The Long-Distance Industry: One Merger Too Many? MCI WorldCom and Sprint (2000) Michael D. Pelcovits...

The Long-Distance Industry: The Long-Distance Industry: One Merger Too Many?One Merger Too Many?MCI WorldCom and Sprint (2000)MCI WorldCom and Sprint (2000)

Michael D. Pelcovits

Presented by YU, Lei and BA, Qing

School of Economics and Finance

The University of Hong Kong

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AgendaAgenda

Introduction

Several IssuesThe Internet Backbone

Conclusion

Q&A

Part One:Part One:IntroductionIntroduction

Firms

Industry Background

Merger Review Process

Outcome

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Introduction: FirmsIntroduction: Firms

On October 4,1999,MCI WorldCom and Sprint announced an agreement to merge. The two companies are the second and third largest traditi

onal long-distance companies in U.S.

The first and second largest providers of Internet backbone service.

Due to overlapping of two companies’s large portion of business activities, concerns about competitive impacts arise.

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The long-distance industry has consolidated significantly in the years prior to the merger announcement.

Finally, the applicants dissolved the agreement in the face of opposition from U.S Department of Justice(DOJ) and commission of the European communities(EU).

This merger become the only merger between major telecommunications carriers that was derailed by the government.

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Importance of this case:

Define the limits of the government’s tolerance for consolidation in the telecommunication industry.

Present a new tool- merger simulation models

Involved some interesting and controversial topics in the growing field of network economics.

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Introduction: IIntroduction: Industry Backgroundndustry Background

Industry and Regulatory Background

Divestiture of Bell System on January 1, 1984

Underlying goal of this decree was to isolate monopoly local service companies from downstream markets.

However, this divestiture did not last long- RBOCS

sought permission to enter long-distance market and other firms began to compete in local markets.

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Bell System After Divestiture

Local telephone

RBOCS Local telephone

Long-distance Long-distance

AT&T

Manufacturing and Manufacturing and

Research equipment

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Competition in the long-distance market flourished in the years following divestititure.

AT&T’s market share declined from 90% in 1984 to 43% in 1998.

During the same period, MCI World Com and Sprint increased their shares from 4.5% to 25.6%, and 2.7% to 10.5%, respectively.

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Introduction: IIntroduction: Industry Backgroundndustry BackgroundFigure 1 AT&T, MCI, and Sprint Shares of Total Revenue in long distance market U.S.

0

10

20

30

40

50

60

70

80

90

100

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

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1996

1997

1998

AT&T

MCI

Sprint

Source: FTC(1999)

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Introduction: Introduction: Merger Review ProcessMerger Review Process First, the DOJ examines the merger under the Clayton Ac

t – Hart-Scott-Rodino process: merger companies give notice to DOJ, then DOJ collects inform

ation and documents from the applicants and other firms in the industry.

DOJ decides whether to file a lawsuit in Federal District Court to block the merger.

Second, Federal Communications Commission(FCC) must approve the merger pursuant to Communications Act – public interest standard.

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Introduction: Introduction: Merger Review ProcessMerger Review Process

Third, state public utility commissions in which the merging parties hold the certificates of authority for intrastate services, must approve the merger.

Finally, the EC must approve the merger under its antitrust laws.

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Introduction: Introduction: Merger Review ProcessMerger Review Process

Merger Review Process in Telecommunications Industry, U.S

SPUC Must Approve Communications Act FCC

Industry

EC Antitrust Law Merger Notice

Applicants Collect Info DOJ No Court

Other Collect Info

Firms

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IntroductionIntroduction: Outcome: Outcome

However, in this case there was no FCC decisions because the application was withdrawn after the DOJ decided to challenge the merger.

There was no final court decision in this case, and the reason as above.

After the case, EC issued a decision declaring the merger incompatible with European law.

