Network Competition, Interconnection and Pricing With Partial Participation and Call Externalities

Ramiro Camacho-Castillo

Ph.D. Candidate, Department of Economics, University of Maryland-College Park

Abstract This chapter extends the literature on competition among interconected telephone networks, in particular with respect to the regulation of the interconecction fee and the choice of pricing regime. We present a model of two vertically dierentiated telephone networks, which pay each other per-minute termination charges and compete in nal markets using nonlinear tarifs. We allow for the existance of call externalities and partial participation, and analize the optimal interconection fee under two pricing regimes: only callers pay, and both caller and receiver pay.

0.1 Introduction
This chapter analizes the determination of the ecient per-minute termination fee that telephone networks should charge each other under a model of two vertically dierentiated networks, which compete by oering calling plans to nal costumers, using general nonlinear taris. We allow for the existance of call externalities under partial participation of costumers, and analize the optimal interconection fee under two pricing regimes: only callers pay (CPP), and both caller and receiver pay (RPP). We build upon the work of Laont (2004), Hahn (2003), Hermalin (2001) and Rochet (2001), who studied competition in horizontally dierentiated networks, to instead study competition between two vertically dierentiated networks. Consumers are heterogeneous, have private information on their preferences for the service and benet from network and call externalities. We study the internalization of call and network externalities and whether the regulator can intervene to bring the coverage and quantity of calls closer to ecient levels. Three types of interventions are considered: setting the interconnection rate, banning/limiting network-based price discrimination and allowing networks to charge for incoming calls. The dissertation will have and introduction and three chapters. In the introduction, I will survey the literature and describe the issues surrounding interconnection, competition, pricing and regulation in the telephone industry. Chapter 1 will study RPP by using a monopoly model with incoming call pricing. A welfare analysis of the eects of moving from CPP to RPP will be carried through focusing in the internalization of call externalities and the eects on participation rates (network

externalities) as well as the allocation of calls. Chapter 2 will study competition under partial participation and the CPP. In this chapter, two interconnected vertically dierentiated networks compete to attract customers and may use the interconnection rate as an instrument of both collusion and internalization of externalities. The welfare implications and possible regulatory intervention are analyzed. Finally, In chapter 3, a model of competition with RPP will look into the determination of prices and coverage under dierent assumption about the determination of the interconnection fee: cost based, bill-and-keep, cooperative, non-cooperative, among others. Network eects in telephony services imply that it is ecient to have all costumers connected to a single network so that each of them can call every other costumer. However, a single rm may charge monopoly prices, which implies that it is also desirable to have competition by at least a few dierent networks to reduce market power and achieve an acceptable level of eciency. Both objectives may be achieved to a greter extent by a policy of mandatory interconection at regulated, ecient rates. Interconection is generally regulated worldwide because, under voluntary interconnection, a large dominante network may deny interconnection to smaller rivals or charge them high termination rates. Network eects, possibly helped by economies of scale, will cause the market to ber monopolized. Free contracting of interconnection terms, would give an advantage to the player with the most costumers, which by refusing interconection, will become a monopolist and foreclose the market from potential entry. Mandatory and regulated interconection is seen as the solution for 2

internalizing network eects and, at the same time, mantaining competition. In practice, operators sign an interonection agreement specifying the terms of exchange among them such as price, place of delivery of calls, capacity, reliability parameters, among others. The interconection rate or termination rate is the per-minute price an operator charges for completing calls within its network. The Termination rate is perceived, both as a source of revenue by the operator receiving the call, and as a cost by the operator sending the call. In this way, networks see their revenue as coming from selling calls to costumers and selling termination services to rivals. The determination of the interconnection rate has been a contentious issue in regulatory agencies ever since deregulation in the 1980s. The literature on the subject has raised concerns that an inapropriate rate may be responsible for low coverage, calling distortions, and collusion among operators. More specically, the literature has identied three eciency eects: (1)The rise-each-other-cost eect, which may be used as a commitment device to facilitate price xing in retail markets. Operators may agree to charge each other a high interconection tari to raise each others perceived costs and credibly commit to keep high prices and low quantities in nal markets. (2) the foreclosure eect, according to which a dominant player sets a high rate to foreclosure small competitors, restoring the natural monopoly tendencies of unregulated markets. Small network will have an incentive to ration trac to the large network, which makes their service less atractive to costumers; and (3) a double marginalization eect from a failure to cooperate. Each network unilaterally increases the interconection rate 3

in an attempt to maximize its margin over the competitors customers. Rates may end up above the monopoly level. Although all three innefciency efects may be present to some extent, it is the second eect (foreclosure eect) that has received more attention by regulators and competition agencies. A small network that is forced to pay high rates for terminating calls in a large network, may respond by either charging high prices for calls to the larger network, or charge the same prices and absorbe the losses. In the rst case, costumers may have and incentive to switch to the large network to save on calls because more costumers are located there. In the second case, the loses may force the small network to exit the market. The small rms may exit, or Potential networks may avoid entry, after observing the low rate of protability of operating under those conditions. In practice, regulators may impose the tarif directly or indirectly via a mechanism that let operators reach an agreement by themselves. In the rst case, the regulator must estimate the right tarif and mandate its adoption. In the second case, operators generally negotiate a rate and the regulator intervenes only to settle disagreements after negotiations fail. The rate may be subject to ex-ante restricctions such as reciprocity or uniformity (non-discriminatory among networks). It is important to notice that, even when the regulator only settles disagrements about the rate, it is really providing a treath point to negotiators. Networks in a weak position may chose not to accept the other operators proposal and take intead the regulators rate. For this, the regulator needs also to provide a value for the ecient level of the interconection rate. 4

In any case, the regulator needs to estimate an ecient rate, and a correct theory of how that interconection rate ultimate produces the right trade os in several variables: quantity of calls, costumer choice of provider, entry of new players, quality, patterns of calls, among others. These rate are dierent under CPP and RPP regimes. In prctice, some regulatory regimes assume that ecient interconecction rates are equal to cost (cost-based regulation), which then is estimated by a cost model such as the Total Element Long Run Incremental Cost (TELRIC). Other regulatory regimes, take a rate of zero (bill-and-keep regulation), and let operators recover cost from their costumers by charging both senders and receiver per minute rates for calls. Network eects are an important component of the overall value of the networks. When the percentage of potential costumers covered by all networks is less than 100%, the optimal regulatory intervention must take that into account and, posibly, choose a particular value of the interconection rate. The network eect component of the interconection rate has been controversial among regulators,and there is sustantial disagreement as to the convenience of using interconection rates to cover universal service goals, intead of other policy tools. The eects of a certain interconnection rate depend on the set of pricing restriction adopted by the regulator for the nal telephone market. The regime may allow or prohibit: (1) Network-based price discrimination where On-net calls may be priced dierently than o-net calls; (2)Callers Pay Principle (CPP), where customers pay only for calls made, not for calls received; or the Receivers Pay Principle 5

(RPP), where both callers and receivers pay. The adoption of these pricing restrictions may have consecuences for ecency and the determination of the interconecction rate. For instance, pricing based on CPP gives raise to call externalities, dened as the benet a receiver gets from receving a call for which he/she does not pay a price. Similarly, network based price discrimination may give rise to foreclosure of small operatos, trough predation or price squeeze tactics, because large operators may charge too low prices for on net calls and too high prices for o net calls. A concern with RPP may be that by charging receivers, network coverage may be too low, which implies loses in potential network eects.

