Competition After Unbundling:
Entry, Industry Structure and
Convergence
George Ford
Chief Economist
Phoenix Center
Basic Setup:
Equilibrium Industry Structure



Firms enter only if they make a profit
Entry stops when “the next firm” expects
a negative profit
When entry stops, the existing number of
firms is the equilibrium number of firms
(N*)


No incentive to enter
No incentive to exit
Formal Theory
S
N* 
E
N* = Equilibrium Number of Firms (symmetric)
 = Weakness of Competition
S = Market Size in Expenditure (isoelastic demand)
E = Sunk Entry Costs
Sources: Sutton, Duvall and Ford (PP10), Beard and Ford
The Entry Decision:
Less Formal Theory

Do gross profits (d) exceed entry costs
(e)?
d–e  0


Gross profits (d) are revenues less variable
costs.
Entry costs (e) are fixed/sunk
What it Means
Time
Revenue
0
Discount
Factor
Discounted
Revenues
1.00
$500.00
1
$100.00
0.91
$90.91
2
$100.00
0.83
$82.64
3
$100.00
0.75
$75.13
4
$100.00
0.68
$68.30
5
$100.00
0.62
$62.09
6
$100.00
0.56
$56.45
7
$100.00
0.51
$51.32
8
$100.00
0.47
$46.65
9
$100.00
0.42
$42.41
10
$100.00
0.39
$38.55
Sum
Entry Costs
$614.46
$500.00
Want Facilities-based Entry?
 Increase
 Reduce
Gross Profits
Entry Costs
Multiple Changes
Higher Profits
Lower Entry Costs
More Entry
Lower Profits
Higher Entry Costs
Less Entry
Higher Profits
Higher Entry Costs
Lower Profits
Lower Entry Costs
Unknown
Unknown
Equilibrium Industry Structure


High Fixed and Sunk Costs allow only few
firms to enter
Historically, local distribution networks for
communications services have tended
toward monopoly


Voice
Video
Factors Driving Profits (d)




Market Size (+)
Intensity of Price Competition (-)
Product Differentiation (+)
Network Overlap (-)
Numerical Example 1
(Table 1, PCPP 21)
Equilibrium Number of Firms, N* = 3
N
d
e
d-e
1
2
3
4
100
40
20
12
15
15
15
15
85
25
5
-3
5
6
7
8
5
4
15
15
15
-7
-10
-11
Numerical Example 2
(Higher Gross Profits)
Equilibrium Number of Firms, N* = 5
N
d
e
d-e
1
2
3
4
200
80
40
24
15
15
15
15
185
65
25
9
5
6
7
16
10
8
15
15
15
1
-5
-7
Factors Driving Profits (d)




Market Size (+)
Intensity of Price Competition (-)
Product Differentiation (+)
Network Overlap (-)
Numerical Example 3
(Intensity of Price Competition)
N
e
Intense Price
Competition
Moderate Price
Competition
Perfect
Collusion
d
d-e
d
d-e
d
d-e
1
15
100
85
100
85
100
85
2
15
28
13
40
25
50
35
3
15
12
-3
20
5
33
18
4
15
6
-9
12
-3
25
10
5
15
4
-11
8
-7
20
5
6
15
3
-12
5
-10
17
2
7
15
2
-13
4
-11
14
-1
Headcount and Competition

With large fixed/sunk costs, headcounts
can be deceiving


A large number of firms may indicate collusion
A small number of firms may indicate intense
price competition
Entry and Collusion
(Based on Post-Convergence Example Above)
Firm 1
Firm 2
Enter
Stay Out
Enter
50
50
40
110
Stay Out
110
40
100
100
Factors Driving Profits (d)




Market Size (+)
Intensity of Price Competition (-)
Product Differentiation (+)
Network Overlap (-)
Product Differentiation and Overlap
Differentiation weakens
price competition.
Price
Overlap increases price
competition.
P1
P2
More Differentiation
P3
Less Differentiation
50%
100%
Phoenix Center Policy Paper No. 21, Figure 1.
Homes/Overlap
Diversion:
Competition and Substitution


Competition occurs between
goods/services that perform a similar task
for consumers
Good X is a substitute for Good Y if the
demand for Good X rises when the price
of Good Y rises (and vice versa)
Diversion:
Competition and Substitution

The relationship of quantities of goods is
not an indicator of substitution


Unless we already know the goods are perfect
substitutes
Substitution is of degree

Airplanes, Buses, Cars, Trains all provide
transportation, but we might be concerned
about a monopoly over any of one of them
Diversion:
Competition and Substitution


