BUSINESS : ECONOMICS AND POLICY IN TMT INDUSTRIES

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1 BUSINESS : ECONOMICS AND POLICY IN TMT INDUSTRIES University of Chicago, GSB Austan Goolsbee Week 1 I. OVERVIEW 1. Telecommunications (3 weeks) Access Pricing, Universal Service, telecom meltdown Mergers, Wireless Net Neutrality, Broadband and Voice over IP 2. Media (3 weeks) Satellite and Cable, Mergers Vertical Integration, Media Conglomerates Online movies 3. Technology (3 weeks) Vertical control, Microsoft, Database protection Online Music/IP/Patents Subsidies, promotion and locational advantages

2 LOGISTICS 1. Website 2. TA: Heleno Pioner 3. Grades: 10% assignments/write-ups 20% participation 70% final 4. Groups are OK (not required) but no more than 5 people

3 II. MICROCONOMICS REVIEW The Identification Problem: Supply vs. Demand When P moves vs. Q moves is it S or D moving?

4 Consumer Surplus Given a D curve: Q D = P -- What is C.S. if P=5 - ½ b*h = ½ * (Q)*(P MAX - 5) = ½ * (50) * (10m - 5m) = $125m--units matter

5 PRODUCER SURPLUS 1. How much benefit do firms get 2. Given a S curve: Q S = 5P what is producer surplus if P = 5 - ½ b*h = ½ * (10)*(5m - P MIN ) = ½ * (10) * (5m - 3m) = $10m - make sure p and Q are in same units

6 ELASTICITY 1. Is a measure of slope in percentage terms η = (Δ Q/Q)/(ΔP/P) = (ΔQ/ ΔP) * (P/Q) 2. For a demand curve like Q= P, vary by P - P=1 η = -10*(1/90) = P=4 η = -10*(4/60) = P=6 η = -10*(6/40) = P=8 η = -10*(8/20) = -4.00

7 COSTS 1. Fixed costs (Overhead) don t vary by output 2. Variable Costs (Wages, Energy) do vary by output 3. TC=FC+VC. 4. Average Costs are Cost/Q 5. Marginal Cost is Δcost/ΔQ=ΔVC/ΔQ OUTPUT FC VC TC MC AC AVC

8 PROFIT 1. Short Run profit is Revenue - Cost = P*Q - TC = Q * (P - TC/Q) = Q * (P - AC) Here they make a SR profit because P > AC

9 PROFIT 1. In short run, you can also make losses Here they make a SR loss because P < AC 2. Producer surplus is area under P & above MC 3. If P=MC in two places go to where cost is increasing

10 MKT POWER: MARGINAL REVENUE VS. PRICE Quant Price Tot. Rev MR MR = P + Q * (ΔP/ΔQ) If next unit reduces P that affects all previous units In perfect competition, (ΔP/ΔQ)=0.

11 MONOPOLY DECISON 1. Output decision A. Set choose Q so that MR = MC B. Charge the demand price at that Q 2. MR=MC maximizes profit

12 MONOPOLY 1. EXAMPLE: Q D = 10 - P MC = 3Q P = 10 - Q D (inverse demand curve) MR = P + Q * (ΔP/ΔQ) = P + Q(-1) = (10 - Q) - Q = 10-2Q (for linear replace Q with 2Q) MR = MC ==> 10-2Q = 3Q Q = 2 Then plug Q into demand curve & get P, here P = 8 2. With competition P=MC so 10 - Q = 3Q Q = 2.5 and P = 7.5 P higher, Q lower with monopoly & there is DWL

13 MONOPOLY MARK-UP FORMULA 1. Monopoly sets MR=MC at best point MR = P + Q * (ΔP/ΔQ) = MC P + (Q/P)*( ΔP/ΔQ)*P = MC P(1 + 1/η) = MC (P-MC)/P = 1/η also known as the mark-up or the Lerner index. 2. For firm with mkt power, p will always have η < -1

14 NATURAL MONOPOLY 1. If the lowest cost of producing Q is with 1 firm - called subadditivity 2. Declining Average Costs may be temporary

