Universal Service and Competition

1
Universal Service and Competition

• Anne Perrot
• Workshop  Antitrust and Regulation 
• Brescia
• April 2004.

2
Introduction

• Competition on network markets induces  cream
  skimming  on profitable segments.
• Reduces the possibility of cross subsidies
  between users.
• In most European countries, Universal Service
  Obligations (USOs) fulfilled by the monopoly
  operator, and funded through cross subsidies.
• End of this system raises questions on
• who should provide US "allocation problem".
• - how these USOs should be funded "funding
  problem".

3
Introduction (2)

• General purpose of this presentation examine
  how competition changes the approach of universal
  service obligations.
• Which firm should incur these obligations?
• How they should be funded?
• How the allocation and funding mechanisms change
  the way competition works?
• What happens when several goods are substitutes?

4
What universal service is

• Several situations involve universal service
  problems
•  Social case  assume two-part tariffs
  (unitary price fixed fee)
• first best price marginal cost fee part of
  the fixed cost.
• Some consumers (low income) do not consume much,
  and cannot afford the fixed fee (and still have a
  positive utility).
•  Geographical case  some consumers (rural
  consumers) generate high costs of connexion to
  the network. If these consumers were charged a
  price corresponding to their cost, they would not
  connect to the network.
• Exclusion of some consumers low income or high
  cost consumers.

5
Monopoly and competition

• Under monopoly regime usually, a single tariff
  for all consumers.
• Low cost (or high income) consumers generate
  margins, pay for high costs (or low income)
  consumers.
• Under a competitive regime entrants tend to
  enter on profitable market segments, i.e. those
  where prices are above costs consumers with
  high demand and revenue, low cost consumers
  (urban areas)    
•  cream skimming 
• Makes cross subsidization impossible.

6
Monopoly and competition (2)

• Under competition, high costs consumers and low
  demand consumers are not profitable for
  operators the willingness to pay of the
  consumers for the network good is lower than the
  cost incurred by the firm,
• either because the willingness to pay is low
• or because connection costs are high.
• They will not be served unless the regulator
  imposes universal service obligations (USOs).
• What are these obligations?

7
What are the USOs?

• European law access (to transport, electricity,
  telecommunications networks) should be
   available  for all consumers, at a
   reasonnable  price.
• Difficult to  translate into economics 
• Ubiquity a firm should necessarily provide the
  service to any consumer that has a positive
  demand for the good.
• Non discrimination all consumers should be
  served at the same price (or should be offered
  the same menu?)
• Remark from the point of view of  pure 
  economic theory, redistribution should be a
  taxation problem.

8
1) Allocation and funding of USOs

• A lot of questions arise
• 1) which firm should incur these USOs? A given
  firm (old monopolist)? another firm? A firm
  endogenously selected? Through which mechanism?
• 2) How should this firm be compensated for the
  costs it incurs? By a legal monopoly on some
  services? By cross subsidies? By direct transfers
  (subsidies)?

9
Level of compensation

• Cost of universal service
• is in fact endogenous, depends on the scheme that
  has been chosen for its organization.
• Important for the definition of state aids!
• The regulator may choose various compensation
  levels
• Monopoly profit of the operator before
  competition.
• Net avoidable costs.
• Profit that the US operator would obtain in an
  optimal situation (first best).
• Profit that the US operator would obtain in a
  competitive world without USOs (competitive
  neutrality).

10
Many regulatory solutions

• Allocation
• restricted entry,
• "pay or play",
• auctions, ..
• Funding two broad classes
• Internal funding
• External funding
• taxation, additionnal charge on the access
  charge to the infrastructure, cross subsidies,
  transfers of public funds...

11
Questions

• What is the impact of these various regulatory
  mechanisms
• on entry?
• on market structure?
• on welfare?
• on redistribution between agents?

