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1 43 ECONOMIC MODEL FOR MONOPOLY ANALYSIS IN TELECOMMUNICATION: PROPOSAL TO DEMONSTRATE UNIQUENESS Jürgen Albinger (PhD) Abstract The Telecommunications Act of 1996 sought to end the monopoly that once existed in the telecommunications industry. Since its adoption, the telecommunications industry has been undergoing a period of rapid change and development. The entry of new players into the market encouraged them to seek new ways to attract and keep customers. These changes have led to a rapid influx of new technology and services. Many times what defines a monopoly is not clear in every circumstance and there are many pending lawsuits for violations of antitrust laws in the courts today. Economic models are useful in resolving issues of whether a monopoly truly exists, or whether claims are unsubstantiated. Previous models were applicable only in certain situations. These models are unreliable in predicting monopolies outside the parameters for which they were designed. This research will develop and test an economic model that accurately predicts the existence of a monopoly in the telecommunications sector, based on the United States of America s marketplace case, as the best representative example to deal with.

2 44 Business Intelligence Journal January Introduction In some ways, it would appear that a monopoly represents a good deal for consumers. By having all of the resources needed to provide a good or service managed by one organization, there are some enormous advantages to be derived including efficiency and availability. Given the negative connotations that have been assigned to the term in recent years, it becomes necessary to understand why these business forms are not being used more frequently today. Indeed, monopolies have been the subject of large amounts of media attention in recent years. Recently, there has been the question of whether Bill Gates constituted a monopoly, or whether his vast empire was a just and fair reward for good business savvy. There have been many questions regarding mergers and acquisitions of corporate giants would create a monopolistic environment, this creating an unfair advantage and virtually destroying any smaller companies that were unable to compete on their scale. Courts are flooded with cases such as these and surrounding all of these cases is one key question, What exactly is a monopoly? Everyone is familiar with the textbook definition of a monopoly, that is, a marketplace where a lack of competition exists and one company and all or a significant portion of the market place. Notwithstanding the outward appearances of representing a good deal for consumers, in reality, a monopoly is only good for one entity: the monopoly itself. A lack of sufficient competition allows them to set their own places and in some cases, no incentive to produce the best quality product available. If the product or service that the monopoly produces is necessary for life, then the customer has only one choice. They must take the product that is offered, and pay the price that is offered, especially if there is a lack of a sufficient substitute product. Monopolies tend to drive up prices and have many negative effects on the establishment of a fair marketplace. One of the key issues surrounding the court cases regarding monopolies is that there are many different types of monopolies that exist for many different reasons. Some monopolies exist because of scale. In this case, the monopoly simply out-produces anyone else in the industry. They are price makers and everyone else must follow their lead. Because of their size, they can often produce goods cheaper than their competition and there fore can offer them at lower prices. Eventually, the smaller companies may be forced out of business and a true monopoly will then emerge. Some monopolies exist due to sheer geographic location. This is particularly common in the telecommunications sector and other utility sectors. In these cases, there may only be one service provider established in an area and the product may be necessary to life. Therefore a monopoly exists due to location. There are other more subtle forms and reasons for a monopoly existing, however, such as the effect that at a provider is the first to offer a service. They establish brand equity and name recognition. This may make entry into the market more difficult for the competition. Monopolies may be complete, where the monopoly is the only provider and has complete control over the marketplace. The monopoly may be partial, where there is competition, but the monopoly retains a significantly large portion of the marketplace. By all accounts, a monopoly makes it difficult to enter into the marketplace. The more complete, the monopoly, the more difficult, entry into the market will be. However, in an incomplete monopoly, it is possible for the monopoly to drive prices up and a lower priced competitor steal a portion of the marketshare from the monopoly. Business Intelligence Journal - January, 2009 Vol.2 No.1

3 45 As can be readily seen, there is not one hard and true definition of what constitutes a monopoly. The term monopoly has many shades and subtleties that make a blackand-white definition a difficult task. There have been many mathematical economic models that have attempted to provide a legal definition by which the courts, businesses, and general public could use to classify whether a market is a monopoly or not. If this clear-cut definition existed, the courts would not be bogged with Anti-trust suits; there would be no argument. This is the purpose for the following research. To this end, this research will focus on the telecommunications industry and develop a mathematical economic model that will be useful in determining if a monopoly exists in the telecommunications industry. This model will be tested through empirical research. Rationale for Study Recent focus in the telecommunications industry has been on the cell phone sector and other new technologies such as broadband communication and other wireless services. However, the predecessor to this expansion in the telecommunications industry began with the Telecommunications Act of Prior to this act, one primary company owned a large portion of the communications industry, which at the time consisted of telephones. This company was Bell Telephone, the pioneers of modern communication. In his essay, TELRIC vs. Universal Service: A Takings Violation?, Buck (2003) reports that: The Telecommunications Act of 1996 ( Telecom Act or 1996 Act ), however, introduced a new wrinkle into the realm of telecommunications pricing. By law, local telephone companies, known as incumbent local exchange companies ( ILECs ), would be forced to lease virtually all of their equipment and facilities to their competitors, the idea being that the competitors could then offer a competitive product to the consumers. The pricing terms of such leases are to be set by state public utility commissions, who must calculate the theoretical cost of constructing a new network. This system of cost-based pricing is known as TELRIC, which stands for total element long-run incremental cost. (p. 2) As others began to wish to enter the marketplace, they found it difficult or nearly impossible to compete with the giant. Clearly, this scenario and comparable ones that resulted were not conducive to the ideals of free enterprise and true capitalism, so the government decided to act. They passed the Telecommunications Act of 1996, which de-regulated the industry and paved the way for open competition. The act included provisions for helping new companies enter the marketplace including providing extra licenses in many areas and funding sources for new business startups. This created a wealth of opportunity for new businesses. In an attempt to out-compete their competition, companies experimented with new services, pricing schemes and eventually, new technology. This created a boom in new technology and led to the invention of cell phones, pagers, and other wireless products. It seemed that everyone has benefited from this move by enjoying lower prices and a wealth of new products and services. Every one has benefited, that is, except Ma Bell. As in other sectors, the privatization of the telecommunications industry has led to a plethora of business startups. Some of these new enterprises became shining stars and rose to the top of their industries quickly, while others crashed and burned. As in any other industry that experiences this type of boom,

