operator has some degree of exclusivity over the implementation of investment decisions, it is clear that access charges have an important impact on the incumbent’s incentive to put effort into innovative activities. In this framework, incumbents may be faced with two types of situations. In the first one, their investments made in the past (before deregulation) are not still fully amortised at the time of deregulation and access prices have to be designed to reflect the residual financing gap. The problem results from the fact that regulated incumbents have made investments approved by the regulator in the past under the assumption that all costs would be recovered and when competitive entry was not fully anticipated. This is the problem of stranded costs. How much compensation should the incumbent receive, if any? How should those costs be apportioned between the incumbent’s customers and entrants who need access to the bottleneck? The answer to the previous questions is obviously very delicate. If regulators are poorly informed about the investments’ costs, the incumbent can deliberately overstate them or he can engage in wasteful practices. When the incumbent has such an information advantage, regulatory approval should not, by itself, guarantee cost recovery. However, the regulatory contract should guarantee compensation for all prudentially incurred costs.
The second situation an incumbent may have to face is an even less pleasant one. Once relevant investments are sunk, there may be post-contractual opportunism on the part of competitors. The entrants do not want to contribute to the financing of the new investment and the incumbent ends up stuck with a larger than fair share of the cost. If anticipated by the incumbent and if the bottleneck has no other potential use (asset specificity), this risk deters initial and future investment. This is referred to as the “hold-up” problem. This classic problem can be avoided by the regulator by ensuring that the access charges are not too low and putting this commitment on paper in a regulatory contract. The need to anticipate the hold up risk is particularly important during transition periods to competition since investments of monopolist operators in the past were probably made with the conviction that they would be recovered under a different (more protected) market structure.
A summary of access pricing
to alternative ways of calculating optimal charges. While it is true that theory is extremely useful to understand the mediating function of access prices, we stress that one first fundamental step should precede any access distortion: whenever possible, the use of access pricing as an instrument for the promotion of too many goals should be resisted and other instruments should be used. Regulators should be aware that there is a sequencing of events that can reduce the complexity of the access problem. For instance, if the regulator believes there are barriers to entry, the tax/subsidy issue of the entry barrier should be addressed directly and be made explicit, rather than burying it into the access pricing problem. The latter could indeed be the only option available, but only after having realised that other options are not feasible. A similar argument can be made for universal service obligations. In other words, by understanding the links between different problems, new instruments become available that allow fine-tuning of the regulatory process.
In a nutshell, the other main messages of this section can be summarised as follows. When financial constraints have to be met, Ramsey prices provide the second best guidelines that take into account both allocative and productive efficiency. This is however not easy to implement since they require a good deal of information. Difficulty, however, does not imply unfeasibility. While it is true that elasticity of demand is difficult to forecast for new innovative services in the communications sector, in other cases patterns of demand are rather standard and predictable so that the regulator could produce such estimates.
Basic case Access charge:
Potential problems: Eventual remedies:
First best marginal cost require lump sums, otherwise
fixed cost not covered
• tariff rebalancing • USO funds
Second best Ramsey • informational content
• may not be sustainable
price cap
Productive efficiency ECPR partial rule
Extensions:
Entry promotion for: • Product variety • Entry barriers • Learning-by-doing
decrease fixed cost may not be
recovered
• direct subsidies • equal access • Bypass
• Cost duplication
Increase small entrants disadvantaged quantity discounts
Risk and hold up (incumbent)
Increase • long-term contracts
• capacity charges
Market power decrease fixed costs may not be
recovered
price regulation
Table 1
level. This is why, in the end, ECPR ignores the fact that profits generated on access can be used to lower retail prices of the incumbent.
