The visible hand in economics

Telecom separation

Posted on: July 22, 2007

So Telecom is to be operationally separated. To prevent the issue of double marginalization, the commerce commission is going to regulate the price set in the access market.

Do you think this is the correct way to regulate the access network.

While I believe it will lead to more competition in the wholesale and retail markets, I can understand the argument that states that this type of regulation will lead to lower investment (as firms invest until MB=MC, if the marginal cost of investment increases in the amount of investment, then lowering the price will lower the marginal benefit, and lead to a less investment.) I hear the government has a plan to improve Telecoms incentive to invest, does anyone know what it is? If so, do you think it will work?

16 Responses to "Telecom separation"

Of course it will lead to lower investment. Why risk money developing new technologies or rolling out more and better networks when the benefits will have to be shared with competitors?

In an industry that is relatively static this would make more sense. But in an industry where technology is constantly evolving and significant capital investment is essential and also risky, heavy handed regulation of profits that can be made from such capital investment goes too far in eliminating to incentive to build more infrastructure.

I agree that regulating prices is strange in an industry that requires high levels of investment. However, if they didn’t then I suspect broadband and other value added service prices would increase.

I’ve heard people say that the government has figured out a way of giving Telecom the incentive to invest. However, I haven’t seen any plan. Also some people say that Telecom was under-investing in the first place. Well guess what, this will lead to even less investment.

Like everything in life there is trade off, regulating prices at least gives Telecom the incentive to reduce costs( as they keep any efficiencies they gain). If we had rate of return regulation Telecom would over invest since they would be guaranteed a profit on any investments they make. Thus in some sense a price cap encourages Telecom to make the “correct” investments.

I acknowledge that there are problems with either form of regulation and I’ll be interested to see what the government proposes.

That is a good point. However, if the government believed that Telecom was under-investing at the market price, then surely cutting the price would lead to less investment, which is contrary to the governments goal.

In a sense, the government believes that Telecom investing has a positive externality on society. So it would be optimal to subsidise Telecoms investment, to account for this.

I definitely agree with you that imposing a binding price cap won’t solve an underinvestment probelm.

The main problem I see with a price cap is when investment is going to have an expansionary effect on demand, which presumeably is the case if investment has network externalities and/or causes new consumers to enter the market because the product is better. This is an issue because we can have a situation where the regulated price is now too low for the market to clear.

This problem isn’t really an issue if investment reduces costs as this could push the market price down.

I don’t agree, say investment shifts the supply curve left, the firm will still only undertake the investment if the MC<or=MB. If the incentive wasn’t their to do that in the free market, it won’t be when prices are set artifically low (at the socially optimum level), as the investment cost must exceed the benefit gained from investing at this price.

I agree that demand will increase when the price is low, thats just the law of demand. However, when demand exceeds supply in a network, it either means some customers will miss out, or all customers will miss out on part of the service. That is not a situation I look forward too (thank god i’m with Telstra Clear).

Actually I agree with agnitio that there are cases where, if the investment reduced costs, and price ceiling could work (e.g. if in eqm profits were 60, with the price cap profits were 20 and with investment profits at the price cap were 50, with a cost of 10 for investment). However, i can think of cases where even if investment reduced costs, the price mechanism wouldn’t work (e.g. if the cost was 40 in the above example). As a result, the problem can be an issue, even if investment reduces costs.

Ultimately, investments will be made if the increase in producer surplus (profits) exceeds the cost. Investment in most telecommunications services is to increase the worth of the service to consumers (demand) rather than decrease the cost to the company. In this case, a regulated price is crazy.

Its important to separate out the question of operational separation and regulation of access pricing. We have had regulation of access pricing since 2001. So, if access prices are already regulated, why have operational separation? The reason given is the ability of a vertically integrated provider to screw the scrum on non-price features – timing, information, etc. Here’s the question: can you find in the papers supporting separation any recording of whether this actually happens, and any analysis of whether imposing the cost of separation is an efficient response?

Interesting. I’m not sure if there are any papers out there discussing the costs of separation. From what I understand, the Commerce commision has monitored information on the access price charged by Telecom, that is where the voluntary separation of Telecom into Wholesale and Retail units occured.

However, now the word is that the commision is going to directly set the access price. This solves some of the problems associated with the separation of telecom (namely potential double marginalisation, leading to higher prices), however it could lead to a lack of investment by Telecom, because of regulatory uncertainty and the fact that the marginal benifit for the firm is now lower, and they invest until MC=MB, where MC is increasing in investment, implying a lower level of investment.

So the main issue we are interested in, in this specific post is the one of investment. Can the commerce commision dream up a scheme where they can set a low price for access to the network, and at the same time provide incentives for the socially optimal amount of investment?

I agree that there are two completely different regulations here, one is regulated prices. Andy said we have had regulated access pricing since 2001. This is not exactly correct, we have had a regulated UBS, which is essentially a wholesale Broadband product, that is sold at retail minus. It is the retail price Telecom sells it for less the savings Telecom has because someone else is taking care of the customer support and other supporting services.

