Thursday, March 28, 2013

Competition and market failures

Econ 101 teaches us that market competition, by enabling efficient price discovery, results in win-win outcomes for both producers and consumers. Alternatively, in the absence of competitive dynamics, markets fail to take off, leaving both consumers and producers worse off.

In this context, this article from FT about the contrasting fates of US and European telecoms market is instructive. It is considered an efficient practice in utility infrastructure to force the network asset owner to share it with competitors for a prescribed fee, most often determined by the sector regulator. This is thought to lower entry costs in such capital intensive sectors and thereby stimulate competition. Accordingly, the India's Electricity Act of 2003 provides for mandatory "open access" of the distribution and transmission network owned by state-owned entities for a fee to private firms for transmitting and distributing their power. 

The same logic has been applied to unbundling of telecommunication networks. However, even as the European Union aggressively pushed through unbundling in the late nineties, it failed to pass legal challenges in the US. Accordingly, while European network owners were forced to share with their competitors the local loop part of their networks that connect to customers, the US carriers managed to maintain exclusivity and retain entry barriers. If the logic of Econ 101 held, then lower entry barriers and resultant competitive pressures would have boosted the European telecoms market while the absence of the same would have weakened the US market. But the fortunes have been reversed, as the FT writes,
Unbundling has been the single biggest difference between the regulatory environments in the US and Europe over the past decade. The idea was first taken up in the US in the mid-1990s, though the established American carriers managed to block the idea in the courts a decade ago. Their peers in Europe had no such avenue for appeal, forcing them to give new rivals low-cost access to the local loop part of their networks to reach customers. The result: more competition, lower prices and dwindling cash flow. That has been a boon to consumers but, along with the slumping economy, has left network companies badly positioned to finance the next round of network-building.
The contrast with the US could hardly be starker. Over the past five years, the operating cash flow of AT&T and Verizon has risen by a fifth, even as cash flow of the main European players has dwindled. As a result, shares in the two dominant US carriers have risen by more than half since the financial crisis, while their European counterparts have slumped, denting their ability to finance upgrades.
In other words, competition has resulted in market failure. Instead of the "more competition, lower prices, more consumers, more profits, and network expansion", the real-world outcome has been "more competition, lower prices and dwindling cash flow".

The fate of European telecoms market is not an isolated example. Much the same market failures have been a characteristic features of telecoms and airline deregulation in India. In fact, India's telecoms market has evolved in a manner that would have pleased a Chicago economist, but is now facing serious troubles. Instead of the expected win-win outcomes, lower entry barriers and cut-throat competition in both sectors have ended up devastating operators. While consumers have undoubtedly benefited from the lower prices, operators are left without resources to finance expansion and technology upgradation.

This is yet another real-world example of how perfect competition often fails to yield the expected outcomes. In all these markets, once entry barriers get lowered, the size of the market and its long-term potential makes it irresistible for competitors to indulge in price wars. As with winners curse in auctions, such price wars invariably result in a race to the bottom.

The point here is not to convey that competition or deregulation is not desirable, but to caution against any unqualified support for such measures. The dynamics of the market is far too nuanced to be explained away by simplified "invisible-hand" reasoning.

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