How to break network bonds

25 April 2010

 

The regulation of mobile phone operators can be used as a case study of how strong network bonds can be broken.

First, some definitions:

On-net: Calls within the same network (Vodacom customer to Vodacom customer)

On-net rate: The rate charged to customers for On-net calls

Off-net: Calls between networks (Vodacom customer to MTN customer)

Off-net rate: The rate charged to customers for Off-net calls

Interconnect rate: The rate charged between networks for cross-network calls

 

Most countries followed a standard process when issuing licenses to GSM spectrum, i.e.: 2 or 3 licenses were issued.

Once licensed, the operators start building networks and acquiring customers. For the purposes of this illustrative example, let’s assume that the networks are Vodacom and MTN.

In order for customers of Vodacom to speak to customers of MTN, the networks must enter into an interconnect agreement which regulates what the networks charge each other for cross-network calls. If the interconnect rate is higher than the on-net rate, then it is impossible for operators to charge customers the same for on-net and off-net calls without running at a loss on the off-net calls.

Example: MTN

Assume the following:

On-net rate (MTN to MTN) R2/min (MTN to MTN)

Interconnect rate R3/min

If MTN were to set the off-net rate as equal to the on-net rate (R2/min) it would make a loss of R1/min (R2/min less R3/min = -R1/min). Therefore it must set the Off-net rate at a minimum of R3/min.

 

The above example shows that a high Interconnect rate allows the networks to give their customers a greater advantage for on-net calls by setting significantly lower on-net rates that are still profitable. This implies that the more customers a network has, the more attractive that network is to potential new customers (all things being equal).

Example: Vodacom vs. MTN

Vodacom MTN

Customers 10,000,000 5,000,000

On-net calls R2/min R2/min

Off-net calls R3/min R3/min

When a potential new customer looks at the above information, he/she realizes that it is 33% cheaper for her to phone most of her friends if she is on Vodacom’s network, because (on average) 66% of her friends will be on Vodacom’s network. Therefore her monthly bill is likely to 33% cheaper with Vodacom than with MTN. Therefore she is more likely to choose Vodacom (assuming price is the most important factor in her decision).

 

The scenario above gives the operator with the largest market share a self-reinforcing advantage in the market place (all other things being equal). The bigger Vodacom’s market share, the more customers they will attract, the more their market share will grow, the more customers they will attract, etc.

Let’s call this the “Interconnect Bond”. It is very weak in the early stages of the market, but as the market grows it becomes exponentially stronger[1]. The Interconnect Bond is very powerful and virtually impossible to break through normal market forces. The only means of breaking this bond is for a smaller operator to willingly take losses on cross-network calls in order to erase the price disadvantage for consumers.

Most developed countries have recognized the existence of the Interconnect Bond and regulators have stepped in and forced operators to reduce the interconnect rate to equal or below the retail rate for on-net calls, thereby allowing the smaller operators to charge the same for off-net calls as for on-net calls.

However, it is not quite so simple! The symmetrical dropping of Interconnect Rates resulted in a significant drop in revenues for the smaller operator.

Example:

Assume each customer makes one call per month for 1 minute

  Vodacom   MTN Total
   
Interconnect Rate 3.00   3.00
Customers 15,000,000 75% 5,000,000 25% 20,000,000
Total minutes 15,000,000   5,000,000   20,000,000
Outgoing minutes 5,000,000   3,750,000   8,750,000
Incoming minutes 3,750,000   5,000,000   8,750,000
Net incoming (outgoing) minutes (1,250,000)   1,250,000  
Net Interconnect Revenue (Cost) (3,750,000)   3,750,000  

 

 

Because MTN has fewer customers than Vodacom, it must, by definition, originate fewer calls and receive more calls. Therefore it is a nett receiver of minutes and Interconnect revenue. In the example above MTN would normally receive R3,750,000 per month. If the Interconnect Rate was reduced to R2 then they would receive R2,500,000, 33% less than previously.

This is obviously detrimental to MTN. It is already earning significantly less than Vodacom, and now Vodacom has had an immediate boost to its financial position (because its interconnect costs have been reduced by 33%). Of course, the advantage for MTN is that potential new customers do not choose their operator by virtue of market size, and MTN can now compete through the other available means (distribution, branding, product, etc).

Unfortunately, by the time Interconnect Rates are forced down by the regulator, the market is nearing saturation and the only potential customers for MTN are existing Vodacom customers. Naturally it is much more difficult and costly to convert someone that is already a Vodacom customer as opposed to someone with no existing mobile phone. (Mobile service providers are extremely sticky, mainly due to the non-portability of your phone number, hence the introduction of number-portability regulation in many countries).

Therefore, in order to alleviate the seemingly unfair financial advantage that has been conferred upon Vodacom, the regulator introduces asymmetrical Interconnect Rates, whereby the largest operator is forced to drop its interconnect rate to equal or less than its on-net rate, whilst the smaller operator may retain the higher interconnect rate, thereby leaving it’s interconnect revenue unaffected, and also allowing it to charge lower off-net rates than the larger operator. The asymmetrical rate regime remains in place until both operators are deemed to be equal in market share at which point a symmetrical rate regime is imposed.

What happens if Vodacom once again regain their dominant market share position through better marketing, distribution, products etc? Do you re-impose asymmetrical interconnect? I would think that gives the wrong incentive to the companies, i.e.: rather don’t work hard because if you succeed then the government will force you to concede your lead.

The principle outlined in this paper should only be applied where companies had an unfair start, for example privatized government monopolies. For the rest, leave them alone. They won the race fair and square.

 


[1] Metcalfe’s Law

 

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