Chapter 1 Monopoly Model 1.1 Basic set up

A monopoly oers a two-way telephony service to heterogeneous customers represented by a taste parameter [, ], which are distributed according to c.d.f. F () and density f (). The monopolist knows the distribution but cannot directly observe individual types. The cost structure of the monopoly is composed of two parts: a xed cost k of adding and servicing a new customer independently of intensity of use; and a marginal per-call cost 2c, which includes the cost of sending a call from the customer to the switching facility and then to the receiver (each step with a cost of c). Customer makes x(, ) calls to custumer and receives y ( , ) calls from costumer . The total amount of calls made and received by costumer are respectivelly: X () = Y () =
L L

x(, )f ( )d y ( , )f ( )d

where L is the lowest type of costumer that subscribes to the monopoly. Customers types in the interval [, L ] do not subscribe, while those in the interval [L , ] do subscribe. We dene the rate of coverage of the market as n = 1 F (L ). For a given level of coverage L , the monopolist maximizes prots by oering 7

each costumer a nonlinear price schedule, T (X (), Y ()), as a functions of total calls made by that costumer. The choice of T() as a function of totals imply that operators cannot set specic prices for individual sender-receiver pairs. In practice, these means that users pay three rates: a xed rate for being subscribed, a perminute rate for calling independent of the identity of the receiver, and a per-minute rate for receiving calls independent of the identity of the sender. The monopolist solves: (L ) = maxT (,)
L [T (X ( ), Y

()) cX ()]f ()d nk where Then, the

monopolist optimazis for coverage L . Costumer gets gross utility from calling equal to u(x(, )), and gross utility from being called by equal to ()u(y ( , )). Here, () = 0 means that receivers obtain benets from being called; () = 0 means no benet, while () = , means sender and receiver enjoy the same benets from a call. We assume that the valuation of incoming calls is non-negative (no-nuisance calls), weakly higher for higher types, and weakly convex, i.e. () 0, ()geq 0, () 0. With respect to the utility function, we assume that u () > 0, and u () < 0. On the other side, each costumer maximizes his utility from sending and receiving calls minus payments to the monopolist:

v () =

x(, ),y ( ,) L

max

[u(x(, ))f ( )d + () u(y ( , ))]f ( )d T (X (), Y ()) (1.1)

subject to: x(, ) y (, ) y ( , ) x( , )

The rst restriction means that, in general, callers are willing to make a certain number of calls, but receivers may not be willing to receive that many calls. Similarly, the second restriccion means that receivers may be willing to receive a certain amount of calls, but callers may not be willing to make that many calls. Senders may be restricted in the number of call they can make by unwilling receivers, while receivers may accept more calls than the sender is willing to make.

1.2 solution
For a given tarif structure and coverage level (thetaL ), the costumer optimization problem has the FOCs: U (x(, )) and (y ( , )) ()U
dT dr dT ds

+ = 0

+ = 0

where = 0 if x(, ) < y (, ) and = 0 if x(, ) > y (, ). while for a given L , the monopolist problem gives FOCs:

1.3 The choice of coverage

Once the amounts of calls as a function of type is determined, the monopolist has to choose the level of coverage, L , or the miminum type of costumer who wants subscribed to the network. Dening H () as the surplus extracted by the monopolist from customer (to be determined below), the monopoly solves:

max (L ) =
L

[H () ncx() k ]f ()d
L

(1.2)

If a local maximum exists, the FOC is given by:

H (L )

dH () f () d = cs() + cnx(L ) + k dL f (L )

(1.3)

which says that the surplus extracted by the monopolist from adding the marginal customer L , plus the gain of surplus extracted from inframarginal customers as a result of the new trac,calls made from and to L must equal the additional cost. A global optimum L generally exists for standard utility functions, taking one of three forms: full coverage when L = ; partial coverage when L (, ); or no coverage L = . Figure 1.1 depicts the shapes for (L ) in each case: C1 , C2 and C3 , respectively. 10

Figure 1.1:

1.4 CPP
We assume that the gross surplus obtained from sending a call is the same regardless of the identity of the receiver. This means that senders demand an equal number of minutes for each potential receiver.1 . Similarly, customers receive the same gross surplus from incoming calls regardless of the identity of the sender. ut, in general, dierent amounts of calls are received from dierent senders. Following Hahn (2003), this is expressed by the inclusion of a linear (in incoming calls) term in the additive utility specication. Under CPP, no user has an incentive to refuse calls and x(, ) is independent of , which means that every recipient [L , ] receives the same amount x() of calls from , so the restriction in 1.2 disapears and both variables are reduced to y (, ) = x(, ) = x(). Simplifying in the original problem we have the FOCs: u (x()) =
dT ds

substituting the optimal value x() in 1.2 we have v () = nu(x ()) + ()

L

u (x( ))f ( )d T (s)

which from the envelope theorem v () = nu(x ()) + ()

L

u (x( ))f ( )d

This is equivalent to assuming that each costumers has an ex ante equal probability of calling

any other costumer

11

By the revelation principle, we can see the monopoly problem as one in which the monopoly chooses directly the quantities x() for all while guaranteeing a surplus v () to every individual [L , ]. As a borderline condition, it must be the case that v (L ) = 0. (L ) =
L L

v ()f ()d +

L [nu(x( ))

+ ()

u (x( ))f ( )d ]f ()d

cx()f ()d Eliminating v () using integration by parts, we can write (L as: (L ) = maxL (L ) =
L [ ( )us

+ ()ur cs k ]f ()d

where () = [
1F () ] f () 1F () f ()

() = [[()

