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by David N. Townsend


The Vital Role of Regulation in Telecommunications Sector Reform

(This article was originally presented as a paper before the World Bank/ITU Seminar on Implementing Reforms in the Telecommunications Sector, and was since reprinted in Wellenius and Stern, eds., Implementing Reforms in the Telecommunications Sector, Lessons from Experience, Washington, D.C., The World Bank, 1994.)

The drive to reform the telecommunications sector in many countries throughout the world is motivated by a conviction that telecommunications can and ought to contribute much more to national prosperity than the sector currently achieves. Low penetration rates, poor quality service, large operating and management inefficiencies, and imbalanced development are the norm in a majority of developing countries, and even where telecommunications technology and services have made strong advances recently, the industry's performance tends to fall far short of its theoretical potential. Typically, the blame for these failings is laid upon the fact that telecommunications remains in the control of the government bureaucracy, interwoven with the postal services as part of a PTT, or otherwise operated according to public sector incentives, restrictions, and goals. Among the often misdirected and inconsistent motivations influencing operating decisions are political pressures to maintain artificially low local tariffs, cross-subsidy of the posts or other areas, civil service commitments to telephone company staff, employee rewards and incentives unrelated to performance, and shifting mandates and obligations tied to changes in administrations and political alliances. The increasing consensus for a solution points toward removing the government from the business of running the telephone company, either entirely by means of privatization, or in principle, through some type of "commercialization" that allows the operator to act according to private market standards.

Among the key anticipated effects of such reforms is a rebalancing of prices for telephone services, bringing down above-cost long-haul and international tariffs and raising subsidized local charges. Such a policy, in an environment of high unserved demand, promises to increase overall revenues, generating new capital which can be used to finance network expansion. The theory is that, in a private market, the operator will naturally move toward such a rebalancing (indeed, in practice, such tariff changes are often explicitly mandated as part of the reform process), since the profit motive will imply revenue maximizing prices.

This picture is not complete, however. There is a risk that, in the rush to introduce market forces into the telecommunications sector, reformers may leap to the conclusion that government involvement in telephone service operation and policy is inherently counter-productive, and should be minimized. On the contrary, the same social policy and economic development objectives that led to public operation of telecommunications in the first place create a vital need for a continued active public role once the system is privatized or commercialized.

"Regulation," in the literal sense of the word, implies maintaining a steady balance or flow, preventing disruptions or extremes, or diversion from a preferred path of activity. This function, the regulatory function, must be performed by the government when direct operation of the telecommunications utility is transferred from public to private or semi-private hands. This is especially the case for those major segments of the industry that essentially constitute a natural monopoly, e.g., the local communications access infrastructure. But even where some degree of competition may be introduced, such as in long distance or value added markets, the government must regulate that competition. The consequences of ignoring this critical element of telecommunications sector reform could be grave, especially given the stakes involved in large-scale privatization.

In this context, it is worth recalling the classic case for government regulation of a monopoly: Telecommunications, like other utilities that rely upon a ubiquitous and interconnected infrastructure, exhibits declining marginal (and average) supply costs over nearly all potential volumes of service output; this is especially true of the basic local network infrastructure. At the same time, demand for telecommunications services tends to be extremely inelastic, which is one reason the industry is classified as a utility in the first place. Thus, at a given level of service, price increases will not tend to drive down demand; similarly, it is not necessary to decrease prices while expanding the network in order to attract a large volume of new customers--the demand is out there, waiting to be served at present, or even higher prices. In this situation, a pure monopolist will establish service levels and prices that maximize profits, the margin of total revenues above total costs. In theory, this price-production point will occur at the point at which marginal revenue (price) equals marginal cost; beyond that point, each new customer would lose the company money, since his willingness to pay would be less than the cost to serve him. However, this profit maximizing supply point will not typically be the social welfare maximizing point. Prices will tend to be higher, and output lower, than society as a whole would prefer. A lower average price would allow additional customers to subscribe, and would increase the "consumer surplus" of all customers.

As abstract concepts, "consumer surplus" and "social welfare" may not be easy to visualize. But in the real world, in an underdeveloped rural area, these concepts could take the form of the ability to use a public telephone to call a doctor in a medical emergency, a timely early warning system in the event of natural disasters, or the ability of low income and illiterate citizens to learn about and participate in democratic politics. If monopoly pricing and investment practices were to prevail, these forms of consumer benefits would be transferred largely to producer surplus, i.e., to greater retained profits for the new private (and often foreign) owners.

In addition to these social policy objectives, there may be more fundamental long-run net economic gains to be achieved through telecommunications development that a monopolist, focusing on pecuniary short-run profits, would not pursue. In the theoretical model, the loss of such concrete economic benefits is known as "dead weight loss". As a practical matter, dead weight loss translates into slower growth, and the potential reversal of progress in many sectors. Consider the example of a farmer who harvests a particular crop, and then must transport his produce by cart some 50 kilometers, over bad roads, to sell or trade in the nearest village. With no access to modern communications, the farmer can have no advance knowledge if, for whatever reason, demand for his crop will not materialize in the village: perhaps another farmer has already been there selling the same crop; perhaps needs are changing; perhaps a flood has washed out the only bridge and he will be unable to reach the village before the crop spoils. With access to a telephone, at least in theory the farmer could learn of these problems in advance, and either travel to another village or make other contingency plans.

