Service Bundling and the Role of Access Charge in the Broadband Internet Service Market

Abstract

Using the classical Hotelling model, this paper analyzes the incentive for a CATV service provider to bundle broadband internet services when entering the broadband internet services market. In addition, the effect of such service bundling by an entrant on the market incumbent with ownership over existing bottleneck facilities is analyzed. Furthermore, an access charge that maximizes social welfare is explored and determined. Two cases are considered: in the first case, the market is fully covered; and in the second case, the market is not fully covered. With full market coverage, an entrant has an incentive for service bundling if there is sufficient service differentiation. The entrant's bundling strategy reduces the incumbent's profit. In this case, the total social welfare is independent of the level of the access charge and only has an effect of redistributing the net surplus between consumers and the incumbent. With partial market coverage, the entrant has an incentive for service bundling at a low access charge. The incumbent's profit increases if the access charge is higher than the cost of access provisioning. In this case, the total social welfare is dependent on the level of access charge and the welfare maximizing access charge is less than the unit cost of providing access.

Full text

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MPRA
Munich Personal RePEc Archive
Service Bundling and the Role of Access
Charge in the Broadband Internet
Service Market
SHIM, Sunghee and OH, Jungsuk
COMMUNICATIONS & STRATEGIES
September 2006
Online at http://mpra.ub.uni-muenchen.de/3553/
MPRA Paper No. 3553, posted 07. November 2007 / 03:17

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COMMUNICATIONS & STRATEGIES, no. 63, 3rd quarter 2006, p. 73.

Service Bundling and the Role of Access Charge
in the Broadband Internet Service Market (*)
Sunghee SHIM
Seoul National University, Seoul, Republic of Korea
Jungsuk OH
KAIST, Seoul, Republic of Korea



Abstract: Using the classical Hotelling model, this paper analyzes the incentive for a
CATV service provider to bundle broadband internet services when entering the
broadband internet services market. In addition, the effect of such service bundling by an
entrant on the market incumbent with ownership over existing bottleneck facilities is
analyzed. Furthermore, an access charge that maximizes social welfare is explored and
determined. Two cases are considered: in the first case, the market is fully covered; and in
the second case, the market is not fully covered. With full market coverage, an entrant has
an incentive for service bundling if there is sufficient service differentiation. The entrant's
bundling strategy reduces the incumbent's profit. In this case, the total social welfare is
independent of the level of the access charge and only has an effect of redistributing the
net surplus between consumers and the incumbent. With partial market coverage, the
entrant has an incentive for service bundling at a low access charge. The incumbent's
profit increases if the access charge is higher than the cost of access provisioning. In this
case, the total social welfare is dependent on the level of access charge and the welfare
maximizing access charge is less than the unit cost of providing access.
Key words: cable TV; broadband internet service; bundling; access charge; convergence.

ith the rapid growth of information and telecommunications
technologies, the process of convergence between media and
telecommunications service industries is accelerating. Many
predictions in the 1990s on "telephone company entry into cable television"
(JOHNSON, 1993) and "cable TV entry into telephony" (KIM, 1996) have
already been fulfilled. Such convergence
telecommunications services demonstrates that competitive forces from
other industries can crowd into a once monopolistic market.
between media and

(*) We wish to thank and acknowledge Prof. Jae-Hyeon AHN of KAIST Graduate School of
Information & Media Management for his critical comments and support throughout the entire
development process of this paper.
W

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74 No. 63, 3rd Q. 2006
The entrance of cable TV companies into the telecommunications
services market is one such example. In the Republic of Korea, System
Operators (SOs), who had been providing only cable TV service to their local
areas, have recently begun to provide bundled high-speed internet access
services, utilizing their cable TV network infrastructure. However, in order to
provide local areas with broadband internet services 1, SOs need access to
various facilities belonging to incumbent telecommunications firms, including
backbone networks, ducts, poles, conduits, and right of way. In response to
the SO's swift penetration into the internet service market (Electronic Times,
2003), incumbent internet service providers (major telcos) have been trying
to increase usage fees for bottleneck facilities 2. In return, SO's have been
accusing the incumbent providers of antitrust behavior. Under such
circumstances, a governmental policy on access and access charges for
bottleneck facilities is of focal interest.
One major issue that has not been clearly taken up is the impact of
service bundling on the competitive behavior of the firms involved. As in the
above example, an entrant's bundling strategy of leveraging its monopoly
power in another market is likely to conflict with an incumbent's defending
strategy of restricting access to components that are essential to
competitors. According to the leverage theory, a monopolist in a particular
market can dominate a second market by leveraging its monopoly power,
thereby weakening fair competition in the second market. However, this
leverage theory has been criticized by many, including POSNER (1976),
BORK (1978), and SCHMALENSEE (1982). It has been argued that
although a monopoly firm in a particular market can extend its monopoly
power by bundling in another perfectly competitive market, this firm cannot
increase its own profit by doing so. In this case, bundling has been regarded
as a tool for price discrimination instead of as an anti-competitive behavior.
In contrast to this criticism, there are several recent studies claiming that
bundling may exclude competition and affect firms' profit and welfare levels.
WHINSTON (1990) and CARLTON & WALDMAN (2002) point out that if a
monopolistic firm in one market is also an incumbent in another market with

