2. Competition After Unbundling: Entry, Industry Structure and Convergence George Ford Chief Economist Phoenix Center

3. Basic Setup: Equilibrium Industry Structure Firms enter only if they make a profit Firms enter only if they make a profit Entry stops when “the next firm” expects a negative profit Entry stops when “the next firm” expects a negative profit When entry stops, the existing number of firms is the equilibrium number of firms (N*) When entry stops, the existing number of firms is the equilibrium number of firms (N*) No incentive to enter No incentive to enter No incentive to exit No incentive to exit

4. Formal Theory N* = Equilibrium Number of Firms (symmetric)  = Weakness of Competition S = Market Size in Expenditure (isoelastic demand) E = Sunk Entry Costs Sources: Sutton, Duvall and Ford (PP10), Beard and Ford

5. The Entry Decision: Less Formal Theory Do gross profits (d) exceed entry costs (e)? Do gross profits (d) exceed entry costs (e)? Gross profits (d) are revenues less variable costs. Gross profits (d) are revenues less variable costs. Entry costs (e) are fixed/sunk Entry costs (e) are fixed/sunk d – e  0

6. What it Means TimeRevenue Discount Factor Discounted Revenues Entry Costs 0 1.00 $500.00 $500.00 1 $100.00 $100.000.91 $90.91 $90.91 2 $100.00 $100.000.83 $82.64 $82.64 3 $100.00 $100.000.75 $75.13 $75.13 4 $100.00 $100.000.68 $68.30 $68.30 5 $100.00 $100.000.62 $62.09 $62.09 6 $100.00 $100.000.56 $56.45 $56.45 7 $100.00 $100.000.51 $51.32 $51.32 8 $100.00 $100.000.47 $46.65 $46.65 9 $100.00 $100.000.42 $42.41 $42.41 10 $100.00 $100.000.39 $38.55 $38.55 Sum $614.46 $614.46 $500.00 $500.00

7. Want Facilities-based Entry?  Increase Gross Profits  Reduce Entry Costs

8. Multiple Changes Higher Profits Lower Entry Costs More Entry Lower Profits Higher Entry Costs Less Entry Higher Profits Higher Entry Costs Unknown Lower Profits Lower Entry Costs Unknown

9. Equilibrium Industry Structure High Fixed and Sunk Costs allow only few firms to enter High Fixed and Sunk Costs allow only few firms to enter Historically, local distribution networks for communications services have tended toward monopoly Historically, local distribution networks for communications services have tended toward monopoly Voice Voice Video Video

10. Factors Driving Profits (d) Market Size (+) Market Size (+) Intensity of Price Competition (-) Intensity of Price Competition (-) Product Differentiation (+) Product Differentiation (+) Network Overlap (-) Network Overlap (-)

11. Numerical Example 1 (Table 1, PCPP 21) Equilibrium Number of Firms, N* = 3 Nde d - e 11001585 2401525 320155 41215-3 5815-7 6515-10 7415-11

12. Numerical Example 2 (Higher Gross Profits) Equilibrium Number of Firms, N* = 5 Nde d - e 120015185 2801565 3401525 424159 516151 61015-5 7815-7

13. Factors Driving Profits (d) Market Size (+) Market Size (+) Intensity of Price Competition (-) Intensity of Price Competition (-) Product Differentiation (+) Product Differentiation (+) Network Overlap (-) Network Overlap (-)

14. Numerical Example 3 (Intensity of Price Competition) Ne Intense Price Competition Moderate Price Competition PerfectCollusion d d - e d d 115100851008510085 215281340255035 31512-32053318 4156-912-32510 5154-118-7205 6153-125-10172 7152-134-1114

15. Headcount and Competition With large fixed/sunk costs, headcounts can be deceiving With large fixed/sunk costs, headcounts can be deceiving A large number of firms may indicate collusion A large number of firms may indicate collusion A small number of firms may indicate intense price competition A small number of firms may indicate intense price competition

16. Entry and Collusion (Based on Post-Convergence Example Above) Firm 1 Enter Stay Out Firm 2 Enter505040110 Stay Out 11040100100

17. Factors Driving Profits (d) Market Size (+) Market Size (+) Intensity of Price Competition (-) Intensity of Price Competition (-) Product Differentiation (+) Product Differentiation (+) Network Overlap (-) Network Overlap (-)

18. Product Differentiation and Overlap Price Homes/Overlap50% 100% P1P2P3P1P2P3 More Differentiation Less Differentiation Differentiation weakens price competition. Overlap increases price competition. Phoenix Center Policy Paper No. 21, Figure 1.

