Supplementary Expert Report of Janusz A. Ordover and Allan L. Shampine

65 Pages·2017·1 MB·English

Supplementary Expert Report of
Janusz A. Ordover and Allan L. Shampine
August 24, 2017
I. QUALIFICATIONS AND QUESTIONS TO BE ADDRESSED ..................................................................... 1
A. JANUSZ A. ORDOVER ............................................................................................................................................. 1
B. ALLAN L. SHAMPINE .............................................................................................................................................. 1
C. QUESTIONS TO BE ADDRESSED .............................................................................................................................. 2
D. ACKNOWLEDGEMENT............................................................................................................................................. 5
II. FIRMS LIKE NBN CAN BE EXPECTED TO ENCOURAGE TAKE-UP AND USAGE AND
EXPERIMENT WITH PRICING ........................................................................................................................ 5
III. NBN’S PRICE CHANGES AND CONSULTATIONS ARE CONSISTENT WITH OUR
EXPECTATIONS FROM EFFICIENT OPERATION OF THE SAU ......................................................... 10
IV. IMPOSING NEW PRICE REGULATION ON THE MTM WOULD DISTORT INVESTMENT
INCENTIVES, RAISE PROBLEMS OF REGULATORY OPPORTUNISM, AND DISCOURAGE
INVESTMENT ........................................................................................................................................................ 13
V. DECLARATION ..................................................................................................................................................... 20
I. QUALIFICATIONS AND QUESTIONS TO BE ADDRESSED
A. Janusz A. Ordover
1. My name is Janusz A. Ordover. I am Professor of Economics Emeritus and
former Director of the Masters in Economics Program at New York University, where I have
taught since 1973. During 1991-1992, I served as Deputy Assistant Attorney General for
Economics at the Antitrust Division of the United States Department of Justice. As the chief
economist for the Antitrust Division, I was responsible for formulating and implementing the
economic aspects of antitrust policy and enforcement of the United States, including co-drafting
the 1992 U.S. Department of Justice and Federal Trade Commission Horizontal Merger
Guidelines. I also had ultimate responsibility for all the economic analyses conducted by the
Department of Justice in connection with its antitrust investigations and litigation, including
economic analyses of collusion and other anticompetitive industry practices. I have written and
consulted in the telecommunications sector and other network industries in the US, Australia,
New Zealand, and in the EU on behalf of private parties as well as regulators. In February 2011,
I was the recipient of Global Competition Review’s Economist of the Year award. In 2014, 2015
and 2016, I was awarded the Who’s Who Legal Competition Economist Award, which is
awarded to one economist each year and is the organization’s top economist award. A copy of
my curriculum vitae is attached as Exhibit 1.
B. Allan L. Shampine
2. My name is Allan L. Shampine. I am an Executive Vice-President of Compass
Lexecon, an economic consulting firm. I received a B.S. in Economics and Systems Analysis
summa cum laude from Southern Methodist University in 1991, an M.A. in Economics from the
University of Chicago in 1993, and a Ph.D. in Economics from the University of Chicago in
1996. I have been with Compass Lexecon (previously Lexecon) since 1996. I specialize in
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applied microeconomic analysis and have done extensive analysis of network industries,
including telecommunications and payment systems. I am the editor of the book Down to the
Wire: Studies in the Diffusion and Regulation of Telecommunications Technologies, and I have
published a variety of articles on the economics of telecommunications and network industries
and on antitrust issues. I am an editor of the American Bar Association Journal Antitrust Source.
I have previously provided economic testimony on telecommunications and other issues for the
United States Federal Communications Commission, International Trade Commission, New
York Public Service Commission, Federal Maritime Commission, Patent and Trademark
Office’s Patent Trial and Appeal Board, arbitrators and district courts, and the European
Commission, Korean Fair Trade Commission, Chinese National Development & Reform
Commission, Info-Communications Development Authority of Singapore, and the Australian
Competition & Consumer Commission (“ACCC”). A copy of my curriculum vitae is provided
as Exhibit 2.
C. Questions to be Addressed
3. We have previously been asked by counsel for nbn (formerly known as NBN Co
Limited and referred to in our initial report as “NBN Co”) to provide our advice on whether
certain aspects of nbn’s 2012 proposed Special Access Undertaking (“SAU”) would provide
appropriate incentives for, and constraints on, nbn over the term of the SAU. In particular, we
were asked to provide our expert opinion on whether, in the context of a vertically separated,
wholesale-only network provider such as nbn, the proposed SAU was likely to lead to efficient
investment, an efficient level of costs, and efficient and not anti-competitive pricing. We
concluded that the 2012 proposed SAU provided for commonly observed, reasonable and
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effective methods of achieving the goals set forth by the Australian Government.1 In particular,
we concluded that the SAU provides correct incentives for durable sunk investment, such as the
billions of dollars required to build and maintain the National Broadband Network. The
specified and regulated NBN Offers provide assurance to potential customers that encourage
take-up and investment, and the modular nature of the SAU allows adaptation to changing
circumstances expected in a dynamic industry such as telecommunications.
4. We were subsequently briefed in respect of the addition of new technologies into
the nbn technology mix – the optimized multi-technology mix (“MTM”).2 Under the MTM, nbn
will determine which technologies are utilized on an area-by-area basis to minimize peak
funding, optimize economic returns and enhance the Company’s viability. We were asked to
provide our advice on whether or how the Government’s transition of nbn from a predominantly
fiber to the premises (“FTTP”) model (along with some fixed wireless and satellite services) to
the MTM model (which adds Fiber-to-the-Node/Basement or “FTTN/B” and hybrid fiber-
coaxial cable or “HFC” technologies) would impact our original expert views. We concluded
that the new structure with the MTM did not alter our conclusions. Because nbn is a wholesale-
only entity prohibited from offering retail services, many of the most vexing concerns that often
arise in designing and policing a regulatory scheme for a vertically integrated access provider do
not apply. nbn has appropriate incentives to ensure its customers are successful, as that will
increase demand for nbn’s own services and the concomitant revenue flow. That is, given nbn’s

