GEORGE S. FORD CHIEF ECONOMIST Economic Tools for Broadband PolicyPHOENIX CENTER 1

The 800 Pound Gorilla … 2

3 Markets Never Work Markets Never Fail

The 800 Pound Gorilla … 4

Realistic Expectations 5 We need to form realistic expectations about …  Market Structure (how many firms)  Nature of Competition  Effect of Competition on Investment and Innovation  The Relationship between Communications Infrastructure and Economic Activity  The Efficacy of Regulation  What Markets Do  What the Data Tells Us

Market Structure 6 N* is Few  N ≈ 2 is not an unrealistic expectation for terrestrial, wireline networks  It appears that N ≈ 3 to 5 is right for wireless communications  “Nearby” competitors (wifi, wimax) offer additional limits to market power

N*: Equilibrium Number of Firms 7 Firms enter until the next entrant loses money When entry stops, and exit does not occur, we have equilibrium N* depends on the size of the market, the fixed/sunk cost of entry, and the intensity of competition

Numerical Example: Policy Paper No Number of Firms (N) Firm Net Revenues Entry CostsNet Profits N * = The Equilibrium Number of Firms is 3. If the 4 th firm enters, all firms lose money. All make money at 3, so this is the equilibrium.

Numerical Example: Policy Paper No Number of Firms (N) Firm Net Revenues Entry CostsNet Profits N* = The Equilibrium Number of Firms is 5. If the 6 th firm enters, all firms lose money. All make money at 5, so this is the equilibrium.

Numerical Example: Policy Paper No Number of Firms (N) Firm Net Revenues Entry CostsNet Profits N* = The Equilibrium Number of Firms is 6. If the 7 th firm enters, all firms lose money. All make money at 6, so this is the equilibrium.

Competition 11 General view is the price falls as the number of firms increases This is the Cournot View with Homogeneous Goods Or, Bertrand with Product Differentiation The full range of outcomes is possible theoretically P M MC Price N      Cournot  Bertrand Collusion A

What About Competition? 12 Intense Price Competition Moderate Price Competition Perfect Collusion NEntry Costs Net Rev. Net Profit Net Rev. Net Profit Net Rev. Net Profit

Competition and N 13 There’s a Difference:  Intensity of Competition  Number of Firms The Intensity of Competition relates to how firms interact Price reductions from additional firms is based on more firms competing, not necessarily a change in the way they behave with respect to price Intensity is behavior, not count, and too much intensity leads to very few firms

The Evidence 14 Can we form a general expectation about the intensity of rivalry? Empirical studies are mixed Experimental work suggests the tendency is Cournot or better. Experimental Results: Fouraker and Siegal (1963) TypeOutcomes Collusion3 Weak Competition1 Cournot7 Bertrand5 Total16 75% were Cournot or Better.

More Like Cournot More Like Bertrand Price is inversely related to industry concentration  P = f(HHI)  P = f(N) Price is not related to industry concentration for 3 or more firms  P≠f(HHI)  P≠f(N)  Price cut occurs at 2 nd firm.  Difficult to distinguish between Cournot with only 2 firms.  Also difficult to differentiate when N gets large 15 Interpreting the Evidence

Too Much Competition? 16 Policy Paper No. 24: Network Neutrality and Industry Structure  Argument: If differentiation is prohibited by rule, firms are homogeneous, leaving only price to compete over.  Intense price competition can deter entry, leaving monopoly and no price competition at all. Paradox  Differentiation softens price competition, but allows for price competition.

What’s the Benchmark? N* = 2 17 Perfect Competition  Marginal Cost = MC Five Firms  P 5 Equilibrium Industry Structure  P 2 is as low as it goes  Profit ≈ 0  N=3, Profit < 0 P M P 2 P 5 MC Price N      Cournot

What’s the Benchmark? N* = 2 18 Perfect Competition  Marginal Cost = MC  Profits = 0 Marginal Cost Pricing Not Possible  Losses = abcd Equilibrium Industry Structure  Can only satisfy zero profit condition with fixed/sunk costs  MC Pricing not possible without massive subsidies P 2 MC 0 $ q Firm Demand Avg. Cost  a b c d Equilibrium N=2

The 800 Pound Gorilla … 19

Competition and Investment/Innovation 20 Investment and Innovation are higher with competition, up to a point Effect 1. Monopolies have the profits to fund innovation, but face no pressure to do so. Effect 2. Competition reduces profits, but firms innovate to escape competition (create market power). Rate of Innovation Competition Maximum  *Aghion et al, Competition, Imitation and Growth with Step-by-Step Innovation, Review of Economic Studies (2001).

