TCS Daily

Ray of Light

By Kevin Hassett - October 7, 2002 12:00 AM

About two-thirds of our nation's economic growth is driven by innovations in information technology. Telecom plays an essential role in information acquisition and dissemination and accounts for the lion's share of IT investment and innovation. A vibrant telecom sector is thus vital to the short- and long-term success of the economy. Yet, after booming in the second half of the 1990s, following the passage of the Telecommunications Act of 1996 (TA96), the telecom industry has fallen on hard times. Hundreds of large and small telecom firms that attempted to compete with the incumbent local exchange carriers (ILECs) have gone broke. Others are close to that fate. The ILECs blame this outcome on the CLECs (competing local exchange carriers). The CLECs blame it on the ILECs and the failure of authorities to competently enforce the Act.

While the two sides and their supporters have been arguing, a ray of light has started to shine at the end of the industry's tunnel. The market share of new entrants has finally begun to increase sharply in a few states that have taken the lead in enforcing the Act. This is producing significant price reductions and savings for consumers and small businesses. For example, local phone customers that switch to CLEC providers can now save $11.40 per month in California. In New York, where the PUC has been particularly aggressive in enforcing TA96, more than 5 million consumers have recently changed their local or long distance phone company to CLECs and are projected to save as much as $324 annually per line.

In a new paper entitled "The Role of Competition in Stimulating Telecom Investment" (partially funded by AT&T), we explore the economics of telecom investment and show that economic theory, properly applied, can shed considerable light on recent industry developments. The paper develops and analyzes a dynamic strategic model of entry that is rich enough to study the role of competition and policy in stimulating telecom investment, raising telecom output, lowering telecom prices, and improving consumer welfare.

The paper begins by reviewing the recent rise and fall of telecom investment. Next, it shows the importance of the Telecommunications Act of 1996 (TA96) in stimulating investment. And third, it develops a model to evaluate the impact of TA96 on the industry. The paper's central conclusions are a) that strengthening competition in the telecom sector by strictly enforcing TA96 is the key to restoring telecom investment, employment, and output and b) reductions in ILEC monopoly rents are likely to signal improving health of the overall industry, rather than represent a source for concern.

Studying the telecom market is a non-trivial exercise. The market is characterized by imperfect competition, regulation, advanced technology, network externalities, strategic gaming, and entry. Policymakers who substitute their intuition for careful modeling of this market do so at their own peril. The same is true for telecom economists who rely on simple static models that miss the fundamental dynamics of markets of this type.

To address the complexities of the telecom market, we constructed and simulated a strategic equilibrium model in which ILECs, CLECs, and cable companies compete over time for market share in interrelated and partially regulated local telecom services markets. Simulated ILECs, CLECs and cable companies compete against each other over geographical areas in order to maximize their profits. In our computer model, the actions of each player change the optimal responses of the other players, much like a chess match. The actions here include deciding whether to enter new telecom markets, whether to remain in existing markets, and how much to produce given entry. Each of these decisions depends on the policy environment.

Though highly stylized, our framework suggests a number of interesting results. First, telecom investment and output usually increase significantly and telecom prices decrease significantly when new firms enter a market. This is true whether or not the entry occurs because of normal economic forces or as a result of wholesaling arrangements under which competitors rent access to customers from incumbents. The improvement in market conditions can be quite striking, with capital investment increasing in some simulations by 40 to 60 percent and prices for local phone service and broadband dropping by 30 percent.

Second, unbundling (forcing the ILECs to rent to the CLECs all or part of their network elements) can dramatically increase CLEC entry by lowering their costs of doing so. Third, competition raises consumer welfare relative to having a regulated monopoly in local voice and an unregulated duopoly in broadband.

Finally, declines in ILEC profits and share valuations can herald good news for the overall telecom industry as well as its customers for one good reason -- competitive entry reduces monopoly profits. Moreover, reductions in ILEC rents don't necessarily spell less ILEC investment or sales. Indeed, in our model, ILECs typically do what they actually did in response to TA96 - they respond to competitive pressure by increasing, rather than reducing, their investment. The reason is that, in the presence of competition, investing less and, thereby, withholding product from the market no longer pays off in terms of higher prices.

To better see this point, consider the following thought experiment. Suppose that you are a monopolist with 100 customers, each paying $30 per month for local phone service. Further assume that your cost at the margin is $10 per month and that your total profit is $2000. There is a 101st customer in your market who does not have a phone, and he tells you he will sign up if you charge him $29.

Should you do it? Definitely not, even though it looks like you might be able to make an extra $19. The reason is that even a monopolist has to charge everyone in the marketplace the same price for the same product. If you lower your price to $29 for the last fellow, then you have to charge everyone else $29 as well, losing $100 in fees to the first hundred customers. If you do that, your profits will be only $1919! This simple example highlights an important point. A monopolist restricts its sales in order to jack-up prices and maximize overall profits.

Now suppose that the price of phone service is set in a more competitive market place. Suppose, for example, that a few new firms enter and start charging $15 a month for phone service. Assume that at the lower price there are 200 people who desire telephone service. What should the former monopolist do? In this case, it is no longer an option to restrict output in order to increase profits, so the monopolist just takes the $15 price as given and does that best it can. Competition changes the entire problem! The price is lower, output is higher, and since it takes additional capital to run 200 phone lines, investment rises as well.

It is important to note the contrast between this analysis and that of ILEC supporters. They argue that allowing entry lowers the return on investment for ILECs so the investment just doesn't happen. Such analysis fails to recognize the important role that increased competition plays in determining capital and output, and is only relevant to a world where ILECs are already competing with numerous other firms for your local phone business. In other words, such analysis ignores the problem altogether.

Our model is highly stylized and does not yet incorporate the profits that the ILECs receive from being allowed to enter the long distance market in exchange for unbundling their networks. Still, the model's preliminary findings that ILEC monopoly profits from local voice service may drop in response to even nascent competition may help explain the ILEC's sharply increased efforts in recent months to overturn TA96, as market conditions have begun to move in the direction implied by our theory. Indeed, when we incorporate unbundling in our model, our simulations are highly consistent with the empirical evidence that TA96, when properly enforced, leads to sharp reductions in telecom prices, significant consumer savings, and major increases in telecom investment and output. The very recent experience in state markets such as New York and Michigan that have experimented with low unbundling prices looks very much like our simulations. When CLECs enter because of unbundling, prices decline, output and investment increase, and ILEC monopoly profits in local voice service decline.

While the ILECs are understandably chagrined to lose any of their monopoly rents, their increasingly loud complaints about TA96 are a clear sign that the law is working and that the public is benefiting. An even stronger sign are the price reductions and cost savings that the public is enjoying in states that are aggressively enforcing TA96. It's too early to know whether this incipient rebirth of telecom competition will spread to the entire county. But if it does, it should not only rejuvenate the telecom industry but also help revive the overall economy.

Kevin Hassett is a Resident Scholar at the American Enterprise Institute and Laurence Kotlikoff is Chairman of the Department of Economics at Boston University.

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