1. Expert Report of Janusz A. Ordover and Allan L. Shampine, September 24, 2012.
https://www.accc.gov.au/system/files/Expert%20Report%20of%20Janusz%20A.%20Ord
over%20and%20Allan%20L.%20Shampine.pdf.
2. Expert Report of Janusz A. Ordover and Allan L. Shampine, March 24, 2016.
https://www.accc.gov.au/system/files/Ordover%20and%20Shampine%20expert%20repor
t.pdf.
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operation as a wholesale-only entity and the other regulatory structures we discussed in our
initial report, the MTM did not raise any new concerns with respect to pricing, discrimination
against or between customers, or investment. Rather, under the SAU and the MTM, nbn will
have incentives to meet the policy goals it is presented with – to use existing infrastructure in an
efficient manner while providing services that meet the specified expectations.
5. We understand that a Revised SAU Variation has been lodged on 22 June 2017
that includes some changes to non-price terms. We understand that no substantive changes have
been made to the structural or price aspects of the SAU which we have previously analyzed, and
note that the SAU variation does seek to extend the operation of the price aspects of the SAU to
MTM. Nevertheless, we understand that the ACCC has sought to consult with industry on
certain aspects of nbn’s pricing construct. In this regard, we have been asked (in the attached
instructions) to consider the following issues:
• Please advise on the types of behaviors that you would typically expect to see of a
wholesale only entity in nbn’s position facing sufficient incentives to price in an
economically efficient manner, including to encourage the take-up and usage of
its services and the achievement of its cost recovery objectives.
• To what extent do nbn’s recent changes to the CVC price (including those
implemented through the DBD scheme) and its current review of its pricing
construct as part of its Pricing Evolution Review suggest that the incentives that
are faced by nbn are working effectively in practice?
• To what extent will the current regulatory approach of relying on nbn’s incentives
and the structural aspects and regulatory backstops in the SAU, along with nbn’s
use of customer engagement and co-design approaches in relation to the review of
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its pricing, deliver economically efficient outcomes relative to alternative forms
of regulatory intervention in relation to nbn’s prices for MTM wholesale services?
6. In this Supplementary Expert Report, we do not repeat our prior discussions, nor
all our citations of the economic literature – the detailed bases for the conclusions in our prior
reports as well as background descriptions are provided in those reports and there is no need to
repeat them here. We assume the reader here is familiar with nbn and the relevant industries and
terms of the SAU.
D. Acknowledgement
7. We have read, understood and complied with the “Expert Evidence Practice Note
(GPN-EXPT)” supplied to us by counsel for nbn – Webb Henderson. We agree to be bound by
the terms of the Practice Note. Our opinions are based wholly or substantially on the specialised
knowledge arising from our training, study and experience as described above and in our
curriculum vitae in Exhibits 1 and 2.
8. In our analysis here, we have relied upon our prior reports, several additional
academic works, and certain materials provided to us by Webb Henderson. These materials are
listed in Exhibit 3.
II. FIRMS LIKE NBN CAN BE EXPECTED TO ENCOURAGE TAKE-
UP AND USAGE AND EXPERIMENT WITH PRICING
9. As we have previously explained, nbn’s pricing flexibility is limited by the price
caps imposed by the SAU (the NBN Offers), but nbn has incentives to price in such a way as to
encourage take-up of its services. To be clear, by “take-up” we mean overall usage of its
services, which is a function of both the number of users (the extensive margin) and the intensity
of use (the intensive margin). nbn has incentives to price in ways that will ensure not just usage
of the network (without which nbn will be unable to recover its investments) but also efficient
allocation of limited capacity amongst different users. Multi-part pricing schemes are a common
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means of addressing such issues and we would expect a firm in nbn’s position to experiment
with such schemes.3 We also note that while nbn will price so as to recover its costs in an
expeditious fashion, and, more generally, maximize its expected profits given the constraints it
faces (i.e., the Long-Term Revenue Constraint Methodology or LTRCM, and the Initial Cost
Recovery Account or ICRA), it is important to note that nbn will seek to maximize the present
value of its expected returns, not just its returns on a year by year basis.4 In a dynamic industry,
particularly one displaying network effects, the distinction between short-term and long-term
goals is important.5 Encouraging take-up can yield great dividends down the road. For example,
providing discounts as usage increases on the intensive margin incentivizes offerings with
greater speeds and capacity. Conversely, pricing too high initially can stunt industry
development and make it more difficult for nbn to earn a positive cash flow from its services in
later years. These effects are strengthened when there are network effects present, as each
additional sale increases the likelihood of further sales by increasing the value of the services.