ECPR is very influential however and is bound to remain central in the debate on access. It has much merit and some potential flaws. On the theoretical side, it introduces the powerful concept of opportunity costs, and in working paper No. 1, we have discussed how these are computed to services which have different degrees of substitutability or in the presence of bypass possibility. On the practical side, ECPR is a rather simple rule and it gives valid guidelines if static productive efficiency remains the only goal. The risk of ECPR is for it to be misunderstood and misapplied. In particular, it performs badly in situations for which the rule is not designed. If not conjoined with complementary instruments (such as final price regulation, or price floors and ceilings), it allows monopoly rents and anti-competitive conduct.
Table 1 also deals with situations in which access prices should be decreased compared to benchmarks in order to promote entry. Again, the first question has to be why entry should be promoted. If this is because entry brings benefits from product variety but there are barriers to entry, a simultaneous effort should be made to remove them (for instance by mandating equal access). A direct subsidy, when feasible, has the merit of being visible and accountable, without having to distort prices. If entry is needed to bring final prices down, one has to assess the alternative of regulating such prices in a more direct and effective way. Only when the most immediate and appealing options are not available do distorted access charges make sense in a static context.
B. Access prices and investment A preliminary look
One of the most important issues in the economics of regulation is how to encourage firms to invest in infrastructure. Intuitively, there is a trade off between optimal access regulation in a static framework and in a dynamic one. If static regulation reduces the use of monopoly power over the infrastructure, then it also reduces profits that can be earned by the investor/owner of the facility. Access regulation based on simple cost recovery rules, while encouraging efficient utilisation of assets, risks discouraging investments. The reason is simple. If operators rationally anticipate that, once somebody has invested, then the regulator will grant access at cost, everybody will then wait for the investment to be done by somebody else and then seek access.
At the same time, the regulator needs to recognise that the entry decision is often not costless. To assess these costs properly, the regulator needs to be able to distinguish between sunk costs (i.e. non-recoverable infrastructure investments) and other barriers to entry, such as customers’ cost of changing supplier, and additional advertising for unknown products. It is quite true that entry assistance is called for where consumers value the product diversity provided by new entrants, or in order to foster learning-by-doing. Low access charges can be used for the purpose of guaranteeing that the entrant breaks even. However, whenever possible, it is better to use other tools. Direct entry subsidies can do the job, but they are unlikely to be legal. In that case, inefficient entry barriers could be directly tackled. This has happened in telecommunications, by the imposition of equal access and number portability.
Entrants also make assessments of the risk of the business they are getting into. All the access rules proposed until now are usage based. In the presence of risky investments, they imply that the burden of risk is largely placed on the incumbent. For instance, if demand is lower than expected, it is the incumbent who ends up providing unused costly capacity. In some situations, the problem can be reduced by capacity based charges. These could be thought in terms of rental charges based on some anticipated share of capacity rented from the incumbent for a certain period of time. Notice how the time horizon is also critical since it represents the length of the commitment by the access seeker.
When feasible, capacity interconnection agreements should have the property of balancing the risk. Since information is spread unevenly among parties, every time the better informed party bears some risk, we should expect efficiency gains. It is likely that the entrant is better informed about its potential market, so that the incumbent should not be required to produce forecasts about rivals’ demand. In principle, entrants would also benefit from increased flexibility in their way of pricing. Usage charges often come with a structure that reflects the incumbent’s underlying tariff structure (this is most evident with ECPR). Under capacity agreements, buyers of access are free to set their individual tariffs, without being anchored to the incumbent.
The R & D Analogy
erode any incentive to pursue any innovative activity in the first place. Hence
conferring property rights to innovations by means of a patent may seem warranted if we are to ensure adequate provision of R&D. There is also a third issue on standards that is relevant but beyond the scope of this report.
The question of how to best balance the aim of encouraging innovative activity by protecting intellectual property against the aim of promoting the competition that such protection inhibits has been an enduring tension in policy debates. A variety of issues emerge once we recognise that competition is not just about maximising profits in the short run (with existing products and technologies) but, instead, is a dynamic process. These issues embrace the incentives firms have to innovate, the relation between R&D efforts and market structure, and the role of public policy in granting temporary monopoly power.