19. Diversion: Competition and Substitution Competition occurs between goods/services that perform a similar task for consumers Competition occurs between goods/services that perform a similar task for consumers Good X is a substitute for Good Y if the demand for Good X rises when the price of Good Y rises (and vice versa) Good X is a substitute for Good Y if the demand for Good X rises when the price of Good Y rises (and vice versa)

20. Diversion: Competition and Substitution The relationship of quantities of goods is not an indicator of substitution The relationship of quantities of goods is not an indicator of substitution Unless we already know the goods are perfect substitutes Unless we already know the goods are perfect substitutes Substitution is of degree Substitution is of degree Airplanes, Buses, Cars, Trains all provide transportation, but we might be concerned about a monopoly over any of one of them Airplanes, Buses, Cars, Trains all provide transportation, but we might be concerned about a monopoly over any of one of them

21. Diversion: Competition and Substitution As long as the own-price demand elasticity is less than –1.0 (or inelastic), then a 5% price increase is profitable As long as the own-price demand elasticity is less than –1.0 (or inelastic), then a 5% price increase is profitable Cross-price elasticities are not indicators of Antitrust markets Cross-price elasticities are not indicators of Antitrust markets Large cross price elasticities are indicators of good substitution, but if own-price is not elastic enough, a significant price increase remains profitable Large cross price elasticities are indicators of good substitution, but if own-price is not elastic enough, a significant price increase remains profitable

22. Example Wireless Substitution and Competition, by Stephen Pociask Wireless Substitution and Competition, by Stephen Pociask lnQ M = -0.56 · lnP M + 1.97·lnP W +  X+  lnQ M = -0.56 · lnP M + 1.97·lnP W +  X+  More wrong with the econometrics of this paper than I could cover in a day, much less an hour “…the models provide compelling empirical evidence that wireless and wireline services are indeed substitute goods, and are not extraneous or complementary goods (at 15).” This model indicates substitution (an implausibly large amount of it), but still not enough substitution to place wireless/wireline in the same market.  Q is quantity, P is price, M is mobile, W is wireline, ln is the nat. logarithmic transformation,  X is the means of the other variables in the model multiplied by their coefficients.

23. Types of Entry Costs (e) Technological Entry Costs (+) Technological Entry Costs (+) Strategic Entry Costs (+) Strategic Entry Costs (+) Regulatory Entry Costs (+) Regulatory Entry Costs (+) Spillovers (-) Spillovers (-)

24. Types of Entry Costs (e) Technological Entry Costs (+) Technological Entry Costs (+) Entry costs that are unavoidable to provide service Entry costs that are unavoidable to provide service Network Network Operating Capital Operating Capital Advertising Advertising Building Leases Building Leases Etc… Etc…

25. Types of Entry Costs (e) Strategic Entry Costs (+) Strategic Entry Costs (+) Entry costs that arise solely because of incumbent firm actions intended to raise entry costs Entry costs that arise solely because of incumbent firm actions intended to raise entry costs Excessive Advertising Excessive Advertising Lock-in Contracts Lock-in Contracts Strategic Pricing Strategic Pricing

26. Types of Entry Costs (e) Regulatory Entry Costs (+) Regulatory Entry Costs (+) Rules that raise entry costs above technological entry costs Rules that raise entry costs above technological entry costs Build-out Requirements Build-out Requirements Gold-plating Networks Gold-plating Networks Entry Fees Entry Fees E911 and other social programs E911 and other social programs If socially-desirable, there may be a trade-off between entry and the provision of the service (e.g., E911) If socially-desirable, there may be a trade-off between entry and the provision of the service (e.g., E911)

27. Types of Entry Costs (e) Spillovers (-) Spillovers (-) Spillovers exist when a firm can use existing assets to enter related markets. Spillovers exist when a firm can use existing assets to enter related markets. This firm has lower entry costs than a firm without existing assets that can be leveraged into a related market This firm has lower entry costs than a firm without existing assets that can be leveraged into a related market Network (DSL over Copper; Cable Broadband over Coax; Fiber over existing rights-of-way; customer relationships) Network (DSL over Copper; Cable Broadband over Coax; Fiber over existing rights-of-way; customer relationships)

