Monday, November 13, 2006

The Natural Monopolies and Externalities in Telecommunications

The economic literature provides two main reasons for regulating telecommunication services (Davis, 1994). First, there are economies of scale and scope in the production of those services to make telecommunications markets natural monopolies. Secondly, use of and subscription to telecommunication services are claimed to yield two types of positive consumption externalities. The first is known as the call externality: a caller provides benefits to called party, who does not pay for those benefits. The second is called the network externality, when new subscribers join the network, existing subscribers receive benefits, without paying an additional charge, from calls by the new subscribers and being able to call them. Both the natural monopoly property and the network externality can lead to market power for an incumbent telecommunications services provider. Incumbent benefits from monopoly granted by government, and on the other hand, new entrants have to deal with high entry barriers.
A monopoly by definition is a market that has only one seller, but many buyers. Because a monopolist is the sole producer of a product, the market demand curve relates the price that the monopolist receives to the quantity it offers for sale. In general, the monopolist's quantity will be lower and its price higher than the competitive quantity and price. This imposes a cost on society because fewer consumers buy the product, and those who do not pay more for it. According to Pindyck and Rubinfeld, monopoly is a form of market power, the ability to affect the price of a good. As the sole producer of a product,

a monopolist is in a unique position. If the monopolist decides to raise the price of the product, it need not worry about competitors who, by charging a lower price, would capture a larger share of the market at the monopolist's expense. The monopolist is the market and has complete control over the amount of output offered for sale. But this does not mean that the monopolist can charge as high a price as it wants - at least not if its objective is to maximize profit. To maximize profit, the monopolist must first determine the characteristics of market demand, as well as its costs. Knowledge of demand and cost is crucial for a firm's economic decision making.
The existence of a positive natural monopoly does not imply that the market possesses the property of a normative natural monopoly (Low, 2000). There are two reasons for this: First, a monopoly may be unsustainable; that is, the incumbent monopolist may be unable to keep out equally efficient entrants while at least breaking even. Secondly, the incumbent and entrant(s) may prefer to coexist under less fierce competition, with possibly all firm is making profits. High sunk cost and other entry barriers that make entry unlikely however, usually accompany natural monopolies. The network externality makes a fully interconnected network the most efficient supply structure. Thus, according to arguments based on natural monopoly and externality, the tasks of telecommunication regulation should be to eliminate market power and mimic the outcome of competitive markets (Duesterberg, 1997). In addition, regulation should ensure the realization of the efficient market structure and help optimize the competition with respect to the consumption externalities.
The best way to test for the natural monopoly property is probably to let the
market discover the best outcome. If, despite restrictions, the market is a normative

natural monopoly, some inefficiency will emerge. But that potential inefficiency has to be compared with the certain inefficiency created by regulation of entry. Most likely, entry will occur only if the natural monopoly properties no longer hold (Vogelsang, Mitchel, 1997)7. In using frequency bands for radio services, Government as regulator must bear in mind that radio frequencies are limited natural resources and that they must be used rationally, efficiently and economically

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