15 PRICING PROBLEM WITH FIXED COSTS 1. Price at MC? 2. Price at AC? 3. Two-Part Tariff? - how set the tariff?

16 MULTI-PRODUCT FIRMS AND PRICING w/fc Standard pricing Ramsey Pricing Ramsey Rule: (P-MC) = constant P η D

17 III. THE TELECOMMUNICATIONS ACT OF Comprehensive telecom, cable, satellite, etc. 2. Administered by the FCC 3. In telecom A. Change the 1983 AT&T separation B. RBOC/ILECs can enter L-D when local open to comp. C. Require interconnection between networks - reciprocal rates but left to negotiation D. Change Universal service obligation E. Forced unbundling

18 UNIVERSAL SERVICE 1. Where does the money come from/where does it go? Typically L-D inflated while Access price artificially low IMPLICIT subsidies, typically not explicit - Rural (high-cost) and low-income users 2. TA1996 says Allow entry Competitively neutral (not just to ILECs) Explicit not implicit 3. Problem of cream skimming p% of high-cost (c H ), (1-p)% low cost (c L ) c L < p < c H Average costs c = f(c H ) +(1-f)(c L ) so subs too low 4. Entry will take the c L & leave only the c H

19 ACCESS TO BOTTLENECKS/PRICING 1. There are some local monopoly bottlenecks The Local Loop, for example 2. Current policy (adopted in TA96) Incumbents must provide access to bottlenecks - at "just" & non-discriminatory prices (else arbitrate) Access, Unbundled Network Elements (UNE), resale Local carriers can enter long-distance if they open local 3. How to set the regulated prices?

20 Access to Bottlenecks MCa=$ 4 MC=$ 7 Say that at $14, sales total 20. MC=7, MC=4 sell at price=14, profit=20 x 3 = 60 P=$ 14

21 Access to Bottlenecks $ 7 $ 4 $ 3 $ 14 Now suppose a competitor comes along, more efficient on the non-bottleneck part. What will monopolist do?

22 7 4 3 Access to Bottlenecks 14 Will they just use the new technology themselves? Bottleneck owner values the new technology. If he sold 20 units before at profit $3 ea. He can now sell 20 units at profit $4 ea. Net: $20 thanks to the innovation. (Possibly more if they lower P to sell more Q)

23 7 4 3 Access to Bottlenecks 14 Evaluating the situation: Will the efficient technology be used? Yes. Is there an incentive to innovate? Yes So why regulate at all?

24 Access to Bottlenecks Efficient Component Pricing Rule: Bottleneck price set at market price minus avoided costs P b = 14 4 = 10 Benefits: Bottleneck owner will not fight it Only efficient competitors enter

25 PROBLEMS WITH ECPR 1. Doesn't eliminate monopoly is infficient entry good? 2. Private or Social opportunity cost? Act says cost based only not include demand curve 3. What if monopolist can lie about costs? 4. It's not Ramsey Pricing: no price discrimination

26 ALTERNATIVE USED IN US: TELRIC PRICING 1. Total Element Long Run Incremental Cost MC + a share of fixed costs + some profit rate Basically like an AC measure 2. BUT, the FCC made it forward looking Interprets this as on the "Hypothetical" network Take AC from best practice today & that's TELRIC Even if paid a lot last year, must sell at today's price Should we care about past costs? Turn over to states for TELRIC determination What counts as a UNE? 3. Incentives to innovate? CLEC & ILEC: Support or oppose

27 DEBATING PRICE POLICY/CLEC ENTRY 1. Was there cream skimming? 2. How well did state PUCs regulate? 3. Were new entrants worthy? Massive error rates by start-ups Most non-facilities based competitors went bankrupt ultimately, large UNE users were AT&T, MCI, Sprint 4. Should UNE exist/should it be limited? 5. In 2006, FCC says complete phase-out of UNE

28 TELECOM MELTDOWN 1. Total market value lost: $2 trillion 2. Losses by sub-sector RBOCs -50% LD -80% CLECs -70% Wireless -60% 3. Price change CPI + 22% Local + 28% LD - 18% 4. What caused it/what should be done?

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