1 Summary of Phoenix Center 2006 Research Dr. George Ford Chief Economist 2006 Annual U.S. Telecoms Symposium Grand Hyatt Conference Center Washington DC December 6, 2006

Research Policy Papers Network Neutrality And Industry Structure Policy Paper No. 24 The Burden of Network Neutrality Mandates on Rural Broadband Deployment Policy Paper No. 25 An Investigation into the Influence of Retail Gas Prices on Oil Company Profits Policy Paper No. 26

Research Policy Bulletins In Delay There Is No Plenty: The Consumer Welfare Costs of Franchise Reform Delay Policy Bulletin No. 13 A La Carte and “Family Tiers” as a Response to a Market Defect in the Multichannel Video Programming Market Policy Bulletin No. 14 Unnecessary Regulations and The Value of Spectrum: An Economic Evaluation of Lease Term Limits for the Educational Broadband Service Policy Bulletin No. 15 The Efficiency Risk of Network Neutrality Rules Policy Bulletin No. 16 Separating Politics from Policy in FCC Merger Reviews: A Basic Legal Primer of the “Public Interest” Standard Policy Bulletin No. 17

Research Major Telecom Issues Cable Competition/Franchise Reform Network Neutrality Universal Service Reform

5 Phoenix Center Policy Bulletin No. 14 “In Delay There Is No Plenty”: The Consumer Welfare Cost of Franchise Reform Delay

6 POLICY BULLETIN NO. 16 Cost of Franchise Reform Delay Competition in Video Markets reduces prices, thereby benefiting consumers Competition in Video Markets reduces prices, thereby benefiting consumers Prices reductions 10% to 40%. Prices reductions 10% to 40%. Franchise process deters competition, thereby a failure to reform it creates consumer welfare losses. Franchise process deters competition, thereby a failure to reform it creates consumer welfare losses. How big are the consumer surplus losses? How big are the consumer surplus losses?

7 Gain to Consumers From Competition POLICY BULLETIN NO. 16 Cost of Franchise Reform Delay Time $ Consumer Surplus  CS Delay

8 Loss to Consumers From Delay POLICY BULLETIN NO. 16 Cost of Franchise Reform Delay Time $ Consumer Surplus  CS

9 POLICY BULLETIN NO. 16 Cost of Franchise Reform Delay Consumer Welfare Effects from Delay YearsDelay Con. Surplus No Delay Con. Surplus With Delay LostSurplus 1$93.2B$85.0B$8.2B 2$93.2B$77.3B$15.9B 3$93.2B$70.1B$23.1B 4$93.2B$63.3B$29.9B 5$93.2B$56.9B$36.3B

10 Phoenix Center Policy Paper No. 24 Network Neutrality and Industry Structure

11 POLICY PAPER NO. 24 Network Neutrality and Industry Structure Our arguments derives from a well-understood principle of industrial economics: Our arguments derives from a well-understood principle of industrial economics: as the products of firms become more alike, price competition intensifies. In the presence of sunk costs, intense price competition renders more highly concentrated markets. In terrestrial telecommunications, the industry is already highly concentrated (duopoly?), so increasing concentration could mean monopoly.

12 POLICY PAPER NO. 24 Network Neutrality and Industry Structure “Moving toward the other firm increases the intensity of price competition.” [J. Tirole, The Theory of Industrial Organization 1995] “Moving toward the other firm increases the intensity of price competition.” [J. Tirole, The Theory of Industrial Organization 1995] “We see that [with homogeneous products] price equals marginal costs (the competitive result), while [if products are completely differentiated] price is set at the monopoly level.” [S. Martin, Advanced Industrial Economics 1993] “We see that [with homogeneous products] price equals marginal costs (the competitive result), while [if products are completely differentiated] price is set at the monopoly level.” [S. Martin, Advanced Industrial Economics 1993] “Where the product or service is perceived as a commodity or near commodity, choice by the buyer is largely based on price and service, and pressures for intense price and service competition results. These forms of competition are particularly volatile []. Product differentiation, on the other hand, creates layers of insulation against competitive warfare because buyers have preferences and loyalties to particular sellers.” [M. E. Porter, Competitive Strategy 1980] “Where the product or service is perceived as a commodity or near commodity, choice by the buyer is largely based on price and service, and pressures for intense price and service competition results. These forms of competition are particularly volatile []. Product differentiation, on the other hand, creates layers of insulation against competitive warfare because buyers have preferences and loyalties to particular sellers.” [M. E. Porter, Competitive Strategy 1980]