1 In particular, most rights of way and facilities such as ducts, poles, and conduits belong to a
leading Korean telecommunications service firm, which also provides internet access service
using xDSL technology.
2 Incumbent providers also accuse SOs of breach of contract. In particular, they argue that SOs
should not provide high-speed internet access service using their essential facilities, since the
original contract specifies that only a cable TV service will be provided via these essential
facilities.

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S. SHIM & J. OH 75
an oligopoly structure, tying can exclude the entry of potential competitors,
by extending the firm's monopoly power. CARBAJO et al. (1990) and
DENICOLO (2000) suggest that bundling can be utilized as a strategic
device for product differentiation and market segmentation, resulting in a
relaxation of price competition. Moreover, such a strategic bundling can
contribute to enhanced profitability 3.
In our opinion, however, even if SO's are monopolistic in their local cable
TV market, they are in a relatively weak position in the broadband internet
market in that they must utilize an incumbent's essential facilities for
broadband internet service provisioning. This situation is a typical example
of a one-way access model. ARMSTRONG (1998) defines one-way access
as "a setting where a firm monopolizes an input or group of inputs which is
needed by all firms". In such a case, "there is the obvious danger that a
network operator controlling key inputs will seek to exclude competitors by
setting a high access price" (ARMSTRONG et al., 1996). Thus, regulation
with regard to access charges is required to ensure socially desirable results
(ARMSTRONG, 1998; LAFFONT & TIROLE, 2000).
To address these market conditions, this paper develops a simple
duopoly model, in which an entrant competes with an incumbent by offering
a bundled service, while utilizing a one-way access that the incumbent
possesses. Our model setting is similar to that of WHINSTON (1990), with
two key differences. Firstly, while a monopolistic firm in a market is an
incumbent in the other market in Whinston's model, our model assumes a
setting where a monopolistic firm in one market is an entrant in a new
market. Secondly, the aforementioned one-way access setting is
incorporated.
Most analyses utilizing the Hotelling location competition model have
assumed full market coverage (WHINSTON, 1990; ARMSTRONG, 1998;
FOROS et al.. 2001). In other words, these analyses implicitly assumed that
consumers' valuation for services offered by the market were sufficiently
high enough that all consumers subscribe to one service or the other. Under
this assumption, profits and market shares of two firms are dependent upon
the price differential. Thus, an interaction between two firms is explicitly
incorporated in the model. In contrast, when the market is not fully covered,
each firm behaves monopolistically within its respective local market. In this
case, an interaction between two firms via price diffential is not explicitly

3 Refer to CHOI (2004) for a summary of research issues and results on leverage of tying.

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76 No. 63, 3rd Q. 2006
present. On the other hand, since an entrant must have an access to an
incumbent's essential facilities, an explicit interaction between two firms via a
one-way access charge is present in both cases.
Our model can be applied to a number of other telecommunications and
media convergence contexts. For example, CATV SO's are also entering the
voice telephony market with the upcoming VOIP service as part of their
"triple service" plan along with the aforementioned broadband internet
service. Following a similar logic to the broadband internet service market
case, entrant SO's need to pay an access charge to incumbent telcos; the
determination of the level of this access charge and its impact is a focal
policy issue.
As another example, a Korean mobile carrier has just launched a service
enabling subscribers to the mobile service to initiate or receive voice calls at
the wireline telephony rate when these calls are initiated or received in the
vicinity of their wireline telephone terminal. In this case, the mobile carrier is
bundling its wireless telephony service with an additional cheapter mobile –
wireline telephony service, in which case the mobile carrier needs to pay the
access charge to the wireline service carrier. Consequently, the wireline
carrier is in direct competition with the mobile carrier in its market due to the
mandated interconnection duty imposed on the wireline carrier. Since the
launch of this service in 2006, the determination of the level of access
charge for both inbound and outbound calls for this mobile carrier, and
eventually, the level of access charge for all telecommunications services,
has been an active policy issue in the Korean telecommunications market
(MUNHWAILBO, 2006).
In this paper, along with a model for bundling incentives, the following
issues are addresed. Firstly, we explore whether there is an incentive to
enter a broadband internet access market by bundling, and, if so, under
what conditions these incentives exist. In addition, we explore how a cable
TV provider's penetration into the market by bundling affects the incumbent.
We subsequently examine how social welfare is affected by the level of the
access charge for bottleneck facilities and determine an optimal level of
access charge for maximizing social welfare.