The Schumpeterian argument that monopoly power promotes innovations has been subject to criticisms. It has been shown that, on the contrary, competitive firms should value an innovation more than a monopolist should. The main reason is due to what is known as "the replacement effect". Competitive firms are just breaking even prior to adopting an innovation, and so value the innovation at the full additional profits with its existing technology. By contrast, the monopolist would be earning monopoly profits with and without innovation: introducing the new process/product means that the monopolist is effectively replacing itself. This displaces in part the previous profits and undermines the investment.
The previous argument is certainly valid, but it is not completely in the Schumpeterian spirit. What would happen if the monopolist were not free from the threat of entry, as in the example above? Consider the opposite scenario in which an incumbent recognises that the alternative to not adopting the innovation is that an outsider firm will. In this case, the opportunity cost to the monopolist of not adopting is much higher, hence he would be willing to pay a lot for the innovation, certainly more than a competitive firm. On this basis it has been argued than an increase in the number of firms in the industry will decrease the amount that each firm is willing to spend on R&D. However, this does not necessarily imply that total industry spending will also fall (the crucial parameter is the demand elasticity).
This brief discussion points to the fact that the debate over the Schumpeterian hypotheses cannot be resolved by an appeal to economic theory alone. Looking at the empirical evidence, it emerges that studies are far from uniform, but one general finding seems to be robust. R&D intensity appears to increase in industrial concentration but only up to a certain value, after which R&D efforts appear to level off or even decline.
Theoretical findings tell that the optimal patent length is typically finite rather than infinite. Since there are decreasing returns to R&D activity, it becomes progressively more expensive to lower production costs, hence it would take progressively greater increases in the number of protected years to achieve a given amount of costs savings. In terms of patent breadth, the question is whether a patent should be long and thin or rather fat and short. On this issue there is not mot much consensus among theorists. At least, it can be said that the answer depends on the type of competition prevailing in the product market. If firms have a greater degree of monopoly power (for instance because products are differentiated), then patents should be short and fat, otherwise long and thin. Unfortunately, it is extremely difficult in practice to apply this approach selectively to different industries.
Incentives to invest
Analysing investment incentives, it is helpful first to address the case of what would happen without any regulation at all. In the absence of regulation, infrastructure owners may want to maximise the use of their facility since the intensive use of the facility would reduce the average cost to all users. However, this desire clashes with another one, since the infrastructure owner would also try to reduce downstream competition, which implies a denial or at least a reduction of access to the infrastructure, by its rivals.
In order to understand which effect would dominate, we need to investigate the nature of downstream competition. If products are sufficiently differentiated, then the use of the investment is non-rival. Infrastructure owners do not fear the rent dissipation caused by downstream competition and have an incentive to optimise the use of the facility.
Imagine a situation where an incumbent operator first decides whether and when to invest. Then a rival chooses whether and when to seek access. Finally, if access is sought, the two parties bargain over the terms of access. As is standard in economics, this game has to be solved backwards. In other words, the investment choice is contingent on the expectations about the rival seeking access and on the outcome of negotiations.
Negotiations can only be over variables that can be altered at the time of negotiation. As the investment has already taken place, infrastructures themselves are sunk and cannot play a role during negotiations. This typically weakens the provider position. By denying the rival the use of the infrastructure, it gains nothing and loses whatever access charge it might receive. What we have just described here is a typical hold up problem due to contract incompleteness. This potential market failure is pervasive in many other sectors, and contracting parties try to overcome it in different ways, without the need of intrusive regulatory intervention.
carrier" speeds up the operators' choices. However it not clear if timing choices are aligned with the social optimum. The racing process may go too far and investments happen too soon, with the risk of being locked in to inferior technology. In Appendix 2 of Working Paper No. 1 we show how, in the simple context of a race between alternative suppliers of very differentiated (non substitute) goods, a simple rule that apportions capital costs according to the relative economic profit that is expected to accrue to the access provider and to the access seeker would allow them to achieve optimal investment choices.
