Economic Tools for Broadband Policy

GEORGE S. FORDCHIEF ECONOMIST

PHOENIXC E N T E R

The 800 Pound Gorilla …

REGULATIONV.

LIMITED COMPETITION

COMPLAINERSV.

IDEALOGUES

Markets Never Work Markets

Never Fail

THOSE OF US WHO ARE AMAZED AT HOW RIDICULOUS THE ARGUMENTS

HAVE BECOME.

Realistic Expectations

We need to form realistic expectations about … Market Structure (how many firms) Nature of Competition Effect of Competition on Investment and Innovation The Relationship between Communications

Infrastructure and Economic Activity The Efficacy of Regulation What Markets Do What the Data Tells Us

Market Structure

N* is Few N ≈ 2 is not an unrealistic expectation for terrestrial, wireline

networks It appears that N ≈ 3 to 5 is right for wireless communications “Nearby” competitors (wifi, wimax) offer additional limits to

market power

COST ENTRYSIZE MARKETN *

N*: Equilibrium Number of Firms

Firms enter until the next entrant loses money

When entry stops, and exit does not occur, we have equilibrium

N* depends on the size of the market, the fixed/sunk cost of entry, and the intensity of competition

COST ENTRYSIZE MARKETN *

Numerical Example:Policy Paper No. 21

Number of Firms (N)

Firm Net Revenues

Entry Costs Net Profits

1 100 15 852 40 15 25

N * = 3 20 15 54 12 15 -35 8 15 -76 5 15 -107 4 15 -11

The Equilibrium Number of Firms is 3. If the 4th firm enters, all firms lose money. All make money at 3, so this is the equilibrium.

Number of Firms (N)

Firm Net Revenues

1 200 15 1852 80 15 653 40 15 254 24 15 9

N* = 5 16 15 16 10 15 -57 8 15 -7

Number of Firms (N)

Firm Net Revenues

1 100 5 952 40 5 353 20 5 154 12 5 75 8 5 3

N* = 6 5 5 07 4 5 -1

Competition11

General view is the price falls as the number of firms increases

This is the Cournot View with Homogeneous Goods

Or, Bertrand with Product Differentiation

The full range of outcomes is possible theoretically

01 2 3 4 5

Cournot Bertran

Collusion

What About Competition?

Intense Price Competition

Moderate Price

Competition

Perfect Collusion

N Entry Costs

Net Rev.

Net Profit

Net Rev.

Net Profit

Net Rev.

Net Profit

1 15 100 85 100 85 100 852 15 28 13 40 25 50 353 15 12 -3 20 5 33 184 15 6 -9 12 -3 25 105 15 4 -11 8 -7 20 56 15 3 -12 5 -10 17 27 15 2 -13 4 -11 14 -1

Competition and N

There’s a Difference: Intensity of Competition Number of Firms

The Intensity of Competition relates to how firms interact

Price reductions from additional firms is based on more firms competing, not necessarily a change in the way they behave with respect to price

Intensity is behavior, not count, and too much intensity leads to very few firms

The Evidence

Can we form a general expectation about the intensity of rivalry?

Empirical studies are mixed

Experimental work suggests the tendency is Cournot or better.

Experimental Results:Fouraker and Siegal

(1963)Type Outcomes

Collusion 3Weak

Competition1

Cournot 7Bertrand 5

Total 1675% were Cournot or Better.

More Like Cournot More Like Bertrand

Price is inversely related to industry concentration P = f(HHI) P = f(N)

Price is not related to industry concentration for 3 or more firms P≠f(HHI) P≠f(N) Price cut occurs at 2nd firm. Difficult to distinguish

between Cournot with only 2 firms.

Also difficult to differentiate when N gets large

Interpreting the Evidence

Too Much Competition?

Policy Paper No. 24: Network Neutrality and Industry Structure Argument: If differentiation is prohibited by rule,

firms are homogeneous, leaving only price to compete over.

Intense price competition can deter entry, leaving monopoly and no price competition at all.

Paradox Differentiation softens price competition, but allows

for price competition.

