summary of phoenix center 2006 research dr. george ford chief economist

Summary of Phoenix Center 2006 ResearchDr. George FordChief Economist

2006 Annual U.S. Telecoms SymposiumGrand Hyatt Conference Center

Washington DCDecember 6, 2006

2006 Research2006 ResearchPolicy PapersPolicy Papers

Network NeutralityAnd

Industry Structure

Policy Paper No. 24

The Burden ofNetwork Neutrality

Mandates onRural Broadband

Deployment

Policy Paper No. 25

An Investigation intothe Influence of Retail

Gas Prices on Oil Company Profits

Policy Paper No. 26

2006 Research2006 ResearchPolicy BulletinsPolicy Bulletins

In Delay There IsNo Plenty:

The ConsumerWelfare Costs ofFranchise Reform

Policy Bulletin No. 13

A La Carte and“Family Tiers” as a

Response to a Market Defect inthe Multichannel

Video ProgrammingMarket

UnnecessaryRegulations

and The Valueof Spectrum:An Economic

Evaluation of LeaseTerm Limits for the Educational

Broadband Service

The EfficiencyRisk of NetworkNeutrality Rules

Separating Politicsfrom Policy in FCCMerger Reviews:

A Basic Legal Primerof the

“Public Interest”Standard

2006 Research2006 Research Major Telecom IssuesMajor Telecom Issues

Cable Competition/Franchise ReformCable Competition/Franchise Reform

Network NeutralityNetwork Neutrality

Universal Service ReformUniversal Service Reform

Phoenix Center Policy Bulletin Phoenix Center Policy Bulletin No. 14No. 14

“In Delay There Is No Plenty”: The “In Delay There Is No Plenty”: The Consumer Welfare Cost of Franchise Consumer Welfare Cost of Franchise Reform DelayReform Delay

POLICY BULLETIN NO. 16POLICY BULLETIN NO. 16 Cost of Franchise Reform DelayCost of Franchise Reform Delay

Competition in Video Markets reduces Competition in Video Markets reduces prices, thereby benefiting consumersprices, thereby benefiting consumers

Prices reductions 10% to 40%.Prices reductions 10% to 40%. Franchise process deters competition, Franchise process deters competition,

thereby a failure to reform it creates thereby a failure to reform it creates consumer welfare losses.consumer welfare losses.

How big are the consumer surplus How big are the consumer surplus losses?losses?

Gain toConsumers

From Competition

$Consumer

Surplus

Loss toConsumersFrom Delay

$Consumer

Surplus

Consumer Welfare Effects from DelayConsumer Welfare Effects from DelayYearsYears

DelayDelayCon. SurplusCon. Surplus

No DelayNo DelayCon. SurplusCon. Surplus

With DelayWith DelayLostLost

SurplusSurplus

11 $93.2B$93.2B $85.0B$85.0B $8.2B$8.2B

22 $93.2B$93.2B $77.3B$77.3B $15.9B$15.9B

33 $93.2B$93.2B $70.1B$70.1B $23.1B$23.1B

44 $93.2B$93.2B $63.3B$63.3B $29.9B$29.9B

55 $93.2B$93.2B $56.9B$56.9B $36.3B$36.3B

Phoenix Center Policy Paper Phoenix Center Policy Paper No. 24No. 24

Network Neutrality and Industry Network Neutrality and Industry StructureStructure

POLICY PAPER NO. 24POLICY PAPER NO. 24 Network Neutrality and Industry StructureNetwork Neutrality and Industry Structure

Our arguments derives from a well-Our arguments derives from a well-understood principle of industrial understood principle of industrial economics: economics:

as the products of firms become more alike, price as the products of firms become more alike, price competition intensifies. In the presence of sunk competition intensifies. In the presence of sunk costs, intense price competition renders more costs, intense price competition renders more highly concentrated markets. In terrestrial highly concentrated markets. In terrestrial telecommunications, the industry is already telecommunications, the industry is already highly concentrated (duopoly?), so increasing highly concentrated (duopoly?), so increasing concentration could mean monopoly. concentration could mean monopoly.

