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Europe's Internet Troubles: The History Continues

Mises Daily: Friday, February 08, 2008 by

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In a recent article, I described how the European Commission was planning to foster broadband penetration across European countries.[1] The EC's main proposal was explained in the light of the theory of price control, developed by Ludwig von Mises.[2]

According to Mises, in the final stage of the process the government "must fix the prices of raw materials and semi-manufactured products, and eventually also wage rates, and force businessmen and workers to produce and labor at these prices."

I closed with this question: "by which proposed means will the government lead the market into this last stage of the theory, central planning?"

It turns out the answer was at hand, less than a thousand miles north of Spain, in Great Britain.

One More Step Near the Final Stage

Ofcom — "Office of communications," the British equivalent of the American FCC — imposed functional separation on the incumbent operator, BT (formerly known as British Telecom), a couple of years ago. As a result, a new firm was set up: BT Openreach.

BT Openreach was launched in January 2006, after BT and OFCOM agreed and signed a set of legally binding commitments (the "Undertakings"). These commitments mean that "while still part of the BT Group, Openreach operates as a separate business with the objective to serve the needs of all Communications Providers in a fair and even-handed way."

This is reflected both in the mission and strategic objectives of BT Openreach, as expressed in its corporate brochure:[3]

We are dedicated to:

  • Ensuring equal access to the services and assets associated with our fibre connections, the local loop and the copper wires that run between telephone exchanges and end users.

Furthermore,

Openreach aims to:

  • Provide equivalent and transparent service to all Communications Providers: We will meet the commitments we have made to Ofcom and ultimately to the industry by ensuring that fairness is at the heart of everything we do.

In summary, BT Openreach is a company that serves other telecom operators, including BT's retail business unit, but does not serve final consumers. It is focused on wholesale services. Its main goal is not so much providing useful or good services, but to provide services in a nondiscriminatory way.

The creation of BT Openreach was greeted as a great success of regulation — an example for other countries. With it, Great Britain had become the land of equal opportunity, at least, for telecom providers.

However…

As of September 2007, there were signs of unrest in the British government regarding deployment of optical fiber within the country, in comparison with the plans announced by other countries, both in Europe and around the world. This is clearly shown in a public consultation launched by OFCOM, entitled "Future broadband: Policy approach to next generation access."[4]

Some days later, the director of equivalence and regulatory and public affairs at BT Openreach said the company was "unsure of fibre demand … The question is at what point those benefits become an investable opportunity. HDTV (High Definition TV) may be a driver, but there is still a lack of clarity around that."

Also: "I don't think anyone feels this is about a huge public-sector investment. If the services are there, the business case will be there, but it's around the right debate and the right vision."[5]

OFCOM, in its document, shows first its concerns about no operator having announced any intention to make wide-scale next-generation access investments, while in some other countries operators are already deploying and operating this infrastructure on a commercial basis.

Then it goes to great pains to show that "there are a number of core rationales" that could explain this apparent delay, e.g., lack of interest in IPTV,[6] lack of competition from alternative platforms, and higher costs of deploying fiber. OFCOM concludes, "this is not evidence of market failure, rather, that the efficient timing for next generation access networks in UK may be later than elsewhere."

It is worth mentioning that OFCOM does not mention the functional separation imposed on BT as a possible cause for this delay, despite the fact that this issue is the clearest difference between Great Britain's market and those of the other countries. This imposition may or may not be the cause of the delay, but it certainly deserved a bullet point, even if only to argue against its relevance.

Austrian economic theory suggests, of course, that the connection between the intervention and the delay is more than coincidental.

"Dis-integrating" the Structure of Production

The first point to note is that, for an Austrian economist, speaking about delays in investments does not make sense. In an unhampered market, investment will occur according to agents' preferences, and will take place at the right time. There is no external standard against which the efficiency of investing in one or another moment can be compared. So the British government should not be concerned about delays with respect to other countries — or rather, they shouldn't be concerned in an unhampered telecommunications market. Unfortunately, as has just been seen, the British telecom market is far from unhampered.

Because of this, it may be legitimate to ask why something that is happening in the rest of the developed countries is not happening yet in the United Kingdom. Moreover, taking into account that this "something" is viewed as positive for governments, they want it to happen and are worried that it isn't happening.