13 Equilibrium Industry Structure (Policy Papers No. 10 and 21) N * = Equilibrium Number of Firms S = Market Size (+)  = Index of Weakness of Price Competition (+) E = Sunk Entry Costs (-)

14 POLICY PAPER NO. 24 Network Neutrality and Industry Structure Policymakers should balance concerns over potential discrimination against the possibility that particular network neutrality rules may encourage very aggressive price competition that is incompatible with multiple firm supply in the face of significant sunk costs and scale economies.

15 Phoenix Center Policy Paper No. 25 The Burden of Network Neutrality Mandates on Rural Broadband Deployment

16 POLICY PAPER NO. 25 Network Neutrality and Rural America If a regulation reduces profits, and binding regulation always impacts profits, there will be and lower profits mean less network deployment. The question is whether urban and rural areas are differentially affected by a profit- affecting regulation (such as network neutrality).

17 POLICY PAPER NO. 25 Network Deployment C = Network cost to serve a household V = Net Value of customer h = homes passed by the network h* is homes passed by the network given C and V. h* V C 100% Homes Passed (h), Ranked by Cost $ 0 Subsidy Required for 100% Homes Passed

18 POLICY PAPER NO. 25 Network Deployment with Higher Cost C R = Network cost to serve a household under Regulation V = Net Value of customer h R = homes passed by the network under Regulation h* V C 100% Homes Passed (h), Ranked by Cost $ 0 CRCR hRhR Subsidy Required for 100% Homes Passed

19 POLICY PAPER NO. 25 Network Deployment, Different Markets h* V C 100% Homes Passed (h), Ranked by Cost $ 0 CRCR hRhR h* V C 100% Homes Passed (h), Ranked by Cost $ 0 CRCR hRhR Cost Curve Is Relatively Flat Cost Curve is Relatively Steep

20 POLICY PAPER NO. 25 Measured Impact of Regulation Our simulation shows that, on average, high-cost (more rural) markets experience larger reductions in network deployment than do low-cost (more urban) markets.

21 POLICY PAPER NO. 25 Network Neutrality and Rural America Very Steep Slope V Relatively Flat Slope Relatively Steep Slope United-MO SBC-TX V V

22 POLICY PAPER NO. 25 Network Neutrality and Broadband Deployment to Rural America Network neutrality rules that reduce the profitability of deploying network -- and binding regulation always reduces profit -- will reduce network deployment generally. But, this reduced deployment may be felt to a larger extent in high-cost, more rural markets.

23 Policy Bulletin No. 16 The Efficiency Risk of Network Neutrality Rules

24 POLICY BULLETIN NO. 16 Efficiency Risk of Network Neutrality General Cost-Benefit Framework for evaluating regulated network “architectures” Analysis of the incentive to invest in cost-reducing technologies

25 POLICY BULLETIN NO. 16 Cost Benefit Framework V i = R i – P i = Net Consumer Value of Network Type i R i = Consumer Gross Value of Network Type i P i = Price Paid for Service of Network Type i

26 POLICY BULLETIN NO. 16 Cost Benefit Framework Stupid Network = S Intelligent Network = I Stupid network preferred if: V S > V I R S – P S > R I – P I R S – M S ·C S > R I – M I ·C I M = Markup over cost; C = Cost

27 POLICY BULLETIN NO. 16 Cost Benefit Framework RS – MS·CS > RI – MI·CI Is one architecture more desirable to consumers than another, and by how much?