Part Two: Part Two: Several IssuesSeveral Issues

Market DefinitionMarket DefinitionMarket PowerMarket Power

Simulation Model Method Simulation Model Method

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Table Lines of Business and Market Presence

Market MCI Sprint Other Firms Long-Distance - Mass

Market Number 2 Number 3

ATT - Number1 600

smaller firms

Long-Distance - Large

Business Number 2 Number 3

ATT - Number1 New

entrants: Qwest,

Broadwing, Frontier

Internet Backbone Number 1 Number 2 Several other large firms,

hundreds of small firms

Local Service New Entrant;

concentrated in metro

area

Traditional carrier in

a few smaller market Dominated by RBOCS and

GTE

Wireless MMDS MMDS, PCS RBOCS, ATT

Notes: MMDS-mutichannel and multipoint delivery service, PCS- personal communication service

Market DefinitionMarket Definition

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Applicant’s Case Claim a new “all distance” market.

Technology advances reducing the sensitivity of telecommunication costs to distance.

Opponents’ Case The merger should be evaluated under current market

conditions.

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Question: What’s the market? How to define the market? The proposed merger affected concentration and

competition in many telecommunication markets.

The area of concern to the government were the two major segments of the long-distance market and the Internet backbone.

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Long-Distance Competition – Network Coverage and Capacity

Long-distance service is provided primarily over fiber optic lines that link together hundreds of carrier locations, known as points of presence(POPS), across the country.

Local telephone companies provide the connections between customers and the nearest POP of the long-distance company.

Question: How to build a long-distance network?

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Obtain the Rights Dig Trenches Place electronics at different

To Cross the and Lay fiber points in the network to create

Entire Net cable and repeat light pulse and

Convert electronic signals

How to build a long-distance network

Install switches Set up computers

To route traffic and software to

Manage network


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MarketMarket Power Power

Question: Because of the huge sunk cost(several billion to get 15,000-30,000 miles),whether there would be sufficient competition among different owners of long-distance networks following the merger? Does the “Big 3” have the market power?

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Market Market Power: New EntrantsPower: New Entrants

Applicants claimed:

Many carriers had recently built large fiber optic network to compete the “Big 3”.

The capacity of fiber optic lines could be expended efficiently to meet demand, and there is no constraint on the capacity to meet any conceivable demand because of innovation in electronics and photonics.

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Fi ber System Route Mi l es of I nterexchange Carri ers

0

10000

20000

30000

40000

50000

60000

1991 1992 1993 1994 1995 1996 1997 1998

year

Mile

s

AT&T

MCIWorl dCom

Spri nt

OtherCarri ers

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Opponents argued: They argued that the entrants network did not have the

geographic reach of those “Big 3, and they have to depend on the Big 3 to fill the gaps in their network in order to offer coverage to their consumers.

Therefore, they concluded that the merger raised the costs of providing service to new network by reducing the number of ubiquitous carriers from 3 to 2, and negatively affected their ability to compete with Big 3 in providing long-distance services.

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Table Area Served by Long-Distance Network, 2000 Company POP LATAS Servise% Population Served% AT&T 705 100 100 MCI World Com 740 99 100 Sprint 398 97 99 Qwest 136 55 81 Williams 110 49 78 Frontier 92 44 72 BroadWing 77 34 63 Cable and Wireless 35 16 48 Level 3 26 13 44 Souce: Hausman(2000)

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Responses of applicants: There would be only 12 LATAS in which the number of

facilities-based long-distance carriers would go through from 3 to 2 as a result of merger.

The entrants did not need to fill in its network by buying from only one other carrier, but rather could assemble a network by piecing together portions from tow or more carriers competing against the “Big 3”.

Therefore, they claimed that the “Big 3” have not market power.

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The views of DOJ: Because each of the networks depends upon the ability of

provider to connect sites at diverse locations throughout the U.S. and, some cases, around the world, the providers must posses a vast network of optical fiber, POPS,nodes, switches, routes, and other associated facilities. Because World Com and Sprint are two of only three such providers in U.S., the effect of the merger will be to eliminate one of the very carriers that possesses the full range of facilities required to compete in these markets.(DOJ 2000)

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Estimating HHI level, pre and post merger: MCI and Sprint failed Merger Guideline.

