Why ADCo? Why Now? An Economic Exploration into the Future of Industry Structure for the "Last Mile" in Local Telecommunications Markets

Abstract

This Policy Paper discusses important economic characteristics of local exchange markets and the firms that participate therein. First, this Policy Paper, building on the work in PHOENIX CENTER POLICY PAPER NO. 10, explains that entry into the local exchange market requires large fixed and sunk costs, making entry risky and necessitating scale economies. Consequently, only a few local access networks can supply the market. These few local access networks cannot be small, however, because a large market share is required to realize sufficient scale economies to effectively compete with the Incumbent Local Exchange Carrier or and survive. Secondly, using publicly available data from the Federal Communications Commission and industry filings with the Security and Exchange Commission, this Policy Paper explains that acquiring sufficient market share in network services to realize scale economies may be difficult for entrants who either attempt to purchase unbundled network elements from the incumbent or attempt to build their own network from the ground up. Instead, given the substantial scale economies required in the local exchange network, it may not be possible for a single carrier to acquire sufficient retail market share in a timely manner to exhaust economies of scale in its wholesale network. An integrated firm supplying the wholesale market, in an effort to expand output, is conflicted; the integrated firm's retail market share raises the opportunity cost of wholesale supply. Accordingly, this Policy Paper shows that if economies of scale are sufficiently large, reaching a scale of operation that allows the entrant to compete with the ILEC may be best achieved through the entry of an Alternative Distribution Company or which is a wholesale-only carriers'-carrier for the proverbial last mile. (This is a very different concept from a LoopCo, which is formed via the structural separation of the ILEC's network facilities and marketing operations.) The ADCo can consolidate the consumer demand held by retail CLECs, thereby reducing risk and costs by expanding output quickly. The disincentives to wholesale supply possessed by the integrated firm, furthermore, do not exist for the ADCo, and therefore the ADCo - unlike the ILEC - has no incentive to sabotage its customers (i.e., the ability to increase or raise the cost of a rival's key input of production by non-price behavior.) As a result, while the number of local access networks the market can sustain may be few, the exclusively wholesale nature of the ADCo nonetheless permits the number of providers of advanced telecoms products and services to be many (the raison d'etre of market restructuring). Equally as important, given the existence of these discriminatory incentives resulting from the current and foreseeable economic conditions of the U.S. telecommunications industry, the most probable and viable long term, competitive market structure involves a substantial presence by an unintegrated, but larger wholesale supplier - in other words, an ADCo - to function efficiently. As such, their presence in the market should be welcomed and encouraged.