Regulated Pricing For Pstn Termination On Non-dominant Carriers

Regulated Pricing for PSTN Termination on NonDominant Carriers

by

Joshua S. Gans University of Melbourne

12th December 1999

Executive Summary This paper considers the issues involved in the regulation of termination services to non-dominant networks. These issues arise in an environment where one or more dominant networks (i.e., those with the greatest market shares) have regulated termination charges. In the absence of regulation, non-dominant networks set: •

termination charges above the marginal cost of providing those services regardless of the regulated termination charge on the dominant network.

•

higher termination charges to regulated dominant networks than they set to each other.

•

higher termination charges, the lower the regulated termination charge of dominant networks.

Given this, the case for regulation of non-dominant networks depends on the strength of substitution between services offered in the industry. If networks’ customer bases are distinct (say because of differing technologies or coverage areas), then regulating all networks termination charges is unambiguously welfare improving. Specifically, regulating non-dominant networks termination charges will lower call prices by increase competition between them. On the other hand, for networks whose services are closer substitutes, the case for regulation depends upon the market share of the non-dominant carrier. When a nondominant network has a sizeable market share, regulation of its termination charge to the dominant network may reduce call prices overall. However, if a non-dominant network has a very low market share relative to the dominant network, regulating its termination charge may increase call prices. This suggests that termination services of non-dominant networks should be regulated on similar terms to those of dominant networks; particularly as the latter become more established. This will result in more competitive call pricing.

Contents

Page

1

Background .............................................................................1

2

Economic Characteristics of Termination .........................3

3

Unregulated Non-Dominant Networks ............................5

4

Regulated Pricing...................................................................7

5

4.1

The Case for Regulation .................................................7

4.2

Benchmark Pricing for Termination...............................8

4.3

Pricing Options Given Dominant Firm Regulation.......9

Conclusion ............................................................................ 11

References......................................................................................... 12

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Section 1

1

Background

Background

In 1999, the Australian Competition and Consumer Commission (ACCC) accepted Telstra’s undertaking to supply domestic PSTN originating and terminating services at prices that reflected the Total Service Long Run Incremental Costs (TSLRIC) of supplying the service. Being the historical monopoly, Telstra had by far the largest network and broadest customer base and was likely to continue to have this in the short to medium term. Consequently, it would be reasonable to characterise Telstra as the dominant network in the market. Nonetheless, with increasing network competition, other networks do and are likely to have sizeable customer bases in the prevision of local call services. This has raised questions as to whether their wholesale services should be subject to regulation on a similar basis as the dominant network. One argument put against regulation is that with network competition, PSTN services will be subject to competition and hence, there is no need for price regulation. However, this argument is incomplete. While network competition may lower prices to end users, it is unclear why such competition would be effective in lowering the price of access to a customer when that customer has already chosen to subscribe to a particular network. Being able to increase interconnect charges in this context will raise a rival’s costs of serving its own customers and consequently, potentially diminish competition. To see this, it is useful to begin by describing the role of termination. A terminating service is essentially the carriage of a call from a point of interconnection between two networks to the consumer for whom the call is intended. Thus, the terminating network bears the trunk and connection costs from that point of interconnect to the consumer while the originating network bears the costs from the caller to the point of interconnect. Under the caller-pays principle of charging, however, the caller is charged for both the originating and terminating services. The originating network collects the call charge and that network and the terminating network must, in turn, transact for the terminating service. It is the price that the terminating network charges the originating one that is the focus of the present paper. Not surprisingly, as that price becomes part of the marginal cost of the call service, it also an important factor in the overall price of the call.