()]

are the coecients representing the proportion of the surplus extracted from user . We assume that the hazard rate are Increasing for (). We also dene: us = nu(x()) ur =
L 1F () , f (

which implies (), ()/, () and ()/

u(x())f ()d

are s gross utility of sent and received calls respectively. The FOCs are: u (x ())[ () +
1 n H

()f ( )d ] = c

The right side of the equation represents an adjustement to marginalcost made by the monopolist in order to partially internalize call externalities. It says that surplus extraction must take into account the fact that receivers are beneted 12

from calls although only senders pay a marginal price. In particular, for the highest type the marginal price is reduced by exactly the amount of gross surplus from reception given to the lowest subscriber L . Surplus extraction from reception of calls is limited to a xed amount for each costumer regardless of type, while surplus extraction from sending calls is () varies across costumer. Finally, the amount of surplus extracted by the monopolist from costumer is: H () = ()us + ()ur

1.5 Benchmarks
The rst best allocation of calls and subscription under observable is the same for a social planner or a monopolist, considering the perfect discrimination capacity for the latter as a result of knowing . In both cases, the quantity of calls has to be determined based on: [ +
1 n H

()f ()d]u(x()) = c

From this, the price of calls is going to be decreasing on pe () = u (x()) =

c
1 1+ n L

( )f ( )d

From this, it is not surprising that, pm () > pe () for every . Under monopoly, even the highest type makes an inecient quantity of calls. Thus the eciency at the top principle of the standard screening model is not veryed. The possibility of subscribers who do not make any call and only receive calls is

13

present depending on the pricing scheme. The opposite is also possible. Subscribers who only make calls but do not receive.

1.5.1 example
Here we assume that costumer are in the interval [0, 1] and have unit demand, so that U (0) = 0 and u(x) = 1 for x 1. Assume also that () = a, with a 1 . Under CPP, whenever a positive coverage is protable, the monopolist chooses L to equate marginal revenue to marginal cost. Costumer L receives gross surplus equal to n(1 + a) from sending and receiving calls to each of the n other subscribers. In this example, scheening of costumers by the monopolists is reduced to separating subscribers from no subscribers. Therefore the mononopolist charges all subscribers the same subscription fee T = nL (1 + a) equal to the surplus of the marginal type, L . The monopolist maximizes the total amount collected minus costs: (L ) = nT n2 c nk solving this problem produces (1 + a c) + ((1 + a c)2 3(1 + a)k ) 3(1 + a)

L = 1

Unsurprisingly, the monopolist restsricts overal participation and quantity of calls made for each . The maximum coverage achievable when k = c = 0 is equal to n = 2/3 or L = 1/3. In contrast, in the socially optimal allocation when an interior solution exists, the marginal costumer is given by: 14

L = 1

(1 + a c) +

((1 + a c)2 (3/2)(1 + a)k ) (3/2)(1 + a)

which is always lower than in the monopolist case(higher coverage). For c and k small enough full coverage (L = 0) is the welfare maximizing choice. This however requires pricing equal to zero, which could be implemented if nancing through non-distortionary public funds were available. If not, the Ramsey pricing level L dened as (R ) = 0 may be the social second best: (1 + a c) + ((1 + a c)2 4(1 + a)k ) (2)(1 + a)

L = 1

Figure shows the shape of the prot functin and welfare as a functon of L . Point A is the choice of the monopolist, while point B is the choice under Ramsey pricing. Notice that the level of coverage that maximizes the social walfare is closer to full coverage. With the posibility of charging for receiving, the monopolist has two instrument to screen costumers: price for sending and price for receiving calls. This means that pricing may separate subscriners in three groups:2 those in the interval [0, L ] are no subscribers, those in [L , L ] are call receivers only, while those in [L , 1] sand and receive calls. To implement this separation, the monopolist chooses two taris: TL equal to
2

for some combinations of k, c and a RPP is the same as CPP, because the monopolist may

not nd protable to have no call-making subscribers. The specic condition is XX PONER CONDICION. Under continuos utility function the no call making costumers becamo all costumers below the

15

(l )(1 h ), the gross utility of costumer L ; and TL the gross utility of L . PL , which is obtained by equating the gross surplus of L from belonging to one or the other interval: aL (1 L ) TL = L (1 L ) L (1 L ) This reduces to: TL = L (1 L ) + aL (1 L ). Coverage is determined by the solution of: maxL ,L (L , L ) = (1 L )TL + (L + L )TL (1 L )(1 L )c (1 L )k With two instruments to screen costumers, the monopolist unambiguosly extracts more rents. However, coverage and monopoly prots are unambiguosly larger, but costumers, welfare may be larger or smaller. In the RPP case the optimal choice of coverage implies the existence of callreceiving only costumers. pricing according to RPP increases screening capacity and prot extraction for the monopolist, but also coverage and social welfare.

1.6 RPP 1.6.1 The Model

We extend the previous model by giving the monopoly the possibility of charging for call reception. As I mentioned above, when receivers cannot refuse or limit the duration of incoming calls, charging per incoming calls can be accomplished trough the the xed part of the tari which was already available to the monopolist when only senders pay. The interesting case arises when receivers can refuse or limit the duration 16

of calls. In such case the monopoly will have an additional instrument to screen customers and a dierent possibly welfare improving pattern of calls and subscription rate is possible. Under certain circunstances, allowing reception pricing may be irrelevant because the monopoly would not choose it. It is also possible that, even if chosen, it may not be welfare improving because by increasing the monopolys ability to screen customers, the deadweight loss of monopoly may increase. As before, customers are oered the nonlinear tari T (s, r) where s and r are the total number of sent and received calls by individuals . The rm cannot charge dierent prices for calls to dierent receivers and senders (receivers) are indierent as to the identity of the receiver (sender) of the calls. For receivers who do not refuse or limit incoming calls because reception charges are small, senders will choose the same number of calls x() to each of those recipients. If receiver refuses calls or limits its number then sender sends x(, ) < y (, ) number of calls to receiver . The limit on reception y (, ) = y ( ) set by is uniform across senders due to the indierence over the identity of the sender. In the rst case x(, ) = x() and in the second case x(, ) varies with . This is equivalent to x(, ) having the form: x(, ) =

x()

if is not restricted by

y ( ) if is restricted by

In this way if individual sends x(, ) to and receives x( , ) from then his/her utility is given by: U (x(, ), x( , )) = where s =
L L [u(x(,

