César Mattos Vertical Foreclosure in Telecommunications Thorugh Access Prices and Interconnection Quality Vertical Foreclosure in Telecommunications Through Access Prices and Interconnection Quality

It is known in regulatory economics the incentive that a vertically integrated company in the telecommunications sector, owning a local and a long distance network, has to deny (or charge a very high price for) interconnecting competitors in the long distance market in its local loop bottleneck or even supply a poor interconnection quality. This occurred in the US telecommunications market, given the dependence of the new long distance competitors (MCI and Sprint) on the AT&T local networks to connect with end users. Aiming to avoid these problems and introduce competition at least in the long distance segment, the telecom reform in Brazil followed closely the US antitrust experience in the AT&T divestiture of 1984, reducing the previous verticalization of the state-owned company TELEBRAS before privatization. There is an extensive economic literature on the idea of vertical foreclosure. Most of this literature concentrate on the idea of a vertical merger between firms in the downstream and upstream markets generating foreclosure. We aim to focus more directly in the issue of a vertically integrated incumbent deciding access prices and interconnection quality to the entrant rival in the long distance segment. We present two models that refer to vertical foreclosure in telecommunications through the optimal access price and through the change on interconnection quality (or cost) to the entrant. In the first case, we use a simple linear demand setting to show that the optimal access price settled by the vertically integrated incumbent is not higher than the optimal access price that would be settled by a single upstream monopolist, owner of the local loop. This means that, under these hypothesis, there will not be vertical foreclosure in telecom. In the second case, we use the linear city model of Hotteling to show that the vertically integrated access provider always has an incentive to reduce interconnection quality when the regulator is not able to observe this variable. These models show that the regulation of the cost and quality of the interconnection can be more important than the regulation of the access price to avoid vertical foreclosure and harm to competition. In Brazil, this justifies not only the vertical break-up of TELEBRAS, but also the strong provisions towards the maintenance of quality and a low cost of interconnection. I) Introduction It is known the incentive that the vertically integrated company in telecommunications, owning a local and a long distance network, has to deny interconnecting competitors in the long distance market in its local loop bottleneck. This occurred in the US telecommunications market, given the dependence of the new long distance competitors (MCI and Sprint) on the AT&T local networks to connect with end 1 Department of Economics at Universidade de Brasília – UNB Brazil. users. AT&T was charged of using its market power to reduce downstream competition, raising rival costs through refusal to deal, high local interconnection charges or even reduction of the quality of the access to competitors. Viscusi, Vernon and Harrington (VVH-1995, p. 504/505) summarize the history of AT&T negotiations with MCI about the requests for local network interconnection: “The initial response of AT&T to entry in 1969 by MCI was simply to refuse to interconnect with them. In the FCC decision in 1971, the FCC said AT&T should interconnect with their competitors, but the terms were left open to AT&T. This did not improve the situation, because AT&T placed considerable restrictions on the specialized common carriers. Only on 1974 did the FCC order interconnection in its Bell System Tariff Offering decision. When MCI expanded entry into message toll service, the same problem arose. Their entry was approved by the US court of appeals in 1975, but not until 1978 was AT&T forced to interconnect with MCI’s Execunet service. Only in 1978 were firms like MCI allowed to interconnect with the local operating company as long lines. Even after achieving this right, the competitors to AT&T in the Intercity Telecommunication Market were still not treated equally. It is generally believed that AT&T’s competitors were given poorer quality connections by Bell operating companies. Customers had to dial twenty digits to make a long distance call with MCI, but only eleven with AT&T. The result was that consumers saw AT&T as offering a higherquality product, which forced its competitors to offer a discount to compete. It was this type of behaviour that led to the original antitrust suit against AT&T”. In the UK, these problems also appeared after the privatization of BT, given the absence of a policy of vertical break-up as implemented in the antitrust suit in the US and the lack of appropriate action by OFTEL. Aiming to avoid these problems, the telecom reform in Brazil followed closely the US antitrust experience in the AT&T divestiture of 1984, reducing the previous verticalization of the state-owned company TELEBRAS before privatization. On the other 2 If the interconnection charge is high enough, it will drive competitors out of the market and the effect is equivalent to a refusal to deal. 3 For a brief history of the AT&T in the US, including the first agreement of the company with the US Department of Justice in 1913 (the Kingsbury Commitment) due to anticompetitive practices, see Noll and Owen (1995, p. 329/333). One of the main duties imposed on the company was interconnection with competitors. 