““Moving toward the other firm increases the intensity of price Moving toward the other firm increases the intensity of price competition.” [J. Tirole, competition.” [J. Tirole, The Theory of Industrial OrganizationThe Theory of Industrial Organization 1995]1995]

““We see that [with homogeneous products] price equals We see that [with homogeneous products] price equals marginal costs (the competitive result), while [if products are marginal costs (the competitive result), while [if products are completely differentiated] price is set at the monopoly level.” [S. completely differentiated] price is set at the monopoly level.” [S. Martin, Martin, Advanced Industrial EconomicsAdvanced Industrial Economics 1993] 1993]

““Where the product or service is perceived as a commodity or Where the product or service is perceived as a commodity or near commodity, choice by the buyer is largely based on price near commodity, choice by the buyer is largely based on price and service, and pressures for intense price and service and service, and pressures for intense price and service competition results. These forms of competition are particularly competition results. These forms of competition are particularly volatile []. Product differentiation, on the other hand, creates volatile []. Product differentiation, on the other hand, creates layers of insulation against competitive warfare because buyers layers of insulation against competitive warfare because buyers have preferences and loyalties to particular sellers.” [M. E. have preferences and loyalties to particular sellers.” [M. E. Porter, Porter, Competitive StrategyCompetitive Strategy 1980] 1980]

Equilibrium Industry StructureEquilibrium Industry Structure(Policy Papers No. 10 and 21)(Policy Papers No. 10 and 21)

N* = Equilibrium Number of FirmsS = Market Size (+) = Index of Weakness of Price Competition (+)E = Sunk Entry Costs (-)

Policymakers should Policymakers should balancebalance concerns concerns over potential discrimination against over potential discrimination against the possibility that particular network the possibility that particular network neutrality rules may encourage very neutrality rules may encourage very aggressive price competition that is aggressive price competition that is incompatible with multiple firm incompatible with multiple firm supply in the face of significant sunk supply in the face of significant sunk costs and scale economies.costs and scale economies.

Phoenix Center Policy Paper Phoenix Center Policy Paper No. 25No. 25

The Burden of Network Neutrality The Burden of Network Neutrality Mandates on Rural Broadband Mandates on Rural Broadband DeploymentDeployment

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network Neutrality and Rural AmericaNetwork Neutrality and Rural America

If a regulation reduces profits, and binding If a regulation reduces profits, and binding regulation always impacts profits, there regulation always impacts profits, there will be and lower profits mean less will be and lower profits mean less network deployment. The question is network deployment. The question is whether urban and rural areas are whether urban and rural areas are differentially affected by a profit-affecting differentially affected by a profit-affecting regulation (such as network neutrality). regulation (such as network neutrality).

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network DeploymentNetwork 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.

100%Homes Passed (h), Ranked by Cost

Subsidy Required for100% Homes Passed

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network Deployment with Higher CostNetwork Deployment with Higher Cost

CR = Network cost to serve a household under

Regulation

V = Net Value of customer

hR = homes passed by the network under Regulation

Subsidy Required for100% Homes Passed

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network Deployment, Different MarketsNetwork Deployment, Different Markets

Cost CurveIs Relatively Flat

Cost Curveis Relatively Steep

POLICY PAPER NO. 25POLICY PAPER NO. 25 Measured Impact of RegulationMeasured 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.

Figure 5. Network Neutrality and Service Reduction

Cost Index, u

uction in H

Figure 5. Network Neutrality and Service Reduction

Cost Index, ū

uction

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network Neutrality and Rural AmericaNetwork Neutrality and Rural America

SBC-TX

Very Steep Slope

United-VA

United-MO

Relatively Flat Slope

Relatively Steep Slope

United-MO

SBC-TX

POLICY PAPER NO. 25POLICY PAPER NO. 25 Network Neutrality and Broadband Network Neutrality and Broadband

Deployment to Rural AmericaDeployment to Rural America

Network neutrality rules that reduce the Network neutrality rules that reduce the profitability of deploying network -- profitability of deploying network -- and and binding regulation always reduces profitbinding regulation always reduces profit -- will -- will reduce network deployment generally. But, reduce network deployment generally. But, this reduced deployment may be felt to a this reduced deployment may be felt to a larger extent in high-cost, more rural markets.larger extent in high-cost, more rural markets.

