Do high spectrum prices damage investment incentives and increase consumer prices?

Telecoms.com periodically invites expert third parties to share their views on the industry’s most pressing issues. In this piece Ade Ajibulu of Coleago Consulting examines the implications of operators paying high prices in recent spectrum auctions.

With the US AWS-3 auction in January generating a record price of $44.89 billion, for spectrum above 1GHz, questions are posed about the implications these high prices will have for consumers, and whether they may damage investment incentives.

In classical microeconomic theory, a firm will maximise its profits by setting its prices so that its marginal revenue equals its marginal cost. In this theoretical world, pricing decisions are independent of sunk costs which are costs that have already been incurred and cannot be recovered, such as spectrum licence fees. Therefore, in the world of microeconomic theory, none of the prices paid for spectrum at auction will be passed on to the consumer. Furthermore, sunk costs should not affect future investment decisions, which should depend on forward looking profits rather than taking into account the recovery of historically incurred costs.

This perspective has arguably led some regulators to underplay the risks of excessively high reserve and final prices at auction for spectrum, because it strongly predicts that consumers are unlikely to be harmed. However, some economists have suggested that this is a poor reflection of the way actual pricing and investment decisions are made, and that consumer welfare may suffer as a result of poor choices in auction design and/or operators seeking to maximise revenue at the expense of economic efficiency.

The inability to recover or escape sunk costs is the key reason why auction fees should not affect prices and investment according to standard theory. Sunk cost should also not affect whether an operator stays in or exits the market. For example, if prices are driven down to marginal cost by competition, the operator is unlikely to recover the cost of acquiring the spectrum. The firm should still stay in the market as long as revenues cover its variable costs, regardless of the sunk cost. The operator may have the option of selling the company or trading spectrum, in which case this should be taken into account. However, the re-sale value of the spectrum is the opportunity cost, i.e. what it is worth to other users, and not the amount paid in the auction which could be significantly different.

The sunk cost argument was most famously used by regulators and their academic auction advisers to justify the sky high prices that were reached in the 3G auctions of the early 2000s and, more generally, it was used to justify the maximising of auction revenues. After the fall out from the 3G auctions, the focus shifted towards economic efficiency. Recently, however, auctions are increasingly being seen as a valid mechanism to raise public funds in the wake of the great financial crash and the sovereign debt crisis, resulting in the sunk costs issue becoming increasingly more important.

A number of economists have challenged the standard sunk cost argument. As Al-Najjar, Baliga & Sandeep have observed:

“Economic theory offers the unambiguous prescription that only marginal cost is relevant for profit-maximizing pricing decisions. On-going fixed costs or previously incurred sunk costs, although relevant for entry and exit decisions, are irrelevant for pricing. This theoretical prescription stands in stark contrast with evidence that pricing decisions of real world firms display a sunk cost bias … Most [US] firms price their products based on costing methodologies that treat fixed and sunk costs as relevant for pricing decisions. Leading textbooks on managerial and cost accounting paint a similar picture. Maher, Stickney, and Weil … assert that, when it comes to pricing practices, “overwhelmingly, companies around the globe use full costs rather than variable costs.” … Horngren, Foster, and Datar … another leading accounting textbook, report other surveys in which a majority of managers in the United States, the United Kingdom and Australia take fixed and sunk costs in to account in pricing.”

Thus the practical reality is that consumer prices may well be increased by the imposition of sunk costs such as spectrum licence fees. Al-Najjar, Baliga & Sandeep believe this is most likely in markets that are neither completely competitive, nor monopolies – in other words, markets that look like most mobile markets today. The extent to which licence fees are passed through means that they effectively become a consumer tax, which suppresses demand for a service known to have significant economic and societal benefits; a tax that will make mobile services less affordable for the digitally disadvantaged.

Other economists have focused on the impact that excessive auction fees might have on the cost of capital. This relies on empirical observations that capital markets are not 100 percent efficient, and that investors may have budget constraints which limit investment. These budget constraints may be worsened by excessively high auction fees. For example, after the 3G auctions, many of Europe’s largest mobile operators became heavily indebted, resulting in a fall in share prices and restricting their ability to raise funds for future investments However, we cannot be sure how much this was due to 3G licence prices, and how much to falling confidence in the revenue potential of the 3G services at that time.

In contrast, few regulators have publicly questioned the standard theory, with the exception of the Czech regulator dramatically stopping its 4G spectrum auction in 2013 due to fears that the level of auction prices would affect prices and investment in the Czech mobile market.

The theoretical doubts and observed weaknesses in the sunk cost argument therefore underline the need for good auction design and for regulators to prioritise efficiency – i.e. that the spectrum ends up in the hands of those who value it most – above revenue raising because of the risks to pricing and investment. This is particularly important in Africa, where mobile adoption is lower than more developed regions and affordability is seen as a major barrier to mobile adoption. With mobile adoption proven to have a significant impact on wider economic growth and social cohesion, it’s therefore vital that high spectrum prices are not used to levy consumer costs, as this would be liable to severely hinder not only mobile adoption, but also socio-economic progress.

Ade Ajibulu, is an economist and a Managing Consultant at Coleago Consulting Ltd. Coleago is a specialist telecoms strategy consulting firm and advises clients on issues relating to spectrum, regulation and network strategy.