)) + () u(x( , )]f ( )d T (s, r) x( , )f ( )d

x(, )f ( )d and r =

17

The amount of sent calls x(, ) will be determined by either the sender or the receiver in the following way: The monopoly may choose marginal prices for sent and received calls as to give either the sender or the receiver the choice over determining x(, ). If the sending price p() is high and the receiving price r() is low, sender will be the one who decides x(, ). If r( ) is high and p() low, then receiver will choose to limit the number of received calls thus choosing x(, ). Given that receivers get the same utility for calls regardless of the identity of the sender but high type senders prefer to send a higher number of calls, we can divide the space (, ) in two regions separated by curve l() (see gure 1.2). Region A is formed by sender-receiver pairs in which sender s is restricted in the number of calls he/she makes to receiver r. Region B is formed by sender-receiver pairs, inwhichenders choose the amount of calls and receivers accept all of them. The possibility of no call making subscribers, no call receiving subscribers and receivers who make all the calls they wish or receive all the calls sent are possible for dierent forms l() may take. For instance, 1 such that l(1 ) = L is the lowest type of caller that is restricted by receivers. It is possible that for some type of customer below 0 , x() be reduced to zero (no call making customer) who, noneteless may be subscribed because of call reception. On the receiver side, 1 is the marginal type of the restricting receivers. > 1 are customers who receive any call they are sent. The curve separating A from B is characterized by the equality y ( ) = x(). Here sender and receiver agree on the amount of calls they want to make or receive respectively. So while customers in 18

A l(2) B

2L 2L

Figure 1.2: improve graph [, 0 ] are not restricted by receivers, customers in [1 , ] do not restrict any receiver.

1.6.2 The customers problem

Customers solves the following maximization problem taking y ( ) as given:

x(),y ()

max US () + ()UR () T (s, r)

(1.4)

where US (x(), y ()) =

l() L

u(y ( ))f ( )d + u(x())

l()

f ( )d

for [L , ]

19

UR (x(), y ()) =

l1 () L u (x( ))f ( )d u (y ()) f ( )d

L

+u (y ())

l1 ()

f ( )d

for [0 , 1 ] for [L , 0 ]

The FOCs for the customer maximization problem are:

dUs x() : dx = () dT (s,r) dx( dT (s,r) dy (

dUr y () : () dy = ()

or simply: x() : u (x ()) =

dT ds dT dr

y () : () u(y ()) =

Substituting x () and y () in 1.7 and derivating using the envelope theorem. We obtain the consumer surplus function. v () = u + () u where u = and u =
L L

u(x (, )f ( )d

x( , )f ( )d

For given 0 L and 1 the monopoly choose x(), y () to solve RP P (L ) = maxx(),y()

L [ ( )us

+ ()ur cs]f ()d

where c and s are as dened above and ur = Ur (x (), y ()) and us = Us (x (), y ()) from which we obtain the marginal conditions for x() and y ().

20

 ()u (x()) + u (x())(l()) = c for [L , ] u (y ())l1 () + () u (y ()) = c u (y ())L + () u (y ()) = c for [0 , 1 ] for [L , 0 ]

For the remaining of this section we assume u () = u(), that is, the asymetry in preferences for a customer acting as sender and as receiver is captured by (). by taking the simpler case u(x) = u (x), the FOC are: u (x())[ () + (l())] = c for [L , ] u (y ())[l1 () + ()] = c u (y ())[L + ()] = c for [0 , 1 ] We have a system of two equafor [L , 0 ]

tions in x() and y (). To solve it, lets invert equation the second equation by substituting for l() we get u (x())[ + (l())] = c for [L , ] By comparing with the rst equation, we conclude that l() must be the solution to + (l()) = () + (l()) and also that 1 must be equal to as implied by the denition l() = 1 in the preceding equation. Furthermore, the function l() = y 1 (x()), being the composition of two increasing functions , is also increasing. Figure 1.3 shows the shape of l() in the (, ) space. For pairs of customers in A and C, senders determine the amount of calls. for customers in B, receivers decide. In particular, for pairs in C receivers never limit incoming calls. Lets take u(x) = ln(1 + x), uniform in [1, 2] and () = a + b. We calculate

21

A l(2) B

2L 2L

Figure 1.3: improve graph l(): l() = (2b + 1 )/b which satisfy l(2) = 2 Substituting l() back in our three FOCs we obtain: x () = y () =
34+a+2b

c b+a+2 3b4c
c

1 1 for [0 , ]

L +2b2b+a

1 CHECK THIS for [L , 0 ]

x () and y () are linear and increasing everywheere in [1, 2] which is necessary for the global ICC. Moreover, marginal prices are decreasing: p() = u (x ()) and r() = (a + b)u (y ()).

22

1.6.3 The Choice of L

We have seen how quantities of sent and received calls are determined and hence the pattern of calls. This pattern is conditional on the coverage level delimited by the marginal participating customer L . The prot function for both the CPP and RPP cases after substituting the x () and y (), respectively are given by: RP P (L ) =
L [ ( )us + ()u r cs ]f ( )d

where u s , ur and s are us , ur and s respectively evaluated at the optimal choice of

x() and y ().

Figure 1.4: improve graph The following proposition shows the divergence in preferred pricing policies for the monopoly and the regulator. Basically, the regulator increases social welfare by imposing CPP over the monopolys preferred RPP policy. The regulators preferred 23

policy results in a lower coverage level.

Proposition 1 Under symmetric preferences for sending and receiving calls, () = and u (x) = u(x): -The monopolist prefers RPP over CPP. -The social planner prefers CPP over RPP. -The level of coverage under RPP is below the lever under CPP.

Figure 1.4 shows the prot function for our example. Although prots under both pricing policies appear to be very similar, the calling patterns are radically dierent. Under RPP, customer sends and receives equal amounts of calls x() = y (). Under CPP, both high and low type customers send a higher amount of calls than under CPP but low types receive more under CPP than under RPP. The marginal customer L sends the same amount of calls under both regimes but receives more under CPP. Proposition 3 assumes identical tastes for send and receive calls. We can argue that a customer gets more (less) surplus as sender than as receiver. In fact, the previous result is valid as long as the derivative of () be equal to 1. That is, () = + c if + c is positive. Under a general function (), the choice of CPP vs RPP will depend only on () because the function l() depends only on the derivative of () reecting the fact that nonlinear pricing tends to extract any constant surplus received by all customers under both regimes. In our example, gure 1.5 depicts the prot function for both CPP and RPP 24

Figure 1.5: improve graph policies assuming () < 1. In this case, the monopoly chooses RPP and a higher level of coverage compared to CPP and it is socially preferable to do so. On the other hand, gure 1.6 depicts the case for () > 1. Here the opposite happens. CPP is superior both for the monopoly and society. Coverage is greater under CPP than under RPP. Although the choice of pricing policy depends only on the derivative of (), coverage and the calling pattern are inuenced by the the xed part of ().

