Monday, July 23, 2007

Restoring competitive balance to the upcoming spectrum auction



In recent days, and especially following Eric Schmidt's July 20 letter to FCC Chairman Kevin Martin, many people have asked us a straightforward question: why don't you just attempt to win the spectrum bidding outright, and then implement an open wholesaling business model yourself? Or, as AT&T has put it, "put up or shut up."

That question makes a lot of sense, especially for those most familiar with the ordinary marketplace structures they see on eBay, or Home Shopping Network, or at Target. In those everyday cases, the buyers and sellers collectively determine what is the fair market value for something, based on what willing participants on both sides agree should be the price. The free market is the optimal market.

But an FCC spectrum auction is a very different animal. Unlike in most commercial transactions, participants in an FCC auction operate in an artificially defined market. Initially, the spectrum comes sliced and diced in predetermined packages of varying bandwidth, geography, and duration. Those discrete slices tend to be compatible with what regulators perceive to be the prevailing services and technologies of the moment, such as centralized voice communications.

Further, given the sizable investments involved, only well-capitalized corporations can afford to bid at auctions. Ordinary citizens or entrepreneurs with novel ideas don't even show up. Even so, players still come to the table with unique assets, and in some cases disparate business models. For the upcoming 700 MHz auction in particular, the issue boils down to the different incentives at work between the existing national wireless carriers -- the incumbents -- and those companies seeking to enter the market for the first time -- potential new entrants.

As we have seriously considered entering the 700 MHz auction, we have been consulting with auction experts and game theorists to help us better understand the dynamics of a typical spectrum auction. What they have been telling us is that in a head-to-head bidding war between an incumbent wireless carrier and a potential new entrant, the incumbent almost invariably will prevail. Why? The answer involves two key economic factors: what we call the "incumbent blocking premium" and the "incumbent dilution discount."

Incumbent blocking premium

A significant economic factor that comes into play in an auction environment is the incentive and ability of one of the players to thwart the designs of the other. In the context of an FCC spectrum auction, there are at least three pertinent elements.

First, incumbent wireless carriers come to the auction with a vast array of existing assets, including thousands of radio towers, tens of thousands of miles of communications "backhaul" networks, and millions of customers, along with numerous retail outlets and tons of advertising. And perhaps most important of all, incumbents already own lots of spectrum -- much of which the FCC gave away for free some years ago, rather than sold at auction. By contrast, a true new entrant has none of these assets. Thus, to an incumbent, purchasing another wireless license is just an incremental investment, one made that much less costly given the existing, readily-available business inputs. To a new entrant, facing the daunting challenges of actually building and operating a network for the first time, the investment is less certain.

Second, the incumbent has the added benefit of operating in a less than fully competitive environment. Some use the term "monopoly rents" to describe the situation where a company enjoys revenues and profits that exceed what normally would be the case in a robustly competitive environment. Potential new entrants do not enjoy the same advantage.

Third, and perhaps most important, the incumbents have every incentive to preserve and protect their existing business model. Given their investment in all the necessary business inputs, and the relatively high prices and low bandwidth characteristics of their existing service offerings, the incumbents must prevent the entry of potential competitors to the market. In a spectrum auction, this means paying whatever it takes to block new entry. Not surprisingly, economists call this a "blocking premium."

As the diagram below shows, these three elements together mean that an incumbent will almost always be in a position to outbid a potential new entrant, simply by bidding above and beyond the fair market price. Unlike in a healthy auction situation, the final price would be higher than otherwise would be commercially reasonable.

Incumbent dilution discount

The second significant economic factor that comes into play in any auction environment is related to the number of players who actually show up to participate in the bidding. Again, in a normal commercial environment, market prices are shaped by the number of willing buyers, from just a few to potentially millions. However, an FCC spectrum auction presents a comparatively artificial scenario.