Generic or emerging carriers could not constrain the prices of the “Big 3” branded products: compared with other industries

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Market Power: SubstitutabilityMarket Power: Substitutability

Residential Long-Distance Markets – Important question: Do the consumers consider the entrants’s product as good substitutes for those of merging applicants? Are there any brands effects in the products of “Big 3”?

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Good substitutes VS Not good substitutes Opponents argued the brand name of the products of Big

3 differentiate them from those of new entrants, so they are not good substitutes for consumers.

Applicants claimed that the new entrants in the long-distance market were perceived as good substitutes for the “Big 3”.

The two parties argued in two ways: traditional approach( such as characteristics of products of both sides, pricing strategies, and consumers’ behavior) and model analysis.

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Applicants’s position: consumers consider the carriers other than “Big 3” as very close, if not perfect substitutes, therefore value of “Big 3”’s brand was very limited and they have not market power. Their weapons are as follows: Market shares Entry strategies of successful emerging carriers Data on the willingness of consumers to switch among ca

rriers Unilateral effects model

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Table Shares of U.S. Residential Toll Revenues, 1995-1997

1995 1996 1997 Changes in

Shares Points

1995-1997 AT&T 68.5 63.3 60.9 -7.6 MCI 14.6 16 15.4 0.8 Sprint 5.6 6.6 5.6 0 Others 11.3 14.1 18.1 6.8

Source: FCC(1999)

The market shares

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The applicants further argued that new entrants had shown an ability to gain market shares rapidly over short period. Excel Telecommunications increased its customer base from 223,

000 to 3,800,000 in just 18 months. Talk.com had sold more than 1.5 million long-distance lines by J

anuary 1999, after first launching service in 1997.

Low- price “dial around” service – not required customers to subscribe to a new carrier – gained substantial market share quickly.

The expected entry of RBOCS into the long-distance markets.

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Customers’ switching behavior – gathered from a survey conducted by Paragren Company, which collected information on long-distance calling by 2000 to 5000 households very month from January 1998 through October 1999. Customers are not loyal.

Customers are willing to use emerging carriers.

Customers do not switch back and forth between MCI World Com and Sprint in Unusually high volume.

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Market Power:SubstitutabilityMarket Power:Substitutability

Opponents’ case: Evidence on brand and advertising:

prices of brand name products advertise heavily to promote and differentiate their brand:

AT&T($1.4 million), MCI($948 million), Sprint($671 million) market structure is stable parallel pricing complex pricing schedules rates net of access charges have increased rates to low volume customers are above cost

Conclusion: “Big 3” operate with great freedom from competitive pressure. Coordinated pricing.

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Market Power:SubstitutabilityMarket Power:Substitutability

MCI and Sprint: closest competitors

Evidence: pricing innovation customers switched carriers more switch more frequently to other carriers

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Merger Simulation ModelsMerger Simulation Models

Merger Simulation Models

Unilateral effects models and cooperated models – the former provide more conservative results.

Cournot model and Bertrand model – homogenous products and differentiated products.

Merger model analysis and structural analysis – the boundary of market, and market shares do not have simple relationship between the merging firms’ shares and effects on price and welfare.

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The goal of the merger model: estimate the strength of the merger to internalize the financial consequences and lessen competition. Is the effect is significant? Can it be offset by efficiencies by the merger?

What do we need in merger models? – Prices, quantities for each firms, aggregate industry demand elasticity, and a single parameter controlling cross-elasticity of demand in the industry(marginal cost).

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Applicants’ Case

Unilateral Effects Evidence A logit model: prices, quantities, market demand elasticit

y and firm price elasticity.

Two approach to estimate the price elasticity of demand: directly calculate be equal to firms’ profit margins

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The Long-distance MarketThe Long-distance Market

Profit margins: internal costs, network utilization, the cost of using capital goods.

Two type of cost used on advertising: fixed cost or marginal cost.