To understand why the British government isn't getting what it wants, we can look to the Austrian theory of production, as described by Murrray N. Rothbard in Man, Economy, and State: "[I]ndividual value scales" determine "the quantity of goods produced, the prices of consumers' goods, the prices of productive factors, the interest rate, profits and losses…." Not only that, but "[g]iven a stock of land and labor factors, given existing capital goods inherited from the past, given individual time preferences (and, more broadly, technological knowledge), the capital goods structure and total production is determined."[7]

Thus, the market process, starting from the individual preferences of each customer, determines not only goods and prices but also the structure of production for those goods (given available resources).

In the real world of uncertainty, this process is carried out by entrepreneurs. One of their basic activities is market calculation, by means of which they are able to make estimates that can guide their ex ante decisions. Absence of market calculation would create grave inefficiencies in the system and, consequently, heavy losses. "Such a situation would therefore never be established on a free market, particularly after an advanced economy has already developed calculation and a market."[8]

In order to accomplish this calculation, explicit markets are needed, that provide information about current prices of the resources involved. "For, without an external market for wage rates, rents, and interest, there would be no rational way for entrepreneurs to allocate factors in accordance with the wishes of the consumers."[9]

In this context, Rothbard refers to the problem of vertical integration in the enterprise.[10] A firm can effectively have vertical integration of several processes, only if there is a real market for each of the intermediate products that provide the firm with an explicit price, that, in turn, allows it to perform market calculation: "For every capital good, there must be a definite market in which firms buy and sell that good." Otherwise, without the price, the firm will not be able to allocate factors and resources from one stage to another.

What would happen in the case of vertical "dis-integration"? Let's suppose that the (more or less) unhampered market has established a concrete structure of production that is the best (so far) for serving the customers. In this situation, the government decides to forcibly alter this structure of production by, say, splitting one activity into two.

In the case of vertical integration, no rational decisions on allocation between stages can be made in the absence of external markets for each stage. In the case of regulatory dis-integration, a new market is created by government fiat, where no market existed in the past. Could this be the solution for eliminating those "islands of computational chaos" created by vertically integrated enterprises?

A telecommunication service can be seen as a group of vertically integrated activities, one of them being the provision of the access network to the costumer. Due to this vertical integration, there was an "island of computational chaos" in the provision of access services. Once government forces the splitting between access services and the rest of activities involved in the provision of telecom services, the new market is created, and the "black hole" erased from the economy.

In summary, by way of functional separation and the creation of BT Openreach, the UK government created a new market for "wholesale access products" out of the one for retail telecommunication services.[11]

Problem solved, right?

Another Kind of Computational Chaos

The only problem is, of course, that this new market does not have its roots in the preferences of costumers, as economic theory has told us, but in the preferences of government. Having been the result of the market process, the previous productive structure was better suited to serve the costumers than the new one is.

In the first place, there is no reasonable way to set a price for the new product. As Rothbard has shown, "any estimate would be completely arbitrary and have no meaningful relation to economic conditions." In other words, because there was no market for the product, and all of the firm's exchanges were internal, there would be no way for that firm or anyone else to determine a price for the good.

But also, we need to ask why, in the concrete case of telecom services, the integrated structure may have been more suitable to serve the costumers than is the new dis-integrated one. (It should be noted that this dis-integration has been taken to its extreme only in the case of Great Britain and BT Openreach; in the rest of the European countries, where the market has also been forcibly created, incumbent operators remain vertically integrated.)

In order to access telecom services, customers must be linked to the operator network by the access network. Deployment of the access network is time and resource consuming. The higher the capacity of this access network, the more diversity and quality the provided services will have. With traditional technology (copper plus DSL), up to 20-25 Mbps can be offered; with fiber, this capacity is multiplied, and so are the possibilities for the services to be provided.

To upgrade from copper to fiber, a heavy investment is needed. This investment will only be justified if the final customers demand new services, services that cannot be provided by means of copper and DSL (e.g., HDTV — the high-definition television to which BT Openreach refers). Consequently, market calculation for upgrading copper network to optical fiber networks involves estimating customer demand for these new services.

When this market calculation is elaborated, the entrepreneur must take production and distribution activities into account together. Both Kirzner and Rothbard have shown that the distinction between the two is arbitrary;[12] both kinds of activities have to be considered in order to sell the product and reap a profit.

By introducing functional separation, the production activities are severed from the distribution activities. In effect, BT Openreach has to deploy and maintain access network, while the rest of the operators sell final telecom services to the customers. BT Openreach is deemed to deploy fiber without knowing whether or not it can be sold. All other operators want this stock of fiber access at their disposal — in case they are able to sell new telecom services to their customers.

