284 INTERCONNECTION network may actually have large amounts of unused capacity and so there is no need for congestion pricing. This may significantly reduce the economic efficiency of the overall system. To prevent LECs behaving as monopolists, it is common for access charges to be regulated. Typical regulatory frameworks are rather complex and treat different classes of interconnecting parties and types of services in different ways, even when there may be little difference in the costs that they generate. For instance, the regulatory regime can depend on whether the interconnecting party is another local carrier, an interexchange carrier, or a subscriber. This complexity in the regulatory framework creates regulatory arbitrage opportunities that motivate entrepreneurs to invent new ways to provide services. The availability of new services can be highly beneficial unless these are motivated solely by artificial differences in regulatory rules. For instance, Internet telephony is not subject to LEC access charges (either originating or terminating) for that part of the call that is placed over the IP protocol. In this respect (besides being more cost-efficient), IP telephony is more competitive than traditional long-distance telephony (where the long-distance carrier must pay access charges). Pressure from Internet-based technologies should cause interconnection regimes based on CPNP to collapse. Looked at another way, so long as interconnection regimes based on CPNP continue to exist, they act as a spur to the introduction of new disruptive technologies such as IP telephony. ‘Bill-and-keep’ may be unfair to a large network that interconnects with smaller networks. A smaller network, with smaller operating costs, may be able to offer lower prices to its customers. Yet because of interconnection with the large network its customers can reach the same population of customers as those of the large network. A way to remedy this could be to split the cost of the interconnection facilities so that customer prices are the same for both networks. This is the idea of facility-based interconnection cost sharing,which contrasts with the usage-based prices that CPNP computes on a per call basis. Another interesting idea is to make the calling party’s network pay all the cost of the call up to the point that it reaches the called party’s network, which then does not receive any payment for terminating the call. That final part of the cost is paid by the called party. In this scenario, the originating network also pays for the long-distance part of the call, and so has the incentive to choose a lost-cost IXC, since the long-distance charge will be seen in the bills of its customers. The reader may wonder why charging for interconnection has evolved differently in the Internet than in traditional telephony. A principal reason is the difference in the market structure. The market for local Internet service that is offered by ISPs is highly competitive, whereas the market for backbone connectivity is less competitive, reversing to some extent the trends of the telephony market. No ISP can survive by charging high access prices. So peering, which is a type of ‘bill-and-keep’, is widely used. In the market for backbone con- nectivity, competition encourages IBPs to adopt a similar peering strategy for terminating each others’ traffic, except that their customers are now ISPs. The limited competition in the IBP market justifies nonnegligible prices in the transit contracts paid by ISPs to IBPs. Note that ISPs have the incentive to operate as efficiently as possible, since they pass on the cost of their local network and its transit agreements directly to their customers, who can easily switch ISP if they feel they are not receiving the best value for money. 12.2 Competition and service differentiation We can use standard models of oligopoly to analyse competition in networks that offer guaranteed services. In these networks, capacity determines the quantity of services that INCENTIVES FOR PEERING 285 can be sold. However, when networks offer elastic services, then we must be more careful in modelling competition, as congestion must now be taken into account. The desire of competing networks to discriminate between consumers who differently value various aspects of the offered services motivates the production of services with different qualities of service. These differing services can be realized by dividing a network into subnetworks with different congestion levels and profit can be increased thereby. However, when more services are offered they will be partly substitutable, and the resulting increase in competition can reduce the profits of all the competing network operators. It is therefore interesting to ask to what extent a competitive market induces service differentiation by making it advantageous for competing networks to offer many types of service. The answer is very sensitive to assumptions. Consider the market for access services. If a customer can subscribe to