Does the nation have a Digital Economy Strategy?

A group of carriers, consumer and small business representatives has formed a coalition that argues that Australia must set an ambitious broadband policy for the next 15 years.

The group today launched a "2030 Communications Vision" project and plans to hold a seminar discussing broadband issues in February.

Retiring iiNet regulatory chief Steve Dalby claimed there has been "an absence of leadership on a broader, integrated view of why telecommunications is important to Australia and the Australian economy. There is no national objective or national strategy to take us forward in the digital economy."

Well - technically there is a strategy, because it was released by the Labor Government in 2011 and updated in 2013.

The status of the 24 actions listed in the update was advised in response to an Question on Notice from February Estimates. The status of the 34 projects was advised in response to an Question on Notice from May Estimates.

Before the election the Coalition released its own - somewhat limited - Digital Economy policy. Amongst a plethora of commitments the policy stated the Coalition would "update the NDES during its first term."

Presumably the construction that the NDES is to be merely further updated not replaced  means the EXISTING updated NDES is still the actual strategy.

Commentator Phil Dobbie in his weekly Crosstalk podcast made some disparaging comment about the NDES. Unfotunately I didn't write it down when I listened and I'm not going to go through it again.

What I'm waiting for is someone to subject the plan - especially as updated - to some decent scrutiny.
 And just maybe it would have helped if industry and consumers had engaged with the Strategy rather than take it as a given.

Competition in telecommunications ... ITU data

This week the ITU has published its latest ICT Development Index. I don't want to write about that now - except to state that like so many other similar exercises calling this an "index" is perpetrating a fraud.

The concept of an "index number" was developed to find a way to relate different prices and quantities in different time periods. The founder of econometrics Irving Fisher analysed said "For those who have made any attempt to penetrate their mysteries, index numbers seem to have
a perennial fascination." This may not be the case for my readers, but the survey article I took the quote from provides plenty of detail on how intricate is the process of developing index numbers for their use in analysing time series data.

The ITU's IDI is not such an index. It is an attempt to make comparisons across countries at one point in time. Indeed the construction of the index guarantees that the change in the index number from one time period to the next for an individual economy has no meaning. The only temporal comparison that can be made is of the rank.

This is because the final index number is composed as the weighted sum of a three sub-indices each in turn based on a number of indicators. The data for the indicators themselves are also first manipulated in a kind of standardisation process.

The report states that "The indicator weights were chosen based on the principal components analysis (PCA) results. The access and use sub-indices were given equal weight (40 per cent each). The skills sub-index was given less weight (20 per cent), since it is based on proxy indicators." Figure 2.2 provides a table of the actual weights used and it is hard to discern from this exactly what role the principal component analysis played.

Most significantly there is no objective test by which it is possible to determine if the IDI measures anything, nor if the value of the IDI has any purposeful predictive power. Indeed, like most indices of this kind (I'm thinking here of the Global Innovation Index) the composition of the index is heavily theory laden. There is nothing inherently wrong in a theory laden index if that index can then be compared to some other observable - because it then works as a test of theory. But if there is no such observable the index runs the risk of becoming part of a circular argument in support of the theory.

But I didn't come here to discuss the IDI - I need to do more maths before I reach any conclusions.

What I did come here to do was to pass comment on analysis in the report that purports to claim that competition in telecommunications markets has a statistically significant impact on reducing prices in telecommunications. I have serious concerns about the methodology employed.

(My own simple working paper on this reached a conclusion that competition is not a significant factor in price reductions).

My two concerns are to do with the model employed and the goodness of fit. Both fixed broadband and mobile market data are modelled. In both cases a simple linear model of prices is developed. This is highly unlikely to be the appropriate functional form for the relationship between prices and the relevant variables - including GNI per capita, industry concentration (HHI), urbanisation and a regulatory variable. At the very least theory would suggest that the effect of a change in concentration would be proportional to the HHI - not a linear composition.

In both cases the modelling claims that all the variables are statistically significant - though competition is identified as explaining only 5% of the variation in prices. However the R-squared for the two models are 0.408 and 0.409. The report claims that such a value of correlation means the models have "medium explanatory power" based on the range of possible values being zero to one.

This is simply rubbish. The reality is that such a low value means that more than half the variability in prices is due to factors not included in the model. One of those at least will be declining costs of technology due to local scale economies and global experience effects. The consequence of adding other variables or changing the functional form so that the explanatory power of the model increases will affect the statistical validity of all the variables.

