Pricing and interconnection agreements in network markets

Reichhuber, Martin

Ever since the beginning of the nineties, interconnection pricing emerged as a high priority regulatory policy question. As more and more state-owned monopolies were privatized, their essential facility (or simply their network) had to be opened to competition. The most viable practice was call-by-call services in telecommunications markets. Entrants were allowed to buy capacity of the incumbent’s network in order to provide service to customers. Because the incumbent always has an incentive to foreclose the market, these agreements between incumbent and entrant were and still are in the focus of regulatory authorities all over the world. Although this so-called one-way interconnection model is still valid, competition between fully fledged networks has become of growing importance. Today cable providers are also capable of offering telecommunication services. However they dispose of a mature network and can bypass the former incumbent’s essential facility. Early models of network competition, such as Laffont, Rey, and Tirole (1998a) and Armstrong (1998) highlight the collusive role of interconnection charges in these settings. Hence the regulator is called for. The present thesis looks at instruments that can be used to regulate interconnection markets. It is comprised of three papers on access pricing in one-way as well as in twoway interconnection models. Chapter 2 looks at instruments that can be employed by the regulator, chapters 3 and 4 introduce fully decentralized mechanisms, where the role of the regulator is reduced to a minimum. Chapter 2 introduces a one-way interconnection model with a vertically integrated incumbent and an entrant who uses the incumbent network. Firms produce differentiated services and compete for customers. Traditional literature on interconnection pricing uses primarily per-unit access charges, hence the interconnection payment depends on he overall amount of traffic exchanged. In this paper we present a different approach to pricing interconnection. Because products are differentiated, the demand for end service is directly dependent on both firms’ retail prices. We generalize the access payment function and make it solely dependent on market prices. I show that a per-unit access price is a special case of a contract on both firms’ retail prices. Because such a function uses at east two instruments, we are able to reproduce specific access charge rules. Furthermore, due to the increased number of instruments, the set of possible outcomes is increased compared to a per-unit access charge. By comparing different benchmark cases and computing their respective parameters, we show that they can be used as a preliminary measure of goodness of the access mechanism. Additionally, we show that bill & keep, that is providing access free of charge, yields lower retail prices than regulating a per-unit access charge at cost. Chapter 3 uses the findings of chapter 2 and introduces as particular mechanism based on firms’ retail prices. We use the exact same model of industry structure, i.e. a vertically integrated incumbent and an entrant, that uses network capacity as an essential input. Product market competition is imperfect, i.e. products are differentiated. The access pricing mechanism is fully decentralized, i.e. other than setting up the rules of the game, the regulator does not intervene in the market at all. This is a particular strength of our mechanism, since traditional access pricing rules always require the regulator to dispose of almost full market information1. The access payment mechanism is modeled as a game between the incumbent and the entrant. Each firm determines a parameter in a linear payment function on firms’ downstream retail prices. We show that this results in lower prices and higher welfare than the regulated per-unit access charge approach. Furthermore we present conditions for which the equilibrium in the model coincides with the optimal Ramsey outcome. Chapter 4 draws on the literature pioneered by Laffont, Rey, and Tirole (1998a), Laffont, Rey, and Tirole (1998b) and Armstrong (1998). It uses a two-way interconnection model, with network-based price discrimination, i.e. firms charge different prices for their own and the competitor’s network. The paper of Gans and King (2001) shows, that when firms are able to charge two-part tariffs, a per-unit access charge is used as a collusive device. The optimal equilibrium access charge is below marginal cost, hence customers save on off-net calls. However this is more than offset by an increase in the flat payment and overall welfare is reduced as compared to a regime with access priced at marginal cost Using a consumer’s net-utility function we derive a new retail price mechanism. Instead of competing in flat fees, firms offer net-utility levels. In that case, the monthly payment is derived from the equilibrium net-utility level and the gross utility of making calls to both networks. The paper shows that using such a mechanism eliminates the collusive power of access charge is vanished and overall welfare is increased. Since net-utility is a function of the flat payment, the result is reminiscent of the literature on Bertrand and Cournot Competition with substitutes. We employ a graphical argument used in Cheng (1985) to show that competition in net-utility levels is a dominated strategy. The same is true for price competition when prices are complements.

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Reichhuber, Martin: Pricing and interconnection agreements in network markets. 2008.

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