paper itseurope 2009 final

8/3/2019 Paper ITSEurope 2009 Final

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WHY IT IS IMPOSSIBLE THAT THE LADDER OF INVESTMENT

ACTUALLY WORKS

September 2009

Fernando Herrera-Gonzlez

Luis Castejn-Martn

Abstract

The ladder of investment is a regulatory approach that has been used by European

National Regulatory Authorities (NRAs), in order to foster infrastructure competition

among operators. According to its proponents, by forcing incumbent operators to open

several levels of access to their network in such a way that alternative operators may

climb up the ladder, they will eventually deploy their own access network and

infrastructure competition will be achieved.

This regulatory approach seems to have failed, as can be seen in the lack of advance to

the last rung of the ladder, the deployment of an alternative infrastructure.

In this paper, it is argued that the ladder of investment can not possibly attain the above

results, by using the methodology of the Austrian School of Economics. Three

arguments are developed: 1) Impossibility of establishing prices outside the free market;

2) Impossibility of defining relevant point of access outside the discovery market

process; 3) Misconception of the investment decisions

Keywords

Regulation, ladder of investment, investment incentives, theory of price control,

entrepreneurship, market process


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1. Introduction

The deployment of an alternative fixed infrastructure to that of the incumbent has

possibly been the main concern of governments and telecommunications regulatorssince the opening of the sector to competition.

According to their logic, deregulation of the sector will only be possible when there is

an important degree of facility-based competition. Otherwise, alternative operators and

competition have to rely on the incumbent facilities and regulation is necessary. If full

deregulation were accomplished from the beginning, several negative effects would

occur, as raise of prices or foreclosure risks.

In summary, to attain the benefits of competition in the telecommunication sector it is

necessary to have an alternative infrastructure to that of the incumbent. The question is

how alternative operators may be able to deploy it in an open market, because the

duplication of the incumbent network is risky and involves high sunk costs, if made at

one time.

The ladder of investment approach provides new entrants with a smooth path for

investments, which allows them to progressively deploy their networks. Lowering in

this way their risk, the probability of deployment is bigger.

The concept was originally proposed in (Cave, 2004). The idea is to force incumbent

operators to open several levels of access to their network (the rungs of the ladder) in

such a way that alternative operators may climb up the ladder, using more of his own

infrastructure, and thus decreasing their reliance on the wholesale products of the

incumbent operator. The final result would be the deployment of their own access

network by the alternative operator, once he has captured the appropriate number of

costumers to profit from the economies of scale of that investment.

Regulators oblige incumbent operators to provide wholesale access products in several

points of their infrastructure. These points require different levels of investment, from

the lowest requirement (for example, resale) to the largest (unbundling). Thus, new


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entrants may start using the incumbent network on the access points requiring the

lowest investments, and then proceed up the ladder, as they build a mass of costumers.

For example, an operator may start providing broadband services by simply resaling

under its own brand those of the incumbents. As it acquires costumers, it gets revenues

that may allow it to further its investments up to the next access point or rung,

deploying its own infrastructure closer to the customer premises, which results in higher

product differentiation and variety, and in less dependence on the incumbents network.

Supposedly, the process goes on, until a point comes where the operator finds attractive

to deploy its own facilities, and to severe their dependence of the incumbent.

This gradual climb is only possible if NRAs regulate prices of the various access

products in a consistent way, and if the right number of rungs is defined to allow for

smooth transitions between each successive rung. Neither of these problems seems to be

easily solved, as the literature points out (Cave, 2006) (Cave, 2004).

In this paper, the methodology of the Austrian School of Economics will be applied to

assess if the ladder of investment approach can possibly work. That is, if the ladder of

investment regulation may attain the objective of facilities-based competition, as their

proponents pretend. The rest of the paper is structured in the following way. In the

second section, the Austrian School of Economics is briefly introduced: its

methodology is explained and the description of the market as a process, one of the

main features of Austrian economics, is depicted.

The third section will deal with the question at stake, that is, if it is really possible that

the ladder of investment attains its goal. The argumentation follows the Austrianeconomics methodology, and revolves around two basic issues: establishment of prices

and production structure outside the free market, and how both issues affect the

investment decisions of operators.

In the fourth section, we will discuss an analysis made for the Spanish market. This

analysis concludes that the ladder of investment has attained its goal. Because this

conclusion is contrary to the results of the theoretical analysis (and to that of other


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empirical studies), it deserves a more detailed appraisal, even if the review of historical

evidence is at odds with the methodology of the Austrian school of economics.

Fifth section concludes and closes the paper.

2. The Methodology of the Austrian School of Economics

In this section, the Austrian School of Economics is introduced, and features of its

methodology are described. After that, focus is made on describing the market as a

process, outlining the main differences with the mainstream economics. Once made the

description, a general categorization of the effects of regulation in the market processwill be presented. This introductory explanation is deemed necessary to understand how

the ladder of investment affects the market.

Introducing Austrian Economics

This paper is built on economic theory developed by the Austrian School of Economics

as opposed to the neoclassical school, which constitutes the current economic

mainstream1. In the past, other schools has been successively considered mainstream,only to be abandoned when they proved wrong.

The Austrian School of Economics has its origins with the Viennese economist C.

Menger (1814-1921). Its specific foundation is dated to 1871, with the publication of

Mengers Grundstze der volkswirtschaftlehre (Principles of economy).

