High tech markets, industrial organization and growth

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T,ie

Here, v(y ) represents the network benefit, which increases with network size but at a

diminishing rate, reflecting diminishing marginal returns. This formulation underscores the

positive impact of larger networks on demand, while excessive total output reduces

individual firm demand due to market saturation.

Under the assumption of zero production costs, firm profits are directly linked to demand

and output levels. The profit function is expressed as:

T,ie

p = (1 + v(y ) - X ) X

i T T,i

Firms maximize profits by choosing output levels that balance the positive impact of network

effects with the negative impact of market competition. In the case of perfect compatibility,

network size is determined by the combined sales of all firms. Conversely, under

incompatibility, each firm operates within its own isolated network. In equilibrium, firms in

compatible networks produce higher output levels compared to their counterparts in

incompatible regimes. Compatibility enhances the total network size, amplifying demand and

increasing both firm profits and consumer surplus. The model demonstrates that under

compatibility, firms’ profits and consumer welfare are maximized, making compatibility the

preferred regime for both firms and consumers.

An intriguing result emerges when considering the impact of competition on firms’ profits in

compatible systems. While increased competition generally reduces profits, the presence of

strong network effects can reverse this outcome. When the indirect positive effect of

competition, which enlarges the network size, outweighs the direct negative effect, firms

experience higher profits with more competitors. This counterintuitive result underscores the

importance of network externalities in shaping market outcomes (Paradox of Economides).

The coexistence of incompatible technologies often leads to "standards wars," where firms

compete to establish their technology as the market standard. Historical examples include

the rivalry between Blu-ray and HD-DVD. Firms may also choose to collaborate and adopt a

common standard, as seen with the adoption of HDMI for televisions. These decisions

depend on factors such as consumer expectations, market history, and the strategic benefits

of compatibility.

Firms employ various strategies to dominate the market or foster compatibility. These include

building early leads, signing agreements with complement providers, pre-announcing

product launches to influence consumer expectations, and adopting open standards to

encourage widespread adoption. Each strategy reflects a calculated response to the network

effects inherent in their market. Switching costs, which arise when consumers transition

between competing products, play a significant role in markets with network externalities.

These costs can be monetary, such as termination fees, or non-monetary, including time,

effort, and psychological barriers. High switching costs create a lock-in effect, limiting

consumer mobility and enabling firms to charge higher prices. While this may reduce market

efficiency, it incentivizes firms to compete aggressively to establish an initial user base.

Lecture 4: Access and Interconnection in Telecommunications

The telecommunications industry represents a cornerstone of the high-tech sector,

contributing approximately 70% of the value generated in high-tech markets. Over the past

two decades, the liberalization of telecommunications markets in Europe has led to

increased competition and significant cost reductions. Historically, these markets were

monopolized, with incumbent firms dominating the landscape. However, liberalization has

encouraged the entry of new firms, particularly in fixed-line and mobile telecommunications.

The most significant barrier to liberalization lies in the local loop, the infrastructure

connecting customers' premises to the central network. This component is both

non-duplicable—owing to its high cost—and essential for service provision. In many

markets, incumbents control the local loop, enabling them to act strategically to

disadvantage new entrants. To mitigate such behavior, regulatory authorities often set the

access prices new entrants must pay to use the local loop. While this facilitates entry without

requiring duplication of infrastructure, incumbents can still influence terms and conditions of

access, potentially undermining the competitive environment.

The dynamics of telecommunications are evolving with the advent of wireless

communications. Unlike fixed-line services, where incumbents control access, mobile

telecommunications enable operators to establish independent networks at relatively lower

costs. This shift introduces two-way access problems, where competition arises among

interconnected mobile networks, replacing the traditional one-way access problem focused

on the local loop.

One way access model: A Fixed line example:

One-way access highlights the vertical structure of fixed-line telecommunications. For

instance, a long-distance call between two users in different towns involves several network

components: the local loops in both towns and the long-distance network connecting them.

Typically, the incumbent owns the local loops and the long-distance network, while new

entrants (Other Licensed Operators, or OLOs) may own only a portion of the infrastructure.

In such cases, OLOs must pay the incumbent for access to the local loop to provide

services.