As long as the own-price demand elasticity
is less than –1.0 (or inelastic), then a 5%
price increase is profitable
Cross-price elasticities are not indicators of
Antitrust markets

Large cross price elasticities are indicators of
good substitution, but if own-price is not
elastic enough, a significant price increase
remains profitable
Example

Wireless Substitution and Competition, by Stephen
Pociask
 lnQM = -0.56 · lnPM + 1.97·lnPW+X+
 More wrong with the econometrics of this paper than
I could cover in a day, much less an hour
 “…the models provide compelling empirical
evidence that wireless and wireline services are
indeed substitute goods, and are not extraneous or
complementary goods (at 15).”
 This model indicates substitution (an
implausibly large amount of it), but still not
enough substitution to place wireless/wireline in
theP issame
market.
Q is quantity,
price, M is mobile,
W is wireline, ln is the nat. logarithmic transformation, X is the means of the other
variables in the model multiplied by their coefficients.
Types of Entry Costs (e)




Technological Entry Costs (+)
Strategic Entry Costs (+)
Regulatory Entry Costs (+)
Spillovers (-)
Types of Entry Costs (e)

Technological Entry Costs (+)

Entry costs that are unavoidable to provide
service
Network
 Operating Capital
 Advertising
 Building Leases
 Etc…

Types of Entry Costs (e)

Strategic Entry Costs (+)

Entry costs that arise solely because of
incumbent firm actions intended to raise entry
costs
Excessive Advertising
 Lock-in Contracts
 Strategic Pricing

Types of Entry Costs (e)

Regulatory Entry Costs (+)

Rules that raise entry costs above technological entry
costs





Build-out Requirements
Gold-plating Networks
Entry Fees
E911 and other social programs
If socially-desirable, there may be a trade-off
between entry and the provision of the service (e.g.,
E911)
Types of Entry Costs (e)

Spillovers (-)


Spillovers exist when a firm can use existing
assets to enter related markets.
This firm has lower entry costs than a firm
without existing assets that can be leveraged
into a related market

Network (DSL over Copper; Cable Broadband over
Coax; Fiber over existing rights-of-way; customer
relationships)
Numerical Example 1
(Table 1, PCPP 21)
Equilibrium Number of Firms, N* = 3
N
d
e
d-e
1
2
3
4
100
40
20
12
15
15
15
15
85
25
5
-3
5
6
7
8
5
4
15
15
15
-7
-10
-11
Numerical Example 4
(Reduced Entry Costs)
Equilibrium Number of Firms, N* = 6
N
d
e
d-e
1
2
3
4
100
40
20
12
5
5
5
5
95
35
15
7
5
6
7
8
5
4
5
5
5
3
0
-1
Spillovers and Convergence


Convergence is relevant only when it
reduces entry costs.
Effects of convergence are generally
limited to firms with existing assets that
can be “spilled over” into related markets.
Numerical Example 5
(Spillovers and Convergence)
Pre-Convergence
Monopoly
Profit
Duopoly
Profit (d)
Entry Costs
(e )
d–e
Market 1
100
40
50
-10
Market 2
100
40
50
-10
Post-Convergence
Monopoly
Profit
Duopoly
Profit (d)
Entry Costs
(e )
d–e
Market 1
100
40
30
10
Market 2
100
40
30
10
Equilibrium Industry Structure:
Summary


There will be few local networks
So, rig the game in favor of entry by new
firms and expansion by existing firms into
related market



Eliminate regulatory entry barriers
Impede strategic entry barriers
Expand markets
Phoenix Center Policy Paper No. 22
The Consumer Welfare Cost of
Cable “Build-Out” Rules
Build-Out Rules




Unambiguously Bad for Entrants
May be good for Consumers
May be good for Incumbents
But can’t be good for both Consumers and
Incumbents at the same time