Access issues become of greater concern when firms that use the infrastructure are also direct competitors of the infrastructure owner. If competition effects are extreme, the infrastructure owner will not grant access unless required to. Here regulation plays a crucial role. The entrant is obviously keen on obtaining access. Without compensation, however, the incumbent will wish to delay investments. This can be solved by requiring the entrant to bear more of the costs. But for the regulator this increase might reduce the possibility of entry itself. The regulator should try to manage this tension between investment incentives and timely competition.
An access price régime can be used by the regulator to create competition between industry participants over the provision of facilities. If a firm "wins" in the provision of infrastructure, it becomes the common provider and receives access payments from other firms. If it loses, it will either pay for access or duplicate the infrastructure. By committing to an appropriate access rule, the regulator can directly determine the difference between winning and losing for operators.
The existing theoretical literature has not come up yet with an answer to this intricate problem. However, the main ingredients that should be taken into consideration are the following:
• there must be at least two potential providers to provoke a race. Hence there should be no legal entry barriers;
• firms should be able to earn economic profits. Hence the access price cannot be set below average cost unless there are some upfront fixed payments involved or the Government gives subsidies;
• the access charge determines the prize of the race;
• the regulator should resist the temptation to treat investment as sunk;
• the regulator should commit to a pricing formula over a reasonable time period;
• any régime that allocates investment costs sends important signals to investors;
• entrants should contribute to incumbents' investments; otherwise this would send a poor signal to incumbent providers and diminish incentives to invest in the first place;
• access prices should compensate for a portion of the replacement value of the assets to whose services access is sought;
Entry and network competition
It is of particular interest to address the question of network competition between an incumbent operator and a new entrant that may invest in its own facilities. This situation should be described as one of two-way access, in the sense that each operator needs access to the rival's network in order to terminate calls originated by its own customers but destined to subscribers belonging to other networks. This scenario is different from the one-way access pricing problem that we described in Part A, since the incumbent operator now has an interest to find a mutual agreement over termination access prices with the rival. Recent literature has found that regulatory concerns under two-way network competition are reduced compared to one-way competition. This is particularly true when operators compete over non-linear prices (e.g. two-part tariffs) to attract consumers.
But careful regulatory oversight may still be needed in the initial phases of competition. This is particularly true if the regulator wants to promote particular entry modes. In particular, the regulator should consider the pros and cons of three basic modes of entry:
• Facility-based competition (FBC). Both the incumbent and the entrant build their own backbones and local loop facilities. Customers can in principle subscribe directly to both operators. The only relevant access price is related to call termination on the rival’s network.
• Local loop unbundling (LLU). Contrary to the previous case, the entrant leases the incumbent’s access facilities. On top of call termination, regulatory oversight should include the line rental that the incumbent receives from the entrant.
• Carrier selection (CS). Customers cannot subscribe directly from the entrant. Every call is originated by the incumbent. Relevant access prices now include both call origination and call termination. This case corresponds to the one-way access problem.
In a recent study, (Entry in Telecommunications Markets, 2000), de Bijl and Peitz have adapted the model of network competition in order to study the three entry modes mentioned above. In particular, they imagine a situation where an incumbent starts competition having a big subscriber base, while the entrant starts at some disadvantage, mostly due to consumer switching costs. They calibrate the model with data from the Dutch market and, after running several simulations, show the following results:
• If FBC is pursued, in the long-run (i.e. when operators are relatively similar), reciprocal and cost-based termination access charges are best for social welfare. However, in the initial transitory phase the regulator may want to use asymmetric access prices, in the absence of alternative instruments. If the incumbent’s termination price is set equal to the cost, while a mark up is allowed for the entrant’s termination price, then the entrant is made more aggressive for two reasons. On top of having lower average termination costs than the incumbent, the entrant tries to capture more customers since they bring additional termination revenues.