multiple services, and so benefit from multiple levels of quality, then it is probable that competing networks will wish to provide services at multiple quality levels, i.e. levels of congestion. However, if a customer can subscribe to just one quality level, then competition effects can outweigh service differentiation effects, and each competing network will wish to offer just one class of service, at a price that depends upon its congestion level. Of course this assumes competition. If network operators collude, then they can maximize profits by each producing at multiple quality levels. In any case, if an access network wishes to distinguish itself by a certain quality level, it must guarantee that quality by buying appropriate interconnection agreements. Thus, the intermediate networks’ quality of service can be a constraining factor on the competitiveness of an access network. 12.3 Incentives for peering Whether or not peering between two networks is beneficial depends on how their customers value those things that differentiate the networks, such as size and location. Network size is very important to users who wish to access a large customer base and buy or sell services through the network. Similarly, location is important to customers that find it easier to access one network than another. A network provider can make his network look more attractive by providing good performance to the traffic of his own customers, and worse performance to traffic that originates from outside. Simple economic models of competition suggest that, as a function of customer preferences, either all or no competing networks may want to peer, or smaller networks may want to peer while larger ones do not. The case in which no network wants to peer occurs when most customers are more interested in network size than location. Here, the market is modelled by a game whose equilibrium solution is asymmetric, in the sense that competing networks grow to different sizes. However, if customers are more interested in location, then networks may wish to peer, since by increasing their customer bases, they add value to what they provide and can charge more for it. If both size and location are important then peering can benefit smaller networks, but not larger ones. This is because, in a competitive scenario, smaller networks can introduce access charges. Peering eliminates the advantage of network size and can encourage customers of larger networks to move to smaller and cheaper ones. In practice, it is typical for a network provider to specify conditions for peering that depend on the other network’s size and geographic span. He might also specify a ‘peering charge’ that compensates him for his loss of income when he peers with another network. Of course it is very difficult to determine this charge. In practice, it is often made a function of the access speed of the connection between the two networks at the NAP where peering takes place. 286 INTERCONNECTION 12.4 Incentive contract issues Interconnection agreements may not always provide sufficient incentives for partners to collaboratively realize the full potential of positive network externalities. In the present best- effort Internet, interconnection agreements tend to be rather simple, specifying a maximum rate and perhaps a volume charge. However, newer Internet applications increasingly require specific network performance guarantees, and so new types of interconnection contract are needed that can account for both quality and volume. These contracts must give the peering network the appropriate incentives to allocate the effort required for the contracted quality. This contrasts with the present practice of flat contracts that do not include incentives for effort. It is difficult to devise interconnection contracts because of asymmetric information about variables. We can discuss this using the terminology of the principal-agent model,inwhich a principal (the contractor who sets the terms of the contract) wishes to induce some action from an agent (the contractee who executes the contract). There are variables, such as peak rate, average throughput and number of bytes, that can be observed and verified by both principal and agent. However, there are other variables that cannot be observed by the principal. For example, a principal who buys from an agent a contract for interconnection may not be able to tell what minimum bandwidth the agent dedicates to his traffic, or the priority class to which his traffic is assigned. These are variables of the ‘effort’ provided by the agent. It is technology that dictates what is observable and what not. Sometimes, the effort of the agent may be observable, but the context in which this effort is exercised may not be known at the time the contract and the incentives are defined. Information asymmetry can provide significant advantage to the contractee, who naturally tends to expend the least effort he can to fulfil his contractual obligations. The contractor takes a risk known as moral