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Section 1

Background

This report focuses on termination charges that arise for calls made from one fixed line network to another fixed line network. Each fixed line network will have an associated termination charge for calls and the originating network pays this charge. The originating network then recovers this charge together with its own costs by charging the calling party who is a subscriber to their network. The setting of these terminating charges raises a number of regulatory concerns. First, if one party wishes to call another specific person who is connected to a different fixed network, then the terminating network has an effective monopoly on incoming calls for that particular customer. The network that has attracted a customer, as a subscriber for outgoing calls, effectively ‘owns’ the termination revenues associated with that customer. The ability to exercise market power over termination charges might give rise to socially inefficient outcomes that are not in the long-term interest of network customers. Secondly, a dominant fixed line network owner might be able to use termination charges to limit the growth of competitors. Consumers value their ability to ring any customer connected to a fixed line network . By setting a high termination charges a dominant network might be able to undermine the ability of its competitors to attract customers. At the same time, asymmetric regulation that is limited to a dominant carrier might not lead to socially optimal outcomes. Given this, the purpose of this paper is to evaluate the case for regulating access to PSTN terminating services provided by nondominant networks. In addition, the paper will also consider whether such interconnect charges should be symmetric across networks. That is, if Telstra’s termination is regulated on the basis of TSLRIC pricing, should the same regulated price apply to other networks? The remainder of this paper is organised as follows. In Section 2, the economic forces that underlie the setting of termination charges are described in more detail. Section 3 then considers what outcomes arise when non-dominant networks are left unregulated while the dominant network is regulated. Section 4 then reviews the case for regulation of non-dominant networks in this light and proposes alternative pricing rules for termination on those networks. A final section concludes.

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Section 2

2

Economic Characteristics of Termination

Economic Characteristics of Termination

It is useful to begin by summarising the economic factors that determine how fixed network owners will set termination charges. There are five key characteristics of terminating services that drive their value and use. These are: (1) market power over access to a consumer; (2) consumer ignorance regarding the network called; (3) horizontal separation; (4) vertical separation; and (5) tariff-mediated network externalities. These are summarised briefly below.1 Telecommunications involves a two-way network, where the party that makes and pays for the call is not the same as the party that chooses which company will terminate the call. Consequently, if one customer wants to contact another specific customer then they have no alternative but to buy terminating services from the network who has the B-party as a subscriber. This means that all fixed line networks have some degree of market power when setting termination charges. This market power over call termination will be exacerbated if the A-party cannot easily identify which network is terminating their call. In such a situation, the A-party’s decisions over whether or not to make the call, and over the length of the call, will be based on an average call price relating to all networks. This customer ignorance means that networks have an increased ability to raise termination prices without facing an adverse customer reaction. Customer ignorance means creates a horizontal externality between the potential terminating networks. One network can raise its termination price and this only affects the average call price form the consumer's perspective. All terminating networks share any reduction in call numbers or length. This provides each network with an incentive to inflate its termination charges as it shares any customer response with its competitors. This is referred to as the problem of horizontal separation.

1

A more detailed discussion is found in the companion paper, Gans (1999). See also Gans and King (1999a).

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Section 2

Economic Characteristics of Termination

An end-to-end PSTN service is constructed by using inputs from one network (termination) that is purchased by another network (the originating network) and sold to the consumer. This vertical separation can lead to well-known problems of double marginalisation where call prices can exceed the integrated monopoly price. Finally, differential termination charges can create network externalities between PSTN customers. If it is less expensive to make intra-network calls rather than inter-network calls, and all consumers potentially make calls to any other consumers, then it is cheaper for all consumers if they all belong to a single network. A carrier might be able to artificially create these externalities, particularly if it is dominant. For example, suppose one carrier initially has almost all customers. Entry by competing carriers will be unlikely if the dominant carrier sets very high termination charges for these new entrants. No customer will join the entrant if this means that they face a high er expected price when they ring other customers. Given these characteristics, termination charges are an issue for all carriers, not just for a dominant carrier. Termination to a particular customer is a ‘bottleneck’ to reach that customer. Because the cu stomer receiving the call does not pay for incoming calls, termination charges will not be fully constrained by competition, even for small PSTN networks. This is reflected in the issue of customer ignorance and horizontal separation. In this sense, call termination differs from a standard access problem. Instead of having a single ‘essential’ facility that requires regulated access, termination creates competitive problems even with relatively small networks or where networks are of comparable size. In fact, some problems created by termination are exacerbated when there are more competing networks. As a result, it will often be expected that regulation of termination charges would apply to all carriers, not just to say a single dominant carrier.

