Robert Wilson for their comments on the a predecessor version of this paper.

Transcription

1 Procurng Unversal Telephone ervce Paul Mlgrom 1 tanford Unversty, August, 1997 Reprnted from 1997 Industry Economcs Conference Proceedngs, AGP Canberra Introducton One of the hallmarks of modern socety s ts pervasve relance on telecommuncatons. Progress n telecommuncatons has deeply changed the nature of socal relatons, poltcs and commerce. Indvduals and communtes wth lmted access to modern communcatons are dsadvantaged n ther efforts to keep abreast of current news, to partcpate n publc debates, and to make ther opnons known to the rest of the world. Busness frms need electronc communcatons to ntegrate ther far-flung operatons. Much more than n the past, frms can now depend on dstant supplers to be well enough nformed to react quckly to ther changng needs. Combnng rapd communcatons wth flexble manufacturng technologes enables frms to make customzed products that respond to ndvdual customers changng demands (Mlgrom and Roberts, 1987). When a geographc area s cut off from modern communcatons, that creates a tear n the socal fabrc, separatng the resdents from the rest of socety. That s perhaps the most compellng reason for a democratc socety to seek unversal access to modern telecommuncatons. There are also good economc reasons as well to ensure wdespread access by ndvdual members of communtes to the communcatons networks, partcularly the telephone network. For example, publc emergency servces polce hosptal and fre servce can be delvered more quckly and effectvely and at lower cost when households have quck and easy access to telephone servces. In addton, there are network externaltes, meanng that broadenng the communcatons network helps not only the newcomers but also those already on the network by enlargng the crcle of people wth whom they can communcate. For all these reasons, many countres have set near-unversal access to telecommuncatons servces as a polcy goal. Achevng such wdespread access to telephone servce s expensve for two reasons. Frst, some customers have such low ncomes that even modest telephone charges are unaffordable. In the Unted tates, programs desgned to subsdze telephone servce to low ncome customers are called lfelne servce programs. econd, the fxed cost per customer of nstallng access lnes to remote areas wth low populaton densty s very hgh. For example, establshng servce to customers lvng on farms and ranches n rural areas typcally requres runnng long wres through dffcult terran even though only a small group of telephone subscrbers s served. Even wthn urban areas, the costs of connectng dfferent customers to the telephone network can vary among customers by a factor of ten. Programs desgned to pay part of the cost of provdng servce to hgh cost areas are called unversal servce programs. In practce, mplementng a program of unversal, affordable access to basc telephone servce nvolves frst establshng what s to be ncluded n the basc telephone servce. 1 I am grateful to Yumko Baba, Hong-Bn Ca, Han Hong, Valter orana, John Woodbury and especally Robert Wlson for ther comments on the a predecessor verson of ths paper.

