James Alleman

A new view of telecommunications economics

1. Overview The Telecommunications Act of 1996 required that charges for interconnection, universal service and unbundled network elements should be based on cost, and directed the Federal Communications Commission to implement this legislation. The parties developed engineering process models to estimate forward-looking costs. Both the engineering economics and the cost model approaches were unsatisfactory. Neither handled uncertainty nor dynamics, or else did so in an awkward manner. The economic and financial literature has moved beyond these static concepts. 2 This literature has methods to handle uncertainty and dynamics in a satisfactory manner. Moreover, it can link the ‘‘real’’ market with the financial market. This has immediate implications for both engineering economics and cost modelling methodologies. Engineering economics uses the tools of discounted cash flow (DCF) with little or no emphasis on how the ‘‘proper’ discount rate is obtained. 3 The more sophisticated analysis may use a riskadjusted discount rate determined by the capital asset pricing (CAPM) model; however, some managers, intuitively, may raise the discount rate above this level to account for ‘‘risk’’. This lowers the cash flow values in later periods, distorts the results and gives incorrect conclusions. Certainty of the cash flow is assumed. Decision tree analysis (DTA) is used to address multiple possible outcomes. The DCF of the expected value of this tree is used for the evaluation. However, neither of these methods adequately deals with management’s flexibility. Real options, on the other hand, does have this capacity.

The poverty of cost models, the wealth of real options

The attempts to estimate forward looking costs worldwide are based on cost models whose foundation is traditionally applied discounted cash flow analysis — exactly the method that the real options methodology has shown can give terribly wrong results. However, these cost models are ideal vehicles to adapt to the real options methodology. This paper develops a stylized cost model to quantify several deficits associated with the cost models in use today. Even without the application of real options methodology, the stylized results show a significant difference between the revenue requirements model and a traditional discounted present value model. With the application of real options techniques, the differences become much greater.

Optimal Pricing with Sunk Cost and Uncertainty

When static models of the firm are considered regulators make serious errors in the determination of the proper wholesale price as the opportunity cost of the delay option is neglected. For an incumbent, the option is exercised and represents an opportunity cost. For a potential entrant the delay option need not be exercised should the regulator allow the purchase access at below economic cost, i.e., operating cost plus the delay options cost. Thus service-based entry is excessive and facilities-based entry remains suboptimal. To summarize, in a static-regulated paradigm: wholesale prices are below their economic cost; inefficient service entry occurs as prices are not set at the correct marginal cost while an entrant is not required to exercise a delay option; social welfare is suboptimal; incumbent firm’s valuation by the financial markets is less; and the cost of capital for incumbent firms is higher. When a regulated paradigm is dynamic the converse holds: optimal prices are higher than for static calculations; only efficient service entry occurs as prices are set at the correct economic marginal cost; facilities-based entrants receive correct price signals; social welfare is maximal; an incumbent’s valuation by financial markets is higher; and the cost of capital is lower than for a regulated paradigm. This chapter has demonstrated the profound implications for regulatory practices. In particular, dynamics and uncertainty matter for the realization of optimal regulatory pricing outcomes. However, much work remains to develop and quantify precise models to fit the telecommunications context.

Charging for local telephone calls: How household characteristics affect the distribution of calls in the GTE Illinois experiment

Abstract When the billing of local telephone service is changed from flat rate to measured service, the distribution of monthly calling rates is altered. This paper models the distribution of flat-rate telephone use in terms of demographic variables and stochastic components; the shift to measured service affects both the systematic and stochastic parameters. The model is fitted by maximum likelihood to data for interviewed households participating in General Telephones local-measured-service experiment in Illinois. Households tend to make more calls if they are larger (more people), older, or include teenagers. They tend to reduce calling proportionately more in response to usage charges if they average many calls under flat rate for any of the above reasons or for other, unexplained reasons. There is substantial variation in telephone use by households with similar demographic characteristics. Consequently, the benefits and costs of local measured service will tend to be diffused across demographic groups.

Trade imbalance in international message telephone services

An econometric model is estimated to identify determinants of trade imbalance in international message telephone services markets. Results indicate that asymmetric market structure is important in explaining bilateral market imbalances for high income country pairs. For low and high income country pairs, GDP per capita is the dominant cause of traffic imbalances. The findings suggest that telecommunications liberalization policies are effective in reducing distortions in international traffic flows and settlement payments. However, liberalization should be accompanied by developmental programmes that enhance income per capita and telecommunications network investment in developing countries. Such programmes may be effective in providing a more equitable distribution of the gains from telecommunications reform across countries.

Forecasting Video Cord-Cutting: The Bypass of Traditional Pay Television

Following the substitution of mobile phones for fixed-line phones (“voice cord-cutting”), a similar transition is now occurring for video services. In the United States, traditional pay television service providers are experiencing some revenue losses and slowdowns. Also, consumers are increasingly streaming or downloading long-form video programming (mainly movies and TV shows). This phenomenon—described as “video cord-cutting” or “over-the-top (OTT) bypass”—suggests that the business models of traditional TV service providers are under threat. There is, however, considerable debate about the severity of that threat.

Next Generation Networks: The Demand Side Issues

The demand for next generation networks (NGN) for communications has mostly focused on the trend in technology. Recognizing that communications is a derived demand, we look at the demand for telecommunications services and then overlay these forecasts on the existing information and communications technology (ICT) infrastructure. We focus on the consumers rather than the technologies. We note that what consumers demand is for communications: The communications may be fixed, mobile, interactive, or unidirectional. With the technology and the move to IP protocol, all of these features can be handled in a few devices and networks – maybe only one. We provide an assessment of the forecast of market trends, and their implications for the regulator. The relevant demand elasticities are nearly unitary. Each of these factors alone implies that the market structure will be monopolist or an oligopoly at best. But amplified in combination, The need for clear, certain regulation of this segment of the ICT sector is an absolute necessity. Demand elasticities must be understood and factored into the consideration of the policy alternatives.

Modelling Regulatory Distortions with Real Options: An Extension

The introduction of uncertainty can make a significant difference in the valuation of a project. In a regulatory environment, this manifests itself, inter alia, in situations where regulatory constraints can affect the valuations of a firm’s investment which, in turn, has an adverse impact on consumers’ welfare. In particular, the inability of a regulated firm to exercise any or all of the delay, abandon, start/stop, and time-to-build options has an economic and social cost. With this view in mind, we specify a model using real options methodology where regulatory delay constraints impact the firm’s cash flow and its investment valuation.

Estimating the Demand for Voice over IP Services: A Contingent Valuation Approach

The demand for Voice-over-IP (VoIP) services is receiving increasing attention as an alternative to traditional switched access based telephone services. This paper focuses on the underlying determinants of demand to assess the potential for VoIP. The authors utilise a model of demand based on a consumer’s willingness to pay and provide estimates of the elasticity of demand for VoIP. The intent of the paper is to add to the discussion of VoIP and to stimulate analysis.

Simple decision making criterion as real options

The purpose of this paper is providing a simple decision making criterion under uncertainty for the managers who are not so familiar with statistics. We introduce a new decision-making index d, which is the expectation of NPV normalized by its standard deviation. We show the break-even point, d = D* = 0.276 occurs when NPV is equal to ROV (real option value). Using D*, we can make more sophisticated decisions considering opportunity loss and cost of uncertainty. This criterion is useful when NPV lies near zero or uncertainty is large. We provide an example that shows the reasonableness of using this decision criterion.