Econ 100Mar 11 2009

Increasing Market Competition:

Deregulation &

Incentive Regulation

Definition of Terms• Deregulation (1970-2000)

– process by which governments remove, reduce, or simplify restrictions on business and individuals with the intent of encouraging the efficient operation of markets.

– rationale for 'deregulation' is that fewer and simpler regulations will lead to a raised level of competitiveness, therefore higher productivity, more efficiency and lower prices overall.

• Liberalization: liberalized market, has less and simpler regulations, can also have regulations in order to increase efficiency and protect consumer's rights, – However, terms are often used interchangeably within

deregulated/liberalized industries.• Distinction between deregulation and privatization.

– Privatization can be seen as taking state-owned service providers into the private sector.

Examples of Deregulation

• Airline Deregulation Act (or ADA) October 24, 1978. – avowed purpose was to remove government control

from commercial aviation and expose the passenger airline industry to market forces

– Since 1938, the federal Civil Aeronautics Board (CAB) had regulated all domestic air transport as a public utility,

• setting fares, routes, and schedules. • CAB promoted air travel by generally attempting to hold fares

down in the short-haul market, to be subsidized by higher fares in the long-haul market.

Deregulation in the Airlines Industry

• ADA (1978)– Removed the CAB’s authority to set prices,

determine/allocate routes• Allowed markets to determine these

– Overlooked strategic behavior in long term gate leases by larger/better financed airlines

• As the text points out, one of the major problems with deregulation is: “difficulty in developing an effective regulatory strategy”

Incentive Regulation

• Sappington & Weisman– Implementation of rules that encourage a regulated

firm to achieve desired goals by granting some, but not complete, discretion to the firm

• Three features of incentive design– Regulatory goals must be clearly specified before

design– Regulated firm is granted some discretion– Regulated firm is not granted complete discretion

Why Not Complete Discretion?

• Firm has better information than the regulator about key aspects of the regulated industry– e.g., costs structure/production

technology, customer preferences/demand

• Firm may have different goals than its customers/society

Deregulation in Telecommunications

• A brief history– 1939 Telecommunications Act

• Established the FCC as the administrating authority (agency)

– 1960’s• AT&T essentially had monopolies in:

– Local phone service (80%)» No one owned their phone; rented from AT&T

– Telecommunications switching equipment, cabling (Western Electric)

– R&D (Bell Labs)

A Brief History

• 1984 Modified Final Judgment (MFJ, Judge Green)– Ended AT&T’s monopoly in long distance, and

equipment provision/manufacturing– Divested AT&T of the Baby Bell’s (RBOCs)

• AT&T and the 7 Dwarves– RBOCs allowed to provide local service and short- and

mid-distance toll (local and intraLATA); but not LD (interLATA)

– MCI and Sprint allowed to compete in the LD market against AT&T

» AT&T no longer provides local service or local toll

MFJ Consequences

1996 Telecomm Act

• Objective– Increase competition in the local phone market where RBOCs

and GTE held a monopoly• Price and technological innovation

– Facilitate (manage) competition, through 3 entry patterns• Facility based competition, resale and unbundled network elements

– Major roadblock• “bottleneck” or “essential” facilities

– Local network necessary for access by competitors for call termination– Local network is also where the scale economies are

» Don’t want to duplicate these facilities• Interconnection agreements between CLECs and ILECs will be

instrumental

Competitive Entry: Facility Based

• Facility-based– Competitors co-locate at ILECs central office

and provide upstream facilites/switching• Compensate for terminating calls on local network

and transferring calls from ILEC• Only path adopted by UK, Canada, Aus, NZ

Competitive Entry: Resale

• CLECs allowed to purchase entire service (line, switching, features) from the ILEC’s retail tariff– Rates established by Efficient Component

Pricing Rule (ECPR)• Difference between wholesale rate and retail rate =

avoided costs (e.g., marketing and billing)• In practice: arbitrarily set at 10%

Competitive Entry: UNEs

• Unbundled Network Elements– Intent: allow CLECs to use a hybrid approach

of mixing facilities competition with leasing of “essential” elements (e.g., loops) from ILECs