Why do both policymakers and incumbents
advocate for build-out rules?
Build-Out Rule:
Graphical Explanation
Price
homes ordered by capital cost
e(h)
e(h): Entry Cost for home i
r(h): Expected Revenue for home i
r(h)
H
Phoenix Center Policy Paper No. 22, Figure 1.
Homes/Overlap
Free Entry Equilibrium
Price
homes ordered by capital cost
Profits from Entry
e(h)
t
w
r(h)
v
h*
H
Homes/Overlap
With Build-Out Rule
Price
homes ordered by capital cost
y
e(h)
Profits from Entry
Losses from Entry
r(h)
u
x
z
v
H
Homes/Overlap
With Build-Out Rule:
The Monopoly’s Decision
Price
homes ordered by capital cost
Profits from Entry
r(h)
Losses from Entry
e(h)
H
The monopolists
decision to build-out is
entirely different than
an entrants.
Homes/Overlap
Build-out Rule:
Matrix of Preferred Outcomes
Participant
Free Entry
Build-out Rule
Entry
No Entry
Consumers
2
1
3
Incumbent
2
3
1
Phoenix Center Policy Paper No. 22, Table 1.
FCC on Build-out Rules
“build-out requirements are of central
importance to competitive entry because
these requirements impact the threshold
question of whether a potential competitor
will enter the local exchange market at
all.” FCC No. 97-346 (1997)
Simulation
Summary of Results
Entrant
H-Pass
Markets
Served
Entrant
CAPEX
Consumer Incumbent
Surplus
Profit
Monopoly
…
…
…
60M
120M
Free Entry
60,000
100
18M
75M
94M
Build-out
15,000
15
6M
64M
113M
Phoenix Center Policy Paper No. 22, Table 2.
Assumptions: Entrant market share = 35%. Price decline for 100% overlap is 20%.
Simulation:
Effect of Market Share
Entrant’s
Market
Share
Share Homes Passed
Entrant Markets Served
Free Entry
Build-out
Free Entry
Build-out
20%
0.10
0.00
100
0
25%
0.26
0.00
100
0
30%
0.43
0.00
100
0
35%
0.60
0.15
100
15
40%
0.69
0.36
100
36
45%
0.75
0.54
100
54
50%
0.79
0.65
100
65
Simulation:
Build-out and Investment
Entrant’s
Market
Share
Share Homes Passed
Investment
Free Entry
Build-out
Free Entry
Build-out
20%
0.10
0.00
2
0
25%
0.26
0.00
7
0
30%
0.43
0.00
12
0
35%
0.60
0.15
18
6
40%
0.69
0.36
22
15
45%
0.75
0.54
26
23
50%
0.79
0.65
28
30
Simulation:
Build-out, Consumers and Incumbents
Entrant’s
Market
Share
Consumer Surplus
Incumbent Profits
Free Entry
Build-out
Free Entry
Build-out
20%
63
60
117
120
25%
67
60
112
120
30%
71
60
104
120
35%
75
64
94
113
40%
78
69
85
102
45%
80
74
76
90
50%
81
77
71
79
Defection

What happens if some communities
abandon the build-out rule when others
maintain it?


Defection raises the defector’s relative
profitability, increasing the prospects for
deployment sooner (rather than later, if ever)
With 25% defection rates, average increase in
profit rank is 38 positions (out of 100)
In Defense of Build-out Rules

NCTA



Incumbent cable firms cross-subsidize low
value areas with profits from high-value areas
Entry in high-value areas only depletes source
of cross subsidy, threatening
upgrades/expansion in low value areas
Entrants should have to build-out too,
regardless of whether it deters entry
In Defense
The Monopoly’s Decision
Price
homes ordered by capital cost
Profits from Entry
e(h)
Losses from Entry
r(h)
H
Profits offset losses for
Monopoly build-out.
Homes
In Defense
Entry with Uniform Price
Price
homes ordered by capital cost
Profits from Entry
e(h)
Losses from Entry
r(h)
H
Profits insufficient to
cover losses. But,
entrant does not enter
(50-50 split of the
market).
Homes/Overlap
In Defense
Entry with Market Segmentation
Price
homes ordered by capital cost
Profits from Entry
e(h)
Losses from Entry
rmonop
rcomp
H
With markets
segmented, higher price
in uncontested segment
reduces loss, increases
profit.
Homes/Overlap
Evaluation of Defense

Cable network is sunk


As long as revenues exceed the incremental
cost of the network (programming,
maintenance), there is no incentive to
abandon the network
According to NCTA, upgrades are done at the
edge of the network, so initial capital cost of
network are somewhat irrelevant
Evaluation: Social Goal

NCTA says build-out is a social goal


Build network where we shouldn’t (in a
market economy sense)
NCTA Solution:

Build 2 networks where there shouldn’t be 1
Evaluation: Social Goal

Why should buildouts be based on cable
franchise markets?