Most relevant contributors to this tradition include L. von Mises (1881-1973), J. A.Schumpeter (1883-1950), F. A. Hayek (1899-1992, Economics Nobel Prize in 1974),

and M. N. Rothbard (1926-1995).

Methodology

1 For a detailed analysis of the important differences between both approaches, see Murphy (2007).


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The methodology used by the Austrian School of Economics is praxeology, or the study

of human action. Two features are characteristic of this methodology: individualism and

subjectivism.

Methodological individualism means that the starting point for economic analysis is

human action: all economic phenomena are the result of actions and interactions of

individuals whose doings generate all outcomes observed in the market. As a

consequence, there are no natural laws in the market.

An individual acts by choosing among several alternatives of action. Methodological

subjectivism implies that these selections are made according to an individuals scale of

preferences. A human acts by allocating his or her resources to the satisfaction of more

urgent needs. This scale is different for each individual and changes with time.

Moreover, it is subjective and cannot be measured nor apprehended by outside

observers. Finally, these preferences cannot be measured in absolute terms; they have an

ordinal, rather than a cardinal, hierarchy.

The Austrian School of Economics starts from the axiom that humans act (i.e., they

have purposeful behaviour) and do so to satisfy ends according to a given scale of

values. From here and through logical reasoning, laws governing the economy can be

deduced.

Because of its logical foundations, praxeology is similar to logic and mathematics. Its

statements and propositions are not derived from experience. They are a priori. They

may be illustrated historically, but they are never verified or falsified experimentally.

For its part, economic history cannot teach any general rule, principle, or law. There is

no way to abstract a posteriori from historical experience any theories concerning

human conduct and policies. Because of this, there is no need of real cases to apply

praxeology to a concrete economic problem. That is, no case supporting the results of

the analysis would further justify its conclusion, and no case contradicting it would

serve to falsify its reasoning.


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It is important to note that all theorems developed according to praxeology are true

regardless of specific circumstances2, unless there is some mistake in the logical

reasoning that underlies them.

The market as a process

Austrian economists understand the market as a dynamic process of discovery generated

by entrepreneurs (Hayek, 2002). (Kirzner, 1985) summarises this view around four key

concepts.

- Competition: understood as rivalrous activities of market players, not as perfect

competition equilibrium, as mainstream economists do.

- Knowledge and discovery: the competitive process does not only mobilize

existing knowledge, but also generate awareness of opportunities whose very

existence was known to no one at all.

- Profit and incentives: Profits are not understood as the mere subtraction of

known costs from known revenues, but as the incentives to locate gaps between

costs and revenues. In other word, profits are a sign that resources are more

valuable in other uses than in the current ones.

- Market prices: in each moment, they are the (disequilibrium) exchange ratios

worked out between market participants; they provide information to

entrepreneurs on the current valuation of commodities, and, thus, on the

opportunities of profits.

In the real world of uncertainty, the discovery market process is carried out by

entrepreneurs. Entrepreneurs are constantly looking for new opportunities of profits,

that is, of gaps between current prices of resources and expected prices of them; this is

done by market calculation, by means of which they are able to make estimates that can

guide their ex ante decisions.

2 See Mises (1949/1998a), chapter 39.


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It is important to note that the market process is not instantaneous; on the contrary, it

takes time to profit from the identified opportunities.

When an entrepreneur detects an opportunity of profits, he has first to acquire the

resources at the current price (invest in resources) and only after a variable lapse of

time, depending on the complexity of the productive process, he will be able to sell

those resources in the new form. Only at that time, will he be able to know if he was

right or wrong in his market calculation: he who was right will attain profits; he who

was not, will suffer losses.

Effects of regulation on the market process

Government regulation drastically alters opportunities for entrepreneurial gain, and

influences the prices emerging from entrepreneurial competition. However, perils arise

out of the impact that regulation have on the discovery process, which unregulated

markets tend to generate. Kirzner identifies four categories of impact on the discovery

process (Kirzner, 1985)

The undiscovered discovery process

Regulators may not correctly address the market course in the absence of regulation.

The unsimulated discovery process

Regulators have no incentives in profit seeking, so it is very unlikely that they are able

to discover opportunities for social betterment that the market process has not already

discovered. Regulation process can not simulate market process.

The stifled discovery process

Regulation may inhibit, discourage or hamper desirable discovery processes which the

market might have generated, activities not yet foreseen by anyone. For example, price

ceilings not only restrict supply from known sources, but also inhibit the discovery of

wholly unknown sources.

The wholly superfluous discovery process


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Regulation may create opportunities for new, but not necessarily desirable, market

discovery processes which would not be relevant in an unregulated market. Regulation

constraints introduce profit opportunities that otherwise have been absent. Such

consequences may be wholly undesired by authorities.

In brief, the competitive-entrepreneurial process, being a process of discovery of the

as yet unknown, can hardly be predicted in any but the broadest terms. The imposition

of regulatory constraints necessarily results in a pattern of consequences different from

and, most plausibly, distinctly less desirable than what would have occurred in the

unregulated market.

3. Can the ladder of investment work?

In this section, it will be proved that the ladder of investment approach cannot possibly

attain the stated objective of getting other operator to deploy their own access. Three

arguments will be developed. Firstly, it will be shown that it is impossible to establish

meaningful prices from outside the market. Any price not resulting from the market

process will distort the investment decisions of entrepreneurs, because it is not

providing the right information about the value of resources. It is likely that, in these

circumstances, resources are misdirected and a sector bubble may be generated.

