National

1
National International Economics

• Regulation in Network Industries
• Simon J. Evenett
• www.evenett.com

2
Overview of todays presentation

• Motivating questionsregulation and business
  strategy.
• Preliminaries on regulation
• Types of regulation.
• Notions of efficiency.
• Theories of regulation.
• Network industries characteristics and market
  dynamics.
• Changing nature of regulation in network
  industries.
• Regulation and business strategy in network
  industries.
• European experience in regulating network
  industries.
• Case Study Comparing UK and German experience.

3
Why study the regulation of networks?

• Why are these regulations of interest to business
  people?
• __________________________________________________
  _____
• __________________________________________________
  _____
• What is the relationship between regulation and
  the design and implementation of business
  strategy?
• __________________________________________________
  _____
• __________________________________________________
  _____
• What is so special about regulation in network
  industries?
• __________________________________________________
  _____
• __________________________________________________
  _____
• What are the sources of enduring competitive
  advantage in regulated network industries?

4
Purpose of this course

• To familarise you with the types and motives for
  regulation.
• To examine the implications of economic and
  political-economy analyses of regulation in
  network industries.
• To discuss the implications of regulation for the
  design of business strategy in network
  industries.
• Approach taken here blend of institutional
  material, economic analysis, and business
  strategy tools.
• Relationship to other courses.

5
Readings for this course and evaluation

• Three readings
• What is regulation?
• Theories of regulation.
• Case study of regulatory games in European
  utility sectors.
• The exam questions will refer to the readings and
  the material covered in class.

6
Main themes of this course

• Firms need not be passive agents in regulated
  sectors.
• Strategic behaviour vis-à-vis the regulator and
  other firms is possible, and maybe even
  essential.
• Strategic behaviour can have market and
  non-market components.
• Cannot rule out that rivals will engage in such
  behaviour.
• It is widely accepted that a free market in a
  network industry is no guarrantee of efficient or
  socially-acceptable outcomes.
• Market outcomes in network industries can shift
  very quickly.
• Precious little can be taken for granted.
• Need to frequently review the source of
  competitive advantage.

7
Regulation in Network Industries

• Preliminaries on regulation

8
Regulation and the market system

• As an alternative to free markets and state
  control of production and consumption.
• At its best, regulation seeks to use the power of
  incentives provided by free markets plus the
  actions of the state to obtain desired outcomes.
• Credible regulation relies on the coercive power
  of the state.
• Why cant the private sector fix the problems
  that regulation is supposed to address?
• Coases Theorem.
• Limited information.
• Organisation and bargaining costs.
• Negotiating impasse.

9
Important characteristics of regulation

• What?
• Form Command and control (thou shall),
  liability, inducements (thou should).
• When?
• ex-ante versus ex-post regulatory measures.
• By whom?
• Sources of regulation government agencies,
  negotiated by state and firms, courts, and even
  private associations.
• For whom?
• Obligations on some rights for others.
• With what?
• Information requirements and generation.

10
Types of regulation

• Control of price.
• Example ______________________________________
• Control of investment.
• Control of rates-of-return.
• Example ______________________________________
• Control of quantity.
• Example ______________________________________
• Control of entry and exit.
• Example ______________________________________
• Control of quality.
• Example ______________________________________

11
Types of regulation

• Control of price.
• Example ______________________________________
• Control of investment.
• Control of rates-of-return.
• Example ______________________________________
• Control of quantity.
• Example ______________________________________
• Control of entry and exit.
• Example ______________________________________
• Control of quality.
• Example ______________________________________

12
Business-oriented questions about regulation

• What factors trigger regulatory responses by
  government?
• In what ways does a regulation affect current
  firm behaviour and market outcomes?
• How do firms respond to regulation?
• How should firms respond to regulation?
• In what ways is future behaviour of firms
  affected by regulations?
• What is the impact on firm profitability of
  different types of regulation?
• In what ways, if at all, can firms influence a
  regulators decisionmaking processes?
• How do regulators learn?

