3.6

Opening Vertically-Integrated Markets

In vertically integrated companies, the management has upstream and downstream control of the procurement, production, distribution/marketing and sales processes.

  • 3.6.1 Benefits and Costs of Vertical Integration

    Economic Theories

    Economists have different theories as to why firms vertically integrate. A common theme is economies of scale which can result in lower prices for the consumers. The Chicago School of thought argues that if management is rational then it will only choose vertical integration if the economic incentives support that way of doing business. This has been termedinternalize complementary efficiencies, the implication being that most forms of regulation will simply distort the incentives and force the firm to operate at a sub-optimal level. They go on to point out that in technologically fast-changing industries, monopolies rarely survive for long.

    The New Institutional school, closely associated with the original work of Chicago economist Ronald Coase* and with University of California economist Oliver Williamson, suggests that vertical integration gives firms access to information along different points of the supply chain and across different markets that would otherwise not be easily available to them. The alternative would be incurring transactions costs of dealing with different suppliers, wholesalers or retailers. Vertical integration can save on these costs. By contrast, the older Institutional School takes its original inspiration from the work of nineteenth century American economist and sociologist Thorstein Veblen and later from the work of economist John Kenneth Galbraith. It points to the personal incentives and psychological motivations of managers preferring to manage larger than smaller corporations.

    In reality all these theories can be correct to some degree. For example, the Chicago School would see the case studies of the Institutional School as examples of managers not doing what is in the best interests of their companies. This would mean they are not acting rationally in terms of the firm, while on the other hand the Institutionalists would see them acting rationally in their own terms. What all these schools of thought have in common is that they do not just describe how firms come to be large and vertically integrated, but why they do so, what motivates their management, and why they remain integrated or why they may choose not to.

    Regulators

    Why is this important to regulators? Two reasons. First, because regulators have to take into account the possibility that the firms are using their control of the supply chain to discriminate in terms of price, quality and timeliness of supply of upstream products and services to downstream competitors. This can result in ‘profits squeeze’ for competing retail service providers forcing them to withdraw from the market. If vertical integration undermines competition then investment, innovation and consumer welfare will suffer. Second, regulators need to understand how economic incentives influence the behaviour of the firm. Regulation that is poorly designed may do more damage than good. For example, policies that try to cap the profits of a dominant vertically-integrated company may simply result in that company shifting its investments from its regulated to its unregulated lines of business. Or, a price-cap that is linked to the rate of inflation and designed to encourage a firm to cut costs if it wants to boost profits (see Module 3.2) may result in the firm meeting its demand targets and then under-investing in efficiency-enhancing capital expenditure while it waits for the next round of price-cap adjustment. This example is given by Cave and Doyle who suggest the regulator “offer firms a menu of increasing investment levels, associated with progressively lower allowable rates of return.”*

    The opposite problem of ‘gold-plating’ arises when rate-of-return regulation allows the firm the same rate-of-profit whatever its level of investment. This is also known as the Averch-Johnson effect.* In the United States, where anti-trust rulings by the Federal Communications Commission (FCC) are regularly tested in the law courts, economic arguments have become compelling, or as Judge Richard Posner, a leading anti-trust economist and jurist put it “an economics-based approach has won in antitrust.”* For this reason, regulators need to have a good understanding of what drives and motivates the companies under regulation.

  • 3.6.2 Remedies to Anti-Competitive Conduct by a Vertically-Integrated Operator

    Anti-Competitive Behaviour

    Anti-competitive behaviour can arise from many different situations. Some example are collusion between equal competitors, or ‘price-leadership’ when unequal competitors prefer the easy life of living under the shadow of the incumbent who fixes the price. Different causes of anti-competitive behaviour call for different remedies. Anti-competitive behaviour that arises from an operator exploiting the advantages of vertical integration has many historical precedents.

