Last month, I was generously invited to join a panel put together by the New America Foundation (“NAF”) at a Capitol Hill event entitled Spectrum Auctions: Promoting More Mobile Market Competition . . . or Less?  (For those interested, video of my panel is available here.)  It was an honor to participate, and kudos to Michael Calabrese from NAF for putting together a great event.  On the panel, I was joined by Mark Cooper (Consumer Federation of America), Fred Campbell (Competitive Enterprise Institute), and Peter Cramton (professor at the University of Maryland).  I found the discussion interesting, informative, and mostly civil.  The variance in the stated views of the participants, in my opinion, could be chalked up to differences in judgment, preferences, or experience, rather than any fundamental error in analysis, though Mark Cooper was an exception in this regard.  Despite his usual verbal passion, Mark’s attempt at a formal analysis of pricing, profits, and efficiency nonetheless was flatly wrong.  Mark is not an economist, so the faux pas is forgivable, but his analysis should be corrected and I do so here.

Mark’s argument can be summarized as follows.  First, he claimed that AT&T and Verizon charge higher prices than Sprint and T-Mobile.  Second, Mark argues that AT&T and Verizon earn higher profits than do Sprint and T-Mobile.  With these two “facts,” Mark then concludes that if “[AT&T and Verizon] had higher profits and lower prices, they would be seen to be earning their rents through efficiency, but when you charge higher prices to get higher profits there’s a really good suspicion that you’re using market power.”  Mark’s argument is meritless. 

Let’s investigate efficiency.  Efficiency can be thought of (for present purposes) as having two extremes.  On the one hand, a firm can be relatively more efficient than its rivals by offering the same service at a lower cost.  The result would likely be a lower price and higher profit for the more efficient firm.  (This is the case Mark is thinking of.)  On the other hand, a firm can be relatively more efficient than its rivals by offering a higher quality at the same cost of its rivals.  The result would likely be a higher price and a higher profit for the more efficient firm.  This is the case Mark ignores and the one that sinks his argument.  Also, it is probably the case that better describes the mobile wireless industry, though I think it is reasonable to presume that the larger carriers benefit from both higher quality and lower costs.

The error in Mark’s logic is apparent by appealing to the most basic law of economics—the law of demand.  Demand slopes downward and this is true whether it’s a market or an individual firm’s demand curve.  Taking Mark’s data on prices as legit, one must then reconcile the fact that AT&T and Verizon have higher prices yet higher market shares than their smaller rivals.  If demand curves slope downward, how can this be?  Simple:  Consumers value the services of AT&T and Verizon more than the others, implying a larger demand for the two larger carriers.  This larger demand permits a higher market share despite higher prices, and also would suggest higher profits (in the form of a return to investments in quality).  A simple graphic illustrates the point.  In Figure 1, we have a constant marginal cost (MC) and two demand curves D₁ and D₂, with D₂ being the larger demand.  Given profit maximization, the price for the firm is p₁ if facing D₁, and p₂ if facing D₂.  Profit for a firm facing D₁ is the rectangle ecdp₁.  Profit for the firm facing the larger D₂ is the rectangle abdp₂.

Looking at the data in Table 1, taken from the FCC’s recent 16th CMRS Report, the evidence points plainly to the superior efficiency of the larger carriers.  ARPU is slightly larger for the big firms though very similar across carriers, but profits are much larger for the larger firms.  AT&T’s ARPU is only $3.85 larger than Sprint’s, but its accounting profit is $11.39 larger than Sprint’s—a huge difference.  Verizon and T-Mobile’s ARPUs are nearly identical ($0.55 difference), but Verizon’s profits are $7.68 larger (60% larger) than its smaller rival.  The relatively large market shares imply that AT&T and Verizon are far more successful at acquiring and maintaining customers, demonstrating that even if Mark is correct that their prices are higher, the two firms have earned it.  This combination of price, market share, and profit data is powerful evidence of superior efficiency—not undue relative market power.  Note also (from Table 1) that both AT&T and Verizon invest far more in their networks than do Sprint and T-Mobile, and this difference may explain the larger carriers’ superiority in the pursuit of customers.

In contrast to his claim, the evidence Mark presented leads to no strong suspicion that AT&T and Verizon are exercising undue market power in the mobile wireless industry.  What the evidence does suggest is that the companies are reaping positive returns on their investments in superior quality, and that’s a good thing.

Addendum:  Table 1 has been altered from the original version that had mistakenly listed as CAPEX the figure for EBITDA less CAPEX.  I thank Mark Cooper for pointing out the typographical error.  The error was limited to the table and the text of the blog remains unchanged.