There are things known, there are things unknown, in between are doors Jim Morrison (1943-1971) Access to telecommunications networks Marcel Canoy*, Paul de Bijl**, and Ron Kemp*** * CPB Netherlands Bureau for Economic Policy Analysis, The Hague ** CPB Netherlands Bureau for Economic Policy Analysis, The Hague, currently at the Ministry of Finance *** EIM, Zoetermeer Paper prepared for European Commission, DG Competition Preliminary version September 2002
Transcript
�There are things known, there are things unknown, in between are doors�
Jim Morrison (1943-1971)
Access to telecommunications networks
Marcel Canoy*, Paul de Bijl**, and Ron Kemp***
* CPB Netherlands Bureau for Economic Policy Analysis, The Hague
** CPB Netherlands Bureau for Economic Policy Analysis, The Hague, currently at the
Ministry of Finance
*** EIM, Zoetermeer
Paper prepared for European Commission, DG Competition
From the very beginning of liberalisation operations in telecommunications markets, access
has been a key issue for regulators. Despite some notable successes in various submarkets,
even in 2002, more than ten years after the first liberalisation steps, incumbent operators still
have strong positions in many aspects of their business and infrastructure competition has not
matured in all parts of the industry. Most notably, there has not been much infrastructure
competition in the local loop and the unbundling of the local loop progresses slowly (Buigues,
2002). As a result, incumbent operators owning local loops may have the opportunity to
engage in anti-competitive behaviour, e.g. by providing access against unfavourable terms.
Because ex-post application of the Competition Law can turn out to be less effective in this
type of situations, regulators face the task of deciding on setting the terms and conditions of
access charges.
Although the legitimacy for regulators to intervene in access charges is easily
understood, there is considerable difficulty in determining how to set these charges in
practice. There are a number of reasons for that. First, economic theory is not always clear-cut
on providing optimal ways of setting access charges. Second, even in cases where theory is
univocal, practice is not as easy as theory predicts. The �difficulty of daily regulation
business� is not just the usual cliché. Admittedly, the usual problems exist here: required data
are often simply not available and time is lacking. But on top of that, access regulation often
serves too many goals. Access charges are used to allocate scarce capacity, provide incentives
for productive efficiency, promote entry, promote investments by incumbents as well as by
entrants, taking a fair allocation of common costs into consideration and meanwhile serving
equity goals such as universal service obligation. This is a bit much for an access charge,
which is, in its simplest form, a one-dimensional price. A number of these goals can easily
conflict. Low access charges can be good for stimulating competition in services, but might
hamper investments in infrastructure. The minimum any regulator has to do is to make sure ex
ante which goals it wants to reach with the access charge, and, in case of conflicts, which
goals have priority and why. Sometimes �smart regulation� is possible to reach seemingly
conflicting goals: an access charge that starts low but rises over time can both promote
services competition in the short run (enhancing static efficiency) and provide incentives for
entrants to invest in infrastructure. But more often than not, choices have to be made.
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This chapter overviews the theory of access charges, with a clear policy perspective in
the back of our minds. Following Armstrong (2001), we distinguish between one- and two-
way access.1 In a situation of one-way access, there is an entrant who needs access to an
infrastructure owned by an incumbent operator, but the reverse is not true. Examples are
Unbundled Local Loop and Carrier Select. Two-way access refers to network interconnection,
that is, operators mutually need access in order to terminate calls on each others� networks.
We shall see that the policy implications in one- and two-way access can be quite different.
Determining access prices implies taking both short and long run into consideration.
Both economic theory and regulation practices (in particular the early days) had a strong
focus on static efficiency (i.e. the short run). However, dynamic considerations are important
and should not be neglected for a number of reasons, one of which is that if competition in
infrastructures matures less regulation is needed. That is why this chapter devotes extra
attention to dynamic considerations.
The main sources used for this paper are surveys of the economic literature on
telecommunications by Armstrong (2001) and Laffont and Tirole (2000), and policy-oriented
research by Cave et al. (2001) and (to a lesser extent) Bennett et al. (2001), as well as many
policy documents, most notably from the European Commission and OFTEL.
This paper is organised as follows. Section 2 discusses one-way access. Section 3
discusses two-way access. Section 4 analyses four special topics, i.e. fixed-mobile
termination, margin squeeze, the allocation of common costs and static versus dynamic
efficiency. Section 5 concludes.
2 One-way access
2.1 Introduction
One-way access is characterised by a vertically integrated incumbent, usually the former
state-owned monopolist, with a local access network. There are one or more entrants who do
not have such a local network, nor are they able to build one in the reasonably short run.
1 Armstrong also mentions competitive bottleneck as a separate category, but we prefer to discuss competitivebottlenecks in the policy chapter.
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Entrants may have their own long-distance network, but this is not necessary2. However, in
order to compete with the incumbent in the retail market for voice telephony and replicate the
pattern of offers of the incumbents, they need access to the incumbent�s local access network.
One-way access is common in the early phase of competition, when entrants have not
yet been able to roll out (part of) their own local connections, but is also relevant in mature
stages of the market. An important example of one-way access is Unbundled Local Loop
(ULL): an entrant gets access to the copper-cable pairs of the incumbent�s local network and
gets control over the use of (parts of) the total frequency spectrum of the copper-cable pairs.
The main implication of this is that it enables the new network operators to offer high
bandwidth directly to consumers and henceforth faster competition for high-bandwidth
services.3
Why does ULL get so much policy attention? First of all, ULL allows for a direct and
comprehensive relation with the end-consumer without the need of a full rolled-out network.
It also creates pressure on operators to offer consumers a whole new range of services, that
uses (parts of) the total bandwidth, such as fast Internet, receiving richer content such as video
on demand, etc. Although there might be alternative technologies that can provide broadband
services, such as cable and UMTS, ULL seems to be deployed most rapidly.
At the moment, the roll-out of broadband services (e.g. ADSL) is relatively limited
(Buigues, 2002). This might have to do with difficulties new entrants face: behaviour of the
incumbents such as excessive pricing, delays in delivery, predatory pricing or price squeezes
and refusals to supply the necessary information or space in the incumbent�s locations. All
these aspects deserve the attention of regulators.
Carrier Select is another example of one-way access: an entrant has originating and
terminating access to the incumbent�s local network. By dialling a prefix (usually consisting
of four digits), consumers can indicate that they want the entrant instead of the incumbent to
carry a telephone call. After some starting problems and other topics that need attention (such
as margin squeeze, or scarcity), this type of access seems to work quite well.
Because of the asymmetry in the incumbent�s and entrants� bargaining positions, as
well as in their interests, it is very unlikely that they are able to agree on the level of the
2 Entrants without their own backbone may lease long-distance capacity from the incumbent. Since theincumbent may have spare capacity, this may be in its interest.3 Only the leasing part of ULL is one way access. The interconnection part is two way access. The interestingregulation issues are however with the leasing part.
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access price. In particular, the incumbent has a strong incentive to set the access price as high
as possible, perhaps even to foreclose entry, whereas entrants prefer cheap access.4 Hence, the
interests are strongly opposed, so that regulation of the access price is necessary. In particular,
the central question concerns the optimal access policy.
2.2 Access pricing
2.2.1 First-best solution
The �first-best� solution, that is the theoretical solution if there are no imperfections, is to set
the access price equal to the marginal cost of access. With such an access price, there are no
distortions in retail prices, and entrants receive correct signals: they can make positive profits
only if they are more efficient than the incumbent. Also, this access price is fair and non-
discriminatory, because it is the same for all entrants and it is not usage-based. In this first-
best world, the incumbent�s fixed cost of its network is covered by a lump-sum payment from
the state to the incumbent.
The first best can rarely (if ever) be implemented in practice. An obvious problem
with the first-best solution is that lump-sum transfers from the government are usually not
feasible, at least not without creating large distortions elsewhere in the economy and seriously
impeding the incentive structure of the incumbent. Therefore, one has to look for an access
price above marginal cost, that helps to cover the incumbent�s fixed network cost.
2.2.2 Ramsey pricing
The practical problems of setting access prices equal to marginal costs, create a necessity to
introduce mark-ups to enable the incumbent to recover its network costs. On a more general
level, one can try to set not only the incumbent�s access prices, but also its retail prices such
that welfare is maximised, subject to the constraint that the incumbent recoups its fixed cost.
Note that welfare, defined as the sum of consumers� and producers� surplus, here refers to
static efficiency. The solution to this problem is known as Ramsey pricing. Put differently, the
problem is to find the price structure for a multi-product (i.e., access and retail services)
regulated incumbent that maximises welfare, given that overall, the incumbent has to break 4 If the incumbent wants to increase traffic on its network, there need not be a conflict of interest (cf. virtual
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even. A priori, Ramsey pricing implies that there should be mark-ups in the incumbent�s
access prices as well as retail prices. The central idea is that to maximise welfare, all the
incumbent�s prices (wholesale and retail prices) should participate in the recovery of fixed
costs. In particular, the optimal access price will be equal to the marginal cost of access plus a
�Ramsey term� (i.e., a specific mark-up).
By construction, Ramsey prices (wholesale and retail) reflect underlying costs as well
as demand characteristics (see Laffont and Tirole, 2000, section 2.2). Hence, Ramsey prices
are at the same time cost-based and usage-based. This implies that they are, in principle,
compatible with a firm�s standard marketing practices, since the latter also takes costs and
demand into account. More precisely, it can be shown that welfare-maximizing prices are
obtained if the firm maximizes its profits under the constraint that it offers a certain minimum
level of surplus to its customers (the "Ramsey-Boiteux" social welfare level). Note that the
regulator is supposed to have full information about cost and demand characteristics.
Intuitively, if the price elasticity for a specific service is relatively low, then the mark-up in
the price for this service can be relatively high. This is optimal for welfare, since the prices of
services with higher elasticities can be reduced while still satisfying the incumbent�s cost
recovery constraint. For instance, it may be optimal to increase the access price above
marginal cost in order to reduce retail prices. In general, mark-ups can be higher when they
lead to less distortion in the optimal allocation.
