Competition in Telecommunications [*].

• Author: Mandy, David

David Mandy [+]

Laffont and Tirole (LT hereinafter) have written a much-needed book that brings together the theory and practice of telecommunications regulation, especially interconnection pricing, in an era of increasing competition. It is almost a cliche to observe that the work of these authors, who have produced so much prominent research in this area, is insightful, comprehensive, and elegant; yet such descriptions are needed to aptly characterize this book.

The main design feature of the book is a separation of the text from technical boxes that present formal models. This is a laudable plan and it succeeds in making much of the book accessible to those who are familiar with the issues but are not professional economists. It is still fairly technical reading and in places cannot be well understood without venturing into the technical boxes. Certainly only professional economists with some prior understanding of the models can fully digest the material. But for professionals and nonprofessionals alike the effort of reading is rewarded as the text lays bare basic economic lessons that are often misunderstood or lost in the contentiousness and complex details of regulatory practice. Even to those who are very familiar with the material, the book is worth reading simply for the enjoyment of witnessing the depth and breadth of LT's mastery of the material, and their customary eloquence in putting it all together.

This book should be read by every consultant, industry participant, and academician with an interest in telecommunications regulation; by any economist who wants to become acquainted with the revolution occurring in the industry; and by the technical staffs of national regulatory agencies. It may be too technical for generalists and state-level regulatory commissions, but it should at least be skimmed by everyone involved in regulating the industry.

Chapter 1

Chapter 1 is an overview of how regulation and competition in telecommunications have evolved since the mid-1980s. This overview is nicely blended with explanations of how the inefficiency of old regulatory regimes and technological developments together pushed for the introduction of competition in some segments and changes in the style and content of regulation. The inefficiency referred to here is the standard problem of poor incentives for a cost-plus regulated firm to minimize cost or innovate.

The first main step in the evolution of regulatory tools discussed is the movement to price caps with their attendant problems: imperfect information in setting the cap, regulatory credibility and discretion, and incentives to shirk on quality.

As competition in some segments became more viable, a need emerged for a second step in regulatory evolution toward regulating access to bottleneck facilities. The canonical problem of this nature in telecommunications is pricing initiation and termination of long-distance telephone calls on local networks. Here, the local network is the upstream "bottleneck facility" to which "access" is needed by the more competitive downstream long-distance industry. LT identify forward-looking long-run incremental cost as the currently dominant paradigm for access pricing. They point out a basic conceptual conflict between this paradigm, on the one hand, and increasing returns and the objective of reduced regulation on the other hand. Pricing access at forward-looking long-run incremental cost does not cover large fixed costs unless the concept of "incremental" is stretched to the point that it bears little relation to the economist's concept of marginal cost, and the concept of "forward" is stretched to include future e conomic obsolescence in today's prices. Even when these concepts are stretched, the currently dominant paradigm makes no pretense of covering fixed costs in a Ramsey-optimal manner. Moreover, such pricing requires heavy regulatory involvement in measuring costs while creating perverse incentives that can only be controlled through more regulation.

The remainder of Chapter 1 reviews recent regulatory reforms in the United States, UK, European Union, and New Zealand that are intended to facilitate competition in those segments where it may be viable while still regulating access to bottleneck facilities. The emphasis is on the U.S. Telecommunications Act, with much less attention to reforms outside the United States and no discussion of Asia (most notably Japan). Consequently, most of this discussion will be familiar to those acquainted with the U.S. Act. It is unfortunate but inevitable in the fast-paced environment of the telecommunications industry that this discussion is already somewhat dated.

Chapter 2

Chapter 2, entitled "Incentive Regulation," begins assembling the analytic tools needed to understand the most recent steps in the evolution of telecommunications regulation. The presentation neatly dichotomizes the standard Baron-Myerson (1982) rent extraction problem under incomplete information from the problem of allocating surplus extraction across multiple products. Predictably for LT, this is accomplished using a procurement context to explain why it is optimal to offer a menu of contracts to a firm when addressing the basic trade-off between performance incentives and informational rents; coupled with a standard Ramsey pricing context to derive optimal allocation rules. A main point clearly elucidated here is that only an aggregate earnings sharing rule is needed to strike the desired balance between incentives for firm efficiency and controlling the firm's informational rents. Such a rule can be implemented with a firmwide menu of price caps, for example. Subject to an earnings sharing rule, price s etting can then in principle be decentralized because the firm will voluntarily set prices across its product lines according to inverse elasticity rules. This leads LT to aptly label Ramsey prices as "business oriented" prices that do not conflict with the regulated firm's incentives, despite their social optimality characteristics.

Balancing performance incentives and informational rents is thoroughly discussed; including extensions to the use of auctions and benchmarking to enhance incentives, the problem of setting the optimal weights in a firmwide price cap, how managerial discretion may defeat attempts to impose heterogeneous performance incentives across different lines of business, and the erosion of incentives for firm efficiency that may occur when there is a lack of regulatory commitment, a concern about quality shirking, or a substantial prospect of regulatory capture.

Likewise, Ramsey pricing principles are given a complete treatment, including the (standard but somewhat exotic) interpretation of nonlinear prices as Ramsey prices in increment markets; and the objections that Ramsey prices have undesirable redistributive (at the retail level) and discriminatory (at the wholesale level) properties, may facilitate regulatory capture, and may forego some potential learning about the social desirability and costs of individual services.

Chapter 3

Chapters 3-5 are the heart of the book, and 3 is devoted to the theory of access pricing for a bottleneck facility. LT begin by presenting the benchmark problem...