MARKET POWER AND ITS IMPLICATIONS FOR MOBILE TERMINATION

1. MARKET POWER AND ITS IMPLICATIONS FOR MOBILE TERMINATION PRESENTED AT INTERNATIONAL TELECOMMUNICATIONS SOCIETY BIENNIAL CONFERENCE, BERLIN, SEPTEMBER 4-7 2004 ROB ALBON AND RICHARD YORK TELECOMMUNICATIONS GROUP AUSTRALIAN COMPETITION AND CONSUMER COMMISSION

2. Caveat • The views expressed are those of the authors and do not necessarily reflect those of the Australian Competition and Consumer Commission.

3. Overview (1) • On the surface there appear to be a number of market failures in mobile markets. • In particular, there appears to be market power in termination and various externalities. • However, mobile carriers and their consultants in Australia and in other jurisdictions have claimed that the free market outcome is efficient. • They argue that termination charges set above cost fund efficient subsidies to mobile subscription.

4. Overview (2) • Regulators in many countries have taken a different view. • They have argued that market failures in mobiles give rise to a case for intervention. • In particular, they favour regulation of mobile termination charges to produce more efficient and more competitive outcomes.

5. Overview (3) • In the traditional public economics paradigm, market failure provides a prima facie case for intervention. • Before intervention can be endorsed it has to be determined that government can do better than the market. • There are two main complexities in proving the case − second best considerations and the efficiency costs of raising revenue to fund subsidies.

6. Overview (4) • We believe that the presence of substantial market power in termination is clear. • In our paper, we address arguments that the mobile network externality justifies either: − a laissez-faire approach to termination, or − the addition of a network externality surcharge on a regulated termination charge. • We also consider the relevance of the fixed-line network externality and of call externalities.

7. Overview (5) Our broad conclusions are that: • the free market outcome is inefficient, • there is a strong case for regulation of mobile termination, and • The case for a network externality surcharge on the regulated access charge for mature networks is very weak.

8. What is ‘Market Failure’? • The presence of market failure provides a necessary − but not a sufficient − basis for intervention. • Market failure is interpreted in terms of the free market failing to yield an efficient outcome. • Simple interpretation of efficiency in terms of Price ≠ long-run marginal cost • Market power and externalities are examples of market failures found in mobiles.

9. What Intervention Seeks to Achieve • Intervention aims to achieve an ‘efficiency gain’. • This is interpreted in terms of satisfaction of the ‘potential Pareto’ or ‘Kaldor-Hicks’ criterion. • This is usually interpreted as a positive change in the sum of consumer and producer surplus. • Such a change results in gainers being able to compensate any losers, while still remaining better off.

10. An Example − Reducing Price to Cost • In the following diagram the policy is a reduction of price from P0 to P1, equal to TSLRIC cost. • Quantity consumed increases from Q0 to Q1. • Consumers gain by the sum of areas A and B. • The producer loses by area A. • The net gain (the ‘efficiency gain’) is area B (+A +B −A = +B).

11. Effects of Reducing Price to Cost Price, cost P0 A B TSLRIC P1 Demand Q0 Q1 Quantity

12. A Stronger Test is Sometimes Set • We note that Crandall and Sidak use a much tougher test − the Pareto criterion. • Under that test any intervention that results in losses to any party fails. • It is almost inconceivable that any intervention would result in gains without any losses. For example, our simple example of price reduction clearly fails. • Use of this test could help explain their strong deregulatory stance.

13. The Prima Facie Case for Intervention (1) • Market failure provides only a prima facie case for intervention. • There is an ‘imperfect’ market, but government may not be able to do better! • The case for intervention has to be proven.

14. The Prima Facie Case for Intervention (2) There are two main difficulties: • Second-best − fixing one problem may worsen another, and not result in a net efficiency gain. • Funding issues − must consider the marginal deadweight loss (MDWL) from taxation necessary to fund subsidies.

15. Marginal Deadweight Loss (MDWL) from Taxation Change in the deadweight loss MDWL = ----------------------------- Change in taxation revenue • As the tax rate increases, the MDWL increases. • The numerator rises at an increasing rate … • … and the denominator rises at a decreasing rate, reaching a peak at the ‘monopoly’ level. • The MDWL becomes arbitrarily large.

16. Market Power in Termination (1) • Empirical and in-principle argument suggests mobile carriers have market power in termination. • Carriers and economists such as Crandall, Sidak and Hausman emphasise substitutes. • Yes, there are some weak substitutes, but unregulated prices are typically two to three times full TSLRIC costs. • This simply could not happen without substantial market power.

17. Market Power in Termination (2) • This market power does not diminish with the addition of more carriers into a market. • Even small carriers have market power in termination. • Denial of this has been described by Laffont and Tirole as a ‘common fallacy’.

18. It is worth recording here the common fallacy that small players do not have market power and should therefore face no constraint on their termination charges. This fallacy results from a misunderstanding of the definition of a market. A network operator may have a small market share in terms of subscribers; yet it is still a monopolist on the calls received by its subscribers. Indeed, under the assumption that retail prices do not discriminate according to where the calls terminate, the network has more market power, the smaller its market share: whereas a big operator must account for the impact of its wholesale price on its call inflow through the sensitivity of rivals’ final prices to its wholesale price, a small network faces a very inelastic demand for termination and thus can impose higher mark-ups … . (Laffont and Tirole, 2000, p. 186)

19. The Mobile Network Externality (1) • Individuals are willing to pay to subscribe to a mobile network according to their (declining) marginal private benefit (MPB). • The source of the mobile network externality is the willingness to pay by existing subscribers for the addition of new subscribers to the network. • The marginal external benefit (MEB) from additional subscribers is also likely to get less as the network matures.