25

Figure 1.6: improve graph

1.6.4 IC Constraints 1.6.5 Second degree IC constraint 1.6.6 No Call Making/Receiving Customers 1.6.7 Benchmarks: , observable
The ecient price allocation under rst degree price discrimination satises: u (x()) +
1 n) L

( )u (x( ))f ( )d = c

or in terms of prices pe ( ) +
1 n L

re ( )f ( )d = c

26

which is the marginal price of sending a call plus the average of the marginal prices for reception of all the subscribers. The solution of this integral equation is technically complex. but, for instance, in the case () = a solution is p() = r() = c/2. Senders and receivers share half of the costs of a call. by comparing with eq(**), this coincides with the RPP allocation. We have then eciency at the top for the symetric case. In general:

Proposition 2 The monopoly allocation under RPP does not satisfy the eciency at the top property of the standard screening model.

By comparing eq ** and eq** at = we have u (xe ()) +

1 n ) L

( )u (xe ( ))f ( )d = c

u (xr pp()) + ()u (xr pp()) = c from which we conclude that xr pp() < xe ().

27

Chapter 2 Competition with CPP 2.1 The Model

There are two competing rms selling vertically dierentiated two-way telecommunications services. The cost structure of rm i, i = 1, 2 can be decomposed in the following parts: a xed cost ki representing the cost of adding and servicing a new customer regardless of intensity of use and a marginal one-way cost ci per standarized call which represents the transit cost of a call from a customer location to the switching facility, the marginal cost of a call to a customer in network j is thus ci + cj . in particular, on-net calls cost 2ci . Customers derive utility from both making and receiving calls. We assume that the gross surplus obtained from sending a call is the same regardless of the identity of the receiver. This means that, from the point of view of a sender, receivers who are identically priced are perfect substitutes and therefore each sender distributes his/her calls uniformly across receivers unless calls are priced dierently for dierent receivers. Similarly, customers receive the same gross surplus from an incoming call regardless of the identity of the sender but, in general, dierent amounts of calls are received from dierent senders. Following Hahn (2003), this is expressed by the inclusion of a linear (in incoming calls) term in the additive utility specication. Let ni be the size of network i and xij the number of calls a subscriber of 28

network i makes to each subscriber of network j . The total number of calls a subscriber of network i makes is then n1 xi1 + n2 xi2 . Calls are priced according to the nonlinear tarif Ti (n1 xi1 , n2 xi2 ) where n1 xi1 and n2 xi2 are the total number of calls made by a subscriber of network i to subscribers of networks 1 and 2 respectively. As in standard models of adverse selection, potential subscribers are repre] and are distributed according sented as a continuum of types in an interval [, to F () with density f (). The distribution of types is public information but rms cannot directly observe individual types. The intensity of a customers preferences for telephone calls is represented by his/her . A customer of type who is subscribed to network i of quality qi gets an utility from sending xij calls to a customer in j equal to qi u(xij ) while he/she gets ()qi u(xji ) from receiving xij from customer of network j . The gross utility of customer in network i is thus

U (xi1 , xi2 ; ) = qi [n1 u(xi1 )+n2 u(xi2 )]+qi ()[

u(x1i ()f ()d+

u(x2i ())f ()d] (2.1)

Here () = expresses the possibility of a customer valuing calls dierently when acting as a sender and as a receiver. Quality qi is the same across both types of calls reecting the assumption that quality is interpreted as mobility. For instance, qi can be high (mobility) or low (xed line). A custumer with a mobile phone gets the same high quality for sent and receive calls. In contrast, a xed line phone gets both types of call of low quality.

29

Notice that

u(x1i )()f ()d +

H L

u(x2i ())f ()d is independent of given

that all subscribers receive the same number of calls regardless of type and that the utility of received calls is an externality because the sender has no control over the variable xji ( ) except in the case = and j = i which is a set of measure zero. We assume that the valuation of incoming calls is positive (no-nuisance calls), higher for customers with higher values of and weakly convex, i.e. () > 0, () > 0, () 0. With respect to the utility function, we assume u () > 0, u () < 0. In this specication, n1 and n2 reect the eect of network externalities. Larger total coverage n1 + n2 benets customers already suscribed. Additionaly, in the presence of tarif-mediated network externalities, the size of the own network matters. When on-net calls are cheaper than o-net calls, a subscriber benets if his/her network is bigger. If o net calls are cheaper subscribers benet if the other network is bigger.

2.1.1 The timing of the game

Firms, customers and (possibly) the regulator play a three stage game with the following timing Stage 1: Firms or regulator choose interconnection rates a1 ,a2 . Stage 2: Firms oer nonlinear tarif T (s1 , s2 ) as a function of number of on-net and o-net calls. Stage 3: Customers make a subscription decision by choosing Firm 1, Firm 2, or the outside option (no participation). They also decide the amounts xij () of 30

calls to purchase.

At stage 2, tarifs cannot be a function of particular pairs of customers other than the on-net/o-net distinction. Calling a customer of higher type is priced the same as calling a lower type as long as both receivers are on the same network. This may be justied because, in thios setting, customers value calls the same regardless of receiver. So, if rms oer customer a menu of taris p(, ) receiver with price possibly dierent for dierent receivers. Because customers do not know exante when they are going to call once subscribers to a network they decide on the based on etc etc 9THIS WAS MISLEADING AS ALREADY SEEN) and therefore, rms have no ex-ante information about pairs of customers when they choose the tarif. Firms and consumers base their pricing, subscription and call consumption decisions on their expectations of network sizes n1 , n2 . We assume that, at equilibrium, their expectations are fullled. The fact that the networks have dierent qualities is interpreted, not as quality of audio or reliability, but as the degree of mobility. In this sense, a wireline phone can make and receive the same quality calls but provide a low quality service because of restrictions on mobility. The existence of network externalities creates a coordination problem because consumers may have dierent beliefs as to the behavior of the other consumers and the networks. Consumers form expectations about the size of each network ne 1 and ne 2 and make subscription/quantity decisions based on those expected sizes. As

31

pointed out by Katz and Shapiro (1985), multiple equilibria are posible by allowing dierent expectations of network sizes. Here, we simplify the analysis by assuming a rational expectation equilibrium. That is, consumers expectations about the size of both networks are the same and expectations are fullled in equilibrium based
e on the corresponding consumption/subscription choices: ne 1 = n1 and n2 = n2 .