13
Assessing market outcomes

• Firms are interested in their current and future
  likely profits but do governments always see
  market outcomes the same way?
• Arguably not markets facilitate the gains from
  mutual exchange and buyers gain as well as
  sellers. Need a metric to take account of gains
  to all parties from exchange.
• Economists first big idea welfare impact of
  market transactions is the sum of the gains to
  consumers and producers.
• Concept of consumer surplus.
• Concept of producer surplus.
• Relationship to firm profits.
• Economists next big idea evaluate market
  outcomes on the basis of this metric.

14
Assessing market outcomes in perfectly
competitive markets

• To see how this metric applies in practice,
  consider a perfectly competitive market where
• no consumer is large enough that their decisions
  affect market prices.
• every consumer obeys the law of demand.
• no producer is large enough that their decisions
  affect market prices.
• the incremental cost of producing each good rises
  as output rises.

15
Consumer surplus difference between willingness
to pay and price paid.
P
MS
P1
MD
Q1
Q
16
Producer surplus is the difference between total
revenues and total variable costs
P
MS
P1
MD
Q1
Q
17
Useful aside Producer surplus is zero if
incremental costs are zero.
This finding has applies whatever the level of
incremental costs. What covers fixed costs?
P
MS
P1
MD
Q1
Q
18
The total gains from exchange.
P
Note P1marginal cost
MS
P1
MD
Q1
Q
19
Efficiency of perfectly competitive markets.
P
MS
Area C is lost
Area A
P1
Area B
MD
Q1
Q
Q2
Q3
20
How governments assess market outcomes

• Maximising the total benefits from exchange
• Efficiency sum of producer and consumer surplus.
• Maximising the total benefits from exchange
  taking account of knock-on effects such as
• Pollution.
• Distribution of surplus between producers and
  consumers.
• Access to good in question.
• Minimum levels of consumption
• Necessities.
• Through impact on favoured or influential
  interest groups.

21
Notions of efficiency

• There is more than one notion of efficiency that
  people use when discussing market outcomes and
  the case for government intervention (which may
  include regulation).
• Allocative efficiency Requires prices to equal
  marginal costs.
• Rationale ____________________________________
• Productive efficiency Requires prices to equal
  minimum possible production cost.
• Rationale ____________________________________
• Dynamic efficiency Requires prices charged over
  time to maximise the benefits of mutual exchange.
• Rationale ____________________________________

22
Violations of allocative efficiency any exercise
of market power
Price
Loss of welfare
P1
MC
D
MR
23
Violation of productive efficiency
Price
AC
MC
P1
D
24
Theories of regulation the questions.

• What do these theories seek to explain?
• Why are regulations imposed?
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?
• Whose behaviour do these theories try to explain?
• Use theories like chop sticksI will explain why
  and how!

25
Theories of regulation the answers.

• Public interest theories.
• Regulation is there to fix market failures.
• Capture theory.
• Regulation promotes the interests of incumbent
  firms and not social welfare.
• Economic theory of regulation.
• Politicians structure regulation so as to
  trade-off the interests of different societal
  groups in such a way that is most beneficial to
  them.
• Which theory is correct has big Implications for
  firm strategy. Why?

26
Public interest theories of regulation

• As much a theory of what the state should do
  rather than what it does do.
• On this perspective regulations are imposed when
  the normal operation of free marketstypically
  competitiondoes not deliver efficient market
  outcomes.
• Regulations are imposed when it is in societys
  interest to impose them.
• When do inefficient market outcomes happen?
• Natural Monopolies.
• Externalities.
• Information asymmetriesadverse selection and
  moral hazard.

27
Public interest theories of regulation

• So you answer the following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

28
Critiques of the public interest theories of
regulation

• Failures in prediction
• It does not explain which sectors are regulated
  and which sectors are not.
• It cannot explain why some sectors are
  deregulated and others are not.
• Incomplete explanation
• Does not explain why the beneficiaries of the
  status quo cannot successfully oppose changes in
  regulation.
• Insufficient attention given to who influences
  regulatory choice.
• What are the implications for business strategy
  of this critique?