4 46 Business Intelligence Journal January there were many allegations of mergers and shining stars becoming monopolistic in nature. This led to a backlog of court cases that is likely to be there for some time in the future. An economic model that tests for the existence of a monopoly in the telecommunications industry would be of great use in determining if a monopoly truly exists, or of the claims are unsubstantiated. This research will examine several existing models for the existence of monopolies. There are many instances in which these existing models reliably predict the existence or nonexistence of a monopoly; however, they were developed for prediction under certain types of markets and market conditions. As a result they are reliable in predicting monopolies in certain sectors of the market, however, prove themselves to be inadequate in predicting monopolies in other sectors. The existing models do work in certain circumstances however, their inability to work in other circumstances has resulted in some cases, particularly that of the telecommunications field, in a predicament where no clear decisions can be reached. Furthermore, there are still some who argue that the Telecommunications Act of 1996 was unnecessary because no true monopoly existed in the first place. For the purposes of this analysis, it is important to keep in mind that every sector of the market has its own set of characteristics. For instance, some are cyclical, such as retail, and some are steady growth, as in the case of many manufacturing sectors. Some sectors have many small players, while others are made of a few larger players. Sometimes one company is the clear leader. Sometimes there is a group who emerges ahead of the pack and sometimes all are on a level field. These varying characteristics make it necessary to develop a separate economic model for each sector or sub-sector in the market. The telecommunications sector has experienced a fundamental restructuring in recent years and is still in a period of rapid change. The most drastic change came after the adoption of the Telecommunications act of 1996; however, this is a rapidly changing industry and by all accounts, there are many more changes to come. In this environment, some observers have suggested that even though there are more companies in competition, that there is still a monopoly, or an environment closely resembling a monopoly. This is particularly true in the case of companies such as Lucent Technologies and AT & T. Mergers Such as Viacom and WorldCom draw even more suspicion as they form conglomerates large enough to force smaller companies out of business, by their shear scale. This is the rationale behind the need for the proposed research. It is the objective of this research to develop an economic model that accurately predicts the existence of a monopoly in the telecommunications industry. The telecommunications industry consists of many sub-sectors and the model will be tested in each of the sub-sectors to assure that it can accurately predict conditions in a variety of conditions within the telecommunications sector. The proposed model will be tested both before the Telecommunications Act of 1995 and after its inception. It will be tested in the rapidly changing environment that exists today. It is the goal of this research to develop a real-world working model that will be helpful in solving the many issues that exist today regarding monopolies and the telecommunications industry. Business Intelligence Journal - January, 2009 Vol.2 No.1

5 47 Scope of Problem The telecommunications sector has been a leader in the technology sector since the influx of new companies and new technologies that resulted in the invention and proliferation of technology after the adoption of the Telecommunications Act of While different components of the industry, the regulators, and the economists expressed different concepts concerning what changes should be made in the telecommunications industry, virtually all stakeholders agree that competition in all segments of telecommunications should be encouraged (Mcmaster, 2002). Anti-trust lawsuits have caused many disruptions in the development of the sector and as a result caused massive overheads for companies that could barely afford it. Many of these lawsuits have centered on the existence of local or large monopolies. These lawsuits lowered the profitability of many companies and forced many of them to go bankrupt pr make drastic cuts in their workforce. The costs of these lawsuits have been devastating and have hurt the profitability of many companies. As a result, the sector, as a whole, has suffered a downturn that will likely take some time to recover. Statement of Hypothesis and Research Questions The hypothesis of this research is that a mathematical economic model can accurately predict the existence of a monopoly in the telecommunications industry as follows: Hypothesis 1 (H1): As market concentration shifts from low to high, the effect on the top four players out of ten in an industry shifts becomes more pronounced than for the remaining top six in a manner discernible through one of the economic models to be analyzed. The successful model will be useful in predicting the existence of a monopoly in the telecommunications industry, and will thereby become a useful tool in resolving the issue of whether a monopoly exists or not. The guiding research questions of this research will demonstrate that the economic model developed as a part of this research will accurately predict the existence or nonexistence of a monopoly in the telecommunications sector. The primary research question will be, Can the model developed for this model accurately predict the existence or nonexistence of a monopoly in the telecommunications sector? Literature Review Given the importance of the industry, it is not surprising that much literature exists on the telecommunications industry and the history of the Telecommunications Act of There is a wealth of scholarly debates regarding whether it has been a help or whether it has been of harm to the industry. It can be debated as to which side holds the most truth at the present time. The following will review the current literature available, both on the telecommunications industry and the models that have been used to describe other monopoly models. The review will be critical in nature and will attempt to summarize as much of the information as possible on the topics at hand. The Telecommunications Industry The telecommunications industry is important and considered a vital part of our everyday lives. The telecommunications industry represents only a small portion of the country s Gross Domestic Product, only 1-2 percent (Stigiltz, 1998). While this amount may seem insignificant, the services that it provides are vital to every other sector

6 48 Business Intelligence Journal January in the economy. Telecommunications is the backbone of many other sectors. The Telecommunications Act of 1996 is one of the most highly debated topics in economics. There are some that say that it has been ineffective and that we now have a monopoly again, as a result of mergers and acquisitions. Despite its constraints, the Telecommunications Act of 1996 was an absolute necessity according to Henricks (1999). This author points out that, Despite the amendments and revisions that have been added throughout the years, Congress saw no choice but to completely replace the obsolete Communications Act of Because communication technology has grown by leaps and bounds over the last few years, the Communications Act of 1934 was considered an antiquated document. Edmund L. Andrews states that advances in technology and rapid change in the marketplace have made [the 1934 act] increasingly outdated and, many experts believe, [the 1934 act] has been harmful to competition and consumers (p. 39). As a result, Congress replaced the 1934 act with a new, more contemporary law that was intended to regulate the electronic media of the 21st century (Hendricks, 1999). There are others who say that it has had the intended result, but that the movement towards a competitive marketplace does not happen overnight. Poulson (1997) believes that achieving a fair market in Colorado will not be immediate and will take some time. There are others who believe that it is working in some cases and not working in others. Alaska is moving towards a more competitive marketplace on a local level. Rural communities often have a localized monopoly as there are not enough customers to attract competition (APUC, 1997). Many have made predictions, similar to the one that will be made by this research project. Many of these feel that the telecommunications market in 2010 will be a pure competition, with no single company emerging as the dominant force. Pehal (2000) believes that the market in 2010 will not be dominated by one type of technology and that the result will be a mixture of the new and the familiar. Powers and associates (2000) predict a similar scenario. Others see the market moving towards a monopolistic setting in the future (Farrell, 1995, Goldstein, 1993, Kanell, 1998, Kitmari, 1998, and others). They are basing these claims on the fact that some companies are now beginning to emerge as monopolies at the current time. Sun is currently being accused of attempting to gain a monopoly of scale (Malik, 1999). According to Black s Law Dictionary (1990), a monopoly is A privilege or peculiar advantage vested in one or more persons or companies, consisting in the exclusive right (or power) or carry on a particular business or trade, manufacture a particular article or control the sale of the whole supply of a particular commodity (p. 1007). Not surprisingly, monopolies can have many negative effects on the marketplace. Monopolies prevent competition and raise barriers of entry into a market. Senator Leahy points out that the cable television companies are a prime example of this (Kenyon, et. al., 1995). A free and open competition ensures that customers will have many benefits, such as lower prices, a variety of new and developing products and services. A competitive market forces companies to strive to maintain a customer base, whereas a monopoly promotes routine and is resistant to change. In a free competition, businesses must strive to provide customers with new and innovative products at reasonable prices or face the loss of customers and declining profits (FCC, 1995). It is the customer and society as a whole that benefits from free competitions. Business Intelligence Journal - January, 2009 Vol.2 No.1