What’s the Benchmark?N* = 2

17Perfect Competition

Marginal Cost = MCFive Firms

Equilibrium Industry Structure P2 is as low as it goes Profit ≈ 0 N=3, Profit < 0

0 1 2 3 4 5

Cournot

What’s the Benchmark?N* = 2

18Perfect Competition

Marginal Cost = MC Profits = 0

Marginal Cost Pricing Not Possible Losses = abcd

Equilibrium Industry Structure Can only satisfy zero

profit condition with fixed/sunk costs

MC Pricing not possible without massive subsidies

Firm Demand

Avg. Cost

EquilibriumN=2

REGULATIONV.

LIMITED COMPETITION

Competition and Investment/Innovation

Investment and Innovation are higher with competition, up to a point

Effect 1. Monopolies have the profits to fund innovation, but face no pressure to do so.

Effect 2. Competition reduces profits, but firms innovate to escape competition (create market power).

Competition

Maximum

*Aghion et al, Competition, Imitation and Growth with Step-by-Step Innovation, Review of Economic Studies (2001).

Efficacy of Regulation(and it’s role)

How good is regulation in a Monopoly setting?How good is regulation in a Duopoly setting?How good is regulation in a Triopoly setting?And so forth?Is limited competition better than regulation?What can regulation improve in a setting of

limited competition?What the role of regulation if we have N* and

its small?What N* = 2, Profit = 0, yet there is collusion?

Congress’ View:The Cable Act of 92

1992 Cable Act deregulated a cable system when it had a competitor that passed 50% of its market (and had a penetration rate of at least 15%). Deregulate at 1.5 firms

Small systems were also unregulated Benefits < Costs

Unbundling/Special Access Triggers (a bit nutty)

Successes and Failures

Cable Regulation – Failure Special Access – Failure Unbundling – Failure Interconnection Reform – Failure USF – Broken? Broadband Ubiquity by 2007 – Failure Payphone Compensation – Repeated Failure Wireless E911 - Failure

Madison River?

Part 68 Rules – Success (Monopoly Period) Number portability wireline, wireless, but not between – Success E911, Wireline and VOIP, not wireless – Success Spectrum Auctions – Success Other ….

How do we pick successful interventions?

Special Access Profit Margins

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Pricing Flexibility/Deregulation

Madison River

VOIP-Capable DSL = $30VOIP-Blocked DSL = $20FCC Says No VOIP-Blocking, or No Price

DifferencesVOIP-Capable DSL = $25 (or something like

that) Now everyone pays $25, where many would prefer to

pay $20Under plausible conditions, such a decision is

welfare reducing (consumer welfare reducing!)

Difference is opportunity cost of lost profit from phone service.

Regulation versus Limited Competition

A little competition probably wins this battle.Regulation is typically for things that the market

cannot fix (Externalities, Natural Monopoly, Social Programs).

Price and Quality are the purview of the market. Firms can impede competition

Perfection is not possible by regulators or markets, because perfection is subjective. Firms typically meet the average needs (cost-benefit test) Some Won’t be Happy

Who’s driving policy today?

Be Realistic About Markets

Markets don’t resolve problems in an instant It is the loss of a large number of customers that reveals a

bad business decision. That takes time. Complaints and news articles are the manifestation of this

emigration. It is often evidence the market is working, not failing.

There will be complaints – people complain incessantly about Wal-Mart. Some people complain about their Toyota or Honda, despite being highly reliable, affordable autos. Complaining is not evidence of market failure. Service prices and quality YOU or I don’t like is not market

failure.

Be Realistic About Markets

Home Networking Network Neutrality proponents use as example Market eventually solved it without regulation

Bluetooth Crippling Another Net Neutrality example Market solved it

WIFI Crippling Another Net Neutrality example Market solved it

Firms are out for profits, so expect manifestations of that. But consumers are out for the best deal, and expect that discipline. Watch for long-term problems.

A REVIEW OF BROADBAND COMPARISONS AND RANKINGS

What About the Evidence?

