Telecommunications, Media, and Technology Economics

Hot Topics in Wireline Economics

New technologies and innovative service providers are challenging the provision of telephone service over fixed lines. Estimates are that by the year 2009 half of all phone calls will be made on mobile phones. Emerging technologies, such as Voice over Internet Protocol (VoIP) and Internet broadband technologies (that have the ability to carry VoIP), such as Wi-Fi, WiMAX, ADSL, and Bluetooth further challenge the incumbents’ market positions. Moreover, regulatory changes and technological advances may create new demand for telecommunications services. Technological advances also exert serious downward pressure on telecommunication prices, directly affecting a carrier’s profit margin. In order to counterbalance the effects of intermodal competition and price competition, fixed-line operators must review their strategies and make difficult decisions about how to effectively compete in this new environment. Fixed-mobile convergence, triple play (video, voice, and data) and quadruple play (landline voice, mobile voice, data, and video) offer fixed-line operators an opportunity to not only offset the impact of mobile substitution but also generate incremental revenues.

Below is a list of current wireline issues that I most frequently encounter, not only in the US but abroad. Please check my blog for additional wireline issues.

Wireline-Wireless Substitution and Intermodal Competition

Many countries report double-digit growth in mobile subscribers and mobile penetration rates as high as 100 percent or more. Conversely, the value of the traditional wireline business is deteriorating as consumers are dropping their fixed lines for mobile services and other newer technologies such as voice over Internet Protocol (VoIP). Furthermore, other intermodal services, such as Wi-Fi, WiMAX, and VoIP increasingly gain competitive momentum. This trend raises a number of important questions that directly affect how we analyze competition in the wireline industry, address anticompetitive complaints, and assess the need (or lack thereof) for regulatory intervention.

Triple and Quadruple Plays and Convergence

What I call “the race to triple and quadruple plays” is a strong industry trend in fixed (wireline) telecommunications. To offset competition from intermodal players, wireless in particular, fixed communications operators seek to bundle their traditional wireline services with Internet (data) and video (TV programming). For instance, Verizon offers customers a portfolio of wireline voice, wireless voice, wireline data (DSL), wireless data, wireline video (FIOS), and wireless video (CastMobile TV). Similarly, AT&T has invested heavily in a bundled/portfolio strategy. Other players, however, have adopted niche strategies. For instance, T‑Mobile and Sprint Nextel thus far have refrained from entering into fixed voice (in fact, Sprint Nextel spun off its fixed operations a few years back which has become Embarq) and do not offer fixed data or fixed video. Which strategy will ultimately prevail remains to be seen. However, triple and quadruple plays have become a strong strategy, not only in the US but also in other countries.

Underlying triple and quadruple plays is the increasing trend of convergence. The phenomenon of convergence in the telecommunications industry has many definitions. This is not surprising since it signifies a number of different developments in that industry—some technological, some market related, and others regulatory. It is instructive, therefore, to consider definitions of convergence that have emerged from various perspectives. According to the US Federal Communications Commission (FCC), the agency with federal regulatory oversight of the telecommunications industry in the US, convergence means that “providers of communication systems can deliver products and services that compete with the products and services now delivered by other networks.” As an example, the FCC cites a cable company that provides local phone service or a local phone company that provides video services.

The European Commission (EC) defines convergence as “the ability of different network platforms to carry essentially similar kinds of services, or the coming together of consumer devices such as the telephone, television and personal computer.” In this more elaborate definition, reference is made to convergence at different levels. In particular, it raises a more nuanced issue—that convergence can mean both intermodal competition (e.g., competition among alternative delivery platforms for communications services, such as fixed-line networks, mobile networks, cable operators, satellite operators, electric power companies, etc.) and integration.

Convergence is sometimes defined with reference to specific contexts, such as the convergence of (1) networks, (2) industries or markets, (3) products or services, (4) firms, and (5) technologies. Examples of each are telecommunications, data, and broadcasting (networks); communications, information, and entertainment (industries); interactive television, video-enabled personal computers, and voice over the Internet protocol (“VoIP”) telephony (products/services); joint ventures or strategic alliances among computing, telecommunications, and broadcasting companies (firms); and fixed and mobile telephony (technologies).

