Response to Submissions on GSM Termination

by

Joshua S. Gans and Stephen King

University of Melbourne

24th February, 2000

 Executive Summary
Gans and King (1999a) and Gans (1999) analyse the competitive effects that influence
termination charges for fixed to mobile calls. Following the publication of these
papers, there has been considerable debate about the validity of the modelling
procedure used and the specific pricing recommendation that followed from the
models. In this response, we consider some of the important points raised in the
debate. In particular we concentrate on issues that suggest a misunderstanding of
our model and potential extensions of our analysis.

Our model involved a number of explicit assumptions that, in our opinion,

provide a reasonable characterisation of the mobile phone market in Australia. The
empirical validity of some of these assumptions has been questioned. In response to
this, we highlight the role of these assumptions and note the implications, if any, of
relaxing some of these assumptions. In particular, we show that even in the absence
of customer ignorance, in a model where mobile phone subscribers also gain utility
from receiving fixed to mobile calls, competition between mobile carriers will not, in
general, lead to socially efficient termination charges.

A number of factors that were omitted from our model have been raised. In
particular, it has been suggested that there might be a positive network externality
associated with lowering mobile subscription charges. It has been argued that this
implies that current termination charges should not be lowered. We note that this
implication is incorrect. Rather, the existence of a positive network externality might
justify the regulation of termination charges above marginal cost if there was no
more appropriate instrument available. However, there is no reason to think that
current termination charges correctly address this externality.

There have been a number of responses that have suggested structural reforms
similar to those suggested in Gans and King (1999a). We clearly support such reform.
Alternative pricing rules have also been suggested. We briefly consider some of these
alternatives, but find them unpersuasive.

Finally, we clarify the link between investment, entry and termination charges,
noting that our analysis implies that any link between these factors is, at best,
ambiguous.
Contents Page

1 Introduction.............................................................................1

2 Sources of Market Power......................................................3

2.1 Customer Ignorance ...................................................... 3

2.2 Relaxing the Assumptions............................................. 5

2.3 Market Context .............................................................. 6

2.4 Structural Change.......................................................... 9

3 Regulated Pricing Options.................................................11

4 Mobile Penetration ..............................................................14

5 Investment and Entry Incentives......................................15

6 Usefulness of Academic Models.......................................17

7 Appendix ...............................................................................18
7.1 Non-linear pricing ........................................................18

7.2 Uniform pricing ............................................................20

8 References..............................................................................22

February 2000 i
Section 1 Introduction

1 Introduction

In November and December 1999, we wrote two papers on the

subject of mobile network termination charges. The first, Gans and
King (1999a) was a detailed exposition of research we conducted into
the nature of competition in mobile telephony, including the
relationship between mobile and fixed line markets. The analysis was
explicitly academic in nature and represented what we believed to be a
first cut at an economic analysis of anti-competitive concerns and
potential regulatory solutions. The second paper by Gans (1999) was
essentially a lay summary of the findings of our research with some
suggestions as to how that research might be applied to regulatory
settings; specifically, the determination of regulated prices.

Both papers were explicit in the limitations of the analysis and

focussed on theoretical rather than empirical details because of the
paucity of data on the latter. The goal of the research was to provide a
clearer understanding of pricing benchmarks that might be achieved
with respect to the termination of mobile calls. However, because of
the sheer complexity of the issues and the numbers of interacting
prices, we conducted a static analysis and did not consider dynamic
issues such as mobile penetration and investment incentives in detail. 1
Although we note that our analysis did have implications for each of
these (something we elaborate on below).

This paper is a response to submissions received in relation to

both Gans (1999) and Gans and King (1999a). Many of the submissions
simply re-state the concerns and limitations that we already noted in
those papers. Some do build on our study and attempt to quantify
some outcomes. In particular, in a paper written contemporaneously
with our own, Wright (2000) develops a very similar theoretical model
of mobile competition and comes to the same conclusion as us on a
number of key issues. His paper focuses exclusively on fixed-to-mobile

1 We are not aware of any analysis of interconnection regulation in telecommunications that explicitly
considers these dynamic forces. Laffont, Rey and Tirole (1998a, 1998b), Armstrong (1998) and Carter
and Wright (1999) each consider a telecommunications market with full coverage by at least one
network. Wright (2000) does endogenise the degree of mobile penetration but does not conduct a pure
theoretical analysis; only a numerical simulation. No research models investment decisions explicitly.

February 2000 1
Section 1 Introduction

termination but does contain numerical results on the interaction

between termination charges and mobile penetration. We will
comment on the relationship between our results and his below.

From the submissions received, we realise that some of the

issues we raised appear to be misunderstood and could be clarified.
Also, in response to the limitations of our study – especially with
regard to the welfare implications – we have developed our model
further and are now able to provide further insight into the competitive
forces that effect mobile termination charges.

February 2000 2
Section 2 Sources of Market Power

2 Sources of Market Power

A persistent issue raised through the submissions of incumbent

mobile carriers was the source of market power by those carriers in the
provision of a terminating service. It should be emphasised that it was
our assumption that the GSM terminating service declaration was not
being revisited. Hence, analysis of the sources of any inefficiency in
pricing – including those arising from the presence of market power –
was only relevant insofar as it assisted in the analysis of the
appropriate means of price regulation.

Our analysis was based on the assumption that competition for

mobile customers by mobile carriers was reasonably competitive with
deviations from perfect competition arising from product
differentiation and not from barriers to entry per se.2 Given this, in our
view, there were two factors that were principally responsible for a
lack of competition in GSM terminating services: (1) (fixed -to-mobile)
customer ignorance and (2) the weight placed by mobile subscribers on
calls that they pay for relative to calls that they receive. We noted in
our original paper that if customer ignorance holds, then having the
mobile subscriber care about incoming call volumes does not alter the
results. Hence, we confine out comments here to a discussion of the
customer ignorance assumption.

2.1 Customer Ignorance

When looking at fixed -to-mobile calls, we assumed that the

fixed line customers making those calls either could not tell the mobile
carrier the person they were calling subscribed to or could not
distinguish any differences in fixed-to-mobile call prices between
mobile carriers. The implication of this assumption was that in setting
fixed-to-mobile call prices, the incumbent carrier would look to
average termination cost and effectively set the same price regardless

2 We are aware that there is disagreement among market participants over the extent of entry barriers so
that our assumption would require empirical verification.

February 2000 3
Section 2 Sources of Market Power

of the network its consumers were calling. 3 Notice that this involved an
implicit assumption that fixed -line customers knew the market shares
of respective mobile carriers. From some of the submissions, it is
unclear that the mobile carriers themselves know these shares
precisely. So customers may in fact be more ignorant than we have
assumed.

The direct implication of customer ignorance is that if a mobile

carrier were to reduce its termination charge, this would increase the
quantity of fixed-to-mobile calls to all networks; not just its own. So, in
contrast to a competitive market, a reduction in its termination charges
would not result in a mobile carrier receiving a greater share of the
market of fixed -to-mobile calls. Consequently, price competition
cannot be relied upon to place downward pressure on termination
charges. Indeed, a mobile carrier can raise its termination charges and
not suffer a drastic reduction in termination revenue – the classic
definition of market power.

Notice that this link between customer ignorance and market

power in mobile termination does not change if mobile subscribers care
about the value of incoming calls as well as outgoing calls. If a mobile
subscriber cares about incoming calls, they might be concerned that
high termination charges would result in higher fixed-to-mobile prices
and a reduction in incoming calls. However, to the extent that there is
ignorance among fixed-line customers, an increase in one mobile
carrier’s termination charges does not alter the price of a fixed-to-
mobile call to that network relative to other networks. Hence, it is not a
factor in causing a mobile subscriber to favour one mobile network
over another as the effect of customer ignorance is to equalise the
incoming call rate across networks. So even if mobile subscribers care
about fixed-to-mobile call prices indirectly through a preference for
incoming calls, this will not alter the relative benefits of subscribing to
one network or another.4

3 This is a common assumption in the analysis of network competition. Usually, however, it is not an
assumption of customer ignorance that motivates this assumption but one of no price discrimination
between on- and off-network calls. See Armstrong (1998), Laffont, Rey and Tirole (1998a) and Carter
and Wright (1999). Wright (2000) also makes this assumption in a model of mobile competition without
explicitly relating it to customer ignorance. Laffont, Rey and Tirole (1998b) and Gans and King (1999a,
1999b) relax this assumption.

4 In exploring the implications of customer ignorance, we concluded that once a mobile subscriber had
joined a network, that network had market power over access to that customer. In stating this we made
an implicit assumption that the mobile customer and fixed-line customer could not agree that the caller
be that person who bares the lowest call cost (likely to be the mobile subscriber). If they could agree to

February 2000 4
Section 2 Sources of Market Power

In the end, the extent of customer ignorance is an empirical

issue. Several submissions claimed substantial differences in
termination charges and fixed -to-mobile call prices among networks;
however, the information we were provided on retail prices suggested
the differences were small. Other submissions noted that for repeat
calls, fixed -line customers will perceive differences among call charges
to respective mobile networks and to the extent that this effects the
termination revenues received by mobile carriers, it will encourage
competition in termination.5 Nonetheless, as yet no study has been
made regarding the extent of customer ignorance in Australia. We,
however, would regard evidence that large numbers of customers
could perceive mobile network and fixed -to-mobile call price
differentials as evidence of a reduction in the degree of market power
mobile carriers have over termination pricing.

2.2 Relaxing the Assumptions

Some submissions suggested that if (a) there is no customer

ignorance and (b) mobile subscribers care about the quantity of calls
they receive, then competition between mobile networks will lead to
efficient termination charges and eliminate any concerns regarding
market power over termination. In the appendix we provide a simple
model to show that this proposition is false. In fact, mobile network
competition will never be sufficient to align termination charges with
socially desirable prices. Rather, termination charges will always be too
high except under the trivial case where it is socially desirable to have
no fixed-to-mobile calls.

The logic behind this result is simple. Competition maximizes

the benefits received by mobile subscribers. But the benefits that the

this then there would be some substitution among mobile-to-fixed and fixed-to-mobile calls; they would
compete with one another. This would mean that a higher fixed-to-mobile call price would result in more
calls being made from mobiles to the fixed network. However, it is not obvious whether this would tend
to increase or decrease mobile termination charges. Any attempt to model this substitution would need to
exolicitly consider the interaction between fixed and mobile subscribers. Further, if the evidence in some
submissions regarding the inelasticity of demand for fixed-to-mobile calls is correct, then call
substitution does not appear to be present in the Australian context.

5 Indeed, when considering mobile-to-mobile termination we assumed that customers were not ignorant
and conducted our analysis on the basis that they could perceive differences between on- and off-
network calls. This is reinforced by the advertising and packages that mobile networks offer for calls that
terminate on their own networks.

February 2000 5
Section 2 Sources of Market Power

mobile subsc riber gains from an incoming call are only part of the
social benefit from that call. The fixed carrier customer making the call
also receives a benefit. Because mobile competition ignores this fixed
customer benefit, it always pays the mobile carriers to increase
termination charges above the socially optimal level and gain extra
termination revenues. While this makes the mobile subscriber worse
off, the subscriber is more than compensated when competition forces
the termination revenues to be passed back to the subscriber through
lowered charges for other services.

In this respect, our two assumptions that led to market power

over termination, while important, are not necessary to establish the
presence of inefficient pricing of fixed-to-mobile calls.

2.3 Market Context

In relation to market power, a final criticism levelled at our

analysis was a neglect of market conditions in the mobile industry in
Australia. In particular, it was argued that pre-selection of fixed-to-
mobile providers and the fact that mobile and fixed carriers negotiated
outcomes rather than independently set charges would make
termination services more competitive and result in more efficient
pricing than our model predicted.6 Our initial paper (Gans and King,
1999a) dealt with each of these issues and clearly stated the
implications of each for our analysis. We briefly re-state those results
here.

With regard to pre-selection, it was noted that our main model

assumed that there was a dominant fixed -line carrier that had control
over fixed-to-mobile prices. Mobile pre-selection has meant that those
prices are in fact controlled by long-distance carriers and are offered as
part of a bundle with those services. We argued that mobile pre-
selection would change the strategic interaction between fixed and
mobile carriers and might lead to a reduction in fixed to mobile prices.
However, by itself, mobile pre-selection does not reduce customer
ignorance and does not diminish the market power held by mobile

6There was also the issue of Telstra’s price cap that influenced the balance of its call prices. This issue
has been reduced by mobile pre-selection but may constrain Telstra's ability to pass on high termination
charges to its fixed-line customers.

February 2000 6
Section 2 Sources of Market Power

carriers over termination charges. There was no additional competitive

pressure there.

It was also emphasised in several submissions that termination

charges are not simply set by mobile carriers but are the result of
negotiations between mobile and fixed -line carriers. In our paper, we
lauded such negotiations as removing the ‘double marginalisation’
problem and hence, would likely see reciprocal termination charges set
at marginal termination cost. However, we did note that this outcome
may not arise were the fixed-line operator to use its market power to
favour one mobile carrier (or its own integrated mobile carrier) over
others. Nonetheless, given the ACCC’s powers in relation to anti-
competitive conduct in telecommunications, we would be surprised if
carriers could achieve such leverage of market power.

However, some submissions noted that negotiated outcomes

could also resolve the externalities that arose from horizontal
separation of mobile carriers. We had argued that when termination
charges are set, mobile carriers neglect the negative impact a higher
termination charge has on the termination revenue of other mobile
carriers. Hence, even in the absence of a ‘double marginalisation’ issue
on the vertical side, termination charges are set too high. Several
submissions appeared to claim that such horizontal externalities were
also taken into account through negotiations:

A non-dominant carrier selling termination services to another

carrier (whether a dominant carrier or a non-dominant carrier) is
usually a buyer of services from that other carrier. This creates a
commercial dynamic between the carriers which is more likely to
produce a commercially acceptable and reasonably efficient outcome
on termination.

In addition, mobile termination for fixed-to-mobile and mobile-to-

mobile calls are general ly negotiated as a bundle, and at similar
rates. (Optus submission, p.55)

Failure to Recognise Complex Bargaining Framework – Many carriers act

in numerous roles in the end-to-end supply of retail services and the
provision of access. The reciprocity between networks in terms of
mutual supply and demand for termination services provides a more
complex bargaining framework than the model postulated in the
Gans Paper. (Vodafone submission p.28)

In our paper, while we recognised that negotiations could eliminate

double marginalisation difficulties and obviate the need for arbitration
based on this type of inefficiency, we had not considered that a ‘more

February 2000 7
Section 2 Sources of Market Power

complex’ bargaining interaction occurred and are not sure what

elements this would include. Certainly such interactions could not
include mutual agreement over termination charges for fixed calls
because this may violate s45 of the Trade Practices Act. We would,
therefore, welcome further elaboration on the scope of such
negotiations from those carriers.

A number of submissions emphasised the immature state of the

mobile market in Australia, noting that mobile penetration is
increasing. These submissions also argued that setting lower
termination charges would necessarily harm the take-up of mobile
phones by new subscribers. Unfortunately, our analysis suggests that
this argument, at best, is ambiguous. If each mobile carrier ignores any
adverse spillover from its own termination charges on the termination
revenues of its competitors, then from the mobile industry perspective
as a whole, termination charges can be set too high. Put simply, all
carriers might be better off if they can co-ordinate to set lower
termination charges. If this were the case, then lower regulated
termination charges could raise total termination revenues for mobile
carriers and lead to more intense competition for new subscribers.
Regulating termination charges would then increase mobile subscriber
penetration.

Clearly, the relationship between changes to termination

charges and total industry termination revenues is an empirical matter
about which we currently have no information. We would be grateful
if any of the parties could provide evidence on this relationship.

Some submission also claimed that current levels of mobile

penetration in Australia are below the social optimum. However, there
was no evidence provided to support this contention.7 Cross-country
comparisons are clearly of little help here, unless it can be argued
which countries do have socially optimal mobile penetration. There
seemed to be a view in some of the submissions that greater mobile
penetration was socially desirable, although no economic argument to
support such a contention was presented.

The submission from Optus argued that mobile penetration

involves a network externality. It is far from clear that there is a

7 Wright (2000, p3) notes that if there are positive network externalities from mobile penetration and
imperfect competition between mobile networks then we would expect that penetration rates would tend
to be too low from a social perspective. We discuss Dr Wright's results in more detail below.

February 2000 8
Section 2 Sources of Market Power

standard network externality associated with mobile phones. In other

words, it is not clear that the value to one consumer of having a mobile
phone is increasing in the number of other consumers who have
mobile phones. This said, there might be a positive externality from
mobile phone penetration in the sense that when one person subscribes
to a mobile service this creates benefits for other people who wish to
reach that subscriber. However, it is far from clear that this externality
is large or important. Again, it would be useful to have empirical data
that shows whether this externality is non-trivial.

2.4 Structural Change

The principle conclusion of our research paper (Gans and King,

1999a, 2000) was that some simple structural changes to the industry
could substantially eliminate the need for pricing regulation of
termination charges.8 In particular, we saw a benefit of direct charging
to fixed line customers by mobile carriers for termination (as a retail
rather than wholesale service) and also the provision of changes that
may increase customer identification. We saw these as potentially less
costly and more effective at generating efficient pricing than direct
regulation of termination charges.

We, therefore, welcome the suggestions in a number of

submissions advocating such change.

If a problem does exist and were significant, much less

distortionary policies may well exist in place of price regulation.
Since Prof. Gans identifies calling party ignorance (lack of
knowledge) as the main problem, the ACCC could require mobile
networks to identify themselves when a call is made. For example,
in the U.S. when a long distance call is made on the AT&T landline
network, AT&T identifies itself and gives the time in the destination
city. If the ACCC determined that a significant market failure exists
for terminating mobile calls, a brief message could be inserted in the
message by the mobile switch (MTSO) that would identify the
terminating network. The calling party could then hang up if the
price exceeded the value of the call.9 Thus, the calling party

8Gans (1999) focussed exclusively on options for regulation of termination charges at the request of the
ACCC.

9 This solution is even easier to implement for 1-800 type mobile calls, which Prof. Gans considers (p.
22). The recipient of such calls can program its switch to use the ANI information to reject calls that it
believes have a charge higher than the value of the calls. While some 1-800 recipients may not have an

February 2000 9
Section 2 Sources of Market Power

ignorance market failure assumption of Prof. Gans would cease to

exist. (Hausman, pp.22-23)

There are a number of ways of addressing the issue of consumer

ignorance. Gans and King have suggested a number of methods to
overcome any consumer information shortfall.10 One alternative is
to allow the mobile carrier to directly set the price of terminations to
fixed line callers. It is not clear under their proposal which carrier
sets the retail price of the call, or if in fact they are suggesting
regulatory control of retail prices. If the mobile carrier were to set
the retail prices, then this methodology also overcomes issues
associated with lack of pass through. It is the regulatory regime
adopted in some overseas jurisdictions, including France and Fiji.

An alternative, and perhaps more acceptable, way to overcome

the issue of consumer ignorance and lack of pass through would be
to accelerated the introduction of multi-basket pre-selection, with the
second basket to comprise fixed-to-mobile calls. This would ensure
that pre-selected carriers focus on both educating consumers and
competing for existing and potential customers on the basis of their
fixed-to mobile call charges. It would also allow the standalone
mobile operators to more easily enter this market space, putting even
more emphasis on consumer education and price competition, and
thereby reducing further any double marginalisation effects.

It must be emphasised that, where these problems exist, they

must be dealt with at source, not via any indirect or distortionary
regulation of mobile terminating access charges. As Lexecon has
stated, “a focus on creation of conditions conducive to effective
competition will typically be the most productive approach for
public policy in markets where competition is feasible”.11 (Vodafone
submission, p.33)

We wholeheartedly agree with these policies and would encourage the

ACCC to reconsider the need for precise regulation of termination
charges12 if mobile carriers introduced such structural changes.

on-premise switch, the large majority will have a switch that can be easily programmed to recognize the
originating mobile network for a given call. Thus, “customer ignorance” cannot be a problem.

10 See Gans and King, 1999, p22. See also the Choe/Jayasiriya annexure.

11 Lexecon annexure, p15.

12Qualified to the extent that there is some dominance of the fixed line network and that there currently
exist a variety of regulatory controls on the dominant fixed line carrier.

February 2000 10
Section 3 Regulated Pricing Options

3 Regulated Pricing Options

In terms of regulated pricing options, we argued that if

termination charges were set at marginal termination cost then this
would lead to a more efficient level of mobile and fixed-to-mobile
prices than in the absence of regulation. Basically, in the absence of
regulation termination charges would rise to undesirably high levels.
In the extreme, these charges could rise to a level that ‘chokes off’ the
demand for fixed-to-mobile calls. This is because taking into account
competition among mobile networks for subscribers, mobile carrier
profits depended on the relative level of their termination revenues so
that, under customer ignorance, increasing termination charges always
increase an individual mobile carrier's profits (although they may
decrease total mobile carrier profits). In equilibrium, termination
charges would be too high and both consumers and mobile and fixed
line carriers would benefit from a reduction in such charges. By
reducing them to marginal termination cost, this would remove
potential cross-subsidisation from termination services as a
competitive instrument and reduce pricing distortions. 13

Some submissions argued that our conclusions differed from the

result of Wright (2000) in essentially the same model; implying that our
results were perhaps incorrect. This, however, is not the case and in
fact all of the theoretical results in Wright’s paper are identical to our
own.14 In particular, in Proposition 4, Wright states that when there is a
monopoly fixed-line carrier, total surplus will be maximised if mobile
termination charges are set below cost; a result that also applies for the
case where the fixed line monopolist is integrated with one mobile
carrier. In that same proposition, Wright also states that consumer
surplus will be maximised if mobile termination charges are set above

13 Vodafone object to the use of marginal cost as a benchmark for termination pricing as it argued that
marginal termination cost was, in fact, zero and this would result in zero termination charges. The
possibility that marginal termination cost may be zero does not alter the conclusion. However, we did
find the argument interesting in light of the concerns of other carriers that it would be difficult to
measure marginal cost. If it is in fact zero, then on-going regulation at marginal cost is unlikely to
generate an undue regulatory resource burden.

14 Wright’s (2000) theoretical results, like our own, are all based on an assumption of 100 percent mobile
penetration. In the latter part of his paper he does some numerical simulation of what will happen with
less than 100 percent mobile penetration and we comment on those results below.

February 2000 11
Section 3 Regulated Pricing Options

cost. It is interesting to us that the submissions of some mobile carriers

should focus on consumer surplus as the appropriate goal for
regulatory policy-making. In our paper, we concentrated on total
surplus that included both consumer surplus and the profits of
telecommunications networks as the appropriate measure for policy.
What the submissions that focussed on consumer surplus are
suggesting is that they are willing to sacrifice profits for the good of
consumers.

A number of submissions provide alternative pricing rules to

setting termination charges equal to marginal cost. Some of these
suggestions are relatively standard. For example, TSLIRIC is suggested
as a cap for termination charges. However, as noted in Gans (1999), it is
far from obvious that a price based on incremental cost would
significantly exceed marginal cost. In particular, given that a particular
subscriber is connected to a mobile network and is provided with call
originating services, there would seem to be relatively few additional
fixed or common costs that are generated by providing that subscriber
with fixed-to-mobile termination services.

If TSLRIC did significantly exceed marginal cost, then it is not

obvious that pricing on the basis of TSLRIC would have any efficiency
benefits and might have significant costs. To the degree that mobile
charges (including termination charges) can be set as non-linear prices,
there seems to be no economic argument as to why the marginal price
for termination should be set using an average cost standard such as
TSLRIC. If the use of non-linear prices were not possible then, as
Professor Hausman notes in his submission, second best efficient
pricing would be based on Ramsey-type formulae. There is no reason
why these prices would equate with TSLRIC. This said, we have seen
no evidence to suggest that non-linear pricing is not possible.

An implication of the submission by Professor Hausman is that

uniform Ramsey pricing might provide an appropriate form of
regulation for termination charges. Of course, uniform Ramsey pricing
would only be an appropriate regulatory option if non-linear pricing
were not possible. In the appendix we calculate the relevant formulae
for optimal linear Ramsey pricing under the assumption that there is
no customer ignorance and that the mobile subscriber cares about the
quantity of fixed to mobile calls that they receive. It should be noted
that the correct Ramsey rule in this situation is not a simple inverse
elasticity formula. Rather, the standard inverse elasticity rule is
reduced to allow for the positive externality created by the fixed line

February 2000 12
Section 3 Regulated Pricing Options

caller when ringing the mobile subscriber. This said, the Ramsey prices
will be related to the inverse elasticity of demand.

Any implementation of uniform Ramsey pricing to fixed to

mobile termination charges involves a number of steps. First, it is
necessary to show the limitations on non-linear pricing, to justify the
use of second-best linear prices. Second, the correct Ramsey formulae
need to be calculated given the structure of the mobile phone industry.
As noted in the appendix, the relevant Ramsey rules are unlikely to be
the simple 'textbook' formulae. Third, the amount of capital required to
be recovered through the uniform prices needs to be calculated.
Finally, the relevant industry parameters, such as demand elasticities,
need to be calculated. While some elasticity estimates are provided in
some of the submissions, it is far from obvious that these estimates are
robust.

As mentioned above and shown formally in the appendix, there

is no reason why mobile network competition for subscribers will lead
to socially optimal Ramsey prices for fixed to mobile termination
charges. In other words, if it is felt that Ramsey pricing is appropriate,
then mobile network competition will not, in general, lead to
appropriate pricing.

A retail-minus approach to pricing is proposed in some of the

submissions. This approach, which is better known as the Efficient
Components Pricing Rule (ECPR) or the Baumol-Willig rule, has well
known limitations. In particular, it will not be socially efficient unless
there is efficient regulation of final product prices. While Telstra is
constrained in the setting of fixed to mobile charges by its price cap
regime, it is far from obvious that the prices currently established for
fixed to mobile calls under this regime are the competitively efficient
price. ECPR rules will tend to lock-in these prices.

