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Real Options and the Costs of the Local Telecommunications Network

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  • Nicholas Economides

Abstract

The Telecommunications Act of 1996 invites entry in the local telecommunications networks whereby entrants will lease parts of the network ("unbundled network elements") from incumbents "at cost plus reasonable profit." A crucial question in the implementation of the Act is the appropriate measure of cost. This paper examines the economic principles on which the cost calculation should be based. I conclude that the appropriate measure of cost (maximizing allocative, productive, and dynamic efficiency) is forward-looking economic cost and not the historical, accounting, or embedded cost of the incumbent’s network. In calculating costs, demand and supply uncertainty, as well as the asymmetric position of incumbents and entrants should be taken into account. Close examination of the issue of uncertainty in the local telecommunications network reveals that (i) for most unbundled network elements, there is little demand uncertainty; and (ii) that those elements that face significant uncertainty, do not have sunk value. Thus, the incumbent does not face higher expected cost by investing. Moreover, the rewards of the incumbent can be higher because buyers prefer to buy services from the owner of the network. Finally, strategic considerations in oligopolistic interaction are likely to dominate any uncertainty considerations and will increase the incentive of incumbents to invest.

Suggested Citation

  • Nicholas Economides, 1999. "Real Options and the Costs of the Local Telecommunications Network," Working Papers 99-11, New York University, Leonard N. Stern School of Business, Department of Economics.
  • Handle: RePEc:ste:nystbu:99-11
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    File URL: http://raven.stern.nyu.edu/networks/real.pdf
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    References listed on IDEAS

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    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
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    Citations

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    Cited by:

    1. Nicholas Economides, 2003. "Telecommunications Regulation: An Introduction," Working Papers 03-22, New York University, Leonard N. Stern School of Business, Department of Economics.
    2. Laura Ferrari Bravo & Paolo Siciliani, 2007. "Exclusionary Pricing And Consumers Harm: The European Commission'S Practice In The Dsl Market," Journal of Competition Law and Economics, Oxford University Press, vol. 3(2), pages 243-279.
    3. repec:vuw:vuwscr:19157 is not listed on IDEAS
    4. Roberto J. Santillán Salgado, 2004. "Application Of The Real Options Methodology To Value A Cement Firm'S Acquisition," Remef - Revista Mexicana de Economía y Finanzas Nueva Época REMEF (The Mexican Journal of Economics and Finance), Instituto Mexicano de Ejecutivos de Finanzas, IMEF, vol. 3(4), pages 313-331, Diciembre.
    5. Clark, Ephraim & Easaw, Joshy Z., 2007. "Optimal access pricing for natural monopoly networks when costs are sunk and revenues are uncertain," European Journal of Operational Research, Elsevier, vol. 178(2), pages 595-602, April.
    6. Heatley, David & Howell, Bronwyn, 2010. "Overseas Investment: is New Zealand 'Open for Business'?," Working Paper Series 4054, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    7. Inderst, Roman & Peitz, Martin, 2014. "Investment under uncertainty and regulation of new access networks," Information Economics and Policy, Elsevier, vol. 26(C), pages 28-41.
    8. Heatley, David & Howell, Bronwyn, 2010. "Overseas Investment: is New Zealand 'Open for Business'?," Working Paper Series 19157, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.
    9. Evans, Lewis T. & Guthrie, Graeme A., 2005. "Risk, price regulation, and irreversible investment," International Journal of Industrial Organization, Elsevier, vol. 23(1-2), pages 109-128, February.
    10. Lewis Evans & Graeme Guthrie, 2006. "Incentive Regulation of Prices When Costs are Sunk," Journal of Regulatory Economics, Springer, vol. 29(3), pages 239-264, May.

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    More about this item

    Keywords

    telecommunications; regulation; cost; real options;
    All these keywords.

    JEL classification:

    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance
    • D4 - Microeconomics - - Market Structure, Pricing, and Design

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