Mandatory Unbundling and Irreversible Investment in Telecom Networks

This paper addresses the impact on investment incentives of the network sharing arrangements mandated by the Telecommunications Act of 1996, with a focus on the implications of irreversible investment. Although the goal is to promote competition, the sharing rules now in place reduce incentives to build new networks or upgrade existing ones. Such investments are irreversible -- they involve sunk costs. The basic framework adopted by regulators allows entrants to utilize such facilities at prices reflecting what it would cost a new, efficient, large-scale network to be built. Such sharing opportunities are extensive, covering virtually the entire suite of network services provided, and extremely flexible, as the entrant can rent facilities in small increments for short duration, with no long-term contracts required. Because the entrant does not bear the sunk costs, this leads to an asymmetric allocation of risk and return that is not properly accounted for in the pricing of network services, which creates a significant investment disincentive.

Uncertainty in Environmental Economics

In a world of certainty, the design of environmental policy is relatively straightforward, and boils down to maximizing the present value of the flow of social benefits minus costs. But the real world is one of considerable uncertainty, over the physical and ecological impact of pollution, over the economic costs and benefits of reducing it, and over the discount rates that should be used to compute present values. The implications of uncertainty are complicated by the fact that most environmental policy problems involve highly nonlinear damage functions, important irreversibilities, and long time horizons. Correctly incorporating uncertainty in policy design is therefore one of the more interesting and important research areas in environmental economics. This paper offers no easy formulas or solutions for treating uncertainty, to my knowledge, none exist. Instead, I try to clarify the ways in which various kinds of uncertainties will affect optimal policy design, and summarize what we know and don't know about the problem.

The Present Value Model of Rational Commodity Pricing

The present value model relates an asset's price to the sum of its discounted expected future payoffs. I explore the limits of the model by testing its ability to explain the pricing of storable commodities. For commodities the payoff stream is the convenience yield that accrues from holding inventories, and it can be measured directly from spot and futures prices. Hence the model imposes restrictions on the joint dynamics of spot and futures prices, which I test for four commodities. I find close conformance to the model for heating oil, but not for copper or lumber, and especially not for gold. The pattern is the same for the serial dependence of excess returns, These results suggest that for three of the four commodities, prices at least temporarily deviate from fundamentals.

Investments of Uncertain Cost

I study irreversible investment decisions when projects take time to complete, and are subject to two types of uncertainty over the cost of completion. The first is technical uncertainty, i.e., uncertainty over the amount of time, effort, and materials that will ultimately be required to complete the project, and that is only resolved as the investment proceeds. The second is input cost uncertainty, i.e., uncertainty over the prices and quantities of labor and materials required, and which is external to the firm's investment activity. I derive a simple decision rule that maximizes the firm's value, and I use it to show how these two types of uncertainty have very different effects on investment decisions. As an example. I analyze the decision to start or continue building a nuclear power plant during the 1980's.

Pricing Capital Under Mandatory Unbundling and Facilities Sharing

The regulation of telecommunications, railroads, and other network industries has been based on mandatory unbundling and facilities sharing - entrants have the option to lease part or all of incumbents' facilities if and when they desire, at rates determined by regulators. This flexibility is of great value to entrants, but because investments are largely irreversible, it is costly to supply by incumbents. However, pricing formulas used by regulators to set lease rates for capital do not compensate incumbents for this flexibility, so that incumbents are effectively forced to subsidized entrants, discouraging further investments. This paper shows how pricing formulas used to set lease rates can be adjusted to account for the transfer of option value from incumbents to entrants, and estimates the average size of the adjustment for land-based local voice telecommunications in the U.S.

Irreversible Investment, Capacity Choice, and the Value of the Firm

A model of capacity choice and utilization is developed consistent with value maximization when investment is irreversible and future demand is uncertain. Investment requires the full value of a marginal unit of capacity to be at least as large as its full cost. The former includes the value of the firms option not to utilize the unit, and the latter includes the opportunity cost of exercising the investment option. We show that for moderate amounts of uncertainty, the firm's optimal capacity is much smaller than it would be if investment were reversible, and a large fraction of the firm's value is due to the possibility of future growth. We also characterize the behavior of capacity and capacity utilization, and discuss implications far the measurement of marginal cost and Tobin's q.

Uncertainty In Environmental Economics

In a world of certainty, the design of environmental policy is relatively straightforward, and boils down to maximizing the present value of the flow of social benefits minus costs. But the real world is one of considerable uncertainty -- over the physical and ecological impact of pollution, over the economic costs and benefits of reducing it, and over the discount rates that should be used to compute present values. The implications of uncertainty are complicated by the fact that most environmental policy problems involve highly nonlinear damage functions, important irreversibilities, and long time horizons. Correctly incorporating uncertainty in policy design is therefore one of the more interesting and important research areas in environmental economics. This paper offers no easy formulas or solutions for treating uncertainty -- to my knowledge, none exist. Instead, I try to clarify the ways in which various kinds of uncertainties will affect optimal policy design, and summarize what we know and don't know about the problem.

Governance, Issuance Restrictions, And Competition In Payment Card Networks

I discuss the antitrust suit brought by the U.S. Department of Justice against Visa and MasterCard in 1998. Banks that issue Visa cards are free to also issue MasterCard cards, and vice versa, and many banks issue the cards of both networks. However, both Visa and MasterCard had rules prohibiting member banks from also issuing the cards of other networks, in particular American Express and Discover. In addition, most banks are members of both the Visa and MasterCard networks, so governance is to some extent shared. The DOJ claimed that restrictions on issuance and shared governance were anticompetitive and should be prohibited. Visa and MasterCard argued that these practices were procompetitive. The case raised important questions: Given that many banks issue both Visa and MasterCard, and that most merchants that accept one also accept the other, do the two networks really compete, and if so, how? And do Visa and/or MasterCard have market power, if so, in what market, and how is it exercised?

Risk Aversion and Determinants of Stock Market Behavior

A simple model of equity pricing is developed to address two related questions. First, to what extent can unanticipated changes in such"fundamental" variables as profitability, real interest rates, inflation, and the variance of returns account for the observed behavior of the stockmarket? Second, how risk averse are investors in the aggregate?We find that the pretax profit rate and the variance of returns are both significant explanators of the market, and interest rates somewhat less so. Estimates of the index of relative risk aversion are obtained that put that parameter in the range of 3 to 4.