It is important to remark that there are potential problems with Ramsey pricing (see
Laffont and Tirole, 2000, section 3.4). First, the informational requirements of Ramsey
pricing are very high. For instance, Ramsey prices require the regulator to have knowledge
about cost levels and demand elasticities, information which the regulator usually does not
have One should, however, not rule out the possibility to obtain reasonable estimates of these
data. Alternatively, the regulator can delegate pricing decisions to the better-informed firm, of
course within the constraints imposed by Ramsey pricing. To see this, notice that unregulated
firms are usually able to use fine-tuned and sophisticated pricing tactics, which suggests that
they have much more information than regulators do. In particular, pricing behaviour tends to
reflect cost levels, elasticities, competitive pressure, and so on. Indeed, it can be shown that
the structure (not the levels) of an unregulated monopolist�s prices is the same as the structure
of Ramsey prices. Therefore, a regulator may obtain the Ramsey pricing structure by mobile operators).
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imposing a global price cap such that (i) access is treated as a final good and included in the
price cap, and (ii) the weights of the price cap are exogenously determined based on
forecasted quantities. If the weights are set appropriately, then the operator internalises net
consumers surplus when it maximises its profits. Although the principles for setting the
optimal weights are rather straightforward, the information that is needed (about forecasted
quantities) depend on actual costs and demand elasticities and may therefore be difficult to
obtain (see Laffont and Tirole, 2000, section 4.7). Nevertheless, this is much less demanding
than obtaining the information needed to set an optimal partial price cap.
Second, usage-based access prices are discriminatory access prices, and therefore
seem to contradict the policy principle of non-discrimination. More precisely, Ramsey pricing
prescribes that the charge paid by an entrant must depend on the use of the service. The access
price typically depends on the incumbent�s price-cost margin in the relevant retail market,
demand-side substitution possibilities, supply-side bypass possibilities, and the elasticity of
the demand for access. For instance, customers of services that are not very price sensitive
contribute more to cost recovery. From an economic perspective, this dependence simply
maximises welfare: access prices should be higher when they are used for services for which
the demand is less elastic. However, applying Ramsey prices can imply a (very) skewed
distribution of prices (see e.g. Jullien 2001) and hence the political feasibility is often
dubious.
Overall, the problems mentioned above are, from an economic perspective, not
necessarily worrisome for policy makers. By construction, Ramsey pricing is the best way to
set access and retail prices simultaneously, that is, it is the �least-bad� departure from first-
best prices. At least, if application turns out to be prohibitively difficult in practice or
politically too unattractive, Ramsey pricing can (or should) serve as a useful benchmark for
access regulation.
2.2.3 ECPR
Whereas Ramsey pricing aims at choosing optimal access and retail prices, it may be the case
that the problem of access regulation is separated from retail pricing. In the latter context, the
Efficient Component Pricing Rule (ECPR) is a popular pricing rule, since it provides a link
between the access and retail.
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ECPR, which is also known as the Baumol-Willig rule, has a background in the theory
of contestable markets.5 A retail market is said to be �contestable� if there is potential hit-and-
run entry which constrains the incumbent�s retail price. That is, the threat of quick entry
disciplines the incumbent�s pricing behaviour. An underlying assumption is that potential
entrants take the incumbent�s price as given. Therefore, the idea is that for a fixed price
charged by the incumbent, a more efficient firm can enter and take over the market; there is
no �in-market� competition.
Another assumption underlying ECPR is that access price regulation is separated from
price setting in the retail market. In particular, retail prices are fixed beforehand by the
regulator. Therefore, ECPR�s prescription is to choose the access price that maximises
welfare given the incumbent�s retail prices. The regulator is not concerned with overall
welfare maximisation, as in the case of Ramsey pricing, but aims at cost recovery and
productive efficiency.
Assuming that final products are homogeneous (which seems a realistic assumption
for voice telephony) and the market is contestable (which is a controversial assumption, as
discussed above), ECPR prescribes that access price should not be larger than the incumbent�s
opportunity cost, which is equal to its marginal cost of access plus its missed retail mark-up.
Equivalently, one can state that the access price should not be larger than the incumbent�s
retail price minus its cost in the competitive retail activity.
An attractive feature of ECPR is that entrants receive correct signals, that is, they enter
only if they have a cost advantage. Also, it is sometimes argued that another positive feature
is that entry is revenue neutral for the incumbent. But it is not clear why one should want to
have revenue-neutrality. If the incumbent�s profits are excessive, they will remain so under
ECPR also if market entry is possible.ECPR and Ramsey pricing do not generally coincide,
although this divergence can − perhaps − be restored if one makes specific assumptions about
symmetry and absence of entrants' market power.An important difference is that ECPR
neglects that the wholesale market and the retail market are related. ECPR is a partial rule, in
contrast to Ramsey pricing. If retail prices are regulated at Ramsey levels, then ECPR is
optimal.
5 See Tirole (1988), chapter 8.
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2.3 Dynamic pricing rules
The pricing rules for access, discussed in the previous subsection were based on the implicit
assumption that firms do not invest or develop new technologies. The purpose was simply to
compensate the incumbent for providing entrants access to its network, in a way that its fixed
investments can be recouped. Since telecommunications markets are changing very rapidly
exactly because of investments and technological progress, dynamic considerations should
also play a role in access regulation. In particular, it is important to note that any access price
affects operators� (potential) profits, and hence also their incentives to enter the market, to
invest in new technologies, to roll out networks, to maintain and upgrade existing networks,
and so on. To deal with these types of dynamic issues, regulators have come up with specific
access pricing rules, which are discussed below. More generally, when assessing the effects of
access regulation on firms� incentives to invest, one has to distinguish between:
• the effects on entrants� incentives to roll out networks themselves (versus using an
incumbent�s existing network), and
• the effects on an incumbent�s incentives to maintain and upgrade its existing network.
These effects depend on current as well as expected access prices. For instance, if the access
price is low and firms expect it to remain low in the future, then the incumbent is not very
eager to invest in its existing network, while entrants feel no urge to roll out their own
networks. On the other hand, competition in the short run will be intense, as entrants can
easily compete by using the incumbent�s network. In the short run this is good for consumers,
but it is uncertain if this is also the case in the longer run. If the access price is high and firms
expect it to remain high, then it makes more sense for entrants to start rolling out their own
networks, which in turn imposes discipline on the incumbent to invest as well, in order to
remain competitive. However, in the short run, it is expensive for entrants to start building up
market share (e.g., by starting with Carrier Select services as long as their networks are not
yet ready), which may negatively affect consumers for a long time. The following subsections
discuss the dynamic consequences of access rules.
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2.3.1 Backward-looking access pricing rules
Backward-looking cost-based access pricing rules are based on the incumbent�s actual or
historical costs (also called embedded costs). An example is Embedded Direct Costs (EDC).
A backward-looking rule can be called fair in the sense that the incumbent is compensated for
its actual network investments. On an ongoing basis though, it may give weak incentives to
reduce costs, since the implicit message is that any cost will be reimbursed. Also, backward-
looking access prices will be relatively high, compared to forward-looking prices (see below),
which makes it harder for entrants without networks to compete with the incumbent.
2.3.2 Forward-looking access pricing rules
Forward-looking cost-based access pricing rules are based on state-of-the-art, currently
available technology. Hence, they explicitly take technological progress into account. If a new
network can be rolled out at half the cost of the incumbent�s network, than the cost of the new
technology serves as the relevant benchmark. Accordingly, forward-looking rules incorporate
cost efficiency; they can be used to correct for possible inefficiencies of the incumbent.
Arguably, they can be used to mimic competition that is not yet existent. Because of the
downward pressure on access prices, it is even possible that an incumbent�s access service,
using an existing or obsolete technology, becomes a loss-making activity. Hence, in theory
forward-looking rules give the incumbent an incentive to keep up with technological progress,
and to keep investing in its network. A downside of forward looking rules is that they tend to
neglect so-called �stranded assets�. If an investment has a 50-50% chance of success, then the
revenue that is needed in case the investment is a success should account for the chance this it
would have failed. If access rules do not take this into consideration, this may lead to under-
investments and risk-averse behaviour.
The main example of a forward-looking rule is Long Run Incremental Cost (LRIC).
LRIC prices can be substantially lower than the incumbent�s actual cost levels. However, it
should be noted that LRIC can lead to substantially higher prices as well (e.g. due to
increasing labour costs, better but more expensive technology), especially in the case of
access to the local loop. LRIC does not seem to be well-suited to incorporate corrections for
quality differences between old and new technologies. It may therefore better be suited for
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interconnection fees (i.e., two-way access prices; see the next section) than for pricing access
to the local loop.6
Despite its intuitive appeal, LRIC has some further drawbacks (see also Laffont and
Tirole, 2000, Leo et al 2002). For instance, note that the cheapest technology that is available
cannot be derived from standard accounting systems. Hence the regulator has to determine
how efficient the incumbent should be (i.e., the regulator does not determine the desired
efficiency level, but can put a lower bound on it). Also, LRIC may not allow the incumbent to
make a profit margin on access. If this happens, the incumbent has strong incentives to deny
access to entrants by using non-price anti-competitive practices, such as refusals to deal, and
delays in interconnection. Accordingly, a possible consequence of LRIC (and other forward-
looking rules) is that the regulator has to continue to play a key role in managing entry. In
other words, LRIC may imply that regulation remains heavy-handed, which is in contrast to
the plan to gradually withdraw regulation as competition matures.
The disadvantages of LRIC have their origin in the implicit assumption that markets
are contestable. Since telecommunication markets are typically not contestable, LRIC fails to
take into account that assets can become stranded and that operators need risk premiums to
take care of that possibility. It follows that applying LRIC without taking these dynamic
considerations into account can be pretty disastrous.
Summarising, forward looking rules such as LRIC are appealing for interconnection.
For access to the local loop there are serious dangers, in particular it puts a lot of weight on
the quality of regulation.Overall, one cannot draw a clear-cut conclusion on the dynamic considerations. The problem is that access
prices, especially in situations of one-way access as we have seen above, often have to perform too many tasks at
the same time. Those tasks are possibly conflicting, as indicated above. In the policy chapter 4 we will come
back to possible solutions of this problem.
3 Two-way access
6 Applying LRIC to certain services (e.g., wholesale services) and backward-looking prices to others (e.g., retailservices) might lead to inconsistencies.
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3.1 Introduction
Two-way access refers to a situation where there are two or more operators with their own
infrastructure (consisting of long-distance and local access networks), that need mutual links
so that any consumer can call anyone else. These operators compete for subscribers to their
networks and need each other to offer maximum network benefits to their customers
(interoperability). The typical situation of two-way access is network interconnection.
Another important example of two-way access is fixed-mobile terminating access: a
network operator can charge a consumer for making use of the network (e.g. a two-part tariff).