Secondly, the question of how to define point of access to the incumbent network will

be tackled. As before, there is no possibility of such a definition outside the discovery

market process. Of course, it is possible to define points of access, but they will be

technical points of access, and not economic points of access, because they are

defined according to a concrete technical structure of the service, and not to the real

demand of the market. Once again, this may possibly lead to bubbles and mal-

investment. Besides, the impossibility of defining prices outside the market is

exacerbated, because prices for each of the points of access are supposed to be

consistent among them, in order for the ladder of investment to work.

Finally, the investment decision will be described, showing that the ladder of

investment not only does not easy investment in new networks by alternative operators,

but on the contrary, it makes considerably more difficult such deployment. The key


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issue is to understand that entrepreneurs make investments only if the expected increase

in revenues is above the amount of needed outlays.

3.1 Prices outside of the free market

In the first place, it will be argued that it is impossible to establish prices outside the

free market. All prices defined from external institutions are necessarily arbitrary and do

not convey any useful information for taking investment decisions. On the contrary,

they severely distort this signal and cause mal-investment to be made.

In the unhampered market, the price is established by the interplay of buyers and sellers.

This price depends on the preferences of buyers and on the available stock. The pricemay vary with time, as preferences or stock are altered.

In the market, sellers and buyers exchange goods (typically, goods for money). The

exchange takes place only if both parties value more that which they receive than that

which they deliver. It is not possible to know which is their valuation of the good

received; the only magnitude an observer may apprehend is the ratio of exchange, i.e,

the price at which the exchange took place.

In words of the Nobel laureate James Buchanan (Buchanan, 1999, chapter 6):

Only prices have objective, empirical content; neither the marginal

evaluations of the demanders nor the marginal costs of the suppliers (the

marginal evaluations of foregone alternatives) can be employed as a basis for

determining prices. The reason is that these are both brought into equality with

prices by behavioural adjustments on both sides of the market. Prices are not

brought into equality with some objectively determinable and empirically

measurable phenomena, on either the demand or the supply side of the market.

However, services defined in the ladder of investment approach are not offered in the

market (there is no free market for these products). Before any access obligation, all

exchanges are internal; there is no price for the good, and no way for the firm or for

anyone else to determine a price for it. In any case, proponents of the ladder of

investment deem necessary to define prices for each of the rungs of the ladder.


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According to (Cave, 2006), access pricing may be used to establish the different prices.

This methodology (as summarised in (Armstrong, 2002)) relies heavily on the notion of

costs as something given or objective3.

According to the Austrian School of Economics, the cost is the loss, prospective or

realized, to the person making the decision, of the opportunity of using those things in

the alternative courses of action

Cost is that which the decision-taker sacrifices or gives up when he makes a

choice. It consists in his own evaluation of the enjoyment or utility that he

anticipates having to forego as a result of selection among alternative courses of

action. (Buchanan, 1999).

Thus, in that view, costs are subjective, they exist only in the mind of the decision-

maker, and cannot be measured by someone other than the decision-maker, because

there is no way that subjective experience can be directly observed.

Even if it could be accepted that prices can be calculated from one or other group of

costs, these are in turn unobservable, except for the entrepreneur making the decision,

who is the only one able to apprehend the costs that his decision poses on him.

(Buchanan, 1999) explains that this false objectification of costs may have resulted

from the extension of the perfect knowledge assumption of competitive equilibrium

theory to the analysis of non-equilibrium choices, whether made in a market or a non-

market process.

And he concludes: The implications of all this for modern welfare economics could

scarcely be underestimated. My argument suggests that almost all of this subdiscipline

has been based on simple methodological confusion. It has converted predictive

propositions into allocative norms which have then been used to make policy

proposals.

3

(Armstrong, 2002) builds its results on the normative results of the perfect competition model. This ideahas been extensive and widely criticized by Austrian School economists, and all those arguments shouldbe brought up here. For example, see (Hayek, 1948).


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In summary, prices are the only objective magnitude; only prices can be apprehended by

an outside observer. It is prices that define costs, and not the other way around. Once a

price for a good is observed in the market, providers have to adjust their offer to that

price, and consequently their costs, if they want to survive in the market place. Costs are

not observable either, because they are subjective to the decision-maker. Of course, unit

counts may be carried out, but these are not true costs, just accounting figures 4.

Any price established outside of the market place is, in conclusion, arbitrary. Proofs of

this arbitrariness are pervasive. For example, in the discussions about the recent EC

Recommendation on mobile termination rates, there were more than 50 contributors5.

The analysis of the contributions to the public consultation shows the wide divergence

of approaches to determine termination rates.

More conclusively, the EC recognizes this fact in the paragraph 2 of the

Recommendation6, when it states:

Although some form of cost orientation is generally provided for in most

Member States, a divergence between price control measures prevails across the

Member States. In addition to a significant variety in the chosen costing tools,

there are also different practices in implementing those tools.

This divergence of approaches is not exclusive of termination rates, but extends to the

implementation of any price regulation, and not only in telecoms but in any other

economic sector.

4 In this respect, see (Mises, 1998a), p. 346. Cost accounting is therefore not an arithmetical processwhich can be established and examined by an indifferent umpire. It does not operate with uniquely

determined magnitudes which can be found out in an objective way. Its essential items are the result of an

understanding of future conditions, necessarily always colored by the entrepreneur's opinion about the

future state of the market. Attempts to establish cost accounts on an "impartial" basis are doomed to

failure.5 Seehttp://ec.europa.eu/information_society/policy/ecomm/library/public_consult/termination_rates/index_en.htm6

European Commission: COMMISSION RECOMMENDATION of 7.5.2009 on the RegulatoryTreatment of Fixed and Mobile Termination Rates in the EU. C(2009) 3359.


