1 TCOM 546 Session 5

2 Overview Analyze access pricing Apply economic analyses to other telecom areas –International settlements –Spectrum

3 Two-Way Access Pricing Consider a duopoly of two regional monopoly companies A and B –2  customers subscribed to each company A localB local A L-D B L-D

4 Two-Way Access Pricing (Continued) Assume  customers of type H who are willing to pay  H for LD, and  of type L who are willing to pay  L Let p i be the price of an LD call from region i (i = 1,2) Utility is then UH = max{  H - p i, 0} UL = max{  L - p i, 0} Assume  L <  H < 2  L

5 Two-Way Access Pricing (Continued) Let a AB denote access charge levied by company B terminating company A traffic, etc. Then profits are  A = q A (p A – a AB ) + q B a BA  B = q B (p B – a BA ) + q A a AB

6 The Access Pricing Game Interaction takes the form of a 2-stage extensive game –Stage I: Both companies set access prices –Stage II: Both companies take access prices as given and set LD prices Now q i = 2  if p i <  L =  if  L <p i <  H = 0 if p i >  H

7 The Access Pricing Game (Continued) So profits are  i = 2  (  L – a ij ) + q j a ji if p i =  L =  (  H – a ij ) + q j a ij if p i =  H = q j a ji if pi >  H Note that setting p i =  L gives a higher profit than  H if 2  (  L – a ij ) >  (  H – a ij ) or a ij < 2  L -  H

8 The Access Pricing Game (Continued) Solve the game backwards –In stage II, the access charges are taken as given, and p i is chosen to maximize profit p i =  L if a ij < 2  L –  H =  H if 2  L –  H < a ij <  H = a ij if a ij >  H

9 The Access Pricing Game (Continued) In Stage I, each carrier sets its value for a –Let  * i be profit carrier i makes from terminating carrier j calls, so  * i = a ji q j –Then  * i = 2  (2  L –  H )if a ji < 2  L –  H =  H if 2  L –  H < a ji <  H

10 The Access Pricing Game (Continued) Hence, carrier i will set access charge a ji = 2  L –  H if  H < 4  L /3 =  H if  H > 4  L /3 Next, calculate profit with these prices: If  H < 4  L /3, then a ji = 2  L –  H and p i =  L and q i = 2  Then  * i = 2  (2  L –  H ) and revenue from LD is 2  L - a ij ) But by symmetry a ij = a ji, so  i = 2  (2  L –  H ) + 2  L  a ij )  2  L

11 The Access Pricing Game (Continued) Similarly, if  H > 4  L /3, then  i =  H Social welfare is calculated as W = 2  U H + 2  U L +p A + p B If  H < 4  L /3 then a ji = 2  L –  H so p a = p b =  L and U L = 0 and U H =  H -  L

12 The Access Pricing Game (Continued) In contrast, if  H > 4  L /3 we find a ji =  H and U L = U H = 0 Finally, social welfare is W = 2  (  H –  L ) + 2  *0 + 4  L if  H < 4  L /3 = 2  (  H +  L ) and W= 4  *0 + 2  H if  H > 4  L /3 = 2  H

13 Access Pricing Conclusion Low access pricing where a ji = 2  L –  H yields higher social utility than high access pricing Market failure occurs when  H > 4  L /3 –That is, high valuation by high-income consumers Regulator should impose a ceiling of 2  L –  H on access prices

14 Access Pricing Conclusion (Continued) Illustrates problem with partial regulation – providers overcharge each other for access –Artificially increases costs –Induces carriers to raise consumer prices –Not socially optimal

15 International Settlement Rates Revenues generated from international calls are collected in the country where the calls originate Generally, the richer country originates more calls than the poorer –E.g, 1997 US to Brazil 495 million minutes, Brazil to US 159 million minutes Carriers use a negotiated settlement rate to balance accounts when there is an imbalance of calls

16 International Settlement Rates Model Simple models to compare situation where each country has a monopoly provider with the fully-competitive situation Assume two countries, N and S Country N has  N subscribers who wish to call country S, similarly for S Assume  N >  S Let p k be price of call from country k

17 International Settlement Rates Model (Continued) Define consumer utility function U k =  – p k if the consumer makes a call = 0 otherwise Let a be the settlement rate Then ignoring production costs, profits are  N = (p N – a)  N + a  S and  S = (p S – a)  S + a  N

18 International Settlement Rates Model (Continued) Note that  N = p N  N + a(  S –  N ) and  S = p S  S + a(  N –  S ) So increasing the settlement rate a decreases N’s profit and increases S’s profit

19 International Settlement Rates Model (Continued) Again we solve the model backwards First, the settlement rate is negotiated Then the companies take the settlement rate as given and set p N and p S independently, giving p k =  if a < , which yields q k =  k = a if a > , which yields q k = 0

20 International Settlement Rates Model (Continued) How is the settlement negotiated? If ak is the profit-maximizing rate for company k, assume companies agree to average the charges a = (a N + a S )/2 =  /2, so p N = p S =  /2

21 International Settlement Rates Model (Continued) This leads to p N = p S =  so that  N =  S =  (  N +  S )/2 Which yields a cash flow from N to S of a(  N –  S ) =  (  N –  S )/2 –Although N still makes a profit

22 International Settlement Rates with Competition Suppose internal markets are competitive –Companies in both countries charge prices equal to marginal costs Then p N = p S = a, and  N = a  S,  S = a  N So, increasing a increases profit for all companies –This is unlike the monopoly case (Chart 21) –Hence, a = , the profit-maximizing rate

23 Spectrum Allocation Allocation of spectrum by means other than auctions is socially inefficient –Consider lotteries, introduced in 1981 for cellular spectrum –Previous method of determining by “public interest” was slow and unwieldy

24 Spectrum Lottery Assume one frequency to be allotted to one company Assume two competitors, A and B, with differing technologies –Assume A has more advanced technology and can raise greater revenue –I.e.,  A >  B > 0 –Assume government is ignorant of which is better, but companies aren’t

25 Spectrum Lottery (Continued) Lottery is clearly inefficient, because the less-efficient company has even chance of winning, which is socially inefficient However, if winner can sell its rights, system becomes socially efficient –However, rents are distributed to private sector, not government

26 Spectrum Auctions Open auction – each company openly announces the maximum it is prepared to pay Nash equilibrium exists at (  B + ,  B ), where  is small Auction is efficient, but Government collects only  B +  not  A –Remaining possible  A -  B +  goes to A as extra profit

27 Other Forms of Auction Read Girard Simultaneous Ascending Auctions and the Federal Communications Commission Spectrum Auction 35 for a detailed discussion of more sophisticated forms of auction as used by the FCC

28 Next Week We will look quickly at the Internet and broadcasting, then move on to start discussing financial statement and cost models

29 Homework Read the Girard paper. List advantages and disadvantages of the FCC’s auction approach. Would you describe the outcome as successful? Shy, Chapter 5, exercise 5 Read Benninga, Chapter 1