network interconnection and competition patrick rey ie business school and fundación ramón areces...

Network interconnection and competition

Patrick Rey

IE Business School and Fundación Ramón ArecesMadrid, 5 April 2011

Patrick Rey Network interconnection and competition 2

Introduction

TopicsTopicsInterconnection (wholesale level)

oconnectivity (capacity, QoS agreements, net neutrality)oaccess prices (termination charges)

Competition (retail level)olinear/nonlinear tariffs (large/small consumers)oon-net pricing (club effects)ocaller pays/receiver pays principles

(consumers/websites)o[entry / investments]

Positive / welfare analysis


Issue: whether to connect / compatibility or qualityIssue: whether to connect / compatibility or quality(Katz-Shapiro AER 85, Farrell-Saloner Rand 85)

Snowballing, club effects (small shocks / large impact)

Inertia, lock-inorole of installed bases oswitching costs?

Coordination problems opositive: coordination devices onormative (Pareto criterion; heterogeneity?)

“one-way” interconnectionbackward/forward compatibility, downgraded version (read-

only)

Connectivity strategies


Large networks are less eager to maintain Large networks are less eager to maintain connectivityconnectivityTrade-off: degraded interconnection

ohas a negative direct effect (network is less attractive)ohas an indirect strategic effect (rival also less attractive)

Strategic effect can dominate is network is large enoughorefusing / degrading interconnection (WC/MCI/Sprint)odeveloping closed / proprietary standards (iTunes)

Large? Installed base of locked-in customers, coordination




Illustration: the WorldCom – MCI mergerIllustration: the WorldCom – MCI mergerCrémer-Rey-Tirole JIE 2000

Pre-merger: 4 backbones (WorldCom, MCI, Sprint, GTE) oall backbones have similar installed bases (1/4, say)opre-merger, all backbones aim at perfect connectivity

Merger between 1 and 2 (installed bases ½,¼,¼) → three connectivity strategies: oaccommodation: maintain connectivity (1,1,1)oglobal degradation (½, ½ , ½ ): never attractiveotargeted degradation + limit on transit (¾ , ½ ,1):

attractive


Interconnection and competition

One-way versus two-way accessOne-way versus two-way accessOne-way access

oupstream: incumbent controls a bottleneck (e.g., local loop)

odownstream: incumbent competes with rivals→ essential facility doctrine, access regulation

Two-way accessonetwork operators compete for subscribersobut need each other to complete calls→ competitive bottlenecks


Interconnection and competition

Cooperation or competition?Cooperation or competition?Interoperability requires cooperation

ostandards, protocols (QoS)ointerconnection agreements

… between competitorso“cooperation” may prevail over “competition”olack of cooperation from incumbents may hurt new

entrants

→ impact of interconnection prices on retail competition


Mobile to mobile termination

Competing bottlenecksCompeting bottlenecksWholesale: bilateral interconnection agreements

operfect connectivity (no club effect)oreciprocal termination charge (access price): a

Retail: price competitionolinear / non-linear (two-part) tariffs (prepaid/post-paid,

subsidy)oon-net pricing (friends and family)oprices for sending and/or for receiving (US/EU)


Framework

Cost structureCost structure

Origination and termination costs: co , ct

Reciprocal access charge aoon-net cost: c = co + ct

ooff-net cost: c = co + a = c + m, where m = a – ct

Network 2Network 1

oc a

co + ct

C2C1

ct – a


Linear retail prices Armstrong (EconJ 1998), Laffont-Rey-Tirole (Rand 1998)

The access charge as a “collusive” device The access charge as a “collusive” device

Access mark-up m = a – ct inflates the “perceived” marginal cost

average marginal cost for network i: ci = c + αj m

In (symmetric, imperfectly competitive) equilibrium

price based on perceived cost : p = pe(c + m/2)o If access prices are set unilaterally: double marginalizationo If bilateral negotiation of a reciprocal charge: collusive device

a high enough termination mark-up sustains monopoly prices

Note: no termination revenue or deficit if “balanced pattern”

o[even if asymmetric market shares: α1 α2 m = α2 α1 m …]

oCompare with “bill and keep”


Non-linear (two-part) tariffs Laffont-Rey-Tirole (Rand 1998)

Two-part tariff Two-part tariff ((FFii,p,pii))

Termination mark-up still drives up usage prices

pi = ci = c + αj m

But competition for subscribers dissipates profitso“waterbed effect” (Paul Geroski for F2M termination)

olower fixed fees, handset subsidies, …

If total demand is elasticoaccess charge is “neutral” for profit→ termination charge no longer acts as a collusive deviceobut decreases consumer surplus / total welfare (wrong signal)


Demand sideDemand side

Full participation α1 + α2 = 1

Balanced calling patterno each user calls all users with equal probability

o demand for calls per subscriber is q(p), indirect utility v(p)

→ variable surplus is wi = v(pi) – Fi

Horizontal differentiation à la Hotelling (differentiation t)

→ operator i 's market share is αi = 1/2 + (wi - wj)/2t

Full participation / waterbed effect


Termination rate does not affect industry profitTermination rate does not affect industry profit