20. The Mobile Network Externality (2) • The total demand for subscription, the marginal social benefit (MSB) is equal to: MSB = MPB + MEB • In a mature network the last subscriber to join will be of no value to existing subscribers. • This is often suggested to be where about 80 per cent of the population subscribes.

21. From Externality to Intervention • The existence of an externality does not necessarily present even a prima facie case for intervention. • It must be relevant at the margin. • That is, the marginal social benefit (MSB) of another subscriber must exceed the TSLRIC cost to the network operator of taking the new subscriber on.

22. The Pigouvian Subsidy • The Pigouvian subsidy is set equal to the MEB. • Payment of this subsidy will induce the socially optimal number of subscribers on to the network. • This is illustrated in the following diagram.

23. P,C MSB Efficiency gain from the Pigouvian subsidy P0 TSLRIC A P1 MEB MPB Q0 Q1 Q

24. The Pigouvian Subsidy is Inefficient (1) • Where there are efficiency costs from raising the necessary revenue the Pigouvian subsidy will never be optimal. • Some smaller subsidy will be optimal in these circumstances. • Determination of the efficient subsidy/tax is a ‘balancing act’.

25. The Pigouvian Subsidy is Inefficient (2) • The marginal efficiency cost of raising the last dollar of revenue for the subsidy must be set equal to the marginal efficiency gain from the subsidy. • In view of the possible need to subsidise some intramarginal subscribers, there could be an efficiency cost even before new subscribers are on the network. • This may mean that the efficient subsidy is zero.

26. Do ‘Competitive Bottlenecks’ Produce an Efficient Outcome? (1) • The interaction of mobile carriers with one-another has been described as one of ‘competitive bottlenecks’. • They exercise (some) market power in termination … • … and compete away some of the profits in the retail mobile market (eg, handset subsidies) in a quest to attract new subscribers.

27. Do ‘Competitive Bottlenecks’ Produce an Efficient Outcome? (2) • The more competitive is the retail mobile market … • … the greater will be the pressure to exploit market power in termination. • We contend that the termination tax will always be too high.

28. Do ‘Competitive Bottlenecks’ Produce an Efficient Outcome? (3) • The tax on termination could be driven to the point where net revenue is maximised, and the MDWL is infinite. • At the same time, the marginal efficiency gain from the subsidy will be falling; eventually becoming negative. • This is illustrated in the following diagram.

29. An Excessive Subsidy Could Result in a Net Efficiency Loss (− > +) MPB MSB + TSLRIC Excessive Subsidy  Pigouvian Subsidy

30. Do ‘Competitive Bottlenecks’ Produce an Efficient Outcome? (4) • As the marginal efficiency gain from the subsidy must be finite, and could be negative, the free-market outcome cannot be efficient. • That is the gainers (mobile subscribers) could not compensate the losers (FTM callers) and still be better off.

31. The Fixed-line Network Externality • This is the benefit enjoyed by fixed-line subscribers through having more mobile subscribers to call. • Like the mobile network externality this will tend to favour subsidising mobile subscription.

32. The Call Externality • This is the benefit enjoyed by mobile subscribers through receiving calls from fixed-line callers. • This suggests a prima facie case for subsidising FTM calling. • Obviously, this is the opposite prescription from that flowing from consideration of the network externalities. • It therefore represents a classic second-best conundrum.

33. Conclusions (1) • Mobile operators have substantial market power in termination. • The claim that the use of profits from taxing termination to subsidise mobile subscription is efficient is questionable. • We have four reasons for believing this.

34. Conclusions (2) • First, the case for a termination tax may not even get off first base. • In mature networks it is unlikely that the mobile network externality is Pareto-relevant. • A subsidy would unambiguously damage welfare in these circumstances.

35. Conclusions (3) • Second, funding the subsidy requires taxation of termination to raise the revenue. • The efficiency costs of this have to be traded off with the efficiency gains from the subsidy. • It is possible that this trade-off could dictate a zero subsidy.

36. Conclusions (4) • Third, the competitive process in mobiles has been depicted as ‘competitive bottlenecks’, and this process is likely to result in an inefficient outcome. • It will entail an excessive tax on termination, and pari passu, an excessive subsidy on subscription.

37. Conclusions (5) • Fourth, the existence of a call externality enjoyed by mobile subscribers on FTM calls they receive suggests a prima facie case for subsidising termination.

38. Conclusions (6) In summary, we are attracted to the following perspective in view of the current state of knowledge: Looking at all these effects and tendencies together, the best advice to regulators would appear to be to tax neither fixed network users for network externalities in mobile networks, nor to tax mobile users for network externalities in fixed networks, until the future trends in substitution between mobile and fixed networks become better understood. (Bomsel, Cave, Le Blanc and Neumann, 2003, p. 24.)

39. Conclusions (7) • In our view there is no ‘paradox’ surrounding the ‘free market’ in mobiles. • Market failures in mobiles are just that, and policy makers cannot rest easy in the knowledge that they will be efficiently accommodated under laissez faire conditions.