When we consider questions related to Internet access policy (as I’ve been doing lately on this blog), it’s useful to have a sense of both the economics and historical trends in this key sector of the economy.  In this post I’m going to provide some of this, using excerpts from a paper I wrote awhile back.  Some of it may be a bit wonky, but I hope it will be useful for anyone wanting some additional background.

One of the key implications of this post’s analysis is that facilities-based wireline competition tends to be economically inefficient and, over time, wireline (and, to a somewhat lesser degree, wireless) access markets tend toward increasingly monopolistic industry structures (often referred to as “natural monopoly.”)

And even when there are already two wireline network operators in place (as in much of the U.S.), the same migration-to-monopoly economics are at work.

For example, AT&T and Verizon, the nation’s two largest telcos, have been experiencing accelerating customer losses in the markets in which they offer only DSL broadband (which account for roughly half of their holdings, if you include mainly-DSL markets recently sold off by Verizon).  Yet, in spite of these accelerating competitive losses, they have decided not to upgrade these markets with fiber optics, which would allow them to compete much more effectively with cable.

The primary reasons for this are:

1) telco DSL networks are fundamentally inferior to cable networks in terms of broadband capabilities, but are expensive to upgrade to the kind of fiber optic-based network that can compete with cable (as Verizon’s is doing quite successfully in the areas where it has upgraded to a fiber-to-the-home network.)

2) the two giant telcos don’t see enough financial payback from upgrading their remaining DSL-only (or dial-up only) markets and, instead, are focusing mainly on wireless, where they are the ones with dominant market power, but which does not provide real competition for cable-delivered broadband (due to speed, reliability, price and other factors).

Thus, as Susan Crawford has pointed out, in much of the nation, high-speed Internet access is migrating to an unregulated “cable monopoly.”  

If we’re serious about Internet policy, we need to understand and deal with this reality.   Hopefully the following will help a little with that understanding:

The economics of local access networks

A fundamental characteristic of the telecommunications industry—especially the wireline access sector—is that it is very capital intensive, with capital and operating costs that are largely fixed. This, in turn, translates into high barriers to entry, since a new market entrant must take on large amounts of fixed costs just to get a foothold in the market.

A simple model of costs and pricing can highlight the impact that the high-fixed-cost nature of telecommunications has on the fundamental economics of facilities-based competition. To keep things simple, we’ll assume the extreme case that 100% of the costs to build and operate a network are fixed.

Under this assumption, adding a facilities-based competitor in a single-provider market would double total network costs, while adding a third and fourth network would increase total costs by 50% and 33%, respectively.

Based roughly on real-world experience, we’ll assume that end-user prices decline by 25% with the addition of the second network, another 15% (from the original monopoly price level) due to the additional competition provided by a third network operator, and a further 10% following the entry of a fourth competitor.

This simple model leads to the following results: a second competitor increases total costs by 100%, but reduces prices by just 25%; a third competitor leads to total costs 200% higher than in the monopoly scenario, with prices only 40% lower, while a fourth competitor results in a 300% increase in costs and a 50% reduction in competitive pricing.

If we assume that new entrants offer roughly the same set of services as incumbents, and that total penetration does not increase with the introduction of additional competitors, these scenarios would translate into dramatic increases in total network costs that would need to be financed through steadily declining total revenues. In the four-network scenario, for example, total capital and operating costs would be four times what they were in the single network model, even as total revenues—which now need to be shared by four rather than one provider—would be cut in half.

The economic inefficiencies—and severe challenges faced by new entrants–in this simple model of facilities-based competition are clear, and would exist in proportion to the real-world ratio of fixed to total network costs. New entrants’ challenges would also be impacted by other factors, including the extent to which: competitors’ services are not highly differentiated; service innovation is relatively modest; end-user willingness to spend is relatively stable and; incumbent service penetration rates are high. All of these, to varying degrees, tend to be the case in the telecommunications sector.

Failures of the 1996 Telecom Act

Though the 1996 Telecom Act was intended to encourage competitive market entry by removing regulatory barriers, its impact over time was actually to introduce new forms of regulatory uncertainty, as FCC rules attempting to implement the Act were constantly challenged and dragged through the courts.

As a result, after being thrown wide open to new facilities-based entrants in the wake of the Act’s passage, the floodgates of investment capital were abruptly slammed shut as the ensuing regulatory uncertainty ended up aggravating rather than ameliorating the fundamentally challenging economic hurdles to successful market entry. The painfully high percentage of bankruptcies in the CLEC and “overbuild” (a.k.a. “competitive broadband service provider”) sectors over the past decade are a testament to this dynamic.

Thanks in large part to this combination of regulation and market dynamics, the mass market telecom sector has migrated to a duopoly model, and a good number of once-highflying CLECs and overbuilders have ended up in bankruptcy.  And as noted at the start of this post, many markets are seeing the cable-telco duopoly structure migrate to a “cable monopoly” structure when it comes to truly high-speed Internet access.

As demonstrated by the bankruptcy-laden history of the CLEC and “overbuild” sectors earlier this decade, private capital can become quickly spooked as the realities of facilities-based market entry begin to sink in. These realities can include intense and arguably-predatory price competition during and after construction phases, lack of cooperation with regard to interconnection and other regulation-mandated requirements, and, in the case of cable operators, use of exclusivity as a competitive weapon (most often related to terrestrially-distributed sports programming, often owned by the cable operator itself).

In the CLEC and overbuild sector, these dynamics have been compounded by relentless regulatory and legal challenges, typically at the state and national level in the telecom sector, and at the local franchise level in the multichannel video market.

Somewhat ironically, the fixed cost nature of telecom networks works largely in reverse for incumbent network operators. Since so much of their costs are either sunk capital costs or fixed operating costs, it is relatively easy for them to cut prices in areas targeted by new competitors and, if needed, offset these with price hikes levied in other geographic or service markets where they do not face comparable competition. And, as our simple modeling exercise suggested, incumbents have strong incentives to nip competitive entry in the bud, if at all possible.