7 49 A natural monopoly exists when the people in an area need a service or product to sustain their daily lives and there is no product substitution (Stoffels, 1999). It also exists where there is no other close competition, due to the fat that there is a lack of resources for expansion into the area. A prime example of this is a rural electric cooperative. Usually the one who ran the lines first can have a monopoly. The people will use whoever is there and have no other choice. It is unlikely that another company will run lines to the same locations due to the cost involved and the uncertainty that customers will switch. In this regard, Gasmi, et. al., (1999) developed a test for a natural monopoly that he feels would be applicable to the telecommunications industry. It was developed to determine natural monopolies in the rural electricity industry. Upon examination of the test, it was felt that it would be useful in certain sectors of the telecommunications industry, especially where rural hardwire telephones were involved. However, it did not appear that it would be useful in other segments of the market, such as cell phones and other wireless products, or in urban areas. In their chapter, A Technico-Economic Methodology for the Analysis of Local Telephone Markets, Gasmi, Laffont and Sharkey (1998) provide an empirical methodology for analyzing the regulation of local telephone markets that combines an engineering process model of costs with models from the new regulatory economics. According to Gasmi and his colleagues (1998), this technico-economic methodology is comprised of two separate analyses. The first step involves studying the properties of optimal regulation under asymmetric information in detail by examining three issues: The extent of natural monopoly when informational rents associated with regulation are taken into account; The extent of the divergence of pricing under the optimal regulatory mechanism from optimal pricing under complete information (incentive correction); and, The implementation of optimal regulation through a menu of linear contracts (Gasmi et al., 1998). The authors determined that for fixed territory, strong economies of scale allow local exchange telecommunications to retain monopoly characteristics even when the (informational) costs of regulation are properly accounted for. In addition, they report that the incentive correction term is small in magnitude, and optimal regulation can be well approximated through relatively simple linear contracts (Gasmi et al., 1998). The second phase of the technicoeconomic methodology involves an evaluation of the relative performance of various regulatory mechanisms, from both traditional and modern (incentive) points of view. This analysis allows us to quantitatively assess the social value of regulatory transfers and of good cost auditing procedures, the redistributive consequences of the various forms of regulation, and the sensitivity of the relative performance of the various methods of regulation to the cost of public funds. The importance of costing methods in regulation of network industries is by now well established. This is particularly the case in telecommunications. Historically, various approaches have been used to evaluate costs in telecommunications, including accounting and econometric methods. However, with the rapidly changing technology, forwardlooking engineering models of costs have increasingly proven useful. Meanwhile,

8 50 Business Intelligence Journal January new forms of regulation have made their way into telecommunications, triggered, on the one hand, by widespread dissatisfaction with the performance of traditional forms of regulation, and on the other hand by the broad political trust in private incentives for enhancing the performance of operators. The technico-economic methodology described by Gasmi and his associates uses the engineering approach in a modern regulatory economics framework for analyzing some important issues facing regulation of telecommunications today. The usefulness of this technicoeconomic methodology is demonstrated through two investigations: This approach was used to empirically investigate in detail the properties of the optimal regulation of the local telephone service and its implementation; specifically, Gasmi and his colleagues researched ways to generalize the natural monopoly test in order to take account of the (informational) costs of regulation. The technico-economic methodology was used to compare the performance of various regulatory schemes from both traditional and modern incentive regulation. In order to successfully assess the various forms of regulation that impact on the technico-economic methodology, a detailed specification, in the context of a representative local telecommunications network, of the firm s observable cost function, the market demand function, the disutility of effort function, and the distribution of the technological uncertainty parameter (Gasmi et al., 1998). The regulatory schemes involved in this analysis are subject to constraints of three types: Mechanisms differ in the (ex post) observability of costs; In the feasibility of lump sum transfers to the firm, and, In the degree of bounded rationality of the regulator (in addressing incentive issues) (Gasmi et al., 1998). A duopoly exists where there are two companies that compete in a marketplace. In this case, there is limited competition, but no clear competitors exist, other than the two duopolists there are some that many consider this situation to be a small oligopoly. In this case, the two competitors must match each other in price and quality. One cannot afford to fail to match the other s price. This market can be good for the monopolists, if cooperation exists between them. However, if they are fierce competitors, the competition will serve to harm both, as they strive to lower prices and out-perform one another; however, Pociask and Rutner (2000) believe that a separate test must be applied when analyzing a monopoly versus a duopoly. In a similar vein, Huisman (2000) explores the specific benefits and effects that a monopoly will have on the marketplace and draws the conclusion that the longdistance market is currently an extremely concentrated market. The proposed MCI WorldCom/Sprint merger will make it even more concentrated. There are those who feel that the MCI WorldCom/Sprint merger will make it even harder to compete for smaller companies. Furthermore, Huisman argues that entry into the marketplace is currently high. The established companies have a considerable amount of brand equity attached to their names. It would take a massive and very expensive media campaign to compete with MCI WorldCom and Sprint. There is Business Intelligence Journal - January, 2009 Vol.2 No.1

