Call externalities, network effects, and market power: The Orange/T-Mobile merger

David Harbord, Steffen H Hoernig 28 September 2010

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Last year the European Commission (EC 2009) issued a recommendation proposing dramatic reductions in the fees mobile firms charge other networks for calling their subscribers. Earlier this year the same Commission approved the merger of Orange and T-Mobile in the UK mobile market (EC 2010). The two decisions interact in important ways.

Mobile termination rates

Mobile termination rates (MTRs) are the charges that mobile firms levy on fixed networks and other mobile operators for completing, or "terminating", calls on their networks. MTRs are not directly observed by consumers but significantly affect what they pay for calls and subscription charges, and indirectly for subscription charges. Concerns about mobile call termination being a "bottleneck" service, coupled with the history of high charges, have led to the regulation of MTRs in every country in the EU (see Harbord and Hoernig 2010 and Harbord and Pagnozzi 2010 for detailed discussions).

The Commission recommends that MTRs be reduced to reflect the actual marginal or incremental costs of providing call termination to other networks. Regulators around Europe have since fallen into line. In the UK, the telecommunications regulator Ofcom is now proposing to reduce MTRs from an average price of more than 4 pence per minute (ppm) to its own incremental cost estimate of 0.5 ppm by 2015 (see Ofcom 2010).

The European Commission's recommendation has been heavily influenced by a recent body of economic literature which highlights the two-sided nature of mobile interconnection markets, and the significant role that "network effects", "receiver benefits" and "call externalities" play in the analysis of competition, pricing, and entry in these markets (see Armstrong and Wright 2009b, Berger 2005, Cabral 2009, Hermalin and Katz 2009, Hoernig 2007, and Jeon et al. 2004).

“Receiver benefits” refer to the fact that both the sender and receiver of a call benefit from it – otherwise no one would ever answer the phone. “Call externalities” arise because under a "calling party pays" regime, such as that adopted in European countries, only the sending party is charged for calls. Hence senders will tend to make too few (or too short) calls, as they will fail to take account of the full value of their calls to receivers.

The level of MTRs not only directly affects the prices paid by consumers for calls, but also indirectly the intensity of competition between mobile networks. High MTRs increase mobile networks' incentives to set large price differentials for making own network ("on-net") versus off network ("off-net") calls. These price differentials create "network effects" which intensify competition between mobile networks to attract new subscribers, and create a competitive advantage for larger networks which can offer cheap on-net calls to a larger subscriber base.1 The strength of these incentives also depends on the importance of receiver benefits, since high off-net call prices only affect subscribers on other networks when they care about receiving calls.

Simulating the Orange/T-Mobile merger

As the economic literature shows, any analysis of competition and pricing – and hence mergers – in mobile markets must therefore take account of both call externalities and network effects. In recent research (Harbord and Hoernig 2010), we use a calibrated welfare model of the UK mobile telephony market to simulate the effects of the merger between Orange and T-Mobile.

The Orange/T-Mobile merger will combine two mobile firms with current market shares of 21.3% and 15.7% respectively, into a single network with more than 32 million subscribers and 37% of the market. We simulate the effects of this merger under two different assumptions concerning the level of MTRs, and for six values for the ratio of receiver to sender benefits, or the call externality parameter (β in our model)
 

Our first assumption sets MTRs at Ofcom's estimates of "fully allocated cost" for the final year of the current price control 2010/11 – around 4ppm. Our second assumption sets MTRs at zero prior to the merger as a proxy for negligible MTRs.

Effects of the merger under 2010/11 MTRs

Under our first assumption we find that the overall effects of the merger depend strongly on the strength of call externalities. In the absence of any call externalities, we find that the merger will improve allocative efficiency and welfare by moving more subscribers on to a single large network, thus avoiding the inefficiencies associated with high off-net call prices. In other words, the merger may help to ameliorate the negative effects of above-cost MTRs as currently allowed by the UK regulatory authorities.

With any significant level of call externalities, however, this result is reversed by the strategic incentive of the newly merged firm to increase its off-net call prices. Indeed, a standard result from the recent literature suggests that, in the presence of call externalities, large networks charge higher off-net prices than smaller networks. Hence there is a critical level of the call externality parameter above which the merger becomes harmful to allocative efficiency and welfare. In our simulations, this always occurs when the ratio of receiver to sender benefits is between one fifth and two fifths (see β in Table 1).2 For large call externalities, our simulations predict overall welfare losses from the merger exceeding £1.4 billion per year, dwarfing the cost savings of £390 to £420 million per year predicted by the companies themselves.3

Since the merger reduces the number of competitors in the mobile market, however, it reduces the intensity of competition between mobile networks to attract new subscribers. This in turn induces mobile firms to raise the level of their fixed charges, increasing profits at the expense of consumer surplus. This reduction in consumer surplus exceeds £1.8 billion per annum in the absence of call externalities (β=0), and exceeds £2.9 billion per year when call externalities are very high (β=1). Losses in consumer surplus are, unsurprisingly, closely mirrored by corresponding increases in mobile firms' profits, as illustrated by Table 1.

