Incentive Regulation in Telecommunications

 

Major, Ivan

We could witness the opening up of telecommunications markets to competition since 1996 in the United States and since 1998 in the European Union. The regulatory reforms aimed at enhancing social welfare in these countries through a broader access to telecommunications and IT services. Enhancing social welfare in telecommunications was perceived as an expansion of services offered to customers, an increased quality of service and an improved cost efficiency of the telecommunications industry. Thus, improvement in social welfare has implied an increased consumer surplus on the customers' side and a larger producer surplus (profit) at the producers.

It has always been the governments' principal concern to find a fine balance between the interests of consumers on the one hand and the interest of the business community on the other. But the market environment dramatically changed in the last decades. A worldwide process of integration unfolded among telecommunications, the IT industry and the electronic media. And several new players entered the telecommunications market itself. Previous regulatory regimes aimed at constraining the monopoly power of the "natural monopolies" in the telecommunications sector while securing the feasible level of cost recovery for the companies (the so-called "rate of return" pricing). Industry regulation needs to tackle a much wider range of issues today than a few decades ago. The most important aspects of regulation are: (1) regulating competition in the market rather than for the market; (2) price regulation; (3) regulating interconnection; and (4) defining and enforcing universal service regulation.

It is a well-known result of welfare economics that perfectly competitive markets provide the most efficient solution for the allocation of national or global resources. Industry regulation aimed at bringing the telecommunications market closer to this "perfect world." The pricing policy that set marginal cost (the "forward oriented long run incremental cost") as a benchmark for pricing rules in telecommunications businesses also served this purpose. But the telecommunications sector - as several formerly public utility - would not be viable had "price must equal marginal cost" rule prevailed. But there is hope: instead of the so-called "high powered" incentives that sort the less than most efficient firms out from the market, we can rely on "low powered" incentives that provide the least socially expensive way of letting competition work while offering a wide range of services. Low-powered incentives mean in practical terms that regulation permits price discrimination of the firms among different customer groups while it protects customers against excessive charges. Price discrimination enhances social welfare whenever the producers may gain monopoly power and investments in the industry are risky. And this is exactly the case in telecommunications. We must accept the fact that the telecommunications market is not a perfectly competitive market. It is not perfect because of the large fixed and overall costs and low marginal cost of the technologies and because the incumbent firms have market strength that needs to be controlled and constrained. At the same time, producers (service providers) need incentives to develop the infrastructure and to engage in long-term investments.

Finally, but equally important: Industry regulation is about intermediation of information between consumers and producers. And regulation needs to address the fact that asymmetric information prevails on several levels in the telecommunications industry. Customers are the "principals" - who demand the service - and the companies are their "agents." And we well know: principals are always under-informed compared to the other party. Consequently, customers are "at the mercy" of much more knowledgeable producers. Government also acts as "principal" who is deprived of some essential parts of necessary information when it needs to regulate the market. Incentive regulation is an efficient way how the most important aspect of economic transactions, the transaction of information between the economic actors can be managed.

The first form of incentive regulation has been the price cap regulation that aimed at inducing productivity increase at the service providers. But it has been clear to regulators and to regulated firms that "adverse selection," "moral hazard" and an ensuing "regulatory capture" weakened the efficiency of price cap rules. The latest results of the regulation literature show that we can apply more sophisticated tools than the simple price cap formulas. I shall present a few practical solutions in my lecture.