Elsevier

Telecommunications Policy

Volume 34, Issue 11, December 2010, Pages 697-710
Telecommunications Policy

Access regulation and the incumbent investment in quality-upgrades and in cost-reduction

https://doi.org/10.1016/j.telpol.2010.09.003Get rights and content

Abstract

This papers studies if access price regulation has an impact on incumbents’ incentives to invest in their network that might differ according to the nature of investments, that is, quality-upgrading and cost-reducing. It is shown that if the marginal cost of quality-upgrading is very low both types of investment are increasing in the access price. If the marginal cost of cost-reducing is very low, both investments decrease after an increase in the access price. Otherwise, a high access price increases the incentives for quality-upgrading and reduces the incentives for cost-reducing. Therefore, regulators should set a higher access price the lower is the marginal cost of quality-upgrading as compared to the marginal cost of cost-reducing.

Introduction

Access regulation and investment: Over the last decades, one of the main goals of economic regulation has been to increase competition in markets that have traditionally been less competitive, namely the telecommunications market. This market is generally characterized by the presence of a bottleneck problem. Indeed, due to the presence of high entry barriers, scale economies, sunk costs and first-mover advantages, it is hard for a new operator to enter as a full-facility competitor. In particular, the building of local access networks, which are composed of circuits connecting end users to switches located in central offices, requires large financial and time-consuming investments.

One of the main instruments used by regulators to solve this problem is to require the incumbent to make parts of its network available to entrants. The idea is that rivals can compete as service-based competitors by using the incumbent's network to supply their services and paying an access price in return. This policy is promoted both in the United States since the 1996 Telecommunications Act and in the European Union since the 1998 liberalization, especially in the form of the “access to the local loop”, and is supposed to generate entry into the market.

More recently, there has been an increasing focus of regulators on the investment incentives of operators, particularly with the emergence of several plans for the introduction of advanced (“next generation”) networks. Incumbents are now investing in the upgrade of the quality of services supplied through their networks1 and in the reduction of the cost of supplying these services.2

In this article, these two categories of investment are distinguished in order to answer the following policy questions: (i) Is it important for regulators to distinguish between quality-upgrading and cost-reducing investments, or do they have the same impact on competition?; (ii) What is the relationship between access price regulation and the investment on each component?; (iii) What is the optimal regulatory policy when an incumbent can decide how much to invest in each component?; (iv) Do things differ when the incumbent cannot isolate the two effects?; and finally, (v) What is the impact of the regulator being unable to perfectly commit to an access policy before investment?

Model and results: To answer these questions, a theoretical model with two operators, an incumbent and an entrant, that compete in subscription prices is developed. The entrant can only compete with the incumbent if it has access to its network, for which it must pay an access price. The model supposes partial consumer participation, therefore it portrays non-mature markets such as the broadband market.

The first contribution of the analysis is the comparison of the incumbent's incentives for two different types of investment: quality-upgrading and cost-reducing. It is shown that, although these two types of investment are complements, the direct effect of an increase in the access price on each type differs. Indeed, when the access price is higher, the incumbent earns more profit with the entrant's subscribers. As a consequence, it has a higher incentive to invest in quality-upgrades, enlarging market demand and increasing both operators’ number of subscribers. On the other hand, it has fewer incentives to invest in cost-reduction since this decreases its rival's number of subscribers, by increasing its cost disadvantage.

In equilibrium, the quality-upgrading and the cost-reducing investments are increasing in the access price if the marginal cost of quality-upgrading is very low. If the marginal cost of cost-reducing is very low, both cost-reducing and quality-upgrading decrease after an increase in the access price. Otherwise, a high access price increases the incentives for quality-upgrading and reduces the incentives for cost-reducing. Total investment increases with the access price when the marginal cost of quality-upgrading is relatively lower than the marginal cost of cost-reducing.

The next contribution of the paper is about the optimal regulatory policy when the incumbent can invest in the two components. It is shown that if the regulator only had static objectives, it would be socially optimal to have the incumbent subsidizing the entrant's activity through a negative access margin. However, when the regulator sets the access price, he must take into account static and dynamic objectives, that is, the access price must be used for three objectives: to increase the intensity of competition, to give incentives for the cost-reducing investment and to give incentives for the quality-upgrading investment.

When both types of investment are decreasing in the access price, the regulator's decision becomes similar to the absence of investment case. If, instead, one or both types of investments are favored by a high access price, the regulator needs to solve a trade-off between static and dynamic objectives, which may give him incentives to set a higher access price. Therefore, and taking into account the interactions between the access price and the different investment types, a regulator should set a higher access price the lower is the marginal cost of quality-upgrading relatively to the marginal cost of cost-reducing.