It is, quite frankly, embarrassing to see a major international organisation publish such a poorly constructed piece of econometric modelling.

Competition in telecommunications...UK style

One of these days I will write a definitive account of how we all got so much wrong in the pursuit of better outcomes in telecommunications than were being delivered in the early 1980s. But today I just want to compare and contrast two countries, the UK and Australia.

The first thing to note is that both countries were early leaders i the move to restructure telecommunications markets - at least amongst those that had grown up under the European PTT model. Both were early (in the 70s) in spinning telecommunications out of the Post Office. Both introduced competition in the late 80s and early 90s.

The UK did one thing differently - they fully privatised BT before undertaking competition reform. But in reality it has made little difference.

The UK stayed with an industry specific regulator with both technical and competition function (Ofcom) whereas Australia dismantled AUSTEL in 1997 and gave competition and access to the ACCC.

BT sold its mobile operation to what became O2. BT also agreed to voluntary functional separation of its access network - but only in the face of a very determined Ofcom Chair Steven Carter.

But today we learn that BTs competitors are complaining through their industry body the UK Competitive Telecommunications Association (UKCTA) that BT still retains a monopoly position "some 30 years after privatisation and 10 years after the formation of Ofcom."

I'll be honest and say that from the Foreword to their report I can't understand exactly what it is that the UKCTA is arguing for. It seems to be another version of "we need you to increase competition by increasing regulation of the monopolist."  This, I might say, sounds awfully like the current refrain of Optus, Vodafone and the Competitive Carriers Coalition in Australia.

They seem to know what they don't like but I haven't ever heard anything that sounds like a convincing story of what the market structure looks like after whatever intervention they seek today. I have drafted something for publication elsewhere on the economics and if it doesn't get a run I'll share it here.

In the meantime getting a new single technology structurally separated access network for 93% of the population was a really good place to start. But no one was ever prepared to hitch their wagon to defending the one thing that could deliver.



Disclaimer: The CCC was originally formed around the meeting table in my office at AAPT. It's original mission was a response to the content sharing deal between Foxtel and Optus. At that time I questioned my colleagues at AAPT on whether as part of the deal we should demand that the Telstra HFC cable be made open access as it provided service in areas poorly served by exchange based ADSL. There was no interest because we did not have the capacity to build a billing and provisioning system to access it.

About tax

No matter how much modern libertarians might fantasise about small government, the size is never zero and so governments need to raise tax.

In determining tax policy there are three objectives that need to be met.

The first is to raise the revenue required to deliver the services demanded (plus or minus any desired surplus or acceptable deficit).

The second is to raise the tax efficiently. This means both the technical efficiency of raising the tax with the least expense in raising taxes and the allocative efficiency of trying to minimise the effect of the tax on price signals and incentives.

The third is equity, to ensure the tax system is equitable in its treatment. Usually two principles are considered here. The first is that two individuals in the same circumstances need to be taxed equally. The second is that tax should be rendered relative to an individual's capacity to pay.

The unfolding story of the growth in tax minimisation strategies by the largest corporations in the world shows how current tax arrangements fail all these tests.

The AFR this morning pulled out Amazon as a particular case. Amazon in Australia has two direct lines of business, and then it has its third role as an importer. Amazon Web services is a cloud hosting service that counts among its clients (possibly indirectly) both the Liberal Party and the Labor Party. It is selling these services domestically and has facilities here.

The second business is the sale of e-books for Kindle. Today as a registered Kindle shopper in Australia I can only order from amazon.com.au, not amazon.com. At least the pricing looks the same (one is designated in $AU the other in $US). I'm prepared to be that delivery also happens from a local server but I can't prove that.

But the transaction by me with Amazon is occurring - in fact required to occur - in an Australian domain. Yet somehow for tax purposes the transaction doesn't occur in Australia. I wonder if it occurs ANYWHERE for goods and service tax purposes or is deemed in each country involved to have occurred in another.

The short answer is "probably not." The topic globally goes under the name of "Base Erosion and Profit Shifting" or BEPS for short. The OECD BEPS project however seems to be mostly focussed so far on inter-administration identification of the transaction flows rather than discussion of how to make sure the "proper" tax is paid. Australian action seems to be similarly limited.

How does the Australian business community react to this issue. The Chief Executive of the BCA addressed the question this week. In doing so she outlined her own view of the objective of the tax system, namely:

Digital technology and increased interconnectedness in the global economy has had a profound impact on our lives and the way we do business....The Business Council has called for a global mindset from Australian businesses to capture these opportunities, specialise within supply chains and access new markets.