Policy Bulletin No. 16Policy Bulletin No. 16

The Efficiency Risk of Network The Efficiency Risk of Network Neutrality RulesNeutrality Rules

POLICY BULLETIN NO. 16POLICY BULLETIN NO. 16 Efficiency Risk ofEfficiency Risk of Network NeutralityNetwork Neutrality

General Cost-Benefit Framework for evaluatingGeneral Cost-Benefit Framework for evaluatingregulated network “architectures”regulated network “architectures”

Analysis of the incentive to invest in Analysis of the incentive to invest in cost-reducing technologiescost-reducing technologies

POLICY BULLETIN NO. 16POLICY BULLETIN NO. 16 Cost Benefit FrameworkCost Benefit Framework

VVii = R = Rii – P – Pii = Net Consumer Value of Network Type i = Net Consumer Value of Network Type i

RRii = Consumer Gross Value of Network Type i= Consumer Gross Value of Network Type i

PPii = Price Paid for Service of Network Type i= Price Paid for Service of Network Type i

Stupid Network = S Intelligent Network = IStupid Network = S Intelligent Network = I

Stupid network preferred if: Stupid network preferred if: VVS S > > VVII

RRSS – P – PSS > > RRI I – P– PII

RRSS – M – MSS··CCSS > > RRI I – M– MII··CCII

M = Markup over cost; C = CostM = Markup over cost; C = Cost

Is one architecture more desirableIs one architecture more desirableto consumers than another,to consumers than another,

and by how much?and by how much?

Does architecture affectDoes architecture affectIndustry structure and thus margins,Industry structure and thus margins,

and by how much? and by how much?

Is one network moreIs one network morecostly than another,costly than another,and by how much? and by how much?

What’s it worth and what does it cost?

POLICY BULLETIN NO. 16POLICY BULLETIN NO. 16 Investment in Cost-Reducing TechnologyInvestment in Cost-Reducing Technology

ScenarioScenario Cost reducing technology is available to a Cost reducing technology is available to a

monopolymonopoly But, the technology reduces the value of the But, the technology reduces the value of the

service to consumersservice to consumers Under what conditions will the firm make the Under what conditions will the firm make the

investment?investment? The investments made if it is profitable to the firmThe investments made if it is profitable to the firm The investment is made only when consumer The investment is made only when consumer

surplus rises (i.e., the lower price more than surplus rises (i.e., the lower price more than offsets the lower marginal valuation)offsets the lower marginal valuation)

POLICY BULLETIN NO. 16POLICY BULLETIN NO. 16 Investment in Cost-Reducing TechnologyInvestment in Cost-Reducing Technology

Voluntary investments by network firms Voluntary investments by network firms in cost-reducing technology are in cost-reducing technology are welfare improving even if the welfare improving even if the technology reduces the marginal technology reduces the marginal value of the services produced by the value of the services produced by the technology. technology.

Even a monopolist will make the right Even a monopolist will make the right decision for consumers.decision for consumers.

Phoenix Center Breakfast Phoenix Center Breakfast Meeting: NARUC, Miami, Meeting: NARUC, Miami, November 2006November 2006

Primer on Competitive BiddingPrimer on Competitive Biddingfor Universal Servicefor Universal Service

Goals of Universal Goals of Universal ServiceService

To provide subsidies so that To provide subsidies so that access at an affordable price is access at an affordable price is provided in areas where provided in areas where access would not be provided access would not be provided at an affordable price without at an affordable price without the subsidiesthe subsidies

To accomplish this task at the To accomplish this task at the minimum economic costminimum economic cost of of providing the relevant set of providing the relevant set of access services.access services.

Losses

Profits

Why Have Universal Why Have Universal Service?Service?