9 51 a certain amount of trust associated with a name. People will not be likely to switch to a small, barely known carrier, even if their prices are substantially lower. There are also considerable regulatory and capital expense barriers that make it nearly impossible to enter into the market. These factors tend to weaken the opinions of those who claim that MCI WorldCom and Sprint do not resemble a monopoly, or a strong duopoly. These carriers are able to meet future demands of a growing client base, therefore it seem unlikely that the current situation will change (Huisman, 2000). To this end, Huisman argues that the MCI WorldCom/Sprint merger should not be allowed, as this will create a true monopoly in the telecommunications industry. As long as the two remain separate, there is at least a limited amount of competition. He feels that a limited amount of competition is better than allowing this market to become a pure monopoly. These two companies have cornered the market on an economy of scale and it would not be possible to retain efficiency in any other way. This is the case in the long-distance area of the market; however, Huisman feels that the merger would be beneficial in other markets such as in the wireless and local exchange services. The merger would provide better interconnectivity but there remains a concern that this would create a smaller competitive market in these areas as well (Huisman, 2000). Clearly, Huisman is against a further concentration in the telecommunications marketplace and argues that re-creates the same situation that the Telecommunications Act of 1996 sought to prevent and suggests that a strong campaign be launched to convince the government to disallow the merger of MCI WorldCom and Sprint; nevertheless, this author maintains that this is not enough and calls for a divestiture of Sprint s equipment and backbone to allow others to enter into the marketplace (Huisman, 2000). In addition, this author suggests that the Telecommunications Act of 2996 was necessary and that the intentions were good; yet, since its adoption, the market has been allowed to develop with no guidance or intervention and that this has created a market similar to that, which existed prior to the Telecommunications Act of The merger will effectively eliminate the two companies who currently have a chance to pose competition to the impending supergiant, Bell Atlantic and GTE. Due to a lack of maintenance, it would seem that we have taken a step backward and that it is Ma Bell all over again (Huisman, 2000). Economic Models of a Monopoly Even a casual review of its circumstances today makes it quickly apparent that the telecommunications industry is a complex entity and there are multiple subindustries within the primary industry. The telecommunications industry has gone from a relatively pure monopoly to an attempted competition, and now it is questionable as to whether it is gravitating towards a monopoly again. In addition, there are now more products and services available. The market is no longer comprised of one market. There is a long-distance market, a local service market, and a cell phone and wireless market. All of these markets have different characteristics and the previously existing models fail to useful in all areas of the telecommunications industry. For instance, the Gasmi Model (Gasmi, et. al., 1999) is useful in the rural local phone service industry in rural areas. However, is very ineffective in prediction in an urban market, where there are many competitors, such as the cell phone market. In this market, there may still be a monopoly but the monopoly

10 52 Business Intelligence Journal January does not have as much power as in a natural monopoly setting. Studies have been conducted on monopolistic markets in other areas. It has been found that monopolies retain certain characteristics and that they are subject to many factors that influence their behavior. Consumers have a set of guidelines, by which they make purchases. Even in a pure monopoly, the company must provide a certain level of perceived quality and cannot engage in overly high pricing schemes. It would seem as if the consumer would have no recourse, especially if they need the product or service. However, disgruntled customers will complain to their government and could pressure the government to break up their monopoly. Many studies by Shimonura and Shimonura and associates ( ) demonstrated that market equilibrium could be manipulated by placing a set of export constraints on the market (Kemp, M., Okawa, M., Shimonura, K., 1996). Other researchers such as Graham, et. al. (1983) studied the airline industry after deregulation. They found that fares are independent of market concentration. Likewise, Rogerson (1982) found that monopolies seek resources directed at obtaining profit and that there are social costs to the monopoly because of this rent-seeking activity. According to Miller (1996), A major rationale of the assault on regulation that has taken place in the work of orthodox economists over the past several decades, and in the courts and legislatures since the late 1970s, is the view that regulation retards technological advance and that an optimal rate of investment in new technology will be a happy by-product of deregulation (p. 719). A monopoly firm s pricing strategy in a market in which consumers have varying perceptions of the quality of the firm s product. The effect is reflected in the price that the firm will be able to secure for the product (Kehoe, 1996). For example, Caminal (1996) found that a monopoly can choose between no advertising and largescale advertising. The monopoly will adopt the most efficient advertising strategy in conjunction with lower fixed prices for their services. In a duopoly, when consumers have a fixed time-horizon, such as signing a oneyear contract, the two firms may alternately dominate the customer base, alternately charging high and low prices (To, 1996). Using a maximum entropy technique, it is possible to approximate the market shares of each firm in an industry using the available government summary statistics such as the four-firm concentration ratio (C4) and the Herfindahl-Hirschmann Index (HHI). The HHI technique is reported to be effective in estimating the distribution of market shares in 20 different industries. Golan et al. (1996) support practice of using HHI rather than C4 as the key explanatory variable in many market power studies (Golan et. al. 1996). According to Jorde and Teece (1992), with regard to the issue of the appropriate Herfindahl-Hirschmann Index thresholds, the Merger Guidelines identifies critical HHIs at 1000 and 1800; however, it is difficult to hypothesize and propose alternative HHIs for technologically dynamic markets, but the inclusion of performance competition and the extension of the time frame of competitive response may mean that it is not necessary to change these critical HHIs (Jorde & Teece, 1992). In addition, Jorde and Teece suggest that with technologically dynamic markets, the dynamics of market structure in the past should provide some guidance to assessing market definition and predicting likely changes in market concentration. Key factors are the change in concentration and the trend in the number of competitors, they advise. Failure to recognize that competition Business Intelligence Journal - January, 2009 Vol.2 No.1