28 POLICY BULLETIN NO. 16 Cost Benefit Framework R S – M S ·C S > R I – M I ·C I Does architecture affect Industry structure and thus margins, and by how much?

29 POLICY BULLETIN NO. 16 Cost Benefit Framework R S – M S ·C S > R I – M I ·C I Is one network more costly than another, and by how much? What’s it worth and what does it cost?

30 POLICY BULLETIN NO. 16 Investment in Cost-Reducing Technology Scenario Scenario Cost reducing technology is available to a monopoly Cost reducing technology is available to a monopoly But, the technology reduces the value of the service to consumers But, the technology reduces the value of the service to consumers Under what conditions will the firm make the investment? Under what conditions will the firm make the investment? The investments made if it is profitable to the firm The investments made if it is profitable to the firm The investment is made only when consumer surplus rises (i.e., the lower price more than offsets the lower marginal valuation) The investment is made only when consumer surplus rises (i.e., the lower price more than offsets the lower marginal valuation)

31 POLICY BULLETIN NO. 16 Investment in Cost-Reducing Technology Voluntary investments by network firms in cost-reducing technology are welfare improving even if the technology reduces the marginal value of the services produced by the technology. Even a monopolist will make the right decision for consumers.

32 Phoenix Center Breakfast Meeting: NARUC, Miami, November 2006 Primer on Competitive Bidding for Universal Service

33 Goals of Universal Service To provide subsidies so that access at an affordable price is provided in areas where access would not be provided at an affordable price without the subsidies To accomplish this task at the minimum economic cost of providing the relevant set of access services.

34 Losses Profits Why Have Universal Service? Homes Passed $ h Capital Cost to Serve R R = Net Revenue

35 Subsidy 100% How do we subsidize? Carefully Homes Passed $ h Capital Cost to Serve R R = Net Revenue

36 How do we subsidize? Uncarefully P Homes Passed $ h Capital Cost to Serve P+S hShS Same Subsidy, Different Result. Subsidized action must be very specific and observable.

37 P+S hShS How do we subsidize? Uncarefully P Homes Passed $ h Capital Cost to Serve Even if we only pay for “new” lines, we can run into problems.

38 Competitive Bidding and Franchise Bidding Competitive bidding is akin to a franchise bidding scheme, where franchise bidding is a competition among firms for the exclusive right to serve. The right to offer service in a market is “auctioned off” to the firm willing to offer fixed level of service at the lowest price. With scale economies, franchise bidding theoretically renders a better outcome than multi- firm competition. We get the competitive outcome with the monopoly cost structure.

39 Competitive Bidding with Subsidy Competitive Bidding is different when a subsidy is involved. The bid price (average cost) is above the “affordable” or target price. Thus, a subsidy is required.

40 Competitive Bidding with Subsidy: Example Lowest Avg Cost of Service: AC = $50 Target Price is: P T = $20 Lowest Subsidy Bid is: S = $30 PT - AC + S = 0

41 Competitive Bidding with Subsidy: Example Lowest Avg Cost of Service: AC = $50 Target Price is: P T = $20 Lowest Subsidy Bid is: S = $20 Firm sells other stuff for margin: M = $10 PT + M - AC + S = 0

42 Total Subsidy Franchise Bidding: With Subsidy PTPT AC Per-Line Subsidy QTQT AC T Quantity $ P T = Target or Affordable Price

43 Total Subsidy Two Firms Subsidy Bidding: Two Firms PTPT AC With two equally-sized firms, the market is split. The bid, equal to AC Q/2, reflects the split. The subsidy grows substantially even if both firms are equally- and most efficient. QTQT AC T Quantity $ S Q/2 AC Q/2 Q/2 S Q/2

