Among U.S. states, New York has been a leader in promoting competition among firms providing local telephone service. But liberalization does not mean instant deregulation. There is still a messy transition phase to go through, especially on the details of interconnection. The question is, does liberalization of telecommunications mean libertarianism, with no governmental regulatory role? And beyond, if there is free entry into all sectors of telecommunications, what will happen?
It is useful to conceptualize telecommunications networks as shown in Figure 4A. Network size is presented on the horizontal axis. The vertical axis indicates the cost of services provided and their utility to the consumer in terms of dollars. Two curves are shown. One is the average cost curve, and one is the benefit, or utility, curve. The average cost curve implies that a network is, in effect, a cost-sharing arrangement, with the burden of cost collectively assumed by users. Networks have a fairly significant fixed cost. As more users join the network the fixed cost is spread evenly over the various users, and the average cost decreases. But, as the network expands, higher-marginal-cost users join the network and the average cost starts to increase. The result is a U-shaped curve for most cost-functions. The curve for participating in the network increases with the number of people on the network. This is due to the positive externalities of network usage. These externalities tend to flatten out as the network reaches a certain size.
There are a number of distinct regions on Figure 4A. Prior to the point where the two curves intersect, cost is higher that utility. Therefore, somebody—either government or private investors expecting a future return—will have to subsidize the network. Beyond the intersection point, there is a region of self-sustaining growth. Beyond the point where the distance between the two curves is at a maximum, there is a range in which the network, left to the decision process of the users, would not grow, because costs are going up faster than utility and thus the net benefits decrease. Eventually, net benefits become negative when the curves again intersect.
This suggests that there are three areas where there will be problems (Figure 4B). We start with the first region on the left, where there is a critical mass problem. In the early stages of a network arrangement, funds for investment must be garnered because the cost of the system is higher than the benefits returned. In the traditional regime, this investment was done by the network monopolist itself. France Telecom, for example, put ample sums of money into Minitel, even giving away the terminals to its customers. Why? Because eventually the combined critical mass of users would be sufficient for everybody to benefit from the network, including its owner, France Telecom.
But, if that is a reasonable approach for a monopoly, it often will not work in a competitive environment because of the possibility of interconnection. A rival company can interconnect with a company's network and benefit from its rival's accumulated critical mass of customers without having made the up-front investments itself.