regulation in network industries

iimt Bd de Pérolles 90 1700 Fribourg Switzerland www.iimt.ch [email protected]

National & International Economics

Regulation in Network Industries

Simon J. Evenettwww.evenett.com

international institute of management in technology © iimt 20052

Overview of today’s presentation

• Motivating questions—regulation and business strategy.1. Preliminaries on regulation:

• Types of regulation.• Notions of efficiency.• Theories of regulation.

2. Network industries: characteristics and market dynamics.3. Changing nature of regulation in network industries.4. Regulation and business strategy in network industries.5. European experience in regulating network industries.

• Case Study: Comparing UK and German experience.


Why study the regulation of networks?

• Why are these regulations of interest to business people?• _______________________________________________________• _______________________________________________________

• What is the relationship between regulation and the design and implementation of business strategy?• _______________________________________________________• _______________________________________________________

• What is so special about regulation in network industries?• _______________________________________________________• _______________________________________________________

• What are the sources of enduring competitive advantage in regulated network industries?


Purpose of this course

• To familarise you with the types and motives for regulation.• To examine the implications of economic and political-economy

analyses of regulation in network industries.• To discuss the implications of regulation for the design of

business strategy in network industries.

• Approach taken here: blend of institutional material, economic analysis, and business strategy tools.

• Relationship to other courses.


Readings for this course and evaluation

• Three readings:• What is regulation?• Theories of regulation.• Case study of regulatory “games” in European utility sectors.

• The exam questions will refer to the readings and the material covered in class.


Main themes of this course

• Firms need not be passive agents in regulated sectors.– Strategic behaviour vis-à-vis the regulator and other firms is

possible, and maybe even essential.– Strategic behaviour can have market and non-market

components.– Cannot rule out that rivals will engage in such behaviour.

• It is widely accepted that a free market in a network industry is no guarrantee of efficient or socially-acceptable outcomes.

• Market outcomes in network industries can shift very quickly.– Precious little can be taken for granted.– Need to frequently review the source of competitive advantage.



Preliminaries on regulation


Regulation and the market system

• As an alternative to free markets and state control of production and consumption.

• At its best, regulation seeks to use the power of incentives provided by free markets plus the actions of the state to obtain desired outcomes.

• Credible regulation relies on the coercive power of the state.• Why can’t the private sector fix the problems that regulation is

supposed to address?– Coase’s Theorem.– Limited information.– Organisation and bargaining costs.– Negotiating impasse.


Important characteristics of regulation

• What?– Form: Command and control (“thou shall”), liability, inducements

(“thou should”).• When?

– ex-ante versus ex-post regulatory measures.• By whom?

– Sources of regulation: government agencies, negotiated by state and firms, courts, and even private associations.

• For whom?– Obligations on some; rights for others.

• With what? – Information requirements and generation.


Types of regulation

• Control of price.– Example: ______________________________________

• Control of investment.• Control of rates-of-return.

– Example: ______________________________________• Control of quantity.

– Example: ______________________________________• Control of entry and exit.

– Example: ______________________________________• Control of quality.

– Example: ______________________________________


Business-oriented questions about regulation

• What factors trigger regulatory responses by government?• In what ways does a regulation affect current firm behaviour and

market outcomes?– How do firms respond to regulation?– How should firms respond to regulation?

• In what ways is future behaviour of firms affected by regulations?• What is the impact on firm profitability of different types of

regulation?• In what ways, if at all, can firms influence a regulator’s

decisionmaking processes?• How do regulators learn?


Assessing market outcomes

• Firms are interested in their current and future likely profits but do governments always see market outcomes the same way?

• Arguably not: markets facilitate the gains from mutual exchange and buyers gain as well as sellers. Need a metric to take account of gains to all parties from exchange.

• Economists’ first big idea: welfare impact of market transactions is the sum of the gains to consumers and producers.– Concept of consumer surplus.– Concept of producer surplus.

