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empirical evidence

This book distils years of work on the mobile telecommunications industry. I became interested in this industry for professional reasons during the mid-1990s, a period when the industry was making the jump from a premium service industry for mostly professional users to a truly mass market. In my capacity as an applied industrial organisation economist, I had the unique opportunity of evaluating the business plans and strategies of a large number of mobile telecommunications firms inside and outside Europe. This provided me with valuable insights into the functioning of this fascinating industry, as well as into its technological and operational concerns.

This book makes extensive use of previously published material. It thus also benefits from joint work done with Marion Hoenicke, Tommaso Valletti and, in particular, Frank Verboven. The credit to them is given in the appropriate sections throughout the book and the relevant papers are quoted in the bibliography. Researching and writing articles with all of them was an intellectually very rewarding experience, and I owe them my thanks. I also received many useful comments and hints from colleagues within the EIB and from the academic world. I would like to thank Tommaso Valletti and two anonymous referees for having read the manuscript and for their detailed comments. Ultimately, all responsibility for the views expressed remains with the author, and they do not necessarily reflect those of the European Investment Bank.

TERM LlflG



Abbreviations and acronyms

Telecommunications terms

AM Amplitude modulation

AMPS Advanced mobile phone service

ARPU Average revenue per user

C-450 German analogue mobile standard

CAMEL Customised application mobility enhanced logic

CCIR International Radio Consultative Committee

CDMA Code division multiple access

CDMA 2000 A 3G system based on CDMA

CEPT European Conference of Postal and Telecommunications

Administrations

CLEC Competitive local exchange carrier

CPP Calling party pays

CTIA Cellular Telecommunications Industry Association (US)

D-AMPS Digital AMPS = US-TDMA

DCS 1800 Digital communications system = GSM 1800

DECT Digital enhanced cordless telephony

EDGE Enhanced data GSM environment; also 2.5G

ERC European Radio Communications Committee

ERO European Radio Communications Office

ETSI European Telecommunications Standardisation Institute

FCC Federal Communications Commission (US)

FDMA Frequency division multiple access

FM Frequency modulation

FTM Fixed to mobile

GPRS General packet radio service; also 2.5G

GSM Global system for mobile communications (formerly Groupe

systeme mobile)

GSM 900 GSM in the 900 MHz band

GSM 1800 GSM in the 1800 MHz band = DCS 1800

GSM 1900 GSM in the 1900 MHz band = PCS 1900



List of abbreviations and acronyms

xvii

Home location register

HSCSD

High-speed circuit switched data

iDEN

Integrated digital enhanced network

IMT-2000

International mobile telecommunications system: the ITU

definition for 3G

IMTS

Improved mobile telephone service

Inter operator tariff

IS 95

Interim standard (US) describing the CDMA air interface

IS 136

Interim standard (US) describing the D-AMPS air interface

International Telecommunications Union

Japanese digital cellular = PDC (Japanese digital mobile

standard)

JTACS

Japanese TACS

Mobile switching centre

Mobile to fixed

Mobile to mobile

MVNO

Mobile virtual network operator

Nordic mobile telephony system (in 450 and 900 MHz

bands) (Scandinavian analogue standard)

Nippon Telephone and Telegraph Cellular System (Japanese

analogue mobile standard)

Oftel

Office of Telecommunications (UK)

Open network provision

Personal communications network (UK) operating at 1800

MHz = GSM 1800

Personal communications services (US, Japan) operating at

1900 MHz

Personal digital cellular (Japanese digital mobile standard)

Personal handy phone (Japanese cordless system)

PLMN

Public land mobile network

Private mobile radio

PSTN

Public switched telephone network

RBOC

Regional Bell operating companies (US)

RC 2000

Radiocommunication 2000 (French analogue mobile standard)

Receiving party pays

Rural Statistical Areas (US)

RTMS

Radio telephone mobile system (Italian analogue mobile

standard)

Subscriber identification module

Short message service

Signal-to-noise ratio



xviii List of abbreviations and acronyms

TACS Total access communications system (an analogue mobile

standard)

TDD Time division duplex

TDMA Time division multiple access (also D-AMPS)