11 53 is often on the basis of performance attributes and not price will lead courts and the antitrust agencies to underestimate the breadth of product markets in industries characterized by rapid technological change. This process, in turn, will lead courts and agencies to exaggerate antitrust dangers. As a consequence, technological development may be retarded (Jorde & Teece, 1992, p. 11). Golan et al. (1996) presented their HHI technique as a one-size-fits all factor that would be useful and applicable in a variety of situation, citing its usefulness in 20 industries. Upon examination of the technique used, however, it was found that many variables were not taken into account, such as changes in industry structure and the existence of markets within markets, Golan and associates tout their method as being useful in almost any situation. However, it was not found to have the wide applicability that they claim. Before applying their method, one should be careful to examine the circumstances to which it was originally applied and to be certain that the situation being tested has similar characteristics to those used by Golan and associates. Golan and associates did apply their method to 20 industries; however, they did not state the conditions in the industry. Generalizations such as these can be dangerous and should be carefully examined when choosing to use the method for one s own analysis. This is not to say that the method is not useful, it certainly has some merit. It is the widespread applicability that is in question in this case, not the method itself. In this regard, Young (2000) notes that the predominant assumption in media economics to date has been that market structure is a central feature of media markets: The problem that has emerged is that once market outcomes (prices and outputs) under conditions of oligopoly are sensitive to the precise specification of firms conjectures with regard to other incumbents and to potential rivals, there is a need to theorize in terms of firm specific behavior (conduct) and less in terms of any structural characteristics of a given industry or market. It is less likely that a summary measure of concentration, such as the widely adopted Herfindahl-Hirschmann index, can convey as much regarding the likely performance of a particular industry. That is, we cannot easily deduce that an increase in the level of concentration is likely to lead to a higher price-cost margin (or high supernormal profits) and a corresponding misallocation of resources. As noted previously, it might, on the contrary, be the case that a particular set of interactions between rival oligopolists, along with specific conjectures regarding likely potential entrants, leads to an outcome that is relatively competitive (i.e., one that is much closer to a perfectly competitive or Pareto efficient state than a pure monopoly outcome). (Young, 2000, p. 31) Lieberskand et al. (1996) examined the impact of corporate restructuring measured at the industry level on industry concentration in US industries. These industries were engaged in the basic, manufacturing, and services sectors between 1981 and The results demonstrated a modest increase in median industrial concentration in sample industries between 1981 and There were few sell-offs of assets at the industry level through horizontal mergers, acquisitions, and inter-firm asset sales increased US industrial concentration during the 1980s (Lieberskand et al., 1996). The Lieberskand study is interesting when one compares the manufacturing industry

12 54 Business Intelligence Journal January to the telecommunications industry. The telecommunications industry has undergone a complete restructuring, as compared to the manufacturing industry. The manufacturing industry has been relatively steady, yet still shows a trend toward a higher level of concentration. The manufacturing industry has high barriers to entry, and in many cases, only one of two producers of a particular product. Lieberskand was baffled by the trend towards a more concentrated marketplace in what he considers to be a free competition. Lieberskand considered the entire manufacturing sector to be a free competition. However, in reality it is a bunch of small natural monopolies. For instance, Colgate/Palmolive makes hundreds of consumer products. There are only two or three competitors that manufacture similar products. One of their primary competitors is Proctor and Gamble. They could be considered to be a duopoly. However, a closer examination of the market shares would have to be undertaken. This industry does not have hundreds of competitors. This represents only one product line. Another example is in the airline industry. There are only two or three major manufacturers of airplanes. Lieberskand made the error in his analysis of considering manufacturing to be one entity. However, it is really a number of smaller entities and this is the factor that confounded Lieberskand s analysis. Lieberskand was confused by his findings and this is explanation that eluded him. Some of these monopolies are natural monopolies. However, most are monopolies of scale. Economic textbooks have called the telecommunications industry an ideal model of a natural monopoly (Thierer, 1994). However, Theirer points out that this monopoly came into existence with the aid of the US government and that many would-be competitors were excluded and not allowed to obtain licenses in the beginning. As stated before, monopolies are detrimental to the market place by creating higher prices and sometimes-lower quality. Let us examine one possible reason why the government would wish to promote a monopoly. A natural monopoly can serve consumers at lower costs than two or more firms. This would seem contrary to popular convention until one considers the high barriers to entry into a natural monopoly. Once a single firm overcomes the initial costs, such as laying the cable, or building the sub-stations, their average cost of doing business drops rapidly, relative to newcomers in the industry. Kellogg, (2000) found that if a monopolist sets their price before they have determined the level of demand for their product, then they have essentially limited the availability of output at lower prices. It cannot lower its prices and this can lead the way for competition and lead to its eventual displacement as a monopoly. Kellogg cautions companies to wait until demand can be determined before setting prices. Kellogg (2001) examined the homogeneous good Cournot model with two existing companies and one potential entrant into the market. This researcher demonstrated that entry can occur even if the entrant has no cost advantage and must rely on existing companies to distribute their product. This is exactly what happened in the wireless portion of the telecommunications industry. In the beginning there were only a few companies manufacturing cell phones. The costs to enter this market are high. However, in spite of this, other manufacturers were able to enter the market and there are now a large number of manufacturers in the industry. Some manufacture their phones and sell them under a larger conglomerate name. This gives the larger conglomerate another product line, for which it does not have all of the manufacturing costs and Business Intelligence Journal - January, 2009 Vol.2 No.1

13 55 gives the smaller company the advantage of the larger companies brand equity. The Cournot model could prove itself to be highly useful in the development of a model for the telecommunications industry. The practice described above is called bundling. Martin (1999) found that bundling be a firm with a monopoly over one product is strategic and that it changes the substitution relationships between the goods. Now the monopoly does not have to worry about the competition as a substitution product. It can now use the product produced by the other company to its advantage. This is a highly profitable proposition for the monopoly. This strategy is usually used by the monopoly to reduce or eliminate competition. In many cases, the larger company will force the smaller company into this arrangement as they can easily override them otherwise. Labor Unions are not usually considered to be an monopoly. However, there have been many models that prove them to have all of the characteristics of a monopoly. Many models have been developed describing the characteristics of labor unions as being monopolistic in nature. Some of these models may be useful in determining the existence of monopolies in the telecommunications industry because the structure of the labor union is similar to the telecommunications industry. Labor unions are national in scope, just as with the national telephone carriers. However, they are local in nature as well, small branches serve limited sections of the population. Labor unions engage in a variety of trades, such as plumbing, painting, electricians, etc. They have many products to offer and each of these products represents a different market. This is very similar to the telecommunications industry where there are long-distance markets, local service markets, cell phones, PDA s and other products, all representing a different market. For these reasons, models that are used to describe the labor unions may prove to be the most useful in describing the telecommunications industry. In order to develop an adequate model for describing the telecommunications industry, it is obvious that an examination of other industries and comparisons will be required. Similarities and differences will have to be carefully considered. Currently, there are many models that claim to be the answer in all cases involving the existence of a monopoly. In the models that make these claims, one thing is obvious: They did not compare the market characteristics of the industries for which they have proposed the model. In the case of the telecommunications industry, it was surprising to find that the labor unions were the most similar in structure and market scope. These may be the most useful in constructing a model for conduct of this research. Many of the models were sound in theory. However, sufficient testing was not performed to substantiate the claims being made. It is not expected that any one of these models will adequately apply to the telecommunications industry. However, in the case of the labor union models, a few modifications may make the most meaningful model. These statements are only speculative at this point and no clear conclusion regarding the methodology can be proposed at this time. The literature on the telecommunications industry has to this point, focused on the effects of the Telecommunications Act of There are as many reports that state that the act created a competitive marketplace. Research has shown that this may have been true, at least for a while. However, it is possible that the marketplace may be changing to a monopolistic model in

