Reverse auctions and universal telecommunications service: lessons from global experience.

• Author: Wallsten, Scott

1. INTRODUCTION II. UNIVERSAL SERVICE IN THEORY AND IN PRACTICE A. Rationale for Universal Service in Telecommunications B. Tax and Distribution Schemes are Inefficient C. How Much Should We Spend and Where? III. GLOBAL EXPERIENCE WITH REVERSE AUCTIONS AND UNIVERSAL SERVICE A. Australia B. Chile C. Colombia D. India E. Nepal F. Peru IV. DISCUSSION AND CONCLUSION I. INTRODUCTION

   Nearly every country in the world has universal service or access regulations in an attempt to ensure that everyone in the country can access telecommunications services at affordable prices, although "telecommunications" and "affordable" are not always easy to define. Universal service subsidies are typically used for telecommunications services in rural areas. The United States also subsidizes schools and libraries, and a small share of the subsidies go to low-income people. (1) Annual spending in the United States on universal service has increased substantially, reaching approximately $7 billion in 2007. (2) Most of this growth is the result of increases in the High Cost Fund (Figure 1). Because these subsidies have been so inefficient, (3) the mounting expenditures--and thus inefficiencies--are creating increasing pressures to reform the system.

   [FIGURE 1 OMITTED] (4)

   The FCC is considering "reverse auctions" as one possible method of controlling these expenditures. (5) Paul Milgrom proposed this idea more than a decade ago, (6) and Dennis Weller developed a more specific proposal. (7) The general idea is for firms to bid for subsidies, and the firm with the lowest bid--that is, the firm that asks for the smallest subsidy--provides the service. While the United States has never allocated universal service subsidies in this way, it is not untested.

   A reverse auction is the standard way in which the government typically procures any good or service. When the government needs to purchase something, it issues a request for proposals (RFP) describing specifically what it wants. (8) Firms reply to this request, and the government picks the firm that submits the best bid. The best bid may be the lowest, but the government may also take other factors into account when making the decision, especially in the case of complex projects. While it is easier to conduct a reverse auction for simple products, the U.S. government has also used them to supply highly complex goods like weapons systems, (9) demonstrating that feasible auctions need not be simple.

   Since a reverse auction for universal service is simply a RFP to supply telecommunications services, and because no-bid contracts are typically controversial, (10) perhaps it should be surprising not that the FCC is considering reverse auctions, but instead that reverse auctions have yet to be used for universal service.

   In addition, other countries have used reverse auctions to provide universal service with some success. Their experiences demonstrate convincingly that reverse auctions can bring down subsidies substantially. Their experiences also demonstrate that, as in any auction, the rules matter a great deal. India's first attempt at reverse auctions was not successful, failing to reduce the subsidy and concluding with the incumbent as the only winner. (11) India persisted, and its most recent auction ended with firms bidding for no subsidy and even bidding to pay to provide service rather than to receive subsidies. (12)

   This Article surveys global experience with reverse auctions in universal service. In particular, it discusses reverse auctions in Australia, Chile, Colombia, India, Nepal, and Peru and draws lessons from these countries for the United States. Figure 2 gives an overview of reverse auctions in these countries, as well as Guatemala and the Dominican Republic.

   Most reverse auctions have been aimed at providing public telephones in developing countries. (13) While this type of universal service differs from universal service in the United States, these experiences have demonstrated that reverse auctions can reduce subsidies paid for universal service and that, in general, subsidies for universal service have been too high. These experiences also highlight the importance of thinking carefully about how to handle the incumbent given its inherent advantages in information and installed capacity. Overall, global experience demonstrates that if the regulator's goal is to reduce the level of subsidies or to provide information about the "right" level of subsidies, reverse auctions can be successful.

   The following Section discusses the theory behind universal service and what it means in practice, while the subsequent Sections discuss these countries' experiences with reverse auctions.

2. UNIVERSAL SERVICE IN THEORY AND IN PRACTICE

   "Universal service" refers to the idea that an infrastructure utility, such as electricity, transportation, water, or telecommunications, should be available to everyone. (15) Universal service policies are typically rationalized in three ways. (16) First, externalities might make it economically efficient to subsidize prices for those who cannot afford the service at cost. (17) Positive externalities imply that the total benefits from providing service to an individual exceed the benefits to an individual subscriber. If the private marginal cost of service exceeds the private marginal benefit by less than the amount of the external benefit, then some individuals will not subscribe even though the social benefit of serving them exceeds their cost of service.

   Second, some services might be "merit goods"--goods and services that society believes everyone should have, regardless of whether they are willing to pay for those services. (18) A policy decision that certain goods and services ought to be subsidized may come from a belief that everyone should achieve a certain minimum standard of living or from a concern that individuals are unable to accurately assess the private benefits of consuming these services. If society is more concerned about consumption of the merit goods than the overall welfare of poor people, subsidies for these goods might be preferable to direct monetary transfers because people may choose to spend cash transfers on something other than the service society wants to encourage.

   Finally, political factors or regional development goals may induce governments to transfer resources to rural or low-income constituents. (19) In countries with large rural populations, in which rural areas are generally disproportionately represented, policymakers may face a political incentive to ensure that their rural constituents have access to the same services as do urbanites.

   1. Rationale for Universal Service in Telecommunications

      The typical economics argument defending universal telecommunications service is that network externalities result in a suboptimal investment. "Network externalities" occur when the benefits that a new consumer accrues from connecting (the private benefits) are less than the total benefits to society; when an additional person connects to the network, all other subscribers benefit by being able to communicate with the new subscriber. Therefore, individuals may not face a strong enough incentive to subscribe, thus requiring subsidies to induce socially optimal subscription.

      This argument, however, is incomplete and therefore misleading, (20) First, even if the benefits to the new subscriber are less than the total benefits, the private benefit may still exceed the cost for nearly all subscribers, in which case a general subsidy of service is mostly wasted. Second, because services become more valuable when more people are connected, the firm providing access captures some of the benefits from network externalities. Consequently, although network externalities are external to the individual, they are not necessarily external to firms providing the service, potentially removing the need for subsidies. In other words, network externalities by themselves do not necessarily imply that without subsidies too few people would subscribe to telecommunications services. Third, all subscribers receive an external benefit from subscriptions by others, implying that each person should subsidize the service of the other. Consequently, on average, the subsidy a subscriber receives to take service ought to be roughly equal to the amount of the subsidy that subscriber should be willing to pay to induce others to subscribe.

      Even if one disregards the point that the theoretical justification for subsidies is weak and believes that subsidies are nevertheless required, the manner in which we pay for those subsidies is inefficient. In particular, we pay for universal service subsidies by taxing other telecommunications services via cross-subsidies. Economics research provides convincing empirical evidence that the case for extensive cross-subsidization in telecommunications is weak, as discussed below.

   2. Tax and Distribution Schemes are Inefficient

      Cross-subsidies in telecommunications are inefficient and costly to society in large part because they tax usage, which has a relatively high price elasticity of demand (e.g., long distance and mobile), in order to subsidize access, which has a very low price elasticity of demand. In other words, our system of funding universal service taxes those services for which people are highly price-sensitive, causing them to change their behavior and use those services less than they otherwise would. Jerry Hausman estimated that each dollar raised in taxes on wireless services costs the economy between $0.72 and $1.14. (21) Jerry Ellig estimated that taxes on wireless services and interstate long-distance services to support universal service reduced economic welfare in 2002--when subsidies were lower than they are now--by nearly $2 billion annually. (22)

      At the same time, those taxes are used to subsidize access, which people are likely to purchase even when prices change. Gregory Rosston and...