TD-SCDMA A 3G system based on CDMA

TETRA Trans-European trunked radio communications

TIA Telecommunication Industry Association (US)

UMTS Universal mobile telecommunications system

UTRA UMTS terrestrial radio air interface

VLR Visitors location register

VPN Virtual private network

W-CDMA Wideband CDMA (the basis for UMTS)

WRC World Radiocommunication Conference

1G First-generation (analogue) cellular technology

2G Second-generation cellular technology

2.5G Enhanced 2G (GPRS, EDGE)

3G Third-generation cellular technology

General terms

ANSI American National Standards Institute

BTA Basic trading areas (US)

CAGR Compound annual average growth rate

CEE Central and Eastern Europe

ECPR Efficient component pricing rule

EMU European Monetary Union

GDP Gross domestic product

ITC International Trade Commission

JV Joint venture

LRIC Long-run incremental cost

M&A Mergers and acquisitions

MoU Memorandum of Understanding

MSA Metropolitan Statistical Areas (US)

MTA Major trading areas (US)

PPP Purchasing power parity

R&D Research and development

ROCE Return on capital employed



1 Introduction

1.1 A new and fast-growing industry

A series of features makes the mobile telecommunications industry an interesting field of investigation for economists: the industry is experiencing very fast market growth combined with rapid technological change; regulatory design in setting market structure is playing a very important role; and oligopolistic competition is unfolding under various forms. The number of subscribers to mobile networks is growing at a rapid rate on a worldwide basis, as shown in figure 1.1. During the 1990s the number of mobile subscribers worldwide increased by an annual rate of 50 per cent. An important year was 2002, when the number of world mobile subscribers for the first time exceeded the number of fixed lines. The number of mobile subscribers was close to 1.2 billion at the end of 2002, while the number of fixed lines was slightly below 1.1 billion. The year 2002 therefore established at worldwide level what had already been observed for an increasing number of countries during the previous few years: mobile telecommunications is the most widespread access tool for telecommunications services. The mobile telecommunications industry has acquired as many users in some twenty years worldwide which took the fixed line telecommunications industry more than 120 years to achieve.

The timely and efficient supply of mobile telecommunication services has had a substantial impact on the economy, which also explains the extensive public interest in this industry. The actions of the industry regulator are of crucial importance for this. For instance, a study on the US market shows that the regulatory delay in licensing mobile telecommunications gave the US consumers welfare losses in the range of $24-50 billion a year.1

As will be shown in this book, two factors have determined the extraordinary rapid development of this industry: technological progress and

1 This figure is quoted from Hausman (1997). However also other studies such as Rohlfs, Jackson and Kelley (1991) find such orders of magnitudes.



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1200 1000 800 600 400

200 0


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COCOCOCOCOCOCOCOCOOO 0)0)0)0)0)0)0)0)0)00 i-i-i-i-i-i-i-i-i-C\IC\l

Figure 1.1 The evolution of the worldwide number of mobile and fixed telecommunications lines, 1982-2002 Source: ITU data.

regulation. The mobile telecommunications industry as it is known today -i.e. using radio waves instead of wires to connect users - is a relatively young industry. However, its basic technological concepts actually date back to the second half of the nineteenth century, when the German scientist Heinrich Rudolf Hertz demonstrated (in 1888) that an electric spark of sufficient intensity at the emitting end could be captured by an appropriately designed receiver and induce action at a distance. The first mobile telecommunications systems were based on the same principles as radio or television broadcasting, by which all conversations could be heard by everybody. These systems had very limited capacity and used the electromagnetic radio spectrum, whose usable portion is only very limited, in a very inefficient way. Significant progress in using the spectrum more efficiently and ensuring privacy in conversations were made with the development of the cellular concept after the Second World War. However it took until the 1970s for the progress in semiconductor technology to allow the construction of cellular mobile networks for commercial use. Analogue technology cellular systems were introduced first at the beginning of the 1980s. The breakthrough for a mass market for mobile telephony occurred only in the 1990s with the advent of digital technology. The scarcity of radio frequencies, necessary for transmission between the users handset and base stations, has since then constituted the bottleneck for the development of the industry. As we have seen, the early analogue technology used the allocated radio frequency spectrum in a relatively inefficient manner so only a relatively small number of subscribers could be connected, who used the system mainly for business purposes. The



introduction of digital technology led to a breakthrough in performance, capacity and quality of mobile telecommunications. Digital technology, such as the European standard, GSM, made better use of the radio spectrum than analogue technology did and could therefore accommodate more subscribers. Lower unit costs could be achieved by spreading fixed costs over more subscribers.

