It is always flattering to be noticed. So it was with some glee that I saw that Henry Ergas in a
letter to the editor of the AFR responded to some comments I made about the Vertigan review in an
opinion piece earlier in the week.
The reply was brief so I'll repeat it in full here (including the title, which I thought was the best bit).
What cost NBN zeal, David Havyatt?
Where two bridges have been built, David Havyatt would destroy one to align reality with the theory of natural monopoly.
Such zeal in pursuit of the NBN caliphate would be commendable were it not to be realised at the expense of taxpayers and consumers. The fact is that the copper network and the HFC now exist and can both be upgraded at relatively low cost. Allowing them to compete might entail some duplication of costs but even if it increased them by an implausibly large 20 per cent, a one-year acceleration in broadband deployment and a 2.5 per cent increase in the rate of productivity growth would more than outweigh that impact.
Effects on this scale are well within the observed range of benefits from greater competition.
I am flattered by Mr Havyatt’s interest in my oeuvre.
Rather than selective quotation from submissions dealing with other matters, readers who wish to explore my views on natural monopoly might do better to consult my book Wrong Number.
Mr Ergas is particularly
fond of the argument by analogy. I have previously been subjected to ones based
on bridges in relation to vertical integration. My response to this one is to
simply note that the correct analogy is that there exist two bridges that today
combined cannot handle the combined demand of the current and future traffic
estimates. The technical solution that constitutes the Multi-Technology Mix is
a solution that bolts an extra lane onto each bridge. Labor's NBN proposed
building a brand new bridge that can handle all that traffic and more.
Mr
Ergas and I would disagree on the wisdom of those two approaches. And that
hinges on our different assessment of how certain we are about future demand.
He and his colleagues in preparing the CBA part of their report place great
store on the idea it may never be required to expand it to that degree.
It
is interesting to note that former Minister Stephen Conroy also liked to use a
bridge analogy and talk about the Sydney Harbour Bridge and what it would be
like if it was only one lane each way. Today we are struggling with the need
for a third crossing.
The
next part of Mr Ergas response is a hypothetical. It is a hypothetical based on
the economist's approach of dealing only with the future costs - all historic
costs being sunk and hence not part of the decision making framework. This is
part of the philosophical underpinning of economics that is not part of my
fundamental argument here - which is being conducted within the framework of
the neoclassical norm. It is discussed in the footnote below.
The
analysis he offers is based on an increase of costs from duplication - somehow
limited to a cost increase of 20%. But to get genuine and complete facilities
based competition the footprint for HFC would need to expand by a factor of 2
and the deployment of FTTN would need to increase by 33% above the costs
incurred in the Strategic Review model. That is a lot more than a 20% increase
in costs.
The
next part is pure faith. The incentive from competition would supposedly on its
own result in a one year acceleration in the roll-out and a 2.5 per cent
productivity increase. These, we are told, are effects that are within the
scale that has been observed from competition. This I simply don't understand,
for two reasons. The only competitive network deployment I've ever observed was
the deployment of competing HFC networks. These were indeed rapid - but they
suddenly ended in stand-off. That's why HFC only covers some 35% of premises.
And competition dramatically increases revenue risk, and that drives up
financing costs of both debt and equity. So competition's first effect is to
drive productivity the other way.
Let's
interrogate what Mr Ergas has to say there about natural monopoly. At page 34
he writes:
Where the access provider's facilities are genuinely a natural
monopoly - that is, a service whose costs are minimised if it is provided by a
single firm - duplication may still be desirable (because the
allocative and dynamic efficiency benefits being brought by
competition might outweigh the cost savings in production by monopoly.)
This
is a very big call.
Allocative
efficiency is the efficiency gained by society's resources being employed to
make output match the preferences of society. If the service is a family of
services there might well be an argument that the process of competition will
result in firms adjusting their prices to match the preferences. The practical
reality has been that competition has resulted in reduction in efficient price
discrimination. In long distance telephony competition saw the elimination of
cost reflective charges based on distance and on time of day pricing. This is
because, at the margin, a competitive firm can always increase profit by
slightly widening the off-peak "window" or increasing the distances
in charge bands.
In
the case of the NBN issues, become even simpler because the industry design has
been to limit the monopolist to only those services absolutely necessary to be
in the one firm. This is the motivation for both the operation at Layer 2 and
the choice of 121 points of interconnect. As a fundamentally single product
firm there is little allocative efficiency to be gained within the provision of
the services.
More
specifically the allocative efficiency loss is the presumption that a profit
maximising firm will reduce output to below the efficient level. This is the
role of regulation. However, as will also be discussed below this includes some
specific assumptions about the incentives of managers.
Dynamic
efficiency is a far more problematic concept. This is an attempt by economists
who otherwise deal in static equilibrium models to address the fact that
efficiency changes over time, and that importantly investment decisions made
today will affect efficiency in the future.
