Managerial economics and business strategy 8e

Deutsche Telekom Case Study

Managerial Economics and Business Strategy, 8e © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 1 | P a g e

Case Summary 1 Pricing at Deutsche Telekom

Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom discussion rather than to present economic or legal fact. The case is a condensed and slightly modified version of the public copy documents involving the Commission of the European Communities’ Case Comp/C-1/37.451, 37.578, 37.579 – Deutsche Telekom AG.

Overview of Germany’s Telecommunication Industry

Deutsche Telekom (DT) owns and operates the fixed telephone network in Germany. DT’s local networks consist of a number of local loops, which are the physical circuits connecting subscribers to the fixed public telephone network. Prior to 1996, the German State wholly owned DT and was responsible for building the fixed telephone network with public resources, which it did over a long period of time. On November 18, 1996, a 25 percent equity share in DT was sold to private investors in order to generate over DEM 20.1 billion in capital to fund further expansion of its network. After DT took over VoiceStream/Powerel in 2000, the German State surrendered part of their holdings. Today, 56.95 percent of DT is owned by institutional and private investors, 30.92 percent by the German State and 12.13 percent by the German recovery bank – Kreditanstalt für Wiederaufbau.

Prior to the enactment of the Telecommunications Act on August 1, 1996, DT was a legal monopoly in the provision of retail fixed-line telecommunication services. To compete with DT, new entrants needed to invest large sums of capital to develop a network infrastructure (optical fiber, cable television, power lines, etc.) to provide retail telecommunication services. Overcoming the economies of scale experienced by DT along with its extensive nationwide coverage made entry by new firms unprofitable.

The 1996 Telecommunication Act, however, required DT to allow new competitors direct access to its infrastructure and thereby created more competition in the provision of retail access to telephone services. While DT is the only operator with nation-wide network coverage, post Telecommunication Act, it faces varying degrees of competition in the provision of telecommunication infrastructure (wholesale access to its network) and in the provision of retail telephone services. The Telecommunication Act leveled the competitive playing field by permitting financially weaker competitors to gain direct access to the German retail market through DT’s network. The rules that govern telecommunication services in Germany are regulated according to access type. That is, the rules governing retail access are different from those regulating wholesale access.

This case examines alleged unfair pricing practices against DT by competitors and retail customers after the Telecommunications Act of 1996. The primary charge against DT is that

Managerial Economics and Business Strategy, 8e © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 2 | P a g e

the margin between the prices DT charges competitors for unbundled access to local loops (wholesale access) in Germany and the prices charged for retail access is sufficiently small making it unprofitable for new entrants to compete.

Product Markets and Regulatory Environment

Wholesale Access

Local-level access to DT’s fixed-telephone networks can take two different forms. One-way DT was permitted to provide access to its networks was line sharing, whereby competitors pay fees for shared use of local loops (initially this connection type was not required). Line sharing permits an incumbent firm (in this case DT) to continue offering voice telephony services and use the same line to permit an entrant to offer a new service, like high-speed Internet access. From a technical perspective, voice and data line sharing are achieved by connecting a splitter and multiplexer (a voice-data filter) between the incumbent’s switch and the local loop. Under line-sharing arrangements the local loop remains an integrated part of the incumbent’s (DT’s) network.

In contrast to line-sharing arrangements, full unbundled access to a local loop occurs when a market entrant completely takes over selected local loops. Technically, at the switch different retail consumers are separated and connected to the subscriber’s main distribution frame. This structured arrangement between the incumbent (DT) and new entrants allows new entrants to access their own local loops without using the incumbent’s switching facilities. Full unbundling of wholesale access, then, gives new entrants complete control over local loops; even control of transmission technologies and types of services offered.

According to German law, charges for wholesale access must have a cost basis and receive prior authorization by the regulatory authority. Moreover, charges set by DT must contain no other special charges or discounts, and cannot confer an anticompetitive advantage to particular operators.

In accordance with German telecommunication law, DT filed an application with the regulatory authority to authorize monthly charges for unbundled access to DT’s local loop, one-off charges for opening new connections and one-off charges for taking over an existing serviceable connection. In 1998, the regulatory authority authorized DT’s one-off charges of EUR 309.84 for opening a new connection and EUR 135.49 for taking over an existing line. But, instead of accepting DT’s proposed monthly charge of EUR 14.73 for unbundled local loop access, the regulatory authority authorized a monthly charge of EUR 10.56. At the time of the decision, the regulatory authority required DT to submit more detailed cost calculation and conjectured that the competitors’ monthly unbundled access charge would fall below EUR 10.

After several years of negotiations between DT and the regulatory authority, by April 2003 the regulatory authority had set competitors’ unbundled monthly access rates to EUR 11.80. Moreover, one-off charges were reduced to EUR 81.12 for new, basic connection, EUR 70.56 for straightforward takeover and EUR 34.94 for discontinuance (with simultaneous customer transfer) or EU 50.71 (without simultaneous transfer).

