ECO 235 Economics of Telecommunication

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ECO 235 Economics of Telecommunication

• Dr. David Loomis
• Department of Economics
• Illinois State University

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What do we do about Monopolies?

• Uncontrolled monopolies have higher prices and
  less output than perfect competition
• They have productive inefficiencies and
  allocative inefficiencies
• Therefore we need government intervention in the
  form of regulation

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Types of Regulation

• Antitrust Policy - seeks to protect consumers
  from anticompetitive behavior through the
  judicial system
• Direct Regulation or Economic Regulation -
  controls pricing and/or output due to the belief
  that the industry is inherently

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Types of Regulation

• Social Regulation - controls undesirable
  consequences of firm behavior to obtain various
  social goods such as clean air and water, safe
  products and workplaces

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Regulating Telecommunications

• Rate-of-Return Regulation

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Rate -of-Return Regulation (ROR)

• Regulators constrain total earnings and revenues
  (formula)
• They determine a fair rate of return a "used and
  useful" rate base and "just and reasonable" rates

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Reasons against ROR

• Gold-plating - "pad the rate base
• Non-cost-based pricing of services causes
  distorted economic signals
• Hinders innovation
• Very Costly - 1 billion annually

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Telecommunication Technology
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Network Technology - Why Switching?

• Suppose 4 people want to call each other. The
  number of lines needed would be 6.

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Efficiencies of a Switch
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Public Network Terminology
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Public Network Terminology
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Cost Characteristics of the Public Switched
Network

• Production facilities have well-defined
  capacities cost of operation is independent of
  usage of those facilities. Variable costs are
  small.
• Network parts are used in joint production of
  several products and services.
• Marginal cost of making a local (unmeasured) call
  is very small less than a penny.
• Traditionally considered to be a NATURAL monopoly

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Natural Monopoly

• When one firm can produce all the market output
  more cheaply than 2 or more firms
• Economies of Scale
• Economies of Scope

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Marginal Cost Pricing?

• In telecom, there are significant economies of
  large-scale production
• In an industry with economies of scale, the LRAC
  curve is downward sloping
• If average cost is declining, then the MC is
  below AC
• if prices were set equal to marginal cost, the
  firms would go bankrupt

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Incentive Problem

• assume regulator prices at PATC and firm earns
  no economic profit.
• No incentive to cut costs - increasing costs lead
  to increasing prices

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Demand Characteristics of the Public Switched
Network

• Individual demand can be random, but market
  demand had regular daily and weekly patterns.
  Highest in late morning and mid-afternoon.
• Calls to one location can't be substituted for
  calls to another.

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Positive network externality

• the value of the network to a given user
  increases with the number of users who have
  access to it.
• Definition - Positive Externality - Result of an
  activity that causes incidental benefits to
  others with no compensating compensation provided
  to or paid by those who generate the externality).

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Benefits of Interconnection

• Because of network externalities, interconnecting
  two separate networks increases the value of
  both.
• Example, early days of e-mail, MCI mail, and
  CompuServe customers could only send messages to
  other subscribers of that network. Internet's
  interconnectivity allowed all mail systems to
  talk to each other.

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Public policy of Interconnection

• "A dominant theme in telecommunication policy is
  defining the rights and responsibilities for the
  interconnection of networks and the appropriate
  payments for interconnection under a wide variety
  of different conditions. Brock p. 62

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Back to Demand Characteristics

• Demand for network access is inelastic
• Local calling is inelastic
• LD calls more elastic but still less than 1.
• Residential demand is more elastic than business
  customers' demand.

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Definition of elasticity of demand

• change in quantity demanded divided by change
  in price.
• If gt1, elastic.
• If lt1, inelastic
• If 1, unit elastic.
• Increase in price causes TR to increase if
  inelastic, decrease if elastic and stay the same
  if unit elastic.

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Calling Party Pays

• In landline network, traditionally the calling
  party pays for the whole call and the called
  party pays nothing even though it receives a
  benefit.
• In wireless, you pay for both sending a receiving
  calls.
• 800/888 numbers - called party pays

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Revenue Sharing

• Revenue sharing arrangements for LD call -
  customer paid single charge to originating telco
  and revenue was divided among the companies
  participating in the call.

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Market Structure Today

• Key to understanding market structure is LATAs
• LATA - Local Access and Transport areas -
  created at the divestiture of ATT, these are
  areas that the RBOCs are precluded from operating
  outside of. (map of IL LATAs)

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Types of Calls

• Local calls - defined by company regulated by
  state commission
• Intra-LATA calls - "toll" calls - calls that
  originate and terminate within the same LATA.
  Usually defaults to the local telephone company.
  Some states allow competition. Regulated by state
  regulatory commissions.
• InterLATA intrastate calls - calls that originate
  and terminate in different LATAs but are still
  within the same state. Regulated by state
  regulatory commissions.

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Types of Calls

• InterLATA interstate calls - calls that originate
  and terminate in different LATAs and states.
  Regulated by the FCC.
• Local telcos provide access to the local network
  to IXCs for interLATA calls. This is called
  "switched access". Access for intrastate switched
  access is regulated by state interstate is
  regulated by FCC.

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Company types Local Exchange Companies (LECs)

• 7 RBOCS - NYNEX Bell Atlantic, Bell South, SBC
  (formerly Southwestern Bell), Ameritech, US West,
  Pacific Telesis.
• In 1982, 25 Bell Operating companies served 81
  of the phone lines but only 41 of the assigned
  geographic territory in the U.S. (Brock p. 65)
• Large "independents" - GTE, Sprint Local
  (Centel), SNET, thousands of small independents
• A total of 1,432 independent telcos served the
  remaining 59 of the territory but provided only
  19 of the telephone lines. (Brock p. 65)

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Company types - Interexchange carriers (IXCs)

• Traditional Long Distance Carriers - ATT
  MCI/Worldcom, Sprint, Qwest, and thousands of
  resellers.

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2001 Market Share of IXCs
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Company types

• CAPs Competitive Access Providers
• ALTs Alternate Local Transport companies
• CLECs Competitive Local Exchange Companies
• Started by supplying high-speed data and voice in
  local market to large business
• MFS, Teleport, Eastern Telelogic

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