Benefits for consumers but also for competing firms | Researcher: Steffen Hoernig
In a recent study, Nova SBE’s Professor Steffen Hoernig and co-author David Harbord develop a calibrated simulation model of the UK mobile telephony market and use it to analyze the effects of reducing the charges the networks pay to each other for outgoing calls (mobile termination rates), as recommended by the European Commission. They find that reducing these charges increases both consumer surplus and networks' profits, since this eliminates an inefficiency in the pricing of calls between networks. Depending on how much receiving a phone call is valued, social welfare may increase by as much as £1 billion to £4.6 billion per year. The researchers also use the model to estimate the welfare effects of the 2010 merger between Orange and T-Mobile and find that the merger led to a substantial reduction in consumer surplus.
The European Commission’s Recommendation
Mobile networks routinely pay charges for sending their calls to other mobile networks. These are called “mobile termination rates”, and have been subject to immense regulatory pressure for more than a decade. In 2009, the European Commission recommended a further reduction of these rates, following a philosophy of only attributing costs directly associated with handling these incoming calls. In this paper the authors set out to quantify the impact of this and alternative regulatory policies on the consumers and welfare in the UK mobile market.
Calibrating a market model
Three specific challenges had to be dealt with: a lack of disaggregated market data, a merger between Orange and T-Mobile in 2010, and a large number of competing mobile networks in the UK (O2, Vodafone, Orange and T-Mobile, Hutchison). The latter problem was solved by using the many-network model which Hoernig published in 2014 in the International Journal of Industrial Organization, which allows for tractable modeling of multiple asymmetric competitors.
Since Orange and T-Mobile decided to keep their separate brands under one umbrella, the merged entity had to be modeled as two separate brands under joint ownership and with a joint pricing policy.
Lastly, the lack of data meant that the calibration of the model, i.e. the assignment of specific values to model parameters describing the UK market, had to be done at an aggregate level using very few data points.
The Effects of Lowering Termination Rates
The researchers compared three different policies of lowering mobile termination rates: i) Reduction to “pure long-run incremental cost” (only costs related to serving incoming calls), as recommended by the European Commission; ii) charges identical to those on fixed networks; and iii) abolishing these charges altogether (“bill-and-keep”). They found that lowering the charges in any of the three ways would increase consumer surplus, profits and welfare. The size of the increase depends strongly on how much consumers value incoming calls, though.
One central finding is that lower termination rates increase efficiency of the market, because the prices of calls between networks will be set closer to their underlying costs. As a result, welfare increases. Contrary to the existing literature, which focused on the case of only two competing firms and showed that lower termination rates reduced competition for consumers and therefore consumer surplus, the authors show that with more firms the efficiency effect dominates and both consumers and firms benefit from the reduction.
The 2010 Merger between Orange and T-Mobile
The modeling framework and calibration of the market for the post-merger outcome allowed the researchers to "backward-engineer” the market equilibrium that occurred before the merger between the two mobile operators Orange and T-Mobile had happened. As mentioned above, in the calibration of their model, which is based on market data after the merger, they treated the two brands as separate but controlled by the same entity. The outcome before the merger can now be modelled as having the two brands decide independently on their pricing and compete against each other (and the other three brands).
They find that the merger can be expected to have led to significantly higher prices by all five networks even if the remaining four firms compete (instead of settling on a collusive outcome). These higher prices are caused by the reduced competitive pressure in the market (so-called “unilateral effects”). These higher prices lead to a substantive loss in consumer surplus, to the equivalent of about £1.4 billion. Even though the merging firms posited a gain of about £400m in synergies, total welfare also tends to decrease because the merging firms raise the call prices to the other networks. This analysis thus shows that the UK’s competition authority should have given more attention to unilateral effects when analyzing the merger.
About the authors:
David Harbord is an economic consultant (Director of Market Analysis Ltd., UK)
Steffen Hoernig is Associate Professor at Nova School of Business and Economics, and Academic Director of its Masters in Economics Program
Publication details: “Welfare Analysis of Regulating Mobile Termination Rates in the UK”, Journal of Industrial Economics, forthcoming, 2016.