Homes Passed

Capital C

ost to

R = Net Revenue

Subsidy

How do we subsidize?How do we subsidize?CarefullyCarefully

Homes Passed

Capital C

ost to

R = Net Revenue

How do we subsidize?How do we subsidize?UncarefullyUncarefully

Homes Passed

Capital C

ost to

Same Subsidy, Different Result.

Subsidized action must be very specific and observable.

How do we subsidize?How do we subsidize?UncarefullyUncarefully

Homes Passed

Capital C

ost to

ServeEven if we only pay for

“new” lines, we can run into problems.

Competitive Bidding and Competitive Bidding and Franchise BiddingFranchise Bidding

Competitive bidding is akin to a franchise Competitive bidding is akin to a franchise bidding scheme, where franchise bidding bidding scheme, where franchise bidding is a competition among firms for the is a competition among firms for the exclusive right to serve.exclusive right to serve.

The right to offer service in a market The right to offer service in a market is “auctioned off” to the firm willing is “auctioned off” to the firm willing to offer fixed level of service at the to offer fixed level of service at the lowest price.lowest price.

With scale economies, franchise bidding With scale economies, franchise bidding theoretically renders a better outcome than theoretically renders a better outcome than multi-firm competition. We get the multi-firm competition. We get the competitive outcome with the monopoly cost competitive outcome with the monopoly cost structure.structure.

Competitive Bidding with Competitive Bidding with SubsidySubsidy

Competitive Bidding is Competitive Bidding is different when a subsidy is different when a subsidy is involved.involved.

The bid price (average cost) is The bid price (average cost) is above the “affordable” or target above the “affordable” or target price. Thus, a subsidy is required.price. Thus, a subsidy is required.

Competitive Bidding with Competitive Bidding with Subsidy: ExampleSubsidy: Example

Lowest Avg Cost of Service: Lowest Avg Cost of Service: AC = AC = $50$50Target Price is: Target Price is: PPTT = $20 = $20

Lowest Subsidy Bid is: Lowest Subsidy Bid is: S = $30S = $30

PPTT - AC + S = 0 - AC + S = 0

Competitive Bidding with Competitive Bidding with Subsidy: ExampleSubsidy: Example

Lowest Avg Cost of Service: Lowest Avg Cost of Service: AC = AC = $50$50Target Price is: Target Price is: PPTT = $20 = $20

Lowest Subsidy Bid is: Lowest Subsidy Bid is: S = $20S = $20

Firm sells other stuff for margin: Firm sells other stuff for margin: M M = $10= $10

PPTT + M - AC + S = + M - AC + S = 00

Total Subsidy

Franchise Bidding:Franchise Bidding:With SubsidyWith Subsidy

ACPer-LineSubsidy

Quantity

PT = Target or Affordable Price

Total SubsidyTwo Firms

Subsidy Bidding:Subsidy Bidding:Two FirmsTwo Firms

With two equally-sized firms, the market is split. The bid, equal to ACQ/2, reflects the split. The subsidy grows substantially even if both

firms are equally- and most efficient.

Quantity

Transfer ofProfit to Consumer

Surplus

Benefits of CompetitionBenefits of Competition

Demand

Competition increases social welfare by reducing the dead weight loss of monopoly. As prices fall, consumer surplus rises faster than profits decline.

QM Quantity

Reduction inDead Weight Loss

Transfer ofConsumer Surplus

to Government

Cost of SubsidiesCost of Subsidies

Gathering funds for subsidy creates distortions in other markets, leading to efficiency losses.

Creation ofDead Weight Loss

DemandMC

Loss of Producer Surplus

Quantity

Let’s make soupLet’s make soupWhat are the relationships of What are the relationships of interest?interest?

PPTT + M – AC + S = 0 + M – AC + S = 0

S/S/AC > 0AC > 0M/M/N < 0N < 0

AC/AC/N > 0N > 0

Let N be the number Let N be the number of entrants:of entrants:

S/S/PPTT < 0 < 0

S/S/M< 0M< 0

S/S/N > 0N > 0Competition increases the subsidy!