• Relationship to firm profits.• Economists’ next big idea: evaluate market outcomes on the

basis of this metric.


Assessing market outcomes in perfectly competitive markets

• To see how this metric applies in practice, consider a perfectly competitive market where:– no consumer is large enough that their decisions affect

market prices.– every consumer obeys the “law of demand”.– no producer is large enough that their decisions affect

market prices.– the incremental cost of producing each good rises as output

rises.


Consumer surplus: difference between willingness to pay and price paid.

P

Q

MS

MD

P1

Q1


Producer surplus is the difference between total revenues and total variable costs

P

Q

MS

MD

P1

Q1


Useful aside: Producer surplus is zero if incremental costs are zero.

P

Q

MS

MD

P1

Q1

This finding has applies whatever the level of incremental costs.

What covers fixed costs?


The total gains from exchange.

P

Q

MS

MD

P1

Q1

Note:

P1=marginal cost


Efficiency of perfectly competitive markets.

P

Q

MS

MD

P1

Q1

Area A

Area B

Area C is lost

Q2 Q3


How governments assess market outcomes

• Maximising the total benefits from exchange:– Efficiency: sum of producer and consumer surplus.

• Maximising the total benefits from exchange taking account of knock-on effects such as:– Pollution.

• Distribution of surplus between producers and consumers.• Access to good in question.• Minimum levels of consumption

– Necessities.• Through impact on favoured or influential interest groups.


Notions of efficiency

• There is more than one notion of efficiency that people use when discussing market outcomes and the case for government intervention (which may include regulation).

• Allocative efficiency: Requires prices to equal marginal costs.– Rationale: ____________________________________

• Productive efficiency: Requires prices to equal minimum possible production cost.– Rationale: ____________________________________

• Dynamic efficiency: Requires prices charged over time to maximise the benefits of mutual exchange.– Rationale: ____________________________________


Violations of allocative efficiency: any exercise of market power

Price

P1

MC

DMR

Loss of welfare


Violation of productive efficiency

Price

P1

D

AC

MC


Theories of regulation: the questions.

• What do these theories seek to explain?– Why are regulations imposed?– What is the incidence of regulation? i.e. what sectors are

more regulated than others?– What factors account for changes in regulation over time?

Can they account for deregulation initiatives?– What are the effects of regulations?– Whose interests are served by regulations?

– Whose behaviour do these theories try to explain?– Use theories like chop sticks—I will explain why and how!


Theories of regulation: the answers.

• Public interest theories.– “Regulation is there to fix market failures.”

• Capture theory.– “Regulation promotes the interests of incumbent firms and

not social welfare.”• Economic theory of regulation.

– “Politicians structure regulation so as to trade-off the interests of different societal groups in such a way that is most beneficial to them.”

• Which theory is correct has big Implications for firm strategy. Why?


Public interest theories of regulation

• As much a theory of what the state “should do” rather than what it “does do”.

• On this perspective regulations are imposed when the normal operation of free markets—typically competition—does not deliver efficient market outcomes.

• Regulations are imposed when it is in society’s interest to impose them.

• When do inefficient market outcomes happen?– Natural Monopolies.– Externalities.– Information asymmetries—adverse selection and moral

hazard.


Public interest theories of regulation

• So you answer the following questions:

1. What is the incidence of regulation? i.e. what sectors are more

regulated than others?

2. What factors account for changes in regulation over time? Can

they account for deregulation initiatives?

3. What are the effects of regulations?

4. Whose interests are served by regulations?


Critiques of the public interest theories of regulation

• Failures in prediction:– It does not explain which sectors are regulated and which

sectors are not.– It cannot explain why some sectors are deregulated and

others are not.• Incomplete explanation:

– Does not explain why the beneficiaries of the status quo cannot successfully oppose changes in regulation.

– Insufficient attention given to who influences regulatory choice.