Given subscription rates n1 , n2 , 0 < n1 , n2 < 1 and n1 + n2 1 and tarif T (, ) a type- customer subscribed to network i chooses outgoing-call quantities by solving: V () = max [U (xi1 , xi2 ; ) Ti (n1 xi1 , n2 xi2 )]
x11 ,x12

(2.2)

Asume that q1 > q2 so that network 1 is the high quality network. Under the appropriate assumptions on f (), we can focus on the situation in which higher types adopt network 1 and lower types adopt network 2 which means that there ] subscribe to are two cut-o values L and H such that individuals in Ai = [H , network 1 and those with values in A2 = [L , H ] subscribe to network 2 while individuals in [, L ] do not subscribe to any network. Type H individuals are indiferent between subcribing to networks 1 or 2 while type L individuals are indierent between subscribing to network L and not subscribing at all.

V1 (H ) = V2 (H ) V2 (L ) = 0

(2.3) (2.4)

32

Throughout the paper and for ease of notation, I will refer intercheangeably to cut-o types H and L or market shares n1 and n2 . Market shares are dened as: n1 = 1 F (H ) n2 = F (H ) F (L ) (2.5) (2.6)

Intead of choosing Ti (n1 xi1 ,n2 xi2 ) rm i choose xi1 () and xi2 () for each and then calculate Ti (, ) by using the FOCs dTi dxi1 dTi qi n2 u (xi2 ()) = dxi2 qi n1 u (xi1 ()) = i = 1, 2. i = 1, 2. (2.7) (2.8)

We can then reduce the problem to one in which rm i calculates xi1 () and xi2 () for each and then recovers Ti (, ) from the above FOCs. For given n1 , n2 , rm 1 solve

1 (n1 , n2 ) = max

x11 x12

T1 (n1 x11 , n2 x12 )2c1 n1 x11 n2 (c1 +a2 )x12 +[a1 c1 ] x21 k1 }f ()d (2.9)

and similarly rm 2 solve:

2 (n1 , n2 ) = x max x

21 22

T2 (n1 x21 , n2 x22 )2c2 n2 x22 n1 (c2 +a1 )x21 +[a2 c2 ] x12 k2 }f ()d (2.10)

x ij =

H L

x2i ()f ()d

T (, ) is obtained from the indirect utility function 1.4 33

Ti (n1 x11 , n2 x22 ) = U (xi1 , xi2 , , n1 , n2 , ) Vi () Substituting Ti (, ) into 1.11 and integrating by parts we obtain:

(2.11)

1 (n1 , n2 ) = max n1 V2 (H ) +
x11 x12

[n1 11 (x11 ) + n2 12 (x12 )]f ()d() +

21 f ()d n1 k1 n1 (2.12)

where: 11 (x11 ) = [ () + (H )]q1 u(x11 ) 2c1 x11 12 (x12 ) = ()q1 u(x12 ) (a2 + c1 )x12 21 (x21 ) = [(H )q1 u(x21 ()) + (a1 c1 )x21 ()

(2.13) (2.14) (2.15)

Here, V1 (H ) is the across-the-board surplus rm 1 has to give each of its customers. That is, every customer of network 1 has to have at least the surplus of its lowest type. () =
1F () f ()

is the coecient representing the fraction

of consumer s baseline surplus from sending calls captured by the rm. In other words, the rm captures ()/u(xij ()) from customer in iwho sends xij () callsto any recipient in j . Consequently, ij () is the per-capita surplus extracted from customer calling from i to j net of marginal costs. The next-to-last term in expression 1.14 is composed of the net gain made by network 2 for each incoming call (a1 c1 ) and the surplus extracted from the receiving customers (H ) multiplied by the number of incoming calls. In the case of on-net calls, the specication of utility used implies that the rm captures a fraction of consumers surplus from outgoing and incoming calls equal to 34

 () + (H ). Surplus from outgoing calls is captured at a dierent rate for dierent customers while surplus from incoming calls is captured at a constant rate equal to the incoming call surplus of the lowest type. For o-net calls, the monopoly only captures surplus from calls sent while surplus from reception by the other network custumers can only be captured indirectly via the interconnexion rate or by modifying H through market stealing. Firm 2s prots are given by: 2 (n1 , n2 ) = maxx21 x22 {n1 V2 (H )(n1 +n2 )V2 (L )+
H L [n2 22 (x22 )+n1 21 (x21 ]f ( )

+
H

12 f ()d() n2 k2 } n2

(2.16)

21 (x21 ) = ()q2 u(x21 ) (a1 + c2 )x21 22 (x22 ) = [ () + 2 ]q2 u(x22 ) 2c2 x22 12 (x12 ) = q2 2 u(x12 ) + (a2 c2 )x12

(2.17) (2.18) (2.19)

2.2 solution
The rs order conditions of the preceding maximization problems are: x11 : x12 : x21 : x22 : [ () + (H )]q1 u (x11 ) = 2c1 ()q1 u (x12 ) = c1 + a2 ()q2 u (x21 ) = c2 + a1 [ () + 2 ]q2 u (x22 ) = 2c2 35 (2.20) (2.21) (2.22) (2.23)

where: 2 = (L ) n1 /n2 [(H ) (L )] As in the standard model of adverse selection,

1F () f ()

is assumed to be non-

negative and decreasing, which makes () increasing. Depending on the values of , H and L , the FOCs may have cut-o points ij in which either
2c1 (HH )+(H )

= q1 u (0) or

2c2 (LL )+2

= q2 u (0) or

ci +aj (ij )

= qi u (0).

In each case, the corresponding xij () will be zero for types ij . This represents the possibility that low types may choose not to make a certain type of call. For instance if in network L is such that < LH , then He/She will make xLH () = 0 calls to network H. We can even have no vall making subscribers in which xLH () = xLL () = 0 which are subscribed merely for call reception. Additionaly, we assume the necessary conditions to guarantee the satisfaction of the IC constraint. Eciency in the amount of on-net calls requires that we take into account the eect of call and network externalities. For H and L given: q1 u (xij ) + qi u (xij ()) or q1 u (xij = ci + cj 1+
E (s|sAj )

sAj

sf (s)ds = ci + cj

which comparing to the FOC above for xij () above, implies that on-net calling is inneciently low for every customer. There is no eciency at the top as in the standard adverse selection model without externalities. Proposition 3 Inneciency of call allocation. Given H and L subscribers con36

sume suboptimal quantities of on-net calls.

Proposition 1 implies that network externalities working through H , L will play a role in reducing this ineciency. Additionaly, eciency in the amount of onet calls will generaly depend on the interconnection charge, which is determined at an earlier stage.