The network operator can also charge other parties to reach their subscribers. There is
competition for subscribers but no competition for reaching the subscribers of a network. The
characteristics of fixed-mobile call termination are that there is competition for mobile
subscribers, but no competition for providing access to mobile customers once they
subscribed to a particular mobile network. The main difference with network interconnection
is that the services are provided to non-competing operators. For example, in fixed-mobile
termination, the mobile operator needs to access the fixed -and conversely- but (to some
extent), they are not exactly competing head-to-head against each other. Much of the theory
that is discussed in this chapter applies to fixed-mobile termination. That is why we have
decided to deviate from the categorisation introduced by Armstrong (2001) who has a
separate discussion on �competitive bottlenecks� (of which fixed-mobile termination is
considered to be the main example). Indeed there are a number of interesting and separate
policy questions related to fixed-mobile termination. E.g. access to the incumbent�s fixed
lines was more heavily regulated than access to mobile. This creates some policy questions
but does not necessarily warrant new theory. We will discuss the policy aspects of fixed-
mobile termination in chapter 4.
Another situation of two-way access seems to be international network
interconnection, which was already relevant before liberalisation started to take off. The
crucial difference (and the reason why we do not consider this two-way access) with the
examples above is that there is no competition for subscribers. This creates other types of
problems, which we will not discuss here. The same applies to international roaming. If a
subscriber roams on another network to enable its mobile to function abroad, the visited
network operator bills the home network operator for this call and vice versa. Since
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international roaming is, in principle, a competitive service, and possible problems related to
it are beyond the access discussions of this chapter, we will not pursue this in this section.
Similar to one-way access, the central question is how high the access price, in this
case the terminating access price, should be. A difference is that by definition, there is always
more than one access price � each operator charges its own terminating access price. Hence,
an additional question is whether terminating access prices should be reciprocal, that is, the
same for all operators, or not. A third question concerns the so-called �missing price�. Because
of the �calling party pays� principle (CPP), there is no price for receiving a call. This fact will
turn out to be important for the discussion.
3.2 Access pricing
There are two questions related to optimal terminating access prices. The first one concerns
the optimal level of access prices, and whether they should be reciprocal. The main issue, at
least in a mature market, is to set access prices that maximise welfare (or, alternatively,
consumers surplus) such that total industry profits are sufficient to cover fixed costs. The
second question is whether operators should be able to negotiate on access prices, or whether
these prices should be regulated.
The results in the literature on the optimal level of access prices in two-way access
situations are somewhat scarce, although there are some recent contributions, for instance De
Bijl and Peitz (2002 a and b). The main results in the earlier literature focused on mature
markets. Nevertheless, a new entrant, starting from scratch and slowly building up its market
share, finds itself in a much more difficult position with regard to the incumbent than vice
versa. The large asymmetry in market shares leads to asymmetric traffic flows between the
networks, and hence asymmetric access payments (depending on the access prices). A result
in the literature (Laffont and Tirole, 2000, chapter 4) is that in a mature market with
symmetric operators that compete in two-part tariffs, welfare is maximised by setting a
reciprocal access price equal to the marginal cost of access. Operators optimally set per-
minute prices equal to marginal costs of calls, and recoup fixed costs on a per-customer basis
through subscription fees.
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A central question in the literature on two-way access is whether the access price is an
instrument of tacit collusion. Under specific assumptions, it can indeed be shown that
operators� profit levels are increasing in the level of the reciprocal terminating access price.
The reason for implicit collusion is that high access prices increase the cost of a unilateral
retail price cut. This is because such a price cut increases the net outflow of calls to the rival
operator, which is costly because of the access mark-up. However, this result of collusion is
not very robust. For instance, an underlying assumption is that there are symmetric operators
who compete in linear prices, that is, in per-minute prices only and not in subscription fees.
This is not very realistic, since entrants are usually quite small compared to the incumbent in
the early phase of competition, and moreover, operators typically do not compete in linear
prices but in two-part tariffs. Although also this result critically depends on the assumptions
of the model (e.g., the demand for subscriptions is inelastic), it is important to note that the
tacit-collusion result may easily vanish, depending on the assumptions of the model that is
used. Overall, the risk of tacit collusion should not be neglected, but in an immature market, it
seems less pressing than protecting small entrants from a high access price charged by the
incumbent.
On a general level, it seems safe to conclude that in a mature market with roughly
symmetric operators, the socially optimal access price is equal to the marginal cost of access.
Since operators who compete in two-part tariffs do no benefit from access mark-ups, it is not
necessary to regulate the access price, at least not in such a stylised situation. In more realistic
cases where operators are asymmetric, access regulation seems to be necessary in order to
protect small entrants as well as to prevent a reduction in consumers surplus (See De Bijl and
Peitz (2000, 2002a, 2002b), who explore the nature of asymmetric competition between a
small entrant and a large incumbent). Moreover, non-reciprocal access prices may be very
useful to stimulate competition in the short run.7 In particular, if entrants are still small
compared to the incumbent (in terms of market shares) while there is customer lock-in (e.g.
because of switching costs, lack of quality track record for new operators), as in immature
markets, it may be optimal to regulate the incumbent�s access price at the marginal cost level
7 E.g., Armstrong (1998) and Laffont et al. (1998) address asymmetric competition between an incumbent andan entrant, but do not consider non-reciprocal access regulation. Laffont et al. (1998) do, however, show thatnon-cooperative access price setting by the operators, which allows for non-reciprocal access prices, may lead tovery high (and inefficient) access prices.
27-09-02 17
(possibly allowing for a modest mark-up that yields a reasonable return), while allowing
entrants to charge an access mark-up. Such an asymmetric access mark-up increases the
entrant�s profits as well as consumers� surplus. Welfare is hardly affected, but the incumbent's
profits are obviously reduced. Although this latter effect is undesirable (and should not
become too large), it is outweighed by the positive effects on consumers surplus and the
entrant's profits. Thus, non-reciprocal access prices may be useful to stimulate competition in
an immature market. In the longer run, when the entrant has built up substantial market share,
cost-based access prices for both firms are optimal for consumers� surplus and welfare.
All the preceding discussion assumes that the �calling party pays� principle (CPP)
applies. And indeed CPP applies in all European countries. Recent literature (Laffont et al.,
2001) has shown that most of the problems mentioned above may disappear when the CPP
principle is abolished. The reason is that under CPP a price is missing, namely a price for
receiving a call. As a consequence, all costs have to be incurred by the caller, while
technically the costs should be split somehow. One of the consequences is that operators have
monopoly power on their incoming calls, which generates problems, e.g. in the fixed-mobile
termination traffic (see section 4.1). Laffont et al. (2001) show under quite general
assumptions that interconnection charges will be set at the competitive level if the missing
price is recovered. In contrast with the CPP case, perfect retail competition can exist and is
viable. In the case of perfect competition, the access charge serves to determine how the cost
of communication is split between the caller and the callee, with the operators being
indifferent (since they achieve zero profits anyhow). However, whenever there is imperfect
competition (market power, even limited), operators� favoured access charge need not
coincide with the socially optimal one; unfortunately, the nature of the operators� bias is not
that easy to predict.
3.3 Dynamic considerations
There are two issues that concern the short and the long run. First, as we have pointed out that
asymmetric access regulation is optimal in an infant market, an important question is at what
moment the market can be considered to be sufficiently mature, so that asymmetric regulation
27-09-02 18
can be lifted. Second, similar to one-way access situations, any access price affects operators�
profit levels, and hence their incentives to invest.
Concerning the first issue, if the regulator imposes asymmetric access prices to
stimulate competition in the short run, a crucial question is: when does the transition phase
end, that is, when are entrants sufficiently large so that there is effective competition? For
policy purposes, this is mainly an empirical question. Clearly, the 'stopping rule' or 'sunset
clause' should be based on observable market outcomes. In practice, policy makers can look at
various indicators, such as growth of entrants� market shares, reductions in retail prices,
quality/price ratios and variety for end-users. There is a risk involved in making the lifting of
asymmetric regulation dependent on market outcomes, though.8 For instance, a criterion
based on market share gives both the incumbent and entrants incentives to compete less
aggressively by increasing retail prices. To see this, notice that the incumbent wants the
entrant to gain market share more quickly so that it no longer incurs the access mark-up
charged by the entrant, and the entrant wants to keep enjoying the access mark-up as long as
possible. Therefore, various regulators have been investigating the criteria for sun-set clauses:
(e.g. Canadian Radio-Television and Telecommunications Commission, 2000, or OFTEL,
1999). However, it is not yet clear what all these dynamic regulation methods have produced.
Concerning the second issue, note that the policy prescription of asymmetric access
regulation (as discussed above) does not conflict with the possibility that the regulator may
want to introduce a bias towards facilities-based entry. Nevertheless, if the regulator explicitly
wants to stimulate entrants to roll out networks themselves, it is more direct to make other
types of entry (Carrier Select, unbundled access to the local loop) gradually less attractive.
This may be sufficient to induce entrants without their own local loops but with experience
and market share to start building them.
4 Policy Issues
In this section, we shall discuss four policy issues in more detail. The issues are fixed-mobile
termination, margin squeeze, the allocation of common costs and static versus dynamic
efficiency. The issues are highly relevant for regulators at this stage of development of the
telecom market. A lot of policy attention concerns issues of fixed-mobile termination and
8 This is pointed out by De Bijl and Peitz (2002b).
27-09-02 19
margin squeeze. The allocation of common costs and static versus dynamic efficiency issues
are important issues in regulation in general.
The structure of this chapter is as follows. For each policy issue we first discuss the
policy relevance, followed by an overview of what economic theory has to say. Sometimes
this implies a summary of earlier chapters. The policy issues proceed with practical
experiences and end with some policy conclusions. The policy conclusions combine insights
from the earlier chapters with the practical experiences.
4.1 Fixed-mobile termination
4.1.1 Policy relevanceFixed-mobile termination receives a lot of policy attention. Quite a number of complaints of
fixed network operators concern this issue and also politicians talk about the high fixed-
mobile termination tariffs. In practice, one can indeed observe that these access prices are
usually very high, compared to the cost of access. Also there is a price asymmetry, i.e. the
cost of being called is higher than making a call (although they place similar demands on the
network). After other mobile operators entered the market, the retail price for making a
mobile call decreased whereas the terminating access price decreased much slower, the price
asymmetry increased. One might conclude that the fixed networks are subsidising the mobile
networks. OPTA (2002) calculates that for 2000 and 2001 the revenue of fixed-mobile
termination was about € 270 million above revenue based on cost orientation, i.e. a cross-
subsidy from about € 270 million from the fixed networks to mobile networks. Furthermore,
the revenues from termination are very significant. For Telefonica, 75% of mobile revenue
was derived from termination and roaming services (OECD, 1999). This might be a reason for
intervention of regulators.
