DISCUSSION PAPER SERIES

No. 2530

LICENSE AUCTIONS AND MARKET STRUCTURE

Philippe Jehiel and Benny Moldovanu

INDUSTRIAL ORGANIZATION

ZZZFHSURUJ ISSN 0265-8003

LICENSE AUCTIONS AND MARKET STRUCTURE

Philippe Jehiel, École Nationale des Ponts et Chaussées Benny Moldovanu, Universität Mannheim and CEPR

Discussion Paper No. 2530 August 2000

Centre for Economic Policy Research 90–98 Goswell Rd, London EC1V 7RR, UK Tel: (44 20) 7878 2900, Fax: (44 20) 7878 2999 Email: [email protected], Website: www.cepr.org

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Copyright: Philippe Jehiel and Benny Moldovanu CEPR Discussion Paper No. 2530

August 2000

ABSTRACT

License Auctions and Market Structure*

We analyse the interplay between license auctions and market structure in a model with several incumbents and several potential entrants. The focus is on the competitiveness induced by the number of auctioned licences. Moreover, we study how the auction format affects the incentives for explicit or tacit collusion among incumbents. A crucial role is played by the relation between the number of incumbents and the number of licenses. We show that auctioning more licences need not result in greater competitiveness when the number of incumbents is greater than the number of new licences. When the number of licenses exceeds the number of incumbents, we display plausible conditions under which all incumbents get a licence. Finally, we suggest a positive role for some auction formats in which the number of licences is endogenously determined at the auction. We illustrate some results with examples drawn from the German and UK licence auctions for 3G mobile telephony.

JEL Classification: D44, D62 and L14 Keywords: auctions, market structure, tacit collusion and war of attrition

Philippe Jehiel Benny Moldovanu CERAS and UCL Faculty of Economics École Nationale des Ponts et Universität Mannheim Chaussées Seminargabäude A5 28 Rue des St-Pères 68131 Mannheim 75007 Paris GERMANY FRANCE Tel: (49 621) 292 5400 Tel: (33 1) 44 58 28 73 Fax: (49 621) 292 5145 Fax: (33 1) 44 58 28 80 Email: [email protected] Email: [email protected] *This Paper is produced as part of a CEPR research network on The Evolution of Market Structure in Network Industries, funded by the European Commission under the Training and Mobility of Researchers Programme (Contract No ERBFMRX-CT98-0203).

Submitted 06 July 2000 NON-TECHNICAL SUMMARY

Telecommunication, public transportation, electricity, water and gas were traditionally provided by (often monopolistic) state firms. It is now widely believed that recent technological advances have undermined the ‘natural monopoly’ argument that has been often advanced in defence of such market structures. During the last two decades many industries have been radically transformed by the introduction of competition. The liberalization was implemented in different ways, according to region and industry. In the telecommunication industry competition was created by licensing several private firms. There are, a priori, many ways to allocate licences. For example, the allocation of first generation licences for mobile telephony was made through lottery or through bureaucratic processes (so-called ‘beauty contests’). Given that resale markets for licences do not function well and are often subject to bureaucratic controls, and given that potential acquirers of licences are better informed than regulators, it soon became clear that such methods lead to suboptimal allocations of licences and that they do not generate substantial revenues. Further allocations of licences were made through auctions (see McMillan, 1994 and McAfee and McMillan, 1996 for accounts of the US experience).

The main goal of most spectrum licence auctions is economic efficiency, which implies that some weighted sum of consumers’ and producers’ surpluses should be maximized.

The difficulty in achieving efficiency is due to the fact that consumers do not directly participate in the spectrum auctions. A proxy for consumers’ surplus is the degree of competitiveness as measured by the number of active firms in the industry.

The difficulty in achieving more competitive industries by licensing new firms is due to the fact that earlier allocations of licences have already established incumbents operating according to some previous technological standard. Potential new entrants (i.e. firms that do not already operate a network) face two handicaps: 1) The fixed cost of setting up a network (say of antennae and relays) is very large. 2) Incumbents are also driven by entry pre-emption motives, which translate into increased willingness to pay for new licences.

In this Paper we consider a situation in which several incumbents are already present in the market. A regulatory agency sells one or more licences. It can determine the number of auctioned licences and some features of the auction format. Potential acquirers of new licences include the incumbents and entrants who are not yet present in the market. The downstream competition among licensed firms is modelled via a reduced-form industry profit function. This modelling approach implies that values for licences are endogenous and depend on the final number of licensed firms. For simplicity, but also in order to isolate the effect of market structure considerations, we assume that there are no informational asymmetries among the potential acquirers.

We focus on two objectives for the regulatory agency: the degree of competitiveness in the industry and the revenue generated by the auction. The degree of competitiveness is measured by the number of licensed firms after the auction (that is, the number of incumbents augmented by the number of entrants who acquire a licence).

Our main insights are as follows. Suppose incumbents currently earn large profits, that old and new licences are close substitutes, and that the addition of one licensed entrant causes a significant drop in per-firm profit in the industry. Then bidding among incumbent firms displays ‘war of attrition’ features: since entry pre-emption has a public good aspect, incumbents are willing to buy new (even ‘worthless’) licences or capacity in order to avoid entry, while, at the same time, preferring that the cost of pre-emption is born by others.

If only one licence is auctioned, the war of attrition results in entry with positive probability. In this case we also show that the incentives for explicit collusion are highest when the expected benefit for entrants is approximately equal to the difference between the incumbents’ post- and pre-entry profits.

The war of attrition between incumbents can be alleviated if several licences are auctioned, resulting in less entry. The point is that, with more licences, the cost of pre-emption can more easily be shared among incumbents even though it is larger. If the number of licences equates to the number of incumbents, each of them can purchase one licence. This completely pre- empts entry and the cost is equally shared among incumbents. We illustrate a similar phenomenon in the context of a German auction for capacity, conducted in October 1999.

The above insight suggests that auctioning the maximum possible number of licences need not induce a higher degree of competitiveness. Restricting supply is a way to combat tacit collusion and induce more entry. Another way to combat tacit collusion is to use sequential auctions with some supply uncertainty about future licences. In some cases, this format induces more entry than supply restriction. Olfhqvh Dxfwlrqv dqg Pdunhw Vwuxfwxuh

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55 91 Dsshqgl{

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58 :1 Uhihuhqfhv

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1

0.8

0.6

0.4

0.2

1 1.5 2 2.5 3 3.5 4 delta

Iljxuh 4

0.6

0.5

0.4

0.3

0.2

0.1

0 1234 market structure parameter d

Iljxuh 5

5; 0.4

0.3

N 0.2

0.1

0 0.2 0.4 0.6 0.8 1 prob. p

Iljxuh 6

5<