• What are the implications for business strategy of this critique?


Critiques of the public interest theories of regulation (2)

• Does not consider the information needed by the state/regulator to set the optimal regulation.– What information is needed?– Who has that information (if anyone)?– Does that agent have the incentive to share the information?

• What are the implications for business strategy of this critique?


Capture theory of regulation

• Motivated by evidence that regulated sectors tended to have prices greater than costs and to have profits.

• One interpretation: producers seek regulations to secure higher profits.

• Example: taxi cabs.• Regulations are supplied in response to industry demands for

them.• The regulatory agency is effectively controlled by the industry.

– Mechanisms of control:– Information:– Budgets:


Capture theory of regulation (2)









Critique of capture theory of regulation

• Does not explain why one group (the incumbent firms) always triumph over other interested parties.

• Hard to reconcile with evidence on:– Discrimination in favour of small producers given in certain

sectors.– Cross-subsidisation imposed on some service providers e.g.

universal service requirements for telecoms companies.– Complaints about business people that regulations are

lowering profits.


Economic theory of regulation

• Predicated on the assumption that the state has the power to coerce and that politicians use that power to advance their own interests.

• Three key assumptions:– Regulation redistrbutes wealth—but is costly to society.– Behaviour of legislators is driven by desire to remain in office.– Interest groups compete by offering political support (votes,

funds) in exchange for favourable regulation.• Prediction: groups that are more easily organised or have more

to gain from legislation tend to receive the benefits of regulation.• Prediction: politicians will limit the amount of regulation given.


Economic theory of regulation (2)









Explaining cross-subsidisation

• Can you use the Economic Theory of Regulation to explain why cross-subsidisation of supply to rural and less-populated reasons happens in telecomunications and in other utility sectors?


Critique of economic theory of regulation

• Voters tend to care about more than one matter—making it easy for politicians to trade-off non-regulation-related benefits for pressures to intervene in markets.

• Politicians may care about things other than reelection.• Assumptions being made about the vulnerability of politicians

and the powers delegated to politicians.– Various forms of representative democracy.

• Can this theory explain the creation of so-called independent regulatory agencies?

• Insufficient attention given to the role of the courts.• Why does any of this matter for business strategy?


Explaining the trend towards creating independent regulators.

• What do we mean by independence?– Ability of regulator to set own agenda?– Financing?

• Need to explain why politicians would delegate their powers to a third party?– Technocratic expertise.– Investment of time and resources in acquiring expertise and

information.• Can each theory effectively explain this trend?• Which sectors would tend to get independent regulators and

which sectors not?


Summary remarks on regulations

• There are many types of regulations and may reasons why they get imposed.

• The fact that regulations can affect business performance is the primary reason why a strategist needs to understand:– Why are regulations imposed?– What is the incidence of regulation? i.e. what sectors are

more regulated than others?– What factors account for changes in regulation over time?

Can they account for deregulation initiatives?– What are the effects of regulations?– Whose interests are served by regulations?


Summary remarks on regulations (2)

• Don’t worry about the fact that there is no one agreed explanation for regulation—the world is very varied and it would be surprising if one story could explain every regulation.

• Regard the theories of regulation as potential explanations—decide which is more relevant to the suitation at hand.

• Important to undertand:– which actors are involved.– their motives.– the options available to a firm.– the need to formulate a coherent strategy for the market

place and in the regulatory arena.



Network industries: characteristics and market dynamics


The changing meaning of “network industry”

• Public policies towards these industries were markedly influenced by how these industries were perceived.

• Until 10 years ago network industries were thought to have a small number of producers—often only one--with a large, possibly central, production facility as well as a distribution system from the producer to each (or many) customers.– On this view network industries were associated with “natural

monopolies” (economies of scale) and the market power that they might employ.

– Often there were multiple, inter-related market failures, e.g. market power and environmental concerns in power generation.


