Why GigaOM has it Wrong on the Comcast/Verizon Spectrum Deal…

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This past Sunday, Kevin Fitchard wrote a piece in GigaOm entitled If Comcast Can’t Make It in the Wireless Biz, Who Can?  In this piece, Mr. Fitchard laments that Comcast’s decision to sell its AWS spectrum to, and enter into a joint marketing agreement with, Verizon, rather than construct their own 4G network, “raises some troubling questions about the state of the U.S. wireless industry.”  According to Mr. Fitchard, “if a company with a $71 billion market cap and deep roots in the telecom service provider business can’t make a go of the wireless business, what hope is there for any newcomer?”  Mr. Fitchard asks a good question, but I think misses the deep insights that answering such a question provides.

Put simply, a newcomer will enter the wireless business when it is profitable to do so.  If entry is not profitable, then the potential entrant stays out.  In the face of large capital expenditures, this in-or-out decision implies that the number of competitors in a market is not infinite.  Firms will enter until the next firm loses money, and when that occurs, entry stops.  By way of a hypothetical example, if it is the fourth firm that loses money, then the industry can support only three firms; if it is the fifth firm that loses money, then the industry can only support 4 firms, and so on.  In economic speak, in this last illustrative scenario, four is the “equilibrium number” of competitors.

We explain the economic theory of industry structure in an intuitive way (rather than a highly technical way) in our paper Competition After Unbundling: Entry, Industry Structure and Convergence (a paper cited frequently by the Federal Communications Commission as an appropriate theoretical tool with which to evaluate the telecommunications industry).  In that paper, we observe that the equilibrium number of firms in any market—what we call N*, which is stated as “N-star”—will be determined by the intensity of price competition, the size of the market, and the amount of fixed and sunk costs necessary to participate in the market.  Large markets, other things constant, support more firms than do small markets.  Markets with high fixed and sunk costs support fewer firms than do markets with low fixed and sunk costs, other things constant.  Markets with aggressive price competition support fewer firms than markets with soft price competition, since lower prices mean lower profits and a diminished ability to incur the necessary capital expenditures.

If we interpret the actions of Comcast in the context of the economic theory of industry structure, then we may conclude that the number of competitors in the wireless industry today is at an upper bound on the equilibrium number of competitors.  That is, additional entry into the wireless industry leads to financial losses and eventually exit by one or more competitors (either incumbent or entrant).  I say “upper bound” because we cannot conclude that the present number of competitors exceeds the industry’s economic equilibrium.  (Both T-Mobile and Sprint are struggling financially and news reports indicate that LightSquared is rapidly running out of cash.)  Comments made by Comcast drive the economics home.  Comcast noted they did not have enough spectrum to operate a viable wireless business and that the “costs of building out a new national network were also too high.”  A plausible interpretation of Comcast’s decision is that there is no money to make by becoming “one more” competitor in the mobile wireless industry, implying that the revenues (derived from the mix of market size and competitive intensity) in the industry today are just large enough to cover the investments of the incumbent firms.  It is also important to note that it was Comcast itself that found entry to be unprofitable, since Comcast brings to the party sizeable spillover effects from its position as a substantial provider of communications services (e.g., related plant, labor, customer base, and knowledge) that makes its entry relatively easy compared to an entity not in the business at all.  A review of the financial evidence shows that profits in the mobile wireless sector are not supra-competitive, making Comcast’s decision unsurprising.  (Indeed, we had a panel on this very topic at our recent U.S. Telecoms Symposium with leading financial analysts who said pretty much the same thing, and you can view the video here.)

Comcast’s decision to sell rather than build again confirms our argument we laid out in our paper entitled A Policy Framework for Spectrum Allocation in Mobile Communications that, contrary to popular belief, more spectrum does not automatically mean more competitors.  Spectrum is but one of many inputs that determines whether entry is profitable.  On this point, I would also comment you to read George’s January 18, 2012 post where George not only explains in great detail the societal trade-offs between having lots of firms with insufficient spectrum and fewer firms with big blocks of spectrum, but he also shows empirically that while the amount of spectrum has risen, industry concentration, as measured by the concentration ratio, has not declined.  Thus, historical evidence does not support the notion that more spectrum means a lower level of industry concentration.  If the topic interests you, we again commend both the post and the full paper.

And for those that have yet to read Competition After Unbundling: Entry, Industry Structure and Convergence, I would also again encourage you to do so.  The nature of competition in the telecommunications industry—and deals like the Comcast-Verizon one—will make far more sense to you when you have a legitimate conceptual framework with which to interpret the facts.  As I see it, the Comcast-Verizon transaction is not a “troubling” indicator for the U.S. wireless industry as some suggest, but rather an indication that competition today is vigorous enough to make additional entry (at least on a national scale) unprofitable.  Moreover, the deal is part-and-parcel of the natural evolution of the wireless sector in the face of a spectrum constraint.  If anything, given the intensity of wireless competition and looming spectrum exhaust, we should probably expect to see more deals like this one over the coming years.

 

2 thoughts on “Why GigaOM has it Wrong on the Comcast/Verizon Spectrum Deal…

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