Chapter 3. Welfare, competition and market structure on Nordic telecom markets

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"Telecompetition"

Chapter 3. Welfare, competition and market structure on Nordic telecom markets

In this chapter we, first, briefly recapitulate the goals of the competition authorities in each of the Nordic countries and conclude that the goals seem to be similar, if not identical. In the words of the Norwegian Competition Act, the common goal is to promote "...competition and thereby contribute to the efficient utilisation of the society's resources." Common goals are clearly a very important precondition for the feasibility of joint policy initiatives. However, we demonstrate that even if overall goals are similar, implementation of these goals in concrete cases may raise difficult questions about weight given to gains and losses that are unequally distributed, either between the individual Nordic countries or between generations.

Second, we note that it is common to condition a high degree of competition on the presence of a large number of competitors. Clearly, this is not the picture emerging from an inspection of the Nordic telecommunication markets. In most markets the number of competitors is limited and the question naturally arises: Is effective competition at all possible with such a limited number of competitors? The answer turns out to be a resounding YES and we explain why many competitors are not a necessary - but maybe sufficient - condition for effective competition leading towards efficient utilisation of society's resources.

Competition and social welfare

The overall goals of Nordic competition laws are formulated in slightly different ways, but the essence is the same: Promoting competition as a means to achieve the goal of more efficient utilisation of society's resources, cf. Box 3.1.

What is efficient utilisation of society's resources?
Broadly taken, efficient utilisation of society's resources is achieved when enterprises employ technologies and inputs such that profit is maximised and when consumers are able to buy goods and services such that their utility is maximised. We often use an alternative term to describe this state of affairs. We say that social welfare is maximised.

Box 3.1: The objectives of Nordic competition laws

Sources: Danish Competition Act no. 539 of 28 June 2002; Norwegian Competition Act of 5 March 2004; Finnish Act on Competition Restrictions (480/1992) w/amendments (318/2004); Swedish Competition Act

First, enterprises should maximise profits, and, as a corollary, minimize production costs. As enterprises base their decisions on prices in the market, it is a clear precondition that prices of all investment goods and inputs should reflect their true costs⁵⁰. If not, enterprises base their production decisions on prices that do not reflect the true costs leading to production costs in excess of what is ideally possible.

Assume for example, that an independent service provider competing with the incumbent must buy access to the only existing network owned by the incumbent. Assume furthermore, that the access price for some reason (e.g. regulation) is lower than the true cost of access. The independent service provider is now able to sell access at a price that does not cover the true costs. But the shortfall of costs has to be borne by someone! The low price gives rise to an excessive demand at a level that is not consistent with maximization of social welfare. In addition, the independent service provider may erroneously decide not to invest in alternative access networks even though the true costs in the new network is lower than the true costs in the incumbents network. In brief, society's resources are not utilized efficiently.

Secondly, consumers should maximise their welfare. Consumers gain welfare by acquiring goods and services based on a comparison of prices in the market with their own willingness-to-pay. Also in this case, it is important that prices reflect the true costs. If prices are higher than the true costs, consumers may decide not to acquire the goods in question and give up welfare even though their willingness-to-pay is higher than the true costs, but lower than the price.

Assume for example, that the price of calls between two Nordic countries for some reason is above the true costs, while the price of calls within a country is below the true costs. Consequently, consumers erroneously limit the volume of Nordic calls because the price in some cases may be higher than their willingness-to-pay even though the true costs are below the willingness-to-pay. Furthermore, consumers erroneously expand the volume of national calls, as their willingness-to-pay in some cases may be higher than the price, even though the true costs are above the willingness-to-pay. In both cases, society's resources are not utilized efficiently.

Issues of interpretation
Even though the objectives of all Nordic Competition Acts are broadly similar, it may still be difficult in a specific Nordic competition case to agree on the proper interpretation of the concept social welfare. As the maximization of social welfare requires consideration of the interests of both enterprises and consumers, it is clear that in concrete cases the question arises how much weight should be attributed to enterprises and consumers and to different consumer groups.