29
Critiques of the public interest theories of
regulation (2)

• Does not consider the information needed by the
  state/regulator to set the optimal regulation.
• What information is needed?
• Who has that information (if anyone)?
• Does that agent have the incentive to share the
  information?
• What are the implications for business strategy
  of this critique?

30
Capture theory of regulation

• Motivated by evidence that regulated sectors
  tended to have prices greater than costs and to
  have profits.
• One interpretation producers seek regulations to
  secure higher profits.
• Example taxi cabs.
• Regulations are supplied in response to industry
  demands for them.
• The regulatory agency is effectively controlled
  by the industry.
• Mechanisms of control
• Information
• Budgets

31
Capture theory of regulation (2)

• So you answer the following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

32
Critique of capture theory of regulation

• Does not explain why one group (the incumbent
  firms) always triumph over other interested
  parties.
• Hard to reconcile with evidence on
• Discrimination in favour of small producers given
  in certain sectors.
• Cross-subsidisation imposed on some service
  providers e.g. universal service requirements for
  telecoms companies.
• Complaints about business people that regulations
  are lowering profits.

33
Economic theory of regulation

• Predicated on the assumption that the state has
  the power to coerce and that politicians use that
  power to advance their own interests.
• Three key assumptions
• Regulation redistrbutes wealthbut is costly to
  society.
• Behaviour of legislators is driven by desire to
  remain in office.
• Interest groups compete by offering political
  support (votes, funds) in exchange for favourable
  regulation.
• Prediction groups that are more easily organised
  or have more to gain from legislation tend to
  receive the benefits of regulation.
• Prediction politicians will limit the amount of
  regulation given.

34
Economic theory of regulation (2)

• So you answer the following questions
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

35
Explaining cross-subsidisation

• Can you use the Economic Theory of Regulation to
  explain why cross-subsidisation of supply to
  rural and less-populated reasons happens in
  telecomunications and in other utility sectors?

36
Critique of economic theory of regulation

• Voters tend to care about more than one
  mattermaking it easy for politicians to
  trade-off non-regulation-related benefits for
  pressures to intervene in markets.
• Politicians may care about things other than
  reelection.
• Assumptions being made about the vulnerability of
  politicians and the powers delegated to
  politicians.
• Various forms of representative democracy.
• Can this theory explain the creation of so-called
  independent regulatory agencies?
• Insufficient attention given to the role of the
  courts.
• Why does any of this matter for business
  strategy?

37
Explaining the trend towards creating independent
regulators.

• What do we mean by independence?
• Ability of regulator to set own agenda?
• Financing?
• Need to explain why politicians would delegate
  their powers to a third party?
• Technocratic expertise.
• Investment of time and resources in acquiring
  expertise and information.
• Can each theory effectively explain this trend?
• Which sectors would tend to get independent
  regulators and which sectors not?

38
Summary remarks on regulations

• There are many types of regulations and may
  reasons why they get imposed.
• The fact that regulations can affect business
  performance is the primary reason why a
  strategist needs to understand
• Why are regulations imposed?
• What is the incidence of regulation? i.e. what
  sectors are more regulated than others?
• What factors account for changes in regulation
  over time? Can they account for deregulation
  initiatives?
• What are the effects of regulations?
• Whose interests are served by regulations?

39
Summary remarks on regulations (2)

• Dont worry about the fact that there is no one
  agreed explanation for regulationthe world is
  very varied and it would be surprising if one
  story could explain every regulation.
• Regard the theories of regulation as potential
  explanationsdecide which is more relevant to the
  suitation at hand.
• Important to undertand
• which actors are involved.
• their motives.
• the options available to a firm.
• the need to formulate a coherent strategy for the
  market place and in the regulatory arena.

