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Europe's Internet Troubles

December 4, 2007

Tags Free MarketsInterventionism

Internet access is one of the main drivers for economic and social development. No wonder that the wide availability of broadband access, as one of the main indicators of technology advancement of the economy, is shaping the agenda of governments. Everyone demands broadband access.

However, Europe is lagging behind other developed countries and is barely above OECD average:

When the European Commission started the review of the regulatory framework for electronic communications in 2006, its main objectives were derived from what is called the "i2010 Initiative: European Information Society 2010."

This Initiative builds on three main pillars. The first is: "A Single European Information Space offering affordable and secure high bandwidth."

In order to achieve this objective, this "pillar" of the future Europe, the more innovative proposal of the European Commission has been the inclusion of functional separation as a new "remedy."

This means that, once the regulatory framework is approved, National Regulatory Authorities (NRAs) will be able to impose functional separation on those operators found to have Significant Market Power (SMP) in any of the markets. In this way, competition and, thus, investment in broadband access will be fostered. Of course, this provision has been strongly contested by incumbent operators, the former monopolists.

When functional separation is imposed on a vertically integrated operator, this "is required to establish operationally separate business entities," so that one of them provides wholesale services both to the retail business unit of the operator and to the rest of the agents.

That way, "the provision of fully equivalent access products to all downstream operators, including the vertically integrated operator's own downstream divisions" may be ensured.[1]

Of course, the EC continues, this obligation may be justified as a remedy only in exceptional cases, "where there has been persistent failure to achieve effective nondiscrimination in several of the markets concerned, and where there is little or no prospect of infrastructure competition within a reasonable timeframe after recourse to one or more remedies previously considered to be appropriate."

This inclusion may come as a surprise to the unaware observer, but not so to economists familiar with the theory of price control, developed by Ludwig von Mises in 1929. For these economists, this is just the logical consequence of government's attempt to control wholesale access services' prices.

Before the description of the concrete circumstances in this case, a short review of Mises's theory is in order.

Theory of Price Control [2]

Mises defines genuine price controls as those "that set prices differing from those the unhampered market would set."

He then classifies price controls in two basic types: minimum prices, to fix a price higher than the market price, and price ceilings, to fix a price lower than market price. He analyzes the effects of both types of controls, and concludes, in both cases, that government has to seize the means of production and distribution (and thus resort to central planning) if it wants to succeed in its goal.

This process evolves through different stages, however. Let us focus on the case of price ceilings. In this case, the goal of the government is to allow "buyers to enjoy goods at lower prices."

  1. Price control: "if the sellers are forced to sell their goods at lower prices, the proceeds fall below costs. Therefore, the sellers will abstain from selling … and hold on to their goods in the hope that the government regulation will soon be lifted. But the potential buyers will be unable to buy the desired goods." Clearly, this was not what the government wanted to achieve.

  2. Forced sales: "But it was never the intention of government to bring about these effects. It wanted the buyers to enjoy the goods at lower prices, not to deprive them of the opportunity to buy the goods at all. Therefore, government tends to supplement the price ceiling with an order to sell all goods at this price as long as the supply lasts."

    However, as the price is "below that which the unhampered market would set, the same quantity of goods faces a greater number of potential buyers who are willing to pay the lower official price. Supply and demand no longer coincide; demand exceeds supply, and the market mechanism, which tends to bring supply and demand together through changes in price, no longer functions.

    "Mere coincidence now eliminates as many buyers as the given supply cannot accommodate. Perhaps those buyers who come first or have personal connections with the sellers will get the goods."

  3. Rationing: "But government cannot be content with this selection of buyers. It wants everyone to have the goods at lower prices, and would like to avoid situations in which people cannot get any goods for their money. Therefore, it must go beyond the order to sell; it must resort to rationing. The quantity of merchandise coming to the market is no longer left to the discretion of sellers and buyers. Government now distributes the available supply and gives everyone at the official price what he is entitled to under the ration regulation."

  4. Regulation of production and distribution: "But government cannot stop here. The intervention mentioned so far concerns only the available supply. When that is exhausted the empty inventories will not be replenished because production no longer covers its costs. If government wants to secure a supply for consumers it must pronounce an obligation to produce."

  5. Central planning: Of course, this implies that, "If necessary, it must fix the prices of raw materials and semimanufactured products, and eventually also wage rates, and force businessmen and workers to produce and labor at these prices."

The case of wholesale access products in the telecommunication market

The rest of this article will focus on a specific wholesale product: the "unbundled local loop." This product allows agents to provide telecommunication services (telephony, television, but, above all, broadband internet access) to consumers by using the local, or access, network of another operator. This local network, the so-called "last mile," connects the consumer premises with the network of the operator.

As can be deduced from the above definition, the local loop is very costly to deploy and is usually qualified as the "main bottleneck" in the telecommunication market. By way of the "unbundled local loop," operators do not need to deploy their own access network; they can just hire this part of the network from any operator willing to offer the wholesale service.