Efficacy of Regulation (and it’s role) 21 How good is regulation in a Monopoly setting? How good is regulation in a Duopoly setting? How good is regulation in a Triopoly setting? And so forth? Is limited competition better than regulation? What can regulation improve in a setting of limited competition? What the role of regulation if we have N* and its small? What N* = 2, Profit = 0, yet there is collusion?

Congress’ View: The Cable Act of Cable Act deregulated a cable system when it had a competitor that passed 50% of its market (and had a penetration rate of at least 15%).  Deregulate at 1.5 firms Small systems were also unregulated  Benefits < Costs Unbundling/Special Access  Triggers (a bit nutty)

Successes and Failures 23 Cable Regulation – Failure Special Access – Failure Unbundling – Failure Interconnection Reform – Failure USF – Broken? Broadband Ubiquity by 2007 – Failure Payphone Compensation – Repeated Failure Wireless E911 - Failure Madison River? Part 68 Rules – Success (Monopoly Period) Number portability wireline, wireless, but not between – Success E911, Wireline and VOIP, not wireless – Success Spectrum Auctions – Success Other ….

Special Access Profit Margins 24 Pricing Flexibility/ Deregulation

Madison River 25 VOIP-Capable DSL = $30 VOIP-Blocked DSL = $20 FCC Says No VOIP-Blocking, or No Price Differences VOIP-Capable DSL = $25 (or something like that)  Now everyone pays $25, where many would prefer to pay $20 Under plausible conditions, such a decision is welfare reducing (consumer welfare reducing!) Difference is opportunity cost of lost profit from phone service.

Regulation versus Limited Competition A little competition probably wins this battle. Regulation is typically for things that the market cannot fix (Externalities, Natural Monopoly, Social Programs). Price and Quality are the purview of the market.  Firms can impede competition Perfection is not possible by regulators or markets, because perfection is subjective.  Firms typically meet the average needs (cost-benefit test)  Some Won’t be Happy 26

Be Realistic About Markets Markets don’t resolve problems in an instant  It is the loss of a large number of customers that reveals a bad business decision. That takes time.  Complaints and news articles are the manifestation of this emigration. It is often evidence the market is working, not failing. There will be complaints – people complain incessantly about Wal-Mart. Some people complain about their Toyota or Honda, despite being highly reliable, affordable autos.  Complaining is not evidence of market failure.  Service prices and quality YOU or I don’t like is not market failure. 27

Be Realistic About Markets Home Networking  Network Neutrality proponents use as example  Market eventually solved it without regulation Bluetooth Crippling  Another Net Neutrality example  Market solved it WIFI Crippling  Another Net Neutrality example  Market solved it 28

A REVIEW OF BROADBAND COMPARISONS AND RANKINGS 29 What About the Evidence?

Broadband Rankings, OECD Korea IcelandDenmark Canada DenmarkKoreaNetherlands SwedenBelgiumIcelandNetherlands Iceland U.S.IcelandDenmarkIcelandDenmarkKorea DemarkNetherlandsCanadaSwitzerland SwedenBelgiumSwitzerlandFinlandNorway NetherlandsSwedenBelgiumNorwayFinland U.S.Japan CanadaSweden SwitzerlandFinlandSwedenCanada U.S.NorwayBelgium SwedenJapanUK U.S.UKLuxembourg U.S.France Japan U.S. 30

Broadband Rankings 31

Broadband Rankings 32

Broadband Rankings, OECD Korea IcelandDenmark Canada DenmarkKoreaNetherlands SwedenBelgiumIcelandNetherlands Iceland U.S.IcelandDenmarkIcelandDenmarkKorea DemarkNetherlandsCanadaSwitzerland SwedenBelgiumSwitzerlandFinlandNorway NetherlandsSwedenBelgiumNorwayFinland U.S.Japan CanadaSweden SwitzerlandFinlandSwedenCanada U.S.NorwayBelgium SwedenJapanUK U.S.UKLuxembourg U.S.France Japan U.S. 33

Normalization of Subscription Counts OECD ranks subscriptions per capita Per Capita is a reasonable choice for normalization, but it is not an innocuous adjustment. Any adjustment introduces error; may not make much of a difference, but it may. Home A: 4 people Home B: 3 people If both have a broadband, then Home A has a subscription rate of 25 while Home B has a subscription rate of 33. Household normalization helps, but does not control for businesses. 34

United States Sweden Persons per Home = 2.7 Persons per Home = Normalization

2006 Broadband Ranking 2003 Telephones Ranking Denmark Luxembourg Netherlands Sweden Iceland Korea Norway Switzerland Denmark Norway Switzerland Finland Sweden Greece Canada UK Belgium Italy UK Germany Luxembourg Netherlands France Spain Japan Czech Republic Some countries tend to rank high in per-capita communications consumption. The U.S. presently ranks 24 th in telephone per capita (wireless and wireline). Over the period , we ranked about 7 th. After 1998, the U.S. has fallen to quickly to the low 20’s (presumably due to mobile phones and different counting schemes). Who ranks high? High Rank for Communications 36