A form of technological convergence that has attracted substantial attention in recent years is that between fixed and mobile telecommunications (often called fixed-mobile convergence or “FMC”). Even this form of convergence occurs at three levels: (1) at the network level (one Internet protocol-based, heterogeneous network that provides voice, data, and video services—the “triple play”; (2) at the service level (one number and one bill, i.e., one-stop shopping for telecommunications services and content); and (3) at the terminal level (single, integrated handset for receiving all applications/services).

In all of this, two facts stand out. First, convergence is both integration (of systems, markets, and services) and competition (among technological platforms that can deliver end-to-end service, i.e., from the source of applications or content to the end user). The first trend in convergence enables seamless consumption by end users of essentially complementary components. The second trend provides significant (and even real-time) choice to end users in how, and from whom, they receive services and content. End-to-end intermodal competition eliminates many of the access and essential facility problems traditionally encountered in network industries.

Second, technological competition is both a source and a response to convergence. For example, vigorous competition between fixed and mobile networks is often credited with having prompted FMC. In addition, in recent years, the two technological platforms to have emerged as the principal standards in the provision of high-speed Internet access are asymmetric digital subscriber line (ADSL) and cable modem service. As is well known, the ability of both ADSL and cable to offer converged services (at least voice and data for now) has spurred competition among telecommunications and cable companies.

Relevant Market Definition

Whether the decision is about allowing two telecommunications firms to merge, imposing or lifting a regulatory burden on incumbent carriers, or reconciling claims of anticompetitive behavior in telecommunications litigation, any economic analysis used in the decision-making process must incorporate a comprehensive awareness of the level of competition in the designated market. The reason for this is simple: If the level of competition is sufficiently high, then a merger is unlikely to harm competition, ex ante regulation is superfluous, and anticompetitive behavior is economically irrational, thus, allegations of such behavior are likely wrong.

To illustrate this point, consider the following examples. First, in 2004 and 2005, the US telecommunications industry experienced a number of incumbent-carrier consolidations—the most significant ones were the mergers between Verizon and MCI (now Verizon) and SBC and AT&T (now AT&T). While opponents of these mergers claimed that these carriers were trying to rebuild “Ma Bell,” the old AT&T monopoly before its breakup in 1984, federal regulators approved these mergers (albeit with consent decrees and conditions). The level of marketplace competition before and after the mergers was a crucial factor in obtaining approval. Specifically, among other reasons, regulators found that in most markets where the parties were competitors, significant competition from third parties as well as the presence of third-party facilities, and in retail voice markets, in particular, growing competition from cable voice over Internet Protocol (VoIP) and wireless providers, was enough to ensure that these companies would not gain market power through their mergers.

Second, regulators in a number of countries are currently considering motions by incumbent local exchange carriers (ILECs) requesting reclassification from “dominant” to “competitive” status, which would reduce their regulatory burden and provide more pricing flexibility. In reviewing these requests, regulators must decide whether granting these motions would pose any competitive harm and if they are in the public’s best interest. For instance, there is significant debate whether ILECs have market power in the provision of special access lines—local wholesale transport facilities that are used to provide high capacity services to businesses and other providers. Competitive local exchange carriers (CLECs) argue (and ILECs deny) that continued regulation is necessary as ILECs continue to have market power in these facilities and that absent regulation these services would be priced in a way so as to foreclose competitive entry into local business service markets. The answers to these questions again should be based on the level of competition, potential competition, and entry conditions in the marketplace. ILECs have traditionally been regulated because of their market power, which could make it impossible for new entrants to succeed in the same market. Therefore, if the economic analysis reveals sufficiently competitive market conditions to alleviate concerns of market power, then regulation becomes unnecessary, and the ILECs’ motions for reclassification should be granted.

An analysis of competition is also crucial in the review of telecommunications litigation. As a third example, consider claims of predatory pricing. Frequently raised in antitrust court cases, predatory pricing is the practice of providing services at prices low enough to drive competitors out of a market in order to monopolize the market. More common in Asian countries than elsewhere, predatory pricing claims have frequently been launched against telecommunications carriers, particularly in the deployment of new services. According to traditional theories of predation, predatory pricing comes in two stages. In stage one, the predator prices its services below some measure of economic cost (variable or incremental cost) with the intention of driving a competitor (the prey) out of the market. Predation is only a profit-maximizing strategy if once the prey has exited the market, the predator can enjoy market power, sustain supracompetitive prices, and recoup the losses from stage one. This stage is often referred to as the second stage, or the post-predation stage, of predatory pricing. If upon the prey’s exit there remain a sufficient number of players or new players can easily enter the market, the predation has failed as the predator was not able to acquire market power even after pricing below cost. Once again, the economic review of predatory pricing claims depends crucially on the level of competition, potential competition, and entry conditions.

