Telephony, the Internet, and the Media

Selected Papers From the 1997 Telecommunications Policy Research Conference

Jeffrey K. MacKie-Mason, David Waterman

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136684258
• Edition: 1
• Topic: Languages & Linguistics
• Subtopic: Communication Studies
• Index: Languages & Linguistics

Commemorating the 25th anniversary of the Telecommunications Policy Research Conference (TPRC), this volume begins with a historical survey of a quarter-century of TPRC meetings as one measure of change in and research about the telecommunications industry. Additional papers reflecting the ongoing pace of change in technological, economic, and policy issues are organized around four topics: * economic analysis of local and international telephone policy; * media industry studies including video competition, guidelines for children's educational television, and the setting of AM stereo standards; * applications and policy regarding the Internet; and * comparative studies in telephone and satellite policy. Collectively, the contents of this volume assess key issues for scholars, policymakers, and practitioners. Research reported in this volume illustrates the continually expanding scope of scholarly concerns about the telecommunications and information industry and contributes to further policy research and analysis.

II
Telephony

2
A Technico-Economic Methodology for the Analysis of Local Telephone Markets

Farid Gasmi
IDEI, Université de Toulouse I and Université de Bretagne Occidentale, Brest, France

Jean-Jacques Laffont
IDEI, Université de Toulouse I, France

William W. Sharkey
Federal Communications Commission

This chapter describes an empirical methodology for studying the regulation of local telephone markets that combines an engineering process model of costs with models from the new regulatory economics. This technico-economic methodology is illustrated through the undertaking of two analyses. First, we study in some detail the properties of optimal regulation under asymmetric information. We examine three issues: (a) the extent of natural monopoly when informational rents associated with regulation are taken into account; (b) the extent of the divergence of pricing under the optimal regulatory mechanism from optimal pricing under complete information (incentive correction); and (c) the implementation of optimal regulation through a menu of linear contracts. We find that, for fixed territory, strong economies of scale allow local exchange telecommunications to retain monopoly characteristics even when the (informational) costs of regulation are properly accounted for. Furthermore, the incentive correction term is small in magnitude, and optimal regulation can be well approximated through relatively simple linear contracts. In the second phase of our analysis, we evaluate the relative performance of various regulatory mechanisms, from both traditional and modern (incentive) points of view. This analysis allows us to quantitatively assess the social value of regulatory transfers and of good cost auditing procedures, the redistributive consequences of the various forms of regulation, and the sensitivity of the relative performance of the various methods of regulation to the cost of public funds.

The importance of costing methods in regulation of network industries is by now well established. This is particularly the case in telecommunications. Historically, various approaches have been used to evaluate costs in telecommunications, including accounting and econometric methods. However, with the rapidly changing technology, forward-looking engineering models of costs have increasingly proven useful. Meanwhile, new forms of regulation have made their way into telecommunications, triggered, on the one hand, by widespread dissatisfaction with the performance of traditional forms of regulation, and on the other hand by the broad political trust in private incentives for enhancing the performance of operators. This chapter proposes a methodology that utilizes the engineering approach in a modern regulatory economics framework for analyzing some important issues facing regulation of telecommunications today.

The usefulness of this technico-economic methodology is demonstrated through two studies. First, we have used this approach to empirically investigate in detail the properties of the optimal regulation of the local telephone service and its implementation. In particular, we have explored ways to generalize the natural monopoly test in order to take account of the (informational) costs of regulation. Second, we have used this methodology to compare the performance of various regulatory schemes from both traditional and modern incentive regulation.

The plan of the chapter is as follows. The next section presents the modeling framework and characterizes each of the regulatory mechanisms. The section after that outlines the main features of the technico-economic methodology used in the empirical analysis of various methods of regulation.

The next section is devoted to the first application: the empirical analysis of optimal regulation. We suggest a way to perform a test of the natural monopoly hypothesis that takes into account the costs of regulating a monopoly under asymmetric information. These costs take the form of an informational rent that the regulator must give up to the firm. The result is that, for a fixed number of subscribers, the social benefits of reduced cost, resulting from economies of scale, may well offset these informational costs. We provide an empirical test of the incentive-pricing dichotomy property, which allows the regulator to differentiate the regulatory role of transfers from that of prices. When this property holds, pricing under incentive constraints is equivalent to (Ramsey) pricing under complete information.  Given this dichotomy, we show how optimal regulation can be implemente in a simple manner. We construct a measure of firm performance of the average-cost type and show how the transfer function is decreasing and convex in this performance variable. This transfer function can then be approximated by a menu of linear cost reimbursement rules giving to efficient-technology firms higher fixed payments and lower reimbursement for cost overruns.

