Industry Canada is preparing to auction Advanced Wireless Services (AWS) spectrum for use by commercial wireless carriers. As it considers the rules and format for the AWS auction, Industry Canada is seeking comments on whether it should implement policies designed to encour- age (or even guarantee) new entry into Canada’s wireless market. The policies under consideration include setting aside of a certain amount of spectrum exclusively for entrants, imposing limits on the amount of spectrum that may be acquired by incumbent wireless providers (Bell Mobility, Rogers, Telus) and mandating roaming agreements between entrants and incumbents.

If these policies are implemented, spectrum rights will not be allocated through a market-driven auction process, but instead the allocation of rights will be managed by gov- ernment. From an economic perspective, government inter- vention into the market’s allocation of resources (for instance, through economic regulation) requires the clear demonstration of a ”œmarket failure” and then only when the intervention is both feasible and likely to lead to an improvement in economic efficiency. The burden of proof to show that government intervention is required, or even opti- mal, rests with those proposing to regulate. Without proof of market failure, caution is the watchword before disturbing the competitive dynamics of the auction and the industry.

Is there a compelling reason for government intervention in the market process for auctioning spectrum for provision of wireless services? In its consultation paper, Industry Canada refers to the possibility that market forces may fail to arrive at an acceptable outcome because of the concentrated nature of wireless service provision in Canada and the barriers to entry facing new providers. As a result, it may be necessary to adopt entry-assisting policies. In contrast, past industry reviews by the Canadian Radio-television and Telecommunications Commission and the Competition Bureau describe the provision of wireless services in Canada as competitive, find- ing no market failure to correct. Given their assessments, government efforts to underwrite or subsidize new entrants appear unnecessary and would risk yielding an inefficient outcome that is ultimately to the detriment of con- sumers. In essence, without a clear demonstration that market failure exists or is likely to arise, the unneeded ”œcure” could be worse than the ”œdisease” it was meant to remedy.

In this article, we discuss why the number of competitors and costs asso- ciated with entry are poor indicators of market failure in modern industries such as wireless service provision. Policies designed to assist entrants are themselves undesirable if entry may not be efficient; a presumption that entry is warranted may be unjustified where large investments are needed to participate in a market, as is the case here. Additional risk lies in the extent or degree of any intervention, as Canada’s history of government-subsi- dized entry has often been one of never-ending government support. Once done, intervention is not easily undone; and, while market forces may eventually correct for inefficient entry, such an episode is costly to society.

The policy alternatives on the table that would tilt the auction process away from existing wireless providers and toward entrants are driven by the belief that more service providers are better for consumers. What is intuitive is that markets with few sellers are like- ly to be less competitive than markets with many sellers; indeed competition policy has historically looked to meas- ures of market concentration as key indicators of the degree of competition. Particular economic models of industry structure (such as the ”œCournot-Nash” model) also generate this clean and intuitive inverse relationship between the number of competitors and the level of prices. At the limit, when there are a great number of small firms such a model tells us that prices will approach the marginal cost of production " the ”œperfectly competitive” price level.

However, a variety of economic models exist where an increase in the number of competitors does not imply a decrease in prices. The simplest (and seemingly the least realistic) is one where firms sell identical products, face constant unit costs of production and compete against each other by strategi- cally choosing prices, with output then adjusting to meet demand (this is the so-called ”œBertrand-Nash” model of industry structure). In this set-up, a firm’s best strategy is to price at marginal cost even if it faces just a single competitor, since a price any higher than mar- ginal cost would be under- cut by the rival, who would then capture the entire mar- ket demand. Increasing the number of firms then has no effect on prices " with only two firms, they are already as low as they can get.

While this model may appear extreme, it provides some useful insights. One is that with relative product homogene- ity, if it is easy for firms to adjust their levels of output such that they are able to serve all or a large part of the mar- ket, pricing tends to be very aggressive even with a few competitors. The model’s prediction of intense competi- tive rivalry stems from any one firm being able to capture a large part of the market’s customers if it can price slightly below its rivals. For this to be a viable threat the firm has to be able to expand output rapidly in order to serve additional customers. The ability to change output levels rapidly is char- acteristic of many high-technology industries. In network industries such as wireless services, once network infrastructure has been deployed in a certain geographic area, expanding service to additional customers in the relevant area is relatively inexpensive.