As a first general example, consider a case that increases the benefits of enterprises more than consumer welfare is reduced? Overall social welfare increases, but enterprises gain and consumers loose? Is this acceptable?

The Norwegian Competition Authorities explicitly takes this conflict into account in the new Norwegian Competition Act by requiring competition authorities to pay "special consideration to the interests of consumers". If it means that only the benefits of consumers should be considered, then the Norwegian Competition Authorities would turn down the case, while other Nordic competition authorities may tend to approve the case because overall social welfare is increased.

As a second example particularly relevant for the telecommunications sector, consider a case that decreases consumer welfare today, but increases consumer welfare - appropriately discounted - tomorrow even more. This is, in particular, an issue in sectors, as telecommunications, with rapid technological innovation, high fixed costs and intrinsic uncertainty. If prices are very low today to the benefit of today's consumers, it may hamper innovation and investment in new capacity and new technologies, lowering the quantity and quality of telecommunication services tomorrow, and in turn harming tomorrow's consumers.

Market structure and social welfare

The standard paradigm of a market structure that maximises social welfare is a market with perfect competition. In a market with perfect competition the number of agents on both sides of the market, the demand side and the supply side, is so large that none of the agents by making own or joint decisions is able to have an impact on the market price or quality. This is clearly not the picture that emerges from an inspection of the Nordic telecom markets.

However, this does not imply that workable competition is impossible with a limited number of competitors⁵¹.

According to the Bertrand paradigm two firms are sufficient to drive prices down to marginal cost level, i.e. the perfect competitive outcome. When firms with homogeneous products compete on prices, a firm can capture the entire market by undercutting the rival's price. It is profitable to do so when the price is higher than the marginal costs. Therefore, the equilibrium under price competition will be that both firms set price equal to marginal cost.

However, the Bertrand paradox relies on some assumptions that are not always met.

Firstly, if the firms have different marginal cost, the most efficient firm can capture the entire market by setting a price slightly below the rival's marginal cost. This means that only one firm will operate in the market. However, the price charged by this firm is determined by the marginal costs of its rivals. This means that the potential competition will discipline the market and prevent monopoly prices.

Secondly, if the firms differentiate their products they will be able to charge a price above marginal costs. In this case, actual competition will discipline the market and prevent monopoly prices contingent on the degree of substitutability between products. The lower is the substitutability, the less effective is the threat of competition, the higher is the mark up on marginal costs, and the less competitive is the market outcome.

Thirdly, if the firms compete repeatedly they may be able to establish (tacit) collusion and agree to set prices above marginal costs.

Fourthly, if firms are constrained in their ability to expand production, the choice of capacity becomes a strategic decision. This changes the competitive regime to Cournot competition, where firms compete in quantities. Under Cournot competition the equilibrium price is between the monopoly price and the price under perfect competition. The crucial question, when determining whether the Bertrand or the Cournot model gives the best description of an industry, is: What can most easily be adjusted, prices or quantities? If capacities are most difficult to adjust, the Cournot model gives the best description of the competition in the industry.

From a social perspective, the optimal number of firms under Cournot competition is determined through a trade-off between obtaining strong competition and minimizing costs by exploiting economies of scale. In fact the number of firms may be too high from a social perspective if there is free entry. A new firm will capture market shares from the existing firms. This is a transfer between firms benefiting the entrant, but not the society. Therefore, if entry does not lead to sufficient expansion of the market, entry may reduce social welfare due to entry costs and loss of economies of scale.

Footnotes

50 Including overhead and financing costs as well as a standard measure of rent.

51 This text is based on: Luís Cabral, Introduction to Industrial Organization, The MIT Press, 2000.

Version 1.0 October 2004 • © Danish Competition Authority.
Published by the Danish Competition Authority, www.ks.dk
Publication produced according to the standard for electronic publication set by the Government