Many other examples of telecommunications regulation and litigation highlight why a review of the competitive conditions in the marketplace is so critical. While this is not a new phenomenon, the question of how to analyze competition in today's telecommunications industry is a fiercely debated issue. Most of the debate focuses on the question of who competes with whom. Do wireline carriers compete with wireless carriers? Is there competition between wireline carriers and cable VoIP providers? Do cellular and other wireless technology providers, such as Wi-Fi and WiMAX compete with wireline carriers? Some analysts argue that wireline compete with each other regardless of the technology, while others argue that wireline competes only with wireline, wireless with wireless, and VoIP, Wi-Fi, and WiMAX are only emerging services with a limited competitive impact.

Reclassification

Given the increased pressure from intermodal competition, many US wireline carriers have petitioned federal and state regulators to have their traditional regulatory burden lifted in order to compete more effectively with today’s market realities. While consumer advocates, cable providers, and competitive local exchange carriers typically object to incumbent local exchange carriers’ reclassification requests, the debate is about market definition (see above) and the competitive impact of intermodal competitors. Particularly, opponents claim that reclassification increases or leads to market power for ILECs.

Fixed-line High-cost Funding

High-cost funding serves many functions, however, it is primarily used to ensure nationwide network coverage and to provide subsidized phone service to low-income and rural customers living in high-cost areas. High-cost funding has been a debated topic for many years as parties question the size of the fund, the method used to calculate it, and who should be eligible to obtain funding and for what service, and so on.

Broadband High-cost Funding

Throughout this site, I have described and listed many new, exciting services. However, concerns are that these services will only be available in dense, metropolitan areas where consumers can afford them. Conversely, the concern is that advanced services will not be available in rural and low-income areas. Consequently, similar to the high-cost fund for fixed-line local service, some regulators have set up a high-cost fund for broadband. For instance, the California Public Utilities Commission (CPUC) has proposed a plan whereby all carriers offering broadband access with 3 Mb/s download and 1 Mb/s upload will be entitled to high-cost funding. This raises a number of interesting economic questions because, if it is not done correctly, it can open up gaming opportunities.

Next Generation Regulation

Regulation under NGNs is a topic of great interest in many countries around the world. For this reason, I have dedicated a separate page to this important trend. Essentially, as networks evolve, so must regulation. The question that regulators and parties debate is how this regulation should look in a world where fiber extends to the curb or home and circuit switches are replaced with softswitches.

Asymmetric Interconnection Regimes

Technological change has had a profound impact on the nature and extent of competitive entry into local exchange markets in recent years. In some instances, entities that would have been considered nontraditional service providers a few years ago, such as mobile wireless and cable providers, are now offering customers packages of new services that compete with those of traditional local service providers. Indeed, a consequence of this development is that it has reduced the “specificity” of the capital investment in telecommunications facilities and has made entry easier.

In order to compete effectively against these former nontraditional providers, and specifically against mobile operators, landline providers have made significant investments in the deployment of NGNs. These NGNs will benefit consumers through the widening of the landline portfolio (for instance, with the offering of broadband Internet access). It is important that regulators both acknowledge this relatively new intermodal competition and convergence trend by removing or at least revising outdated regulation. To further competition, innovation, and price reductions, regulators ought to regulate as lightly as possible. Heavy or asymmetric regulation can hamper investments by discouraging operators from committing large sums of money to new infrastructures or advantage one group of competitors over another. With respect to interconnection rates, NGNs, convergence, and intermodal competition mean that asymmetric interconnection rate regimes must be discontinued and replaced with symmetric rates that are based on the costs of an efficient firm. Only symmetric rates provide the proper signals to market participants, thus ensuring that competitive distortions do not arise.