Broadband Rankings, OECD

2001 2002 2003 2004 2005 2006

Korea Korea Korea Korea Iceland Denmark

Canada Canada Canada Denmark Korea Netherlands

Sweden Belgium Iceland Netherlands Netherlands Iceland

U.S. Iceland Denmark Iceland Denmark Korea

Demark Netherlands Canada Switzerland Switzerland

Sweden Belgium Switzerland Finland Norway

Netherlands Sweden Belgium Norway Finland

U.S. Japan Japan Canada Sweden

Switzerland Finland Sweden Canada

U.S. Norway Belgium Belgium

Sweden Japan UK

U.S. UK Luxembourg

U.S. France

Broadband Rankings

What should ourbroadband ranking

Broadband Rankings

What are the policy ramifications of

our rank?

2001 2002 2003 2004 2005 2006

Sweden Japan UK

U.S. UK Luxembourg

U.S. France

Normalization of Subscription Counts

OECD ranks subscriptions per capita

Per Capita is a reasonable choice for normalization, but it is not an innocuous adjustment.

Any adjustment introduces error; may not make much of a difference, but it may.

Home A: 4 peopleHome B: 3 peopleIf both have a

broadband, then Home A has a subscription rate of 25 while Home B has a subscription rate of 33.

Household normalization helps, but does not control for businesses.

United States Sweden

Persons per Home = 2.7

Persons per Home = 2.0

Normalization

The U.S. needs 35% more connections than Sweden to make up the

difference.

2006 Broadband

Ranking

2003 Telephones

RankingDenmark Luxembourg

Netherlands SwedenIceland IcelandKorea Norway

Switzerland DenmarkNorway SwitzerlandFinland FinlandSweden GreeceCanada UKBelgium Italy

UK GermanyLuxembourg Netherlands

France SpainJapan Czech Republic

Some countries tend to rank high in per-capita communications consumption.

The U.S. presently ranks 24th in telephone per capita (wireless and wireline).

Over the period 1991-1998, we ranked about 7th.

After 1998, the U.S. has fallen to quickly to the low 20’s (presumably due to mobile phones and different counting schemes).

Who ranks high?

High Rank for Communications

2001 2002 2003 2004 2005 2006

Sweden Japan UK

U.S. UK Luxembourg

U.S. France

Time and Subscription

SubscriptionRate

Measure

At Time t0

Measure

At Time t1

A fall in rank may suggest leadership.

Must have some guesstimate of terminal subscription for rank to relevant.

Household Penetration of Broadband:US and EU OECD Members

Norway

Denmar

Finlan

Belgium

German

Austri

Irelan

kia US0

70Household Penetra...

Source: EU Commission, E-Communications Household Survey (Apr. 2007). U.S. from Pew Internet and American Life Project (2007).

Complaint: Different studies/methodologies. But, where does the OECD data come from?

Broadband Nirvana:All Homes and Business Have Broadband

Country Subscription Rank Country Subscription Rank

Sweden 54.1% 1 Norway 40.3% 16

Iceland 48.9% 2 New Zealand 39.8% 17

Czech Republic 47.8% 3 Portugal 39.2% 18

Denmark 47.8% 4 Japan 39.0% 19

Finland 47.7% 5 United Kingdom 38.9% 20

Germany 44.9% 6 United States 38.0% 21

Netherlands 43.7% 7 Luxembourg 37.8% 22

Australia 31.5% 8 Greece 36.2% 23

Switzerland 42.9% 9 Slovak Republic 35.1% 24

France 42.4% 10 Ireland 34.7% 25

Canada 41.9% 11 Poland 34.1% 26

Hungary 41.1% 12 Spain 33.8% 27

Belgium 41.% 13 Korea 25.4% 28

Austria 40.6% 14 Mexico 24.7% 29

Italy 40.4% 15 Turkey 21.2% 30

Determinants of Broadband Subscription

The Broadband Nirvana ignores the impact of income, age, density, and so forth on subscription.

PHOENIX CENTER POLICY PAPER NO. 29 measures the impact of a wide range of determinants of broadband subscription to assess whether or not countries are exceeding, meeting, or falling short of “expectations.”