Table 1. Effects of the merger under 2010/11 MTRs

Call externalities
β=0
β=0.2
β=0.4
β=0.6
β= 0.8
β=1
Change in welfare
24
6
-56
-210
-573
-1465
Change in consumer surplus
-1821
-1883
-1982
-2142
-2418
-2932
Change in profits
1845
1889
1926
1932
1844
1467

Effects of the merger under near-zero MTRs

Under our second assumption with much lower MTRs, the effects of the merger on aggregate welfare are much reduced. The merger's effects on consumer surplus vary depending on the impact of the reduction in MTRs on market shares. We considered two possibilities. First, that MTRs are reduced prior to the merger, with no short-run effect on network market shares. In this case, with very low call externalities the merger improves allocative efficiency by just over £2 million per year, but this welfare gain falls to zero with moderate call externalities and to a welfare loss of just over £29 million per year when call externalities are high. If we allow for the companies' claimed cost savings of £390 – £420 million per year, this means that the merger will be efficiency improving for all reasonable values of the call externality parameter.

But the merger still results in large decreases in consumer surplus for all levels of the call externality, up to a maximum of £2.74 billion per year. Even when we take into consideration the ameliorating influence that reduced MTRs have on the competitive advantage of larger networks, we still find that the merger creates significant welfare losses for consumers and significantly increases the profits of the mobile networks.

Conclusion

In March this year, the European Commission approved the merger between Orange and T-Mobile, subject to certain undertakings agreed by the companies relating to network-sharing arrangements and divestiture of spectrum (see European Commission 2010). Yet in every scenario we have modelled, competition and consumer surplus are significantly reduced while profits rise. It is difficult to see how these undertakings address the competition policy and welfare-related concerns illustrated by our simulation model..

References

Armstrong, M and J Wright (2009a), “Mobile call termination”, Economic Journal, 119:F270-F307

Armstrong, M and J Wright (2009b), “Mobile call termination in the UK: a competitive bottleneck?” in B Lyons (ed.), Cases in European Competition Policy: The Economic Analysis, Cambridge: CUP.

Berger, U (2005), “Bill-and-keep vs. cost-based access pricing revisited”, Economics Letters, 86(1):107-112.

Cabral, L (2009), “Dynamic price competition with network effects”, forthcoming in Review of Economic Studies.

Competition Commission (2009). Mobile phone wholesale voice termination charges: Determination, HMSO, London.

European Commission (EC) (2009), Commission Recommendation on the Regulatory Treatment of Fixed and Mobile Termination Rates in the EU, 7 May, Brussels.

European Commission (EC) (2010), Mergers: Commission Approves Proposed Merger Between UK Subsidiaries of France Telecom and Deutsche Telekom Subject to Conditions, Brussels.

Harbord, D and S Hoernig (2010), “Welfare Analysis of Regulating Mobile Termination Rates in the UK (with an Application to the Orange/T-Mobile Merger)”, CEPR Discussion Paper 7730, March.

Harbord, D and M Pagnozzi (2010), “Network-based price discrimination and `bill-and-keep' vs. `cost-based' regulation of mobile termination rates”, Review of Network Economics, 9(1), Article 1.

Hermalin, B and M Katz (2009), “Customer or complementor? Intercarrier compensation with two-sided benefits”, mimeo, Haas School of Business, University of California, Berkeley.

Hoernig, S (2007), “On-net and off-net pricing on asymmetric telecommunications networks”, Information Economics & Policy, 19(2):171-188.

Hoernig, S (2010), “Competition between multiple asymmetric networks: a toolkit and applications”, mimeo, FEUNL, July.

Jeon D, J-J Laffont and J Tirole (2004), “On the receiver pays principle”, RAND Journal of Economics, 35:85-110.

Ofcom (2010). Wholesale Mobile Voice Call Termination: Market Review, Volume 2 -- Main Consultation, 1 April, London.

Orange and T-Mobile (2009), Combination of Orange UK & T-Mobile UK: Creating a New Mobile Champion, 8 September.


1 Harbord and Pagnozzi (2010) provide empirical evidence on the importance of on-net/off-net price discrimination in European mobile markets and the strength of the associated network effects.

2 All results are stated in million pounds per calendar year in 2008/09 prices. Increases of the variables under consideration are given by positive values and decreases by negative values.
3 Our estimate of the merger's expected annual cost savings is based on information provided in Orange and T-Mobile (2009).
 

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Topics:  Competition policy

Tags:  European Commission, Competition policy, Mobile phones, merger

Director, Market Analysis Ltd.

Steffen H Hoernig

Associate Professor of Economics at Universidade Nova de Lisboa