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Section 3

3

Unregulated Non-Dominant Networks

Unregulated Non-Dominant Networks

It is useful to consider the need for regulation of non-dominant networks by examining what is likely to happen in the absence of such regulation. It will be assumed throughout this discussion that a single dominant network has reg ulated termination charges.2 In this situation of asymmetric regulation, all other things being equal, the regulated network faces higher costs than the unregulated one. This is because the termination charge it pays to other networks is higher than the charge they pay to the regulated network and to each other. If, because of consumer ignorance, networks charge the same price for on and off network calls, then the regulated network will face high relative costs than unregulated networks. Hence, it will find it more difficult to compete aggressively on price. The end result of this is to relieve competitive pressure on other networks. Consequently, the lower regulated charge will not be fully passed on to consumers. In addition, the unregulated networks are likely to raise termination charges to the regulated network and exacerbate this effect. This result follows from a number of effects. First, if networks sell highly differentiated products, lowering one network’s termination charges will flow through into the prices charged by other networks. The double marginalisation effect is reduced and average call prices fall. But at the same time, non-dominant networks have an incentive to partially undermine this flow through and seize some of the benefits for themselves by raising their termination charges. Second, as networks become closer substitutes, the reduction in termination charges will tend to alter the way each network, including the dominant carrier, sets its prices and attracts subscribers. With uniform prices, reducing a dominant firm’s termination prices tends to lower non-dominant firms’ prices, as noted above, and this leads to a competitive response from the dominant carrier. But this is partially offset by the reduction in the dominant network’s termination revenues. Carriers use these revenues to compete more vigorously for subscribers, and reducing these for one carrier reduces that network’s

2

The formal statement of these results can be found in Gans and King (1999b).

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Section 3

Unregulated Non-Dominant Networks

competitive position. Because the regulated carrier is dominant, the overall effect is lower call prices. What termination charges will unregulated networks set? Not surprisingly, given their market power, unregulated termination charges will be set above the marginal cost of providing those services regardless of the regulated termination charge on the dominant network. Such pricing of termination charges will lead to prices for calls that strictly exceed the monopoly price. This follows directly from the effects of vertical and horizontal separation. Greater network competition may encourage greater retail price competition. However, it will also exacerbate incentives to raise termination charges. Indeed, if networks sell differentiated products, both termination charges and call prices will tend to rise if there are more relatively small networks. Once again this is a consequence of consumer ignorance and horizontal separation. A small network has a relatively small effect on the average price of calls and so has a greater incentive to raise termination charges relative to a larger network. Overall, a system with many small networks will have higher average termination charges than a system with fewer large networks.

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Section 4

4

Regulated Pricing

Regulated Pricing

The previous section argues that simply regulating a dominant network is unlikely to result in socially optimal outcomes. A key question, however, is whether further regulation will improve upon the dominant network regulated outcome? In this section, the case for regulating non-dominant networks is considered and possible pricing options are proposed.

4.1

The Case for Regulation

The first key issue is whether non-dominant networks’ termination charges should be regulated at all. When those networks offer products that are highly differentiated or operate in different markets, 3 then the need for regulation is clear. In this case, regulating all networks termination charges is unambiguously welfare improving. Such regulation simply eliminates the anti-competitive effects of horizontal and vertical separation. That is, unregulated termination charges were set above marginal cost. This leads to call prices above their monopoly levels, reducing both consumer and producer surplus. When only a single dominant network is regulated, this problem is alleviated to some degree but does not necessarily lead to lower call prices for consumers. Instead, it has the main effect of helping competitors rather than helping competition. However, when each networks’ charge is reduced, this has a positive external effect on other producers and, by lowering their costs, allows a flow through to consumers in terms of lower call prices. If networks sell products that are closer substitutes then the case for regulating non-dominant networks’ termination charges is more difficult. One has to distinguish between the termination charges nondominant networks set for each other and the charge they would set for termination of calls from the dominant (regulated) network. Certainly, between two non-dominant networks, a regulated 3

This would apply for networks operating from different modes (e.g., fixed line and wireless) but are otherwise interconnected.

