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Real Consumers and Telco Choice: The Road to Confusopoly

Professor Joshua Gans
Melbourne Business School University of Melbourne
Presentation to the Australian Telecommunications Summit, Sydney, 21st November 2005

Is Competition Enough?
●Can competition enable consumer choice? ●It is a necessary condition
●Consumers need options

●But is it sufficient?
●Can consumers make the necessary comparisons? ●Will competition reduce exploitation of consumer irrationality?

Confusopoly
●Scott Adams: “a group of companies with similar products who intentionally confuse customers instead of competing on price.” ●Examples: energy retailing, insurance, mortgages, credit cards, etc. ●But what about telecommunications?

Search Model
● Consider an industry with several producers of an homogenous product ● A consumer considering switching suppliers will switch if: Pold > Pnew + D

● where D are switching costs including any disconnection fees

● A consumer will only search for a new supplier if: Expected Savings > S
● where S are search costs

Diamond Paradox
●With many suppliers, why would you expect to get a better deal?
●If all highly competitive, then can’t do better ●Only if you think firms will offer you a customer specific deal; but will they?

●According to Diamond (1971): each firm won’t lose many customers by charging a slightly higher price than other firms
●In equilibrium: all charge the monopoly price and no search occurs.

‘Sleepy Incumbent’ Model
● Customers may expect to get a better deal if switching from an incumbent
● Implication: entrants should advertise pricing deals (high marketing spend relative to their market share) ● Incumbent may accommodate this by charging higher prices (Guilietti, WaddamsPrice, Waterson, 2005)

● Should see incumbent retailers charging a higher price than entrants in an area

Energy Retailing
● In July, 2005, I considered energy retailing in Victoria
● Utilising the Essential Services Commission calculator I found that the complex pricing schemes of AGL, Origin and TRU were identical and equal to the regulated cap ● Evidence for the Diamond Paradox

● Would telecommunications be better given that it is based on an incumbent/entrant model rather than a divided incumbent model?

Which Model for Telcos?
●Which model applies in telecommunications? Diamond Paradox or Sleepy Incumbent ●With this in mind, examined choice between fixed line versus mobiles for long distance
●Are these substitutes for consumers? ●(Thanks to Nera for data gathering and analysis)

Plans (calls to landlines)
Telstra Telstra Complete Plus 1.49 Per minute charge Surcharge Cap
23c (peak), 15c (off peak) 35c
<20 min ($2) off peak only

Optus Mobile
60c

Vodafone Hutchison

24c (peak), 12c (off peak) 35c
<20 min ($1.49)

60c

70c

20c

20c

30c

$49 cap ($230)$79 cap ($500) $49 cap ($230) $79 cap ($500)$149 cap $69 cap ($400) ($1200) $129 cap ($800) $149 cap ($1300)

Assumptions
● Calls modelled are long distance within Australia, and to mobiles within Australia; ● Distributions of call durations as below, with means of 5 and 10 minutes respectively; ● Ownership of a mobile on a base plan (the lowest cost) is assumed for each mobile network; ● Calls switched to mobiles have the same distribution as the distribution they were drawn from. That is, consumers do not only switch calls of a particular duration from fixed to mobiles this is a future line of analysis; ● 50% of calls are in the peak period; ● 70% of calls are to fixed lines, 30% to mobiles. The phone of choice is independent of whether the call is made in peak period or not – this assumption can easily be relaxed with appropriate data; and ● 45% of calls to mobiles are to Telstra mobiles (reflecting Telstra’s share of the mobile market).

Call Patterns (5 min average)

0.018 0.016

Switching from Telstra Complete to Mobile
Hutchison

350 250
Nera analysis

Vodafone

Optus 5 min average

Switching from Telstra Plus 1.49 to Mobile

350 250
Nera analysis

Hutchison Vodafone

Optus

5 min average

Switching from Telstra Complete to Mobile

350 250
Nera analysis

Hutchison Vodafone

Optus 10 min average

Switching from Telstra Plus 1.49 to Mobile

350 250
Nera analysis

Hutchison Vodafone

Optus

10 min average

Summary
● Difficult to compare price offers
● Depends on a consumer’s specific calling pattern.