The difference in concrete economic value between the two scenarios is obvious, and quite large. By extension, the effects of telecommunications development in rural areas is likely to have a very important direct economic impact upon those areas which, over time, would certainly contribute to national growth, and thus (at least indirectly) could support the costs of the network investment itself. Yet these types of gains will not show up in villagers' short-term ability to pay for telephone services themselves, and thus the prospect of rural investments will not seem appealing to a private carrier operating entirely on its own. Instead, it will choose to invest only where short run demand is capable of paying the cost of network expansion, and to charge prices that will prevent most rural and poor citizens from subscribing, even where service is made available.

Still, it might be argued that these are long-run, theoretical considerations, since in the short run, price increases for local service are what is most necessary to support the development of the network, whether in rural or urban areas, and the private monopolist will surely agree to higher prices, even in exchange for specific commitments to invest in unprofitable areas. However, simply increasing prices to generate revenue to support expansion is not an end in itself; even achieving this goal successfully only means that the relatively wealthy can get access, but the poor will still be shut out. Eventually, the government must come to grips with the affordability of service for the bulk of the population that is to be served by the expanding network.

In the long run, some form of price regulation will always be required, as increasing volumes of investment allow the carrier to achieve greater economies of scale. Returning to the classic declining cost model of the monopoly utility, this suggests that a pure "price cap" model, for example, for a newly privatized carrier, would allow permanent and increasing margins above costs, since while prices would increase with inflation, unit costs would actually be declining. A price cap model with offsets for productivity would be more appropriate, but it is important that the productivity measures be based upon actual experience; in the U.S. and the U.K., productivity offsets to price caps have hovered in the low single digits, recognizing that those networks are near full development, and further scale economies will be relatively slight. In a severely underdeveloped network, however, the carrier will begin expansion at the most steep portion of the cost curve, and productivity gains in just a few short years could be of a magnitude of 50% to 75% or more. A U.K.-style productivity offset of 6-7% in such an environment would be entirely inappropriate, and lead to outrageous profit margins before long, and will frustrate the goal of making service affordable to the majority of the population.

Beyond price regulation, the regulator must play an active role in monitoring and promoting compliance with network expansion agreements. Left alone, carriers will invariably find means of meeting the most minimal obligations for unprofitable expansion, while avoiding the most high cost investments. For example, in Mexico, the recent Telmex Concession requires expansion to rural areas and remote villages according to certain general parameters. One requirement is that Telmex install service--e.g., a wire center or a public telephone--in any village with 1000 or more inhabitants whenever at least 100 applications for service are received from such a village. Think of the regulatory questions this requirement raises:

What constitutes an "application for service"?

Who monitors, and counts, such requests?

Will the government take the initiative to inform villagers of these provisions, and to encourage them to submit applications, facilitate the application process?

How will the scope and timing of the Telmex response be overseen?

Finally, and most important, consider the interaction of expansion obligations with pricing decisions. Typically in Mexico, an application for service has involved more than simply making a formal request for a telephone. It usually requires a deposit payment, sometimes of up to a year's service fees plus installation charges, for the application to be officially processed and the applicant to be placed on the waiting list. How much impact, then, will a substantial increase in the prices of local services have upon villagers' ability to make such deposits and thus to apply formally for service? If the 99th or 100th person in the village can't afford the deposit, the village may not get service for several more years.

The point is that only the regulatory authority is in the position to assure that telephone network resources are adequately and fairly distributed. The impact of tariff increases will always have two conflicting sides: on the one hand, more capital for expansion will be available; on the other, the affordability of service will be increasingly shifted toward the wealthier segments of the population. A private telephone company, naturally seeking profits and efficiency according to the laws of the marketplace, can help maximize the potential resources available within the sector, but it cannot be expected to strike the balance between growth and allocation, in effect between market efficiency and distributional justice. This is the role, the vital role, of the regulator.

Thus, in the process of reforming the telecommunications sector, the function of regulation must not only be maintained, and maintained at the center of the industry, but must typically be strengthened as well. At present, most developing country telecommunications administrations or PTT operators (and many of those in industrialized countries as well) do not even have enough basic knowledge of their own national industry to begin assessing realistic policy choices. The questions of how much to invest, how much to cross-subsidize, how efficient is the sector, cannot be answered until more fundamental information gaps are closed. Especially in a situation of planned privatization, these types of data are vital before any reliable concession agreement can be achieved. For example, in order to consider cross-subsidies, it is necessary to know the levels of current costs and related revenues on a service by service basis. Many administrations, indeed many carriers, do not maintain or study this information except in the most aggregated form. Such considerations as long-run incremental costs, scale economies, demand elasticities, and the like, should all be central to public policymaking as well as private investment planning.

It is therefore apparent that the greatest emphasis in the area of regulatory sector reform should be on developing the basic tools and information sources necessary to begin considering alternative development policies. Ideally, these types of programs should precede any large scale privatization effort, so that the cooperation of the government-controlled PTT can be assured, before the lure of market forces inevitably begins to conflict with public regulation of the telecommunications utility.

David N. Townsend & Associates

Telecommunications Economics, Policy, Regulation

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1997 David N. Townsend