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Section 4

Regulated Pricing

termination charge can increase competition and lead to lower prices. 4 Regulating non-dominant networks termination charges will lower call prices by increasing competition between them. The reason call prices are reduced is that, in the absence of regulation, termination charges are set too high – once again due to the problems of horizontal and vertical separation – and competition between networks only partly alleviates the consequent double marginalisation effect. Regulating non-dominant networks in this way will reduce their profits but only to the extent that they were earning monopoly rents. It will, therefore, have the effect of securing lower call prices without the additional costs of over-investment in duplicate networks.

4.2

Benchmark Pricing for Termination

Before considering the effect of alternative regulated pricing rules it is important to consider what level the regulated termination charges should be set – regardless of whether the network is dominant or not. Optimal termination prices would be set below the marginal cost of termination. If regulated termination charges are set at marginal termination cost, with highly differentiated products, call prices will be at their monopoly level. The social goal should be to reduce them to competitive levels; consistent say with average cost pricing.5 A simple way of achieving this would be to institute a ‘bill and keep’ system of termination pricing. In this system, termination charges are, in fact, set at zero. It is well known that asymmetries in network market shares would not mean that this caused an undue burden to small or larger networks. Instead, it is likely that flows to and from networks will be roughly symmetric regardless of size. 6 This is because, from a large network’s perspective, it has more customers who could make calls off net but there are fewer consumers who could receive th em. As such, the savings they would realise by not having to pay another network for termination would offset any losses networks would incur.

4

See Armstrong (1998), Laffont, Rey and Tirole (1998a) and Carter and Wright (1999).

5

This is sometimes referred to as TSLRIC in telecommunications regulation. However, note here that this is the goal for call prices. The prices for the termination service itself should lie below marginal (and hence, average) cost to achieve this. In this respect, the benchmarks of TSLRIC are far too relaxed a standard for termination or interconnect charges. Only when regulated prices and call prices are a two part tariff could this perhaps be used (see Gans and Williams, 1999b). 6

See Williams (1995).

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Section 4

4.3

Regulated Pricing

Pricing Options Given Dominant Firm Regulation

The previous sub-section described the socially optimal price for termination for all networks. However, in the present environment, the dominant carrier has a regulated termination charge above marginal termination cost. Given this, what is the effect of reductions in the termination charges for non-dominant networks? As discussed above, when two networks have services that are not close substitutes, regulation of termination is unambiguously desirable in order to reduce the cost of calls to a given network. This is because that network has market power over termination that is not tempered by network competition. This suggests that the regulated price should be as low as possible – certainly no higher than the marginal cost of termination.7 On the other hand, when the dominant and non-dominant networks have services that are close substitutes, the effect of regulating the non-dominant carrier is ambiguous. On the one hand, regulation will lower the overall costs of the dominant network and enable it to profitably lower call prices. However, regulation will reduce the non-dominant network’s benefits from attracting customers away from the dominant network. Without regulation, if a customer switched to its network, it would receive the termination revenues from calls made to that customer. However, with regulation, those revenues are reduced and hence, so are the potential benefits from attracting marginal customers. This will tend to put upward pressure on call prices. Nonetheless, when a non-dominant network has a sizeable market share, regulation of their termination charge to the dominant network may reduce call prices overall. In this situation, regulating its termination charge will put upward pressure on its call price but it will put downward pressure on the dominant network’s call prices. This may lower prices on average. In contrast, if a non-dominant network has a very low market share relative to the dominant network, regulating their termination charge to the dominant network may increase call prices. This is because the dominant network may actually

7

See Gans (1999) and Gans and King (1999a) for a complete discussion of pricing options for this case.

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Section 4

Regulated Pricing

raise its call price in response to the higher price by the non-dominant network. This suggests that while a network need not have its termination charge regulated immediately upon entry, as it becomes more established it should be subject to regulation. The level of ‘establishment’ of a network could be determined with respect to factors such as market share, stability of customer base and length of time in the market. Nonetheless, new entrants would receive the benefits of regulated termination charges for calls made from their network to other established carriers. If a non-dominant carrier is to be regulated, the next key question is whether its termination charge should be above, equal to, or below that of the dominant network. If it were above the termination charge of the dominant network, this would soften the dominant network’s response to its price competition and, as noted above, is likely to lead to higher call prices than if it were more tightly regulated. On the other hand, if its termination charge were below that of the dominant carrier, the non-dominant carrier would be at a cost disadvantage relative to the dominant carrier. While this may lower call prices, this could also send an undesirable signal to new entrants that they will face harsh competitive conditions if they were to become established. Consequently, long-term competition in the industry may be compromised. This suggests that symmetric regulation of dominant and nondominant networks is likely to result in a (second8) best outcome. This means that termination charges in the industry would be the same regardless of the particular cost characteristics of the carrier involved. This solution retains the benefits of competitive neutrality as neither the dominant or non-dominant networks are at a cost disadvantage relative to the other. This means that consumers will be able to select networks on non-price terms that are distortion free and also that the incentives of incumbents to upgrade infrastructure and new entrants to enter with cost effective technologies are balanced. This balance is precisely the outcome that a competitive neutral environment should engender.