14 56 Business Intelligence Journal January the near future, especially with the upcoming proposed merger between MCI WorldCom and Sprint and AT&T and Bell South. Michael Porter and Monopolies and Clusters By all accounts, segment differentiation and geographic scope are central concepts of international strategy at the business level (Porter, 1986). According to Cooke (2001), Michael Porter is one of the leading proponents of clustering for competitive advantage. From a competitive advantage perspective, the goal of segment differentiation is to customize products and services to better fit the needs of different groups of customers; however, Porter points out that such segment differentiation is expensive because differences in product designs, advertising programs, distribution channels, and so forth work against the development of economies in research and development, production and marketing. In contrast, Carpano, Chrisman, and Roth (1994) advise, if a firm fails to segment its market, it risks sacrificing effectiveness for efficiency; few customers will be attracted by a product that fails to meet their needs, no matter how economical the purchase may be (p. 640). In an industry characterized by multidomestic enterprises, the needs of customers are regarded as being heterogeneous; companies that do not adequately respond to the diversity of customer needs and buying motives may find themselves at a competitive disadvantage compared to companies that do (Carpana et al., 1994). On the other hand, they advise, customer needs in a global industry are predominantly homogeneous. In this instance, a firm that attempts to differentiate its offerings to different national markets may see its attempt go unrewarded. It has, in other words, sacrificed efficiency with no corresponding gain in effectiveness (Carpana et al, 1994, p. 640). Knowledge Engineering in Relation to Monopolies and Business Intelligence Applied to Monopolies According to Davidson (1999), Today s knowledge-based organisations have a problem. Their most important assets tend to be in the heads of their workers. As a result they need tools to capture, store and redistribute this knowledge, so that the corporation doesn t grind to a halt every time an employee walks out of the door (p. 37). To date, computer scientists have been able to integrate various individuals knowledge into expert systems that autonomously perform complex tasks such as configuring large-scale computer systems and assessing credit applications. It was not that long ago that such knowledge engineering systems, though, were considered too restrictive in their scope to be of any real significant use to all but the most esoteric applications. For example, Davidson notes that although experts in artificial intelligence had created a number of knowledge engineering tools to help build expert systems, at the time, Few companies have the time or resources to use them to capture knowledge in this depth. Nor would they necessarily want to. Expert systems are limited inevitably to a single, specific field of interest, whereas what companies often want from their knowledge workers is flexibility and creativity (Davidson, 1999, p. 37). This situation is no longer the case today, however, and a wide range of expert systems, algorithms, knowledge bases and various business intelligence applications can help model real-world settings and help researchers better understand the various forces at play. According to Hakken (2003), Business Intelligence Journal - January, 2009 Vol.2 No.1

15 57 knowledge engineering requires a solid theoretical basis: [A] computer, no matter how sophisticated, is useless if you have no rules to drive the inference machinery designed to process data. Knowledge Engineering attempts to codify and distil information so that it can fuel the increasingly powerful logic machines processing the data stored in their memories. Intelligent knowledge-based systems (IKBSs) and expert systems are computer-based systems which take information and process it in an intelligent manner (Hakken, 2003, p. 154). From another perspective, then, clusters are monopolies in the market for economic space (Cooke, 2001). Some early uses of knowledge engineering for estimating forward-looking costs of a local telephone exchange were made by Mitchell (1990, cited in Mackie-Mason & Waterman, 1998) who used a heuristic model of the local exchange network, including the local loop, end-office switching, tandem switching, and interoffice transport. According to these authors: Simple linear functional forms were assumed for individual cost components of the network, and these were calibrated either by econometric techniques where data were available, or by engineering estimates provided by Pacific Bell and GTE of California, in whose territory the study was conducted. Both capital costs (network investments multiplied by a 15 percent annualization factor) and operating expenses (primarily maintenance and billing costs) were considered. The end result of the study was an estimate of both the fixed costs and average incremental costs associated with each of the network components. Mitchell s study focused on estimating the incremental cost of an additional access line or an additional minute of usage of the network. These results are of potential interest in guiding investment decisions of telecommunications providers and, in a regulatory context, for setting price floors or for detecting predatory behavior. Using such knowledge engineering systems to improve returns on investment tend to accrue to first-mover firms in a knowledge-based industry or those that otherwise gain a monopoly position in a given market has become increasingly common today. In this regard, more recently, Cooke (2001) reports that: Some Knowledge Economy firms with an arm-lock on key Internet technologies, like Cisco Systems, virtual monopolists in Internet routers which control Internet communication channels, have this characteristic, as did telecommunications monopolies before privatization and the introduction of competition for telecom services market-share. Increasing returns arise from the widespread and repetitive gains that accrue from the continuously improved codified knowledge responsible for the technological change in question. In Cisco s case this is achieved by acquisition of specialist knowledge-intensive smaller businesses in appropriate technologies. In other cases it arises from equity investment by corporate venturing arms of such (quasi)-monopolists in equivalent small businesses, as in the case of Intel Technology, which is assumed to possess this increasing returns characteristic. This, in turn, requires the replacement of the neoclassical cornerstone assumption of perfect by one of imperfect competition, since increasing returns to scale clearly imply monopolistic rather than fair competition. [M]ost of these models suffer from some of the same unrealistic assumptions and the same