Broadband Rankings, OECD Korea IcelandDenmark Canada DenmarkKoreaNetherlands SwedenBelgiumIcelandNetherlands Iceland U.S.IcelandDenmarkIcelandDenmarkKorea DemarkNetherlandsCanadaSwitzerland SwedenBelgiumSwitzerlandFinlandNorway NetherlandsSwedenBelgiumNorwayFinland U.S.Japan CanadaSweden SwitzerlandFinlandSwedenCanada U.S.NorwayBelgium SwedenJapanUK U.S.UKLuxembourg U.S.France Japan U.S. 37

Time and Subscription Time Subscription Rate Measure At Time t 0 Measure At Time t 1 A fall in rank may suggest leadership. Must have some guesstimate of terminal subscription for rank to relevant. 38

Household Penetration of Broadband: US and EU OECD Members Source: EU Commission, E-Communications Household Survey (Apr. 2007). U.S. from Pew Internet and American Life Project (2007). 39 Complaint: Different studies/methodologies. But, where does the OECD data come from?

Broadband Nirvana: All Homes and Business Have Broadband CountrySubscriptionRankCountrySubscriptionRank Sweden54.1%1 Norway40.3%16 Iceland48.9%2 New Zealand39.8%17 Czech Republic47.8%3 Portugal39.2%18 Denmark47.8%4 Japan39.0%19 Finland47.7%5 United Kingdom38.9%20 Germany44.9%6 United States38.0%21 Netherlands43.7%7 Luxembourg37.8%22 Australia31.5%8 Greece36.2%23 Switzerland42.9%9 Slovak Republic35.1%24 France42.4%10 Ireland34.7%25 Canada41.9%11 Poland34.1%26 Hungary41.1%12 Spain33.8%27 Belgium41.%13 Korea25.4%28 Austria40.6%14 Mexico24.7%29 Italy40.4%15 Turkey21.2%30 40

Determinants of Broadband Subscription The Broadband Nirvana ignores the impact of income, age, density, and so forth on subscription. P HOENIX C ENTER P OLICY P APER N O. 29 measures the impact of a wide range of determinants of broadband subscription to assess whether or not countries are exceeding, meeting, or falling short of “expectations.” Relevant determinants are: Price (-), Income (+), Income inequality (-), Education (+), Age (-), Density (+), Phones (+), Business Size (-), Time (+). 41

Algebra: y = a + bx Algebra: y = a + bx Econometrics: Regression 42 Regression Analysis y x      y = 30 – 5x y x      We try to fit the curve to “messier” data           

Univariate Regression y = a + bx Univariate Regression y = a + bx Multivariate Regression: y = a + bx + cz Multivariate Regression: y = a + bx + cz 43 Regression Analysis y x y x                                    

Effect Size of Determinants VariableEffect for a 10% Increase VariableExplanatory Power GINI-8.4%AGE6550 GDPCAP+8.1%GDPCAP42 AGE65-7.3%BUSSIZE41 BUSSIZE-3.5%DENSITY31 PHONE+2.5%GINI30 PRICE-2.3%PHONE20 EDUC+1.8%PRICE18 DENSITY+0.8%PHONE218 BIGCITY-0.6%EDUC13 HHSIZE+0.4%BIGCITY04 HHSIZE00 44 AGE65 Japan = 26.9% AGE65 Korea = 12.4%

Broadband Policy 45 90% of differences in broadband subscription across OECD is explained by non-policy factors

Broadband Performance Index (Alternative Specification) 46 Exceeds Expectations Below Expectations Meets Expectations

What Should We Rank? 47 Estimate the BPI regression only for the top 15 of OECD countries excluding the U.S.  Coefficients are driven by the most successful countries U.S. Ranks 10 th Absent reformulations of the counting schemes across countries (like for wireless), the U.S. should rank about 10 th in subscriptions per capita  This is roughly consistent with its rank for telephones/pop before wireless

From Rank to … The rank statistics often precedes claims about  Lack of deployment  Lack of Bandwidth/Speed Ubiquitous availability might move us up 4 spots in the rankings  Assuming 10% unavailability, we go from a subscription rate of to  Assuming 5% unavailability, we go up 3 spots. 48

Does Speed Matter? Higher speeds will only draw in the marginal users Those that want speed the most have already subscribed to broadband Speed is unlikely to increase our broadband ranking, or reduce it SpeedValue AValue B At $30, the high-value customer buys broadband at any speed. Speed must be 6Mbps for the low-value customers to buy. POINT: Higher speeds impact only marginal users. 49