4 Noll and Owen (1995, p. 342) describe in more detail other means of reducing the quality of the rival calls through interconnection. 5 The lack of vertical break-up is also found in the Canadian experience as shown by Crandall and Waverman (1995,p. 67/68). 6 According to Armstrong, Cowan and Vickers (1994, p. 239) “Mercury should be protected against anticompetitive behavior by BT, and it is unfortunate that resolution of the question of interconnection was held up for as long as it was...”. 7 This was considered the largest antitrust settlement of all history and started in November, 1974 lasting almost 10 years until implementation. hand, in the UK, the government did not proceed to any restructuring of the state-owned company before privatization. There are some important differences between the Brazilian reform and the US antitrust law suit, however. First, the Brazilian government imposed line of business restrictions on the long distance companies to operate in the local services, which did not occur in the AT&T break-up. In this regard, the BMTR was more stringent than the US antitrust intervention. Second, there were seven regional companies divested from AT&T (called Regional Bell Operating Companies or RBOCS) that could only provide long distance service in a very limited area. The Modified Final Judgment in the US, which resulted in the break-up of the AT&T, divided the country into 160 Local Access and Transport Areas (LATAS). Each RBOC, despite owning local networks in several LATAS, was only permitted to provide long distance service inside each LATA. In Brazil, the regional companies can provide long distance service in all its territory. Therefore, in this regard, the US instituted a more radical vertical break-up compared to the BMTR. The following table summarises the differences among Brazil, US and UK regarding vertical separation of the incumbent company in telecommunications. Table 1-International Comparison of Vertical Separation in the Telecommunication Sector Country Brazil US UK Vertical Separation of Long and Local Distance Networks of the Incumbent Yes Yes No Scope of Provision of the Long distance Service The three regional companies are allowed to make long distance calls inside their whole respective areas, but not between areas The seven RBOCS are only allowed to make long distance calls inside each one of the 160 LATAS in which the country was divided, but not between areas. None Temporary Line of Business Constraints Yes, from the local companies to the long distance and vice-versa. Yes, but at the federal level. only from the local companies to the long distance service. No In the next section, we provide a brief survey of the literature on vertical foreclosure that is behind the concerns on these kinds of procedures on telecom reform in Brazil and the US. II) Brief Survey of the Literature on Vertical Foreclosure 8 Vickers and Yarrow (1988, p. 237) criticised the UK model in this respect: “There are several ways in which BT could have been split in order to promote effective competition and regulation before privatisation (or indeed in the future). The operation of local and long distance networks could be separated, perhaps with several local or regional network operators as in the United States. ......... Restructuring of this kind can enhance the effectiveness of competition and regulation by altering incentives and information conditions in such a way that private motives are directed more to social ends”. 9 This occurred more in practice until the promulgation of the competition Act in 1996, since several State regulators restricted entry in the local service or even long distance service in small areas. 