Access charges and quality choice in competing networks

doi:10.1016/j.infoecopol.2004.01.007

Information Economics and Policy

Volume 16, Issue 3, September 2004, Pages 391-409

https://doi.org/10.1016/j.infoecopol.2004.01.007 Get rights and content

Abstract

We study the impact of reciprocal access charges on the incentives to invest in networks of higher quality. We show how private and social preferences always diverge once investments are endogenized. Private negotiations never lead to charges being set at their marginal cost. Whether or not marginal cost charges have good dynamic properties depends on the way investments in quality impact on traffic generated on the networks.

Introduction

A recent but expanding literature on two-way access pricing has addressed the question of interconnection in a deregulated environment. When competing operators have sufficient network coverage to reach all customers, they still need access to rival networks in order to terminate calls originated by own customers but destined to rival's subscribers. The policy concern is that firms might use interconnection terms in order to weaken the intensity of price competition. The answer to this problem was first provided by the seminal works of Armstrong (1998) and Laffont et al. (1998) (hereafter ALRT) and depends on the form of pricing strategies that firms follow. In the realistic case of two-part tariffs ALRT find a result of “profit neutrality”: access terms cannot be used to sustain higher profits. This can be understood by noting that, with two-part tariffs, operators can build market shares without having to inflate their outflow charges. A high access would give profits to a network when it terminates a call, however all the profits thus generated would be used to lower the fixed component. These effects cancel out, producing the result of profit neutrality with respect to access charges.

Profit neutrality depends on a number of assumptions. In the ALRT benchmark firms are symmetric, they charge only for outgoing calls and consumers do not get utility from receiving calls, and the market is mature, i.e., there is 100% participation rate.¹ In particular, by relaxing the first of such assumption, Carter and Wright (2003, hereafter CW) show that asymmetries do matter. In particular, they show that the larger network always prefers the reciprocal interconnection charge be set at cost, which is efficient in their model under many reasonable situations. Hence they conclude that it is possible to achieve desirable outcomes with minimal regulatory intervention by letting the parties negotiate and, in case of disagreement, by allowing the larger network to choose the reciprocal interconnection rate.

As the degree of asymmetry between networks is generated by investments in brand image, quality and so forth, a natural question arises as to what impact interconnection charges have on the incentives to invest. While most of the existing literature is static, in Valletti and Cambini (2003) and Cambini and Valletti (2003) we provide a first analysis of the dynamics of access pricing. We extend the framework of ALRT by introducing an investment stage – prior to price competition – where the level of quality chosen is the source of asymmetries in later stages of competition. When the regulator can commit to access rules prior to the investment stage and consumers' traffic is affected by network quality, we show that, in order to induce firms to invest in an efficient manner, socially optimal access charges should be set below costs. On the contrary, if firms are left alone to negotiate reciprocal termination charges, they would set reciprocal termination charges above cost, in order to underinvest and avoid a costly investment battle. Above-cost access charges are then “tacitly collusive” as they make a firm more reluctant to become big and overtake the rival: the reason is that an increase of the own investment in quality, relative to the rival, generates more outgoing calls and therefore creates a costly access deficit.

The purpose of this paper is to study the similarities and differences between our approach, that leads to a negative view of unregulated charges, and that of CW whose results imply a rather non-intrusive role for regulation. We first study the impact of access charges on investments when quality gives a fixed benefit to consumers, but does not alter their calling patterns. We show that, to the extent to which firms or the regulator can commit to access charges prior to investments, then CW's results are reversed: there is never an alignment of private and social interests over the optimal level of access charges. We then extend our prior work by analyzing an alternative specification of utility where quality impacts on traffic. Also in this case we confirm the divergence between social and private preferences and we show how socially optimal charges depend on the way traffic is generated.

The rest of the paper is organized as follows. Section 2 introduces a model of network competition based on ALRT with a quality feature that enters additively in consumers' utility. Section 3 recalls CW's results for a given level of investments, while Section 4 endogenizes quality choices and analyzes the impact of access charges on investments. Section 5 extends the analysis to the case where quality affects the number of calls made at a certain price. Section 6 concludes and discusses the main findings.

Section snippets

The model

The model follows ALRT. There are two networks (differentiated à la Hotelling) competing in a telecommunications market. A unit mass of consumers is uniformly located on the segment [0,1] while the network operators are located at the two extremities. We denote by 1 (respectively, 2) the firm located at the origin (respectively, at the end) of the line. Network operators compete in two-part tariff, i.e., $T_{i} (q)=F_{i} +p_{i} q, i=1,2$ , where the fixed fee F_i can be interpreted as a subscriber line charge

Price competition

The consumer indifferent between the two networks determines the market share of the two firms. In particular firm i's share is α_i where: $α_{i} =α(w_{1},w_{2})=1/2+σ(w_{i} −w_{j}),$ where w_i=v(p_i)+k_i−F_i is the net surplus for customers connected to network i.

In the last stage investments are fixed, hence network i has to solve: $max F_{i},p_{i} Π_{i} = max F_{i},p_{i} π_{i} −I(k_{i}) π_{i} =α_{i} {(p_{i} −c−t)q(p_{i})+F_{i} −f}+α_{i} (1−α_{i})(a−t)[q(p_{j})−q(p_{i})].$

Since our model in stage II corresponds to CW's model by replacing their brand parameter with β=2σ(k_i−k_j), we

Investment decision

In stage I, the FOC w.r.t. quality of firm i can be obtained subtracting from Eq. (5) the cost of investing, leading to this expression: $∂ Π_{i} ∂ k_{i} =2 α_{i}^{∗} σ ∂ α_{i}^{∗} ∂ k_{i} −(a−t) ∂ Ω ∂ k_{i} −I^{′} (k_{i})=0, where Ω=(α_{i}^{∗})^{2} q(p_{i}^{∗})−q(p_{j}^{∗}) .$

As before, we take LRIC as the starting benchmark. We are now interested to see if, starting at a=t, a firm would increase or decrease quality when the access charge is slightly increased above cost. In Appendix A, we are able to obtain this important result:

Proposition 2

In a neighborhood of a=t, investments

Quality choice and interaction between networks: A multiplicative quality setting

In this section, we consider the case where the quantity of calls is influenced by the investment in quality. Imagine situations that involve a high-speed network like ISDN, DSL or another broadband connection. These technologies require expensive network investments and permit the users to surf the Internet, receive calls, download documents, web pages, MP3 files or video clips. In all these examples, for a given price, a higher quality feeds into higher traffic generated by users. It is then

Conclusions

This paper has derived one robust result: once investments are endogenized, there is never an alignment between private and social interests over the setting of reciprocal interconnection charges. In particular, in all the specifications that we have studied, LRIC would never be chosen by firms, while in most cases they would agree on above cost termination charges. Whether or not LRIC has good dynamic properties for total welfare depends on how investments affect traffic. If investments do not

Acknowledgements

We thank Julian Wright for very useful comments. We acknowledge support from the Italian Ministry for Scientific Research MIUR Grant No. 2002 131535_005.

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Network competition with price discrimination: bill-and-keep is not so bad after all
Economics Letters
(2003)

There are more references available in the full text version of this article.

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Access charges and quality choice in competing networks

Abstract

Introduction

Section snippets

The model

Price competition

Investment decision

Quality choice and interaction between networks: A multiplicative quality setting

Conclusions

Acknowledgements

The theory of access pricing and interconnection

Network interconnection in telecommunications

Economic Journal

Network competition with price discrimination: bill-and-keep is not so bad after all

Economics Letters