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Ladder of investment proponents also reflect this arbitrariness in their proposals. For

example, in (Cave, 2006) there is a lengthy discussion: If a price-based approach is

chosen, this can rely upon the well-understood theory of option pricing (). It may

seem that an access charging regime based on long run incremental cost (LRIC) plus

common cost, using the appropriate asset-specific cost of capital, would then send the

correct make or buy signals to other operators.() Precise estimates of the option

value of delaying investment until uncertainties have been resolved can be made ().

The key factors for applying the approach to telecommunications include the degree of

demand uncertainty and the expected change in input and output prices. () The

product of the calculation is the mark-up on LRIC associated with pricing the option.

Dixit and Pindyck estimated it as 100%, but a recent paper by Dobbs (2004), taking

account of other factors influencing output prices, suggests that a mark-up of 550% is

more likely. () This estimate can then be built into a dynamic access pricing regime

consistent with incentives to invest

Even if the proposed methodology and all other component were accepted without

discussion, there is still a mark-up associated with pricing the option that can oscillate

between 5% and 100%!.

Both theoretical analysis and empirical evidence seem to show the same result: the only

fair, non arbitrary, price in the market is the one at which both buyer and seller freely

choose to make the interchange7, and prices established outside the market are arbitrary.

Because of this, these prices do not contain sensible information for entrepreneurs, and

contribute to distort the market process.

In the case of the ladder of investment, prices below market prices would surely giveplace to instances of the stifled market process and wholly superfluous market process.

Prices too low for wholesale services will produce lower profits (if at all) and thus will

repel entrepreneurs willing to enter the market; this will probably led to stifled

innovation due to lack of incentives.

7 Vance L.M.: The Myth of the Just Price, 31 March 2008, available inhttp://www.mises.org/story/2918


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On the other side, those prices will raise profits in retail, attracting more entrepreneurs

that would be the case in the free market and creating a wholly superfluous market

process, not demanded by consumers. Entrepreneurs will wrongly think that there is an

opportunity of investment, more investments will be carried out and a bubble will be

produced, that is, an economic growth that is not based on costumers preferences, and

is not sustainable.

3.2 Identification of points of access

The other relevant element of the ladder of investment approach is the definition of the

rungs of the ladder, that it, points where access to the incumbent network is forced.

In the free market, it cannot be discarded that wholesale services would be offered by

the incumbent. Individual value scales" determine "the quantity of goods produced, the

prices of consumers' goods, the prices of productive factors, the interest rate, profits

and losses." Not only that, but "given a stock of land and labour factors, given

existing capital goods inherited from the past, given individual time preferences (and,

more broadly, technological knowledge), the capital goods structure and total

production is determined." (Rothbard, 1993), chapter 9, p. 624.

Thus, the market process, starting from the individual preferences of each customer,

determines not only goods and prices but also the structure of production for those

goods (given available resources). As already explained, this process is carried out by

entrepreneurs, using market calculation on the known prices.

In order to accomplish this calculation, explicit markets are needed, that provide

information about current prices of the resources involved. "For, without an external

market for wage rates, rents, and interest, there would be no rational way for

entrepreneurs to allocate factors in accordance with the wishes of the consumers."

(Rothbard, 1993), chapter 9, p. 608.

This poses limits to the vertical integration of enterprises: a firm can effectively have

vertical integration of several processes, only if there is a real market for each of the

intermediate products that provide the firm with an explicit price, that, in turn, allows it


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to perform market calculation: "For every capital good, there must be a definite market

in which firms buy and sell that good." Otherwise, without the price, the firm will not be

able to allocate factors and resources from one stage to another. (Rothbard, 1993),

Chapter 9, paragraph 3.E: "Vertical Integration and the Size of the Firm," p. 609-616.

There are some instances of wholesale services provided spontaneously by incumbents.

For example, Telefnica started offering bitstream national services in 2000 with

commercial conditions. Only later, in 2007, was this service regulated.

In summary, in the free market, economical points of access would appear, in the

sense that they would be driven by costumer preferences, possibly due to the limits of

vertical integration described.

However, according to the ladder of investment approach, it is necessary to define those

points without regard to the market preferences. Market preferences have to be

substituted then by other criteria (for example, replicability of the asset (Cave, 2006))

and that takes us back to the realm of arbitrariness. No longer are market preferences

defining the capital structure, but arguable, non objective, criteria.

The structure of production established by the unhampered market was the best (so far)

for serving the customers. If, in this situation, the government decides to forcibly alter

this structure of production by, say, splitting one activity into two, the resulting

productive structure will be worse for their purpose8. The point of access so defined

may be termed as technical point of access, as opposed to economical.

In order to define points of access with the ladder of investment approach, it isnecessary to define a chain of production for the provision of the retail service. Once

this is known, points of access to that chain may be identified. In the case of broadband

services, this is done in (Cave, 2006), p. 230-231. The proposed set of activities is the

following:

- access to the customer via a copper loop or shared loop;

- DSLAMs located at the local exchange;

8 For an explanation of the consequences of this splitting in the concrete case of BT and functionalseparation, see (Herrera-Gonzlez, 2008).


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- ATM backhaul;

- access to an IP network;

- access to the world wide web via transit or peering services;

- retailing functions (marketing, billing, helplines, etc.).