Mergers and Acquisitions

Market consolidation through mergers and acquisitions has been a hotly debated issue, particularly in the US. Opponents of these mergers claimed that these carriers were trying to rebuild “Ma Bell,” the old AT&T monopoly before its breakup in 1984. This, however, is not the case. As I explain above, market conditions, in terms of both technology and competition, have changed drastically since 1984. While it cannot be said categorically, the recent market consolidations in the US have been a reaction to increased competition from companies that previously were considered noncompetitors, in other words, there are new guys on the block that have to be taken into account.

Video Franchising

In order to be allowed to offer video service, fixed-line operators, as well as everybody else, first need to apply to all municipalities in the US and negotiate a franchising agreement. This process can take a long time and potentially can delay competitive entry by nontraditional TV operators. Fixed wireline operators have petitioned regulators to consolidate the video franchising process. Cable operators, however, have opposed such consolidation or easing of the rules as they also had to first obtain franchising rights before entering the video market.

Net Neutrality

International clients are particularly interested in hearing about Net neutrality, a US-coined term describing a proposal to make the Internet “free.” An exact definition of this concept does not exist, and net neutrality has taken on various different definitions, becoming increasingly political and making it hard to really study the economics of the proposed measure. Briefly, proponents of Net neutrality should be free of any restrictions imposed by the owners of Internet backbones, and there should be no price or any other type of discrimination. Each bit traveling the information highway should be treated equally, regardless of its origin. The economics of Net neutrality are rather weak as there is no economic support for such a proposal, and there is no concrete evidence that backbone owners have exercised market power and engaged in illegal discriminatory practices.

There are two excellent pieces on Net neutrality that discuss the economics underlying it. One is by Alfred Kahn, a prominent professor of economics at Cornell University and Special Consultant to NERA, and the other one is by a colleague of mine, William Taylor, SVP at NERA.

To read Dr. Kahn’s take on Net neutrality, click here: http://www.heartland.org/Article.cfm?artId=20209

To read Dr. Taylor’s take on Net neutrality, click here: http://www.nera.com/Publication.asp?p_ID=3264

Wiretapping

There are several lawsuits pending in US courts discussing the legality, or lack thereof, of wiretapping. For instance, the Electronic Frontier Foundation (EFF) has filed a lawsuit against AT&T, alleging that the company unlawfully cooperated with unconstitutional government surveillance programs.

Cost Modeling

Cost modeling has been and remains a hot topic in wireline telephony. The basic idea of cost modeling is straightforward. When regulators seek to intervene in a market, they frequently set retail and wholesale prices, or they regulate interconnection prices. These regulated prices are often based on costs. For instance, regulators can elect to set prices at long-run incremental cost (LRIC), or LRIC plus a reasonable markup to help cover general and administrative costs, or fully allocated costs, which are supposed to cover all the costs incurred by a company. There are a number of different pricing methods, but “costs” form the basis of most of them. However, not all telecommunications companies keep their books in the exact format required by regulators to assess costs to specific services. Therefore, various so-called cost models have been proposed over the years for determining the cost of specific services. Some of these cost models calculate the cost of providing telephone service or a component of telephone service based on the existing network, while others calculate costs based on a brand new, forward-looking network. Although in recent years, cost modeling has become a less highly debated topic as most countries have decided on a proper cost and pricing structure. However, with the emergence of next generation networks (NGNs), we are in for a repeat of the cost model arguments as these models will be key in determining regulated prices (wholesale, retail, or intercarrier). Please check out my page about NGNs where I discuss some economically sound cost modeling approaches.

Wholesale Network Access

Wholesale network access is allowing a third party to connect to your network. Often this is done on a voluntary basis. For instance, networks interconnect all the time, relying on commercially negotiated interconnection agreements. In some countries, such as the US, regulators have mandated that competitive carriers  can lease part or all of the incumbent’s fixed network. This was a highly debated issue in the mid to late 1990s. However, with wireless becoming more competitive and new services, such as mobile TV or 3G mobile services, the question of mandating wholesale network access has come up again. Please visit my pages on mobile TV and MVNOs for further discussion of this subject.

Want to discuss any of these topics? 

Please let me know if you would like to discuss any of these or other topics that affect the economics of wireline telephony. Most of these topics are related and a thorough understanding of the entire communications industry is crucial in correctly analyzing strategy questions or legal and regulatory claims.

Interested in another topic? 

Yes, there are many other issues that affect the wireline industry, but I hope that I have listed the most important above. Please feel free to send me an email if you think I have missed a current hot topic or would like me to comment on another.