Entry, Cream Skimming, and Competition: Theory and Simulation for Chile's Local Telephony Market

Abstract

After privatizing local exchange companies (LEX), many countries are introducing competition in local telephony in order to encourage both allocative and productive efficiency. However, enormous sunk costs, and scale, scope and network economies cannot guarantee perfect competition. This paper shows that depending upon characteristics of the market - such as market structure or demand - competition may be complete, partial, or even nonexistent. We use a game theoretical three-step model in which an entrant firm cream skims the market. We illustrate our results by using consistent Chilean data, and the model predicts that Chile's local telephony market will not become a deeply competitive market. This result is robust to changes in the model, in particular to price cap regulation. This model provides us with two interesting economic policy conclusions. First, cream skimming makes more profitable the entrance in the market, but this practice reduces the possibility of full competition in the market. Second, Santiago's local telephony market should not be fully liberalized in the near future and prices of the dominant firm should still be regulated.