This identification is arbitrary, as could be expected after the previous theoretical

analysis. This is recognized by the author (see (Cave, 2006), footnote 16).

There are other problems caused by this approach. The proposed chain of production is

one technical solution for the provision of broadband services using a legacy copper

network. It is arguably the more widely used solution at this moment in time, and it may

even be regarded as the most efficient solution at present. But by no means is the only

possible solution, neither at present nor for the future, especially if innovation is

allowed.

With the static approach, it is usual to consider that technology does not change. If it is

assumed that technology will not change, and regulatory steps are taken with that

hypothesis in mind (i.e, points of access are defined according to a given technical

solution), it is very likely that technology will effectively not evolve. Alternative

operators will rely on the regulatory rungs for their own deployments and will in fact

replicate the technical solution chosen by the incumbent, instead of looking for

alternatives. In that way, dependence of the incumbent network increases, contrarily to

the purpose of the ladder of investment approach. Thus, the regulatory definition of

rungs of the ladder of investment tends to freeze the chain of production, leaving it as

that definition was assuming, in a self-fulfilling prophecy..

The process does not even stop here. Following (Mises, 1998a) p.742), It is important

to realize that what those benefited by these measures consider an advantage for

themselves lasts only for a limited time. In the long run the privilege accorded to a

definite class of producers loses its power to create specific gains. The privileged

branch attracts newcomers, and their competition tends to eliminate the specific gains

derived from the privilege.


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Once the regulatory possibilities of competition are exhausted (for example, all

operators are in the best rung), the only way ahead for alternative operators is to ask for

further rungs in the ladder9. The demanded rungs will of course depend on the specific

business model chosen by each operator10. So, the incumbent operator will be obliged to

open more and more rungs for these customized ladders of investments. This is clearly

seen in Spain, where specific operators are now demanding wholesale services like

naked DSL and shared access without telephony service. The first is demanded by

operators who chose VoIP to provide voice services over the unbundled local loop,

where the second is demanded by those who opted for indirect access services.

Finally, a thought should be given to the consistence of the prices of the rungs. In the

previous section, it was concluded that any price defined outside of the market is

arbitrary. The ladder of investment approach requires defining prices for all of the

offered rungs. In the case that there are inconsistencies, all operators will tend to the

best rung, that which allow more profitability, and will not move ceteris paribus.

Is it possible to assure consistence among prices of the rungs? In the free market, the

factor prices tend to the discounted value of the marginal product they are able to

produce. On the other side, the wholesale services included in the ladder of investment

may be regarded as highly specific factors, because they can only be used to provide a

concrete retail services (i.e, broadband access to Internet). Because of this, all prices of

the wholesale services in the ladder would basically depend on the retail price and on

the prices of the factors that have to be incorporated to the process as a consequence of

climbing up a rung11.

In turn, the concrete factors depend on the subjective decisions of entrepreneurs and cannot be apprehended by any outside institution. There is no unique way of climbing

from a rung to other rung. That logically implies that there is no objective way of

determining the factors to be used, and whose price should consequently be discounted

in order to achieve consistence among prices. In brief, to the general arbitrariness of

9 In the words of Mises: Thus the eagerness of the law's pet children to acquire privileges is insatiable.They continue to ask for new privileges because the old ones lose their power.10 This is rightly identified as a problem in (Cave, 2004), but it is not addressed: Competitors are likely

to have different business models, and seek various access points. They will also have an interest indenying their rivals the access points they seek.11 See (Rothbard, 1993), chapter 7: Production: General pricing of the factors.


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defining prices outside the market, it is joined the specific arbitrariness of determining

which factors are to be removed/added from one rung, and their costing. It can be safely

concluded that it is impossible that prices of the different rungs of the ladder are

consistent among them.

As a sample of this arbitrariness, it is interesting to refer to the margin squeeze tests that

are proposed in order to achieve this consistence. In (Cave, 2004), it is stated that the

formulation of these tests begs many questions about the range of products over which

the test should be conducted, the methodology for measuring costs, the firm whose costs

are relevant to the test (firm A, firm B or some hypothetical efficient retailer) and the

period over which costs should be calculated. (p.21). The discussion on margin

squeeze tests is of course a prolongation of the general discussion on methodologies to

establish prices outside the market, already illustrated.

The mere definition of the rungs in the ladder of investment approach will likely give

place to instances of the unsimulated market process, the stifled market process and the

wholly superfluous market process.

As said, the rungs of the ladder of investment have to be defined outside the market, and

its definition implies a certain model of production. However, the only way to identify

the model of production that better satisfies the consumers preferences in each moment

is the market process. As the government is not guided by profits, it cannot simulate this

process, and its election will surely be not the best from the economical point of view,

even if it is from the technical point of view. Moreover, the government cannot react to

adapt the model of production to changes in demand preferences.

The a priori definition of a production model and of the wholesale services will stifle

the innovation of entrepreneurs. They will see as better alternative to rely in the

incumbent network and replicate its architecture instead of looking for other solutions to

serve the market. So, the regulatory defined production model will tend to stay and so

will the rungs.

In fact, a wholly superfluous market process will be created, as entrepreneurs startlooking for new rungs in the ladder of investment and new wholesale services that allow


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them to grasp more profit according to their chosen business models. Innovation will

thus be driven from the search of alternative network solutions, to the search of new

uses of the incumbent network.