40
Regulation in Network Industries

• Network industries characteristics and market
  dynamics

41
The changing meaning of network industry

• Public policies towards these industries were
  markedly influenced by how these industries were
  perceived.
• Until 10 years ago network industries were
  thought to have a small number of producersoften
  only one--with a large, possibly central,
  production facility as well as a distribution
  system from the producer to each (or many)
  customers.
• On this view network industries were associated
  with natural monopolies (economies of scale)
  and the market power that they might employ.
• Often there were multiple, inter-related market
  failures, e.g. market power and environmental
  concerns in power generation.

42
The changing meaning of network industry (2)

• Old view overlooked the consumer-related benefits
  of network membership.
• Essential point Increasing returns to
  consumption.
• Has three possible meanings
• Consumers derive benefits from the total number
  of other consumers who are consume the same good
  or service.
• Incremental benefit enjoyed by a consumer
  increases with the amount consumed.
• Consumers derive benefits from consuming lots of
  related products.
• Can you think of examples of each?

43
How can we characterise these consumer
preferences?

• Remember key concept is the willingness to pay.
• In standard supply and demand theory, we assume a
  consumers willingness to pay obeys the law of
  demand.
• Remember, however, that was only an assumption!
  Reality may be very different.
• For example, the willingness to pay for a good
  depends not only on its price but also on the
  number of other consumers who are willing to
  produce the good.
• What about the other two logical possibilities?

44
Network effects but still obeys law of demand
Willingness to pay
D (many network members)
D (few network members)
Premium due to more members in network
Own demand
45
Network effects but breaks law of demand
Willingness to pay
Own demand for MSN messenger
46
Demand for internet time rises if ISP offers more
programmes in its package.
Willingness to pay
D (many features)
D (few features)
Premium due to more features
Own demand for internet time
47
Node and link representation of networks

• Highlights other features of networks, which will
  have important public policy implications.
• Here, a network is defined as a set of
  complementary nodes and links between suppliers
  and consumers.
• The increasing returns to scale feature of
  consumption is retained, however the supply side
  features of networks receive more attention.
• Example Star network.
• Could be a traditional telecoms network.
• Willingness to pay rises as number of customers
  rises.
• More than one part of the network is used by each
  customer at any one time.

48
A Star Network
A
S
B
E
e.g. B does not link to C directly
C
D
49
A Long Distance Network
V
W
B
A
SA
C
X
SB
D
Z
F
Y
50
Virtual networks have a common technical
platform. e.g. Razors and blades.
R1
B1
R2
B2
R3
B3
R4
B4
There is a distinction between one-way and
two-way networks
51
Strategic choices available in network structures.

• Prices charged to end consumers.
• Charge customers to send or receive data.
• Charge for technology to access to network?
• Two part pricing of the above.
• Price discrimination among customers.
• Intertemporal pricing to foster network
  expansion.
• Types of services offered to customers.
• Prices charged to rivals for access to own
  network.
• Technical standards employed.
• Compatiability or engage in a standards war.
• Protection of intellectual property.

52
Some practical questions that follow from this
analysis

• How to price internet services?
• Whether to give away internet software?
• How to price roaming charges on cell phones?
• How to price razor blades?
• Whether to introduce a blade that is compatiable
  with existing razor?
• How to price an improved version of Excel?

53
Which of Porters five forces are affected by the
characteristics of network industries?
54
Implications for market outcomes in network
industries

• Over time, large differences in market share and
  performance are possible in markets where firms
  were initially pretty equal
• small differences can matter a lot and path
  dependence.
• Large networks can generate substantial barriers
  to entry and the appearance of large profits.
• Concentrated market outcomes are not necessarily
  to the detriment of consumers.
• In the limit monopoly may be most efficient.
• Bottlenecks can emergegenerating market power.
• One standard may eventually dominate another even
  though initially they had the same market
  sharecritical role of customer expectations.

55
Public policy questions raised by network
industries

• Sectoral regulation
• Pricing access to networks.
• Prices to final consumers.
• Regulation of investment decisions and entry.
• Standard setting.
• Competition law.
• Abuse of dominance.
• Pricing (including predatory pricing).
• Use of standards.
• Barriers to entry.
• Merger review.
• Barriers to entry.