hazard.Thereisanadverse selection problem when, at the time the contract is agreed, the agent knows some important information that the principal does not. For instance, if the principal is the provider of the interconnection service and the agent is the network generating the traffic, the agent knows how he values ‘heavy’ or ‘light’ use of the contract. If he intends to make heavy use of the interconnection service, it is to his advantage not to reveal this to the principal. He would rather be charged the cost of a contract that is targeted at the average customer. In practice, there are many important ways that information asymmetry can occur and can influence the performance that is obtained from an interconnection contract: ž Perhaps an ISP signs an interconnection agreement, but subsequently does not maintain or upgrade his network capacity. The result is that the interconnection traffic receives poor service. As peering agreements are presently based on best-effort services, one party cannot easily tell whether or not the other party is properly managing his network. ž An ISP carrying a high load of local traffic might actively discriminate against packets that enter his network from an interconnected partner. The damaging effect of the discrimination may be camouflaged as natural congestion, and it can be hard for his partner to detect the true cause. ž A client party cannot easily predict the traffic load that a network offering interconnection service carries on its backbone. It is hard for that party to know the other party’s available spare capacity, his resource allocation and routing policies, or whether he effectively uses statistical multiplexing and overbooking. Resource allocation and traffic multiplexing can strongly affect network performance. In negotiating peering or transit agreements, all the above are critical. However, information about these issues is not readily available, and ISPs have little incentive to reveal it. Present market practices only partly address the problem. Large ISPs exert their MODELLING MORAL HAZARD 287 bargaining power to extract information from smaller partners. However, the requirements and terms of their agreements are private and undisclosed to third parties. 12.5 Modelling moral hazard To model asymmetric information problems in the market for Internet connectivity, three fundamental parameters must be defined: effort, outcome, and the cost of providing effort. The effort of a network service provider is defined in terms of how he treats his client’s traffic; e.g. how an IBP treats the traffic of client ISPs. Quantitatively, it can be described in terms of the resources that he allocates and the scheduling policies he applies to serving the client’s traffic. When multiplexing traffic from different sources and applications, the network manager can assign different priorities to different flows of packets according to subjective criteria, such as the type of application being served (e.g. email vs. videoconferencing), the identity of the sender or recipient, and the revenue generated by the traffic transferred. The dangers inherent in being unable to verify the level of effort can be reduced by using pricing mechanisms that provide the IBP with suitable incentives to exert the effort required to ensure the required performance. In effect, such mechanisms make the IBP responsible for the effort he provides by making his profit depend upon the outcome, after accounting for uncertain conditions. Performance indicators, such as average delay or packet loss, could be used to measure the observable outcome in an interconnection agreement. Effort has a cost. This cost could be defined as the opportunity cost of not serving (or reducing the quality of service for) other client ISPs of the same network. An alternative but equivalent definition of this cost is based on the negative externality (congestion) imposed on the network and its other users. It is quite difficult to estimate this cost, as it depends on parameters that an IBP may not reveal. Often, a key component in the cost of serving the interconnection traffic is the load of ‘local traffic’ in the network, i.e., the traffic that originates from the network’s other customers and which it is already contracted to carry. Information about this load may be available to the network provider before he must decide how to treat transit traffic from an ISP with whom he peers. The cost of allocating effort to the traffic of the new contract is negligible when the local traffic load is small, but increases quickly as the local load becomes greater and exceeds a certain threshold. This threshold may depend upon the total available capacity, the multiplexing algorithms used, and the burstiness of the traffic. In principle, the greater the amount of effective bandwidth that is allocated to the specific contract, the less bandwidth is available for the rest of the traffic, resulting in some opportunity or congestion cost. For an incentive contract to be successful, one must be