Relevant determinants are: Price (-), Income (+), Income inequality (-), Education (+), Age (-), Density (+), Phones (+), Business Size (-), Time (+).

Algebra: y = a + bx

Econometrics: Regression

Regression Analysis

0 1 2 3 4 5

y = 30 – 5x

0 1 2 3 4 5

We try to fit the

curve to “messier” data

Univariate Regressiony = a + bx

Multivariate Regression:y = a + bx + cz

Regression Analysis

0 1 2 3 4 5

Effect Size of Determinants

Variable Effect for a 10% Increase

Variable Explanatory Power

GINI -8.4% AGE65 50

GDPCAP +8.1% GDPCAP 42

AGE65 -7.3% BUSSIZE 41

BUSSIZE -3.5% DENSITY 31

PHONE +2.5% GINI 30

PRICE -2.3% PHONE 20

EDUC +1.8% PRICE 18

DENSITY +0.8% PHONE2 18

BIGCITY -0.6% EDUC 13

HHSIZE +0.4% BIGCITY 04

HHSIZE 00

AGE65 Japan = 26.9% AGE65 Korea = 12.4%

Broadband Policy

90% of differences in broadband subscription across OECD is explained by non-policy factors

Broadband Performance Index(Alternative Specification)

Exceeds Expectations

Below ExpectationsMeets Expectations

What Should We Rank?

Estimate the BPI regression only for the top 15 of OECD countries excluding the U.S. Coefficients are driven by the most successful

countriesU.S. Ranks 10th

Absent reformulations of the counting schemes across countries (like for wireless), the U.S. should rank about 10th in subscriptions per capita This is roughly consistent with its rank for

telephones/pop before wireless

From Rank to …

The rank statistics often precedes claims about Lack of deployment Lack of Bandwidth/Speed

Ubiquitous availability might move us up 4 spots in the rankings Assuming 10% unavailability, we go from a

subscription rate of 0.196 to 0.218. Assuming 5% unavailability, we go up 3 spots.

Does Speed Matter?

Higher speeds will only draw in the marginal users

Those that want speed the most have already subscribed to broadband

Speed is unlikely to increase our broadband ranking, or reduce it

Speed Value A Value B1 40 52 50 103 60 154 70 205 80 256 90 307 100 358 110 40

At $30, the high-value customer buys broadband at any speed. Speed must be 6Mbps for the low-value customers to buy. POINT: Higher speeds impact only marginal users.

Speed and Subscription:No Help Here

SubscriptionRate

After about here, the additional impact of speed on subscription is trivial.

For OECD countries, advertised speeds (provided

by ITIF) are unrelated to broadband subscription rates in a well specified

model.

Speed and Time

Speed/Technology

•Technology improves over time.

•Investments are made at time t.

•Network remains for x years.

•Later investments are in better technology.

•Perpetual game of catch-up or leap frog.Invest

Invest

Are we paying the price for being a first mover?

Time and Subscription

SubscriptionRate

Measure

At Time t0

Measure

At Time t1

A fall in rank may suggest leadership.

Must have some guesstimate of terminal subscription for rank to relevant.

The Demand for Bandwidth: Korea (KTT)

Service Up Down % SubsLite 640Kpbs 4Mpbs 84%

Premium 4Mpbs 13Mpbs 4%Special 4Mpbs 20Mpbs 5%Ntopia 4Mpbs 50Mpbs 12%

Source: S. Wallsten, Progress on Point 14.13 (June 2007).

Broadband Speeds

Country Claimed Speed (Mbps)

Actual Speed(Mbps)

Japan 61.0 12.0Korea 45.6 3.4

Finland 21.7 3.6Sweden 18.2 7.4France 17.6 4.7

Netherlands 8.8 5.0Portugal 8.1 3.1Canada 7.6 3.6Poland 7.5 1.6

U.S. 4.8 4.7

Sources: Claimed Speed, D. Correa, ITIF (2007). Actual Speed, www.speedtest.net (2007); Korea may be slightly understated due to a lack of a local test server. Sample sizes in Speedtest.net data are often very large.

