Competition after unbundling: entry, industry structure, and convergence.

AuthorFord, George S.
  1. INTRODUCTION AND SUMMARY II. INDUSTRY CONCENTRATION IN COMMUNICATIONS MARKETS III. AN ENTRY-ORIENTED MODEL OF INDUSTRY STRUCTURE FOR POLICY ANALYSIS A. Factors Determining Profits 1. Market Size and Entry 2. The Intensity of Price Competition 3. Degree of Product Differentiation 4. Geographic Overlap B. Types of Entry Costs 1. Technological Entry Costs 2. Strategic Entry Costs 3. Regulatory Entry Costs 4. Spillover Effects IV. MODERN COMMUNICATIONS POLICY AND THE ENTRY MODEL: FOUR APPLICATIONS A. Effect of Convergence on Industry Structure B. Market Size and the Deployment of Advanced Communications Networks C. Deterring Entry by Treating Entrants and Incumbents Equally D. What Entry Says About Collusion V. CONCLUSION I. INTRODUCTION AND SUMMARY

    In the last few years, the goal of U.S. telecoms policy has been to promote and rely upon facilities-based "intermodal competition"--that is, competition among network platforms. This approach marks an important change from the initial implementation of the Telecommunications Act of 1996, in which policymakers vigorously enforced various network sharing and unbundling obligations aimed at jump-starting competition through "intramodal" means.

    This brave new world of telecoms competition raises very basic and essential questions for policymakers: (1) what will be the market structure of this new "intermodal" market, in which competition is effectively limited to firms that own their own network facilities; and (2) will we be satisfied with the results? In this Article, we provide policymakers with a framework for analyzing this emerging industry structure. The linchpin of our framework is its focus on the entry by new firms and the expansion by existing firms into related markets--i.e., for facilities-based "intermodal" competition to work, entry by new firms should be encouraged, and existing network platforms must be able to expand freely into other markets in which their respective network platforms are capable of serving.

    At the outset, it is important for all to understand that facilities-based competition in local communications markets will be characterized by only a few firms. As consistently demonstrated by academic research, given the huge fixed and sunk costs inherent to the construction and commercial operation of communications networks, the equilibrium level of concentration of terrestrial firms in local communications markets (voice, video, and data) will be relatively high. (1) As we discuss below, fewness arises because scale economies and sunk costs limit the number of firms that can profitably serve a market--and local communications networks are notoriously riddled with scale economies and sunk costs. Any policymaker interested in local communications markets should, therefore, start from the assumption that there will, at best, be only a "few" facilities-based firms. The notion that the local market can sustain five to seven local terrestrial networks all offering highly substitutable services is both naive and unrealistic. (2) Indeed, a federal policy that relies on facilities-based, intermodal competition in communications markets is a decision to embrace, or at least tolerate, more concentrated industry structures.

    But, policymakers should not let the "perfect" become the enemy of the good: competition, even among a few firms, is vastly superior to (even regulated) monopoly. (3) While it is highly unlikely that dozens of local networks or facilities-based competitors could thrive in the communications markets (i.e., various forms of video, voice, and data services), this lack of headcount does not mean that competition is absent or that consumers do not reap substantial benefits from a more limited number of competitors. Indeed, many telecommunications markets deemed substantially competitive are concentrated. In the wireless industry, the Herfindahl-Hirschman Index ("HHI") is nearly 3,000 (the numbers equivalent of three firms), (4) and in the long-distance market, the three largest firms (AT&T, MCI, and Sprint) controlled nearly seventy percent of that market in 1999, fifteen years after divestiture and prior to Bell company entry into that market. (5) Yet, both markets are characterized historically by substantial price and quality competition.

    Nor do few facilities-based local distribution networks imply few competitors. For example, over 1,000 firms offer long-distance services over about six nationwide long-haul networks. (6) A more contemporary example is the existence of many firms, large and small, offering consumers telephone service using Voice-over-Internet-Protocol ("VoIP") technology. These "service" providers can provide meaningful benefits to consumers in both price and non-price dimensions, even though these providers did not spend billions to construct networks.