10 See Noll and Owen (1995, p. 151). There are two main theories behind any antitrust intervention in vertical integrations in the US: i) the entry barriers theory and ii) the “market foreclosure” or “essentialfacility” doctrine. The latter one is by far the most important and we concentrate on it. Rey and Tirole (1997,p.1) state the fundamentals of the “market foreclosure” reasoning in the antitrust literature and jurisprudence: “According to the received definition, foreclosure refers to any dominant firm’s practice that denies proper access to an essential input it produces to some users of this input, with the intent of extending monopoly power from one segment of the market (the bottleneck segment) to the other (the potentially competitive segment). The excluded firms on the competitive segment are than said to be “squeezed” or to be suffering a secondary line injury. Essentiality means that the dominant firm’s product cannot cheaply be duplicated by users who are denied access to it. Examples of essential facilities or bottlenecks to which competition law has been applied include a stadium, a railroad bridge or station, a harbor, a power transmission or a local telecommunications network, and a computer reservation system. The foreclosure or essential facility doctrine states that the owner of an essential facility may have an incentive to monopolize complementary or downstream segments as well. This doctrine was first discussed in the United States in Terminal Railroad Association v. U.S. (1912), in which a set of railroads formed a joint venture owning a key bridge across the Mississipi river and the approaches and terminal in Saint Louis and excluded non-member competitors”. In the case of AT&T, the local loop was considered an essential facility given the difficulty of duplication by competitors, mainly because of its natural monopoly characteristics. The foreclosure theory was severely criticised by the Chicago school, mainly through the writings of Bork (1978) and Posner (1976) that argued the lack of economic rationality for firms to reckon with a vertical merger strategy to raise their profits, by foreclosing the market. For these authors, the single explanation for vertical integration would be the generation of efficiencies. Rey and Tirole (1997, p. 7) summarises the Chicago criticism: “The thrust of the Chicago School critique of this doctrine is that there is only one final product market and therefore only one monopoly power to be exploited, and that it is not obvious how the monopolist could further extend its monopoly power”. 11 The entry barrier theory is based on the fact that vertical integration may increase the capital requirements for another firm to enter the market. According to Perry (1989, p. 197), this theory was originally conceived with the first body of theoretical work related to the concept of barriers to entry of Bain in 1956: “Bain argued that vertical integration creates a capital barrier to entry by forcing potential competitors to contemplate entry at two stages of production rather than just one. In addition, he pointed out that vertical merger also eliminates one of the most natural potential entrants into each stage”. See Posner (1979) as quoted by VVH (1995, p. 160), for the most impacting critique against this theory. 12 See Comanor (1969) for a full critique of the foreclosure idea as well. The main point for this author was that the degree of market power would not be “additive at successive stages” which will become the core of the Chicago critique. Given the lack of rationality to exclusionary behaviour in the foreclosure approach, these authors defended the intrinsic efficiency aspects of the vertical mergers. The force of this criticism resulted in a change of the antitrust policy toward vertical mergers in the US, with a less interventionist approach. Indeed, there are many critiques of the foreclosure theory. Surveyed by Ordover, Saloner and Salop (1990, p. 128/129), one of these critiques can be applied to the essential facility case of an integrated company owning a bottleneck like the telecom local network case. According to these authors, this critique relates to the fact that “..lost upstream profits” due to downstream competitor foreclosure “may exceed the increased downstream profits” of the integrated firm and thus there would be no reason to foreclose. The emergence of these critiques was mainly due to the lack of a rigorous analysis of the economic rationality of vertical foreclosure. Several authors started to provide more rigorous economic rationales, improving the understanding of the possible economic reasoning behind foreclosure, escaping from the naive leverage version of the theory that was used by the US courts until the seventies. Tirole (1988, p.193/198) provides a survey of these efforts from the end of the seventies up to the publication of his textbook. One important aspect that emerged is that socially inefficient market foreclosure could be obtained through a myriad of generic strategies aiming to raise rival costs including exclusionary vertical long term contracts rather than only vertical mergers. Concerning the issue of market foreclosure by vertical integration, Tirole (p. 195) states that, with few exceptions, the main failure of the economic literature was not explaining why integrated firms do not sell or buy on the 13 The other criticisms are i) “The supply of inputs available to rivals is not necessarily reduced.... because the integrated firm also reduces its demand for inputs produced by unintegrated suppliers.... it merely will necessitate a rearrangement in supply relationships”; ii) “...remaining suppliers may not have the