1. 1 End of Regulation? Jerry Hausman Professor of Economics MIT July 2005 Jhausman@mit.edu

2. 2 Why do we regulate? Market Failure –Markets do not work “perfectly” or we would regulate everything –Telecommunications markets are “imperfectly competitive” –Regulation does not work “perfectly” (1) Exercise of market power –Prices above comp level

3. 3 Market Failure Type (2) “Externalities” are effects not taken into account by market prices –Network effect caused by US and other countries to cross subsidize local phone service. No longer needed 90% of people have Now paid for by long distance bills Cannot last with VOIP which can avoid the “tax” Cable companies will have an advantage—non- neutral competition –Levy tax on all monthly telecommunications revenue Include cellular and cable Better approach it to use general tax revenues like food stamps and only target the poor.

4. 4 Where are we are: Telecom Act of 1996 Changes in Industry –Mobile penetration was at 16% in 1996 now at 64%. Average mobile usage also increased by 6 times Prices per minute have decreased by 2/3 No broadband included in act No VOIP existed at the time. Flawed conceptually: based on “artificial regulated competition”. –Incumbents expected to share networks –Justice Breyer of US Supreme Court said not “real competition”. Need facilities based competition

5. 5 Problems with Regulation Main Problem: may cause facilities (platform) based competition not to emerge –Regulated prices set too low –Stopped investment by incumbents –Stopped investment by new entrants Less expensive and less risky to rent rather than to buy Regulators gave a “Free option” –Creates a disincentive to innovate and invest in new technology –Once regulation was changed for new technology incumbents investing in fiber to the node and fiber to the home to offer TV in competition with cable

6. 6 Problems with Regulatory Approach FCC Misapplies “necessary and impair standard” –Focuses on “competitor welfare” not the actual state of competition DC Circuit Court of Appeals Review –States FCC doest not understand competition Failure of competition is basis for regulation and needs to be primary focus –Problem with FCC leadership –No economic or business background –Lawyers have not training to understand competition US policy changed to focus on competition, but leadership of FCC has not changed its approach

7. 7 Competition ends need for regulation With competition cannot price above competitive level Example of Long distance –I gave a speech in 1994 stating AT&T would not exist in 10 years –FCC regulations provided “regulatory life support” to AT&T AT&T was doomed because of changes in technology –Fiber optic transmission means you do not need a hierarchical network based on switches –A “flat network” ends the reason for long distance companies

8. 8 Results of End of Regulation of Long Distance Long distance is now unregulated as of 2004 –Academic study demonstrated that BOC entry and the end of regulation led to lower prices by 15%. –Save consumers approximately $15 billion per year –Expected because of “double marginalization” Example of situation where regulation harmed consumers Focus of 1984 breakup of AT&T –Technology changed but regulation did not adapt sufficiently quickly –Markets change more quickly than regulation can adapt

9. 9 Should Landline Service Still be Regulated? Important principle of economics –Only marginal customers need to switch with no price discrimination to constrain exercise of market power Apply principle to landline service –Low MC to price so you only need a small percentage –Calculation: Only need about 6% to shift –I demonstrate calculation in my 2002 paper. Under US law not allowed to price discriminate to similar customers so the finding of a small percentage holds

10. 10 Mobile Competition for Voice Mobile offers very price competitive packages –Price is $39.99-$49.99 per month –Offers near unlimited local and long distance calling Less expensive than Verizon landline bundle for unlimited local and long distance Many young people only use mobile Mobile does not yet offer a competitive broadband access package

11. 11 Cable competition for Broadband and Voice Competition from cable is quite high for broadband –Cable passes 96% of US household –Cable has about 2/3 of broadband customers –Quality of cable modem service is superior to DSL Cable now doing VOIP which offers voice competition –Time Warner, Comcast and Cox which are the 3 largest cable companies –Cox claims 33% of customers now use cable voice service –Well above the 6% critical level

12. 12 Competition among Cable and Telephone Cable currently has superior consumer package –Cable offers “triple play” –Services are broadband, phone, and TV. Telephone hope to do “quadruple play” –Fiber to the home or curb will allow TV –Other 3 components are landline voice, broadband, and mobile Cable expected to make a competitive response Time Warner and Comcast expected to do MVNO deal with Sprint Sprint already does MVNO with Virgin and Disney

13. 13 End of Regulation? With competition do not need regulation –Regulation often leads to consumer harm –Regulators try to protect competitors FCC is a bloated bureaucracy –Number of employees has doubled –Not what I expect from a leaner government My regulatory proposal: incumbents provide landline voice service for residential and for small business customers at current subsidized rates and deregulate every thing else –Competition takes care of other services –Voice service can be deregulated when VOIP has 10% of the market

14. 14 Reasons to End Regulation Benefit: allows incumbents to provide new services to compete with cable –Video streaming services Currently a crazy situation that harms consumers: –Firms without market power (incumbents) are regulated –Firms with market power (cable) are not regulated! Regulation has not been able to keep up with changes in technology and has led to billions of dollars of consumer harm –Delayed introduction of new services (e.g. mobile) –Higher prices to consumers (e.g. mobile and also long distance)