What are the options for intervention? Regulators can decide not to intervene. One can
expect that the situation will remain the same because in the short run no alternatives for
mobile termination are to be expected. Fixed subscribers subsidise mobile subscribers.
Regulators may decide to intervene and treat fixed-mobile termination as a
competitive bottleneck and regulate the terminating access tariffs. Different pricing principles
can be applied to calculate cost-oriented tariffs (see section 2). Ramsey pricing and LRIC are
27-09-02 20
most commonly referred to. When Ramsey pricing is applied, the problem might not be
solved in a way that satisfy the concerns of the regulators (excessive prices).9 The common
costs will be allocated based on the demand (elasticities). Demand in the retail market is more
elastic than in the fixed-mobile terminating market. This implies that the largest part of the
common costs will be recovered in the terminating market. The current price asymmetry
might therefore be in line with Ramsey pricing. The alternative is LRIC, which is commonly
used by regulators in this situation. To recover the common costs, a fair share of these costs is
often set on top of the price based on LRIC. The calculation of this fair share is arbitrary. This
implies that parts of the common costs that are now recovered in the fixed-mobile access
market have to be recovered in another market. If this cannot be recovered because of
competitive forces in that market (e.g. the mobile retail market), this implies that companies
will make losses. This might result in a shake-out in the market. On the other hand, if the
common costs can be recovered, this might imply that retail prices will increase (see also
section 4.3.2 on common costs).
Call termination might be tied to the price of mobile originating, e.g. a termination
charge has to be proportional to the originating access charge. While this option might seem
appealing, it also comes with a cost, i.e. the price-setting in a competitive market will be
influenced by the regulatory action.
4.1.2 Economic theoryFixed subscribers, when they want to reach mobile users, have no choice but to pay the high
access fee (as part of the overall per-minute price). The level of the fixed-mobile termination
access price does not directly influence the level of the usage-based mobile retail prices, but
part of the fixed cost related to the mobile subscribers (e.g. lower subscription fee or subsidies
on hand sets). That is, high access mark-ups imply that fixed customers subsidise mobile
users. Mobile users benefit from high fixed-mobile access charges, to the extent that retail
prices are subsidised.
Under rather standard assumptions, it can be shown that welfare is maximised by
setting the terminating access prices equal to marginal costs (see Armstrong, 2001). However,
it seems that there is no effective competitive pressure to set terminating prices at marginal
costs. The policy discussion focuses on the issue to what extent different mechanisms restrict
9 It is not clear however, if that would constitute a problem in terms of welfare.
27-09-02 21
the MNO�s to behave to an appreciable extent independently of its competitors, customers
and ultimate consumers. In other words, has the MNO a dominant position or not? If the
MNO is dominant and (in addition) sets excessive terminating access prices, intervention
seems required.
To what extent do mobile consumers care about how much it costs others to call
them? One might argue that mobile users can be reached in other ways as well, for instance
by using a fixed connection. This argument, however, misses the point that one usually tries
to reach mobile users at their mobile phone when they are mobile, that is, remote from home
or office where there is a fixed line with a known phone number (or remote from other
alternatives to contact them). Even when there are substitution possibilities, they may not be
strong enough to result in substantial downward pressure on access charges.
Furthermore, one might argue that market forces already exert sufficient discipline on
mobile operators. For example, suppose that mobile customers derive utility from being called
(which is undoubtedly true in many cases). If consumers want to receive more calls, they may
care about the termination access price charged by their operator, and hence they may take the
costs of inbound calls into account when they choose a mobile subscription. As a
consequence, the presence of �call externalities� gives mobile operators an incentive to reduce
fixed-mobile termination access prices, although it is unclear how strong this effect is in
reality. Armstrong (2001) actually shows that if mobile subscribers derive utility from
incoming calls, then welfare is maximised by setting termination charges below the marginal
cost of access. The reason is that access below cost encourages fixed subscribers to make calls
to mobile subscribers. Another way in which consumers may take the costs of inbound calls
into account occurs if one assumes that they care about the costs incurred by people calling
them. In theory, if mobile customers, when they choose a mobile operator, internalise the
welfare of people calling them, then again mobile operators have incentives to reduce
termination fees (Armstrong, 2001). This story has some realistic content, since people often
receive most calls from family members or direct colleagues.
Ultimately, it is an empirical question how much mobile customers care about the
costs of incoming calls. Existing evidence (e.g. Oftel 2001) together with casual observation
(the rates are indeed very high all over Europe) suggests that it is most likely that mobile
customers do not care that much for the costs incurred by people calling them when they
choose a subscription.
27-09-02 22
As the current system of the �Calling Party Pays� (CPP) and customer pressure does
not seem to exert enough downward pressure on the terminating access prices, one might
choose changing the payment principle. The alternative is to let mobile operators charge their
customers for incoming calls. That is, call recipients pay a per-minute price for receiving calls
from fixed subscribers (instead of the CPP principle). This remedy takes away the bottleneck
problem (given that the mobile operator does not charge the fixed operator for the termination
anymore), since customers who have to pay for incoming calls will be more sensitive to prices
for that service.10 Changing the system may create a distortion, i.e. subscribers pay too little
for calls to mobile users if the costs between callers and callees are split for fixed-mobile but
not for fixed-fixed. It is not clear how serious this distortion is, but to solve it one may
consider to introduce the split also for other services.
The conclusion is that policy intervention seems to be necessary. There might be some
mechanisms that restrict the behaviour of the MNO�s, but the effect is too small to conclude
that competition in the fixed-mobile termination market is effective. On the short run, most
research indicates that these mechanisms will not increase sufficiently in strength to create a
situation of effective competition (see e.g. Armstrong 2001).
4.1.3 Practical experiencesThe central part in the debate on fixed-mobile termination is whether fixed-mobile call
termination is a �bottleneck� and whether Mobile Network Operators (MNO�s) can exercise
market power. A lot of policy discussions between Regulators and market players concern
this point. The principle of the �calling party pays� is a central point in this discussion.
Arguments can be given why there is no (or limited) effect on the height of the terminating
access prices versus arguments why there is enough pressure on MNO�s to compete on the
terminating access prices (see e.g. OFTEL, 2001, IRG, 2002). Despite the results of this
discussion, Armstrong showed that in most cases the pressure from these mechanisms is too
small to restrict the behaviour of MNOs in setting their termination access prices. The high
terminating access prices seem to support this argument. Most regulators also follow this line
of reasoning and intervene.
OFTEL (2001) discusses different mechanisms that might constrain the behaviour of
MNOs. First of all, mobile subscribers might care about the costs of calling them and take the 10 However, it does not solve the originating access from fixed to mobile. These charges should still be
27-09-02 23
termination prices into account when making a choice for a MNO. Their conclusion is that
mobile callers put little weight on terminating prices (this might be different for different
groups). Second, the effect of closed user groups11 generates a limited pressure on termination
prices. Furthermore, OFTEL concludes that there are no real alternatives and buyers have no
countervailing power. The conclusion is that there is insufficient competitive pressure to
constrain the terminating prices and that the pressures are expected to remain insufficient.
OPTA uses more or less the same arguments as OFTEL and comes to the conclusion
that mobile call termination is a bottleneck facility. OPTA decided to intervene and set a
timeframe to come to cost-oriented terminating access tariffs in 2003. In between, OPTA
suggested terminating prices that they considered as fair.
For calculating terminating access prices, the regulators use the LRIC pricing principle
or are planning to use it in the near future. LRIC is preferred over Ramsey pricing because
Ramsey pricing might be difficult to calculate and might result in an unfair allocation of
common cost (cross-subsidisation and/or big price asymmetries). Also the common costs
seem to be a relatively small problem (see section 4.3 on common costs).
4.1.4 Policy conclusions
The policy conclusions combine insights from the earlier chapters with the practical
experiences from above.
• Fixed-mobile termination is a hot topic in the telecom sector and receives a lot of attention
of the regulators. So far, the conclusion of most regulators is that fixed-mobile termination
is (close to) a bottleneck facility. There are too little competitive pressures to restrain the
behaviour of the MNOs and therefore regulation is considered to be necessary. It is,
however, important to review the developments of the potential mechanisms that might
result in effective competition. It is, for example, unclear how closed user groups will
develop and to what extent they might restrict the behaviour of MNOs.
• Another important issue is the potential of alternatives for the calling party pays (CPP)
principle. CPP is common practice in Europe. CPP might be exchanged for receiving
regulated.11 Closed user groups are groups which have an interest in how much it costs to call each other and therefore allsubscribe to the same network (e.g. familymembers or a company). For these closed user groups special offersare often made.
27-09-02 24
party pays (RPP) or a combination of both. RPP can put effective pressure on the call
termination prices because the individual who chooses the network operator is charged for
both outgoing and incoming calls. The individual has the possibility to switch to a
different network operator with better prices. Countries with CPP have significant higher
terminating access prices than countries with RPP (OECD, 2000: 50). Therefore, RPP
might result in lower terminating access prices. On the other hand, RPP might have
disadvantages as well. Prepaid might become less attractive. The subscriber not only has
to pay for outgoing calls, but also incoming calls, about which it has no control (besides
disconnecting the mobile). It will be more difficult for a prepaid subscriber to control the
telephone expenses. It is also argued that CPP has more potential to help the mobile
market to grow (OECD, 2000). Under CPP it becomes increasingly valuable to join a
network, because it is �free� to receive calls as well as that prepaid cards are more
attractive in markets with CPP. Finally, with the new proposed ONP, it will be easier to
designate MNO�s to have significant market power in narrower markets (e.g. mobile
termination) and not intervene in the more competitive retail market.
• Competitive pressures might also be introduced by giving consumers more alternatives.
For instance, it might be possible to give consumers the possibility to choose a different
network for receiving calls than the one for making calls. The mobile subscriber can select
the network operator with the lowest originating and the lowest terminating prices. This
implies that two separate markets are created. It is not clear to what extent operators
focusing on a separate market (e.g. only terminating) can compete with operators that
provide a bundle of originating and terminating services. For this option, it is also
necessary that SIM cards could communicate with all mobile networks. Furthermore to be
effective, it is necessary that the mobile subscriber takes the costs of the calling party into
account.