incentive to raise their input prices”,and , then, the denial of supply by one supplier will not raise rival costs; iii) the likelihood of foreclosed competitors integrate vertically with remaining suppliers; iv) even if input prices increases, the supplier that integrated would have to be compensated by the forgone potential extra profits obtained by their rivals. This compensation can decrease the profitability of the merger “possibly to the point that no merger occur”; v) “Since the firm that is foreclosed is placed at a disadvantage, it ought itself to participate in the bidding for the scarce upstream resource”. This last criticism can be used to the case of a single natural monopoly supplier as in the case of telecommunications. The difference with the AT&T case is that the integration happened before the entry of MCI and Sprint in the market. 14 According to Rey and Tirole (1997,p. 4): “The Chicago school view has had the beneficial effect of forcing industrial economists to reconsider the foreclosure argument and to put it, we believe, on firmer ground”. 15 See Salop and Scheffman (1983). Salop and Scheffman (1987) extend the basic model of 1983 to other situations, including the one where a dominant integrated firm prefers not to produce their own inputs more efficiently and buy more expensive inputs in the market aiming to raise the rival costs. Anyway, in this case, the vertical integration is not the source of foreclosing behavior. See also Salop and Kratenmark (1993). 16 The most known model of exclusive dealing arrangement that forecloses inefficiently the market comes from Aghion and Bolton (1987), also summarised by Tirole (1988 p.196/198). The model replies formally the criticisms from Bork (1978) and Posner (1976) that criticized the decision of the courts in the exclusionary contracts of the case United Shoe Machinery Corporation of 1922 on the basis that there was not any incentive for the buyers to feed a monopoly on the other side of the market, signing contracts that exclude competitors. In their model, the capacity to impose fines high enough for the breach of the contract coupled with some degree of uncertainty regarding the entrant efficiency results in long term contracts that ensues a degree of foreclosure greater than the social optimum. intermediate goods market instead of foreclosing. The two exceptions were published afterwards on the papers of Salinger (1988) and Ordover, Saloner and Salop (1990). Salinger (1988) shows with three simple assumptions that the vertically integrated firm after the merger does not participate in the upstream input market but only supply its downstream associated company, foreclosing the access of other downstream firms. The author defines as an economically meaningful definition of market foreclosure of downstream firms, an increase in the price of the input, which, as we will see, is closer to the first model we are presenting here. Ordover, Saloner and Salop (1990) structure a model where vertical foreclosure can emerge as an equilibrium in a successive duopoly setting. The model is a four-stage game where the final equilibrium is obtained through backward induction. The main importance of the paper is that it replies the six main criticisms against the foreclosure doctrine. The main result of their model is that the vertical merger hurts both downstream companies. At the same time, both upstream firms are benefited and the consumer is unambiguously hurt, since final price always increases. The full structure of the game results in the two downstream firms facing a prisoner dilemma regarding who will be the first to integrate. Hart and Tirole (1990) build a very rich and complex set of hypotheses under which foreclosure can emerge and antitrust intervention can be welfare enhancing. One of the important features of their model is that they do not restrict their framework to any particular contractual arrangement, which enlarges considerably the application of their model to real world cases. Three variants of the basic model are constructed: a) ex post monopolization is the single variant that results in output contraction; b) scarce needs where the downstream firms face capacity constraints and the main reasoning for vertical integration is the need of one of the upstream firms to ensure that the downstream firm purchases its supplies and not from the rival’s; c) scarce supplies where the upstream firms face capacity constraints and the main reasoning for the vertical merger is the need of one of the downstream firm to ensure that the upstream firm channels its scarce supplies to it instead to the other downstream firms. In the last two cases, foreclosure can emerge as a by-product and not as the main motivation for the merger. The model of Rey and Tirole (1997) provides a rationale for the foreclosure theory relating this idea to the known Coase model of the “durable good” monopolist. Rey and Tirole (p.10/17) show that the bottleneck facility owner facing oligopolists in the 17 The first stage of the game happens when both downstream firms bid to acquire one of the upstream suppliers. In the second stage, input prices are determined. As one of the bidding downstream companies acquire one upstream firm, the other downstream firm bids to acquire the remaining supplier in the third stage. Finally, downstream prices are chosen in the fourth stage. 