WHY IT IS IMPOSSIBLE THAT THE LADDER OF INVESTMENT ACTUALLY WORKS

September 2009 Fernando Herrera-Gonzlez Luis Castejn-Martn

Abstract

The ladder of investment is a regulatory approach that has been used by European National Regulatory Authorities (NRAs), in order to foster infrastructure competition among operators. According to its proponents, by forcing incumbent operators to open several levels of access to their network in such a way that alternative operators may climb up the ladder, they will eventually deploy their own access network and infrastructure competition will be achieved.

This regulatory approach seems to have failed, as can be seen in the lack of advance to the last rung of the ladder, the deployment of an alternative infrastructure.

In this paper, it is argued that the ladder of investment can not possibly attain the above results, by using the methodology of the Austrian School of Economics. Three arguments are developed: 1) Impossibility of establishing prices outside the free market; 2) Impossibility of defining relevant point of access outside the discovery market process; 3) Misconception of the investment decisions
Keywords

Regulation, ladder of investment, investment incentives, theory of price control, entrepreneurship, market process

1. Introduction
The deployment of an alternative fixed infrastructure to that of the incumbent has possibly been the main concern of governments and telecommunications regulators since the opening of the sector to competition.

According to their logic, deregulation of the sector will only be possible when there is an important degree of facility-based competition. Otherwise, alternative operators and competition have to rely on the incumbent facilities and regulation is necessary. If full deregulation were accomplished from the beginning, several negative effects would occur, as raise of prices or foreclosure risks.

In summary, to attain the benefits of competition in the telecommunication sector it is necessary to have an alternative infrastructure to that of the incumbent. The question is how alternative operators may be able to deploy it in an open market, because the duplication of the incumbent network is risky and involves high sunk costs, if made at one time.

The ladder of investment approach provides new entrants with a smooth path for investments, which allows them to progressively deploy their networks. Lowering in this way their risk, the probability of deployment is bigger.

The concept was originally proposed in (Cave, 2004). The idea is to force incumbent operators to open several levels of access to their network (the rungs of the ladder) in such a way that alternative operators may climb up the ladder, using more of his own infrastructure, and thus decreasing their reliance on the wholesale products of the incumbent operator. The final result would be the deployment of their own access network by the alternative operator, once he has captured the appropriate number of costumers to profit from the economies of scale of that investment.

Regulators oblige incumbent operators to provide wholesale access products in several points of their infrastructure. These points require different levels of investment, from the lowest requirement (for example, resale) to the largest (unbundling). Thus, new

entrants may start using the incumbent network on the access points requiring the lowest investments, and then proceed up the ladder, as they build a mass of costumers.

For example, an operator may start providing broadband services by simply resaling under its own brand those of the incumbents. As it acquires costumers, it gets revenues that may allow it to further its investments up to the next access point or rung, deploying its own infrastructure closer to the customer premises, which results in higher product differentiation and variety, and in less dependence on the incumbents network. Supposedly, the process goes on, until a point comes where the operator finds attractive to deploy its own facilities, and to severe their dependence of the incumbent.

This gradual climb is only possible if NRAs regulate prices of the various access products in a consistent way, and if the right number of rungs is defined to allow for smooth transitions between each successive rung. Neither of these problems seems to be easily solved, as the literature points out (Cave, 2006) (Cave, 2004).

In this paper, the methodology of the Austrian School of Economics will be applied to assess if the ladder of investment approach can possibly work. That is, if the ladder of investment regulation may attain the objective of facilities-based competition, as their proponents pretend. The rest of the paper is structured in the following way. In the second section, the Austrian School of Economics is briefly introduced: its methodology is explained and the description of the market as a process, one of the main features of Austrian economics, is depicted.

The third section will deal with the question at stake, that is, if it is really possible that the ladder of investment attains its goal. The argumentation follows the Austrian economics methodology, and revolves around two basic issues: establishment of prices and production structure outside the free market, and how both issues affect the investment decisions of operators.

In the fourth section, we will discuss an analysis made for the Spanish market. This analysis concludes that the ladder of investment has attained its goal. Because this conclusion is contrary to the results of the theoretical analysis (and to that of other

empirical studies), it deserves a more detailed appraisal, even if the review of historical evidence is at odds with the methodology of the Austrian school of economics.

Fifth section concludes and closes the paper.

2. The Methodology of the Austrian School of Economics

In this section, the Austrian School of Economics is introduced, and features of its methodology are described. After that, focus is made on describing the market as a process, outlining the main differences with the mainstream economics. Once made the description, a general categorization of the effects of regulation in the market process will be presented. This introductory explanation is deemed necessary to understand how the ladder of investment affects the market. Introducing Austrian Economics This paper is built on economic theory developed by the Austrian School of Economics as opposed to the neoclassical school, which constitutes the current economic mainstream1. In the past, other schools has been successively considered mainstream, only to be abandoned when they proved wrong.

The Austrian School of Economics has its origins with the Viennese economist C. Menger (1814-1921). Its specific foundation is dated to 1871, with the publication of Mengers Grundstze der volkswirtschaftlehre (Principles of economy).

Most relevant contributors to this tradition include L. von Mises (1881-1973), J. A. Schumpeter (1883-1950), F. A. Hayek (1899-1992, Economics Nobel Prize in 1974), and M. N. Rothbard (1926-1995). Methodology

For a detailed analysis of the important differences between both approaches, see Murphy (2007).

