By year 2000, the market continues to be dominated by three operators. The incumbent, Telstra, controls the largest piece of the pie with almost half of the market share, while the two early entrants, Optus and Vodafone hold the remaining half, with thirty-three percent and eighteen percent respectively.
Prices
The major players engaged mostly in non-price competition, using marketing, distribution and handset finance plans to differentiate themselves. Price competition, where the main marketing emphasis would have been on delivering mobile calls at a cheaper rate, was not a feature of the market. According to Mobile Asia Pacific (2000), the cost of mobile services in Australia has been the highest in the Asia Pacific region. The average cost of mobile calls in Australia is now about fifty Australian cents per minute, compared with about twenty-five cents in Europe and the United States. In addition, Australian mobile call prices, on average, fell by about ten percent in the year 2000, while they dropped by forty percent in the United States and fifty to eighty percent in Europe. Furthermore, the fall in call charges have been offset by the increase usages of value-added services such as short messaging service and international roaming. As a result, the average annual service charges incurred by individual consumer in the last five years have consistently been in the range of between eight hundred and nine hundred dollars.
Investment
The mobile industry has spurred more than A$14 billion in network infrastructure investments alone since 1987. No data pertaining to other fixed costs and operational costs could be obtained. However, it should be reasonable to conclude that they are negligible in comparison to the magnitude of the fixed network infrastructure costs.
In addition to the licenses that were auctioned to the operators at prices ranging between A$95M to A$302M, it has been estimated by BIS Shrapnel that the outlay to deploy a first phase 3G network in Australia is approximately A$1.7bn (for the first three years).
Profitability
The critical mass required to generate sufficient operating cash flows to begin to pay off the sunk license cost and fixed network establishment costs is half a million subscribers.
Determinants of changes in demand and supply
The law of demand and supply stipulates that a change in demand or supply is caused by a change in a non-price determinant. This section of the paper will examine such possible determinants pertinent to the Australian mobile industry.
Income
According to the Australia Bureau of Statistic, real income grew by around 2.5% a year during the past decade, between 1991 and 2001. Real net national disposable income per capita, which reflects Australians' capacity to purchase goods and services, is a key indicator of material living standards. Therefore, the increase in disposable income would have been a key factor in the increase of demand for mobile service.
Network Effects
Telecommunication service shares a unique product characteristic like those in some high tech industries – the network effects. “Network effects, which first entered economic theory via the analysis of communication networks, occur when the value of X to each user is greater the more users of X there are.” Economists' favorite example is the fax machine. Fax machines are virtually useless unless many people have them. Now that virtually all businesses and many households own them, fax machines are valuable precisely because of their ubiquity. Similarly, the mobile operators employ pricing strategies to promote the network effects, by discounting tariffs for intra-network calls. Consequently, the larger user base that an operator commands, the greater incentive for new users. When users bite the bait, the operator will make it expensive, or at least a hassle, for them to switch.
Prices of related goods
The prices of related goods such as mobile handset and fixed line service can affect the demand for mobile service. Mobile handset is a complimentary good to mobile service. Hence, the rise in mobile service uptake in the past can be attributed to the availability of cheap mobile phone and the operators’ subsidy to the cost of the mobile phone in return for service contracts with the users. On the other hand, fixed line service is a substitutable good to mobile service. A local call from residential telephones and payphones presently cost twenty and forty cents respectively. That is considerably cheaper than the per-minute charge of fifty cents for mobile service. The disproportionate prices may have discouraged many users from using more of mobile service, with the exception of intra-network calls.
New Usages
Although the current generation of mobile network technologies supports the use of rudimentary data applications, such as short messaging and WAP (a reduced version of Internet access service), its usage has been predominantly voice. This can be attributed to the consumers’ preference for higher quality and performance of data applications available through other means. However, the next generation mobile service, 3G, is expected to overcome the limitations of the earlier technology. It is therefore forecasted that data applications will generate new demand to outpace the growth of voice services to represent one-fifth of the total traffic by year 2003.
