Telephone regulation makes no economic sense

Telephone regulation makes no economic sense Presentation by Valentin Petkantchin, MEI Research Director, as part of the 2nd Annual Canadian Telecommunications Forum (panel: The technology is changing: Does public policy measure up?) organised by Insight Information, Ottawa, October 27 & 28, 2004.

The Canadian Radio-television and Telecommunications Commission (CRTC) argues that there is not enough competition in the telecommunications industry. In a public notice issued last December, it suggested imposing artificial handicaps on the former telephone monopolies to enable new providers to enter the market(1). In a more recent public notice, dated April 7, 2004, the CRTC suggested extending these handicaps to the new field of Internet telephony. This may be consistent with the antitrust and competition policies that the governments of western countries started adopting in the late 19th century, but it is not supported by contemporary economic analysis.

Two views on competition

There are two economic conceptions of competition. One is based on the model and the ideal of “perfect competition,” in which there are so many small competitors that none can individually influence the market price. This ideal gave politicians the theoretical legitimacy to regulate economic activity, because under perfect competition, or so the argument goes, consumer welfare would be improved.

In this approach, there was one special case in which monopoly was deemed to be unavoidable: the case of so-called “natural monopolies.” A natural monopoly is an industry (or firm) in which, because of wide-ranging economies of scale, the average cost of production decreases until market demand is entirely satisfied. If a firm is a natural monopoly, however, it can outcompete all others. The state, the theory argued, must prevent such a monopoly from charging a higher price than the perfectly competitive price.

In modern economics, a more realistic and relevant vision of competition replaced the “perfect competition”/natural monopoly model(2). It views competition as a dynamic process of rival entrepreneurs who must make guesses about the future and engage in risky investments. The number of competitors in one sector is less important than the presence, or not, of market rules and the possibility of free entry. Even with a concentration of activity in one sector, and even if entry may turn out to be costly in terms of initial investment, competition can still be intense. The competition comes not only from the potential entry of new competitors in the same sector but also from the supply of similar products and services, satisfying the same consumer needs, by firms in other sectors of the economy.

A new entrant will sometimes face high investment costs, but breaking into the market remains possible if there are no legal barriers. Thus, competition does not need to be “perfect” – and in the real world, it cannot be –, but the absence of perfection is not sufficient reason for government intervention.

Competition in telecommunications

The telecommunications sector has long been regulated, mainly by the CRTC since 1976. The CRTC has protected regional telephone monopolies such as Bell and Telus, deemed to be natural monopolies, until the 1990s, when it started allowing some regulated competition. The former regional monopolies are still subject to price controls and are required to lease their facilities, at regulated tariffs, to new competitors that are less heavily regulated.

Following this partial deregulation, the CRTC now argues that there is not enough competition. But this conclusion is still based on the old end-state vision of perfect competition – for example, on the observation that 95% of local wirelines are supplied by the former protected monopolies and that there is only a few players in the sector.

According to its December 2003 public notice, the CRTC aims to increase competition by imposing artificial, and anticompetitive, constraints on former monopolies that are now operating in competitive markets. The CRTC suggests requiring them to price their own retail basic services (say, access to a local loop) at 25% over estimated cost, while they are obliged to sell the same services to their competitors at wholesale prices of cost plus 15%. In other words, the CRTC wants to force the former monopolies to give their competitors a margin guarantee. The second type of restriction the CRTC wants to force on the former monopolies is a 10% cap on the discounts it offers on bundled services (for example, local and long-distance service with Internet access), plus limits on the discounts offered on high-volume and long-term contracts.

More generally, the CRTC wants to prohibit the former monopolies from using targeted pricing. This competitive technique exists in many sectors; for example, airlines offer different prices for return flights requiring a Saturday-night stay in order to charge more to business travellers. Actually, the CRTC itself has always imposed price discrimination in favour of residential users as opposed to business users. Economic theory shows that this sort of price discrimination is economically justified when high (fixed) investment costs have to be included in prices.

But even if there is not a large number of competitors in a given sector of the economy, what counts is potential competition. This can come from new entrants or from firms that offer substitutes in “other” markets. The static view in which competition is measured by the number of firms does not take account of “competition for the market,” as opposed to “competition in the market.”

This distinction is important. Competition comes not only from firms operating in the traditional wireline telephone industry but also from other related industries. Where the line is drawn between different “markets” depends on which goods and services consumers consider easily substitutable, and this remains arbitrary. But for any given “market,” there is competition among the suppliers already in the sector, and between those firms and suppliers from other industries who compete for the market. Competition for the market maintains a competitive process even when competition in the market seems limited.

Consumers, not producers, define markets. They may regard things produced by very different technologies (snail mail and fax, for example) as close substitutes, and they may also regard things produced by similar technologies (scanners and digital cameras, for example) as distant substitutes.