56
Perils of applying traditional static efficiency
criteria to analysing markets.

• What is the correct marginal cost to use?
• Especially if there is learning-by-doing.
• Firms setting prices below current marginal
  costs.
• What happens when the marginal cost is zero?
• Financing of investment.
• Rapid technical change suggests that competition
  is often for the market and not in the market.
• But for analysis.
• Emphasis on counterfactual.
• Dynamic efficiency considerations taken into
  account.

57
Summary remarks on competition in network
industries.

• Key feature of these markets increasing returns
  to consumption.
• Need to understand the form the increasing
  returns takes.
• Networks differ in structurecreating different
  potential strategic choices.
• Market outcomes are subject to much more path
  dependence small differences can really matter.
• Large size is not necessarily associated with
  much market power.
• But control of access to the network and
  proprietary technology can be important sources
  of market power.
• Competition can be for the market as well as in
  the market.

58
Regulation in Network Industries

• Changing nature of regulation in network
  industries

59
1980s and 1990s

• Shift from public ownership and public financing
  of network infrastructure to private hands.
• Many publicly owned firms were vertically
  integratedbreak up different functions. e.g.
  power generation, railways.
• Publicly owned firms had universal service
  mandates.
• Fears about security of supply gave way to
  optimism about incentives created by private
  enterprise, especially cost control.
• Government happy to see private sector bear
  burden of investment.
• Governments in Europe tended to choose
  privatisation over concessions.

60
1980s and 1990s (2)

• Privatised firms were subject to strict
  regulation.
• Abandon rate-of-return regulation.
• Can you think of the incentives created by this
  regulation?
• Introduced fixed term price contracts, often with
  RPI-X formulas.
• Was an attempt to solve the long-standing natural
  monopoly problem.
• Can you think of the incentives created by this
  regulation?
• Many firms introduced competitive tendering for
  suppliers.
• Competition from rival technologies, especially
  relevant in telecommunications and entertainment.

61
1980s and 1990s (3)

• Two widely-acknowledged failures affected
  regulation of network industries
• Californian energy crisisreminded critics of
  security of supply provisions.
• Issue separation of production from supply
  network.
• British railwaysHatfield railway crash in
  October 2000.
• Attention on who is responsible for maintaining
  the infrastructurewho invests and who pays for
  maintainence.
• Upgrades require slow train speeds for weeks.
• Both cases raise issues of coordination in
  vertically integrated network industries.

62
Regulating Telecoms in OECD nations

• Main findings of OECD June 2005 study (released
  on 11 January 2006).
• Responsibilites of regulators have tended to
  expand as ministries have transferred powers to
  them.
• Several telecoms regulators have been merged with
  broadcasting regulators.
• Shift towards joint responsibility for sector
  with competition agencies, sometimes with formal
  cooperation mechanisms established.
• Although seen by some as temporary institutions,
  whose job would be over when competition reigned
  in telecoms, sectoral regulators have survived.
• Why? Foreberance and new technologies.
• Next generation networks expected to create
  pressures for single regulatory regimes in
  telecoms-related sectors.

63
Characteristics of Telecoms regulators

• To whom does the regulator report?
• How is the regulator financed?
• Who appoints the head of the regulatory agency?
• How long a term does the head have?
• Can the head be dismissed?
• How are decisions made within the regulator?
• Which bodies, if any, can overturn the decisions
  of the regulator?
• What do the answers to these questions imply
  about the form that independence of a regulator
  takes?
• Are their sub-national regulatory agencies in
  telecoms?

64
Relationship between telecoms regulator and
competition agency

• Shift since end 1990s away from sole, full
  responsibility given to one agency to joint
  responsibility for competition-related matters by
  both agencies.
• Not for regulators authorisation and licensing
  functions.
• Competiton agency can have parrallel powers (e.g.
  UK).
• Sometimes agencies enter into cooperation
  agreeents to clarify areas of individual or joint
  jurisdiction (e.g. Canada.)
• Sectoral regulator reports cartel violations to
  competition agency (e.g. Austria).
• Sectoral regulator can issue opinions to
  competition agency (e.g. Italy).
• Sector regulator may seek opinion of competition
  agency (e.g. Turkey).
• Why does all of this matter for strategy
  formation?

