Vertical integration in telecommunications and foreclosure: The role of quality and the long run

Abstract

It is known in regulatory economics the incentive that a vertically integrated company in the telecommunications sector, owning a local and a long distance network, has to foreclose interconnecting competitors in the long distance market in its local loop bottleneck. This occurred in the US telecommunications market, given the dependence of the new long distance competitors (MCI and Sprint) on the AT&T local networks to connect with end users. Aiming to avoid these problems and introduce competition at least in the long distance segment, the telecom reform in Brazil reduced the previous verticalization of the state-owned company TELEBRAS before privatization. We introduce a model that shows the incentive of the incumbent to reduce the quality of the call provided by the entrant through interconnection in a linear city model of the Hotelling type. The incentive to reduce quality, however, is not absolute and there is an incentive to leave the entrant operating in a given portion of the market. On the other hand, when we introduce long run considerations, the incentive to reduce quality can become absolute in the sense of not allowing entry anyway. The crucial hypothesis is that the entry in the long distance segment in the short run provides the basis for that, through a learning process, the entrant enters also in the local service in the long run. This shows the requirement of a strong monitoring by the regulator over interconnection quality.