2 2 What optons should be avalable? What level of qualty should be mantaned? econd, an affordable prce must be establshed. Thrd, a servce provder or provders must be dentfed, and a means must be found of footng the bll. In the Unted tates, unversal servce has been mplctly subsdzed both through reduced prces for basc telephone servce supported by hgher prces for other telecommuncatons servces and through the use of unform telephone rates over wde areas. In Calforna, for example, even today, anyone n the area servced by the largest telephone company, Pacfc Bell, can purchase basc telephone servce for $11.25 per month. Ths prce s the same for hllsde dwellers n remote mountan communtes as for resdents of large apartment buldngs n downtown Los Angeles, even for apartments that are just a block away from the man telephone swtch. The phone company s cost per phone lne of hookng the apartment and ts resdents nto the system, though, s much lower than for the mountan dwellers, because a sngle short hgh capacty wre can be used to provde servce to all of the large buldng s resdents. The mplct subsdes n the system are enormous: one estmate for the subsdy to rural servce alone s about $5 bllon per year 2 and the estmated sze of all rural and urban subsdes s hgher stll. o long as local telephone servce s provded by monopoles that are free from compettve market constrants, ths system can be sustaned. In recent years, however, the local telephone monopoles have come under sege. New phone companes have sprung up to offer servces n places lke Manhattan (ntally for busness customers), where the hgh densty of telephone lnes makes the average cost of servce qute low. In the U, the passage of the Telecommuncatons Act of 1996, whch ams to reduce regulaton and ncrease competton n telecommuncatons, s destroyng the monopoles at the foundaton of a system of unform local servce prces for all customers. The Act provdes for the establshment of a fund to subsdze servce to customers n hgh-cost-of-servce areas. The Act also requres that the subsdy levels n each area be adequate to cover the unversal servce provder s costs. It s now the task of regulators to decde how to mplement the Act s provsons, keepng n mnd the two man goals of encouragng competton n the provson of telecommuncatons servces and keepng down the cost of subsdes (and the taxes needed to support them), as well as subsdary goals lke reducng the need for ongong regulaton. Wth these goals n mnd, two man knds of polcy optons have been dscussed. The frst calls for the use of an aucton n whch bdders name the prce they requre to accept a unversal servce oblgaton n a servce area. Ths means that the selected supplers stand ready to offer a prescrbed basc servce package at a prescrbed affordable prce. The advantage of ths opton s that competton among would-be unversal servce provders could drve down the necessary level of subsdes. Also, once auctons are conducted, there would be no further need for cost studes to determne approprate levels of subsdy to a monopoly telephone suppler. Nevertheless, ths opton s often regarded as unsatsfactory because t results n a sngle provder n each servce area. Wth nether competton nor regulaton to dscplne the sngle provder, there would be lttle pressure on t to ntroduce 2 What Prce Unversal ervce?: Impact of Deleveragng Natonwde Urban/Rural Rates, Telecommuncatons Industres Analyss Project, Cambrdge, MA., 1993.

3 3 new servces and mantan hgh standards of qualty. Also, new telephone provders may be able to brng valuable new servces, lke cheaper long-dstance callng, or packages ncludng telephone servce wth wreless or cable televson servces. Havng a sngle provder denes these potental new servces to customers. The second opton calls for estmatng the costs of provdng basc servce n each area and then makng that level of subsdy avalable to any company that s wllng to accept a unversal servce oblgaton for the area. Ths makes compettve entry relatvely easy, wth all the advantages that competton entals. However, t has two bg dsadvantages. Frst, because t bases subsdes on the exstng wrelne technology and gnores the revenues from new servces that mght be delvered over the telephone network, t locks n the subsdes at an unnecessarly hgh level. econd, t requres ongong regulatory nterventon n the form of both cost studes (to meet the legal and practcal requrement that subsdy levels are adequate) and coercve servce requrements on the ncumbent telephone company at the establshed subsdy levels. Each of these optons has advantages and dsadvantages. Across the Unted tates, the condtons of entry vary as well, wth some areas already home to local telephone competton and others where the prospect of competton seems dstant. These combned facts rase some obvous questons: Is t possble to talor the regulatory system to the local condtons? Is there a system that does that automatcally, wthout the need for an omnscent regulator to choose the proper regulatory nterventon? Is there a mechansm that s demonstrably optmal for the unversal servce problem n such vared envronments? An Optmal Aucton Mechansm for Unversal Telephone ervce In the process of answerng these questons, our analyss ntroduces an mportant new alternatve nto the polcy debate. Ths s an alternatve n whch the number and denttes of the compettors s determned by the market process tself, rather than beng set by fat as n tradtonal aucton proposals. In partcular, the new mechansm promotes dfferent market structures n dfferent geographc regons, as s certan to be approprate gven the very dfferent cost condtons that preval n dfferent areas. Compared to the older proposals, the new alternatve s more balanced n encouragng competton both n the market after the aucton, to promote better servce and more varety, and competton for the market n the aucton, to reduce the level of subsdes that need to be pad. 3 Because the actual stuaton n supplyng unversal telephone s so complex, the theoretcal analyss advanced here ams only to capture a few of the most mportant features of the real stuaton. We begn by specfyng the objectve of the whole exercse, whch s to maxmze a total welfare crteron or objectve consstng of three terms: Expected Benefts to Consumers + Expected Profts Enjoyed by ervce Provders α Expected ubsdes Pad to Provders The frst term s the benefts enjoyed by the consumers n an area, whch depends on the level of competton n the local telephone market. More compettors vyng for customers 3 ee Dana and per (1994) for a closely related analyss.

