1 Why Regulate Telecommunications? Dr Rob Albon Senior Economic Adviser (Regulatory Development) Australian Competition and Consumer Commission

2 Telecommunications has never been free of government intervention … Since the beginning of telecommunications in the late nineteenth century, telecommunications markets have never been free of government intervention. Generally, existing postal monopolies were extended to take over monopoly control of the emerging telecommunications industry.

3 Why not uncontrolled competition? There will tend to be three major problems with a free-market approach: Natural monopoly – the tendency towards monopoly will be wasteful of scarce resources as new entrants fail. Externalities unattended – private decisions do not always reflect social values, so some externalities may not be properly attended in a free market. Dynamic efficiencies forgone – properly regulated entry will find new techniques and innovations.

4 Traditional Intervention (1) There has always been intervention but the form has changed. Traditional intervention usually comprised: Government ownership and operation – usually as part of a government department. Statutory (legislated) monopoly Politicised pricing and investment; including uniform geographical pricing.

5 Traditional Intervention (2) This was aimed at pursuing social and political objectives … … not just addressing ‘market failure’. Governments in the past – and present? – have used their influence on telecommunications to bestow political favours.

6 Inadequacy of Traditional Intervention The traditional model is now regarded as having produced inefficient outcomes: Too many resources to produce given outputs (‘productive inefficiency’) Inefficient pricing through ‘cross-subsidies’ (‘allocative inefficiency’) Insufficient incentives for invention and innovation (‘dynamic inefficiencies’)

7 Reforms (1) Reforms in the last 20 or so years addressed these problems and constraints through: Corporatisation – taking the function out of a government department and giving it a more commercial structure. Independent regulation – inappropriate to have the incumbent regulating entry, anti- competitive behaviour, etc!

8 Reforms (2) Controlled introduction of competition – the major focus of these presentations Transparency and independent funding of USOs/CSOs Privatisation

9 Why is Natural Monopoly a Problem? Natural monopoly means that having more than one producer causes higher costs of producing a given level of output (or given bundle of outputs). Economies of scale, economies of scope and network economies are defining characteristics of ‘natural monopoly’.

10 Economies of Scale Economies of scale means that the fragmentation resulting from ‘duplication’ would result in higher overall costs of producing a given level of output. This can be seen in the following diagram:* * LRAC = long-run average cost

11 LRAC Q This area multiplied by two is the excess cost of producing 2Q in two identical firms rather than one. 2Q2QQ

12 Economies of Scope Economies of scope means that a given bundle of outputs can be produced at a lower total cost than if the outputs were divided between one or more producers. This arises from the sharing of common network infrastructure by a multi-product producer. Perhaps the line-sharing service (LSS) is a perfect example?

13 Addressing Natural Monopoly Not all production components are naturally monopolistic. Competition has been introduced by giving new entrants regulated access to those network elements that have ‘natural monopoly characteristics’. These elements are sometimes known as ‘essential facilities’.

14 Essential Facilities An essential facility is both:  prohibitively costly to reproduce (natural monopoly) and  essential for development of competitive downstream markets (like long-distance and international).

15 Sources of ‘Bottleneck’ Market Power (1) The classic example of an essential facility is the public switched telecommunications network (PSTN). Other telecommunications facilities may be natural duopolies, triopolies, quadropolies, etc. Natural monopoly characteristics are not the only source of ‘bottleneck’ market power.

16 Sources of ‘Bottleneck’ Market Power (2) Termination of fixed-to-mobile (FTM) and mobile-to- mobile (MTM) calls by mobile carriers provides a special case of bottleneck market power. Subscribers to a particular network can only be reached by access to that network. The addition of new networks does not directly mitigate this market power. Even small mobile networks have market power because they control access to their subscribers.

17 Why Network Externalities may be a Problem Network externalities arise when new subscribers result in external benefits to existing subscribers, additional to their own private benefits. This means marginal social value (MSV) of a new subscriber exceeds marginal private value (MPV). The free market will produce too little subscription.

18 Marginal social value Marginal private value Potential efficiency gain ‘Cost ’ Free-market subscription Socially-optimal subscription Subsidised price necessary Cost-based price

19 Addressing Network Externalities Some potential subscribers will need to be subsidised before they will join. This may be through uniform pricing (‘cross-subsidy’) or direct subsidies. The potential gain is shown in the diagram.

20 Issues (1): Determining the MSV Getting the subsidy right requires knowing the MSV of an additional subscriber. This is hard to determine because – by definition – the value of an externality is not determined in a market. Carriers can be very ‘creative’ in valuing externalities!

21 Issues (2): Funding the Subsidy All ways of funding the subsidy (usually it is cross-subsidy) result in efficiency costs. The efficiency gains from the subsidy must be weighed against the efficiency loss from the tax. The gain and the loss must be equated at the margin.

22 Issues (3): ‘Second-best’ Considerations There is usually more than one externality. For example, there may be a call-receipt externality enjoyed by the receivers of mobile calls. This may negate any mobile network externality.

23 Why Dynamic Efficiencies May be Lacking To the extent that new entrants are doomed to fail in a free market, an access regime can lead to a dynamic efficiency benefit. Entry in downstream markets could generate dynamic efficiencies. For example, there may be new niche service offerings, not previously available from an incumbent supplier.

24 Promoting Dynamic Efficiencies Even where the entrants offer very similar services to the access provider, it is possible that entrants could offer more innovative arrangements for pricing, billing, etc. The famous economist of the 1940s, Joseph Schumpeter, highlighted the creative and destructive forces of competition.

25 Social and Political Objectives Universal service obligations (USOs) and community service obligations (CSOs) can be better addressed than by cross-subsidy and direct intervention. These require:  Better definition and targeting  Greater transparency  More efficient funding