16 58 Business Intelligence Journal January measurement problems as the old growth models. In particular, they take little or no account of organizational innovations and of the interplay between institutional change, technical change and investment. (Cooke, 2001, p. 35). Finally, other knowledge engineering techniques that have been applied to the telecommunications industry in recent years include the Local Exchange Cost Optimization Model (LECOM), used to calibrate the cost function for local telecommunications costs. According to Mackie-Mason and Waterman (1998), LECOM has been developed to determine the degree of economies of scale and scope in local telephone markets and the cost-minimizing deployment of technology (e.g., analog vs. digital or fiber vs. copper). The software for LECOM combines an engineering process model, which computes the cost function for a local exchange network with a given configuration of switch locations, using an optimization algorithm which solves for the optimal number and location of switches (p. 21). The LECOM knowledge engineering applications allows the user to specify the size of the local exchange territory, which is comprised of three concentric rectangles representing a central business district, an area of mixed residential and commercial demand, and a residential district. The size and the population density of each region are both specified by the user, as well as specific data concerning calling patterns. Furthermore, the user is able to specify a set of technological inputs and a detailed set of input prices in order to calibrate the model to the specific characteristics of an exchange area (Mackie-Mason and Waterman, 1998). By all accounts, more sophisticated applications of these techniques are expected in the near future. Methodology This research will be conducted in two phases, to be discussed in detail in the remainder of this section. The first phase of research involved a detailed review of the telecommunications industry, both historically and in present times. Existing methodologies for determining the existence of monopolies were explored in detail and compared to the needs of the telecommunication industry. Finally the developed model was tested using examples from the telecommunications industry both before and after the Telecommunications Act of Description of the Study Approach The first section of this research involves development of the model. This involved a detailed study of existing models and how they apply to the circumstances for which they were originally developed. These models were then studied to determine if they would be useful in the telecommunications industry. Unique factors in the telecommunication industry will be identified and worked into the equation. The model in this research served as the research instrument. After the development of the model, the model must be tested to ensure that it works as planned. It will be tested in several environments. It will be tested before the adoption of the Telecommunications Act of If the model reacts as planned it would be expected that the model will show strong evidence for the existence of a monopoly. The model will be tested after the adoption of the Telecommunications Act of 1996, where it should not show strong evidence for the existence of a monopoly. A variety of tests will be conducted in more recent times where the existence of a monopoly is questionable. If the results obtained fail to Business Intelligence Journal - January, 2009 Vol.2 No.1

17 59 make the expected results, then the model will be reexamined and adjusted. The tests will be repeated until the desired results are obtained and found to be statistically significant. Sample Population The sample population for this study will be various sub-sectors of the telecommunications sector over the period of time from 1986 through 2002; this period will cover the period both before and after the Telecommunications Act of It is not believed from historical literature examined that going farther back than 1986 will produce significant results, as the market remained relatively unchanged until this time. According to Compaine and Gomery, using the year 1986 as the base year for comparison is appropriate for this purpose because it was the first year after the Federal Communications Commission relaxed the number of television stations under the ownership of a single firm from 7 to 12; in addition, 1986 was the year that News Corp. first successfully challenged the longstanding dominance of the major three commercial networks, thereby creating an opportunity for additional competition in the broadcasting industry (Compaine & Gomery, 2000). Furthermore, in the early 1990s, the FCC s restrictions on broadcast networks owning a financial interest in prime time programming were eased and by early 1996, the Telecommunications Act essentially eliminated the size of broadcast radio groups and further loosened restriction on television station group ownership (Compaine & Gomery, 2000). As the research progresses, the exact time periods of interest are expected to emerge. One example may be to study sector structure at the beginning of the advent of cell phones, and then one year after their inception to determine if any leaders have emerged and if they did, if they began to resemble a monopoly, either by scale or by location. Then the same sector would be analyzed three years after its beginning to study how it has changed in that time. This is only one example of the types of questions that may be examined in this research. There are many such issues that may be examined upon closer investigation of the sectors over time. Data Analysis The first portion of data analysis will be to determine if, when the model is applied, a monopoly is found to exist. Each time period examined will be considered to comprise one data set. Each data set will be either positive or negative for the existence of a monopoly. Some may be considered to be partial monopolies. These will be treated as a monopoly for purposes of this study. This data will be analyzed and scatterplotted according to time to determine if more or less monopolies come into existence over a long period of time. Patterns in this data are expected to reveal trends in the formations of monopolies over a period of time. Trends in the movement towards a monopoly or towards a more even competition are expected to be revealed by this graphical method. Regression analysis will be used to attempt to predict future trends in the formation of monopolies in the telecommunications sector in the future. Findings It is expected that the data will reveal definite trends in the telecommunication industry. For many years the telecommunications industry was dictated by a few large-scale companies. There were virtually no smaller players and even if they

18 60 Business Intelligence Journal January did exist, they could not compete with the Bell conglomerate. The Telecommunications Act of 1996 paved the way for a free market in the Telecommunications sector. Immediately following the passage of the 1996 Act, a plethora of small companies emerged. The government supported the growth of the industry by providing more licensing opportunities and providing grants and low interest loans to those who wished to enter into the lucrative enterprise. When an industry booms such as this one, there are many who enter that are not prepared to compete. Many lack the knowledge and skills necessary to make a sustainable proposition. As a result, many of these fledgling businesses fail in a short amount of time. This left gaps in the market to be filled, either by another new company, or by an existing company that is positioned to take over that area of the market. More often than not, the latter is the case. This makes the existing company stronger and more able to control a larger section of the market. During this phase of market development, this same process occurs many times over. In the end, many of the small companies that were unable to compete will disappear and the market will emerge with fewer players, each controlling a larger section of the market than in the beginning of this development. Sometimes, as many believe is the case currently in the telecommunications sector, one of these strong contenders will capture a large enough marketshare that they themselves become another monopoly by scale. Mergers and acquisitions can help play a role in this process. At this stage, prices tend to level, production levels and the market will eventually reach equilibrium. This has been the stage that has occurred in the telecommunications industry. Currently the market is in the stage where many of the smaller companies are beginning to fade into the sunset, and the few stable success stories are beginning to emerge. The main question that must be posed at this juncture in time is whether there is currently a monopoly either existing now, or arising in the telecommunications sector? The other question is to attempt to determine whether this trend will continue in the future or whether there will again be another restructuring in the telecommunications industry. It is expected that the data will demonstrate the trends described earlier in an emerging market and that the market will be found to be reaching a period of more stability and steadier, less explosive growth. No predictions regarding findings concerning the existence of a monopoly can be made at this time. Nor can predictions regarding future trends be revealed until the data for the final report is collected and analyzed. Conclusion The telecommunications industry is unique and previous models to product the existence of a monopoly have to this point proven inadequate. Many of them only apply in certain sectors of the market, while others are only applicable on a limited basis, such as in the rural local telephone industry. It is expected that the final model will draw from these previous models, but that it will have to be modified to fit the circumstances unique to the industry. The possibility exists that one model may not be adequate in assessing the entire telecommunications industry. A series of models may eventually have to be developed which are applicable in various markets, or situations in the market. This cannot be determined until the research is underway. Many of the models discussed in the literature review purport to have a wide applicability. However, upon closer Business Intelligence Journal - January, 2009 Vol.2 No.1