4 4 can lead to varous benefts for consumers, ncludng more varety, better servce offerngs, and more responsve servce. More compettors may lead to lower prces, too, f splttng the market does not ncrease costs too much. To account for the nterests of telephone company shareholders, we add the frm s profts to the socal objectve. These two ntal terms, however, do not nclude all the economc benefts and costs. The taxes or surcharges used to pay unversal servce subsdes dstort choces made n the economy and result n a loss of welfare. For example, f unversal servce were funded by a tax on long-dstance calls, that could result n fewer such calls beng made calls that would be made f the prce of long-dstance callng were not made artfcally hgh by the addtonal tax. The welfare loss from such dstortons s approxmately proportonal to the total subsdes pad; t s captured by the thrd term n the formal objectve. To smplfy the problem for ths presentaton, we make a number of assumptons whose sgnfcance we dscuss brefly at the end of ths lecture. We focus on the case where there s a sngle regon n whch unversal servce s to be provded and where all subsdes are pad n the form of a lump sum. There are assumed to be N bdders ndexed as =1,...,N. Each of the bdders has a cost type θ that determnes ts cost of provdng servce to some or all of the customers n the servce area. We may thnk of lower values of θ as correspondng to lower total and margnal costs for frm allowng t to earn greater profts n any partcular compettve stuaton. Let θ denote the N-tuple (θ 1,...,θ N ). Let π (θ,) denote the proft earned by frm when the set of frms recevng subsdes to accept the unversal servce oblgaton s and let B(θ,) denote the benefts enjoyed by consumers. We assume that (1) both consumer benefts B(θ,) and each frm s operatng profts π (θ,) are ndependent of the types (θ, ) of the frms not actually present and provdng telephone servce, (2) a frm can earn profts only f t s authorzed to supply subsdzed servce, that s, π (θ,)=0 f, (3) π (θ,) s contnuously dfferentable n θ, and (4) for all θ and all, profts are decreasng n θ : π (θ,) π θ < 0 and non-ncreasng n the set of compettors. The aucton that s mplemented, ncludng the rules for the knds of bds that can be made and the way frms behave n the aucton game, determnes whch frms wll receve subsdes n exchange for bearng the unversal servce oblgaton and what subsdy payments they wll receve. The actual outcome of the aucton cannot be predcted n advance because t depends, of course, on the cost types θ. One can descrbe the lkely outcomes by a set of functons whch express the probabltes p (θ) that wll be the set of frms selected to be supplers when the cost types are gven by θ and the correspondng expected levels of subsdy payments x (θ) to each frm. Wth the outcomes descrbed n ths way, the correspondng expected level of welfare, gven θ, s: p ( θ) B( θ, ) + p ( θ) π ( θ, ) α x ( θ). The three terms n ths objectve correspond to the consumer benefts, profts and burden of taxaton term n the welfare calculaton. The expected value of the welfare measure s to be maxmzed by choosng functons p (θ) and x (θ) (=1,...,N) correspondng to a feasble aucton and assocated bddng N =1