The methodology used by the Austrian School of Economics is praxeology, or the study of human action. Two features are characteristic of this methodology: individualism and subjectivism.

Methodological individualism means that the starting point for economic analysis is human action: all economic phenomena are the result of actions and interactions of individuals whose doings generate all outcomes observed in the market. As a consequence, there are no natural laws in the market.

An individual acts by choosing among several alternatives of action. Methodological subjectivism implies that these selections are made according to an individuals scale of preferences. A human acts by allocating his or her resources to the satisfaction of more urgent needs. This scale is different for each individual and changes with time. Moreover, it is subjective and cannot be measured nor apprehended by outside observers. Finally, these preferences cannot be measured in absolute terms; they have an ordinal, rather than a cardinal, hierarchy.

The Austrian School of Economics starts from the axiom that humans act (i.e., they have purposeful behaviour) and do so to satisfy ends according to a given scale of values. From here and through logical reasoning, laws governing the economy can be deduced.

Because of its logical foundations, praxeology is similar to logic and mathematics. Its statements and propositions are not derived from experience. They are a priori. They may be illustrated historically, but they are never verified or falsified experimentally.

For its part, economic history cannot teach any general rule, principle, or law. There is no way to abstract a posteriori from historical experience any theories concerning human conduct and policies. Because of this, there is no need of real cases to apply praxeology to a concrete economic problem. That is, no case supporting the results of the analysis would further justify its conclusion, and no case contradicting it would serve to falsify its reasoning.

It is important to note that all theorems developed according to praxeology are true regardless of specific circumstances2, unless there is some mistake in the logical reasoning that underlies them. The market as a process Austrian economists understand the market as a dynamic process of discovery generated by entrepreneurs (Hayek, 2002). (Kirzner, 1985) summarises this view around four key concepts.

Competition: understood as rivalrous activities of market players, not as perfect competition equilibrium, as mainstream economists do.

Knowledge and discovery: the competitive process does not only mobilize existing knowledge, but also generate awareness of opportunities whose very existence was known to no one at all.

Profit and incentives: Profits are not understood as the mere subtraction of known costs from known revenues, but as the incentives to locate gaps between costs and revenues. In other word, profits are a sign that resources are more valuable in other uses than in the current ones.

Market prices: in each moment, they are the (disequilibrium) exchange ratios worked out between market participants; they provide information to entrepreneurs on the current valuation of commodities, and, thus, on the opportunities of profits.

In the real world of uncertainty, the discovery market process is carried out by entrepreneurs. Entrepreneurs are constantly looking for new opportunities of profits, that is, of gaps between current prices of resources and expected prices of them; this is done by market calculation, by means of which they are able to make estimates that can guide their ex ante decisions.

See Mises (1949/1998a), chapter 39.

It is important to note that the market process is not instantaneous; on the contrary, it takes time to profit from the identified opportunities.

When an entrepreneur detects an opportunity of profits, he has first to acquire the resources at the current price (invest in resources) and only after a variable lapse of time, depending on the complexity of the productive process, he will be able to sell those resources in the new form. Only at that time, will he be able to know if he was right or wrong in his market calculation: he who was right will attain profits; he who was not, will suffer losses. Effects of regulation on the market process Government regulation drastically alters opportunities for entrepreneurial gain, and influences the prices emerging from entrepreneurial competition. However, perils arise out of the impact that regulation have on the discovery process, which unregulated markets tend to generate. Kirzner identifies four categories of impact on the discovery process (Kirzner, 1985) The undiscovered discovery process Regulators may not correctly address the market course in the absence of regulation. The unsimulated discovery process Regulators have no incentives in profit seeking, so it is very unlikely that they are able to discover opportunities for social betterment that the market process has not already discovered. Regulation process can not simulate market process. The stifled discovery process Regulation may inhibit, discourage or hamper desirable discovery processes which the market might have generated, activities not yet foreseen by anyone. For example, price ceilings not only restrict supply from known sources, but also inhibit the discovery of wholly unknown sources. The wholly superfluous discovery process

Regulation may create opportunities for new, but not necessarily desirable, market discovery processes which would not be relevant in an unregulated market. Regulation constraints introduce profit opportunities that otherwise have been absent. Such consequences may be wholly undesired by authorities.

In brief, the competitive-entrepreneurial process, being a process of discovery of the as yet unknown, can hardly be predicted in any but the broadest terms. The imposition of regulatory constraints necessarily results in a pattern of consequences different from and, most plausibly, distinctly less desirable than what would have occurred in the unregulated market.

3. Can the ladder of investment work?

In this section, it will be proved that the ladder of investment approach cannot possibly attain the stated objective of getting other operator to deploy their own access. Three arguments will be developed. Firstly, it will be shown that it is impossible to establish meaningful prices from outside the market. Any price not resulting from the market process will distort the investment decisions of entrepreneurs, because it is not providing the right information about the value of resources. It is likely that, in these circumstances, resources are misdirected and a sector bubble may be generated.

Secondly, the question of how to define point of access to the incumbent network will be tackled. As before, there is no possibility of such a definition outside the discovery market process. Of course, it is possible to define points of access, but they will be technical points of access, and not economic points of access, because they are defined according to a concrete technical structure of the service, and not to the real demand of the market. Once again, this may possibly lead to bubbles and malinvestment. Besides, the impossibility of defining prices outside the market is exacerbated, because prices for each of the points of access are supposed to be consistent among them, in order for the ladder of investment to work.