Usage price to average marginal cost: p = c + m/2

Termination revenue dissipated on fixed fee: F = f + t – m/2

Consider stealing a caller from network rival network

o retail profit: neutral since price p∗ covers average cost c + m/2o termination between own subscribers: saves & loses mq∗/2o termination from rival’s subscribers: brings mq∗/2

→ net gain of mq∗/2: the fixed-fee is reduced by this amount

Industry profit is independent of m: 2Π = t

Full participation / waterbed effect


On-net pricing Laffont-Rey-Tirole (Rand 1998), Gand-King (EconL 2001)

Reintroduces club effectsReintroduces club effectsPerfect connectivity

But, for same prices, users favour larger networks

Similar to compatibility / connectivity analysisSimilar to compatibility / connectivity analysisFiercer competition among similar networks

Profits are maximal for a termination charge

… below cost

However, also exacerbates the risk of “tipping”


Receiver pays regime Laffont-Marcus-Rey-Tirole (Rand 2003)

Two types of usersTwo types of usersMobile in the US: senders/callers vs receivers/callees

Internet: websites send traffic / consumers receive it

Two pricesTwo prices

price for receiving traffic pr, demand Dc(pr)

price for sending traffic ps, demand Dw(ps)

→ volume of traffic (“balanced pattern”) Dc(pr) x Dw(ps)



The off-net cost pricing principleThe off-net cost pricing principleFor network i

πi = (pis + pi

r – c) DiwDi

c (on-net)

+ (pir + a – ct) Dj

wDic (incoming off-net)

+ (pis –a – co) Di

wDjc (outgoing off-net)

= [pis – (co + a)] Di

wDc + [pir – (ct – a)] Di

cDw

Under perfect competition, prices reflect off-net costs

ps = co + a, pr = ct – a



Pretty robust principlePretty robust principleArbitrary number of networks

Mixed traffic patterns

Customer cost heterogeneity: cost ctk, co

k for group k

Quality of service: pr+ = ct+ – a, ps+ = co

+ + a

Welfare implications (Ramsey pricing)Welfare implications (Ramsey pricing)

+ = ( , = ) =' '

r r s s

s r r st o r r s s

S p S pp p c p c a p c a

D p D p


Policy puzzle

Theory: when networks compete in non-linear tariffsTheory: when networks compete in non-linear tariffsProfits are not affected by the termination charge

oLRT Rand 1998oheterogeneous users (Dessein Rand 2003, Hahn IJIO 2004)

Or maximal for termination charges at or below costoGans-King EL 2003oelastic demand (Dessein Rand 2003, Schiff RNE 2008)oasymmetric networks Carter-Wright (RIO 2003)

PracticePractice

Operators favour termination rates above cost While regulators push for low rates

o EU recommendation: termination rates at LRIC by 2012o France: from 14,94/17,89 c€/mn in 2004 to 3,0 / 3,4 in January

2011


Spanish Mobile Termination Charges

18,98

14,6253

11,7214

7,00

21,2153

17,7572

13,1303

10,08

14,3649

11,736410,4174

8,749,61

7,87

9,058,03

13,0523

0

5

10

15

20

25

jul-01 31/10/2002 02/10/2003 21/10/2004 29/09/2005 oct-06 abr-07 oct-07 abr-08 oct-08 Abril-09 -Sept-09

euro

cen

ts/m

inut

e

Movistar Vodafone Orange Yoigo

GLIDE PATH


Revisiting MTM termination

Link between FTM and MTM rates Link between FTM and MTM rates Armstrong and Wright 2008 Arbitrage (“hedgehogs”) / regulatory policies FTM: partial waterbed effect / double marginalization (unilateral

setting)

Asymmetric competition and entry barriersAsymmetric competition and entry barriers

Cazalda-Valletti 2008, Hoernig 2007 (predation), Lopez-Rey 2009

Users’ expectationsUsers’ expectations

Lopez-Hurkens 2010

Here: demand heterogeneity (heavy / light users)Here: demand heterogeneity (heavy / light users)call imbalance and different participation elasticities


Main insightsJullien-Sand Zantman-Rey (2010)

Assume that consumers exhibiting traffic deficit Assume that consumers exhibiting traffic deficit … have also a more elastic participation … have also a more elastic participation large users churn but always participate small users mostly receive calls and may not participate

pre-pay/post-pay, large/small users in post-pay, teenagers...