able to quantify reasonably well the expected cost to the contractee of the required effort, and the value of the resulting quality to the contractor. These issues are illustrated in the following example. There is information asymmetry at the time the contract is established. A rational service provider will provide the minimum possible effort, unless he is given appropriate incentives. In our simple model, we assume that some network conditions are unobservable (implying an unobservable cost to the agent), but that the provider’s effort is observable. The latter assumption is reasonable since interconnection contracts are typically of long duration, and so a customer ISP should be able to rather accurately estimate the parameters that he needs to infer the effort allocated by the contracted ISP. Only if contracts were of short durations, say a connection’s life, might such estimation be inaccurate and effort unobservable. For simplicity, we focus on the modelling issues and the resulting optimal incentive schemes, omitting the complete analysis. 288 INTERCONNECTION y y ∈{y 1 , y 2 } a ∈{a L , a H } aC (1 − a)C x Figure 12.2 A model for an agent’s effort. He operates a link serving two queues: one for the transit traffic and the other for his internal traffic. The effort given to the transit traffic is measured by the fraction of capacity Þ dedicated to serving the first queue. The rate of internal traffic at the time the contract is instantiated is random, taking values y 1 , y 2 with probabilities p 1 , p 2 , respectively, with y 1 < y 2 . Example 12.1 (A principal-agent problem) Consider a transit agreement between two network service providers, using the formulation of the principal-agent model. Suppose a principal, P, contracts with an agent, A, for transport of a packet flow through A’s network. We model A’s network by two queues; one is dedicated to A’s internal traffic and the other is dedicated to P’s transit traffic (see Figure 12.2). The service capacity of the network is C,ofwhichÞC is allocated to the P’s transit traffic. For simplicity, we restrict the choice of Þ to two values, Þ L , Þ H ,whereÞ L <Þ H . Thus, Þ is the effort that is provided by A in the context of his contract with P. We suppose that A has no control over the rate of his internal traffic at the time he begins serving P’s traffic. He can control the fraction of his capacity that he will allocate to it, and he knows the distribution of the future rate of his internal traffic at the time he agrees the contract with the principal. These are reasonable assumptions for many practical situations. The contract defines a service to be provided at some later point in time, and statistical information is available on the future state of the network. Let us denote the rate of the internal traffic by y, and suppose that it is known that it will take one of the two values y 1 and y 2 , with probabilities p 1 and p 2 D 1  p 1 , respectively, where y 1 < y 2 . The cost of allocating capacity to P’s flow is the extra delay experienced by packets of A’s internal flow. Assuming, for simplicity, that this is a M=M=1 queue, we can calculate the cost using the fact that if a flow of rate y is served at rate C then the average packet delay is 1=.C  y/.Taking as the monetary value of the cost of one time unit’s delay, this implies a rate of delay cost of  y=.C  y/ per unit time. Thus, the cost of allocating a fraction Þ of the available effort to the contract with P is c.y;Þ/D  y Ä 1 .1  Þ/C  y  1 C  y ½ Let c.ij/ denote c.y i ;Þ j /, i 2f1; 2g, j 2fL; Hg. It can be proved that c.2H /  c.2L/>c.1H /  c.1L/>0 In other words, a change from low to high effort is more costly to A when the system has a greater internal load. Of course, such a change benefits P, since it reduces the average delay of his packets. Denote by r L and r H respectively the monetary value of the service received by P when the effort levels are low and high. Our task is to design an incentive contract in which P pays A an amount w.Þ/.This payment is determined after the completion of the service and depends on the level of effort Þ allocated by A, which we suppose P can estimate both accurately and incontestably. Perhaps P measures the average delay of his traffic and then uses the delay formula for the M=M=1 queue to compute the effort that was provided by A. MODELLING MORAL HAZARD 289 Let the contract specify that P pays A amounts w L or w H as A provides low or high effort respectively. Once these are known, A needs to decide whether or not to accept the contract. His decision is based on knowledge of the distribution of the rate of the internal traffic at the point that service will be instantiated. At that point, he observes the rate of internal traffic and decides what level of effort to provide to P’s traffic. This decision is rational, and is based on the information available. He maximizes his net benefit by simply computing the net benefit that will result from each of his two possible actions. This is easy to find for