19 61 examination, it can be found that they were not adequately tested to make such claims. In addition, the samples for these tests were not selected according to a certain criteria. It cannot be determined if the sample sets used to make draw these conclusions contained markets that were similar in characteristic, or if the models were tested on a variety of markets under widely varying conditions. In order to make the types of claims made by these models, one would have to have more information on the markets and test conditions than was provided in the reports. The primary concern in developing the model or models that will be used to determine that existence of a monopoly will be certain to learn from past mistakes and not make the same mistakes as our predecessors. In order to avoid this conundrum, the research and test methods must include protocol for testing in various time periods under varying market conditions. In addition enough tests will have to be performed to make an accurate determination as to the applicability. The actual test results will have to be critically view to be certain that they are logical given what is qualitatively know about the market place. The entire industry will have to be tested as a whole, as well as the individual sectors separately. Only then can one make a determination as to the usefulness of the model in varying market conditions. Though the previous models have been criticized, they cannot be discounted altogether. They will still be useful as examples in developing the final model. Surprisingly, the labor union models for determining monopolies were initially revealed to hold the greatest promise for providing a basis for the model. The market is nationwide, yet local in nature. It involves many trades, all representing different markets. These markets are similar to the various subsectors in the telecommunications industry. The labor union models may provide an interesting ground for cross- testing our own model to determine if it applies in other industries as well. Today, the telecommunications industry is changing rapidly and there is a growing need to define what constitutes a monopoly in this sector. This research hopes to resolves the existing dilemma by developing and testing a model for predicting the existence, either now or in the future of monopolies. The telecommunications industry is unique and models developed in the past fail to meet the needs of this industry. It is hoped that the model developed as a result of this research will prove useful in settling the many questions surrounding anti-trust in the telecommunications market. Data Analysis Herfindahl-Hirschmann Index. According to Jorde and Teece (1992), the term Herfindahl-Hirschmann Index is a term used to refer to the total of the squares of the market shares of all actual competitors in any relevant market (Compaine & Gomery, 2000). This measure of concentration is increasingly being used in empirical work and is typically abbreviated to HHI (Sawyer, 1991, p. 29). This index is defined according to the number of firms in the industry (T), with the share of each firm (si) weighted by itself; while the concentration ratio places a weight of 1 on the share of the largest n firms and zero on the share of the other firms, this index places a weight equal to the share on the share of the firm. As a result, the index is able to incorporate information on all firms rather than just the largest n firms. In addition, the HHI can vary between a value of zero (where there are a large number of roughly equally sized firms) and unity (where there is just one firm) (Sawyer, 1991).

20 62 Business Intelligence Journal January Traditionally, economic criteria have been the only or at least the key criteria that have been used to determine the concentration in all industries; while the congressional debate over the Celler-Kefauver Amendment to Section 7 of the Clayton Act suggested that social and political criteria should be considered in antitrust proceedings, the amendment itself did not include such language (Compaine & Gomery, 2000). Consequently, the assessments of efficiency and entry to an industry are measured by such criteria as the percentage of industry revenue accounted for by the largest players, as well as by the more complex Herfindahl- Hirschmann Index. In the most conservative determination of oligopoly, proposed by Carl Kaysen and Donald Turner (1959, cited in Compaine & Gomery, 2000), the eight largest firms would have at least 33-1/3 percent of sales and the 20 largest at least 75 percent; this is called a type II oligopoly. In this calculation, the index number increases as the number of companies declines and the inequality in the largest and smallest increases; HHIs of 1,800 or greater represent industries of great concentration and index numbers at or below 1,000 are signs of no concentration; according to Compaine and Gomery (2000), From an antitrust viewpoint, an industry must reach a type I oligopoly, at which time the eight largest firms have 50 percent of receipts and the 20 largest at least 75 percent, before the concentration allows firms to charge prices and make profits above competitive levels and to misallocate resources (pp ). Among the various economic measures of concentration, the Herfindahl-Hirschmann Index (HHI) is one of the more robust because it reflects... the number and size distribution of firms in a market, as well as concentration of output (Compaine & Gomery, 2000, p. 558). As noted above, the HHI is calculated by squaring the market share of each player in the industry. Generally speaking, an HHI score of greater than 1,800 indicates a highly concentrated industry; a rate that is under 1,000 is regarded to be unconcentrated, with scores in between representing degrees of moderate concentration (Compaine & Gomery, 2000). In an example of an industry with 10 providers, the HHI has the ability to differentiate between a marketplace where the market is relatively equally divided and one where a few players hold most of the revenue. In example A, the three largest players account for 30 percent, 25 percent and 20 percent, respectively, of industry sales. The remaining seven divided up 25 percent about equally. This example has an HHI of 2,014, which is highly concentrated. By contrast, in example B, the largest firm has a 15 percent market share, the second firm 12 percent, the third 10 percent and the seven remaining firms roughly divide the remainder; the HHI in this industry is 1,036, which is a low concentration (Compaine & Gomery, 2000). Yet another study applied the HHI model to the book publishing industry from 1989 to 1994 (Greco, 1999). According to Greco s analysis of a media monopoly in the book publishing industry using the Herfindahl- Hirschman Index to ascertain whether Department of Justice antitrust guidelines were violated because of these mergers and acquisitions. Between 1960 and 1994, there were approximately 72,000 mergers and acquisitions in the United States. This metamorphosis captured the attention of scholars eager to understand the impact this transformation had on the business landscape (Greco, 1999, p. 165). This period followed several decades of apparent consolidation from mergers, including the 1970s period that resulted in the decision by the Federal Trade Commission to investigate media concentration in 1978 (Greco, 1999). Business Intelligence Journal - January, 2009 Vol.2 No.1

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