3.3 Distortion of the investment decisions

Both the identification of access points and the determination of the corresponding

prices are arbitrary when made outside the market process. It has already been shown

that these decisions distort the discovery market process in several ways. In this sub-

section, it will be described how the ladder of investment distorts the investment

decisions of entrepreneurs, causing precisely the opposite effect to that pursued by the

government, that is, it hinders the deployment of alternative access networks.

In order to prove so, it is first necessary to understand how do prospective investors take

the decision to invest. In actual life, the existing stock of capital goods is always the

result of an accidental historical process, consisting of a succession of unforeseen

changes, and they will never be reproduced in exactly the same form. They were only

produced in this particular form because certain kinds of equipment happened to be

available as the result of past history. (Hayek, 1941)

Any asset becomes an ex-post error as market conditions change. If investors would

have had the information they got days, months or years after their investment, they

would have invested in other assets or, at least, would have deployed their assets in

other ways. For example, if at the moment of deploying copper to provide voice

services, there would have existed wireless technologies for its provision, it is likely that

no deployment of copper wire would have happened.

In the same vein, if operators would have known that citizens would demand broadband

services in the future, they would probably have chosen another technology instead of

copper wire as access technology. But, in the moment they got that information, it was

too late, and copper wire became an ex-post mistake.

However, the adaptation of the production infrastructure to the new situation is not

automatic. It requires an explicit decision of the entrepreneurs, and it depends not only


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of the relative obsolescence of the current assets, but, most importantly, on the

incremental profits that the new investment is able to accrue.

The adoption of new techniques is limited by the usefulness of already given capital-

goods structure. (...) The fact that investment in a new technique is unprofitable means

that the use of capital in the new process at the cost of scrapping the old equipment is a

waste from the point of view of satisfying consumer wants. (Rothbard, 1993)

Applied to the ladder of investment approach, this means that, the decision of an

operator to progress from one rung to the next one is not automatic. Most importantly,

the operator, when taking this decision, will not consider the absolute level of profits

after the investment (i.e. the climb to the next rung), but only the incremental profits itwill get.

For example, suppose that in rung A the operator is obtaining XA Euros of profit, and

that it estimates that it may obtain XB Euros in rung B. The decision to invest is NOT

based on XB, but only in the increment XB XA. Only if that increment justifies the

investment, it will be accomplished. Otherwise, the situation will remain. This fact

logically implies that any operator is less likely to progress from one rung to another,than to directly start in the second rung. In the first case, the operator only sees XB XA,

but in the second it sees the full XB.

Only if there is high degree in the re-use of investments to reach one rung, allowing for

a lesser investment, is this conclusion reverted. This degree of re-use may be relevant

when progressing between wholesale services of the incumbent operator, but it is

clearly not relevant when climbing to the own access network rung.

Let us focus on the specific case of the last rung of the ladder of investment, according

to ERG. It consists of passing from the use of Unbundled Local Loop (ULL) to its own

infrastructure. As just described, in order to take this decision, alternative operators will


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take into consideration the following items (roughly): current Average Revenue per

User (ARPU), expected ARPU and current recurrent cost12.

In their own infrastructure there are no recurrent costs. The current cost is the ULL

regulated price. The decision will be based on the following magnitude (the higher, the

more likely the investment): ARPUExpected (ARPUCurrent PriceULL). According to

European Commission, the average price for ULL in the EU is 10,88 Euros per month

(fully unbundled LL), being 11,43 in Spain13. This means that the key issue for this

decision is the expected increase in the ARPU, which, in turn, depends on the services

for which costumers are willing to pay, of those that can be offered on the new

infrastructure, but could not be offered with the current one.

With ULL, alternative operators can provide telephony, broadband access services and

TV. These are the services that are currently demanded by end users; demand

uncertainty for services requiring higher speeds is great at this moment, even if there are

talks of HDTV. So, the prospects of increasing the ARPU with investment in new

infrastructure (like optical fibre) are currently dim for alternative operators. In these

circumstances, there is no possibility of progressing to the last rung of the ladder.

Compare this situation with that of an operator who is no present in any rung in the

ladder of investment. For this operator, the decision on investment depends only and

completely on the expected ARPU. Of course, this ARPU will include that derived of

new services (like HDTV), but it will also include the current ARPU obtained by an

operator using ULL. If there is an increase in the expected ARPU (due, for example, to

positive prospects for new services), it is easier that a new entrant deploy infrastructure,

than that an operator using ULL do it.

It is interesting to analyse how the price of the ULL affects the investment decision of

operators using ULL. Recall that this decision depends on the magnitude ARPUExpected

12 Note that this analysis is ceteris paribus to isolate cause and effect. In concrete, the number ofcostumers is left untouched. It is not possible to praxeologically infer any effect on the number ofcostumers from a change in the used rung of the ladder of investment.13 European Commission: Progress Report on the Single European Electronic Communications Market

(14th Report)(COM(2009)140 final). Available athttp://ec.europa.eu/information_society/policy/ecomm/library/communications_reports/annualreports/14th/index_en.htm


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(ARPUCurrent PriceULL) and the higher the increase, the higher the probability of

investment. It is immediate to show that PriceULL has a positive impact on the

magnitude, and, the higher PriceULL, the higher the probability of investment.

However, NRAs in Europe seem to go in the contrary direction. This price is decreasing

in the EU, as shown in the graphic14.

Once again, this regulatory behaviour is contrary to the goal pursued. But it has other

effects. Let analyze the investment decision process in order to progress among

intermediate rungs of the ladder, i.e., those between wholesale services of the

incumbent. For example, from bitstream services to ULL services.