Then Then profits are maximal for MTM termination rates above

cost welfare is maximal for MTM termination rate

o also above cost o but below the level that maximizes profits


Light usersLight users Do not call but receive calls Elastic (symmetric) subscription demand βi = β(Pi,Pj)

o aggregate demand βTT(P) = 2βii(P,P) is decreasing in P o replacement ratio γ(P) = ∂β2(P,P)/∂P1 (╱ -∂β1(P,P)/∂P1) [0,1[∈

Heavy users Heavy users Total participation of 1 + βT

→ heavy users’ surplus becomes wi = (1+ βT)v(pi) – Fi

(they benefit from being able to call more light users

Full participation → operator i 's market share is αi = 1/2 + (wi - wj)/2t

Heavy and light users


Symmetric equilibriumSymmetric equilibrium

Network i 's profit is equal to

Πi = αi [(1+βT)(pi - c)q(pi) – (αJ+ βj)mq(pi) + Fi – f] + (αi+βi)αjmq(pj) + βi(Pi - φ)

The usage price maximizes the surplus from trade (LRT)

p1 = p2= p∗ = c + m/2; q∗ = q(p∗)

The equilibrium subscription fees are then

F∗ = f + t + (βT - 1)mq∗/2

Equilibrium: heavy users


Consider stealing a caller from network rival networkConsider stealing a caller from network rival network

No light user (βT = 0)

o net gain of mq∗/2 o the fixed-fee is reduced by this amount

With light users (β1 = β2 = βT/2 > 0), the reduction is smaller

o loses termination revenue from own light users: (βT/2)mq∗

o the fixed fee is augmented by this amount

Intuition


Equilibrium: light users

Network i's profit then writes asNetwork i's profit then writes as

Π i = (1/2)[F∗ - f + (1/2 + βi)mq∗ + (βi - βj)(m/2)q∗] + βi(Pi - φ)

Optimizing with respect to POptimizing with respect to Pii amounts to maximize amounts to maximize

G(Pi,Pj) = (Pi - C) βi(P1,P2) – C∗ βj(P1,P2)

C = φ - 3mq∗/4 represents the direct opportunity cost of attracting light users, net of the benefits from calls received on-net (half the charge) and off-net (full charge)

C∗ = mq∗/4 represents the opportunity cost of the rival’s light users corresponding to the termination deficit (the price charged for calling these light users covering only half of the termination charge)


Equilibrium: light users

Equilibrium subscription for light usersEquilibrium subscription for light users

where ε(P) denotes the own price elasticity of light users' subscription demand

*

* *

* *

3

4 1

PP mq

P P


Impact of termination rates

Increasing the termination rate has two effectsIncreasing the termination rate has two effects intensifies competition for light users via two channels

o waterbed : light users generate larger net termination revenue

o opportunity cost : preventing the other network from attracting a light user saves on termination costs

reduces competition on the heavy usersthe cost of losing a heavy user to competitor is weakened by the larger termination revenue that the calls to light users will generate (again because there is no equivalent volume of calls from light users to this heavy user)


Equilibrium profit

The operators’ profit isThe operators’ profit is

2Π∗ = t + (P∗ - φ + mq∗) βT(P∗)

PP∗∗ depends on depends on mm only through access revenue only through access revenue r = r = mq∗mq∗

→ the operators’ profit depends only on the access revenue r and is maximal when the termination markup is at monopoly level

mR = argmaxm mq(c+m/2)


Equilibrium surplus

Light users' surplus is increasing in access revenue Light users' surplus is increasing in access revenue rr

Effect on heavy users is ambiguous Effect on heavy users is ambiguous

heavy users' net variable surplus is SH = (1+ βT)v(p∗) – f – t – (βT - 1)mq∗/2

→ increasing the termination rate

raises network externalities from light users (through r = mq∗ and βT)

but also raises usage prices: p∗ = c + m/2

→ for m small, increasing m raises heavy users' surplus if light users' subscription demand is very elastic or if heavy users' usage surplus is not very elastic

→ → total welfare is maximal for a termination markup that is positive total welfare is maximal for a termination markup that is positive but smaller than the monopoly levelbut smaller than the monopoly level


Extension: on-net/off-net

With on-net/off-net price discrimination the analysis is With on-net/off-net price discrimination the analysis is similar with additional effectssimilar with additional effects usage price = marginal cost (on-net and off-net) revenue from light users' received calls is smaller (no gain

from on-net calls) tariff-mediated network effects intensify competition on heavy

users additional effect of light users on tariff-mediated network

effects

Welfare is maximal for a positive termination mark-upWelfare is maximal for a positive termination mark-up

Profit is maximal for a termination mark-up that may Profit is maximal for a termination mark-up that may be smaller or even negativebe smaller or even negative


Extension: FTM termination rate

Each subscriber generates an extra revenue Each subscriber generates an extra revenue from FTM terminationfrom FTM termination

waterbed effect on both userso both subscription fees decreaseo reduction can be larger for either type of user

the presence of light users

… limits the waterbed effect on heavy users

industry profit increases


Conclusion

The level of termination rate has contrasted effects on the The level of termination rate has contrasted effects on the intensity of competition for different types of consumersintensity of competition for different types of consumers high termination rates benefit small users due to more

competition than even the waterbed effect suggests

high termination rates reduce the intensity of competition for large users

Consistent theory explaining a positive effect of TR on profitConsistent theory explaining a positive effect of TR on profit

Regulation is useful but the rate should be set above costRegulation is useful but the rate should be set above cost

How much above costs? → need for empirical workHow much above costs? → need for empirical work

Effect of Receiver Pays Principle? Effect of Receiver Pays Principle?

network interconnection and competition patrick rey ie business school and fundación ramón areces...

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