Given the existence of the incumbent blocking premium, as described above, it is often the case that there are no new potential entrants to bid against an incumbent. Why should a new player even bother to bid, or bid aggressively, if the incumbent inevitably will prevail? Where there may be only two incumbents -- or even one -- left to bid for a license, obviously the resulting price will not reflect the fair market value that otherwise would have been reached. The dilution of competitive bidders means the final price will be lower than otherwise would be the case. Recent studies have confirmed that this is a pervasive aspect of the FCC auction environment.

Un-skewing the spectrum auction

When looking at the combined impact of the incumbent blocking premium and the incumbent dilution discount, it's easy to see how FCC auction results become skewed.

Ironically enough, it is Google that has been accused of attempting to skew the auction structure, by our recommendation that the licenses be conditioned on certain "open platforms" requirements. Of course, as we have explained it is the current auction system that skews the results away from potential new entrants and in favor of existing incumbents.

Our position is simple enough. FCC Chairman Kevin Martin and the other commissioners have argued persuasively that we need a real third pipe broadband competitor in this country. They also believe that the upcoming 700 MHz auction is the best way to get there. All we are saying is that, based on what we know, new broadband competition will emerge from the upcoming auction only if the FCC's rules allow it to happen. For Google, and other potential new entrants, the prevailing imbalance can be corrected most effectively by introducing license conditions based on open platforms.

While Google embraces the kinds of openness and innovation that are the hallmark of the Internet, the incumbents apparently prefer their existing business models. That of course is their prerogative. However, open platforms -- specifically, open applications, open devices, open wholesale services, and open network access -- together make the spectrum more valuable to Google, or any other potential bidder seeking to create innovative, higher-speed, lower-priced offerings.

That is why Google has indicated that it is willing to spend a minimum of $4.6 billion in the auction, which is the FCC's reserve price for the particular spectrum block in question. At the same time, incumbents are unable to leverage anti-competitive blocking in this scenario. Regardless of who wins the bidding, however, the end result is an auction that yields a fair market price, with the added bonus of a new broadband network that is open to all comers. The American people get full value for their spectrum, plus open broadband platforms -- and even the possibility of a real third pipe competitor. Not a bad deal overall.

If the FCC ultimately decides not to adopt open platforms conditions that "un-skew" the 700 MHz auction, we believe it is unlikely that robust new broadband competition will emerge. In that case, our country would have lost a golden opportunity. Nonetheless, we remain optimistic that the FCC will stand up for its stated public policy goals, and pave the way for a much brighter broadband future for all Americans.

19 comments:

Ikeda, Nobuo said...

Hi, I'm a researcher of spectrum policy at a university in Japan.

I wrote a paper "The Spectrum as Commons" five years ago. I think it's similar to your proposal.

Tom Coseven said...

As I understand Chairman Martin's plan, he sets a $4.6B reserve price for an auction with open devices and open applications. If the reserve is not met, a new auction will be held with no open requirements and the same $4.6B reserve.

It seems to me that he can now set a reserve price of $4.7B for the same plan (open devices, open applications, no wholesale). If the reserve is not met, a new auction can be held starting with Google's $4.6B bid including wholesale. If google says, "um, well you see we really didn't mean it," then a 3rd auction could be held with no restrictions and a $4.6B reserve.

This way the telcos and MSOs can't say they were forced to no bid because of a wholesale requirement. Google has to put up or shut up. AND us consumers have a 2 out of 3 chance of getting open devices.

dclist said...

Implying that, absent regulation providing monopoly rent rights, spectrum would be a 'free market' good is disingenuous. Spectrum is a public commons. There is no free market in spectrum any more than there is one for air or light.

Randy said...

You might find this post on our faculty blog of interest:
http://uchicagolaw.typepad.com/faculty/2007/07/the-google-spec.html

Anthony DiSanti said...

@dclist:

I think you may be misinterpreting Google's position here...

By removing the monopoly regulation for the spectrum, new competitors would enter the auction as the spectrum would lose its purpose as a marginal cost to preserve the incumbent's monopoly (Incumbent Blocking Premium).