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2) USOs with substitutes

• In some cases, a good submitted to USO has a
  (partial) substitute without USOs (ex.
  electricity/gaz).
• Are there substitutability or entry
   thresholds  that make USOs non viable?
• Should the competitors participate to the funding
  of USOs?

13
Impact of USOs on entry and tariffs Anton,
Vander Weide, Vettas (2000)

• 2 markets
• Urban, profitable, oligopolistic.
• Rural, non profitable, auctions.
• USO imposes a unique price. Creates a link
  between the two markets.
• Consequence urban price increases (softer
  competition), disadvantage for the firm active on
  both markets. Compensation required.
• Rural market competition for the market. Good
  for consumers.

14
Comparison of regulatory rulesChoné, Flochel,
Perrot (2000, 2002)

• Network market open to competition
• 2 firms an incumbent and an entrant
• 2 regulatory constraints ubiquity, non
  discrimination, may be imposed together or
  separately.
• Some consumers are non profitable global surplus
  on these consumers is negative. Firm(s) active on
  that segment need compensation.
• Various regulatory regimes.

15
Comparison of regulatory rules

• Allocation through
•  Restricted entry  the incumbent is in charge
  of USOs.
•  Pay or play  the incumbent is in charge with
  the USOs, but the entrant may serve himself
  (play) the unprofitable market instead of paying
  a tax (pay).
• Funding through
• Cross subsidies (possible only if the same firm,
  serves both markets).
• Taxes levied on the entrant
• Transfers of public funds.
• Compensation level
• First best, second best, competitive neutrality

16
Timing of the regulatory  game 

• The regulator announces the tax that will be
  perceived on each unit of the good sold.
• Then firms compete in order to attract consumers
  , i.e. choose the part of the surplus that will
  be left to each type of consumers through the
  tariff.
• Competition differs according to the regulatory
  regime.

17
The regulatory rules

• Restricted entry
• The incumbent incurs the USOs ubiquity or
  ubiquity non discrimination between users.
• Incumbent offers tariffs to each type of
  consumers.
• Entrant offers a tariff to the profitable
  consumers only.
• Pay or play
• The incumbent incurs the USOs ubiquity or
  ubiquity non discrimination between users.
• Incumbent offers tariffs to each type of
  consumers.
• Entrant offers a tariff to each type of
  consumers.

18
The various regimes

• Benchmark competitive case without USOs
• High costs consumers are excluded.
• Low cost consumers are served by the more
  efficient firm (incumbent or entrant).
• With USOs many regimes
• Incumbent serves both types and cross subsidizes.
• Entrant serves both types (possible only with pay
  or play) and cross subsidizes.
• Incumbent serves high cost consumers, entrant
  serves low cost consumers and pays the tax.

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Restricted entry (only the incumbent serves the
high costs)

• Regime depends on the USOs ubiquity alone, or
  ubiquity non discrimination.
• Ubiquity only
• For a given level of tax the regime coincides
  with the choice of the regulator
• if the tax is high, incumbent alone and cross
  subsidies,
• if the tax is low, the entrant may serve low cost
  consumers.
• Only distorsion with regard to productive
  efficiency due to the tax, that increases its
  cost, entrant  less  active than without the
  tax.

20
Restricted entry (only the incumbent serves the
high costs)

• Ubiquity non discrimination
• Creates an additional distorsion all consumers
  served by the incumbent face the same tariff.
• Choice of incumbent no longer coincides with that
  of the regulator.
• Incumbent is constrained both by competition with
  the entrant and by the ND constraint (tariff
  constrainted by the high cost consumers).
  Incumbent less competitive on the low costs
  consumers
• Taxation regime appears  too often  (and cross
  subsidies not enough), with entrant  too active
  on the low cost consumers (compared to
  efficiency).

21
Pay or play

• Entrant may serve high costs consumers.
• Will occur if entrant very efficient, or tax too
  high).
• No ND constraint on the entrant ex ante, but at
  equilibrium in fact the entrant offers the same
  tariff to both types of consumers.
• If entrant  plays  regime of cross subsidies
  by the entrant (also profitable to serve low
  cost)
• If entrant  pays  taxation regime.
• If entrant is not active cross subsidy regime
  by the incumbent.