It
is interesting that Ergas should pursue this line because in all other work he
has been a promoter of real options theory. Most particularly, this is usually
described as the value to an incumbent firm of the value of delaying an
investment decision rather than of making it. The Vertigan panel did not
include a quantified option value in its Cost Benefit Analysis (because you
can't quantify it), but did refer to the option value of delay in making its
case for the Multi-Technology Mix.
The
practical examples of a monpolist attempting to delay but competition forcing
action date as far back to the 1970s when Telecom Australia was slow to
introduce fixed point to pint data services which promoted much of the initial
deregulatory thrust. More recently it was Telstra's competitors who first
invested in ADSL2+.
It
is hard to accept that the dynamic efficiency benefits from competition are
worth pursuing when the proponent puts so much store in the value of
delay.
Ergas
reveals that his real issue is with the comparison between regulated monopoly
and competition when he writes (at page 98):
Productive and/or dynamic inefficiency is more likely to arise
from the regulation of
monopoly than from the fact of monopoly per se.
And
on this Ergas is absolutely right. The critical issue is the form of
regulation.
One
of the conclusions that those who developed the initial NBN policy reached was
that there was no form of regulation that managed efficiently regulation of
access to the "bottleneck" elements of a vertically integrated telco
incumbent. It comes down to the fact that if it is possible to grow the total
market, the incumbent will make that decision based on marginal costs. But the
competitive firm under access pricing will always face a version of an average
price.
That
is, structural reform is a key aspect of changing the regulation.
Ergas
addresses the structural question at some length at pages 164-7. He notes that
"vertical externalities" can result in significant inefficiencies in
price, service quality, investment and ongoing adaption to change. These arise
because the upstream and downstream firms are both making investments but if
they are not aligned they are inefficient.
The
same thing can, and does, happen inside single firms. If the factory only makes
green widgets and the sales department only sells red widgets you don't get
much sold. You need to design your incentive scheme correctly to avoid these
issues.
Normally
we rely upon the market and price signals to transit this information. The
problem arises if there is significant market power in both the upstream and
downstream markets where monopoly pricing trumps market pricing. The consequent
problem is called double marginalisation. But the issue disappears if the
upstream firm is a regulated monopoly and the downstream firms are in a highly
competitive market - the planned design under the NBN.
The
other three elements listed all come down to information flow. Experience with
vertical structural separation has shown that the firms do struggle with the
co-ordination issues. However, these are not unsolvable problems. For example,
structuring prices for the monopoly elements can be done using a take-or pay
contract structure following an iterative demand bidding process. This mimics
for the industry the process of market price signals as opposed to regulatory
determination.
Marginal economics, atomistic agents and
the real world
My
critique above has been framed within the paradigm of neoclassical economics.
However, there are very good reasons why this dominant theme itself should be
questioned.
Specifically
this school is also known as the marginalist school, because all its
theoretical insights emerge from what economic agents will do "at the
margin." Questions of the type "Will I trade one pound of butter for
one new gun?" underpin the construction.
From
this analysis two big concepts are developed - demand and supply. In the
ontology of economics these are actually imbued with an existence, they are not
just analytical tools (the latter was the position Milton Friedman argued for
in his piece on Positive Economics).
As
a consequence of imbuing demand with existence economists will then undertake
exercises such as a Cost Benefit Analysis wherein the net benefit to consumers
is defined to be the whole area under this demand curve up to the point of
quantity actually consumed. But in almost all cases the concept of demand is
only well-defined in the immediate vicinity of the current market.
Consumers
and suppliers both make decisions based on heuristics, or rules of thumb. It is
technically impossible to access and process all the information to make a
"fully informed rational decision." We are hard wired for this, in
nature we often need to make decisions before being able to access additional
data. And so preferences are formed by current and recent experience.
One
of the things that informs us is our experience and expectation of price
movements, both of the commodity under investigation and all others. As a
consequence expected demand today winds up being a function of actual demand
today. The system as a whole has all the properties of a non-linear dynamic
system. The conclusion of that is that "demand" can exhibit rapid
unexpected and dramatic shifts.
This
is the mathematics of a bubble in asset prices. When house prices start being
determined more by the expected value from a subsequent sale than from the
"real" value of either potential rental income or rental outgoings
foregone, then they rise rapidly. At some, unpredictable point, the gap between
the two values increases to the point where profit takers halt the rise. If
prices ease of as a consequence of this mild change in demand, the overall
"sentiment" can change so that pricing is almost exclusively based on
"real" value. And hence the bubble is burst.
Marginalism
also infects the approach to assets. As in the case of telecommunications
assets, once the asset is purchased and if it has no scrap value - it is sunk -
the marginalist regards it as no longer being part of the analysis.
In
doing so the marginalist commits a variant of Zeno's paradox of Achilles and the tortoise - In a race, the quickest
runner can never overtake the slowest, since the pursuer must first reach the
point whence the pursued started, so that the slower must always hold a lead. (as
recounted by Aristotle, Physics VI:9, 239b15)
Because
by the time the next decision is made the expenditure thus far is sunk the
marginal upgrading of an existing asset will always win out over a decision to
replace the asset.
