Atanu Dey On India's Development

The King of All Telecom Scams — Part 2

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[Follow up to Part 1.] We will examine two issues now. Who actually pays for the spectrum? And, the nature of competition in the market as opposed to competition for the market. Later we will examine the notion of multiple equilibria and what the social welfare consequences of multiple equilibria are.

A Robinson Crusoe Economy

Consider a Robinson Crusoe economy. It has a population of one, Mr RC. RC “owns” the spectrum. He sells it for $100 bucks to Hutchtel, a massive telecom giant which wants to provide telecom services to the RC economy. More accurately, the spectrum is only leased out for a period of 10 years. Hutchtel wants to at least break even. The telecom infrastructure needed will cost Hutchtel $50. There are no other costs. Total cost to Hutchtel is therefore $150. Hutchtel has $150 in their pocket. Instead of providing telecom services to RC, Hutchtel could put $150 in a fixed deposit in a bank and at the end of 10 years, get $50 as interest. That’s the only alternative investment available to Hutchtel. Therefore the total cost (including the $50 opportunity cost) to Hutchtel is $200.

Suppose at $1 per call, RC is willing to make 200 calls in the next 10 years. Total revenues to Hutchtel is thus $200. Hutchtel makes $50 in accounting profits but zero economic profits because the alternative that Hutchtel had of sticking the $150 in the bank would have resulted in the same $50 earned on an investment of $150.

Hutchtel buys the rights to use RC’s spectrum and then RC buys telecom services from Hutchtel. The price that RC pays per call to Hutchtel depends on how much RC demanded from Hutchtel for spectrum use. RC gets $100 now but eventually over the next 10 years pays back that — and more — to Hutchtel.

In the case of an RC economy, it does not matter at what price the spectrum is sold. Selling it at zero price is the same as selling it for billions of dollars.

If instead of a RC economy, imagine that the economy is made of millions of people but all of whom are clones. They have the same abilities and preferences, wealth and incomes, and the need to make phone calls, and so on. In that case also, the story remains the same.

But if you have an economy with a heterogeneous population, we have a different situation. Distributional and equity aspects of the deal creep in. Even if we agree that all citizens equally-shared ownership of spectrum, we still have to figure out how the proceeds of the sale of the spectrum are to be allocated. Does every citizen get a check in the mail for a sum equal to the revenues divided by the total population? Call this Scheme A.

How about Scheme B? The government takes the proceeds of the sale and funds a kind of “national rural employment guarantee scheme” which pays people to just sit around. In that case, it is a transfer of resources from the productive people who have to use telecom services to unproductive people who don’t use telecom services and are only valuable as a vote bank for the government.

How about Scheme C? The government uses part of the proceeds to subsidize universal primary education, and the rest for building non-telecom related infrastructure.

The variety of schemes one can dream up are myriad, with different efficiency and equity outcomes. Depending on the objectives of the society, the objectives of the government, the planning horizon, etc, these schemes can be ranked. They are all context sensitive, and therefore what should be done depends on our understanding of the specifics of the case.

There are some very important questions. How much should the spectrum be licensed for and for how long? What should be done with the revenues? How many companies should be allowed to provide telecom services?

Getting back to the question of “Who actually pays for the spectrum?” That’s a hard question to answer in general but you can be certain of one thing:

The telecom company is NOT paying for the spectrum. You — the end user of the spectrum which you actually have shared ownership of — are the one who is actually paying for the spectrum.

Multiple Equilibria

Before moving ahead, a quick note on multiple equilibria. An equilibrium is price/quantity pair at which the “market clears” — in other words, at that price, the quantity supplied to the market by suppliers is equal to the quantity demanded by consumers. The main function of the market is to determine the price at which the market clears. The market, so to say, discovers the price at which there are no shortages or surpluses. In a competitive market, one which has a large number of sellers, the market determines the price, and suppliers don’t have the power to dictate the price.

(Compare that to a monopoly situation. The monopoly seller dictates the price. The consumers take what they can get. Think of say the Indian government and its monopoly control of certain markets. Railways is a good example, as was air travel until the liberalization of that sector. In general, a monopolist has the freedom to choose the price and/or set the quantity that it supplies to maximize its profits.)

In ideal competitive markets, there is only one equilibrium. In the real world, however, the presence of things like scale economies, imperfect information, etc, you can have more than one equilibrium. Suppose you have the blueprints of a certain car yet to be produced. You figure that if you produce only 100 of these, you break even (and make a normal profit) at $250K for each. If the demand for these cars at $250K each is 100 units, then you have an equilibrium. But wait. If you produce 500,000 of these cars, then you break even (and make a normal profit) at $20K for each. And if at $20K a car, you can sell half a million cars, that is another price-quantity pair at which the market clears. Scale economies enter in this case due to the high fixed costs of car mass production.