22
Pay or play

• Ubiquity constraint alone.
• Entrant will serve the market if it is more
  efficient than tax (i.e. than the incumbent)
• Pay or play always better than restricted entry.
• Ubiquity non discrimination
• this no longer holds.
• Pay or play may be detrimental to welfare!

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Why?

• If the tax is very low no incentive to serve
  high cost consumers for the entrant.
• Intermediate values of the tax tradeoff for the
  entrant.
• High level of the tax the entrant will play, no
  more taxation regime.
• Two cases where pay or play is less efficient
  than restricted entry
• For intermediate levels of the tax and some costs
  configurations, the entrant is  too  active on
  the high costs market, not enough cross subsidies
  by the incumbent.
• For high levels of the tax, no more taxation
  regime. In some cases, this would however be
  better than cross subsidies.

24
Other types of regulation

• Auctions
• for the right to serve the unprofitable market
  segment
• Lowest subsidy
• Funded by transfers through taxation
• Not necessarily welfare improving
•  Too much  disconnection between profitable and
  unprofitable markets.

25
USOs with substitutes

• Example electricity is submitted to USOs, gaz
  is not and both goods are partially substitutes,
  but captive use of electricity.
• Is it good or bad for universal service?
• Bourguignon, Ferrando, Perrot (2003),
  Bourguignon, Ferrando, (2004).

26
The context

• Consumers differ according to their connexion
  costs to the gaz and to the electricity network.
• Two goods light (produced only by electricity)
  and heath (produced by gaz and electricity).
• Consumers need light (light essential good).
• Electricity submitted to U and ND constraints.
• Gaz is not submitted to ubiquity constraint, but
  if gaz firm active on a segment, must offer the
  same price to all consumers (ND).
• Two part tariffs.

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The context (2)

• Electricity firm alone (monopolist)
• If not constrained, does not serve the whole
  market.
• USOs necessary. Constrained by the U ND
  constraints.
• Cross subsidies in order to finance the losses.
• Duopoly the gaz firm chooses in addition its
  entry level (which level or coverage of the
  market?)
• Where both firms are present, they compete in two
  part tariffs, under the constraint for the
  electricity firm that all consumers should be
  connected to the network at the same price
  (UND).

28
Results

• When the gaz firm enters the market, since there
  is competition, prices decrease and welfare
  increases.
• Two part tariffs firms can try to take back
  that amount of additional surplus through the
  fixed fee.
• But the electricity firm is constrained by the U
  ND constraint.
• The electricity firm charges a unitary price
  below the marginal cost at equilibrium.
• The more the gaz firm enters the market, the
  lower the unitary price of electricity, the
  higher the fixed fee for electricity.

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Results (2)

• Aggressive competitive behavior from the
  electricity firm induces less entry from the
  gaz firm and lower profits for the gaz firm.
• Is this predation?
• Classical predatory behavior tradeoff between
  losses today/benefits tomorrow.
• Here no losses.
• Electricity firm benefits from the entry of the
  gaz firm.
• Being constrained is an advantage! Commitment.

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Comments

• If the only instruments of the regulator are U
  ND contraints, (no price regulation), then
• Gaz underdevelopped
• Price of electricity too low.
• Merger between gaz and electricity firm is better
  from a collective point of view (the unique firm
  internalizes the adverse effect).

31
Conclusion

• Competition may have unexpected effects.
• In some cases, cross subsidies are a good thing
  the methods that lead to a separation of markets
  (pay or play, auctions) may be bad.
• But in general more competition is a good thing
• Especially for the  universal service
  consumers 
• The various constraints (UND) are very different
  in terms of distorsions.
• The firm that incurs the USO may have an
  advantage (commitment effect).