To promote product switching with ease, products have to be substi- tutable. This raises two factual ques- tions: are the products sufficiently homogeneous and are switching costs de minimis? Within a given coverage area, wireless service offerings across providers are de facto not very different even though providers seek to distin- guish their service offerings through advertising and marketing (to mute the intensity of price competition). As a result, competition among wireless providers forces their service products to be substitutable in terms of both quality and areas of coverage. While switching costs are not zero, policies such as number portability reduce these switching costs.

Inferring competitive intensity from the number of competitors alone is also problematic when there are great differences in the sizes of the firms par- ticipating in a market. Consider, for example, a market in which a product is sold by a single very large firm and nine very small firms. Compared with the same market if served by two equal- sized firms, it is very possible that the former structure " which economists refer to as a dominant firm with a com- petitive fringe " would result in higher prices. More generally, the addition of a very small firm to such an already stable structure need not lead to any meaning- ful increase in the level of competition, at least as measured by the price level. What may also hold is that the domi- nant firm became dominant because its product quality and service levels are highly valued by the market. Delivering what consumers want can lead to one firm experiencing success and in the process capturing a large part of the market. In this scenario, it is up to the other firms (perhaps later entrants) to match what is demanded by the market so that competition for market share can produce an efficient result. Successful entry by others where their products meet the competitive quality level can erode the market share of any dominant firm. As noted, what is key is for entrants to match or exceed the pre- vailing product quality in the market, and for switching costs to be low.

This leads to consideration of a fur- ther complication: the story thus far (which has focused on price levels as a competitive outcome) is by no means the only or even the most useful way of considering competition. Where firms must make costly investments in areas such as research and development or capital expenditures on infrastructure in order to offer service, product pricing is only the second stage in a two-stage competitive process. Competition in the first stage " the investment phase " may be more relevant for consumers than competition in the second stage. Consider an example in which firms are developing a new technology (such as high-definition DVD players), only one version of which is likely to be adopted by consumers as the standard. Ex ante, each firm is equally likely to succeed, and if its technology is adopted as the standard a sponsor will be able to sell at the single-period monopoly price, while unsuccessful sponsors may not be able to sell their products at all. Each producer will then invest up to the point at which its research expenditures just equal its expected profits (again, viewed ex ante), so that total expected returns net of investment equal zero. At the investment stage, there is active competition while the expected sale of products at the monopoly price is the inducement for that competition. In this sense it is quite inaccurate to look at the market ex post and suggest that com- petition is absent " all meaningful com- petition took place at the investment stage. Sometimes this scenario is labelled as ”œcompetition for the field.”

Thus, in our simple example a mar- ket with a single ex post producer may be one which reflects a very active compet- itive process ex ante. Moreover, the entry of additional firms at the second stage does not enhance competition, at least under a longer-term view. True, the sec- ond-period price would be lower, which would benefit consumers ex post. But similarly positioned firms elsewhere in the industry (or even in the same mar- ket, contemplating the next stage in the development of the product) would now expect their return on investment to be lower as a result of enhanced prod- uct market entry, and would tend to invest less in the first stage, to the ulti- mate detriment of consumers.

In considering whether to adopt entry-inducing policies, Industry Canada has noted that there are high barriers to entry in the provision of wireless services in Canada, and that as a result entry by new competitors is not likely to occur without altering the mar- ket-based auction mechanism. This rais- es the following critical initial questions: what are relevant barriers to entry, and how do these yield market failure? Industry Canada cites access to spec- trum, the need for costly (and risky) investment in infrastructure and access to incumbent facilities as barriers to entry. Operating as a wireless service provider does require costly invest- ments, many of which must be incurred ex ante before services can be offered (and without any guarantee that con- sumers will subscribe in numbers that justify the necessary investments to achieve efficient service). Such costs are not unique to entrants, as existing providers also face these costs. Moreover, for technology-driven servic- es like wireless data and voice to remain competitive, all providers, old and new, need to re-invest as the technology changes and improves.