Let’s make soupLet’s make soupConsider a case where we use Consider a case where we use bidding and allow multiple winners bidding and allow multiple winners (N>1).(N>1). What happens relative to an What happens relative to an exclusive winner?exclusive winner?

PPTT + M – AC + S = 0 + M – AC + S = 0

Competition in subsidized markets increases Competition in subsidized markets increases the amount of subsidy both through margin the amount of subsidy both through margin declines and cost increases.declines and cost increases.

What’s competition What’s competition worth?worth?

To consider what competition is To consider what competition is worth, let’s assume AC is constant worth, let’s assume AC is constant (not rising with the number of (not rising with the number of firms).firms).

PPTT + M – AC + S = 0 + M – AC + S = 0

Margins fall, Margins fall, benefiting benefiting consumers.consumers.

Subsidy Subsidy rises, rises, harming harming consumers.consumers.

Competition and SubsidiesCompetition and Subsidies

QMQuantity

$ Subsidized Market

Quantity

$ “Taxed” Market

These cancel

This is not the usual transfer from firms to This is not the usual transfer from firms to consumers as a result of competition, it is a consumers as a result of competition, it is a transfer from consumers in one market to transfer from consumers in one market to consumers (and producers) in another. consumers (and producers) in another.

Loss to Consumers

Loss to Firms

Gain toConsumers

Competition and SubsidiesCompetition and Subsidies

QMQuantity

$ Subsidized Market

Quantity

$ “Taxed” Market

What are the relative sizes of these things?

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

* J. Hausman, Taxation by Telecommunications Regulation, NBER Working Paper W6260 (1997).

If we need $1 of subsidy due to a $1 margin If we need $1 of subsidy due to a $1 margin decline, then we need $1 of subsidy collection. decline, then we need $1 of subsidy collection. Thus, there are distortions created (higher Thus, there are distortions created (higher “taxes”) for the distortions eliminated (lower “taxes”) for the distortions eliminated (lower margins). Rough estimates suggests a $1 margins). Rough estimates suggests a $1 price decline in the subsidized market price decline in the subsidized market generates $0.05 of additional surplus, but generates $0.05 of additional surplus, but costs $0.65 of surplus in collection on costs $0.65 of surplus in collection on average.average.** At the margin, collection costs are At the margin, collection costs are $1.25 per $1 of subsidy. $1.25 per $1 of subsidy. The subsidy payout scheme should be determined The subsidy payout scheme should be determined jointly with the subsidy collection scheme (or at least jointly with the subsidy collection scheme (or at least considered).considered).

* J. Hausman, Taxation by Telecommunications Regulation, NBER Working Paper W6260 (1997).

In fact, AC will rise, indicating In fact, AC will rise, indicating competition is likely a net loser in competition is likely a net loser in social welfare terms.social welfare terms.

PPTT + M – AC + S = 0 + M – AC + S = 0

Competition further lowers social Competition further lowers social welfare by raising costs and, thus, welfare by raising costs and, thus, increasing subsidies. Just like with increasing subsidies. Just like with competition, $1 in higher costs competition, $1 in higher costs requires $1.60 in welfare to collect.requires $1.60 in welfare to collect.

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

Some CaveatsSome CaveatsI’ve assumed that competitive I’ve assumed that competitive bidding renders a zero profit bidding renders a zero profit equilibrium, like it should in theory equilibrium, like it should in theory (but may not in practice).(but may not in practice).

I’ve assumed competition only I’ve assumed competition only affects prices.affects prices.

Administrative costs are Administrative costs are ignored.ignored.

Strategic bidding is absent.Strategic bidding is absent.

I’ve assumed any subsidy cap is I’ve assumed any subsidy cap is not binding.not binding.

2006 Annual U.S. Telecoms SymposiumGrand Hyatt Conference Center

Washington DCDecember 6, 2006

summary of phoenix center 2006 research dr. george ford chief economist

intense price competition

price competition e

aggressive price competition

intensity of price competition

differentiated price

forms of competition

service competition

sunk entry costs policy

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