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Margit Vanberg, Entry barriers in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 69 - 70

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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69 costs of production is not clear (Carlton and Perloff, 2005: 230; Dixit and Stiglitz, 1977: 301). The monopolistically competitive equilibrium could be biased either in the direction of too much product diversity or of too little product diversity in the market, depending on the preferences of consumers for product variety and the extent of the economies of scale. Because divergence from a second-best optimum is not systematic, it is difficult, if not impossible, for policy makers to correct the monopolistically competitive result towards a second-best optimum. Monopolistically competitive markets therefore offer no justification for government intervention. 4.3.3 Entry barriers The central characteristic common to the models of monopolistic competition is that their positive equilibrium properties depend on the assumption of free market entry. The theories of monopolistic competition show that the question of when competitive forces are sufficient to restrain market power can be approached by analyzing the possibilities for market entry. As long as economic profits in a market entice market entry, firms in this market cannot be said to have market power. Only when economic profits are realized over an extended time period without inducing market entry is market power present. There are different traditions with respect to defining barriers to market entry. The traditional industrial economic theory on entry barriers is represented by Bain (1956). Embedded in the structural approach, which explains market outcomes by a given market structure, Bain formulated a broad theory of market entry barriers that includes variations of economies of scale, product differentiation advantages of incumbents, and capital requirements (Schmalensee, 1989: 968). In essence, Bain considers all market characteristics that lend cost advantages to an incumbent firm to be barriers to entry, even if these cost advantages are only temporary. For example, if economies of scale allow the installed firm to produce a higher level of output at lower average costs of production, then, according to Bain, this must be looked at as a barrier to market entry. Potential entrants would initially produce less output at higher costs. Also, when product differentiation by the incumbent forces potential entrants to spend more on advertising than the incumbent is currently spending, then this is considered a barrier to market entry. A far more narrow definition of barriers to entry was formulated by Stigler, a representative of the Chicago School. Stigler defines: “A barrier to entry [...] as a cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry” (Stigler, 1968: 67). This definition focuses on long-run cost asymmetries between an incumbent firm and firms willing to enter the industry. The foremost reason for long-term cost advantages held by incumbents is the irreversibility of investments necessary for production. When the incumbent has already made these investments, their costs are no longer decision-relevant to him. They are, however, relevant to a firm contemplating entering the industry. Other reasons for asymmetric cost advantages can 70 be that the incumbent, for some reason, has access to a more efficient production technology or lower input prices than potential entrants, for instance, due to control over natural resources. When the requirements for long-term cost-advantages are not fulfilled, then entrants have access to the same efficient production technologies as the incumbent. Short-term cost-advantages of the incumbent, which Bain includes among the barriers to entry, will disappear over time and can therefore, according to Stigler, not deter entrants from entering a market in which above competitive profits persist. Product differentiation activities, for instance, can be undertaken by either firm. In fact, product differentiation is a central expression of competition in markets. The costs of differentiating one’s service or product are the same for both incumbents and newcomers. The fact that the expenditures for product differentiation and advertising may occur at different points in time for the incumbent and the new entrant is negligible when both have access to efficient capital markets.59 Even economies of scale and scope in the relevant region of market demand cannot be considered barriers to entry in the long run. When both the incumbent and the entrant have access to the same production technologies, then the entrant can potentially replace the incumbent and produce the same level of output at the same average cost of production (Knieps, 2005b: 82). In the extreme, even a natural monopolist has to fear being replaced by a potential entrant, when the entrant can expect to produce on the same long-run cost function as the incumbent.60 4.4 A reference model for justifying sector-specific regulation in network industries Given the typical market characteristics of network industries, it is easily recognizable that the use of market shares as a criterion to localize market power will promote errors of the first order. In these industries especially, it is important to use a model of monopolistic competition as a reference model to judge the effectiveness of competition in the market. This section introduces the theory of monopolistic bottlenecks as a reference model, which was designed explicitly to localize stable market power in network industries (Knieps, 2005b: 82). It is a theory grounded in network economics and therefore able to differentiate between typical characteristics of network industries and evidence of market power. Based on this theory it is possible to identify stable market power ex-ante and therefore to justify ex-ante sector- 59 This argument is backed up also by empirical studies which do not support the hypothesis that advertising expenditures are a barrier to entry (Schmalensee, 1989: 981). 60 Empirical studies on the correlation between concentration and profitability have produced mixed results and in sum do not support the hypothesis of a positive concentrationprofitability relationship (Schmalensee, 1989: 973-977). 70 be that the incumbent, for some reason, has access to a more efficient production technology or lower input prices than potential entrants, for instance, due to control over natural resources. When the requirements for long-term cost-advantages are not fulfilled, then entrants have access to the same efficient production technologies as the incumbent. Short-term cost-advantages of the incumbent, which Bain includes among the barriers to entry, will disappear over time and can therefore, according to Stigler, not deter entrants from entering a market in which above competitive profits persist. Product differentiation activities, for instance, can be undertaken by either firm. In fact, product differentiation is a central expression of competition in markets. The costs of differentiating one’s service or product are the same for both incumbents and newcomers. The fact that the expenditures for product differentiation and advertising may occur at different points in time for the incumbent and the new entrant is negligible when both have access to efficient capital arkets.59 Even economies of scale and scope in the relevant region of market de and cannot be considered barriers to entry in the long run. When both the incumbent and the entrant have access to the same production technologies, then the entrant can potentially replace the incumbent and produce the same level of output at the same average cost of production (Knieps, 2005b: 82). In the extreme, even a natural monopolist has to fear being replaced by a potential entrant, when the entrant can expect to produce on the same long-run cost function as the incumbent.60 4.4 A reference model for justifying sector-specific regulation in network industries Given the typical market characteristics of network industries, it is easily recognizable that the use of market shares as a criterion to localize market power will promote errors of the first order. In these industries especially, it is important to use a model of monopolistic competition as a reference model to judge the effectiveness of competition in the market. This section introduces the theory of monopolistic bottlenecks as a reference model, which was designed explicitly to localize stable market power in network industries (Knieps, 2005b: 82). It is a theory grounded in network economics and therefore able to differentiate between typical characteristics of network industries and evidence of market power. Based on this theory it is possible to identify stable market power ex-ante and therefore to justify ex-ante sector- 59 This argume t is backed up lso y empirical studies which do not support the hypothesis that advertising expenditures are a barrier to entry (Schmalensee, 1989: 981). 60 Empirical studies on the correlation between concentra ion and profitability have produced mixed results and in sum do not support the hypothesis of a positive concentrationprofitability relationship (Schmalensee, 1989: 973-977).

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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.