Finally, the investment decision will be described, showing that the ladder of investment not only does not easy investment in new networks by alternative operators, but on the contrary, it makes considerably more difficult such deployment. The key

issue is to understand that entrepreneurs make investments only if the expected increase in revenues is above the amount of needed outlays. 3.1 Prices outside of the free market In the first place, it will be argued that it is impossible to establish prices outside the free market. All prices defined from external institutions are necessarily arbitrary and do not convey any useful information for taking investment decisions. On the contrary, they severely distort this signal and cause mal-investment to be made.

In the unhampered market, the price is established by the interplay of buyers and sellers. This price depends on the preferences of buyers and on the available stock. The price may vary with time, as preferences or stock are altered.

In the market, sellers and buyers exchange goods (typically, goods for money). The exchange takes place only if both parties value more that which they receive than that which they deliver. It is not possible to know which is their valuation of the good received; the only magnitude an observer may apprehend is the ratio of exchange, i.e, the price at which the exchange took place.

In words of the Nobel laureate James Buchanan (Buchanan, 1999, chapter 6): Only prices have objective, empirical content; neither the marginal evaluations of the demanders nor the marginal costs of the suppliers (the marginal evaluations of foregone alternatives) can be employed as a basis for determining prices. The reason is that these are both brought into equality with prices by behavioural adjustments on both sides of the market. Prices are not brought into equality with some objectively determinable and empirically measurable phenomena, on either the demand or the supply side of the market.

However, services defined in the ladder of investment approach are not offered in the market (there is no free market for these products). Before any access obligation, all exchanges are internal; there is no price for the good, and no way for the firm or for anyone else to determine a price for it. In any case, proponents of the ladder of investment deem necessary to define prices for each of the rungs of the ladder.

According to (Cave, 2006), access pricing may be used to establish the different prices. This methodology (as summarised in (Armstrong, 2002)) relies heavily on the notion of costs as something given or objective3.

According to the Austrian School of Economics, the cost is the loss, prospective or realized, to the person making the decision, of the opportunity of using those things in the alternative courses of action Cost is that which the decision-taker sacrifices or gives up when he makes a choice. It consists in his own evaluation of the enjoyment or utility that he anticipates having to forego as a result of selection among alternative courses of action. (Buchanan, 1999).

Thus, in that view, costs are subjective, they exist only in the mind of the decisionmaker, and cannot be measured by someone other than the decision-maker, because there is no way that subjective experience can be directly observed.

Even if it could be accepted that prices can be calculated from one or other group of costs, these are in turn unobservable, except for the entrepreneur making the decision, who is the only one able to apprehend the costs that his decision poses on him.

(Buchanan, 1999) explains that this false objectification of costs may have resulted from the extension of the perfect knowledge assumption of competitive equilibrium theory to the analysis of non-equilibrium choices, whether made in a market or a nonmarket process.

And he concludes: The implications of all this for modern welfare economics could scarcely be underestimated. My argument suggests that almost all of this subdiscipline has been based on simple methodological confusion. It has converted predictive propositions into allocative norms which have then been used to make policy proposals.

(Armstrong, 2002) builds its results on the normative results of the perfect competition model. This idea has been extensive and widely criticized by Austrian School economists, and all those arguments should be brought up here. For example, see (Hayek, 1948).

In summary, prices are the only objective magnitude; only prices can be apprehended by an outside observer. It is prices that define costs, and not the other way around. Once a price for a good is observed in the market, providers have to adjust their offer to that price, and consequently their costs, if they want to survive in the market place. Costs are not observable either, because they are subjective to the decision-maker. Of course, unit counts may be carried out, but these are not true costs, just accounting figures4.

Any price established outside of the market place is, in conclusion, arbitrary. Proofs of this arbitrariness are pervasive. For example, in the discussions about the recent EC Recommendation on mobile termination rates, there were more than 50 contributors5. The analysis of the contributions to the public consultation shows the wide divergence of approaches to determine termination rates.

More conclusively, the EC recognizes this fact in the paragraph 2 of the Recommendation6, when it states: Although some form of cost orientation is generally provided for in most Member States, a divergence between price control measures prevails across the Member States. In addition to a significant variety in the chosen costing tools, there are also different practices in implementing those tools.

This divergence of approaches is not exclusive of termination rates, but extends to the implementation of any price regulation, and not only in telecoms but in any other economic sector.

In this respect, see (Mises, 1998a), p. 346. Cost accounting is therefore not an arithmetical process which can be established and examined by an indifferent umpire. It does not operate with uniquely determined magnitudes which can be found out in an objective way. Its essential items are the result of an understanding of future conditions, necessarily always colored by the entrepreneur's opinion about the future state of the market. Attempts to establish cost accounts on an "impartial" basis are doomed to failure. 5 See http://ec.europa.eu/information_society/policy/ecomm/library/public_consult/termination_rates/index_en. htm 6 European Commission: COMMISSION RECOMMENDATION of 7.5.2009 on the Regulatory Treatment of Fixed and Mobile Termination Rates in the EU. C(2009) 3359.