Your argument that the free market good doesn't exist, is actually saying that the license is worthless with open standards. To protect the FCC's financial interests, Google has personally guaranteed the reserve price. Alternatively, if the monopoly regulation were left in place, the spectrum is equally worthless as long as one of the big wireless companies wins it and no new competitors are allowed to enter the market. This devaluation is reflected in a less competitive auction between 2 or 3 companies (Incumbent Dilution Discount).

The important part of Google's argument is what actually effects the consumer. None of us are profiting from nor participating in the FCC's auction. We don't care who wins the license, we care about how the prices we need to pay for wireless access are affected.

Although some may argue otherwise, the current prices of wireless services are out of control. This is what happens when a company gains a monopoly. In a free market, a monopoly can only maintain itself if its product is truly superior and new competitors are unable to match its quality. However, most monopolies exist because of government protection and are then regulated by a federal or municipal agency. The wireless companies are one flagrant exception to the rule, they are being auctioned a "license" that effectively provides them government protection of a monopoly with no further regulation. Normally the purpose of a regulated monopoly is to achieve free market prices in a market where true competition has a negative impact on society (i.e. Energy Distribution - we don't want multiple companies tearing up our streets and running wires all over the place).

The 700 MHz spectrum is in no need of regulated monopoly, and certainly not of unregulated monopoly. A free market IS best for the consumer and Google is merely trying to ensure that we the consumer are best served. True, Google may choose to enter this market as a competitor and provide cheaper access than the current government protected corporations, and that's exactly what we need right now.

Greg said...

The only problem I have with 700MHz is the fact that it's even being allowed for auction. The FCC has changed it's position so many times on 700MHz that everyone seems to have completely forgotten it's original intent: Exclusive Public Safety usage. No public wireless networks, no vendors trying to impose a standard (or even Google's intent toward open standards and evolving technology). Nothing to cause interference in a band that was earmarked for exclusive PS usage.

I realize that many people look at the opening of channel blocks in 700MHz as another feeding frenzy for new proprietary networks. It's a band that offers better propagation (let's face it, 1900MHz is terrible) and the potential for uncluttered spectrum once analog TV is fully removed from the space. However, the FCC has shown us once again that it'll do anything to feed the black hole with an endless supply of cash while continuing to shirk their duties in the enforcement arena. There is nothing wrong with Google's concept in my opinion... just a problem with the fact that none of this should be happening in 700MHz.

Just one man's opinion, and I'm sure I'll get flak for this one.

Suznne said...

The government has no rght to auction or give away airwaves. They belong to the citizens of the US. Ask the citizens what they want.

Michael said...

Rather than impose more rules to correct the market power that existing rules have caused, why not eliminate the original offending rules that require licenses to use spectrum, as Ikeda Nobuo suggests in the paper he linked to in the first comment on this blog? This article argues the same point in layperson's terms.

Daniel said...

The argument in the post is superficially academic, but for the most part breaks down upon careful analysis.

(1) That incumbent carriers' existing equipment means their spectrum bids are lower risk is not a distortion. The risk for the new entrant reduces the value of the asset in its hands, and so reduces the social value of awarding the asset to the entrant.

(2) There is such thing as a "blocking premium" -- if you assume that there is a monopolist. But there only has to be one more incumbent for this argument to break down. When there are multiple incumbent firms, they would all be better off if someone bought and retired the new license, but the incumbent who buys it will shoulder the entire cost as all of the incumbents benefit. So unless you are accusing all of the incumbent carriers of colluding to buy spectrum, this argument is a non-starter.

(3) The argument that incumbents have access to rents has no bearing on how much they would be willing to pay for a license. Having higher revenues on existing spectrum doesn't increase the value of new spectrum. If an entrant really had a higher value, they could raise the capital to purchase the license by issuing debt or selling equity, just as every other firm in every other industry does.

Moreover, the "open services" and "open networks" portions will likely be disastrous.

"Open services" (reasonable nondiscriminatory wholesale prices) will require government price regulation (by deciding what is "reasonable"). The government setting prices is rarely a good idea. It generally discourages innovation and is subject to regulatory capture. Just who do you think rotates in and out of the FCC (hint: incumbents' employees). Government rate regulators would be captured pretty much instantaneously. The "nondiscriminatory" portion is a bad idea as well. Price discrimination is generally procompetitive, increasing output and reducing costs for lower-intensity users. Perhaps Google, being a high-intensity user, is not exactly innocent in advocating this . . .