any given w L and w H . First, observe that if the value of the state is i ,the rational action for A is j D arg max ` fw `  c.i `/g, and the payoff is w j  c.ij/. Thus, the sign of w L  w H  [c.iL/  c.iH/] determines the most profitable action for the agent. The participation condition (i.e. the condition under which A will agree to accept P’s traffic) can be written as p 1 maxfw L  c.1L/; w H  c.1H/gC p 2 maxfw L  c.2L/; w H  c.2H/g½0 Depending upon the parties’ risk preferences, different incentive schemes can result. For example, P might be risk-averse, while A is risk-neutral. This could happen if A, who is perhaps a backbone provider, has many customers and so can spread his risk. His expected utility is then the utility of his expected value. The ideal contract for P is one that induces A to choose the efficient action, so maximizing total surplus from the interconnection agreement; and then extracts this entire surplus from A. (Note that A has to be willing to sign the contract – the participation condition must be satisfied – so that this is the best that P can achieve.) Simple convexity arguments suggest that a franchise contract is best for P. He keeps a constant amount F for himself, regardless of the outcome, and offers the surplus from the interconnection relationship minus the franchise payment F back to A. F is set so that A receives zero expected net benefit (or some tiny amount). Suppose our risk-averse principal has a utility function of the form U .r  w/,whereU is assumed concave, and the random variables r and w are respectively the value obtained by the principal and the value of his payment to A. These are well-defined for each pair w L ;w H . The principal’s problem is to maximize E[U.r  w/] over w L ;w H , subject to A’s participation, and we know that this is achieved using a franchise payment F to P. For instance, if both actions L ; H are enabled by the optimal incentive scheme, w L ;w H must satisfy r L  w L D r H  w H D F for some F which should be equal to the difference between the average value generated for the principal and the average cost to the agent as a result of the incentive scheme w L ;w H . Observe that there are finitely many candidate Fs, since the number of different incentives provided by any choice of w L ;w H is finite (in our case four). This suggests that we first compute all possible values for F and then choose w L , w H to realize the largest. This optimal F will depend on the values of the parameters r L , r H , c.1L/, c.1H /, c.2L/, c.2H /. There are four cases to consider: 1. Always select high effort. Then F H D r H  [p 1 c.1H / C p 2 c.2H /]. 2. Always select low effort. Then F L D r L  [p 1 c.1L/ C p 2 c.2L/]. 3. In state 1 select high effort, and in state 2 select low effort. Then F HL D p 1 r H C p 2 r L  [p 1 c.1H / C p 2 c.2L/]. 4. In state 1 select low effort, and in state 2 select high effort. Then F LH D p 1 r L C p 2 r H  ð p 1 c.1L/ C p 2 c.2H / Ł . Let us restrict attention to the interesting case, r L < r H and determine the optimal value of F as a function of r L and r H . In the region marked F H in Figure 12.3, where r H  r L ½ 290 INTERCONNECTION 45° F H F HL F L c(2H) − c(2L) c(1H) − c(1L) r H r L 0 Figure 12.3 Optimal franchise contracts. There are three regions in which the principal’s optimal franchise contract is different. Here r L and r H are the monetary value of the service received by P when the effort levels are, respectively, low and high, r L < r H . c.2H / c.2L/, F H is the best franchise contract and w L D 0, w H D p 1 c.1H /C p 2 c.2H /. In the region marked F L ,wherer H  r L Ä c.1H/  c.1L/, F L is optimal and w H D 0, w L D p 1 c.1L/ C p 2 c.2L/. In the region marked F HL ,wherec.1H /  c.1L/ Ä r H  r L Ä c.2H /  c.2L/, F HL is optimal, and w L Dp 1 .r H  r L / C p 1 c.1L/ C p 2 c.2L/, w H D p 2 .r H  r L / C p 1 c.1L/ C p 2 c.2L/. The intuition is that, given r L ,whenr H is sufficiently large we would like to provide incentives so that high effort is always used. As r H decreases, it becomes economically sensible to use high effort only when the cost of providing it is not too great, which is when the system is in state 1. If r H decreases even further and becomes close to r L , then the greater cost of high effort does not justify its choice, regardless of the state of the system. It is only when c.1H /  c.1L/ Ä r H  r L Ä c.2H /  c.2L/ that one needs to design a nontrivial incentive contract, i.e. one in which the provider’s effort depends on network conditions. 