44 Transfer of Profit to Consumer Surplus Benefits of Competition PCPC QCQC Demand Competition increases social welfare by reducing the dead weight loss of monopoly. As prices fall, consumer surplus rises faster than profits decline. PMPM QMQM Quantity $ Reduction in Dead Weight Loss

45 Transfer of Consumer Surplus to Government Cost of Subsidies P Q Gathering funds for subsidy creates distortions in other markets, leading to efficiency losses. PSPS QSQS Creation of Dead Weight Loss Demand MC Loss of Producer Surplus Quantity $

46 Let’s make soup What are the relationships of interest? PT + M – AC + S = 0  S/  AC > 0  M/  N < 0  AC/  N > 0 Let N be the number of entrants:  S/  P T < 0  S/  M< 0  S/  N > 0 Competition increases the subsidy!

47 Let’s make soup Consider a case where we use bidding and allow multiple winners (N>1). What happens relative to an exclusive winner? P T + M – AC + S = 0 Competition in subsidized markets increases the amount of subsidy both through margin declines and cost increases.

48 What’s competition worth? To consider what competition is worth, let’s assume AC is constant (not rising with the number of firms). P T + M – AC + S = 0 Margins fall, benefiting consumers. Subsidy rises, harming consumers.

49 $1 Competition and Subsidies D PMPM QMQM Quantity $ Subsidized Market P Q D Quantity $ “Taxed” Market $1 PSPS QSQS PCPC QCQC These cancel This is not the usual transfer from firms to consumers as a result of competition, it is a transfer from consumers in one market to consumers (and producers) in another. MC Loss to Consumers Loss to Firms Gain to Consumers

50 Competition and Subsidies D PMPM QMQM Quantity $ Subsidized Market P Q D Quantity $ “Taxed” Market PSPS QSQS PCPC QCQC What are the relative sizes of these things?

51 What’s competition worth? If we need $1 of subsidy due to a $1 margin decline, then we need $1 of subsidy collection. Thus, there are distortions created (higher “taxes”) for the distortions eliminated (lower margins). Rough estimates suggests a $1 price decline in the subsidized market generates $0.05 of additional surplus, but costs $0.65 of surplus in collection on average. * At the margin, collection costs are $1.25 per $1 of subsidy. With franchised bidding, competition in subsidized markets is likely welfare reducing, even if we ignore the undesirable cost impacts of competition. $1 competitive benefit costs $1.60. * J. Hausman, Taxation by Telecommunications Regulation, NBER Working Paper W6260 (1997).

52 What’s competition worth? If we need $1 of subsidy due to a $1 margin decline, then we need $1 of subsidy collection. Thus, there are distortions created (higher “taxes”) for the distortions eliminated (lower margins). Rough estimates suggests a $1 price decline in the subsidized market generates $0.05 of additional surplus, but costs $0.65 of surplus in collection on average. * At the margin, collection costs are $1.25 per $1 of subsidy. The subsidy payout scheme should be determined jointly with the subsidy collection scheme (or at least considered). * J. Hausman, Taxation by Telecommunications Regulation, NBER Working Paper W6260 (1997).

53 What’s competition worth? In fact, AC will rise, indicating competition is likely a net loser in social welfare terms. P T + M – AC + S = 0 Competition further lowers social welfare by raising costs and, thus, increasing subsidies. Just like with competition, $1 in higher costs requires $1.60 in welfare to collect.

54Conclusion Competitive bidding schemes that allow competition in the subsidized markets are likely welfare reducing and should be avoided.

55 Some Caveats I’ve assumed that competitive bidding renders a zero profit equilibrium, like it should in theory (but may not in practice). I’ve assumed competition only affects prices. Administrative costs are ignored. Strategic bidding is absent. I’ve assumed any subsidy cap is not binding.

Annual U.S. Telecoms Symposium Grand Hyatt Conference Center Washington DC December 6, 2006