Ladder of investment proponents also reflect this arbitrariness in their proposals. For example, in (Cave, 2006) there is a lengthy discussion: If a price-based approach is chosen, this can rely upon the well-understood theory of option pricing (). It may seem that an access charging regime based on long run incremental cost (LRIC) plus common cost, using the appropriate asset-specific cost of capital, would then send the correct make or buy signals to other operators.() Precise estimates of the option value of delaying investment until uncertainties have been resolved can be made (). The key factors for applying the approach to telecommunications include the degree of demand uncertainty and the expected change in input and output prices. () The product of the calculation is the mark-up on LRIC associated with pricing the option. Dixit and Pindyck estimated it as 100%, but a recent paper by Dobbs (2004), taking account of other factors influencing output prices, suggests that a mark-up of 550% is more likely. () This estimate can then be built into a dynamic access pricing regime consistent with incentives to invest

Even if the proposed methodology and all other component were accepted without discussion, there is still a mark-up associated with pricing the option that can oscillate between 5% and 100%!.

Both theoretical analysis and empirical evidence seem to show the same result: the only fair, non arbitrary, price in the market is the one at which both buyer and seller freely choose to make the interchange7, and prices established outside the market are arbitrary. Because of this, these prices do not contain sensible information for entrepreneurs, and contribute to distort the market process.

In the case of the ladder of investment, prices below market prices would surely give place to instances of the stifled market process and wholly superfluous market process.

Prices too low for wholesale services will produce lower profits (if at all) and thus will repel entrepreneurs willing to enter the market; this will probably led to stifled innovation due to lack of incentives.

Vance L.M.: The Myth of the Just Price, 31 March 2008, available in http://www.mises.org/story/2918

On the other side, those prices will raise profits in retail, attracting more entrepreneurs that would be the case in the free market and creating a wholly superfluous market process, not demanded by consumers. Entrepreneurs will wrongly think that there is an opportunity of investment, more investments will be carried out and a bubble will be produced, that is, an economic growth that is not based on costumers preferences, and is not sustainable. 3.2 Identification of points of access The other relevant element of the ladder of investment approach is the definition of the rungs of the ladder, that it, points where access to the incumbent network is forced.

In the free market, it cannot be discarded that wholesale services would be offered by the incumbent. Individual value scales" determine "the quantity of goods produced, the prices of consumers' goods, the prices of productive factors, the interest rate, profits and losses." Not only that, but "given a stock of land and labour factors, given existing capital goods inherited from the past, given individual time preferences (and, more broadly, technological knowledge), the capital goods structure and total production is determined." (Rothbard, 1993), chapter 9, p. 624.

Thus, the market process, starting from the individual preferences of each customer, determines not only goods and prices but also the structure of production for those goods (given available resources). As already explained, this process is carried out by entrepreneurs, using market calculation on the known prices.

In order to accomplish this calculation, explicit markets are needed, that provide information about current prices of the resources involved. "For, without an external market for wage rates, rents, and interest, there would be no rational way for entrepreneurs to allocate factors in accordance with the wishes of the consumers." (Rothbard, 1993), chapter 9, p. 608.

This poses limits to the vertical integration of enterprises: a firm can effectively have vertical integration of several processes, only if there is a real market for each of the intermediate products that provide the firm with an explicit price, that, in turn, allows it

to perform market calculation: "For every capital good, there must be a definite market in which firms buy and sell that good." Otherwise, without the price, the firm will not be able to allocate factors and resources from one stage to another. (Rothbard, 1993), Chapter 9, paragraph 3.E: "Vertical Integration and the Size of the Firm," p. 609-616.

There are some instances of wholesale services provided spontaneously by incumbents. For example, Telefnica started offering bitstream national services in 2000 with commercial conditions. Only later, in 2007, was this service regulated.

In summary, in the free market, economical points of access would appear, in the sense that they would be driven by costumer preferences, possibly due to the limits of vertical integration described.

However, according to the ladder of investment approach, it is necessary to define those points without regard to the market preferences. Market preferences have to be substituted then by other criteria (for example, replicability of the asset (Cave, 2006)) and that takes us back to the realm of arbitrariness. No longer are market preferences defining the capital structure, but arguable, non objective, criteria.

The structure of production established by the unhampered market was the best (so far) for serving the customers. If, in this situation, the government decides to forcibly alter this structure of production by, say, splitting one activity into two, the resulting productive structure will be worse for their purpose8. The point of access so defined may be termed as technical point of access, as opposed to economical.

In order to define points of access with the ladder of investment approach, it is necessary to define a chain of production for the provision of the retail service. Once this is known, points of access to that chain may be identified. In the case of broadband services, this is done in (Cave, 2006), p. 230-231. The proposed set of activities is the following: 8

access to the customer via a copper loop or shared loop; DSLAMs located at the local exchange;

For an explanation of the consequences of this splitting in the concrete case of BT and functional separation, see (Herrera-Gonzlez, 2008).

ATM backhaul; access to an IP network; access to the world wide web via transit or peering services; retailing functions (marketing, billing, helplines, etc.).

This identification is arbitrary, as could be expected after the previous theoretical analysis. This is recognized by the author (see (Cave, 2006), footnote 16).

There are other problems caused by this approach. The proposed chain of production is one technical solution for the provision of broadband services using a legacy copper network. It is arguably the more widely used solution at this moment in time, and it may even be regarded as the most efficient solution at present. But by no means is the only possible solution, neither at present nor for the future, especially if innovation is allowed.