12.6 Further reading The interconnection issues addressed in the first part of this chapter are covered by Huston (1998), Huston (1999a), Huston (1999b) and Metz (2001). The web site of EP.NET (2002) provides information regarding Internet NAPs. Atkinson and Barnekov (2000) address facilities-based interconnection pricing issues. Mason (1998) discusses the international accounting rate system and the reasons this may be affected by Internet telephony. An interesting discussion of ISP interconnection agreements and whether regulation should be government-led or industry-led is given by Cukier (1998). The ideas about competition and service differentiation in interconnected networks at the end of Section 12.2 are pursued by Gibbens, Mason and Steinberg (2000), Cremer, Rey and Tirole (2000) and Lafont, Marcus, Rey and Tirole (2001). The information asymmetry issues in Section 12.4 and Example 12.1 were introduced by Constantiou and Courcoubetis (2001). The book of Macho-Stadler and Perez-Castillo (1997) is also a good source on asymmetric information models for incentives and contracts. 13 Regulation The regulator’s job is to supervise a market so that it operates efficiently. He acts as a high level controller who, taking continual feedback from the market, imposes rules and incentives that affect it over the long term. In the telecoms market the regulator can influence the rate of innovation, the degree of competition, the adoption of standards, and the release to the market of important national resources, such as the frequency spectrum. The efficiency of an economy can be judged by a number of criteria. One criterion is allocative efficiency. This has to do with what goods are produced. The idea is that producers should produce goods that people want and are willing and able to buy. Another criterion is productive efficiency. This has to do with how goods are produced. The opportunity cost of producing any given amounts of products should be minimized. Resources should be used optimally. New technologies and products should be developed as most beneficial. Finally, distributive efficiency is concerned with who things are produced for: goods should be distributed amongst consumers so that they go to people who value them most. In general, competitive markets tend to produce both allocative and productive efficiency. However, in cases of monopoly and oligopoly firms with market power can reduce effi- ciency. We say there is market failure. In this case, regulation can provide incentives to the firms with market power to increase efficiency. The incentives can either be direct, by im- posing constraints on the prices they set, or they can be indirect: for example, by increasing the competitiveness of the market. There is no single simple remedy to market failure. Sometimes competition actually reduces allocative efficiency. In the case of a natural monopoly, social welfare is maximized if a single firm has the exclusive right to serve a certain market. This is because there are large economies of scope and scale, and because the rapid creation of industry standards leads to efficient manufacturing and also to marketing of complementary products and services. We see this in traditional telephony, and other public utilities, such as electric power, rail transportation and banking. The job of the regulator is to ensure that the monopolist operates efficiently and does not exploit his customers. Information plays a strategic role in the regulatory context, because regulated firms can obtain greater profits by not disclosing full information about their costs or internal operations. A principal difficulty for the regulator is that he does not have full information about the cost structure and the production capabilities of the firm, nor does he know the actions and effort of the firm. This is another example of the problem of asymmetric information, already met in Section 12.4 in the context of interconnection contracts. We illustrate this in Section 13.1, with some theoretical models, and then explain ways in Pricing Communication Networks: Economics, Technology and Modelling. Costas Courcoubetis and Richard Weber Copyright  2003 John Wiley & Sons, Ltd. ISBN: 0-470-85130-9 292 REGULATION which the regulator can achieve his goals despite his lacking full information. The firm’s information about the future behaviour of the regulator may also be imperfect; this leads to intriguing gaming issues, especially when decisions must be made about large, hard to recover investments. In Section 13.2 we describe some practical methods of regulation. Section 13.3 considers when a regulator ought to encourage competition and how he can do this. In Section 13.4 we discuss the history of regulation in the US telecommunications market and describe some trends arising from new technologies. 