18 The authors summarize this intuition stating that “the fear of being foreclosed drives each firm to attempt to foreclose the other. As a result, all the rents from foreclosure are dissipated through the bidding and all the profits accrue to the upstream firm(s)”. 19 Coase (1972) showed that when the durable good monopolist cannot commit to future prices, the buyers delay purchases in order to benefit from expected lower future prices. This happens because the monopolist himself will be tempted to reduce prices after some level of sales have been achieved, behaving opportunistically with the former buyers. In this regard, the monopolist faces intertemporal competition from himself. Thus, the durable good monopolist is not able to enjoy all his monopoly power that he/she would achieve when he can commit ex-ante to not lowering future prices. complementary market may not be able to credibly commit that he will maintain the monopoly result in the contracts with each of these players. This result can be obtained with the bottleneck monopolist offering to each of the oligopolists a “take it or leave it” contract that specifies the quantity supplied and total remuneration. The upstream firm always has an ex-post incentive to open secret renegotiations, acting opportunistically against the downstream contractors. Anticipating this result, each downstream oligopolist does not accept the contracts that ensues the monopoly result for the upstream bottleneck. This represents a decrease on the bottleneck monopolist’s profit. There are two main ways to deal with this problem: an exclusive dealing arrangement with one of the oligopolists or a merge. In both cases, the bottleneck monopolist refuses to deal with the others, foreclosing the market to them. In this case, the temptation for opportunistic behaviour is eliminated. The monopolist bottleneck is able to extract all monopolist rents from the complementary market and the chosen downstream firm will not fear about opportunistic behaviour. In this regard, the result is a departure from the conventional wisdom since foreclosure does not aim to extend market power from one market to another, but rather to reestablish the market power from a situation where the oligopolists in the complementary market fear the opportunistic behaviour from the bottleneck monopolist. More recently, Kuhn and Vives (1999), extending and formalizing a conjecture raised by Perry (1989), link the foreclosure caused by vertical integration and the “excess entry” result from Mankiw and Whinston (1986) arising from the “business stealing effect”. In their model, foreclosure brings down the number of players in the market more in line to the social optimum. Thus, vertical integration by increasing foreclosure and hurting competitors can increase efficiency and social welfare. The “excess entry result” was also addressed by Vickers (1995) in the context of the linkages between a natural monopoly market with a potentially competitive one. The novelty of his analysis is the introduction of price regulation at the monopolistic level, mainly access regulated prices, considering the information asymmetry of the regulator. This is a crucial departure from the previous literature on foreclosure and applies more closely to the situation of the regulated sectors, including telecommunications. The models described above represent the core of the current literature on foreclosure. However, almost all of them (with the exception of Vickers’ model) are quite focused on the effects of vertical mergers and not on the more simple idea that an already integrated firm owning an essential facility will often have an incentive to foreclose supply to downstream competitors. III) Vertical Foreclosure Through Access Pricing First, we have to define vertical foreclosure in a broader sense, since full foreclosure is a particular and extreme case of a general case of discrimination of a vertically integrated 20 The basic trade-off of the cost and benefits of keeping vertical integration is stressed by the author (p. 4): “Vertical integration has the disadvantage that the regulator’s task is made harder insofar as the monopolist has incentives to raise rivals’ costs, but it may have the advantage of offsetting excess entry and hence allowing a more efficient production structure in the competitive industry”. incumbent against an entrant. We provide two definitions based on the tools used by the access provider to foreclose: the access price and the interconnection quality and cost. The first candidate rule to obtain a proper definition would be the access price differential with marginal access cost. However, since the