Date created: 26 March 1997

Last modified:18 December 2002



Maintained by: John Quiggin

How cable tied profits in knots

Mar 26 1997

Recent reports suggest that the great cable war between Telstra and Optus may finally be coming to an end. The cable war has cost ordinary Australians billions of dollars as consumers of telecommunications services and as taxpayer-owners of Telstra. Economists can at least have the satisfaction that some basic lessons of micro-economics have been reaffirmed.

The first lesson is that competition is not always better than monopoly. This lesson was first learned in the 19th Century, when competing railway companies built parallel sets of tracks linking the same destinations. It rapidly became apparent that railway tracks were an example of natural monopoly, where a good or service was most efficiently provided by a single firm.

In the recent flush of enthusiasm for competition, many have claimed that technological change has rendered the category of natural monopoly obsolete. Telstra and Optus have provided us with a graphic demonstration that this is not so. Their parallel sets of cables are technically inferior to what could have been provided by a single supplier. The service is drastically inferior. Two separate connections are required to gain access to content that could easily be carried by a single cable. Environmental considerations have been being sacrificed to speed of rollout, but, because both companies are racing to serve the same areas, the provision of services is proceeding more slowly than under monopoly.

The fact that two sets of cables represent a massive waste of resources is obvious, but not obvious enough for successive telecommunications ministers. Michael Lee vigorously defended duplication in these pages  (9 Jan 1996) and Richard Alston has taken much the same view. So Telstra and Optus have provided us with a homely illustration in the form of duplicate Rugby League competitions. Obviously, one league with all the top teams would be better than the two parallel leagues we have. The fans can see it, and are staying away in droves. Yet the whole Super League fiasco is only possible because of the Federal Court's ruling that the ARL contracts guaranteeing a single league were anti-competitive.

A second lesson is that competition between two firms is not the same as competition involving many firms. The most striking illustration may be seen in the the market for long-distance phone calls, where duopoly competition has failed to producea general reduction in prices.

When Optus was admitted to the market, Telstra was regulated by a price cap which required that, at worst, consumers as a group should do no worse under competition than they would have done under continuation of the Telstra monopoly. The cap required that average prices should change each year by CPI-X, where X was set equal to the real rate of reduction in prices observed prior to deregulation. Telstra has met its price cap exactly, reducing average prices by the amount required by law and no more. Within this average, there has been considerable variation. Consumers most likely to switch to Optus have received special deals while, until recently, consumers on the standard STD rate got nothing. This is exactly what would be expected from a regulated monopolist. Optus has done exactly what would be expected of the junior partner in such a situation (what economists call a Stackelberg follower). It has set its prices just below those of Telstra and picked up as many as possible of the high profit customers.

With these lessons in mind, we can begin to answer the most puzzling question of all. Why have Telstra and Optus been willing to burn billions of dollars in such an obviously wasteful exercise as cable duplication ? The basic answer is that their duopoly position in the long-distance market gives them money to burn. Duopoly profits have been used to subsidise loss-making cable operations. Neither Telstra nor Optus would benefit from a reduction in prices, but Telstra in particular would be subject to regulatory pressure to cut prices if its profits rose too rapidly. In these circumstances, duopolists typically look for a mechanism for holding prices up while ensuring that the other party does not cheat. Investment in a set of duplicate cables is an ideal mechanism in this respect, since there is no scope for cheating.

Finally, it is not surprising that peace talks are happening now. Optus had five years in which to convert its temporary privilege as Telstra's only competitor into a permanent 'first mover' advantage. A deal with Telstra, giving Optus part-ownership of a unified cable network would be just such an advantage. For Telstra, the central objective must be to gain a strong position while not being classed as a dominant firm, and therefore tightly regulated. A deal with Optus could fit the bill.

The lessons for the future are clear. The fact that local telephone and cable services are natural monopolies cannot be wished away. The solution is not duplication, but a regulated common carrier with appropriate access rules.

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