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Margit Vanberg, Justifying government intervention into markets in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 62 - 64

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6 https://doi.org/10.5771/9783845212906

Series: Freiburger Studien zur Netzökonomie, vol. 14

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62 4 A framework for localizing market power in network industries Competition is generally regarded as the wellspring and safeguard of economic welfare. A competitive order leads to economic efficiency in a market and fosters an environment in which technological progress and real economic growth is spurred. Therefore, when competitive forces are restricted because of market failures, competition policy may be called for to modify market conditions such that welfare is improved. Traditionally, natural monopoly and network externalities are viewed as the primary causes of market failure (Viscusi et al., 2000: 314). Network industries have received a lot of attention from competition authorities, because the cost and demand characteristics of network industries are likely to lead to natural monopoly and network externalities. Section 4.1 of this chapter discusses when and why government intervention into market processes can generally be justified. A short overview of the differences between general competition law and sector-specific regulation is given in section 4.2. In section 4.3 the focus is on the special case of network industries and how competition authorities can judge the level of competition in these industries. Section 4.4 describes a reference model that can be used to justify sectorspecific regulation in network industries. The conditions under which the application of general competition law to network industries can be justified are discussed in section 4.5. Section 4.6 concludes the chapter. 4.1 Justifying government intervention into markets As mentioned above, alleged market failures provide common justification for intervention into market processes. However, the conditions under which market failures are so severe as to warrant sector-specific regulation are a matter of controversy among scholars.54 A decision in favor of competition policy needs to bear in mind the trade-off between costs and gains from policy intervention. The costs of government intervention into market processes are not only the administrative costs of implementing regulation. There are also inefficiencies in any political process, which need to be taken into account. In his seminal paper on information and efficiency, Demsetz (1969) argues that public policy considerations should not be based on a “nirvana approach,” which would entail comparing the existing institutional arrangement to an ideal norm, as if governments act solely in the interest of social 54 The terms “general competition law” and “antitrust” are used interchangeably here. The former term is more common in the competition policy of the European Union (EU). The latter is generally used in U.S. policy. 63 welfare and are able to bring about any market outcome of their choosing. Instead, the evaluation of government intervention should use a comparative institution approach which entails comparing existing conditions to feasible institutional alternatives. Demsetz urges interested parties to come to a realistic understanding of what government interventions into markets can bring forth. The economic theory of regulation underwent such a change of perspective in the 1960s. The traditional public interest theory of regulation assumed that regulatory agencies act in the interest of social welfare and are able to costlessly correct market failures. Research on regulation first criticized the assumption of costless regulation by focusing on unintended consequences of regulation (i.e. Averch and Johnson, 1962). Eventually, the public interest theory of regulation was replaced by the positive theory of regulation which emphasizes the effects of rent-seeking behavior by interested parties (i.e. Stigler, 1971).55 The positive theory of regulation evaluates the efficiency of government intervention by considering the incentives of the competition authority or the regulatory agency, the incentives of the regulated firm, the incentives of industrial and consumer associations, and the ability of each of these affected parties to implement its own agenda (Spulber, 1989). Taking all these factors into account, it becomes evident that government intervention cannot be used to pursue an ideal market outcome. The following statement is a good example of the modern view of regulation (Brunekreeft, 2003: 23): “Even in cases where an unambiguous claim of market power can be made, it can still be controversial whether regulatory intervention would improve the situation.” Given the institutional and informational constraints under which government interventions into market processes take place, a nonintervention market outcome may well be closer to the ideal norm than an intervention outcome, even when market failure is apparent. This holds even more, the less severe the market failure which is to be corrected and also the more dynamic the market, in which the market failure is observed, because market conditions in these markets change rapidly. For government intervention to increase social welfare, it is essential that the regulatory framework be designed very carefully. Firstly, the institutional framework should make the regulatory process as transparent as possible. The criteria for applying particular policies or for lifting certain policies should be made public. Secondly, the new rules should be fixed for a substantial time period to prevent adhoc changes in policy. This can help reduce the likelihood of special interests influencing government action. Thirdly, because of the inherent limitations of competition policy, market interventions should be based on strong justifications and only be applied very restrictively. A formal depiction of the trade-off that needs to be considered in implementing sector-specific regulations is the distinction of Type-1 and Type-2 errors (Knieps, 2006: 70). A Type-1 error is committed when regulatory authorities intervene in a market even though competition is effective (false positive). A Type-2 error is 55 For an overview of economic theories of regulation see Viscusi et al. (2000: Chapter 10). 64 committed when regulation policy is not applied, even though market power is inhibiting effective competition (false negative). Most industrialized democracies are committed to free markets and fear a weakening of the market process in their countries. When free market processes are to remain the norm, then it is better to err on the side of committing a Type-2 error as compared to the side of committing a Type-1 error. Market intervention should therefore be made difficult by placing strong demands on the justification of sector-specific regulation. 4.2 Competition policy vs. sector-specific regulation General competition law and sector-specific regulation differ in several aspects. Competition law applies to all sectors of the economy. It is concerned with the supervision of mergers and acquisitions, with monopolization and with cartelization of markets. In “single dominance” (monopolization) or “collective dominance” (cartelization) cases the competition authority investigates claims of anti-competitive behavior, such as tying, predatory pricing, or refusals to deal. Competition authorities have the authority to reject or approve mergers, to impose fines and to prohibit particular behavior by dominant firms. Market intervention based on general competition law is always decided on a case-by-case basis. Competition authorities can, in theory, use several market characteristics to approximate market dominance. In practice, the criterion most often applied to measure market dominance is the relative market share in the relevant product market. Further criteria used are the existence of barriers to expansion and entry and the market position of buyers in the market.56 Generally, antitrust is applied ex-post when abuse of market power has been established (at least according to the competition authority). Thus, the likelihood of committing a Type-1 error (false positive) is reduced since market outcomes can be observed. Only in merger policy a decision needs to be taken ex-ante, before the consequences for the market can be directly observed. In contrast to general competition law, sector-specific regulations are designed for a particular industry. Regulation is far more intrusive than antitrust action because the intervention pertains to ongoing activities of the regulated firm. Regulation can, for instance, be applied to restrict the price-setting freedom of the regulated firm or to mandate access to its industrial or intellectual property. A further fundamental difference to general competition policy is the fact that sector-specific regulation is 56 Traditionally, competition authorities were quick to equate large market shares with market power (Spulber, 1989: 501). Competition authorities have increasingly recognized the shortcomings of this simplified approach and are striving to enrich their definition of market dominance by adding more criteria (see, for instance, a speech which Neelie Kroes, member of the European Commission in charge of competition policy gave before the Fordham Corporate Law Institute on 23rd September 2005, entitled “Preliminary Thoughts on Policy Review of Article 82.”)

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Zusammenfassung

Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.