provision of access is also a business, we can expect that even an independent non-integrated bottleneck supplier will charge access prices greater than the marginal access cost. So, the access price/marginal cost differential does not only capture the incentive of a vertically integrated incumbent to protect its own downstream business, but also its incentive to make positive profits in the access business. Thus, we have to pick a definition that eliminates this “access business profit-seeking” effect that will occur regardless of vertical integration. This is made through the following definition: Definition 1There is partial vertical foreclosure through access pricing from the upstream bottleneck segment to a downstream potentially duopolistic segment, when both downstream competitors have the same efficiency, but there is a positive access price differential between the situation where the upstream access provider is a vertically integrated firm and the situation where the access provider is an independent nonintegrated access supplier that is able to price discriminate in his access business and faces the same number of downstream firms from the first situation. Since the access price of the independent access provider will contain an access business profit-seeking effect, differently from the marginal access cost, the differential between the access price of the vertically integrated firm and the independent provider will isolate for the effect of the ownership of the upstream access provider in the access price rule, capturing for the vertical foreclosure incentive. Note that the source of the bias could also stem from an efficiency differential and not from vertical integration. That is why, we restrict the comparison to the case of equal efficiency (equal marginal cost). Furthermore, it is important to allow for the independent access provider to price discriminate whenever he wishes. We will come back for the motivation behind this hypothesis ahead. The requirement of the independent supplier facing the same number of downstream firms avoids potential differences associated to a different number of downstream firms, not directly related to the incentives for vertical foreclosure. Suppose a vertically integrated monopolist incumbent facing an entrant in the downstream market. Assume that the entrant is not able to enter the local service (upstream) if he did not enter the long distance service yet. The inverse demand function and the profit functions of the upstream (1u) and downstream (1d) segments of the incumbent firm and the entrant firm (2d) in the long distance business are given, respectively, by: 21 We can suppose that the marginal cost of the entrant, given that he does not operate in the long distance, is infinity. The role of this assumption is to force the dependence of the entrant in the long distance to the incumbent local network in the short run. 22 For the sake of simplicity, we also restrict to the case of two downstream companies and not “n”. 2 1 2 1 1 ) ( q q q q P − − = + (1) ) )( ( ) , ( 2 1 2 1 1 q q c a q q u + − = ∏ (2) ) ( ) 1 ( ) , ( 1 1 2 1 1 2 1 1 q C q q q q q d − − − = ∏ (3) ) ( ) 1 ( ) , ( 2 2 2 1 2 2 1 2 q C q q q q q d − − − = ∏ (4) Variable qi is the quantity traded by the downstream firm i (i=1d,2d). C1(q1) and C2(q2) are the total costs, respectively, of the incumbent and entrant downstream firms. a is the access price charged by the upstream incumbent, 1u for both downstream firms 1d and 2d. We suppose that one unit of access results in one unit of long distance service provided and there are no fixed costs at all. The parameter c is the marginal cost of the upstream firm providing any input (access) quantity qi to the downstream firms. The expressions for the total costs of the downstream firms are: 1 1 1 1 1 ) ( q c aq q C + = (5) 2 2 2 2 2 ) ( q c aq q C + = (6) The parameters c1 and c2 are the constant marginal costs of each downstream firm. As the upstream firm is integrated with the downstream 1d, their profits must be aggregated. Notice that when we derive the aggregate profit function of the vertically integrated incumbent, the terms including the access price a cancel out in the sum. This is a revenue to the upstream firm but an expense to the downstream firm. The profit equation of the vertically integrated and entrant firms are, respectively 1 1 2 1 2 2 1 1 1 ) ( ) 1 ( q c q q c aq q q q − + − + − − = ∏ (7) 2 2 2 1 2 2 ) ( ) 1 ( q c a q q q + − − − = ∏ (8) The oligopolists play a Cournot-Nash game in the downstream market. Given the parameters of this game, the vertically integrated incumbent chooses the optimal value of the access price a that he charges the entrant. We assume that the parameters are such that there are only interior solutions. The reaction functions of both companies in the downstream market are given by: 0 2 1 1 2 1 1 1 = − − − − = ∂ ∏ ∂ c c q q q 2 1 2 1 1 q c c q − − − = (9) and 0 2 1 2 1 2 2 2 = − − − − = ∂ ∏ ∂ c c q q q 2 1 1 2 2 q c a q − − − = (10) Solving for q1 and q2, we get: