IP: Too weak to compete

[Dave Farber <dave () farber net>]

From: "John F. McMullen" <observer () westnet com>
Date: Sat, 20 Jul 2002 06:01:45 -0400 (EDT)


> From the Financial Times --
http://search.ft.com/search/article.html?id=020719000702&query=Eli+Noam&vsc_
appId=totalSearch&state=Form

Too weak to compete
by Eli Noam

A stench of scandal is hanging over the telecommunications industry. But
to focus on individual misdeeds is to miss the fundamental structural
problems of telecoms economics and policy. These problems will not go away
with corporate reforms or criminal sanctions.

For telecoms to recover, the corporate strategies and public policies of
more than two decades have to change radically. The basic policy,
spreading from the US and the UK to become the new orthodoxy, has been to
force the traditionally monopolistic markets open. After a period of
protection for new entrants, competition would take hold and the role of
government would wither away.

Wherever one looks, however, telecoms companies are drowning in red ink.
The cumulative debt of the seven largest European carriers is greater than
Belgium's gross domestic product. In the US, most of the new entrants into
local telecoms have gone bankrupt. All big long-distance carriers are
bleeding. Across the sector, stock market valuations have dropped
dramatically. Performance has been poor in such a large number of
companies and countries that one cannot simply blame specific management
teams.

Although growth is unlikely to return to the levels of the boom years, the
present downturn is probably only temporary. Yet the real problem for the
industry is that it has entered a period of chronic volatility in which
boom-and-bust patterns will become a common occurrence rather than an
aberration.

One cannot really blame a drop in consumer demand for this instability.
Telecoms usage has kept growing at a rate that would make most other
industries proud.

The problem is not low demand but low prices, based on oversupply. During
the late 1990s, the network companies over-optimistically projected their
market shares over the long term. This was aggravated by the tendency of
analysts to value a company's progress by physical measures of its
infrastructure, such as cell sites and fibre miles. In consequence,
capital expenditures grew enormously, in the US by an annual rate of 29
per cent.

A related factor was that while the cost of building a network is high,
the incremental costs of serving a customer are low. Hence, competitive
prices dropped dramatically, 54 per cent annually for transatlantic
circuits and 43 per cent for trans-Pacific ones. Business plans based on
higher prices became worthless.

Technological and economic obsolescence will gradually take capacity out
of circulation. But disinvestments take time. For Texas office space, it
took more than a decade to dissipate the excess supply. Another strategy
would be to stimulate a substantial growth in user demand, probably from
video over the internet. But this, too, will take time. And when it
arrives, it will stimulate another boom-and-bust cycle.

In the meantime, what will telecoms companies do? The textbook responses
are to cut costs and prices. But these strategies will quickly be matched
by competitors and will leave everyone even worse off.

The main strategy will therefore be to raise prices above competitive
levels, reducing competition and the commodification that lowers
profitability and future investments. To do so this requires market power,
or at least collaborative cartels or oligopolies within market segments,
both among telecoms companies and with related platforms such as cable
operators and wireless carriers.

Such market power is highly valued by investors. In the US, rural phone
companies maintained their value much better than those active in
competitive markets.

The problem with any cartel is its instability. Hence, government will
become engaged in the process. Historically, government has often been
recruited as an enforcer of cartels to stabilise vital industries whose
competitive equilibrium was not sustainable. In the US, airline and
railroad competition was, and to a certain extent still is, reduced by
government regulatory bodies. In telecoms, for many decades the Federal
Communications Commission and the state utility commissions played a
similar role.

It will not be easy for politically sensitive regulators to hold off from
stabilising the industry when the downturn persists, when essential
service providers falter, when service quality deteriorates and employment
drops.

For governments to moderate competition in favour of stability would
require a fairly radical departure in regulatory philosophy. For a
generation now, liberalisation, deregulation and competition have been the
keystones of telecoms policy.

One business cycle later, competition is giving way to consolidation and,
soon, co-operation. Thus, the traditional system of regulated market power
will return. This scenario, unfortunately, will look more like the old
telecoms than the new, but we must face reality rather than engage in
denial.

The writer is professor of economics and finance at Columbia university

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------ Forwarded Message
From: "Faulhaber, Gerald" <faulhabe () wharton upenn edu>
Date: Sat, 20 Jul 2002 08:33:44 -0400
To: "'Dave Farber'" <dave () farber net>


The Noam FT article is a very thoughtful piece by one of the bright lights
in telecoms economics.  I hope his conclusion is not true, but in fact
regulators/politicians may see their role as "rescuing the industry from
itself."  There are already worrying signs of this in the US, and the
European governments are ever ready to jump in to "fix" the industry.  A
distressing outcome, but quite possible.

Professor Gerald Faulhaber <http://rider.wharton.upenn.edu/~faulhabe>
Business and Public Policy Department
Wharton School, University of Pennsylvania
Philadelphia, PA 19104

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