With the static approach, it is usual to consider that technology does not change. If it is assumed that technology will not change, and regulatory steps are taken with that hypothesis in mind (i.e, points of access are defined according to a given technical solution), it is very likely that technology will effectively not evolve. Alternative operators will rely on the regulatory rungs for their own deployments and will in fact replicate the technical solution chosen by the incumbent, instead of looking for alternatives. In that way, dependence of the incumbent network increases, contrarily to the purpose of the ladder of investment approach. Thus, the regulatory definition of rungs of the ladder of investment tends to freeze the chain of production, leaving it as that definition was assuming, in a self-fulfilling prophecy..

The process does not even stop here. Following (Mises, 1998a) p.742), It is important to realize that what those benefited by these measures consider an advantage for themselves lasts only for a limited time. In the long run the privilege accorded to a definite class of producers loses its power to create specific gains. The privileged branch attracts newcomers, and their competition tends to eliminate the specific gains derived from the privilege.

Once the regulatory possibilities of competition are exhausted (for example, all operators are in the best rung), the only way ahead for alternative operators is to ask for further rungs in the ladder9. The demanded rungs will of course depend on the specific business model chosen by each operator10. So, the incumbent operator will be obliged to open more and more rungs for these customized ladders of investments. This is clearly seen in Spain, where specific operators are now demanding wholesale services like naked DSL and shared access without telephony service. The first is demanded by operators who chose VoIP to provide voice services over the unbundled local loop, where the second is demanded by those who opted for indirect access services.

Finally, a thought should be given to the consistence of the prices of the rungs. In the previous section, it was concluded that any price defined outside of the market is arbitrary. The ladder of investment approach requires defining prices for all of the offered rungs. In the case that there are inconsistencies, all operators will tend to the best rung, that which allow more profitability, and will not move ceteris paribus.

Is it possible to assure consistence among prices of the rungs? In the free market, the factor prices tend to the discounted value of the marginal product they are able to produce. On the other side, the wholesale services included in the ladder of investment may be regarded as highly specific factors, because they can only be used to provide a concrete retail services (i.e, broadband access to Internet). Because of this, all prices of the wholesale services in the ladder would basically depend on the retail price and on the prices of the factors that have to be incorporated to the process as a consequence of climbing up a rung11.

In turn, the concrete factors depend on the subjective decisions of entrepreneurs and can not be apprehended by any outside institution. There is no unique way of climbing from a rung to other rung. That logically implies that there is no objective way of determining the factors to be used, and whose price should consequently be discounted in order to achieve consistence among prices. In brief, to the general arbitrariness of
In the words of Mises: Thus the eagerness of the law's pet children to acquire privileges is insatiable. They continue to ask for new privileges because the old ones lose their power. 10 This is rightly identified as a problem in (Cave, 2004), but it is not addressed: Competitors are likely to have different business models, and seek various access points. They will also have an interest in denying their rivals the access points they seek. 11 See (Rothbard, 1993), chapter 7: Production: General pricing of the factors.
9

defining prices outside the market, it is joined the specific arbitrariness of determining which factors are to be removed/added from one rung, and their costing. It can be safely concluded that it is impossible that prices of the different rungs of the ladder are consistent among them.

As a sample of this arbitrariness, it is interesting to refer to the margin squeeze tests that are proposed in order to achieve this consistence. In (Cave, 2004), it is stated that the formulation of these tests begs many questions about the range of products over which the test should be conducted, the methodology for measuring costs, the firm whose costs are relevant to the test (firm A, firm B or some hypothetical efficient retailer) and the period over which costs should be calculated. (p.21). The discussion on margin squeeze tests is of course a prolongation of the general discussion on methodologies to establish prices outside the market, already illustrated.

The mere definition of the rungs in the ladder of investment approach will likely give place to instances of the unsimulated market process, the stifled market process and the wholly superfluous market process.

As said, the rungs of the ladder of investment have to be defined outside the market, and its definition implies a certain model of production. However, the only way to identify the model of production that better satisfies the consumers preferences in each moment is the market process. As the government is not guided by profits, it cannot simulate this process, and its election will surely be not the best from the economical point of view, even if it is from the technical point of view. Moreover, the government cannot react to adapt the model of production to changes in demand preferences.

The a priori definition of a production model and of the wholesale services will stifle the innovation of entrepreneurs. They will see as better alternative to rely in the incumbent network and replicate its architecture instead of looking for other solutions to serve the market. So, the regulatory defined production model will tend to stay and so will the rungs.

In fact, a wholly superfluous market process will be created, as entrepreneurs start looking for new rungs in the ladder of investment and new wholesale services that allow

them to grasp more profit according to their chosen business models. Innovation will thus be driven from the search of alternative network solutions, to the search of new uses of the incumbent network. 3.3 Distortion of the investment decisions Both the identification of access points and the determination of the corresponding prices are arbitrary when made outside the market process. It has already been shown that these decisions distort the discovery market process in several ways. In this subsection, it will be described how the ladder of investment distorts the investment decisions of entrepreneurs, causing precisely the opposite effect to that pursued by the government, that is, it hinders the deployment of alternative access networks.