"Open networks" (allow purchase by third-parties wherever along the network stack it is technically feasible) is also problematic. Essentially, this regulation would prevent vertical integration. But vertical integration is generally procompetitive. When firms all along the distribution chain have market power, they end up charging more independently than they would if they set price together -- an effect called "double marginalization". Moreover, when the parts of the distribution chain fit together in fixed proportions (as seems likely in telecommunications), the entire monopoly profit can be extracted from any point along the distribution chain, meaning that this regulation would have little chance of reducing prices or increasing quality. Note that none of this counterargument even depends on the costs that providing and administering such connections would bring, which could be enormous.

I appreciate that you are trying to make an economic argument; it is certainly better than the general populist rhetoric about such things that appears in the media. But I would also appreciate if you actually did economics, rather than applied economic principles haphazardly.

Michael said...

Also, Ikeda Nobuo's article makes a very different suggestion that the one Google is putting forward. He proposed complete deregulation, whereas Google proposes increased regulation in an attempt to mitigate the negative effects of current regulations.

mcbride said...

Googles should just buy the lower 700MHz licenses from Aloha Partners and a hand full of other smaller players and then go back into the auction and buy the 12Mhz B block in CMA sizes the lower 700mhz band. Now you have 24mhz in a band with a 15 year biuld out and 50 watts of power better spectrum the the upper band and a lot less cost to your stock holders plus you can even buy the 12mhz in the A block later down the road for 36MHz which you will need in the big U.S Metro markets. This would be about half the price for a nation wide network in the upper band without having to try to out bid the big three. Stick it to the pigs at the about 60 billions and then go buy the lower B band CMA makets and just bring onboad with you all of the small auction winners in the B band. You see by buying the B band licenses you can play both sides for the pother 12MHz the A block and the C block or both of the blocks for 36 mhz of band in the same spectrum band. One thing for sure, Googles must buy the spectrum and build a network or give full control of your company over to AT&T or make a bid for AT&T. The mobile internet will be the only internet in year 2050. It is now or never Googles has get into the mobile game or you will be dead in the water.

Frank Gilroy said...

This article carried a great deal of credibility with me until the part where you state that you're optimistic the government will do the right thing. Come on, be honest, what's your game plan when they side with AT&T?

Andrew said...

I want to start off by saying thank you to Google for looking out for the consumer. Cell phone companies are very abusive in their business practices and encouraging smaller companies to enter into this area should benefit me, the tax paying customer.

That being said, I'm afraid that the above analysis misses a very important piece to this puzzle. The money that encombant businesses, and Google, spend lobying the FCC. I'm guessing by the FCC responce to Googles suggestions that encombant businesses spent a lot more money than Google did to get thier message heard.

Mitchell said...

I may not have much, but i'd like to help.
Is there a fund where citizens can
help donate money to Google to
use to bid for the spectrum?

Also - i've seen other posters saying that the FCC members are influenced by incumbents to help further their side. I would assume that if the FCC were corruptible in this fashion that it would only take a few private investigators and a subpeona of bank records to find that out? I'm sure choicepoint would be willing to help.

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Cell Phone said...

A year later it is interesting to see the results. Based upon Google's public policy of pushing more for the "open format" and not just another copy-cat business model from the wireless industry proves that Google never really intended to win.

I am ashamed at the FCC. Giving away spectrum for free to begin with reminds of "It's a Wonderful Life" when the millionaire offers more than 100% value for the assets and the little Savings and Loan says "he's not buying he's owning (or something rather)."

The correlation, The FCC is giving away something that is not there. To have a "open-format" would require a free market, which is contradictory if the FCC is making you buy from the government. Even with a corporate public policy as Google's it would never happen unless Google almost had a unquenchable thirst for it, and not just the minimum requirements met- the typical rules that were posted by Google here would have to be ignored.

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