2.3 No call making subscribers

Before continuing to interconexion and coverage issues, we have to point out that some customers may be subscribers but make zero calls at least to some subscribers. There are three possibilities, zero on-net calls, zero o-net calls or zero of both (no-call-making subscribers). We assume that no-call-making subscribers are present only in the low quality network. That is, the high quality network has all its customers making a positive number of calls in equilibrium. To delimit the extent of no call making subscribers we assume two cut o points LL and LH [L , H ] such that customers in [L , LL ] make zero o-net calls (xLL () = 0) and customers in [L , LH ] make zero o-net calls (xLH () = 0) and as a consequence customers in [L , min(LL , LH )] do not make any call whatsoever. Alhtough it is in principle posible that some customers above H subscribe to network 1 and choose to make zero number of calls on or o-net, we are going to assume away this case based on monotonicity of call making with respect to type.
1

the conditions for this will be discused in an apendix

37

The values LL and LH are dened by:

[ (LL ) + 2 ]]q2 u (0) = 2c2

(2.24)

and [ (LH )]q2 u (0) = a1 c2 (2.25)

No call making subscribers exist only if LL or LH are above L . Whenever no call making subscribers are discussed we will assume L < LL < LH . That is, the lowest type customers make zero calls to either network then higher types make only on-net calls while those above LH make both types of calls. This condition is equivalent to on-net calls being cheaper so that lower types drop o-net calling before droping on-net calling. Customers in [L , LL ] make zero calls of both types and therefore must be required to pay a xed subscription fee equal to the utility of the lowest type L . That is (L ) x where x is the sum of calls received from every sender: x =
H

x HL ( )f ( )d +

H L L

x LL ( )f ( )d

customers in [LL , LH ] additionaly pay according to the amount of o-net calls sent. In this way, rm 2 obtains prots from both types of calls: 2 (n1 , n2 ) =
H LL

n2 22 (x LL ( ))f ( )d +

H LH

n1 21 (x LH ( ))f ( )d n2 k

38

Similarly, Firm 1 obtains prots: 1 (n1 , n2 ) =

H

n1 11 (x HH ( ))f ( )d +

n2 21 (x LH ( ))f ( )d n1 k

2.4 The Choice of xij ()

Before tackling the choice of coverage, lets see how the monopoly would choose its pricing schedule under 3 dierent cases: Case 1: Knowledge of both both sender and receiver types (, known) Case 2: Knowledge of only senders type. Case 3: Knowledge of neither sender or receivers type. In the rst case the monopolist can observe pairs of sender-receiver (, ) and price calls individually. In the second case, the monopolist can observe senders types but cannot price discriminate according to receivers of a call. The tarif T (s, ) is a function of types and total number of calls sent only. This implies that although high s will call more, they will make no distintion as to revceiver of the same network and will end up calling each one of them the same amount. Receivers will end up receiving the same amount of total calls regardless of type. In the second case, the monopolist charges tarifs T (s, ) under CPP and T (s, r, ) under RPP. In the third case, knowledge of sender and receivers is not assumed. Taris are: T (s) and T (s, r) for CPP and RPP respectively

39

In the second and third cases the total amount of calls received is the same across types under CPP, while dierent types generally receive dierent amounts of calls under RPP.

2.5 Case 1: Fully Ecient Allocation under CPP

The monopolist chooses xij (, ) such that M U = M C as follows qi u (xij (, )) + ()qj u (xij (, )) = ci + cj This can be replicated by charging only outgoing calls at: pij (, ) = ci + cj 1+
cj ( ) ci

(2.26)

(2.27)

which for = , i = j and () = we have p = c, price is equal to half the marginal cost.

[qi i + qj j ]u (xij (i j ) = ci + cj

(2.28)

In an ecient assignment of customers to rms, the high type rm will serve cus] while the low type rm serve customers in [L , H ] tomers in [H ,

2.6 Case 1: Fully Ecient Allocation under RPP

Because of the full information assumption, charging for receiving calls does not change the allocation xij (, ) of calls. In general we can choose prices:

p(, ) = qi u (xij (, )) 40

(2.29)

r(, ) qj u (xij (, )) or p(, ) qi u (xij (, )) r(, ) = qj u (xij (, ))

(2.30)

(2.31) (2.32)

For all p(, ) that satisfy the condition. So, we can support the ecient allocation with multiple pricing strategy

2.7 Ecient allocation when charges depend only on total number of calls sent (CPP second case)
The previous section assumed that the planer was able to identify and set a tarif for each sender-receiver pair. In this section we assume that the palner knows the type of each customer but cannot price discriminate for callssent to dierent receivers other than the on/o-net disctintion. This can be explained as the result of regulation or information costs or asymetries. For instance, the fact that new customers do not know who are they going to call after subscribing makes them expect to be given simple tarifs sucha as the marginal tarifs for on-net and o-net calls. Otherwise a tarif contingent on the receivers type may be too complicated or create the incentive for rms to cheat customers. This is a realistic assumption given that cellphone rms price discriminate more usurd on sending than receiviong of particular calls. This is equivalent to assume that T (s1 , s2 ) is a function of total amount of sent to customers on-net and o-net. 41

Now under this restriction, the planer determines xij () such that

qi u (xij ()) + qj

1 u (xij ())E ((s)|s Aj ) = ci + cj nj

(2.33)

Where Aj is either the interval [L , H ] for j = 1 or [H , ] for j = H . Equations (**) reects the fact that marginal utility of sending a call plus the expected marginal utility of receiving it across all receivers equals cost. Notice that pij () = qi u (xij ()) is increasing in but u (xij ()) is decresing in so xij is increasing

pij () =

1+

ci + cj qj E ((s)|sAj ) qi

(2.34)

From equation ** we can see that, in the case () = (symetry between senders and receiver utilities) on-net calls are marginally priced at 2ci E (s|sAi )

pii =

1+

(2.35)

while o-net calls are priced according to ci + cj 1+

qj E (s|sAj ) qi

pij () =

(2.36)

Prices for on-net calls are high for high types and low for low types. There is eciency at = E (s|s Aj ) at which point pi i() = ci but inneciently everywhere else. For o-net calls The ecient amount of calls sender makes under unobservable recipients is equal to the amount of calls himself will send to an average recipient in each

42

network under full observability. Such recipients j , for j = H, L. are dened by by E ((s)|s Aj ) = (j ) (2.37)