In order to prove so, it is first necessary to understand how do prospective investors take the decision to invest. In actual life, the existing stock of capital goods is always the result of an accidental historical process, consisting of a succession of unforeseen changes, and they will never be reproduced in exactly the same form. They were only produced in this particular form because certain kinds of equipment happened to be available as the result of past history. (Hayek, 1941)

Any asset becomes an ex-post error as market conditions change. If investors would have had the information they got days, months or years after their investment, they would have invested in other assets or, at least, would have deployed their assets in other ways. For example, if at the moment of deploying copper to provide voice services, there would have existed wireless technologies for its provision, it is likely that no deployment of copper wire would have happened.

In the same vein, if operators would have known that citizens would demand broadband services in the future, they would probably have chosen another technology instead of copper wire as access technology. But, in the moment they got that information, it was too late, and copper wire became an ex-post mistake.

However, the adaptation of the production infrastructure to the new situation is not automatic. It requires an explicit decision of the entrepreneurs, and it depends not only

of the relative obsolescence of the current assets, but, most importantly, on the incremental profits that the new investment is able to accrue.

The adoption of new techniques is limited by the usefulness of already given capitalgoods structure. (...) The fact that investment in a new technique is unprofitable means that the use of capital in the new process at the cost of scrapping the old equipment is a waste from the point of view of satisfying consumer wants. (Rothbard, 1993) Applied to the ladder of investment approach, this means that, the decision of an operator to progress from one rung to the next one is not automatic. Most importantly, the operator, when taking this decision, will not consider the absolute level of profits after the investment (i.e. the climb to the next rung), but only the incremental profits it will get.

For example, suppose that in rung A the operator is obtaining XA Euros of profit, and that it estimates that it may obtain XB Euros in rung B. The decision to invest is NOT based on XB, but only in the increment XB XA. Only if that increment justifies the investment, it will be accomplished. Otherwise, the situation will remain. This fact logically implies that any operator is less likely to progress from one rung to another, than to directly start in the second rung. In the first case, the operator only sees XB XA, but in the second it sees the full XB. Only if there is high degree in the re-use of investments to reach one rung, allowing for a lesser investment, is this conclusion reverted. This degree of re-use may be relevant when progressing between wholesale services of the incumbent operator, but it is clearly not relevant when climbing to the own access network rung.

Let us focus on the specific case of the last rung of the ladder of investment, according to ERG. It consists of passing from the use of Unbundled Local Loop (ULL) to its own infrastructure. As just described, in order to take this decision, alternative operators will

take into consideration the following items (roughly): current Average Revenue per User (ARPU), expected ARPU and current recurrent cost12.

In their own infrastructure there are no recurrent costs. The current cost is the ULL regulated price. The decision will be based on the following magnitude (the higher, the more likely the investment): ARPUExpected (ARPUCurrent PriceULL). According to European Commission, the average price for ULL in the EU is 10,88 Euros per month (fully unbundled LL), being 11,43 in Spain13. This means that the key issue for this decision is the expected increase in the ARPU, which, in turn, depends on the services for which costumers are willing to pay, of those that can be offered on the new infrastructure, but could not be offered with the current one.

With ULL, alternative operators can provide telephony, broadband access services and TV. These are the services that are currently demanded by end users; demand uncertainty for services requiring higher speeds is great at this moment, even if there are talks of HDTV. So, the prospects of increasing the ARPU with investment in new infrastructure (like optical fibre) are currently dim for alternative operators. In these circumstances, there is no possibility of progressing to the last rung of the ladder.

Compare this situation with that of an operator who is no present in any rung in the ladder of investment. For this operator, the decision on investment depends only and completely on the expected ARPU. Of course, this ARPU will include that derived of new services (like HDTV), but it will also include the current ARPU obtained by an operator using ULL. If there is an increase in the expected ARPU (due, for example, to positive prospects for new services), it is easier that a new entrant deploy infrastructure, than that an operator using ULL do it.

It is interesting to analyse how the price of the ULL affects the investment decision of operators using ULL. Recall that this decision depends on the magnitude ARPUExpected
Note that this analysis is ceteris paribus to isolate cause and effect. In concrete, the number of costumers is left untouched. It is not possible to praxeologically infer any effect on the number of costumers from a change in the used rung of the ladder of investment. 13 European Commission: Progress Report on the Single European Electronic Communications Market (14th Report)(COM(2009)140 final). Available at http://ec.europa.eu/information_society/policy/ecomm/library/communications_reports/annualreports/14t h/index_en.htm
12

(ARPUCurrent PriceULL) and the higher the increase, the higher the probability of investment. It is immediate to show that PriceULL has a positive impact on the magnitude, and, the higher PriceULL, the higher the probability of investment. However, NRAs in Europe seem to go in the contrary direction. This price is decreasing in the EU, as shown in the graphic14.

Once again, this regulatory behaviour is contrary to the goal pursued. But it has other effects. Let analyze the investment decision process in order to progress among intermediate rungs of the ladder, i.e., those between wholesale services of the incumbent. For example, from bitstream services to ULL services.

Recall that the decision depends positively on the difference XB XA being XB and XA the profits respectively obtained at rung B and rung A. In the case under analysis, the difference may be formulated as (ARPUExpected PriceULL) (ARPUCurrent PriceBitstream), equivalent to (ARPUExpected ARPUCurrent) + (PriceBitstream - PriceULL). However, in this case there is a clear increment in ARPU, because it is not possible to provide TV with commercial quality using bitstream services. Moreover, the lower the
14

European Commission: Progress Report on the Single European Electronic Communications Market (14th Report)

PriceULL, the higher the magnitude, and the higher the probability of investment. Finally, it should not be forgotten that investment to progress between two rungs on the incumbent network is considerably lower than to deploy a new infrastructure. This explains why operators tend to flock on the ULL rung of the ladder of investment, but do not progress from here.