• Also the calling party might be able to call a mobile subscriber by using different MNOs.
The mobile subscriber might have more mobile phones (not very realistic) or the mobile
subscriber can be reached by different MNOs. This provides MNOs an incentive to
compete on terminating access prices. This last option also implies that the SIM cards
could communicate with different mobile networks. It implies that the mobile subscriber
owns the SIM card instead of the MNO and that the networks need to be highly
standardised. It is, however, unclear if this will be possible and desired in the future.
27-09-02 25
• Increasing the awareness of mobile subscribers about terminating access costs might
enhance their willingness to take these terminating costs into account. Transparency on
the pricing structures is a tool in this. To be effective, fixed network operators need to
differentiate their retail tariffs for the different MNOs.
4.2 Margin squeeze
4.2.1 Policy relevanceTelecom operators or independent service providers may rely on a key input (upstream
market) of the vertically integrated operator while at the same time compete with that operator
in the downstream market. If the vertically integrated operator is dominant in the upstream
market, there could be scope for it to leverage its dominant position into the downstream
market, resulting in a margin or price squeeze.
A margin squeeze occurs if the retail prices charged by the dominant operator are so
close to the wholesale prices of services offered to competitors that even a more efficient
competitor cannot enter into or survive in the market. The vertically integrated operator can
subject its competitors to high access prices (raising the cost of the key input) and/or lower its
prices in the downstream market. The total revenue of the vertically integrated operator may
remain unchanged. In extreme cases, the access price may even be higher than the
incumbents� retail prices. In a situation of a margin squeeze, there is too little room for
competitors to compete. Therefore, a margin squeeze can harm the development of effective
competition in the long run (relatively high prices, low quality, etc).
The absence of (efficient) entrants or competitors does not necessarily reduce welfare.
If the incumbent is much more efficient than its (potential) competitors and the benefits are
passed on to the customers, it is not a problem that there are no entrants/competitors. If this is
not the case, then a margin squeeze is a problem because efficient competitors do not enter
into or stay in the market and competitive forces cannot do their job.
More formally, a margin squeeze can be defined as (given that access and retail
services are strictly comparable12
12 If different retail services use the same access service, the allocation of common costs to the different retailservices will come into play, see section 4.3.
27-09-02 26
a + c > p
where:
a = access price charged by incumbent to entrants;
p = incumbent�s retail price of the corresponding service (provided that access and retail
services can be compared);
c = incumbent�s cost of delivering the retail service, on top of costs already included in
access price a.
This implies that:
the incumbent would make losses if it buys access itself at price a, given retail price p;
p � a does not reflect the incumbent�s own downstream cost c; the �notional downstream
margin� on the incumbent�s retail activities is negative, p � (a+c) < 0.
Is the possibility of a margin squeeze enough reason to intervene as a regulator is a margin
squeeze part of the process of becoming a competitive industry? Is a margin squeeze the result
of normal business practices or anti-competitive behaviour? To assess the need for (potential)
intervention, it is worthwhile to look at what economic theory has to say about margin
squeeze.
4.2.2 Economic theoryThe critical point in a margin-squeeze case is that an efficient (not vertically integrated)
competitor cannot enter into or stay in the market and earn a normal profit because of pricing
behaviour of a (dominant) vertically integrated incumbent. In order to understand the case of a
margin squeeze and the potential remedies, one should look at the causes of the margin
squeeze. There can be three different cases that may cause a margin squeeze:
a. access price too high (and competitive retail price), risk of exploitative abuse
b. retail price too low (and cost-based access price), possibly predatory pricing;
c. margin squeeze between the prices above, possibly cross-subsidisation.
We shall discuss these cases in more detail.
27-09-02 27
Access price is too high: risk of exploitative abuse
In the case of excessive access prices, it is important to look at the reason for the level of the
access price and the relation with the underlying costs. Excessive access prices are
characterised by an absence of a reasonable relationship between the price and the economic
value of the product/service supplied. If there is a big gap between the price and underlying
costs, profits are higher than it could be expected in a competitive setting. There can be
different reasons for excessive access prices. Access prices may be too high as a result of a
dominant position. From an access perspective, this is one-way access situation (see section
2). On the other hand, access prices may be too high as a result of conflicting objectives in
regulation practices.
In theory excessive access prices at the upstream market are no problem if it attracts
new entrants on to the network market. This depends on the barriers to entry in this market.
Especially for the local loop, the barriers to entry are high and no disciplinary forces can be
expected at any short notice. Therefore, the regulators might decide to intervene.
Access price might also be too high without an intentional abuse of the incumbent.
Price-regulation rules set by the regulators might result in excessive access prices (in relation
with retail prices). This can be the result of conflicting objectives and/or different pricing
principles at the access and the retail market. The objective of efficient investments (access
price based on cost) might contradict the objective of creating effective entry and competition
at the retail level (retail minus). In such a situation, the regulator has to set priorities: not all
objectives can be reached at the same time and some objectives are more important than
others.
Retail price is too low: possibly predatory pricing
Different causes can underlie the retail prices being too low. As a result of different pricing
rules charged by regulators on the wholesale and retail market, the retail prices might be too
low (compared to the access price). Also a uniform national retail price might be too low
compared to cost-based access prices in a rural area. On the other hand, low retail prices can
also be the result of an intentional abuse of the incumbent, i.e. a special case of predatory
pricing.
27-09-02 28
A margin squeeze as a particular form of predatory pricing implies that an efficient
entrant or competitor cannot redeem its downstream costs and will not enter or leave the
market. The incumbent chooses for a short-term loss in order to make long-term extra profits
as a result of a dominant position.
Predatory pricing implies that there is a price reduction that is profitable only because
of the added market power the predator gains from eliminating, disciplining or otherwise
inhibiting the competitive conduct of a rival or potential rival (Bolton et al., 2000). Customers
may benefit in the short run from lower prices, in the longer run weakened competition will
lead to higher prices, lower quality or less choice. The fact that an activity is being run at a
loss, is not enough for a case of predatory pricing, the question is whether it has an anti-
competitive effect. In order to prove the anti-competitive effect of predatory pricing, Bolton et
al. (2000) propose a five-criteria rule:
1 a facilitating market structure,
2 a scheme of predation and supporting evidence,
3 probable recoupment,
4 price below cost and
5 absence of efficiencies or business justification defence.
ad 1) The market structure must make predation a feasible strategy. A company must have the
power to raise prices (or otherwise exploit consumers or suppliers) over some significant
period of time (dominant firm or small group of jointly acting firms, entry and re-entry
barriers).
ad 2) Predation pricing and recoupment require that predation is plausible ex ante and
probable ex post. This means that must be a predatory scheme ex ante under which the
predator can expect to recoup its initial losses. Using tools of applied game theory can help to
identify economic conditions under which predation is rational profit-seeking conduct by a
dominant firm. Ex post probability is shown by subsequent exclusion of rivals and post-
predation market conditions that make future recoupment likely.
ad 3) At a minimum, the losses incurred from the predation strategy must be recouped
somehow. If the operator is not able to recoup the losses, because of competition from
existing or potential competitors, the predation strategy is not viable. Recoupment is only
possible if there is an exclusionary effect on (potential) rivals or the disciplining of the rival�s
competitive conduct. The most common and straightforward recoupment occurs when prices
27-09-02 29
rise above the competitive level in the predatory market. In more complex settings,
recoupment can occur through other channels, e.g. by raising prices of complementary or
closely-related services. It is essential that these latter price increases should unambiguously
be explained by the earlier predatory pricing (see also Cabral and Riordan 1997).
ad 4) In the predatory period, prices should be below average variable cost, although also
prices that are above average variable cost but below average total cost might be predatory
and injure competition13. The most used cost standards are average total cost (ATC) and
average variable cost (AVC) (OFT, 1998) or long-run average incremental cost (LRAIC) as
substitute for ATC and average avoidable cost as a substitute for AVC (Bolton et al., 2000). If
prices are above ATC, there is no problem. If prices are below AVC, predation can be
assumed. A price between ATC and AVC is either presumptively or conclusively lawful. If
the price is presumptively lawful, there is a need for evidence that the operator intends to
eliminate or discipline a competitor.
ad 5) Finally, there can be cases where below-cost pricing by an operator with dominance
might be efficiency-enhancing rather than predatory. However, in these cases one has to look
very closely whether the efficiency enhancement is also to the benefit of the consumers in the
long run. Otherwise the argument can be abused to foreclose a market on the basis that it is
�efficient� to do so.
The five-criteria rule provides a clear procedure how to handle a potential predatory
pricing case. However, predatory pricing might be hard to prove, especially the intentional
part. In the section on policy conclusions, we shall discuss the practical value of this rule in
more detail.
Margin squeeze between access price and retail price: possibly cross-subsidisation
Cross-subsidisation occurs where an operator uses revenues from one market to subsidise
losses on another market. If the revenues are earned in a market in which the operator has a
dominant position and are used to subsidise losses in a competitive market, this hampers
competition and might be unlawful. In a case of cross-subsidisation, the losses in one market
are redeemed by another market. Cross-subsidisation is especially viable if the market is
13 If prices are below cost but stay on that level �for ever� then there is no predation. This can be a viablebusiness strategy in industries characterised by network externalities or learning by doing. The period of belowcost pricing extends no longer than necessary to achieve the network economics or untill the cumulativeproduction experiences result in lower costs. See also the next section on cross-subsidisation.
27-09-02 30
characterised by economies of scale and economies of scope, i.e. scale and scope economies
widen possibilities for incumbents to use part of their business to cross-subsidise other parts.
Causally attributable and avoidable costs of a service can be labelled as common costs
resulting in too low incremental costs. If the price is set to incremental cost, then there is a
case of cross-subsidisation (see also section 4.3 on common costs).
There is a case of cross-subsidisation if the revenues are expected to fail to cover the
cost of the associated activities over its economic lifetime. If the costs are covered over the
economic lifetime of the service, relatively low prices at the introduction of the service might
be a normal business strategy (penetration strategy) and hence there is no anti-competitive
behaviour. For example, if the production of a service is characterised by economies of scale
or learning effects, an appropriate business strategy might be to offer the initial service below
cost price (for the first customers). As demand significantly grows, as a result of the low
price, this will result in a sharp decrease of production costs. This option might result in a
higher profit over the economic lifetime of the service (low price, big quantity and substantial
lower costs) than the alternative of a high price and slower decrease of costs.
