Distorted access regulation with strategic investments: Regulatory non-commitment and spillovers revisited

Abstract

We reexamine the properties of access regulation and an incumbent’s incentive for infrastructure investment under regulatory non-commitment and spillovers through access. The results show that when the degree of spillover is small, the incumbent’s strategic opportunity to invest in infrastructure distorts the access charge set by a regulator from a welfare perspective. In particular, when the degree of spillover is small and the incumbent’s investment cost is high (low), the incumbent has an incentive to utilize regulatory non-commitment to induce a high (low) access charge by overinvesting (underinvesting) in infrastructure.

Introduction

The purpose of this paper is to reexamine the properties of access regulation and an incumbent’s incentive for infrastructure investment under regulatory non-commitment and spillovers through access to infrastructure. Regulatory non-commitment means that even when a regulator can determine an optimal access charge from a welfare perspective, the ability to enforce such a policy is weaker than the incumbent’s ability to commit to the level of infrastructure investment in question. This non-commitment results from the short economic life-span of a regulatory contract relative to that of an infrastructure investment, given the irreversibility of such an investment. In fact, a regulator’s non-commitment to access regulation allows the incumbent to strategically use the opportunity to invest in infrastructure. As is well known, the incumbent’s strategic opportunity may generate distortions from both short- and long-term welfare perspectives.

Spillovers through access to infrastructure mean that, in addition to the incumbent, the penetration of the infrastructure also benefits entrants (i.e., rival firms) that pay an access charge to use the infrastructure. For example, if an incumbent with an upstream Internet service provider (ISP) upgrades from narrowband to broadband using fiber optic cables, a rival ISP that pays to use the incumbent’s broadband can also provide high-quality Internet service to its customers. Notably, the degree of spillover varies according to retail production technology (e.g., the production technology used for Internet contents). When the incumbent’s retail production technology fits well with the upgraded infrastructure and that of the rival does not, the degree of spillover to the rival is considered to be low (and vice versa). Hence, the variability in the degree of spillover reflects the relative inferiority (or superiority) of a rival that uses the same upstream resources and competes with an incumbent in a retail market.

In this paper, we address the case in which spillovers through access are small. Our treatment is justified by the situation in which new infrastructure, such as Fiber-to-the-Home (FTTH) or 3G (or 4G) networks, emerges in telecommunications. When new infrastructure emerges in telecommunications, a vertically integrated incumbent firm may introduce a new retail service fitted with the new infrastructure faster than vertically separated entrants would due to its superior position to obtain knowledge of the new infrastructure. A good example is the introduction of the virtual private network (VPN) for business customers in Japan. In Japan, OCN, which is an incumbent ISP of Nippon Telegraph and Telephone (NTT), could provide an extensive Internet VPN to its business customers when fiber optic networks were prevalent, while other ISPs could not. This maneuver certainly benefited OCN’s business customers more than the customers of independent ISPs.

Furthermore, although regulatory authorities require an incumbent to offer access to matured or basic infrastructures, such as ADSL or mobile 2G networks, they typically do not require the incumbent to offer access to new or upgraded infrastructures, such as FTTH or 3G. For example, the broadband unbundling policy was reversed in the US, as shown by the Federal Communications Commission’s Triennial Order of 2003 and the Revised Unbundling Order of 2005. The idea behind the reversal of the unbundling policy was that new or advanced technologies should not be unbundled to induce investment incentives for the deployment of new infrastructures (such as FTTH), whereas access to basic infrastructures should be included in the unbundling policy.¹ The different regulatory treatment of access between matured and new infrastructures makes the entrant’s services inferior to those of the incumbent when new infrastructures emerge in the market. In addition, when the delivery of different services (such as voice and data) proceeds through rapid technological convergence, a regulatory delay is often created due to the restructuring of regulatory institutions.² The regulatory delay highlights the regulator’s different treatment toward access to matured and new infrastructures. This different treatment justifies the assumption that spillovers through access are small.

The results in this paper show that when the degree of spillover is small, the incumbent’s strategic opportunity to invest in infrastructure forces the regulator to set a distorted access charge from a welfare perspective. This behavior is explained by balancing the two tasks performed by the regulated access charge: promoting a level playing field (i.e., promoting competition in the retail market) and making high-quality goods prevail in the market. When the degree of spillover is small, the incumbent has an incentive to strategically utilize the second task by controlling the level of infrastructure investment. In particular, when the degree of spillover is small and the investment cost is high, the incumbent has a chance to create a large quality difference between the goods of the incumbent and an entrant by overinvesting in infrastructure even if the investment cost is high. Given the large quality difference, the regulator is forced to set the access charge higher than the access cost, because the incumbent’s high-quality goods should be used by a large fraction of consumers. Therefore, when the degree of spillover is small and the investment cost is high, the incumbent induces the access charge above the access cost by overinvesting in infrastructure. Moreover, as a result of the high access charge, excess foreclosure occurs in equilibrium.

On the other hand, when the degree of spillover is small and the incumbent’s investment cost is low, the incumbent induces a low access charge by underinvesting in infrastructure. When the degree of spillover is small and the investment cost is low, the incumbent’s private incentive to invest in infrastructure may be smaller than the socially desired incentive under regulatory commitment. This situation results in a small quality difference between the goods of the incumbent and the entrant. Given the small quality difference, the regulator then has an incentive to set the access charge equal to the access cost. Therefore, in this case, a level playing field is excessively promoted in equilibrium.

Our study is closely related to that of Foros (2004), who examines the effect of access regulation using a model that includes regulatory non-commitment and spillovers through access. To examine the effect of access regulation by comparing the regulated and unregulated environments, his study focuses on the case in which a regulator sets the access charge equal to the access cost. The cost-based access charge set by the regulator in his analysis is justified from a welfare perspective. In fact, Foros’ analysis corresponds to the situation in which the spillover is greater than the threshold level derived in the following analysis. In our study, the range of spillovers is enlarged to examine the effect of regulatory non-commitment on the properties of the regulated access charge. This analysis demonstrates that an incumbent’s strategic opportunity to invest in infrastructure distorts the access charge set by a regulator when the degree of spillover is small. The distorted access charge then induces biases in both infrastructure investment and the promotion of a level playing field, depending on the level of the incumbent’s investment cost.

In addition to Foros (2004), several other studies have addressed the issue of regulatory non-commitment in terms of the relationship between access regulation and investment in telecommunication networks.³ For the environment wherein all entrants are price takers, Kotakorpi (2006) suggests the possibility of underinvestment in infrastructure under regulatory non-commitment and spillovers. Gans and King (2004) discuss regulatory non-commitment in their examination of the effect of access holidays. Similarly, Brito et al. (2010) analyze regulatory non-commitment when examining the effectiveness of a two-part access charge as a regulatory tool.⁴ In his survey article, Guthrie (2006) presents the restrictions preventing a regulator from behaving opportunistically.⁵ Cambini and Valletti (2004) examine how private and social preferences for investment diverge under regulatory non-commitment in the context of two-way access. Although a private preference for investment in the context of two-way access is different from that in the context of one-way access, Cambini and Valletti’s research motivation is similar to that of our study. In the context of one-way access, our study demonstrates that a firm’s private preference to invest in infrastructure distorts the access charge set by a regulator from a welfare perspective when the degree of spillover is small.

In Section 2, the framework of the model is explained. In Section 3, we derive the equilibrium and the second-best optimum as a benchmark. Section 4 compares the equilibrium and the second-best optimum and discusses the possibility of the distortion of the access charge set by a regulator. Finally, concluding remarks are provided in Section 5.