Note that NRAs, with their decisions, are steering operators to the ULL rung of the ladder of investment. And, it is precisely for the operators in this rung for which more difficult is to find viable an investment in new infrastructures, as shown before.

In summary, the theoretical analysis shows that the ladder of investment approach hinders the deployment of alternative access infrastructures, instead of easing it, as its proponents defend. It is contrary to the goal it admittedly pursues.

4. Does the ladder of investment work?

In this section, it will be discussed if, according to historical evidence, it can be said that the ladder of investment is working. The analysis will focus on the case of broadband access services on the Spanish market. In this regard, at least, two papers have been published stating that the ladder of investment is working for this market15. As this seems contrary to the conclusion just deducted, those analyses deserve a detailed review. 4.1 Empirical analysis under Austrian School of Economics methodology It should be noted that, as explained in section 2, the Austrian methodology does not rely on empirical or historical evidence for its conclusions, but on logical reasoning. According to the Austrian school, economics is a science in the same sense that mathematics and logic are sciences. Its claims are based on logical deduction from indisputable axioms, and may be illustrated historically, but never verified or falsified experimentally. In the same way, we do not ask for experimental verification that a straight line is the shortest distance between two points on a two-dimensional plane.

15

See (Lpez & Vives, 2008), (Lpez, 2009).

Thus, the conclusions achieved in the precedent section are true (provided there are no flaws in the logic reasoning), with independence of the results of the historical evidence. If this evidence shows that the ladder of investment has not worked in the past, it could be due to exogenous causes not related to the regulatory implementation. In the same vein, if the historical evidence showed that the ladder of investment has worked in the past, it does not imply that it will work in the future, not even that the results observed were due to the regulatory implementation. Historical phenomena are too complex to allow the isolation of a concrete cause for a given event.

In brief, the historical analysis now proposed does not change in any direction the theoretical results already developed.

4.2 Review of the empirical analysis for the Spanish market As is usually the case, empirical research in this area throws contradictory results. There are several studies that seem to conclude that entry regulation discourages infrastructure investment, both for incumbents16 and for new entrants17. This seems in line with the theoretical conclusion of this paper.

Being the ladder of investment one concrete form of entry regulation, the same should be expected for broadband services in Spain. However, the conclusion reached in (Lpez & Vives, 2008) and (Lpez, 2009) seems to be the contrary.

Those conclusions are based on historical data of the Spanish market. The authors analyse the evolution of wholesale services between 2001 and 2008, distinguishing
100% 90% 80% 70% 60% 50% 40% 30%
16 17

25,19% 14,17%

27,16%

30,66% 34,02%

35,57%

34,85% 42,39% 60,65% 37,99% 26,94% 23,36% 23,11%

IIQ 2008 IIIQ 2008

42,62% 41,33%

See 20% (Baake & Kamecke, 2007), (Kotakorpi, 2006) See (Friederiszick et al., 2008), (Waverman et al., 2007) 10%
0% 2001 2002 2003 2004 2005

2006

2007

Resale+Bitstream access

shared access

Full ULL

between resale+bitstream, shared access and ULL. They analyse the data in relative terms, with the results shown in the graphic below18.

From this data, they conclude: En conclusin, aparentemente parece confirmarse la teora de la escalera de inversin en el sector espaol, al menos hasta el punto de presencia que se corresponde con la desagregacin de bucles locales. Sin embargo, todava falta por saber si los operadores alternativos darn el paso final de acceder directamente al hogar del consumidor desplegando su propia red mediante el uso de tecnologas alternativas. (Lpez & Vives, 2008), p.10 Existe competencia basada en infraestructuras en Espaa? La desagregacin del bucle supone una inversin considerable en infraestructuras, podemos por tanto considerar tanto el cable como la desagregacin de bucles locales competencia basada en infraestructuras. (Lpez & Vives, 2008), p.11 Por un lado tenemos que el proceso de la escalera de la inversin hasta el bucle local se ha cumplido en Espaa, y para ello ha sido fundamental la regulacin del sector que ha incentivado el despliegue de redes. (Lpez, 2009), p.3.

It is surprising to note that alternative accesses are not analysed in any of the papers. Taking into account that the admitted purpose of the ladder of investment is to facilitate alternative operators the deployment of their own access network, it is difficult to see how conclusions about its efficacy can be reached without that information.

In fact, their conclusion is that the ladder of investment up to the local loop has been accomplished in Spain. But this conclusion misses the point, because the goal of the ladder of investment is not that, but the deployment of alternative accesses. And it cannot be inferred from the fact that it has worked up to the ULL, that it will keep working to the last rung. In fact, none of the operators involved in ULL in Spain has made any progress to the last mile, after 8 years of ladder of investment.

18

Source: The ladder of investment in Spain Slides- ngel L.Lpez, 17 March 2009. Available at www.nerec.es. Last accessed: 21 August 2009.

The only alternative infrastructures for fixed access in Spain are those deployed by cable operators. None of these operators have used any of the wholesale services provided under the ladder of investment regulation.