13.1 Information issues in regulation 13.1.1 A Principal-Agent Problem In this section we present a simple model for the problem of a regulator who is trying to control the operation of a monopolist firm. Unless he is provided with the right incentives, the monopolist will simply maximize his profits. As we have seen in Section 5.5.1, the social welfare will be reduced because the monopolist will tend to produce at a level that is less than optimal. The regulator’s problem is to construct an incentive scheme that induces the firm to produce at the socially optimal level. We can use the principal-agent model with two players to illustrate various problems in constructing incentives and the importance of the information that the regulator has of the firm. Recall, as in Section 12.4, that the principal wants to induce the agent to take some action. In our context, the principal is the regulator and the agent is the regulated firm. The firm produces output x, which is useful to the society, and receives all of its income as an incentive payment, w.x/, that is paid by the regulator. In practice, firms do not receive payments direct from the regulator, but they receive them indirectly, either through reduced taxation, or through the revenue they obtain by selling at the prices the regulator has allowed. To produce the output, the firm can choose among various actions a 2 A, and these affect its cost and production capabilities. There are two types of information asymmetry that can occur. The first is known as hidden action asymmetry and occurs when the regulated firm is first offered the incentive contract and is then free to choose his action a. The level of output x takes one of the values x 1 ;:::;x n , with probabilities p a 1 ;:::;p a n , respectively, where P i p a i D 1 for each a 2 A. The firm’s cost is c.x; a/. Think, for example, of a research foundation that makes a contract with a researcher to study a problem. Once the contract is signed the researcher chooses the level of effort a that he will expend on the problem. ‘Nature’ chooses the difficulty of the problem, which together with the researcher’s effort determines the success of the research. Note that the researcher does not know the difficulty of the problem at the time he chooses his level of effort. He only knows the marginal distribution of the various final outcomes as a function of his effort, for instance, the probability that he can solve the problem given that he expends little effort. The research foundation cannot with certainty deduce the action a, but only observe the output level. This is in contrast to the full information case, in which the regulator can observe a and make the incentive payment depend upon it. One way that full information can be available is if each output level is associated with a unique action, so that the regulator can deduce the action once he sees the output level. Another possibility is that the regulator does not know the firm’s cost function at the time he offers the incentive contract. We call this hidden information asymmetry.Nowa denotes the type of the firm, and c.x; a/ is its cost for producing output x. At the time the contract is made, the firm knows its own c.Ð; a/, but as we will see, it can gain by not disclosing INFORMATION ISSUES IN REGULATION 293 it to the regulator. It turns out that information asymmetry is always to the advantage of the firm, who can use it to extract a more favourable contract from the regulator. By trying to ‘squeeze’ more of the profits of the firm from the contract, the regulator can only have negative effects on social efficiency. Let us investigate the problems that the regulator must solve in each case. In the case of hidden action asymmetry the principal knows the cost function c.a/ (where for simplicity we suppose this cost depends only upon the action taken), but he cannot directly observe a. The principal’s problem is to design a payment scheme w.x/ that induces the socially best action from the agent. Let u.x/ be the utility to the society of a production level x.The problem can be solved in two steps. First, compute the socially optimal action by finding the value of a that solves the problem maximize a " n X iD1 p a i u.x i /  c.a/ # Now find a payment scheme that gives the agent the incentive to take action a rather than any other action. Since there may be many such payment schemes, we might choose the one that minimizes the payment to the agent. This is the same as minimizing his profit. Let v.w/ be the agent’s utility function for the payment he receives. In most practical cases, v is concave. The principal’s problem is minimize w.Ð/ n X iD1 p a i w.x i / (13.1) subject to n X iD1 p a i v.w.x i //  c.a/ ½ 0 (13.2) n X iD1 p a i v.w.x i //  c.a/ ½ n X iD1 p b i v.w.x i //  c.b/; for all b 2 A nfag (13.3) Condition (13.2) is a participation constraint: if it is violated, then the agent has no incentive to participate. Condition (13.3) is the incentive compatibility constraint: it makes a the agent’s most desirable action. The solution of (13.1) provides w a .Ð/, the best control. As a function of the observable output only, it induces the agent to take action a. Observe that at the optimum (13.2) holds with equality; otherwise one could reduce w by a constant amount and still satisfy (13.3). Hence, we must have that P i p a i v.w.x i // D c.a/. In the full information case, in which the principal observes a,asimplepunishment policy solves the problem. Constraint (13.3) is ensured by taking w D1if any action other than a is taken. When a is taken, the optimal payment is w.x i / D w Ł for all i , where v.w Ł / D c.a/. Such a payment provides complete insurance to the agent, since he is recovers the cost of a, no matter what the outcome x i . Unfortunately, such a simple policy will not work if the action cannot be observed. If we use a complete insurance policy the agent will pick the policy with the least cost (as he has a guaranteed revenue). To guarantee (13.3), the payment must depend on the [...]