Termination-Based Price Discrimination: Tariff-Mediated Network Effects and the Fat-Cat Effect + Jörg Claussen a, Moritz Trüg b, Leon Zucchini b * a Ifo Institute Munich, Poschingerstr. 5, D-81679 Munich b Munich School of Management, Ludwig-Maximilians-University Munich, Schackstr. 4/III, D-80539 Munich Working Paper December 2011 * Acknowledgements. The authors gratefully acknowledge helpful comments from Christoph Dehne, Tobias Kretschmer, David Sauer, and participants at the TIME Colloquium at the University of Munich. + Corresponding author: [email protected] Termination-Based Price Discrimination: Tariff-Mediated Network Effects and the Fat-Cat Effect A B S T R A C T Mobile telecommunications operators routinely charge higher prices for off-net than on-net calls. Previous research provides two alternative propositions on whether on-net / off-net price differentials (OOD) are more attractive for large or for small operators. On the one hand studies on tariff-mediated network effects suggest that large operators use OOD to damage smaller rivals. On the other hand research on consumer behavior suggests that small operators may use OOD to attract customers with low on-net prices, trapping large operators with the “Fat-cat effect”. We test the relative strength of the two effects using data on tariff setting in the German market for mobile telecommunications from 2004 to 2009. We find that large operators are more likely to offer tariffs with OOD but that there is no significant difference between large and small operators in the magnitude of the differentials. Our findings support the proposition that large firms use tariff-mediated network effects as a competitive instrument, but also suggest the alternative theory may have some merit. Keywords: Telecommunications, Competition, Network effects, Customers, Pricing JEL: D22, L11, L96 1 1. Introduction Mobile telecommunications operators routinely charge their customers a higher price per minute for calls to subscribers on their own network (on-net) than for calls to subscribers on other networks (off-net). This “termination-based price discrimination” is interesting because it lowers compatibility between mobile operators‟ networks, creating co-called “tariff- mediated network effects” (Laffont et al., 1998). As telecommunications markets are subject to network externalities, compatibility is of key importance for competition and can strongly influence market structures and profitability (Katz and Shapiro, 1994). Understanding how firms use termination-based price discrimination is therefore important for scholars, managers and policy makers. Termination-based price discrimination is also interesting because previous research offers two alternative propositions on whether it is used by large or by small telecommunications operators. On the one hand, research on tariff-mediated network effects suggests that termination-based price discrimination is used by large network operators because it allows them to use their superior installed base to force small operators out of the market or prevent them from entering in the first place (Laffont et al., 1998; Hoernig, 2007). On the other hand, research on marketing and consumer behavior suggests that it is favored by small operators because it allows them to advertise with low on-net prices while recouping profits with high off-net prices (Haucap and Heimeshoff, 2011). Imitating this strategy is costly for large operators due to the “Fat-fat effect” (Fudenberg and Tirole, 1984). To our knowledge there is no systematic empirical test for whether one of these two effects is dominant, i.e. whether termination-based price discrimination is used predominantly by small or large operators. Our study addresses this gap using data on tariffs in the market for German mobile telecommunications from 2004 to 2009. We find that large operators are more likely to offer tariffs with on-net / off-net price differentials, but that the relative discount for on-net calls is not significantly different between large and small operators. Our findings suggest that tariff-mediated network effects are the dominant effect, but also conclude that the fat-cat argument may have some merit in our empirical setting. Our study contributes to research on termination-based price discrimination by empirically testing whether large or small firms are more likely to use it, allowing us to draw tentative conclusions about alternative explanations for the phenomenon. We also contribute to research on tariff-mediated network effects by providing evidence that they are taken into account for firm strategies. 2 The remainder of the paper is organized as follows. Section 2 reviews the related literature and describes the two alternative mechanisms proposed in previous research. We describe our data and research methods in Section 3 and present our results in Section 4. Section 5 concludes. 2. Tariff-Mediated Network Effects and the Fat Cat Effect 2.1 Tariff-Mediated Network Effects Telecommunications is a standard example for an industry with direct network effects, and a considerable body of research has investigated how they affect competitive behavior and welfare (Katz and Shapiro, 1994; Koski and Kretschmer, 2004). Generally, telecommunications operators charge consumers for their services using tariffs that comprise several price components like monthly fixed fees, minute prices per call, prices per text message, etc. In some of these tariffs they charge customers a lower per-minute price for calls to subscribers on their own network than for calls to subscribers on rival networks. This practice of using “on-net / off-net price differentials” (OOD) is known as termination-based price discrimination (Berger, 2004). There has been concern among both scholars and regulators that OOD may be used by telecommunications operators as an anticompetitive instrument (Harbord and Pagnozzi, 2010; Hoernig, 2008), and a substantial body of theoretical research on tariff-mediated network effects has broadly supported this prediction. Some studies even go so far as to call for regulation (Gerpott, 2008). The basic argument is that in telecommunications markets consumers derive utility from being able to call other consumers on their own or other networks (Katz and Shapiro, 1985). If the networks are perfectly compatible, welfare simply increases with the number of mobile consumers. However, if there are several network operators competing for market shares, they may have incentives to reduce compatibility to other operators using OOD, creating what are known as “tariff-mediated network effects” (Laffont et al., 1998). In markets with symmetric operators, studies have demonstrated that operators will use OOD to reduce the attractiveness of the rival networks (Jeon et al., 2004). In markets with asymmetric operators scholars have found that the problem of tariff- mediated network effects is exacerbated. There, theoretical work has demonstrated that large operators can use OOD as an anticompetitive instrument to damage their smaller rivals or to forestall market entry (Jeon et al., 2004). By charging higher prices for off-net than for on-net calls, large operators can reduce the number and duration of calls received on the smaller operators‟ networks. This enables them to leverage their larger installed base and make the 3 smaller rivals‟ networks less attractive (Hoernig, 2007). Consequently, the small operators attract less customers than the large operators and the large operators grow even larger (Cabral, 2011). If termination prices are a strategic variable as well, the situation is even worse. In this case the price differential by the large operator will result in a call imbalance between the networks as more calls are placed from the small to the large operator than vice versa. This in turn will result in a net outflow of termination fees for the small operator, further reducing their profits (Hoernig, 2007).1 In addition to using OOD as a predatory pricing mechanism against existing smaller competitors, large operators may also use them to forestall entry. Scholars have argued that if OOD are sufficiently large they make new operators with small installed bases less attractive (less incoming calls). Consequently, building up an installed base is more difficult and makes entry less attractive for potential rivals (Calzada and Valletti, 2008). This mechanism is also stronger if there is a corresponding rise in termination prices (Harbord and Pagnozzi, 2010). The theoretical results concerning tariff-mediated network effects rely on the assumption that there are significant network effects in telecommunications markets. This is supported by a number of empirical studies. In addition to direct tests of network effects (Doganoglu and Grzybowski, 2007), there are several which analyze the influence of tariff-mediated network effects on consumer choice and generally conclude they play a significant role. For example, Birke and Swann (2006) find that in British mobile telecommunications consumers‟ choice of operator is related to the size of the operator‟s previous installed base, and that consumers make a disproportionate number of calls are on their own network. This strongly suggests that consumers‟ utility from subscribing to a mobile network is influenced by its size, i.e. by network effects. Similar results are reported by Kim and Kwon (2003) and Fu (2004) for the mobile telecommunications markets in South Korea and Taiwan, respectively. In summary, research on tariff-mediated