Day 2 Session 1

The basis of economic

regulation
Jeremy Turk

The economic context of regulation

Regulators everywhere
Tiger Woods hit 15
greens in regulation
The issue of Licences
will regulate entry to
the mobile market
The market is the
best regulator

Regulation is
necessary to
protect vulnerable
consumers

The
Telecommunications
Act sets out the
regulations with which
companies must
comply

The regulator will

control profitability at a
level that will encourage
investment

Aspects of regulation
Regulation as control
Regulation as rule setting
Regulation as standard setting
The market is the best regulator regulators
should only do what markets cannot do, or facilitate
the effective introduction of markets
Regulation must be impartial, consistent and
transparent and independent from politics
Protecting and fostering competition within a
framework of legal rules is the essence of modern
telecommunications regulation (as in the EU
template)

The ideological revolution

End of history

Free market
economics

Keynesianism

Decline of
public
ownership

World Bank
model
Competition
Ownership

Privatisation

Liberalisation

Corporatisation
Role of
public
policy

Telecommunications
a publicly provided
utility

Costs of political
interference,
bureaucracy and
rent-seeking

Development of
market
economics

Incentive
regulation

Incentive-driven
regulation
Direct
regulation

Role of law in
commerce

Promoting
competition

Competitive
standards

Dynamic
competition

Economising of
competition policy

Protecting
competition

Competitiondriven regulation

Requirements of
transnational
harmonisation

Creating
markets

Technological revolution

Source: ITU

The intensity of regulation: 3 stages

Intensity
of
regulation

State
provision or
private
monopoly

Transition from
monopoly to
competition

Effective
competition in many
sectors

Monopoly

Monopoly and competition

Competition

After Neven and Seabright

The market

The market place

Freely operating markets can bring together a
multitude of buyers and sellers of the same product
Because there are many buyers, suppliers can target
many customers
Because there are many sellers, consumers can
choose from many suppliers
No one (or a few) buyers or sellers can influence the
price in the market they are all price takers
Supply and demand
Supply curve shows the prices at which producers
will bring a product to the market
Demand curve shows the price that consumers are
willing to pay for the product

Market prices provide all the information needed

The market: many buyers and many sellers

Demand
PRICE

Supply

The
market
price

Pm
Seller
behaviour

Buyer
behaviour

SALES

The marginal concept

Focus on the last unit
Is consumption of the last unit desirable for any
buyer?
Is the production of the last unit the last unit
profitable for any seller?
When buyers and and sellers are both are
satisfied an equilibrium is established
Under normal market conditions, this
equilibrium is stable
At this equilibrium, no buyer or seller can do
any better it is a social optimum

Consumers and demand

The demand curve is about substitution

Products or services that meet the same functions
compete with each other
If a price changes, consumers want to change the pattern
of their purchases for example, substitute pasta for rice
if the price of rice alone rises or domestic for foreign
holidays if the exchange rate worsens or Pepsi for Coca
Cola if the price of Pepsi falls:
Necessities will have steep demand curves price changes
will have little effect on demand
Luxuries will tend to have shallow demand curves demand
is sensitive to price

Markets are defined by patterns of substitution

It is important to distinguish between the demand curve
for the market as a whole and demand curves facing
individual suppliers

Consumer surplus

CONSUMER
SURPLUS

Supply
PRICE

Demand

SALES/OUTPUT

Maximising consumer surplus is a key

characteristic of well functioning markets

The idea of consumer surplus

Consumers will differ in their valuation of products; some
will buy at a high price others only at a lower price
Only at the margin (for each consumer or for the
marginal consumer) will value be exactly equal to price.
All units less than this will have a higher value to the
consumer than the price paid in the market
The total of this extra value is called consumer surplus
Effectively operating markets will tend to maximise
consumer surplus and regulators will play close attention
to it in assessing the impact of regulatory action