28. Numerical Example 1 (Table 1, PCPP 21) Equilibrium Number of Firms, N* = 3 Nde d - e 11001585 2401525 320155 41215-3 5815-7 6515-10 7415-11

29. Numerical Example 4 (Reduced Entry Costs) Equilibrium Number of Firms, N* = 6 Nde d - e 1100595 240535 320515 41257 5853 6550 745

30. Spillovers and Convergence Convergence is relevant only when it reduces entry costs. Convergence is relevant only when it reduces entry costs. Effects of convergence are generally limited to firms with existing assets that can be “spilled over” into related markets. Effects of convergence are generally limited to firms with existing assets that can be “spilled over” into related markets.

31. Numerical Example 5 (Spillovers and Convergence) Pre-Convergence Monopoly Profit Duopoly Profit (d) Entry Costs (e) d – e Market 1 1004050-10 Market 2 1004050-10 Post-Convergence Monopoly Profit Duopoly Profit (d) Entry Costs (e) d – e Market 1 100403010 Market 2 100403010 No Entry

32. Equilibrium Industry Structure: Summary There will be few local networks There will be few local networks So, rig the game in favor of entry by new firms and expansion by existing firms into related market So, rig the game in favor of entry by new firms and expansion by existing firms into related market Eliminate regulatory entry barriers Eliminate regulatory entry barriers Impede strategic entry barriers Impede strategic entry barriers Expand markets Expand markets

33. Phoenix Center Policy Paper No. 22 The Consumer Welfare Cost of Cable “Build-Out” Rules

34. Build-Out Rules Unambiguously Bad for Entrants Unambiguously Bad for Entrants May be good for Consumers May be good for Consumers May be good for Incumbents May be good for Incumbents But can’t be good for both Consumers and Incumbents at the same time But can’t be good for both Consumers and Incumbents at the same time Why do both policymakers and incumbents advocate for build-out rules? Why do both policymakers and incumbents advocate for build-out rules?

35. Build-Out Rule: Graphical Explanation Price Homes/OverlapH homes ordered by capital cost r(h)r(h) e(h)e(h) e(h): Entry Cost for home i r(h): Expected Revenue for home i Phoenix Center Policy Paper No. 22, Figure 1.

36. Free Entry Equilibrium Price Homes/Overlaph*h*H homes ordered by capital cost tvtv w r(h)r(h) e(h)e(h) Profits from Entry

37. With Build-Out Rule Price Homes/OverlapH homes ordered by capital cost uvuv x y z r(h)r(h) e(h)e(h) Profits from Entry Losses from Entry

38. With Build-Out Rule: The Monopoly’s Decision Price Homes/OverlapH homes ordered by capital cost r(h)r(h) e(h)e(h) The monopolists decision to build-out is entirely different than an entrants. Profits from Entry Losses from Entry Entrant’s r(h)

39. Build-out Rule: Matrix of Preferred Outcomes Participant Free Entry Build-out Rule Entry No Entry Consumers213 Incumbent231 Phoenix Center Policy Paper No. 22, Table 1.

40. FCC on Build-out Rules “build-out requirements are of central importance to competitive entry because these requirements impact the threshold question of whether a potential competitor will enter the local exchange market at all.” FCC No. 97-346 (1997)

41. Simulation Summary of Results EntrantH-PassMarketsServedEntrantCAPEX Consumer Surplus Incumbent Profit Monopoly………60M120M Free Entry 60,00010018M75M94M Build-out15,000156M64M113M Phoenix Center Policy Paper No. 22, Table 2. Assumptions: Entrant market share = 35%. Price decline for 100% overlap is 20%.