Unless one adopts the CRTC’s old static, end-state view of competition, there is no question that substantial competition exists in telecommunications. Especially, there is a lot of competition for the local residential market, from suppliers with new technologies (or existing technologies used differently) like Internet telephone (“voice over Internet protocol,” or VoIP), cable telephone and, of course, cellular phones. Thus, phone (wireline and wireless) companies, cable companies, Internet-based competitors, and perhaps even electricity utilities will soon be able to offer the same telecommunications and broadcasting services. For example, Rogers Communications, whose Rogers Cable subsidiary is the largest cable company in Canada, announced its intention to compete with phone companies by offering Internet telephony (VoIP) services. Vonage and Group Telecom already launched VoIP services on the Canadian residential market. Other players have announced that they, too, will join the fray.

The CRTC’s current regulation of telecommunications as well as its proposals for more regulation reflect a poor understanding of the nature of competition and economic efficiency. On this issue, Professor Donald McFetrige of Carleton University writes: “It is seldom the case, perhaps never the case, that inhibiting competition increases competition.”(3) If regulation does not prevent it, competition will increase by itself.

The latest public notice published by the CRTC in April compounds problems with the existing regulatory framework by suggesting that it be extended to VoIP launched by ILECs, while new competitors (many of which are also large companies) would be free to offer services as they choose at unregulated prices.

All this suggests that new technologies and ways of providing telecom services by means other than through the traditional networks are a clear manifestation of the competitive process at work. There is no legitimacy for the CRTC to continue to be concerned with the number of telephone providers. Real competition can only be curbed by artificial handicaps and regulated prices. Instead of extending them to the new field of Internet telephony, as the CRTC suggested, it would be better advised to consider, for example, abolishing the obstacles to entry raised by the foreign ownership restrictions in telecommunications. Eliminating those restrictions would further intensify competition with new competitors obtaining financing more easily on international capital markets. Offering a protection package to new competitors, as the CRTC is doing, is, on the contrary, anti-competitive.

Richard Posner, a well known American economist who is also a federal judge, wrote three decades ago: Communications is a contemporary example of an industry undergoing rapid technological changes that are apparently opening up a host of new competitive opportunities. … The most pernicious features of regulation would appear to be precisely its impact on change – its tendency to retard the growth of competition that would erode the power of regulated monopolists(4).

Conclusion

The CRTC is a powerful and entrenched bureaucracy. The intensive lobbying that the CRTC’s power generates suggests that the anti-competitive privileges it grants have considerable value for recipients and that extensive resources are wasted in trying to obtain those privileges. Economists call this phenomenon “rent seeking.” This means that the social cost of the CRTC’s regulation of telecommunications is probably very large.

In the field of telecommunications, the CRTC protected monopolies against entry when it should not have, and it now grants privileges to their competitors while there are no more economic reasons to do so. Even if it could be argued that telephone services were a natural monopoly before the development of the new telecommunications technology, this is not the case any more, and it seems that the CRTC no longer has any reason to intervene in this sector. A good economic case can be made for a real and complete deregulation of telecommunications in Canada.
 

Notes

1. The former telephone monopolies are called “incumbent local exchange carriers,” or ILECs, in bureaucratic jargon, while the new providers are called “competitive local exchange carriers,” or CLECs.
2. See F. Hayek (1968), M. Blaug (1997), P. McNulty (1967) and (1968), among others.
3. D. McFetridge (2004), p. 9.
4. R. Posner (1999), p. 106.

References

Economic theory of competition, regulation and Public Choice

-Blaug, M. (1997), “Competition as an end-state and competition as a process,” in Trade, Technology and Economics, ed. by B. Curtis Eaton and Richard G. Harris, Brookfield, Edward Elgar Publishing Company, p. 241-262.
-Hayek, F. A. (1968), “Competition as a discovery procedure,” in New Studies in Philosophy, Politics, Economics and the History of Ideas, Routledge & Kegan Paul, London.
-McNulty, P. (1967), “A note on the history of perfect competition,” Journal of Political Economy 75 (4), August, 395-9.
-McNulty, P. (1968), “Economic Theory and the Meaning of Competititon,” Quarterly Journal of Economics, LXXXII, November, pp. 639-656.
-Mueller, D. (2003), Public Choice III, Cambridge, Cambridge University Press.
-Posner, R. A. (1999), Natural Monopoly and Its Regulation, 30th anniversary edition, Washington, Cato Institute.
-Stigler, G. (1988), “The Theory of Economic Regulation,” in Chicago Studies in Political Economy, The University of Chicago Press, pp. 209-233.
-Viscusi, W., Vernon, J. M. & Harrington, J. E. (2000), Economics of Regulation and Antitrust, 3rd edition, Cambridge, MIT Press.

Competition in Canadian Telecom and the CRTC

-Quigley, N. (2004), “Dynamic Competition in Telecommunications,” C.D. Howe Commentary, no 194, February.
-McFetridge, D. (2004), Comments on Public Notice CRTC 2003-10, 30 January.
-CRTC (2003), Status of Competition in Canadian Telecommunications Markets, Ottawa, Report to the Government in Council.
-Telecom Public Notice CRTC 2003-10 (2003), Amendments to Telecom Public Notice CRTC 2003-8, Review of price floor safeguards for retail tariffed services and related issues, 8th December.
-Telecom Public Notice CRTC 2004-2 (2004), Regulatory framework for voice communication services using Internet Protocol, 7th April.