The assessment of cross-subsidisation is related to the assessment of predatory pricing.
If the revenues exceed the long-run incremental cost (including the cost of capital), the service
would be sustainable in the long run and there would be no case of cross-subsidisation
(OFTEL, 2000). If services share common costs, the evaluation is more complex (see also
section 4.4). In that case, total costs consist of the long run incremental costs of all services
and the common costs. In a case of cross-subsidisation, a dominant operator might charge a
higher price to cover the common costs in the market wherein it has a dominant position and
uses a price that equals the incremental costs in the competitive segment. Although this is not
unlawful in terms of predation, it might hamper competition. A competitor that does not
provide all services of the dominant operator might be at a cost disadvantage in the
competitive market (cannot recover the common cost in another market).
The economic literature focuses on two tests for cross-subsidisation: the incremental
cost test and the stand-alone test (Braeutigam, 1989: 1337-1342, Sharkey, 1982, Faulhaber,
1975, as cited in Nicolaides and Polmans, 1999). The incremental cost test requires that the
revenues from each subset S at least cover the increment to the total costs that occurs when S
is produced as opposed to not being produced at all. If revenues of S do not cover the
incremental cost of S, then service S is subsidised. The incremental cost test sets the lower
27-09-02 31
bound on the subsidy-free price range. The stand-alone test argues that if the revenues of S
exceed the costs of providing service S alone, then users of S are subsidising other services.
The stand-alone test sets an upper level to the revenues generated by S. The tests must be
done for all possible subsets14 (often referred to as the combinatorial cost test).
Economic theory produces important insights on margin squeeze, its causes and ways
to assess different forms. The theoretical insights have to be interpreted in real life cases.
4.2.3 Practical experiences
Until recently, regulation and intervention of regulators focused on the prevention of
excessive prices (e.g. price caps). The last 2-3 years, regulators get more attention for the
potential harmful effects of low prices. As a result of complaints of entrants and new
competitors, the hampering effects of low prices for competition became more perceptible.
The interest in margin squeeze increased as a result of the potential problems with Local Loop
Unbundling (European Commission, 2001).
Margin squeeze does not necessarily imply intentional abuse. Margin squeeze can be
the result of incomplete rebalancing of prices. If prices are not completely rebalanced on cost-
oriented bases, prices do not adequately represent the underlying costs. This may result in
overcharging or underpricing. The Commission can launch infringement proceedings against
Member States to solve this problem.
Also accounting inconsistencies may result in margin squeeze. Certain pricing
principles focus on static efficiency (e.g. Ramsey pricing), whereas others focus on dynamic
efficiency (e.g. LRIC). National uniform retail prices might conflict with differences in
regional costs of providing access. Pricing principles may conflict and may result in margin
squeeze.
Most regulators studied the effects of price squeezing and suggested price-squeeze
tests when they approve interconnection tariffs of the incumbent (e.g. OFTEL, 2000, OPTA
and NMa, 2001). This ex ante regulation can be interpreted as part of the cost-orientation
check of regulators. In a price-squeeze test, the costs of the incumbent are studied, more
specifically the costs that the incumbent has to make to provide the service internally. The
14 This also solves the discussion with which subset to start.
27-09-02 32
extra costs the incumbent makes to deliver the access service (e.g. billing) should be left out
of the test. In determining the access tariffs, most of the regulators use LRIC or plan to use
LRIC in the near future.
A problem might arise when using LRIC in a sector with high common costs. The
telecommunication sector is such a sector. A multi-product supplier can choose the market in
which to recover these common costs, on the condition that it does not abuse its dominant
position. If all services are priced at LRIC, the common costs are not recovered. To test if
there is no case of predation, OFTEL tests if the prices of the services are at least at LRIC
level plus a fair share of the common costs. If a dominant operator is pricing below LRIC,
predation is presumed, unless the operator provides solid arguments. On top of that, all the
relevant services should together be able to recover all common costs (combinatorial test
(OFTEL, 2000)). If the dominant operator prices above LRIC, but revenue overall fails to
cover total costs and the dominant operator has the intention to eliminate a competitor,
predatory pricing is presumed.
OPTA and NMa (2001) published price-squeeze guidelines. These guidelines explain
how the price-squeeze test will be executed. The test might be applied to all retail products of
the dominant operator and will be applied to the different components of the retail price (set-
up cost, peak, off-peak, etc.). As a result of this detailed approach, it will be difficult for
entrants to cherry pick.
Another issue that needs attention is the allocation of costs (costs related to access
versus related to retail activities, see also section 4.3 on common costs). An incumbent might
allocate costs that are related with the retail activities to access activities. As a result, the costs
of access are too high and retail costs are too low. If the access prices are cost-oriented based
on these (high) access costs, then the entrant is paying too much (i.e. part of the incumbents
retail costs). Therefore, when setting access prices based on information of an incumbent, the
relevance of the cost must be addressed.
To conclude, most regulators recognise the problem of price squeeze. They developed
or are planning to develop a price-squeeze test. This instrument is used as part of the cost-
orientation check. As this instrument is relatively new, it is too soon to draw conclusions on
the effectiveness of price-squeeze tests.
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4.2.4 Policy conclusions
Theoretical insights need a practical interpretation. A margin squeeze can be difficult to
assess, proper data are hard to get and interventions can also come at a cost. Mistaking
competitive pricing for a margin squeeze will tend to distort the market. On the other hand,
mistaken predation for competition may result in less competition and higher prices in the
long run.
To minimise these mistakes in practice, it is important to look at the cause of the
margin squeeze. Depending on the cause and the effect on competition, the regulators might
decide to intervene. Therefore, the regulators should first investigate what is the cause of the
margin squeeze. The discussion in the theoretical part can be an important starting point.
There are a few issues that need special attention. These are: the time dimension, allocation of
(common) costs, information asymmetry and ex ante regulation versus ex post intervention.
− Time is an important issue in margin-squeeze cases caused by predatory pricing and cross-
subsidisation. In a predatory pricing case, time refers to the period that is necessary for
recoupment. The period in which recoupment is possible is likely to be short, especially in
the telecom sector with its fast technological development. On the other hand, path
dependence might imply that once a company missed a stage, it will be very hard to make
up the disadvantage. Also entry barriers for new technologies might increase the period
for recoupment. In a cross-subsidisation case, time is important to evaluate if certain
business practices are anti-competitive behaviour or not. For normal business practice,
revenues over the economic lifetime of the service should cover the costs. If the costs are
covered, the operator uses a penetration price in order to quickly build up a large custom
base. If the costs are not covered over the economic lifetime of the service, there might be
a case of cross-subsidisation.15
− A case of margin squeeze can be very complex if common costs are involved. If the
revenues of a service are higher than the LRIC plus the common costs, then there might be
a case of cross-subsidisation. By using the incremental cost test and the stand-alone test
one can identify if there is a case of cross-subsidisation. Also predatory pricing is more
15 A practical issue is how to determine the economic lifetime. This is an accounting issue.
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difficult to prove if common costs are involved. Part of the problem is related to the
allocation of the common costs over the relevant services.
− It is clear that a case of margin squeeze caused by predation or cross-subsidization is hard
to prove. It is difficult to get all the necessary information on costs and allocate the costs
to the relevant activities. If a regulator cannot perfectly observe the incumbent�s cost
levels, the incumbent may try to hide such a margin squeeze by allocating to its wholesale
activities costs that are actually incurred as a result of its retail activities. Accordingly, in
practice, the risk of a margin squeeze is closely linked to information asymmetry.
Secondly, it is hard to prove intentions of operators. The chance that a specific case
satisfies all criteria will be limited.
− Finally, there is a trade-off between ex ante regulation versus ex post intervention. An ex-
ante margin-squeeze test clearly helps to make regulation transparent and creates clearness
for market parties. It can contribute to more competition in the market. On the other hand,
it can result in too much and perhaps needless regulation, especially if the price-squeeze
test is very detailed. Margin-squeeze cases can also be dealt with ex post, with the risk that
intervention becomes too late (complaints procedures take a very long time). Regulators
have to make a trade-off between perhaps needless regulation and the risk of too late
intervention.
4.3 The allocation of common costs
4.3.1 Policy relevance
One of the hardest regulation problems concerns the allocation of common costs. Technically
speaking, entrants only use part of the infrastructure when e.g. leasing a line or using only
parts of the spectrum. However, access would be of no use if the other parts (i.e. the parts of
the infrastructure it does not directly use) were not there. In other words, there are parts of the
infrastructure that are �used� for various services but it is not clear in what proportion the
costs of that part of the infrastructure should be allocated over those services. A related but
slightly different issue arises when the costs do not depend on the amount of the bandwidth
that is actually used or the number of services that run on it. Finally, there are also often
provisions for public services to be shared among the various services. When the regulator
decides to intervene, the regulator has to come with an answer by deciding upon some
27-09-02 35
allocation method of the common costs. A misallocation of these common costs can distort
competition.
4.3.2 Economic theory
The necessity to finance part of the common costs is a problem that is reasonably well
covered by the economic literature (see e.g. Armstrong 2001 or Laffont and Tirole 2000). At
the same time, it is acknowledged there is no easy way to do it. Determining access charges
typically consists of two stages. In stage one, the regulator determines the causally attributable
costs (see section 2 for various methods). Stage two then deals with the common costs. The
lack of allocating appropriate costs in stage one implies that the residual would also contain
costs which might otherwise have been allocated as causally attributable costs, but will be
allocated as if they were common costs. The question then becomes: how to allocate these
common costs?
Theoretically there is an optimal way (Ramsey pricing, see section 2.2.2). In short,
common costs are allocated inversely proportional to price elasticity of the service, i.e. the
service with the lowest price elasticity carries the highest burden. There are three reasons why
Ramsey prices are rarely used in practice. The first is a political reason: Ramsey prices often
involve a (very) skewed distribution of prices over services and may imply sky-high prices for
some services, which may be politically unattractive. The second reason is a practical one: to
calculate Ramsey prices, one may need very detailed information, which is often unavailable.
The third one is that Ramsey prices do not allow for clear comparisons between countries or
operators. Such comparisons could be useful for benchmarking (see e.g. Jullien 2001).