5 5 behavor. For the expected value calculaton, we assume that the θ s are ndependent and dstrbuted accordng to dstrbuton functons F wth correspondng denstes f, =1,...,N. Thus, expected welfare s: z L N M F I O p ( θ) B( θ, ) + π ( θ, ) α x ( θ) f ( θ) dθ =1 P N HG In order to characterze the maxmum n ths problem, one frst must characterze the constrants on the p and x functons that are mpled by our postulates concernng how the bdders wll behave. We assume that the bdders wll play the Nash equlbrum strateges of whatever aucton game we may desgn and, f there are multple equlbra, that the bdders wll play the equlbrum selected by the mechansm desgner. To solve the maxmzaton problem, we utlze technques frst developed n the Roger Myerson s 1981 analyss of auctons that maxmze the seller s expected revenues. The full detals of the mathematcal analyss wll not be reported here. What Myerson s analyss demonstrates s that the p functons combned wth the avodance of unnecessary subsdes to losng bdders combne to determne unquely the necessary expected subsdy levels E[x (θ) θ ]. Ths allows one to substtute for x n the objectve functon, rewrtng t as the expectaton of the followng alternatve objectve functon: where p KJ ( θ) V(, θ) V B F ( θ ) (, θ) = ( θ, ) + ( 1 + α) π ( θ, ) + απ ( θ, ). f ( θ ) F HG The functon V(,θ) s called the vrtual welfare functon. We lmt attenton here to what we may call the regular case, whch s characterzed by two assumptons about the functon V(,θ). The frst s that t s more attractve to add low-cost types θ than hgh cost types. We wrte ths as a decreasng dfferences condton: V( {},θ)-v(,θ) s decreasng n θ. The second condton s that frms and types may be ranked by an ndex such that V- maxmzng collecton of frms conssts of some number of frms wth the hghest ndex values. Varous partcular assumptons may be made whch mply ths structure. The upshot of the analyss s the followng: Proposton. In the regular case, an aucton desgn s optmal f and only f t results n outcomes n whch (1) for almost every θ, p (θ)=1 for the maxmzes V(,θ) and (2) the expected net profts (gross proft plus subsdy) of the hghest cost types are zero. A strkng aspect of the optmal aucton s that t calls for the market structure to be endogenous. Ths means that the number of frms partcpatng n the market may depend on the frms cost characterstcs, whch are the prvate nformaton of the varous frms. If there are several ndependent regons n whch unversal servce s to be suppled, the result s that dfferent numbers of compettors may be present n each, accordng to the prvately known cost nformaton of the frms. Q I KJ

6 6 In determnng the optmal set of frms to nclude n the market, the profts of the frms are gven extra weght n the vrtual welfare functon compared to the orgnal socal objectve: t s multpled by 1+α. In addton, V(,θ) ncludes terms (F j /f j ) to account for the bddng ncentves of the frms. Awardng unversal servce subsdes to many frms tends to reduce the ncentve of each frm to bd aggressvely, snce even a less aggressve bd s more lkely to result n a reward. Therefore, unless there are dseconomes of scale (whch s unlkely n practce), one consequence of desgnng an aucton to allow multple unversal servce provders s hgher average subsdes. An optmal aucton desgn takes that effect nto account, typcally reducng the number of frms both to ncrease pre-subsdy ndustry profts and to ncrease the ntensty of competton for the market. Although the frst part of the Proposton dentfes qute specfcally the crteron for who the wnners n an optmal aucton should be, the Proposton does not specfy a unque rule for how payments should be made. Rather, the second part of the Proposton specfes only that hgh cost types should expect zero profts, that s, that no unnecessary subsdes should be pad. The multplcty of optmal payment rules means that there s scope for usng the payment rule to pursue secondary objectves. One such objectve s to arrange that each bdder has a domnant strategy. The advantages of domnant strateges were frst dentfed by Vckrey (1961), who emphasze that these smplfy the bdders problem, avodng potentally costly errors and provdng no ncentve for bdders to make wasteful expendtures tryng to guess each other s bds. The basc rule for makng truthful reportng of cost data a domnant strategy s also one that Vckrey (1961) had dentfed. One acheves that by payng each seller for hs supply an amount equal to what he could extract as a perfectly prce dscrmnatng monopolst [aganst the resdual demand curve]. In ths case, the analogous rule s as follows: For each θ, pay frm j a subsdy that makes ts post-subsdy proft equal to the ncrease n the maxmal value of the vrtual welfare functon, V(,θ), that results from expandng the set of avalable frms N\{j} to N. Ths rule mplements the allocaton dentfed n the Proposton, and makes truthful reportng a domnant strategy. Another possble secondary objectve s to pay unform subsdes to all subsdzed unversal servce supplers. There may be legal reasons to prefer unform subsdes. Unform per subscrber subsdes may also be desred because they avod advantagng any partcular compettor when the competton for customers begns. Although unform subsdes are possble, t s not possble to acheve both unform subsdes and domnant strategy mplementaton of the optmal aucton. Lmtatons and Possble Extensons The foregong analyss s a prelmnary one that s valuable because t ntroduces a new opton. However, the recommended soluton s only as good as the underlyng model. The model tself has several lmtatons. One of the most mportant assumptons of the model s that subsdes are pad n the form of a lump sum, regardless of the number of subscrbers served. In realty, lump sum subsdes have some undesrable ncentve propertes. Bdders have weaker ncentves to provde good servce f the subsdes are ndependent of the number of customers served. Indeed, because