As noted above, our first preference, as expressed in Gans and

King (1999a) is for structural changes to overcome the competitive
problems in mobile termination. Some of these changes could relate to
prices. For example, we suggested in the paper that separate charging
for mobile origination and termination might be helpful. Other
suggestions that might help overcome the tendency for high
termination charges and avoid on-going intrusive regulation would be
helpful.

February 2000 13
Section 4 Mobile Penetration

4 Mobile Penetration

The theoretical analysis and numerical simulations in Wright

(2000) present a sophisticated argument for a socially optimal deviation
from marginal cost termination pricing. Dr Wright argues that in the
absence of full mobile penetration, there will tend to be too little take-
up of mobile services due to the subscriber ignoring the positive
network externality that they create. Dr Wright then uses a numerical
simulation to analyse the relationship between network penetration
and termination charges.

If there is a positive network externality then this does suggest

that there will be too little take-up from a social perspective. It implies
that there might be a social case for reduced mobile subscription
charges. In the absence of any subsidy from other sources, this might
be used as an argument for indirect funding via termination revenues.
Of course, the degree of mark-up of termination charges above
marginal cost would depend on the size of the positive externality. It is
also far from clear that funding mobile subscription by increasing
termination revenues is an efficient instrument to overcome the
positive externality.

Importantly, while the existence of a network externality for

mobile subscriptions can be used as an argument to raise termination
charges above marginal cost, it is not clear that it is an argument for
claiming that there should be no regulation of termination charges. In
fact, in Wright’s model, as in ours, no regulation leads to termination
prices that are so high that a decrease in these prices would in fact
decrease subscription charges. In this sense, the positive externality
argument is an additional reason why some regulation of mobile
termination charges can be desirable. In particular, there is no reason
why current termination charges correctly ‘internalise’ the positive
externality.

February 2000 14
Section 5 Investment and Entry Incentives

5 Investment and Entry Incentives

A number of the submissions note the important interaction

between investment incentives, entry of new networks and regulation.
While our analysis was not dynamic, and so did not explicitly
investigate either investment or entry, it is worth noting that any link
between investment or entry and mobile network termination revenues
is not clear-cut. The reason for this is simple. In our analysis mobile
network profits do not alter as termination charges alter. To see this,
suppose that a change in mobile termination charges leads to an
increase in total termination profits for the mobile networks. (As noted
above, this change may be either an increase or a decrease in
termination charges depending upon the initial level of these charges).
Then from the perspective of the mobile carriers, the increased
termination revenues make it more desirable to attract new
subscribers, so that mobile network competition is intensified. In this
situation, mobile subscription fees will fall, lowering mobile carrier
profits. In equilibrium, these two effects offset each other. As a result,
while the level of termination charges does affect social surplus and the
benefits received by various market participants, it does not tend to
raise total mobile carrier profits. Because of this, regulation of mobile
termination fees will have no effect on either investment by existing
mobile carriers or the entry of new mobile carriers.

While this result is strong, it suggests that any analysis that

simply assumes that the regulation of termination revenues will effect
either investment or entry is poorly founded. In the absence of any
significant empirical or theoretical evidence15 to the contrary, the
correct starting assumption is that termination charges are both
investment and entry neutral.

We do emphasise, however, that there is a need for research on

the linkages between interconnection pricing and incentives to invest

15 Wright (2000, Figure 2) calculates what happens to mobile network profits as termination charges are
mutually adjusted when there is partial mobile penetration. From a starting point of high termination
charges, a fall in those charges actually increases profits to a point and then for further falls there is a
reduction in profits. So in contrast to the case of full mobile penetration there is a inverted U-shaped
relationship between regulated termination charge levels of mobile carrier profits; in contrast to no
relationship in the case of full mobile penetration.

February 2000 15
Section 5 Investment and Entry Incentives

in infrastructure. While appropriate regulated pricing rules exist for

traditional (or one-way) access issues that can generate socially optimal
infrastructure16 the interconnection issue is fundamentally more
difficult; especially given the interaction between competition and
horizontal trade between incumbent and entrants.

16That is, the efficient investment pricing rules developed by Gans and Williams (1999a, 1999b) and
Gans (1999) that are variants of two part tariffs.

February 2000 16
Section 6 Usefulness of Academic Models

6 Usefulness of Academic Models

Finally, we would like to comment on the usefulness of precise

theoretical modelling as a guide to policy analysis. Some submissions
expressed concerns that such models were too special to be useful. On
this point we disagree. When dealing with complex environments such
as telecommunications, it is particularly important to write precise
models and lay bare key assumptions.

Telecommunications theory and policy lie at the intersection of

regulation and competition, yet their study has often been treated
informally, and important policy decisions have been and are being
made on ad hoc reasoning in the absence of clear guidance from
economic theory. We regret this state of affairs; in our experience,
policy choices could often be improved through abiding by some
simple principles derived from theory. (Laffont and Tirole, 1999,
p.xiii)

We are encouraged by the submissions in that they focussed on the

reality or otherwise of the key assumptions (i.e., customer ignorance
and 100 percent mobile penetration) laid bare in our paper. We were
also encouraged by the independent exercise of Wright (2000) that
replicated our results and also chose to emphasise similar assumptions.
Finally, the fact that the technical analysis of Wright was used by
market participants to support their positions demonstrates that the
ACCC is not alone in considering such research to be of practical policy
relevance. We only hope that further research on this topic, particularly
on the area of incentives to invest in telecommunications
infrastructure, will be supported by the industry.