    Remedies a regulator can use include the following:

    • Open the doors to new entrants and assist them in establishing a foothold in the market, for example, by unbundling the local loop, by regulating interconnection agreements, by allowing them to share facilities, by introducing number portability, etc.
    • Encourage the adopting of new technologies, including Internet-based services that can offer consumers a real choice
    • Require the regulated operator to offer equal access to competitors, if necessary along with incentives to comply
    • Enforce separations if other measures are ineffective, either accounting, functional or structure separation
    • Use a public subsidy for an independent network construction company and/or wholesale operator with an equal access obligation

    There is no question that competition from new entrants using the most up-to-date and cost-effective technologies associated with all-IP broadband NGNs is the most effective way to combat anti-competitive behaviour by vertically-integrated incumbents. The important caveat is that policy-makers must support competition, if necessary by revising the terms and conditions of the incumbent’s licence and the telecommunications laws under which it is issued. This process may require a compensation agreement to cover the loss of exclusive rights conveyed by the licence. Compensation can be in the form of cash, as was the case when the Hong Kong policy maker took back the exclusive international telecoms licence from Hong Kong Telecommunications to open up the market. Alternatively, the new licence can give the incumbent access to markets it could not previously enter. When AT&T in the US was broken up (‘divested’) through structural separation in 1980s into seven independent Regional Bell Operating Companies (RBOCs) otherwise known as Incumbent Local Exchange Carriers (ILECs), it was given the right for the first time to compete in call international markets.

    Separations

    Separations are a radical step for a regulator to take. In the UK in the 1990s, British Telecom (BT) voluntarily agreed to a functional or operational separation of its various business units in order not to lose the economies of scale that come from sharing some of its overheads and investment in R&D, including vital strategic business information. The restructuring was approved on an ex post basis, meaning that regulator agreed to a light-handed touch to see how well the new structure worked. See figure3.10 for BT’s new structure.

    Image
    FIGURE 3.10
    BT's Functional Restructuring

    No one has more detailed information about operational costs, markets and investments than the operators themselves, and this places regulators in a difficult position. To be effective the regulator needs the full compliance and cooperation of the regulated operator. This cooperation can come at a cost if the regulated operator manages to ‘capture’ the regulator, meaning the regulator becomes beholden. If the incumbent operator has close ties with high-level policy makers, which is quite likely, then the issue of transparency becomes very important.

    Regulators who examine the case for separations need the cost accounting information of the operator to determine what would be the most cost-efficient means of separation. For example, if the wireless cellular operation is part of a competitive market but the fixed line PSTN is not, then the argument for an accounting or financial separation may be sufficient to ensure mobile prices are not cross-subsidized from fixed line rentals and usage charges.  But that may not be sufficient if, for example, backhaul is provided to the mobile business unit but not for competitors on an equal basis, unless the competitors are also full service operators.

    Vertical integration is not by its nature transparent. Even an incumbent operator may not know the true cost of its many activities simply because under the traditional regime of monopoly pricing it never needed to know them. The traditional way an incumbent set prices was to allocate or distribute costs across a range of services based upon what the market would bear. In more competitive markets, where the elasticity of demand will be higher, the prices would be lower, while in more captive markets where the elasticity of demand will be lower, the prices would be higher. This is also known as Ramsey pricing.The following figure, from the World Bank’s Telecommunications Handbook summarises the different cost allocation methods available to operators and regulators alike.

    BOX 3.10
    Costs, Prices and Vertical Integration
    Image
    FIGURE 3.11

    From the bottom-up the figure illustrates the following:

    1. Stand-alone costs when there is one output or service and all the costs must be covered in the sales price.
    2. Fully Distributed/Allocated Costs (FDC/FAC): when there are two or more service outputs, for example local, long distance and international voice services, the costs of any of them consists of an apportionment of common costs, e.g., property taxes, and of joint costs, e.g., the cost of the switch used for both services, such that all common and joint costs are covered  by each of the services in combination, plus the fixed costs specific to that service, such as the costs of the cable landing station or satellite station, plus the incremental costs associated with that service, such as the total of marginal costs of switching or routing traffic.
    3. Total Service Long-Run/Long-Run Average Incremental Cost (TSLRIC/LRAIC) with uniform mark-up: the same as FDC/FAC with two exceptions. Costs are forward-looking (not historical) based upon new technologies, and the allocation of common and joint costs is done on some defined proportionality basis, such as the percentage volumes of traffic or revenues.
    4. Total Service Long-Run Incremental Cost (TSLRIC) with mark-up: the same as TSLRIC/LRAIC except mark-ups distinguish between common and joint costs shared by services, and residual costs that arise even at zero output, sometimes referred to as “keeping the lights on.”
    5. Total Service Long-Run Incremental Cost (TSLRIC): the same as TSLRIC/LRAIC except that the allocation of common and joint costs only includes those that are genuinely common or joint costs of the services under consideration.
    6. Total Service Long-Run/Long-Run Average Incremental Cost (TSLRIC/LRAIC): same forward-looking costs as above without the mark-up, so only incremental (variable) direct costs and a proportion of fixed costs are included.
    7. Long-Run Incremental Cost (TSLRIC): only forward-looking incremental (variable) direct costs are involved.

    An example of regulatory costs accounting is the emphasis the FCC placed upon ‘modularity’ or open access following the Telecommunications Act of 1996. The FCC ruled that vertically-integrated RBOCs or Incumbent Local Exchange Carriers (ILECs) would be required to offer various ‘unbundled network elements’ (UNEs) as separate modules to local competitors at a cost-based price. For example, access to the registry of residential and business telephone numbers. This was to ensure that if the LECs offered interconnection to their competitors they did not force them to pay for network elements they did not need. The FCC  used a methodology called total element long run incremental cost (TELRIC) to determine an appropriate price of UNEs. 

    Going Vertical: Mergers & Acquisitions

    Vertical integration works well for firms with a relatively narrow-range of products, but as the range get wider the challenges of management coordination grow and the efficiencies get called into question. If the products and services are complimentary then the advantages of becoming big probably outweigh the disadvantages. However, if the product range is diverse, includes substitutes or competing services, and results in the need for a variety of different investment and marketing strategies, then big can spell trouble. For example, the merger of a telecoms and a cable or IPTV business may seem to be a case of convergence, but the investment profiles and management skills required by each are entirely different.  For these reasons, in some some  industries mergers and acquisitions (M&As) may end up destroying more value than they create. In other cases, such as when an incumbent acquires an innovative start-up which has recently entered the market, the big question is whether what is being acquired are the inventors and innovators behind the start-up or just the intellectual property. Whether M&As add value or destroy value is something that can only be tested in the marketplace; for regulators that is not the issue, rather it is whether there is or is not a high probability competition, and therefore innovation and customer choice, will be reduced. 

    This presents regulators with a range of issues. First, is a vertically integrated telecoms company dominant because it is efficient or because it is abusing its market power and discriminating against weaker competitors? Second, when an M&A is proposed, will it significantly reduce competition in the market, or will it increase efficiency and present consumers with better value services? Third, even without discriminatory behaviour, is  the vertically-integrated company in any way ‘dominant’ and if so does it wield ‘significant market power’ (SMP) such that it can independently influence market prices for itself and its competitors? Dominance is only a measure of potential market power. Whether the company exploits that power in anti-competitive ways is a judgment call by the regulator who has to decide whether to regulate ex-ante (on the presumption of anti-competitive behaviour) or ex-post (on the basis of observation and assessment) – see module 3.2.

    These are essentially economic issues, but there are also issues of political power and social influence. Cross-ownership rules are designed to curtail the concentration of power in too few hands and are usually part of an M&A assessment process. There are further issues, such as a concentration of foreign ownership if a country identifies some of its telecom services as national economic or security concerns. But it is important that trade  commitments made under the WTO are honoured to achieve the greatest possible benefits from investment in open markets. The telecoms regulator may not be the final arbiter on whether an M&A is allowed to proceed, but where the merged companies involved a telecoms operator the view of the regulator on the possible outcome is important.