• Catalyst to full, facilities based competition

– Rates set using total element long-run incremental costs (TELRIC)

• Engineering based models (hypothetical)• Reflect forward-looking economic costs, rather

than historical (embedded) costs

TELRIC Pricing

• TELRIC – Attempt to estimate marginal costs using the

most efficient technology deployed and the incumbent’s network

• Ignored facilities in place (historical costs)• Modeled using current demand and customers

– No uncertainty – network sized for current demand with no “insurance/reserve” capacity

– Hatfield model• Generally adopted by regulators• Built by folks without an Telecomm experience

TCA 1996: Pricing Impacts

• Resale– Wholesale prices about 10% lower than retail prices

• Res – $16 per month retail (cost ~$30)– Subsidized by business lines and LD rates

» Universal service

• Bus - $60 per month retail (cost ~$30)

• UNE – If the CLEC reassembled all of the UNE elements ->

45-50% discount on TELRIC costs

What Would You Do?

• Suppose you’re a CLEC– You can enter through any/all of three modes: facility-

based, resale, UNEs– Would you build your own facilities?

• Consider that the FCC has developed TELRIC costs from assuming that the most efficient technology is used and demand is known perfectly

– Would you use Resale or UNE?• Might the strategy be different for Residential and Business

customers?• Given the cross-subsides in the old rates, which customer

would you target first?

Telecommunications Act of 1996

• The Act both deregulated and created new regulations. Congress forced local telephone companies to share their lines with competitors at regulated rates if "the failure to provide access to such network elements would impair the ability of the telecommunications carrier seeking access to provide the services that it seeks to offer."

• This led to the creation of a new group of telephone companies, "Competitive Local Exchange Carriers" (CLECs) that compete with ("ILECs" or Incumbent Local Exchange Carriers).

Telecomm Act

• TCA permits new telephone companies to lease the incumbent telephone companies’ network facilities at wholesale prices far below costs.

• Rules encourage entry of firms that avoid building alternative networks and depend on subsidized networks’ facilities. – Few entrants that built alternative networks are now abandoning

these networks (chart) for subsidized leased facilities. • Because regulated wholesale prices are set far below

costs in many states, incumbent telephone companies have also cut their investments. – Neither incumbent nor new entrant investing, equipment

manufacturers have closed plants and industry employment has fallen by half a million jobs.

www.newmillenniumresearch.org

• CLECs are abandoning their own networks to lease UNEs at bargain prices The recent increase in leased lines is coming at the expense of lines built and owned by CLECs themselves.

• UNE prices are set so low that they discourage CLECs from investing in alternative telecommunications infrastructure.

• Low UNE prices make the ILECs’ wholesale services unprofitable, which discourages continued ILEC investment.

• As a direct result of low wholesale prices, industry-wide telecommunications investment has fallen 40% over the last two years.

• This study finds that the fall in telecommunications investment results in an annual

decline in economic output equivalent to $101 per average household annually. In contrast, the benefits of price reductions resulting from local competition are estimated to be $11.41 per household annually.

• This study finds finds that the economic costs associated with setting artificially low wholesale prices far outstrip the consumer financial benefit

Brookings Institute

• Robert Crandall of the Brookings Institutehas argued that the forced-access provisions of the 1996 Act have had little economic value, and the primary, sustainable competitive forces in phone and related, non-'radio', telecommunications are the wireline telephone companies, the cable companies, and the wireless companies.

• The Act was claimed to foster competition. Instead, it continued the historic industry consolidation begun by Reagan, whose actions reduced the number of major media companies from around 50 in 1983 to 10 in 1996 , reducing the 10 in 1996 to 6 in 2005.

So What was the Goal?

• Goals of regulation– Efficiency in Production– Promote Technological Innovation– Efficiency in Allocation