Recall that the decision depends positively on the difference XB XA being XB and XAthe profits respectively obtained at rung B and rung A. In the case under analysis, the

difference may be formulated as (ARPUExpected PriceULL) (ARPUCurrent

PriceBitstream), equivalent to (ARPUExpected ARPUCurrent) + (PriceBitstream - PriceULL).

However, in this case there is a clear increment in ARPU, because it is not possible to

provide TV with commercial quality using bitstream services. Moreover, the lower the

14 European Commission: Progress Report on the Single European Electronic Communications Market(14th Report)


22/29

PriceULL, the higher the magnitude, and the higher the probability of investment.

Finally, it should not be forgotten that investment to progress between two rungs on the

incumbent network is considerably lower than to deploy a new infrastructure. This

explains why operators tend to flock on the ULL rung of the ladder of investment, but

do not progress from here.

Note that NRAs, with their decisions, are steering operators to the ULL rung of the

ladder of investment. And, it is precisely for the operators in this rung for which more

difficult is to find viable an investment in new infrastructures, as shown before.

In summary, the theoretical analysis shows that the ladder of investment approach

hinders the deployment of alternative access infrastructures, instead of easing it, as its

proponents defend. It is contrary to the goal it admittedly pursues.

4. Does the ladder of investment work?

In this section, it will be discussed if, according to historical evidence, it can be said that

the ladder of investment is working. The analysis will focus on the case of broadband

access services on the Spanish market. In this regard, at least, two papers have been

published stating that the ladder of investment is working for this market15. As this

seems contrary to the conclusion just deducted, those analyses deserve a detailed

review.

4.1 Empirical analysis under Austrian School of Economics methodology

It should be noted that, as explained in section 2, the Austrian methodology does not

rely on empirical or historical evidence for its conclusions, but on logical reasoning.

According to the Austrian school, economics is a science in the same sense that

mathematics and logic are sciences. Its claims are based on logical deduction from

indisputable axioms, and may be illustrated historically, but never verified or falsified

experimentally. In the same way, we do not ask for experimental verification that a

straight line is the shortest distance between two points on a two-dimensional plane.

15 See (Lpez & Vives, 2008), (Lpez, 2009).


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Thus, the conclusions achieved in the precedent section are true (provided there are no

flaws in the logic reasoning), with independence of the results of the historical evidence.

If this evidence shows that the ladder of investment has not worked in the past, it could

be due to exogenous causes not related to the regulatory implementation. In the same

vein, if the historical evidence showed that the ladder of investment has worked in the

past, it does not imply that it will work in the future, not even that the results observed

were due to the regulatory implementation. Historical phenomena are too complex to

allow the isolation of a concrete cause for a given event.

In brief, the historical analysis now proposed does not change in any direction the

theoretical results already developed.

4.2 Review of the empirical analysis for the Spanish market

As is usually the case, empirical research in this area throws contradictory results. There

are several studies that seem to conclude that entry regulation discourages infrastructure

investment, both for incumbents16 and for new entrants17. This seems in line with the

theoretical conclusion of this paper.

Being the ladder of investment one concrete form of entry regulation, the same should

be expected for broadband services in Spain. However, the conclusion reached in

(Lpez & Vives, 2008) and (Lpez, 2009) seems to be the contrary.

Those conclusions are based on historical data of the Spanish market. The authors

analyse the evolution of wholesale services between 2001 and 2008, distinguishing

16 See (Baake & Kamecke, 2007), (Kotakorpi, 2006)17 See (Friederiszick et al., 2008), (Waverman et al., 2007)

34,85%

42,39%

27,16% 30,66%

23,36%

60,65%

26,94%37,99%

23,11%

14,17%

42,62% 41,33%

25,19%

34,02%35,57%

0%

10%

%30%

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005 2006 2007 IIQ 2008 IIIQ 2008

20

Resale+Bitstream access shared access Full ULL


24/29

between resale+bitstream, shared access and ULL. They analyse the data in relative

terms, with the results shown in the graphic below18.

From this data, they conclude:

En conclusin, aparentemente parece confirmarse la teora de la escalera de inversin

en el sector espaol, al menos hasta el punto de presencia que se corresponde con la

desagregacin de bucles locales. Sin embargo, todava falta por saber si los operadores

alternativos darn el paso final de acceder directamente al hogar del consumidor

desplegando su propia red mediante el uso de tecnologas alternativas. (Lpez &

Vives, 2008), p.10

Existe competencia basada en infraestructuras en Espaa? La desagregacin del

bucle supone una inversin considerable en infraestructuras, podemos por tanto

considerar tanto el cable como la desagregacin de bucles locales competencia basada

en infraestructuras. (Lpez & Vives, 2008), p.11

Por un lado tenemos que el proceso de la escalera de la inversin hasta el bucle local

se ha cumplido en Espaa, y para ello ha sido fundamental la regulacin del sector que

ha incentivado el despliegue de redes. (Lpez, 2009), p.3.

It is surprising to note that alternative accesses are not analysed in any of the papers.

Taking into account that the admitted purpose of the ladder of investment is to facilitate

alternative operators the deployment of their own access network, it is difficult to see

how conclusions about its efficacy can be reached without that information.

In fact, their conclusion is that the ladder of investment up to the local loop has been

accomplished in Spain. But this conclusion misses the point, because the goal of the

ladder of investment is not that, but the deployment of alternative accesses. And itcannot be inferred from the fact that it has worked up to the ULL, that it will keep

working to the last rung. In fact, none of the operators involved in ULL in Spain has

made any progress to the last mile, after 8 years of ladder of investment.