This implies a pattern of too few calls to high types and too many for low types compared to the full observability case. Comparing case 1 and case 2, we can see that, while marginal price in general depends on and under case 1 it is constant w.r.t. under case 2. Graph ** shows that, under case 2, customer in A1 pay the price he/she would have to pay under case 1. Customers makes too many calls to low type receivers ( low) and too few calls to h igh type receivers ( high). The receivers H and L are such that any sender calling them are calling an ecient amount as in the full information case regardless of the on-net/o-net origin of the call. Although H and L are constant w.r.t. , they are increasing in H and L respectively. In the special case () = a + b both lines intersect at = E (s|s A1 ) for every a. A smaller a (weaker call externalities) moves both curves upwards but leaves unafected so that for a tends to 0 (uniform call externalities) lack of knowledge of the recepient is irrelevant for eciency purposes (the number of calls is ecient for every ) and the marginal price in both cases pij =
ci +cj q b 1+ qj
i

. Furthermore, if b = 0 (no

call externalities then the marginal price is constant p() = ci + cj so that total tarif is T (x11 , x12 , x21 , x22 ) = F +
j {1,2}

pij xij this is true for every choice of coverage

H , L which enters in the tarif trough nj .

43

2.8 Pricing inder CPP

The planer/monopoly
2

observes the type and chooses p() and r() as

to maximize the total surplus from calling. The choice of prices will involve call rationing by receivers such that high types calling low types will normaly be rationed more compared to low types calling high types. This is expressed in the the solution by the existence of a curve l() which gives the marginal recipient who rations calls sent by . That is, if < l(), sender is rationed by receiver such the amount of calls exchanged y ( ) will be determined by actiuj upon reception price r( ). On the other hand, if > l() then recipiend receives all x() calls sent by . The monopoly chooses x(), y () by maximizing the sum of the surplus generated by each . For a xed such surplus is:

l()

u(y (s))f (s)ds + [1 F (l())]u(x()) + ()u(y ())[1 F (l1 ())]+ (2.38)

l() l()

( )
H

y (s)f (s)ds (c1 + c2 )x()[1 F (l())] (c1 + c2 )

u(y (s))f (s)ds (2.39)

H

The F.O.C. are: c1 + c2 E ((s)|s>l()) c1 + c2 1+

E (s|s>l1 ()) ()

p() = u (x()) = r() = ()u (y ()) =

1+

(2.40) (2.41)

where l() is such that y (l()) = x(). This is a nonlinear sistem of equations in 3 variables u (x()), u (y ()) and l(). They express the fact that l() crosses the
2

Given that is observable and no price discrimination according to receivers is posible. The

monopoly and planer are going to choose the same allocation

44

45o line at . This is veried by substituting , l() above. Type customers are rationed by every receiver < but they do not but they do not ration any lower type custumer. The slope of l() will, in general, depend on the slope of () and wheather such slope is >< 1 as shown in the linear example: () = a + b. The F.O.C. reduce to l() =
(1a) , a

whioch is linear and does not depend on b. l() = and lies below

the 45o line for a < 1 and above if for a > 1. For a = 1, l() = 0. Furthermore, for a < 1 there are some customers at the bottom who are never rationed as sender no mather how H is choses. Also for a > 1 some customers at the bottom never reject a call from anyone. Now in this example, p() is always increasing while r() is increasing only for a<2
b

In the special symetric case a = 1 and b = 0 prices are: c1 + c2 1+

+ 2

p() = r() =

(2.42)

Notice that only custumers calling their own type, share the costs equally. Calls between arbitrary and are such that: c1 + c2 1+
+ 2

p() + r( ) =

c1 + c2 1+
+ 2

< c1 + c2

(2.43)

unless both = = otherwise, marginal price will sum up to less than marginal cost. Alternatively, if a = 0 and b > 0 so that recipients are equal in the surplus

45

they get from being conected then p() = r() = c1 + c2 b 1+ c1 + c2 1+

b

(2.44) (2.45)

which implies a constant reception charge for every recipient. If b to 0 then r() to0. Also receivers pay less than half the marginal cost because b < while sender pay more/less the marginal cost if they are higher/lower than the b type. Proposition 4 When markets are young CPP is comparatively more atractive than RPP with respect to the mature phase. That is,
d[wRP P wCP P ] dc dH dc

<? > 0[VER ESTO] and

>0

In terms of real world pricing this implies that when costs of billing customers are present (it is costlier to bill customers under RPP than under CPP) then CPP may be preferrable when the market is in the early stages of development (low coverage and high c). As long as c falls and the spectrum of customers for which the it is ecient to consume the services widens (even if billing cost remains constant), then RPP will be more desirable so that at some point the switching fron CPP to RPP is necessary.

2.9 Fully ecient allocation:The choice of H and L

Let i,j (, ) be the surplus generated by a single call from customer in i to customer in j . i,j (, ) = qi u(xij ()) + qj ( )u(xij ()) (ci + cj )xij () 46 (2.46)

Let sij () be the surplus net of marginal cost customer in network i obtains from calling customers of network j . sij () = rij ( ) = i,j (, )f ( )d i,j (, )f ()d (2.47) (2.48)

Aj

Ai

where Aj is the interval [L , H ] if j = 2 and [H , ] if j = 1. Now the total surplus is given by: S=
i,j H,L Aj

sij ()f ()d

(2.49)

Now to nd H we get the F.O.C. [s11 (H )+s12 (H )][s21 (H )+s22 (H )]+[r11 (H )r21 (H )][r12 (H )+r22 (H )] = k1 +k2 (2.50) or SH SL = k1 k2 where SH () = s11 () + s12 ()] + [r11 () + r21 ()] SL () = s21 () + s22 ()] + [r12 () + r22 ()] (2.52) (2.53) (2.51)

Are the total surplus added by (his or others) by sending and receiving calls. The equality above expresses that the increase in surplus H creates by moving from network L to network H must equal the increase in xed cost of belonging to H rather to L. Similarly we can deduct the condition for L as: SL (L ) = k1 if L > 47 (2.54)

which is simply the condition that total surplus added by L must be equal to xed cost. In the case L = , then only the st condition applies From the conditions above, we can see that for the particular case of monopoly, satises the simpler condition s11 (L ) + r11 (L ) = k1

2.10 Competition: The Choice of L and H

Firm 1 and rm 2 solve the respective problems:

max (H : L , a1 , a2 )
H

(2.55) (2.56)

max (L : H , a1 , a2 )
L

from which we obtain H (L ) and L (H ) respectively. The equilibrium choice of coverage H and L is the mutual best response: H (L ) = H L (H ) = L (2.57) (2.58)

48

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