42. Simulation: Effect of Market Share Entrant’s Market Share Share Homes Passed Entrant Markets Served Free Entry Build-out Build-out 20%0.100.001000 25%0.260.001000 30%0.430.001000 35%0.600.1510015 40%0.690.3610036 45%0.750.5410054 50%0.790.6510065

43. Simulation: Build-out and Investment Entrant’s Market Share Share Homes Passed Investment Free Entry Build-out Build-out 20%0.100.0020 25%0.260.0070 30%0.430.00120 35%0.600.15186 40%0.690.362215 45%0.750.542623 50%0.790.652830

44. Simulation: Build-out, Consumers and Incumbents Entrant’s Market Share Consumer Surplus Incumbent Profits Free Entry Build-out Build-out 20%6360117120 25%6760112120 30%7160104120 35%756494113 40%786985102 45%80747690 50%81777179

45. Defection What happens if some communities abandon the build-out rule when others maintain it? What happens if some communities abandon the build-out rule when others maintain it? Defection raises the defector’s relative profitability, increasing the prospects for deployment sooner (rather than later, if ever) Defection raises the defector’s relative profitability, increasing the prospects for deployment sooner (rather than later, if ever) With 25% defection rates, average increase in profit rank is 38 positions (out of 100) With 25% defection rates, average increase in profit rank is 38 positions (out of 100)

46. In Defense of Build-out Rules NCTA NCTA Incumbent cable firms cross-subsidize low value areas with profits from high-value areas Incumbent cable firms cross-subsidize low value areas with profits from high-value areas Entry in high-value areas only depletes source of cross subsidy, threatening upgrades/expansion in low value areas Entry in high-value areas only depletes source of cross subsidy, threatening upgrades/expansion in low value areas Entrants should have to build-out too, regardless of whether it deters entry Entrants should have to build-out too, regardless of whether it deters entry

47. In Defense The Monopoly’s Decision Price HomesH homes ordered by capital cost r(h)r(h) e(h)e(h) Profits offset losses for Monopoly build-out. Profits from Entry Losses from Entry

48. In Defense Entry with Uniform Price Price Homes/OverlapH homes ordered by capital cost r(h)r(h) e(h)e(h) Profits insufficient to cover losses. But, entrant does not enter (50-50 split of the market). Profits from Entry Losses from Entry Entrant’s r(h)

49. In Defense Entry with Market Segmentation Price Homes/OverlapH homes ordered by capital cost r comp e(h)e(h) With markets segmented, higher price in uncontested segment reduces loss, increases profit. Profits from Entry Losses from Entry Entrant’s r(h) r monop

50. Evaluation of Defense Cable network is sunk Cable network is sunk As long as revenues exceed the incremental cost of the network (programming, maintenance), there is no incentive to abandon the network As long as revenues exceed the incremental cost of the network (programming, maintenance), there is no incentive to abandon the network According to NCTA, upgrades are done at the edge of the network, so initial capital cost of network are somewhat irrelevant According to NCTA, upgrades are done at the edge of the network, so initial capital cost of network are somewhat irrelevant

51. Evaluation: Social Goal NCTA says build-out is a social goal NCTA says build-out is a social goal Build network where we shouldn’t (in a market economy sense) Build network where we shouldn’t (in a market economy sense) NCTA Solution: NCTA Solution: Build 2 networks where there shouldn’t be 1 Build 2 networks where there shouldn’t be 1

52. Evaluation: Social Goal Why should buildouts be based on cable franchise markets? Why should buildouts be based on cable franchise markets? Franchise boundaries are arbitrary, not economic boundaries Franchise boundaries are arbitrary, not economic boundaries ILEC territories often don’t match ILEC territories often don’t match If broadband availability is a function of video in the bundle, then local governments are interfering with federal role in broadband deployment If broadband availability is a function of video in the bundle, then local governments are interfering with federal role in broadband deployment

53. Evaluation: Social Goal Entry deterrence is the purpose of build- out requirements Entry deterrence is the purpose of build- out requirements Incumbent profit is always less the more the entrant overlaps the existing network Incumbent profit is always less the more the entrant overlaps the existing network Econometric analysis shows build-out rules (level playing field rules) deter entry Econometric analysis shows build-out rules (level playing field rules) deter entry