In an increasingly competitive business environment, taxation arrangements influence where we work and invest. International tax laws should not be an obstacle in the unstoppable evolution of the global economy. They should not be so excessive or complex such that they hinder trade, investment and innovation. 

Rather they should be modernised to ensure they remain fit for purpose in achieving their dual objectives of revenue raising, and incentivising growth and investment.

It is worth noting the extent to which the issue of BEPS is directly associated with the Digital Economy. It provides both the transactions that are problematic, but also provides the means to make other transactions become problematic.

But far more telling is the BCA's understanding of the objectives of tax design. Firstly it is NOT an objective of tax policy to "incentivise growth and investment", the objective is to limit the distortionary effects of taxation. The second is that there is no recognition of the role of equity.

The BCA then advances this flawed thinking into its own proposals. After first cautioning Australia about doing anything alone, and how everything needs to be managed within international tax arrangements, the BCA goes on to assert that Corporate Australia is over-taxed. (That this argument sounds like the defence of copyright piracy - we only steal because you charge so much - is just delicious irony).

So as far as the BCA is concerned the real issue is simple:

But in listening to the OECD on BEPS, it is important to hear the message in the context of its overall advice on tax reform and its role in economic growth. This is about getting a better tax mix between direct and indirect taxes to better encourage investment, innovation and entrepreneurialism – key drivers of growth.

Competition in global corporate tax rates has intensified. Japan and Spain recently announced corporate tax cuts to boost investment and growth. If we look back a decade, our corporate tax rate of 30 per cent was a little above the averages of the OECD and our competitors in the Asia-Pacific region – which were about 29 and 28 per cent, respectively. Since then, these averages have fallen around 5 percentage points while we have stood still.

In a nut-shell, because corporations choose where to invest (or more importantly where to pay tax) Australia needs to lower its corporate tax rate. To make up the revenue indirect taxes need to increase.

This is where the PM comes in having been duped by this argument. So he has initiated his discussion about Federation as a means to get the States to demand the rate of the GST increase...as part of fulfilling the BCA agenda.

But it is all absolute rubbish.

Firstly, by ignoring the equity argument the BCA is ignoring the fact that some of its members are paying far higher tax rates than others - depending a lot on their corporate structure. Secondly, a lot of the Digital Economy transactions are simply escaping the nett of indirect taxes - as my e-book example shows. And finally, in a result owing to Ramsey that for a mark-up on prices to have minimum economic distortion the mark-up should be in inverse proportion to the elasticity of demand.

The most important feature of the BCA's own tax paper is that Australia is a low tax economy.

We need a decent discussion on tax, but the BCA should not be at the centre of it. Personally I doubt that any of the CEOs who actually comprise the BCA would have the slightest clue about tax as a policy issue. They understand it as a private issue - if the company pays less tax I can pay a higher dividend the share price goes up and I get a bonus.

And the first thing we need to agree globally is that shifting transactions and notional company locations for the purposes of tax minimisation are economically distortionary and to be eradicated. It can be done. A challenge is that a country that sets a low tax level can have actually increased its total tax take as a consequence and will be reluctant to change. But the change can be effected by the countries at the ends of the transactions (for example, by jointly agreeing that the intermediate transactions did not exist).

Note: Interesting question what impact the lack of a GST has had on the prices of education and health services discussed yesterday. It is possible that the relative price has been able to rise because of the lack of tax...

The use and abuse of price signals

I was somewhat confused to read in this morning's Oz about Tony Abbott's plans for the G20.

We all know that the G20 goal is to try to come up with initiatives to increase global growth by 2%. Apparently the PM's approach to this is a bit like his approach at the World Economic Forum - to just tell everyone what we are doing domestically.

Apparently the PM told the Oz "that price signals on healthcare and market fees for universities would be part of the nation’s formal pledges at the G20 summit."

The Australian went on to note "Mr Abbott played down the chances of a major commitment on climate change and confirmed his plan to make the gender gap on workforce participation a key issue at the event."

So let's just unpack those two for a moment. The PM is apparently a fan of the use of "price signals" and "markets" when it comes to traditional Government service delivery like health and education, but his most significant election commitment - now delivered - has been the abolition of a price on carbon. 

He wants to move away from Government spending on health and education and instead make direct payments to industry to reduce carbon emissions. This is a Prime Minister who embraces the concept of "markets" only when the direct beneficiary is the corporate sector, and embraces Government action when the direct beneficiary is...the corporate sector.

