Chapter I. Economic Underpinnings: The Economics of Communications Networks, Market Power, and Vertical Foreclosure Theories

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CHAPTER I

ECONOMIC UNDERPINNINGS: THE ECONOMICS

OF COMMUNICATIONS NETWORKS, MARKET

POWER, AND VERTICAL FORECLOSURE

THEORIES

A. Introduction

This chapter introduces the concept of market power and explains

the characteristic features of communications markets and providers that

are often relevant to allegations of market power and abuse of market

power in communications industries. The chapter continues with a

discussion of market definition, which is an element in a typical analysis

of whether a firm has market power. It concludes with a general

overview of potential anticompetitive effects that flow from the exercise

of market power, with a particular focus on vertical foreclosure theories.

Vertical foreclosure refers generally to the use of vertical integration or

other vertical restraints by an input supplier to achieve market power in

an output market. In communications networks, theories of vertical

foreclosure have been of particular prominence, and such theories partly

motivated the vertical divestiture from AT&T of the Bell Operating

Companies in the mid-1980s.1 More generally, in communications

networks a supplier of a key input may also be a downstream competitor,

which may have implications for the incentives of the vertically

integrated firm and its customers/competitors.

The application of the vertical foreclosure concept is neither simple

nor straightforward. Vertical integration concerns remain a significant

driver of communications policy and of antitrust litigation initiated by

competitors. As will be discussed in later sections of this chapter,

depending on their alignment with incumbents versus competitors, there

are often fundamental differences among economists in the analysis of

these issues, making a balanced presentation of these issues particularly

challenging.

1. See discussion at part E of this chapter.

2 Telecom Antitrust Handbook

B. An Introduction to Market Power in Communications Markets

With respect to federal oversight of the communications industry, the

concept of market power arises in both the contexts of antitrust

enforcement and economic regulation. The chief goal of the federal

agencies charged with enforcing the U.S. antitrust laws is to prevent the

acquisition of an increased ability to exercise market power and to

prevent the illegal maintenance of market power. For example, mergers

are prohibited under Section 7 of the Clayton Act if their effect “may be

substantially to lessen competition, or to tend to create a monopoly”2 or

are prohibited under Section 1 of the Sherman Act if they constitute a

“contract, combination . . . or conspiracy in restraint of trade.”3 The 2010

Merger Guidelines4 of the federal antitrust agencies lay out the

enforcement policy of these agencies with respect to mergers. The

“unifying theme of these Guidelines is that mergers should not be

permitted to create, enhance, or entrench market power or to facilitate its

exercise.”5 Antitrust enforcement against monopolization or attempted

monopolization is also based on core principles focused on “market

power and separating the legitimate, procompetitive ways it is acquired

and preserved, from the illegitimate, anticompetitive ways.”6

The Federal Communications Commission (FCC) uses a different

framework for evaluating mergers than that of the 2010 Merger

Guidelines—what it terms a broad and flexible” public interest standard.7

However, a key component of the evaluation is a determination of

whether a merger “will allow firms . . . to exercise increased market

power through either unilateral or coordinated anticompetitive

behavior.”8 The FCC also applies the concept of market power in non-

2. 15 U.S.C. § 18.

3. 15 U.S.C. § 1.

4. U.S. DEP’T OF JUSTICE & FEDERAL TRADE COMM’N, HORIZONTAL

MERGER GUIDELINES (2010), available at www.justice.gov/atr/public/

guidelines/hmg-2010.html [hereinafter 2010 MERGER GUIDELINES].

5. Id. § 1.0.

6. Joel I. Klein, Rethinking Antitrust Policies for the New Economy,

Haas/Berkeley New Economy Forum, May 9, 2000, available at

www.usdoj.gov/atr/public/speeches/4707.htm.

7. 47 U.S.C. §§ 214(a), 310(d) (1997); Applications of NYNEX

Corporation Transferor, and Bell Atlantic Corporation Transferee, For

Consent to Transfer Control of NYNEX Corporation and Its Subsidiaries,

12 F.C.C.R. 19985, 19987, ¶ 2 (1997).

8. Application of WorldCom, Inc. and MCI Commc’ns for Transfer of

Control of MCI Commc’ns to WorldCom, Inc., 13 F.C.C.R. 18025,

Economic Underpinnings 3

merger contexts, as when it has chosen to forbear from imposing certain

regulatory requirements (e.g., rate and entry/exit regulation) on non-

dominant carriers (that is, carriers that it has determined to lack market

power).9

Market power is generally defined in economics as the ability to

affect the market price of a good.10 In the economic model of “perfect

competition,” every firm is small relative to the market and products are

homogeneous, so no one firm can affect the market price. In such

markets, long-run equilibrium is achieved when prices are equal to the

marginal cost of the firms in the industry.11 In this case, another way of

expressing this definition of market power is that it involves the ability to

set and sustain prices above marginal cost.12 In general, however, in

multiproduct firms the level of prices even in free-entry, zero-profits

market may exceed marginal cost due to the presence of fixed common

costs,13 and this difference is particularly important for

telecommunications markets where such costs are a significant

proportion of total costs.14 Hence, as a matter of economic theory, market

18036, ¶ 16 (1998) [hereinafter WorldCom/MCI Order]. Nonetheless, the

“public interest” standard affords the FCC considerable leeway in its

merger review, and it has recently adopted the practice of permitting

parties to proposed mergers to take on “voluntary commitments” as a

means of mitigating concerns related to their potential exercise of market

power. See, e.g., SBC Commc’ns and AT&T Corp. Applications for

Approval of Transfer of Control, 20 F.C.C.R. 18290, 18391, ¶ 205

(2005).

9. See, e.g., Report and Order, Competition in the Interstate Interexchange

Marketplace, 6 F.C.C.R. 5880, 5887-89 (1991) (largely eliminating price

regulation upon determination that interexchange carrier AT&T lacked

market power in business services, based on supply and demand elasticity

as well as pricing and market share evidence).

10. ROBERT S. PINDYCK & DANIEL L. RUBINFELD, MICROECONOMICS 340

(6th ed. 2005).

11. Marginal cost is the increase in cost associated with an additional unit of

output. See, e.g., id. at 85.

12. Another related way to define market power is the ability to raise price by

restricting output. IIA PHILLIP E. AREEDA, HERBERT HOVENKAMP &

JOHN L. SOLOW, ANTITRUST LAW ¶ 501 (2002).

13. See, e.g., WILLIAM J. BAUMOL, JOHN C. PANZAR & ROBERT D. WILLIG,

CONTESTABLE MARKETS AND THE THEORY OF INDUSTRY STRUCTURE

199-217 (1982).

14. J. NUECHTERLEIN & P. WEISER, DIGITAL CROSSROADS: AMERICAN

TELECOMMUNICATIONS POLICY IN THE INTERNET AGE 10 (2007).