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Theoretical Approaches to the Economics of Pricing Under Differing Market Structures

In a pure monopoly, a variety of price structures may be consistent with cost recovery, and the firm (or regulators) may be able to select price structures that promote political or social goals such as universal service or unbundling of raw transport. In a competitive market, this flexibility may not exist. Under perfect competition (which assumes no barriers to entry and many small firms), the price per unit will be equal to the cost per unit (where costs are defined to include the opportunity costs of all resources, including capital, that are used in production). There is no pricing flexibility. When neither of these pure market forms exist, economic theory does not provide any general conclusions regarding equilibrium price structures or industry boundaries. While substantial progress has been made in developing game theory and its application to oligopoly,3 no completely general results on pricing are available. This is particularly true in the dynamic context where interdependencies between current and future decisions are explicitly considered. Some theoretical work in this area is summarized in Shapiro.4 An important result in game theory asserts that no general rules can be developed: "The best known result about repeated games is the well-known 'folk theorem.' This theorem asserts that if the game is repeated infinitely often and players are sufficiently patient, then 'virtually anything' is an equilibrium outcome."5 Modeling based on the specific features of the telecommunications industry may therefore be a more promising research strategy.

The economic analysis of competition among network service providers (NSPs) is further complicated by the presence of externalities and excess capacity. Call externalities arise because every communication involves at least two parties: the originator(s) and the receiver(s). Benefits (possibly negative) are obtained by all participants in a call, but usually only one of the participants is billed for the call. A decision by one person to call another can generate an uncompensated benefit for the called party, creating a call externality. Network externalities arise because the private benefit to any one individual of joining a network, as measured by the value he places on communicating with others, is not equal to the social benefits of his joining the network, which would include the benefits to all other subscribers of communicating with him. Again, the subscription decision creates benefits that are not compensated through the market mechanism. It has been argued that the prices chosen by competitive markets are not economically efficient (in the sense of maximizing aggregate consumer and producer benefits) when externalities are present.6

It has also been argued that "[i]ndustries with network externalities exhibit positive critical mass—i.e., networks of small sizes are not observed at any price."7 The consequent need to build large networks, together with the high cost of network construction (estimated by some to be $13,000 to $18,000 per mile for cable systems8), implies the need for large investments in long-lived facilities. The major cost of constructing fiber optic links is in the trenching and labor cost of installation. The cost of the fiber is a relatively small proportion of the total cost of construction and installation. It is therefore common practice to install "excess" fiber. According to the Federal Communications Commission, between 40 percent and 50 percent of the fiber installed by the typical interexchange carriers is "dark"; the lasers and electronics required for transmission are not in place. The comparable number for the major local operating companies is between 50 percent and 80 percent. The presence of excess capacity in one important input is a further complicating factor affecting equilibrium prices and industry structure.

To summarize: a full economic model of the networking infrastructure that supports the NII would need to account for at least the following features:

Oligopolistic competition among a few large companies that invest in the underlying physical communications infrastructure;

Network and call externalities at the virtual network level; and

Large sunk costs and excess capacity in underlying transmission links.

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