The PM who wants to be known as the "infrastructure Prime Minister" asserts that "the continued move from short-term consumption spending to long-term investment spending will continue." And yet the infrastructure Minister is struggling to find anything new to announce other than projects where rail has been de-funded to fund a road (Melbourne's East West link).

He also says "Australia’s commitment at the G20 would be to promote growth through private investment rather than relying on public outlays." This marries up with e B20 message about infrastructure. It is the corporate sector's desire to have Government fund the private sector to build infrastructure which the corporate sector benefits from. 

Let's be really clear that the main beneficiaries of the PPP model are the finance sector and the construction industry. The latter is corrupt to the core and is responsible for Australia having the most expensive construction sector (just use the North West Rail as a guide).

But let's go back to two issues. The value of price signals in health and education and the economic value of increased female workforce participation.

Despite the pervasive presence of public sector delivery of health and education services, these are not actually free. There are already prices for many of the services in these sectors - and they are included in the ABS statistics on the Consumer Price Index. In fact, they are both measured with their own group index (education since 1982 and health since 1989).

That means we can inquire into how the price of these services have changed relative to other prices. The chart below is prepared by converting all the group and overall indices to a common base of 100 in September 2014. The group indices have then been divided by the overall index to effectively create a "real" index. 

This shows that the real price to Australian consumers of health and education services has been growing solidly over the last fifteen years. Somehow the PM seems to be under the impression there is no "price signal" already in this market, whereas the reality is the price signal is very clear and has been increasing. 

Anyone who seriously wants to address the question of "cost of living" pressure faced by households should study this graph. (As an aside since this is the DigEcon Gazette - I will write more separately about the decline in communication prices...but will simply note that trend line actually stretches over 40 years!)

Now let's turn to the question of workforce participation. Two things stand out. The first is that when unemployment is high, the availability of labour as an economic input isn't a constraint on growth. The second is that the PM talks as if his initiative of a paid parental leave scheme will be the first great intervention to grow participation.

The G20 wants to increase growth BECAUSE of persistent high unemployment rates, especially in the European economies (see list below taken from the 25 October 2014 Economic Data in The Economist).

Country	Unemployment Rate
Argentina	7.5%
Australia	6.1%
Brazil	5.0%
Canada	6.8%
China	4.1%
European Union	11.5%
France	10.5%
Germany	6.7%
India	8.8%
Indonesia	5.7%
Italy	12.3%
Japan	3.5%
Mexico	4.8%
Russia	4.9%
Saudi Arabia	5.6%
South Africa	25.5%
South Korea	3.2%
Turkey	9.8%
United Kingdom	6.0%
United States	5.9%

Workforce participation rates between the two genders have been converging.  

Analysis of only the lines themselves might suggest the convergence is slowing - but measuring the difference (green columns measured on right hand vertical axis) shows the trend continuing.

In other words, accelerating female labour force participation is unlikely to be the most important critical issue. (I should do additional analysis by age because I suspect that part of the effect is due to older segments of the female population having a lower participation rate - paid maternity leave doesn't fix that).

So our PM is going to lecture other leaders about his inconsistent application of price signals and markets, and a post hoc justification of his expensive PPL when labour availability is not their major issue.

This is the PM trying to sell his modern day Thatcher/Reagan agenda as economic planning. 

The PM is more accurate when he simply says "“Lower taxes, less regulation and long-term fiscal discipline are at the heart of our plan." Just what the BCA asks him to say.

It would be nice if he and his Treasurer could really look at what the economy of the future looks like and what the capabilities we need are - a skilled and healthy workforce and (as I wrote on my other blog) clean energy.

Missing in Action: The Productivity Commission and ICT in the 21st Century

(This paper was originally drafted over two years ago - but its conclusions are still valid)

In the late 1990s the Productivity Commission’s focus was in seeking to explain the surge that had occurred in Australia’s productivity over the preceding decade.

A PC staff research paper in 2001 considered the impact of ICT on Australia’s productivity surge.[i]  A particular focus of that report was whether Australia was disadvantaged by not having an ICT manufacturing capability.  The paper found that “ICT-related productivity gains can be accessed through use and not just production; and that, through rapid uptake of ICTs, Australia has already caught an ICT-related productivity wave.”

The comments of that paper were captured in a speech delivered by PC Chairman Gary Banks in 2002.[ii]  The key points in that speech were listed as;

•               Australia’s productivity growth surged to a record high in the 1990s – more than double the rate achieved over the 1980s. Australia’s productivity surge was also very strong by international standards.