In the next section, we present the second application: the empirical analysis of the performance of alternative methods of regulation. After presenting some general features of the empirical data, we suggest a comparison of the various regulatory schemes along three dimensions: incentives, transfers, and cost observability. An important finding is the good performance of price cap with sharing of earnings, a method which has been widely used in telecommunications. We then analyze the welfare consequences of the regulatory mechanisms and highlight the trade-off between consumer surplus and the firm's rent. We investigate the sensitivity of our results to the price elasticity of demand and the cost of public funds. This analysis allows us to discuss the relevance of incentive regulation to less developed economies. The final section concludes and suggests some extensions of the analysis.

The Regulator–Regulated Firm Relationship: A Unifying Framework

The new view of regulation stresses the role of asymmetric information in the analysis of the regulator—regulated firm relationship. In a framework where the regulator designs the regulatory contract, the main consequence of this information asymmetry is that the regulator must recognize the need to give up a rent to the firm (which has superior information) in order to provide it with (social welfare enhancing) incentives to minimize costs of production. This is the fundamental rent—efficiency trade-off that regulators have to face when regulating public utilities. This section outlines the basic features of a conceptual framework of this regulator—regulated firm relationship.

The production technology of the regulated firm is assumed to be described by a cost function that gives the total cost of producing various levels of output. This technology is, however, better known by the firm than the regulating authority. More specifically, the regulated firm may possess knowledge about technological parameters, such as the magnitude of fixed and marginal costs, that is unavailable to the regulator. Further, the firm may invest in some cost-reducing activity to efficiently use productive resources (e.g., labor) that the regulator cannot observe. In the former case the information problem concerns an exogenous variable (this leads to a so-called adverse selection situation), whereas in the latter case the information problem concerns an endogenous variable (this is a moral hazard situation). Hence, total cost of production is a function of these two variables as well. Except for the values of these two variables, the regulator is assumed to know this function.

The market conditions are described by the firm's technology and by a known demand function for the good produced by the firm. Maximization of social welfare, which aggregates consumers' and firm's welfare associated with the production of the good, is assumed to be the sole objective of the regulator. When the firm exerts a cost-reducing effort, the total cost of production properly includes the disutility generated by this effort. The regulatory relationship can then be modeled in a simple manner, where the regulator delegates to the firm the provision of the good to consumers. If the regulator observes ex post costs, one can adopt the accounting convention that the regulator collects the revenues from sales, reimburses the firm's production cost and gives it a compensatory payment. Because the regulator collects funds through distortionary taxation, it must account for the (shadow) cost of each dollar transferred from consumers to the firm when evaluating social welfare.

As a benchmark, we first consider an ideal world of complete information where the regulator knows perfectly the technological characteristics of the firm, and observes the cost-reducing effort. This situation is referred to with the label CI. In this circumstance, the regulator can merely instruct the firm to choose the output and effort levels that maximize social welfare. Society dislikes leaving rents to the firm as they must be paid for with costly public funds. Hence, the informed regulator assigns zero rent to the firm in this complete information context.

One realizes, however, that the regulator does not know with perfection the technology used by the firm. Furthermore, the regulator cannot observe how great an effort the firm is putting into improving its use of inputs. The regulator's objective is then to generate the highest social welfare possible, given these informational constraints. The optimization program is contingent on the observables (cost and output) and the beliefs that the regulator has formed about the technology of the firm. Knowing that the larger the efficiency gains that accrue to the firm, the greater the firm's incentives to produce efficiently, the regulator leaves some (informational) rent to more efficient firms. Characterizing optimally this trade-off is at the heart of opt...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Authors
• Acknowledgments
• Preface
• Introduction
• I Historical
• II Telephony
• III The Media
• IV The Internet
• V Comparative Studies in Telephony and Satellite Policy
• Author Index
• Subject Index