54. Phoenix Center Policy Paper No. 23 Video and Broadband Network Deployment

55. Want Facilities-based Entry?  Increase Gross Profits  Reduce Entry Costs

56. Index of Consumption (Pew Survey 2002) Group Cell Phone Cable/SatellitePremiumInternet All 1.00 Men 1.14 1.03 1.10 1.09 Women 0.88 0.95 0.93 0.87 Whites 1.00 0.96 0.98 0.97 Blacks 0.90 1.16 1.14 1.02 Latino 1.25 0.96 1.30 0.88 Col. Grads 1.22 1.09 0.97 1.47 Students 1.08 1.01 0.95 1.30 Employed 1.23 1.00 0.96 1.20 Urban 1.02 1.07 1.04 1.15 Suburban 1.03 1.07 0.94 1.02 Rural 0.95 0.74 0.94 0.76

57. Census 2003, Subscription Rates IncomeTelephoneInternetDial-upCable/DSL Less Than 5000 92.026.615.910.2 5000 To 7499 94.220.314.05.9 7500 To 9999 96.519.614.25.0 10000 To 12499 97.122.816.56.2 12500 To 14999 97.224.618.25.8 15000 To 19999 96.829.521.57.8 20000 To 24999 97.836.926.79.9 25000 To 29999 98.342.629.612.0 30000 To 34999 98.449.035.113.2 35000 To 39999 98.757.741.915.0 40000 To 49999 99.266.345.220.2 50000 To 59999 99.271.947.024.0 60000 To 74999 99.479.949.829.1 75000 To 99999 99.384.248.035.2 100000 To 149999 99.790.442.346.4 150000 and Over 99.792.436.454.2

58. Cable Subscription and Income Mediamark Research, Inc. Mediamark Research, Inc. Income < $25,000; 54% Income < $25,000; 54% $25,000 < Income < $49,999; 62% $25,000 < Income < $49,999; 62% $50,000 < Income < $74,999; 70% $50,000 < Income < $74,999; 70% Income > $75,000; 75% Income > $75,000; 75% GAO Regression Analysis (2005) GAO Regression Analysis (2005) Negative relationship between basic cable penetration rate and incomes Negative relationship between basic cable penetration rate and incomes

59. Video, Income, Deployment $ Income (y) homes ordered by income r(y): Expected Revenue for home i, which is a function of income y k: Capital Cost per Home Passed Phoenix Center Policy Paper No. 23, Figure 1. y*

60. Video, Income, Deployment $ Income (y) homes ordered by income r1kr1k Phoenix Center Policy Paper No. 23, Figure 2. y* y’ r 1 + r 2 k+d Add Good 2 to the product mix, at incremental cost d Good 1 = Good 2 in expenditures

61. Video, Income, Deployment $ Income (y) homes ordered by income r 1 k = r 3 Phoenix Center Policy Paper No. 23, Figure 3. y* r 1 + r 3 k+d Add Good 3 to the product mix with Good 1, at incremental cost d Average of Good 1 = Good 3, but Good 3 has no relationship to income

62. Simulation Results IncomeBroadbandBroadband+Telephony Broadband + Video All Three Services y < 20,000 --0.840.88 20,000 < y <30,000 --0.880.90 30,000 < y <40,000 --0.930.95 40,000 < y <50,000 -0.040.980.99 50,000 < y <60,000 0.010.091.00 60,000 < y <70,000 0.020.201.00 70,000 < y <80,000 0.090.541.00 80,000 < y <90,000 0.140.761.00 90,000 < y <100,000 0.340.921.00 100,000 < y <125,000 0.831.00 125,000 < y <150,000 0.97 1.00 y > 150,000 1.00

63. Summary We are now faced with a facilities-based only entry method into local markets (video, voice, and data) We are now faced with a facilities-based only entry method into local markets (video, voice, and data) We must eliminate any unnecessary barriers to facilities-based entry if we are to have competition We must eliminate any unnecessary barriers to facilities-based entry if we are to have competition Market limitations Market limitations Build-out Rules Build-out Rules Etc. Etc.

64. Summary Consider the source of policy proposals Consider the source of policy proposals Build-out rules are only good for cable incumbents if entry is deterred; thus, they are betting on entry deterrence Build-out rules are only good for cable incumbents if entry is deterred; thus, they are betting on entry deterrence Cross-subsidy is the enemy of competition, because competition is the entry of cross-subsidy Cross-subsidy is the enemy of competition, because competition is the entry of cross-subsidy Social agendas may need to be re-evaluated and refinanced Social agendas may need to be re-evaluated and refinanced