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Similar estimates for Sprint and AT&T:

Conclusion: “Big 3” have no significant market power.

Advertising not marginal Advertising marginal

Sprint -4.7 -6.5

AT&T -2.8 -3.2

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Cost saving: sales and administrative, cost of transporting traffic from local central offices to long distance network, operator services, advertising cost.

Total cost saving: from 13.5% to 18.5%

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Conclusion : Based on the price-cost margins, emerging carriers is r

egarded as effective substitutes. A unilateral effects model: lower the average long-dist

ance price paid by residential consumers in the range of 0.2 to 0.8

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Opponents’ Case

Carriers is not regarded as an effective substitutes. Evidence:

the pricing and marketing behavior of the “Big 3” the price cost relationship of their services demand analysis merger simulation model

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Two model: impact of the merger Standard Cournot Model:

a) pricing cost margins of MTS and Discounted MTS,

b) consumer loss,

c) cooperative pricing or not

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d) conclusion: a substantial increase in long-distance prices.

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Two model: impact of the merger Bertrand unilateral effects model:

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Two model: impact of the merger

a) compared with estimates presented by the applicants.

b) conclusion: an increase in price.

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The Department of Justice’s Position

Repeat many of conclusions presented by opponents: Indicate a unique position of “Big 3” in the long-distance

market. Reject the evidence on consumer switching behavior pres

ented by applicants Coordinated or collusive pricing About emerging carriers

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Large Customer MarketsIntroduction Many segments in this market Provide sophisticated services Only major suppliers: “Big 3” Some entrants

Applicants’ case Entrants can control any exercise of market power postme

rger and provide complete set of services Customers’ demand

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Opponents and DOJ’ opinion

New entrant can not deliver the demanded services and do not exist potential competition power

Substantial barriers Without a reputation for reliability

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the DOJ Killed MCI-Sprint Long-distance telephone rates may rise when the "Big 3"

service providers become the "Big 2." Upstart phone service providers won't have the brand

recognition to compete sucessfully with the two largest providers.

control too large a share of the Internet's backbone networks

Sprint and WorldCom face new competitive pressures from regional Bell operating companies.

The Internet BackboneThe Internet Backbone

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The state of competition in the internet market

The internet is an interconnected “ network of network” The antitrust authorities divided the market into tiers: tier

1 and smaller carriers Network externalities

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How could a larger and stronger MCI come to dominate the internet: The internet is a hierarchical network The tier 1 industry is highly concentrated MCI attempt to degrade the quality of interconnection

provide to its rivals

The applicants’ opinion: The internet is not hierarchical

Two model of dominant internet backbone

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Whether a voluntary divestiture of Sprint’s internet business can be sufficient to satisfy the antitrust authorities’ concerns

Depend on the circumstances: remain an effective competitor in the market.

EC’s opinion

Conclusion Conclusion

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ConclusionConclusion

Subsequent events Residential and small business long-distance market MCI, AT&T, Sprint and RBOCs Large business market: emerging carriers

The longer-term effect of the collapse of this merger: depend on the entrance of RBOCs in the long-distance m

arkets

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Main mergers after 2000

In 2001, AT&T sold CATV to Comcast Co. at the price of $47 billion and divested its AT ＆ T Wireless business.

In 2004, Cingular,the second largest provider of wireless business merged with AT ＆ T with the price of $41 billion

Sprint Corporation and Nextel Communications, Inc. (Nextel) approved a strategic merger and contemplated spin-off of the local telecommunications business in 2004

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Main mergers after 2000

In 2004 Bell-southwest merge AT&T at the price of $16 and became the largest communication provider

In 2005, Verizon offered $6.8 billion in cash to merge with MCI and Qwest, the smallest of the Bells, is eager to offer $7.3 billion so it can offer nationwide services.

Q & AQ & A

Any questions are welcome!

Your participations are essential!!

The Long-Distance Industry: One Merger Too Many? MCI WorldCom and Sprint (2000) Michael D. Pelcovits...

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