A
related problem for the marginalist school is its approach to economic actors
as if they are all single atomistic agents. The particular problem this raises
was first identified by Berle and Means who identified that the managers of
firms - the ones who make the actual decisions - were not necessarily motivated
by profit maximising. Growing their own status was one specific alternative
goal - a goal to which was attributed acquisitions that grew the company and
hence the CEO's importance without growing returns.
The
principal-agent model - in which a principle (shareholders) seek to ensure
agents (managers) act in the principles interests rather than their own - has
had its major impact in creating remuneration schemes that tie senior executive
pay to company performance. In practice this is an attempt to ensure that the
neoclassical economists assumptions about the behaviour of firms might be
reflected in practice.
There
have been many consequences of this, the most notable being a shift in the
focus of firms to short term performance over long term performance - despite
the fact that the bulk of investors are mostly concerned with long term
returns.
But
it is the implication for policy makers that is of interest here. The
assumption of privatisation has been that the "profit motive" drives
efficiency - despite the existence of the principal-agent problem. The issue
becomes far more complex when the subject is also a monopoly that will be
subject to regulation - because now there is a second principal to whom the management
team are accountable. "Incentive regulation" was a device designed to
create a pathway for managers as agents to meet the requirements of both
principals.
It
does seem, however, that the incentive issue is far simpler if there is merely
one relationship - formed by public ownership.
“The core of public finance”, as Jurgen von Hagen has succinctly
put it, “is that some people spend other people’s money”. This separation
between spenders and payers gives rise to a wide range of problems of
accountability and control (which economists typically analyse under the rubric
of ‘principal-agent’ problems), reflecting divergences of interest between
these parties and the inability of voters and taxpayers to costlessly and
perfectly discipline the behaviour of those who spend money on their behalf.
These principal-agent problems are aggravated by the fact that the spenders
themselves are not a monolithic entity. Even if spenders as a whole face the
collective consequences of their decisions, each individual spending unit (such
as a Minister, a Department or a territorial level of government) may view the
stock of available public funds as a ‘common pool’ (like an open seas fishery),
which it can draw on at a fraction of the resulting opportunity cost while
still garnering for itself all or the bulk of the political benefit. The scope
to transfer the costs of wasteful projects to future generations, which have
little or no voice in the political process, as well as to future governments
(which will bear the political consequences of ‘pulling the plug’ on failed
ventures), then makes the risks of inefficient outcomes all the greater.
From
this Ergas made the case for formal project appraisal as part of the control
mechanisms to manage these risks. This year's Nobel Prize Winner in Economics
Jean Tirole made similar observations in his analysis of privatisation (in Incentives for Procurement and
Regulation with Jean-Jacques
Laffont). There the concern is the inability of the principal in the case of
public owners to make long term commitment to objectives for the public
enterprise.
The
issue here though is the treatment of principal-agent issues as add-ons or
simple tools for critique of other outcomes. Principal-agent issues need to be
dealt with in the core of the economic analysis. Market design needs to not
only include design of the institutions but also the incentives to apply.
In
the specific context of the NBN relying on the incomplete contracts (in an
economic sense) devised by lawyers without effective incentive regimes is a
major flaw in the policy development to date.
This
is a convenient point to wrap up this much wider discussion.
However
I do want to touch on one recommendation made by both the Harper inquiry into
competition and the Vertigan panel - that access regulation for all regulated
industries be moved to one regulator focussed only on that task. This is
nowhere near as new and novel as suggested - it was the original intention
behind taking access issues from AUSTEL to the ACCC. But it is interesting in
the light of one of the key items noted in the citation for Tirole's Nobel Prize.
The progress in these areas largely reflects two methodological
breakthroughs: game theory and the theory of mechanism design.2 By the end of
the 1970s, the time was ripe for applying these tools to the major issues of
imperfect competition, regulation, and competition policy. Over the next
decade, many economists were drawn into these fertile fields. The analytical
revolution was to a large extent a collective effort but, among many
contributors, Jean Tirole stands out. No other scholar has done more to enhance
our understanding of IO in general, and of optimal policy interventions in
particular.
...
Although general theories can be of great value, in the end all regulation must be industry-specific. This point is illustrated by
example in Laffont and Tirole (2000), where they consider the regulation of the
telecommunications industry, as well as in Tirole’s studies of other
industries, ranging from banking to electricity. The research on the regulation
of specific industries illustrates Tirole’s exceptional ability to grasp the
central features of an economic environment, to formulate these features
mathematically, to analyze the resulting model, and to produce normative
conclusions of great practical significance.
(Emphasis
added)
(My
own copy of Laffont and Tirole's Competition
in Telecommunication (2000) is autographed by both!)