Non regulated Fee case

When there is no regulatory oversight, the incumbent telecom company, referred to as M,

has complete control over setting the access fees for other companies, known as Other

Licensed Operators (OLOs). These fees are critical because they determine whether smaller

companies can compete effectively in the market. Initially, consider the scenario where M

operates as a monopoly, controlling both the infrastructure (e.g., local loop connections to

users) and the services provided to customers. In this case, M maximizes its profits by

setting a price that balances customer demand with its costs of maintaining and operating

the network. This price is derived to be higher than the marginal cost of providing the

service, enabling M to achieve substantial profits due to the lack of competition.

When competition is introduced, OLOs enter the market to provide services to customers.

However, they rely on M’s infrastructure, such as the local loop, to reach customers. To use

this infrastructure, OLOs must pay an access fee () to M. This fee becomes a strategic tool

for M to manage competition. By increasing M raises the costs for OLOs, making them

,

less competitive in the market. At the same time, M benefits by earning revenue from these

access fees, even if it loses some market share in the downstream service market.

Interestingly, this system can lead to a situation where M earns more profits with competition

than it would as a monopoly. This counterintuitive outcome occurs because OLOs are often

more efficient at providing services than M. For example, their costs of serving customers

might be lower due to better technology or operational practices. By charging them an

access fee, M effectively captures some of the efficiency gains of the OLOs and turns them

into additional profits. This is particularly evident when OLOs are significantly more efficient

than M, represented by a low efficiency parameter ().

The optimal access fee that M sets is calculated to maximize its total profits. It is always

higher than the cost of maintaining the network (), and its value increases when OLOs

become more efficient. This strategy ensures that M retains its dominant position while still

benefiting from the presence of competitors in the market.

Regulated Access Fees

When a regulatory authority intervenes, the goal is to set access fees in a way that balances

the interests of all stakeholders—consumers, the incumbent, and OLOs—while maximizing

overall social welfare. The approach differs depending on whether the regulator focuses on

the short term or the long term.

In the short term, where the number of OLOs is fixed, the regulator aims to set the access

fee so that prices reflect the true cost of providing services. This ensures that consumers are

not overcharged and that OLOs can compete fairly. The optimal access fee in this scenario

is:

This fee allows efficient OLOs to enter the market and compete while covering the costs of

the incumbent’s infrastructure.

In the long term, the number of OLOs is determined by market conditions, such as the

profitability of entering the market. A lower access fee encourages more OLOs to enter,

increasing competition and lowering prices for consumers. However, this also raises total

fixed costs, as more firms duplicate infrastructure and other investments. The regulator must

find a balance by setting an access fee () that maximizes social welfare while considering

these trade-offs:

Here, f represents the fixed cost of market entry. Lower access fees are ideal when OLOs

are highly efficient (θ is small) and fixed costs are relatively low.

Local loop unbundling is a key mechanism that allows OLOs to use the incumbent’s

network while maintaining some level of independence. The degree of control OLOs have

over the network depends on the type of unbundling. Bitstream access offers the least

control, while full unbundling allows OLOs to lease the entire network line, granting them full

autonomy but requiring significant investment. Shared access lies in between, enabling

OLOs to offer distinct services, such as internet, while the incumbent provides voice

services. Unbundling plays a transitional role in telecom liberalization. Initially, it enables

service-based competition, where OLOs rely on the incumbent’s infrastructure. Over time, it

encourages infrastructure-based competition, where OLOs build their own networks, leading

to greater independence and market efficiency.

Two-way access interconnection

When several telecommunications operators own independent infrastructures, the market

shifts from a one-way access problem (where new entrants pay the incumbent for access) to

a two-way access problem. In this setting, operators both buy and sell access services to

one another whenever their customers place calls between networks.

The simplest example is a duopoly involving two firms, A and B. These firms:

-​ Compete on prices while offering slightly different services (e.g., quality, contracts, or

customer support).

-​ Each manages their own network, allowing calls within their own network (on-net

calls) and between networks (off-net calls).

For simplicity:

●​ On-net calls involve both the call’s origination and termination within the same

network, costing 2c per call (where c is the marginal cost of each step).

●​ Off-net calls require origination on one network and termination on another. Here,

the calling network incurs an origination cost (c) and pays an interconnection fee (t)

to the receiving network, making the cost c+tc