•               A new set of service industries – especially Wholesale trade and Finance & insurance – made major contributions to the 1990s productivity acceleration.

•               Australia was comparatively quick in adopting information and communications technologies (ICTs) in the 1990s and their use has featured in the productivity accelerations of the new service industry contributors.

•               Microeconomic reforms were pivotal in Australia’s improved productivity performance, by sharpening incentives for businesses to be more productive and providing them with greater flexibility to adjust to a more competitive environment. Microeconomic reforms encouraged and assisted the uptake of ICTs and the transformation of industries in ways that tap new productivity potential.

•               In looking to the future, further productivity gains are possible from continued ICT uptake and business transformation, and Australia is well placed to benefit from e-commerce.

•               Policy will continue to play an important role – particularly in relation to labour market flexibility and the development of ‘human capital’ (in the widest sense).

In brief the adoption of ICT had been a significant past contributor to the productivity surge and could be expected to continue to be so.

In 2007 another staff research paper compared Australia’s productivity performance to that of the US.[iii]  That paper suggested Australia might never be as productive as the US and concluded;

Broadly speaking, government policy will be most supportive of productivity catch-up by putting in place the framework that underpins sound private choices within firms and industries. This means focusing on economic incentives (such as competition), capabilities (such as skills and research and other infrastructure) and flexibility (the scope for firms to adapt, experiment and to implement new business models).

The PC has, however, tended to focus its efforts very much on the first of these over recent years.

The PC has conducted a research project that links the first and third title “An analysis of the effect of product market competition on innovation and productivity in Australia”.[iv]  This study is taking as a starting point a joint PC/ABS paper that draws on the ABS Business Longitudinal Database.[v]  That study interestingly did not find a simple correspondence between increased competition and innovation, as other market characteristics were also important.

It is unclear whether this study controlled for the separate findings of another ABS study on the same data set that found strong evidence of a link between ICT use and innovation.[vi]  This links ultimately links innovation to (communications) infrastructure.

It could indeed be disappointing if the PC were to reach a conclusion about innovation and competition without also considering the link between broadband and innovation.

Despite all the evidence provided by the PC about the productivity surge of the 90s and its link to ICT, and its views about productivity growth being fuelled by further ICT adoption and infrastructure investment, the PC has been strangely silent on the NBN.

Indeed its only foray was the one that led the Minister to redefine appropriate language for a lunchtime television audience when he was asked about a competitive neutrality complaint report emanating from the PC. 

There has been much commentary about suggestions made by the coalition that the Government should have conducted the PC to undertake a cost/benefit analysis of the NBN plan.  The PC has not historically undertaken many cost benefit analyses.

However there is nothing stopping the PC undertaking its own research into the productivity impacts of investment in broadband.  The fact that it has ignored the topic for over a decade indicates that there may indeed be some substance to the view that the PC is now pursuing a myopic view of the determinants of productivity; a myopic view not even supported.

---

[i] Dean Parham, Paul Roberts, Haishun Sum Staff Research Paper: Information Technology and Australia’s Productivity Surge Productivity Commission 2001

[ii] Gary Banks  The drivers of Australia’s productivity surge Presented at Outlook 2002, hosted by the Department of Industry, Tourism and Resources and the Australian Bureau of Agriculture and Resource Economics, National Convention Centre, Canberra, 7 March.  Productivity Commission

[iii] Ben Dolman, Dean Parham, Simon Zheng Staff Research Paper: Can Australia Match US Productivity Performance? Productivity Commission 2007

[iv] http://www.pc.gov.au/research/productivity/product-competition-effect the study is due to conclude in June 2012.

[v] Les Soames, Donald Brunker, Tala Talgaswatta Research Paper: Competition, Innovation and Productivity in Australian Businesses Australian Bureau of Statistics and Productivity Commission 2011

[vi] Jessica Todhunter and Ruel Abello  Research Paper: Business Innovation and the Use of Information and Communications Technology Australian Bureau of Statistics 2011

The Ergas retort that wasn't

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.

Mr Ergas says he is flattered that I showed an interest in his wider body of work. I could delve into it in much more depth but suffice to say at least I'm well aware of his little book Wrong Number. Indeed, I wrote a review for the Australian Journal of Telecommunications. 

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.

In a piece for the Economic Society Mr Ergas did a nice job of describing the different dimension of the principal-agent problem as it applies to public policy:

“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!)