    Similarly, focusing narrowly on terrestrial, local distribution networks can present a misleading picture of rivalry. Alternative technologies, including wireless and satellite platforms, clearly expand service offerings to consumers, and in some cases provide meaningful price competition to more traditional communications services, even if only for subsets of consumers. (7) Wireless carriers are investing billions in 3G technologies (e.g., EVDO) capable of providing advanced services, including some video applications. Even if these intermodal substitutes (versus intermodal competitors) do not provide a significant constraint on market power in traditional voice and video markets (though they may), they can have the effect of shrinking the negative effects of market power by reducing the size of traditional markets. (8) Minutes of long-distance telecommunications traffic have fallen by twenty-five percent over the past five years, probably due to increased use of wireless telephone services and email. (9) While such substitution may not reduce prices, it clearly reduces the relevance of any residual market power in the long-distance market. (10)

    Alternatively, intermodal competitors (in contrast to intermodal substitutes), like intramodal rivals, strike directly at margins, providing substantial and direct consumer benefits in both price and nonprice dimensions. (11) A government study shows, for example, that wireline (intramodal) competition in the cable television industry provides three times the price reduction as satellite competitors do (intramodal competition). Our focus in this Article is on intermodal competitors of arguably the most significant kind, that is those competitors offering very close substitutes to the traditional services (voice, video, and data) consumed by the vast majority of consumers (or the typical household).

    Given the inevitability of fewness in the number of competitors of this kind, it is vital for policymakers to understand the entry decisions of firms so that the number of competitors can be maximized under the relevant demand- and supply-side constraints of the market.

    First and foremost, policymakers must identify and change those policies that make it more difficult for firms to enter or to expand into related markets. Recent advances in technology have substantially expanded the potential for facilities-based entry and intermodal competition, provided regulation does not foreclose opportunities for competitive entry, and that regulators do not act in concert with incumbents to raise effective entry barriers. The value of one more entrants in a concentrated market is sizeable, so policymakers should favor entry to the greatest extent possible. To do so, policymakers must understand the entry calculus of firms and be able to apply the logic of this entry calculus to decipher how particular policies may affect entry. We provide in this Article a simple conceptual framework of entry ideally suited for the evaluation of policies that may influence the entry decisions of firms.

    To flush these important points out in further detail, this Article is outlined as follows: Part II first establishes the fact that local telecoms markets will be characterized by only a "few" facilities-based firms. This Part draws on the economic literature on entry to show that given the huge sunk costs required for entry, the equilibrium number of terrestrial firms for the local market will be highly concentrated. Part III goes on to present a simple and intuitive economic model of entry accessible to the layperson, which illustrates the concept of an equilibrium industry structure. In this Part, we describe the primary determinants of competitive entry and present simple numerical examples to facilitate comprehension. Part IV includes four applications of the logic of our entry model to real-world policy issues.

    For example, there has always been great talk about "convergence," but true convergence (i.e., one that actually affects the underlying market structure) is not the offering of a "bundle" of several products into a single service offering, but is, in fact, a technological spillover that reduces entry costs so that existing firms find it profitable to extend their networks into related markets, a decision that would not be profitable without the spillover. As such, "convergence" does not generally mean that busloads of new firms can now enter the market--it means only those firms with assets in a related market that have been affected by the spillover can afford to enter.

    Similarly, if policymakers artificially restrict or impede access to various ancillary product markets, then firms may not expand into related markets or upgrade their existing networks (e.g., copper to fiber) to facilitate the technological "convergence" discussed previously. If network modernization is to occur, then regulatory entry barriers that exist in any market that the network is capable of serving must be eliminated to the greatest extent possible.

    The same can also be said about arguments for so-called "regulatory symmetry," such as franchise and...

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