Regulatory reform is the other driving force behind the spreading of mobile telecommunications. Because ofthe radio spectrum constraint, the industry is structurally considered as an oligopoly and the development of the industry crucially depends on pre-entry regulation. In emerging industries, characterised by significant technological progress, there is usually little consensus on the optimum policies concerning the development ofthe sector. Among other issues, the debate focuses on how and when entry should be promoted and whether technology standards should be imposed centrally or selected by the market forces in a decentralised way. Because ofthe lack of consensus, governments have taken different policy options, and often change directions as experience accumulates.

The effects of entry in the cellular mobile industry are particularly interesting to analyse. Radio spectrum is the scarce resource to be assigned and constitutes the entry barrier for the firms. However, technological progress permits greater efficiency in spectrum usage and thus potential for accommodating more firms. Governments throughout the world have also taken quite different options regarding the timing and the number of entry licences. This provides interesting data for assessing the effects of licensing on the evolution of the industry.

Such pre-entry regulation in mobile telecommunications has various dimensions. First, the policy maker needs to decide whether to set a single national (or international) standard, or whether to allow multiple technological systems to compete. Second, the policy maker has to decide how many firms a licence will be granted. This also involves an important decision with respect to the timing of first and additional licences. Third, the government needs to decide how to grant licences. In the early days of mobile telecommunications, licences were often granted on a first-come-first-served basis. With the introduction of the cellular technology, the first licences were frequently granted by default to the incumbent fixed operators. Additional licences were initially granted through an administrative tender procedure (lotteries, or beauty contests) and then more and more through auctions. This evolution has greatly changed the nature ofthe firms in the market and their competitive behaviour.

Economic theory can give guidance on these issues, but the propositions of traditional textbook economics are complicated by the fact that mobile telecommunications is a network industry. For instance, in markets



without network effects, it seems to be unambiguously desirable to allow multiple competing technological systems. In contrast, in markets with network externalities there are both advantages and disadvantages to having multiple systems rather than a single standard. The presence of (strong) network externalities typically leads to tipping markets, where the winning technology takes the whole market. Should the government intervene in this race by imposing a single standard? Or should the markets decide themselves on which standard will eventually win? The theoretical literature does not provide an unambiguous answer to these questions.2

There is also the question to which extent network externalities are in fact present in cellular telecommunications markets. The main sources of network externalities arise from the fact that mobile users can use their handset only within the areas that support their technological system. Thus, depending on the mobility of consumers, network externalities are local, national, or even international in scope. In addition to reducing consumer switching costs and creating roaming possibilities, the presence of a single technological system also has the traditional advantage of exploiting economies of scale in the manufacture of equipment. Various incompatible technological systems have been developed in the cellular mobile telecommunications industry (most of them with the support of leading countries). Each system is subject to network externalities in that consumers value a system more the more users adopt it. The relevant policy question is whether governments should impose a single standard, or whether the markets should select a winning standard in a decentralised way. Advantages of mandatory standards are that potential network externalities can be realised faster, and that users technological uncertainty is reduced. Advantages from a decentralised approach are that there may be less a risk of being locked in with inferior technologies and that incentives for innovation to better systems are preserved. Yet a counterargument is that also the decentralised, market-based, approach may lead to lock-in with inefficient technologies. Despite the extensive theoretical literature, there exists little empirical work that compares the effect of imposing standards on the diffusion of a new technology with the effect of allowing multiple systems to compete. Again, the cellular mobile telecommunications industry offers an interesting opportunity to make such a comparison, since countries have followed quite different and changing policies regarding standards. While chapter 2 gives a general overview of the main issues affecting the mobile telecommunications service industry, chapter 3 is an extensive description of the evolution of the mobile telecommunications industry looking at representative countries. The aim is

2 See, for instance, Katz and Shapiro (1994) and Shapiro and Varian (1999).



to highlight the importance of country-specific effects, especially at the beginning of the industry. These country-specific effects tend to peter out as the industry progresses. Chapter 4 provides answers to questions ofthe role of different regulatory policies on the diffusion of cellular mobile telecommunications, relying on quantitative methods and using a worldwide data set.