3. For a technical discussion of the efficient pricing of inputs in the presence of scale
economies and differentiated customers, see, e.g., J. A. Ordover and J. C. Panzar, “On the
Nonlinear Pricing of Inputs,” 23 International Economic Review 3 (1982): 659-75.
4. For a detailed discussion of the Long-Term Revenue Constraint Methodology and the
Initial Cost Recovery Account see our prior reports. In the present instance, the relevant
fact is that nbn is subject to price caps but is incentivized to promote uptake and usage of
its network and to reduce costs. More generally, we understand that “nbn is a
commercial entity operating in a market environment and can compete and innovate like
other companies in this environment in accordance with legal and policy parameters” and
that nbn is expected to “operate its business on a commercial basis.” Statement of
Expectations, Shareholder Ministers of NBN Co Ltd., 24 August 2016.
http://www.nbnco.com.au/content/dam/nbnco2/documents/soe-shareholder-minister-
letter.pdf.
5. Technically, the presence of intertemporal network effects implies a higher perceived
elasticity of demand and thus creates incentives for lower prices relative to those that
would be profit maximizing in the absence of such effects.
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Also, sales of higher speed and capacity access products (e.g., products with 100 Mbps downlink
/ 40 Mbps uplink) spur provision and usage of services that take advantage of those access
products, further increasing the demand for higher speed and higher capacity access products.
This is the classic “chicken and egg” problem of network economics. Content developers are
more likely to develop products for which there is a ready base of customers that can take
advantage of those products given their existing access plans, just as customers are more likely to
purchase higher speed and capacity access plans if content is available that takes advantage of
those capabilities. Encouraging uptake and usage of higher speed and capacity access products
not only directly increases usage of nbn’s network, but can be expected to stimulate content
development that will further increase demand for nbn’s network. Conversely, if prices are set in
a way that discourages consumers today from obtaining such access products, that can have a
long-term chilling effect on usage of the network.
10. The NBN Offers serve important roles for both nbn and nbn’s customers. The
SAU as currently structured provides assurance to nbn that its investments will not be
expropriated by regulators, while the NBN Offers provide assurance to nbn’s own customers that
nbn will not expropriate their investments. This assurance to nbn’s customers is valuable to nbn.
For nbn to recoup its enormous sunk investments, it requires successful downstream customers,
and the assurance provided by the price caps in the NBN Offers helps encourage investment by
those downstream customers in the same way that the SAU encourages investment by nbn. The
downward flexibility available provides the ability to further incentivize downstream investment
based on market developments.
11. As a general matter, then, it is clear to us that an entity in a position similar to
nbn, and subject to the similar set of regulatory and market constraints/incentives, would focus
on implementing business strategies designed to ensure its long-run profitability or, at least,
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reaching some reasonable rate of return (or internal rate of return) targets.6 The goals of
promoting efficient evolution of Australian telecommunications infrastructure, ensuring
sustainability of nbn as an operating entity, and avoiding imposition of undue demands on
government budgets (i.e., taxpayers), all require that nbn be permitted (and encouraged) to earn
at least a normal rate of return on its incremental investments and, if possible, make a
contribution towards the recovery of its fixed (and by now, to a large degree, sunk) costs.
12. With respect to pricing behaviors, sunk costs do not go away: they must be borne
by someone. They should be borne by those who cause them – the principle of cost-causality is
a sound one and should be adhered to as much as possible. Pricing structures that reflect usage
of the network are consistent with this principle. (We do note that in Australia there has been a
deliberate policy decision made to include some cross-subsidy built into nbn pricing structure.
Economic pressures will tend to push against cross-subsidies, and their continued existence
should be made explicit and considered a part of the broader telecommunications policy. We
understand that there is a government process being devised that will price these cross-subsidies
and deal with them explicitly through an industry levy.)
13. More concretely, a firm like nbn would be expected to develop pricing strategies
as would any business operated “on a commercial basis,” i.e., to bring it to profitability on the
forward-looking basis, which in this case involves being able to recoup the massive investments
sunk in the network. We expect that this would entail experimenting with price levels and price
structures (e.g., finding the proper balance between fixed and variable components of a multi-

6. We refer here to a normal risk-adjusted economic profit, or rate of return. One of the
risks of investing in a large-scale infrastructure project such as the national broadband
network is that usage will be insufficient to allow the investors to obtain a normal rate of
return on their investment, or potentially even allow recoupment of the principal itself.
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