18 Source: The ladder of investment in Spain Slides- ngel L.Lpez, 17 March 2009. Available atwww.nerec.es. Last accessed: 21 August 2009.
http://www.nerec.es/http://www.nerec.es/


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The only alternative infrastructures for fixed access in Spain are those deployed by

cable operators. None of these operators have used any of the wholesale services

provided under the ladder of investment regulation.

All these results are consistent with the theoretical analysis of the previous section. On

one side, alternative operators tend to flock around one of the intermediate rungs,

without progress to the last rung. In this case, they seem to flock around ULL services.

On the other side, investment in alternative infrastructures is more likely to come from

operators that are not using ladder of investment services. In the case of Spain, they

come from cable operators.

Besides, the authors make no analysis proving that the cause of this accomplishment is

the regulation of ladder of investment. It is just stated in the paper. A more rigorous

causal analysis would be necessary in order to reach that conclusion, but this is absent

from any of the papers. Thus, even if it were accepted that the ladder of investment is

working (in a perfunctory way), it would still be needed to prove that it is due to the

related regulation and no other cause.

In order to do so, it would be interesting to analyse the evolution of wholesale services

in light of the regulated prices of the different rungs. Specifically, it would be necessary

to analyse if the relative increases of ULL and shared access with respect to bitstream

are correlated in time with changes in difference of the regulated prices of both services.

In that case, the evolution of access should be traced not to the ladder of investment

approach per se, but to the changes in relative attractiveness of wholesale prices. The

theoretical analysis has shown that there is a strong influence of that difference whendeciding to move from one rung to the next one of the incumbent network. In other

words, if the climbing of the ladder is due to changes in prices, the efficacy of the ladder

of investment is falsified19. Unfortunately, nothing has been done in this regard.

19 Of course, ladder of investment proponents will argue that the original prices were wrong, and only

after the change could the ladder work. It has already been shown that it is impossible to have the pricesright in any case. Besides, even if this argument is accepted, why is then necessary to keep reducingthem?


26/29

Finally, the authors state that the unbundling of the loop supposes a significant

investment in infrastructures, thus we can consider both cable and unbundling of local

loops as infrastructure-based competition. If this statement is accepted, then of course

the ladder of investment has achieved its purpose in Spain.

The statement is, however, wrong. The amount of investments that ULL requires has

nothing to do with it being or not an alternative infrastructure. ULL-based operators

keep relying on the incumbent network, with independence of the investment required.

Thus, it is fallacious to state that cable and ULL constitute infrastructure-based

competition. In Spain, the real infrastructure competition is between cable operators and

incumbent. And this competition has nothing to do with the ladder of investment.

In summary, there is no historical evidence showing that the ladder of investment is

working in Spain, in spite of the analysed papers. Nor there is evidence that the

evolution of wholesale access is due to the ladder of investment regulation.

On the contrary, the historical evidence in Spain seems consistent with the theoretical

analysis developed previously: alternative operators tend to flock around ULL services,

without investing in alternative infrastructures. This investment has only come from

cable operators, which have never used wholesale services of the ladder of investment.

5. Conclusions

Since the opening of the telecommunications market for competition, European

governments have sought the deployment of an alternative access infrastructure. This is

the only way in which they see that effective competition can be achieved, as

competition will not rely anymore on the incumbent network. Surprisingly, they do not

seem to consider mobile networks as an alternative infrastructure, even if these

networks would seem capable to cater for the needs of most users.

In any case, it is not for the economic analyst to wonder about the goals of the

government, but only to analyse if the proposed means are able to attain those goals. As

already said, European governments, led by the European Commission, have


27/29

implemented the ladder of investment approach in order to achieve the deployment of

an alternative fixed access network.

It has been proven that the referred approach can not possibly attain that goal, but, on

the contrary, it hinders it. In the first place, it is impossible to establish a price outside

the market; prices set by the government will distort the investment decisions of

entrepreneurs, causing them to direct resources to wrong places.

In the second place, it is also impossible to establish relevant points of access outside

the market process: the rungs defined are thus arbitrary. Even if they are reasonable

from a technical point of view, this does not imply that there is a need for them in the

market. This definition will probably freeze innovation in the productive process and

will cause that all operators opt for the regulated production process.

Thirdly, as the decision to progress between rungs depends on the incremental profit,

not on the absolute level of the same, it is more difficult for an operator already present

in the ladder of investment to deploy its own access network, than it is for a whole new

entrant. However, the current regulation is driving prospective alternative operators to

the ULL rung, making it very unlikely that there is any deployment of alternative access

networks.

Even if the analysis of historical evidence is irrelevant for the methodology used in this

paper, a couple of papers on the Spanish market were reviewed, as they seemed to

conclude that the ladder of investment has worked in Spain. However, the empirical

evidence presented in those papers did not prove so. On the contrary, it was consistent

with the theoretical analysis presented, as it showed that the only alternativeinfrastructures had been deployed by the cable operators (which do not use any ladder

of investment service) and that no ladder of investment-based operator has deployed any

access.

In summary, the ladder of investment approach fails to achieve its goal. The theoretical

analysis unambiguously shows this conclusion, and the presented empirical evidence

seems consistent with the result. Given these conclusions, it would be desirable thatEuropean regulators and European Commission stopped pursuing this approach, not


28/29

only for the legacy copper network, but most importantly, for the new optical fibre

networks.

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paper itseurope 2009 final

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