Number of suppliers
Beside the three established operators, there are altogether five new entrants to the market. The arrival of new players, with fresh ideas and product plans, is expected to give the incumbents a run for the money. However, One.tel and AAPT have both disappeared as a source of competition. The three remaining new entrants, backed by solid foreign parent companies, will likely have the staying power to reach the critical mass – about half a million subscribers – thereby causing an increase in supply to the market. As the new networks have comparable features compared to the established players, price competition appears likely to be a key strategy.
Demand Elasticity
Since there is no sufficiently granular data in terms of the change in quantity demanded, and the price of mobile service has been held constant for an extended period, it is not possible to compute the precise elasticity of demand. However, there exist conditions to conclude that the demand for mobile service is both price and income elastic.
Two reasons suggest that mobile service is price elastic. Firstly, the cost of mobile service, in proportion to the income of a significant percentage of the user base, the residential users, is a big-ticket item. Any change in this already significant cost will likely compel the users to reappraise their expenditures. Secondly, fixed line service as a very affordable substitute is pervasively available with 99.75% of households covered by Telstra’s PSTN network. The combination of the two factors, significance of cost and availability of substitute are likely to cause high price elasticity.
The analysis in the earlier section indicated that rising income is one of main factor to cause the demand curve for mobile service to continuously shift to the right. The income effect hints that mobile service is at least a normal good or is positive income elastic. This can be further substantiated by research conducted for the mobile telephone manufacturer Nokia, which indicated that for the vast majority of Australians, the key reason for buying a mobile service is lifestyle considerations.
The nature of the cost structure
In this section, the paper analyzes the fixed and variable cost structure of the typical mobile service operator operating in an oligopolistic market. The long-run capacity of mobile service operators vary according to the capital expenditure in network infrastructure, billing operation, and call centers etc. On the other hand, its short-run inputs are, for instance, labour, such as retail outlet salespeople, customer service personnel, and network management engineers.
Short-run production curve
The law of diminishing returns states that the marginal productivity of incremental use of variable inputs will eventually diminish when the fixed inputs are constant. Accordingly, the graph below indicates that the marginal product curve, MP as measured by the number of subscribers being serviced, is experiencing increasing return to scale with the input of short-run resources such as labour. It subsequently tapers off to a decreasing return to scale. A firm seeking to maximize economy of scale should therefore maximize the production level with further variable inputs until when the marginal product level almost reaches zero at point A. That is when negative return to scale begins to occur.
The average product curve, AP, is shown to have a direct sloping relationship with MP, and the intersection, point B, is where AP is at its maximum. This is the minimum production level.
Short-run cost curve
Nearly all of the costs to render mobile service are fixed cost stemming from infrastructure development. As indicated earlier, the sunk cost in bidding for the license, and the fixed capital outlay to build the phase one network infrastructure total almost A$2bn, which excludes the cost to setup the call centers, billing operations, buildings, etc. Variable costs such as marketing and labour are likely to be negligible when compared to the magnitude of the fixed capital investment. As such, while theoretically possible, it is very unusual for operators to incur total variable cost, TVC, that exceed the total fixed cost, TFC. The graph below shows the relationship between the total cost, total fixed cost, total variable cost and the phase one fixed cost.
Economic efficiency is achieved when the combination of TFC and TVC result in the lowest average cost to render service to each customer. Point B in the short-run costs graph below indicates the marginal cost curve, MC, intercepts where the average total cost curve, ATC, is lowest. In other words, production level up to where MC equals ATC is the economic breakeven point or is economically efficient.
The research data indicates that the price of mobile service has scarcely changed in the last five years. As such, the operators are interacting according to the kinked demand curve model relevant to the oligopoly structure. Accordingly, the point A on the demand curve at where the discontinuity of the marginal revenue curve, MR, intercepts the MC is the profit maximization point for the oligopolists, and profit is maximized by producing q1 at p1. Since A is priced at a level higher than point B, this suggests that the firm is realizing a profit, marked by area ACp1p2.