8

The outcome is second best because the dominant network’s termination charge is regulated above marginal termination cost. Hence it is not possible to achieve socially optimal call prices. Nonetheless, given this commitment, a regulated price equal to other regulated termination charges will be the optimal solution for that environment.

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Section 5

5

Conclusion

Conclusion

This paper has examined the principles and issues behind the setting of termination charges for non-dominant networks. It has found that there is a case for regulating non-dominant networks and that such regulation is likely to lead to lower call prices for services that use PSTN termination; particular, as networks become more established. It should be noted that such regulation may diminish incentives to enter the industry. This is because when the dominant network is regulated while an entrant is left unregulated, the entrant faces cost advantages that will lead to non-competitive call prices in the long-run. In other words, an unregulated entrant is able to enter without dissipating monopoly profits. Consequently, entry does not produce its socially desired outcome of more competition and lower prices in an industry. Instead it distorts investment toward new entrants and away from the dominant carrier. This may result in excessive investment in duplicate facilities and consequently social losses. In this respect, it should be remembered the facilitating entry is should only be a goal of competition policy where it is consistent with the overall call of more efficient pricing in the industry. When regulation of dominant and non-dominant networks is asymmetric, the usual link between entry and lower prices is potentially broken. Hence, it is more appropriate for regulators to focus on the pricing that will result from regulation rather than intermediate considerations such as the number of competitors and the degree of concentration.

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Section 0

References

References Armstrong, M. (1998), “Network Interconnection in Telecommunications,” Economic Journal, 108 (May), pp.545-564. Carter, M. and J. Wright (1999), “Interconnection in Network Industries,” Review of Industrial Organization, 14 (1), pp.1-25. Gans, J.S. (1998), “Regulating Private Infrastructure Investment: Optimal Pricing of Access to Essential Facilities,” Working Paper, No.98-13, Melbourne Business School. Gans, J.S. (1999), “An Evaluation of Regulatory Pricing Options for Mobile Termination Services,” mimeo., Melbourne Business School. Gans, J.S. and S.P. King (1999a), “Termination Charges for Mobile Phone Networks: Competitive Analysis and Regulatory Options,” Working Paper, Melbourne Business School, University of Melbourne (www.mbs.unimelb.edu.au/jgans/research.htm). Gans, J.S. and S.P. King (1999b), “Regulation of Termination Charges for NonDominant Networks,” Working Paper, Melbourne Business School, (www.mbs.unimelb.edu.au/jgans/research.htm).

Gans, J.S. and P.L. Williams (1999a), “Access Regulation and the Timing of Infrastructure Investment,” Economic Record , 79 (229), pp.127-138. Gans, J.S. and P.L. Williams (1999b), “Efficient Investment Pricing Rules and Access Regulation,” Australian Business Law Review, 27 (4), pp.267279. King, S.P. and R. Maddock (1996), Unlocking the Infrastructure, Sydney: Allen & Unwin. Laffont, J-J., P. Rey and J. Tirole (1998a), “Network Competition I: Overview and Nondiscriminatory Pricing,” RAND Journal of Economics, 29 (1), pp.1-37. Laffont, J-J., P. Rey and J. Tirole (1998b), “Network Competition II: Price Discrimination,” RAND Journal of Economics, 29 (1), pp.38-56. Williams, P. (1995), “Local Network Competition: The Implications of Symmetry,” Annual Industry Economics Conference Volume, Bureau of Industry Economics: Melbourne.

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