... introduction to the issues of asymmetric information, see Chapter 25 of Varian ( 199 2) A good book on incentives and contracts is Macho-Stadler and Perez-Castillo ( 199 7) The method of average price regulation is described by Vogelsang and Finsinger ( 197 9) The total surplus subsidy method is due to Loeb and Magat ( 197 9) and the incremental surplus mechanism is due to Sappington and Sibley ( 199 8) A classic FURTHER... 307 on the economics of regulation is the book of Kahn ( 199 8) A theoretical treatment of regulation issues and policies can be found in Wolfstetter ( 199 9) Many regulators have excellent web sites We recommend the sites of the UK and US regulators: Oftel (2002) and FCC (2002b) These contain well-presented material on topics such as the unbundling of the local loop, call termination, network interconnection,... homogeneous or heterogeneous In a homogeneous auction a number of identical units of a good are to be auctioned, and we speak of a multi-unit auction Multi-unit auctions are of great practical importance, and have been applied to selling units of bandwidth in computer networks and satellite links, MWs of electric power, capacity of natural gas and oil pipelines In the simplest multi-unit auction, each... television, broadband access, spectrum allocation, satellite, technology standards, security, and media ownership An excellent reference for competition issues in the telecommunications sector, and specially the Telecommunications Act of 199 6, is the web page of Economides (2002) A good starting point for study of condominium fibre customer-owned networks is the web site of CA*net 3 (Canada’s Research and Education... long-distance provider of the ILEC More specifically, the 199 6 Act requires that ILECs (i) lease parts of their network (the UNEs) to Competitive Local Exchange Carriers (CLECs) at cost plus some reasonable profit; (ii) provide to competitors at a wholesale discount any service the ILEC provides; and (iii) charge reciprocal rates in termination of calls to their network and to networks of local competitors... costs and production has large economies of scale A related notion is that competition can lead to excessive entry The presence of a large number of producers, each producing a relatively small output, can rob society of the costreducing advantages of production economies of scale So, although the prices decrease and consumer surplus increases, individual firms produce less efficiently and the economies of. .. used to transport any type of information, and the convergence of content services of retrieving and displaying digitized information using the uniform Internet application protocols of the World Wide Web, together with the use of personal computers at the edge of the network for multiple tasks (from telephony to watching interactive video), creates a new ubiquitous computing and communication platform... parts of its market 302 REGULATION Of course, the disadvantage of a monopoly is the allocative inefficiency, since a monopolist will seek to maximize his profits and this will be at the expense of overall social welfare Increasing the number of competing firms has the positive effect of reducing prices This can sometimes be achieved without actually increasing the number of competing firms The theory of. .. to make sure that all communities can enjoy the benefits of condominium fibre networks In the above, we have an example of demand aggregation, a strategy that can be used to facilitate the deployment of broadband services and infrastructures When access is the expensive bottleneck, a single customer may not be able to justify the cost of broadband services if he has to provide the infrastructure completely... part of the Bell System The government sought a divestiture of Western Electric The case was settled in 195 6 with AT&T agreeing not to enter the computer market, but retaining ownership of Western Electric The second major antitrust suit, United States vs AT&T, began in 197 4 and was eventually settled in 198 4 The government claimed that (i) AT&Ts relationship with Western Electric was illegal, and (ii) . depends on network conditions. 12.6 Further reading The interconnection issues addressed in the first part of this chapter are covered by Huston ( 199 8), Huston ( 199 9a), Huston ( 199 9b) and Metz (2001) are large economies of scope and scale, and because the rapid creation of industry standards leads to efficient manufacturing and also to marketing of complementary products and services. We see. Cukier ( 199 8). The ideas about competition and service differentiation in interconnected networks at the end of Section 12.2 are pursued by Gibbens, Mason and Steinberg (2000), Cremer, Rey and Tirole