Long-run cost curve
In the long-run, new operators will enter the market because there is profit to be made. It must also be mentioned that, neither significant performance nor functionality differentiation could be achieved between operators because the type of network technology used is tightly regulated by the government to ensure compatibility between networks, both domestically and internationally. Hence, the established operators and new operators alike will have similar cost curves.
As the new entrants increase the supply to the market, the demand curve will shift to the left. New entrants are inclined to undercut the price level of the established operators by pricing at below the long-run average cost level, LAC, such as to gain the network effects of its own, and to reach a critical mass of five hundred thousand subscribers. However, the prices in the long-run will have to return to the p2 level where no profit or loss is made. When new operators such as AAPT and One.tel, could not reach the critical mass before it runs out of funds, it will have to bow out of the market.
Pricing strategies and interaction between operators
The combined share of the three dominant operators in the industry is ninety-eight percent. That is sufficiently significant to produce the monopoly profit-maximizing output. In the graph below, the total marginal revenue, MR, and marginal cost, MC, between the three operators are projected as the MR and MC respectively. The profit maximization level of output and price are thus q1 and p1 respectively, where MR intersects MC. Since the MR curve is below the demand curve, this production level is in the elastic range of the demand curve. This affirms the earlier analysis that the demand for mobile service in Australia is elastic. As for the individual firm, the profit is simply the difference between p1 and its average total cost level at p2, based on its allocated share of q1, that is q2. As the operators are maximizing profit, the market therefore lacks the incentive for them to achieve allocative efficiency in increasing supply to match the demand level.
Supposing that the industry is one of perfect competition, new operators will enter the market to increase supply and push MR to equal demand. A new equilibrium that is economically efficient will then emerge at point A, whereby quantity has increased to q3 and price dropped to p3.
The research finding indicates that the supply curve has expanded in the past decade; however, the table below indicates that Australia has the lowest mobile service penetration among the industrialized countries.
In conjunction with insufficient supply, the Sweezy’s kinked demand curve model is taking place, hence holding the price at an artificially high level. The operators maximize profit by means of lowering their average cost. In the case of Telstra and Optus, they lower cost through economies of scope, which is by sharing infrastructure and operational cost across several lines of businesses, such as fixed line, cable television, Internet services etc.
Only when the average cost is exceeding the output and price equilibrium, the operators use marketing, promotional and other non-price strategies to compete for new market share.
As the demand curve is also shifting to the right, it will eventually exhaust the operators’ economy of scale and pressure the price to move upward. The operators then have to reinvest in infrastructure expansion to ease the demand and to rediscover the scale of increasing return. In this process, the operators are also building the network effects to strengthen their respective market power. This effort to emulate the monopolist will further heighten the barrier to entry for new operators.
New entrant’s pricing strategy
Should a firm decide to compete on price, the short-run cost curve below indicates point C, where MC equals to AVC, is the shutdown point. In other words, production level at q2 must be priced at minimally p2, where marginal revenue could at least overcome the total variable cost. This strategy however is only sustainable in the short-run, as to how long the period is depends on the size of the firm’s war chest.
The nature, extent and impact of Government policies
The allocative efficiency of perfect competition has two key characteristics,
- Freedom of entry ensures that firms produce at the least possible cost.
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Each firm being a price taker causes a perfectly elastic demand curve. As such, firms will produce a given quantity such that marginal cost equals the price that is the lowest possible given the demand and cost conditions.
On the other hand, the Australian mobile service industry is an oligopoly market structure, in other words, one of imperfect competition, and this can be attributed to the policies of the government. There are reasons to suggest this.
Firstly, firms lack the freedom to enter the market. Entrance is subject to the prerogative of the government, which levies a sunk cost to the entrants amounting to about ten percent of the initial capital outlay. Certainly, the levy serves a purpose: as compensation for the potential lost profit for the government due to the increased competition that Telstra faces. As a result, the firms are not producing at the least possible cost.
