Graduate School of International Corporate Strategy, Hitotsubashi
                     Asian Tax and Public Policy Program

            Economic Analysis of Regulation and Public Enterprise

                                REGULATION IN


                       Why, What and How to Regulate?

                                        Bakhodir Mardonov IM0313

                              February 20, 2001
Recent empirical studies have showed  that  national  indicators  correspond
closely to the degree of competition in telecommunications markets.  Greater
competition has generated greater innovation, investment and  spin-offs  for
the  economy  as  a  whole.  However,  many  governments  have  found   that
competition in telecommunications can bear good results only if  appropriate
regulatory  institutions  are  functioning  effectively.  Consideration   of
advantages  and  disadvantages  of  specific  regulatory   policies   raises
questions on why regulate, what to regulate and how to regulate.

Why Regulate Telecommunications?

There  are  different  approaches  trying  to  answer  this  question,   but
basically they are split into two views: whether government should  regulate
actively or intervene only in case of market failure.

Public policy goals: Even though  the  ultimate  goals  are  the  same,  the
relative priority given  to  different  goals  may  vary.  For  example,  in
developing countries with a limited access to  telecommunications  services,
the  policy  goal  to  make  them  universally  accessible   is   especially
important. While, in developed countries,  the  priority  goals  may  be  to
raise the efficiency of telecommunications and maintain  a  basic  telephone

Market failure: General goals such as universal  accessibility  cannot  be
enough to justify regulatory intervention when the  prevailing  view  relies
on market forces to promote efficiency and innovations. In  this  case,  the
strongest  justification  takes  the  form  of  market  failures  and  the
regulator may intervene in order to  facilitate  competitive  entry,  combat
abuse of market power and redistribute benefit.

Actually, the nature of the problems addressed depends on the  structure  of
the telecom services industry, the general economic,  political  and  social
situation  and  the  prevailing  set   of   fundamental   telecommunications
policies,  particularly  those  concerning  the  roles   of   monopoly   and
competition. Accordingly, we may consider three  groups  of  countries:  (i)
full monopoly, (ii) partial monopoly and (ii) full market system.

As some countries have moved from one of  these  groups  into  another,  the
major problems to be solved by regulators  have  changed.  For  example,  as
Mexico introduced  competition  in  cellular  services  and  privatised  its
former state telephone monopoly, Telmex, it has faced  controversial  issues
concerning the interconnection  of  different  carriers'  networks.  In  the
United States, the evolution of the  telecommunication  industry  since  the
1950s illustrates a gradual transition from the first group  via  second  to
the last one: if in the beginning, the  regulatory  policy  concern  was  to
assure  the  universal  availability  of  telecommunications  services  with
reasonable rates, over the years, as competition has  developed,  regulators
become more confident about the provision  of  different  telecommunications
services. Thus, a  gradual  relaxation  and  withdrawal  of  some  forms  of
regulation (notably controls on the pricing of services  to  end-users)  has
been introduced. At the same time, new forms of regulation have arisen  from
the need to solve new kinds of problems, concerning for example,  the  terms
of interconnection between different carriers' networks, or control  of  the
numbering plan in a multi-carrier environment.