1.2 Business strategies for firms

One of the main features of a mobile telecommunications network is to provide coverage. The fact that a user can utilise a mobile phone over a very large portion of the territory distinguishes it from the fixed network. This coverage can be provided by only a limited number of firms. The radio spectrum bottleneck acts as barrier to entry and makes the industry intrinsically oligopolistic. The question arises which type of strategies firms are able to pursue in such an environment concerning pricing and product positioning. For instance, there may be scope for vertical product differentiation by providing different levels of coverage. However, differentiation in coverage seems to be possible to only a limited extent, mostly during the early years ofthe life cycle ofthe industry, when firms have to spread network build-out over time for cost reasons, but in the longer term firms typically have regulatory obligations to provide full coverage. This means that there is little scope for relaxing price competition through product differentiation in terms of coverage. But when differentiation is possible, studies shown that price competition is relaxed. Empirical studies also show that price competition is of the Cournot type, i.e. with price above marginal cost and decreasing with the number of firms in the market.

Pricing of mobile telecommunications services is multidimensional and hence complex, both at the wholesale and the retail level. Retail pricing decisions concern mainly services such as subscription, on-net and off-net calls. Wholesale pricing also include interconnection pricing among networks. Theory provides limited guidance, as the economic literature still has to explore many aspects of pricing in network industries. The market power of individual firms may be exerted to a different degree at each level. It may thus be important from a social welfare point of view to check abuse of market power through ex ante regulation - i.e. through measures that limit damaging behaviour before it occurs. There is a consensus among the policy makers that such ex ante regulation, if necessary at all, should be as light as possible. This implies that such regulation should be much lighter in mobile telecommunications than in fixed telecommunications, where natural monopoly positions seem to be much more entrenched.



Regulators took some time to appreciate that cost allocation mechanisms could be profoundly different between fixed and mobile networks. While fixed network infrastructure used to be based on plant and equipment that from an accounting point of view had been depreciated, mobile network infrastructure was typically new and thus carried high depreciation charges in cost accounting. This, for instance, led to regulated interconnection prices that were favourable to mobile telecommunications firms. Cost allocation mechanisms are important when it comes to establishing other aspects of interfirm compensations and how these are transferred to the users. There are two principles: calling party pays (CPP) and receiving party pays (RPP). Although from a theoretical point of view RPP seems to have better characteristics for ensuring allocative efficiency, CPP has been the overwhelming success in terms of worldwide diffusion. Only a few countries, in particular the USA, actually have RPP in place, and for legacy reasons rather than for choice. CPP allows firms to exercise market power in call termination. The favourable interconnection arrangements with CPP provided the mobile telecommunications industry with the financial resources for subsidising the acquisition of customers, and this may account for a substantial part of the rapid growth in the mobile telecommunications subscriber base. Regulatory attempts are underway to fence in the market power mobile telecommunications firms have on traffic termination. Similar considerations apply for international roaming, where there are actually elements of RPP but where firms are nevertheless able to exploit the lack of information on the customer side. In any case, the evolution of overall mobile telecommunications service pricing shows a general trend towards more competitive pricing, but there are still some large areas where this does not apply. These issues are addressed in detail in chapter 5, which sets a framework for the business strategies concerning product positioning and pricing. Particular attention is devoted to market segments where market power can be exercised more easily.

1.3 Radio spectrum availability as a key determinant for market structure

Radio spectrum, the key input for the supply of mobile telecommunications services, is a public good, but its use is exclusive when employed for mobile telecommunications services. Its allocation thus needs to be regulated. Other services such as broadcasting compete for the allocation of spectrum and hence only a limited portion of the spectrum is available for mobile telecommunications services.3 This combined with the high sunk

3 The technical properties of the radio spectrum and the technical description of mobile telecommunications are discussed in more detail in the appendix.



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