Secondly, the government enforces strict technological standards for the industry, hence hindering the technological change and innovation needed to achieve greater efficiency in the market.
In light of the oligopolistic nature of the industry, the government has put in place some measures to discourage collusion and price fixing through the presence of the Austel (Australian Telecommunications Authority) and Australian Competition and Consumer Commission (ACCC). These administrative entities have likely prevented the three dominant operators from colluding to fix and divide the output level. However, this is insufficient to prevent the operators from using other strategic means to maximize profit, such as price discrimination through post-paid versus prepaid services and providing different service level to corporate versus residential customers, etc.; using the network effects to promote customer loyalty to prevent turnover; etc.
Recommendations
The oligopolistic nature of the Australian mobile service industry has many features that disadvantage the new entrants.
- High barrier and cost of entry – The entrance of new operators into the market will encourage the industry marginal revenue to eventually equal that of the demand curve, hence facilitating a market equilibrium that is allocatively efficient. However, the licensing requirement, high entry cost, and the network effects that the existing operators already have, all contribute to the lack of competition in the market.
- Government conflict of interest – The government’s majority stakes in Telstra presents a conflict of interest that disadvantages the private or foreign firm in entering or competing in the market.
- Restriction of technological change – Technological change enables the operators to continuously innovate and implement new technology to derive greater efficiency and lower cost. This also allows the operators to compete based on performance and functionality differences. However, the restrictions currently in place favor those with economies of scope/scale and high network effects.
To compete successfully in the Australian mobile service industry, Murphy Inc should therefore employ one of the following strategies,
- If the firm is a foreign telecom operator, it should therefore seek to acquire or invest in one of the three dominant firms. This strategy is similar to the recent Singapore Telecom acquisition of Optus. This allows the acquiring firm to inherit the market power of the oligopolist, and to consolidate its international operations to further strengthen its economies of scope/scale.
- If the firm seeks to establish its own infrastructure, it has to be a firm with a sufficiently large war chest. Given that the differentiation strategy is not possible, it would necessitate the firm to assume a price leadership strategy and sustain an extended loss period, as discussed in Section 6.1, before it builds up the critical mass and its own network effects. Such is the case of Hutchison 3G, backed by the namesake Hong Kong based conglomerate. As and when the firm reaches the economic breakeven point, then it has qualified itself a seat in the oligopolistic club of Australian mobile service industry.
Bibliography
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Australian Bureau of Statistics. 2002. Measuring Australia’s Progress 2002: National Income.
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BIS Shrapnel, Technology Applications Group. 2001. Telecommunication Infrastructures in Australia 2001, A Research Report, prepared for the Australian Competition and Consumer Commission (ACCC). Australia: BIS Shrapnel.
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Katz, M. L. and C. Shapiro, “Network externalities, competition and compatibility,” American Economic Review. 1985. Pp. 424-440.
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Katz, M. L. and C. Shapiro, "Systems Competition and Network Effects," Journal of Economic Perspectives. 1994. Pp. 93-116.
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Mctaggart, D., C. Findlay, M. Parkin. Economics, Second Edition. 1997. Australia: Addisson-Wesley Publishing Company.
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Mobile Asia Pacific. 2000. Counting the Cost of Mobility. UK: Nexus Media Ltd.
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William, Jeremy B. & Roger Lawrey. 2000. New Economics for the Asia-Pacific. Australia: Irwin/McGraw-Hill.
Unless otherwise stated, the data and indicators in this section pertaining to the industry performance are based on BIS Shrapnel, “Telecommunication Infrastructures in Australia 2001”, pp. 104-124.
Williams and Lawrey, 2000: 1.15
Unless otherwise stated, this section is based on Katz and Shapiro, 1985,
BIS Shrapnel, 2001, pp. 32
BIS Shrapnel, 2001, pp.118
Williams and Lawrey, 2000: 4.7
Williams and Lawrey, 2000, pp.4.11
Mctaggart, Findlay & Parkin, 1997, pp.261