● Networks differentiate on call duration ● Mobiles are a potential substitute for fixed line calls ● Imperfect analysis but substantial savings possible ● ‘Sleepy Incumbent’ (rather than ‘Diamond Paradox’ model) alive and well in telcos Despite competition regulated Telstra prices still important.

Reform Option?
● Portuguese Competition Authority analysis ● Conclusion:
● Wide number of mobile plans difficult for consumer to assess ● This impeded price competition

● Reform:
● Require all networks (and agents) to provide a web-based program to allow consumers to identify the cheapest plan ● Supply information to allow regulator to host a program to allow consumers to compare competing plans between mobile networks.

Can competition protect consumers?
Re-considering bundling

The contention
●If consumers can be exploited (i.e., pay for goods they don’t value enough), won’t market forces fix this? ●If there is competition, there will be at least some suppliers who will find it profitable to actually supply consumers with products they value.
●So competition protects consumers

The issue …
●In May, David gets asked to give a talk on regulation on the 21st November and happily accepts. ●On the 17th November, David wishes he could defer giving the talk even though nothing has changed. ●This lack of self control is common.

… it’s even worse …
●In May, David does not anticipate that he will regret, in November, his decision to give the talk. ●This is a common failure to anticipate your future position – it is a naïve approach.

The point …

From The Onion …
LOMPOC, CA—The Bally Total Fitness membership purchased Monday by Alex Scarbe already appears destined for failure. "I really should go buy some new shoes, so I can come back tomorrow and work out," Scarbe said, moments after completing the membership paperwork. "Just getting in here and signing up is enough for today. I think I'll reward myself with a smoothie." Scarbe will return to Bally's twice in April, then once in May to use the whirlpool, and ultimately cancel his membership in 2007, when he notices Bally listed on his credit-card statement.

Supplying what they demand
●If consumers lack self-control but are otherwise sophisticated, firms will offer products to help them commit
●E.g., low unit price for gym visits

●If consumers lack self-control but are naïve, firms will exploit this
●E.g., extract payments for automatic renewal fees

Behavioural Economics
●New economic approaches for dealing with consumer irrationality ●Basic idea:
●When faced with an upfront cost and future options, consumers with over-weight option value and spend too much upfront ●When faced with an upfront benefits and future avoidable costs, consumers will under-weight ability avoid costs and spend too little upfront

Implications for Switching
● Consumers will under-weight importance of disconnection fees ● Consumers will under-weight ability to opt out of automated payments to switch in the future ● Consumers will under-weight future switching costs ● Consumers will fail to invest in information to make choices transparent
● And firms will not have an incentive to provide transparency as consumers will demand more upfront to compensate for switching costs later on.

Themes
● Demand in a market is based on actual consumer behaviour.
● For time-based consumption, naïve consumers will place too little weight on future costs and anticipate getting more value than they actually receive ● Consumers will purchase today more than they would if they anticipated their wants in a sophisticated manner ● Over-consumption for any given price

● Competition works to ensure consumers are supplied with what they demand at a lower price not with what they want.

Welfare Impact
$ Welfare Loss

Supply

Pn P*

Naïve Demand Demand Q* Qn

Impact of reduced competition
$ Supply without competition

Supply with competition Pm Pn P*

Overall welfare is increased! Consumer welfare may not be improved.
Naïve Demand Demand Q* Qm Qn

Bundling and add-on pricing
●Buy one product (hotel, groceries) and then buy another (phone calls, petrol) ●Consumer reaction
●Sophisticated consumers anticipate add-on prices and substitute away (benefit of lower price for initial good) ●Naïve consumers do not anticipate prices and over-consume

●Firms price first good low and naives crosssubsidise sophisticates ●Suspicious of bundling without any efficiency or value rationale.

Educating consumers
●Under monopoly,
●May have incentive to educate naives if don’t want to price discriminate against them

●Under competition,
●If educate a naïve, then they learn to substitute away – go to another firm and receive cross subsidy ●No incentive for a firm to educate

●Education is a public good

Conclusions
● Implication of behavioural economics: cannot rely on competition to protect naïve consumers
● Difficult to exercise consumer choice ● Competition generates more supply of things they don’t want

● Education and information are public goods (underprovision in market place) ● Regulators should focus attention on undesirable practices
● E.g., disconnection fees, automatic renewal fees, unbundling ● Critical for future issues such as cross-media ownership