RESTRUCTURINGINNETWORKINDUSTRIES:COMPETITIONAND MERGERSINTELECOMMUNICATIONS By MARKA.JAMISON ADISSERTATIONPRESENTEDTOTHEGRADUATESCHOOL OFTHEUNIVERSITYOFFLORIDAINPARTIALFULFILLMENT OFTHEREQUIREMENTSFORTHEDEGREEOF DOCTOROFPHILOSOPHY UNIVERSITYOFFLORIDA 2001 Copyright2001 By MarkA.Jamison Tomywife(Patti),mychildren(JohnandLaura), andmyparents(JohnandJudae) ACNOWLEDGMENTS Imustfirstthankmysupervisorycommitteemembers. Dr.DavidE.M. Sappington,thechairofthecommittee,tooknumeroushourstogivedirectionandadvice andtocorrecterrors. Hisknowledgeandinsightwereinvaluable. Dr.StevenSlutsky,a member,providedimportantguidancethroughoutmygraduatestudiesandwasaquick studyofmymanyefforts. Dr.ChunrongAi,amember,providedexpertadviceon econometricproblemsandthepresentationofeconometricstudies. Dr.HeatherElms, theexternalmember,gavegooddirectionandinsightsbeyondthenormalrangeof economics. Iherebythankthemallagain. Outsideofmysupervisorycommittee,IamgratefultoDr.SanfordBerg,who madeitpossibleformetocometotheuniversity,andwhoseopinionsandleadershipare respectedworldwide. IamalsoindebtedtoDr.W.AndrewMcColloughforhisforesight inallowingDr.Bergandmetoembarkontheenterprisethatwehavebuiltatthe university. IamalsogratefulforadvicefromDr.WalterBeckertandDr.DavidFiglio. Aspecialthankyouisduetomycolleague,JaniceHauge,withoutwhomgraduate studieswouldhavebeenimpossible. IwouldalsoliketothankEricChiang,JoshSilverboard,JasonMills,EileenPun, Verizon,Sprint,SBC,andBellSouthfortheirassistancewithdata. Thanksarealsodue toJamesSichterofSprintandMarkSievers,EdLowery,andLinkHoewingofVerizon fortheirwillingnesstodiscussissuesandprovideinsights. IV Lastly,IwouldliketothankallofthePublicUtilityResearchCenter(PURC)and departmentalstaffthathavemadetheworldworkduringmytenureasastudent. Cynthia StehouwerandtherestofthePURCstaffkeptmyprojectfinancesandtasksinorder; MistySwainkeptmygraduateprograminorder;DianStudstillkeptalladministrative mattersflowing;andDorthyPadgettprovidedimportantassistanceinproducingmy book. TABLEOFCONTENTS Page ACKNOWLEDGMENTS iv ABSTRACT viii CHAPTERS 1 RESATNRDUCMTEURRGIENRGSIINNNTEETLWEOCROMKMIUNNDIUCSTARTIIEOSN:SCOMPETITION 1 2 MARKETCONCENTRATIONANDINCENTIVESTO DISCRIMINATEAGAINSTRIVALSINNETWORK INDUSTRIES 5 2.1 Introduction 5 2.2 TheModel 10 2.3 Symmetric,SingleMarketCase 17 2.4 MonopolistEntryintoaCompetitiveMarket 18 2.5 NewCompetitiveEntryintoaFormerlyMonopolyMarket 20 2.6 Conclusion 24 3 NETWORKINTERCONNECTIONANDTELECOMMUNIATIONS COMPETITION: THECASEINTHEU.S 26 3.1 Introduction 26 3.2 LiteratureReview 31 3.3 HistoricalBackground 33 3.4 TheModels 39 3.5 ModelResults 54 3.6 Conclusion 63 4 NETWORKEXTERNALITIESANDCROSS-BORDERMERGERS INNETWORKINDUSTRIES 64 4.1 Introduction 64 4.2 TheModel 69 4.3 QualityChoices 75 VI 4.4 AnalysisofPureCross-BorderMergers 79 4.5 MixedMergers 88 4.5 Conclusion 93 5 CONCLUSION 95 APPENDICES A PROOFSANDLEMMASFORCHAPTER2 99 B APPENDIXFORCHAPTER3 107 C PROOFSANDLEMMASFORCHAPTER4 HO REFERENCES 119 BIOGRAPHICALSKETCH 125 « VII AbstractofDissertationPresentedtotheGraduateSchool oftheUniversityofFloridainPartialFulfillmentofthe RequirementsfortheDegreeofDoctorofPhilosophy RESTRUCTURINGINNETWORKINDUSTRIES:COMPETITION ANDMERGERSINTELECOMMUNICATIONS By MarkA.Jamison May2001 Chairperson:DavidE.M.Sappington MajorDepartment:Economics Thisdissertationaddressesthreeissues. Thefirstiswhetherlargeservice providersinnetworkindustries,suchaslargeInternetbackboneproviders,havean