Speed and Subscription: No Help Here Speed Subscription Rate After about here, the additional impact of speed on subscription is trivial. For OECD countries, advertised speeds (provided by ITIF) are unrelated to broadband subscription rates in a well specified model. 50

Speed and Time Time Speed/Technology Technology improves over time. Investments are made at time t. Network remains for x years. Later investments are in better technology. Perpetual game of catch-up or leap frog. Invest Use Invest Use 51

Time and Subscription Time Subscription Rate Measure At Time t 0 Measure At Time t 1 A fall in rank may suggest leadership. Must have some guesstimate of terminal subscription for rank to relevant. 52

The Demand for Bandwidth: Korea (KTT) ServiceUpDown% Subs Lite640Kpbs4Mpbs84% Premium4Mpbs13Mpbs4% Special4Mpbs20Mpbs5% Ntopia4Mpbs50Mpbs12% Source: S. Wallsten, Progress on Point (June 2007). 53

Broadband Speeds CountryClaimed Speed (Mbps) Actual Speed (Mbps) Japan Korea Finland Sweden France Netherlands Portugal Canada Poland U.S Sources: Claimed Speed, D. Correa, ITIF (2007). Actual Speed, (2007); Korea may be slightly understated due to a lack of a local test server. Sample sizes in Speedtest.net data are often very large. Of actual speeds, U.S. ranks 8 th of 100 countries. 54

The Japanese Miracle? Japan is touted as a “broadband miracle”  Claim: 100 Mbps Fiber Service for $30 Reality  Avg. Download Speed = 10Mbps  100Mbps = $53/month  Japan is ranked 14 th in OECD, basically with the same subscription rate as U.S.  58% DSL; 29% Fiber; 14% Cable Zero and Low Interest Loans for Networks Tax Incentives (not very important with 0% loans) 33% of Municipal System Construction Costs are Subsidized 55

Investments in Broadband K = Investment Amount r = Hurdle Rate P = Price you can sell it for (price structure) c = incremental cost n = number of buyers I = Information available Q = Quality of Service Z = Other stuff like income, education, etc… 56

Investments in Bandwidth Cost of the upgrade must exceed the net revenue from the sale of the services made possible. If you upgrade your network to 50Mbps, how many people will buy it? Communications carriers can only spend what investors will give them. Investors demand a return. That’s the world we live in. If you don’t reward investors, the money won’t come. 57

Investments in Bandwidth "It is not the multitude of alehouses … that occasions a general disposition to drunkenness among the common people; but that dis- position, arising from other causes, necessarily gives employment to a multitude of alehouses." Adam Smith, Wealth of Nations (1776) 58

Investment in Bandwidth MARKETS DON’T WORK  That depends on what you want markets to do.  Rather than saying the market has failed to provide adequate speed and coverage, why not say the market is providing us information that the demand for speed is low and the demand is inadequate to cover costs in some markets.  A proper perspective leads to proper policy responses  Markets work because they are the fastest way to disseminate and incorporate information. Look to the market as a source of information.  An all-knowing being could mimic the market (but I’m not interested in the job). 59

Investments in Broadband K = Investment Amount r = Hurdle Rate P = Price you can sell it for (price structure) c = incremental cost n = number of buyers I = Information available Q = Quality of Service Z = Other stuff like income, education, etc… 60

Investments in Broadband ActionEffect Price RegulationProbably Less Investment Net NeutralityProbably Less Investment Tax IncentivesMore Investment Low Interest LoansMore Investment SubsidiesMore Investment (if done right) Connect KentuckyMore Investment More CompetitionDepends (up or down slope?) 61

Firms Invest Less than Society Desires (Complaints are to be expected) Interestingly, charges different prices to different people/groups reduces the difference. Regulatory risk inflates r. FCC says competition inflates r. 62

[PRELIMINARY] BPI FOR U.S. STATES 63 What about the US?

Effect Size of Determinants VariableEffect for a 10% Increase VariableExplanatory Power INSCHOOL-22.0%RURALFARM0.57 NATIVE-20.0%NATIVE0.40 GINI-13.2%RURAL0.37 HHSIZE-12.8%GINI0.36 ENGLISH+8.7%ENGLISH0.34 RETIRE-3.4%HHSIZE0.14 PERCAPINC+3.3%RETIRE0.12 SELF EMP.+2.6%SELF EMP.0.11 RURAL-2.3%INSCHOOL0.08 EDUC+2.1%PERCAPINC0.08 BUSSIZE+1.5%BUSSIZE0.06 RURALFARM-1.4%EDUC

BPI – Sort of (Preliminary) 65