Three extensions to the model are considered. In the first extension, the case where the incumbent cannot isolate the quality-upgrading and the cost-reducing effects of its investment is analyzed, and it is shown that the relationship between investment and the access price is positive when the quality-upgrading effect has a higher weight, and negative otherwise. As a second extension, the analysis is in the context of imperfect commitment, when the regulator is only able to commit to an access price set before investment with a probability lower than 1. The results are, however, very similar to the full-commitment context, although the incumbent has weaker incentives to invest. Finally, a short analysis of a mature market is provided. In this case, the quality-upgrading investment increases with the access price, while the cost-reducing investment is invariant to it.

Related literature: This paper analyzes the impact of access regulation on the incumbent's incentives to invest. The contribution to the literature results from distinguishing between two different types of investment, quality-upgrading and cost-reducing, which interact in equilibrium.

The recent literature on the relationship between infrastructure investment and the different regulatory regimes has been surveyed by Guthrie (2006). Cambini and Jiang (2010) also provide a survey on the relevant theoretical and empirical literature about the relationship between regulation, at both retail and wholesale level, and investment in telecommunication infrastructures.

This literature has never distinguish between different types of investments, instead it generally focus on the optimal level of one type of investment.3 Thus, it neglects the possible interactions between different types of investment. Foros (2004) and Kotakorpi (2006) analyze the investment of an incumbent firm in quality, assuming that the regulator cannot commit to a regulatory policy previous to investment. According to these authors, the incumbent firm, being exposed to the “regulatory risk” of below-cost access, tends to reduce its investments unless it is much more efficient than its rivals in the downstream market. Klumpp and Su (2010) show that, when the access price is set according to a revenue-neutrality principle, open access leads to a higher investment in quality. Cambini and Valletti (2004) study the impact of access charges on the incentives to invest in quality, but in a context of two-way access. They derive the result that firms would choose an access price above marginal cost in order to diminish each other's incentive to invest. Brito, Pereira, and Vareda (2010) discuss the impact of the regulator's inability to commit on the investment of the incumbent firm on a new network which allows the supply of higher quality services, and show that two-part tariffs are not always enough to solve the dynamic consistency problem that emerges in this context. In addition, there are some papers that consider cost-reducing investments, such as Biglaiser and Ma (1999), Cabral and Riordan (1989) and Sappington (2002), the first in a context of an incumbent firm and the other two consider a monopoly.

There are also several empirical studies analyzing the effect of access regulation on incumbent firms’ investment. Willig, Lehr, Bigelow, and Levinson (2002) examine the relationship between access prices and Bell companies’ investments, and conclude that lower access prices stimulate incumbents’ investment. A study by Hassett, Ivanova, and Kotlikoff (2003) obtains similar conclusions. Haring, Rettle, Rohlfs, and Shooshan III (2002) criticize the estimation methodology of Willig et al. (2002) and develop their own econometric model. They obtain the opposite relationship that low access prices reduce the profitability of incumbents’ investment leading to a reduction in that investment. Hausman and Sidak (2005) corroborate this opinion in their case study about the local loop unbundling experience in the US, New Zealand, Canada, United Kingdom, and Germany. A study by Chang, Koski, and Majumdar (2003) using US data finds that lower access prices have spurred investment by incumbents. Even so, the same study points in the opposite direction for Europe. This paper also contributes to the clarification of this controversy by determining under which conditions an increase in the access price leads to an increase or a decrease in the incumbent's total investment.

The remainder of the paper is organized as follows. The model is described in Section 2, and in Section 3 the equilibrium of the game is solved. In Section 4 some extensions to the model are analyzed, and finally, Section 5 concludes. All proofs are in the Appendix.

Section snippets

The model

Consider a model of a telecoms market where two firms compete on subscription prices. The operators on this market are: one vertically integrated operator (denoted as incumbent), and one non-integrated operator (denoted as entrant) which needs access to the incumbent's network to be able to compete in the retail market. There is a third party, the regulator, who sets the access price in order to maximize social welfare. The access price is the only instrument available to the regulator, which

Equilibrium of the game

In this section, the Subgame-Perfect Equilibrium of the game is characterized by using backward induction.

Non-separable investments

In this section, and contrary to the previous ones where the incumbent was free to choose the level of investment in each component, it is assumed that it can only choose the total amount of investment, being the two effects – quality-upgrading and cost-reducing – exogenously given. In fact, many investments in next generation networks have an impact both on demand (increasing bandwidth and the number of potential services) and cost (decreasing marginal costs due to the use of more

Conclusions and policy discussion

This article analyzes whether access price regulation has an impact on incumbents’ incentives to invest in their infrastructure that might differ according to the nature of investments, both quality-upgrading and cost-reducing.

It is shown that, in non-mature markets, such as the broadband market, these two investment types are complements but have different impacts on the entrant's number of subscribers. Thus, although one should expect to have both investments moving together due to their

Acknowledgments

Helpful comments from Steffen Hoernig are gratefully acknowledged. Thanks are also due to Pedro P. Barros, Marc Bourreau, Martin Peitz, Pedro Pereira and Tommaso Valletti. Financial support from POCI 2010/FCT and FSE is also acknowledged.

References (22)

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