7 7 subsdes are needed only for hgh-cost customers for whom servce s unremuneratve, t s necessarly wrong to suppose that servce would be provded at all, let alone at the same level, f subsdy levels were low. To put the pont more generally, the level of subsdes s lkely to affect the ntensty of competton among supplers, and the exstng model fals to account for that. A second potentally mportant omsson concerns varatons n costs among customers n the area of unversal servce. If the cost varatons are large across the servce area, frms may be tempted to offer servce only to the customers n the lowest cost segments of the servce area. That problem could be resolved by runnng auctons for smaller, more homogenous areas, and ndeed such a proposal has been made n the Unted tates. However, f small servce areas are specfed for the aucton, t may be napproprate to consder the costs of servce separately for each area, because there could be mportant shared costs among them. As of the date of ths lecture, the mportance of such shared costs for unversal servce remans an open queston. A thrd pont concerns how the aucton wll operate when some of the servce provders purchase some of ther nputs from an ncumbent telephone company. In the Unted tates, the law governng local competton requres the ncumbent to provde unbundled network elements at regulated prces, whch confounds the queston of whether the aucton can help to dentfy the low-cost provders. Fourth s the need to account for possble dependences among areas n desgnng the aucton. One sgnfcant possblty s that the cost of servng a set of adjacent areas s sgnfcantly reduced when a sngle frm serves them all. In that case, there are two practcal approaches possble. The frst approach treats the several areas as a sngle unt. That works tolerably well when the same groupngs are approprate for all the bdders. The second approach s more complcated but also more flexble. It nvolves allowng bdders to specfy bds for combnatons of areas and then selectng wnners to take account of these economes of scope. Aucton desgns lke that are stll novel and unproved, but some promsng desgns are currently beng tested for other applcatons. Fnally, durng the transton to compettve provson of local telephone servce n the Unted tates, the ncumbent local exchange carrers contnue to have a specal oblgaton to offer servce. The analyss suggested here has been vague about the detals of how the transton wll be made. The tmng of auctons n dfferent servce areas could be mportant, as could ssues about the relaton of the aucton rules to other local competton rules. All of these detals need to be worked out carefully f unversal servce auctons are to be successfully mplemented. Concluson Competton n provdng local servce has made obsolete the old model of a monopoly provdng servce at a unform rate over wde servce areas. Yet, for a wde varety of poltcal, socal and economc reasons, t s desrable to have affordable servce even to relatvely remote communtes. Up to now, the ways of achevng that goal have ether nvolved contnued regulaton or an aucton that preserves monopoly supply status for some frm.

8 8 Our new proposal combnes the advantages of an aucton scheme, n whch bddng keeps burdensome subsdes low and avods the need for detaled prce regulaton, wth those of a fxed prce free entry scheme, n whch the number of enterng frms depends on market condtons. Although many detals reman to be specfed, ths approach offers the promse of a mechansm that can be appled flexbly to balance the several conflctng objectves n establshng a unversal servce plan.

9 9 References Dana, James and Kathryn per, Desgnng a Prvate Industry, Journal of Publc Economcs 53 (1994): Mlgrom, Paul, Procurng Unversal ervce: Puttng Aucton Theory to Work, n Le Prx Nobel: The Nobel Przes, 1996, Nobel Foundaton, 1997, Mlgrom, Paul and John Roberts, Communcaton and Inventores as ubsttutes n Organzng Producton, candnavan Journal of Economcs, 90, 1988, Myerson, Roger, Optmal Aucton Desgn, Mathematcs of Operatons Research 6 (1981): Vckrey, Wllam, Counterspeculaton, Auctons and Compettve ealed Tenders, Journal of Fnance, 1961: Vckrey, Wllam, Auctons and Bddng Games, n Recent Advances n Game Theory, Prnceton: Prnceton Unversty Press, 1962.