    Vertical Value Chains

    Over recent decades in the supply chain for the fast-growing mobile sector of telecoms equipment there has been something of a tug-of-war between the vendors who manufacture the handsets and the operators who connect them to their networks. Although vendors may decide to sell their handsets through retail outlets the bulk of their sales is often to the carriers.  Through bulk purchases of handsets the carriers get important discounts which they can pass onto their subscribers, adding their own discounts to attract new customers in cases where the mobile services markets are highly competitive. But there is also competition between the vendors and the operators to determine which of them secures the larger share of the value along the supply chain.

    Branding, designs (‘form factors’) and operating systems have been the key areas of competing demands. Vendors want to their name as the band. As with other products, better known branded handsets sell at a premium over lesser brands. But equally, operators such as Vodafone and DoCoMo and Hutchison’s “3” benefit from name recognition if the handset carries their brand. Bulk-buying has sometimes swung the balance of branding power towards the carriers, especially those who won licences to pioneer the next generation of mobile services, such as 3G. With branding power (the logo on the phone) often went the power to dictate the designs or ‘form factor’ of the phones, such a flip-tops, slide phones, swivel phones, touch screens, their colours and shapes. But the power of operators tends to diminish as the carrier market itself becomes more competitive. Their power is further eroded if they are unable to dominate the market by ‘locking’ the handsets they connect to the network so that only their SIM cards can be used in those phones. This erosion can arise from regulation which outlaws the practice, or by customers shifting to the unlocked services of their competitors which may happen, for example, when cheaper phones are bought in increasing numbers by lower-income and often pre-paid users.  

    Apple is a vendor that has traditionally locked its phones and made agreements with carriers to keep them locked. The iPhone, launched in 2008, is widely accepted to have been a game-changer for the industry. For the public its brand name and designs were major attractions, in particular its touch-screen features, but behind both was Apple’s innovative iOS operating system. Operating systems (OS) determine which apps can be run, their screen appearance as well how to navigation a phone’s many functions, which are themselves apps. Like the now defunct Symbian OS used by Nokia, Ericsson and others, they may be owned by a consortium of vendors, or like iOS they may be vendor-specific, or like Google’s Android OS they may be owned by one vendor but freely available to all. They constitute a vital part of the intellectual property of handset manufacturers and, where they are under a commercial licence, an important source of royalty revenue.The outstanding feature of the handset market today is how fast the technologies develop, the apps develop, the form factors change. This has resulted in market leaders of yesteryear falling behind or even exiting the market. It has resulted in component manufacturers and original engineering and manufacturing (OEM) companies entering into alliances with one or other of the major vendors, or in some cases, such as HTC vying to become a major vendor in its own right by selling direct to large carriers, for example, in China. This underscores how quickly the balance of market power can shift horizontally between vendors and vertically between vendors and carriers. After the iPhone kick-started a radical shift towards smartphones, Apple held enormous market power, for a short time catapulting the company into being the largest in the world by value. Apple could more or less dictate terms to the carriers it selected to market the iPhone, with previously unheard of commercial agreements which included the carriers to guarantee a local subsidy to iPhone retail prices and even a revenue-sharing agreement. That power was derived from the strength of consumer demand for, and loyalty towards, each new iPhone release.But the market has never ceased moving on, seeing new vendors including social networks like Facebook moving into the mobile market. In many ways it is appropriate that this is the case. The very last part of the traditional telecommunications market to face competition and to see innovation was the telephone receiver. Only in the 1980s was there widespread opening of the consumer premises equipment (CPE) markets, which began with non-black plastic telephone designs, and then telephones with additional functions such as stored numbers, call holding, recall, etc., which could be bought in supermarkets at low prices. The OS of mobile handsets has set new standards of innovation because they are linked to the Internet. For regulators, the issues raised are many, but they mostly revolve around competition and consumer protection issues to be with pricing, locking, blocking of apps and net neutrality.