In spite of variations of the  regulators  mandate  across  each  group  of
countries, some of his basic missions can be defined as following:
1) Promotion of universal service targeting low-income  households,  users
   in remote geographical  areas,  or  disabled  persons.  For  example,  in
   Argentina, this was done through setting goals for the expansion  of  PTO
   networks; in the United Kingdom and  U.S.,  through  imposing  lifeline
   tariffs for low-income users.
2) Protection of user interests.
3) Change in the industry structure. The desired change is  usually  towards
   a more competitive industry structure, but this mission can be  far  from
   "deregulation".  For  example,  in  Japan,  the  Ministry  of  Posts  and
   Telecommunications caused NTT to maintain  high  charges  between  Tokyo,
   Osaka  and  some  other  major  locations  for  the  initial  period   of
   competitive entry, to help new entrants gain a foothold.
4) Movement towards a no discrimination policy or level  playing  field.
   However, in this case, the concern on the need to discriminate  in  favor
   of new entrants has to be addressed (mission 3).
5)  Supervision  of  the  dominant  PTO  in  case  of  limited   or   absent
   competition. This can be done, for example,  through  applying  price-cap
   regulation like in Mexico.
6) Stimulation of innovations. In many countries, the regulator is  seen  to
   anticipate  opportunities  for  innovations  and  creating  a  favourable
   environment for their timely exploitation. For  example,  in  the  United
   Kingdom the pioneering action of  OFTEL  in  granting  licenses  for  the
   Personal Communications Network (PCN) and  Telepoint  (CT2);  in  France,
   current activity by DRG on PCN licensing; in the U.S., policy of granting
   "pioneer's preference" in the licensing of radio frequencies to companies
   pioneering new service concepts and technologies.
7) Management of common resources effectively.
8) Stimulation of investments in the public network.
9) Network interconnection.  Open  entry  requires  interconnection.  It  is
   important to create favourable environment  for  interconnection  of  new
   network operators and other providers of telecom services.  However,  the
   more innovative the services of the new entrant, the tougher the  problem
   may become for the dominant carrier. This subject  requires  considerable
   study and analysis, since it lies  at  the  heart  of  the  challenge  of
   finding economically efficient means of facilitating entry and  promoting

In  practice,  the  regulators  mandate  represents  a  mixture  of   these
different concepts. Not only does the "mix" vary from  country  to  country,
it also evolves over time. For example, in Canada,  telecom  regulation  has
traditionally followed the mission of supervising  the  dominant  PTO.  More
recently, the mission of changing the industry structure has  emerged  as  a
major thrust of Canadian telecom regulation  policies.  A  cellular  duopoly
was established and a second long-distance carrier,  now  known  as  Unitel,
was granted operating and interconnection  rights  to  the  local  telephone
companies' networks. This consent was initially given only  for  leased-line
and packet-switched service, and not for switched telephony, but  Unitel  is
now licensed to provide a full range of  long-distance  services,  including
voice services.

What to regulate?

The provision and use of telecommunications services  may  be  regulated  in
the following ways:
1) licensing carriers;
2) establishing and supervising  technical  and  operational  standards  and
   practices for network operations by carriers;
3) overseeing the quality of service provided by carriers;
4) regulating  the  pricing  of  telecom  services,  either  by  controlling
   telecom operators' rates (tariffs) in detail or  by  applying  some  more
   general form of control such as a price-cap;
5) setting the terms  (administrative,  financial  and  technical)  for  the
   interconnection of different carriers' networks, including  the  "access"
   pricing charged by one carrier  to  another,  where  there  are  multiple
   carriers and one carrier needs to interconnect with another's network;
6) controlling type approval of customer premises equipment  (CPE)  and  its
   attachment to the public network;
7) controlling the numbering plan and related matters.

The decision on "what to  regulate"  has  substantially  varied  in  various
countries since it  depends  on  what  outcomes  are  to  be  achieved.  For
example, in full monopoly group  countries  (e.g.  Spain,  Italy  and  the
majority of developing countries), the regulator's goals will imply that:
 . supervision of the monopoly PTO's technical standards and practices  may
   be unnecessary;
 . price regulation will be necessary and important;
 . licensing new carriers and regulation of network interconnection is  not
At the other extreme, in a highly competitive  group  countries  (e.g.  U.S.
long-distance telephone service), the regulators goals will imply:
 .  regulatory  control  of  some  technical  and  operational  matters  is
   essential since effective competition requires extensive interconnection
   of different carriers' networks;
 . price regulation may become unnecessary, at least in  some  segments  of
   the industry;
 . licensing function may be unnecessary or minimal;
 . rules concerning the interconnection of different carriers' networks are
   of critical importance.

But what if  a  government  chooses  not  to  regulate  at  all?  Experience
suggests that this decision is too illusory: in  the  unregulated  or  self-
regulated monopoly, someone must determine whether or not  the  monopoly  is
acting in the public interest, and intervene if it is not.

These considerations, among others, have led the countries of  the  European
Community to collectively enact EC legislation requiring  the  establishment
in each country of an explicit  regulatory  process  for  telecommunications
and a regulatory body to implement  that  process  which  is  separate  from
operational PTO  organisations,  even  in  those  countries  where  national
legislators have  chosen  to  maintain  a  monopoly  of  basic  fixed  voice

How to regulate?