65
Areas of potential dispute between regulators and
competition agencies

• Pricing interconnection.
• Rules on price competition, especially rules
  against lower prices beyond a certain level.
• Mergers and acquisitions.
• Conditions imposed on new entrants.
• Forebearance of anti-competitive practices so as
  to meet a social regulation.
• e.g. unfunded universal service requirement.
• Even where the competition agency does not have
  formal powers it may engage in advocacy to
  those that do.
• Regulatory capture may not be enough!

66
Regulation in Network Industries

• Business strategy and regulation in network
  industries

67
Firms in network industries need integrated
strategies.

• Such firms operate simultaneously in a market
  environment (think Porters 5 forces) and a
  non-market environment (made up of non-commercial
  actors.)
• The non-market environment can be just as much as
  a threat to firm profitability as any of the five
  forces.
• David Baron argues that firms need integrated
  (that is, coherent) strategies in the market and
  non-market environment so as to protect against
  threats to profitability.
• He adapted Porters five forces approach to
  include the non-market environment.
• Lets do that here in the context of regulation
  of network industries.

68
Businesses operate in two environments
simultaneously.
69
Examples of non-market strategies.

• Two main objectives creating and exploiting
  opportunities and countering threats.
• Create opportunities for selfopening foreign
  markets.
• Alter rivals current opportunitiesraising
  rivals costs through impact of differential
  regulation.
• Block rivals opportunities altogetheropposing
  rivals MA plans.
• Reducing threats from rivalsblocking entry by
  imports, patents.
• Reducing threats from the stateself regulation
  in financial services.
• Mitigating threatsstate bail outs and insurance.
• Creating threats and uncertaintythreatening
  legal action.

70
Firms develop strategies for the market and
non-market sphere.

• Need not involve a change in the objectives of
  the firm.
• Effective strategy formation involves
• Identifying the relevant 4Is and 5 forces.
• Identifying a set of strategic options which may
  have market and non-market components.
• Anticipating strategies of actors in market and
  non-market environment.
• Given 1-4, evaluating strategic options decision
  and coherence in both spheres.
• Implementationconsideration of resources
  required.
• Mitigation of risks.
• Evaluation of prior decision. Start of feedback
  loop.

71
Important characteristics of non-market
strategies.

• Appropriability Are the gains from pursuing
  non-market strategy only appropriated by those
  firms pursuing such strategies? If not, what are
  the implications for the desirability of a
  non-market strategy?
• Collective versus individual action Would
  collective action be preferable to individual
  approaches?
• Sustainability. What are the sources of
  distinctivethat is, hard to copy yet
  effectivenon-market strategy? Can non-market
  strategy be a source of long term competitive
  advantage?
• Reversibility Does precedent matter? Can a
  particular strategy be reversed? If not, does it
  matter?

72
Regulation in Network Industries

• Case study on Regulatory Games in Utility Markets

73
Notes on case study (1)
74
Notes on case study (2)
75
Concluding remarks.

• Corporate strategy tools can be adapted to the
  special circumstances of network industries.
• Those characteristics include
• Increasing returns to consumptionor how
  networks create value!
• Generates mutiple pricing opportunities.
• Control over access to network.
• Choices concerning standards adopted
  (compatiability, and intellectual property.)
• Competition is often for the market, not in the
  market.

76
Concluding remarks (2)

• Concentrated market outcomes is often the
  resultprompting calls for government
  intervention.
• Plus there is legacy of government regulation in
  many sectors.
• Regulation calls for integrated strategies by
  firms to take account of the non-market
  environment.
• Critical to understand which regulators matter,
  how they make decisions, on what basis, and who
  they talk to.
• Regulators are often deeply influenced by
  national bureaucratic traditions.
• Dont make assumptions about due process and
  procedural fairness.
• Effective non-market strategy typically requires
  distinct resources and capabilities to implement.