All these results are consistent with the theoretical analysis of the previous section. On one side, alternative operators tend to flock around one of the intermediate rungs, without progress to the last rung. In this case, they seem to flock around ULL services. On the other side, investment in alternative infrastructures is more likely to come from operators that are not using ladder of investment services. In the case of Spain, they come from cable operators.

Besides, the authors make no analysis proving that the cause of this accomplishment is the regulation of ladder of investment. It is just stated in the paper. A more rigorous causal analysis would be necessary in order to reach that conclusion, but this is absent from any of the papers. Thus, even if it were accepted that the ladder of investment is working (in a perfunctory way), it would still be needed to prove that it is due to the related regulation and no other cause.

In order to do so, it would be interesting to analyse the evolution of wholesale services in light of the regulated prices of the different rungs. Specifically, it would be necessary to analyse if the relative increases of ULL and shared access with respect to bitstream are correlated in time with changes in difference of the regulated prices of both services.

In that case, the evolution of access should be traced not to the ladder of investment approach per se, but to the changes in relative attractiveness of wholesale prices. The theoretical analysis has shown that there is a strong influence of that difference when deciding to move from one rung to the next one of the incumbent network. In other words, if the climbing of the ladder is due to changes in prices, the efficacy of the ladder of investment is falsified19. Unfortunately, nothing has been done in this regard.

19

Of course, ladder of investment proponents will argue that the original prices were wrong, and only after the change could the ladder work. It has already been shown that it is impossible to have the prices right in any case. Besides, even if this argument is accepted, why is then necessary to keep reducing them?

Finally, the authors state that the unbundling of the loop supposes a significant investment in infrastructures, thus we can consider both cable and unbundling of local loops as infrastructure-based competition. If this statement is accepted, then of course the ladder of investment has achieved its purpose in Spain.

The statement is, however, wrong. The amount of investments that ULL requires has nothing to do with it being or not an alternative infrastructure. ULL-based operators keep relying on the incumbent network, with independence of the investment required. Thus, it is fallacious to state that cable and ULL constitute infrastructure-based competition. In Spain, the real infrastructure competition is between cable operators and incumbent. And this competition has nothing to do with the ladder of investment.

In summary, there is no historical evidence showing that the ladder of investment is working in Spain, in spite of the analysed papers. Nor there is evidence that the evolution of wholesale access is due to the ladder of investment regulation.

On the contrary, the historical evidence in Spain seems consistent with the theoretical analysis developed previously: alternative operators tend to flock around ULL services, without investing in alternative infrastructures. This investment has only come from cable operators, which have never used wholesale services of the ladder of investment.

5. Conclusions
Since the opening of the telecommunications market for competition, European governments have sought the deployment of an alternative access infrastructure. This is the only way in which they see that effective competition can be achieved, as competition will not rely anymore on the incumbent network. Surprisingly, they do not seem to consider mobile networks as an alternative infrastructure, even if these networks would seem capable to cater for the needs of most users.

In any case, it is not for the economic analyst to wonder about the goals of the government, but only to analyse if the proposed means are able to attain those goals. As already said, European governments, led by the European Commission, have

implemented the ladder of investment approach in order to achieve the deployment of an alternative fixed access network.

It has been proven that the referred approach can not possibly attain that goal, but, on the contrary, it hinders it. In the first place, it is impossible to establish a price outside the market; prices set by the government will distort the investment decisions of entrepreneurs, causing them to direct resources to wrong places.

In the second place, it is also impossible to establish relevant points of access outside the market process: the rungs defined are thus arbitrary. Even if they are reasonable from a technical point of view, this does not imply that there is a need for them in the market. This definition will probably freeze innovation in the productive process and will cause that all operators opt for the regulated production process.

Thirdly, as the decision to progress between rungs depends on the incremental profit, not on the absolute level of the same, it is more difficult for an operator already present in the ladder of investment to deploy its own access network, than it is for a whole new entrant. However, the current regulation is driving prospective alternative operators to the ULL rung, making it very unlikely that there is any deployment of alternative access networks.

Even if the analysis of historical evidence is irrelevant for the methodology used in this paper, a couple of papers on the Spanish market were reviewed, as they seemed to conclude that the ladder of investment has worked in Spain. However, the empirical evidence presented in those papers did not prove so. On the contrary, it was consistent with the theoretical analysis presented, as it showed that the only alternative infrastructures had been deployed by the cable operators (which do not use any ladder of investment service) and that no ladder of investment-based operator has deployed any access.

In summary, the ladder of investment approach fails to achieve its goal. The theoretical analysis unambiguously shows this conclusion, and the presented empirical evidence seems consistent with the result. Given these conclusions, it would be desirable that European regulators and European Commission stopped pursuing this approach, not

only for the legacy copper network, but most importantly, for the new optical fibre networks.

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Kotakorpi, K. (2006). Access price regulation, investment and entry in telecommunications. International Journal of Industrial Organization, 24, 10131020.

Lpez A.L. & Vives X. (2008). Inversin en banda ancha: Competencia en infraestructuras y competencia en servicios. Economistas, Espaa 2007: Un balance.

Lpez A.L. (2009).Despliegue de redes de telecomunicaciones y difusin de banda ancha. Economistas, Espaa 2008.

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Waverman, L., Meschi, M., Reillier, B., & Dasgupta, K. (2007). Access regulation and infrastructure investment in the telecommunications sector: An empirical investigation. Study for ETNO.