Regulator with a defined  mission  can  fulfil  it  using  widely  differing
regulatory approaches. Actually, there are basically two  kinds  of  choices
that must be made to define regulatory approaches:
1. How far the regulator will exercise control, and how far  the  regulator
   will act "by exception." To  what  extent  will  certain  matters  (e.g.
   "access charges" for interconnecting) be controlled by the regulator, or
   will the regulator only  intervene  "by  exception"  when  a  particular
   regulatory case requires this?  In  the  case  of  access  charges,  for
   example, U.S. practice involves  continuous  and  mandatory  control  of
   access charges for fixed-service carriers. In  the  United  Kingdom,  by
   contrast, the regulator does not  automatically  exercise  control  over
   these charges, but may exercise the power to determine  the  charges  if
   the various carriers fail to reach agreement.
2. How far the regulator controls outcomes  directly,  or  indirectly.  For
   example, if one goal of regulation is low prices for service,  will  the
   regulator  control  prices  directly,  or  seek  to   influence   prices
   indirectly by promoting an industry structure that is considered  to  be
   favourable to achieving low prices? Or, to take  another  example,  will
   the regulator directly impose particular targets for  network  expansion
   and modernisation, or rely on the  effect  of  a  general  framework  of
   incentives designed to encourage carriers to pursue these goals?

In this context, lets consider one of the  most  fundamental  issues  about
whether or not the regulator should intervene to promote  innovation.  There
are three different views on this matter:
1.  Regulator  as  Patron:  the   regulator   identifies   the   promising
   innovation, and takes steps to ensure that the organisation  most  likely
   to implement it is not only authorised, but have priority access  to  the
   resources necessary to implement the innovation.
2.  "Pro-active  Removing  of  Obstacles":  the  regulator  does  not  "pick
   winners" in this way, but nevertheless  actively  seeks  to  ensure  that
   regulation itself does not impede promising innovations and to  act  pro-
   actively to provide an environment that is favourable for innovation.
3. Arm's Length Approach: the regulators role is minimised  in  decision-
   making about innovation, and the regulator  will  respond  to  innovation
   initiatives  from   the   PTO   or   other   interested   parties   (e.g.
   telecommunications  users,  resellers   or   providers   of   value-added
   services). This may occur if the innovation needs the regulator  to  take
   specific actions before it can proceed.

Although  these  approaches  are   different,   they   are   not   clear-cut
alternatives. There are many intermediate approaches between them. In  table
1, the main advantages and disadvantages  of  these  tree  alternatives  are

Concluding all  above,  we  can  say  that  establishing  proper  regulatory
institutions is an important  precondition  for  successfully  restructuring
the telecommunications sector and  increasing  the  involvement  of  private
initiatives and market forces. Three basic questions are to be addressed  at
the outset - why, what and how to regulate  in order  to  settle  the  main
two  principal  issues:  how  to  ensure  a  proper  interface  between  the
regulated and competitive  parts  of  the  telecommunications,  and  how  to
encourage the innovative forces in the sector.

 Table 1   Advantages and Disadvantages of the Broad Regulatory Alternatives
                            Concerning Innovation

|                  |Advantages                                |Disadvantages                             |
|Regulator as      |May stimulate important innovations not   |Regulatory complexity and cost.           |
|Patron            |previously foreseen.                      |Blurs the line between regulatory and     |
|                  |May significantly increase the rate of    |commercial decision-making.               |
|                  |innovation.                               |                                          |
|Pro-Active Removal|Maintains dividing line between regulatory|A country with this approach may in some  |
|of Obstacles      |and commercial decision-making.           |cases become follower of a country with   |
|                  |May still significantly increase the rate |the regulator as patron model.          |
|                  |of innovation.                            |                                          |
|Arm's Length      |Simplicity and low cost for the regulator.|May result in slower rate of innovation.  |
|Approach          |                                          |May entail significant delays since the   |
|                  |Maximises the clarity of the dividing line|regulator needs to undertake new policy   |
|                  |between regulatory and commercial         |development efforts, after initiatives are|
|                  |decision-making.                          |received, before he can respond.          |