In telecommunications, there are very high fixed costs and therefore you can have multiple equilibria. Priced at $1 per minute, the quantity of mobile minutes demanded will be low, and at $0.02 per minute, the quantity could be huge. The revenues in both cases may end up to being the same, and so you have a choice of two equilibriums — one that is high-price-low-quantity, and the other low-price-high-quantity.

So what’s all this about? We are building up some simple vocabulary to understand the economics of telecommunications. A couple more concepts and then we can fully appreciate the recent “telecom scam.” Let’s see the distinction between “competition in the market” and “competition for the market”.

If there are a large number of firms — dozens of them — supplying something to a market, there’s competition in the market. In this case, firms cannot set prices, and therefore cannot make abnormal profits. Life’s tough but one gets by. Firms don’t have market power. Other firms can enter the market if they so desire. There are no barriers to entry.

Now suppose that if somehow only a few firms — two or three — were supplying to the market. The market would have limited competition and therefore the firms will have the power to set prices, and therefore make above-normal profits. It will be good to be a supplier to a market with little competition in the market. Which implies that firms could be made to compete for the right to be a supplier in the limited competition market. That’s competition for the market.

So if you have the power to restrict entry into a market, you have the power to shift the firms’ competition in the market (which is a good thing for the consumers because it leads to low prices) to the firms’ competition for the market (which is not good for consumers because of high prices.)

Why would you make firms compete for the market, instead of competing in the market? Because if you have that power, you can auction off the license to operate in the market and thus extract some of the profits that the firms expect to make in the market.

Suppose a firm expects to make $100 million in profits in a limited-competition market, it should be willing to pay at least a part of that to get the license. Who gets to keep the money? If it is a transparent auction (such as occurs in developed economies), then the money goes into some public kitty; if it is a banana-republic, then the dictator and/or bureaucrats get paid under the table. Mining, mineral rights, logging rights — all these are often given out to the highest bidders.

The major source of very high corruption occurs in the awarding of licenses in third world countries and banana republics.

Talking of natural resources (such as minerals and spectrum) and corruption, it is easy to understand the connection between resources, government control, corruption, poverty and the so-called “natural resource curse.”

The greater the opportunity to make money by gaining control of an economy, the greater is the incentive to get that control. Once you become the minister for “Steel and Mines” or telecom minister, or the minister for industrial policy, etc., you have no competition. That is, no competition IN the market. Hence intense competition FOR the market. People spend huge amounts to win elections because of that. If you are going to make a billion dollars a year as the minister, you could easily spend a few hundred million seeking that position. That is at the core of India’s million problems.

With this brief introduction, it is time to move on to the Raja telecom scam and see what exactly was the loss to India’s exchequer and what are the welfare consequences of the deal. I will argue that massive corruption is involved, that there are deeply adverse social welfare consequences, and that this pushes India a few steps closer to the brink. One important lesson among others is that for petty personal gains, immoral and unethical persons can impose disproportionate costs on others. One may receive only a few million dollars worth of kickbacks but in the process end up costing the country a few billion dollars.

[Go to Part 3.]

  • sports legends

    The information about “The King of All Telecom Scams — Part 2″ is very nice.Talking of natural resources and corruption, it is easy to understand the connection between resources, government control, corruption, poverty and the so-called “natural resource curse.”this is useful information.

  • Amit S

    Eagerly waiting for Part 3, because it is still not clear to me how a publicly owned resource can be allocated to businesses.

    Let us assume that as a nation we did not need the money from the spectrum licensing for any other public good. We simply want to allocate spectrum efficiently and maximize the “overall experience” (whatever that means) of the citizens with the telecom services. Then how would we decide how much spectrum bandwidth to give to whom for how long?

    Perhaps, spectrum rights could be given to an infrastructure company that will charge the lowest average price per bit of information to the overall economy through a transparent process. The telecom operators that use the infrastructure of this company are free to compete for customers in terms of price, quality, customer service, and other drivers important to customers. This is the model that public utility companies (e.g water supply) are based on, because they use a public resource (water) and supply it to private consumers and businesses. These businesses in turn use this water to cook Thai food or brew coffee and compete for your business.

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  • RM

    Atanu,

    Great point – what do you think about revenue neutrality as a policy when allocating “public property” such as Spectrum, till India reaches a >90% tele-density and broadband density, because of the positive externalities of widespread telephone and high-speed Internet connectivity?

  • http://www.facebook.com/SatyamevaJayate.FanPage B Shantanu

    Great post Atanu, waiting for Part III.

  • larissa

    Interesting article appearing in the Indian Express

    CBI knows who handled 2G bribe money: Shourie
    http://www.indianexpress.com/comments/cbi-knows-who-handled-2g-bribe-money-shourie/712290/

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