incentivetodiscriminateagainsttheirsmallerrivals. UsingCoumotinteractions,each networkprovidersimultaneouslychoosesquantity,qualityforcommunicationswithinthe provider'sownnetwork(internalquality)andqualityforcommunicationsbetweenthe provider'snetworkandothernetworks(externalquality). Largernetworkschoosehigher internalqualitythandosmallernetworks. Allnetworkschooselowerexternalquality whenconnectingwithsmallernetworks. Largenetworksandsmallnetworkschoose identicalexternalqualitywheninterconnectingwitheachother. Lastly,incumbent providersaresometimeswillingtoraiserivals'percustomercosts,butnevertheir interconnectioncosts. Thesecondissueishowregulatorypoliciesrelatingtonetworkinterconnection affectentrants'incentivesandabilitiestoenterlocaltelecommunicationsmarketsand vm expandsupply. Ifindthatlowpricesforresellingincumbents'services,leasingfacilities, andexchangingtrafficincreaseentry,buttimeforentry,accesstoincumbents'buildings, andreformofuniversalservicesubsidiesdonot. However,ifpricesforleasingfacilities arelowrelativetoincumbents'retailprices,thenlessentryoccurs,presumablybecause incumbentsexertefforttoprotecttheirretailprofits. Higherpricesforexchangingtraffic increaseentrants'marketshare,presumablybecausetheytargetcustomers(suchas InternetServiceProviders)whoreceivemorecallsthantheymake. Lowpricesfor resellingservicesdonotcauseentrantstochooseresellingoverothersupplymethods. Thethirdissueishowmergersaffectmarketperformanceinanetworkindustry. Networkproviderschoosequalityforcommunicationswithintheprovider'sown network,qualityforcommunicationsbetweentheprovider'snetworkandothernetworks, andoutput. Thedissertationshowsthatcross-bordermergersprovidefirmswithan incentivetoincreaseindustryoutputbecausemergersallowfirmstointernalizepositive networkexternalities. Thedissertationfurthershowsthatcross-bordermergersimprove thewelfareeffectsofhorizontalmergersincertaincircumstances. Lastly,mergersthat arebothcross-borderandin-marketincreasewelfareiftheaggregatesizeofthemarkets thatthepre-mergerfirmshadincommonbeforethemergerislargerelativetothe aggregatesizeofthemarketsthattheyindividuallyservedbeforethemerger,andifthe valuecustomersplaceonnetworkexternalitiesishigh. ix CHAPTER 1 RESTRUCTURINGINNETWORKINDUSTRIES:COMPETITION ANDMERGERSINTELECOMMUNICATIONS Thisdissertationconsistsofthreestudiesoftherestructuringofcommunications industries. ThefirststudyexaminesmarketconcentrationintheInternet. Thisisoneofthe issuesthatcausedthecollapseoftheWorldCom-Sprintmerger. Iexamineanoligopoly modelinwhichfirmssimultaneouslychoosequantities,networkqualityforinternal communications(internalquality),andinterconnectionqualityforcommunications betweennetworks(externalquality). Ishowthatfirmsbasetheirqualitychoiceson networksize,customervalueofinterconnection,andthecostofinterconnection. Networkschooselowerexternalqualitywhenconnectingwithsmallernetworksthan whenconnectingwithlargernetworks. Largernetworksandsmallernetworkschoosethe sameexternalqualitywhenintercormectingwitheachother. Ialsofindthatlarger networkswillnotoptimallychoosetosabotagerivalsbyraisingtherivals'costsof interconnection. Idevelopandexplainmyresultsbyapplyingastaticoligopolymodel. Firms haveidenticalcostfunctionsofprovidingquality,butmayhavedifferentcostfunctions forproduction. Costasymmetriesarisefromdifferencesinnetworksizes. Anincumbent canraiseitsrivals'costs,forexample,bydelayingaccesstoessentialfacilities. Firms 1