Imagine a shoemaker who doesn't sell shoes. He just makes them. The more shoes he makes, the more he tosses into a heap in his shop. This is because he is forbidden by law to sell shoes to individual consumers. Other entrepreneurs may sell shoes, but not the shoemaker.

Shoe salesmen, if they are lucky enough to sell some shoes, will come to the shoemaker's shop and grab the needed shoes from the heap in order to deliver them to the buyer. Only at that point do they pay the shoemaker. If they don't sell, shoes keep piling up in the heap.

The shoemaker hasn't the slightest idea which shoes he should make or how many; he just keeps making shoes; if they are sold, good news for him and the seller; if not, well, he still has to keep making shoes.

If the shoemaker asks the shoe sellers for any guidance, they tell him to keep making shoes of every class possible. They don't want to limit their options. The growing heap of unsold shoes is not their problem.

This is the scenario confronting BT Openreach. As its distribution activity has been severed from its production activity, it has no basis for predicting the future demand for fiber. Any estimates from the other operators will probably overestimate the demand. After all, they want to have fiber ready when HDTV becomes the rage. But the stock of fiber will be like the heap of shoes: a cost borne only by the producer.

Conclusion

OFCOM, by forcing the functional separation of BT and the creation of BT Openreach, altered the structure of production that the market had set up in answer to customer preferences.

This alteration consisted in the vertical "dis-integration" of one of the activities in that structure. A new market was created, and, arguably, an "island of computational chaos" eliminated. But, in this way, production activities were effectively severed from distribution activities, making market calculation for the production unit impossible.

$60 $50

In the absence of market calculation, it will be very difficult for BT Openreach to make any sensible decision regarding deployment of new infrastructures, be it fiber or something else. Of course, it will keep trying to sell its current stock of copper-based network access,[13] but it will lack the needed information for deciding whether to upgrade the network in those places where copper is already available.

It is important to realize that this separation has only happened in the United Kingdom. Even if markets for wholesale access have been created in the rest of Europe, the incumbent operators in those countries remain vertically integrated and can use market calculation to allocate their resources. This is why those incumbents can make announcements about deployment of optical fiber, and many have even started operating this infrastructure. BT Openreach cannot do the same.

No wonder BT Openreach is "unsure of fibre demand." The problem is not uncertainty of the future; all operators face that same uncertainty. The problem lies in the basic inability to accomplish market calculation under current regulatory constraints.

Denied the means of market calculation, it is not surprising that BT Openreach is resorting to a poll of so-called stakeholders.[14] If that is how the "proud guardians of national local access networks" are planning to make their upgrade decisions, there is no doubt that Britain is about to complete the fourth stage of Mises' theory of price control, and is ready to plunge into "central planning," the last step back to public utility and monopoly in telecommunications.


Fernando Herrera-González is a telecommunications engineer and an economist. He writes from Spain, where he is pursuing a Ph.D. in Austrian Economics applied to telecommunication regulation. Send him mail. Comment on the blog.

Notes

[1] Herrera-González, F.: "Europe's Internet Troubles," Mises Daily Article, 12 April 2007.

[2] Mises, L.v., 1977: "Theory of Price Control," in Mises, L.v.: A Critique of Interventionism, Arlington House, 1977

[3] See BT Openreach's corporate brochure.

[4] See public consultation launched by OFCOM.

[5] Zdnet.co.uk: "BT Openreach unsure of fibre demand," 28 September 2007.

[6] TV provided by means of an Internet connection.

[7] Rothbard, M. N.: Man, Economy, and State, Auburn, AL: Ludwig von Mises Institute, 1993. See chapter 9, page 624.

[8] Ibidem, page 609.

[9] Ibidem, page 608. The role of prices as signals for entrepreneurial action is the subject of classic essays by Hayek.

[10] Ibidem, Chapter 9, paragraph 3.E: "Vertical Integration and the Size of the Firm," pp. 609-616.

[11] In fact, it is not necessary to impose functional separation on the operator; in the rest of the EU countries, this has been accomplished by imposing an access obligation.

[12] Kirzner, Israel M., Competition and Entrepreneurship, Chicago: Chicago University Press, 1973, See chapter 4.

[13] It will even invest in those places where there is no infrastructure, because traditional telephone service demand is well known; the problem arises when estimating if it should invest in upgrading the network in order to make possible the provision of new services.

[14] See BT Openreach consultation. See also footnote 4.