In an unhampered, competitive market, these wholesale services could have appeared spontaneously. Needless to say, this was not the case with the telecoms; this market has been a legal monopoly almost since its commercial foundations, with no place for free competition for most of its history.

Therefore, when governments decided to open the market for (more or less) free competition, it was generally understood that the incumbent would not have any incentive to provide this kind of service to potential competitors.

With no time given for exploring the benefits of "free" competition in the market, it was decided to set the prices for wholesale access services in a cost-oriented basis, with the goal that buyers (in this case, competing operators) could buy the goods at fair prices — not lower prices, of course, because there was no historical price reference for this service. In any case, this is the first stage — price control — of the sequence described by Mises in his theory.

Of course, at the fixed price, the seller (i.e., the incumbent operator) is not keen to sell, particularly considering that the service provided is an input for the buyer to dispose the seller of its current customers.

As a result, we enter into the second stage — forced sales — in which government (by means of the NRA) imposes on the incumbent operator an obligation to grant access to all operators demanding it.

In the case of "unbundled local loops," operators need to deploy equipment on the premises of the incumbent operator in order to be able to enjoy the service. This equipment requires physical space in the building that houses the switch; of course, the most attractive switches are in densely populated areas, that is, in big cities, where this kind of space is expensive.

Space is also needed in the incumbent's equipment to link them with those of the alternative operators, and this space is even more scarce. (It may seem simple enough to put another cable in place, but it is not always the case when referring to tens of thousands of cables.)

It is very difficult, then, to grant both resources to any operator that demands them. For that reason, in this moment, as Mises anticipated, "Mere coincidence now eliminates as many buyers as the given supply cannot accommodate. Perhaps those buyers who come first or have personal connections with the sellers will get the goods."

Of course, the buyer who has better "personal connections" is the incumbent operator, owner of the entire infrastructure needed to implement the wholesale product. More importantly, the unbundled local loops sold to the incumbent operator itself are profitable, because, for these, the integrated operator gets the full retail revenue. As a consequence, it has the right incentives to keep offering itself these products, without this necessarily meaning that its goal is to exclude competitors.

"But government cannot be content with this selection of buyers." And thus the rationing stage of the process is entered. In the present case, rationing takes the shape of a nondiscrimination obligation for the incumbent operator. In this way, an attempt to mitigate the discrimination described before is undertaken.[3]

By now, it is difficult for the incumbent to find incentives to keep updating or even just to reorganize the switch equipment in order to provide unbundled local loops to third parties in an efficient way, which could render the service profitable in an unhampered market.

This is an analogous situation to that described by Mises, which justifies the need of the stage of regulation of production and distribution: "The intervention mentioned so far concerns only the available supply. When that is exhausted the empty inventories will not be replen­ished because production no longer covers its costs."

"Discrimination" problems keep arising as a result of the lack of incentives to provide wholesale access in regulated conditions. It is not a matter of handicapping outsiders, it is just that it does not pay to invest in improving infrastructures and procedures to better serve them. It should not be forgotten that this infrastructure was designed and developed by an operator who was not expecting to share it with third parties, so they are not fit for such arrangements.

The regulation of production and distribution will in this case be accomplished by the proposed remedy of "functional separation," by means of which "non discrimination" between incumbent operator and alternative operators will be assured, at least according to the European Commission.

Conclusions

And so it goes. This obligation is envisaged, as has been said, for exceptional circumstances.

It cannot be doubted that these exceptional circumstances will happen sooner or later, and that functional separation will be imposed on operators across Europe.

Regulatory agencies will easily show that "there has been persistent failure to achieve effective nondiscrimination in several of the markets concerned" and, with only slightly more difficulty, will prove that "there is little or no prospect of infrastructure competition within a reasonable timeframe." (They will not tell us, however, how it would be possible to have infrastructure development competition when its rental is compulsorily offered for free.)

These events would not surprise anyone familiar with Mises's theory. Neither should it surprise us that functional separation fails again to meet the goals of the government, and that it will have to resort to another "definitive" remedy in order to solve the problem that the government itself created in the first place.

The only question is this: by which proposed means will the government lead the market into the last stage of the theory, central planning.

Is it possible that, after all, the solution will turn out to be the granting of a legal monopoly on wholesale access services? No doubt, it would constitute an ironic finishing touch to the telecommunication market liberalization in Europe.

Notes

[1] See introductory paragraph 43, "Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of … 2007 amending Directives 2002/21/EC on a common regulatory framework for electronic communications networks and services, 2002/19/EC on access to, and interconnection of, electronic communications networks and services, and 2002/20/EC on the authorisation of electronic communications networks and services," available here.

[2] Mises, Ludwig von, "Theory of Price Controls" in A Critique of Interventionism.

[3] To be sure, European Governments grouped together these three stages of the process, imposing at the same time the three obligations on incumbent operators: price control, access, and nondiscrimination. Maybe they were aware of Mises's "Theory of Price Controls" and decided to save time by jumping directly to the third stage.

 


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