The changing meaning of “network industry” (2)

• Old view overlooked the consumer-related benefits of network membership.

• Essential point: Increasing returns to consumption.– Has three possible meanings:1. Consumers derive benefits from the total number of other

consumers who are consume the same good or service.2. Incremental benefit enjoyed by a consumer increases with

the amount consumed.3. Consumers derive benefits from consuming lots of related

products.– Can you think of examples of each?


How can we characterise these consumer preferences?

• Remember: key concept is the willingness to pay.• In standard supply and demand theory, we assume a

consumers willingness to pay obeys the law of demand.• Remember, however, that was only an assumption! Reality may

be very different.• For example, the willingness to pay for a good depends not only

on its price but also on the number of other consumers who are willing to produce the good.

• What about the other two logical possibilities?


Network effects but still obeys law of demand

Willingness to pay

Own demand

Premium due to more members in network

D (few network members)

D (many network members)


Network effects but breaks law of demand

Willingness to pay

Own demand for MSN messenger


Demand for internet time rises if ISP offers more programmes in its package.

Willingness to pay

Own demand for internet time

Premium due to more features

D (few features)

D (many features)


Node and link representation of networks

• Highlights other features of networks, which will have important public policy implications.

• Here, a network is defined as a set of complementary nodes and links between suppliers and consumers.

• The increasing returns to scale feature of consumption is retained, however the supply side features of networks receive more attention.

• Example: Star network.– Could be a traditional telecoms network.– Willingness to pay rises as number of customers rises.– More than one part of the network is used by each customer

at any one time.


A Star Network

S B

A

D

E

Ce.g. B does not link to C directly


A Long Distance Network

SAC SB

B

D

A

F Z Y

X

WV


Virtual networks have a common technical platform. e.g. Razors and blades.

R1

B2

B1

R4

R3

R2

B4

B3

There is a distinction between one-way and two-way networks


Strategic choices available in network structures.

• Prices charged to end consumers.– Charge customers to send or receive data.– Charge for technology to access to network?

• Two part pricing of the above.– Price discrimination among customers.– Intertemporal pricing to foster network expansion.

• Types of services offered to customers.• Prices charged to rivals for access to own network.• Technical standards employed.

– Compatiability or engage in a “standards war”.– Protection of intellectual property.


Some practical questions that follow from this analysis

• How to price internet services?• Whether to give away internet software?• How to price roaming charges on cell phones?• How to price razor blades?• Whether to introduce a blade that is compatiable with existing

razor?• How to price an improved version of Excel?


Which of Porter’s five forces are affected by the characteristics of network industries?

Inter-firm rivalry.

Relations with suppliers.

Relations with customers.

Introduction of new varieties.

Entrance of new firms.


Implications for market outcomes in network industries

• Over time, large differences in market share and performance are possible in markets where firms were initially pretty equal:– small differences can matter a lot and path dependence.

• Large networks can generate substantial barriers to entry and the appearance of large profits.

• Concentrated market outcomes are not necessarily to the detriment of consumers.– In the limit monopoly may be most efficient.

• Bottlenecks can emerge—generating market power.• One standard may eventually dominate another even though

initially they had the same market share—critical role of customer expectations.


Public policy questions raised by network industries

• Sectoral regulation:– Pricing access to networks.– Prices to final consumers.– Regulation of investment decisions and entry.– Standard setting.

• Competition law.– Abuse of dominance.

• Pricing (including “predatory pricing”).• Use of standards.• Barriers to entry.

– Merger review.• Barriers to entry.


Perils of applying traditional static efficiency criteria to analysing markets.

• What is the correct marginal cost to use?– Especially if there is learning-by-doing.– Firms setting prices below current marginal costs.

• What happens when the marginal cost is zero?– Financing of investment.

• Rapid technical change suggests that competition is often for the market and not in the market.

• “But for” analysis.– Emphasis on counterfactual.– Dynamic efficiency considerations taken into account.