Now we also have regulated access to the copper which is cost plus. It is a regulated rate which is the cost of installing the copper to your house in the first place plus a reasonable return on investment. This is the part where there may be a negative impact on investment. There is firstly a positive impact on investment because other providers install better equipment to provide better broadband than Telecom, and Telecom also upgrades its equipment to compete with other providers. We have now seen this happening in Auckland and will soon see it around the rest of the country. While Telecom has a monopoly on its copper network, and little incentive to improve it becuase there is no increase in revenue, there is an increase in revenue if it can make investments to keep the copper with Telecom itself, rather than its competitors. We have seen this with cabinetisation. Telecom is investing in cabinets, shortening the local loop because the business case for competitors to install equipment in a cabinet (serving 400 customers) is much more difficult than installing equipment in an exchange (serving 12,000 customers). Therefore Telecom knows by investing in cabinets they will face lessened competition.

True Access regulation has actually increased investment in both the access network and service equipment because it has removed the monopoly. There is little incentive to invest when it was a monopoly because there is little extra revenue to gain from investment. However now there is incentive to invest in order to protect their existing revenues.

Now as far as separation goes its about changing the incentives on Telecom so that Wholesale doesn’t try to screw competitors to Retail, and so that the Access Network unit doesn’t try to screw competitors to Retail and Wholesale. It should have a positive impact on investment because normal competitive pressures are in place. Without it competitors to Telecom have a lower level of service than Telecom, and cannot compete.

Hi Steve

It’s been a while since I’ve thought about this so hopefully I don’t contradict myself!

I’m curious whether you think that monopolies in general have little incentive to invest or if there is some special reason you think telecom would not invest?

I’m a bit short on time so haven’t had too much time to digest your comments but I interpreted you to be saying monopolies only invest for strategic reasons. ( I may be misinterpreting you, that’s the danger of thinking and writing on the fly!)

Accepting the fact that monopolies are greedy profit maximizers, would it not also be the case that if a monopoly could make an investment that profitably reduced cost or expanded demand they would do so?

I’m not saying monopolies don’t make strategic investments that screw potential competitors; I just think they can make investments whose only malicious purpose is increasing profit through an increase in the total surplus available.

Agreed, if monopolies could make investments to reduce cost or expand demand they would, but only if the investment makes them a substantial enough increase in revenue (beyond not investing) to make it worthwhile.

In this case Telecom doesn’t recieve any extra benefit from cabinetisation (if we had no LLU) but with LLU, customers can easily leave Telecom and reduce revenues. By cabinetising, it makes it harder for customers to leave Telecom (at least at the wholesale level) and it makes it harder for competitors to justify investment in new areas, (also making the customer stay with Telecom) thus the investment is worth it to decrease the ammount revenues are falling by.

Also in Telecommunications there are two types of investment, equipment and capacity. Telecom has invested in equipment which essentially reduces operating costs. This is what every telco is doing with moving to an all IP network – IP packets use less bandwidth so use less capacity. Separately Telecom has not invested in increasing capacity especially in certain bottlenecks where it faces limited competition because it recieves no extra benefit from it.

As a monopoly Telecom can maintain profits, lower costs with certain investments, but does not invest in increasing capacity because it doesn’t gain anything from it. However with Access Regulation Telecom faces competition on those bottlenecks (the access line to your home), and so is investing to keep customers on its network

Why does telecom recieve no benefit from investing in capacity? Presumeably any benefit they would recive would be from reducing cost or providing a better service that consuemrs are willing to pay for. If investment doesn’t do either of these things then it would be a good thing they don’t invest

Yes, it would provide a better service, but consumers do not pay more for it. That’s why your internet slows down between 6 and 10 pm because there isn’t enought capacity to share with all the other people down the street on the same pipe. Even if they increase capacity, they don’t charge anymore. As a monopoly, you can’t buy your services elsewhere so by having a better service who are they gonna steal customers from>?

but with access regulation competitors can have a better service, therefore there is reason to invest in order to encourage customers to stay with Telecom rather than go to one of the unbundled competitors.

Even with a monopoly, if consumers value the better service they would be willing to pay more for it so there would be no reason not to invest if the additional amount you could charge consumers exceeds the cost of investing

What this tells me is that that the amount telecom believe they could charge consumers would not cover the costs of increasing capacity, therefore telecom hasn’t (and shouldn’t invest).

You are exactly right, and I agree Telecom shouldn’t invest unless additional revenue can cover the cost of investing. Afterall a company exists to maximise profits for its shareholders.

But with competition, the ammount of revenue they could lose if they didn’t invest is enough to cover the costs of increasing capacity. With competition the opportunity cost of not investing is much higher.

Investing is cheaper than the opportunity cost of losing revenue to Telecom’s competitors.

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