February 2000 17
Section 7 Appendix

7 Appendix

We use a model with strong (Bertrand homogeneous product)

competition to illustrate our result that w hen customers are not ignorant and
mobile subscribers care about incoming calls, competition does not force
termination charges down to a socially efficient level. This model has the
strongest possible degree of network competition. Further, as some
submissions have questioned whether non-linear or linear tariffs are
appropriate for various mobile charges, we show that the result does not
depend on the nature of the charges. We consider both non-linear charges
and the situation where only uniform prices can be charged. In each case,
termination charges under competition are set above socially optimal levels.

7.1 Non-linear pricing

Take a simple model of mobile network subscriber competition. There

are two networks that compete for subscribers. We will consider a
representative subscriber who values outgoing calls and incoming fixed-to-
mobile calls as well as the amount that they pay for mobile services. In
particular, given a zero price for receiving calls (i.e., the caller pays for fixed-
to-mobile calls) the sub scribers’ utility is given by
∞
∫po
qo ( p o )dp + v(qt ) − F ,

where po is the price per outgoing call, qo ( po ) is the (representative)

subscribers inverse demand for outgoing calls, qt is the quantity of fixed-to-
mobile calls received by the subscriber, v( qt ) is the utility value of those calls
to the subscriber and F is any fixed subscription fees paid by the subscriber.
We can think of the subscriber as having a quasi-linear utility function so that
there are no income effects associated with changing po . Also note that qt is
not a direct choice variable for the subscriber but reflects decisions made by
fixed line customers.

The mobile networks provide an identical product so that the

representative consumer will simply join the network that offers them the

February 2000 18
Section 7 Appendix

greatest personal utility.17 Total social surplus from the subscriber’s decision,
however, is given by

∞ ∞

∫ qt ( p t )dpt + ∫ qo ( p o )dpo + v ( qt ) + ( pt − ct ) qt + ( po − co ) qo − Γ
pt po
(0.1)

For convenience, we assume that the receivers of mo bile originating calls

receive no utility from those calls, and use ct and co to refer to the total
(constant) marginal cost of fixed-to-mobile and mobile-originating calls
respectively. The fixed subscriber charge F is a transfer and so is eliminated
from the above equation and Γ refers to the relevant mobile network fixed
costs.

From equation (0.1), the socially optimal prices are given by po* = c o
and pt* = ct − ∂∂qvt . Note that the socially optimal price of mobile-originating
calls is simply equal to marginal cost. This reflects our assumption that there
is no utility benefit generated by receiving such a call. But the socially optimal
price for fixed -to-mobile calls is below marginal cost. This reflects the positive
externality created by a fixed -line customer ringing a mobile subscriber under
the assumption that the mobile subscriber gains utility from receiving calls.
Finally, note that the zero profit constraint for the mobile carrier at the social
optimum is that F ≥ Γ + ( ct − pt* )q ( pt* ) under the assumption that all pricing
below marginal cost for fixed-to-mobile calls is reflected just in mobile
termination charges.

Will competition between mobile networks lead to these socially

optimal prices? The answer is that it will not whenever it is socially optimal
to have a positive number of fixed-to-mobile calls. To see this, suppose that
the mobile carriers are perfect substitutes, so that the representative
subscriber will simply join the network with charges that maximize their
personal surplus, subject to the network not operating at a loss. For
convenience, assume that all non-mobile carrier elements are set at marginal
cost so that there is no ‘double marginalisation’ with the fixed-line carrier.
Then the competitive equilibrium prices will solve

∞
max po ,p t , F ∫ q (p
po
o o )dp + v( qt ) − F

subject to ( po − co ) q o + ( pt − ct ) qt + F − Γ ≥ 0

17In Gans and King (1999a) we used a differentiated Bertrand model with a weaker degree of mobile
competition than that here.

February 2000 19
Section 7 Appendix

The first order conditions from this problem give the competitive charges as
poe = co ,  pte − ct + ∂∂qvt  ∂∂pqte + qt = 0 with the fixed fee F just set so that the
t

mobile carrier’s profits equal zero. The superscript e simply represents that
the above equations define a competitive equilibrium. We will assume for the
present that the equilibrium fixed fee does not drive the mobile customer
away from subscribing to either network.

While competition will lead to socially optimal pricing for mobile-

originating calls under our assumptions, it will not in general lead to socially
optimal prices for fixed-to-mobile calls. In fact, competition only leads to
socially optimal prices in the trivial case where it is socially desirable to have
no fixed -to-mobile calls. This is easily seen by substituting the socially
optimal price into the equation for the competitive equilibrium price.
Whenever there are any fixed -to-mobile calls, the competitive price will be
higher than the socially optimal price pte > pt* . The reason for this is simple. If
a mobile provider raises the price of fixed-to-mobile calls above the socially
optimal level, then this causes a loss of surplus to both the mobile subscriber
and the fixed-line customer. But it also raises mobile termination revenues.
While these revenues are less than the total loss of surplus, they are greater
than the loss of surplus to the mobile subscriber. So if the mobile company
passes these termination revenues back to the subscriber through a reduced
fixed charge, then the mobile subscriber is strictly better off. Competition will
drive the mobile companies to maximize subscriber utility, so they will raise
termination prices above the socially optimal level.