Because of these practical difficulties, regulators had to come up with alternative
approaches (see DTe 2000, Europe Economics 2001, OFTEL 2001). We mention four of
them:
• Equal proportionate mark-up (EPMU)
The mark-up for common costs is proportional to the incremental costs of the service
provided on it. The difference with Ramsey prices is that the willingness to pay does not
count, only the costs. Henceforth, this method neglects demand-side factors and scores worse
27-09-02 36
than Ramsey pricing on allocative efficiency. In cases where common costs are small relative
to incremental costs, this distortion is modest.
• Pro-rata appointment
The mark-up on common costs is decided by a fixed proportion between various services. The
proportion can be decided by the regulator. The advantage of this method is that it is very
simple to implement, and can easily be tailor-made to a specific goal by the regulator.
However, unless the regulator comes up with plausible arguments, the proportions are set in
an arbitrary way.
• Incremental and stand-alone costs
This method is based on the calculation of two extremes. The boundaries of the costs to be
allocated to any service are provided by:
- a floor, the incremental cost � the cost that would be avoided were that service not
provided, and
- a ceiling, the stand-alone cost � the cost that would be incurred if that service were
provided in isolation.
The difference between these two boundaries represents the level of common costs. With
pricing at incremental cost, the service concerned makes no contribution to common costs;
with pricing at stand-alone cost, the service concerned bears the totality of common costs. At
intermediate prices, the service makes some contribution towards common costs. This method
is particularly useful in casting light on what causes costs. The method provides an estimate
of the magnitude of common costs which is independent of the accounting data and thus
could be applied as a cross-check to the identification of attributable and common costs. As a
method of determining some intermediate level, the same criticism is applicable as to the pro-
rata method.
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• Commercial negotiation
The regulator sets prices that are consistent with a hypothetical commercial negotiation
between two independent parties in advance of the expenditure being incurred (Europe
Economics 2001). The advantage of this method is that it takes demand-side consideration
into account but is not likely to lead to the extreme Ramsey outcomes, nor does it require such
a high information burden. The downside is that it is not clear a priori what would be the
outcome of this method. In the worst case, the method is as arbitrary as pro-rata appointment.
4.3.3 Practical experiences
Before going into the main telecommunication experiences, it should be observed that other
utilities face quite similar problems. We mention an airport and an electricity example.
• Airports U.K.
In a number of European Airports, regulators are considering a so-called �dual-till� system.
Under a dual till, airport activities would be divided into �aeronautical� and �non-
aeronautical� activities, and only costs and revenues in the former category, termed the
�regulatory till�, would be taken into account when setting the price control for regulated
charges (Europe Economics, 2001). The U.K. has the longest and best documented experience
with it, so we focus on the U.K. here.
Europe Economics (2001), in advising the regulator on inter alia common costs,
rejects Ramsey pricing for practical and political reasons, such as discussed above. It rejects
the EPMU, because it would cause profitable activities to cease (or prevent others from being
introduced). Here, the absence of demand-side considerations takes its toll. As a compromise,
Europe Economics (2001) suggests the commercial-negotiation principle. In practice, the
method boils down to a variant of EPMU but corrected for demand-side factors.
• Electricity in the Netherlands
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The Dutch regulator considers �the local electricity loop� as regional natural monopolies and
regulates access to the local loop via yardstick competition. Of course, the regional structure
of the electricity networks helps the regulator in applying yardstick competition. But even
TenneT, the national grid company, is benchmarked against best-practice grids in the U.S. and
Europe (DTe, 2000). Yardstick competition implies that there is no relationship between
access charges and the costs of the network. Access charges are set on basis of the best-
practice performance in the country (or elsewhere). Yardstick competition obviously avoids
any discussion on common costs. The applicability of yardstick competition for
telecommunication depends on how comparable accounting and regulation principles are
between European countries. If they are comparable, then yardstick competition could be a
useful alternative for other types of price-cap regulation. A recent example is the Local Loop
Unbundling in Ireland, where tariffs are based on international comparisons (Office of the
Director of telecommunication regulation Ireland, 2001).
Now we move into the two main telecommunication applications:
• Unbundled Local Loop/shared access in the U.K.
Unbundled Local Loop (ULL) enables competing operators to lease the local loop of the
fixed-line incumbents and install equipment at their exchange sites. The main implication of
this is that it enables these operators to offer high bandwidth directly to consumers and
henceforth foster competition for high-bandwidth services. ULL is a typical situation of one-
way access. Section 2 already discussed access charges with ULL, but left the common-cost
aspect to this section. One way to reduce additional costs for consumers of hiring these new
operators of their high bandwidth is to introduce shared access (see e.g., EC Commission
Recommendation C2000 1059, OFTEL). An issue specific to shared access is how to split the
common costs between high and low frequencies.
OFTEL has suggested a method for sharing common costs in the case of shared access
(OFTEL, 2000). It first observes that shared loops differ from fully unbundled local loops, in
that the competing firms only lease a portion of the local loop - the high frequency one. So
after applying step one, the attributable costs (in this case, LRIC is used), in step two it has to
27-09-02 39
be determined what to do with the costs of the loop that are invariant with the bandwidth
used.
OFTEL rejects Ramsey pricing for the usual reason: the information burden is too
high. It goes on stating that its objective is to adopt a method that ensures that the take-up of
higher-bandwidth services is neither discouraged nor deterred, i.e. allocative efficiency in
DSL services seems to be the main goal. OFTEL concludes that the easiest way to achieve
these goals is to let the local loop provider (LLP) set the access charges themselves provided
non-discrimination, i.e. the LLP cannot charge competitors a different amount than it charges
itself. Since the LLP�s do not charge any of the common costs to their own downstream
higher-bandwidth business, OFTEL suggests that the total of common costs will be allocated
to voice.
• Fixed-mobile termination
From section 3 and section 4.1, it has been concluded that fixed to mobile termination is a
service that should be regulated since mobile network operators (MNOs) have a near
monopoly position in this service. Indeed, a number of regulators have adopted RPI-X
regulation to prevent MNOs from exploiting their near monopoly position (see e.g. OFTEL,
Review of the Charge Control on Calls to Mobiles - 26 September 2001).
OFTEL opts for the EPMU system for the common costs (Kobold and Maldoom,
2001). It underpins this choice since the recovery of these costs is a relatively minor issue in
the context of mobile termination because the common costs of a mobile network are
relatively small. In OFTEL�s cost model, common costs amount only to about 3%-5% of the
total costs of a 900 MHz and 1800 MHz network. The common costs comprise the cost of a
network-management system plus the fixed costs of coverage, i.e. the cost of acquiring,
renting and operating the number of sites required to provide coverage. The characteristics of
a 1800 MHz spectrum mean that more base stations are required to provide the same degree
of coverage, which is why common costs are a slightly higher proportion of total costs than in
a 900 MHz network. As a consequence, the distortion of EPMU is modest. Since EPMU is
easy to implement, the choice is clear.
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4.3.4 Policy conclusions
• Ramsey pricing, though theoretically appealing, is often discarded as being unpractical or
politically unfeasible. Still, the message of Ramsey pricing is that demand-side factors
can be important, in particular in situations where the common costs are relatively large
relative to incremental costs.
• When common costs are large, Ramsey prices, or more generally demand-side factors,
should no be discarded that easily. Difficult data requirements can sometimes be
resolved. Imperfect demand estimations can be better than no demand-side estimations.
Political (income-distribution) problems can also sometimes be solved otherwise.
• In cases where Ramsey pricing is unfeasible, the regulators will find themselves at cross-
roads since none of the alternatives can be assessed as being a priori superior to the other.
• The two leading questions that determine the best available alternative are: (i) To what
type and what level of distortion does the method lead? (ii) Which are the main objectives
that the regulator wants to achieve with the access charges?
• The first question gives a feeling for the relative damage that the method inflicts: In the
case of fixed mobile termination, e.g., we saw that the common costs were relatively
small, implying that an alternative such as EPMU only causes a small distortion.
• The second question puts weights on the distortions: one distortion is not as bad as the
other. In the Airline example, we saw that demand-side considerations were considered
very important, which made EPMU unappealing.
• A totally different perspective came from the electricity market. Indeed, one can wonder
how international comparisons either by benchmarking or even by the more formal
brother of benchmarking (yardstick competition) is a feasible option in
telecommunications land in the future.
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4.4 Static versus dynamic efficiency
4.4.1 Policy relevance
Sections 2 and 3 paid some attention to dynamic consequences of access prices. Because of
the policy relevance in virtually all access problems, the lack of a theoretical consensus in
general, as well as the lack of a well developed analysis of the linkage between access pricing
and dynamic efficiency, this section comes back to the issue in more detail.
Why do regulators struggle with this question? There are a large number of
explanations. First, theory is well developed for static access rules, not for dynamic ones.
Second, while the emphasis was on developing competition for services in the early stages of
liberalisation, the attention has shifted (at least to a certain extent) to competition for
infrastructures. Third, there could be trade-offs between static and dynamic efficiency.
Regulating access prices that foster competition for services does not automatically foster
competition for infrastructure. The well-known example here is low one-way access prices:
entrants who can �free-ride� on the incumbent�s network do not have incentives to build their
own networks. Fourth, partially because of the low market sentiments for telecommunication,
investments in new infrastructure are not as booming as expected (with some notable
exceptions). Fifth, there is considerable political pressure on regulators to play easy on
telecommunication operators because a tight regulation is allegedly harmful for investments,
particularly given the current market sentiments. Finally, the emphasis on dynamic
considerations cannot be overstated. The telecommunications industry is an industry largely
driven by innovation and investments in new infrastructure. So putting the incentives for
investments and innovation right can easily dwarf any of the static considerations.
Throughout this section, we use the notions of static and dynamic efficiency.16 This
allows us to address the possible trade-off between short- and long-run implications of policy
choices. Roughly speaking, static efficiency is high if competition is sufficiently intense, there
is downward pressure on prices, consumers can choose between several suppliers, and they
get good value for money. Some drivers of static efficiency are: low entry barriers, no
collusion and no substantial consumer switching costs. Unfortunately, one cannot measure the
16 See also Bennett et al. (2001) and Leo et al (2002), in which the notions of static and dynamic efficiency playa central role to address various policy issues in telecommunications markets.
27-09-02 42
static efficiency of a market, but in practice, it can roughly be assessed by consulting industry
experts, antitrust economists who and consumer organisations that each may have specific
views on certain indicators related to the drivers of static efficiency.