Managerial Economics and Business Strategy, 8e © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 3 | P a g e

Retail Access

Retail access to DT’s fixed telecommunication network is achieved in two ways. First, retail consumers can access DT’s network via a traditional analogue connection. The second means of access is through a digital narrowband connection (integrated services digital network, or ISDN). Both of these access methods provide connection over DT’s existing copper pair network. Upgraded broadband connections are also available for faster Internet connection.

Retail charges (tariffs) for access to one of these connection types consist of two components. This first is a basic monthly charge that varies with the connection quality. The second component is a one-off charge for a new line connection or the takeover of an existing line.

Unlike charges for wholesale connections to competitors, which are regulated according to cost principles, retail prices for analogue and ISDN lines are regulated under a price cap system and only permitted to change according to a set basket of telecommunication services (prices do not adjust as the cost of providing individual services change). Retail prices for broadband connection, however, are not subject to either type of regulation.

In 1997, the Federal Ministry of Posts and Telecommunication introduced the price cap mechanism for retail fixed-network charges. At that time, two baskets were established: One for residential connection to standard analogue or ISDN lines, the other for services to business customers for similar connection types.

At this time, the Ministry ordered DT to reduce the aggregate price for each basket by 4.3 percent during the first price cap period; the period spanning 1 January 1998 to 31 December 1999. After this period ended, the price for a basket was further ordered to fall by 5.6 percent during the second price cap period; the period spanning 1 January 2000 to 31 December 2001. The logic behind these mandatory price-cap reductions was to capture productivity and efficiency gains realized by DT.

Given the mandatory price reductions, DT was free to modify charges for individual components with the caveat that these changes were subject to the approval of the regulatory authority. There was no restriction on the number of adjustments for which DT could apply in any price-cap period. This means that DT could increase prices for one or more basket components provided that the cap for the overall basket was not exceeded.

During periods one and two, DT reduced retail prices far below the required reductions. These reductions applied only to call charges. The monthly and one-off access charges for standard analogue connection remained unchanged over both periods. During those periods, DT’s monthly subscription fees were EUR 10.93. Yet, basic monthly charges for ISDN connections remained relatively stable until 31 March 2000. DT did, however, apply to reduce the prices on several specialized ISDN lines in December 1999, which were given regulatory approval on 16 February 2000. Retail one-off charges for analogue and ISDN lines remained at EUR 22.22 for takeover of a serviceable connection and EUR 44.45 for providing a new connection over the period 1998 to 2001.

In January 2002, a new price cap system was established by the regulatory authority. The new

Managerial Economics and Business Strategy, 8e © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 4 | P a g e

system replaced the two-basket model for residential and business consumers with a four- basket system. Baskets for retail services now consisted of a basket for retail lines (end-user lines), local calls, domestic long-distance calls, and international calls. As a result, DT was required to increase its charges for retail lines.

As mentioned, retail prices for broadband connections are not regulated under the price-cap system. Instead, DT is free to set these prices at its own discretion. After prices for certain broadband connection decreased and several complaints from DT’s competitors occurred, the regulatory initiated an investigation of broadband connection pricing practices. The basis for the investigation was whether DT lowered its price below cost and constituted anticompetitive pricing practices. Despite having found some evidence that DT’s prices were below cost for certain products, the regulatory authority took no action against these prices. Instead, in other decisions made during March 2001, the regulatory authority ordered DT to make it possible for competitors to sell wholesale local network services to other consumers and to make joint use of local loop (line sharing). DT, however, did not comply with these orders resulting in re-investigation of the alleged broadband connection charge abuses. DT did eventually increase its monthly charges for broadband connection services, which resulted in the regulatory authority terminating its case again DT.

Complaint Against DT

Several competitors allege that DT’s charges to competitors for wholesale access to its fixed network (both monthly charges and one-off charges) are so expensive that competitors are forced to charge prices to retail consumers that are far in excess of what DT can charge retail consumers for similar services. Thus, competitors argue that they can never make a profit or efficiently compete with DT. This situation is called a margin squeeze.

DT argues that its pricing practices cannot constitute a margin squeeze since wholesale charges are imposed by the regulatory authority. DT contends that a margin squeeze must be the result of excessive wholesale prices or insufficient retail prices (or some combination of the two). The legal solution, DT argues, can only be corrected if it can vary both wholesale and retail charges. In the present environment, DT only controls retail charges.

Others’ contend that the margin squeeze is relevant to this situation since a competitor buys wholesale services from an established operator and depends on the established operator to compete in the retail market. Thus, a margin squeeze can exist between regulated wholesale and retail prices.

Managerial Economics and Business Strategy, 8e © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 5 | P a g e

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