Summary remarks on competition in network industries.

• Key feature of these markets: increasing returns to consumption.– Need to understand the form the increasing returns takes.

• Networks differ in structure—creating different potential strategic choices.

• Market outcomes are subject to much more path dependence: small differences can really matter.

• Large size is not necessarily associated with much market power.

• But control of access to the network and proprietary technology can be important sources of market power.

• Competition can be for the market as well as in the market.



Changing nature of regulation in network industries


1980s and 1990s

• Shift from public ownership and public financing of network infrastructure to private hands.– Many publicly owned firms were vertically integrated—break

up different functions. e.g. power generation, railways.– Publicly owned firms had universal service mandates.– Fears about security of supply gave way to optimism about

incentives created by private enterprise, especially cost control.

– Government happy to see private sector bear burden of investment.

– Governments in Europe tended to choose privatisation over concessions.


1980s and 1990s (2)

• Privatised firms were subject to strict regulation.– Abandon rate-of-return regulation.

• Can you think of the incentives created by this regulation?– Introduced fixed term price contracts, often with RPI-X

formulas.• Was an attempt to solve the long-standing natural

monopoly problem.• Can you think of the incentives created by this regulation?

– Many firms introduced competitive tendering for suppliers.– Competition from rival technologies, especially relevant in

telecommunications and entertainment.


1980s and 1990s (3)

• Two widely-acknowledged “failures” affected regulation of network industries:– Californian energy crisis—reminded critics of security of

supply provisions.• Issue: separation of production from supply network.

– British railways—Hatfield railway crash in October 2000.• Attention on who is responsible for maintaining the

infrastructure—who invests and who pays for maintainence.

• Upgrades require slow train speeds for weeks.– Both cases raise issues of coordination in vertically

integrated network industries.


Regulating Telecoms in OECD nations

• Main findings of OECD June 2005 study (released on 11 January 2006).– Responsibilites of regulators have tended to expand as

ministries have transferred powers to them.– Several telecoms regulators have been merged with

broadcasting regulators.– Shift towards joint responsibility for sector with competition

agencies, sometimes with formal cooperation mechanisms established.

– Although seen by some as temporary institutions, whose job would be over when competition reigned in telecoms, sectoral regulators have survived.

• Why? Foreberance and new technologies.– “Next generation networks” expected to create pressures for

single regulatory regimes in telecoms-related sectors.


Characteristics of Telecoms regulators

• To whom does the regulator report?• How is the regulator financed?• Who appoints the head of the regulatory agency?

– How long a term does the head have?– Can the head be dismissed?– How are decisions made within the regulator?

• Which bodies, if any, can overturn the decisions of the regulator?

• What do the answers to these questions imply about the form that independence of a regulator takes?

• Are their sub-national regulatory agencies in telecoms?


Relationship between telecoms regulator and competition agency

• Shift since end 1990s away from sole, full responsibility given to one agency to joint responsibility for competition-related matters by both agencies.– Not for regulator’s authorisation and licensing functions.

• Competiton agency can have parrallel powers (e.g. UK).• Sometimes agencies enter into cooperation agreeents to

clarify areas of individual or joint jurisdiction (e.g. Canada.)• Sectoral regulator reports cartel violations to competition

agency (e.g. Austria).• Sectoral regulator can issue opinions to competition agency

(e.g. Italy).• Sector regulator may seek opinion of competition agency (e.g.

Turkey).• Why does all of this matter for strategy formation?


Areas of potential dispute between regulators and competition agencies

• Pricing interconnection.• Rules on price competition, especially rules against lower

prices beyond a certain level.• Mergers and acquisitions.• Conditions imposed on new entrants.• Forebearance of anti-competitive practices so as to meet a

“social” regulation.– e.g. unfunded universal service requirement.

• Even where the competition agency does not have formal powers it may engage in “advocacy” to those that do.