Put simply, competition maximizes the mobile subscriber’s utility and

ignores any external effects on fixed -line customers.

7.2 Uniform pricing

The above analysis considered two-part tariffs. Some of the submissions

note that two-part tariffs or other non-linear prices may have limited practical
relevance, perhaps due to differences in subscriber willingness-to-pay for
mobile services. In the extreme, competition may only involve linear
(uniform) pricing. If we maximise social surplus, subject to the constraint of
uniform pricing for calls then we obtain the standard Ramsey price formula
for mobile-originating calls, but a modified rule for fixed -to-mobile calls: 18

18 Note that we have assumed independent demands. The formula is easily adapted to allow for
interdependent demands

February 2000 20
Section 7 Appendix

∂v
p *o − co λ
p *t − ct λ
∂q
= − 1+λ
and = − 1+λ − t
po*
εo *
pt εt 1 + λ

where ε i refers to the own price elasticity of demand for product i and λ is
the relevant multiplier. Notice that because the mobile subscriber values
receiving mobile calls, that the optimal uniform price for fixed-to-mobile calls
is lower than under standard Ramsey pricing.

If we consider the equilibrium prices under competition, by

maximising subscriber surplus subject to the mobile operators' zero profit
constraint, we obtain
1+ µ
peo − co µ p te − ct 1 1 ∂v
= − and =− −
poe
εo e
pt ε t µ ∂q t

Note that, unlike the socially optimal Ramsey price for fixed-to-mobile calls,
the competitive equilibrium price is set at the monopoly level with a mark
down for the value of calls to the mobile subscriber. It is again easy to see that
competition will not drive prices to the socially optimal level. Thus, if the
competitive equilibrium price of originating calls is set to the optimal Ramsey
price (so that µ = −(1 + λ ) ) then the competitive price for terminating calls is
strictly higher than the optimal Ramsey price. In general competition will
result in mobile originating charges that are too low compared to the socially
optimal prices and terminating charges that are too high. The subscriber’s
gain from a decrease in originating charges compared to the socially optimal
price more than offsets the subscriber’s loss from receiving fewer calls. Put
simply, under competition, fixed -to-mobile calls bear too great a share of the
fixed mobile network costs from a social perspective.

February 2000 21
Section 8 References

8 References

Armstrong, M. (1998), “Network Interconnection in Telecommunications,”

Economic Journal, 108 (May), pp.545-564.

Carter, M. and J. Wright (1999), “Interconnection in Network Industries,”

Review of Industrial Organization , 14 (1), pp.1-25.

Carter, M. and J. Wright (2000), “Local and Long-Distance Network

Competition,” mimeo., Auckland.

Gans, J.S. (1998), “Regulating Private Infrastructure Investment: Optimal

Pricing of Access to Essential Facilities,” Working Paper, No.98-13,
Melbourne Business School.

Gans, J.S. (1999), “An Evaluation of Regulatory Pricing Options for Mobile
Termination,” mimeo., Melbourne Business School.

Gans, J.S. and S.P. King (1999a), “Termination Charges for Mobile Phone
Networks: Competitive Analysis and Regulatory Options,” Working
Paper, Melbourne Business School, University of Melbourne
(www.mbs.unimelb.edu.au/jgans/research.htm).

Gans, J.S. and S.P. King (1999b), “Using ‘Bill and Keep’ Interconnect
Arrangements to Soften Network Competition,” Working Paper, No.99-
12, Melbourne Business School, University of Melbourne
(www.mbs.unimelb.edu.au/jgans/research.htm).

Gans, J.S. and S.P. King (1999c), “Regulation of Termination Charges for Non-
Dominant Networks,” Working Paper, Melbourne Business School,
(www.mbs.unimelb.edu.au/jgans/research.htm).

Gans, J.S. and S.P. King (2000), “Mobile Network Competition, Customer
Ignorance and Fixed -to-Mobile Call Prices,” Working Paper, No.2000-
03, Melbourne Business School, University of Melbourne
(www.mbs.unimelb.edu.au/jgans/research.htm).

Gans, J.S. and P.L. Williams (1999a), “Access Regulation and the Timing of
Infrastructure Investment,” Economic Record, 79 (229), pp.127-138.

Gans, J.S. and P.L. Williams (1999b), “Efficient Investment Pricing Rules and
Access Regulation,” Australian Business Law Review, 27 (4), pp.267-279.

February 2000 22
Section 8 References

King, S.P. and R. Maddock (1996), Unlocking the Infrastructure, Sydney: Allen
& Unwin.

Laffont, J-J., P. Rey and J. Tirole (1998a), “Network Competition I: Overview

and Nondiscriminatory Pricing,” RAND Journal of Economics, 29 (1),
pp.1-37.

Laffont, J-J., P. Rey and J. Tirole (1998b), “Network Competition II: Price
Discrimination,” RAND Journal of Economics, 29 (1), pp.38-56.

Laffont, J-J. and J. Tirole (1999), Competition in Telecommunications, MIT Press:

Cambridge (MA).

February 2000 23