Dynamic efficiency is high if, typically, there are low entry barriers for new
technologies developed by rival firms, and firms have incentives to invest in R&D and
innovation. Some drivers of dynamic efficiency are: low entry barriers for players with new
technologies, the possibilities to recoup R&D investments, small regulatory uncertainty, and
effective standardisation. Again, it is hardly possible to measure dynamic efficiency, but in
practice one can look at the levels of investment in product and process innovation, R&D
budgets, the number of patents, the prospects for new players to introduce new technologies,
and consumer take-up of new products. These types of indicators may give a good
approximation of dynamic efficiency. It is important to stress that a high level of innovation
does not always mean that dynamic efficiency is high. There can also be too much innovation
in a market, for example in a situation of planned obsolescence.
4.4.2 Economic theory
Summarising the theoretical insights of sections 2-3 we see six conclusions:
1. Forward-looking access rules (e.g. LRIC) may give better incentives for investment
than backward-looking ones, although the empirical evidence is somewhat mixed (Cave
et al., 2001).
2. However, by implicitly assuming that markets are contestable, LRIC rules can have
adverse dynamic consequences, which can completely offset the positive incentives
mentioned above. Typically, telecommunication markets are not contestable: there are
substantial sunk costs as well as many unsuccessful investments (stranded assets).
Failing to take this into account can hamper investments and innovation.
3. Providing ex ante clarity on the leading regulation principles reduces uncertainty and
thereby contributes to dynamic efficiency.
4. Uncertainty can further be reduced by defining �sun-set clauses�, i.e. regulators
predetermine conditions under which regulation can be lifted or softened.
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5. Dynamic efficiency is not one-dimensional: access charges that are good for investment
incentives for incumbents are not always so good for those of entrants and investment is
not equivalent to innovation.
6. A simple focus on incentives for investments by the entrants is too short-sighted:
investments can be wasteful. It is only useful to provide incentives for entrants if the
incumbent�s infrastructure is replicable.
4.4.3 Practical experiences
There are a number of practical experiences with access in a dynamic context. In principle,
virtually all practical experiences can be mentioned here, but we focus on a couple of
experiences where the dynamic nature is most apparent. Much of this subsection on practical
experience is taken from Cave et al. (2001) and Bennett et al. (2001).
• Country experiences
We mention three country studies taken from Cave et al. (2001). The fourth is taken from
Bennett et al. (2001).
In the U.K., OFTEL realized in 1996 that their interconnection regime should be revised,
because insufficient attention was given to dynamic considerations. The new regime was
characterized by low (forward-looking) interconnection charges for entrants. Entrants
obtained a special status (Relevant Connectable Systems) that allowed them these low
charges. At the same time, OFTEL made it clear that operators could not assume they would
keep that status unless they were prepared to invest.
For the U.S., there is empirical evidence that access charges influence investment
levels, to the extent that lower access charges promoted greater deployment of digital
technology among US incumbent local-exchange carriers.
For the Netherlands, empirical evidence suggests that interconnection policies have
influenced the level and structure of investment, most notably in relation with ULL. A new
27-09-02 44
group of DSL providers entered the market, which boosted investments in fibre optic
networks.
In the Netherlands, there has been a policy debate as to whether cable companies
should be forced to mandatory access to their cable infrastructure. Mandated access to the
cable is good for the television market, where cable companies have a dominant position. It
can also be good for static efficiency in the Internet market. The effects on dynamic efficiency
are unclear, since it may provide disincentives for cable companies to invest. Potential harm
to dynamic efficiency can be reduced by time-dependent access regulation, taking the
stranded assets discussion (see section 2.3.2) into consideration.
The conclusion of these country experiences is that various countries have experiences
with dynamic consequences of access charges. While these consequences are considered
important, it is not yet clear what lessons to draw from these experiences.
• Unbundling of the local loop
The discussion on ULL also yields interesting results for the discussion on static versus
dynamic efficiency. Consider various types of entry, where entrants adopt different strategies
or maturity of the market differs (quoted from Cave et al., 2001; some marginal editing by us
in italics).
�First, a cable operator like UPC [a Dutch cable operator] will have already replicated some
aspects of the local loop, although further investments are required both for telephony and
development of Internet services. In this respect, local access pricing makes little difference.
The cable operator has to buy call termination from the incumbent, probably in respect of the
majority of calls. This service is wholly non-replicable. But reciprocal pricing between
operator and incumbent neutralises this factor. Finally, the cable operator needs access to
long-distance conveyance, which is replicable, either by the cable operator and by other
entrants and should, with time, be competitively priced.
Second, consider the case of Tele2 [the biggest Dutch Carrier select player], whose
strategy consists of targeting a mass market, involving marketing and advertising expenditure,
on the basis of � initially at least � a minimal investment in infrastructure. As time passes,
27-09-02 45
Tele2 makes further investments in switching and conveyance at the national level, but its
investments are limited (possibly confined to marketing costs).
Third, consider the case of non-cable entry into the high-bandwidth markets. This is a
new market, in which the incumbent has no historic market share, although clearly it has the
advantage of providing the related service of basic telecommunications to the vast
preponderance of domestic and business customers. Incumbents and entrants are under the
same necessity to make the appropriate investments in servers. In this instance, the key non-
replicable resort for entrants is the local loop, or access to part of the bandwidth provided by
the loop. Setting on one side wireless technology, which essentially untried, unbundling of the
loop is a necessity.
This raises the key question of how the unbundled loop should be priced [see also
section 2]. Commitment to a low regulated rental for the unbundled loop would clearly
encourage a competitor�s complementary investment. If, however, the regulator were
concerned about the entrant�s short-term cash position, it might choose to alleviate its
difficulties in the early phase of entry by a lower rental charge, which would then rise to
above cost. The choice of a final level on the price curve at which the price would be
stabilised would be influenced by the regulators preference for network duplication. If the
preference were slight, then a level-pricing policy would be preferable (or one which levelled
off at cost). If the preference for duplication was strong, then this could be reflected in a
pricing strategy which rose to above cost. A time limitation on mandated access to the local
loop might also be appropriate. But this last policy, which has been adopted in certain areas in
Canada, appears to carry the risk that entrants� fear is about what might happen towards the
end of the period of mandated access might discourage investment.�
This leads to the conclusion that regulators have two instruments to influence
investment decisions. The first one relates to whether the assets by the incumbents are
replicable or not. Clearly, entrants are not sensitive for access charges in parts of the network
they cannot replicate. Second, access charges can have a dynamic nature. Most entrants
choose a gradual investment strategy, leasing lines from the incumbent in the initial stages
and meanwhile investing in their own networks. A dynamic access policy takes this into
consideration: access charges can rise over time, or the level can be made contingent on the
level of investments.
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4.4.4 Policy conclusions
A number of policy conclusions emerge from above.
• Universally high access prices are not smart
A possible implication of static analysis is that the best way to stimulate infrastructure
investment is to have universally high access prices, i.e. access prices that are high and remain
high over time. The argument is that high access prices provide an investment incentive for
incumbents (risk premiums, stranded asset discussion) as well as for entrants (who can avoid
high access prices by investing themselves). This is not necessarily true when taking a
dynamic view. There is no evidence to support high-cost access pricing as a means of
encouraging infrastructure competition, neither theoretical nor empirical. The reason is that
future profit opportunities are more important than current price levels when considering an
investment decision. Admittedly, if entrants are certain that future access levels are at so low
levels that it will always be cheaper to obtain access than to invest, then (future) high access
levels are problematic. But there are many reasons why that picture may look different. The
investments can yield other type of returns (unrelated to access) and there can be a belief that
regulators will reward investments in infrastructure.
• Eligibility and replicability
Access charges that take investments and investment possibilities by entrants explicitly into
consideration, do well on dynamic efficiency. Think of OFTEL�s strategy of conditioning
charges or status of operators on investment decisions.
• Sun-set clauses and other dynamic regulation
Regulatory uncertainty can be lowered by pre-specifying sun-set clauses, not only (or rather:
not necessarily) the date, but the market condition under which some regulation can be
removed. Access charges that rise over time or contain some other temporal element enable to
fulfil both static and dynamic goals.
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• A dynamic focus can reduce the need for future regulation
Setting appropriate access charges is difficult. Stimulating investments in new infrastructure
that provides the basis of removing access regulation and replacing it by bilateral agreements
on interconnection charges.
5 Conclusions
This chapter overviewed the literature on access regulation and provided some lessons for
regulation practice.
A common element in all discussions in this chapter is that access prices can, by
definition, never be neutral. Any access price affects competition, or more precisely,
operators� profits, market shares, and retail prices.
A second element is that access charges are often performing too many tasks.
Access charges are used to stimulate static as well as dynamic efficiency and meanwhile
serving equity goals such as universal service obligation. This is a bit much for an access
charge, which is, in its simplest form, a one-dimensional price. A number of these goals can
easily conflict, so choices have to be made.
A third element is that focus has shifted from competition in service to competition in
infrastructure. Successful competition for infrastructure can reduce the need for access
regulation and does not preclude competition for services to take place at the same time.
Dynamic access policies, e.g. access charges that rise over time, enable to fulfil both static
and dynamic goals. It is important to reduce uncertainty by providing regulatory transparency
on these time-related issues.
A fourth element concerns various methods of determining access charges. No method
is a priori superior to the other. What determines which method is best is both the relative
levels and weights of distortions. Some methods distort dynamic efficiency, but if the focus is
on static efficiency, the method could be adequate. Other methods ignore demand-side
considerations, but if the distortion from that is small, the method could be used. Ramsey
methods require a high information burden, but sometimes this burden can and should be
overcome. Also the possibility of creating margin squeeze as a result of the selection of the
methods should be taken into account.
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A final element is the potential of alternatives for the �calling party pays� (CPP)
principle. CPP is common practice in Europe (with the notable exception of international
roaming). The CPP principle implies that a receiver obtains a service (receiving a call) but
does not pay for it. As result, some distortions take place, e.g. interconnection tariffs and fixed
-mobile termination, and Internet charges may be set at sub-optimal levels, when a balanced
cost allocation would lead to incentives to set the charges at competitive levels (Laffont et al.,
2001), thus reducing the need to regulate services that are currently under scrutiny of
regulators.
27-09-02 49
References
Armstrong, M. (1998), �Network interconnection in telecommunications,� Economic
Journal, Vol. 108, pp. 545-564.
Armstrong, M. (2001), �The theory of access pricing and interconnection,� in: M. Cave,
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