Of actual speeds, U.S. ranks 8th of 100 countries.

The Japanese Miracle?

Japan is touted as a “broadband miracle” Claim: 100 Mbps Fiber Service for $30

Reality Avg. Download Speed = 10Mbps 100Mbps = $53/month Japan is ranked 14th in OECD, basically with the same

subscription rate as U.S. 58% DSL; 29% Fiber; 14% Cable

Zero and Low Interest Loans for NetworksTax Incentives (not very important with 0% loans)33% of Municipal System Construction Costs are

SubsidizedIs it unbundling or zero-interest loans?

Investments in Broadband

K = Investment Amountr = Hurdle RateP = Price you can sell it for (price structure)c = incremental costn = number of buyersI = Information availableQ = Quality of ServiceZ = Other stuff like income, education, etc…

K(1 + r) ≤ (P-c).n(P,I,Q,Z)56

Investments in Bandwidth

Cost of the upgrade must exceed the net revenue from the sale of the services made possible.

If you upgrade your network to 50Mbps, how many people will buy it?

Communications carriers can only spend what investors will give them. Investors demand a return. That’s the world we live in.

If you don’t reward investors, the money won’t come.

Cost≤ Benefit

Investments in Bandwidth

"It is not the multitude of alehouses … that occasions a general disposition to drunkenness among the common people; but that dis-position, arising from other causes, necessarily gives employment to a multitude of alehouses."Adam Smith, Wealth of Nations

(1776)

Investment in Bandwidth

MARKETS DON’T WORK That depends on what you want markets to do. Rather than saying the market has failed to provide

adequate speed and coverage, why not say the market is providing us information that the demand for speed is low and the demand is inadequate to cover costs in some markets. A proper perspective leads to proper policy responses

Markets work because they are the fastest way to disseminate and incorporate information. Look to the market as a source of information. An all-knowing being could mimic the market (but I’m not

interested in the job).

K = Investment Amountr = Hurdle RateP = Price you can sell it for (price structure)c = incremental costn = number of buyersI = Information availableQ = Quality of ServiceZ = Other stuff like income, education, etc…

K(1 + r) ≤ (P-c).n(P,I,Q,Z)60

Action EffectPrice Regulation Probably Less InvestmentNet Neutrality Probably Less InvestmentTax Incentives More Investment

Low Interest Loans More InvestmentSubsidies More Investment (if done right)

Connect Kentucky More InvestmentMore Competition Depends (up or down slope?)

K(1 + r) ≤ (P-c).n(P,I,Q,Z)61

Firms Invest Less than Society Desires(Complaints are to be expected)

Private Decision: K(1 + r) ≤ (P-c).n(P,I,Q,Z)

Social Decision: K(1 + r*) ≤ (P-c).n(P,I,Q,Z) where = ratio of 1 plus the Avg. Consumer Surplus per unit relative to profit and r* ≤ r.

Interestingly, charges different prices to different people/groups reduces the difference.

Regulatory risk inflates r. FCC says competition inflates r.

[PRELIMINARY]BPI FOR U.S. STATES

What about the US?

Effect Size of Determinants

Variable Effect for a 10% Increase

Variable Explanatory Power

INSCHOOL -22.0% RURALFARM 0.57

NATIVE -20.0% NATIVE 0.40

GINI -13.2% RURAL 0.37

HHSIZE -12.8% GINI 0.36

ENGLISH +8.7% ENGLISH 0.34

RETIRE -3.4% HHSIZE 0.14

PERCAPINC +3.3% RETIRE 0.12

SELF EMP. +2.6% SELF EMP. 0.11

RURAL -2.3% INSCHOOL 0.08

EDUC +2.1% PERCAPINC 0.08

BUSSIZE +1.5% BUSSIZE 0.06

RURALFARM -1.4% EDUC 0.05

BPI – Sort of(Preliminary)

Mississ

Colora

Washin

Delawar

Wyoming

Wiscon

Minnes

Califor

Montan

New Yor

Distric

t of C

olumbia Utah

Kentuc

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