Does the fact that these investment costs exist (for both current providers and entrants) necessarily lead to market failure? In an otherwise com- petitive market, it is fundamentally inconsistent to subsidize entry for the purpose of driving down prices, while at the same time acknowledging that entry is extremely costly; this creates artificial entry where none would be expected to occur naturally. From an economic perspective, barriers to entry that raise market failure concerns are those that prevent entry that benefits consumers in the long run or socially desirable entry. In a well-functioning competitive market, what is socially desirable and what is privately prof- itable or desirable are in lockstep. To understand what is desirable from a social perspective in such a case, one need only ask what a rational firm seeking profitable opportunities would do. If the profits generated by sales to consumers once entry occurs are expected to be insufficient to justify the investment costs required to enter, par- ticularly relative to the risk- adjusted profits that can be earned by making similar investments elsewhere, a rational firm would choose not to enter. It is difficult to imagine why this private decision process would be any different from society’s point of view; inducing a firm to enter a market where in the absence of special provi- sions (in the form of subsidies or the equivalent) entry would not occur is tantamount to sponsoring inefficient entry. This is neither an efficient alloca- tion of society’s resources nor a good use of government resources.

But without these policies in place, would existing wireless providers have an incentive to overbid on spectrum in an open, unrestricted auction in an attempt to hoard valuable spectrum from entrants? If so, should the auction process restrict the amount of spectrum that can be successfully won by exist- ing wireless providers? What is not evi- dent is that overbidding by incumbents to hoard spectrum would be a profitable strategy even if the motive were to protect current returns. Furthermore, it is not clear that the cur- rent level of competition is inadequate and yields supra-competitive returns to incumbents, a necessary element for any hoarding strategy to succeed. Given this, the burden to prove that hoarding is profitable rests with those advocating such views. Nor in our view should there be any concern that suc- cessful regional entrants confronting competition would not have the appropriate incentives to roll out a national or international service. Failure to supply the appropriate level of quality would soon yield to an ero- sion of any customer base.

In some markets, the competitive outcome may result in three self-sus- taining firms (perhaps with numerous smaller players), just as we see in the wireless market in Canada. We can see this elsewhere: the recent OECD Communications Outlook shows that in 2005, there were three or fewer mobile operators serving customers in 15 of the 30 countries. We would not expect a market the size of Canada’s to yield a competitive equilibrium with a large number of small wireless firms because of the large investments and inherent risks associated with market participa- tion. Nor would we expect the wireless market to become a monopoly " indeed, wireless service has historically been left unregulated precisely because the degree of competition was deemed sufficient. In Canada’s current wireless market, if entry is efficient then it should arise through the normal auc- tion process. Should entry be induced unnecessarily, it may lead to lower prices in the short term, but this would be at the cost of future disincentives to invest. As a result, subsidized entry could result in redundant and duplica- tive network costs, an unstable period of competition and ultimately further consolidation.

To sum up: government needs to consider what the possible conse- quences are of a policy designed to induce entry in the Canadian wireless market. In the absence of special auction rules for new entrants, would the upcoming spec- trum auction produce a strong additional player that would enhance competitive vigour, yielding lower prices and improved services? The answer is perhaps.

The tentative nature of the answer does not mean that subsidization is necessary. Any short-term consumer benefits that might accrue from special entry-inducing rules need to be measured against the increased risk and long-term costs of inefficient entry. The risk is not justified by any evidence of existing or potential future market failure. Therefore, public policy directed at regulating the auction to tilt the field toward entrants and away from incumbents is not required. The consequence of such a policy would be the need for continuing subsidies or, absent ongoing support, the need to consolidate assets in the future as some players would be unsustainable. All in all, resources would have been ineffi- ciently spent on creating network facili- ties that were economically unjustified with the end result being a net long-term loss to consumers.

 

The authors are grateful to Margaret Sanderson for detailed comments.