Supply and costs

The supply curve is about costs

Suppliers are driven by the search for profits
the excess of revenues over costs
Supply decisions will depend on a
comparison of price (more generally marginal
revenue) with marginal cost
The fundamental determinant of supply is
cost but what does cost mean?
Costs may be very different in the short and
long

Supply in the short term

Producers will make decisions related to the margin in
deciding how much to supply at any price:
We have to consider existing producers who have to decide
whether to produce more (or less)
And new producers who might enter (or leave) the market

With any fixed amount of capital, marginal cost will tend

to rise as output increases, for example because:
Additional skilled labour is more expensive as it has to be
competed away from other employers
Capacity constraints are reached, perhaps causing congestion
Using capital more intensely may cause it to wear out more
quickly

Supply in the long term

The production of output requires investment in
capital equipment (including human capital - skills);
these costs are fixed in the short term but variable
in the long term
Spreading fixed costs over progressively higher
output will cause average cost to fall as output
increases. After some point however, this may be
offset by rising short term marginal costs
This will tend cause long run average costs to have
a U shape
A U-shaped average cost curve will mean that
there is an optimal size for each firm in the market

Optimum economic scale

Price
Marginal cost

Each firm will

have a scale at
which costs
are lowest

Average cost
Price (= marginal
revenue)

Optimum
economic
scale

Output

Free entry will

ensure that all
firms operate
at minimum
cost

Markets at work in the long term

In the long term, if it lowers costs, existing firms would be
able to expand capacity by investment and new firms
would be able to enter the market
A properly operating market will therefore allow new firms
to enter the market and existing firms to exit
New firms will enter the market as long as there is money
to be made in other words, until they can just cover their
costs plus an amount of profit (normal profit) that will
just make it worthwhile staying in the market
With free entry and exit, efficient new firms will be able to
establish themselves in the market at the optimal scale of
production while existing firms that cannot meet that level
of efficiency will not be able to survive

Economies of scale and scope

The precise shape of the cost curves in the long term will
depend on whether or not there are economies of scale
If expanding capacity causes cost to fall, there will be
economies of scale larger firms will be more efficient
If expanding capacity by increasing all inputs in the same
proportion replicates costs there will be constant returns to
scale
Eventually, the firm may be too big and incur diseconomies of
scale

Economies of scale may continue over a very large range of

output this is typically the case with physical networks
Investments like networks may also have large economies of
scope the same capital investment in networks may enable
more and more services to use the same network so that
average costs across all networks falls
Networks also display economies of density average costs
tend to fall with the density of users

Different kinds of cost structure

Cost

Average
total cost

Marginal
cost

Cost
Long run
average
cost

Long run
marginal
cost

Output

The normal case

marginal and average costs
rise at relatively modest
outputs

Output

An extreme case all

costs fall without limit in
the long term

The importance of competing suppliers

The market only works properly if consumers have
a choice of suppliers if substitution can take place
within the market
Competition amongst suppliers in the market is
what matters to ensure the ideal market outcome
Economies of scale and scope threaten this,
especially in small or bottleneck markets: one, or a
few, suppliers may be able to control the market and
cause distortion away from the ideal market
equilibrium

Competition and efficiency

Competition and efficiency

Competition is a major determinant of whether the

right price will exist in a market
Competition may also affect the level of costs over
time by affecting the behaviour of rival producers
The best if all monopoly profits is a quiet life:
competition reduces slack and inefficiency
Competition enables natural selection:
competition enables efficient firms to prosper at the
expense of inefficient firms
Competition encourages innovation

Competition: dynamic efficiency

New technologies are the most powerful enablers
of lower costs
New products are especially important in
increasing economic welfare
Creative destruction: Competition from the new
commodity, the new technology, the new source
of supply, the new type of organisation which
strikes not at the margin of profits and the outputs
of existing firms but at their foundations and their
very lives. (Schumpeter)
Are monopoly profits often an incentive to
innovation and entry?

The market is the best regulator?

