Margit Vanberg, Competition policy vs. sector-specific regulation in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 64 - 66

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
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.”) 65 generally instated ex-ante to prevent abuse of market power, which has not yet occurred. Lastly, since regulation is generally ongoing, the potential for phasing-out of regulation needs to be reviewed explicitly. As antitrust decisions are taken on a caseby-case basis they do not need to be reviewed again. The likelihood of committing a Type-1 error (false positive) is larger in sectorspecific regulation than in antitrust policy. The most important reason for this is that regulation is implemented before abuse of market power has occurred. It is therefore based on less reliable conjectures of what might have happened had market processes run their course. Furthermore, sector-specific regulation requires more information on the industry to fine-tune regulatory intervention than antitrust actions, which generally only prohibit particular actions, afford. This information is difficult to impossible for regulators to obtain. Lastly, regulation is far more intrusive with respect to the freedoms of the regulated firm than general competition policy. For all of these reasons, sector-specific regulation is likely to commit a Type-1 error. As a consequence, regulation should be based on an even stronger justification for market intervention than general competition law (Knieps, 2006: 49). A robust definition of market power is needed which can make it plausible that the market outcome can be improved by the application of regulation. In practice, the criteria used to justify regulatory intervention are very similar to those used to justify antitrust actions. The European Commission (EC), for instance, explicitly aligned the definition of market dominance used in its framework for the regulation of electronic communications markets with the definition used in general competition law (EC, 2002: §5): The notion of dominance has been defined in the case-law of the Court of Justice as a position of economic strength affording an undertaking the power to behave to an appreciable extent independently of competitors, customers and ultimately consumers. Therefore, under the new regulatory framework, in contrast with the 1998 framework, the Commission and the NRAs will rely on competition law principles and methodologies to define the markets to be regulated ex-ante and to assess whether undertakings have significant market power (‘SMP’) on those markets. To localize significant market power (SMP), which may require the application of sector-specific regulation, the Commission suggests the following criteria (EC, 2002: §78): …overall size of the undertaking, control of infrastructure not easily duplicated, technological advantages or superiority, absence of or low countervailing buying power, easy or privileged access to capital markets/financial resources/, product/services diversifications, economies of scale, economies of scope, vertical integration, a highly developed distribution and sales network, absence of potential competition, and barriers to expansion. The list is long and includes many market characteristics that do not give reason for stable market power. The Commission’s guidelines are not clear on how the criteria are to be applied. At least in practice, the criteria are not being applied cumulatively; and since market shares are relatively easy to measure, regulatory autho- 66 rities, just as competition authorities, often resort to market shares only as the main determinant of a dominant market position.57 4.3 Criteria for judging competition in network industries The focus now turns to a normative discussion of how the competitiveness of a market can be assessed for the purpose of judging the need for government intervention into market processes. Since market characteristics and therefore also the characteristics of competition in a market depend on the particularities of the industry, such an analysis must be undertaken for a particular industry in question. The present section focuses on the special case of network industries. Competition policy for network industries is made difficult by the fact that network industries do not feature the typical characteristics of competitive markets. A main reason for this is that building a network infrastructure involves large fixed costs. On the physical layer of a network industry, there will therefore often be only one or very few active market players. The strong network externalities associated with the demand for network services may also favor fewer larger firms on the applications layer of network industries. The central characteristics of network industries therefore lead to a market structure in which only a few large competitors are far more likely to exist than many small firms. Does this imply that competition is not possible in network industries with large fixed and common costs? 4.3.1 Sufficient conditions for natural monopoly One critical concept for understanding the competitive forces in a market is the concept of natural monopoly. A market is considered a natural monopoly when a single firm can produce the relevant output at lower costs than several firms. A formal definition of natural monopoly employs the concept of strict subadditivity of the cost function in the relevant range of output (Baumol, 1977). The necessary conditions for subadditivity are different for single-product and multi-product production. In the case of a single-product firm, economies of scale, defined by the fact that a proportional increase in all inputs leads to an over-proportional increase in output, are sufficient to prove subadditivity of the cost function (Baumol, 1977: 810). Economies of scale are, however, not a necessary condition for subadditivity in the single-product case. It is possible that a cost function is subadditive in the relevant range of output even for output ranges in which the demand curve crosses the marginal cost curve in the range of increasing marginal costs. Given large fixed costs of production, it can be less costly to have a single firm produce in the range of increa- 57 See discussion in section 9.2.2 below.

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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.