• “Regulatory capture” may not be enough!



Business strategy and regulation in network industries


Firms in network industries need integrated strategies.

• Such firms operate simultaneously in a market environment (think Porter’s 5 forces) and a non-market environment (made up of non-commercial actors.)

• The non-market environment can be just as much as a threat to firm profitability as any of the five forces.

• David Baron argues that firms need integrated (that is, coherent) strategies in the market and non-market environment so as to protect against threats to profitability.– He adapted Porter’s five forces approach to include the

non-market environment.– Let’s do that here in the context of regulation of network

industries.


Businesses operate in two environments simultaneously.4 I’s Non-market environment Market environment

Issues: subject matter. Regulations, proposed laws, court judgments etc.

Inter-firm rivalry, consumer tastes, supplier difficulties.

Institutions: decision-makers and their

processes.

Regulators, NGOs, elected officials etc. Collective and/or non-unanimous decisions.

Arms length market transactions. Voluntary decision-making

Interests: goals (hopes, fears) of actors.

Social and economic goals of policymakers. Fairness. Stability.

Higher prices, better quality, etc.

Information: beliefs, knowledge of actors.

Prejudices, rumour, state reports, press coverage, etc.

Market research, reputation, advertising.


Examples of non-market strategies.

• Two main objectives: creating and exploiting opportunities and countering threats.

1. Create opportunities for self—opening foreign markets.2. Alter rival’s current opportunities—raising rivals costs through

impact of differential regulation.3. Block rival’s opportunities altogether—opposing rival’s M&A

plans.4. Reducing threats from rivals—blocking entry by imports,

patents.5. Reducing threats from the state—self regulation in financial

services.6. Mitigating threats—state bail outs and insurance.7. Creating threats and uncertainty—threatening legal action.


Firms develop strategies for the market and non-market sphere.

• Need not involve a change in the objectives of the firm.• Effective strategy formation involves:

1. Identifying the relevant 4I’s and 5 forces.2. Identifying a set of strategic options which may have

market and non-market components.3. Anticipating strategies of actors in market and non-market

environment.4. Given 1-4, evaluating strategic options: decision and

coherence in both spheres.5. Implementation—consideration of resources required.6. Mitigation of risks.7. Evaluation of prior decision. Start of feedback loop.


Important characteristics of non-market strategies.

• Appropriability: Are the gains from pursuing non-market strategy only appropriated by those firms pursuing such strategies? If not, what are the implications for the desirability of a non-market strategy?

• Collective versus individual action: Would collective action be preferable to individual approaches?

• Sustainability. What are the sources of distinctive—that is, hard to copy yet effective—non-market strategy? Can non-market strategy be a source of long term competitive advantage?

• Reversibility: Does precedent matter? Can a particular strategy be reversed? If not, does it matter?



Case study on Regulatory Games in Utility Markets


Notes on case study (1)


Notes on case study (2)


Concluding remarks.

• Corporate strategy tools can be adapted to the special circumstances of network industries.

• Those characteristics include:– “Increasing returns” to consumption—or how networks create

value!– Generates mutiple pricing opportunities.– Control over access to network.– Choices concerning standards adopted (compatiability, and

intellectual property.)• Competition is often for the market, not in the market.


Concluding remarks (2)

• Concentrated market outcomes is often the result—prompting calls for government intervention.– Plus there is legacy of government regulation in many sectors.

• Regulation calls for integrated strategies by firms to take account of the non-market environment.– Critical to understand which regulators matter, how they make

decisions, on what basis, and who they talk to.– Regulators are often deeply influenced by national bureaucratic

traditions.– Don’t make assumptions about due process and procedural

fairness.– Effective non-market strategy typically requires distinct resources

and capabilities to implement.

regulation in network industries

Documents

publicly owned firms

perfectly competitive markets

concentrated market outcomes

public interest theories

consumers derive benefits

incremental costs

market outcomes

requires prices