Properly operating markets, with many competing
buyers and sellers, can bring consumers and
producers together in a way that maximises
economic efficiency
Competition in markets also encourages cost
reduction and innovation
Competition is the best regulator
It is not certain, however, that markets will always
operate in this way
In particular, cost conditions may restrict the
number of efficient competitors
And there may also be other causes of market
failure

Market failure

The fundamental driver of economic

regulation: market failure
Market failure occurs when freely functioning
markets, operating without government intervention,
fail to deliver an efficient or optimal allocation of
resources. Therefore economic and social welfare
may not be maximized and there will be a loss of
economic efficiency.

The fundamental driver of regulation is the belief that

intervention can remove, reduce or offset market
failures

Reasons for market failure

Cost and demand conditions that lead to market power and
dominance

Economies of scale, scope or density in relation to market size

Externalities which cause private and social costs and/or

benefits to diverge

Inputs and outputs not traded in markets

Transactions and switching costs

Impediments to market transactions

Inadequate information
Too little, too much or asymmetrically available information

Networks: substitutes and complements

SUBSTITUTES
B
CHOICE: B

CHOICE:
A+B+C

A
A

COMPLEMENTS

Fixed network cost structure

Contestable
Core

Backhaul

S1

Access

S5

S2
S3

S4

Natural
monopoly

Scope for competition also depends

on the size of the market

Wireless network cost structure

Total
cost

Capacity
expansion

Cost of
coverage
Call minutes

Mobile networks tend to be natural

oligopolies, and licensing policy often
strengthens this trend

Supply: the problem of natural monopoly

Economies of scale because of high fixed costs can lead
to constantly falling long run average and marginal costs.
The optimum size of firm may be very large possibly
there is a natural monopolist.
Economies of scope can lead to similar situation in which
cost is lowest when one or a small number of firms
produce a range of services that use the same basic
infrastructure.
For many years, telecommunications networks were
regarded as natural monopolies.
Now, with the arrival of more modular technologies,
monopoly may be confined to only some parts of the
network especially the access network and other
bottlenecks
Natural monopoly (or seriously diminished competition)
can still be a major regulatory issue

Information and the market

The value of information is not known until it has

been obtained
It may be difficult to ensure that information is
gathered, even if the benefits from it would be very
high
Both consumers and regulators may have less
information than suppliers
Information may be a potent source of market
power and a significant source of market failure

Consumer switching costs

There may be costs of making economic
transactions notably switching suppliers
These switching cost can create market power
Markets do not work well for consumers where
switching costs are high especially when they are
created by sellers
But if there are many competitors all may try to do
the same with relatively little overall impact
Regulators will especially look out for costs faced by
consumers switching away from an incumbent

Externalities and network effects

Externalities are a broader source of

market failure

The factory .

and the laundry

Externalities are interrelationships not

reflected in market prices

External effects of joining a network

Everybody benefits but not everybody

pays for it ..

Telecommunications externalities
Network externalities: by joining a network a
subscriber creates calling opportunities for existing
customers
Call externalities: under calling party pays, receiver
benefits from call
Mobile telecommunications appears to speed up
economic growth
Broadband connectivity appears to speed up
economic growth

Network effects
Network effects are a broader phenomenon than
pure network externalities
Networks may be physical or virtual
In networks it is relationships between network
elements that matters
Networks frequently show positive feedback
Network effects are like demand side economies of
scale
Some network effects are true externalities, not
captured by markets
Other network effects do operate through markets
but in complex ways and often imperfectly

Positive and negative feedback

Negative feedback

Positive feedback

Classical markets

Typical network effects

Market failure and regulation

Lack of competition may lead to the manipulation and use of
market power
A major duty of the regulator is to create, support and protect
competition
Externalities and network effects that are not taken into
account may lead to economic performance that is less good
than possible
Regulators are often charged with the duty to ensure that
network effects and other externalities and social impacts
are properly taken into account