Franchise boundaries are arbitrary, not economic
boundaries
ILEC territories often don’t match
If broadband availability is a function of video in
the bundle, then local governments are
interfering with federal role in broadband
deployment
Evaluation: Social Goal

Entry deterrence is the purpose of buildout requirements


Incumbent profit is always less the more the
entrant overlaps the existing network
Econometric analysis shows build-out rules
(level playing field rules) deter entry
Phoenix Center Policy Paper No. 23
Video and Broadband Network
Deployment
Want Facilities-based Entry?
 Increase
 Reduce
Gross Profits
Entry Costs
Index of Consumption
(Pew Survey 2002)
Group
Cell Phone
Cable/Satellite
Premium
Internet
All
1.00
1.00
1.00
1.00
Men
1.14
1.03
1.10
1.09
Women
0.88
0.95
0.93
0.87
Whites
1.00
0.96
0.98
0.97
Blacks
0.90
1.16
1.14
1.02
Latino
1.25
0.96
1.30
0.88
Col. Grads
1.22
1.09
0.97
1.47
Students
1.08
1.01
0.95
1.30
Employed
1.23
1.00
0.96
1.20
Urban
1.02
1.07
1.04
1.15
Suburban
1.03
1.07
0.94
1.02
Rural
0.95
0.74
0.94
0.76
Census 2003, Subscription Rates
Income
Telephone
Internet
Dial-up
Cable/DSL
Less Than 5000
92.0
26.6
15.9
10.2
5000 To 7499
94.2
20.3
14.0
5.9
7500 To 9999
96.5
19.6
14.2
5.0
10000 To 12499
97.1
22.8
16.5
6.2
12500 To 14999
97.2
24.6
18.2
5.8
15000 To 19999
96.8
29.5
21.5
7.8
20000 To 24999
97.8
36.9
26.7
9.9
25000 To 29999
98.3
42.6
29.6
12.0
30000 To 34999
98.4
49.0
35.1
13.2
35000 To 39999
98.7
57.7
41.9
15.0
40000 To 49999
99.2
66.3
45.2
20.2
50000 To 59999
99.2
71.9
47.0
24.0
60000 To 74999
99.4
79.9
49.8
29.1
75000 To 99999
99.3
84.2
48.0
35.2
100000 To 149999
99.7
90.4
42.3
46.4
150000 and Over
99.7
92.4
36.4
54.2
Cable Subscription and Income

Mediamark Research, Inc.





Income < $25,000; 54%
$25,000 < Income < $49,999; 62%
$50,000 < Income < $74,999; 70%
Income > $75,000; 75%
GAO Regression Analysis (2005)

Negative relationship between basic cable
penetration rate and incomes
Video, Income, Deployment
$
homes ordered by income
r(y): Expected Revenue for home i,
which is a function of income y
k: Capital Cost per Home Passed
y*
Phoenix Center Policy Paper No. 23, Figure 1.
Income (y)
Video, Income, Deployment
homes ordered by income
r1+ r2
k+d
$
r1
k
Add Good 2 to the
product mix, at
incremental cost d
Good 1 = Good 2 in
expenditures
y’
y*
Phoenix Center Policy Paper No. 23, Figure 2.
Income (y)
Video, Income, Deployment
$
homes ordered by income
r1+ r3
k+d
r1
k = r3
y*
Phoenix Center Policy Paper No. 23, Figure 3.
Add Good 3 to the
product mix with Good
1, at incremental cost d
Average of Good 1 =
Good 3, but Good 3
has no relationship to
income
Income (y)
Simulation Results
Income
Broadband
Broadband+
Telephony
Broadband
+ Video
All Three
Services
y < 20,000
-
-
0.84
0.88
20,000 < y <30,000
-
-
0.88
0.90
30,000 < y <40,000
-
-
0.93
0.95
40,000 < y <50,000
-
0.04
0.98
0.99
50,000 < y <60,000
0.01
0.09
1.00
1.00
60,000 < y <70,000
0.02
0.20
1.00
1.00
70,000 < y <80,000
0.09
0.54
1.00
1.00
80,000 < y <90,000
0.14
0.76
1.00
1.00
90,000 < y <100,000
0.34
0.92
1.00
1.00
100,000 < y <125,000
0.83
1.00
1.00
1.00
125,000 < y <150,000
0.97
0.97
1.00
1.00
y > 150,000
1.00
1.00
1.00
1.00
Summary


We are now faced with a facilities-based only
entry method into local markets (video, voice,
and data)
We must eliminate any unnecessary barriers to
facilities-based entry if we are to have
competition



Market limitations
Build-out Rules
Etc.
Summary

Consider the source of policy proposals


Build-out rules are only good for cable
incumbents if entry is deterred; thus, they are
betting on entry deterrence
Cross-subsidy is the enemy of
competition, because competition is the
entry of cross-subsidy

Social agendas may need to be re-evaluated
and refinanced